How to trade with least Risk

Twitter: @ProdigalTrader
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Price move in market is always controlled by either of the following mechanism

1. Momentum - Trend
2. Reversion to mean – Counter Trend

See this picture for clarity

Suppose we are trading with trend and took the breakout trade

We will enter long above the high of the breakout candle. Breakout candle is usually a high momentum
candle making it too far away from the base of the break out level. Hence SL will be too far away. Which
will severely affect the position size u can afford in ur first entry
Now let’s see a more realistic picture

Here u would see breakouts usually undergoes deeper mean reversion rather than going to the
same direction. Such moves always big threat to the SL we place in the trade.
Because in most case reversion goes way beyond breakout level

For safety, if u decide to keep SL below the previous swing low, once again risk in the trade is way
too high and u will have to content with smaller position size with huge risk. That’s not a right
approach.
What else can be done?

We need to develop a method which accounts for the potential mean reversion after the breakout
move. So if we allow the stock to pull back to the mean & plan ur entry on reversal after the
pullback, SL will be so very tight that u will be able to find a new higher price support point (which
is just below the low of the pullback move). Ur entry will just above the reversal candle pattern
high in the pullback.
So how to formulate a method considering all these points??
Following is a systematic approach to formulate a method which upon the trades can be taken with minimal
risk.
It’s just one case study among many approaches out there is the market.

Let’s divide the approach

1. Find scrips which starts complying with bullish Dow Theory after a downtrend.
Specifically we need a scrip which just finished pullback/correction. We need specifically One
Higher High and Two Higher Lows in place

2. Price breaks out with increased volume

 3. Price Pulls back to 20 SMA with lower volume.

4. For entry u can use a simple bullish reversal candle pattern at or just below the 20SMA

This is the set up.

One need to make long entry close to 20SMA.

Here in this method, there was two potential entry points

1. First one was to make long entry at breakout
2. Another one was to enter near pullback to 20 SMA
We chose not to enter at breakout. The reasons are three

1. We cannot assess if the breakout will sustain or not. Becoz, the scrip has just came out of a pullback
and have only 1 HH and 2 HLs. This simple pullback might end up as a lengthy correction.
2. All breakouts are susceptible to mean reversion below the breakout level and also below the
breakout bar low. The mean would be much lower in many cases. So Breakout buy will end up being
in loss as the price falls below Breakout bar low.

3. Breakout bar will have high volatility and big candle spread. This makes SL very wide and risk, many
a times, unreasonably large.
Hence we avoid breakout buy, rather go for pullback at 20 SMA
We validate the strength of the trend by a poor volume pullback after a high volume breakout.

Here the risk is much more under control as volatility near the pullback end will be very less that we would
be able to take safe long entry much closer to 20SMA and keep SL below it.

Pros in this approach is

1. During pullback candles will be smaller and less volatile making SL much smaller
2. There wouldn’t be any rush as pullback isn’t as hot as breakout as far as public intrest is concerned.
One will be cheapest bids filled
3. Even initial entry can be divided into parts as price will stay enough time near to 20 SMA

Why 20SMA, not 50SMA?

Here the principle is based on the concept that during breakout price would be too far away from short-
term moving average. Price can’t stay away from MA much longer.

Either price would stall so that MA catches up

Or
Price fall to MA
This principle of mean reversion applies on a short term average only

If u consider 50SMA, that’s too much of an MA length to consider as price would need unreasonably higher
amount of time to reach 50SMA. And in that case it won’t be mean reversion anymore. That would be a
correction and strength in the trend which we were looking to rely upon would be long gone.
Examples - EOD timeframe – short to medium term trading

15min TF – Day or swing trading

One major advantage in this approach is that as price continue to go up maintaining the trend, during all
such weaker pullbacks, positions can be added again into it. Thus scaling into winner can multiply the profit.

EOD timeframe – Scaling In

15min timeframe – Scaling In

This approach can be applied in any time frame stating from weekly to 1min.
Everywhere u would see the price would pullback to short-term moving average such as 20SMA before
making further upmove
The setup is so common that u would see it in almost all scrips and indices, in all timeframes

Twitter: @ProdigalTrader
Telegram: prodigaltrader