How to Use “Crayon Drawings” to Make Money Trading (Part 2)

07/27/2010 12:01 am EST

Focus: STRATEGIES

Timothy Morge

President, MarketGeometry.com

(Continued from Part 1)

How can you use the these simple “crayon drawings” to find quality entries? Let's see what Sean has in mind. First, he marked out the market structure map on his chart, and then he waited for price to interact with his map.

chart
Click to Enlarge

Sean is looking for price to “fill in the mountain” and come down to test the multi-pivot line. Although this line has been penetrated, if his order to get long Burger King (BKC) is filled at 16.58, his initial stop loss order will be within his own maximum stop loss size of $2.50 and will also be about 50 cents below the prior major low at 15.61, where he expects there will be large limit buy orders in the market, left by whales to establish new positions.

Now let me add in a zoomed-in chart using some of my charting tools that I have not taught to the “crayon crowd” that may be of some use when evaluating the pluses and minuses of this potential trade:

chart
Click to Enlarge

After price makes a major low at 15.61, it begins to climb out of the hole and then forms the multi-pivot line that Sean is using as his buy area—if price comes back to test it.

As price climbs higher, it has normal pullbacks, as most rallies do in their early stages, then price heads nearly vertically higher and forms double tops before heading back lower in the same near-vertical fashion (this is the “mountain” being formed, by the way). Now note that just before price went higher in a vertical fashion, I added a black, down-sloping simple trend line connecting the lower highs of that corrective swing. I call this the “change in behavior line.” It bisects negative and positive price action. It's easy to see that price went higher in a near-vertical fashion once it broke above this change in behavior line, and while price is above this line, I expect that we will see maintained positive price behavior.

Note that I marked where the change in behavior line and the multi-pivot line formed an area of confluence (where they cross). I often find these areas give a good indication of the time when price may change directions. In this case, price left double tops after going vertical and is headed back lower in an attempt to fill in the base line of a mountain formation (mountains and valleys are two of the simple market structures I teach the crayon crowd). This is the area where Sean wants to get long Burger King stock. Let's keep our eyes on this area marked with a green circle and see if it does give us a good time component for the potential trade entry.

chart
Click to Enlarge

Now you know Sean's entry area and his initial stop loss order. And I added a few of my own charts to give you a feel for what I was thinking (but not pointing out to him) as he showed me his trading plan. At one point, I asked him to show me where he planned on taking profits if price filled the mountain, letting him in, and didn't immediately hit his initial stop loss order.

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One of the key money management tools I teach the crayon crowd is acceptable risk/reward ratios in their trading. Let's look at Sean's chart that outlines his ideas for taking profits on this potential trade:

chart
Click to Enlarge

Though many of you may recognize the magenta-colored, down-sloping lines as a rolling chop, one of the formations I have made popular and have traded quite profitably for more than 30 years, it isn't a formation or market structure that I teach the crayon crowd. I teach them how to draw simple trend lines, and as you can see here, it didn't take Sean long to realize that the slope of connected highs or lows can be part of a powerful measuring tool.

When he showed me this chart, I asked him where his profit target was, and he told me price was cascading lower, a term I use when describing this type of market structure, and that he planned on using two profit targets:

  • His first profit target on half the position would be a handful of cents (i.e. more than five cents and less than 20) below the upper down-sloping line (magenta)

  • His second target for the remaining position would be below the lowest prior swing high, at 18.93. If price climbed that high, he was interested in booking the rest of his profits and looking for a new trade entry

When I asked him about his risk/reward ratio on this trade, he had an interesting answer that those of you trying to build smaller accounts into larger accounts might find interesting. He is trading based on daily bars, and if the market fills his limit buy entry order, he will quickly collapse his risk (unless he immediately gets stopped out), a technique he has seen me use over and over when portfolio trading using daily, weekly, and monthly bars. The initial risk/reward on the first half of his trade is just about one-to-one, assuming price immediately climbed higher to test the magenta line at the 18 to 18.20 area. The risk reward on the second half would be just over 1.5-to-1.

I have said many times that the higher your risk/reward ratio, the lower your risk of ruin. These are the simple truths popularized by those doing work on betting statistics. But when working with smaller accounts or when trading using market structure that often doesn't give you many pivots to work with, you sometimes have to work with what you have, as my mother would say. In longer-term portfolio trading, 'V' bottoms are more common and entry opportunities are often few and far between. I have developed two methods I use hand in hand when portfolio trading: Collapsing risk and dynamic risk/reward ratios. My students at the mid-day mentoring sessions have seen me use these techniques over and over, and Sean has seen them as well.

As I mentioned before, my role is to make certain that Sean prepares himself before a trade is executed and that he follows the hard and fast rules. I may have opinions about one of his trades, but I don't share them, even if he asks. The goal is to see if he can trade using what he has learned and what he is taught, and more important to me, to find out if he enjoys trading enough to consider becoming a full-time professional trader.

More tomorrow in Part 3…

By Tim Morge of MarketGeometry.com

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