A Trading Model in Action

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.

I only have a few articles to go until Harje returns, so I’d better hurry up and start giving you some useful nuggets for your trading and investing. I will still be recording a weekly video that you can find below the main article in Money Morning on Mondays. So be sure to check that out if you are interested in trading Aussie stocks and technical analysis.

Let’s do a quick recap of what I have been discussing over the last few weeks and then I’ll see if I can tie things together for you so you can understand the nuts and bolts of my approach.

The main point I have been trying to get across is that technical analysis has nothing to do with trying to predict the future, but is instead a tool for managing risk. No one knows the future.

If you have ever traded any positions in the past you probably know the mental anguish that can arise as prices fly around. Whether you are in the money or out of the money, there are plenty of things to worry about.

If you have made a lot quickly, you watch prices every day worrying that your profits might disappear. If you are out of the money, you watch prices every day feeling the pain of every tick as your hard-earned cash is whittled away.

You will never buy or sell the exact low or high, so invariably whatever outcome you get will be less than it could have been. There will always be a sense of dissatisfaction.

Remembering past mistakes, vowing not to make them again and then making exactly the same mistake again can send anyone around the bend. If you can’t describe exactly what your mistake was or define exactly what your trading plan is, so you can review your actions in the future, you will be destined to chasing your tail.

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A map of human emotion

Technical analysis is just a map for yourself in an unstructured environment.

It is a map of human emotion as it reflects the mistakes made by countless traders as they are shaken out of their positions across different time frames. The widening distribution that I have shown you has characteristics that manage to shake out both the bulls and the bears.

Even trends will manage to shake off most traders by having large corrections of previous waves before carrying on.

The 75–87.5% retracement of a wave is the area where I find most of my opportunities. But in order to increase the strike rate of winning trades, I need to add further filters. The key one being the buy or sell pivot which tells me that momentum is possibly shifting in the opposite direction. I will wait for a daily, weekly or even monthly buy or sell pivot before acting.

But I don’t act as soon as the buy or sell pivot is confirmed. The market doesn’t give up its secrets that easily. The edge of my trading system goes a few steps further than that, but I’m not about to divulge those secrets here.

Consider what I am showing you the skeleton.

Let’s have a quick look at an actual trade that we did in Alpha Wave Trader recently to show you how the simple idea of searching for zones where markets often change direction and acting once there are signs that momentum is shifting can pay off.

The stock I recommended was Fluence Corporation Ltd [ASX:FLC]. They are a company that I have been following for a few years with great interest. Their stock price had been suffering after an initial burst higher a few years ago based on excitement about the prospects of their water treatment technology.

As happens with many stocks, initial excitement usually turns into the hard slog of reality as a new company works towards becoming cash flow positive. There are always delays and disappointments.

The traders who were late to the party when the stock was surging are usually the first to jump ship as prices fall back to Earth. Once the trend turns down, it can be hard to shift as traders who are out of the money take any opportunity to dump the stock on a bounce in prices.

Soon enough, prices have retraced most of the prior rally and HotCopper is soaked in despondent threads about the ‘dog with fleas’ that can’t lift its head.

A large shareholder was also selling out of their shareholding and had been sitting on the stock for months. The business itself was continuing to build momentum. Revenue was growing rapidly, and orders were starting to flow from around the world for their water treatment solutions. They weren’t and still aren’t cash flow positive, but the signs were growing that they were gaining some traction.

Prices had retraced into the buy zone of the whole wave higher during the early euphoric stage. So my ears were pricked up, although I was wary because the downtrend was so entrenched.

A widening distribution started to form in the buy zone, so I could combine the theory of distributions with the theory of how waves develop in a trend to find a good entry point.

Let’s have a look at what the chart looked like at the time:

FLC getting ready to pop

Money Morning

Source: CQG Integrated Client
[Click to open new window]

After testing the bottom of the buy zone and having a false break of the bottom of the widening distribution that was forming, I knew it was getting close. I needed to wait for a weekly buy pivot to confirm that momentum was shifting to the upside again.

We bought the stock at 37 cents in early January and then I sent out another alert to buy the stock at 37 cents in early March, after a huge crossing of stock that I felt must be the final tranche of stock belonging to the large shareholder who had been selling for months.

Let’s have a look at what happened next:

FLC wakes up

Money Morning

Source: CQG Integrated Client
[Click to open new window]

FLC rallied 56% in the three weeks following the second buy alert. The initial target I set on the trade was at 50 cents. The stock then rallied to a high of 58 cents and was trading at 48.5 cents at time of writing. So, we have taken part profit on the trade and have an average entry price much lower than current levels.

Alpha Wave Trader members now have a free option to see what happens next without risking their initial capital on the trade.

If the stock does hit cash flow positive later this year and more orders start flowing from around the world and China in particular, the sky really is the limit.

That may not happen. As I said, I don’t know the future. I don’t need to if I use the mistakes made by other traders as my signpost to entering trades with solid risk/reward characteristics that allow me to take part profit quickly to create a free option.

The basis for the trade was years of observation and study of their technology and its potential. I wanted to own the stock, but do I want to own it at $1.00 or at 37 cents? What is a company worth if it is still not decided that it will even survive? Who knows?

That’s where technical analysis comes in. I don’t have a clue whether the company will ultimately survive. I know I really like the story, but I’ve liked a lot of great stories in the past that came to nothing.

My actual trading decision to enter was based on the model of price action that I have been describing to you over the past few weeks. It combined the theory of waves in a trend with the theory of widening distributions to find an entry point that I knew had a good probability of having a move to the point of control of the current range. Mean reversion, in other words.

We were never out of the money more than a few cents and first profit has been taken within a few months of taking a position. All up a pretty stress-free experience.

They’re not all like that, of course. But with a stop-loss and confidence in the approach, you view the failed trades as a necessary part of the process rather than something to beat yourself up over.

Regards,

Murray Dawes,
Editor, Alpha Wave Trader

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Murray Dawes is the Editor of Alpha Wave Trader and contributing Editor at Money Morning. He was one of five, from 5,000 applicants, chosen for a graduate position with the Swiss Banking Corporation — now part of banking giant UBS. The bosses quickly cottoned on to his potential and pushed him up the ranks as a futures broker on the floors of the Sydney Futures Exchange. Murray later broke out on his own, and developed custom trading systems to trade leveraged financial instruments like futures. Due to his success, Murray became the ‘hired gun’ trader for Australia’s rich and famous. Today, Murray runs a trading service through Port Phillip Publishing to help everyday Aussie investors use his advanced trading methods.


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