Trading System Thoughts: Context and Using Cumulative Tick on ES/NQ

My time is being stretched in many directions–custom projects, donor requests, beginning iPhone app development, and working on my own trading skills. This post is one focused on my recent trading thoughts.

First, an unsolicited testimonial. I’ve been part of Richard Todd’s Move the Markets Team for a while now. I find it to be incredibly valuable. If you are looking for a community of experienced traders that are serious about improvement, both of themselves and of newer members, look no further. I recommend it highly. There are a lot of free areas to start with, and if you want to go deeper, he charges a modest monthly fee for full access.

As part of a conversation I had recently with Richard, I was once again reminded about the importance of market context. As I talked about in my WWJT posts, in a trending market, almost ANY trend-following setup will work. In a choppy environment, almost ANY trend-following setup will die horribly. The specific setup DOES NOT MATTER. There is no “best” set of parameters to filter out the losers on a setup basis. The problem is not with the setup, it’s with the market context. A raincoat is not the best clothing to wear on all days, just on rainy ones. Flip flops are ideal footwear on the beach, but not for climbing Mt. Everest. You pick your clothes based on the weather context you expect to encounter. Don’t agonize over whether a blue raincoat or a yellow raincoat works best, and don’t look for the magic set of sandals that keep you warm even on a snowy day. Metaphor overload, core dump…

The most important thing is to identify when the markets are likely to trend, and then to apply a trend-following setup (buy a pullback in a trend, buy a breakout, etc.) or sit out. Conversely, identify when the markets are choppy and listless, and apply a range-bound setup or sit out. I have demolished myself in the past two Augusts by playing dummy trades (trend continuation) in a seasonally flat and choppy market. I get stuck in the trap of obsessing over the entry, target and stop parameters, so I needed this reminder to get back on track.

I believe your time is best spent practicing contextual skills rather than mining for the Holy Grail setup or magic parameters. Try these steps:

1. Become proficient in identifying chop and trends after the fact. This one should be relatively self evident. Look at the day’s chart after the close, and annotate where the trends were, and where the chop was. Continue to do this on intraday charts until you can do it instantly and effortlessly.

2. Go to live data and practice identifying whether the market is in a trend or in chop RIGHT NOW. Don’t worry about if the market is going to keep trending or keep chopping. Just correctly identify what it is currently doing. Continue until you can do it instantly and effortlessly.

3. The last step is to start to try to predict what is likely to happen next during the day. Will the trend be likely to continue? Will the range probably be broken? Many things can give clues to this including volume, time of day, support/resistance levels, tape speed, pending news announcements, and so forth. Along the way you should also gain the skill of predicting whether a trading day may be trending or choppy before the day begins, and also knowing what events and price levels would imply a change to that prediction. This one can take years of screen time to become proficient. Patience and work are needed! I have started to notice myself having the beginnings of this skill. I can only chalk it up to screen time. Watching what has worked, what has failed and what has generally happened in the past. Feeding years of price data into the most complicated neural network there is: the human brain.

Note that in all of these things, I have mentioned words such as “likely to continue” and “probably”. None of this is an exact, deterministic science! You also have to be able to think, make decisions and accept outcomes probabilistically. That means that the specific outcome of any one event does not determine whether a probabilistic decision was the right one or not! In a deterministic situation, the outcome judges the decision. Gravity always pulls you down to the earth, 100% of the time. Jumping off a cliff is always a bad idea, because you will always plunge to the bottom. In a probabilistic situation, it’s the odds up front and the information you had at decision time that say whether a decision was the right call or not. The odds will play out to a degree of “rightness” in the long run, even though you may be taking a beating in the short run. This way of thinking is very difficult for many to attain, including myself. My Outcome Simulator is one tool that can help. The excellent book Trading in the Zone: Master the Market with Confidence, Discipline and a Winning Attitude by Mark Douglas is another good resource. But unless you are hard-wired this way, and most of us aren’t I would imagine, this takes PRACTICE.

Now, I’ve been watching the cumulative tick on ES 5 minute charts. I’ve noticed a couple of things. Assuming that the context is a trending market, the cumulative tick does well at picking the trend direction and also giving an entry spot. If the cumulative tick changes from bearish to bullish, then buying the first DOWNWARD tick spike across the average of the tick lows gives a great entry point. You are basically buying the first pullback in what you hope turns out to be a new uptrend, but are using the tick to tell you when the pullback is in play instead of choosing it based on price alone. If you continue to get downward tick pressure on the next bars, that clues you in that the uptrend may be failing. Otherwise, buying should pick back up and you have a winner in very short order. This strategy would work great with a partial exit, taking some off after some number of points and trailing the rest. Here’s an example paper-trade I took in the NASDAQ-100 e-minis (NQ) today:

I bought the gap fill on a tick downspike (gray oval). The tick downspike is the entry signal, but the reason for the trade is the context: I didn’t buy the first downspike because we were still in space over the gap. The second tick downspike was the first retrace to yesterday’s high. Also, a strong opening gap = bullish tones for the morning, so that said to fade the downspike, not go short. I expected a bounce, and we got it, all the way to new highs, even! Opening gaps that clear the prior day’s highs and lows are typically strong. Gaps inside the prior day’s range are less so.

Back to the trade: Ended up “buying” 1 tick above the day’s low so far (!) I traded 2 contracts, both with a 2 point initial stop. One I “sold” after a 3 point target (first green oval) and the other I put on a 3 point trailing stop and “sold” much higher (second green oval). Net +12.5 “points”.

I’ll be posting more charts and a modified cumulative tick indicator sometime over the next week. I’ll also be working on my market context skills, because that is the only effective way to minimize your losing trades, and is the foundation to using a setup in the right way. My ultimate goal is to choose a trending setup and a chop fade setup, know when to use them, and then consistently apply them, accepting the outcomes as they happen. That should be my last hurdle to arrive at net profitability. It’s been a long, hard journey, but I think I can see the oasis from here!

Weird Cumulative Tick Plot: Distribution or Math Artifact?

Okay, this is making me scratch my head a bit. Here’s a plot of the ES with my “Messing around with Cumulative Tick” indicator on it, showing 1 hour bars since March 1:

There are two sub-panel indicators. The upper is showing a histogram of the high and low values of the NYSE Tick. There are also two lines. The green line is an EMA(20) of the high values of the Tick. The red line is an EMA(20) of the low values of the Tick. If the Tick high was above the high EMA, the Tick bar is green, else it’s gray. If the Tick low was below the low EMA, the Tick bar is red, else it’s gray. The third dashed white line is the mean of the high EMA and the low EMA.

This is graphically showing what is going on under the hood in the lower indicator, which is my cumulative tick indicator. If a Tick high is above the high EMA (showing as green), then the difference between the high and the EMA is summed. Opposite for the Tick lows. So basically the more extreme a spike in the Tick compared to the corresponding EMA, the more it will move the cumulative tick.

You can see that we’ve been in a consistent downward trend in the cumulative tick. The Tick spikes on the downside have far outweighed the spikes on the upside. Normally I would chalk that up to underlying weakness in the market, and stock distribution in the face of rising prices. But it has been persistent in the face of a strong uptrend. I noticed two things:

1. The high EMA is further from the zero axis, so the strong high Tick readings aren’t getting as much credit. The low EMA is closer to the zero axis, so the strong down Tick readings are getting maybe too much influence.

2. The mean of the high and low EMA’s is almost always above zero. The broad buying strength is showing up here, but not making its way into the cumulative tick calculation.

Back when I came up with this idea, I was assuming that the zero line would be the natural balance point for Tick readings. And in a sideways market, that’s probably true. In this bull phase, it seems to be based around +200. If the broad undercurrent is important, then I need to add it. If only the extremes are important (the rest being noise) then we could be seeing huge weakness under the market’s hood. I tend to think it’s the first, and that I need to add a trend component into the calculation.

What do you think? Is this highlighting a divergence in the markets, hidden stock distribution, or is it an artifact of the numerics of my calculation?

UPDATE: I added the value of the mean of the EMA’s into the calculation. At every bar, the upspike-downspike+mean is calculated. So a -300 net downspike will be tempered by a +200 upward mean value. Then the chart looks like this, and all is right with the world:

I updated the code in “Work in Progress” with the code I’m using for this. It’s the same indicator for both sub-plots. I just hid different plots for each one manually in the chart studies window.

One Trade Today in ES: Sometimes You Are Just Wrong

I took a trade in ES this morning based on what I thought was an imminent breakdown of a channel boundary. I stayed out until after 10:00 ET for the new home sales to come out. I was watching a 1600 tick chart and a real-time plot of the Advance-Decline of the S&P from my CAT tool. We touched the lower channel boundary and stalled. The A-D chart was pressing towards a new low, so I went short, expecting a quick move out of the channel towards the daily pivot. Here’s the charts:

Price:

A-D Zoom showing time of Trade:

And overall A-D plot:

Bada bing, bada boom. Quick 2 point loss. On this one I was just wrong. This highlights the fact that you can’t know for sure what will happen in advance. You always take a risk when you put on a trade. If I would have gone long instead of short, I would have won. And then about 10 minutes later, a channel breakout was the right trade.

I still struggle at my entries. I have discipline to stop trading, ability to accept a loss and be wrong, and discipline to stick to the pre-trade plan. My entry timing is just plain wrong. That adds up to net losses.

One Trade Today: S&P 500 e-mini (ES)

I took one quick trade just after the open today for +2.5 points. I annotated a chart with some of my thoughts during the trade:

I mentioned on twitter that when we open at or above R1 (or at or below S1) we tend to have a trend day more often than not. I’ll have to test that out and get the stats on it. But that along with the break above the first opening swing told me to go long. On the retrace, I stayed, and it paid. And of course, I got lucky too. But half of luck is preparation and having a plan, right?

Adaptive OR Trade Plan, and Today’s Trades

I went back over the last 5 days of Adaptive OR trades, and did a lot of research. I looked at parameters like profit at first favorable swing point (first peak), first pullback swing point after the first peak, max profit without reversing back across the opposite side of the OR, and so forth. I looked at all trades all day, and I counted 34 over the 5 day period so far. I will keep adding to my database as time progresses.

Using a target of 1 or 2 points increases the win rate to near 70%, but kills you because your losers are bigger than your winners. Targets of 3-5 points were best for maximizing profit. Taking trades after the first two per day decreased profits significantly (choppy day if levels are revisited over and over). I assumed that if the first pullback went back across the opposite OR, it was a full stop loss, and if we never hit the target (an input) that you would eventually be stopped out at the first pullback level + 1 tick slippage.

After this analysis on all of the Adaptive OR setups over the last 5 days, I came up with this trading plan:

Use AdaptiveOR_Pro(0930,5,3) on a 133 tick chart.

Take (up to) first two OR breakouts of the day.

Entry is 1 tick outside OR levels.

Target is 4 points (limit order).

Initial stop is 1 tick outside opposite OR level.

After first pullback swing point prints, raise stop to 1 tick behind that level.

Sit on hands.

Trading this plan over the last 5 days would have made +20 ES points on about 7 trades. So today I traded this plan exactly. Here’s the results:

The first trade short entry (yellow line) got slipped a tick against me because my stop entry order waited until price crossed it rather than touched it (??). Then we had the pullback, so I lowered the stop and got out for -0.5 points. No biggie. Then I took the opposite long entry right after (other yellow line), and it immediately ran back to my stop for a full -2.5 point loss, total -3 points. So I stopped trading, because my research said that a choppy day was ahead. Perfectly executed plan, apart from the first entry weirdness (I used a market order for the second entry).

And guess what? If I took the third trade, I would have made my +4 points if I got a good fill on my target limit (green line), or +1 point worst case if my first pullback stop was hit (red line), or the full 4 points if neither got filled, because it eventually went through my limit target (I’m still not sure how the Think or Swim stops fire. It seems that it doesn’t work on price quotes, only on the bid or ask crossing your stop level?)

The lessons: Even if you do everything “right”, sometimes you still lose. And sometimes doing the “right” thing makes you miss out on a win. And I have an incredible timing ability, apparently. The days I traded this week were chop days, until I stopped trading and then boom went the dynamite. What can you do?

Apart from continuing to gather the data on the setup, I’m going to see if I can come up with some kind of follow-through filter that will help me bail early to minimize losses on the immediate losers (like the second trade this morning), but sit tight for the 3-5 point profit on the others.