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.
The previous two editions of Profit Talk our focus was earnings release trades and the use of credit style options strategies to exploit the heightened state of implied volatility that is generally associated with an company’s earnings announcements. As you’ve learned, credit style strategies offer a high probability for success and are therefore a good vehicle to use in harnessing steady income from the financial markets. But, these strategies are limited in how much profit can be made from each trade. Some, premium selling traders, such as myself like to augment their trading with the use of Debit style directional trades.
Debit Style Trading
Directional, debit style positions have an incredible advantage when it comes to the level of profit that can be made from each trade. Depending on the type of strategy utilized, the profit may be unlimited. In addition, using options as the investment vehicle instead of traditional stock buying can greatly reduce the amount capital required to place the trade and the amount of money at risk in the trade.
The downside, when it comes to straight directional trading, is the need to be correct on direction in order to profit in the trade. For this reason, as mentioned, I like to allocate the majority of my available capital for use with credit style strategies. Both, directional and nondirectional types. Remember, when using credit style strategies, even directional trades don’t necessarily have to go “your way” to produce profit. This allows for a high chance of steady income coming from the constant Theta decay associated with the various short premium strategies.
But, using the remaining capital for pure directional trades can provide a very nice boost to your account performance and these trades are not only very profitable when they work out but a lot of fun as well. Let’s face it, nailing a directional trade and making a killing doing so makes for a great story. It’s this kind of trade that can make headlines and the storylines for Hollywood movies. Personally, I think making steady income from being marginally right on direction, such as the case with premium selling, is pretty exciting. But, it’s just not the kind of story that’s going to make the news or inspire Hollywood. Also, nothing is more awe inspiring to friends, family and co-workers than sharing the story of an amazingly profitable directional trade. But, the reality is, it’s difficult and rare to actually pull-off these kind of trades.
When it comes to pure directional trades, the challenge comes with the statistical probabilities for success. Statistically speaking, a stock has a 50/50 chance of moving in either direction. This fact can create a problem when trying to profit from a directional move. Investing with a 50/50 chance becomes a zero sum game in the end.
Fortunately, there are steps that can be taken to skew the odds a bit more in the favor of the directional trader. The science and art of technical analysis can go along way to support the investor interested in taking directional trades. Technical or “Chart” analysis is the study of historical price and volume behavior with the intention of using the information to predict future price moves. In my experience, I’ve seen that proper use of chart analysis does have the ability to increase the odds for success when directional trading. This is because all price behavior is really human behavior or emotion playing out through the buying and selling of the particular asset. Detractors of technical analysis try to argue that price doesn’t have any memory and therefore has no predictive value. They are forgetting one vital truth about price. Price comes from people and people definitely have memories. As you know, people have very long memories, especially when it comes to pleasurable or painful experiences. Financial or otherwise. This fact creates the foundation which supports technical analysis.
Let’s review the basic concepts behind chart analysis as covered in the December 5th, 2016 edition of Profit Talk called “Directional Trading Options”. As mentioned, the price chart is a graphical display of the supply and demand forces at work. Ultimately, it’s a flowing history of investor emotion involving the particular asset. That is good news for investors because emotions do hold some predictive value.
Fear & greed associated with money and investing displays cyclical patterns. These patterns play out over and over again and reveal themselves in price which is displayed in graphical form on the chart.
The key to useful chart analysis is to break the information down to the essential facts about price behavior, or more accurately, people’s behavior in the market place. There are two key factors that must always be kept at the forefront when performing chart analysis. These factors are trend and supply & demand.
The power of trend has been well documented by successful traders for centuries. Although, the idea of using trend in your chart analysis may fall in and out of favor among the financial pundits, don’t let short term popular culture thinking steer you off course with your chart reading. Let me make something very clear, trend will NEVER go out of style when it comes to its influence on price. Trend is to price what the tide or prevailing current is to a body of water. A chart analyst who ignores trend is like a pilot of a ship ignoring the tide or prevailing current of the water they are navigating.
The other key factor to consider when performing technical analysis is where the supply & demand areas are located. In the end supply and demand determine everything, even trend. The trend direction and momentum is determined by supply and demand. Uptrending markets are doing so because the buyers outnumber the willing sellers. Price must go up in order to incentify sellers to sell.
But, as we’ve covered previously, the price action is fractal, so these forces are at work in multiple time frames. This means during an uptrend on a larger time frame the smaller time frame of the same market will experience “mini” market crashes. These periods look like a complete meltdown on the smaller time frame, while on the larger time frame they appear as small pullbacks in an upward moving market. These counter trend phases or “pullbacks” to demand areas offer opportunity to hop aboard the prevailing trend. Conversely, when a market is in an established downtrend, rallies up in price into a supply area provide opportunity to enter the downtrend with a short sell trade.
This style of trading, is contrarian in nature, at least to the short term view. I consider the style, which is my style of directional trading to be what I call “short term contrarian and long term conformist”. Meaning, I ignore the short term “noise” of the market and follow the long term facts of the prevailing trend. I use that noise as opportunity. These pullbacks in price that occur in bigger picture uptrends or rallies in price that occur in big picture downtrends, can provide opportunity to join the current trend.
There are two key factors to consider.
First, is the crucial fact that the directional bias must be in line with the big picture trend. So, it’s never about just being contrarian and buying a stock because it has gone down or selling a stock because it’s gone up. It’s about being contrarian to the very near term direction but in line or conforming with the longer term view. That means buying a stock that has recently fallen in price but still remains in an uptrend on the big picture time frame. Or, shorting a stock that has recently rallied, but still remains in a downtrend on the big picture time frame.
The second factor is the entry must be made in or very near a supply or demand area. Never just buy a stock because it’s going down in the context of an uptrend or sell a stock because it’s going up in the context of a downtrend. On the controlling time frame, the entry point must line up with a demand area for going long in an uptrend or supply area when going short in a downtrend.
This style of trading simply stated involves buying stocks that are in a big picture uptrend when they pull back to a demand area on the controlling chart and selling stocks that are in a big picture downtrend when they rally up to a supply area. Using this as a basis for a directional trading philosophy can bring significant, positive results for directional trades.
More to the Story
The study and use of trend analysis in combination with supply and demand areas constitutes the bulk of the efficacy found through the use of chart analysis concepts. However, this is not the whole story when it comes to creating profitable directional investments. A crucial key to mastering the benefits that can come with chart reading is understanding and properly using the reward to risk ratio. In fact, the longer I practice the skill and see the results in my trading, the move convinced I am of the powerful influence the manipulation of the reward to risk ratio can have on your investing results.
My journey learning technical analysis or “chart reading” skills began as it did for many who are interested in subject, with reading the top books in the field of study and practicing the techniques. At this time there were not on-line courses or video courses available. Early successes with the techniques spawned deeper interest. This interest turned into a bit of an obsession which led me to learn as much as possible on the subject. I eventually became interested in creating my own trading strategies, so I learned some computer code and began to translate my trade set-up entry and exit ideas into automated strategies for backtesting.
Creating and testing trade set-ups accelerated the learning process immensely and also revealed some very powerful insights about directional trading. Ultimately, I was able to develop several trade set-up strategies that performed exceptionally well. These set-ups formed my directional trading style and forever altered how I trade. I’ll share with you what I think are the biggest factors for success when it comes to directional trading.
One discovery is what amounts to probably the biggest single influence on the outcome of a directional trade. This influence is longer term trend direction. As you know, I give significant weight to aligning the trade direction with the “big picture” trend direction. The importance of doing so was made very clear to me when creating and testing trade set-ups. The platform I use for strategy creating and backtesting is the Tradestation software. Their strategy testing technology includes an optimizer called Walk Forward Optimization. Without getting to technical here I’ll give a quick explanation. Many trading strategies fail in real world trading because they are built and tested on the same set of historical data. The Walk Forward Optimizer aids in the mitigation of this problem by performing a set of "walk-forward" performance tests against as-yet-unseen market data, thereby simulating the unpredictability of trading a strategy under real market conditions. The result is, many strategies that initially perform well under the standard backtesting criteria fail when tested using the Walk Forward Optimizer, which means they’ll probably fail when trading them for real.
As I was forced to deal with strategies that performed well outside of the WFO process, but failed when the “optimizer” was used. The testing and subsequent adjustments I made led to some amazing discoveries about price action. I found that one of the biggest single factors to affect the outcome of a trading strategy was trend direction.
Several of the strategies I’d created that performed well without the WFO scrutiny, failed when tested using the Walk Forward Optimizer. When I added the filter to allow trade entry only when trade direction was aligned with the larger time frame trend direction the failed strategies performance was boosted significantly which resulted in many of strategies passing the WFO test. While it’s true that other factors involved with strategies are significant to the results, no single factor, outside of adding the trend direction filter, transformed failing strategies into passing strategies.
To be clear, when I say failing strategies, I’m referring to failure at the WFO level. In some cases, the strategies did perform profitably prior to adding the big trend filter but were not able to overcome the hurdle created by the WFO. But, adding a trend filter did so for many of the set-ups. I think this is significant. If price action is completely random and/or if trend doesn’t really matter that much how was such significant result achieved when trend direction was used as a filter? Trend absolutely matters, don’t ever allow anyone to tell you otherwise. They are wrong.
I know I’m going on about trend and will move on now, but I wanted you to get an idea why I am personally convinced of the effect trend can have on price.
Another huge factor when it comes to achieving profitable results when directional trading is the reward to risk ratio. This is another important element that needs to be regulated to achieve positive results when trading, directional or otherwise. I’ve covered the importance of this ratio in previous Profit Talk issues and have stated it may be the most important ratio in all of investing.
Let me illustrate how this is possible with a quick example.
The reward to risk ratio is simply the ratio between the amount of projected profit that can be obtained from the trade and the amount of possible loss that may occur. Creating a positive reward to risk ratio scenario for your trades can result in profitable trading even when the percentage of losers is higher than winners. Imagine a trade set up with a profit target that equates to a $1000 gain and a stop loss that is also set for $1000. This means the trade will be closed at either the $1000 profit or the $1000 loss point. This is a 1/1 reward to risk ratio. This scenario can only be profitable if there are more profitable trades then there are losing trades. You must have a better than 50/50 result in order to profit.
On the other hand, imagine a reward to risk ratio that is 2/1. Meaning the profit target is twice what the stop loss amount is. This means that if 10 trades were placed and 6 ended up being losers and only 4 of them were winners the strategy would still be profitable. That would be 4 winners for $2000 profit each, equalling $8000 in profit and 6 losers for $1000 each for $6000 in losses. The result is a $2000 profit overall.
How about a 3/1 reward to risk ratio. This ratio can produce a profit if only 3 out of 10 trades are winners. You would have 3 winning trades that were winners and profited $3000 each, for a total of $9000 in profit, while 7 of the trades lost $1000 each for a total of $7000 in losses.
The final result is a profit of $2000. This means a strategy that is profitable with just a 30% success rate in picking direction correctly. (Figure 1)
Clearly, adhering to a sensible reward to risk ratio plan can make a significant difference in the outcome of your trading activity. This fact combined with the influence aligning trade direction with trend direction are what I believe to be, hands down, the biggest factors that affect financial market investing success. This is especially true when directional trading and not relying on the advantages provided by short option strategies. Meaning, when the trade performance is not being augmented by profit from Theta decay. This applies to all the major asset classes, such as stocks, futures and forex. In fact, I’m convinced that properly working with just the three factors discussed today, trend direction, supply and demand and the reward to risk ratio you can obtain profitable trading results.
You must understand that profit is dependent on consistently carrying out a plan designed for success. The most significant thing I’ve learned from all the chart study and strategy testing, plus more importantly, from my personal trading experience and results is; learning to profitably trade directionally is more about disciplined action regarding the reward to risk ratio then about getting direction of the stock right. I’ve said before, I love charting and I’ve spent 1000’s of hours on the subject, but I don’t want my income from trading to rely on predicting the short term direction of a stock. That is not a recipe for success.
In practice, the best results for me come when I follow a disciplined plan backed by logic and designed for profit. Yes, there are particular price scenarios that play out on the chart which do, in my opinion and experience and backtesting, provide an “edge” if you will, for getting the price direction more right than wrong. A huge factor is trend. But, just as powerful and scientifically more reliable, is adhering to a profitable reward to risk scenario. Doing that correctly will make up for the lack of consistency that can result from trying to get direction correct.
As you know, the goal of Profit Talk is to not just to give you trades but teach you how to find your own trades. As we move forward with future Profit Talk issues I will share with you the important specifics involved with various trade set-ups I’ve developed over the years including how to create them for your own use. The top 4 or 5 entry and exit set-ups I use in my own trading and for finding trade ideas for Profit Talk are the best of the best when it comes to the strategies I developed using the ideas and technologies covered in this edition. Including, the directional trade ideas for this week.
The trade ideas this week were found using the same process as outlined in the 12/5/16 edition of Profit Talk called “Directional Trading Options”.
The trade ideas this week are bullish candidates. For brevity’s sake in this issue, review the 12/5/16 lesson for the process and philosophy details behind this edition’s trade ideas.
I will share the top picks for this edition which were found using the philosophy discussed. As covered in the 12/5/16 edition, the weekly charts provide the best success when it comes to directional trading. They also provide the biggest possibility for a significant price move. The candidates this week were found using the weekly chart as the controlling time frame.
The initial automated scan resulted in a list containing 10 prospects that meet the criteria and do not have earnings in the next 45 days. They have already reported. You don’t want to take a directional trade ahead of an earnings release.
I’ve narrowed the list to two picks. As always, the final decision for taking a trade or not should be based on personal risk tolerance and how your current portfolio stocks up in terms of “Delta Match”. Delta Match details were covered in the 12-12-16 edition of Profit Talk. Only take trades that are appropriate for your situation and current holdings.
The top picks include:
Nucor Steel ticker NUE entry zone is between $57.50 and $56.00 per share. Risk defense point is $54.20 and the 1st profit target is $64 per share and the second target is $69 per share.
The other pick is Jet Blue airlines ticker JBLU. Entry zone is between $19.40 and $18.70. The risk defense point is $17.80. The first target is $22.70 and the second target is $23.70.
The main takeaways from today’s lesson are.
First, directional trading is less consistent but has higher reward. This style of trading is great for enhancing the performance in an account over the long term.
Second, aligning trade direction with trend direction has a significant positive influence on eventual outcome when directional trading.
Third, the reward to risk ratio is also extremely helpful when properly used and can create profits when you’re directionally wrong on more trades than you’re right
Last week we did experience a tiny bit of weakness but nothing too significant. The weakness did cause entry into the trend trading zone of the major broad market indexes including the Dow and S&P. If you did join the trend then you are profiting at this point. The Dow is holding on to it’s break of the 20,000 mark at this point. (Figure 4)
The high impact reports due out this week include:
Wednesday 2/8 - Crude Inventories
Thursday 2/9 - Unemployment claims
Friday 2/10 - Preliminary Consumer Sentiment
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.