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.

S&P E-mini Futures (ES) Trades: 7-28-09

I took two trades today off the open in ES. Here’s the chart:

I used a 133 tick chart of ES. You can see my Shaded Opening Range Indicator on there (set from 0930 to 0931), as well as my Volatility-Based Trailing Stop. I’ve also got two exponential moving averages: one is a 5 period and the other a 20 period. But instead of using the close in the EMA calculations, I’m using the pivot point of each bar, or (H + L + C) / 3. I got the idea from John Person’s book, Candlestick and Pivot Point Trading Triggers + CD-ROM: Setups for Stock, Forex, and Futures Markets. Finally, you see a study I called PACD (Pivot-based Average Convergence Divergence). Nothing too exciting–just the MACD using hlc3 to compute the EMA’s instead of close, but I changed the inputs to match the EMA’s (5, 20, and an arbitrarily chosen 5 signal line). This is showing if the 5 EMA is above the 20 EMA or vice versa, and could be used in place of the EMA’s eventually. None of this is set in stone, and it is a bit discretionary, but it’s working for me.

The first trade was a short on a pullback inside the 1min OR. The Volatility Stop was pointing short, and the NYSE A-D ratio and Tick were down and going lower. The market was fading the A-D line, but I expected the futures to fall, and 969 was the overnight low, 2 points below my target. Soon after entry, everything switched directions, but I still waited to see if it would go my way. I was within one tick of being stopped out for a bit, and then got a push back lower. I stayed with it, but in hindsight, the Volatility Stop switched directions and the 5/20 hlc3 EMA’s had crossed over (or equivalently, the PACD went above zero). I should have bailed out there for a smaller 1 or 2 tick loss, but I stayed with the original stop and it was hit, -5 ticks. Then I went long on a bounce off the OR high, stop under the OR low. This time the internals were with me, and the PACD and Volatility Stop were as well. I set a profit target for 8 ticks, and was filled. If I had margin for multiple contracts, I could have traded two, sold one at this first target and let the other go with a trailing stop, and I could have had a point or two more, but I’m happy to stop with a net positive day at +3 ticks or 0.75 points. For my personality and where I’m at as a trader, I’d rather be net positive by a fraction every day than be up big some days and down big some others. That will change down the road as I pursue net profit over time as the primary goal, but consistency and confidence is what I want to gain right now, not bags of money. Consistency first, moneybags afterwards.

My strategy lately has been to play for smaller profits, and keep wider stop losses–the exact opposite of the 1:5 Risk:Reward home run trades I have historically tried. I never would hit my targets, and I often got stopped out. So I’m bringing the two closer together, and it’s working. I intend on watching the tape and getting out in a controlled manner (like I should have on the first trade) if things aren’t shaping up as planned. The stop loss is just in case of disaster. I also don’t get greedy and take the money when it’s there at a closer target, which is different than in my past. So far so good!

A Monumental Day: The Eagle and the ES

Today was the 40th anniversary of the Apollo 11 landing. What an incredible feat of engineering, daring and national will! Lots of great coverage out there on the web if you are interested. The Eagle has landed! Here’s Neil at Tranquility Base from a camera on the top of the LM:

It was also a monumental day because I took my first trade since January. I played the open on the ES futures. I was watching a 133 tick chart on Think or Swim. My plan was to play a quick 2 point move off the earliest opening range balance, whether long or short. I also wanted to follow the direction of the internals. I wanted to be exposed to the market for as short a time as possible, so I would either have immediate follow-through (within a minute or two) or I would get out.

Here’s what my chart looked like when I made my move:

I saw that we were pausing near the upper end of the initial range (grey lines) and that there was about 2 points to run from there to the 944.75 pre-market highs. I was also watching these charts of the $TICK and the $ADVN-$DECN for confirmation:

You can see that as of 8:32 CT (9:32 ET) we were in the green on both internals and rising. I got long at 942.50, target 944.50, initial stop 941, just under R1 (red line w/dots). Here’s how the trade played out:

Just a quick hesitation and then off we went. As we thrashed near 942.50 for the first bar or three, I was sorely tempted to just bail out to lock in a tick of profit for my first trade back in the markets, for psychological reasons. I sat on my hands and made myself just watch–stick with the plan; I got my immediate follow through, and I was in the green. When we hit 943.75, I thought we would make it to my target, and as I went to move my stop up to breakeven, I was filled for +2 points. Mission accomplished in around two minutes.

I’m a better trader than I give myself credit for, and my years of watching the markets are starting to give me some “tape sense”. While I’m happy for a win (of course), I’m happier that I made myself follow the plan and stick with it, and that I got my feet back in the water at all. I’ve been avoiding it for far too long.

So break out a beverage today in celebration of Neil Armstrong, Buzz Aldrin, Mike Collins, and me. 🙂

Tick Fade Indicator for Think or Swim

Here is a Thinkscript indicator that plots a dot if the NYSE TICK for the current chart timeframe breaches a threshold value. Compare the chart below to see what I mean:

I plotted the Tick Fade indicator on both charts, so the bottom chart is comparing the TICK to itself. With this indicator, if you set up a chart for 5 minutes, then you will get a paintbar if the high NYSE tick on a 5 min bar is over the threshold value (default 1000). Similar for a low tick. The timeframes are linked in this study, so the primary timeframe for the chart will dictate the corresponding timeframe for “high”, “low” etc. for the TICK reference.

I call this the Tick Fade indicator because I want to fade an extreme move in the TICK, as an indication that too many stocks are all moving in the same direction. If I’m in a trade, and I get a high TICK reading in my direction, I want to take some profit, as this is likely to be close to the final extreme of the move. In Mastering the Trade, John Carter uses extreme TICK readings that are adverse to his position as a signal to get out, which is not a fade, but an anticipation of more strength to come. Richard at Move the Markets has a lot of good articles about the TICK and its use. Many different strategies, but now you know how to use the TICK info without having to keep a separate chart of the TICK open on your layout.

You can download the Tick Fade indicator at my Google site under “Released Thinkscript Studies“.