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A big gap open is expected in the stock market Tuesday morning. I analyzed a selection of past -2% gaps lower. After careful analysis, I designed my anticipated pattern and game plan. My game plan is to buy after the open on a strength violation in the 5 min chart. A similar violation after 9 am is another buy target. A mid morning high will be established around 10am and I hope to have locked in a good 75% total position profit by then. I’ll look for some finishing strength after 1 pm for a strong finish into the close.

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Playing a breakout everyday can lead to nasty drawdowns. It would be nice to avoid the bad times. If you like playing blackjack then you are familiar with card counting. Card counters raise their bets when the count is unfavorable for the dealer. They are filtering the data and optimizing bet size. The same principle can be applied to trading.

How?

Look for a filter that is correlated to your pl. Once you find it use it to vary your bet size like a card counters. Since I play intraday breakouts, I found my filter in implied volatility. Implied volatility data is hard to find but I will give you a good substitute. A simple 10 day moving average of daily range is a great simple filter. It’s an easy filter to program as an indicator in a charting program or excel. When the average is rising, increase your size and let winners run. When he average is falling cut your size and play for targets.

The importance of risk management can not be overstated. But, what parameters aid the trader in his evaluation of his risk on each trade or as a portfolio? All trades should have a predetermined exit point at initiation. Rules governing the entry and exit will help alleviate the pressure of emotion and standardize trading results. It also creates the necessary parameters to measure risk and evaluate performance. This is our goal.

Stop Value
The initial stop controls the first measure of risk. Never risk more than 1 to 2% of total capital on any individual trade. Next, set a stop that includes a volatility factor. Initial stop size should expand as volatility increases and likewise contract as volatility decreases. The initial dollar amount will not change. For example, if you have 100,000 in capital then a 1000 stop for each trade is set. That would leave 1 lot for a $1000 stop in crude if your stop was 1.00. If the volatility contracts to 50 cents then your trading size will increase to 2 lots.

Risk Multiple

The initial stop size of 50 cents is your risk multiple or 1*Risk. This is your yardstick for every trade. The goal is to shave every loss to 60% of the initial risk. The average loss should be .6R. In our example that would be $600. As the trade develops, use multiples of the 1R to set goals. A simple goal for your trading is a 50% win percentage with an average win to average loss ratio of 2 to 1. If your average loss is .6R then the average win must be higher than 1.2R. The expectancy of this system is .3R= ( .3= .5(1.2)+.5(-.6) ). It doesn’t sound like much but it is enough to retire as a daytrader. Always know yout 1R and use it as a quick calculation to evaluate performance during the day nad during each trade.

How can volatility expansion help the daytrader?

It sounds like a simple concept. I have a little homework for you. Click on this Amazon link . It is a book by Toby Crabel. I’m sure that you have never heard of him. But he is a legend in the managed futures industry and manages 5 Billion dollars. He wrote a book before he started his fund and now the book is out of print. It originally sold for $35. It now goes for $700. Do you want to know the technique that is in that book? Volatility Expansion.

A Simple breakout technique

Use implied volatility to sort daytrading candidates. Stocks or futures that have had a contraction in implied volatility are prime candidates for breakout trades. Check the list daily for candidates. Conversely, isolate the high implied volatility markets for choppy trades and fade breakouts.

I will be expanding on all these concepts and more in the future.

After designing a breakout strategy, it’s time to improve the results. There are many methods but I will describe my two favorites. Filtering before the trade is one technique and recognizing a trend day is another method.

Filtering the days

Look for trends in the daily pl of your trading. Identifying a trend in pl that is either up or down is the goal. It’s always easiest to start with the losing streaks. Try and find correlating factors. Volatility is the most correlated for my system. After sustained upward volatility my overall pl and individual sectors level off at best or head into a drawdown. A simple 10 day moving average of daily range is the most basic filter. After a prolonged winning streak that shows a rise in the 10 day range, I will cut size and shift to more profit target trading. It’s time to be defensive. After range falls to a lower level I will return size to normal and be aggressive in my entry and let my profits run. The graph shows a 10 day mva on a daily chart

Trend Days

True trend days occur on 15% of the trading days. they have a basic pattern.

1. Price moves quickly away from the open.
2. Initial breakout trades will have little adverse movement.
3. Price will level off and then retest the breakout move to a higher level or lower level if the move is down.
4. Intraday breakouts will be with the trend or counter moves will be quick in time and price.
5. The time and price duration of consolidations will be shallow and consistent.
6. The finish will be strong in the direction of the trend.
7. The open and close will be on the opposite ends of the price bar and the overall daily range will be in the upper 15% of recent ranges.

As the trading day progresses use this as a checklist. The earlier you recognize trend days the better your results.

The close can be an important point to evaluate the market’s direction. But, the open is the most important number to watch all day. It has several important factors.

It shows the early morning strength or weakness

It is where the trading day begins and is the first barometer of market sentiment. A gap up shows strength but also sets the reversal trap. A gap up that fails will accelerate movement through the opening price

It can anchor any good intraday breakout system

The open is a great base for any price breakout. Adding and subtracting a value to the open serves as the basis of many intraday breakout systems. Analyzing a trend day shows a large range day with the open and close on the extremes.

It is the source of intraday stops

After the market moves towards a breakout, the open is the reversal magnet. Large funds will place stops there. If a long breakout falters a move to the open will accelerate through the price as funds exit through a small window.

Great poker players calculate the odds before every move. They determine the expected value based on their cards and their estimates of their opponents cards. If the number shows a positive expected value to call or raise then they follow the numbers. Great traders follow the same philosophy.

Expected Value Calculation

The essential calculation is the expected value. The probability calculation for expected value is below.

expected value=(prob of event1)(payoff of event 1)+ (prob of event2)(payoff of event 2)

The probability is the winning percentage of our trading

Event 1 in our equation is a profitable trade

Event 2 in our equation is an unprofitable trade

For example, If you average 50% winners and the winning trade is $1.0 and the losing trade is .50 then the expected value is below

.25=(.5)(1)+(.5)(-.5)

Goals

In order to maximize our expected value then we have three options

1. Raise our winning percentage
2. Raise our average win
3. Lower our average loss

Those are the goals. If you improve on any of those parameters then your results will improve.