Notes from a High Probability Stock Trading Course

What is trading all about?

Most importantly: Money Management.

I can illustrate this by flipping a coin, so 50/50 odds. If I make R2 every time I am right, but lose just R1 every time I am wrong, then after 10 flips, on average, I would have made 5 x R2 = R10 and lost 5 x R1 = R5. So with a strategy that is only right half of the time, I will still make money as long as I have a positive expectancy (ie make more when I am right than what I lose when I am wrong). Here we had a reward to risk ratio (R:R) of 2:1. And the longer this strategy continues the more money I make.

80/20 – Trading is 80% psychological and 20% methodology. And by the time it becomes boring then you are doing things right – not taking too much risk, not being emotionally involved, and in complete control because you are following the rules. Trading is about discipline.

What do you need to start? Not much. R100k in start-up capital (not borrowed money), easy to use trading platform with live pricing and basic charts, plus support from your family, a positive mindset, perseverance and discipline.

Now, lets identify some high probability trades.

The big picture

Top-down approach – start by comparing markets to markets, sectors to the market, then shares vs the sector and last shares against each other. You can do this with momentum indicators like and RSI and moving averages.

Current* strong sectors compared to the JSE Allshare index include: industrials, retailers and financials (banks are flat). Current* weak sectors include: gold, platinum, resources and construction.

A Trader looks at momentum in the short/near term, whereas an Investor looks at dividends, income and long term growth, ie Buffet: “When is the right time to sell a good company? — Never.” Then again, even for a Trader, when the market is at an all time high the longs are happy and the shorts are squeezed or cutting, so the upwards momentum may continue higher.

For example, take the Retail Sector. Weak shares: LEW, JDG, CLS, MSM, PIK, SPP, TRU, SHF (starting to turn). Strong shares: MPC, WHL & TFG. *Please note these examples were accurate at the time (not necessarily when this note was published).

Trade like a jellyfish, always with the current. For strong shares in strong sectors – buy the dips. For weak shares in weak sectors – short the tops. And pairs trades could be used in slow & uncertain markets. Their is an abundance of opportunities. be patient. If you miss this opportunity, the next one is around the corner.

The small picture

Tools to help you when to enter a trade.

Trendlines – beware of false breaks, focus on horizontals, big levels with institutional orders and when they are filled the price can run (ie a hedge fund exiting a position after a long horizontal resistance).

Moving Averages – have you ever measured when most of your wrong trades occur? Bet it’s when you go against the 50d SMA. Trend is your friend, always go with it. For medium term use 50+200d MA. For short term use 7+21d MA. Golden cross up is a buy and death cross down is a sell or short, but doesn’t work in a sideways market.

Oscillators – this chap uses a default slow stochastic, RSI and CCI, not a MACD. Negative or reverse divergence sets up very high probability trades and is important enough to expand on, see below.

Normal divergence

  • Normal bullish: price makes HH, indicator makes HL
  • Normal bearish: price makes LL, indicator makes LH
  • Normal divergence is a warning of a change in trend

Reverse divergence

  • Reverse bullish: price makes HL, indicators makes LL
  • Reverse bearish: price makes LH, indicator makes HH
  • Reverse divergence is a confirmation of a change in trend

Fibonacci, if you must – 0 1 1 2 3 5 8 13 21 34 55 89 144 and so on. Each number is approx 61.8% of the following number, and 161.8% of the previous number. It ties in with Elliot waves. Can be used to determine levels for potential turns or profit taking.

Elliot waves – 1-2-3-4-5 (up) then a-b-c (down). Can get waves within waves (like Inception) and sometimes you need to be under the bottle to see any waves. Just know of them and that they tie in with FIB levels above. Corrective waves (2 and 4) can take on patterns such as triangles or flags, so important to identify them if you want to take part in the powerful waves 3 and 5.

Sample trade was Vodacom:

  Trading above the 50d MA
  Bullish divergence
  Sector is up
  Support level

London bus analogy

  1. Many trades around — just like many buses en route
  2. Wait for the trade — don’t jump in front of the bus
  3. Wait for the right time — for the doors to open
  4. Don’t chase after it — the next one is around the corner

Candles – the basics is enough; doji = turn, engulfing = turn, hammer = turn. Filter daily, this process can be automated.

Triangles – are continuation patterns, so are pennants (small triangles) and wedges. When it comes to a flag, it’s price target is the height of the flag (continuation up or down). A failed head and shoulders is very bullish.

If triangles coincide with Elloit waves 3 or 5 they are very powerful, but must break out 2/3 or 3/4 of the way so don’t trade all the way into the corner. Probability is 66.6% right and 33.3% wrong.

Gaps – there are 24 hours in a day, but we only trade for 8, so there are 16 hours in which things can change overseas. Breakaway gaps are at the beginning of a move and Exhaustion gaps at the end of a move. An Island reversal is the most powerful, with gaps on either side.

Money management – never risk more than 2% of your capital in any one trade. And aim for a reward to risk ratio of 3:1.

Once you are in the trade

  Never average down.
  Never add to a losing trade.
  No more than 8 trades at a time.

  Add to profitable trades.
  Always stick to your stop loss.
  Put this in action. Do 30 trades and see.
  At target, rather sell half & run trailing stop on remainder.

Trading checklist

  Going with the trend?
  Trade levels carefully set out?
  Is the position size manageable?
  Reward/risk ratio at least 2:1?
  Stop loss in place?

Cricket analogy – Be patient. Trading is like cricket. Protect your wicket. Meaning your capital. Hit singles to keep the score card ticking. The loose balls will come. This is a test, not T20. Enjoy.

Invest in yourself – deal with the bad times, and equally with the good times (don’t become cocky). And read, a lot. Set up a trading performance histogram to track your progress. Set up your charting template with candles, 50+200d MA, stochastic, RSI or CCI and volume. And check out our trading do’s and don’ts.

 

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