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amount of the profit already realized by the trade. Recall from Chapter 10 on the Directional Day Filter that this line often creates a resistance level itself. This was certainly a possibility here and one worth avoiding with a fairly tight trailing stop. Certainly the bigger profit would have been desirable, but remember that you win the day trading game with singles and doubles, rarely with home runs.

The initial stop for our new long position rests slightly below the reaction low that stopped us out of our first long position, as identified by the closest Category 3 support level. This dashed line is marked as 1. Subsequently, as the market continues its rally, we are able to move our sell stop to points 2 and 3.

The next support level, marked by a solid line, is actually a reversal point as we are operating in an open sell window at this point. The sell window is a function of the last dual stochastic indicator plot placed on the chart at 1:50 p.m. Since there are no intervening buy windows opened up by this indicator, the sell window is still active when the market violates the stop level marked by the solid line.

Although it is a questionable decision to take a new position this late in the trading session, especially in light of the recent strong rally, I have chosen to leave this trade on the chart to once again illustrate the reversal principle as it is applied under this trading scenario. Two contracts are sold at this point, the first liquidating the present long position and the second initiating the new short position.

Again, as with previous trades, the protective stop is placed slightly above the most recent Category 3 resistance, as marked by the dashed line labeled 1. The market later allows us to move the stop to the number 2 dashed line. This stop is not activated by market activity, and the position is closed lower at the end of the trading day.

Next we will examine a trading day that starts in a similar fashion but ends with a considerably different result (Figure 12.14).

Here we have a two-minute chart of Brocade Communications Systems Inc. (BRCD) stock as it traded in late October 2000.

Step one indicates that we again have a nontrending day for our strategies to handle. At the 60-minute point on the chart the market activity is fairly well distributed above and below the plotted filter line. Although the close of the signal bar representing the entire range of the day so far is below the midpoint of that range, visual observation is not convincing enough on either side of the matter to give this day an up-

ide CoirnnuruMlions Syslei

t4E *lık 0=217750 H=232.000 l =217.500 V=«67100

Percent 4 Sell-- .. .- . . ;

Category 3 Resistance


i Reverse


/ ..Reverse..

232.000 230.000 228.000 226 000 224.000 222.000 220.000. •218.000 216.0C0 214.000 21 2.000 210.000 7

Percent R Buy-

/ J Buy ;"---

Category 3 Support


- ) 1 - 1 -13 11;M-

1:aa 12:03 13:33 1;M 1:21

Figure 12.14 The Directional Day Filter, dual Percent R, and Category 3 support and resistance generatethreetrades during a sideways day. Chart created with TradeStation® 2000i by Omega Research,Inc.

ward or a downward bias. This is a day during which we will expect both new highs and new lows to be placed on our intraday chart.

This chart is very similar during the first 75 percent of the session to the chart of the S&P 500 just discussed. An early sharp drop triggers the opening of a buy window, this time using our dual settings of the Percent R oscillator to determine the short-term trend of the day for step two of our four-step method.

Our initial long position is established at $215.25 as the market trades through our buy stop located at this level by our familiar Category 3 resistance point. The initial stop for the position is located first at the most recent Category 3 support, again in this instance found just below the intraday low. The initial stop is first placed at slightly above the $209 per share level. Granted, this stop level could expose the position to a loss level that some may consider too great for their comfort zones. Those with this opinion may have considered the fairly flat spot formed by several lows immediately prior to the buy signal to be a preferable location for the initial stop simply due to the proximity of the stop to the entry point. This stop selection creates a lower potential loss should the stop be activated. Unfortunately, this stop placement would have been activated shortly after it was placed, creating a loss for the position. There is a defined risk that is present in

any trade. Arbitrarily altering the placement of stops rather than following predefined rules is usually a mistake.

As before, our Category 3 support provides successively higher trailing stop placement as the market trades higher. A sell window remains open for the entire rally courtesy of the dual Percent R indicator, giving the trader the option of a reversal at any of the stop placement points designated by the dashed lines. It is questionable to enter into a reversal trade in this situation, because we find ourselves in a position that has been maintained for a significant period of time and has accumulated significant profits. Although the index futures can undergo swings late in the day that can be profitable trading opportunities, it is more rare to see individual stocks do so. The much more common occurrence is for an individual stock issue to cap off a daylong rally by simply finishing out the session meandering back and forth as it establishes a rather broad closing range for the day. There is probably a fundamental reason for the rally (or decline, in some cases) to have proceeded as it has for the day. The chances for this fundamental factor to change abruptly during the last portion of a trading day and precipitate a significant trend in the opposite direction of the dominant trend for the day is fairly remote. Hence, the possibilities of adding to the bottom line with a reversal trade, which in effect is taking a position against whatever factors are responsible for the big move, are not great. With these assumptions in mind it is usually prudent simply to allow the trailing stop to exit such a position and wait for another day to trade this issue again. I have diagrammed the reversal on this chart as an example of how this routine can be used to generate these trades, not necessarily as a recommendation to do so.

As the market rises above the $228 area, a reversal sell stop is placed at $225.25. Assuming our benchmark 100-share trade level for these examples, the order placed by the trader would read "sell 200 shares $225.25 stop." The first 100 shares sold will liquidate the original long position, while the remaining 100 shares establish the new short position.

While still in the new short position, the predominantly sideways trend now adopted by this market stimulates the opening of a buy window by the dual Percent R oscillator. We are prompted once again to reverse the position back to the buy side when the market trades through the solid line marking the resistance point pegged by the Category 3 resistance. This reversal produces an approximate $1.50 per

share loss. Another small loss is taken as the new long position is closed out on the daily close at a level slightly lower than the entry.

You will note on this chart that I have been careful to identify the several Category 3 resistance areas. Why do this when they are not involved at all in the long trade we have watched unfold?

These points can be used as supplemental entry areas should the trader wish to add to a winning position as the day and the trade progress in his or her favor. Recall from several previous discussions that each resistance point formed by the same chart pattern has an equal probability of success. In actuality this theory then is suggesting that each overhead resistance point, when combined with an open buying window, is as valid an entry point as the one that initiated our initial long position.

Figure 12.15 below designates appropriate points on our chart at which additional positions may be added as the position becomes more profitable. Although it is usually deemed unwise to add to a losing position, it is usually considered acceptable, through a variety of pyramiding strategies, to add to a profitable position. Our Category 3 resistance points as illustrated here certainly provide a high-probability method of entering additional long positions.

Figure 12.16 shows an S&P chart that was used earlier in Chapter

BRCD LAST-2 min 10f27f2000 C~22i>5\

,™ Tid«J*;?ilalion Ch<i[l [BRCD) Siooade Communications Systems l"c LAS -2 n

0=156.250 H=16G.250 L=146.000 " 6= 4850

Percent R : ...........< •• .........

rateaoipj3 Resistance jlplkRevarse jj I

lllJ Ii,



226.000 224.000 222.000 220.000 21B.000 216.000 -214.000 212.000 2 . 0 289.000

Category 3 Support

Figure 12.15 Several points at which it would be acceptable to add to a profitable position are selected by Category 3 resistance. Chart created with TradeStation® 2000i by Omega Research, Inc.

10, "Directional Day Filter," to explain the relationship between the indicator and successive new highs as they are formed. The filter has predicted an uptrend here, so only buy signals will be considered for actual market entry. Here we have applied the dual stochastic indicator (black dots) and the Category 3 support and resistance indicator (black squares).

Our first buy signal comes at the 11:45 time frame as the market trades through overhead resistance marked by the Category 3 formation. This trade is stopped out for a two-point loss a few bars later. The next two buy signals are exited at the dashed line slightly below the 1,500 level as the stop loss placed at that point is activated as the market drops through this price. Details of these trades can be examined on the expanded chart (Figure 12.17).

As is obvious to anyone who has traded at all, all days are not the perfect ones to trade. The day just reviewed is such a day. All indications are from the start that we should have a day in the S&P market that should provide several profitable buying opportunities as things progress through the session. As you can see, this was not the case tn day. However, we didnt lose our shirt, either. The real test of any trading strategy is to see how it performs on days when it doesnt

0=1 493.00 H=1 494.00 L=1477.50 v = o ;Dual StOChastic(7,45,12,30,2)

Figure 12.17 Two buy signals are issued on the nontrending portion of this


Chart created with TradeStation® 2000i by Omega Research, Inc.

work as well as on other days. As you can see here, on a day when the market didnt set up as well as we would have liked, the fact that we traded only on one side of the market and used entry and exit stops as dictated by previous experience kept us from getting our heads handed to us by the market.

Figure 12.18 was first used in the Directional Day Filter chapter to demonstrate the activity of the indicator during a down day. I have described the entry and exit of two trades generated by our strategy on this chart. As you can see, a considerable amount of detail is required to demonstrate adequately the interaction of the various components that are involved in the placement of the entries and exits for the trade. For this reason the chart is reproduced as several separate segments to more clearly explain the anatomy of each transaction.

In Figure 12.19, a one-minute S&P futures chart, we first determine that this is indeed a day during which it is expected that there will be additional new lows formed for the day after one hour into the market. The Directional Day Filter also is predicting that there is a low probability that there will be new price highs for the day, therefore meeting the criteria we had established earlier for determining that this will be a down day in the market. Examine the structure of the chart at the 60-minute point and note that there is indeed a majority of the price activity below the filter line and that the close of the 60-minute bar is in close proximity to the intraday low at this point.

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