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July 21, 2012 / redman59

An Indicator I Use to Analyze the Risk I Should Take

When a trader puts on a trade there is a known and an unknown. The known is the risk that they are willing to accept. The unknown is the future price direction. Everyone is a genius when they look at the left hand of the chart but its what is on the right side that determines the profit and loss when the trader puts on the trade and if price action follows their strategy.

Today we had a great gap and go with some late morning/pre-afternoon fright, only to see us close near the highs. Overall a mental capital drain for those that are heavy in the market. With the gap and go I wanted to show an indicator that I like to use when I decide how much risk I should put on. Of course it is not perfect, but it lets me know the risk I should allocate. The indicator is the Person Pivot with a Weekly setting. I use the thinkorswim platform, which it is provided for free, but I am not sure about other platforms.

All charts are on the RUT (Russell 2000 Index). I use this on a 30 minute chart but below are pictures of a 60 minute chart so that I could get more data with less clutter on the charts, but either way the Person Pivot numbers are the same. The data goes back to October options expiration and is broken down into 3 different hourly charts:

1) October 2011 options expiration to January 2012 options expiration

2) January 2012 options expiration to March 2012 options expiration

3) March 2012 to current price as of 5/29/2012

What I like about the Person Pivot Weekly levels is that it contains the price within the high and the low pivot…. for the most part. Again no indicator is perfect. I like to use this for a risk management standpoint and below the charts show the levels for the week on a 60 minute chart. What I found interesting and why I thought about writing this today is that the price is mostly contained within the upside Pivot, noted with the red line. As you will see from the charts below is that when there is a breach to the upside, that high breach point is contained the next week.

The first chart from October 2011 options expiration to January 2012 options expiration. You can see that there were two big moves of +35 and +43.5pt rips to the upside but the following weeks the price action was contained and adding to longs after a breach would be risky after that week.

The second chart shows from January 2012 options expiration to March 2012 options expiration. This one shows a nice rip to the upside for +17pts and the next was +2.5pts. What I find interesting was the following weeks and that those highs were contained quite well and adding to long positions would have been risky.

The third chart shows from March 2012 to current price as of 5/29/2012. These charts show two moves to the upside but the breaches were contained quite well with nice moves to the downside, that would have effected new long positions.

Now these are charts on the RUT which I primarily use for a monthly options strategy I use, but I also use this for my overall portfolio and ask myself “should I add more risk”? From what I have seen, when I see moves that breach the upside, it is best to watch the rest of the week as a move further can happen, but statistics show that these highs of the week of the breach are often stalling points and it is best to add on a retracement. I bring this up because we saw a nice move to the upside that breached the Person Pivot Weekly High and it is tempting to get in, but I like to exercise patience here for the rest of the week and see where we end up. I may miss out on some moves to the upside as this has happened but those highs of the big moves are also stalling points at time. For me, I’m in a “prove it to me” mode and will mostly observe waiting to add on a retracement.

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