Risk Management Conditions for Entry

1. I s the stop loss less than 2 percent of the total cash in account?

2. Is the stop loss risk calibrated with the win/loss ratio?

This book focuses on a most important and particular challenge: detecting variations in the pattern called the "trend." Properly detecting trend conditions is integral to improving long-term trading results. It is well known that going against the trend is a major source of trading losses. If a trader became more effective in identifying and quantifying trend conditions, losses would be minimized as a result. We will learn that this can be done with price break charts.

Let's begin by looking at the commonly accepted technical definition and visualizations of a trend. The technical definition of an uptrend is the occurrence of higher highs and higher lows. The technical definition of a downtrend is the occurrence of lower highs and lower lows. Some technical analysts require two touches of a trend line to achieve the conditions of drawing the line, while others require three. The more touches, of course, the better the confirmation. The commonly accepted method is to draw the downtrend line by locating the highest high and next lower high, and then extending it out into future time (Figure 2.1). To draw the uptrend line (Figure 2.2), locate the lowest low and then the next higher low and extend the line further across the chart, following the arrow of time into the future. The idea is to obtain a sense of where the trend would continue if the price stayed within the boundary.

The classic use of trend lines does a good job of generating initial boundaries. Once a trend line is drawn, it becomes a contour map of where sentiment might change. Depending on the intentions of the trader, trend lines can serve as the boundaries of buying and selling

Figure 2.1 Downtrend Line
Figure 2.2 Uptrend Line

zones. However, there is a lot of ambiguity for the trader who wants to put on a trade in the direction of the trend. Several questions arise in the mind of the trader. Is the trend getting tired? Is there a counter trend cycle? Where is the best point of entry? How does the trader detect when a trend is weakening or reversing? How does the trader detect when a trend has been weakening? If a trend has been broken, when is that break confirmed? This reminds us of the refrain, "The trend is your friend—unless it is at an end." An even more important question is, "What is the best set of price conditions for entering a trade?" This is an ambitious set of questions, and many books exist on entry strategies. Ask these questions of any number of traders and you will get a large variety of answers.

The goal of this chapter is to bring the trader greater clarity in (1) identifying and evaluating trend conditions, (2) determining how to detect direction, and (3) diagnosing a change in sentiment. The result, we hope, is that the trader will be able to shape and engage in trading strategies and tactics more effectively.

To accomplish these objectives we turn first to price break charts. Understanding price break charts provides traders with a powerful capability to be more precise about trend identification. As a result, their ability to diagnose market sentiment can be greater than ever before. The rest of this chapter explores the underlying concepts of price break charts.

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