Welcome to the February 20th 2017 edition of Profit Effect’s investment newsletter Profit Talk
where you learn new ways to understand the latest market trends, gain strategy insights, and learn from the experts. My name is Rod Mahnami and I’m grateful that you’ve given me this opportunity to join you on your investment journey.
At Profit effect we know that the only “secret” to successful investing is well-informed investors applying sound market strategies. That’s why the Profit effect mission is to teach you how to understand the market, the modern tools available for successful investing, and how to apply both for investment success.
As bit of a chart geek, I have to say I’m excited to get into the subject matter we’ll be covering today. We’re going to dive into some chart reading essentials and I’m going to show you one of my favorite directional trading setups and how to create a scan to help you quickly and easily find directional opportunities.
Also, once we’ve gone through the process of how to find prospects, we’ll cover a risk defense technique using stock that is sometimes referred to as stock neutralization.This risk management tactic is an excellent technique to use when directional trading with debit style strategies. It provides a way to greatly reduce, neutralize or reverse the directional risk in the trade.
Demand and Supply
When it comes to directional trading, nothing will enhance your success more than an ability to locate high quality supply and demand areas on a chart. As I’ve made very clear in previous editions of Profit Talk, big picture trend direction has a huge influence on price behavior. But, as I’ve also said, there is something even more important than trend direction when it comes to future price action. It’s what determines trend in the first place. I’m referring to demand and supply.
The terms support and resistance or demand and supply are used to describe areas where market technicians have determined that either buyers, in the case of demand or support, or sellers in the case of supply or resistance, are numerous enough to change the current market direction. That is to either reverse the current direction or cause sideways price action before continuing the current price direction or trend.
These levels are generally categorized by three types, a classic trend line, a moving average or a horizontal level. The classic trend line is not generally used in our strategies as it is too subjective. A moving average however, will provide objectivity and can act as a support/demand area in an uptrend, or as resistance/supply in a downtrend. But only when in the correct “big picture trend”. They tend to be weak levels to use when going counter to the bigger time frame trend. Also, they are only profitable long term when used in a strategy with clearly defined entry and exit rules that are designed to take advantage of the given market situation. In addition, when combined with horizontal levels, moving average strategies can be incredibly accurate for use in exploiting price movement…or lack of.
Horizontal levels or zones are areas where in the past price either reversed direction (pivot lows/highs) or reacted strongly in the current direction after a short lived countrend move or a pause in price. In uptrends those instances are often referred to as a drop-base-rally or rally-base-rally respectively. (Figure 1)
In down trends they are the exact opposite, rally-base-drop and drop-base-drop. (Figure 2)
Another type of horizontal zone forms when price breaks through what was previously and area of demand or supply. This causes the area to become opposite of what it was. Previous supply that fails is now demand and previous demand that fails is now supply. This type will often appear on the chart as a “stair stepping” pattern. (Figure 3)
Quality horizontal demand and supply levels are considered the best indicator to determine whether price will experience a change. This change may be a reversal or sideways price action, sometimes called basing or range bound price action. This information can be used to trade an asset directionally or as options traders, we have the ability to take advantage of sideways or range bound trading through the use of non-directional trading strategies. Technical or price knowledge provides better insight on certain habits of price. This chart reading skill combined with the correct option strategy works well to increase your edge when trading.
The problem with Quality horizontal levels is that they are very subjective. Especially when adding the word quality. We don’t like subjectivity, it’s inconsistent and we desire consistency. Also, they are difficult to measure in mathematical terms, so we cannot write strategies, scans or indicators to assist us in finding trades and determining the parameters of the trade.
So, why do we use them? Because, they are probably the best indicator to determine whether price will react when in that particular area or “price zone”, and when these zones are combined with our other technical analysis, the probabilities of having a successful trade increase dramatically.
Quantifying Demand and Supply
We have used the term Quality Horizontal Level, the key word here being Quality. So, let’s talk about how we can quantify Quality. We will break this process into a handful of key steps designed to helps us create as much objectivity as possible.
Profit Effect uses Zone Quality Quantifiers to help quantify price. Today will focus on
Zone Quality Quantifier #1 – Explosive move away from zone.
The best indication of a demand/supply imbalance having occurred on the chart is an extreme price move. Let’s look the charts to find some examples.
This first step is to clear your chart of any indicators. The chart should have just the candlesticks and the time and price information….x and y axis.
First, take a moment to look at the chart back through time and get a feel for the type of moves that have occurred in the past.Look for moves that jump out at you with either a gap or extended range candle ERC.
Look for areas that mark a turn in price after a significant trend in one direction, sometimes referred to as pivot lows and pivot highs. Also, look for areas that during a strong move in one direction, pause for a few small range bars, a bit of basing or perhaps a Doji and then explode in the same direction as before.
When these moves or dramatic price changes happen, they will leave people “wishing”. Yes, wishing they had or wishing they hadn’t. That is bought or sold at that price. These sitting orders not only exist in the hearts and minds of the average retail trader, who got “juked” by the move, but more importantly, banks and institutions who build large positions, are caught in these dramatic moves as well. And, they will have existing, unfilled orders sitting in these areas.
The fact that price left the area in a dramatic fashion proves that there was an imbalance in the number of buy and sell orders, so price had to move to fill the orders. Period, there is no argument if this happened. The only question is, when price returns to the area are there enough orders to reverse or at least affect price in a way that can be useful to us.
Now that you’ve got a an idea of what supply and demand looks like on a chart, let’s take a look at combining that knowledge with another quality of price and the emotions behind it. I’m referring to the tendency of price to overshoot on the upside and downside. These situations are typically referred to as overbought and oversold conditions. They can provide incredible entries for directional trades.
One of my favorite entry set-ups to use for directional trades is one I designed called the “CCI Reversal”. It can be used for bullish or bearish entries. We will go through the process of creating a scan query to find bullish prospects.
The “CCI Reversal” bullish set-up is looking for a market that is extremely oversold while in an uptrend. We use the analysis from 3 separate sources, the CCI indicator with custom settings, a Reversal pattern and demand zone.
The Commodity Channel Index “CCI”, developed by Donald Lambert, is an oscillator which measures the current price level to an average price level over a specific period of time. It can be a great tool to measure oversold and overbought conditions. Mr. Lambert designed it so that approximately 70 to 80 percent of the CCI values will fall between +100 and -100.
For, the CCI Reversal set-up I increase the CCI range by 50% and set the oversold and overbought signals to fall beyond +150 and -150 values.When oversold conditions at these levels occur within the context of an uptrend, price often reverts back to its mean.
The biggest mistake a lot of traders make when using oscillators is not paying attention to trend. Oscillators work well in sideways market phases. They can also be used in trends but only when using signals to join the current trend.That means using oversold signals for bullish entries only in uptrends or sideways phases of uptrends. And, overbought signals for bearish entries only in downtrends or sideway phases of downtrends. Ignore all signals for entry counter to the current big picture trend.
In addition, for bullish trades, these signals should always be in conjunction with a reversal pattern that is formed in a demand area.We never just buy an oversold signal or sell an overbought signal on it’s own. A reversal pattern such as any version of a hammer, or bullish engulfing candlestick pattern or a key reversal pattern must occur in a demand zone.
The Key Reversal signal is a 1 day price pattern that is often associated with a reversal in the current price direction. The Key Reversal pattern for a short term downtrend is normally defined as follows:
When price has been moving down with at least 3 down days in a row, the day of the reversal, price must open lower than the previous day low and then close above the previous day’s high. This constitutes what’s known as a Key Reversal pattern. When using candlesticks it will show as bullish engulfing candle, which opens lower than the previous bar but ends up closing higher than the previous bar. (Figure 4)
Scanning for markets with the CCI signal that are displaying a reversal pattern, along with our standard Big Picture trend filter, allows us to search for markets experiencing extremely oversold conditions in the context of an uptrend, that are now showing strength. That is the idea behind the CCI Reversal bullish entry setup.
Here are the rules which govern the set-up for the CCI Reversal bullish trade entries:
The controlling time frame 20 EMA (not price) must be above the larger time frame’s 20 EMA
Price does not have to be above the controlling or big picture time frame’s 20 EMA
The CCI Indicator value must read -150 or less currently or within the past 1 day
A Key Reversal/Bullish Engulfing or hammer pattern must occur to signal entry
The reversal pattern must coincide with a demand area
Entry can be made on following bar if priced is still in the zone
Risk defense point is just below zone, no more than 1 X ATR maximum from entry
The first profit target is 2 X the distance between our entry point and risk defense point and our second target is 3 X that distance
You can create a custom scan to search for the scenario. We’ll go through the process of setting up the bullish version using the daily chart as the controlling time frame chart.
Set the scan universe to “all optionable” by using the drop down menu under “Category”. Then, you set-up your standard minimum price and volume filters as is always done. Click the “Add filter for stock” button. Use the drop down and choose last for last price. The put your minimum stock price. Mine is $15 per share as a minimum. Then add the next standard stock filter. Use the drop down and choose volume. Set that for 1,000,000 daily shares traded as a minimum.
Next add the custom filter to look for markets where the daily 20 period exponential moving average is above the weekly “big picture” 20 EMA. Replicate the weekly 20 ema on the daily time frame by using a 100 period daily moving average. Five trading days make up one week. That makes the weekly five times larger than the daily 5 X 20 = 100. Create this filter by clicking on the “Add study filter” button. Use the drop down and choose “custom”. Delete the default study and then click “Add condition”. Use the drop down and select study. Search for and select MovAvgExponential”. Set the length to 20. Next select “is greater than” and then select “Study”. Find “MovAvgExpontial” set length to 100 period. Click “Save” and then “OK”. Then add another study for the CCI scan. It can be found using the drop down menu under popular scans, or in the search bar. Add the CCI then use the drop down menu to select the condition as “Less Than” -150. (Figure 5)
You can save the scan query by using the drop down menu to select “Save scan query”. The name and save the scan.Then run the scan and if prospects are found save the list.
Now go through and look at the candles and see if we have any bullish patterns appearing, are they in conjunction with a demand zone and is the shorter term average above the larger time frame average. You can use the 100 period on the daily as a proxy for the the weekly.
The main thing you look for in this case is any sort of demand and room for price to make it to your profit targets. You want a 2:1 reward to risk minimum for the first target and 3:1 if possible for the second profit target. The importance of the risk to reward ratio when directional trading was covered in some detail in the February 6th, 2017 edition of Profit Talk called “Directional Trading Philosophy”.
Eliminate any candidates where price has completely broken away from the previous trading range.
Let’s go through and eliminate this list:
PI goes away because there is no IVP rank. This area where price shot away from is a good demand area. Especially right where it broke out of the previous range. Put this one on the maybe list. Mark the entry zone. CPB…ah. Let’s keep looking. UNH united health, I like it lower, filling the gap and lining up with the zone around the big picture trend. The fact that price is still above the big picture trend is a plus, though not required by the strategy rules. Put that on the list of finalists. Next is MOH. That broke pretty bad. Let’s keep going. The dutch oil RDS has nice demand area just below, but price is below the long term trend, let’s keep looking. RSX is the Russian ETF. This one traded right into a nice zone on Friday. This makes the finals. This is the same dutch as before. Next is SJM, that one is over already. If you got in the zone today by any chance you’re already taking profits. WDC, I like this one lower, where price shot away.
Right here where price shot away from this consolidation area. That typically leaves demand.
WDC is definitely a top contender.
I continued that same analysis on the rest of the prospects and saw another that topped the list, Kinder Morgan ticker KMI. The top contenders include, United Health UNH, Russian ETF RSX, Western Digital WDC and Kinder Morgan KMI. I would personally take any of those trades as long as they are trading their prospective zones and I’m using the proper reward to risk management.
Among the list of candidates, I like the look of the chart for ticker symbol WDC. The recent sell off is bringing an oversold symbol lower than -150 on the CCI oscillator. Also, price is trading very near a demand zone. See how previous action has price shooting out of this area with some gusto. (Figure 6) That is a nice looking demand zone. If it made it down there quickly I would like it even better as it would pierce the lower band, while remaining in the uptrend. That’s a high probability trade. Of course, the individual trade itself may wind or lose, with the proper risk to reward ratios in place and adhered to, the strategy is profitable in the long run.
The entry zone is between $73.15 and $71 per share. The risk defense point can be set to $70.75. That creates a standard style risk zone of $2.40. The risk defense point is calculated by subtracting the risk defense number from the top of the zone number. This $73.15 - $70.75 = $2.40 in this example. Although, depending on the option strategy used, the risk defense point may be much lower. We’ll make the final determination for risk defense after creating the option strategy.
When directional trading, the profit targets are based on the risk size. The targets must look “doable”. Meaning price looks like it’s probable to go there. The minimum profit must be two times the risk. This means the first profit target must be $4.80 above the entry price. $2.40 x 2 = $4.80. For the example trade, let’s say the entry was made at the top of the zone, at $73.15 per share. (Figure 7) This makes are first profit target $77.95, ($73.15 + $4.80) per share and the second profit target $80.35, which is 3:1 reward to risk. Or, 3 X $2.40 + $73.15, assuming that as the worst possible entry price, which is the top of the zone.
In regards to the type of option strategy to use for the trade, the IVP rank is very low so it’s a perfect candidate for a debit style trade. Remember, debit style trades require low IVP. For the sake of this example, let’s look at using a “Free Trade” option strategy as outlined in the December 5th, 2016 edition of Profit Talk called “Directional Trading Options”
To create the position, use an option expiration with 90 days or more to expire. Buy 1 ATM or ITM Call and sell 2 OTM Puts to pay for some or all of the position. In this case, buying the $72.50 Call and selling 2 $67.50 Puts creates the position for just 3 cents. In fact, that also creates a condition where this trade can’t lose more than 3 cents per share, which is $3 per spread until it falls below $67.50 per share.
This means, the risk defense point can be moved from $70.75 per share down to $67.50 per share to make an almost zero risk trade. Or, take the same $2.40 cents of risk and increase the zone even further, down to $67.50 - $2.40 = $65.10. This shows another clear example of how using options provides a much better chance for success than straight stock buying. That creates a huge no-lose zone. Try doing that with straight stock buying. Also, the position represents about 117 shares as shown by the deltas. The buying power cost is just about $2,260 for 117 deltas or shares using this option strategy. Buying 117 shares of the stock in the traditional way at $73.15 per share would cost over $8,500.
Risk Defense with stock
When it comes to defending losing debit trades we use an alternative method to rolling the position when it comes to containing risk. Instead, you can use the stock to reduce or neutralize your directional risk in the trade when it reaches our risk defense point. To neutralize the position at the risk defense point you sell or buy of shares inverse to the deltas of your position.
This means, in the case of our bullish example, if price reaches the risk defense point. You would sell short shares in the underlying stock to reduce or eliminate the downside directional risk. The degree of directional risk reduction from shorting shares is determined by how many shares are sold. If complete neutralization is desired then shares in number equal to the deltas of the position should be sold.
Our deltas will be different at that point compared to entry
We can use our risk graph to determine a good estimate of what they will be and put in an advanced order to execute the trade to sell the appropriate amount of shares.
Looking at the risk graph you can see what the delta of each spread will be at that price. Our example trade of 117 deltas will carry about 133 deltas at the breakeven risk defense point, in which case you would sell 133 shares to have 0 net delta exposure in the position.
Or, if using the expanded zone down to $65.10, then you’d neutralize through selling about 139 shares. Once the neutralization has triggered the directional risk in the trade is nullified.
However, that does work both ways and if the price turns back in our favor we will not profit as long as we have the “hedge” on.We need to take off the hedge at a predetermined point if price reverses. I use the rule that when price crosses back across the risk defense point in the trade favor by ¼ ATR , I can take off the hedge. ATR stands for average true range. It can be determined by using the chart indicator called “ATR”.
The loss from the hedge or neutralization will be the ¼ ATR X the number of shares sold
This loss is locked in and will take from the maximum profit but, is much smaller than the complete loss on the trade had we closed the trade or rolled it.
WDC has an ATR of $1.86. That’s the daily average price range of the stock. ¼ of that is 47 cents. This means the hedge should be removed if price reverses back above the risk defense point by 47 cents. In this case, the hedge would result in a loss of 47 cents X 133 shares which is $62.51. But, if the trade continues to profitability, the relatively small loss will be worth the effort. The alternative is to close the position and lock in any loss plus miss out on the eventual price move which favors the position, if that does occur.
When using the neutralization method, if the price continues going against the trade, the max loss is contained to whatever it is at the point of neutralization.This method offers the best of both worlds, risk containment at the maximum loss point combined with the ability to stay in the trade if it does resume direction in favor of the position.
There are downsides. One is the buying power taken up in holding stock. If the funds available are limited, the cost of carrying short shares can make this technique difficult. Another downside is when neutralization triggers and then price recovers so we take off the shares with our ¼ ATR loss but then price reverses again and we have to re-establish the hedge.
After which, if price does not recover and is eventually closed as a loser, any losses created by placing and then removing a hedge will be added to the eventual loss. This can and does happen on occasion, sometimes, frustratingly it can happen more than once in the same trade.
But, in my experience it works out in my favor more often than not and this type of rules based, mechanical approach to trading and especially to controlling risk and “staying in the game” works out much better than the alternative over the long haul.
I use the technique almost exclusively with debit trades and hardly ever with credit trades, because of the reward/risk ratio difference between the two strategies. The neutralization method described here is not recommended for credit style trades in most cases.
The main takeaways today are first, demand & supply have the most powerful influence on price behavior.
Second, identifying and using demand & supply areas on the chart that correlate with other signals to place trade entries can greatly enhance results.
Third, stock neutralization is superb technique to use for risk management with debit style directional positions.
Looking at the markets this week. We’ve got a short trading week as the markets are closed on Monday the 20th in observance of Washington's birthday.
As far as the broad market indexes. All the major markets are still experiencing and incredible uptrend and powering higher. The Dow Jones has climbed 600 points since breaking through the 20,000 mark. If any weakness brings price into the trend trade entry zone, a buy trade can be placed to join the current trend. (Figure 9)
It’s a fairly light week as far as high impact report releases goes.
Wednesday 2/22 - The Federal Reserve minutes will be released.
Thursday 2/23 - Unemployment claims and Crude Oil inventory numbers are released.
I hope this has been helpful for you. Thank you so much for being a Profit Talk subscriber. I look forward to joining you for next week’s edition of Profit Talk. Until next time keep trading and investing the Profit Effect way proven, consistent and stress free, just the way trading is supposed to be.