Practical Details

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Practical Details

Will you be buying stocks that break out to new highs? Shorting double tops? Buying pullbacks? Looking for trend reversals? Those approaches differ from each other, and you can make or lose money with each of them. You need to select a method that makes sense to you and feels emotionally comfortable. Choose what appeals to you, what matches your abilities and temperament. There is no such thing as generic trading, any more than there is a generic sport.

To find good trades, you need to define the pattern you want to trade. Prior to using any scan, you need to have a crystal-clear picture of what it should look for. Develop your system, and test it with a series of small trades to make sure you have the discipline to follow your signals. You have to feel certain that you’ll trade the pattern you’ve identified when you see it.

Different styles of trading call for different entry techniques, different methods of setting stops and profit targets, and very different scans. Still, there are several key principles that apply to all systems.

■ 53. How to Set Profit Targets: “Enough” Is the Power Word

Setting profit targets for your trades is like asking about pay and benefits when applying for a job. You may end up earning more or less than expected, but you need to have an idea of what to expect.

FIGURE 53.1 VRSN with 13- and 26-day EMAs, the Impulse system, and a 4% envelope. MACD 12-26-9. (Chart by Stockcharts.com)

Swing Trade: Taking Profits in the Value Zone

This record of shorting VeriSign Inc. (VRSN) comes from my trade journal. It was one of several stocks that developed a setup for my “false breakout with a divergence” strategy. The last three days on this chart are marked a, b, and c. On day “a” VRSN broke out and closed above resistance, marked by a horizontal dashed line, while MACD-Histogram couldn’t even rise above zero. The next day, marked “b,” VRSN opened below the orange line, showing that the previous day was a false upside breakout (some would call it an upthrust). As soon as MACD-Histogram ticked down, creating a bearish divergence, the pattern was completed, and I immediately went short.

VRSN kept sinking all day and closed lower. The next day, marked “c,” it tried to form a base, and since the daily price was already in the value zone, I decided that it was enough and covered my shorts. Taking an 82 cent profit on 3,000 shares brought in $2,460 before commissions. I could have made more by holding longer, but in swing trading, fast quarters are better than slow dollars. Taking profits in the value zone reduces the level of uncertainty and cuts the time your trade remains at risk.

Write down your entry level, profit target, and stop for every planned trade in order to compare your risk and reward. Your potential reward should be at least twice as big as your risk. It seldom pays to risk a dollar to make a dollar—you might as well bet on color at a roulette table. Having a realistic profit target and a firm stop will help you make a go/no-go decision for any trade.

Early in my trading career I didn’t think of profit targets. If anybody asked me about them, I’d answer that I didn’t want to limit my profit potential. Today, I would laugh at such an answer. A beginner without a clear target price will feel increasingly happy as his stock goes up and more despondent as it grinds down. His emotions will prime him to act at the worst possible times: continue to hold and add to his longs at the top and sell out in disgust near the bottom.

FIGURE 53.2 EGO 25- and 5-minute charts with 13- and 26-bar EMAs, the Impulse system, and Autoenvelope. MACD 12-26-9. (Chart by TradeStation)

Taking Profits of a Day-Trade near the Upper Channel Line

This record of buying Eldorado Gold Corp. (EGO) comes from my trade journal. It illustrates using Triple Screen for day-trading and profit-taking. The strategic decision to buy EGO was taken on a 25-minute chart in area A, where the moving average turned up and the Impulse system changed to green (notice that on the previous day there was a false downside breakout—it indicated that this stock didn’t want to go down and may be setting up to rally).

My trading strategy here was “pullback to value,” which I executed on a 5-minute chart, as prices gapped up at the open but then pulled back into the value zone (area B). I went long at $9.51; my initial target was $9.75, near the upper channel line on the 25-minute chart, with a stop at $9.37, for a nearly 2:1 reward/risk ratio. Since this was a day-trade, I had it on my screen all day long.

At first, with the uptrend being so strong, I considered taking it overnight, but then bearish divergences began to develop in area C, and I placed an order to sell at $9.75. That turned out to be the high of the day, and my order wasn’t filled. As prices turned down from their bearish divergence on a 5-minute chart, I scrambled to lower my sell order to $9.70. It was filled, and I was out with a profit before the close. Taking a 19-cent profit on 2,000 shares brought in $380 within a few hours.

When calculating a trade’s profit potential, we run into a paradox. The longer your expected holding period, the bigger the profit potential. A stock can rally much more in a month than in a week. On the other hand, the longer your holding period, the higher the level of uncertainty. Technical analysis can be quite reliable for shorter-term moves, but many unpleasant surprises will occur in the longer run.

In an earlier chapter on choosing the time horizon for trades, we examined our three main options. The holding period for position trades or investments is measured in months, sometimes years. We may hold a swing trade for a few days, sometimes weeks. The expected duration of a day-trade is measured in minutes, rarely hours. Moving averages and channels help set profit targets for swing trades. They also work for day-trades; only there you need to pay more attention to oscillators and exit at the first sign of a divergence against your trade. Profit targets in position trading are usually set at previous support and resistance levels.

FIGURE 53.3 IGOI with 13- and 26-day EMAs, the Impulse system, and a 4% envelope. MACD 12-26-9. (Chart by Stockcharts.com)

Setting a Profit Target for a Long-Term Trade at the Resistance Level

At the right edge of the weekly chart, iGo, Inc. (IGOI) is trading slightly above $3, with a rising EMA confirming a new uptrend. Its previous major top was above $60 (notice a kangaroo tail), two recent intermediate rallies had fizzled out, the most recent one near $15, and the previous one near $22 (all marked with purple dashed lines). If this is the start of a new bullish trend, it would be reasonable to set the first profit target near $15, the next near $22.

The three targets mentioned above—moving averages, channels, and support/ resistance levels—are fairly modest. They don’t have you shooting for the moon, but are realistic. Keep in mind that “enough” is a power word—in life as well as trading. It puts you in control, and by getting “enough” in one trade after another, you’ll achieve excellent results over time.

How to define “enough”? I believe that moving averages and envelopes, along with recent support and resistance levels can show us what would be “enough” for any given trade. Let me illustrate this with several examples: one a swing trade, another a day-trade, and the third a long-term investment.

VRSN was a fairly common example of a modest swing trade: entering near one of the channel lines and taking profits in the value zone between the two moving averages (Figure 53.1). This isn’t elephant hunting; this is rabbit hunting, a much more reliable activity.

The EGO day-trade in Figure 53.2 illustrates buying a pullback into the value zone during an uptrend, with a profit target at the upper channel line. I used an oscillator to speed up my exit when the market wouldn’t let me exit at the initial target. “Fallen angels” is the name of a scan I use to look for possible investment candidates. It marks stocks that have fallen over 90% from their peaks, stopped declining, bottomed out, and slowly began to rise. A stock that had lost 90% of its value has every right to die, but if it chooses to live, it’s likely to rally.

The best time to look for “fallen angels” is when a bear market starts showing signs of bottoming. That’s when you find many candidates that survived bear attacks and are starting to get up from the floor. This example shows an old bull market darling IGOI that got badly mauled but stopped declining and began to rise. The weekly chart in Figure 53.3 shows two prior attempts to return to the multiyear peak area. Each of those rallies retraced just about half of the previous bear market.

Is this going to be an easy trade? Far from it. First of all, the latest bottom was near $2, and if you place your stop there, your risk per share will be quite high, and you’ll have to reduce trade size. Also, the expected rally may take anywhere from a few months to several years to get going. Are you prepared to wait that long, with your capital tied up? Last but not least, the volume of this stock is low. It will rise if prices rally, but if the rally fizzles out, selling will not be easy. Taking all these factors into account, you can see how hard it is to buy for the long haul.

■ 54. How to Set Stops: Say No to Wishful Thinking

A trade without a stop is a gamble. If you’re after thrills, better go to a real casino. Take a trip to Macao, Las Vegas, or Atlantic City, where a gambling house will serve you free drinks and may even comp you a room while you’re having fun. Gamblers who lose money on Wall Street receive no freebies.

Stops are a must for long-term survival and success, but most of us feel a great emotional reluctance to use them. The market reinforces our bad habits by training us not to use stops. We all have been through this unpleasant experience: you buy a stock and set a stop that gets hit and you exit with a loss—only to see your stock reverse and rally just as you originally expected. Had you held that stock without a stop, you would’ve profited instead of losing. Getting repeatedly whipsawed like that makes you feel disgusted with stops.

After several such events, you start trading without stops, and it works beautifully for a while. There are no more whipsaws. When a trade doesn’t work well, you get out of it without a stop—you have enough discipline. This happy ride ends after a large trade starts going bad. You keep waiting for it to rally a bit and give you a better exit, but it keeps sinking. As the days go by, it inflicts more and more damage on your account—you’re being chewed up by a shark. Soon enough your survival is in danger, and your confidence is shattered.

While you trade without stops, the sharks circling the perimeter of every account grow bigger and meaner. If you trade without stops, a shark bite is only a question of time. Yes, stops are a pain—but using them is a lesser evil than trading without them. This reminds me of what Winston Churchill said about democracy: “It is the worst form of government except all the others that have been tried.”

What should we do? I suggest accepting the irritation and the pain of stops but focusing on making them more logical and less unpleasant.

In my previous book The New Sell and Sell Short, I dedicated a long chapter to the intricacies of placing various types of stops. Rather than repeat myself here, I’ll offer you a quick summary.

Place Stops outside the Zone of “Market Noise”

Put a stop too close and it’ll get whacked by some meaningless intraday swing. Put it too far, and you’ll have very skimpy protection.

To borrow an engineering concept, all market moves have two components: signal and noise. The signal is the trend of your stock. When the trend is up, we can define noise as that part of each day’s range that protrudes below the previous day’s low. When the trend is down, we can define noise as that part of each day’s range that protrudes above the previous day’s high.

SafeZone stops are described in detail in Come into My Trading Room. They measure market noise and place stops at a multiple of noise level away from the market. In brief, use the slope of a 22-day EMA to define the trend. If the trend is up, mark all downside penetrations of the EMA during the look-back period (10 to 20 days), add their depths, and divide the sum by the number of penetrations. This gives you the Average Downside Penetration for the selected look-back period. It reflects the average level of noise in the current uptrend. You want to place your stops farther away from the market than the average level of noise. That’s why you need to multiply an average downside penetration by a factor of two or greater. Placing your stop any closer would be self-defeating.

When the trend, as defined by the EMA slope, is down, we calculate SafeZone on the basis of upside penetrations of the previous bars’ highs. We count each upside penetrations during a selected time window and average that data to find the Average Upside Penetration. We multiply it by a coefficient, starting with 3, and add that to the high of each bar. Shorting near the highs requires wider stops than buying near quiet, sold-out bottoms.

Like all systems and indicators in this book, SafeZone is not a mechanical gadget to replace independent thought. You have to establish the look-back period, the window of time during which SafeZone is calculated. You also need to fine-tune the coefficient by which you multiply the average penetration, so that your stop goes outside the normal noise level.

Even when not using SafeZone, you may wish to follow its principle of calculating an average penetration against the trend that you are aiming to trade—and putting your stop well outside the zone of market noise.

Don’t Place Your Stops at Obvious Levels

A recent low that sticks out like a sore thumb from a tight weave of prices draws traders to place stops slightly below that level. The trouble is most people place their stops there, creating a target-rich environment for the running of stops. The market has an uncanny habit of quickly sinking back to those obvious lows and triggering stops before reversing and launching a new rally. Without trying to assign blame for raiding stops, let me suggest several solutions.

It pays to place your stops at non-obvious levels—either closer to the market or deeper below an obvious low. A closer stop will cut your dollar risk but increase the risk of a whipsaw. A deeper stop will help you sidestep some false breakouts, but if it gets hit you’ll lose more.

Take your pick. For short-term swing trading, it generally pays to place your stops tighter, while for long-term position trades, you’d be better off with wider stops. Remember “the Iron Triangle of risk control”—a wider stop demands a smaller trade size.

One method I like is Nic’s stop, named after my Australian friend Nic Grove. He invented this method of placing a stop not near the lowest low, but at the second lowest (more shallow) low. The logic is simple—if the market is sliding to its second lowest low, it is almost certain to continue falling and hit the key low, where the bulk of stops cluster. Using Nic’s stop, I get out with a smaller loss and lower slippage than would occur when the markets drop to more visible lows.

The same logic works when shorting—place your Nic’s stop not “a tick above the highest high” but at the level of the second highest high. Let’s review some recent examples of both longs and shorts in Figure 54.1.

You may want to explore several different systems for placing stops, such as Parabolic, SafeZone, and Volatility stops, described in the books mentioned above. You can get fancy or you can stay plain, but keep in mind the most important principles: first, use stops; and second, don’t place them at obvious levels, easily visible to anyone looking at that chart. Make your stops a little tighter or wider than average stay away from the crowd because you don’t want to be an average trader.

For the same reason, avoid placing stops at round numbers. If you buy at $80, don’t place a stop at $78 but at $77.94. If you enter a day-trade at $25.60, don’t place a stop at $25.25—move it to $25.22 or even $22.19. Round numbers attract crowds—put your stop a little farther away. Let the crowd take the first hit, and perhaps your own stop will remain untouched.

Another method, popularized by Kerry Lovvorn, is to use Average True Range (ATR) stops (see Chapter 24 for the explanation of the ATR). When you enter during a price bar, place your stop at least one ATR away from the extreme of that bar. A two ATR stop is even safer. You can use it as a trailing stop, moving it at every bar. The principle is the same—place your stop outside the zone of market noise. (Figure 54.2)

One of the advantages of using trailing stops is that they gradually reduce the amount of money at risk. Earlier we discussed the concept of “available risk” (Chapter 51). As a trade followed by a trailing stop moves in your favor, it gradually frees up available risk, allowing you to make new trades.

Even if you don’t use SafeZone or ATR stops, be sure to place stops at some distance from recent prices. You don’t want to be like one of those fearful traders who jam their stops so close to current prices that the slightest meaningless fluctuation is certain to hit them.

FIGURE 54.1 Daily charts with 13-day EMA, the Impulse system, and MACD-Histogram 12-26-9. (Charts by Stockcharts.com)

Nic’s Stops—Long KO and Short ISRG

On the chart of The Coca-Cola Company (KO), we see a false downside breakout with a bullish divergence. The Impulse system has turned from red to blue, permitting buying. If we go long, where should we place our stop?

Bar A—the low was $37.10

Bar B—the low was $37.05

Bar C—the low was $36.89 (a false downside breakout, exceeded the low A by 21 cents).

Bar D—the low was $37.14

The crowd will have set its stops below 36.89, but Nic’s stop will go to $37.04—a cent below the second lowest recent low, the bottom of bar B.

On the chart of Intuitive Surgical, Inc. (ISRG), we see a false upside breakout with a bearish divergence. The Impulse system has turned from green to blue, permitting shorting. If we go short, where should we place our stop?

Bar A—previous peak reached $447.50

Bar B—the high was $444.99

Bar C—the high was $447.75 (a false upside breakout, exceeded previous peak by 25 cents).

Bar D—the high was $442.03

The crowd will have its stops above $447.75, but Nic’s stop will go to $445.05—a few cents above the second highest recent high, the top of bar B.

The concept of signal and noise can help you not only place intelligent stops but also find good entries into trades. If you see a stock in a strong trend but don’t like to chase prices, drop down one timeframe. For example, if the weekly trend is up, switch to the daily chart, and you’ll probably see that once every few weeks, it has a pullback below the value zone. Measure the depths of several recent penetrations below the slow EMA to calculate an average penetration (see Figure 39.3). Place a

FIGURE 54.2 S&P 500 and a 20-day New High–New Low Index. (Chart by TradeStation, programming by Kerry Lovvorn)

A 2-ATR Trailing Stop following a Spike Bounce signal

A Spike Bounce signal (described in Chapter 34) occurs when the 20-day New High—New Low Index drops below minus 500, indicating a bearish imbalance, and then rallies above that level, showing that bulls are coming back. Spike Bounce signals are marked by vertical green arrows. Here S&P bars get colored green while the Spike Bounce signal is, in effect, purple after it disappears. The red line trails two ATRs below the highs of the bars of the S&P 500.

The Spike Bounce gives buy signals for the entire market, and this chart trails each buy signal with a 2-ATR close-only stop (intraday crossovers don’t count—the market has to close below the stop to activate it). Notice the very productive signals A, B, and C. The buy signal E is still in effect at the time of this writing. The signal D resulted in a loss—there are no universally profitable signals.

buy order for the day ahead at that distance below the EMA and keep adjusting it every day. You will use a splash of noisy behavior to get a good entry into a trendfollowing trade.

Don’t Let a Winning Trade Turn into a Loss

Never let an open trade that shows a decent paper profit turn into a loss! Before you put on a trade, start planning at what level you’ll begin protecting your profits. For example, if your profit target for that trade is about $1,000, you may decide that a profit of $300 will need to be protected. Once your open profit rises to $300, you’ll move your protective stop to a breakeven level. I call that move “cuffing the trade.”

Soon after moving your stop to breakeven, you’ll need to focus on protecting a portion of your growing paper profit. Decide in advance what percentage you’ll protect.

For example, you may decide that once the breakeven stop is in place, you’ll protect a third of your open profit. If the open profit on the trade described above rises to $600, you’ll move up your stop, so that the $200 profit is protected.

These levels aren’t set in stone. You may choose different percentages, depending on your level of confidence in a trade and risk tolerance.

As a trade moves in your favor, your remaining potential gain begins to shrink, while your risk—the distance to the stop—keeps increasing. To trade is to manage risk. As the reward-to-risk ratio for your winning trades slowly deteriorates, you need to begin reducing your risk. Protecting a portion of your paper profits will keep your reward-to-risk ratio on a more even keel.

Move Your Stop Only in the Direction of Your Trade

You buy a stock and, being a disciplined trader, put a stop underneath. That stock rises, generating nice paper profits, but then it stalls. Next, it sinks a little, then a bit more, and then goes negative, inching towards your stop. As you study the chart, its bottom formation looks good, with a bullish divergence capable of supporting a strong rally. What will you do next?

First of all, learn from your mistake of not having moved up your stop. That stop should have been raised to breakeven a while ago. Failing that, your options have narrowed: take a small loss right away and be ready to reposition later—or continue to hold. Trouble is you feel tempted to go for the third and utterly unplanned choice to lower your stop, giving your losing trade “more room.”

Don’t do it!

Giving a trade “more room” is wishful thinking, pure and simple. It doesn’t belong in the toolkit of a serious trader.

Giving “more room” to a losing trade is like telling your kid you’ll take away his car keys if he misbehaves, but then not following through. That’s how you teach him that rules don’t matter and encourage even worse behavior. Standing firm brings better long-term results.

The logical thing to do when a trade starts acting badly is to accept a small loss. Continue to monitor that stock and be ready to buy it again if it bottoms out. Persistence pays, commissions are cheap, and professional traders often take several quick stabs at a trade before it starts running in their favor.

Catastrophic Stops: A Professional’s Life Jacket

Soon after moving to a house near a lake I bought a kayak, and immediately went shopping for a life jacket. All I had to do to be legal was to have a jacket in the kayak—any cheap piece of junk would suffice. Still, I spent good money on a quality jacket that felt snug and didn’t interfere with rowing when I wore it.

All I planned to do with that kayak was to paddle peacefully on a lake, not anywhere near white water or currents. I never expected to actually need that jacket. Did I waste my money buying it? Well, if ever some motor boat clips me, then wearing a high-quality jacket can make the difference between life and death.

It’s the same with stops. They’re a nuisance and often cost you money. Still, there will be a day when a stop will save your account from a life-threatening collision. Keep in mind that a bad accident is much more likely in the market than on a lake. That’s why it’s essential to use stops.

A “hard stop” is an order you give to your broker. A “soft stop” is an order you keep in your head, ready to place it when needed. Beginners and intermediate traders must use hard stops. A professional trader, sitting in front of a live screen all day, may use a soft stop if he has the discipline to exit when his system tells him to do it.

Still, accidents happen. A professional trader friend described how he fought against a market reversal. His soft stop was set at a $2,000 loss level, but by the time he threw in the towel and got out, his loss grew to $40,000—the worst of his trading career. This is why, even if you don’t use hard stops on a regular basis, you should at the very least use a “catastrophic stop” for every trade.

For any A-trade, whether long or short, draw a line on your chart where you absolutely do not expect that stock to go. Place your hard stop at that level and make it GTC: “good ‘til cancelled.” That will be your catastrophic stop. Now you can play with the luxury of soft stops. Paddle your kayak hard, knowing that you’re wearing a reliable life jacket.

Had my friend whose $2,000 drawdown metastasized into a $40,000 loss used a hard “catastrophic” stop, he would have taken only a relatively small loss, sidestepped a disaster, and avoided the financial and psychological hurt of a shark bite.

Stops and Overnight Gaps: Only for the Pros

What will you do if your stock gets hit by a major piece of bad news after the market closes for the day? Looking at pre-opening quotes the next morning, you realize that it’ll open sharply lower, deep below your stop, promising massive slippage.

This is a rare occurrence, but it does happen.

If you’re a new or intermediate trader, there isn’t much you can do—just grit your teeth and take your loss. Only coldly disciplined pros have an additional option: day-trade your way out of that stock. Pull your stop, and after the stock begins trading, handle it as if it was a day-trade you bought at the first tick of that morning.

Opening gaps are often followed by bounces, giving nimble traders an opportunity to get out at a smaller loss. This doesn’t always happen—which is why most traders should never use this technique. You may actually deepen your loss instead of reducing it.

Be sure to get out before the close. Your damaged stock may bounce today, but tomorrow more sellers are likely to come in and drive it lower. Don’t let a bounce lull you into a false hope of a reversal.

■ 55. Is This an A-Trade?

Your performance in any field will improve if you take tests. Getting graded on them will help you recognize your strengths and weaknesses. Now you can work on reinforcing what’s good and correcting what’s not.

Whenever you complete a trade, the market gives you three grades. It grades the quality of your entry and exit, and most importantly, it delivers your overall trade grade.

If you’re a swing trader and use a combination of weekly and daily charts, look for your grades on the dailies. Your buy grade is based on the location of your entry, relative to the high and low of the daily bar during which you bought.

$$Buy\,\,grade = \frac{(high-buy\,\,point)}{(high-low)}$$

The closer to the bar’s low and the farther away from the bar’s high you buy, the better your buy grade. Suppose the high of the day was $20, the low $19, and you managed to buy at $19.25. Entering those numbers into the formula gives you a buy grade of 75%. If your buy grade is 100%, it means you bought at the bottom tick of the day. That’s brilliant, but don’t count on it happening. If your buy grade is 0%, it means you bought the top tick of the day. This is terrible and should serve as a reminder not to chase runaway prices. I calculate my buy grade for every trade and consider anything above 50% a very good result, meaning I bought in the lower half of the daily bar.

The following is the formula for your sell grade

$$Sell grade = \frac{(sell point - low)}{(high - low)}$$

The closer to the bar’s high and the farther away from the low of the bar you sell, the better your sell grade. Suppose the high of the day was $20, the low $19, and you managed to sell at $19.70. Entering those numbers into the formula gives you a sell grade of 70%. If your sell grade is 100%, it means you sold at the top tick of the day. If your sell grade is 0%, it means you sold at the bottom tick of the day. This terrible grade should serve as a reminder to sell earlier instead of panicking. I calculate my sell grade for every trade and consider anything above 50% a very good result, meaning I sold in the upper half of the daily bar.

When evaluating any trade, most people assume that the amount of money they make or lose in that trade reflects its quality. Money is important for plotting the equity curve, but it’s a poor measure of a single trade. It makes more sense to rate the quality of every trade by comparing what you’ve got to what was realistically available. I find my trade grade by comparing points gained or lost in a trade to the height of the daily chart’s channel measured on the day of the entry.

$$Trade\ grade = \frac{(sell-buy)}{(channel\ high-channel\ low)}$$

A well-drawn channel contains between 90% and 95% of prices for the past 100 bars (see Chapter 22). You may use any number of channels—parallel to the EMA, Autoenvelope, Keltner, or ATR channels—as long as you’re being consistent. A channel contains normal price moves, with only the extreme highs and lows protruding outside it. The distance between the upper and the lower channel lines on the day you enter a trade represents a realistic maximum of what’s available to a swing trader in that market. Shooting for a maximum, though, is a very dangerous game. I consider any trade that gains 30% or more of its channel height an A-trade.1 (Figure 55.1)

¹ This term comes from the U.S. school grading system: A is excellent, B good, C mediocre, and D poor.

FIGURE 55.1 ADSK daily with 13- and 26-day EMAs and a 7% envelope. Impulse system with MACD-Histogram 12-26-9. (Chart by Stockcharts.com)

Buy, Sell, and Trade Grades

This chart comes from my diary of a trade in Autodesk, Inc. (ADSK) while working on this book (you saw my plan for this trade in Figure 38.1). I was piggybacking one of the Spike picks, and my strategy here was “pullback to value.” ADSK had recently staged a deeper than average pullback—notice a false downside breakout marked by a red arrow, followed by a successful retest, marked with a green arrow.

Day A—Feb. 10, 2014, Monday: high $52.49, low $51.75, upper channel line $53.87, lower $47.61 (we’ll need channel values to calculate the trade grade on exit). Bought at $51.77. Buy grade = (52.49 − 51.77) / (52.49 − 51.75) = 97%.

Days B and C—Tuesday and Wednesday): rally continues, start moving up stop.

Day D—Thursday: high $54.49, low $53.39. Sold at $53.78. Sell grade = (53.78 − 53.39) / (54.49 − 53.39) = 35%. Trade grade = (sell − buy) divided by channel height = (53.78 – 51.77) / (53.87 − 47.61) = 32%.

My buy grade in this trade was unusually high, the sell grade below average, but the overall trade grade was very good. Busy with the book, I traded only 200 shares, so my profit, after commissions, was less than $400. Had I graded my trades by profits, this one would be easy to overlook, but catching 32% of channel earned me an A.

A comment by Kerry Lovvorn at the 2012 annual reunion of SpikeTrade grabbed my attention: he challenged all participants to define what he called ‘an A-trade’—a setup that signals the likelihood of an excellent trade. “You have to define this pattern for yourself,” he said. “If you don’t know what’s your ‘A-trade,’ you have no business being in the market.”

I knew full well what my A-trades were—a divergence coupled with a false breakout or a pullback to value. Still, if I saw no A-trades on my screen, I’d go for B-trades, and on a really slow day, reach for a C-trade.

FIGURE 55.2 The Strategy box in the Trade Journal. (Source: SpikeTrade.com)

Whenever you plan a trade, be sure to specify what system you’ll use. Ask yourself whether this planned trade looks like an “A-trade” according to your system.

I use the words “system” and “strategy” interchangeably—both mean a trade plan. As you can see from this snapshot of my trade journal’s Strategy box, taken in September 2013, I currently trade three systems. My main one is a “false breakout with a divergence.” I also occasionally trade pullbacks to value—buying pullbacks during uptrends and shorting rallies in downtrends. On rare occasions, I trade against the extremes, buying severely beaten down stocks or shorting stocks whose wild rallies are stalling.

Returning home from that reunion, I attached a plastic strip to one of my trading screens with the question: “Is this an A-trade?” Ever since then, I have it in front of me whenever I place an order. The results came quickly: as the number of non-A-trades sharply declined, my equity curve began to rise at a steeper angle.

You need to have a clear idea of what would be a perfect setup for you, “an A-trade.” Perfect doesn’t guarantee profits—there are no guarantees in the market—but it means a setup with a strong positive expectation. It also means something you’ve traded before with which you are comfortable. Once you know what it is, you can start looking for stocks that exhibit that pattern.

One of the few advantages of a private trader over an institutional one is that we can trade or not trade when we like. We have the luxury of being free to wait for excellent setups. Unfortunately, most of us, in our eagerness to trade, throw away this amazing advantage.

I’ve added the question “Is this an A-trade?” to my Tradebill, a trade management form we’ll discuss in the next chapter. Whenever I see a potential trade, I ask myself this question. If the answer is “yes,” I start calculating risk management, position sizing, and planning my entry. If the answer is “no,” I turn the page and go looking for another pick. (Figure 55.2)

No matter how grand an idea or a stock tip, I will not trade it unless it fits into one of my three strategies. Ideas come and go, fly or flop—but strategies stay and grow better with age, as you learn how they perform under various market conditions.

Gradually, you may develop new strategies and drop others. You can see that the ones I use are numbered 1, 4, and 7. The rest of the numbers were strategies I stopped using.

Your system can be very mechanical or quite general, with just a few key principles, like my Triple Screen. Either way, you must know what your “A-trade” looks like before you plan your next trade.

I’ll walk you through one of my strategies, but remember that you don’t have to copy it (Figure 55.3). The way we trade is as personal as handwriting. Define a strategy that feels comfortable to you, test it, and then find a chart that perfectly represents it. Print that chart and post it on a wall near your trading desk. Now you can search for trades that look the way that chart looked on the day you entered that trade.

FIGURE 55.3 SLB daily with 13- and 26-day EMAs and a 6% envelope. Impulse system with MACD-Histogram 12-26-9. (Chart by Stockcharts.com)

False Downside Breakout with a Bullish Divergence

This chart, from my Trade Journal, shows a near-perfect example of a swing trade strategy that I abbreviate as “01 FB + BD”—a false breakout with a bullish or bearish divergence. Schlumberger, Ltd. (SLB) was in a well-established downtrend, and when it reached a new low at A, it looked like just another bottom during a long and painful slide. I look at the entire circled area of MACD-Histogram as a single bottom because it never crossed above the zero line. In area B, the picture became more interesting: MACD-Histogram rallied above its centerline, “breaking the back of the bear.” The weekly Impulse system (not shown), which had been red until then, turned blue, removing its prohibition of buying. In area C, SLB cracked to a new low, but MACD declined to a much more shallow low, setting up for a bullish divergence.

Look carefully at the first blue bar after several red bars in area C. That’s where MACD-Histogram ticked up, completing a bullish divergence. In addition, that bar rallied and closed above the downside breakout level, marked by a purple dashed line: it marked previous bars as a false downside breakout.

I bought during that bar (marked by a vertical green arrow), without waiting for it to close, going long 2,000 shares at $60.80, with a stop at $59.12. Four days later, as prices began approaching the upper channel line as well as the level of the previous top I started taking profits. I sold 1,000 shares at $66.55 and the rest on the following day at $67 (both marked by red arrows). I booked nearly $6 per share, for a total of $11,950 before commissions in five trading days. The system delivered a beautiful trade.

This is the chart I have in mind when looking for stocks and futures to trade. I want to find those that have completed their bottom A and top B and are declining into what could become bottom C. In the background, the Impulse system on the weekly chart cannot be red because that would prohibit buying.

In the next section, on trade planning, you’ll see how to use a form I named Tradebill to make trading decisions more objective. Every trade has several parameters, and it’s easy to overlook some of them in the heat of action. Just as a pilot goes through a preflight checklist, a trader needs to check his list before deciding to place an order.

■ 56. Scanning for Possible Trades

There are thousands of stocks out there, and in the days and weeks ahead, some will rise, others fall, and some will fluctuate. Each stock will make money for traders whose systems are in gear with it—and lose money for the rest. Developing a trading system or a strategy must come before scanning. If you don’t have a clearly defined strategy, what will you scan for?!

Begin by developing a system that you trust. Once you have it, looking for trading candidates will become quite logical and straightforward. Looking at your list of candidates, the first question about any pick will be “Is this an A-trade?” In other words, is this pick close to your ideal pattern? If the answer is “yes,” you may start working up a trade.

Scanning means reviewing a group of trading vehicles and zooming in on trading candidates. Your scanning can be visual or computerized: you may flip through multiple charts, taking a quick glance at each, or else have your computer run through that list and flag stocks whose patterns appeal to you. To repeat, defining a pattern you trust must be your first step, scanning a more distant second.

Be sure to have realistic expectations for scanning. No scan can find you the needle in a haystack—the one and only gem to trade. What a good scan does is bring up a group of candidates on which to focus your attention. You can make that group bigger or smaller by loosening or tightening scan parameters. A scan is a time saver that delivers potential candidates; it is not a piece a magic to free you from the necessity of working up your picks.

Begin by describing what stocks you want to find. For example, if you’re a trendfollower, but don’t like chasing stocks, you may design a scan to find stocks whose moving average is rising but the latest price is only a small percentage above that average. You can write a scan yourself or hire someone to do it for you—there are programmers who offer this service.

The raw list of stocks to be scanned can be as small as a few dozen or as large as the S&P 500, or even Russell 2,000. I like looking for trading candidates on weekends, and depending on how much time I have, take one of the two approaches—one lazy and the other hardworking. The lazy way, when my time is limited, is to review Spikers’ picks for the week ahead. Spikers are the elite members of SpikeTrade.com, and I figure that among a dozen picks by super-smart traders who compete for the best pick of the week there ought to be a stock or two for me to piggyback. I examine those picks, while adding my market opinion to the mix. Depending on my outlook for the week ahead, I focus primarily on long or short candidates.

The hard-working way consists of dropping all 500 components of the S&P 500 into my software and running a scan for potential MACD divergences. I’ve seen many divergence scans, but never a reliable one—they all delivered too many false positives and missed many good divergences. Then I realized that a divergence was “an analog pattern”—clearly visible to a naked eye but hard to pick with digital processing. I turned to John Bruns, who built me a semiautomatic MACD divergence scanner. Instead of looking for divergences, it scans for patterns that precede divergences and delivers the list of candidates to watch in the days ahead. (Figure 56.1)

Running my MACD divergence semiautomatic scan over the weekly and daily charts of all 500 components of the S&P 500 takes only a minute, but the real work begins when I review the lists of bullish and bearish candidates delivered by this scan. First, I compare the sizes of bullish and bearish lists. For example, for several weeks prior to writing this chapter, my scan for bullish divergences among the components of the S&P 500 produced four to five candidates, while the scan for potential bearish divergences returned between 70 and 80 stocks. This great imbalance indicated that

FIGURE 56.1 WFM daily with 13- and 26-day EMAs. Impulse system with MACD-Histogram 12-26-9. Red dots—potential or actual bearish divergences. Green dots—potential or actual bullish divergences. (Chart by TradeStation, scanner by John Bruns/elder.com)

MACD-Histogram Semiautomatic Divergence Scanner

We’ve reviewed MACD Histogram and its divergences in Chapter 23 and returned to this pattern repeatedly throughout this book. Instead of looking for completed divergences, this semiautomatic scan finds stocks that have completed parts A and B of a potential divergence. As part C (the second top or bottom) begins to emerge, this scan starts putting red dots above or green dots below the bar to alert one to the possibility of a divergence.

This chart of Whole Foods Market, Inc. (WFM) shows that a scanner isn’t an automatic trade finder. It is a watchdog that alerts you to the possibility that this market is ready to trade—long or short. Having received such a signal, a trader needs to work up that stock to establish the level at which the divergence would be completed and write down entry, target, and stop levels.

the market was perched at the edge of a cliff and I needed to find some shorts for the coming downturn. I prune my weekly list of trading candidates down to five or six picks that show the most attractive patterns and the best reward to risk ratios. These are the stocks that I’ll aim to trade during the week. I have friends who can juggle twenty stocks at once—this can be done, but not by me, and every serious trader must know his limitations.

Another “hardworking way” of finding trade candidates involves scanning stock industry groups. For example, if I think that gold is approaching an important bottom, I’ll pull up the list of all 52 gold stocks and 14 silver stocks that are listed at this time and look for buying candidates. While doing that, I’ll keep in mind my SLB chart shown in Figure 55.3—I want to find stocks whose patterns look close to my ideal.

If you’re going to scan a large number of stocks, it pays to add some negative rules. For example, you may want to omit stocks whose average daily volume is below half a million or even a million shares. Their charts tend to be more ragged and their slippage worse than in more actively traded stocks. You may want to exclude expensive stocks from your scans for buying candidates and cheap stocks from your scans for shorting candidates. Choosing at what levels to place your price filters is a matter of personal choice. This is why scanning is best left for experienced traders. Learn to fish with just a few lines in the water before casting a broad net.