you have been consistentin applying your rules, then you will find in most cases that yourconsistency will have paid off and you will have profits to showfor your efforts.
Even if your trading was not successful, you will have learned agreat deal. You will have learned that you can follow a system ormethod that you can trade in a disciplined fashion and, moreover,that the only way to do so is to be persistent by following as manyof the trading rules as possible.
Compare this to the ignorance and confusion that come fromhaphazard trading or by applying trading rules inconsistently.Think back to your experiences as a trader. Remember your worst10 ‘Chapter One
Summary
losing trades. You will find that those losses, which occur as aresult of following a system or method, are easier to accept psycho-logically than those that are the result of breaking the rules.
Losses due to lack of discipline have often turned into terriblemonsters, ultimately costing you much, much more than theyshould have, financially as well as psychologically. If you wouldlike to master the skill of persistence, then you will need to prac-tice it. Make the commitment, and you will see some wonderfulresults, even over the short term.
Willingness to Accept Losses. Here is yet another importantquality that the effective futures trader must either possess ordevelop. Perhaps the single greatest downfall of all traders is theinability to take a loss when it should be taken.
Losses have a nasty habit of becoming worse rather than better.Unless they are taken when they should be, the results will not beto your liking. Although it is easier on one hand for the futurestrader to take a loss than it is for the position trader (since a lossmust be accepted by the end of the trading day), it is still thedownfall of many futures traders who are unwilling to accept theloss when it is a reasonable one. The disciplined futures tradermust have the ability to take a loss when the time to take a loss isright. What's right is dictated by the particular trading system orrisk management technique that is being used. I would venture tosay from my experience and observations that perhaps 75 percentor more of all large losses are due to the fact that they were nottaken when they were relatively small or when they should havebeen taken.
These are just a few of my random thoughts on the topic of daytrading and discipline. Remember that in the day events, pricesand trends move quickly. Decisions must be made almost instant-ly. Hence, your discipline and persistence are of paramountimportance. There are many wrong things you can do and only afew right things. Know the right ones and act accordingly!
This chapter has acquainted you with some of the issues, assets,liabilities, and challenges that face the day trader. While there isno doubt whatsoever in my mind that day trading can be a highlyprofitable venture, J am just as certain that there are few tradersA Perspective on Day Trading I1
who will consistently achieve success in day trading unless anduntil they understand the rules, follow the rules, master their self-discipline, and use effective trading systems and methods. Therest of this book will attempt to give you those tools clearly, con-cisely, and logically.
Remember that day trading is a dynamic process. Marketschange, traders change, and underlying conditions change. Hence,as a day trader you must not allow yourself or your marketunderstandings to stagnate. You must constantly be on the searchfor new methods, new market relationships, new techniques, andnew procedures that will help you take advantage of current con-ditions. Where there are basic indicators and understandings thatare perennially effective, there are always new perspectives andnew methods. These can only be discovered by ongoing researchand by ongoing evaluation of your current systems and methods.A Review ofMarket TimingIndicators
I slept and dreamed that life was beauty;I woke and found that life was duty.ELLEN STURGIS HOOPER
As we all know, the quintessential issue in futures trading is tim-ing. No matter how valuable a forecast may be, timing is the criti-cal variable. There is a distinct and vast difference between a mar-ket forecast and market timing, and there is a distinct differencebetween a “feeling” or a “hunch” and actual market timing.Timing is quasi-scientific. A hunch and a feeling are emotional.Although they may be based on some internal sense of logic, theyare not sufficiently operational or mechanical for use by the daytrader. Hence, they must be discarded. They have no place in therepertoire of the day trader. Eliminate them from your bag oftricks. They will not serve you well.
This chapter is dedicated exclusively to a review of the majortiming indicators that are popular among day traders. E.L.Thorndike, the “father” of American learning psychology, statedthat there are millions of things a person can do wrong but only ahandful of things that are right. Hopefully, this chapter will help
1314
Chapter Two
you weed out some of the wrong or ineffective things while direct-ing you to those that can make you money as a day trader.
My brief review includes an example of each indicator, as wellas my evaluation of its pros and cons. I will not discuss the meth-ods of calculating these indicators. This information is available invirtually any good book on technical market analysis. Although Imay ruffle some feathers by making negative comments aboutyour favorite indicators, I can only be objective within the scope ofmy experience and research as a day trader.
Traditional Moving AverageIndicators (MA)
Whether you use one, two, or three moving averages, the conceptis generally the same. Either the market price must close above orbelow its MA to signal a buy or a sell, or the MAs themselves mustchange their relationship to one another in order to signal a trade.A sample chart showing three MAs and buy/sell signals on anintraday chart is shown in Figure 2-1.
The Good News. Traditional MA indicators tend to do extreme-ly well in major trends both on an intraday and longer-term basis.They will make you a lot of money when a major trend begins.
The Bad News. Traditional MA indicators give many false (ie.,losing) signals. They will often get you into a move well after it hasstarted, and when a change in trend occurs, they will often get youout after you have given back a considerable amount of your profit.
Hence, such moving averages tend to be very inaccurate andoften have considerable drawdown as well as many consecutivelosing trades. Figure 2-1 shows the buy (B) and sell (S) signals gen-erated by this method on a 5-minute S&P 500 chart. As you cansee, the performance of the signals is marginal. There are numer-ous trades within the time frame of a day, all costly in terms ofcommission and slippage. Only the last trade of the day appearsto be profitable. This is typical of MA intraday systems. They tendto trade too often, and they create too much “heat” (losses) andoften very little “light” (profits).
Solutions. Some of the problems with moving averages can bedecreased as follows:A Review of Market Timing Indicators 15
 
Figure 2-1. Triple MA timing (4, 9, 18 period) on an intraday chart. Buy (B) and sell (S) sig-nals marked accordingly.
= Use a weighted, exponential, smoothed, or displaced MA.
= Use a different MA length to exit a trade than you use to enter atrade.
® Use different MA lengths for stop losses.= Use another indicator to confirm or negate MA signals.
Variations on the Theme ofMoving Averages
There are many variations on the theme of moving averages.These include MA-based oscillators such as the MACD (movingaverage convergence/divergence), the MAC (moving averagechannel), and various high/low MA combinations. A thoroughdiscussion of the MAC method can be found in The Compleat DayTrader. (The MACD was specifically designed for S&P trading byGerald Appel, while the MAC is my brainchild.)16
Chapter Two
The Good News. These variations on the MA tend to be moreaccurate and more sensitive than simple MA combinations of theclosing price. The MAC can also be used to determine concise sup-port and resistance levels. This approach can be very helpful tothe day trader who wishes to trade very actively in the directionof the trend.
The Bad News. There is a tendency, as with many MA-basedsystems, to give back too much profit once a change in trend hasdeveloped. This is true of all lagging indicators.
Solutions. Here are some suggestions as to how one mightovercome the limitations of MA-based indicators:
® Use a shorter combination of MA lengths for exit. Hence, exitwill be triggered before the MAs indicate a reversal in trend.
= Use another indicator to confirm the MA signals.= Use another indicator that is not MA-based for exiting positions.
= Develop a trailing stop loss plan that will enhance exit while notsignificantly diminishing system accuracy
Stochastics (SI) and RelativeStrength Indicator (RSI)
Dr. George Lane popularized the stochastic indicator (SI). RSI isessentially similar to the SI. The difference is that SI has two values,while RSI has only one. The second SI value is derived by comput-ing a moving average of the first SI value. Both indicators are oftenused to indicate theoretically “overbought” or “oversold” condi-tions. They may both be used as timing indicators as well as indi-cators of so-called “overbought” and “oversold” conditions.
The Good News. Both the RSI and SI have considerable sexappeal. By this I mean they look good on a chart. They tend toidentify tops and bottoms quite well.
They are also useful in timing, provided one uses the appropri-ate crossover areas for timing trades. See Figures 2-2 and 2-3 forexamples of SI and RSI, respectively.
The Bad News. The concepts of overbought and oversold are notuseful, and they can get you into trouble. Both indicators tend toA Review of Market Timing Indicators 17
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Figure 2-2. Stochastic buy (B) and sell (S) signals; how “overbought” stochastics can be mis-leading.
 
continue in what is called “overbought” territory or “oversold”territory for a long time. As prices move higher and higher, theindicator remains “overbought,” and vice versa. The problem isthat traders often equate the term overbought with a market topand oversold with a market bottom. This is not always true. Manytimes a market will push higher and higher while traders continueto fight the trend based on an overbought RSI or SI reading. Thesame will hold true in downtrends.
Solutions. Don’t use the SI and RSI for determining overboughtor oversold conditions. Use these indicators as timing methodswhen the readings cross above or below certain values. You mightalso consider using RSI and SI with other timing indicators.
Finally, I have developed my SI “POP” method that may behelpful in trading moves that occur in overbought and oversoldterritory (see my book Short-Term Trading in Futures). Anothermethod of using the RSI and SI is to exit trades using a shorterindicator length than was used for entry.18 Chapter Two
 
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RSI= 59,11 : i ieT C*Y GQ tag TFigure 2-3. 9-period RSI on 10-minute T-bond futures showing buy (B) and sell (S) signals.
Note that one method of using RSI is to buy on RSI values above 50 and to sell on RSI valuesbelow 50.
 
Chart Patterns andFormations
These methods are based on the traditional analyses as proposedby Edwards and McGee, as well as other methods such as thosedeveloped by W.D. Gann, George Bayer, and R.N. Elliott. Thereare many different chart formations and various outcomes possi-ble for each. They require a good deal of study and are, at times,quite intricate. I have included only one example of these, sincethe literature is loaded with methods and. systems based on theseapproaches. (See Fig. 2-4.)
The Good News. These methods are highly visual. In otherwords, you can draw lines on a piece of paper and see whatshould be done. In addition, the methods don’t necessarily requirea computer, and they can be learned by almost anyone. FrequentlyA Review of Market Timing Indicators 19
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Figure 2-4. A few chart patterns on an intraday coffee futures chart.
the prescribed actions are specific, once you have completed thenecessary interpretation of the chart patterns. The methods areusually quite logical. Hence, they have a good deal of face validity.
The Bad News. In most cases, these methods are highly subjec-tive and difficult to test for accuracy. The Gann and Elliott meth-ods, for example, have been known and used by traders for manyyears; however, there is considerable disagreement, even amongexperts, as to what patterns exist at any given point in time and, infact, how these patterns should be traded.
Solutions. A possible solution would be to use the methods inconjunction with other timing that is more objective and opera-tional.20 ~~ Chapter Two
Parabolic
The parabolic method is based on a mathematical formula derivedfrom the parabolic curve. It provides the trader with two valueseach day: a sell number and a buy number. These serve as sellstops and buy stops.
Penetration of the buy number means to go long and close outthe short, while penetration of the sell number means to close outlongs and go short. J have included an example of a parabolicindicator plotted on a intraday price chart in Fig. 2-5.
The Good News. The parabolic indicator is totally objective. Itcan be used as a mechanical trading system with risk managementmethods. In addition, it provides a buy and sell stop and is there-fore capable of changing orientation from long to short very quickly.
The Bad News. This method can get “whipsawed” badly insideways or highly volatile markets (note Figure 2-5). The parabol-ic method can catch some very large moves; however, it has manyof the same limitations that are inherent in the use of traditionalmoving averages.
ee
Figure 2-5. Dow Jones futures parabolic signals.
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 A Review of Market Timing Indicators 21
Solutions. Use parabolic with other indicators that are not nec-essarily based on price, i.e., volume and/or open interest. Useshorter-term time frames for exiting parabolic trades. Also, sinceparabolic, in its pure form, is an “always in the market “system,you may be able to adapt it by specifying certain conditions inwhich it goes into a neutral stance (i.e., no position).
ADX and DMI
ADX and DMI are unique indicators based on reasonably solidtheories about market movement. They are calculated with rela-tive ease and may be used either objectively as part of a tradingsystem or as trend and market strength indicators. (See Figures 2-6and 2-7.)
The Good News. These methods are not based on effete con-cepts or market myths. They are well worth investigating fordevelopment into trading systems.
un SEG I TS ARTE Ba2erorné of : ‘
 
Figure 2-6. 21-period DMI difference on intraday silver.22 = Chapier Two
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Figure 2-7. 9-period DMI bearish divergence on intraday silver.
Cycles
The Bad News. They tend to lag somewhat behind market topsand bottoms. As a result, they can give late signals that will costyou money.
Solutions. Use these indicators in conjunction with other indi-cators that are based on different theoretical understandings of themarkets. The DMI difference is the indicator I recommend forDMI work.
Use a derivative of the DMI or ADX as part of your method. Inother words, compute a moving average of the ADX or the DMIand use the moving average to develop more accurate timing.
Cyclical methods are based on the fact that price history repeats.There is a significant body of academic theory and research tosupport the existence of economic cycles and market cycles. TheFoundation for the Study of Cycles has documented a consider-Seasonals
A Review of Market Timing Indicators 23
able body of evidence to support the cyclical approach to trading.In addition, Jay W. Forrester at MIT has developed a highly intri-cate and statistically valid method of evaluating long-term eco-nomic cycles.
The Good News. Cycle trends and cyclical patterns are relative-ly easy to find and can be subjected to major mathematical testingand evaluation. Price cycles exist in virtually every market and inmany different time frames.
The Bad News. Cycles are not always accurate. At times, cyclelows and highs are skipped; other times, cycles can bottom late orearly or top late or early. Hence, timing is an issue of major impor-tance. There is also some doubt as to whether cycles even occur ona very short-term basis. Dyed-in-the-wool proponents of cycleswould argue that cycles exist in all time frames, although there isstill insufficient statistical evidence to support this contention.
This does not mean, however, that cycles are totally useless forday trading. It is possible to extract cyc lical tendencies that, whenused with timing, can prove effective in day trading. See Figures 2-8and 2-9 for examples of intraday cycles.
Solutions. Use timing indicators with cycles. Do not make themistake of thinking that cycle lengths are written in stone.Remember that cycles can be skewed. Tops can come very late orvery early, as can bottoms.
Seasonality also has a lengthy research history. It is based on thevalid and fundamentally sound idea that prices repeat their pat-terns within the course of a year, based on a variety of causes suchas weather, supply, demand, and consumption.
Seasonals appear in monthly, weekly, and daily data. Seasonalpatterns can also be found in spreads and in ratios. But the goodnews for the day trader is that there are also seasonals on a dailybasis. We know for a fact that certain markets have shown a highprobability of closing in a given direction on certain dates of theyear and at certain times of the year. Such date-specific seasonaltendencies have occurred with very high degrees of accuracy inthe stock market and in stock index futures. There are several24 Chapter Two
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Figure 2-8. Is there a 210-minute average cycle in Japanese yen futures?
schools of thought on how best to study the history of such sea-sonals.
The Good News. Seasonals are often specific and capable ofbeing tested historically as well as validated mathematically.Seasonals can be used with or without intraday timing. Seasonalscan also be validated with respect to current factors to determineif they are likely to develop in the present year.
The Bad News. Seasonals have gotten a bad reputation in thelast 10 years because of slick and dishonest sales practices by vari-ous futures options firms. This should not dissuade you fromusing seasonals, provided they are based on sufficient data.
In addition, several firms publish seasonal data based on limit-ed history. The historical results of such seasonals are also suspect,so be careful. For an example of daily seasonal tendencies, seeFigure 2-10. It shows percentage of time up or down closings overthe last 19 years in June Treasury bond futures. Note that the per-A Review of Market Timing Indicators 25
239 10 MINUTE BF RO © 1998 COG INC.
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Figure 2-9. Is there a 320-minute average cycle in crude oil futures?
centages that appear in the bottom row are calculated on a daily-close to daily-close basis. The line plots show the average seasonaltrend for the time frame indicated.
Solutions. Use daily seasonals with intraday timing indicatorsor with trend indicators as a filter. (This will not always work,however.) Also use seasonals that are based only on a lengthy his-tory base. In some cases there is only a base of 15 years. Try toavoid seasonals with less than 15 years of history. If you usefutures options with seasonals, then use at-the-money or close-to-the-money options. Generally speaking, however, I advise againstthe use of futures options for the purpose of day trading.
Remember that seasonals are not perfect—they do takelosses no matter how high their historical reliability may
have been.
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Figure 2-10. June T-bond futures chart showing daily seasonal tendencies.
Momentum (MOM)/Rate of
Change (ROC)
These indicators are actually one and the same in the final analy-sis. Although they are derived using different mathematical opera-tions, their output is the same in terms of highs, lows, and trends.1 believe that both momentum and ROC have been ignored andunderrated as trading indicators and as valid inputs for tradingsystems.
The Good News. These indicators are very adaptable. They canbe used not only as indicators, but they can also be developed intospecific trading systems with risk management. They can also beused for the purpose of timing intraday spread entry and exit.
The Bad News. They are lagging indicators to a given extent.Asa result, they tend to be a little late at tops and bottoms.A Review of Market Timing Indicators 27
Solutions. Momentum and rate of change indicators can beplotted against their own moving averages in order to reduce thetime lag of signals. Another way of improving the signals is torequire that the oscillator remain above its zero line for at leasttwo or three time units before taking action. The signals shown inFigures 2-11 through 2-14 have been filtered for this requirement.As you can see, it eliminates whipsaw-type signals. Figure 2-15shows an intraday spread using momentum and its moving aver-age to generate signals.
Market Sentiment Indicators
These indicators are based on the concept of contrary opinion. Theidea here is that the majority will be wrong most of the time. Thereare several indicators or sources from which contrary opinion canbe evaluated. These include Market Vane, the USDA Commitment ofTraders Report, odd lot short sales (for the stock market), and myown Daily Sentiment Index (DSI). The theory is simple: When bull-
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Figure 2-11. Momentum goes negative and the trend continues lower.Chapter Two
 
Figure 2-12. Price trend and bullish/bearish momentum signals.
ish sentiment is too high, prices tend to top, and when bullish sen-timent is too low, markets tend to bottom.
The Good News. Market sentiment and contrary opinion havea lengthy history of validity and reliability. They can be used in anobjective way, preferably with timing and other technical tools.
In addition, they can be used with fundamentals and as inputsin neural network systems. Market sentiment indicators tend to beleading indicators. They can also be used for short-term and inter-mediate-term swings.
The Bad News. These indicators are sometimes too early inpicking tops and bottoms. In some cases the data is not timely,since there is a lag in the time it is collected and the time it is madeavailable to traders. (To the best of my knowledge, my DailySentiment Index is the most timely. It is usually issued within sev-eral hours of market closings for the day.)
Some measures of market sentiment are not objective (e.g., 
A Review of Market Timing Indicators 29
a yn
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Figure 2-13. Price trend and bullish/bearish momentum signals.
examining newspaper headlines and stories for their bullish orbearish content).
Solutions. Use these indicators in conjunction with markettrends and timing. Use moving averages of market sentiment datato develop a timing approach.
Breakout Methods for
Day Trading
Of all the trading techniques and tools available to day traders,those methods that use breakouts above resistance as buy signalsand breakouts below support as sell signals appear to be the mostviable for the average trader. As we already know from methodspresented earlier in this chapter, this approach is often the mostdifficult for traders to follow, since it requires buying at a highprice and (hopefully) taking profits at a higher price, or selling at a30 = Chapter Two
 
 
: BUY SWISS ooauyswiss \, Sete YENSeu YEN SELL Swiss :
GU YEN
 
Figure 2-14. Swiss franc versus Japanese yen intraday spread momentum signals.
Summary
low price and (hopefully) taking profits at a lower price. Amongthe methods for achieving this end are several that I discussed inmy first book on day trading, The Compleat Day Trader. Of these, themost widely followed is the critical time of day (CTOD). WhileCTOD was a good method and is still viable, 1 have developedanother breakout method called the 30-minute breakout.
Another breakout method is my range breakout system. Thisapproach is a day-trading variation on the theme of the Keltner-typeresistance and support breakouts. Several breakout methods are dis-cussed in this book. I believe that such methods are among the mostreliable, most consistent, and most profitable for day traders.
This chapter provided an overview of the major timing and trendindicators most often used by contemporary traders. Of those dis-cussed, only a precious few have merit for the day trader. I present-A Review of Market Timing Indicators 31
Ee Gud oten Boe AR seereeeseeeneees Pree eet ee cree
 
Figure 2-15. Japanese yen versus Canadian dollar spread with momentum and MA.
ed the pros and cons of each major approach, indicating how thelimitations might be overcome. I rejected some methods as eithertoo subjective or too inaccurate. While some methods and systemsappear to make sense on a surface level, they do not make profitswhen tested or traded. Other methods were rejected as grosslyinaccurate or as having drawdown periods that were too large.
The day trader has many methods, systems, and indicators fromwhich to choose. This chapter has attempted to help narrow thefield and direct your focus to the few approaches that appear tohave merit. While there is a great temptation for the trader to beintuitive, it is always better in the long run for a trader to be objec-tive, leaving as little as possible to the imagination. Objective, rea-sonably scientific, and mechanical systems are favored.Day Trading
Art or Science?
Truth lies within a little and certain compass,but error is immense.HENRY ST. JOHN
Anyone who has traded the futures markets for a reasonableamount of time realizes fairly early in the game that method andtechnique go hand in hand; that art and science are inseparable.While much may be said in support of a purely mechanicalapproach to day trading, there is also a great deal of anecdotalevidence to support the fact that a good portion of success as aday trader depends upon the art of the science of day trading. Iam not implying by this statement that anyone who is artistic intrading terms can succeed. I also believe that when closely exam-ined, what may be considered artistic or intuitive is actually aninternalized scientific approach.
Rather than accepting this possibility at face value, I’d like toexplore, in some considerable detail, its ramifications for the daytrader. While it may be unpalatable to the rigid day trader toaccept the possibility that there is some art to the science of daytrading, the fact remains that there is, to a certain degree. Let’sexplore the art of the science that will be analyzed and explainedin this book.
3334 = Chapter Three
An Issue of Discipline
The first and foremost area where art and science diverge is theissue of discipline. The simple fact is that discipline in trading isnot inborn or easily acquired. Every trader has a penchant to sub-vert and pervert his or her market discipline. This occurs becauseof the involvement of ego and pride. Few traders are willing toadmit to being wrong. Although it may be their timing methodsthat are wrong, they take the loss personally, and this ultimatelyprevents them from acting in a disciplined fashion.
Now enter hope and fear. These are the two emotions that ulti-mately transform a disciplined trader into an undisciplined trader;a good trader into a bad trader; a successful trader into a losingtrader. And here is also where science becomes art.
If all traders were perfectly disciplined, then there would be noneed for this commentary or analysis. But the simple and undeni-able truth is that traders lose their discipline and revert to art,emotion, sensation, intuition, and random response. Were this notthe case, the number of losers in all types of trading would not beas large as it is. Hence, we have no choice but to accept the factthat the trader can and will make mistakes based on his or heremotional, intuitive, and psychological responses to the markets.The real issue is what can be done to overcome the negative effectsof such behaviors. Following are a few of my thoughts regardingthe above issues.
Where Art and Science Diverge
First, let us be perfectly clear where art and science part company.Rules are rules. They are specific, operational, mechanical, andexact. Anything that diverges from these rules constitutes achange and/or violation of the trading system, method, or indica-tor. Therefore, it should be perfectly clear when a trader has vio-lated the rules of his or her trading system. Note here that tradingsystems that are not perfectly clear in terms of their rules, are sit-ting ducks for rule violations that may go undetected. Hopefully,the methods and systems I have presented in this book are suffi-ciently clear, precise, and operational to allow a clear and concisedetermination of when rules are being violated. Therefore, anychange in the rules constitutes a violation of the system and isclearly a step into art as opposed to science.
Art and science diverge when trading mules are changed, whenDay Trading 35
trading boundaries are overstepped, and/or when specific proce-dures are altered. What were method and system now become artand intuition. The ability to discern and distinguish between artand science will be facilitated if your trading rules are specific andhighly operational. Hence, I advise you to devise and follow preciseand concise rules that are defined as clearly as possible. In both thelong and short run this will be a great benefit to you. I do not dis-count the role of intuition; however, I assign it minimal importance.
When Science Has BeenTransformed into Art
Clearly, the lack of specific and operational trading rules will pre-cipitate the crossing over from methodology to mythology. In thelong run this will not serve the trader well. It will prompt an emo-tional and intuitive trading style that will likely have losingresults. There is, therefore, no choice but to do the following:
= Be aware of when your trading rules have been altered, viol