ive Accumulation). Slow, steady movementupward with consistent volume indicates so-called good buying andmeans the start of upward momentum. (See Figure 9.3.) Those who areaccumulating need to be very careful in such situations. They are buyingenough shares to support the stock’s direction, but they aren’t buying so
FIGURE 9.3The beginning of a trend. (RealTick graphics are used with permission of Townsend Analytics, Ltd.)
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much that it attracts the majority. This is often a tough game to playbecause any hint that the footprints are being seen by the majority will initiate a price and volume spike, thereby ruining the intention of the smartmoney to establish a position at better prices. This is why we often laughabout upgrades and downgrades or stock picks. If the company reallywanted the best prices, it certainly wouldn’t tell the world to buy it, thusmaking it harder to buy the stock at a low price. This leads us to the conclusion that the company has already established its position and thenalerts the public to buy it, so it can begin to unload shares. Unethical orunfair doesn’t matter to us as traders. Our job is to understand how theminority works in order to feed off the usual ignorance of the majority.The movement of stock being quietly accumulated is slow and oftenaccompanied by nasty pullbacks. Those pullbacks are caused by smartmoney desire to keep the upward movement in check. Buyers who try toestablish a large position don’t want the stock to rocket out of sight ontheir own buying. If they need to buy 1 million shares, they most likelyare going to buy 1.5 million and sell 0.5 million, switching from the buyside to the sell side now and then, jockeying around, and keeping the lidon the movement when it becomes too fast. Level 2 players in the recentpast could see this phenomenon when the market maker who sat on thebid, chasing stock up for hours, all of a sudden appeared on the offer withsize, thus causing panic among those who had decided they figured themarket maker out. That is a visual example of masking intentions.Switching the sides, using ECNs (Electronic Communications Networks)to hide the buyers’ identity, showing sizes that are intended to scaretraders into taking certain action rather than getting that size filled, andmany other tricks were and still are being used to mask real intentions.That’s why we are always skeptical of attempts to trade on a pure Level 2reading. Attempts to beat professionals in this game are not likely to beconsistently successful considering the professionals’ experience, bigarsenal of tricks, and access to big money. Instead, traders are better offfocusing on the bigger picture, on reading the movement with methodsthat allow them to separate what is shown to the public from what is reallyhappening behind the scene.3. Trend Confirmation (Aggressive Accumulation). The trend confirmation principle describes a slow price advance with steady increasing volume that indicates continuing upward momentum. (See Figure 9.4.) Thesame can be reversed for the short side. During this stage of the move, theposition may be held as the majority has yet to catch onto the trend. Whenyou see the majority begin to participate, the rate of volume will increase
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FIGURE 9.4The continuation of a trend. (RealTick graphics are used with permission of Townsend Analytics, Ltd.)
coupled with a steeper angle of the price movement. This is the point atwhich it is time to observe carefully as price movement can easily accelerate, switching to the euphoria mode. This stage comes naturally after thetrend beginning and serves as a preliminary phase before euphoria. If wewere to describe the principles in their logical order as subsequent stagesof move development, we would put euphoria after trend confirmation.However, we prefer putting euphoria/capitulation first to emphasize itsimportance as a trend reversal sign. Later we show the logical consequence in typical scenarios and practical examples.4. Shallow Retracement Trend Continuation. This principle entails a relatively big volume increase on the price advance with shallow volume onthe pullback, indicating a continuing uptrend. (See Figure 9.5.) Thisshows that there is reasonable support for the stock and no real willingness to sell at the current price by either smart money or the majority.There are often one or two identifiable market participants who show solidsupport for the stock as they absorb any meaningful wave of selling. Inthis case, we look for a break of the previous high to provide confirmationthat the trend is still intact.
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FIGURE 9.5Shallow retracement trend continuation. (RealTick graphics are used with permission of TownsendAnalytics, Ltd.)
This situation can be seen in both the trend beginning and trend confirmation stages. It is natural pullback caused either by some profit-takingor by desire of those who accumulate the shares to limit the movementuntil the right time. Other factors can be part of the mix as well, such as alow level of confidence during the uncertainty of the first phases of themove or stubborn attempts by the opposite side to resist the move. In anycase, if the pullback is not deep and is accompanied by decreasing volume, it’s usually a sign of trend continuation. Throughout the remainderof the book we provide many setups and examples of how we use volumechanges as indications of what we are going to do.5. Decreasing Volume Reversal. This is a slowing pace of buying withdecreasing volume which indicates that the top of this stage of movement
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FIGURE 9.6Decreasing volume reversal. (RealTick graphics are used with permission of Townsend Analytics, Ltd.)
is near. (See Figure 9.6.) Most traders refer to this as “Buying is dryingup.” As the price advances to this area, it fails to attract attention and itslowly slides lower off that high.Here, again, volume indications help us determine our actions. Theidea is simple. As the price rises, buyers do not consider this area attractive; they want to accumulate their shares at lower levels. They evaluatethe upside as minimal from here, or they are not confident that buyingpressure is going to be strong enough to overcome resistance. At the sametime they are not yet motivated enough to start liquidating their positions.This creates a temporary standoff where neither side is aggressive enoughto move the price. The volume decreases significantly, and most often thissituation leads to a price retreat.6. Passive Accumulation/Distribution. Big buying volume without theprice changing indicates distribution and means there is a resistance level
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FIGURE 9.7Passive distribution. (RealTick graphics are used with permission of Townsend Analytics, Ltd.)
(passive distribution). (See Figure 9.7.) This is often the case when astock moves into resistance defined by technical indicators such as a chartor moving average resistance. Early buyers distribute shares they accumulated at lower levels. They feel that the current level is the easiest levelin which to unload their intended positions. Many often wonder why theydon’t raise their offer and fill the rest at a higher price. The answer is simply that, at higher prices, they will have to compete to sell their shares ifbuying dries up. They basically choose a level that has little competitionso that they can distribute their shares to the buyers; thus they are able tocomplete their intended sales without much effort. This creates a temporary standoff in which both sides are fairly aggressive. Unlike the previous case, volume is big at this level.This resistance level doesn’t necessarily mean that a short should beentered here. As we will see in the following chapters, this kind of situation often leads to consolidation followed by breakout.Big selling volume without price changing indicates accumulationand suggests a support level (passive accumulation). (See Figure 9.8.)This is the exact opposite of distribution. Buyers are supporting the stockat levels in which the sellers unload their positions. The buyers’ intention
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FIGURE 9.8Passive accumulation. (RealTick graphics are used with permission of Townsend Analytics, Ltd.)
is to give strong support to the stock, which eventually leads to the dryingup of the selling pressure, thus leaving the sellers frustrated as the solidsupport holds and leads to a reversal. Should this support level break, alllong positions should be closed. Again, as with distribution, this supportdoesn’t necessarily mean that the stock is going to reverse. Consolidationnear the low often leads to a breakdown and a further downtrend.As we can see, this principle describes the situation of a congestionarea where one side is betting on the continuation of the trend while theother side places its hope in reversal.Distribution and accumulation by themselves do not suggest whataction we should take. They simply mark certain levels that can be usedto form setups. We discuss this in the following chapter as we show howsetups are built and played. Notice also that we call this passive accumulation/distribution. It’s important to distinguish these two principles fromaggressive action. Passive accumulation is bidding, buying only fromactive sellers. Often it’s accompanied by a willingness to drop the biddingprice if sellers become too strong. Passive accumulation by itself does notlead to a price advance. Rather, it lays the foundation for a future priceincrease if and when the sellers get exhausted. Aggressive accumulation
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is characterized by buying at the offered price, chasing the price, and bidding the stock up. Aggressive accumulation does move the price up asdescribed in principles 2 and 3.The importance of tape reading is its ability to save us from making market predictions and arbitrary egotistical assumptions about the value of astock. Your opinion about that stock’s price is not important. What isimportant is where the shift of supply and demand for a particular issue inany time frame moves a stock. The principles described above can be usedas a stand-alone system, because they represent what the minority does inorder to feed off the majority’s reactions to what it thinks should happen.Furthermore, tape-reading principles as we’ve revived them can be complemented by other studies of trading, including, but not limited to, technical or fundamental analysis.It’s often asked how tape reading relates to technical analysis. Theyare not mutually exclusive. Tape reading is the root, whereas technicalstudies and indicators are derivatives. They play the role of interpreters.The market talks to us in its original language of price, volume, and pace.You can read this language on your own, or you can use the help of interpreters to one extent or another. In examples in Part Three we show howwe use some simple technical analysis to support and detail the reading ofthe movement. We don’t like to overcomplicate this process. Manytraders overwhelm themselves with vast numbers of studies that cloudtheir perception. This makes their approach too formal and detached fromthe reality of the market.With the use of reading the crowd mentality and the footsteps of theminority, we are able to put the probabilities of success on our side. Weare not concerned with creating certainties in the market because the market is too random to achieve any kind of certainty. We are concerned withputting the probabilities on our side. An understanding of true marketreality increases our chances for success. Remember that there is no HolyGrail of trading. But there is a window of truth into the market, and ourtape-reading principles can allow this window to be wide open for yourdomination of the trading arena.
CHAPTER 10
The Role of Setups
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here is a question often asked in many different forums: Does technicalanalysis (TA) work? The answer depends on what you expect TA to dofor you. If you want TA to tell you what the future will bring, then no, itdoes not. If you want TA to help in your trading, then sure, it does.To us, TA has no predicting value. By this we mean that one oranother setup or pattern does not tell us in advance which way the pricewill go. The value of TA is different. It imposes a structure on what otherwise seems like chaos—price movements.Following is an illustration: Suppose you see a car on the road, andyou try to figure out which way it’s headed. Much like we do when we arelooking at stock action and trying to determine which direction it will gofrom the current price. There is a crossroads ahead. Until the car actuallyreaches it, you don’t know which way it will go. This is just like lookingat a stock chart for the first time. When you see the car’s right-turn signalflashing, you can assume that the car is going to make a right turn. Is itabsolutely certain that it will? No, it isn’t. The stock may head up or down,but is it certain the direction will continue? The driver of the car can havea change of mind, but the probability of the right turn is high enough.When the car makes the right turn, you can assume with even higher confidence that it will go to the right. Can it stop and back up? Sure, it can.Just as a stock can go up for only a few ticks and then reverse. But if youbet on the car going right after making the right turn, you have the oddsin your favor. At the same time, you recognize the signals that tell youyour initial assumption is wrong—the car reaches a crossroads, turns rightafter signaling a right turn, but then the car backs up and turns left. Thisis the same as seeing the signals that a stock should go higher, watchingit go higher for a few ticks, and then seeing it reverse and go much lower.107
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FIGURE 10.1Trading the range break.
This is how trading setups work. They give you signals. When youhave signals, you know what to look for to determine which direction hasa higher probability of being taken. For example, a stock is moving in arange between $19.75 and $20. You want to play a break of this range inthe direction of the break, assuming that, if the stock breaks to the upside,it’s a sign of strength, and vice versa for the break to the downside. (SeeFigure 10.1.)Your setup is for a long side trade on the breakout over $20 withsupport at $19.75. There are two signals. The break of $20 indicatesupward movement, and the break of $19.75 indicates downward movement. These signals provide you with your set of if-then scenarios. Youalso have your safety net. If the price moves through $20 and drops to$19.75 and breaks it, oh well, the driver was drunk.As you can see, Figure 10.1 doesn’t tell you whether or in whichdirection the breakout is going to happen. It gives you an idea of what youshould do if and when it happens. That’s what we mean when we say thatTA doesn’t offer predicting value. TA doesn’t tell you which side is goingto be broken. But it does provide structure and favorable odds. It providesindications of the most probable direction of the trend. This is one moreway in which “Trade what you see, not what you think” works.Technical analyses work, as long as you read them to your advantage and do not expect them to tell you what to do. They are your tools.Tools do not work by themselves. It’s how you master them that determines your success or failure. Traders who expect TA to do their tradingare similar to musicians who expect their pianos to play music.Let’s build a set of if-then scenarios, from the simplest one to more
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complicated ones, and adding new factors that will bring us from puretheory to reality. At this point we will discuss only entry and initial stopplacement. Taking profit and stop trailing are discussed next. The example that follows is devoted to a particular setup, “Break out of the narrowrange.” Later we go over other setups and apply the same methodology ofscenario building.1. If the stock price breaks over $20, then we buy.2. If the price drops to $19.75 after our buy, then we get stopped out.3. If the price breaks below $19.75, then we sell short.4. If the price hits $20 after our short sell, then we get stopped out.Now that we have our first signals and our trading idea defined, it’stime for more factors to come into play. The first of them is overall market condition. This is a breakout setup, but is the market really favorablefor breakouts at this moment? If it is, we can go for a breakout in a broadmarket direction with confidence and act aggressively. A strongly trending market will act like busy traffic that will not allow our car from theexample above to back up and change direction. If we have a narrowranging market with no follow-through on breakouts, we should choose aconservative approach. Let’s analyze what a conservative approach iscompared to an aggressive one.First realize that there is a trade-off on the price you get, the ease offilling your order on the one side, and confidence in the trade outcome onanother. You can get the best price by buying the bottom of the range, butthere is not the slightest sign of a future breakout. Your confidence is lowest at this point. You can wait for the entire move to be done, and yourconfidence in it will be 100 percent (what could be more certain than theresults of an event that has already happened?). But the price that you getat the top of the move is the worst possible and leaves you no room forprofit. Trading is about finding a balance. It’s the fine line between whereyour confidence is at an acceptable level and where the point of entry isaffordable.
DIFFERENT METHODS OF ENTRYLet’s look at a case with a long play in a positive market. If you have areally strong trending market moving in the direction of your breakout,you have reason to be aggressive. In this case it would mean entering thestock before the actual breakout. If you see buying pressure building andthe price approaching the breakout limit, you can buy at let’s say $19.90.
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(See Figure 10.2.) It gives you a better price, an easier fill of your order(which might be very hard on an actual breakout, which tends to occurvery quickly), and a tighter stop. However, the trade-off is that thisinspires less confidence in the breakout itself. The market strength favoring the direction of your trade is what increases your odds for a successful trade and allows you to enter before the actual confirmation of thebreakout. Notice that the more aggressively you intend to act, the lowerthe price of your entry would be. For the purpose of further discussionlet’s call this the aggressive method of entry.If you are not sure of the follow-through because of the weakertrend, you should wait for the actual breakout to occur, thereby giving yougreater confidence in your trade. Again, the trade-off would be the worseprice and a wider stop because you buy farther from the support level.This kind of entry would be moderately aggressive. (See Figure 10.3.)Let’s call it the regular method of entry.If there is no trend and your confidence in the breakout trade is low,you should adjust your level of aggressiveness accordingly. Before youtake this trade, you will want to see as much confirmation as possible. Inthis case you apply a conservative approach, which means that you skipthe breakout level itself and wait for the stock to pull back. If it tests new
FIGURE 10.2Method of aggressive entry.
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FIGURE 10.3Method of regular entry.
support (the former resistance level) and keeps above it with confidence,then you’ve got your confirmation of the strength and you can buy thestock anticipating further movement. (See Figure 10.4.) The trade-off hereis going to be the risk of missing the trade altogether if the stock runs onyou with no pullback.Figure 10.4 shows entry just above a new support level. Dependingon how much confirmation you want to see, you can wait for a break overthe new high of $20.25, thus effectively deepening the trade-off of moreconfidence for a worse price.Notice that the breakdown of different ways to trade the same setupcan be applied to any setup. When we describe setups in the followingchapters and Part Three, we talk mostly about the regular way of entering a trade, which means “Enter at the trigger level.” But this distinctionas to the method of entry is always possible and is left to the trader’sdiscretion.There are endless variations on the way you can play the setup, andwhat you choose becomes part of your edge. Following are a few moresetups to give you more ideas to choose from.You can let the trigger go and wait for the stock to bounce back intoyour range. At this point you try to enter as close to the stop level as possible. You will need to find the entry at the moment when the stock stalls
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FIGURE 10.4Method of conservative entry.
and is getting ready to reverse. This way, you can make your stop as tightas possible and your profit potential bigger compared to your entry on thetrigger. You also have more confidence as compared to an aggressiveentry since your trigger was hit once, thus shaking the confidence of thosewho believed that the level would hold. Drawbacks are the risk of missing the play altogether if the stock goes in the direction of the setup andnever looks back. This play requires perfect timing.You can enter half of your position at any of the above-mentionedpoints (at the trigger, near the stop level, before or after the actual trigger)and add another half as the stock hits another indicative point. Forinstance, if you enter the first half near the stop level, you can add the second half as the stock hits the trigger. Or you can enter the first half at thetrigger level, adding the other half if a bounce takes the stock within therange and the action weakens. There are other variations of adding to yourposition as the stock goes in your favor. Obvious drawbacks are a possible increase in commissions and the possibility of being left with just halfof your planned shares if the stock doesn’t give you an additional opportunity to enter.As you can see, setups provide you with structure that you canexploit in any way that matches your risk tolerance, your temperament,and your personal objectives.
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There is one more important element to add to your observations:volume. As we know from tape-reading principles, we want volume toincrease when the price moves in the direction of our trade. In this casewe want volume to rise as price rises and dry up as price pulls back.Figures 10.1, 10.2, and 10.3 include volume to show that we need it to beshaped to increase our confidence in our breakout success.Now our set of scenarios becomes more complicated. It includes notonly the setup structure but also market conditions and our confidence ina successful break. It also includes volume as an element of a generalreading of the movement. At the same time there are no more scenarioswith the short side since we defined that market as favoring long plays.The new look of it would be:1. If the market is very strong, then we look to buy at the first sign ofstrength and don’t wait for the actual break.a. If (1) the stock trades over $19.90 and (2) the volume increases onthe buying, then we enter.b. If $19.75 is hit, then we get stopped.2. If the market is trending but not overly strong, then we look to buy theactual breakout.a. If (1) the stock trades at $20 and (2) the volume increases, then weenter.b. If the price drops to $19.75, then we get stopped.3. If the market is uncertain, then we look to buy only after the break anda successful retest of new support.a. If (1) the stock breaks over $20 and (2) we retest it on pullback, and(3) we see volume increase on upward movement and dry up on pullback, then we buy it on the first sign of strength over $20.b. If the stock loses $20, then we get stopped at $19.90.By building scenarios, you can determine your action for any market situation. This is the way in which you discipline yourself and protectyourself from the uncertainty of the market. Instead of trying to guesswhat the market is going to do next, you determine what you are going todo in response to any development. This is the biggest role that setupsplay in your trading. They solve the conflict between the necessity of certain action and an uncertain environment.
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CHAPTER 11
Stop-Loss Placement and Trailing
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e have already discussed the role of stops in trading and the psychological implications of this part of the trader’s job. Now we need to seehow stops should be placed so that they can do what they are supposed todo, which is to prevent losses from growing on one side and protect usfrom being taken out of the trade until it’s proven no longer valid on theother side.Let’s start with the factors that determine where we put our stop.There are two major factors that influence our decision. The first is market indications of trade failure. We don’t want to exit the trade on the firsttick that happens not to be in our favor. The market has too much noise,and such an approach would lead to our being shaken out too often. As wediscuss in Chapter 10, there are signals that indicate the rising odds of atrade not working. So our stop should be placed under the level that indicates a trade failure if this level is broken. Usually such a level is a levelof support for a long side trade (resistance for a short side). The idea is,that if support is broken, we don’t want to be long. And, if resistance isbroken, we don’t want to be short.Support is often established by the level that a stock has tested several times and bounced off of. It also can be a former resistance that hasbroken to the upside. After such a break this level acts as support. (This isa commonplace occurrence, so we will refrain from providing explanations of how and why it happens.) Other examples of support are the trendline, the moving average, Fibonacci numbers, and so on. There are different levels of support within different time frames. When supports fromseveral time frames coincide at the same price level, it makes the supportmore important.115
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REVISITING RISK MANAGEMENTThe second factor that determines where we put our stop is our risk tolerance. Now and then we face situations in which the price differencebetween levels indicating trade trigger and trade failure is bigger thanwhat we are willing to tolerate. Should we move our stop closer to theentry price in such cases? No, because it would increase the odds of ourbeing shaken out. This is a mistake we see many newer traders make. Riskmanagement in this kind of situation should determine position size. If ourrisk is $250 on each given trade, then we go for 1000 shares on the tradewith the difference between the trigger and the stop levels being 25 cents.If this difference is 50 cents, we decrease our share size to 500, keepingwithin our risk parameters and still following market logic.We need to add two more distinctions here. The first is slippage. Ifthe theoretical price difference between the trigger and the failure level is25 cents, it doesn’t mean that we can get this price automatically in reallife. We have to evaluate the risk of slippage, and our major tool for thisis Level 2, which allows us to judge the depth of the market for each givenstock. As a rule of thumb, signs of a risky stock with the possibility of bigslippage are a wide or often-changing spread, a big gap between price levels, small sizes shown by market participants, and few players at eachprice level. It takes little practice to learn to tell a jumpy, dangerous stockfrom one that usually trades in an orderly fashion.The second distinction to risk management is stop padding. This isa more sophisticated technique that factors in attempts by market participants to move the price to the level where most stops are located. This isknown as “running the stops.” Many traders mistakenly assume that themarket makers can see the stops entered in the system. This is not so, butexperienced players understand how most traders think, and this understanding allows them to guess where the popular stop levels will be witha high degree of accuracy. Padding means simply moving our stop a littlefarther, to place it a bit aside from the popular levels so that we won’t beeasily shaken out. As you can see, the theoretical 25-cent stop can in reality easily turn out to be a 30–35-cent stop. We need to factor this in whenwe consider our share size.For simplicity’s sake, we discuss long trades. It’s easy to apply thesame principles to short entries.
Initial Stop PlacementTo define the level of an initial stop placement, we need to identify thereason for the trade. Then we can determine the sign of trade failure.
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FIGURE 11.1A breakout trade.
1. Breakout Trade. A breakout trade is taken on the assumption that, ifthe stock is trading above a higher limit of the range, then it’s going to gohigher. The stop should be placed below the support level. Support in thiscase is defined as the lower limit of the range the stock moved in beforebreaking out. (See Figure 11.1.)2. Range Trade. The reason for entry in a range trade is a bounce fromsupport, assuming that a stock remains within the range. If the lower limitof the range is getting broken, the reason is no longer valid because theassumption hasn’t proved correct. The stop should be placed below thelower limit of the range. (See Figure 11.2.)3. Capitulation Sell-Off. The entry for a capitulation sell-off is taken onthe assumption that panic selling has washed the sellers out and a Vbottom is forming. (See our capitulation setup in Chapter 13.) A V-bottomis a visual representation in which the left side of the V represents sharpselling, the bottom of the V represents the reversal, or pivot, point, and theright side of the V represents sharp buying. The stock is usually trading inuncharted territory for the day, so there are no support levels defined bythis day’s trading. Considering a higher risk for a larger than expectedstop loss due to thin liquidity, this kind of trade’s stop loss should be
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FIGURE 11.2A range trade.
placed just below the low a stock made on the last decline, within our risktolerance. In other words, any new low should be considered trade failure.(See Figure 11.3.)
Stop TrailingAs a stock moves in our favor, we want to protect our profits. Usually wecombine stop trailing with partialling, or scaling, out, which means theselling of portions of our shares. Most often it’s half and half. Sometimes,when the market shows a very strong trend, we can go for half, quarter,and quarter. For example, if we enter with 1000 shares, we can sell 500and 500 or 500, 250, and 250.There are some comments that need to be made about this methodology. From the pure statistics point of view, partialling in is a better wayto trade than is partialling out. Do not confuse partialling in with averaging down. Averaging down is adding to your losing position, which wedon’t do. Adding to your position as it moves in your favor (so-calledpyramiding) goes along the lines of “letting your profit run.” By partialling out, you limit your profit potential. Also keep in mind that yourentry point is usually the point of lowest confidence. As the trade develops, your confidence level rises with new confirmations that your initial
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FIGURE 11.3A capitulation sell-off.
idea is right. It makes perfect sense to enter just part of your position whileyou have no confirmation and add to it as the market tells you that you areright. If the trade doesn’t work, you get stopped with just part of yourposition. In a real day trader’s life, however, other factors come into play.Fast intraday trades do not always allow for multiple entries along withtrend, because trends come and go much more quickly than they do forlonger time-frame players.Furthermore, from a purely psychological standpoint it’s much easier to keep your position when part of your profit is secured. Of course,psychological comfort is not something that we should let govern ouraction, as we discuss in Part One. Still, most of us have to maintain mental balance in order not to get burned out from everyday tension. Partiallingout serves this purpose well. Is some ways partialling out functions likeinsurance. In most cases insurance is a waste of money because nothinghappens. But in those rare cases when something does happen, insurancesaves you from a hard hit. What is it that you insure against when youscale out? It’s a trade turning around halfway and hitting your stop. Byscal