The following image was a part of last week's newsletter article, "Real Opportunity is Found at the Edges of Market Structure".
Following the publishing of that article, I received a great question via email…
"Isn't buying at the lower low (D) just trying to catch a falling knife?
If a downtrend consists of LL’s and LH’s, I don't understand why are you advocating to buy at a lower low in a downtrend?"
This is not catching a falling knife. I'd certainly call it such if I were buying a new low simply because I felt it had moved too far. That is financial suicide. That is not what is occurring here.
I am not a pattern trader. My analysis and trading method are NOT based solely on a mechanical assessment of trend via swing highs and lows.
Instead, I trade the forces of strength and weakness within the price movement itself. I trade the internal forces that go on to create trends and other price action patterns.
You're correct that this is a downtrend. And if I was a simple pattern trader then you're right that trading counter-trend like this would not be considered wise.
But I'd like to think that a professional trader can operate at a level a little more sophisticated than the simple pattern trader. And at times they should be able to recognise a good counter-trend opportunity.
Let's look at the price action from the perspective of strength and weakness; also considering context from the wider market structure.
If this was indeed a strong bearish market then the break at A should lead to strong follow through. But instead the market showed very little conviction in the bearish direction. Look at the following four candles, none of which were able to close to new lows. We have a mid-close range candle, a mid-close range candle, a low close range candle and a high close range candle. There is NOTHING bearish here at all.
The market is finding support. This is not surprising at all given the wider context… as we see that price has moved into the area of the prior day's close.
The following candle is a large red bearish candle… a low close bear… but note that even this supposedly bearish candle is unable to close below the bar three prior.
These are NOT the actions of a bearish market. The market is struggling to go lower.
Still, this alone is not enough to convince me to go long. What I really require is a trap of some kind. Some signal that destroys the final hopes of the bears.
And that is what is occurring at D, as we break above the green candle (high close range).
Having broken lower at A and then stalled, the bears will be under some stress. The large red candle then gives them hope. But that hope is again dashed as the market fails yet again to go lower.
I'm not just "buying a lower low in a downtrend" as you suggest. I'm buying to profit from the pain of the bears.
I'm buying because the market has shown a lack of bearish strength into an area of potential support and then offered a final trap to the bears – a bar that looks like giving hope again, before rapidly trapping them in a losing position from which they must exit. This should have reasonable follow through to the bullish side. At least sufficient to take partial profits and ensure a free trade with the remainder.
This is very different to catching a falling knife.
By far the best traps are those that occur with a trend. So in a bearish trend I will primarily be looking for traps that re-enter me in the bearish direction. But in a weak bearish trend that offers a trap when pushing into an area of potential support, that's a valid long in my books.
Taking an entry like this is a result of a different mindset and a process of skill development.
See here for more:
And of course here.