From the July/August 2013 issue of Futures Magazine • Subscribe!

Scaling into reversals to gain an edge

Wide berth

When a trader scales into longs during a bearish move, wide stops are necessary. If the E-mini has a recent daily range of 10 to 15 points, a reasonable risk might be four to six points from initial entry. This is a catastrophic stop that is designed to give the market room, but liquidate the position with a tolerable loss. You should never plan to let such a wide stop get hit, and almost always get out at a much better price. Once your premise is no longer valid, exit immediately.

In “Breakdown” (right), the market had a bear breakout below the previous day’s low, but then formed an inside-inside (ii) pattern at bar 4. This means that bar 4 is an inside bar (its high and low do not extend beyond the range of the prior bar), and the prior bar also is an inside bar. An ii pattern is a common reversal one, and reversals are common on the open, especially after a breakout beyond the previous day’s range.

It is reasonable to buy on a stop above the high of bar 4 for a possible low of the day, and the buy order would have been filled on the next bar. Although many traders would place a protective stop below the low of bar 4, others would use a wider stop in case the market fell a bit below bar 4 and then reversed higher, as it did at bar 6.

In fact, many bulls would have placed limit orders to buy more at the bar 4 low, expecting a bear breakout to fail, which it did at bar 6. Some would even use a tiny stop of three or four ticks on that entry. The math is good for the trade because even if it only had a 40% chance of success, the reward would be many times greater, resulting in a positive Trader’s Equation. (The probability of success times the size of the profit target is significantly greater than the probability of loss times the size of the stop.)

Bulls would look to buy any sign of bear strength because they are expecting the market to rally enough to make a profitable scalp and the shorts to be losers. They might buy on a limit order at the bar 5 low or at the bear close on the bear bar that followed. There are institutions on both sides of every tick, so never assume that the market has to keep falling or rising. The probability only becomes lopsided during strong breakouts, and most of the time the market is well balanced, even when trending.

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