How to Use "Crayon Drawings" to Make Money Trading (Part 4)

07/29/2010 12:01 am EST

Focus: STRATEGIES

Timothy Morge

President, MarketGeometry.com

(Continued from Part 3)

If price continues higher out of this area, the two probes below the multi-pivot line will be a “wash and rinse,” especially because the second daily bar made a new low for the move. Many traders who had built small long positions in front of the multi-pivot line probably stopped themselves out of their long positions when price made the second probe, which made a new low for the move. And some traders probably left orders to get short if price made a new low by even a cent or two below the prior low. These are the breakout traders looking for the new lows to generate momentum to push prices significantly lower. But this day's close had some of the smarter traders realizing they had stopped themselves out of their long position and price still hadn't begun a new leg lower. In fact, if price has a higher close tomorrow, they'll want to be long. So some of the smarter retail traders went home with a new long position and put their stop loss just under the prior low. If price heads higher the next day, more of these traders will jump on board…and that's how a change in trend begins.

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Price gapped open higher again and ran quite a bit higher. Price has now begun to separate itself from the congestion area, marked with the green ellipse. Sean is long at 16.58 and the close is at 17.20, so his position is moving nicely away from his entry level. His initial stop loss was at 15.03, but now that price has moved well back above the multi-pivot line and the area of congestion, there's no need for him to risk that much money. If price breaks below the prior lows by much, a new leg lower will be unfolding and he'll want to be out of his position at a smaller loss. He decided to snug his stop loss to 16.08, which is 25 cents below the prior low. He is currently risking 50 cents total per share on this position. When I portfolio trade, I call this “collapsing risk.” Price has left a natural area of support and it only makes sense to move your stop loss up to take advantage of this area.

Right above the current price action, the open gap looms large. This can only be a successful trade if the open gap is filled, and open gaps often attract large orders. Will there be whales selling as price nears or enters the open gap zone?

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In one daily bar, price closes the open gap and closes near its high. Price has shown strength just when it needed to. There are two breakaway bars above the area of congestion. At the end of the day, when price closes at 17.50, Sean cancels his stop loss order at 16.08 and replaces it with a breakeven stop order. After testing the key area of support and then showing this much strength, he is no longer willing to take a loss on this trade.

He doesn't ask me what I think of his money management orders, but they are exactly how I would have handled my orders.

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I zoomed back out so we could get view of where price has been and where it is at present. You can see on this chart just how effective the change in behavior line was. When price was testing support, it gave us a wonderful measure of the timing of a likely turn.

And once it was obvious the whales had left large limit buy orders at or near the multi-pivot line, smaller traders turned to buyers—more became buyers each day that price closed higher. But as price heads higher and approaches the magenta-colored, down-sloping rolling chop line, how will price react? Price had no problem filling the open gap; will it show the same strength at the rolling chop line looming overhead?

More tomorrow in Part 5 …

By Tim Morge of MarketGeometry.com

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