Applying Risk Parameters: Would You Take This Trade?

July 12, 2010

Mish's Daily Articles

By Mish Schneider

I've been trading for 30 years. I spent 12 years on the New York Commodities Exchange with only a roll of graph paper to create my own point and figure charts. The remainder of those 18 years, I've been planted in front of several computers all at once, tricked out with every conceivable high tech advantage. Seriously. I have access to scanning tools that find, sort, rank, and dissect financial instruments in every timeframe, plus automated trading strategies that can essentially trade for me. Yet, unless I implicitly understand the risk and the expected gain of the trade before I hit the "buy" or "sell' button, I cannot call myself a professional trader nor can I make money even with disposal to all of the tools under the sun.

Let's use NFLX as an example of both a long and short trade over a 2 day period-July 7th and 8th. On the daily chart, notice that on July 6th, NFLX was trading underneath the 50 day moving average, confirming a phase change (last week's article) from bullish to warning. The following day, the bias is negative, but the market comes in higher and NFLX crosses back over the 50 day moving average. Now, the questions begin: Should I trade with the trend and wait to sell a rally? Should I buy it? For what timeframe: daytrade, miniswing, swing trade? What other points must NFLX clear? What do I see as the upside potential? Am I going to use the 5 or 30 minute opening range breakout? And, the single most important question: How much am I going to risk?

NFLX Chart

Looking at the intraday one minute bar chart on July 7th, within the 1st minute, NFLX puts a low of 107.28 in place. After 5 minutes, the high is 108.84, still under the 50 day moving average of 109.20, therefore, still in a negative trend, yet, above the prior day's low. After 30 minutes, an opening range high of 109.65 is in place but NFLX does not confirm the breakout until it trades above there for 5 consecutive minutes (see chart).

NFLX Chart

You decide to buy, but most likely will not get filled until 110.15. As a daytrade, the risk is to under the low of the day or nearly $3.00. The average true range of NFLX is $6.00. That's too much as we like to keep daytrading risk to 1/4-1/3 of an ATR. As a miniswing trade lasting from hours to a day or so, (The Complete Swing Trading Course by Marketgauge), the risk parameters are fine (1/2 ATR). But the real stop should be underneath the prior day low or 106.29 as it is so close, which makes the risk $4.00 or 3/4 of an ATR. Now, given that Nasdaq is in a distribution phase and NFLX had just confirmed in a warning phase the day prior-would you be willing to risk that much while basically bucking the trend? Maybe, if one was expecting a big countertrend rally.

However, most stocks are in a bearish or weak phase. Furthermore, the previous day high is at 111.40, so now you are buying with a huge risk and substantial overhead resistance $1.35 away from the entry price. Moreover, the 10 day moving average is at 113.07, another major point of resistance so even if NFLX takes out previous day high it has maybe another $2.00, which makes the risk/reward less than 1:1 on a daytrade. Not good. Of course, in hindsight, NFLX surged to 118.50, but that was extraordinary. If you follow a disciplined system, you can't possibly expect to always catch unusual moves when the risk is so out of whack to begin with. No regrets. Why? Because if the opposite happened and the market had failed, you would have been long against the overall trend, and lost way too much compared to the reward.

The following day, the same issue occurred in reverse. NFLX made a high of 122.75, the sell signal came under the 30 minute opening range low or 119.36 but did not confirm on time or price until 118.94, and now the risk to the highs is nearly $4.00 once again. The only difference is that a short would be in line with the overall trend of the market, but now, out of synch with NFLX , which had closed above both the 10 and 50 day moving averages the day before. Again, bucking the trend of the stock with a risk that doesn't make sense for the reward. Are you going to miss these trades when they have more follow through than expected? Most definitely. But, will you make more money than you lose in the long run by trading intelligently? Absolutely!