Stock Trading Systems

I was rummaging around my trading library the other day.  It’s full of books written by famous traders like Martin Pring, Joe DiNapoli, Larry Connors, and even J. Welles Wilder  I will often pick up some of these volumes and thumb through them looking for a little gem that I may have missed or not understood on my first or second reading.

There are some books that are always at my fingertips.  Usually because I’m looking for a reference or validation of some trading idea.  One of those books was written by Steven Achelis.

Does the name Steven Achelis ring a bell?  He was one of the founders of Equis International, makers of the charting program, MetaStock.  Once in a great while Mr Achelis used to do an interview on CNBC.  Haven’t seen him in years.  Nonetheless, he is a very gifted trader and analyst.  And a few years ago he wrote a book called, Technical Analysis From A To Z.

Now this book isn’t for everyone.  In fact, if you’re the least bit interested try and get a copy and thumb through it.

The author uses the same format for each indicator he describes.  First he gives an overview.   The next brief section is how to interpret the indicator and then an example of the indicator plotted on a chart.  The section ends with a discussion of the math.

This book really helped me understand technical analysis indicators.  It’s very clear and straightforward.    But it can be quite complex, especially in the math section.

The greatest benefit from this book was its ability to spark my interest in creating my own measurements and indicators.

My trading doesn’t involve the use of many technical analysis indicators.  But it can be useful to plot and view what price is saying.  It’s also helpful to measure today’s price behavior against earlier price action.

When I get stuck for a solution or need a bit of clarification, Steven Aechlis’ book is the first one I grab.

There are few one bar price patterns that bear watching or should be included in a trading system.  The exception are the key reversal bars.  They don’t happen too often, but can be reliable clues to a trend change.

Lets first look at a key reversal bar up.  This is going to be a little counter intuitive, so bear with me.

A key reversal bar up occurs during a down trend. You can identify it by looking for these three conditions:

• The open is less than the last close.
• The low is less than the last low.
• the close is greater than the last high.

This is a key reversal bar on a daily chart of the S&P 500 in late July of this year.  Notice it has all three points from above.

A key reversal bar down appears after an uptrend.

• The open is above yesterday’s close.
• Price makes a new high.
• The close is below yesterday’s low.

Here’s the same chart with two key reversal bars down:

It’s best not to trade on one indication by itself.  Try pairing it with another condition and see if the two agree.

Using key reversal bars with channels, stochastics, or the relative strength index will improve the odds of success.

Key reversal bars are also useful to re-enter or add to a position.

I’ve rarely seen the opportunity to add to a short position on a reversal bar.  But they will occur during an uptrend –my method is to add above the high of the reversal bar, like this –

And one final point, the most reliable key reversal signals usually appear during or after a strong trend.

The best possible entry will not make money.  It’s the exit that puts cash in the bank.

Think of your trading system as a cooking project.  The goal is to prepare something tasty, i.e. profits.

It wouldn’t be wise to put a pan on the stove and let it go unattended while the flame  provides constant heat.  Yet that is what often happens.  Portfolios are built with thought and care and then the cook walks out of the room.

Back in the day, when the market was not so volatile, most people were encouraged to “buy and hold.”  They were told, that over the long run, ” the market will take care of you,” or “the market will come back.”

Yet there were probably many investors or traders that wished they had been more proactive.

How many times have you looked at a chart of a stock in your portfolio and said, “I wish I would have sold it up there, instead of down here!”

Record volatility levels have shown the fatal flaw of buying and holding.

Here are a few suggestions to avoid the misfortune of buy and hold.

No matter what you trade — a volatile group of stocks, or sector ETFs  — know your exit point.

As you plan to purchase, plan to sell.  Know where the exit is before the equity ever starts to decline.  This makes executing the exit easier and removes the emotion and second-guessing.

It will help quantify the risk, too.

My experience shows the best method is to give the initial exit plenty of room to move.  The wider initial exit will likely improve the number of winning trades.  But this means more risk.

Reduce the risk with fewer shares.

A tight initial stop may hurt overall performance and increase trading costs (commissions).  It’s frustrating to have a tight stop hit, only to see the stock go on and make good gains.  Whipsaws are a hallmark of stops that are too tight.

Average true range is a volatility measurement and a useful instrument to gauge stop levels ( visit stockcharts.com for a very complete discussion of ATR).

ATR tends to filter out the “noise” or randomness of price movement.  It also can help avoid multiple whipsaws as it adapts to volatility swings.

In the next post, I’ll suggest a simple trailing stop strategy that uses the  ATR.