[dc]I[/dc] want to share with today an example of an actual trade I made in September. Two points before we begin: this is, perhaps, a slightly complex example. If you are unfamiliar with the patterns of trading pullbacks, come back to this post in a few weeks when we’ve looked at simpler examples. Second, this was an actual trade made in a separately managed account. The trading record for this account is being used to establish a track record for a tactical equities fund that will launch sometime next year. Though this is an example of a good trade, I do want to put all my cards on the table and say that September was not a great month overall. (The account was up slightly less than 1.0% for the month.) I had a few losing trades (most memorably, short COG near the open of 9/19, which resulted in a 1.0X loss before the end of the session. It is unusual for me to take a full-sized loss on a trade because I move stops in rather quickly, and also unusual for it to happen on the entry day. Stuff, as they say, does happen.) Overall, the lackluster performance for that month was probably due to me just being a little too conservative, and a little too quick to exit some winning trades. So, though this is an example of a great trade managed well, please keep it in perspective of the bigger picture, which was not impressive.
Consider the daily and weekly charts of Alpha Natural Resources, Inc, (Nyse:ANR), as they stood on the close of 9/9/11. I keep careful records of all my trades, including the information I actually had at each step in the decision tree. It is much more difficult to reconstruct this after the fact, but seeing what you saw at the time of trade entry is very important. Here are the charts I saw in my review over that weekend:
The daily chart of ANR (left pane) is a bit of a mess at first glance: six swings in a consolidation pattern with fairly sharp reversals make for a difficult trading pattern. The lower high on the daily chart is not enough motivation for the trade, but the weekly chart tells a different story–it shows a clean and simple bear flag. True, we are shorting after what is (roughly) the third swing down on this chart, the market is slightly overextended, but broad market and sector considerations (not shown on this chart, of course) tilt the scales a little more in favor of this trade. (The “indicator” on the weekly chart shows the stock’s relative performance to the S&P 500 index. This is a useful tool when evaluating longer-term charts.) I decided to enter a full-sized short position on the next day’s open. Consider next how the trade evolved over the following week:
The weekly chart shows a small-range bar near the bottom of the consolidation. This usually leads to a downside break, but the daily is even more significant. (This is the point of this post!) Note that the daily chart shows a small consolidation or bear flag, near the breakout point of a higher timeframe pattern. This is one of the trading patterns I included in the book, calling it a nested pullback. In this specific example, I slightly increased my position size and tightened the stop against the new formation. I tend to be the kind of trader who goes “all in” on position entries, because I usually identify markets at inflection points. I already had a full position size, meaning that if my initial stop were hit, I would lose the N% of my account equity I had planned to lose. However, it pays to be responsive to evolving market structure. In this case, I was able to increase my position size while actually reducing the total risk in the trade (to approximately 0.8X at the new stop level). Be aware that any modification like this affects both the reward/risk ratio and the probability of the win. In this case, I had definitely reduced the probability of the win against a closer stop, but it was justified by the trade.
Here is how the trade played out over the next few weeks:
If you are a short-term trader without a position, you have some difficult decisions to make on the gap down on 9/21/11. Do you fade the gap? Go with? At any rate, dealing with the intraday order flow and volatility is difficult. Because I was already positioned, I was doing one thing that day: buying a little bit all day. This is the beauty of entering technical patterns in anticipation of moves. Your stress and activity levels will plummet as you find yourself a willing provider of liquidity to short-term traders on large market movements. In this case, I covered a little on the two large gap down days; both of these are model exits, but my exit three days later was perhaps less than ideal. It might seem that I should have re-shorted on the next day following my exit, but I would also point out that my objective is simply to take the easy money out of a single swing in the market (this, by the way, is what swing trading really means, not a specific holding period.) Furthermore, the weekly chart was now far overextended and on the fourth (or more, depending on how you count) swing down, so it was no longer an exceptional trade.
Did I leave money on the table with this trade? Yes, but we always do. It is impossible to buy the low and sell the high of every move. Should I have been a bit more aggressive in pushing the exit, perhaps holding some for another swing down? I could certainly make a compelling argument that the answer to that is “no” and that I did just fine, but I asked another question in my end of month review: would I have managed this trade differently if I had been having a great month as opposed to a flatish month? The answer to that, I’m afraid, is yes, so that suggests to me that I can still improve on some element of the trade management process here.
Ignoring the complex (and very trader and situation-specific) questions regarding position management, there are several important points I’d like you to take away from this post:
- Consider patterns from the perspective of multiple timeframes.
- If you increase your position size, you cannot increase your total risk on the trade.
- Be responsive to developing market structure.
- The pattern of a nested pullback often allows precise entries in what would otherwise be complicated patterns.