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Trading with the Big boys: Take Advantage of CBOT's New $25 Dow Contract
by: John F. Carter
Where are the best opportunities to trade? Carter takes a look at a few new and entertaining choices.
&LProfessional traders make money not because they are right more often than not, but because they know how to take advantage of all the “fresh meat” sitting out there in the form of amateur, unprepared traders. “Fresh meat” traders are still trying to understand why they can’t place a sell stop order to limit losses on a short position—but that’s another story. Or maybe they have been slinging their cash in the markets for decades, their ultimate sin being that they have yet to learn how the markets really work. Many traders never learn, and they remain in a victim-like state all of their trading lives.
It All Comes Down to Skill
Trading is not about everyone holding hands, belting out the lyrics to John Lennon’s “Imagine,” and making money together. The financial markets are truly the most democratic places on earth. It doesn’t matter if a trader is male or female, white or black, American or Iraqi, Republican or Democrat. It’s all based on skill. The only way to become a professional trader is to obtain that blunt edge of a weapon that separates you from the rest of the migrating sheep. How does one gain that edge? By using specific chart setups and trading methodologies that take into account the five key points listed in the sidebar (see Market Truths). Also, traders need to understand the psychology of the trader taking the other side of the trade. Otherwise, as you enter the revolving door to the financial markets, filled with excitement and anticipation, the predators are licking their lips, because what they see is a slab of freshly cured meat, ripe for the eating. And feast they will.
New CBOT Product
Into this trading arena is being launched a new weapon—the BIG Dow $25 futures contract, symbol DD. (One sure bet is that traders will affectionately call this new contract the “double D.”) This is the big brother contract to the mini-sized Dow, symbol YM; both of the contracts trade at the Chicago Board of Trade (CBOT). I’m excited about this contract, and I’ll tell you why.
I focus on both day trading and swing trading. I like to use the minis for day trading, but I love the big contracts for swing trades. I can take positions and leave them alone and focus on the smaller e-mini S&P contract (ES) and YM contracts for day trading. This allows me to be a time-frame-independent trader. One of the most common mistakes I see traders make is that they get into a trade based on a setup on a daily chart, then panic when it goes against them on a one-minute chart. It’s an amusing cycle to watch but in the end it’s a pathetic way to try to make a living. I will talk about a strategy for staying “time-frame independent” in a moment. First, let’s continue to examine the importance of having this new contract available to us for trading.
Market Truths
The minority who endure and join the ranks of consistent winning traders are the ones who have learned the following truths:
- The financial markets are naturally set up to take advantage of and prey upon human nature. As a result, markets initiate major intraday and swing moves with as few traders participating as possible. A trader who does not understand how this works is destined to lose money.
- A trader can know more about a market than anyone else in the world, but if he applies the wrong methodology to their trading set-ups, he will lose money.
- A trader can know more about an indicator or group of indicators than anyone else in the world, but if he applies the wrong methodology to those indicators, he will lose money.
- A trader can know exactly what he is doing, but if he is trading the wrong
market for his personality, he will lose money. - A trader can know exactly what he is doing, but if he applies the same strategies he used to become successful in other areas of life, he will
lose money.
New Flexibility
The main thing I like about this is that now we have the option of both a big and a small electronic contract available to trade on the same market — as opposed to many contracts where the big contract is pit traded and only the mini contract is electronic. This situation opens up a couple of nice opportunities for the trader. My favorite way to take advantage of this is to use what I call SM2TF (same market, two time frame) trading. This means I could be long on a 60-minute signal in the big contract and then take short trades on the five-minute signals in the smaller contracts. This way, instead of trying to stay on top of different markets, I can watch the same market on different time frames and take advantage of the natural ebbs and flows within each time frame. This is also a way to stay hedged when a larger time frame trade is going against you. Just because your daily time frame trade is going against you on a five-minute chart doesn’t mean it’s time to freak out and get out of the trade.
I also like the DAX (the blue chip index of Deutsche Börse AG traded on Eurex). It’s a big contract like the big S&P, but it’s electronic, which makes me a little more comfortable about getting in and out of the contract quickly. In fact, many traders I know have flocked to the DAX for exactly that reason—it’s big, it moves and, most important, it’s electronic. Well, now we have available to us the DD, a contract that is big, it moves and most important, it’s electronic, on what I think is the easiest index to trade—the 30 stocks that make up the Dow Jones Industrials. Now that we’ve seen what the DD can do for us, let’s take a look at what I call the propulsion play.
Catching Moves On Multiple Time frames: Propulsion Plays
To me, some of the greatest risk-takers on Wall Street are long-term investors. They will stubbornly hold onto a stock they bought three years ago because they have a “long-term view.” It doesn’t matter that the company is beating off creditors with a lead pipe. It doesn’t matter that the stock is down more than 80 percent from the entry price. It doesn’t even matter if the CFO was recently seen sharing an 8 × 8 cell with Martha Stewart. What matters is that, come hell or high water, they have blind faith that by stepping back and taking the long-term view, all will be well in the end. All’s well that ends well, right? Of course. Unfortunately, this ain’t a Shakespeare play; this is Wall Street.
Propulsion plays involve a systematic approach to getting positioned in a stock or an index over a few days to a few weeks. Seventy percent of the time these instruments spend their days backing and filling in a tight range, building up steam for their next major move. This approach looks for stocks or indexes that are done with their “resting period” and are getting ready to spurt higher (or lower) once again.
The idea is to already be in the trading instrument when it makes a push higher (for longs) or lower (for shorts), instead of trying to chase it intraday. I also think it is important to include larger time frames that will require a trader to hold positions over the course of a couple of days or longer. The reason I like to do this is that there are many times in the market when very few intraday trading opportunities set up. However, there will always be that one day where the stock indexes make that out of the blue move up or down, typically in the form of a runaway gap, that leaves most traders behind. I say “out of the blue” with tongue in cheek because these moves are almost always in the direction of the larger trend. Being positioned in the indexes on a swing basis allows me to be pickier for my intraday plays. I don’t feel forced to get into intraday trades in the stock index futures when nothing is really setting up. This is because I already have positions on that are set up to take advantage of their next “mini-move.” Let’s review.
Trading Rules for Buy Fades (Sells Are Reversed)
I am looking to sell strength and buy weakness using 8- and 21- period exponential moving averages (EMA) crossovers as an entry trigger.
- For these plays I start with a daily chart and then drill down to the smaller time frames. It is critical to set up each play as time-frame dependent. This means that when a trader gets into a trade on a daily chart, they also exit based on the daily chart signals. However, they can set up the swing trades with the DD contract, then set up opposing trades with the YM contract on the smaller time frames.
- The only indicators I place on the daily chart are an 8- and 21-period EMA.
- For longs, I want to see the 8-period EMA trading above the 21-period EMA. Once this upward cross happens, then I can start looking for a setup to occur.
- The specific setup I’m looking for, once the 8-EMA has crossed above the 21-EMA, is a pullback to the 8-EMA. I will continue to buy pullbacks to the 8-EMA unless the market actually closes below the 8-EMA. In this case I will still play out a position if I’m in it, but if I’m waiting to enter a new position, I will wait until we close above the 8-EMA before initiating any new trades.
- The initial stop is time-frame dependent: For daily charts, 50 points, 60-minute charts, 25 points, and five-minute charts, 15 points.
- For daily charts: Once I’m up 50 points, I close out half the position and move my stop to breakeven. At this point, I leave my stop in place unless and until the 21- EMA goes above my stop. I will then start using a trailing 21-EMA as a stop once again. I also have a target on the second half of 100 points. I will stay in the second half of the position until my stop or target is hit. If my target is hit, I will set up another bid at the eight-EMA. Note, on the daily charts, the 21-EMA rarely comes into play as a stop.
- For 60-minute charts: Once I’m up 25 points, I close out half the position and move my stop to breakeven. At this point, I leave my stop in place unless and until the 21-EMA goes above my stop. I will then start using a trailing 21-EMA as a stop once again. I also have a target on the second half of 50 points. I will stay in the second half of the position until my stop or target is hit. If my target is hit, I will set up another bid at the 8-EMA.
- For five-minute charts: Once I’m up 10 points, I close out half the position and move my stop to breakeven. At this point, I leave my stop in place unless and until the 21-EMA goes above my stop. I will then start using a trailing 21-EMA as a stop once again. I also have a target on the second half of 20 points. I will stay in the second half of the position until my stop or target is hit. If my target is hit, I will set up another bid at the 8-EMA.
Let’s take a look at Figure 1 and walk through market action. Each number explains that area of market action on the chart.
- On November 1, 2005, the 8-EMA on the daily YM chart crosses higher above the 21-EMA. At the end of the day I place a bid just above the 8-EMA to buy any pullback to this level. I get long at 10,529. I place a 50-point stop at 10,479, and targets for half at 10,579 and 10,629 respectively. Note, I set these trades off the daily chart on the $10 pit traded Dow contract as “double D” wasn’t trading yet. On these same setups today I’m using the electronic $25 Dow contract. On this day the market rallies right into the close, hitting both of my targets for gains of +50 and +100 points respectively. I set up another bid to buy the next pullback to the 8-EMA.
- The Dow rallies without me, but my patience pays off six trading days later. I keep raising my bid along with the rising 8-EMA and on November 10 my bid is hit at 10,676. I place a stop at 10,626 and targets at 10,726 and 10,776 respectively. Again the Dow rallies all day and both my targets are hit for gains of +50 and +100 points. I place another order to by the next pullback to the 8-EMA.
- I watch the market race without me for another five trading days, raising my bid each day. Finally on November 17 I’m filled at 10,824. I immediately place a stop at 10,774 with targets at 10,874 and 10,924. My first target is hit later that same day and I raise my stop to breakeven. The next day the market almost hits my second target, then pulls back hard to 10,841, 17 points from my new stop. (Note in Figure 2 I set up shorts on the sell off while still long in this trade). From here the markets firm and move higher into the close. Then, on the third day, the markets continue their advance, hitting my second target, for gains of +50 and +100 points on the play. I set up my next bid at the 8-EMA.
- The Dow explodes and I watch it rally nearly 200 points without me over the course of a few days. I keep methodically moving up my bid as the 8-EMA rises with the market. Finally on November 30 I’m filled at 10,992. I place a stop at 10,942 and targets at 11,042 and 11,092. After I’m filled, the Dow continues to sell off and comes within spitting distance of my stop, but doesn’t quite get there. Neither of my stops or targets are hit today, so I take it home overnight to see what the next day will bring. The next day, December 1, we rally and my first target is hit. I move up my stop to breakeven. We get to within 13 points of my second target but it doesn’t quite make it. (Close only counts when you are throwing a grenade). I hang on for another day. On December 5 my stop is hit. On this trade I’m out for +50 on the first half and +0 on the second half.
- I look to set up a new trade, but because we have closed below the 8-EMA, I have to wait until we get a close back above the 8-EMA before setting up any new plays. Once that happens, I will look at setting up long plays again until the 8-EMA crosses below the 21-EMA which in that case would cause short plays to be set up.
Now, let’s take a look at Figure 2 to demonstrate how two time frames and two of the same yet different sized contracts can be used to enhance a trader’s P. In Figure 2 we see a five-minute chart of the YM that details the action on November 18. On the daily chart, I’m in long from an entry from the day before, and I still have half my position. However, today the markets start off with some strength that quickly turns into fierce selling. While I’m long on the daily charts using the big contract, I’m looking at the five-minute chart for setups that I can use with the mini. About ten minutes after the open, the moving averages cross and I get short on a quick retest of the 8-EMA. I’m filled at 10,898. I place a 15-point stop at 10,913. I set a first target at 10,888 and a second target at 10,878. My first target is hit about seven minutes later. I move my stop to breakeven. The second target is hit just a few minutes later and I’m out for +10 and +20 points on the minis.
At point 2 we rally back to the 8-EMA and I short again at 10,873. I place a 15-point stop at 10,888 with targets at 10,863 and 10,853 respectively. The markets roll over and my first target is hit in about eight minutes. The markets continue to sell off and get close to my second target but not quite. At point 3, I am stopped out at the 21-EMA at 10,870. Once the 21-EMA eclipsed my breakeven stop at 10,873, it became the new stopping point.
Simplify
And there we have it. Two time frames, two electronic contracts, one market. This is a great way for traders to simplify their lives by narrowing their focus on the number of markets they are watching, but to expand their trading opportunities by flowing in and out of various time frames. In the end, for traders, it doesn’t matter whether the markets go up, down, or sideways, whether the economy is growing or we are in the midst of a great depression. There will always be opportunities to trade.