Fascinating Intraday Action

Jun 2, 2008: 8:36 PM CST

Today’s intraday price action gave us a major lesson in price patterns, volatility, and clean high probability trade set-ups.  Let’s see what we could have learned today in the SPY.

First, the day began with an overnight gap, which led to a stop-loss if you tried to trade back into the gap.  Often, when a gap-fade trade fails, this sets up considerably higher odds that the day’s action will then unfold into a Trend Day style environment, which calls for aggressive tactics.

Indeed, the day resembled a trend day move which exhausted itself to the downside in a clean ‘measured move’ formation and triple momentum divergence.

With the market plunging lower and stabilizing into the noon hour, you should have been looking to play short, which set itself up with the price pullback (consolidation) to the falling 20 period moving average which set up the “Impulse Sell” trade that came after a new momentum low.

In this case, the trade gave significant profits quickly as the 5-minute period volume high was actually made around 12:30 in an interesting, climactic sell pattern.

Despite lower prices, the momentum oscillator formed a higher low, creating a divergence that clued us that the price action had lower probability of heading lower.  In fact, the divergence set up a quick countertrend “scalp” back (long) to the 20 period moving average.

Price then completed its intraday reversal to the upside by breaking above the 20 and 50 period moving averages, preventing the day from closing at the lows of the session.

Also, one could have noted a type of bear flag (more like a pennant) that occurred prior to the mid-day sell-off.

Always annotate charts of interesting patterns or interesting days so that you can internalize the patterns better to make quicker, more accurate trading decisions.

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Gap Fade Statistics for May

Jun 2, 2008: 1:02 PM CST

With the month of May winding down, it’s now time to see how many days resulted in an overnight gap, and how many of those overnight gaps filled, giving us clues as to whether or not the “Gap Fade” strategy continues to work.

Using Excel and daily data for the DIA (Dow Jones ETF), I define an overnight gap as a price differential of at least $0.20 (20 Dow Points) to classify as an overnight gap. I will, however, look at other values for the month.

For the 21 trading days in May, 2008, here are the results:

TOTAL Number of Gaps:              13
TOTAL Number of Gaps Filled:      7
Un-filled Gaps:                             6

% Of Gaps Filled:                54%

Gap-Ups Filled:                            6
Gap-Downs Filled                        1

What happens if we define a gap of $0.50 (50 Dow Points)?

Total Number of Gaps:                4
Total Number of Gaps Filled:      2

% of Gaps Filled:                         50%

The largest monthly gap that WAS filled was +$1.33 on 5/2/08.
The largest monthly gap that WAS NOT filled was -$0.71 on 5/20/08.

Here are the monthly culmulative totals for 2008 from January to the end of May:

Total Number of Gaps ($0.20):       67
Total Number of Filled Gaps:         43

% of Gaps Filled:                           64.18%

If we get a little more conservative with our definition, and define a gap as $0.25 (25 Dow points instead of 20), then the percentage of filled gaps only changes to 64.06%.

See the other monthly posts for more information below:

January Gap Fade Statistics
February Gap Fade Statistics
March Gap Fade Statistics
April Gap Fade Statistics

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The Five Components of Successful Trading – Whiteboard

Jun 2, 2008: 9:08 AM CST

What are the Five Components of Successful Trading? Adam Hewison details these five points in a recent, brief educational video.

I’ll give you a hint – Adam’s #1 Rule, as is mine, is stated “Know Your Risk!”

What are the other four components? Adam writes:

In this edition of Traders Whiteboard, we will be looking at five key components that you need to be successful in your trading. The ones we have picked out today are not on every pro trader’s suggested list, so I think they will be a surprise to you.

We consider these five components to be incredibly important to anyone’s trading success, most of all yours.

The Five Components of Successful Trading

If you have missed our other Traders Whiteboard lessons, not to worry! We now have a total of eight lessons that you can benefit from and they’re available here.

The Full Trader’s Whiteboard Series

Feel free to check out the other educational posts. Also, be sure to visit and consider joining the Market Club if you have not done so, or at least visit the What you Get page to see if the Market Club daily services could be of benefit to you.

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Does a 95% Win Rate Result in Net Profitability?

Jun 1, 2008: 11:41 AM CST

Earlier, I discussed Win Rate as a factor of Fixed Stop-Loss and Fixed Profit Targets, and I showed how it was easily possible to achieve a 95% win rate… but now it’s time to see if these outcomes lead to net system profitability.

Please refer to the earlier post for the full descriptions and parameters of the study, but here is a summary:

DIA daily chart from 1998 to present
Momentum Long Entry:  Buys when indicator momentum crosses zero and stays above for one bar
MACD Cross: Buys when MACD Line crosses above the Signal Line
20 MA Cross: Buys when price closes above, after crossing above a 20 period SMA
TradeStation and Excel

I specifically asked you if a system which clearly generated a 95% win ratio (meaning when you play for a target of $1 while using a stop-loss of $20) yields a net profit.  Thank you for those who responded with your thoughts.  Let’s see the answers now:

Fact:  I assume TradeStation commissions in the calculation, which means for every 100 shares, a round-trip commission would be $2.00 and I also assume $2.00 slippage just to be safe and to mirror real-life execution.  This means that $4.00 was eliminated from all trades (a $100 profit would actually be recorded as a $96 profit while a $100 loss would actually be recorded as a $104 loss in terms of the net profitability calculation).

All trades are fixed at 100 shares, meaning a $1.00 profit in the DIA would result in a profit of $100 per trade.

Let’s refresh (Win Rate or % profitable with a $1 target and $20 stop):

Momentum:      96.50% (115 trades)
MACD:             95.08%
(61 trades)
20-MA Cross:   94.73%
(76 trades)

On to the results:

Playing for $1.00 ($100) while risking $20 ($2,000) per trade does yield a 95% win rate for all three systems I tested, but here are the results of Net Profitability (dollars gained) by the 10 year strategy trading 100 shares:

Momentum:      $2,591 (115 trades, 4 losers)
MACD:             $33
(61 trades, 3 losers)
20-MA Cross:   -$150
(76 trades, 4 losers)

Let’s take the pure results and add back $4 per trade to see what would have happened before commissions and slippage per trade:

Momentum:      $3,051 (115 trades, giving back $460)
MACD:             $277
(61 trades, giving back $244)
20-MA Cross:   $154
(76 trades giving back $304)

Congratulations to reader Cedric who provided us a formula who most accurately estimated the results.  His comment read:

Isn’t it just:
(Win %) * (Profit Target) – (100% – Win %) * (Stop)

So for the $6/$2 with the Momentum (roundest numbers):
0.26 * 6 – (1 – 0.26) * 2 = 0.08 (Net Profitable)

A tiny edge, but an edge nonetheless. Although most brokerages would eat that tiny edge up in fees.

Wes was also right with the logic :

If you risk $20 to make $1 then with a win rate of 95%, out of 100 trades you will lose 5 times for a loss of $100 and you will win 95 times for a gain of $95. I guess you can go broke being right.

By the way, the DIA was near $70 at the start of the 10 year period and ended recently near $125, for an increase of $55, meaning if you had bought and held 100 shares of the DIA when these three test periods started, you would have ended near $5,500.

The Momentum study, with the highest win rate and net profitability rate, achieved half that total, despite taking 115 trades and achieving a 96.5% win rate.  The Momentum study actually experienced 4 losing trades.  With the other two strategies, you roughly broke even, net of fees.

I’ll continue to address this topic, and will provide the Excel charts for Net Profit and other factors relating to the tests, including number of trades, average trade size, average bars (days) in a trade, etc.

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Dry Ships Hits a Rock

May 31, 2008: 1:43 PM CST

Popular stock Dry Ships Inc (DRYS) recently formed a major trend exhaustion (possible reversal) pattern that is worth further study.  Let’s look at this pattern and what it may mean for the stock.

Price rapidly increased from $20 to $130 throughout 2007, while collapsing at the end of the year, which brought us to the price lows of $50  at the beginning of 2008.

Now, price has resumed its daily uptrend and formed a clean swing pattern that took price back to $115… but wait!

Earlier this month, price formed an exhaustion or euphoria pattern which will become one of two patterns:

1.  A trend reversal (meaning lower prices are yet to come)
2.  A clean retracement (meaning higher prices are yet to come)

What’s interesting to me is the cleanliness of the patterns that occurred.  There are two overarching patterns that set-up that I want to draw educational attention:

1.  Exhaustion Gap
2.  Bearish Engulfing Candle

Both of these would signal greater odds for the trend reversal case, but there is an interesting overriding factor.

There appears to be strong support via the 50 and 200 period moving average on the daily chart; the 20 period moving average at $80 on the weekly chart; and the recent swing high at $85 from the prior price swing.

Note also that there was a new momentum high on the price chart, meaning higher prices could be yet to come PROVIDED that the recent pattern was not a euphoric (or climactic) trend reversal where everyone who wanted to buy, has already bought, meaning there are few if any further buyers to push price higher.

Let’s continue to watch this development and how these interesting potential reversal patterns might play out with such solid support beneath price at the $80 level.

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