Trading the Emini S&P 500 day session, there are 81 bars on the five-minute chart, and most go above the high or below the low of the prior bar. Each instance is an Emini breakout and, as with all breakouts, there is an opportunity to make money.
In a market as large as the Emini, the market virtually never can move, even one tick, unless one or more institutions are willing to buy at one tick above or sell at one tick below the current price. We, as individual traders, make up only 5% of the volume and are simply too small to move the market, and the market does not care whether or not we exist.
Because of this balance of power, the market is never out to steal our money by stopping us into losing positions or stopping out of winning trades. The market cannot move above the high of the prior bar unless one or more institutions are willing to buy higher. The buying can be to initiate a new long or to exit a short position. The exit can be with either a profit, if it was initiated at a higher price, or with a loss. For an institution to be able to buy, there has to be another institution willing to sell at that same price. If there are more institutional dollars eager to buy above the high of the prior bar than willing to sell, the market will have to move up at least one more tick to find enough sellers to fill the buy orders.
If the imbalance is great enough, the move can last for many ticks, and any trader who bought as the market moved above the high of the prior bar will be able to make a profit. On the other hand, if there were more institutional dollars willing to sell at one tick above the high of the prior bar than willing to buy, the market will have to fall one tick to find enough buyers to fill those orders. If the selling intensifies as the breakout above the high of the prior bar continues to fail, the market will fall far enough for an individual trader who is short to make a profit.
High-frequency trading firms can make a profit if the market moves only a tick or two up or down, but individual traders realistically need the market to move at least a couple of points to be able to make enough of a consistent profit to earn a living. If a trader becomes good at assessing whether there likely will be more institutional dollars buying or selling as the market moves above the high of the prior bar, he will be in a position to trade profitably.
Similarly, the market cannot fall below the low of the prior bar unless one or more institutions are willing to sell lower.
The key to being a successful trader is being able to determine when there likely will be an imbalance in the buy or sell orders, and whether the imbalance is great enough to move the market far enough to make a profitable trade.
A trader always should know his risk and have a good idea of his potential reward when entering a trade. His risk is the number of ticks from his entry price to his protective stop. His reward is the number of ticks from his entry price to his profit target. Most traders always should have a risk that is at least as large as the reward, otherwise they have to win on 70% or more of their trades to be profitable. That is an unrealistic goal for most successful traders, and a delusion for anyone starting out.
If a trader uses a reward equal to his risk — let’s say two points for both — then he has to be right at least 60% of the time to begin to make a profit. That still is difficult to do, but possible with experience. If his reward is two or more times greater than his risk, then he can be right just 40% to 50% of the time and be profitable. Because of the math, most traders should start out looking for trades where the reward is at least twice as large as the risk. This consideration affects how we approach our analysis of the prior price bar.
When a bar is forming and it has not yet gone above or below the prior bar, a trader needs to consider whether it is likely that there will be an imbalance between buyers or sellers on a breakout above or below that prior bar. Next, he has to decide whether the breakout will go far enough to make a reward that is at least as big as the risk.
For example, if a trader is buying a two-legged pullback to the moving average in a bull trend, and the market forms a strong bull reversal bar at the moving average, buying at one tick above the high of that bar, risking to one tick below the low of that bar, is likely to result in a move up at least as great as the number of ticks at risk. This means that this is a mathematically sound long (the trader’s equation is positive, which means that the probability of success times the reward is significantly greater than the probability of failure times the risk). In general, for a move above or below most bars, the trader’s equation is not positive enough to take a trade or a trader cannot confidently make the assessment. However, with experience, a trader might see about 20 to 30 potential trades a day on the five-minute chart, and he might feel confident enough to take five to 15 of them.
There are, of course, variables that a trader has to consider when deciding the probability of a successful trade. The most important is the overall context. If the market is in a strong bull trend, only look to buy and assume that every sell signal will fail and evolve into a bull flag. In a bear trend, look for shorting opportunities. In a trading range, look to buy low, sell high, and scalp, realizing that the market will create strong rallies that repeatedly lead to reversals down and strong sell offs that soon will reverse up. As strong as the rallies and sell offs often are, don’t get tricked into trading in the wrong direction, because 80% of the breakout attempts will fail and lead to reversals.
Traders have to assess the strength of the signal bar, especially in relation to the past several bars. If a sell signal bar has a one-tick bear body and it follows four big bull trend bars with big bodies, the signal is weak and there might be more institutional dollars looking to buy at and below the low of that sell signal bar than there are dollars looking to sell. In that case, it makes more sense to place a limit order to buy at or below the low of that sell signal bar than it does to go short there.
Support and resistance also are important. If a trader is looking to buy and the bull signal bar is reversing up from a bull trendline, the chance of a profitable trade is greater. The more signs of strength of a breakout are present, the better it is to look to enter on a stop in the direction of the breakout.
Although a trader can sell on a stop or buy on a limit order below a bar, or buy on a stop or sell on a limit order above a bar, beginners only should enter on stops. It is simply easier emotionally to enter when the market is going your way than when it is going against you, as it is with a limit order entry. However, with experience, traders can enter with either stop or limit orders. In general, enter with stops when looking to enter as a pullback ends and a trend resumes, and when there is a major trend reversal (see “Entering with stop orders,” below). There must be a break of the trendline, a test of the trend’s extreme, and then a strong signal bar in the direction of the new trend.
Experience allows entering on limit orders (see “Entering with limit orders,” below). Look for stop setups that are particularly weak, and then fade the breakout. For example, if there is a one-bar pullback at the bottom of a weak bear channel and you doubt money could be made shorting on a stop at one tick below the low of that bar, instead place a buy limit order at or just below the low of that sell signal bar, expecting the downside breakout to fail and quickly reverse up.
To make that determination, weigh the signs of strength of the bear trend against the signs of weakness. For example, if the bear leg is beginning to have many bull trend bars and bars with prominent tails at the bottoms of the bars, these are signs of buying pressure, meaning that the bulls are becoming more aggressive. If there is a weak sell signal bar, like a doji or a small bull trend bar, and the market is just a few ticks above two or three types of support, a trader might assume that the downside breakout is more likely to reverse up within a few ticks. If that is the case, buy as the market falls below the sell signal bar and hold for a reward that is at least as large as your risk. If you risk six to eight ticks, place a profit taking limit order that is at least six to eight ticks above the entry price.
Market analysis does not have to be complicated. Trust that whatever complex methods you devise, the massive institutions that dominate each day’s volume have something far more sophisticated. As individual traders, our best approach is to embrace each day’s price action and anticipate short-term moves based on past experience. Using the experience earned through constant observation and the repeated application of proven, simple price action setups, we can put ourselves in a position to profit when the market moves as expected.
This is based on an article from the February 01, 2012 issue of Futures magazine.