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the close on the last trading day (see "") is above the 20-day moving average? |
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Is the psychology clear to you? The great tug-of-war between buyers and sellers is being played out right before your eyes in this setup. The sellers took firm control and drove the price down. Then the buyers stepped up, defined the bottom, and started driving the price back up strongly. When you see this pattern, you know that the buyers are poised to take the stock even higher. But will they? That's the big question for you as you get ready to trade the next day. |
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Here's where back testing comes in. From your back testing, you know that one more thing has to happen to make this trade a winner for you. You know that the buyers have to establish a new higher price to signal that they are willing to drive the price higher. That is market psychology at its most pure! The buyers have come back into control, but as a new day dawns, the battle begins again. |
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Will the buyers continue to assert themselves or will the sellers gain the upper hand? The answer is: If the buyers will step up and establish a new price above the highest price they were willing to pay yesterday, then and only then will you enter this trade. |
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You set an entry point that is 1/8 of a point higher than the high on the last trading day (see 3 on the chart). If the buyers will set this new, higher price, your back testing shows you that this trade will be profitable more than 50 percent of the time. |
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But there is more to do before you make the trade. Remember about managing your risk and your reward! In this trade, you set your initial protective stop (IPS) at 1 point below your entry point (see 4 on the chart). |
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Then, for this pattern, you set your exit target |
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at a point either 3 points about the entry point, which helps you shoot for a risk/reward ration of 1:3, which exceeds your requirement; or |
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at 50 percent of the average daily range above the entry point, whichever is greater (see 5 on the chart). |
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With those three prices set, you wait to see if the buyers will step up and set that new, higher price. Remember, never jump the gun. You do not have a proven trade set up until that price has been traded. |
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Now look at Figure 13.2 which shows what happened in this particular trade. The next day the stock opened right at your entry point and moved easily to your exit target, for a 3-point winner. |
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