Trading: The Process and the Mechanics

It is helpful for traders to develop their own ways of viewing markets. Initially, traders learn by mimicking others, then by integrating parts of what they learn from others into their own styles.

For me, a trade idea begins with a price target, not an entry pattern. During the day, I am watching how we are trading relative to several benchmarks:

* The day's volume-weighted average price (VWAP);

* The overnight trading range;

* The previous day's trading range

Those help me to gauge whether we are in a short-term rangebound environment or a trending one.

The other guides I use during the day to assess range trading vs. directional trend trade are:

* NYSE TICK - The number of stocks trading on upticks vs. downticks; the cumulative value of TICK during the day will be positively or negatively sloped on trend days;

* Market Delta - The number of ES contracts trading at the offer vs. bid price; the cumulative Delta will be positively or negatively sloped on trend days; trend days will typically see cumulative TICK and cumulative Delta moving in gear;

* Intraday Advances/Declines - I look at how many stocks in my basket (and how many sectors) are rising or falling relative to their opening prices for the day. This will be quite skewed on trend days; more mixed in range environments.

* Relative Volume - How volume at a particular time today compares with the average volume that trades at that time of day; this serves as a guide to the day's volatility, with low relative volume common on range days.

Overall, almost all days will take out either the high or low from the overnight trading range. About 85% of days will not be inside days; i.e., they will take out either the previous day's high or low price.

The proprietary price targets that I post to Twitter each morning before the open (free subscription via RSS) are different from traditional pivot targets in that they are adaptive to the market's recent volatility. In a volatile trading environment, such as we had late in 2008, the price targets will be set further away; in a less volatile environment, they will be set nearer. The targets are set a defined distance from the market Pivot, which is an estimate of the prior day's average trading price.

Here is the basis for the pivot derived targets:

* The market since 2000 has hit the R1 or S1 target on about 70% of all days;

* The market since 2000 has hit the R2 or S2 target on about 50% of all days;

* The market since 2000 has hit the R3 or S3 target on about 33% of all days.

On average, the longer it takes a market to hit a nearer price target (such as the overnight high or low or the prior day's high or low), the less likely it is that we will hit the more distant R1/R2/R3 or S1/S2/S3 targets.

On average, 70% of days will touch the prior day's Pivot, which becomes a worthwhile price target when markets cannot sustain moves above or below their prior day's high or low.

The idea of a trade is to catch directionality (or lack of it) as the market is trading, so that you can profit from a move to one of the defined price targets. I trade three basic patterns; that's it.

Where the entry setup becomes important is in the execution of the trade idea, so that you are risking less than you can make on the trade. Where trade management is important is in the decision of how to size the trade initially and in whether to scale into or out of the trade as we approach the target. Much of profitability comes from trade execution and management, though these often receive the least attention in writings about trading.

More to come on the topics of trading process and trading mechanics.
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