Online Trading Academy Lessons from the Pros 06/26/06: Ask the Editor

Ask the Expert!
June 26, 2006

Hi Mike,

Question: What do you use to determine if you are going to trade on the long, short side or not to trade now? Do you use the S&P, $VIX, Dow??

How do you make sure that you're not trading against the market, the trend?.. for example right now, we are way oversold according to the news, and with the dow dropping so much, what do you use to help you determine if it's going to keep on dropping or if it's ready to change to the long side?

The reason that I have this question is because I have noticed that even if you use the Linear regressions, the support and resistance, Moving avg, stoch, RSI... and you take a trade to the long side with all these indicators on the oversold and at support, thinking that you have an edge with all these indicators telling you that there is a stronger possibility that the stock is going up... then you get surprised that instead of the stock going up, it dropped even more...

Please advise.

Thanks...

John Paul

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Welcome to trading, John,

There is no way that you will ever "know" - we discussed this at great length. No indicator, certainly no newscaster, nor any index will "tell" you when to buy or sell. All you can do is have tight stops and be willing to reverse your mind – you cannot call the market with things that have already happened.

There are 12 situations minimally:

1.) The market is trending up
2.) The market was trending up and is about to reverse
3.) The market is trending down
4.) The market was trending down but is about to reverse
5.) The market is trapped in a range
6.) The market was trapped in a range and is about to break out (up or down)

That is 6 scenarios – then you multiply that by 2 actions –

1.) Open the Trade
2.) Do Not Open the Trade

Total of 12 choices. Our job is to determine through observation as to when one scenario is in place or is changing to another scenario. The indications will help but not tell when. For instance, in a downtrend, all indication shows over sold and any hint of "up" will cause Stochastics, MACD, etc to twitch up. You can gamble, or wait for confirmation, or stay out.

The Gamble – Place 100 shares (or less) and see what happens. You need a very tight stop loss, just beyond the ATR for the period traded.

The confirmation - Open only after seeing definition applied - a series of higher lows and higher highs with decent volume AND the Stoch/MACD or Linear Regression in harmony as an example

Stay out – you cannot lose money. People see "Not Opening" as wishy-washy – it is not. It should be a concerted decision based on your state of mind, the actions of the market and the probability of success.

I know this is not the clear, concise answer you wanted but then there is no clear concise answer. If there was, there would be no market. Test carefully a plan of action, repeat until you are certain the plan is not working. Do not take the time and effort to create a plan of action and only try it once or twice. Conversely, do not "pay" too much to find out.

For "my" vision, I watch a stock that is highly correlated with the S&P Futures, VIX, Volume, simple Support & Resistance and trend lines. I rarely use technical indication.

Hope to Help,

Mike
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Hi Mike,

Do you think that is a good thing to be watching the financial news through out the day? Does it really matter if you're on top of the news to help you make better trades?

Or is watching what the S&P support and resistance, $VIX and the simple Support and resistance on the stock your trading enough?

What do you personally do? What do you recommend for me to do? I work from home now so I have access to the news all day.

Thanks.

John Paul
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Hi John:

As I mentioned last note, no retail newscaster is going to tell you what will happen – they only report what Has happened and often not too timely. It is possible to buy wholesale news but the event still has "happened" and the market is already eating it up. While it is satisfying to know "why" price went up or down, it is not important.

What is important is to see price move. People will repeat behaviors – when they are scared, they sell, when they are brave, they buy. The news tells us "why" they WERE afraid or brave – it does NOT tell when it will happen again.

So, we use news as cleverly as we can, but ultimately, the people will be afraid - or brave - to the approximate level they were afraid or brave to last time – this then sets Pivot levels ( not the calculated ones but the emotional ones :>) Going through those levels has a lower probability than their relative strength. So, we look to buy when the sell off weakens – we look to sell when the greed starts to fade. This can be seen through volume, momentum and time of day.

So, you ask the same question – what does "Mike" do – I will tell you, but it will not help "John Paul". It may suggest hints. but you have to learn to "see" on your own. Stop looking for an "answer" and start spending your time looking at the market overall and the price action of the instrument you are trading. There is a relationship, although it slowly changes.

From your comments, I assume you have moved from options to equities.

It does not matter to me to have the news on all day – I do have Bloomberg TV on while I trade but I keep the volume down very low. When I hear a "buzz" word that relates to my plan/stock, I will glance or turn up the volume but really it is for courage, not decision. I do not "watch it" – it keeps me company and provides a little insight.

As noted before, my typical trade plan is to look at the recent highs and lows and use them as S&R lines. Much of what we did from Fall to Feb was to try to determine a "map" , a "field of play". Once we understand the logical boundaries, we then lay out a plan – any plan is better than no plan. I told you what I use but here is a simple layout.

As an example – our stock is trading at $50 dollars. It has an average daily trading range (ADR) of $5. This would be a volatile 10% mover and not recommended – I am just using this for the sake of round numbers.

So scenario 1 is to open at $50 and move to $55 – strong market and well correlated

scenario 2 is to open at $50 and drop to $45 – weak market and well correlated

scenario 3 is to open at $50 and move to $52.50 and then down to $47.50 or vice versa – inside market and well correlated or volatile market and instrument is not well correlated.

With this "field" in mind, we know the probable highs and lows ( 55-45), we know likely resistance and support ( 52.50 and 47.50), we know that round numbers and halves are always natural S&R’s -so the playing field looks like this:

R10 = 55**
R9 = 54.50
R8= 54
R7=53.50
R6= 53
R5 = 52.50**
R4= 52
R3= 51.50
R2= 51
R1 = 50.50
Current Price = 50
S1= 49.50
S2 = 49
S3 = 48.50
S4 = 48
S5= 47.50**
S6 = 47
S7= 46.50
S8 = 46
S9= 45.50
S10 = 45**

So the breaking of any given level is an entry, the next level, in trend, is the partial target, with "**" being "key" prices based on the 3 scenarios.

As an example trade plan:

Go Long if price beaks above R1
Initial stop is 15 cents below R1 ( 50.35 or approx 1/3 of next goal)
1st goal is R2 = take 50% ( or perhaps 25% or 33% depending on size)
2nd goal is R5 – see scenario 3
Trail stop with Average True Range plus 3 cents for period being traded – or 10 EMA or percentage of profit to be protected,etc
Last Goal - R10 or EOD

Go Short if price break below S! (49.65)
Initial Stop is 15 cents above S! ( again, about 1/3 of next goal)
1st goal is S2 = take 50%
2nd goal is S5 – see scenario 3
Trail stop with Average True Range plus 3 cents for period being traded - or 10 EMA or percentage of profit to be protected,etc
Last Goal – S10 or EOD

This is an ADR (average daily range) trade based on an S&R Ladder. There are many other tactics based on price action and technical indication.

Mike

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