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****************************************************
The Key Elements of Successful Short-term Trading
By
Walt Downs
*****************************************************
Section1 Contraction, Expansion, and Price Movement
Market Contraction
Market contraction is considered to be in effect when either of the
following two
situations occur:
A.) . A trending indicator such as ADX displays a very low reading.
This indicates
that the current trend in the market has slowed, and that the average
daily range
has contracted as well. In essence the market is "building energy" for
a substantial
move.
B). Implied (current) volatility of the underlying market varies in a
signifigant
fashion from the historical (average) volatility for that market over a
long period
of time. For example: Let's say the Historical volatility was 13.96,
and suddenly,
the implied volatility decreased to a number less than 50% of this, say
6.0 .
Statistically, we can now expect the market to "expand" in order to
bring itself
back in line with its "natural" voloatility.
Short-term Market Contraction and Expansion, Both in Volatility, and
in Price.
Very short term market expansion and contraction is also one of the key
ingredients in
short-term trading. Trading with this "ebb and flow", is what puts the
trade in sync with
the market. It allows the trader to trade when he has a statistical and
psychological
"edge". In order to adequately identify and trade this phenomenon, we
will view the
market in terms of a "framework", under which the flow of the market can
be quantified
and analysed. Once we understand the framework, we can statistically
quantify and test
short-term price movement.
The Framework
.The Taylor Theory of 3 Day Market Rythm.
In the 1940's a grain trader named George Douglas Taylor, put forth the
theory that the
grain markets exhibited a 3 day market pattern. This consisted of a
"Buy" day, a "Sell"
day, and a third day in which the larger forces of the market
"conspired" to create a day
on which prices "faked" going in one direction, and then reversed
sharply. The methods
that he and others developed to take advantage of this phenomenon are
irrelevant. What
does matter, is that the trader be aware of this "market flow", and
attempt to be in sync
with it. This pattern can be viewed in all markets.
Price Movement Within the 3 Day Market Rythm:
Price movement within the 3 day market rythm can be defined almost to
exclusion, to the
following:
Single Bar Action
Expansion Bars -- A OHLC bar which is signifigantly larger than
previous bars.
When a bar of this type is present, and the Open and Close are at
extremes of the
bar, two statistical factors are now present:
1. There is an 85-90% chance that prices will trade higher the next
day.
2. There is a less than 50% chance that prices will close higher than
today's high. Now the trader has discovered a statistical "edge" in
which
he knows the market is likely to reverse direction the next day.
Contraction Bars-- A OHLC bar which is signifigantly smaller than
previous bars.
When a bar of this type is present, one statistical factor is now
present:
1. Brekaouts from the High or Low of this bar the next day, will tend
to
continue strongly in the direction of the breakout. Now the trader has
discovered a statistical "edge" in which he knows that the market is
likely
to continue it's direction from specific points the next day.
Multiple Bar Action
Swing Bars -- In order for a market to trend higher or lower, it is a
mathematical
fact that a higher or lower bar must be established. Therefore when a
trader sees
any two OHLC bars that exhibit the following pattern, he knows that
there is a
distinct possiblity of the market continuing in a two day set which is
statistically signifigant:
Pattern1-- Today's bar has a High rouglhy equal to the center of the
previous day's
bar, and today's bar has a low which is lower than the previous day's
Low. Now
the trader knows there is a statistical likelyhood that if the next
day's price action
penetrates the High of today's bar, then the price will continue in the
direction of
the breakout.
Pattern2 -- Today's bar has a Low rouglhy equal to the center of the
previous day's
bar, and today's bar has a High which is Higher than the previous day's
High. Now
the trader knows there is a statistical likelyhood that if the next
day's price action
penetrates the Low of today's bar, then the price will continue in the
direction of
the breakout.
Completion of the Pattern -- If Pattern1 or Pattern2 is present, and
today's Price
action does indeed breakout, then on the next day of trading, the
trader knows that
statistically there is a strong chance that the market will reverse.
Why this is so
will become apparent when reading the following section on Floor
Traders
(Enemy/Friend number one for all OTF (off the floor) traders. ).
Summary: The above information dictates 90% of all short-term market
action. By
aligning himself with these patterns, the trader gives himself the
needed statistical edge
in trading a market.
Section 1 tought us what type of "price action" to expect, but the
picture is not
complete unless the trader understands who he is primarily trading
against, how
they think, and, more importanlty, how they trade. These traders can be
our best
allies or our worst nightmares, and it behooves us to understand them
well.
Section2 Talking the Talk ain't the same as Walking the Walk
Floor Traders, How They Think, and How they Trade
Floor Traders exist for the sole purpose of adding liquidity to the
market place. Without
them, sufficient trading volume could not be found in order to enter and
exit positions
quickly. Floor traders make their money by trading to points of
short-term resistence or
support, running the stops placed here by unwitting traders, and then
reversing the
market. They would deny this if you asked them, but that is how they
make their living.
Therefore, it is important that we understand when the "Floor" is for
us, and when the
"Floor" is against us. Remember also that floor traders are human. There
are times when
they make mistakes, and times when they panic. It is our job as OTF
traders to take
advantage of them in any way possible. remember also that you are not
trading against
the best traders here. That is because extremely successful Floor
Traders usually don't
stay on the floor long! They move to upstairs offices, or begin trading
as representative
brokers for larger firms. So the floor in general CAN be handled.
How the Majority of Floor Traders Trade
Did you know that most exchanges don't allow computers in the "pit" ?
How then, does
the average Floor Trader know where the support and resistence areas
are, and how does
he trade against them or with them in general. The answer for most Floor
Traders is the
use of a somewhat mechanical framework reffered to as the "Pivot". What
follows is the
formula for calcualting the "Pivot" and it's resulting areas of support
and resistence, and
how Floor Traders use it to trade:
Formula for Pivot and Associated Sup/Res Levels
P = Pivot
NH = Next High
HH = Highest High
NL = Next Low
LL = Lowest Low
O = Open
H = High
L = Low
C = Close
P = (H + L + C) /3
NH = (2*P) - L
NL = (2*P) - H
LL = P - (NH - NL)
HH = (P - NL) + NH
Extended formula for recalculating the Pivot snd Sup/Res levels after
trading has been
going on for a few minutes:
Recalculate Pivot by using the formula: P = (H + L + C + Today's
Open)/4 Then,
recalculate the sup/res levels using the new Pivot number, and the H,L,
and C, as stated in
the above formula.
How Floor Traders Trade the Pivot in General
The Pivot is the average price that the market has traded at. IF
Market in Uptrend, and Price > Pivot THEN the Floor BUYS.
Market in Downtrend and Price < Pivot THEN the Floor SELLS
Market trading in Range THEN the Floor SELLS the NH and BUYS the LL.
Market trades above HH, THEN the Floor BUYS
Market trades below LL, THEN the Floor SELLS
In making sure that you keep the "big" (For an ST Trader ) picture in
mind, it is often a
good idea to calculate the Pivot numbers for 1 weekly OHLC bar as well.
In section 1 and section 2 we learned the basics of short-term market
rythm, short-
term price movement, and and the general who and how of our competitors.
Now we
will learn about a few applications of very simple and very powerful
indicators to
aid in our trading:
Section3 Indicators
The use of Historical vs. Implied volatility.
As stated earlier, this concept entails trading when the tmarket
exhibits a strong statistical
possibility of major movement. When the implied volatility is less than
half the historical
volatility, a major breakout may be due.
Historical Volatility almost always defined as : The Average volatiity
of a market over a
100 day period.
Implied (current) volatility most popularly defined as : 4 days, 6 days
or 10 days.
So, the calculations are usually based on the difference 100 to 4, 100
to 6, or 100 to 10.
formulas for the calculations of these ratios are readilly available
from many sources.
ADX
ADX is an indicator designed to measure average market movement. When
this indicator
declines to very low levels (Less than about say 16) then statistically,
the market is due to
break out. The most popular calculation for ADX periods is 14, but I
have used 9 days
with some success as well.
If you have a market that is displaying BOTH low ADX AND Low volatility,
it is usually
SHOWTIME. : )
Out of all the stuff I have studied and looked at over the years,
this small group, is the most consistent in producing profitable
trading results.
If you are into cycles or Gann or Fibonacci retracements, then feel free
to add them
to the above market theories as "confirming" indicators, however, if
some "guru" is
telling you that you don't need to look at this stuff for short-term
trading, and that
all you need is a "magical" date or retracement value, PLEASE, don't
change a
thing, I WANT you in the market just the way you are ; ).
Walt Downs
CIS Trading
http://www.cistrader.com
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