Matthew Kerkhoff, options expert and editor of Dow Theory Letters, continues his 14-part educational...
How to Determine Risk/Reward Ratio on Your Trades (Part 2)
07/21/2009 12:01 am EST
Let's see what tools I can come up with that will help me narrow in on a high-probability trade entry. I zoomed in here so you can see that price has pulled back to test and briefly penetrate the blue, up-sloping lower Median Line parallel, but the pullback was brief. Price is once again making higher highs.
Price fell in a near-vertical fashion, so I know from experience that a specific type of Median Line, the modified Schiff Median Line, will give me the best projection of the likely path of price going forward. I add a modified Schiff Median Line and its parallels from pivots A, B, and C. This new, smaller Median Line should project forward the probable path of price and its upper and lower parallels should give me a good idea of how far away from the Median Line price can oscillate without running out of directional energy. You can think of the Median Line as the anchoring line and think of price as it comes off of the Median Line as a pendulum swinging from that anchoring line. But you have to keep in mind that while the length of the pendulum may contain the length of the downward move, the pendulum can literally slide forward along the anchoring Median Line, so it's not a simple arc movement.
Let's see if there are any other tools I can use to predict a high- probability trade entry:
Price poked below the lower Median Line parallel and then immediately traded higher, making higher highs and higher lows. This immediate rejection of any price action below the lower parallel tells me there are buyers in the area. I draw a line parallel to the Median Line from the low of that poke, and that's called a sliding parallel. If price comes back to test this line and I can afford the initial stop loss, I'll consider a long position entry.
So what do we have working for us?
I have two different techniques that I know produce high-probability trade entries in very similar areas. And price has shown a further sign of strength by trying to break and close below the lower parallel, although failing to do so. In fact, price is now making higher highs and higher lows.
These two techniques give me a zone of confluence, a zone where I’d like to get long if price comes back to test while I still have a reasonable initial stop loss order.
|Let’s see what price does tomorrow in Part 3.|
|Read Part 1 | Read Part 3 | Read Part 4 | Read Part 5|
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