Price action trading: Avoiding the fundamental folly

August 31, 2014 07:00 PM

Ed Note: This article is Part 2 of a series of 6 articles on price action trading. Click here to read the first part: Price action trading: The basics.
 

A trader often loses money because he takes a trade with one goal and manages it as if he entered with a different goal.

For day traders, this usually happens because the trader entered anticipating a subsequent price swing, but instead he managed the trade like a scalp. For example, say the trader shorted the EUR/USD in the forex market at what he thought was a strong top.  He was planning on holding for a 100-pip (tick) profit, while using a 20-pip protective stop, but instead the trader exits whenever he had a 10-pip profit (ensuring he will lose money over time).

The trader might consistently convince himself that the price action unfolded differently from what he expected, and this change in his premise justified changing the trade from a swing to a scalp. 

However, if he does this with frequency, he will lose money. A swing trade usually has a low probability of success, but the expected reward is many times greater than the risk, and that creates a positive Trader’s Equation. However, if the trader instead accepts a profit that is not much bigger or less than his risk, he will lose money over time with low-probability trades, which most swing trades are.

If a trader changes his mind and grabs a scalper’s profit, he is scalping, not swinging. Plug some numbers into the Trader’s Equation. A typical swing setup has about a 40% chance of success. If the trader is risking 10 pips to make 10 pips, he will lose money. To make money on a scalp, a trader needs a high probability of success (60% or more) because his reward is usually about the size of his risk.

At any instant in any market, a trader can trade profitably by buying or shorting for a swing because the probability of success for a profitable long or short is rarely ever less than 40%. This means that if he manages his trade correctly and holds for a reward that is at least twice as large as his risk, he will make money over time. Traders should only scalp if the probability is 60% or higher. Most traders cannot consistently maintain this high a probability and therefore should swing all of their trades. (My definition of a swing is any trade where your intended reward is at least twice as big as your risk.)


Scaling entries

Some experienced scalpers win more than 90% of the time, but this is rare, and usually involves scaling into and out of positions. Many experienced traders scale into trades to increase the probability of their position’s success (see “Improving your odds,” below).

However, beginners should be careful about this because they almost always scale into the wrong trades. A common example is scaling into what they believe is a pullback when they do not realize that it is actually a reversal. They can quickly lose far more money than they imagined was possible, but that makes sense; if you are trying to get more probability, you have to pay for it with some combination of increased risk or reduced reward.

Two 2013 articles in Futures highlight scaling into trades: one for scaling into trends and the other about scaling into reversals. You can find them in the Futures archives.

Time perspective

When discussing opportunities on daily and weekly charts, traders usually refer to themselves as long-term traders or investors, rather than swing traders or scalpers, but the idea is the same. An investor often takes low probability trades, which means that he might lose 60% or more of the time. However, if his average reward is several times greater than his risk, he will be profitable over time. A trader plans to hold his trade for only a day to a week, and is going for a small reward relative to his risk. He can only do that if his probability is 60% or higher. 

This brings us to the concept of fundamental analysis. Over time, fundamental information can only benefit investors who hold positions for months at a time. Although you often hear traders on television mention fundamentals when they place trades lasting for a few days, they do not realize that they erroneously believe that the fundamentals improve their profitability. The fundamentals do not; they are mentioning the fundamentals because of tradition on Wall Street that makes them fearful of losing respect for being purely technical traders.

Technical trading was disparaged for generations, but it is slowly being accepted as a profitable way to trade. Most high-frequency trading (HFT) firms use technical information exclusively, and many are making fortunes. This has gone a long way in making the Street and the public accept the proposition that technical trading can be profitable long term.

However, HFT trading is done by computers, and there is still resistance to the idea that many traders can trade profitably manually using technicals alone. The reality is that almost all profitable traders who hold their positions for only a few days or fewer are making their decisions entirely based on price action, even though most do not realize it. They want to be seen as mainstream members of the Street, where all of the firms are still dominated by a fundamental mindset, and feel compelled to find a fundamental reason to support their trade.

Over time, this fundamental bias will disappear, and traders will feel free to admit to themselves and to their friends that they are getting rich from price action trading alone.
 

Short-term gains

As a day trader, I am out of most trades within 15 minutes to an hour, and this means that fundamentals are totally useless for me. Fundamentals ultimately control the direction of any market over the course of months to years, but their impact on markets is far less clear than what the public believes.

Nobel Prize laureate Bob Shiller got it right when he said, “The whole idea that the stock market reflects fundamentals is, I think, wrong. It really reflects psychology. The aggregate stock market reflects psychology more than fundamentals.”

If JPM is a better bank than a competitor, it is worth relatively more. In simplest terms, its stock will usually have a higher price per dollar of earnings. However, if the overall economy is falling apart, its P/E ratio will fall, meaning that its price will fall, even if its earnings are good. So, what should its price be? No one ever knows, but investors will likely pay more per dollar of earnings than they would for a bank of lesser quality. That is pretty much the extent of the impact of fundamentals, other than an occasional news event. 

The fundamentals have nothing to do with the actual price of anything, only with the relative price, and even then, their effect is too non-specific to be of any value to a trader, who will hold a position for minutes to a few days.

Traders should never pay any attention to the fundamentals or the news because neither can fully be understood, whereas the price action is undeniable to traders who know how to read it. If more dollars want to buy, the price will increase and anyone can see it on the chart. It does not matter if the fundamentals, news, or experts on TV say it should go down. Buy!

Simple solutions

New traders naturally look for information and ads as reasonable resources. They will invariably find many that are professional and showcase lots of indicators, concluding that complicated computer screens with lots of quote screens and charts filled with indicators are an inescapable necessity. However, professional traders instead talk about the market testing its old highs or a trendline, not complex tools. How could these traders ever be making money without all of those indicators? Because most profitable traders have a relatively simple approach, and it almost always is based on reading price action. They look for support and resistance and watch how the market responds when it gets there.

During a strong bull breakout, successful traders simply buy at the market and hold until the market gets to resistance, where they take partial or full profits. During a strong bear breakout, they take profits at support. Beginners are naturally afraid and are looking for protection. They look to gurus and indicators, hoping that these “gods of trading” will protect them from trading death and lead them to nirvana.

What they soon learn is that they still lose money, even when they follow the experts’ advice precisely. How can that be? The experts on television look rich and must be great traders. The indicators in the ads must surely be what the professionals use. What they do not realize is that trading is much simpler and the key to success comes from within. Traders simply have to spend a lot of time learning how to find support and resistance and how to structure and manage trades. Everything else is a lie.

Consider “Two views” (below). The first chart looks like it could be in an ad. There are a lot of colorful indicators, but they make it difficult to see what you are actually trying to trade: the price. The second chart is the same chart, but without indicators except for a 20-bar exponential moving average. Even that is not necessary to trade profitably. I use it because it acts as support and resistance and therefore reveals several trades that might not otherwise be evident.

The simple chart is how I look at charts when I trade, and most successful traders use something similar. Some traders might use tick or volume charts, or one or two indicators, but they all make most of their decisions based on price action. They want to buy at support and sell at resistance, and the best traders are extremely good at understanding the many forms that support and resistance take and how tests look when they are likely to be successful. The stronger the buying pressure, the more likely the market will go up, whether it has pulled back to support or rallied to resistance. The stronger the selling pressure, the more likely it will go down. 

The next installment will cover the market cycle, buying and selling pressure, and intraday gaps. You can read Part 3, Price action trading: The market cycle, here.
 

Al Brooks, MD, has traded for his personal account for 27 years. He is a regular contributor to Futures and the author of a three-book series on price action published by Wiley: Price Action Trading: TRENDS; Price Action Trading: TRADING RANGES; and Price Action Trading: REVERSALS. He also provides live intraday E-mini price action analysis and free end-of-day analysis at www.BrooksPriceAction.com. His 36-hour-long video trading course is available at www.BrooksTradingCourse.com.

About the Author

Al Brooks, M.D., is author of the Brooks Trading Course (27 hours of videos at BrooksTradingCourse.com), several books on Price action (Reading Price Charts Bar by Bar: The Technical Analysis of Price Action for the Serious Trader, Wiley, 2009, and the 500,000 word, three-book series, Trading Price Action, Wiley, 2012), and numerous articles in Futures Magazine. He also provides live intraday E-mini price action analysis and free end-of-day analysis on www.brookspriceaction.com.