Discretionary Traders - Don't Talk About Your Open Positions

In browsing around the web I often encounter discussions of the merits of a particular trade and opinions about the direction of a market. I know that the traders who voice these opinions have good intentions and much of the discussions could be helpful to the person receiving the information. (Some of these discussions are on our Forum.) However the provider of the opinion must be very careful that he doesn't start believing too strongly in his position because he has made the mistake of going public with it.

This is an important psychological issue that I seldom see discussed. Taking losses is always difficult and the reluctance to promptly acknowledge that we are on the wrong side of the market is probably the single most costly error a trader can make. Even under the best of conditions we hate to take losses. Publicly advocating a particular trade or the direction of a market just makes being wrong all the more painful and harder to accept. If we make it a policy to go around advocating the merits of our trades it will only make it harder to recognize when we are wrong.

Many years ago when I was a young futures broker at E. F. Hutton and Company, the firm decided that it would be a good idea to send our commodity research analysts on the road whenever they came up with a well researched idea that appeared to have great potential. Let's assume for a minute that our sugar analyst has decided that sugar is going to make a big move to the upside over the next six months. After publishing his research he would be sent from city to city where he would speak at meetings for brokers and clients suggesting why everyone should be buying sugar. At first the analyst road shows seemed like a great idea. The clients received the benefit of hearing about a well-researched idea straight from the analyst himself and also had the opportunity to ask questions and engage the analyst in a discussion of the details of the sugar market. The clients enjoyed the meetings and a lot of new commodity business was generated as a result.

However, it turns out that the objectivity of the analysts was completely lost after the story had been told and the bullish scenario presented a dozen times or more. The analyst felt obligated to the firm and to the clients. The firm had spent a lot of money to send the analyst on the road and to host these meeting all over the country. As a result of the meetings the clients now knew the analysts by name and his personal and professional reputation was clearly on the line. This analyst was now committed and he was going to be bullish on sugar regardless of what happened in the market or what new information came to light. From the point of the tours onward the analyst would only look for information to support his opinion. To ever admit that he was wrong would be such public humiliation that the analyst would tend to ignore any contrary information and would stick to his original position through thick and thin. We eventually learned that the talented Hutton research analysts did a much better job when they were free to change their minds as new facts were revealed without the pressure and responsibility generated by their repeated espousing of a particular position on a specific trade.

Discretionary traders should learn from this example and avoid discussing their open positions or their opinion about the direction of a market. It will only distort their objectivity and make it harder to take a loss promptly when that is the best course of action. Losses that only we know about are tough enough but losses that everyone knows about become much harder to stomach and we tend to postpone our exits in hope that the market will eventually turn around and prove us right. Remember that the best discretionary traders are usually very neutral about their positions and tend to take their guidance from the price action and the flow of new information. Its OK to listen to others talk about their positions but don't make it a habit of discussing your open trades. It will only cost you money, especially if you repeat your opinions often enough that you might actually start believing what you are saying.

Fortunately, systematic traders seldom get married to a position. They enjoy the luxury of being able to blame the system if a trade doesn't work out. Since there is little personal attachment to any trade, the psychological problems of systematic trader are much different than those of discretionary traders. But even systematic traders have their share of psychological problems. Perhaps we can discuss some of these problems in a future Bulletin.

Why Use Multiple Exits?

A recent message from one of our members questioned our use of multiple exits and the fact that the exits in a particular system were very complex and would sometimes move closer to the prices and then suddenly move farther away. The member questioned whether the exits were working properly and wondered about the logic of having so many different exit strategies operating within one system. I sent the member a brief reply and promised to write a Bulletin that explained our philosophy and procedures about the use of multiple exits in more detail.

When we develop trading systems the entry is usually just a few lines of code but the exit strategies and coding are often very complex. We may have a system with only one very simple entry method and that system may have a dozen or more exit strategies. The reason for devoting so much effort and attention to achieving accurate exits is that over our many years of trading we have come to appreciate both the importance and the difficulty of accurate exits.

Entries are easy. Before we enter any trade we know exactly what has occurred up to that point and if those conditions and events are satisfactory according to the rules of our system we can generate a valid entry signal. Entries are easy because we are able to set all the conditions and the market must conform to our rules or nothing happens. However, once we have entered a trade anything can happen. Now that we are in the market the possible scenarios for what might happen to our open position are endless. It would be extremely naïve to expect to hope to efficiently deal with all possible trading events with only one or two simple exit strategies. However, that seems to be the common practice and, in fact, many popular trading systems simply reverse the entry rules to generate their exits.

We believe that good exits require a great deal of planning and foresight and that simple exits will not be nearly as efficient as a series of well planned exits that allow for a multitude of possibilities. Our exit strategies need to accomplish a series of critical tasks. We want to protect our capital against any catastrophic losses so we need a dependable money management exit that limits the size of our loss without getting whipsawed. Then if the trade is working in our favor we would like to move the exit closer so that the risk to our capital is reduced or eliminated. As soon as possible we need to have a "breakeven" exit in place that prevents our profitable trade from turning into a loss.

In most of our systems, our goal is to maximize the size of our profit on each trade so we do not simply take a small profit once we see it. This goal means that we need to implement an exit strategy that protects a portion of our small profit while allowing the trade to have the opportunity to become a much bigger profit. If the trade went in our favor every day the exits could be greatly simplified but unfortunately that is not the way markets typically trade. We have to allow room for some minor fluctuations on a day to day basis. In order to facilitate our objective of maximizing the profit of each trade, in some cases we may decide to move our exit point farther away to avoid getting stopped out prematurely. For example, lets look at our Yo Yo exit that is based on the theory that we never want to stay in a position after a severe one-day move against us. (See Bulletin number 14 for an explanation of the Yo Yo exit.)

This highly efficient exit is based on measuring the amount of price movement from the previous day's close. For example we may want to exit immediately if the adverse price movement reaches one and a half Average True Ranges from the previous close. This volatility-based exit will move away indefinitely as the result of a series of adverse closing prices caused by days where the price moved against us but our volatility trigger was never quite reached. Obviously an exit that can move away from prices indefinitely is no use at all in limiting the size of our losses so the Yo Yo exit must always be used in conjunction with other exit strategies that do not move away. Now that we have implemented the Yo Yo exit to protect our trade from a severe one-day reversal in direction, we have still not addressed the question of taking profits. So far, we have exits in place to protect from large losses, to lock in a break-even point and to get us out on a sudden trend reversal but we still have not addressed the important issue of taking some profits on the trade.

We like to shoot for big profits and the bigger the profits become the closer we like to protect them. This strategy calls for multiple profit-taking exits. If we have a $1,000 profit we might want to protect 50% of it and be willing to give back $500 of our open profit. We can place an exit at $500 above our entry price. This will allow us to hold the position in the hope that the profit will grow. However if we have a $10,000 open profit I'm sure we wouldn't want to give back 50% of that. Also, let's hope that our exit stop is not still sitting back there at $500 above our entry price. For best results our exits need to adjust at various levels of profitability.

Many traders have asked us about the robustness of a system that has a many exit rules. The general perception is that a system with fewer rules is likely to be more robust. However I would disagree with applying that common belief without careful thought. Look at the exits in these two over-simplified systems:

System A:
Use a $1500 money management stop. (Limits loss to $1500.)
When profit reaches $5,000, exit with a stop at entry plus $4500.


System B:
Use a $1500 money management stop. (Limits loss to $1500.00)
When profit reaches $1,000, exit with a stop at entry price.
When profit reaches $2,000, exit with a stop at entry plus $1,250.
When profit reaches $3,500, exit with a stop at entry plus $2,500.
When profit reaches $5,000, exit with a stop at entry plus $4500.
When profit is greater than $7,500 exit with a stop at the previous day's low.

Some system traders might argue that since system A has fewer rules it should be more robust (most likely to work in the future.) We would suggest that system B is much more likely to work in the future even though it has more rules. System A is not going to make any money at all if the open profit never reaches $5,000. Once the profit exceeds $5,000 the only exit is at the $4,500 level. System A is very limited in what it is prepared for. It either makes $4,500 or it loses $1500.

As you can see, system B is obviously prepared for many more possibilities. It is conceivable (but not likely) that system A may somehow produce better test results on a historical basis because of an accidental (or intentional) curve fit. However, we would much rather trade our real money with system B. Simpler is not always better when it comes to exit planning.

Doubly Adaptive Profit Objectives By Chuck LeBeau

Having well-planned profit objectives is the best way to maximize closed-out profits. The tendency is to either take profits too soon or too late and most traders tend to err on the side of taking profits too soon. Taking a quick profit always feels good and helps to maintain our winning percentage because these "nailed-down" profits will never turn into losses. However, taking profits too soon can be one of the most costly of all possible mistakes.

It has been argued that profits in trading (especially in futures) are possible because the distribution of prices is not normal and is not a typical bell-shaped curve. The tail on the right hand side tends to be surprisingly thick indicating that unexpectedly large profits are possible. The opportunity for large profits comes our way more often than one might expect. However if we went for big profits on every trade we would also be making a big mistake. Major profit opportunities are the exception not the rule.

In very general terms there are two ways of having an advantage or "edge" in trading. One is to have gains much larger than losses and the other is to have more winners than losers. To succeed as traders we need to do our best to maximize both the percentage of winners and the size of the winners. These two worthy goals appear to be mutually exclusive. If we take the quick small profits we can have a good winning percentage but we eliminate any possibility of more substantial profits. However, if we fail to take some of the small profits they may well turn into losses.

Wouldn't it be ideal if we could know when it was best to take small profits and when it was best to hold patiently for big profits?

In previous Bulletins we have discussed the advantages of using profit objectives expressed in units of Average True Range. To quickly summarize that discussion, the ATR expands and contracts with the volatility of the market. In a quiet market a profit objective of 2 ATRs might bring us a profit of $600. In a very volatile market, two ATRs of profit might be $1400 or more. By expressing our profit goals in terms of ATRs instead of fixed dollar amounts we make them highly adaptive to what is going on in the market in terms of variations in volatility. However, what we will propose in this Bulletin goes a big step beyond that highly recommended procedure.

We have done a great deal of research using the Average Directional Index (ADX) that leads us to believe it is possible to vary our exit strategy to stay in tune with the trendiness of the market as well as the volatility. By having a doubly adaptive profit-taking strategy we can happily accept small profits when that is the best the market has to offer or we can change the strategy and hold out for unusually large profits when those opportunities are known to be present.

Volatility as measured by ATR is obviously important but daily volatility does not always relate to direction and trendiness. It is quite possible that we can have lots of big ranges in a market that is merely going sideways or we could have small ranges in a market that is highly directional. It is the correct combination of directional price movement and volatility that will allow us to maximize our profits in relation to what is happening in the market at any given time. For the best possible results we want to combine our knowledge of ATR and ADX.

As we have described in previous Bulletins, ADX tells us the underlying strength of any trend. When the trend is strong the ADX will rise. When the trend is weak the ADX will decline. This is true in stocks as well as in futures. It also applies in downtrends as well as in uptrends. A rising ADX means a strengthening trend and a declining ADX means a weakening trend.

Let's go back to our earlier example where our plan was to take our profits at the 2ATR level. With this adaptation to volatility we are counting on the changes in volatility to produce large profits and small profits based on a constant target of two ATRs of profit. However we can go a step further and get even better results. Under our new plan, when the ADX is declining we will reduce our expectations and accept profits of only 1.5 ATRs instead of two. And when the ADX is rising we will double our expectations and wait for profits of 4 ATRs instead of 2. Now we are adapting our exit strategy to both the current volatility and to the amount of trendiness in the market we are trading. As you might expect the difference in results is dramatic because our profit-taking strategy is doubly adaptive.

The logic of this strategy should be obvious. When the market is not trending strongly we improve our results by reducing our profit expectations and maintaining our winning percentage. When the market is trending strongly we know it is time to abandon our small profit targets and time to take advantage of some unusually large profit opportunities.

The examples of 1.5 ATRs as a profit target in a non-rending market and 4 ATRs as a profit target in a strong trending market are just broad guidelines and we need to vary these parameters depending on the particular market and type of system we are operating. Short-term systems may require smaller objectives and long-term systems may require much larger objectives.

We suggest you start with a 20 day ATR and a 14 to 18 day ADX. Play around with the units of profit and see what a dramatic improvement you can make in your trading results by combining ADX and ATR.

Moving Average Crossovers May Not Be The Best Entry Signals

There are many ways of using moving averages to trade but by far the most common method is to trade when a short-term moving average crosses over a longer term moving average. For example, if the 10-day MA crosses above the 30-day MA we typically assume that we have a new buy signal.

Let's stop for a minute and think about what exactly is occurring at the point of a crossover. When the 10-day MA and the 30-day MA are at the same price, the trend is not nearly as clear as it should be. What we are really observing at the crossover point is that the average of the last 30 prices is exactly the same as the average of the last 10 prices. If we are looking for trends to trade, this equal relationship of the two moving averages is not a reliable or logical indication of a trend. In an upward trending market the average prices over the last 10 days should be much higher than the average of the last 30 days. By implementing new trades at crossover points we are limiting our trading to points that may not clearly reflect what we should be doing. For best results in a trend-following system we want to be trading when the trend is clear and reliable; not when the trend is confused and questionable.

Instead of trading at crossovers we should be implementing our trades when the moving averages are parallel or when the short-term moving average is moving farther away from the longer-term moving average. Perhaps the short term MA should remain a minimum of some units of Average True Range above the longer term MA for several days. I believe that this procedure would give us more reliable and more frequent entry signals in the direction of the prevailing trend, which is exactly what we want. To identify the most reliable trends we want to see the slopes of various moving averages all moving steadily in the same direction and not crossing back and forth.

Take a look at a chart of any market with a strong trend. You will see that the moving averages are not crossing back and forth repeatedly. They will be moving in the same general direction in a more or less parallel fashion. Now look at a chart of a non-trending market. As this market moves sideways the moving averages will be crossing back and forth very frequently. Look at the implications of this simple examination of the charts. If we are trading the crossovers we will be trading most frequently in non-trending markets and trading most infrequently in strongly trending markets. Is that what we want? No, it's obviously not what we want. We want just the opposite. We want frequent entry opportunities in trending markets and we want to avoid as many trades as possible in non-trending markets.

The error in the logic of trading moving average crossovers also extends to some interpretations of MACD (Moving Average Convergence and Divergence) and DMI (Directional Movement Indicator). If we are looking at MACD we want to see both lines (each line reflects a moving average relationship) moving in the same direction. We don't want to see them crossing. When looking at DMI we want to see the Plus DI lines and the Minus DI lines moving in opposite directions and definitely not crossing. Remember, when the Plus DI and the Minus DI lines intersect it is telling us that the market is in balance and has no direction; the amount of upward and downward directional movement are exactly equal. What makes our favorite indicator, the ADX, so effective is that it rises only when the Plus DI and the Minus DI are moving in opposite directions and the distance between the two indicators is widening.

With a little thought and effort I'm sure we can design some reliable entry signals that are based on moving averages but avoid the typical crossover signals. For example we could measure the slope of several moving averages and when all the averages slope upward we would have a buy signal.

We could also measure the distance between several moving averages and implement our trades when the averages are all headed in the same direction but start getting farther apart. This procedure would give us a series of entry signals within the same original trend. This should provide an excellent entry and re-entry strategy.

Switch Time Frames For Better Exits
By Chuck LeBeau

I just returned from a weeklong Trader's Camp hosted by Dr. Alexander Elder in a beautiful island nation in the South Pacific called Vanuatu. When I studied geography in school many years ago, Vanuatu was known as the New Hebrides islands. Vanuatu is located about 1,000 miles west of Fiji.

If you have read Elder's excellent book, Trading For A Living, you will recall that Dr. Elder is an advocate of using multiple time frames for trading both stocks and futures. For example, he suggests looking at the weekly chart to make sure that the weekly trend is firmly up before trading the long side of a market based on the daily chart patterns. This approach makes good sense and I highly recommend his book and his strategy.

While listening to Dr. Elder explain his multiple time frame strategy for entries, my thoughts wandered to the application of his ideas to my favorite subject - exits. One of my goals in trading is to find exit strategies that do a good job of protecting open profits. One method of accomplishing this goal is to simply move the daily stops closer once a specific profit objective has been reached. However, it might also make sense to simply switch to a chart with a shorter time frame once we have reached a reasonable profit objective.

Here is an example of how such a strategy might work. Let's say that we have been trading XYZ stock on an intermediate term basis using daily charts. The trade is working out very well and we now have six ATRs of open profit. (See previous Bulletins for an explanation of how to use Average True Range to set profit targets). Up to this point we have been using our well-known Chandelier trailing stop placed at 3 ATRs below the high point of the trade.

However, now that we have reached our primary profit objective we want to tighten up our stop to protect more of our profits. We could reduce our Chandelier stop from 3 ATRs to 2 ATRs and continue using the daily bars or we could switch our chart to one hour bars and continue to trail the Chandelier exit at 3 ATRs based on the intraday one-hour bars. The basic idea is to switch to a chart with a shorter time frame once we have reached our profit objective. This procedure should allow us to let our profits continue to run but we would be protecting our open profits with much closer stops by using the chart with a much shorter time frame.

Combining our exit strategy with Dr. Elder's entry strategy would provide the following sequence: for entries we first examine the weekly chart and then use the daily chart to trigger the trade. Once we are ready to exit our trade we examine the daily chart and then trigger our exit using the hourly chart.

Of course this strategy would require some extra work as well as the use of intraday data. The alternative would be to simply reduce the number of ATRs used to hang the Chandelier exit on the daily chart. Either way we do it, the logic is to move our stops closer once we have achieved a worthwhile trading profit.

ADX for V Tops and V Bottoms
By Chuck LeBeau


We have often described how the ADX (J. Welles Wilder's Average Directional Index) can be a useful tool for measuring the strength of trends. (Please review Bulletins 5 and 6 if you are not familiar with our recommended use of ADX.) To briefly summarize our previous advice, we have found that when the ADX begins to rise it is telling us that a strong trend is developing. A rising ADX has proven to be a particularly reliable indicator after a market has been going sideways for a while and then begins to trend. For best results, the ADX should begin its rise from a low level (less than 15 or 20) because the low level of the ADX indicates that a sideways basing pattern has been formed. Most of our applications of the ADX strategy have been predicated on finding these highly profitable patterns where a trend suddenly emerges after an extended sideways period.

Unfortunately not all trends begin with a sideways pattern. There are many V tops and V bottoms that our rising ADX strategy fails to capture. In a V pattern the ADX rises and then peaks out and declines. The ADX does not begin rising again in time to catch the change in direction in a timely fashion. By the time the ADX falls and then begins to rise again a major portion of the new trend will have already been completed. As we have pointed out in our previous Bulletins, any entry on a rising ADX that was not preceded by an extensive sideways period is not a very reliable pattern.

Recently in our research on using the ADX for trading stocks we have observed another ADX pattern that we believe shows great promise. This new ADX pattern signals very timely entries that allow us to profit from possible tops and bottoms that are V shaped.

Here is how these V shaped top and bottom patterns can easily be recognized:
1. Make sure that your plot of the ADX also includes the plot of the Plus DI and the Minus DI. The pattern begins when the ADX is above both the Plus DI and the Minus DI. Most often when the ADX is above both the Plus and Minus DI the ADX will be at a high level, perhaps greater than 30 or 35. The high level of the ADX indicates that the previous trend was a very strong one. Now we are going to try and catch the reversal of that strong trend.
2. With the ADX at a high level and declining, look for a crossing of the Plus DI and Minus DI. If the Minus DI crosses above the Plus DI it indicates that a strong up market has ended and weakness has set in. If the Plus DI crosses above the Minus DI it indicates that a strong downtrend has ended and a new uptrend can be expected.
3. These reversal patterns should be entered only as the market moves in the new direction. (We suggest that you use stops for entry triggers.) Once you have entered the trade you should expect a substantial move in the new direction.
4. Be sure to use a stop loss at the recent low or high of the previous trend. Be willing to make more than one attempt to catch the new trend. (Sometimes the Plus and Minus DI will cross back and forth more than once before the new trend emerges.)

We have found that this simple pattern identifies major changes in direction in almost any market. However you should be aware that the change of direction pattern we have described is not as reliable as the typical rising ADX pattern that starts with a basing action. However the trades that do work are exceptionally profitable and we know of no other method that is as timely at catching major changes in direction. Most traders take a great deal of personal satisfaction in quickly recognizing major changes in direction. This simple entry method can produce some truly outstanding trades and provides a welcome change from typical trend following strategies.

Our Phoenix Bond system uses this technique to identify major bottoms in the bond market. The same system also spots bottoms in individual stocks. To catch major tops we simply reverse the logic. Just put up some charts with the ADX and look for the pattern we have described in this Bulletin. We think you will be very surprised at its accuracy. Give us your comments and observations on the Forum.

The Parabolic Trigger for V Tops and Bottoms
By Chuck LeBeau


Our previous Bulletin #45 about using the ADX for V shaped tops and bottoms was surprisingly well received. We had a great deal of very favorable feedback from our members who experimented with it. This very valuable pattern seems to do an excellent job of spotting major turning points in almost any market from Palladium to Natural Gas to Soybeans or even Lumber. This pattern seems to work extremely well in almost all futures, stocks and even the hard to trade stock indexes.

Much like a kid with a new toy, we've been having fun scanning through our charts and finding all the important signals that have been generated. For example, when looking at the stock index charts we had some very timely and important signals that the strong bear market in stocks was finally reversing. Let's review very briefly the conditions that create the pattern we are looking for.

REVIEW OF SETUPS and TRIGGERS: For those of you who are new to our work, we strongly recommend a two step process for entries. The first step is to identify some "setup" conditions that tell us that an entry is near. The second step is the "trigger" that tells us we must enter the trade NOW.

Just to refresh your memory from the previous Bulletin, let me review the "setup" conditions that we are looking for. Remember that we are trying to anticipate important "V" shaped reversal patterns. We want to be able to trade as near as possible to major tops and bottoms. As most of you are aware, a major directional price move will cause the ADX to rise to a high level. Depending on the direction of the price movement, either the Plus DI or the Minus DI will also move to an unusually high level. As the market peaks the DI will begin to decline while the ADX is flat or still rising. Near the top (or bottom) the ADX will become the highest line and will be above both the Plus DI and the Minus DI lines. This is our "setup" and alerts us that an important change in direction is likely in the very near future. The relationship of the three lines with the ADX being the highest tells us that there has already been a very extended price move that is running out of gas.

FINDING A TIMELY TRIGGER: While studying the charts using our new ADX pattern we found that our setup conditions often occurred early and that our DMI triggers were sometimes a little bit late. We don't mind having the setup conditions occur early. After all, lead indicators are rare and very hard to find. However to make this entry pattern even more exciting we thought we would see if we could make the triggers occur sooner.

Now that we have our lead indicator in place we want to find a timely entry trigger that gets us started in the direction of the new trend that should just be getting started. In Bulletin 45 we suggested that the crossing of the Plus DI and Minus DI lines could be the entry trigger. Although this method is acceptable and produces excellent results we observed that there might be room for further improvement. In many cases, by the time the Plus and Minus DI have crossed some profits in the new direction have already been left behind.

After some trial and error we found that the Parabolic indicator did just what we wanted. We believe we can use the Parabolic indicator instead of the DMI crossovers to provide much more timely entry triggers.

We have never liked the Parabolic stop and reverse (SAR) method as an independent trading system which was the intent of J. Welles Wilder, its originator. However we do like to use the Parabolic indicator for exits. As a system we find that the Parabolic reversal points occur much too frequently and this reversal system would drive us crazy with far too many false changes in direction. However the features of the Parabolic indicator that make it useful as an exit strategy are exactly what makes it the timely trigger we need for our ADX reversal pattern.

The Parabolic indicator accelerates steadily as the prices trend until the reversal points are very, very close to the peak of the move. The stronger the trend the closer the Parabolic gets to the prices. That is exactly what we want. When the Parabolic indicator is close to the prices and we have fulfilled our ADX setup conditions we are all set for an outstanding trade. Even a very small countertrend move will now quickly cross the Parabolic and signal our timely entry.

AN IDEAL ENTRY PLUS AN ADD POINT: We view the marriage of the ADX setup with the Parabolic entry trigger as an ideal combination. The entries now occur in a much more timely fashion than when we relied on the DI crossovers for our trigger. In fact, once the Parabolic has been crossed we can use the DI crossover as a confirmation and add to our position. I don't normally believe in pyramiding positions but in this case we are trading a very reliable pattern that is designed to identify a major reversal in direction, so I think that adding to positions early is a very good strategy.

As you can probably tell, I really like this ADX and Parabolic entry technique and I think that we have a lot of good concepts working for us here. We have an early setup, a timely trigger and now we can use the delayed confirmation of the DI crossovers as a point to pyramid the position. You can't ask for much more than that for an entry strategy that does a great job of catching big moves early. Take a look at this pattern on your favorite market and give me your comments.

By the way, I recently did an online seminar for Zap Futures brokerage firm where I discussed this new ADX - Parabolic trading pattern. This free online seminar has been archived and can be viewed by going to http://209.220.83.136/zapforms/clarch.cfm
The online seminar lasts a little over an hour and includes many charts as well as my voice-over presentation. This presentation is a preview of the type of material we cover in our workshops.

A New Exit Strategy - The ATR Ratchet By Chuck LeBeau

Recently I've been doing quite a bit of research on new systems for stock trading. The research is on behalf of a new hedge fund that will be starting later this year. The fund will be managed by Tan LeBeau LLC, the company that funded this research project. After some serious internal discussion about the advantages of keeping this new exit strategy a company secret, the LLC has graciously given me permission to share this discovery with our System Traders Club members. Here is a bit of background on how the new exit strategy came about.

In the process of testing various exit strategies for our stock trading systems we found that we needed a profit-taking exit that performed somewhat along the lines of the Parabolic SAR but that could be made more flexible and easier to code and apply. We found that the Parabolic was hard to use because it was often on the opposite side of the market from our trades or it was starting from a point that was too low for what we wanted. After spending a great deal of time with the Parabolic we decided it was not helpful for the particular systems we were creating. As an alternative to the Parabolic exit we decided to test some new exit ideas based on my extensive work and experience with the Average True Range. After a great deal of tinkering and experimentation we were pleased to learn that the new exit strategy worked surprisingly well for profit taking and had many very useful features and applications. I decided to name this new exit strategy the "ATR Ratchet".

The basic idea is quite simple. We first pick a logical starting point and then add daily units of ATR to the starting point to produce a trailing stop that moves consistently higher while also adapting to changes in volatility. The advantage of this strategy over the original Parabolic based exit is that when using the ATR Ratchet we have much more control of the starting point and the acceleration. We also found that the ATR based exit has a fast and appropriate reaction to changes in volatility that will enable us to lock in more profit than most conventional trailing exits.

Here is an example of the strategy: After the trade has reached a profit target of at least one ATR or more, we pick a recent low point (such as the lowest low of the last ten days). Then we add some small daily unit of ATR (0.05 ATR for example) to that low point for each day in the trade. If we have been in the trade for 15 days we would multiply 0.05 ATRs by 15 days and add the resulting 0.75 ATRs to the starting point. After 20 days in the trade we would now be adding 1.0 ATRs (.05 times 20) to the lowest low of the last ten days. The ATR Ratchet is very simple in its logic but you will quickly discover that there are lots of moving parts that perform a lot of interesting and useful functions; much more than we expected.

We particularly like this strategy because, unlike the Parabolic, the ATR Ratchet can easily be implemented any time we want during the trade. We can start implementing the stop the very first day of the trade or we can wait until some specific event prompts us to implement a profit-taking exit. I would suggest waiting to use the exit until some minimum level of profitability has been reached because, as you will see, this stop has a way of moving up very rapidly under favorable market conditions.

The ATR Ratchet begins very quietly and moves up steadily each day because we are adding one small unit of ATR for each bar in the trade. However the starting point from which the stop is being calculated (the 10 day low in our example) also moves up on a regular basis as long as the market is headed in the right direction. So now we have a constantly increasing number of units of ATR being added to a constantly rising ten day low. Each time the 10-day low increases our ATR Ratchet moves higher so we typically have a small but steady increase in the daily stop followed by much larger jumps as the 10 day low moves higher. It is important to emphasize that we are constantly adding our daily acceleration to an upward moving starting point that produces a unique dual acceleration feature for this exit. We have a rising stop that is being accelerated by both time and price. In addition, the ATR Ratchet will often add substantial additional acceleration in response to increases in volatility during the trade.

The acceleration due to range expansions is an important feature of the ATR Ratchet. Because markets often tend to show wider ranges as the trend accelerates the ATR will tend to expand very rapidly during our best profit runs. In a fast moving market you will typically find many gaps and large range bars. Because we are adding multiple units of ATR to our starting point, any increase in the size of the underlying ATR causes the stop to suddenly make a very large jump that brings it closer to the high point of the trade. If we have been in the trade for forty days any increase in the ATR will have a forty-fold impact on the cumulative daily acceleration. That is exactly what we want it to do. We found that when a market was making a good profit run the ATR Ratchet moved up surprisingly fast and did an excellent job of locking in open profits.

Keep in mind that this exit strategy is a new one (even to us) so our experience and observations about it are still very limited. However I am going to discuss a few observations about the variables that might help you to understand and apply this exit successfully.

Starting Price: One of the nice features about the ATR Ratchet is that we can start it any place we want. For example we can start it at some significant low point just as the Parabolic does. Or we can start it at a swing low, a support level, and a channel low or at our entry point minus some ATR unit. If we wait until the trade is fairly profitable we could start it at the entry point or even somewhere above our entry point. The possible starting points are unlimited; use your imagination and your logic to find a starting point that makes sense for your time frame and for what you want your system to accomplish. Our idea of starting the Ratchet from the x day low makes it move up faster than a fixed starting point (as in the Parabolic) because the starting point rises repeatedly in a strong market. If you prefer, you could just as easily start the Ratchet at something like 2 ATRs below the entry price and then the starting point would remain fixed. In this case the Ratchet would move up only as the result of accumulating additional time in the trade and as the result of possible expansions of the ATR itself.

When to Start: We can very easily initiate the exit strategy based on time rather than price or combine the two ideas. For example, we can start the exit only after the trade has been open for at least 10 days and is profitable by more than one ATR. My general impression at this point is that it is best to implement the ATR Ratchet only after a fairly large profit objective has been reached. The ATR Ratchet looks like a very good profit taking exit but I suspect it will kick you out of a trade much too soon if you start it before the trade is profitable.

As I mentioned, one of the things I like best about the ATR Ratchet is its flexibility and adaptability. Here is another idea on how to start it. We can start it after fifteen bars but we don't necessarily have to add fifteen ratchets. The logic for the coding would be to start the Ratchet after 15 bars in the trade but multiply the ATR units by the number of bars in the trade minus ten or divide the number of days in the trade by some constant before multiplying the ATR units. This procedure will reduce the number of ratchets, particularly at the beginning of the trade when the exit is first implemented. Play around with the ATR Ratchet and see what creative ideas you can come up with.

Daily Ratchet Amount: After testing it the daily Ratchet amount we chose when we were first doing our research turned out to be much too large for our intended application. The large Ratchet amount (percentage of ATR) moved the stop up too fast for the time frame we wanted to trade. After some trial and error we found that a Ratchet amount in the neighborhood of 0.05 or 0.10 (5% or 10% of one 20-day average true range) multiplied by the number of bars the trade has been open will move the stop up much faster than you might expect.

As a variation on this strategy the very small initial Ratchet can always be increased later in the trade once the profits are very high. We could start with a small Ratchet and then after a large amount of profit we could use a larger daily Ratchet increment. There are all sorts of interesting possibilities.

ATR Length: As we have learned in our previous uses of ATR, the length that we use to average the ranges can be very important. If we want the ATR to be highly responsive to short term variations in the size of the range we should use a short length for the average (4 or 5 bars). If we want a smoother ATR with less reaction to one or two days of unusual volatility we should use a longer average (20 to 50 bars). For most of my work with the ATR I use 20 days for the average unless I have a good reason to make it more or less sensitive.

Summary: We have just scratched the surface on our understanding of the possibilities and variations of the ATR Ratchet as a profit taking tool. We particularly like the flexibility it offers and we suspect that each trader will wind up using a slightly different variation. As you can see, there are many important variables to tinker with. Be sure to code the Ratchet so it gets plotted on a chart when your are first learning and experimenting with it. The ATR Ratchet is full of pleasant surprises and the plot on the chart will quickly teach you a great deal about its unusual characteristics.

Be sure to let us know if you come up with any exciting ideas on how to apply it.

Valuable Tools for Traders - The RSI By Chuck LeBeau

In our past Bulletins we haven't written much about one of our favorite trading tools, the Relative Strength Index (RSI). As most of our members are aware, the RSI is a popular overbought -oversold oscillator. Stock traders must be careful not to confuse this indicator with the "relative strength" that is used to compare the strength of one stock with another or with an index. The RSI oscillator is another invention of J. Welles Wilder, the originator of ADX and many other valuable trading tools.

The RSI calculates the ratio of "up closes" to "down closes" over the period of time selected (usually 14 bars) and expresses the results as an oscillator with a scale of 0 to 100. Readings above 70 are commonly thought to indicate an overbought condition while readings below 30 are believed to indicate an oversold condition.

The RSI indicator is included in most charting software packages but the formula is very simple if you needed to calculate it by hand or in a spreadsheet.

RSI = 100 - (100/ 1 +RS) where RS equals the average of up closes of the last n (14?) bars divided by the average of down closes of the last n bars.

Here are two of our favorite applications of this valuable tool.

1. Defining dips in an uptrend. A "dip" occurs when the RSI declines by 10 (or more) points from a recent peak that was at a high level. For example, a drop from 80 to 70 or less would qualify as a dip as would a decline from 90 to 75. In our experience we have found that most RSI dips tend to be 25 points or more but in very strong trends (our favorite) the dips tend to be of a lesser magnitude. Our measurement of 10 OR MORE will work in either type of market. Once a "dip" has been defined we can either buy at the market or wait for some sign of a reversal. It is often a good idea to also consider and limit the minimum level that the RSI reaches on the "dip". If the RSI declines too far without reversing we have probably seen a market top, not a dip.

2. Defining rallies for profit taking. Once we have been in a trade long enough to accumulate a worthwhile profit it often makes sense to exit on strength rather than waiting to be stopped out on weakness. For example, once we have at least two ATRs of profit we want to be ready to exit whenever the RSI reaches 75 or more. (I prefer to use 75 and 25 as thresholds rather than the more popular 70 and 30 levels.) This strategy of exits on strength will tend to maximize our profits over the short run but may not be as effective as a trailing stop over the long run. However, if you are trying to trade effectively over short time frames it often makes sense to exit on strength rather than on weakness. This is particularly true for day traders who do not have the option of letting profits run indefinitely. Once the RSI reaches 75 or more we have the option of closing out the trade "at the market" or watching closely for the first sign of a change in direction. A lower close or a close lower than the open seem to work well for this purpose.

Other popular applications of the RSI can be found in our book (starting on page 124). As is true of most indicators, the RSI can be much more effective when its application is combined with a quick glance at the ADX. Typically the RSI indicates an oversold condition whenever it rises above 75 and many counter-trend traders look to sell short at this point. This procedure would be a very big mistake if the ADX were rising. When the ADX is rising, the RSI will tend to move more or less sideways at the high levels rather than reversing direction as it would normally be expected to do. Instead of breaking to the downside the market being tracked will remain overbought and will persistently continue to make new highs. Entering a counter-trend trade simply because the RSI indicates an overbought or oversold condition is a big error if the ADX is rising.

We would also caution our members about using the RSI level as a filter for entries. Many traders will not enter a new buy order if the RSI indicates an overbought condition. Most of the time this is an effective entry filter that avoids buying just before the market is ready to correct an abnormal price excursion. However, this procedure would be a very big mistake if the ADX were rising. When the ADX is rising, many of the best entry signals come when the RSI is at a high level. Our research indicates that eliminating these entries would reduce the profitability of the trading strategy substantially.

We believe that the RSI is a valuable trading tool that belongs in every trader's toolbox. Take the time to study it and become familiar with its many helpful applications.

Be sure to let us know if you come up with any exciting ideas on how to apply it.

The STC RSI Stock Trading System By Chuck LeBeau

Our Bulletin number 48 about using RSI sparked some very interesting discussion on our FORUM. One of the messages suggested that buying stocks when the RSI was below 25 and then selling them when the RSI went above 45 produced some excellent historical results, particularly in the Dow stocks.

I thought I would check it out and ran some historical tests. Lo and behold it worked remarkably well. I immediately observed that there was the makings of a viable system here. All it needed was a little refinement.

After a few days on tinkering I came up with a version of the system that I think is worth trading. Since our members on the FORUM originated the basic system, I thought I would also pass along my work on this system so that all of our members might benefit.

Here are the stock trading rules I came up with:

ENTRY: When the 14-day RSI is 25 or less, enter an order to buy tomorrow on a stop at today's close plus some small amount. Use a couple of cents or .02 units of Average True Range above the previous close. We need to avoid buying on weakness because it's a bit like trying to catch a falling safe. When the RSI is at a low level the stock is likely to be gapping lower and falling apart to the downside and we don't want to buy that much weakness. So to avoid buying on further weakness we require that we must buy only on a price above today's close. That requirement keeps us out of a lot of trouble.

PROFIT TAKING: Take profits when the 14-day RSI recovers and closes at any level above 45. Just sell the next day on the open. Closing out the trade at such a low level on the RSI seems counter-intuitive but it works. What tends to happen is that the RSI can often recover quickly and gap well above 45 so that we are often taking the profits at levels much greater than 45. I tried a lot of other levels trying to increase the profits on the winners but selling above 45 makes the most money.

LOSS PROTECTION: After the trade has been open for four days or more exit on any day that the RSI closes lower than yesterday. Just sell the next day on the open. This is our equivalent of loss protection. If we have been in a trade for four days or more and the RSI has not recovered to 45 we don't want to hold it while the RSI declines again.

I tested the simple system described above on a portfolio of 28 stocks from 1987 through October 2001. In this more or less random portfolio there were some Dow stocks plus a few stocks with more volatility. The results were generally acceptable but there were some particular results that I thought were truly amazing.

First the typical performance results from buying $10,000 worth of stock on each signal with no compounding:

Total net profit: $255,557 Number of trades: 1849 Winning trades: 1124 (60%) Losing trades: 725 (40%) Average winning trade: $489 Average losing trade: $406 (Ratio avg. win/avg. loss 1.21) Maximum consecutive winners: 18 Maximum consecutive losers: 8 Average bars in winners: 3.5 Average bars in losers: 4.4 Largest intraday drawdown: $28,820 (This occurred in October 1987) Profit factor (Gross profits divided by gross losses) 1.87 Sharp ratio: 1.12

Now these results are pretty good overall but what really got my attention was a couple of additional calculations that are provided in my BEHOLD software. We like to look at the number of rolling 2month windows and see how many 12-month periods were possible. (After the first eleven months each new month provides a new12-month period to be examined.) There were 161 of those 12-month windows in our test and every one of them was profitable. This system did not have a single 12- month period where it lost money. That is truly remarkable. Although the biggest intraday drawdown was in October 1987 (no surprise) the system actually finished that month with a big profit. This is a system that seems to be able to take advantage of market weakness.

Another measurement that got my attention was the percentage of bars in the market and the dollars returned per day in the market (based on buying $10,000 worth of stock). This system is not in the market very often; it had trades on only 7% of the bars. But it returned a profit of $35.64 for every bar in the market. To put this number in perspective, any return of $10 per day or more on a $10,000 investment is considered very good.

Now as always, there are a few warnings. When testing stocks that have been back adjusted for splits it is nearly impossible to factor in commissions with any accuracy so no commissions or slippage are included in these results. But we are trading stocks now for a penny a share or less and commissions should not have a big impact because the system trades very infrequently. (About 4 trades per year per stock.) If we deduct a few thousand dollars from our results to cover costs the results are still very acceptable.

This system has no fixed dollar stop loss so the potential loss on any trade is unlimited. For this reason you would want to trade very small positions relative to your total capital (a good idea in any case). That way if you took a big hit on one trade it would represent a very small percentage of your capital. In our historical testing the largest losing trade was $3,239.

We think this RSI based system deserves further examination. We intend to incorporate a version of it on our StreakingStocks web site (www.StreakingStocks.com). We like the way it takes advantage of buying during periods of extreme market weakness. If we combine this system with a good trend-following system that can make money when the market is strong we should be able to make money on a very consistent basis.

Test the system yourself and see what you think. If you come up with any improvements please let us know.

Combining RSI and ADX


By Chuck LeBeau

Now that I am spending seven hours a day doing trading for the new hedge fund I haven't had much time for research or writing new Bulletins. However a comment in one of the trading newsgroups that I monitor got me thinking about the potential benefits of combining our knowledge of RSI and ADX into a simple system. Both the ADX and RSI are valuable trading tools and a combination of the two would seem to offer some interesting possibilities. I like to use the RSI primarily as an indicator for buying on dips in an uptrend. The ADX is my primary indicator of trend strength.

Here are a few ideas on how the two indicators might compliment each other in a system that "knows" when to enter on strength and when to buys on dips. (I'm only going to use the long side for examples but the logic should apply to short trades as well.)

When the ADX is rising it usually indicates that a strong trend is underway. In many cases waiting for any sizeable dip would be costly because the market could run away and the dip entry would be too late to maximize our profits. In this case we must enter on strength. To make this idea into a simple trading rule we might state that if the ADX is rising (and we have some indication it is rising because an uptrend is underway) we will buy whenever the RSI is below some very high threshold like 85. This rule would give us a very prompt entry in most cases and the result would be almost identical to simply trading whenever the ADX is rising which seems to be a good idea. The RSI has little, if any, benefit in this situation except it might occasionally keep us from buying into an extremely overbought market where the RSI was above 85. In this case a slight delay on the entry might be prudent.

The RSI, however, can play a much more important role when the ADX is flat or declining. In this case the rule would be that when the ADX is not rising we should postpone our entry until the RSI is below some more typical threshold like 45 or 50. Since the ADX is not giving us a signal that the trend is unusually strong we would need some additional indicator to show that the market has some minimal amount of upward direction. Otherwise we would not be buying a dip within the framework of an uptrend. Something simple like an upward sloping 20-bar moving average might work in this application.

Now that we have combined the ADX and RSI for our entries we might also want to combine them for our exits. When a market is rising but the trend is not particularly strong any spike in the RSI represents a good opportunity to take a profit. For example when trading in stocks the 9-bar RSI rising above 75 or 80 often signals that a correction is imminent. If the market trend is not unusually strong we would probably be happy with taking our profit on strength rather than waiting to get stopped out on weakness. However if the ADX is rising we might want to risk a correction in hopes of riding the trend even further. In this case when the ADX was rising we would ignore the RSI signal to take our profit. However, once our patience has allowed us to accumulate a very substantial open profit we might be best served by acting on the next RSI signal and nailing down the big winner. Also, when the ADX is rising it would not make much sense to be buying at a high RSI level and also selling at a high RSI level. We would be in and out of our trades almost immediately. Therefore we need to ignore the RSI extremes until our profit has had a chance to accumulate.

In summary, the important concept to remember is that our knowledge of the ADX can make the RSI a much more useful trading tool. When the ADX is rising the RSI tends to get overbought and it can often remain overbought for a surprising length of time. On the other hand when the ADX is flat or declining any spike to the upside in the RSI is an opportunity to nail down a profit. Conversely, any spike to the downside can be a potentially profitable entry point.

Here is the logic of a simple little system based on this discussion. (Just the rules in text form, you will have to do your own coding.) The parameters selected have not been tested or optimized. For example the 20-day moving average is just a number I picked out of the air. This is enough information to get you started and you can vary the rules to make the system trade over whatever time frame you prefer.

Long Entries:

1. The 20-bar moving average must be rising.
2. If the ADX is rising (ADX today is 0.20 or more higher than yesterday) then buy if the 14 bar RSI is less than 85.
3. If the ADX is not rising (ADX today is not 0.20 higher than yesterday) then buy if the 14 bar RSI is less than 50. Here is where you can influence the frequency of trading. For more trades use a higher threshold like 60. For fewer trades use a lower threshold like 40.

Long Exits

1. If the ADX is not rising (ADX today is not 0.20 higher than yesterday) then sell (long exit) if the 9-bar RSI is greater than 75.
2. If the ADX is rising (ADX today is 0.20 or more higher than yesterday) and the open profit is greater than (pick some amount - maybe 4 ATRs or some unit of price) then sell if the 9-bar RSI is greater than 75.
3. You need some additional exit rule for the losing trades. Use your favorite loss-limiting exit or you might want to exit when the price goes below the 20-dat moving average or when the 20-day moving average turns down. (See entry rule 1.)

Good luck and good trading.

Chuck LeBeau (Be sure to read the messages below for a valuable free gift certificate.)