Trading the Shortstack episode #3

In the past episodes of Trading the Shortstack we learned that in order to square off against Mother Market we must first put on our magical armor of risk management. With this armor, we can shrug off multiple attacks without serious injury while we wait for the proper moment to retaliate. We also learned that we should not attack until the market gives us an opening that offers a reward commensurate with the risks we are taking. Lastly, we know that we must control the engagement by waiting for the trade setup we want to appear instead of chasing missed opportunities. This is the equivalent of an army seeking higher ground in preparation for a battle. So here we are standing on top of a hill wearing our magic armor waiting for Mother Market to show her ugly face. What's next? We wait some more!

Did you know that a cheetah can accelerate faster than a sportscar by reaching 60 miles per hour in less than 3 seconds and is capable of reaching top speeds of over 70 miles per hour. Read that again! (its more fun if you do it with a smarmy sounding nature channel voice.) Thats fast enough to get a speeding ticket in most states!

Yet even with the ability to outrun anything on the planet it will patiently stalk its prey until the perfect opportunity presents itself. Only when its success is all but guaranteed will it begin the hunt. On top of that extraordinary patience, if the cheetah cannot catch its prey quickly, it will immediately break off the chase and go back to the drawing board. This is exactly the type of approach traders should emulate when they are seeking to develop a trading plan. If we can stalk a trade for days and patiently wait until the proper setup materializes, we will have forced the market to agree to our terms and significantly skew the odds in our favor. Let's examine a sample trade based on a chart that was freely available to the stockguy22 community. (If you aren't a member, I highly recommend you look into joining our site. There are an incredible amount of ideas shared by great traders every day and being a part of this type of environment will improve your trading immediately.)

On December 6th, I posted a chart of MAP Pharmaceuticals (MAPP) after noticing support at the $14 level as well as a compression in its range as it pressed up against a descending trendline and 20 day moving average. The first thing a trader should do when stalking a trade is notice the area which would signify a failed trade to stop out of.

In this case, it would be just below $14. A reasonable short term target on this trade would be the top of the range at around $16.80. This gives us a rough estimate of around 50 cents of risk versus a reward of about $2.30. Almost 5 – 1, not bad, but keep in mind that this may narrow as the chart develops as we will likely buy on strength if it breaks above its averages/trendline. Seven trading days later, the entry I was looking for finally emerged.

Notice how the stock had a string of doji as buyers and sellers fought to gain control of it between the low $14's and its 20 and 200 day moving averages. It is important to identify these battle zones, and to have the patience to stay away until they have been decided. Once MAPP was able to hold above its averages and broke the descending trendline that had held it in check throughout most of October and November a clear entry presented itself around $14.75. If a trader took this signal and decided to give it a loose stop at $13.75, MAPP still presented a 2 – 1 reward to risk ratio with its $16.80 target. A more aggressive trader could have placed his stop under the day's low just under $14.40 risking .30 to make 2.10(7 – 1 rewards to risk ratio). While this type of trade will fail more often, it will make up for it when it succeeds. While the actual targets and stops vary from trader to trader, the important thing to focus on is that a good trader will wait patiently for a trade that offers the reward to risk ratio that he is comfortable with, and will not trade until such an opportunity arises. As we can see in the next chart, a trader's patience would have been quickly rewarded by MAPP.

As a matter of fact, MAPP didn't have a red candle until after it tested the top of its range. While not every trade is resolved this quickly or easily, as long as a trader exerts the self control necessary to avoid a poor entry, they can avoid having to hold through the choppy mess that often comes before a significant move. Having clearly defined exits also keeps a trader from second guessing the position if it stalls at intermediate resistance levels or even if it fails immediately. While individual strategies such as scaling in and out or incorporating options into the trade will vary from trader to trader, the single most important act a trader can do is to develop a system like we have done over the last three episodes that allows him to plan his trade ahead of time and control his risks. After developing a detailed trading plan like this, the only thing that will stand in the way of a trader is his discipline. If he can master that, he will master the markets.

If you have any questions or comments, feel free to contact me on twitter @stockdarts or in our great chat room if you are a stockguy22 member.

Posted in General Trading