Tuesday, December 06, 2016

Stalking A Trade: Patience Is a Virtue

Almost two weeks ago, we discussed a bull pennant pattern setup drawn by General Electric (NYSE: GE).  A pennant breakout occurred twice in the last two weeks, however neither of them were solid trade setups.  Let's take a look at the chart as of this morning and review why we are still stalking this trade as opposed to holding on to an open position.

GE Daily Chart
The initial post called attention to the bull pennant following the close above that pennant on 22 November 2016.  Notice the caution flag, though.  I pointed out that the breakout occurred on low volume.  When trading any breakout, it's important to confirm that there's true conviction behind the move.  Flag and Pennant breakouts have been popularized in numerous publications, and as a result, market makers will often take advantage of the pattern by targeting the entry stops that they know will exist in large numbers.  What you see in that case are a lot of traders getting trapped by an entry at the right spot at the wrong time, only to have the stock pull back into the original pattern.

The sign to watch is volume.  A breakout on low volume significantly reduces the probability of a successful trade and is a warning sign that you're falling into either a bull or bear trap depending on the breakout direction.  We see that clearly in the week following 22 November.  A couple of lackluster narrow range days on equally low volume followed, and the stock then dropped back into the bottom of the pattern.

But what about that second breakout on 1 December?  That was a nice, strong move to the upside, and look at the volume!  Sure that confirms the move, right?  Well, not so fast.  There was, indeed, high volume that should be the confirmation we're awaiting, however two warning flags kept us out of this move, as well.  The first warning flag was the rising volume on the two days preceding this breakout.  Both of those were down moves with confirming volume.  Why is supply coming into this stock, now? The second warning flag is that horizontal resistance level at 31.50.  Not only did it form an extremely strong and persistent level of resistance in that tight horizontal move from 5 August to 2 September, but the level held firm again when tested four times between 25 November and 5 December. 

That the resistance level sits close to the 61.8% retracement level of the overall pattern is a bit of a warning sign in and of itself.  That it has held firm now for four months is a major warning sign.  It will take some conviction to break through that barrier, and thus far we haven't seen it.

This is why we stalk a trade and seek multiple confirming signals before committing capital to a position.  As swing traders, we know that we're not going to catch the precise top or precise bottom of a move.  Many novice swing traders attempt to do just that, but in reality, it's the quickest path to draining an account that you can find.  Well, maybe the second quickest.  Not having a solid risk management plan with a well-documented exit strategy for a trade is likely quicker.  Either way, we know we're trading the middle of moves, not the full range.  So, in reality, when you factor in slippage, commissions, and actual entry and exit points, there has not been much profit potential for the retail swing trader between the top of that pennant and that overhead resistance line.  Before we commit capital, we need more confirming data points that a move is genuine.

So what are we waiting for here?  Well, a volume-confirmed break of that resistance line would be good.  From a Wyckoffian cause and effect perspective, that resistance line has build up a significant amount of cause.  The move off that line, therefore, can reasonably be expected to produce significant effect.  In fact, point and figure charts (not shown here) point to potential upside targets in the 34 to 38 range.  The time period for such a move would be well outside our swing-trade time horizon, of course, but you see the point.  A significant amount of cause is being built, and that normally results in a significant effect (i.e. price move.)

The point of all this is that we need to seek multiple confirming signals to increase the probabilities of a successful trade.  Pattern breakouts are but one signal.  Volume patterns are a second.  Support and Resistance Lines are a third.  Fibonacci retracement levels are a fourth.  Any combination of those converging in the next greater or next lower time period (e.g. a weekly or hourly chart if we're trading off the daily) would add a fifth.  The more confirming signals we have, the higher the probability of success.  At a minimum, we would like to see two signals, but if we're going to commit to a full position size, we would prefer to see three or four confirming signals.

Such a conservative strategy means missing some opportunities, of course.  Our objective, however, is not to capture every opportunity.  Rather, our objective is first and foremost to protect our capital.  That means managing risk properly, and only committing that capital when the probabilities strongly favor a successful outcome.  Stalk your trade, and display patience before committing capital to a position.  Leave it to others to fall victim to bear and bull traps by attempting to capture every move out of a widely known and well publicized pattern.  Instead, patiently enter after the weak hands have been shaken out of the market, and ride the wave generated by the market makers taking their own positions to the target profit level.  Trade with the market makers, not against them.

Happy Trading.

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