Tuesday, January 06, 2009

Defining Profit Targets and Formulating Targeted Trading Plans

In a past post, I wrote about how I use pivot-based support and resistance points to establish price targets for trade ideas. The basic approach is to define potential targets in advance and then use unfolding price/volume/indicator action to handicap the odds of hitting those targets. For example, once I see the Cumulative NYSE TICK trending higher, I will enter a long position to hit the R1 and R2 price targets. (Please consult that earlier post for details re: conventional ways of calculating the upside R1/R2 and downside S1/S2 targets).

In general, I've found those conventional ways of calculating targets to be helpful, but not optimal. My current methods of calculation are based on historical analysis going back to the year 2000. Since that time, the P pivot level from the previous day has been touched by the market during regular trading hours about 75% of the time. The market touches the S1 *or* the R1 level calculated from the previous day's data about 75% of the time. The market touches the S2 *or* the R2 level about 55% of the time.

Let's say that SPY opens near its pivot (P) level. The market chops around in the first half hour of trading and then moves briefly lower on negative economic news at 9 AM CT. The NYSE TICK, however, goes only modestly negative and quickly bounces back to positive territory, as SPY moves above P. Noticing the upward trend in TICK and the themes of risk-seeking across related asset classes, I wait for the first pullback in TICK that stays above P and then go long SPY with a target of R1. If TICK turns negative and we move below P--a sign of a range day--I will stop my position with a modest loss. If we continue to see buying interest, I will consider adding to the position on the way to the target(s) on pullbacks in TICK.

Should the upswing occur with strong TICK on enhanced volume, the odds of hitting R2 are enhanced, and I will leave at least a piece of the position on to hit that target. Because volume is closely correlated with volatility, keeping tabs on relative volume--how today's volume compares with the 20-day average--is quite useful in estimating the odds of hitting R2 or S2.

My newer, proprietary way of calculating P, S1/S2, R1/R2 adjusts the targets for the market's volatility, so that I'll naturally seek more modest moves in slower, narrower markets and larger moves in more active, volatile markets. Because I target the exits in advance, I'm better able to gauge the risk/reward of each trade by comparing how much I'm willing to lose in the trade (the distance to my stop point) with how much I stand to gain. This makes the target points very useful in trade planning.

For traders who might be interested, I'll begin posting the SPY target levels for the day's trading each morning as part of my Twitter service. Also included in the morning Twitter posts will be the usual indicator data (new highs/lows, Demand/Supply, % stocks above moving averages, Technical Strength readings for the basket of 40 stocks). By comparing the most recent day's data with the data from the prior day, you can gauge whether the market is gaining or losing strength day over day. As a rule, I'll look for strong/strengthening markets to hit R1/R2; weak/weakening markets to hit S1/S2; and mixed/range markets to revert toward P.

Future posts will illustrate the use of these target calculations in trade setups. The morning indicator and target data will appear under "Twitter Trader" on the blog page prior to the market open, or you can subscribe via RSS free of charge.
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6 comments:

Jorge said...

Dr. Steenbarger,

Thank you for this welcome addition.

If I may ask, without disclosing the exact calculation of your proprietary pivots, could you please explain how you adjust for volatility (I understand that the day's volatility is inherently a part of the pivot points formula, so do you use a longer measure of the ATR, the VIX, a deviation from average volume...? Am I missing something?). Also, do you see a correlation between the times (and/or length of time) the TICK hits extreme levels (800, 1000, >1200) and volatility for that day?

Best trading,

Jorge

SSK said...

Hello Brett, thanks for the inclusion of the Pivots! SSK

TelespallaBob said...

These posts are the most usefull pieces of trading lesson around, many thank's Brett.

ScottTrader said...

You are really stepping it up Brett. Our community is lucky to have you.

SSK, you are a real blessing too.
Scott

Charles said...

Dr. Brett, I just started following you on twitter...great thanks for posting your SPY levels.

I see you also post 20-day new hi/lo's...so I was wondering if you know of a way (in Tradestation or something) of calculating new hi/lo's for other timeframes, like 5 days or 3 days...again, thanks for helpin' out man!
-charleS

kevin said...

Dr. Steengarber,

Thanks for this post. It helps take emotion out of the trading to have definitive decision points. Have you run any statistics on the conventional method? How does one get access to the proprietary method?