During the AM Meeting I spent a few minutes discussing the importance of focusing on the “right stocks”.?? The right stocks are one’s that have the attention of a sufficient number of market participants to cause them to have powerful and clearly defined moves on many different time frames.?? Too often traders attempt to execute trades in every stock that they think has a good “technical” setup.?? I also mentioned a nice long setup in RIG that would be triggered if it got above 56.

One of the noobs decided that RIG was the right stock for him but he was in no way married to the idea of being long.?? He very well could have taken the attitude that “Steve said this” or “Steve said that” and used it as a crutch to not make the short trade that was warranted by the price action he observed.?? I love that!

He knew that 54 had been support last week.?? When he saw the weakness around 10:00 o’clock and RIG traded below 54 he got short.?? He told me that he wussed out initially but was able to get back in and make a 60 cent chop as RIG continued to trade lower.

Nice job of thinking independently and even better job of getting back into a stock that was offering opportunity.?? Perhaps more good things to come from this noob in the future.?? I will keep you posted.

Today, the Market appears set to open lower. The levels we are watching in the SPY are 111.00 and 111.80 (resistance), 110.00, 108.50, and 107.25(support).

Our best AM Idea for today, which we highlighted in our AM Meeting is to buy ORCL on a pull back at 24.30.

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I am on much-needed vacation this week, so I will not be blogging or trading.?? As you can probably tell from my posts, I have been doing a lot of thinking about how to keep improving my trading lately, and I have spent a lot of time going back through my old notes and early trading journals.?? In lieu of writing a blog post, I want to share something I wrote in late 2002 in the form of a letter to some trader friends of mine who were struggling to achieve consistency along with me at the time.?? I had just come out of the “Eliott Wave” period of my trading.?? (I think most technical traders have that period in our background.?? We’re not proud of it and we don’t like to talk about it.?? Most of us overcame it, and we’re probably better off for having gone through it.?? )?? This was the precise moment in my trading life when I sat down after a Thanksgiving holiday, and realized that trading was actually a heck of a lot more simple than I had been thinking.

Since 2002, the direction of my trading has been constant simplification to a point of practical minimalism today.?? I am sharing this document, with almost no editing, for several reasons.?? One, it’s kind of funny to see the Crude Oil chart at $27!?? Two, that makes a very good point… this was 8 years ago, and absolutely nothing has changed.?? For all the structural changes we have seen in market microstructure, the big technical picture is absolutely unchanged.?? Lastly, I was right in what I wrote.?? I really was onto something… this is the fundamental, underlying structure that drives all price action–and it was even more simple than I thought.?? (And it’s kind of amusing to see me toying with ideas like maybe emotions have something to do with price patterns.)?? More on all of this when I get back from vacation, so without further ado, here is what I wrote to some friends in November, eight years ago:

======================================================================================

It is my proposal that there is a fundamental, underlying structure that is the same in all markets and all timeframes. Many writers have talked about waves in various contexts (Elliott, Gann, et al,) but the difference here is that I think this is actually much more simple than any of them would have you believe. I propose a “fundamental structure” is very simple and does not require intense study, complex wave counts, and does not depend on a litany of qualifications and exceptions. This underlying structure is immediately obvious when looking at any price chart in any timeframe, and should have real utility for any trader working in any timeframe. I hope what you see here will ring true and that your own observations will reinforce mine.

So what is this fundamental structure? Very simply, an impulse push, a retracement and another impulse in the same direction as the first. Graphically, it would look something like this:

The structure is exactly the same whether the market is in uptrend or downtrend'the only difference is that the structure is inverted. (For the rest of this, let’s forget about the downtrend for a moment and just work with the uptrend line.) Notice that there are two impulse waves (wave A and C), and one retracement wave that moves in the opposite direction of the impulse waves (B). Understand that this is just a rough schematic structure, but try to be very clear about the nuances of what I’m saying before we look at real market data.

The A wave has a sense of urgency to it. If the market has been dull and flat for some time, the appearance of an A wave is a welcome sign, and it feels like the market is coming back to life. Now, talking about how something feels may not seem very scientific, but it’s completely appropriate because I am starting to believe that these patterns appear as a result of trader psychology. I think that most of the patterns we see are not the result of manipulation by the floor traders, but are simply what happens when a lot of people have emotional reactions of fear and greed at different points in time.

It can be very hard to tell when an A wave is going to end or how far it’s going to go. Suffice it to say, one of the most amateurish trading mistakes is to buy the market near the top of the A wave and dump it in frustration near the bottom of the B. Been there and done that? I have several times this week already! Again, I think it goes back to emotions, and this is one of the main functions of the market: to create emotional reactions in the market participants. Be aware that trading according to these market-induced emotions is rarely going to be profitable. In fact, the purpose of the market is to generate emotions that cause the mass of market participants to do the wrong thing at the wrong time. We must understand this structure so that we can stand apart from the crowd! This is also why good trades feel uncomfortable sometimes. We are going against the emotional patterns of the market, but these patterns are designed to separate suckers from their money. A few last words on A waves: the slope and duration of the A wave provide a method to quantify the strength of the A impulse. Steeper and longer waves have more strength.

The B wave is a natural reaction to the A wave. B must follow A. It’s almost like a law of nature: day follows night, rest follows action, action follows rest, reaction follows action. An extremely interesting fact about B waves is that they seem to respect the ratios and proportions described by Fibonacci numbers. In other words, we expect the B wave to terminate at 38%, 50% or 62% of the length of wave A. Especially on shorter timeframes, retracements of 21% and 89% are also quite common. Though many times these points will be hit exactly and the market will turn, allow some room for noise and error. If the market is close to one of these areas start watching for a turn. Do not be upset if the market turns at 41% instead of 38%. This is all just a way of quantifying the market structure so that your brain can deal with it! You can simplify even farther and say that the B wave normally retraces 50% of the A wave, with a margin of error of about 10%-15% +/-. This statement will upset a lot of hard core fib traders, but it is the fundamental understanding. [2010 update: I was on track but a little sidetracked by all the Fibonacci ratios. I now look for retracements to end roughly within 1/3 to 2/3 of the length of the impulse wave.)

The character of the B wave tells us quite a bit about the overall health of the market. The more deeply B retraces, the weaker the trend is assumed to be. A B wave that can only pull back 21% of A is a market that is quite strong, with a real sense of urgency. In this situation, we might well expect continued moves to the upside. On the other hand, a market that pulls back very deeply (62% or more) may not even reach the peak of the A wave again. We can “feel” this on the charts. A steep and long B wave will feel like the market is giving up the gains of A, while a shallow flat B will feel like the market can’t wait to continue the move started in the A wave. I think there are some good clues about when we should be looking at counter-trend trades and when we should be looking for continuation in the strength of the B waves. Graphically, some of these B’s look like this:

A rule of thumb for the length of the C wave is given by a “measured move objective”. This simply means the C wave will be about as long as the A wave was. To put it more mathematically, take the length of the A wave from its base to its peak, and add that value to the end of the B wave (this means we have to see the B wave turn first). This will project an ending value for C. Again, this is not rocket science, and sometimes these values will not be hit exactly, but it does give us a way to quantify the market’s action. On a chart, this looks like this:

There are other variations of this structure, but these are the most common and probably the most significant.?? I don’t personally feel it’s necessary to make this theory precisely account for all variations of market action; as long as it provides a basic framework that gives some sense and structure to the market, it’s doing it’s job. Remember too, the market has a certain degree of “noise” (chaos, randomness?) in the price action. This noise can distort the underlying structure and make it hard to recognize, but it is still there!
It is also important to understand that this structure is playing out in various timeframes and levels at the same time. If we are looking at a 5 minute ES chart, we can usually see the structure very clearly. It is also important to understand that the 5 minute structure is a microscopic view of the 30 minute structure, and that patterns on the 5 minute chart are going to be strongly influenced by the 30 minute chart. In other words, even if the 5 minute chart looks like a short, if the 30 minute chart is coming up to a retracement level you want to be very careful of that short. If you’re interested in predicting, the highest probability turning points occur when several timeframes give significant projections at the same levels (confluence). I have come to believe that THE key to successful trading is being aware of the influence of the higher timeframe on the timeframe you are trading. Also keep in mind that these “timeframes” are yet another arbitrary structure we impose upon the market. Why 5 minute bars and not 4 minute 45 second bars? No real reason other than convenience.

At the same time you’re aware of the influence of the higher timeframe, also be aware that the patterns you are seeing on your chart are the result of the interactions of the lower timeframes. When you go down to a certain level in the market, most markets (except for the most active) become untradeable. The stock indices work down to 1 minute bars, but most markets are difficult to trade below 5 minute bars (though equal tick bars will make recognizable patterns out of the thinnest markets.) Keep in mind the influence of this lower timeframe as well. The pauses you see in your timeframe are likely due to turning points in that lower timeframe. Patterns that appear to be aberrations are often just the normal interplay and interference patterns between waves at different levels and timeframes. The most powerful patterns happen when several timeframes roll over in the same direction simultaneously–this creates a situation with potential for intense positive feedback. You can visualize this multi-level structure something like this, being aware that everything on this chart would be part of the A-B structure of the next higher timeframe:

One more small but important refinement is to be aware that these are impulse waves. There are plenty of times when the market is locked in a trading range and is moving sideways. At these points, I suspect the market still respects, on some level, this ABC structure, but the level of noise to signal becomes so high in trading ranges that it is very difficult to make any directional calls. The market does clearly alternate between periods of relative rest and relative strength. In a trading range, it is usually best to stay out of trouble and wait for the emergence of real impulse. Only then can we make directional calls and forecasts with any degree of certainty. Most trading tools work best when there is a supply/demand imbalance, which will show itself on the tape as strong buying or selling.
Well, that’s it for the basic structure. Let’s quickly apply this to a few charts. Notice that sometimes the ideal structure is a little skewed or distorted. Many times it will be unclear exactly how the market is conforming to the theory. This is to be expected when looking at real market data, but at least understanding this structure gives you a better sense of where the market is at any point in time:

Start looking for and watching this structure in all timeframes (down to even the tick level). Good trading!

Question:
Hey SMB Prop Traders,
Keep up the hard work I have a lot of respect for what you guys do. I’m currently heavily engulfed in learning the in and outs of trading before committing to any positions. Something that has been playing on my mind since reading an article in the Australian Financial Review regarding EFT transactions is how as a trader can you determine the true trading volume without the institutional edge. For instance EFT transactions have increased dramatically from 3% for July to 10% for August across the investment banks (predominantly goldman sachs). This may seem deceptive for the everyday tarder as low trading volume may not be the case with high EFT volume off the market and away from the public eye. Do you have any insights as to decipher the trading volume? and how closely should it be tracked given its mystery?

Bella Responds

You are not the first person to have difficulty reading the order flow with an ETF. There are many times when you cannot. Let’s focus on when the tape does give us an edge.

1) Spot much more volume being done at the same price than other levels. If next the ETF breaks in the direction of the intraday trend then this is a high probability trade. If 50k shares are done every penny and then 500k share and done at the same price, now you have an important price from reading the tape. So much volume being done at the same price may signal a large order has entered the market.
2) On the Open the tape is easier to read. A held bid after an ETF has gapped up on the open, with fresh news that will move your ETF, is a trading play to consider so you do not miss an opening drive.
3) A fresh news event that moves your ETF will leave a tape that tends to trend better and is easier to read.
4) If you spot strength on the tape near a support level or right above a previous resistance level, this is an excellent trading opportunity.
5) Follow the order flow in the last hour as stocks are much less likely to reverse.

We rarely make trades based solely on the order flow. We make decisions by combining intraday fundamentals, reading the order flow, and technicals. For certain trades the tape receives a healthy part of our decision making, and for others a much smaller slice. Please keep this in mind when you use the tape to make trading decisions.

Reading the Tape is a skill. While I offer the points above to point you in the right direction, you cannot develop the skill by reading this blog. Now it takes a great deal of practice, critical feedback, and sustained energy working on this skill from you.

Mike Bellafiore
Author, One Good Trade: Inside the Highly Competitive World of Proprietary Trading (Wiley Trading)

10. You miss a lot of bad movies.

9. You are excused for most things no guy ever wants to do with their significant other.
8. You are never bored.
7. Crystallizes what you most enjoy doing.

6. You learn how much your success or failure depends on others.
5. You appreciate how powerful the proper process is.
4. Your parents are proud of you.
3. You gain more interesting friends.

2. You learn how hard it is to be great at anything.
1. When you pick up your head from your exhausting, elbow greased, grinding journey, you will have accomplished more than you ever could have imagined.

Mike Bellafiore
Author, One Good Trade: Inside the Highly Competitive World of Proprietary Trading (Wiley Trading)

Watch Mike Bellafiore,??author of One Good Trade: Inside the Highly Competitive World of Proprietary Trading (Wiley), in our new video series SMB Trading Lesson of the Week for StockTwits U. ??This week we discuss: Rehearsing the Open Before the Open.

We hope you enjoy!

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Dear Mike

I am an avid follower of your blog and am completely sold on the idea of trading in-play stocks as a result of a greater likelihood of subsequent predictable intraday behaviour.

I have a couple of quite specific questions on the consolidation play that is mentioned in several places on the blog.

Context:
Assume an in-play stock has run up considerably at the open on very high relative interday volume and has got some kind of strong intraday fundamental news fuelling the move. Suppose that the stock has been consolidating at near the highs for an hour or so, with a significant decline in volume, suggesting that the morning buyers are still in their positions.

Stops, targets, and historical win rate
In your Tradersinterview piece, you mentioned that you are a proponent not of earning a mere 2 or 3 times the initial risk, but 5 times the initial risk.

Question 1) In order to earn 5x the risk, I would imagine that you would have to place your stop pretty much at the base of the consolidation. Would this assumption be correct ?

Question 2) Clearly one would not need to be correct many times to still make money, on a trade expectancy basis. I was wondering what a reasonable win rate %, breakeven % (assuming you raise stops to breakeven at some multiple of risk) and loss rate % would be for the consolidation play on in-play stocks. Having looked through quite a few charts, I have come up with 30% (5x) wins, 20% scratches and 50% losses, and a long-term net gain per trade of pretty much exactly the risk taken. How close to the mark do these numbers come to your much greater experiences with the consolidation play.

Thank you for any input that you are able to give.

Bella Responds

Super job attempting to apply statistics to your trading. GMan has been a great influence to me on thinking of my trading more statistically. Very well done here!

You will read that you can profit with a 30 percent win rate. There are some trades I will make with even a lower win rate. I must caution that psychologically it is very difficult for most traders to accept a win rate of 30 percent. And you must consider this for your trading. That is an awful lot of being wrong.

You might start with higher probability consolidation plays and build from them. This will enable you to add other set ups to your playbook that offer this lower win rate. So I might seek confirmation on the tape which increases my win rate with a consolidation play.

One more note, please make sure you understand the big picture with this trade. Where is the next significant resistance level on your long term charts? If this is near we might want to pass on the trade until it clears resistance, even if our intraday indicators scream buy.

Mike Bellafiore
Author, One Good Trade: Inside the Highly Competitive World of Proprietary Trading

When I was younger I played a lot of pickup basketball. ??Many times I was matched up against players who were either bigger, stronger or quicker than me. ??Well maybe not stronger ??I found playing “up” to my competition was much more enjoyable than playing “down”. ??Playing better competition tends to heighten your focus and forces you to improve as a player. ??I would make mental notes about various opponents so if I faced them in the future I was better prepared to take away their strengths and exploit their weaknesses.

In trading you don’t necessarily want to find the toughest competition. ??It is not necessary nor desirable to pick the most erratic and illiquid stocks to trade each day. ??Nor should you focus on the most convoluted set ups that require mind bending analysis to figure out how to best trade your position. ??Where trading most closely matches up to my basketball analogy above is with respect to learning about your competition.

I have always been a fan of trading momentum stocks for this reason. ??Momentum hedgies flock to these names as quickly as zero hedge flocks to a governmental default rumor. ??As a trader it is important to understand which setups the hedgies like best. ??One such setup began to unfold earlier this week in CRM. ??If I had to give it a name I would call it a Secondary Earnings Momentum Play. ??After a large runup on good earnings hedgies will accumulate the stock on any weakness in the days following the runup. ??This accumulation creates a clearly defined range, which if it breaks can lead to a sizable multi-day move.

On August 20th CRM gapped up on better-than-expected earnings. ??It closed near its high on huge volume. ??During the next week it consolidated in a fairly tight range. ??By the time I returned from vacation on Monday it appeared ready to begin its next up leg. ??Based on observing the recent price action I determined that if CRM got above 113.40 on good volume that it was beginning to make its next up move that should take it to 118 or higher.

Why does this play work so well? ??In addition to all of the momentum hedge funds who are watching CRM you have a ton of other market participants who are keeping tabs on the momentum names. ??There are the retail traders who are checking all of the top IBD stocks on a daily basis. ??Professional traders are scanning the highest beta names for good technical setups each day as well. ??Momentum stocks are also all over the Stocktwits recommended stream being ??pushed by heavily followed traders such as @Traderflorida.

One thing in particular caught my attention on the weekly chart when I was preparing to write this blog. ??There was a ton of volume done in CRM in the week it consolidated after the big move from earnings. ??I drew a couple of conclusions from seeing such heavy volume following earnings. ??One, a lot of people who wanted to exit were able to do so and would therefore not be a hindrance to the next up leg. ??And two, there were some seriously committed buyers in this stock after earnings for it not to have had a steeper retracement after such a large up move.

My 113.40 price alert was triggered on Wednesday, which also happened to be the day the market had broken its most recent downtrend. ??Strong stock and strong market generally are a good combo for a successful breakout.

Hi, Mike! I asked for your advice about daytrader’s midday activity. What your young traders do tipically do during 12.00-14.00? I used to ovretrade during midday, so I decided not to trade at all during slow market hours. Can I do something useful for my trading game within two hours? Maybe rip through charts or watch some trading videos, read some blogs?
Thanks!

Bella Responds

I like the idea of you developing a distinct plan for the midday. The midday is a separate business from the open and the close as Dr. Steenbarger has taught. A few ideas:

1. Trade only the best set ups.
2. Trade with less size.
3. Yes, rip through charts.
4. Write in your trading journal.
5. Read blogs.
6. Find great set ups for the close.
7. Talk to others about the open.

Mike Bellafiore
Author, One Good Trade: Inside the Highly Competitive World of Proprietary Trading

Today, the Market appears set to open higher. The levels we are watching in the SPY are 111.00 (resistance), 110.50 and 109.50 (support).

Our best AM Idea for today, which we highlighted in our AM Meeting is to keep any gains and enjoy your holiday weekend.

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