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 and market moves in advance with a very high degree of accuracy. This is the only way to attain low-risk and high-reward entries into market (trading) positions. Whether you are a short term trader for income or a longer term trader for wealth, 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 desires better returns. Most of the time, they are not necessarily losing money but they are not making money or not making enough money, and desire more. 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 plan and the importance of following that plan. The other half says they do have a plan and for the most part, follow it much of the time. 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, there is a rule or two that is 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 of this piece.
Before we discuss this rule and its importance, let’s first turn our attention back to market turning points. Where are market turning points and where do market moves originate? 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.” They then describe supply which is “Rally – Base – Drop.” These are the two pictures that clearly show price levels where demand and supply are out of balance 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 as 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 and they need to. Quantifying exactly what “demand” (or supply) is to you and your plan is a key component to a trading plan that helps you have an edge over other trading plans that don’t. To explain this further and dive into the details, let’s look at an options trade I recently took and shared with some XLT students.
The chart above is a weekly chart of General Motors (GM). In the upper left portion of the chart, we identified an XLT supply level. As you can see, it is a large time frame rally – base – decline, the base is in between the two black supply lines which create our supply zone. 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. The initial profit zone in this case is the distance between the two black circles (supply and demand). The presence of a significant profit zone is key for two reasons. The first is that it helps quantify the risk and reward. Second, the larger the profit zone, the higher the probability. This is because a big profit zone means price is far from equilibrium and out at price levels where the demand and supply imbalance is greatest. Compare the size of the supply base area between the two black supply lines with the distance to the demand below. The distance between the two black lines is the distance from our entry point to our protective stop loss price. We sell short at the supply zone and place our stop above the supply zone. This helps measure our risk. The distance from the supply zone to the demand below represents our potential profit zone. The logic is that if price was able to fall that far, this means there is no significant demand until the demand level below or lower. Back to our rule…
Rule: A supply level only becomes a supply level if the distance from the supply level to the demand is at least three times the supply level (1:3 Risk/Reward). Meaning, if the distance from entry to stop is two points in a market, the profit zone must offer at least six points or it does not qualify as a supply level for me. I will typically ignore any levels that don’t meet this minimum requirement.
While I require a 1:3 as a minimum requirement to actually meet the definition of a quality level, it may be different for you. You may require 1:4 or whatever. One of the most important factors for this successful trade was the profit zone and the length and speed of price to and from those levels. This is a rule many market speculators fail to consider.
Many people talk about supply and demand when trading and writing trading plans. Few actually define what supply and demand levels are exactly. 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. If you have any questions or comments, feel free to email anytime.
Hope this was helpful, have a great day.