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March 7, 2005 Comments: I haven't posted a stock index trade here in a few weeks, so for those of you that only trade the S&Ps, Nasdaqs and Dax futures, here's a nice profitable trade that ties in with our recent discussions of how to use sliding parallels in your intraday trading. This is a classic trade set up. In all of the trades we show here, we want to look for an "edge," something to trade against, something to lean against, something or somewhere in time and price that will give us a clear place to make a stand: On one side, everything's fine...on the other side, we're out of here! The edge needs to be logical, well defined, something we see on a regular basis so we can watch it unfold countless times and "test" its probability of success. And of course, once we have identified the edge, we must couple it with solid risk reward strategies and solid money management, which means we will have to have a complete plan before we enter the trade and then execute the plan automatically, no matter how price and time play out in front of us.
Let's look at the chart above, and see if we can identify just such an edge. And if we can identify an edge, let's try to lay out a solid plan that takes advantage of it, using good risk reward and money management practices.
Price has been trading in an up trend and on Friday, it zoomed through an up sloping Major Median Line. Looking at the chart carefully, we can see that price has flirted with breaking above this Major Median Line several times, but this is the first time we can identify a number of consecutive bars that close above this Major Median Line. That is obviously a sign that price got an infusion of fresh energy on Friday: It had the power to break above two spike highs at the 1223 area and stay above this Major Median Line for the rest of the day. This action from Friday gives us our first clue for what we want to look for in an edge: Price had a fresh infusion of Energy. It's in a strong up trend. It's closed above the Major Median Line for the first time. All of these signs tell us we should be looking for a place to get long to take advantage of the strength of this market *until* it reaches a place where its potential energy has been expended. As the market gets set to open, we get another cue that points us towards a potential edge: Price is gapping open higher, and since the gap is not very great, we can expect that the short-term traders will want to try to fill that gap. IF they try to push this market a bit lower, we see we MAY get a re-test of this up sloping Major Median Line, a classic zoom and re-test set up. That's a time tested "edge" set up that we have shown here hundreds of times: We're going to wait for price to retrace to test what once was Major Long Term Resistance and is now support and we're going to try to get long this market, with stops below this support.
And let's add one more bit of support to this edge: If I take the three pivots I used to draw the smaller time frame Median Line and its Upper and Lower Parallels [marked a, b and c] and do a little simple math, I can project forward, into time and space, likely areas of support and resistance. I think of them as horizontal frequencies that are generated by the interaction of the sloped frquencies carried by the three pivots [I view Fibonacci retracements in the same manner, by the way...It's all Energy and Frequency to me].Here's the math:
Pivot "a" is drawn off a low of 1198.25
Pivot "b" is drawn off a high of 1217.00
Pivot "c" is drawn off a low of 1204.50
The distance from Pivot "a" to Pivot "b" is 1217.00 - 1198.25 = 18.75
I take that distance and add it to Pivot "c" to give me a 1:1 projection:
1204.50 + 18.75 = 1223.25
A 1:1 projection is the most important projection, because it simply projects forward 100 percent of the inherent Energy in the three original pivots. In other words, it assumes price is continuing forward with constant potential Energy, which is the safest [and most reliable] assumption. I do not view these areas as places where price is going to stop and change direction [it doesn't matter whether I am looking at the .618, 1.00 or 1.618 projections] but rather, I view them as Energy Points or nodes or [to bring in an obscure astronomical term] Lagrange Points, which are areas where bodies in motion often rest before then moving on in EITHER their original direction or a new direction. I use these areas in context with other tools to give them meaning.
So let's summarize before moving on: Price zoomed above the Major Median Line Friday and held above it for the rest of the day. Price is gapping a bit higher on the opening this morning, so it is likely that the short term traders will attempt to push price back down to try to fill this opening gap. Looking at the chart, you can see we also identified an area of confluence just below this market: We had two recent prior spike tops at 1123, we have two Median Lines intersecting just below 1123, and we have a 1:1 Fibonacci Projection that comes in at 1123.25. That all adds up to an edge to me. We'll now use this 1123 area to try to enter a long position, with stops below this confluence of support. Let's see how the first few bars of the morning session plays out: |
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We've seen the fourth fifteen minute bar of the morning close and price is still above the up sloping Major Median Line and the area of confluence support at 1123. It's not clear that we will get a chance to buy a re-test of the Median Line, but let's set up the paramaters of our trading plan and get our orders in the market in case price DOES re-test the Median Line and confluent support at 1123. First, I calculate where price would intersect with the Major Median Line for the next bar and that comes in between 1123 and 1123.50, so we'll put our buy order at 1123.50, which is just above the 1:1 Fib Projection of 1123.25, right at the intersection of the re-test of the Median Line, above the confluence formed where the two Median Lines intersect and above a pair of spike highs at 1123. And although I didn't draw it in, because it would make the chart TOO cluttered, the Gap Filler line is at 1123.25. I still expect the short term traders will attempt to fill this gap, but with all the support right at this area, I don't think they will be able to push price much lower [and if they ARE able to get price through this area with any sort of momentum, we'll want to be out of this trade immediately, which is why we ALWAYS enter stop loss orders at the same time we put in our entry orders].
Now, where should we place our stop loss order? The S&Ps can be relatively noisy at times, so we have to strike a balance between minimizing potential losses if we are wrong and yet giving the trade enough room to run in a noisy environment. Several thoughts come into my mind as I look at the chart and think about stop placement in this situation: I want to tuck it below the confluence area. I want to tuck it below the Median Lines. I can't put the stop TOO close or the short term traders might trigger the stop when they attempt to fill the opening gap, assuming there are some stops built up just below that area. What else can I see that might provide another level of support? Looking at the price action from Friday, I see three tops and one bottom that come in at 1122 and so I'll use these multiple tops and bottoms as my final layer of support. I decide to put the initial stop at 1121.50, which is 1 1/2 points below the confluence of support, below the Median Lines and several ticks below these multiple tops and bottoms. If price makes it this far below the support areas and the Median Lines, the re-test has most likely failed and I want to be out of the trade.
The last ingredient of the trade plan is setting an initial Logical Profit Target. This is an equally important part of the plan, because it will tell you whether the risk reward values of the trade are acceptable [In other words, am I risking ten points to make two points? That's probably not an acceptable risk reward ratio...]. Looking at the chart again, I notice that price has moved above the shorter term up sloping Median Line several times, only to fall right back down to the same Median Line. In effect, this market is trading in an up sloping rolling chop. And we can define the area where price is likely to have expended its stored Energy by drawing a line parallel to the shorter term Median Line that bisects the three most extreme prior highs where price clearly DID run out of Energy. It's important to note that we are not saying this Sliding Parallel will halt price in its tracks. We're not looking to get short at the test of this Sliding Parallel. At this point, we feel the market is in an up trend and we are simply looking for an area where price is likely to stall because it has run out of stored energy. It's at that area that we want to get our profits out of this trade. What price does AFTER it reaches this area is not important to us. This is our logical exit point and having it allows us to calculate our initial risk reward ratio. And because this line has a rising slope, the area where price will intersect with this Sliding Parallel goes up just a little bit with the close of each bar.
If the profit target goes up with the close of each bar, how does that square with price carrying a certain amount of stored energy? Think of it this way: If you have one gallon of gas in the tank of your car and if you step hard on the gas pedal, you'll move very fast but you'll burn that gallon of gas you have available much faster than if you pushed on the pedal just a bit and kept going forward at a constant speed for a longer period of time. Your car might jump ahead [spike higher] for a brief period, but you'll soon have expended all your stored energy. On the other hand, a less aggressive use of your gas might get you a further distance over a longer period of bars [a series of higher highs that eventually exceed the spike higher of the more aggressive driver after a number of bars].
So we calculate where price will intersect with the Sliding Parallel during the next bar, knowing that this intersection level will move higher with the close of each bar. But the initial intersection level gives us a minimum expectation IF the trade is immediately successful. That initial intersection is 1227.75. Now we can look at our risk reward ratio: We are trying to enter a long position at 1223.50, with a stop of 1221.50, a risk of two points. Our initial profit target is at 1127.75, which would be a gain of 4.25 points, which is just about a 2:1 risk reward, assuming we get long and hit out profit target on the same bar we enter. With the high probability of success of this trade set up [I calculate it at better than 70+ percent after studying thousands of these actual trades], this is a very acceptable risk reward ratio. And remember, as time goes forward, our profit target will adjust higher, resulting in a better risk reward ratio [although more risk is associated with being in a trade for a longer period of time, but that is another discussion for another day].
Now we have our entry order [at 1223.50], our initial stop loss order [at 1221.50] and our initial profit target [at 1227.75]. We call our broker and give him these orders as contingent orders, meaning they are tied together. For example, it's only logical that we won't sell any E*Mini S&Ps on our stop loss order unless we also buy them at our entry level, because price is currently trading above both levels. To get to our stop loss order, price MUST trade through our entry order, getting us long, so we can enter both of these orders at the same time without worrying about the stop order getting filled BEFORE our entry level is filled. It just can't happen. The tricky part here is the profit order: IF your broker accepts contingency orders, make the profit order contingent on your entry order being filled. Remember: You don't want to sell when price gets to the Sliding Parallel UNLESS you are long from the re-test of the Median Line. If your broker DOES NOT accept contingency orders or if you are using an electronic platform to enter your own orders, you'll have to wait to enter your profit order until you can confirm that you were filled on your entry order. And remember!!! Just seeing the price print doesn't mean a thing. In fact, seeing price tick below your entry price MAY NOT mean you are filled. There are times when these markets are deemed "not held" by the exchanges because of illiquid market conditions, so ALWAYS double check that you are filled on your orders as soon as possible. If you are using a broker, call him and get a verbal fill. If you are using an electronic platform, check the audit trail of the platform and make certain you see your fill confirmed by the exchange. Once you are sure you are long, enter your profit order in the market [or if your broker accepts contingency orders, it will already be working]. If you can, attach an "OCO" to the stop loss order and profit order, which means "One Cancels The Other." In simple terms, if the stop order is hit first, the broker cancels the profit order. If the profit order is hit first, the broker cancels the stop loss order. Now that we have our orders ready, let's see what the markets do next: |
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| During the next bar, the short term traders do push prices low enough to test the Median Line, just getting a tad below our entry level before price rebounds nicely. We call our broker or check the audit trail of our electronic platform and confirm that we were filled on this move lower. We're now long at the Median Line re-test at 1223.50 and we're working an initial stop loss order of 1121.50 and a profit order of 1227.75. At the close of this bar, we'll adjust the profit order a tad higher, to reflect the upward slope of the Sliding Parallel where we think price will expend its energy. If you're curious, the intersection with the sliding parallel moves higher by just a touch less than .20 ticks each bar. So it does have to be moved higher, but to be honest, in this trade, I wouldn't have moved the profit order with every bar...probably after every couple of bars. Let's see how the trade unfolds: |
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| Three bars later, price nearly makes it to our profit order. Note that I have already adjusted it higher once. We're now working a profit order of 128.50. But what about our stop loss order? Price nearly hit our profit order, so perhaps we need to re-evaluate whether we want to allow this trade to turn into a loss IF price turns back lower from this point: |
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| Stop management is the one area where the personality of each individual trader comes into play the most. I am a bit torn here: On the one hand, price nearly hit our profit target, meaning price MAY have expended its stored energy and made its run higher, just missing our profit order. If that's the case, I don't want the trade to turn into a loser before I am stopped out, because in essence, all the logic behind this trade played out as expected but we'll have taken a loss on the trade. On the other hand, I want to give the trade every chance to play out the scenario we spelled out in our plan. In the end, I feel that price has come close enough to the Sliding Parallel that I need to snug up the stops. Looking at the chart, I see that price left two consecutive bars with the same low of 1124.25 and I expect that these double bottom bars will act as some support. If I snug up my stop order to three ticks below these two bars, it will become a break-even stop-loss order. I cancel the initial stop loss order at 1121.50 and put in a break-even stop loss order [or stop profit order, as I labeled it on the chart]. Now that we've adjusted both our profit and stop orders, let's see what the market does next: |
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| For the next four bars, price consolidates in a lower range, not getting low enough to threaten our stops, but not making any new highs either. If you look at this chart, you can see that price has often advanced with a few wide bars higher, followed by periods of smaller "consolidating" bars, so this pattern has been repeated again and again during this "rolling chop" higher. Prices generally trade in a range as Energy is being re-stored, so I suspect Energy is being re-stored and I expect we'll soon either see an acceleration to the upside or an acceleration to the downside. I adjust our profit target again and it is now up to 1229.25. Let's see which way price decides to expend its energy: |
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| When price moves higher and closes higher for the second consecutive bar, again approaching our profit area, I look at the swing low formed by the past four bars of consolidation. The low of that mini-swing comes in 1225.00, so I snug up my profit stop to three ticks below this swing low, at 1224.25. I also adjust my profit order again, to 1229.50. With any luck at all, we'll get more follow through during this next bar and we're close enough to the profit target that we may get filled. |
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| Price indeed makes it to our profit target during the next bar and I immediately call my broker to confirm that my profit order was filled at 1229.50 and that he has now cancelled the stop profit order he was working for me at 1224.25. And as always, I ask him to repeat, "You're flat and working nothing," which is just a good habit I have that makes him reinforce to me that I have checked both my position and my order status and everything is as it should be. After executing a nice trading plan profitably, I don't want any surprises. Let's take one last look at how the day played out, so we can see if the Sliding Parallel did indeed give us a good measure of where price's stored energy would be expended: |
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As you can see, the Sliding Parallel did a great job predicting just where price would run out of its stored energy. That was as much as we could have squeezed out of that trade, and yet the level was projected before we entered the trade by looking at the prior energy expenditures of price on prior moves higher. I maintain that it is correct to say that price contains a given frequency, or if you prefer to think of it in terms of thermodynamics, price has a finite measurable amount of stored energy in most cases. This type of measured movement based on energy expenditure has been a very powerful tool for me in my trading and once you start to think in these terms, you might find it to be a powerful tool to put in your own trading tool kit as well. I wish you all good trading!
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