A Key Rule, Often Overlooked

All market speculators share the same goal which is to enjoy consistent low risk profits. To accomplish this goal, you must be able to identify market turning points as this is the only way to attain low risk and high reward entries into market (trading) positions. Whether you are a short term day trader or a longer term investor, nothing changes. Identifying key market turning points is the only way to attain the ideal risk / reward opportunity. Leading the Extended Learning Track (XLT) classes for so long, I have come across many people in the program. Occasionally, I receive an email from a member that is not satisfied with their results and desires better returns. Most of the time, they are not necessarily losing money, but they are not making money or not making enough money, and desire more. One of my first questions to them has to do with strategy. I ask them, "Do you have a plan and are you following that plan?" Half the time the answer is no, so we dive into creating a proper plan and the importance of following that plan. The other half says they do have a plan and for the most part, follow it much of the time. For this group, my questions turn to the details of their plan, the strategy, where I look to see if their rules are proper or not. Sometimes, there is a rule or two that is incorrect and the student doesn't know it, so we correct it. In my many years of experience, I have found that most of the time, there is one specific and crucial rule that is missing from people's plans more than any other and that is the focus of this piece.

Before we discuss this rule and its importance, let's first turn our attention back to market turning points. Where are market turning points? Price movement, in any and all markets, is a function of an ongoing demand and supply equation. Market prices turn when this simple and straight-forward equation is out-of-balance. Therefore, price in any market turns are price levels where demand and supply are out-of-balance which means the strongest turns in price occur at price levels where demand and supply are most out-of-balance. So, the question for us is this: What exactly does this picture look like on a price chart?

When I ask students this question, they quickly describe the picture of demand that I have shown in articles for years which is a "Drop – Base - Rally." They then describe supply which is "Rally – Base – Drop." These are the two pictures that clearly show price levels where demand and supply are out-of-balance which is what we as market speculators are looking for. Next, students go right into their rules for entries, targets, and stops and this is where I stop them as they are ignoring perhaps the most crucial rule that should be included in their trading plan. Drop – Base – Rally may be the picture of a price level where demand exceeds supply, a demand level. But, what EXACTLY is a demand level for you and your trading plan? I find that most people don't quantify this with numbers. Quantifying exactly what "demand" (or supply) is to you and your plan is a key component to a trading plan that has an edge over other trading plans that don't. To explain this further and dive into the details, let's look at two recent XLT trade setups I identified with students during our swing trading sessions.

The chart above is a daily chart of Crude Oil Futures. In the lower left portion of the chart, we identified an XLT demand level. As you can see, it is clearly Drop – Base – Rally, the base is in between the two black demand lines which creates our demand zone. Just because it represents the pattern/picture we are looking for does not at all mean we have a low risk / high reward trading opportunity. One of the most important questions that comes next is whether there is a significant profit margin associated with this demand level or not. The presence of a significant profit margin is key for two reasons. The first is that it quantifies the risk and reward. Second, the larger the profit margin, the higher the probability. This is because a big profit margin means price is far from equilibrium and out at price levels where the demand and supply imbalances are greatest. The rule most people fail to consider is illustrated in the grey shaded area on the chart. It shows us how far price was able to rally from that demand level before returning back to that demand level for our low risk, long entry. Compare that rally to the area between the two black demand lines. The distance between the two black lines is the distance from our entry point to our protective stop loss price. We buy at the top black demand line and place our stop just below the lower black demand line. This measures our risk. The grey shaded rally represents our potential profit margin. The logic is that if price was able to rally that far, this means there is no significant supply until the top of that rally and higher. That initial rally "opens up" a profit margin for us as we are willing buyers when price revisits that level which it did in mid-December. Back to our rule...

Rule: A demand level only becomes a demand level if the initial rally from the demand level is at least three times the demand level (1:3 Risk/Reward). Meaning, if the distance from entry to stop is two points in a market, the initial rally from that level has to be at least six points or it does not qualify as a demand level for me. I will ignore any demand levels that don't meet this minimum requirement.

While I require a 1:3 as a minimum requirement for the demand level to actually meet the definition of a demand level, it may be different for you. You may require 1:4, or whatever. In this example, the length of that initial rally from demand was much more than three times the distance from entry to stop and that's good; we only needed the 1:3. What this suggested was the probability of price hitting our first target (T1) of 1:3 was very likely. This does not mean that my target has to be the top of that rally. It simply means that this opportunity is offering me at least three times the move that I am risking. As you can see on the chart in our XLT trade, target one (T1) was nowhere near the top of that rally, and that's fine. Price ended up reaching target one and two for a low risk and high reward trade. One of the most important factors for this successful trade was the length and speed of the initial rally away from the demand level, and this is a rule many market speculators fail to consider.

Let's look at another swing trading opportunity we identified and took in the XLT. The chart below is a daily chart of the 10 Year Note. Again, notice the grey shaded area. This represents how much of the demand below our supply level was absorbed by the sellers during the initial decline in price from supply (grey shaded price action). The fact that price declined so far so fast was the reason our short position was able to rather easily reach target one (T1). Remember, compare the distance between the two black lines that make up the supply level to the distance of the decline in price from the supply level (grey shaded price action). Make sure it meets your minimum requirement before you can even call it a supply level.

Many people talk about supply and demand when trading and writing trading plans. Few actually define what supply and demand levels are to them. This is another step in building the edge required to get paid from your competition instead of paying them. There are more subtle but important rules to consider but they are beyond the scope of this piece. If you have any questions or comments, feel free to email anytime.