Tuesday, November 24, 2009

This article is in two parts. Watch out for Part 2
lthough we try to explain the processes of trading clearly there is no escape for the fact that trading is a complex activity. A successful trade brings together many different features. It includes the right selection of indicator tools appropriate for the type of trade. It includes selecting a type of trade that is compatible with our trading style, our emotional reactions and to the way the market is performing at the time. There are always a wide variety of trading opportunities in the market. There are far too many for any individual trader to trade, so we are forced to make choices. The mistake the novice often makes is to search for those trades which offer the most spectacular returns rather than find trades which offer high probability trading situations.

We prefer trade opportunities which offer higher than average returns, but these are in addition to the high probability trading situation. We like chart patterns because they point the way to high probability trades. Stocks that pass this filter are then selected on the basis of higher potential profits. We do not start with potential profits and hope for high probability.

Compatibility of technique and indicator selection is very important for success. A reader wrote to us during the week. He noted that he had learnt that when he buys a stock he has to manage its trend. This is correct and at the core of almost all trading opportunities. The trend may be very short term, as in an intra day trade. It may persist for several days or weeks, as with position trading. Or it may prevail for weeks and months as was common with many stocks between 2004 and 2007. Each of these opportunities is a trend trade, but each calls for different types of management and tools.

The reader continued, noting that he can manage the trend using the count back line, straight edge trend line, the 2xATR indicator and Darvas boxes. Although this is correct, there is an important division in this list. The Darvas approach is a stand alone approach that does not incorporate any additional indicator tools such as trend lines.

The reader asked which of these tools is good to use and which tool is most commonly used to manage the trend? If there was a simple universal answer then trading would be a much easier profession to master. The answer relies on easy to use indicators, but complex combinations that are custom designed to suit each individual. Many people will use the same collection of indicators, but each will apply and interpret them in slightly different ways. Each trader will manage the trade in different ways, reacting to growing profits, or small losses in ways different from other traders. The result is a completely different, and perhaps successful trade, based on the same stock. The current series of notes on finding the trader’s edge is a practical demonstration of these differences.

This combination complexity should not deter new traders, but it is important to be aware of it. The selection of type of trading techniques which are compatible with your personality and preference is an individual issue. The solution also changes as you gain more experience in the market. In these notes we skip this aspect of trade selection and assume you have found the type of trending situation that you are comfortable in trading. Once this first step has been taken the next most important issue is behavioural compatibility.

The MBL chart from more bullish times is a good example of the initial decisions made about stock and indicator compatibility with a trading approach. Many stocks are in the breakout stage of this trend development. When traders look at this chart they have two choices. One choice is to decide what type of trading opportunity exists with MBL based on the past 2 to 3 months of price activity. There are a variety of solutions, including short term rally trading, counter trend trading, or perhaps taking a put warrant or short side trade. These answer the question: What type of trading opportunity exists on this chart? These are all valid solutions, but they are not our solution.

The question we have to answer is about compatibility with trend trading. The question we have to answer is this: Is this chart a trend trade? This is the second choice we have as traders and that is to decide if the stock is compatible with our preferred trading technique. Our focus in these notes is on trend trading approaches so the answer is a clear “No.” For much of 2003 MBL was compatible with trend trading techniques. Since October 2003 this had not been the case with MBL. We do not need to decide what is the best trading method for this period. We simply need to note that this period is not suitable for trend trading. The nature of the trend changed, and the nature of the price action changes after October. It is pointless attempting to make any of the trend trading techniques fit this chart.

The foundation of a successful trade rests upon selecting a chart or stock with a behaviour pattern that suits our trading approach. A trend trade is built around stocks that are moving steadily upwards. The point at which we identify this compatibility will change. Initially MBL was a breakout trade as the previous downtrend ended. Sometime in this period other traders noted the potential for a trend trade. This is indicated by the way the trend trade line starts at a midpoint in the breakout trade segment of the chart display. There is no clean cut off point or date that says this is a breakout trade and this is a trend trade. Aggressive traders recognise trend trades early. Conservative traders wait for much longer before accepting a new trend is in place. This effects their entry point, and the level of profit achieved from the developing trade.

To read more articles and commentaries from Daryl Guppy, click HERE


Article contributed by Private Trader, Market Expert, Trading Coach and Best-Selling Author Mr. Daryl Guppy. For more articles and commentaries from Daryl Guppy, click HERE.

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