Today we are going to look at how we can use the stochastic indicator to help us better identify potential entry points. Stochastics can give us both buy and sell signal by looking at the actual line as well as it can show us potential divergence on the chart. When a chart has moved up or down a significant amount you will often times see it move into an overbought or oversold area. These areas are where we can look to buy or sell as the price begins to reverse the direction.

Take a look at the chart below to see how overbought and oversold conditions might give us times to buy or sell.

In this chart you can see that the stochastic indicator has moved into the areas above 80 and below 20. Then it is below 20 it is considered oversold and when it is above 80 it is considered overbought. As the stochastic indicator begins to move up this is suggesting that the price should begin to show some bullish strength and when the stochastic line begins to move down the price should show some bearish movements. Of course there is not guarantee that the price will move in the desired direction but it can give us a heads up that price may begin to move.

When trading the stochastic line you will want to make sure price confirms the movements that you are anticipating. Just because the line is above 80 doesn’t mean that it can’t stay above it and the price continue to move higher. Use this to give you a warning of a possible price direction change.

The other help we can get when using the stochastic line is to look for divergence. This simply means that the price and the stochastic line with be showing strength or weakness in the opposite directions. Take a look at the chart below to see both bullish and bearish divergence.

Here you can see the bearish divergence on the left where the price made higher highs while the stochastic indicator made lower highs. This would suggest that the price is getting weaker and to look for a bearish move in the price. On the right you can see the bullish divergence which the price is making lower lows while the stochastic indicator is making higher lows.

As you look at using the stochastic indicator for both over bought and oversold entries as well as finding divergences, you will see that this tool can give you a good ideas that the price is ready to move. The final piece using the stochastic indicator is to make sure you rely on the price action to confirm the movement is going to happen.

Take some time to practice using this indicator to see how it can help you improve your trading. As you get more acquainted with how this indicator works you will find that you will be able to read the charts a bit better. Don’t rely on it solely but use it as a tool to help you confirm your entries.

When trading, often, we can look at the charts after the fact and it is easy to identity good, positive trades. However, in real time, as the markets are moving, it is often more difficult to identify the best trades. The key to technical trading is to use the indicators and the price patterns on the charts to help identify good, high probability setups. Today, I would like to discuss a price pattern that is fairly simple and is commonly referred to as a 3-bar reversal.

Let’s look an example of a 3-bar reversal and discuss how to identify them and then how to possibly trade them.

Figure 1: S&P Chart 3-Bar Reversal

On the chart above, we are looking at the S&P 500 daily chart. You will notice that in May of this year, we have the market moving in a strong upward trend (bullish) and there is a classic 3-bar reversal pattern that develops by moving down against the trend. You will also note that once the 3 bars reverse, or go down against the trend, that the fourth bar is a bullish bar and moves up into the upper half of the range of the third down bar. This fourth candle is very important because it is not only confirmation that the 3-bar reversal is over, but also that the market is moving back in the direction of the trend. This is what is referred to as a confirming bar or candle on the chart. Once we have a confirming candle moving back in the direction of the trend, we could enter the trade long. As a good rule of thumb, don’t enter the market long until the candle has moved at least half the distance of the third candle in the reversal. It is important to make sure that you wait until the fourth candle has actually closed before entering the market, as sometimes it looks like a strong confirming candle, but then actually closed lower than the half of the range mark. A more conservative approach would be to wait until the trend has moved back up to above the top of the market or the top of the pattern. This is often referred to as the top of the flagpole, as this pattern falls into the category of a bullish flag pattern. The recommended stop loss would be just below the bottom of the third candle or the bottom of the pattern.

In a down or bearish trend, the 3-bar reversal pattern would be the opposite pattern with 3 bars or candles moving up against the downtrend. And you could trade the market short if the confirming candle closes down more than half of the range of the third reversal bar, also setting a stop order just above that at the top of the pattern or the third reversal bar.

In summary, this is a fairly simple pattern to identify and understand and, if confirmed, can be a nice setup pattern to get a good trade in the direction of the overall trend after a minor 3-bar pullback. As a good exercise, go back and look at your charts for this pattern so you can more easily identify them in the future.

In our article today we are going to talk about three different types of market movements that happen when trading. These are different than what we have talked about in the past, when we have discussed deliberate and non-deliberate movements. Although deliberate movements are important, and we should use this concept, today we are going to look at the actual directional movements that happen. The three different movements we see in the market are: upward movements, downward movements and sideways movements. Each of these types of movements can give us trading opportunities, as long as we know the direction they are going.

The first market movement we will discuss is the upward movement, or the uptrending price action. This type of movement is known as a bullish trend. In a trend like this, we will be looking to buy. When buying in an uptrend, we will look for the best opportunity to enter into the trade. This usually happens as the price begins to move up and off of the area of support. By trading at this time, we are allowing the trend to have the biggest impact on the success of the trade. Of course, there are many indicators or entry triggers that can get us into the trade, but the important thing to look at first is the price action on the charts.

The second type of market movement we will discuss is the downward movement, or the downtrending price action. This type of movement is known as a bearish trend. In a trend like this, we will be looking to sell in the direction of the trend. When selling in a downtrend, we will look for the best opportunity to enter into the trade. This usually happens as the price begins to move down and off of the area of resistance. Just like the uptrend, a downtrending price action can help us succeed in our trade as we take advantage of the price action.

The final type of market movement, and the one the can often times be the most frustrating, is the sideways market movements. This is difficult because the price is really not moving anywhere. It seems to go up a bit, then down a bit, but does not have any real movement in one direction. As we try to trade this, we, often times, will get closed out of our trades quickly as the price changes. This can be concerning unless we adjust our trading to incorporate the buying and selling as the price reverses off of the support and resistance areas. If we can recognize that the movements are not trending up or down, we can change how we trade so we can take advantage of this type of movements.

So, as you look at the charts you are trading, take some time to determine if the price action is up, down or sideways. If you do this first, you will know what type of trading and the direction of the trades you will be placing. It will save you the frustration of trading in the wrong direction from the price action.

Today, let’s look at several different trade orders and how they work. Basically, a trade order is an order that tells the broker to enter or exit a security position. Let me discuss some of the basic, but important, order types.

Market Entry and Exit Orders
To begin, the most basic trade order, and the one many new traders use, is simply ‘Buy and Sell at Market’ orders. These are the easiest of all trade orders and they work great; however, market orders are all manual and require paying a lot of attention to the position, with constant monitoring, almost like “babysitting” the trade from entry to exit. If you walk away or get distracted, you can put yourself at greater exposure and unnecessary risk.

Stop Entry Orders
Most modern internet trading platforms allow you to also use advanced orders to enter the market with a pending order set in advance. Specifically, a pending ‘Stop Entry’ order allows the trader to enter a position at a certain price once the stop entry level at that price is reached. These pending stop loss orders can be used to enter the market, both long or short, using a buy stop entry order to go long or a sell stop entry order to enter short in the market. These stop entry orders are very useful for traders who want to confirm momentum in a certain direction.

Limit Entry Orders
An additional pending entry order is a ‘Limit Entry’ order, which will guarantee an entry at a specified limit price or lower price for a buy limit order. The opposite is true for a ‘Sell Limit’ order where you will enter the market short at a certain price or higher. If the market gaps up above the buy limit price or below the sell limit price, the trade will not be entered unless the market moves back to the limit price.

Protective Stop Loss Orders
In addition to entry orders, certain order types allow traders to walk away and not babysit a position waiting for the best time to exit. One of the most important pending exit orders is a ‘Protective Stop Loss’ order. This is one of the most important orders for the purpose of risk management because it limits trading losses by creating a hard exit at a predetermined price, like a “line in the sand” where the position will not lose any more than the predetermined exit level. Using advanced order types, like a protective stop loss order, can be set up as soon as the trade is entered, allowing you, the trader, not to have to sit and watch the market and also protects against missing an exit in a faster moving market.

Pending Profit Target Limit Order
In addition to the stop loss exit order, there is the ‘Profit Target Limit’ order. This order can also be placed to exit a current position, at a certain price, once the level has been reached. These orders are also very helpful to exit your position at a profit without having to be present or manually exit the trade.

These basic trade order types are important to understand, especially the pending entry and exit orders, to allow active traders to trade the market without having to constantly be present, monitoring the market. With many current trading platforms, you can enter one or two additional pending orders, so that once you trigger the entry, you can have the exit stop loss and limit profit target orders trigger as well.

The classic definition of insanity is doing the same thing over and over, but expecting different results. If this is actually true, why do so many traders continue to use the same losing methods over and over, hoping that someday things will change and they will win? Highly successful people often times state that one of the reasons that they are successful is because of their attitude; they never let the thought of failing into their consciousness. Basically speaking, all this really means is that if you think like a failure you will likely fail and if you think like a winner you will most likely win.

These are two separate and distinct concepts, but I believe that they are both very much related. The more complex a trading method or trading system is, the more refined and fine tuned it is, but I believe that because of this, it is also more susceptible to failure, due in large part to its narrow view of the market. I have recently realized, after observing different markets over a long period of time, that most good methods or trading systems will begin to break down or fail at some point. The method or system didn’t change or all of the sudden become bad, they stayed the same, but the market changed around them, rendering them either less effective or not effective at all. It is said that recognizing a problem is the first step to recovery, but what I observe is that a lot of traders that have created trading methods and systems believe so staunchly in them that they are unwilling to recognize a failing method or to adjust it even when the evidence that the method is no longer effective is clear. At some point, a good trading method will likely become effective again, but, as previously stated, it has nothing to do with the method, but everything to do with the way the market is moving, which means that, not only will it begin to work again, it will also go through periods where it will not work at all.

Our expectation around our trading results will become reality, so the more we can win and the better our attitude is around trading, the more likely we are to have success. Perception is reality, so the more we focus on our winning trades and on managing our winning positions, versus lamenting over our losers and our losing positions, the more success we are likely to have. Losing is easy, anyone can do it, but winning takes a lot of discipline. A lot of traders become so accustomed to losing that they actually trade with the expectation of losing, so when they do win they are surprised. This type of attitude is almost a guarantee that they will fail, more than they will win. If you are going to go into trades with a losing attitude, you may as well stay out of the market, stay out of the trade, and simply give the money that you would have traded with to a charity. At least if you did that, there would be no stress and someone may end up with the money that will actually do something useful with it.

Trading, in general, is not easy; when you trade, you are competing with some of the best traders in the world and, just like all competitions, not everyone can win – you are either the shark or the mark. Putting yourself on the winning side is as much about attitude as it is about knowledge and luck, so before you even begin to trade, make sure that you are mentally charged up, ready to handle it, and make sure that you truly believe that you can win.

Today we are going to discuss the important topic of how much to risk when taking a trade. Along with this, we need to know how much we are willing to risk over our entire account with all the trades we are currently taking. One of the first things we learn when trading is to determine the maximum amount we are willing to risk in each trade. A common number that is taught is that we should never risk more than 2% of our account in any single trade.

An important thing to point out here is that this amount should be the maximum we risk. It doesn’t necessarily mean that we must risk this amount. In fact, when beginning to trade a new strategy, it may be wise to trade much less than this maximum amount. As you learn to trade with these smaller amounts and show you can trade it successfully, you will then want to increase your risk amount. If you do it this way, you will avoid the possibility of taking too big of losses during your learning process.

Another misconception with trading risk is dealing with our stop losses. Many times, traders will assume that having a tight stop loss will be less risky than having a larger one. While this may be true in certain situations, having a tight stop loss will, often times, cause us to get stopped out prematurely. Just because our stop loss is tight does not mean it is the most appropriate place to put it.

When looking to determine our risk amount and position size, we first need to do it by placing our stop loss in the most appropriate place. In order to do this, we will need look at things like the trend, as well as support and resistance. Knowing these things will help us place our stop losses in the best position. If we are constantly placing our stops at a certain level without looking at these things, we will find that we get stopped out quite often.

In order to correctly determine our position size, we will first look at the chart to determine the best level. For example, if we are taking a long position, we will look to identify the most recent area of support. This could be a moving average, past swing low, or other areas where price has been supported. Once we do this, we can look to place our stop loss just below this area. Sometimes this may be a small amount, while other times it may be a larger amount. Regardless of the size of our stop loss, our risk will be the same.

If we begin by risking 1% of our account on our trade, we will risk that amount, regardless of where our stop loss is located. The only thing that will be different is the size of our position. If our stop loss is tight, our position size will be bigger. If our stop loss is large, our position size will be smaller. In the end, our risk will be the same.

So take some time to determine the amount you are going to risk in each trade, placing your stops in the most appropriate area by identifying support and resistance, then calculate the size of your trade based off of this. Doing these things will help you keep your risk at the best level for you.

In the past, we’ve discussed the importance of trading with the trend. Sometimes it is hard to tell if the momentum in the market is going to continue or reverse. If you can identify weakness in the current momentum or the current trend, you then can identify potential reversals. Let’s look at a couple of common reversal price patterns. These patterns can be used in all different markets, including equities, Forex, and commodities.

First of all, let’s look at a price pattern called a double top. This pattern is also commonly referred to as an “M” pattern because it will roughly form an M at the top of the market. Look to the chart below for an example of a double top.

 

Figure 1: AUD/USD Double Top “M” Pattern

In Figure 1 above, you can see how, at the top of the market, the momentum was weakening and the price moved down to a support level, then back up top about the same peak or top as the first top. Then as the price moved back down to the support level or the middle of the “M”, this completes the pattern and we have a solid double top pattern. Now how do we trade this pattern? Once the pattern has completed and the market has broken the lower support level indicated by the green line at 1.03602, I generally recommend you don’t enter immediately, but that you wait for the “retest” that happens a few bars latter. Often, when looking at support and resistance levels, you will find that the market will retest those levels; therefore, I generally wait until the retest has occurred and then enter the market. In this case, short the currency pair for about a 200 pip gain.

Now, at the bottom of the market, you would be looking for a double bottom pattern, which is the reverse of the double top, creating a “W” at the bottom of the market.

 

Figure 2: Double Bottom or “W” Reversal Pattern

As illustrated in figure 2 above, you can see that the “W” is formed by the market moving down to a double support level with two valleys being formed and a new short-term resistance level at the top of the pattern. The entry for a long trade-off of this double bottom pattern would be if the price action moves above the green line, or at .92266. Also notice, again, the small retest as the market moves up immediately above the resistance level and then back down to the green line and then bounces off the resistance, heading higher. Again, I recommend that you wait until after the price action retests the resistance level and then enter the market off the bounce. This would be on the 5^th candle or, in this case, the 5^th day after the original move up through the resistance.

Now these reversal patterns are not perfect; however, when they are present and the pattern completes and retests the new support or resistance level, there is significant evidence that the original momentum has changed and a reversal is in progress. Remember as with any trade always use an appropriate stop loss order to manage your risk on your trades. Go back and look at when these reversal patterns have occurred in the past and look for them in the future!

In many parts of the country, this time of the year is when young students return to school. This is often times of excitement for both the student and their parents. Students generally assess their clothing situation and make the determination of what new clothes they will need to purchase so they look good when returning to see their friends at school. They also look at the classes they will be taking and purchase supplies so they are prepared for the class. Parents will often look at this time of the year as a new start. After a long, hot summer, they will turn their attention back to life without a house full of kids running around all day. They will be able to assess what they can do to improve what they are doing. Just like other times of the year, when we feel like we can have a fresh start with our trading, this time of the year can give us an opportunity to evaluate and assess how we are doing with our trading. With this in mind, I want to suggest a couple of things that you can evaluate to determine how you are doing and what you might need to change.

The first thing is – do you have a well-defined and written trading plan? If you do not, you should take some time to write down your motivation(s) for trading, as well as your trading plan. This trading plan will give you the rules you will follow when both entering and exiting your trades. If you do not have this, you will be guessing when to get in and hoping that you will be successful. Having a written trading plan will allow you to gain confidence in your trading strategy.

The next thing you should evaluate is your trading stats. These stats can give you an insight into what might need to be changed. It can let you know if you are on the correct path or if you need to stop trading and make some changes. The first stat you should know is your win to loss ratio. This number tells you how many winning trades you have and how many losing trades you have. For example, you may have 60 wins and 40 losses. Knowing this number is the first stat you will need to know to determine if you are profitable or not. Having a high number of wins does not always mean we are profitable, so we need to look at this next stat to know our profitability. The next ratio tells us our average win to our average loss. Ideally, we will have a higher average win than our average loss, but that is not always needed if our win ratio is high enough.

As we look at these two ratios together, you will be able to see what needs to be improved. If you have a high win ratio, but a low average win, you might not be profitable. This might tell you that you need to work on letting your winner run. The important thing with these ratios is that they are in the correct relationship to each other. If they are not, you will not be profitable.

Having a written plan, along with knowing our ratios, will give us the overall picture as to how our trading is going. Take some time to write your rules down and then evaluate your trading ratios so you know what you need to improve.

A well-known condition of the stock market and markets in general is that perception is reality. It doesn’t matter what is true and what is not true what matters is what people believe is true so what should be important to us is that we recognize this allowing us to act according to the perception of the masses. This becomes very obvious in our perception of how our national economy is doing at any given time as well. The government publishes economic reports at various times throughout any given month which are supposed to give us and them an indication of the health and well being of our economy but how much of the information that they are presenting is actually true? I’m not necessarily saying that the government makes the numbers that are presented in the reports come out in a way that is most beneficial to them but I am saying that since perception is reality the way that information is presented often times can be perceived in different ways. If the economic reports present information that makes it appear as though our economy is getting better then people who see that information and do not question it will likely believe that our economy is improving, they may express this to others around them in normal conversation and they may spend more money based on the beliefs that they have around this. Making people perceive something in a particular way can be very beneficial regardless of how much truth the information is actually based on.

Before the Great Recession a few years ago the biggest and most important monthly economic report that was published was the report that set current short-term interest rates. The main reason that traders and investors looked at the other reports throughout the month is so they could get an idea about what the Fed may do around short-term rates. During the recession interest rates effectively went to zero where they still stand today so there currently isn’t much to glean from this report, the reports that became more important when rates went near zero were reports that had something to do with the real estate market and reports regarding employment and unemployment. The unemployment report is good example of people perceiving things in a way that is not always true. Our unemployment rate has been reported to be going down which makes people feel good about the job market and the economy in general however what is not publicized much is that one of the reasons that the unemployment numbers have improved is because many people have been out of work long enough that they are no longer considered to be unemployed so they do not factor into the unemployed count; the report says one thing so it and the economy in general are perceived in a given way but the facts are different and if they were widely known and publicized people would likely feel much differently.

The trading exchanges and markets in general want the general public to believe that they operate with the upmost efficiency and integrity, they want the average investor or trader to believe that the markets are not manipulated and that there is no insider trading, because of course that would be illegal, but how true is this? The Fed has literally been pumping billions of dollars into the US economy to spur growth and to avoid a worse economic crisis than we have already had but in doing so an unintended or possibility a very much intended result of this is that the stock market has been on a major bull run for the past few years. This is a clear case of market manipulation. Perception is reality in the markets so as people believe that the economy is getting better, regardless of what he truth is, they will invest more and more driving prices up which in part created the Bull Run.

Up until earlier this year the Australian government had not changed their interest rates for well over a year, a very large and famous investor just happened to short the Australian dollar a few hours before an announcement was made that the Australian short-term interest rate was dropping. Within approximately 15 hours after the announcement the investor was reported to have made over 60 Million dollars off of that trade. Was he really that smart or that intuitive or was he tipped off by an insider or someone that knew what the report was going to say?

I have been involved in the markets for over thirty years and one thing I have come to believe is that you should question everything. It doesn’t matter what the source of the information is don’t blindly believe everything that you see, hear or read and just because self proclaimed exerts call themselves experts it doesn’t mean that they know any more than anyone else. It doesn’t really matter what the truth is what is important is recognizing that the truth may be different than what is perceived by most people, this will allow you act accordingly allowing you to see a given situation for what it really is. It doesn’t matter that the stock market euphoria is at least partially based on the governments manipulation but what does matter is that we recognize this so that we can take advantage of it while being aware that at some point the euphoria will end which will likely give us good opportunities to short the markets.