A strong trading signal must be accompanied by solid money management for a trader to fully exploit the benefit of the signal. Money management concerns the proper administration of profits and losses and must be synchronized with trading tactics to achieve discipline and maximize profits.
Most novice traders aren’t even aware of the money management aspect of trading. They approach the markets with a hit-and-run attitude. They miss the big picture. The astute trader knows if he takes care of the losses then the profits will take care of the trade. But novice traders can learn this skill. They just need to combine their tactics with a reliable money management strategy.
INTRA-RECTANGLE TRADES
While money management is vital for success, it still needs an indicator that can properly time the markets. This is where intrarectangle trades come into play.
To apply this strategy, we need to understand trading rectangles and the average true range (ATR). A trading rectangle is a formation that appears on a chart when prices form a tighter trading range through time. The average true range is the arithmetic average of the true range. The true range is the distance between the current day’s high and low or the current day’s high or low and yesterday’s close, whichever is greater.
An intrarectangle trade is one that takes place within the confines of the rectangle itself. To execute these intra-rectangle trades properly, we first have to measure the height of the rectangle. If the value is at least twice that of the 20-period ATR, then at least two trading opportunities present themselves:
1. Trading on the counter move. Look for price to reach or close near its boundaries, as determined with the help of Bollinger bands or an oscillator such as stochastics or momentum. The usual profit target will be the opposite trendline that forms the rectangle, although an exception is if a subsequent breakout occurs on big volume and strong price movement. This can extend the profitable move to as much as twice that of the intrarectangle height. For a more reliable setup, the oscillators should exhibit a “hook” in the overbought or oversold zone. For a short entry, the Bollinger bands should be overextended. The ideal initial stop loss for this trade is just three ticks below (or above) the lower (or higher) trendline.
2. Trading the failures. A failed setup is usually first identified by the failure of the stochastics or momentum oscillator. Trading with the failure is usually a low-risk, high-probability trade. For a long entry, place an initial stop loss about three ticks under the lower boundary of the rectangle, or at 62% of the rectangle’s high if it’s a tall formation. Reverse these instructions for a short entry. Keep the stop loss tight, moving it to breakeven as soon as possible. If your account allows it, add on after the first close above the upper trendline. The stop loss should now be moved up to three ticks under this trendline.
EXTRA-RECTANGLE TRADES
The decisive parameter in these kinds of trades is patience. We are never sure which direction the price will break. It is vital to wait for the market price to close outside the upper/lower trendlines before trading in the direction of the breakout. Once a close outside the rectangle has happened, we will have several choices based on the circumstances of the price action.
If the breakout occurs on a price bar that has an above-average ATR, which is a situation that we frequently find beneath the upper trendline, we have a prime setup for a long or a short trade (going with the direction of the breakout). In either case, we will want to adjust our stop strategy depending on the market condition.
For a strong breakout of a relatively tall rectangle it’s OK to be aggressive. Place the stop three ticks inside of the just broken trendline. Do not hesitate to re-enter if the stop is taken out, but only if the market conditions indicate a resumption of the move.
If a more conservative approach is called for, place the stop at the 62% retracement point from the upper trendline for a long trade, or the lower trendline for a short trade. This also will set up profiting off a failed trade situation. If the stop is taken out, it is likely the price will continue toward the opposite trendline forming the rectangle.
An even more conservative approach can be implemented by placing the stop three ticks below the lower trendline for a long trade, or the upper trendline for a short trade. This is most appropriate when the rectangle is relatively small or narrow. If this stop is taken out, it is likely the price may continue to the next most recent rectangle that was formed on that side of the market.
The key to success is knowing when to be aggressive and when to be conservative. For that, you need to develop a feel for what constitutes a narrow, tall or average-sized rectangle formation. It’s not something that can be objectively determined; it only can be learned through practice and observing the market through time. The profit target for all trades should be the first move that’s 100% of the rectangle’s height. Once this level is reached, the stop loss should be immediately brought up as tight as possible. At this point, the market is ripe for an extended move. Keep
trailing stops one to two ATRs behind the market. And watch for the failed breakout. This often precedes a move in the opposite direction.
ADVANCED TRADES
Some trades require specific market conditions. However, if you avidly scrutinize what’s happening with prices you can uncover these opportunities. First, when a narrow bar range is made up of four to seven smaller-than-normal ATR bars and the price action tracks a trendline closely, this constitutes a rectangle within a rectangle, so to speak. Sometimes it occurs just outside the larger main rectangle formation.
The intriguing aspect of this pattern is it can precede potentially explosive price action, carrying prices far beyond the range of the main rectangle. From this point on, it can take on the characteristics of a traditional breakout trade on greater than normal ATR readings.
Another setup for more advanced traders is a rectangle pattern forming around an expected news event, such as the announcement of an important economic figure or company earnings. Indeed, it is best to only attempt such a trade after you’ve observed related announcements in real time. It’s important to familiarize yourself with price action before, during and after the event.
Again, price action and stop placement are similar to what you will employ with rectangle breakout trades; expect those occurring on news events to be faster and more extreme. Most important, the window of opportunity will be much smaller.
SEEING TRADES
By mastering rectangle trading tactics and money management techniques, the trader creates a more solid foundation to produce consistent profits. It’s easy to miss rectangle trades. Unfortunately, there’s no piece of software that objectively and reliably identifies these before the fact. It simply takes practice to see them; looking for the hook-like appearance in the oscillators, seeing pullbacks, partial declines and short-term corrections for what they are.
Don’t hesitate to go back in time and study missed trades, but practice patience when it comes to executing positions on future formations. Look for low-risk, high-probability opportunities, and when they present themselves, apply stop and profit management rules with discipline and consistency.
Dr. Mircea Dologa is a commodity trading advisor who operates www.pitchforktrader.com.
E-mail him at mircdologa@yahoo.com.
