How a Professional Builds a Case for Entering a Trade (Part 2)

08/31/2010 12:01 am EST

Focus: STRATEGIES

Timothy Morge

President, MarketGeometry.com

(Continued from Part 1)

Carl may have been correct in his earlier guess that there were whales with large limit buy entry orders at or around the red, lower multi-pivot line. If you look closely at the last bar on this chart, you will see that price not only tested (or “looked behind the door”) of the red multi-pivot line, it also closed well above, which generally means there were good limit entry buy orders sitting there, which caused the market to bounce as they began to be executed.

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Does this mean the cascade lower is over and Carl missed his potential trade? Not at all. One bar may tell us a little, and the action after that one bar will tell us a bit more, but at the moment, Carl's market map is showing us a cascading downtrend and price is currently testing potential support. To put it simply, it isn't time to trade unless you are one of the whales and have a reason to be buying at or near the level of the red multi-pivot line.

chart

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Carl watches price bounce back from the test of the red multi-pivot line and notes that there probably whales buying in that area. But again, he had no prior knowledge in the form of a prior test of this line to base a decision to attempt a long position. And even though price found buyers in this area, price is still cascading lower. The current market context hasn't changed.

I don't know if Carl pushed his chair back from his desk and looked at this chart from further away (something I do a lot when creating my market maps in order to keep perspective), but look what he wrote: “This fork is HUGE” (He was referring to the blue, down-sloping Median Line and its parallels). Then he added that the “Direction may be right still but this is a 20 minute chart.” And of course, he echoed my earlier comment with, “I bet there are multiple trades on the way down.”

What's he saying here? Price has come down quite a ways, and yet, it is still between the upper parallel and the Median Line. There is lots of room to trade within this Median Line. Price tested its upper parallel, but ever since, it has been an orderly cascade lower, right to the area where price may run into potential buyers. Why would whales be buying at this level? This is a 20-minute chart, but yet you can see that even though the immediate current trend is down (price is rolling down, we'd say), the actual earlier uptrend hasn't yet been damaged. The whales who wanted to get long at lower prices much earlier may still have that same interest! They don't have to chase price higher, and most whales never chase price unless they are stopping themselves out of a losing position.

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Carl has a fairly well detailed market map in front of him, and it seems to be working just fine. He is patiently waiting in the weeds, reading his market map, just waiting for an easily recognizable trade before getting involved. If more traders would exhibit this sort of patience, they would find their trading much more profitable. I'll say it again: There will always be another trade! Wait until you see an entry you recognize before getting involved, and even better, trade with the market when it is rolling. Trading just to make a trade is an addiction, much like gambling. If you find yourself doing this often, you are gambling, not trading. Slow down and look for trades that make sense. 

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Carl's patience and his market map are starting to pay off. If he hurried into a short position and chased price, this bounce may have either hit his stop loss order—or at least his breakeven stop order—and taken him out of his rhythm. Instead, he is looking for a trade entry he recognizes with a quality stop loss order that is hidden behind market structure and has a good risk/reward ratio.

He marked the first swing high that price has been able to break back above, and now he has a quandary: Is this the beginning of a new uptrend, or is this the pendulum pulling back into his sell zone in the current downtrend? How will he tell? He has already built a wonderful market map. He also gave you a clue about his intuition: He wasn't willing to try a long entry where whales might be hiding their limit long entry orders. Instead, he said he was “looking for the layup,” meaning he wanted to trade with the rolling market.

What about the whales’ limit buy orders below? They are now a part of his market map. They were there the first time price tested that area, so he will have to keep that in the back of his mind if price approaches that area again.

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Now Carl thinks out loud: He marked the inner quartile between the blue, down-sloping Median Line and the upper parallel. Price could not hold below this inner quartile, so he is considering it the line of maximum excursion (remember, it has a downward slope). Then he asks, how did we zoom above this line when we were briefly below it? Think carefully about the price action near the lows and see if you can imagine what it would take to get price to zoom out of this hole.

As price made new lows, some traders chased price lower, entering or adding short positions at lower and lower levels. And some traders tried to pick bottoms, were stopped out, but they are still leaning toward holding long positions. When the selling hits the large limit buy orders from the whales, the selling is absorbed and then dries up and both the whales and the traders who had an interest to be long begin to buy. Soon, a rally starts, and price does not have to go too far before those traders who sold in the hole either to establish new short positions or to add to their existing short positions are forced to begin buying just to cover their losing positions or to protect any profit left in their short positions. As Carl said, “How do we get a zoom? We need traders bailing out of positions.”

Carl's last comment is an important one: By the time price seems to have changed to a minor uptrend, the price action is so sloppy on both sides that he stands aside. One of the keys of market context is to be able to instantly assess volatility, as well as changes in behavior. This market has become a free for all, and right now, Carl wants no part of it.

More tomorrow in Part 3…

By Tim Morge, president and founder of MarketGeometry.com

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