The Foundations of Profitability for Traders (Part 3)
03/12/2008 12:00 am EST
I believe there is a third way to exploit order flow, and this style seeks to find areas where the market has little to no liquidity. This lack of order flow tends to create an area with little resistance to movement, and this market environment can deliver quick profits to the astute trader. I call these trades "magnet trades", and over the course of the next few newsletters will try to describe several ways to exploit this particular edge.
In order to understand the psychology behind a magnet trades profitability, we must first look at a representative example. The chart below shows the price action in the S&P 500 Index proxy (Amex:SPY). On this chart we see three moving averages. The green line is a 20 period exponential moving average and the red line is a 40 period exponential moving average. For this magnet trade, we will be focusing on the blue line-a 200 period simple moving average. This is a very commonly followed indicator, and there are many trading constituencies that utilize this roving area of support or resistance to trigger their trades.
The first component of any good magnet trade is a trendless market. As you can see from the chart below, this 5-minute chart of the S&P 500 Index proxy (Amex:SPY) is a market without sponsorship. It drifts up, it drifts down, but there is no technical reason for powerful order flow to enter this market. If price breaks down below the base, that would provide a short signal to many trading constituencies. And if the market rallied up to test the 200sma, that would act as a powerful area of resistance against which to initiate a short position.
|Part 1 | Part 2 | Part 4|
By Bo Yoder, of BoYoder.com