Wednesday, April 13, 2011

Price Channels and Market Breaks

Monday and Tuesday were fairly nasty days for my highly leveraged set of positions, as a general, rather small market break caused prices to wash over their stops, closing out at losses.

These small typhoons sweeping across the roiling market seas will always be a fact of life that will make things interesting for traders from time to time. The task for traders who take a management approach to their positions (as opposed to a casino approach) is to devise practices to mitigate the worst of the damage.

Within the confines of the trading system I use, several possibilities come to mind:

1) Keep tight stops, ensuring that the position closes with small losses. It raises the cost of trading, but transaction costs are small. If $10 or $20 is a major factor in profitability, then the position size is too small.

2) Raise the barriers to opening positions. If you're not in a position, you can't get hurt when the price heads south. Of course, you can't make money, either, when the price moves in your direction.

Some possible barriers:

a) Don't open until the two-day rule has been fulfilled. The two-day rule invalidates a breakout above the price channel only if the price closes above the channel on at least one of the two subsequent days. (Read "How I Trade" for a full explanation.) This confirms that the forces behind the breakout are more than trivial.

The two-day rule now is an exit rule. Observing it as an entry requirement would help eliminate the breakouts that lack conviction.

b) Require two consecutive closes above the breakout level as a condition for entry, or even stricter, two days of trading entirely above the breakout level. You'll give up a bit of the price movement, but remember, we're in this for the long haul.

c) Require establishment of a three-day trend before entry. A signal is not a trend. So, after a bull breakout, for example, this rule would require three days of higher highs and higher lows before entry, or in the case of a bear breakout, lower highs and lower lows.

d) Candlesticks. Require a confirming candlestick pattern as a requirement for entry. Personally, I think this is a bit quirky, but it would certainly work. It would just be hard to manage -- there are a lot of candlestick patterns.

e) Require confirmations from the chart basics in the form of a volume spike, or a full day's trading entirely above the breakout level, or a breakout that closes up for the day.


That's what I'm thinking about these days. I haven't made up my mind yet what I'll do for my own trading. I'm doing some testing to see how such rules would impact results.

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