A few weeks back, I kicked off the Intelligent Investor Series as part of my weekly commentaries. Th...
Get an Edge, Even Over the Smart Money
01/26/2012 2:00 pm EST
Diagnostic trading aims to find where large market orders are placed in order to get positioned ahead of the inevitable moves to those levels, says Darrell Martin, explaining how it’s done.
My guest today is Darrell Martin. We’re talking about something called “diagnostic investing,” what it is, and how it affects your portfolio. So Darrell, first of all, what is diagnostic investing?
Well, before I even get into what diagnostic investing is, one of the mistakes that traders make is they believe that there’s this magical indicator that if this average crosses this average, then it’s definitely going to be a buy, or definitely going to be a sell.
There’s Fibonacci; there’s Gann; there’s golden ratio; and there’s MACD; and there’s all these other indicators out there. There are a lot of indicators that people use, and a lot of them being the ones that I just mentioned.
See related: There Is No “Holy Grail” Indicator
What diagnostic trading does is steps back instead of saying, “I’m going to be a technical trader,” or “I’m going to be a seasonal trader.” It asks, “What would a technical trader do?”
A technical trader would buy when it hits the 50-day moving average or sell when it hits the 50-day moving average. You don’t know what they’re going to do, but you do know there are a lot of orders going to be placed at these certain points.
When they come together, and a Fibonacci line and a support line and a 50-day moving average are all intersecting, there’s going to be a lot of orders right there.
Well, the market exists for one purpose and one purpose alone. There’s only one thing that drives the market, and that literally is orders.
So, as a trader, if you want to be successful, instead of being the guy that’s trying to guess what’s going to happen when it hits that point, you know it’s going to hit that point. You know it’s going to go to where the orders are located because that’s why the market exists.
Instead of waiting until it gets there, you buy before it gets there, or you sell before it gets there. So if I’m buying before I get to that point, I’m going to take off part of my profit—like, say, half my position—right before that point. If I’m honest with myself, it’s a 50/50 chance once it gets there whether it shoots up or shoots down.
So I put money in my pocket, I’m done to make things easy, but then I take the rest of my position and I move it up to at least breakeven, if not higher, where I can get more profit. If the thing goes to the moon, I get to participate; if it falls, I have nothing to worry about.
In summary, diagnostic investing is about how other traders look at the market and how to use that to be one step ahead when I place my orders instead of one step behind.
You mention charts; obviously, that’s one tool for doing this. Do you look at a depth of market or a Nasdaq Level II to also get a feel for how much order flow is coming in?
Oh, definitely. One of my favorite things is actually to look at the depth of market, where you can see all the prices and you see the contracts sitting at each level.
To give an easy example, if you see there’s a hundred orders sitting at every level, and with this order, there’s 700 contracts. That’s a clue there’s a lot of orders there. Markets like to fill orders.
So if my stop loss on my system says one tick, or pip, or percent in front of that, well, I’d rather be behind that. I may move it up, and not that I’m trying to move my stop because I don’t want to lose money, but I’m trying to move it so I can get myself out of the line of fire. I may move it up a couple ticks to behind that 700.
Now if I’m taking my profit and my system says to take profit and it’s above the 700 orders, well, I want to be in front of the line, not behind it, so I’ll move it down.
So it really does give you an edge because there’s nothing like being a trader and you have your order behind that 700, and it keeps hitting it and hitting it, and you’re just waiting for that one more tick, one more cent so you can make that money, and then you don’t hit it.
So by getting in front of it, it makes it a lot easier to get your fills—or to not get the fill that you don’t want—and it gives you a better probability of being able to make money on a consistent basis.
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