THE NEW TRADING OF A LIVING- PRACTICAL DETAILS

THE NEW TRADING OF A LIVING


PRACTICAL DETAILS

Will you be buying stocks that break out to new highs? Shorting double tops? Buying pullbacks? Looking for trend reversals? Those approaches differ from each other, and you can make or lose money with each of them. You need to select a method that makes sense to you and feels emotionally comfortable. Choose what appeals to you, what matches your abilities and temperament. There is no such thing as generic trading, any more than there is a generic sport. To find good trades, you need to define the pattern you want to trade. 

Prior to using any scan, you need to have a crystal-clear picture of what it should look for. Develop your system, and test it with a series of small trades to make sure you have the discipline to follow your signals. You have to feel certain that you’ll trade the pattern you’ve identified when you see it. Different styles of trading call for different entry techniques, different methods of setting stops and profit targets, and very different scans. Still, there are several key principles that apply to all systems.

How to Set Profit Targets: “Enough” Is the Power Word

Setting profit targets for your trades is like asking about pay and benefits when applying for a job. You may end up earning more or less than expected, but you need to have an idea of what to expect. Write down your entry level, profit target, and stop for every planned trade in order to compare your risk and reward. Your potential reward should be at least twice as big as your risk. It seldom pays to risk a dollar to make a dollar—you might as well bet on color at a roulette table.Having a realistic profit target and a firm stop will help you make a go/no-go decision for any trade.

Early in my trading career I didn’t think of profit targets. If anybody asked me about them, I’d answer that I didn’t want to limit my profit potential. Today, I would laugh at such an answer. A beginner without a clear target price will feel increasingly happy as his stock goes up and more despondent as it grinds down. His emotions will prime him to act at the worst possible times: continue to hold and add to his longs at the top and sell out in disgust near the bottom.


FIGURE  VRSN with 13- and 26-day EMAs, the Impulse system, and a 4% envelope. MACD 12-26-9.

When calculating a trade’s profit potential, we run into a paradox. The longer your expected holding period, the bigger the profit potential. A stock can rally much more in a month than in a week. On the other hand, the longer your holding period, the higher the level of uncertainty. Technical analysis can be quite reliable for shorter-term moves, but many unpleasant surprises will occur in the longer run. The holding period for position trades or investments is measured in months, sometimes years. 

We may hold a swing trade for a few days, sometimes weeks. The expected duration of a day-trade is measured in minutes, rarely hours. Moving averages and channels help set profit targets for swing trades. They also work for day-trades; only there you need to pay more attention to oscillators and exit at the first sign of a divergence against your trade. Profit targets in position trading are usually set at previous support and resistance levels.


FIGURE  EGO 25- and 5-minute charts with 13- and 26-bar EMAs, the Impulse system, and Autoenvelope. MACD 12-26-9. 

The three targets mentioned above—moving averages, channels, and support/resistance levels—are fairly modest. They don’t have you shooting for the moon, but are realistic. Keep in mind that “enough” is a power word—in life as well as trading. It puts you in control, and by getting “enough” in one trade after another, you’ll achieve excellent results over time.

How to define “enough”? I believe that moving averages and envelopes, along with recent support and resistance levels can show us what would be “enough” for any given trade. Let me illustrate this with several examples: one a swing trade, another a day-trade, and the third a long-term investment. VRSN was a fairly common example of a modest swing trade: entering near one of the channel lines and taking profits in the value zone between the two moving averages. This isn’t elephant hunting; this is rabbit hunting, a much more reliable activity.

The EGO day-trade buying a pullback into the value zone during an uptrend, with a profit target at the upper channel line. I used an oscillator to speed up my exit when the market wouldn’t let me exit at the initial target. “Fallen angels” is the name of a scan I use to look for possible investment candidates. It marks stocks that have fallen over 90% from their peaks, stopped declining, bottomed out, and slowly began to rise. A stock that had lost 90% of its value has every right to die, but if it chooses to live, it’s likely to rally.


FIGURE  IGOI with 13- and 26-day EMAs, the Impulse system, and a 4% envelope. MACD 12-26-9.

The best time to look for “fallen angels” is when a bear market starts showing signs of bottoming. That’s when you find many candidates that survived bear attacks and are starting to get up from the floor. This example shows an old bull market darling IGOI that got badly mauled but stopped declining and began to rise. The weekly chart shows two prior attempts to return to the multiyear peak area.Each of those rallies retraced just about half of the previous bear market. Is this going to be an easy trade? Far from it. 

First of all, the latest bottom was near $2, and if you place your stop there, your risk per share will be quite high, and you’ll have to reduce trade size. Also, the expected rally may take anywhere from a few months to several years to get going. Are you prepared to wait that long, with your capital tied up? Last but not least, the volume of this stock is low. It will rise if prices rally, but if the rally fizzles out, selling will not be easy. Taking all these factors into account, you can see how hard it is to buy for the long haul.

How to Set Stops: Say No to Wishful Thinking

A trade without a stop is a gamble. If you’re after thrills, better go to a real casino. Take a trip to Macao, Las Vegas, or Atlantic City, where a gambling house will serve you free drinks and may even comp you a room while you’re having fun. Gamblers who lose money on Wall Street receive no freebies.

Stops are a must for long-term survival and success, but most of us feel a great emotional reluctance to use them. The market reinforces our bad habits by training us not to use stops. We all have been through this unpleasant experience: you buy a stock and set a stop that gets hit and you exit with a loss—only to see your stock reverse and rally just as you originally expected. Had you held that stock without a stop, you would’ve profited instead of losing. Getting repeatedly whipsawed like that makes you feel disgusted with stops.

After several such events, you start trading without stops, and it works beautifully for a while. There are no more whipsaws. When a trade doesn’t work well, you get out of it without a stop—you have enough discipline. This happy ride ends after a large trade starts going bad. You keep waiting for it to rally a bit and give you a better exit, but it keeps sinking. As the days go by, it inflicts more and more damage on your account—you’re being chewed up by a shark. Soon enough your survival is in danger, and your confidence is shattered.

While you trade without stops, the sharks circling the perimeter of every account grow bigger and meaner. If you trade without stops, a shark bite is only a question of time. Yes, stops are a pain—but using them is a lesser evil than trading without them. This reminds me of what Winston Churchill said about democracy: “It is the worst form of government except all the others that have been tried.” What should we do? I suggest accepting the irritation and the pain of stops but focusing on making them more logical and less unpleasant.

Place Stops outside the Zone of “Market Noise”

Put a stop too close and it’ll get whacked by some meaningless intraday swing. Put it too far, and you’ll have very skimpy protection. To borrow an engineering concept, all market moves have two components: signal and noise. The signal is the trend of your stock. When the trend is up, we can define noise as that part of each day’s range that protrudes below the previous day’s low. When the trend is down, we can define noise as that part of each day’s range that protrudes above the previous day’s high.

SafeZone stops are described in detail in Come into My Trading Room. They measure market noise and place stops at a multiple of noise level away from the market. In brief, use the slope of a 22-day EMA to define the trend. If the trend is up, mark all downside penetrations of the EMA during the look-back period (10 to 20 days), add their depths, and divide the sum by the number of penetrations. 

This gives you the Average Downside Penetration for the selected look-back period. It reflects the average level of noise in the current uptrend. You want to place your stops farther away from the market than the average level of noise. That’s why you need to multiply an average downside penetration by a factor of two or greater. Placing your stop any closer would be self-defeating.

When the trend, as defined by the EMA slope, is down, we calculate SafeZone on the basis of upside penetrations of the previous bars’ highs. We count each upside penetrations during a selected time window and average that data to find the Average Upside Penetration. We multiply it by a coefficient, starting with 3, and add that to the high of each bar. Shorting near the highs requires wider stops than buying near quiet, sold-out bottoms.

Like all systems and indicators in this book, SafeZone is not a mechanical gadget to replace independent thought. You have to establish the look-back period, the window of time during which SafeZone is calculated. You also need to fine-tune the coefficient by which you multiply the average penetration, so that your stop goes outside the normal noise level. Even when not using SafeZone, you may wish to follow its principle of calculating an average penetration against the trend that you are aiming to trade—and putting your stop well outside the zone of market noise.

Don’t Place Your Stops at Obvious Levels

A recent low that sticks out like a sore thumb from a tight weave of prices draws traders to place stops slightly below that level. The trouble is most people place their stops there, creating a target-rich environment for the running of stops. The market has an uncanny habit of quickly sinking back to those obvious lows and triggering stops before reversing and launching a new rally. Without trying to assign blame for raiding stops, let me suggest several solutions.

It pays to place your stops at non-obvious levels—either closer to the market or deeper below an obvious low. A closer stop will cut your dollar risk but increase the risk of a whipsaw. A deeper stop will help you sidestep some false breakouts, but if it gets hit you’ll lose more. Take your pick. For short-term swing trading, it generally pays to place your stops tighter, while for long-term position trades, you’d be better off with wider stops. Remember “the Iron Triangle of risk control”—a wider stop demands a smaller trade size.

One method I like is Nic’s stop, named after my Australian friend Nic Grove. He invented this method of placing a stop not near the lowest low, but at the second lowest low. The logic is simple—if the market is sliding to its second lowest low, it is almost certain to continue falling and hit the key low, where the bulk of stops cluster. Using Nic’s stop, I get out with a smaller loss and lower slippage than would occur when the markets drop to more visible lows.

The same logic works when shorting—place your Nic’s stop not “a tick above the highest high” but at the level of the second highest high. Let’s review some recent examples of both longs and shorts. You may want to explore several different systems for placing stops, such as Parabolic, SafeZone, and Volatility stops, . You can get fancy or you can stay plain, but keep in mind the most important principles: first, use stops; and second, don’t place them at obvious levels, easily visible to anyone looking at that chart. 

Make your stops a little tighter or wider than average— stay away from the crowd because you don’t want to be an average trader. For the same reason, avoid placing stops at round numbers. If you buy at $80, don’t place a stop at $78 but at $77.94. If you enter a day-trade at $25.60, don’t place a stop at $25.25—move it to $25.22 or even $22.19. Round numbers attract crowds—put your stop a little farther away. Let the crowd take the first hit, and perhaps your own stop will remain untouched.

Another method, popularized by Kerry Lovvorn, is to use Average True Range (ATR) stops. When you enter during a price bar, place your stop at least one ATR away from the extreme of that bar. A two ATR stop is even safer. You can use it as a trailing stop, moving it at every bar. The principle is the same—place your stop outside the zone of market noise.

One of the advantages of using trailing stops is that they gradually reduce the amount of money at risk. Earlier we discussed the concept of “available risk”. As a trade followed by a trailing stop moves in your favor, it gradually frees up available risk, allowing you to make new trades. Even if you don’t use SafeZone or ATR stops, be sure to place stops at some distance from recent prices. 

You don’t want to be like one of those fearful traders who jam their stops so close to current prices that the slightest meaningless fluctuation is certain to hit them. The concept of signal and noise can help you not only place intelligent stops but also find good entries into trades. If you see a stock in a strong trend but don’t like to chase prices, drop down one timeframe. 


FIGURE Daily charts with 13-day EMA, the Impulse system, and MACD-Histogram 12-26-9.


For example, if the weekly trend is up, switch to the daily chart, and you’ll probably see that once every few weeks, it has a pullback below the value zone. Measure the depths of several recent penetrations below the slow EMA to calculate an average penetration. Place a buy order for the day ahead at that distance below the EMA and keep adjusting it every day. You will use a splash of noisy behavior to get a good entry into a trend following trade.

Don’t Let a Winning Trade Turn into a Loss

Never let an open trade that shows a decent paper profit turn into a loss! Before you put on a trade, start planning at what level you’ll begin protecting your profits. For example, if your profit target for that trade is about $1,000, you may decide that a profit of $300 will need to be protected. Once your open profit rises to $300, you’ll move your protective stop to a breakeven level. I call that move “cuffing the trade.”

Soon after moving your stop to breakeven, you’ll need to focus on protecting a portion of your growing paper profit. Decide in advance what percentage you’ll protect. For example, you may decide that once the breakeven stop is in place, you’ll protect a third of your open profit. If the open profit on the trade described above rises to $600, you’ll move up your stop, so that the $200 profit is protected.


FIGURE  S&P 500 and a 20-day New High–New Low Index. 

These levels aren’t set in stone. You may choose different percentages, depending on your level of confidence in a trade and risk tolerance. As a trade moves in your favor, your remaining potential gain begins to shrink, while your risk—the distance to the stop—keeps increasing. To trade is to manage risk. As the reward-to-risk ratio for your winning trades slowly deteriorates, you need to begin reducing your risk. Protecting a portion of your paper profits will keep your reward-to-risk ratio on a more even keel.

Move Your Stop Only in the Direction of Your Trade

You buy a stock and, being a disciplined trader, put a stop underneath. That stock rises, generating nice paper profits, but then it stalls. Next, it sinks a little, then a bit more, and then goes negative, inching towards your stop. As you study the chart, its bottom formation looks good, with a bullish divergence capable of supporting a strong rally. What will you do next?

First of all, learn from your mistake of not having moved up your stop. That stop should have been raised to breakeven a while ago. Failing that, your options have narrowed: take a small loss right away and be ready to reposition later—or continue to hold. Trouble is you feel tempted to go for the third and utterly unplanned choice—to lower your stop, giving your losing trade “more room.”

Don’t do it! Giving a trade “more room” is wishful thinking, pure and simple. It doesn’t belong in the toolkit of a serious trader. Giving “more room” to a losing trade is like telling your kid you’ll take away his car keys if he misbehaves, but then not following through. That’s how you teach him that rules don’t matter and encourage even worse behavior. Standing firm brings better long-term results.

The logical thing to do when a trade starts acting badly is to accept a small loss. Continue to monitor that stock and be ready to buy it again if it bottoms out. Persistence pays, commissions are cheap, and professional traders often take several quick stabs at a trade before it starts running in their favor.

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