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Day Trading with Price Action Volume IV: Positive Posi tive Expectancy
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Copyright © 2014-2016 by Galen Woods (Singapore Business Registration Registrati on No. 53269377M). 5326 9377M). All rights reserved. First Edition, 1 September 2014. Second Edition, 5 April 2016. Published by Galen Woods (Singapore Business Registrati Registration on No. 53269377M). All charts were created with NinjaTrader™. NinjaTrader™ is a Registered Trademark of NinjaTrader NinjaTrader™, LLC. All rights reserved. No part of this publication may be reproduced or transmitted transmitted in any form or by any means, electronic or mechanical, without written permission permission from the publisher, except as permitted by Singapore Copyright Laws.
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Disclaimer The information provided within the Day Trading with Price Action Course and any supporting documents, software, websites, and emails is only for the purposes of informati information on and education. We don't know you so any information we provide does not take into account your individual circumstances, and should NOT be considered advice. Before investing or trading on the basis of this material, both the author and publisher encourage you to first seek professional advice with regard to whether or not it is appropriate to your own particular financial circumstances, needs and objectives. The author and publisher believe the information information provided is correct. However we are not liable for any loss, claims, or damage incurred by any person, due to any errors or omissions, or as a consequence of the use or reliance on any information contained within the Day Trading with Price Action Course and any supporting documents, software, websites, and emails. Reference to any market, trading time frame, analysis style or trading technique is for the purpose of information and education only. They are not to be considered a recommendation recommendat ion as being appropriate to your y our circumstances or needs. All charting platforms and chart layouts (including time frames, indicators and parameters) used within this course are being used to demonstrate and explain a trading concept, for the purposes of information and education only. These charting platforms and chart layouts are in no way recommended as being suitable for your trading purposes.
Charts, setups and trade examples shown throughout this product have been chosen in order to provide the best possible www.tradingsetupsreview.com
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demonstration of concept, for information demonstration information and education purposes. They were not necessarily traded live by the author. U.S. Government Required Disclaim D isclaimer: er: Commodity Futures Trading and Options trading has large potential rewards, but also large potential risk. You must be aware of the risks and be willing to accept them in order to invest in the futures and options markets. Don't trade with money you can't afford to lose. This is neither a solicitation nor an offer to Buy/Sell futures or options. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed on this web site. The past performance of any trading system or methodology is not necessarily indicative indicative of future results.
CFTC RULE 4.41 - HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT BEEN EXECUTED, THE RESULTS MAY HAVE UNDEROR-OVER COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFIT OR LOSSES SIMILAR TO THOSE SHOWN.
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Contents Chapter 1 - Introduction to Positive Expectancy ......... .................. ............. ....1 1.1 - Definition De finition of Expectancy Expectan cy ................................ ............... ............................. ............ 2 1.2 - Definition De finition of Winning Probability ................................ ............... ................... 3 1.3 - Probability versus Reward-to-Risk Reward-to-R isk............................... ................ ............... 4 1.4 - Beyond Price Action Analysis A nalysis .................................. ................. ................... .. 16 1.5 - Conclus C onclusion ion .................................. ................. .................................. ........................... .......... 19 Chapter 2 - Stop-Loss Stop-Los s .................. .................................. .................................. ...................... .... 21 2.1 - Initial In itial Stop-loss Sto p-loss ................................ ................ .................................. ...................... .... 23 2.1.1 - A Method for Losing Small ................................ ............... ................... .. 25 2.2 - Trailing Stop-losses ................................................ 27 2.2.1 - Price Action Setups ........................................... 29 2.2.2 - Support and Resistance ..................................... 31 2.2.3 - Market Volatility ................................ ............... ................................. ................ 33 2.3 - The T he W Wrong rong Way to t o Place Stop-losses Stop-loss es ............... ......................... .......... 37 2.4 - Consistency of Stop-losses....................................... 41 2.5 - Conclus C onclusion ion .................................. ................. .................................. ........................... .......... 42 Chapter 3 - Targets ................................... .................. .................................. ........................ ....... 43 3.1 - The Importance of Profit Targets in Day Trading ......... 44 3.1.1 - Trailing Tr ailing Stop-loss S top-loss ................................ ................ .............................. .............. 44 3.1.2 - Profit Pro fit Target T arget .................................. ................. ................................... .................... 44 3.2 - Finding Targets ...................................................... 49 3.2.1 - Support and Resistance ..................................... 49
3.2.2 - Price Pr ice Thrust Projection Project ion .................................. ................. ...................... ..... 53 3.2.3 - Price Pr ice Channels .................................. ................. ................................. ................ 59 www.tradingsetupsreview.com
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3.2.4 - Volatility Projection ........................................... 67 3.3 - Exiting with a Reversal Signal .................................. 70 3.3.1 - Anti-climax Pattern ........................................... 71 3.3.2 - Merged Congestion Zone .................................. ................. ................... .. 74
3.3.3 - Additional Notes ................................ ............... ................................. ................ 79 3.4 - Targeting Examples ........................................ ........................ ........................ ........ 81 3.4.1 - FDAX 10-Minute Example ................................. ................ ................... .. 82 3.4.2 - ES 10-Minute Example .................................. ................. ...................... ..... 85 3.4.3 - 6J 10-Minute Example ....................................... 89 3.4.4 - CL 3-Minute Example ................................. ................. ........................ ........ 92 3.5 - The Wrong Way to Place Targets .............................. 98 3.6 - Conclus C onclusion ion .................................. ................. .................................. ........................... .......... 99 Chapter 4 - The Meaning of Likely ..................................... 101 4.1 - How to Assess the Probability of Winning ................. ................. 103 4.2 - Conclusion Conclus ion .................................. ................. .................................. ......................... ........ 106 Chapter 5 - Achieving Positive Expectancy............. Expectancy...................... ............. .... 108 5.1 - The Split Second .................................................. 110 5.1.1 - R2R Indicator ................................................. 113 5.2 - Complete Trading Examples ................................ ............... .................... ... 117 5.2.1 - CL 4-Minute Example (14 April 2014) .......... ................ ...... 119 5.2.2 - CL 4-Minute Example (1 May 2014) .................. .................... 126 5.2.3 - CL 4-Minute Example (5 May 2014) .................. .................... 133 5.2.4 - CL 4-Minute Example (12 May 2014) ................. ................. 146 5.2.5 - CL 4-Minute Example (15 May 2014) ................. ................. 156 5.2.6 - FDAX 3-Minute Example (8 August 2014) ........... ........... 164 5.2.7 - FDAX 3-Minute Example (31 July 2014) ............. ............. 171 www.tradingsetupsreview.com
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5.2.8 - FDAX 1-Minute Example (20th November 2015) .. 180 5.3 - Managing Trades for Positive Expectancy ........ ................. ......... 190 5.4 - Conclusion Conclus ion .................................. ................. .................................. ......................... ........ 194 Chapter 6 – The Analytical Cycle .................. ........................... ................... ............ .. 196
6.1 - Establish Rules and Guidelines ............................... 199 6.2 - Record Ongoing Analysis ....................................... 202 6.2.1 - Thought Process for Basic Analysis ........ ................. ............ ... 203 6.2.2 - Written Analysis as a Tool ................... ............................ ............. .... 205 6.2.3 - Tools for Recording ..................... .............................. ................... ............ 212 6.3 - Classify Trades ................................. ................. .................................. .................... .. 214 6.4 - Review Trading Records ........................................ 219 6.4.1 - The T he Holy Grail Gr ail................................ ............... .................................. ................. 220 6.4.2 - Measuring Expectancy ..................................... 224 6.4.3 - Computing Drawdown (for Position Sizing) ........ .......... 232 6.4.4 - Improving Expectancy ..................................... 239 6.5 - Refine T Trading rading Rules and Guidelines..................... Guidelines........................ ... 253 6.6 - Conclusion Conclus ion .................................. ................. .................................. ......................... ........ 254 Chapter 7 - A Risk-Based Approach to Trading ................. .................... ... 255 7.1 - Identifying Id entifying Risks .................................. ................. .................................. ................. 256 7.2 - Risk R isk Management Card ................................. ................. ......................... ......... 260 7.3 - Financial Financia l Risk ................................. ................ .................................. ...................... ..... 263 7.3.1 - Trading Capital ............................................... 263 7.3.2 - Living Expenses .............................................. 265 7.3.3 - Currency Risk ................................................. 267 7.4 - Operational Operationa l Risk .................................. ................. .................................. ................. 269 7.4.1 - Trading Computer ........................................... 271 www.tradingsetupsreview.com
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7.4.2 - Electricity E lectricity ................................. ................ .................................. ...................... ..... 273 7.4.3 - Internet Connection ........................................ 274 7.4.4 - Broker ........................................................... 276 7.4.5 - Trading Platform ............................................. 280
7.4.6 - Execution Process ........................................... 281 7.4.7 - Trading Environment ....................................... 283 7.4.8 - Minimise Minimise Risk by Keeping It Simple .................. .................... 284 7.5 - Psycholog Psy chological ical Risk R isk ............... ................................ .................................. ................. 285 7.5.1 - Psychological Foundation ....................... ................................ ........... 289 7.5.2 - Practical Prac tical Strategy ................................ ................ ............................ ............ 292 7.5.3 - The Final Determinant ..................................... 303 7.6 - Integration of Risks .............................................. 303 7.7 - Conclusion Conclus ion .................................. ................. .................................. ......................... ........ 305 Chapter 8 - End of the Beginning ...................................... 307
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Chapter 1 - Introduction to Positive Expectancy The expectancy of a trading setup refers to the expected outcome of taking that setup many times times over a long period of time. The sole aim oftoevery trader to take setups with positive expectancy in order accumulate accumula te is profits. Otherwise, your trading capital will be depleted in a matter of time. Having a positive expectancy is also referred to as having a trading edge. Conceptually, it is akin to a casino’s edge. Over a large number of bets, the casino expects to make a profit at the gamblers’ expense. As profit-driven traders, positive expectancy is everything. The difference between us and the casinos is that their edge is rooted rock solid in statistics. They have rigged the games in their favour, and they know it. They can even ev en prove it. As for us, we are trying to rig the game, not quite knowing if we have succeeded. It is a much tougher play for traders. So, if you can get over the legal issues and possibly moral qualms, I suggest that you open a casino rather than day trade futures. When it comes to trading, there are numerous topics covering strategies, indicators, setups, entries, exits, risk management, psychology, software, hardware, and many others. Ultima Ultimately, tely, these pieces should fit together to help you take trading setups that exhibit positive expectancy. Positive expectancy is the single most important concept in trading. Hence, it is essential that every trader has a thorough understanding understandi ng of it and see how the different parts of a strategy
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come together to highlight highlight opportunities with positive expectancy. While the concept of having a trading edge is covered in many trading books, most of them do not give it the attention attenti on it deserves. The earlier volumes taught you how to analyse market bias and trading setups. However, they did not show you how to trade, because nobody can trade without understanding the concept of positive expectancy. To learn how to trade, read on. In this first chapter, we will break down the concept of expectancy into concrete aspects that we can examine and improve with respect to each trading opportunity. The u ultima ltimate te purpose is, of course, positive expectancy for each trade we take.
1.1 - Definition of Expectancy To this end, we cannot be content with the one-line basic definition mentioned above. Expectancy is more than a fluffy trading concept. It is a statistical concept. To achieve positive expectancy, we have to understand it statistically. If you did not enjoy your mathematics mathematics classes, do not fear. There are only three ingredient ingredients. s. Probability of winning a trade = W Probability Reward of a trade = R Risk of a trade = L
Expectancy = ( W x R ) – [ ( 1 – W ) x L ]
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Both intuition and mathematics tell us that to maximise expectancy, we need to:
Maximise the probability of winning a trade (W) Maximise the reward of a trade (R) Minimise the risk of a trade (L)
It seems like there are three distinct steps to finding great trading opportunities. 1. Find a high probability trade. 2. Place our target far away to maximise maximise profit. 3. Place our stop-loss near to minimise risk. That sounds simple. Unfortunately, the above recipe is wrong. The greater Unfortunately, misfortune is perhaps the large number of traders with this erroneous understand understanding. ing. To uncover the correct approach, you need to understand the true meaning of winning a trade and the inter-relationships between the winnings odds, our target, and our stop-loss.
1.2 - Definition of Winning Probability Many traders discuss the probability probability of winning win ning a trade as though it is independent of its potential reward and risk. That understanding cannot be any further from the truth and is a very dangerous idea. Any discussion of the probability of a winning trade is flawed if it does not incorporate its potential reward and risk. It is important to comprehend why. The first step is to understand what it means when we say we win a trade. It means that the trade results in profits.
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Let’s assume that each time we enter the market, we place a target limit order and a stop-loss order, and we do not adjust them.
It follows that for a trade to be profitable, the market must hit our target before hitting our stop-loss. If our stop-loss level is hit first, then our trade results in losses and not profits. Hence, the probability of winning a trade is the probability of the market hitting our target price before hitting our stop-loss point. This is why the probability of winning a trade is not independent of its target and stop-loss. Thus, we must integrate them into a single thought process. As mentioned, mentioned, a useful way to formulate the winning probability of a trade is the “probability that the market will hit our target before hitting our stop-loss” .
PROBABILITY OF WINNING Probability that the market will hit our target before hitting our stop-loss
This definition offers great insight. It shows clearly that the probability of winning a trade is dependent on how well we set our target and stop-loss.
1.3 - Probability versus Reward-to-Risk The next step is to find out exactly how our targets and stoplosses are related to our winning probability. probability. For clarity, let’s start with a completel c ompletely y random market. A random market implies that, assuming there is no slippage and commissions, the long run outcome of any trading strategy is breakeven. www.tradingsetupsreview.com
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Let us establish a long position in this hypothetical market. We place a sell limit order above our entry price as our target and concurrently place a sell stop order below our entry price as a stop-loss. Our target and stop-loss are equidistant equidistant from our entry price. For illustrative purpose, let’s assume that both the target and stop-loss are 10 ticks away from our entry price as shown in Figure 1-1. 1-1.
Target (50%) 10 ticks Entry price 10 ticks Stop-loss (50%)
Figure 1-1 Equidistant target and stop-loss stop-loss
Since the market is random, the probability that it will move up 10 ticks is the same as the probability of moving down 10 ticks. Basically, the probability of either scenario is 50%. This means that over the long run and over many such trades, 50% of the trades will make us 10 ticks each, and 50% of the trades will incur 10 ticks of losses each. Since the profit per winning trade is the same as the loss per losing trade, we will end up in a breakeven position. (Assuming that that there are no slippages slippages and commissions.)
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Now, let’ s consider a trade with a 20-tick target and 10-tick stop-loss. What are the odds of this trade being profitable? Is it still 50%?
If it is, according to our expectancy formula, we expect to make 5 ticks per trade (0.5 x 20 – 0.5 x 10). When we say we expect to make 5 ticks a trade, we mean that our average profit per trade over a large number of trades is 5 ticks. Wow, fantastic. Simply by using a larger target, we have managed to squeeze some money out of a random market. Is that possible? Absolutely not. It is impossible to make money from trading a random market over the long run. By placing our target further from our entry price, a random market will no longer churn out winning trades and losing trades with equal probability. Instead, the market will have a lower probability of hitting our target first and a higher h igher probability of hitting our stop-loss first. This is because the distance between our target and our entry price is larger than the distance between the stop-loss and our entry price. The 50-50 probability applies only when the target and the stoploss are at the same distance away from our entry price (i.e. when our reward-to-risk ratio is 1). When we push our target further to 20 ticks away and maintain our stop-loss at 10 ticks away, our reward-to-risk ratio increases to 2. Thus, the probability of the market hitting our target order before hitting our stop-loss order decreases to approximately
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33.3%. The probability of the market hitting our stop-loss before reaching our target increases to roughly 66.6%. Figure 1-2 illustrates this change in probability.
Target (33.3%)
20 ticks
Entry price 10 ticks Stop-loss (66.6%)
Figure 1-2 Lower winning probability for higher reward-to-risk ratio ratio
How do we know this? How did we get the probabilities of 33.3% and 66.6%? Recall that the market we are talking about here is random and the outcome of any trading strategy over the long run is breakeven. Simply put, it indicates an expectancy of zero. By plugging the value of zero into the expectancy formula, we can work out the relationship relationshi p between the probability of winning a trade, and the target and stop-loss of a trade, in a random market.
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Expectancy = 0 (Random market)
W – Winning probability R – Reward L - Risk
(W x R) – [(1 - W) x L] = 0 W x R = L x (1 - W) R / L = (1
W) / W
–
We plotted a graph of Winning Probability Probability (W) against RewardRewardto-Risk (R/L) using this equation in Figure in Figure 1-3. It 1-3. It reveals an important importa nt relationship. In a random market, the probability of winning decreases as our reward-to-ri reward-to-risk sk ratio increases.
Figure 1-3 Decreasing probability with increasing reward-to-risk ratio ratio
This graph illustrates the definite breakeven outcome in a random market without trading costs like commissions and
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slippage. The expectancy of every trade is zero and falls on this line. The relationship depicted in Figure in Figure 1-3 is intuitive. Achieving the target is necessary for winning a trade. The further the target, the harder it is for the market to achieve it. Hence, the further we place our target, the higher the reward, and the lower the probability of winning the trade. Conversely, if our target is near, our probability of winning increases. Another necessary condition condition for our trade to succeed is that the market must not hit our stop-loss before hitting our target. Thus, tighter stops lower our winning probability probability because the market has a higher chance of hitting them. Wider stops are less likely to be hit by the market. Hence, the further we place our stop-loss, the larger the risk, and the higher our winning probability. When we combine these two lines of thought, we conclude that the higher the reward-to-risk ratio, the lower the winning probability. This inevitable trade-off between the winning probability and the reward-to-risk ratio is an essential trading concept. This random market marks our theoretical start point. Now, let’s move on to considering the same relationship in real markets. Does the relationship relationship described above hold true for the real financial markets that we intend to trade? The efficient market hypothesis is relevant for this discussion. I am not going to expound on the full-fledged theory, and will just present a short explanation before we move on. Basically, the hypothesis states that markets are efficient at absorbing price-sensitive information. The more efficient they
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are in doing so, the harder it is for anyone to make money from the market. The underlying explanation is very logical. If there is a trading strategy that works, everyone will jump in and trade with that strategy. In doing so, the trading edge of that strategy is eroded. For instance, let’s consider the January effect1 which is the tendency for stock prices to rise in January each year. This is purportedly due to income tax reasons. The trading strategy to take advantage advantage of the January effect is to buy stocks near the end of the year and sell them in January after the stock prices has risen.
However, if everyone employs the same strategy, s trategy, then they would all buy near the end of the year. By doing so, they push up the prices. As a result, the difference between their their cost basis and the eventual (supposedly higher) price in January narrows. Their potential profit diminishes. If the market is perfectly efficient, efficient, this impact will be so pronounced that January effect simply ceases to exist. In a perfectly efficient market, all information is reflected in its price and movements cannot be anticipated. Thus, all movements are random. In that case, the relationship in Figure in Figure 1-3 would hold. Everyone who is trying to make money from the market believes that financial markets are not entirely efficient. They believe that inefficiencies of varying degrees exist in the market. Some detractors of the efficient market hypothesis go as far as to say that the hypothesis is wholly wrong and completely useless. 1
First documented by Sidney B. Wachtel in his 1942 paper “Certain Observations on Seasonal Movements in Stock Prices”. Prices”.
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I do not agree with this extreme view. The efficient market hypothesis does make sense. Its underpinnings underpinnings are logical and rational. Hence, I believe that it is difficult to make money from trading the market and profitable opportunities are fleeting. The generally high failure rates of traders and the underperformance of most fund managers prove this point. At the same time, to believe that markets are completely efficient is naïve. Thus, a realistic view is that it is possible, although challenging, to make money from predicting market movements. movements. The relationship in Figure in Figure 1-3 holds true in financial markets most of the time. However, at times, the market exhibits a kink in the relationship that offers positive expectancy. Those kinks represent the trading opportunities we are looking for. Figure 1-4 illustrates where these positive expectancy opportunities opportuniti es lie.
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Chapter 1 - Introduction to Positive Expectancy
Positive Expectancy
Negative Expectancy
Figure 1-4 Positive expectancy region on the right of o f the curve curve
Recall that the curve represents zero expectancy. Note that traders do not start on the line of zero expectancy. Due to trading costs like commissions and slippage, all traders start in the negative expectancy region. Our job as traders is to focus on getting on the right side of the line where we find trading setups with positive expectancy. These setups can be the result of a higher h igher probability or higher reward-to-risk reward-to-ri sk ratio or o r both. A reward-to-risk ratio of 1 paired with a winning probability of 0.5 (50%) produces zero expectancy. If there is a chance to enter the market with a reward-to-risk ratio of 1.5 and probability of 0.5, do we take it? Yes, because it has a better reward-to-risk reward-to-ri sk ratio than a zero expectancy trade. It carries positive expectancy. Great, we know where we want to be - on the right side. But how do we get there?
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The key factor that causes opportunities to open up on the right side of the zero expectancy line is the market bias. The market bias denotes a higher tendency of the market to move in one direction, either up or down. If the market has no bias, then it is random. In that case, there is no money to be made. If the market has a bias and we manage to decipher it, then there is money to be made. Thus, if we get the market bias right, we have managed to squeeze through to the right side of the graph. This T his is why we devoted the entire Volume II to the art of figuring out the market bias. This is also why the market bias is our foremost consideration when we look at any market we intend to trade. If we are unsure of the market bias, we are unsure if we are on the left or right side of the graph in Figure in Figure 1-4. When 1-4. When we are unsure, we should not trade.
“He will win who knows when to fight and when not to fight.” Sun Tzu, The Art of War
However, even after we confirm the market bias, b ias, we cannot enter the market until we are able pinpoint an exact entry with a clear reward-to-risk ratio and an acceptable probability. To define our reward-to-ri reward-to-risk sk ratio, we need to find a reliable trading setup aligned with the market bias. It will give us our entry price and stop-loss level. The difference between them is our risk.
Concurrently, we must figure out where to put our target by examining the market support/resistance and by employing
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target projection techniques. The difference between our target price and our entry price is our reward. Then, we can finally put our reward and risk together to find out our reward-to-risk ratio. How about the probability of winning? Recall that the probability of winning refers to the probability of the market reaching our target before hitting our stop-loss. It follows that the probability of winning depends on how well we select our stop-loss and target. We need a stop-loss that the market is likely to stay away from. This means that we need to find a high h igh quality trading setup. Then, we need a target that the market is likely to move to, which means that we need to find a magnetic target level that draws the market towards it. Accordingly, to maximise the winning probability, we need to examine how we select our target and stop-loss, and if they are reliable. Summing up the above, we get the correct approach to finding trading opportunities opportunities as shown in Table in Table 1-1. 1-1.
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Chapter 1 - Introduction to Positive Expectancy
No.
Task
Purpose
1
Determine the market bias
Open up the possibility of positive expectancy
2
Find a reliable stop-loss point
Define risk
3
Find a reliable target level Determine how likely it is for the market to hit the target before hitting the stop-loss
Define reward
4
5
Calculate Calculate expectancy
Define probability Evaluate if the trade offers positive expectancy
Table 1-1 Correct trading approach approach
We enter the market only if the setup offers positive expectancy. Let’s take a look at our progress with respect to this trading approach. Assessing the market bias is the subject matter of Volume II. Return to it if you are still unsure of the techniques for uncovering the market bias. Items 2 to 5 lay out the roadmap for the first part of this volume. In Chapter 2, you In Chapter 2, you will learn that a high h igh quality trading setup will provide a reliable stop-loss. As we have already discussed the attributes of a high quality setup in Volume III, we will devote our time to learning about alternative alternative stop-loss techniques and their implications. implications. In Chapter 3, you will pick up techniques to identify reliabl reliable e targets. We will rely heavily on our earlier discussion on support and resistance, in particular the different types of swing pivots and the Congestion Zone. We will also talk about the importance of using target limit orders in day trading.
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In Chapter 4, we will embrace the fuzziness of deriving the probability of winning. We ask ourselves what is the likelihood that the market will hit our target before hitting our stop-loss? This is where we decipher the inner workings of our mind in an attempt to arrive at a quantified quantified probability of a successful trade. In Chapter 5, we will combine risk, reward, and probability using the expectancy formula to decide if a trading opportunity is worth taking. This chapter also contains comprehensive examples to bring you through the entire trading process, from evaluating evaluati ng the market bias b ias to deriving the expectancy of a trade. These important examples serve to reinforce everything we have learned and show how they fit together to produce profitable trading prospects.
1.4 - Beyond Price Action Analysis The second part of this volume, from Chapter 6 onwards, moves beyond price action analysis. Our trading approach creates our trading edge. Beyond that, we need to focus on two things. First, we work on improving our trading edge or expectancy. We will deal with this in Chapter 6 in which we will focus on keeping good records of our trades and learn how to analyse them to improve our trading performance. Next, we ensure that we are adequately prepared to exploit the positive expectancy of our trading strategy. In Chapter 7, we will discuss the three main risks that might affect our ability to trade. First, we must avoid financial risks, in particular the risk of ruin. Every trading strategy suffers drawdowns, including
those with positive expectancy. For instance, you have a trading strategy that would cause you to lose $1,000 before making
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$5,000 for each traded contract. That is a great strategy with positive expectancy. However, can you start trading it with $500? Clearly not, because if you start trading with $500, there is a good chance that you will run out of money before you can realise the expected profit of $5,000. You will need at least $1,000, preferably more, for each contract you trade. The basic idea here is that you must have enough money to rough it out before you realise the positive expectancy of your trading strategy. strategy. It is about surviving until you make it. Hence, we will work on ensuring that you have enough trading capital for the results of a positive expectancy strategy to manifest, and finding out the position size you can trade given your trading capital. Second, we must be prepared for contingencies during the actual trading process. We will identify a list of possible risks that might affect our ability to trade according to our analysis. Basically, Basically, we try to answer the question of what might go wrong during our trading session.
Will the Internet connection drop? Will our broker be unavailable? Will your wireless mouse run out of battery?
We will implement a framework for reviewing and handling such risks. In doing so, we will establish standard trading procedures and controls to govern our actual trading process. This is essential to ensure that we are able to take advantage of the good trades we identify.
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Chapter 1 - Introduction to Positive Expectancy
We must know what trading aids to place on our charts and which screen to pay attention to at which point in time. When a trading opportunity with positive expectancy arises, you must know exactly which button to click and be able to click c lick it without a family member barging into your room. Focusing on the things that might go wrong helps us to drill down to the tiniest detail in our trading process and hammer them out clearly. Only then, we are able to act without hesitation hesitati on or interference when a trading opportunity arises. Third, we need to manage the risk of emotions running amok. We will face a trader’s worst psychological demons.
Very often, taking negative expectancy trades is not fatal, as long as the good trades more than make up for them. What is fatal is giving in to the fear and greed and other mental demons that cause you to neglect all the trading principles you know. That will lead you will ignore the trading rules you’ve set for yourself and trade excessively. To realise the positive expectancy of our trades, we must keep our emotions, chiefly fear, in check. It is important to understand that managing these three types of risks merely enable us to take positive expectancy trades. Managing them does not create a trading edge. It merely preserves our trading edge, if we indeed have one. Having a lot of money will not help you make more money if you do not have a trading edge. You’ll just survive longer as a losing trader. (Okay, with a lot a lot of money, you might create a trading edge to make money. But most ways of doing that are illegal.) Maintaining iron-clad discipline to take negative expectancy trades will just deplete your trading capital in an orderly fashion.
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Chapter 1 - Introduction to Positive Expectancy
However, these aspects of trading are almost as important as the analytical aspects because without them, you are unable to realise the results of your market analysis. And if you do not pay attention to them, you may end up eroding your trading edge. In all, these factors are necessary but not sufficient for trading profitably.
1.5 - Conclusion The most important concept in this chapter is the definition of the probability of winning. It is the probability of the market reaching our target price before hitting our stop-loss. This single concept enjoins our entry, stop-loss, and target, and is extremely instructive on the right way to find solid trading setups. Taking trades with positive expectancy is our o ur sole purpose. Every single aspect of our trading plan must bring us closer c loser to doing so. Chapter 1 to 5 of this volume is on how to find trades. Chapter 6 and 7 discusses the business and psychological aspects of trading. I’ve chosen to combine them in one final volume to highlight an often neglected fact – trading is more than just your trading strategy. Your strategy, process, and psychology fit together to produce the elusive positive expectancy.
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Chapter 1 - Introduction to Positive Expectancy
POSITIVE EXPECTANCY Look for trades with positive expectancy
Understand that the winning
probability of a trade depends on its probability stop-loss and target
Prepare yourself financially, operationally, operationall y, and mentally
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Chapter 2 - Stop-Loss Stop-loss orders are orders placed to limit our loss in the event that the market moves against us. Typically, they are placed as stop orders after our market entry. Stop-loss is not a popular topic. Some new traders are not even aware of the concept of stop-losses, and many traders often avoid talking about it. This is because stop-losses are associated with losing. It is never good for business (and ego) to discuss too much about losing in the market. At best, these traders treat stop-losses as an invisible but necessary evil. If we adopt this attitude, we will miss exploring a crucial aspect of trading. Of course, I do not like to lose as well. However, losing is such an important theme in trading that we should pay it proper attention. To a large extent, trading is about losing right, and losing small. And stop-losses are our best tool to achieve this.
LOSING MONEY CORRECTLY Trading is about losing right, and losing small
How do we lose right? Losing right refers to losing as part of a set s et of consistent trades with positive expectancy. Within a set of trades with positive expectancy, we expect overall gain. However, we are also aware that not all trades will be profitable. There will be losing trades. These losing trades are desirable because they accompany winning trades that surpass them in aggregate results.
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Chapter 2 - Stop-Loss
Hence, to ensure that we lose right, we must focus on taking positive expectancy trades. As long as we are doing so, even if we are stopped out, we know that we have lost desirably. How do we lose small? Small is a relative concept. It is relative to the size of the potential profit. The smaller the potential loss, the larger reward-to-risk reward-to-ri sk ratio. It is also relative to the winning probability. probability. Hence, to find out how small is enough, we need to plug our potential loss into the expectancy formula. This will be done in Chapter 5. Stop-losses help us lose correctly and lose small. It also means that a stop-loss serves two competing aims. aims. It should help us lose small and limit our losses.2 This implies that a tight stop-loss is desirable. desirable. However, it should help us lose right. To do so, it must allow enough room for a good trade to unfold and hit the profit target despite market fluctuations. fluctuations. This means that the stop-loss should be placed at a safe distance away. Given these considerations, setting a stop-loss is delicate business. The ideal stop-loss level is the tightest one that offers enough room to accommodate reasonable movement against your trading position. What is considered reasonable movement against our position?
2
Stop-loss orders are generally not guaranteed. They take the form of stop orders.
When the market hits the specified price, the stop order turns into a market order to be executed immediately. However, the exact execution price depends on market conditions. Thus, although stop-loss orders help to limit our losses, they do not guarantee the amount we stand to lose.
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I do not have a straightforward straightforward answer for you. But I can tell you that it depends on three factors: price patterns, support/resistance, support/resista nce, and volatility. volatility. In the following sections, we will examine the impact of each factor on our stop-loss placement. placement.
2.1 - Initial Stop-loss The probability of winning a trade is the probability that the market will reach our target before hitting our stop-loss. The stop-loss plays an important role in our search for high probability trades. We need to find a reliable initial stop-loss level for each trading opportunity. What is a reliable stop-loss? In the context of a long trade, a reliable re liable stop-loss level is one that the market is more likely to stay above. For a short trade, the market tends to stay below a reliable stop-loss level. In addition, a reliable stop-loss level is one that signals that our analysis is wrong when the market hits it. Recall that in our price action framework, we always place the stop-loss order a tick below the setup bar for a long trade and a tick above the setup bar for a short trade. This is because our setups are based on price points where we believe buying or selling pressure will take over and push the market to our advantage. Hence, if our trading premise is right, the opposite extreme of the setup bar is a reliable stop-loss point. Thus, the reliability of our stop-loss depends on the quality of our trading setup. This is a concept I have highlighted in the
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introduction of the previous volume. The analysis analysis of the market bias and trading setups covered in the last two volumes will help us to find reliable stop-loss points. Finding a good trading setup gives us an entry point. po int. More importantly, it gives us a reliable stop-loss level. To find reliable stop-loss points, look for high quality setups in the direction of the market bias. The quality of the setup depends on the support/resistance support/resistance areas, confluence of price patterns, and the form of the setup. (Refer to Volume III Chapter 19 for details.) Re-entry equivalent setups also offer quality trading opportunities. opportuniti es. (Refer to Volume III Chapter 12 for details.) Price action setups, market volatility, and support/resistance support/resistance affect how we place our initial stop-loss. stop-loss. However, I recommend using price action setups for initial stop-loss placement as it offers a direct way to link our entry conditions with our exit strategy. So far, we have been using a price action setup as our basis for placing initial stop-loss. We consistently place our stop-loss a tick below a long setup bar or a tick above a short setup bar. Moreover, we do not adjust it regardless of the price action that follows after our entry. This is passive trade management, management, which refers to keeping our stop-loss and target constant regardless of how the trade progresses. The implication of passive trade management is that we maintain a fixed reward-to-risk ratio for each trade. Having a fixed reward-to-risk ratio simplifies the calculation of expectancy and makes it easier for us to assess if a trade has positive expectancy.
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2.1.1 - A Method for Losing Small I mentioned that we want to lose correctly and small. So far, we have been focusing on finding reliable setup bars and placing our stop-loss around them. This helps us to lose correctly.
To lose small, I have a simple s imple method for you. Take only narrow range setup bars.
To define a narrow range bar, use a long-term moving average of bar range as a benchmark. Any bar with a range below the benchmark is a narrow range bar. (We will use this definition again when we learn to trail stops using market volatility later.) What is a long-term moving moving average of bar range? It is a moving average that uses bar range (bar high – bar low) as its input. It is not a standard indicator on most trading platforms. 3 However, if your trading platform allows you to nest indicators, you can set it up easily. Simply set bar range as the input of your moving average indicator. For the look-back period of the moving average, use the total number of bars in five trading sessions. The moving average will then include five complete sessions and account for any day-ofthe-week nuances in volatility. For instance, in an hourly chart showing 24-hour trading sessions, we would use the average range of the last 120 price bars (24 hourly bars x 5 trading sessions). Narrow range bars are favourable setup bars for two reasons.
3
It is not the Average A verage True Range (ATR) indicator found on most platforms. The difference is that the ATR accounts for gaps g aps between price bars. You may use ATR for swing trading, but stick to a simple moving average of bar range for day trading.
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First, as our trade risk is determined by the bar range, a narrow range setup bar means a lower trade risk. Next, assuming that the market continues to move with the average volatility (bar range), it produces a better reward-torisk ratio. Generally, a narrow range setup bar in a volatile market is likely to enjoy a higher reward-to-risk ratio. These reasons explain why there is a variety of price patterns surrounding narrow range bars like the NR4 and NR7.4 (If you use the R2R indicator to project minimum minimum targets, you may choose to hide the targets for wide range bars by specifying the appropriate look-back period. Learn more in Chapter 5.1.1 Chapter 5.1.1 - R2R Indicator.) Indicator.) There are a few important things to note when implementing implementing this technique. First, narrow range bars in isolation do not produce a trading edge. Hence, while you should aim to take narrow range setup bars, you should not take a trade simply because the setup bar has a narrow range. Always assess the quality of the setup first. Then, use the bar range as a filter. If the bar range is too wide and the trade entails too much risk, skip it. Next, this technique is an extreme measure to lose small. When applied rigidly, it might cause you to skip many high quality trades that happen to have wide range setup bars. Hence, weigh your decision against the quality of the trading setup. If the trading setup is fantastic, a wide range bar might be acceptable.
4
Refer to Toby Crabel’s Day Trading with Short Term Price Patterns and Opening Range Breakout. Click here for more information. Breakout. information.
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If the trading setup is of average quality, insist on having a narrow range setup bar. Finally, in your attempt to make use of narrow range bars to control risk, be aware that narrow range bars often occur in congested markets. Hence, if you see too many narrow range bars too frequently, consider avoiding the possibly congested price action instead of jumping into the market.
2.2 - Trailing Stop-losses In contrast to the passive trade management that we have been employing, some traders prefer to manage their trading positions actively. They adjust their stop-loss according to the price action that unfolds after their entry to try to improve their trades. This practice is known as trailing stop-loss. Trailing a stop-loss always refers to moving the stop-loss in the direction of the trade. You can move the stop-loss closer to the entry price to lower the trade risk. You can also move it to lock in profits once the market has moved in your favour by a reasonable margin. However, under no circumstances should a stop-loss be moved against the direction of the trade. For instance, in a long trade, the stop-loss order should never be moved to a lower price level. It should only be shifted upwards. As long as the stop-losses are adjusted based on price analysis, trailing stop-loss is a valid technique. However, it should s hould only be used by experienced and proficient traders. This is because there are two significant drawbacks that might bring new traders more harm than good. First, it is generally more challenging to control your emotions after you enter a position. You might be able to remain calm
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and conduct solid analysis leading up to your trade entry. But after you have taken a financial interest in the market, your emotions and cognitive biases tend to flare up. Your perspective becomes anchored to your entry price. Your mind is fixated on not becoming a loser. It becomes a lot harder to analyse the market clearly. Without proper analysis, you will not be able to adjust your stop-loss with sound reasoning. You end up adjusting your stop-loss emotionally, and not analytically. analytically. Even if you are able to control your emotions when it comes to trailing stop-losses, you will still need to deal with a technical difficulty. With simple passive targets and stop-losses, calculating the expectancy of a trade is straightforward straightforward as we have a fixed reward-to-risk reward-to-ri sk ratio for each trade. However, with trailing stoplosses, our reward-to-risk reward-to-risk ratio fluctuates throughout the trade. This varying reward-to-risk ratio has a profound impact on our trade's expectancy. We might get stopped out with a smaller loss or with a smaller gain. By adjusting the stop-loss, we also inevitably affect the probability of winning. If we trail the stop-loss too tightly, we decrease the probability of winning. If we trail it too widely, we increase the probability of winning but might decrease the size of our reward. Undeniably, trailing stop-loss complicates Undeniably, complicates the expectancy of a trade and its impact is difficult to grasp. Only experienced traders who are confident that their active trade management is adding value should adjust stop-losses during a trade. To find out if trailing stop-losses is adding value to your trading performance, you need to keep detailed trading records that include your trade management management decisions and rationale. rationale.
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If you are game for trailing stop-losses, you may employ the following techniques techniques to do so.
2.2.1 - Price Action Setups Since we place our initial stop-loss based on a price action setup, there is no reason why we should not adjust them according to subsequent new setups. If a new long trading setup forms while we are in a long trade, we have the option of moving our stop-loss order upwards to just beneath the setup bar of the the new long setup. setup. This will will tighten our stop-loss and decrease our potential potential trade risk. Similarly, a new short trading setup in a short trade gives us the option of shifting our stop-loss down. Conceptually, trailing a stop-loss based on a trading setup is no Conceptually, different from entering a new trading setup. We are merely taking into account a setup that occurred when we are already in the market. In fact, if you are not trading your maximum number of contracts, other than shifting the stop-loss order, you can also add to your position according according to the new setup. Thus, in deciding if you should trail a stop-loss according to a new trading setup, consider the quality of the setup. A good setup implies a good stop-loss level. Hence, evaluate the quality of the new setup. The better the quality of the setup, the stronger the case for trailing your stop-loss. Figure 2-1 shows an example of trailing a stop-loss down in a short trade as a bearish Pressure Zone setup occurred.
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Chapter 2 - Stop-Loss 2. Stop-loss order almost hit 3. Bearish Pressure Zone
4. Trailed stop-loss here 1. Bearish Congestion Break-out Failure; shorted here
Figure 2-1 Trailing a stop-loss down with a bearish Pressure Zone
1. The market bias was bearish. Hence, we sold a tick below this bar due to the bearish Congestion Break-out Failure. As usual, we placed a stop-loss order a tick above the high of the setup bar. 2. After moving down for two bars, the market reversed up and went right up to the high of our setup bar, which was just a tick below our stop-loss order. Although that caused some traders to hold their breath for a moment, price soon fell. 3. During the descent, a bearish Pressure Zone formed. This Pressure Zone formed right after price was rejected from the high of our original setup bar. In addition, the last bar of the Pressure Zone was a powerful bear trend bar. Hence, we adjusted the stop-loss order down to just above the last bar of the Pressure Zone. This new stop-loss level helped to lock in a 2-tick profit without stifling the setup’s profit potential.
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2.2.2 - Support and Resistance We can find support and resistance with swing pivots, trend lines, and Congestion Zones. Technically, we can trail our stoplosses according to any type of support and resistance in long and short trades respectively. However, basic and tested pivots are usually less reliable for trailing stop-losses. Hence, I recommend the following price action formations for the purpose of trailing trailing stop-losses.
Valid pivots Pivots with Congestion Zones
The first method simply trails the stop-loss order a tick below a valid low for long trades, and a tick above a valid high for short trades. (If you are not sure what a valid pivot is, refer back to Volume II. Valid pivot is the most reliable type of pivot and often acts as major support/resistance.) support/resistance.) The second method is an effective trailing stop-loss technique that uses Congestion Zones to find reliable reliable pivots as stop-loss points. Basically, for long trades, we wait for price to clear above a Congestion Zone before bringing our stop-loss to the nearest pivot low below the Zone. For short trades, after price clears below a Congestion Zone, we bring the stop-loss to the nearest pivot high above the Zone. This technique is demonstrated in a long trade in Figure in Figure 2-2. 2-2. The dotted boxes in Figure in Figure 2-2 represent Congestion Zones.
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1. Bullish Congestion Break-out Failure; bought here
3. Similar logic but with a bullish setup too 2. This bar cleared above the t he Congestion Zone, so we adjusted the stop-loss to the t he nearest pivot below the Zone Figure 2-2 Using Congestion Zones as a guide for trailing stop-loss stop-loss
1. To trade the bullish Congestion Break-out Failure, we bought a tick above this setup bar. As usual, our stop-loss was placed a tick below it. 2. The higher bar was the first that cleared above the Congestion Zone. It confirmed the Zone as a support area. Hence, we shifted the stop-loss order to the pivot low just below the Congestion Zone. 3. Again, a similar s imilar situation situation emerged and we trailed the stoploss order higher. In addition, in this case, we had another reason for trailing the stop-loss because the Congestion Zone also led to a bullish Congestion Break-out Failure. In many cases, you will find that trailing stop-losses using support/resistance support/resista nce produces similar results as using a trading setup. This is not surprising as our trading setups are designed to find short-term reliable stop-loss points, which are essentially finer and more precise support/resistance points.
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2.2.3 - Market Volatility The two methods we just discussed rely on price action formations. formati ons. The market must form swing pivots or other price action patterns before we have a basis to adjust our stop-losses.
However, at times, the market might move quickly in the direction of your trade without offering any suitable price action formation formati on for trailing stop-losses. When that happens, consider the use of volatility volatility stop-losses. The underlying concept is that with a given volatility, a directional market is unlikely to retrace more than a certain distance. Volatility is typically measured by the average bar range or standard deviation. Using volatility as a basis for trailing stop-losses makes sense. Chuck LeBeau popularised the idea of placing p lacing stop-losses based on market volatility with his Chandelier Stops. It is a stop placement technique technique based on the average true range (ATR). The ATR is a way to compute average bar range while taking into account the gaps between bars. The Chandelier Stop is then placed and trailed as a multiple of the ATR behind price movement. As gaps are uncommon within intraday time frames, day traders do not need to compensate for gaps. In fact, be careful when using the ATR in intraday charts. This is because the ATR will take the gap between trading sessions into account, resulting in an overstated value. Hence, the volatility stop-loss technique I am about to introduce uses the average bar range, which is a simple moving average of bar range (high-low), and not ATR. Let’s call this technique the Wide Range Bar Trail.
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Before we proceed, let’s define a wide w ide range bar.
If you have been observing a particular market within the same time frame for some time, you can easily tell if a bar ’s range is wide or narrow without the help of indicators. For a technical definition, definition, I suggest s uggest using a long-term moving average of bar range as a benchmark. Any bar with a range r ange above the long-term average is a wide range bar. For the lookback period of the moving average, use the number of bars in five trading sessions. The moving average will then include five complete sessions and account for any day-of-the-week nuances in volatility. For instance, the 60-minute chart of 6E futures in Figure in Figure 2-3 has 24 bars in each 24-hour trading session. Hence, we will take the 120-period (24 x 5) moving average of bar range as our benchmark. Any bar with a range that is higher than the benchmark is a wide range bar. In a long trade, once a price pr ice bar closes above the high of a bullish wide range bar, we shift our stop-loss to a tick below be low the wide range bar. In a short trade, once a price bar closes below the low of a bearish wide range bar, we shift our stop-loss to a tick above the wide range bar. Figure 2-3 demonstrates the Wide Range Bar Trail method in a bullish context. The bullish wide range bars are highlighted in yellow.
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D
1. Closing above bullish wide range bars C
B
A B
D C
3. When price closes above these bars, the stop-loss can be adjusted higher again
2. And their corresponding trailing stop-loss level A Figure 2-3 Using the Wide Range Bar Trail for a long position position
1. Each letter above the price bars indicates a close above a bullish wide range bar. Each close was a signal for us to tighten our stop-loss according to the Wide Range Bar Trail. 2. The corresponding trailing stop-loss levels are marked below the price bars. You can match each trigger signal to its associated stop-loss level using the letter labels. (E.g. after bar close A, trail to stop-loss level A) 3. We would not adjust the stop-loss order to a tick below these two bullish wide range bars until a price bar closes above them. Figure 2-4 shows a Wide W ide Range Bar Trail example within the context of a short trade. The bearish wide range bars are highlighted in yellow.
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1. First trail A
3. Choose the tightest stop-loss option B
A
2. The first close below four bearish wide range bars
B
Figure 2-4 Wide Range Bar Trail for a short position position
1. The example above follows the same labelling convention as the previous one (Figure 2-3) 2-3).. Level A was the first trailing stoploss in this chart. 2. This bar closed below four bearish wide range bars at once, offering us with four possible new stop-loss levels. 3. Under such circumstances, choose the tightest stop-loss level. However, this is not a strict rule. Choosing the tightest opti option on is conservative. If you would like to be more ambitious and allow more room for the market to wiggle, use the furthest option. The Wide Range Bar Trail offers a sensible stop-loss level for two reasons. For ease of explanation, let’s assume that we are in a long position. First, a bullish wide range bar represents powerful bullish strength. When the market closes above it, it is a decisive signal www.tradingsetupsreview.com
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that the market is following through with the bullish force. Hence, for a price action trader, the low of the wide range bar is a logical stop-loss level. Second, as we place our stop-loss below a wide range bar, we are providing our setup with above average range as breathing room. This space serves to accommodate potential potential trend retracement before the market moves further in our favour. Thus, this trailing stop-loss method combines both volatilit volatility y and price action considerations. Before you start to use the Wide Range Bar Trail, make sure you go through the two notes that follow.
First, trailing stop-losses using price patterns, and support and resistance is more reliable. This is why you should employ the Wide Range Bar Trail only when price is moving quickly in your favour without offering suitable support and resistance for stoploss placement. Next, if the wide range bar has an exceptionally wide range and extremely high volume, it might be a sign of price pr ice exhaustion. In a bull market, it means that all the buyers have bought. No one is left to buy, and a bearish reversal is imminent. In a bear market, it means that traders who want to sell have sold. No one is left to sell, and a bullish reversal would follow. In such cases, it is prudent pr udent to exit immediately immediately using a market order, instead of tightening your stop-loss order.
2.3 - The Wrong Way to Place Stop-losses Earlier, we tried to define the ideal stop-loss, which is the tightest possible stop-loss that offers just enough room to
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accommodate reasonable movement against our position. We accommodate defined it to guide us as we explore the various techniques for placing stop-losses. However, in real trading, we can only dream of having the perfect stop-loss and can never pinpoint it. Generally, the tighter the stop-loss order, the more likely it is for the market to hit it. Thus, market reality re ality forces us to choose between small trade risk and low probability of our stop-losses being hit. You either lose small and frequent, or lose big and seldom. We have examined the different techniques of placing stoplosses and adjusting them. Trade management is a very personal issue because it occurs at a stage where the trader is already financially committed to the market. Some traders prefer to trail stop-losses closely to control their trade risk while facing higher chance of being stopped out. Others prefer to keep their stop-losses away by a conservative margin. For these traders, while their average risk per trade is higher, they are more likely to obtain a higher win rate. Regardless of your preference, you should employ an analytical mind in trade management, using the techniques described above. Stop-losses come in many flavours including initial and trailing stops, pattern stops, volatility stops, support/resistance stops and many others that lie beyond our scope. However, we can simplify them into two types that matter. The first type uses market analysis as its basis. The second type arises from our emotions. Adhere to a simple principle. Stoplosses arising from your analysis are acceptable, acceptable, but those prompted by your emotions are not.
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EMOTIONS Avoid placing and adjusting stop-losses based on your emotions
We have preferences when it comes to managing our paper profits and losses. However, do not let your preference manifest itself emotionally. The prime example is the breakeven stop-loss. It refers to a stop-loss that is placed at the trade entry price so as to ensure that the trade will never become a loser. A breakeven stop-loss is the favourite tool of traders who prefer to lose small and frequent. They think that breakeven stop-losses will achieve their objective of cutting losses. However, by placing breakeven stop-losses, they are blatantl blatantly y giving in to the anchoring bias. They anchor their perspective to their entry price. Since a breakeven stop-loss is placed only to avoid losses, it is driven by a fear of losing money, rather than by the market’s price action. The market does not care if the trade makes or loses money, but the trader does. This disparity between the market reality and the trader’s mind-set affects the trader’s performance. Placing and adjusting stop-losses based on emotions is never a good idea.
If you prefer to lose small and to lock in profits whenever possible, you should wait for the market to offer a natural price action development before trailing your stop-losses. sto p-losses. Placing stop-losses in the middle of nowhere without considering either price action or volatility is a recipe for strangling s trangling the positive expectancy in your trades. An example of an emotional stop-loss is shown in Figure in Figure 2-5. 2-5.
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1. Bearish Anti-climax in a bull trend
4. Using pivot lows for trailing stop-losses is the way to go 2. Long Anxiety Zone setup bar
3. If we had moved the stop-loss to breakeven without an analytical basis, we would be stopped out here
Figure 2-5 A breakeven stop-loss has no price action basis basis
1. Price rose with a bearish Anti-climax pattern. Given the bullish market, we did not take the short setup. Instead, we waited for it to fail and lead us into an eventual long Anxiety Zone setup. 2. The setup bar came in the form of a bullish reversal bar. We bought as price broke above it. Our initial stop-loss stop-loss was a tick below the setup bar. 3. The market gave us three consecutive co nsecutive bullish bullish bars which were enough to prompt the impatient trader to place a breakeven stop-loss at our entry price. price. However, the the entry price had little significance as a support s upport level. Hence, that decision was not rooted in analysis, but in emotions. This bearish outside bar hit the breakeven stop-loss to the tick. 4. The correct way to lock in our profits was to wait for at least a basic pivot low before shifting our stop-losses upwards. As it turned out, the subsequent pivot lows served as excellent stopwww.tradingsetupsreview.com
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losses that managed to lock in profits while still allowing the market to continue rising. Here, we used a basic pivot low to trail our stop-loss order. As support levels, basic pivot lows are not as reliable as valid lows. Nonetheless, it is much better to use a basic low to trail a stoploss order, rather than trailing it to your entry price which has no technical significa s ignificance. nce.
2.4 - Consistency of Stop-losses While you are free to employ any stop-loss placement method, method, you must make sure that it is consistent with your trading strategy, especially especially in the case of trailing stop-loss. It is a simple concept. Generally, the more ambitious you are with respect to setting your trade target, the larger the margin you should provide for your trade to wiggle. Practically,, the questions that you need to consider are: Practically
How do you expect the trade to pan out? Is your stop-loss consistent with your expectations?
Let’s say you are a scalper aiming for very small profits. For profitable trades, you would expect price to hit your target swiftly without any pullbacks. Hence, you should be very aggressive in tightening your stop-loss.
On the other hand, if you entered the market believing that it was the start of a new trend and hence placed an ambitious profit target, you should be less aggressive when it comes to tightening tighteni ng the stop-loss. You cannot reasonably expect the market to cover a large distance without any pullbacks. Hence, your stop-loss strategy should account for this and leave greater room for possible pullbacks. For example, you should avoid
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using basic pivots for trailing stop-losses and stay with the more significant valid pivots instead. As you should have gathered by now, consistency is a major theme in this book. Every aspect of a trading strategy should be consistent. Only then, we can aim for long-term sustainable sustainable profits.
2.5 - Conclusion With a trading setup, we know where to enter and where to exit. Thus, we know how much we stand to lose. We have derived an important input of the expectancy formula - risk. For beginners, stick with the default method of placing stoplosses based on price patterns. In addition, adopt passive trade management. managem ent. Once you gain sufficient experience, you can experiment with trailing stop-losses. As for active trade management management (active adjustment of stoplosses and targets), we will discuss more about the thought process governing it in Chapter 5.
STOP-LOSSES Stick to passive initial stop-loss using trading setups when starting out
Use price patterns, support and resistance, and volatility to place your stop-loss
stop-losses s emotionally Do not set stop-losse
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Chapter 3 - Targets As opposed to the chapter on stop-losses, this chapter is a happy one about taking profits and making money. A profit target is placed with the aim of exiting the market with a profit once the market has moved in our favour for a reasonable distance. Target orders are usually limit orders placed above the market price for long positions and below the market price for short positions. While many traders agree that a stop-loss order is absolutely necessary to control our trade risk, they differ in their opinions regarding the need for target orders. This is because while a stop-loss is the only reliable r eliable way to limit our potential loss, there are several ways to secure our potential profit. profit.
Exit with a trailing stop-loss (as discussed in last chapter) Exit with a fixed target (static limit order) Exit with a moving target (shifting limit order like with the price channel I will introduce later) Exit with a reversal signal (market order)
As you can see, traders can choose to take their profits with stop-loss orders, target limit orders, or simply s imply market orders. There is a perpetual argument over the best way to exit a trade. This argument is pointless because nobody needs the best way. We just need a consistent method that makes sense and ensures positive expectancy.
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3.1 - The Importance of Profit Targets in Day Trading Let’s take a closer look at exiting with trailing stop-loss and target limit orders as they are two of the more common exit methods among day traders.
3.1.1 - Trailing Stop-loss In the last chapter, we saw examples of trailing stop-losses with price patterns and support/resistance levels to lock in profits. From the perspective of profit-taking, trailing-stops have the following characteristics.
Locks in profits by trailing behind favourable market
movement Allows profits to run if the stop-loss is placed appropriately Gives some paper profits back to the market
3.1.2 - Profit Target The implications of using target limit orders are different. Target limit orders by definition exit at the most favourable price attained during the trade and do not give back paper profits. Figure 3-1 shows how we use a limit order to exit at our profit target.
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3. Measured move target based on this upthrust
4. Sold here with a limit order
2. Bought here 1. Long Congestion Break-out Failure
Figure 3-1 Using a limit order to exit at our profit target
1. This chart shows a long Congestion Break-out Failure. Failure. 2. We bought as the market broke above the setup bar. 3. We projected our target using a measured move based on an earlier bullish thrust. We will discuss this technique later in this chapter. 4. Price rose swiftly to hit our sell se ll limit order placed just below the projected target. In this case, it appeared to be an ideal target as price formed a double top around that price level before collapsing back to our entry price level. However, a drawback of using target orders is that we decide how much profit we can take from the market rather than letting the market decide. In other words, we fail to let profits run and miss out on windfall profits profits when the market blasts away in the direction of our trade. www.tradingsetupsreview.com
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Figure 3-2 reveals the price action that follows our exit in in Figure Figure 3-1. It 3-1. It shows how the market continued to rise higher without hitting our stop-loss level.
2. The market continued to rise
1. We exited here
Figure 3-2 What we missed out
1. This was our earlier exit. 2. The market continued to rise. We could have earned around three times more if we did not exit with the profit target. So, which method is better? Trailing stop-loss or fixed target limit order? Many traders repeat this mantra, “Cut your losses short, and let your profits run.” Thus, conventional wisdom seems to advocate using trailing stop-losses which have the ability to let our profits run.
Using a trailing stop-loss is definitely beneficial for traders operating within the daily time frame and above. Let's take swing traders for instance. They enter the market with the www.tradingsetupsreview.com
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intention of capturing the next market swing over the next few days to the next couple of weeks. However, if the trade takes on favourable momentum, momentum, they can choose to extend the duration of their trade and trail their stop-loss prudently5. In this case, they can potentially capture a huge chunk of a prolonged secular trend. That is a very attractive proposition. However, this proposition is not present p resent within the context of day trading. By definition, day traders exit before the end of a trading session. Hence, our profit potential is limited by the range of each trading session. We need to bear this in mind when we decide on our exit technique. Day traders try to capture market movements within intraday time frames and must exit before the session ends. Hence, even with a prudent trailing stop-loss strategy, there is a clear limit to our profit potential compared to that of higher h igher time frame traders. The opportunity to catch the next major market swing does not exist for day traders. Thus, the incentive for employing trailing stop-loss for intraday trading is diminished. Within this context of limited profit potential,, we should aim for realistic and modest targets. Along potential with this line of reasoning, I strongly suggest that day traders use target orders to secure their profits.
TARGET LIMIT ORDERS Day traders should use target orders due to a limited time horizon
The decision to use target orders stems from our need to exit by the end of a trading session. This limit on our o ur holding period 5
Assuming that they are not trading short-term options that have high time decay.
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places a major obstacle to windfall profits. Hence, for strict day traders who exit by the end of each session, target orders are sensible. However, for traders operating within intraday time frames but hold positions across trading sessions, trailing stop-loss makes as much sense for them as for swing traders. This is because these traders are effectively effectively longer term traders operating within intraday time frames in order to fine-tune f ine-tune their entries. They are not interested in lower day trading margins or in avoiding overnight risk. Consequently, they are able to raise the limit on their profit potential. Many forex traders operating within the 4-hour time frame fall within this category. In addition, a profit target enhances discipline which is critical for day traders making swift decisions. When we exit a position with a target limit order, we know the exact price point where we are taking profits off the table. We have a plan. And having a plan is far more important than having the perfect plan. Without an exit plan, we get confused and emotional. We become timebombs. Remember that we do not need the perfect exit. First, there is no perfect exit. Next, we can afford to leave some money on the table and walk away, as long as the trading opportunity offers positive expectancy in totality. Despite the fact that a trailing stop-loss is not the ideal tool for day traders to take profit, we are not precluded from using trailing stop-loss in conjunction with profit targets. We can certainly use the former to reduce risk and lock in some profits, while maintaining a pre-set profit target within the market. The key point is that day traders should always have a working profit target in the market. Now that we have established the importance of profit targets in
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day trading, let’s look at the different ways to find reliable targets.
3.2 - Finding Targets A reliable target is a price level that seems magnetic and attracts price to it. How does a price level become magnetic? A bullish market will rise until it hits a resistance level. Hence, as a bullish market rises up to the resistance, it seems as though it is attracted to the resistance level. A more accurate description is that the market was bullish and rose, until it was resisted. The resistance was more of a roadblock than a magnet. Likewise, in a bearish market, price tends to fall until it is hindered by a support area. Thus, our aim is to find these potential roadblocks roadblocks and use them as our targets. To do this, we need to map out the support/resistance support/resista nce levels of the market to find out where prices might stall. In addition, we can also apply target project techniques to find suitable targets.
3.2.1 - Support and Resistance As the market rises, price tends to stall at resistance areas. Hence, for a long trade, a target right below a resistance area is ideal. A falling market tends to stall at support areas. Thus, for a short trade, our target should be placed right above a support area. In application, we should mark out the support and resistance areas around our entry price and observe the ease of market movement around these levels. It is usually sufficient to mark out the three support/resistance support/resistance levels closest to the market price. This is because it is unlikely for price to bust through three resistance/support levels without a significant pullback.
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The useful support/resistance areas include:
Swing pivots Congestion Zones High/low/close close of trading sessions High/low/
What is the basis of our observation? We look out for support/resistance areas. Then, how do we find reliable targets? The basic idea is to examine the degree of support and resistance between the entry price and the potential target target..
The likelihood that the market will hit a target in a long trade is inversely related to the amount of resistance between the entry price and the proposed target price. The higher the amount of resistance in between the two levels, the lower the likelihood of the market reaching the target. Let’s say we are considering a long trade, and there are five resistance levels above the current market price. The nearest resistance level is the most reliable target. The next higher resistance level is a less probable target as the market has to defeat the first resistance before it can reach it. Following this logic, each of the further resistance represents a less reliable target.
Similarly, the likelihood that the market will hit a target in a short trade is inversely related to the amount of support between the entry price and the proposed target price. The higher the amount of support in between the two levels, the lower the likelihood of the market hitting the target. Avoid plotting so many support/resistance levels that www.tradingsetupsreview.com
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meaningful analysis becomes challenging. meaningful challenging. I usually only consider at most the past 30 days of price action when I map out the support/resistance support/resistance areas. Figure 3-3 shows an example of how to analyse support levels to find a good profit target.
1. Short Pressure Zone setup bar
4. Low of previous session
2. Previous extreme low
3. Merged Congestion Zone 5. Session low two sessions ago
Figure 3-3 Mapping out the support areas for a short trade
1. As we consider taking the short Pressure Zone setup, we checked out the support areas below for a potential profit target. For now, let’s focus on the part of the chart to the left of the setup bar. 2. The nearest support was the last extreme low of the current market descent. Basically, it was the lowest pivot p ivot low formed just before the market pulled back up to form the the bearish Pressure Zone. These previous extremes are usually the most reliable profit targets as was the case in this example. 3. Moving down, the next lower support was a merged Congestion Zone from two sessions ago. As a prior zone of www.tradingsetupsreview.com
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significant price congestion, it was clearly a potential support area. 4. Furthermore, the low of the previous session was also within the Congestion Zone. Together, they provided a confluence of potential targets that enhanced the reliability of using that price level as a profit target. We will explore the concept of confluence in greater detail later in this chapter. 5. The most ambitious target on this chart was the support provided by the session low from two sessions ago. This was because for the price to hit a target placed here, the market had to first push through the thick merged Congestion Zone. Based on the above, the low of the previous session offered the most suitable target. This is due to the confluence with the Congestion Zone which is an effective price magnet even in isolation. Now, let’s look at the price action after the short Pressure Zone setup.
The Congestion Zone was obviously a key price area that contained the market for a couple of swings before sending it on its way up again. Although the market fell through the Congestion Zone and hit the furthest target we marked at the session low two sessions ago, you must realise that this target level was indeed a less probable target than the ones above or within the Congestion Zone. Support/resistance areas represent a vital factor in setting Support/resistance targets. In our targeting process, we should accord the greatest weight to support/resistance. The target projection techniques
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using price formations and volatility we will look at below serve to complement the support/resistance support/resistance structure.
3.2.2 - Price Thrust Projection The support/resistance framework framework for working out targets is only useful when we are able to rely on the price action of the recent past to project support/resist s upport/resistance. ance. For instance, in the example in Figure in Figure 3-3, we 3-3, we were able to project support levels based on the price action from the past two sessions. However, when the market is moving into a price range where it has not treaded through recently, we are unable to rely on past price action to project support/resist s upport/resistance ance areas. In such cases, target projection techniques are useful. Target projection techniques refer to using the magnitude magnitude of a recent significant price movement or formation as the basis for projecting targets. Even when there are support/resistance support/resistance areas to guide our targeting process, projection techniques still offer a valuable second opinion. Among the price formations that can be used for projecting targets, I find that price thrusts work the best for a trend trading framework. The following explains how to find potential targets using price thrusts. For projecting bullish targets, 1. Look for a series of bullish bars that contains at least two bull trend bars. The ideal thrust comprises at least three consecutive bullish bars with at least two bull trend bars. (For the definition of a trend bar, refer to Volume III Chapter 4.)
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2. Measure the distance between the lowest opening price and the highest closing price of the thrust. 3. Project the same distance from the highest close of the thrust to obtain the target level. Figure 3-4 shows an example of a bullish target projection in the ES 10-minute time frame. 4. Projected target hit here
3. Project the same distance
Highest closing price
1. Three-bar bullish thrust
2. Measure the distance between
Lowest opening price
Figure 3-4 Projecting a bullish target with an upthrust
1. We selected the first three-bar bullish thrust of the session. 2. We were only interested in the body of the thrust. Hence, we marked out the lowest opening price and the highest closing price of the thrust to measure the distance between them. 3. Then, we project the measured distance from the highest close of the bullish thrust to get our target. 4. The projected target turned out to be around the highest price of the trading session, offering an excellent target for any long trades initiated in the earlier part of the session. www.tradingsetupsreview.com
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For projecting bearish targets, 1. Look for a series of bearish bars that contains at least two bear trend bars. The ideal thrust comprises at least three consecutive bearish bars with at least two bear trend bars. 2. Measure the distance between the highest opening price and the lowest closing price of the thrust. 3. Project the same distance from the lowest close of the thrust to obtain the target level. Figure 3-5 shows an example of projecting bearish targets within the NQ 5-minute time frame.
Highest opening price 1. Nine-bar bearish thrust 2. Measure the distance between
Lowest closing price
3. Project the same distance
4. Projected target hit here Figure 3-5 Projecting a bearish target using a strong stro ng downthrust
1. The market started with a three-bar bullish thrust before changing into the reverse gear with a nine-bar downthrust. 2. We measured the distance between the opening price of the first bar in the downthrust and the closing price of the last bar.
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3. Then, we projected the same distance downwards starting from the last close of the downthrust for the profit target. 4. The projected target price caught the low of the day, as closely as we could have asked for. This trading session truly demonstrates the power of target projection using price thrusts. Let’s take a closer look at the other bearish thrusts in this trading session as pointed out in Figure 3-6. 3-6.
1. Nine-bar bearish thrust
2. Five-bar downthrust 3. Three-bar downthrust
Figure 3-6 Bearish price thrusts suitable for target projection
The targets projected using these three downthrusts are shown in Figure in Figure 3-7. 3-7.
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These 3 solid lines are the projected targets
Figure 3-7 Confluence of three targets pinpointed the session low
The solid lines mark out the targets projected using the three downthrusts. (Dotted lines mark out the start and end of each thrust.) This is a remarkable example showing the effectiveness of price thrust projections, especially when they cluster around the same price level. When you get clustered projections like this, you must pay attention, as they provide extremely reliable price targets. Please do not take this example as proof that price thrust projections are the perfect price targets. If you select random thrusts for target projection, you will find that many projections do not work as well and at times do not work at all. Nonetheless, when the market bias is clear, firm price thrusts in its direction offer a solid basis for projecting targets. The following types of price thrusts project particularly reliable targets.
The first strong thrust that leads to a change of the market bias
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A break-out thrust from a prolonged sideways market
I do not know exactly why target projection techniques work, but they seem to work often enough for me to include them in my analysis. However, I do have a plausible explanation that I consider when I apply the projection techniques discussed above. There are numerous target projection techniques including:
Measured moves Fibonacci extensions Channel projections Andrew’s Pitchfork Point and figure projections p rojections Chart pattern targets
While they seem diverse, it is in fact not a challenge to describe them in general terms. Basically, they focus on a price formation formati on (wave, thrust, consolidation, trend line or pattern) and measure its magnitude magnitude (in terms of price). Then, they project a target from the same price formation by the measured magnitude. magnitud e. This pretty much sums up all target projection methods. I believe that in each case, the price formation used for target projection is one that indicates the participation of the big market players or what some traders call c all the institutions. The general consensus among small retail traders is that the big players are smarter. Hence, when these smart monies flow into the market, they are probably expecting a significant market move. And it is reasonable to believe that the price impact of their entry (i.e. the price pr ice formation used for target projection) reflects their expectations of the extent of the subsequent move (i.e. the projected target).
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The above explanation is also consistent with the observation that price thrusts at the beginning of a trend and out of congested price action work better. To kick start a trend or to push the market out of a prolonged congestion definitely require the participation of the big players. This is why I am selective about the price formations I use to project targets. I stick to clear and obvious price thrusts for target projections. Finally, despite the numerous options for target projection, you should focus on using one or two of them for consistent trading. Using too many target projection techniques techniques is like using too many trading indicators. Despite being valuable individually, trying to use a dozen of them adds more confusion than efficacy. It is not worth it, especially when no projection technique works 100% of the time.
3.2.3 - Price Channels Price channels are powerful tools for profit taking. In addition, they offer a gauge of how realistic your targets are. Drawing a Price Channel
To draw a price channel, you need to know how to draw a trend line. (Not sure? Refer back to Volume II.) To get a bull channel, follow these steps. 1. Start with a bull trend line. 2. The bull trend line has two pivot points. Find the highest price point in between the two pivot points.6 That’s the origin of your channel trend line.
6
If there are two more equal highest price points (for e.g. double top), use the point that will produce a narrower channel.
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3. From that origin, draw a line that is parallel to the bull trend line. To get a bear channel, follow these steps. 1. Start with a bear trend line. 2. The bear trend line has two pivot points. Find the lowest price point in between the two pivot points.7 That’s the origin of your channel line. 3. From that origin, draw a line that is parallel to the bear trend line. Figure 3-8 demonstrates how to draw a bear channel. The resulting channel trend line turned out to be an effective target objective.
1. Bear trend line drawn with these two pivot points
A B
2. Lowest point between the two pivots; draw a parallel line starting from here
C
3. Look at how the channel trend line served as support; good idea to cover short positions here
Figure 3-8 Drawing a bear channel
7
If there are two or more equal lowest price points (for e.g. double bottom), use the point that will produce a narrower channel.
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For most charting software, you can draw a channel by selecting the channel drawing tool and clicking the points A, B, C in sequence. 1. This bear trend line was drawn with these two pivot highs. 2. In between the two pivot highs, we looked for the lowest price point. From there, we added a line that was parallel to the bear trend line. 3. Look at how the bear channel trend line acted as support. A good support is a good target for short trades. In this case, even if you think that the market would fall lower, covering at the channel trend line would have helped you avoid a strong adverse movement against your position. You can then re-enter your short position later at a better price. As trend lines get adjusted, the corresponding new channel become effective. Figure effective. Figure 3-9 below shows an example using the price action that follows Figure follows Figure 3-8. 3-8.
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2. This bear channel was possible after the market fell below point C
A
B
1. The channel from Figure from Figure 3-8
C
3. Channel trend line offered a great exit for short trades again Figure 3-9 Adjusting the channel to stay relevant relevant
1. The dashed lines mark the channel from Figure from Figure 3-8. 3-8. 2. After the market fell below point C, point B became a valid high. That allowed us to draw a new steeper bear trend line. Together with this new bear trend line, we drew a bear channel. 3. This channel trend line, like the one in the last example, served as a great target for short trades. Targeting with a channel means shifting your target limit order with every new price bar. This is because the price channel offers a moving target, one that gets more ambitious over time. What you can see from Figure from Figure 3-8 and Figure and Figure 3-9 is a common scenario. Right after a price channel is formed, the market moves quickly to the channel trend line before bouncing up with equal swiftness. Hence, in actual trading, to use a channel trend line as your target objective effectively, effectively, you need to anticipate the channel. www.tradingsetupsreview.com
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This means drawing potential channels, even before a trend line is confirmed. By anticipating the channel, you can place and adjust your target limit orders in advance. Channel Expansion
When the market is inorbreak-out mode and you offer expect large price swings, narrow shallow channels might targets that are too conservative. In that case, it might be useful to consider an expansion of the price channel. You can expand a channel by drawing an additional parallel line at an equal distance away from the channel trend line. Figure 3-10 shows an expanded price channel.
3. 200% line target hit
200% line
2. Equal distance Channel trend line or 100% line
Bull trend line
1. Bull trend line drawn with these two pivots Figure 3-10 Expanding a price channel
1. This bull trend line was drawn by connecting these two pivots. It was the basis of our bull channel.
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2. The distance (in terms of price) between the trend line and the channel trend line is the same as the distance between the channel trend line and the 200% line. I also call the channel trend line as the 100% line to distinguish it from the 200% line. 3. A target set based on the 200% line turned out to be accurate to the tick. Once you understand how to expand the channel to the 200% line, you can work out further expansions. (E.g. 300% lines and 400% lines) Guidelines for Using Price Channels
Here are some useful notes for trading with price channels. Normal targets should stay within the channel trend line (100% line). Targets beyond the 100% line are ambitious and might be unrealistic. unrealisti c. This is a rule of thumb you can apply to evaluate target options. For instance, you have two target options for a long setup. One is slightly below the 100% line and the other one is slightly above it. Despite the fact that the two targets are just a small distance apart, the market is a lot more likely to hit the target below the 100% line, at least before any deep retracement. For narrow and/or shallow channels, 200% lines can be considered for setting target objectives. However, always exercise greater caution when using target objectives beyond the 100% line. The earlier figures show textbook examples. You will encounter messier situations in your trading. Channels do not always work.
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At times, the market might fall short of the 100% line or it might go far beyond it. Like any other profit-taking method, it’s not perfect. Just like trend lines, the more reliable channels are those formed at the beginning of a new trend. Although price channels are built on the concept of trend lines, I did not write about them in detail in Volume II where we covered market bias and trend lines. This is because I use price channels primarily as a profit-taking tool to set my target orders, not as a tool to determine determine market bias. But clearly, channels have more to offer.
In general, all channel trend lines are potential support and resistance. You can interpret them in the same way you look at other forms of support and resistance. An example is the flipping of support into resistance and viceversa. Figure versa. Figure 3-11 below shows how a broken bullish 100% line flipped from a resistance into a support.
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2. 100% line broken here
3. The market found support at the broken 100% line
1. Bull channel drawn from here Figure 3-11 Channel trend line flipped from resistance into support support
1. This bull channel had its origins many bars back. 2. This bullish trend bar broke above the 100% line resistance. 3. Thereafter, the broken 100% line clearly acted as a support for the market. Recall that we draw our trend lines with valid pivots. That is because we want to stick to the most significant trend lines and limit the number of trend lines on our charts. We want a clean chart that we can actually analyse. Channel trend line offers another reason for drawing trend lines selectively. selectivel y. Imagine drawing every trend line you can with every pivot you can find, together with their channel trend lines. Figure 3-12 shows the disaster you will get with that approach.
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Figure 3-12 Many lines, little value value
The point is that a few consistently drawn trend lines, with the added utility of a channel, are sufficient for sound price action analysis. Keep your charts simple and uncluttered. unc luttered.
3.2.4 - Volatility Projection We have used the concept of market volatility (average bar range) for adjusting stop-loss orders. Naturally, it is also sensible to project profit targets with volatility. Although I do not use volatility targets extensively, it is useful when there is no suitable price formation for target projection. Volatility-based Volatili ty-based profit targets are also more robust as they depend on the market’s objective volatility rather than our subjective selection of the base price formation. formation. Generally, the range of price bars expands as it moves in the direction of the market bias and contracts when it retraces against the trend. This means that when the market is rising,
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the average range of bullish bars is higher than that of bearish bars. Thus, in a bullish market, it is conservative to assume that that each bullish bar is of average bar range. Then, let us consider the average number of bars in a price pr ice swing. Again, we would expect more bars in an impulse wave. This means that generally, there should be more price bars in an upswing compared to a downswing when the market bias is bullish. According to observations across instruments and time frames, the average number of bars in a price swing is around three. Hence, in a bullish market, the assumption that each upswing has three price bars is again a conservative one. In the case of a bullish setup, our ideal setup bar is the first bar of an upswing. Hence, we expect the swing to last another two bars before coming to an end. Combining this expectation with our earlier assumption that each bullish bar is of average bar range, the implied target is located at two times the average bar range above our entry price. (The average bar range is the long-term average described in the Wide Range Bar Trail in Chapter 2.) Relying on the same logic, in a bearish market, we can safely assume that the average bearish bar range is the average bar range, and the average bearish swing has three bars. Since we expect a short setup bar to be the first bar in a downswing, the implied target is also two times the average bar range below our entry price.
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VOLATILITY TARGET Aim for a profit that is two times the average bar range
Figure 3-13 shows an example of a volatility target projection for a long setup.
Target 3. Average bar range was 11 ticks, so we projected a target of 22 ticks
1. Bullish Pressure Zone
2. Not ideal for target projection
Figure 3-13 Projecting a volatility-based target target
1. We were considering our target options for this long Pressure Zone setup. 2. There was only one three-bar bullish thrust. However, it was not an ideal thrust to use for target projection as only the last bar in the thrust was a bull trend bar. 3. Hence, we decided to go with a volatility target. The average bar range was 11.7 ticks. We rounded it down to 11 ticks and
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doubled it to obtain a potential reward of 22 ticks. Then, we placed a target 22 ticks above our entry price. pr ice. As you can see, the market made its way up to our target. However, it was nothing like the orderly and ideal swings that we visualised in deducing the volatility target. It took three swings and 15 price bars to reach the target, and not the one swing and 2 price bars that we assumed. This volatility approach is based on an orderly market with ideal swings in the direction of the market bias and might seem simplistic. But it is made up of conservative assumptions and logical deductions. Hence, it does offer a reliable targeting option when we lack other basis for targeting. Whatever it lacks in precision, it makes up with simplicity. Of course, you must still evaluate volatility targets like any other target projection technique and consider them within the context of market support and resistance. If there is significant support/resistance support/resista nce standing in between the market and the projected volatility target, the reliability of the volatilit volatility y target decreases.
3.3 - Exiting with a Reversal Signal The three techniques discussed above help us identify potential profit targets. Then, as we enter the trade, we place a target limit order at the level we choose. Adopting a passive approach, we would wait for the market to hit our target before exiting. There is no further meddling. This is the recommended approach for beginners. As you gain experience in reading price action, you can consider early exits based on reversal signals. When we project our profit target levels, past price action is our
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basis. However, that does not mean that ongoing price action is useless. In fact, the current c urrent market movement provides more timely signals for exiting our positions. Thus, the question we are looking at now is if the market presents a reversal signal before our target is hit, do we exit? It depends on the quality of the reversal signal. s ignal. Since reversal signals go against the market bias, most of them will fail as the market resumes its trend. Hence, we should ignore most reversal signals. However, if the reversal signal s ignal is especially strong or worrying, it might warrant an immediate exit. The possible reversal formations that could prompt an early exit are varied and impossible to enumerate. Thus, in this section, we will focus only on two highly effective price formations that should prompt an early exit.
3.3.1 - Anti-climax Pattern As we saw in Volume III, the Anti-climax pattern is very effective at finding market tops and bottoms. When the Anticlimax pattern forms at a support or resistance area, it offers an extremely good reason to exit our trade. Figure 3-14 and Figure and Figure 3-15 show an example where a bullish Anti-climax Anti-clim ax pattern gave us the last warning to grab our profits.
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2. Short Congestion Breakout Failure setup bar
1. Price broke below the last swing low and the bull trend line with momentum
3. Bullish Anti-climax Figure 3-14 Short Congestion Break-out Failure trade
1. After forming several bars showing increasing upper shadows (selling pressure), the market broke below the last swing low and the bull trend line with firm momentum. This confirmed that the market bias had turned bearish. 2. Following the bearish thrust, price formed a congestion pattern. Price broke out above it and failed immediately, presenting us with a short Congestion Break-out Failure setup. We shorted a tick below this bar. In this case, the bullish breakout bar was not apparent. Hence, it was not surprising for the market to try to rise once more before plummeting. plummeting. 3. The second downswing after our entry was a bullish Anticlimax pattern. Figure 3-15 shows the price action prior to Figure to Figure 3-14. It 3-14. It points out why we had to exit with the bullish Anti-climax pattern, in the event that we haven’t already.
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2. Starting point of the last bull trend line
1. Shorted here
Tested low Valid low 3. Bullish Anti-climax was the second test of the valid low Figure 3-15 Bullish Anti-climax at a major support
1. For ease of reference, this bar corresponds to the short setup bar shown in Figure in Figure 3-14. 3-14. 2. We have marked out the support levels as our potential profit targets. The closest one was the starting point of our last bull trend line. As the bull trend line was relatively short-lived, this support was not significant. The next level was a tested low. The furthest and most ambitious target was a valid low. 3. The bullish Anti-climax pattern formed as the market tested the valid low for the second time. Given that the valid low was a potential major major support level, we should have placed our profit target at that level. If for any reason we did not do that and were still in the short trade, the bullish Anti-climax gave us the last warning to exit before the market erased our profits. Anti-climax patterns are effective when you Anti-climax yo u are looking for potential reversals that might prompt an early exit.
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3.3.2 - Merged Congestion Zone When the market runs into a Congestion Zone, it can either move past it swiftly, reverse, or start to congest. Let’s say we are in a long trade and the t he market rises into a
Congestion Zone. If it rises r ises above it without stalling, there is no reason for us to exit. If it reverses, we need to look at the quality of the reversal pattern to determine if it warrants an early exit. Most reversal patterns are merely false signals to trap more counter-trend traders. Hence, we should not treat every reversal signal as a signal to exit. The situation we are talking about here is the third scenario in which the market starts to congest within a Congestion Zone. The overlapping congestions will produce a merged Congestion Zone. A market congesting within a Congestion Zone is an ominous sign. There isn’t clear c lear strength busting through the Congestion Zone, and there are no reversal signs for us to examine. With our greatest effort, all we can decipher is the uncertainty uncertainty brought about by this new Merged Congestion Zone. Facing such development, we should exit at the market and wait for clearer signs to emerge. Figure 3-16 shows an example of a merged Congestion Zone within the context of a short trade.
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2. Valid low was a good target
3. Congestion Zone was also a possible target
4. New Congestion Zones were a clear signal to cover our shorts
Figure 3-16 Congestion to the power of three
1. We took a short s hort Congestion Zone setup that occurred after the bull trend line was broken. 2. This valid low was a good profit target. 3. The Congestion Zone below was also a reliable target option. 4. As the market descended into the Congestion Zone, it formed two more Congestion patterns (drawn with solid lines). This phenomenon of overlapping congestion was a clear signal that this price zone was a key support. Traders who have not covered their shorts should do so. Figure 3-17 shows the subsequent price action to highlight the power of merged Congestion Zones.
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1. The same short Congestion Zone setup
3. See how the market rose
2. Congestion within congestion Figure 3-17 Congestion Zone became the low of a new bull trend
1. This was the short Congestion Zone setup shown in Figure in Figure 3-16. 3-16. 2. This was the point where the market was forming forming new Congestion Zones within a prior Zone. 3. The resulting merged Congestion Zone turned out to be the low of a new bull trend. Figure 3-18 shows another example of a Merged Congestion Zone exit.
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1. Bear trend line drawn with this valid high 2. A bearish Deceleration setup bar with resistance from a Congestion Zone, trend line, and the last basic pivot
3. Congestion Zone projected from several sessions ago
4. New Congestion Zones were a clear signal to cover our shorts
Figure 3-18 Trapped by congestion
1. This session opened with a bullish gap from the last session. However, the market fell and soon formed a valid high. Using this valid high, we drew a bear trend line and took on a bearish market bias. 2. This was the setup bar of a bearish Deceleration setup. This setup was particularly impressive as it occurred with the blessing of a Congestion Zone, bear trend line, and a basic pivot. Moreover, the five-bar thrust did not even clear above the last basic high. (However, the five-bar thrust was still a reasonable concern and a more conservative method was to wait for a delayed entry, which came two bars later in the form of a bearish inside bar.) 3. This was a Congestion Zone projected from many sessions ago. It was a potential target for our short trade. However, we placed the target order more ambitiously to aim for the high of the last session. (Below the price range shown in Figure in Figure 3-18) 3-18)
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4. As the market descended, it formed three congestion patterns (solid line boxes). We were interested in the last two patterns as they formed within the Congestion Zone, creating a Merged Congestion Zone. Such price action prompted an early exit. Figure 3-19 shows what happened after the formation of this Merged Congestion Zone.
1. Shorted with this bar
3. The market cleared above the Merged Congestion Zone
2. Covered here
4. Tested Merged Congestion Zone twice and rose sharply
Figure 3-19 Merged Congestion Zone caught the low of the session session
1. This is the short setup bar in Figure in Figure 3-18 shown for reference. 2. We covered here due to the formation of the Merged Congestion Zone. 3. After more sideways s ideways movement, the market rose and cleared above the Merged Congestion Zone.
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4. Both tests of the Merged Congestion Zone met strong rejection, confirming confirming its significance significance as a support area. The market then shot up sharply. Both Merged Congestion Zone examples above show how Merged Congestion Zones caught the low of a new bull trend. I expect some temptation to trade reversals with this concept. Is it a good idea to trade tr ade reversals using Merged Congestion Zones? It is feasible to construct a reversal trading strategy using Merged Congestion Zones. If not, I would not have recommended it for profit-taking. profit-taking.
However, this is not the trading approach we are focusing on here. Our method is one that simplifies the game by focusing on one direction and wins the game by selecting only high quality trades.
3.3.3 - Additional Notes As you use reversal signal signals s to guide your trade exits, bear in mind that support/resistance support/resistance areas are still the pivotal factor in determining determini ng when to grab your profits. Reversal price formations formati ons merely augment the support/resistance areas. The examples above also highlighted the same as we saw a bullish Anti-climax pattern at a support level (Figure 3-15) and 3-15) and the market’s hesitation around a Congestion Zone acting as support (Figure 3-17). 3-17). Since reversal signals are effective for profit-taking, is it possible to do without profit targets and simply let reversal signals show us when to take profits?
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It is possible but there are several challenges to this approach. First of all, exiting based on reversal signals requires a high level of discretion that only experienced traders can exercise effectively. effectivel y. Regardless of the exact reversal signal, exiting at the market when a reversal signal occurs requires not only swift interpretation of market conditions but also extreme discipline. The slightest hesitation on the part of the trader would cause him or her to miss the best opportunity for exiting. Moreover, if greed takes over, the trader might be tempted to hold the position despite the reversal signal. s ignal. These factors cause confusion and disrupt our exit strategy. Without a clear plan for taking profits, we will never be profitable. profitable.
The next problem is that of assessing positive expectancy. We have mentioned this challenge challenge before in our discussion on stoplosses. Without a fixed target order, our reward-to-risk ratio is unknown. This would obscure our assessment of the expectancy of the trading setup. I am not saying that we must have a fixed profit target in order for our trades to exhibit positive expectancy. What I mean is that the expectancy of our trades becomes harder to assess without a fixed target. The implication is that we become increasingly increasingl y unsure of our trading edge. Again, this might not be a problem for experienced traders who have already verified with their track records that their discretion does more good than harm. Finally, taking profits with reversal signals, like all the other techniques, is not perfect. The market does not always offer a clear reversal signal before turning back. A sharp reversal without warning is possible, especially in fast-moving markets. In such cases, we might get stopped out before we could react
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to the reversal. If we had a profit target working in the market near a support/resistance zone, we might have exited already. Nonetheless, exiting by observing price action instead of having hav ing static targets is reasonable. When used correctly by skilled traders, it has the potential to do better than static targets. Thus, my advice is that you should practise exiting based on reversal signals only after you have mastered the skill of reading price action in real-time. Meanwhile, I strongly recommend that you maintain a profit target limit order in the market whenever you get into a trade. Having actual stop-loss and profit target orders in the market helps to ensure a disciplined and orderly exit.
3.4 - Targeting Examples We will go through more trading examples to demonstrate the analysis needed to find reliable profit targets. Before that, let’s go through the steps.
1. Plot the three closest resistance and support areas for bullish and bearish targets respectively. respectively. Include In clude channels if possible. 2. Project targets using price thrusts. 3. Look for confluence of potential targets. In your evaluation, evaluation, consider the following (listed from the most important to the least):
Confluence (clustering) of support/resistance support/resistance and projected targets Support/resistance
Projected targets
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Confluence is extremely important for setting profit targets. An example of a good cluster target for a long trade is two bullish price thrust projections clustering just below a resistance level. You will find more examples examples below.
3.4.1 - FDAX 10-Minute Example In this example, we will consider our options for setting targets for the long Pressure Zone setup shown in Figure in Figure 3-20. 3-20.
1. Original bearish market bias 3. Bullish momentum confirmed the bullish bias
2. Far below the trend line 4. Bullish Pressure Zone
Figure 3-20 Long Pressure Zone setup setup
1. The market was exhibiting a bearish bias. 2. However, price fell too far below the bear trend line and we became alert for any sign of reversal to a bullish bias without a trend line break. 3. This upthrust had a strong close above the previous swing high and managed to stay above it for three complete price
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bars. Its strong bullish momentum confirmed confirmed a bullish bias change. 4. Hence, we considered taking this bullish Pressure Zone setup. Concurrently, we were on the lookout for potential target levels. Figure 3-21 shows a safe and reliable target option.
3. Two-bar thrust projection
2. Last extreme high
4. Another bullish Pressure Zone 1. Long Pressure Zone setup Figure 3-21 A conservative target at the last extreme high high
1. I have marked out the long Pressure Zone setup we discussed above for ease of reference. 2. The last swing high before price retraced down to offer this long entry was the obvious and highly reliable profit target level. It was the most conservative target option. 3. A two-bar bullish thrust led us into our trade. Using this upthrust for target projection, we obtained a target that was slightly above the last extreme high. It confirmed that a target placed at the last swing high was reliable. www.tradingsetupsreview.com
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Note that this projection was possible only after our long Pressure Zone entry. Hence, we could not have considered it before taking the trade. However, it gave good confirmation for traders who decided to place their target at the last extreme high. 4. If you missed the first Pressure Zone setup, you would be considering a late entry. The market offered a second bullish Pressure Zone setup. Traders considering this second setup would have greater confidence in the target due to the confluence of the prior swing high and a price thrust projection level. We also considered another target as shown in Figure in Figure 3-22. 3-22.
2. Congestion Zone
3. Two-bar thrust projection
1. Long Pressure Zone setup
Figure 3-22 An ambitious but reasonable target target
1. Again, we have marked the same long Pressure Zone setup. 2. In this case, we looked beyond the last swing high for the next resistance area. We found a Congestion Zone that formed
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earlier in the trading session. It was a potential resistance area and served as a reasonable price target. 3. On top of that, the projection from the strongest bullish price thrust in the session so far produced a target price that was slightly above the Congestion Zone. Considering the close proximity of the Congestion Zone and the projected target, placing our target limit order a tick below the Congestion Zone was a sound move, albeit more ambitious than the target in Figure in Figure 3-21. 3-21. The bear trend line was also a significan s ignificantt overhanging resistance. Using a trend line for targeting is not a fixed target approach as the price level of the trend line changes with each price bar. It is a dynamic approach that requires us to adjust the profit target to match the trend line level. Here, the trend line was relatively shallow and overlapped with the Congestion Zone for several bars. Due to this confluence of resistance, the Congestion Zone was a very reliable reliable profit target level.
3.4.2 - ES 10-Minute Example Figure 3-23 shows a bullish Anti-climax setup. Let’s see how the possible targets for this setup were found.
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Bullish Anti-climax
Figure 3-23 Bullish Anti-climax setup
To find potential profit targets, we had to look for resistance levels from the (far) left of the chart as shown in Figure in Figure 3-24. 3-24.
3. Tested pivot high
2. Basic pivot high
1. Bullish Anti-climax
Figure 3-24 Resistance level as possible targets
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1. The last bar on the chart shows the bullish Anti-climax setup bar. 2. The basic pivot high from four sessions s essions ago served as a minor resistance. Given that it matched the current high of the session we were trading in, it was a promising target level. 3. This tested pivot high was also the start of the significant decline that the market was then recovering from. In order to consider projected targets together with the resistance levels we identified, we need to zoom in again to the current session. Figure session. Figure 3-25 shows the entire session. The resistance levels we identified in Figure in Figure 3-24 are marked out for comparison.
Tested pivot high
2. Target projected from a three-bar thrust
3. Target projected from a four-bar thrust
Basic pivot high
1. Bullish Anti-climax Figure 3-25 Not much confluence of potential targets targets
1. We have the same bullish Anti-climax pattern here as a point of reference.
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2. Using the three-bar bullish thrust just before the Anti-climax pattern, we projected a target. This target level did not enjoy any confluence. 3. With a four-bar thrust after our entry, we managed managed to project another target. As this projection was only available available after our entry, we could not use it for setting our initial target. However, we could consider it in our trade management, assuming we were still in the position by then. Considering the above, the high of the session at the point of our trade entry was the most reliable target as it enjoyed confirmation confirmati on from a basic pivot high. The tested pivot high was also a reasonable, albeit ambitious, option as it represented a major resistance level. Although this level stayed beyond the grasp of the market in this session, it was hit a couple of sessions later. As for the projected targets, they turned out to be the best target option for the trade within this session. Placing our target order in the middle of the two target projections would be perfect. However, we should not justify the means using the ends, at least not with a single trade outcome. When we were consideri considering ng our target options, the projected targets did not enjoy any sort of confluence. They did not appear as reliable targets. Hence, despite the outcome, we should stand by our analysis. (Unless, across a large sample of trades, you find out that projected targets without confluence served as better targets consistently. From my experience, confluence is always more reliable.) Wait a minute. After discussing so much, which one is the best target level?
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There is no best target level. There are only acceptable acceptable ones. And what is acceptable depends on our holistic assessment of the market bias, the setup, and the target. A target that together with the market bias and the setup offers positive expectancy is one that is acceptable. This is something we will work on in Chapter 5.
3.4.3 - 6J 10-Minute Example You should have gathered by now that looking for targets requires looking back (to the left of the chart). Figure chart). Figure 3-26 shows another example. Don’t worry about the details. We will zoom in later. For now, we just need to see the larger picture.
3. Points of interest are circled
1. Long setup
2. Look forby potential resistance looking left
Figure 3-26 Looking for resistance on the left
1. The long setup bar in this case is the right-most bar on this chart. Figure chart. Figure 3-26 shows exactly what we would see before taking the setup. 2. In our quest for possible targets, we looked left, searching for potential resistance.
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3. The significant pivot highs and congestion patterns are circled. From these points, we projected the resistance lines across the chart. Now, let’s consider our options more closely in Figure in Figure 3-27. 3-27.
4. Four major resistance areas above
3. Target projected with a six-bar thrust
2. Confluence of Congestion Zone, resistance level, and last extreme high
1. Long Pressure Zone setup bar Figure 3-27 Deciding on a target
1. The long setup we were interested in was a bullish Pressure Zone. 2. The dotted lines wrap around a Congestion Zone. The solid line below represents a major resistance level. Both levels were clustered just above the last extreme high of the market before it started to move sideways. sid eways. This triple confluence made this potential profit target extremely attractive. 3. This target was projected from a solid six-bar upthrust. 4. Above the projected target, there were four major resistance levels projected from past pivot highs, forming a thick zone of overhanging resistance. The market would find it difficult to www.tradingsetupsreview.com
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push through this level, but would also be attracted to it. The triple confluence mentioned in Point 2 offered the most conservative and highest probability target. The projected target in Point 3 did not enjoy confluence, but it was just below the very significant resistance zone. Hence, it offered a good target objective if you expected the market to do more than just testing the last extreme high. In other words, if you expected the bullishness to resume and push the market higher, the projected target was a sound choice as aiming above the four resistance levels would be too risky. Let’s see what happened with this setup.
4. Price reversed at the lowest resistance level
3. Projected target hit 2. Price pushed through the Congestion Zone with ease
1. Long Pressure Zone setup bar Figure 3-28 Interactions between price and resistance
1. We have marked out the same long Pressure Zone setup bar. 2. Price pushed through the Congestion Zone, which was also our most reliable target, with ease. It was a signal that the www.tradingsetupsreview.com
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market was likely to rise undeterred until the next significant resistance. 3. Hence, it was not surprising that the projected target was hit within the next three bars. 4. Our anticipation of resistance beyond the projected target came true as price reversed right below the lowest of the four resistance levels. In the retracement, the market fell just a little short of the Congestion Zone before resuming the trend. It then tried to push against the resistance level again.
3.4.4 - CL 3-Minute Example If you have decided to manage your trades actively, this example is for you. Here, I ’ll demonstrate how to adjust targets using the price action after our trade entry. This is a more complex example. As I’ve said, active trade management does complicate things.
In this example, we are looking for possible targets for the Congestion Break-out Failure setup shown in Figure in Figure 3-29 below.
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Long Congestion Break-out Failure setup bar
Figure 3-29 Long Congestion Break-out Failure setup bar
In the recent past, there were three significant significant resistance levels as shown in Figure in Figure 3-30 below. There was also a projected target with the six-bar bull thrust.
4. Congestion Zone
5. Thrustprojected target
3. Valid high
2. Last extreme high in this upwards trend
1. Long Congestion Breakout Failure setup bar
Figure 3-30 Nearby resistances as potential targets
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1. The long setup bar we were considering in this example. 2. The last extreme high was the most conservative target. 3. This valid high from the last session was a more ambitious one. 4. This Congestion Zone could be a price magnet if the market decides to test the price range of the last session. 5. This target was projected pro jected from the most powerful bullish thrust of the session. This would have been a good initial target. target.
3. This valid high, being within the channel seemed like a reasonable target
2. This bar confirmed a valid low and we drew the bull channel
1. Long setup bar
Figure 3-31 Evaluating targets with the new channel
1. We went long here. 2. This bar made a new high and confirmed a valid low for us. With that valid low, we drew a bull channel. 3. After adding the bull channel to our chart, it was clear c lear that the Congestion Zone target was beyond the channel. The valid www.tradingsetupsreview.com
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high from the last session fell within the channel. Hence, the latter was a more reasonable target. For traders who placed their target orders below that valid high, they had a chance to shift their target upwards to the valid high as part of their position management management.. A great deal took place in the price action that followed. Let’s take a closer look in Figure in Figure 3-32 below. This chart zooms into the price action after our entry. 2. New thrustprojected target 1. Thrust-projected target hit
3. As the market broke the bull trend line before resuming, the old channel was no longer in play; p lay; the new narrower channel took over Our setup bar Figure 3-32 Powerful confluence of channel and thrust targets
1. This bar hit the thrust-projected target mentioned in Point 5 of Figure Figure 3-30. 3-30. 2. The market formed a new bullish thrust on its way up to hit the target. Based on this new two-bar thrust, you could set a more ambitious target here. 3. Price broke the bull trend line before resuming, promp prompting ting us to draw a new channel (with thicker lines). www.tradingsetupsreview.com
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Look at the last bar in Figure in Figure 3-32. It 3-32. It hit three targets at once: 1. The valid high mentioned in Point 3 of Figure Figure 3-30. 3-30. 2. The new thrust-projected target mentioned in Point 2 of Figure 3-32. 3-32. 3. The channel trend line of the new channel mentioned in Point 3 of Figure Figure 3-32. 3-32. This confluence of three targets was a solid reason to take profit and close out any long positions. Figure 3-33 shows what happened after the achievement of the triple confluence target.
1. The bar that hit the triple confluence target
2. The market went into a deep retracement right after
Our setup bar
3. The market resumed its bullish path towards the end of the session
Figure 3-33 Not perfect, but useful
1. This bar hit the triple confluence target. 2. The market fell right after the target area was hit. It was not a shallow retracement, as it descended with good momentum. momentum.
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3. Towards the end of the session, the market resumed its bullish path and pushed to a new high. So, did the triple confluence target offer a good exit for our long setup? Looking at it ex-ante, it was definitely a good place to take profit. Three projected resistance in close proximity is not something you find frequently. When it shows up, it pays to take heed. Considering it ex-post, it showed uncanny accuracy in pinpointing the top of a deep retracement. It reduced our time in the market as prices went against us.
Although, of course, we can always point to the fact that the market eventually rose higher, and our initial stop-loss (below our setup bar) was never hit despite the deep retracement. With that in mind, we can complain that the target was not good and that we should have held our trade until the end of the session for a greater gain. But that’s not a healthy perspective for a trader , for two reasons. First, perfection is not what we are after. Chasing after the perfect exit will not make you happy and will not make you money. Focus on finding reliable reliable targets based on informati information on you have before and during the trade, not on regretting and complaining after the trade has ended. Second, a target must be judged together with your stop-loss and entry.
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If you do not trail your stop-loss and give it sufficient room for that deep retracement, retracement, it might be fine to hold on to your position and choose not exit at the triple co confluence nfluence target. But it was certainly a good idea to exit if you’ve already trailed your stop-loss to the last swing low. By doing so, you were giving the trade less room to breathe. This means that you should s hould not be targeting ambitiously either. For a market to hit an ambitious target, it requires more breathing space. If you are not giving it sufficient space, then you should use a more conservative target. target. In this case, if you did not exit with the triple confluence target, your trailed stop-loss at the last swing low would have been stopped out during the deep retracement downwards. downwards.
3.5 - The Wrong Way to Place Targets There are often several possible possible profit targets for each trade. The closest one alway always s has the highest probability of being achieved. The further the profit target, the harder it is for the market to reach it. This is because the market has to work through more support or resistance areas and cover a larger distance to reach targets that are far away. However, many traders disregard this simple relationship and choose to place their limit orders at the furthest profit target. For day traders, a common reason for this irrational beha behaviour viour is the desire to make up for losses incurred earlier in the session. In fact, many day traders are so obsessed with not having a losing session that they place their profit p rofit targets with the intention of earning the amount they lost earlier. e arlier. For instance, a day trader who has already lost 20 ticks earlier in the session would then place a profit target 20 ticks away. If
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his target is hit, he would not have to end the session feeling like a loser. That is a dumb way to place a profit target. Do not place your profit target orders further simply because you want to make more money or wish to make up for earlier losses. The market does not care if you want to make more money. When you care more about something more than the market does, you will lose.
3.6 - Conclusion Finding realistic realistic targets is critical to the success of a trade. Placing unrealistic unrealistic targets is very effective at ruining otherwise good solid trade entries. Use the techniques in this chapter to find realistic targets. In summary, observe support/resista support/resistance nce and target projections to find potential targets. Then, place a limit order at the target level as you enter the trade. This is especially important for day traders. As you gain more experience and confidence interpreting price action while you are financially committed, committed, you might consider exiting with a reversal signal. Regardless of our target analysis, due to the nature of the market, the nearest target will always present the highest probability of being hit by the market but offer the lowest amount of reward. The furthest target will always be hardest to hit but offer the greatest potential reward. This is a trade-off relationship relationshi p that we must accept. However, the trade-off relationship relationship is not linear. The best target is not the one with the highest probability or the one that offers the largest amount of reward. It is the one that offers the highest expectancy. Again, we are talking about the kinks to the
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right side of the trade-off graph between probability probability and reward-to-risk ratio mentioned in our introduction. (Figure 1-4) 1-4) Having a good target is as important as having a good stop-loss. If we enter the market without knowing when to exit, we have no edge. You need not know exactly what price to exit ex it at. However, at the very least, you must know what conditions would trigger an exit. Otherwise, it only means that you have no way to take your profits. In that case, you will not be profitable. It is like letting your winning lottery ticket expire because you do not know how to claim your prize.
PROFIT TARGETS
Place a working profit target order in the market support/resistance ance constantly Observe support/resist to look for potential targets
Watch out for confluence to find reliable targets
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Chapter 4 - The Meaning of Likely We have discussed about our stop-loss and derived our trade risk. We have also talked about our profit targets and derived our potential reward. Combining them will give us our rewardto-risk ratio. Now, there is only on ly one ingredient missing from our expectancy formula, and that is the probability of winning. Let’s work on it now.
As discretionary traders, there is at least a part of our trading edge that cannot be quantified or encoded mechanically. mechanically. Essentially, Essentiall y, the trading instinct which we believe to be the source of our trading edge seems unquantifiable.
However, we must understand that, ultimately and statistically, our trades must exhibit positive expectancy. And to assess if a trading opportunity offers positive expectancy, we need these three numbers: reward, risk, and probability of winning. With our stop-loss and target, we can easily calculate our risk and reward. The problem lies with the winning probability. How do we quantify that? In this chapter, we seek to reconcile our trading instinct with the mathematics mathema tics of positive expectancy. We aim to keep things as simple and intuitive as possible. Recall the definition of probability of winning a trade. It is the probability of the market reaching our target before hitting our stop-loss. When we are presented with a trading setup, consider its implied implie d stop-loss point. Then, size up the possible targets and choose a reliable option. At last, ask yourself if it is likely that
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the market will hit the chosen target before hitting the implied stop-loss? If the answer is “unlikely” , forget about the trade. If the answer is “likely” , we can then contemplate the possibility of entering the market. Let’s take a closer look at our answer, at the word “likely”. When we say “likely”, what do we really really mean? Can we attempt to quantify the probability implied by “likely”? “ likely”? Think of any question with the word “likely”. For instance, are you likely to go out tonight? to night?
Usually, this is not a question we can or are required to answer with mathematical certainty. However, for the sake of this exercise, let’s assume that you know you have a 90% chance of going out tonight. In that case, you would certainly certainly answer that you are likely to go out o ut tonight. How about when you know there is an 80% chance that you will go out? Still translates to likely. How about 51%? If you are compelled to answer, you would probably still agree that it is likely that you will go out tonight. But what if there is only a 49% chance that you will go out tonight? Would you still answer that it is “likely” that you will go out? Probably not. Our minds are programmed to think of 50% as a universal threshold. Hence, I am arguing that when we conclude that something is likely to happen, our mind in fact perceives at least a 50% probability of that thing happening.
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It follows that when we decide that the market is more likely to reach our target before hitting our stop-loss, the implied winning probability is at least 50%. Of course, it could be 60%, 70%, or 90%. However, we are traders, and we want to continue being traders. Thus, we should be conservative and assume that our winning probability is 50%. If your “likely to win” trades implies a higher probability, your track record will let you know eventually. For starters, let’s work with 50%. When we think that it is likely for a trade to succeed, the implied winning probability is at least 50%. However, there is a wellestablished cognitive bias that we should take into account. It is the overconfidence bias. This bias causes us to overestimate overestimate our abilities. This means that when we think that a trade is likely to succeed, the lower-bound of the implied implied winning probability is in fact lower than 50%. To account for this bias, I propose that we reduce our working figure for the implied winning probability to 40%. This figure is partly based on pure gut feel, and partly based on my own observation which typically shows a winning probability of between 40% and 50% for a large sample. Hence, the meaning of likely is 40%. This is the winning probability that we will use in our positive expectancy calculation.
4.1 - How to Assess the Probability of Winning Consider the following: Certainty y of the current market bias Certaint Reliabili Reliability ty of potential stop-loss level
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Reliabili Reliability ty of potential profit target level
Then, ask yourself this: Is it likely that the market will reach your profit target before hitting your stop-loss? To answer this question, your mind goes through some inexplicable inexplicabl e process to sum up the three factors above. Then, you will answer either yes or no. If the answer is yes, it is likely that the market will reach your target before your stop-loss, assume that the probability of winning is 40%.
If the answer is no, assume that the probability of winning is 0%.
40% The implied winning probability of a trade that is likely to succeed
You might be disappointed to find out that you only have 40% chance of winning each time you enter the market. In your mind, you think that there must be a way to win 90% of the time, or at least 80%. I have three responses to this 80% to 90% winning probability probability that many traders desire. The first is that ultimately, the winning probability is not as important importa nt as the resultant expectancy.
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You can take trades with 90% probability of winning. If those trades have negative expectancies, you will still lose in the long run. You can take trades with 10% winning probability. But if those trades have positive expectancies, you will still be profitable over the long run. High probability trades are overrated. Taking positive expectancy trades is the key to success. The second response is that a higher than 40% probability probability of winning is definitely possible if you select your trades very carefully. In deducing the winning probability of 40%, we’ve assumed the worst case scenario by taking the least implied probability of the word “likely” “ likely” and adjusting it lower to account for the overconfidence bias. This assumption helps us to trade conservatively until we figure out our trading edge. A probability figure of 40% may well be an underestimation underestimation of your winning probability. However, it is better to let your track record show you that you are capable of finding higher probability trades than to overestimate your own trading skills. If your trading records reveal that your winning trades make up a higher percentage of the trades you take, then by all means start using a higher probability figure. You might also realise that for certain types of setups, your winning probability is consistently consistentl y higher (or lower). In those cases, you can also adjust the probability figure accordingly. When it comes to estimati estimating ng our winning w inning probability, we are almost certainly wrong, if wrong means inexact. Thus, it is better to be wrong with an underestimation than to be wrong with an overestimation. overestimation. If we underestimate our winning probability, we will look for higher reward-to-risk ratios in our setups. Then, our expectancy will be higher than expected. If we overestimate our winning
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probability, we will settle for lower reward-to-risk ratios in our probability, setups. Then, our expectancy will be lower than expected. It might even become negative. negative. The drawback of underestim underestimating ating our winning probability is that we will end up taking fewer trades. This is because a lower winning probability requires a higher reward-to-risk ratio to achieve positive expectancy, and setups with high reward-torisk ratio occur infrequently. Trading less is not fatal as it is surely more important to ensure our profitability than that of our broker. Last but not least, although a higher than 40% winning probability is possible, I seriously doubt that a 90% win rate strategy with positive expectancy exists, with the exception of clear arbitraging opportunities. A 90% win rate strategy is definitely possible, but it will not be profitable in the long run. To get there, just aim for a 1-tick profit with a 1000-tick stop-loss. DO NOT DO IT. For this, the efficient market hypothesis offers the best explanation. explanati on. The financial markets are certainly not completely completely efficient. However, they are largely efficient. Hence, it is only logical that money-making opportunities are infrequent and fleeting. A winning strategy with 90% win rate r ate remains the stuff of daydreams.
4.2 - Conclusion In this chapter, we arrive at two simple conclusions. The first is that when we think that the market is likely to hit our profit target before hitting our stop-loss, we should assume a winning probability of 40%.
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The second conclusion is that high probability is in fact not high h igh at all. It refers to 40%. This is why we must be very careful with our selection of trades. Now, armed with a probability figure, we have all we need to pursue positive expectancy opportunities in the market.
MEANING OF LIKELY Start with a conservative winning probability probabilit y of 40%
Adjust it higher if your track record justifies a higher probability probability
Understand that positive expectancy is more important than win rate
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Chapter 5 - Achieving Positive Expectancy Now that we have gathered all the pieces of the positive expectancy puzzle, we can finally start trading. Let’s begin with assessing the expectancy of a simple example (Figure 5-1), 5-1), before moving towards a general formulation of our trading process.
1. Bearish Deceleration
2. Anxiety Zone setup bar (Risk of 2.5 points)
Figure 5-1 Anxiety Zone entry and trade risk
1. In this ES 10-minute chart, a bearish Deceleration formed in a rising market. The first two bearish bars that followed the pattern were not triggered. 2. The third setup bar was triggered and set up an Anxiety Zone. This bullish reversal bar was the long Anxiety Zone setup bar. It had a bar range of 2 points. Given that we planned to enter a tick (0.25 point) above it and place our stop-loss a tick below it, our total trade risk was 2.5 points.
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Figure 5-2 shows how we obtained our potential profit target.
2. Implied profit of 7 points
1. Measured move target using this bullish thrust Figure 5-2 Projecting our target
1. There was no appropriate overhanging resistance serving as a price magnet. Hence, we projected a measured move target using the most apparent bullish thrust of the session. 2. We intended to place our target limit order a tick below the projected level. That gave us a profit potential of 7 points. Now, let us calculate the expectancy of this trade. To recap:
Winning probability = W (40%) Reward of a trade = R (7 points) Risk of a trade = L (2.5 points)
Expectancy = (W x R) – [(1 - W) x L] www.tradingsetupsreview.com
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= (0.4 x 7) – [(1 – 0.4) x 2.5] = 2.8 – 1.5 = 1.3 > 0 Since the expectancy is positive, we should take this trade.
5.1 - The Split Second As demonstrated in the example above, trading requires us to analyse the market on an ongoing basis. Concurrently, we are trying to figure out the market bias, possible entries and stoploss levels, and possible target levels.
Then, the moment we find and target we quickly ask ourselves if a it reliable is likely stop-loss that the market will level, hit the target before hitting our stop-loss. If the answer is yes, we have to decide in a split second if the opportunity offers positive expectancy. Most day traders would not enjoy the luxury of time t ime that all allows ows them to compute the expectancy of the trade slowly like what we did above. This is particularly true for traders operating in fast-moving intraday time frames below the 5-minute time frame. If you are trading slower time frames like 30-minute or 1-hour, you might be able to do so. However, if the current price pr ice bar changes its form significantly significantly towards the last few seconds of its formation, it poses a difficulty as well. Hence, we need to devise a method or a tool to help us evaluate the expectancy of a trade swiftly. We can first reduce the challenge by recognising a simpler objective. In fact, we do not need to know the exact expectancy of a trading opportunity. All
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we need to know is if the expectancy of the trade is positive. If it is, we take the trade. If not, we pass. To begin, let’s revisit the three key components: risk, reward, and probability.
Our assessment of the potential risk and reward depends on our ongoing analysis of the market as we look for reliable stop-loss and target levels. Hence, they are constantly subject to change. On the other hand, we are assuming that our winning probability is always 40% when our minds conclude that a trade is likely to succeed. Thus, it is easier to use this static probability input as our starting point.
Given the winning probability of 40%, what is the minimum reward-to-risk reward-to-ri sk ratio required for a trading opportunity to offer positive expectancy? To recap: Probability of Winning a Trade = W (40%) Probability Reward of a Trade = R Risk of a Trade = L
Expectancy = (W x R) – [(1 - W) x L] (W x R) – [(1 - W) x L] > 0 W x R > L x (1 - W) R / L > (1 – W) / W R / L > (1 – 0.4) / 0.4 R / L > 1.5 www.tradingsetupsreview.com
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Given a winning probability of 40%, we need a reward-to-risk ratio above 1.5. Remembering this minimum reward-to-risk reward-to-risk ratio is extremely useful in that split second. It implies that as long as the trade we think is likely to succeed offers a rewardto-risk ratio of at least 1.5, we should take the trade. Let’s bring back the most important graph in this book. Look at Figure 5-3. 5-3.
Positive Expectancy
Negative Expectancy
Figure 5-3 We want to be on the right side of the graph
The sole objective of a trader is to find f ind opportunities opportunities to enter the market while staying on the right side of the graph where the expectancy is positive. In that split second when the setup bar is completed, we need to decide if we want to place p lace an order to enter the market. Our reward is based on the target we projected on the chart using projection techniques and by observing support/resistance. support/resista nce. Our risk is based on the bar range of our setup bar on the chart. Since both our reward and risk are implied implie d by technical levels on the chart, the best way to assess www.tradingsetupsreview.com
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the reward-to-risk ratio is by adding a simple indicator to our charts.
5.1.1 - R2R Indicator The Reward-to-Risk (R2R) indicator is a simple indicator that adds great value to our trading process. It is immensely immensely useful for facilitating decision-making decision-making in that split second. This indicator has only one mandatory input, and that is the probability of winning. The default value is 40%. However, depending on your trading skills and the specific trade setup you are considering, you may increase or decrease the probability.. Essentially, it represents your judgement of how probability probable it is that the market will hit our target level before hitting our stop-loss point. With the winning probability figure, the indicator is able to work out the minimum reward-to-risk ratio required for positive expectancy. Our standard trading method involves buying a tick above the setup bar and selling a tick below it. Hence, our trade risk r isk is the range of the setup bar plus two ticks. However, in actual trading, our trade risk is slightly higher due to trading commissions and slippage. We do not always get filled at the price we want. When we get filled at a worse price than where we placed our stop orders, the additional loss is called slippage. On top of all these, there is always room for human error (fat finger) that might cause us to incur additional risk. I am referring to errors in executing the trade, like accidentally accidentall y placing the order at a wrong price, and not in analysing the market. These are factors that will increase our trade risk.
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To factor these additional risks into our expectancy analysis, you can specify a buffer amount for these additional risks. (Default is 1 tick.) Based on that input, the R2R indicator automatically calculates the total trade risk. With the trade risk and the minimum reward-to-risk ratio, the R2R indicator computes the amount of profit necessary to justify taking that trade. By adding the profit required to our entry price, the indicator is able to mark out the price level that corresponds to the minimum acceptable acceptable profit target. Thus, our trading decision is simplified. If our target lies beyond the R2R chart marker, we can proceed to take the trade. If our target is within the chart marker, we should forgo the trade.
Figure 5-4 demonstrates how the R2R indicator simplifies simplifies our trading process.
2. There was a 40% chance that the market would reach this target before hitting our stop-loss order 4. The target was above the R2R projection
3. R2R projected minimum target
1. Bullish setup bar
Figure 5-4 Split second decision-making with the R2R indicator
1. We considered buying a tick above this bullish reversal bar.
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2. We assessed the context for possible targets and decided that the last extreme high of the trend was a conservative and reliable target. Looking at the target and the setup bar, it was likely that the market would reach the target before hitting our stop-loss below the setup bar. Hence, we assumed that the winning probability was 40%. 3. Taking the winning probability to be 40%, the R2R indicator projected the minimum target price required for the trade to offer positive expectancy. 4. As our intended target level was was above the R2R projection, we could take this trade without hesitation. hesitation. Figure 5-5 shows how the R2R indicator tells us that a subsequent setup bar in the same chart was not acceptable. 2. There was a 40% chance that the market would reach this target before hitting our stop-loss order
3. R2R projected minimum target
4. The target was below the R2R projection
1. Bullish setup bar
Figure 5-5 R2R helps us say no to a trade trade
1. For this example, we were considering to buy a tick above a setup bar that formed later.
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2. We assessed the probability of the market hitting our target before our stop-loss. For the sake of illustration, illustration, let us assume that again we were 40% certain. 3. This was the R2R projected minimum minimum target price level for positive expectancy. 4. As our intended target level level was below the R2R projected target, this trading opportunity did not offer positive expectancy. Although this setup bar was a clear bullish trend bar, it entailed a higher trade risk. Moreover, it was nearer our target level and offered less profit potential. Hence, with the same winning probability, this setup did not offer positive expectancy.
The R2R indicator is not a magical indicator indicator that finds you trades that are guaranteed to win. However, it is a nifty tool that constantly reminds us to look out for positive p ositive expectancy and helps us assess trading opportunities opportunities quickly. We offer our subjective input in the form of the winning probability after sizing up the market bias, target level and stoploss point. (Default is 40%.) The T he R2R indicator then transforms that subjective input into an objective criterion which is the minimum target level for positive expectancy. The principle of garbage in, garbage out applies here. Our estimation estimati on of the winning probability is the key. The reliability of the minimum target depends on the accuracy of our winning probability.. In turn, the accuracy of our winning probability probability depends on how well we interpret the market bias, the setup, and the selected target level. Given the correct probability input, the R2R indicator will always help us verify if a trade offers positive expectancy.
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Note that the R2R indicator is only valid for a trading method that fulfils the following criteria.
Enters the market on break-out of a setup bar Places a stop-loss order just below the setup bar
Our trading framework certainly fits the bill. If you have a different entry and stop-loss placement placement technique, you cannot use the R2R indicator. However, you can still use the same logic to design a tool to simplify expectancy analysis. Note that this indicator is not needed to trade profitably. profitably. I deplore trading books that explain a marvellous trading strategy before telling you that a proprietary black-box indicator is needed, not to mention the fact that the indicator costs thousands of dollars. This indicator adds only convenience and serves as an active reminder of the concept of positive expectancy.
5.2 - Complete Trading Examples We have been going through piecemeal examples examples concerning specific parts of the trading process. It was sufficient for explaining and clarifying individual concepts like the market bias, setups, targets, and expectancy. It is now time to put them together. In this section, we will go through complete examples that show you how to evaluate trading trading opportunities end-to-end. My intention is to show you how to trade in real-time real-time and not how to conduct post-trade analysis. Hence, the examples below are based on my trading experience. They explain my actual considerations during a trading session. (I trade mainly in the CL and FDAX futures market.)
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For each trading example, example, we will discuss d iscuss the following in detail. 1. 2. 3. 4.
Market bias assessment Setup analysis Probable target analysis Expectancy evaluation
The market bias assessment always comes first. If you can decipher the market bias, start to look for setups. If not, keep watching the market. If you change your market bias repeatedly within a short per period, iod, it means that you are confused. Turn off your trading terminal, terminal, and go for a walk. Listen to some music.
If you have a solid read of the market bias, you can move on to searching for actual trading setups. In most cases, the setup analysis and the search for probable targets would take place concurrently. Evaluating if a trading opportunity has positive expectancy is the last step. Take the trade only if your evaluation e valuation of the expectancy is positive. To fully understand the following examples, examples, you must be familiarr with the tools, techniques, and concepts explained so familia far. If you are unclear, refer back to the relevant section before proceeding.
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5.2.1 - CL 4-Minute Example (14 April 2014) Assessing the Market Bias
4. Price trapped between two trend lines; unclear bias 2. Strong bull thrust warning against taking short positions
5. Bearish momentum below the bull trend line; bearish turn
1. Gap open below the bear trend line
3. First valid low
6. These five bullish bars did not reach the last pivot high
Figure 5-6 Bearish bias bias
1. This session opened far below the bear trend line from the last session. Hence, we started this session with a bearish outlook. 2. However, the market rose for seven consecutive consecutive bars. Due to the large distance between the market and the bear trend line, we were sensitive to any bullish signs. Hence, this strong upthrust was sufficient to deter us from considering any short setup. 3. With this new valid low, we changed our bias to bullish. 4. However, the bear trend line was still effective, and there was overhanging resistance from a Congestion Zone projected from the previous Hence, pricefrom was trading trappeduntil between the two trend lines. Itsession. was wise to refrain the market bias became clear. www.tradingsetupsreview.com
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5. Eventually, the market broke below the bull trend line. The second tested low showed momentum as one bar stayed completely below the last pivot low. This was our signal to adopt a bearish bias. 6. Shortly after, a series of five bullish bars made us slightly unsure of the new bearish bias. However, the last two bars in the five-bar thrust did not make new highs, and the entire bullish thrust did not even hit the last pivot high. In conclusion, the market bias was bearish. However, it was not crystal clear, as with most newly established market bias. Analysing the Trading Setup
To highlight the price action surrounding the setup, we are zooming into the later part of the chart.
1. Congestion Zone and bear trend line acting as resistance
2. Bearish Pressure Zone
3. Setup bar implied trade risk of 9 ticks
Figure 5-7 A high-quality short Pressure Zone setup setup
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1. The market found resistance as it rose into a Congestion Zone and a bear trend line. It was the second rejection from this resistance combination. combination. The first was the one that led to the break of the bull trend line. This double rejection provided an excellent backdrop for any short setup. 2. A bearish Pressure Zone formed to confirm the selling pressure at the resistance area. 3. The last bar of the Pressure Zone was a bearish bar and served as our setup bar. Using our standard stop and entry method, this bar (range of 7 ticks) implied a trade risk of 9 ticks. This bearish Pressure Zone setup was of a high quality with solid resistance above it. We have defined our trade risk of 9 ticks. Analysing Probable Targets
For this short trading setup, we considered nearby support levels as possible targets.
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2. Valid low (33)
1. Tested low (27)
3. Session low (87)
Figure 5-8 Support levels as possible targets with implied profit (in ticks) ticks)
1. The target that the market was most likely to hit was this tested low. This target implied a profit of 27 ticks. 2. A valid low below the tested low was a slightly less probable target which if hit, would offer 33 ticks as the reward. 3. The most ambitious target was the session low. Ambitious traders would be targeting 87 ticks in profit. Traders using this target must have a strong conviction that the original bearish bias (indicated by the bear trend line) would resume. The first two support levels were relatively close to each other. They were six ticks apart. Six-tick was small compared with the average bar range in that trading session. Hence, we could consider the zone between them as a highly reliable target zone with the confluence of two support levels.
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Evaluating the Expectancy
Our market bias was bearish. However, as it was not crystal clear, we would prefer a high-quality trading setup if we were to go short. The bearish Pressure Zone setup resisted by both the Congestion Zone and the bear trend line offered us just the high quality opportunity we needed. Overall, it was likely that the market would hit the most conservative target at the nearest pivot low before hitting the stop-loss implied by this high quality Pressure Zone setup.
Winning probability = 40%
The trade risk was 9 ticks. The T he profit target offered the potential for earning 27 ticks. For simplicity, we are ignoring commissi commissions ons and slippage.
Potential reward = 27 ticks Potential risk = 9 ticks
With these pieces of information, information, we can calculat calculate e our expectancy for this setup. Expectancy = (40% x 27) – (60% x 9) = 5.4 ticks Hence, we expect to earn 5.4 ticks per trade over the long run taking trades of this profile. Given the positive expectancy, we should take this trade. Figure 5-9 shows the outcome of this trade.
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Stop-loss Shorted here
Target hit
Figure 5-9 A good and lucky trade trade
For this trade, we were lucky. Our target was hit, and we exited with 27 ticks before commissions. commissions. In fact, our target level turned out to be the best we could have hoped for. Wait a minute. We were lucky? Didn’t we scrutinise the market for its bias, a delicate entry, and a likely target for this trade? Isn’t the success of this trade a result of our trading skill and technique?
Yes, we did all that and determined that this setup had a positive expectancy before entering the market. Thus, it was a good trade. However, even good trades fail. The market could still have gone against us to hit our stop-loss order before hitting hitting our target limit order. If that had happened, it still does not change the fact that it was a good trade.
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With our trading skills, we take good trades. Over the long run, good trades will make us profitable. Hence, our job as a trader is to take good trades. However, for each individual good trade, it can either succeed or fail. That depends on luck. It is completely beyond our control. Recognise this. Fortunately, over time, luck will even itself out. The good luck we enjoy will cancel out the bad luck we suffer su ffer from. Hence, as long as we focus on taking good trades, we will be consistent. The point is that even if this trade resulted in a loss, we should not regret taking it, because it is a good trade.
The seasoned and consistent trader feels happy the moment he enters into a good trade. Even if the trade ends up with losses, the perfect trader remains equally content because he took a good trade with rigorous analysis analysis and clear procedures. An amateur trader feels happy only after he exits the trade with profits. If the trade ends up with losses, the amateur feels unhappy because he has lost money by taking the trade. This is because the amateur does not care if a trade is good. He just j ust wants winning trades. That’s unrealistic. We will return to this idea later when we discuss the Ultimate Litmus Test.
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5.2.2 - CL 4-Minute Example (1 May 2014) Assessing the Market Bias 2. This strong bull thrust might be a sign that the bias has turned bullish
1. A gap open below the bear trend line
6. With this new high, the bull trend line was adjusted
to the shallower solid line 5. This bear trend line acted as resistance for a while before breaking
3. The first tested low showed relatively weak momentum
4. Valid low that allowed us to draw the dotted bull trend line
Figure 5-10 How the market turned from bearish to t o bullish
1. The session opened with a gap below a bear trend line that originated from past sessions. Despite the extreme bullishness of the session’s first bar, we started with a bearish market bias. 2. As the first tested high of the session showed bullish momentum, we considered if the bias had turned bullish. While momentum, this development was sufficient to deter us from taking bearish setups, it was premature to confirm a bullish bias. This upthrust was also a bearish Anti-climax pattern, which we did not take due to the bullish momentum and the lack of resistance at that level. 3. The short Anti-climax setup showed promising follow-through downwards. However, as it formed the first tested low of the session, it was unable to exhibit clear momentum. Although Although it managed to close below the last pivot low for two bars, it was unable to clear below it. www.tradingsetupsreview.com
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4. As the market rose, it formed the first valid low of the session, and we drew the dotted bull trend line based on it. We then assumed a technical bullish bias. 5. However, we did not rush in to look for bullish setups as the bear trend line was still s till an effective resistance. Furthermore, the market has risen near the bear trend line and offered little room for potential profits. The bear trend line did not hold as a resistance for long. Eventually, E ventually, price meandered sideways and broke it. 6. Then, the market pushed up to make a new n ew high, giving us the green light to adjust our bull trend line to accommodate accommodate the recent sideways action.
Based on the adjusted bull trend line, the clearing of the bear trend line, and the lack of bearish momentum in the session, we changed our market bias assessment to bullish . Analysing the Trading Setup
For clarity, Figure clarity, Figure 5-11 shows a close-up of the price action just after the bear trend line was broken.
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2. This bar did not clear above the Congestion Zone
1. Three-bar congestion pattern
3. Confluence of support from Congestion Zone and bull trend line
Figure 5-11 Long Congestion Zone setup with trend line support
1. In the sideways movement that broke the bear trend line, a three-bar congestion pattern formed. Accordingly, we projected a Congestion Zone to the right. 2. The bar that made a new high did not clear above the Congestion Zone. Thus, according to our Congestion Zone trading rules, we should not use the Zone as a support level yet. 3. However, we exercised our discretion and treated the Congestion Zone as a support level for a long setup. This was because we were certain that the market bias has turned bullish. In addition, the bar mentioned in Point 2 almost cleared above the Zone. It was a borderline case. (If the low of the bar was one tick higher, it would have cleared it.) Hence, we considered a (modified) Congestion Zone setup as the next price bar found support from both the Congestion Zone and the bull trend line.
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Despite not being a perfect Congestion Zone setup, it had the support of a newly adjusted bull trend line. Hence, it was a reasonable setup. Taking this setup entailed a trade risk of 15 ticks. Analysing Probable Targets Let’s zoom out again and look at th e larger picture for possible profit targets. 4. Target projected from the bullish thrust 2. Last valid high 1. High of session
3. Most powerful thrust of the session with consecutive bull trend bars
Figure 5-12 Last valid high coincides with a target projection
1. The high of the session was of course a candidate for profit target. In fact, it was the most reliable one. 2. If the market managed to rise higher than that level, the next resistance level would be the price level of the last valid high. 3. For a second opinion, we identifi identified ed the strongest sustained bullish thrust of the trading tr ading session and projected a target based on it.
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4. The projected target was just a tick below the valid high, offering a confluence of target levels. The high of the session was the most conservative target. target. However, the next higher profit target looked reliable reliable as well with the confluence of a thrust-projected target and the most recent valid pivot high. Hence, we decided to go with the further target which implied a reward of 46 ticks. Evaluating the Expectancy
I was sure that the market bias had just turned bullish. Although I took some liberties with the Congestion Zone setup, the support provided by the bull trend line was assuring. Furthermore, I had a reliable profit target level at the last valid high. Considering these factors in totality, it was likely that the market would hit the target before hitting my stop-loss. However, does that mean that this trade offered positive expectancy? Let’s put our R2R indicator to use here for a quick answer. We used 40% as our estimate of the winning probability given our
intended stop-loss and profit target. In Figure In Figure 5-13, the 5-13, the horizontal mark shows the minimum target required for positive expectancy.
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3. Intended profit target level
2. Minimum required target level
1. Setup bar
Figure 5-13 A simple and visual way to evaluate e valuate expectancy
1. This was the Congestion Zone setup bar we were considering. 2. This blue mark above it was drawn by the R2R indicator. This indicator marks the minimum target level that implies positive expectancy. If our intended target is above this mark, the trade offers positive expectancy. 3. In this case, our intended profit target target at the last valid high was higher than the R2R mark, offering us a trading opportunity with positive expectancy. Hence, we took the trade. Of course, we could also go through the expectancy calculation like the last example and deduce that the trade was worth taking. However, the R2R indicator has greatly simplified simplified the process for us. If our planned target was at the current session high, we would not have taken the trade. It means that with a 40% certainty that the market would hit the nearer target before hitting our www.tradingsetupsreview.com
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stop-loss, the trade would not offer positive expectancy. (Figure 5-14) 5-14)
2. Minimum required target level
3. Intended profit target level
1. Setup bar
Figure 5-14 Skipping a trade with the help of the R2R indicator indicator
1. The setup bar remained the same. 2. Since our estimati estimation on of the winning probability and trade risk stayed the same, the minimum required target for positive expectancy was also unchanged. 3. However, in this case, the target level was below the minimum required. required. Hence, we had to skip the trade. If your assessment of the probability (given the more conservative target) was much higher than 40%, this trade might be acceptable. Take note that we do not adjust the target in order to achieve positive expectancy. We always plan our stop-loss and target level before considering the winning probability. Assessing if the trade has positive expectancy is always the final step. If we www.tradingsetupsreview.com
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adjust the target to a more ambitious level at this stage, we would need to decrease the winning probability. If not, the expectancy calculation calculation is no longer valid.
5.2.3 - CL 4-Minute Example (5 May 2014) Assessing the Market Bias 1. With this valid high from the last session, we drew this bear trend line
4. But there was no bullish momentum 5. The first bar of this session gapped up and fell rapidly
2. The bear trend line 3. Pivot lows formed above was broken here the trend line
6. With this new low, we adjusted the bear trend line
Figure 5-15 A broken trend line does not mean reversal
1. With this valid high from the last session, we drew the bear trend line (dotted). 2. The market rose and tangled with the trend line for a while before rising above it. Instead of concluding a change of market bias to bullish, we should observe for confirming bullish signs. 3. Pivot lows formed above the bear trend line, suggesting bullishness.
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5. That included the first bar of the current session, which gapped up before falling down swiftly. The speed with which the opening gap was closed issued a strong bearish signal. Moreover, this downswing cleared the last pivot low from the last session. With these mixed signals, it was better to wait for more price action to unfold. 6. With this bar, we were able to confirm the high of this session as a valid high. Hence, we adjusted the bear trend line to accommodate accommodat e it. The dotted trend line was adjusted to the higher and shallower solid trend line. With W ith this adjustment, we also adopted a bearish market bias. The first downswing of this session was peculiar and worthy of a closer look. Remember what marks the end of a downswing? An up bar. A bar with a higher h igher bar high and a higher bar low. Look at Figure 5-16 and try to find the first up bar of the session. at Figure
First bar of the session
Support from the
First up bar
last swing low
Last extreme low
Figure 5-16 A single swing, technically
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a single downswing to clear below two support levels. The bearish momentum was apparent. This observation cemented our bearish outlook. (The 6th, 16th, 17th, 19th bars had higher bar highs. However, they did not have higher bar lows. Hence, they were outside bars, and not up bars. If you are unclear on how I define outside bars, refer to Volume II Chapter 3.) Analysing the Trading Setup
For a clear point of reference, Figure reference, Figure 5-17 also begins with the first bar of the session.
First bar of the session 2. Bearish Anti-climax rising into a Congestion Zone
3. Setup bar
1. Congestion Zone
Figure 5-17 Anti-climax at a Congestion Zone
1. As the market tried to clear below the pivot low from the last session, it formed a six-bar s ix-bar congestion pattern which we projected to the right as a Congestion Zone. 2. After clearing below the Congestion Zone, the market rose up into the Zone with a bearish Anti-climax pattern. We also noted
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that the Anti-climax upswing did not clear the last swing high despite closing above it for two bars. It implied a lack of bullish momentum. 3. The next bar was a bearish bar which was our potential setup bar. Considering the bearish pattern and the resistance offered by the Congestion Zone, it was a reliable setup. Selling a tick below the setup bar called for a trade risk of 9 ticks. Analysing Probable Targets
To observe the larger picture for potential profit targets, we included the past two sessions into Figure into Figure 5-18
1. Short setup bar
2. Current session low
4. Congestion Zone
3. Valid low
5. Targets projected with downthrusts
Figure 5-18 Finding confluence
1. This was our short Anti-climax Anti-climax setup bar.
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2. A conservative target would be the current session low. If the market resumed its bearish move, that target would certainly be hit. 3. A more ambitious target would be the valid low from two sessions ago. 4. This valid low coincided with the level of a thin Congestion Zone projected from earlier price action. The confluence of the valid low and a Congestion Zone offered a highly reliable target. 5. In addition, we also projected several targets with the bearish price thrusts of the session. Let’s take a closer look at these projected targets in Figure in Figure 5-19. 5-19.
1. A solid downthrust for projecting bearish target
Short setup bar 3. Less ideal thrust
2. Projected target with the first thrust
4. Second projected target within the Congestion Zone
Figure 5-19 Projected target in the middle of the Congestion Zone Zone
1. The first three bars of the session was a solid thrust that was great for projecting a bearish target. 2. The projected target was a little below the Congestion Zone we first highlighted in Figure in Figure 5-18. 5-18. www.tradingsetupsreview.com
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3. This two-bar downthrust was less ideal for target projection. It contained two bearish bars of which only one was a bear trend bar. However, we still projected a target with it for a second opinion. 4. The projected target turned out to be right in the middle of the Congestion Zone and was just a tick below the valid low. The clustering of a valid low, a Congestion Zone, and a projected target gave us no choice but to choose that price level as our intended target. The potential reward was 34 ticks. Practically, you should be plotting these potential target levels on an ongoing basis, even before the formation formation of any trading setups. The constant question you can pose to yourself is “If I were to enter the market market now, where where can I place place my target order?” In this way, once a setup appears, you can size up the winning probability swiftly. Evaluating the Expectancy
The market bias was clearly bearish. The trading setup comprises a bearish Anti-climax pattern and a Congestion Zone acting as resistance. The target was reliable with a cluster of three support levels. Hence, it was likely that the market would hit the target before hitting our stop-loss. The assumption was again that we were 40% sure.
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1. Setup bar 2. Minimum required target level
3. Intended profit target level Figure 5-20 Evaluating expectancy with the R2R indicator
1. This was our setup bar for the short trading opportunity we were evaluating. 2. The R2R indicator marked out the minimum required target level for positive expectancy, assuming a 40% winning probability. 3. As our intended profit target target level was beyond the R2R chart marker, this setup offered positive expectancy. Hence, we should take the trade. However, as you can see in Figure in Figure 5-21, the 5-21, the market did not go our way.
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Stop-loss level
A firm bullish bar hit our stop-loss Profit target level
Figure 5-21 Stopped out! out!
The third bar after our short Anti-climax entry stopped us out. It was unfortunate. However, the real question was if our analysis was consistent and did we follow our trading rules. We did. Hence, we should not dwell unnecessarily on this loss. Instead, we should continue to monitor the market with the same objective lenses so as not to miss out on subsequent trading opportunities. opportuniti es. In particular, we should watch out for the possibility of a re-entry.
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Re-entry
3. Did not close above Congestion Zone
4. Possible reentry setup bar
2. Price did not clear above the high of the setup bar
Profit target level
1. Price cleared below the low of the setup bar
Figure 5-22 Examining the possibility of a re-entry
1. After our entry, the market cleared below our setup bar. However, the bearish momentum was short-lived, and we were soon stopped out. 2. Despite hitting our stop-loss, the price bars did not clear above the high of our Anti-climax setup bar. 3. Furthermore, the Congestion Zone remained effective effective as a resistance area. 4. This bearish reversal bar was the potential re-entry bar. Should we re-enter? Let’s recap the criteria for re-entering a short trade and go through them for this instance. (Table (Table 5-1) 5-1)
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No.
1
2 3 4 5
Criterion
Bearish bias must be intact. Original setup must be a high quality setup. Price must not clear below the low of the setup bar. Price must not clear above the high of the setup bar. Re-entry setup bar must be bearish.
Evaluation
Bearish bias was intact. No sign of bullish bu llish momentum and no bear trend line break. The original setup combined both an Anti-climax and a Congestion Zone setup. It cleared below for one bar. It did not clear above. It was a bearish reversal bar.
Table 5-1 Re-entry evaluation evaluation
Technically, this instance did not meet our criteria for re-entry Technically, as one price bar cleared below the low of the setup bar. However, I decided to exercise my discretion, bend the rules, and re-enter anyway. This was because the session has not shown any bullish momentum. Thus, I was relatively confident that the session would be bearish. Moreover, price cleared below the low of the setup bar for only one bar. Recall that the rationale of Criterion 3 was to ensure that we were not re-entering trades that had already succeeded to a reasonable extent. In this case, despite clearing below the setup bar for one bar, it did d id not go anywhere near the low of the session, which was the most conservative target for this setup. Hence, the trade has not succeeded. Notwithstanding my decision to re-enter, I must assess if the Notwithstanding re-entry offered positive expectancy. As the re-entry setup bar had a larger bar range, the trade risk for the re-entry was bigger than that of the original entry.
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1. Re-entry setup bar 2. Required target level
3. Intended profit target level Figure 5-23 Expectancy of the re-entry setup
1. This was the re-entry setup bar. Our stop-loss would be placed a tick above it, requiring us to risk 14 ticks. 2. Assuming a 40% winning probability, the R2R indicator marked out the required target. (In fact, on average, re-entries enjoy a higher winning probability than original setups. However, for simplicity, we maintained the probability at 40%.) 3. We kept to the same profit target, and the potential reward was 40 ticks. Since the profit target was below the R2R marker, the re-entry implied positive expectancy. Thus, we re-entered the market. Figure 5-24 shows the entire session including the outcome of our re-entry.
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1. Anti-climax short setup 2. Re-entry setup
3. Target hit here
Figure 5-24 Price action after the re-entry re-entry
1. This was the original short Anti-climax setup, which we were stopped out of. 2. This was the re-entry setup bar. 3. Our target was hit with a strong bearish bar. Before we conclude this example, there is one more point to make. Remember how breakeven stop-loss is a bad idea? This re-entry trade example reiterates this point. po int.
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1. Re-entry setup 2. This bar would have hit a breakeven stop-loss to the tick
Figure 5-25 Just don’t don’t try try to breakeven
1. This was our re-entry setup bar. We shorted a tick below it. 2. If we had shifted our stop-loss order to breakeven (a tick below the low of the setup bar), this bearish outside bar would have stopped us out. Using a breakeven stop-loss (that has no price action basis) would have cost us our trading commissions instead of earning us 40 ticks. In fact, after the formation of the bearish outside bar, we could have trailed our stop-loss order to a tick above it. Remember that we are not against tightening tightening stop-losses. We are against tightening tighteni ng stop-losses without an analytical basis. In this case, the high of the bearish outside bar offered a short-term resistance point which we could rely on to tighten our stop-loss.
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5.2.4 - CL 4-Minute Example (12 May 2014) 20 14) Assessing the Market Bias
1. Gapped above the bear trend line from the last session; started with a bullish bias
2. Bearish momentum might reverse the bias but none came
3. This bar confirmed the first valid low of the session
4. Then, we could draw this bull trend line
Figure 5-26 Forming the first trend line of the session
1. The previous session closed with price poking slightly above the bear trend line. The first bar of this session ses sion gapped above the bear trend line with momentum and confirmed a bullish bias. 2. At this point, there was no bull trend line supporting the market. Hence, we looked out for bearish momentum that might change our market bias but none came. However, there was no bullish momentum as well. Basically, all the tested pivots were unable to clear their respective r espective preceding pivots. The market was moving sideways. s ideways. 3. Eventually, the market drifted upwards and made a new session high. This new high confirmed the circled swing low as a valid low.
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4. With this valid low, we were able to draw a bull trend line from the low of the last session. The bull trend line did not pass through the valid low because we had to accommodate all of the price action that occurred before the current extreme high. (If you are not sure how to draw the trend line, you can review the rules in Volume II Chapter 4.) Now, let’s zoom in and look at how the market interacted with this new bull trend line. Figure line. Figure 5-27 shows the same market as Figure 5-26 but retains only the price action of the current session.
1. Selling pressure
2. The first trend line break lacked momentum
3. The attempt to continue the bullish trend was rejected by a bearish outside bar; note the fivebar downthrust and the bearish momentum Figure 5-27 A double top that changed the market bias
1. Although this bar confirmed a valid pivot low, there was clear selling pressure. Obviously, this new price high was not met with enthusiasm. 2. The bull trend line was broken almost immediately after we drew it. However, a mere trend line break was not enough to turn our bias bearish.
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3. The market tried to exceed the session high again. The sellers reacted with a bearish outside bar strong enough to form a double top. That reaction resulted resu lted in a five-bar downthrust. The last bar of the thrust cleared the previous pivot low, showing bearish momentum. At this point, we had to switch our market bias to bearish. Analysing the Trading Setup
1. Congestion Zone (dotted box)
2. Bearish Pressure Zones (solid boxes)
3. Short setup bar for two bearish Pressure Zones and a Congestion Zone
Figure 5-28 A matter of Zones
1. The nearest Congestion Congestion Zone (dotted box) above the market was projected by a tight congestion pattern. It was formed just before the market made a new extreme high. 2. After the five-bar downthrust, the market made two attempts to rise. However, both attempts attempts were met with selling pressure. Look at the solid boxes that represent bearish Pressure Zones. In particular, the second Pressure Zone overlapped with the resistance provided by the Congestion Zone.
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3. With the support of two bearish Pressure Zones and a Congestion Zone, this short setup looked extremely good. However, I had a small concern. There was a thicker Congestion Zone surrounding the current price action as shown in Figure in Figure 5-29. 5-29.
2. Intended short setup bar
1. Seven-bar congestion pattern
3. The market still seemed stuck within this larger Congestion Zone
Figure 5-29 Could the market make it out of the Congestion Zone?
1. During the meandering earlier in the session, there was a seven-bar congestion pattern. (The arrow points to the last bar of the congestion pattern.) It projected a thick Congestion Zone. 2. This was the short setup bar we were considering. 3. However, looking at the more recent price action, the market had difficulty pushing out of the thick Congestion Zone. If the market continued continued to be restrained by the Zone, this short setup might not be such a good idea. After summing up the above aspects, I decided that this setup was still a reliable one. I had two main reasons. www.tradingsetupsreview.com
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First, it was a double bearish Pressure Zone setup that found resistance at a Congestion Zone. It was clearly a high quality setup. Second, although the market had difficulty moving beyond the thick Congestion Zone, the way it was moving has changed. Before the break of the bull trend line, the market formed several congestion patterns. After the trend line break, br eak, despite finding support at the bottom of the thick Congestion Zone, the market did not form any more congestion patterns. This was a signal s ignal that the market has moved from a meandering phase to one that was ready to make more substantial price swings.
This setup implied a trade risk of 9 ticks. Analysing Probable Targets
We kept tabs on the support levels below the current market price as marked out in Figure in Figure 5-30. 5-30.
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1. Valid low 2. Current session low 5. Target projected with the five-bar downthrust 3. Congestion Zone from the last session
4. Low of the last session Figure 5-30 Profit target options
1. The only valid swing low of the current session was the obvious conservative profit target. 2. The next lower target was the lowest price of the same session. 3. For more ambitious targets, we had to examine the price action of the previous session. The closer one was a Congestion Zone from the last session. 4. The furthest option shown on this chart was the low of the last session. 5. We also projected a bearish target with the five-bar downthrust. It was the first real downthrust of the session and the one that led to a change of market bias. Technically, Technically, three out of the five bearish bars were bear trend bars. For these reasons, this downthrust was especially suitable for target projection.
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The only sign of clustering among these levels was the closeness between the current session low and the target projected with the five-bar thrust. Hence, I decided on placing a target order o rder just above the thrust-projected target, aiming for a reward of 27 ticks. Evaluating the Expectancy
Given the recent change in market bias to bearish, the multizone short setup and the reliable price thrust projection target, it was likely for the market to hit the target before reaching the stop-loss a tick above the setup bar. It was then time to examine the expectancy. In evaluating our expectancy, we assumed that we were 40% sure again. (You may adjust this figure according to your confidence level for each trading setup. This is after all, your most important discretionary discretionary input in the trading process.)
1. Setup bar
2. Required target level for positive expectancy
3. Intended profit target level Figure 5-31 Target must be below the R2R marker marker
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1. This firm bearish bar was our short setup bar. We intended to short a tick below it. 2. According to our R2R indicator, the target for this short trade must be below this level in order for it to result in positive expectancy. 3. As our intended profit target was was below the R2R marker, this trade offered positive expectancy. Hence, we placed a sell stop order a tick below b elow the setup bar. The next bar triggered the order. Figure order. Figure 5-32 shows how this trade panned out.
1. Setup bar 4. Breakeven stop hit
2. Target hit
3. Warnings to exit
Figure 5-32 Target hit swiftly swiftly
1. Our sell stop order a tick below this setup bar was triggered by the next bar. 2. The market tumbled down to our profit target without any significant resistance. resistance. We exited with 27 ticks of profit.
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3. Subsequently, the market went sideways and found resistance at the low of the first bar of the session, forming a triple bottom. These signs of resistance were warning traders to cover their short positions if they had not already done so. (Another warning sign was the five consecutive bearish bars that could not push the market down to a new low.) 4. Again, look at how placing a breakeven stop-loss indiscriminately does more harm than good. Let’s say you did not place a profit target or you had an ambitious ambitious target order that was not hit yet. After the impressive eight-bar bearish thrust, you wanted to let your profits run but you also wanted to ensure that you will definitely be a winner. Hence, you adjusted your stop-loss order to breakeven despite the fact that the breakeven level had no technical significance. significance. This bar would have hit the breakeven stop-loss to profit. the exact tick, before plunging down into more than 20 order ticks of Some traders support the idea of having h aving breakeven stop-losses because of their psychological benefits. Knowing that your worst case scenario is breakeven and that your trade will never become a losing one offers comfort. It reduces the fear of losing and the trader will find it easier to let his profits run. Not to mention that this idea involves responding irrationally to an irrational fear, its psychological benefits often backfire. Look at the same example in Figure in Figure 5-32. Your 5-32. Your breakeven stoploss order was hit exactly to the tick. Not a tick more or less. Then, the market plunged down again in your favour. You felt that your analysis was right, and yet instead of earning 20 ticks, you merely scratched the trade. You thought that you deserved the profits. Why is the market against you? You will be tempted to over-trade to get back the profits you think you deserve. Under such situations, situations, you will need extreme discipline to stop yourself from revenge trading.
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On a separate note, this example also highlights h ighlights another important importa nt trading concept. Entries, stop-losses, and targets are equally important for profitability. In Figure In Figure 5-32, the 5-32, the market did not hit our original stop-loss order for the rest of the session. That meant that our choice of the trading setup ((i.e. i.e. entry and stop-loss level) was good. However, our choice of profit target would have made a huge difference to the trade outcome. With the profit target we chose by observing support levels and projected targets, we ended the trade with 27 ticks of profit. If we did not use a profit target order or placed our target too far away, we might still be able to exit with around 20 ticks of profit by observing the warning signs pointed out earlier. If we had entered the trade without placing a realistic profit target and ignored the warning signs, we would have held the trade to the end of the session and exited with a 5-tick profit. The ability to choose realistic realistic targets and to t o react to warning signals is as important as choosing the best entry point. This is especially true for day trading. Focus on selecting selecting realistic targets first. Learn to react to warning signals later.
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5.2.5 - CL 4-Minute Example (15 May 2014) Assessing the Market Bias 2. Shallow bear trend line from the last session
1. First bar of the session opened with a gap past the last swing low
3. Congestion around the low of the last session 4. Price continued to fall, confirming the valid swing high
Figure 5-33 Gapping into a bearish market bias
1. This session opened with a down gap past the last swing low. It showed solid bearish momentum. 2. The down gap also confirmed a valid pivot high from the last session. Thus, we drew the bear trend line and adopted a bearish outlook. However, as the bear trend line was shallow and the market was a distance below it, we remained alert to any signs of a bullish reversal. 3. Unsurprisingly, price meandered around a support level projected from the low of the previous session. 4. After making two tested highs, the market continued to fall with good momentum. This fall confirmed the earlier tested high as valid high. Accordingly, weresult adjusted line to catch up awith this development. The was our the trend steeper bear trend line. www.tradingsetupsreview.com
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The steeper trend line was broken quickly as shown in Figure in Figure 5-34. It 5-34. It shows the price action in the current session.
1. Steeper trend line from Figure from Figure 5-33
4. Price did not reach the last valid high
3. Tested high could not even close above the last swing high
2. upthrust theFour-bar trend line but didbroke not test the last swing high Figure 5-34
Bias change? Or not?
1. This was the steep trend line from Figure from Figure 5-33. 5-33. 2. This four-bar bullish thrust broke the bear trend line. Remember that a mere trend line break is insufficient to change the market bias, unless there is clear accompanying momentum.. Moreover, despite the four consecutive bullish bars, momentum the market did not even test the last swing high. 3. This was the first tested high after the trend line break. However, the bars could not close above the last swing high. 4. Furthermore, despite a protracted upwards drift, the market did not even hit the last valid swing high. Due to a lack of bullish momentum, despite the trend line break, our bias remained bearish .
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Analysing the Trading Setup
1. Congestion Zone
4. Second Congestion Zone setup (Re-entry) 2. Short Congestion Zone setup
3. Re-entry setup bar (not triggered)
Figure 5-35 Skipping the first setup
1. The earlier price action projected a Congestion Zone that acted as a resistance area. 2. The four-bar bullish thrust bumped into the Congestion Zone but was unable to close within in. Although it presented a Congestion Zone short setup, I chose to skip it and waited for a re-entry equivalent trade due to the four consecutive bullish bars. Bullish thrusts like this, even if they do not reverse the market bias, seldom reverse down without whipsaws. whipsaws. Moreover, the setup bar in this case had a lower shadow which implied buying pressure. 3. The preceding bullish bar would have hit a stop-loss order placed above the short Congestion Zone setup bar. Hence, this was a re-entry setup bar. We placed a sell stop s top order a tick below this bar. However, the next bar did not trigger the sell stop order as it shared the same low as the re-entry setup bar.
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As the best re-entries happen swiftly, I chose to cancel the sell stop order and observe further. Another reason for cancelling cancelling the order was that the market did not test the Congestion Zone again for resistance. 4. This setup bar offered another chance for re-entry as the market had not cleared above the high of the original short setup bar (marked in Point 2). Furthermore, it was the second bounce from a Congestion Zone and was a short double Congestion Zone setup. This failed second incursion into the Congestion Zone presented an excellent opportunity to get into a short position. This setup bar implied a trade risk of 10 ticks. Analysing Probable Targets
At the same time, we have been looking out for support levels below the market. These levels were potential target levels. As usual, we had to zoom out to the larger picture as shown in Figure 5-36. 5-36.
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1. Short setup bar
2. Current session low
3. Merged Congestion Zone from two sessions ago 4. Another Congestion Zone 5. Low of two sessions ago Figure 5-36 Analysing potential support below the market
1. This was the short Congestion Zone setup bar we were analysing. 2. The most probable target was the current session low. 3. If we looked a little further, the Merged Congesti Congestion on Zone from two sessions ago was also a great option. Merged Congestion Zones are particularly effective as price magnets as they are made up of overlapping congestion patterns. 4. Looking further back in the same session, we found another Congestion Zone. 5. Then, the most ambitious target option shown in this chart was the low of the session two days ago. Looking at the support levels, the Merged Congestion Zone was a significant support area and it was definitely unwise to place our target objective below it. Thus, we considered having a
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target order between the current session low and the Merged Congestion Zone. Let’s look at thrust-projected targets to see if there was any confluence with the support levels.
1. Short setup bar
2. used forDownthrust projecting target
3. Projected target within the Merged Congestion Zone Figure 5-37 Projected target within the Merged Congestion Zone
1. This was our short setup bar, marked out for reference. 2. This three-bar bearish thrust was the obvious candidate for target projection. 3. The projected target was within the Merged Congestion Zone we identified in Figure in Figure 5-36. 5-36. Due to this confluence, we settled on using the th e thrustprojected target as our objective.
Placing a target limit order a tick above the projected target gave us a potential reward of 51 ticks. (A more conservative
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approach would be to place the target a tick above the Merged Congestion Zone.) Evaluating the Expectancy
Again, no trade can be taken without considering expectancy. expectancy. Assuming weour were 40% certain that the theR2R market would hit our target that before stop-loss, we used indicator indicat or to assess if this trade was worth taking.
1. Setup bar
2. Required target level for positive expectancy
3. Intended profit target level Figure 5-38 Expectancy analysis
1. This was our short setup bar. 2. According to the R2R indicator, we should only take the trade if our intended target was below this price level. 3. As our intended target was below it, it was an opportunity of positive expectancy. In this case, if you thought that it was likely for the market to reach only the current session low (and not the Merged
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Congestion Zone), you would still enter a short position. This is because the R2R marker was above the current session low as well. This highlights an important point in the development of discretionary trading skills. Our analyses of entries, stop-losses, targets, and probabilities might differ. However, as long as the final expectancy analysis says positive, it is a valid trade. There is no one path to positive pos itive expectancy. Figure 5-39 shows the outcome of this trade.
1. Setup bar
2. Target hit
3. Merged Zone as Congestion effective support Figure 5-39 Outcome of the short Congestion Zone trade
1. We shorted a tick below this bar. 2. The target was hit just before the market went into a tight trading range. 3. This test of the Merged Congestion Congestion Zone towards the end of the session confirmed the effectiveness of the Zone as support. It also offered a second chance to cover any short positions. www.tradingsetupsreview.com
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5.2.6 - FDAX 3-Minute Example (8 August 2014) Assessing the Market Bias 1. This bar made a new high and confirmed the earlier tested lows as valid lows, but it was rejected
2. These valid lows allowed
3. Despite a bearish wide range bar, this tested low did not produce bearish momentum
us to draw a bull trend line
Figure 5-40 Rejection from both sides
1. After a period of meandering, the market finally made a new session high. This bar confirmed the valid lows (circled). However, the fact that the break-out failed immediately (as a bearish reversal bar) was worrying. 2. Nonetheless, we were able to add a bull trend line on the chart with the help of the valid lows. 3. As we watched carefully to assess this new development, development, price fell and tested the previous valid low and the newly drawn trend line. This price bar ended with a long bottom tail, showing clear rejection from this support cluster. The last bar in Figure in Figure 5-40 brought the session to a new price high. in Figure 5-41 below.It led us to adjust the trend line as shown in Figure
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2. This five-bar bullish thrust showed great momentum
1. This bar made a new high and we adjusted the trend line (from black to blue)
Figure 5-41 A clear bullish market that might be overextended
1. This bar corresponds to the last bar in Figure in Figure 5-40. 5-40. It It showed that the bulls have won the earlier struggle. With this new high, we adjusted the trend line to contain all prior price action, resulting in the shallower blue trend line. 2. The break-out upwards enjoyed strong follow-though. The market carried on and produced a five-bar bullish thrust that showed powerful momentum. Both the market structure s tructure and momentum supported a bullish market bias.
Our only concern was that the bullish strength might have climaxed and might not continue. However, as always, unless there are bearish signs, we prefer not to call a top. Thus, we continued to look for bullish setups, but with caution.
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Analysing the Trading Setup
To look for trading setups, we zoomed into the price action after the five-bar bullish thrust. (Figure 5-42) 5-42)
2. Bearish Pressure Zone as the basis for a long Anxiety Zone setup
3. Instead of falling, the market formed a bullish Pressure Zone 1. A successful long Trend Bar Failure setup
Figure 5-42 Finding trapped traders
1. After the five-bar bull thrust, there were two bear trend bars. The second bear trend bar led to a long Trend Bar Failure setup. We skipped it as there were no other bullish signs, and we were concerned that the market might be overextended. However, this setup was a success and helped to cement our bullish bias. 2. As the market tried to rise higher, a bearish Pressure Zone formed. This bearish Pressure Zone must have looked very attractive attractiv e to counter-trend traders because it came right after a seemingly exhaustive exhaustive five-bar bull thrust. Our market bias was bullish, so we observed it for its potential as a long Anxiety Zone setup.
3. Indeed, despite being triggered by the next bar, the bearish Pressure Zone had poor follow-through. It presented us with a
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clear bullish Anxiety Zone. Furthermore, the three bars that followed the bearish Pressure Zone formed a bullish Pressure Zone. It boded bad news for the traders who shorted with the bearish Pressure Zone. Another notable feature of this pullback was the lack of congestion patterns. With a bearish Pressure Zone and a bullish Pressure Zone in such close proximity, congestion patterns were expected but none formed. This was a sign that the Pressure Zones represented real interest and were not just by-products of a congested area. With a long Anxiety Zone setup and a bullish Pressure Zone, we have found a high-quality trading tr ading opportunity.
Analysing Probable Targets
We took a step back to study the market landscape in order to find potential targets.
2. Congestion Zone from the previous session
1. Target projected from the five-bar bull thrust
3. Target projected from the three-bar thrust
Figure 5-43 Three options for targeting
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1. This target was projected from the five-bar bull thrust. 2. This Congestion Zone projected a potential resistance area that we could use as a target. 3. This target was projected from a more recent three-bar price thrust. Both targets projected from bullish price thrusts were standing alone, without confluence with other resistance levels. Moreover, the pivot highs around the Congestion Zone were basic pivots and not tested/val tested/valid id pivots. Given that the market has already breached above the low of yesterday’s session, it was likely that price will continue to drift up to test the nearest resistance within the price range of yesterday’s session. Hence, the Congestion Zone appeared to be a good target option. Evaluating the Expectancy
3. Intended profit target level 2. Required target level for positive expectancy
1. Setup bar
Figure 5-44 Expectancy analysis
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1. Strictly speaking, the setup bar for the long Anxiety Zone setup was the preceding bar (second last bar on Figure on Figure 5-44). 5-44). However, that bar did not have the support of the bullish Pressure Zone. The next bar would have completed a bullish Pressure Zone, offering us the confirmation confirmation that this setup was of high quality. 2. With a high quality setup and a reliable re liable target, target, we assumed that there was a 40% chance that the market would hit the Congestion Zone before falling below the bullish Pressure Zone. Plugging 40% into the R2R indicator, it indicated the minimum target level required for a sensible trade. 3. Our target based on the Congestion Zone was higher than the R2R target marker. Hence, this trade offered positive expectancy. Let’s take a look at how this t his trade panned out.
3. Target hit
1. Setup bar
2. The market made a strong downthrust
Figure 5-45 A great target (somewhat lucky)
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1. The setup bar is marked for reference. We bought a tick above it. 2. The first pullback after our entry was a solid bearish thrust. If we had decided to place p lace an ambitious target, it would have promoted us to rethink. (Recall that none of our target options were particularly impressive.) impressive.) Conservative traders would have adjusted their targets to the last swing high before this downthrust. (Slightly below the Congestion Zone.) 3. The target at the Congestion Zone turned out great. The Congestion Zone served as an excellent resistance. The market could not even close above the Congestion Zone before suffering a deep pullback. Whenever we enjoy (almost) perfect outcomes like this, we must remind ourselves that we are lucky. Exact precision in trading is a myth. When we get it, we are simply lucky and luck will even out itself. This will keep our expectations in check and prevent us from becoming overconfident.
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5.2.7 - FDAX 3-Minute Example (31 July 2014) Assessing the Market Bias
1. Bear trend line from the last session
2. First bar of the current session
3. swing of the dayFirst continued the bearish momentum Figure 5-46 Healthy bear trend
1. A bear trend line extended e xtended from the previous session lent structure to the falling market. 2. The first bar of the current session was a strong bearish bar that closed below the last swing low of the previous session. 3. The second bar of the current session continued the bearish momentum and cleared below the last swing low. The bearish momentum was undeniable right from the beginning of the session. Given the bear trend line and the bearish momentum, our market bias was clearly pointing down.
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Furthermore, the market was not too far below the bear trend line which was a sign of a healthy bearish market. If the market was too far below, sharp reversals are more likely. Analysing the Trading Setup
Figure 5-47 zooms the recent price It also shows the next two bars of theinto session that we areaction. examining.
3. Trend Bar Failure
2. Trend bar
1. Bullish Pressure Zone
Figure 5-47 Bullish reprisal
1. These three bars formed a bullish Pressure Zone. As our market bias was bearish, our interest in this Pressure Zone was limited to its potential failure and creation of an Anxiety Zone. 2. The last bar (setup bar) of the Pressure Zone was also a bullish trend bar. It was a sign that at least some bullish traders have entered against the downwards trend. 3. However, although the following bar was bullish, it was not a trend bar. Hence, it presented a short Trend Bar Failure setup.
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To trade this setup, we would place a sell stop order a tick below this bar. But was this Trend Bar Failure a high quality setup? Strictly speaking, it was not as it did not enjoy confluence from other setups. However, we were anticipating anticipating the formation of a short Anxiety Zone setup at the same time. More importantly, importantly, the bearish market bias was clear. Hence, it was reasonable to consider this short Trend Bar Failure setup. Let’s say we wanted to be conservative c onservative and held back our entry. The next bar would have given us the confirmation confirmation we needed.
Figure 5-48 shows the next bar which triggered the short Trend Bar Failure setup.
2. Short Anxiety Zone setup bar
1. Bearish Anxiety Zone Figure 5-48 A higher probability late entry with the Anxiety Zone
1. We constructed this Anxiety Zone based on the long Pressure Zone Setup bar. www.tradingsetupsreview.com
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2. This strong bear trend bar triggered the sell stop order of the bearish Trend Bar Failure pattern. It was also the setup bar of the short Anxiety Zone setup. If we did not enter a short position with the Trend Bar Failure earlier, this bar gave us a second chance to enter. We could place a sell stop order below it. This example offers excellent opportunity to explain the tradeoff between winning probability and reward-to-risk ratio. Both the short Trend Bar Failure and the Anxiety Zone setups were reasonable entries. The later entry (Anxiety Zone) had h ad a higher winning probability. probability. However, it suffered in terms of its rewardto-risk ratio. Let’s understand why. The Trend Bar Failure setup stood alone with no confluence from other price action formations. Hence, we were less certain of its reliability. The Anxiety Zone setup presented itself a bar after the bearish Trend Bar Failure. It enjoyed confirmation confirmation from the decent follow-through follow-throug h of the bearish Trend Bar Failure setup. Hence, this setup was more reliable. However, it offered a worse (lower) entry price than the Trend Bar Failure setup. Being a wide range bar, it entailed a larger trade risk as well. Ceteris paribus, these factors led to a deterioration deteriorati on of the reward-to-risk ratio. This was the price we had to pay for the increased reliability of the later setup. So which setup was the better one? The Trend Bar Failure or the Anxiety Zone? There is no definitive answer. It depends on your preference and your assessment of the market.
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If you like high probability trades, you should wait. If you like low risk entries, you should enter early. You cannot have both. If you are extremely certain that the bearish market would continue, feel free to enter early. If you need that extra push to be certain, wait and see. Both entries are valid as long as they offer positive expectancy. This is an issue we will discuss again soon. Analysing Probable Targets
In an existing downwards trend, there are usually several price thrusts available for target projection. Figure projection. Figure 5-49 shows two of them in this instance.
2. Target projected from the four-bar bear thrust
1. Safest target
3. Target projected from the two-bar bear thrust
Figure 5-49 Target analysis
1. As usual, the safest target was the last extreme low before the current pullback.
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2. This was a target projected from a four-bar bear thrust from the last session. 3. From the two-bar bearish thrust that started this session, we projected another potential target. From this chart, it seemed like none of the price targets enjoyed confluence. However, as we looked further back for potential support, we found a pleasant surprise as shown in Figure in Figure 5-50. 5-50.
1. Current area of analysis
2. Major support from a swing low
3. Support was close to the lower projected target
Figure 5-50 Target confluence
1. We have been looking at this area. 2. This obvious swing low projected a major support level below our intended entry. 3. The support level was only one point away from the target we projected from the two-bar thrust. (This support line was also pointed out in Point 3 of Figure Figure 5-49.) 5-49.)
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This confluence highlighted this support level as a great target option. Hence, we considered it as our target for this trading setup. Evaluating the Expectancy
Given clear it market bias for andthe themarket solid target at a major the support, was likely to hit option our target before hitting our stop-loss. Earlier, we considered two possible entries with either the Trend Bar Failure or the Anxiety Zone. Let’s examine their expectancy separately, starting with the Trend Bar Failure setup in Figure in Figure 5-51. 5-51.
1. Trend Bar Failure setup bar
2. Required target level for positive expectancy
3. Intended profit target level Figure 5-51 Expectancy analysis for the Trend Bar Failure setup
1. This was the setup bar for the short Trend Bar Failure setup. 2. For that setup bar, this was the required target level for positive expectancy. Again, we were assuming a 40% winning probability.
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3. Our chosen target was substantially lower than the required target. Hence, this setup exhibited positive expectancy. Now, in Figure in Figure 5-52, 5-52, let’s examine the expectancy of the Anxiety Zone setup that formed later.
1. Anxiety Zone setup bar
2. Required target level for positive expectancy
3. Intended target level Figure 5-52 Expectancy of the Anxiety Zone setup
1. This was the Anxiety Zone setup bar. We were planning to sell a tick below it. 2. Assuming a 40% winning probability, this was the required target for positive expectancy. As this setup bar had a wider range, the trade risk was higher than that of the Trend Bar Failure setup. Hence, the required reward was higher. This explains why the required target price for this setup was further. 3. Nonetheless, our intended profit target met the criterion for positive expectancy. Hence, this setup was acceptable as well. An important caveat here is that, for simplicity, we used the same winning probability (40%) for evaluating both setups. www.tradingsetupsreview.com
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However, as we discussed earlier, we were more confident in the Anxiety Zone setup. Hence, in reality, we should be using a higher winning probability for evaluating the Anxiety Zone setup. That would have led to a more favourable expectancy result. Figure 5-53 shows the outcome of the trade.
1. Trend Bar Failure setup bar 2. Anxiety Zone setup bar
3. Target hit Figure 5-53 Target hit
After our target was hit, the market retraced upwards for four bars before falling again. The market continued to make its way much lower for the rest of the session. If we had held on to our trade, we might have made a lot more. However, that’s inconsequenti inconsequential al within the context of a single trade. We have taken a trade with positive expectancy and that was all that mattered.
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5.2.8 - FDAX 1-Minute Example (20th November 2015) I added this example in the second edition of this book. It reflects the faster 1-minute time frame I have been trading recently.
As I mentioned, I use the PATI (introduced in Volume II) to monitor the market that I trade, and I prefer to trade as closely to the MTTF as possible. The recent price action in the market has lowered the MTTF in the FDAX futures market. However, if you are new to trading, the 1-minute 1-minute chart might be too fast for you to perform your analysis correctly. Be aware of that if you decide to move to a faster time frame. Notwithstanding the faster time frame of this example, it demonstrates the same price action approach. Assessing the Market Bias
2. But it also confirmed this valid high, allowing us to add a bear trend line
1. This rejection from the new low was slightly worrying Figure 5-54 New bear trend line
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1. This push to a new low was rejected by the market. No bar closed below the last extreme low. 2. At the same time, the push to the new low confirmed this pivot as a valid high. With this valid high, we drew a bear trend line and assumed a technical bearish bias. As mentioned, the difficulty experienced by the market pushing to a new low was worrying for those with a bearish bias. Hence, examining the momentum here with tested pivots would be useful. To do that, let’s zoom into the more recent sideways action of the chart in Figure in Figure 5-55. 5-55.
2. Bullish momentum this bar cleared aboveas the preceding swing high
1. Bearish momentum confirmed by multiple bar closes below the last swing low
3. Bearish momentum returned soon, confirming that the bears were still in control
Figure 5-55 The bulls tried but failed
1. After a climati c limatic c bullish thrust (the bullish Marubozu), bearish momentum showed themselves themselves quickly. We could see that from the ease with which the market fell below the last swing low. 2. This bar cleared above the last swing high and confirmed the presence of bullish players. www.tradingsetupsreview.com
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3. However, bearish momentum returned swiftly after that. This bar cleared below the last swing low after the previous bar punched below it with strength. These observations, coupled with the fact that the market continued falling throughout these price fights, confirmed that the market bias was bearish. Analysing the Trading Setup
Figure 5-56 zoomed into the price action after the rejection from the low. The valid high we used to draw the bear trend line is marked out as a visual anchor.
Valid high 3. Congestion Zone short setup with the bear trend line as resistance
1. Congestion Zone projected from here 2. Three consecutive bullish bars Figure 5-56 Congestion Zone short setup
1. From here, we projected a Congestion Zone to the right. This zone was a potential support area. 2. After the market tried to push to a new low, it formed three consecutive bullish bars.
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3. This was a Congestion Zone short setup bar. With W ith the bear trend line providing resistance, this setup looked good. While it was acceptable to take this setup, it was more prudent to skip it. There were two reasons for skipping this setup.
The first was the rejection from the new trend low which we discussed in Point 1 of Figure Figure 5-54. While 5-54. While this development would not affect our bearish bias, it prompted us to be more selective of our short setups. The second was the three bullish consecutive bars noted above. Three or more consecutive bullish bars represent sustained buying and can be taken as a sign of bullish momentum. So, let’s be patient and wait here another setup, possibly a reentry setup. The next selling opportunity came soon as shown in Figure 5-57. 5-57.
Valid high
2. Strong bearish bar as Deceleration and re-entry setup bar
1. Three consecutive bullish bars forming a bearish Deceleration pattern Figure 5-57 A better re-entry setup with bearish Deceleration
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1. Shortly after the Congestion Zone short setup was triggered, the market formed another series of three bullish bars. But in this instance, the three bars also formed a bearish Deceleration pattern. Furthermore, the last two bullish bars were Dojis. Clearly, this bullish thrust was weaker than the one before. This thrust upwards would have stopped out traders of the earlier short Congestion Zone setup. 2. This strong bearish bar was in stark contrast with the two bullish Dojis preceding it. It was an excellent setup bar for the bearish Deceleration Deceleration pattern and re-entry of the short Congestion Zone setup. Overall, this was a great short setup. Analysing Probable Targets
Now, let’s take a look at our target options for this setup. To do that, we need to take a look at the larger picture in Figure in Figure 5-58 below.
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3. Potential new bearish channel
1. From this bearish thrust, we projected a target here
2. From this more recent downthrust, we projected another potential target
Target B
Target A Figure 5-58 Considering Considering two projected targets
1. From this five-bar bearish thrust, we projected Target A. 2. From this more recent four-bar downthrust, we projected Target B, a more conservative target. (Note that we did not consider the three-bar thrust in the middle of the chart. That was because the market had already breached the corresponding target.) 3. As mentioned earlier when we introduced price channels, it is useful to anticipate potential channels to employ them in the targeting process. Here, the two arrows point to the potential bear trend line and channel trend line respectively. This potential channel would become the effective channel once the market pushed down to a new low. (The current effective bear trend line is faded as a dotted line.) The most important observation here is that Target B was within the potential bear channel, while Target A was beyond it. This www.tradingsetupsreview.com
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means that Target B was far more likely to be achieved compared to Target A. Hence, Target B was our selected s elected target.
However, that might change because the bear channel trend line offered a moving target. A bearish channel is a downwards sloping line which offers a more ambitious target with each new price bar. Hence, we might get a chance to aim more aggressively. But for that, we’ll see. Evaluating the Expectancy
The last step is to evaluate the setup expectancy. With a bearish bias and an excellent short setup, it was likely that the market would hit Target B before hitting our stop-loss. If the probability of this trading setup was 40%, should we take the trade? Figure 5-59 below shows the answer with the R2R indicator.
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1. This was our short setup bar
2. Target B was below the R2R marker
Target B
2. Required target level for positive expectancy
Target A
Figure 5-59 Expectancy analysis for the Deceleration setup
1. This was our short setup bar. 2. For that setup bar, this was the minimum target for positive expectancy, assuming a 40% win rate. 3. Since Target B was lower than the minimum required target for this short setup, we had a positive expectancy setup.
Let’s see what happened with this trade in in Figure Figure 5-60 below.
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1. Short setup bar
2. This bar hit both targets and tested the channel trend line Target B Target A
Figure 5-60 Projected targets hit
1. This was our short setup bar, for visual reference. 2. The market went straight for our target. This bar was critical as it hit both targets and tested the channel trend line all at once. To appreciate the value of a price channel in our target evaluation, evaluati on, we need to zoom out and look at what happened after our target was hit.
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2. After the market bounced up from the channel trend line, it never looked back
1. We exited here Target B Target A
Figure 5-61 Ignoring the confluence of targets was a bad idea idea
Figure 5-61 shows the entire bearish trend and ended with the last 1-minute bar of the session. 1. This was where we exited. 2. The market found support at the channel trend line to the exact tick. Then, it bounced up and never looked back. By the end of the session, the market has retraced around half of the prior downtrend. This example demonstrates the effectiveness of a channel as a target. But in this case, this support area was particularly particularly potent because there was a confluence of the channel trend line with two thrust-projected targets (Target A and B). To ignore it would be foolhardy.
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5.3 - Managing Trades for Positive Expectancy In our earlier discussion of stop-losses and profit targets, we came across the concept of active trade management. management. Active trade management involves one or more of the following actions.
Adjusting the stop-loss order Adjusting the target limit order Exiting at the market with a reversal signal
My recommendation was that active trade management should be reserved for advanced traders who are capable of reading price action confidently without being affected by their P&L. If you decide to start experimenti experimenting ng with active trade management, managem ent, pay attention here. In this section, we will discuss the correct mind-set of active trade management. In order to manage your trades effectively, remember that what you are trying to achieve is, ultimately, positive expectancy. Hence, each decision taken to actively manage your trades must make sense in the context of achieving positive expectancy. Before you decide to adjust your stop-loss order and/or profit target order, you should go through the same thought process you go through when considering a new trading opportunity. You should adopt the following steps. 1. Consider the target and stop-loss level you intend to adjust to. 2. Determine if the market is likely to hit the intended target before hitting the intended stop-loss level. (Estimate probability.) www.tradingsetupsreview.com
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3. Work out the new reward-to-ri reward-to-risk sk ratio. 4. Evaluate if the adjustments to the stop-loss and target orders would improve the expectancy of your position. In other words, would you enter a fresh trade at the current market price, given the current price action context, with the set of target and stop-loss levels you intend to adjust to? Let us drill deeper into this concept with an example. With the help of Figure Figure 5-62, let’s work through the thought process of a stop-loss adjustment.
Original stop-loss Intended stop-loss
1. Short Congestion Break-out Failure setup
Current price
2. Considering a stop-loss adjustment at this point
Target (Unchanged) Figure 5-62 Considerations for tightening a stop-loss order order
1. We shorted based on this Congestion Break-out Failure Failure setup. The stop-loss order was placed a tick above the setup bar. The horizontal line at the bottom of the chart represents a target set with the low of the previous session. 2. At this point, the market made a new low. We considered the possibility of tightening our stop-loss to the level marked as “Intended stop-loss”. www.tradingsetupsreview.com
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The question we need to ask ourselves is this. Would we enter a new short position at the current price with the intended stop-loss and the same target? Would such a trade offer positive expectancy? If the answer is yes, then we should adjust the stop-loss. The above explains the correct motivation motivation for adjusting our exit orders. The consideration for exiting at the market before any of our exit orders are hit (stop-loss or profit target) is slightly different. We should exit at the market if both conditions below are met.
Our assessment of price action tells us that our current
position is no longer one that offers positive expectancy. There is no way to adjust our stop-loss or target orders to preserve a state of positive expectancy. expectancy.
The above sounds great in theory but is difficult to put into practice. This is why active trade management is an advanced technique. However, it is critical and extremely useful to remember that the objective of any trading decision including active trade management is to achieve positive expectancy. We do not tighten our stop-loss so that we get to breakeven. We do not bring our target closer so that we can feel like a winner. We do not push our target further so that we can make up for earlier losses. This is because none of these reasons have anything to do with positive expectancy.
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We should only actively manage our trading position for the purpose of increasing its expectancy or avoiding a position of negative expectancy. Let’s take the practice of taking partial profits as an example.
If you trade more than one contract, you have the option of taking partial profit profit by exiting part of your position. But why does a trader take partial profits? Does it improve the expectancy of the trade? Most traders do not consider this question when they exit partially. partiall y. They just want to feel good about having some profits in their pocket without considering the impact on expectancy. Let's say you entered with two contracts at 1000. You exit one contract at 1005 and one contract at 1010. Conceptually, you are engaging in two trades.
First trade – Entry: 1000 & Exit: 1005 Second trade – Entry: 1000 & Exit: 1010
With hindsight, we know that the second trade gave a better outcome. However, in real-time, we could only assess expectancy. Which trade had higher expectancy? If the first trade enjoyed higher expectancy, then you should have closed both contracts at 1005. If the second trade had higher expectancy, then you should have exited both contracts at 1010. Why split them up?
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This is why I do not see a need for taking partial profits. As I mentioned, conceptually, taking partial profits is like taking two (or more) different trades trades at the same time. In that case, I need to assess the changing market conditions with respect to multiple trades concurrently and that complicates complicates my analysis process. I would rather spend my effort on analysing one trade well and focus my position size on it. Of course, practices like moving your stop-loss order to breakeven and taking partial profits have psychological benefits. They help to make you feel safe, and feeling safe might put you in a better state of mind to trade. But what you need to understand is that these psychological benefits have a cost, in terms of trade expectancy. Whether or not these benefits are worth the cost, I’ll leave you to decide.
“Successful farmers don't plant a crop and then dig it up every few minutes to see how it is doing. They let it germinate, let it grow. Larry Williams, Long-Term Secrets to Short-Term Trading
5.4 - Conclusion This chapter is the closest I can bring you to the thought process underlying live trading. This is the only chapter with examples of entire trades. We have pieced together everything we have learned so far and completed the journey from analysis to trading. Trading is not about picking a setup and clicking a button. It involves market analysis with different objectives and putting www.tradingsetupsreview.com
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these analyses together to find trading opportunities that offer positive expectancy. The framework we have gone through is useful for a discretionary trader. We use objective tools (trend lines, pivots, price patterns) and interpret them to arrive at subjective decisions regarding the market bias, our potential stop-loss and target level. Then, we exercise our judgement to estimate the most important importa nt piece in the puzzle of discretionary trading – likelihood of winning. Finally, we plug all these pieces of information into the expectancy formula to determine if the trading opportunity is worth our effort. This thought process emphasises emphasises the interplay interplay between objective trading tools and subjective interpretation, interpretation, and brings the concept of positive expectancy to the foreground. Even if you do not employ the exact price action trading techniques described, this thought process remains applicable. applicable.
ACHIEVING POSITIVE EXPECTANCY Learn to decide if a trade offers positive expectancy in a split second
Write down your ongoing analysis
Manage trading positions to increase or maintain expectancy
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We have learned how to judge the market bias, find setups and targets, and how to integrate them together to decide if a trade is worth taking. If you’ve understood the complete examples in the last chapter, you can easily practise these skills with your own charts with historical price data. However, in real-time trading, when your charts are constantl constantly y being updated with new price bars, do you know what to do? The actual process of market analysis is an active process. We do not stare at the screen aimlessly until a setup appears, and simply click “buy” . We need to constantly evaluate the market bias, look for setups, and consider potential targets. It is an ongoing process. Evaluating the market bias always comes first. Then, constantly, we need to keep a lookout for signs that the market bias has changed. This is the most important goal. After we have deciphered the market bias, we start looking for trading opportunities. To find trading opportunities, we need to pay attention to potential setups and targets concurrently. We need to pick out pairs of stop-loss point and profit target, and ask ourselves if the market is likely to hit the target before the stop-loss. That’s not the end. We will need to evaluate if our assessment of the winning probability and the reward-to-risk reward-to-risk ratio offers positive expectancy. Luckily, we have the R2R indicator to simplify this step.
However, it remains that you have a boatload of tasks on your mind. And, this is only the first aspect of your analysis.
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The second aspect involves reviewing our trading premises, trading records, and trading results. By analysing them, we try to find out what is working and what is not. The aim is to understand, verify, and improve our trading edge. It is clear that as traders, we need to perform two types of analysis. The first is the analysis analysis of the market to identify trading opportunities. opportunities. The second is the analysis of our trading records to improve our trading performance. Most traders understand these two types of analysis and their objectives. However, they treat them as distinct activities and fail to appreciate the relationship between them. To achieve the best trading performance, it is essential to understand how these two types of analyses influence each other. Hence, in this chapter, we will introduce the Analytical Cycle to close this gap. This cycle offers a systematic guide for implementing and improving your trading edge. The Analytical Cycle is a five-stage process with dual objectives. Figure 6-1 illustrates the cycle.
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Figure 6-1 The Analytical Cycle (solid steps and dotted goals)
The solid boxes contain the actions we need to take within the cycle. These five steps go through a feedback loop. The first step is to establish our trading rules and guidelines. The last step is to refine them before going through the cycle again. This cycle has two objectives which are highlighted in the dotted box. The objectives are: 1. Trade consistently while keeping your emotions in check. 2. Verify and improve your trading edge. In the following sections, we will elaborate e laborate each step of the process. We will discuss how to perform them correctly, so that we achieve our two objectives. The Trading Toolkit included is useful for working through the Analytical Cycle.
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6.1 - Establish Rules and Guidelines To manage our analysis in a systematic and efficient manner, we need a set of trading rules and guidelines. Hence, the Analytical Cycle starts from establishing our trading rules and guidelines to aid our market analysis. In this stage of the cyc cycle, le, we aim to consolidate what we have learned about market behaviour and price action into written principles to guide our analysis. Before we start making a list, we must first understand the difference between rules and guidelines. Trading rules must not be broken under any circumstances. Due to their absolute nature, having rules prompt action without deliberation. deliberation. Thus, they help to enforce discipline and encourage swift decision-making. decision-making. A key benefit of having trading rules is ensuring the consistency of your trades.
For instance, you have a trading rule stating that you must take setup bars that close in the direction of your intended trade. According to that rule, you must never buy above a bearish bar or sell below a bullish bar. You cannot exercise any discretion discretion here. Hence, you do not need to consider the validity of the setup bar on a case-by-case basis. As a result, you are able to make trading decisions swiftly. Trading rules can encompass all aspects of trading including the instrument to trade, the time frame, the time period, trading strategies, and trade management methods. Trading guidelines can be broken with justification. Remember the bending of rules we discussed in the last
volume?
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Guidelines are “rules that we can bend”. Essentially, guidelines offer room for us to exercise our discretion and potentially achieve better trading results. The drawback is the additional analysis we must perform each time in order to justify breaking a guideline.
For instance, a guideline states that long setups should only be taken if the market is in a support area. Thus, generally, you should look out for long setups only when the t he market has retraced down to a support area. However, when the market bias is clearly bullish and the long setup looks particularly strong, you might decide to ignore the guideline and take the long setup even if the market has not fallen back to a clear support area.
Of course, guidelines should not be broken according to your whims and fancies. You need to justify any deviation.
RULES VERSUS GUIDELINES Never break rules; Break guidelines for good reasons
Neither rules nor guidelines are fixed f ixed permanently. permanently. Both are subject to review. Rules and guidelines can be altered, added, or removed. A rule can become a guideline, and likewise a guideline can later be encoded as a rule. However, again, changes to trading rules and guidelines should not be arbitrary. How do we know when to change our trading rules and guidelines?
We letand theguidelines. Analytical Cycle us in our review of trading rules In theguide subsequent steps of the Analytical Analytical Cycle, we will collect information to keep track of the www.tradingsetupsreview.com
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effectiveness of our rules and guidelines gu idelines to justify any changes. By adjusting our rules and guidelines with informed decisions, we move towards our goal of improving our trading edge. It is a trader’s t rader’s personal responsibility to create trading rules and guidelines based on what he has learned and to refine them over time. Recall what you have learned from your own trading experiences, this book, and other educational materials you have studied. Then, start making your own trading rules and guidelines. It will always be a work-in-progress. In the Toolkit, you will find a sample list of trading rules and guidelines for new traders. You may use it as a basis or an example for your own trading rules and guidelines.
When creating your rules and guidelines, there are several guiding principles to bear in mind. Your trading rules and guidelines should reflect your market beliefs and trading style. For instance, if you believe that your trading edge stems from trading market trends, you should have a rule of trading only when the market is trending. And of course, for any sane trader, taking a trade only when you perceive positive expectancy is certainly a trading rule. Your trading rules and guidelines should also reflect your level of experience, and the level of discretion you are prepared to exercise in your trading. We have discussed the subject of exercising discretion in trading in the last vo volume, lume, and I emphasised that the level of discretion a trader should exercise depends on his or her trading proficiency. Thus, beginners should definitely start with more rules and less guidelines. As they gain experience and get better at interpreting interpreti ng price action, they can convert some rules to
guidelines. Experienced discretionary discretionary traders tend to have more guidelines than rules.
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Your trading rules and guidelines should strike s trike a balance between efficiency and efficacy. Trading rules are rigid but they enable efficient decision-making. decision-making. We know exactly what we need to do or cannot do. We do not need to over-think. However, rigid rules might throttle our trading performance.
On the other hand, guidelines offer us a solid basis to exercise our judgement and adapt our trading decisions to the changing market. While guidelines might offer more room for better trading performance, they require more input from the trader. Hence, guidelines slow down our decision-making. To summarise, trading rules narrow our battlefield and guidelines empower us to use the right weapon for each battle. Having clear trading rules and guidelines is critical to a systematic systemati c trading process.
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1. Review your trading style, beliefs, and experience 2. Refer to the sample trading rules and guidelines in the Toolkit 3. Write down your own trading rules and guidelines
6.2 - Record Ongoing Analysis With the trading rules and guidelines in place, we can then start to analyse price action in real-time.
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In this section, we will explore a structured approach that uses written analysis to focus our attention, attention, control emotions, and build confidence. Together with the trading rules and guidelines, gu idelines, this approach will help you maintain a consistent and unemotional une motional perspectiv perspective e of price action. In addition, the written analyses will form an important part of your trading records which you will review to verify and improve your trading edge. More about this in Stage Four of the Analytical Cycle.
6.2.1 - Thought Process for Basic Analysis First, let’s go through the basic process of ongoing price analysis and how to record it. Then, we will have a deeper discussion of using written analysis to help us deal with the emotional emotional and confidence issues in real-time trading. The constant process of price action analysis follows a simple four-step template. 1. Identify the current price action feature. Describe what you see. 2. Understand what it means. Does it show momentum? Does it show selling pressure? Does it imply support? 3. Integrate it with prior analysis. What is the price action context? What is the market bias? 4. Decide its impact on our potential actions (if any). Do you buy or sell? Do you wait for further price action? In a nutshell, focus on the current price pr ice action and integrate it with past price action to form expectations expectations of future price action.
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It is an active process of extracting value from our observations. Each observation results in:
A trading action (enter, exit, adjust positions); and/or An idea of what to look out for to confirm or refute our market hypothesis.
Let’s go through some examples. Bearish Momentum
1. Identify a tested low that cleared below the previous swing low. 2. Understand that it means bearish momentum. 3. Consider it within the context of a bullish market. 4. Decide that you will hold off long setups until there are more bullish signs. Merged Congestion
1. Identify price moving up into and congesting within a Congestion Zone, forming a Merged Congestion Zone. 2. Understand that a Merged Congestion Zone is a significant resistance. 3. Consider that the market has just formed a bearish Anticlimax pattern. 4. Decide that you exit from your long position. Deceleration Pattern
1. Identify a bearish Deceleration pattern. 2. Understand that it means that the short-term buying interest is not forthcoming. 3. Consider that the market bias is bearish and the Deceleration pattern ended in a resistance area (Congestion Zone).
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4. Decide to enter a short position. (Assuming that expectancy analysis is positive.) In fact, we have already seen dozens of such examples throughout this book, especially in the complete examples in the previous chapter. The process of price analysis would have guided us to think through the following:
Reasons for entering the trade Reasons for adjusting our stop-loss/target orders Reasons for exiting the trade
We always start our analysis with observing the current price action. And we end our analysis by concluding its impact on our trading actions. These actions include sitting on our hands, or entering, exiting, and managing a trade. By following this four-step process (identify-understandintegrate-decide), we ensure that every action we take is backed by our interpretation interpretation of price action.
6.2.2 - Written Analysis as a Tool Analysing price action as it forms is a very different exercise compared to looking for historical trading setups. There T here are two important aspects of live real-time trading that are missing when we study historical price action. The first aspect is the emotional woes. We might feel anxious to trade. We might feel that we are missing out on the next big move if we do not enter. Such feelings of anxiety and sense of urgency are absent when we review historical data. In actual trading, these emotions will push us into seeing trading
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opportunities when there are none. The result is overtrading, opportunities one of the worst sins among day traders. The second aspect is the lack of confidence in your analysis. With some training, most people can analyse and explain a historical chart. However, trusting your own real-time analysis requires solid trading experience. If you are not confident of your own analysis, you will hesitate to act on the trading opportunities opportuniti es despite identifying them. In that case, you will never realise the full potential of your analyses. The best way to handle these difficulties is to write (or type) your ongoing analysis. Writing encourages objective analysis. The written records of your analysis also serve as a valuable resource for your review in later stages of the Analytical Analytical Cycle.
WRITING IT DOWN Writing down your analysis encourages objectivity objectivi ty and helps in reviewing
The four-step process explained in the last section is not merely a mental exercise. You need to expand it into a writing exercise. Keep Emotions in Check
As you analyse the market, write down your assessment of the market bias. Write down if there is a trend line supporting the market bias. Write down if the momentum is aligned with the trend line. Write down what are the trading setups telling you about the market bias. Write down your evaluation of possible targets. Write down the confluence of target levels above and below be low the market price.
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Write down if the setup you are looking at is a high-quality one and explain why. Write down what would make you buy. Write down what would make you sell. Write down why you plan to deviate from your trading guidelines. This will help to ensure that you are not abusing the trading guidelines. Writing down your analysis forces you to think about price action seriously. It holds you accountable and prevents emotional reactions reactions to the market. Thus, write as though you are writing a report for your boss. Be serious.
However, your boss happens to be one that does not care about your grammar or your presentation format. Your boss does not mind even if you just scribble on your draft paper. You can write or type, whichever is faster for you. You need not write in complete sentences. While writing your analysis is important, it should never get in the way of your trade execution. If necessary, come up with your own abbreviations to facilitate swift recording. Writing down your analysis is the single most powerful way to help you tell apart your subjective analysis from your emotional whims. Yes, of course your analysis is subjective. It is your analysis. Subjectivity Subjectivity is not bad. Subjectivity is inherent to judgement and and evalua evaluation. tion. Good judgement judgement leads leads to good results. Bad judgement leads to bad outcomes. And all judgements are are subjective. subjective. While subjectivity is not a problem, emotional decisions are. By writing down why you decide to take a certain course of action, you avoid making emotional decisions. decisions. Or at the very least, you are fully aware that you are making an emotional decision.
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“Because of the bullish momentum momentum shown by the tested low just now, I should not be shorting until bearish momentum takes control.” If you had just written the above and are now staring at it, the likelihood of you taking a short position without proper justification justificati on decreases. And even if you do proceed to take a short position, you know that your actions have deviated from your analysis. The problem is psychological. We tend to be in denial about psychological issues, but having your written analysis in front of you makes it a lot harder to lapse into denial. “Price is bouncing off a bull trend line with a bullish Decelerati Deceleration on pattern. Setup bar is a bullish reversal reversal bar rejected by a Congestion Zone. Good long setup. Potential target at the next higher resistance coincides with the thrust-projected target. It is likely that the market will reach the target before hitting the stop-loss below the setup bar.”
You wrote the above and proceeded to take a long trade. However, you got stopped out within the next two bars. Does that mean that it is a bad trade? No. Should you feel bad about it? Absolutely not. This is because you had a good basis for taking the trade. The quality of a trading opportunity is determined before the entry and not after the exit. You have already concluded that it is a good setup before you entered. Regardless of the outcome of www.tradingsetupsreview.com
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the trade, the fact remains that it is a good trade. Your written analysis reminds you of this probabilistic nature of trading. The process of writing your analysis offers a constant reminder that you are not a gambler. Your sole aim is to take good trades (i.e. trades with positive expectancy), and not to feel happy over individual winning trades or disappoi d isappointed nted over each losing trade.
“One reason why assignment writing is especially demanding is that it forces you into a deep and powerful kind of learning.” Ellie Chambers and Andrew Northedge The Arts Good Study Guide
Build Confidence in Your Trading Skills
Writing down your price action analysis ex-ante is also the key to building confidence in your trading skills. To achieve this objective, as you record your observations of price action, you must also write down your corresponding expectations. expectations. Write down what you think will happen next. Write down what you think might not happen. h appen. Write down what you think might happen if what you think might not happen eventually happen. You get the idea. Write down the kind of price action that will confirm what you think. Write down the kind of price movement that will w ill refute your current market view. You are never always correct. If you cannot think of any price development that can refute your market view, you basically
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think you cannot be wrong. When you think that you can never be wrong, you are in great danger. Writing down your expectations is an important step in honing your trading skills and gaining confidence in reading the market in real-time. Figure real-time. Figure 6-2 shows the ideal recording-learni recording-learning ng cycle.
Record ex-ante
Price Action Observation
Expected Outcome
Record ex-post
Actual Outcome
Improve skills and gain confidence
Figure 6-2 Learning cycle for real-time price analysis
Start with recording your observation of price action. For instance, you observe that price is moving down towards a bull trend line sluggishly without momentum. You record this observation. Together with that observation, you also record what you expect the market to do. do. Let’s say you expect that price will bounce up from the bull trend line. This process corresponds to the four-step process discussed earlier. Then, you pay attention to the actual price action. When the market finally reaches the trend line, it forms a bullish reversal bar and rises to a new high. You record this too. www.tradingsetupsreview.com
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At this point, you are able to compare your expected outcome with the actual outcome and note down the extent to which they coincide or differ. This process is not limited to your analysis of trading setups. It should extend to every piece of significant price action that you observe. After completing completing this cycle for a number of times, you can evaluate if the market usually does what you expect it to do based on your observations and interpretations. interpretations. If it does, you will gain confidence in your ability to interpret price action in real-time. You should aim to keep objective records. Write down your observation and expected outcome ex-ante, and record the actual outcome ex-post. With objective records of your expectations and the actual outcome, you can learn to trust your analysis without subjecting yourself to confirmation confirmati on bias and overconfidence bias. The quality of your trading records will determine if your confidence is justified. Confidence developed this way is healthy and not misguided. I must emphasise the importance of writing down your observation and expected outcome before the actual outcome emerges. Without doing that, it is too easy to lapse into a selfdeceiving state of mind that encourages denial and distortion of memory. The hindsight bias (or creeping determinism) is wellestablished. It refers to the tendency to falsely claim that you knew it all along only after the outcome emerges. You see the market moving in a certain manner, and you convince yourself into thinking that you expected it. But the reality is that you saw the outcome, and then looked for signs to confirm your thinking. This self-delusional process might keep you going for a while, but it is not at all sustainable or profitable.
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On the other extreme, the records might show that the market does not do what you expected it to. In that case, the records will provide you with valuable information to help you improve your price action reading skills. For instance, through the records, you realise that whenever you anticipated anticipated a change of the market bias, you were wrong most of the time. This means that you should consider waiting for more confirmation before concluding a change of market bias. Without a clear record of your analysis, you will not be able to come up with any concrete steps for improving your trading skills. You might be a price action genius. You might also be a reckless trader who has no clue of how to perform price action analysis. In any case, you are always better off knowing which one you are.
do is not “If someone is able to show me that what I think or do right, I will happily change, for I seek the truth, by which no one was ever truly harmed. It is the person who continues in his self-deception and ignorance who is harmed.”
Marcus Aurelius, Meditations
6.2.3 - Tools for Recording To get started with writing down your analysis, refer to the Toolkit where you will find an Analysis Matrix that breaks down the objectives and contributing factors of ongoing analysis. Other than written analysis, a screen capture of the chart containing each trade is also essential. Most charting platforms offer the ability to save the chart image. If not, there are several great note-taking software software that you can use to capture screenshots easily. (Refer to the Toolkit Too lkit for recommendations.) recommendations.)
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An alternative to written notes and chart images is to capture your trading process with a screen-recording software. You can also narrate your analysis as part of the video. Recording your trading process as a video offers the several advantages. By replaying your trading process, you can simulate your analysis and emotions during the trading process. This T his simulation simulati on process is very useful for an in-depth study of an individual trade. A video also captures the speed of the market (intra-bar), an aspect that static chart images are unable to retain. However, ultimately, we always need to review a sample of trades, and not any one trade, to arrive at constructive conclusions. For reviewing a set of trades, it is more efficient to scan through written analyses and chart images than replaying dozens of videos and noting down their similarities and differences. Other than our price action analysis, after each trade, we must record its outcome, together with its basic details. These details include:
Traded instrument Entry and exit time Entry and exit price Outcome (Net profit) Direction of trade (Long/short) Position size Commissions Commissi ons and other trading costs
Your broker or clearinghouse records the trade details above automatically automati cally as they are essential for processing your trades. Your trading platform might might also store a copy locally on your computer. Hence, you do not need to trouble yourself with
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recording them while trading. You can easily retrieve these records after each trading session and compile them for further analysis. Thus, you just need to familiarise yourself with the level of trade details required and the process of retrieving this information. In the Toolkit, you will also find a Trade Records worksheet for recording this informati information. on.
TASKS
STAGE TWO
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1. Practise analysing real-time price action with the four-step process 2. Write down your analyses in the Analysis Matrix, in real-time as well 3. Fill up the Trade Records worksheet in the Toolkit
6.3 - Classify Trades Armed with a multitude of trading records, you might be tempted to start examining them for clues to avoid losses and increase your trading profits. Hold on. Do not rush into analysing your trade records without first organising them. Before you can conduct any form of meaningful meaningf ul analysis with your trading records, you must first classify them. This classification is a critical step that traders often neglect.
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To classify your trading records, rely on the rules and guidelines you established in Stage One of the Analytical Cycle. Essentially, separate trades that comply with the rules and guidelines from those that do not. Relying on our trading rules and guidelines, we can separate our trades into three types. Table types. Table 6-1 sums it up. Type
Rules Complied
Guidelines Complied
Guidelines Justified
Consistent
Yes
Yes
N/A
Discretionary Discretiona ry
Yes
No
Yes
Yes
No
No
No
No
No
No
Yes
N/A
Rogue
Table 6-1 Trade classification
If you had followed your trading rules and guidelines completely, the trade is consistent. Rules are sacred. The moment you break a trading rule, the trade becomes a rogue trade. However, if you violate v iolate a guideline, your trade might be discretionary or rogue. If you can justify it with price principles, you have made a discretionary trade. If you cannot, the trade is rogue. For instance, your guidelines state that you should take only long setups that overlap with a support level. However, you took a long setup that did not overlap with a support area because you had not taken a single trade in the session and were feeling impatient. impatie nt. That is a rogue trade.
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On the other hand, if you took the setup because you noticed a confluence of setups (for e.g. Deceleration Deceleration and Pressure Zone), you have a valid reason for ignoring the guideline. In this case, the trade is discretionary. This three-group classification is extremely important for trade analysis. By studying the group of consistent trades, we are able to examine the soundness of our trading rules and guidelines. By looking at the group of discretiona d iscretionary ry trades, we are able to measure the effectiveness of our discretionary trading skills. By analysing our rogue trades in a separate group, we are able to isolate the quality of our analysis from the strength of our trading psychology. Tagging each trade as one of the three types above lays the foundation for measuring our trading edge and identifying the areas that are lacking. For instance, after collecting a large sample of trades, you find that your set of consistent trades is profitable but your discretionary trades are barely profitable. You can then reasonably conclude that you have sound trading rules ru les and guidelines, but your trading gut needs further honing. It probably implies that you should turn some guidelines into rules. In addition, your rogue trades are showing overall losses. Thus, it is undeniable that rogue trades are damaging your profitability. profitabili ty. It offers strong motivation to work on your trading discipline. Classifying a trade as consistent is straightforward. The tricky part is in differentia d ifferentiating ting between a discretionary trade and a rogue trade. Very often, we distinguish a discretionary trade from a rogue trade by a valid explanation for violating a guideline.
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For example, let’s use the same guideline that you should only take long setups that overlap with a support area. You took one that did not.
The reason is that it was a re-entry equivalent trade (of an earlier Trend Bar Failure setup) and was a Deceleration setup at the same time. Since a re-entry equivalent is usually more reliable and having a confluence of setups is also a sign of a high quality setup, the guideline violation violation seems justifie justified. d. Hence, the trade was a discretionary one. However, there is no clear answer key for reasonable explanations explanati ons of guideline violations. Furthermore, in most cases (unless you work with a trading partner or mentor), you offer the explanation, and you decide if the explanation is valid. Clearly, this is a problem. In other words, we are the problem. Since we are both answering and judging the answer, it is easy for our minds to play tricks on us. These tricks would cause us to recognise a rogue trade as a discretionary trade or vice versa. Why would we recognise a rogue trade as a discretiona d iscretionary ry trade? One reason is that we do not want to admit that we have taken an inconsistent and emotional trade. Hence, we force feed ourselves some irrational justification justification and accept a rogue trade as a discretionary one. Another reason is that the trade turned out to be profitable. profitable. If we classify it as a discretionary trade, it means that we can take credit for it. We would feel good. Why would we recognise a discretionary trade as a rogue trade?
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The common reason is that the trade turned out to be a loser. We do not want to admit that our trading technique is faulty. We would rather push the responsibility to a momentary lapse in discipline. In that way, we can protect the effectiveness of our trading strategy, at least in our minds. Clearly, the outcome of each trade offers incentive for us to overlook facts and erroneously classify our trades. We want to take credit for trades that went well and dissociate ourselves from those that brought us losses. As a result, it is difficult for most traders to distinguish distinguish rogue trades from discretionary trades. Fortunately, we already have an excellent solution to this problem. We write down our ongoing price action analysis to justify our trades. The key point here is is that we write write them before we know the outcome of each trade. These ex-ante written analyses are critical in an objective classification of our trades. We have our trading rules and guidelines. And we have already analysed the price action according to our rules and guidelines before deciding to take a trade. The answer to whether each trade is consistent, discretionary, or rogue can be answered at the point when we decide to take each of them. Hence, we should classify each trade before we know its outcome. In doing so, we ensure that the trade outcome does not taint our classifi c lassification. cation. The ex-ante written analysis analysis makes it possible to do so.
EX-ANTE CLASSIFICATION Classify a trade as consistent, discretionary discretiona ry or rogue once you decide to take it, before you know its outcome
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However, there is one exception to the ex-ante classification rule. It is when we break our trading rules or guidelines after our trade entry. The best example is the breaking of our exit rule. For instance, we shifted our target without justification after our trade entry. In that case, we need to change our classification classificati on ex-post to mark the trade as a rogue trade. At this stage, we are able to appreciate how all steps of the Analytical Cycle tie in together. The rules and guidelines and the ongoing written analysis analysis not only help us trade better, they are also the key to a proper trade classification that will eventually enable a meaningful trade review. In the Trade Records worksheet (in the Toolkit), there is a column for classification. You can classify each trade by choosing one of the options: Consistent, Discretionary or Rogue.
TASKS
STAGE THREE
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1. Understand the difference between Consistent, Discretionary, and Rogue trades 2. Classify them as soon as you decide to take the trade 3. Label the trades in the Trade Records worksheet
6.4 - Review Trading Records In this final stage, you will use the trade records you collected in the earlier stages to answer a few important questions.
Do you have a trading edge?
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What size should you trade? (This depends on your maximum drawdown.) How can you improve your trading?
To answer them, you will conduct simple statistical anal analyses yses with your Trade Records. At this point, I must reiterate the importance of keeping objective and detailed Trade Records. importance This is because you will rely on them to answer the three key questions above. Remember “garbage in, garbage out”. After answering them, we will revisit our trading rules and guidelines to refine them. Using these improved rules and guidelines, we will work our way through the Analytical Analytical Cycle again, and again. Ideally, each cycle is based on an improved set of trading rules and guidelines.
6.4.1 - The Holy Grail Before we dive into the technicalities of reviewing our trade records, let’s take a look at the main obstacle that plagues the review process - the problem of the Holy Grail. As briefly discussed earlier, when we review our trades, we tend to allow their outcomes to affect our review. (This is the issue of ex-ante versus ex-post.) This is a common yet often ignored problem. When we encounter a winner, we tend to think that our analysis was good. When the trade turns out to be a loser, we think that we must have overlooked something important. important. Hence, we must find out what we had overlooked, so that we can avoid losing in the future. What is wrong with thinking this way?
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There is nothing right about it. First, it highlights a lack of understanding of the probabilistic nature of trading. It assumes that a winning trade is a good trade and a losing trade is a bad trade. These assumptions are plain wrong in a probabilistic game like trading. Desirable trades are trades that have a positive expectancy. Positive expectancy trades are trades that are expected to produce positive profits over a large sample of trades. As for an individual trade with a positive expectancy, it can be either a winning or losing trade. The same goes for trades with negative expectancy. The key point here is that winning trades are not always always good trades. Table 6-2 clarifies this point. Positive Expectancy
Negative Expectancy
Winning Trades
Desirable
Undesirable
Losing Trades
Desirable
Undesirable
Table 6-2 What is truly desirable?
We should desire to find trades in the “Positive Expectancy” column. This objective poses a problem to most traders because it seems to imply that we must desire losing trades as well as winning trades. Human nature dictates that nobody likes to lose. Hence, most traders do not look for trades in the “Positive Expectancy” column. Instead, they look for trades in the “Winning Trades” row. This is commonly known as the quest for the Holy Grail, which is time-consuming time-consuming and entirely futile.
Why is looking for 100% winning trades a futile goal?
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Trades with positive expectancy share common price action characteristics. characteristi cs. For instance, they are in the direction of the market bias and are found along support or resistance area. Hence, by focusing on these common characteristics, characteristics, we can reliably choose trading opportunities that promise positive returns for a large set of trades. On the other hand, winning trades do not share common attributes. You can win any trade within any market conditions due to the element of luck. One winning trade might be going along with the trend and another winning trade might be going against it. There is nothing in common about them, except that they both concluded with profits. If their profitable outcome is the only similarity between them, it follows that we have no basis to anticipate them. This This is because we cannot use the outcome of an event to predict the occurrence of that event itself. Let’s look at an analogy.
I want to cross the road without getting getting hurt. I know that in order to cross the road without getting hurt, generally, I need to look out for traffic on both sides, estimate the distance and speed of oncoming vehicles, and cross with a speed fast enough to avoid a collision. By implem implementing enting these steps, I can cross the road each time knowing that most likely, I will not be hurt. These are crossings of positive expectancy. I might still get hurt due to a million other reasons. I might faint in the middle of the road because I didn’t eat my breakfast. I might get crushed by a falling plane (absurd, but not impossible). I might have missed an oncoming car. A driver with murderous intent might accelerate beyond my expectati expectations. ons.
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Now, let’s say I want a 100% safety rate for my road-crossings. I want to cross the road knowing that I will never ever be hurt.
To ensure that I will not faint in the middle of the road, I must complete a health check-up just before I cross the road. To ensure that no plane will fall on me, I must carry air radar equipment at all times when I cross roads. These are absurd solutions and even with them, it is impossible to completely eliminate elimina te danger in crossing roads. The only certain way to not get hurt when you cross a road is not to cross it at all. Looking for guarantees is not only a crazy idea in trading, but in most things in life. Understand this before reviewing your trades and learn to like losing trades with positive expectancy. The wrong way to think: When we encounter a winning trade, we think that our analysis is good. When a trade turns out to be a loser, we think that we must have overlooked something importa important. nt. Hence, we must find out what we overlooked, so that we can avoid losing in the future. The right way to think: When we encounter a large number of trades that result in positive returns, we should think that our analysis was good. When a large number of trades produce losses, we should find out the problem, so that we can avoid losing in the future. Isolated trades do not tell much. A sample of trades tells a better story.
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Hence, there is no need to go through a review after every trade. Due to the probabilistic probabilistic nature of trading, studying trades in isolation offers limited benefit. It is best to gather a set of trades (at least across 30 traded sessions) before performing your first review. Subsequently, aim to review your trades weekly or monthly depending on your trading frequency. Another option is to conduct a review after a fixed number of trades. For instance, review your records after every 30 trades.
6.4.2 - Measuring Expectancy We have learned to assess trading opportunities to select those that offer positive expectancy. Our objective as traders is to take trades with positive expectancy. Ideally, every trade we take should offer positive expectancy. However, we cannot be absolutely certain that the expectancy of each trade we take is positive. This is because a trade with positive expectancy can be a winner or a loser. We will only find out after a large number of trades over time. This seems to imply that if we are profitable after taking a large number of trades and after a long period of time, we must have been taking trades with positive expectancy. That is not true. Even if we are profitable in the long run, it does not mean that all the trades we took had positive expectancy. Theoretically, we can separate the large number of trades we Theoretically, took into two sets. 1. Positive expectancy trades with $A profit 2. Negative (and zero) expectancy trades with $B losses
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The first set will, in aggregate, produce profits. The second set will result in losses. As long as the profits from the first set of trades exceeds the losses brought about by the second set of trades (A>B), the overall outcome of our trades will still be positive. In other words, we took some s ome desirable trades and some not-sodesirable trades, but the winnings from the desirable ones exceed the losses we incurred by taking the bad ones. Hence, even if we are profitable after a large number of trades, we should not conclude that all of our trades had positive expectancy. What we know for sure is the outcome of each trade. We know exactly if a trade is a winning one or a losing one. What is not so clear but far more important important is its expectancy. Expectancy is a probabilistic concept, and we should not expect a deterministic deterministic answer. However, it is such an important concept to traders that we should at least attempt to estimate it. Measuring expectancy refers to verifying that we are taking desirable trades with positive expectancy. This is the first objective of this section. As mentioned in our introduction, a casino does not only enjoy positive expectancy, it knows that it does. As for traders, we might or might not have a trading edge, and we are never 100% sure if we do. This is a serious handicap. If we are not sure whether or not we have a trading edge, why are we even trading? Hence, we must attempt to measure the expectancy of our trades as a whole.
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There are many ways to measure the expectancy of our trading methods. However, none of them offers absolute certainty. certainty. This is something we must accept. Accept that no trading strategy guarantees a trading edge. Hence, we must also decide how certain we need to be before we trust a trading method sufficiently sufficientl y to commit real financial capital to it. Since no measurement method offers certainty, I prefer to use one that is the most intuitive. The method I recommend is the Monte Carlo simulation.8 You can trust it for two reasons. First, it was developed by nuclear n uclear scientists (very smart guys, basically). Second, when statisticians say “simulation”, they usually mean Monte Carlo simulation. It is a standard. This is how it works. Let’s say you have made 100 trades using
the price action techniques in this book. Using the 100 trades as our sample, we pick a random trade.
Are we more likely to pick a winning trade or a losing trade? Are we more likely to pick a large winner or a small winner? Are we more likely to pick a large loser or a small loser?
All these questions depend on the sample. It depends on how many winning and losing trades the sample contains and the distribution of their magnitudes. Ultimately, Ultima tely, it boils down do wn to how you traded. If, in the 100 trades that you took, you ensured that your trade risk never exceeded $150, then there is zero chance that we would pick a losing trade with a loss greater than $150. As another example, if you had more than 50 winning trades in the 8
For an alternative method to assess your trading edge, refer to the “R Multiple” concept explained in in Dr Van Tharp’s books books..
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sample, then it is more likely that a random trade picked from the sample is a winning trade. Intuitively, the sample represents the profile of your trading Intuitively, performance. Assuming that you will continue to produce trades that are consistent with the ones in the sample, picking random trades from that sample offers you a way to simulate your future trades. Why would you want to simulate your future trades? Remember that your objective is to check if your trading strategy has positive expectancy over the long run. If it does, it should produce a net profit over a large number of trades. Hence, if we can simulate taking a large number of trades numerous times, we can more reliably evaluate if your trading strategy offers positive expectancy. This is where Monte Carlo simulation simulation comes in useful. By picking a series of random trades from your trading sample, you are able to construct numerous sets of 100 trades. If most of these sets of 100 trades are profitable, then you can be relativel relatively y confident of your trading edge. As we pick a trade out of the provided sample to simulate your trading performance, performance, we have the option of replacing it. If we replace the trade into the sample, we would be able to pick out the same trade again in a subsequent draw. If we do not, we will pick out each trade once. In that case, we are merely replicating replicatin g the same 100 trades in a different sequence. For assessing our trading edge, we must conduct the simulation simulation with replacement. The method with replacement introduces greater uncertainty uncertainty in the results. It allows us to err more conservatively. Furthermore, we are interested in the conservatively. profitability of the simulated samples (i.e. the cumulative
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profit). If we were to simulate without replacement, the cumulative profit of each random sequence will be the same as that of the sample. It is ineffective for our purpose.
Note that there are dozens of caveats in using Monte Carlo simulation. simulati on. I will not elaborate on them. The method used here strikes a balance between intuition and statistical reliability. reliability. It is a suitable way to assess your trading edge without getting mired in advanced statistical methods. In the Toolkit, you will find a basic Monte Carlo simulation tool. Refer to it as you read the following to learn how to use the tool correctly. To perform a Monte Carlo simulation, we need to provide three inputs. 1. Sample of trades 2. The number of trades per sequence 3. The number of sequences to simulate
Figure 6-3 Monte Carlo Simulator inputs
Figure 6-3 shows a screenshot of the inputs section of the Monte Carlo Simulator in the Toolkit. www.tradingsetupsreview.com
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1. Start with a sample of at least 30 trades. The more, the merrier. The simulation will draw the sample from the “Net Profit Per Contract” column of our Trade Records. 2. For the number of trades per iteration, choose a reasonably large number. It also depends on the time horizon you would like to assess. For instance, if you want to find f ind out the likelihood of you being profitable each month, use the average number of trades you take in one month. 3. The number of iterations to perform depends on the volatility of your trade sample. Volatile samples require a higher number of sequences. Performing more sequences is better but it could be time-consuming.
A simple way to find out the suitable number of sequences is by trial and error. Start with 1,000. Perform the simulation a few times and watch how the results vary. If the results vary too much, double the number of sequences to generate. Then, perform a few simulations again and observe the variation in the results. Keep increasing the number of sequences simul simulated ated until the results are relatively relatively stable. To make sense of the simulated results, you need to decide on how sure you need to be. Do you want 100% of the simulated simulated sequences to be profitable? profitable? If 95% of the sequences show positive positive cumulative profits, is it good enough for you? How about 90% or 80%? You must determine the level of certainty that is good enough for you to risk your trading capital. Most statisti statistical cal analyses are satisfied with 95% as a threshold for certainty. www.tradingsetupsreview.com
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Figure 6-4 Monte Carlo Simulator results results
Figure 6-4 shows the results section of the simulator. By entering 95% into the first box, it will show you the worst return of the top 95% of the sequences. Essentially, Essentially, it disregards the worst 5% of the results. For instance, if it shows $1,000, it means that for 95% of the simulated runs, you earn at least $1,000 in cumulative profits. A simulated positive cumulative return means that you have a trading edge. If it shows a cumulative loss instead of a profit, then you do not have a trading edge. For new traders, I suggest that you trade in simulation simulation mode until your trading records confirm that you have a trading edge that you are comfortable with (e.g. 95% of the simulated trade sequences are profitabl profitable). e). You can also specify similar percentages for the number of consecutive losses and maximum drawdown per contract. The former will give you a sense of the number of consecutive losses you need to prepare yourself for psychologically. The latter will have an impact on your position sizing, a topic we will discuss d iscuss in the next section. Our simulation uses “Net Profit Per Contract” as our input. The
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Why is there a need to eliminate the impact of position sizing in assessing our trading edge? Position sizing is usually a function of the amount of trading capital at our disposal. d isposal. For instance, some traders aim to risk 2% of their trading capital for each trade. Let’s say you got a capital injection from a family member. Naturally, you started trading larger positions according to the fixed percentage model. At the same time, you got lucky and had a winning streak. In that case, simulation using “Net Trade Profit” would produce a high cumulative profit figure. However, the high figure is partly due to the larger position you happened to be trading when you got lucky. It has nothing to do with your trading edge. By taking “Net Profit Per Contract” as our input, we are able to eliminate this impact. However, some traders deliberately use position sizing to improve their trading edge. They vary their position size according to the assessed quality of each trading setup. They attempt to increase their position size for a good setup and decrease their position size for a less optimal one. If they are able to correctly distinguish a good setup from a less ideal one, this practice will contribute to their trading performance. If not, it might harm their performance. For these traders, they might want to analyse if their position sizing efforts have given them an extra edge in their trading. To do so, they need to use a simple tagging method which we will explain later in the section under “Improving “I mproving Expectancy”.
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6.4.3 - Computing Drawdown (for Position Sizing) Assume that we have a trading edge. Do we then make full use of it and start trading the maximum number of contracts we can afford?
No. This is because even if our trading strategy has positive expectancy, consecutive losses are possible. Streaks of losing trades lead to drawdowns. Drawdown is the peak-to-trough decline in your trading capital. Look at Figure at Figure 6-5 for a chart that plots the balance in a trading account against the number of trades taken. The drawdowns are marked with red arrows.
Figure 6-5 All trading strategies produce drawdowns drawdowns
I simulated this graph trading one contract with a trading strategy that has equal likelihood of producing the following four outcomes:
$-100
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$0 $100 $200
The expectancy of each trade in this simulated strategy is therefore: (-$100 x 25%) + ($0 x 25%) + ($100 x 25%) + ($200 x 25%) = $50 It is a trading strategy with positive expectancy. Nonetheless, there would be drawdowns due to streaks of losing trades. To ensure that we remain in business long enough to reap the profits of this trading strategy, we must ensure that the maximum drawdown of our trading activities does not ruin our account.
The two key concepts are the maximum drawdown and the account ruin point. The maximum drawdown is the largest peak-to-trough decline. For our example, the maximum drawdown is $400 as marked out in Figure in Figure 6-6. 6-6.
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Maximum drawdown is $400 for one contract
Figure 6-6 The maximum drawdown in this case is $400 $400
Now, let’s determine our account ruin point. The account ruin point is different for every trader, depending on your agreement with your broker and your trading strategy. Use the following definition definiti on to figure out your trading account ruin point.
TRADING ACCOUNT RUIN A trading account is ruined when it cannot execute minimum size for its intended tradingthe strategy
For instance, I have a day trading strategy for the NYMEX crude oil futures market (CL). I use an all-in, all-out approach, so I do not need to trade multiple multiple contracts. The minimum size for my strategy is 1 contract. As a day trader, I avoid overnight margins. My broker tells me that the day trading margin for the CL contract is $1,000 per contract. For each round-turn transaction, the trading cost
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(commissions, exchange fees, etc) per contract is $5. Hence, if (commissions, my trading account falls below $1,005, I am unable to execute my trading strategy. Thus, my account ruin point is $1,005. I have a clear objective. My trading account cannot fall below this amount because I need to maintain the ability to trade. Given a maximum drawdown of $400, I need at least $1,405 to start trading. In that case, even if I experience the maximum drawdown right from the start, my account balance will not fall below the ruin point of $1,005. According to the calculations, I need $1,405 to trade one contract. Am I sure? Not really. I am confident of my account ruin point because my day trading margin and trading costs are certain. However, I am not so sure of my potential maximum drawdown. Using the same parameters as the trading strategy shown in Figure 6-5, I 6-5, I performed a second simulation. The resultant equity curve is shown in Figure in Figure 6-7. 6-7.
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The maximum drawdown is $600 for one contract
Figure 6-7 A larger maximum drawdown drawdown
Over the same number of trades, the maximum drawdown is $600 this time round. Given a larger maximum drawdown, we need more money in our trading account to start trading. In this case, we need $1,605. It is clear that we are uncertain about our maximum drawdown even if we are certain that we have a trading edge. Given the uncertainty uncertaint y in our future trading performance, how sure are we that the maximum drawdown will not exceed $600? The best way to find out is to repeat many sequences using the Monte Carlo simulation. Other than simulating the expectancy using our Trade Records, the Monte Carlo tool in the Toolkit also calculates the maximum drawdown for each simulated sequence. Similar to the process for measuring expectancy, we need to Similar decide on the level of certainty we are comfortable with. If you choose 95%, it will show you the worst maximum drawd drawdown own of the simulated sequences after leaving out the bottom 5%. www.tradingsetupsreview.com
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Let’ s say you run 1,000 sequences of 30 trades each. It means that if you take 30 trades for 1,000 times, the maximum drawdown shown is not exceeded for 950 times.
Is that good enough for you? You have to decide by considering your hunger for profits and your need to avoid risk of ruin. By demanding a lower certainty for the maximum drawdown figure, you will be able to trade larger sizes which would theoretically lead to more profits. However, the lower certainty also means that you face a higher risk of ruin due to possible pos sible underestimation underestimation of the maximu maximum m drawdown figure. I use 99% for estimating maximum drawdown. I prefer to stay conservative for this measure as it affects the likelihood of my account being ruined. I like to continue trading more than I like pushing my profits to its theoretical maximum. I am satisfied knowing that as long as my account is not ruined over the long run, I will be profitable. The point of trying to find out our maximum drawdown drawdown is to decide on our position size. With the maximum drawdown and our account ruin point, we are able to do so. For trading one contract, we need: Account Ruin Point + (Maximum Drawdown x Safety Multiple) = $1,005 + ($9009 x 2) = $2,805
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Simulated the same sample strategy for 1,000 sets of 30 trades
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The safety multiple is another feature to deal with uncertainty. A low multiple is aggressive (minimum 1) and a high multiple is conservative. I use a default of 2. For a $10,000 trading account, the position size is: $10,000 / $2,805 = 3 (rounded down from 3.56) Our Monte Carlo tool calculates the position size for you automatically using the maximum drawdown from your simulation simulati on results. Just enter your account size, ruin ru in point, and safety multiple multiple and it will compute the position size s ize for you. Figure 6-8 shows a snapshot of the position sizing tool included with the Monte Carlo Simulator.
Figure 6-8 Position sizing tool linked to Monte Carlo drawdown results results
Bear in mind that our calculation assumes that the minimum trade size of your trading strategy is one contract. This position sizing model is easy to understand and can be tweaked according to your risk appetite. It is simply based on the objective of avoiding the risk of ruining your trading account. There are many other position sizing models ranging from a simple 2% risk rule to the more sophisticated Kelly criterion derived from probability theory and inter-temporal inter-temporal portfolio choice. If you are keen to explore other position sizing models, refer the resource page page..
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Regardless of which position sizing model you employ, there is an important first principle. If the expectancy of your trading strategy is not positive, your trade size should be zero.
FIRST PRINCIPLE Do not trade if your trading strategy does not have an assessed positive expectancy
6.4.4 - Improving Expectancy We must trade with a strategy of positive expectancy. If our expectancy is negative, we ought to improve it until it becomes positive. Even if we are confident that we have a trading edge, we still have great incentives to improve it or at least monitor it for deterioration. This is the topic we are dealing with here. Our general approach is to classify/tag trades according to certain characteristics characteristics and analyse them to draw useful conclusions. Reviewing Trading Performance
To start tweaking our trading process, we must first find out what is working and what is not. We need to answer these questions 1. Are our trading rules and guidelines sound? 2. Is our discretion adding value to our trading performance? 3. Are we disciplined? Recall the trade classifica c lassification tion we performed earlier - Consistent, Discretionary, and Rogue. We are unlocking its value here to Discretionary, help us answer these questions.
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Are your trading rules and guidelines sound?
1. Filter your Trade Records to show only the Consistent trades. 2. Measure the expectancy of your Consistent trades, according to the steps described earlier. A positive expectancy reflects the soundness of your trading rules and guidelines. It means that total compliance with your rules and guidelines contributed to your trading edge. If the expectancy is negative, it is likely that you need to tweak the rules and guidelines. To find out what tweaks are necessary: 1. Focus on the Consistent trades. 2. Retrieve the Analysis Matrices that supported these trades. 3. Look at their charts. 4. Aim to find the difference in price action between the winning and losing trades. What is common to the winning trades and is generally not found in the losing trades? What is common to the losing trades and is generally not seen in the winning trades? Even if the expectancy of your Consistent trades is positive, you can still adopt the same process to further improve your trading performance. For instance, you might find out that long trades tend to fail if they take place right after three consecutive bearish bars. Similarly, Simila rly, short trades tend to get stopped out when they occur right after three consecutive bullish bars. At A t the same time, you find that none of the winning trades showed this specific price action feature. In that case, you should consider adding a trading rule/guideline rule/guideline that forbids such trades.
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However, it is important not to fall into the trap of the Holy Grail. In your review of the losing trades, you might be tempted to find something that can eliminate all losing trades. That is the lure of the Holy Grail. Do not fall for it. To avoid the trap, be reasonable and always ponder on the consistency of any new trading rule/guideline rule/guideline or any modifications modifica tions to them. For instance, the “three consecutive bars” example above seems to suggest that we should not act against market momentum. momentum. Such a rule is consistent with our understanding understandi ng of price action. You might find that if you take a small profit of 2 ticks each time, you can avoid all losing trades in the sample. Should you then add a trading rule to take a 2-tick profit for every trade? You should not because this trading rule is unreasonable and inconsistent. It is unreasonable unr easonable because eliminating eliminating all losing trades is not our aim and is often a clear sign that we are seeking the Holy Grail. It is inconsistent because we know that taking small profits of 2 ticks will almost definitely push most trades into negative expectancy. Furthermore, our understanding understandi ng of price action clearly tells us that we should target using price action features or market volatil volatility. ity. Both factors are dynamic. Using a fixed tick target is contrary to our understanding. Is your discretion adding value to your trading performance?
1. Filter your Trade Records to show only the Discretionary trades. 2. Measure the expectancy of the Discretionary trades, according to the steps described earlier.
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If the resulting expectancy is positive, you are proving your competence as a discretionary trader. With the help of your Analysis Matrices, recall your thought process and feelings during each trade. Then, attempt to positively reinforce them in your future trading decisions. On the other hand, if your Discretionary trades show negative negative expectancy, you should reduce the discretion you take and stick to your trading guidelines. This is especially so if your Consistent trades exhibit solid positive expectancy. Being able to review Discretionary trades is a huge advantage; it allows you to know if your discretion is adding value to your trading. Most discretionary discretionary traders work under a pure trust of their trading gut. It does not have to be that way. For novice traders, being able to monitor the progress of your discretionary trading skills is helpful and reassuring. Are you disciplined?
1. Filter your Trade Records to show only the Rogue trades. 2. Measure the expectancy of the Rogue trades, according to the steps described earlier. This is straightforward. The mere fact that you have Rogue trades in your Trade Records means that you are not entirely disciplined. Most traders do not have a system to keep track of Rouge trades and are unable to quantify the losses brought about by these bad trades. With records of Rogue trades, we are able to quantify the cost of not being disciplined and giving in to emotions. Having an actual loss figure attributed to a lack of discipline and mental resilience makes it a lot harder to deny that you have a www.tradingsetupsreview.com
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problem with your psychology. It also provides concrete incentives to improve your discipline. d iscipline. “If I had been disciplined, the balance of my trading account would be $X higher.” Everyone says that psychology is important to trading performance and stops at that. With records of your own Rogue trades, trading psychology is no longer a vague concept. It has a dollar amount attached to it. What if our Rogue trades show a net profit or even positive expectancy? Does that mean that you should continue to ignore your trading rules and guidelines? gu idelines?
No. This is because you cannot replicate your performance with Rogue trades. Rogue trades, by definition, defy your trading rules and guidelines. You cannot reproduce them with your trading rules. You cannot even write down any trading rules that might reproduce them. The real underlying problem with Rogue trades is not the losses they bring, but the inherent inconsistency. Thus, even if your sample of Rogue trades shows a net profit, you should not rejoice as it means nothing beyond transient good luck. As I have mentioned, we all tend to judge the validity of our actions (trades) by their outcomes (net profit). Hence, when faced with a set of profitable profitable Rogue trades, it is unsurprising that some traders start to argue that it is their subconscious trading talent at work. They say that they are good discretionary traders, although although they are not sure how to articulate their their reasons behind each trade. This is why we must insist on ex-ante trade classification. classification. Based on our ongoing written analyses, we classify a trade the moment we decide to take it and before we know its outcome.
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Ex-ante classification classification of trades is far more objective than expost claiming of credit on the basis of some unknown X factor. On this note, let me expand on the topic of what makes a discretionary trade. I agree that it is not always possible to explain the reasons behind a discretionary discretionary trade. Generally, rules must be complied with. Guidelines, if broken, must be justified. What if you cannot justify the violation of a guideline in words? All you know is that you have this nudging feeling that this trade is likely to succeed. In that case, ask yourself if you are taking this trade out of fear, greed, or boredom. If you are not affected by any of these undesirable feelings, then mark the trade as “Discretionary” . It boils down to how truthful you are with yourself. Regardless of how you differentiate between a Discretionary trade and a Rogue trade, always remember to classify your trades ex-ante. This practice is important for you to distinguish between luck and skill. The difference between luck and skill is simple. If I am skilful at singing, I can say “Listen to me. I am going to sing in tune.” And then I proceed to sing in tune, most of the time. (In this respect, being tone deaf, I am not at all skilful.) This is how we prove that we are skilled at doing something. The point is that being able to perform what we set out to do consistently consistentl y is a mark of skill and not luck. It means we know what we are doing. The unacceptable approach is this. I simply sing without saying anything. If I happen to sing in tune, I claim credit. If I go out of tune, I start trying to explain that it was an isolated incident because I was distracted by the bird flying past the window.
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This is why we need to commit to classifying classifying our trades ex-ante instead of pushing blame or taking credit only o nly after our trades conclude. Similarly, in trading, a skilled trader should be able to say “Look Similarly, at this trade I am going to take. It is a trade with positive expectancy.” And then, the skilled trader proceeds to take the said trade.
Pay attention to what the trader said: “Trade with positive expectancy” and not “winning trade”. Hence, each individual trade need not be profitable. profitable. The expectation is that a large sample of such trades should be profitable. Consider a large sample of trades that exhibit positive expectancy according to our Monte Carlo simulation. simulation. For each trade within the sample, the trader has classified them as Consistent, Discretionary, Discretionary, or Rogue ex-ante. Under such circumstances, it is undisputable that the trader is skilled. Again, this section highlights the relationship among the different stages of the Analytical Cycle. It is important that we perform the trading, recording, and classifying seriously to enable a proper review of our trading performance. In conclusion, there are three ways to improve our trading performance. 1. Improve our objective criteria for taking trades 2. Improve our trading gut (discretion) 3. Improve our discipline and mental resilience All three ways are challengi ch allenging. ng.
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However, improving our discipline and mastering our emotions produces the most certain and greatest improvement in trading performance. In fact, if you are not disciplined enough to follow your rules and ignore your destructive emotions, no amount of improvement in your trading rules and skills sk ills would matter. We will discuss more about the psychology of trading in the next chapter. Drilling for Specifics
Reviewing our trades according to the classification classification of Consistent, Discretionary, Discretionary, and Rogue is helpful. We are able to find out the strengths and weaknesses of our trading rules, trading skills, and mental state. However, if we want specific and practical ways to improve our performance, we need to expand the review with finer classifications. classificati ons. Essentially, we go beyond Consistent, Discretionary, Discretiona ry, and Rogue. Ro gue. We classify our trades according to their characteristics. characteristics. The objective is to analyse how different trade characteristics contribute to our trading performance. There are many ways to tag your trades. You can use any attribute of a trade as long as you can reliably re liably determine determine it. The process is akin to an experiment. First, we form a hypothesis about a factor that might be affecting our trading performance. Then, we identify trades with that factor and group them together. Finally, we examine if our hypothesis is correct. For instance, I notice that the price action on Fridays is usually dull and there are not many opportunities for profit. As a result, my trading style does not perform well on Fridays.
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To confirm this, I identify all my Friday trades and compare their overall performance with trades from other weekdays. If I find that, indeed, my Friday trades on a whole are barely breaking even, while my trades on other days are making making most of the profits, I should consider resting on Friday. Alternatively, I could also attempt to tweak my trading strategy on Fridays. Day of the week is an example of an objective segment. Other examples include:
Time of the day (first two hours, last two hours) Market (CL, ES, FDAX) Time frame (5-minute, 30-minute, 1-hour) Setups (Deceleration, Trend Bar Failure, Anti-Climax)
For day traders, when we trade is almost as important as how we trade. It is not because Lady Luck smiles more at certain hours of the day. It is because market volatility varies throughout a trading session. For most markets, the first two hours of the session are the most volatile. volatile. As a result, many traders find that most of their profitable trades are concentrated in the earlier part of the trading session. In that case, they might do better by restricting their trading to the first two hours of each session. Of course, this might not apply to you, given your traded market and trading style. However, if you have kept good trading records, it should not take too much to find out if certain hours are superior for trading. Simply filter your Trade Records to show only trades within the first two hours of each session and examine their performance as a whole. Many traders look for different setups in multiple markets and various time frames before eventually specialising in a couple of them. This is because the price action (including speed and volatility) of each market differs. A trader’s preference depends
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on his or her temperament and trading style which will take time to develop. We have already recorded the basic trade information in the Trade Records worksheet. Hence, you can easily filter the trades accordingly. For instance, you can filter to show only trades in the Crude Oil market. Then, compare it to the trades in the S&P E-mini market. If you find that you are consistently making money from Crude Oil and not so in S&P E-mini, you might consider focusing on the Crude Oil market. You can experiment with different filters using other parameters like time of the day and type of setups.
There are also less objective, but equally useful segments. These segments are often based on price action features. It usually involves questioning if our current price p rice action analysis is effective and paying attention to ways to improve it. For instance, as I trade, I notice that the first trade after a newly formed trend line has a higher probability of success than subsequent trades. To confirm this observation, I manually tag the first trade after the formation of a new trend line. After tagging a number of trades, I am able to review their performance and assess my hypothesis. If it turns out that the first trade following a new trend line has a higher expectancy, I can focus on finding such trades or consider increasing my position size for these trades. There are infinite possibilities. possibilities. This is why our Trade Records has additional columns from “Custom 1” to “Custom 10”. You can replace the headings and use these columns to help you tag trades according to their price action features.
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For instance, replace “Custom 1” with “First Trade after a New Trend Line”. Then, for that column, enter “Yes” if a trade follows right after a new trend line. Once you have collected a decent sample of trades with “Yes”, filter your Trade Records to see if they are indeed superior trading opportunities in terms of expectancy.
This is a systematic approach to catalogue your price action observations and develop your trading instinct. Other than tagging trades based on their characteristics, characteristics, there is another productive use of these “Custom” columns. We can use them to consider the impact of virtual decisions. What are virtual decisions?
Virtual decisions are alternative trading actions that you would like to track and examine. For instance, in a long position, you exited with a target order at the nearest resistance with a small profit. At the same time, you wondered if it was better to let your profits run by trailing a stop-loss order below each new swing low. To find out, you can make a virtual decision. Virtual decisions are the what-if scenarios. What if I place the stop-loss order below the entire price pattern and not just below the setup bar? What if I exit a trade if it does not show positive momentum within five bars? What if I wait for the high of the session to be cleared before taking a long position?
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What we really want to find out is if taking these alternative (virtual)) decisions would produce better trading results. Does (virtual the alternative lead to a better or worse trade outcome? Considering these what-if scenarios is a natural progression for any trader seeking to improve his or her performance. In fact, it is an important endeavour and a means to achieving better results, especially for more experienced traders. To find the answer, each time you see an opportunity to consider an alternative action, record it as a virtual decision and note its outcome. For instance, at some point after you enter a trade, you are thinking about moving your stop-loss order to breakeven. However, your rules do not allow you to do so. Being a disciplined trader, you stick to your rules. However, you can record a virtual decision of shifting your stop-loss to breakeven. To do so, replace one of the “Custom” headings with “Breakeven Stop-Loss”. Then, in the row belonging to the trade you are recording, enter the net profit/loss of taking that alternative action, which is placing a breakeven stop in this case. Let’s say for the actual trade, you exited with a 20-tick profit without adjusting your stop-loss to breakeven. And if you had shifted the stop-loss to breakeven when you thought of doing it, you would have exited the trade at breakeven due to whipsaw whipsaws. s. In this case, you would record 20-ticks as your actual profit and 0 tick as your virtual profit resulting from the virtual decision.
After a series of trades implementing implementing the same virtual decision, you will get a sense of whether the alternati alternative ve action is superior to your current rules and guidelines.
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The best part of making virtual decisions is that you can stick to your trading rules while exploring new possibilities in your trading method. You do not influence your live trading with premature conclusions. At the same time, you do not give up any chance of gaining new price action insights. w ith implementing virtual decisions. However, don’t go crazy with There are infinite what-ifs in trading. It is impractical to keep tabs on too many alternat alternate e decisions. Based on your trading experience, choose several promising alternatives and monitor them.
Essentially, our approach to improving the expectancy of our Essentially, trades revolves around classifying/tagging classifying/tagging our trades to segment them for review. Table review. Table 6-3 shows the tags and their respective functions. Tag
Consistent Discretionary Rogue Objective Characteristics Characteristics (using standard columns) Subjective Characteristics Characteristics (using custom columns) Virtual Decisions (using custom columns)
Function
Monitor the soundness of trading rules and guidelines. Monitor the development of discretionary discretiona ry trading skills. Quantify losses due to psychological issues. Refine trading period, time frame, market, etc. Refine price action interpretation. Test alternative course of action.
Table 6-3 Tags and their functions
Before we end this section, I would like to warn you against vanity metrics. Armed with a large set of Trade Records, you will be able to slice and dice them in numerous ways and calculate various metrics.
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Regardless of what you do with the data, do not waste your time calculating metrics that are not actionable. For instance, the Sharpe ratio is a popular risk-adjusted performance measure among portfolio managers. Some traders calculate this ratio as well. The question is: what do you do with it? How does it lead to an improvement of your trading performance? I do not calculate the Sharpe ratio as I do not know what to do with that number. Do not calculate numbers and run simulations for the sake of doing so. The objective of a trade review is to arrive at practical steps to improve our trading. This also explains why we use a tagging approach in our review. We tag trades according to certain characteristics characteristics and review them. If the tagged trades are superior, we can improve our trading by looking out for those characteristics. If they are inferior, we can improve by avoiding those characteristics. In any case, we are always able to link our review process to practical actions to help us improve our trading.
TASKS
STAGE FOUR
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1. Measure your expectancy using Monte Carlo simulation 2. Derive your position size using the maximum drawdown method 3. Tag your trades and review them for areas of improvement
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6.5 - Refine Trading Rules and Guidelines It’s time to complete our Analytical Cycle. The key purpose of going through the prior stages is to improve our trading premise, before we start all over again. Based on what we gather in Stage Four, we can refine our trading rules and
guidelines. There are two pertinent points to note for refining trading rules and guidelines. First, do not change your trading rules based on a small sample. Accumulate more trade records before concluding if the intended change in a trading rule or guideline is beneficial. Your actual trades might not offer a sufficient sample size. In that case, record trades that you missed as well, either because you were away from your trading desk or did not trade the session. I am referring to trades that you would have taken according to your trading rules if you had the chance. These trades should be tagged as “Virtual Trades” using one of the custom columns. Use them only for assessing possible improvements. improvement s. Do not include them for measuring your trading expectancy or maximum drawdown as they were not taken in real-time. When you are unsure if you should alter a trading rule or guideline, don’t hesitate to use a virtual decision to gather more information informati on before deciding. Next, avoid drastic changes. “Refine” means making minor improvements. improvement s. Drastic and frequent changes to your trading rules and guidelines make it difficult to review your trading performance.
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Trading rules and guidelines form the basis for every trade you take. They ensure the common ground for trade review and improvement.. Drastic and frequent changes destroy the improvement common ground and render your trade review ineffective. If the basis of your trades changes from trade to trade, there will be hardly any ground for comparison.
6.6 - Conclusion The Analytical Cycle sounds like a chore. However, I assure you that it is a solid framework that will work regardless of your traded market, time time frame, or strategy. As you work your way through the cycle repeatedly, you will gain confidence in your trading skills and eventually develop your own trading style. Do you want to create your own trading success without relying on trading gurus? Do you want to continue trading profitably in a changing market? Do you want to get out of a state of denial and speculation when it comes to trading? If you answered yes to the above questions, you must employ the Analytical Cycle. It is based on common sense and designed to mitigate cognitive biases. It is simple and straightforward. And being a generic approach, it works for all trading styles and is yet independent from any trading style. On top of that, your Toolkit has everything you need to embark on this rigorous tracking of your trading activities. You just need to enter your trade information into the Trade Records worksheet. Start today!
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Chapter 7 - A Risk-Based Approach to Trading In many ways, “trader” is a misnomer for describing people like us. We should be called risk managers. “Trader” describes describes what
we clickby the buy and sell buttons. However, what are do wewhen reallywe doing pressing the buttons? We are assuming and managing trade risks. The game is about finding risks that are worth taking. Hence, “risk manager” more more accurately describes what we do constantly. At the core of our trading process, we are basically taking on risks. With each trading opportunity, we are assessing if the trade risk is worth taking. The main idea is to take on risk that promises net positive returns over the long run. We evaluat evaluate e the risk and take them on with the intention of making money. Assuming the right trade risks is what gives us our trading edge. Finding desirable desirable trade risks has been our focus so far. Indeed, that is the main role of a trader. However, traders face many risks beyond the amount we stand to lose for each trade. With an in-depth examination of the risks associated with trading, you will realise that being a trader is much more than being an analyst and extends very much beyond the market. To complete your trading plan, you need to look beyond trade risks. You will realise that, in a nutshell, focusing on risks is the best way for a trader to put everything together.
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7.1 - Identifying Risks Risks do not occur in a vacuum. Risks are defined in relation to our environment, resources, and most importantly, importantly, our objectives. Hence, our first step is to refocus on our objective.
Objective: To earn a profit by taking trades of positive expectancy.
With respect to this objective, let’s separate a trader’s risks into intrinsic risks and external risks.
INTRINSIC RISK We do not know how to find trades that offer positive expectancy
Intrinsic risk relates directly to our objective. It is the essential/pre-requisite essential /pre-requisite skill of any endeavour. In this case, it is the skill of looking for trades of positive expectancy. It represents the risk of not being able to find trades that offer positive expectancy. If you do not know how to analyse the market to find trades of positive expectancy, you cannot succeed as a trader. You can buy a super computer, pay zero commissions, commissions, lease a CME membership, and start with 1 million dollars. You will still fail. This is because you have not addressed the intrinsic risk of your objective. This is the type of risk we have been focusing on so far. The way to manage this risk is to learn how to read the market to find opportunities of positive expectancy. We have learned how to read price action and pinpoint specific trading setups that offer positive expectancy. The previous chapter completed www.tradingsetupsreview.com
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our treatment of the intrinsic risk with techniques to assess and improve our trading edge. Employ the price action trading techniques you’ve learnt and trade in simulation mode to build up your trading record. Then, use the Monte Carlo simulation simulation tool to assess if your records exhibit positive expectancy. These steps will ensure that you have the skills to pick out trades with positive expectancy. Essentially, Essentiall y, these steps help to control your intrinsic risk. Assuming that we know how to find trades with positive expectancy, does that mean that we will become profitable traders? No, because there are external risks that we need to address.
EXTERNAL RISK We know how to find trades that offer positive expectancy, but we are unable to take them
External risks do not give us our trading edge. However, they can easily destroy our trading edge if they are not managed well. Traders commonly blow up their trading account because they mismanage misma nage or neglect these risks, even though their trading strategy is sound. If such risks are not controlled, they can easily wipe wipe out your trading edge. These risks stem from the fact that being able to find good trades will not make us a single cent. I can note down every single trading opportunity with positive expectancy in my notebook, sit there, and stare at the screen. Even if these
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trading setups turn out to be profitable, I would not have made a single cent. Why? Because I have not placed any order to be executed in the market. I have not traded. Without actually trading, regardless of how fantastic my market analysis is, I cannot make a living. To achieve our objective of making money, we must actually trade based on our analysis. To start making your first dollar from the market, you need to actually execute a trade. Let’s look at an analogy. You aim to become a successful author by publishing a great novel. You have dealt with your intrinsic
risk, that is, you have acquired the writing skills and exercised your creativity to finish a great novel. However, does that mean that you will become a successful published author? No. You face the risk of losing your only manuscript when your computer fails. You face the risk of not having the confidence to pitch your book to literary agents. You face the risk of being rejected by the big publishing houses. If you intend to selfpublish, you face the risk of not having enough cash flow. There are many risks. These risks are external to your great creative work. The truth is that a writer has to worry about more than just writing a great book. Similarly, a trader has to worry about more than just finding great trades. Finding good trades is necessary but not sufficient for trading successfully. We must be able to commit to these trades financially financial ly in order to attain our objectives. There are many risks and obstacles that might stand in our way.
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The identification identification of external risks is a structured yet creative process. We need to go through each step of our trading process methodically and yet actively imagine what could possibly go wrong. It should be a painstaking first step. Fortunately, we have many fellow traders to learn from. A simple literature review and my personal trading experience reveal that the risk to our ability to trade according to our analysis revolves around three aspects. Remember that in addressing external risks, we are assuming that our analysis is solid. We should follow what our price action analysis dictates. dictates. However, due to one or more of the reasons below, we might be unable to do so.
1. When we run out of money, we cannot trade according to our analysis. (Financial risk) 2. When our trading infrastructure/environment infrastructure/environment is not working, we cannot trade according to our analysis. (Operational (Operatio nal risk) 3. When our minds are hijacked by our emotions, we cannot trade according to our analysis. (Psychological (Psychological risk) Each of the reason above corresponds to a type of risk that requires our attention. We have already dealt with intrinsic risk. Hence, this chapter will focus on external risks. The integration of the different risks will complete our trading perspective and, more practically, practically, our trading plan. In the following sections, we will take a closer look at specific risks. For each of them, we will complete a Risk Management Card, a simple tool to help us to work our way from risk awareness to practical ways of managing risk.
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Risks are highly dependent on the circumstances of each individual trader. Hence, I cannot and will not provide an exhaustive list of risks. We will focus on the major risks and the common means to deal with them. The real aim of this chapter is to increase your risk awareness and to use the Risk Management Card to manage individual risks.
7.2 - Risk Management Card To ensure that our discussion concludes with actionable steps to manage each type of risk, we adopt an established risk management managem ent process. 1. 2. 3. 4. 5.
Identify risks Analyse risks Prioritise risks Treat risks Supervise risks
This framework is derived from the “Overview of Enterprise Risk Management” issued by the Casualty Actuarial Society. It is also included in the curriculum of the Financial Risk Manager (FRM) qualification. qualificati on. It is designed with an enterprise in mind. The resources available available to an enterprise are beyond that of any one trader. Luckily, the risks that a trader faces are also more
limited in scope. The Risk Management Management Card represents a practical application of this robust framework for the individual trader to manage his risks.
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Table 7-1 explains the parts of a Risk Management Management Card.
Risk
Identify
Function
State and describe the risk. For every step in your trading process, ask “What could go wrong?”
Analyse
Explain the factors that affect the probability and magnitude magnitud e of this risk. Apply simulation techniques and scenario analysis. Focus on their impact and likelihood of taking place. Seek to understand the true nature and implications implicati ons of each risk.
Prioritise
Examine the impact of leaving this risk unmanaged and prioritise it. This will affect the amount of time and resources we devote to managing this risk.
Treat
For each assessed risk, we should try to:
Eliminate it; Reduce it to an acceptable level; Transfer it; Accept it; or Exploit it.
Our analysis above would have revealed the potential impact of leaving the risk unmanaged and the likely costs of containing it. To decide on our course of action, we need to review our resources and environment to understand how they advance or hinder our path to our goal of taking trades with positive
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Risk
Function
expectancy. State how we intend to avoid, reduce, or transfer the risk. Depending on the circumstances, we can also accept or exploit the risk. Focus on action items. Remember that you can always choose to accept a risk if the probability of a loss is low compared to the cost of mitigating it. This is the essence of a risk-based approach. approach. We are not trying to create a zero-risk environment. We are aiming for an awareness of risk factors in our trading process and environment, and to treat them sensibly, given our resources. The courses of action listed in the Risk Management Cards that follow are general recommendations. recommendat ions. Adapt them for your personal circumstances.
Supervise Risks evolve. List down relevant risk items to monitor. (E.g. drawdown or financial soundness of broker etc.) Table 7-1 Risk Management Card
In the following sections, we will assume the perspective of a futures trader who intends to day trade using price action. From this standpoint, we apply the Risk Management Card on specific risks.
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7.3 - Financial Risk Let’s break down the main financial risks of a trader. (We are not talking about trade risk here.)
1. Risk of not having enough trading capital 2. Risk of not having enough living expenses 3. Currency risk
7.3.1 - Trading Capital We have discussed the risk of drawdown in trading strategies in the previous chapter. Here, the Risk Management Card provides a structure to our thought process.
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Risk
Function
Identify
Every trading strategy encounters drawdowns. Hence, we face the risk of not having enough trading capital for the strategy.
Analyse
How much trading capital is enough? We have already gone through the drawdown analysis in the last chapter. The maximum drawdown figure from the Monte Carlo simulation is a good starting point.
Prioritise
The impact of having insufficient trading capital is severe. It will render us unable to trade. This is top priority.
Treat
1. Use drawdown analysis to calculate the amount we need to trade the minimum size. 2. Save enough trading capital to start trading. 3. Impleme Implement nt position sizing model according to the maximum drawdown approach. For details, refer to Chapter 6.4.3 Chapter 6.4.3 - Computing Drawdown (for Position Sizing). Sizing).
Supervise
1. Review the maximum drawdown figure regularly using a larger trade sample for simulation analysis. 2. Adjust the position sizing model inputs accordingly.
Table 7-2 Risk of not having enough trading capital
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7.3.2 - Living Expenses A trader’s risks often extend beyond the market and the trading strategy. If you intend to day trade for a living, you need to pay attention attenti on to the risk of not earning enough.
Even for a profitable trader, the cash flow from your trading income will be largely irregular, unlike a salary from a normal job. Thus, traders traders need to watch watch their their personal finances finances closely.
Risk
Function
Identify
Trading produces volatile volatile income (if any). Hence, traders face the risk of not being able to meet their living expenses.
Analyse
How much living expenses do you need? Keep records of your expenditure over a few months to estimate your average monthly spending. Do you trade full-time or part-time? If you intend to rely on trading for your sole source of income, the volatile nature of trading represents a major risk. If you intend to day trade part-time, your income from your day job should be able to meet your living needs. The risk of not having sufficient living expenses while you trade is reduced.
Prioritise
Treat
Without income for basic survival, surviva l, we are unable to trade. Hence, this risk is top priority. 1. Avoid this risk by securing another source of income to meet your living expenses. 2. If you intend to trade for a living, save at
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Risk
Function
least 1 year worth of living expenses before you start day trading. That sum does not include your trading capital. c apital. 3. If you plan to trade part-tim part-time, e, lower the savings amount accordingly. Supervise
1. Monitor your living expenses to ensure that it is within your projection. 2. If your trading proves profitable, profitable, consider setting up a system for withdrawi withdrawing ng profits to cover expenditure.
Table 7-3 Risk of trading income not meeting living expenses
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7.3.3 - Currency Risk The currency risk discussed below shows how risks depend on the circumstances of individual traders. Day traders are generally not exposed to significant currency risks due to their short holding periods. However, currency fluctuation fluctuati on might pose a problem if the currency cur rency of your trading account is different from your home currency (i.e. the currency you intend to spend in). For instance, you trade the US markets using a USDdenominated denominat ed trading account. However, you stay in Thailand and expect to withdraw your earnings in Thailand Baht (THB). The value of your profits to you is affected by the strength of USD versus THB. If USD appreciates, you stand to gain. If USD depreciates, your USD trading profits convert to less THB.
Risk
Function
Identify
The value of your trading account balance is subject to currency risk due to the difference between the currency base of your trading account and your home currency.
Analyse
How much do you intend to keep in your trading account? The larger the amount in your trading account, the larger the currency risk. What is your view on the volatility of the relevant exchange rate? It depends on the historical volatility volatility of the currency pair and your take on its future volatility. volatility. The larger the volatility, the greater the risk.
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Risk
Function
Prioritise
The priority of this risk depends on the currency pair involved and the size of your trading account. However, while currency changes might affect the value of our trading account, it is unlikely to have a catastrophic impact on our trading activities. Generally,, this risk is of medium priority. Generally
Treat
1. Avoid this risk by using a trading account denominated denominat ed in your home currency. (subject to the availability of brokerage account options and trading markets) 2. Reduce this risk by keeping just enough money in your trading account to trade your trading strategy. 3. Transfer the risk using hedging techniques. (spot forex/currency futures) 4. Accept the risk if the size of your trading account is relatively small. 5. Exploit the risk if you think that the currency change will be in your favour. You can do this by timing your withdrawal w ithdrawals. s. However, this is equivalent to taking a separate forex trade. Proceed with caution.
Supervise
1. Monitor currency changes and account balance. 2. Review brokerage account options. For instance, your broker might start to offer a trading account denominated denominated in your home currency.
Table 7-4 Currency risks of international trading trading
The above risks represent some of the major financi financial al risks that might impede your trading. If you become aware of additional financial risks, use the Risk Management Card to assess them like we did above.
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7.4 - Operational Risk Within the context of an individual day trader, operational risk refers to the risk associated with the actual trading process - the actual action of clicking the mouse button to place a trade.
Trading process here refers to the actual placing of orders to trade and not the process of analysis. analysis. Placing a trade may seem like just a mouse-click. However, it is clear that we need a great deal more than just a computer mouse to place a trade. To place a trade in the market, we need the following:
Computer with keyboard and mouse Electricity Internet connection Brokerage account Trading platform Knowledge of how to use the trading platform Working space clear of distracti d istraction on
To break down the aspects of operational risk, we need to go through each part of our trading process. For instance:
What can go wrong with our computer? What can go wrong with our electricity supply? What can go wrong with our Internet connection? And so on…
These are the type of questions we need to ask to pinpoint specific operational risks.
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The following Risk Management Cards address the risks associated with each aspect stated above.
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7.4.1 - Trading Computer Risk
Function
Identify
Risk of trading computer failure
Analyse
What is the condition of your computer? The probability of a computer c omputer breakdown is a function of its age, workload, and quality. However, the failure of a computer is certain. Your trading computer will fail. The question is when.
Prioritise
If you cannot power up your computer to start trading, simply buy a new computer. This is a lowrisk event. However, if your computer fails or hangs during a trade, it might bring about catastrophic consequences. We will not be able to monitor the trade. For a day trader, this might bring about unexpected large losses. This is especially so if your stop-loss and target orders are held locally by your computer. If so, after your computer shuts down, you have no stop-loss and target orders working for you. Your potential loss is unlimited. This is top/medium priority.
Treat
1. Avoid the risk of unmanaged open positions by looking for a broker that holds your orders at their servers. 2. Have your broker on speed dial so that you can close your open positions in case of emergency. 3. Reduce the risk by taking care of your
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Risk
Function
4. 5. 6. Supervise
computer. Dedicate a computer to trading. Do not use it for any other activities. Get a backup computer/laptop. computer/laptop. Backup trading records.
1. Look for signs of failure. (E.g. increased errors, slowdown, automatic shutdowns etc.) 2. Replace your computer if necessary. From a business aspect, it’s a good idea to plan the replacement of your computer to ensure work continuity. If you wait until your computer fails before buying a new one, your trading will be disrupted and data transfer will be more tedious.
Table 7-5 Risk of computer failure
Adapt the Risk Management Card according to your specific context. For instance, if you use a wireless computer mouse, it will run out of power. You do not want to miss a trade because of that. You can devise ways to treat this risk. You Y ou can prepare spare batteries, use a wired mouse, or learn how to execute trades with only your keyboard.
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7.4.2 - Electricity Risk
Function
Identify
Risk of unreliable electricity supply.
Analyse
What is the probability of the electricity supply being disrupted? It depends on the utility infrastructure of the country/area you intend to trade from. On top of that, the likelihood of disasters like earthquake and hurricanes also play a role as they might disrupt electricity supply.
Prioritise
The consequence of a disrupted electricity supply is similar to that of a computer failure. This is top/medium priority.
Treat
1. Avoid the risk by using an uninterruptible uninterruptible power supply. 2. Accept the risk if the probability of electricity failure is extremely low.
Supervise
1. Monitor the reliability of your electricity supply, especially if you have moved your trading operations to another locality.
Table 7-6 Risk of a power disruption
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7.4.3 - Internet Connection Risk
Function
Identify
Risk of having an unstable Internet connection.
Analyse
What is the probability of the Internet connection being disrupted? It depends on the communications infrastructure infrastructure of the country/area you intend to trade from. It also depends on the reliability reliability of your network components like router, Ethernet cable, Wi-Fi adapter etc. For day trading, while the speed of your connection is important and should be reasonably high (at least 1mbps), the stability of your connection is even more critical. If an Internet connection drops off while you are trading, you stand to lose far more than a millisecond delay in getting your orders to the exchange.
Prioritise
The consequence of a failed Internet connection is similar to that of a computer failure. For all trading purposes, the computer is useless without an Internet connection for us to download price data and send our trading orders. This is top/medium priority.
Treat
1. Reduce the risk of your Wi-Fi signal dropping off by using an Ethernet cable for wired Internet connection. 2. Get a standby Internet connection from another provider. (Just in case the problem is ISP-wide.) For instance, a 3Gmobile data connection tethered from your
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Risk
Function
device. 3. Have your broker on speed dial so that you can close your trading position without an Internet connection. Supervise
1. Monitor the reliability of your Internet connection, especially if you have moved your trading operations to another locality.
Table 7-7 Risk of disrupted Internet connection
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7.4.4 - Broker Risk
Function
Identify
Risk of technical issues with our broker.
Analyse
What is the probability our broker experiencing technical issues? Our broker’s technical expertise and systems are largely opaque to us. However, generally, most reputable and well-regulated well-regulated brokers have decent infrastructure.
We are largely concerned with technical issues that affect our ability to trade according to our analysis. This refers to problems with trading platform platforms, s, servers etc. Other technical issues are less important important to us. For instance, problems with your broker’s informational website. Prioritise
Technical issues might affect the execution of our trading orders and their accuracy. It might also affect our connectivity to the broker’s server. Basically, we will not be able to trade freely according to our trading strategy if our broker is having problems. This is top/medium priority.
Treat
1. Familiarise yourself with alternative channels of trading through your broker. For instance, alternative trading platform p latforms, s, trading engines, or phone trading might be working as usual. 2. Get a standby brokerage account that you can use to continue trading or to hedge your
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Risk
Function
position.
Supervise
1. Monitor the reliability and responsiveness of your broker when they encounter technical issues. Timely updates about technical problems are expected. 2. Keep an eye out for reviews and news on your broker and potential alternativ alternative e brokers.10
Table 7-8 Risk of our broker experiencing e xperiencing technical issues
10
A good way to do d o so is to set a a Google Alert Alert to monitor news on broker.
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Beyond technical issues, a broker or Futures Commission Merchant might also experience financial issues.
Risk
Function
Identify
Risk of our broker going bankrupt or defrauding us.
Analyse
How safe is the money in our trading account? It depends on how well the broker is regulated and the jurisdiction it is under. The financial numbers of the broker, if available, will also shed light on its financial soundness. The segregation of client’s funds is a key concept
here. It means that the funds you and other traders deposit with your broker must be kept separate from the broker’s own funds. The broker cannot use its clients’ monies under any circumstances, circumstance s, even if it goes bankrupt. If there is proper and honest segregation, your broker’s financial soundness does not affect the monies in your trading account. However, in the case of financial fraud, we might have little recourse against a bankrupt firm. Prioritise
We risk losing our entire trading capital. This is top priority.
Treat
1. Perform due diligence on your broker to assess fraud risk. 2. Reduce the risk by keeping the minimum sum you need to trade with your broker. The bulk of your savings should not be with your day trading broker.
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Risk
Supervise
Function
1. Monitor any news on your broker. 2. Re-perform due diligence at regular intervals.
Table 7-9 Risk of losing our trading capital due to fraud or bankruptcy
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7.4.5 - Trading Platform Risk
Function
Identify
Risk of our trading platform failing.
Analyse
How reliable reliable is our trading platform? Most trading platforms are reliable as long as their minimum requirements are met. When trading platforms fail to function, it is often a problem with the backend of the broker. In that case, we have already addressed the risk in Table in Table 7-8. 7-8.
Prioritise
Possible technical issues might affect the execution of our orders and their accuracy. It might also affect our connectivity to the broker’s server. Basically, we will not be able to trade freely according to our trading strategy if our trading platform malfunctions. This is top/medium priority.
Treat
1. Reduce the risk by ensuring that your computer exceeds the minimum requirements requirement s of your trading platform. 2. Prepare alternative trading platforms if available.
Supervise
1. Update your trading software in a timely manner. 2. Monitor if new versions of the software have different requirements and update your trading computer accordingly.
Table 7-10 Risk of trading platform failure
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7.4.6 - Execution Process Risk
Function
Identify
Risk of making mistakes in trade execution due to the lack of knowledge or focus.
Analyse
How familiar are you with operating the trading platform? The more familiar you are with the trading platform,, the less prone you are to mistakes in platform trade execution. What is your physical and mental condition? You need to feel physically well and mentally focused. The probability of negligence increases with your level of fatigue.
Prioritise
Clicking sell when you intend to buy or entering a larger position size than you intended are stupid mistakes with potentially potentially huge costs. If you are not alert enough to use the platform correctly, you should not be trading. This is top priority.
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Risk
Treat
Supervise
Function
1. Trade in simulation mode to familiarise yourself with the trading platform. 2. Whenever possible, use the trading platform to minimise errors. For instance, set the default trading size to your regular trading size. Setup a pair of target limit order and a stop-loss order to be placed automatically with each new trade entry. Essentially, you are transferring your execution risk to your trading platform. 3. Conduct a self-check on your physical and mental well-being before starting a trading session. Avoid trading when you feel unwell.
1. Check changes in familiarise new versions of your tradingfor platform and yourself with any changes.
Table 7-11 Execution risk (Self)
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7.4.7 - Trading Environment Risk
Function
Identify
Risk of making mistakes in trade execution due to external distractions.
Analyse
How vulnerable vulnerable are you to external distractions? distractions? Examine your trading environment. A locked, sound-proof room is conducive for trading without distractions. distracti ons. A common room where kids roam r oam around is less ideal.
Prioritise
We risk executing our trades wrongly or missing good trading opportunities. This is top/medium priority.
Treat
1. Ensure a quiet trading environment conducive for intense focus. 2. Communicate with your family/housemates and let them know that you should be left alone during your trading hours. 3. Turn off your mobile and other communication communica tion devices.
Supervise
1. Monitor changes to your trading environment and take steps to mitigate any new risk that arises.
Table 7-12 Execution risk due to external distractions
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7.4.8 - Minimise Risk by Keeping It Simple We started our operational operational risk analysis by stating the required items for trading. Then, we examined what could go wrong with each item.
It follows that the more items we need for trading, the more room for things to go wrong. This means that a complicated trading process entails more risks. Thus, the best way to minimise risk is to keep things simple. Imagine a trader who has two trading computers running three trading platforms from the four different brokers he’s using to trade five markets with the six different trading approaches he picked up from the seven mentors he found online. Even if we disregard the eight trading screens he has in front of him, can you imagine the multitude of things that could go wrong? I am not referring to the trader who has one computer for trading and one for backup. I am referring to the trader who, for some reason, requires both computers to trade. If he plans for backup computers, he would need four trading machines. Instead of one computer that will fail, you have two. With three trading platforms, platforms, it iis s harder to become proficient in using them. Execution risks increase. Basically, having more components in your trading process complicates complicates your risk context and increases the challenge of managing risks effectively. The best policy is to keep things simple. Start with a minimalist mind-set. Use one computer with one screen. Stick with one trading platform and broker. Employ one trading method in a single market. Seriously consider the marginal value of any addition to your trading process.
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Does it help you move closer to your objective of taking positive expectancy trades? If it does not, do not add it to your arsenal. If it does, then consider its costs and risks. r isks. Is it worth it?
“Simplicity is the ultimate sophistication.” Leonardo Da Vinci
7.5 - Psychological Risk You have learned how to analyse the market and how to trade. Over time, you will hone your trading skills further. In other words, with enough effort and in a matter of time, you will know exactly what to do in real-time trading. The problem is, however, at times we deviate from what we know we should do. This deviation is commonly described as a lack of discipline that stems from our cognitive biases and emotional flares – psychological risk. Psychological risk is the greatest challenge challenge to a trader’s consistent profitability. profitability. Challenged by our emotions, we risk ignoring the trading rules we designed to protect ourselves.
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Risk
Function
Identify
Risk of not following our trading rules due to the lack of discipline and control over our emotions.
Analyse
How well do you appreciate the probabilistic probabilistic nature of the market? How scared are you of losing your trading capital? capital? How confident are you in your trading plan? Ultimately, we are humans. Psychological risk is a constant.
Prioritise
If we do not trade according to our trading plan, we have no consistent trading edge. If we do not follow our risk management rules like the position sizing model, we face a high h igh probability of ruining our trading account. Managing our psychological risk is top priority.
Treat
1. Understand the probabilistic probabilistic nature of the market. 2. Plan your trades meticulously. 3. Get a trading buddy/mentor to improve accountability.
Supervise
1. Keep a trading emotion journal. 2. Review results of rogue trades.
Table 7-13 Psychological risk risk
Conquering our emotions and maintaining maintaining discipline is critical cr itical to consistent trading performance. In the following sections, I will elaborate on how to handle this risk that is embedded deep inside our minds.
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I have briefly described several cognitive biases as I explained our analysis process previously. Instead of repeating them with additional academic academic descriptions, I will condense the psychological risks of a trader and deal with its root cause. Although there are numerous psychological aspects of trading, a trader's mental challenges can be summed up with one word: fear. While fear and greed are often touted as the two emotions that plague traders, we can in fact simplify our perspective and just focus on fear. This is because greed is profoundly related to fear. In most cases, greed is a form of fear. Greed is the fear of losing out or missing out. I’m scared of missing out on the next profitable trade. This is why I am going to take this trade although the trade risk is more than 50% of my trading capital. Don’t ever do that. I’m scared that I will not capture the entire price swing. So I held on to my position although the technical signals are telling me to exit. These are behaviours that some might describe as greedy. I see them as forms of fear.
Greed also stems from a disrespect d isrespect of fear. In fact, greedy traders are at times fearless. They do not fear the market because they think they are in full control or simply do not recognise the reality of financial markets. They pay so much attention to the potential gains from the market that they forget about their risks. As we will discuss in-depth later, fear is useful as long as we respond to it constructively. Fearless trade traders rs are not good traders. Traders who respond well to fear are. Most mental obstacles of a trader stem from fear.
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Traders Traders Traders Traders Traders Traders
are are are are are are
scared scared scared scared scared scared
of of of of of of
losing losing a session a losing week a losing month missing out on good trades taking too few trades
Traders Traders Traders Traders Traders Traders
are are are are are are
scared scared scared scared scared scared
of of of of of of
taking too many trades consecutive losses exiting too early exiting too late being called a loser not being able to trade anymore
These fears cause traders to ignore their trading rules and act emotionally. emotionall y. For instance, the fear of having a losing trade causes uslosing to exit prematurely The fear of having a session causeswith us totiny setprofits. an unrealisti unrealistic c target to get back what we lost earlier. Although fear is correctly identified as part of a trader’s psychological problem, talking talking about it seldom leads to any improvement in a trader’s psychology. When we discuss the psychological difficulties difficulties of trading, we often lapse into abstract ideas of how to improve our mental resilience to enhance trading performance. Working through such uncollected thoughts might be interesting but hardly beneficial. To address our psychological demons effectively, we need to go one step back and understand the reasons for our fear. This will empower us with a solid foundation to recognise that our fears are not compatible with the market, and that our response to fear is irrational. Then, we need to go a step forward and put in place measures to help us act correctly when we are fearful. Thus, we have a two-pronged approach.
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First, we need to understand why most of our fears are unfounded. This step is aimed at eliminating the fear factor in our trading process. However, we are humans and we can never entirely uproot fear from our minds. That’s okay, because we should not ignore fear entirely. Fear is an instinct that heightens our senses to help us protect ourselves. This also leads us to the second part of our solution to fear. The second part relates to our response to fear. We must condition ourselves to react to fear constructively and not destructively.. Do not underestimate destructively underestimate this mental conditioning. Without mastering your reaction to fear, the slightest destructive element is a potential start to a downward spiral that could wipe out your trading account.
7.5.1 - Psychological Foundation To manage your trading psychology, there are three things you should know. 1. It is natural to feel fearful. 2. The market does not care about how you feel. 3. It is our response to fear that matters. matters. It is natural to feel fearful. Our mind is programmed to fear uncertainty, uncertaint y, loss, and pain. The feeling of fear protects us by heightening our senses. In fact, psychologists have suggested that humans have only a small set of innate basic emotions and that fear is one of them.
Hence, we should not think that feeling apprehensive is wrong and attempt to deny feelings of fear. Instead, as you will see, in order to trade well, we need to embrace fear.
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Fear is necessary for profitable trading. We depend on other market participants feeling fearful to make our profits. If every market player is perfectly rational and is not affected by their emotions, the market would be much more efficient than it is. It would be much harder to make money out of it. The very fact that humans act emotionally undermines the efficient market hypothesis theory. Fear is more desirable than being fearless. Fearless traders are either gamblers or arrogant traders who think they will always win. To avoid certain ruin in your trading career, make friends with fear. The market does not care about how you feel. The problem with fear is not that we experience it. The reality is that the
market does not care. While your every step is drenched in fear, the market does nothing in response to it. By nature, we are afraid of uncertainty and our fear stems from a craving for certainty. However, the market is nothing but uncertain. This fundamental difference between what we crave for and what the market epitomises epitomises is the root of our psychological troubles. As mentioned above, as traders, we are fearful of dozens of things. How does fear cause us to flout our trading rules? Regardless of the exact rule you flouted or the excuses you give yourself, it always boils down to one root cause - you want something that the market cannot give. “I want the next trade to be a winner. I’m afraid to be labelled a loser.”
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The market cannot promise that because trades are governed by probabilities probabilities and not certainties. certainties. They are not governed by your desires. “I don’t want to lose. I’m afraid of losing.” The market cannot promise that because it changes. f or the losses earlier in the session. I’m “I want to make up for scared of having a losing session.”
Again, the market cannot promise that. The profit potential in the later part of the session does not increase simply simply because you need to have a profitable profitable session.
We want certainty and that is what the market is unable to give. If you act like you are going to get a guaranteed outcome from the market, you will suffer. It is important to stay away from the quest to buy at market bottoms and sell at market tops. The market will never let you do that consistently. A quest for perfection is bad for a trader’s health and wealth; a quest for positive expectancy with prudent position sizing for scaling up is excellent for both. The real quest is to find a positive expectancy approach that works for you. It is our response to fear that matters. We know that we experience fear in the markets. However, we must realise that it is not the feeling of fear that destroys us. It is our response to fear that is destructive.
For instance, after a series of losses in the morning, I am scared of having a losing session. But in fact, everything is still cool. coo l. I still have money in my trading account. I have not engaged in destructive actions.
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Fear, as a feeling, is not destructive. However, in response to that fear, I decide to ignore my position sizing rules and double my trading size for the next trade, hoping that I can make up for earlier losses. Then, I end up blowing up my trading account as the market goes against me again in the afternoon. This response to fear is destructive. Fear is neutral. It is our response to it that determines its impact on our trading performance. Each time I feel fearful, I can take a step back and rely on my rules. Or I can choose to ignore my rules and behave destructively. Fear can be a warning to help us improve our trading or an impetus for misbehaviour. “We have met the enemy and he is us.” Walt Kelly, Pogo
7.5.2 - Practical Strategy Other than understanding the theoretical underpinnings underpinnings of our psychological risks, we also need a practical method to manage our psychological risks. For the method to be effective in realtime trading, it must be specific and not overly complicated. In most trading books and online sources, you will find lists of maxims related to trading psychology. A sample list includes:
Stay mentally focused while trading.
Follow your system with no questions asked. Seek consistency over profits.
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There are dozens of such maxims everywhere. I will not repeat them, not because they are untrue. In fact, I have mentioned a handful throughout this series. They are mostly great advice. They are fantastic for anyone who can actually follow them. However, most traders do not benefit from simply reading them. Another reason for not repeating them is that they are freely available availabl e online and from other sources. Instead, I want to show you a tangible plan for managing fear. This plan’s objective is to help you to improve your emotional awareness and to react to your emotions constructively.
Trading Emotion Journal
Before entering or exiting a trade, ask yourself these three questions. 1. Am I scared? 2. Why am I scared? 3. How should I respond to this fear constructively? Start a Trading Emotion Journal and answer these questions. (There is a template for the journal in the Toolkit.) Am I scared?
If you are scared, turn off your trading platform immediately, immediately, no questions asked. If you are fearful and do not know how to deal with that fear, you will not trade well. Most likely, you will be gambling instead of trading. So don’t bother.
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Traders working in a bank or a proprietary trading firm must trade and must be profitable. profitable. Or else, they will be asked to go. While they enjoy superior infrastructural and financial support, they face immense pressure to perform on other people’s terms. Even when they are not in the best condition to trade, they have no choice but to risk it. That circumstance is obviously suboptimal. However, as individual traders, our greatest advantage is the ability to choose whether or not to trade. We have no organisational organisati onal pressures upon us. We have every reason to make full use of this flexibility. By choosing not to trade when you are not feeling up to it, you gain a clear advantage over institutional instituti onal traders.
“You have power over your mind - not outside events. Realize this, and you will find strength.” Marcus Aurelius, Meditations
You trade only when you are emotionally prepared. You trade when you are “in the zone”. Institutional traders trade because they are expected to. They trade even when they are not “in the zone”. Who do you think will do better?
This is exactly why you must exercise the option of not trading when you are not emotionally ready. Don’t feel compelled to trade. If you feel compelled to trade, you are giving up a key advantage advantag e over institutional institutional traders. Given their superior technical resources, this is an advantage advantage you cannot afford to waste.
Hence, and the first is why. to learn scared don’tstep know to stop trading when you are
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The next step requires us to embrace our fears. Think about the reasons behind your fear. Given that you have worked your way to this final part of the book, finding the answer should not be difficult. In the sections below, you will find sample entries of a Trading Emotion Journal.
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Entry 1 Why am I scared?
I am scared that the next trade will be a loser. I want it to be a winner. But I know that the market cannot guarantee that it is a winner. So why am I hoping for something that the market cannot give? Because if the next trade is a loser, my trading account will fall below the minimum amount I need to trade. Clearly, this fear stems from a lack of trading capital. How should I respond to this fear constructively?
Stop trading and build up more risk capital. Resume trading only after you’ve accumulated sufficient risk capital. Alternatively, look for a market that I can trade with less capital (for e.g. micro lots in spot forex). A destructive response would be to continue continue trading and exit once my position shows a small profit. Exiting with a small profit might increase my winning probability. However, due to a proportionately larger decrease in my reward-to-risk reward-to-risk ratio, the expectancy of each trade would decrease.
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Entry 2 Why am I scared?
I am afraid that if I exit now, I might lose out on a huge chunk of profits. I want to exit at the best possible position and get the largest possible profit. But I know that there is no perfect exit. ex it. More importantly, importantly, I know that I do not need the perfect exit to achieve positive expectancy. So why am I hoping for the perfect exit? Because I saw that in my previous trade, the market went much further than I targeted and I missed out on a huge chunk of profits. This fear of losing out (or greed) is the result of a single recent experience. How should I respond to this fear constructively?
I should not change my trading plan because of one isolated trade. Moreover, even if I want to change my exit plans, I have no idea how to. Let profits run? But how? Should I push my target 20 ticks out? Should I push it to the next support level? Should I throw on a moving average and let it guide my exit? I have no real solution. Hence, I should not change my exit plan, for now. However, it might be a signal for me to start exploring if setting my targets more aggressively produces better results. This is an excellent chance for me to implement implement virtual decisions (as discussed in 6.4.4 in 6.4.4 - Improving Expectancy) to Expectancy) to test the impact of setting more aggressive targets.
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A destructive response would be to cancel the target order and attempt to let my profits run. However, without a concrete plan dictating how exactly I should let my profits run, I would end up confused and doubting myself with every price tick.
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Entry 3 Why am I scared?
I did not get any trading opportunities in the earlier part of the session. I am afraid that I might not get a chance to trade. But I know that it is better to take fewer high quality trades than to take more low quality ones. So why am I scared that I might not get a chance to trade? Because I feel that I am missing out on the market action. How can I call myself a trader if I am not trading? The fear in this case originates from the thinking that a trader must be trading at all times. How should I respond to this fear constructively?
My objective is not to take trades. My objective is to take trades with positive expectancy. Hence, instead of being tempted by inferior setups, I should congratulate congratula te myself for being selective and look forward to the next high quality setup. A destructive response would be to compromise compromise my trading rules and take trades that are inconsistent with my trading strategy. These are rogue trades that would inevitably lead me into self-doubt issues.
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The fears discussed above are clearly not exhaustive. The objective of the three questions is to enhance your emotional emotional awareness while trading. Becoming aware of your feelings and asking the right questions can uncover a lot about your trading psychology. Fear is obvious. You can always detect it. When you start to hope and pray, you are fearful. When you start to hold your breath, you are fearful. This is why the feeling of fear is the best starting point for monitoring our psychological risks and enhancing our emotional awareness. The Ultimate Litmus Test
In chemistry, a litmus test distinguishes acid from alkali with a single liquid drop. In politics, it is a simple question to determine a candidate’s attitude towards contentious c ontentious issues. In both cases, a litmus test is a simple test with great clarifying implications. A major theme in a trader’s emotional issues is the constant conflict between the trader’s desire for certainty and the market’s probabilistic nature. Truly understanding and accepting the market’s probabilistic nature is the key to minimi minimising sing your psychological woes.
Based on this understanding, I have formulated an ultimate litmus test to help you decide if you should be taking a trade. The test has just one simple question. Before taking each trade, ask yourself: Will I regret taking this trade if it turns out to be a loser?
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This is a simple but powerful question. It drills into the heart of your market understanding and your rationale/motivation rationale/motivation for wanting to take each trade. If you took a trade that was consistent with your trading plan, you should not regret taking the trade even if it results in losses. A trader’s job is to execute his trading plan. If you have done so, you have no cause for remorse. The loss incurred is merely a necessary cost of your trading business. Doing the right thing, taking the right trade, unaffected by your emotions, is something that is independent of of the trade outcome. If you understand the probabilistic nature of the market, you will understand this principle. Thus, if you can answer “yes” to the ultimate litmus test, then you may take the trade. “Every battle is won or lost before it is ever fought.” Sun Tzu, The Art of War
However, if you rejoice with winning trades and regret taking losing ones, then you are not ready to embrace the probabilistic nature of the market. You are not ready to trade. In fact, you have the mind-set of a gambler. The psychology of trading is similar to the psychology of gambling.. However, there is one profound difference. gambling A trader’s mind is geared towards allowing long-term expectancies to emerge. Traders want luck to even itself out in the long-run, which means that individual outcomes are
unimportant.
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On the other hand, a gambler’s mind is focused on not wanting the long-term expectancies to emerge. Gamblers want luck to be on their side, and individual bet outcomes are important to them. If luck evens out, the gambler will inevitably end up broke. Let’s say that you took a trade that was consistent with your trading plan. It resulted in a loss, and you regret taking it. You should not regret taking a trade merely because it resulted in a loss. Losses are expected. Hence, if you regret taking that trade, you have not fully comprehended the probabilistic probabilistic nature of trading. You should not be trading. Now, let’s say that you took a rogue trade that was profitable. Despite the profits, you should regret taking it because it is a
rogue trade. It is inconsistent with your trading plan and you know that you will not be able to replicate such trades consistently. After entering a trade, you should be proud that you have entered a good trade according to your rules and should not be praying for the success of the trade. The key here is that if a trade is worth taking, it is worth taking regardless of its outcome.
ULTIMATE LITMUS TEST Will I regret taking this trade if it turns out to be a loser?
Asking yourself this question will keep you from taking rogue trades and remind you of the probabilistic nature of trading.
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7.5.3 - The Final Determinant Ultimately, the burden of managing Ultimately, managing psychological risks rests squarely on you, the trader. The first step is to be truthful to yourself. If you stay in denial and refuse to take steps to react constructively to your emotions, nothing can help you. Indeed, there are various methods to manage trading psychology like getting a trading buddy/mentor, using computers to control your risk with hard limits, and even with neuro-linguistic neuro-lingui stic programming. programming. Yet, no method is impervious to your overriding. You can stop employing these methods as quickly as you yo u adopted them. You, the trader, are the final determinant. determinant.
PSYCHOLOGICAL RISKS Start a Trading Emotion Journal (Template (Templat e included in the Toolkit)
Employ the Ultimate Litmus Test
Be truthful to yourself
7.6 - Integration of Risks Up to this point, we have been discussing each risk in isolation for clarity. However, in reality, risks are often inter-related. To understand the overall risk context, we need to pay attention to the relationships among the different risks.
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This is hardly a new concept. Throughout T hroughout the book, as we speak of assessing trade risks, we also discuss how psychological risks might affect them. A good example is found in Chapter 2.3 Chapter 2.3 The Wrong Way to Place Stop-losses, where Stop-losses, where we discussed how the fear of losing can affect our stop-loss placement. In particular, you will find that psychological risk is deeply integrated integrate d with other risks. The following are classic examples showing how financial risk is tied to emotional risk. We have discussed using a simulated drawdown figure as our basis for computing the amount of trading capital we need. However, that is only the statistical aspect. The amount of trading capital we need to trade also depends on our emotional considerations. Your trading capital must be large enough so that consecutive losses do not take a toll on your emotions. Even if your trading capital remains statistically healthy, if you become afraid because of the magnitude of drawdown, then you might need a larger amount of trading capital. The same influence runs the other way. If you have a technically technically sound position sizing model that you truly understand, it is less likely that you will experience stress when you suffer drawdowns. We have also discussed the issue of living expenses and the risk of volatile income for full-time traders. Traders who are stressed by insufficient income are more susceptible to their emotional whims. When you feel the heat to earn more or enough to pay the bills, it’s easy to get tempted to overtrade and take on a large (unsafe) position size.
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Understanding how risks are integrated will only come with Understanding actual trading experience. However, this is an important area to bear in mind as you design a risk-based trading approach. approach.
7.7 - Conclusion First, deal with intrinsic and external risks separatel s eparately. y. Remember that external risks do not give you any trading edge. They merely prevent your trading edge (if any) from deteriorating. deteriorati ng. Hence, manage your intrinsic risk first and make sure that you have the ability to find trades with positive expectancy. Next, recognise that risk management management is a process. There is no destination. destinati on. You need to constantly evaluate the effectiveness of your controls. You also have to watch out for new risk factors that might warrant intervention. Even for the risks that you have decided to accept, you need to continue monitoring them in case they increase to an extent that you find unacceptable. Moreover, your access to resources (financial,, technological, and intellectual) (financial intellectual) might change over time. Some risks might become harder or easier to mitigate. This might cause you to re-evaluate your original risk decisions. I recommend performing performing a risk review rev iew (i.e. update your Risk Management Cards) Cards) every two to three months. I am not professionally trained to manage risks in the way enterprise risk managers or actuaries are. In addition, I am not an expert with computers, statistics, or psychology. psy chology. The perspectives above are simply how I think about the various risks I face as a professional trader. While they are generally applicable to individual traders, as I have mentioned time and again, you must consider them within your own risk environment.
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Remember that the best traders are often the best risk managers.
Risk-Based Trading Manage your financial and operational risks with Risk Management Cards
Start a Trading Emotion Journal and react constructively to your emotions
Review your risk management measures every two to three months
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Chapter 8 - End of the Beginning We have reached the end of the book. However, it is really just the beginning for some of you. Depending on your level of trading experience, you would have picked up varying ideas from this series. For new traders, I’ m sure that this book and the Toolkit contain everything you need to start day trading with a realistic and sound foundation. For experienced traders, I’ m certain that you will be able to integrate at least some of the price action concepts into your trading. The Toolkit documents were built with Microsoft Excel
which is a common yet powerful software. This is so that you can adapt it for your own use easily. I expect you to agree with some parts of the trading framework we discussed and disagree with others. That is great, and unsurprising. Most successful traders I know are fiercely independent.. It also shows that you have been engaging the independent ideas actively. I hope that you’ll continue to learn and evolve as a trader. I have benefitted immensely from writing this series. It has allowed me to crystallise my trading approach and improve my trading performance. I want to thank you for giving me this opportunity.
“We cannot teach people anything; we can only help them discover it within themselves.” Galileo Galilei
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Galileo got it right. I am not teaching you much. Ultimately, you must find the successful trader within yourself. I wish you all the best in tackling the challenge of day trading with price action.
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