 andthe amount of data you have.
False  (Trend)  Signal,  Quickly  Reversed
Days  in  underlying  trade:  one  or  two.  Days  in  reversal  trade:  zeroor  one.
H  Trade  horizonI
I
Time
b
-
-
-
-
-
-
_  Stop  Level
REVERSAL  LOGIC.  Some 
FIGURE  6.5The  difficulty  is  in  distinguishing  between  an  eventual  trend  winner  (A)and a loser  (B),  which both wander back and forth across the originalpoint  of  entry.
reversals  are 
just  plain  mistakes.
These  are  great:  the  original  trend  trade  is  just  plain  wrong,  andthe  market  breaks  decisively  in  the  other  direction  immediately.Keeping in mind that these reversal trades were ended &en  the un-derlying trend trade stopped,  sharp reversals were most commonlyquick  trades.  Moreover,  because  the  market  action  was  sharpenough to end the trend trade, it is often sharp enough to trigger asharp  move,  one  whose  profitability  is  not  caught  by  these  tradingrules. The reversals force closure within two days and often end thetrend trade the same day. Nearly half the trades (48) were this type.
146  Reversing  Bad  Trades
Inspection  147
These were generally profitable and served to make up some of thelosses from the underlying trade.
Unfortunately,  we  don’t  see  the  full  extent  of  the  profits  fromthese trades in this data because the reversal trades are closed at theend of the underlying trade. This means we are closing out a tradethat  is  headed  in  the  correct  direction.  Also,  the  underlying  tradewould  reverse  itself  immediately  or  soon  thereafter  and  go  on  toglory.
It seems that once you hit the MAE stop in Crude, the best guess
is that the market is going to go in the other direction.
No  Movement
Days in underlying trade before reversal: three or more. Days in re-versal trade: three or more.
These 18 (19%) are trades that occur three or more days into theunderlying trade and last for another three to ten days. The marketis  not  moving  enough  to  end  the  underlying  trade,  or  the  expiringdata  in  the  averages  is  moving  so  coincidentally  with  the  new  datathat an end to the trend trade is not signaled.
Profitability  on  these  trades  is  indifferent,  with  no  great  losses  or
profits.
Sharp  Reversal  of  Trend
Days  in  underlying  trade:  three  or  more.  Days  in  reversal  trade:zero  or  one.
Here, a trade proceeds profitably for several days before in a sin-gle  day,  it  reverses  direction  sharply,  setting  off  the  reversal  tradeand  ending  the  underlying  trade  on  the  same  day.  Adverse  excur-sion  on  these  reversals  is  difficult  to  evaluate  accurately  using  dailydata because you don’t have intraday information on maximum ad-verse excursion  a&r  the  reversal  trade  is  triggered.  That’s  the  daythe  reversal  and  the  underlying  trade  most  often  end,  so  this  is  awarning.
In this data I have, by inspection of the opening, closes, and sub-sequent price action, judged the likely level of adverse excursion, ifany.  Those  with  intraday  data  can  check  more  closely,  though  inmy sampling I’ve found this a sterile exercise. In this exercise, therewere  18 
instances  (18%)  of  sharp  reversals.
Getting Right with the Trend
It’s  remarkable  how  seldom  this  happens  (about  three  times  in  99reversal  trades),  but  after  all,  our  original  trading  system  was  de-signed to be right with the trend. If reversals did that job, it wouldbe a real conceptual problem. What reversals actually do is get youout of a mistake (and occasionally into another), get you right withthe reaction to a trend, or get you out of a trend trade that doesn’tgo 
anywhere.
Figure  6.6  points  out  that  whatever  trend  with  which  we  getright  had  better  play  out  within  five  days  and  certainly  no  more
.
PROFITABILITY  VS.  DAYS  IN  TRADE.  Net  profitability  of
FIGURE  6.6reversal trades, 1984-l 994. The longer you’re in a reversal, the moredismal the results. Good things usually happen quickly, within two days.
148 
Reversing 
Bad 
Trades
Profitability  of  Reversing  149
than  ten.  All  the  profitability  is  concentrated  in  the  first  ten  days  ofthe  reaction.  Given  that  most  reversing  trades  from  trending  arefinished  in  two  days,  the  variability  of  the  result  widens  rapidlyfrom three days on upward, as seen in Figure 6.6. These data sug-gest that a reversal trade that lasts more than two days is a very un-certain situation; beyond ten days  itis almost certainly a loser.
Just to sharpen the point that reversals are fast and furious, lookat Figure 6.7. The most common underlying trend trade lasts just asingle  day  and  is  most  commonly  closed  within  the  next  day  (zerodays in the reversal trade). To restate that, about half the time a re-versal is triggered, the underlying trend trade will have been put onyesterday.  Today  we  get  kicked  out  of  it  and  reverse.
Furthermore, within five days, 80% of the reversals are finished,that is, half the time the reversals we do get will be over today andmost  of  the  rest  will  be  done  within  five  days.  This  just  reinforcesthe lesson in Figure 6.6 that the reversals can be profitable quickly,recovering some or all of the losses experienced in reversing.
There also exists a rough reverse symmetry between days in theunderlying trade and days in the reversal trade, as shown in Figure6.8. For example, trades occurring only one day after the  underly-
FIGURE  6.7 DAYS FROM BEGINNING OR END OF UNDERLYINGTREND  TRADE.  Reversals  that  happen statistics.  What’s  more,  underlying only  last  a  single  day.
inside  one  day  dominate  the
trades  generating 
reversals 
typically
B 
“. “Yi:’  ‘..
.’
FIGURE  6.8 DAYS  IN  TRADE  VS.  DAYS  BEFORE  TRADE.  Days  inversus  days  before  reversals  entered  on  the  first  day  of  the  underlyingtrade  could  last  quite  a  while,  but  those  entered  late  in  the  underlying’slife  are  likely  to  be  brief.  Here  the  frontier  of  this  relationship  is  drawn.
ing  gets  under  way  could  go  on  for  35  days.  (uou  probably  gotnicked with a spike downward of 32 ticks.) At the other extreme, areversal  triggered  on  the  12th  day  of  the  underlying,  would  be  ex-pected  to  last  zero  days-the  underlying  trade  would  end  thesame  day.
PROFITABILITY  OF  REVERSING
Reversing from trend trades is generally profitable and low loss. AS-suming  the  stop  level  is  our  original  entry  we  assume  only  .31   ofloss. Even after we absorb the 11% of trades that hit the trend MAEstop and went on to become winners (that is, they were big loserswhen reversed), reversal trading is probably comparable to add-onsas an additional source of profitability, as shown in Table 6.1.
Although  reversal  trading  is  profitable,  its  true  impact  is  proba-bly  understated  in  Table  6.1.  First,  reversals  that  become  trendtrades  are  cut  off  when  the  original  trend  trade  ends.  Second,  thetrend  winners  that  hit  the  trend  MAE  stop,  if  reversed  again,would  have  contributed  more  profits.  However,  because  there  aretoo  few  of  those  to  trust  the  sampling,  I  omit  their  results  from  a
150  Reversing  Bad  Trades
Summary  151
verse (say, short) and it ends up below our MAE stop level, some ofthe  losses  can  be  recovered.  Of  course,  it  may  end  up  above  theMAE  stop  level  or  even  above  the  entry  point  for  the  underlyingtrend trade, in which case we eat a second loss. It all depends onwhere you’ve set the MAE stop level and the characteristic behav-ior  of  your  market.
Reversing  is  an  essential  skill  for  a  campaigning  trader.  A  mar-ket will not always trend, so the inevitable bad trades must be han-dled  gracefully  so  as  to  recover  some  of  the  losses  with  reversals.The willingness to reverse is a key sign that, psychologically, you’rewilling to win rather than be correct calling the market.
That  said,  it  may  be  that  the  reversal  strategy  would  not  workwith  your  tradable.  You  must  do  the  analysis  to  make  the  tradingrule.  If  it  turns  out  to  be  viable,  at  least  as  far  as  experience  goeqyou add it to the campaign plan, which already includes trend trad-ing and two kinds of add-on trades.
TABLE  6.1
CAMPAIGN 
TRADING  PROFITABILITY,
NEW  YORK  LIGHT  CRUDE.  1984-1994.
Mode
TrendTrendTrendTrend
Rllk
stop  Level
Two moving averagesAdd-on day tradesAdd-on position tradesReversal
.31.31.31.31
Profit/Lossbointsi
360025006401827
tabulation.  I  do  advocate  your  becoming  familiar  with  them,though. Were I to reverse a trend trade on an MAE stop hit by justthree  or  four  ticks  within  a  day  or  two,  followed  by  a  strong  re-bound  in  the  original  trend  direction,  I’d  feel  justified  in  reversingagain  with a loss potential of  .31,   This  is  just  personal  judgment  ofthe Crude market. You’ll make a conclusion based on your analysisand  experience.
Another  point  about  reversals:  Because  reversals,  by  definition:take  you  out  of  the  trend  trade,  your  capital  requirement  is  notnecessarily increased by  reversing.s   Add-on  position  trades,  beingseparately capitalized, do tend to increase the total amount of cap-ital required as large portfolios are assembled. For example, if trad-ing only one item, it’s hard to conceive of having 50 trades (100% +2%)  on  at  the  same  time.  On  the  other  hand,  if  trading  200  items,you could easily have 100 trades on at one time. That would mean(if all have the same acceptable loss level) you’d need at least twicethe capital you’d need in the first situation.
S U M M A R Y
If a trade hits our MAE stop, there’s a high probability that, withinour  trading  horizon,  it  will  end  up  a  loser.  It  may  be  that  if  we  re-
3 Your capital requirement may be increased if  your analysis of runs of trades in-dicates  an  uncomfortable  probability  that  your  capital  could  be  reduced  to  thepoint  that you couldn’t undertake those reversal trades you need to complete yourcampaign of trading. This complex subject I leave to a more detailed treatment ina later book.
Switching Modes:Trading  Ranges
We’ve just spent six chapters on the most popular trading situation:trending.  It’s  commonly  said  that  most  trading  instruments  aren’ttrending all the time or even most of the time. More objectively, wecan  tell  from  the  number  of  reversal  trades  from  false  signals  thatour  trend  indicator  is  often  wrong.  While  a  truly  active  trader  willconstantly  screen  for  trending  behavior,  shifting  his  vehicle  as  nec-essary, this book is about another approach: a concerted campaignto exploit fully one vehicle. To do that, we need to trade when ourtradable  isn’t  trending.
Every  trend  ends.  In  our  example,  the  end  came  when  the  rulesfor  exiting  were  tripped.  One  or  the  other  of  the  averages  brokestep with its mate. It could have been any set of rules and the im-portant  thing  was  that  it  set  the  time  horizon  for  our  trading.  Nowthat  the  trend  trade  (and  any  add-ons)  are  finished,  what  do  wehave?
For  one  thing,  we  might  get  a  lot  of  chances  to  trade.  Was  theNew York Light Crude market in trending mode only a third of thetime?’ Actually,  no.  For  Crude,  from  1984  to  1994,  with  the  rules
I I couldn’t resist checking this and found that “time in trend trade” was 50 + 102 +161 +  145+  137+  150+  189+  177+  132+  123+  164=  1,530of2,800days,or55%.
154
Switching  Modes:  Trading  Ranges
Recognizing  Ranging  155
we’ve  used  here  the  market  was  in  a  trend  (i.e.,  one  lasting  morethan three days) 55% of the time, a number I find surprisingly high.Nevertheless, there were periods when the trending indicator couldnot  pick  up  meaningful  advances  or  declines.  Arbitrarily,  I’m  goingto  call  these  nontrending  periods  trading  rqqs   and  try  to  extractsome money from them.
A campaign trader may expect to see ranging prices at the begin-ning  of  a  trend  rather  than  at  the  end  of  a  trend.  In  physical  com-modities  and  stocks,  there  are  often  long  basing  periods  beforetrends, situations that are best handled as trading ranges, How-ever,in  rates  and  currencies,  particularly  the  former,  ranges  appearingafter  trends  seem  to  be  those  preparatory  to  a  new  trend.  Long-term basing seems uncommon in rates and currencies compared tostocks.
Wherever  we  look,  the  first  problem  will  be  to  see  the  range
forming  in  time  to  exploit  it.
RECOGNIZING  RANGING
If  I  showed  a  number  of  people  three  or  four  charts,  nearly  everyperson  could  probably  pick  out  areas  where  the  price  was  goingnowhere over a period of time. (Refer, again, to the perception is-sue  described  in  Chapter  2.)  This  perceptual  phenomenon  occurswhether we’re looking at tick charts, daily, weekly, or month charts(see Figure 7.1). And, just for starters, I’m going to circle the areasI pick out.
However, to eventually get this idea of prices being relatively sta-ble  into  a  computer,  I’ll  need  to  be  more  objective.  Clearly  lowerlows/lower  highs  or  higher  highs/higher  lows  will  not  constitute  atrading  range.  Prices  must  return  to  the  approximate  levels  theyachieved  in  some  period  before.~   Otherwise,  the  central  value,  ifthere is, one, is still moving upward or downward.
This return to a previous price level can be observed visually andby the computer. All the computer needs to know is how far backto look when making its comparison. As shown in Figure 7.2, if we
PICKING OUT RANGES.  Ranging behavior  crops  up  onFIGURE  7.1all  time  scales,  intraday  to  monthly.  Picking  it  out  visually  usually  isn’ttoo  difficult.  Getting  a  computer  to  see  what  we  see   is  tougher.
set that look-back period too short, it won’t see the last low. If weset it too long, it might pick up a low six months ago.
How far back do we look? If we can see trading ranges on daily,weekly, monthly, or even five-minute charts, which one is relevant?This is where the time horizon discussed earlier comes into play.
Time  Horizon
First,  you’ve  already  chosen  how  often  you’ll  monitor  the  market,usually looking at the data for entry signals. A retail speculator hasthe  luxury  of  choosing  his  time  frame:  intraday,  daily,  weekly,  bi-weekly  and  so  on  whereas,  institutionally,  the  exigencies  of  servingcustomers  or  the  business  often  dictate  the  trading  horizon.  Al-though  there  exist  retail  day-traders,  most  don’t  have  the  daytime
156 Switching  Modes:  Trading  Ranges
Recognizing  Ranging  157
Higher  Highs
Ranging
Price  
jj$!ces  
Vs.  /lJ$f
I
Time
e
FIGURE  7.2 SIMPLE DEFINITION OF RANGING.  The absence ofhigher highs with higher lows and the return to previous price levels isthe first clue to ranging behavior. When we see  this. we have a well-defined trade entry because a long will be quickly stopped out  or beprofitable to the other side of the range.
free,  and  the  majority  of  them  use  daily  prices  or  weekly  prices,Daily prices give the most data points so I’ll use those.*
Second,  you  look  for  cyclic  content.  Chapter  1  discussed  usedmaximum  entropy  spectral  analysis  (MESA).  Another  alternativeis Fourier analysis.
Most  traders  also  constrained  by  how  deep  their  pockets  are.The  longer  the  time  frame,  the  greater  the  excursion  of  prices  andthe greater the potential losses they face. Traders who can take thelosses from trading daily bars may not be able to handle the swingson  a  weekly  or  monthly  basis.  Some  will  luxuriate  in  having  thedepth  to  handle  a  longer  time  frame  while  choosing  to  trade  in  ashorter  time  frame,  but  most  traders  will  intuitively  watch  the  mar-ket as much as necessary to control losses in relation to the size oftheir  accounts.
In  Chapter  2,  all  of  these  considerations,  but  primarily  the
cyclic, dictated using averages of 12 and 58 days.
2 I’m also  very  uneasy with the overnight gaps in prices in intraday data. Try as Ihave,  I  cannot  find  confidence  in  computations  that  mix  today’s  fix-minute  barwith 
yesterday’s,
“Trend” is a word that could use some analytical rigor, especially inthe  trading  literature.  Frankly,  there  is  a  lot  less  to  trading  thanmeets the  eye,s  and  the  old  Dow  rule  of  higher  highs,  higher  lows(or the reverse) is what many trading indicators come down to. Atthe  least,  that  sort  of  activity  will  trigger  nearly  all  indicators  look-ing for trends.
To  trade  ranges,  we’re  looking  for  the  absence  of  trend  withinthe time frames of 12 and 58 days. Possible rules, among hundreds,include
1.  n-day  range  diminishes  and  volatility  declines2.  n-day  absolute  average  slope  diminishes  and  volatility  de-
clines
3. not  in trend mode, however trend mode is defined4. absence of higher highs/higher lows or lower lows/lower highs5. simple crossing of price over trailing average6. pivot point highs and lows not exceeded for  11 days
You  can  see  that  this  speculation  could  go  on  forever.  Havingpicked a definition, you’ll test it to see if (1) it occurs and (2) it oc-curs enough for trading. If so, we proceed to trading.
Our  Definition
For  our  purpose  of  demonstrating  campaign  tactics,  we  need  onlya  simple  system.  We  have  one  in  the  trend/no  trend  notion.  Whenthe movement of prices kicks us out of our trending state, we havea  possible  range  situation.  For  the  exemplary  rules,  all  that’sneeded  is  for  one  average  to  go  in  a  different  direction  from  theother. Practically, that’s almost always a reversal (a change in  direc-
’  A  quote  often  attributed  to  Richard  Dennis.  A  Chicago  speculative  trader  who’sgone  boom  and  bust  several  times,  Dennis  is  famous  for  having  created  a  group  oftrading  trainers  called  the  Turtles  to  prove  you  could  teach  trading  to  others
158
Switching  Modes:  Trading  Ranges
Recognizing  Ranging  159
tion) of the short average. In Figure 7.3, the prices go from point  1to point 2 to point 4, rising above the short average at point 3.
One  point:  During  the  trend,  we  record  the  extremes  of  price  inthe  trend’s  direction.  That  will  be  one  potential  side  of  our  range,That’s point 2 in Figure 7.3. When persistence in price change anddirection  (point  1)  ends,  the  averages  will  go  in  different  directionsand we’ll be in a nontrending state (point 3).
After we’re kicked out of the trend trade, we need to find the re-action  level  (point  4).  Moreover,  the  reaction  level  should  occurwithin a reasonable period of time defined by the cyclic periodicityof the tradable. For Crude, we expect that to be within 12 days. Af-ter  all,  if  the  market  is  to  oscillate  back  and  forth  in  a  range,  whatmore likely time to see cyclic behavior?
Lastly, prices must recross the average to point 5.What  could  go  wrong  here?  For  one  thing,  we  could  never  get  intoa  range:  we  might  go  right  into  another  trend.  Our  first  hint  will  bethe failure to retrace from point 4 to point 5. Many trends lift off, re-trace briefly to retest the area of the previous low, and then resume
their advance. If the trend indicator is working properly, it w-ill kickback into trend mode and the ranging idea will be shelved.
Another  bad  possibility  is  that  the  tradable  might  not  stay  in  ournewly defined range,  There’s nothing that says a market must tradeabout a central value or that the value must be constant. All that isjust a hypothesis. The worst of these situations is a broadening range,one of which popped up in the 1994 Crude market (see Figure 7.4).Another  thing  that  can  go  wrong  with  range  trading  is  a  marketthat  settles  on  the  upper  or  lower  range.  What  if  the  market  wan-ders  around  one  of  our  trading  levels:  whipsawing  back  and  forth?Will we survive being long (see Figure 7.5) in a slowly falling mar-ket?  Are  there  a  lot  of  these  situations?  Do  they  make  it  impossi-ble to trade ranges? Points like these can only be settled by experi-ence, not  (I priori,  because we don’t know how markets work norall  the  factors  influencing  them  at  any  given  time.  We  must  exam-ine  the  specifics  of  our  experience  given  defined  trading  rules  and
I
RANGING MODEL. If  the  market  is  not  trending,  assume
FIGURE  7.3it’s in a nontrending or ranging market. Although you’ll probably neversee this idealized situation, an active campaigner will always be alert forthe onset of ranging. Once the range is found, the campaigner will tradeinto  the  range  until  forced  to  reverse  into  a  trend.
~.
BROADENING FORMATION.  As  highs  go  higher  and
FIGURE  7.4lows  go  lower,  range  trading  becomes  impossible  without  serious  losses.This  was  one  of  two  broadening  formations  in  11  years.
160
Switching  Modes:  Trading  Ranges
Ranee  Tradine   MAE  161
A
1
Trailing  werage
-
-
-
-
-
-
-
-
-
-
3
-PliCBS  f  *  -  -  t’-  ++  ;  ‘-  ‘_  -
-
P
ce
:k
T i m e
FIGURE  7.5trading ranges occurs  when prices whipsaw across range lines.
RANGE  WHIPSAW.  One  thing  that  may  go  wrong  with
see  if  the  rules  generate  distinctive  distributions  of  loss  for  win-ning  trades  and  losing  trades.
RANGE  TRADING  MAE
Now, we’re interested in how far bad a winning range trade goes inCrude. Our game plan is to trade at the range levels into the rangeand exit when we’ve crossed to the other side. When we do that,some trades will work, some will be immediate losses and some willbe in between, as shown in Figure 7.6.
In Figure 7.6, we trade back into the range at point 6 before giv-ing  up  and  reversing  long  at  point  7.  The  whole  question  is  wherethe  stop-reverse  level  is  and  the  only  answer  is  experience.  We’lltrade in this manner and see what the adverse price movement ex-perience tells us.
Defining  Ranges  for  a  Computer
Let’s  define  these  situations  for  a  computer  and  see  what  it  finds‘Use  the  following  rules,  keeping  in  mind  that  they  are  specific  tothe example of Crude oil.
L
Time
.
REVERSING  OUT  OF  RANGE  TRADING.  Plan  on  taking
FIGURE  7.6a loss when breaking out of your range. Ideally, that will be somewhatoffset by the profit going from point 5 to point 6.
1.
2.
3.
A trend of at least six days must exist. That is, both averagesare moving together for six days. Why six days? As shown inthe  charts  of  the  trend  lengths  in  Figure  7.7,  the  genuinetrends seem to last longer than five days, at least the trends aswe  have  defined  them.  Also,  six  days  is  the  half-cycle  lengthfor  the  short-term  average  we’re  using.  Because  the  chart  isconsistent with cyclic content,  I use six days as a good start-ing  point.Trend  is  broken  by  prices  crossing  an  average  (usually  theshort average) and forcing it out of sync with its partner. Dur-ing  the  trend,  we’ve  accumulated  the  lowest/highest  close,”which  will  be  our  initial  guesstimate  of  one  side  of  the  range.Once  prices  cross  the  average,  we  seek  the  high  side  of  therange  as  long  as  trending  does  not  resume.  (Again,  trendingwould need to be in evidence for at least six days.) If rangingis  in  force,  the  prices  should  make  that  reaction  high  or  lowand  then  recross  the  average,5   at  which  point  the  reaction’s
4  Within  the  last  12  days,  that  being  the  cyclic  length  we‘re  using.5  Formally,  within  6  days  (the  half-cycle  length)  of  ori@ally  crossing the  average.Given  the   slop  in  estiites   of  cyclic  length,  I  give   it  up  to  the  full  cycle  length:  12  days
162
Switchine  Modes:  Tradine  Ranees
Results  163
FIGURE  7.7 DAYS  IN  TREND.  As  defined  by  the  two  movingaverages, trend signals lasting longer than five days have a good chanceof  solidifying  into  a  strong  move.  Coming  out  of  trends  identified  thisway  will  be  the  setup  for  identifying  a  range.
extreme close will be the opposite side of our range (see Fig-ure  7.8).
A  choice  exists  in  declaring  a  range:  once  when  price  re-crosses  and  closes  across  the  average  after  setting  a  reactionhigh/low or when the price returns to the original low/high setduring  trending.  The  former 