TECHNICAL STRATEGIES

If you are a technical trader, you will most likely use indicators in your
strategies. Before you put them into a strategy you will need to figure out which indicators will work the best for you, and you will need to learn
how to use them. There are countless indicators you can use when trading,
many of which will tell you the same thing. Using them together may
be overkill, so I find it best to keep it simple. Indicators can also be used
differently by different people. A breakout trader can use the RSI one way,
while a reversal trader can use it to confirm a market is overbought, and
a third person can look to see if there is divergence between the indicator
and the market. Like everything else, finding out which indicators you like
will take time and a lot of trial and error. Toy around with the indicators
you think you like until you figure out what works for you. You will learn
a lot about trading when you really start getting into how indicators work
and respond to the market. Though I devoted a few chapters to it in High
Probability Trading, you may want to pick up a good technical analysis
book (I like John Murphy’s Technical Analysis of the the Futures Markets;
he also has one for financial markets) to have as a reference guide when
learning to trade using indicators.

Fundamental Strategies

Not all strategies are based on technical analysis. Some are purely based
on fundamentals and news. Others can be a combination of both technical
analysis and fundamentals. An example of a fundamental strategy is you
purchase a stock when an earnings report comes out that is better than the
previous quarter’s earnings, and you hold onto the trades until net earnings
per share decreases for a quarter. This would be a long-term system with
no technical analysis involved at all, but it’s still a trading system. To be
safe you should include a stop that may be derived using some technical
analysis, too. But you can put in a monetary stop that doesn’t.
There are many ways to trade using purely nontechnical strategies. You
could trade off of the unemployment numbers, or the American Petroleum
Institute (API) reports if you trade the energies. Some people use the
weather to trade markets like corn or orange juice. Some use earnings for
stocks, or the Consumer Price Index (CPI) or Producer Price Index (PPI)
numbers. Whatever the case may be, if you are going to trade off of the
news you should have a preplanned strategy for it. You should test your
ideas and put them in a trading plan, and then you should be prepared for
the trading day by including them in your game plan. Your strategy could
say something like if the API numbers show a lower than expected stockpile
in crude inventories and the market rallies, buy on the first dip. However,
if the market does not rally then short. I definitely would recommend
combining this with technical analysis so you can determine exit points,
stops, and how much to risk. Without charts it becomes a much more difficult
task to determine these things. I like to have a clear picture in front
of me, so I don’t have to guess when to exit. It’s because of this that many traders don’t even bother with the news. They look at the charts and believe
that the news is reflected in the market, so why bother with more
clutter in their heads? I used to be that way, but now I like to know why
things happen.

Discretionary Strategies versus Systematic
Strategies

There are two main types of strategies, well actually three, when you combine
the two. First, you can have a totally systematic strategy, which generates
pure buy and sell signals that you follow to the letter. The ultimate
example of a systematic strategy would be a black box programmed trading
system. These are systems that are bought and generate signals without
you even knowing how the system was made. The system can even be
set up to automatically enter trade orders in the market so that the trader
doesn’t even have to be in front of a machine. The traders have little say
in what happens as the orders go in despite what they think or feel. The
average trader with a program like TradeStation can do the same thing. If
he has a system on his computer, he can have it send orders directly to the
brokerage firm while he is out golfing.

The other type of strategy is discretionary, where your trading decisions
are hopefully based on a formula/strategy/system you have developed
but aren’t automatically entered into the market and you have some say as
to what you want to do. Discretion has a very wide base spectrum. In the
worst case, discretionary trading can mean you have no rules and your
trades are made off the cuff and you never know what they may be. But
this approach is not going to make anyone a great trader. A trader can be
discretionary, yet still follow a system. He may have several indicators he
looks at, and when he gets two of three giving the go-ahead he takes the
trade. Or he can have a solid system but then use discretion as to when
to enter the trade. He may get a go-ahead signal from some news item but
then use a technical analysis strategy to correlate it and plan the trade.
You do not need to have a computerized system to have a system, as
long as you have buy and sell rules you will have a system/strategy. Then
you can use discretion as to when to take the trades and how many contracts
to trade depending on the risk. I think most traders fall into this category.
The ones who turn out to be successful, though, are the ones who
have proven strategies that generate the signals, whether they are automatically
entered or the trader uses some discretion. The problem with discretion
comes when traders have little discipline. These are people who constantly
jump the gun or let trades go by because they overanalyze them. But
more importantly they have no discipline when it comes to getting out of
trades. It’s always hard for a person with poor discipline to exit a trade with a small loser. Even if the system tells him otherwise, he can always find
an excuse for staying in. I would recommend a person start out by never
breaking the rules. If you have a system that generates signals on your computer,
take every trade with no thought process at all until you learn discipline.
Once you gain that discipline then you can start thinking a bit.
If you can’t do it, hire someone to sit at your computer and do it
for you. There was one time when I had to run an errand, so I had a
nanny come and watch my son who was sleeping (he always napped from
2:30 P.M. to 4:30 P.M. letting me trade in the afternoon). I was long the S&P
with a stop in but no exit order. I told her to sit at my computer, and I drew
her a target area where I wanted to get out and said if the market goes
to here press this button (I had already set up my order), then cancel this
other order (my stop). Though she was terrified, she followed my system
signals to a tee, and I could not have done any better myself.
As you develop into a better trader, I would say it is okay to use some
discretion because you will start to see things in the market that can help
you avoid bad trades or getting out at the worst time. I like to use discretion
to time my trades, especially in strong trending markets. If I get a signal in
a strong market, I’ll look to see if I can get a pullback before diving in. This
is actually part of my strategy, so it’s not like I’m breaking any rules.
Look at the five-minute chart in Figure 5.1 for an example of this. The
market has been in a strong uptrend then had a small five-day dip and now
looks like it is ready to go back up as seen in Figure 5.2 (I’m looking at the
last day of the chart.) I’m going to skip a few steps and go to the five-minute
chart to show how I’d wait for a pullback before getting in.
I get my signal at the first oval as the market breaks out of a little congestion
in the upward sloping triangle. I don’t want to jump the gun or get
filled two points away, so now I sit and wait for the pullback. For me, that
signal comes when the stochastic indicator hits oversold and turns upward.
We are in a strong market, so I’m content with getting in as soon as it turns
upward and not waiting for it to leave the oversold area. I draw a trend line
and place a stop and I’m good. Just for fun let’s say I missed this trade and
got a different signal later on. I could use the sell-off just before Entry 2
as a place to get in. The divergence between the stochastics and the market
would be an entry signal. I’d then make a new trend line and place an
appropriate stop.