Drawing Up Scenarios
A long-term investment is a short-term investment that failed.
As part of your prep for the trading day, you should have started the night before to draw up scenarios for what could have happened and then fine-tuned it in the morning. One important thing a well prepared trader will have done is gone over the market and tried to outguess it by imaging everything it could possibly do. You need to know what you will do if it keeps going in your favorwill you add to it or start lightening your positions? What will you do if a trend line gets broken? What if it reverses midday? What is the worst-case scenario? Not only must you do this before the market opens but you need to do it throughout the day as well, as the market can be a lot different at 2 P .M . than it was before the open or at 10 A .M .
As I continue, Ill show you how I would do it for the Dow Jones Mini futures contract that I like to trade. You, however, should apply it to whatever you trade.
KNOW YOUR MARKETS REVISITED
This is where the chapter on knowing your markets comes in helpful. If you are going to trade something, you should know what makes it move, what its typical trading range is, whether it has patterns it follows, and so on. It takes time to get really acquainted with a market, but its time you should put into a market if you are going to trade it. For those who trade a couple of hundred different stocks, you will never do as well as a guy who specializes in just one or a handful of stocks; those guys know their stuff inside and out. They know pretty much everything they need to know that will help them be prepared to better trade and monitor their position. This puts them in a much better position to make money than a guy who is all over the place.
As you are making the morning game plan, make a list of variables that can affect your positions (if you have any on) or the market you are about to trade. For me, it could be that there is a Federal Reserve interest rate announcement today at 2:15, or the market is approaching its 50-day moving average, or the stochastics are at an overbought level and starting to turn down. This list will change every day as market conditions are always changing. Its part of your homework to be prepared to know what can happen. You should know which reports affect your markets and by how much, and you should know when they are coming out. There is nothing worse than being surprised by a report that moves a market in a big way. For example, if you trade crude oil you should be aware that every Wednesday there will be a report released by the American Petroleum Institute regarding inventories. This report moves the market and usually violently. You do not want to be caught unexpectedly on the wrong side of this move. You probably wouldnt want to get caught on the wrong side even if you were expecting the report, but at least then you would have made your own bed.
GETTING THE BIG PICTURE
If you have open positions, start with them. Lets say Im long the Dow Jones, the first thing I want to know is why I got into the position. This shouldnt be hard to do if you have kept your game plan from prior days. But before I continue, I need to backtrack and go through the thinking process that got me into the position. Ill show you how Id go about drawing up scenarios that led to getting into this position first.
First, I know I want to take primarily long trades. You can see in the weekly chart of the Dow Jones Industrial Average, Figure 9.1, that the market has been in a nice bull market for close to five years now, and the rallies are much more powerful than the pullbacks. This is typical of a bull market. Though there are several places where one would get hurt going long, for the most part the market is a strong one and should be bought. The one thing Id prefer to see if Im looking to get long is that the market was closer to the trend line as there is room for a 1,000-point drop while still remaining in a strong uptrend. The fact that it could drop so much and still be in an uptrend is one of the scenarios Id have if I were to make a trade. As I look at this chart I see two scenarios: one is this possible drop, but the other is that it is in a strong uptrend and it looks like it may take off and make new highs.
Im looking at the actual index here and not the futures. As I mentioned in Chapter 6, I make my decisions using the actual indices and then trade the futures, as I believe its a truer indicator of the markets big picture.
GETTING A BETTER PICTURE
Next Ill look at a daily chart to get a better picture of whats going on. The market has been in a downtrend the last two months, but finally it may have had a move that could break that trend and begin sending it back up again. The Dow had a pretty huge day, jumping about 350 points, which followed a day where it jumped about 200 points after closing on its low the day before (see Figure 9.2). During this day, the market crossed the downward trend line of the past two months, the stochastics turned positive and started crossing over the oversold area, and the market rose above my two moving averages. With all these things looking good, I would consider this could be a sign of reversal toward the upside. But this is just one step in my confirmation of going long. I need to look at other time frames to confirm that I should be going long. The daily chart alone would give you a signal deep into the move, so I also look at other time frames to get a better picture, anticipate a trade, and time an entrance point. By taking it down a time frame and looking at the 60-minute futures chart, Figure 9.3, I was able to get a jump on the trade, but you can also use it to both confirm a trade and to start planning an entry.
When I look at the 60-minute chart, the first thing I notice is that the market has made two successful lows on Nov. 21 and then again on Nov. 26, while the stochastics indicator has not. This divergence is one of my favorite reversal signals. Im looking for a pattern to get me long, and this is a great one; however, I dont want to jump the gun so I will wait for it to break the downward trend line. On Nov. 27, it closes just above it but not significantly enough to give me a signal. I know Im on to something though, so Ill plan to possibly make a trade on the next day if it breaks this line on the open. If I did want to get in early the close above the trend line would have been a place I could have chosen to do so.
Come the next day as Im doing my pre-market homework, I see the futures are called to open somewhat higher. The open would cause my moving averages to cross to the upside, which is a buy signal for me. Now I need to start to draw up some scenarios. There are a few things that can happen. First is that the market opens higher and then closes the gap, going negative and back below the trend line of the 60-minute chart. Or it closes the gap but then rallies. It could also open higher and take off with the momentum of both the breaking of the down trend line, and the daily stochastics (Figure 9.3) showing it is coming out of oversold territory. The market has plenty of room to take off and this may be the push it needs to do so. The last scenario I would consider is that it opens higher, tries to go higher, and then fails. My plan for the morning is that Ill look at the 5-minute chart (Figure 9.4) and see what it does for the first 30 minutes. If the market is higher than where it opened at that point I will get in and for now my stop area will be at the low of the move from two days prior, but I could fine-tune this later. By the way, for the purpose of the rest of the book if I say put a stop at the low of, or something similar, it means at a comfortable level below that spot so that I dont get filled by the market should it retreat to near that technical spot, I want a little cushion to be safe. On the upside, if I hold this trade long enough I think it could go above 14,000. The reward-to-risk ratio is a little more than 2:1, which is good but not great, but I know I can raise my stop once the trade is established, putting the ratio much more in my favor.
As you look, the 5-minute chart of Dow futures, the market does open higher and goes straight up, never backing off at all in a very bullish day. I place my order to buy at 30 minutes after the bell rings and get filled at 13,165. So now the trade is on and I have to start drawing scenarios for what to do with it. For now, I have an emergency stop and my long-term target is at least a new market high, which I believe is very possible in the next couple of weeks. However, I want to move my stop up for this trade as the original stop is just too far away. For a tighter stop I want to move up to just below the low of the day, because if the market breaks the low of the day, I believe it will fill in the gap, at which point I will reevaluate. Though I know my stop and my target I have one other criteria for this trade and that is that it closes in the top half of its trading range for the day. Otherwise, in my opinion, it is a failed attempt at a rally and break of a trend line, and I dont want to be in. If at 4 P .M . its below the middle of the trading range I will get out, otherwise Ill hold on. As I plan to hold this trade for at least a few days, Ill end up spending more time looking at it every night and morning to see if things have changed, rather than during the day. I do, however, go over all my trades and potential trades at lunchtime and before the close to make sure they are still valid trades and that I want to hold them. This is a typical thinking process of how Id enter a trade. Before I do, Ill have all the angles covered so nothing will surprise me. Ill do this every day looking at the markets I like to trade, looking for some opportunities. Maybe I cant always find a great setup like this, but there are always trades to be made, even if some of them are only for a couple of hours. Its tempting not to want to short a market that has been down trending for the last two months, but I always have to think longer term and try and find places to buy. I will, however, short on occasion if I see a fantastic short-term shorting scenario with a tight stop.
This whole scenario-making process can be done by the active day trader as well, but using a slightly different approach. Like I did before for this scenario, a day trader should analyze his markets and determine from which side of the market he will be trading. Yes, you can trade from both the long and short side throughout the day if that is your style, but I prefer to have one side and concentrate on that. If Im trading from the long side, instead of reversing when the trade is done, Ill sit out till the next opportunity.
Once you have determined a side, you have to keep in mind that markets do have major turnarounds at times or can be trading choppy, which means youll be better off buying and selling. As part of your scenarios, you have to be aware that these things can happen. And constantly throughout the day update your scenarios depending on what the market is doing. Id say you should do it an hour after the market opens, at midday, halfway between that and the close, then about 45 minutes to an hour before the close, and if you plan on taking anything overnight once more in the last 10 minutes.
Getting into a trade is the easiest part of trading. Next come the harder parts: monitoring and knowing when to exit. This is where money is made or lost, so dont let down your guard after you are in.
END OF THE DAY
If Im considering holding trades overnight, the last hour of trading is critical to me. This is when I have to decide for sure if Im going to keep the trade overnight or not. Its not until the last 15 minutes of trading that I make that final decision. Most of the time it coincides with the evaluation I did in the last hour, but I have changed my mind a few times in the last few minutes. During this hour, I want to make sure I know what lies ahead for me. Ill make sure to know if there are any reports that could affect the position. If so, I want to make sure that doesnt change the risk involved. Ill go over my indicators and see if anything has changed to the point where it changes my outlook. Ill confirm that the trade is acting the way I had intended it to when I put it on. If I bought into the Dow and I was expecting a strong move that day and didnt get it, I would consider getting out even though it may be within my target and stop levels and I could be making some money on it. It didnt act the way I had expected it to, so why stay in? During this end of day evaluation I could say something like, Its acting great. If it stays above 13,250 Ill keep the trade, if not Ill get out. Or I might say, Everything is still as planned, even though Im down a little on it, I wasnt expecting it to shoot out the gate, and I still believe the trade will do what I expected it to so Ill hold it overnight.
I dont reevaluate long-term targets and stops at this point. That will be done later. This time is just spent deciding If I want to keep the trade based on its performance, how things may have changed, and whether there may be something coming up the next day I may have missed earlier. I usually know if my intentions are to get in and out of a trade in the same day or hold it overnight before I put on the trade, but things change throughout the day and its important to change with them. This doesnt mean you should make a long-term trade out of a short-term trade that failed.
BACK TO MONITORING OPEN POSITIONS
Okay, I have spent about six pages, more or less depending on how it comes out in print, explaining how I got into a position, which probably should have gone in Chapter 11 on entering trades. Anyway, now that I have a position, I need to start monitoring it. And I have to do it I every evening and morning. You saw before how important it was for my entry to know that the market was expected to open higher when making my scenarios. This is why the morning period is critical to planning out your day, as you simply cannot know the opening call at night. The best way for me to monitor my positions is to start making up scenarios of what can happen every day. You shouldnt just forget a trade once its on and expect to either get stopped out or filled at your target. You have to actively monitor it.
If something is working for me, Ill tend to hold it for as long as it works. This could be a few days or two months. I let the trade decide how long that is, regardless, I take it one day at a time. When I made this trade my intended target was for the market to make new highs. This doesnt mean I will not exit it sooner if it is not working. After putting on the trade it looked like I was going to be right, but it ended up not working out that way. As you can see in Figure 9.5 the rally ended up failing and we never did make those new highs. But thats okay, not every trade will work out as planned, but I stuck to my plan, which is important. The trade took off like a bandit the day I made it (the shaded circle), the market was up over 350 points for the day and I had 170 points in it, which is a nice cushion. But you never want to let how much money youve made affect your trading decisions as you make up scenarios.
So that first night I have to start looking at the market and think, What do I want to do now? My first concern is not to turn it into a big loser, because one scenario is that it could completely turn around and give back the 350 points plus some the next day. The market had been pretty wild the last half year so anything is possible. First thing I want to do is make sure my stop is a good one, which will give the trade room to work. For now, Im content with my stop below the gap, but I will want to start raising it soon. Thats pretty much it. Im still looking at a nice move in this market, and until I see something that may change that opinion, Ill stay long. Its too soon in the trade to add to the position or take some of the profit. My main concern is that it is working and that Im protected.
