Market Adaptive Trading Techniques : Daily Trading Plan

MAT STEP FOUR: WRITING YOUR DAILY TRADING PLAN

The fourth step in market adaptive trading is writing down your daily trading plan. The process is to look at the current market conditions and determine if they are favorable to trading longs, shorts, or remaining in cash. If the market is in a clear trend, then normal position sizes may be used. If the market is in a trading range, then half size positions may help compensate for the increased risk that the market typically presents in trading ranges.

Using smaller position sizes when the market transitions from a trend to a trading range will also help protect the profits made during the more favorable trending period. Many trading patterns show a higher percentage of winners during market trends than they do when the market is in a trading range. If you reduce your position sizes while the market is in a trading range, you are adapting to the market by compensating for periods of increased risk caused by lower winning percentages.

These techniques are fairly simple, but it takes a lot of practice to get good at them. Nothing in trading is a magic bullet. It takes time, effort, and money (e.g., some losses) to learn trading techniques. One of the best ways I have found to improve results is to write down my market analysis and trading plan every evening. In this I include an analysis of the key market levels and volume patterns as well as what would make me take longs, take shorts, or remain in cash.

The process of writing out my trading strategy and market analysis grew into publishing The Timely Trades Letter. Whether or not you decide to use a newsletter, or work alone, it is important to write out your market analysis and trading strategy. There is something about writing it down that makes you really think it through. Trading on emotion or gut feel is usually a bad idea. Having a well thought out plan helps keep you focused on what is important.

The best way to illustrate the fourth step in MAT is by a couple of examples. On the following pages, we show two examples of trading plans to help illustrate the points made above. Refer to the market charts associated with each example in order to see what the current market conditions were at the time the trading plans were written.

EXAMPLE TRADING PLAN: TREND LINE BREAK TO TRADING RANGE

Figure 8.12 shows the market as of December 10, 2006. The trading plan as published in The Timely Trades Letter is reprinted on the next page. Note that trend lines are used to provide trading guidance along with what the market’s volume pattern is implying about risk levels. This same type of analysis is the part of market adaptive trading that serves as a guide to the next day’s trading. Also note that the trading plan outlines when to take longs, when to take shorts, and how the number of trading positions should be adjusted based on what the market is doing. Analyzing the market and knowing what will cause me to go long, go short, or increase/ reduce the number of trading positions helps take the emotion out of trading and allows me to focus on what the market is actually doing before I react to it.

FIGURE 8.12: DECEMBER 2006 MARKET CONDITIONS

12.10.06. The market pulled back to retest the lower boundary of the ascending trading channel again on Thursday and Friday. Thursday’s distribution day was the third one in the last two weeks, which indicates more caution on the long side is warranted. Traders can become more cautious by reducing the number of positions they are trading or by reducing position sizes.

As long as the market remains within the current ascending trading channel, as shown on Figure 8.12, I will focus on trading longs. The distribution days during the last two weeks are an indication of some weakness in the market. The distribution days do not mean the market has to pullback, but they do increase the odds. Since the odds of a pullback have increased, I need to reduce my exposure a bit. If the market stops producing distribution days and starts showing accumulation, I will increase my exposure again.

If the market continues up without showing significant distribution, I will continue trading longs by replacing positions that hit their targets with new triggers. Since we have seen recent distribution, I will be looking for the stronger volume triggers and pass on ones that are below average volume. If the market continues showing distribution, I will keep reducing the number of positions I am willing to trade and look for stronger volume triggers.

New shorts are not yet attractive. The recent distribution is a warning sign, but as long as the market is trading within the ascending channel the trend is up and shorts carry above average risk. If the market clearly breaks below the lower boundary of the trading channel, I will add a couple of shorts and then look for a retest of the lower trend line from below and then a continuation down as a signal to increase the number of short positions beyond just a few. A break below the 2340 minor horizontal support area would also have me looking to increase the number of short positions.

If the market continues moving up within the ascending trading channel, I will take long triggers as my existing positions hit their targets. If the market moves to the upper ascending trend line, I will focus more on managing existing positions rather than adding new ones unless the market shows accumulation. If the market moves up on declining volume or continues to show distribution, I will reduce my number of long positions because moving up on declining volume is a warning sign.

In addition to the boundaries of the ascending trading channel, shown on Figure 8.12, I am watching the 2470 horizontal resistance area and the 2390 horizontal support area. A move above the horizontal resistance area on volume would mean I would slightly increase the number of positions. A move below the horizontal support level on volume would mean that I would increase the number of short positions from the first few initiated on a break below the lower boundary of the ascending trading channel.

EXAMPLE TRADING PLAN: UNUSUAL MARKET MOVES

When the market does something that seems unusual, backtesting techniques allow traders to find out how often it has happened and how the market has responded. Again, this approach allows traders to make fact-based decisions and not emotional ones. Figure 8.13 shows the market conditions on February 28, 2007, the day after the market showed the largest drop of the past couple of years.

FIGURE 8.13: FEBRUARY 28, 2007 MARKET CONDITIONS

My trading plan about the February 28 drop is summarized in the excerpt from The Timely Trades Letter of 02/02/07 below. As you read my market analysis, note that it describes the same techniques that I’ve outlined throughout this book. Ignore the talking heads on TV and analyze the price and volume patterns in the market.

02.02.07. The market showed a significant drop on huge volume during Tuesday’s session. Our recent strategy of caution, and not wanting to have a lot of money at risk, protected us from serious losses. As noted in recent Letters, the relatively flat period of the last few months and recent indecision implied weakness and caution. This is why I always want to see any market breakout prove itself by showing a successful retest, or continuation pattern, before significantly increasing exposure. Any run worth trading does not require you to be in the first few days, and getting in too early can hurt you.

Just a week ago the news was all about the DOW moving to multi-year highs, and how the markets were looking good. Now the same pundits are talking about a major correction. The DOW consists of just 30 huge cap stocks and is not representative of the overall market. It is more like a big cap ETF than a market indicator. Successful traders watch the market itself, not what the pundits are saying.

The question is always, “what next,” and the answer lies in market analysis. The NASDAQ has not seen a drop of over 90 points since 09/17/01 when the market fell 115 points. This type of move is unusual during recent years. However, the NASDAQ had 13 instances of 90 point or greater down days in 2001, with 36 of them in 2000.

The 49 days during 2000 and 2001 when the market was down, at least 90 points came during a very powerful bear market period. This was a great time to be short, or swing trading, and brutal if you were a buy and holder. The important question is; “what happened shortly after these drops,” since that may shed some light on the current situation. I tested a strategy of buying the day after a 90 point or greater drop and holding for three days during the 2000 through 2001 period, when the market showed 49 of these strong one day drops. The interesting thing is that 51% of the trades were profitable and 49% of the trades were losing positions.

In the strongest bear market in recent memory (the period of 2000 to 2001), the odds of making money by buying the market the day after a 90 point or greater drop, and holding three days, were a coin flip. Even during a strong bear market, the plunges were followed by a brief bounce about half the time. When I ran the same test using a five day holding period, only 40% of the trades were profitable. With an eight day holding, 45% of the trades were profitable. Large down days lead to short term bounces about half the time.

This data indicates that a large drop is not strongly predictive in terms of the short term direction. This implies that we should continue to look at support and resistance levels, along with the Bollinger Bands, to determine the trading plan.

I also looked to see what some of the largest drops were in the period between the 115 point drop on 09/17/01 and today. The only single day drop of 80 points or more during this period was Tuesday, 2/27/07. The only drop of 70 points or more was a 75 point drop on 10/17/01. There were four one day drops of 60 points or more with the most recent being a 64 point drop on 12/20/01.

The NASDAQ showed 22 single day drops of 50 points or more since 09/17/01 with the most recent being the 54 point drop on 11/27/06. The interesting thing about these recent large single day drops is that buying the morning after the large drop, and holding for three days, was profitable 72% of the time. Buying the day after the drop and holding for five days was profitable 65% of the time.

The strong bear market of 2000 and 2001 showed larger one day drops more often than the recent years, and yet the odds were about even that the market would be up three or four days later. The last six years have only shown four one day drops more than 60 points, and 22 more than 50 points. The interesting part is that in recent years the odds favored at least a small bounce after a large single day drop. This is why I will pick up a couple of longs if the market moves up in the next few days. I do not plan to hold them long, just in and out.

Does this data mean that the market must go up over the next few days? No, the odds favor it, but it is not a given. I do the research, know the odds, and trade when the odds are in my favor. This is why I will pick up a couple of longs if the market moves up in the next few days. I do not plan to hold them long, just in and out.

Nothing in the history of large one day drops implies that we should change the way trading plans are developed. Given this, let’s review the market conditions and outline a trading plan for the rest of the week.

Tuesday’s (2/27/07) huge volume move took the market below the short term ascending trend line, drawn between the lows of 11/03 and 01/03, which was our trigger to close any remaining open longs, and pick up a few shorts as outlined in the last Letter. We had three strong volume long triggers this week. FPL triggered Monday with well above average volume, then moved significantly above the upper Bollinger Band indicating it was time for a quick profit. AEP also triggered Monday on strong volume, but it did not hit a target, and it reversed during Tuesday’s market drop for a small loss. DPL triggered on Monday with strong volume and did not quite hit the upper Band. It reversed during Tuesday’s action for a small loss.

When the market broke the short term ascending trend line on Tuesday, I followed the plan by closing any remaining longs and looking for a few shorts. Given the huge down volume on the NASDAQ, I shorted the QQQQ. In addition to trading the Q’s, recent short setups from the Letter that triggered on volume include BMC, LXK, and QLGC. BMC hit the lower Bollinger Band after triggering for a nice 4 /0/o profit. LXK triggered on strong volume and moved below the lower Band for a quick 4% profit.

Tuesday’s action moved the market well below the lower Bollinger Band, which is a condition that rarely lasts long. During today’s action, the market tested horizontal support in the 2390 area then bounced up on strong volume and retested the lower Bollinger Band. At this point the market has three choices: continue down, bounce, or move sideways in a narrow range.

If the market decides to move down immediately, I will be cautious since it closed today right on the lower Bollinger Band. Adding new shorts when the market is near the lower Bollinger Band carries above average risk. I would like to see a little more bounce or some sideways movement to let the market pull away from the Band before getting serious about picking up short positions.

For traders that are unable to take short positions in certain accounts, take a look at DOG, PSQ, and SH, which are ETFs that are inversely correlated to the DOW, QQQQ, and SPY. Taking positions in these ETFs may allow one to profit from declines in the respective index.

If the market moves sideways a couple of days, or bounces a bit then continues down, I will watch for a break below horizontal support in the 2390 area as a signal to add a few more strong volume shorts. Just as I wanted to see any potential move up prove itself before getting aggressive, I now want to see any move down prove itself by a successful retest of support or a successful continuation pattern before significantly increasing the number of trading positions. On any initial move below horizontal support, I will be looking at trading a few short positions. I will then increase the number of positions and the position sizes if and when the move proves itself.

If the market decides to bounce from current levels, I will look for a move above the 2430 area on above average volume as a signal to pick up a few long positions. I would continue to focus on triggers with above average volume and take profits quickly after about 3% or three days. The interesting thing about longs on a bounce is that there is a huge gap on the daily from Tuesday’s action, and these gaps often close within a week or ten days. Just to stay on the safe side, I would look at taking profits on longs as the market approaches the short term ascending trend line drawn between the lows of 11/03 and 01/03.

Writing down your analysis of the market and developing a trading plan every evening helps you understand what is normal in the market and how to react to times when the market does something unusual. In general, the way to trade is to position to profit if the market does the usual thing, such as bouncing off support or retracing from resistance. When the market does something unusual, it is best to exercise caution and reduce risk.