Studying Your Risk Taking Ability

Mar 14, 2007: 8:09 AM CST

As posted earlier, to achieve higher rewards (profit), you must take on more risk (uncertainty).

But how do you know how to analyze your risk-taking behavior? In short, it comes from taking risk and writing down your responses – physical (sweating, increased heart rate, shaking, etc) and emotional (doubts, fear, negative thinking, anger, etc). You must collect data to analyze it, yet so many people do not take this step, even though they know they should. How many of you keep a trading journal? How many include a component that includes recording emotional reactivity? Now how many of you don’t keep a journal at all?

When you analyze your risk-taking behavior, consider the following:

  • Your propensity to set a concrete target (price or behavioral) and then take risk incrementally to achieve this goal
  • Your trading strategy and how it relates to your natural personality (conservative? aggressive? passive?)
  • Whether or not you are getting the results you envisioned and whether you are taking steps to correct your course
  • The kinds of chart patterns (or indicators) that naturally attract your attention and what edge these patterns have over time
  • Your internal confidence in yourself, your system (which is larger than pattern recognition), and your abilities to achieve your clear targets
  • Barriers (internal) to achieving the goals you envision and how to overcome them

A wonderful way to analyze your trading performance is to write down and analyze a few key trade set-ups that you can recognize easily and quickly (as they develop in real time), and try to identify where these patterns happen in the chart cycle. Identify the highest high and lowest low on a chart and identify where your trade fits in the cycle.

  • Does your chosen pattern(s) occur at the beginning, middle, or end of a longer-term move?
  • What implications can you imply from this?
  • Are you trying to call the top and the bottom through your pattern?
  • Is the pattern most likely to occur at the bottom, middle, top, or does it occur at all stages?
  • Is there a particular phase of the chart where you personally feel most comfortable taking your trade when you see your pattern?

Obviously, if you are scalping or day-trading, “longer term charts” will be relative (meaning 15 minute charts or daily charts) to your chosen time frame.

Seek the larger picture of your pattern, and once you discover this, use this information to try to place the next trade you take (with this pattern) in the context. When you understand where your pattern occurs in a normal cycle, you can take on more risk because of increased confidence in your pattern – what is left is increased confidence in yourself to TRADE that pattern when you recognize it in real time market action.

It is still important to analyze your patterns, your ability to recognize “your” patterns, psychological responses to identifying these patterns, and barriers that prevent you from entering trades based on these patterns. Questions that help identify your own personal risk-taking behaviors highlight your willingness to take on increased risk, and increased confidence in your identified patterns and your ability to trade these patterns will likely increase your profitability.


Daily Market Analysis – Mar 13, 2007

Mar 13, 2007: 9:10 PM CST

I am trying to keep this site educational in nature, and not inject too much analysis into the blog, but it has been requested that I provide a little more updates on market action. As a disclaimer, please keep in mind I do not offer trading advice – all charts are posted for educational purposes to highlight strategies and areas of possible price movement.

That said, I pray that today’s market action did not shock or surprise you. I hope you did well today shorting the market, or at least had removed most of your long positions prior to today’s action and weren’t tricked by our “ghost rally” on low volume.

Dow Mar 13

I am attaching my Swing Chart to accompany the Candle Chart. Please refer back to my post “Anticipating a New Swing Lower“for a bit more analysis and charts from last year to supplement the market action.

Dow Swing Chart

For reference:

  • Green Line: 20 Period Exponential MA
  • Blue Line: 50 Period EMA
  • Red Line: 200 period Simple MA
  • MACD 3/10 Oscillator (bottom pane)

It is still not safe to invest in the markets (the S&P 500 and Nasdaq are showing similar patterns – I am most familiar with the Dow for analysis).

The momentum is still strongly with the bears and the sellers, and the rally attempt by the bulls on anemic volume was quickly vanquished. The only “magnet” for price on the chart is the rising 200 period moving average which should not only act as support, but will end the “Equal Swing” down which typically occurs after a large standard deviation swing.

Individual charts are showing busted support levels, and before that, they were showing momentum divergences (some for a lengthy period), and leading stocks are rolling over into lower territory.

I have heard some say “we are in a new downtrend.” We are not. We are VERY close to the trend confirmation zone, or the “Sweet Spot” in the Data. It is possible that a “Sweet Spot” trend entry may occur should price take out the most recently formed lower low at Dow 12,030. We would definately entertain the thought of a new downtrend birth should the Dow take out 12,000. Downtrends are much more risky to play than uptrends, and it is generally unwise to establish long-term position trades short an equity index.

Realize that – after the most recent “rally,” – the highest probability trade would have been to enter short after a counter-swing rally (which occurred today) and play for the most recent swing-low for a small target, which formed at Dow 12,030. We achieved most of that high-probability position today. There is a difference between playing for a large target and a small target.

This helps illustrate why playing the market short is so difficult: Fear is a much stronger motivator than greed and prices will fall (and achieve short profit targets) much earlier than their greed counterparts (which gradually grind prices higher). A price swing that may have taken days to unfold in an up-market is achieved almost instantly (within a day) in down market. It has been said “Price takes the escalator up and the elevator down.”

There is danger for shorts if you enter now. Bulls might attempt to test the most recent swing low by entering new long positions. Odds are against them, but they may try to make one last stand at this recent “possible” support area. Realize that the path lower will not be clean and efficient, as people find a hard time believing prices are headed lower and are attempting to find value at these areas. Unfortunately, those attempting to find value here will most likely be more fuel to the fire of continued price declines.

Regardless of how you trade, utilize caution ahead still. Odds favor success at shorting, and the most likely outcome is a continuation of the new swing low we are experiencing currently.

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Rules of the Game and Victory through Manipulating Them

Mar 13, 2007: 9:04 AM CST

Is it possible that market success can be achieved by going against common knowledge and popular ‘rules’ in the market?

We accept as a fact (whether true or not) that 80% or more traders fail after their first six months or year of dedicated trading. Many people attribute this to emotional failure or a variety of other sources. I wanted to add a quick, generalized comment on one possible reason why this is so.

Money flows from those “out of the loop” to those “in the know.” Money flows from the uninformed masses to the informed and experienced minority. The ‘mass’ rushes in at just the wrong time and exits at just the wrong time – when everything feels too comfortable or too painful. Their decisions are made either with ill-informed information, untested strategies, tested strategies that no longer work given current market conditions, or strictly on their emotions (greed or pain tolerance). Those professionals who are on the opposite side of their trades are profiting from their lack of experience.

There are rules to the stock market game and we must know those rules to be successful. Rules might include generalities such as “follow trends,” “let winners run and cut losers short,” “follow strict money management,” etc. Some rules are not meant to be broken, as they create higher probabilities of success, or are timely strategies that have been used by market professionals through the years.

What I am addressing is common knowledge, or common rules of the game. These generally refer to technical analysis, such as enter a trade at a retracement to a moving average, enter a trade at a test of a trendline, exit at the break of a trendline. I refer to things that “should” work and feel comfortable to execute.

“Fading the crowd” and “playing against the prevailing opinion” is extremely difficult, and is something I am struggling to learn with consistency and comfortability, because taking these actions are psychologically unsettling. Selling when everyone wants to buy creates strong internal resistance, and it becomes so easy to go along with rising prices and join the crowd and ride the market to higher levels and riches.

But it doesn’t work that way. How many times have these events happened to you?

  • You can’t stand it any longer and so you buy, yet moments after you buy, the market reverses and you are sitting on losses
  • You can’t stand these losses any longer, and so you sell out, only to see the market stall and reverse upwards
  • You study and find a great opportunity, yet the next morning, the stock gapped up in your favor, and you cannot compel yourself to buy now at higher prices
  • You see a trade you like and you enter, place your stop at the proper place, then get stopped out, only for the market to violently rally in your intended direction afterwards
  • Hear that a company has excellent earnings or news and the stock will rise quickly, you enter, yet the stock plummets on great news

There are many experiences which are frustrating in the market and there is no way to avoid them. But professionals not only avoid them more than novices, but they seek out such moments and enter trades where your stop-loss is being triggered, and are shorting the stock to you when you “just can’t wait” to get in.

“That’s not fair!” you say, and maybe it isn’t. But remember (especially in the futures and options market), every dollar you lose is a dollar gained by someone else, and the vast majority of traders lose while the small minority of traders win.

This concept is very difficult to understand, but allow me to attempt a explanation that makes sense to me.

I loved watching ABC’s The Mole, a reality TV show with great psychological concepts dealing with game theory and misdirection of information. The premise – and rules – are simple:

  • 10 (or more) players must work together to complete challenges that require teamwork and win money for the group pot
  • A mole – an insider – is hired by the producers to sabotage the team and work against them to keep them from winning money
  • Players who cannot identify the Mole on weekly quizzes are eliminated
  • The winner correctly identifies the Mole on the final quiz and collects the entire money earned

While it seems simple, consider the game if these rules were applied exactly as stated (much like rules are applied exactly in the stock market)

  • All the 9 players would cooperate with each other and win money by completing each challenge successfully
  • The Mole would openly sabotage the game and everyone would know who the Mole was

So how do you win the game? Or what strategy do you use (as a player) to win?

  • Successful players must draw suspicion to themselves, and behave like the Mole by losing challenges (as they are not supposed to do)
  • Successful Moles must gain trust and win challenges (which they are not supposed to do), and behave like players
  • Players who win challenges and cooperate excessively (as they are supposed to do) are never suspected for being the Mole and are deceived by “pretending” Moles.
  • Typically, the game winner is the person who drew the most suspicion and many players strongly believed he/she was the mole

Back to the stock market.

We are told certain ‘truths’ about the market and develop certain strategies that make sense. However, there are professionals in the market which are doing the opposite of what is expected, and the opposite of what is taught in “classic technical analysis books” and fading the crowd and collective knowledge and making big money while the crowd loses it to them.

There are so many “headfakes” and false moves that are designed to draw in retail traders while professionals either establish positions or unwind them. Because “big money” needs liquidity to enter and exit positions, they attempt to create situations that draw in unsophisticated traders and play against them. Also, if every trader were successful, there would be no inefficienies the market to exploit, and this would decrease the profits of the “big money” and they certainly would not allow this willingly.

I will be developing this idea in further posts and discussing potential strategies to take advantage and put yourself on the right side of the trade with confidence.


Momentum Precedes Price #2: Momentum Divergences

Mar 11, 2007: 4:03 PM CST

Momentum can also be a leading indicator when divergences between price and momentum arise and can lead to some profitable, high probability trades.

Please understand that the set-ups I am about to discuss are countertrend tactics, and as such, you must employ a hard stop in the event that the trend reasserts itself and you are on the wrong side. Contrast this tactic with the principle: “Trends have a higher probability of continuation than reversal.”

When you play for a momentum divergence trade, you are always playing for a small target and playing for a possible shift in buying/selling pressure. You can find various other sites that describe the concept of divergences with various indicators, and before attempting any such trade, I suggest researching further on this potentially profitable topic.

Some of the most popular indicators for uncovering price divergences include the MACD, stochastic, RSI, Ultimate Oscillator, momentum, rate of change, price oscillator, etc. You have to discover which indicator works best for you. Indicators are used as ‘training wheels’ until you can develop an intuitive sense of determining where the buying and selling pressure (momentum of the move) are diverging with the price action. This process takes time, yet indicators can help highlight these conditions. There is no perfect indicator to do this. I am using a fast MACD oscillator in my chart examples. I also play divergences in the RSI oscillator.

In this sense, momentum precedes price in that a slowing of momentum indicates that a possible change in price is yet to come. Do not get caught in the trap of searching for momentum divergences all over the chart. Examine them at the (possible) end of mature trends for greater probability. Again, we are not seeking the end of a trend move (reversal), but just a retest and a small target. In fact, we are playing for a simple retracement swing against the direction of the prevailing trend. This illustration may help:

The top pane always shows price. In this case, we are in a mature uptrend and price is continuing higher. A situation develops where the buyers are becoming less aggressive in their momentum (force of buying pressure) and momentum is declining while price is not.

Of importance to note (and the reason behind the divergence in the oscillator) is also price based. Note the steep rise of the previous swing up (creating heightened oscillator/indicator readings) and then the more gradual rise of the second swing up (creating a lower peak in the mathematical oscillator). This sets up the divergence while the reason for it is declining momentum.

If momentum precedes price, then in this case, a decline in momentum forecasts a decline in price as the most probable swing play. If buyers are less aggressive to raise their offers, then it won’t take much effort for price to fall and those who own the stock will begin to sell.

Here are some charts which highlight momentum divergences:


Ebay 2006 Daily Chart

GOOG 15m Divergence

Divergences are difficult to quantify for a mechanical system, so this is one area discretionary traders may have an edge over programmers.

Chart #1: EBAY Daily (end of 2006). With momentum (buying pressure) decreasing, a countertrend divergence trade sets up to test the most recent swing low. Target achieved.

Chart #2: EBAY 60 min chart (October 2006). Buying pressure (momentum) is declining and we can play for a small target with a tight stop.

Chart #3: GOOG 15 min chart (March 2-6, 2007). After declining for a few days, a four-point touch divergence develops in the oscillator and a flatline base forms (this is where experience over oscillators triumphs – the decline in selling momentum is best picked up by the oscillator, yet the basing area is easy to spot on the chart). Even though price continued above our target, the divergence play is only good for a small target. Note the new momentum high and reaction against it on this 15 minute chart.

I did want to highlight another point through the use of various time-frames. Divergences and momentum concepts are valid across all timeframes.

There are a few caveats to be aware when identifying momentum divergence plays:

  • Momentum divergences are invalidated (and nonexistent) in rangebound, consolidating markets
  • Only look for momentum divergences in the context of a mature trend (however short the time-frame)
  • Momentum divergences work best after a “three-impulse” pattern in a trend
  • Momentum divergences can be used in conjunction with Bollinger Bands or Keltner Channels (for increased probability)
  • Momentum divergences are to be played for a SMALL target (price correction) and NOT for a reversal in trend direction
  • The best divergences resemble “double-top” or “double-bottom” chart patterns
  • Keep a tight stop in the market close to entry in the event that the strong trend reasserts itself and causes great losses.
  • Exit divergence trades which do not resolve within 15 bars (create a time stop parameter)

Trading momentum divergences is a complex strategy and should only be attempted after repeated exposure and internalization of the price behavior that sets up the pattern.


Momentum Precedes Price Chart Examples

Mar 11, 2007: 1:06 PM CST

I wanted to include a post that highlighted examples of the market principle: “Momentum Precedes Price”. It has been suggested that this principle be restated “Increases in momentum imply price will continue in the same direction of the momentum.”

I do not refer to the indicator “momentum” in this sense, but rather pure price action. A better word might be “impulse” which implies temporary, yet significant imbalance between supply and demand. Price moves in waves and when one wave is significant in scope, it is expected that the imbalance will continue to play out in the direction of the original disturbance of balance.

Nelson Elliot (of Elliot Wave Theory fame) coined the term “impulse” to describe marked increases in momentum and noted that following an impulse wave, there tends to be (at least) three pushes up in the trend direction (with two corrective waves). While I am not an Elliot Wave theorist, the idea behind his concept is applicable.

In the first few examples, the trade I’ve found that works best is the following:

After identifying a new momentum high AND a new price high (confirmation), look to ENTER the market on the first REACTION against the price high and play for a small target: the most recent price swing high (or just beyond). Your stop is placed a tight distance below entry, which usually corresponds with a moving average or prior swing low.

This drawing may help clearly see the pattern I am trying to convey. I call this the “Impulse Buy“.


Caterpillar. Weekly chart.

Point 1: Following a short consolidation period, we see a quick thrust of price upwards, creating our initial “impulse” condition. Our bottom panel indicator prints a higher high along with price. We look to enter the trade on the first reaction against this initial impulse. Your entry depends on your risk tolerance: aggressively would have entered at the moving average ($23 – green bars) while conservatively would have waited for price to turn-up (the yellow bars – also $23). Price “shook out” below the moving average in this case.

Stop placement is also dependent upon risk tolerance. Overly conservative may have placed stop just below moving average (and would have been stopped out) while overly aggressive would have placed stop below most recent swing low at $18.

If we look simply at price bars, notice the large expansive bars that occur upwards – range expansion also indicates an ‘impulse’ or momentum move may be underway.

The target is the most recent swing high (or just beyond) which formed just below $26.

Chart point #2 indicates our target which has been achieved. After a new price and momentum high, new price highs are likely yet to come.

Here are some other examples, but fewer comments. The play is the same. Identify impulse (range expansion or new momentum high), wait for pullback, play for the most recent swing high. Exit.

Some observations: The charts are purposely simplified to highlight the impulse and momentum conditions, and it would be wise to look at larger charts to see these moves and add volume analysis.


A) DIA Weekly Jan 2005: Impulse and two-bar range expansion out of consolidation. Entry: $104. Target: $108.
B) GOOG Daily Sept 2006: Gaps helped serve as initial impulse, along with momentum readings, consolidation, and then retest (and beyond) recent swing high
C) CTSH Daily Aug 2004: Gap and two-bar expansion (along with momentum reading) serve as initial trigger. Target of recent swing high achieved.

The idea behind these patterns is that an initial impulse move will result in a corrective reaction against this move (to shake out the weak hands), yet price will reassert itself (temporarily) in the direction of the impulse and retest (or exceed) the most recent high.

For me, I have found more success in these patterns when I play simply for the retest only. If you get greedy and expect a new swing higher, you may be disappointed. It is best to enter your position, enter a hard stop, and enter a hard profit target. This keeps emotions at bay at trade entry, trade development, and trade exit.

The type of trade discussed here is a cross between a “trend retracement entry” and a “retest” entry, so be aware of the distinction and how they overlap.

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