High-probability Trades
High-probability Trades Timothy Morge combines median lines and failure patterns to stalk high-probability trades.
EDGE
High-probability Trades
i n my opinion, price shows repeatable patterns. You must pay close attention to spot the patterns. Once you detect them, you can keep track of them and use them to conduct statistical analysis. Study many charts of many instruments over many timeframes and mark the patterns when you see them. After you have found one to two hundred, take a closer look to see if the pattern leads to a
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repeatable outcome most of the time. Such a pattern is potentially tradeable. I have found that all I need are a few easy-to-spot, repeatable patterns that I can consistently trade profitably. Find a few that work, use solid money management and then get down to business. I work the same handful of patterns over and over, and think of it as 'making the donuts'.
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High-probability Trades
Let me show you a simple trade in the CME Australian Currency Futures market (the Australian Dollar against the US Dollar futures contract), built around a simple but powerful pattern, which I call a 'failure'. Failures are patterns that appear when price has built up a good deal of energy and then breaks above a major recent swing high or an area of tested resistance; on the down side, failures appear when price has built up a good deal of energy and then breaks below a major recent swing low or an area of tested support. Why is the pattern called a failure? Let me finish the description: after breaking above or below major resistance or support, when price is full of energy and ready to make a huge run in the direction of the breakout, it makes only a small breakout and then congests – and heads right back below the prior highs or above the prior lows. Price ‘failed’ to use its stored energy in the predictable manner. Most traders get caught holding a position based on the breakout. When the breakout fails, they are left with a losing position and must find a way to exit. Some of the largest, most easy to spot moves come after failures. I look for them, trade them when the risk/reward is acceptable and find them very profitable. Figure 1 shows a chart setting up the CME. Green boxes on figure 1 show two failures. I don't necessarily look for more than one failure, but as I was doing my morning premarket chart work I spotted the first failure and then noticed the second failure, which looked remarkably similar. In figure 1 price shows a nice uptrend, with a steep upward sloping line of force. Then price levelled off as it ran low on upside directional energy; it congested for quite some time, leaving multiple highs, before selling off a bit. You can see it wasn't a deep pullback: as price sold off it made a wide range bar spike lower, but the spike bar closed back near its highs. This was a sign that there were probably new limit entry buy orders built up in that area, left by traders anticipating a pullback. Price
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Figure 1: Australian Dollar versus US Dollar 20-min cash forex 24-session ch
rallied a bit and then sold off again, but it stopped at the same area, leaving double bottoms. There were now many limit buy entry orders, most likely left by the 'whales' (very large traders) in this time zone, at this level. I marked this area of limit buy orders with a magenta multi-pivot line. Once it was clear there were good limit buy entry orders in that area, price began a near vertical rally, easily breaking above the multiple highs from its earlier rally. I marked these highs with a black multi-pivot line. Breaking above the black multi-pivot line, price should be headed for a major rally. All the pieces were in place: • Price had congested and restored its energy; • Price had sold off and had seemed to find limit buy orders left by 'whales'. The existence of these large buy orders was confirmed with a nice retest of the same area; • When price broke above the overhead resistance marked by the black multipivot line, stop-loss buy orders left by traders who had shorted this market began to be executed and the stop-buy entry orders left by the breakout traders
were also executed, adding more fuel to the fire. This market had everything it needed for an explosive rally. Yet it was only able to make a brief rally above the black multipivot line before price congested a bit, and then sold back off. It is interesting to note that the multi-pivot line gave no support as price headed back lower – generally, tested resistance, once broken, acts as support. Quite a nice selloff came directly after the first failure. It was fuelled by traders who had gone long on the breakout to new highs and who now had to exit their long positions at a loss. Price approached but did not test the magenta multi-pivot line, where the whales had been buying earlier. When price rallied after the initial selloff, there were good limit sell orders sitting in the market as price approached the black multi-pivot line from below – so the area was once again acting as solid resistance. In my opinion, the whales had switched from buying to selling and had no problem spotting the likely overhead resistance, which was now a good area in which to leave new limit sell entry orders. Price failed to rally enough to test the
MAR/APR 2011
High-probability Trades
overhead resistance and so a fresh selloff began. Price congested a bit around the magenta multi-pivot line, but once it was clear the magenta multi-pivot line wasn't going to act as solid support there was hard selling, with price eventually breaking below the prior lows that had spawned the initial rally (the double bottoms on the far left of the chart). After this near-vertical fall, price ran out of downside directional energy and a new rally began. The rally was nearly vertical, testing the magenta multi-pivot line before finding any willing sellers. Price pulled back, restoring its energy, and then approached the magenta multi-pivot line, this time breaking through the overhead resistance. Once again, all the conditions for a significant rally were in place: • Price was making higher highs and higher lows, convincing traders a change in behaviour may have occurred in the form of a new trend higher; • Price congested in a narrow trading range, restoring its energy, so it should have been full of upside directional energy; • Price broke and held above the overhead resistance, marked by the magenta multi-pivot line; • When price cleared the overhead resistance, stop-loss and stop-entry buyer orders were triggered, adding additional fuel to the fire for an upside rally from this area. Figure 2 shows the results. Price had a limited upside rally and then pulled back to test the magenta multi-pivot line from above. The multi-pivot line acted as support and price began a new rally, but it fell short of the recent swing high. Price then turned lower, and the magenta multi-pivot line gave no support this time, sending price lower in a near-vertical selloff. With price in a vertical selloff, I added a modified Schiff median line, which generally does a much better job than the traditional median line in capturing the probable path of price in this type of near-vertical move. I used the highest high of the first failure, the
Figure 2: Australian Dollar versus US Dollar 20-min cash forex 24-session chart – L
major swing low, and the right swing high of the second failure, as my pivots for the median line, and shifted the 'A' pivot 50 per cent down towards the 'B' pivot and 50 per cent to the right towards the 'B' pivot to form a modified Schiff median line. I always try to think ahead of all the possibilities when I trade – I call this ‘using the language of price'. I added the new down-sloping median line to help me anticipate the probable path of price: when price sells off vertically, it often performs a 'pendulum pullback', giving traders who use the 'language of price' an ideal opportunity to attempt a short entry. If price pulls back to test the down-sloping upper parallel, there should be a good number of limit sell entry orders left by the whales at the magenta multi-pivot line; if price rallies and fails to break above the magenta multi-pivot line, another leg lower should begin. This new leg lower was coming after a second attempt to form a significant rally, and in both cases, the results were failure patterns. Price did rally to test the upper parallel of the modified Schiff and then congested around the magenta multi-pivot line as the
limit entry sell orders were filled. When price began to break below minor swing lows (in the language of price, 'look left, be right!'), I framed out my potential trade as follows. I want to sell a re-test of the upper parallel at 9812. My initial stop loss is above two prior swing highs (look left, be right!) at 9836. My first quandary is that I can see at least three logical areas to use as profit targets. The first would be a test of the modified Schiff median line. Dr. Andrews’ original work at MIT and my own body of statistical work show that price will reach the median line 80 per cent of the time. This is the easiest choice and the least aggressive – I call it 'Andrews 101'. The second potential profit target would be a test of the prior major swing low – many traders leave limit buy orders to take profits at prior major lows. But because price has tried to rally twice, and both times the rallies resulted in failure patterns, I expect price to fall quite a bit further, to the lower parallel. Any of the three profit targets makes good trading sense – it is from intuition and style that I choose the lower parallel for my potential profit target.
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After the flood
As I frame out my potential trade, I check to make sure the size of the initial stop-loss order is within my risk tolerance: I am initially risking 24 ticks and that's a normal-sized risk for me in this market and timeframe. It's important to note that I hid my stop-loss order behind key market structure, two prior swing highs, because there should be additional limit sell orders at these swing highs, and the orders should slow any rally, helping to protect my stoploss orders. If I run my chart cursor right below my limit entry sell order, I see my potential profit target is at 9622, so I am risking 24 ticks to make a potential 190 ticks, giving me a risk/reward ratio of 8 to 1, which is very good. One of my earliest mentors, Amos Hotstetter of Commodities Corporation fame, taught me never to take trades with a risk/reward ratio lower than 2 to 1, and that advice has served me well over my more than 40 years as a professional trader and money manager. This trade has all the things I look for in a quality trade set up. I double-check my orders and then put both my limit sell order and my initial stop-loss order into the market at the same time. I always enter my initial stop-loss order at the same time as I enter my limit entry order, because if the unexpected happens, I am protected (as Amos would say, 'Keep the cheese, just let me out!'). I won't enter my potential profit order unless and until my limit entry sell order is executed. Price did rally (figure 4) to re-test the upper parallel, and my limit sell entry order
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Figure 3: Australian Dollar versus US Dollar 20-min cash forex 24-session chart – my trade plan
was easily filled at 9812 – but my initial stop-loss order was never in danger of being executed. Price then began to drop quickly. After I had roughly 50 ticks of profit in the position, I cancelled my initial stoploss order and began working a breakeven stop order. Price easily broke through the modified Schiff median line, but, as Dr Andrews’ original work predicted, it soon re-tested the median line from below (I call this pattern a 'zoom and re-test'). Though price broke briefly above the median line, it soon turned lower and made a new low for the move. This is important, because it confirmed the high of that brief move back above the median line as a new swing high.
I quickly cancelled my breakeven stop order and began working a profit stop order above this new swing high (where there should now be new limit sell entry orders sitting). At the lower parallel, the chart shows that as each bar closed, I measured where price would intersect with the lower parallel and continually lowered my profit order. This means that the more time passes, the more profit I earn if price reaches my profit target. Any time you have an open position, you are subject to unexpected events that might have a negative effect on your position, so the longer you are in an open trade, the more you need to be paid for taking this risk.
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