Blog for Trading Success

In 20 years or so of mentoring, one mistake newbies make stands heads and shoulders above the others: they mistake the map for the territory. What did Ray say? What map, what territory?

The map is the best guess we make about future market direction; the territory is the reality of what the market is doing. Add to this mistake, the human tendencies of hindsight bias and selective perception and we have the reason why so many of us fail at trading.

Let’s see how the errors operate. I’ll use the analysis on the video to illustrate the points I am making (http://www.tradingsuccess.com/stcuser/market-profile/03-03-2008/mp.html). The analysis for trading of March 4, 2008 was:

1. I had interpreted the price action until the ‘J’ period as one where there would be trend day down.
2. On the video, I expressed concern that the new low had lacked ‘downside umph’. For me this raised the red flag that the analysis was incorrect. I know the ‘K’ period for the ES often produces acceleration or rejection of the day’s trend. So, when in the ‘K’ period the market started to rally, I had solid reasons for believing my analysis was wrong. Because the potential for a reversal occured at previous support, I covered not only the shorts I had instituted that day, but also the ones entered on February 28.
3. I received posts here and privately telling me that they disagree with me - that the Day Type for March 4 was a trend day down.

Now here’s the point. The posts were 100% right - I did get it wrong. But we knew that only after the event! Similarly, if I had been looking for rejection off the 1310 low, I’d only have known I was right after the event. This is the crucial error newbies make. They assess their performance after the event has completed. If we view our performances in that light, we never learn.

It’s really more important to ask:

• Given my experience and knowledge, was there anything that occurred prior to the ‘J’ period low that would have told me that the market was ready to rally?
• Assuming I don’t have prescient powers, can I learn anything from the event that will allow me to correctly identify a Neutral Day earlier than I did?

In this way, we add to our store of knowledge, knowledge that allows us to continually update our scenarios as fresh information comes in. To do this effectively we need to avoid selective perception of information.

I experienced a great example of this yesterday.

On March 4, we ended up with a Neutral Day closing in the upper extreme. This suggested more upside until at least the end of the Initial Balance. On March 5, the market has an open-gap that is not closed after the first 60-minutes of trading. In addition:

• We have a Reverse-Open up (suggests a Neutral Day)
• We opened above the previous day’s Value Area and
• The Initial Balance had a range of 17 points. (The Normal Range is about 22 points).
• We are in a congestion range between the 1400 high and 1310 low.
• The market had failed to breakdown on a test 1310 generating what I call a 313O buy signal.

Based on the range of the Initial Balance, and the context (within the sideways boundary), I opted for a Normal Variation Day as the most likely event. The second most probable event was a trend day up (market opened above value, confirming the Neutral Day). I thought this less likely because there is CPI on Friday and the buying delta volume for March 4 suggested short covering than fresh buying.

I dismissed a strong possibility of a Neutral Day because of where the market was trading. Neutral Days tend to occur as test days at end of trends or on the boundaries of congestion; they seldom occur in the middle of congestion ranges.

Figure 1 shows the Profile to the ‘F’ period.

FIGURE 1 March 5

In the ‘F’ period the market made a new high on light volume and then returned to congestion - this suggested a high was in. At this point, I revised the probability of a Neutral Day from low to moderate. The ‘F’ period extended the range to a mere 17 points. This was below the normal of 20. Given the price action of the March 4, I thought we’d do at least 20 to 25. So we were either going to have a below Normal Range Day (I rated this as the highest probability) or a Neutral Day.

When in the ‘H’ period we covered the ‘A’ extreme on volume, the probability of a Neutral Day became the best-case scenario. I range extension had three possible targets:

• The normal range 1345 - 20/25 = 1325 to 1320
• The close of the 4th 1327
• The top of value 1322 - 1321
• The inflection point at 1319

If I were day trading, I’d have passed with the ‘go with’ break of the low at 1328. My stop would have been above the midpoint (1327) and the best would be a 10-point gain. On the other hand, if I waited for the end of the range extension, I’d have a 3 - 4 point stop and since the target would have been the POC, the reward:risk would have been at least 1.3:1: much better odds and possible more. For example, if the market bounced off 1327, I’d enter say 1330 risking 1324.75 (6 points) for a target to 1338 (8 points); if it bounced off 1319, I’d enter 1322 risking 1316.75 (6 points) for a target 1338 (20 points).

Figure 2 shows the options.

FIGURE 2 Risk Reward

For those curious Figure 3 shows the completed profile for the day.

FIGURE 3 EOD Profile

• Notice that my initial assessment of the market was wrong. But as the day developed and new information came in, I reassessed the probabilities. At the end, if I were trading, I’d probably have made around 10 to 12 points. Notice too the superiority of the Profile to other tools when it comes to entering the market. The Profile gives us a greater probability of success by using volume as trading occurs rather than waiting for the end of a period.

If you are a day trader, assessing reality correctly in the light of new information is a key to success. What the market looks like at the end of the day, doesn’t matter after a day’s trading: by then you have closed shop!

Tomorrow I am going to the other end of the spectrum and introduce the Ray Wave.

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