Sunday, September 18, 2011

New Trading Rules

As promised, here are the new trading rules:

Contents

Introduction
Charts
Market Direction
The Trend
Trading Rules
Choices
Trade Sizing
Posting Schedule
Housekeeping

Introduction

"Wait a bit, Tyek," Farad'n said. "There are wheels within wheels here." --Children of Dune, by Frank Herbert.

I divide my price-trend strategy into three classes. All require an opinion of the overall direction of the market and a determination of the trend. In addition, I also use a covered call strategy that relies on option volatility rather than trend.

In my trading I use the concepts of phase and trend: Bull phase, bear phase and neutral phase. I don't think of stocks themselves as being inherently bullish or bearish. They are constantly changing, and today's bull stock can be tomorrow's bear stock with a single rumor or news release.

Moreover, phases contain phases within them. The six-month price rise contains lots of shorter-term declines. The current phase depends upon how closely the trader is looking.

A phase and a trend are two different beasts.

A phase is derived from technical signals on the chart -- it is an artificial contruct, an overlay, that imposes an arbitrary structure on prices. Under my system, bull phase means the price is trading above the 20-day price channel, and bear phase means the price is below the channel.

A trend, by contrast, is purely a matter of a price and its position relative to other prices. In the trend, only the price exists. There is none other.

A series of higher highs and higher lows is a rising trend, or a bull trend. A series of lower highs and lower lows is a falling trend, or a bear trend.

It is not only possible, but common to have a bear trend within a bull phase, or a bull trend within a bear phase.

Wheels within wheels.

How are phases and trends used in practical trading? They represent different degrees of persuasiveness. A phase shouts, “Hey! I’m real! Take this trade!”. A trend whispers, “You might want to check this out. There may well be something to it.”

Charts

My initial analysis is done on six-month charts showing one candlestick or price bar per day, with further analysis done on intraday charts: half-hour for stocks and exchange-traded funds, and one hour for currencies.

The daily chart is overlaid with the 20-day Donchian price channel and is used along with two indicators: The 10-day average true range (ATR) and 10-day average directional index (ADX). Both were invented by J. Welles Wilder Jr., a prolific developer of ways to analyze stock prices. He well deserves to be called the Thomas Edison of technical trading.

The intraday charts have no overlays or subsidiary indicators.

The average true range provides the average daily movement of a stock for the past 14 trading days. It is an extremely useful gauge of volatility.

The average directional index measures the strength of a stock’s trendiness -- the higher the ADX, the stronger the trend.

(Note that the price-channel period under my prior trading rules was 55 days, and the ATR and ADX periods were 14 days. I’ve reduced them to capture shorter-term moves -- for higher velocity trading.)

Market Direction

There is no single way of forming an opinion of the broad direction of the market. One method is to use a simple 200-day/50-day moving average cross-over applied to SPY, the exchange-traded fund that tracks the S&P 500.

If the 50-day average is above the 200, then I am bullish the market; if below, then bearish.

Or, for a more short-term view, a 50/20 cross or 40/10 cross can be used.

Another method is to look at a month or week chart -- each bar represents one month or one week -- and determine if it is making higher highs and higher lows, or lower highs and lower lows. The former is bullish; the latter is bearish.

I set great store by Elliott Wave analysis, as practiced by Robert Prechter at Elliott Wave International. His opinion of the market direction at the Minor Wave level influences my thinking greatly. See his book, Elliott Wave Principle, for a detailed explanation of his methods.

An opinion should not be formed by reading the daily market reports by The Associated Press, Reuters, Bloomberg, or any other news organizations that begins stories with premises such as “The market fell on fear that Greece will default on its debt” or some such. The markets move on a complex set of decisions that are unknowable in their totality, and even in their broad outlines.

My rule, then, is to rely on technical signals, not news reports.

The Trend

An uptrend is a series of higher highs and higher lows. A downtrend is a series of lower highers and lower lows. If the price pattern meets neither of those criteria, then the price is either in a sideways trend or a state of unknowable confusion.

It is the nature of price movements that they contain trends within trends. However, by looking at a chart, it is relatively easy to pick out the major reversal points. So rather than trying to define strict rules governing what constitutes a significant reversal, I adhere to the Supreme Court’s principle, first applied to pornography: I know a significant price reversal when I see it.

I find it useful to mark the trend on the chart by drawing a line, connect the lows for an uptrend, or the highs for a downtrend.

Trading Rules

Class A Trades: Price Channel Breakouts

Entry into a position is signaled when the price breaks beyond the boundaries of the 20-day Donchian price channel.

Single options, option vertical spreads and stock shares are suitable vehicles for the strategy.

In the best case, a Class A position will be opened on the day the price breaks beyond the channel. However, if the price is trending upward after already breaking beyond the channel, then the entry day’s channel level is used as the breakout level.

Class B Trades: Congestion Breakout

This class of strategy is used to capture the breakout of a price from a sideways trend, which traders often refer to as congestion.

Single options, option vertical spreads and stock shares are suitable vehicles for the strategy.

Determine the boundaries of the sideways channel by drawing horizontal lines through the highs and the lows. The breakout levels are at an offset beyond those lines. One way of determining the offset is to determine the width of the channel by subtracting the lowest low from the highest high, and then applying a percentage, such as 23.6. The formula: (High - Low)/0.236.

Class A and B Rules

I always like to know how I’m going to get out before I get into a risky position. The first rule of life: Know Your Exits.

Exits:

Determine a stop/loss interval as a multiple of the average true range. I generally use the range itself for stocks and one-half the range for currencies. However, I will at times use smaller intervals to produce tighter stops.

Apply that interval to furthest point beyond the breakout level for the initial stop/loss, and trail the price as it moves further of the price channel, maintaining that interval.

Entries:

Determine a breakout level, as discussed below in separate sections for each class.

If yes, then can the position be opened at a stock price beyond the breakout level?

If yes, then is the trend in the direction of the breakout on both the primary (mainly daily) and intraday (hourly for stock, half-hourly for currencies)?

If yes, then open the position..

Class C Trades: Sidewinders

This class of strategy is used to capture profits from an ongoing sideways trend.

Iron condors, which earn a profit if a stock price remains within a range, are a suitable vehicle for this strategy. Single options, option vertical spreads and stock shares can be used to capture individual legs of the fluctuations within sideways range, treating them as alternating bull trends and bear trends.

Exits:

The stop/loss is set at an offset beyond the boundaries. One way of determining the offset is to determine the width of the channel by subtracting the lowest low from the highest high, and then applying a percentage, such as 23.6. The formula: (High - Low)/0.236.

Entries:

Is the price about midway between the boundaries of the range?

If yes, then open the position.

Choices

In trading, opportunities always outnumber available dollars. So, how to choose?

I give a lot of weight to realities on the chart (rather than stories on the message boards, machinations of analysts, Cramer's enthusiasms or other noise that pervades the agora).

1) I give preference to trades that are new breakouts. That means I'll have a chance to ride more of the trend than would otherwise be the case. Also, the longer a trend continues, the more money that is drawn to it and the less money there is on the sidelines to provide further fuel for the trend.

2) From among the new breakouts, I tend to throw out any that will be announcing earnings within the next 30 days. Earnings plays can be interesting, but they are essentially unknowable prior to the event. If I can’t estimate the odds, then I’m not interested.

3) I tend to favor higher volumes over lower (greater liquidity), higher volatility over lower (greater opportunity), and a higher average directional index reading over lower (greater momentum).

4) I don't give a lot of weight to a company's financials and other fundamentals, since generally I don't stay in these positions long enough for them to matter much. I do like to avoid real stinkers, such as companies with really high debt levels as compared to equity, or with negative return on equity.

I don't mechanically take every trade as its offered. Some are too expensive -- the minimum unit (a share or an options contract) exposes me to outsized risks. In some, the price broke out of the price channel, but without a lot of conviction. Sometimes, I'm suspicious of recent news.

When decision time comes, ultimately, I look at the chart and trust my instincts. Sometimes a chart just looks right. Sometimes it doesn't. I've been studying charts for 30 years, and I've found the queasy feeling in my stomach can be a pretty good market analyst.

Trade Sizing

Nothing is more important to the trader than trade sizing: Risking the proper amount of money on each position. Too little, and your profits get eaten by commissions. Too much, and if the trade heads south, you’re left with too few resources to trade another day.

I calculate my trade sizes as "units". A unit is 1% of the total funds I have available for trading, both committed to positions and uncommitted.

I then adjust that unit for the historical volatility of the position by dividing it by the 10-day average true range (ATR).

Sometimes, the adjustment can give outsize results. So for price-channel trades, in no case will a unit be more than 2% of total funds. This is the "double unit rule". (If low volatility triggers this rule, I often reconsider the trade. Volatility is the mother of profit.)

For example, assume a trader has $100,000 in his or her account and wants to open a position in SPY.

The base unit size is 100,000/100, or $1,000.

The ATR on SPY is 1.3048. So, 1,000/1.3048 = $766, and that’s how much the trader can risk on the trade.

Assume a trade, instead, on a less volatile issue, such KEY.

The ATR is 0.1986, and 1,000/0.1986 = $5,035.

However, under the double-unit rule, no position can exceed $2,000, and so the trader can buy $2,000 worth of KEY.

It is almost impossible, of course, to hit the size precisely in actual trading, but I come as close as possible, rounding down.

But what does risk mean?

If I enter a trade for $1,000 and place a stop/loss 2% below the entry point, do I have $20 at risk ($1,000 x 0.02), or do I have $1,000 at risk (the whole amount)?

I calculate that risk by the amount of money I would lose if the position disappears entirely. I was in the market during the 1987 crash. I know what can happen in a day.

But, there’s a case to be made for the stop/loss method of calculating risk. I mean, 1987 was more than 20 years ago, and nothing like it has happened since (if you ignore the so-called Flash Crash, which had no lasting impact).

Does a trader live in constant fear of such a rare event? That’s like refusing to take a luxury cruise because of vivid memories of the Titanic.

The whole position method of calculating risk allow for greater diversification, and therefore greater security. But by accepting a greater limit on risk, the trader inevitably gives up greater opportunities for profit. Risk and gain are proportional to one another.

The stop/loss method of calculating risk provides economies of scale for trades in stocks and options (although not in forex). It also allows the trader to carry fewer positions on the book in order to be fully invested. This has the benefit of reducing the span of control, something that’s always problem when a trader has many positions.

If I were to adopt the stop/loss method -- and I may down the line -- I would protect myself by limiting market exposure in all positions to a fraction of my total trading funds, say one-third or one-half.

Posting Schedule

Generally, I start posting each day after the New York currency markets open, at 8 a.m. Eastern.

Forex: I scan the currency, generally the 54 pairs that have 20% margin under U.S. government regulations. I discuss any positions I see that are candidates for one of my three trade classes.

Indicators: These are exchange-traded funds that help give me an overall impression of where the markets are going. These include stock index funds, bond funds, commodity funds and global currency and emerging markets funds.

Watches: Midway through the trading day, I scan the charts of liquid stocks and exchange-traded funds. If I find any that meet my criteria for trading, then I’ll do a separate write-up, with the headline consisting of the ticker symbol followed by the word “Watch” (as in NFLX Watch for Netflix).

The day ends with the Almanac, almost always posted within 15 minutes of the market close at 4 p.m. Eastern.

Housekeeping

All content on Tim Bovee, Private Trader is copyright 2009-2011 by Timothy K. Bovee. All rights reserved.

Quotations of up to 200 words each are allowed. No need for permission, but please let me know what you've used. See the next paragraph for how to get in touch.

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