Throughout my last three blog entries, I stressed the importance of developing and incorporating a risk management strategy into a trading system. In this entry, we will examine another important part of a trader's system, his trade setups. As traders, we are bombarded with incredible amounts of information every minute of every day. Between CNBC, twitter, stocktwits, message boards, chat rooms and even our own watchlists, we have to process hundreds of possible ideas and trades every time we sit in front of the computer. When you are overwhelmed with this many choices, much like standing in front of a vending machine with a crispy dollar bill, it helps to have a plan of attack. For instance, in my case I will first look for something in the Honeybun-Bearclaw range (yes, I like my sweets). If not, I will fall back on some sort of chocolate bar or perhaps a hard candy like Skittles, and if that fails, perhaps potato chips or I just walk away. Being prepared like this allows me to avoid panicking into a terrible decision like a bag of trail-mix. As traders, we need to have the same approach. You have your Honeybun setups which you look for first, followed by your Twix setups, followed by your Skittles setups. If you don't find any setups, you walk away and look for another machine. This doesn't mean that you ignore really tempting discretionary trades that may appear (like Twinkies) , but you don't want to be that guy paralized in front of the glass because he had no clue what he was looking for when he got there.

(Don't be this guy.)

While I don't name my setups after sweets, I do give them unusual names that are easy to remember and visualize. As a big sports fan, I name most of my setups after athletes that remind me of certain scenarios. The particular setup I'll be sharing here is called Beastmode and is named after one of my favorite players in the NFL, Marshawn Lynch (unfortunately, I'm a Buffalo Bills fan).

click here to see what Beastmode is!

This is a breakout strategy that looks for range expansion after a prolonged period of range contraction at or near recent highs. While you can give it a boring name like narrow range breakout play, I find that giving my setups colorful names lets me recall and visualize them easier. For instance, with this one I like to picture Lynch barrelling into the line of scrimmage, breaking through it, and ripping off a long run. This is exactly what I expect price to do when I enter a Beastmode trade.

A perfect example of a Beastmode trade is one I am currently involved with in Coventry Health Care Inc. (CVH).

The first thing I look for when scanning for this setup is range contracting as it bumps up against a key price level, falls towards its rising moving averages and then bounces back to resistance and begins the cycle again. This typically sets up an ascending triangle like CVH did throught November and early December. Please remember that when we study charts, we are not looking at magical lines that affect price, we are seeing visual representations of crowd psychology. A rising trendline or moving average shows us that the consensus opinion of a stock's price is steadily improving in the eyes of market participants. A horizontal trendline such as the one that held CVH in check around the $27 area is a price level that market participants see as significant for a particular issue. In this case, the consensus opinion of CVH was steadily improving as more and more buyers found it to be an appealing buy from $23 up to $27. Once it reached $27, sellers appeared showing that the consensus opinion was that CVH was too expensive over $27. These two opinions as shown by the converging trendlines would need to be reconciled soon, and led to an initial breakout above $27 on December 13th. This breakout quickly failed and price began a slow drift just below $27 as it began to tangle up with its moving averages. This long string of doji candles throughout late December showed us that the crowd was becoming increasingly confused about the value of CVH. This is the most important criteria I look for when looking for a Beastmode trade. Range has to contract in an orderly fashion that shows me that the consensus price is in limbo at the moment. Once range begins to expand, especially when it breaches a price level that has held the stock in check it signifies that market participants have finally agreed that the current price is buyable, and we have our entry. In CVH's case, this was on Monday, January 3rd. Notice how this is the first candle CVH printed in several weeks with a decent sized body. It also reclaimed its key 20 day moving average on increasing volume. Because this is a breakout trade, I prefer to set a stop at the entry day's low unless there is an obvious level of support relatively close to the breakout point because a reversal below these levels would indicate a failed breakout and thus the trade thesis would be null. In this case, I set my stop just under the recent doji lows around $26.20. My entry was at $26.80 giving me a risk of .60. I expect the stock to have a decent run on this type of trade, so I prefer a strategy of slowly scaling out at either key resistance levels , or in some cases multiples of whatever amount I risked initially. On a side note, I highly recommend that traders pay close attention to their exit stategies as they are as important if not more important than their entries. After all, you make or lose money when you exit a trade, not when you enter it.

Another chart that is in Beastmode right now is Sunrise Senior Living Inc. (SRZ).

While I missed this trade, it is a perfect example of what I am looking for when I stalk a chart for this setup. At first examination, you would think this is a different type of trade than the CVH trade since SRZ had more of a descending triangle type of consolidation, but the key component is there, which is range contraction at a key level. SRZ cleared the $5.50 area on December 16th of last year, but the trading action for the next couple of weeks showed indecision on the part of market participants as they struggled to find a price level they were comfortable with. Notice how the candles kept narrowing day after day on declining volume. While the holiday season most likely had an affect on the volume, it is also a characteristic of indecision on the part of traders as they try to figure out the percieved value of a stock. SRZ offered a beautiful entry on January 3rd when traders were forced to either let price drift under the swiftly rising 20 day moving average or break out above the descending trendline. The bulls won out on this one and pushed the stock upwards on good volume. As you can see, SRZ has followed through nicely on the breakout and offered an excellent trading opportunity.

One last example of a stock going Beastmode is the Walt Disney Company's (DIS) chart.

DIS offered a clean trade as well, never violating its trendlines until it broke out on heavy volume. Throughout November and December, DIS bounced back and forth between a rising trendline and overhead resistance at about $38. As it neared the apex of the ascending triangle, DIS put in a string of seven doji candles showing that buyers and sellers had reached a point in which neither side could gain control. The seventh candle gave us a hint that the bulls could break through on the next day as it gapped above the previous candles and had slightly heavier volume than the days preceding it. Either way, on Jan. 4th, DIS broke out decisively on heavy volume and continued it nicely the next day. Once again, this would have been an easy trade for a trader as it had an obvious entry that worked immediately.

One of the most important keys to trading this setup is to have the patience to wait for the “obvious” entry. You may miss opportunities when stocks breakout before you want them to, but it will also prevent you from waiting for stocks as they dilly-dally around if you enter early.

Below are a few charts I will be stalking over the next few days to weeks to see if they can go Beastmode on the markets.

Atlas Pipeline Partners (APL) has been coming to terms with the price area between about $24-$26 after a strong gap up on heavy volume in mid-November. I'll continue to watch it as it hopefully gets wedged between its moving averages and the apex of the converging trendlines in the near future.

Monster Worldwide Inc. (MWW) appears to have had some range expansion already after a prolonged drift of narrow range candles, but I didn't like the pattern as it didn't really have enough narrow days before the range expanded and failed on that day as well.  However, it is wedged up against resistance on expanding candles, and I'll be watching to see if it breaks above Wednesday's highs on good volume. If it doesn't have enough steam to break out, I wouldn't mind seeing it drift back down and offer aa better setup.

Teekay Corp. (TK) has been oscillating back and forth between about $31 to $34 or so after a big move in October as it comes to terms with its new price level. While it has a bit of a sloppy top when trying to figure out its resistance area, it has had steadily rising support and has had a pretty orderly consolidation while it waited for its 50 day moving average to catch up with it. The last three candles have shown a failure to hold above the $33.50 area and I would love to see a string of steadily contracting candles as it come to rest on its coiling averages.

I hope seeing one of my trade setups inspires you to do the same if you don't already have a playbook and if you are a trader that already approaches the market like this I hope it inpires you to add new plays this year.

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, Stocks, Watchlist