What is Recovery Factor (RF)
The Dynamic Trend Profile is designed to find potential trade setups, calculate the entry and stop levels and provide projected target prices. The software performs the aforementioned tasks efficiently and updates data in real time. Along with this information, the software provides strength and momentum levels to evaluate the trade potential before taking the trade.
We have taken this one step further by asking the following questions: What are the odds for a price recovery to the target? If the prices recover to the target, how fast would it recover? Would the price recovery be average or below average? To answer these questions, we have developed the Recovery Factor : a mathematical model that predicts the potential recovery speed. A very high RF value typically generates a very fast price recovery.
For the stock, futures and Forex trader: A fast recovery implies your capital is tied up for less time. In addition, a fast recovery eliminates the potential of waiting through a trade that seems to go nowhere and consumes your time and patience. Also, trades that recover faster tend to be positive right away and reduce initial draw downs.
For the Options trader: A fast recovery means a potential increase in volatility once the recovery starts. This increase in volatility is created by the increase in the rate of change of prices in the underlying equity. Higher volatility usually leads to a higher premium for options. In addition, different options strategies can be implemented based on how the prices are expected to recover.
For example, trades with a very high price Recovery Factor tend to trade to its target quickly. A high price Recovery Factor indicates a great deal of interest and strength in higher rooms that are currently subdued due to a pull back. As soon as the recovery starts, the strength in the higher rooms quickly re-emerges, and the volatility tends to pick back up. Due to renewed interest, the prices recover faster to its target and leads to increase Option premiums and potential profits. With a very high RF value, one could consider buying straight calls, initiating a Back (credit) Spread Options strategy or other bullish Options spreads.
Trades with a low price Recovery Factor may still trade to its price target. However, the recovery tends to take a longer time, and a great deal of sideways price action is seen during this sluggish recovery phase. With a very low RF value, one might consider Options spreads that take advantage of moderately bullish to sideways markets.
Now we will discuss the Recovery Factor and show how this value can be used for selecting better trades.
To illustrate the underlying concept of the Recovery Factor,
consider the following common situation of recovery:
ANKLE INJURY and RECOVERY TIME
Immediately after ankle surgery, the average person's ankle is completely immobilized and has zero strength. As time progresses, the surgically repaired ankle heals, and the patient goes through physical therapy to regain strength. In about nine months, the average person regains close to one hundred percent of his or her ankle strength back.
Now refer to the healing process of a professional athlete. Many professional athletes have been able to regain one hundred percent of their ankle strength in three months. In terms of ankle injury, the professional athlete recovered faster than the average person. The fast healing time of the professional athlete may be attributed to the peak condition of the athlete prior to the surgery and his or her strong dedication to return to a competitive lifestyle.
COMPARE INJURY RECOVER TO STOCK/FUTURES RECOVERY
As in the analogy discussed above, stocks and futures tend to exhibit either an average price recovery or a faster price recovery. Similar to the factors influencing the professional athlete's recovery, the interest from higher rooms (peak condition) and rate of momentum (dedication) dictates the speed of the stock/s price recovery.
We have taken this concept and developed a formula to measure the interest from the higher rooms and the rate of momentum. Through empirical testing, we have further refined this formula to create a price Recovery Factor. By reducing this concept to an equation, a trader can easily identify trades with high Recovery Factors. On a normalized scale, the price Recovery Factor ranges from negative fifteen to positive fifteen.
On a normalized scale, the price Recovery Factor ranges from negative fifteen to positive fifteen. Positive RF numbers are used for long positions; negative RF numbers are used for short positions.
A RF of positive thirteen to positive fifteen indicates a very high interest in the stock, and price recovery should be very strong and quick. A RF of positive twelve indicates an average interest, and price recovery should be average. A RF of positive eleven is borderline, and a RF of positive ten or less would indicate a below average price recovery.
A RF of negative thirteen to negative fifteen indicates a very high interest on the short side, and price declines should be very strong and quick. A RF of negative twelve indicates an average interest on the short side, and price declines should be average. A RF of negative eleven is border line, and a RF of negative ten or lower would indicate a below average price decline.
Let's look at the DT Profile Screen for Halliburton (HAL). Based on the Profile rules, a highly reliable Buy trade set up is located in the PA room. The following is a quick review of the Profile rules posted in lesson four on our website:
1. Active blue Bullseye in the PA room (inner circle) indicates a good Buy signal.
2. The Normal Trend level in the PA room is blue (same color as the Bullseye).
3. Check two rooms higher. In the above example, the PC room shows blue (strength) in all three bars (Normal, Super and Momentum). In addition, the Momentum is greater than 2.5. (Half the bar indicates 2.5, and the full bar indicates 5.)
4. Check the Stock Trade Balance (top left window). In this example, the trade is taken in the PA room, and the strength is located behind (PB room) and in front (SD room). This trade setup meets all the criteria for a pristine trade setup. Now refer to the entry, exit and target prices on the next image.
A very high RF value would indicate that the prices should recover faster as illustrated by the blue line.
A very low RF value would indicate a slow price recovery with sideways or sluggish action during the recovery phase as illustrated by the red line.
For LONG TRADES, a positive RF such as the following, indicates:
Positive thirteen to positive fifteen indicate a very fast, above average price recovery.
Positive twelve indicates an average price recovery.
Positive eleven indicates a borderline price recovery.
Less than positive ten indicates a substantially below average price recovery.
For SHORT TRADES, a negative RF such as the following, indicates:
Negative thirteen to negative fifteen indicate a very fast price decline on the short side
Negative twelve indicates an average price decline.
Negative eleven indicates a borderline price decline.
Less than negative ten indicates a substantially below average price decline.
In the HAL example, the price Recovery Factor was positive fifteen (a very high RF number). A RF of positive fifteen indicates a very high interest in Halliburton from higher rooms. Price recovery should be very strong and quick. As projected, the price recovery was very quick, and the stock traded to its target very quickly.
For Stock and Futures traders: Trades with a very high RF value usually indicate that the trade should start being positive right away. This allows the trader to focus on locating the next trade setup instead of micro managing an existing position.
For Options traders: A very high price Recovery Factor tends to increase the volatility and Options premiums once the recovery starts. This creates an opportunity for Options traders. Trades with a very high Recovery Factor (near fifteen) are good candidates for buying outright call Options and perhaps a Back (credit) Spread.
In the above example of Halliburton, the entry price was 56.69 with a target price of 61.66 (indicating that a 60 call Option would be in the money if the prices trade to the target). If enough time is left, you would expect a substantial time premium due to increased volatility once the recovery starts. The actual Options prices for the sixty calls are shown on the next image.
Both the September 60 call and the October 60 call prices are shown below. On the day, the prices cross the Buy Trigger level--the September 60 calls traded around seventy cents. The same Options traded as high four dollars when the stock traded to its target. As you can see, there was substantial time premium in addition to the intrinsic price value.
The October 60 call traded around $1.60, and the same Options traded as high as five dollars when the stock traded to its target. Again, the fast price recovery increased the volatility, and substantial time premiums were present in addition to the intrinsic price value.
In the Matrix, select stocks or futures (including Forex) and the room size you want to trade in. The Matrix will display all trade setups in that room along with their RF values. You can also sort the RF column to list trade setups with RF values of fifteen at the top. In addition, the software displays the RF values for all room sizes in the Profile screen.
In the Matrix, select Options.
1. The software looks for an ideal strike price between the entry level and the target level. In addition, this strike price should be in the money if the underlying equity meets the target level.
2. If a trade setup has an ideal strike price, the software automatically calculates the minimum time required to complete the trade. This time is shown as the strike month and includes an additional two weeks for exit. If the calculated strike month is not available for a certain stock, select the next available strike month.
3. The Recovery Factor is displayed next for all the trade setups. You can also sort the RF column to list trade setups with RF values of fifteen at the top.
The next column is Options Reward Risk (ORR). We estimate what the Options prices should be worth if the underlying equity trades to the target. We have also developed a formula to calculate the potential Reward. Trade setups with ORR values greater than one are ideal trade setups. If the ORR value drops below one, the Reward Risk potential is very low.
Recovery Factor Rules for Stock, Futures and Options
1. When you have a very high Recovery Factor value between fourteen and fifteen, you can override the Star Ratings. (Thirteen is acceptable too.) This allows you to enter trades with Star Ratings of one or higher (provided the RF values are positive thirteen to positive fifteen for long trades and negative thirteen to negative fifteen for short trades).
2. All Profile rules apply (such as Bullseye in the inner circle, Normal Trend level in the same room and strength confirmation from two rooms higher).
The following example demonstrates a trade taken in the Day Trading Room, DD. The Profile for Goldcorp Inc. (GG) is displayed below. The trade setup is in the DD room, and all the Profile rules apply. The RF value is positive fifteen; therefore, the low Star Rating of one can be an acceptable idea. Remember, any time you wish to further improve your understanding of a trade, load up a chart and do additional Technical analysis work to better define supports/resistances, particularly if you are trying to better compensate for a lower star rating.
This example shows a trade taken in the Day Trading Room DC. The profile for S&P 500 E-MINI futures is displayed below. The trade setup is in the DC room and all the Profile rules apply. The RF value is +15 and a fast price recovery is expected.
The following example demonstrates a trade taken in the Day Trading Room, DC. The Profile for Euro/USD is displayed below. The trade setup is in the DC room, and all the Profile rules apply. The RF value is positive fifteen, and a fast price recovery is expected.
The following example of Valero (VLO) shows that a highly reliable Buy trade set up is located in the PB room. All the Profile rules apply to this trade setup.
1. Active blue Bullseye in the PB room (inner circle).
2. The Normal Trend level in the PB room is blue (same color as the Bullseye).
3. Check two rooms higher. In this example, the PC room is used for checking strength because it is the highest room displayed on the Profile screen. This room shows blue (strength) in all three bars (Normal, Super and Momentum). In addition, the Momentum is at 5.0.
4. Check the Stock Trade Balance. In this example, the trade is taken in the PB room, and strength is located behind (PC room) and in front (PA room).
The PB room also displays the Recovery Factor. The RF is positive fifteen--a very high value indicating a very strong and fast recovery potential.
The very high RF of positive fifteen also overrides the low Star Ranking. This trade meets all the criteria for a pristine trade setup.
The entry trigger is 68.88, and the projected target is 88.71. With a high RF factor of fifteen, you could enter the trade at the trigger level and expect a very fast recovery to the target. Since this trade setup was located in the PB room, the average time required for trades to complete is five to ten weeks. In this example, the stock reached its target in eleven weeks.
The high RF value of fifteen indicates a very high interest in the stock from higher rooms, and price recovery should be very strong and quick. In addition, once the recovery starts, you can expect the volatility and Option premiums to increase. Therefore, this trade setup is a good candidate for Options strategies.
The first task is to observe if there is a suitable strike price between the entry trigger (68.88) and the target (88.71). The suitable strike prices are the 70, 75 and possibly the 80 call. The Options prices of these strike prices are shown on the next image. Since PB trades require five to ten weeks for the trade to complete, you would select a strike month to allow a minimum of ten weeks plus an additional two to three weeks for Options expiry. The Matrix screen automatically calculates the ideal strike price and expiry month. (In this example, the ideal expiry month is September.)
This type of Trade setup also creates opportunities for initiating Back Spread Options strategies. This is an Options strategy where you would sell one in the money call Options and buy two or more of the out of money call Options (usually for a credit). Many Options related websites provide education on the aforementioned strategy.
Again, the key is to find trade setups with very high Recovery Factors and a projected target that will be in the money if the target is met.