I Love it When a [Trading] Plan Comes Together!
Saturday, October 15, 2011 at 06:16PM
Timothy Morge

As a trader, there is nothing more fulfilling than watching a trading plan play out exactly as you designed it. As an educator, it is equally exciting to watch a student plan a trade and then watch that plan unfold, step by step, as the student artfully executes it. Let me take you step by step through a recent trade by one of our students at Market Geometry:

During a live session a few Monday’s ago, we drew out the following map of the 240 minute $USDAUD [the Australian Dollar against the U.S. Dollar]:

We began by noting and marking the ‘Sunday Gap Rip’. When markets first began trading literally 24 hours a day, from Sunday afternoon until Friday afternoon, gaps became less and less common occurrences. But the recent high volatility in the markets have begun spinning more and  more gaps into the picture – and the traders not experienced enough to remember how to deal with them have to do their homework to understand the implications of gaps and how to deal with them.

One of the ways I have found to help traders think about open gaps is the ‘Gap Rip’. Imagine printing out a chart and ripping it down the middle, separating price into two discontinuous sections: You have two charts of the same commodity or currency but they are no longer connected. When a market Gaps open and the Gap remains open, this is exactly what has happened: the Price action was so violent it disconnected the current action from the prior price action.

The first Open Gap lower on the chart occurred on a Sunday opening and it not only disconnected the current action from the prior price action, it broke below prior minor Swing Lows to the left. At that point, we added a red Major down sloping Median Line and its Parallels to give us the Probable Path of Price. We then noted that after heading lower, price climbed back to retest the Open Gap area but failed to climb higher to test the red down sloping Upper Parallel.

When price broke back below the Gap Zone with a Wide Range Bar, we added a green down sloping inside Median Line and its Parallels that seemed to be doing a much better job interacting with price action. Three bars later marked the end of trading on Friday. When trading resumed on Sunday afternoon, price Gapped open lower once again, and the Gap remained open, literally ripping the price action from the prior week away from the unfolding price action of the upcoming week. These are signs of a violent move lower-the sellers have a lot to sell and they are pressing to sell before price slips further away from them!

The last three bars deal with the price action on Monday, when we were hosting our live mid-day Mentoring session. If you look above at the first open gap, I marked the timing of the horizontal consolidation with a dotted magenta line – and then transferred it down to the current opening bar from Sunday night. This dotted bar serves to remind me that price consolidated for that amount of time above, at the prior Open Gap, before beginning its violent move lower. I put it in place now because one of the Newtonian Laws we use over and over, as stated in the Emerald Tablet, ‘As above, so below’, generally comes into play in these situations [For every action, there is an equal and opposite reaction]. I will watch closely as price unfolds and I literally expect a violent reaction as price reaches the end of the magenta dotted timing bar.

As I pointed my feelings about this timing bar and its relationship to the ‘Gap Rip’ to the members attending the live session, I also circled the confluence formed by the red down sloping Median Line and the green down sloping Outer Parallel –and remarked that the area of confluence [or Energy Point] coincided with the end of the timing bar, and the Energy Point would hit around Friday. I told everyone it should be interesting to watch how price played out between now [that Monday] and Friday. If it formed a mature structure with some horizontal consolidation, I would expect there might be a great opportunity to short this market Friday if price had not significantly violated the Open Gap area. I finished marking out the chart and saved it in my charting program, so we could revisit it later in the week to see how price had unfolded. We also put this chart on alert as a part of everyone’s homework for the week.

As it turned out, we did revisit this chart on Friday, though it was on everyone’s homework alert. But let’s see what one student did with the simple map I drew on Monday as Friday approached:

Though we did not revisit the potential trade set up on Friday, at least one of our students did her homework: As Friday approached, she entered her limit sell order at 1.0370 in the Australian Dollar with a 41 pip initial stop loss order. She noted on her chart that price had consolidated in a horizontal fashion all week and there was selling pressure at the Open Gap area all week long. She placed her stop loss order above that selling pressure at the same time she placed her limit sell order and waited patiently as Thursday turned into Friday – she was letting price catch up with the price action. And when Friday came around, she was rewarded with a fill in her limit sell order. She noted on her chart that she was planning on holding the position over the weekend. She also marked several potential Profit Objectives with purple horizontal lines, just below 1.02, around 1.01 and the last at 0.9925. Any of these objectives if reached would give her a solid risk reward ratio – at minimum, well over four to one using a 41 pip stop.

Let’s see how the trade looked after the weekend:

Price Gapped open lower again on Sunday night by 50 pips. On Monday morning, she took a partial profit on one half of the position at 1.0180, booking 190 pips. As price climbed back out of the hole early Tuesday, she entered an order to sell back out the half she had taken profits on at 1.0302, with an initial stop loss of 1.0333 [a stop loss of 31 pips] and was filled on her limit sell order quickly. It is important to note that she is treating this second entry as a separate order, with its own stop loss. Though it is not apparent on this chart, she moved to a break even stop loss order on the open half of her first trade. She is now playing with the market’s money, and even if she is stopped out of both of the current open positions, she will make money on this idea and the two positions combined. She framed her trade and as price unfolded, she adapted it to the market conditions, taking profits on one half and then reinstating the full position at a better price. She is continuing to use the Open Gap to show here where the selling pressure remains – that is the key to the original trade as well as the secondary entry at 1.0302.

Let’s take a look at how the trade progressed on Tuesday and Wednesday:

Take a close look at this last chart and read her comments as the trades unfold. She started with a carefully framed trade, looking to reach a potential four to one risk reward ratio. Bu taking partial profits and then re-entering at the Open Gap resistance area, she was able to successfully adjust her plan as price unfolded after price opened on Sunday afternoon.

Here are the profit objectives she planned and achieved:

  1. 1.0180, on one half of the position, netting her 190 pips, reached on 9/19/2011 at 10 am.
  2. 1.0150, on one half of the position, netting her 220 pips, reached on 9/21/2011 at 2:30 pm.
  3. 1.0088, on the one half she re-entered, netting her 214 pips, reached on 9/21/2011 at 2:30 pm.

Her total risk on this position was 113 pips total and her total profit for this position was 624 pips. This gave her a total achieved risk reward ratio of better than five to one, better than her originally planned risk reward ratio of four to one.

As she did her post analysis of this trade on her last chart, note that she chided herself what she considered a mistake: She believed price would test the prior low [‘look to the Left and be Right’] and her original order was to take profits on her entire position at 1.0090 but the anxiety of holding the position made her change her plan and take half off at 1.0150 – but all in all, this trade was a planned well and executed well. She had very logical entry points and did a wonderful job collapsing her risk, moving her initial stop loss entry to break even as soon as price moved well below her entry level and then finding logical areas to leave her limit buy orders to lock in profits.

We stress the importance of planning your trade before entering your trade and then trading the plan you have made. If you wish to trade like a professional trader, you have to learn to think, manage and execute like a professional trader. Our upcoming seminar, Building a Professional Trade Plan, will focus on this extremely important topic, taking you step by step through all the essentials a solid trade plan needs if you wish to be consistently profitable. 

Let’s use this trade to highlight one last important thought about trading: Some have tried to paint Market Geometry, our web site, as giving ‘endless education’ but giving no live analysis or signals. First, we are proud to offer ‘endless education’; there is no better compliment in my mind. Second, the results of our students speak for the results of our efforts to teach traders to be consistently profitable using what they have learned from us to find and enter their own trades in any market, on any time frame. We teach live, we use live charts, we point out potential trade areas in advance, as diagrammed in the trade above – we just don’t hold ourselves out as a ‘chat room’ that is there to call out mindless trades. Let’s compare the results of this single trade with an entire month’s results from a ‘chat room’ style web site.

Before I begin this rate of return analysis, let me state up front I am not taking these results from one of what I consider to be a ‘shady’ website, one that misrepresents their results. I am using their results because they are stated relatively clearly, their numbers seem to be accurate and the results they show on their web site look quite impressive. Here are their results for the same month our student made her Australian Dollar trade: 

According to their risk disclaimer, subscribers must have a minimum of $200,000 in their account and this amount will be fully margined; at minimum, they trade two full size Gold futures contracts and two Silver futures contracts at all times. Here are there results for the month:

On $200,000 worth of margined positions, they made a gross profit of $73,060 – This looks like a very handsome profit, indeed! In their disclaimer at the bottom of the page, in smaller print, they note they are currently in a drawdown of $42,300 from that profit and are apparently still holding the open position. According to my calculations, that leaves them with a net profit of $30,760 for the month, based on $200,000 of margin. But let’s assume they finished the month with their entire $73,060 intact.

Now let’s see how our student’s single trade, lasting about three trading days, holds up to their month of trading. To compare ‘apples with apples’, we will normalize the leverage used by adjusting the amount of contracts she used when entering her planning and executing her trades to match their leverage:

To make the math easier, we’ll convert her trades from cash Forex to CME Australian Dollar futures contracts. Each Australian Dollar future requires she put up a minimum margin of $2,363. If she used the maximum $200,000 as margin, she would be able to trade $200,000/$2363 = 84 contracts. Since she made 660 ticks, she would have netted a profit of over $554,000 on her $200,000 account in three trading days [a simple rate of return of over 750 percent]. Now stop for a moment and look at these numbers, please. Are they possible? Yes. Are they repeatable over time? No.

If you used maximum leverage on your account, as many ‘chat sites’ and ‘trade touting’ sites show in their flashy numbers, when you hit a losing streak, you will quickly lose all the money in your account and more.

Let’s assume a more conservative stance: The web site we referred to stated they traded at minimum two Gold contracts and two Silver contracts. Because of a recent margin hike by the CME Group in August, it would take $72,700 in margin to trade two Gold futures contracts and two Silver futures contracts. If our trader had used $72,700 in margin, she would have been able to trade 30 Australian Dollar futures contracts and she would have netted $198,000 in profits before brokerage, compared with their stated net maximum profits for the month of $73,060.

But are those numbers realistic and sustainable: Of course not! Our trader would have made over 270 percent on her over-leveraged account but any run of losers would quickly wipe her account out. These numbers are unrealistic and not sustainable.

We teach traders to be consistently profitable. We want them to learn their craft and then be around for years to come, as their accounts grow at a sustainable pace. Let’s look at a ‘sustainable’ rate of return. If our trader had $200,000 cash in her account and traded 8 contracts, using a total maximum margin of $18,904, she would have used less than ten percent of her account on a margined basis and she would have netted over $52,000 on her three day trade. She would have realized a 26 percent simple rate of return. These numbers are more realistic – and had she taken a loss, she would not have lost her trading account; had she been stopped out at her initial Stop Loss order, she would have lost $3,280 – roughly 1.6 percent of her account.

But let’s look at her trade using an even more conservative approach: What if she used no leverage in her trading, simply trading $200,000 unleveraged in the cash Forex markets? If she sold $200,000 worth of Australian Dollars at 1.066 and bought them back at 1.000, she would have made a net profit of $13,200. On a single trade that lasted three days, she would have netted a simple 6.6 percent rate of return. Is this realistic? This is absolutely a realistic rate of return, though I would caution everyone, including her, that the best traders in the world lose at least 1/3 of the time, so solid money management is extremely important, even when you are trading using low or no leverage. Top money managers average 15 to 35 percent rate of returns, not 200 or 300 percent.

The key to becoming a consistently profitable trader is to begin with a solid trade plan, based on quality money management principles. Only take trades with good risk reward ratios [I suggest three to one or better as a starting place for most traders] and set a maximum stop loss you are willing to take on any trade and never take a trade requiring a larger stop loss. Last, once you plan your trade, keep that trade plan in front of you and follow it religiously. ‘Plan your trade and trade your trade’.

If you are interested in learning more about what we teach, how we teach professional traders to be better traders and non-professional traders how to be become consistently profitable, come visit us at Market Geometry. And if you want to learn how professional traders plan their trades, we’re hosting a seminar October 22nd via the internet. You can see all the details by clicking here.

Article originally appeared on MedianLine - Classic Trading Techniques Energized (http://www.medianline.com/).
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