Stacking the Deck
Using Cycles, Pattern and 
Volume to Increase Your Odds

By Kent Austin and Mike Endert

Buying and Selling in the market is, and has always been, a game of probabilities. Investors who buy stocks and hold for years are betting on the probability that earnings per share will be higher 10-20 years later, driving the market price for their shares higher. This higher e.p.s. can be the result of a well-run business, or a consequence of our country’s growth in Gross Domestic Product. Either way, the probabilities are on the side with the 10-20 year investor, but not with the 6-month investor. 

Due to the recent reduction in transaction costs, a trading bonanza has erupted in the marketplace of securities. The increase in technological advances over the past 7 years have made buying and selling frequency more convenient and at a fraction of the cost. Therefore, the retail public has recently experienced unprecedented access to what had previously been considered as the “greatest game in town.” As investors continue to shop for “value”, many are replaced by the new paradigm of those who shop for volatility and liquidity. The presupposition of this article is that the game hasn’t changed much at all, despite the recent changes in technology. In order for the investor or trader to succeed in the marketplace, opportunities are taken only where the odds are stacked in favor of success. This article will address how a successful S&P day trader stacks the deck in his/her favor each business day by: 

1. Eliminating a “chart’s real estate”.
2. Exploiting pattern recognition.
3. Riding volume’s tailwind.
4. Applying effective money management.

Eliminating Real Estate
During the trading day, the game lasts for 390 minutes in the cash market and 405 minutes in the futures. The concept of pivot points in price and time are an important concept because it allows the trader to focus his/her actions at specific prices and times that lead to discipline and consistency. There may be 405 minutes in the day, but the professional is focused on perhaps, only 80 minutes, partitioned throughout the day. These cycle windows lead a path to where the market prefers to pivot. The same is applied to price. Both the cycle windows and the price points are a forecast.

The professional is also aware that not all forecasted price and time pivot points can be exploited for profit. However, when coupled with other reinforcements, on many occasions, these points of force prove the most powerful weapon in the trader’s arsenal. Such a perspective allows the professional trader to eliminate 80 percent or more of the “real estate” on his/her 2 dimensional screen. By eliminating this much real estate, the trader can focus directly on the “meat” of the market. Cycles can be a tricky subject for the novice. However, when coupled with pattern, cycles can be applied easier and more appropriately. 

Exploiting Pattern Recognition
Anyone who studies price behavior long enough will eventually come to realize that the pattern which price draws on the chart/scale is the result of price being an output or function of time. Without taking additional courses in engineering or physics, it should be fundamental to all traders that the “Z” patterns which show up in all advances or declines are really ellipses as some market analysts have discovered. The ellipses are really circles, they just appear as ellipses from the chart’s “relative” perspective. These circles are full cycles, 1/2 cycles, 1/4 cycles, and even 1/3 of a cycle as understood by the subject of harmonics. If one wants to understand why harmonics show up, a study of the subject of sympathetic resonation is in order. Nevertheless, monitoring these ellipse pattern progressions, on forecasted cycle harmonics significantly separates the “men from the boys” with respect to buying and selling in the market. Obviously, news can add energy to the market at any time. However, one quickly discovers that the most fundamental news releases are usually scheduled for before or after market hours. 

Here is a simple, yet very effective ratio to monitor the progression/regression, swing extensions/retracements of these ellipse patterns. The number 2 is an important concept with respect to the octave of sound (frequency doubling), but its square root can also be used to monitor momentum strength/weakness. If cycle/price pivots call for a complex top/bottom such as a “W” pattern or “M” pattern, check the ratio of the final extension against its previous reaction. If this semi-major (extension) is equal to or less than 1.414, then the momentum is static. The logic is simple if one accepts logarithmic progression in the form of squares. 1.414 is well known by mathematicians as the ratio of a square’s diagonal to its side.

The inverse of 1.414, or .707 is used conversely when trading with the trend at a forecasted cycle. If a retracement of .707 or less is observed, one can expect the trend to continue without excessive swing action. Many articles and books have been written about this ratio (and others related to the square) showing up in the market when price swings are related to each other. These ratios, in the author’s opinion, should not be overlooked for quantifying momentum. When momentum and cycle point in the same direction, the odds for profit increase. 

Finally, for the acute observer and student of price, each ellipse should be viewed as the mating of two triangles. One will observe that the minor axis of the ellipse is shared by each triangle. And to keep the research appetite wet, here is additional “food for thought”. Market students who identify A, B, C, D ellipses (where D is either the high or low of a particular market move) always keep the inverse close at hand. That’s correct... an inverse exists. It simply cannot be shown through price. Therefore, do not be discouraged with the research if a cycle time forecasted shows up at C instead of D. This occurs every day. The solution is to let the triangle complete at the cycle points of force. Additionally, the size of this triangle is a determining factor with respect to money management. 

Riding Volume’s Tailwind
Wouldn’t it be great if measuring the accumulation/distribution in the market was as easy as licking your finger to find out which way the wind is predominantly blowing? One indicator works better than any other I am aware of as a precursor to big breaks in the market. What’s even better is knowing what ratio really acts as a pivot for converting the market from bearish to bullish. Dick Arms’ indicator, also known as the TRIN Index, measures the up-volume and down-volume for a complete basket of stocks and can be created for any basket of stocks. Today as this article is being written, the TRIN index has been bearish all day. Therefore it should be no surprise that the fastest move as measured by angle speed was to the downside, despite the fact that the market has traded above its opening tick for most of the day. 

Most traders are familiar with .618 as an important ratio to follow. The square root of .618 is more important when monitoring the TRIN index. This ratio is .78 and is also the 4th harmonic of PI, or 3.14 divided by 4. Most textbooks will tell you that a TRIN index below 1 is bullish and above 1 is bearish. After further observation, .78 - .88 is completely neutral. Only after the market has been trading below .78, should one expect any significant advances for the market. It’s almost as if the market needs extra air in the pump to keep things primed. Oh sure, the market “bucks” the wind often. But if one is to put the odds in favor of a “big break” occurring, it is best to trade with the wind. In the first 30 min. of trading the TRIN can be less effective because specialists are “shoring” up their books from open orders, etc. For the first 30 minutes, the opening tick takes precedence. Otherwise, checking the TRIN before making the trade can lead to a “10-bagger”. It’s the only technique discussed that addresses the odds favoring the reward side of the equation. Now for the risk side... 

Money Management
“Cut your losses short; let your profits run” is probably the best laymen version for one of Newton’s laws of motion ever stated. Letting profits ride always seems less challenging (psychologically) when the position has moved in one’s favor beyond the point of break even. But nothing seems more paralyzing than watching a P&L “pivot” between profit and the risk of the position. A “catch 22” seems inevitable for those who have only risked a small amount on a position because prematurely moving a stop loss to break even can flutter one out on volatility alone. On the other hand, “letting profits run” calls for letting the trades play out. 
Here is a technique that accelerates the position to risk free, without prematurely moving the stop loss to break even and jeopardizing the trade’s ability to “play out.” When momentum is quantified properly as discussed earlier, a position can hit risk free in a matter of minutes, prompting additional patience on behalf of the trader to “let the house’s money ride.” The trick is to catch a break by which one covers half of the position back at a profit equal to the original risk on the trade. The accompanying chart shows this trade technique. Of course there is less profit, but money management is focused on the expense side: limiting losses. 

More times than not the cover point on half the position is very close to where the final cover signal comes in or the trail stop is hit. Additionally, one can discover that he/she was originally wrong on the trade, but did not withstand a loss. When profit on a position hits 3-4 times the amount at risk, a .382 trail stop is in order. When you find yourself frequently canceling and replacing a stop order due to a parabolic move in your favor, enjoy the process; as it is a good problem to have as a disciplined money manager. For those of you fishing for the big one, where .382 is too much to give back (on such a parabola), PI’s inverse of .318 or .214 may serve as alternatives. .214 is the difference of .786 from 1 and the inverse of Feigenbaum’s constant 4.66 for parabolic bifurcation.

Hopefully these aforementioned techniques illustrate a professional approach to stacking the odds in one’s favor. Certainly additional statistical studies can be applied for correlating market turns, etc. However, the key is to place oneself in a position to receive only what the market is willing to give as frequently as probable. Joe Montana is considered one of the most successful professional quarterbacks ever to play the game of football. Those who enjoyed the privilege of watching Joe play for most of his career, remember a quarterback who constantly exploited what defenses were willing to give up. Whether it was finding the open receiver in the “soft spot” of the zone or capitalizing on a particular man to man mismatch, Joe was the best. The result: a movement of the chains, and some of the best drives in football history. The best way to “keep the chains moving” in the brokerage account is simply taking what the market gives by those who can recognize a “stacked deck.” 

For more information on this program go to www.tradersworld.com/doubleedge