Thursday, October 9, 2008

Elder Stops

Your money management stops belong in the forexmarket. They represent your maximum allowable risk level, which you may not violate under any circumstances. If your technical analysis stops are closer to the forex market, you may hold them in your mind as you monitor prices and are prepared to exit if those levels gets hit.
Here, I want to share with you two advanced forex methods for placing stops. Try to program them into your forex software and test them on your forex market data. Until now, I have never disclosed SafeZone to traders, except to small groups in Trader’s Camps, where I like to share my latest research. It is my principle not to withhold information from my books. I write as I trade and maintain my edge not by secrecy but by developing new forex methods.

The SafeZone Stop

Once in a trade, where should you put your stop? This is one of the hardest questions in technical analysis. After answering it, you’ll face an even harder one—when and where to move that stop with the passage of time. Put a stop too close and it’ll get whacked by some meaningless intraday swing. Put it too far, and you’ll have very skimpy protection.
The Parabolic forex System, described in “Trading for a Living”, tried to tackle this problem by moving stops closer to the market each day, accelerating whenever a stock or a commodity reached a new extreme. The trouble with Parabolic was that it kept moving even if the market stayed flat and often got hit by meaningless noise.
The concept of signal and noise states that the trend is the signal and the nontrending motion is the noise. A stock or a future may be in an uptrend or a downtrend, but the noise of its random chop can obscure its signal. Trading at the right edge is hard because the noise level is high. I developed SafeZone to trail prices with stops tight enough to protect capital but remote enough to keep clear of most random fluctuations.
Engineers design filters to suppress noise and allow the signal to come through. If the trend is the signal, then the countertrend motion is the noise. When the trend is up, we can define noise as that part of each day’s range that protrudes below the previous day’s low. When the trend is down, we can define noise as that part of each day’s range that protrudes above the previous day’s high. SafeZone measures market noise and places stops at a multiple of noise level away from the market.
We may use the slope of a 22-day EMA to define trend. You need to choose the length of the lookback period for measuring noise level. It has to be long enough to track recent behavior but short enough to be relevant for current trading. A period of 10 to 20 days works well, or we can make our lookback period 100 days or so if we want to average long-term market behavior.
If the trend is up, mark all downside penetrations during the lookback period, add their depths, and divide the sum by the number of penetrations. This gives you the Average Downside Penetration for the selected lookback period. It reflects the average level of noise in the current uptrend. Placing your stop any closer would be self-defeation. E want to place our stops farther away from the market than the average level of noise. Multiply the Average Downside Penetration by coefficient, starting with two, but experiment with higher numbers. Subtract the result from yesterday’s low, and place your stop there. If today’s low is lower than yesterday’s, do not move your stop lower since we are only allowed to raise stops on long positions, not lower them.
Reverse these rules in downtrends. When a 22-day EMA identifies a downtrend, count all the upside penetrations during the lookback period and find the Average Upside Penetration. Multiply it by a coefficient, starting with two. When you go short, place a stop twice the Average Upside Penetration above the previous day’s high. Lower your stop whenever the market makes a lower high, but never raise it.
I anticipate that SafeZone will be programmed into may software packages, allowing the traders to control both the lookback period and the multiplication factor. Until then, you will have to do your own programming or else track SafeZone manually (See Table 6.1). Be sure to calculate it separately for uptrends and downtrends.
Here are the rules for calculating the SafeZone using an Excel spreadsheet. Once you understand how it works, try to program SafeZone into your technical analysis software and superimpose its signals on the chart. Compare the numbers from the spreadsheet and the trading software. They should be identical; otherwise, you have a programming error. Comparing results from the two software packages helps overcome pesky programming problems.
Rules for Longs in Uptrends When the trend is up, we calculate SafeZone on the basis of the lows because their pattern determines stop placement.
Obtain at least a month of data for your stock or future in high-low-close format, as shown in Table 6.1 (lows are in column C with the first record in row 3).
Test whether today’s low is lower than yesterday’s. Go to cell E4, enter the formula =IF(C3>C4,C3-C4,0) and copy it down the length of that column. It measures the depth of the downside penetration below the previous day’s range, and if there is none, it shows zero.
Choose the lookback period and summarize all downside penetrations during the time. Begin with 10 days and later experiment with other values. Go to cell F13, enter the formula =SUM(E4:E13), and copy it down the length of that column. It will summarize the extent of all downside penetrations for the past 10 days.
Mark each bar that penetrates below the previous bar. Go to cell G4, enter the formula =IF(C4Count the number of downside penetrations during the lookback period, in this case 10 days. Go to cell H13, enter the formula =SUM(G4:G13), and copy it down the length of that column. It will show how many times in the past 10 days the lows have been violated.
Find the Average Downside Penetration by dividing the sum of all downside penetrations during the lookback period by their number. Go to cell I13, enter the formula =F13/H13, and copy it down the length of that column. It will show the Average Downside Penetration for each day, that is, the normal level of downside noise in that market.
Place your stop for today at a multiple of yesterday’s Average Downside Penetration below yesterday’s low. Multiply yesterday’s Average Downside Penetration by a selected coefficient, starting at 2 but testing as high as 3, and subtract the result from yesterday’s low to obtain today’s stop. Go to cell J14, enter the formula =C13-2*I13, and copy it down the length of that column. It will place a stop two Average Downside Penetrations below the latest low. If today’s low penetrates yesterday’s low by twice the normal range of noise, we bail out.
Refine the formula to prevent it from lowering stops in uptrends. If the above formula tells us to lower our stops, we simply leave it at the previous day’s level. Go to cell K16, enter formula =MAX(J14:J16), and copy it down the length of that column. It will prevent the stop from declining for three days, by which time either the uptrend resumes or the stops is hit.
Rules for Shorts in Downtrends
When the trend is down, we calculate SafeZone on the basis of the highs because their pattern determines stop placement.
Obtain at least a month of data for your stock or future in high-low-close format, as shown in Table 6.1 (highs are in column B with the first record in row 3).
Test whether today’s high is higher than yesterday’s. Go to cell L4, enter the formula =IF(B3>B4,B3-B4,0) and copy it down the length of that column. It measures the height of the upside penetration above the previous day’s range, and if there is none, it shows zero.
Choose the lookback period and summarize all upside penetrations during the time. Begin with 10 days and later experiment with higher values. Go to cell M13, enter the formula =SUM(L4:L13), and copy it down the length of that column. It will summarize the extent of all upside penetrations for the past 10 days.
Mark each bar that penetrates above the previous bar. Go to cell N4, enter the formula =IF(B4 < B3 ,1,0) and copy it down the length of that column. It will mark each upside penetration with 1 and no penetration with 0.
Count the number of upside penetrations during the lookback period, in this case 10 days. Go to cell O13, enter the formula =SUM(N4:N13), and copy it down the length of that column. It will show how many times in the past 10 days the highs have been violated.
Find the Average Upside Penetration by dividing the sum of all upside penetrations during the lookback period by their number. Go to cell P13, enter the formula =M13/O13, and copy it down the length of that column. It will show the Average Upside Penetration for each day, that is, the normal level of upside noise in that market.
Place your stop for today at a multiple of yesterday’s Average Upside Penetration above yesterday’s high. Multiply yesterday’s Average Upside Penetration by a selected coefficient, starting at 2 but testing as high as 3, and add the result from yesterday’s high to obtain today’s stop. Go to cell Q14, enter the formula =B13-2*P13, and copy it down the length of that column. It will place a stop two Average Upside Penetrations above the latest high. If today’s high penetrates yesterday’s high by twice the normal range of noise, we bail out.
Refine the formula to prevent it from raising stops in downtrends. If the above formula tells us to raise our stops, we simply leave it at the previous day’s level. Go to cell R16, enter formula =MIN(Q14:Q16), and copy it down the length of that column. It will prevent the stop from rising for three days, by which time either the downtrend resumes or the stops is hit.
To use SafeZone with your favorite stock or future during an uptrend, begin by multiplying the average downside penetration by the factor of three, and subtracting that from the low of the latest bar. Putting your stop closer than the average level of noise means asking for trouble, and even twice the average level is often too close. Once your system identifies an uptrend, SafeZone starts following prices, getting you out before the trend reverses. You can see that SafeZone stop as hit at points A, B, C, and D, catching the bulk of the uptrend and avoiding downdrafts.
The right edge of the chart illustrates why it is a good idea never to hold a stock below its SafeZone level. JEC is in a free fall, wiping out the profits of a month in just two days—a trader using SafeZone cashed out early in the decline.

1 comment: