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

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), 1/16^th 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, 1/16^th 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, 1/16^th 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, 1/16^th 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, 1/16^th 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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