Using Simple Box Formations for Big Trading Profits (Part 3)

08/04/2010 12:01 am EST

Focus: STRATEGIES

Timothy Morge

President, MarketGeometry.com

(Continued from Part 2)

Price breaks out of the narrow range to the upside, then note it tries to trade lower back within the range but fails; resistance has become support. The next day, price gaps open much higher and trades higher for two more days before it gaps open higher again. Note that price leaves these gaps open and trades higher, heading right for the middle multi-pivot line. But what will price do when it gets there? Are there limit sell orders waiting, or is the majority of the market caught short?

chart

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Do you think price will head higher, breaking through the middle multi-pivot line? Do you think mid-size and smaller traders got caught trying to sell this market in this sharp rally, expecting the gaps to be filled?

Do you think price will test the middle multi-pivot line and then turn lower after finding a good deal of limit sell entry orders—and perhaps some limit sell orders left by the traders who were able to read price well enough at lower levels to get long for this quick ride higher?

chart

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I am preparing to teach gifted elementary and middle school children across the country this upcoming school year how to use technical analysis to make money trading stocks, so I seem to be spending more and more of my time evaluating stock charts. And of course, I funded my son Sean with a small seed account after his wonderful performance in this same program last year, so I am watching his results with an actual financial interest! The prior charts in this series were prepared by me so that you would have a perspective on this particular chart. Sean knocked on my trading room door after the market closed several weeks ago and told me he was going to put in orders to attempt a long position in this stock.

As has always been the case since I began teaching him, I didn't share my opinions about the actual potential trade; instead, I looked at his use of the trading tools he has been taught, especially the money management tools. I calculated the risk/reward ratio and then internally pondered his logic behind the trade, as well as his areas for entering stop loss orders and profit orders. I told him it was an interesting chart and made sure that if he had limit buy entry orders in the market, he also had actual working stop loss orders in the market for protection, and he assured me he did. As with all traders I mentor, if I find they are trading without “hard” stop loss orders in the market to limit their losses, I no longer work with them. Harsh as it sounds, if Sean violated this rule, I would close his account immediately and our “working” relationship would be permanently ended.

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Sean viewed the upper yellow area as a new box formation and he was impressed that price climbed from one box formation to another, leaving a large open gap on the way, which was still unfilled. He particularly liked that traders tried to push price below the box formation in an attempt to fill the open gap, but this down move was an immediate failure. In his opinion, whales had left large limit buy entry orders at or near the top of the open gap, and he wanted to enter a long position if price headed lower to retest the recent lows.

Sean wanted to buy a retest just above the recent lows, at 53.60, with an initial stop loss order at 53.08. Where did he get his stop loss level? He felt there would be large limit buy entry orders at or near the top of the open gap. If there were enough sellers to push price through to the middle of the gap (the high of the open gap is at 54.17 and the low of the open gap is at 52.00, so the middle of the gap is (54.17 + 52.00) / 2 = 53.085), or if he was wrong and there were very few limit buy entry orders and price made it to the middle of the open gap, he felt it likely they would at minimum fill the open gap to the downside—and this would be a significant change in behavior.

His logical profit target would be just below the multiple highs clustered together, at 58.45.

He would be risking 52 cents on this trade to make a potential $5.37, which means his risk/reward is 537 divided by 52, or just over ten-to-one—a nice risk/reward ratio by anyone's standards. The stop is small by his standards and the risk/reward is very attractive. He liked the trade entry setup, so he entered his limit buy order and his initial stop loss order. Remember, he can't enter a limit sell order to take profits until he has a position, so that order will have to wait.

What do you think about Sean's trade setup and the logic behind it? Do you see what he thinks are tracks left by large limit buy entry orders (“whale tracks”), or do you see a clear break of the boxy formation to the downside?

chart

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As I said earlier, I don't tell Sean or any of my students my opinion of their trade entry ideas; I personally find that when other traders dissect my trade entry idea on a potential trade with me, it changes the clarity or conviction I have of that particular trade, so I will check their money management and make sure they are using their trading tools correctly, but I wait to share my feelings about their trade idea until after the trade has either played out or been discarded because price never let them into the trade.

But I once I've seen Sean's trade entry idea, I am intrigued. To me, it isn't a strong enough reason to go long—at least as he presented the idea on his chart. But maybe he is seeing something he hasn't or can't communicate. For example, maybe his “charting eyes” are good enough to “see” the frequency of price, but he hasn't drawn that in, or perhaps he recognizes the frequency internally, but isn't in the habit of drawing it in or doesn't have the tools to draw it in yet. Remember, I do not teach the elementary and middle school traders about action-reaction lines and Median Lines.

More tomorrow in Part 4…

By Tim Morge of MarketGeometry.com

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