ading profile and matching it to the three money management ratios discussedhere. I build on these basic elements in detail in Parts 2 and 3 of GSIFTS.
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2Part
Developing a TradingCodex
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4Chapter
The Codex NotebookYou learn more from your losses than from your wins.—Charles B. Goodman
t is time to begin thinking in codex process terms and developing your ownpersonal trading codex. In this book I use my own FxCodex approach as theexample, but each trader will develop a codex according to his propensitiesand decisions with respect to trading techniques, style, and money management.The first step is to begin a codex notebook. This is where you will keep allyour trading parameters as well as copies of your daily and weekly trading reports and post-trade comments. In the remaining chapters of Part Two, I definethe codex trader and help you assemble everything needed to trade using thecodex approach.
I
From Traditional to CodexFive key elements separate the traditional approach and the codex approach:1. The trading elements of techniques, style, and money managementare wrapped into an integrated, dynamic process instead of each element being considered separately from the others, one after the otherin linear fashion.2. Your codex is defined in advance of your trading. It may and willchange from time to time, but the basic framework should be in placefrom the very beginning of your trading career.
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3. Your perspective toward markets is in seeking trading opportunities,first qualifying them as candidates and then moving gradually to executing an actual trade. The elements are subordinate to that process.4. Changes to your codex—your comprehensive trading approach—should be made in small evolutionary moves derived from trading results and experience. Avoid major and frequent changes.5. You will constantly review your trading performance in light of yourcodex.Elements versus Codex ApproachElements• Trading tools• Style• Money managementCodex• Selection• Entry• Monitor• Exit• PostmortemOne student told me she considers process as the fourth element,after trading technique, soft elements, and money management. Ifyou are a neotraditionalist, perhaps this is a good way to organizecodex materials.
Codex NotebookYou are encouraged to begin a notebook to keep a written record of your codexselections and decisions. Later you will add a section for record keeping, including a daily and weekly trade plan.You should keep your codex notebook with you at all times. You maywant to keep a computer-based copy of it, but I strongly recommend maintaining a hard copy next to your computer whenever you trade or even watch themarkets. The very act of writing things down, instead of putting them in acomputer document, can make them more meaningful to you. You will wantto keep records of all your trades in some fashion and in enough detail so that
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you can refer to them months later and remember most of the circumstancessurrounding them. You also will want a daily and a weekly game plan—youranalysis of ongoing and potential trades, and proposed actions you will takegiven different market circumstances.You should create five sections: Trading Tools, Style, Money Management, Process, and Reports. If, after you look at the report examples in PartFour, these seem too onerous, you may replace them with a shorter diary.The Codex Notebook—SectionsSome traders keep extensive commentary, others only shorthandnotes. Whichever works for you is best. The primary idea is to beable to remember and reconstruct a trade and the conditionssurrounding it at a later time.1. Trade summary. This should include entry and exit dates, pricein/price out, and net proﬁt in both pips and dollars. Leave two orthree additional columns for calculating cumulative results later.2. Daily trade plan. This should include contingencies for as manyprice occurrences as possible. If the market moves higher, if themarket moves lower; if the market opens higher then falls, if themarket opens lower than rises; if Market Environment factors,especially directional movement and volatility, change dramatically; what news or announcements are pending and how themarket reacts to them.3. Daily and weekly trade summary. Provide enough information toreconstruct the trade(s) and the conditions surrounding it at alater date.4. Codex summary. Keep a record of all the trades you are watching or trading.5. Diary. A diary allows you to summarize your trading day—thegood, the bad, and the ugly. It is here that you want to rate youremotions going into the session and again coming out of thesession.
Trading ToolsIn the codex approach, trading tools are used to select candidate trades. In thissection of your notebook, you will monitor candidates until they eitherdisqualify themselves or become legitimate trading opportunities. The sametools are then used to execute the trade, monitor the trade, and exit the trade.
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Trading Tools ChecklistAs you enter a trade, check off your trading tools to make sure youhave considered them all in your selection process. You may keepthis as a separate notebook entry or in your daily trade plan. If youhaven’t considered a particular tool, why not? Altering the processwithout a very good reason is not recommended.• Bar chart• Swing chart• GSCS• Nofri• Indicator 1• Indicator 2• Market environment ratings• Filters
StyleHere you will define your soft elements. The soft elements refer to things notobjectively quantifiable, such as psychology and attitude. A trading profile mayalso fit into the soft category. Every trader must make adjustments from time totime. The markets ebb, flow, shift, and change—and so do we. But over thelong haul, these changes occur gradually and should not require wholesalealterations to your codex or your trading.Soft Elements ChecklistKeep a list of your soft elements, refer to it for each trade, and keepa record of those elements for each completed trade.The two most critical questions to ask here are:1. Does the trade match your trader proﬁle—guerilla, scalper, daytrader, position trader?2. How do the market environment factors for each trade (directional movement, volatility, thickness, and rhythm) match upvis-à-vis performance?By reviewing a few dozen trades for market environment you willsee what ME proﬁles work best for you—and what proﬁles to avoid.
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Money ManagementIn the codex approach, money management decisions derive from your softelement decisions and the trading tools selections. Very little is done withad hoc rules, as is typical in the traditional approach to trading.After you define your trading profile, it is possible to create simple riskreward tables to see how a prospective opportunity shapes up vis-à-vis yourprofile.
Money Management ChecklistFor each trade, keep in a log:• Your intended risk/reward (stop/proﬁt objective) levels. If youdon’t know these in advance, don’t make the trade!• Your intended stop/proﬁt objective method: system, ﬁxedratio, support/resistance. I strongly recommend the ﬁxed ratiomethod for new traders, moving to the system (Goodman)method after at least three trading campaigns of 10 tradeseach. I recommend against the support/resistance method.Both broker/dealers and professional traders gun for stops incommon support/resistance price levels.• Your intended entry/exit versus the actual entry/exit.
ProcessIn your notebook, create a fourth section for codex process. Your codex summary should indicate where in the process each of your trades and trade candidates are at the beginning and the end of each session: select (candidate), entry,monitor, exit, or debrief (postmortem).For trades in the monitor area, it is critical you have your daily trade plantied in to any and all markets.Reports or DiaryThe fifth section is for reports or a diary. This section must include the basicdetails of each trade: when you entered, when you exited, prices, and time.Even a one-sentence comment on the trade—what went right or wrong, whatseemed to work or not work—is useful. Write enough so you can recall the circumstances of the trade later.
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SummaryYour notebook is designed to allow you to review past trades you have completed, keep track of ongoing trades, and prepare for future trades. There is obviously much flexibility in how you organize this information, but those are thethree primary goals of a notebook.Now it’s time to begin the real work of building your personal tradingcodex.
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5Chapter
The Codex ToolboxKeep it simple, Dad!—Charles B. Goodman
art Two introduces the tools and other methods you will use for yourpersonal codex. In Part Three, I show how they are utilized in the processof tracking, selecting, entering, monitoring, and exiting an actual trade.The tools I use for trading are simple and transparent. They can be usedeffectively by traders of all proﬁles and in any FOREX market. The marketscan only go up or down; everything beyond that simple fact should be irrelevant to the codex trader.Trading is a simple business; do not make it unnecessarily complicated.The more complicated your trading techniques, the more difﬁcult it is to ﬁndgood trades, make trades, and diagnose problems.The codex trader seeks only trades meeting the criteria within all three elements of the toolbox, the trader’s style, and money management. Because thereare so many markets to trade, it makes good sense to be picky. Most of themoney you make will come from “sitting on your hands.” If you select yourcodex materials correctly, it is easy to ﬁnd good trades. You will have done muchof the work in advance and the markets will receive your full concentration.
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Trading Techniques—The Codes ToolboxFor trading, the only tools you need are the following:• A tool to quickly deﬁne what type of market you are studying.• A tool to visually observe market action.
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• A tool to zero in on a market when a promising opportunity arises.• A tool to forecast the market for determining entry and exit.I emphasize again the danger of using too many different tools to trade.The markets are not that complicated, nor is any magic involved. Use as fewtools as possible, and use only tools that are inherently transparent and easy touse, understand, and apply. See Figure 5.1.
Market EnvironmentI devised the market environments approach in the 1980s and have used itconsistently since that time. It is a simple and useful method for quickly determining what type of market you are trading or considering to trade. Usingmarket environments, you can also quickly and easily see if a market’s underlying structure is changing.There are four components to a market environment. Taking themtogether I call eyeballing a market. I believe you can learn more about a marketin this manner than with a large variety of complex indicators. You can see all
Select a Candidate
EntryMonitorExit
DebriefReportPostmortemFIGURE 5.1 The Codex Approach.
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of them simply by looking at a bar chart. Gaining information about a marketfrom a chart is always preferable to secondary methods such as indicators.Every market you trade may be deﬁned in terms of directional movementand volatility (DM/V). These are the two primary components of market environment and eyeballing a trade.Directional Movement and VolatilityDirectional movement (DM) is the net change in prices over aspeciﬁed number of time units. Volatility (V) is the aggregate pricemovement over a speciﬁed number of time units given a minimummeasured price ﬂuctuation.EUR/USD Weekly Average Price117.5116.9117.7118.0117.4117.5117.0118.1DM = .9V = 4.3The volatility number (4.3) is a raw value and is typically used asthe variable to compute a volatility index or moving average.
Directional movement is the net price change over some period of time.Volatility is how much price movement occurs in addition to the straight line ofdirectional movement. The former denotes the basic trend of a market; the latter, how actively it is trading.I use a simple computer program for market environment that creates a16-combination matrix of directional movement and volatility. It shows a continuum going from low directional movement and low volatility to high directional movement and high volatility. You can also subdivide according towhether the basic market trend is up or down. This, then, gives 32 possiblemarket environments. Eyeballing is almost as good. After you have studiedsome charts, you can get a good estimate of both factors and where a marketlies on the continuum.The basic market environment uses these two features of prices—directional movement and volatility. As stated earlier, directional movement is
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the net price change from one time unit to another. Volatility is the gross pricemovement between those two points. See Figures 5.2 and 5.3.The Visual Basic 6 code in Appendix A will allow you to work with market environments more precisely, should you want to do so. If you are unable touse the code, you can simply eyeball the chart you are watching for the two factors of directional movement and volatility. Also watch for changes in both factors as prices develop. You can visually plot the movement of a market on theDM/V scale as it evolves over time.23222120191817161514131211109876543210
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FIGURE 5.3 15-Minute Volatility.
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The Market Environment ContinuumDirectional movement can be valued on a continuum from 1 to 10,where 1 is the lowest DM in the data sample and 10 is the highest.A similar continuum may be used for volatility.A 1-1 market exhibits low DM and low V. A 10-10 market exhibitshigh DM and high V.
Secondary Market Environment FactorsThickness is the third market environment factor. Thickness refers to how muchoverlay there is in prices from high to low from one time unit to the next. (SeeFigure 5.4.) Some FOREX pairs seem to be naturally thick. Thick marketstend to trade more slowly, even sluggishly. As a practitioner of the Belgian Dentist style of trading, thick markets appeal to me. In Europe, the term BelgianDentist is used to refer to the most ultraconservative of traders.
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FIGURE 5.4 Thickness.Thickness measures how much of the price value, from high to low, for agiven time unit (X), is used in the next time unit (X+1). The market on theleft is thick, and the market on the right is thin. Thin markets tend to havehigher directional movements, but it is not always the case.
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A note of caution: Thickness may also indicate that a pair is relativelyilliquid. That is, there is not a great volume of trading involved and the thickness actually represents a wide bid-ask spread.In Part One I wrote about cyclical analysis. I’ve long ago concluded thatthe markets do have some natural rhythms and cycles, which would be an excellent avenue for further technical analysis exploration. Surprisingly little hasbeen done in this ﬁeld, especially regarding FOREX.But you don’t need software or complex indicators to get an overview of amarket’s rhythm, which is the fourth basic component of market environments.Simply observe the following:• The lengths of the upswings in a market and the corresponding lengthsof the downswings.• The time between peaks and valleys, peaks and peaks, and valleys andvalleys.You want to trade with the market’s rhythm, not against it. If a market ishaving fairly regular 200-pip upswings and 100-pip downswings, you don’twant to enter a sell order after a 50-pip upswing unless you have overwhelmingevidence to the contrary.Most markets exhibit some rhythm. Rhythm may be either time-based,meaning the units of time from peak to peak and valley to valley are regular, orprice-based, meaning primary and secondary price swings are regular.Keep a mental or written notation of average rhythm. Rhythms dochange but they tend to change gradually and predictably.Rhythm can be used to time market entry and exit (see Figure 5.5).These, then, are the four components of market environments. I truly believeyou can be a successful trader by simply learning, reﬁning, and using these factors.
Bar ChartsThe best chart to use for studying market environments is the bar chart. Barcharts are also the best backbone tool a trader can use, although the traditionalinterpretation patterns such as pennants and head-and-shoulders are essentiallyworthless nowadays.Price charts are simply visual records of price movements. They allow youto see prices over an extended period of time. Each type of chart—bar, pointand ﬁgure, candlestick, and swing—has its own speciﬁc characteristics andadvantages. But they all perform primarily as recording devices.Bar charts are the most popular. They are widely used on FOREX broker/dealer trading platforms and are the most commonly used and discussed in
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FIGURE 5.5 Rhythm.This market has both time and price rhythm. Watch for both types ofrhythm, and rhythm for peaks/primary-valleys/secondary (in up markets)and valleys/primary-peaks/secondary (in down markets). Watch for rhythmin all three of your chart price scales.
the literature of the market. Candlesticks are second in popularity, with pointand ﬁgure and swing charts a distant third and fourth.A single vertical bar on a bar chart represents the range of prices for aspeciﬁed period of time, from the highest price during that time period to thelowest price.Charlie always said, “Keep it simple,” but he could just as well have said,“Keep it visual.” To be close to the market’s pulse, you need tools directly derived from market data; in the case of FOREX, that means prices.Volume and Open InterestFutures and option traders use volume and open interest ﬁgures toanalyze markets. Volume is a continued total number of futuresoption contracts that have traded during a speciﬁed tradingsession. Open interest is the number of futures or option contractsopen at any given time.Because there is no central clearinghouse for FOREX, currencytraders do not have access to these useful tools. It is possible tosynthesize volume and open interest using price data. See theFOREX Propensity Index on www.fxpraxis.com.
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Each time data is translated—for example, to create an indicator—it becomes more difﬁcult to use. Each translation or conversion also tends to lowerthe clarity of the information. We all know what happens when a picture orgraphic is copied and then the copy is copied again. It loses resolution andeventually you cannot recognize the image itself. The same is true of data generally and market data speciﬁcally. See Figure 5.6.Bar charts typically now indicate the opening price for that time period aswell as the closing price. These are represented by small horizontal dashes attached to the main vertical bar. See Figure 5.7.The time period selected for a bar chart may vary enormously. InFOREX, bar charts may be used for time frames of seconds (5, 10, 30), minutes (1, 5, 10, 30), or even days or weeks. Most broker-dealer trading platformsoffer a wide variety of time frames. Properly used, these can be an enormousbeneﬁt to the FOREX trader. (See Figure 5.8.) The time period(s) you selectfor your codex will be determined by your trader proﬁle. The shorter term youtrade, the shorter term will be the time frames of your bar charts.
FIGURE 5.6 A Bar Chart.A bar chart connects the high to the low price on a speciﬁed time unit. Barcharts may be used with any time unit from ﬁve seconds to monthly oreven yearly. Most bar charts add a small horizontal bar to indicate closingand sometimes opening prices.
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FIGURE 5.7 A Completed Bar.Many traders ﬁnd value in the relative locations of all four values: high, low,open, and close. The relationship between open and close is especially wellscrutinized, and a variety of indicators have been designed to analyze theirrelative values.
Bar charts, point and ﬁgure charts, and swing charts are all refractive. Thismeans that without seeing the time and price legends, it is impossible to tell aﬁve-minute chart from a weekly chart in most cases. The useful corollary of thisis that trading techniques used on one time frame can be used on all others.This is an important feature of technical analysis and also of great value to theFOREX trader.Popular Bar Chart PatternsTraditional bar-chart interpretation looks for speciﬁc formations within the chart.There are many so-called patterns, but the following are the ones most commonlywatched for and used. For more information, see Encyclopedia of Chart Patterns byThomas Bulkowski (New York: Wiley Trading, Second Ed., 2005).• Head and shoulders• Pennant• Flag• Double bottom/double top• V-top/V-bottom
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FIGURE 5.8 Time Frames.Time frames, or time scales, are a very valuable tool to the currency trader.Each gives a different perspective on a market, and the relationshipsbetween the frames are useful. Typically you will select markets off themiddle frame, and use the larger frame for long-term perspective and thesmaller from for entry and exit timing.
I do not recommend trading using these patterns as they are too popularand the market tends to anticipate them, which prevents them from workingvery well. It is useful to watch for them if only to know what many othertraders might do in reaction to them.These patterns are very well known because they have been popularizedover many years in many books and other market instruction. For this reason Ido not believe they are effective over the longer term. You may certainly ﬁndone that works according to plan, but for each one that works, several will fail.As an example, see Figure 5.9.Traditional bar-chart patterns also tend to be backward-looking, and themarkets are always forward-looking. If you look at a bar chart, you will easilysee many of these patterns after the fact, after they have been completed. Thosewon’t help you make a successful trade; it’s too late! Keep in mind the difference between a tool being descriptive or predictive. A descriptive tool is notmuch use unless you have a time machine.Figure 5.10 shows a bar chart pattern. But hold a piece of paper over thechart and then move it one time frame at a time to the right (as prices progress).At what point would you execute a trade based on the pattern visible so far? Remember, you haven’t seen the entire pattern because it hasn’t yet formed.
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FIGURE 5.9 Failure of a Bar Chart Formation.The two circled points connected by the horizontal sloped line is the“neckline” of a head and shoulders formation. According to the theory, oncethe neckline is broken by downward-moving prices, a sharp downwardtrend will continue. Often, however, prices will break the neckline, only tohead back up.
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FIGURE 5.10 Descriptive or Predictive?This trend line appears to be very tradable. But was it predictive or simplydescriptive?
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If you review a large number of charts you will see many head and shoulders formations that worked. The problem is these patterns tend to be descriptive rather than predictive. To accurately measure reliability cover a chart with aplain piece of paper, then move it one frame at a time and attempt to predict ahead and shoulders. Your results will differ substantially! Beware of tools thatare descriptive (you can see them work after the fact) but are not predictive.The codex approach does not use these patterns, but it is useful to be ableto recognize them. In Part Three I show you how the codex trader uses them totheir greatest effectiveness.Another issue with traditional patterns is that because so many tradersfollow them, they simply cannot work. The market will not let them work orelse everyone would win, which is impossible.I once acted as an expert on an Internet FOREX forum. The moderatorgave me the boot because my ideas about chart patterns were not mainstream.But mainstream doesn’t win in the markets—stocks, futures, or FOREX.In the old days, traders created their own bar charts by hand. This wasvery time consuming but it also had advantages. The very act of making thechart helped the trader tune in to the markets. Because you will be tradingmultiple markets with very short time frames this is, unfortunately, a luxury nolonger affordable.Bathtub AnalysisMy mentor