Thursday, September 22, 2011
Risk of pullbacks and failures
Traders are often surprised at how violently their stops are sometimes taken out such as the short below b14 or the long above b15. Signal bar selection is very important if you wish to use stop entries to enter on the breakout of signal bars. Almost all failures for stop entries have a few common characteristics and mastering them will reduce your error rate.
1. Overlaps: Overlaps, especially large bar overlaps are the easiest risk to recognize and evaluate. In general large bars are poor signal bars regardless of overlap. Any overlap practically guarantees the trading range attribute of the signal bars and you should wait for a small bar at one end of the overlap (b16, b26) and take the fBO of the overlap. Overlaps of small bars such as b47-51 are usually ok to take a second attempt with-trend. These should never be taken in a trading range (expecting a breakout for example) and never the first attempt.
2. Dojis before reversal bars: Dojis represent a trading range and a reversal bar after the doji does not invalidate this fact (b21-22). A second attempt, especially after trapping traders in both directions (b35) may be an OK entry to take even with dojis.
3. First attempts: Its clear from the charts that first attempts (b22, b33, b60) are highly likely to fail compared to second attempts. First attempts should be reserved for very clear and very specific cases such as 1Rev (b3), W reversals (b72) and 1PB or at the very least only for excellent signal bars.
4. Poor signal bars: Poor signal bars (b11, b60) almost certainly will give a pullback simply because some traders will fade its breakout. This is why a second attempt is recommended if the signal bar is the wrong color, has a long entry-side tail or is a doji. Even if the first attempt succeeds, there is usually a pullback before the market moves too far from the entry off a poor bar.
If you consider bars that had minimal pullback, i.e., went a large distance before a pullback and hence are swing candidates(b7,64,72), they usually are well-formed bars with a strong close or are second attempts (b16, 35). Restricting your entries only to such bars should greatly reduce your error rate, which is a precondition to increasing your trade size.