Method to Madness III

Let's break the setup down to elements so we can define our actions in terms of that setup and price actions.

First, setup must have a trigger. Trigger will define a point of entry. In terms of breakout setup for instance, a trade above the established resistance level is a trigger for our entry for a trend continuation.

Second, setup must have a failure indication. This indication will give us an idea for a stop placement. Again, if we are talking about breakout setup, such indication would be a loss of a support level.

Putting these two together, we have an entry and risk control. To illustrate it on a particular chart formation, let's have a look at the Cup and Handle. Rim level defines a resistance to break while handle's bottom defines the closest support. Our trigger for an entry is going to be a trade above the rim level, while our stop will be located under the handle bottom.

Third, setup usually has certaing supporting factors that are in fact parts of the setup. One of the most useful is volume configuration. You want volume to support your chosen direction by increasing as a stock inches toward a breakout level and drying up during a retreat. Among other supporting factors you may want to list a broader market directional support, or cetain technical study you utilize.

Fourth, you need an idea of an exit level on a profit side. This is where your particular setup intersects with your chosen style of trading and method of reading. You remember the discussion of risk/reward ratio in articles on scalping. If you aim for 1:1 ratio, you will look for a signs of exit around that level. What are those signs? That depends on your method of reading - for instance as a tape reader you will look for a sharp price spike combined with volume increase as this combination usually signals an end of a current stage of a movement. If you use certain technical indicator, you will watch for it to show the exaustion of the movement. The important thing here is a logical alignment between the tools that you use for an entry and exit indication. While it should be self-explanatory, I will mention and example of horrible misalignment, simply because I do see this happening with some traders. If you find your entry on a daily chart using japanese candlesticks and look for an exit using MACD on one-minute chart, you ask for troubles.

Finally, fifth element of your setup structure is a fine-tuning of an entry in terms of aggressiveness. While there is a trigger for a trade, you may find that in certain markets entry in advance works better. Entering on a trigger would be a regular way to initiate the trade. Entry in advance counting on a future trigger would constitute an aggressive way which offers its trade-offs. Finally, there is a conservative way to enter which would mean letting a trigger go and entering later on if certain conditions are met. There are trade-offs to this way, too. Let's make it a matter of a ceparate post. For now, you are armed with the way to structure your setup so you have your actions defined by what's happening with your stock. Your ultimate plan of action can now be put in terms of IF-THEN scenario where each IF is a market action and each THEN is your response. This offers you a lot more than just entry and exit points, and this is what we discuss in our next post.

Method to Madness II

So, how do you go about structuring your trading? First thing to ask yourself is, what kind of movement are you going to play? Trend following? Trend reversal? Range? This is going to define the kind of setups you are going to look for. Let's try to give some examples.

If you are playing trend following, you are going to look for breakout setups (breakdown too if playing short side, but let's limit it to long simplicity sake). In terms of chart formations for instance, you are going to look for Cup and Handle, JBE, Ascending Triangle etc. If you prefer candlestick formations, you will select those that reflect trend continuation; similarly, with any other study or indicator you want to use, you will be concentrating on those that match your chosen type of the movement. I am staying with chart formations in this example because is easier to envision and this is going to come handy when we finally get to particular setup structure.

If you decide to focus on trend reversal, you will be on hunt for Double Bottom, Head and Shoulders. Finally, if you want to play range, you will look for, well, range - price locked in a certain horisontal limits.

Out of the universe of setups, you will pick several that match your approach. 3? 5? About that, and could be just a couple at the beginning. No point in starting out with 10, you will get lost in their variations. If this step in structuring your trading feels like a small one, it's a misconception. What you just did is a big step: you made a transition from a very general idea (kind of movements to trade) to a very particular thing (exact setups to learn and to hunt for). However mundane the task of matching one to another seems, you would be amazed by how many say they want to trade trend continuation and go ahead looking for double bottoms or tops.

What we are going to do in the next post on this topic is to start structuring our setups - break them down by elements and see how you put those elements together in order to come to a logical, meaningful, structured and controllable way to trade.

Cure for guilt

If I ever feel guilty about not posting anything for a few days, I go out and look at this. Guilt is cured.

Surgeons, dentists and... traders

Those of you who read my books and/or listened to my periodic rants on trading psychology topics remember analogy I use frequently when discuss the idea of focussing on trading right and not on making money. For those who haven't, brief outline: the idea is to focus on doing things right and to perceive money as a reward for the job well done, as opposite to being focused on making money which serves as nothing but distraction from the following the rules, working out correct strategy etc - because the matter to focus on is reading the market movement and exploiting it. The analogy I like to use in order to make the meanbing clear is one of a surgeon who, in order to be a good one, must focus on performing the procedure right and not on the money he is going to obtain for the surgery performed. And if he does think of his reward while working on you, do you really want to be his patient, do you have full confidence in his ability to deliver the result? If the answer is NO, as it well should be, then the reason for such answer is very clear: our surgeon is not focused on the subject of his job which is not the money - just as a subject of a trader's job is a market movement, not the money.

So, yesterday I am having a dinner with a small group of friends one of whom is a dentist of huge experience, many decades in the field, creator and a head of various governmental programs, inventor of new technologies, highly respected by colleagues etc etc. Conversation touches on education, the ways to bring up new generations of trained professionals, he talks about his teachers, tells stories from his student past... Now, can you imagine how fascinated I was when he told about one teacher of his who would say often: Do not focus on money, do not see your patient as a cash register, think of doing your job right, focus on that and money will follow...

Seems to be universal principle, doesn't it :)