Lessons On Building A High Performance Trading Method

March 30, 2007

Name: John Person

Company: Sponsored by FX Futures.com

Years Trading: 27

Favorite Movie: The Godfather

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All traders search for ways or information that will give clues to spot high probability entries to buy or sell whether the market is at the beginning stages of a bottom or breaking out of a congestion phase or a sideways channel.

Determining the market condition, whether it is bullish, bearish or neutral is what will help in our trading decisions. There are many forms of technical analysis studies to help us achieve that, the simplest is a trend line approach. In determining an up-trend you start with the lowest low point on a chart and then draw the line up and connect to the next corrective low point and extend outwards.

Another popular method is the use of moving averages. There are more variations and more complex ways that we can use this technical tool or we can simply use moving averages to determine a trend's strength or when a trend is nearing completion or exhaustion, from a strict chart reading perspective, some clues are given by watching the relationship of the close of the current time periods value to past highs and lows as well as the direction of the trend or the moving average. I am going to introduce you to various concepts for moving averages, time periods that can be used and various conditional settings that can be chosen. I will also show how traders can integrate other forms of analysis to help generate and help filter out high probability buy and sell signals.

One trait I have noticed that most novice traders possess is that they try to over analyze and complicate matters, but in order to help simplify your thinking remember this, there are only four common denominators that each of us have equal access to and that is the OPEN, HIGH, LOW and CLOSE of any given market, in any given time frame. There are two exceptions to this observation, one is, there is VOLUME and for Futures traders there are OPEN INTEREST values to measure. However, even these two elements cannot be finalized or completely calculated until the close of each trading session. Therefore it is important that you realize that the CLOSE is the single most important aspect when using and applying all forms of technical analysis studies.

So no matter what market or trading vehicle you are trading whether it is a Stock, a Futures or commodity market, Stock Index, and even more appropriate, trading in the Foreign Currency markets, you need to watch the CLOSE of the time period for which you are trading in to capture a clue in order to initiate a trade, manage the trade and identify an exit spot.

The close is the most important element and what matters most when trading. It is the relationship of the close to past price action and to the other three elements such as the High, Low and Open that will help measure or weigh a value of a given market at a given point in time. Once you grasp the understanding that it is the close that shows you what the current markets value is, it should then give you a clue as what your next trading decision should be. If you learn to act on the Close for your trading decisions, and triggers, that information will help stack the odds in your favor that you are going with the current flow or the right market direction. That includes any time period for which you are trading. That means if you are a day trader using a five minute period you cannot act on an intra-time period signal. You need to wait for the five minute period to conclude before acting on a trigger. The same goes for a fifteen minute, a sixty minute, a daily time period a weekly or even a monthly time period.

These "clues" that we as traders are looking for are what we need to initiate a trading decision and are what I define as a trading TRIGGER. Once you have an understanding on how markets work, how to understand simple charting techniques, the fundamental working knowledge of indicators, what dictates increases or decreases in values of a given product at a given point in time such as supply and demand factors and how that is represented on a chart, then you will have gained a better edge in the market and you will have stacked the odds of success in your favor.

There are all kinds of traders and each one uses different forms of analysis. What I teach for futures traders is that there is really immediate and equal access to four common denominators. These are what each and every trader to work with, without prejudice and exclusivity. It is the data for the Open, the High, the Low and the Close. For stock traders there is a fifth element and that is, volume. I believe it applies to futures traders who are longer term or like to confirm the strength or weakness of the trend. In futures, unlike in stocks, the volume is not given to the investing public in real time. Truthfully that is why the futures markets depended on technical analysis to speed the analytical process to determine a market move on pure price action. After all, it is how we analyze, interpret and act on the information that makes us different as traders. It helps to have equal and fair access to prices and that is what the futures markets offer due to the reporting from a centralized market place. Most technical analysis tools measures the current price or the close in relationship to the four common denominators.

The High
The Low
The Open
The Close

Therefore it helps to have equal and fast access to this information. What makes each trader different is how we interpret and act on this information. That is what makes us better or worse than the next guy or girl. The trader's job is to look for set-ups and triggers that depend on the current market condition or last price (close) as it relates to these past four common denominators

Moving averages are considered classic indicators and are very popular with traders today. Most technicians view the moving average as a way to signal a change in the direction of the trend, as well as a way to smooth out the volatility of the market. Both of these attributes appeal to traders.

The name moving average aptly describes the calculation and the result of this type of indicator, of which the simple moving average is the most popular. Other moving averages include exponential, weighted and variable. These more complicated calculations make the indicator more sensitive to the latest closes by weighting the latest closing prices based on various formulas. The simple moving average (the arithmetic mean) is the most popular moving average used in technical analysis. The simple moving average is the sum of a defined price over a period of sessions divided by the number of sessions. The typical defined price is based on the close. As new data is added to the calculation, old data is removed. By averaging the price data, a smoother line is produced and the trend is much easier to recognize. For the simple moving average, divide the sum of the closing prices by the number of closes. For example, the total of the last 18 day's closing prices, divided by 18, results in an 18-day simple moving average. With each new day, that day's closing price is added into the new calculation, while the first closing price is eliminated, thus maintaining a fresh 18 day moving average. This is how and why the calculation "moves" along with the prices.

There is a simple rule or trading method to follow: If the price closes above the moving average, the trend is now up. If the price closed below the moving average, the trend is now down. You do not have to wait for the value of the moving average to start rising or falling to determine the trend, simply a close above the moving average will trigger a long and a close below the moving average will trigger a short position.

Regression to the Means

Another method trader's use moving averages for is to determine what is called "regression to the means". This is a term many traders hear of but really do not understand. It refers to the condition when prices deviate too far away from the mean or average, prices will regress or return to the averages or the market will pause or consolidate until the average catches up to prices. When the price "gaps" or separates too far away from the moving averages it can give a trader an opportunity for a counter trend trade. Another way to describe this is when a market deviates or departs too far away from the moving average, it gives an opportunity to a speculator to take advantage of this condition which generally ends up that prices reach an unsustainable extreme and then return back towards the moving averages.

The question is at what distance or price level do prices deviate or move too far away from the moving average before the market price returns to the moving average or the market pauses in order for the moving average to catch up to prices. Using the aid of indicators such as moving averages in addition to an oscillator such as stochastics we can identify the "gaps" that occur in prices and show that when prices move too far too fast in one direction a condition known as overbought or oversold develops. This is when these price moves are unsustainable and thus form what we call overvalued or undervalued in relationship to the means or moving averages. Most markets behavior as reflected by human emotion goes into extremes as is even the case in trending markets. They move either too fast or too far in any one direction and then simply pause or correct back above or below the various moving averages as you will see from the example below.

Building a Trading System

The chart below is the British Pound Currency Futures. This market has an inverse relationship with the US Dollar. As the dollar moved lower the Pound moved higher and vice versus. Even as strong as this up-trend was in late March 2007, notice as it separated too far away from the longer term moving average it would return back and or move below the moving average. As the market made a complete reversal back under the moving average notice how once it departed too far from the moving average it came back up to retest that price level.

Before I continue, let me explain why the Futures markets can give traders an advantage over cash Forex. To start with, many traders can benefit from trading the futures market through the responsible use of the margin system, otherwise referred to as a good faith deposit. The Futures market through the IMM of the Chicago Mercantile exchange has tighter "spreads" between the bid and asking price plus there is no interest charge or rollover fee every other day as exists in the spot forex markets. The fact that there is a central market place gives all traders equal access to prices and level two capabilities to see quantity of bids under the current market price and the quantity of offers above the current market price often referred to as the depth of market or DOME. In addition, the futures market offers options for longer-term traders. There are transaction costs that apply per round turn, but if the brokerage commission exchange, regulatory and transaction charges can be less than the PIP Spread in Forex, an active speculator would be given a better cost advantage using the Futures markets

Now let me get back to our tutorial on building a trading system. We can combine the use of Pivot Point analysis which gives us predictive support and resistance levels in addition we can use various moving average combinations to determine a markets trend and help give us a clue as to the markets condition.

Using Pivot Point analysis with various time frames such as weekly and or monthly numbers may help give a clearer picture as to what price level the market is over or under valued. This method will help in determining if the market is near a reversal stage which can turn into a high probability counter trend trade set-up.

There are many different combinations we can use for measuring or calculating moving averages. We can use different times periods such as 5 period vs. 10 period, or 50 day versus 200 days. We can also measure the opening prices, the highs, the lows, and even volume. Stock and stock index traders can even take moving average calculations using VOLUME and VOLATILITY such as the VIX the VXO or the VXN. Perhaps we will expand on this for later articles, or you can read about these methods in my book Candlestick and Pivot Point Trading Triggers + CD-ROM: Setups for Stock, Forex, and Futures Markets available on www.amazon.com or on my website at www.nationalfutures.com.

Most traders use a moving average based on just the close. In order to determine if a trending condition really exists one can integrate a moving average of the highs and lows and watch for breakdowns or breakouts of those values to determine a confirmed continuation or reversal for the momentum or change in price direction. These can be considered a "band" or channel, if the current closing price is below the moving average based on the highs of X periods, then the conditions are bearish. When the close is above the moving average value of the lows then we have identified a conditional bullish value change in the market.

Let me introduce you to another concept using what we call the pivot point as a moving average. This is a concept I use and teach using the pivot point, which is an average of the sum of the high, low and close, divided by three.

P=(H+L+C)/3= pivot point.

It captures the relationship of the close to a low or high as a reference point, thereby giving a better gauge of value than just a moving average based strictly on the close. When we introduce a mixture of conditional moving average components such as a simple moving average on a closing basis, combined with a pivot point moving average we can help illuminate and confirm a markets condition or change in value. When we combine two different time periods and two different conditions such as a moving average on the close and one base on the pivot point we now have four different variables to measure and help identify value changes. In addition, when we spot price action by closing above or below both moving averages and the moving averages cross, this really illuminates a momentum change in the market.

As for choosing the right time values one concept many traders use reflect Fibonacci series numbers (3, 5,8,13, 21, 44, 55…). Just remember the shorter the time frames used the more sensitive the moving averages will be to price changes.

In the chart below I have a trading model built on several factors. One the use of pivot point support and resistance levels, the use of three different moving averages, two are simple moving averages based on the close, one is longer term, one is shorter term and one is using a pivot point calculation. In addition I have the stochastics indicator helping to identify the market's cycle high and low points. When a green triangle forms it indicates a bullish change in momentum and when an orange triangle forms it indicates a bearish change in momentum.

We can help time the entry and exits when prices trade at or near a pivot resistance or support level. The moving averages overlaid on prices helps me identify the current markets condition so when a bullish signal is generated I look to go long, especially if the stochastics is near an oversold level and if we are near or at a pivot support level. The buy signal is still valid as long as prices continue trading above both moving average values. Then as the indicators warn of an overbought condition (generally readings above 85%) and if prices are near a projected pivot point resistance, that is when a trader can make a decision to tighten stops, scale out of a portion of a position or exit the trade entirely.

I believe, like many things in life, the more you repeat positive actions, the more you will experience and receive positive reactions. In trading that translates to simply following rules, wait for signals to transpire and then act on those signals rather than anticipate that signals will form. When signals trigger a buy then go long when a signal triggers a sell then exit the long or go short. Following a set of rules will not guarantee that you will be 100% right in your trading results, but by not following a set of rules your chances increase that you may be closer to 100% wrong in your trading results. One must learn to cut losses and let winning trades ride. It sounds like an old cliché to hardened trading veterans, but the fact is, it is so simple, yet it is hard to do. By accepting this simple fact of learning some simple principles and then following a few set of rules, which we discussed in this article, it may help you become a better trader, and that may translate into understanding what to look for in order to spot high probability trade signals.

About the Author

John Person is the author of three trading books and two trading courses, His first book, The Complete Guide to Technical Analysis for the Futures Markets, was the first ever to introduce traders to a powerful combination of candlesticks and pivot point analysis. His second book took traders to an entirely different level - Candlestick and Pivot Point Trading Triggers + CD-ROM: Setups for Stock, Forex, and Futures Markets, includes a pivot point calculator, instructional videos and exact rules for entries and exits on trades. In his third book, Forex Conquered: High Probability Systems and Strategies for Active Traders, he shares a trading system with the codes for Genesis and Tradestation users. His appears regularly on CNBC and is editor of the Bottom Line Newsletter found on www.nationalfutures.com website.