How to Use Widening Distribution to Plan Trades
Editor’s note: Murray Dawes is the editor of Alpha Wave Trader, a short-term trading service that trades stocks and indices from the long and short side. He is filling in for Harje while he is away overseas.
How are you coping with the start of the election campaign? My own path through the quagmire is to actively avoid articles that pontificate on every twist and turn of the dog and pony show. TV ads force me to change channels even if only for a second.
I’m not going to embark on my own political campaign. I don’t think I need to harangue you with my political leanings. I promise to make this an election free zone.
All that matters in that regard is whether one side or the other will cause your investments to take a nosedive. My feel is that a Labor victory won’t be good for the stock market. If you are making promises to siphon off countless billions for your pet projects, that money must come from somewhere.
Hitting up retirees, housing investors, large businesses, high income earners and expecting nothing to change is foolish. The shift in negative gearing and capital gains tax alone will have a profound impact on the property market beyond what most commentators are expecting in my view.
That doesn’t mean I’m not voting for them. I’m keeping that information to myself.
But as I look at the stock market nearing multi-year highs, I wonder if those levels can be sustained as we head towards an election that will see a changing of the guard that could bring real change. If I was one of the big players, I would consider lowering my exposure at some point as we near the election to hedge my bets on the outcome and market reaction.
So if that is my view on things, does that mean I should head out and blindly short the ASX 200 index and hope for the best? What would my stop-loss be? How big should my position be? Should it be based on how confident I am of my hunch? Should I enter the position as soon as my hunch crystallises? If not, when should I enter the position to ensure I have the best chance of success?
As you can see, there are many questions that need answering when contemplating a trading position in the market. The wider your stop-loss, the more chance you have of success, but the smaller your position must be to ensure your dollars at risk isn’t too large. If your choice of a stop-loss price level is based on the size of the position you want and the amount you are willing to risk, without reference to the surrounding price action in the past, you are liable to be taken out of your position without being proven wrong by the price action.
The first question to answer is therefore ‘where am I proven wrong?’ Your position size will flow from that and the amount of dollars you are willing to risk, which may be a set percentage of your capital (0.5–2% for example).
So if we are mainly interested in finding out where we are proven wrong, the best trades will be at a point where we are proven wrong very quickly. Because that will enhance the size of position we can put on based on the amount of dollars we are willing to risk on any trade.
In my last few essays I have been introducing you to the different characteristics of the widening distribution and how they wrongfoot both the bulls and the bears.
Now that you hopefully have a working knowledge of the characteristics that I have already outlined (if not, you can access my previous Money Morning articles here), I want to show you how you could use this knowledge to help you in planning trades.
This is not my current process, but it will be instructive as we head towards an understanding of what a trading opportunity looks like.
Let’s look at the model of the widening distribution again:
Model of widening distribution
Source: Port Phillip Publishing
[Click to open new window]
If the trend is up and you wanted to buy this stock, and you understood how these distributions formed, where would you want to buy the stock? How would you work out where you would be proven wrong quickly?
We know that the area 61.8% below the range (the thick black ‘reaction’ line above) usually provides strong support if the range is going to continue and a return to the point of control is on the cards.
With the long-term trend up, we are interested in buying after a false break of the low of the range. If prices are bouncing from the level 61.8% below the range, then we are extremely interested.
So if we do see a bounce from that zone and it looks like prices will re-enter the range, we could buy with a stop-loss somewhere below the most recent low. That is a very small stop-loss in the scheme of things.
Let’s have a look at what I am saying in a diagram:
Model of potential trade opportunity
Source: Port Phillip Publishing
[Click to open new window]
You can see in the diagram that I have placed an initial target at the point of control. Taking part profit at a point that we know has a high probability of happening makes sense. Who knows what will happen once prices return to the point of control (POC)? If we are wrong about the uptrend continuing prices will find resistance at the point of control and we could see prices turn and plummet from there.
So we want to be free carried once prices reach the POC and in reality the whole trade could be that leg alone. What’s wrong with taking the meat in the sandwich and leaving the unknowns to take care of themselves?
If prices fail to reach the point of control and turn back down and fall through the recent low by a good margin, we can feel comfortable that we were wrong and the distribution is at risk of completely failing. Look at the chart and notice how small the distance is between the entry point and the stop-loss in relation to the overall volatility? We are proven wrong very quickly with this trade.
The entry point is based on waiting until a series of stop-losses have gone off once the current low of the structure is breached. Traders usually place their stop-losses just below recent lows, so the market is great at setting them off and then turning back up.
A few questions remain that need to be answered when looking at the above model.
When have prices turned back up? What time frame do you use to determine that probabilities are high that a return to the POC is on the cards?
I’ll leave the answers to those questions until next time. We’ll also revisit the current set up in the ASX 200 and why I think there is an opportunity brewing to get short.
Have a wonderful Easter break.
Editor, Alpha Wave Trader
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