The Odds Enhancer Too Many Overlook

05/18/2014 7:00 am EST

Focus: STRATEGIES

Sam Seiden

Chief Education, Products and Services Officer, Online Trading Academy

Sam Seiden explains a trading plan component that is effective in qualifying risk/reward and defining key support and resistance levels, a function that enables traders to take more low-risk, high-probability set-ups.

All market speculators share the same goal, which is to enjoy consistent, low-risk profits. To accomplish this goal, you must be able to identify market turning points, as this is the only way to attain low-risk, high-reward entries into market (trading) positions.

Whether you are a short-term daytrader or a longer-term investor, nothing changes. Identifying key market turning points is the only way to attain the ideal risk/reward opportunity.

Having lead trader education sessions for so long, I have come across many people with varying backgrounds and experience in the markets. Occasionally, I receive an e-mail from a member that is not satisfied with their results and desires better returns. Most of the time, they are not necessarily losing money, but they are not making money.or not making enough money, so they desire more.

One of my first questions to them has to do with strategy. I ask, "Do you have a plan and are you following that plan?" Half the time, the answer is "no," so we dive into creating a proper plan and the importance of following that plan.

The other half says they do have a plan and for the most part, they follow it much of the time. For this group, my questions turn to the details of their plan-the strategy-where I look to see if their rules are proper or not. Sometimes, there is a rule or two that is incorrect, so we correct it.

In my many years of experience, I have found that most of the time, there is one specific and crucial rule that is missing from people's plans more than any other, and that is the focus of this piece.

Before we discuss this rule and its importance, let's first turn our attention back to market turning points. Where are market turning points? Price movement in any and all markets is a function of an ongoing demand and supply equation. Market prices turn at price levels where this simple and straightforward equation is out of balance. Therefore, price in any market turns at price levels where demand and supply are out of balance, which means the strongest turns in price occur at price levels where demand and supply are most out of balance. So, the question for us is this: what exactly does this picture look like on a price chart?

When I ask students this question, they quickly describe the picture of demand that I have shown in articles for years which is a "drop, base, rally." They then describe supply, which is "rally, base, drop." These are the two pictures that clearly show price levels where demand and supply are out of balance, which is what we as market speculators are looking for.

Next, students go right into their rules for entries, targets, and stops, and this is where I stop them because they are ignoring perhaps the most crucial rule that should be included in their trading plan. Drop, base, rally may be the picture of a price level where demand exceeds supply (a demand level), but what exactly is a demand level for you and your trading plan? I find that most people don't quantify this with numbers.

Quantifying exactly what "demand" (or supply) is to you and your plan is a key component to a trading plan that has an edge over other trading plans that don't. We have a number of "odds enhancers" at Online Trading Academy which are key to quantifying and identifying real demand and supply.

To explain this further and dive into the details of one of the most important odds enhancers, let's look at a trade I took recently and shared with XLT students during our sessions.

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The chart above is a daily chart of the euro. In the upper left portion of the chart, I identified an XLT supply level. As you can see, it is clearly a rally, base, drop, and the base is in between the two black demand lines which create our supply zone.

Just because it represents the pattern/picture we are looking for does not at all mean we have a low-risk/high-reward trading opportunity. One of the most important questions that comes next is whether or not there is a significant "profit margin" associated with this demand level, and this is the key odds enhancer most overlook.

chart
Click to Enlarge

The presence of a significant profit margin is key for two reasons. The first is that it quantifies the risk and reward. Second, the larger the profit margin, the higher the probability. This is because a big profit margin means price is far from equilibrium and out at price levels where the demand and supply imbalances are greatest.

The distance between the two black lines is the distance from our entry point to our protective stop loss price. We sell short at the bottom black supply line and place our stop just above the upper black demand line. This measures our risk. The distance between our supply and demand represents our potential profit margin.

Notice the strong rally in the form of big green candles that takes price up to supply for our short entry. That rally "opens up" a profit margin for us, as we are willing sellers when price revisits that level, which it did, offering us our short entry.

Rule: A demand level only becomes a demand level if the initial rally from the demand level is at least three times the demand level (1:3 risk/reward). Meaning, if the distance from entry to stop is two points in a market, the initial rally from that level has to be at least six points or it does not qualify as a demand level for us. I will ignore any demand levels that don't meet this minimum requirement. Just reverse this for supply.same concept and rule.

While I require 1:3 as a minimum requirement for the supply level to actually meet the definition of a supply level, it may be different for you. You may require 1:4 or something else. In this example, the length of the initial decline from supply was much more than three times the distance from entry to stop, and that's good, but we only needed the 1:3.

What this suggested was the probability of price hitting our profit target was very likely. This does not mean that my target has to be at the bottom. It simply means that this opportunity is offering me at least three times the move that I am risking.

Price ended up reaching the target for a low-risk, high-reward trade. One of the most important factors for this successful trade was the length and speed of the initial drop away from the supply level combined with how price rallied back to the level, and this is a rule many market speculators fail to consider.

Read the remainder of this article here.

By Sam Seiden, instructor, Online Trading Academy

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