Can you think of a time when you’ve been in the same mood all day? If you can, this was probably an abnormal day. Over the course of most days, our moods go up and down.

We may wake up feeling refreshed or tired; we may go into lunch feeling hungry or distracted; we may feel revived in the afternoon, or ready for a siesta; and we may come home refreshed or exhausted after a long day – depending how it went.

Over the course of a day, we may decide to enter a few trades – each time in a certain mood.

The mood elevator

The mood elevator is a term that’s thrown around a lot, usually in annoying jokes such as, “Looks like you’ve got a case of the Mondays! You need to raise your mood elevator!”

International firm Senn Delaney, which is focused on transforming work cultures, has a more serious and helpful definition of the term ‘mood elevator’.

At the top of the mood elevator is the higher mood level – including feelings such as resourcefulness, inspiration, energy and curiosity. Lower levels include emotions such as worry, irritation, a feeling of victimisation and overall lowness.

Being at the higher level in the mood elevator is good in that your thinking tends to be clearer. When you’re in a better mood, studies show that your IQ and EQ (emotional intelligence) also tend to be higher than average.

On the other hand, lowered mood leads to clouded thinking, excessive judgmental tendencies and unhealthy impatience. This means you’re probably making smarter trading decisions when you’re at the top of the mood elevator, and bad decisions when you’ve hit ground floor.

What to do

Senn Delaney outlined five steps to follow in order to keep mood clouding your judgment.

1. Note your state of mind and use your feelings as a guide to the quality of your thinking. Make an obvious effort to constantly check where you are on the mood elevator – make sure unhealthy thoughts aren’t recurring.

2. Take care of yourself. Our physical state has an impact on our thinking. If you’re tired and warn out, your mood will lower and your thinking will be cloudy. Better physical health leads to strength of mind.

3. Remember low mood equals unreliable thinking. If you’re feeling down, this is the important time to check yourself. Try not to make any major decisions; don’t make a bunch of trades just to make yourself feel better. If you can’t stop yourself from trading, use caution and don’t overreact.

4. Sense of humour is key. Sit back at some point during the day, think of what you have to be grateful for, and go over the last few things that have made you laugh. “Laughter is the best medicine” is a cliché we hear a lot, but it’s true… think about what a lot of your favourite TV shows are – chances are there are a few comedies in there. Humour and a light mood can help you handle challenges more efficiently.

5. Mood is contagious. Senn Delaney outlines this point in terms of management leadership, but the point behind this last tip is valid: if you are trading amongst other traders, or even while you’re at work amongst non-traders, the mood of others can greatly impact you.

Organisational studies show that a company’s culture and climate can be something you carry home with you. If it’s been a bad day for you at work, try not to let this shadow follow you home.

Carl Capolingua
Follow Carl on Twitter @CarlCapolingua
Head of Education
Australian Stock Report

 

   Written by: Carl Capolingua   Other posts from: Carl Capolingua

In today’s guide to investing we discuss Groupthink, a concept developed by social psychologist Irving Janis in 1972.

The term refers to the phenomenon whereby a group will make faulty decisions, because group pressures lead to declines in mental efficiency, reality testing and moral judgments.

In other words, groupthink occurs when groups tend to make irrational decisions and ignore rational alternatives.

A group is especially vulnerable to groupthink when all of its members are similar in background, and the group is insulated from outside opinions.

Groups are also particularly in danger when there are no clear rules for decision making. Scarily, this sounds a bit like the investment community, don’t you think?

Characteristics of groupthink

Think about your trading behaviour and mentality. Could you be someone who is vulnerable to groupthink?

Common symptoms of groupthink are:

- Maintaining an illusion of invulnerability
- Being tempted to rationalize poor trades (also known as “cognitive dissonance”)
- Believing in the morality of the group, or in the case of the market, investment community sentiment
- Using group stereotypes to guide your decisions
- Feeling the need to maintain an appearance of unanimity
- Ignoring your true gut feelings
- Putting up “mindguards” to blind yourself and the group from negative information.

If you’re engaging in the above behaviours, you might be succumbing to groupthink. It’s a very tempting thing, after all, to succumb to groupthink when you’re in a group or community.

This is especially so when there is a lot of pressure to make a quality decision, which is what the stock market is all about. However, the pressure to make a quality decision can lead to carelessness and irrational thinking.

People suffering from such pressures tend to disregard rational alternatives and feel that, since there is safety in numbers, one might as well act in accordance with the group – even if group thinking may seem faulty to an outsider.

Unfortunately, studies have shown that decisions guided by groupthink have a low probability of achieving successful outcomes.

The market and groupthink

We as investors are in danger of groupthink when we become heavily involved in the investment community emotion of the time – optimism during bullish times, and paranoia and fear during bearish times – and get swept away with this emotion.

Another example can be found in buying and selling behaviour. Groupthink works so that people feel that they have to follow the behaviour of the majority of the group.

It’s not an easy thing to stick to your guns on an opinion that is different from the rest of the group. That’s why at times – especially volatile times – we’ll see a lot of people moving to buy a security at once, or a lot of people hurrying to sell a security.

This is because it’s tempting to have your opinion validated by others in the group. And this temptation is never stronger when the market is suffering volatility.

The temptation to become part of a “herding mentality” becomes very strong. Investors are scared of making a bad decision, and scared of acting alone, so they follow the mentality of the crowd.

However, this doesn’t mean the herd mentality is right. Sometimes the market will react in an irrational way towards the latest economic news, even if the fundamentals of a company or sector are still strong.

It’s important to keep your head in these times; look at the facts, and act as an individual on the facts, and don’t succumb to a panic mob mentality.

No one has made it in the market by being swayed by the latest panic-spreading press releases or rumours!

Carl Capolingua
Head of Education
Australian Stock Report
Follow Carl on Twitter @CarlCapolingua

   Written by: Carl Capolingua   Other posts from: Carl Capolingua

Modern economics makes an assumption for both social and economic behaviour, and that is that all individuals will choose the best course of action based on the stable preferences and limitations facing them.

This is known as “rational choice theory”. Individuals will choose as rationally as possible based on the information made available to them. Though it is primarily an economic-social theory, rational choice theory is used in a number of fields, including criminology.

For the purpose of this lesson, however, we will look at the economic and psychological perspective of the theory.

It’s your choice

Rational choice theory is based on the idea that group behaviours are the result of individual actions. Typically, people are motivated by money and the idea of making a profit, so the theory fits in well with economics.

The concept is that people tend to be rational in character, and will calculate costs and benefits of any action before deciding what to do. The theory therefore rejects the idea that social action may be anything other than rationally motivated, even when it appears irrational.

One would hope that this is how individuals act when they make their trading decisions: they choose trades based on rational decision-making and the information available to them.

But is this what really happens in the market?

Throwing the market into the mix

The stock market is made up of many individuals making a number of financial decisions. Rational choice comes in when traders try to anticipate outcomes of different courses of action, and calculate which choice is the best for them. Right?

Well, yes and no. As traders, we try to make the choice that seems like it will deliver the best possible outcome to us as individuals. However, even when a decision looks like a good one, there is no guarantee that the likely outcome will eventuate.

The stock market is characterized by a lot of players and a lot of conflicting individual activity, meaning that nothing is certain.

Check your emotion at the door

Rational choice won’t always lead to successful trades, because there can be factors or information outside of our control that will lead to unpredictable outcomes.

However, rationality will always win out over emotionally-driven decisions, because it takes into account as much information as possible. Rational choice involves reinforcement. If a rational trading strategy is successful, the strength of this strategy will be reinforced by the reward of the successful trades.

Therefore, rational choices that lead to successful outcomes will be reinforced in our trading behaviour over time.

Carl Capolingua
Head of Education
Australian Stock Report
Follow Carl on Twitter @CarlCapolingua

   Written by: Carl Capolingua   Other posts from: Carl Capolingua

Though it’s important to use logic when setting up a trade, it may surprise some that creativity also has its place in trading. Creativity is generally considered to be the ability to combine novelty and usefulness, hopefully to obtain an innovative result.

It is also considered to be the ability for a person to restructure their understanding of a situation in a manner that may not be obvious to all.

Am I creative?

Apart from simple (possibly subjective) observation, it is difficult to determine whether a person is creative or not.

There isn’t a generally accepted method for testing creativity. Different studies have employed various tests, such as the “divergent thinking” test where a subject is asked to come up with new and useful purposes for an everyday object (such as a pencil).

Others have maintained that possessing a good sense of humour is an important aspect of creativity. You might watch a funny film or TV show and wonder, “how did the writers even come up with that idea?” because it’s not a concept that crops up in everyday thinking.

Testing conducted by Dr. Rex Jung, a research scientist at the Mind Research Network in the US, has shown that whilst the brain works like a straight road to get you from point A to point B when it comes to intelligence, the regions of the brain associated with creativity looks like a collection of side roads with interesting detours.

Another interesting fact about creativity is that, contrary to popular opinion, creativity doesn’t just spontaneously show up as inspiration just because someone happens to be “creative”.

A recent study suggests that creativity takes a slower path than that of intelligence, so the concept of a quick-thinking “creative genius” is more of a myth.

Using creativity

Anyone can employ creativity by letting go of their habitual response to a situation. Try to shut down what would be your automatic logical reaction to a situation, and “think outside the box”.

It doesn’t matter how long it takes you to think of a creative idea – once you’ve searched for a unique idea once, you will find it easier to come up with creative solutions the second, third, fourth (and so on) time.

Creativity can be important when you’re trading because it forces you to think about the market in new ways – and you might find a whole new trading style that could bring you greater success.

It should be good news to most traders out there that most of you probably are naturally creative. Risk-taking is associated with creativity, and most traders by nature are able to embrace risk.

Creative connections crop up when most people are relaxed. And what’s a great way to relax? To laugh. And the driver for laughter? Humour. Go rent out your favourite funny film, or take a look at that new show your friend swears is hilarious. (First make sure you friend has good taste.)

Then go have a glance over your recent trades. Are any new ideas for future trades cropping up?

Carl Capolingua
Head of Education
Australian Stock Report
Follow Carl on Twitter @CarlCapolingua

   Written by: marketpulse   Other posts from: marketpulse

It’s tempting to think that we can use technical indicators, like the MACD, RSI, and stochastics, to guide our trading, but we should never place too much emphasis on any particular indicator.

If we want to focus on anything, it should always be the same thing: price and volume.

For all the wealth of tools available to you, they pretty much all come from the same two sources; price and, for confirmation, volume.

Know where you’re coming from…

Traders need to understand that the technical indicators that have been created over the last 20 or 30 years all derive their results from a mix of price and volume.

Therefore, if the price is telling you one thing, and the indicator something else, then you need to give precedence to price. So, do you only look at charts from now on? Just ignore indicators?

Of course we don’t. We should use as many pieces of information as we can, or feel comfortable with, when planning and executing our strategy. And, indicators will often point to a change in trend. Divergence, when the price is indicating one thing but an indicator another, is an important part of technical analysis.

…and know where you are going…

But, at the end of the day, you make money from prices, not indicators. So focus on prices and volume – and let indicators give you a second opinion.

With price, this is obviously the defining characteristic of any shares, and it determines whether we will make money with the trade. We don’t need to over-complicate matters – technical analysis can be just as effective when it is simple.

When looking at price, we need to focus on the price action relative to its past. For example, where the price closes relative to its open, or the previous close, will tell us how the market feels about a company.

In turn, after several days or weeks of price action, the market will then appear to move in one direction or the other, or in a broadly sideways pattern, signaling whether the stock is trending or consolidating.

Volume counts too!

Volume is of key importance when looking at the market, because it instantly shows whether price action is a result of few or many buyers and sellers.  This shows you the level of commitment to price action.

If the price jumps higher on very low volume, you might discount the move. However, if the price jumps higher on very high volume, this is confirmation that a greater than usual number of traders are committed to the stock.

Most importantly, a spike in volume signals a sudden change in sentiment toward a stock.

Specifically, it signals an increase in interest in a stock; investors might have become more negative or more positive, but they’ve definitely become more something.

In all, when using technical analysis, it is important to remember that core ingredients are just price and volume – and we don’t really need much more than that. Sign up for 7 days of free recommendations - click here.

Carl Capolingua
Head of Education
Australian Stock Report
Follow Carl on Twitter @CarlCapolingua

   Written by: Carl Capolingua   Other posts from: Carl Capolingua

We’ve all heard the term “herd behaviour”, but before explaining how it relates to investors, its best to provide some background into the term.

Herd behaviour describes how a group acts together without any planning or logic behind their actions.  Animals tend to exhibit herd behaviour when under attack from a predator.

If a group of zebras are running away from a lion, each additional zebra that joins the herd does so because they see a group running away from something; therefore they must join that same group. None of these new zebras attempt to verify the existence of the lion; they will merely do what all the other zebras are doing.

Back to the markets

So, how does this relate to the stock market? In strong bull or bear markets investors have a tendency to act like these zebras.

Consider the bull market leading up to the global financial crisis.  During the middle part of the decade, nearly all stock markets around the world moved in one direction – upwards.

We can safely assume that a significant percentage of the people that bought equities during this time did so because they wanted a piece of the action.

People were making money from the stock market, drawing other people into investing, which further pushed stock prices higher, and so the cycle would just continue.

Now consider the bear market that followed.  When stock markets were crashing throughout 2008, people were getting scared and selling off their shares.

The sell off depressed share prices, which caused more people to sell their shares, which therefore continued the cycle. In both the bull and bear markets mentioned above, consider how many investors assessed the merits of the stocks before buying or selling them.

People saw other people “running” into (or out of) stocks and simply decided to join the “herd”.  They were acting on emotion – specifically, the emotions of greed and fear.

The effects of herd behaviour

Not every person who invests does so because everyone else is doing it.  Smart investors buy or sell stocks because they have done their homework before actually investing. These same investors would have noticed the massive run up in equity prices in late 2007 was driven in some part by herd behaviour.

They would have calculated that stocks were becoming overvalued, and so they sold their investments at the height of the bull market, thus locking in a nice profit.

Others would have noticed this and sold their investments as well. The process then cascaded until everyone was selling their investments, and the end result – the 2008 stock market crash.

How to avoid herd behaviour

Avoiding heard behaviour can be especially hard during periods of mass euphoria or panic.  When stock markets are falling 50%, it is tempting to just throw in the towel and sell your own shares.

During these times, it is important to keep a level head when making investment decisions.  A cardinal rule in share trading and investing is never act on emotion.

If you sold your shares in March 2009 because of fear, you would have missed out on the strong recovery that followed. When everyone is either buying or selling shares, assess whether buying or selling is the right thing for you to do.

Whether you follow Fundamental Analysis, Technical Analysis, dartboards or tarot cards, all your trading should be based on a system and not on emotion. That’s the only true way to ensure you don’t get trampled by the herd. Sign up for 7 days of free recommendations - click here.

Carl Capolingua
Head of Education
Australian Stock Report
Follow Carl on Twitter @CarlCapolingua

   Written by: Carl Capolingua   Other posts from: Carl Capolingua

The world is made up of a lot of casual traders. You may know a few friends who don’t know a lot about the market, but occasionally buy shares anyway, usually because someone else has told them this trade is a “get rich quick” surety.

Anyone who has friends like this knows that hardly anyone makes money in the market this way. I’m talking about people who hear that some new pharmaceutical company is going to come out with some ground-breaking medicine, somewhere down the line – so they run out and buy a few shares.

What’s the result of this? The friend buys shares, the rumours about the company’s exciting product line are unsubstantiated or unfulfilled, and the friend loses money.

Generally, the friend might hold onto these shares for years, waiting for them to “go back up”, because they are too stubborn to take a loss.

Unfortunately, most of the time, these shares never do go back up. Your friend – who has treated trading as a mere “get rich quick” hobby – has lost money.

And they’ll continue to lose money for as long as they hold onto these ‘hobby’ trades.

Trading as a business

Successful traders treat trading as a serious business venture, not a hobby. This is because successful traders know that if you want to see rewards, you need to take trading seriously and see it as a business venture.

‘Hobby’ traders think, “Well, I’ve got a few shares and I look after my portfolio when I can”. However, that’s usually the extent of it; and if you don’t take trading seriously and treat it as a mere hobby, it is going to cost you money.

Now, it’s fine to have hobbies, and hobbies often cost money. But when you’re trading, your goal is to make money, not fritter it away. Trading is not a hobby. There is no ‘hobby’ enjoyment from watching trades crash because you haven’t put in any effort.

Reset your goals

If you really want to make money in the market, it doesn’t happen because you’ve treated trading as a casual side activity.

Try to think of millionaires who have made money through one lucky trade. It doesn’t happen, because rich, successful traders have been clear about their goals from the outset. They want to make money in the market, and they are serious in their intentions. They have put in the research and legwork, and become successful through experience.

Trading is not a joke; it involves your hard-earned cash. If your goal is to be successful in the market, and you’re treating trading as a hobby, maybe it’s time to rethink your strategy and goals. If you – or your friends – are going to trade, you need to treat it seriously. And that means putting in time and effort.

Think about the last time you went away for short holiday. How many hours did you spend researching restaurants, hotels, travel routes and sights? Now think of how many hours of research and analysis you did before placing your last trade. One that you possibly committed thousands – or tens of thousands – of dollars to. That little exercise can be quite sobering.

So what do you need to do? Just like a well-run company has a well-thought out business plan, so should every trader have a well-thought out and clear trading plan. One that details what you want to achieve from the markets and how you will achieve it.

Only then can you hope for your hobby to stop costing you money.

Carl Capolingua
Head of Education
Australian Stock Report
Follow Carl on Twitter @CarlCapolingua

   Written by: marketpulse   Other posts from: marketpulse

Welcome to MarketPulse, Australia’s most insightful look into the markets and trading!

Over the last few MarketPulse articles, we have discussed the various steps which traders need to go through to design a robust trading system. For those who may have missed those articles, a trading system contains a series of conditions which need to be met before we enter a trade. When these conditions are met we are said to have a ‘setup’. Setups are an integral part of our trading plans and are essential to improving our consistency and performance in the markets.

This week we will put into practice the trading system we designed in the previous article. To recap, the trading system involved:

Long term trading system

Entry Rules

Condition 1

Before a long entry can be considered, the 100 day moving average must be at its greatest level in the last 20 periods, and the last closing price must be above the 100 day moving average.

Condition 2

Buy when the 20 period ma crosses above the 40 period ma, or if a cross up has occurred within the last 40 days, then the 20 day ma must still be above the 40 day ma.

Holding and Exit Rules

Condition 3

Initial stop loss is to be placed 2.5% below the 40 day moving average.

Condition 4

Stop is to be trailed higher each day to 2.5% below the 40 day moving average at the conclusion of each trading session.

Back to the future

We are going to take the approach most professional traders will use when testing a system and run a ‘back test’. A back test is a simulation of how a trading system performed on historical data.

To run a back test we need to choose a sample of data and record in meticulous detail each entry and exit for the system based upon its explicit rules. We then sum the results of many trades over an extended period of time to get an idea of how effective a system has been in the past.

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For this back test we are going to use a security which has been in the news quite a lot of late, the Australian Dollar versus the US dollar (AUDUSD). Of course, one could back test on any asset which has a history of prices, so you may wish to further the research on this system and test over your favourite stocks or commodities.

The period of time we test over should be far from random. If we are going to design a system, then preferably the system works over all types of market conditions (rising markets, falling markets, sideways markets and variations thereof). This article is not meant to be a comprehensive tutorial on back testing, but I will make one important point on this topic here: We must choose a period to test which contains each of the various market conditions in the past.

To highlight the importance of this item, consider if we chose to test over a period of data which happened to only contain strongly rising prices. If we discover our system works very well, it is highly likely that the system will work only in a similarly strong market into the future. If the market into the future is not as it was in the sample testing period, we are likely to experience significant losses. Similarly, we may find the system failed miserably in testing over this sample, yet worked very well in the ensuing bear market. In summary, if we wish to obtain a system which is robust over multiple market conditions, we therefore need to test over multiple market conditions.

Secondly, (and again briefly here because the topic of back testing is a vast one) it is also important not to run a test up to the current day. We should select a period of time in the past which contains multiple market conditions, and then a similarly diverse period of time subsequent to this period to conduct further testing on. This is because we can test the strategy on the initial period, optimise any parameters to improve its performance, and then test the optimised system on the second, most recent sample.

This is called ‘out of sample’ testing and is far preferable to simply testing up to the current date and then taking the system ‘live’. In each case, the system will be tested on data it hasn’t seen before, however in the latter, we have no risk of losing our shirts during the testing process! Testing on out of sample data invariably leads to a more robust trading strategy and better real life results.

Taking all of the above into consideration, we will select the period of time from December 1998 to December 2007 to do our initial testing (see below).

 

We can see from the price data above that the AUDUSD has moved in all manner of trends over the sample period. Importantly, the period of time subsequent to this and up to today (on which we can eventually conduct our out of sample trading) has a similar variety of price trend conditions.

For our system we will assume that an entry (green arrows) is only made when each one of our official entry conditions are satisfied. As this system is based upon end of day data, a setup is only confirmed at the conclusion of a trading day. This means that when a signal occurs, we may only enter a trade on the open of the next trading day (we will use the open price in our results). We will also assume that upon entry we immediately placed our stop loss 2.5% below the 40 day ma and then trailed it dutifully in this fashion each day (exits are red arrows).

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This is a long only system (we never go short), and we only traded in one contract at a time, not increasing our position even if subsequent buy signals to our original were encountered. By the way, anywhere we refer to ‘days’ in this example, we mean trading days – not calendar days. Finally, as our stops are automatic, we assume that they were triggered in real time. For simplicity, there are also no commission costs, financing, or slippage in our example (this is the reason why we chose to test over an FX pair as these are typically very small anyway).

When we overlay our trading system on the AUDUSD Spot, we get the following series of entry and exit points over a 9-year period.

Our simple moving averages system allowed us to make 2,264 pips profit. On one standard contract, which is worth US$10 per point, this would amount to US$22,640 profit over 9 years. This is an annual return of approximately $2,500 on an investment of approximately $500 margin for one standard contract. Better than a poke in the eye – yes, but it’s fair enough to say it’s not enough to retire on!

Note that our strike rate was less than 50% and our system was still very profitable. This is because our average win size was nearly three times greater than our average loss size. Our average profit or loss per trade was a profit of 174 pips. Again we have to emphasise that strike rate is not all that important in building a good trading system. It’s how much you can expect to make on each trade, and overall, in the long run that really counts.

That’s all we have time for in this week’s MarketPulse. For now it is important to note two things:

Firstly, that just because a system made zillions of dollars over the last 50 years, it doesn’t mean it will make a cent in the next 50 minutes! All we can do is take our back testing with a pinch of salt and understand that in the future anything can happen.

Secondly, the system we have outlined here is a very basic system and has a very long way to go before it is actually tradeable. I.e. read between the lines here: these articles do not constitute a recommendation to trade this system! It’s just an example, and one which we will expand on next week.

Until then, happy systems testing!

See Carl Speak at a FREE Trading Workshop near you. Click for more!

   Written by: marketpulse   Other posts from: marketpulse

Over a number of previous MarketPulse articles, we have discussed the various steps which traders need to go through to design a robust trading system. As a recap, a trading system contains a series of conditions which need to be met before we enter a trade. When these conditions are met we are said to have a ‘setup’. Setups are an integral part of our trading plans and are essential to improving our consistency and performance in the markets.

Over the next couple of weeks we will attempt to put everything together, and design a trading system which readers might actually wish to implement for themselves. We’ll also point out a few important practical considerations traders need to take note of when designing and testing a trading system.

System 1 – Simple, but effective

As we said in the last article on this topic, systems need to have objectives. The objective of the system we will design and test today is to capture major long term swings in the market the system is operating on. Generally such systems are trend-following systems which have wide stops and open-ended targets. This trading system would be suited to a long term investment portfolio or a self managed superannuation fund.

Whilst this might not sound too exciting for many of you ‘seat of your pants’ traders out there, we conduct this analysis to show how timeframes and objectives are important in successful system design. We will test some shorter term systems in future weeks.

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Once we have our objectives, we must begin to construct the ‘Framework’ we described in Part III of this series of articles.

1. The trading system needs a set of rules for entry.

Any long term trading system should first and foremost start with defining and following the long term trend. Our proxy for the broader trend will be the 100 period moving simple average (ma). So, Condition 1 for our set of entry rules becomes:

Long term trading system – Entry Rules

Condition 1

Before a long entry can be considered, the 100 day moving average must be at its greatest level in the last 20 periods, and the last closing price must be above the 100 day moving average.

What the above should do is only put us in trades where the long term trend is up, and the trend is still in place (as the 100 day ma has been rising over the last 20 periods, and the price is still above the average).

On top of this basic condition, we will now add further conditions or ‘filters’ to improve the effectiveness of our overall entry signal. For this system, we are going to try and filter out trades where the shorter term momentum is not strong – even though Condition 1 may have been met.

Condition 2

Buy when the 20 period ma crosses above the 40 period ma, or if a cross up has occurred within the last 40 days, then the 20 day ma must still be above the 40 day ma.

An entry signal will occur when each of the above conditions are met. We talked in Parts III and IV about ‘setups’ and the above is an example of purely technically based trend setup. We think that there is more to a setup than just the entry signal however, and each setup should be considered in terms of risk and reward, and where we can place our stops.

Only fools rush in…

An entry signal is only a small part of a trading system. As we showed in the case of the coin toss example in Part I, it is also sometimes the least important element of a system. This brings us to items 2, 3, and 4 of our Framework.

2. The system needs a set of rules to determine how we take profit,

3. The system needs a set of rules to determine how we take losses, and

4. The profit we take should be larger than our losses.

A trade setup consists not only of the entry signal, but also some consideration of where a stop loss can be safely placed, and how much we are risking at that stop loss compared to the potential profit we may make if we are successful.

We feel that with trend based systems, we’re better off just letting our profits run and letting the market decide how much profit we eventually take. For such systems, whilst we might have a ‘loose’ target in mind, we prefer not to set a hard-and-fast point for where to exit at a profit.

For stops, we are prepared to give the trend based system some room, but we also have a motto when it comes to the relationship between setting stops and setting profit targets:

“Whilst we are brave in victory, in defeat we run like frightened animals!”

This means that whilst we like to let our profits run, we want to keep our losses as small as possible. This will help in building a system with positive expectancy.

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We have discussed each of the above elements of the Framework in detail in previous articles, and based upon those considerations and the ones above, we will add the following conditions to our trading system:

Long term trading system – Holding and Exit Rules

Condition 3

Initial stop loss is to be placed 2.5% below the 40 day moving average.

Condition 4

Stop is to be trailed higher each day to 2.5% below the 40 day moving average at the conclusion of each trading session.

We have now defined each element of the setup, from entry to stop placement. So what do we do now? How do we know if the system is any good!?

Well you might want to start testing this system on a few stocks, FX pairs, or commodities to see how well it works. However rather than calling up the bank manager and taking out a second mortgage on the house to have a go, you may prefer to take the approach most professional traders will when testing a system and run a ‘back test’.

A back test is a simulation of how a trading system performed on historical data. We will choose a sample of data and record in meticulous detail each entry and exit for the system based upon its explicit rules. By summing the results of many trades over an extended period of time, back testing allows us to get an idea of how effective a system has been in the past.

Back testing itself is a major field of technical analysis, and if performed correctly, it can also give us some valuable insights into how a system may perform when we trade it live with real money in the future.

Next week we’ll do just this and investigate how well the above system is likely to work in practice. Until then – happy testing!

See Carl Speak at a FREE Trading Workshop near you. Click for more!

   Written by: marketpulse   Other posts from: marketpulse

Welcome to MarketPulse, Australia’s most insightful look into the markets and trading!

In previous MarketPulse articles we have been discussing in detail the steps required to create a robust and effective trading system. As a recap, a trading system is a significant part of a broader trading plan which defines the conditions through which we engage the market.

A trading system is certainly not a complete trading plan however! Getting into the market is just one of the considerations a trader must take into account when trading over a period of time. Other factors such as risk management, portfolio allocation, exit rules, and self assessment and adaptation are all far more important to long term trading success. Nonetheless, few traders will start anywhere else but in systems design. The search for the Holy Grail is on!

Setups revisited

In the last MarketPulse article on developing a trading system we introduced the concept of a setup. We said that a setup was a series of conditions which needed to be met before we entered a trade. Traders strictly only ever enter a trade when a valid setup is observed.

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Here’s an example of a purely technically (using charts only) based setup which may trigger a system entry:

1.     The size of Candle 1 must be greater than 1% of the share price and be in the colour of the prevailing trend (e.g. black candle in an downtrend and white candle in an uptrend).

2.     Candle 2 must open below the open of Candle 1 and close above the close of Candle 1 for a long trade and open above the close of Candle 1 and close below the open of Candle 1 for a short trade (i.e. a ‘bearish engulfing’ pattern).

3.     RSI must have crossed above 30 within last 3 periods for long trade, or crossed below 70 within last three periods for short trade, or enter after conditions 1 and 2 have been met and an RSI cross subsequently occurs.

Setups can generally be defined as trend, reversal, range, and breakout setups. If there’s another phase of the market – we haven’t thought of it yet. But generally prices are in one of these phases. The above example is primarily a reversal setup.

Reversal Setups

Reversal setups tend to be very responsive. A setup’s responsiveness will determine how much of a price move will be missed before an entry is made. Given that reversals are generally rapid changes in price direction, we’d want to use the most responsive tools available to us to identify them. We find that pattern based technical analysis tools are best suited to reversal setups rather than fundamental tools which may have a significant delay before actually affecting prices.

For reversals setups, we find that candlestick patterns are extremely useful, as are more conventional bar chart patterns such as double tops, double bottoms, and head and shoulders. Indicators such Bollinger bands, stochastics, and the MACD with timeframes less than 20-periods can be used for confirmation of the observed price patterns.

Whilst reversal setups are generally suited to those trading with shorter time horizons, of course, quite often when a reversal is made a new trend is commenced. Thus the trader may find that a trade initially entered on a reversal set up is maintained because it also ends up meeting the criteria for a trend setup down the track.

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Trend Setups

Trend setups are generally less responsive than reversal setups because trends tend to last for a long time, and therefore the timeliness of an entry is not as important as for reversals. Also, we generally want to be pretty sure that we are actually in a trend before we enter, and thus should be prepared to trade off some profitability for certainty of the trend being in place. Trend setups are therefore better suited to those who have a longer term trading horizon.

For many traders, setups conditions may also include fundamental aspects such as price to earnings per share ratio (PE), and earnings growth. These are used as broad filters to whittle away those stocks less prone to trend. It’s fair to say that stocks with attractive valuations, and both growing earnings and a solid history of earnings growth, are more likely to trend than those who don’t meet these criteria.

From the subset of stocks generated by our fundamental analysis, we will generally then run a series of technical filters to ascertain the direction and strength of the trend. In this case, we prefer to use moving averages of a duration appropriate to the timeframe we are looking to trade, and look for confirmation from the tools such as the momentum indicator, relative strength index (RSI), and on balance volume (OBV). Generally, we are using longer timeframes on these indicators – of more than 20 days in duration.

Here’s an example of a trend setup which takes into account both fundamentals and technicals:

1.     PE should be less than 15

2.     Earnings in last 3 reporting periods must have increased by 10% pa on each occasion

3.     Consensus estimates for 1 year future earnings growth are great than 10%

4.     Price must be above 50-day moving average

5.     20-day moving average must above the 50-day moving average and rising

6.     RSI must be above 20 but below 80

Really, in the above example, stocks which meet the criteria will be trading on fairly cheap price to earnings multiples, have a consistent history of growing earnings and likely to continue to do so for the near future, be in a medium to long term uptrend as measured by the 50-day moving average, and price momentum will be increasing given that the shorter term moving average is rising and the RSI is still in an expansion phase.

Setups give us better trades

Imagine if you only ever considered trades which met the above criteria? How much better would your portfolio have performed over the last 5 years or so?

Well, that’s the whole point of your setups: To try and put you in trades which have a high probability of success and which are of a similar nature each time. Anything else but stocks which fit your entry criteria will be ignored.

In each case, it is important to clearly define the set of rules under which a trade will be entered. There should be little-to-no room for discretion or interpretation – otherwise you don’t have a system! So, be very specific in defining exactly what needs to transpire before a trade signal is generated.

Be careful however to not make the number of criteria required to be met too onerous so that very few signals are generated, or so loose that too many signals of a lesser quality are generated.

We’ll investigate further in future MarketPulse articles.

See Carl Speak at a FREE Trading Workshop near you. Click for more.

   Written by: marketpulse   Other posts from: marketpulse