traders june

June 2012

Interview: Stephen Temes – Striking out on One’s Own

»» Equity Curve ControlFocus on the Bigger Picture of Your Performance

»» Trading WarbotsThe Impact of High Frequency Trading on Markets

»» Explaining the Mechanics A High Frequency Trader‘s Apology

»» Vivaldi Revisited The Benefit of Seasonality

Why Most Traders Fall Victim to

False Breakouts

2

06/2012 www.tradersonline-mag.com

TRADERS´ EDITORIAL

TRADERS´ comes to you free of charge. This is possible because of the support of our spon-sors and advertisers. So please take a good look at their messages and help them develop their business. Moreover, we are looking for-ward to your feedback. This is the only way for us to constantly improve our magazine. Please write to: [email protected].

I recently read Brent Penfold‘s book titled “The Universal Principles of Successful Trading”. It touches on an interesting concept that every trader really ought to give thought to at one time or another – the so-called “placebo traders”. A placebo trader is someone who has found a trading technique that works and that he therefore regards as the incontrovertible “truth” of the market. This may be an indicator in a particular setting, a specific chart pattern, or Fibonacci ratios. Whatever it is – it causes the trader to gain an enormous vote of confidence in himself and his method so that he can survive even difficult markets and deep draw downs. The amazing thing is that most of these techniques have no statistical significance but can nevertheless work. In other words, these traders are not that good because they use the tool they trust but because they are good traders and adhere to their principles which are inextricably linked to their trading approach: limiting risks, boosting profits and always following rules. Perhaps they trade on the basis of a nonexistent relationship, but are nonetheless successful on account of structured processes. What an insight!

This raises the question of whether all traders are not placebo traders in the end. Perhaps we ultimately need our setups only to gain confidence in the consistent application of a sound process? This would mean that the setup itself was not the direct determinant of success. Instead, it would be our own behaviour in staying the course of a good trading process, and our ability to turn this into a success story in the markets.

It is arguably impossible to either prove or disprove whether Brent Penfold’s thoughts have any validity. Find out for yourself then whether it is your setup that makes you profitable, or whether those profits are generated by a good trading process applied on a regular basis. You may well be amazed by your own abilities.

Good Trading

Lothar Albert

Placebo Trading

http://tradersonline-mag.com/index.php/forum

http://www.eSignal.com/pro

4


TRADERS´ CONTENT

06/2012 June

COVER STORYDo not Fall Victim to False Breakouts

13 INSIGHTSEquity Curve Control – Part 3

41 STRATEGIESCandlestick Outliers

36 STRATEGIESMean Reversion

61 BASICSThe Benefi t of Seasonality

COVER STORY

Why Most Traders Fall Victim to False Breakouts

The aim of this article is to prove to you that breakouts are indeed a powerful strategy but more often than not traders are committing a number of critical errors which drastically reduces their probability of success.

INSIGHTS

Equity Curve Control – Part 3 Focus on the Bigger Picture

of Your Performance

What Type of Trader Are You? Are You an Amateur with a Hobby

or a Professional with a Business?

2012 – A Year of Low Commodity Volatility? How to Benefi t from Narrow Ranges in Gold, Coffee, and Co

Trading Warbots: Are They Affecting the Market?

The Impact of High Frequency Trading Technology on Markets

Explaining the Mechanics – Part 1 A High Frequency Trader‘s Apology

TOOLS

New Products

Bookmark

Web Review

STRATEGIES

Stage 3: Mean Reversion How to Modify Up

Trending Trading Strategies

Candlestick Outliers Bollinger Band Outliers in

Combination with Candlestick Reversal Patterns

Profi table Medium Term Investment with Matching Indicators

How to Combine Stochastic and Moving Average

Red-White-Red Pattern Trading Low Risk, High Reward

BASICS

Fundamental and Technical Analysis of Currency MarketsAn Introduction to the Currency Markets

Smart Trader’s Edge – Part 3 Competence and Confi dence,

Two Major Trader Qualities

Vivaldi Revisited: The Two SeasonsThe Benefi t of Seasonality

PEOPLE

Stephen TemesStriking out on One’s Own

64 PEOPLE Stephen Temes

5


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PhoneFax

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Subscription Service

Address of Editorial and Advertising Department

Editor-in-Chief

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Disclosure

TRADERS´ media GmbHBarbarastrasse 31, D-97074 Wuerzburg+49 (0) 9 31 4 52 26-0+49 (0) 9 31 4 52 [email protected]

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Lothar Albert

Prof. Dr. Guenther Dahlmann-Resing, Corinne Endrich, Marko Graenitz, Theresa Hussenoeder, Sandra Kahle, Nadine von Malek, Rodman Moore, Stefan Rauch, Bjoern Sommersacher, Tina Wagemann, Florian Walther, Sarina Wiederer

Tillie Allison, Bert Antonik, Clem Chambers, Andrew Hecht, Bill Henner, Travis McKenzie, Bruce Milbury, Florian Neinert, Keyur Panchal, Chris Stucchio, Dan Valcu, Dirk Vandycke, Paul Wallace

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The information in TRADERS´ is intended for educational purposes only. It is not meant to recommend, promote or in any way imply the effectiveness of any trading system, strategy or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Trading and investing carry a high level of risk. Past performance does not guarantee future results.

TRADERS’ media GmbH is a fi nancial markets publisher specialising in education and continuing education in the fi eld of trading and securities markets. TRADERS’ media was founded in April 2004 and publishes the trading ma-gazine TRADERS´ in the English (digital), French (digital) and German (print) languages monthly. TRADERS´ maga-zine was founded in 2001 by market mavericks Lothar Albert and Allison Ellis. Lothar Albert is CEO of TRADERS´ media GmbH and chief editor of TRADERS´ magazine. Further TRADERS´ editions will follow focusing on Asia (Singapore), India and Russia and coming soon in the very near future, an edition for Latin America in Spanish. TRADERS´ was awarded the title of World’s Best Magazine for Traders by Trade2Win, an international community of traders four years in a row, from 2004 through 2007.

TRADERS´ is unique because we do not offer advice or recommendations on what to trade. This makes our con-tent markedly different from other market magazines. We are not interested in giving people specifi c buy and sell recommendations, but rather focus on teaching the basics of trading from the beginner to the professional levels.

Our magazine has established itself as a source for information and communication for elite traders in Europe and around the world. Current information about technical, mathematical and psychological aspects of the markets are discussed in professional articles and interviews. Each issue contains articles about trading strategies (for basic, inter-mediate, and advanced traders), risk management, technology for traders, business issues for traders, book and website reviews, and much more!

Still today, the trader-elite are interested in professional and cur-rent trading knowledge and experience. Dedicated traders have no need for buy and sell recommendations. Trading pros make their decisions with self-confi dence and are self-suffi cient. These people know that trading can be profi table in both bull and bear markets. The question is what markets, tools and strategies lead to success? TRADERS´ magazine addresses this question every month in multiple languages.

TRADERS´ COVER STORY 6A breakout can be likened to a volcano. As the lava builds under the earth’s bedrock the pressure builds and builds until finally the pressure gets too much and lava explodes from the earth’s core. As a breakout trader is scanning their charts they are attempting to locate price levels where price is testing that level but cannot break through it. Eventually the pressure becomes too much for the price level and price breaks through with a fast explosive move.

But how can we tell the difference between an explosion that will continue on and one that will peter out (i.e. false breakout)?

In the author‘s experience there is a large number of things traders do wrong when trading breakouts but in this article he is going to cover what he considers to be the five most critical errors.

Error 1: Relying on too Few Criteria The most critical error traders make when trading breakouts is that their breakout strategy requires too few criteria to line up before they will take the trade. We like to use the analogy of baking a chocolate cake. You cannot bake a chocolate cake with only two ingredients and neither can you have a successful trading strategy with only two criteria lining up.

The author will often speak to traders who tell him that

Revealing Five Common Mistakes

Why Most Traders Fall Victim to False BreakoutsLike a large majority of traders the first strategy we ever learnt was the humble breakout. It is a common strategy that you will find in a large number of trading books and courses. Whilst it appears on the surface to be a simple strategy that is easy to master, more often than not most traders struggle to be consistently profitable with it. Falling victim to false breakouts is the main reason why traders discard breakouts and continue their search for a profitable strategy. The aim of this article is to prove to you that breakouts are indeed a powerful strategy but more often than not traders are committing a number of critical errors which drastically reduces their probability of success.

7


Travis McKenzie

Travis is the Head of Online

Trading at Trade With Precision

(www.tradewithprecision.com)

where he is one of their most

highly sought after speakers

and trading educators.

Experienced in both intra-

day and swing trading, Travis

largely focuses on forex &

stock markets where he

applies his precision trading

methodology. Throughout his

career Travis has spoken on

behalf of some of the largest

names in the financial world

including the CME Group,

TradeStation Securities, ETX

Capital, CMC Markets and

City Index to name only a few.

breakouts do not work. When he probes them a little he typically discovers that they only really have two criteria they are looking for. The first criteria will be they need to locate an area of support or resistance. The second criteria will be that they want price to break and close above/below that level before they will enter in the direction of the break.

The simple truth is that two criteria simply is not enough in order to create a high probability trading strategy. Yes, with only two criteria you will find a large number of set ups but they will be substandard and will lead to a large number of false breakouts.

When the author is scanning for a breakout he has a list of 19 possible criteria that he is looking to have aligned. Out of those 19 he looks for a minimum of nine of them to align before he would even consider it a valid set up. Obviously the greater the number of criteria which align the higher the probability becomes of that set up being successful.

Error 2: Trading Breaks of Sloping Support/Resistance LevelsBreakouts can be categorised into two broad categories: (a) breaks from sloping support/resistance levels e.g. trend lines or patterns such as symmetrical triangles or (b) breaks from horizontal support/resistance level.

Please note that breakouts can be applied to any market and any time frame therefore we have intentionally cut off the market and time frame for the accompanying diagrams as it really does not make a difference what market or timeframe the chart is.

Breaks of Sloping LevelsIn the author‘s opinion breakouts are often a self-fulfilling prophecy, that is because so many traders are looking for and trading them that they work. If we are correct on that point, then would not it make sense that the most powerful and highest probability breakouts will result from those breakouts which are the most obvious and identified by the greatest number of traders?

The biggest issue a trader has who attempts to trade breaks of sloping levels is that the drawing of sloping levels is so subjective, every trader seems to draw them slightly differently from the next trader. If we gave a room full of traders a chart and asked them to draw sloping trend lines on that chart it would come back looking like Figure 1. So where exactly on that chart is the breakout level?

If the author‘s theory is correct that the highest probability and most powerful breakouts result from those breakouts which are the most obvious and identified by the greatest number of traders

F1) Subjective Sloping Levels of Support/Resistance

Every trader seems to draw sloping levels of support/resistance differently therefore making them extremely subjective.

Source: www.tradewithprecision.com

F2) Far Less Subjective Horizontal Levels

The large majority of traders will agree where to draw horizontal levels of support/resistance.


8


TRADERS´ COVER STORY

then can you now see the issue you have with subjective sloping levels. Most traders will be drawing in their levels differently to you therefore meaning that very few traders will be entering at the same level you will be entering and without the crowd support the likelihood of the move being a false breakout is dramatically increased.

Breaking Horizontal LevelsNow let us take the same chart we used in Figure 1 and ask the same room of traders to locate any horizontal levels of support/resistance. It is more than likely that the large majority of those traders would return a chart like the one in Figure 2.

Horizontal levels are much less subjective and only trading the obvious ones will assist us in ensuring we are only entering breaks where a large number of other traders are entering and this crowd participation will lead to a stronger initial move and more follow through as late comers also join the party.

The author also believes that it is crucial that you only look for what he calls true levels of support/resistance. His definition of a true level of support/resistance is a level that has been tested two or more times (the more times the better as this will mean a stronger level but also give more people the opportunity

to locate the set up too). By testing a level he means price has hit (tested) that level, bounced off that level and then tested it again (this is opposed to simply price consolidating around a level without really testing it). Refer to Figure 3 for an example of three clear tests of a level.

Error 3: Not Enough Emphasis on Trading with the TrendAnother critical error traders make which leads to false breakouts is they attempt to trade breaks against the trend or where there is no clear trend. This is often what a trader will be doing when attempting to trade a break of a sloping level. For example the sloping level trader in Figure 1 would be trading against a very established downtrend if they were to go long on the break of the downward sloping trend line.

We also see a lot of traders of horizontal levels make this mistake when they find a market which has formed a consolidation box (ie a horizontal level above and below the current price action) and then they simply enter long if the upper level is broken or enter short if the lower level is broken. They have absolutely no regard for the current trend and therefore often find themselves trading against the trend and once again a victim of a false breakout.

The trend really is your friend when it comes to avoiding false breakouts.

In assessing trends the author tries not to overcomplicate it and use good old fashion price action, assessing highs and lows to establish the trend direction. He will only go long in an uptrend, short in a downtrend and sit on his hands in a non-trending market. If you want that sustained follow through then you need to trade with the trend.

Error 4: Trading off Only One Time frameSome of the more advanced traders may be incorporating trading with the trend as one of their criteria but then they often fail to take into consideration what the higher time frames are doing. Trading off only one time frame is like driving your car on a foggy night. You will have no trouble seeing what is right in front of you but it is impossible to see any danger that lies further ahead on the road. The biggest danger that lurks in the fog for traders is that the shorter term trend they are trading with is actually in conflict with a bigger more powerful higher time frame trend. See Figure 4 for an example.

The most powerful moves with the greatest follow through will occur when you have as a minimum two time frames in agreement.

F3) True Level of Support/Resistance

Price must test the level, bounce off the level and then retest it again before it is considered a true level of support/resistance.


F4) Multiple Timeframe Analysis

A long trade out of this consolidation box is actually against the higher time frame trend therefore dramatically increasing the probability of a false breakout.


9


TRADERS´ COVER STORY

line will always guarantee that the trader will be getting in at a worse price with a much wider stop and therefore will need the market to run on so much further just so they can get a 1:1 target.

If you are trading true levels of horizontal support/resistance in the direction of not only the set up chart’s trend but also the higher timeframe’s trend then there is no need to wait for extra confirmation, enter as the initial break occurs.

ConclusionIf you are currently trading breakouts and not getting the results you desire or you have given up all together then hopefully we have demonstrated to you in this article that they can be an extremely powerful strategy when traded correctly. Ensuring you have a large number of criteria aligned is critical for any trading strategy and breakouts are no different. Based on the above you can now add the following criteria to your checklist: (1) Trade only horizontal levels of support/resistance. (2) Ensure it is a level of true support/resistance with a minimum of two tests. (3) Trade only in the direction of the set up chart’s trend. (4) Ensure you are also trading in the direction of the trend on the next higher time frame. (5) Enter as price breaks the flat level, do not wait for a close above/below the flat level.

F5) Trading the Break as It Occurs

Trading the break as it occurs allows for a tighter stop and consequently multiple targets are hit.


F6) Waiting for the Breakout Candle to Close

What may seem like a safer option on the surface will actually dramatically decrease your profitability.


Strategy Snapshot

Strategy name: Breakout TradingSetup: Support/Resistance Level tested twice to be a true levelEntry: As the break occursStop loss: Short: above a recent short-term high; Long: below a

recent short-term lowTake profi t: Three targets at a Risk/Return Ratio of 1, 2 and 3Trailing stop: OptionalRisk and Money Management ConservativeAverage number of signals: Depends on market and timeframeComments: Hit rate increases if traders avoid errors 1-5

Error 5: Waiting for too Much Confirmation of the Break Before EnteringThe final critical error occurs when a trader waits for price to break through and close above/below the support/resistance level before entering the trade.

On the surface it may seem like a smart thing to do as the trader is waiting for confirmation that the break has held and therefore should not fall victim to as many false break outs. But what they do not realise is that by waiting for the candle to close they are often getting in far too late and missing a large portion of the move.

If a breakout level is obvious and a large number of other traders is also trading it then the break of the horizontal level should be powerful and price will quickly race away. If you refer

to Figure 5 you will see that the trader who has entered on the break could have potentially hit all three of their targets before the trader seeking confirmation has even entered.

The confirmation trader will have no choice but to put their stop where the more aggressive trader also had theirs. The confirmation trader now needs a massive market move just so they can get to a 1:1 target (refer to Figure 6).

In addition to the above by waiting for one candle to close above/below the breakout level is not going to guarantee the trader avoids false breakouts as most false breakouts will see at least a couple of candles trade above/below the breakout level before price rolls over and stops them out. Whereas by waiting for that close above/below the breakout

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11


TRADERS´ NEWS

Free Book on Spread Betting

“Better Spread Betting” is the brand new no-nonsense financial spread betting book being authored live online by trading author and occasional TRADERS´ magazine contributor Tony Loton. Read it for free, watch it evolve, and help shape the content by commenting on the chapters at www.betterspreadbetting.com.

Source: www.betterspreadbetting.com

Herbalife Plummets after Questions by Einhorn on Call

Herbalife shares got hammered amid heavy trading volume on 1 May after hedge-fund manager David Einhorn asked pointed questions about the company’s financials during a conference call this morning. Herbalife, a maker of nutrition and weight-control products, reported a higher-than-expected quarterly profit but issued an earnings forecast below Wall Street’s expectations. Shares were down four per cent earlier on 1 May prior to the conference call. But the stock was halted twice this morning, once at 11:42 am Eastern Time and another time at 11:48 after hitting single-stock circuit breakers. Einhorn, of Greenlight Capital, asked specific questions pertaining to how Herbalife quantifies distributors, consumers and other clients. Einhorn also asked the company why it stopped disclosing the percentage break-down among its distributors. The questions seemed to show an interest in the kind of minutiae of Herbalife’s business that Einhorn mined last year, when he issues a scathing report on Green Mountain and made a big bet against the company.

Source: http://blogs.wsj.com, written by Steven Russolillo

Do Hedge Funds Really Generate No Alpha?

Morgan Stanley strategist Adam Parker did an analysis of HFRI equity hedge index and found out that hedge funds do not have alpha anymore. This is not unexpected. It just means that you must be really dumb to hand your money to an average hedge fund. There are two explanations. Successful hedge fund managers are flooded with money. They usually do not have 50 great investment ideas. They may have five great investment ideas and maybe another five good investment ideas. The rest will be average investment ideas. When they are flooded with money they have no choice but to invest in all of their investment ideas. Their other choice

is to return money back to their investors but in that case they would not be collecting the two per cent fee.The second problem is more sinister. There are a lot of unskilled fund managers. Maybe they themselves know this or maybe they do not. The problem is the average investor usually does not know who is a good manager and who is not. As the number of hedge funds explodes investors have only three bad choices. First they can invest in an average hedge fund. This is a bad idea because they do

not have alpha anymore. The other two choices are to hand their money to a fund of hedge funds or hand their money to one of the large reputable hedge funds. Both choices are bad. Fund of hedge funds charge more than what they contribute. Large hedge funds invest in marginal ideas.So what is the solution? The solution is to find the best hedge fund managers based on their recent track records and invest in their best stock picks.

Source: www.insidermonkey.com, written by Meena Krishnamsetty

Gulf Investors Now Can Trade Copper Futures Contract

Dubai’s government-owned commodities center is poised to list copper futures on the Dubai Gold and Commodities Exchange (DGCX) soon as attractive market conditions provide a favourable environment for the exchange’s long-standing plan. Copper futures were one of the first projects that were proposed when the exchange was set up. DMCC-linked DGCX commenced trading in 2005. Other projects the trading center is looking at include tea and diamond futures, these were more difficult to implement.

Source: www.arabnews.com

http://www.insidermonkey.com

http://www.betterspreadbetting.com

http://blogs.wsj.com

http://www.arabnews.com

12


TRADERS´ NEWS

Green Mountain Chairman Hit with Margin Call

Robert Stiller, founder and chairman at Green Mountain Coffee Roasters (GMCR), has been hit with a margin call, following the 51 per cent May 2 when the K-Cup maker cut guidance. According to a Form 144 filed Tuesday morning with the Securities and Exchange Commission, Stiller indicated he planned to sell 5 million shares worth roughly $125.5 million pursuant to a “margin sell-out.” Stiller has long been an active seller

of Green Mountain shares. Lately, he’s stepped up his activity. In February, Stiller sold 1 million shares, netting more than $66 million in gross proceeds. Looking back, those sales look well-timed. Green Mountain has since cut its 2012 outlook. And Starbucks (SBUX) unveiled plans to make its own single-cup coffee brewer that some investors expect will eat into sales of Green Mountain’s Keurig brewer.

Source: www.marketwatch.com, written by Matt Andrejczak

StockTwits Unveils Heatmap

StockTwits is known as a social network for traders, which is, for the most part, accurate. Now the company has rolled out a new function that appeals to market-following masses. It is a Heatmap page that provides a cool visualisation of which stocks the site’s 200,000 members are discussing most, in real time. You can break it down by sector and by time frame (last hour, six hours, 24 hours), and the algorithm takes volume, influence of those discussing the stock, and velocity into account. If a company has never been discussed but suddenly

a small handful of prominent members mention it, it will surface on the heatmap faster. Naturally Apple dominates discussions. StockTwits founder Howard Lindzon says Apple has become the Justin Bieber of finance.

Source: www.pandodaily.com, written by Erin Griffith

US House Prices Inflation-adjusted on the Level of 1895

The latest data to the house prices by Robert Shiller show that they have fallen inflation-adjusted to the level of 1895. At that time a high has built in price development that has been reached again today. The data can be accessed on Shiller‘s website.

Source: www.econ.yale.edu/~shiller

The Scariest Jobs Chart Ever

This chart compares the pace of this jobs recovery vs. every other one since World War II by looking at the trajectory of jobs lost and gained since the recession began. The red line shows recovery in the current recession so far. In comparison it clearly represents some deep and long kind of plunge.Source: www.calculatedriskblog.com

Spanish Banks in Crisis

Spain’s bad loans reached an 18-year high in February. About 8.16 per cent of loans held by banks in February were non-performing, the highest since October 1994. In January, only 7.9 per cent of total debt was non-performing. The amount of doubtful debt rose to EUR 143.8 billion, up EUR 3.8 billion from January. The current doubtful loan data have been suppressed by Spanish banks camouflaging the true deterioration of their loan portfolio to the construction and property sectors by undertaking debt for asset swaps. Bad loans will rise steadily throughout 2012 and could spill into 2013, with construction companies and property developers facing accelerating house price falls alongside a stock of around one million unsold new properties.

Source: www.rttnews.com

http://www.marketwatch.com

http://www.econ.yale.edu/~shiller

http://www.pandodaily.com

http://www.calculatedriskblog.com

http://www.rttnews.com

13

Second Order Technical Analysis

Equity Curve Control – Part 3Though technical analysis thrives on the premise that price and volume are the ultimate synthesis of all market information digested by all market participants, it is equally important for a trader to see the bigger picture of his performance in the long run. Handling each trade right is of course very important. But the weight of each trade on performance diminishes the more trades are taken. Or at least it should. This series of articles eventually goes beyond evaluating that performance and shows how it even can be controlled to a certain degree, by focusing on that bigger picture.

In the first article of this series (TRADERS´ 03/2012) we talked about system dynamics and how it relates to financial markets. How tuning a system by definition consequently changes it, making any conclusion about the tuned system practically worthless with regard to the original system. After all, it is curve fitting. The basic premise we came up with, was that it will likely be better to view the system as an unchangeable black box, using external performance indicators to measure the quality of that system.

In the second article (TRADERS´ 04/2012) we introduced several possible indicators to both quantify and qualify a system. An honourable mention goes out to streaks (the clustering) of winners and losers as a possible quality indicator of the system. We also introduced the concept of an equity curve, giving us the evolution of system equity throughout time. This article tries to exploit the equity curve to the fullest, using it

to control the systems output without knowing or tinkering with its internals.

Control EngineeringTo control the system without knowing anything about the rules it encloses, we will take a control engineering approach. Take a very familiar example like a thermostat in a central heating system. As a temperature-sensitive automatic device that regulates and keeps the temperature within determined limits, it can be developed and used without any knowledge about any part of the heating system at all. All it does is combine a plain old thermometer with a switch to turn off the heating when a temperature is reached and switch it back on when the temperature drops below a certain threshold. There is not intervention of the controller in the systems internals. The whole system is just switched on and off, based on some external measurement of its performance (temperature).

14


TRADERS´ INSIGHTSTRADERS´ INSIGHTS

xxxxxxxx

xxxxxxxxxxxxxxxxxxx

xxxxxxxx

xxxxxxxxxxxxxxxxxxx

Dirk Vandycke

Dirk Vandyke has been

actively and independently

studying the markets for over

15 years, with a focus on

technical analysis, market

dynamics and behavioural

finance. He writes articles

on a regular basis and

develops software partly

available at his website www.

chartmill.com. Holding master

degrees in both Electronics

Engineering and Computer

Science, he teaches software

development and statistics

at a Belgian University. He

is also an avid reader of

anything he can get his hands

on. He can be contacted at

[email protected].

Feeding Back the OutputIf the equity curve is the output of the system, than we can use this output as feedback to the system itself. This is where the magic starts. Feeding back the output to the system to control it, is what control engineering is all about. In our daily lives we have many applications using this principle. And very often the controller itself is just a person. A computer mouse, for instance, is far from a precise instrument. The user is actually the controller, continuously adjusting over- and undershooting while trying to minimise aiming errors. Take a car with a driver wanting to adjust to the speed limit. He reads his speed and starts controlling the system with his brakes if necessary. The driver is the controller.

For a trading system the same applies. We measure the output through the equity readings and use our brakes and gas pedal accordingly. As we do not want to change the system or its rules, we are going to adjust the per cent risk taken per trade, based on the equity curve. In its most basic form we can stop live trading and switch to paper trading if equity is going down.

Such a feedback/control loop for a trading system is depicted in Figure 1. To avoid changing the systems internals we have to take total abstraction from

it, viewing it as a closed black box that receives external inputs from whatever sources (fundamental, technical, really any possible input at all). The second abstraction step is decoupling the system’s input from its output. We will measure the systems performance only by its equity curve, or some other performance indicator which we will analyse. We discussed some performance indicators in the previous articles in this series.

The equity curve analysis can be done manually (i.e. subjectively) or mechanically, by an algorithm. Now, this analyser acts like a process controller steering the system it tries to control. And just as a classic process controller, our equity curve analyser will switch the system on and off, based on its performance. The controller knows nothing about the system or the rules that lie within. It only switches the system on or off based on its performance. The system in turn knows nothing about the external controller, nor about the fact that it is turned on and off based on its performance. It just gets the signal to stop or resume trading from the equity curve analyser.

At this point a deadlock problem occurs. If a system gets switched off, it cannot trade anymore. If it cannot trade anymore, it cannot generate

F1) Equity Curve Control Feedback Loop

The equity curve at the output of a system is analysed. Based on this equity curve analysis, the system trades live or on paper (to be able to continue measuring a theoretically paper equity curve). The theoretically ‘paper’ equity curve is shown in grey, the real equity curve is blue. As soon as the system starts ‘working’ again, live trading is resumed.

Source: www.chartmill.com

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TRADERS´ INSIGHTS

trades and a performance flow. No performance means a flat equity curve disabling our equity curve analyser to switch the system back on. This is where paper trading comes in.

Paper TradingPaper trading is the act where a trader pretends to trade a virtual account and records everything as he would do with a real account. It is a different kind of discipline to a trader, because all emotions are taken artificially out of the picture. Nevertheless one has to maintain discipline to keep recording (and not resetting) the virtual account. Brokers often provide paper trade accounts.

One place where paper trading shines is back testing. Remember though, what we said about back testing in the previous article. Strange enough, the same technique of paper trading comes to the rescue in this possible alternative to back testing.

Paper trading is necessary as we must be able to keep measuring our (now theoretical)

equity curve. To see what would have happened if we had continued taking trades live through the system. We resume live trading as soon as this theoretical equity curve starts going up again. As such, the real (adjusted) equity curve becomes dampened, guarded against too large a draw downs. This whole cycle is shown in Figure 1. The results on an actual equity curve are shown in Figure 2.

Building an EQAThe Equity Curve Analyser (EQA) might seem to be the most important and intelligible part of the whole control system. As analysis of the characteristics of markets and financial products shift to an analysis of their performance. But in reality such an EQA, like most process controllers, can be and are better kept very simple. The possibilities are endless. One could build an EQA based on trend lines, moving averages (of the equity curve of course), or even a simple volatility adjusted filter starting to switch between live/paper trading whenever a retracement of the equity curve exceeds a certain Average True Range (ATR*) multiple from a record top or bottom. Mainly just like the principle behind a volatility based stop loss such as the chandelier exit described by Alexander Elder. Any technical analysis used

on price charts (first order) can potentially be used on the equity curve (second order).

The most conservative approach in forward testing is to initialise the EQA with a paper trade state. Such a system has to prove its worth from the beginning, even before it can be used for live trading.

EQA AggregationThe whole point of building an EQA and deciding how complex it should be, can be taken yet one step further. First, there is the idea of an EQA being discrete, switching the system on/off in a very rigid all or nothing way. In a continuous version of the EQA idea, a controller could turn the tap giving the system more or less money, based on its recent performance. As such, the amount of money given to a system, or percentage risked on any trade could range over a [0,1] interval. Zero being the prohibition of live trading and one being able to trade or risk the maximum amount.

Next, one could aggregate a set of very simple but non- (or low) correlated trade systems by multiplexing its money to the best performing systems, deriving the worst performing systems at each moment from live trading possibilities. Nevertheless, monitoring each system even if its equity curve is composed of

F2) Results on an Actual Equity Curve

Equity curve of a trend following trading system through changing market environments. Both trend lines and moving averages are shown on the chart. Moving averages being slightly better candidates for algorithmic implementation (software). The charts also show the new equity curve not only being rescued from a draw down but also starting out avoiding one from the beginning. This implies that the control loop was started in paper trading mode (the most conservative approach through the eyes of a feed forward test).

Source: www.chartmill.com

Notes

(*) Average True Range, the average daily range, taking gaps into account. A measure for the volatility of a time series.

(**) Independent return streams

16


TRADERS´ INSIGHTS

paper trades. After all, remember the first article of this series. Bad performance is, in effect, most probably just a synonym for “currently out of synch”.

So the result would be like an array of non-correlated** very simple systems, together making for a robust aggregate system watched by an EQA playing the role of a money manager allocating money to the best performing (in synch) systems while closely watching the others (out of synch) by measuring their paper trade performance. As soon as the latter start to improve, these systems will regain access to real money and resume live trading.

There is a bit of an analogy here with computer hardware where we started using a bunch of independent and inexpensive disks to build one disk far more robust than any single disk one could buy. This is called a RAID (redundant array of inexpensive/independent disks). This far outweighs the costs building evermore reliable single disk hardware. This application does the same, building a robust system out of lots of independent and easy to understand (inexpensive) systems. We could introduce the acronym ASITS (array or Aggregate of Simple

Independent Trade Systems). No need any more to back test, fine tune curve fit rules and look for a one-size fits all system holy grail.

The biggest win in such an aggregate EQA idea is that all of the trade systems in the pool can be kept very simple, simply being a harbinger for robustness. After all, simplicity is the ultimate sophistication.

Finally, we should keep monitoring the correlation between the systems in our ASITS as that might change over time as well. There is no need for, or even some danger in, having correlated systems in aggregate.

Where to StartMany traders and trade systems builders probably will have too many ideas on what rules and systems to combine. But a few places to start looking for non-correlation could be combining long and short systems or retracement and swing systems with momentum systems and breakout strategies. Even value systems with growth systems. It might be even as simple as combining systems making the same decisions (perhaps built on moving averages) in different time frames. That way the true winners in longer term time frames will start to shine when markets are trending. In non-trending or more volatile

markets, the shorter term systems probably will kick butt.

Just start experimenting and do not forget to share your ideas, feedback and results on your ASITS with me. There is still a lot of ground to cover on this idea which I developed in our company (www.chartmill.com).

Next Time …… is question time. We will take on some hard questions and criticism regarding the ideas in this series of articles that eventually led up to the idea of ASITS. Any questions would be very welcome by the end of May 2012. Just send them to [email protected].

http://www.chartpattern.com

http://www.nadex.com

Part 5: Are You an Amateur with a Hobby or a Professional with a Business?

What Type of Trader Are You? Achieving consistent success in trading comes only once we learn to trade in line with our individual personality, character and beliefs. It is garnering this self-knowledge that becomes the real treasure on your trading journey. This series of articles will help you raise your awareness, develop self-knowledge and improve your approach to your trading business as you gain clarity on what type of trader you are.

19


Paul Wallace

Paul Wallace spent six

years in the Royal Air Force

controlling fighter jets before

embarking upon a career

in the City. He is one of the

principal forex traders at

Kaizen Wealth Management

UK and runs Tradingbeliefs, a

performance support practice

for traders. Contact:

[email protected]

Well for this instalment, fellow trader, we might as well just cut to the chase. Quite simply are you an Amateur with a hobby or a Professional with a business? Come on; be honest, if not with me at least with yourself.

Do you like to have a bit of a play at trading? Do you tell friends that you are “playing the markets”? Let the author provide you with a spot of advice. If you “play” the markets then you should not be too surprised when you end up being the one that is “played”.

Is your investment in trading nothing more than a few pounds, dollars, euro’s or francs in a trading account, a trawl of trading forums and perhaps the odd book you may have picked up? Are you going to free trading events – basically sales seminars – in the hope of discovering some Holy Grail style revelation that will open up the treasure trove of abundance that is trading?

Do you spend all your research time on the “hard-skills” of trading? Namely devoting all your time looking for new trading strategies, tips and ideas. Do you think that the “soft-skill” talents like a business plan, a trading strategy plan, trading records, a trading journal and some personal development goals are a waste of time? Do they sound much too boring to spend your time on when you could be

getting excited over some new trading strategy you picked up from a friend of a friend?

If those things are true for you then be honest with yourself and admit that you are an Amateur with a hobby. As Ed Seykota once said, “Everybody gets what they want from the markets.” What exactly do you want from the markets? Is it excitement? A diversion from everyday life? The status? An intellectual challenge? Maybe even revenge? Be honest with yourself and spend some time investigating your underlying drivers.

A Professional with a BusinessOn the flip-side are you a Professional with a business? Do you conduct your trading as if it was a professional business? Do you have a business plan as well as a trading strategy plan?

Does that business plan cover your goals, objectives and contingency plans? Have you done a SWOT analysis on your business ... and yourself? Do you have a financial plan? Do you understand the cost of your business in absolute terms and relative to your overall trading capital? Does it cover your

disaster recovery plan? Does it cover allocation of resources etc.?

In your trading strategy plan do you have your trading tactics all written out with plenty of examples of those trade set-ups? Do you keep a trading journal as

a means of learning more about yourself? Do you see that as an aid to determining what type of trader you are with a view to improving your performance? Do you keep records of all your trades and use them to improve your trading?

Does it cover your daily, weekly and monthly routines? Do you have systems in place for all aspects of your business? Do you have objective debriefs of your performance? Do you have success structures in place to help you overcome obstacles and setbacks?

Remember, most people spend money on their hobbies and make money from their business. Is that your experience of trading?

ConclusionThe author makes no apologies if the article is perhaps a little harsh. This is ultimately a harsh business and you should not underestimate the amount of time and effort required to achieve a level of business success.

The author suspects that the vast majority of private traders if they were really honest with themselves would say that they are an amateur with a hobby as opposed to a professional with a business. Let us try to be positive and

say that at least raised awareness is the first step towards making better choices about your future path. The other good thing is that being a professional with a business entails a set of actions that are all within your control. You will be required to take personal responsibility for your success.

So if you have admitted that you are presently an amateur with a hobby what one thing are you going to do today to move you towards being a professional with a business? It may be no more than making a simple decision to do what is required to be a professional. That is a start.

And work on becoming a professional.

Most people spend money on their

hobbies and make money from their business.

20

2012 – A Year of Low Commodity Volatility? Commodity markets traded in a very narrow range for the first three months of 2012. Range bound trading has returned after a volatile decade with commodity prices experiencing a secular bull market. This article documents the lower volatility and explains why various markets experienced narrow trading ranges. The author also looks to the future which promises to be very different from action in the first quarter.

How to Benefit from Narrow Ranges in Gold, Coffee, and Co.

The first quarter of 2012 ended with a whimper. Commodity prices ended up for the quarter by 3.74 per cent but that is only a small part of the story. Anaemic trading dominated commodity price movement. We have witnessed some of the smallest ranges in commodity prices during the first quarter in memory.

Volatility Has Decreased Enormously from 2011 to 2012In 2011 the range of the 19 commodities tracked by the author averaged a price range of 61.05 per cent. Some commodities had tremendous volatility. In 2011 the cotton market had a price range (from high to low) of 169.12 per cent! The smallest price range last year was in live cattle – it only moved 25.51 per cent.

2012 has been a different story. The 19 commodities averaged a price range for the first quarter of 21.38 per cent. The widest price range was in natural gas which moved 51.92 per cent from high to low. Coffee had a range of 38.21 per cent making it the second most volatile commodity. Other commodities did not move much. Lean hogs had a range of 11.69 per cent, corn only moved up and down by 12.72 per cent and live cattle had a range of 13.22 per cent. The author views the lack of volatility in the commodities market during the first quarter as

21


Andrew Hecht

Andrew Hecht is a commodity

trader and expert with over 30

years of trading experience.

He has traded a wide range

of physical commodities

and commodity derivatives

over the course of his career.

Andrew currently writes

weekly for the Sovereign

Investor as well as for a

number of trading services

including Trader Hunter and

Commodity Trend Alert.

Contact:

www.sovereign-investor.com

a significant development. This phenomenon is due to a number of important factors.

Reasons for Low VolatilityThe MF Global debacle caused many commodity hedgers, speculators and investors to lose a lot of money when the company went belly up and apparently misappropriated customer segregated account funds. Many of the customers of MF Global have not come back to the futures markets. Many other futures traders have lost faith in the brokerage companies that hold customer segregated accounts due to the actions of MF Global. This has decreased trading volumes.

Increased activity in computer driven, high frequency trading (HFT), has also narrowed trading ranges in the commodity markets that trade on futures exchanges. These computers buy and sell frequently and often for a few price ticks. The increased activity from HFT trading has increased volume but has resulted in decreased price ranges.

The scent of intervention in some key commodity futures markets has kept commodity prices stable. On February 29th a huge sell order in gold caused the price to plummet. Gold was bumping up against its key psychological resistance level of $1800. A major Wall Street bank sold 15,000

contracts (1.5 million ounces) quickly on the floor of the COMEX exchange. The timing of the order was interesting. Fed Chairman Ben Bernanke was speaking as the order hit the floor of the exchange. Gold prices plunged due in part to the speed of execution of that order. That order turned all of the commodity markets around. Gold plunged $100 from the highs on that day alone. Gold has traded in a tight range since.

Finally, there has been some evidence that China, often the demand side of the equation in the commodity world, has been attempting to stabilise global commodity prices as the Chinese government fears the effects of inflation on the tenuous Chinese economy. China is very good at keeping their commodity needs quiet to keep a lid on prices. All of these factors contributed to the low volatility in the commodity futures markets during the first quarter of 2012.

Highlights of Low VolatilityPrecious MetalsThe entire precious metals sector combined was up 9.71 per cent for the first quarter. The gold and silver markets are consolidating after the damage done to the markets on February 29th. The sharp move in precious metals was primarily due to platinum prices which exploded 17 per cent and silver prices that were

F1) Gold Daily Chart

This chart illustrates the market action in gold after 15,000 contracts (1.5 million ounces) were sold on February 29th, 2011 as Fed Chairman Ben Bernanke was speaking. Gold was approaching the $1800 level and plunged after the selling.

Source: www.tradesignalonline.com

22


TRADERS´ INSIGHTS

15.53 per cent higher during the first quarter. All precious metals saw tight trading ranges in Q1 2012 when compared to 2011.

EnergyThe energy sector was up 2.56 per cent for the first quarter of 2012. That is only a part of the story. Oil and oil products rallied sharply during the quarter while natural gas continued on its path lower. When the natural gas market decides to roll over and rally, watch out – the shorts will have to exit positions and that liquidation could be very expensive for them. All energy commodities saw lower price volatility in Q1 2012 than in 2011. Natural gas is the only commodity that had a significant range and natural gas prices were a one way street-lower.

GrainsThe combined action in the grain markets was up 5.67 per cent for the first quarter of 2012. In grain markets the important thing to watch is Asian demand and the weather. The long term fundamental picture remains unchanged. There are more mouths to feed as populations grow and arable land is a finite resource. The grain markets will be volatile in the future and price dips, while scary, create big opportunities to make significant profits for months and years to

come! Much lower price ranges in the corn; soybean and wheat market during Q1 of 2012 was the outstanding characteristic that defined trading.

Soft CommoditiesThe soft commodity sector was down 1.82 per cent during the first quarter of 2012. Sugar, cotton and cocoa all posted small gains while orange juice was down a touch. The big loser in the sector was coffee which dragged the sector results down. Seasonal patterns and fundamentals will continue to dictate prices. The author believes that softs will regain some ground and prices will edge higher overall during the balance of 2012. Coffee is the authors favourite pick given price action during the first quarter and continuing levels of low global stocks. The soft commodity sector saw lower trading ranges in the first quarter of 2012.

Live Cattle and Lean HogLive cattle and lean hog prices finished Q1 trading mixed. Live cattle prices were down 4.36 per cent after rising over 12.56 per cent in 2011. The lean hogs were up 7.24 per cent after losing 9.40 per cent in 2011.

These two commodities traded in a narrow range so far in 2012. Live cattle traded in a 13.22 per cent range from high to low while hogs traded in an 11.69 per cent

range. In 2011 they traded in a 25.51 per cent and 39.39 per cent range respectively. The author believes that these markets will trade in a range during 2012 and that they will continue to make a series of higher highs and higher lows as the bull market for animal protein continues due to demographic trends.

Base MetalsBase metals prices moved higher during the first quarter of 2012 with a few exceptions. Aluminium prices moved 5.53 per cent higher gaining back some ground from losses sustained during 2011.

Nickel prices moved 4.65 per cent lower in the first quarter prompting the world’s largest nickel producer, Russia’s Norilsk Nickel, to warn that below $18,000 a ton five per cent of annual nickel production becomes uneconomic. With nickel currently trading at $17,840 a ton Norilsk projected 2012 average nickel prices at $18,000 per ton.

Zinc prices gained 8.67 per cent for the first quarter. A deficit in the zinc market is likely to emerge by 2014. On going demand for the metal coupled with significant mine depletion was the reason for higher zinc prices.

Lead prices were little changed and down a meager 0.16 per cent for the first quarter. The big winner in the base metals sector

F2) Silver Daily Price Chart

This chart illustrates the market action in silver after 15,000 contracts (1.5 million ounces) of gold were sold on February 29th, 2011 as Fed Chairman Ben Bernanke was speaking. Silver had broken through key technical resistance above $36 and plunged after the selling.


F3) Coffee Monthly Chart

Coffee is in a long-term uptrend. The price correction during the first quarter of 2011 has brought the price down close to long-term support. Stocks are low and fundamentally coffee prices should rebound.

Source: TRADERS´ graphic

23


TRADERS´ INSIGHTS 23for the first quarter was the tin market. Tin prices plunged last year. Indonesia is the world’s largest producer of tin accounting for 40 per cent of global sales of the metal. Indonesia cut supplies late last year after the price plunge. Tin was up a whopping 19 per cent for the first quarter!

China is an important factor in the base metal markets. The overall rebound in these metals during the first quarter has signaled that China may not be experiencing a hard landing.

T1) Commodity Volatility Chart Q1 2012 vs. 2011

This table shows the range from high to low (as a function of price) of commodity prices for 2011 and compares it to the range during the first quarter of 2012.

Source: www.cqg.com

Commodity 2011 price range (high to low) 2012 price range (high to low) Q1Gold 46.88% 14.02%Silver 89.43% 33.40%Platinum 39.40% 24.99%Palladium 61.12% 18.27%Copper 55.29% 17.60%Sugar 76.86% 16.81%Coffee 48.45% 38.21%Cocoa 101.58% 23.10%Cotton 169.12% 14.41%Orange Juice 38.38% 29.12%WTI Crude Oil 53.21% 15.26%Natural Gas 72.68% 51.92%RBOB Gasoline 48.58% 22.03%Heating Oil 36.11% 14.18%Soybeans 34.11% 22.07%Corn 49.21% 12.72%Wheat 74.57% 13.59%Live Cattle 25.51% 13.22%Lean Hogs 39.39% 11.69%

61.05% 21.40%

ConclusionOf all of the commodities that the author tracks, not one was more volatile in the first quarter of 2012 than prices ranges witnessed in 2011. In fact, with the exception of a few most of the commodities traded at a minimum of 1/3 the price range. Looking Ahead Commodity prices recovered 3.74 per cent in the first quarter of trading in 2012. However that was not the story. The story for

the first quarter is the tight ranges across all commodity sectors and the lower volatility of individual commodities.

Looking ahead to the balance of 2012 the author sees a pickup in trading activity particularly in the grain and precious metals sector. He is looking for higher prices in both sectors. Events surrounding Iran will dictate oil and oil product prices in the coming months. Natural gas prices will surely continue to suffer from over supply conditions unless there is a shock to the system in the natural gas markets. Base metals prices will continue to trade in a range as China’s recovery weighs on the mind of the markets. Animal protein should continue to make higher highs and higher lows as the year wears on.

Each year the markets tend to experience a shock. Last year it was the earthquake and tsunami in Japan and the European debt crisis. In 2008 and 2009 we experienced a global financial meltdown.

This year we look forward to a hotly contested and perhaps nasty Presidential election in the US. The Presidential election could be a very close contest. There is a clear division of ideology in the US at this time. The election or perhaps some other unforeseen event will cause the commodity markets to move.

History tells us to always expect the unexpected in the world of commodities. History tends to repeat itself!

The lack of volatility in the commodity markets during the first quarter is telling. The MF Global scandal resulted in lower volumes in the futures markets as some customers of commodity brokerage houses exited the markets. These customers had lost faith in the futures markets, the regulators and the safe keeping of their precious assets.

A pick up in high frequency trading has changed the daily trading patterns in futures markets with computers trading for tiny ticks. February 29th appeared to be a watershed day in commodities in 2012. The actions in the gold and silver markets felt like intervention of some sort. In an election year the last thing that an administration in power wants to see is runaway precious metals prices. Volatility in the commodity markets in the first quarter was one-third of what it was in 2011.

In the US, Congress and the administration cannot agree on anything. The level of gridlock in the U.S. is unprecedented. Washington is getting nothing done for the American people. Politicians are spinning their collective wheels.

Deficits and the declining value of paper currency define

our current economic system. Eventually, inflation will rear its ugly head as deficits eat away at the buying power of the U.S. dollar and other currencies. Higher commodity prices are here to stay in the long run and volatility will continue. It is possible that we will see more dips in the commodities markets over the coming months. Global demographics point to a continuation of the mega bull trend that started several years ago in commodity prices – in the long run it is simply the supply and demand equation with finite supply and ever increasing demand due to more people in the world.

Just remember, markets do the unexpected and they usually cause a great deal of pain and shake out even the strongest position holders before they correct. The author expects incredible volatility to re-emerge in some commodity markets in 2012.

In the markets where options are not expensive, enhance your portfolio by using long commodity option strategies. Due to the low level of volatility in the commodity market during the first quarter, option premiums have gone lower across the board. Long options will help an investor sleep at night in these markets, which are bound to start moving violently sometime during 2012.

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25

The Impact of High Frequency Trading Technology on Markets

Trading Warbots: Are They Affecting the Market?

Technology has revolutionised trading. Real-time stock tickers, charts and trading platforms have provided investors with an arsenal of tools that they can apply to use in making their fortune. But, has technology changed things for the worst and do they actually beat the market, as is often claimed? Private investment guru Clem Chambers, CEO of the financial markets website ADVFN.com and author of ADVFN Guide: A Beginner’s Guide to Value Investing, casts his expert eye of the current state of market technology and asks what impact it is having.

“Hedge funds and investment banks use robots to trade stocks“ has emerged as one of the realities of today’s global markets and one that needs to be looked at closely.

High frequency trading is just another attempt to beat the highly efficient market – yet the truth of the situation is different from the perceived threat currently creating controversy.

It is natural to think that if you trade faster, you can beat a market opponent to the punch. Lightning speed means you can run rings around others like a cheetah preying on slower animals.

The nearly perfectly efficient market means there might be some money to be made, yet this edge will quickly be neutralised by others playing the same game…unless someone is cheating.

Flash Orders –A Thwarted ScamHigh frequency trading came to prominence due to “flash orders”. Flash orders were considered

26


Clem Chambers

Clem Chambers is CEO of

ADVFN (www.advfn.com).

His book “101 Ways to Pick

Stock Market Winners” was

published on 24th February

2011 by Beautiful Books,

Paperback, £6.99.

by many in the market to be cheating. Certain traders were given advanced notice of other people’s orders on their way to the market.

This micro-second advanced notice was enough to sweep up cheap shares and feed them to the flash order. This let high frequency traders make a bit of money on each of these orders. Small profits turned into huge ones when repeated hundreds of times a day. This felt like a scam and was stopped.

It was a scandal. It was the advanced notice given to a sub-set of the market that created the inefficiency that allowed this profit – not simply the raw speed of execution. It was outrageous that exchanges should give advanced warning in the first place.

Once this edge was removed, speed was irrelevant for this “strategy” and the free ride ended. However “high frequency trading” had by then earned its infamy and has kept it.

This story might not sound convincing enough you say? Surely trading at trans-human speeds is a way of making money?

Machine-readable Feeds – Is Faster Really Better? If a computer can read news, interpret it and jump on a bandwagon before anyone else, surely it would give the

high frequency guys an edge. You would think so, but having studied the machine-readable feeds of key players myself, none demonstrated response to news in a way indicating superfast traders were getting to the news in microseconds.

So, if in theory this is possible, up until recently and over an extended period of time, this is not what is driving the market.

Another question to ask, “who is the most successful, richest trader of all time?” The answer is of course: Warren Buffett. An ultra-low frequency trader. Meanwhile, where are the incredibly rich day traders? Apart from the emotional logic, why should faster be better when human plus speed normally equates to hospitalisation?

Of course, the reason high frequency trading is in the headlines is because it is so “sexy”. You do not have to be too bright to conclude that high frequency trading sounds like “cheating” – and we all understand cheating is a tried and tested way to win. Winning the financial game by cheating should be a formula for infinite wealth. What could be more hypnotic than that prospect?

As such, “high frequency trading” has all the spice and

dazzle required to sell a hedge fund to certain kinds of investors.

The pitch is basic and well-rehearsed: “Invest with a high tech hedge fund, full of pointy headed geniuses. We are

trading at the speed of light. Our machines are feet away from the stock exchanges computers. Lights, cameras, action!”

City marketing men always “sell the sizzle not the steak”. High frequency trading is the latest reason to be parted with two and 20 per cent as the hedge fund industry piles on the smoke and mirrors.

High Frequency Trading – Not What People Think It MeansHigh frequency trading is just the kind of slick story that lures in the same kind of investors that fell for Bernie Madoff and the legion of funds that lost other peoples shirts while skimming off fortunes.

Once you leave the financial Barnum’s behind, high-speed trading robots sit in the markets and work out large orders

by chopping them up into manageable pieces and dealing them out over extended periods. This tranching of large trading blocks is necessary to get the best price for the client.

Some robots are working on complex positions that are, in practice, large insurance policies for institutions with huge exposures needing to cover them with hedges. Market robots doing this

grunt work are overwhelmingly the major component of “high frequency trading” and for that matter, the overall trading on the world’s markets.

This “high frequency trading” is a benign phenomenon that improves the efficiency of the market, but it is not what people think of when they hear the phrase.

ConclusionWhat is feared when it comes to high frequency trading is that its capacities are effectively market abuse. Market abuse is illegal. It is the job of regulators to spot activities that disrupt the market and disallow them. Pure speed however, is not in itself abuse. Like all tools it can be used as a weapon, but that is no different to any number of potential risks that will always stalk the market.

Pure speed however, is not in itself abuse.

A High Frequency Trader‘s Apology

Explaining the Mechanics – Part 1The author is a former high frequency trader. And following the tradition of G.H. Hardy, he feels the need to make an apology for his former profession. Not an apology in the sense of a request for forgiveness of sins committed, but merely an intellectual justification of a field which is often misunderstood. In this blog post, he will attempt to explain the basics of how high frequency trading works and why traders attempt to improve their latency. In future articles in this series, he will attempt to justify the social value of High Frequency Trading (HFT) under some circumstances, and describe other circumstances under which it is not very useful.

28


Chris Stucchio

Chris is a software developer

with a focus on backends

and data analysis. In the

past, he was working at

Mesh Capital devising and

implementing strategies for

high frequency trading. Chris

is an expert in data analysis/

number crunching, systems

programming, and full stack

web development. He holds

a PhD in Mathematics from

Rutgers University. Chris is

currently working as Chief

Technical Officer of Styloot.

www.chrisstucchio.com

Mechanics of HFTAny serious discussion of HFT needs to begin with an explanation of the mechanics of how HFT works. The fundamental object in HFT (or exchange-traded securities in general) is the order book. Suppose a guy named Mal comes along and wishes to purchase some shares of Blue Sun. He will probably have in mind some quantity he wishes to purchase, and he probably has some maximum price in mind. So Mal approaches a matching engine (e.g., ARCA, BATS) and places his order there:

BUY(owner=Mal, max_price=20.00, quantity=100)

At this point Mal has not bought or sold anything – he has merely informed the world of his desire to buy. The matching engine takes his order and displays it (anonymously) to all other traders with a data feed.

Now suppose a woman named Inara comes along and wishes to sell some shares, say 200 shares @ $20.10. She places her orders, and it is again displayed to the world (anonymously) and stored. The order book now looks like this:

SELL(owner=Inara, min_price=20.10, quantity=200)BUY(owner=Mal, max_price=20.00, quantity=100)

At this point, no trades have occurred – Mal is only willing to give $20 or less, Inara is only willing to receive $20.10 or more, so no trade occurs. At this point the market has created a bid/ask spread of $0.10 = $20.10 - $20.

Let us continue the example. Suppose now a few more people place orders – suppose Kaylee places an order to sell 200 shares @ $20.21 and River places a sell order for 100 shares @ $20.10. These orders are also stored.

Finally, suppose Simon comes along and places a buy order for 250 shares @ $20.21. He would be happy to trade with Inara, Kaylee or River – all are willing to sell at a price less than or equal to $20.21. The matching engine uses two primary rules to determine who will trade:

• Price. The best price always wins.

• Time. If the price is equal, then whoever placed their order first wins.

So at the moment before Simon’s order is placed, the order book looks like this:

SELL(owner=Kaylee, min_price=20.21, quantity=200) – Trades thirdSELL(owner=River, min_price=20.10, quantity=100) – Trades second

SELL(owner=Inara, min_price=20.10, quantity=200) – Trades first


When Simon places his order, the matching engine will match it as follows:

• Simon buys 200 shares from Inara at price $20.10. Simon trades with Inara before River because Inara was the first to place her order.

• Simon buys 50 shares from River at price $20.10 because River offers a lower price than Kaylee.

Simon has now bought 250 shares, just as he desired.

At the end of this process, the order book then looks like this:

SELL(owner=Kaylee, min_price=20.21, quantity=200)

SELL(owner=River, min_price=20.10, quantity=50)BUY(owner=Mal, max_price=20.00, quantity=100)

Because Kaylee is not willing to offer a good price, her order goes unfilled. Poor Kaylee. Anyway, this is the basic mechanics of trading. There are many more details, of course, and far more order types than merely limit

orders. But limit orders are sufficient for this blog post.

Market MakingMost HFTs run a market making strategy. What this means is they play both sides of the table – they take no position on whether a stock will go up or down. Instead, they try to offer securities both to buy and sell. If you want to buy, they will sell to you at $20.10. If you want to sell, they will buy from you at $20. As long as their buys and sells match do not get too out of whack, the HFT will collect $0.10 = $20.10 - 20.00.

Of course, the market maker takes on risk – he might buy at $20 and then watch the stock tank. If he buys at $20, and the stock goes to $15 before he can sell, he just lost $5. So the market maker needs to balance risk with reward – if he sets the bid/ask spread too low, he will lose money, while if it is too high, no one will trade with him.

It is important to note that market making is nothing new. In the era when stocks were traded in 1/8ths and 1/16ths, market making was done by humans working in the pit. A single human trader would often run a market making strategy on larger stocks with significant volume. Later on, from the 1980’s to the early 2000’s, human day traders would often fill this role. To a much lesser extent they still do.

29


TRADERS´ INSIGHTS

Automated trading systems have replaced these human market makers for a very good reason – cost. For a strategy (and note: this strategy works only for a few securities, no human can track hundreds of stocks mentally) to be worth a financial professional’s time and effort, it must generate at least $20-200k profit each year (this assumes a human smart enough to day trade would work for $20k/year). In contrast, a single server in a data center can run hundreds of strategies at a cost closer to $50k/year, and they can do it faster and more accurately than any human.

The rise of algorithmic trading is merely a special case of machines replacing humans. Traders are no more immune to this than factory workers.

Latency and Order FlowFor market makers, the name of the game is order flow. As long as your buys and sells are well matched (i.e., every time you buy, you also sell), your profit is going to be proportional to

(# of shares traded) x (Ask price - Bid price).

The constant of proportionality depends mainly on the skill of the high frequency trader at gauging the risks.

Basically the more you trade, the more money you make (all else held equal). So how can a market maker trade more?

The answer is that he needs to be close to the top of the order book. As we saw in our previous example, Inara traded more than River, and River traded more than Kaylee. The simplest way to reach the top of the order book is to offer the best price. Supposing Jayne wants to jump to the top of the queue on the buy side, he needs to offer a better price than Mal:


SELL(owner=River, min_price=20.10, quantity=50)

BUY(owner=Jayne, max_price=20.05, quantity=100) – Jayne offers a better price than Mal, so he will trade first.


Of course, there is a balance to be struck. Since Jayne will only be earning $0.05/share traded, he needs to make sure this reward outweighs the risks. Let us suppose that the border between expected profit and loss is $20.05 – that is to say, there is not a

single market participant who believes he can make a profit by offering more than $20.05. In that case, Jayne will always trade first, since he placed his order earliest.

This fact shows why speed matters. Suppose that at precisely 10:31:30:000 AM, new information becomes available which suggests that it will now be profitable to place a buy order at $20.07 –

perhaps a press release has hinted that the price will go up, or a correlated security has just gone up in price. Because of this, both Mal and Jayne want to change the price on their orders to $20.07. Whoever happens to be fastest will rise to the top of the book:


SELL(owner=River, min_price=20.10, quantity=50)

BUY(owner=Mal, max_price=20.07, quantity=100) – received at 10:31:30:427

BUY(owner=Jayne, max_price=20.07, quantity=100) – received at 10:31:30:639, 212ms too late

This is why automated market making has morphed into high frequency trading, and why so much effort is poured into creating low latency systems. Whoever places their order first will be the most likely to trade.

A second reason why speed is important is because when the market moves, traders often wish to cancel their orders. At 10:31:30:000, an event occurred which suggested the price of the security will go up. It is likely

beneficial for River to cancel her sell order at price 20.10 and raise it to $20.20. Conversely, after this event, it might also be beneficial for another trader (say Wash) to pounce on her sell order at $20.10. River can make more competitive sell offers if she has the ability to rapidly pull them from the market. If Wash has the ability to pounce on River’s orders after the market moves, she will need to be more conservative, perhaps offering only $20.15 even though she would be happy to sell at $20.10 (that way she only loses $0.05 if Wash pounces).

Why Does Everyone Pile on at the Same Price?The astute reader will probably ask this straightforward question – why did Mal and Jayne both agree that the best price to offer was $20.07? Isn’t it possible that Jayne’s calculations predicted the right price to be $20.075, while Mal thought it was $20.071? The answer is yes, it is quite possible that Mal and Jayne actually disagreed on the best price to offer. There is no reason whatsoever why Mal and Jayne’s computer programs or trading strategies would both predict prices identical to within many decimal places.

However, regardless of what their trading strategies say, they are not permitted to place orders at their best prices. SEC Rule 612 explicitly forbids offering to buy or sell securities in subpenny increments - i.e., Buy 100 shares @ $20.07 is legal, while Buy 100 shares @ $20.075 is not. This is also called the Sub-Penny Rule. Prior to 2001, the limit was actually $1/16 or $0.0625.

In real markets, with more than just four to five participants, you can also expect many orders to be placed below the top of the book (the highest bid price), at $20.06, $20.05, etc. But the phenomenon of many people piling up near the top of the book does repeat in real life.

This article is reprinted from www.chrisstucchio.com/blog

The simplest way to reach the top of the

order book is to offer the best price.

This is neither a solicitation to buy or sell any type of financial instruments, nor intended as investment recommendations. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS OR TESTIMONIALS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. Thomson Reuters assume no responsibility for errors, inaccuracies, or omissions in these materials, nor shall it be liable for any special, indirect, incidental, or consequential damages, including without limitation losses, lost revenue, or lost profits, that may result from reliance upon the information presented.

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31


TRADERS´ TOOLS

TradingViewFXCM

Alpari (UK) Limited has launched the live MetaTrader 5 (MT5) platform. The key benefits of MT5 trading with Alpari (UK) include among other things a non-dealing desk (NDD) execution with access to multiple liquidity providers (bank liquidity), direct market access (DMA) and market depth to analyse market liquidity, and one-click trading and no re-quotes for speed of execution. Alpari (UK) offers MT5 on the new ECN (Electronic Communication Network) account that requires a minimum deposit of just USD200. Traders can use the ECN account to trade Forex and precious metals. They can choose from 34 currency pairs plus spot gold and silver. ECN trading on MT5 is available on the iPhone, iPad and Android. Demo accounts are also available. With MT5 traders can apply their Expert Advisor (“EA”) strategies in a highly efficient way. The new MetaTrader 5 Strategy Tester enables traders to test and optimise EA strategies in minutes rather than hours. Additional details can be found at www.alpari.co.uk

AgriCharts, the agricultural division of Barchart.com, Inc., which provides market data, agribusiness website hosting and technology solutions to the agricultural industry, announces

a new relationship with Weather Decisions Technologies (WDT), a provider in state-of-the-art weather services, to provide WDT’s iMap, a dynamic and interactive weather mapping solution, to clients of AgriCharts. The new interactive weather maps are available to clients using AgriCharts’ website hosting service and content solutions. The iMap solution utilizes the

Google Maps API and provides users with the ability to launch the weather map into full screen mode, as well as view weather from a global level all the way down to a farm level, including local high resolution. AgriCharts’ iMap interactive weather features include among others zoom in and out – even to the farm level (from World to Street Level views), ClickCast (click anywhere and receive current conditions and forecast), launch into Full Screen Mode with a single click, and radar and satellite overlays

(including Local High Resolution). For more information, please visit www.agricharts.com

FXCM Inc. has launched an improved and faster version of its MetaTrader 4 (MT4) platform offering. FXCM has added new trading features including micro lots (0.01 trade sizes), max deviation, and the ability for MT4 traders to use FXCM’s mobile products to trade anytime and anywhere. FXCM has eliminated third-party bridge software, cutting out the need for auto syncs and speeding up order submission and execution. New features include the ability to: create stop-loss and take-profit orders while creating market and entry orders; choose to close a trade entirely, or scale out by closing a portion of it; control potential slippage with max deviation; and trade new currency pairs, including USD/ZAR, USD/SGD, USD/HKD, SGD/JPY, USD/TRY, EUR/TRY, USD/RUB, EUR/HUF, USD/HUF. More details can be found at www.fxcm.com TradingView, the social media offshoot of trading software company MultiCharts, is offering users, financial website owners, and reporters the opportunity to embed its proprietary charts on news sites, forums, blogs, and mobile platforms for free. Investors use TradingView to

present and share ideas and trading strategies with other users. The editable desktop-quality charts illustrate trends, targets, support, and resistance in real-time with the website automatically grouping together related and similar ideas by ticker symbol, time frame, applied studies, and line tools. Users can also apply indicators, including the MACD, Elliott Wave, and

moving averages, and comment on their own and other people’s charts. Any published chart can be embedded into any web resource (forum, blog, or website) through the IFRAME script, which is available by clicking the “Share” button. Currently, TradingView supplies free stock and index charts using data from the BATS exchange plus forex, with stock fundamental data and futures on the way. For more information, please see www.tradingview.com or www.multicharts.com

Barchart.com has released CommodityNetwork, a service of INTL FCStone Inc and an important online source of in-depth news, information and analysis about commodities, a suite of services including real-time quotes and powerful charting functionality. The platform incorporates

custom CommodityNetwork features and information, as well as CommodityNetwork branding. Barchart is providing CommodityNetwork with both a Professional and Lite version of the application, as well as mobile services. CommodityNetwork’s services include CoffeeNetwork (www.coffeenetwork.com), Globecot News Network (cotton, fibers and textiles)

and eDairy (dairy products). The partnership with Barchart allows CommodityNetwork customers to configure market data screens that deliver real-time market quotes, charts and option pricing as well as breaking news and analysis which is necessary to make timely trading decisions. The service is hosted and maintained by Barchart, as well as cloud-based providing maximum scalability, speed and reliability. Additional details can be found at www.barchart.com or www.commoditynetwork.net

http://www.alpari.co.uk

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http://www.fxcm.com

http://www.tradingview.com

http://www.multicharts.com

http://www.commoditynetwork.net

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32


BOOKREVIEW

Title: The Greatest Trades of All TimeSubtitle: Top Traders Making Big Profits

from the Crash of 1929 to Today

Author: Vincent W. Veneziani Available on: Hardcover, eBookPrice: £30.99

Publisher: Wiley TradingWebsite: www.wiley.com

About the author:Vincent Veneziani is Markets Media‘s content development manager and author of the book “The Greatest Trades of All Time: Top Traders Making Big Profits from the Crash of 1929 to Today”. He has appeared on CNBC, BBC, Russia Today, Barron‘s and other financial publications. He has also written in the past for Business Insider, Gawker Media, AOL and the New York Daily News. He currently resides in New York City.

BOOKREVIEW Top Traders Making Big Profits from the Crash of 1929 to Today

The Greatest Trades of All TimeBy Vincent W. Veneziani

Financial and commodity markets are characterised by periodic crashes and upside explosions. In retrospect, the reasons behind these abrupt movements often seem very clear, but generally few people understand what is happening at the time of the moves, and fewer still have the conviction to make a big bet to capitalise on their unique insights. However, some top traders and investors have the ability to stand apart from the crowd, embrace a view that is contrary to other market players, and the willingness to make a big bet. When markets break their way and there is a mad rush to get in or out of the market by the general public, the traders who got in early made the huge profits.

“The Greatest Trades of All Time” describes how top traders made huge profits during the most momentous market events of the past century. From the 1929 stock market crash to

the 2008 subprime mortgage meltdown, this book will chronicle how a select few traders anticipated market eruptions and positioned themselves to reap huge profits.

Traders and events discussed include Paul Tudor Jones, who shorted the stocks prior to October 19, 1987, the most severe one-day crash since 1929; George Soros, who made an estimated $1 billion shorting the British pound during a currency crisis in the 1990s; Jim Chanos, who spotted Enron's fraud early on and shorted the stock prior to its complete collapse; John Templeton, who's career was bracketed by two amazing trades: buying undervalued U.S. stocks near the end of the Depression, just prior to World War II, and shorting Internet stocks just prior to the collapse of the Internet bubble in 2001; John Paulson, who shorted subprime mortgages in 2008, capitalising on the collapse of the U.S.

housing bubble; and finally Jesse Livermore, who shorted stocks and made a fortune in the 1929 stock market crash.

Author Vince Veneziani describes the economic and financial forces that led to each market cataclysm and how these individual traders perceived what was happening beforehand and decided to place big bets, often at great risk and in opposition to consensus opinion at the time. This book brings to life important historical moments in the financial markets and provides contemporary traders and investors insight on how great traders make great trades.

“The Greatest of All Time” is a fascinating historical narrative on how big traders profited during financial market upheavals from one of the top business experts out there. It is for anyone interested in the history of trading and profit and for anyone looking to learn from some of the best traders in our history.

33


TRADERS´ TOOLS 33WEBREVIEW

Screening-Tool with IQ

FusionIQrank.comIt is the investors dream to choose only those stocks or ETFs among the thousands offered that promise the highest profits. At the same time it would be helpful to receive information if certain stocks or industrial sectors produce new signals. Other requirements: Screening should combine not only technical but fundamental criteria as well. Of course, all this should be affordable and easy to use. Wishful thinking? Not at all, the web-based software Fusion IQ Rank offers all this and more.

Screening Is the Magic WordInvestors and traders who are active in the stock market have the same goal – and that is to fi nd stocks that offer attractive opportunities to profi t. While some of them start the search based on technical analysis, others believe in the power of fundamental analysis. A combination of these two approaches would not hurt – quite the contrary! But the implementation of the screening is not quick or easy.

How about an All-in-One-solution that is ideal for everybody who trades on a daily basis and has only limited time? The US company Fusion Analytics Research Partners provides exactly this. Their online platform www.fusioniqrank.com offers a wide screening tool for thousands of stocks and ETFs that are listed at US stock exchanges.

The Best of Two WorldsWhat is the concept behind Fusion IQ Rank? The web-based software is a stock ranking system that – as the name implies – is based on the fusion of technical and fundamental analysis. Based on many key fi gures an in-house algorithm provides a quantitative ranking of over 8000 shares, industrial sectors and ETFs. Thus emotions and individual opinions are removed and the investor or trader gets a tool that offers the possibility to achieve higher yields than the whole market. On the technical side seven factors are used that are evaluated individually and build a scoring-number. Trend, money fl ow, short interest and the share of the institutionals invested are analysed and rated. On the fundamental side the focus lies on expected profi ts and cash fl ow. Both scorings are added

F1) Main Page

The Main Page can be created individually and offers a good overview of all information. In this precise example the watchlist and the portfolio are placed on the left side. Below you see the stocks with the biggest moves in ranking. On the right side the Market Risk Model is placed as well as lists with new buying signals, breakouts and single stocks that scored more than 90 points recently.

Source: www.FusionIQrank.com

34


TRADERS´ TOOLS

to one Master-Score that has a value between zero and 100. Thus, the user sees at one glance if a share is interesting or not.

The most important functions of Fusion IQ Rank are:

• Quantitative rankings of over 8000 stocks, industrial sectors and ETFs with clear signals (Buy/Hold/Sell)

• Trading Screen with overview of technically interesting stocks

• Chart Book: Slide Show-function for charts

• Portfolio with monitoring und alarm functions

• Watchlist with monitoring und alarm functions

• Individual screenings

On-Road TestThe core of the platform consists of three parts (apart from a research and charting item) that are introduced in the following. Under “Rankings” investors can retrieve rankings (updated daily) that are based on technical and/or fundamental criteria.

An example: An investor wants to fi nd individual stocks with the best overall valuation. With one click the list appears (see Figure 2). It is possible to make further limitations – for example, only technology shares with a buy signal are shown. If you want to follow this stock in the future, you add it to your own watchlist

with a single click. The top-down approach is easily implemented as well. You start with the strongest industrial sector and work through to the strongest titles.

A highlight for traders is the second menu “Trading Screens”. Updated technical signals are shown in table form. There are a lot of signals to choose from, for example breakouts, short squeezes, timing-signals, gaps or stocks with noticeable volume. A trader who, for example, wants to identify all stocks with a new yearly high gets a list ordered by subsectors that fulfi l this criteria. Signals from the past are shown in this table as well as information about performance, volume and short interest. If you want to take a closer look at one stock you just click on the ticker-symbol. The result is a report based on the stock. You can print all results, convert them into an excel-sheet or save them as PDF. And the best: you can also take a look at them in a slide show – a perfect feature to get a quick overview of the selected stocks.

The third part includes all individually adjustable features. The user can confi gure his main page, select certain main criteria (for example market capitalisation, liquidity) and manage his own portfolio and the watchlist. The best: the usual performance data is shown as well as the current rankings and their historical

change. Therefore you get very good insight into the current market situation and the various sector rotation. The alarm functions have to be highlighted as well. And for creative treasure hunters there is the screening tool that can be set up individually, but is tied to the rankings.

Pro-Tool for Everybody Interested in StocksThe screening tool Fusion IQ is a success all around. The user gets a modern, structured and time saving tool that enables a systematic choice of interesting stocks, industrial sectors and ETFs. The ideal confi guration and the ease of use invites you to do “treasure hunting” and analysis. Investors receive several investment ideas; traders can fi lter attractive candidates from a huge universe. The use of the watchlist and portfolio function is very convenient and helpful. The user is always kept up-to-date if the rankings of candidates in his portfolio change or if there are new timing signals. Therefore the software serves as a kind of early warning function. There is the slide show-function for fans of charting, that allows browsing through umpteen stocks within minutes. If you are interested you can apply for a free 30-day trial version (regular price: 49.95 USD per month) and let the software convince you of its qualities.

F3) Snapshot

You can choose one stock and then a snapshot is shown, that includes the scoring data as well as a short company description and a chart. The trading signals (buy/hold/sell) are shown in the chart.


F2) Ranking

Investors can fi nd interesting stocks that are updated daily and evaluated based on technical and/or fundamental criteria using the “Rankings“ menu. There are different rankings for stocks, industrial sectors and ETFs. After the fi rst evaluation the user can make further limitations, interesting stocks can be added directly to your own watchlist. A convenient view of all charts with slide show is possible as well.


http://www.fxstreet.com

Market Stages and Trading Strategies – Part 3

Stage 3: Mean Reversion

The S&P 500 has declined a few per cent off the highs of 1422 since the most recent article, Market Stages and Trading Strategies – Part 2, was published in April (TRADERS´ 04/2012). In the most recent article about up trending strategies, traders were to anticipate a possible trend change as the S&P 500 rallied into historical highs (supply zones). How do we modify the up trending trading strategies if the trend is weakening in the supply zones?

37


Tillie Allison

As an instructor for Online

Trading Academy, Tillie began

teaching following the fi nancial

disruption of 2007. Her goal is to

educate students on the

realities of the markets and to

teach students how to develop

a skill set to successfully trade

the markets. She is a member

of The Market Technicians

Association, The Certifi ed

Financial Planning Board of

Standards, has an Associates

Degree in the Applied

Science of Real Estate, and a

Bachelors Degree in Business

Administration.

F1) SPY Weekly Chart

Moving averages are used to determine the direction and the strength of the trend. The supply zone of 142.84 and demand zone of 136.07 are used to identify trading opportunities.

Source: www.tradestation.com

While the news reports focus on earnings announcements, debt, and other current events, technical traders focus on key price levels to anticipate where markets will likely change direction. Earnings reports have been good. According to briefi ng.com, over 70 per cent of reported earnings have beat expectations today, but that is actually below the almost 80 per cent rate posted so far this quarter for all companies. Overall, the S&P 500 rallied more than twelve per cent in Q1 of 2012 and on Friday, March 23, the S&P 500 closed negative for the week. Again, on Friday, March 30, the S&P 500 closed negative for the week suggesting that the S&P 500 was weakening.

Fund managers rebalance portfolios using tactical asset allocation models and technical traders use key price levels to determine where fund managers are accumulating (buying) and distributing (selling) a variety of global markets. Weekly analysis of the S&P 500 prepares technical traders in advance of

where fund managers are likely to rebalance.

As the S&P 500 climbed higher week after week (above the 50 SMA and above the 20 EMA on the weekly chart), technical traders rely on supply zones to indicate where fund managers are likely to distribute, signalling a trend change from an uptrend (stage 2) to a downtrend (stage 4). In Figure 1, the supply zone is identifi ed in advance and when the S&P 500 began to show weakness on Friday March 23, 2012, technical traders reacted by either protecting profi ts in long positions and/or selling short in stage 3 and stage 4 (stages defi ned in TRADERS´ 03/2012). Stage 1 is accumulation, stage 2 is an uptrend, stage 3 is distribution, and stage 4 is a downtrend.

Trading Derivate Markets on Smaller Time framesThe SPY is the most popular traded Exchange Traded Fund (ETF) and used primarily for portfolio management. After the S&P 500 declined more than four

38


TRADERS´ STRATEGIES

per cent off the weekly highs, technical traders use the demand zone to anticipate where fund managers will buy back in and/or cover short positions. Futures traders also analyse the SPY and the cash S&P 500 index to cross reference data. Cross referencing data means to use the analysis from the weekly time frame as a point of reference when analysing the daily chart of the same, related, or correlated derivate markets.

On April 5, 2012, the SPY closed below the 20 EMA on the daily chart confi rming a trend termination (stage 4 downtrend). In Figure 2, there are key price levels from the weekly chart and there is also a moving average for the daily trend. The demand zone of 136.07 is a very important level since it is a weekly demand zone. The demand zone of 136.07 was tested on April 10 and the SPY gapped up on April 11, confi rming the validity of the demand zone. Planning to buy in the demand zone using the moving average on the daily chart as a profi t target, is called, “mean reversion strategy”. Since the trade is using a weekly demand zone, the trade is in the direction of the primary (weekly) trend but the daily trend is down. The entry will be near the demand zone of

136 and the exit will be near the 20 EMA of 138.56 on the daily chart and the trade parameters will be identifi ed on smaller timeframes.

Strategy for Buying in a Weekly Uptrend and Daily DowntrendMean Reversion is a popular trading strategy. With the demand zone of 136.07 on the weekly time frame, futures traders

cross reference the data with the ESM12 (ES) to determine the parameters for a high probability trade in the futures market. Since the market is in a stage 4 on the daily chart, the 20 EMA is used as a dynamic supply zone and will be cross referenced with horizontal supply zones on an intraday time frame of the ES.

In Figure 3, the chart of the 240-minute time frame is used to cross reference and “fi ne tune” data points from the higher time frame. The 20 EMA on the daily chart is near 138.50 and the ES has a supply zone near 1385.50.

The demand zone of 136.07 on the daily chart is near the 1360.70 demand zone on the ES. With the demand and supply zones clearly labeled on the 240-minute chart, the high line of the demand zone is identifi ed as 1367.50 and the high line is used to plan the trade entry price. The “high line” is defi ned as the “proximal demand line” relative to the supply zone. The “high line” or “proximal

demand line” was identifi ed on April 17 at 8:00 am CST when the ES clearly traded out of the zone (labeled with a 1 in Figure 3). When the proximal demand line is identifi ed on the 240-minute time frame, the trader can plan to use that level

for an entry zone for buy orders the next time that price trades into the zone. As price drops into the zone trader will determine trade parameters including the entry price, the stop loss, and profi t targets.

Pullback Plan and ExecutionThe rally out of the proximal demand zone on April 17 reveals that there is demand (buying power) near 1367.50 on the ES. On April 19, price trades into the zone and the parameters for the trade are identifi ed on the 5-minute chart. It is very

F2) SPY Daily Chart

The SPY closed below the 20 EMA on the daily timeframe on April 17, 2012. This trend termination prepares traders for continuation of stage 4 and is used to trade the mean reversion strategy as price rallies from demand zones to the 20 EMA.


The trader must understand each

component of the plan in detail.

39



important to cross reference the data points to calculate the score of the trade. Trading with levels of “higher time frames” like weekly charts, daily charts, and 240-minute charts, increases the probabilities of success for the Intraday trader. The 5-minute chart helps traders minimise risk by determining what the low is as the market trades into the zone and out of the zone.

In Figure 4, the demand zone of 1367.50 was identifi ed in advance so there are no surprises when price drops into the zone at 2:40 CST.

Trade Details• Entry: 1368• Exit 1: 1373• Exit 2: 1376• Exit 3: 1381• Stop: 1365

Risk-to-RewardThe risk-to-reward parameters are determined on the 5-minute time frame. Although the demand zone was originally identifi ed on higher time frames, the 5-minute candles enable traders to reduce risks by placing the stop-loss below the wick of the candle on the 5-minute chart. The profi t targets are determined by the supply zones on the 5-minute time frame. The risk per trade for one contract of the ES is three points (1368 - 1365 = 3). The ES point value is $50.00. The total risk of $150 (3 points x $50 point value) is then compared to the potential reward for the trade. There is a potential of $650 (13 points x $50 point value) if the position is entered at 1368 and closed at 1381.

F3) ES 240-Minute Chart

The 240-minute timeframe shows the proximal demand zone of 1367.50. The proximal demand zone is used to plan trades.


Many traders apply a rule-based system to increase size during the trade while managing risks. There are also automated trading systems that are programmed to trade these moves electronically under strict supervision. The trader must understand each component of the plan in detail to properly monitor the mean reversion strategy.

ConclusionDetermining whether mean reversion is the right strategy for you will depend on a variety of factors. You may need training to manage the volatility as price trades into the zone. People get very confused during market hours if emotions kick in. We usually listen to live trading sessions when trading to make sure we are on target and following the plan. All of this hard work goes out the window if emotions interrupt the process. There are also online tutorials and quizzes available to help speed up and strengthen memory skills. Cognitive thinking skills are necessary to manage emotions and to execute the strategy successfully. Mean reversion (also known as counter trend trading) and trend trading strategies are applied to all markets. Specifi c parameters are determined for each market but the same rule-base strategy and process is applied.

Strategy Snapshot

Strategy name: Mean Reversion on the daily chartMarket selection: S&P 500 FuturesMarket tick value: $12.50Market hours: Regular and 24 hour sessionsIndicators: 20 EMA on daily, 50 SMA (Simple Moving Average) and 20 EMA

(Exponential Moving Average) on weeklyDemand zone: Gap up on daily chart & proximal demand zone on 240-minute timeframe

Supply zone: 20 EMA on daily chart and intraday supply zones on the 5-minute timeframe

Risk-to-reward: Risk less than 1/3 of profi t per trade Size: No more than one to two per cent of account value

F4) ES 5-Minute Chart

The 5-minute timeframe is used to determine intraday and swing trading parameters. The mean reversion trade was fi rst identifi ed on the daily chart as a swing trade and also traded intraday on the 5-minute timeframe.


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Examine the Power of Candlestick Reversal Patterns That Are also Bollinger Bands Outliers

Candlestick OutliersWhat is a candlestick outlier? It is the combination of a Bollinger Band Outlier while also qualifying as one of the candlestick reversal patterns. When price closes outside the Bollinger bands (more than two standard deviations) it is an event that happens only about four per cent of the time. Additionally, if the outlier is also a candlestick reversal pattern, this would lower the odds of an occurrence considerably and create a truly “Blue Moon Event” worthy of a speculator’s attention. However, by choosing to only apply this strategy to daily charts, it gives the speculator the luxury of scanning across the universe of tradable asset classes including stocks, forex and commodities increasing the odds of finding one.

42


Bruce Milbury

Bruce had the privilege of

having the last secular bear

market of the 20th century

(1966-82) teaching him the

perils of long term investing

early on; hence, a trader was

born! Due to that experience,

he has many insights on how

to survive and flourish in the

current secular bear market

that started in March 2000.

Excelling at class management

and meeting students‘ indivi-

dual needs are skills Bruce has

honed from numerous years of

classroom teaching.

LogicThe key to successful trading is to have an edge in one’s trade selection. Otherwise, it can feel like you are playing the ole shell game. The pea “was” there but not now. Successful speculators develop a screening process for their trade selection within an overall trade plan. Most platforms will allow a trader to scan Bollinger Band Readings. Outliers would, statistically, be negative readings for price below the lower band and readings above 100 for price above the upper band. All outliers are not created equal. First, if the outlier is not one of the candlestick reversal patterns it has little significance. Secondly, where the outlier occurs is very important.

Overall, the significance of the outlier is raised considerably if it occurs within a dip in an uptrend or after a rally in a downtrend. In a sideways market, reliable signals can appear in overhead resistance or down in support areas. Counter trend trades, although not the best scenario, “can” be effective at extreme levels – especially if the rally or drop is encountering old zones of resistance or support respectively. Lastly, a true outlier is “closing” above or below the

high or low bands, respectively. Preferably, the entire body is outside the bands. However, we will also consider “partial” outliers where just part of the candle was violating the bands but not closing outside them. Partial outliers are not the best situation, but still an edge to exploit.

Rules for EntryOnce the signal occurs as a total or partial outlier (former preferred) there are three possible entries depending on one’s level of aggressiveness. The most aggressive would be entering immediately as a swing trade risking the high or low of the candle pattern. Or one can wait for conventional confirmations of candle reversal patterns (not covered in this short article). Usually, confirmation would occur the next day or two. Day traders can look for entry the day after the signal by looking for a little technical confirmation on their intraday charts such as momentum breakouts of higher highs or lower lows or breakouts from intraday triangles, reversal patterns or even just the breaking of a trend line etc. Signals as mentioned “should” be of higher octane when preceded by an outlier.

F1) Soybeans Daily

The soybean continuation chart reveals over eight months of sideways activity, with multiple set-ups in a sideways market. Trade profit/loss will only be noted “if unprofitable”. See comments on trade entries 1-14 in the article.

Source: TradeStation

43



For the sake of simplicity risk is defined by violating the highs or lows of the candle pattern and reward is three times risk – making most of these candlestick outliers profitable. Either targets or stops exit trades. Of course traders may elect to extend the holding period in trending markets. Money management could also be tweaked with adjustments with stops before hitting the target level to lock in profits or create a break even situation. One Cancels the Other (OCO) orders are recommended.

Let us examine three different asset classes with three different scenarios: 1) A sideways market with soybeans (future). 2) An upward trending market with BMC (equity). 3) Lastly, a downward trending market with USD/JPN (forex; long U.S. Dollar/short Japanese Yen).

Figure 1: Soybeans Daily1. Short partial outlier of

shooting star.2. Short bearish engulfing partial

outlier – unprofitable.3. Bearish engulfing – barely

qualifies as outlier with both candle shadow just touching the bands.

4. Hammer partial outlier. Was preceded with a “complete outlier” but was not a candle pattern. Almost was a harami, but smaller white body needed to be totally inside preceding black candle.

5. Bullish harami as partial outlier.6. Hammer – partial outlier.7. Bullish harami – needed to be

patient to cash in on this one.8. Bearish engulfing partial

outlier.9. Bullish harami – nail biter that

paid off.10. Another bullish harami – barely

touching the lower band.

11. Bearish engulfing. Yes, the little body is the same colour as the big body (normally different). This is an accepted exception when smaller body is really small.

12. This is a total outlier of bullish harami and yet another exception. The smaller body is usually an opposite colour. When the pattern is in oversold territory for bullish harami – this qualifies and is called a homing pigeon – happens enough to make a note of it. As a bonus the little black body was also engulfed by subsequent white candle (Bullish engulfing Pattern). And the engulfing also was a partial outlier.

13. Spinning top – not truly a reversal pattern, but does indicate hesitation of the trend. Also, notice how the bodies are becoming smaller and smaller indicating a loss of momentum as the old resistance area from February is approached. Partial outlier.

14. Hammer – partial outlier and unprofitable. Notice how support area was violated with first closing low below it – paving the way for additional declines.

Figure 2: BMC Outliers1. Partial – bullish harami. Could

have been sold for profit as the gap was closed or at least

F2) BMC Outliers

One stunningly great set up with a dip in an up trending market.


Strategy Snapshot

Strategy name: Candlestick OutlierStrategy type: Buying dips and selling ripsTime horizon: Daily charts with swing holding timeSetup: Bollinger Band outliers; Setups come from the daily charts – looking for

overbought or oversold conditions for short or long positions respectivelyEntry: Candlestick pattern break outs on daily charts or follow up intraday trading

with bias from daily patternStop loss: Above the high or below the low of the candle patternsTake profi t: When position rewards 3x the initial riskExit: When stops or target are met as described in article

44



break even when lower low was made.

2. Partial – bullish inverse doji hammer (being aware of potential double bottom).

3. Partial – no candle pattern. No trade taken by this strategy. However, not to forget basic technical analysis, there was a significant declining wedge that could have been taken upon breakout.

4. Partial, but body totally outside lower band. This is just a doji not a major reversal pattern. However, it is a dip in an uptrend which is very good. Another interesting observation is the magnitude of change. Notice how the candles were getting progressively smaller indicating the selling is running out of steam with the doji, by itself, indicating hesitation of the downtrend.

Figure 3: USD/JPY Daily1. Partial outlier – bearish harami

which actually was a counter trend trade from prior price action (not shown).

2. Partial – Hammer that was also part of bullish engulfing. Counter trend that lost steam

at mean reversion of Moving Average (20).

3. Partial – bullish engulfing and counter trend trade that was a loser.

4. Barely touching the lower bands with this bullish harami.

5. Total outlier of spinning top

which is also part of a bearish harami.

6. Partial – counter trend piercing pattern.

7. Total outlier, but not a candle pattern. I would be inclined to take those that are flowing with the trend and this definitely qualifies.

8. Partial – hammer with long shadow on top. Count trend trade as loser.

9. Almost total outlier – doji hammer. Counter trend trade – loser.

10. Partial – hammer – counter trend trade as yet another loser. See a theme here yet?

11. Partial – not one of the reversal patterns, but small body is a spinning top

indicating hesitation of the existing trend (down) given extra credence by the high wave pattern just before it. The high wave boldly illustrates hesitation of the current trend. Buying above the shadow of the spinning

top would be the way to approach this for a little confirmation.12. Partial – as with many examples before this, we are looking at two different candle signals. The black bar engulfs the little white body before it forming a

bearish engulfing. The little white body is also a bearish hanging man.

13. Almost total outlier – hammer that is still working.

ConclusionConstantly referencing the daily chart and candlestick dynamics can really help deliver very profitable trades with high risk/reward ratios that can more than overcome many small losses for swing traders. For the day trader, paying closer attention to the overall daily patterns will provide (we believe) higher octane entries and exits. Regardless of style, any trader will see improved results by noticing candlestick outliers!

F3) USD/JPY daily

Multiple set ups in a down trending market with some of the countertrend trades working as well.


Any trader will see improved results by noticing

candlestick outliers.

Confirm Entry/Exit with Less Risk

Profitable Medium-Term Investment with Matching IndicatorsIndicators show buy and sell signals for a particular short period of time which generate maximum return out of a trade. This generally depends on the parameters of indicators which are applied by a trader or an investor for analysing intraday, daily, weekly or monthly charts. Standard parameters with standard indicators will provide successful trades with confidence.

46


Keyur Panchal

Keyur Panchal has an MBA

in finance, a Masters in

cost accountancy & finance

and is pursuing his CFA.

He has been working as a

Finance Research Analyst

in Ahmedabad, India. He

is also handling his clients’

portfolios using technical and

derivative analysis of market

movements to profit in any

kind of situation. Contact:

[email protected]

Price Line and Standard IndicatorsIn technical analysis, there are many indicators like MACD (Moving Average Convergence Divergence), Stochastic (full, slow, fast etc.), RSI (Relative Strength Index), William % R, Trix, Momentum, and so on. All of these indicators are analysed using the price line. There are three major standard indicators which are generally used for short, medium, and long term period i.e. MACD, Stochastic and RSI. But here we are going to learn how to get maximum reward out of the perfect combination of MACD and Stochastic.

In this article, we will analyse the most commonly used parameters for MACD and Stochastic i.e. twelve (fast), 26 (slow), three (signal) exponential averages for MACD and five (%K), three (%D) for Stochastic. The MACD indicator is primarily used to trade trends and should not be used in a ranging market. Signals are taken when MACD crosses its signal line. Whereas the Stochastic indicator consists of two lines; %K compares the latest closing price to the recent trading range and %D is a signal line calculated by smoothing %K. Practically, traders can change

the inputs for both indicators for long or short term view for any trade which means, the higher the parameters, the longer the view for analysis. In the general scenario, Stochastic vibrates more than MACD in a chart with standard parameters and gives a short term view to a trader.

Setup and Method of Getting View from Combination of MACD and StochasticAccording to general thought about crossovers, traders believe that a crossover below 20 or nearer (cutting upward) is the signal to buy or take a long position and a crossover above 80 or nearer (cutting downward), is the signal for selling or exiting the position (20 and 80 are the stochastic measurements indicating oversold and overbought respectively, for a stock).

Both MACD and Stochastic generate crossovers in the longer period time horizon. But what to do if one indicator is cutting upward and another is cutting downward at the same time or is nearer (one by one)? This may be the most frequently asked question of users of these two indicators. This event occurs several times in any stock. Here are some explanations of how

F1) EUR/USD MACD and Stochastics Crossovers

Figure 1 shows the MACD and Stochastic crossovers with price movement for EUR/USD in the 1-hour chart. Drawn rectangles are the indication of accumulation and correction with related indicators of an underlying.

Source: www.icharts.in

F2) EUR/USD Crossover Signals

Figure 2 shows the EUR/AUD 1-hour chart, which shows a crossover in Stochastic between the two crossovers in MACD.


47



to use both indicators and get the most benefit from them. If we draw MACD below the price line, you will see some good accumulation in a stock when the indicator is cutting upward or the crossover is below/near zero. The opposite is true on the other side, heavy selling pressure or profit booking can be seen while the indicator is cutting downward or the crossover is above/near zero. These events can be seen in Figure 1.

We will take MACD (12,26,9) and Stochastic (5,3,3) below the price line. The general difference between the two crossovers in MACD is 15 to 25 candles, and five to ten candles in Stochastic. Now, the main objective of this

article is to identify the small differences and locate exact entry and exit points for confirming results. However, this will not happen if a trader takes a long position and immediately hits a stop loss then the price line moves on to the target price. By putting MACD and Stochastic together below the price line, you will see two to three crossovers of Stochastic between two crossovers of MACD as indicated in Figure 2.

EntryThe right entry level determines the profit of a trade. In Figure 2, we can see some crossovers of Stochastic (points # 2, 3, 4, 5) which are between the two

crossovers of MACD (points # 1, 6). This shows that there are some correct entry and exit levels in Stochastic between points 1 and 6. If we check the trend between points 1 and 6, it is up and MACD also shows buy indications.

On the other hand, point 2 which is a sell signal of Stochastic occurred immediately after point 1 which is a buy signal in MACD. Here, a general scenario occurs: A trader will take a buy position at point 1 and makes a stop loss below two per cent or at the recent low level for the target of the next crossover from above zero in MACD. But in this case, its stop loss will be triggered because Stochastic is

F3) Entry and Exit Levels

Figure 3 shows the right entry and exit levels with the help of Stochastic and MACD. This event remains only for short term, as a result, traders should keep in mind to exit from the position.


Strategy Snapshot

Strategy name: Profi table medium-term investment with matching indicatorsStrategy type: Trend reversal pattern for short-medium period of timeTime horizon: 1-hour and daily chartSetup: Normal or increasing volume, no fundamental news and rumoursEntry: Entry at Stochastic crossover below or near 20 for buy position and above or near 80 for sell positionStop loss: Stop loss at level at recent three candle‘s lowest low for buy position and level at recent three candle‘s

highest high for sell positionTake profi t: Book profi t at immediate MACD crossover after entryTrailing stop: Trailing stop at cost to cost when gaining equal as pre-determined risk, with normal volumeExit: Exit with market price order at profi t booking price level if in profi t and putting stop loss at lowest low and

highest high and vice versaRisk and money management: Two per cent risk of margin accountAverage number of signals: Average number of signals is one out of 30 to 40 candles, if traded underlying has normal volumeAverage hit rate: Nearly 70 per cent success ratio if conditions are fulfi lled

48



indicating a sell signal at point 2 and then the price line reaches the target level. The trader should wait for a buy crossover in Stochastic after the buy signal in MACD. In Figure 3, point 1 and point 2 are not proper levels to enter the underlying but point 3 is the right level for opening a buy position because its low levels may hit the stop loss if the trader has taken a buy position earlier at point A in the price chart.

This strategy is only for short to medium term time periods. As we discussed earlier about first a buy and then a sell position, in the same way, a trader can first do a short sell and later cover the position i.e.

indicated in Figure 3, as points 7 to 10 in the indicator graph.

Position SizeA trader will take a large position if he is convinced about the trade. But if any news, rumours or some fundamental information come out, the price line will be highly affected and the trader may face huge losses. Hence, the position size should be determined as to whether it is a confirmed trade or not. Practically, a trader should not take risk more than two per cent of his margin account. So, the number of stocks = 0.02 * margin account / (difference between entry and exit levels).

ExitThe exit level measures the profit earned from the position. Only a proper exit plan will realise profit with less risk. In Figure 3, point D which is the crossover of MACD above zero, is the exit level if the entry level is point B in the price chart. In simple words, an immediate MACD crossover after entering the position will be the exit level. Only the most risk tolerent traders can speculate and open an inverse position against the MACD trend shown in Figure 3 as points G (entry) and F (exit) i.e. crossovers of Stochastic between two MACD crossovers (points 7 and 10).

The stop level is of the same significance as entry and exit points. For this strategy the recent three candle‘s lowest low level will be the stop level for a buy position, and vice versa, the recent three candle‘s highest high level will be the stop level for a short position. As a result, the trader will not ruin his portfolio should successive loss making trades occur. In calculation, risk = entry level - three candle‘s lowest low level for a buy position, and risk = three candle‘s highest high level - entry level for a sell position. The stop can be triggered if some unexpected fundamental

news, rumours from other traders or low volume in the underlying occur.

Review and OutlookThe objective of this article is to identify successful trades by combining MACD and Stochastic crossovers which are two of the most well known indicators in the world of technical analysis. With this article we can use and analyse both the indicators not only for oversold and overbought conditions of the stock but also for justifying making successful trades out of them. This strategy can be used in the 1-hour and daily chart.

Read in the next TRADERS´ July issue from 28. June 2012

COVERSTORY

Poker for Your Profi tsby Thomas WackerA successful poker player must know when he should push his stake, wihtdraw, or just pass. This is true for trading as well. However, here you do not look at the face of your opponent but have to make your decisions by means of technical analysis. The charts tell the trader what he has to do: waiting, entering or passing? Playing poker and trading have a lot in common, therefore it should be noted: poker for your profi ts.

PEOPLEMark MinerviniMark Minervini is one of America‘s most successful stock traders; a veteran of Wall Street for nearly 30 years. Minervini is featured in Jack Schwager‘s “Stock Market Wizards – Conversations with America’s Top Stock Traders”.

INSIGHTSThe Long Sought forby Mustapha AzeezUltimately, Holy Grail exists in trading and it is what this article is all about. Those who think the secret lies in a complicated trading system are wrong. Key is to keep everything safe and simple.

STRATEGIESTrading with Heikin-Ashi Chartsby Christian Kaemmerer Gradually the more or less familiar Heikin-Ashi charts fi nd their way into the world of trading. Let us have a look at the world of Japanese candlesticks and be convinced by its visual clarity.

http://tradersonline-mag.com/index.php/component/users/?view=registration

Low Risk, High Reward

Red-White-Red Pattern TradingPattern Trading can be a low-risk and highly profitable style. Ever-returning formations are easy to describe, and can be easily tested for their profitability. The pattern introduced here does not only awaken associations with the Austrian flag but might also fill up your cash box for vacationing. This article will show how we can use it to our advantage.

50


F1) Hammer

Figure 1 shows you two occurances of one of the simplest price patterns –the hammer. The market makes new lows in the course of the day, but recovers and closes near the opening. After the fi rst hammer, displayed in red, the market could build neither a new high nor a new low. The pattern therefore remained without consequence. The second hammer clarifi es how the idea should work. The market rises further on the day after the hammer and we go long on the high of the hammer and place the initial stop on the low of the hammer.


Price PatternsIn general, price patterns count as highly profi table investment strategies. You will hardly fi nd a trading professional who does not in some way or another integrate the conclusions he draws from recurring formations in his trading decisions.

The most famous pattern is probably the candlestick pattern “hammer”. It describes the behaviour of the markets in one day, and shows where and how the open/high/low/close is arranged in the price scale. This in turn allows us to draw conclusions about the market behaviour of the following day.

A hammer is a day in the downtrend, which might lead to a trend reversal. The day begins weak, but then the change comes. The market compensates for the lost terrain and closes near the opening. The chartist does not care about what introduced the reversal in the market direction. The only important thing is that the market removes itself from the daily low and closes where it had already opened. Figure 1 shows this candlestick pattern.

For the next day, this means the following: If the market is

able to continue rising and pass the high of the previous day, this is a strong bullish sign and we can think about a long position. If, however, the market begins to fall again and reaches new lows, the intraday trend reversal of the hammer was, after all, a premature strengthening of the bulls. In case we are already long, we should close our position at the latest at the low of the hammer.

Therefore, a pattern presents a good possibility of indicating exactly where to place the entry and exit stops. With known stops, it is possible to choose the correct position size – and, as we know, this is the key to a successful trade.

Red-White-RedThe red-white-red pattern includes three days total. It does not describe the market behaviour of one day only, but determines the precise sequence of the development of three successive days. The fi rst day of the pattern is a falling day, represented as a red candle in the chart. This negative day is followed by new lows and a short break; the market closes above its opening on day two of the

Philipp Kahler

Philipp Kahler studied Electrical

Engineering and has worked in

fi nance for many years. After

working as proprietary trader

at Bankgesellsachaft Berlin he

now developes and oversees

quantitative portfolios for insti-

tutions. He lives in Graz and

Berlin, and can be contacted at

http://quanttrader.com.

51



pattern. This day has to be the lowest low of the three days. On the last day of the pattern there is another negative day. The correction of the previous day is over, though the bears are not strong enough to push the price under the previous day’s low; the market has to trade above the low of the white candle, however close under its opening. In Figure 2 we see several examples of this pattern. The two upper charts show the DAX30 index, both lower charts show the S&P500 index.

The idea behind the pattern, as we can see in the chart, is that a trend reversal is imminent after these three days of indecision and today’s higher low. Whether this pattern is signifi cant enough, and how you could trade it, is what we will discuss next.

EntryWith this defi nition of the pattern, we know its setup. However, to be able to make money with such a pattern we have to decide exactly where the position should be opened, how large it should be, and when the position should be closed – hopefully with an appealing profi t. The pattern itself (and this is true for all sorts of patterns) is not a suffi cient reason to jump into the market immediately and build a position. First of all, the market has to confi rm the idea. It has to show

that the expected uptrend will follow the red-white-red pattern, which we have discoverd.

Only when the market exceeds the high of the last two candles, in other words when the bulls clearly have taken over, is it your time to enter the market.

When the market rises above this point and therefore makes a new high, one can no longer talk about selling pressure. The market seems to have made up its mind about direction after three days of indecision. In addition, the low of the white candle of the formation was confi rmed by the new high as a “swing low”.

In practice, you can make this entry with the appearance of this pattern by sending a valid stop-buy order to your broker on the high of the last two days for the following day. However, you should only enter the market if it has not already opened with a gap above the formation.

Position SizeParacelsus knew that the dose decides whether it is poison or medicine, and it is similar for us traders when we have to determine the size of the next position.

Before we think about how many stocks we should buy, we have to consider the point at which our trading idea proves false and we have to close the

trade at a loss. Hence, we have to defi ne our initial stop and therefore determine the point loss which is the maximum possible for this trade.

As an entry point we decide to enter the market as soon as it is clear that new highs are forming. If this new high proves a bull trap, and the market falls below the low of the white candle, it is clear that in this case the pattern has not worked, and we have to close our positions again.

Therefore, the span between the high of the last two days (= point of entry) and the low of the formation (= worst-case exit) is the risk that we take when trading this formation.

To determine the number of stocks we should buy from these two values, we remember the old money management rule stating that one should never risk more than one percent of one‘s trading account in a single trade. The number of the stocks we should buy therefore results from the equation: number of stocks = 0.01 x trading account / (entry level – exit level). This approach is visualised in Figure 3.

This ensures that we do not ruin our portfolio with several successive losing trades. On the other hand the position size is large enough to promote the development of our portfolio in case of a win.

F2) Price Pattern Red-White-Red

Figure 2 shows the appearance of the price pattern in the DAX30 and S&P 500 indexes. The red-white-red pattern is made up of a total of three days. The fi rst and the last day close below its opening, the middle day builds the lowest low of the triplet and closes above the opening rate. If the high of the previous two days is exceeded, another breakout to the upside can be expected after three days of indecision.


F3) Position Size

A possible entry into a long position at the high of the two last candles of the pattern. The worst-case scenario for the fi rst day is when the market takes the old highs, then turns and falls under the low of the formation (= stop point for the long trade). The position size results from the risk of the trade (28.60-28.04 = 0.56€) and the account size. In case you want to trade this pattern e.g. with a trading account of 10,000€, you would risk 1% of your capital when you trade 10,000 * 1% / 0.56 = 180 stocks.


52



ExitSo far I have shown how to recognise the red-white-red pattern, how large the position should be, when to enter the market, and where the initial stop should be placed. However, this will not have made us any money, but merely controlled our risk. In the next step I will show how to minimise our losses, let our profi ts run, and thereby trade this formation with a positive result.

The entry is usually only a very small step on the way to a successful trade: the money is made with the exit, and therefore the most consideration has to be put into this exit. When testing

this approach yourself, you will quickly see that you can combine this exit with different patterns and entries.

We can see successful patterns in the chart immediately ex post, so I want to show a few examples in Figure 4 where this pattern would not have worked. These examples are far more important for the development of the exit than those in which the pattern works as planned. From these we can learn what may happen, and we can then decide on the method by which we can get out of such negative examples with the least possible damage.

In cases where the market explodes after the appearance of the pattern it is not diffi cult to trade further (see Figure 2), we merely wait and count the money. More challenging are the cases where the market does not go up after all. Should we always wait until we are stopped at the low of the formation, or should we stop, with small losses, when we realise that it does not work this time, and that we had better wait for the next opportunity?

We have already talked about the fi rst exit: the initial stop at the low of the formation. The next exit deals with the scenario where we do not see the low of the F4) When It Does Not Work

Figure 4 shows you four examples where the expected sustainable uptrend did not follow the price pattern. Clockwise: In the fi rst example, the market could only take the high only one day after the appearance of the pattern. Thereupon, it stagnated on a high level. Example 2 shows the case that the market did get above the formation in the fi rst day, then however turned around and fell under the low of the formation. Example 3 presents a similar problem like in example 1: the market cannot decide for the uptrend. Example 4 is comparable to example 2, where the market turns after two days and starts to fall. An intelligent exit should be able to limit losses in such situations.


Your Point of Entry toFinance and Media Industry

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Ideally you are a practical trader and have considerable knowledge of technical analysis and all the related subjects like risk and money management, trading software, trading systems and trading psychology. You will work from home, on your own time-schedule and submit the webinars and seminars at specifi ed deadlines. You should be able to act on your own and have experience in presenting. You will not only present and moderate but also contribute content.

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53



formation, however neither does the market begin to rise. In this case we close the position if it is not in the plus two days after the entry towards the trading end.

The purpose of this is to eliminate the time risk. The longer we are in the market, the higher the risk that something will happen to our disadvantage. Originally the idea was that the market rises sharply after this formation. If this does not happen, our analysis may have been wrong. It is often better to close the trade, realising small losses, than to wait for our luck and be exposed to the risk of being stopped out with the worst-case scenario loss at the low of the formation.

Tests with the stock basket from the Dow 30 and the DAX30 show that with these two exits we will at the very least survive. This strategy does not generate money, but the losses are kept within a limit. However, this strategy can be improved.

With the second exit, the risk was further reduced and those cases where the market does not go up further were dealt with. However, one more risk remains to be considered before we think about making profi ts.

What if the market rises for a few days, but then turns, and starts to sink? This is what exit number 3 is made for. It is activated from the third day

onward, and closes the trade when the market falls back to the entry price. Although nothing is won by this strategy, nor is anything lost, and this is often a small victory in itself.

With these three exits, and the correctly chosen position size, we have risk under control as much as possible, and can turn our attention to how and when to take profi ts.

The fi rst exit to profi t taking is a simple profi t target. Here, the profi t is realised automatically when the trade has brought in three times the amount of the initial risk. The initial risk was the distance from the low of the white candle to the high of the last two candles of the formation.

We can also work with a lower target. This raises the hit rate in sideways markets, as the target is repeatedly triggered by accidental movements. This does, however, prevent larger profi ts during trend phases. This can be a clever methode when we already have a trend-following strategy in use, otherwise choose a target no smaller than double the original risk.

If the target is not reached within about six days, I try the exit at the high of the previous day. This usually brings a few extra points of profit compared to the possibility of closing the trade after a fixed time. It is also possible to not wait

F5) Exits

Figure 5 shows you different possibilities of getting out of a position. In the fi rst case, the position is closed after four days at the entry price. This prevented the exit at the low of the formation. Example 2 shows the lucky case of a time exit. Since the position was not in the win two days after the entry, it was closed. Example 3 demonstrates how reasonable a profi t target can be. The high opening was used for the exit since it was more than three times the original risk above the entry. In example 4, the position is closed after six days at the high of the previous day. The position size was chosen in a way that in every trade the same amount of money was at risk.


for a fixed number of days for this exit, but rather try and get out at the high of the previous day as soon as no new high has developed for one to two days. The exit at the entry price always stays active – just in case. In Figure 5 you can see what these exits look like in practice.

Review and OutlookThis article shows us a potentially signifi cant price pattern and a technique to use this pattern in trading. The technique can be exspanded in many ways, and can be combined with other formations and entry ideas. The exits introduced show the importance of bringing the risk of a trade under control as quickly as possible. We have to close all those trades which do not develop as intended. Not only does this apply to the losers, but also to all those cases in which the market only tends sideways after the expected breakout. Time is also a risk, and if the trade does not develop as intended, it is often best to accept small losses and wait for the next chance.

By now do you really still believe that the Austrian fl ag can predict the behaviour of the markets? Or is it rather the consolidated exit plan and the correct position size which are responsible for the profi ts?

http://www.network.mta.org

55

Most people have, at one point or another, been active in currency trading before – at least at a bank in order to prepare for the holidays by buying dollars, Czech or Swedish crowns and Hungarian forints necessary for their travels abroad. However, few private investors have dared to engage in currency trading as a possible source of income and as an activity for speculative purposes. This despite the fact that in recent years there has been a steady improvement in general conditions especially for small and private traders: An increasingly wider range of banks and brokers are offering currency trading, the trading platforms are becoming more and more professional and efficient, and trading is being made easier by convenient access via the Internet and by telephone as well as most recently even by using the mobile phone via Smartphone, iPad & Co. Furthermore, falling costs caused by stiff competition have resulted in forex becoming one of the most attractive markets for traders to be active in.

But currency trading is no exception to the initial question being raised, on what basis trading decisions should be made, and which parameters should determine entry and exit points. Fundamental and

technical analysis provide two competing, but complementary approaches designed to assist investors in their trading setup.

Technical AnalysisMost of the tools provided by technical analysis may also be used in currency trading. Classic chart formations like trend channels or resistance and support lines can be used for trend detection just as much as advanced techniques can, and indicators, oscillators, and candlestick patterns help determine the optimal entry and exit points.

Two Heads Are Better Than OneHowever, all the findings of technical analysis will apply only if the fundamental environment confirms and supports the technical signals and support. What is true of other asset classes may apply even more to currency trading. Even if the trading systems used and the trading decisions made are primarily or even exclusively based on the results of technical analysis, a basic understanding of the fundamental factors moving the currency market is of paramount importance. The fundamental influences, even on a short term level, are too strong to be completely ignored.

How to Keep Track of Things in Forex Trading

Fundamental and Technical Analysis of Currency MarketsForex trading is considered by many traders to be the pinnacle of trading with average daily sales totalling four trillion dollars. No other market is as liquid as that. As with all other asset classes, traders also have the opportunity to make their investment decisions on the basis of fundamental or technical analysis. This article is designed to show you which factors to consider when trading currencies.

56


Florian Erik Neinert

After completing his

information-science studies,

Mr Neinert worked as a

researcher in finance and

technology. For many years

he has been busy studying

the various aspects of trading

and speculation. Besides

technical analysis, the major

focus of his interest is on

the psychological aspects of

trading. Contact:

[email protected]

For Best Results, Combine Technical and Fundamental AnalysisAs is the case with stocks, futures and commodities, a combination of the two analytical approaches seems like an obvious choice: The general situation and the overall situation as well as the overall trend direction are identified by way of fundamental analysis while technical analysis is used to optimise the specific entry and exit points.

Fundamental AnalysisHow do exchange rates develop? Who decides how many dollars a euro will cost today? Clearly, as a largely unregulated off-exchange OTC market, currency trading is a free market and prices are established on the basis of supply and demand. If the demand for dollars is high among many participants, the price of the dollar will rise. However the fact remains, that is not all there is to it, due to a peculiarity of the asset class FX: Unlike, for example, equities or commodities, there will always be two elements in forex trading that are traded at the same time: the base currency and the currency traded. So you can speculate on rising dollar rates by buying dollars and selling euros at the same time. If both the dollar and the euro are in demand, the logical consequence may be that

there is hardly any change to the EUR/USD exchange rate.

Exchange Rate Regimes and Central Bank InterventionsAnother constraint on unrestricted currency trading is imposed by governments and central banks issuing each currency. Certainly not all countries in the world allow their currencies to develop freely and do so exclusively on the basis of the forces of supply and demand. In this connection the German Bundesbank makes a distinction between ten different types of exchange rate regimes – from currency boards with unilateral exchange rate pegs (for example, Hong Kong’s peg to the US dollar) to conventional systems with fixed exchange rates (the currencies of many Arab countries are pegged to the US dollar, some African countries to the euro) and stabilised exchange rate regimes (China, Vietnam) to countries with freely floating rates. But even in the latter, most market oriented system, governments and central banks often keep the option of interventionist action open.

Key Interest RatesIn addition to the direct purchase or sale of their own currencies, central banks often use the key interest rates to keep the exchange rate within an intended range. The higher the key interest

rates are, the more attractive the currency is for foreign investors investing their money in the local currency at high interest rates, causing high demand to develop. Here the key interest rates impact both the overnight rates of the banks and fixed interest securities.

Foreign Trade and Capital MovementsBesides the interest rate level of a country, the size of its foreign trade has a significant impact on the value and development of its currency. A summary of statistics on this can be found in the so-called “balance of payments” with two subcategories being of particular interest to currency traders:

The capital account measures the cross border financial flows while the trade balance represents the value of the goods and services that are imported or exported. Among other things, capital movements include direct

investments (a German company building a new manufacturing facility in the United States or an American company buying shares of a German company), and securities transactions (a German investment fund buying shares of a Brazilian joint-stock company or a Chinese sovereign wealth fund buying a stake in a German corporation) as well as loans from countries, financial institutions and other lenders. By contrast, the balance of trade records the volume of foreign trade. A large part of this cross border trade has the actual trade in goods usually complemented by a currency trade designed to exchange the foreign currency revenues achieved abroad for the local currency or to allow goods ordered abroad to be paid for in the currency that is legal tender there.

There are also hedging transactions used by companies that want to protect themselves against possible future changes in

Info

Typically, central banks intervene whenever the money supply, inflation or other conditions that are generally considered to be important undergo changes that are detrimental to the country. Japan had long been known for intervening to keep its yen artificially low – for the good of the country‘s export oriented industry, which enabled it to sell its goods cheaper in the world markets. The Japanese central bank managed to keep the yen weak by continually buying dollars for yen, causing demand for the U.S. currency to increase in comparison to its own.

57


TRADERS´ BASICS

the exchange rate that work to their disadvantage. The more closely a country is tied to other countries by trade and capital transactions, the higher also is the forex volume of its currency, usually. And indeed, the largest economies in the world also boast the currencies most commonly traded in the foreign exchange market. The only exception to this rule is provided by countries with strict exchange rate regimes, as has already been noted above.

Economic and Political EnvironmentCapital is as timid as a fawn, as the saying goes. Whenever there is a worsening of the political or economic conditions of a country – or such a deterioration is only anticipated –, investors are liable to withdraw their capital. As a result, the value of the currency concerned will decrease. As regards economic stability, one should keep an eye on the price index, gross domestic product and unemployment rate. And although the degree of correlation between equity and currency markets is usually considered to be low, it is still useful to follow the price trend on the stock markets because it is especially during stock market crashes that a significant reaction in exchange rates can be expected.

The fact that natural disasters have an impact on the financial

markets was clearly visible to investors in Japan, for example. In addition to the stock markets, there was a significant reaction of the yen’s exchange rate to the news of the earthquake, tsunami, and impending nuclear disaster. In the first few days after the quake, the yen initially made significant gains against the euro, but fell again later.

There is an even more sustainable influence on exchange rates when the following factors come into play: An increase of the political imponderables of a country, for example, as a result of laws restricting personal and entrepreneurial freedom, lack of independence of the judiciary, rampant corruption, increasing governmental arbitrariness, and diplomatic or even military conflict with neighbouring countries. In such cases, not only short term oriented speculators but also long term investors such as investment funds, hedge funds, businesses and banks will withdraw their capital from the country concerned.

Deadlines, DeadlinesEspecially prior to important publication dates, there will be a great deal of movement in the forex market, which is particularly the case whenever interest rate decisions by the central banks are pending but also upon the

release of the latest economic figures. There are many traders specialising in this kind of news trading. Beginners, at least, should engage in news trading with caution though, as large price movements are possible – not only during the release of the data but even in the days and weeks leading to such a release.

ConclusionExchange rates are significantly impacted by central bank policies, the key interest rates, the economic and political development as well as by the volume of trade and capital transactions with other countries.

Make sure that you keep track of exchange rate related news. Be prepared for news and release of data. Know the dates of central bank meetings, make an educated guess of how the decisions could turn out, read between the lines, (for once) pay attention to the assessments made by experts, and position yourself in advance. Use the chart analysis to check and see where the support and resistance lines are and where limit and stop loss orders may be placed. Also, watch out for round prices that are, consciously or unconsciously, used by many market participants as a reference mark (“anchor“) and where the price remains “stuck“ even for no particular reason.

F1) External Factors and Exchange Rates: EUR/JPY

The earthquake, the tsunami and the threat of a nuclear meltdown in Japan led to a violent reaction in the currency markets. When the news increasingly indicated that a meltdown was approaching, the yen strongly appreciated against the euro initially, but later was again down significantly.

Source: www.tradesignalonline.de

58

Competence and Confidence

Smart Trader’s Edge – Part 3

The Smart Traders Edge articles are not specific buy or sell triggers. They are techniques and alerts to help determine high probability trading opportunities. This issue will focus on the competence and confidence needed to identify and act when opportunities exist to enter into a high probability low risk position.

From our previous articles (TRADERS´ 01/2012, 02/2012), we understand that trading is actually very easy and because it is so easy the market purposely provides excessive information in order to maintain a level of mystique so that those not properly educated will remain confused. That statement may seem harsh or contradictory but the undeniable truth is confused traders are the necessary contributors from whom the properly educated derive their gains.

Properly educated in trading means you understand and apply the KISS (Keep it simple, stupid!)-Principle, that less is more! Less complicated and simpler trading techniques usually produce more consistent and far better results.

59


Bert Antonik

Mr Bert Antonik is a retired

US Navy Commander and

senior instructor for Online

Trading Academy who brings

over three decades of trading

knowledge and experience to

his classroom presentations.

For more information, go to:

http://www.tradingacademy.

com/about-us/instructors/

Bert-Antonik.aspx

This months’ Smart Traders Edge will try to explain why competence alone will not result in consistent gains. The challenge is to have the confidence to act without procrastination. An even greater challenge for some traders is to accept concepts that conflict with what the market preaches. The best way to illustrate this is to share a recent experience.

It Cannot Be That EasyYou may recall from the last smart trader‘s edge article, whenever a price is involved, supply and demand will dictate valuation at any point in time. If there is more supply than demand, price must fall. If there is more demand than supply price must rise. If there is a balance between supply and demand price stays within a stable range. It then becomes a matter of simple logic to realise that if price exits the stable range very quickly many traders will be taken by surprise. Sometimes miracles do happen and the unexpected move will result in a windfall. More often than not, an unexpected and not anticipated strong price move results in a loss. The trader that learns to identify where the demand and supply levels are and has the confidence to take the trade will usually come out ahead of the game. It really is that easy.

How Do We Demonstrate Competence? Step 1: Have a PlanIt was about 15:30 in Singapore and the author was getting ready for a traders workshop that was scheduled to begin at 19:00 that evening. When talking about trading during a workshop, he likes to actually demonstrate live trades based on the supply and demand trading strategy defined in his trading plan.

Step 2: Follow the Trading Plan Because at 19:00 in Singapore the only live tradable market is Forex, the author looked for a trading opportunity in the EUR/USD currency pair using the following routine, see Figure 1.

a) Determine the closing price of the prior day. In Forex that would be the last trade just before 5 PM New York time. Draw a horizontal line, the green line in Figure 1.

b) Determine the daily ATR(15). Add and subtract the ATR (Average True Range) to and from the prior close. This defines the likely maximum high and low for the current trading day. If price approaches either the max high or max low there is a high probability it will change direction. There is an even greater probability if the level also falls within a supply

F1) EUR/USD Pre-Trade Set Up Routine

a) Prior day close; b) ATR levels; c) Demand Zones; d) Day high/low ATR extensions; e) Stop, entry and target levels.

Source: www.esignal.com

60


TRADERS´ BASICS

or demand area plus other traders edge layers.

c) Determine supply and demand areas within the high to low ATR from paragraph b) above.

d) Plot the current day low plus ATR and current day high minus the ATR. This is done each time a new current day high or low is made. Now we know where price may reverse within the high to low ATR from paragraph b) above. Again, look for layers of multiple conditions to increase probability and improve your edge against other traders.

e) Place the stop, entry and target orders based on high probability supply and demand areas particularly if the area is enhanced by additional traders edge layers.

f) Wait to see the results! Wait to see the results! Wait to see the results! No typo here, the plan is to, Wait to see the results!

At about 18:30 the first

workshop attendees arrived. The discussion centred on whether it was possible to anticipate,

with a high degree of accuracy, where price was likely to change direction. Traders who do not understand the market timing strategy based on the universal law of supply and demand will always say that there is no way to accurately anticipate, with a high degree of probability, where price is likely to change direction.

After being presented with the 15:30 screen shot, Figure 1 above, the focus immediately shifted to the live market. During the first 30 minutes and by the end of the workshop, attendees recognised that market timing is possible.

Now let us focus on the result of the trade placed into the market at 15:30 earlier that day.

How Do We Demonstrate Confidence?The consistently profitable trader is both competent, knows what to do, and is confident, knows that he or she knows what to do and does it. Placing a live buy limit trade into the market at 15:30 required competence, knowing how and what to do to establish

a low risk high probability trade. But, the confidence to actually take the risk and enter the trade comes first from a willingness to accept the market timing strategy and then consistently repeating an objectively defined process that produces positive results.

From 18:30 to about 19:00 attendees were repeatedly asked if they would consider going long. Not one was willing to take the long trade. All were surprised when price did exactly as anticipated. Take a look at Figure 2.

Just after 19:00 the pending limit buy order was filled and simultaneously the predefined stop and initial target were placed by the charting platform. Price moved sideways and then quickly rose to the first target. After a pullback into the demand area price again moved up all the way to the second target. Obviously the rest of the workshop discussion focused on how to recognise supply and demand areas in order to implement market timing trading strategies.

Once competent at objectively identifying supply and demand on a chart and applying rule based market timing strategies that consistently result in profits, it should come as no surprise that a trader’s confidence will also grow. The end result is that when traders trade with competence and confidence it puts money into their account.

F2) Trade Results That Surprise the Naysayers

Market timing produces another low risk high probability profitable trade.

Source: www.esignal.com

What is the Smart Trader‘s Edge?

To gain a Smart Trader‘s Edge, Market Timing Traders use Technical Analysis Techniques to focus on the fundamental law of Supply & Demand in order to make High Probability, High Reward and Low Risk trades. (For more information on “Market Timing Trades” based on Supply & Demand go to OnlineTradingAcademy.com)

61

Use Seasonality to Improve Your Portfolio Performance

Vivaldi Revisited: The Two SeasonsSimilar to human behaviour, financial markets have their ups and downs (read ‘cycles‘). When markets are roaring, price retracements are seen as normal and are a healthy sign for the trend. People buy on dips anticipating that the future looks bright. But in bear markets, the tide leaves many swimmers naked and the view is far from nice. During these times, the buy-and-hold strategy is a nostalgic story. Both traders and investors must find other strategies for better timing across various time frames. Traders (may) have access to rule-based black boxes, swing trading, or day trading. What is left to investors? Entries and exits based on seasonality are an option to consider very seriously. This article will show how investors can use simple seasonality ideas to improve portfolio performance and gain more confidence. At the end of the day the basic question which must be answered is “Do you want to eat better (trader) or sleep better (investor)?”

are removed from the analysis. A stunning final capital of $987,120 shows that for capital growth an investor must avoid lethal blows.

These findings highlight that 1) some periods are (far) better than others in terms of investing and (2) the focus should be on risk and capital management.

A Plain Vanilla TestHow real and effective is the adage “Sell in May and Go Away”? To answer this question we slice the year into two periods: May 1 to October 30 and November 1 to April 30. For each period we run a buy-and-hold test for the S&P 500 and the DAX and look at the results.

For these tests on daily data the following rules apply:

• For May 1 to October 30Buy at close on May 1 or the next trading day if May 1 is a non-trading day

Not All Trading Days Are Made EqualThis truth may be known already but a study made by Birinyi Associates for S&P 500 for the period February 1966 to October 2001 reveals some alarming realities about buy-and-hold in various situations.

For an investor holding tight during the entire period, $1000 translated into $11,710 at the end (S&P 500 investing is hypothetical but helps make the point).

Each year has its best and worst days. The same buy-an-hold strategy is applied to the same period after eliminating the best five trading days of each year. The result? $150 left, a drop of -85 per cent. The conclusion is simple: If you miss, as an investor, the best days during the years, you should look into something else than investing.

Finally, the third scenario applies to the same period but the worst five days of each year

62


Dan Valcu

Dan Valcu is a Certified

Financial Technician (CFTe),

Board Member of the

International Federation of

Technical Analysis (IFTA),

Founder and technical

analysis consultant with

Educofin Ltd, and a private

trader. He is the author of

the first book on Heikin-Ashi

“Heikin-Ashi – How to Trade

Without Candlestick Patterns”.

For more information visit

www.educofin.com.

Sell at close on October 30 or the next trading day if October 30 is a non-trading day

• For November 1 to April 30Buy at close on November 1 or the next trading day if November 1 is a non-trading daySell at close on April 30 or the next trading day if April 30 is a non-trading day

For the S&P 500 the coverage is January 3, 1950 to April 18, 2012 and for the DAX the coverage is January 2, 1991 to April 18, 2012. Commissions and slippage are not included.

The results shown in Table 1 are astonishing (for many) but they highlight the benefit of slicing the trading year into two equal periods with a clear advantage when staying invested during May 1 to October 30 in both the American and German primary markets.

The American market offers gains during both periods with November to April showing a gain of 4111 per cent during the period covered by S&P 500. The German market shows a different pattern: A loss of 46 per cent during the least favourable halves of the trading year (May to October) and a gain of 615 per cent during November-April since 1991.

The immediate conclusion is that in both markets, the period May to October does not invite

investors to embrace the buy-and-hold strategy. On the other hand, November to April is a gold nugget (statistically speaking) and has its merits deserving the patience to wait.

Seasonality and MACDThe previous tests showed that market index performance was far better during November to April than May to October. They did not include any technical indicators which may have improved the financial or/and emotional performance. Technical analysis offers a wide range of indicators and we chose the Moving Average Convergence-Divergence (MACD) due to its inherent ability to highlight trends.

The next question is “Can MACD add more value to the index performance during October to April?” (Note: the word value can be translated into financial gains/losses or/and improved confidence.)

The rules applied to daily data are changed now:

Buy at close during either October, November, or December and MACD(20,50) crosses above its signal line(15) or is already above it.

Sell at close during either April, May, or June and MACD(20,50) crosses below its signal line(15) or is already below it.

The results shown in Table 2 are in line with the previous

T1) Buy-and-hold Summer (May - Oct) and Winter (Nov - Apr) Seasonality

Comparison between buy-and-hold in the US and German primary markets during two different periods of the trading year.

S&P 500 May - Oct Nov - Apr DAX May - Oct Nov - AprStart capital (units) 100,000 100,000 Start capital (units) 100,000 100,000

Net profit % 40.22 4111.21 Net profit % -46.07 615.15Annual return % 0.8 9.24 Annual return % -2.86 9.67

# of trades 62 62 # of trades 21 21# of winners 38 46 # of winners 12 16

Max system % DD -51.02 -36.24 Max system % DD -71.66 -37.20Profit factor 1.13 4.14 Profit factor 0.65 4.67

T2) Buy-and-hold Winter Seasonality Taking into Account MACD Signals

Comparison between buy-and-hold in the US and German main markets taking into account a technical indicator (MACD(20,50,15)).

S&P 500 DAXStart capital (units) 100,000 Start capital (units) 100,000

Net profit % 4704.27 Net profit % 621.57Annual return % 9.58 Annual return % 9.72

# of trades 62 # of trades 21# of winners 47 # of winners 16

Max system % DD -41.02 Max system % DD -39.02Profit factor 3.61 Profit factor 5.37

great results generated during November to April.

Final ThoughtsSeasonality in the financial markets is already known and used in various markets and time frames. The ideas exposed in this short article relate to investors and can be used by each of them to stay longer, safer, and with increased confidence in the stock market (US and Germany). When not invested

in the stock market, an investor may look at other ways to put the capital to work or, simply, can wait for the next favourable window. These findings can also be used as a filter for rule-based strategies aiming for more frequent trading.

The bottom line is to consider seasonality a reality, know about it, and use it to your advantage to squeeze more juice out of the fruit that may appear dry at certain times.

http://www.affinitytrading.com

64

Stephen Temes

Striking out on One’s OwnUntil 2001, Mr Stephen Temes worked as a trader for Wachovia (Wells Fargo), having enjoyed a brilliant career even before then. Following the terrorist attacks of 11 September and the crash of the market, he decided to quit his 16-hour work days and take a long break. After spending some time in the Caribbean he became bored, causing his interest in trading to be rekindled. So he returned to New York and founded the proprietary trading firm Lincoln Capital, which he ran on his own at first. Over the years, he hired other traders as partners, expanding his company to include as many as 14 traders with offices in New York and Miami. Marko Graenitz met Stephen Temes for an interview during Traders Expo in New York. Enjoy a top-notch trader’s story and his ideas!

TRADERS : Could you please tell us how you got into stock-market trading in the fi rst place?Stephen Temes: I grew up in Kentucky and attended Tulane University in New Orleans, majoring in business. Even then I took a great deal of interest in the stock market programmes on CNBC. After I graduated, I knew exactly where to go next: New York City. I was chasing a dream, and that was working on Wall Street. However, I did not know then what that meant and had no

contacts either to find an entry-level job at a big company.

TRADERS : How did you manage to get by in New York under such unfavourable circumstances?Stephen Temes: It was tough initially. I did not have an apartment of my own and had to apply for any kind of job. I quickly realised that an aggressive approach was needed here, so I bought myself a decent suit and began to cold call one broker after another. Finally I got lucky

and landed a job at Butcher and Singer on Wall Street. After a short stint there I moved on to Oppenheimer, where I got my first big break as it were, having been all but ready to give up in view of the difficult circumstances prevailing then.

TRADERS : How did that break happen? Stephen Temes: I got a call from an insurance company that wanted to talk to our options department. I had the presence of mind to respond by saying,

65


TRADERS´ PEOPLE

“You are speaking to the options department.” At this point, I practically created the options business at Oppenheimer out of nothing and went on to expand it steadily, eventually even becoming a partner of the company. Later on, I left to go to Wachovia and you know what the rest of the story is.

TRADERS : How can young traders get into proprietary trading?Stephen Temes: Actually, it does not matter how much money you have – all that matters in trading is discipline. However, in order to get into professional proprietary trading if you do not have enough equity yourself, you first need an excellent track record. For example, I am extremely picky myself when it comes to hiring new traders. Once you have managed to be part of a team of traders, it is important to learn from the best and most experienced traders in the team. Trading is a combination of statistics and experience, and that is what matters.

Stephen Temes’s phone rings. He talks briefly to one of his traders about the open positions

on the market before we continue with the interview.

TRADERS : You have just been on the phone, how are your positions doing on the market today?

Stephen Temes: One of my traders is monitoring my positions, giving me an update from time to time while I am here at the Expo. I have complete trust in him. We have just discussed making slight adjustments to one of my positions, but the market is reasonably quiet today.

TRADERS : Can you remember your fi rst few trades?Stephen Temes: Yes, absolutely. I started with options right away because I had little money and therefore needed good leverage

to make it all worthwhile. A family friend was working for a broker and therefore in a position to give me good conditions for my trades, so I was not overwhelmed right away by the transaction costs. My tactic was to watch the

ticker tape indicating current prices and then figure out good trading opportunities on that basis. Those were the good old days when options were often priced wrong and it was still relatively easy to make a good trade.

TRADERS : Did you witness the crash of 1987?Stephen Temes: Yes, that was really hard. I had been on Wall Street for barely a year when

it happened. I saw experienced traders crying. Something like that leaves a lasting impression as a reminder of the risks involved in trading.

TRADERS : And did you do any trading at all during the crash?Stephen Temes: I clearly remember that I bought Pepsi shares on the day after the crash and that I sold them again after a short time as the market recovered. However, I did not know what price I had got – I only had that in writing three days

F1) Positive Surprise at Caterpillar

F2) Cummons Stock on the Watch List

In January, the Caterpillar (CAT) long position performed very well. In late January the company reported quarterly results that were a positive surprise, justifying the previous price increase.


Stephen Temes kept track of the Cummons share on his watchlist. If it meets the screening criteria next time, a long trade will be called for.


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TRADERS´ PEOPLE

later. Just imagine that, not until three days later!

TRADERS : How would you describe your trading style today?Stephen Temes: I am a very aggressive trader. I usually have a core position around which I trade all the time. So I increase or reduce my position depending on how my assessment of the stock changes. And if there is a complete change in my assessment, I also sell the core investment. This approach spared me a lot of losses in 2008 because I did not hold on to bad trades during the market slump.

TRADERS : Which indicators do you pay special attention to?Stephen Temes: The first thing I always look at is the chart. That is the most important thing. In a more detailed analysis I also look at indicators such as the 50-period moving average, the Relative Strength Index (RSI) or the stochastics.

TRADERS : How do you select the best trading opportunities from the multitude of stocks? Stephen Temes: I have a colleague programming my criteria for me. This scanning process then filters out all the appropriate setups for stocks and exchange traded funds (ETFs). Depending on the chart,

market situation and fundamental assessment, I then decide in a discretionary manner which filtered stocks to actually trade.

TRADERS : So you include fundamental data in your trading decisions as well?Stephen Temes: Basically, I do. Ideally, there is a clear price movement and I can identify the catalyst early. In principle, anything can act as a catalyst – acquisitions, important upcoming events, clear estimates by analysts and so on.

TRADERS : Can you give us an example of a simple technical fi ltering criterion?Stephen Temes: A very simple concept that has always worked well is the retracement towards the 50-period moving average. I can tell you that many traders watch out for this indicator. When prices break above the average line and a pullback forms right up to the line later at low volume, then this is a very good entry. It sounds really simple, but just look at a few charts of strongly trending shares according to this criterion.

TRADERS : How exactly do you enter your trades?Stephen Temes: In general, my rather large position size does not allow me to just open my positions all at once. Besides, it is

mentally easier to build a position over several hours or over the course of a day since on the whole you never buy at the high (though never at the low either). I use an algorithm that executes my orders over a certain period of time. The algorithm is based on the volume-weighted average price (VWAP for short) to execute each order when price-volume relationships are favourable.

TRADERS : How many positions do you hold concurrently?Stephen Temes: Long and short positions combined, eight to ten on average. During bad periods, I sometimes only hold four positions, and in very good times up to 20. Traders with little capital should hold correspondingly far fewer positions at the same time. Usually it is best to have just a few well performing trades where you get a sense of the movement behaviour of the stock. I think it is a mistake to have too many positions.

TRADERS : What do you look out for in the stops?Stephen Temes: I always have hard stops at key chart markers of the market. Everything is based on my risk management. If things are going well for me, I use trailing stops in order to use the “money in the market” to bet on even higher profits. Sometimes I then exit in a discretionary

F3) Las Vegas Sands for $2.90

F4) Good Timing at FCX

In the case of Las Vegas Sands (LVS), Temes managed a near-perfect entry at 2.90 dollars, making it one of his best trades ever.


Here, too, Stephen Temes caught the stock after its final low. The bull market in the spring of 2009 quickly drove the stock markedly higher.


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TRADERS´ PEOPLE

manner if the behaviour of the stock changes or key chart markers are approached.

TRADERS : Do you have something like a time stop?Stephen Temes: Yes, if the stock initially does not perform as expected, I will exit as soon as possible.

TRADERS : Can you remember any particularly good trades?Stephen Temes: Many of my best trades I made right after the major downward movement of 2008. I well remember buying the Las Vegas Sand (LVS) stock for a mere $2.90. Also, Freeport-McMoRan Copper & Gold (FCX) for 16 dollars.

TRADERS : Can you give us an example where you had to close a trade with a loss?Stephen Temes: Obviously this happens, too. For example, last year I underestimated how much prices of treasuries can increase. I went short in summer 2011 when there had been a decent rise, but was then surprised by a further upward movement of quotations. I did not think that bonds could rise that far (i.e. interest rates would fall that far).

TRADERS : Which stocks or sectors do you consider to be particularly risky?Stephen Temes: Obviously, biotech stocks most of all. That is where I was once affected myself. I was long on a biotech

stock hit by allegations of fraud against the management, which is always bad. Basically there is also an inherent risk in the binary character of alternative developments. If a biotech company is essentially just developing a major drug or something similar, its price reaction, for example, to any news about the approval process will be highly volatile. In the end, it will come down either to the drug “being okayed” or “not being okayed”. Either way, there will be massive price movements,

F5) Misjudgement of U.S. Treasuries

F6) Out of Favour

Temes had not expected bond prices to rise further in 2011. The short trade went underwater although it had opened at an already high level.


A prime candidate for Stephen Temes‘s long list is Bank of America stock (BAC). “I like those stocks that are really totally unpopular. Once the right moment is there, I will pounce.” In March 2012, about a month after the interview, the stock enjoys a high of more than ten dollars.


usually with large gaps. From a risk-management point of view this is, of course, less than desirable. By the way, this could – in a diluted way – also apply to major stocks such as Johnson & Johnson (JNJ) if they were

sued, for example, on account of one of their major products. Shares with such a risk profile should therefore be treated with caution.

TRADERS : What other principles do you use in trading?Stephen Temes: The primary goal is to control the risks, i.e. to trade in such a way that you can still play the following day. I want my trades to be – relatively speaking – among the

first to be in on a movement. And I want to be among the first to be flat again. To a degree, all good traders sell too early, and shares often continue to perform well a lot longer. But getting out too early still beats exiting too late. Otherwise I stick to keeping at least some short positions in weak stocks even during good market phases and, vice versa, at least a few long positions in relative-strength stocks during downward phases. The reason for this is that this means that I am “automatically” moderately

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hedged as far as market direction is concerned. However, I do not force any trades – that is, I will only trade a setup if, on average, I benefit from it. Sometimes, though, I need to muster a great deal of patience for that.

TRADERS : What does your daily routine look like?Stephen Temes: I usually get up at 3.30 am in order to see how the European markets are doing. I then go back to bed again to get some sleep. Despite years of experience I still have sleepless nights, but I think this is important – it is a sign that I am focused and fully committed to my job.

At 7.15 I am usually the first one to show up at the office. My favourite time for doing research is in the morning. From 9.30 to 4 o’clock in the afternoon I trade on US markets. In general, I will be out of the office by 5 pm.

TRADERS : What are the biggest mistakes that traders and investors keep making?Stephen Temes: If you have a bad trade and for some reason do not exit it, then this is a disastrous error. Doing a “part-time job” as a trader is also problematic since you keep having to do something else as well. Either you do this the right way or you do not do

this at all. And then people make the mistake of not working hard enough to keep improving. Also, I think that most people like buying stocks that are fundamentally rated “favourably”. In my view, however, this is of no benefit to anybody.

TRADERS : What is the biggest problem in professional trading?Stephen Temes: If you own a proprietary trading company with several partners – but also when managing other people’s assets in a hedge fund – the biggest problem is the residual risk in risk management. This has nothing

to do with the question of stops and position sizing in general. The actual risk is individual traders who can really mess things up, the so-called rogue traders. Examples of this have occurred time and again at major investment banks, but in principle it can happen anywhere.

TRADERS : Can you describe for us the rogue-trader risk in more detail?Stephen Temes: A classic example is a trader who exceeds his exposure limits in a big way when trading on behalf of a trading firm or a fund and does so without any of the internal

monitoring systems noticing anything. This is made possible, for example, by an over-the-counter (OTC) transaction. If a gap then occurs overnight that is contrary to the direction of trade, this may result in a disaster. Now imagine the other traders in the office not knowing anything about the OTC transaction and the trader responsible having sloped off. That is the worst that can happen, and there is no way that this residual risk can be resolved in the end.

TRADERS : Mr Temes, thank you for these fascinating insights!

Chart JunkieI trade daily, and I always want to have complete control overmy charts. At Tradesignal Online, I can find the international priceinformation and professional tools that I need for charting.And it's all done through my browser – free of charge.

My charts, my analysis, Tradesignal Online!

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TRADERS´ TOOLS

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TRADERS´ COLUMN

The Greatest Myth About Trading

Brian Lund

Great father. Good friend. Decent

trader. Lacking husband. Solid

drummer. Sometimes funny.

Crappy poker player. Too smart.

Contact: bclund.com

Twitter: @bclund

Risk is something that most people associate with trading. In fact, to the public at large, you are often likely to get the response, “Isn’t that risky?” when you tell them that you trade for a living. However, I think that is one of the biggest myths about trading, and I assert that trading is no more risky than most other jobs.

When I ran my own business, on the first of each month, the moment I woke up I was 60K in the hole. That meant that in order to just “keep the lights on” I had to generate 60K in revenue each month, even before taking

a quid out for myself. And every month that I decided to keep my company going, I had to take the risk that I would not meet my nut.

Trading has no operational costs (or very minimal ones), which makes the decision to pursue the endeavour a relatively risk free one.

“Yeah, but where else do you have the possibility of losing more money than you started the day with?” is the lame rebuttal I often hear. Really? These people obviously have never run a business. If one of my employees damaged a client’s merchandise or backed a truck into a parked

car I could easily lose more money than I started the day with.

Trading has no operational risk. No employee is going to hurt his back and jack your workman’s comp rates up. No douche from Occupational Safety and Health Administration (dreaded US government agency) is going to unexpectedly show up at your office and tell you that you are not in compliance with a new law passed the previous week and you are now on the hook for a large fine. And you are not going to have a piece of equipment go south on you that you have to drain your bank account to replace.

But that is only for business owners right? What if you do the “dance” by getting a four-year degree and going to work for a solid blue chip company? Well in some ways that is one of the riskiest things you can do. Now you have turned over the fate of your continued employment to some mid-level management functionary or fair weather board of directors. Take a look at how many people took that “safe” path to corporate security and got tossed out on their ear when the economy imploded in 2008.

Trading does not carry that kind of risk. Nobody will even come into your trading room and tell you that you are being downsized, or that the macrame conglomerate you work for is

going out of business after 75 years because the board of directors could not resist getting involved in arbitraging high risk Collateralised Debt Obligations.

At the end of the day, trading is one of the rare businesses where only you decide the amount of risk you are willing to take.

The reason that most people go off the rails and blow their account out is not because there is any outsized risk associated with trading, but because the barriers to entry are so low, they are able to jump in feet first without really knowing what they are doing (or they are a seasoned pro who lets their ego get the best of them).

Being a professional athlete is risky. Being a fire-fighter is risky. Being a jet fighter pilot is risky. But the average Joe cannot just jump into those positions without a crap-load of training and without attaining a high level of competency. And thus the risk is less for a David Beckham, for a fire Captain, and for a Top Gun pilot.

Trading gets a bad rap due to the “Sydney or the bush” portrayal it has received in pop culture and Occupy Wall Street type propaganda. Its perception has been “Gekkoized.” But in reality it may be one of the safest professions, if you do it properly and make the choice to keep your ego in check.

http://www.pro.benzinga.com/

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