Monday, February 6, 2012

Brooks, Trading Price Action Trading Ranges

The second of Al Brooks’s three-volume magnum opus, Trading Price Action Trading Ranges: Technical Analysis of Price Charts Bar by Bar for the Serious Trader (Wiley, 2012), focuses on that area where markets spend the majority of their time—in trading ranges. He looks at trading ranges themselves, breakouts from ranges (transitions into new trends), and pullbacks (trends converting to trading ranges). The other two parts of the book deal with magnets (support and resistance) and orders and trade management.

In keeping with Brooks’s general style, the 600-page Trading Price Action Trading Ranges is a detailed and necessarily somewhat repetitive book. After all, if patterns didn’t repeat, technical analysis would be completely bogus.

I, on the other hand, don’t want to repeat myself. Since I reviewed the first volume in December, I’m going to take a different tack this time around and share a couple of points Brooks makes about trading ranges and trade management that I think might be of general interest.

First, on the relation between pullbacks and trading ranges. Brooks writes: “All pullbacks are small trading ranges on the chart that you are viewing, and all trading ranges are pullbacks on higher time frame charts. However, on the chart in front of you, most attempts to break out of a trading range fail, but most attempts to break out of a pullback succeed.” (p. 183)

Second, on so-called reversal patterns: double tops and bottoms and head and shoulders tops and bottoms. “Since trends are constantly creating reversal patterns and they all fail except the final one, it is misleading to think of these commonly discussed patterns as reversal patterns. It is far more accurate to think of them as continuation patterns that rarely fail but, when they do, the failure can lead to a reversal.” (p. 319)

And third, a description of trading ranges in terms of trends. “Every rally in a trading range is essentially a bear flag and every selloff is effectively a bull flag. Because of this, traders trade the top of the range the way they trade a bear flag in a bear trend. … They expect that attempts to break above the trading range will fail, that the bear flag breakouts will succeed, and that the market will soon reverse down and test the bottom of the range.” (p. 331)

Finally, just one of many thoughts on protective and trailing stops. “Traders can use wide stops when they are fading breakouts in stairs patterns or on trending trading range days. If the average range in the Emini is about 10 to 15 points and there is a breakout that runs about five points, a trader might fade the breakout and risk about five points to make five points, expecting a test of the breakout. In a typical situation, this trade has better than a 60 percent chance of success and therefore has a positive trader’s equation.” (p. 523)

Brooks, who believes that “trading is entirely about math,” (p. 437) offers examples of trades with a probability of success of 70%, 60%, 50%, 40% or less, and 40-60%. Naturally, he also describes the reward: risk ratio necessary to break even on each of these types of trades.

As for risk management, he writes graphically: “If you are 60 percent confident that the market will go up, that means that in 40 percent of the cases it will instead go down, and you will lose if you take the trade. You should not ignore that 40 percent any more than you would dismiss someone 30 yards away who is shooting at you, but who has only a 40 percent chance of hitting you. Forty percent is very real and dangerous, so always respect the traders who believe the opposite of you.” (p. 442) Amen.

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