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Author: globalist2013 Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35377  
Subject: Building a Trading System Date: 1/13/2013 3:59 PM
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A ‘trading system’ is your ‘investment plan’. It’s the set of rules you’ve agreed to follow. The rules provide answers to the Five Essential Questions: “What?” “Why?” “When?” “How Much?” “Exit Point?” If you’ve proven through testing that your rule set has a positive-expectancy, then sticking to your rules will make you money. And not following your own rules is really, really stupid.

The number of markets that can be traded --err, ‘invested in’ -- is limited. Stocks, bonds, commodities, currencies, real estate, “collectables”, and some derivatives based on them, such as ‘volatility’. The rule sets are infinite in their variety. But they all share the same, two characteristics. They have to be ‘explicit’, and they have to ‘match the personality of their user’. Other than that, nearly anything can be made work. Fundamental analysis, technical analysis, quantitative analysis, ‘top-down’, ‘bottom- up’, etc. It just doesn’t make any difference how an edge is found and exploited.

But if your time is limited, focusing on the supply-and-demand dynamics of the market itself (aka, using ‘technical analysis’) is a good way to go. You make the assumption that you won’t have access to ‘insider info’ and that by the time any news that might affect price has gotten to you, the market has already reacted. This isn’t to say that the market has reacted correctly, and that becomes part of your ‘edge’. The abstraction called ‘the market’ (which is merely a shorthand way of describing the collective action of buyers and sellers) is going to get it wrong enough times for you to profit from their mistakes. OTOH, the market is also going to get it right often enough that you can piggyback on their buying/selling. They’ve done the fundamental work for you and voted their opinion by buying or selling shares. Your decision is simply to bet with them or against them based on how you read a price-volume chart.

Those price-volume charts can take a lot of formats: P&F, Bar, Line, Candlesticks, Renko, Heikin-Ashi, etc. And if you go to a charting site like www.stockcharts.com , you can explore all of them. Additionally, ‘indicators’ can be applied to charts that range from traditional ‘line studies’ to more modern derivatives such as Bollinger Bands, MACD, etc., concerning all of which, there are two schools of thought. One says that none of them are needed. “Just read the tape. The info is there.” Another school says that selected indicators can be useful if they help you see the essentials of what the chart might be saying. It takes a practiced eye to read and trade off a bare chart. So most investors would be better off applying some indicators to charts to simplify what otherwise seems lot a lot of noise and clutter. (This is one of those rare instances where ‘more’ might really be ‘more’.)

Everyone’s going to have their favorite indicators, and there’s a good chartist (Quillnpenn) who hangs at the forum Ask a Foolish Question who freely describes his methods, and who is constantly creating charts for stocks that are asked about. By his own reports, he’s making killer money, and from what I’ve seen of his analytic work, I don’t doubt his claims. The chief decision-engine of his method is the cross of a 13-day Exponential Moving Average (EMA13) over/under a 50-day EMA, augmented by appeal to what indicators like True Strength, MACD, KST might be saying.

I admire his work hugely. But I don’t like trading systems based on MAV crossovers, because I’m not willing to let prices move that far against me. Instead, I prefer to trade off the reversals signaled by candle patterns, which is a technique originally used to trade rice futures in the 17th century that tries to capture to the psychology of buyers and sellers. E.g. did prices close for the day pretty much where they opened (a formation called a Doji)? Obviously, there’s indecisiveness in the market, and when that doji occurs on light volume and at the end of a trend (up or down) you can bet on a reversal of direction happening the next day. Not always, not every time. But often enough to create an edge. However, extreme volume occurring in a well-defined trend might also signal a reversal. “If everyone who wants to buy (or sell) has made their move, then prices have nowhere to go but the opposite direction.”

In other words, interpreting charts can quickly become complex, which is why additional aids can be helpful. Indicators like Keltner Channels or Bollinger Bands are a way to estimate whether prices are moving in a well-defined trends, or whether their volatility has increased, thus, setting up an expectation for ‘mean-reversal’. Indicators like TSI, MACD, RSI, KST speak to the strength of the price increases or declines. Still other indicators, like Chaiken’s Money Flow, attempt to measure the amount of money flowing into or out of the stock. What all of the hundreds of indicators have in common is the attempt to convert ‘data’ into ‘information’. If a particular stock that normally tracks the broad market has begun to lag in terms of Relative Strength (confirmed by money flows out of the stock), do you assume that price will recover, or do you get out? You don’t know why sellers are selling. But it can be seen in the tape that they are. That, at least, is a warning sign. You can try digging into the news to discover why, and --sometimes-- an answer can be found. But, also, if you look at enough charts, you’ see this. Many, many times before bad (or good) news was announced, traders had already begun to make their moves. You can see it in the tape. Volume has increased, and prices have begun to accelerate or to reverse. So, you wait? Do you “buy the rumor, see the news”? Or do you simply follow your set of rules?

Exactly which set of rules each investor will create for her or himself will be different, because each investor or trader is different. Some are patient and will allow an opportunity to come to full maturity even if there are price moves against the position along the way. Others will “shoot first, and ask questions later.” So there’s no one right way to do any of this stuff, and no one can trade anyone else’s system. Also, there really are no “secrets” except the fact that “there are no secrets”. No one’s “market advisory newsletter” is any better than anyone else’s, and every one of them is merely a trading system that might (or might not) work for you. But the odds are they won’t and that you could put together a set of rules that better fit your own needs, means, skills, and objectives. In short, if you want to invest, first take the time to write a plan.

Charlie
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