My last visit to New York proved to be a very fruitful one as I had the opportunity to attend the Trader's Expo, and more importantly, I got a chance to sit down with Bo Yoder from BoYoder.com. I've known of Bo when I first started here at INO, but he took time out and refocused on some top projects that meant a lot to him. He's back now and I'm excited to introduce you to him, his site, and the article below. Please enjoy the article and comment below so you can make Bo feel welcome!
As the markets fight for a bottom, there is a new wave of interest in the world of active trading and self-directed investing. These new traders have so many wonderful tools available to help guide them and accelerate their learning curve. Archives such as those offered by INO.com have all the information needed to build a solid background as a technically focused trader.
However, many beginning traders fail to understand that technical analysis at its root is the science of interpreting order flow. Let's look at one of the most fundamental technical analysis price patterns... the double bottom.
In a double bottom, the market first finds support and bounces after a decline into capitulation. This bullish reversal is exactly what we are currently experiencing on the daily chart of any major market index. The bounce builds momentum, and creates excitement in the investing community. Traders and investors take long positions in a steady cascade of buy orders as their investment strategies trigger.
At some point, the very last strategy will go green, and the very last block of technically driven shares will be taken. For a very brief moment, the market will hover without buyers, then head lower as the inherent selling pressure takes it down towards levels of higher liquidity.
If the market has bottomed in a "V" as it has been doing in the real world recently, the heaviest liquidity pool will be often centered at the lows for the year. The majority of technical traders will have put their stop-loss orders below that level, and this liquidity pool will tend to "suck" price down for a test.
Put yourself in the mindset of the bull at that point... You took a trade according to your investment strategy, and had some nice open profits at the end of the run up. Now, the market has come back down to retest your initial support level, and is trading perilously close to stop-loss orders. If the market has bounced particular violence, it is likely that many traders will have missed the run and be frothing at the mouth to get long on any excuse. As the market retests support, they take this opportunity to buy and this surge of order flow creates the support needed to drive the market higher.
This supply/demand imbalance takes the market cleanly off the lows and forms the "W" pattern which is characteristic of a double bottom. Once the bottom has formed, the market tends to rally back up to the last minor swing high, and another massive constituency will be triggered to go long as that swing high is broken.
The traditional trader, taking entry as that swing high is violated is taking several points in risk for the potential of buying into a major market bottom. While this is a perfectly acceptable trading methodology, and carries solid edge... I can show you how to more than double your profit on this exact same investment opportunity!
For a real world example, let's look at the market action in IBM...
As you can see, a classic double bottom had formed just below the $85 per share area. A traditional trader would be going long at approximately $93 a share. A traditional stop-loss orders set below the lows would put the trades risk and a little more than $10 per share. (For every 100 shares taken, a pattern failure would cost the trader $1000).
In terms of a profit objective, the 200 period simple moving average (blue line) would be a logical place to take profits. Since this level of technical resistance is currently hovering near $100 per share, the trade will yield a little less than one to one if successful. From a mathematical perspective, this is not a very attractive proposition. Even though the pattern is technically perfect, there isn't that much reward for having your market opinion proven correct.
Most beginning (and intermediate for that matter) traders are more focused on profits and profit potential than risk management or loss avoidance. They are more afraid that they will miss out on an investment opportunity, then they are cautious about taking a mathematically disadvantaged trade. They also forget that the market constantly wiggles...
It is that tendency to wiggle that will prove so powerful once you learn to harness it. If we go back to our chart, you can see that the breakout above $93 per share did indeed attract a great deal of bullish attention... but as is often the case, that technically driven order flow was short lived. The market then spent a few days basing sideways, and then fell sharply off a gap open and retested the breakout zone around $93 per share.
And that my friends is the magic entry point...
Let's look at the math...
If entry is taken into areas above chart as well as moving average support around $93 per share, then to my eye the $90 per share area would be logical for stop-loss placement. This puts the risk for the breakout/retests trader at a very manageable three dollars per share. Whereas the original pattern recognition entry demanded a 10 point stop, the fullback trader can take nearly 3 times the position size while assuming the same dollar risk.
In this example, support did indeed hold... and the market tested the 20 period simple moving average just a few days later. If profits were taken at that level, then the pullback trader would have enjoyed a risk to reward ratio of better than 2 to 1!
So here is our bottom line...
The first trader took 100 shares at $93 per share, held them through the wiggle and exit it into the $100 per share level for a $700 profit...
The second trader took 300 shares at $93 per share and held them for what was a smooth four-day moon shot to the profit objective. The 300 share position was sold at $100 per share for a profit of $2,100.
Now of course, no trading decision or investment strategy is without its downsides... The downside on waiting for the retest after a breakout is that you may miss out on the trade entirely if no wiggles are present. If this should occur, the only cost to you is an emotional one... No money will change hands in either direction!
But wouldn't you be willing to run the risk of emotional discomfort for the opportunity of doubling or even tripling your profit potential for every trade? I know I would! (And do on a daily basis...)
So as you learn about traditional technical investment strategies, spend some time looking within the pattern itself to see if there isn't an alternate entry strategy that will yield a much stronger return to its employer. It is this kind of thought that allows me to enhance so many traders returns when working with them as an edge consultant as I help them to Optimize Their Trading Edge!