The Contrarian

“In the investment markets, what everyone knows is usually not worth knowing.”

The Dohmen Setup

Someone called our attention to something that was written in Jon Markman’s book, SWING TRADING, about Bert Dohmen. It was picked up by trader, Thomas Bulkowski and is reproduced below:

Bulkowski’s Dohmen Setup

Written by and copyright © 2005-2017 by Thomas N. Bulkowski. All rights reserved.
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The following trading setup is best suited for position trades, those positions held for the longer term until the trend changes. Performance is best when the general market, industry, and stock all begin trending (avoid if any of those remain in a trading range).

The following trading setup is discussed in the book, Swing Trading: Power strategies to cut risk and boost profits, by Jon Markman.

In the book, Markman interviews several traders to discover how they make money. Bert Dohmen is one of them. Dohmen founded the investment research firm Dohmen Capital Group, and is a swing trader, according to the book.

The Dohmen Setup

Let’s review Bert Dohmen’s position trading (or swing trading, depending on your definition) setup.

  1. Own no more than 10 to 20 stocks split into 3 or 4 industries, with a maximum of 5% in any one position. The key Dohmen is trying to make with this rule is diversification. Put as many stocks in your portfolio as you can comfortably handle, providing you do not concentrate them in any one industry. I have a preference for picking stocks from several industries, not just 3 or 4.
  2. Select the strongest stock in the strongest sector. Dohmen is looking for a momentum play: Buy high and sell higher.
  3. The sector should be trending higher, along with the stock. A quick check of other stocks in the industry will verify that many are moving up, too. A high relative strength ranking also reinforces that you are playing in a hot sector. To this list, I would add the general market. If the S&P is not trending upward, then avoid this type of momentum setup. You can also use the chart pattern indicator as a trend signal. Trade in the direction of the prevailing market trend.
  4. Look for a stock making a yearly high, preferably a multi-year high. I used a monthly (seldom) or weekly (often) chart to look for longer-term trends.
  5. Look for a high volume breakout from a congestion area. The congestion area is easy to find, but I would use a buy stop to enter the position on the breakout and hope that high volume is present. If not, I don’t care, but that is my preference. This rule suggests you wait until after the breakout to evaluate its strength.
  6. On day of entry, place an initial stop below the low of the prior day. This is a tight stop. If you correctly pick the momentum play, price should continue to move up. If it doesn’t then get out. I would be nervous with such a tight stop. I only place a stop below the prior low when I am day trading in a strong upward price trend (price has little or no overlap). This also works for non-intraday trades, too, but I only use that when I am nervous about a stock reversing. Stock research indicates that placing a stop below the prior low will stop you out 41% of the time with an average loss of 4.29%. In other words, you will be stopped out a little less than half the time.
  7. Once the stock moves in your favor, place a trailing stop 10% to 12% below the close each day, below a trendline, or below the 21 or 50 day moving average. Presumably, this will allow price to retrace and not stop you out. When you should change from the prior low to a stop 10% away is unclear. If the position survives placement of the initial stop and price moves higher, then I would apply the trailing stop.You might consider using a volatility stop instead of the hard 10% to 12% values. A volatility stop will tailor your stop position according to the stock’s volatility. Stocks that bounce around a lot should have stops placed farther away… I prefer a volatility stop.
  8. Use a 38% to 62% Fibonacci retrace of the prior up move to add to the position or when it retraces to a support level. In a strong move up (a straight-line run), the stock will not retrace until the impulse has finished. Often it will pause along the way, forming small knots of congestion. That would be the time to add to a position. If price breaks down through support, then sell the entire position.
  9. Each successive buy should be smaller than the prior buy. This is averaging up instead of down, but fewer shares are purchased each time to keep the average price as low as possible. What you don’t want to happen is to buy small at first and add more shares as price rises so that the last buy is the largest of the group. When price reverses, you may suffer a loss. If you buy large and then taper down as price rises, you stand a better chance of retaining your profit when the trend ends.
  10. Draw a trendline at least 2 months long and use that as a potential exit signal when price closes below it. Confirm this with other indicators. I often use a trendline penetration as an exit signal. You may confirm it with divergence or maybe a sell signal from an indicator. Perhaps price pierces your favorite moving average.

An Example

The following analysis was done on June 3, 2008.

I show a chart of Nabors Industries on the daily scale. Price formed a descending broadening wedge followed by a rectangle top. A rectangle is often a good congestion region for the Dohmen setup. The breakout often occurs on high volume but it settles down quickly. In this stock, price has formed a congestion area where price has moved sideways for about two weeks (green lines, upper right of chart).

I selected this stock because it comes from an industry ranked 5 for relative strength among 48 that I follow. Individually, the stock has a rank of 16 out of 551 stocks for price performance over the prior 6 months. Most of the stocks in the group are pausing but are at or very near the yearly highs. The oilfield services and equipment industry is neighbors with the petroleum and natural gas industries that seem to have made being in the top 10 a permanent fixture.

As I look at the top picture, what bothers me are the wicks on the candles. It suggests a reluctance of price to move higher. When price does climb, the bears force it back down. Thus, an upward breakout is likely to be a bumpy ride. As I write this 2 hours before Tuesday’s close, price has reached 43 and dropped. If you decide to trade this stock then I would not recommend placing a stop below the prior low, but below the congestion region.

This next chart shows the stock on the monthly scale. I wanted to see if the yearly high translated into a multi-year high. It does. I drew red lines from each peak forward in time to emphasize what price does. Notice that each time the stock moves above the prior high for a bit and then retraces. Whether that will happen this time is anyone’s guess, but be prepared for it to make a new high and then reverse. The move from A to B is 35% and B to C is 32%. Thus, it looks like a 25% to 30% move might occur before price reverses.

If this stock does not float your boat, then perhaps these suggestions may work out better. Anadarko (APC) is in the producing petroleum industry (ranked 1 out of 48 for performance) and the stock has a relative strength rank of 53 out of 551. It is near a multiyear high on the weekly charts but on the daily it needs to surpass a peak made about a week ago.

Energen (EGN) is a diversified natural gas player (ranked 2/48 and 111/551). The stock shows a nice tight consolidation region in a stock that has been trending upward for years (weekly scale). I like this one as much as Nabors Industries but look for more of a retrace (downward breakout) from the congestion region.

Praxair (PX). This stock is from the diversified chemicals industry, ranked 4/48 and 137/551. The congestion region is loose looking and price will probably take a few days to push higher. Since late last year, the swings have become more violent, suggesting a top to me, but you never know. This is not my best pick because price is too loose and it looks to be forming a head-and-shoulders top.

Aftermath

The chart shows how the theoretical trade progressed.

I show the June 2 price bar where the prior chart of Nabors Industries (NBR) ends (daily scale). Three trading days later, price broke out of the rectangle in a long white candle, which I show as point A. A buy stop placed above the top of the rectangle would have worked well. A stop loss order a penny or two below the prior candle’s low would also have worked.

Price continues rising, following the blue trendline. When price closed below the blue trendline at B, in a long black candle, that would have been my exit signal. I would have closed out my position at the open the next day.

If you used the green trendline (a longer trendline with more widely-spaced price touches, suggesting a more significant and meaningful event when price closed below it), it would have been a safer exit (meaning it would have allowed price more opportunity to continue rising, which it didn’t in this case), but the exit price would have been lower.

Entry would have been at 43, using a penny above the rectangle high on 6/5/2008.

Exit would have been at 46.01, the opening price on 7/8, the day after the tall black candle at B for a gain of 7%.

Using a close below the green trendline as an exit signal, selling at the opening price the next day, the exit would have occurred at 44.80 for a gain of 4%.

In the bear market of 2008, the stock dropped all the way down to about 8 in March 2009. Such a large drop shows the value of having a stop loss order in place.

— Thomas Bulkowski

Tom has an interesting website that you might want to check out. http://thepatternsite.com/