Invest with the Probabilities

Invest with the Probabilities

Not every trade is going to shoot straight up after the buy signal appears. There will be many entry points that fit the perfect buying conditions, yet fade just after you fill your position. Mistake? Depends on how the rest of the day fin­ishes. Will every trade work the way the signals indicate? Definitely not! Never­theless, back to the basics. You are looking for the best possible place for your money to make the best returns while minimizing risk. Hopefully, the signal itself is representing well above a 50/50 probability of making money This ratio maybe 60%, 68%, or 74%. Fine-tuning the entry process may increase the probabilities by another 3%, 4%, or 5%. A good evaluation of the entry also has the element of limiting the losses. If a trade is placed, and the basis for entering the trade disappears immediately, and the buyers have disappeared, then liquidate the trade immediately. The loss may only be 1%, 3%, or maybe as much as 5% if it is liquidated that day or on the open the next day. The gains get an opportunity to run when the buy signal is not negated. The losses are trimmed immediately if the signal fizzles. All from a simple premise! Are the buyers still in control?

There is a good rule of thumb for protecting a newly established position. If after a buy signal, a position is established, and the prices back off by the end of the day, closing more than halfway down the bullish candle that identified the buy signal, close out tire position. Statistically, this represents that the sell­ers still have the upper hand. However, keep in mind that a buy signal did form at the bottom of the trend. Despite having to exit the trade at a small loss, be prepared to see new buying evidence soon. If so, re-establish the position. The initial buy signal occurred for some reason.

The most important decision-making area is at the reversal points. Is it a reversal or is it a pullback in the trend? That is where the analysis and monitor­ing is most important. A buy signal requires follow-through. The weight of a sustained downtrend needs a strong change of sentiment to reverse its course. If the reversal has only two or three days of an up move, do not be hesitant to take quick profits once a weak signal appears. There may be a more opportune time to get into a position if a pullback occurs. Will the current low hold, act as a support level? You should be watching for a new buy signal. This is your opportunity to get into the position again.

If the previous low does not hold and prices go lower, watch for the next buy signal to occur at lower levels. This is true whether a short-term trader or a long-term holder.

Fig. 9-6, Hovnanian Enterprises Inc. illustrates the Candlestick investors’ minor dilemma. All the parameters say to buy this stock. A Hammer is followed by a Bullish Engulfing pattern. The stochastics have turned up, volume is picking up. But the next day the price opens much lower than what would indicate that buyers were still active. What is the best way to enter this position? Are the sellers taking back control for some reason? Maybe the indexes opened much lower. In keeping with the practice of buying a stock that is going up, the best entry strategy would be to put a buy stop at the close of the previous day. If the buyers are still participating, it will be evident when the price moves from the lower ‘open’, and then back up through the close of the previous day. Buying the stock at a slightly higher price is a small premium to pay for knowing that you are getting in a position when the buyers are around.

If the buy stop never gets executed, the lower open and a close below the previous day's close would form a Harami. This formation would indicate that the buying had stopped. You are not in a position where the sellers may be taking control again. If the buy stop is executed, a buy signal is con­firmed.

As described in “Profitable Candlestick Trading” a Hammer signal can show the investor great amounts of information. In the example of Hovnanian Enter­prises Inc, the buyers did come into the stock, executed the stop, and continued to show strength. This made for a good trade.

If market conditions were weaker or profit taking comes into a stock, it can create a different evaluation after the close. Fig. 9-7, Movie Gallery Inc., for example, creates an evening of less positive possibilities for the next day. In this case, the price opened lower, came up during the day, and executed the buy stop. Now the position closed lower than where it was bought, forming a Doji/ Harami. That could lead to a few days of consolidation. However, it is still early in the up-trend. Stochastics are heading up. Fortunately, the buying continues the next day and moves prices positive. Again, the overriding factor boils down to the appearance of a Morning Star “buy” formation. As seen in the chart, the Morning star formation was the bottom reversal point for a strong uptrend.

One of the most common chart patterns is the Doji after a big up day. Consider the dynamics that are occurring in the investors’ minds. In an example such as Fig, 9-8 (following page), Scansoft Inc., there has been a recent distinct downtrend. All of a sudden, a Bullish Engulfing pattern emerges. The buyers are stepping in. They have overwhelmed the sellers to the point of reversing the trend. The following day after the big up surge, there will still be sellers that will take advantage of being able to get out at a higher price than just a couple of days prior. This continued selling is met with buyers coming into the position. It is not unusual to see a Doji day after a big up day. However, when the sellers see that the buying is now soaking up all the selling, they get con­cerned and step out of the way. The following day should see higher prices.

Don’t let the Doji Day concern you. It is the transfer of stock from selling hands into buying hands. If the price opens higher the next day, you can be assured that the buyers have now gained control. The rally should continue.

Entering a trade involves a combination of evaluations. Just as you would make a decision about what you are going to wear today involves a number of obser­vations. You may have heard the weather report saying that it is going to be cold and rainy today. You peer out the window to see what the conditions are. You look at the thermometer to see what the temperature is doing. You may open a door to see if it is windy or calm. You do the same process when getting ready to enter a trade.

You investigate. You have already done your research and decided on what position you want to buy in the morning if the conditions are right. You check the futures in the morning to see what the general market sentiment appears to be. You can check to see if the bid and ask have moved one way or the other during the non-market hours. You can check on other stocks in the industry to see how they will open. You may look for any news reports since the close yesterday that would influence the stock price.

If nothing seems out of kilter, based upon what the “buy” signal was indi­cating to make your “buy” decision, then the final input will be how prices are actually opening. If nothing appears to be out of line, purchase the position. That is what the Candlestick signal had indicated should be done. Fine-tuning the entry process will minimize getting into a bad trade. For each bad trade that can be avoided, more opportunities are available to put investment funds into a good trade. Eliminating a very small percentage of losing trades will increase your returns in geometrical proportions. Avoiding a loss negates having to make back those losses with a positive trade while using up that next trade and time to get back to even.

“If skills could be acquired just by watching, every dog would be a butcher.”