Starting in part seven of this series, I thought I’d flip the coin over and talk about when price and volume actually agree.
I’ve written a fair bit about the edge that can be gained by watching for a proverbial scuffle to break out between price and volume, Fight Club style. But you can also use price-volume agreement to your advantage to reduce your overall information risk for a trade.
What’s information risk? Well, in a nutshell, there are (at least) two kinds of risk you can incur in deciding whether to act in or around a trade. And it’s hard to talk about information risk without talking about price risk at the same time. Price and information risk are twins conjoined… yin and yang… a zero-sum pairing. The first kind of risk – information risk – is the bigger threat to your P & L over time. Information risk is when you wait too long to take action because you’re seeking confirmation or additional information.
Here’s a scenario. You’ve done your homework, and during that homework you saw 1350 in the ES as an important level. In your plan you noted that this price should be strong support on a test from above sometime during the day. And you think that 1347.50 would be a good stop placement for what could potentially a 10-point trade. That’s a 2.5 points of potential risk for 10 points of potential profit. Nice.
But when price comes to your level, 1350, instead of getting long (or scaling out of your short) you wait. It was in fact a good support level, and buyers step out of nowhere en masse right there at 1350 and price rockets up from that level. Knowing you were right and seeing its a good trade, you decide to take action and by the time you get your orders in price is at 1353.50, and you can’t get filled until 1354. You still have that same potential for a 10 point swing, but there’s just one trouble. You’re stop is not valid at 1351.50 – which is 2.5 points below your actual entry. You can place the stop there but it’s quite possible – likely even – that you’re going to get taken out at a loss during what would be a normal rotation before more upward movement. 1347.5 is still the only “safe” stop for that particular trade. And for your entry as executed (not as you planned!) that means you have to take 6.5 points of risk for only 6 points of potential profit. Not so nice.
And there it is. You’ve sabotaged your risk-reward ratio and your profit potential in this scenario because you took excessive information risk. Price risk, as it turns out, is not really risk at all. In fact it should be called price reward. As you can see above, the actual trade-off is between taking action when you don’t yet know what’s going to happen for sure or waiting for more information. Knowing and/or waiting, in trading at least, can really cost you.
But you can mitigate your information risk. That’s what your price and volume analysis tools are for. It’s not just that they are pretty, cool and even pretty cool (ha), it’s that they can help you mitigate and manage your information risk in real time.
And there was one unusually clear example this week that, not by coincidence, could have aided any trader embroiled in the scenario above. Note the prices in the actual chart below don’t match the scenario above exactly. I used round numbers above to make it easier to explain.
But the idea is this – you expected buyers to step in at your 1350 price. They did. Your tools – the Acme Volume Impression in this case – were giving you clear visual evidence that your hypothesis about the trade was correct. Price is doing want you expected. Volume is very clearly agreeing. So what’s the right thing to do? When? Which kind of risk do you really want to take?
This one picture answers all.
Have a great weekend, amigos. Trade ’em well next week…