So often in the trading world, I hear people talk about where price is likely to turn next, where is the next key supply or demand level, where is the next big market move going to originate from, and so on. The question I hardly ever hear anyone asking is, “where is the next big profit margin (zone)?” This is one of if not the most important things to consider when speculating in markets.
The profit margin is the distance in price between the entry point and the profit target price. Another way to say that is the distance between demand and supply. When looking for trading opportunities, people tend to focus on where the next big turn in price will happen. As I often write about, these turns happen at price levels where supply and demand is out of balance. When looking at charts, you will find that there are many supply and demand levels. By no means are we interested in taking trading opportunities at all the levels we find. In fact, when considering profit margin into the filtering mix, we would ignore most of the supply and demand levels we find and narrow our focus down to the supply and demand levels that have large profit margins associated with them.
To explain the concept of profit margin and its importance in trading, let’s take a look at a trade from the Extended Learning Track (XLT), the graduate level program at Online Trading Academy. Here we are looking at a small time frame chart of the QQQ (NASDAQ). Notice the supply level above. This is where we expected there to be more willing supply than demand. The strategy tells us that banks and institutions are selling NASDAQ at that level. The origin of the gap below is where there is likely to be demand. The circled area on the chart is the “profit zone” which is basically the distance from the supply level to the demand level. Notice in that circled area, all we have is open space with no trades. In other words, there are no supply or demand levels to stop price from moving through that area. The trading opportunity was to sell short at the supply level above and profit from a move down through that circled area to the demand level below.
The key element here is to identify where the demand and supply is, then look at current price, and finally determine the “path of least resistance” as that is where the next move in price is likely to go. Meaning, price is likely to have a relatively easy time moving through that circled area, the profit margin. Keep in mind a VERY important point here: I am coming to all these conclusions BEFORE I enter the trade. You must perform your analysis in advance and make your decisions before it’s time to push the button or this will never work. This is exactly what we did in the XLT that morning, before the market opened.
As I mentioned earlier, there are many supply and demand levels on a chart and many large and small profit margins. The key for the astute trader is to be able to identify objective supply and demand levels. Then and only then will you be able to find supply and demand levels that have huge profit margins associated with them. What I do is ignore most supply and demand levels on a chart and only focus on the ones that have a great distance (huge profit margin) between them. This does two things. First, it obviously offers an attractive risk /reward opportunity. Second and just as important, the larger the profit margin, the greater the probability of the trade working out. This is because when you have a big profit margin, by definition your supply and demand levels are far out on the supply and demand curve. Entering your trades at market price extremes increases the probability of success.
To better understand the concept of profit margin in trading, think of profit margins in any other business. Think of how companies who sell products determine what to sell. Most of the decision if not all of it comes down to profit margin. Think about companies who produce products and how they decide what to produce. Most if not all of that decision comes down to profit margin. The decision on which trading opportunities to put your hard earned money at risk on is absolutely no different and in fact, we chart profit margin the same way as any successful company would.
Hope this was helpful. Have a great day.