Thursday, June 28, 2007

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.
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