How to invest in commodities? How to trade forex? How to invest in stocks?
After several years of experience - of study of financial markets - whe have our answer: an efficient trading system.
Hereafter, briefly, is our trading system:
We are not infallible, but many predictions are exact. See for yourself.
- recognize the market direction: uptrend, downtrend or trading range
- draw trendline, channels, horizontal support and resistance
- analize chart patterns
- study market internals: COT, SSI and Total Option Volume
- look at the seasonality
- use the Volume Spread Analysis developed by Tom Williams
- a little bit of intuition
The sedimentation process
To trade you must have a solid system (trading system) which helps you to maximize profits and minimize losses. Easier said than done, because, apart from a few lucky guys touched by the divine grace, to develop a succesful trading system we all have to go through a long period of trial and error, tests, experiments, anguish, remorse and (sporadic) enlightment. It often takes years, but in the end, if you don’t get lost along the way, something begins to take shape and sediment.
There are dozens of trading systems and methods developed by the most ingenious minds of the planet, but after all many of these simply do not work: they work for those who created them, but more often because of their personal talent rather than for the intrinsic goodness of the methodology. Other systems, instead, work pretty well, but they don’t fit to our personality: it happens, and for example we aren’t yet sure if trading relying mainly on an ‘indicator’ such as RSI, Stochastic or the MACD isn’t good in absolute terms or simply doesn’t work for us as specific individuals. We still have no answer, but, in the end, who cares ...
Ultimately, what we need is a trading system that has a solid foundation, brilliantly passes the various tests of fire and, last but not least, is well suited to our personality and our way of life.
In fact, the 'settling' of a trading system consists of selecting the technical procedures, study them thoroughly and then test them on the field until one is able to reject them as unsuitable or welcome them in its own bag of tricks. Sometimes it even happens to run into a certain methodology, not understand and turn soon away from it, except take it back into consideration a few years later, finally grasping its profound logic and falling in love with it. Even this can happen, and indeed has happened to us just with the Volume Spread Analysis, our favorite trading system.
We cannot save you the long and arduous process of sedimentation, and yet we think we can help you to speed it up by explaining what is our method, which techniques and procedures we were able to select and organize an effective system. Hereafter, briefly, is our trading system.
1. Market direction: uptrend, downtrend or trading range?
A market can only do three things: rise, fall or move sideways. It may seem strange, but studying a chart it isn’t always easy to see in which of these three states the market actually is, also for the landscape changes dramatically depending on the timeframe considered: weekly, daily, hourly ...
In our articles and training online courses we will get into more detail, but here we want to remind you that
Charles Dow had formulated the golden rule: when we have higher highs and higher lows the trend is bullish, when we have lower lows and lower highs the trend is bearish, when highs tend to stop at a certain price level, and the lows behave the same way, we are in presence of a trading range.To recognize the state of the market is important because it defines the objective of our operativity: if the trend is bullish I want to get long, maybe after a nice pullback, if the trend is bearish I will enter short, again after a retracement, and if the market moves in a consolidation area (trading range) I want to run a fade trade (enter long on wave dips and short on wave tops). It sounds easy, but it's amazing how many trades can fail because it was not held sufficient account of the market trend.
2. Market lines of force: trendline, channels, horizontal supports and resistances
After having realized where the market is directed, it is necessary to identify the correct entry point to take advantage from the movement. To do this it is very useful to draw simple horizontal and diagonal lines, in order to identify areas of support and resistance. If I want to enter long during a bull market I will probably prefer to wait for a retracement on an horizontal support area or on the bottom edge of a channel or trendline. The beginner is surprised every time he observes the market reaching one of this lines of force and reacting one way or another as if, by magic, an invisible hand intervened to divert the price course. By the time one realizes this is due to the fact that all traders, in every corner of the world, draw these lines in much the same way, and behave accordingly. It is as if the markets were driven by a single collective trader, who plays the graphs according to the most solid technical knowledge developed by the investors’ community.We also publicly declare (!) that, in addition to horizontal supports and resistances, trendlines and channels, we like very much and frequently utilise the so-called ‘pitchforks’ (Andrews pitchforks), that rely on the statistical concept of ‘median’
3. Market geometry: patterns
What is true for the lines of support and resistance is also true for the well known 'patterns' as triangles, flags, pennants, normal or inverse head and shoulders, double or triple tops and bottoms. Over time investors have found that when certain geometric figures appear on the charts is very likely that the dynamics of the price evolve in a certain way. Again, since all traders tend to recognize more or less the same geometric patterns, the premises are self-confirming and prices end up behaving as expected. Patterns are many and sometimes also complex, but here literature comes to the rescue. The community of traders has in fact a real 'bible' which authority is out of question: this is the encyclopedic book Edwards & Magee, Technical Analysis of Stock Trends, over eight hundred pages of very detailed always strictly 'evidence based 'discussions of all possible chart patterns under the sun.
4. Market internals: COT, SSI and Total Option Volume
Some markets provide useful info on the bullish or bearish positions taken by the major categories of investors. You have to study a little to learn how to correctly interpret these data, but when you get some experience the competitive advantage that it yields is remarkable.For future markets we’got the well known Commitment of Traders (COT), which every Tuesday photographs the market positions of Commercials (companies that produce or purchase certain assets - such as the future of wheat or beef - in order to protect themselves against price fluctuations), the Funds (investment funds that follow trends in order to obtain reasonable speculative profits) and the mistreated Small Speculators, the so-called 'weak hands', which usually end up to find themselves on the wrong side of the market.For the Forex currency market there is the Speculative Sentiment Index (SSI), published daily by the broker FXCM, which reveals the positions taken by their retail customers against each currency pair (euro/dollar, dollar/yen, australian dollar/US dollar, etc.). Usually it is a contrarian indicator: if the majority of retail traders is bullish, most likely the couple in question will lose value, and vice versa. For stocks are available many internals indicators, but our favorite is the Total Volume of Option traded (Total Volume Option), which is the most difficoult but also the most fascinating of these tools.
5. Market Cycles: Seasonality
It is known that financial markets move in repetitive cycles, some of which occur over many years or even decades (the so-called Kondratieff’s Wave lasts between 50 and 70 years), others in the course of a single year; in the latter case we speak of 'seasonal cycles'.All markets follow their own specific seasonal cycle, calculated on the basis of the last five, ten, fifteen or forty years, that many investors use to 'synchronize' their entrances and their exits from the market. A paradigmatic case is that of Larry Williams, who pushes the statistical calculations up to determine the bullish or bearish trend of every single day of the month (Williams’ Trading Days of the Month).Of course, the seasonal cycle may be more important in the case of grain futures (think of the renowned 'february break') and less important in the case of an under-capitalized stock belonging to a secondary index, but it is always present and a good trader shoul take it into account. We, needless to say, keep it in high regard.
6. Market undeclared secret: Volume Spread Analysis
It takes a little to fully realize it, but when you finally do your trading radically improves. Realizing what? Simply, that market are constantly manipulated or, if you prefer, run, managed, by the so-called ‘market makers’, institutional traders that on the one hand ensure the necessary liquidity to markets, and on the other hand exploit their particular role to secure huge profits at the expense less informed investors. They have access to information that we do not have; they see the market from within and know at what price levels are the majority of buy or sell orders; in the end they are the ones who determine the sudden price movements that many times take us off guard. The maket’s law is not the same for everyone: some (market makers) have undeniable benefits and use them to ensure a strong competitive advantage over all others (crowd).This is bad news, but there is also a good one: the market makers’ operativity leaves traces, it is detectable and intelligible as long as you know how to correctly read the data relating to the volume of transactions, or even better the ratio between volumes and the spread of the price bars, according to the technique developed by Tom Williams and called Volume Spread Analysis. Revealing market makers’ moves, VSA allows us to align ourselves with them and to position on the right side of the market.
7. Market’s Synchronicity
As we gain experience with the markets we realize that, under equal correctness of rational assessments, the difference between a successful and a failed trade often lies in the ability to internally synchronize with the markets. We commonly call it ‘intuition’ or ‘insight’. It is said that the famous trader Ed Seykota used to bring his students in front of the sea and asked them to move their hands back and forth in time with the sea waves. Whimsical? Might be, but those who trade agricultural futures or currency pairs every day know that Seykota’s exercise is anything but foolish.
Only a check-list
Here are the seven cornerstones of our trading system. Basically it's just a check list: if we can flag all these points or most of them, then we execute the trade, otherwise we do not. The game is to put as many odds on our side, and act accordingly. Two or three elements, by themselves, are not sufficient; but if we can line up five, six out of seven or even seven out of seven (Bingo!) then we can set fire to the powder.