Matthew Kerkhoff, options expert and editor of Dow Theory Letters, continues his 14-part educational...
Using Simple Box Formations for Big Trading Profits (Part 4)
08/05/2010 12:01 am EST
I begin to look carefully at Sean's chart to see if there is a reason for price to run out of downside directional energy where he wants to enter his long trade. Besides the potential for large limit buy entry orders at the top of the open gap, might there be a reason based on price's frequency for price to run out of directional energy here? Or is Sean simply leaning on potential whale tracks and willing to take the trade because it has a very small stop and a great risk/reward ratio?
I start by drawing in an up-sloping multi-pivot line, beginning at a prior swing low that also formed the baseline of a mountain-and this baseline would later become an important multi-pivot line that mapped out the consolidation before price formed the current open gap and box formation above it. This up-sloping multi-pivot line is also a center line. Note how it catches the frequency of price in both of the box formations and how it cuts through the center of the open gap formations. This line seems to catch frequency; let's see if the frequency is found elsewhere on the chart.
I add a parallel up-sloping line that starts at the swing high that forms the same mountain. It's a nice parallel line, one I label an "action line," but will it have any meaning going forward in price and time? The question goes back to "As above, so below." Will "equal and opposite" have any meaning on this chart?
Now I measure the distance from the action line to the center line and project that same distance forward in space and time. To complete the projection of frequency from the up-sloping center line, I add an up-sloping parallel line-the reaction line-at this projected distance.
Now I do what I teach my younger traders to do when evaluating a chart: I slide my chair back a good three or four feet, close my eyes for a few moments to clear my head, and take a clear look at the entire chart. I see the stacked box formations separated by the open gap, and more, I see where the reaction line projects forward in price and time-right where traders just tried (and failed) to fill the open gap.
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When I first glanced at Sean's chart, I wondered if price was simply going to rally slightly and then continue lower in a cascading formation. But this reaction line gave an excellent projection of where price should run out of downside directional energy. Price turned right at the projection! Now let me add Sean's limit entry, exit, and initial stop loss orders to this market map:
Now, there's some noise present in this market, but remember these are daily bars, so this gap has been unfilled for almost a year! The distance between the center line and the action or reaction line is a similar distance, so you have to expect some noise. But all in all, it's a very compelling chart, and I am willing to lean on "As above, so below" until the gap is filled. After spending some time of my own drawing on Sean's chart, I like his entry set up, I love the size of the small stop and the risk/reward ratio, and the chart does project the frequency of price nicely.
I add one other line: I connect the last three swing highs on the right-hand side of the chart. Each is lower and price may have trouble climbing above this down-sloping magenta trend line. Sean used a similar simple trend line to take partial profits in his first live trade, Burger King, and it turned out to be a gorgeous area to take profits. I wonder if he will see this same line (I won't show him because I want to see what he can "see" and how he uses his trading tools).
Nearly two weeks go by before Sean is filled on his open limit buy order. Remember that because he will soon be in school all day long, I do not allow him to watch the markets during the day. He is allowed to check his orders and the day's price action for fifteen minutes at 4:30 pm Arizona time; he can then cancel and replace his orders, do charting homework, and enter new orders if he finds a new trade entry setup he likes that fits his trading style and is within his trading rules.
I get a knock on my trading room door at about 4:35 pm that day-he's long and he's excited! I ask to see his trading plan and a printed chart of his new position (this is a requirement I make of all my students). If you want to talk about a position, you must bring your trading plan and a current chart showing your orders and your interpretation of the current market structure, whether it is an in-person meeting or a virtual mentoring session.
I'm not surprised to see Sean has added the magenta down-sloping line connecting the prior three swing highs and will take profits on half his position if price gets there before stopping him out of his new long position. Sean is excited price did not make a new low for the move, and though I don't say anything to him, I notice that price closes near its lows on a wide range bar. Is this the resumption of the cascade lower? Or does Sean see whale tracks better than most traders? I'll give him this: He is either entering this market at just the right time, when no one in their right mind (other than whales) want to get long and many mid to smaller traders are being stopped out of long positions from higher levels, or he is entering right as price tips off a cliff and begins a freefall that fills a gap that has been unfilled for nearly a year.
But he has a plan, the stop is small compared to his maximum allowable stop, and the risk/reward ratio on his original profit target-if he is not stopped out of this position-is well over ten-to-one! The risk/reward ratio on the first half of the position-selling half just before the down-sloping magenta trend line that connects the prior three swing highs-is better than seven-to-one. He has a plan, he has a position, and his stop and profit orders are in the market. Now he just has to manage his emotions and follow the plan.
More tomorrow in Part 5...By Tim Morge of MarketGeometry.com
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