Saturday, January 28, 2012

Is There a Way to Calculate Risk/Reward for Breakout Trading?

One of the most exhilarating e-mini trades is participating in a successful breakout trade. Of course, whether or not the trade is successful is what makes this trade so exciting; not to mention that these trades sometimes run for a considerable gain, which is a result sure to put a smile on every traders face.

The problem is simple though, how do we (as traders) know which market move is going to break through known support/resistance (SAR) as opposed to the false breakouts which will move several ticks through SAR then sputter and collapse?

In my trading, I have found that channel breakouts are least likely to succeed and generally fail after moving 4 to 6 ticks past support or resistance, then retrace back into the channel. Needless to say, I do not actively trade channel breakouts or breakdowns.

On the other hand, other classes of breakouts and breakdowns succeed at a higher rate and it is essential to evaluate the risk reward ratio on these breakout/breakdowns. Having read the previous paragraph, you can safely assume that successful breakouts do not occur in channels. Usually successful breakouts transpire mid-trend, when the market has taken a break, and traders are anxiously watching the price action move sideways hoping for some indication of when and where the price action is next headed.

Most astute e-mini traders have been noting support and resistance levels up and down their chart for quite some time. There are all sorts of predictive type support and resistance tools; like Fibonacci extensions, Murray math, and a collection of different pivots of dubious algorithmic origin. Generally speaking, I shy away from the predictive types of SAR tools and rely upon the support and resistance lines I drew when the price action last passed through the area in question.

That being said, price action will usually move to the next area of support/resistance or sometimes even move up 2 support and resistance levels. I pay close attention to volume as the market is moving upward, looking for a buildup of volume at a specific SAR. High volume around support and resistance points generally indicate a climax in directional movement and signal the market is ready to take a short breather. So I generally set my profit targets at the first level above the potential breakout SAR. Conversely, I will set my protective stops near the previous SAR below the breakout support and resistance line. This method seems to make the most sense to me, as opposed to some of the mechanical formulations for establishing profit targets and stop loss points, which are generally based upon J. Welles Wilder's Average True Range (ATR) calculations. There is absolutely nothing wrong in using ATR readings to establish your profit and stop loss points, but I feel using specific chart data is a far more natural and logical method to evaluate risk and reward. Obviously, it is necessary to evaluate how far the potential move upwards can be in relation to the underlying SAR where you will want to place your stop loss. In short, these numbers need to be relatively equal to construct a good trade. For example, you would not want to risk 12 ticks on a trade that has a nominal upward target of 7. Each breakout in a trend can be evaluated in this manner to decide whether the next move upwards make good sounds from a probability point of view.

In summary, we have discussed breakouts and breakdowns in relation to support and resistance and ruled out channel breakouts and breakdowns as good candidates for trading. We have identified trending markets as the best situation to evaluate the risk reward ratio and described the methodology using previous support and resistance numbers to evaluate the potential for a smart and high probability trade. Finally, I have stated that I seldom use predictive tools to calculate risk reward potential on breakouts and breakdowns in favor of known support and resistance.

Tuesday, January 24, 2012

Investing: Day Trading Article Category

It seems to me that most countertrend trades are the result of individuals attempting to trade retracements in an established trend. As a trader, you will often be presented with some very enticing setups against the trend. Uninitiated traders often mistake these enticing countertrend trades for trend reversals and dive headlong into these setups, often with disastrous results.

From the onset, let me state that countertrend trading is the bane of trading success. Although there is a small cadre of very experienced traders who have mastered countertrend trading, the vast majority of countertrend traders find the practice detrimental to their futures account balance. While it may sound corny and overused, the saying "the trend is your friend" cannot be over emphasized.

The small countertrend trades that occur along established trend lines are called retracements. These retracements occur for a variety of reasons, but the generally they are traders established in a trend taking profits. These retracements vary in length, with shorter retracements generally occurring in a strong trend and longer retracements occurring and a weaker trend. I should point out, though; that the preceding statement is merely a guideline and you can find the occasional retracements of substantial length in a strong trend, and very strong retracements in a weak trend. However, stronger trends favor weaker retracements and weaker trends favor longer retracements as a rule of thumb.

In my trading, my general rule is to avoid trading any retracement in an established trend. Why? For the reasons outlined above, there is no established methodology to definitively divine the length of any retracement in any trend. That being said, probability tells me that since I cannot determine with any accuracy the length of a given retracement, I have to assume the worst and operate under the assumption that it will be short. Of course, there is no worse feeling than watching a retracement move 30 ticks before rejoining a trend, but there are enough 2 tick retracements in an established trend to reinforce my general rule; don't trade retracements an established trend no matter how enticing the set up may present itself.

In summary, I have briefly outlined a trading strategy for retracements that took many years to develop. The methodology is simple, but the emotional strain can be a substantial; I don't trade retracements and a trend and because I cannot positively identify, and a quantitative sense, the potential length of any given retracement. Lacking that key tidbit of knowledge, I have concluded that retracements results and poor performance regardless of the quality of the retracement set up. In a more general sense, retracements require me to initiate a countertrend trade, and countertrend trading is generally unproductive and unprofitable.

Sunday, January 22, 2012

E-Mini Trading: The Dead Cat Bounce

I have heard this particular expression used often and in a variety of e-mini trading situations and thought it might be useful to clarify exactly what e-mini traders are referring to when they described a "dead cat bounce." Since this term is indelicate, at best, and tasteless at worst, we shall abbreviate it DCB. Nonetheless, recognizing this formation can keep money in your pocket, as it occurs often and can be a tempting trade. For some, this trading formation is a chance to make some quick money. In any event, it is helpful to know how to identify a DCB and react accordingly.

As I mentioned in the opening paragraph, the term "dead cat bounce" is often used in New York and Chicago. There are two individuals credited with coining this phrase. It was first written in the Financial Times in 1985 by Chris Sherwell when he described a sharp decline on the Singapore stock market. It was also mentioned by Raymond DeVore, Jr., who is a research analyst, and commissioned a bumper sticker stating "Beware the Dead Cat Bounce" in 1986. Though the history is claimed by both individuals, the fact is that the term has been around for more than 20 years and increased in popularity, it seems, with each passing year.

A DCB occurs after a violent downward spike in market price caused by an adverse news event announcement. At some point, sometimes after as much as a 20% decline, the market finds its initial bottom and rallies for a short period of time, say 5 to 10 bars, more or less. After this short rally, the market generally resumes its downward trajectory until it finds another bottom, which may or may not be a true bottom. In theory, the longer the first leg down extends the higher the DCB will extend. A skilled trader can trade the DCB and take a quick profit, while a novice or unskilled trader may try to make the same trade and stay in a the trade too long and find himself/herself careening downward at a high rate of speed as the market resumes its downward spiral. In short, trading this bounce is strictly for experienced traders and should be avoided by less experienced traders. There are several reasons inexperienced traders fail at this trade:

· They stay in the trade too long because of sheer greed.

· They stay in this trade too long because their momentum indicators have switched to a bullish reading.

· They stay in a trade too long because they misinterpret the rising volume levels as a positive confirmation of trend change instead of being profit taking.

In summary, we have given a reasonably accurate definition of the dead cat bounce (DCB), along with a less offensive an acronym, and described the conditions from which it arises. We have also cautioned inexperienced traders to avoid trading this formation and given solid reasons to avoid trading a DCB. Finally, we have noted that experienced and nimble traders can sometimes grab a quick profit when trading the DCB.

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Saturday, January 21, 2012

Scalping As A Day Trading Strategy - Why?

The majority of day trading systems and strategies being sold to the public these days involve scalping. Scalping is a strategy where the trader makes multiple trades in a single market per day with the hope of making small and consistent profits within a short period of time. The idea is that this is supposedly less risky than position trading. The scalp day trader trades all day, but ends the day with no positions, and therefore, no risk.

The simple fact of the matter is that the vast majority of traders and day traders lose. It has been estimated over the years that 90% of futures traders and day traders are unprofitable. Many of these traders have tried to make a living by scalping in and out of stocks, Forex, and futures markets.

Therein lies the question. If the majority of traders lose, and many of those losers are day traders, does it not seem logical that scalping is not an easy way to make money in the markets? There is a video of a trader that can be found on YouTube and this trader indicates that he has been trying to day trade since 1996, but up until recently, has never been profitable. That is an eye opening statement. His video is actually a testimonial for another day trading web site that is selling a scalping product.

The bottom line is that there is no holy grail, and scalping as a way of making money is extremely difficult. Transaction costs eat away at the account, since the trader is only shooting for small profits to begin with. Over time, they do not achieve anywhere near the required high winning percentage on their trades to offset these transaction costs, and their account eventually dwindles to nothing.

Another issue with scalping is it is actually an exhausting way to trade. Many very short term traders suffer from burnout, because scalping requires the trader to monitor the markets all day long. Yet, many are allured to this type of trading for the action alone, just like the gambling addict sitting at the blackjack table for hours on end.

Truth be told, there are few professional traders who manage client assets who trade this way. One famous trader attempted to do this, but found that it was difficult trying to juggle his trading, which was short term in nature, with handling the clients themselves, along with bookkeeping and other facets of the money management business.

However, there are hedge fund traders that do trade short term strategies where positions are held for a few days or less. These strategies require strong execution to keep transaction costs low, but are easy to automate in liquid markets such as large cap stocks, stock index futures, Forex and treasury markets. Very few of these traders scalp in and out of markets in just a few minutes, because it is simply too difficult to manage this type of trading across many markets.

With all this in mind, the new trader should only consider position type trading rather than scalping. It is less intensive, allows the trader to have another source of income to pay their bills, and combined with proper risk management strategies, will keep the trader in the game longer. The facts are the facts, there are few profitable scalpers out there, in spite of the ads in magazines and on the internet.

Tuesday, January 17, 2012

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