From the June 01, 2009 issue of Futures Magazine • Subscribe!

Safe profits: Trade an intraday stair

The key to making limited-risk profits is a willingness to be patient. Do not enter a trade until a situation meets your harshest conditions. A strict definition of an uptrend is a series of consecutively higher lows. Likewise, a strict definition of a downtrend is a series of consecutively lower highs.

“Bumper pool” is a 180-minute chart spanning 11 days of the SPY exchange-traded fund (ETF), which tracks the S&P 500. The 11-day period covers March 9 through March 23, 2009. Each intraday price bar represents 180 minutes. Examine the SPY chart with the mindset of a swing trader, a trader who is willing to hold a position for the short-term. After studying this SPY chart, you likely will pick up on the multi-day rally. The price ran higher above an ascending, approximately 45-degree trendline. You may suspect that you would have taken the long side of this trade, particularly if your conditions include a rally above an ascending trendline. Even admitting that trading is easy in hindsight, you’re confident you could have ridden this price move.

Look closely at this SPY chart, however. Each day’s low was not consecutively higher. On March 12, March 17 and March 20, the low for the day undercut the preceding day’s low. Each day’s low was higher than the preceding day’s low only on average. You could have followed this trend higher using the condition of a rising trendline but you could not have followed this trend higher using the more strict conditions of consecutively higher daily lows. Deciding how much play you should have in your trading rules is a challenge for any trader.

DAY TRIPPERS

A day-trader might take a different view of this chart. Even with the benefit of hindsight, a day-trader would have to admit that while price went up, the action was rough. Day-trading this chart would have been hard.

Just like a swing trader, a day-trader must decide how much play to have in his rules. Assume we’re following the strictest definition of trend, and circle the days when the intraday 180-minute price bars show a series of consecutively higher intraday lows. Consecutively higher lows are like a set of ascending stairs. Each higher low is a step higher. You should have circled March 10, 12, 17, 18 and 23.

Now you might think that you get it. This chart isn’t that hard. You enter on a new consecutively higher intraday low, and you exit if a preceding intraday low is broken to the downside. If you encounter a lower intraday low while you’re on the sidelines, you stay on the sidelines. Before the end of the day, since you’re a day-trader, you’re going to cash anyway. You do not day-trade the long side of SPY until these strict conditions are met. You wait. You limit risk. You bank safe profits. On a slow day, you make a little. On a good day, you make a lot. On a choppy day, you stay on the sidelines.

A swing trader can employ the same level of strict interpretation by waiting for consecutively higher lows on a daily basis. This is a rare condition, but multi-day trends do occur when each day’s low is consecutively higher. In this example, the swing trader might have stayed with the trend until March 20, and probably missed March 23, but already would have made a nice profit.

The inverse is true on the short side. A strict definition of a downtrend is a series of consecutively lower highs. The lower highs are like a set of descending stairs. Enter when you see a new lower high. Exit if the preceding high is broken to the upside.

WILL TO WIN

Whether you are a swing trader or a day-trader, waiting for consecutively higher lows, or lower highs, takes determination. You will chafe at being restricted to these conditions but you will limit your risk and make safe profits.

The conditions for entering a long side stair trade are to wait for a new higher low. The conditions for exiting are to wait for a preceding low to be broken to the downside.

Traders tend to specialize. Stepping outside your specialty can be an invitation to losses. Specializing in trading a stair is a way to cross over between swing and day-trading: The time frames are different, but the technique is the same. When conditions are right, swing trade a stair. When conditions are right, day-trade a stair.

The trade-off in being selective is that you will find fewer opportunities to trade. Being able to switch-hit between swing trading and day-trading using the stair technique is a way to widen your pool of opportunities. Even a trade meeting the strict conditions of a stair is a calculated guess. There is still risk. You may enter a stair too late. A stair can reverse suddenly. Even though you are trying to trade safely, you must still accept that you can be wrong.

TRADING SNOWFLAKES

Benoit Mandelbrot is known for, among other things, pioneering studies in fractal geometry. A fractal may be defined as a geometric shape that is similar at multiple levels of magnification. The shape self-replicates at each scale of observation. (See “Watch out for those fat tails,” April 2009, for more on the influence of Benoit Mandelbrot.)

A price stair is a fractal concept. In the SPY example, an 11-day chart with 180-minute price bars is used. This is not the only time compression that depicts this pattern. Stairs can appear on each level of the chart. You can use different time periods and different price bar durations. The stairs may appear at different points along each chart, but they will appear.

This suggests another technique for making safe profits. Compare multiple charts set to different time periods. Simultaneously, for example, keep open a six-month chart, 11-day chart, three-day and one-day chart of the same market. You’re after multiple scales of observation. Be ready to swing trade or day-trade. Watch for a stair and trade accordingly.

TRUE OR FALSE

If you had entered the SPY on the long side early on March 19 and March 20, you would have exited early with a loss. Even during March 23, a preceding intraday low was broken more than once. The key is telling the difference between a true break (where price breaks further) and a false break (where price recovers and rallies higher).

Strictly speaking, you would treat every break the same. A compensating technique is to smooth out each succeeding intraday low with a close-fitting moving average, such as, in this case, a five-period moving average. Hold a long position as long as the close-fitting moving average continues to rise.

“Stairway to heaven” (page 43) shows 10-minute SPY chart for March 23, from 9:30 a.m. to 4 p.m. (New York Stock Exchange regular trading hours). Consider where you might have entered or exited. Pay special attention to the afternoon action. Notice the higher lows and the close-fitting five-period moving average. It would be easy to think this is a daily chart or weekly chart or longer.

Another technique for trading a one-day chart is to wait for a day to develop. The early price action on a one-day chart is prone to chopping. See how the day’s action unfolds. If an intraday stair begins, and the general situation is bullish, ride that stair. If the day is choppy, stay on the sidelines. Wait for a better day to trade.

RKH, the regional bank ETF, often drives SPY. “Banks buoyed” (page 43) shows a one-day chart for RKH for March 23. Notice the higher lows and the close-fitting five-period moving average. You might have used RKH to confirm the action in SPY or you might have traded RKH itself.

“Belly flopped” shows June 2009 euro currency futures. The time period is March 25 through March 27, 2009. March 27 shows a series of consecutively lower intraday highs. This is a sign of a safe intraday short-side trade. Recall that a strict definition of a downtrend is a series of consecutively lower highs. The lower highs are like a set of descending stairs. Enter when you see a new lower high. Exit if the preceding high is broken to the upside. It is a mix of opposites to combine “patience” and “short-term trading” in the same sentence. Nevertheless, if you can combine the two, you have a formula for safe profits.

Richard L. Muehlberg uses linear regression channels and intermarket analysis to day-trade his own account. His Web site is www.DayTradingWithLinesInTheSky.com. E-mail him at richardmue@yahoo.com.

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