.Remember that the trend works because it capitalizes on the distributionof price movement called the fat tail. Price patterns have fewer short runs(one day up or down followed by the opposite price move) and more longerruns (more than 10 ups or downs in a row). Price movement is not distributedrandomly.
Calculating the Methods on a SpreadsheetAll four trending methods can be easily calculated on a spreadsheet. You canuse the trend direction to create a long or short trading signal. Figure 4.15 isan Excel spreadsheet that uses Microsoft prices for calculating the fourtrends over a 10-day period (columns F, G, H, and M) and shows the marketpositions that should be held for each system (columns J, K, L, and M). Theformulas are shown so that you can do your own comparison.
TRADE ON THE CLOSE, NOT ON THE NEXT OPENYou’ll find it very convenient to do all your calculations after the marketcloses, and then have your orders ready for the next morning. Don’t do that.Placing your orders on the close by calculating the trendlines justbefore the close of trading puts you ahead of almost everyone else. Youalways need to be ahead, not behind. If prices have crossed an importantresistance line on the close, then you’ll see prices jump higher on the nextopen. Entering your trade before that jump gives you free exposure. Takeadvantage of it.
71
(C)
(D)(E)
Microsoft prices and volumeLowCloseVolume85.406 86.4694086460083.125 83.8134598280083.000 83.4063687460079.438 79.5314457580077.438 80.0006397260080.813 82.6255493340079.875 80.0313864680079.313 80.3133684700080.188 81.3753018300078.563 78.8753146520077.281 78.1253683340074.250 75.0005060780071.992 72.8755851760072.875 73.8753654280072.375 74.4064625720075.250 77.7194755340076.375 76.4383384840074.813 76.7503540860074.750 75.0632963660074.750 75.8752916600073.813 74.2812928480073.531 74.8133839920074.063 76.1253084820076.563 77.4692365140077.500 79.5002336300079.875 80.9064506480079.594 80.6882655740079.656 80.7193147420078.406 80.0943669760078.938 82.9383030480010EXP
(G)10LRS
(H)
81.6480.8179.9378.8878.3177.7577.2676.9076.5475.9175.6175.2375.2175.5375.8976.4076.7277.1577.5478.0578.75
81.3880.9280.4179.4378.2477.4476.8977.0476.9376.9076.5776.4476.0575.8275.8876.1776.7777.5278.1078.5878.8579.59-0.942-1.126-0.938-0.778-0.801-0.809-0.742-0.668-0.510-0.3090.2080.6750.5110.0910.0620.4080.9260.9911.0371.0390.977
"MA=@average(D3:D12)"EXP=G11+(2/($G$1+1))*(D12-G11)"LRS=@slope(I3:I12,D3:D12)
10MA
(F)
Excel spreadsheet showing the calculations for the four trend methods.
High87.96986.28184.93884.18880.81382.78183.37582.18881.93881.84479.93877.06375.68874.62574.50077.81379.68876.87576.25076.28177.06375.34476.75077.68879.61782.37581.25082.28181.37583.000
Date199902011999020219990203199902041999020519990208199902091999021019990211199902121999021619990217199902181999021919990222199902231999022419990225199902261999030119990302199903031999030419990305199903081999030919990310199903111999031219990315
FIGURE 4.15
(B)
(A)
123456789101112131415161718192021222324252627282930
(I)(K)(L)
Trading signalsEXPLRS
ShortShortShortShortShortShortLongShortLongShortLongShortShortLongLongLongLongLongLongLongLong
ShortShortShortShortShortShortLongShortShortShortShortShortShortLongLongLongLongLongLongLongLong
ShortShortShortShortShortShortShortShortShortShortLongLongLongLongLongLongLongLongLongLongLong
"MA=if(D13>F13,"L","S")"EXP=if(D13>F13,"L","S")"LRS=if(H13>0,"L","S")"NDB=if(B13>max(B3:B12),"L"," if(C13<min(C13:c12),"S",M12)
MA
(J)
ShortShortShortShortShortShortShortShortShortShortShortShortShortShortShortShortShortShortShortShortShortShortShortShortLongLongLongLongLong
NDB
(M)
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A SHORT COURSE IN TECHNICAL TRADING
Can We Figure Out, in Advance, When the Moving AverageWill Change Direction?Of course, and it’s a surprisingly simple calculation. If you’re using a 10-daymoving average, simply calculate the value of the 9-day moving average (leaving off the oldest day). That value is the turning point. If today’s prices arehigher, the trendline will turn up; if today’s price is lower, the trendline willturn down. For any moving average, just remove the oldest day and take theaverage of the remaining days to get the critical turning point. That will helpanticipate where you will go long or short just before the close. Remember:Moving average turning point = average of closing prices over N − 1 dayswhere N is the calculation period you are using for your moving average.
What if You’re Wrong?Sometimes it looks as though the trend will definitely turn up 10 minutesbefore the close and then wham!, big selling on the close forces prices downand the trend doesn’t turn up. You’ve already bought. Just close out yourtrade on the next open. It sounds awful, but prices don’t usually make asevere move in the last 10 minutes of trading. More often they just languishand drift lower, just missing your trend signal. You can get out in the morning with little price change.Over time you’ll find that anticipating the trend change is much moreprofitable, even when you’re wrong a few times. Always move ahead of theother traders.
WHICH TREND SPEEDS WORK AND WHY THEY WORKChoosing a trend speed is not a random event. There is a big picture thatmust be understood in order to be successful in the long run.We first need to be aware of market noise. Noise is the erratic up anddown movement that results from the high volume of trading by investors, allwhom have different objectives. Not all buying and selling is done by hightech traders and bank dealing rooms, each trying to get the most profit out ofeach position. Much of the stock market activity reflects movement of pension money by big funds. As money flows in and out, these funds must adjusttheir positions within a few days. Other activity may be the result of investorsliquidating part of their portfolio to have cash for a new house, or some other
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Calculating the Trend
unrelated market event. In futures markets, many of the transactions are forhedging financial commitments, that is, reducing risk exposure, rather thanfor profitable returns.This buying and selling, not focused on making a killing in the market,causes noise. When there is a lot of noise you can get false trend signals.Prices move quickly higher, causing the moving average to turn up. Pricesthen fall back to their original level, and the moving average turns back down.
The Relationship Between the Moving Average Speedand Market NoiseThe slower the moving average, the less it is going to be fooled by noise. Thelonger calculation period makes a single day less important and the averagemore able to hold onto the longer-term direction.Some markets have more noise that others. The high-volume index markets have the most noise and, if you’re going to find the trend, you’ll need totake a very long view of those price moves. Foreign exchange markets andstock sectors have less noise and can be traded with a somewhat faster trend(medium speed is considered to be 25 to 60 days).If you use a very fast trend, then you’ll want to take profits as often aspossible since noise causes prices to change direction unexpectedly, asseen in Figure 4.10. If you can’t expect prices to trend, then you must takeprofits often.To summarize the way you need to look at a trading method based onlong-term and short-term trends, remember that the short term is stronglyinfluenced by noise, while the long term makes noise appear less important:Short-Term TrendNoise dominates short-term pricemovement.Take profits often because noisecauses sudden changes of direction.Expect many small profits and afew large losses.Use daily or intraday data.
Long-Term TrendNoise is small compared to the lengthof the trend.Stay with the trend, and don’t takeprofits. Take advantage of the fat tail.Expect many small losses and a fewlarge profits.Use daily or weekly data.
TREND PROFITS USING DIFFERENT TREND SPEEDSTo see that trend trading works best for slower trends—longer calculationperiods—we can look at a summary of trading results for Eurodollar futures
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A SHORT COURSE IN TECHNICAL TRADING
FIGURE 4.16 Eurodollar results using six trending methods. Faster trends have moretrades and their results are farther to the right. Regardless of the trend method, profits areconsistent with slower trends. As trends become faster, none of the systems are profitable.
in Figure 4.16. The risk-adjusted returns, return divided by risk, are shown onthe left, and the number of trades for a 10-year period are shown along thebottom. The more trades, moving from left to right, the faster the trend.Six trending methods are used in Figure 4.16: moving average (MA),exponential smoothing (EXP), linear regression slope (LRS), swing (SWG),point-and-figure (P&F), and N-day breakout (NDAY). The results clearlyshow that as any system trades faster (more trades), the results turn tolosses. It is not a matter of selecting the best method—there is no bestmethod for trading fast with a trend. It just doesn’t work.
HOW MANY DAYS OF PRICE HISTORYDO YOU USE TO TEST A TREND?If you’re using a computer, use as much data as possible to test yourtrend system—or any trading method. When there is more data, there aremore price patterns and more chance that the trend will see good times andbad times.
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Calculating the Trend
Even when you use 10 or 20 years of daily price history, you still maynot have all the patterns. Be sure you include the market crash in 1987. Youneed to see how your trend would have fared during as many bad scenariosas possible.Be sure your data includes a bull market, a bear market, and a sidewaysmarket. That might be a problem for U.S. Treasury bonds, because they’veonly gone up for the past 20 years (that is, rates have dropped).Do the best you can. Just remember that more data is better.
A COMPARISON OF FAST AND SLOW TRENDING METHODSThink about how fast or slow trading interacts with price movement:Slow Trading
Fast Trading
Emphasizes the trendMust let profits runHas large profitsHas frequent lossesBest with weekly-monthly data
Sees mostly market noiseNeeds to take profits oftenTakes larger losses than profitsHas frequent profitsBest with hourly-daily data
Price noise prevents you from seeing the trend; you need to view the biggerpicture of longer-term prices to overcome market noise.
LEARNING FROM THE PASTMoving averages were used before computers and before electronic calculators. Because it took time to calculate longer averages by hand, the 10-dayaverage was the most popular. All you needed to do was add 10 numbers andmove the decimal point one place to the left. Besides the 10-day average, the5-day and 20-day averages were the most common. Traders believed thatthe average of the week and month were most important. They were probably right.Rather than use a computer to test every possible moving averagespeed looking for the most profitable, why not decide which calculationperiod makes the most sense? Weekly is good, monthly is good, and perhaps quarterly is even better. For stocks, most of the reporting is quarterly.
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A SHORT COURSE IN TECHNICAL TRADING
Perhaps the market simply flops around in between but must come true toits direction each quarter. Monthly might also be good because many of thegovernment economic reports are issued monthly and pension funds mustadd and withdraw by the end of a month. Why not use something logical?By the way, for calculation purposes, a trading month has 21 days.
Questions1. Using the following S&P index prices from November 2002:
908.35, 915.36, 923.76, 902.57, 894.73, 876.19, 882.95, 882.53, 904.27,909.81, 900.36, 896.74, 914.15, 933.79, 930.55, 932.87, 913.31, 938.87,936.31, 934.53a. What are the last three values of a 10-day moving average?b. Is the trend going up or down?c. What would be the next price in order to change the direction of thetrend?2. Which trend will change direction first—a 10-day moving average or a
20-day moving average?3. With percentage smoothing, the most recent price changes are given
(a) less importance, (b) the same importance, or (c) more importancethan previous price changes?4. If today’s closing price is $50, yesterday’s trendline value was $40, and
you are using a percentage smoothing of 10 percent, what is today’strendline value?5. When the slope of a regression line is greater than zero, are prices rising
or falling?6. What is the daily slope of a regression line that rises 10 points in five
days?7. When the slope values today and yesterday are both 1.5, are prices rising,
unchanged, or falling?8. If yesterday’s slope value was 1.5 and today’s slope value is 1.0, are prices
rising, unchanged, or falling?9. Using a moving average to trade, when do you get a buy signal? A sell
signal?
Calculating the Trend
77
10. Using a breakout system, the previous 10-day high was $30.50 and the
previous 10-day low was $28.50. Prices break out to the upside and youbuy 100 shares at $31.00. What is the risk of your trade in dollars?11. Which of the four trending methods, moving average, smoothing, break-
out, or slope,a. Is usually most reliable?b. Has the smallest losses?c. Has the largest losses?12. If the moving average method produced good profits when you checked
its performance on the history of IBM, but none of the other trendingmethods were profitable, would you trade IBM using the moving average? Why?13. You’ve just read an advertisement for a trend system that has 80 percent
profitable trades and very low risk. What’s wrong with that statement?
CHAPTER 5
The Trading Game
A Brief Review and a Little Extra• The reason for using a trendline or moving average is to get an objectiveassessment of the price direction.• Disciplined trading is most important because it clearly tells you when to getout of your trade and take your loss.• You can’t follow the trend and take profits at the same time. Profit-takingworks with short-term trading, but profit-taking fights with the long-termtrend. You can’t hold onto a trend trade to get a big profit and at the sametime take a small profit when things go your way for a few days. You’ll needthe big profits to offset lots of small losses.• Trend analysis says (à la Yogi Berra) the market is going up when it is goingup. There’s no hocus pocus. Fundamentals, or value investing, may say thatthe company is in great shape while prices are falling. You’ll do much bettertrading technically.
ou now know enough to start trading—that is, paper trading. You can’tlearn everything from reading; you need to make trading decisionsand see what works best for you. Everyone must develop their owntrading style—fast, slow, conservative, or aggressive. This experience is asimportant as anything else you might get out of this course. Although we’veonly learned about trendlines and calculated trends, they are the most important techniques for trading, and for now, that’s what we’ll use.
Y
78
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The Trading Game
During this course there will be three trading games, each one looseningthe rules to allow more natural trading. At all times you can apply any trading techniques that you’ve learned, whether in this course or from others, butdon’t go outside the other rules for each game. The object is to learn how tomake these tools work for you.From now on, at the end of each chapter, we’ll review the trading problems that you might have encountered. You’ll see that you’re not the only onethat makes mistakes. Remember that you can’t learn to trade without takinglosses, and it’s best to learn from those losses now, before you try it with yourown money.
OBJECT OF THE GAMEWe have some ambitious goals for the trading game:1. Apply technical analysis correctly.2. Achieve the highest returns with the lowest risk.3. Learn how to be disciplined and objective about your trading decisions.4. Learn how to place orders correctly.5. Get used to taking a loss.
TO BEGIN GAME 11. You have $100,000 cash available for trading.2. You have a portfolio of six stocks and three futures contracts. I suggest
you start with a sample of interesting stocks from different sectors. Youmight choose from:Amazon (AMZN)IBM (IBM)Tyco (TYC)Barrick Gold (ABX)Wal-Mart (WMT)
AOL Time Warner (AOL)Microsoft (MSFT)American Airlines (AMR)Exxon Mobile (XOM)Procter & Gamble (PG)
General Electric (GE)Nokia (NOK)Raytheon (RTN)Merck (MRK)
Try to pick stocks that have had good movement during the past threemonths. We don’t want to get bored; we’re trading, not investing. In addi-
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A SHORT COURSE IN TECHNICAL TRADING
tion, you need to watch the futures markets that have the greatest impacton the economy:10-year Treasury notes (TY)Euro FX (EU, European currency unit)S&P 500 index (SP)Treasury notes are traded on the Chicago Board of Trade from 7:20 A.M.to 2:00 P.M. Central Time), and the Euro and the S&P are traded on theChicago Mercantile Exchange (International Monetary Market and Index& Options divisions). The Euro trades from 7:20 A.M. to 2:00 P.M., and theS&P 500 from 8:30 A.M. to 3:15 P.M., both Central Time. The emini S&P 500trades 24 hours.For futures markets you’ll need to watch the nearest contract for delivery. If you’re trading in the month of February, it will be the March contract. These three markets have four delivery months each year: March,June, September, and December (months are coded as H, M, U, and Z, sothat Treasury notes to be delivered in December 2003 are usually seen asTYZ3 on your screen). Remember that the trading hours for futures arenot the same as those for the stock exchange.3. You can track these stocks on the Internet at a wide variety of websites.
Try looking at BigCharts.com, MoneyCentral.msn.com (where you can alsodownload the prices), or Bloomberg.com. Futures prices are not as easy tofind, but INO.com has both intraday and daily prices for all active domestic futures markets. European quotes can be found on Eurexchange.com.You can also go directly to the exchange websites, CME.com and CBOT.com,to get prices. All of the websites deliver delayed quotes that are 15 minutes late. That’s why they’re free. On some of these websites you canenter and display your own moving average and other indicators. If youdon’t have access to a computer on any particular day, you can use theold standby, the Wall Street Journal, or Investors Business Daily.
TRADING RULES1. Begin trading on Monday. Orders must be placed at least five minutes
before the close for execution on the close. Orders must be placed atleast five minutes before the open for execution on the open. There areno market orders (orders executed immediately) in this game. You needto plan in advance.
The Trading Game
81
2. All positions will be liquidated on the close of Friday in four weeks.3. Send all orders by e-mail to an address set up for just this. There are
many free e-mail vendors where you can set up a new account.4. The only orders that are allowed are market on open (MOO), market on
close (MOC), stop (STOP), and limit (written as limit, OB, or nothing). Nomarket orders are allowed. An explanation of how to place ordersappears later in this chapter.5. All equity orders are for 100 shares. All futures orders are for 1 contract.
You won’t be using much of your $100,000 in this game.6. You must be in at least three positions at any one time. They can be a
combination of stocks and futures.7. You can only go long in stocks. You can go long or short in futures. To
sell futures short, you simply place a sell order. To exit, you place a buyorder for the same quantity. There are no extra costs or complications.The Clearing House keeps track of everything.8. There will be no commissions and no slippage. We’ll trade for free. It’s
unrealistic but not important at this point. You need to make the righttrading decisions and not spend too much time on your accounting.9. Along with your e-mail order, include a one sentence explanation of why
you’re making this trade. Be sure it’s technical.10. After you’ve entered the trade, you must place an order to exit if prices
go the wrong way. It’s a bad habit to have an open trade without risk protection.11. You will need to keep a record of all your trades, marked to the market.
Marked-to-market means that you calculate the accumulated profits andlosses each day. You must see whether you a making or losing moneyon the trades. It’s best that you do this each day, but no later than Fridayof each week. You can use the spreadsheet in Figure 5.1 to record yourpositions, profits, losses, and capital used.
A Little Advice Before Starting1. Diversification reduces risk. Avoid holding positions in only one or two
markets.2. Trading too quickly incurs large transaction costs. The price you get in
real trading will usually be worse than the one you expect, and commission costs add up. Don’t try to get in and out each day.3. A small loss is better than a big loss; don’t fall in love with your trade.
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A SHORT COURSE IN TECHNICAL TRADING
4. Don’t trade unless you have a plan and the timing is right; otherwise, you
can be earning interest in a money market account on the unused funds.5. Review your positions at the end of each week. Look at the major trend.
Look at your risk. Look at your profit potential. If you would not get intothe same position today, then you should get out.
HOW TO PLACE AN ORDERYou need to be very careful and very precise when placing an order. This istrue especially if you place the order by telephone. In the heat of trading,even experienced traders can make the mistake of buying when theywanted to sell. With electronic order entry you should not press the sendbutton before you’ve checked and rechecked that you’ve entered everythingcorrectly.
TerminologyYou’ll need to get familiar with using the right words to enter an order. Longdescriptions don’t work. The order clerk doesn’t care why you’re making thistrade. Learn the following terms:1. When you have no position and you buy, you are initiating (entering) a
long position.2. When you are holding a long position and you sell, you are liquidating
(exiting) a long position.3. When you have no position and you sell, you are initiating (entering) a
short position.4. When you are selling short, you are initiating (entering) a short position.5. When you are holding a short position and you buy, you are liquidating
(exiting) the short position.In futures:• If you are long 1 contract and you sell 2 contracts, you have closed outyour long and you are now short 1 contract.• If you are short 1 contract and you buy 2 contracts, you have coveredyour short and are long 1 contract.• When you go from long to short, or short to long, you can say that you’vereversed your position.
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The Trading Game
TABLE 5.1
Types of Orders
Notation
Description
MARKET
Market order (at the market). You want your order filled immediately, atwhatever price is being traded (the asking price when you’re buyingand the bid price when you’re selling).
MOO
Market on open. You want your order executed at the opening of thenext session. The opening session is about the first 60 seconds oftrading. You may get any price within that 60-second period.
MOC
Market on close. You want your order executed at the close of thetrading session. The closing session is usually the last 60 seconds oftrading. You do not get the closing price, but any price within the last60 seconds.
PRICE
Price order (the word “price” is not actually used). You want you orderexecuted at a specific price or better. If you are buying at $15, then youmust get a price of $15 or better; otherwise, you are not filled. A priceorder is placed below the currently traded price when buying and abovewhen selling.
STOP
Stop order. You want your order executed if the price is reached. A stoporder is placed above the current market price when you are buying. Ifthe price moves up and reaches your price, your order becomes amarket order.
OCO
One cancels the other. You place two orders and if one is filled, then theother is automatically cancelled.
CANCEL
Cancel order. You want to remove the order from the system.
CR
Cancel replace. You want to change your previous order. If you do notcancel it, then the new order will be placed in addition to the originalorder.
GTC
Good ‘til cancelled. Your order remains active until you cancel it. Unlessspecified, all orders are day orders; that is, they are automaticallycancelled at the end of the trading day.
The type of order must be one of those shown in Table 5.1. You can combine these orders in a variety of ways, as shown in Table 5.2.There are other types of orders, and more complex combinations, butyou’ll be able to trade for a long time without knowing them. These ordersare all that’s needed. Be sure you practice writing the orders in the correctform. It’s always:Buy or SellBuy
Quantity100
Stock or FuturesMSFT
Price65.00
Type of OrderSTOP
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A SHORT COURSE IN TECHNICAL TRADING
TABLE 5.2
Combinations of Orders
Notation
Order
Description
MOOMOC
SELL 100 IBM MOOBUY 1 TYH4 MOC
Sell 100 shares of IBM on the next open.Buy 1 contract of March 2004 Treasury notefutures on the close.
Price
BUY 100 IBM 51.00
Buy 100 shares