that it keepsyour risk defined to a conditional change and helps you from gettingknocked out of a position from intraperiod volatility. Stop-close-onlyorders (SCOs) are for end-of-day trading and can be placed on mosttrading platforms. The SCOs can be used for day trading; however, theymust be used manually, as most platforms do not accept intradaySCOs. Some consider these mental stops, which are predefined riskfactors. However, many traders violate the rules once a signal calls for
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an exit but they do not exit, thereby increasing their losses. A traderneeds to have a strict disciplinary approach.The challenge in selecting the right stop is to reduce risk while notbeing shaken out of the trade by market volatility. It is important to tryto maximize your trading results and to stay in profitable trades as longas possible. Employing random stop-losses and profit targets can ruina trading strategy, making it perform significantly worse than it wouldhave otherwise. One successful method is to use trailing stops thatadapt to market volatility so that the stop is placed far enough away,which combines enough sensitivity to price changes with flexibility tofit your risk/reward parameters. Using this combination may provideprofitable consistency from a stop-placement aspect for the intermediate-term trader. The trailing stop is used as an attempt to lock in someof the paper profits that could accrue should the market move in the direction desired. Like an ordinary stop, the trailing stop is started atsome initial value but then is moved up (in a long trade) or down (in ashort trade) as the market moves in your favor.Testing has demonstrated that a proper combination of even simpleexit methods, such as placing a stop below the low of the prior past twotrading sessions, can substantially improve the behavior of a tradingstrategy, even turning a random, losing strategy into a profitable one!Another less complicated method to use for a bullish trending market condition is placing a stop below the lowest low from the most recent 10-day period. Another method is a trailing stop method using thelowest low from the last conditional change. I define the last conditional change as a higher closing high. This is a much more importantevent than a higher high. Buyers who stepped in on the open have astrong conviction that price should expand to new higher territoryonce the market established a new high ground. Therefore, if the lowsare violated, then the market is demonstrating weakness. In Figure 9.3,we are looking at the daily chart on gold. Starting from the low on November 4 near 465, the market does not make a lower closing low. OnDecember 1, we see a close at a doji low but not below the low of thedoji. The trend then continues higher with a sequence of higher highs,higher lows, and higher closing highs.It is not until the shooting star develops that the intermediate topis made. A stop placed beneath the low of the candle prior to the starwould be the last conditional change or the last higher closing highthat occurred. That would be where you would want to place a sellstop. Using the two-period lowest-low method, you would have beenstopped out at 528. If you used a stop-close-only below that low, yourfill was the next time period’s close; and that was not as friendly or asprofitable, as the market closed at 514. However, using the lowest low
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FIGURE 9.3Used with permission of esignal.com.
for the most recent 10 periods, your stop-out point was all the waydown at 497.Let’s examine this method with a day trade using a chart exampleon the spot forex British pound market from 2/6/2006 using a 15-minutetime frame. Figure 9.4 shows a low close doji trigger to sell short at176.07. The initial stop per the LCD trigger states to use a stop-closeonly above the doji high. That would be 176.28. As you can see, the market stalls in a traditional sideways channel, as forex markets are knownto do. But, sticking with your trading rules, as the market starts to deteriorate, you would change the stop from a stop-close-only to a regular stop one tick above the high of the second conditional lower closinglow candle. You now have the option to move stops above the highsof the last reactionary high points; and if you follow the trail of themarket, you will notice the high from the last conditional lower closinglow. This failed reactionary high was the perfect spot to move yourstop down to just one PIP above that high point. At the end of the run,you want to trail the stop to the point one PIP above the high of the
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FIGURE 9.4Used with permission of esignal.com.
second-to-last candle that made a conditional change, which would bea lower closing low.Let’s explore this method further for day traders in the stock indexfutures. Figure 9.5 shows a 15-minute candle pattern showing anotherlow close doji trigger to sell short. The fill would be 1279.25, and the initial stop would be a mental stop-close-only above the doji high at1283.5. As we want to see when short, immediate results materializewith the sequence of events such as lower highs, lower lows, and, bestof all, lower closing lows. We now have the option to change and traila hard stop above the high of the second conditional change candle.Here, a conditional change is a candle that makes a lower closing low.Prices now decline to 1270.75; we have over an eight-point gain, or $400per contract. We can do several things, such as taking profits on half ofour positions, because the market has reached a move equal to the average daily range from the most recent 10 trading days, or moving stopsdown to lock in profits and letting our winners ride. We should nowplace a trailing stop above the high of the last conditional change or anSCO to exit the balance of positions.
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FIGURE 9.5Used with permission of esignal.com.
In this example, you would not have been able to sell the high orbuy the low using a set of trading rules. However, a solid chunk of middle of that trading session was captured with having little-to-no riskpressure. The trailing stop method would allow you to stay with thetrade until the bearish conditions changed. The chart in Figure 9.5 isalso a great illustration of how a market moves from a trending condition to a consolidation phase. Once you have captured the profit, it istime to wait for another trade setup.There are many different variations to placing stops. The key iswatching for conditional changes; for example, in a declining market,you should watch for the last reactionary high as the peak at which toplace a trailing stop once you are in a short position. You should use astop-close-only above a conditional change candle especially on a twoperiod time count. These methods will help you limit losses, preventyou from being prematurely knocked out of a trade, and reduce emotional stress, while capitalizing on letting your winning trades ride.
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THE BOTTOM LINEThe bottom line is this: Stops are not for sissies. You just need to knowwhen changes in a market’s condition occur to help determine when to exita trade. If you are in a trending condition for too long, chances are that youmay be overextending your welcome; therefore, tightening stops is a goodway to protect profits. After all, it really counts most when you get out ofthe trade. All traders struggle with stop placements. There is no one singlebest method. The concept is to develop a consistent method that helps youdefine cutting your losses and letting winners ride.
CHAPTER 10
Projecting Entryand Exit PointsLearn to Scale Out
W
hat are some of the most important things that successful tradersdo? They have:
• A system or a method that provides an accurate daily market forecast,helping them define where the market might go each day.• A set of rules for when to get in and out of the market and a bit of discipline to follow these rules.• A set of timing indicators to help them pull the trigger at the key areas.The legendary basketball coach Bob Knight often says, “Most peoplehave the will to win; few people have the will to prepare to win.” This is truein many aspects of a person’s life, be it in athletics, academics, business, aprofession, or trading.Trading is about making money, not about being correct in marketanalysis or being a great prognosticator. Traders must be consistent in theirapproach and strive to completely remove emotion from trading decisions.This is often best achieved by having and sticking to a plan for every trade.We trade in the future markets, not in the past markets. Hindsight is always20/20. Keep in mind that you will never trade as well in real time with realmoney as you will by looking at or trading in the past. Trading in the past isan exercise in futility that will only harm your psyche going forward. Youshould view every trade you make as the best trade you could make at thetime with the information available. That is why I like to scale out of my positions as a short-term trader at market points that signal when a trend has269
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a loss in momentum. The reason I like to keep a portion of positions on issimple: As good as my triggers can be, I cannot predict the future. I do notknow if a market will develop into a consolidation phase or if it is simplypausing before continuing the trend or getting ready to reverse the trend entirely. Therefore, it is crucial to take money off the table when given the opportunity, while letting a trade mature and potentially develop into a largerprofit. There is only one way I know to manage such a feat, and that is byscaling out of partial positions. The question some traders ask is, “What isthe formula or percentage that I use to take positions off?” I normally usethe 50 percent rule, but at times the one-third rule works as well. In orderto define what the percentage figure is, I need to judge what condition themarket is in. I do that by using the diagnosis described in this book. In thetrade process, there are three critical stages:1. Gathering information on which to make decisions.2. Using that information to help formulate a trading idea.3. Planning the actions to be taken.
The gathering of information involves collecting past data and then applying it to a specific means of market analysis, such as what I have coveredin this book using pivot point analysis. In formulating ideas, you may lookat the pivot point moving averages to help determine a market’s ability tomake a certain price range. This step helps you to predict where the marketmight head and then gives you information so that you can decide where itshould be going. Planning action involves thinking creatively about alternative courses of action, evaluating their feasibility, and making decisionson implementation of the plans. This step involves helping you decide if youshould be in multiple contracts or if you should scale back on your normalposition size. If the risk is not worth the reward, then trade with fewer positions. In other words, scale back your normal position size.
STEPS TO SUCCESSThe steps outlined here are a review of the overall purpose of the tradingmethods discussed in this book. Pivot point analysis helps give me a “headsup” on the potential range of a session. The moving average of the pivotpoint helps give me a truer reflection of the market’s value, and that helpsme define the market’s condition and possibly the correct direction. Candlestick charts help illustrate and define the trigger, which enables me tocarry out a systematic process of arriving at optimum plans and strategiesfor my trades. With that, I am now aware of the full range of issues to be
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considered in a systematic thinking process before entering a trade. By examining a set of relevant questions, such as how low the market can go,what the next support target is, how high the market can go, and what thenext resistance level is, I can formulate a trading plan with a clear, concisestrategic idea. Exiting the positions and taking money off the table shouldbe the easy part. However, as it turns out, that is the hardest part for mosttraders.Let’s take a trade example as shown in Figure 10.1. The hammer forms;I buy on the close, as the market closed above the moving averages; and Ihave immediate results. I entered at 10765; and the bullish momentum carried the market higher, as indicated by higher highs, higher lows, and higherclosing highs. The market has lost the bullish momentum, as I see a lowerclose-than-open pattern develop on two time periods followed by a doji.That is the definition of price action demonstrating a loss in bullish momentum. Therefore, that dictates for me to liquidate half of my position,which is at 10780. Hardly a profit to speak of, considering the mini-Dow is$5 per point, which is only a $75 profit. But it is a profit.
FIGURE 10.1Used with permission of esignal.com.
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Now what about the balance of my positions, and where do I place mystops? In this example, I would suggest either moving stops up to mybreak-even point or, as just discussed, placing the stop on a close belowthe low of the most recent conditional change candle (a higher closinghigh), which occurs at the 6:15 time period. At this point, I do not know ifthe market will move higher or lower, but I definitely have a loss of momentum. In this situation, prices established a pause, or consolidation; andthen the market did break out and continued the uptrend. With scaling outof half of the position, I have a profit and am continuously participating ina tremendous trending condition, as the market ends up more than 10870.That equates to more than a 110-point gain, or $550 per contract, on the balance of positions. As a day trader, did I do wrong in liquidating half of myposition? Not if you follow rules. In this situation, I did not have a classicsell signal, just an indication of a loss in momentum. Therefore, it was aprudent measure to get paid on partial positions and let the balance ride.So in this example, there was a reason or a call to action, but not a signalfor a reversal of the long.
FIGURE 10.2Used with permission of esignal.com.
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Ever heard of the saying “Character in great and little things means carrying through what you feel able to do”? Covering half of your positionswhen markets signal a loss in momentum is carrying through what you areable to do. You made money and stayed with the trade.In Figure 10.2, we have a low close doji trigger, a classic crossover ofthe moving averages, and prices closing below both moving averages. Atrigger to sell short was generated at 10523. We see a beautiful event unfold—immediate results with lower highs, lower lows, and lower closinglows—until the 11:50 time period; and the market moves sideways in a consolidation pattern. It does take on the form of a bearish descending triangle;however, we do not know what the outcome will be. As the market is at10490,. we are staring at a 30-point mini-Dow move, which translates into a$150 profit per contract. At this time, it is prudent to cover half of the position and put the stop in at breakeven. The market in fact happens to movein the direction of the original trend as the bearish triangle indicated. By following the market flow, we finally see a specific reason to cover the balance of the position with the high close doji signal at 10483. Here we havea 40-point gain on the second half of the trade for a $200 gain. We have, inessence, captured the majority of the trend and kept disciplined in our trading approach while scaling out of half of the position.
DO SOMETHING GREATI am sure you have read or heard this expression sometime in your life: “I’drather attempt to do something great and fail than to attempt to do nothingand succeed.” By scaling out, you have a profit in your trading accountwhile letting the trade mature. You have accomplished a great thing, a truesense of following a business plan—and you made money.Scaling out of positions is the most apropriate method when the market gives you a clue that the trend momentum is slowing. It allows you tocapture a profit while participating in a potential market move. As a daytrader, you are not so much concerned with long-term macroeconomic situations as you are with riding a momentum wave. Granted, it helps to havea good understanding of fundamental conditions; but for the most part, youare looking to ride a move and profit from it. That is your job. In short-termtrading, conditions change; and you need to capture opportunities as theybecome present stocks. Foreign exchange (forex) and futures markets areideal for momentum trades. Traders need assistance with capturing theprofits while letting the balance of the position ride or, better stated, withan execution plan. The foreign currency markets also tend to trend wellover the course of 7 to 10 days, allowing swing traders opportunities to capture larger price swings over a given period of time. One of the greatest ben-
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efits here is that you have access to the markets on a 24-hour basis, unlikethe equity markets.
SCALE AND TRAILThe euro currency chart in Figure 10.3 demonstrates a nice swing tradingopportunity and how scaling out of half of your positions is a great mechanism to capture profits while staying with a potentially longer-term trend.As you can see, the sell signal triggers at 124.80. Immediately we see the sequence of events develop: lower closes than opens, lower highs, lowerlows, and lower closing lows. This is what we want to see each time weplace a short position in the market. As the price declines, a hammer forms;and as you know, that generally gives a clue that a market reversal is developing. The market does make a higher closing high, which would giveyou reason to scale out of half of your positions at 122.65. Not a bad trade,which took place over 11 trading sessions.
FIGURE 10.3Used with permission of esignal.com.
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The market has not given any confirmation of a trend change; therefore, you would want to move a stop down on the balance of the positionsto just above the high of the candle that made the last major conditionalchange of a lower closing low. Trading with scaling out of the balance ofhalf of your positions combined with the trailing stop method we went overin Chapter 9 will help you capture profits while participating in the majority of a trending market condition.
INTEGRATE PIVOT POINTS TO HELPTIME OUR EXITS?We have gone over how to move the stops and why it is good to scale outof positions. We can integrate pivot points to help us trigger our entries anduse the pivot point support or resistance levels to help us target our exits.As shown in Figure 10.4, we have a 15-minute candle chart showing a classic sell signal with a low close doji at pivot resistance, and we see how the
FIGURE 10.4RealTick graphics used with permission of Townsend Analytics, LTD.
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moving averages have crossed and the market is trading below both values.We have a call to action to sell on the close or on the next open. This chartis the e-mini–Standard & Poor’s (S&P), and we would be filled at 1264.25.The market declines in the perfect order—lower highs, lower lows, andlower closing lows—right until we see the market trade down to the pivotsupport target. This is a perfect opportunity to scale out of half of your positions. Remember that in Chapter 2 we went over the fact that once a market goes into trend mode, it will then go into a consolidation phase. We donot know if the trend will continue or reverse; so at this point, it makessense to trail a stop on the balance of positions.I use the point just above the last conditional change, which is the candle that made the last lower closing low. We cover half of the positions at1260.75 for a 3.5-point gain, or $175 per contract. We would lower our stopson the balance to 1262.25 to lock in profits on the balance of positions.Using the pivot point target levels will help you identify when and where toscale out of positions.
BUY SUPPORT, SELL RESISTANCEThroughout this book, I have made many references to why I look for buysignals at the predetermined pivot point support levels and take sell signalsat predetermined resistance levels. This also falls along the lines of notknowing the outcome of the trading signal and market trend conditions,which can and do change. As a day trader looking to capture a portion of aday’s potential trading range, you have to use a plan. Scaling out of positions is such a plan of action. Take a look at Figure 10.5. We have a spotforex euro currency versus the U.S. dollar. Notice that the market breaksbelow the targeted pivot point support several times; however, prices donot seem to decline very far or carry any momentum. In fact, a low closedoji pattern develops, which means, if you follow my rules, you do not takesell signals at support. This helps filter out the false trading signals. Oncewe have a high close doji trigger to go long at 119.83, we now can place ourstop and follow the developments as the trade matures. We see higherhighs, higher lows, and higher closing highs. The market closes closer tothe highs of each successive candle, and the closes of each candle areabove the opens. These are all very bullish signs, and the market blasts beyond the first resistance (R-1) point. So far, we do not have a reason to liquidate the position or scale out of the trade. Then as the market trades atthe R-2 level, we see a doji form; and that will be the clue to scale out ofhalf of the position near 120.20. At this point, we trail our stop on the bal-
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FIGURE 10.5RealTick graphics used with permission of Townsend Analytics, LTD.
ance of positions to the low of the last conditional change candle, which isthe one that made the last higher closing high. We do get knocked out ofthe trade, as the market develops into a consolidation phase. This trade resulted in capturing a nice chunk of the middle of a beautiful intraday trending market condition. Scaling out of the first half of the position wouldhave generated a 40-point profit, or $400 per $100,000 contract lot value;and the balance would have made nearly 30 points, or $300. There was little to no pressure once the trade was initiated. Pivot points helped you target the entry and scale out of the exit. As an interesting note, remember thestatistic that stated that dojis form close to the highs and/or pivot point resistance levels. Figure 10.5 is just another chart to help visually validatethat claim.Most people use scale trading as a means to stagger positions to enteras well as exit a market. There are many variations and specific techniques.It can be argued that rather than scaling out of half of the positions, you
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should actually add on to trades to really pyramid profits. I personally donot use this style of trading. I encourage you to explore any and all methods, but I like to stick to the methods that work for me. When I have a projected entry price based on pivot point analysis, I never have a “guaranteed”profit until I liquidate the trade. By scaling out, it is the finest method Iknow of that puts cash in my account while allowing me to further participate in gains on the balance of positions.
CHAPTER 11
The SampleAnalysisThe Proof Is in the Back-Testing
hort-term system traders make their money, leave the game, and waitto execute the next setup; they don’t have to worry about being aneconomist. They get in when the signals indicate and get out when thesignals dictate. It has been stated many times and proven by history thattraders who consistently make money are those who follow a program or aset of predefined rules. These rules have been tested, and they correspondin a variety of time periods and with diversified or noncorrelated markets.You may have made observations on changes in the market, such aswhen the stock index futures are trending up by 10:30 A.M. (CT) on a Friday,the market has a tendency to trade higher through the end of the day. Actually, that was a casual observation of mine as described on page 212 ofmy first book, A Complete Guide to Technical Trading Tactics (Wiley,2004). With that said, once you have a trading idea about the way a marketmoves, through your own observation, you can apply it to computer codeand have a computer generate an alert to inform you when a signal is generated.Through the proficiency of computers, we can take historical data andback-test the results to see how reliable and accurate the theories are. Notall systems work well. Some are good in trending market conditions, andothers will work well in nontrending market environments. Therefore, it isimportant to back-test a methodology for various time periods and in various noncorrelated markets to see if the principles are sound and stand thetest of time. So far, with what we have gone over, you can develop yourown rules based on pivot point and candlestick patterns.
S
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One such example is if we assign a positive (+) value to a candle witha higher close than open, if you have a sequence of three positive valuesafter a succession of, say, five negative (–) values, and if the low of a givencandle is within two ticks, or 5 percent of, the average daily range on a 10day average, then a buy signal is triggered. Another way of stating this is:• For a positive assigned candle:Close (C) is greater than open (O) ( C > O)• For a negative assigned candle:Close is less than open (C < O)• For a doji candle, with a neutral (=) assigned value:Close is equal to open (C = O)• You can program your own system to generate an exit strategy basedon an average holding period of, say, seven or eight periods or until themarket forms a lower close than open (C < O) or a negative assignedvalue and if that time period closes below the prior time period’s low.Another methodology or system that is a simpler program would be tocombine a three-period pivot point moving average with a five-period pivotpoint moving average. After a series of lower closing lows, once the threeperiod moving average crosses above the five-period moving average and ifthe market was within five points above or below a pivot point first supportlevel (S-1) target number, then a buy signal would be generated. For addedoptimization, you could add a filter that if the stochastics indicator wasbelow the 20 percent line, once %K and %D crossed and closed back abovethe 20 percent level, a buy signal would trigger.Using the value of the pivot point resistance target of R-1 while combining the three-period pivot point moving average with the five-periodpivot point moving average, once the three-period crossed and closedbelow the five-period pivot point moving average, within five points eitherabove or below the R-1, a sell signal would be generated. For added finetuning, you could add another element, such as a stochastics reading, so ifboth moving averages were above the 80 percent level and once %K and %Dboth closed back below the 80 percent level, a sell signal would be triggered.The hard part in coding is comprehending or understanding the software language and then thinking like a computer. You can’t just state “sell”when stochastics gives a sell signal. The software or computer programdoes not know what your interpretation of a sell signal is.If you recall, in Chapter 1, I suggested that traders need to ask morequestions. That is what a system trader does. In order to develop a tradingplan or a mechanical system, you need to search for answers to questionsuch as:
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Will this be for day or position trading?Will volume studies be used and, if so, how?What will be the average holding period?What methods do we want to use and what parameter will we choose?
A trader needs to use various tools to get the job done, so to speak.That is why I have several trading platforms and quote services. GenesisSoftware allows me to develop my own “black box” of algorithms and indicators and to back-test the program. In order to develop a good system, youneed to decide if the trading concepts are valid. Once you have come upwith your set of rules or criteria, then you can start to optimize the program. You have heard of the “Keep It Simple” rule? Leonardo da Vinci iscredited with saying “Simplicity is the ultimate sophistication.” If Leonardoliked things simple, well then, it is good enough for me, too!A trading system should be designed from simple yet effective rulesthat blend key concepts of momentum changes and trending conditions.A well-defined trading strategy can be developed to generate buy and sellsignals in most markets in various time periods. Believe it or not, designing a trading system is easy to do once you have an idea of what the callto action, or the trigger, will be to enter a position. In this book, we havegone over several good techniques with which you can start, such as whenindicators correspond near pivot points like the stochastics 80 percent/20percent close line technique or the moving average convergence/divergence (MACD) zero-line cross signal. You can develop a system based onthese two indicators and then determine how many time periods, or thelength of time, a position should be in the market. Now all you need to determine is how many holding periods (such as 4 or 8 periods) are neededbefore an exit strategy is triggered. You can develop a trigger on movingaverage crossover to initiate a signal, just like the pivot point moving average we went over in Chapter 6 or a simple moving average using 5-periodversus 10-period parameters. You will want to test the system over alengthy time frame and with various noncorrelated markets. If there is anyvalidity to the rules or methods, then you should see positive performanceacross the board.Not all systems that show results of extremely high profit levels arebest. A system also depends on drawdowns, or periods of equity loss. Also,it is important to have software that will show you a trading system’s weakness or will help point out specific time periods or time frames in which youshould not trade. Being able to closely follow your drawdown patterns is ahuge benefit to the computer-friendly active systems trader, finding answers to such questions as: What is the recovery period to gain back losses?What is the depth or magnitude of the losses? These are very importantquestions because if a system has great returns but absurd equity draw-
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downs for long periods, then it is most likely a poor system for an averageinvestor to trade. When you are designing your system, ask yourself whatyou want this system to do. The obvious answer is to make money; but youalso want to know how long and how deep the drawdown periods are orwhether there are consistently more winners than losers. As a trader youneed to evaluate new techniques, especially ones that increase your profitability while reducing your risk and exposure in the market. Systems needto be developed with the idea of triggering a turning point in the market earlier than other indicators and other traders do. Considering that most indicators are lagging, you need a signal that identifies turning points as theyoccur, and you need to use indicators to confirm that the position is valid.Pivot point analysis does just that, especially when combining support andresistance levels and by implementing a moving average approachOne of the best features or benefits to using mechanical trading systems is that they alert a trader to initiate a trade or to act on a signal as it occurs, rather than on a hunch or on the two main destructive emotionalelements, fear and greed. Based on a system that is tested, you have statistical evidence to validate the entry; and that should help eliminate tradingon a hunch, a rumor, or a feeling, which is what drives most trading decisions from inexperienced traders. As this book has demonstrated, it is notmy intention to portray the ability to buy the exact low or sell the exacthigh. In most cases, I am looking for a