What Works In Trading & Why: Anchoring Your Trades (Pt 1)

Discussion in 'Strategy Development' started by NoiseTrader, Jul 4, 2006.

  1. What Works In Trading & Why: Anchoring Trades (Pt 1)

    I've been absent from the forums for a few months, I 've had some health problems to resolve and have been working on better ways of communicating the analysis I do and the trading process I've developed.

    I'm going to explain that process in more detail than previously and in three Parts:

    Pt. 1: Anchoring Trade Analysis in A Primary Trend Model
    Pt. 2: Ideal trade Location & Variant Perception
    Pt. 3: Reversals & the Order Flow Bias

    Some of what I've posted before was objectionable to some and controversial to others, so if for some odd reason, what I write about or how I write it is irritating then read no more.

    In this series of posts, I'm going to demonstrate, as clearly as I can, how it works and why it works. I don't and won't explain everything explicitly, but the process is explained and you can use a lot of tools you have confidence in to fill in the blanks.

    If you want the complete version (this is edited) of this process then go to my blog http://www.street-noise.net/articles/ There is a gray box on the right side where you can drop me an email and I'll send you more complete PDF versions along with updated analysis of current markets and current conditions.

    Here goes...

    Pt. 1: Anchoring Trade Analysis in A Primary Trend Model

    High frequency timeframes (daily & intraday) are frequently noisy, yet that's where most traders focus their time and effort. It's really the low frequency timeframes (quarterly, monthly & weekly) which drives trends and controls how various market structures (price swings and price patterns) are going to resolve.

    In this first Part 1, I'm going to walk through some charts and demonstrate how primary trends control the resolution of structures that develop in lower timeframes, but first we have to define a controlling trend.

    The idea of a primary trend is to isolate a higher timeframe where the bids or offers in that timeframe offset or dominate what is happening in lower timframes. In this way a primary trend, is a controlling timeframe.

    Rising quarterly equilibrium price levels drives what I call primary bull markets in most markets. At the end of each quarter, I run a proprietary calculation to determine a historical quarterly equilibrium price level. Equilibrium can be thought of as a price level around which perceptions of value aggregates.

    I've uploaded a set of charts that accompany this post. If you want the charts with the text, drop me an email (as outlined at bottom of this post) and I'll send you a PDF version with charts.

    In the monthly Gold chart (Primary_B) the solid blue line at X is historical quarterly equilibrium. I also run new estimates every month for the new quarter (see chart above, solid light line at Y).

    When the solid blue line is clearly rising, quarterly equilibrium price levels are rising and the primary trend is up.

    In the lower timeframes (weekly and daily, etc) the major reactions back to quarterly equilibrium have been nothing more than strategic opportunities to reduce short inventory and increase longs.

    At the recent lows, Gold moved back to quarterly equilibrium as it tested the light blue line, which is the where I expect quarterly equilibrium to be in 3rd Quarter 2006, giving me enough confidence to accumulate gold and gold stocks a couple weeks ago near the low.

    Likewise, when the solid blue line is clearly in decline (see the 10-Yr Notes chart, Primary_C) quarterly equilibrium price levels are declining and the primary trend is down. Notice the primary trend reversed in the 1st Quarter of 2006 and the rally in the 1st Quarter was nothing more than a strategic opportunity to reduce long inventory and increase short inventory.

    In the monthly Dollar chart (Primary_D) the solid blue line at X is historical quarterly equilibrium. Notice the primary trend turned down in 2nd Quarter 2002 and exerts a controlling influence as every rally attempt failed for 2 years. After a brief primary bull move up, the primary trend turned just down again in the current 3rd Quarter 2006.

    Finally, look at the S&P 500 Stock Index monthly (see Primary_e). It entered a primary trend bear market in the 1st Quarter of 2001 and once again every major rally failed for two years.

    The S&P then reversed into a primary trend bull market in the 3rd Quarter of 2003. As of June 2006, the recent decline is a correction, not a bear market, because quarterly equilibrium is still rising.

    At the recent lows, the SPY had moved back to quarterly equilibrium giving me enough confidence to increase long inventory in certain individual stocks a couple weeks ago very close to the extreme low.

    Reviewing these charts it becomes self-evident how important it is to anchor trade analysis in higher timeframe trends.

    In sum, seeing trade location, where price is currently positioned relative to a primary (controlling) trend, anchors the analysis by placing a trade in a context where you can see if an asymmetry exists betwen risk and reward and why a price structure in a lower timefame should ultimately resolve in a reversal back with the primary trend.

    Of course, most traders need a finer degree of resolution than monthly bars offer, in order to convert a general strategy into viable tactics.

    In Part 2, to follow which I'll post as a new thread, we'll drill down into weekly bars and talk about ideal trade location in a more specific way.

    I publish this type of analysis (in more detail) for a range of important current markets as PDFs. If you want to follow more current examples and learn more about the tactics simply go to my blog http://www.street-noise.net/articles/ There is a gray box on the right side where you can drop me an email address. It's currently FREE to all.
     
  2. What Works in Trading & Why -- Pt. 2A: Ideal trade Location & Variant Perception

    A. ISOLATING STRATEGIC CORRECTIONS

    In Part 1, we defined a primary trend and provided examples showing that almost ALL major corrections back to quarterly price levels REVERSE BACK in the direction of the primary trend. The only exceptions occur when the primary trend itself reverses and these events are infrequent.

    Here in Part 2, we touch on the notion of "ideal trade location" and "variant perception."

    You'll need to download the chart set titled charts_2A.zip (below).

    We'll focus on three major situational opportunities that occur in markets where the risk-reward is asymmetrical -- which means the risk exposure is a fraction of the potential reward.

    IDEAL TRADE LOCATION. We call these three situations "ideal trade locations" because they represent optimal price regions for making portfolio adjustments (initiating or closing out shorts and longs). But ideal trade location also varies according to: 1) the type of market environment you are facing; and 2) the location of price relative to rising or declining quarterly equilibrium levels.

    Markets exhibit a high degree of efficiency, but they are not 100% efficient. This means profits holding long or short inventory are difficult, but possible--and even highly probable, if you are selective about where you initiate changes in your long or short inventory.

    VARIANT PERCEPTION. Profitable trading situations tend to coincide with a divergence in the perceptions of various kinds of traders as to what exactly is occurring in a given market. This type of divergence is called a "variant perception." We'll illustrate how this manifests on a chart shortly.

    The first of three ideal trade locations is what we call a "strategic correction".

    STRATEGIC CORRECTIONS. When the primary trend is up, a retracement back to rising quarterly equilibrium is a strategic correction.

    NOTE: retracement into strategic sell zones present a set of opportunities to increase short inventory or reduce long inventory.

    Chart 1. In the chart (right), there are four strategic corrections in Crude Oil.

    During strategic corrections we really need a finer degree of resolution in order to monitor price action more closely in order to execute trades.

    Chart 2, left, is a weekly chart, not a monthly chart. This chart has the higher timeframe quarterly equilibrium displayed (light and dark blue lines).

    STRATEGIC BUY ZONES. We call the zones (green boxes) between the most recent quarterly equilibrium estimates (the light blue lines) and actual quarterly equilibrium (the dark blue lines) a "strategic buy zone."

    In Chart 2, there are three strategic buy zones visible in Crude Oil.

    NOTE: In a strategic correction, the ideal trade location for initiating changes in long and short inventory is within a strategic buy or sell zone.

    In primary trend bull markets, when price moves into strategic buy zones, the correct strategy is to increase long inventory and decreasing short inventory.

    <<page 2>>


    STRATEGIC CORRECTION IN GOLD.
    Chart 3. In the Gold weekly, left, the deep reaction in Gold into the 6/14/06 low was a strategic correction into a strategic buy zone.

    Since the quarterly equilibrium is still rising the move into the strategic buy zone was a move below rising value.

    Chart 4. All tradables (commodities, futures, stocks, stock indices, bonds, FOREX pairs and individual stocks) obey the same primary trend rules described here.

    Here is the Google monthly chart, at right. Pull up your own daily or weekly chart for Google and you'll see that even in a large trading range the extreme reactions within the range often resolve as strategic opportunities that emerge around quarterly equilibrium.

    <<page 3>>

    VARIANT PERCEPTION.

    Momentum traders tend to naturally gravitate to high frequency (daily, and intraday timeframes) because momentum itself tends to be transient and short-lived. But, high frequency timeframes also tend to be noisy and more difficult to read.

    Value traders, on the other hand, tend to naturally gravitate to low frequency data points (monthly & quarterly timeframes) because value-based analysis tends to incorporate much larger quantities of time.

    Chart 5. In May-June '06 the daily SPY (at left)appears to be in a high momentum move down, a disorderly freefall.

    Chart 6. The low frequency monthly chart, at right, indicates that what appears to momentum traders as a high momentum move down with no bottom in sight in the daily timeframe (refer back to Chart 5) is in fact a orderly move to value and equilibrium in a higher timeframe.

    This is an example of variant perception among different groups of traders in a marketplace observing the same price, only at different frequencies.

    In this particular case, momentum traders perceive that the probability for a continuation of the move down is higher than the actual probability. This error in perception is because major reversals occur at rising quarterly equilibrium levels (as illustrated in Part 1).

    Meanwhile, value traders perceive that the probability for a continuation of the move down is low because they correctly expect major reversals to occur at rising quarterly equilibrium levels.

    This does not mean value traders are always correct and momentum traders are always wrong. It means in this particular configuration value traders have the edge.

    As we'll see in the next installment, there is a different set of dynamics where momentum traders have the edge over value traders.

    This post is also available as a PDF. I also publish this type of analysis (in more detail) free for a range of important current markets as PDFs.

    If you want to follow current live examples; learn more about putting this to work and how to manage trades simply go to my blog http://www.street-noise.net/articles/

    Find the gray box on the right side column where you can drop me an email address. It's currently FREE to all.