The KP2 Ratio Strategy
The KP2 Ratio Strategy is based on the concept of Accumulation and Distribution. The KP2 ratio indicator is a unique ZoneTraderPro tool to measure the density of limit orders. When there is a significant density of limit orders, this suggests that large lot traders are accumulating contracts and establishing a position. A large lot trader can not submit a market order for thousands of contracts. This would cause the market price they would pay to significantly increase. This also establishes a significant number of traders that are trapped on the wrong side of the trade.
In the above picture we see a short trend trade where the KP2 Ratio was a 159. This is based on limit order density from the low to the high. At the same time, ZoneTraderPro is picking up Distribution Divergence. What is unique is that this Distribution Divergence is based on market orders from the high to the high in this trade. Something completely different.
Price traded down over 7 points and into an accumulation limit order KP2 ratio of -76. The ZoneTraderPro is now also picking up standard divergence. The KP3 is the number of contracts from the low to the low, and it was positive by 1938 contracts, so the cumulative delta was divergent by this amount.
Without ZoneTraderPro you had no way of knowing that as price fell, they were accumulating contracts on limit orders and you were trading into a buy side divergence.
Developing a Trading Strategy
The strategy was developed in response to the current market volatility caused by the virus pandemic. Numerous calls and emails were received about how volatile the market was and how easy it was to enter a great trade setup, and have the position stop out due to illiquidity.
The answer to this problem was simple. There was too much risk being taken, without a proper trading plan that has been adjusted for the volatility because these traders were using the regular E-mini contract. Traders now have the ability to trade the Micro E-mini- ES contract and adjust risk accordingly.
THE FOLLOWING IS NOT TRADING ADVICE, SUGGESTING A TRADING PLAN, OR PROMISING THAT YOU CAN ACHIEVE THE SAME RESULTS. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.
Because the micro contract is .1 the size of a full contract, if the trade moves against the initial position, additional contracts can be added, creating a better average cost. Over a 3 day period I traded for 673 ticks and a $841 profit (excluding commissions). These trades are detailed in the videos at the bottom of this page. Do the micros cost more to trade? YES. What is the cost of 1 regular E-mini losing trade? I traded a total of 40 contracts for that profit. At .62 per contract, that comes to a whopping $24.80 in commissions. Each day I traded abut 1-2 hours and put the profits in the bank.
ISN’T THIS A MARTINGALE STRATEGY?
It is not a Martingale strategy if you develop a set of trading rules defining the exit to a trade. In a Martingale strategy, you are just constantly adding to a losing position until you hopefully get lucky. Adding “hopefully” to any strategy is not very profitable.
By defining an exit strategy you are creating a trading plan that doesn’t include the word hope or Martingale. There are at least two exit strategies that can be studied. The first is an absolute dollar about and the second is the behavior of the KP2 indicator. The individual trader will need to develop the criteria for exiting a trade at a loss. This can be done by examining past examples of losing trades. However, past performance is not necessarily indicative of future results.
If there wasn’t enough legal disclaimers in this section, HERE is the complete list. Now lets study the strategy idea.
Understanding the KP2 Ratio Indicator
The KP2 Ratio indicator is not difficult to read once you understand what it is telling you. In its’ most basic form, the indicator is giving you the real time status of the amount of limit order support and resistance.
What we want to see is a V shape in the pattern and the ratio indicator responding with the market. In the chart on the right we see the KP2 Indicator responding in sync with price. This is good and what we want to see at the lows.
Why? After the ratio formed a new reading, just after 10:41, price rose and so did the ratio. Then price fell and so the ratio. When price hit the ultimate low, the ratio values rose again. So why is this happening?
As price was falling, more limit orders to buy were coming in to support price. This caused the ratio number (a negative number) to increase (that’s good). Then price rose because of market orders. Buyers were no longer passively supporting the market, they were the aggressors with market orders. Since when there were no more contracts being bought on limit orders, the ratio naturally rose.
What can go wrong? There are two things that can wrong.
The first significant thing that can go wrong is if you see the ratio indicator doing the opposite of price. When this is happening, it is because limit order support is being withdrawn and price is likely to continue in the direction it is moving.
In the chart on the right, price is about move 15 points higher in the next 30 minutes. As price moved higher, limit order resistance was being reduced. When resistance is pulled, price trades higher.
The second thing that can wrong is more significant because it will lead to losing trades unless it is identified. When it is identified, you would likely already be in a losing trade, but recognizing the pattern will prevent further losses.
What happens is that you see a great ratio and you enter the trade. Then instead of getting a V shape indicator ratio from the market orders, price and the ratio trade sideways. This is likely to end up badly because the ratio going sideways represents consolidation. Buyers and sellers are now equally supporting the price.
The example below is a live trading example using the micro contract. The example represents the largest position (7 micro contracts) I took in the micros’ while developing the strategy. What it also represents is why you should understand and know the ZoneTraderPro price patterns like the back of your hand. Having a trading plan would have helped also.
After exiting the short position, I took a long trend trade that had a great ratio. It was initially about a -150, or double The number I was using to define an acceptable trade. Initially a contract was added and the indicator was responding as expected. Limit order support initially increased into the trade which was why another contract was added. I quickly added another contract when price trades to the green intermediate support. I have to admit that at this point I am feeling really good about this trade. These guys just gave me a great opportunity to add to a trend trade with huge limit order support. Can anyone say GREED?
Then the indicator went generally sideways, even increasing at one point to a -176. I added to the trade two more times. At the low (not seen on this chart) was a Special Divergence long signal. My average at this point was 2967. At this point my stop was now about a point away, so adding the contracts increased my risk by only about $10. Can anyone say FEAR?
Originally I had a target of 2970, where the red intermediate resistance zone was. This was over a 13 point down move, and the price had traded from blue resistance to blue support. This is a ZoneTraderPro strong trend reversal pattern. You can see the red warning at the bottom of the chart. Now after making a 55 tick move, price retraces to the tick of minor resistance, creating the strong trend reversal trade pattern. The ratio at that point was 199. The trade was immediately exited.
Reviewing the trade I identified two mistakes. Staying in the trade and adding to it when the indicator was going sideways was number one. But I traded against a strong trend reversal and I had not moved my target to minor resistance, until after I saw the 199 ratio. Here is a question that needs to answered by a trading plan. What if the ratio was 40? The answer was easy when the ratio was 199. But ask yourself the hard questions, before you trade. This needs to be planned in advance and NOT when in the middle of a trade.
This illustrates a core principle that you should have and why it needs to be followed. This trade was not made according to any trading plan. Should you be trading against a strong trend? What were the rules for an exit?
Price then traded almost 10 points higher on the Tick Divergence long Exhaustion pattern that followed at 12:45. One other point here. The ratio for the exhaustion pattern was a 78 so it met our criteria. And you notice that there could have been 2 entry points. One at the blue counter trend zone and then one just 2 points below it. This illustrates the Micro idea strategy perfectly. Both entries had order flow and the first was that great setup we talk about. But then price traded 2 points lower and you are wondering what you did wrong. The answer was nothing. They ran more stops, maybe including yours if you were trading a full contract.
The point is this. If I had followed a set of rules, and taken the long exhaustion pattern that followed, I never would have had to deal with the trade going against me. Second, this strategy idea was created before the SPY Divergence and BloodHound VIX templates. Read about why they are more important HERE
To illustrate this wasn’t a one off pattern, this chart occurred two days later. Exactly the same pattern, except it was a short trade. Again after a huge strong trend move, price retraces to the tick to the minor support level, forming the strong trend long pattern.
Again notice what happens when you trade with the ZoneTraderPro patterns. After the initial move higher, there were 4 pattern trades, each getting at least 5 points. The exhaustion pattern alone was good for over 10 points. Super important to note about the exhaustion trade. The KP2 was -420 and the KP2 ratio was a -20 going into the trade. So this was not a distribution pattern. It was a special divergence pattern. As price rose over 5 points, the large lot traders were SELLERS.
Here are some videos to review all of the live trades and the KP2 Ratio Indicator
Reading Support and Resistance using ZoneTraderPro
Identifying Iceberg Orders using ZoneTraderPro
Using Volume Analysis to Trade Stocks and Futures
Using The ZoneTraderPro KP2 Indicator
Trading Volatility Using KP2 Ratio Indicator
Micro Emini Trade Review for 5/20/20
Trade Review For 5/21/20 Using the Ratio Indicator
Trade Review For 5/22/20 Using the Ratio Indicator with Bookmap and SpotGamma
Using Spot Gamma with ZoneTraderPro
Here are some pictures of losing trades. Losing trades are much more important to study than winning trades, because the illustrate what you need to study to create a trading plan. There were 16 losing trades over an 11 day trading period from April 9 to April 23.
They are from a month and half ago. So they are an out of range sample. As expected, they represent what was described above as the reason for a trade loss.
Illustrating All of the Concepts
The following example is from the afternoon of May 27, 2020. After a good long entry signal, the ratio went sideways as price was going higher. This example is similar to what you see as a losing trade. However there was never ratios that reached tradable distribution levels. This is however an example of the ratio indicator not following price. If there was going to be resistance, then the ratio indicator would be getting higher as price went higher. This is so important. This looks just like what you get in a losing trade.
Then what happens next is a set of trades that were all perfect setups. The blue line on the chart is a simple indicator created to show the middle point between the price high and price low. It is very common to see pullbacks to this area.
One each pullback to the mid line, there were good accumulation ratios. The 1st two times (1227 and 1300 hours), the trades were good for about 10 points. The third time (1334 hours) was good for over 18 points. Notice how the Special Divergence trade signals a 10 point short trade (1250 hours) with a good ratio, and then a long signal (1300 hours) on the opposite side. The divergence indicator then picks up accumulation divergence on the third long trade (1334 hours) from the mid line. Price trades into a strong trend (1438 hours) with a great ratio for over 12 points. Then a final accumulation divergence long signal (1535 hours) with Special Divergence at the low, into the close.
These trades illustrate every important concept of this trading idea.
- At each of the 7 areas circled in green, the indicator formed a good V shape and responded with price.
- The indicator going sideways as price rose illustrates an accumulation, and what to avoid, even if the ratio had been greater.
- Two trades saw increasing ratios as price was falling. This illustrates increasing limit order buyer support as price fell.
- Divergence patterns can be used to enter trades or add to existing positions.
- When price was in a strong trend at 1412 hours but with a good ratio, there was only a small retracement. The strong trend pattern that followed was a significantly better option with a higher ratio. This is why the software identifies strong trends so they can be avoided.
- As price was trading higher at 1520 hours, the ratio was falling, indicating less limit order resistance. The pullback was only 5 points.
- Notice what happened in the ratios before the 35 point higher. The buy ratios were -123, -82, and -78 respectively. The sell ratios were 43, 79 and 34. Who was more interested in committing their money to a trade? This is also why you see the ratio increasing into the strong trend trade at 1438 hours, and then what happened to the sellers that put up the 116 ratio?. They got stopped out into the close.
- Every trade illustrated here is not a ZoneTraderPro price pattern. Every move higher or lower is not going to be a pattern. Some will and some will not. However, when there is a pattern, especially a strong trend pattern, caution should be urged trading against it. If the ratios support the common patterns, (exhaustion, trend, reversal and broken reversal), then that information can support the trade.
Final Steps - Creating a Trading Plan
A trading plan must be created so that you can anticipate your trading actions in real time. That includes your entries, exits, and stops.
For the entry you need to understand your risk tolerance and decide on an initial number of contracts to trade. Then you need to decide what is your criteria for adding to a trade. Lets say you are in a trade, and you get a special divergence signal in the direction of your trade. Do you add to it? Don’t be looking at just one chart in a vacuum. In the videos I illustrated adding to a trade when I was given a divergence from the standard 2 point zigzag chart. What will you do if that happens?
Do you use a market or limit order? I can think of several trades where I entered limit orders and price moved away before I was filled. Is the cost of missing a winning trade worth the $2-3 extra dollars in making a market order?
For your exits, you need to decide on your criteria here. Is it 5 points from your initial entry, your averaged entry, or based on 5 points from any high or low that had been put in? Or do you base it on something else. What do you do in a trade if you are given an opposing divergence signal as you are approaching your target?
By reviewing past historical winning trades, you may need to create a rule that moves your stop to breakeven once a new zone is formed and you haven’t hit your target.
Next you need to go back and study the historical losing trades. Take pictures of these trades and study them. What do you use as a stop? Is it determined by an absolute point value or a dollar value?
The historical losing trades are probably your best resource in determining these answers. None of these answers are hard to find either. They just take time and effort.
Next, rather than risking real money, trade in the sim until you can prove your plan has worked. This sim time is also important because something may come up that you may not have anticipated. As illustrated on this page, this occurred to me and I was fortunate to exit a trade without any loss. When trading in the sim, you may realize your idea for a profit target needs to be changed or your stop adjusted.
The only way you can find these answers is by trading and making decisions. By trading in the sim, you risk nothing and you build a knowledge base.
At the end of the day review all of your trades. Did you miss something in real time, that looking at a static chart, is pretty obvious?
This sounds like a lot of work. The point is that if you do the work on a static chart, and not on a live chart trading real money, you will come up with better answers because you are not under stress.