500 margin in a single day.
FIGURE 8.24Used with permission of esignal.com.
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Case in PointCombining the statistical data that we went over in Chapter 7 (which indicated the frequency with which dojis, hammers, and shooting stars form)with the correlating markets (such as the S&P, the Dow, gold, and currency) gives you high-performing patterns; and trading using these patternsshould not be ignored. If the markets outlined here have both a high frequency and a strong tendency to form tops and bottoms by the developingdoji candle and if you learn to wait for that specific setup and act on a trigger rather than guessing or anticipating when a market is ready to turn, youmay see a significant improvement in your trading results.
Triggers on StocksIn Chapter 1, I gave an example of how an exchange traded fund may notreact as much or at all compared to a stock in that group or sector. Onesuch stock I showed was in Figure 1.15—Toll Brothers. If you broke thatmonthly chart down to a weekly and then a daily time frame and used thecombination of the techniques taught so far with pivot point analysis in conjunction with these specific candle patterns, you would have been alertedto a top in the market in the summer of 2005.Why don’t traders act on these signals? Most traders do not realizewhat pivot point calculations are and how the markets react to them. Theresistance target levels are “hidden,” meaning you cannot see a projectedhigh because it is not drawn from a past chart pattern; rather, it is derivedfrom a mathematical calculation. This gives a projected price expansion ona measured-increase based on the previous time period’s range accordingto the pivot point formula. Using the monthly pivot point method, takingthe trading data for Toll Brothers from June would have helped predict thehigh for July. Figure 8.25 shows the Pivot Point Calculator with the high,the low, and the close from the month of June. Notice that the R-2 targetnumber was 58.12. The exact high in July was 58.67!The chart in Figure 8.26 illustrates the low close doji trigger. In addition, we had the moving averages cross over, and prices traded beneathboth moving averages to help confirm that the market had lost its bullishmomentum.To some traders, the tall white candle at the top may have appeared tolook like a buying opportunity, especially as the market made a slight correction. The low close doji against the longer-term monthly pivot point resistance told a different story. Identifying the doji at or near a pivot point isa great guideline to alert you almost every time that there is a potentialprice change or reversal coming. Once the market makes that lower closing
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FIGURE 8.25Used with permission of www.nationalfutures.com.
low, that is the trigger to sell. That will hold as a valid statement until themarket closes back above the doji’s high.
The Best Predictive IndicatorThe best predictive market analysis tool is the pivot point, especially whenusing the higher time periods, such as the monthly and weekly time frames.We did cover the power of confluence, which should never be ignored.Using the monthly time frames, any investment vehicle like forex, futures,and stocks, especially after a market starts to form a doji on a daily chart,
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FIGURE 8.26RealTick graphics used with permission of Townsend Analytics, LTD.
is a sure sign that there is a strong possibility that a price or trend changeis about to occur. A great example of using this method to help uncover apotential disaster in the stock of clothing retailer American Eagle Outfitterswas used in mid-July. Taking the trading data from June as shown in Figure8.27, the Pivot Point Calculator shows the monthly R-1 was 32.86 and theR-2 was 35.07. The actual high was 34.04, right in the middle of the target resistance levels.One thing interesting here is that in Figure 8.28, the variation eveningdoji star does create the low close doji setup and indicates that the bullishmomentum, or uptrend, had stopped. However, the market traded in a consolidation range for two weeks before the trend reversal occurred. The trigger to go short was not elected because there were two elements missing:(1) The market did not close below both moving average values; (2) theshorter-term moving average did not cross below the longer-term movingaverage. Those variables came later, as you can see on the chart. But thefact is that the monthly pivot point kept the market from establishing further gains; and the low close doji trigger was a significant warning to exitlongs, buy put options, or at least tighten stops or move stop orders up toprotect profits from long positions. The initiative to sell short was also a
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FIGURE 8.27Used with permission of www.nationalfutures.com.
very viable action. Using a stop-close-only above the doji’s high, a traderwould not have been knocked out of the short position at any time.One of the more popular stocks in 2005, which mystified traders as itmade a stratospheric rise, was Google. Figure 8.29 shows the price movethat many thought would never end. Stock analysts were making upgradescalling for 600 per share in the first week of January 2006, and some wereclaiming as high as 2000. As you can clearly see, the low close doji patternforetold of the market top; more important, it traded near the monthly R-2resistance level of 466.95. Once again, here was a high-profile stock thatformed a major top with an LCD trigger at a monthly pivot point target resistance number.
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FIGURE 8.28RealTick graphics used with permission of Townsend Analytics, LTD.
FIGURE 8.29
Google riseUsed with permission of www.GenesisFT.com.
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FIGURE 8.30
THE JACKHAMMERIn my experience, the one candle pattern that is associated or synonymousmore than any other with the word capitulation is the hammer as Figure8.30 shows. In Chapter 7, we identified the frequency or the percentage oftimes over a course of the year on a 15-minute time interval when the hammer candle pattern formed at or near the low of a given day. The jackhammer, however, develops in the middle to the end of the trading session.Usually immediately following the hammer is a bullish candle, or a marabuzo, a tall green positive (+) assigned candle.What specifically describes the jackhammer? The jackhammer patternis a hammer candle, but it occurs in the middle to the end of a trading session. I call it “the search and destroy” stop-loss order pattern. The generalmarket characteristics of this pattern starts off with the market establishing a low, then consolidates or trades sideways for a bit, and then withoutwarning sells off abruptly. It is generally that particular sell-off that createsa hammer pattern. Therefore, anyone who had intraday stops too close,under what is considered the primary low for the day, got “bagged andtagged.” In other words, stop-loss orders were elected, and longs werejacked out of their positions and money—as in hit over the head with a billyclub and “jacked” (robbed).
Trading Rules DefinedThe jackhammer formation is an extremely powerful intraday reversal formation that requires immediate action to enter a long position. The sequence of events that occur for this pattern is:
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• The hammer formed is a secondary low with the close at or near theprimary low’s low.• It does not matter whether the real body is formed with a higher closethan open or positive assigned value; however, it is generally a moresolid signal when the close is above the open.• This action generally completes a bullish convergence in the stochastics or MACD oscillator.• Buy on the close of the hammer or the next time periods’ open; initialrisk is a regular stop below the hammer’s low.• Give additional importance if this pattern develops near pivot pointsupport targets, especially if there is a confluence of pivot support targets from different time frames.• Stock traders should watch for an increase or a volume spike, which indicates an exhaustion bottom is confirmed.Figure 8.31 shows a 5-minute chart on the CBOT mini-Dow. Notice thatthe “midsession” is defined by the middle of the day. The first intraday lowhas been established, nearly three hours pass by, and the market makes anosedive as prices hit a new low for the trading session. In this example, thehammer closes back within the primary low’s range. The trigger to go longis on the hammer’s close or on the open once the hammer formation is con-
FIGURE 8.31Used with permission of esignal.com.
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firmed. Generally, the jackhammer is followed by a blast-off secondarycandle as prices surge ahead. What we also have happen is that the marketcrosses above both moving average values, thus signaling confirmation thatthis is a valid buy signal. The trigger to buy was at 10393; as you can see, themarket ran straight to 10473 before giving an LCD trigger to exit at 10443for a 50-point Dow move, or $250 per contract.So far in this book, I have given you several patterns that work well forgreat day trading vehicles, such as the stock index futures contracts. Theelectronic markets offer retail traders a competitive advantage becausethey can use a home computer with a DSL or a broadband connection to integrate charting software packages and equal access to markets. The stockindex futures contract, such as the mini-Dow contract, has what technicaland fundamental traders need: News-driven events and other technicaltrading market participants both provide volatility and liquidity. Many ofthe chart examples contained in these pages are a great representation ofan average day’s trading patterns. That’s not to say the other stock indexmarkets, such as the e-mini–S&P and the Russell, perform differently; theyinteract extremely well with each other. In fact, at times I may have a trigger in the mini-Dow and take the trade in the S&P, and vice versa. Mosttimes, when the Dow gives me a trigger, that is the market I will trade in.Consider that the e-mini–S&P have an influence from the tech sector. Dowat times may or may not have a similar dollar value move as the S&P. Bothmarkets are great day trading vehicles, as is the Russell. The Dow moretimes than not has more distinct trading signals; for that reason, I have illustrated these setups with using the Dow.As another example of spotting a jackhammer pattern, look at Figure8.32, which is another 5-minute chart in the Dow. Here you see the secondary low bounce right off a pivot point support; and as the white or positive assigned values show, the candles’ closes are above the opens andwhat is indicated immediately after the hammer forms. Notice the immediate reaction of the market as the sequence of higher highs, higher lows, andhigher closing highs occurs. You can also see confirmation of the buy signal with the moving averages crossing over and with the second candleafter the hammer is formed—it closes above both moving average values.This is the confirmation that should give you the confidence to maintain along position. The stop is initially placed below the hammer’s low. Thisshould not be a stop-close-only as this setup should see an immediate positive reaction. The trigger to go long here was at 10935; the first sign thatthe bullish drive lost momentum was the lower closing low at 10965, whichresulted in a quick 30-point gain.There are times when we see this pattern late in the trading session.But keep in mind that the CBOT Dow contract trades continuously until 4
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FIGURE 8.32RealTick graphics used with permission of Townsend Analytics, LTD.
P.M. (CT), whereas the e-mini–S&P closes at 3:15 P.M. (CT) and reopens at
3:30 P.M. (CT). This offers day traders more time to play those shortsqueeze plays that tend to occur toward the end of the day. More important,I covered why I do not look to sell at support levels. These short squeezeplays occur as those who may have sold at higher levels look to cover andtake profits, as we see at certain times when the secondary low was rejected, which is what the hammer represents. Prices tend to move sharplyhigher in a very short period of time, signifying a rejection of lower prices.It is that price action that shows buyers attracted to the market, and bearsstart buying back or covering their shorts.Therefore, when you are looking for a pattern such as the high closedoji or the jackhammer in this situation, it is a more fruitful venture. Onegreat example is in Figure 8.33, where the jackhammer forms near the endof the session. The trigger to go long was at 10784, which we see as almostan immediate reaction for prices to move sharply higher to nearly 10830.This was another quick 40-point-plus gain, or $200 per contract. Again,this does not sound like big money; but when you consider that the daytrading margin is $500 at most online brokerage firms, that is a healthlypercentage gain.
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FIGURE 8.33RealTick graphics used with permission of Townsend Analytics, LTD.
Trading Tips• If the stop level is too great a distance, lower or reduce your contractsize.• Place hard stop below the low of the hammer candle.• Scale out of positions when the market gives you a windfall profit, andmove stops on balance of position above your entry price.
Bullish Convergence PatternIn Chapter 4, we went over how the market price makes lower lows, but notby significant measures, and that when prices are at oversold extremes, weshould be cautious for market reversals. We went over the market condition of bullish convergence and how to use the stochastics and MACD indicators to confirm buy signals when that market condition exists. Thejackhammer is a formation that seems to be present in such a situation.Therefore, it is a great method for setting up a potential buy signal once thepattern is confirmed. Look at Figure 8.34, which is a 5-minute chart on the
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FIGURE 8.34Used with permission of esignal.com.
e-mini–S&P 500 futures. As you see, the midsession of the trading day at12:30 shows on the charts that the market takes a secondary decline, forming that spike bottom hammer pattern. Notice that the very next candleafter the hammer is a tall engulfing candle that forms a higher high. Pricesthen continue on in the sequence of higher highs, higher lows, and higherclosing highs, while continuosly trading above the moving averages. If youexamine the stochastics at the bottom of the chart, notice that when theprice made a new lower low, the reading from the stochastics made ahigher low, identifying that bullish convergence existed. If you watched forthe stochastics to close back above the 20 percent line to confirm the pricereversal and the trigger to go long, you would have had a stress-free tradethat resulted in immediate returns.In Figure 8.35, you see another example of the e-mini–S&P, this timewith the aid of the MACD study. The jackhammer occurs past the midsession and actually closer to the close of business. Here we see both the moving average and the histogram components alerting us to the fact that theprice action was oversold and that a reversal was likely. The one-two combination of the jackhammer and then the bullish engulfing pattern revealeda forthcoming price reversal.
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FIGURE 8.35Used with permission of esignal.com.
Stocks Get Jacked, TooThe psychological aspect of this formation occurs in stocks as well. Believeme, they are not immune to the ravages of human emotion. The example inFigure 8.36 is Comcast Corporation and is a great illustration of how thestochastics indicator confirms that the jackhammer, or secondary low buysignal, was triggered as confirmed with a bullish convergence signal. Thefast stochastics indicator shows the timing of both %K and %D closed backabove the 20 percent line, confirming a bottom was in place. The trigger togo long here is on the close of the hammer at 26.63; and before the close at4 P.M. (ET), the market price is at 26.84.
The Jackhammer’s One-Two PunchFigure 8.37 shows a 30-minute chart on United Technologies that illustrates, depending on the time period, that the jackhammer pattern can existfrom one day to the next, like a one-two knockout punch that attacks thestops and immediately pops up. Since many traders look at the obvious lowpoint to place their stop-loss order, as this example shows, the jackhammertook out the prior day’s low; and then once again, the one-two pattern develops with the hammer and then the next candle being the tall white, or
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FIGURE 8.36RealTick graphics used with permission of Townsend Analytics, LTD.
FIGURE 8.37RealTick graphics used with permission of Townsend Analytics, LTD.
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bullish, engulfing candle. This starts the immediate price reversal, with thesequence of higher highs, higher lows, and higher closing highs. See howthe market also closes above and continuously trades above both the moving average values.If you know what to look for, trading for a living is a great opportunity;but with opportunity comes responsibility. Prior to entering a trade, youshould have your “pregame” setup, complete with your market analysis andrules for entering a trade. Certain rules should start with the techniquescovered in this book so far, which include:• Identifying what the market condition is—overbought or oversold bullish, bearish, or neutral.• Identifying the levels that the pivot points lines are at, using the varioustime frames—monthly, weekly, and daily periods.• Setting up your charting software parameters with these specific pivotpoints moving average values.• Experimenting with variation settings on your own.Then you need to watch and identify when and at what price points thedojis, hammers, and shooting stars develop. Knowledge of these items willarm you with critical information that can help provide protection fromovertrading as well as from adverse moves and such pitfalls as reacting onemotions rather than on actual trading signals.
SUMMARYThe method of market analysis described in this book is designed so youwill be educated on the importance of developing your personal tradingsystem and so you can apply the techniques on a consistent basis, whichwill allow you to make decisions in a mechanical and nonemotional way.Common mistakes that traders make are not testing a strategy and not making a logical determination of whether the strategy is viable for their trading style. Many traders adopt a new strategy, trade with it, and immediatelystart tweaking different components of the strategy. The best approachthat I have found in trading is to establish trading rules and to test thoserules until an outcome is determined based on a reasonable number oftrades. Also, I have several different trading strategies for different marketsor conditions. The high close doji, the low close doji, and the jackhammerpatterns are just a few of my proprietary setups that I watch for meetingthese conditions.If you are in a declining market, once an apparent bottom occurs near
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a pivot point support target, watch for the high close doji or the jackhammer pattern to develop. In a rising trend, once the market trades at or neara projected pivot point resistance, watch for a low close doji or a shootingstar pattern. These specific patterns can be added to your personal toolboxof setups or used exclusively as a day trading plan. By understanding thecurrent market conditions (uptrend, downtrend, or sideways), you canheighten your awareness of specific patterns that can be applied to thattrading environment. All that is left after entering a position is risk andtrade management, which is the focus of the next chapter.
CHAPTER 9
Risk ManagementSetting Stops
his chapter will walk you through the various types of stop ordersand when and where to place them. It will also provide a great deal ofimportant information on the reasons for stop orders, the type ofstops that should be placed at critical price levels, and identifying these specific price levels. If a trader is to maintain a degree of profitability over time,managing risk and using a system that helps evaluate price changes are essential. When you have finished this chapter, you will understand how to select stops to limit your potential losses and how to let profits ride.The process in selecting stop placement as a risk management toolstarts with the price of where the trade was initiated. Here are some finerpoints on the rationale for using a risk method, or having a stop-loss systemin place.
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• Predetermined stops help conquer emotional interference.• Stops should be part of a system or included in a set of trading rules.• The risk/reward ratio should be weighed before entering trades, and astop objective should be set.• When volatility is low, stops can be placed closer to an entry level.• When volatility is high, stops should be placed further away from entrylevel.One of my favorite bits of advice that I give students and have taught atseminars is that the first rule of trading starts with the premise that it isokay to form an opinion on a gut, or instinctive, feeling—just act on a trade
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signal that substantiates that opinion. Write your rules down and havethem posted on your trading screen on your computer. Before you enterthe trade, check your rule list; and make sure you know why, where, andwhat type of stop to place. As you gain more experience in the business,you will undoubtedly get caught in a news-driven, price-shock event, that is,if you have not already experienced one. These are unavoidable and hard toescape unscathed. It is considered a cost of doing business and should notreflect on your abilities as a trader. Managing risk is your job, and capturing as much profit as possible from winning trades should be your utmostgoal. The descriptions of the types of stops and the pros and cons of eachshould help you make the right decision for the various circumstances ormarket conditions.
PLACING STOP ORDERSStop orders are often referred to as a protection method against losses.These orders can also be placed to enter positions. Specifically, a stoporder is an order that you place either through a broker or online. If themarket trades at a certain price, then the order is triggered and becomes amarket order to be filled at the next best available price. The general rulesof stop placement are:• Buy stops are placed above the current market price.• Sell stops are placed below the current market price.
GENERAL USES OF STOP ORDERSThis chapter will focus on protective stops used to offset a position and toprotect against losses and against accrued profits. You can also use a stopto enter a position. There are a variety of stops that can be used dependingon your situation, the market you are trading, and what you are trying to accomplish. There are various types of available stops and several techniquesthat can be used with these stops to help you manage your position and reduce your overall risk.• Dollar Limits. Stops can be based on a dollar amount per position.The dollar amount is categorized under money management for tradingsystems. If you are risking $250 per futures contract in an e-mini–Standard & Poor’s (S&P) contract, then your stop level would beplaced at a five-point distance from your entry price. This method is
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used less frequently by professional traders because it has no relevancyto a mechanical trading model, especially systems that are in the market all the time, such as a moving average system. However, there arebenefits to this feature with setting a daily dollar amount on a loss limitfor active day traders. Some electronic order platforms allow you to seta daily loss limit. Rather than per trade, it sets an overall loss limit onyour account.• Percentage Figures. Most traders hear of using a stop of a certain percentage of the overall account size. Generally speaking, that numbercan be 2 percent up to as much as 5 percent of the overall account. Unfortunately for most traders in futures or foreign exchange (forex) markets, the average size trading account is $10,000, which means the stopis $200 to $500 dollars per trade. This leaves little room for error. Normally, you want to use at least a two-to-one risk/reward ratio on yourtrades. So if you risk 5 percent on a $10,000 account, you should expectto risk $500 and make $1,000 per trade.• Time Factors. After a specific time period, if the price does not movein the expected direction or if the velocity of such a move does not warrant holding onto the position, then exit the trade. If you see a lowclose doji (LCD) or a high close doji (HCD) signal, it is my experiencethat the market generally demonstrates an immediate reaction withintwo or four time periods. After a long period of the market not responding to this type of signal, liquidate the position. The timing of thetrade did not correspond with the historical tendency and did not generate the desired results in a given period.Another consideration in the art of placing stops using a time element is the aid of a moving average. A moving average is simply atrend line that is considered a time-driven price-directional tool. Onetime factor that one can use as a stop placement method is thecrossover point of reference created when using two moving averagevalues. Once the shorter-term moving average crosses the longer-termmoving average, it reflects a value change in the market. In Figure 9.1,once the market triggers a signal to go long with the high close doji,combining a close below doji low and the crossover point (using boththe one-period pivot point and the three-period pivot point moving averages) can act as a stop placement level. Once again, you would wantto look at the point of crossover of the two moving average values; andif the market closes below the low of the doji’s low and the moving average (M/A) values, then a trigger to exit the position would be warranted. As you can see, a bullish trend develops with the goldensequence of events: higher highs, higher lows, and higher closing highs.The stop-loss was placed at a critical point.• Price Levels. Traders often use basic statistics to measure the degree
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FIGURE 9.1Used with permission of esignal.com.
of price volatility that can occur on a daily basis in a given market.These measures can then be used to place a stop order or a limit orderthat takes into account these natural daily price movements. Statisticsthat are often used are the mean, the standard deviation, and the coefficient of variation. The best trailing-stop approach has been explored by many technicians. The various methods include placing astop using a set price amount, which could be as much as 50 percent ofthe average true range of a given time period, either above or below the10- or 20-day moving average.Why is this an important method? If you place a stop near a specificchart point of interest, such as an old high or an old low, that level isobvious to every chart watcher. Markets do “test” and penetrate fromtime to time those levels. If you set your stop too close, such as settinga sell stop below an old low point or a buy stop above an old price high,chances are that your order may be executed if it is too close, such aswhat the jackhammer or shooting star represents. So generally, a certain factor or distance should be calculated for your stop placement.Since most traders believe a market has reached a peak, they will place
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a stop slightly above an old high or below an old low. Depending onwhere you place your stop, the market may demonstrate a spike pattern that will hit your order and then proceed to move in the desired direction, without you, of course. Figure 9.2 shows an example of whenthe market is at a major turning point, how a price spike occurs. Youmay want to take the average daily range of the most recent 10 or moreperiods and then use a factor between 20 percent and 50 percent of the10-day average daily range. When entering a short position you woulduse a protective buy stop based on a percentage above the 10-day average range. For example, if you take the average daily range for the 10trading sessions from the low back on October 12 up to the first peakon October 25, you have an average daily range for that 10-day periodof 174 PIPs (percentage in points), or points. The first spike top exceeded the prior high by 34 PIPs.If you established a short position and wanted to place your stopout of harm’s way, then using a stop of 20 percent of 174 PIPs above thepredetermined high would not have worked out, as that was 34 PIPs,the exact amount by which the market exceeded the high. If you in-
FIGURE 9.2Used with permission of esignal.com.
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creased the stop amount by 50 percent of the 10-day average dailyrange, then you would have an 87-point stop above the high; and thiswould have kept you from getting stopped out. By using 120 percent ofthe average of the last 10-day period range, this method would accomplish the goal of not getting stopped out. Realistically, that may be waytoo much risk for an individual trader. But examine the risk/rewardratio on that particular trade. A risk of 150 percent of the average dailyrange from the most recent 10-day period would have been 261 PIPs.The stop would be placed above the high on October 25 at 181.30. Thelow was at 170.65, made nearly one month later on November 22.Granted, depending on your risk tolerance, this may seem excessive;but you can select and back-test any percentage variable of an averagedaily range stop placement.The key idea here is to keep your stops out of harm’s way. If atrade is to become profitable, there should be signs, such as in the caseof selling short, that you see immediate results with lower highs, lowerlows, and lower closing lows. Even in the days where we see spikehighs or spike lows, notice where the market closes in relation to theirrespective highs and lows. The price penetrates the highs but closesback below the prior highs. The reverse is true at the spike lows. Thisis a good clue that the market has exhausted a trend and is ready to reverse. Keeping a stop out of harm’s way will allow you to participate inthe move using a variation of an average daily range stop placement.• Conditional Changes. A conditional change is defined as a higherclosing high in a downtrend or a lower closing low in an uptrend. Suchas the case with a spike top, the market does not close above an oldhigh. Therefore, one factor such as the stop-close-only order will be ofgreat use to a trader not looking to get bumped out of a position. Thereis, as with any stop, the unknown risk that there is not a guaranteedprice at which your stop order will be filled. This order has a negativeconnotation among traders because it spells too much risk. A buy stopwill be elected and will knock you out of a position if the market closesabove the stop price; and a sell stop will be elected and will knock youout of your position if the close is below your selected price level. Theunknown is how far away the market will close from the selected stopprice. The key benefit in using a stop-close-only order is