What I am sharing with you are somewhat random observations about a topic that has been very importa...
How I Stalk My Trades to Find Good Entries (Part 1)
08/09/2010 11:53 am EST
Most traders are focused on entries and are sadly unprepared when it comes to market structure, money management, and framing their trades to give them solid risk/reward ratios and reasonable exit targets. Everyone is afraid they will miss the “big move” and so they focus entirely on complicated entry techniques; techniques that I would contend give them many false signals. To me, simple is better, and often, less is much, much more.
Watch how I stalk a trade using extremely simple lines, solid money management, and favorable risk/reward. I pay strict attention to market structure, down to the detail of how each bar unfolds—the range of the bar, the relative length of the bar, and where the bar opens and closes. If it sounds like work, it is! Trading can be quite tedious, and I would never turn my own capital over to a curve-fit indicator or model—I'll trust simple lines and solid money management over them every time.
Here is a wonderful example of using simple lines to make a market map. You wouldn't leave on a trip to a new destination without a map in your car, would you? You shouldn't trade the markets without first mapping out the major market structure and the defining characteristics of the current market because you may have ideas about where the market is going, but you never know where it is going. Remember that price is always right and price goes where it wants to go.
But there are markers we can read that will show us the likely path of price or show us signs that the market has just done something significant. Learn to pay attention to these signs!
On this chart, price was in a nice orderly downtrend, in a formation I named a “rolling chop” many years ago. It is testing the upper and lower set of simple trend lines that have the same slope. These lines differ slightly from simple channels because of how I found the correct slope and applied these lines. Let me explain: I used the major swing high and connected it to the high of a wide range bar that opened near its low and closed on its low. This type of bar is a marker for weakness. Now look at the next bar: It, too, was a wide range bar and it gapped lower, opening on its high and making a new low for the move. But then it rallied to close on its high, and this is a sign that there are buyers in that area.
Even though price seems to be in a downtrend, I don't ignore that price just made a wide range bar, opened on its highs, and closed on its highs. Instead, I copy the slope of the down-sloping simple trend line drawn from the major swing high and add a new down-sloping line from this wide range that closed on its highs. This bar represents the “buy area” of this market map at the moment, but it's important to understand the buy area moves lower as each bar unfolds, because price is in a downtrend. People who follow my work have heard me state countless times that you have a ten-percent edge when you trade with the trend, i.e. when you trade in the same direction of the slope of the lines on your market map. In a downtrend, support areas (other than support from pure market structure) and profit targets tend to move lower as space and time moves on; the opposite is true in an uptrend.
There's an important line drawn on this chart that I purposely did not name or point out. See if you can identify it!
If price is going to remain in this down-trending rolling chop formation, there's a line price should not significantly violate. The pullbacks to this line are the pendulum swings that define the back and forth action of a moving or rolling market. But what if the pendulum swings go too far?
Do you see the line? What would it take for you to suspect that this rolling chop formation has been violated so far that it is no longer valid?
You should have your market map in front of you and be looking for road signs, as well as signs on the road that trouble may be ahead!
Price opened higher and traded higher all day, closing on its high. Look closely at the dotted green down-sloping simple trend line above which price opened. This line had been defining the rolling chop formation on the top side, but if price was moving in a less-orderly fashion, it would represent what I call the “change in behavior line.” When price opens above this down-sloping line and trades higher, closing above it, it's a sure sign of warning for traders who think the market is in a clear downtrend.
Is the downtrend over? No. No material damage has been done to the overall downtrend. No major swing highs have been broken to the upside, but the rolling chop formation and its trade plan are dead.
More tomorrow in Part 2…By Tim Morge of MarketGeometry.com
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