Thread by @ProdigalTrader

How to trade with least Risk??

Price move in market is always controlled by either of the following mechanism

1. Momentum - Trend
2. Reversion to mean – Counter Trend

See this picture for clarity

1/22

2/22

Suppose we are trading with trend
& took breakout trade

u enter long above the high of the breakout candle.
Its usually a high momentum candle
making it too far away from the base of the break out level.

Hence SL will be wide
Which will severely affect the position size

3/22

Now let’s see a more realistic picture

Here u would see breakouts usually
undergoes deeper mean reversion
rather than going to the same direction.
Such moves always big threat to the SL we place in the trade.
Because in most case reversion goes way beyond breakout level

4/22

For safety,
if u decide to keep SL below the previous swing low,
once again risk in the trade is way too high
and
u will have to content with smaller position size
with huge risk.
That’s not a right approach.

What else can be done?

5/22

U need to develop a method
which accounts for the potential mean reversion after breakout move
If u allow the stock to pull back to the mean
&
plan ur entry on reversal after the pullback,
SL will be so very tight that
u will be able to find a new higher price support point

6/22

(which is just below the low of the pullback move).
Ur entry will just above the reversal candle pattern high in the pullback.

So how to formulate a method considering all these points??
Read on...............

7/22

Following is a systematic approachto formulate a method
which upon the trades can be taken with minimal risk.

It’s just one case study among many approaches out there is the market.

Let’s divide the approach into 4

8/22

1. Find scrips which starts complying with bullish Dow Theory after a downtrend.

Specifically u need a scrip which just finished pullback/correction.
u need One Higher High and Two Higher Lows in place

9/22

2. Price breaks out with increased volume
3. Price Pulls back to 20 SMA with lower volume.
4. For entry u can use a simple bullish reversal candle pattern at or just below the 20SMA

This is the set up.

10/22

Here in this method, there was two potential entry points

1. First one was to make long entry at breakout
2. Another one was to enter near pullback to 20 SMA

11/22

u chose not to enter at breakout.
The reasons are three

1. u cannot assess if the breakout will sustain or not. Becoz, the scrip has just came out of a pullback
and
have only 1 HH and 2 HLs.
This simple pullback might end up as a lengthy correction.

12/22

2. All breakouts are susceptible to mean reversion below the breakout level
and
also below the breakout bar low.
The mean would be much lower in many cases.
So Breakout buy will end up being in loss
as the price falls below Breakout bar low.
Look at the chart below

13/22

3. Breakout bar will have high volatility and big candle spread.
This makes SL very wide
and
risk, many a times, unreasonably large.

look at the chart below

Hence we avoid breakout buy,
rather go for pullback at 20 SMA

14/22

Here the risk is much more under control
as volatility near the pullback end will be very less
that we would be able to take safe long entry
much closer to 20SMA
&
keep SL below it.

15/22

Pros in this approach is

1. During pullback bars r less volatile making SL much smaller
2. No rush as pullback isn’t as hot as breakout. Even cheapest bids fills
3. Even initial entry can be divided into parts as price will stay enough time near to 20 SMA

16/22

Why 20SMA, not 50SMA?

Here the principle is based on the concept that during breakout price would be too far away from short-term moving average. Price can’t stay away from MA much longer.

17/22

Either price would stall so that MA catches up
Or
Price fall to MA

This principle of mean reversion applies on a short term average only

If u consider 50SMA
that’s too much of an MA length to consider
as price would need unreasonably higher amount of time to reach 50SMA

18/22

And in that case it won’t be mean reversion anymore.
That would be a correction
and
strength in the trend which we were looking to rely upon
would be long gone.

19/22

Example

EOD timeframe – short to medium term trading
15min TF – Day or swing trading

20/22

One major advantage in the approach is
as price continue to go up maintaining the trend,
during all such weaker pullbacks,
positions can be added into it.
Thus scaling into winner can multiply the profit.

Example

EOD timeframe – Scaling In
15min timeframe – Scaling In

21/22

This approach can be applied in any time frame stating from weekly to 1min.
Everywhere, in all markets, in all scrips, in all timeframe
u would see the price
revert to short-term moving averagesuch as 20SMA
before making further upmove
You dont need to make a scanner so

22/22

End of the thread.
Donot treat the write up as a strategy,
use it as an approach towards formulating a risk controlled method developemnt.
Wish u good luck.