When Weak Hands Fall, Opportunity Knocks: Trading The Trend Knock-Out

  • January 6, 2001
  • Dave Landry

While
it’s a good idea to trade in the direction
of the trend, I’ve learned you’re much better off waiting until
the weak hands are knocked out of the market before entering yourself.
The reason is, you never know when these traders are going to dump their
positions and take you out with them. Trend
Knockouts (TKOs) identify strong trends from which the weak hands have already
been knocked out. By placing your order
above the market, you have the potential to capture profits as the trend
resumes.

Here are the rules
for Trend Knockouts:

For Buys: (Short
Sales are reversed).

  1. The market
    should be in a strong trend as defined by a computer based indicator such as

    ADX     >= 30 and +DMI > -DMI or in a strong uptrend as defined Trend
    Qualifiers.*

  2. The market
    should make at least a two-bar low. Buy tomorrow or the next day (allow
    yourself two days to get filled), 1/16th above today’s high.

  3. Place a
    protective stop the low of the knockout bar (2).
    If this is more than 5% away from your entry, risk no more than 5% of
    the stock’s value.

  1. Virata
    Corp.
    (
    VRTA |
    Quote |
    Chart |
    News |
    PowerRating)     qualifies as a strongly trending stock by having an ADX of
    52 and +DMI > -DMI. Other
    Trend Qualifiers include its doubling in value in two weeks and having wide
    range bars and strong closes in the direction of the trend (a), (b), (c),
    (d).

  2. The
    stock sells off and takes out (trades below) the two prior lows.
    Buy tomorrow at 71 13/16, 1/16th above today’s high.

  3. The
    stock     trades at 71 13/16 and
    we go long.

  4. Because
    the low of the setup (61 ¼) is more than 5% away from our entry, we place
    our protective stop at 63 3/16 for a risk of 5%.

  5. The
    trend     resumes as the stock
    gaps open and explodes over 30 points higher on the following day.


Here we have an
example of getting filled on the second day.

  1. Gene Logic (GLGC)
    qualifies as a strongly trending stock by rising more than 300% in less than
    a month and by having an ADX of 63 and +DMI > -DMI (not shown).

  2. The
    stock makes a two-bar low. Buy
    tomorrow at 79 7/8, 1/16th above today’s high.

  3. No
    fill.

  4. The
    stock trades at 79 7/8 and we
    go long.

  5. The
    low of the setup (68) is more than 5% away from our entry so we place a
    protective stop at 75 7/8 for a risk of 5% of the entry price.

  6. The
    trend resumes and the stock explodes higher over the next few days.

  1. Abgenix
    (ABGX) qualifies as a strongly trending stock by having an ADX of 47 and +DMI
    > -DMI (not shown). Other Trend Qualifiers include its more than doubling
    in less than three weeks and having wide-range bars and its having strong closes in the direction of the uptrend.

  2. The
    stock makes a two-bar low. Buy tomorrow or the next day at 68 9/16, 1/16th
    above today’s high.

  3. The
    stock trades at 68 9/16 and we go long.

  4. The
    low of the formation (57 7/8) is more than 5% away from our entry so we
    place a protective stop at 65 1/8 for a risk of 5%.

  5. The
    trend resumes and the stock trades over 20 points higher over the next
    six days.

Here’s another
example of Gene Logic (GLGC) but this time, it’s on the short side.

  1. Gene
    Logic qualifies as a strongly trending stock by having an ADX of 31 and -DMI
    > +DMI (not shown). Other Trend Qualifiers include its losing more than
    80% of its value in a month and its having wide-range bars and weak closes.

  2. A
    two-bar high. Go short tomorrow at 43 7/16, 1/16th below
    today’s low.

  3. The
    stock trades at 43 7/16 and we go short.

  4. Because
    the high     of
    the setup (51 ¾) is more than 5% away from our entry, we place a protective
    stop at 45 5/8 for a risk of 5%.

  5. The
    downtrend resumes and the stock drops over 24 points in seven days.

Q&A

Q.
How did you discover this pattern?

A. Many times,
I would get stopped out of positions, only to watch in frustration as the trend
resumed.

Q. Why not
just re-enter when the trend resumed?

A. I now know
that second entries after being stopped out, are often the best entries, but I
didn’t always know that. Someone once said that a loss is not a loss as
long as something is learned from it. I learned TKOs from getting stopped out .

Q. So the
losses were painful?

A. Yes. I
found it aggravating that I sold stock or futures at a bargain to someone who
was now making money. I would eventually “throw in the towel” and jump back
into the market, only to get knocked out one more time.
I knew I had to come up with a better way to enter strongly trending
markets.

Q. The
setup calls for “at least” a two-bar low. Does a three-bar low or greater
work better?

A. Yes, in
general, the more players that are knocked out the better. You are just less
likely to get filled.


*Trend Qualifiers include
“clues” that a trending market leaves behind. These include gaps,
laps, base breakouts, new highs, percentage moves, strong closes, wide-range
bars (thrusts), proper order of moving averages, positive slope of moving
averages and Daylight (lows greater than moving averages. Source: Dave
Landry On Swing Trading.

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