In the past few days I’ve received quite a few emails regarding the risk and reward of the recent market volatility. This week, I thought I would write an article on the concept of “Profit Zone,” the biggest opportunity with volatility.
All market speculators share the same goal which is to enjoy consistent low risk profits. To accomplish this goal you must be able to identify market turning points as this is the only way to attain low risk and high reward entries into market (trading) positions. Whether you are a short term day trader or a longer term investor, nothing changes. Identifying key market turning points is the only way to attain the ideal risk/reward opportunity. Leading Extended Learning Track (XLT) sessions for so long, I have come across many people in the program. Occasionally, I receive an email from a member that is not satisfied with their results and desire better returns. Many times they are not losing money, but they are not making money or, most often, not making as much as they’d like. One of my first questions to them has to do with strategy. I ask them, “Do you have a plan and are you following that plan?” Half the time the answer is no; so we dive into creating a proper trading plan and why it is important to follow that plan. The other half says they do have a plan and for the most part follow it. For this group my questions turn to the details of their plan, the strategy, where I look to see if their rules are proper or not. Sometimes a rule or two are incorrect and the student doesn’t know it, so we correct it. In my many years of experience, I have found that most of the time there is one specific and crucial rule that is missing from people’s plans more than any other and that is the focus on this piece, Profit Zones.
Before we discuss the Profit Zone and its importance, let’s first turn our attention back to market turning points. Where are market turning points? Price movement in any and all markets is a function of an ongoing demand and supply equation. Market prices turn at price levels where this simple and straight forward equation is out of balance. Therefore, price in any market turns at price levels where demand and supply are out of balance, which means the strongest turns in price occur at price levels where demand and supply are most out of balance. So, the question for us is this: what exactly does this picture look like on a price chart?
When I ask students this question, they quickly describe the picture of demand that I have shown in articles for years which is a “Drop – Base – Rally” (DBR) or “Rally – Base – Rally” (RBR). They then describe supply which is “Rally – Base – Drop” (RBD) or “Drop – Base – Drop” (DBD). These are the pictures that clearly show price levels where demand and supply are out of balance. The same place where banks are buying and selling which is what we as market speculators are looking for. Next, students go right into their rules for entries, targets and stops and this is where I stop them. They are ignoring perhaps the most crucial rule that should be included in their trading plan. Drop – Base – Rally may be the picture of a price level where demand exceeds supply, a demand level. But, what EXACTLY is a demand level for you and your trading plan? I find that most people don’t quantify this with numbers. Quantifying exactly what “demand” (or supply) is to you and your plan is a key component to a trading plan that gives you an edge over those whose trading plans don’t. We have a number of “Odds Enhancers” at Online Trading Academy which are key to quantifying and identifying real demand and supply. To explain this further and dive into the details of one of the most important Odds Enhancers, let’s look at a recent trading example from our Supply and Demand grid.
NASDAQ Futures – 9/29/2015
The chart above is the Nasdaq Futures. The demand level is a DBR. Just because it represents the pattern/picture we are looking for does not at all mean we have a low risk / high reward trading opportunity. One of the most important questions that comes next is whether there is a significant “profit zone” associated with this demand level or not; and this is the key Odds Enhancer most overlook and sometimes not even considered. The presence of a significant profit zone is key for two reasons. First, it helps quantify the risk and reward. Second, the larger the profit zone, the higher the probability and potential profit. This is because a big profit zone means price is far from equilibrium and out at price levels where the demand and supply imbalances are largest. The distance between the two black lines is the distance from our entry point to our protective stop loss price (risk). We buy at the proximal black demand line and place our stop just below the distal demand line. This helps measure our risk. The distance between our demand and opposing supply represents our potential profit zone or initial profit zone. Notice the strong decline, in the form of big red candles, that takes price down to demand for our buying opportunity at the circled area. That decline “opens up” a profit zone for us as we are willing buyers when price revisits that level, which it did, offering us our long entry. Back to our rule…
Rule: A level only becomes a level if the initial rally from the level is at least three times the level itself (1:3 Risk/Reward). Meaning, if the distance from entry to stop is two points in a market, the initial price move from that level has to be at least six points or it does not qualify as a level at all. I will typically ignore any levels that don’t meet this minimum requirement.
While I require a 1:3 as a minimum requirement for the demand (or supply) level to actually meet the definition of a level, it may be different for you. You may require 1:4 or whatever you’re comfortable with. In this example, the chart was offering more than 1:3 so an ideal target was just less than that. What this suggested was the probability of price hitting the profit target was very likely. This does not mean that the target has to be at the supply level. It simply means that this opportunity is offering me more than what I am looking for and this will increase winning percentage, if that is an important factor for you. Price ended up reaching the target for a low risk and high reward trade. One of the most important factors for this successful trade was the length and speed of the initial rally away from the demand level combined with how price declined back to the level; and this is a rule many market speculators fail to consider. It all comes down to fresh levels and significant profit zones. The key is being able to see this with your eyes and process it in your head.
Many people talk about supply and demand when trading and writing trading plans. Few actually define what supply and demand levels really are. This is another step in building the edge required to get paid from your competition instead of paying them. There are more subtle but important rules to consider but they are beyond the scope of this piece.
Hope this was helpful, have a great day.
Sam Seiden – firstname.lastname@example.org