January 14, 2015 06:11 PM

A beginner often waits for many bars before finally finding a trade that will work. That trader then watches the market reverse quickly stopping out the position, and it occurs to him that he would have made a profit doing the exact opposite. Over time, it dawns on the trader that it is important to respect the institution taking the other side because 40% to 60% of the time, that institution will win and he will lose. That is the nature of trading.

During strong breakouts, the probability of continuation can be 70% or higher, but the stop is then far away. Remember, there always has to be a reason for an institution to take the other side. If you have high probability, then it has a big reward relative to risk. Other than during strong breakouts, the probability that the market will move 10 ticks (or any number) up before going down 10 ticks is between 40% and 60%, and if the trader always goes for a reward that is at least twice the risk, he will have a positive trader’s equation. This means that he will make money over time if he manages his trades correctly.

In general, traders should look at any market as either a stop-entry market or a limit-order market. Also, traders should assume that every limit order is the opposite side of a stop order. If you buy on a stop at one tick above the high of the prior bar, you should assume that the institution taking the other side entered with a limit order. If you shorted with a limit order at the high of the prior bar, you should assume that the institution that bought the other side of your trade entered with a stop order.

You never know who took the other side of your trade or how or why they did, but it doesn’t matter. As a trader, you should look at every breakout, even a breakout above or below the prior bar, as likely to succeed or fail. Once you have an opinion, if you can structure a trade that makes sense, then you can take the trade.

For example, if there is a small bull flag at the top of a trading range, you know that most breakouts fail, and therefore the probability is that the sellers will overpower the buyers at the high of the prior bar. This means that you can consider shorting with a limit order at the high of the prior bar. A bull might be willing to buy with a stop order above that bar, taking the opposite side of your trade. However, he knows that the probability of his trade is small. He is willing to take it because he also knows that if the breakout succeeds, the rally might go for at least a measured move up. The result is that he took a low probability trade (one where he knew that he would probably lose), but since the reward was so much greater than the risk, the math was still good.

Although the math is good for either side of the low-probability trade, high-probability trades are easier to manage. This is because low-probability trades often look bad for many bars after entry, and the trader is constantly tempted to exit. If he exits too many trades before they reach their targets, he will not get those infrequent big wins that are needed to offset his frequent small losses.

The high-probability side is easier to manage because, by definition, you will make money on most trades. This means that you can mess up occasional trades and still end up profitable over time. This obviously sounds great, but it is not easy. Remember, there has to be something in it for the other side. If you get high probability, that other side gets big reward relative to risk. This means that you get small reward relative to your risk.

In the EUR/USD, if you are buying a strong breakout on the five-minute chart, and you enter on the fourth bar of the breakout, your stop is below the low of this four-bar rally, which might be 50 pips (ticks) away. Also, because you are entering late, the profit that remains in the trade is less, and your reward might be only as big as your risk, instead of two or more times greater.

Position size

A beginner is quick to do the math. “If you make \$100 a day with one contract, you will make \$2 million a year with 100 contracts!” He is too quick to think about trading big positions, and even when he starts out, trading what he thinks is a small position, he is usually trading too big.

How can a beginner tell if his position size is too big? That’s easy. He just has to ask himself, “Did I manage all of my trades today, or did I exit too early because I was feeling nervous about how much I would lose if my stop got hit?”

If the trader did not manage correctly, then he cared. He is trying to compete with computers that have no feelings and certainly do not care about anything. My recommendation is that traders should trade their “I don’t care” size. Whatever a trader thinks it is, he should then trade 50% to 75% smaller so he really won’t care if the trade goes against him. Over time, he can handle larger positions while still not caring. If the trader increases too quickly, he can back off and try to increase again later.

When I tell traders this, some get angry and quickly ask me how they can ever get rich trading so small. The answer is simple. Successful traders don’t constantly think about getting rich, although many end up that way. Instead, they only think about doing the right thing all day long. That is the first goal. They know that if they do, they will make money, which is the second goal. Sometimes, they will make a lot of money, which is the third goal, but they never worry or think about that.

Most successful traders are not making \$100 million dollars a year. However, many make far more than the richest doctors and lawyers, and that is plenty to have a great life.

There is one other point about position size. It should always be dictated by the number of ticks to your protective stop. If you normally trade \$100,000 in a forex trade and risk 20 pips, but you want to buy a strong breakout and the bottom of the breakout is 40 pips below the current price, you should trade half size, which is a \$50,000 position.

Also, if you bought \$50,000, and the breakout continued up for 40 more pips without a pullback, your stop is now 80 pips below the current price. Your entry price is irrelevant. All that matters is where your stop is. If you are now risking 80 pips and you normally risk only 20, you need to take profits so that you can reduce your position to 25% of your usual size. In this case, you would take profits on half of your position, leaving yourself with only a \$25,000 position. If there is a pullback followed by a buy signal, and the stop for the new position is only 20 pips below, you can now have a \$100,000 position, which means you can buy \$75,000 more and put the stop for the entire position at one pip below the new signal bar, or 20 pips below this latest entry price.

The open

The “open” may have a great trade from the first bar (a trend from the open bull or bear trend day), which happens about once a week, or only after a couple of hours of going sideways. Most traders concentrate hard during the first couple of hours because it is the most likely time that a swing setup will form.

If the open does not trend immediately, or it does not quickly test support or resistance in the first few bars and then reverse into a trend, it usually forms some type of double bottom or top that leads to a breakout of the developing trading range and then at least a measured move, based on the height of the range. For example, if it opens below the moving average, rallies to the moving average and falls back, and then rallies again to the moving average, traders will look to short this second test if it also turns down, betting that his double top might be the high of the day. The high or low of the day (or at least of the next three or four hours) occurs on the first bar of the day about 20% of the time, within the first seven bars on the five-minute chart about 50% of the time, and within the first 90 minutes about 90% of the time. Because of these high probabilities, traders look carefully at every reversal or breakout early on to see if they can place a swing trade, meaning that the reward is at least twice as big as the risk (see “Trading the open,” below).

Reversals

The greatest fear that a beginner has is losing money, which he erroneously addresses by using the smallest stop possible, not aware that there are two other variables that are just as important. This makes him always want to buy the exact bottom or sell the exact top because he realizes that the stop is then close to his entry, just beyond the opposite side of the signal bar.

The trader sees lots of great reversal setups in books and on websites and assumes that they are common. However, he wonders why he watches the market day after day and never sees anything as perfect as what he was hoping to find. The reality is that there has to be an institution taking the opposite side of his trade, and no institution is going to give him perfection because then the institution would be accepting something perfectly bad—a low probability of winning where the risk is much bigger than the reward. That means that there has to be something wrong with every reversal—and with every trade!

What could possibly be wrong? The beginner sees a perfect bull reversal bar, just like in the books, and the market is reversing up from a trendline or some other support. This should be perfect! However, the context may be saying something different, which is all of the bars to the left. Trends, like trading ranges, have inertia and therefore strongly resist reversal attempts. In fact, 80% fail and just become pullbacks (bull flags in bull trends and bear flags in bear trends).

This is true of all reversals, including head-and-shoulders patterns and double tops and bottoms. Most are simply flags and the trend will continue. Rarely, there will be a reversal, but you will lose money if you just mindlessly short every head-and-shoulders top because most are just triangles in bull trends and are followed by higher prices.

If the context is right, a head-and-shoulders pattern might be worth trading. For example, if there is a bear trend and then a head-and-shoulders bottom, the rally up from the low might break above the bear trend line, which forms the top of the bear channel. The right shoulder then is simply a pullback from that breakout and is therefore a breakout pullback buy. I prefer not to use the term “head and shoulders” and instead use either a breakout pullback or a “major trend reversal,” because those terms more clearly describe what is happening. They imply that the context supports a reversal. “Head and shoulders” does not tell you anything about the context, and the overuse of the phrase has traders constantly looking for reversals when they should instead be expecting trend resumption.

Incidentally, I mentioned earlier that trends are followed by trading ranges, which are then followed by trend resumption or trend reversal. Head-and-shoulders patterns usually do not have enough bars to make the odds favor reversal. The odds still favor resumption, and this means that most head-and-shoulders patterns are medium-sized triangles (bull or bear flags) and not reversal patterns. Most trends do not abruptly reverse into opposite trends and have to first enter a trading range.

This means that most reversals involve a trading range, which usually is a final flag or a major trend reversal. Most climax reversals are usually variations of small final flag reversals. After the reversal, a major trend reversal then usually forms. For example, after a buy climax reverses down, there is usually a test up to form a lower high, major trend reversal, which usually leads to at least a “leg one equals leg two” measured move down (see “Flags and reversals,” below).

If there is no significant buying pressure, the chances that a strong bull reversal bar will lead to a reversal are small. At best, a small pullback might form, but that is not enough of a reward to offset the low probability, and a trader continues to lose money. On the other hand, if there recently was a rally that went above the moving average and had several good size bull bodies with closes near their highs, and the sell off to the bull reversal lacked strong bear bars, then the odds of a profitable reversal where the reward would be at least twice the risk would be higher and probably at least 40%. This means that waiting for a strong context converts the trade into a mathematically sound one, even if the probability is only 40%. (It might be higher, if the context was strong.)

This is a major trend reversal, which is a type of double bottom. There is a bear trend and then a reasonably strong rally lasting about 10 bars. In this case, the signs of strength included several strong bull bars and a move above the moving average. The sell off to test the bear low was weak. It does not matter if the sell off is a perfect double bottom—most double tops and bottoms are not perfect—or if the bull reversal bar formed a higher low or a lower low. All are double bottoms. If the move down to test the low falls below the low by five or more bars, the bulls probably need another strong leg up above the trendline and then another test of the new low. They need to look for a new major trend reversal. Once the move up begins, it usually will go up for at least two legs and it usually will test the top of the bear channel. At that point, a large trading range usually develops, but the bulls will still have a reasonable chance of a swing up before that happens.

Another common reversal is a final flag. In any trend, after it reverses, you can look back at the last flag in the trend, which ended up as the final flag. As final flags are forming, they usually have characteristics that alert traders to watch for a failed breakout and then a reversal. For example, if there is a bull trend that has lasted a long time, say 40 or more bars, and now it forms a trading range with good two-sided trading (maybe a double bottom bull flag, which is a type of high 2 buy setup, or a triangle), the upside breakout might fail and this trading range might become the final flag of the bull trend. Traders will assess the selling pressure within the trading range.

Were there many bear bars with good size bodies and closes near their lows? Is the market just below a resistance area? Was the bull breakout weak, and did it have two or three small pushes up (like a wedge top)? If so, traders will look to sell below a bear reversal bar, especially if it is strong, looking for a swing down (at least ten bars and two legs) to a support level. The first target is the final flag. If the bear breaks below, then traders will look for a measured move down to a trendline or an earlier higher low, maybe based on the height of the trading range or the size of the final bull leg.

There are many forms of climactic reversals, but V bottoms and tops virtually never exist. They are all variants of some other pattern, like a small final flag. In general, most trend reversals last at least 10 bars and two legs on the time frame you are watching. If the trend lasted 80 or more bars, the reversal is probably also a higher time frame reversal (like a 15 minute reversal if you are looking at the five-minute chart), and it will probably last at least 10 bars and two legs on that higher time frame.

What happens if you miss the initial entry? Only good things! Once you see that the reversal down is strong (maybe it has four consecutive bear bars that all close near their lows), the always-in direction will have flipped to short and the probability will go up for the bears. Yes, the stop will be further away and there be fewer ticks remaining in the selloff, but the probability of a profitable trade might be 60% or higher, which makes it a great short.