Contents
This document is intended to provide guidance only. Any
decision to enter a trade is your decision alone. Whoever
initiates an order to buy or sell a security is totally responsible for
the trade. If you don't understand this you should probably stick
to something more safe, like base jumping; this will improve the odds
you are eliminated from the gene pool. Don't take this statement
personally, the market does not care about you or your money, it is
completely dispassionate - yet it is composed of people and
institutions some of which have scruples and some of which do
not. If you don't understand the risks of the market you will
likely be eliminated from the market quickly and mercilessly. If
that gene pool comment put a lump in your throat or raised ire in any
way then you will need rules to manage your overactive emotions; in
this document we share some of our rules, but do not promise to share
all our rules or that it is up to date with our current rules - we do
promise we used these rules at one time in order to improve our results
from trading beyond those rules we were using before these. The
only one who can decide if these are of use to the reader is, in fact,
the reader - use your own discretion at your own risk. In all
honesty, we at least care enough about you keeping your own money and
profits to share these rules which have helped us, we just don't know
if you are smart enough to use them safely.
No honest system will guarantee that trades cannot lose. They
can at best contribute to keeping losses small and allowing gains to
accumulate. Bad rules will still help you to lose money, but good
rules can help you to grow money when applied consistently.
Documenting rules makes it easier to apply them consistently.
There are discretionary rules and there are absolute rules - absolute
rules leave no room for question and must be followed
unconditionally. These are discretionary rules, there are
decision points where judgment is required and your decision may be
different than ours following the same rules because the difference is
experience and opinion. But the discretionary decisions may
(perhaps should) be backed up (at the users discretion) by absolute
responses when the decision is proven to be wrong.
You are expected to know basic candle and price patterns. If
you don't we have suggestions for learning them in the definitions
section. If you don't understand something then don't trade it or
you will lose money. If you trade something you don't understand
and make money they you have luck, not skill.
You may, for some strategies, be expected to know standardized
options and how they can be traded in combination with each other and
stocks to manage risk. You should know Delta, Theta, Vega and
their Risk Profiles for Long and Short Calls and Puts. You should
know what every word in the last sentence means, really, every single
word. You should know how different expirations and strike prices
will affect the risk of a trade and how changes in price, time, and
volatility will change the risk. You should know how market
conditions will affect factors like volatility.
There are elements of these rules which are discretionary.
Your decisions will affect the performance. Even good decisions
can lead to losing trades. Understand how these rules work before
you try to trade them and you will bring confidence to the table.
Confidence that you understand and interpret market action will lead to
a higher probability of success. Good rules can lead to a
probability of smaller losses and greater gains. Proper
interpretation of the key factors in successful trading can make good
rules work even better.
A Complete Trading System consists of identification of market
conditions and the appropriate strategy to apply in the current
conditions, then provides specific rules for strategies appropriate to
those conditions. The strategy depends on the analysis of the
specific security being traded, but it is best to trade with the broad
market and the sector or industry group of any single stock.
A Complete Trading System also includes portfolio management.
Most of that we leave entirely to your discretion, but we provide our
own guidelines. We help you to understand the risks in each
strategy which should allow you to figure out your own risk management
for your own purposes.
As our technical analysis skills improve we are finding that we tend
to use the same sets of indicators for trade decisions. What we
tend to change from trade to trade is the strategy we employ based on
the market conditions. This document is intended to provide
guidance by identifying the signals we watch and act upon, and how we
tend to act under certain conditions. The purpose to having rules
to trade with is to remove emotions from the business of trading.
There are numerous catch phrases along these lines, but suffice to say
that fools and money are parted often - so be smart.
It is our intention with these studies to create a set of entry and
exit signals from which various strategies can be employed depending on
the trend. As we pointed out, we tend to enter trades on the same
general type of trigger, using candles we enter bullish trades above
the
high of the low day and bearish trades below the low of the high
day. We typically trade breakouts of short-term price pattern
signals such as flags, but allow those trades to become longer term
when proven correct; when conditions change we may change our exit
conditions as part of a strategy to preserve gains.
We will use a set of technical studies to determine trend. We
will also use a visual analysis of candles, price patterns, and support
and resistance. Some of these are somewhat subjective causing our
results to be different from yours, this is interpretation (not
discretion) which will be affected by opinion and experience.
Here is another dimension where your mileage may vary.
The key factors in successful trading are Trend, Support and
Resistance, and Momentum. Proper analysis of these will improve
your ability to make successful trades.
I'm not making this section alphabetical - forcing you to hunt for
terms and look through things here to learn what they mean. They
are grouped, paired, and somewhat logically organized. There are
some terms which are pretty basic, and others which are provided
because they may be subjective in general use but have specific meaning
within the context of this document.
We use candles as short term momentum indicators, and there are certain parts of the candles which have particular significance for short term support and resistance:
These generally apply to the previous day's candle, but the
influence of a tall candle may be apparent for several days. A
tall candle generally refers to the body, not the shadows. These
should not be confused with Pivot Points which use confusing similar
designations but are computed in a very different way.
Big Money - The force which moves the market. The theory is
that
markets do not move on their own, they are moved by Big Money; our task
is to follow big money.
Support and Resistance - Horizontal or Sloped 'lines drawn on
charts' where the
underlying price tends to bounce (down for resistance and up for
support) by the action of big money.
Support - A price range (generally not a specific price) where big
money decides to accumulate a security, preventing the price from
moving below support.
Resistance - A price range (generally not a specific price) where big
money decides to distribute a security, preventing the price from
moving above resistance.
Security - Any financial instrument which may be traded at an agreed
price, in this document generally stocks, ETFs and Options.
Underlying - Any basic security which does not derive its value from
the value of another security, or an Index or ETF which is used as the
basis for Option Prices.
Derivative - Any security (index or fund) which derives its value in
whole or part from the value of another security (Options).
Long - Any position entered by paying a debit.
Short - Any position entered by collecting a credit.
Short Term - Days to Weeks
Intermediate Term - Weeks to Months
Long Term - Months to Years
Bullish - Any position which makes money as the underlying price
goes up.
Bearish - Any position which makes money as the underlying price goes
down.
Spread - [1] Any combination of Long and Short positions (typically
option positions). [2] The difference between the Ask and Bid of
a security (Bid-Ask Spread or baSpread).
SMA - Simple Moving Average gives equal weight to each sample in the
population.
EMA - Exponential Moving Average gives greater weight to the most
recent sample in the population.
MACD - Moving Average Convergence and Divergence - A technical study
based on a comparison of 2 EMA studies, also smoothed with an EMA.
Stochastic - A technical study examining the current (closing) price
to the price range (low to high) over a period of days, smoothed with
an SMA.
Crossover - When 2 technical signals cross (MACD signal crossing 0,
or 5-Day EMA crossing 20-Day EMA. Each EMA crossing the next
slower EMA indicates greater strength behind the forming trend.
The following technical studies are used to determine trend and
entry/exit methods.
We have a custom Stochastic Study which produces 2 stochastic line
pairs with different periods on the same lower study.
We also have a Market Forecast Study which we apply to Funds more
than single stocks, but only for reference, not for triggering trades.
A Up Trend is indicated when:
A Down Trend is indicated when:
In both cases the significance of the trend is small when in includes only short-term indicators and becomes more significant.
A Flat Trend is indicated when:
These can be reversed for bearish trade triggers. They are
custom studies which require the operator to select a reference date
and support/resistance strategy, and offset strategy.
Support Strategies are: S1, S2, S3, EMA(lows), Lowest Low
Resistance Strategies are: R1, R2, R3, EMA(highs), Highest High
Offset Strategies are a scale multiplier times one of: EMA(True
Range), EMA(Standard Deviation), Percentage
The trigger is tripped (trade entered or exited) when the stock
price crosses the trigger line (either Support-Offset or
Resistance+Offset).
We have found a nice place to start is an offset of
0.3*EMA(TrueRange,15) but suggest looking over potential trades on the
target underlying security to see if the offset scale should be
adjusted. This allows tuning the triggers to the current behavior
of a security if desired. The use of StDev or TR allows the
offset to adapt automatically to the price and volatility of a
security. We arrived at 0.3*EATR by applying an offset of 1% to
SPY in February 2009, and computed the multiplier to get roughly the
same amount from the EATR. If you then move back in time and look
at, for example, 2006 and apply a 1% offset you find that this is a
huge move compared to the volatility in 2009, but the 0.3*EATR offset
tightens up with the lower volatility and becomes a visually, and
successful, adjustment to the price to confirm an entry point. We
found this applies well across several different ETF's and even over
single stocks, though some stocks require a higher scale factor.
The trigger strategy is selected depending on the conditions at the
time a trade is entered or exited. This is discussed in the Rules.
I really don't know why nobody uses this. Most people don't
realize the number value of the MACD is in price, dollars in the
US. This means it is scaled to the price of the stock so the
actual literal number is generally not useful because it depends on the
price of the stock. My MACD study is scaled by a 5-Bar EMA of the
closing price to read in percent. This means that in my MACD
study the value of 2.5 means the same thing whether the stock is $15 or
$75 or $375 - allowing technical triggers for MACD strategies to be
uniform for any security being analyzed.
Determine the Trend, and likely Support and Resistance with trend
and horizontal lines. Your results may be different for different
time frames.
We tend to be intermediate term traders, with trades lasting up to
months, but generally days to weeks. We tend not to enter counter
trend trades unless there are special circumstances.
The studies are used to first determine the Trend, Support and
Resistance, and Momentum. The results of this analysis will lead
to selection of a strategy to apply. The strategy will have rules
for application of entry and exit conditions and definitions for help
with risk management.
The most significant part of this overlying strategy set is that
when the
market changes, we want to be able to adapt to those changes.
Certain option strategies may not translate well, but long stock and
like trades should manage changes to exit rules based on changes in the
price performance. For example, entering a short-term trade on a
counter-trend bounce can change to a longer-term exit if a trend
develops.
If, for example, a credit spread is in play and the bounce becomes a
trend then the credit spread can continue to run, but it may be
desirable to add a directional trade as well, but this is the next to
last step...
These studies are used to help determine when a price fluctuation is
likely due for a short term reversal, or flag. They provide
insight into the Momentum (growing, holding, falling) of a trend.
The MACD has 2 lines and a histogram. It starts with the
difference of 2 EMA studies. It filters the difference with
another EMA study. These make up the 3 numbers you usually find
associated with MACD if your charts allow you to change the parameters
of the study. The fast line is the MACD. The slow line is
the Signal (MACD Smoothed). The histogram is the difference of
those 2 values. The histogram is the most sensitive to price
fluctuations, but the smoothed line is the best indicator of the
strength of a trend.
The Stochastic has 2 lines. It starts with the price range
(lowest low to highest high) over the last several bars and where the
last price fits into that range, smoothed by 3 days in the Slow
Stochastic. The second line is smoothed by an EMA study. As
with the MACD, the smoothed line is the best indicator of the strength
of a trend.
Together these studies provide insight into the momentum of a trend
and its strength.
These are used to help determine the current trend. As the
price crosses each moving average the strength of the trend should be
reassessed. As each
moving average crosses the others a trend becomes stronger, the longer
the trend runs the more likely it is to have a correction.
These are somewhat subjective, and identification depends on
experience and interpretation. Support is where big money decided
to accumulate shares, resistance is where big money decides to
distribute shares. These decisions happen during trends, leading
to the ability to draw sloped lines, and also at specific prices
forming horizontal lines. People who buy at highs will hold until
the price gets back to where they can break even and sell forming
horizontal resistance. People who buy at a low price will buy
again if the price gets that low again forming horizontal support.
These can be very subjective, and depend on experience and
interpretation more than Support and Resistance. When properly
identified they can predict certain price targets over time
periods. They are not a guarantee even when properly identified,
but it is amazing how patterns work out over time.
Many value investors say that price patterns are not real, or that
they are nothing but coincidence. They are correct, to a
point. Big money more often makes decisions based on value, less
often based on technical analysis, but regardless of their decision
process the decisions result in price action - and creates price
patterns. Sure it is coincidence, caused by their own actions...
In the end it is our job as trading investors to identify the action
of big money by identifying price patterns and then riding their coat
tails.
These are somewhat subjective. You rarely get textbook
patterns, but certain patterns have confirmation signals which can be
used to trigger trades.
Candles are short term momentum indicators and patterns only suggest
action over the next few bars. They can be used to identify the
point of reversal of a trend.
Few circumstances lead us to enter counter-trend trades. Among
them are reversals after strong runs and manifestation of certain price
patterns such as double tops and bottoms.
Counter Trend trades start as short term trades with short term
exits, but if the result is a trend change the exit can be modified to
allow the trade to run further.
Before we get to trades, you need to read the land, as it
were. Whether you are trading a single stock, or and ETF for some
basket of stocks, you need to identify the key factors to entering a
successful trade: Trend, Support and Resistance, and
Momentum. Then you can pick a strategy and play its rules...
The strongest factor must be the trend. The (up) trend starts
as
the result of big money accumulating shares. Whatever their
reasoning, it does not matter, it need not make sense to you, they are
buying and you only need to decide to follow or not. Price
movement of single stocks usually follows the industry group,
sector, and major market related to the stock. Make note of the
price
motion, particularly in single stocks, of the related markets and make
sure the rest of the market is moving in the direction of the trade.
We also mark trends with trend lines, which are lines marking where
price action has changed. These may be flat or sloped, but are
rarely violated during the trend. They are also support and
resistance.
Support and Resistance will affect the trend. Support and
Resistance are also observed in longer term charts where
the price found highs and lows in the past. In a trend there are
also
sloping lines the price rarely violates. Often the moving
averages themselves are apparent areas of support and resistance.
Support is where big money decides to buy and resistance is where
big money decides to sell. More subtly support is where big money
decides to stop selling and resistance is where big money decides to
stop buying. If big money is just taking a break for a while then
the trend remains intact and will continue, but if big money has
changed its mind then the trend will change.
When observing a correction it is important to identify if the
momentum change is temporary or not, and whether it is minor or
significant. This is the only real place that the volume of trade
may be of significant use. A trend change is normally indicated
with an increase in volume. When many reversal price patterns
play out the volume increases in the counter-trend direction and
decrease in the old trend direction.
There are studies to help idenitfy trend changes by combining price
and volume: On Balance Volume, Momentum, Accumulation and
Distribution for a few that we use.
Moving averages and trend lines will help with this. When the
moving averages are close, crossing, and confused the trend is probably
sideways and directional momentum is low. This is best confirmed
by support and resistance - a sideways trend has areas where buying and
selling are fenced in. These ranges may extend a bit, but watch
for fakeouts as well as breakouts.
It seems obvious, but changes in trend are first apparent in the
short term, and become more pronounced as time passes. As moving
averages converge, cross, and begin to follow a new direction our
outlook changes from a short-term trend, intermediate, and long term
trend. Identification of Support and Resistance will help.
It is important to understand that trends will sometimes expand their
price range without significantly changing the trend, but new highs and
new lows can be misleading, so breakouts should be handled as short
term trades just like reversals, until confirmation is determined.
When selecting a strategy remember that when there is a direction to
the market then nothing beats trading with the market. Things get
more complex when the trend is flat, or neutral.
We will identify the following 5 basic trends with appropriate
strategies and rules to follow for each strategy. These apply to
the specific underlying security being traded, but it is best to have
the support of the broad market, or the sector or industry group to
help push the price by the action of more big money:
All bullish directional trades are recommended in this
condition. These include Long Stock, and Long Call trades.
Premium is likely to be poor with Put Credit Spreads, but Call Debit
Spreads are reasonable if capping the profit is acceptable. Long
leveraged funds can be considered, too, as can Synthetic Long positions.
Indentify this trend earliest when the MACD lines are moving up
strongly along with the Stochastic lines. More mature when the
MACD lines are high and flat along with high and flat Stochastic
lines. First the fast and then the slower moving averages turn up
and spread out. This stock price is consistently above the
shortest moving average study even in small price fluctuations.
Support is an upward sloping line often parallel with and close to
the shorter moving averages, but the price range may extend leaving the
trend intact.
Be careful when hedging because when not properly managed a hedge
will always cost profits if the trend continues.
Consider conditions for possible reversal trades as counter-trend
and handle them as short term trades. Strong trends don't often
last very long without some correction.
Bullish directional trades can work. Long Stock trades are not
subject to time decay, but Long Call trades are somewhat risky.
Call
Debit Spreads and Put Credit Spreads are ways to approach trading in
this market condition. Combinations of these strategies can be
used to reduce sensitivity to time and volatility. Long leveraged
funds can be considered, too.
Indentify this trend earliest when the MACD
lines are moving upward along with the Stochastic lines either moving
upward or above 50%. More mature when the MACD lines flatten out
above the zero line. This can happen before or after a Strong Up
move. The shorter moving averages are close together and may
touch or even cross slightly. The longer moving averages will
close in on the slower ones. The stock is generally above the
intermediate moving averages and moves above and below the shortest
moving averages being more above than below.
Hedging bullish trades can protect profits and offset losses in
these conditions.
Support is an upward sloping line often parallel with and close to the slower moving averages. Remember that the price range can extend without really altering the trend.
Short Term Bullish and Bearish directional trades can work with
stocks. Credit Spreads are recommended, Debit Spreads and long
options will not perform as well without perfect timing. Long
calendar and diagonal spreads are also potentially profitable in these
conditions.
Indentify this trend when moving averages are crossing each other in
confused directions. The MACD lines will be flat around the zero
line, and Stochastic studies oscillate with roughly equal time above
and below the 50% line. In this trend the stochastic studies are
often more helpful interpreting short term momentum.
Support and resistance are flat or slightly sloped. Remember
that Support and Resistance may extend without really altering the
trend, these prices are not exact, but are ranges which we tend to
reduce in concept to a price around a specific value for short hand.
Hedging can protect both long and short positions in this condition,
but is more useful with positions that already have profit which you
don't want to exit yet.
Bearish directional trades can work. Short Stock trades are
not subject to time decay, but Long Put trades are somewhat
risky.
Put Debit Spreads and Call Credit Spreads are ways to approach trading
in this market condition. Combinations of these strategies can be
used to reduce sensitivity to time and volatility. Long inverse
funds and leveraged inverse funds can be considered, too.
Indentify this trend earliest when the MACD
lines are moving downward along with the Stochastic lines either moving
downward or below 50%. More mature when the MACD lines flatten
out below the zero line. This can happen before or after a Strong
Down move. The
shorter moving averages are close together and may touch or even cross
slightly. The longer moving averages will close in on the slower
ones. The stock is generally below the intermediate moving
averages and moves below and above the shortest moving averages being
more below than above.
Resistance is a downward sloping line often parallel with and close to the slower moving averages.
All bearish directional trades are recommended in this direction. These include Short Stock and Long Put trades. Premium is likely to be poor with Call Credit Spreads, but Put Debit Spreads are reasonable if capping the profit is acceptable. Long inverse funds and leveraged inverse funds can be considered, too.
Indentify this trend earliest when the MACD lines are moving down
strongly along with the Stochastic lines. More mature when the
MACD
lines are low and flat along with low and flat Stochastic lines.
First the fast and then the slower moving averages turn down and spread
out. This stock price is consistently below the shortest moving
average study even in small price fluctuations.
Resistance is a downward sloping line often parallel with and close
to the
shorter moving averages, but the price range may extend leaving the
trend intact.
Be careful when hedging because when not properly managed a hedge
will always cost profits if the trend continues.
Consider conditions for possible reversal trades as counter-trend
and handle them as short term trades. Strong trends don't often
last very long without some correction.
The following sections provide description of the given
strategy. The link leads to a page with the specific trading
rules for a strategy.
Some stock and option combinations produce a similar risk profile to
another combination of pure option trades - these are called synthetic
positions or just complex option positions. The Think or Swim
trading platform software provides a fantastic chart to visualize trade
risk and how it is affected by changes in market conditions.
Complex option positions and combinations of stocks and options can
be entered in stages. Called legging into the position, this is
generally done by opening one leg of a position and then adding options
at a later time when market conditions change.
Strategies are organized below with the base strategy and then
strategies which result from adjustments to the base strategy.
This is a moderately bullish position and is the basic form of
investment. Buy a stock. There is no time sensitivity, only
price sensitivity. This produces a simple linear risk curve, and
options can be added to hedge risk under certain circumstances.
This is a strongly bullish trade - the underlying MUST move up to offset the cost of the put option, but allows the trade to continue without liquidation of a stock position during a significant correction. This trade can increase the cost basis, but provides a guaranteed sell point or a reduction in cost basis if the price pulls back more than just a little bit. The combination of a long stock and a long put creates a risk profile resembling that of a long call option.
This is a weakly bullish trade - the underlying can move up or down weakly while time decay of the call option provides profit. This is a way to make money from a stock that is not going strongly upward; it can decrease the cost basis, but puts a cap on the profit if the stock continues (or begins) an uptrend. The combination of a long stock and a short call has a risk profile similar to that of a long put option at the same strike price as the Covered Call.
This is a weakly bullish trade with insurance against a significant
correction. A Covered Call finances a Protective Put - both caps profit
and protects gains. This combination has a risk curve similar to
that of a Put Credit Spread.