2 × stdev(A81:A100)Lower Bollinger band = average(A81:A100) − 2 × stdev(A81:A100)
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Using the standard deviation gives us a measure of confidence. Becauseof the non-normal distribution of prices, two standard deviations means that87% of all prices will close inside the Bollinger bands, or 13 prices out of 100will be outside either the upper or lower band.Bollinger bands do a better job isolating the highs and lows of the upwardmove of AMR, shown in Figure 6.6, compared to the percentage bands in Figure 6.4. As the standard deviation promises, the peaks and valleys penetratethe bands in fewer cases, and their occurrence seems to be spread out overthe entire upward move. In Figure 6.4 many of the penetrations through thetop band remained above the band for many more days than they did inFigure 6.6.If we now look at the AMR problem period from mid-1998 to mid-1999(see Figure 6.7), the Bollinger bands are penetrated on the downward moveat the same point in July 1998; however, prices do not stay below thelower band. Bollinger bands do a better job of isolating the extrememoves. It doesn’t help our trading profits because prices do not return to the
FIGURE 6.6 Bollinger bands. Bollinger’s 2 standard deviation bands on either side of a20-day moving average seem to adjust to the shape of price movement. The bands contain 87out of every 100 prices.
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FIGURE 6.7 Bollinger bands during a more volatile period. Even though Bollinger bandsare an improvement over the percentage band, buying on the break during July 1998 results inthe same loss.
the center of the band until August, giving us the same result as the percentage band.Overall, Bollinger bands are more responsive to price movement. Theycan be very helpful identifying overbought and oversold conditions usedin combinations with chart patterns such as tops and bottoms; they can improve your entry timing in a trend. You can learn more about Bollinger bandsby going to the website www.BollingerBands.com.Finding a Calculation Period That Works. There is always a solution ifyou look in the right place. When prices are as volatile as they are in July andAugust of 1998, we can simply extend our calculation period. The 2 standarddeviation bands will then show the 5 percent highs and lows that penetratedthe bands during the longer period.In Figure 6.8 we apply a classic 200-day moving average with Bollingerbands. In this case we greatly improve the results, but have fewer tradesand more risk. By the nature of the standard deviation, prices will only
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FIGURE 6.8 200-day Bollinger bands. A longer calculation period can reduce the initialrisk for volatile markets, but provides fewer opportunities. Once you are in the trade, prices canfluctuate widely before they reach the price objective at the center of the band.
penetrate the bands 5 percent of the time, or 10 days during the past 200.Of those 10 penetrations, 5 should be highs and 5 lows, although that is notguaranteed.Using a 20-day calculation period, the band width was about $15 (seeFigure 6.7), but when a 200-day period is used, the band width increases toabout $30. Once the lower band is penetrated and you get a buy signal, it canbe a long time and a lot of price fluctuations before you finally see pricesreach your objective at the center of the band.
Regression Bands: The Economist’s ApproachAlthough the methods used by economists often do not apply to trading, theregression line is very appealing for constructing bands. When we think ofthe trend of prices, we instinctively draw a straight line through the pricepattern and observe whether that line is angling up or down.The classic way of creating confidence bands is to draw the regressionline through the center of the price pattern, and then find the standard devi-
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FIGURE 6.9 Classic bands formed around a regression line. This economist approachrequires the use of a spreadsheet for calculations, but gives the most intuitively satisfying results.
ation of the price changes in the same manner as Bollinger bands. If youcontinue to use 2 standard deviations for the bands, you would get the channel shown in Figure 6.9. For this six-month period, the channel is a perfectfit. Unfortunately, as with the percentage band and Bollinger band methods,the only period we can use for trading is the last day of the calculation. Theother days are considered “in sample”; that is, they were used to constructthe bands.If you calculate a new 60-day regression every day and look only at thelast point on the regression bands, you’ll see that the bands can bend withprice changes in the same way that Bollinger bands change direction. InFigure 6.10 the center line is the last point of a straight line drawn throughthe last 60 days. It tends to be in the middle of prices more that the movingaverage. The bands around the regression points get narrower and wider,reflecting price volatility, but they are penetrated by highs and lows atgood points less often than in the other charts because of the longer 60-daycalculation.
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FIGURE 6.10 Rolling linear regression bands. Plotting the end points of the linearregression and 2 standard deviation bands shows a different pattern.
THE REALITY OF USING CHANNELS AND BANDSChannels and bands both have the same objective—to put a frameworkaround price movement. They tell us when prices are unusually high or low.We can turn that into trading by buying at the low end of the channel, orwhen prices penetrate the bottom band, and selling at the high end. It worksmost of the time. It is best when prices aren’t moving too fast.By expanding the channel or band width and slowing down the trendlineused to form the bands, we can identify more extreme price moves and bemore selective about our buy and sell signals. This helps eliminate some badsituations, but it reduces the number of trades and increases the time you arein a trade. We know by now that the longer you hold a trade, the larger theprice swing you will endure.There is no perfect channel or band. They all have the same basic problem. When price begin moving quickly higher, selling is a mistake; whenprices drop sharply, buying is a mistake. All trading methods will have situations in which they lose.
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As we develop our trading skill further, we will find ways to reduce therisk of a large loss. We may use a protective stop-loss order, or a rule thatsays that the trend direction requires that we exit or reverse our position. Wecan be more conservative by only buying in an uptrend and being net short ina downtrend.
TRADING GAME TIPS1. You should have lost money the first week. In the first few days of trad-
ing it is most important to chart the trends correctly and place yourorders where the price breaks the trendline. Alternatively, you can followyour moving average trend. Making money is important, but don’t expectmuch the first week. Losses teach you more than profits.2. Problems when buying on a pullback. It seems sensible to buy when
prices drop to a support level, but it doesn’t seem to work in practice.Major support levels are good points to buy, after prices have stoppeddropping and the support level has still not been penetrated. Minor support and resistance levels are not reliable, and the opposite seems towork more often. When prices drop to a minor support level, they aremost likely to continue lower. When you’re starting out, wait for a confirmation that prices are stopping. That may be a small upward movement after the decline.3. Overusing moving averages. Moving averages are good indications of
the long-term trend, but they are not very good at telling you the bestplace to get in or out of a trade. Combine the moving average with asupport or resistance level. If you a looking for a buy signal, you’ll wantthe moving average to be trending up and want to buy when prices moveup and through the next resistance level. That will help your timing.
Questions1. Once you’ve drawn an upward trendline, how do you draw the upward
channel line?2. When would you redraw the upward channel line? What point would you
use to redraw it?3. If you are trading a channel, where would you buy and where would you
sell?
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4. If you’ve bought near the bottom of the channel, where are the two
places you would exit the trade?5. If prices move above the channel line for only one day and then fall back
below the channel line, explain why you would or would not redraw thechannel line.6. How do you construct a 3 percent band around a 10-day moving average?7. How would you trade a percentage band?8. What are two advantages of Bollinger bands over percentage bands?9. If prices penetrate through a 5 percent band too often, what can you do?10. What are two disadvantages of a larger band?11. When does profit-taking work best? Anytime you have more than a 10
percent profit, in a noisy market, or as a long-term trend follower?
CHAPTER 7
Event-Driven Trends
here are two distinct types of trends, one based on how prices moveover time and the other triggered by events. The two methods havevery different trading signals and different performance profiles. Themoving average represents a time-driven trend and a breakout is the eventdriven approach. There are an equal number of traders in each camp. In thischapter we’ll look at breakouts.
T
TIME-DRIVEN OR EVENT-DRIVEN?A moving average system is time-driven; that is, the moving average closesin on current prices when the price movement slows. In Figure 7.1 Exxon(XOM) prices move sideways from January through mid-April 1997, beforethe sideways period. The moving average tracks rising prices smoothly, andthen turns down at the beginning of March although prices only show a slightdecline. Using the trendline for the buy and sell signals forces us to close outour trade at the March lows, although prices are $1 higher one month later.This characteristic of the moving average can’t be removed. It is a benefit when prices turn slowly from up to down, and a problem when prices slowdown and then continue in the same direction as in Figure 7.1.A clear example of an event-driven trend is the breakout. We learned inChapter 3 that a breakout that creates an upward trend begins with a newhigh and ends with a new low. The trend doesn’t change unless prices moveto new highs or new lows. You can consider a new high price as being causedby an event: a news release, an earnings report, or a change in government
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Sideways price movementMoving averageturns down
FIGURE 7.1 A moving average is time-driven. It has an agenda. Prices must continue tomove in the same direction or the moving average will turn down and the trade ends. It performspoorly in sideways markets.
policy. Prices can drift up and down within a reasonably small range and thetrend doesn’t change.Using a 40-day rolling breakout applied to XOM, we see nearly the sametrades as when we used the moving average (see Figure 7.2), except thatprices failed to make a new low in March, and the breakout trend held itslong position.The rolling breakout is not entirely immune from time change. Therolling calculation period moves forward in time. If prices become lessvolatile, then the highs and lows that trigger a new buy or sell signal will getcloser together. Two methods that are completely independent of time areswing charting and point-and-figure charting, and the trading signals thatthey generate.
SWING CHARTINGSwing charting is based on identifying prices swings that are greater than apoint value or a percentage. Anything larger than the swing size triggers a signal; anything smaller is ignored. In Figure 7.3 we’ve taken XOM again and
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4 Buy
3 Sell
2 Buy
1 Sell
FIGURE 7.2
A breakout trend is event-driven. Using a breakout system, prices can movesideways as long as they do not make new highs or lows during the calculation (observation)period. It is intended to get a signal on a price event. Trading signals are shown in July andSeptember but not during the sideways period from January to April 1997. These breakout rulesuse a 40-day calculation period.
shown the tops and bottoms of 5 percent swings using large dots, and 2.5 percent swings using small dots.
Calculating the Swing ChangesYou should be able to take any chart and plot the swing highs and lows by following these rules:1. Decide your minimum swing size. We’ll use 5 percent to get the major
swing points.2. Start with any high or low price. Let’s say prices are at a relative high of
$23. We say that the swing high is $23 and the swing direction is up. Thisis just for the purpose of starting.3. Prices drop to an intraday low of $22 (an intraday low is the low of the
day, rather than the closing price). That is a drop of 4.3 percent; therefore, we do nothing. Prices must drop at least 5 percent before we takenotice. The direction is still up.
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4. Prices move higher, peaking at $25. We can ignore the previous drop
because it did not fall 5 percent from the high of $23. We now have a newswing high of $25 and the direction is still up.5. Prices now drop to $24, or 4 percent. We do nothing. The direction is still
up. The swing high is still $25.6. Prices drop again to $23 for a total of $2 off the high, or 8 percent.
Because the swing exceeded our minimum swing size of 5 percent, theswing direction is now down. The previous swing high of $25 is nowfixed. It cannot be changed.7. Prices drop another 50¢. The direction is still down and the swing low is
now $23.50.8. As long as prices move lower, we simply record the low price as the
swing low.9. Prices now turn higher and close at $24, up 2.1 percent. There is no
change in the direction or swing low.10. If prices move to $24.68 (the low of $23.50 times 1.05), then the previous
swing low is fixed at $23.50 and the swing direction changes to up.
FIGURE 7.3 Marking the swing high and low points. Prices must change direction by5 percent in order to create a new major swing high or low (the large dots). Changes of 2.5 percent can be considered minor swing points (the small dots).
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In Figure 7.3 the swings points that are separated by 5 percent are shownwith large dots. Reducing the size of the minimum swing from 5 percent to2.5 percent sharply increases the number of swing points. You can chooseyour swing size to identify tops and bottoms that fit your style. Using 5 percent may be too large and 2.5 percent too small.
Swing Trading RulesA swing system is not governed by a calculation period, only by a priceevent. It can be a simple picture where only the swing highs and lows areused (see Figure 7.4). The buy and sell signals are very similar to the breakout system:Buy when the current upward price swing goes above the high of the previous upward swing.Sell when the current downward price swing drops below the low of theprevious downward swing.A swing upward trend begins when prices make a new high, and a downtrendbegins when they make a new low, the same as the buy and sell rules. Thehighs and lows of the swing are at least as far apart as the minimum swing
Sell
Buy
FIGURE 7.4 A swing chart. In a traditional swing chart only theswings are shown without any indication of how long it took to movefrom a swing high to a swing low. A buy signal occurs when the currentswing high moves above the high of the previous swing. A sell is triggeredwhen the current price moves below the low of the previous swing.
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amount (2.5 percent or 5 percent in our example). As in the breakout system,if prices move back and forth, making moves less than the minimum swinglevel, then the current trend is unchanged and the price changes don’t evenappear on the chart.
POINT-AND-FIGURE CHARTINGSwing charting and point-and-figure charting may have been the firstattempts at systematic trading. They both have very clear rules for entering and exiting and are known to have been used at the turn of the century(that is, the twentieth century). Breakout methods are still popular today,and they tend be more reliable indicators of price direction than movingaverages.
Rules for Plotting Point-and-Figure ChartsPoint-and-figure charts are plotted on graph paper. Each box is assigned apoint size. If you assign a small number of points to a box, the resultingprice patterns are more sensitive to change. This technique is still used byfloor traders on the Chicago Board of Trade, where they plot the smallestpossible price moves, trying to identify the trend before anyone else. Asmall box for IBM would be 10¢; a large box would be about $1. The initialchart for IBM is shown in Figure 7.5. To plot a point-and-figure chart, followthese rules:1. Choose a box size. This should be no smaller than the minimum price
move. You may begin by dividing the current daily price move (high tolow) by 4 to get the box size. If the box size is, for example, 50¢, then fill
IBM32.0031.5031.0030.5030.00...
FIGURE 7.5
Setting up a pointand-figure chart for IBM. Start withan empty sheet of chart paper withsquare boxes. We use box sizes of 50¢to get medium sensitivity.
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39.50 X39.00 X O38.50 X O38.00 X O37.50 X
FIGURE 7.6
Reversal from an uptrend. A reversal from upto down is plotted as a new column of 0’s beginning one columnto the right and one box below the highest X. It must fill 3 boxeswith O’s to be a new downtrend.
in the left scale of the chart with values near the current price level insteps of 50¢. If you are plotting IBM and it is trading at $30, then startnear the bottom of the paper at $15 or $20 and go up the chart by adding50¢ at each box. The left scale should read $30, $30.50, $31, $31.50, andso on.2. To begin, we see if today’s price move was up or down. If up, put an “X”
in each box where the traded price crossed the price marked on the box.If IBM traded from $38.25 to $39.55, then put an X in the box next to$38.50, $39.00, and $39.50. If today’s move was down, then put an “O” inthe boxes next to the price range.3. If we began with a column of X’s, we first see if the next trading day filled
the next higher box or boxes. If yes, then we put an X in each of thoseboxes and ignore any downward move. Point-and-figure encourages“price persistence”; that is, it favors the continuation of the trend. If thereis an uptrend (a column of X’s), then you look first to see if a higher boxwas filled.4. If we are in an uptrend (a column of X’s) and prices do not fill another
box higher, we then look for a trend reversal. To get a reversal, the lowprice of the day must be at least as low as the value three boxes belowthe highest X box. On our IBM chart, if the highest X box was $39.50, thena reversal doesn’t occur unless prices print at $38.00. This is called athree-box reversal (although we are putting an O in the fourth box downfrom the highs). If a reversal occurred, we move one column to the rightof the X’s and begin a column of O’s one box lower than the highest boxwith an X (see Figure 7.6).5. We do just the opposite if prices are currently in a downtrend (a column
of O’s). We first look to see if the downtrend continues by filling a lowerbox. If not, we look to see if the high of the day would fill the fourth boxup from the lowest box of O’s. If there is a reversal, we move one columnto the right, leave the lowest box empty, and fill at least the next threehigher boxes with X’s.
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FIGURE 7.7 Point-and-figure chart of Amazon. Upward trends are shown as columns ofX’s and downward trends as O’s. This chart used a 25¢ box size. Note that each new columnstarts one box below or one box above the previous column and each has at least 3 boxes tobegin a new direction.
A point-and-figure chart of Amazon.com, automatically produced byTradeStation, is shown in Figure 7.7. The O’s are shown as rectangles.
Point-and-Figure Trading SignalsBy now you can guess the rules for buying and selling with point-and-figure(all breakout methods are alike):Buy when a column of X’s goes above the high of the previous columnof X’s.Sell when a column of O’s goes below the previous column of O’s.By goes above we mean that the next higher box is filled, not just anyprice higher than the value of the previously filled box. Goes below meansthat the next lower box is filled. Trading signals can be seen in Figure 7.8.Once a buy signal occurs, you hold the long position until the next sell. Youcan’t tell from the chart how long you should hold each trade. Time is not afactor in point-and-figure trading.
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Buy
BuySellSell
Buy
Buy
SellBuy
SellSellSellBuy
Sell
BuySellSell when “O” is lower than the low of the previous column of “O’s”
Buy
Buy when “×” is higher than previous column of “×’s”
FIGURE 7.8 Point-and-figure buy and sell signals. This chart of XOM using a box size of12.5¢ (18⁄ minimum move) shows buy signals when the new column of Xs fills the box higher thanthe high of the previous column of X’s. A sell signal is given when the new column of O’s fills thebox lower than the low of the previous column of O’s.
SUMMARY OF EVENT-DRIVEN SYSTEMSWe will refer to event-driven systems and breakout systems together becausethey have the same major characteristics. They give buy or sell signals onlywhen a new price high or low occurs. We make the assumption that pricewould only move to a new level if it was driven by an event. This may notalways be true, but it is a successful working premise.The trend is the single most important technical indicator, and breakoutsystems are the most successful trend-following methods. It is necessary toinclude one of them in your regular work.Floor traders look at fast changes in price direction; therefore, they typically use a small point move as their box size. At one time most floor tradesplotted point-and-figure charts on very large graph paper, taping the sheetstogether. Floor traders are only in for a few minutes or a few hours and theycan get out quickly if the price changes direction.
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The reliability of a breakout system, and all trend systems, increases asyou look at longer time periods. Shorter periods can work, but market noisecan fool you in more cases, and the dependability of the trend is far lower.The principle of buying new highs and selling new lows remains sound,and most traders who use charts rely on a breakout, a swing chart, or a pointand-figure chart as part of their decision-making.
TRADING GAME TIPS1. It’s good to have a bias. You can have a fundamental opinion of where
prices are heading and still be a technical trader. A bias can be very sensible. For example, when the Fed cut interest rates to under 2 percent,it removed a lot of profit potential from a long Treasury note trade. Thepotential profit fell to less than the likely risk of a trade. On the otherhand, going short Treasury notes doesn’t guarantee a profit becauseprices can drift sideways for a long time, but you’ll want to trade onlysmall positions long Treasury futures.2. Try to distinguish between a bias and wishful thinking. The stock
market is at very low levels, but a bias to the upside is wishful thinking. Itmay happen, but prices could still go lower. It’s not the same as interestrates, where they are approaching a bottom of zero. Hopefully, the stockmarket will never get to the point where it is so low that it can’t go lower.3. Are you still confused about the use of limit and stop when you’re plac-
ing an order?A stop order is used in the following situations:• When you are long and you are selling at a lower price (usually toexit the trade).• When you are short and you are buying at a higher price.You will want to buy at a higher price at the point where the trend turnsup. Remember that a stop becomes a market order when the price istouched. You must use the word stop in your order.A limit order is used in the following situations:• When you are long and you are selling at a higher price (to take profits).• When you are short and you are buying at a lower price.• When you a trying to buy at a support level or sell at a resistancelevel.4. You can combine an MOC order with a price, but all conditions mustbe met to get an execution.
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• If you’re long IBM at $52 and want to exit if prices close lower, butbelow a specific price, then you enter SELL IBM 48 STOP MOC. Youwill be executed at the closing price if it is anywhere below $48. It isunlikely you will get $48 as your price, but you won’t be executed ifprices dropped to $46 during the trading session, but closed at $49.• If you have no position and you want to buy IBM on an upward breakout above $55 but only if it closes above $55, then if IBM is at 52, BUYIBM 55 STOP MOC.• You wouldn’t want to use this order to take profits on your IBM position because you would prefer to get a higher price anytime during theday. If you wait for the close, prices may have fallen back from theirhighs. If you are long IBM at $48, you would want to place the orderSELL IBM 53. That gives you a $5 profit if IBM trades at $53 or higherduring the day.
Questions1. What is the key element that distinguishes a moving average trend from
a swing trend?2. If the swing direction is up, the high price is $50, and you are using a
3 percent swing value, at what price would the swing direction turndown?3. If prices make a swing high of $30, a swing low of $25, and a swing high
of $31, at what price would you get a swing sell signal?4. Would you get more point-and-figure signals using a box size of $1 or 50¢?5. If you had a point-and-figure box size of $1, and prices have just declined
from $48.00 to $41.50, at what price would you begin a new column ofX’s.6. Using a $1 box size, we plot a column of X’s with the highest box filled at
$28, followed by a new column of O’s and then another column of X’s.What is the lowest price that would give you a buy signal?
CHAPTER 8
Controlling the Riskof a Trade
ou cannot trade successfully without controlling your losses. A stoploss order is the most common technique for limiting your loss. Youcan never forget that there are no profits unless you can control yourrisk and your losses.You will want to place a stop-loss order at a point where you believe thatthe trade has gone wrong. You do not place at stop-loss based on how muchyou can personally afford to risk on a trade. That’s a different problem thatwill be covered later.
Y
THE STOP-LOSS ORDERThe stop-loss order is a sell if you are long and a buy if you are short. It isplaced below the current price level if you are long and above the currentlevel if you are short. If prices go the wrong way, the stop-loss order will beexecuted and you should be out of your trade very close to that price.If you are long 1,000 Amazon (AMZN) at $15 and there was support at$13, you would place the order:SELL 1000 AMZN 13.00 STOPIf the price touches $13, your stop order becomes a market order and itis executed at the first available bid. You might choose to place your order at$12.95 to be sure prices move through support, or you could place your stoporder at $13.10 to get out before prices dropped suddenly.
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IMPORTANT CONSIDERATIONS ABOUT RISKAs a trend trader, using a moving average trendline, we don’t always think ofrisk clearly. We know that slower trends allow larger price swings withoutchanging the direction of the trend. Faster trends respond quickly to pricechanges. Those risks are implicit in the use of a trend method and can’t beseparated out.One of the dilemmas of using a stop-loss to limit your risk to a “comfortable” amount can be shown best in an example. Suppose you’ve been following a trend system and you are long 1000 Amazon at $30 and now hold a$10 profit ($10,000 on your trade). You would like to protect those profits;therefore, you place a stop-loss at $28, risking only $2,000 of your gains. Sureenough, prices drop and you are stopped out. Prices continue down to $27.50,turn back up, and move above $40.00 to new highs. During the drop to $27.50the moving average trendline never turned down. It would not have turneddown until $22.00. You are now out of the trade but the trend is still up andprices are making new highs. What do you do? Do you jump back in and tryto catch the rest of the upward move, or do you stand aside until there is anew trend signal?None of these choices are good. If you going to trade the trend, then youmust look at the risk in advance and decide how many shares you can buyand still hold the trade comfortably when prices move against you. A stoploss fights with the trend system. The trend system wants to stay long andyou want to get out. It just doesn’t work.You cannot trade more than you can afford to lose. Your position is toolarge if you are uncomfortable with the day-to-day risk.
LIMITING THE RISK OF A TRADEA stop-loss works when you are using basic charting techniques to identifysupport and resistance lines. Stops can be used very effectively. There is anorderly process in deciding on how to apply a stop-loss, or whether to applyone for a specific trade.Consider whether the natural buy and sell signals for your tradingmethod provide adequate risk control. When the trade goes against your longposition, does the system create a sell signal that gets you out with an acceptable loss? For example,