TUTORIAL: Trading Boxes and how to draw them for entries and exits

by DAN WM LULU EW 
I want to talk just talk real briefly about drawing these boxes that I talk about a lot. First of all, they are not Darvas Boxes, that’s different; they are not used for predicting. What I use them for is just a simple method I started, frankly, when I have been spending so many years, it seems like, where one of my job descriptions is, teach proper entries to Stock Market Mentor members. And because we always have people coming in, most stay, some go, then some come back, etcetera, etcetera, it’s like a never-ending process. And so what I started doing was saying this, “You can buy a stock anywhere here but the only time you can do it right now is on the hard right edge, as Alan Farley calls it. You can only buy the stock here.”

It is a common attempt that newer traders make to try to predict where the stock is going to go. When they do that they wind up getting all wrapped around the axle because they start expecting the unexpected. Oh, I see the stock is right up at resistance here. That’s failed 5 times at that level. This is the time it’s going to break out. Dude, how do you know that? You don’t, you’re guessing. You are saying that you know it because at the end of the sentence you are not putting a question mark; you are putting an exclamation point on it.

This is what I do: I say, “Okay, you’re looking at buying, say, Waste Management ( NYSE: WM ), right now. Let’s start right where the price is now and that’s the upper left hand corner. And then what I am trying to do is this, I will put it right here. We have all looked at thousands, some of us millions of charts and we see all of these different price patterns and things that happen. And so you have to be thinking about it in this way, when you are buying a stock what you are saying is (if you are just drawing the box here), this stock will not fall into the box at all. If it were going to fall into the box you wouldn’t be buying it there. So instead you are saying, “Upper left hand corner, this is where I am buying and I expect this stock to not come back into this box.” In other words, this is a really good entry right here. And so if that is what you believe then you go ahead and make that trade.

But then there is another side, if you say, “Well, maybe I am a little too optimistic. Maybe the stock could fall into the box.” Okay, fine. How far down could it fall to where a box would capture the decline? Could the stock fall all the way down here and match this September low? Sure it could, but what we have had going here is, we have had this kind of a price move here. And we’ve got, we could look at kind of a flat channel there, so we see these as our relevant trendlines. This is all speculation guys, that’s what trading is. It’s not guessing and it sure isn’t winning, it’s speculation.

I would look at this and say, “Okay, I see what’s happening here so I would think that this stock could fall clear down here to the top of this line.” So if that’s your thesis then what you are really looking at is buying the stock here and you have to give it a 2.5 percent risk; because you have to base your trade on something. And so your basis is, I do not believe that this stock is going to fall low enough to break this trendline. So therefore my stop will be right here at this trendline wherever it is. Right now it’s here so this is where my stop is going to be. So I am buying here at the top of the box and I have got my stop right down at the bottom of the box, which is my judgment as far as how far the stock could fall based on my technical analysis and that is about 2.5 percent. So that’s your box, that’s your trading box. You are saying, “If the stock falls into the box as long as it doesn’t fall out the bottom I’m okay.”

Now, why is this important? I will tell you why it’s important. This is a little bit subtle but let’s say you are buying this stock here. We are not just going back on the chart for a results oriented analysis this is real. So we just looked at where that box would be, now we are here. And we see this stock up here and we decide we are going to buy it right here, right now. So where would that box go? How far down would we have to extend this box to encompass what we believe would be a reasonable price decline? Well, we see that in the past, over the last several weeks, the 20-day moving average held the stock. It’s the same thing here. So wouldn’t we then have to assume that the stock could fall, if it did peak here, that the stock could fall clear back to the 20-day moving average? To me, that would be a pretty safe assumption. And so if that’s the case then we have to put the bottom of the box here, the top of the box right up here, so we’ve got a different box. And that now, you have to pack on about a 4.5 percent loss that you could take before you would even know whether you were wrong or not because this is the pattern, the 50-day moving average.

This is important, again, not because it is a predictor, I am not looking at this saying, “Oh yes, I think the stock is going to fill that box.” No, I am saying, “Right here, right now, if I decide to buy this stock what’s my risk? What’s my risk?” If you can’t look at the downside and find some logical support level for the stock then you are actually just guessing. That’s really is, you are just guessing.

Let’s look at a couple of other charts that can give you maybe a better idea, just some stuff that I’m looking at now. I took a position in Lululemon ( NASDAQ: LULU ) a few days ago. I was actually going to add to it today but I looked at the market, I looked at my position and I thought, okay, and think about this in your own trading, I’m thinking, okay, I don’t mind taking on more risk right now because this is a pretty small position. But do I want to take on a lot more risk? Answer, no I don’t. I could take on a little risk and then I would be in a position to make more money if the stock keeps going. But then I am thinking, and this is just stuff that I was thinking in my brain as I was looking at the stock. It took a heck of a shorter amount of time to go through my thought process than it is telling you about it. So I look at this whole thing and I decided that it is less than $2.00 below $200.00, which I would have to assume is going to be some type of resistance. So do I want to take on more risk, more money in a stock that probably has about $2.00 of upside before we could at least expect it to be tested? My answer was no. I just decided, hey, I got a good one. I am in at the right time. This is not the right time to add so I am just going to stick with what I have.

Now, where was my box? When I got in, I think it was on this day, on the 7th. What I was doing at that point was, I’m looking at this saying, “Alright, the 50-day moving average is support but actually this stock fell even below that level. So any pullback I have to put my stop below here. I would have to put it below this level here, which is the low, we’ll call it 185.00. I have to put it below 185.00 because if I put it above, let’s say I put it slightly below the 50-day moving average.” Well, the stock was down there on the 3rd and it rebounded and it went higher so if I keep the stop really super tight then I am risking getting stopped out on normal volatility only to see the stock turn around and rocket higher because it is in kind of a little bit of a squeeze.

So what I did was, I looked at where the price was and I drew this box down here. Don’t read into it that I’m drifting it to the left instead of the right I am just showing you that this is where the low was. So I drew it right down here and then my stop would be a little bit below that level, we’ll say right around 185.00. So now I am buying it here at 192.00, the stop is at 185.00, I am risking about 4 percent. And so as I look at this box I am saying, “Yes, I can see the stock going down in that level.” It didn’t and so that was actually a pretty good trade.

Now, let’s just continue this analysis. If I did choose to buy more today this is what I would have had to do; I would have had to take this box and say, “Okay, I am buying right here at 198.00. Where’s my box? If the stock falls into the box where would it be? How far down could it go?” Well, it could go clear down to the 50-day moving average again. I am not so worried about this level anymore, this 185.00 level because we got a little pullback here and so that is kind of a higher low, we’re really doing microscopic surgery on this. But I would have to look and say, “The stock could fall back, it could come back tomorrow, come down here, fritter around, I could see the stock basically coming all the way down to the bottom here and then ultimately, hopefully, doing this kind of move, it could do that.” So if I can see the stock doing that, coming back again to test the 50-day moving average then this has to be the length of my box. It has to be clear down here.

Again, the whole reason I am doing this is to go through this exercise of saying “Okay, if the stock moves against me, how far is it likely to go just as a normal function of the way it trades and I have to extend it to clear down here?” And so then I would pull this down. Now to buy this stock today like I was considering doing, let’s assume it was right at the close, then I would be taking this kind of risk. I am buying it here I have to take almost 6 percent of risk. Well, I don’t want to take that amount of risk right now, not in this market. But if I said I only want to take 3 percent? All right, well what’s this going to do? I could get stopped out of this stock just at the open or something.

I will just wrap it up with this; again, this box is not a predictor. You are not going to draw it up here to see how high can it go? No, I am talking about basing it on what’s happened in the past; previous price action. Where could this stock go if it didn’t do what you are hoping it will do, which is skirt around the upper left side and just keep on going? And where this is really most helpful is in a situation like this. When you are looking at this stock and you see this, you see this kind of price action here and you are saying, “Okay, it’s not a Fitzpatrick textbook base because it’s a little steep. There is not really much downside here. But if I am buying here at 190.00 my assumption is that the stock is not going to go down to test this prior low/” So if that’s my assumption then I have to put the bottom of the box right down here, like that’s it. So now I’ve got a very, very tight box because I am able to do that. Why would I have the box any lower than that when my expectation, based on what the stock has done in the past, my expectation is that it is not going to fall below this day’s intraday low. So my support, the low part of the box, has to be there. The upper part is right there. So this is a really, really tiny box. There is a greater likelihood that the stock is actually going to just keep going around the box and keep going up.

This is just an exercise, it will probably take a while to kind of figure it out but it is definitely worthwhile. Because what it is going to do is keep you out of bad trades. You are going to look and say, “Wow, that’s a tall box from where the stock could go to where it is right now. I think I better look for a better entry.” We have seen other stocks like Edwards ( NYSE: EW ); I could do a 30-minute video on how to do these boxes. The bottom line is this: Make sure it is logical for you to be able to look at the upper left corner of the box and have it tagging where you are buying the stock and make sure it’s logical to say, you know what? I have seen a bunch of charts just like this and a lot of them do just keep on going and they never fill the box. If you can say that you’re in a good trade. But if you can’t, if you are saying, “Well, I see a lot of them, they would absolutely fall into the box but I think this is going to be different.” Then you are not really trading, you are gambling.

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