Trend indicators, are they needed?

Trend indicators are useful but are in lag? Our method is systematic price action with trend identified through context.

Price action is a good fit for the methodical approach to trading. Relatively easy to establish, back-test and edit. Based on the close of a bar and that bar relative to as many prior bars as is necessary.

Trading range or trend?

The market spends most of its time in a trading range. Trends take up only a small proportion of the demand. Our systematic approach must, therefore, work in both markets. To do otherwise, as many trend-following systems do, is to miss the majority of trade opportunities.

The problem with price action and a systematic approach is the identification or confirmation of a trend. To help, many traders rely on trend indicators. For example, the  MACD is a valid trend indicator when employed in the correct time frame.

Moreover, there are many ‘to buy’ trend systems available that claim to provide a reliable trend identification system; this may be. However, all indicators take their cue from price, and the price has to change sufficiently to give the trend.

A pure price action trader, on the other hand, will read the context of the chart to indicate a trend; this is made to sound natural to achieve by established price action traders. But as with anything after many hours of practice and once mastered will always seem easy from that point.

Let’s take a look at a trending opportunity this week with Sterling.

We can see from the yellow box that we have three bear bars. Our system took the close of the first of the bars within the yellow box short. But we are now flat waiting for more information. We know that the more significant trend supports a sell short but in our timeframe, an hourly chart in this instance, we are at the bottom of a trading range indicated by the red arrow. A reversal is 50/50.

The two bull pull-back bars, however, are weak and support an early entry short at this point, or if uncertain we can wait for an entry bar, which comes next. We sell short for a target equal to a measured move of the yellow box.

Trading range or trend? It's all in the context.
Not yet a trend but the last two pull-back bars are weak.

It is the second move down (the second yellow box) that established the trend short for at least three to four times the distance of the first yellow box.

We need to sell short and join the trend.
Trend short, at least for another measured move, is probable.

We can either hold our second trade (most advisable for intermediate traders) or exit with profit and re-enter for the final leg.

We say most advisable above as many traders once out with profit would not get back into the trade quickly enough to take advantage of the trend.

Take the profit as the trend has a possible three push short already, or hold for price action?
Exit at the measured move or hold until price action says otherwise?

To finish our point about trend identification. The remainder of the day, as shown by the chart below, are tradable pull-back bars. As we are reactive and not predictive, we can trade each appropriate bar or sequence of bars relative to context.

Context does not support a trend long, therefore scalp only.
Context does not support a trend long, therefore scalp only.

Notice there are three possible pushes long with the final bar being an extension driven, probably, by the welcome UK financial news released at the time.

We do not consider this a trend due to the context to the left, the identifiable three pushes already and the news-driven extension or possible exhaustion bar.

We only traded the close of the bull bar, the fifth bar after bar 1, long for a scalp. The imminent release of financial news of significance at about bar 3 kept us flat.

Better to be the active rather than the defensive trader

To be the active trader, always preferable to the defensive trader.

More on Hans Zimmers idea of questions and answers and how it relates to financial trading.

We need to be on the watch for the smallest of hints that something isn’t quite as it seems.

A question or three

The currency markets we trade have been in a bear trend for some time. Meaning that all the ‘answers’ are short trades and all the ‘questions’ are long trades.

We want to be going short where possible. However, this ought not to make us blind to the detail. If we get the detail wrong, this is not necessarily a losing trade if our stop is sufficiently distant.

But getting it wrong can concentrate our efforts on managing the loss which in turn creates missed scalp questions and lost entries to better-placed answers.

Short entry price action but context says different

A couple of days ago from early morning each of the markets provided short entry price action opportunities. Each was answers. Therefore they had swing potential.

However, if we take a closer look at the conversation prior (the context of the chart), we notice a wedge or three pushes.

If we had missed this observation, we would have been distracted, mainly Euro and Ozzie dollar, for some 30 hours managing an out of the money trade.

The pictures below are the same stories for the EUR and AUD. GBP has a similar connotation but is in a trading range and therefore only provides questions.

What kept us as an active trader

AUD/USD wedge probability long but wait for an entry bar.
AUD/USD wedge probability long.
EUR/USD wedge probability is long but wait for an entry bar.
EUR/USD wedge probability is long, but we wait for an entry bar.
GBP/USD wedge and a trading range.
GBP/USD wedge and a trading range.

It is unusual that all three screenshots provide the same clue. A pullback is now probable. In all cases, the ‘actual’ pullback was a 100 pips or so. We wait, however, as these pullbacks are questions and we need an entry bar first to trade a question.

Active trader in EUR/USD

If we look at the EUR/USD in more detail, we see that we have a possible expanded wedge, being three pushes, as well as the embedded wedge; and adds confluence to a low probability short.

Notice the pullback, marked by the green circle, closed slightly above the resistance level of the past half dozen bars; this improves the odds of at least a measured move (a scalp) up to the green horizontal mark.

Three pushes big picture and embedded gives confluence.
Three pushes big picture and embedded gives confluence.

The next screenshot is four hours later. It follows our analysis and more importantly, we are not distracted managing an out of the money trade – we have a win and are viewing price with an active rather than a defensive perspective.

We make the measured move long. Active rather than defensive
We make the measured move long.

 

The music process of questions and answers can help in financial trading

Story and conversation with questions and answers as explained by Hans Zimmer can help the technical, financial trader.

Many traders have their trading ideas that help them win.

Such ideas, however, are not a panacea or substitute for all the hard work that goes into understanding how to trade the financial markets.

They are more to do with a traders discipline and a traders personal way of trend and context identification.

Hans Zimmer and answers

We like the thought process of the composer Hans Zimmer.

In composing his music, he says it can be summed up in one word – Story. For the financial trader, the story is the market cycle.

We apply his methodology in our trades. Conversation is context; question and answer notes are price action.

Below we have a series of ‘trade’ questions and answers. For us, the sequence of bars following the green arrows are the questions, and those within the red arrows are the answers.

We will trade a question but only from an entry bar and just as a scalp. Answers, however, can be taken from signal or entry bars as swings or scalps.

When does a question become an answer?

If the bull bar with the blue circle had closed above the resistance – the next price level that is determined by the bars about midway across the screen – this ‘blue circle’ bar might have premised into an answer.

Questions and answers are a price action.
Questions and answers are price action

We concluded that the blue circle bar would close low and remain a question. Therefore, we shorted the bar at about the centre of the blue circle.

Accurate enough, the answer bar came next and resulted in over 60 pips of profit in less than an hour.

Hans Zimmer’s explanation of Q and A in his music can similarly help a technical trader maintain the all-important market perspective on the chart.

Reactive or predictive in financial trading, what’s best?

Did our career ethos demand reactive or predictive decisions? What about financial trading?

It is right that most professions require predictive decision making. Engineers, doctors, entrepreneurs, lawyers, pilots.

Many of us from these disciplines have a go at financial trading in some form or other.

Why not apply the same predictive philosophy to trading that has always stood us in such good stead.

Mistake

Sorry, but that is mistake number one. To have any hope of success trading the financial markets, we need to change our career lessons of predictive bias to reactivity.

We all find this hard to do, it takes time to relearn, and most will never truly grasp the new concept.

We need to think of probability as the belief in an alternative outcome; it is not about the odds.

Highly probable trades are the essence of our (Slow Trader) strategy and paradoxically the most difficult to trade reactively.

Reactive, always

To do otherwise, to trade predictively rather than reactively, is to mistake possibilities for probabilities.

And knowing when not to trade is as important as knowing what trades are probably worth making.

Context trumps price action

Context is the thing. The financial markets are often seemingly bipolar. Why did it not do what we expected?

Many times we can find the answer from the bars to the left within our timeframe.

Context example

The chart below shows AUD/USD hourly bars. Bar 4 is a definite trend bar short and an excellent bar to take. Why did it not work?

Many websites overly concentrate on price action. That is the shape of the single entry bar. Often this will work if it has the power of a trend behind it, but not in this case.

A single bar is secondary to context. All the bars to the left. To take advantage of this, we need to understand the market cycle as this changes how we trade.

In our example, bars 1 and 2, not apparent at the time, are a breakout.  It is after we get all the bars between bar 2 and 3 can we see a channel; a channel that measures the same price difference as the combination of the breakout bars.

Bar 4

What has this got to do with bar 4? We know that more often than not on the achievement of a measured move of a channel price regresses to the end of the breakout point. From there it usually develops into a trading range.

Therefore the probability at the close of bar 4, even though it is a trend bar, is not for a continuation of the trend but a pullback to the top of the channel and a possible trading range.

Market cycle

The problem with not taking market cycle, the context or the bars to the left into consideration, is that a mistake here would have resulted in a hefty loss.

Most stops would have been positioned slightly above bar 3, and the market provided no pullback breakeven opportunity.

Context is king.
Context overrules price action

Another example below this time shows the US 500 SPTRD. Again we have the breakout bars followed by a channel that extends to a similar distance to the sum of the breakout bars.

As before we have a dramatic pullback to the start of the channel. The pullback will put many traders in to go short. But those traders that read the context will know that the probability is for the price to reverse and form a trading range.

In this case, the development of the trading range was interrupted by the weekend.

A context example of breakout, channel and pullback.
A context for US 500

Investor or speculator?

To be categorised as an investor or speculator can be made at all levels of finance.

Traditionally an investor is a long-term contributor to securities that have undergone a rigorous fundamental analytical process.

Shudder at the thought, the traditionalists consider, that a technical trade can be anything other than speculative.

But Mr Market can sometimes be nuttier than a fruitcake, and most financial decisions are bets if taken for less than 20 to 30 years. (Graham, The Intelligent Investor)

Controlling ourselves

Investing isn’t about beating others at their game. It’s about managing ourselves on our own. And as we are pattern seeking animals we technically convince ourselves of a particular market flow where one does not exist.

We know that if we speculate instead of invest, we lower our odds of building wealth and raise someones else’s.

An investment is not based on fundamental or technical detail per-say but is the safety of principle that attracts an adequate return. It is (1) analyse, (2) protect and (3) performance that is satisfactory, not extraordinary.

In other words, an investor calculates and a speculator gambles; regardless of whether it is based on technical or fundamental information or taken over a short or longish period. 

Online investor?

To that end, arguably online trading can be either depending on our approach. 

Remember the investor will analysis, protect and target. 

The speculator treats online financial trading as a way to mint money, a nonstop commercial video game. They busy themselves trading the low and medium probabilities.

The ‘investor’ of the online financial trades looks for high probability trades.

Screenshot 1, investor

In the screenshot below a high probability, entry presents itself at the green arrow. The target is 30 pips distant and the stop 60 pips. Would we hold if the trade went against us all the way to the stop? Probably not.

In any case, the stop distance makes sense. The doji bar soon after entry made us question the trade, but six hours later we achieved our high probability target.

An investors high probability trade.
Investors high probability trade

Screenshot 2, speculator

From the following day, our screenshot below provides a different picture. We considered this a high probability trade and entered long where indicated. We measured bar 2 for a measured move target.

Bar 3 was short of the goal. At the close of bar 3, we set to break even which we achieved. If we had not fortuitously done this, we would have exited with a loss at the close of bar 4.

It was only afterwards in debrief that we knew that this trade was speculation. The investors stop, having to be so distantly disproportionate to the target is a giveaway.

The investors (high probability) trade was short at the close of bar 5. In this trade stop and target were in proportion. 

Not an investors trade as stop too disproportionate to target.
Not an investors trade, as it turned out

Strategy and tactics are often confused by traders

Strategy and tactics, what’s the difference?

In the military fast jet world determining a clear strategy was the responsibility of the Generals. Throughout the Cold War period, most Western countries got it wrong.

Politics and industry drove strategy.

In the 70’s The United States Air Force (USAF) allowed a different approach. They put strategy above everything else. The outcome was the achievement of world air superiority, which they maintain to this day.

The USAF influence was from the “Fighter Mafia” and fighter pilot mavericks such as Colonel John Boyd. They realised the F15 and F16.

Colonel John Boyd, USAF fighter pilot, maverick and strategy.
Colonel John Boyd, USAF fighter pilot, maverick and strategy (ist)

A strategy is (almost) immovable. It is a principle on which to base all tactics.

As in warfare, a trader determines a strategy from which they can hang many tactics.

Most trading websites say strategies when they express tactics – “means by which a strategy is carried out”.

Low probability low risk

All beginners enter low probability trades. Reversals and trades that have a 40% or less chance of success.

We associate such trades with low risk which suits beginners that are frequently risk-averse. However, stops are often too close further reducing the probability.

Moreover, to counter the low probability when such a trade is successful the bet has to be held for a distant target to balance the strategy.

Medium probability medium risk

From an entry bar rather than a signal bar. However, an entry bar without good trade premise and thus a 50% probability. Traded by beginners and intermediate level traders.

High probability high risk

A trade that is (1) with a trend or (2) in the ‘probable direction’ from a significant break in a premise (3) or opposite in direction to an exhaustion bar.

Stops are distant which in turn provides high risk.

Can provide a 60% probability of success, better if we scale-in correctly. Almost exclusively traded by experts.

Our intraday trading strategy

“We take every HIGH PROBABILITY trade that fits market cycle, context and the economic calendar; we manage it procedurally whether the trade takes us in or out of the money, and a measured loss is acceptable”.

Conclusion

“Tactics are disposable. A strategy is for the long haul.” (Seth).

If high probability trades is our strategy, then everything else is tactics.

To Colonel, Boyd strategy was a compass, and tactics made the map.

Market cycle is more reliable the higher our time frame

Market cycle favours the higher time frame charts.

Why it’s easier to trade from a higher time frame chart?

A time frame is not a direct representation of decision time available. If we trade from a five-minute chart, we don’t have all five minutes to analyse and make a decision.

On such a chart we often have but a moment.

Mostly, however, we feel that ‘time’ to decide is what we gain from trading higher charts.

Another aspect of time and a higher chart, the daily for example, we need only look at a chart briefly but once a day.

Contrast that with a 5-minute chart where a trader looks at the chart all day long.

However, more important than the time available is the representative market cycle.

Take a look at the diagrams below to see the various market cycles, all screenshots taken within a moment of each other of sterling/dollar.

See how each time frame mostly projects a different cycle.

The higher the time frame traded, the more stable or more assured is the corresponding market cycle.

Traders work in larger or smaller market cycle microcosms the higher or lower the time frame chosen.

We can assimilate this to a swell at sea. As the swell approaches land, we get waves. In the shallows, we get choppiness and back currents.

The swell represents the weekly chart; waves are daily charts and the choppy shallows the five-minute chart.

Our current preference is the one-hour chart. As a full-time trader, this chart is mostly intraday; many bars meet the minimum scalp criteria and the market cycle, we think, is suitably defined.

Market cycle within a weekly chart
Market cycle, a weekly chart
Market cycle within a daily chart.
Market cycle, a daily chart
Market cycle within an hourly chart.
Market cycle, an hourly chart
Market cycle within a 5-minute chart.
Market cycle, a 5-minute chart

Time frame, which is best for intraday and short-term traders

Train with lower time frame charts, trade with higher.

We often like contrarian solutions. It says ‘doing something different from the crowd’.

About day trading they say: ‘do not’, ‘it’s risky’, ‘short-term volatility’, speculator’.

In the assimilation of information from a lower time-frame chart is the determination of probability possible?

Often it is not.

In a figure title in The Intelligent Investor Graham uses “the faster you run, the ‘behinder’ you get”.

Benjamin Graham, his time frame was value.
Benjamin Graham

He makes a point superbly by showing a bar chart that reflects the extremely patient keeping their gains and how the hyperactive made their broker rich, not themselves.

A dilemma, however, is that a technical trader dealing solely in the higher time frame will not trade often enough to gain the necessary skills to succeed.

The day trader is the tennis player that is on the court all the time. She attempts shots from every angle, overhead, volley and smashes.

The higher time frame trader, in this simile, takes a couple of swings a week or a month – are they match ready?

Traders with experience, skill and emotional stamina might profit in the lower time frame. For the rest of us, this area is our training ground for the higher charts.

What higher time frame to choose depends on our circumstances and personality. The 1-hour bars are the lowest so-called higher time frame that we ought to consider.

We favour the 1-hour, but we are happy to trade full-time intraday.

Others may prefer the daily bars.

For UK share traders using daily bars this is fine but other areas such as FX then New York close bars are required for correct price action.

Price action does not need to be significant, but it helps

In our chart below, price action suggests probability but is context more important?

Trading Range

The hourly bar chart below shows a trading range (TR) and a possible breakout.

Bar 2 was a consideration for an entry short. If we look to the bars to the left, we see that the close of bar 2 was at or above the TR base (shown by a yellow arrow). Therefore, although bar 2 was prominent, engulfing the prior three bull bars, it did not, to our mind, qualify as an entry bar.

If we had taken the entry short at bar 2 our stop would have been twice the width of the TR, putting it marginally above the spike of bar 3. Weak traders had their stops taken by the peak of bar 3.

Price action, bar 3

Bar 3 provided a reasonable price action. The close of bar 3 was below the TR (the yellow arrow). However, most breakouts from a TR fail. Moreover, bar 3 was possibly the final push of a wedge, in this instance three drives short.

That provides us with a dilemma. We have a wedge and a prominent trend long. However, the price action (that is the shape of bar 3) provided an acceptable probability of a measured short against the trend.

How to measure our target. Unusually we measured the whole of bar 3, wick included and got a measured target some 92 pips below. The trade was exited with 36 pips of profit and at the 21st bar since entry. We try not to let a deal go beyond 21 bars.

Traders equation

Context overrides price action, nearly every time. In this instance, a 30 pip measured move for a scalp of the body of bar 3 may have been the more intelligent trade. The issue with that is the stop would have been three times further away than the target, therefore not a traders equation.

On that point, at least we took a planned 1R trade (that is reward/risk were equal). Our actual trader’s equation, the pullback against bar 3 and our entry, was 11R. In other words, our gain was eleven times more than our ‘actual’ risk.

Price action against the trend, scalp only.
Price action against the trend, scalp only