Kirk Report – Winning Trader’s Edge Comments

Mar 5, 2007: 11:23 PM CST

Kirk at The Kirk Report summarized ten steps to a trading edge from George Fontallis (author of The Stock Market Course and The Options Course) and – while I will not list all ten (visit his site!), I wanted to expand on a few of them that are pertinent to trading psychology.

1. Understand the psychology of the trade: never believe you are smarter than the markets as the markets will always win.

I was glad to see this as rule #1! Every trade you enter MUST have a guiding purpose based on a valid market principle/observation you have tested, and that you understand. It is often wise to step back before entering a trade and know not only the reasons for entry, but the logic on your side of the trade AND the logic or emotions of the trader(s) on the other side of your trade.

Realize that when you enter a position, someone is giving their shares to you (or taking the opposite side of your trade. Do you think they do so with anticipation of losing money? No, they are betting on the opposite result that you are anticipating (this is true for short-term trades – not for investments). I like to describe it as the “Western Cowboy Theory” which envisions two gunmen at a duel with guns pointed at each other, betting on a specific outcome with high stakes on the line. One will win; one will lose.

Now envision you are a fade trader and there is a clear channel or range in price occurring. When the market reaches the upper edge of the channel, you enter short, playing for a retest of the bottom of the channel. At the exact same time, another trader (or group of traders) are entering early, anticipating a breakout of the range. Price has reached a “technical decision node” and will either break-out, or fail and (likely) fall back down to the bottom of the range. Either way, one of you will lose and the other will win. Odds and probability help place you on the right side… but the MARKET ultimately determines which side will win or lose (and shockingly it is not always the side which has the odds in their favor….)

2. Acquire the knowledge on how the markets truly work then test and retest your ideas and concepts until you feel confident.

This is big on my list and has helped me in my developing career. Knowledge is critical for success in the game. Period. Knowledge can be gained from books, articles, blogs, websites, etc OR it can be gained from personal trading experience. The two kinds of knowledge are distinct and critically different. You must apply the knowledge you have learned or it is worthless; also, you must obtain knowledge before attempting to trade or else it is likely you will suffer sustained and large losses early.

Knowledge is not enough. Markets change character as the masses ‘catch on’ and close inefficiencies. Volatility cycles. Trend dynamics change. Economic factors become more or less important depending on where we are in the business cycle. Classic chart patterns which worked for a while are popularized and their odds for success diminish.

There are certain timeless concepts in the market (such as “cut losers short and let winners run”), yet the exact application of these concepts through strategies varies as the years progress. The market does change character. There is no magic indicator, formula, or mechanical system. There never will be. All we can do is quantify what works and abandon what does not. This can lead to endless frustration… or excitement due to the thrill of the challenge of trying to solve an engaging puzzle which has many shifting solutions.

8. Integrate fundamental, technical, and sentiment analysis into a real world trading approach that enables you to best understand market performance.

I could speak for hours for this point, but suffice it to say that the best longer term trades (and even short-term trades) develop from a correct reading of economic conditions, place in the economic/business/market cycle, and a fundamental “story” develops. From this ’story,’ technical decisions (entry points, stop-loss points, and possible profit targets) arise which fine-tune entry into a rising stock or sector in a rising/expanding economy. Finally, sentiment indicators (over optimism or over pessimism/fear) help warn of possible turning points in the market. It may seem counterintuitive, but when everyone is bullish, prices WILL fall (and sometimes will fall hard). Also, when everyone is selling their shares and cursing the stock market, prices WILL rise. Learn to read possible extremes in sentiment. A proper trading strategy that works long-term certainly is difficult to develop, yet it will contain elements from these three approaches to market analysis.

Of all these, perhaps reading market psychology is the only one which is stood the test of time (in that mass euphoria leads to market tops and vice versa). Unified continuation of thought can carry price far beyond any proper fundamental valuations (or far below fair market value at capitulation bottoms) and beyond any technical indicator can read.

9. Specialize in one sector and one strategy at a time.

Remember, you are developing and you have your whole life ahead of you. Don’t try to do it all at once; you’ll get overwhelmed. Remember the acronym K.I.S.S. and “keep it simple.” This keeps psychological stress and frustration to a minimum and prevents you from being overwhelmed by the vast amount of information out there.

10. Give yourself the winner’s edge by always continuing to actively pursue the learning process.

The final point echoes earlier point about education, application, and constant exposure to the market. There are few successful passive traders (yet there are various passive investors). As a trader, you must be active and honing your edge. There are no shortcuts and there is no easy way to do it. Passion, love of the game, and a constant desire to learn more both about yourself and the market will keep you through the rough times and in this game for the long haul.

Thanks to Kirk for bringing out these helpful observations from George Fontallis!

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Recent Dow Momentum Divergence Resolved

Mar 5, 2007: 10:29 PM CST

Did the most recent stock market decline come as a surprise to you?

My guess is yes, and to be honest, its violence and rapidness came as a surprise to me – but I had been sensing things just weren’t right with the market for some time. Unfortunately, this intuition kept me sidelines and missing out on profits to be realized to the long-side as I kept anticipating a market correction (never to the magnitude we’ve just experienced, and not so quickly) but I did want to point out the reason for my skepticism (other than my natural skepticism).

I follow momentum indicators and typically try to play short gains when I (think) I spot a momentum divergence forming. I actually tried playing some of the recent index divergences to the short side, only to be stopped out and frustrated when the market would reverse. I kept focusing on the intraday frames recently as the market kept rallying then countertrending/correcting then rallying, all in a creeping, oozing trend. Also note the trend-trading tactics which could have been employed as the market retraced frequently back to the rising 20 period moving average (these served as new entry points).

I did want to point out something interesting I just noticed with the recent action. First, let me point out the gross momentum divergence that was appearing in almost any oscillator indicator you use. I am using StockChart’s graph and showing RSI (at the top) and MACD (bottom). Note the divergent direction of the indicators with the (creeping) upwards price action.

Please pardon all the lines I’ve annotated, as I’m sure you can see the building divergences yourself, but I wanted to highlight the swing highs in price and their relation with the two momentum indicators.

Imagine the momentum divergences as a coiled spring. The longer they go unresolved, the sharper (harder) the resolution (release of pressure) will be when pressure is released. Typical divergences resolve after a simple two point occurrence (between two swing highs) yet this continued longer than I anticipated.

I had been out of the market for longer term trades since the beginning of this year in anticipation of the release of the three-point divergence I observed, which carried over for an additional two months before the final resolution recently. My family and friends kept yelling at me for “missing opportunities and leaving money on the table!” I couldn’t properly explain that something was wrong with the market – it was a gut thing. The market wasn’t “swinging” (retracing/correcting) as it should be. Typical swings and volitility were contracting too much for my comfort. Typically, expansion occurs after volatility contraction, and we just experienced that in a big way (as fear/panic drive stock prices lower faster than greed drives them higher).

What was shocking to me – and will lead me to examine more market data – is that the price corrected the divergence exactly (and now beyond) where the divergence initially began – in this case around 12,100 on on the Dow (late October, 2006). This piques my interest and I will begin examining whether divergence targets test out to resolve back to the initial point of divergence. I hope to have this analysis in the next few weeks.

In the meantime, play it safe out there, enjoy the recent bout of volatility we are experiencing, and show courage in the face of this newly awakened market.

(Note: The same momentum divergences can be observed on the S&P 500 and the NASDAQ).

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Short Scalp Trade Today – QQQQ: Momentum Divergence

Mar 5, 2007: 9:28 PM CST

I am not in the habit of posting trades I have taken, but I will be posting trades that highlight general principles, or high probability trades (whether they worked or didn’t work for me). I will be posting more about my style, which is between scalping and day-trading for small profits and taking only high-probability, tested set-ups that fit my style and (conservative) risk tolerance.

I did want to highlight a momentum divergence set-up (scalp) I took today in the QQQQ’s. First of all, I suspected the market action to be weak today and was surprised by the gap-fade up in the morning (well, surprised isn’t the operative word – the first play following a gap is to fade the gap back to the open price and then the second play is to play the direction of the gap after it has been closed). The market overshot its gap close and I was looking to short the market today and was having difficulty finding a set-up to do so. I decided to enter a small “probe” position when I saw what I suspected to be a “double top” combined with a possible momentum divergence (will be discussing in a later post) AND pivot level resistance (R1). I decided there would be a very strong probability of lower prices. Attached is the chart moved back to the entry time:

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Logic: Momentum Divergence, Stochastic Sell, Resistance at R1 Pivot

Entry: Short as close to $42.70 as possible (filled at $42.65).

Stop: Above most recent swing high and resistance at $42.75 to $42.80 (depending on how risk-tolerant you are).

Target: Most recent swing low at $43.40 (this is the highest probability small target)

(Chart facts: March 5th, 10:30 central, 5 minute chart, TradeStation).

Remember the highest probability arises from playing the market one swing at a time.

Risk/Reward: 5 cents or 10 cents risk to 30 cents reward (either 1:6 or 1:3, depending on risk tolerance).

The second chart reveals the closing of the trade.

The divergence occurs with the momentum oscillator at the bottom of the chart. As price swings up to retest the most current swing high ($42.70), the oscillator clearly makes a lower high, signaling “Loss of momentum.”

Remember, Momentum Precedes Price. You could have entered this trade on this axiom alone, yet the confirmation zones strengthen your probabilities and your confidence going in to the trade.

Trading is about putting the odds in your favor and playing for small, frequent gains. Even though this may not be an ‘exciting’ set-up, it puts the edge in your favor through multiple points of confirmation.

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We acheived our target of the most recent swing low at $42.40.

Trade closed for $0.30 profit (actually, 24 cents for me I covered and was filled at my profit target limit at $42.41). That “scalp” lasted about 40 minutes.

This highlights mainly how I trade. I apply support/resistance parameters, swing highs and lows, and momentum divergences that provide clear profit and stop-loss targets. I play for small targets and manage my risk carefully (actually, probably too carefully).

I might make two or three high probability “day trades” (I consider them scalps) per day and usually trade either futures (for a bit more leverage) or the index ETFs themselves (DIA, QQQQ, or SPY). I follow the TICK, TRIN, and Breadth, but they usually support my decision-making, rather than trigger trades.

For the sake of trivia, the QQQQ ran a little lower than my target, set up a nice momentum buy divergence, then played out the buy divergence to the upside as expected before rolling over to close at $42.16. I saw the divergence but decided to pass because of the overall weakness of the last few days.

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To Over-Conservative Traders – Comments from a Master

Mar 5, 2007: 9:44 AM CST

In his book Technical Analysis and Stock Market Profits, Richard Schabacker – also known as “The Father of Technical Analysis” – wrote parting comments to naturally conservative or risk averse investors that I wanted to share. Keep in mind, these words were written in the 1920s.

He states that most market students need words of restraint, rather than encouragement to action. Traders who are over-cautious are in the minority, but, as Schabacker states, “this class also makes the most consistent success in technical chart trading.”

“The student who has the innate character most favorable to profitable chart trading is … naturally conservative and skeptical… towards all chart rules, and will therefore fear to trade where others will rush in blindly and overconfidently to their ultimate loss.”

“Though those of careful and skeptical temperament are clearly in the minority, they are the successful majority.”

“Although the conservative student will err on that side of his nature, he may – for that reason – be more successful in the long run. However, he must guard against over-conservatism and excessive doubt and timidity. The chief stumbling block for this group is hesitation.”

In describing a typical pattern, the trader properly reasons the market and patterns clearly, then he weighs the opposite possibilities too carefully and decides to wait for confirmation. When the confirmation arises, the movement gets away from him and the more he procrastinates, the more hesitant he becomes, the more psychologically uncertain he becomes, and the less likely he is to profit from his correct initial analysis.

“The result of his procrastination is not only a possible psychological upset, but the tendency resolves itself either in frustration or rushing in without careful analysis and entering at the time the proper move which was forecast is now ending, or about to reverse itself.”

To the over-conservative trader, “his aim should be to give direct and prompt expression to the dictates of his study and analysis, once they have led him to a sound conclusion.”

Over-conservative traders will find comfort in stop-losses. “By using stop-loss orders as protection whenever he fears an upsetting of a conscientious analysis, he may venture definite action on his conviction, with the serenity that comes from knowing exactly how much it is possible to lose in case the market does indeed move unexpectedly in opposition to analytical conclusions.”

Finally, “Conservatism in moderate doses is a critical characteristic for market success, but conservatism may be carried to profitless extremes just as easy as radicalism. A healthy mingling of decisiveness and conservatism is the ideal mixture for the successful trader, as for most other careers as well.”

Indeed I still find comfort in those words and can show countless examples in my own life where I would study charts and news endlessly, decide on potential trade candidates, and when I would open my order entry screen, be scared away by pointless second-by-second ticks. Either the price would decline and I would pass altogether and pat myself on the back, or the market would move (or have gapped) in my favor and I would say “Well, I missed that one. It’s time to do more analysis for the next one.” When the “next one” came, I would engage in the same self-defeating head-games.

Stop losses are a comfort, and are essential, but if you place your stops too close to your entry (or too close to support/resistance), then natural market action will take you out for a frustrating loss and that cycle continues the fear cycle you are trying so hard to overcome. Then the next time, you will likely be more hesitant and might pass on the trade simply because of insignificant reasons you searched for to ease your mind.

Although you might find comfort in the quote “…conservative traders have the most success long term…” realize that you must guard against over-conservatism. A healthy dose of skepticism in market action is fine, yet when experienced in large doses, it keeps you frozen in the present with a trading account staying constantly stagnant. While traders certainly want to avoid their trading account heading to zero from overtrading, we also want to avoid an account staying bogged down from chronic undertrading.

(Quotes come from “Trading Tactics,” Chapter XII, – P. 417)

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The “Sweet Spot” in the Data: Trend Beginnings and Playing for Large Targets

Mar 4, 2007: 5:05 PM CST

Would you like to know the true, statistically tested spot of a new trend in development? Is this the secret to riches?!

No, there is no secret, unfortunately, but with this objective model of quantifying trend birth, you’ll be more “in the know” than those who miss this key “Sweet Spot” in the market structure.

We know that trends have higher odds for continuation than reversal, and that it takes considerable power and money to shift a trend, but is it possible to spot the EXACT price that a trend changes? Studies have identified a sweet spot where odds are highest for a confirmed trend change, stops (if incorrect) are closest to the zone, AND profit potential is substantially higher than your risk target. This truly is a rare find but it can lead to high profits, if you are patient enough to identify these spots and hold your position with leverage (or higher than normal) position size.

While this may be intuitive to some, it was a major revelation for me. We know that uptrends are characterized by Higher Highs and Higher Lows on a swing chart (don’t try to be exact, just look for recent swing highs and lows). Downtrends are the opposite (in trend structure). Here are a few questions regarding trends:

  1. If price makes a higher high after a sustained downtrend, is this the signal for a new uptrend? Answer = NO.
  2. If price makes a higher high AND a higher low following a sustained downtrend, is this the signal for a new uptrend? Answer = NOT YET. (Reason = price may continue to roll lower and invalidate the recent higher high and lure you in to buy when really the price is still rolling over in a confirmed downtrend)
  3. If price makes a higher high, then makes a higher low, THEN takes out the most recent higher high, is this a new uptrend? Answer = YES!

Not only is this the statistical trend beginning confirmation zone, but it is a zone for you to establish and hold a core position and utilize swing trading tactics (retracement entries) with confidence following this point. It answers the question: “When do I play for a Small or a Large Target?” Finding these areas provide one of the only locations to play for a large target (this is true across any timeframe, for that matter – targets are relative to time-frames).

I am providing a Weekly chart example of Boeing in 2003 as it changed its trend with a technical confirmation pattern (Chart from TradeStation).

Of note, the “Trend Confirmation Point” came just above $36 when price took out the new higher high. Two strategies arise here:

1. Enter at the market at the trend confirmation zone and hold until a price extreme occurs OR price takes out the most recent (new) swing low. The stop would be placed just above $30 – the most recent (higher) swing low.

2. Wait for the market to PULLBACK following this point and then enter with a very tight stop.

Waiting for the pullback is almost always the best strategy as your risk is so low. Price pulled back to $34, which happened to occur as the 20 period and 50 period Moving Averages provided a strong support floor for the trade. It is times like this that you place a larger than average position on and hold for a large target.

Not only are the odds stacked so strongly in your favor, but your risk (stop-loss) is so close to entry that the trade becomes almost irresistible. A conservative stop would be $33.50 while an aggressive (proper, in this case) stop would be $31 (below recent swing low).

Please realize that these “Sweet Spots in the Data” occur on 5-minute charts, 30 minute charts, daily, and weekly charts. You simple identify confirmed turning points in the market.

A question always is: “Why not buy at $26, or the absolute low?” The simple answer is that you cannot do this consistently over various time frames and through hundreds of trades. The risk is too high and odds are strongly stacked against you based on core trend structure. Yes, you will surrender potential profits by waiting for confirmation, but at the point of confirmation, odds are so strong for a successful trade that it creates a strongly positive edge which can be played out over hundreds of trades and new trend confirmation zones.

Never try to be perfect; only try to make money. Making money is done by putting the odds (edge) in your favor consistently and knowing when to get out when simple probability goes against you.

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