By Sam Seiden, an experienced equities and futures trader, as well as a trading educator*
Posted: July 18, 2008

 

Many email messages I receive deal with entries, so I thought it would be a good idea to revisit this topic. "Profit Margin" is the term we use when referring to the objectively derived potential profit of a trade. We calculate the profit margin by measuring the distance between the supply (resistance) level and the demand (support) level.

In the chart shown above, the profit margin is the circled area. There are only two types of entries someone can possibly take, the pullback entry and the breakout entry. A key factor in determining whether the trade will work out or not is this: Is there a profit margin or not?

All you have to do is look to your left. When you are about to buy, look to your left and make sure supply is far above. When shorting, look to your left and make sure demand is far below.

How far? For me, the initial profit margin must be at least 3 times the stop. In other words, I am looking for a reward to risk of at least 3:1 to the first profit target. Most of the time, price will go well beyond the first target, but 3:1 is a good margin to get the trade started and in your favor.

You need to quantify the demand and supply accurately and make sure the profit margin is substantial. A losing trader is just like the individual who wants to open a business, doesn't do the research, buys inventory at $4.00 (supply) but finds out too late that the market will only bear $3.00 (demand).

< class=MsoNormalp>This is literally what happens in every market every day. It's incredibly simple, yet the vast majority miss the whole game being played out because of the illusions presented to them by those who have more to gain by obscuring reality.

 

An Example of Profit Margin: The 10-Year Note Futures

Here, we're looking at one of my favorite markets, the 10-year note. It is one of my favorites because of the huge volume and significant profit margins.

Notice the supply (resistance) level in the example above, labeled by the red lines. This level is ideal because of the strong initial decline from the level. This suggests a large supply / demand imbalance at the level, which means that price is likely to fall fast the first time price revisits the level.

Focus on that initial decline in price from the level. The fact that it moves down to the low it does before returning to the supply level shows us what the initial profit margin is. Traders could look to sell short in the supply area because the initial profit margin is greater than 3:1.

An S&P E-Mini Futures Example

This S&P example chart shows a demand (support) level that's a bit below. There is also a strong move out of this level, suggesting that we may see a nice trade if and when price revisits the level for the first time.

There is one issue with this level, however, that does not make it a high probability level. In the larger picture, this demand level is not well placed on the supply and demand curve. Therefore, day traders would likely see a bounce higher from this level. However, it is not an ideal area to initiate a swing trade.

Newell Rubbermaid (NWL)

NWL was a stock that has traded into supply (resistance) toward the end of 2007. This is a large level, which is not always a good thing. The strong rally into the level on no basing did make this trading opportunity one to watch. Volume on this stock was good but not great, so you may have wanted to watch it for the educational value.

What we had here at the supply level were buyers who were buying AFTER a large advance in price and at a price level where supply EXCEEDED demand. The laws of supply and demand tell us that this buying is not a consistently profitable trader, so we would want to find this buyer and take the other side of his / her trade.

Goldman Sachs (GS)

Goldman Sachs had been moving higher for a while from the August 2007 low. Notice, however, that it began exhibiting the big green candles and "gap up's" after the advance in price.

The key word here is "after". Consistently profitable traders don't buy after a large advance in price, so we can conclude that novice buyers were starting to enter this market. If price got up to the supply level, we would have been selling to the buyer who was buying after an advance in price and into a supply level.

All of these little pieces of information are designed to give you an edge. If you don't have an edge in competition, don't compete. In sports, you will lose the game. In trading, you will lose your money.

*Reprinted (and modified) with permission from Online Trading Academy www.onlinetradingacademy.com. Sam Seiden can be reached at: sseiden@tradingacademy.com.