As has been the case for the last few days, the market was once again focused on the financials and the futures trading was frantic…..from -132 pts early on to +162 and higher after I stopped
trading for the day. Lehman Brothers and it’s attendant problems, along with oil, sub prime mortgages and every imaginable malady ran the market at a manic pace. I stayed fairly conservative all day, more out of fear than anything. Entries and exits were difficult to pinpoint, so I stayed at a 12 tick and stop limit and made out okay…though I did not trade more than 3 contracts at any point during the day. I was up 4 pts by the time it was over, but felt like I’d been on an out of control roller futures trading coaster. Support and Resistance levels, along with pivots were honored now and then, but by and large the market staggered around like a drunken sailor….searching for leadership and direction.

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I will post my trading chart later this evening…it was an exceptional day in that the market basically went straight up, with a short respite over the noon hour.

Which brings me to a timely topic, and an oft talked about topic We’ve talked some about entries, at least in a simplistic manner, but the topic of exits has not come up. If ever there were a plethora of theories on a subject, when to exit a trade ranks near the top and few traders are without some sort of opinion on the topic that differs from the next trader…and so on.

On one hand, it’s nice to let your trades run as long as you can. Of course, this is some dicey business since the market does not post neon signs indicating just when it is going to change direction. One hard and fast rule I follow is this:

Never let a winning trade become a losing trade!

This goal can be accomplished through many different means, but I still see the most errors, including my own, at exiting at the proper time. You may have read my own disgust with myself when I exit a trade several points to early. Lately I have been placing my sells 3 points (or 12 ticks) above my entry point. I have done this to take advantage of the volatility in the market lately as it can be very difficult to manually exit a trade without losing a bundle of ticks. That being said, it can be very unnerving to exit at 12 ticks and watch the index price slide up another 4 points. It is a sinking feeling indeed. Essentially then, I have been setting up bracketed 12 tick trades at my point of market entry.

Now it would be safe to point your finger at me and say, “Dave you are trading like a wimp”. You would probably be on safe ground in saying so, but the fact of the matter is simple, this low volume market has made me a bit wimpy. A bird in the hand may be as good as two in the bush.

Under normal trading conditions I use the slower of the stochastic lines to determine my exits. When that line begins a divergence from the direction of the trade I am in I exit. However, the psychotic nature of the market traders lately would force me to have much faster reactions than I have been able to exhibit. I will devote a full blog entry to using the stochastic to exit trades in a future post, as it takes a bit of explanation to assimilate the information.

I am also very cognizant of price exhaustion while in a trade, and price exhaustion can provide a piece of your exit strategy if used properly. Higher highs, and lower lows and deviation from market direction, a fractal, are indications of a possible change in market direction. Again, with so much information to cover, I will save extended discussion of my pet market direction indicator, the fractal, for later discussion. For now, you could consider successive higher highs and higher lows as a continuation of a market directional move to the upside, and conversely, low lows and lower highs as the corollary pattern on the short side.

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I use a portion of the stochastic formula to exit my trades, and for the time being I thought I would introduce you to the concepts and premises of stochastic measurement. There are many variations of the stochastic model and tomorrow we will discuss the manner in which I set the parameters and setting to optimize your exit strategy.

Stochastic is an oscillator that is very popular and has been around for several decades. It is a price oscillator tracking overbought and oversold conditions. It is often used in the red light/ green light trading systems which can cause problems for traders unless they understand how stochastic works, why it was created, and what it was designed specifically to track.

Stochastic was written by George Lane and is a true oscillator which means it was primarily designed to track either overbought or oversold price conditions in a range.

In the stock market, the term “overbought” means that it can be assumed everyone who wanted to buy the stock is now fully vested and there are no more buyers or insufficient buyers to move the stock up.

Oversold is just the opposite, there are insufficient sellers to move the stock down.

The reason oversold and overbought is critical in sideways markets is that the shift from buying to selling can happen rather quickly.

George Lane wrote the indicator Stochastic formula based upon the presumption that as a run moves up (or down) a stock will close nearer to its high as buyers keep rushing in to buy the stock. But as momentum tapers off or buyers become scarce, then a stock will close lower from the high price for the day.

This is a presumptive statement that works in trading range markets. The theory fails during strong rallies and velocity markets because stochastic will move into the overbought area or oversold area signaling an exit just as the stock begins a huge run.

Therefore, Stochastic should not be used during momentum or velocity markets, platform markets, or bottoming markets as it will create a premature exit signal just as the stock is about to run up strongly. Below is a chart showing how stochastic moves to the overbought line during a strong momentum price move. This chart shows a typical platform building pattern followed by the strong velocity move up. This kind of chart pattern occurs during value-oriented markets when institutions are quietly accumulating.

During a velocity market you should use a different indicator than stochastic. Instead switch to an accumulation indicator and quality indicators as these will help you get into the stock early before the big moves up.

Below you can clearly see how stochastic is showing overbought exit signals even though the stock keeps moving up. This is why stochastic should not be used all the time but only for certain market conditions for which it was created.

Below is a chart of Stochastic showing the oscillation of the indicator suggesting overbought, or oversold conditions. This is the normal pattern that most trading systems are attempting to find. You can see that this is a very different price action than the previous chart.

The Stochastic Formula and what it is intended to reveal:

There are 2 lines for the George Lane stochastic formula: %K and %D usually represented in red and black lines on charting software. First, the K line must be calculated.

K=100((C-L)/(H-L))

Where K+ the location of price relative to the current price range

C= the last close price

L=the n-period low price

H=the n-period high price

n=any time period specified

K is smoothed twice with a 3-period SMA which creates the %K line, usually black on charts.

Then %K is smoothed again with a 3-period SMA to create %D line which is usually red on charts. Only the %K and %D lines are used in the chart analysis. So you will only see 2 lines to represent the 3 lines in the formula. Because it uses a fixed time period to period calculation, the lines can jump and move erratically if price fluctuates significantly.

Most stochastic indicators have predefined 80% overbought line and 20% oversold line on the chart. A few charting software programs allow you to move the lines to whatever percentage you wish.

If you are a beginner, simply use the settings of 80% and 20% for a trading range market.

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