Too Much of a Good Thing

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Too Much of a Good Thing

It may strike you that there are too many indicators from which to choose. Instead of simplifying our lives, has the computer only served to complicate things by giving us so much more to look at? Charting packages offer 80 different studies that are available to the technician. How does one possibly reach any conclusions (and find the time to trade) with so much data to contend with? We’ll say a few words about some work being done in that direction.

SOME COMPUTER NEEDS

Charting software can be applied to virtually any financial market. Most software is user-friendly, meaning that it can be easily implemented by choosing from successive lists of available routines. The place to start is with a charting software package that works for the computer you already own or are thinking of buying. Bear in mind that most charting software has been written for IBM-compatible computers.

Charting packages do not provide daily market data. The user must obtain that data elsewhere. Data can be collected automatically from a data service over telephone lines (requiring a phone modem). Charting packages provide the names of various data vendors from which to choose. These data vendors provide all the software and instructions needed to set up and collect the data files.

When first starting out, the user must collect historical data going back for at least several months to have something to work with. After that, data should be collected daily. It is possible to analyze “on line” data during the trading day by hooking up to a quote service. However, in our use of daily data, we will be referring to end-of-day data, which is available after the markets close. The final piece of equipment you might want is a printer to obtain a copy of whatever appears on the terminal screen. CD-Rom capability is highly recommended since some software vendors provide you with several years of historical data on a CD-Rom disk to get you started. There are some data vendors that also provide charting capability, which simplifies your task even more. One such service is Telescan (5959 Corporate Drive, Suite 2000, Houston, TX 77036, (800) 324-8246, www.telescan.com).

GROUPING TOOLS AND INDICATORS

The following list groups some of the chart and indicator options.

• Basic Charts: Bar, line, point and figure, and candlesticks
• Chart Scales: Arithmetic and semilogarithmic
• Bar Chart: Price, volume, and open interest (for futures)
• Volume: Bars, on balance, and Demand Index
• Basic Tools: Trendlines and channels, percentage retracements, moving averages, and oscillators
• Moving Averages: Reference envelopes, Bollinger Bands
• Oscillators: Commodity Channel Index, momentum, rate of change, MACD, Stochastic, Williams %R, RSI
• Cycles: Cycle Finder
• Fibonacci Tools: Fan lines, arcs, time zones and retracements
• Wilder: RSI, Commodity Selection Index, Directional Movement, Parabolic, Swing Index, ADX line

USING THE TOOLS AND INDICATORS

How does one cope with so much from which to choose? A suggestion is to

first use the basic tools such as price, volume, trendlines, percentage retracements, moving averages, and oscillators. Notice the large number of oscillators available. Pick one or two that you are most comfortable with and go with them. Use such things as cycles and Fibonacci tools as secondary inputs unless you have a special interest in those areas. Cycles can help fine tune moving average and oscillator lengths, but require study and practice. For mechanical trading systems, Wilder’s Parabolic and DMI are especially noteworthy.

WELLES WILDER’S PARABOLIC AND DIRECTIONAL MOVEMENT SYSTEMS

We’re going to spend some time on two studies that are especially useful. Both studies were developed by J. Welles Wilder Jr. and discussed in his book, New Concepts in Technical Trading Systems. Three of Wilder’s other studies included on the computer menu—Commodity Selection Index, Relative Strength Index, and the Swing Index—are also included in the same book.

Parabolic System (SAR)

Wilder’s Parabolic system (SAR) is a time/price reversal system that is always in the market. The letters “SAR” stand for “stop and reverse,” meaning that the position is reversed when the protective stop is hit. It is a trend-following system. It gets its name from the shape assumed by the trailing stops that tend to curve like a parabola. (See Figures 15.1-15.4. Notice that as prices trend higher, the rising dots below the price action (the stop and reverse points) tend to start out slower and then accelerate with the trend. In a downtrend, the same thing happens but in the opposite direction (the dots are above the price action). The SAR numbers are calculated and available to the user for the following day.

Wilder built an acceleration factor into the system. Each day the stop moves in the direction of the new trend. At first, the movement of the stop is relatively slow to allow the trend time to become established. As the acceleration factor increases, the SAR begins to move faster, eventually catching up to the price action. If the trend falters, or fails to materialize, the result is usually a stop and reverse signal. As the accompanying charts show, the Parabolic system works extremely well in trending markets. Notice that while the trending portions were captured well, the system whipsawed constantly during the sideways, nontrending periods.

Figure 15.1 The Parabolic SARs look like dots on the chart. A buy signal was given when the upper SAR was hit (first arrow). Notice how the SARs accelerated upward during the rally and caught most of the uptrend. A small whipsaw occurred to the upper right, which was quickly corrected. This system works when a trend is present.

Figure 15.2 A longer range version of the previous chart shows the good and bad aspects of Parabolics and any trend-following system. They work during trending periods (to the left and right of the chart). But are useless during the type of trading range that occurred from August to January.

Figure 15.3 Parabolics can be used on a monthly chart to track the primary trend. A sell signal in early 1994 was followed by a buy in late summer. Except for one whipsaw during 1996, this system has stayed positive for almost four years.

Figure 15.4 Parabolics applied to weekly chart of Dell Computer. After staying positive through most of 1997, a sell signal was given during October. That sell signal was reversed and a buy signal given as 1997 ended.

That demonstrates both the strength and weakness of most trendfollowing systems. They work well during strong trending periods, which Wilder himself estimates occur only about 30% of the time. If that estimate is even close to reality, then a trend-following system will not work for about 70% of the time. How then does one deal with this problem?

DMI and ADX

One possible solution is to use some type of filter or a device to determine if the market is in a trending mode. Wilder’s ADX line rates the directional movement of the various markets on a scale of 0 to 100. A rising ADX line means the market is trending and a better candidate for a trend-following system. A falling ADX line indicates a nontrending environment, which would not be suitable for a trend-following approach. (See Figure 15.5.)

Figure 15.5 The ADX line measures the degree of directional movement. A downturn from above 40 (left arrow) signaled the onset of a trading range. The upturn from below 20 (right arrow) signaled the resumption of a trending phase.

Because the ADX line is on a scale from 0 to 100, the trend trader could simply trade those markets with the highest trend ratings. Nontrending systems (oscillators, for example) could be utilized on markets with low directional movement.

Directional Movement can be used either as a system on its own or as a filter on the Parabolic or any other trend-following system. Two lines are generated in the DMI study, +DI and -DI. The first line measures positive (upward) movement and the second number, negative (downward) movement). Figure 15.6 shows the two lines. The darker line is + DI and the lighter line -DI. A buy signal is given when the +DI line crosses over the - DI line and a sell signal when it crosses below the - DI line.

Figure 15.6 also shows both the Parabolic and Directional Movement

systems. The Parabolic is clearly a more sensitive system, meaning that more frequent and earlier signals are given. However, by using the Directional Movement as a filter, several of the bad signals in the Parabolic could be avoided by following only those signals in the same direction as the Directional Movement lines. It appears then that the Parabolic and Directional Movement systems should be used together, with Directional Movement acting as a screen or filter on the more sensitive Parabolic.

Figure 15.6 The Directional Movement lines along the bottom of the chart can be used as a filter on Parabolics (upper chart). When the +DI line is above the -DI line (far left and far right of chart), all Parabolic sell signals can be ignored. That would have eliminated several whipsaws during the rally phases.

The best time to use a trending system is when the ADX line is rising. (See Figures 15.7 and 15.8.) Be forewarned, however, that when the ADX line starts to drop from above the 40 level, that is an early sign that the trend is weakening. A rise back above the 20 level is often a sign of the start of a new trend. (The ADX line is essentially a smoothed difference between the +DI and -DI lines.)

Figure 15.7 The 14 week ADX line peaked in early 1996 from well over 40, and initiated an 18 month trading range in utilities. The ADX upturn during the summer of 1997 from below 20 signaled that utilities were starting to trend.

Figure 15.8 An ADX line overlaid over a monthly chart of the AMEX Oil Index (XOI). The ADX peaked above 40 in 1990, ending the oil stock rally. The upturn in the ADX line from below 20 at the start of 1995 signaled the end of a 4 year trading range in oil stocks, and correctly spotted the start of a

new upleg.

PROS AND CONS OF SYSTEM TRADING

Advantages of Mechanical Systems

• 1. Human emotion is eliminated.
• 2. Greater discipline is achieved.
• 3. More consistency is possible.
• 4. Trades are taken in the direction of the trend.
• 5. Participation is virtually guaranteed in the direction of every important trend.
• 6. Profits are allowed to run.
• 7. Losses are minimized.

Disadvantages of Mechanical Systems

• 1. Most mechanical systems are trend-following.
• 2. Trend-following systems rely on major trends in order to be profitable.
• 3. Trend-following systems are generally nonprofitable when markets are not trending.
• 4. There are long periods of time when markets are not trending and, therefore, not suitable for a trending approach.

The major problem is the failure of the system to recognize when the market is not trending and its inability to turn itself off. The measure of a good system is not only its ability to make money in trending markets, but its ability to preserve capital during nontrending periods. It is this inability of the system to monitor itself that is its greatest weakness. This is where some overriding filtering device, such as Welles Wilder’s Directional Movement system or the ADX line could prove especially useful by allowing the trader to determine which markets are most suitable for a trending system.

Another drawback is that no allowance is generally made for anticipating market reversals. Trend-following systems ride with the trend until it turns. They don’t recognize when a market has reached a long term support or resistance level, when oscillator divergences are being given, or when an Elliott Wave fifth pattern is clearly visible. Most traders would get more defensive at that point, and begin taking some profits. The system, however, will stay with the position until well after the market has changed direction. Therefore, it’s up to the trader to determine how best to employ the system.

That is to say, whether it should be followed blindly or whether it should be incorporated into a trading plan with other technical factors. That brings us to our next section on how a mechanical system can be used as just another technical input into the forecasting and trading process.

Using System Signals as a Disciplining Device

The system signals can be used simply as a mechanical confirmation along with other technical factors. Even if the system is not being traded mechanically, and other technical factors are being employed, the signals could be used as a disciplined way to keep the trader on the right side of the major trend. No short positions would be taken as long as the computer trend was up. No longs would be taken in a computer downtrend. (This would be a simple way for fundamentally oriented traders to use a technical device as a filter or trigger on their own trading ideas.) Trend direction can be a matter of judgment. The computer signals relieve the trader of some degree of uncertainty. They can prevent him or her from falling into the trap of “top and bottom picking.”

Using Signals as Alerts

System signals can also be used as an excellent screening device to alert the trader to recent trend changes. The trader can simply glance at the trend signals and instantly has several trading candidates. The same information could be found by studying all of the charts. The computer just makes that task quicker, easier, and more authoritative. The ability of the computer to automate system signals and then alert the trader when signals are triggered is an enormous asset, especially when the universe of financial markets has grown so large.

NEED EXPERT HELP?

One of the products offered by Omega Research called TradeStation offers a variety of Expert Features (Omega Research, Miami, FL 33174, (305) 551- 9991). You can call up its Expert Commentary, which interprets indicators for you based on current market conditions. Omega’s Expert Analyst will determine which indicators should work best in the current market and interpret them for you. In addition, it has two Expert Tools. The Trendlines Automatic Indicator actually draws trendlines for you. The Candlestick Patterns Indicator reads the more common candlestick chart patterns.

TEST SYSTEMS OR CREATE YOUR OWN

Omega Research also includes a library of the most popular trading systems used by traders. You can test them, change them, or create your own if you wish. All of Omega’s charting tools, indicators, and trading systems are written in a relatively simple language called EasyLanguage. EasyLanguage takes trading ideas that you have described in plain language and converts them into the machine code needed to run the program. It’s hard to overestimate the value of being able to develop, test, optimize if you wish, and then automate your own trading ideas—without being a computer programmer. The computer will even generate the appropriate trading orders for you and alert you via your alphanumeric pager that signals have been triggered. (In Appendix C, we’ll use Omega Research’s EasyLanguage and TradeStation to show you how to go about creating a trading system of your own.)

CONCLUSION

This chapter introduced a couple more of Welles Wilder’s systems to you— Parabolics and Directional Movement (DMI). Parabolics can generate useful trading signals, but probably shouldn’t be used alone. The two Dl lines can be used as a filter on Parabolics or any other sensitive trend-following trading system. The ADX line, which is part of the DMI system, provides one way to determine which type of market you’re dealing with—a trending or a trading market. A rising ADX line suggests a trend and favors moving averages. A falling ADX line suggests a trading range and favors oscillators. We also used the Parabolic examples to show the good and bad sides of most trendfollowing systems. They work well when a trend is present. They’re useless during a trading range. You have to be able to tell the difference. We also touched on the merits of mechanical trading systems. These systems remove human emotion and can be very helpful in the right market climate. They can also be used as technical alerts and used in conjunction with fundamental analysis. (See Appendix C for more on system trading.)

There’s no question that the computer has revolutionized financial market analysis and trading. While our interest is primarily in technical analysis, software programs also allow you to blend fundamental analysis with the technical. When the first edition of this book was published in 1986, it cost about $5,000 to outfit yourself with the necessary computer hardware to perform serious technical analysis. The leading software package of the day cost close to $2,000. How things have changed. You can now obtain incredibly powerful computers for less than $2,000. Most software packages

can be had for less than $300. The better ones provide you with up to 20 years of historical price data on a CD-Rom disk at little or no additional cost.

Another big benefit is the amount of educational help that you can obtain with those software packages. The user manuals alone are the size of a book and include technical formulas and all kinds of useful explanations. The screening and alert capabilities of today’s computer are especially helpful to those monitoring global bond and stock markets and thousands of individual common stocks, not to mention mutual funds. In Chapter 17, we’ll talk about an even more sophisticated use of computer technology for developing neural networks. But the message to you is clear. If you are serious about investing or trading financial markets, get a computer and learn how to use it. You’ll be glad you did.

INTRODUCTION

The previous chapters presented the major technical methods used to forecast and trade financial markets. In this chapter, we’ll round out the trading process by adding to the task of market forecasting the crucial elements of trading tactics (or timing) and the often overlooked aspect of money management. No trading program can be complete without all three elements.

THE THREE ELEMENTS OF SUCCESSFUL TRADING

Any successful trading program must take into account three important factors: price forecasting, timing, and money management.

• 1. Price forecasting indicates which way a market is expected to trend. It is the crucial first step in the trading decision. The forecasting process determines whether the trader is bullish or bearish. It provides the answer to the basic question of whether to enter the market from the long or short side. If the price forecast is wrong, nothing else that follows will work.
• 2. Trading tactics, or timing, determines specific entry and exit points. Timing is especially crucial in futures trading. Because of the low margin requirements and the resulting high leverage, there isn’t much room for error. It’s quite possible to be correct on the direction of the market, but still lose money on a trade if the timing is off. Timing is

almost entirely technical in nature. Therefore, even if the trader is fundamentally oriented, technical tools must be employed at this point to determine specific entry and exit points.

3. Money management covers the allocation of funds. It includes such areas as portfolio makeup, diversification, how much money to invest or risk in any one market, the use of stops, reward-to-risk ratios, what to do after periods of success or adversity, and whether to trade conservatively or aggressively.

The simplest way to summarize the three different elements is that price forecasting tells the trader what to do (buy or sell), timing helps decide when to do it, and money management determines how much to commit to the trade. The subject of price forecasting has been covered in the previous chapters. We’ll deal with the other two aspects here. We’ll discuss money management first because that subject should be taken into consideration when deciding on the appropriate trading tactics.