11/30/2020 The Most Common Market Trap And How To Avoid It.

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The Most Common Market Trap And How To Avoid It.

Fausto Pugliese
May 25, 2006 at 9:00 AM

Updated on Mar 25, 2019 at 5:32 PM

Is trading just a game of cat and mouse? Do we smaller traders – the mice – get noticed nibbling the
cheese (pro ts) on the mouse traps set by the cats (the major player)?

A Game of Cat and Mouse

In my decades of trading, I?ve learned many lessons about the market.  The chief of these lessons is

that I don?t know anything about the market; at least, in comparison to the market makers on Wall

Street.  Think about it.  The traders at rms like Goldman Sachs, Merrill Lynch and the like pull down

salaries of several million dollars each year.  I refuse to believe that they are so richly compensated

because they don?t know anything.  They know a lot!  It?s their job!

As a result, like many individual investors, I engage daily in a game of follow the leader.  In other

words, I nd out what the market makers are doing and then I follow their lead.  If the market maker

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has set a strategy of buying at, say, $10.48 and selling at, say, $10.75, guess what my strategy is?

Of course, I?m not the only one employing this strategy. 

There are literally tens of thousands of us playing this

game of cat and mouse.  I know this to be true because,

over the years, I?ve trained countless investors to do just

that.

The Cats Have Caught On

Sadly, in any game of cat and mouse, some mice are

going to get caught in a trap.  And, sadly, the individual

investor is the mouse in this game.  The truth of the matter is that the market makers are onto us. 

They?ve noticed us nibbling away at their pro ts and are now taking defensive action.  In short, they

are attempting to camou age their actions.  Even worse, in many cases, they will engage in active

deception to make us think they have one strategy (e.g., to buy) when their strategy is just the
opposite (e.g., to sell).

How are they able to pull this off?  In a sense, trading in the market is like playing a game of poker; a
really big game of poker.  The players (at least, the good ones) attempt to keep their cards close to the

vest.  Think about it.  The worst thing you can do in a game of poker is to show your opponents your
cards.  If you do, they will know when they should bet and when they should fold.

The same is true in the trading game.  A market maker with a weak position isn?t going to tip his

hand.  Instead, he?s going to try to bluff you into thinking that he has a strong position.  Likewise,

when the market maker has a strong position, he will attempt to ?slowplay? his hand to sucker you

into making a mistake by betting against him.  Market makers use this same level of deception in the

stock market.

Remember, when you look at a Level II screen like the one below, you get a wealth of information. 

However, don?t be fooled into thinking that you?re getting the whole story.

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In the previous example, we can see that SBSH (Citigroup) is offering to sell 10 round lots at $12.48. 
However, this doesn?t mean that the Citigroup trader doesn?t have more than 10 round lots to sell. 

He might be sitting on 10 or even 100 times that amount.

Obviously, if he were announce to the world that he was sitting on tons of shares, it would negatively

impact the price of the stock.  The players on the bid side of the equation would know that Citigroup

has an excess of inventory and act accordingly.

So how does Citigroup camou age its position?  It?s actually quite simple.  Instead of putting up all

1,000 (or 10,000) lots at the same time, it simply dribbles them out a little at a time.  Every time, the

trader is able to dump a few shares, he immediately refreshes his ask to re ect that he has a few more

shares to sell.

In addition, don?t forget that market makers are free to trade through ECNs, just like you and me.  By

trading through an ECN, they can camou age their position.  In the example above, we see that ARCA

(Archipelago) is looking to sell 721 round lots at the same price.  Who says that some (or even most of
these shares) aren?t held by Citigroup?

As you can see, market makers have multiple options in which to throw you off the scent.  However,

even worse, in some cases, the market makers will do more than just hide their motives.  They?ll trap

you into thinking that they are going one way and then head in just the opposite direction.  The most

popular (and dangerous) of these ?head and shoulder fakes? is for them to use reverse psychology on

you.

Don?t Get Turned Upside Down

If you?re not careful, a clever market maker can get you so turned around that you don?t know up

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from down.  Take a look at the following Level II screenshot:

As you can see, the ask side of the equation is literally lled with sellers.  Three market makers want

to sell at $22.49 and at least another 17 want to sell at $22.50.  Do you think this stock is going to rise
in value?  On rst glance, the answer is ?No.?  There seems to be simply too much sell-side pressure

on the stock.

And you certainly wouldn?t want to go long on this stock.  Even if the stock rises, the next umpteenth

trades are going to be at $22.49 and $22.50.  You have very limited upside potential.  On the other
hand, if the stock reverses course and trades go off at the bid price, the stock could fall to as low as

$21.92.  No one in their right mind would buy a stock with a 2¢ upside when the down side is more
than 50¢, right?

Sadly, this is just what the market makers want you to think.  You?ve taken the bait.  In the example
below, the stock rose to $23.01 in a matter of minutes.  How did this happen?  It?s actually quite

simple.  The market makers set a reverse psychology trap.  They made the average investor think that
the stock was going down by cluttering the ask side with several tiny trades at or just slightly above

the current trading price.  At a casual glance, the typical investor would think that the sell side
pressure was too great and avoid getting in on the action.

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Needless to say, market makers set bid side traps as well.  They will clutter the bid side with many
small orders to purchase at or just above the current stock price.  The average investor will look at all

of this buy-side pressure and think, ?This stock is going to the moon!  I?ve got to get in on it.?  And
sadly, within a matter of minutes, they will see the stock drop sharply.

The market makers knew it all the time, but they needed someone to purchase their shares before
the stock tanked.  Therefore, they created the appearance of a buying opportunity when it was

actually a time to sell sell, sell.  The investors who get caught in such a trap never see it coming.

The Trend is Your Friend

So how do you avoid being one of these investors?  How do you spot a trap?  Well, let?s take another
look at the screenshot from above:

The key to recognizing this trap is to look at the trend lines.  As I like to say to my students, ?The trend
is your friend.?  In this case, the stock was trending upward while the bids and asks made it look like a

loser.  Whenever you see such an inconsistency, watch out!  You?re probably walking into a trap.

To illustrate take a look at the following real-life example I observed:

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At rst glance, this stock looks like a real winner, right?  There seems to be a lot of buy-side pressure. 

There are several market makers looking to purchase shares at $5.45-$5.52.  On the other side of the
coin, the ask side is not nearly as crowded and the prices vary much more; from $5.53-$5.86.  There

doesn?t seem to be too much downside in purchasing the stock and a lot of upside in doing so, right?

Not so fast.  Look at the trend lines on the left.  This stock has been trending downward for the last
two hours.  Want to take a guess at which way the stock went?  You guessed it.  Down!  And quickly. 
By the end of the day, this stock was trading at $5.34.  I don?t want to think about how many people

fell victim to that market maker trap.

A Word to the Wise

You don?t have to be one of these people so long as you remember that the trend is your friend. 

Whenever you?re evaluating the bid and ask prices of a stock to determine where the smart money is,
make sure that it jibes with the current trend.  If the current trend is down but the stock looks like it?s

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going up, be wary.  Be equally wary if the opposite is true.  Remember, in a game of cat and mouse, the

cautious mouse stands a much better chance of avoiding the metal spring of the trap.

Fausto Pugliese
Website

Cyber Trading University was co-founded in 1990 by Fausto Pugliese.  Fausto

was one of the original SOES bandits of the early 1990's.  Fausto was one of the
rst independent traders to take advantage of the Direct Access Trading
technology boom that started in 1987.  He acquired a wealth of knowledge from
years of hands on experience and working side by side with some of the most
experienced successful traders in the industry.As a result of his knowledge and
experience, others immediately noticed his success as a trader in the industry.
Soon after, Fausto was swamped with emails and telephone calls from other
traders who wanted his trading advice. Fausto took pride in sharing his
knowledge and advice with his associates and strangers as well.  As the
questions, emails, letters and phone calls came pouring in, Fausto found himself
overwhelmed with this unexpected responsibility and decided to establish a
university where his knowledge can be shared with others in a more appropriate
environment. As a result, Cyber Trading University was created. Today, Fausto
continues to trade his portfolio in addition to providing training and education
to his students.  His partner continues fuel the ongoing process of improving the
quality and size of CyberTrading University.This school has been educating
individuals in the art of day trading since 1990. Thousands of investors nation
wide have taken our courses and continue to visit our school for continuing
education and updates. These courses are taught by some of the most
experienced day traders in the industry. Our instructors are required to have at
least 8 years of trading experience and must pass a dif cult placement test with
our company before they come aboard. These measures are taken to insure that
our students have a learning experience of the highest quality.

Fausto Pugliese
Cyber Trading University was co-founded in 1990 by Fausto Pugliese.  Fausto was
one of the original SOES bandits of the early 1990's.  Fausto was on...

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View thread (5 replies)

PitBull
Established member
 620  58

May 26, 2006  #2

Glad to see some stuff on Level 2. What is explained is one of my core strategies of using Level 2. If it seems
obvious then be on guard. Wait for the trigger to show that it is a fake and then you're in. Doesn't add up does
it? High of the day and MM's want to sell? Unlikely!!

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SwingDoctor
S Newbie

6 2

May 27, 2006  #3

I enjoyed that article and found it helpful in that it helped illuminate some of the games the MMs play. It also
con rmed my own ndings that I need to use the chart as my main guidance, and be wary of information from
the Level II ordersheet. At least that's what works better for me.

TheBramble
T Legendary member
 8,395  1,170

May 27, 2006  #4

Yes i was a good article. One of the few around on LII. While there is always a higher probability of a trend
continuing than not, LII is also one way to get a 'heads up' when the MMs know it's at the end, and about to
bend!

So what I'm saying is that it's not always going to be a spoof when the situation described in the article occurs -
just more often than not.

Good to read some plains-peak about a topic that doesn't get nearly enough open coverage.

Swap
S Newbie

3 0

May 29, 2006  #5

Brilliant article, spot on in fact. I'm sure this will help any
beginners on L2; a control check for any strategy in determing
entry & exit points.

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DaveD78
D Newbie
6 0

Oct 30, 2012  #6

A real way to make money

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