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Sunday
May162010

It Can All Start with One Simple Line

A simple line can be the start of everything. In this presentation, I am going to begin a series of discussions about Action Reaction Lines and Diamonds®, a proprietary charting method I developed well over 20 years ago. Both have served me well in my own trading and this is one of the first times I have given any information publicly regarding the correct rules for using either technique--both are simple, yet powerful if you use solid money management.

Let us begin this journey with a look towards physics.

Sir Isaac Newton is thought of as a physicist, a mathematician, and the founder of calculus. But he was also the 'Master of the Mint' later in his life and literally saved England's financial system by switching from the silver standard to the gold standard. Even less well known, Newton was a Master Alchemist, so heavily involved in alchemy that he eventually died from having massive amounts of mercury in his body from his many alchemical experiments.

But Sir Isaac Newton's contributions to science should not be diminished; he developed the first practical reflecting telescope and his Three Laws of Motion dominated the scientific world until the early 20th century. His Third Law of Motion 'For every action there is an equal and opposite reaction', is particularly useful when applied to the trading markets. The Third Law of Motion may have had its founding in Newton's first and true love, alchemy, for he was truly one of the most important alchemists in his lifetime. His favorite alchemical manuscript was the Emerald tablet.

Hermes Thrice Greatest or Thoth, was reported to have lived around 1900 BC. The Emerald tablet is attributed to Hermes and Sir Isaac Newton's translation is perhaps the most popular alchemical work still studied today. Its essence is simple: 'As above, so below'.

Let's take a look at the chart. It can all start with one line:

We are looking at a chart of the Euro FX futures on the Chicago Mercantile Exchange.  The 60 minute bars on this chart appear in early March of 2010.  I begin with a major low pivot on the left of the chart and draw a blue up sloping simple trendline that touches many smaller pivots. I call this simple trend line with many touches a multi-pivot line. Let's look at another chart and I'll show you the pivots I chose to draw this line.

When working with charts and hand drawing lines in particular, it's important that you remember and mark where you trained or curve fit the particular line you are going to work with. Here you can see that I used many pivots and the up sloping blue simple trend line does a good job catching the highs and lows of price as it moves forward. Remember every bar within the blue box was used to train or draw the simple blue trendline.

What can I do with this simple blue trendline? Another name for this simple trendline that goes through so many pivots is a Center Line.

 

I look to the left and see a Major Swing Low. Starting at the Major Swing Low to the left,  I copy the Center Line and project it forward. The original simple trend line is called the Center Line and  the second line is called the Action Line. It carries the same slope or frequency as the Center Line. Note that the Center Line captures the frequency of Price and the pivot of the Action Line always precedes or comes before the Pivot that begins the Center Line.

Now I think back on the Emerald tablet: 'As above, so below'.

 

I have generated a Center Line that catches the frequency or probable path of Price and I copied the Center Line to a prior Major Pivot to generate an Action Line.

'As above, So below'.

Now I ponder: 'For every action, there is an equal and opposite reaction'.

I measured the distance from the Center Line to the Action Line and using the same distance, I create a line that has the same slope or frequency of the Center Line and add it below the Center Line. This is called the Reaction Line.

It can all start with one line. One thing passes into another.

Price has been in an uptrend but now consolidates, leaving three simple drives to the top. The three pivots, when connected, have a negative slope. But eventually, price begins its move higher again.

Using the pivot on the far left, I connect the three drives to the top and this gives me a red down sloping simple trendline. You can see that once price broke through this trendline to the upside, it switched back and retested this simple trendline from the upside and then began its climb higher; when it retraced, it tested the simple red trendline from above, and the trendline acted as support.

It can all start with one line.

This is a down sloping Center Line. You can see the pivots and switchbacks marked with green circles that I used in defining this Center Line. I was taught Action and Reaction Lines and the theory behind them from Dr. Alan Andrews. In the mid-1920s, Dr. Andrews studied the work of Roger Babson who was a devout student of Sir Isaac Newton's Laws of Motion. Babson was particularly focused on Newton's Third Law of Motion, 'for every action there is an equal and opposite reaction'.

Though Babson had his own methods of technical analysis, Andrews and a group of graduate students at MIT literally tore Babson's work apart, piece by piece, and then developed the Action Reaction method. It all starts with one line. The one line is the Center Line, which projects the probable path of Price.

'As above, so below'.

 

Once I find the Center Line, I simply transfer the slope, or frequency, down to the prior Major Swing Low to the left. The second line drawn always begins with a pivot before the pivot that anchors the Center Line and is called the Action Line. The distance between the Center Line and the Action Line when combined with the frequency of the Center Line is used to project a Reaction Line.

Once again, I simply measure the distance between the Center Line and the Action Line and then using the frequency or slope of the Center Line, I draw a line equidistant from the Center Line but this time above it.

You should take note that I have blue up sloping lines and red down sloping lines on the same chart. Because these lines have opposite slopes, they are lines of opposing force.

Let's take a closer look at these lines of opposing force.

I have been a professional trader for nearly 40 years now. When I begin trading, the personal computer not been invented, so software charting packages were not available. In the early 1970s, there were a handful of companies that published comprehensive chart books that came out every Friday afternoon. Most professional traders either subscribed to the services and had them delivered by mail on Saturday or picked them up at a bookstore late Friday afternoon.

Some traders kept their own charts by hand; I was taught to hand chart at a very early age by one of my older brothers that traded commodities. I continue to hand chart to this day. It's one of the routines that I use in my preparation each day.

More than 20 years ago, I began to notice that some of my more effective charts had both up sloping and down sloping lines and both sets of lines had important roles in defining the probable path of price. I did extensive research on these lines of opposing force and they quickly became one of my tools of choice. I named them Diamonds® because of the space formed when lines of opposing force are overlaid on the same chart. Though I have been using them successfully for more than 20 years, this is one of the first presentations of my proprietary work with Diamonds®; in fact, this is also one of my first public presentations of Action Reaction Lines and the theory behind them.

When using Diamonds®, you can project support and resistance from two different sets of lines, lines of opposing force, well into the future. These two sets of lines were defined in early March and by simply measuring the distance from the Center Line to the Action Line and projecting it forward above and below the Center Line numerous times, Diamonds® were formed that project far into the future.

If you look carefully at the top of the chart, you'll see that I marked a pivot that touches the up sloping blue Center Line with a circle. This will help us keep track of where price and time is as we move on to the next chart.

Now orient yourself by finding the place mark on the top left corner of the chart; This place mark coincides With the place mark on the prior chart.

You can see that price sold off hard and looking closely at the large swing down, you should be able to tell that price found support and resistance T both Lines of Opposing Force and their projections. In essence, using Diamonds® adds a fourth dimension to traditional three-dimensional charting. Diamonds® will give you a very accurate probable path of Price if your Center Lines reflect frequencies of price; once you've set up your Diamonds®, look for repeatable entry setups that you know have likely profitable outcomes.

Action Reaction Lines and Diamonds® require the use of strict money management. When you add the second layer of Action Reaction Lines, you will find many more interactions of Price with tested lines. At times, you will be buying against down sloping lines and selling against up sloping lines--something I rarely do when using Median Lines. It is imperative that you master these tools before using them with real money in your trading account--and more important, you must use surgeon-like money management skills to limit your risk. I was taught many of my money management skills by Bruce Kovner, while I was a money manager and mentor at Commodities Corporation--and I urge those that would try to master these tools to work hard on their self discipline and money management skills.

Once the long wave lower is finished, Price corrects and begins to move higher but then it heads lower again; note that it does not make a lower low. Price then begins a vertical move higher and gaps significantly higher one weekend when the markets are closed. Price tries to trade lower but is unable to fill the gap. Once it fails to fill the gap and turns higher, I start to pay particular attention, because an open gap is an unusual event on a long-term chart. Price generally comes back to fill gaps.

The last Major Swing High tested the red down sloping Reaction Line and then traded lower. Price is now testing the intersection or confluence of a red down sloping Reaction Line and a blue up sloping Reaction Line. I call these areas where Lines of Opposing Force meet Energy Points, and find that when price interacts with these Energy Points, either a change in trend occurs or an acceleration of the ongoing trend occurs.

Price stopped at the Energy Point and then turned lower; note that Price failed to break above the prior Major Swing High. Just as the unfilled gap caught my attention, the inability of price to climb above the prior Major Swing High alerts me that there are probably significantly large limit sell entry orders, meaning large traders are looking to enter short positions in this market and have left their orders at or near the last Major Swing High.

As a place marker, note that I've drawn an ellipse. Let's zoom in on this area and take a closer look.

I have zoomed in on this chart to make easier to analyze the significant areas as well as show what entry set up pattern I have spotted. I have also marked in my limit sell entry order as well as my initial stop loss order; both will be entered on my electronic platform at the same time. Never trade without 'hard' stops; stops protect your capital from ruin.

Once again, looking at the chart, price retested the red down sloping Reaction Line. The Reaction Line acted as solid resistance and note that price was unable to break above the prior Swing High. Large traders are aware that markets tend to fill gaps and are looking for a relatively high probability area to enter new short positions. On the test and retest of the red Reaction Line, I note that both tests were made with large range bars that closed with good separation below the Reaction Line; this is another clue that there may be a good amount of sell orders above the market.

Four bars after the retest of the red Reaction Line, I put my orders in the market. I'm risking 40 ticks and even if price only makes it to the retest the top of the open gap, I should make 125 to 140 ticks of profit, giving me a potential risk reward of better than 3 to 1.

Now that the orders are in the market, let's see what price does.

Four or five bars later, price rallies and retests the red down sloping Reaction Line; my limit sell order is filled, so I'm short this market. I immediately check to make sure that my initial stop loss order is in the market and being worked on the exchange server.

Let's see how this trade plays out.

 

You can see that once I was short this market, my initial stop loss order was never threatened; in fact, price never re-tested the red down sloping Reaction Line again.

Now it's a matter of style and money management: I marked five areas with circles that were potential profit targets. You could have taken profits as early as the area where price filled the gap, or you could have taken profits when price tested either the first or second up sloping blue Reaction Line. Or you could have chosen to take profits at either of the two energy points where down sloping and up sloping Reaction Lines [Opposing Lines of Force] met.

I also marked the new swing highs that were left as price continued to ratchet lower. If you are position trading, you can simply work lower and lower stop profit orders as price leaves new swing highs at lower and lower levels until you eventually get stopped out. If you followed this method strictly. you'd probably still be short the Euro FX futures, with a stop profit order above the prior Swing High. This is called boxing in profits and is generally how I position trade, although I usually do have a logical profit target in mind - some significant level - in this case around the area of confluence or Energy Point just below 126 in the Euro FX futures [There are some Major Lows in the 1.25 to 1.27 area from March and April of 2009].

Whether you are a Physicist, an Alchemist, a Greek or Egyptian God or just simply a trader, it can all start with one simple line.

Monday
Apr192010

Is Your Trend Running Out of Gas?

Wouldn't it be nice if you knew where price would be four bars from now? Sound crazy? Sound impossible?

Maybe it is. But consider this: Wouldn't it be great if you knew where all the police cars and cameras were that were monitoring speeding, so you could drive down the road at your own pace and then slow down when you got near the speed traps? Does that sound crazy too? Have you heard about radar detectors, laser radar detectors, and even GPS real-time systems that mark out the current speed detection traps near you? Some people have all of this and more on their smart phones already!

Wouldn't it be great if you knew when the person you were playing poker against was bluffing, or holding a poor hand but trying to bet up the price of staying in the game, just hoping you'll fold? Did you know that most people who play poker have personality traits that make them do something physical when they are nervous, holding that bad hand, trying to drive the price of the pot higher? Some talented poker players can easily spot the “tics” or “tells” of their opponents after playing a few hands against them.

What if you could see the tics or tells of a trending market as it is stretched ever higher, while there are fewer and fewer new buyers? This market will eventually turn—wouldn't it be great if you could spot a sign that the market was running low on directional energy and likely to turn soon? I'm not talking about squiggly computer-generated lines that lag price by ten or 20 bars! By definition, they may confirm changes in behavior, but they won't give you changes in behavior in advance. I'm talking about real signs the market offers, to those who look for the signs, that will give you a tell that the current trending market may be running out of directional energy.

Does it sound crazy? Does it sound like one of those “Get Rich” ads you read in the trading magazines that (hopefully) make you chuckle?

Let's see if I can make a believer out of you!

Here's a chart of the CBOT 30-year bond futures. You can clearly see price was in a nice downtrend and then began to consolidate. After some time, price climbs out of the consolidation, making a series of higher lows and higher highs. And then price shoots higher, breaking above major swing highs to the left in one bar—a clear sign that there has been a change in behavior.

Wouldn't you like to have been able to read the signs that this change in behavior was coming?

Price gave you the signs you needed. It left tells that its downtrend was ending and a likely change in behavior was on the way. Looking at the chart now, can you identify those signs? Can you see the tells the market left? Let's go on and see what the market offers us. We're looking at market structure and signs that there may be changes in behavior coming.

Price continues higher, breaking above the up-sloping Median Line before pulling back, but note that it does not test or break the lower parallel, nor does it break below the prior major swing low. Then price heads back higher in a stair-step fashion. You'll note I added a pink line that has the same slope as the Median Line and connected it to the first major swing high, and this line catches the current high to the tick.

Median Lines and their parallels mathematically project the path of least resistance for price—and this means it is the most probable path of price, since all things in motion seek the path of least resistance.

You can see that price is currently making higher highs, but if you measure its progress against the sloped lines, its path of least resistance, it is just re-testing its prior high. I'll bet I've just totally confused many of you! When I show these charts in live seminars or live Webcasts, I tell people to turn their head to the right and look at how far price has moved upward against the sloped lines. But I believe most people don't turn their heads, and truthfully, most people listen to me talk about price making progress against the sloped lines, but really don't understand what I am talking about.

So let me quote an old saying: “A picture is worth a thousand words!” Here goes!

 

 

By rotating the chart so your eyes align the sloped Median Line with the natural horizontal plane, you can now see that as measured against the probable path of price, the Median Line and its parallels, price is not making new highs, but instead re-testing its prior highs. There are no signs that this market is turning yet, no tells that this market may soon exhibit a change in behavior. But when you looked at the prior chart, price was clearly making new higher highs.

When you look at the same chart aligned with the path of least resistance, price is merely re-testing prior highs. Don't worry if you still don't understand what I mean. I believe humans are visual in nature, and I have plenty of pictures!

Let's see where price goes now. Looking at this chart, you can see that price made a series of higher highs and then pulled back before making a new, higher high. Price never tested or broke the lower parallel line and it really never broke below any major swing lows. Price worked its way higher to new highs. And “worked' is the key word!

How much energy is price expending to make each of these new highs?

Like the gas tank in a car, price only carries a certain amount of potential, or directional, energy, and when that is used up, it must either pause and refill its tank or else a change in direction (behavior) occurs.

As I said, the key word here is “work:” How efficient is price using its stored directional energy?

When price becomes less and less efficient, it runs out of directional energy that much quicker. Suppose you are driving your car at 55 miles per hour, burning the gas in your tank at 35 miles per gallon, and then decide to pass a series of cars. You push down harder on the gas pedal and your engine revs up and your car speeds up to 80 miles per hour as you scoot past the cars to the right of you while your engine is now burning gas at 8 miles to the gallon! Your car's efficiency has just declined dramatically, and even though you are now further along the highway and ahead of the cars that were ahead of you, if you continue burning gas at this less-efficient rate, you will run out of the gas in your car's tank much more quickly and have travelled a much shorter distance than if you had continued to use the gas in your car's tank at 35 miles per gallon.

We are visual in nature, so let's see what that looks like on the same chart we just looked at.

 

Price continues to make higher highs—in fact, it made a new high—but it is becoming less and less efficient. When I turn the chart so the path of least resistance, or the Median Line, is aligned with the horizontal plane, your eye should tell you that price is not making new highs. In fact, using this efficiency chart, price is actually now making lower highs! As price becomes less and less efficient, it is more and more likely to either pause to restore its expended potential or directional energy or else a change in behavior will occur. If I hadn't turned these images, most of you would not have seen the “tell” that price is giving you. It's there for you to read, as clear a sign that when a particular poker player rubs their chin when they up their bet, they are bluffing!

Price will show you where it is likely to go if you slow down and look for the signs.

By now, if you hadn't been looking at the tilted charts, it's obvious price has undergone a change in behavior. But if you were relying on a squiggly, computer-generated line to show you signs of the coming change in behavior, it wouldn't have caught it. And most of you who just look at standard charts wouldn't have gotten excited about getting short until price broke below a major swing low or the lower parallel Line…but price was long gone by then! Once again, let's begin by looking at the below efficiency chart. By looking at the “tells” that price leaves behind, you can be ready before the change in behavior occurs. You would be surprised how much this simple visual trick can improve your trading!

 

In the MarketGeometry.com mid-day mini mentoring sessions, I had been telling members to turn their head to the right for months as I talked about price “losing efficiency” just before a change in behavior occurs. And though I swore to myself I was going to keep this visual trick to myself until my new advanced seminar debuted in late-April, several weeks ago, in a moment of weakness, I just popped up a tilted chart, a chart clearly showing price losing its efficiency, and the chat session stopped dead in its tracks! All the members had heard me, over and over, talking about it. But when I showed a tilted chart, the light went on. I also saw a distinct change in the profitability of some of the traders I mentor. One of them is now on a nice winning streak and she attributes the improvement in her trading to beginning to pay detailed attention to the efficiency of price. Her new mantra is, “Trade less, pay attention more, make more.” It was clear that I had been seeing price losing its efficiency and using it as a visual clue for years. I had been talking about it and trying to explain it to the traders I teach for years, but it took a simple visual tool to clearly explain the idea. Once members and the traders I taught saw the tilted efficiency charts, the idea was clear.

After I debuted the tilted efficiency chart, whenever I begin analyzing a chart bar by bar in the mid-day mini mentoring sessions, once price begins to lose its efficiency, people catch it and call it out before I can even mention it. It's a very powerful concept that can help you catch many major turns. Now that I showed how powerful a tell the lack of efficiency can be, did you go back to the first chart I showed you and look carefully for the signs price left right in front of you that it was either going to consolidate and re-store its energy or exhibit a change in behavior?

Ok, I'll scroll back in price and time and see if we can spot some of the signs price left for us.

 

Price went through several phases in this downtrend. It headed lower quickly, reaching its most efficient point as it tested the lower pink reaction line. But when it was unable to hold below the reaction line, it quickly climbed higher and tested the upper parallel, or the action line. Once again, price failed to break out of the action/reaction line set. Price gapped lower and then spent a great deal of time restoring its energy, trading in a consolidation pattern, or energy coil. It stayed in this trading range so long that it drifted out of the action/reaction line set to the right, but note that price was unable to make it above a line with the same slope, equal in distance and projected forward in space and time. Price headed lower again, but once again, it began to lose efficiency.

Did you see any of these signs? Did you tilt your head?

And now you can see we are right where we started this charting exercise. Price lost efficiency, trading in a consolidation phase, and then a change in behavior occurred when price was able to trade well above pivot B, a major swing high. Tilt your head, tilt your screen, but by all means, pay attention to the signs, or “tells,” that price is giving you! There is so much information contained in simple price charts if you just take the time to look for them.

It's a pleasure and an honor to be back writing!

I wish you all good trading,

Tim

Thursday
Apr012010

Rolling It Forward

I have been teaching professional traders to become better traders since 1987, both at well known institutions [JPMorgan Chase, Goldman Sachs and Commodities Corporation] and various Exchanges. Over the past 23 years of teaching professional traders, it's become pretty easy to classify what trading practices will drain a trading account:

  1. Not planning your trade before you enter it
  2. Trading and not using 'hard' stops
  3. Using too much leverage
  4. Using stops that are too large [similar to number 3, above]
  5. Being too anxious to find trades: Over Trading
  6. Trading with Risk Reward Ratios too small for your winning percentage
  7. Not sticking with your plan after the trade begins: Don't take profits because you are nervous. NEVER move your stop to a 'worse' level!

Traders are people and they tend to share the same human strengths and weaknesses. I like to say technical analysis is 80 percent science and 20 percent art [though that 20 percent is quite large!] and in this case, I'd say that keeping your thoughts and emotions under control when you trade is much more than half the battle. I like to plan my trades before I enter them and write the plans on paper with a pen [writing the plans on excel spread sheets on my computer do not evoke the same feelings in me]; this allows me to have the plan in front of me and I can 'follow along' or 'paint by the numbers' as the trade unfolds. If I get anxious or if I walk out of the trading room and come back in and need to refresh my mind, the plan is there in front me: I simply look at the plan, find my place, and go back to executing the original plan. Plans, if you stick with them, take many of the emotions out of your trading.

Last year, I had the good fortune to host a daily pre-market morning session, sponsored by the CME Group; I recently moved from Chicago to Arizona, so this year, the daily pre-market morning sessions became the Market Geometry Mid-Day Mini-Mentoring Sessions. Our goal at MarketGeometry, and one we try to foster in each mid-day session, is to help each trader become more consistently profitable. For over an hour each day, we work hard on reading market structure, trying to identify the current frequency [or trend and speed of trend in any given market]. We always stress the importance of solid money management and good Risk Reward ratios. As each session unfolds, we never know where we are headed and where we are likely to end; the goal is to foster good trading practices and help members become more consistent in their trading.

One of the techniques we have been talking about recently has really struck a chord with some of our members and it has helped their trading immensely. I call it 'Rolling It Forward' and it's a technique that can help take the pressure of 'making money' out of your trading. If you are new to trading or you are not a consistently profitable trader, you constantly feel pressure to have a winning trade. This constant pressure clouds your judgment and often makes you take trades you would not have taken if this pressure weren't there; or this pressure causes you to change your trading plan, exiting trades early because you 'must' have a winner!

Though I hadn't started talking about 'Rolling It Forward' to the mid-day session members until a few months ago, the idea came about when I mentored about 350 Chicago Mercantile Exchange Members that were trying to learn to trade 'off floor', out of the pits, in 2005. Even though I had been a CME Member in the 1990's, I was surprised just how impulsively most of these professionals traded once they were 'off floor'. If the bars on the chart on their screens started to turn up, they'd often get long at the current price, with no thought about the where they would get out if the trade were profitable, no thought about where they'd get out if the trade turned against them. They bought or sold however many contracts they felt like trading at the time: sometimes 10, sometimes, 25, sometimes 5--there was no rhyme or reason. This meant they might make a wonderful trade using 5 contracts and follow it up with a losing trade using 25 contracts and then lose all they had just made and more! In short, most of them came off the floor and did whatever felt right--and it just wasn't working. And so they came to my CME Seminars, looking for guidance.

The idea of 'Rolling It Forward' is simple: If you use relatively constant position sizes and have a positive winning percentage, it's pretty easy to find yourself halfway through the month with enough profits in your account to nearly guarantee a winning month, assuming you keep trading the same style the rest of the month. But if you trade 'Helter Skelter', varying your position sizes and moving your stop loss orders when your emotions overcome your better judgment, you'll soon be looking for work as something other than a trader! There are many tips and tricks I developed to help off floor traders during that period, but this is one I had completely forgotten about until someone in one of the on-line Mid-Day Sessions asked me about position sizing [increasing the size of your positions as you accumulate more profits in your account].

I initially answered that the first and foremost goal was to become consistently profitable, and we still had too many people attending that weren't consistently profitable. I explained that 'consistently profitable' meant that if you looked at the new profits and losses of the past five or six months, one or two months should stick out--and those should be the losing months, not the winning months. Having profitable months had to be the 'norm' before you could even begin to think about increasing the size of your positions. And so I re-dedicated all we do at Market Geometry to making its members more consistently profitable. And that reminded me of the 'Rolling It Forward' exercise I had used with the CME Members and just how powerful a concept it can be. Let me walk you through it.

First, I went back and chose the results from a CME Professional member that was just beginning mentoring. These are the first five actual consecutive trades he brought to his first session for me to look at, in summary form [presenting them in a chart by chart form would not aid this discussion].

 

[Download an Excel version of this spreadsheet]

Looking at his composite spreadsheet, you can see his trade parameters as he planned them, the results and my comments.

He started out alright. My only advice to him was that in general, five S&P points was a little large for an initial stop because if he wanted to reach a 3:1 Risk Reward target, he'd have to take his profits fifteen S&P points past his entry--and fifteen points was at or around the entire day's average recent range, so he would have to catch most or all of the range on a normal day if he constantly used five point stops. I also noted that his original plan had included a 1:1 Risk Reward; in general, a trader would need to have a winning percentage of over 75 percent to trade with 1:1 risk reward ratios, after you factor in slippage and commissions.

I suggested he use slightly smaller initial stops and look for trades with Risk Rewards that were at 2:1 or higher. I personally do not take trades with initial stop losses larger than three S&P points and I never take a trade with a Risk Reward below 2:1--I am much more comfortable in the 3,4 or 5:1 area when intraday trading. I don't find these trades that difficult to find once you get used to looking for them and if I have to wait to find a trade that fits my acceptable profile, that doesn't bother me at all. I want to be
consistently profitable and it costs me nothing to wait for an acceptable trade.

He had a good plan for his next trade: He used a smaller initial stop loss and the Risk Reward was greater than 2:1. The trade started out as a nice winner and looked like it was going to run straight to his profit target--it was already five S&P points in his favor! But when it began to turn back lower, he let his emotions get the better of him: He had that feeling that the market was going to continue to head lower and hit his stop loss. He didn't want to take a losing trade! This was the pressure of 'making money' talking to him and he threw his plan out of the window. Rather than risk having this trade become a loser, he panicked and took the two S&P Points still left in the trade [If you are curious, he would not have been stopped out and price would have reached his original profit target if he had stuck with his plan]. Once the trade was closed, he realized he had two winning trades for his first two trades. He was riding an emotional high: This 'off floor' trading wasn't hard!

The next day, he saw his third trade opportunity right after the S&P open, when the market gapped open lower. Most floor traders 'know' the market loves to fill open gaps, so that gave him his trade idea. He already had two winning trades and was feeling good about his trading, so he decided he would go back to using 'looser' stops for this trade. The market had just opened and the economic numbers that had come out before the opening
[ and caused the market to gap open lower ] had left this market volatile, with fairly wide range bars. He didn't want to get stopped out and then have the market turn around and fill the gap!

This trade had nothing going for it: The initial stop was too large, the risk reward was poor, he was taking an entry right after the open that was fighting against the trend. And he made matters worse: When price got near his initial stop loss level, he looked at the screen and the size of the 'buy' orders shown by his platform. Then he watched price hesitate and turn just a bit higher. He was certain the buyers at this level would keep price from going lower, but price was so close to his stop, he cancelled his existing stop and moved it five S&P points lower. Remember, he just had two winning trades in a row and was running on an emotional high. He was certain price would never break through this level and hit his new stop loss order.

But price did break through the lows and quickly stopped him out for a rather large loss. On this single trade, a trade he was certain was a sure winner, he had lost all he had made on the prior two trades and quite a bit more. If you 'eye up' the first three trades, you should be able to see the usefulness of 'same size' maximum stop losses per contract, as well as what damage you can do to your account if you move your initial stop loss order to a worse level.

I haven't yet mentioned leverage. Though many brokers will let you trade three or four E Mini S&P contracts per $10,000 Dollars, by doing so, you are exposing your account to extremely large percentage swings on each and every trade. Overtrading [trading too frequently] and using too much leverage will drain an account faster than anything else--and people that lose all the money in their accounts are generally guilty of both of these.

I understand not everyone has $100,000 for their trading accounts or $50,000 or even $25,000. Many of you scraped about $10,000 together [or a touch less] to begin trading. Think of this money as your Trading University funding. You need to practice, practice, practice--without losing all your capital. Using simulated trading is fine, up to a point, but eventually, you will have to trade using real money, because only then will you experience all the positive and negative emotions that you have to master before you can become a consistently successful trader.

If you are trading a $10,000 account [or something close to that], if you choose to trade E Mini S&P futures, learn trading only one contract. That one contract will give you all the spills and chills and thrills you can handle, and then some. The goal is to survive the learning period, with as much of your capital intact as possible. No matter what instrument you decide to trade, use leverage carefully, use consistent sized smaller stops and don't take a trade just to take a trade: Have a trading plan and use it.

He continued to use a large initial stop [seven S&P points] for his fourth trade, because he saw what he thought was a great set up right after lunch: Price was trading in a range and when it broke out, he'd catch the move! This was going to be a sure 16 point winner and it would get him all the money he had lost on the last trade and a little more! He had two winners in a row; that last large loser was because of the opening gap, but it was afternoon now and he was sure he'd get his money back by the close.

Price broke out to the upside and he went long [just as he had in the morning]. He was sure now that they'd fill the gap left on the open--Price broke above the top of the range and he put his initial stop loss well below the bottom of the range.

Price went a little higher after he went long but then it broke back into the trading range; a few bars later, it headed towards the low of the trading range. Soon, he was looking at where his stop was placed and where price was trading and he realized he had only put his stop loss order one S&P point below the low of the range! He decided that was too close to the prior lows and they might 'wash and rinse' him and then take price back higher, but he wasn't going to let that happen! He moved his stop loss order to a worse level to give the trade more room. Now he was risking 10 S&P points to make 16 S&P points: The size of his stop was huge and his risk reward ratio was only 1.6:1.

They did wash and rinse those traders that had tried to go long at the bottom of the range; he breathed a sigh of relief when he wasn't stopped out and price climbed back into the range. But the relief didn't last long. Two bars later, price headed lower again and this time, ran into quite a few stop loss orders; the selling continued and he was quickly stopped out for his second losing trade.

Please take the time to notice that the size of his two losing trades are much larger than the size of his two winning trades. When you look at your trading statistics [and I hope you all keep trading statistics and review them regularly], this is a sign you are on the road to ruin.

When he eyed up what would be his fifth trade, he decided he had been risking too much on each trade. He decided to go back to the five S&P point stop he had used for his first trade; three S&P points seemed too small and he didn't want to lose seven more S&P points, so he settled on five S&P points. He had used five points on his largest winning trade--that one worked pretty good.

Price started to sell off on the opening and after watching it head lower for awhile, he decided the sell off was probably going to continue. He found a place on his chart where price had run into resistance yesterday afternoon and when price got to that area, he got short three S&P contracts.

Price congested underneath this area for five or six bars; to him, it felt like there was a giant order to sell just above the market! Other traders also had this feeling that there was a giant seller just above the market--and more and more short S&P positions were created right below this resistance area.

Price suddenly began to spike higher. He looked at his charts again and realized he had placed his stop loss order right at the bottom of that trading range from yesterday, so he moved it higher, now risking eight S&P points on the trade--but he was confident the bottom of the range from yesterday would stop the rise. And it did stop the rise for a few bars.

Then price began to creep higher, slowly edging into the trading range. As soon as he began to feel his stop loss order was in danger of being executed, his first thought was: I can't take another large losing trade! The last two losses had really cut into his trading account. He was certain price was just about to turn around and head lower--so he couldn't allow them to stop him out of his short position now! He moved his stop loss order higher [for the second time!] by four more S&P points.

The end of this trade came swift this time: Roughly two minutes after he cancelled his stop loss order and moved it higher by four points, price spiked much higher, taking him out of his position with a twelve point S&P loss.

In three trading days, he managed to have two winners and three losers. That's not a fatal win/loss ratio; in fact, if he had an actual risk reward ratio above 3:1, he would have net made money. But in his five trades, he had made seven S&P points and lost 35 S&P points! You don't even have to do the math to know that that risk reward ratio was fatal.

In three trading days, he managed to take a $10,000 trading account and lose $4,200 of it. And the sad truth was he wasn't really trading a $10,000 account; I proportionally down sized everything [his account and the positions sizes, profits and losses] to a $10,000 account so most of you would better relate to the sizes of the wins and losses. He was actually trading with a multi-million Dollar account [so imagine how much money he actually lost].

'Where did I go wrong?', he asked me when we met at the end of the week. I started to list the mistakes--and he had made most of the mistakes I have on my 'Don't ever do this' list:

  1. Don't use too much leverage. Once you become a consistently profitable trader, there are simple ways to slowly increase your position size without emptying your account.
  2. Keep your stops relatively small. Stops are often your best friends. By using consistently sized maximum stops, you'll be around much longer to learn your trading skills.
  3. NEVER trade without stops and NEVER move your stops to a 'worse' level. Once the trade begins, you have emotions tugging at you and you often make poor judgments; in my opinion, your first thoughts about a trade are usually the best because they came before this emotional tug of war.
  4. A solid actual risk reward ratio pays for many sins. If your actual risk reward ratio is 3 or better, you can have three or four losses in a row and if you are using consistently sized smaller stops, you can still have a good month.
  5. When you take a trade, don't think about 'getting the money back'. Take trades because they make sense. The market has no memory, so trying to take revenge on the market is a waste of emotional energy--and these 'revenge trades' seldom work.
  6. If you find you have had several bad losses in a row, try taking a few days off to let your head clear and then evaluate what you were doing that led to the large losses. Make certain you learn something from your mistakes!
  7. Set 'circuit breaker' levels in your trading account--perhaps at every ten percent. If you lose ten percent of your account, take some time off, then re-evaluate your trading plan. If you are trading multiple contracts, you must lower your number of contracts at one of these 'circuit breaker' levels. If you manage to make back the ten percent, you can always slowly increase your number of contracts.
  8. Set rules for yourself and never violate them. If you violate a rule, impose a stiff penalty on yourself: a week off of trading? When you violate rules, it is a clear sign you are out of control.

What should a solid five trades look like? Here is a set of five consecutive trades I took in the 30 year Bond Futures. You can see the chart that spawned the last trade in last week's Moneyshow article: ' How to Develop Your GPS for Chart Reading'.

The first thing you should note is that I am using much less leverage than the trader in the first example. And I am using smaller consistent stops for each trade. I don't HAVE to use all five ticks, but I like to hide my stop order behind market structure and that generally takes all five points.

Now look at my planned or initial risk reward ratios: 6:1, 8:1, 4:1, 3:1 and 8:1. By looking for trades that realistically have initial risk reward ratios of better than 2:1, I am able to withstand two or three [and maybe four losses in a row] without doing much damage to my account. How do I know if the initial risk reward ratio is realistic? Here are the actual outcomes: 3:1, loss, loss, 3:1, 9:1. There is nothing I can do about the losses, but if my winning trades had actual risk reward ratios of 0.5, 1.2, 1.6 when I had been looking for 3:1 or 4:1 or 8:1, it would be time for me to re-evaluate how I was choosing my initial profit targets.

By using consistently sized smaller stops, the two consecutive losing trades didn't take my account into negative territory. And here's the key: In the first trade, I 'Rolled Forward' three stop losses. That means that when I took a profit of fifteen ticks in the bonds on that first trade, I had fifteen ticks in my account as padding against a string of losing trades. Since I was consistently using 5 tick stops, I could have lost five ticks on the next trade and only been back to break even--I still would not be feeling the pressure of 'needing to make money' to recover from large losses.

As I said last week, a picture is worth a thousand words. Let me show you what 'Rolling Forward Stops' look like.

This spreadsheet says it all. You can see how many ticks I have added to my account after each winning trade and how many I lost from my account after each losing trade. The center column shows you how many losses I have 'Rolled Forward'. And finally, the last column shows you how many losses I have left in my account before I begin to draw down actual capital from my starting levels.

By using consistently sized smaller stops, even if I had started out with two losing trades, with a solid risk reward ratio of 2:1 or better, my third trade would have easily covered the losses from the first two losing trades. Don't dig big holes! Trust me, they are MUCH harder to fill up! Trade with consistent sized stops, use smaller leverage, only take trades that make sense and just keep Rolling Forward those stops.

The goal is to become a consistently profitable trader. And that means three or four winning months in a row--and the losing months should be barely negative, because you are controlling those losses!
Here's the secret to having a winning month: At the end of week three, if you have 13 losses rolled forward, it is extremely likely you will have a nice winning month. There is no pressure left for the rest of the month, so you can relax and trade free! And once that winning month closes, you have positive momentum to start the next month out with. Keep the same stops, the same risk reward ratios and the same realistic profit targets and do it again. Before you know it, you'll be on your third or fourth winning month. You'll be a consistently winning trader!

Just keep Rolling Them Forward!

I wish you good trading.

Timothy Morge
www.marketgeometry.com
www.medianline.com