I often get asked: “Why do you set out so many scenarios when preparing your trade? Why not create a simple plan e.g. buy at xxxx.xx with a stop at xxxx.xx?”
I answer: “It’s because I don’t know what future will bring”.
By this I mean how a market does something, is at least as equally important as how it does it. Yesterday’ price action in the S&P is a great example of what I mean.
In yesterday’s blog, I set out four scenarios. The one I felt to be most probable was the one speculating on a smaller than normal range day. At time that I was writing the piece, the market was up about 9 points. Hence I focused on what I would look for if the market broke the highs. I suggested that the level representing 50% of the gap would hold. This was the second favoured scenario.
However, by the time the market opened yesterday, it was only 1.5 points up. At the open this is what we knew:
- Tuesday’s high was 1436.5 and its low was 1396.5;
- On Jan 9, Wed, the ESH8 opened at 1398.
Given the above, at the open on Jan 9, the greatest probability occurrence was the 1st scenario that provided for a small range day but now we’d be looking for a breach of the lows. Notice that although, I shifted from looking for a breach of the highs to one looking for a breach of the lows, the essential nature of the scenario remained unchanged – I was looking for a smaller than normal range day.
What does ‘normal’ mean? I define normal as being mean +1 to mean 0.5 standard deviation.
A more important point: recall that I had, as a third scenario, canvassed the possibility that the market would break to new lows. For the reasons stated in Tuesday’s blog, I had decided not to participate in any further shorting.
Now, let’s turn to the picture when yesterday, the market broke to new lows on two occasions: (Market Profile’s) ‘E’ period and then the ‘I’ period. When we broke for the first time, (‘E’ period), we had a True Range of 16 points. This was in keeping with what I was expecting – a smaller than normal range. Mean 25 points and we have a standard deviation of 10. Hence I was looking for a range no more than mean -0.5 stdev i.e. 20.The ‘I’ period extended the True Range to 22: we now had normal and when it rotated back into the day’s range, it raised alarm bells for my short positions.
Here’s what I noted:
- Yesterday was the 9th consecutive day of lower lows and lower highs. On a 1-day swing, the market was statistically overbought.
- The market was in the Primary Sell Zone: an area that would support a rejection of the down move IF the uptrend was still intact.
- If the market now extended the range up, we’d have a Market Profile Neutral Day. If a Neutral Day closes in the middle, we have a balanced day that warns us of a possible trend change; a close in the top quartile is stronger evidence of a reversal since it provides for Free Exposure.
So when the market returned to the day’s range, I decided to:
- Place stops on half my remaining shorts above the day’s high
- Place stops above the Tuesday’s high on the balance
- Exit if the market closed in the top quartile.
- Go ¼ size long if the market closed in the top quartile.
Given the close, I ended the day being ¼ size long. I’ll manage the trade using Free Exposure guidelines.
The blog today I feel is one of my most important ones. It sets out how I manage trades using present tense information.
Chart 1 shows the Profile
Chart 1 Market Profile