How to Develop Winning Trading Systems

That Fit You Workshop

Dr. Van K. Tharp, PhD

RJ Hixson

1R Section Handout for Video Recording, July, 2021

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Determine 1R: Setups

Objectives

1. To define the kind of conditions that might produce the moves you want to trade.

2. To learn a number of different setups and help you decide which might best fit your objectives.

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Setups Market Type Whatever market type classification system you use, your current market type and knowledge about market types will direct which systems you can trade. In effect, the market type is a setup for the appropriate trading systems. Filters versus Setups People want to know the perfect entry signal to the market so that they can “control” the market prior to entry. When you are looking at past data, the more you can use indicators to fit that data, the more accurate those indicators will seem to perfectly predict every turn in that data.

Many indicators = good historical fit and poor future results The result is that you will probably feel extremely confident about trading, but find that your “highly optimized” indicators do not help you at all when trying to trade today’s markets.

Short-term optimization with continual updates.

Simple systems with few indicators work!!!!! Setups, based upon different data, can be useful. This really provides us with a critical difference between filters and setups. Filters are typically all based upon the same data and should be avoided in your system. Setups that are based upon different data are quite useful. As long as your setups are based upon different, but reliable, data, more is generally better. Trading Universe Will you trade this system in the Forex market? In the major pairs only or in any pair? Is there any currency you would not trade? If you are trading stocks, will you stick to the S&P 500? A system might be designed for penny stocks only. In your setup, define the tradable universe you will trade with this system.

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Setups That Work 1. Time: You have some idea when a move is supposed to occur because of your various models. Time is different from price data, so such a setup could be very useful. Time might include cycles, seasonal data, astrological influences, etc. 2. Price data in sequence: You might require that your price data occur in a specific sequence. This is usually more valuable than simple price data if it’s based upon some high probability relationship that you’ve observed in the market. Tests and retracements are both examples of sequential price setups. Retracement setups are based upon such a sequence of price data: 1) the market establishes a trend; 2) the market makes a retracement; and 3) the market shows some sort of movement back in the direction of the original trend. These are all price data, but they occur in a specific logical sequence that has some meaning. 3. Fundamental data: You have some idea what the “supply” and “demand” characteristics are for the market you are trading. For example, you might have statistics for the soybean crop and also some statistics about new foreign demand for this market. 4. Volume data: The amount of activity in your particular market is quite different from the current price data and could be quite useful. There’s a lot written about volume data, especially by stock market experts like Richard Arms. The Arms Index is now given regularly with market updates. It was originally known as the TRIN trading index. This is the ratio of advances to declines divided by the ratio of up volume to down volume. Here’s how you might use it as a setup. Use a moving average of Arms Index (typically use about 5 days). A reading above 1.2 indicates a potential bottom and a reading below 0.8 indicates a potential top. These are short term trading opportunities of one to three days. However, these readings should be combined with an entry signal of price moving in the expected direction. 5. Composite data: If your market consists of a number of items, then you might have some valuable information simply knowing what those various items are doing. For example, in the stock market you have the price of your individual stock, but knowing what the market as a whole is doing is quite different, but valuable, information. How many stocks are advancing? How does the volume of rising stocks compare with the volume of declining stocks? If you are trading a market index, you can look at what all of the individual stocks are doing. Generally, people who try to trade a market index, such as the S&P, without looking at anything but price data are at a severe disadvantage compared with all of the experts who are looking at composite data. One example of a composite indicator, given with every market update, is the tick. The tick is the difference between all NYSE stocks on an uptick vs. those on a downtick. A divergence in this information, especially when the market makes an extreme, is often a good setup.

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6. Volatility: This refers to the amount of activity in the market and is generally defined by the range of prices. Narrow volatility is often a good setup. Here are a couple of ideas for narrow range setups.

1. Market is in a trend as measured by any number of indicators such as being above/below a moving average, having a high ADX value, etc.

2. Market moves into a narrow range that might be shown by comparing the range of the

last 5 days with the range of the last 50 days. The ratio would have to fall below some predetermined value such as the range of the last 5 days being less than or equal to 60% of the range of the last 50 days. The second narrow range setup might be something more like the following:

a) Market has an inside day (i.e., its price range is contained between the

high and low of the previous day).

b) Market has the narrowest range of the previous X days. When you have an inside day of this sort, a breakout in either direction is typically a good short-term trading pattern. 7. There’s an Order to the Market. If you believe that there is some magic order to the market, then the methodology that you use to determine that order might be considered a setup. Examples here might include delta turning points, Gann magic numbers, Fibonacci, Elliot Wave, etc. 8. Business Fundamentals: What are the earnings? What is the yield? What are sales? What are profit margins? What are the owner’s earnings? How many shares are outstanding? What is the book value and earnings per share? How has business grown? This sort of information is quite different from price data. 9. Management Information: Who is running your potential investment and what is their track record? Warren Buffett had several tenets for management. And, whether you buy a stock or a mutual fund, the track record of the person behind your investment is probably critical to the success of that investment.

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Stock Market Setups In this discussion of stock market setups, I have no intention of giving an exhaustive collection of possible setups for use in the stock market. Instead, I think it’s much more useful to examine three different approaches that make money in the market. Each method is quite different from the others. And by comparing the setups that are used in each, you’ll get a much better understanding of them and be able to invent your own. William O’Neil’s CANSLIM Model One of the most successful and widely followed models for trading has been promoted by William O’Neil and David Ryan—the CANSLIM model. O’Neil has presented the model well in his book, How to Invest in Stocks.” CANSLIM is an acronym—with all of the letters standing for entry setups. “C” stands for current earnings per share, with O’Neil’s criteria being an increase of 70% over same quarter a year ago. Therefore, the current earnings per share are the first setup criteria for O’Neil. “A” stands for annual earnings per share. O’Neil believes that the annual earnings per share over the last five years should show at least a compounded five-year rate of about 24%. Again, this is another setup. “N” stands for something new about the company. This new factor could be a new product or service, a change in management, or even a change in the industry. It also means that the stock has reached a new high price. Thus, “N” would really be two setups for entry. However, the new high price might actually be the entry trigger signal as discussed in Chapter 10. “S” stands for shares outstanding. O’Neil did a study of the best performing stocks and found that their average capitalization was under 12 million shares, with a median capitalization of only 4.8 million shares. Thus, another setup criterion for O’Neil is a small number of outstanding shares—less than 25 million. “L” stands for leader. O’Neil believes in a relative strength model of the market. People who use relative strength typically rank the change in the price of all stocks over the last 12 months. A stock in the top 75% to 80% would probably be one to consider. Some people also give more weight to the amount of change that has occurred in the last 30 days. O’Neil’s ranking is probably something of that nature. He says to only pick stock which he rates above 80%—so that’s another setup. “I” stands for institutional sponsorship. It usually takes some institutional sponsorship to produce a leading stock. But a lot of sponsorship is not desirable, since there would be a lot of selling if anything went wrong. In addition, by the time all the institutions have found it, it’s probably too late to expect a good move. However, some institutional sponsorship is another setup for O’Neil.

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“M” in the formula stands for what the overall market is doing. Most stocks—75% or more—tend to move in the direction of the market averages. As a result, you want to have positive signs for the overall market as a setup, before you buy your stocks. The Warren Buffett “Value” Model Warren Buffett is perhaps the most successful investor in the world today. Buffett has never really written about his approach to the market, but many books have been written about Warren Buffett and his approach to the market. Some of the better ones include Of Permanent Value by Andrew Kilpatrick; Warren Buffett by Andrew Kilpatrick, Buffett: The Making of An American Capitalist by Roger Lowenstein, and The Warren Buffett Way by Robert Hagstrom, Jr. Buffett’s real strategy is to buy a business: he does not consider that he is buying stock. Here are 9 of his 12 criteria that he looks for before buying any company.

1) Buffett needs to be able to understand any business he might own and it must be simple. He’s not willing to invest in great high-technology stocks because he does not understand that sort of business or the risks involved.

2) The company needs to have a consistent operating history. He wants a long-term track record and tends to avoid companies that are going through any sort of severe change.

3) Companies that can raise prices regularly without any fear of losing business. The only companies that can do this are those that have a product or service that is needed and desired, which has no close substitute or problems with regulations. Management of the company. Running a business, Buffett understands, is a psychological enterprise and depends entirely upon the strength of the management.

4) Management must be honest with the public. Buffett deplores managers who hide weaknesses in their business behind generally accepted accounting principles. In addition, he believes that managers who are not frank with the public are not likely to be honest with themselves. And self-deception definitely leads to sabotage.

5) Managers who are rational in their allocation of capital. If the company reinvests its capital in the company at less than the average cost of that capital, a very common practice among business managers, then it is being completely irrational. Buffett avoids those companies completely.

6) Avoid managers who tend to be conformists and constantly compare themselves with other managers. These people tend to resist change, develop projects just to use up available funds,

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imitate peer companies, and have “yes” men working for them who will find reasons to justify whatever their leader wants. Financial Setups

7) The business must achieve good returns on equity while employing little debt. Return on equity is basically the ratio of operating earnings (earnings less unusual items such as capital gains or losses, etc.) to shareholder equity where shareholder equity is valued at cost rather than market value.

8) Owner earnings consist of net income plus depreciation, depletion, and amortization less capital expenditures and the working capital necessary to run the company. Buffett says that about 95% of American companies require capital expenditures that are equal to their depreciation rates, so that should be considered when estimating owner earnings.

9) Buffett is very concerned with profit margins. Consequently, he’s looking for managers who are in tune with the idea of systematic cost cutting to increase margins. Benjamin Graham Value Model

1) Determine the current assets of a company (you can find this on Yahoo). These are assets that could be liquidated within a year.

2) Determine the total liabilities of the company and subtract from the current assets. Is this even a positive number? For many companies it is not.

3) Divide the difference you get by the number of shares outstanding. This is basically Graham’s number.

4) Compare this with the current price. If the current price is about 60% of Graham’s number and the stock is rising in price, you have a great stock. Graham averaged 17% a year using this technique during the 1930s and 1940s.

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Futures Market Setups Perry Kaufman’s Market Efficiency Model Perry Kaufman, in his book Smarter Trading, says that trading in the direction of the trend is a safe, conservative approach to the markets. But trend following must be able to separate the trend from the random noise of the market. If market is noisy compared with amount of trendiness, it’s hard to make money. If market is trending rapidly, noise becomes a less significant factor. Kaufman’s Efficiency Ratio combines both noise and speed. It essentially divides the net price movement between two time periods by the sum of the individual price movements (with each movement assumed to be a positive number). This is essentially a ratio of the speed of the movement to the noise of the market. Kaufman only uses 10 days in which to constantly update the ratio, but you could select a larger number. Here are the formulas for the efficiency ratio. Movement Speed = Close yesterday minus close 10 days ago Volatility = ∑ absolute value [close today minus close yesterday] over the 10 days Efficiency Ratio = Movement Speed/Volatility The Efficiency Ratio essentially ranges from 1 (no noise in the movement) to 0 (noise predominates the overall movement). This Efficiency Ratio is an excellent setup that can be mapped onto a range of speeds for a number of different entry signals. Doing so is slightly tricky. Kaufman gives a great example of how to do so with different moving averages. However, you could simply require that this number be above some particular value (i.e., 0.6) as a required setup prior to taking an entry signal. William Gallacher’s Fundamental Trading Method Gallacher, in his book Winner Take All, provides a scathing critique of system trading and then goes on to show how someone with a fundamental approach (setups) can make a lot of money First, Gallacher says that you must select markets according to value—meaning that they are historically “cheap” or “expensive.” He says that this can be done for certain markets (i.e., a pound of bacon is cheap at $0.99 and expensive at $2.99), but not for other markets (i.e., gold has gone from $35/oz. to $800/oz. to $300/oz.—so what is expensive and what is cheap?). Thus, the market selection phase of entry is an important part of Gallacher’s methodology.

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Second, Gallacher says that the trader must develop a critical eye for “what is important” fundamental information to a particular market. He says that is “what’s important” is constantly changing, but presents his current opinion of that information for various futures markets. For example, he says that annual variations in supply are the big movers in corn. Generally, the corn produced in the U.S. is the main grain for hog production. Most of it is consumed domestically with only about 25% being exported. The demand is fairly constant. Thus, variations in supply are the major determinants of value for corn. Gallacher says that previous bad markets were sheltered by large carryover stocks from previous harvests. However, he says that when such carryover is historically low, then a bad crop could push prices to very high levels. Thus, for corn the critical fundamental setups would be “carryover” and the amount of supply in the “new crop.” Ken Roberts’ Method Ken Roberts has been marketing a commodity trading course to thousands of beginners all over the world. The primary method taught, although several systems are given in his course, is quite simple and involves rather subjective setups. Essentially, the setups require that the market make a major high or low and then show a reversal hook pattern. You open a position when it’s “clear” that the major trend is reversing. The major high or low: Essentially, in this method, the first set up is for the market to make a nine month to one year high (or low in prices). Thus, if the market produces the highest high of the last nine months or the lowest low of the last nine months, you have the first setup.

The market makes a 1-2-3 Reversal: Point 1 is the high or low determined in the first setup. The next important setup is for the market to move away from the high or low to what’s called point 2. The market then moves back towards the high or low and forms point 3. Point 3 cannot be a new all-time high or low. The market then goes past point 2 and you have an entry point.

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Two Common Categories for Price/Time Setups

Test Setups Test setups are basically failed tests of previous highs or lows. After that high or low occurs, many interesting patterns occur. The Ken Roberts’ method is based upon a failed test setup. The reason such tests can work is because they are commonly used as entry signals. These entry signals might set up trades that return big profits, but they are not that reliable. The logic behind tests as an entry signal is to use false breakouts (moving to a new high or low) to set up the trade. Turtle Soup (Connors and Raschke). It’s called turtle soup because a famous group of traders, called the Turtles, was known for entering the market on 20-day breakouts. In other words, if the market makes a new 20-day high, we enter. Or, in contrast, if the market makes a new 20-day low, we also enter into a short position. Today, most of these 20-day breakout signals are false breakouts—the market falls back. Thus, Turtle Soup gets its primary setup from 20-day breakouts. Trending Day plus Higher Opening

1) The market has a trending day—opening up at one extreme and closing at another.

2) The market opens with another move in the same direction as the close (i.e., if it closed lower, then the market opens down even more; if it closed higher, then the market opens up even more).

3) The market reverses to yesterday’s high (sell signal) or low (buy signal). This is very similar to a pattern Larry Williams calls Oops!

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Retracement Setups Basically, this kind of setup involves the following:

1) Finding the longer term trend of the market through some sort of setup.

2) Getting some sort of pullback to and from the trend.

3) Entering in the direction of the trend based upon some third type of signal such as a resumption of the trend with a new high. Connors’ and Raschke’s “Holy Grail.” The ADX must be greater than 30 and rising. This typically indicates that the market is in a long-term trend. Their second setup is that the market must retrace to some moving average that is just a little longer than the period in the ADX. However, one could easily use an extreme oscillator signal against the trend as the pullback signal (i.e., in a strong up market, you get an RSI reading that moves to 30). You then need an entry signal that shows some movement in the direction of the trend. Connors and Raschke simply suggest that you put a buy stop above the high of the previous bar (i.e., for an uptrend entry) or that you put a sell stop below the low of the previous bar (i.e., for a downtrend entry). Retracement setups are an excellent consideration for trend-followers.

1) They allow you to place tight stops and thus extract high reward-to-risk trades. 2) You can use them for both short-term “swing” trading or for long-term “position” trading. 3) They give you a way to get into a market that you might have originally missed. 4) They provide you with an excellent way to get back into a market once you have been stopped

out.

Consider developing your own setups!

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Determine 1R: Entry

Objectives

1. To learn entry methods that will best help you capture the kind of moves you are looking for either 1) high reliability or 2) large R-multiples.

2. To define 1R (setup, entry, and initial stop) for a trading system based on a set of objectives you develop. You will work on this with a small group of several people who have similar trading system preferences.

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Entry Channel Breakouts Enter the market on either the highest high of the last X days on the long side or the lowest low of the last X days on the short side. If the market is going to trend up, then it must make new highs. If you enter on one of those new highs, then you will not miss an uptrend. Similarly, if you enter on a new low, then you will not miss a downtrend. The channel breakout technique was originally described by Donchian in the 1960s. It was then popularized by a group of traders known as the “Turtles” who have made billions of dollars trading commodities with this entry technique. They originally entered on 20-day breakouts, and were quite successful with it. But as they continued to use the method, eventually 20-day breakouts stopped working as effectively. As a result, they simply moved up to 40-day breakouts. Today, research seems to indicate that breakouts between 40 and 100+ days still work fairly well. Breakouts involving fewer days are not that good, except to go short. Since bear markets tend to have swift, sharp moves, they need a much quicker entry signal. This technique is very simple to apply. You can plot the daily highs or lows. When the market makes a higher high than any time in the last 20 days, you enter a long position. When the market makes the lowest low of the last 20 days, you enter a short position. The Table shows how this might work. It gives you 60 days of corn prices during early 1995. New 40-day high prices are shown by highlighting them. Each highlighted price is an entry target or an actual entry signal.

Table: Early 1995 Corn Prices Date Open High Low Close

1/3/95 164.5 164.5 161.5 162 1/4/95 162 163 161.25 162.25 1/5/95 163.5 164.5 163 164.25 1/6/95 165.25 165.5 163.75 165.25 1/9/95 165.25 166.75 164.25 166.25

1/10/95 165.25 166 165 165.75 1/11/95 166.25 166.25 165.5 166 1/12/95 168.5 170.25 167.75 167.75 1/13/95 168 168.5 166.5 167.5 1/16/95 167 168.5 166 168 1/17/95 168.5 170 168 169 1/18/95 169 169 167.75 168.25 1/19/95 167.75 168.25 167 167.75

Table: Early 1995 Corn Prices (Continued) Date Open High Low Close

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1/20/95 167.75 168.5 166.25 167 1/23/95 166.25 166.5 165 166.5 1/24/95 166.75 167.25 166 166.75 1/25/95 167 167 166.25 166.75 1/26/95 166.5 167.5 166 166.5 1/27/95 166 166.5 165.5 165.75

1/30/95 165 165 162.25 163 1/31/95 162.75 164 162.5 163

2/1/95 163 165 162.75 164.5 2/2/95 164 165.75 164 165.25 2/3/95 165.5 166.5 165.5 166 2/6/95 166.25 170 165.75 169.25 2/7/95 168.25 169 167 167.25 2/8/95 167 167.5 166.5 167.25 2/9/95 166 167.5 165 167.25

2/10/95 168 169 167 168 2/13/95 167.75 168 167 167.5 2/14/95 167.25 168.5 167 168.25 2/15/95 168 168.25 166.75 167.75 2/16/95 167.25 167.25 166.5 166.75 2/17/95 166.25 166.75 165.75 166.25 2/21/95 165.75 166 164.75 165.75 2/22/95 165.5 167 165.25 166 2/23/95 167 167.75 166.25 167.25 2/24/95 167 167.75 166.75 167.25 2/27/95 167.5 167.5 166.5 167.25 2/28/95 167 168 166.75 167.5

3/1/95 167 168.5 167 168 3/2/95 167.5 168.25 167 167.75 3/3/95 167.5 167.5 165.75 166 3/6/95 165.75 171.5 165.75 169.25 3/7/95 169 171.5 168.5 170.5 3/8/95 169.75 170.5 169 170 3/9/95 169.75 170.75 169.5 170.25

3/10/95 170.5 171.75 169.75 170.75 3/13/95 171.25 173.25 171.25 173 3/14/95 172.75 173.5 172.25 172.75 3/15/95 173.25 174.5 172.25 174 3/16/95 173.25 174.25 172 172.5 3/17/95 172.5 174 172 172.75 3/20/95 172.25 173.5 171.75 172

The baseline, which ends on January 30, 1995, is in bold on the chart. During the initial 20-day period the market high occurred on January 12th at 170.25. It almost reached it on February 6th when it hit 170 and that soon became the 20-day high. No other prices came that close until March 6th when the market gave a clear entry signal by hitting 171.5. Cop

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Notice that the market also gave entry signals on March 10th, March 13th, March 14th, and March 15th, which are all in bold. These would have set you up for one of the all-time best moves in corn. In the case of the data given, we would have gotten the same signal if we had been looking for a 40-day channel breakout. The March 6th signal was also a 40-day high. Now, let’s look for downside signals. During the initial 20 days, the lowest price is 161.25, which occurs on January 4th. That is not surpassed and soon the 20-day low becomes the price on January 30th of 162.75. This again is not surpassed. By the end of February, the 20-day low becomes the price 20 days ago, which continues to rise, practically each day. During this entire period, a new 20-day low was not set. The channel breakout can be used with any number of setups. And it can also be used as a filter. Visual Entry Based Upon Charts Many experts don’t have an exact entry signal into the market. Instead, they visually inspect the charts and act on their gut feelings about what they see. For example, one of the best traders I’ve ever met said that his entry technique was to look at a long-term chart of the market he was considering. He’d put the chart on the wall and go to the other end of the room and look at it. He said that if the market’s trend was obvious from the other side of the room, then he would have no trouble entering that particular market in the direction of the trend. One of my past clients now makes a million dollars in profits each year trading stocks for his own account. He only uses visual patterns for entry, although he claims that his visual entries are somewhat intuitive. This particular type of entry has some real advantages for people with the discipline to follow it. For example, price information is much purer that any summary information you might get from some indicator. If price information indicates a clear trend, then the chances are pretty good—probably as high as 60%—that the trend will continue for some time. Thus, entry in the direction of the trend is probably much better than a random entry.

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Patterns

Daily Patterns o gaps o spikes o key reversal days o thrust days o run days o inside days o wide-ranging days

Continuation Patterns o triangles o flags o pennants

These have little meaning unless you wish to enter in the direction of the major trend after a breakout from these patterns.

Top and bottom patterns o double bottoms and tops o head and shoulders patterns o rounded tops and bottoms o triangles, wedges o island reversals

Obviously, these would tend to be entry signals for top and bottom pickers. Other charts are composed of candlesticks, where the difference between the open and the close is either “clear” or “filled-in” depending upon whether the price is up or down, respectively. Books have been devoted to describing the various patterns that can be made with these candlesticks If you are interested in a pattern approach to trading, then read the appropriate chapters of Jack Schwager’s book, Schwager on Futures: Technical Analysis. It has excellent descriptions of all of these patterns as well as numerous chart examples. However, such patterns are very difficult to computerize and thus test. In addition, when people do test these various patterns, they do not find any evidence that they increase the reliability of entry signals beyond the 50% level. Cop

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Pure Prediction Prediction techniques include Elliot wave, Gann, Delta, and various forms of counter trend trading that predict tops and bottoms. My belief (VT) is that prediction has nothing to do with good trading. Many good forecasters, despite being excellent at their craft, have a great deal of trouble making money in the markets. I once met a man who described himself as the “Michael Jordan” of the markets—meaning that he believed that no one was better than he was at trading the markets. He claimed that the markets were perfectly orderly and that he had worked out some “patented secrets” that he wouldn’t sell for a million dollars. He showed me some old accounts that he had taken from $5,000 to $40,000 in less than six months to prove his knowledge and skill. I wasn’t particularly interested in his secrets, but I was interested in how he traded. As a result, I watched him trade for about six months. During that time, the account he was trading dropped in value by 97%. Just over 22% of his trades made money and the account was never profitable throughout the entire six months. Be wary of people who claim extensive trading skill. Watch their trading, and in particular, their money management. If they don’t practice low-risk money management, then run away—don’t walk. If you think you can predict a market bottom or top, fine. But don’t trade it until the market shows you some sort of confirmation that it is turning.

Volatility Breakouts Volatility breakouts are essentially sudden dramatic price movements in a particular direction. Suppose the average true range is about 3 points. We might define a volatility breakout to be a move of 0.8 times the average true range (from the prior close) in a single day or 2.4 points. Let’s say today’s price closed at 35. A volatility breakout would be a move of 2.4 points from the close, either up or down. If the price moved to 37.4, then you’d have an upside breakout and you’d want to buy. If the price moved to 32.6, then you’d have a downside breakout and you’d want to short the market. This is the kind of entry signal that I would recommend for those of you who have setups that involve market prediction. Wilder recommends that the average true range be multiplied by a constant of 3.0 (called the ARC). This essentially is used as a trailing stop from the close and it becomes both an exit point for a current position and an entry point for a new position. In essence, the exit is almost exactly the same as the exit that we use on the random entry system (i.e., three times the average true range).

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Generally, when the market makes a strong move in some direction, it’s a good sign that you may want to be in the market on the side of that move. For example, you may have a strong up-trend, but a solid volatility breakout to the downside would be a good indication that the trend was over and that you need to go with the market in its new direction. At minimum, you probably don’t want to go against a strong volatility breakout. This type of price movement is quite different from the channel breakout. As a result, at least part of the movement in a volatility breakout would have little correlation with a channel breakout. Volatility breakouts are ideal for people who use various models to predict price movement. Price prediction is very dangerous unless it is accompanied by a sound trading system. Volatility breakouts could help you achieve the entry part of that solid system to trade your “secret knowledge” about how the markets work. Directional Movement and the Average Directional Movement Used to define trendiness. Basic Assumption behind Directional Movement:

1. When the trend is up, today’s high price should be above yesterday’s high price. Thus, the difference between the two prices is the “up” directional movement.

2. When the trend is down, today’s low price should be below yesterday’s low price. Thus, the difference between the two prices is the “down” directional movement.

3. Inside days, when the high and low of today does not fall outside of yesterday’s range, are essentially ignored.

4. Outside days, when both the high and low are outside of yesterday’s range, will add both an up and down directional movement. Only the larger value is used. Cop

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The directional movement indicator is calculated as follows:

1. Add the “up days” (∑DI+) and the “down days” (∑DI-) for a predetermined period of days (Wilder suggests 14).

2. Divide each sum by the average true range for the same number of days.

3. Determine the difference between the ∑DI+ and the ∑DI- and find the absolute value. That is, DI Difference = [(∑DI+) - (∑DI-)] treated as a positive number.

4. Determine the DI sum = ∑DI+ plus ∑DI-.

5. The Directional Movement Index defined by (DI difference)/ (DI sum) × 100. Multiplying by 100 normalizes the Directional Movement Index so that it falls between zero and 100. ** 14 to 20 day periods are all good. ** Average Directional Movement Index or ADX. The ADX is simply a moving average of the directional movement index. It’s usually averaged over the same number of days that was used previously (e.g., 14). The size of the ADX tells you the strength of the trend, but it says nothing about the direction of the trend.

1. As long as the ADX is rising, any level of the ADX above 15 indicates a trend.

2. The greater the increase in the ADX, the stronger the trend. For example, a jump in the ADX from 15 to 20 is probably a better signal than a jump from 25 to 27.

3. Decreases in the ADX only mean that the trend is weakening or that the market is no longer trending.

4. When the ADX is rising, indicators such as overbought or oversold oscillators will not work. Such oscillators only work when the ADX is falling. Cop

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Possible Entries on ADX

1) Enter on crosses of the DI+ and the DI-. Long trades would occur when the DI+ goes above the DI- and the high of the previous day is penetrated. Short trades would occur when the DI- goes above the DI+ and the low of the previous day is penetrated.

2) Enter in the direction of the market movement when the ADX moves more than four points in two days. Of course, you’ll need a setup (such as a visual inspection of the chart) to tell you whether to go long or short since an ADX rise only indicates a strong trend.

3) Enter when the ADX reaches the highest value of the last 10 days. Once again, you’ll need another signal (also a setup) to tell you which direction to go.

Moving Averages and Adaptive Moving Averages It’s the sum of the prices over the X days, divided by the number of days. That number moves with time. When you get tomorrow’s price, you simply drop the price X days ago (i.e., the number of days in the moving average), add in the new price, and once again divide by the number of days. One number is simpler for most people to grasp than, for example, 30 bars might be, even though the 30 bars might give you a lot more information about what the market was really doing. But people feel more control over the market when they transform data in some way. As a result, a lot of traders and investors use moving averages. If you have a lot of days in your average, then you will have a slow moving average. If your moving average only includes a few days, then it will move quickly. For example, many stock market followers use one year moving averages to indicate the overall trend of the market. When the price has been going up consistently, it should be well above the one year average. When the price drops below the one year moving average, some people make the assumption that the direction of prices has changed. Colby and Meyers, in their Encyclopedia of Technical Market Indicators (1988), found that buying stock when the price crossed above the one year average and selling it when it crossed below that average, outperformed a buy-and-hold strategy by a large margin. Short moving averages, in contrast, are quickly moving. A market does not have to go up too many days for the price to be above its 5-day moving average. Similarly, prices could quickly drop below that average. Cop

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Donchian’s Moving Average Crossover. When the 5-day average crossed above the 20-day average, you went long. When the 5-day average went down and crossed below the 20-day average, you reversed and went short. During consolidation periods such a system gets whipsawed continually. Three Moving Averages. R.C. Allen popularized a method in the early 1970s involving the 4-, 9-, and 18-day moving averages. When the 4-day and 9-day averages have both crossed the 18-day average, you would enter the market—long if they are moving up and short if they are moving down. When the 4-day signal crosses back across the nine, you get an exit signal. However, you don’t get a new entry signal until both the 4 and the 9 are on the same side of the 18-day average. Thus, this sort of system gives you a neutral zone. Weighted Moving Average. The simple moving average gives as much weight to the day that drops off as it does to the most recent day. Some people argue that this is not the best way to trade because the newest price is the most important Weighted moving averages can get very complex because you can just give the last day extra weight, or you can give a different weight for each day Exponential Moving Average. The exponential moving average weights the most recent data most heavily and it doesn’t drop anything out. For example, a 0.1 exponential moving average (equivalent to about a 20-day average) would multiply the current day’s price by 0.1 and add it to yesterday’s average. Nothing would be subtracted. These are quite handy for calculations and they do give more weight to the most recent data. Displaced Moving Average. Since a moving average tends to be very close to the prices, the signals can often be too quick. As a result, some people have elected to “displace” their moving averages by moving them into the future a number of days. This simply means that you are less likely to get whipsawed by a moving average signal. Adaptive Moving Averages. Adaptive moving averages became quite popular in the mid-1990s. Both Kaufman (1995) and Chande and Kroll (1994) have various versions of adaptive moving averages. These particular systems change speed according to some combination of market direction and speed.

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Oscillators / Stochastics Oscillators such as RSI, Stochastics, Williams %R, etc. are all designed to help people who are trying to pick tops and bottoms. Might use oscillators as a retracement signal.

1) Market gives a clear signal of being in a trend. This is a price-based setup.

2) Market reverses slightly and your oscillator gives a sign that the reaction is probably at a peak. Step 2 also is a price-based setup, only it must occur after the first one from step 1.

3) Enter the market in the direction of the previous trend when the market gives a signal that it will again move in that direction. An example would be a return of price to the previous high (or low for a short signal) prior to the extreme oscillator signal. This sort of trading sets up the possibility of a highly reliable trading signal with a very small stop (i.e., the extreme of the reaction). In addition, since the risk on such a trade is quite small, it means that the reward-to-risk ratio of the potential trade could be very high. This, in my opinion, is the best way to trade oscillators.

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Determine 1R: Initial Stop, an

Introduction to Exits

Objectives

1. To learn several types of stops that will best meet your criteria for 1R.

2. To define 1R (setup, entry, and initial stop) for a trading system based on a set of objectives you develop. You will work on this with a small group of several people who have similar trading system preferences.

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Setting Your Initial Stop Loss (Knowing when to get out to preserve capital.)

Basically, you don't have a system unless you have some idea of when you'll get out at the time you get in. Your initial stop loss also allows you to apply a good position sizing strategy management overlay. Your initial stop serves two purposes 1. Determines the maximum loss on a per unit basis 2. Establishes your risk amount so you can measure the risk adjusted returns for your system

Sound stop loss methods are based on the market telling you when your idea isn’t working and when you should get out to preserve capital.

1. Natural Support and Resistance Above or below a consolidation area is logical but don't be too obvious as specialists and high frequency trading systems know about these levels as well

2. Volatility Based.

You could use any number of volatility measures to find points when volatility is about to increase or decrease such as ATR, Bollinger Band Width, standard deviation of range, etc. For example, if the range of the market over the last X number of days has averaged Y, and today the market moves against you by some multiple of that average range, then there is a good chance that your idea about the move is wrong. 1.5X to 3X volatility is probably a good range.

3. Based Upon Your Technique.

The one advantage of counter trend following systems is that you must have some reason to predict a turnaround. Thus, you can use a very close stop, based upon your entry concept. As a result, if you're wrong, you lose little money.

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4. Time Based

If the position hasn’t moved by some minimum amount (+/-.5R) and your research shows it could stay flat for a while or go against you, you might have an initial stop based on some number of bars or time. This can be combined with other initial stop methods

5. % Retracement

If the position has retraced a certain percentage, you might use that an indication that it is likely to move more against you and exit at that point.

6. Dollar Value Stop This is an arbitrary amount used for the initial stop ($.25, $1). You can use a dollar amount and make it a fixed benchmark that you can then test your other stops against.

7. Reversing Stop When the market tells you that your idea is not going in your direction, it may be telling you the actual move is in the opposite direction. For these kinds of systems, the initial stop is actually the entry for the opposite direction move.

The primary question you will need to answer about your initial stop method is “How tight will it be?” Here are some points to consider -

• A tighter stop, that is an initial stop price closer to the entry price, will tend to lower your win percentage and generally increase the size of the R multiples on your winning trades.

• Looser stops, that is initial stop prices that are farther away from your entry price, will tend to increase your win percentage and generally decrease the size of the R multiples on your winning trades.

• Does a looser or tighter initial stop tend to fit you better psychologically? • Which one works better with your particular system?

o Test via backtest or looking at a lot of charts. • How does a tighter or looser initial stop affect the SQN score? • Do you have a sense of what your MAE (maximum adverse excursion) is for this

method? Cop

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