One trader`s toolbox

When I put on my first trade ever, the worst possible thing happened. I made money. That lucky break created the delusion that trading was easy. I began jumping into other trades—with a predictable outcome.

As I recovered and rebuilt my devastated account I knew I had to educate myself. I began to read voraciously about the markets. I looked up sources and references in every book I read, and then read those books as well. In those faraway, pre-Internet days I was fortunate to find a gentleman in Los Angeles by the name of Donald Mack who ran a business called The Investment Centre Bookstore. I must have become his biggest customer. My fantasy was that if I read everything there was to read and learn about every method, I’d surely find a good money-maker.

Once again, the outcome was predictable, and it was back to my day job, working and saving to rebuild my tiny account. Even though I lost money, all that reading left me with something positive—a good overview of the field.

Over the years, as I continued to trade and study the markets, it became increasingly clear to me that in this field “less is more.”

Whenever we look at a chart, we deal with only five pieces of data— each bar has an open, high, low, and closing prices, plus volume. If you trade futures, add open interest. It makes no sense to use a long list of tools and indicators to analyze these five numbers. An abundance of tools only increases the level of noise and adds to the confusion. I established a rule of “five bullets to a clip”—allowing me to use no more than five indicators on any given chart. You may use six if you desperately need an extra one, but never more than that. For myself, I do well with four: moving averages, envelopes, MACD, and Force Index.

This does not mean that you should use the same indicators. You should feel perfectly comfortable using others—just be sure to understand how your indicators are constructed, what they measure, and what signals they give. No one can master everything in the markets, just as no physician can master all of medicine. You need to choose a small handful of tools that feel comfortable to you.

Market newcomers often become fascinated by technical trading tools. They imagine that if they get the “right” software, the “right” indicators, and the “right” settings the profits will just roll in. Nothing could be further from the truth! While technical tools are important, they are responsible for only a small share of any trader’s success. You also need to focus on trading psychology, money management, and record-keeping. Each of those factors is like a leg of a chair, and technical analysis is just one of them. A chair that has only one leg is useful only for firewood.

Beginners’ childish faith in the power of technical analysis is often coupled with a great deal of laziness. Each week I receive e-mails from people who ask for “the exact settings” of moving averages, MACD, and other indicators. Some say that they want to save time by taking my numbers and skipping on research so that they could get right on to trading. Save the time on research, my elbow! If you do not do your own research, you will not have the necessary confidence during the inevitable drawdown periods.

My Toolbox

My approach is based on the Triple Screen trading system which I developed in the 1980s and continue to improve to this day. Since every market can be analyzed in several timeframes, Triple Screen insists that you begin by defining your favorite timeframe in which you like to work, such as daily, hourly, or weekly chart. Once you know what your favorite is, do not look at it! You must first go to the timeframe one order of magnitude higher, make your strategic decision there, and return to your favorite timeframe only to make a tactical decision—where to buy or sell—and then trade only in the direction of the longer timeframe.

Since my favorite timeframe tends to be the daily, I use weekly charts
to make my strategic decisions, and return to dailies to implement them. The weekly and daily charts are my first two screens. The third screen is the entry method, for which you can either use an intraday chart or simply place an order using a daily chart.

MOVING AVERAGES

Price is a consensus of value at the moment of a trade. A moving average (MA) reflects an average consensus of value in its time window. If price is a snapshot, a moving average is a composite photograph. It provides two important messages to traders. First, its slope identifies the direction of change in the public’s mood. A rising moving average reflects growing optimism (bullish), while a falling MA reflects growing pessimism (bearish).

Another important role of the MA is differentiating between what I call “value trades” and “greater fool theory” trades. If you buy near the moving average, you’re buying value. A person who buys well above the moving average is in effect saying—”I’m a fool, I’m overpaying, but I hope to meet a greater fool down the road.” There are very few fools in thefinancial markets, and a person who keeps buying above value is not likely to win in the long run. He may get lucky once in a while, but buying near value is a much more sensible strategy. I like using two EMAs on my charts, one showing a longer-term, and another a shorter-term, consensus of value. I call the area between them “the value zone.” There are several types of moving averages, but I always use exponential ones. EMAs are more sensitive to incoming prices and less sensitive to old prices.

ENVELOPES OR CHANNELS

One of the very few scientifically proven facts about the markets is that prices oscillate above and below value. You could say that markets are manic-depressive—rising too high and falling too low, only to swing back to the normalcy of the value zone.

There are several types of channels, and my favorite is a straight envelope—the lines above and below the EMA, both parallel to it. A well-drawn channel fits like a good shirt, covering the body of prices, with only the most extreme prices—the neck and the wrists—sticking out. Amateurs love to buy breakouts, but professionals tend to look for buying opportunities near the lower channel line and shorting opportunities
near the upper channel line.

Some traders like to use standard deviation channels, often called Bollinger Bands, which expand and contract in response to market volatility. They are only useful for options traders because volatility is a key factor in option pricing. If you trade stocks, futures, or forex, you are better off with straight envelopes.

MACD LINES AND MACD-HISTOGRAM

Moving Average Convergence-Divergence (MACD) is an indicator whose fast line represents the short-term consensus of value, and the slow line the long-term consensus. When the fast line rises above the slow line, it shows that bulls are dominant, and when the fast line is below the slow
line, the bears are in charge.

MACD-Histogram measures the power of bulls and bears by tracking the difference between the two MACD lines. When their spread increases, it shows that the dominant market group is becoming stronger—it is a good time to trade in that direction. Divergences between peaks and bottoms of MACD-Histogram and price are among the strongest signals in
technical analysis.

MACD-Lines and MACD-Histogram are derived from three exponential moving averages of closing prices. Their settings—12, 26, and 9—have migrated into trading software and become default settings in many packages. In writing my books, I used those settings to illustrate this indicator.

What settings should you use? If you want to use the same ones as everyone else, use 12, 26, and 9 because the crowd is basically lazy and uses the default values. You can also choose settings that are a little faster or a little slower. Think about it and experiment with the values, or use the defaults.

FORCE INDEX

Everybody watches prices, but it is volume that moves them. Volume reflects the intensity of traders’ commitment, the heat of their exuberance, the depth of their fear. Instead of looking at a plain plot of volume, I use Force Index, which links volume with price changes. Divergences between Force Index and prices tell me when a trend is becoming weak and ready to reverse. By contrast, new highs of Force Index tell me that
the trend is strong and likely to continue.

THE IMPULSE SYSTEM

This system identifies bullish and bearish phases in any market or timeframe by combining two indicators. The slope of the fast moving average identifies the inertia of the market, while the slope of MACD-Histogram identifies the push of the bulls or bears. The Impulse system gives a buy signal when both the EMA and MACD-Histogram rise, and a sell signal when both decline. When the two indicators get in gear, they mark especially bullish or bearish periods. Just as importantly, the Impulse shows when bulls or bears start slipping, and a trend starts growing weaker.

One of my Traders’ Camps graduates, a brilliant programmer named John Bruns, programmed the Impulse system for several popular software packages, coloring each bar in accordance with the Impulse system. When the EMA and MACD-Histogram rise at the same time, the market is in gear to the upside and the bar turns green. When both fall, bears are in control and the bar is red. When the two indicators point in opposite
directions the bar is blue.



The Impulse system works best as a censorship method. When the Impulse is green, you may buy or stand aside but absolutely no shorting is permitted. When the Impulse is red, you may go short or stand aside but buying is prohibited. I wait for the Impulse system to go “off green” before shorting and “off red” before buying.

Some programs do not allow users to change the color of their bars on the basis of conditional formatting, but you can still identify green or red Impulse by noticing the slope of the EMA and MACD-Histogram.

Adapted from Entries & Exits by Dr. Alexander Elder,
John Wiley & Sons, Inc., 2006


I believe that successful trading is based on three M’s—Mind, Method, and Money. Your Method—the indicators and tools—is just one component of this equation. Equally important is the Mind—your trading psychology—and the Money, or risk control. Record-keeping ties all of these three M’s together into a firm, working structure.

In a moment we will talk about the Mind, the Money, and the Record-Keeping. But before we move on, let us stay a little longer with the trading tools and review what I think is the best leading indicator of the stock market—the New High–New Low Index.