Trader’s Narrative

I find the fractal nature of financial markets fascinating. You can look at a minute chart, a 30 minute chart, a daily chart, a weekly chart and you will see basically the same formations, the same elemental forces of support and resistance and the same setups.

As a trader, you can use this to your advantage. Switching time frames can help you avoid a “noisy” market. It’s also a great trick to avoid looking at the same charts that everyone else is looking at. It can, in fact, be an edge if everyone is looking at the 15 minute chart, for example, and you’re looking at the hourly chart or the 40 minute chart. You will see things that others will simply miss.

To illustrate what I mean, let me show you an example of a trade executed following the basic rules of the dummy trading setup: look for a thrust (expansion in price), then a contraction or pullback and hop on as the contraction is taken out by the continuation of the trend. The dummy trading setup is meant to be executed intraday but knowing the fractal nature of the markets, there is no reason we can’t trade it at a higher time level. This example is a swing trade using daily charts.

Metalico Inc. (MEA) is in the hot metals sub-sector. It put in a stable, long base for over 4 months. Then in early April it broke out with unusually high volume. It consolidated a little around the $5.25 breakout area and continued higher. If you missed this first opportunity, the next one came on April 18th 2007 as price pulled back significantly. It formed a hammer like candlestick with a very long tail. This was a tell that price was being supported as a second wave of buyers saw their chance to get in on price levels they had missed before.

The next day there was a contraction as it printed a narrow range, inside candle. This is what a “dummy trader” looks for! The break-out of this contraction (green line) then took price to the previous swing high and beyond. Notice also that the volume shrank significantly as price pulled back in mid April. This was another tell that people really weren’t interested to part with their shares but rather to accumulate more (blue rounded box).

How you trade this setup is really up to you. You can wait for a tightening of the price range or you can wait for a real pullback. Traders like Tony Oz only get in on a deep pullback, preferably all the way back to the break out price. But as you can see with Metalico’s example, you may not get such a deep pullback when faced with a strong trending stock.

I don’t think anyone can say one entry setup is better than the other. Ultimately it is up to each trader to fine tune the setup to their liking and temperment. But keep in mind that such setups are merely starting places. Take them and build on them with your own ideas.

In any case, getting back to the point about different time frames… take a look at M&F Worldwide Corp. (MFW) on a weekly chart. Yes, weekly. And then count how many “dummy spots” you notice!

As much as trading seems complicated, or perhaps, as much as we fall into the trap of making it complicated, there are really only three types of trades you could ever put on. In order of difficulty, here they are:

With the Trend
Trading with the trend is perhaps the most common, and I would argue the easiest of the three types. Turtle trading would fall into this category, as would dummy trading, Linda Raschke’s “Holy Grail” setup and many others. When you trade with the trend, your thesis is to go along with the crowd and ride the emerging or existing trend. A break-out type play would go under this category, as would a retracement type play - since both are anticipating a continuation of the dominant & previous trend.

Counter Trend

The opposite is to go against the crowd and to anticipate a change in direction. Most would tell you to never “fight the trend”. Although I wouldn’t recommend it to newer traders, it is a legitimate way to trade and make money. Or as Paul Tudor Jones II puts it: “I believe the very best money is made at the market turns. Everyone says you get killed trying to pick tops and bottoms and you make all your money by playing the trend in the middle. Well for twelve years I have been missing the meat in the middle but I have made a lot of money at tops and bottoms.”

Non-Directional

This is perhaps the most “advanced” form of trading and therefore the most difficult to execute. And for those new to trading, it is perhaps the most difficult to grasp. How can you make money if the thing just meanders??! You do so through the modern marvel of financial derivatives. Within a range of prices (blue lines), many option combinations allow you to make money through the sale of a ‘premium’. The simplest is a covered call position (or if you flip it around, a short put position). There are other combos that are incredibly complex and would make a PhD math student go cross-eyed. Do not venture into this territory without a good grasp of the greeks (delta, gamma, vega, etc.).

That’s it! So if you’re totally new to trading, or are a veteran trying to come up with a new strategy, it may be usefult to step back, wipe the slate clean and realize that no matter what kind of trade you put on, it will fall into one of these three categories.

Ahhh, the elegance of simplicity.

While quite a few traders are using gaps to create watchlist candidates these days. I’ll share one other way to trade a very familiar pattern.

You simply find strong, trending stocks and find a pullback (which is what a dummy spot really is) to buy. Last week I gave a short watchlist of strong trending stocks. Among them was Republic Airways (RJET). It has just broken out and was in ‘open air’ territory. There were no unhappy longs in this bunch.

Since previous resistance had now flipped to support, an orderly pullback to that area would be a good low risk opportunity to climb aboard this trend:

Note that this is more of a swing trade example with a longer time frame (hourly). The stop loss was were I felt it would be clear that the new support had not held.

Put another way, the expansion was on March 15th (Thursday) when the resistance was taken out. The contraction was the following day - when the trade was entered. And the expansion continued in the following days. Expansion, contraction, expansion… now where have I heard that before?

My point in showing this is that you don’t really need gaps (although they are a good pattern too). The important thing is to take an idea, add your own thinking and come up with something which you can call yours. All great traders got there by doing their own thinking and forging their own paths. And thanks to the nature of the market, there are a myriad paths to success.

Take a look at the other strong stocks I featured and you’ll see there were others like RJET.