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How to Use “Crayon Drawings” to Make Money
Trading the Markets

| Author: Tim

. . . Those of you who have been following my writings for some time may have noticed I have been showing more stock charts lately. In fact, there was a time when I rarely — if ever — showed a stock chart, let alone an actual trade in a stock. People new to my websites often email asking if the methodologies I use in my trading work for stocks (in addition to futures markets), and it usually reminds me I have to teach more about the history of many of the methods uses, since they were invented to trade stocks in the decade before the (prior?) Great Depression.

But there are 3-reasons I have been showing more stock-market charts:

I thought it might be interesting to see one of my son's current open positions and his thoughts behind the trade. Remember, I teach him trading basics and solid money management, but I do not show him trades, nor do I wave him off of trades I think might be losers. The most important part of this exercise is he can show both himself and me he can trade, and also decide if he likes trading enough to consider it as a profession. The rules are simple: He must have a trading plan written down before any trade is taken, he has a maximum amount he can risk per trade (and he set it, not me), he has a maximum amount he will risk at any one time (and he set it, not me), and he has a “kill switch,” an amount closes down his trading account  (a $2,000 total drawdown from the opening balance of the account—I set that!).

Sean uses what I call “crayon drawing,” or crayon trading—no special or fancy technical analysis tools. He draws in simple market structure, which by its nature, should keep his trades and his stop losses and profit targets close to areas where the “whales,” or large traders, are leaving their orders. Once you can read the whale tracks, I believe the market becomes much easier to read and trade. Let's look at a chart and I'll show you what I mean:

Crayon drawing involves drawing simple, easily recognizable lines to try to identify market structure. If you identify where the whales may have left their buy and sell orders and draw these simple lines over and over again, market structure becomes easier and easier to identify. So, let me break out a crayon and mark up this same chart with some simple lines!

For those of you who actively trade (or desire to learn how to trade) the financial and futures markets, there are a lot of other things outside the markets you should be following. But, I guess my bigger message is for those of you that aren’t in the futures markets, whether you trade them or not, the futures markets have a significant impact on what happens in the other financial markets, including forex, currencies, options and stocks. That’s why you should soak up every piece of good trading knowledge like a sponge in a quest to clearly see the bigger picture.

There's nothing magical about drawing in the highest high and the lowest low on a chart, but all analysis must begin somewhere, so we always begin there. Then I teach students to literally get up from their chair and take a step or two back from their computer monitors, and after looking away from the screen for ten or 20 seconds, look back at the chart in front of them and see what catches their eye right away. Is this always the most important thing on the chart when they are done doing their analysis? No, but it leads them down a visual path and helps unlock their minds to what is right in front of them. People of any age are generally visual in nature, and once they begin process, the visual path is open and ready to be used.

Now, remember those were my charts, not Sean's charts. Let's take a look at his style of chart, with fewer lines and less annotations:

Many traders have their charts filled with lagging indicators (moving averages, CCI, RSI, MACD, etc.), but this method simply identifies the market structure price has left. By identifying market structure, you have identified where the whales may play well in advance of price reaching those areas. means this method is built entirely on leading indicators. I'd much rather trade knowing in advance where the market structure shows me buyers or sellers are likely to emerge than rely on lagging indicators, which will get me into moves well after they have started.

How can you use the these simple “crayon drawings” to find quality entries? Let's see what Sean has in mind. First, he marked out the market structure map on his chart, and then he waited for price to interact with his map.

Sean is looking for price to “fill in the mountain” and come down to test the multi-pivot line. Although this line has been penetrated, if his order to get long Burger King (BKC) is filled at 16.58, his initial stop loss order will be within his own maximum stop loss size of $2.50 and will also be about 50 cents below the prior major low at 15.61, where he expects there will be large limit buy orders in the market, left by whales to establish new positions.

Now let me add in a zoomed-in chart using some of my charting tools I have not taught to the “crayon crowd” may be of some use when evaluating the pluses and minuses of this potential trade:

After price makes a major low at 15.61, it begins to climb out of the hole and then forms the multi-pivot line Sean is using as his buy area—if price comes back to test it.

As price climbs higher, it has normal pullbacks, as most rallies do in their early stages, then price heads nearly vertically higher and forms double tops before heading back lower in the same near-vertical fashion (this is the “mountain” being formed, by the way). Now note just before price went higher in a vertical fashion, I added a black, down-sloping simple trend line connecting the lower highs of corrective swing. I call this the “change in behavior line.” It bisects negative and positive price action. It's easy to see price went higher in a near-vertical fashion once it broke above this change in behavior line, and while price is above this line, I expect we will see maintained positive price behavior.

Note I marked where the change in behavior line and the multi-pivot line formed an area of confluence (where they cross). I often find these areas give a good indication of the time when price may change directions. In this case, price left double tops after going vertical and is headed back lower in an attempt to fill in the base line of a mountain formation (mountains and valleys are two of the simple market structures I teach the crayon crowd). This is the area where Sean wants to get long Burger King stock. Let's keep our eyes on this area marked with a green circle and see if it does give us a good time component for the potential trade entry.

Now you know Sean's entry area and his initial stop loss order. And I added a few of my own charts to give you a feel for what I was thinking (but not pointing out to him) as he showed me his trading plan. At one point, I asked him to show me where he planned on taking profits if price filled the mountain, letting him in, and didn't immediately hit his initial stop loss order.

One of the key money management tools I teach the crayon crowd is acceptable risk/reward ratios in their trading. Let's look at Sean's chart outlines his ideas for taking profits on this potential trade:

Though many of you may recognize the magenta-colored, down-sloping lines as a rolling chop, one of the formations I have made popular and have traded quite profitably for more than 30 years, it isn't a formation or market structure I teach the crayon crowd. I teach them how to draw simple trend lines, and as you can see here, it didn't take Sean long to realize the slope of connected highs or lows can be part of a powerful measuring tool.

When he showed me this chart, I asked him where his profit target was, and he told me price was cascading lower, a term I use when describing this type of market structure, and he planned on using two profit targets:

When I asked him about his risk/reward ratio on this trade, he had an interesting answer those of you trying to build smaller accounts into larger accounts might find interesting. He is trading based on daily bars, and if the market fills his limit buy entry order, he will quickly collapse his risk (unless he immediately gets stopped out), a technique he has seen me use over and over when portfolio trading using daily, weekly, and monthly bars. The initial risk/reward on the first half of his trade is just about one-to-one, assuming price immediately climbed higher to test the magenta line at the 18 to 18.20 area. The risk reward on the second half would be just over 1.5-to-1.

I have said many times the higher your risk/reward ratio, the lower your risk of ruin. These are the simple truths popularized by those doing work on betting statistics. But when working with smaller accounts or when trading using market structure often doesn't give you many pivots to work with, you sometimes have to work with what you have, as my mother would say. In longer-term portfolio trading, 'V' bottoms are more common and entry opportunities are often few and far between. I have developed two methods I use hand in hand when portfolio trading: Collapsing risk and dynamic risk/reward ratios. My students at the mid-day mentoring sessions have seen me use these techniques over and over, and Sean has seen them as well.

As I mentioned before, my role is to make certain Sean prepares himself before a trade is executed and he follows the hard and fast rules. I may have opinions about one of his trades, but I don't share them, even if he asks. The goal is to see if he can trade using what he has learned and what he is taught, and more important to me, to find out if he enjoys trading enough to consider becoming a full-time professional trader.

Let's take a look at how the market unfolds as price approaches the area of confluence.

Sean's limit buy order at 16.58 was filled right at the confluence formed by the change in behavior line and the multi-pivot Line. As I mentioned earlier, these areas of confluence often act as energy points, and after working them now for many years, I feel their most important contribution is they inject an element of time (or space, if you are using non time-based bars) to the right side, or unfolding side, of your charts.

Looking at this chart, I like traders probed the area below the multi-pivot line. In essence, the market wants to know if the whales still have interest in buying more stock down at area. Price closed well back above the multi-pivot line, so at least for this day, there appeared to be a good deal of limit buy orders at or near 16.58, including Sean's order, of course.

Let's quickly talk about attention to detail: Sean will be back in school in early August, so one of our first rules was he was not allowed to day trade, nor was he allowed to watch his positions during the day. (Yes, I'm sure he likely peeked now and then, since he interrupted one mid-day mentoring session to tell me his position was up more than 50 cents on the day near the close, which got quite a few “Go Sean!” or “Is Sean taking clients yet?” comments during the session.)

But the cardinal rule cannot ever be broken under any circumstance is this: Initial stop loss orders are always put into the market at the same time limit entry orders are placed. There’s no such thing as “soft” stop loss orders, though I have had many an argument with other professionals about the concept. Stop loss orders are your best friend; they protect you from losing all trading capital in your brokerage account should something go wrong. Learn how to effectively use stop loss orders — it is the first thing I teach the crayon crowd.

Once the market closed, Sean checked to make sure his order was filled, and then he checked his “good 'til canceled” stop loss order was in the market. At point, he measured where price would intersect with the magenta-colored, down-sloping line and put in a limit order to sell one half of his position at 18.03 and a separate limit order to sell the second half of his position at 18.93. Let's see how the market traded in the few days followed.

Two days later, price opens near its high but then trades lower and closes in the lower third of its daily bar after making a new low for the move. I zoomed in on the price action so you can clearly see each bar. Price has closed lower six straight days in a row! Who would buy this stock with this sort of price action?

The whales would! They “need” this type of action at or near their price entry point to get smaller traders to dump their long positions. Looking at this chart after the close, I clearly remember my opinion: If Burger King (BKC) did not find significant buying orders at this level the following day, Sean would quickly be stopped out of his position. Conversely, if the whales did have orders at these levels and a rally began, no smaller traders were long and they'd be forced to chase this stock higher once they understood what was going on. At the close of this day, Sean's position in Burger King would either be a very-well-thought-out long, or he had held out his hand and tried to catch a falling knife. The next day's action should be interesting, indeed!

If you’re wondering, Sean did not ask my opinion after the close and I did not offer it. Part of finding out whether he liked trading and could be a good trader was watching him follow or not follow his trading plan.

Price gapped higher the next morning and climbed higher all day, closing near its high. After the market closed, Sean pulled up his charts and then knocked on my trading room door. He asked a very insightful question: “What would price need to do tomorrow to make me feel there were whales or large limit buy orders at the recent area of congestion (right at the multi-pivot line)?” The obvious answer is price simply has to go higher, but the logic behind the answer is more important, and I think that’s what he was really asking about.

If price continues higher out of this price range, the two moves under the multi-pivot line will be a “wash and rinse,” especially because the second daily bar made a new low for the move. Many traders who had built small long positions in front of the multi-pivot line probably stopped themselves out of their long positions when price made the second probe, which made a new low for the move. And some traders probably left orders to get short if price made a new low by even a cent or two below the prior low. These are the breakout traders looking for the new lows to generate momentum to push prices significantly lower. But this day's close had some of the smarter traders realizing they had stopped themselves out of their long position and price still hadn't begun a new leg lower. In fact, if price has a higher close tomorrow, they'll want to be long. So some of the smarter retail traders went home with a new long position and put their stop loss just under the prior low. If price heads higher the next day, more of these traders will jump on board … and that's how a change in trend begins.

Price gapped open higher again and ran quite a bit higher. Price has now begun to separate itself from the congestion area, marked with the green ellipse. Sean is long at 16.58 and the close is at 17.20, so his position is moving nicely away from his entry level. His initial stop loss was at 15.03, but now price has moved well back above the multi-pivot line and the area of congestion, there's no need for him to risk much money. If price breaks below the prior lows by much, a new leg lower will be unfolding and he'll want to be out of his position at a smaller loss. He decided to snug his stop loss to 16.08, which is 25 cents below the prior low. He is currently risking 50 cents total per share on this position. When I portfolio trade, I call this “collapsing risk.” Price has left a natural area of support and it only makes sense to move your stop loss up to take advantage of this area.

Right above the current price action, the open gap looms large. This can only be a successful trade if the open gap is filled, and open gaps often attract large orders. Will there be whales selling as price nears or enters the open gap zone?

In one daily bar, price closes the open gap and closes near its high. Price has shown strength just when it needed to. There are two breakaway bars above the area of congestion. At the end of the day, when price closes at 17.50, Sean cancels his stop loss order at 16.08 and replaces it with a break even stop order. After testing the key area of support and then showing this much strength, he is no longer willing to take a loss on this trade.

He doesn't ask me what I think of his money management orders, but they are exactly how I would have handled my orders.

After price had no problem filling the open gap, the question remained whether it would show the same strength at the rolling chop line looming overhead.

Sean chose to deal with this question by trying to exit half his position before price tested the rolling chop line.  He left limit sell orders for half his position at 17.78 and is now working a break even stop loss order.

Sean's done a very good job framing out this trade … so far. The area he identified where whales might have left large limit buy orders acted just as he expected: His limit buy order was filled and though traders probed the area, making minor new lows, price congested there briefly and then turned back higher.

He was able to collapse his risk using my concept of “Dynamic Risk Reward,” has now taken profits on half his position, and is working a break even order on the rest of his position. He has rolled forward some stops in his small trading account — I cannot stress how important concept is—and he is now using the market's money to try to stretch his profits on the remaining position.

I have given him little, if any, input on his trading decisions; if he asked a specific question about market structure or market behavior, I was as helpful as possible. I haven't voiced my opinions to him about this trade or his other open trades, nor has he asked my opinion. In my view, traders do best when they educate themselves and then stand on their own two feet — and Sean apparently shares my beliefs.

Three bars after Sean takes profits on half his position, he sees his first live example of the bubbling enthusiasm leads to a rolling chop, one of my favorite trading patterns. Once price breaks and closes above the simple down-sloping trend line, the last small traders were certain a new up trend had begun and they were not going to miss this move higher! Buy orders flooded the market on the open the next morning, but once everyone was long, there was only one place for price to go: Lower! Even though price closed on its high and above the magenta-colored rolling chop line two days in a row, when the buyers dried up, gravity took over and the following day, it gapped lower and closed near its lows, well back within the rolling chop channel. Many of the traders who went long were now finding themselves holding long positions were either established at higher levels, or they were watching their profits evaporate.

After the market closed, Sean came into my trading room and told me he moved his stop profit order to five cents above his entry level. His reasoning? He had a nice profit in his first real position and he was trying to build his account. Even though he took half his profits at 17.78, he wanted to book some profits on the second half, even if it was just a few cents. I certainly couldn't argue with his logic; this was not only rolling forward stops, but it was also building confidence in his skills by making certain the entire position was a winner.

Let me show you the current chart, through the close on Friday.

Sean's profit stop five cents above his entry level just missed getting filled. In fact, we were at the Grand Canyon day with my 91-year-old mother, and when we got home quite late, he checked the price on my computer and was certain he had been stopped out. He wouldn't believe me until I showed him the time and sales from the day, and even then, he pulled the chart up on his own computer, certain my computer's prices were wrong!

As you can see, price is working its way back higher, and Friday's close was above the magenta, down-sloping rolling chop line. Sean left his orders exactly as they were, and for the first time, he came to me and told me even though he understood why the market isn't open on the weekends, it makes him anxious waiting for the market to re-open. (Welcome to “mastering yourself,” my son!) The most difficult part of trading is between the ears, but so far, I think he has done a very nice job managing this trade. I particularly like he took some money out of the market and has rolled forward some stops, which will help when he has his first losing trade. This is one of the most important ways to build up account equity in a small trading account.

I admit this trade is not my style, but then, I go out of my way to help my students of all ages to develop their own winning styles. I have no interest in creating a cloned army of Tim Morges out there; every trader is different and my goal is to help them become the best trader they can be — the best “them.”

I hope watching the ups and downs of Sean's first live trade — though it is not closed out yet — has been interesting and informative. Because I am building quite a large group of material for traders who are just beginning for our Web site, as well as getting ready to teach elementary and middle school students this fall, I'll keep you all informed on how Sean's trades are progressing, He's my in-house student experiment!

I wish you good trading!

Used with permission of Timothy Morge. Copyright by Market Geometry

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