Figure 5.7 Japanese Yen with daily and weekly stochastics, reflecting short-, intermediate-, and long-term trends.

Japanese Yen with DaHy and Weekly Stochastics Reflecting Short-. Intermediate-, and Long-Terrn Trends

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playing breakouts unless the stock has strong improving fundamentals. In the case of Eli Lilly, the whole drug and health care sector has been experiencing strong fundamentals and was considered pretty bullish at that time. And since Eli Lilly is one of the most active drug issuers in the sector, buying the breakout provides strong reward/risk.

At circle B, the stock hits a major resistance. It is normally not a good idea to short a stock with strong fundamentals on the verge of breaking out. However, aggressive traders can take on that opportunity as the 15-day RSI is extremely overbought and is turning down. Give yourself a half-point stop above the breakout point, just in case you are wrong. The potential gain in this trade is huge as the trading range goes from 53.25 to 66.875, a 13.625 range! But never assume you are going to gain the whole downside move on the full 13.625 points. I always try to take profits at half the trading range since that is where the reward/risk turns neutral (upside range equals the downside range) or turns negative, since there will be fewer smart traders selling.

So how profitable is this trade? Using the expected return equation:

Net Expected Return per trade = (Avg gain X Win odds) - (Avg loss X Loss odds)

- Slippage - Commission

Assuming win odds and loss odds at 50 percent each and avg gain equals half the 13.625 pt range = 6.81 pts, avg loss at 1 pt stop. The Net Expected Return per trade = (50% x 6.81pts) - (50% x 1 pt) - 0.125 slippage - 0.125 of commission = 2.65 pts, and is a pretty good risk/reward trade. That is how I quantify my trades using charts and the expected return equation. Traders should develop the habit of using the expected return equation since charts that look good to the human eyes might not necessarily produce positive return trades. Assigning the odds on the win/loss ratio takes skill and subjectivity.

As it turned out, Eli Lilly did retrace all the way to circle C, a strong support line. That is a very good buying point since the support is strong, RSI is oversold, and Eli Lilly and the drug sector have good fundamentals. But whats more important is that the expected return equation is positive on that trade. Give yourself a 1-point stop and take profits at half the trading range at $60.

Once again the trade turns out to be an excellent one as the stock rallied all the way back to the high of the year testing its resistance again at circle D. At D, aggressive traders could once again repeat what we did at circle by selling short. However, this time we are stopped out of this trade with a 1 -point loss as Eli Lilly broke out of the resistance with a powerful cup and handle pattern.

Smart traders should immediately reverse their trades and buy the breakout giving it a half-point to 1-point stop. As it turned out, Eli Lilly stayed above the breakout point and went higher. Note that when playing breakouts, the RSI is always pretty overbought. Therefore, unless the underlying stock has strong improving fundamentals, traders should be less reluctant in playing it.

Always look at the whole range of variables before initiating an entry. The variables include chart patterns such as support/resistance, momentum indicators such as the RSI, the underlying fundamentals of the instrument, and most important of all, the expected return equation. Being able to structure strong risk/reward trades with the preceding tools makes the trader a wizard above all competitors.

Conclusion

• Never apply any technical indicator to a market or stock blindly. Homework is the key.

• Always look at the whole range of variables before initiating an entry.

• Buy an oversold situation and sell into an overbought market.

• Assigning the odds on the win and loss ratios of a trade takes skill and subjectivity.