Trading Price Action Trading Ranges

Technical Analysis of Price Charts Bar by Bar for the Serious Trader

Al Brooks

• Publisher: Wiley
• Year: 2011
• ISBN:
  9781118172339
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Praise for Trading Price Action Trading Ranges

"Al Brooks has written a book every day trader should read. On all levels, he has kept trading simple, straightforward, and approachable. By teaching traders that there are no rules, just guidelines, he has allowed basic common sense to once again rule how real traders should approach the market. This is a must-read for any trader that wants to learn his own path to success."
—Noble DraKoln, founder, SpeculatorAcademy.com, and author of Trade Like a Pro and Winning the Trading Game

"A great trader once told me that success was a function of focused energy. This mantra is proven by Al Brooks, who left a thriving ophthalmology practice to become a day trader. Al's intense focus on daily price action has made him a successful trader. A born educator, Al also is generous with his time, providing detailed explanations on how he views daily price action and how other traders can implement his ideas with similar focus and dedication. Al's book is no quick read, but an in-depth road map on how he trades today's volatile markets, complete with detailed strategies, real-life examples, and hard-knocks advice."
—Ginger Szala, Publisher and Editorial Director, Futures magazine

Over the course of his career, author Al Brooks, a technical analysis contributor to Futures magazine and an independent trader for twenty-five years, has found a way to capture consistent profits regardless of market direction or economic climate. And now, with his new three-book series—which focuses on how to use price action to trade the markets—Brooks takes you step by step through the entire process.

In order to put his methodology in perspective, Brooks examined an essential array of price action basics and trends in the first book of this series, Trading Price Action TRENDS. Now, in this second book, Trading Price Action TRADING RANGES, he provides important insights on trading ranges, breakouts, order management, and the mathematics of trading.

Page by page, Brooks skillfully addresses how to spot and profit from trading ranges—which most markets are in, most of the time—using the technical analysis of price action. Along the way, he touches on some of the most important aspects of this approach, including trading breakouts, understanding support and resistance, and making the most informed entry and exit decisions possible. Throughout the book, Brooks focuses primarily on 5 minute candle charts—all of which are created with TradeStation—to illustrate basic principles, but also discusses daily and weekly charts. And since he trades more than just E-mini S&P 500 futures, Brooks also details how price action can be used as the basis for trading stocks, forex, Treasury Note futures, and options.

Part I

Breakouts: Transitioning into a New Trend

The market is always trying to break out, and then the market tries to make every breakout fail. This is the most fundamental aspect of all trading and is at the heart of everything that we do. One of the most important skills that a trader can acquire is the ability to reliably determine when a breakout will succeed or fail (creating a reversal). Remember, every trend bar is a breakout, and there are buyers and sellers at the top and bottom of every bull and bear trend bar, no matter how strong the bar appears. Since every trend bar is a breakout and trend bars are common, traders must understand that they have to be assessing every few bars all day long whether a breakout will continue or fail and then reverse. This is the most fundamental concept in trading, and it is crucial to a trader's financial success to understand it. A breakout of anything is the same. Even a climactic reversal like a V bottom is simply a breakout and then a failed breakout. There are traders placing trades based on the belief that the breakout will succeed, and other traders placing trades in the opposite direction, betting it will fail. The better traders become at assessing whether a breakout will succeed or fail, the better positioned they are to make a living as a trader. Will the breakout succeed? If yes, then look to trade in that direction. If no (and become a failed breakout, which is a reversal), then look to trade in the opposite direction. All trading comes down to this decision.

Breakout is a misleading term because out implies that it refers only to a market attempting to transition from a trading range into a trend, but it can also be a buy or sell climax attempting to reverse into a trend in the opposite direction. The most important thing to understand about breakouts is that most breakouts fail. There is a strong propensity for the market to continue what it has been doing, and therefore there is a strong resistance to change. Just as most attempts to end a trend fail, most attempts to end a trading range and begin a trend also fail.

A breakout is simply a move beyond some prior point of significance such as a trend line or a prior high or low, including the high or low of the previous bar. That point becomes the breakout point, and if the market later comes back to test that point, the pullback is the breakout test (a breakout pullback that reaches the area of the breakout point). The space between the breakout point and the breakout test is the breakout gap. A significant breakout, one that makes the always-in position clearly long or short and is likely to have follow-through for at least several bars, almost always appears as a relatively large trend bar without significant tails. “Always in” is discussed in detail in the third book, and it means that if you had to be in the market at all times, either long or short, the always-in position is whatever your current position is. The breakout is an attempt by the market either to reverse the trend or to move from a trading range into a new trend. Whenever the market is in a trading range, it should be considered to be in breakout mode. There is two-sided trading until one side gives up and the market becomes heavily one-sided, creating a spike that becomes a breakout. All breakouts are spikes and can be made up of one or several consecutive trend bars. Breakouts of one type or another are very common and occur as often as every few bars on every chart. As is discussed in Chapter 6 on gaps, all breakouts are functionally equivalent to gaps, and since every trend bar is a breakout (and also a spike and a climax), it is also a gap. Many breakouts are easily overlooked, and any single one may be breaking out of many things at one time. Sometimes the market will have setups in both directions and is therefore in breakout mode; this is sometimes referred to as being in an inflection area. Traders will be ready to enter in the direction of the breakout in either direction. Because breakouts are one of the most common features of every chart, it is imperative to understand them, their follow-through, and their failure.

The high of the prior bar is usually a swing high on some lower time frame chart, so if the market moves above the high of the prior bar, it is breaking above a lower time frame swing high. Also, when the market breaks above a prior swing high on the current chart, that high is simply the high of the prior bar on some higher time frame chart. The same is true for the low of the prior bar. It is usually a swing low on a lower time frame chart, and any swing low on the current chart is usually just the low of the prior bar on a higher time frame chart.

It is important to distinguish a breakout into a new trend from a breakout of a small trading range within a larger trading range. For example, if the chart on your screen is in a trading range, and the market breaks above a small trading range in the bottom half of the screen, most traders will assume that the market is still within the larger trading range, and not yet in a bull trend. The market might simply be forming a buy vacuum test of the top of the larger trading range. Because of this, smart traders will not buy the closes of the strong bull trend bars near the top of the screen. In fact, many will sell out of their longs to take profits and others will short them, expecting the breakout attempt to fail. Similarly, even though buying a high 1 setup in strong bull spike can be a great trade, it is great only in a bull trend, not at the top of a trading range, where most breakout attempts will fail. In general, if there is a strong bull breakout, but it is still below the high of the bars on the left half of the screen, make sure that the there is a strong trend reversal underway before looking to buy near the top of the spike. If you believe that the market might still be within a trading range, only consider buying pullbacks, instead of looking to buy near the top of the spike.

Big traders don't hesitate to enter a trend during its spike phase, because they expect significant follow-through, even if there is a pullback immediately after their entry. If a pullback occurs, they increase the size of their position. For example, if there is a strong bull breakout lasting several bars, more and more institutions become convinced that the market has become always-in long with each new higher tick, and as they become convinced that the market will go higher, they start buying, and they press the trades by buying more as the market continues to rise. This makes the spike grow very quickly. They have many ways to enter, like buying at the market, buying a one- or two-tick pullback, buying above the prior bar on a stop, or buying on a breakout above a prior swing high. It does not matter how they get in, because their focus is to get at least a small position on, and then look to buy more as the market moves higher or if it pulls back. Because they will add on as the market goes higher, the spike can extend for many bars. A beginning trader sees the growing spike and wonders how anyone could be buying at the top of such a huge move. What they don't understand is that the institutions are so confident that the market will soon be higher that they will buy all of the way up, because they don't want to miss the move while waiting for a pullback to form. Beginners are also afraid that their stops would have to be below the bottom of the spike, or at least below its midpoint, which is far away. The institutions know this, and simply adjust their position size down to a level where their dollars at risk are the same as for any other trade.

At some resistance level, the early buyers take some profits, and then the market pulls back a little. When it does, the traders who want a larger position quickly buy, thereby keeping the initial pullback small. Also, the bulls who missed the earlier entries will use the pullback to finally get long. Some traders don't like to buy spikes, because they don't like to risk too much (the stop often needs to be below the bottom of the spike). They prefer to feel like they are buying at a better price (a discount) and therefore will wait for a pullback to form before buying. If everyone is looking to buy a pullback, why would one ever develop? It is because not everyone is looking to buy. Experienced traders who bought early on know that the market can reverse at any time, and once they feel that the market has reached a resistance area where they think that profit taking might come in or the market might reverse, they will take partial profits (they will begin to scale out of their longs), and sometimes will sell out of their entire position. These are not the bulls who are looking to buy a few ticks lower on the first pullback. The experienced traders who are taking partial profits are scaling out because they are afraid of a reversal, or of a deeper pullback where they could buy back many ticks lower. If they believed that the pullback was only going to last for a few ticks, and then the bull was going to resume, they would never have exited. They always take their profits at some resistance level, like a measured move target, a trend line, a trend channel line, a new high, or at the bottom of a trading range above. Most of the trading is done by computers, so everything has a mathematical basis, which means that the profit taking targets are based on the prices on the screen. With practice, traders can learn to spot areas where the computers might take profits, and they can take their profits at the same prices, expecting a pullback to follow. Although trends have inertia and will go above most resistance areas, when a reversal finally does come, it will always be at a resistance area, whether or not it is obvious to you.

Sometimes the spike will have a bar or a pattern that will allow aggressive bears to take a small scalp, if they think that the pullback is imminent and that there is enough room for a profit. However, most traders who attempt this will lose, because most of the pullbacks do not go far enough for a profit, or the trader's equation is weak (the probability of making a scalp times the size of the profit is smaller than the probability of losing times the size of the protective stop). Also, traders who take the short are hoping so much for their small profit that they invariably end up missing the much more profitable long that forms a few minutes later.

Traders enter in the direction of the breakout or in the opposite direction, depending on whether they expect it to succeed or to fail. Are they believers or nonbelievers? There are many ways to enter in the direction of the breakout. Once traders feel a sense of urgency because they believe that a significant move might be underway, they need to get into the market. Entering during a breakout is difficult for many traders because the risk is larger and the move is fast. They will often freeze and not take the trade. They are worried about the size of the potential loss, which means that they are caring too much to trade. They have to get their position size down to the “I don't care” size so that they can quickly get in the trade. The best way for them to take a scary trade is to automatically trade only a third or a quarter of their normal trade size and use the wide stop that is required. They might catch a big move, and making a lot on a small position is much better than making nothing on their usual position size. It is important to avoid making the mistake of not caring to the point that you begin to trade weak setups and then lose money. First spot a good setup and then enter the “I don't care” mode.

As soon as traders feel that the market has had a clear always-in move, they believe that a trend is underway and they need to get in as soon as possible. For example, if there is a strong bull breakout, they can buy the close of the bar that made them believe that the trend has begun. They might need to see the next bar also have a bull close. If they wait and they get that bull close, they could buy as soon as the bar closes, either with a limit order at the level of the close of the bar or with a market order. They could wait for the first pause or pullback bar and place a limit order to buy at its close, a tick above its low, at its low, or a tick or two below its low. They can place a limit order to buy any small pullback, like a one- to four-tick pullback in the Emini, or a 5 to 10 cent pullback in a stock. If the breakout bar is not too large, the low of the next bar might test the high of the bar before the breakout, creating a breakout test. They might place a limit order to buy at or just above the high of that bar, and risk to the low of the breakout bar. If they try to buy at or below a pause bar and they do not get filled, they can place a buy stop order at one tick above the high of the bar. If the spike is strong, they can look to buy the first high 1 setup, which is a breakout pullback. Earlier on, they can look at a 1, 2, or 3 minute chart and buy at or below the low of a prior bar, above a high 1 or high 2 signal bar, or with a limit order at the moving average. Once they are in, they should manage the position like any trend trade, and look for a swing to a measured move target to take profits and not exit with a small scalp. The bulls will expect every attempt by the bears to fail, and therefore look to buy each one. They will buy around the close of every bear trend bar, even if the bar is large and closes on its low. They will buy as the market falls below the low of the prior bar, any prior swing low, and any support level, like a trend line. They also will buy every attempt by the market to go higher, like around the high of a bull trend bar or as the market moves above the high of the prior bar or above a resistance level. This is the exact opposite of what traders do in strong bear markets, when they sell above and below bars, and above and below both resistance and support. They sell above bars (and around every type of resistance), including strong bull trend bars, because they see each move up as an attempt to reverse the trend, and most trend reversal attempts fail. They will sell below bars (and around every type of support), because they see each move down as an attempt to resume the bear trend, and expect that most will succeed.

Since most breakout attempts fail, many traders enter breakouts in the opposite direction. For example, if there is a bull trend and it forms a large bear trend bar closing on its low, most traders will expect this reversal attempt to fail, and many will buy at the close of the bar. If the next bar has a bull body, they will buy at the close of the bar and above its high. The first target is the high of the bear trend bar, and the next target is a measured move up, equal to the height of the bear trend bar. Some traders will use an initial protective stop that is about the same number of ticks as the bear trend bar is tall, and others will use their usual stop, like two points in the Emini. Information comes fast during a breakout, and traders can usually formulate increasingly strong opinions with the close of each subsequent bar. If there is a second strong bear trend bar and then a third, more traders will believe that the always-in position has reversed to down, and the bears will short more. The bulls who bought the bear spike will soon decide that the market will work lower over the next several bars and will therefore exit their longs. It does not make sense for them to hold long when they believe that the market will be lower in the near future. It makes more sense for them to sell out of their longs, take the loss, and then buy again at a lower price once they think that the bull trend will resume. Because the bulls have become sellers, at least for the next several bars, there is no one left to buy, and the market falls to the next level of support. If the market rallied after that first bear bar, the bears would quickly see that they were wrong and would buy back their shorts. With no one left to short and everyone buying (the bulls initiating new longs and the bears buying b...