Volatile Moves in a narrow range

Friday's price action tells us that there is a lot of intra day volatility inside a narrow range. The Nifty is locked in a range between 4940 and 5080 for past eight days. Inside this range, we see big moves on some days giving the impression of volatility. In reality, it is not volatile, but probably random moves inside an indecisive market.

What about my absence? I was in Ahmedabad for two days, on a private visit. I did my CNBC interview on Thursday morning from the city. I received a report from my office giving the basic features of market on Wednesday. Then, at 10:00 AM, the Nifty opened slightly lower. Udayan asked me for my Nifty strategy for the day. That one was easy. Obnly for the day trader - go short with a stop above 5080 and look for a 40 - 50 point downside reaching somewhere around 5000. The Market did almost exactly this.

Why was this easy? On the prior day, Nifty futures moved in a narrow range of 47 points. This was the narrowest in a month. Any break from this range should give some kind of a trading move. When the Nifty opened lower on Thursday, a down move to 5000 support was reasonable to expect.

Traders are well advised to study the process of contraction and expansion in the markets.

Now for responses to comments:

Gaurav asks: "So if we are of the view that India is going to underperfom in coming years...should we tarde other markets like DOW,HANSANG,FTSE etc...what are the advantages and challenges for tarding other markets specialy the FOREX."

My response: Diversifying into other markets will become essential for traders. Forex is an easy option, because you can trade the USD-INR in India, and, trade the many forex pairs on websites abroad. (http://www.interactivebrokers.in/ offers such facilities in Indian Rupees).

Sanjeev asks: "What are the basic principle/assumptions which determines sidewise market ?"

My response: This is a sensible question, but requires a more detailed answer. Basically, market often has periods when it does not exhibit any trend. Visually, on the chart, it becomes possible to define boundaries of support and resistance inside which prices appear to be locked. The Average True Range Indicator will fall to its lows, Bollinger bands will contract (come closer).

Nirav asks: "Can you tell me that what is the difference between Elliott Wave and Normal Wave Count which you normally prefered?"

My Notes; Some differences are:
1. Elliot Waves will always try to find some wave count or the other. Often, the market is not moving in a wave sequence. Momentum waves will identify wave counts only when they are visible.
2. There are possible many rules in Elliot Waves. In momentum waves, we have simple rules, easily understood.
3. Every technical trader can use momentum waves (because they are easy to use), but only specialized wave practioners can trade with Elliot Waves.

How to apply Auto Waves in Trend Analyzer

Get high leverage with low risk

Traders make money from fluctuations in price levels. By using leverage, traders can maximize return on capital. Leverage involves using margin to make more money than you can with your own funds.

Margin trading provides high rewards when you are right, but may also cause huge losses if you are wrong.

Traders are then confronted with some confusion: Leverage or margin trading can enhance return but carries high risk. This becomes a difficult decision since traders should not go for any increase in risk, but should at all times try to leverage their money for more profits.How can these two opposing viewpoints be reconciled.

The Answer:

If margin trading can be used with an always known and strictly limited risk, it becomes High Leverage with Low risk. (HLLR).

The instruments of HLLR are Put and Call options.

Buyers of puts and calls gain an enormous amount of leverage while applying only a small amount of capital. They also have limited and well defined risk.

Advantages of Option buying:

You do not have to possess large amounts of capital. (Remember, all trading activities require that you should be well capitalized.)

As an option buyer you enjoy all the benefits of margin trading when your are right, without the risk associated with leverage, if you are wrong.

Total risk is always known and limited. The maximum risk is the cost of your option.

A Trading Plan:

Successful trading depends on knowledge, courage of conviction, the discipline to execute your plan, and hard work required to develop the knowledge, courage & discipline.

In trading options, you must have the financial and the psychological strength to face adverse situations when they arise. (This applies to all trading methods).

Improve the performance of your Trading System

Trading Systems offer profitable opportunities for making money. The Profit Test feature in Trend Mechanic allows you to test and them implement systems in real time trading. But, all systems go through periods of drawdowns. Often, the periods of drawdown are so severe that the trader abandons the system, or even system trading. While losses are inevitable, here are some suggestions to change the trading style to that we can remain in the business. There are two aspects to trading systems which can be adjusted to increase our chances of winning consistently.

First, we can try to reduce losing trades. This is not possible in a casino, but trading is a mind game, so it is possible in trading. We can try to identify conditions that are more favorable to our winners and include them in our system. We should also identify circumstances where a loser is more likely, and skip those trades. For example, if we notice that most of our winners are entered on days where the overall market has moved in the same direction as our trade, then only enter trades when the overall market is moving in the correct direction. This means that our trade is in the same direction of the overall market, rather than against it.
Another example might be that trades that are entered just before major news announcements, like the union budget or quarterly earnings, often get stopped out as losers due to increased volatility, so you should skip those trades. A study of past trades can be rewarding. It should be possible to identify many patterns of profitable & losing trades.

Second, we try to improve the average size of winners versus losers. Increasing the ratio of profits to losses so that the winners win more on average than the losers lose depends on the way you handle your stops. Having large winners in relation to losers can make up for a low win percentage, and mean that you will still make money playing the game. One method is to have a trailing stop that moves up as a trade becomes a winner. If you have fixed stops for losing trades that limit losses, but trailing stops for winning ones that allow winners to grow, then you are increasing your chances of your average winner being larger than your average loser. Generally it is better to be strict on losers by having ttighter stops that keep losses to a minimum and generous with winners by having stops that allow profits to grow. In any case you want to make losers small and winners large, so never add to a losing trade – that would be doing the opposite of what you want to achieve.

As traders, we should do whatever we can to improve the performance of our trading system, in the manner described here.

Advantages of Systematic Trading

Advantages of Systems Trading:
There are many reasons why futures traders are turning to mechanical trading systems as their primary trading style. One of the biggest mistakes traders make is allowing emotions, excitement or fear, to overpower their logic and control over their trading. With systems trading, the trader relies on the system to select the trades; thus, freeing the trader from the burden of emotional fear and greed decisions.

Why there is NO Perfect System:
Selecting a trading system can be a difficult task. All system results are hypothetical, because they are based on past results and have the huge benefit of hindsight. The disclaimer for hypothetical results typically reads: “Past Performance does not guarantee future results.” Many trading systems seem too good to be true. Smart consumers know that when something looks too good to be true, it usually is.

Although trading systems are designed to select the most statistically desirable trades, they cannot completely or accurately predict market trends and cannot guarantee success. Countless factors contribute to market changes: price, volatility, news, shortages, wars, interest rates, increasing or decreasing money supply, etc. While some systems work in a bull market, some in a bear market, others do best during a choppy market.

What Goes Up Must Come Down:
While there is no system that can consistently assures success, that does not imply that systems trading is never profitable. Trading systems may deliver large profits during certain phases and then provide large losses later. Newton’s law of Gravity tells us that: “What goes up must come down.” Financial markets mimic this by having Bull markets and Bear Markets. Market prices will never continuously move in an upward trend. In the same way, the equity curve of any trading system will never continuously move positively. The equity curve for any high risk investment will fluctuate up and down; there will be winning and losing periods for any system.

While every trader will find himself in a losing period at times, there are strategic moves to attempt to minimize losses. A common strategy is diversification. By utilizing multiple trading systems, the trader is acknowledging that there is no trading system that can consistently make a profit. Many traders choose to use multiple automated systems, so that when one begins to lose during a certain market period, another may profit. The overall performance is not tied to only one set of rules.

Basic Techniques for Multiple Systems Trading: Portfolio vs. Selective

With portfolio systems trading, the “portfolio trader” runs multiple trading systems at the same time. The idea behind this style of multiple systems trading is that if one system suffers a loss then another system will hopefully receive a gain, thus minimizing or eliminating the loss. However, this style not only minimizes losses, but also minimizes profits: if one system is trending upward and profiting while another system is losing, then the losing system will reduce or eliminate the profit. The minimum account size for an individual trader using “portfolio trading” tends to be relatively high, because each system is trading a separate set of contracts each with margin requirements, thus portfolio system trading tends to be used primarily by high volume or high net worth traders.

The selective style falls into the category of multiple systems trading, because the trader utilizes several different systems, one at a time. Selective systems trading is designed to improve the trading performance of the systems based on modifications to the “working time” of any given system in the Market. The basic idea is to switch (turn one system off; turn a different system on) a trading system when the equity curve is expected to stop rising. While the strategy of the “portfolio trader” is to avoid taking major losses by balancing losing trades on one system with winning trades on another, the “selective trader” replaces a system that is losing or predicted to stop winning with a different system. There is no perfect method for predicting downward trends and ensuring consistent profit; profit cannot exist without loss. The process of predicting a downward trend in selective system trading is very complicated and will never be perfect; the goal is to minimize extended losing periods. A hypothetical example is detailed below.

Example: Hypothetical Selective Systems Trading Strategy for Determining when to Change Systems

Basic guidelines:

Switch system when the account has an overall daily loss at the close of the trading day.

Switch system after the account has a 5 consecutive days of overall daily profit.

Conclusion
While there are many advantages to systems trading, it must be acknowledged that there is no perfect system. While we would all like to hope that technology will advance to the point where a perfect system can be created, we must accept that the day may never come. Until that day, we feel the that the best approach is through the simultaneous use of multiple systems with a selective timing approach, so that if one system is not performing the other systems in the portfolio have an opportunity to potentially compensate and make for a smoother equity curve.

Risk Disclosure: Futures, and options trading contains substantial risk, is not for every trader, and only risk capital should be used. Any form of trading, including forex, options, hedging and spreads contains risk. Past performance is not indicative of future results. No representation is being made that any account will or is likely to achieve profits or losses. There have been no promises, assurances or warranties suggesting that any trading will result in a profit or will not result in a loss. Because there are no actual trading results to compare to the hypothetical performance results customers should be particularly wary of placing undue reliance on these hypothetical performance results.

Thoughts on Trading

1. A trade is neither right nor wrong. A trade can only be pofitable or not profitable. a) Profitable is good. b) Unprofitable is bad. Do something!

2. Therapy for traders on a losing streak:
a) Brag about your losses. Tell everybody. Get on the phone!
b) You’ll soon discover that for a losing trade the only thing to brag about is how small you kept the loss, how quickly you stopped the bleeding.

3. The market is uncaring. If you hang on to losing trades, telling
yourself “I’m right, I know I’m right”, the market will reduce your
trading capital down to zero.

4. As an individual trader, you’re competing against guys with PhD.s in math and physics, against giant super-computers.

a) The PhD.s are probably smarter than you.
b) Your computer is no match for the competing computers.
c) Always know where the escape hatch is for each and every trade. How fast can you get through it? Practice!

5. If you start believing that you have some special insight into the market, that you’ve “cracked the code”, discovered “the natural order of the market”, that the market will go where you say, then put your money in Bank Fixed Deposits and take a long vacation. Motorcycle drivers who stay afraid of their machines die of old age. Those who think they are “daredevil charlie” land up in hospitals.

6. The market is a mechanism for transferring wealth. It does so by causing pain. Great wealth transfers in times of great pain. Losses are a way of causing pain. Trading is a business. You go to work in the morning, go home at night, and earn a paycheck at the end of the week. Keep the size of your trades reasonable.

7. Once in a while a sure thing comes along. It’s a good day to skip trading and take a walk on the beach.

8. Getting market direction right is only the first step of a trade.
Selecting the best trade (trading strategy) is the next step. For
example, is it better to go long a put (it will decay against you)?… or to enter a call spread for a credit (it will decay for you)? The answer depends on market conditions. Money management is the 3rd step. Your goal is to make a profit, not show the world. Your profit/loss statement will accurately reflect your trading at the end of every day. Read it carefully. Understand its message.

Overtrading: Are you Guilty ?

The first rule to understand is this: Futures trading may not be suitable for everyone. The risk of loss can be substantial.

One of the most common mistakes made by FNO traders is overtrading.

When you create a trading position which is much larger than justified by your capital, this is overtrading.

What is too large? A simple rule is to ensure that any single loss should not exceed 2% of your trading capital. If your trading positions require you to take a loss which is larger then your volume is too large – you are overtrading.

Here are some psychological signals that you are taking more risk than proper:

Sweating during trading hours while sitting in an AC room

Watching Television but switiching channels hoping that some channel will provide you with “suitable” news

Closing your position at a loss which actually brings you relief, only to see that the market moves in your favor after you exit

Shouting at your spouse, children, office people for no apaprent reason (the real reason is that you are losing money on a large position)

Calling your broker every five minutes seeking assurance that your positions are correctly placed.

This is not the life of your dreams, is it ? The solution is to reduce your volume and trade small. But, you will ask, how can I trade small and make a living ? I will answer this question here.

On trading small volumes:

My thinking is that if you’re a good trader with good ideas, each trade you make isn’t significant. It’s the sum total of a lot of good ideas over a lot of years that will make you wealthy. Everyone is wrong sometimes and what happens If you risk it all (or most of it) on a single trade, and you’re wrong? If what I’m saying makes sense, then trading small makes sense. Good opportunities come along fairly often.

Trading with a small capital

Use the Mini Nifty contract
Trade only in stock futures which have a small value
Learn how to hedge with options

Trading with Market Flow

Learning to trade with the market is a key part of improving trading results. There are many trading systems that work well in some market conditions and not at all in others. There are few, if any, systems that work in all market conditions. Trading results are improved when the trader has a variety of techniques available, and selects the one most appropriate for the current market conditions.

Trading success does not come from finding the Holy Grail; it is the mastery of several different aspects of trading that leads to success. It takes time, effort and money to learn this. Mastering trading, like many other professions is well worth the investment you make.

Consider a two-year period in the Nifty. Buy and hold investors who bought in May of 2001 ended up in pretty much the same place in May of 2003. Strategies with long holding periods showed draw downs during the first half of the period, and gains during the second half. The net result of holding during the 2001-2003 period was essentially breakeven.

Short-term traders could make profits during the first half of the period by using effective shorting strategies, and profits during the second half of the period by using effective long strategies. Trading with the Market requires one to have a variety of strategies that are known to work in different Market environments, and a method for determining which strategy to use.

We have developed a number of different scans that find setups suitable for a variety of different market conditions. There are scans that look for long and short pullbacks, volume accumulation, volume distribution, and various patterns. We have tested these scans in bullish, bearish, and trading range market periods; so we know which ones work best in any given market environment. We make a careful analysis of the current market conditions each evening then select the right tool for the job.

The key to selecting the best trading system to use for current market conditions is determine whether the current market is in a narrow trading range, a wide basing area, or a trend. Once we determine what the current market environment it is we know which of the trading tools to use because we have tested each tool in these different market conditions.

We use trend lines on the NIFTY to determine whether to focus on long or short scans. If the NIFTY is above an ascending trend line, we select tools that perform well in an up trending market. If the NIFTY is below a descending trend line, we select tools that perform well in a down trending market. We have also found moving averages to be effective tools for determining which trading tools to use. Backtesting results indicate that several of our systems respond well to limiting Long Entries to periods when the 30-day zero lag moving average for the NIFTY is moving up.

When the NIFTY broke above the descending trend line in April 2003 it implied that it was time to stop focusing on tools that perform well in down trending markets and select another tool. A trend line break does not imply the immediate start of a new trend. It indicates that something has changed; the market may base awhile then resume the original trend or start a new one. In either case the indication that something has changed in the market indicates that the trader must change with it. The way traders change is to change the tools they are using and their position sizing.

After a trend line break we reduce position size. The reason for this is that swing trading in bases carries more risk than trading in trends, so reducing position size is one way to compensate for this. After the April break of the descending trend line the market bases for four weeks. During this basing period we focus on tools and techniques that have tested well in this type of environment and also continue to trade half size positions. At some point the market will either break above or below the base, and attempt to start another trend. When it does we will trade with the break using the appropriate set of tools.

When the Market is in a clear trend, either up or down, we focus on tools and techniques for Swing or Intermediate term trades. When the Market is range bound , we generally focus on Short Term or Swing trades. The Market conditions tell us which type of trading patterns and techniques to focus on, and the type of trading determines the exit strategies.

Short Term Trading involves taking quick profits on the breakout. We typically exit after 1-2 days, or after a quick pop. This approach can be profitable in range bound markets when the market is only moving up or down a few days at a time. Holding periods of more than a few days in this type of market usually just churn the account.

Swing Trading requires the market to be moving in a large basing range or trending. We place a stop under the low of the setup pattern and close positions as the stock approaches support or resistance. This tends to be more profitable than Short Term trading when the Market is trending or trading in bases that take at least five days to move between the top and bottom of the range.

Intermediate Term trading generally is preferred when the market is strongly trending. We will place an initial stop under the low of the set up pattern and hold while market conditions remain favorable. We will sell when the Stock or the market breaks a key Trend Line or shows signs of topping.

Range bound markets are generally poor places for intermediate term trading. Short term or Swing trading techniques can provide better results. In Narrow bases, where the market moves between the top and bottom in less than four days we limit ourself to short term trading techniques when the market is bouncing off support or resistance, or stand aside. Narrow ranges require quick, decisive action. We just focus on taking a quick profit on the initial move after a trigger.

When the market is in a wide base where it takes at least five days to move between the top and bottom of the range swing trading can be effective. We focus on entering trades when the market is bouncing off support or resistance and avoid taking trades in the middle of the range. The reason for this is trades taken in the middle of the basing area have less time to work out than ones taken on either end. We refer to the middle third of a basing area as the ‘no zone’, and avoid taking new trades in this area.

Intermediate term trading works best when the Market is in a clear up or down trend. We watch for the break of an intermediate or long-term trend line, or a successful retest of a base breakout as possible beginnings of a new trend. We focus on Swing Trading until the market makes a higher low. After a higher low is established we can draw a trend line and consider Intermediate term trading techniques until the trend line is broken.

In order to use Intermediate term trading techniques, the market must be in a clear trend. An up trend usually is not clear until the market has formed a higher low. Until a higher low is formed it is often safer to focus on short term or swing trading rather than intermediate term trading.

Sometimes the market conditions will allow you to use more than one trading style. When the market channels up active traders may use both Intermediate and Short Term Trading techniques. To use short term trading in a channel focus on entering longs as the market bounces off the bottom of the channel, and taking profits as the Market approaches the upper channel boundary.

Successful traders analyze the market to determine the trading system and techniques most suitable to the current conditions. Ignoring market conditions can lead to significant draw down’s for most systems. It is important to have multiple techniques in the traders toolbox that have been tested in bull, bear, and trading range markets, then select the right tool for the current market environment.

Summary

The Market is a strong force that influences the outcome of most trades. Taking all trades generated by a system regardless of Market conditions will likely give you lots of practice at taking draw downs and stop losses. Having different systems that test well for Bull, Bear, and sideways Markets and selecting the right tool for the current Market conditions can improve your results.

Rather than focusing on Short, Intermediate, or Long Term trading consider developing expertise in all three and letting Market conditions determine which set of rules to use.

Why buying on dips is generally a good idea

What The Professionals do, and Don’t Want You To Know

Judging from my email, it is apparent that I have not explained a very important concept very well – one that professional traders DO NOT want you to know about.

Here it is:

You want to be buying stocks on down days in the market – not selling!
You want to be selling stocks on up days in the market – not buying!

I get emails that go something like this:

“Sudarshan, I just bought XYZ stock. Is this a good trade?”

First of all, I can’t predict the future, so I have no idea if it will be a good trade. Second, the stock was bought on a major up day in the market. So, when the market pulls back, it will likely pull the stock with it and this person will get stopped out!

Now, I realize that buying on down days can be psychologically hard to do. After all, those in the media are saying things like this:

“The market sold off hard today as investors are worried about ‘X’.”

“The Nifty is down 100 points today on ‘X’ concerns.”

With all this negativity, it is no wonder why you could be worried! But, you have to learn to ignore the media.

“But what if I buy a stock on a down day and the market continues to sell off?”. Good question, but you could also say the following: “What if I buy on an up day and then the market sells off”!

At least in the first scenario, you got in after a wave a selling has already taken place. That is certainly a lot better than getting in before a wave of selling has taken place!

So…

Wait for a down day in the market. Now run your scans. Look for stocks that are up. Or, if the market is trading at the bottom of it’s intraday range, look for stocks that are trading at the top of it’s intraday range.

You are looking for stocks that have relative strength – stocks that are stronger than the market. Many times, these stocks will just trade sideways until the overall market reverses.

Then you will be sitting pretty. You will have already established a position. Now you can just watch all the novice traders move the stock in your direction.

You NEED these traders to buy after you buy. You NEED these traders to sell after you short.

That is a sensible way to make money trading stocks.

Requirements of Successful Trading

This is not a list of “trading rules”; it’s a list of requirements for successful trading. Most worthwhile truths are simple, and this list contains only five items. Like most rewards life offers, market profits are not as easy to come by as the novice believes. Making money in the market requires a good deal of education, like any craft or business. If you’ve got the time, the drive, and the right psychological makeup, you can enter that elite realm of the truly professional, or at least successful, trader or investor. Here’s what you need:

1. A method.
I mean an objectively definable method. One that is thought out in its entirety to the extent that if someone asks you how you take your decisions, you can explain it to him, and if he asks you again in six months, he will receive the same answer. This is not to say that a method cannot be altered or improved; it must, however, be developed as a totality before it is implemented. A prerequisite for obtaining a method is acceptance of the fact that perfection is not achievable. People who demand it are wasting their time searching for the Holy Grail, and they will never get beyond this first step of obtaining a method.

2. The discipline to follow your method.
This requirement is so widely understood by the true professionals that among them, it almost sounds like a cliche´ . Neverthless, it is such an important cliche´ that it cannot be sidestepped, ignored, or excepted. Without discipline, you really have no method in the first place.

3. Experience.
Paper trading is useful for the testing of methodology, but it is of no value in learning about trading. Why? Because the markets are not merely an intellectual exercise. They are an emotional (and in extreme cases, even physical) one as well. To put it mildly, you will find it impossible to approach your task with the same cool detachment you displayed in your living room. This new situation is real, it matters, it is physical, it is dangerous, other people are watching, and you are being bombarded with stimuli. This is what your life is like when you are actually trading. You know it is real, you know it matters, you must physically pick up the phone and speak to place orders, you perform under the scrutiny of your broker or clients, your spouse and business acquaintances, and you must operate while thousands of conflicting messages are thrown at you from the financial media, the brokerage industry, analysts, and the market itself. In short, you must conquer a host of problems, most of them related to your own inner strength in battling powerful human emotions, in order to trade real money successfully.

There is only one shortcut to obtaining experience, and that is to find a mentor. Locate someone who has proved himself over the years to be a successful trader or investor, and go visit him. Observe not only what he does, but far more important, what he does not allow himself to do.

4. Accept the Fact that Losses Are Part of the Game.

The perfect trading system does not exist. Expecting, or even hoping for, perfection is a guarantee of failure. Speculation is akin to batting in cricket. A player scoring 60 runs in a one day match is good. A player scoring 100 is great. But even the great player fails to hit 60% of the time! He even gets out for low scores often. But he still deserves to be called a good player, because although not perfect, he has approached the best that can be achieved. You don’t have to be perfect to win in the markets, either; you “merely” have to be better than almost everybody else, and that’s hard enough.
Practically speaking, you must include an objective money management system when formulating your trading method in the first place.

How about the last requirement for successful tradiing ?

5. The Mental Fortitude to Accept Huge Gains.

This comment usually gets a hearty laugh, which merely goes to show how little most people have determined it actually to be a problem. But consider. How many times has the following sequence of events occurred? For a full year, you trade futures contracts, making 1000 here, losing 1500 there, making 3000 here and losing 2000 there. Once again, you enter a trade because your method told you to do so. Within a week, you’re up 4000. Your friend/partner/acquaintance/broker/advisor calls you and, looking out only for your welfare, tells you to take your profit. You have guts, though, and you wait. The following week, your position is up 8000, the best gain you have ever experienced. “Get out!”, says your friend. You sweat, still hoping for further gains. The next Monday, your contract opens limit against you. Your friend calls and says, “I told you so. You got greedy. But hey, you’re still way up on the trade. Get out tomorrow.” The next day, on the opening, you exit the trade, taking a 5000 profit. It’s your biggest profit of the year, and you click your heels, smiling gratefully, proud of yourself. Then, day after day for the next six months, you watch the market continue to go in the direction of your original trade. You try to find another entry point and continue to miss. At the end of six months, your method finally, quietly, calmly says, “Get out.” You check the figures and realize that your initial entry, if held, would have made a profit of 450,000.
So what was your problem? Simply that you had allowed yourself unconsciously to define your “normal” range of profit and loss. When the big trade finally came along, you lacked the self esteem to take all it promised. Who were you to shoot for such huge gains? Why should you deserve more than your best trade of the year? You then abandoned both method and discipline. To win the game, make sure that you understand why you’re in it. The big moves in markets only come once or twice a year. Those are the ones which will pay you for all the work, fear, sweat and aggravation of the previous eleven months or even eleven years. Don’t miss them for reasons other than those required by your objectively defined method.

[Excerpts from an article by Robert Prechter]

Be prepared for the trading day!

The process of maneuvering around the financial markets and trading profitably has become an even more difficult task. We must be prepared and equipped with the appropriate tools in order to trade successfully.

The first and most important weapon to obtain is knowledge. As the saying goes, “knowledge is power,” and this is what will initially separate you from the majority of people who try their hand trading the markets. Secondly, proper money management is extremely important and should be taken very seriously in order to survive and play the game for many years. Lastly, preparation before the trading day is something that is mandatory in order to give yourself an edge against those you are competing against. This last tool, preparation, refers to having a trading game plan and knowing what you are going to do given certain movements in the market.

At first glance, preparation may not seem pertinent to succeeding as a trader, but have you ever placed a trade and then come to realize that you did the wrong thing? Or how about this one? The
market makes a huge move in one direction or the other and you are stuck wondering how you should adjust your trade. Instead of reacting immediately, you stop to think and before you know it, the opportunity has passed you by. These are things that should not happen to you and the proper preparation will keep you out of these costly and frustrating situations.

Be prepared for the trading day!

The process of maneuvering around the financial markets and trading profitably has become an even more difficult task. We must be prepared and equipped with the appropriate tools in order to trade successfully.

The first and most important weapon to obtain is knowledge. As the saying goes, “knowledge is power,” and this is what will initially separate you from the majority of people who try their hand trading the markets. Secondly, proper money management is extremely important and should be taken very seriously in order to survive and play the game for many years. Lastly, preparation before the trading day is something that is mandatory in order to give yourself an edge against those you are competing against. This last tool, preparation, refers to having a trading game plan and knowing what you are going to do given certain movements in the market.

At first glance, preparation may not seem pertinent to succeeding as a trader, but have you ever placed a trade and then come to realize that you did the wrong thing? Or how about this one? The
market makes a huge move in one direction or the other and you are stuck wondering how you should adjust your trade. Instead of reacting immediately, you stop to think and before you know it, the opportunity has passed you by. These are things that should not happen to you and the proper preparation will keep you out of these costly and frustrating situations.

Donchian's guide to trading

Richard D Donchian first published his ideas in 1934 to help stock market traders. Donchiian is one of the most respected technicians on wall street, specially in commodities.

General Guides

1. Beware of acting immediately on public opinion. Even if correct, it will usually delay the move.

2. From a period of dullness and inactivity, watch for and prepare to follow a move in the direction in which volume increases.

3. LIMIT LOSSES, ride profits – irrespective of all other rules.

4. Light positions are advisable when a market position is not certain. Clearly defined moves are made frequently enough to make life interesting, and concentration on these moves to the virtual exclusion of others will prevent unprofitable “whipsawing”.

5. Seldom take a position of an immediately preceding three day move. Wait for a one day reversal.

6. Judicious use of stop orders is a valuable aid to profitable trading. Stops may be sued to protect profits, limit losses and to take positions from certain formations such as triangles. Stop orders are apt to be less treacherous and more valuable if used in proper relation to the chart formation.

Breakouts: Follow the momentum

Traders who trade breakouts and breakdowns do so because they are following momentum – a market making new highs or lows.

Trading breakouts and breakdowns requires a trader who can withstand a retracement because stocks that break through key price levels will often come back to test those price levels. While learning the process of trading breakouts, the trader must be prepared for many wrong calls as he/she learns the rules. Once the rules have been learned you will realize that not all breakouts and breakdowns are the same. This will ensure you get less number of calls going wrong.

Breakouts have their foundation in the theory that price will tend to continue in the direction of an expansion of volatility. All trend start with some kind of a breakout. The trader who catches these can ride a trend for a long period, with substantial gains.

Problems with breakouts / breakdowns:


Often, the breakout results in a short term surge which eventually fails. This happens when the breakout occurs in the very last leg of a trend. Immediately thereafter, a correction begins causing losses to the breakout trader. Even if the trend remains intact, the trader may have to sit through a correction holding a losing position.

Selection of breakout / breakdown candidates:

Select charts that show an ongoing trend.

1. The trader should try to identify the type of breakouts or breakdowns that are most likely to follow through then the rewards can be large. Generally a wise breakout / breakdown trader will be looking for strongly trending stocks that consolidate with light volume and clean price action. (Clean price action means a chart with well defined trending moves & shallow pullbacks). Avoid charts where recent price action looks like a whipsawing market.


2. On breakout, price action should suggest a decisive move in the trend direction. The signs can be:

a) Gaps


b) Range expansion (RE)


c) Price moves above Short term averages


d) Green & red Alligator turn in the trend direction


e) Price breaks a previous well defined top or bottom.

Please understand that the presence of any or all of these signs is not a guarantee of a profitable trade. But it does enhance the probability of getting it right.

Anticipating a breakout:

Although as traders we always try to buy at the lowest price and sell at the highest price, being too early on the entry often does not help the breakout / breakdown trader. Entering slightly late, after a breakout or breakdown, is often a better method because at least a trader has witnessed the key price level violated. Yes, that may mean sitting through the correction, but the expansion of volatility principle is working on behalf of the trader.

Trading Breakouts effectively: A short course

This is a short course on breakout trading.

When you think of breakouts, what comes to mind? Stocks making daily highs, two-day highs, weekly highs, all-time highs? As you see, breakout means a lot of things to a lot of people. So, why do so many people lose money day trading breakouts? Why are traders constantly buying stocks when they hit intraday highs, only to have them rollover within minutes. How many times have you shorted a stock on a breakdown through a critical support level, go get coffee, come back and see the stock has bounced and you just bought a five-thousand rupee cofee? Well, this article will give you the “secret” that so many breakout day trading professionals use everyday to take themselves from ordinary to extraordinary.

The ideas discussed here are applicable to breakouts in all time frames. Many of the examples are for day traders or swing traders but the concepts are universal.

Basic Principle. Prices move between contraction and expansion. Contraction represents a trading range or similar area of congestion. A breakout occurs when prices emerge out of contraction. The process of contraction can be considered a period of rest, when either the bulls or the bears are building up their energy. Finally, this energy is unleashed leading to a breakout from a congestion area.

Congestion areas have overlapping bars. Visually, it is often easy to identify well defined support and resistance levels in a congestion since these areas look like a straight line.

Expansion has price bars which do not overlap – they move in any one direction with relatively similar open and close positions.

Rule 1: A false breakout often takes place when there is little or no congestion near the breakout location. Even if the breakout is genuine, prices will often retrace sharply if there is no congestion to the left of the breakout area. On the other side, if the breakout emerges out of nearby consolidation or congestion, this area will act as support, thus avoiding a sharp retracement.

For Short term traders, this pattern is reflected in the opening gap. If the market was consolidating in the previous afternoon, then a gap open has more chances of success / follow through. On the opposite side, if the previous day closed with expansion bars, thern today sees a gap open, there remains the possibility of a sharp intra day correction since there is no congestion to the left of the gap.

Secondary Indicator – Volume. Ideally, volume should increase on expansion bars, decrease on retracements. But this may not always happen, specilaly in short term trading with smaller time frame bars. Always, it is price which is supreme.

Rule 2: A breakout that emerges from a period of contraction is a tradable breakout. The initial target for a breakout should be any previous support or resistance. A moving average on a higher time frame could also be a potential target for a breakout. Stops are always placed slightly below the support area for buys, or slightly above the resistance for shorts.

First Breakout is the initial move out of consolidation. The consolidation may have taken place at the end of a down move, or as part of a period of rest in an ongoing trend.

Retracement is a reverse move towards the intial breakout level. The stock should find support around the previous consolidation and resume its up move. A retracement is a low risk opportunity to enter a breakout.

Next chance is a breakout that occurs after another small period of consolidation. This consolidation should happen near the high recorded in the first breakout. This is another opportunity to catch the breakout.

Rule 3: A breakout that occurs without a nearby consolidation is a high risk trade. A retracement is likely, which can easily shake out the breakout traders. Such trades should be avoided. if this reads like a repetition of rule 1, it is. Example: A stock has seen a high, a deep retracement then a sharp expansion that takes prices above the earlier high – this is an improper trade since there is no consolidation before the breakout. A move above previous highs is not good enough reason to get in the trade, since a sharp pullback can come any time with no support to hold it.

Rule 4: A wide range bar at the point of breakout is a signal that the breakout has strength. A wide range bar shows commitment and has high odds of follow through. If there is no overhead resistance, then a breakout through a wide range bar could go further than expected.

TRADING TACTICS

Monitor charts for breakouts on any time frame. Our favorites are – 5 minute, 30 minute, 60 minute & end of day.

The First Breakout should be a well thought out trade. Examine the quality of the consolidation from which prices have broken out. A wide range bar on breakout is a plus point. A narrow, tight consolidation lasting 8 to 10 bars is better than a consolidation with many wide bars having long shadows. In there is overhead resistance nearby, the breakout may face difficulties. Consider all factors carefuly. If satisfied, buy a breakout from a consolidation area, with a stop below support. Remember, you do not have to trade.

If there is any doubt, it is wiser to wait for a retracement to enter. Sometimes, a runaway market will not retrace at all. In such cases, the trader lets go of the trade. There will be many more opportunities.

The Next chance entry comes after the original breakout has occured. There may be more than one Next chance entry in a trending market. These trades are low risk, since a protective stop can be placed below the small consolidation that offers the next chance.

GAPS:

If the gap is above/below a consolidation area it is more likely to be sustained. If the consolidation is nearby, traders can enter immediately. If the gap is wide, traders should look for a small consolidation after the gap, then enter in the gap direction.

A gap that occurs after an expansion has strong chances of going through a retracement. Of course, there will always be exceptions. But, it is wise to stay away from such gaps. Wait for retracement or Next chance .

ANTICIPATING A BREAKOUT

Should you anticipate a breakout and take an early position ? No. This is not a good idea. What happens if the breakout occurs in the opposite direction, or the stock simply continues drifting ? You will be left with a trade for which there are no trade management plans.

Breakout trading with less whipsaws

Investors trading in breakouts often buy breakouts to new highs or new lows. Many of these breakouts then end up as whipsaws, when the security begins a sharp correction after a sustained trend or reverses the trend itself. If you’re going to be buying breakouts you need to know how you can improve the percentage of winners by identifying stocks that may have a higher probability of success after a breakout. Many technical ideas that can help a trader to do the filtering.

Many filters can be used to screen breaking out stocks for increased reliability of the trend continuing. By using these filters, traders can substantially improve their odds of success in trading breakouts of any kind.

1. The breakout is accompanied by a trend qualifier. In the Level 1 Seminar, we discuss many trend qualifiers – signals that reinforce the trend. Our favorite is RE -Range Expansion. If the breakout day also has an RE or a gap open then so much the better. This could be a real breakout.

2. Breakout stock has higher relative strength verses the Index. This tells us that the stock is outperforming. When a stock breaks out in price and also in its Relative Strength vs. other stocks, it is much more likely to be a true market leader and is more likely to follow through.

3. Breakout-day occurs on strong volume. Strong volume could be defined to mean at least 30% higher volume that its 20 day average, or the highest volume in past 20 days.You definitely want strong volume on the day of the breakout to show significant demand is coming in. Strong volume can also be defined as the very highest volume since the trading range started.

4. Before breaking out, in the trading range, there were signs of accumulation. In its simplest form, an accumulation day is a day that closes higher with the volume also higher than the previous day’s volume. You can also use accumulation distribution indicators to check if the indicator is giving signs of accumulation prior to the breakout.

5. Indicators leading price breakout could be a sign of strength in the stock. This happens when accumulation / distribution or momentum indicators such as the RSI breakout a day or two before prices breakout.
By checking out on such filters, you can screen breakouts to identify the candidates most likely to succeed.

Trading the Wide Range Bar

A wide range bar has a range (High minus Low) which is higher than the average range. Such a bar may be either bullish or bearish depending on where it takes place in the set up. If it comes at the end of a buying climax, it is bearish. However, it is positive if it is breaking out of a formation. Most of the wide range bars have a pull hack on the following bar. The buy zone is in the lower 50% of the range of the bar. Conversely the take profit zone is 50% to 100% added to the high of the wide range bar. This obviously is for short-term trading. The market tends to rotate by having a narrow range bar after a wide range bar. This is not 100% objective and the definition of a wide range bar is subjective. This is where the art of chart reading comes into focus. This talent ia developed only by looking at many charts over a long period of time.

Wide-Range Reversal Bar after Run Up

When the market is moving aggressively up in new high ground and the following actions take place, it is time to move stops closer or take profits:
1. A wide-range reversal bar.
2. A narrow-range or inside bar comes after the wide range bar.
This type action implies supply is entering the market.

TWO-DAY INTERSECTION

Two wide-range bars to the upside that overlap only a small amount indicate aggressive demand for two bars in succession. The intersection of these two bars is a zone of support/resistance . Orders placed around these points can let one get on board with a small risk. Stops would be just outside the zone.

Wide Range Bar as a breakout.

A price breakout from a consolidation with a wide range bar, is a sign of strength.

A chart pattern that Swing Traders 'MUST' trade

The One Chart Pattern That You Must Trade

No, it’s not a cup and handle pattern. It’s not a triangle. And it’s not a head and shoulders pattern.

It’s a First Pullback.

What’s a first pullback?
This is just the first pullback after a significant price event. For example:

The first pullback after a trend line break.
The first pullback after a breakout.
The first pullback after break down (short).
The first pullback after a “kicker” candlestick pattern.
The first pullback after a break to new highs.

(I think you get the idea!)

This is the one pattern that you should hope to find the most – that perfect first pullback scenario that swing traders (and day traders) have come to know and love!

Buying on dips & Selling on rallies with BAT

Buy Weakness and Sell Strength

Buying weakness and selling strength is the art of buying pullbacks. Stocks that are in up trends will pull back offering a low risk buying opportunity and stocks that are in downtrends will rally offering a low risk shorting opportunity.

As a swing trader, you have to WAIT for these opportunities to happen because…

Doesn’t it make more sense to buy a stock after a wave of selling has occurred rather than getting caught in a sell-off?

Doesn’t it make more sense to short a stock after a wave of buying has occurred rather than getting caught in a rally?

Absolutely! If you are buying a stock then you want as many sellers out of the stock before you get in. On the other hand, if you are shorting a stock then you want as many buyers out of the stock before you get in. This gives you a low risk entry that you can manage effectively.

Buying Pullbacks And Shorting Rallies

Where do you buy a pullback and where do you short a rally? You buy them and short them in the Buffer Area for Traders (BAT). This is how you create the BAT:

BAT – The Trading Strategy

The Buffer Area for Traders (BAT) is a buy and sell zone on a chart that swing traders can use to identify possible reversals in a stock.

This is just simply “area” that we look at to see if a stock that is in a strong uptrend, after pulling back to this area, will likely reverse, and, vice versa for down trending stocks.

BAT is the area in between the 10 period moving average and 40 period moving average.. This is where you, as a swing trader look for reversals back to the upside when going long and reversals to the downside when shorting stocks.

For the 10 period, use the Triangular average, while for the 40 period use the Weighted average. But, the actual choice of moving average type is not very significant. It doesn’t matter whether you use sma’s or ema’s. There is little difference between different methods so don’t get caught up in the variations. We are just using these moving averages to create a zone that we will find our entries for long and short positions.

The area between the two moving averages is a buffer. We use the averages to identify the trend. If the 10 day is above the 40 day, the trend is UP. If the 10 day is below the 40 day, the trend is down.

When going long, wait for the decline into the BAT and when going short, wait for the rally into the BAT.

Swing Points

For a swing point low, the first candle makes a low, the second candle makes a lower low, and the third candle makes a higher low. This third candle tells us that the sellers have gotten weak and the stock will likely reverse.

For a swing point high, the first candle makes a high, the second candle makes a higher high, and the third candle makes a lower high. This third candle tells us that the buyers have gotten weak and the stock will likely reverse.

For our long entry strategy, we are trying to find stocks that have pulled back into the Buffer Area for Traders that have made a swing point low.

Now lets look at a stock on the short side. We are looking for a stock in a nice downtrend with the 10ma below the 30ma. Then we wait for a rally into the BAT that forms a swing point high.

A second setup: Consecutive Price Patterns

Many a time, you will notice that a pullback in an uptrend consists of three consecutive down days with lower highs and lower lows. (or two down days and one inside day).

That is what you want to look for in a pullback. You can buy the stock the first time it trades above the previous candle high. This will also complete the swing point low.

In a downtrend, you will see often that the stock has three consecutive up days with higher highs and higher lows (or two up days and one inside day). The fourth candle continues tol makes a higher high and a higher low. The fifth candle finally makes a lower high and a lower low – completing the swing point.

My point in explaining the pullback in a down trend was this : Pullbacks do not have to consist of exactly 3 consecutive up days (for short trades) or down days (for long trades.) Sometimes you will run your scans and find stocks that have more than that.

One final note: When you are looking for swing points to develop, you always want to look to the left of the chart to see if the stock is at a support or resistance area on the chart. That will improve the reliability of this entry strategy.

Ok, now that we know how to get into a trade, how do we get out? We need an exit strategy.

How To Take Profits And Control Your Losses

Your exit strategy consists of two parts: Where will you get out of the trade if the stock does not go in your favor? Where will you take profits if the stock does go in your favor? These are the two questions that make up your exit strategy. You have to be able to answer these questions before you can place the trade!

Part One – Your Stop Loss Order

First, lets put to rest the debate about where or not you should use a physical stop or use a mental stop. A physical stop loss is an order to sell (or buy if you are short) that you place with your broker. A mental stop is YOU clicking the sell (buy) button to get out of the trade. From a technical perspective, it does not matter which type you use.

Before you get into a trade you will have a plan that will determine when to get out of the trade if it does not go in your favor. You are a disciplined trader that always follows your plan (right?). What difference would it make whether or not you have an actual order placed with your broker or if you are going to pull the trigger yourself? There is no difference. In either case, you will get out of the stock when your plan (exit strategy) tells you to!

Personally, I always use physical stop loss orders placed with my broker. This is because I do not want to sit at my computer and look at a monitor all day long! Ok, maybe that’s a slight exaggeration, but you get the point!

Where is your stop going to be? First of all you need a stop that makes sense and you need it to be out of the “noise” of the current activity in the stock.

Look at the average true range of the stock over the past 10 days. If the average true range of the stock is, say, Rs 11, then your stop needs to be at least that far away from your entry price. It doesn’t make any sense to have your stop Rs 3 away from your entry price when the range is Rs 11. You will surely get stopped out prematurely!

For long positions, your stop should go under a support area and a swing point low.

For short positions, your stop should go above a resistance area and a swing point high.

Part Two – Taking Profits

Use trailing stops! This is an easy and unemotional way of exiting a trade. If this trade is going to be a typical swing trade with a holding time of 2-5 days, then you can trail your stops a few rupees under the two day low. (This is the low of the last two days). Once you have spent 2 or 2 days in the trade, tighten the stop to just the previous day’s low.

Note: Initially, on the day of entry, your stop should be based on your stop loss order. the trailing stops come in, on the day your trade becomes profitable.

If this is a first pullback scenario, then you may want to hold this for a longer time frame. Having some big winners every now and then will fatten up your trading account! In this case you can trail your stops under the swing lows (or highs for shorts) until stopped out.

In either case, you should always determine where your stop is going to be and how you are going to take profits before you get into the trade. Have a solid plan in place (write it down). This will take all of the emotion out of the trade. Then you can relax and trade the “map” that you have created. This will make your exit strategy easy to follow and it will put you on the path to success.

What is so special about this zone?

I have found that for swing trading, a lot of reversals happen in this area. So in order to create a focus in your trading strategy, it is helpful to narrow down your potential stock setups to one area on a chart. This zone provides a number of setups on a daily basis.

We are not really concerned with the moving averages themselves. When a stock pulls back into this zone, look to the left to identify support and resistance, trend lines, candlestick patterns, etc. You are looking for multiple signals all pointing in the same direction.

Will this strategy make me a profitable trader?

You may be surprised by my answer.

The answer is no. There isn’t ANY trading strategy that will make you a consistently profitable trader. Sorry to disappoint you. The only thing that will enable you to consistently pull money out of the markets is YOU.

YOU must have discipline. YOU must be able to take losses. YOU must be able to take your profits. YOU must eliminate fear. Put simply, you must be able to control the emotional and psychological problems that prevent success.

That will be your biggest challenge in learning how to trade stocks with any strategy.

CrossOvers - An easy path to swing trading

Apply the tm Alligator indicator to your end of day chart.

Watch for a crossover. A bullish cross over must open below the three Alligator lines and close above them on the same day. We repeat that this should happen on the same day. You may relax the rules a bit, to permit a composite (across two days) cross but to be honest I prefer those that happen all in one day. No hesitation normally means that the stock is going to go up. Note that the direction of the three lines or even their order is not considered.

If you are tracking the market during trading, you can buy before the close. otherwise, buy the next day. Put your stop (mental or actual) below the candle that crossed and let them run.

Exiting a cross over is up to you – I expect 3% to 5% and after that everything is golden. My stop is always just below the crossing bar because the beauty of the cross over is – it works or it doesn’t. I use a close as a trigger to sell the stock. In other words an intra-day move below the candle will not cause me to sell but a end of day close below the candle definitely will. While some traders accept a pull back, I prefer the ones that go straight up.

Such crossovers will not come often. I think, we get one in two months, on an average. But, remember there are many stocks to swing trade, so there should be a stream of such patterns coming in. Remember, patience is the best friend of the trader. And impatience is the reason why many traders go broke instead of rich.

If you are trading in Futures, you can also go for the short sell signals. This will increase the number of signals that come in. A bearish crossover takes place when price opens above the three lines and closes below it. The stop is above the high of the crossover day.

The theory behind the Alligator lines is simple. When the lines converge it suggests that volatility is damping out and when they diverge it suggests that the volatility is excessive and needs to come back. A crossover will normally happen when the lines are converging. The crossover is giving a message that the decline in volartility may be over.

So instead of looking at the three lines as just three more lines on a chart – start looking at them as a function of volatility and they might start making more sense to you.

You may also experiment with replacing the Alligator lines with three moving averages to your end of day chart – the 4, 8 and 21 EMA. I have found the Alligator to be a better method.