Trend Following and an Identity Crisis
What are we doing?
It dawned on me, seemingly out of no where. I, and most technical analysts, are looking at it all wrong. it should be so simple, so obvious, yet is disregarded every single day.
In a rising market, everyone–and i mean everyone–is looking for resistance levels. In a declining market, everyone is looking for support levels. if one were a range bound trader, this is probably the mindset needed. however, day in and day out i see trend followers doing the same thing. its pure insanity.
We preach that ‘the trend is your friend’, ‘for a rising trend to change to a declining one you need lower highs and lower lows’. Yet, a mindset of looking for resistance in an advance is the exact thought process that denies us the ability to follow trends. we have a self identity as trend followers, yet think with the mindset of a range bound trader.
This undoubtedly is a problem, if not an identity crisis.
No wonder so many people cant make money in the markets. ill often bring up that most people when looking at fundamentals miss the boat. that they have the mindset that they should just be able to look at a stock, and if its ‘cheap’ based on what they see, then the stock ’shouldnt’ go lower. Yet this is often the case (and Warren Buffett would say thats a silly assumption). Yet, we trend followers, chartists, technical analysis, we look at support and resistance levels in disregard for trend. if there is an upcoming resistance level in a rising market, that becomes the focus. even though we do not have evidence of lower highs and lower lows.
A New Motto
Support and Resistance is a derivative of trend. In an uptrend, we want to buy dips. Correct? This means resistance levels need not be of importance in a rising market. Instead, when the market rises we should be looking for the next support levels and not resistance levels. When a market is declining, we must stop obsessing with “when will it stop?” We should be looking at potential resistance levels as places to potentially initiate new short positions.
Fear and ego drives this identity crisis.
It sounds easy, but there is an internal drive that causes us to focus on levels and limits to the market as opposed to trend. We fear to death that we’ll be the fool who bought the top of the market, the hand ringing loser who sold at the bottom. So we “protect” ourselves by looking for evidence that the market is turning, that we should be exiting because of a level that the market shouldnt breach. we create fibonacci retracements and extensions, look at days of the month, momentum indicators, oscillators, prior levels the market turned at. we attach bollinger bands, keltner channels, resistance lines–we do whatever we can to constrain trends and put them in a neat little box.
Just doesnt work that way is all. doesnt help us make money. Im aware some, many…most, are actually not in the market to make money and there are deeper seated desires being sought out. I’m just attempting to not be one of them.
Failed Breakouts – A Working Theory
Ive spoke a lot on what to look for when trading breakouts. I now begin with what seems to be what indicates failed breakouts.
Something ive seen in a few failed breakout days is that there is a gap into the next trading session, this gap is filled and bull dosed through. Then the next day moves with the breakout, and then that day is reversed on the following day.
two examples:
With DSX i was put off from the start. ADX kept me out of the trade as this “breakout” was with the ADX above 25. they can happen with an ADX that high, i just dont like them nor am i interested in what will probably be a short move. in addition, a fellow trader had pointed out the real breakout was much lower around 13.5 with a triangle and an ADX around 10. i missed that.
With OXY however, just wasnt right. it broke out of a long channel. closed properly on that day. then gapped up, took out the gap, then moved higher but 66 was still resistance. i took profits and rolled stop up to break even. sure enough, next day i was stopped out.
DSX can also be explained on the weekly chart.
Here we see the low ADX, the channel, it breaks out, but doesnt close in the top 77%. hell, it doesnt even close above the open. thats a failed breakout.
OXY from a weekly chart shows us perhaps it was a breakout on the weekly chart, showing the initial stop should have been placed at the low of the week, around $58ish
The hunt is on for further examples of what happens in the following days of a potential breakout day that turns into a failed breakout move.
Volatility Cycle Trading – The Complete Roadmap
In the past few months i have taken on a vastly new trading style and system. This involves a major market cycle. not one of timing, but of magnitude. it searches for narrow ranges, price patterns, and then seeks a structured way to exploit the breakout from this. Here are the follow blog posts on this system.
Its my opinion that within these posts, one could easily learn to set up and trade markets on all timeframes, using all market instruments. it further only requires setting buy stops and being presant for the first and last hours of the trading session.
Of all the work ive put on this blog, as well as others that have yet to be posted on here, i believe this is my most complete and thorough strategy to date. Hopefully there are more to come and that it helps other traders find what they are searching for in the market.
Alternative Option
Using the screening process of a low ADX and a bollinger band within the keltner channel, we can screen for fantastic daytrading strategies through options.
Often times markets will move, then consolidate towards the close, leaving a bollinger band squeeze on intraday timeframes. this allows us to place a straddle or strangle on the underlying and take advantage of the upcoming move. enter at the close, exit on the following open.
The markets ive chosen to trade this are simple and basic. others may want more action in their lives.
Trading vehicles: For myself, I’m trading specifically the DIA, SPY, and GLD for this strategy. all of which have fantastic liquidity. volume almost always over 100, open interest almost always over 1000. markets that could potentially be on this list in the future include USO, SSO, QQQQ, IWM. as a side note, i really enjoy selling option spreads on $RUT which has great liquidity and priced highly.
This not only is a nice way to make some quick trades, but it also only requires that you be at your screen for the first and final hour of the trading session. No scanning for stocks, just check a few quick indexes and option pricing to see if a trade is set up or not. perfect for those that cant or wish not to be in from of their screen for an eternity (i fall into the latter camp).
BB/Kelt Set up
Larry Williams talks about how there are three main components to a trade and a trading system.
1) Selection
2) Timing
3) Management of the trade
In keeping with this i am outlining the three main components for the BB/Kelt Trade
1) Selection: Start by scanning a basket of major ETFs (the spiders are a great example). Then look for a sector or industry with a low ADX line, Bollinger Bands have contracted within the Keltner Channel, BB width has been cut in half from its previous peak. Then go about looking with these sectors for stocks that show the same characteristics
2) Timing: In oder to time this there should be a price formation (i.e. rectangle, triangle etc.). in addition, there should be a price channel that has held up within the formation. when price breaks the formations trendline and the price channel, that is the entry into the trade.
3) Management:
- Initial protective stop. When you enter on a wide range up day, you take the 10 min bollinger bands, and use the bottom bands lowest point as your inital protective stop. However, if you get a pullback, make sure it doesnt have a 3 min bar close below the 38.2% retracement. this is cause for an early exit and signs of a potential reversal.
- Taking 1/4 of the position off and rolling the 3/4ths stop up to break even after a 2x ATR profit. This doesnt always keep you in the move, but it can often lock in gains and protect you from failed breakouts.
- once the trend has extended, and 10 day %R has pulled back to -80, then risen back to -50, place your stop under that low.
- Channel stop. take the channel that held the original consolidation, say 30 days, and divide it by 3. thus we would–in this instance–use a 10 day price channel as our stop.
- Finally, on large range breakouts that do not retrace 38.2% of the intraday move, sell options at the price formations target. this not only minimizes the risk of a failed breakout, it also helps you take advantage of the explosive move which should cause the options in that direction to become overpriced, and well worth selling as insurance.
Large Range Days, again
Adding more to our discussion on large range days. ive observed the ADX to be a good indicator for this. Using either 5 min 14 period ADX, or 3 min 23 period ADX.
+DI and -DI do not cross in the first 2 hours for sure, and almost always the first 3 hours of trading. many times they do not cross at all, or just once for a noon swoon or a small dip into the final hour.
Large range up days close in the upper 77% of the days range, and above VWAP. for down days, this is just reversed.
A/D is favoring one side by a large margin. certainly 60% of stocks are advancing in an up move, but more clarity is provided if it is 70% or greater. 80% and you definitely have a wide range day set up.
When the noon swoon or late day shake out happens, it should not retrace more than 38.2% of the days move on a 3 or 5 min bar closing basis. if it does, often an event happened mid day to drastically change traders minds. this is a sign to exit the position.
Thus entries are best between the 10:00-11:30 time period. after that the trade is either lost or waiting for the pullback that starts to show signs of recovery above a 38% retracement.
Failure: breakouts that break out of a channel on the open, if the 3 min bar closes more than one ATR within the channel, after breakout out for opening price, thats a failed breakout.
Breakout bars should exceed one ATR. it should stand to reason that a large range day cant be very large range if its within the average range.
Safety First
Im dabbling in a theory that when it comes to commodities and commodity stocks, the stocks lead the commodities out of the bottom. The premise is that after trading futures, its just very apparent that you have to be a commercial user or it is nuts to go counter trend. too much leverage for speculators, which means stops or margin calls are hit very easily on countertrend moves.
With stocks though, with “safety” stocks, you can make a bit of a stand and pick up a dividend too.
So here we see XOM, the safest of safe with a very secure dividend, bottoming out before RIG did–which doesnt have a dividend but is a stock. and RIG bottoming out before oil did. Now, they both started their higher low as oil made its low, but they held up when oil did not.
The question i have right now, are natural gas stocks signaling the same thing? if so, there is a killing to be made in the futures. On the flip side, XOM seems to top out before oil. and RIG followed USO
However, natural gas stocks topped out when natural gas did.
So perhaps there is no “safety” stock like XOM in natural gas. or it has a different nature. that is what im unsure of at the time. It does seem to be an interesting intermarket relationship that id like to study further.
the Baltic Dry Index and DRYS is another one im intrigued by
Notice how in this double top formation, DRYS never made the higher high that the BDI did.
My general assumption it is easier to take speculative/countertrend positions in stocks because they are less leveraged. Therefore, they are a leading indicator of their underlying commodity.
After Action Review
“There are only two ways to lose money in the market
1) Improper Analysis
2) improper implementation of correct analysis.
if you focus on just these two things, thats all youll ever need to trade.”
- Bill Williams
For many years now, ive asked what am i doing right or wrong. ive asked; was it a winning trade? why not? did i like the trade instinctively? why not? stuff like that. they were fine questions. but i dont think it ever took the mind where it needed to go. it didnt extract as much potential as it should have. with the help of Brett Steenbarger i believe ive fixed that.
this is essentially a culmination of many trades, many questions, and few answers.
Questions:
1. What was expected to happen?
(why did you take the trade in the first place)
2. How was i supposed to behave?
(What disciplines was i supposed to follow?)
3. What actually happened?
(were my expectations correct?)
4. How did i behave?
(did i act with discipline, consistency, follow the plan?)
5. Was there any discrepancy in what i was supposed to do and what i did? if so, why?
(where you admit you either acted correctly or as a fool,and what caused it)
6. Were my expectations wrong? or were my actions?
(where we decide if the analyst or the trader needs improvement…or if both were right)
7. If it was a losing trade, write, “it was a losing trade”. For winners, was the end profit greater than the initial risk taken? If not, does this styles accuracy make up for it? if not, then its probably time to drop that strategy, regardless of how well it backtests.
(did we put ourselves in the right position for success? With the odds in our favor)
8. What have I learned?
(where we combine all of these things to decide what our strengths and weaknesses are)
if what you expect never happens, then you have a problem with your EXPECTATIONS in the market place
if what you expect does in fact happen often, but you are not good at acting on it, then you have a CONFIDENCE problem.
If your expectations are proper, and your actions are proper, then your profits should be proper as well.
“On occasion you have to know what you’re doing before you can do it right.”
-
“The problem is you feel responsible for Goose, and you have a confidence problem. Up there we’ve gotta push it, thats our job.”
-Top Gun
Tieing Bands Together
Further work has been done on the bollinger band/keltner channel squeeze.
Identifying breakout days: Following the work of Larry Williams, breakout days should close in the upper 80% of their range (or lower for breakdowns). this lets us know something key about if we are participating in a breakout day before that days close. its important not to get too picky about this and say, “it was only 78%”. whats important in a breakout day is that the majority of the people on the wrong side lose, and the majority of the people betting in the right direction are in a profit. In addition, these days often arent ones that flirt with the open too much. they establish the first 30 min range, and typically stay on one side of it for the majority of the day (just as Jake Bernstein said)
Throwbacks: after watching these on multiple timeframes and markets, it appears evident to yours truly that when you have a real volatility squeeze, a real breakout, you dont get throwbacks too often. For this, we want a Band squeeze of at least two weeks (for daily charts), ADX below 20, and a consolidation channel of 9 days or greater. These tend to explode out of their consolidation formations without hesitation. News events that spur the ignition of trend are highly coveted.
Stops stops and more stops: Initially, i set the trade up so that you put your stop below the breakout days low, and then only use a channel stop as the trailing exit, along with a price target exit. after trading enough of them though, i sense this is too wide, too long, too “dangerous” for most traders. psychology was not considered. The new rules are such.
1. Initial stop is placed below the breakout days low. To standardize this, I am using a 10 min bar bollinger band. the low of the bollinger band on the breakout day (which is almost always below the low of the day) is where the initial protective stop is placed.
2. Once youve attained two Average True Ranges (ATR) of profit, take 1/4th of the position off and roll your stop on the remaining 3/4ths to breakeven. Or, below the low of the first three breakout days. This allows us to book profits, and take away the anxiety of trading as quickly as possible, without getting out of a trend too quickly.
3. The next stop is to wait for %R to make a counter trend move. in up moves, %R would go to -80, then back above 50. in downtrends, %R would go up to -20, then back below 50. when this happens, you can roll the stop on the remaining 3/4ths to that low or high.
4. Afterwhich, youll want to use the channel stop or price target exit.
5. contingency. Though youll want to use a channel stop for most cases at this point, there are instances where youll get another bollinger band squeeze, while still being in the trade. If that squeeze/formation moves against your original position, close out your profits and flip the position. If it moves your way, it would then be up to you to add to the position or keep the original position on.
These are the things ive learned while trading this system. Evidence is not very convincing it is the most profitable way to trade it, but it is probably the most practical an psychologically soothing. Things we always seek as traders.
Example:
KSS, a trade i put on for this system, breaks out above 40, and so the initial stop is below that days low at roughly 38.9. then, taking that days ATR ($2.00), we add $4 to the breakout and take profits at $44 then put the stop at break even. we then see %R come down and touch -80, and the price associated with this is $42, we then roll the next stop up to there. Then,
When the 20 day channel (62/3-20.66) rises above 42 we will then use that as the next trailing stop with a $53 target.
Hopefully more developments will follow. happy trading.
