Today’s Trading Lesson From TradingMarkets

Editor’s Note:

Brice

Daytrade Risk,
Big-Trade Reward

By Mark
Boucher

One of the most reliable and profitable patterns a stock or futures contract
can develop is a strong breakout of a flag-type trading range. A flag trading
range is a pattern where price runs up strongly and then consolidates for a
period of time before breaking out to the upside again. Particularly in stocks,
but also in futures, strong breakouts from flag trading ranges often lead to
prolonged moves higher. In fact, simply trading flag trading ranges in their own
time frame can be a very profitable endeavor.

However, for the purposes of short-term trading patterns, we will discuss how
to take advantage of these situations by mixing time frames, which allows you to
position with low, short-term bar risk distance between an open protective stop
(OPS) and an entry point, and at the same time participate in a move that is
many, many times initial risk that can develop into a longer than short-term
move. This is how capital can be multiplied many-fold without significant risk:
by finding low-risk trades that return many times that risk, and by finding
short-term risk opportunities that have the potential to develop into
longer-term moves.

For our examples, we first look at daily bars and then go to 30-minute bars
for the pattern. In other words, we screen a 30-minute pattern with a
longer-term bar chart. Even shorter-term traders could do the same thing on a
shorter time frame. You could look at a 30-minute bar chart to screen 5- or
10-minute bar patterns, for instance. The key point is that you are entering
with entry points set on a shorter time frame–and you may be able to capture a
move that develops into a longer time frame run-up in order to profit many
multiples of your initial risk.

The pattern I will show you is called the “flag within a flag pattern.”

Understanding the pattern

As a brief side note, investors using these patterns should understand that
they can achieve better results, both in terms of reliability and profitability,
by concentrating on commodities that meet our runaway criteria. Adding these
filters is certainly not necessary to profitably trade these patterns, but it
does enhance results rather dramatically.

We’re looking for stocks making new highs after having just broken out of at
least a 17-day flag trading range pattern. Again, the flag pattern is a sharp
run-up in price followed by a consolidation for 17-plus days that does not
retrace 38 percent of the initial run-up. We are looking for prices to break out
on a gap from the prior close or on a large-range day

Let’s look at an example, shown in Figures 1 and 2. Tuboscope, Inc. (TUBOS)
began to make the 52-week new high list in mid-June 1997 when it broke out of a
six-month trading range (it also met our runaway-with-fuel criteria). It moved
up from a low of 11 1/2 on 2/11 to 20 3/8 on 7/3, an 8 7/8 point move. From 20
3/8 it developed a consolidation pattern that declined to 18 5/8, a drop of 1
3/4 points, or 19.7 percent of the prior up move (<38 percent). The
consolidation lasted 17 days or longer before a breakout developed on a gap on
7/23. Our criteria for a flag breakout on a daily chart were met.

Figure 1. Tuboscope (TUBOS), daily bar. Source: Bloomberg.

Figure 2. Tuboscope (TUBOS), 30-minute bar. Source: Bloomberg.

Note that we need to first find daily flag patterns making new 52-week highs
before looking for what will ultimately be our two shorter-term patterns. In
this way we are adding a short-term element to an already explosively profitable
situation.

Now, an investor could certainly buy the breakout and use an OPS just below
18 5/8 with pretty low risk for a decent trade. But we’re going to show you how
you can get far more bang for your buck by adding a short-term pattern to this
already lucrative setup. Look for stocks that have made new highs and have
consolidated in a flag pattern for 17 days or more without retracing 38 percent
of the prior up move, so as not to miss an opportunity.

The short-term flag within the longer-term breakout works as follows. Once
you get alerted of a breakout or a new high following a breakout, go to the
30-minute chart. Often, following an initial upthrust half hour, a stock will
consolidate, making a short-term flag pattern of four bars or more that does not
retrace 38 percent or more of the last 30-minute upswing. A breakout above the
high bar of this 30-minute pattern is the entry signal, with a protective
stop-loss below the low of this 30-minute flag pattern.

TUBOS, for example, broke out on 7/23, consolidated via a 30-minute
stochastic correction and rose to new highs again on 7/28. It made a flag
pattern, consolidating between 22 1/4 and 21 3/4 for eight 30-minute bars,
before breaking to new highs again in the second half hour of 7/29, where it
could be purchased at 22 3/8 to 22 5/16 with a 21 5/8 OPS–a risk of only 3/4
points. By the end of the day the stock had traded as high as 24 1/4, closing at
23 5/8. Traders could exit half the trade when original risk is first covered,
making the trade a breakeven at worst, and let the rest ride. This is one way to
build a big position with low risk in a runaway stock.

A trader risking 1 percent of capital per trade (risk = distance between
entry and OPS) and starting with a $100,000 account could have risked $1,000, or
if we allow a generous slippage and commission estimate of 1/4 point, could have
purchased 1000 shares. Taking a quick half-position profit at 23 3/8 to clear
risk would have yielded $475 after commissions. Open profits at the close were
$625 on the remaining half position–a profit of 1.1 percent in a day, with the
strong possibility of being able to hang on to 500 shares of a stock that has
just broken out of a trading range and is likely to move much higher with no
more risk to original capital (at least theoretically) because the profit taken
on the first half position more than covers the risk on the second half. We have
just locked in a large potential profit with very little risk. A portfolio with
several of these trades can return large profits with very little risk, which is
what we’re trying to accomplish as traders.

Remember that once a stock or future emerges from its flag base it will go on
our watch list for this pattern each time it moves into new 52-week high
territory until one of the following happens: it gets overvalued (stock: PE > =
its five-year growth rate or its current quarterly earnings growth rate);
over-owned institutionally (40 percent or higher institutional plus bank
ownership of capitalization); overbought (weekly, daily, and monthly RSI above
85); until the trend turns (below the 50-day moving average is good rule of
thumb), or until the Relative Strength drops below 65 on a reaction or below 80
on a new high.

In other words, once a stock breaks out of a flag and does not violate any of
the above criteria we still watch for internal 30-minute flags on each new
52-week high because the stock still shows strong potential for a big move. The
prime time to buy is just after a breakout, but one can continue to watch for
this short-term pattern even if the stock has broken out recently and continues
to be one of the strongest in the market as shown in the following example
(Figures 3 and 4).

Figure 3. CTS (CTS), daily bar. Source: Bloomberg.

Figure 4. CTS (CTS), 30-minute bar. Source: Bloomberg.

CTS first broke out of a trading range flag in early April and traded sharply
higher making the new high list almost daily into early June, where it formed
another flag and broke out in early July. On July 23 it made a strong close to
new highs on a wide 30-minute bar. It was still undervalued via its quarterly
and five-year growth rate compared to PE, still owned less than 40 percent by
institutions, not yet wildly overbought on a weekly, daily and monthly basis all
at once, was definitely in a strong up trend with RS above 90 (and making new
highs yet again).

It clearly qualified for a potential short-term internal flag pattern. The
next morning it consolidated for five 30-minute bars below the highs of the last
bar of July 23 (75 1/2) with a low of 75 1/8. When it broke above 75 1/2 if you
bought the high of that half hour you got in at 75 5/8 and could have used a 75
OPS–a risk of only 5/8 of a point. 1100 shares could be purchased with 1
percent risk. July 24 closed at 79 13/16 a profit of 4.19 points or almost five
times your initial risk! If you took quick profits on half the position at 76
5/8 you still ended up over $2,600 on the day (2.6 percent) and have no original
capital at risk in a very explosive stock that has continued to move higher.

Using the pattern in futures and in bear markets

What about bear markets and what about futures? Surely if the pattern is
robust it should hold up in runaway down vehicles as well as runaway up markets.
Our next example should help answer those questions. If you run a relative
strength analysis on futures contracts around the globe (which you can do with
Investigator search function) you can pinpoint the strongest and weakest futures
just as you can in stocks. One of the weakest futures (RS < 5) at the time of
this study were the D-Mark futures. There was an excellent recent flag within a
flag pattern in this runaway bear market.

Figure 5. D-mark, daily bar. Source: Bloomberg.

Figure 6. D-mark, 30-minute bar. Source: Bloomberg.

On June 30, 1997 (Figures 5 & 6), the D-Mark gapped down to a new low
breaking out of a daily chart flag pattern. It continued to decline thereafter.
On July 22 the D-Mark gapped down on the open to a new low–with a new low,
clear very bearish runaway characteristics, and super-low RS, traders should be
on the lookout for bearish flags within a flag in this market.

The D-mark consolidated and then made a big thrust to new lows on the seventh
30-minute bar of the day. It then made a four-bar flag pattern on the 30-minute
chart off of 5515 low and a rally to 5528. Traders with a $100,000 account would
have sold five contracts on a 5514 stop with a 5529 OPS for a 15-tick risk,
about $200 after commissions per contract risk. The market closed at 5502 and in
order to cover risk traders would have taken a quick $400 profit after
commissions on three contracts, keeping two open with risk more than covered by
profits taken. With the D-Mark continuing to collapse and at 5385 today, traders
who took a 1 percent risk on 7/22 would now have $3200 (3.2 percent) in open
profit on those remaining two contracts with large potential profits on a
break-even, worst-case situation.

When a futures contract is especially bearish we can apply the same pattern
in reverse for short signals. And when the stock market eventually turns lower
in a bear market, we can do the same in stocks. Until such time that new 52-week
lows move above new 52-week highs, we recommend investors stick with bullish
patterns in the U.S. stock market.

The bottom line

The bottom line is that this simple pattern allows us to get in on a good
short-term day-trade, and also leaves open the potential of a much more
lucrative opportunity in the some of the most explosive stocks or futures
available in the markets. It allows us to position heavily in the strongest
stocks, but in a way that takes very small risk to original capital and yet
still allows traders to profit at sometimes astronomical rates.

If you can’t take enough profits the first day (or second day if it is
entered in the second half of the day) on half the position to cover the risk on
the remaining half then get out and wait for another opportunity. Cautious
traders may only want to take trades in the first half of the day so they don’t
have to take overnight risk unless they have large open profits and have booked
profits on a day trade in the first half position. More cautious traders may
also want to book the whole profit at the close unless the close is at least as
far above your entry as your original OPS was below it.

We hope you can watch and profit from such a pattern m the future, and that
it becomes a key arrow in your quiver of short-term trades toward maximum
profits. In addition, we hope short-term traders note that the huge upside
potential of this trade comes from taking a risk on a short-time frame and
getting into a move that can last much longer and move up many, many times that
small initial risk.

Probably the biggest problem with short-term trading is that it is rare to
get a reward 10 or 20 times risk because you have to get out at the end of the
day. However by positioning in vehicles set to move up sharply on a daily basis,
by taking quick day-trade one-half profits, and by only staying in overnight
when a large profit exists at the close, short-term traders can both book
reliable trades consistently, and often find a ten-bagger without taking very
large risks–and without having to wait years to realize it by using this
pattern.