3 Things That Define All Great Trades

03/14/2013 12:00 pm EST

Focus: TRADING

L.A. Little

Contributing Editor, Minyanville

L.A. Little is a popular trader, commentator, and speaker at The MoneyShow and Traders Expo. In this interview, we discuss the three things he says define a great trade and what you need to set yourself up for success in trading. We also discuss how he spots areas of supply and demand on multiple timeframe charts and which sector he feels is offering the best trading opportunities right now.

Tim Bourquin: Hello everybody and welcome back to another interview here on the Trader Talk podcast. My guest today is L.A. Little. He's been a speaker at the shows in the past. We're going to talk to him about his approach to the markets and how he finds good opportunities. So L.A., first of all, thanks for joining me over Skype today.

 
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L.A. Little: Thank you so much, Tim. I appreciate being here.

Tim Bourquin: Okay. Because my favorite question to start off with is just describe for us if you will your overall approach to the markets. Are you a technician, a fundamentalist, a little of both, what do you like to do?

L.A. Little: Well, I think the ideal trader/investor is someone who has a decent understanding of both because in the end it comes down to supply and demand and the current price levels. My solid approach is the technical side. That's what I've done for some 30 years. That's where I focus and over the years I've developed my own system that attempts to measure supply and demand as you find it on the charts versus elsewhere.

Tim Bourquin: So what does supply and demand look like on the charts? How do you know what it is?

L.A. Little: Well, the approach actually is an attempt to understand that by looking at key points on the chart, it’s where evidence lies. What I mean by that is if I look at any timeframe and I try to divide charts up into three timeframes like most technicians, what you're looking for are any signs of significance on a particular bar. I usually keep it to about 60 bars per chart, whatever I'm doing, whether it's day trading or swing trading, then I pick timeframes that give me about 60 bars per chart. I look for high volume days, which is common amongst technicians.

I look for wide price spread days, I look for swing points and then I look for the congruence or the overlap between those things to give me zones of where that shows me significance was felt. Then once you have that, what I attempt to do is examine how those zones are tested when price comes, too, and that gives me some sense of whether or not supply is greater than demand or vice versa.

Tim Bourquin: I like the fact that you call them zones because I think so many traders see support and resistance as a point to the tick that something may touch and rebound off of. It seems like traders are always trying to get in early to try and catch that buy and inevitably get stopped because it goes through it or it doesn't quite reach it. So we talk about a zone, are we talking about 50 cents, a dollar within? What do you like to see there?

L.A. Little: Neither. What I'm talking about is whatever the market tells me it is. I don't put a value on that zone in terms of it can only be a price number like 50 cents or 2% or whatever it is. That zone is what the zone is. If it happens to be 10%, then it's 10%. That just changes the way you look at that particular chart and that particular entry and exit because you have a much wider zone that you have to work with.

Tim Bourquin: Now one of the things that you talk about in your charts are candlesticks that are together. Are you a candlestick reader in terms of doji and things like that or not?

L.A. Little: You know, I've traded for many years and I traded all the classical stuff until the last four or five years. As I developed my own system then I pretty much, well it's not that I forgot the classic, well, I still understand it all and certainly the candlesticks, dojis, 3-flight crows, on and on, they have significance. I mean, they're certainly patterns and I like candles versus bar charts because they give you a lot more information, and I think most traders realize that. You can see at a glance where the supply and demands was felt on that particular bar in terms of how to open and close.

NEXT PAGE: How to Find Ideal Trades

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Tim Bourquin: Your book Trend Trading Set-Ups talks about trend trading obviously. Trend trading, I found, means different things to different people these days. What does trend trading mean to you?

L.A. Little: Well, I have a systematic, automated, programmatic view of the market. I was a programmer in my former engineering life and so I've developed a number of applications that automatically assign trend to any that trades that I can pull data for as long as there's volume associated with it. So the programs use a simplistic-type approach to model the market, to model trend.

In the book prior to the one you mentioned, Trend Qualification and Trading, that whole book laid out that system of how do you determine what a trend is, how do you determine when a trend transitions, and it's not difficult. It's just that what you want to do is look at it across all the instruments. Let me back up and do it a different way. If you think about let's just take something like JP Morgan (JPM). JP Morgan trades in the financial sector. The XLF is a good proxy for that sector. That sector trades inside the S&P 500. I want to look at all three of those when I'm deciding what I want to do about JP Morgan, and I want to know what the qualified trends are for all of those across all the timeframes that I'm interested in.

Tim Bourquin: So you want to see the rising tide raises all boats. That's not quite the phrase but you know what I mean.

L.A. Little: Yeah, yeah, yeah. No, you do—there's certainly and in the book that you mentioned the Trend Trade Set-Ups, there is some data analysis. Given my approach to the "defining trend," there's a lot of data analysis in there that does prove that a rising tide lifts all boats.

Tim Bourquin: I notice you spoke recently at a show. What was your workshop about the show? What were you teaching there?

L.A. Little: That particular show was actually a takeoff of the book and you know the book is an attempt to define a methodology for one to discover the great trades, the trades that have the potential to be great. That talk was a highlight of what that book is about, which is how do you know what those things are, what are you looking for, how do you know when they trigger. So the talk was really about how do you find the great trades?

Tim Bourquin: Can you give us an example of some of the things you look for just to get a feel for your ideal trade, if there is such a thing?

L.A. Little: Yeah, sure. No, there are ideal trades and they happen all the time. They happen less frequently than one would probably like but if you're looking at all trades, then you have a much better chance of finding them right and that's why the systematic approach and the programmatic approach. If you think about and we're recording what is this about February 27, I believe, or 26.

Tim Bourquin: Late February, yeah.

L.A. Little: Yeah, and gold had set up, for example, just recently with the great trade. The great trade in that particular case was that gold had formed the ledge and that's the classical technician talk. If I look at the GLD contract as a proxy for it, there were lows around, I think it was around 158, 158 a quarter and that happened to be a swing point and a swing point being what you use to define trend transition. There happened to be a swing point there at that price level on the weekly and on the daily on multiple timeframes.

Usually when you see a swing point tested and violated especially on the way down, the probabilities of a fast, furious move in the direction of the break is a good probability. In that particular case on February 14, gold actually closed under that swing point, and after hours, you could have taken a position in the GLD short and the next day it gapped down about $15, $20. So the conditions were right. The trend of that particular contract was right. You had multiple swing points breaking on multiple timeframes. It closed at that to confirm it. All those kinds of things took place, and there's a number of other characteristics but those are the main ones and they all were there and of course it broke and it broke fast.

NEXT PAGE: Components of a Great Trade

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L.A. Little: You know, it brings up an interesting point. If we define what a great trade is, it really is three things. One is there's the common thing that most people think about, which is the reward to risk. You know, what's that ratio, do I have a 3:1, 4:1 whatever the number is. That's one that most people talk about. But another one that isn't talked about so much is the probability of success. I mean sometimes you can have a trade that's eventually going to be a good trade, except for your timing on entry wasn't very good, and so you'll end up losing on it even though it was the right move. So the probability of success, and what I mean by that, is you're going to have stop parameters and you're going to have target parameters. You want to hit the target before you hit the stop.

So that's the other piece is the probability. The Last one is you really want your money on the table and you want as much as possible on the table on the best setup that you find. So when you put those three things together, that's really what gives you the great trade. You know, don't have your money at risk for very long, probability of success is very high, and your reward to risk is good.

Tim Bourquin: What does your system tell you about profit targets and stop losses? You have a very scientific approach to finding those ideal trades. Do they tell you when to exit as well?

L.A. Little: Sure. I mean, matter of fact, if you go back to what we originally talked about, which it was the anchored resistance and support zones, which are really where you're looking at supply demand, you've got characteristics on each chart of various zones where supply and demand should be filled. Those zones end up being your targets both in terms of stops and in terms of profit taking. So what you're really doing is you're dividing the chart up into areas that you know are areas that you should see either supply come forth or demand come forth if you're going down.

Those are the areas that you want to be sensitive to in terms of where you put your stops, where you have your targets at. That, in fact, gives you that reward to risk characteristics so that you can measure prior to entering a trade where your targets are, where your risk is, and you can determine that piece of it. The probability piece that's where you have to have data that you've done the analysis on that is what the great trade is about. That book it looks at those various probabilities that exist when certain events take place.

Because in technical trading, you really have three things, you got time, price, and volume. What is hard to understand is the price, I mean the time part of it and that's why everybody always has a difficult time with. That's why options are so popular. Nobody knows how long it's going to take. But there are ways of weaving time into all this and one of the ways I talk about in Trend Trade Set-Ups is an engineering concept called mean time to failure.

If you think about it, trend is no different than a light bulb. It comes into existence. It has a useful life cycle, and then it goes away. So if you can look at trend across all instruments and if you can aggregate that, you can create an MTTF a mean time to failure for any trend and you can say this trend has 70% cumulative failure rate. In other words, it's getting long in the tooth and you can bring time into it based on how long it should last.

Tim Bourquin: Let me ask you about that. So, if you're trading on multiple timeframes, and you see there's something at 70% done on an hourly chart, but maybe looks like it's got a long way to go on a daily or even weekly chart, what do you do then?

L.A. Little: Well you take partial profits with the idea of scaling back in when it pulls back on the short term.

Tim Bourquin: Do you like to see most of those timeframes line up to say similar things or does that matter?

NEXT PAGE: What is Neoclassical Trading?

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L.A. Little: Well, the ideal situation is where they're all very young or they're all very old, right? I mean, because then, you know that this thing is very extended if it's very old on all three timeframes, it's a very high number. To me a high number in MTTF from all the analysis I've done is in the 60%-70% range. Some of them get up to 80% and 90% but usually about 70% your nosebleed area. If they're all up there, then you know that there's a good possibility that this thing is going to turn. In that particular case, you definitely want to protect whatever profits you have or potentially be looking for a failure.

Now, that tells you it's been a very strong trend up but that could be the case where that's usually not the great setup on a short because you really want something that's weak. That just gives you a good setup in knowing that you really need to protect what you have because the odds are getting more and more extended that this thing is going to turn.

On the flipside, though, when it's very young whether it's going down in a bearish trend and it's young across all three timeframes or going up in a bullish trend in all three timeframes that's the ideal time that you want to enter something.

Tim Bourquin: Let me switch gears a little bit and talk about some of the things I was reading on your blog recently. You talked about what is neoclassical trading. Can you define that for us?

L.A. Little: Yeah. Neoclassical is really just beyond the classical, and classical was all about patterns. If you look at Edwards and McGee, if you look at almost all the literature that's out there, it's all about patterns, pattern recognition and then there's some -you know, underneath everything is mostly underneath most signals and oscillators and all those things are trend in one form or another. Classical was all about those types of pattern recognition, both in terms of the signal like an oscillator, an MACD, whatever, that type of stuff or not so much or but in my case I'm not really interested so much in the patterns but the levels.

I want to see how price lines up, how it tests support and demand areas that I've identified through the resistance zones or the anchored resistance zones, the anchored support zones and then use that to tie my entry, not a pattern, a breakout on a triangle for example. You know, a lot of times you can break out on a triangle and fail. Why do you fail? Well usually there's some support zone, I mean resistance zone up above you that you didn't recognize. Maybe for some other timeframe, or maybe even on the same timeframe and you just don't recognize it. I think that patterns if one wants to use them certainly combine them with the neoclassical thought of support and demand.

Tim Bourquin: I noticed you also talk on your blog quite a bit or at your website TAToday.com about waves, A, B, C, D that sort of thing. Are you an Elliott wave watcher, as well or is that just the A, B, C, D pattern that is a simple wave pattern?

L.A. Little: Yeah, it's the simple. Matter of fact, that's probably the only classical thing I do because that definitely is more of the classical setup. It's a projection and it's an important projection. I don't really do the A, B, C, D. I mean I really don't do the waves in terms of the five waves like Elliott but it is important to be able to project where a move is going to go and you project that two ways. If you have a left side of the chart where you can look at supply and demand, then of course, you use that. If you don't, which in some cases is true, then you need some way of projecting and A, B, C, D, E extensions are good ways to do that.

Tim Bourquin: One of the things that came up at the New York Traders Expo quite a bit and it has now for at least a year is high frequency trading and the effect on technicians. I heard people say that short-term day trading is just nearly impossible for the retail traders these days and you almost have to become a swing or a position trader to make money as a trader. Do you agree with that?

NEXT PAGE: The Best Trades in 2013

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L.A. Little: No, I don't. I believe that high frequency trading, like any other form of trading, will have some effect, and in particular, this one definitely has an effect. But every time someone comes up with something that displaces the way things were, somebody else will come along and gain it. So eventually, it will take care of itself. I've been asked many times about dark pools and things of that nature and how does that affect in terms of fact that I look at volume. Well, I think all those things are out there. Yeah, they have an effect. The real question is does what you do still work? Do the probabilities play out?

I mean, I did a trade here today on Apple (AAPL), and it was a day trade and Apple was set up with a nice little pattern using the classical sense. But if you look at it from a neoclassical sense, there is a resistance zone at about 440. If Apple was going to break over 440, that resistance zone, again now putting it on a day trader perspective, that resistance zone was going to allow for a quick move in the direction of the break and that is what happened. I suspect that frequency traders are probably doing the same thing. So, as long as you're aligned with supply and demand, it still works. So, I would disagree.

Tim Bourquin: Let's talk about your thoughts on the market here. Where do you think the best trades are coming from early here in 2013 and maybe if you look further ahead than that coming into summer? Do you see sectors or even individual stocks or anything where you think these are some good trading times right now?

L.A. Little: Well, the market has started off again this year as the last two with a strong push out of the gate. I don't want to belabor the supply and demand stuff too much, but you can't forget that the central banks around the world continue to push out money and they continue to prop up anything that has to do with assets. Whether it's a stated goal, a side effect, whatever it is, that money does make its way to the markets.

So as long as that remains part of the landscape, one has to realize that there is artificial demand out there that will continue to push these markets higher until it disappears and that's true of the bond market, that's true of stock market. So from that perspective, I think that and that's what the trend shows, I think that the market will continue to find a way to gravitate towards the upside versus the downside and these downsides first will be short lived and then you'll see buyers come back in because the Fed is still behind everything. It's not just the Fed, you know I always hear the words yeah, the Fed’s behind it, well it's central banks around the world and so it's important to realize that its happening in Europe, it's happening in Japan, it's happening here, it's happening in China, it's everywhere. So that's a big effect.

In terms of what areas this huge area that still, you know, if you look at the various sectors, like the homebuilders last year were the lead sector all year, they're due for a rest. In a bull market, things rotate and if you look around to say where can things rotate, the place right now to me that holds the most promise is the financial sector. That sector is still down about 50% off the 2007 highs. It just did a breakout across multiple timeframes going back to that same idea this year on, if you look at the XLF, you can see the breakout.

Now what it's doing right now as I talk is it's coming back to retest and regenerate, which is another theme that I've put out there, another neoclassical thought. Which is essentially when something breaks out, even if it has the demand characteristics and it shows up in the volume and it's a "confirmed breakout," almost inevitably stocks will come back and sectors will come back to retest that area where they broke out from, and then attempt to regenerate back higher. So what you want to do carefully is watch how that retest takes place, whether or not it holds in that zone that it should. If it does, it's probably going to regenerate higher and I believe the XLF is going to do that. The financials are probably the place to be this year.

NEXT PAGE: What Charts Reflect

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Tim Bourquin: All right good, good tip on that. You know, one of the things that we haven't talked about is the new side of it and maybe it doesn't matter because you are such a strong technician. But we're recording this at the end of February. Yesterday's news for the Dow being down a couple hundred points was the Italian election. It's been was it the Wall Street Journal today. I'm thinking are you kidding me the Italian election that's what they think the markets are affected by? I mean, does that make sense to you? I understand we're a global market these days, but can the Italian election really move the Dow 250 points these days? That doesn't make a lot of sense to me. That sounds like making something up.

L.A. Little: Well Tim, you know, as well as I do the way the market moves many times makes the news. So if the Dow goes down, it could have been somebody in Bolivia doing something, I mean it doesn't matter. They'll find something to tag it on. So whether it's the Italians or whether it's China, you know, one of the premieres said something or maybe whatever it is, something will come out. Something will be tagged as the excuse. It had nothing to do with the Italian elections.

Tim Bourquin: Yeah, that's my thought as well.

L.A. Little: They just need an excuse to go down and the excuse came a week before with the Fed minutes, right, because the drop off the top happened last week. It wasn't this week so last week you had the first sign that there was a little tendency to take some profits, a little profit taking, a little worry off the Fed minutes then you got the big push back up on Friday, which set up the Monday fall.

Tim Bourquin: Does that argue for being a pure technician? I mean it sure makes a lot of sense when they see some people talk about that everything I need to know is in the chart. Maybe I wouldn't put on a trade on right before a non-farm payrolls no matter how much I believed in my technical analysis. Other guys would say I sure would because everything is in the chart. What are your thoughts there?

L.A. Little: Well, the chart is a reflection of what's happened. So you just gave an example of the future and the past. Certainly, the future is unknowable, but the charts give you a decent read on the probability of what's going to happen given the way that they're set up. If the charts were set up properly and from the jobs payroll number ,yeah, I would take the trade. I wouldn't just be dissuaded. Now I may not take the same size as a result of the risk, the headline risk that's there, but if the chart is set up properly, yeah. I mean, you can't jump in and out of everything right. I mean, you got to stick around otherwise you'd never make any money. I mean, it's important to move the portfolio around over time but you can't just avoid every possibility of a problem. You have to take risks somewhere.

Tim Bourquin: Well, L.A., you write some great articles for the Trading Deck at MarketWatch. You've got your own website at TAToday.com. Any other places where our listeners should go to find your stuff?

L.A. Little: I do occasionally write for Minyanville and then in the print magazines. I've always been an admirer of Stocks and Commodities, so I try and contribute there.

Tim Bourquin: All right, great. Well listeners, you can find out more about L.A. Little and his writing at TAToday.com. That's probably the best place to start. L.A., thanks for your time today.

L.A. Little: Thank you so much. It's been a pleasure.

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