Trading Systems

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Trading Systems

A system is a set of rules for finding, entering, and exiting trades. Every serious trader has one or more systems. Compare this to a surgeon who has systems for performing operations. He doesn’t waste time and energy deciding whether to order anesthesia, where to make the cut, or how to find the sick organ. He follows a well-established routine, which leaves him free to think about strategic issues, finesse his technique, or deal with any complications.

Some people use strictly defined systems that leave very little room for personal judgment—we call them mechanical traders. Others use systems that leave plenty of room for personal decisions—we call them discretionary traders. There is a very thoughtful discussion on matching one’s personality type to various trading styles in Richard Weissman’s book Mechanical Trading Systems. Whatever approach you take, the key advantage of any system is that you design it when the markets are closed and you feel calm. A system becomes your anchor of rational behavior amidst the turbulence of the market.

It goes without saying that a proper system is written down. This needs to be done because it’s easy to forget some essential steps when stressed by live markets. Dr. Atul Gawande in his remarkable book The Checklist Manifesto makes a convincing case for using checklists to raise performance levels in a large variety of demanding endeavors, from surgery and construction to trading.

A mechanical trader develops a set of rules, back-tests them on historical data, and then puts his system on autopilot. Going forward, his software starts flashing orders for entries, target, and stops, and a mechanical trader is supposed to place them exactly as shown. Whether he’ll stick to his plan or attempt to tweak or override those signals is another story, but that’s how the system is supposed to work.

An amateur feels relieved that a mechanical system, either his own or purchased from a vendor, will relieve him from the stress of decision making. Unfortunately, market conditions keep changing, and mechanical systems eventually get out of gear and start losing money. The market is not a mechanical entity that follows the laws of physics. It is a huge crowd of people acting in accordance with imperfect laws of mass psychology. Mechanical methods can help, but trading decisions must take psychology into account.

A professional trader with a mechanical system continues to monitor its performance like a hawk. He knows the difference between a normal drawdown and a period when a system goes out of gear and has to be shelved. A professional trader can afford to use a mechanical system precisely because he is capable of discretionary trading! A mechanical system is an action plan, but some degree of judgment is always required, even with the best and most reliable plans.

A discretionary trader approaches each day in the markets afresh. He tends to examine more factors than a mechanical trader, weigh them differently at different times, and be more attuned to changes in current market behavior. A good discretionary system, while giving you plenty of freedom, includes several inviolate rules, especially in the area of risk management.

Both approaches have pluses and minuses. On the plus side, mechanical trading can be less emotionally tense. You build your system, turn it on, and go about your life without watching every tick. On the minus side, these living and breathing markets have a sneaky way of changing their tunes and behaving differently from how they did when you built your system.

The main plus of discretionary trading is the openness to fresh opportunities. Its biggest minus is that people’s judgment tends to slip under stress, when they become excited by greed or frightened by sharp moves.

In my experience, mechanical traders tend to deliver more steady results, but the most successful traders use discretionary methods. Your choice is likely to depend on your temperament. That’s how we make some of our most important decisions in life where to live, what career to pursue, whom to marry. Our key choices stem from the innermost core of our personalities rather than rational thought. In trading, cooler and more obsessional people tend to gravitate toward mechanical trading, while the more swashbuckling types turn to discretionary trading.

Paradoxically, at the high end of performance, these two approaches begin to converge. Advanced traders combine mechanical and discretionary methods. For example, a friend who is a died-in-the-wool mechanical trader uses three systems in his hedge fund but keeps rebalancing capital allocated to each of them. He shifts millions of dollars from System A to System B or C, and back again. In other words, his discretionary decisions augment his systematic trading. I am a discretionary trader, but follow several strict rules that prohibit me from buying above the upper channel line, shorting below the lower channel line, or putting on trades against the Impulse system (described below). These mechanical rules reduce the number of bad discretionary trades.

Much of this book deals with discretionary trading, but you can use the tools described in it for mechanical trading. I wrote this book to help both types of traders.

■ 38. System Testing, Paper Trading, and the Three Key Demands for Every Trade

Before trading real money with a system, you need to test it, whether you developed it yourself or bought it from a vendor. This can be done in one of two ways. One is backtesting: apply your system’s rules to a stretch of historical data, usually several years’ worth. The other is forward-testing: trade small positions with real money. Serious traders begin with backtesting, and if its results look good, switch to forward-testing; if that works well, they gradually increase position size.

Looking at printouts of historical results is a nice start, but don’t let good numbers lull you into a false sense of security. The profit-loss ratio, the longest winning and losing streaks, the maximum drawdown, and other parameters may appear objective, but past results don’t guarantee the system will hold up in the real world of trading.

You may see a very nice printout, but what if, once you begin to trade real money, that system delivers five losses in a row? Nothing in your paper testing will have prepared you for that, but it happens all the time. You grit your teeth and put on another trade. Another loss. Your drawdown is deepening, and then the system flashes a new signal. Will you put on the next trade? Suddenly, an impressive printout looks like a very thin reed on which to hang the future of your account.

There is a cottage industry of programmers who back-test systems for a fee. Some traders, too suspicious to disclose their “sure-fire methods,” spend months learning to use testing software. In the end, only one kind of backtesting prepares you to trade—manual testing. It is slow, time-consuming, and cannot be automated, but it’s the only method that comes close to modeling real decision making. It consists of going through historical data one day at a time, scrupulously writing down your trading signals for the day ahead, and then clicking one bar forward and recording new signals and trades for the next day.

Begin by downloading daily price and volume data for your trading vehicle for a minimum of two years (for futures you may use continuous contracts). Open a chart and, without looking, swing immediately to its very beginning. Open your spreadsheet, write down your system’s rules at the top of the page, and create columns for dates, prices, and signals. Open two windows in your analytic program—one for your weekly chart and its indicators, the other for the daily chart. The two most important keyboard keys for testing are and because they let you switch between windows and programs.

As you click forward, one day at a time, trends and trading ranges will slowly unfold and challenge you. At that point, you’ll be doing much more than testing a set of rules. Moving ahead one day at a time will test and improve your decision-making skills. This one-bar-at-a-time testing is vastly superior to what you can get from backtesting software.

How will you deal with gap openings, when the market leaps above your buy level or drops below your stop at the opening bell? What about limit moves in futures? Clicking forward one day at a time and writing down your signals and decisions will get you as close to real trading as you can without risking cash. It’ll keep you focused on the raw right edge of the market. You’ll never get that from a neat printout of a system test. Manual testing will improve your ability not only to understand the markets but to make decisions.

If one-bar-at-a-time testing shows positive results, start trading small positions with real money. These days, with brokerage commissions as low as $1 for buying or selling 100 shares, you can test your indicators and systems while risking tiny amounts. Be sure to keep good records, and if your real-money results continue positive, start increasing the size of your trades. Do it in steps, all the way up to your normal trade size.

Paper Trading

Paper trading means recording your buy and sell decisions and tracking them like real trades, but with no money at risk. Beginners may start out paper trading, but most people turn to it after getting beat up by the markets. Some even alternate between real and paper trades and can’t understand why they seem to make money on paper but lose whenever they put on a real trade. There are three reasons.

First, people are less emotional with paper trades, and good decisions are easier to make with no money at risk. Second, in paper trades, you always get perfect fills, unlike real trading. Third and most important, good trades often look murky when you consider them. The easy-looking ones are more likely to lead to problems. A nervous beginner jumps into obvious-looking trades and loses money, but paper trades the more challenging ones. It goes without saying that hopping between real and paper trades is sheer nonsense. You either do the one or the other.

Psychology plays a huge role in how your trades turn out, and that’s where paper trading fails to deliver. Pretend-trading with no money at risk is like sailing on a pond—it does little to prepare you for real sailing on a stormy sea.

There is only one good reason to paper trade—to test your discipline as well as your system.

If you can download your data at the end of each day, do your homework, write down your orders for the day ahead, watch the opening and record your entries, then track your market each day, adjusting your profit targets and stops—if you can do all of this for several months in a row, recording your actions, without skipping a day—then you have the discipline to trade real money. An impulsive person who trades for entertainment will not be able to paper trade that way because it requires real work.

You may open an account with one of several websites set up for paper trading. Enter your orders, check whether they have been triggered, and write down those “fills.” Enter all paper trades in your spreadsheet and your trading diary. If you have the willpower to repeat this process daily for several months, then you have the discipline for successful real trading.

Still, there is no substitute for trading real money because even small amounts rev up emotions more than any paper trade. You’ll learn much more from even small real trades than from months of paper trading.

In recent years, I’ve had a front row seat watching traders progress from paper trading to profitable real-money trading. In SpikeTrade.com, we reduce fees for members who contribute picks, creating an incentive to do homework. The discipline of submitting a weekly trade plan with entry, target, and stop gets people into the habit of being organized and focused. As their picks improve, they start earning performance bonuses in our weekly competition. At that point, I may receive an e-mail saying that while they’re doing well in the competition, their private trading lags behind. I tell them they’re on the right track and to continue what they’re doing. Sure enough, several months later their new skills migrate into real trading. Now they may write that their private trading is better than their performance in the competition. Sure—I reply—it’s because you pay more attention to real-money trades!

Speaking of trade setups, it’s essential to write down all relevant numbers before you enter a trade. You’re more objective before you put any money at risk; once in a trade, you’ll be tempted to give it “more room to run.” That’s how losers turn small drawdowns into disasters. I once consulted a man who refused to take a $200 loss until it ran into a $98,000 wipeout.

We’ll focus on risk and money management in a later chapter when I discuss the concept of “The Iron Triangle of risk control.” At this point, I only want to make clear that risk management is the essential part of serious trading. Forget the days when you would look at the ceiling and say, “I’ll trade 500 shares,” “I’ll trade a thousand shares,” or any other arbitrary number. Later in this book, you’ll learn a simple formula for sizing your trades, based on your account and risk tolerance.

At the time of this writing, I have three strategies that I trade. My favorite is a false breakout with a divergence. My second choice is a pullback to value during a powerful trend—that’s the strategy of the trade shown on the screen (Figure 38.1). Last, I occasionally “fade an extreme”—bet on a reversal of an overstretched trend. Each of these strategies has its rules, but the key point is this—I’ll only take a trade that fits one of them. No chasing of random cars for this old dog!

Three Key Demands for Every Trade

There are three essential angles that must be considered for every planned trade. We’ll briefly review them here and then elaborate in the chapters on specific trading

FIGURE 38.1 Three key demands for every planned trade.(Source: SpikeTrade.com)

This is a screenshot of a trade plan I drew several days prior to writing this chapter (you can see how I implemented it in Chapter 55). Notice several essential features that belong in every trade plan:

• A. Trade setup—write down the three key numbers for every trade: your entry, target, and stop. Before entering the market you need to decide how much you’ll pay, how much you’ll risk, and how much you expect to gain. The ratio of potential reward to risk should normally be better than two to one. The only time to deviate from this rule is when technical signals are especially strong. Of course, don’t fudge your target to turn a borderline trade into an acceptable one. Your target needs to be realistic.
• B. Risk management—decide in advance how many dollars you’re prepared to risk on this trade. Divide that amount by your risk per share—the distance from your entry to your stop. This will give you the number of shares you may trade.
• C. Last but not least, every single trade must be based on a specific system or strategy. “It looks good to me” isn’t a system! It’s easy to become excited after hearing a stock tip or seeing a runaway trend, but the days of chasing stocks like a pup chases cars are over. If you want to trade for a living, you need to define your trade plans, strategies, or systems—call them what you like—and enter only those trades that fit their criteria.

systems and risk management. The discipline of these three demands is essential for anyone serious about trading.

■ 39. Triple Screen Trading System

I developed this system and first presented it to the public in an April 1986 article in Futures magazine. I’ve been using it for trading since 1985, and it stood the test of time. I continue to tweak it, adding or changing minor features, but its basic principle remains unchanged: making trading decisions using a sequence of timeframes and indicators.

Triple Screen applies three tests or screens to every trade. Many trades that seem attractive at first are rejected by one or another screen. The trades that pass the Triple Screen test are much more likely to succeed.

The Triple Screen combines trend-following indicators on long-term charts with counter-trend oscillators on the intermediate charts. It uses special entry techniques for buying or selling short as well as tight money management rules. The Triple Screen is more than a trading system: it is a method, a style of trading.

Trend-Following Indicators and Oscillators

Beginners often look for a magic bullet—a single indicator for making money. If they get lucky for a while, they feel as if they discovered the royal road to riches. When the magic dies, amateurs give back their profits with interest and look for another magic tool. The markets are too complex to be analyzed with a single indicator.

Different indicators give contradictory signals in the same market. Trend-following indicators rise during uptrends and give buy signals, while oscillators become overbought and give sell signals. Trend-following indicators turn down in downtrends and give signals to sell short but oscillators become oversold and give buy signals.

Trend-following indicators are profitable when markets are moving but lead to whipsaws in trading ranges. Oscillators are profitable in trading ranges, but give premature and dangerous signals when the markets begin to trend. Traders say: “The trend is your friend,” and “Let your profits run.” They also say: “Buy low, sell high.” But why sell if the trend is up? And how high is high?

Some traders try to average out the signals of trend-following indicators and oscillators, but those votes are easy to rig. Just as Republicans and Democrats in the United States keep redrawing electoral districts to create “safe” seats, traders keep selecting indicators that deliver the votes they want to see. If you use more trend-following tools, the vote will go one way, and if you use more oscillators, it’ll go the other way. A trader can always find a group of indicators telling him what he wants to hear.

The Triple Screen trading system is designed to filter out the disadvantages of trend-following indicators and oscillators, while preserving their strengths.

Choosing Timeframes—the Factor of Five

Another major dilemma is that the trend of any trading vehicle can be both up and down at the same time, depending on what charts you use. A daily chart may show an uptrend, while a weekly chart shows a downtrend, and vice versa. We need a system to handle conflicting signals in different timeframes.

Charles Dow, the author of the venerable Dow Theory, stated at the turn of the twentieth century that the stock market had three trends. The long-term trend lasted several years, the intermediate several months, and anything shorter than that was a minor trend. Robert Rhea, the great market technician of the 1930s, compared these three trends to a tide, a wave, and a ripple. He recommended trading in the direction of the tide, taking advantage of the waves, and ignoring the ripples.

Times have changed, and the markets have become more volatile. Computers are cheap, or even free; live data have created better opportunities to capitalize on faster moves. We need a more flexible definition of timeframes. The Triple Screen trading system is based on the observation that every timeframe relates to the larger and shorter ones by approximately a factor of five (see Chapter 32).

Begin by asking yourself, what’s your favorite timeframe. Do you prefer working with the daily, 10-minute, or any other charts? Whatever timeframe is your favorite, the Triple Screen calls that the intermediate timeframe. The long-term timeframe is one order of magnitude longer. The short-term timeframe is one order of magnitude shorter. Once you select your intermediate timeframe, you may not look at it until you examine the longer-term timeframe and make your strategic decision there. For example, if you want to carry a trade for several days or weeks, then your intermediate timeframe is likely to be defined by the daily charts. Weekly charts are one order of magnitude longer, and they’ll determine the long-term timeframe for you. Hourly charts are one order of magnitude shorter, and they’ll determine the short-term timeframe.

Day traders who hold their positions for less than an hour can use the same principle. For them, a 5-minute chart may define the intermediate timeframe, a 25-minute chart the long-term timeframe, and a 2-minute chart the short-term timeframe.

Triple Screen demands that you examine the long-term chart first. It allows you to trade only in the direction of the tide—the trend on the long-term chart. It uses the waves that go against the tide for entering positions. For example, when the weekly trend is up, daily declines create buying opportunities. When the weekly trend is down, daily rallies provide shorting opportunities.

First Screen—Market Tide

Triple Screen begins by analyzing the long-term chart, one order of magnitude greater than the one you plan to trade. Most traders pay attention only to the daily charts, with everybody watching the same few months of data. If you begin by analyzing weekly charts, your perspective will be five times greater than that of your competitors. Begin by selecting your favorite timeframe and call it Intermediate. Do not even glance at your intermediate chart because it’ll prejudice you. Go immediately to the timeframe one order of magnitude longer—your long-term chart. That’s where you’ll make your strategic decision to be a bull or a bear. After that, return to the intermediate timeframe and start making tactical decisions, such as where to enter and where to place a stop.

If you make the mistake of looking at the daily chart first, you’ll be prejudiced by its patterns. First, make an unbiased decision on a long-term weekly chart before even glancing at the daily.

The original version of Triple Screen used the slope of weekly MACD-Histogram as its weekly trend-following indicator (Figure 39.1). It was very sensitive and gave many buy and sell signals. Later I switched to using the slope of a weekly exponential moving average as my main trend-following tool on long-term charts. After I invented the Impulse system (described in the following chapter), I began to use it for

FIGURE 39.1 Gold weekly, with 26- and 13-EMAs and MACD-Histogram (12-26-9). (Chart by Stockcharts.com)

Using Weekly MACD-Histogram as the First Screen of Triple Screen

Triple Screen requires us to examine weekly charts before even looking at the dailies. The slope of MACD-Histogram is defined by the relationship between its two latest bars.

This indicator flashes a buy signal when its slope turns up and a sell signal when its slope turns down. The best buy signals occur when MACD-Histogram turns up from below its centerline. The best sell signals are given when its slope turns down from above its centerline (see Indicator Seasons in Chapter 32).

When the slope of MACD-Histogram turns up (arrows A, C, and E), it allows us to trade only from the long side or stand aside. When that slope turns down (arrows B and D), it allows us to trade only from the short side or stand aside.

Note that the buy signals at A and E are of better quality than at C—because the signal C occurred above the centerline. It is better to buy in spring than in summer. At the right edge of the chart, the uptrend is very strong because the signal E came from a bullish divergence: a double bottom of prices (A and E) was accompanied by a much shallower second bottom of the indicator.

the first screen of Triple Screen. The Impulse system combines the best features of the previous two methods. It is not quite as jumpy as MACD-Histogram but is faster to react than the slope of an EMA.

As you’ll read in the next chapter, the Impulse system colors every bar green when it’s bullish, red when bearish, and blue when neutral. The Impulse system doesn’t tell you what to do. It’s a censorship system that signals what you’re prohibited from doing. When the Impulse system is red, it prohibits you from buying. When it is green, it prohibits you from shorting. Glancing at a weekly chart when you want to buy, you have to wait until it stops being red. Glancing at a weekly chart when you want to sell short, you have to make sure it isn’t green. The blue Impulse permits you to trade either way.

Some traders use other indicators to identify major trends. Steve Notis wrote an article in Futures magazine showing how he used the Directional System as the first screen of Triple Screen. The principle is the same. You can use most trend-following indicators, as long as you analyze the trend on the weekly charts first and then look for trades on the daily charts only in that direction.

Screen One Summary: Identify the weekly trend using a trend-following indicator and trade only in its direction.

A trader has three choices: buy, sell, or stand aside. The first screen of the Triple Screen trading system takes away one of those options. It acts as a censor who permits you only to buy or stand aside during major uptrends. It allows you only to sell short or stand aside during major downtrends. You have to swim with the tide or stay out of the water.

Second Screen—Market Wave

The second screen of Triple Screen identifies the wave that goes against the tide. When the weekly trend is up, daily declines point to buying opportunities. When the weekly trend is down, daily rallies point to shorting opportunities.

The second screen applies oscillators, described in a previous section, to the daily charts in order to identify deviations from the weekly trend. Oscillators give buy signals when markets decline and sell signals when they rise. The second screen of the Triple Screen allows you to take only those signals on the daily charts that put you in gear with the weekly trend.

Screen Two: Apply an oscillator to a daily chart. Use daily declines during weekly uptrends to find buying opportunities and daily rallies during weekly downtrends to find shorting opportunities. I like using Force Index, described in chapter 30, for the second screen, but other oscillators, such as RSI, Elder-ray, or Stochastic also perform well.

When the weekly trend is up, Triple Screen takes only buy signals from daily oscillators but doesn’t short their sell signals. The 2-day EMA of Force Index gives buy signals when it falls below its zero line, as long as it doesn’t fall to a new multi-week low. When the weekly trend is down, Force Index gives shorting signals when it rallies above its centerline, as long as it doesn’t rise to a new multi-week high (Figure 39.2).

Other oscillators, such as Stochastic and RSI (see Chapters 26 and 27), give trading signals when they enter their buy or sell zones. For example, when weekly MACD-Histogram rises but daily Stochastic falls below 30, it identifies an oversold area, a buying opportunity. When the weekly MACD-Histogram declines but daily Stochastic rises above 70, it identifies an overbought area, a shorting opportunity.

Third Screen—Entry Technique

The Third Screen is your entry technique, and here you have quite a bit of latitude. You can go to an even shorter time-frame, especially if you have live data, or you can use the same intermediate timeframe.

In the original Trading for a Living I recommended looking for a ripple in the direction of the market tide: buying a breakout above the previous day’s high for entering longs or shorting a breakdown below the previous day’s low for entering shorts.

FIGURE 39.2 Gold daily, with 26- and 13-EMAs and 2-day Force Index. . (Chart by Stockcharts.com)

Daily Force Index—the Second Screen of Triple Screen

The 2-day EMA of Force index is one of several oscillators that can work for the second screen of the Triple Screen trading system. Force Index marks buying opportunities when it falls below its centerline. It marks selling opportunities when it rises above its centerline. When the weekly trend is up (marked here with a green horizontal bar), take only buy signals from the daily oscillator for entering long positions. When the weekly trend is down (marked by a red horizontal bar), take only sell signals for entering short positions.

Notice a bullish divergence, accompanied by a false downside breakout before the start of the uptrend (marked with a diagonal green arrow). At the right edge of the screen, Gold is flying, along with most gold stocks. I’m actively buying them—but not Gold ETFs. A Traders’ Camp graduate from Australia wrote the other day: “I bought XAU ETF but it is being left far behind by NCM, our biggest Gold Miner. Is that the normal scenario for ETFs?” Yes, Sir!

The downside of that approach was that the stops were quite wide. Buying a breakout above the previous day’s high and placing a stop below that day’s low could mean a wide stop after a wide-range day, either putting a lot of money at risk or reducing position size. At other times, when the pre-breakout day was very narrow, placing the stop right below its low would expose that trade to the risk of being stopped out by market noise.

The breakout technique is still valid, but I seldom use it. With the wide availability of intraday data, I like to switch to 25-minute and 5-minute charts and use daytrading techniques for entering my swing trades. If you don’t have access to live data and need to place an order in the morning, before leaving for the day, I recommend an alternative approach which I call “an average EMA penetration.”

Almost every rally is penetrated by occasional pullbacks, and you want to measure how deeply those pullbacks drop below your fast EMA. Look at the daily chart for the past four to six weeks, and if it is in an uptrend, measure how deeply prices penetrate below their EMA during normal pullbacks (Figure 39.3).

FIGURE 39.3 Gold daily, with 26- and 13-EMAs. (Chart by Stockcharts.com)

An Average Downside Penetration—the Third Screen of Triple Screen

Here we zoom in on the chart from Figure 39.2. We can sharpen Triple Screen buy signals by not waiting for the 2-day Force rally back above zero. We can use its declines below zero as alerts and then place our buy orders below value, using an average downside penetration.

• Calculate an average penetration
• Subtract yesterday’s EMA level from today’s and add this number to today’s EMA: this will tell you where your EMA is likely to be tomorrow.
• Subtract your average penetration from your estimated EMA level for tomorrow and place your buy order there. You’ll be fishing to buy at a bargain level, during a pullback—instead of paying a premium for buying a breakout.

In the example in Figure 39.3, prices dipped below their fast EMA (colored red) on four occasions. An average downside penetration was $9.60. At the right edge of the screen, the 13-day EMA stands at $1,266. Deducting the recent average downside penetration from that number suggests that if today sees a spell of panic selling, we should place our buy order approximately $9 below the latest level of EMA. We can perform this calculation on a daily basis, until we finally get an opportunity to buy low. This is a much more peaceful approach than chasing runaway prices.

These rules are for buying during an uptrend. Reverse them for selling short in downtrends. Keep in mind though that downtrends tend to move twice as fast as uptrends.

Weekly Trend	Daily Trend	Action	Order
Up	Up	Stand aside	None
Up	Down	Go long	EMA penetration or an upside breakout
Down	Down	Stand aside	None
Down	Up	Go short	EMA penetration or a downside breakout

Triple Screen Summary

When the weekly trend is up and a daily oscillator declines, place a buy order below the fast EMA on the daily chart, at a level of an average downside penetration. Alternatively, place a buy order one tick above the high of the previous day. If prices rally, you will be stopped in long automatically when the rally takes out the previous day’s high. If prices continue to decline, your buy-stop will not be touched. Lower your buy order the next day to the level one tick above the latest price bar. Keep lowering your buy-stop each day until stopped in or until the weekly indicator reverses and cancels its buy signal.

When the weekly trend is down, wait for a rally in a daily oscillator and place an order to sell short above the fast EMA on the daily chart, at a level of an average upside penetration. Alternatively, place an order to sell short one tick below the latest bar’s low. As soon as the market turns down, you will be stopped in on the short side. If the rally continues, keep raising your sell order daily. The aim of a trailing sell-stop technique is to catch an intraday downside breakout from a daily uptrend in the direction of a weekly downtrend.

Triple Screen in Day-Trading

If you day-trade, you may select a 5-minute chart as your intermediate timeframe. Again, do not look at it, but go to a 25- or a 30-minute chart first, which will be your long-term chart. Make a strategic decision to be a bull or a bear on that longerterm chart, and then return to your intermediate chart to look for an entry and stop (Figure 39.4).

FIGURE 39.4 On the left: AMZN 30-min chart with a 13-bar EMA and 12-26-9 MACD-Histogram. On the right: AMZN 5-min chart with a 13-bar EMA, 0.6% channel, and 2-bar Force Index. (Charts by Stockcharts.com)

Triple Screen in Day-Trading

The shares of Amazon.com, Inc. (AMZN) are a popular trading vehicle, thanks to their volatility and liquidity. The principles of Triple Screen are the same here as on the longer-term charts. Here, a longer-term chart whose every bar represents 30 minutes of trading defines the long-term trend. With it rising, we turn to a short-term chart, whose every bar represents 5 minutes of trading. When its 2-bar Force Index dips below zero, it marks a wave that goes against the tide—an opportunity to buy at a lower price. A channel that contains approximately 95% of all prices helps set profit targets.

A neat combination of timeframes for day-trading stocks is a set of 39- and 8-minute charts. The U.S. stock market is open from 9:30 a.m. to 4 p.m.—six and a half hours or 390 minutes. Using a 39-minute chart as your long-term screen neatly divides each day into 10 bars. Make your strategic decision there, and then drop down to a chart that’s 5 times faster—an 8-minute chart—for tactical decisions on entries and exits.

Don’t mash together too many timeframes. If you’re swing-trading, you can briefly use an intraday chart to time your entry, but then return to the daily charts. If you keep watching intraday charts, chances are they’ll shake you out of the trade prematurely. If you day-trade, then the weekly chart is not really relevant, but you may take a quick look at the daily chart. The rule is this: select your favorite (intermediate) chart, pair it with a long-term chart that is 5 times longer, and go to work.

Stops and Profit Targets

Proper money management is essential for successful trading. A disciplined trader takes his profits at targets, cuts losses short, and outperforms those who keep hoping and hanging on to bad trades. Before you enter a trade, write down three numbers: the entry, the target, and the stop. Placing a trade without defining these three numbers is gambling.

Triple Screen calls for setting profit targets using long-term charts and stops on the charts of your intermediate timeframe. If you use weekly and daily charts, set profit targets on the weeklies but stops on the dailies. When buying a dip on a daily chart, the value zone on a weekly chart presents a good target. When day-trading and using a 25-minute and a 5-minute pair, set the profit target on a 25-minute chart and the stop on a 5-minute chart. This helps you aim at the greater results, while holding down the risk.

The Triple Screen trading system calls for placing fairly tight stops. Since it has you trading in the direction of the market tide, it doesn’t give much room to losing trades. Get on with the tide—or get out. We’ll return to this topic in Chapter 54, “How to Set Stops.”

■ 40. The Impulse System

The idea for the Impulse system came to me in the mid-1990s. I woke up in the middle of the night in a faraway hotel and sat up bolt upright in bed with the thought that I could describe any market move in any timeframe, using only two criteria: inertia and power. By combining them, I could find stocks and futures with both bullish inertia and bullish power and trade them long. I could also find stocks and futures with both bearish inertia and power and sell them short.

A good measure of the inertia of any trading vehicle is the slope of its fast EMA. A rising EMA reflects bullish inertia, while a falling EMA reflects bearish inertia. The power of any trend is reflected in the slope of MACD-Histogram. If its latest bar is higher than the previous bar (like the height of the letters m–M) or less deep than the previous bar (like the depth of the letters y–v), then the slope of MACD-Histogram is rising, and the power is pushing up. If the latest bar of MACD-Histogram is lower than the previous one (like the depth of the letters v–y or the height of the letters M–m), then the slope is declining, and the power is pushing down. When we use MACD-Histogram to define power, it doesn’t matter whether it’s above or below zero: what matters is the relationship of the last two bars of MACD-Histogram.

It is relatively simple to program most software packages to color price bars or candles using the Impulse system. If both indicators are rising, the bar is green bullish. If both are falling, the bar is red—bearish. When the two indicators move against one another, that bar is blue—neutral (Figure 40.1).

At first, I anticipated making this system automatic—buy green, short red, and cash checks on all colors. Backtesting the Impulse system threw cold water on that idea. The automatic system caught every single trend, but it got whipsawed during trading ranges, where it kept flipping between green and red.

I set the Impulse system aside, but kept thinking about it. A few years later it dawned on me: this wasn’t an automatic trading system—it was a censorship system! It didn’t tell me what to do—it told me what not to do. If either weekly or daily bar was red—no buying allowed. If either weekly or daily bar was green—no shorting permitted.

Ever since that discovery, I’ve been using the Impulse system for all my trades. I presented it to the public in my 2002 book Come into My Trading Room, which Barron’s named a book of the year. The Impulse system is becoming increasingly popular worldwide, and its terminology has entered the language of trading.

The Impulse System
EMA		MACD-H		Impulse	Yes	No
7	$\ddot{}$		=		Buy, stand aside	Short
	$\ddot{}$		$=$		Short, stand aside	Long
Τ	$\ddot{}$		$=$		Long or short
	$\ddot{}$		$=$		Long or short

FIGURE 40.1 The colors of the Impulse system.

• EMA rising & MACD-Histogram rising (especially below zero) = Impulse is green, bullish. Shorting prohibited, buying or standing aside permitted.
• EMA falling & MACD-Histogram falling (especially above zero) = Impulse is red, bearish. Buying prohibited, shorting or standing aside permitted.
• EMA rising & MACD-Histogram falling = Impulse is blue, neutral. Nothing is prohibited.
• EMA falling & MACD-Histogram rising = Impulse is blue, neutral. Nothing is prohibited.

And that’s how I’ve been using the Impulse system ever since (Figure 40.2). It keeps me out of trouble. I may develop my trading plans based on any number of ideas, signals, or indicators—and then the Impulse system forces me to wait until it no longer prohibits an entry in the planned direction. In addition, the Impulse system helps me recognize when a trend starts weakening and suggests an exit.

Entries

Green and red bars of the Impulse system show when both inertia and power are pointing in the same direction. At a green bar, bulls are in charge and the uptrend is accelerating. At a red bar, bears are dominant and the downtrend is in full swing. A fast EMA and MACD-Histogram may stay in gear with each other for only a few bars, but that’s when the market travels fast—the impulse is on!

Before you start applying the Impulse system to your favorite market, remember the Triple Screen’s insistence on analyzing markets in more than one timeframe. Select your favorite timeframe and call it intermediate. Multiply it by five to define your long-term timeframe. If your favorite chart is daily, analyze the weekly chart first and make a strategic decision to be a bull or a bear. Use the Impulse system to decide when you’re permitted to enter long or short positions.

• If you’re a short-term momentum trader, you can buy as soon as both timeframes turn green and take profits as soon as one of them fades to blue.
• When trying to catch market turns, the best trading signals are given not by green or red but by the loss of green or red colors.

If a stock is falling, but your analysis indicates that a bottom is near, monitor the Impulse system on weekly and daily charts. If even one of them shows red, the downtrend is still in force and buying is not permitted. When both timeframes stop being red, they allow you to buy.

If you think that a stock is forming a top and is about to turn down, examine the Impulse system on both weekly and daily charts. If even one of them is green, it’s a sign that the uptrend is still alive, and no shorting is permitted. When the green disappears from both timeframes, you may start shorting.

The shorter a timeframe, the more sensitive its signals: the Impulse on a daily chart almost always changes colors ahead of the weekly. When day-trading, the 5-minute chart changes colors ahead of a 25-minute chart. If my studies show that the market is bottoming and getting ready to turn up, I wait until the daily chart stops being red and turns blue or even green; then I start watching the weekly chart, which is still red. As soon as it turns from red to blue, it allows me to buy. This technique saves me from buying too soon, while the market is still declining.

I use the same approach to shorting. When I think that a top is forming and the daily Impulse stops being green and turns blue or even red, I closely monitor the weekly chart. As soon as it loses its green color, it permits me to go short. Waiting

FIGURE 40.2 SSYS weekly with 13- and 26-week EMAs, 12-26-9 MACD-Histogram and the Impulse system. (Chart by Stockcharts.com)

The Impulse System

The Impulse system can sharpen any method of finding trades, whether technical or fundamental. Let’s review an example, using the stock of Stratasys, Inc. (SSYS)—one of the two leading stocks in the additive manufacturing industry. In 2012, I published the world’s first popular e-book on additive manufacturing in which I called for a boom in its stocks. Vertical green arrows mark bars immediately following red bars. Red prohibits you from buying. The best time to buy is immediately following red’s disappearance. You can see how those green arrows pick one intermediate bottom after another, including the buy signal at the right edge of the chart. Having an objective method gives you the confidence to buy as soon as a decline screeches to a halt.

The Impulse system also suggests good areas for profit taking. Slanted red arrows point to blue bars that occur after a series of green bars far away from value. They indicate that bulls are choking up—a good time to cash out and wait for the next buying opportunity.

for both timeframes to lose the color that is contrary to my plan helps ensure that I trade in gear with the market and not against it.

Remember, the Impulse system is a censorship system. It doesn’t tell you what to do—but it clearly tells you what you’re not allowed to do. You’re not supposed to go against the censor.

Many programs for technical analysis include a feature called “conditional formatting.” It allows you color price bars or candles depending on the slope of the EMA and MACD-Histogram. A brilliant programmer in Chicago named John Bruns used this feature when he included the Impulse system in tool kits we call elder-disks1 .

¹ These are available for various trading programs, listed at elder.com.

If you use a platform that doesn’t permit conditional formatting, you can still use the Impulse system. Simply observe the slopes of the EMA and MACD-Histogram: their combination will tell you what should be the color of the latest bar.

If you know how to program, you can add more features to the Impulse system. You can test different EMA lengths or MACD settings, looking for those that work best in your market. A day trader can program sound alarms to monitor color changes in several markets without being glued to the screen.

Exits

If you’re a short-term momentum trader, close out your trade as soon as the color of the Impulse system stops supporting the direction of your trade, even in one of the two timeframes. Usually, the daily MACD-Histogram turns ahead of the weekly. When it ticks down during an uptrend, it shows that the upside momentum is weakening. When the buy signal disappears, take profits without waiting for a sell signal.

Reverse this procedure in downtrends. Cover shorts as soon as the Impulse system stops being red, even in one of the two timeframes. The most dynamic part of the decline is over, and your momentum trade has fulfilled its goal.

The Impulse system encourages you to enter cautiously but exit fast. This is the professional approach to trading. Beginners tend to do the opposite; jump into trades and then take forever to exit, hoping for the market to turn their way.

A swing trader may stay in a trade, even if one of the timeframes turns blue. What he should never do is stay in a trade against the color. If you’re long, and one of the timeframes turns red, it is time to sell and go back to the sidelines. If you’re short, and the Impulse system turns green, it signals to cover your short position.

The Impulse system helps identify islands of order in the ocean of market chaos by showing when the crowd, usually so aimless and disorganized, becomes emotional and starts to run. You enter when a trend pattern emerges and exit when it starts to sink back into chaos.

■ 41. Channel Trading Systems

Market prices tend to flow in channels, like rivers in their valleys. When a river touches the right edge of its valley, it turns left. When it touches the left rim of its valley, it turns right. When prices rally, they often seem to stop at an invisible ceiling. Their declines seem to stop at invisible floors. Channels help us anticipate where those support and resistance levels are likely to be encountered.

Support is where buyers buy with greater intensity than sellers sell. Resistance is where sellers sell with greater intensity than buyers buy (see Chapter 18). Channels show where to expect support and resistance in the future.

Channels help identify buying and selling opportunities and avoid bad trades. The original research into trading channels was conducted by J. M. Hurst and described in his 1970 book, The Profit Magic of Stock Transaction Timing.

The late great mathematician Benoit Mandelbrot was hired by the Egyptian government to create a mathematical model of cotton prices—the main agricultural export of that country. After extensive study, the scientist made this finding: “prices oscillate above and below value.” It may sound simple, but in fact it’s profound. If we accept this mathematical finding and if we have the means to define value and measure an average oscillation, we’ll have a trading system. We’ll need to buy below value and take profits at value or sell short above value and cover at value.

We have already agreed that value is in the zone between a short and a long moving averages. We can use channels to find normal and abnormal oscillations.

Two Ways to Construct a Channel

We may construct a channel by plotting two lines parallel to a moving average: one above and another below. We may also vary the distance between the channel lines depending on that market’s volatility (standard deviation channels).

A symmetrical channel, centered around a moving average, is useful for trading stocks and futures. A standard deviation channel (sometimes called Bollinger bands) is good for those who trade options.

Channels mark the boundaries between normal and abnormal price action. It is normal for prices to stay inside a well-drawn channel, and only unusual events push them outside. The market is undervalued below its lower channel line and overvalued above its upper channel line.

Symmetrical Channels

Earlier we’ve discussed using a set of two moving averages for trading (see Chapter 22). With such a pair, use the slower one as the backbone of your channel. For example, if you use 13-day and 26-day EMAs, draw your channel lines parallel to the 26-day EMA.

The width of a channel depends on the coefficient selected by the trader. This coefficient is usually expressed as a percentage of the EMA level.

Upper Channel Line = EMA + Channel Coefficient • EMA

Lower Channel Line = EMA − Channel Coefficient • EMA

When setting a channel for any market, start with 3% or 5% of the EMA and keep adjusting those values until a channel contains approximately 95 percent of all price data for the past 100 bars, about five months on a daily chart. This is similar to trying on a shirt: you look for the one that fits not too loose or too tight, with only your wrists and neck sticking out. Only the extreme prices will protrude outside of a well-drawn channel.

Volatile markets require wider channels, while quiet markets require more narrow channels. Cheaper stocks tend to have higher coefficients than expensive ones. Long-term charts require wider channels. As a rule of thumb, weekly channel coefficients are twice as large as daily ones.

I used to plot channels by hand until my programmer wrote an add-on for several software packages called an Autoenvelope. It automatically plots correct channels for any trading vehicle in any timeframe (Figure 41.1). It’s included on elder-disks for several popular programs.

Mass Psychology

An exponential moving average reflects the average consensus of value in its time window. When prices are near their moving average, the market is fairly valued. When they decline near the lower channel line, the market is undervalued. When prices rise to the upper channel line, the market is overvalued. Channels help find buying opportunities when the market is cheap and shorting opportunities when the market is dear. When prices fall below their moving average, bargain hunters step in. Their buying as well as short covering by bears stops declines and lifts prices. When prices rise above value, sellers see an opportunity to take profits on long positions or go short. Their selling caps the rise.

When the market sinks to the bottom of a depression, its mood is about to improve. Once it rises to the height of its mania, it’s about to start calming down. A channel marks normal limits of mass optimism and pessimism. The upper channel

FIGURE 41.1 Euro futures, with 26- and 13-day EMAs, the Impulse system, and Autoenvelope. (Chart by Tradestation)

Channels: Autoenvelope

This chart shows several recent months of trading in the March 2014 Euro currency futures (ESH14). Futures are much more transparent and true than the murky forex deals. Whenever I trade currencies, I use currency futures.

Warren Buffet refers to the stock market as a manic-depressive fellow, and his description applies to non-equity markets. Here you see the Euro swinging above and below value. When it rises above the upper channel line, it shows that the market has become manic (marked with a letter M), and when it falls below the lower channel line, it is depressed (marked with a letter D).

Buffett observes that the trouble with most people is that they become infected by the mood of Mr. Market—they want to buy when he is manic and sell when he’s depressed. Plotting a channel helps you diagnose the market’s mania and depression and avoid becoming infected by either. One of my strict rules is never to buy above the upper channel line or sell short below the lower channel line. I may miss a runaway trend because of this restriction, but my safety is greatly increased. At the right edge of the screen, the Euro is rising very near its upper channel line—it looks like a manic episode is about to develop.

line shows where bulls run out of steam, while the lower channel line shows where bears become exhausted.

At the upper channel line, bears have their backs against the wall as they fight off the bulls. At the lower channel line, bulls have their backs against the wall and fight off the bears. We all fight harder when our backs are against the wall, and that’s why channels tend to hold.

If a rally shoots out of a channel and prices close above it, it shows that the uptrend is exceptionally strong. When a rally fails to reach the upper channel line, it is a bearish sign, as it shows that bulls are becoming weaker. The reverse applies to downtrends.

My friend Kerry Lovvorn finessed this idea by plotting not one but three sets of channels around a moving average. The width of his channels is driven by Average True Ranges (see Chapter 24). His three channels are set at one, two, and three ATRs away from the moving average. Normal moves tend to stay within 1-ATR channels, while only extreme moves go outside of 3-ATRs, indicating a reversal is near (Figure 41.2).

Channels help us remain objective, while other traders get swept up in mass bullishness or bearishness. When prices rally to the upper channel line, you see that mass bullishness is being overdone, and it’s time to think about selling. When prices drop

FIGURE 41.2 RSOL daily with 21-day EMA and 1-, 2-, and 3-ATR channels, MACD-Histogram 12-26-9, and the Impulse system. (Chart by Tradestation)

Multiple ATR Channels

This chart of Real Goods Solar, Inc. (RSOL) reflects several months of action:

• Area A—Warning. Prices stab outside +3 ATRs—the uptrend has reached an extreme.
• Area B—Sell. Prices couldn’t hold above +2 ATRs—take profits on long positions.
• Area C—Alert. Decline stopped at −2 ATRs—a sign of bottoming.
• Area D—Alert confirmed. Prices holding above −2 ATRs—bottom is being built.
• Area E—Buy. False downside breakout reaches −3 ATRs and rejects that low.
• Area F—Warning. Prices stab outside of +3 ATRs—watch whether +2 ATRs will hold.
• Area G—Warning. Prices stab outside of +3 ATRs—watch whether +2 ATRs will hold.
• Area H—Another warning. Prices stab outside of +3 ATRs—watch whether +2 ATRs will hold.

Area I—Sell. Prices couldn’t hold above +2 ATRs—take profits on long positions.

near the lower channel line and everyone turns bearish, you know that it’s time to think about buying instead of selling.

Trading Rules

Amateurs like to bet on long shots—they tend to buy upside breakouts and short (if they ever sell short) downside breakouts. When an amateur sees a breakout, he expects riches from a major new trend.

Professionals, on the other hand, tend to trade against deviations and for a return to normalcy. The pros know that most breakouts are exhaustion moves that are soon aborted. That’s why they like to fade breakouts—trade against them, selling short as soon as an upside breakout stalls and buying when a downside breakout starts returning into the range.

Breakouts can produce spectacular gains when a major new trend blows out of a channel, but in the long run it pays to trade with the pros. Most breakouts fail and are followed by reversals, which is why channel lines mark attractive zones for entering trades against breakouts, with profit targets in the value zone.

You can use moving-average channels as a stand-alone trading method or combine it with other techniques. Gerald Appel, a prominent market researcher and money manager in New York, recommended these rules for trading with channels:

• 1. Draw a moving average and build a channel around it. When a channel is relatively flat, the market is almost always a good buy near the bottom of its trading channel and a good sell near the top.
• 2. When the trend turns up and a channel rises sharply, an upside penetration of the upper channel line shows very strong bullish momentum. It indicates that you will probably have one more chance to sell in the area of the highs that are being made. It is normal for the market to return to its moving average after an upside penetration, offering an excellent buying opportunity. Sell your long position when the market returns to the top of the channel.

This also works in reverse during sharp downtrends. A breakout below the lower channel line indicates that a pullback to the moving average is likely to occur, offering another opportunity to sell short. When prices return to the lower channel line, it is time to cover shorts.

The best trading signals are given by a combination of channels and other technical indicators (Figure 41.3). Indicators give some of their strongest signals when they diverge from prices. A method for combining channels and divergences was described to me by the late Manning Stoller.

• 1. A sell signal is given when prices reach the upper channel line while an indicator, such as MACD-Histogram, traces a bearish divergence. It shows that bulls are becoming weak when prices are overextended.
• 2. A buy signal is given when prices reach the lower channel line while an indicator traces a bullish divergence. It shows that bears are becoming weak when prices are already low.

We must analyze markets in multiple timeframes. Look for buys on the daily charts when prices are rising on the weeklies. Look for shorting opportunities on the dailies when prices are sinking on the weekly charts.

3. Go long near the moving average when the channel is rising, and take profits at the upper channel line. Go short near the MA when the channel is falling, and take profits at the lower channel line.

When a channel rises, it pays to trade only from the long side, buying in the value zone which lies between the fast and slow moving averages, and then selling at the upper channel line. When a channel declines, it pays to short in the value zone and cover at the lower channel line.

FIGURE 41.3 SIX daily with 26- and 13-day EMAs, 6% channel, MACD-Histogram 12-26-9, and the Impulse system. (Chart by Stockcharts.com)

Combining Channels and MACD Signals

This chart reflects several months of action in Six Flags Entertainment Corporation (SIX).

• Area A—while prices have reached the lower channel line, a new record low of MACD-Histogram suggests that this low will be retested or exceeded.
• Area B—channel line rejected, rally is likely ahead.
• Area C—prices reached their upper channel line and recoiled—reversal is likely.
• Area D—buy. Prices have reached the lower channel line, while MACD-Histogram has traced out a bullish divergence between bottoms A and D, with a break at C.
• Area E—while prices have reached their upper channel line, a new record high of MACD-Histogram suggests that this high is likely to be retested or exceeded.
• Area F—pullback to value completed; MACD-Histogram breaks below zero, creating a setup for a possible bearish divergence. Still may buy to ride back to the prior high. Area G—sell and sell short. Prices have reached the upper channel line, while MACD-Histogram has traced out a bearish divergence between tops E and G, with a break at F.

Standard Deviation Channels (Bollinger Bands)

The unique feature of these channels is that their width changes in response to market volatility. Their trading rules differ from those of regular channels.

• 1. Calculate a 21-day EMA.
• 2. Subtract the 21-day EMA from each closing price to obtain all the deviations from the average.
• 3. Square each of the deviations and get their sum to obtain the total squared deviation.
• 4. Divide the total squared deviation by the EMA length to obtain the average squared deviation.
• 5. Take the square root of the average squared deviation to obtain the standard deviation.

These steps, outlined by Bollinger, have been included in many software packages. A band becomes wider when volatility increases but it narrows down when volatility decreases. A narrow band identifies a sleepy, quiet market. Major market moves tend to erupt from flat bases. Bollinger bands help identify transitions from quiet to active markets.

These bands are useful for options traders because option prices are largely driven by swings in volatility. Narrow Bollinger bands help you buy when volatility is low and options are relatively cheap. Wide bands help you decide to write options when volatility is high and options are expensive.

When we return to options in the following chapters, you’ll read that buying options is a losers’ game. Professional traders write options. Wide Bollinger Bands can signal when to be more active with your writes. If you trade stocks or futures rather than options, it’s better to use regular channels as profit targets; trading is hard enough without trying to shoot at a moving target, such as a Bollinger Band.