Matthew Kerkhoff, options expert and editor of Dow Theory Letters, continues his 14-part educational...
Bring All Your Tools! Part II
08/08/2007 12:00 am EST
In the last article, I showed you EURO/USD 20 minute charts showing this market was in a very strong down trend and had recently experienced a near-vertical fall. I also highlighted a very powerful but simple to use measurement tool that helps me reliably project large magnitude profit targets. Price has been consolidating but I feel it will likely return to its very strong down trend. Now let me introduce another charting tool I find extremely useful:
There is a special consideration here: Price made a near vertical fall and that often gives any and all indicators and lines fits, because it 'skews' the scale of the rest of the price action. Simply said, the vertical fall was abnormally large ranged bars with abnormally large volatility and the bars following the fall are of normal range, with normal volatility. Using abnormal ranges or volatilities and then projecting forward mathematical relationships onto markets that are trading with normal ranges and volatilities generally degrade the precision of your mathematical projections. Again, stated simply, if you use a yardstick to measure the size of a grain of sand, the measurement won't be very accurate.
You can see I added another type of Median Line, one that uses an "A" Pivot shifted from its original position to 1/2 between the high price at Swing High "A" and the Swing Low "B" and also 1/2 between the 'space' measured from Pivot "A" and Pivot "B".
This type of Median Line is named an Schiff Median Line and was developed by Jerome Schiff, a New York based trader that was well known around the kitchen table at Dr. Andrews' home in South Miami. Schiff always wondered if there was a way to know, after a near-vertical move in stocks, when the large one-way move was over. And in his research, he came back to Dr. Andrews with a new type of Median Line that was 'shifted' in a similar fashion to what I have drawn here. His contention was that once price made a vertical down move, if price then climbed back above and made several daily closes above the down sloping Upper Median Line Parallel, it was time to begin to look for trade set ups to get long. After reviewing his research, Dr. Andrews made a few minor tweaks and thus the Schiff Median Line was born [in Andrews 'Action-Reaction Course', it is referred to as the modified Schiff Median Line, because there are still uses for the Median Line Schiff originally presented to Andrews].
Why did I draw this Schiff Median Line? From all the years of experience I have, I know that the vertical move has skewed the relationship between the obvious alternating pivots I am likely to choose when drawing a Median Line that a Schiff Median Line will most likely give me a better indication of the boundaries of where price will run out of up side and down side directional energy--and that's what I need to know to initiate trades!
Price consolidates in a classic Energy Coil as it re-stores the energy it expended making the vertical drop and then slowly climbing out of the hole. Energy Coils and Energy Points generally turn out to be areas where market moves begin or accelerate. The trick, of course, is identifying which direction the market is going to take and then find a repeatable entry pattern to enter with solid money management.
One of my 'bread and butter' entry set-ups is one I call 'test and re-test'. And by this, I mean that once I draw in a Median Line or Trend Line, I want to see price test that line and if it fails to break above a down sloping line, for example, I will then sell the next re-test of that down sloping line if I like the risk reward and money management of the potential trade.
In this chart, you see the 'test' of the red down sloping Upper Median Line Parallel [and remember this is a Schiff Median Line, so even though price had a vertical drop of abnormal volatility, I expect this Schiff Median Line and its parallels to contain price unless the trend changes.
After the 'test' bar, price trades and closes right back within the Energy Coil. I have a short bias in this market, I have now seen the 'test' of the Upper Median Line Parallel, now let me see if I can diagram out a potential trade set up:
Now that I have seen the 'test' of the Upper Median Line Parallel, I'm going to try to use one of my favorite trade entry set ups, the 'test and re-test', to enter this market. I want to sell a retest of the red down sloping Upper Median Line Parallel. To find where price would intersect with this down sloping line, I simply run my cursor over the line one or two bars worth of space to the right of where the current bar is unfolding. That gives me my potential entry price. I could place my entry order slightly below this line, as an aggressive entry, but I find that I like it better when I let the market 'stretch' to re-test the line--and it also makes my initial stop loss entry as small as possible. So I want to sell the EURO/USD at 1.3753 limits.
Now, what about the initial stop loss order? I could simply place a ten-tick initial stop loss order above my entry price, which would give me an initial stop loss order at 1.3763. But looking at the chart, I notice that there are a series of lower highs to the left of the Energy Coil that are right at and slightly above that price. These tops should act as resistance. And of course, it would be even better if I could hide my initial stop loss above Swing High C, because there should be even more sellers just before and at the Swing High.
If I am right about the potential magnitude of the drop that this price should give me [133 pips], I am more than willing to use what I consider to be wider than normal initial stops. I know this market has had some large range bars and I want to be careful that I don't miss this down move because I used too small an initial stop order. I place my initial stop loss order at 1.3775, 20 pips above the price spike that 'tested' the red down sloping Upper Median Line.
And my profit target? I've already done the math for you: I measure 133 pips down from Swing High C and that gives me a logical profit target of 1.3638. If I can take 120 pips out of this market, I'll take my money and run!
This set of orders means I am risking 22 pips to make 120 pips, which is a risk reward ratio of about 5 1/2:1. What about the size of my stop? It's a bit pricey relative to my normal 10-15 pips, but because I perceive this as a very strong down trend and also have what I consider to be a very high probability profit target that gives me such a large potential risk reward ratio that I am willing to accept the size of this stop order.
Well, sometimes price just doesn't cooperate--at least immediately. You can see that price continues to trade within the narrow Energy Coil and has not yet come back to re-test the red down sloping Upper Median Line. And so I am not yet short this market.
Also note that as price consolidates underneath a down sloping line, the re-test area will be lower as time [or space] continues to move forward, so as each bar finishes, I run my cursor over where price would intersect with the red down sloping Upper Median Line Parallel to find where my sell order should be placed. As the intersection changes, I cancel and replace my order. Note that there may be a price where the stop becomes too expensive! Currently, I am working a sell order at 1.3748 and my initial stop loss order remains the same: 1.3775. That means I am now risking 27 pips [an additional 5 pips from my first limit sell order price] and my risk reward ratio is right around 5:1, so it has come down some but it is still a very good risk reward ratio.
I am near the point where I will not be willing to take this trade because of the size of the initial stop--But note that if price continues to trade within this Energy Coil much longer, it will have drifted out of the Upper Median Line Parallel to the right, and I'll then no longer be interested in getting short. It's 'now or never' for this trade set up!
Two bars later, price does indeed test the red down sloping Upper Median Line, getting me short at 1.3748. The bar closes back within the Energy Coil with nice down side separation but because price is now so close to the Upper Median Line, price needs to begin a down move soon or I am in danger of price 'drifting' outside and above this down sloping Upper Schiff Median Line and that would change my view of this entire trade set up.
Once I see my sell entry price print, I check the audit trail on my electronic trading platform to be certain I am filled. Then I double-check that my initial stop loss at 1.3775 is working and in the market. Once I check those, I enter my limit buy order at 1.3638, my profit target. And I make this order contingent or 'OCO' with my stop loss order, so that if one order is filled, the other will automatically be cancelled.
Next Week: We'll watch how this trade unfolds. I'll highlight how I use solid money management and price formations to 'box in' profits as a position moves in my favor. These simple techniques can be applied to stocks, futures and Foreign Exchange in all time frames. I hope you'll join me next week for Part III to see how this trade turns out.
I wish you all good trading!Timothy Morge www.medianline.com
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