427
 
 
FIGURE 16-2 Opening gap as a percentage of daily move.
Opening Gap as a Percent of Daily Move
Pork belliesSoybeansCrude oil
Silver E 3 gGold FESS 5 5 Ses
British poundDeutschemark (in %)
Japanese bondGerman bund
. Euroyen
U.S. Treasury billsU.S. Treasury bonds
 
0 20 40 60 80 100Percent represented by opening gap
 
few seconds even though volume may vary. For practical purposes, prices might be con-sidered equally spaced. But consider an extreme example. The price of a less liquid mar-ket changes every 15 seconds during more active times, then quiets to 5-minute intervals;at one time, there is a lull of 15 minutes followed by a jump in price. Is there a differencein the way we would interpret the following two patterns? Is there a difference in the waya moving average would calculate the trend?
 
TimeA Price Time B10:00 5005 10:0010:01 5010 10:0510:02 5005 —~ 10:06- 10:03 5015 10:1640:04 5025 10:26 .10:05 5020 -10:06 - 501510:07 5025
 
 
Pattern A shows a gradual upward movement over equal time intervals; pattern Bshows slow rallies and fast drops. When interpreted by a trader, pattern B is often consid-ered soppy; it is a market struggling to go higher with anxious sellers, Moving averages ofpattern A, taken as_.shown, and pattern B, interpolated to equal intervals, will have thesame trend direction at each point. There is not enough information to know which is best,but it is clear that the patterns can be interpreted differently.428 DAY TRADING
 
More on Choosing the Length of the Intraday Bar
While there is no right bar length, traders most often choose 5-, 10-, 15-, 30-minute, and1-hour periods to chart. Most of the commercial software packages require that the inter-val be evenly divided into 1 hour; therefore, a 64-minute interval is not allowed. Whenusing longer bars, such as 1 hour, it is important to consider the length of the last bar ofthe day. A 1-hour bar will post its first price at the end of the first actual hour, rather than1 hour after the open; the last bar will be the interval from the last whole hour to the close.In the case of oil, this may only be 10 minutes. When bars are uneven in this way, the priceranges and corresponding volume are no longer comparable with one another.
There is a difference in opinion between analysts over the choice of intraday intervals.One group prefers to pick a standard number because it conforms to the way others trade;for example, you can expect orders to flow more actively every hour. This approach may beparticularly valuable if you plan to take the opposite position. The other group of tradersare constantly seeking their own time interval, avoiding uneven order flow and price dis-tortion caused by most other traders. If you are part of this group, you may choose yourinterval by dividing the total number of minutes in the trading session by a value that givesyou equal-length bars, You may also want to find a bar length, such as 21 minutes, that rep-resents a Fibonacci number and comes close to dividing the day equally.
MARKET PATTERNS
A trade that lasts from 1 to 3 days can be improved if short-term patterns or cycles can befound. For example, in a trending market there are outstanding weekly and weekend pat-terns. It is most common to find that the price movements from Thursday to Friday (close-to-close) are in the direction of the major trend and that the movement on Monday is acontinuation of that trend: By Tuesday (or. sometimes Wednesday), the strength of newbuyers or sellers has faded, and the market reverses due to lack of activity and some profittaking. It often stays in this state through Wednesday or early Thursday when it againresumes the trend. In a sideways market, the Friday and Monday directions differ from thedirection during the prior week and often differ from each other.
Support and Resistance \
Support and resistance levels are important to the short-term trader. If prices start to movehigher, slow down, and finally reverse, it is natural to consider the top price as a resistancepoint. Prices are thought to have been stretched to their extreme at that level. Any subse-quent attempt to approach the previous high price will be met with professional selling inanticipation of prices stopping again at the same point. In addition, it is common for thesame traders and others to place orders above the previous high prices to take new longpositions or close out shorts in the event of a breakout.
This method, very popular among floor traders and active speculators, tends to createand emphasize the support and resistance price levels until they define a clear tradingrange. Within a 1- to 3-day period, these ranges can be narrow and yet effectively containprice movement. During the life of the trading range, it will continue to narrow as the lev-els become clear to more traders and the anticipation of a reversal at those levels becomesimminent. .
To take advantage of the smaller ranges caused in this manner, it is necessary to enterpositions during the middle of a trading session, frequently holding that trade until themiddle of the next session. An example using the Chicago Board of Trade December 75 Sil-yer contract, during August 1975, will help to illustrate this. Prices on 4 consecutive daysare seen in Table 16-4. The opening and closing prices for the first 3 days do not indicateMARKET PATTERNS 429
 
 
TABLE 16-4 December 75 CBT Silver
 
 
Open High Low Close
August 21 500.50 505.00 493.00 498.2022 501,00 504.00 494.50 500.00
25 501.00 594,50 496.00 503.80
26 502.50 504.00 483.80 483.80
 
any opportunity for trading. Prices were generally in the middle of the daily range. By usingthe high and low of the previous day, this situation can be traded either of two ways.
Thursday, August 21, forms a range of 505 to 493, closing near the center of the range.After the next open, buy just above 493 and sell just below 505 to be certain of enteringand exiting the position. For protection, a stop can be entered at about 506 and 492 toreverse the position on a breakout. Had this procedure been followed, entering 2¢ (200points) before the bounds of the range, Table 16-5 shows how trades would have been exe-cuted,
In each case, the entry was 200 points before the level at which prices had reversed onthe prior day. The Stop-Loss order was placed to limit losses to a 100-point penetration.Although this is an ideal situation, professional traders frequently use this method. It canbe seen that the support levels did actually rise from 493.00 to 494.50, and then to 496.00.When support was penetrated, prices rapidly broke to new lows of 483.80, down to thepermissible limit. Similarly, the resistance level remained intact going from 505.00 to504.00, 504.50, and finally, 504,00. It is generally accepted that the resistance level'repre-sents a more volatile area that must be watched closely for false breakouts. .
Support and resistance levels gain importance the more time they remain intact. Thehigh and low of the prior day are not as significant as the weekly or the monthly range.Each can be traded using the same technique. The major support and resistance levels arecontract highs and lows, which rarely allow breakouts with less than one attempt. Longer-term price objectives can be identified using a continuation chart. This chart plots only thenearest (spot) futures contract of a specific market to allow the location of support andresistance levels when the current contracts are in a new high-or low area.
Before 1990 there were very few published day-trading systems. The more recent oneshave had the benefit of sophisticated computer programs and large historical databases.The following method precedes this era and remains unique and a valuable part of our lit-erature.
 
TABLE 16-5 Trading December 75 Silver Using Support and Resistance
 
 
~ ProfitiLoss
August 22 Sold at 503.00
Closed-out short and bought at 495.00 - +8.00August 25 Closed-out long and sold at 502.00 +7.00
Closed-out short and bought at 496.50 +5.50August 26 Closed-out long and sold at 502.00 +5.50
Closed-out short and bought at 498.00 +400
Closed-out long and sold at 495.00 ss. -3.00
Open position +11.20430 DAY TRADING
 
The Taylor Trading Technique
In 1950, George Douglass Taylor published his book method of day trading, which he hadbeen using for many years in both the stock and grain markets.” The method is based onthe experience of discipline and timing, but is carefully set down and can be implementedin either a sophisticated or simplified state. The system is intrinsically cyclic, anticipating 3-day movements in the grains. These 3 days can vary in pattern when they are within anuptrend or downtrend. Taylor’s explanation of his method is thorough and includes manyvaluable thoughts for traders interested in working with the market full-time. The sum-mary and analysis presented here cannot replace a reading of the original material.
Taylor developed his approach to trading through experience and a belief that there isa basic rhythm in the market. The dominant pattern is seen to be a 3-day repetition withoccasional, although regular, intervals of 4- to 5-day patterns. Taylor’s cycles are based oncontinuous trading days without regard to weekends and holidays. The 3-day cycle variesslightly if prices are inan uptrend or downtrend. The uptrend is defined as having highertops and bottoins over some selected time period such as a week, month, or season. Adowntrend is the reverse. During an uptrend the following sequence can be expected:
1. A buying day objective, where prices stop declining and a purchase can be madebefore a rally begins .
2. A selling day objective, at which the long position is closed out
3. A short sale day objective, where prices meet resistance and can be sold prior to areversal. ,
Following the third day, after a short position is entered, the cycle begins again with abuying day objective. Because an uptrend is identified, Taylor has given extra lativude tothe long position with part of the day between the liquidation of the long (2), and enter-ing a new short (3) reserved to allow the upward momentum to exhaust itself. Downtrendsare the opposite, expecting some added time for the downward move to finish before therally begins. ,
The actual objectives are extremely short-term support and resistance levels, usuallyonly the prior day’s high and low prices or occasionally the high and low of the 3-day cycle,which may be the same prices. On a buying day, the objective is a test or penetration of theprior day’s low price, but only if it occurs first, before a test of the prior‘highs. Taylor’smethod is then a short-term countertrend technique, which looks for prices to reversedirection continuously. His belief was that speculation caused these erratic, sometimeslarge, cyclic variations above and below the long-term trend.
Taylor placed great emphasis ‘on the order of occurrence of the high and low on eachday. To buy, the low must occur first. If this isa buying day in an uptrend, a long position isentered after any lower opening whether or not the prior low is reached. Taylor reasonedthat because an uptrend is generally stronger toward the close, the first opportunity mustbe taken on a buying-day. However, if a high occurs first and prices then decline nearing thelows toward the end of the trading day, no long position is entered. This pattern indicates alower open the following day, which will provide a better opportunity to buy. During adowntrend, the violations of the lows, or penetratioris toward the close, are more common.By waiting until the next day to purchase, the 3-day cycle is shifted to favor the short sale.
Consider the same problems with regard to closing out a long and entering a newshort during an uptrend. If on the same day that the long was entered prices railiedsharply, touching or penetrating prior highs, a higher opening would be expected the nextday, at which time the long position would be closed out. Because of the uptrend, a small
? The Taylor Trading Technique, by George Douglass Taylor (1950) (reprinted by Traders Press, PO. Box 6206.Greenville, SC 29606, in 1994).MARKET PATTERNS 431
 
setback and another test of the highs might be expected. It would then require another dayto ensure that the strength was exhausted. If the highs of the se/ling day were tested on theopen of the short sale day, a new short would be entered immediately. If the short sale dayopened lower and finished higher, no position would be taken.
Shorter reactions to price moves are expected when a long position is entered on abuy day, or on the next open, when a downtrend exists. If prices rally sharply on the sameday, the position is closed out at a profit. This is important to remember, because tradingagainst the trend does not offer the latitude of waiting for the best moment; time is work-ing against the position.
Taylor called this his book method because he recorded all the information necessaryfor trading in a small 3” x 5” spiral notebook that he carried. The organization of the bookis shown in Table 16-6, an example that uses the November 75 soybean contract. Of course,in Taylor’s book, there would be only 1 month per page due to its size. The first fivecolumns contain the date and day, followed by the open, high, low, and closing prices. The
 
TABLE 16-6 November 1975 Soybeans
 
 
 
 
 
 
 
 
1975 Open High Low Close D R 8H BU NetMarchM lo. 540 535 5404T i 435 560% (535) 560A 7 18% 0Ww 12 560 552 571A 37H 13 568: 559 560%F 14 553 559 549% 28 0 10 42%M 17 548 (7560) 548 548 HWT 18 555 538 5384w 19 530 546 3454 29 0 9H 20 543 540 S474 26F “2 S474 S474 S67 . ~I%M - 24 573 581 573 6% 13% 0T 25 573 564 574 4Ww 577 574 594H 7 587 590 585 15 0 0 4314M 31 592 589 5954 24%April
T 1 599 584 591%Ww 2 589 5914 575% 24 0 9H 3 570 565 566% 0F 4 570 567 576% -12M ~ 7 577 577 565% 16 0 5T 87 566 563 68% 17%w 9. 565 YEAH 10 571 575 581% 18 1 SAF It 560 558 563% 84 ~9M 4 561 S554 S61J 15 585 569% 563% 7A in 0Ww 16 - S62 553 559% 5AH 7 560 558 5634F 18 583 563 559 8 0 i -I432 DAY TRADING
 
first 10 days are used to determine where the cycle begins. Scanning the daily lows, circlethe lowest of the first 10 days, in this case March 19. Then work backward and forward, cir-cling every third low price. These are buying days. The sequences of two in-between daysare circled in the high column and indicate the selling day and the short sale day, respec-tively. This example is especially simple because it assumes a consistent uptrend and showsno variation from the 3-day cycle.
To judge the opportunities for buying and selling, the next columns, marked D and R,indicate the number of points in the decline from the short sale to the buying day, and thenumber of points in the radZy from the buying day to the selling day. In both columns, the dif-ferences are taken using the highs and lows only. These values represent the maximum num-ber of points that could have been made in those trades, provided the highs and lowsoccurred in the proper order. An “x” ora “¥” in the circle next to the high or low means thatthe opportunity to buy or sell occurred first (if an x) or last (ifa /). In the case of the first,the trade would have been entered that day and in the other case, Taylor would have waited.
The next two columns, BH and BU, show the adversity and opportunity of that day’sprices to the buying objective. BH means a buying day bigh and is entered with the num-ber of points that the day traded above the prior day’s high (the short sale day); BU showsthe opportunity to buy under, by recording the number of points by which the day soldunder the low of the prior day—the area to buy if the low occurred first. If neither situa-tion occurred, zeros were entered.
Awide column on the right is used to indicate the net weekly change in direction bytaking the difference between the prior Friday’s closing price and the current Friday'sprice. This should be used to compare with the trading performance.
By observing columns D and R in Table 16-6, it can be seen that there ¥ was ampleopportunity for profits on both the long positions and short sales, with only one case of azero entry on April 3. The trades that would have been entered or liquidated can beapproximated using the BH and BU columns and the X and V notations. For consistency, itmight be assumed that the ¥ indicates that a position was taken on the next open. In eithercase, the results would have been good.
Taylor’s daily method requires care in monitoring the market, which only a full-timetrader can provide. The order of the highs and lows must be observed, as well as whetherthe new low is going to penetrate or fail to penetrate the prior lows. The trades must betimed carefully for maximum profit. In addition; it would be helpful to combine thismethod with a good trend identification technique as well as observe seasonal patterns toimprove the choice of the overriding market direction.
For those who cannot watch the market constantly, Taylor offers a rigid 3-Day TradingMethod, which is a modification of his overall daily method. The cycles remain the same,but the buying and selling objectives are entered into the market in advance. This methodis expected to work on balance, as are other well-defined systems. What is primarily lost bythis approach is the order of occurrence of the highs and lows; otherwise, the concept ofthe system remains intact.
It is interesting that this technique profits froni penetration of support and resistancelevels. Most other methods consider a breakout of prior Highs and lows as a major trendchange indication, but Taylor views it as a better opportunity to do the opposite. It is oneof the few examples of such an approach and could only succeed in the short term, wherethe behavioral aspects of trading are dominant.
Intraday Breakout Systems .-
As discussed earlier in this chapter, there are unique intraday price patterns caused by anuneven distribution of volume throughout the day. By far, the most popular systematicMARKET PATTERNS 433
 
approach to day trading is the N-day breakout applied to intraday data; this transforms itinto the N-bar breakout. Entry and exit signals occur during the trading session instead ofonly at the close; in addition, there may be more than one buy or sell during the day ifprices have wide swings.
A variation of this technique intended for intraday data is the opening range breakout,’which gives the underlying entry and exit signals based on how far prices move from theopen of the day. The trader is then buying when prices move up from the open by, forexample, 8 ticks in bonds, in the same manner as a trend follower. If prices then decline to8 ticks below the open, the long position would be reversed to a short. This approach usesthe opening price as the pivot point for the day, claiming that price direction, relative tothat point, is important. Tests exited all trades on the close of the day.
It is also reasonable to use the close of the previous day as the pivot point. Most traderswatch today’s prices to see if they are higher or lower than the prior close, which connectstoday’s price patterns to the previous day. In its basic form, the opening range breakouttreats one day as independent to previous price movements. This seems unnecessarilyrestrictive. Crabel, in his extensive study of intraday patterns, has found that combinationsof inside days, low volatility, bull and bear hooks, and other patterns that precede the cur-rent day, all contribute to a selection process that improves trading. Table 16-7 shows acomparison of an opening range breakout with and without a preceding inside day.’ Theimprovement due to selection is significant.
If you consider that intraday trading may give one new signal each day, any methodthat helps select the better trades is welcome. The intraday trading profile of many. smallprofits and losses allows you to be more selective without fear of missing the one big tradeof the year, which is a problem typical of a long-term trend-following system. Skipping as
3 See Toby Crabel, Day Trading With Short Term Price Patterns and Opening Rarige Breakout (Traders Press,Greenville, SC 29603).* Toby Crabel, “Opening Range Breakout, Part 4,” Technical Analysis of Stocks & Commodities (February 1989).
 
TABLE 16-7 Opening Range Breakout, % Profitable Trades*
 
 
Any Day (%) Inside Day (%)
Bonds Open plus £6 ticks 60 76Open plus 8 ticks 55 74Open minus 8 ticks 56 62Open minus 16 ticks 56 66
S&P 500 Open plus 160 points 68 6bOpen plus 80 points 55 57Open minus 80 points 49 48Open minus 160 points - 49 45Soybeans Open plus 10 cents 60 70Open plus 5 cents 56 67Open minus 5 cents 58 69Open minus 10 cents 63 76Cattle Open plus 50 points 65 55Open plus 25 points 58 _55_ Open minus 25 points 58 60Open minus 50 points 63 oF 73
a*Source: Toby Crabel.434 DAY TRADING
 
AFIGURE 16-3 (a) Omega TradeStation code for first-hour breakout system. (b) OmegaTradeStation code for first-hour breakout indicator.
 
( System: 1st hour Breakout (adapted from M. McNutt, 1994) |
{10} MaxBarsBack(*] Generate Realtime Orders{*] Do not allow multiple entries in the same direction
System uses ten minute bars of S&P futures for data 1 and 60 minute bars for data2 (daily data is held in data 3]
vars: SesslFirstBarDAte (9, data2), SesslFirstBarHigh(0, data2),Sess\FirstBarLow(0, data2), avedayrange(0,data3);input: Ranin(10);
avedayrange = @average(high of data3 = low of data3, RanLn) of data3:
Af (time of data2 = SesslFirstBarTime of data2) or(date of data2 > date(1]) of data2) then begin’SesslFirstBarDate = Date of data2;SesslFirstBarHigh = high of data2;SesslFirstBarLow = Low of data2;end;If (SessiFirstBarDate = Date of data2) and(time of data2 < SesslEndTime of data2) then beginif close[l] < SesslFirstBarHigh then buy atSesslFirstBarHigh + 20 point stop;if close{1] > SessiFirstBarLow then sell atSesslFirstBarLow - 20 point stop;end;
if low <= SesslFirstBarHigh - avedayrange then exitshort at market;
if high >= SesslFirstBarlow[1] + avedayrange then exitlong at market;. , (a)
{Indicator: 1st hour Breakout (adapted from M. McNutt, 1994) }
vars: SesslFirstBarbAte (9, data2), SesslFirstBarHigh(0, data2),SesslFirstBarLow(0, data2), avedayrange(0,data3);
avedayrange = @average(high of data3 - low of data3, 10) of data3;
if (time of data2 = SesslFirstBarTime of data2) or(Date of data2 > date{1] of data2) then beginSesslFirstBarDate = date of data2;SesslFirstBarhHigh = high of data2;SesslFirstBarLow = low of data2;end;
if (SessiFirstBarDate = date of data2) and{Time of data2 < SessltndTime of data2) then begin_ Ploti(SesslFirstBarhigh, "Ist Buy”);~ Plot2(SessiFirstBarLow, "Ist Sel1");Plot3(SesslFirstBarlow + avedayrange, "Buy stop");Plot4(SesslFirstBarHigh - avedayrange,”Sel} stop")end;
(b)
a er a IEA tent ESEMARKET PATTERNS: 435
 
many as 50% of the trades should not limit your profit potential, you should be able tostand aside and start again without much concern about continuity.
Breakout Ranges Based on TimeInstead of a breakout that occurs when prices move a fixed number of points away fromthe opening price, you can establish an opening range based on the first 60 minutes oftrading.’ After this time, a new high or low would be a signal to enter a long or short posi-tion. This is a trade-off between avoiding the erratic movements of early trading and miss-ing the beginning of a price move to start early and continue in the same direction.Combined with the first-hour breakout is a calculation of the day’s trading range to beused for reversing your position or taking profits. The projected range high is calculated asthe average daily range added to today’s low price after the first hour of trading; the low isthat same range calculation subtracted from the high of the first hour. The Omega EasyLanguage code for this system involves the use of multiple time frame data and can befound in Figure 16-34; an indicator that shows the signal on a chart page is given in Figure16-36. In the practical application of this method, the first-hour range must be penetratedby at least 20 points for the S&P If the first-hour range is nearly as large as the average 10-day range (used for the exit targets), use the anticipated high and low for buy and sell sig-nals, rather than a breakout of the first-hour range. Other risk controls, such as a trailingstop (in addition to a reversal if the opposite signal is given) and a fixed stop, are also rec-ommended. :
5 Malcolm McNun,, “First-Hour Breakout System,” Technical Analysis of Stocks & Commodities (July 1994).| 17
Adaptive Techniques
 
ple as using a percentage stop-loss; however, technicians have begun to associate the
idea of “adaptive” with a broader scope, although the purpose remains the same—tohandle more changing conditions without manual intervention. The trends and indicatorsthat are discussed in this chapter are able to change the calculation period. Under someconditions, such as sideways markets, it may be best to use a slow trend or momentum,and during explosive intervals those same methods are expected to work better if theyrespond quickly.
A n adaptive technique is one that changes with market conditions. It could be as sim-
ADAPTIVE TREND CALCULATIONS
We begin by looking at techniques that vary the length of the trend. These techniques arebased on a common premise that it is better to use a longer-term trend, one that is slowerto react to price change, when the market is either in a “sideways” pattern, has low volatil-ity or, in the case of Kaufman, has high relative noise. This may seem a reasonable assump-tion, but identifying a sideways market is very difficult. A price may be unchanged from aweek ago, yet during those 5 days it rose-quickly for 3 days, then reversed sharply and,coincidently, was at the same level on the 5th day, as it continued to plunge. In many waysthese adaptive techniques improve the basic performance of standard trend calculations,but they cannot solve all of the problems.
Kaufman's Adaptive Moving Average
Kaufman's Adaptive Moving Average (KAMA),’ which began taking form in 1972, is basedon the concept that a noisy market requires a slower trend than one with less noise. That is,the trendline must lag further behind in a relatively noisy market to avoid being penetratedby the price, which would cause a trend change. When prices move consistently in onedirection, any trend speed may be used because there are no false changes of direction. TheKAMA is intended to use the fastest trend possible, based on the smallest calculation periodfor the existing market conditions. It varies the speed of the trend by using an exponentialsmoothing formula, changing the smoothing constant each period. The use of a smoothingconstant was selected because it allows for a full range of trends, compared with the simplemoving average that uses integer values and is limited in the selection of the fast-end speeds(see the discussion of exponential smoothing in Chapter 4, “Trend Calculations”).7
KAMA, = KAMA, - , + sc, X (Price ~ KAMA, - 1)
where KAMA, is the new adaptive moving average valueKAMA, , is the previous adaptive moving average valuePrice is the current price (for period f)
“sc, is the smoothing constant, calculated each period as follows:
* See Perry J. Kaufman, Smarter Trading (McGraw-Hill, New York, 1995, pp. 129-153) for a complete