In part two of the Reward to Risk series I demonstrated how to calculate your risk multiple. Now in the final part of the series I  want to demonstrate how you’re winning percentage and your reward to risk multiple works as a team to help you reach your trading goals.  Okay, I want to warn you, we’ve now reached the math component of the lesson, so you’re going to see a lot of numbers. It’s all very logical and believe me it will be worth it.

First, let’s look at a 50 percent winning percentage.  In this example, we keep the 3.15 reward to risk multiple that we learned earlier and if we had an average loss of $1,000.00, this would mean we make $3,150.00 for our reward.  If we win 50 percent of the time, that’s $15,750.00.  The 5 trades we lose, would total $5,000.00 for a net result of positive $10,750.00. Let’s take a look at the relationship of the winning percentage as it decreases. With a 40 percent winning percentage, you can see with the same reward to this multiple, you’re still going to make a very profitable result with $6,600.00 net.

If we go down to a 30 percent winning percentage, you’re still profitable with $2,450.00 net.

I’ve often said if you can win at least 30 percent of the time and keep a 3:1 ratio in your favor, you’re still going to make money in the markets.  Here you can clearly see the importance of keeping your winning percentages as high as possible and maintaining your reward to risk multiple.

In the next series of slides we’ll take a look at a decreased reward to risk multiple. Remember we discussed if you actually calculate your average win and your reward doesn’t make it to the 3:1 that you intend, you’re fooling yourself.  Here we have a multiple of 1.55 and with a 50 percent winning percentage, you’re still coming out ahead at $2,750.00, but it’s nowhere near the over $10,000.00 that you had before with the larger reward multiple.  The results with a small change in reward multiple makes a huge difference in the results.

If we decrease to a 40 percent win percentage using the same multiple, we’re practically break even.  Previously, you still had a great gain of over $6,000.00, but by decreasing our actual reward in half and maintaining a 40 percent win percentage you’re basically winning some and losing some and not really making any money. This is very common and also know as “spinning your wheels”.

If you recall on the previous slides, you actually made money with a 30 percent winning percentage.  Here, with a 30 percent winning percentage, you’re losing a lot of money.  Even though you’re making more than you lose, you’re losing way too often and your reward to risk multiple is way too low.  This is the area a lot of intermediate traders find themselves in.  They lose more often than they win, and they don’t make nearly enough when they do win.

Let’s look at an example.  Here we can see an entry price of $17.23.  I use this as an end of day trade, so I’m using end of day results.  The entry price is $0.05 cents above the previous high on the following day.  The stop loss price is $0.05 below the entry day’s bar at $16.55.  That’s a total of $0.68 risk.  The projected target is based on previous resistance; I see $19.00 as a projected target.  $17.23 minus $$19.00 has a potential gain of $1.77.  $1.77 divided by $00.68 gives you a risk multiple of 2.6.

Now you need to ask yourself a question of, “Does this trade make sense?”  Do you take this trade according to your trading plan?  Remember, you can’t manipulate the numbers in order to fit them into your trading plan.  You know the numbers ahead of time.  If these numbers don’t make sense to your plan, then you would have to pass on this trade.  Now there are a few exceptions we can talk about here.  First of all, you may have a 2.5 or higher reward to risk multiple if you’ve done your numbers and you know that you’re still profitable at that level.

Another exception is you might have more than one target.  That’s fine if you chose $20.00 as a second target because that would increase your reward multiple.  But don’t forget, just putting it on a chart doesn’t mean you hit it.  You have to determine what your actual average winner is to determine your reward to risk multiple going forward.  Remember, it makes no sense to set a reward multiple of three or higher if you’re only taking one and a half or lower.

Another way to take advantage of your reward to risk multiple is if you have the ability to shrink down and zoom in on a shorter time frame that you could get a better entry price.  Potentially $17.00 or lower and you took depending on where the resistant levels are on a lower time frame, you might actually set your stop a little tighter.  These are other issues that you have to look at to see if you have the ability to trade on shorter time frames.  Just changing that number slightly will dramatically reduce the rewards risk multiple that you have set here.  Again, all of these factors have to be according to your trading plan.

Your strategy and your chart set up are going to determine your initial reward to risk.  You should know these things ahead of time.  You need to have an entry, a stop and a target.  The quality of your trade selections and how you manage them are going to determine your overall profit and loss.  It doesn’t matter what numbers you come up with, as long as you have good trade selections and that you manage them properly according to your money management rules and your position sizing. These factors will determine your overall profit and loss.

It really is a game of numbers.  Small changes are going to make big differences in your results.  You saw that with the win percentage and the risk multiple.  Just changing your risk multiple even slightly will increase your results dramatically.  The same goes for your winning percentage and vice versa.

You need a solid understanding of the math behind trading.  If you’re just trying to wing it, you’re almost always going to end in disaster.  If you have no plan and no trading rules in place, then you’re really just gambling and that’s not really a safe way to approach the markets.

In part 1 of the Reward to Risk series I covered what “risk” is and the 3 components you need to calculate your reward to risk ratio. In this article you will learn how we’re going to calculate this multiple. The risk, in this context is simply the difference between your entry price and your stop loss price. So, if your entry was $20.00 and your stop loss is $19.00, you have a total of $1.00 at risk. Your reward is the difference between your entry price and your target price. So, again, if the entry was $20.00 and the target was $25.00, your potential reward would be $5.00. In this case, we have a 5:1 reward to risk multiple.

Earlier we discussed how you can’t just set your target by using a multiple of three times your risk, because that will set an unrealistic target price. It’s sort of a backwards way of doing things. The proper way to set your target is to use previous areas of support and resistance. Now, on this chart, you can clearly see areas of new highs that now act as resistance points. So these areas become excellent targets to set. On the next chart $93.00 would’ve been a good target area, at least for the first half of the trade.

Looking at another example, you clearly see three red boxes for potential future resistance areas. The stock does break out and in all three occasions at these areas, so all three of these potential entries would have targets somewhere in these boxes, at least for the first half of the trade. If there’s no support and resistance on the chart, the next logical choice is to use the next largest whole numbers. So in this example, 13, 14, 15 and 16, these areas are good areas to set targets because they act as natural resistance points. Many people use their stop losses and their targets in the same areas and so that’s why these areas are very strong.

Look at this chart we can clearly see whole numbers acting as resistance, here at 21, 23 and on 3 separate occasions at 27, the whole number acted as a resistance point. Setting targets at whole number, whether it be 25, 26, in this case 27 is where the resistance actually occurred. Now if you had more than one target, the best method is to average them out. If target 1 was $6.00 away, and target 2 was $3.00, target 3 was $1.00; you can simply add those up and divide them by 3, that will give you a target of $3.00. As long as your risk was 1 or less, you have the necessary 3:1 ratio that you require.

What else do you need to consider when you’re calculating your reward to risk? Well the first thing is you need to know your actual average winner compared to your actual average loser. What exactly is that? Well if you add up the total results of your winners and divide it by the number of winning trades you have, that will tell you how much you win on average. It’s quite simple. If you make $500.00, $600.00, $1,000.00 and $1,500.00, you add the altogether and divide them by the number of winners and you’ll know how much you win on average. The same applies for your average losers. You add up the totals of how much you lose in all your trades and divide it by the number of losing trades you have and you’ll know exactly how much you lose on average.

These numbers are important because now you need to know how that compares to your intended reward to risk. Remember, we discussed this before. If you only make $1.50 instead of the $3.00 you were expecting then you’re fooling yourself into thinking you have a good reward to risk ratio. Another example we see here, if you have $4.25 and risk $2.35, you now have a reward to risk ratio of 3.15 and then you need to ask if that fits into your trading plan. I recommend 3 or higher, but you might use a multiple of 4 or higher. It really depends on what you use in your trading plan.

The third point is, are you able to maintain a high reward to risk multiple and a high winning percentage? It really is a balancing act between the two. I’d recommend 3 or higher for a reward multiple and a 40 percent win percentage. I will show you the numbers in a moment how, but if you can maintain those figures, you’ll be very successful. You need to focus as much attention on both of these as you can and keep them as high as you as possible. In part 3 of the reward to risk series I will cover the “nitty gritty” math behind the formula and how you winning percentage and reward multiple work in tandem to maximize your results.

In this lesson we’re going to discuss reward to risk. What exactly is reward to risk? Well, quite simply, it’s a ratio that determines how much money you intend to make versus how much money you intend to risk on any one trade. This seems like a simple concept and most people use it in a simplified way, that’s if they use it at all. The majority of people take on way too much risk and don’t take anything into consideration with regards to reward to risk ratios. In this lesson, I will dive deep into how to calculate reward to risk and how it can help improve your trading and hopefully demystify the concept for you.

The first thing we need to know is, every trade has three components in order to calculate your reward to risk. Those components are an entry price, a stop or stop loss price and a target price. Now the entry and the stop are going to be very precise and they’re going to be based on your trading plan, so whatever strategy you’re using or trading tactic you’re using, that will determine what your entry and what your stop loss price is. The price target, however, is going to be a little more confusing. It’s going to be a little fuzzier and a little trickier to determine. The fact remains, though, that you will choose what your price target is. In fact, you might even have more than one price target in place. The key point is that you have to have at least one price target in place before you enter the trade, that’s how you’re going to calculate your reward to risk ratio.

Let’s take a look at a standard formula for calculating a reward to risk. The first thing you would do is determine your total risk by taking the number of shares, your entry price, minus your stop loss price and multiplying that by your number of shares. In this example, let’s say you had 1,000 shares and stop loss of $19.00 with and entry price of $20.00, the difference being $1.00 multiplied by 1,000 shares; you would have a total at risk of $1,000.00. In order to calculate your target, you would multiply that risk by 3 in order to give yourself a 3:1 reward to risk ratio.

This is the conventional wisdom, having a 3:1 reward to risk. You’ll hear that a lot and I recommend it to my clients and my subscribers, in, Trading Master Plan, However, it’s not quite that simple. Using that type of method really over simplifies the calculation. There are some other considerations you need to include in order to calculate this ratio. 3:1 is an excellent rule of thumb and like I said, I recommend that to most of my clients. It’s great for beginners, but if you have a deeper understanding of trading math, you’ll quickly realize that if you lose 4 out of 5 trades, you’re not going to make any money.

If you make $3,000.00 on a trade that you win, and you lose $1,000.00 on a trade that you lose, but you lose 4 times out of 5, you’re still losing money despite the fact you make 3 times the money you win. If you multiply that risk by three, it might result in an area on the chart that’s not likely to be reached, so you’re setting an inflated target by using that method. A good example of this is by looking at a strong area of resistance. It would be pointless to put your target outside of that area because it’s not likely to be reached. You’re just setting yourself up for failure if you’re setting your targets using that method.

Another point to consider is, what if you have a 3:1 reward to risk in your trading plan but you only make 1.5-to-1 or even 1-to-1? Some of the reasons for this might be you sell too early or other psychological issues, the main reason being fear. Over the course of 20 trades if you go back and do the math and you determine that you’re only making 1:1 instead of 3:1, clearly you can see how that’s going to affect your bottom line, long term.

Let’s look at an example of this, visually. You’re expecting to make 3:1 reward versus what you risk. However, if you look back and you calculate the averages and you determine you’re only making $1.00 for every $1.00 at risk, even if you win 50 percent of the time, you’re not going to make any money. In fact, and I have said this and mentioned it in Trading Master Plan that if you can win 3 times as much as you lose, and win only 50 percent of the time, you will make money. But the key is to keep that 3:1 ratio in place and to reach that 3:1 target on a regular basis. If you’re only making 1:1, then you’re just fooling yourself into thinking that you have a good reward to risk ratio. Long term, the results will reflect that.

Next point to consider is even if you do meet your 3:1 target, how many trades are you getting right? It’s very important to determine what your winning percentage is. I touched on that earlier. If you’re winning 50 percent of the time and you do achieve your 3:1 target, then you’re going to make money, in fact, you’re going to be very successful in the markets. With those types of numbers, you could actually win 30 percent of the time and still be an overall winner.

What tends to happen is you end up making your 1:1 target as opposed to 3:1 and if you only win half the time, you win some, you lose some, you really end up getting nowhere, you’re just spinning your wheels in the mud. Once you know what your true reward to risk ratio is and you have a great understanding of what your winning percentage is, you’ve got two key ingredients you’re going to need in order to be successful in trading.

Now that we have a better understanding of what’s involved with calculating reward to risk, we have an idea of what the problem is and most people, if they’re using this at all, are going wrong. In part 2 I will show you how to calculate your reward to risk ratio.

The inner ("Idiot") voice that influences your decisions.

Is there an idiot inside of you right now that’s making decisions for you?  Now, that’s kind of funny and I just want you to think about this for a second.  Every day we have 60,000 thoughts.  We have this inner voice inside of us that is constantly talking to ourselves and we’re always asking ourselves questions and rationalizing and so forth.  So we have this inner voice.  Now you might think this is kind of hokey and a little bit weird, but if you’re thinking that right now, that is your inner voice talking to you right now, as you’re saying that to yourself.  That’s how I know this works.  This is how I know this is true.

Now, in trading, that inner voice is actually an idiot because this concept is amplified in trading because you have money on the line and that inner voice, or idiot, is pretty worried about the fact that you have money on the line.  The idiot is going to constantly come up with reasons why a trade is not going to work, trying to keep you out of the trade.  The idiot’s always going to be second guessing your decisions, because no matter how nice the setup looks, you’re always going to have that inner voice, that inner idiot, giving you some doubt.

When you finally do enter a trade, the idiot is going to be constantly talking in your head with every possible decision you have to make.  Should you sell now?  Should you hold on?  This is going to happen.  Earnings are coming out.  All these things are playing in your mind and this idiot is constantly trying to undermine your decisions.  If price does go up a bit, this idiot is going to want you to sell it immediately and if price goes up a lot, the idiot’s going to want you to hold on and squeeze more profits out.  Its greed and fear in a nutshell.

Come on, you know this is true.  You’ve been in trades before and you’ve had that little voice telling you “Hang on” or “Sell now”, “Ring the cash register” and when price finally does go down, the idiot tells you to hold on because price will come back eventually, the famous last words.  I’ve been there.  You’ve probably been there.  How many times have you held onto a stock as it blows past your stop loss, if you had a stop loss in the first place, and that little voice told you to “Hold on, don’t worry, it’ll come back eventually.”  Does that ever really work?  If it does, how much time does it waste?

How do you control this idiot? Well the fact is you can’t eliminate the idiot completely.  It’s you.  It’s your inner voice in your own head.  But you can learn to deal with him or her, with a boss/employee relationship.  What do I mean by that?  When I’m buying a stock, I’m hiring a stock to do a job for me, and that job is to make me money.  If it doesn’t do its job, I fire it immediately.  This isn’t a marriage where we have to compromise and talk about our feelings and do all kinds of weird stuff.  This is a business and if it’s not doing what it’s supposed to be doing, it gets fired.  When the idiot starts talking to you on the employee’s behalf, you need to understand that you are the boss and you make the final decisions, and you know what’s best for your business or your portfolio, and if it means firing it, you need to listen to that instinct.  Just remember, you are the boss and stick to your rules.

Breaking down the trading equation.

Why did I say 95 percent?  You may recognize this from another video that I’ve done.  It’s also actually in my book right now.  I used to say “Trading psychology was worth 55 percent”.  Why 55 percent?  Well I wanted to emphasis the fact that it was worth more than half the battle, so to speak, and I wanted to pick a number that was more than 50 percent, so I can put it in a nice pretty pie chart here, which I’ve done.  Money management and system are still critical components.  I can’t emphasize that enough, but the real reason I’m now saying its worth 95 percent, and that’s because I’ve found that despite having a proven system with solid management rules, you still might not follow it.  Your emotions get in the way.  The inner idiot is talking in your head.

It doesn’t matter how good the system is or what money management rules you follow, if you don’t stick with them, none of it matters.

What is the absolute best way to get control of your emotions?  Are you ready?  It’s having a detailed trading plan. More specifically, have a detailed set of money management rules within a trading plan.  Now does this contradict my last statement?  I don’t think that it does.  You can have money management rules, stop losses, entries, and still not have a trading plan.  If you have a detailed set of specific rules for all aspects of your trading, it takes emotions out of the equation because now you are forced to just follow your rules.  As long as you can maintain the boss/employee relationship with your inner idiot, then you’re not going to have any problems.  If you just have some loosey goosey trading rules, sometimes I do this, sometimes I do that, I have a little loose stop loss, then you’re constantly going to be opened up for these emotions to creep in and start second guessing yourself.

Ask yourself, do you have a trading plan?

The big question is, do you actually have a trading plan?  If you do, great job.  I commend you for that for sure.  My success didn’t really start to happen until I finally wrote a trading plan down on paper.  If you don’t have one and you don’t know where to start, it doesn’t really have to be this complicated 100 page document.  Just start with something.  Write down what your entry rules are, what your exit rules are, what your basic trading rules are, such as how are you going to take your targets?  How much are you going to put into one trade?  How much of your portfolio into one trade?  These are the types of things you really need to know and you really need to start putting down on paper.

My trading plan is a living, breathing document that’s changed tremendously over the past three years.  But by just having it written down, it really cements all the things that I’ve learned, and by constantly updating it with new experiences, it really helps me understand the concepts even better. I highly recommend that you start writing down some things.  Even if you write it on a napkin, it’s better than not having anything at all.

Want to Use My Trading Plan as a Template? CLICK HERE

Trading is 95% Psychological

Watch the video at the bottom of this post!

The cold hard truth is this:  You are your own worst enemy in trading.  There.  Now you know.  Maybe you sort of knew this.  Maybe you’ve been sort of ignoring this fact or maybe you’ve been blaming the ‘big, bad market’ for stepping on you all the time, but the simple truth is, you’re the one making decisions and your emotions are usually getting in the way and you are your own worst enemy.

Now you’re probably going to develop a lot of technical skills.  If you’re a trading junkie, like I am, you’re going to be reading a lot of books, taking a lot of courses and seminars and you’re going to learn a lot of the technical side of things, and when I say ‘technical’, I’m talking about technical analysis, but not just technical analysis, I’m talking about other technical aspects of learning something.  In the end, you’re going to constantly end up shooting yourself in the foot because you are your own worst enemy and you haven’t learned to master your own trading psychology, yet.

Okay, okay, what is trading psychology?  Well, it’s knowing when to quit and when to push.  That’s a big part of it.  Sometimes the markets are just not good to trade. You should not be trading in the stock market if the markets are in a very bad mood and you’re just not able to handle it.  Other times, you need to know when to push.  If you’re doing extremely well and you need to use more leverage, you really need to stack on to trades and so forth, that’s part of the psychology aspects of trading.

Taking your stop losses: If I still need to tell you that you should have stop losses. Then clearly you haven’t been listening to anything I’ve ever said.  If you’re not using stop losses, then please give your head a shake ‘cause you know you should know better.  That’s all I’m going to say about stop losses.

Hitting your targets: It’s usually a pretty good idea to have a good target price in mind.  If you’ve got a target price and when it actually does hit your target, you don’t actually buy or sell, whatever the case may be, then that’s a psychological issue you need to address because clearly, you’re not following your rules.

Controlling greed, fear and hope: We all have these things.  They’re inside of us all the time, especially when we’re in a trade, these emotions are constantly tugging at you, trying to make you make bad decisions.  If I was to tell you that greed, fear and hope was a huge part of trading, it would be a huge understatement.

The last point here is ‘Discipline, discipline, discipline’.  I am extremely lazy when it comes to trading.  I don’t want to be stuck in front of the computer all day long.  I don’t want to be scanning the markets for hours on end trying to find opportunities, so I try to make it as easy as possible.  But the simple truth is, if you want to be successful in trading, if this is more than a hobby for you, then you’re going to need to develop some serious discipline so that you can do the things and continue to do the things that you need to do to be successful.  It’s going to take some work – oh, the dreaded ‘work’ word – but I keep it at a minimal amount of work, for sure, and discipline is huge part of that.

Are you an average trader?

I want to talk to you about what an average trader is.  The majority of people fall into this ‘average trader’ category.  Basically, they seem to think that trading is easy and for whatever reason they buy a stock, the stock’s immediately going to go in their favor.  Heaven forbid they actually are successful, because now that reinforces that behavior going forward and it really sets up for a major disaster.  If you’re an average trader, you have no trading plan or view of trading.  It’s just that simple.  Most people treat this as a hobby and they have no trading plan to speak of.  They have absolutely no money management rules.  If you’re sitting here reading this and you have no money management rules whatsoever, don’t worry.  You’re part of the average trader that is out there.

Are you prone to emotional swings?  So, price goes up, you’re immediately happy; if price goes down, you’re trying to jump out of a window.  Those types of emotional swings are typical with average traders.  Are you nervous most of the time when you’re in a trade?  Can you sleep at night?  Average traders don’t have confidence in their system or their plan so they’re usually pretty nervous whenever they’re in a trade.  You quickly give back to the market your recent gains.

Let me know if this sounds familiar:  You make $500.00 on a winning trade.  You feel great.  And then on the very next trade you get cocky and, bang, you end up losing $500.00 or more and you give back all of those gains that you just made to the market.  This is very common.  It doesn’t mean you’re a failure.  It just means that you’re average.

You try to recoup losses immediately, also known as revenge trading.  Oh, I used to love revenge trading.  Basically, here’s how this goes.  You end up taking a huge loss.  We’ll just pick a number.  Say you lose $1,000.00 on a trade.  Now, you’re on a mission.  You immediately go out looking for a trade that you can make so that you can make that $1,000.00 back.  You end up chasing a bad entry or for whatever reason you end up pushing the pace and get into a wrong stock and you end up losing even more.  Any of these sound familiar so far?  I’m not done yet.

You’re glued to your computer all day long watching every price movement like a hawk.  This goes hand in hand with your emotional swings.  It goes up, you’re happy; it goes down you’re ready to beat your head on the keyboard.  If you’re stuck all day watching prices and you’re constantly on an emotional roller coaster?  Don’t worry.  You’re not alone.

How about this one?  Do you ever review your trade results and follow up on your winners and your losers?  I can guarantee you that professionals definitely follow up on their trades.  And if you’re not following up on your winners – do you think this might be a good idea?  You have a winning trade and you actually look back at it and say “Hmm, what did I do right in this trade?”  How about your losing trades?  How about looking at your mistakes and determining where you’re going wrong over and over again?  Do you think that’s something that might help you improve your trading?  Most people don’t do this and they continue to lose. This is why they’re average traders.

Here’s a really easy one.  Are you losing money in the stock market?  If you are, you’re like the majority of people, which puts you in the average trader category.  I remember reading a quote that if you want to be successful in the markets the easiest way to do that is to “not be average”. In part 2 find out if there is an “idiot” making trading decisions for you.

The Ideal trend consolidation pattern.

In this segment of the trend trading series I’m going to go over some final thoughts and the three key points that will help you manage trending stocks and trend consolidations. In part one I explained the popularity and importance of trend trading. Part two covered the top three ways to confirm a healthy trend. Now it’s time to tie it all together and make trading trends much easier and more profitable.

1. Volatile, “Whippy” Price Action Equals Indecision

The first important point is that volatile whippy prices translate into indecision between buyers and sellers. Psychologically what’s happening is traders don’t know where the price is going to go, so they’re continually buy and sell and prices are all over the map (or chart). Bottom line, choppy prices basically means greed and fear is in control.

When price takes off, traders buy because of greed. They want to get in at a good price, and when as it turns around, immediately their greed turns to fear and they sell and wait until the next round of greed occurs. Emotions are constantly changing from greed to fear and traders really don’t know what they want to do, which leads to the second important point.

2. Avoid Prices Patterns without Clean Looking Charts

You want to avoid choppy price patterns. You want to look for the clean charts. Why would you want to look at a chart with a whippy pattern that’s all over the place when you really don’t know which way it’s going to go? Technical analysis can have predictive patterns that you can follow, but in a choppy pattern, it really minimizes the predictive power of any patterns that you see on a chart. You really have no idea what’s happening on a choppy chart. You want to look for those clean, quiet patterns that are just steady in price.

These are the charts that are going to give you a really good entry. Stick with the easy, clean patterns. It’s far easier than trying to bang you head against the wall and trying to trade whippy indecisive price action.

3. Hold Your Stop Loss and Ride out the Storm

Article summary

The last key point I want to cover is if you do own a stock and it does turn choppy and whippy, you want to hold your stop loss and try to ride out that storm. Try and hold on and maybe the trend will continue, but usually, when price starts to do that, it means that trend is weakening. With each choppy price move, the bears are gaining control (in an uptrend) and eventually, they’re eventually going to take price downward and create a new downtrend.

Don’t worry if you are stopped out. You want to move on to the next trade and look for the next clean chart that is an easy tradable pattern.

This is why money management is so important. You can’t control the movement of stock prices, unless you’re a multi-billionaire but that is for another article. The only thing you can really control is your money management plan and your own trading psychology and discipline. Master these areas and you’ll be ahead of 90% of traders.

Is the Trend Healthy or Weak?

In part one I explained the importance of a strong trend and the popularity of trend trading systems.  The biggest question remains; how do you know the strength of the trend and will that trend continue?

There are three things you can use to help you determine whether you are in a healthy trend consolidation or a weakening trend breakdown.

1. Price is in a Narrow or Sideways Base

The first thing you want to look for is a narrow or sideways base.  This looks more controlled than a very whippy topping phase.  During a topping phase, traders are uncertain of the future direction so the stock is going to move much more erratically and is going to be much more volatile.

Price Trades in a Narrow Range (Re-Grouping)

2. Decreased Trading Volume During the Base

The second point is a decrease in volume during the base.  During a pause, volume slows as the stock loses its momentum to take a break.  This mild hibernation allows the stock to regroup before the next leg to the upside.  If price is smooth, controlled and calm. It’s telling you “there’s nothing really happening here”.  It’s almost like the stock is in a little coma or a mild hibernation.  The volume is extremely light and price is just taking a break.

Volume is Calm, Buyers are Resting

3. Look for Rising Moving Averages

Lastly, we want to look rising major 20 and 40 period moving averages.  A strong trend is going to pause allowing the moving averages to catch up so another up move can be made.  During long consolidations, the averages are going to flatten.  During a topping phase, the averages are going to reflect the whippy prices by continually crossing over each other. With whippy prices the averages are going to be lagging behind trying to catch up.

With all three of these factors present you may have an ideal consolidation or pause in a trend. If price breaks above the base, you have a breakout play and if there’s volume behind that move, you have a very good breakout setup.

You can look to enter above that consolidation base.  If you miss the move don’t chase the stock, wait for the first pullback.  The first major pullback offers you the first opportunity to get in again, which is usually near the 20 period moving average.

Breakout with Volume Behind it. Risng Moving Averages Indicate Trend is Healthy

Don’t forget to have a plan before entering the trade. You should know ahead of time what your stop loss is, what your profit targets are and how much you will be risking on the trade.

In this final segment of the trend trading series, I’m going to go over some final thoughts and the three key points that will keep help you manage the trending stocks you’re trading.

The age old question; will this trend continue?

Trend trading is immensely popular and a good trend trading system with a proper trading plan can be very profitable. One of the questions I get asked allot is something along the lines of “How do you know if you’re in a sideways pattern, if it’s a pause or a breakdown in the trend?” It is a very good question and we’re going to go over that very quickly here.

There are many trend trading software programs available designed to help you find emerging stock trends and capitalize on them. The key to a good trend trading strategy is to understand how to trade trends effectively and understand when it may be breaking down or ready to continue.

First let’s explain what a good trend is. In this example, we’re going to use an up trend.  An up trend is defined by a series of higher highs and higher lows.  With higher highs and higher lows, price is getting higher, higher, and higher and the low prices are getting higher, higher, and higher. Trends tend to last for long periods of time and if you can “catch a trend” early you can reap huge rewards. This is likely the main reason why trend trading systems are so popular.

Example of a stock making higher highs and highers lows.

Let’s take a look at a chart.  Here we can see a stock that’s in an up trend and we know that because we have our first low here and it makes a higher high with a higher low, then a much higher high, makes another higher low and makes another higher high up near the top.  We can clearly see the stock is in an up trend.

So what are some key points to determine whether or not it’s a trend consolidation or a pause?  Well the first point to consider is that stocks are going to pause and rest by correcting sideways after a prolonged up move.

They’re not just going to go up indefinitely because it can’t sustain those prices.  Eventually it’s going to reach a price where people are not willing to pay any higher and then it’s going to fall.  So that’s basically what’s happening when a stock gets too high in price.

Now, with a correction or a consolidation pause, the price is going to go higher, take a rest and then continue onward or pull back and continue onward and then pause and then continue onward and that’s basically what’s happening in an up trend.  These pauses are very healthy for the move in the stock, which brings us to the second point.

A consolidation is healthy as it helps prepare the stock for another run to the upside.  So, again, it goes up, pauses, continues.  This pause is the buyers taking a break, they’re regrouping, gathering momentum, getting ready for the next big move, when the volume picks up again and it breaks out, they’re all jumping in again and fueling the price higher.

The last point here is many traders are unable to determine if this is a healthy pause or an unhealthy topping phase.  We’re going to cover that a little more detailed in the later on, but generally speaking, a healthy pause is going to be these nice controlled pull backs and pauses and going forward.  An unhealthy topping phase is going to be very whippy in price because the buyers and sellers just don’t know where they want to go with the prices, so it’s going to go up and down, up and down as they continue to swing from team to team, from buyer to seller, trying to determine and pick a winner.

“Whippy” price action, makes patterns hard to predict.

If we look at an example of the chart again, we’ve got the stock that’s in an up trend and things are very calm and controlled, nice and smooth, and then finally, we have the nice breakout with this huge volume behind it as opposed to a chart that looks like this, which is extremely whippy.

Here you can see the prices are getting higher for a period of time, but the prices, when it got up in here, got very whippy.  There are big bars here, as the volatility was really picking up.  It goes up, huge green day and then a huge down day, fights back, goes back down, up, down, just doesn’t know where it wants to go. This is indicative of a possible topping phase and these are the type of patterns you want to try to avoid.

In trend trading part 2 I will show you the 3 things to look for to confirm you are in a healthy sideways trend consolidation.

Rather watch than read? Watch the video at the bottom of this article.

Short selling in action with HEW-NYSE

We already covered “What is short selling?” now we’re going to cover an actual short sell trade that I made in one of my accounts.
Here you can see a chart of Hewitt Associates on the NYSE, symbol HEW, and you might be asking, “Where and how did I find this stock?” Well, it was very simple.

All I did was some simple scanning, using Stockcharts.com scanning tools to build a watch list and once I had this stock on my radar, I simply waited for an opportunity to present itself. There was definitely some major pain here. A lot of people felt a lot of pain with this big red candlestick, with volume. It closed at an area of support, rallied off of there a little bit, created a new resistance point, which actually is a previous area of support. Now it’s acting as resistance.

One of the things that caught my eye as well was the fact that the 20 period and the 40 period moving average crossed downwards. Now it’s really indicating that the bears have taken control and you might want to start looking for short opportunities. After this minor resistance has been established, I’m looking for another opportunity to short at or near that area. You can see here, it actually tests that resistance, comes back down to that previous area of support, so you got a very strong support area here. It rallies off of there again and goes back to roughly the same area of resistance. This is where I’m really starting to watch, and actually, on this exact candlestick – you can see a shooting star candlestick pattern showing up here – this is when I’m zeroing in for the kill and getting ready to short sell this stock.

Entered position at $26.85, stop $27.55. Covered half at $25

Let’s take a look at the trade on the next chart. Here we have our shooting star candlestick and my entry point is on June 7th at $26.85. Why $26.85? Well, we have this candlestick pattern where it trades all the way up to a high level, very near the resistance point, and then starts to come back downward again. Now I’m immediately shifting my focus to a shorter time frame, getting ready to pounce on this stock. I finally decide to do so at $26.85, which is $00.10 below the opening price of the day, that really confirms to me that this is weakness and that the bears have now taken control away from the bulls and are ready to take this stock lower.

I purchase 600 shares and I have a comfortable price target of $25.00, which is an area of major support. Now why 600 shares? Well, my portfolio is large enough so that I can sustain a larger position, but I don’t want to take on more than 30 percent the size of my actual portfolio in any one trade. So, I’m actually only risking with this stop loss, $420.00, not including commissions, and that is calculated based on the fact that my entry is $26.85, my stop loss is $27.55. That is $0.70 times 600 shares, which is going to mean, even if it goes to my stop loss priced at $27.55, the most I’m only going to lose is $420.00 on this trade. This is a very small and very comfortable amount of money if you have a large portfolio, so the risk is limited.

After entering this trade, the proceeds of $16,110 is then placed into my account until I actually buy back the shares, hopefully, at a lower price. In this case, that does happen. The price falls quite nicely so on the 13th of June, which is the long red candle. I hit my price target of $25.00. I sell half my position at $25.00. I get back $7,500.00 here, cost for the first half of the trade and I’ve now lowered my trailing stop loss to $25.86, the $25.86 is a full $00.25 above this day’s high of the day. I’m giving myself a $00.25 cushion plus the difference in the closing price and the high price.

Pretty comfortable spot to be in and I’ve already made a profit on the front half and if you noticed, $25.86 is below my entry price of $26.85. Now I’ve locked in a profit on the back half also.Essentially I have a free trade on the back half and this eliminates the emotion of greed and fear, because I’ve already made my profit. That appeases the greed demon and my fear is now gone because I’ve locked in a price target that’s going to guarantee me a profit on the back half.

Net profit of $1935 or 12% in only 8 trading days.

Things continue to go very well here. We have this huge down day again, with volume, on this candlestick here. I have the Trading Master Plan 5xMA trailing stop rule in place. In this case, the calculated stop loss was $22.44. However, the stock did not quite hit that price. It actually had a low of $22.95 for the day, which is very close and I was definitely ready to go for the next day, hoping to hit that price target.
I actually re-adjust the following day using the same 5xMA rule and because the moving average has now fallen even further. The 5xMA rule has created an even lower price target of $22.25 and this time it does hit, I sell the back half, 300 shares at $22.25 for another cost of $6,675.00 back. By the way, the low of the day was only $22.14 for that day, so we were only $0.09 away from the low on that day.

If we’re going to do trade analysis here, we would see that the proceeds of $16,110.00 less the cost that we got back when bought the shares back. Had a net profit of $1,935.00, which translates to 12 percent in only 8 trading days. This was a very productive and very quick trade. . I took a very limited risk of a little over $400.00 and I have quadrupled that with a gain of 12 percent in only 8 days.

Just a note on this chart here, the actual low a couple of days later was $21.66. I’m not too worried about it. I mean, I did fantastic in this trade. I managed it properly throughout, continued to stick to my trading rules and do you think I’m really worried about not getting $21.66? You know, the trade went extremely well. Does every trade go this way? Absolutely not. This is obviously a very good example that I’m using here. I had several trades. This is one of my better ones for the last month or so. Certain trades are going to stop out. If things had gone against me and stopped out immediately, I would’ve lost $400.00. No big deal. Move on to the next play.

This is where money management really saves you. It keeps you in the game so that you can get these types of trades more often and then hit nice home run trades. I wouldn’t say this is a home run, but a very good trade that’s going to build your portfolio, really create that long term wealth that the majority of people are looking for.

Rather watch than read? Watch the video at the bottom of this article.

Selling a stock you do not own.

Now we’re going to discuss “What is short selling?” The way I’m going to do that is I’m going to use this fancy graphic that I put together in about two minutes to illustrate what exactly is going on when you short sell a stock.

Basically, what you’re doing is you’re selling a stock that you do not own. There’s always going to be a buyer and you’re going to sell this person a stock that you do not own. How are you going to do that? You don’t own the stock, so your broker is going to lend the shares to you. How they’re going to do that is they’re going to either take the shares from their own inventory and lend them to you or they’re going to borrow them from another client’s account and then lend them to you, so that you can then sell them to a buyer.

You’re going to receive the proceeds just as if you had sold them outright. So say you sold 100 shares at $30.00, you’re going to receive proceeds of $3,000.00, which are going to be held separately in your account. And at some point in the future, you’re going to need to buy back those shares that you sold. If you’re buying them back at a lower price and then you keep the difference between those two balances.

If you buy them back at $10.00, that’s only $1,000.00, you’re buying them back for. But you’ve already received $3,000.00. So after you give the $1,000.00 back to your broker for buying them back, because now you’re paying off your debt, you’re going to have a difference of $2,000.00, which is your profit.

Why would you Short Sell?

Of course, if the share prices go up in value, then you can, of course, lose money. If the share prices went up to $40.00, let’s say. You need to buy the shares back and it costs you $4,000.00, you only received $3,000.00 in proceeds, initially. You still need to give back those shares, $4,000.00 worth, so you’re actually short $1,000.00, or at a loss of $1,000.00 in order to give those shares back to your broker.

So, what exactly is short selling? Short selling is selling the stock, the seller, or you do not own. When you short sell a stock your broker’s going to lend those shares to you. They’re going to do that either from their own inventory or from the stock of someone else that they have an account with. The shares are sold and the proceeds are going to be credited to your account and if the price drops, you buy the shares back at a lower price and you profit the difference.

Why would you short sell? Well, the obvious answer would be to speculate. You want to profit from the downside movement in the stock or stock market. That’s pretty straight forward and that’s how most people are short selling in the markets. Another reason you may not be aware of is you can hedge by using short selling, so, you can protect your other long positions by short selling. So, say you anticipate a down move coming in the market and you have long term positions that you want to protect, you can then short sell shares of a correlated stock, another stock in the same sector that you expect is going to fall, the gains will offset the losses of your long positions if the market falls.

Uptick rule restrictions removed.

There are some restrictions you need to know about when short selling. First, you can’t short sell penny stocks and most short sales need to be done in round lots, i.e., a block of 100 shares, 200, 300, 500 or 1,000 shares.

Let’s take a look at a short selling transaction. So, say you decide that company XYZ is ready for decline. The stock is currently trading at $45.00, but you predict it will trade much lower in the coming months, so you decide that you want to short sell 100 shares of that stock. Let’s just say things go your way. You short sell and the stock price sinks to $20.00 and you borrowed 100 shares at $45.00, you’ve received proceeds of $4,500.00 for those shares and then you bought them back at a later date at $20.00, which is only $2,000.00 that you’re buying them for. You get to keep the difference after you give back the shares to your broker, of $2,500.00.

If things don’t go your way, however, say the stock prices rises to $70.00 and you borrowed 100 shares at $45.00, so you received proceeds of $4,500.00. You buy

How you make money "shorting"

back the shares at $70.00, which is $7,000.00, so you need to pay back that $7,000.00 for the shares to your broker and you’re at a net loss of -$2,500.00 in that situation.

Let’s take a look at some of the risks involved with short selling. The first risk is that the market has a bias to upward prices, so over the long run most stocks are going to appreciate in value. What this means is that shorting is betting against the overall trend or direction of the market. When you short sell, your losses can be infinite; a short seller loses when a stock price rises. Theoretically, a stock price could rise to infinity. On the other hand, a stock cannot go below zero, so your upside for short selling is limited to if the price actually reaches zero.

Shorting stocks involves using borrowed money, otherwise known as margin trading. So if your account slips below the minimum margin level, you’re subject to a margin call. You’ll be forced to put more cash into your account or liquidate your position. Without going into the finer details of margin, let’s just explain it this way. You’re borrowing the stock. You’ve received proceeds which are being held separately in your account and you essentially borrowed that stock from your broker. So you need to put up a percentage of equity value, or buying power in your account to do that.

How you can lose money "shorting"

If the stock goes against you, meaning goes higher in price, you’re going to continue to put up more margin, or buying power in your account in order to maintain that position. If you don’t have enough margin to continue to maintain the position, you’re going to receive a margin call which is going to force you to put more money in, which would give you more margin, or you’re going to need to cover the position, or liquidate the position.

Another risk is if a stock starts to rise and a large number of short sellers try to cover the positions at the same time, it can quickly drive up the price even further. This is known as a ‘short squeeze’. For example, prices start to go up; people are buying the shares, so there’s some buying pressure and if short sellers are in the stock and they notice prices are going up, they may be having their short stop losses triggered, which then causes them to buy the shares back to cover their positions. Now you’ve got buyers and short

sellers who are buying, which is causing a lot of buying pressure, which of course, feeds the price movement which then can create what’s known as a short squeeze, because now there’s a lot of buyers stepping in, as well as the short sellers covering the position in panic.

Bottom line is short selling is a very important tool that you need to add to your trading tactics and techniques. If you’re not comfortable short selling, there’s nothing wrong with that. But you need to stay out of the market is the market is in a nasty mood. If you really want to start trading with a professional mindset, then you need to learn how to use short selling to your advantage and incorporate that into your trading plan.

Example of a short trade

Let’s take a quick look at a chart of Dell, you can plainly see that it is having a rough time in the last couple of months. Clearly it is in a downtrend, if you’re trying to go long on this chart where was the long position that you were trying to enter? Was it somewhere here? Near the bottom as a long entry break out? If that’s what you’re looking for, then your perspective is very short term.

If you were short selling, you can clearly see a nice area of support which was clearly broken, and in fact, actually gaps down quite heavily.

If you didn’t get in on that, fine, but you had an excellent area right here that was short able. Here you see the resistance point was touched by the down trending, 20 period moving average, which gave you a good entry, and then it materializes again, here, with a 40 period moving average acting as resistance.

Where it’s going to go from here, who knows, but there was actually a good little play in there and whether or not this is going to act as major support or not, remains to be seen. We’ll just have to see how this plays out.

Next I’m going to go over a trade analysis of an actual short selling trade that I made recently and I’m going to show you the entry and the exit techniques that I used as well as how I manage my stop losses with a trailing stop and of course, all the other money management I incorporated into that trade.