How To Reduce Your Risk By Trading With Zones

"When you're crying you should be buying, and when you're yelling you should be selling”

A wise mentor of mine once told me this, and I’ve never forgotten it. In fact, it’s turned out to be one of the most important lessons I’ve learned as a trader, and very similar to Larry Connors' "Buy The Fear, Sell The Greed" philosophy.

Many traders learned to trade by buying breakouts -- which can work -- but the problem is that when they fail, they can fall a long way. In this lesson, I will show you how to minimize your risk by buying a "zone" rather than buying a breakout or a first support level. Not only that, but if your stock does go on to break out, you'll have gotten in at a much lower price than all the breakout players.

A zone is an area of support/resistance that can be used to initiate positions at several prices. Scaling into trades in this fashion minimizes your risk and helps takes the emotion out of the trade because its all part of the plan. If the trade moves past your first support level, your second planned support level is right underneath, and you're still sticking to your plan.

The last week of September is a good example of this strategy in action. The market had just given up all of its recent gains and traders were dismayed by the failed breakout. In this case, finding a high-probability trade zone to enter into the fear was the right idea.

Summer support and resistance levels (black horizontal lines) contained all the trading between June 16 and Sept 2. On Sept 2, we finally broke the summer range to the upside, though volume on the follow-through was light. Profit taking, followed by panic, set into the markets after a top in mid-September. First, we broke the 20 MA (blue), then we broke the summer resistance-becomes-support level (black), and finally we broke the 50 MA (blue).

For many traders, a long at this point was practically unthinkable. But rather than getting caught up in the emotion of the selloff, let's look objectively at what's happening. The second-largest volume day of the year was at a 61.8% retracement, as well as summer trendline support. This is an excellent example of "stop running" just below the 50-day MA. "They" took the market down to where the stops were, and cleaned out the sellers. Now we're going higher to look for the buyers.

Let's look for an entry into the panic:

Rather than trying to pinpoint your entry with full size, consider the possibility that your first entry will not be the exact bottom, and plan on buying the balance of your trade at the next reasonable support level. You are giving yourself a margin of error. This is not doubling down, this is trading with a plan. Buy the first 1/2 at (1), at the 38% retracement/summer support line. If there is further selling down into the 50-62% retracement zone (2), pick up the other half. Place your stop on the other side of your zone. Total risk: $2.00 on 1/2 normal position and 25 cents on the other 1/2. Your risk is $2.25 and you're looking to make at least $4.00 on half and let the other half go.

Let’s examine the other side of that. Suppose that point (1) on the 120-min chart is the bottom. The trade starts to move in your favor and you only have ½ a position on. If this happens, you can initiate the other half at the breakout point above the highs, with your stop at the first entry point.

This strategy will keep you from paying "retail" prices and put you on the "wholesale" side of the trade. This and many other topics will be featured in my up-coming seminar with Larry Connors.

Feel free to email or call with questions.

Todd