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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Note that one of the best signs of an amateur trader is a person who only uses tight stops or a 3:1 risk reward ratio on every tradeNote that one of the best signs of an amateur trader is a person who only uses tight stops or a 3:1 risk reward ratio on every trade. Most beginning traders are taught by their brokers lo use this light slop formula^ risking one point to get three points. As the traders wonder why they always get stopped out just before the market turns, their broker is tallying up commissions generated on the day. In general, wider stops produce more winning trades. They key with wider stops, of course, is to play only setups that have a greater than 80 percent chance of winning. The gap play I'm describing, with the parameters that I use, has a greater than 80 percent chance of winning with the risk-to-reward ratios I utilize. By using a tight stop on a gap play, the probabilities of the trade working out fall dramaticallyless than 30 percent. In essence, one of the reasons many traders fail to make it in this business is because they are using stops that are too tight. This might seem like a contradiction, but if almost every trade is stopped out, it's tough to make any money. What is also important to remember for gap ptays is that an active program of trailing stops will negatively affect your win/loss ratio. Once the parameters are set in place, the best thing a trader can do is to walk away and lei the orders do their job. Although tweaking is a good thing to do when giving a car a tune-up, tweaking the parameters of a gap trade won't work. Mini-Sized DowSeptember 2004 Contract, August, 2, 2004 I've found that most traders get too caught up in the reasons for the gap. In reality, the reason is meaningless. Gaps happen because a flurry of emotion hits the tape at the opening bell. However, the reason for the gap has little significance on whether or not the gap fills. On Sunday, August 1. 2004, the U.S. government issued a terrorist warning claiming that there was chatter on the airways about a plan to blow up a large financial institution. The markets got nervous and the markets gapped down in a big way on Monday morning, August 2 1. On Friday, July 30, 2004, the mini-sized Dow futures closed at 10142. 2. On Monday, August 2, 2004, the markets open for trade at 10091. down 51 points. Buy here right at the 9:30 a.m. Eastern open. I place a stop at 10040, The markets spend a good part of the day chopping around, and I talk with other traders who are nervous about the terrorist threat news. Do 1 let this ''nervousness get into my own trading? Should 1 listen to the reasons for the gap? 3.Later that same day, the markets grind higher and I am out at the gap fill. Gaps are the ultimate contrarian play; don't get caught up with the crowd. This trade nets a profit of $255 per contract. E-mini S&PSeptember 2004 Contract, August 24, 2004 1. On August 23 the ES closed at 1097.00 (see Fig. 6.6). 2. The next morning the 9:30 a,m. opening trade prints at 1101.00, four points above its close. 1 short at the open, placing a stop at f 105.00. 3. A little over an hour later, my target is hit as the E-mini S&Ps fill their gap for a total gain of $200 per contract. E-mini S&PSeptember 2004 Contract, August 4, 2004 1. On August 3, the ES closes at 1097.50 2. The next morning, the market gaps down and opens at 1094.25. This gap is 3.25 points, so I use a 114:1 risk-to-reward ratio, and place my stop at 1089.25. 3. I buy at the open. The market chops up, and then pushes down to new lows. A little over an hour later, the market has firmed, and I' m out of my position at the gap fill. The markets spend a good portion of the day in a tight, choppy range, only rallying in the final half-hour of trade. On many days, the gap play is not only the safest, but it is really the only trade to take. We call the market choppy when it trades in a narrow, low volume range because it chops up newer traders to death. This trade nets a total of $162,50 per contract. E-mini S&PSeptember 2004 Contract, July 14, 2004 1. On July 13 the E-mini S&Ps closed at 1114.75. 2. The next morning the market opens down -5.75 points at 1109.00. 3. I buy at the open and place a stop at 1 103.25. 4- The gap fills in a little under an hour. This is another example of a Bahamas Gap, as it is very relaxing to trade with a mini mum of false moves. This trade nets a total profit of $287.50 per contract. WHAT TO DO WITH UNFILLED GAPS One important thing to remember: If 80 percent of these plays win, that means 20 percent of them lose. I actually like losing trades for one main reasonthis leaves an open gap in the markets. An open gap is like a black hole or a tractor beam, eventually sucking prices back to their opening gap levels. Whenever the markets leave an open gap, I mark thai level on a Post-it Note and place it on my computer. Lets look at this example: Let's get a tittle more specific on how to play this using a $100,000 account, and utilizing nine contracts for a full position, approximately one contract for every $11,100 in the account. Yes, a person can trade a lot more contracts than that in a $ 100,000 account, and many brokers will encourage a person to trade more than that. With some brokers a trader can get enough leverage to trade 100 contracts on a $100,000 account. This is, purely and simply, insane. Just because people can do something, doesn't mean they should. The leverage here is far too much. Traders who are using a modest two-point stop on the S&Ps could get stopped out four times in a row. Where does this leave them? 2 points X $50 X 100 contracts = $10,000. Four stops in a row = $40,000. I've seen more than my fair share of people do this, and it is just inexcusable. There are many things people can do in life. They can drink one glass of wine or the whole bottle. They can drink one cup of coffee or the whole pot. They can go to the gym each day or sit and watch TV. It all comes down to choice. Just because people can do something, doesn't mean that it's a good idea- Choose with your best interests in mind. Let's go back to the example. On August 18, we gapped up a modest 44 points in the Dow prior to some economic numbers. I short at the open. We rallied, suld off into the economic numbers, and then shut higher once the numbers were released. J had a 44-point stop, and the markets rallied just through that level, producing a loss of $220 per contract, or $ 1,980. I head into the next trading day knowing there is now a black hole gap below. I can actually hear the sucking sound. The next day we have a modest low volume 13-point gap higher that works out quickly, for $65 per contract ($585). The day after* we get a nice 52-point gap lower that takes a few hours to fill, but creates few headaches, for $260 per contract ($2,340). The next day we get a 44-point gap higher that is on moderate volume. It conies close to our stop but eventually fills the gap for $255 per contract on four contracts. I covered the first five contracts when we got to 50 percent of the gap fill level, which is 22 points. 4 contracts x 44 points X $5 = $880, and 5 contracts X 22 points X $5 = $550 for a total of $1.430 on the play. Finally on August 22 we get the sucker gap when Intel announces cautious upside earnings revisions.** The market explodes and gaps up 62 points, right into key resistanceon low premarket volume. I short the gap. Six bars later, my target is hit for 62 points or $310 per contract ($2,790). The sucking sound of the black hole below is getting louder. During the afternoon session we get a bear flag consolidation, 1 set up a sell stop at 9392 to let the market take me into a breakdown of that flag formation. 1 gel the fill and set my stop above intraday resistance at 9455, My target is the 8/18 black hole open gap at 9304, The market spends the rest of the day on its hands and knees, dry heaving, trying to hold back the internal pressure. This pressure proves to be too much, and, like a freshman college student during his first year away from home, the market eventually falls over and vomits. The gap fills for an 88-point gain or $440 per contract ($3,960). When there are open gaps left in the market, I always write them down and mark them on my chart. The markets will take them out eventually, usually within 5 to 10 trading days. STRATEGIES FOR THOSE WHO CAN'T TRADE FULL TIME Gaps are one of the best strategies for people who are holding down a full-time job. On the West Coast this is particularly easy as the markets are open well before most people have to head to the office. The main consideration to keep in mind is that a person will want a system like NinjaTrader (see Chapter 4) that will automatically cancel a stop once the target is hit. Another, often overlooked alternative is to have a broker who can be called with the parameters. Typically these brokers will cost a little more in commissions, but it is worth it to have someone watching out for the trade. The biggest advantage of doing this trade as a part time trader is that you won't be prone to making the very mistakes most full-time traders make while watching the trade progress. They get antsy, they get fidgety, and they end up bailing out too soon. Someone who is at the office and doesn'i have time to watch the trade actually has a big edge over most of the traders who haven't learned to control their emotions. Another alternative is to have this setup auto-traded by a broker There are a number of brokers who will trade these setups automatically based on parameters that are given to them. Additional information on this option is available at www.tradethemarkets.com. POSITION SIZING WITH A $100,000 ACCOUNT One frequent question I get is How many contracts or shares are you trading with this strategy? These same plays can be executed in five different markets. There are the mini-sized Dow and E-mini S&P futures, the SPY and DIA ETF shares, and there are also futures available on the DIA through One Chicago. The table following shows the different instruments and the number of shares or contracts I would trade on a $100,000 account using this setup. The DIA futures are nice if a trader is using a smaller account. They are a happy medium between having a lot of leverage with the mini-Dow and E-mini S&P futures and no leverage with the DIA and SPY slock. The example shown in Table 6.3 is with a gap that occurred on July 24. SUMMING UP THE GAPS Gaps are the one moment of the trading day where all the players have to show their poker hand* and this creates the single biggest advantage for the shon-term trader. Understanding the psychology behind the gaps is paramount to playing them successfully on a daily basis. The gaps are so powerful that many traders make a nice living playing these setups alone. The key is to know how they work and to develop a solid methodology and sei of rules to trade them. After reading about this setup and understanding the specifics behind the setup* the serious trader will have a better foundation for a plan to trade the markets successfully on a full-time basis: a proven setup to play, markets that best fit that set-up, and a plan of action to maximize the play. That is pretty much all a trader needs to survive and thrive in this greatest of professions. PIVOT POINTSGREAT FOR TRENDING DAYS AND EVEN BETTER FOR CHOPPY DAYS BEATING INDICATOR-BASED TRADERS TO THE PUNCH One of the simplest and most effective position entry techniques I use is based on what I call the multipivol levels. This is a setup that can be used on a variety of markets, though I typically use them on the mini-sized Dow (YM), E-mini S&P (ES), E-mini NASDAQ (NQ), and E-minj Russell (ER) futures contracts* as well as some individual stocks. They can also be used on the corresponding stock index ETF via the DIA, SPY, QQQQ and 1WM. The main advantage of this system is that it is price-based as opposed to indicator-based. By the lime most indicators generate a buy or a sell signal, the move is already well under way. By following this price-based methodology, I will get into a trade before the indicator-based traders, and 1 usually end up handing off my position soon after a buy or sell signal is being generated on a stochastic or other oscillator type of system. This is especially true on choppy days. Just as the Johnny-come-latelies are jumping in, I'm closing out my position and looking for the next setup. On choppy days, it's the indicator-based traders who get taken out back and shot. Their buy signals get them in at the top of the move and their sell signals get them in at the dead lows, leading to a frustrating day with a negative P&L Pivots are set up to naturally take advantage of their mistakes, essentially siphoning money from these trading accounts into your own. This is also a good system for traders who don't have time to stare at the charts all day long, or, not surprisingly, for traders who have a bad habit of chasing the market higher and lower. Playing the pivots automatically creates trader discipline, because the entries and exits are determined before the trading day even starts. The other thing I like about the pivots is that they can be used as a tool to quickly determine what kind of trading day it's going to be. On a trending day, markets will move to a pivot level, consolidate for 15-20 minutes, and then continue to march in the direction of the trend. On these days I wait for the move through the pivot level and then buy the first pullback to that level. On choppy days, however, the markets will move up to a pivot level, hang around fora short time, and then drift back in the direction from whence they came. Many traders get chopped up during these types of trading days, losing money and making their brokers rich in the process. The pivots are naturally set up to be faded on these days and are one of the few profitable ways to trade the low volume, narrow range chop. There are two very easy ways to tell if the market is trending or chopping. The first is to look at how the markets react to the pivot levels once they reach them. The second is to set up a five-minute chart of the E-mini S&Ps and see what kind of volume is coming into the market after 10:00 a.m. Eastern (see Chapter 5). If the volume is over 10,000 contracts on each bar, then the market has power and volatility behind it. These types of days usually have wide ranges and strong trends. However, if the volume after 10:00 a.m. Eastern is consistently below 10,000 contracts on a five-minute chart, then there is little power to move the beast, and the end result will be a slow, choppy day. On the first type of day, I wait for the markets to move through pivot levels, and then I set up an order to get in on the first retracement. On the choppy days, I place open buy and sell orders against the pivots and have standing orders to fade these moves throughout the day. There is nothing to watch on these types of days, so I generally let my orders do the work for me while I spend some quality time at the driving range. NOT ALL PIVOTS ARE CREATED EQUAL So what exactly are the pivots? There is no big mystery or secret to them, and many readers will have heard about them and have used them in their own trading on a regular basis. For the uninitiated, I explain how I set them up and why they work, and then we can jump into the setups that I use with them. Pivots are readily available and have been around for a long time. They are support and resistance levels calculated by floor traders using a simple mathematical formula. These levels became widely known and have moved off the floor. Today many traders are aware of them and try to use them, but in my experience they are using them incorrectly. To add to the confusion, there are different formula versions and different time frames that ane used when calculating pivots. So, to get started, let's look at what I use, which is one of the standard pivot formulas: R3: Rl + (High - Low) R2: Pivot + (High - Low) Rl: 2 X Pivot - Low PIVOT: High + Low + Close/3 SI: 2 X Pivot-High S2: Pivot- (High -Low) S3: SI -(High-Low) Once a trader has this formula, then the key data needed are the high, low, and close of the previous session. For my own trading, I like to utilize 24 hours' worth of data to capture the highs and lows. However, it is absolutely imperative to use the settlement price for the close, as this is the only closing price that matters. Often a 24-hour setting on a chart means midnight to midnight, and that will destroy the validity of the data. We will go over this in more detail shortly. Once I get this high/low/close, I plug these into an Excel spreadsheet with the formulas listed above. This information generates seven important levels for the next trading day: a central pivot, then three levels above (Rl. R2, and R3) and three levels below (SL S2. and S3). The central pivot has the most weight of the seven levels, [n addition to these daily levels, I also utilize the midpoints between these levels. Finally, I like to know where the weekly and monthly levels are located. These are calculated by taking the high/low/close of the previous weekly or monthly bar While the daily pivots change each day, the weekly pivots charge only once a week, and the monthly pivots once per month. It is important to note that it is extremely rare for a stock index to hit its daily R3 or S3 levels. This is important to know because if a market rallies to R2 or a sells off to S2, that usually ends up being the dead high or the dead low of the day. This knowledge will help temper a trader's emotions and keep them on track to follow this system. |
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