Making Money When You are Wrong
When we go to school, we study various subjects and we complete tests. In these tests we are supposed to give the correct answer. If we give the correct answer, at least in the opinion of the teacher, we get marks. Accordingly, over a large portion of our formative years, we learn the importance of being ‘right’.
Unfortunately, this is a very ineffective approach to the markets. It is fine if you wish to be an analyst, but not if you wish to be a trader. In trading, the object is not to be right; it is to make money. And as the title of this article suggests, it is possible to make money when you are wrong.
As it is with every other aspect of trading, we must have rules. In the Number One Trading Plan, David Bowden provides a rule about making money when we are wrong - the Trend Reversal Rule. This rule is to be used when you are trading a double top or bottom setup. I don’t have sufficient space here to discuss the strengths of various double top and bottom setups but, of course, they are not all created equal. However, it is worth having criteria for analysing them in your Trading Plan, and if those criteria are met, then you must take the trade.
To illustrate this, let’s look at a setup in the Japanese Yen. I normally follow the futures contracts for the currency markets, although I generally don’t trade currencies. I know most of you are more familiar with the FXUSJY chart, due to Mat Barnes’ excellent coverage of this market.
Chart 1 – US Dollar-Japanese Yen
click chart to enlarge
Going back to November, 2012, we see one of the simplest and best trade setups in the book – a double top on a 50% retracement level. W.D. Gann regarded these setups as so strong that his rule was to go short immediately the 50% level was hit and price started to fall. So, on 2 November, he would have been short about 10 ticks off the high. He eould have placed his stop a set number of points above the 50% level, with orders to go long if this was hit.
For me, this rule is too aggressive. I prefer to wait for confirmation, although in this case, the close in the middle of the bar suggested late selling and weakness. (As always, there are many alternatives and you have to select the rules that suit your own trading style and personality).
Chart 2 – Failed Trade
click chart to enlarge
Fast forward to 15 November when the market broke through the double top. This was the place to apply the Trend Reversal Rule. But I’m getting ahead of myself. Let’s step through the trade.
After the double top was formed on 2 November, the next day was an inside day. A conservative entry would have been the following day (the 6th) when the low of the inside day was broken. Even so, you would have been a bit nervous with the high close that day. Your stops would be above the high on the 2nd, but whatever your position size, you would have a stop for twice that amount. That is, if your stop was hit, you would immediately be in long.
The sell-off continued into the 9th and at this point you would be happy with the progress of your trade. If you look carefully you will see a previous top in September when the market found support. I like to split my positions in two and take some profits at milestones and allow the other half to trail swing tops. If you apply ABC points to 25 June, 13 September and 2 November, that low on the 9th failed to reach the 50% milestone. That day was also around the seasonal date, so you would want to be careful.
Bearing in mind that the safety of your capital is paramount and that you do not want to let a profit turn into a loss, it would be prudent to move stops on at least half of your position to cover your entry, or perhaps even to lock in profit on that half while leaving your other stops above Point C. The rule I am applying here is the Advanced Entry Plus Commission rule from the Number One Trading Plan.
Whichever way you managed the trade, on the 15th you were out of your short trade and should have been automatically in long. You might have taken a loss on the trade but it should have been small, as per the above strategy. Given the strong move up that day, you would be comfortable placing your stops under the low of that day, which would make your risk about the same as it was on your short trade at the double top.
Chart 3 – What Happened Next
click chart to enlarge
While what happened next was extraordinary by anyone’s standards, you didn’t need to know that this was going to occur in order to make fantastic profits. All you had to do was to follow the simple rules in the Starter Pack and Number One Trading Plan. Indeed, this failed double top trade in early-November probably turned into the trade-of-the-year, if you stuck to the rules.
But again, I have jumped ahead – I just get excited when I see yet another example of how well the simple rules can work! You are long on 15 November with a stop under the low of the day. Now, what are you going to use as a profit target? Again, there are alternatives. One is to use the Risk Reward tool to find what price would give you a 2:1 Reward:Risk ratio. Another is to measure the range down from the 2 November high to the 9 November low and project that upwards from the high. This would give you a target of 82.28, which was hit on the fifth day of your long trade.
If you were trailing stops under one-day swing bottoms, you may have been stopped out of that position on the outside day on 26 November. You will have to check this yourself on the chart as I haven’t noted it on Chart 3. But you would quite possibly have missed moving your stops that day as you wouldn’t have known to put a swing in the chart and move your stop until a day later. If so, this would prove to you that luck plays a part in the markets because no other one-day swing bottom has been broken from the 9 November low until today – 11 February, some 94 days later!
Another way of saying this is that if you went long on 15 November and took every additional trade signal since then, you would have a total of five positions trailing bottoms on the one-day swing chart. The first trade was your Trend Reversal trade on the 15th. The rest were standard ABC long trades, with the exception of the one around the 31 December low.
31 December formed an outside continuation day and you would have taken another long position that day following the rule in the Number One Trading Plan. Point C is marked on the chart two days later but as you can see, the swing bottom was on the 31st, and that is the day you should have entered. You would have to have been on the ball to get into this trade but if you saw the low open and the subsequent rally, you should have placed your entry order even though you were probably not watching the break when it happened.
This trade narrowly failed to reach its 100% milestone before retracing but the other four trades all met the target. Thus, if you were using Currency Stops for your milestone positions, your profits would have been handsome indeed.
Currently the move shows no signs of ending and if you had traded this entire move you would simply keep taking each additional signal and forget about trying to call the top. Quite possibly your final trade will make a loss but, considering all the money you have made in the previous three months, this wouldn’t really worry you.
There is nothing here that requires any more knowledge than what is provided in the Number One Trading Plan and the Interactive Trading Workshop. Thus, anyone who has progressed to that level should be able to understand and replicate these trades. I will leave it to you to work out what profit you would have made. Do not worry if you were not trading this market at the time; this example is meant to show you how to apply these simple rules to any market.
Knowledge is Power!