Ana_Idkit

After my presentation at the Share Investor Expo on December 6, I spent some time speaking about the fallacy of wanting a high win rate. I know that some ‘did not get the point’ – this blog is for you.

The key to investing/trading success lies with the Expectancy Return Formula:

(Avg$Win x Win Rate) – (Avg$Loss x Loss Rate) = Positive result.

The formula makes it clear that the first product MUST be larger than the second. So, how do we do this i.e. in periods of uncertainty? How do we as traders increase our profit potential while limiting the risk?

Figure 1 shows the way.

Entry at the mode zone (two vertical lines labeled RISK) will mean we take a trade when the probability of loss is at its trough and the probability of profit at its zenith. In addition, we take trades when the benchmarks are clearly defined e.g. we can say that if ‘XYZ’ happens we’ll stay in; if ‘ABC’ happens we’ll exit; and we can say that as for the rest, we’ll hold for another day provided we don’t get stopped out.

Figure 1 shows that when we take the trade at the mode of probability of success, our reward:risk ratio is at its optimum.

FIGURE 1: Optimum Profitability

That’s the theoretical picture. To attain this ideal in day-to-day trading, I take a trade when I feel I have 5 items in my favour. As an example let’s have a look at Figure 2, the 12-Month swing (yearly trend) on the S&P

1) The structure of the market: In the S&P, we have a potential 313 Outside Buy Signal (See Figure 1 and The Nature of Trends). I would view such a buy signal as to the left of the Mode of Probability. The context suggests that a failure at the Failure Zone has at least an equal probability of success as the 313 Outside Buy. Unless I could take a buy trade with a relatively low dollar risk i.e. within no more than one ATR 741, I’d bypass the buy trade for the moment.

2) A Price Zone to take a trade

3) The Price/Volume relationship:

The benchmarks I’d use is the average volume per bar as the market rallies to the Failure Zone (the preferred zone is the 66.67% and 50% provided that zone is confirmed by other zone projections):

• If the Avg Volume is at or less than 931,236, then the probability is there will be a Failure. In this case, I’d be looking to sell at the Failure Zone.
• If the Avg Volume is 1,724, 603 or greater, the market will probably reach the Primary Sell Zone at 1553 to 1452. In this case, I’d be willing to buy on a pull back provided the Reward:Risk Ratio is satisfactory.

4) Time: I use statistical estimates to provide a time and price window for the conclusion of a move. I also use some time ratios.

5) Momentum: I’d use Ray’s Clock (see The Nature of Trends)

Once in the trade, I’d use time, structural and price stops to keep the trade within the Optimum Risk Zone (the vertical parallel lines).

FIGURE 2 12-M S&P Cash

One idea I seek to impart in my teachings is the importance of keeping our minds open to data that do not support our decisions. ‘The Psychology of Intelligence Analysis’ points out one drawback of our brain’s use of mindsets: once we have made a decision, it takes a lot more effort to change our minds or to even take notice of events ‘prejudicial’ to the decision reached. Yet it is critical to a discretionary trader’s success to keep an open mind.

The current S&P structure is at a cusp. Keeping an open mind will allow us to take advantage of the opportunities created by the market. There are 3 possibilities. Here are the scenarios in my order of probabilities, with the most likely first.

1. A 1966 to 1982 type market (See Figure 1)
2. A deflation type market (see Figure 2)
3. A continuation of the bull market – for why this is unlikely, see Figure 3.

In Figure 1 we have a Yearly chart of the DJIA. Notice that at this stage we have not even exceeded the 1937 to 1942 pullback (52.55%). We need to see acceptance below the Maximum Extension of the 14198 to 7197 range to negate this scenario i.e. see acceptance below 5795. If this scenario proves correct, the sideways market should end no later than 2017.

Given that the 60-month bull market is still intact, this is my preferred technical analysis scenario.

FIGURE 1: 1-Year DJIA

Figure 2 shows the deflation scenario confirmed on acceptance below 5795. This calls for the bear market to end around 2025 (see Figure 3) around DJIA 760.

FIGURE 2: DJIA 1931 to 2007

Figure 3 shows the stats pertaining to bear and bull markets since 1802. I am treating the DJIA high in 2000 as the orthodox termination of the bull market that began in 1982. If that is the case, in 2000 we ended a bull market that lasted for 18 years and gained 14.8% (adjusted for inflation). Such a bull market is unlikely to have a mere 8-year correction. For this reason, I rate the resumption of the bull market before 1911 an unlikely event.

Statistically, the minimum correction for scenario one (sideways) would be 11 years i.e. the correction would end in 2011. In the case of scenario two (deflation), the minimum correction would last to 2018.

FIGURE 3: Bear/Bull Stats

I started this piece by saying we need to keep an open mind. So what benchmarks do I need to see to define which scenario is likely to be taking place?

The key will be the DJIA’s Failure Zone (33% to 67% in Figure 4). If this sideways market is to fail, it will fail there (see Figure 4). Another benchmark will be the Xmas Rally. According to MRCI’s seasonal charts, the 2nd week of December should be a low; this low is to be followed by a rally to the last week of December.

If we do get such a rally, the volume per bar will be instructive in telling us if there is to be a failure. If we see lower volume per bar up, then we can expect the failure to occur; equal or higher volume than the down leg will confirm scenario one.

Stay tuned.

FIGURE 4: Failure Zone DJIA