How Successful Traders Manage Their Trades (Part 2)

07/07/2009 12:01 am EST


Timothy Morge


Framing this trade made all the difference in the world. When I intraday trade gold futures, I generally use a chart that is made up of bars that contain 1350 contracts per bar, rather than a time-based chart. And I use initial stop loss orders as large as $2.50 per contract but I am always looking for a risk reward ratio of 3-to-1 or higher (in all my trades in all instruments, I never take trades with a risk reward below 2-to-1, but in the instruments I do not trade quite as often, I look for slightly higher risk rewards).

Because I planned to use a much smaller initial stop loss on this trade, it would not take much downside movement to capture a respectable risk reward-but could I identify a logical profit target that was realistic and that would give me a risk reward ratio worth taking this trade and would the potential profit be large enough to justify a trade? Let me clarify this last set of conditions: I could put a $0.10 stop on the trade and look for $0.50 profit per contract, but by the time I add in slippage and the noise of the market, this flawed trade idea would have a respectable 5-to-1 risk reward ratio, but I would never consider taking this trade.

Once I began to frame this trade, the levels became easy to identify: I would use a $1 initial stop loss on this trade; the multiple highs at this area of confluence should hold further limit sell entry orders and they would either hold any rise in price or I would quickly be stopped out for a $1 loss. Seeing the multiple areas of strong support below price made it easy to categorize this trade as a range trade. The goal of this trade would be simple: Enter a short position with a small initial stop loss, ride a selloff in price towards the first area of support and then exit before price tested the first area of support. If all went according to plan, would the range trade be worth the risk?

I would be risking an initial $1 and if price sold off fairly quickly, I should be able to lock in a quick $7 before price ran into the likely limit entry buy orders at the first prior swing low. This meant a simple range trade, if successful, would give me a risk reward ratio of 7-to-1 and a quick $7 in profits-a nice profit in the gold futures. Remember that each gold futures contract controls 100 Troy ounces of gold and the minimum tick of 0.1 per ounce is worth $10, so each $1 move would be equal to $100. If I were able to capture the full value of this range trade, it would translate into $700 profit per gold futures contract, with an initial risk of $100 per gold futures contract (less slippage and commission, win or lose).

I could have executed this trade in the mini-gold futures contract market, which features contract sizes and tick values 1/3 that of the larger 100 ounce gold futures contract, but especially when range trading, I want to trade the most liquid contract, because I trade a large amount of contracts and I want in and out of my position as efficiently as possible. And to be honest, with such a small initial stop loss, this range trade called out for the larger contract. I discussed all these issues as I planned out and framed this gold trade in the Market Maps live session.

Once I was certain I had thought through my trade plan, I wrote it down (no easy feat when also hosting an online session with several hundred people watching live, but something I still do religiously), then I "tweeted" my entry order and initial stop loss order to the trading world, and I sent out a chart of the trade as well using the popular financial twitter based StockTwits network. Let me show you the orders I put into the market:

Click to Enlarge

Let me recap the "frame" of the trade: This is a simple range trade. I want to use a relatively small stop loss order and if successful, get profits out of what I considered to be the easy to identify portion of the range. If prices continued lower, that would be to someone else's benefit. Looking to the left on this chart, I marked the controlling swing of the market. I wanted to get short at a high probability area with a small stop loss and then grab profits from a portion of that controlling swing. When done correctly, this type of trading is near surgical in nature: Get in, get out. Done.

Before entering any orders, I added a new down sloping green Modified Schiff median line and its parallels; it's A pivot was taken from the highest high at 949, it's B Pivot was taken from the lowest prior swing low-just below the low of the controlling swing, and the C pivot was taken from the current area of confluence formed by the multiple tops, the 61.8 percent pullback and the red up sloping outer parallel, now acting as switchback resistance.

This new green pitchfork brought the profit target into focus for me. Here are the orders I entered into the market:

  1. I wanted to sell a test of the energy point, where up sloping and down sloping lines of opposing force meet, right below the cluster of prior highs, at 942.70.
  2. My initial stop loss order would be $1 above my limit sell entry area, which would still place it above the cluster of prior highs. I expected there would be limit entry sellers at or near this cluster of prior highs, but I also felt that if price breached this area to the upside, there would be stop loss buyers and stop entry buyers that would quickly push price higher. I was willing to risk $1 a contract, but not much more; this trade had to work quickly or I doubted it would work at all.
  3. My logical profit target came into sharp focus when I added the down sloping green Modified Schiff median line. I now had an area of confluence formed by two down sloping median lines: This was the area where price should run out of downside directional energy, according to my methodology. I would place my limit buy order, my profit order, just above this area of confluence, at 935.70.

Now let's see if the market filled my limit sell order!

More tomorrow in Part 3. Read Part 1 | Read Part 3 | Read Part 4 | Read Part 5

Timothy Morge

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