THE MAGIC NUMBER IS 4

Whenever you are thinking of scaling into the market, remember that the magic number is 4. If you are trying to get an average price, you need to break your order into at least four equal parts. If you are trying to get a better than average price, then you cannot divide your order into more than three equal parts. Four or more equal parts gets you close to an average price, three or less gives you a chance to get a better than average price.

The best scenario is to buy your entire position at one time at the lowest price. We would all like that, but it’s unrealistic. Therefore, you decide how long you have to enter your position, a few hours or a few days, and look for opportunities during that window. Let’s say that prices are trading in a range from $35 to $40 and you expect good news to move prices through the $40 level to $50. It’s Monday morning and you think this will happen by the end of the week after dividends are announced. The price is now $38. What are your choices?

1. You could buy one-third of your position now, one-third on today’s close, and one third sometime tomorrow, for an average price.
2. You can wait for prices to test the low of $35, placing a buy order for your entire position at $35.50. However,what happens if you are right and prices move straight up to $50, never pulling back to $35? You’ve missed the move.
3. You can buy one-third now, one-third at $35.50, and one-third at $40.10 on a break above $40. That’s a bit better because you are sure of getting twothirds of your position at $39.05. If prices drop instead of rally, you have two-thirds of your position at $36.25. The only time you have a full position is if the price pattern is exactly as you predict—first declining to support, and then rallying up through resistance.

How realistic is case 3? Not very. If we knew how prices were going to move, we wouldn’t need all this planning. It’s difficult to forecast where prices will be in a few days; it’s even more difficult to predict the pattern prices will take to get to that goal. There is a very small chance you will be able do both.
Try the average price method. In the example above you might buy two of the three parts by averaging into the trade, and then add the third part on a breakout through $40 in order to have a confirmation. In that case you raise your average price, but have the comfort of knowing that you were right about your prediction.
Some traders would wait for the breakout before entering any of the position. They get a worse price but a better chance of success. Other traders would enter the entire position between $39.75 and $39.90 looking for the breakout and trying to get free exposure from the jump through $40—a little more risk, but a lot more reward.

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AN AVERAGE PRICE OR A BETTER PRICE?

It’s always safe to get an average price. If you’re concerned that you’ll buy IBM at $50 today and it will drop to $45 by the end of tomorrow, then you could just wait. Most likely, you’re not sure that it will drop. If the employment report comes out favorably and the economy looks strong, then IBM could even jump to $60 by the end of today.
If you don’t know what might happen in the next two days but you have a strong opinion that IBM will be going up, then average into the position. To get an average price, you buy equal amounts over equal time intervals. If you plan to buy 200 shares, then you buy 50 this morning, 50 this afternoon, 50 tomorrow morning, and the last 50 at tomorrow’s close. You now have a reasonable approximation of an average price.
When you’re trying to get an average price, breaking up your order into small pieces and feeding it into the market is the simplest way. You don’t need to do it one share at a time. If you separated your 200-share order into eight parts of 25, you would get very close to the average.

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EVOLUTION IN PRICE PATTERNS

A change has occurred in the market because of the ability to trade the S&P 500 index directly rather than individual stocks. S&P futures have become an active vehicle for both speculation and hedging. If you think that stock prices are about to fall because of a pending interest rate announcement by the Fed, you can protect your portfolio by selling an equivalent amount of S&P futures. Afterward, when you have decided that prices have stabilized, you can lift your hedge and profit from rising prices. It’s an easy and inexpensive way to achieve portfolio insurance.
When institutions and traders buy or sell large quantities of the S&P futures, that price can drop while the share prices of the stocks that comprise the S&P Index may not have fallen yet. Enter the big business of program trading. If you have enough capital and the difference between the S&P futures price and the S&P cash index is sufficiently large, you can buy the S&P futures and sell all of the stocks in the S&P 500 cash index. It is a classic arbitrage that brings prices back together.
How does program trading, or just the trading of S&P futures, affect the price patterns of individual stocks? The answer is that all the stocks in the S&P Index move together at the same time. It doesn’t matter whether IBM is fundamentally stronger the GE, or that Xerox is at a resistance level and Ford is at support, or even if Enron is under investigation. When you buy the the S&P you buy all of the stocks at the same time.
Today’s technical trader must keep one eye on the individual stock and the other eye on the index. Exxon may have moved above its recent resistance level but stops because the S&P Index is at its own resistance level, and there are more traders watching the S&P than Exxon. In today’s market, you can anticipate when a stock will find support and resistance by looking at the S&P chart rather than at the stock chart.
During times where there is no news, the stocks all move together. When there is positive news for a specific company, it will gain over other stocks, but it will still meet resistance where the S&P as a whole meets resistance. This change in the way stocks are traded reduces the ability to get diversification by trading across sectors and increases your risk. Short-term traders will not be as affected as those holding positions longer.

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COMPARING SIDEWAYS AND ROLLING BREAKOUT METHODS

There is no doubt that an intelligent technical trader could identify the sideways patterns better than the computer, but the computer can do it faster and give you the chance to trade a more diversified group of stocks and futures. That’s important and we’ll discuss that as we move forward. Let’s now try to follow the weekly S&P 500 prices during the strong upward move from 1994 to 1997 by drawing sideways ranges manually and comparing the results to a rolling breakout. It’s difficult to be objective when looking back at the entire picture, but let’s try:

1. The sideways period from April 1994 through February 1995 is very clear. The lows form a support line and the highs in March, September, and October (A, B, C) form resistance. The resistance line is drawn across the highest high, point B, but we could have lowered that to cross A and C, cutting the top off at B. Cutting the tops off is the better way.
2. We get a breakout to the upside in mid-February. The rolling 30-week breakout also gets a buy signal because prices move over point B, which is within the past 30 weeks.
3. The steady move up doesn’t require any decisions until the sideways period, beginning in July 1995, has a sharply lower move in October. We don’t see the sideways pattern until prices start to fall to point H, the lowest level of the pattern.
4. The decline to H stops at exactly the same level as D, but we may have sold when prices first broke through the line formed by F. We may have drawn a support line connecting the two lows on both sides of F. If we sold at the first line, we take a profit of about 115 points and then sell short.
5. If we’re fast, we sell at the thin support line crossing at F, and then see prices stop at the major support line drawn from D to H. Prices rebound higher, and we realized that support held and we need to get net long again. The new high is at 950, at which point we would be sure the uptrend has resumed but take a 60-point loss in the S&P.
6. You may have waited for the major support line at H to be broken and remained long. Prices would have dropped from 950 to about 870, a loss of 8.4 percent. Would you have been able to wait that long? Not likely.
   

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TRADING GAME TIPS 1

You made the wrong trade. Every trader makes mistakes, even buying when you meant to sell. Don’t try to manage the position; just get out. It’s the wrong trade, and you can’t manage it correctly. It will distract you from other trades and eat up your time. Close out the trade as soon as possible, and get on with your life.
The time of day to trade. There are two reasons to select the time of day to trade. Volume varies considerably during the day. The greatest volume is near the open; the second greatest volume is at the close. After the open the order flow steadily drops until its low point in the middle of the day. Many of the traders are off the floor—some actually eat lunch. During the middle of the day orders dribble in. If one large order hits the market, it could push prices higher or lower but have very little meaning with regard to price direction.
The open and close are the two most likely times to show the high or low of the day. If prices open and start to drop, then the open is most likely to be the day’s high. The middle of the day is the next most likely time to be a high or low. Prices drop from the open and quiet at midday while there is little activity. When traders come back onto the floor and activity increases, they
may move prices higher again. Then the midday price becomes the low. If they move prices lower, then the close becomes the low.

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TRADING GAME TIPS

1. It’s good to have a bias. You can have a fundamental opinion of where prices are heading and still be a technical trader. A bias can be very sensible. For example, when the Fed cut interest rates to under 2 percent, it removed a lot of profit potential from a long Treasury note trade. The potential profit fell to less than the likely risk of a trade. On the other hand, going short Treasury notes doesn’t guarantee a profit because prices can drift sideways for a long time, but you’ll want to trade only small positions long Treasury futures.
2. Try to distinguish between a bias and wishful thinking. The stock market is at very low levels, but a bias to the upside is wishful thinking. It may happen, but prices could still go lower. It’s not the same as interest rates, where they are approaching a bottom of zero. Hopefully, the stock market will never get to the point where it is so low that it can’t go lower.
3. Are you still confused about the use of limit and stop when you’re placing an order?
   A stop order is used in the following situations:
   • When you are long and you are selling at a lower price (usually to exit the trade).
   • When you are short and you are buying at a higher price.
   You will want to buy at a higher price at the point where the trend turns up. Remember that a stop becomes a market order when the price is touched. You must use the word stop in your order. A limit order is used in the following situations:
   • When you are long and you are selling at a higher price (to take profits).
   • When you are short and you are buying at a lower price.
   • When you a trying to buy at a support level or sell at a resistance level.
4. You can combine an MOC order with a price, but all conditions must be met to get an execution.

   • If you’re long IBM at $52 and want to exit if prices close lower, but below a specific price, then you enter SELL IBM 48 STOP MOC. You will be executed at the closing price if it is anywhere below $48. It is unlikely you will get $48 as your price, but you won’t be executed if prices dropped to $46 during the trading session, but closed at $49.
   • If you have no position and you want to buy IBM on an upward breakout above $55 but only if it closes above $55, then if IBM is at 52, BUY IBM 55 STOP MOC.
   • You wouldn’t want to use this order to take profits on your IBM position because you would prefer to get a higher price anytime during the day. If you wait for the close, prices may have fallen back from their highs. If you are long IBM at $48, you would want to place the order SELL IBM 53. That gives you a $5 profit if IBM trades at $53 or higher during the day.

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THE ROLLING BREAKOUT

We normally find a sideways period and the corresponding breakout levels by looking at the chart. However, computerized programs have taken a different approach by always looking backward by the same number of days. If we always use the highest high and lowest low over the past 20 days, we call that a 20-day rolling breakout or simply a 20-day breakout system. For each new day we drop off the oldest day and find the highest high and lowest low of the new 20-day period.
Is the “Rolling Breakout” Better Than the Old-Fashioned Method?
No, but it can be very profitable, and it can be tested on a computer. It has the same profit and risk characteristics as the handdrawn lines but sometimes gets fooled into using the wrong highs and lows. It’s a lot more practical than drawing lines on each of a large number of charts each day. A computer can calculate the breakout trends of all the markets in a few seconds. If you like the diversification of trading a number of markets, the rolling breakout is a good method to use.

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EVOLVING MARKETS

The market is dynamic. It is not the same as it was, yet it is driven by the same underlying economic forces.
What Has Changed?

• The equipment has changed, allowing instantaneous analysis, program
trading, electronic orders (smart order entry), high-momentum trading,
and unreasonable expectations.
• Methods have changed, with far more systematic traders, especially professional
fund managers.
• Participants have changed, with a larger influence from pensions, designer funds, and institutional investors. Day traders are common because commissions are low.
• Electronic exchanges and side-by-side trading are new. You can beat your competition by creating an electronic order the instant a system “signal” is triggered.
• Globalization has changed the way world markets move, with alternating leaders and followers.
• There are more trading vehicles, including ETFs for index and sector investing, and single stock futures.
• Markets are noisier because of more participation. Sometimes they have irrational swings because of piggy-backed orders. The frequency of extreme moves is increasing, causing greater volatility.
Will a system that worked in 1990 work in 2002? Probably not. Will the people who made money in the 1990s make money now? If they change, too.

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How Do We Normally Decide to Buy a Stock?

• We make a qualitative decision: Is it a good company?
• Is it profitable? Has it paid dividends regularly? Is the stock rising? Does it have a lot of debt? Is the P/E ratio high or low? In other words, is the company a good value?
• Is the company healthy? Is it in good strong hands? Is the management competent? Is there a large employee turnover? Are salaries reasonable?
• Is the company likely to be competitive in the future?
• Add to these concerns some new questions, such as: Does the CEO have a sensible exit package? Are there any accounting irregularities?

All of these questions and answers are important. They try to reach the vital areas that determine whether a company is sound and likely to remain that way. The problem is whether you can get answers to these questions, and whether those answers are reliable. Even when they appear to be answered, what is your level of confidence in a decision based on so many complex issues?

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TECHNICAL TRADING AND VALUE

A technical trader may also be influenced by fundamentals. A long-term trend follower—one who buys a stock when the trend is rising—is really tracking the increase in the value of the stock in an objective way. If Mrs. Hathaway was long Cinergy (a public utility) in 1997 based on a 100-day trend, she would be taking advantage of the Fed policy of lowering rates even though the reason for rising prices might not be important to her, and she may not have seen the close relationship between Cinergy’s stock price and interest rates.
The fast systematic trader could even profit if the stock or futures market were above value. He or she could be in a trade for a few hours or a few days. The value of a stock isn’t very important for a fast trader, only its volatility and short-term direction. Even when stocks were trending higher, as they were in 1997, the impact of the long-term trend on a one-day trade was very small. You could buy or sell and still return a profit. Value, or fundamental information, is of minor importance for short-term traders.
We choose systematic trading because
• It provides discipline.
• We can backtest (check the rules using historic prices) to see if the trades would have been profitable.
• We have confidence by knowing what results to expect both risk and return.
• We can monitor current performance to decide if the method is still working as we expected.

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TIME-DRIVEN OR EVENT-DRIVEN?

A moving average system is time-driven; that is, the moving average closes in on current prices when the price movement slows. In Figure Exxon (XOM) prices move sideways from January through mid-April 1997, before the sideways period. The moving average tracks rising prices smoothly, and then turns down at the beginning of March although prices only show a slight decline. Using the trendline for the buy and sell signals forces us to close out our trade at the March lows, although prices are $1 higher one month later.
This characteristic of the moving average can’t be removed. It is a benefit when prices turn slowly from up to down, and a problem when prices slow down and then continue in the same direction as in Figure
A clear example of an event-driven trend is the breakout. That a breakout that creates an up ward trend begins with a new high and ends with a new low. The trend doesn’t change unless prices move to new highs or new lows. You can consider a new high price as being caused by an event: a news release, an earnings report, or a change in government policy. Prices can drift up and down within a reasonably small range and the trend doesn’t change.
Using a 40-day rolling breakout applied to XOM, we see nearly the same trades as when we used the moving average except that prices failed to make a new low in March, and the breakout trend held its long position.
The rolling breakout is not entirely immune from time change. The rolling calculation period moves forward in time. If prices become less volatile, then the highs and lows that trigger a new buy or sell signal will get closer together. Two methods that are completely independent of time are swing charting and point-and-figure charting, and the trading signals that they generate.

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CHOOSING THE SYSTEMATIC WAY

It is not a choice between “which is better,” investing based on fundamentals or technical trading. They are two very different methods chosen for completely different reasons. The fundamental investor may be looking for a cheap price or good value on a piece of merchandise with the idea of holding it until it returns to value, or appreciates in value. You don’t want to overpay for real estate or stocks because it cuts into your returns.

The systematic trader is foremost a trader. A trader doesn’t hold a position based on value, but decides whether the price is relatively too high or too low, whether it is in a long-term or short-term trend, extremely volatile or quiet. For each of these technical qualities, the systematic trader has a clear rule to follow. The rules are based on common sense and then tested using historical data to be sure they actually work. We will learn how a spreadsheet or special computer program may be used to validate the rules. You will find that many of the rules that are based on charting methods have been handed down from one generation to another.

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EXTRA BENEFITS OF TRADING

When you actively trade a stock or a futures contract, you are not holding a position all of the time. That’s very important because stocks spend a lot of time doing nothing, or doing the wrong thing. To offset these sometimes prolonged periods of aggravation or boredom, we get an occasional price shock, such as September 11, 2001, the U.S. invasion of Kuwait, a presidential election, or a surprise interest rate increase by the Federal Reserve. A price shock causes an unpredictable, large jump in prices.
Note that the term unpredictable means that you can’t plan to make a profit, no matter how clever you are. When you are always in the market, you will always be tossed around by price shocks, most of them small, a few of them very big. We’re going to spend some time throughout this course looking back at price shocks. They are the rare random events that cause the greatest losses among traders. The longer you trade, the more you’ll see price shocks. You don’t ever want to make the mistake of thinking that it was skill that netted a big profit from a price shock. It was luck. Next time, or the time after, you won’t be lucky. It’s a 50-50 chance.

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TREND TRADING RULES FOR TRENDLINES

It may seem clear from the charting examples that the trendlines show where to buy to enter a trade and sell to exit; however, traders place their orders in a few different ways:
Entry Rules
• Buy when the price closes above the downtrend line (conservative).
• Buy when the intraday price penetrates the downtrend line (aggressive).
• Buy in an upward trend when prices decline to near the upward trendline.
Exit Rules
• Sell when the price closes below the upward trendline (conservative).
• Sell when the intraday price penetrates the upward trendline (aggressive).

Notice that the aggressive trader buys during the day when prices cross through the trendline. A more conservative trader will wait to see if the closing price is going to be above the trendline. Price action during the day can be very volatile and the direction of prices can change, and often does, from midday to the close. On the other hand, if important news reaches the market during the earlier trading hours, the first one that buys gains the most profit. You can only decide your style from practice. Start with the closing price as a measure of direction until you are confident that another way is better.

Getting Out of the Trade
When the upward trend is finished, prices will move down through the trendline. At that point you sell, closing out your trade, hopefully with a profit. However, not all trades are profitable. About two-thirds of all trend trades lose money, and yet trend trading is still a reliable, profitable way to trade.

Profits Through Persistence. The majority of times, a change of direction does not turn into a trend; however, when prices do continue in one direction, they produce good profits. Success is a matter of numbers. You can expect 6 to 7 out of 10 trend trades to be losses, some small, some a little larger. Of the 3 or 4 good trades you can expect one small profit, two medium-size profits, and one large profit. On average, a profitable trend trade should be about 2.5 times the size of a loss. With enough trades, that should result in a net profit in your trading account.
As an example, say we lose $100 on each of the 6 losing trades, for a total loss of $600. On the four profitable trades we get an average of $250 per trade for a total profit of $1,000. The individual profits are most likely $100, $200, $200, and $500. That’s a $400 gross profit less some slippage for entering and exiting and commissions on 10 trades. If instead of 6 losses there were 7 losses and 3 profits, we would net only $50. Expect the real results to be somewhere in between $50 and $400.


The Fat Tail
Trend trading is successful because losses are kept small and profits are allowed to grow. That technique is called conservation of capital. What makes trend trading profitable in the long run is the unusually large number of big profits compared to what is expected in a normal distribution. For example, in a normal distribution of 1000 coin tosses, half of them would be single runs of heads or tails. Half of those, 25 percent, would be a sequence of either two heads or two tails. Half of the remaining, 12.5 percent, would be sequences of three in a row, and so on. Therefore, in 1,000 coin tosses you can expect only one run of 10 heads or tails in a row.
Apply that to prices. In 1,000 days of trading (about four years) you would expect only one time that prices would go up or down 10 days in a row. However, that happens much more often than once; therefore, price movement is not normally distributed, and not random. It has a fat tail distribution. There are fewer days where prices turn from up to down, or down to up, and more longer runs. That’s what makes trend trading profitable.

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The Relationship Between the Moving Average Speed and Market Noise

The slower the moving average, the less it is going to be fooled by noise. The longer calculation period makes a single day less important and the average more able to hold onto the longer-term direction.
Some markets have more noise that others. The high-volume index markets have the most noise and, if you’re going to find the trend, you’ll need to take a very long view of those price moves. Foreign exchange markets and stock sectors have less noise and can be traded with a somewhat faster trend (medium speed is considered to be 25 to 60 days).
If you use a very fast trend, then you’ll want to take profits as often as possible since noise causes prices to change direction unexpectedly If you can’t expect prices to trend, then you must take profits often.
To summarize the way you need to look at a trading method based on long-term and short-term trends, remember that the short term is strongly influenced by noise, while the long term makes noise appear less important:
Short-Term Trend
Noise dominates short-term price movement.
Take profits often because noise causes sudden changes of direction.
Expect many small profits and a few large losses.
Use daily or intraday data.

Long-Term Trend
Noise is small compared to the length of the trend.
Stay with the trend, and don’t take profits. Take advantage of the fat tail.
Expect many small losses and a few large profits.
Use daily or weekly data.

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Application of Currency Option

The users of the option market are widespread and varied, but the main users are organisations whose business involves foreign exchange risk. Options may be a suitable means of removing that risk and are an alternative to forward foreign exchange transactions. In general, the exchange traded options markets will be accessed by the professional market makers and currency risk managers, where the standardisation of options contracts promotes tradability, but this is at the expense of flexibility.
In spite of the fact that options are becoming more and more popular with corporate clients, funds and private individuals, there is still some client resistance to using options as a means to managing currency exposures. Some clients consider options to be expensive and/or speculative.
When you buy an option, the most you can lose is the premium (price paid for the option). In some cases, options can help minimise downside risk, while allowing participation in the upside potential. One of the reasons a client may choose to use an option, instead of a forward to manage their downside risk, is this opportunity to participate in the upside profit potential which is given up with a forward contract. Clients who buy currency options enjoy protection from any unfavourable exchange rate movements.
Companies use currency options to hedge contingent/economic exposures, hedge an existing currency exposure, and possibly profit from currency fluctuations, while funds may use options to enhance yield.
Sometimes a strategy may involve more than one option and some option strategies employ multiple and complex combinations. Certain combinations can yield a low or no-cost option strategy by trading off the premium spent on buying an option with the premium earned by selling an option.

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HOW TO MAKE YOUR TRADING ADAPT TO CHANGING VOLATILITY

Enough of the theory. The best way to use volatility to improve your trading is to make your profit-taking objectives and your stop-loss targets get closer and farther away as volatility decreases and increases.
Changing Profit Targets Based on Volatility
If AOL is trading in a $1 range each day, you might want to target a short-term profit of $2. That would be reasonable if prices moved in one direction for about three or four days. If AOL was much more volatile, ranging $4 in one day, then an equivalent profit target would be $8. More important, if volatility dropped to $0.50 then a profit target of $2 would take much longer to reach and you’ll want to set your goal at $1.
When you set your profit target by finding a resistance level on a chart, the volatility of prices tells you where to look. Don’t pick a minor resistance level that’s $1 above the current price when the market volatility is $2 a day, and don’t expect a profit of $10 when prices only range $0.50 each day.
Changing Your Stops to Reflect Volatility
The same principle applies to stop-loss orders. If the stop is inside the normal daily trading range of AOL, then you can be sure that you’ll be stopped out. How far away should you place your stop? Look for a support level at about 3 times the volatility below where you enter your long trade and place your stop-loss on either side of that level—depending on whether you are looking for free exposure or confirmation.
If you’re a technical trader and you are not using charts, then you can set your profit target and stop based entirely on volatility. If you have just entered a long position in AOL at $15 and the stock has been trading in a $1 daily range, then:

Profit target = entry price + (profit factor × daily range)
= 15 + (2 × 1)
= 17
Stop-loss = entry price − (stop factor × daily range)
= 15 − (3 × 1)
= 12

You’ll note that the profit target is 2 times the volatility and the stop is 3 times the volatility. The profit target is closer than the stop-loss. This is the normal pattern when you’re a short-term trader. You want to be sure you capture profits as often as possible. To do that, you’ll need to take a larger risk on each trade. If you make your stop closer than your profit target, then you’re sure to be stopped out more often and end up as a loser. The closer order is most likely to be hit.

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Range Expansion Search Code

In creating a list of patterns for trading programs, there are two ways to proceed. The first method is to observe the markets and investigate hunches as to market behavior. Occasionally, using this method, useful trading patterns will be detected. This is the method I used until I came across the written opinions on the subject of star trader, Monroe Trout on this subject. Trout learned to trade while working for my former employer, Victor Niederhoffer in New York. Trout logically proposes the idea that a more efficient method of pattern research is to simply test all possible parameters and intermarket relationships to see if any of the results look statistically valid.
What I will present to you in this chapter is a sample program that you can use to test all possible patterns of a technique called range expansion. If you are unfamiliar with the concept of range expansion, let me explain. Range expansion refers to any system that takes the value of one chart point, subtracts the value of another chart point and then adds or subtracts this value from an opening or close to derive a buy or sell point.
In many cases, we will be using a percentage of the value we calculate and then add or subtract this value to tomorrow's opening for our buy and sell points. Since it is easy to run a comprehensive search of all volatility expansion patterns and then to consider the possibilities, we will demonstrate the technique.
Our Tradestation program to find volatility expansion sell signals reads as follow:

Inputs: cha(O), opt(O), per(O), tday(O);
Vars:voll(0), vol2(0);
voll=highest(high,cha) - lowest(close,opt);
vol2=highest(close,cha)-lowest(low,opt);
if day of week (date)=tday and
voll [ vol2 then sell tomorrow at open tomorrow -(voll*per) stop;
if dayofweek(date)=tday and
vol2 [ voll then sell tomorrow at open tomorrow - (vol2*per) stop;
Our program to search for volatility expansion buy signals looks as follows:
Inputs: cha(O), opt(O), per(0), tday(O);
Vars:voll(0),vol2(0);
Voll=highest(high,cha)-lowest(close,opt);
Vol2=highest(close,cha)-lowest(low,opt);
If dayofweek(date)=tday and
Voll [ vol2 then buy tomorrow at open tomorrow+(voll*per) stop;
If dayofweek(date)=tday and
Vol2 [ voll then buy tomorrow at open tomorrow + (vol2*per) stop;

This program will test every day of the week for volatility expansion trades. It alters the values that are searched as well. Since the highs, closes and lows are inputs, we can test all values from 1 -5 days ago and all days from 1 -5 (Monday to Friday) and all percentage expansions from 109& to 200%. We will use the lesser of the two values that we calculate. In addition, we will test all parameters of each of the three components to get a sense as to whether there is a range of values that shows some promise.
If we only find a single working value, we must suspect an over-optimized system and avoid it. Our general rule is to base our trading only upon pattern systems that have profit factors above 3 and percentage accuracy in the area of 70% or better and many similar profitability reading at different parameters.

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DOUBLE-SMOOTHED MOMENTUM

Originally, we saw that momentum was unbounded and erratic. It is similar to most other trends but not quite as smooth. There is a technique called double smoothing that will turn a questionable indicator into a very valuable one.

The success of double smoothing is that it creates a trendline that has less lag than a moving average. Less lag means that you can react faster to changes in the direction of prices. Double smoothing does this by averaging the momentum rather than the prices.

Momentum is speed. It shows faster movement and more sensitivity than prices. If you take the first difference in prices (a one-day momentum), then you speed up price movement. If you then average the momentum, you smooth out the prices and slow down the speed. First speeding them up and then slowing them down results in no lag.

However, a momentum indicator that is smoothed once is still not quite enough. If we now average the new result, we are averaging something that has already been averaged. We have smoothed it twice. For convenience we use percentage smoothing rather than a moving average. Figure 15.13 shows Microsoft with 20-day and 40-day momentum indicators in the center panel, and a double smoothing of the 20-day indicator in the bottom panel. The double-smoothed indicator begins with the one-day price differences and smoothes them with a 20-day period (smoothing value of .0476). It then smoothes the new values by .0476 again.

This first example of double smoothing does not produce a trendline that is as smooth as a moving average. It also has different value than the original prices; therefore, it can’t be plotted along with prices in the upper panel. That’s not a big problem because we only need to see the direction of the trendline to decide whether prices are going up or down. Most important, the new double-smoothed line does not have a lag. The highest point and lowest point of the trendline in the bottom panel correspond to the highs and lows of the price chart.

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IMPORTANT CONSIDERATIONS ABOUT RISK

As a trend trader, using a moving average trendline, we don’t always think of risk clearly. We know that slower trends allow larger price swings without changing the direction of the trend. Faster trends respond quickly to price changes. Those risks are implicit in the use of a trend method and can’t be separated out.
One of the dilemmas of using a stop-loss to limit your risk to a “comfortable” amount can be shown best in an example. Suppose you’ve been following a trend system and you are long 1000 Amazon at $30 and now hold a $10 profit ($10,000 on your trade). You would like to protect those profits; therefore, you place a stop-loss at $28, risking only $2,000 of your gains. Sure enough, prices drop and you are stopped out. Prices continue down to $27.50, turn back up, and move above $40.00 to new highs. During the drop to $27.50 the moving average trendline never turned down. It would not have turned down until $22.00. You are now out of the trade but the trend is still up and prices are making new highs. What do you do? Do you jump back in and try to catch the rest of the upward move, or do you stand aside until there is a new trend signal?
None of these choices are good. If you going to trade the trend, then you must look at the risk in advance and decide how many shares you can buy and still hold the trade comfortably when prices move against you. A stoploss fights with the trend system. The trend system wants to stay long and you want to get out. It just doesn’t work.
You cannot trade more than you can afford to lose. Your position is too large if you are uncomfortable with the day-to-day risk.

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Market Conventions : OPTION PRICE

How should one ask for an option price? The required pieces of information, in the preferred order, are as follows:

• The two currencies involved and which is the put and which is the call, e.g. dollar put, Swiss
  franc call;
• The period, e.g. two months or the expiry or delivery date, e.g. expiry 12 December, for
  delivery 14 December;
• The strike, e.g. 1.5010;
• The style, e.g. European or American style;
• The amount, e.g. 10 million dollars.

There are many ways of stating the period, but usually, if one date is stated, it is assumed to be the expiry date but it is much safer always to specify. In the same way, if a 10-day option is requested, it is assumed that the required option has an expiry date 10 days from the current date. If, however, an option is requested with a period in terms of months or years, e.g. three months, the dates of the option are worked out as follows:

• Calculate the spot foreign exchange date for that currency pair, using the same conventions as the spot foreign exchange market.
• Take the period, e.g. three months from that date, using the forward market conventions.

This gives the delivery date. The expiry date will then usually be two working days before that. The exceptions occur in any currency pair where spot is not two working days, for example the Canadian dollar, where the expiry date would be one working date before the delivery date.
Please note that with cross currencies and dates involving American holidays or in any cases where there may be confusion, it is always best to quote both the expiry and delivery dates required.
In asking for an option price, always state which currency is the call and which is the put. For example, does dollar/Swiss franc ($/sfr) put mean a dollar put or a Swiss franc put? On the option exchanges and in the OTC interbank market, this would usually refer to a Swiss franc put/dollar call. However, most corporations would probably mean a dollar put. For this reason, always state the case in full, e.g. dollar/call Swiss franc put or vice versa.

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Symmetrical Pattern

Traders trained in macroeconomic theory run the risk entering trades based upon superficial analysis of inter market price action. As many of you know, a sharp upward move in a commodity such as crude oil or gold can scare S&P 500 traders into selling their stock positions or going short. Commodity prices are perceived as having an inverse relationship with stock prices.
The reasoning of many traders taking short positions springs from the following logical chain: 1) commodity prices rising means that inflation is growing and therefore the Federal Reserve is more likely to raise short-term rates. 2) This monetary tightening will be bad for stocks and therefore S&P's should be sold based upon the commodity price rise. This macroeconomic logic, used at the wrong moment, leads to what I call the commodity fakeout trap. This chapter should get you to steer clear of this trap.
The psychology behind the average trader's decision to trade must be studied. It is this psychology that will take the poor trader into the wrong positions over and over. The methods that I teach you are designed to move the average trader's losses into the credit field of your account statement. Remember, in a field as complex as leveraged trading, decisions of the average trader will nearly always prove incorrect. I am about to show you one situation in which intuition may lead you astray.
What I have done is identify intermarket patterns that trick the average trader into making a mistake. By acting in a counterintuitive fashion and by taking the opposite side of the trade, we will move ourselves into the small camp of winners.

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The Main Instruments For Foreign Exchange Trading

The main instruments for foreign exchange trading include both traditional products such as spot, forwards and swaps, and more exotic products such as currency options and currency swaps. The beauty of the foreign exchange market is its ability to accommodate new products, for instance currency options come in all shapes and sizes, all tailor made to serve a specific purpose.

The products used today are described as:

• Spot – a single outright transaction involving the exchange of two currencies at a rate agreed on the date of the contract for value or delivery (cash settlement) within two business days.
• Forward – a transaction involving the exchange of two currencies at a rate agreed on the date of the contract for value or delivery at some time in the future (more than two business days).
• Swap – a transaction which involves the actual exchange of two currencies (principal amount only) on a specific date, at a rate agreed at the time of conclusion of the contract (the short leg) and a reverse exchange of the same two currencies at a date further in the future, at a rate agreed at the time of the contract (the long leg).
• Currency swap – a contract, which commits two counterparties, to exchange streams of interest payments in different currencies for an agreed period of time and to exchange principal amounts in different currencies at a pre-agreed exchange rate at maturity.
• Currency option – a contract, which gives the owner the right, but not the obligation, to buy or sell a currency with another currency at a specific rate during a specific period.
• Foreign exchange futures – this is a forward contract for standardised currency amounts and for standard value dates. Buyers and sellers of futures are required to post initial margin or security deposits for each contract and have to pay brokerage commissions.
  
  

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