Combining Trend-Following and Countertrend Indicators

One of the oldest adages in all of trading is that "the trend is your friend." This has become an old adage primarily by virtue of the fact that it is true. As the trend defines the prevailing direction of price action for a given tradable security, as long as the trend persists, more money can be made by going with the current trend than by fighting against it. Nevertheless, it is a natural human instinct to want to buy at the lowest price and to sell at the highest price. The only way to do this in the financial markets is to attempt to "buy the bottom" and "sell the top", which by definition is a countertrend approach to trading. (Check out some common technical indicators in 7 Tools Of The Trade.)

Each trading day the struggle between those attempting to buy or sell into an established trend and those attempting to buy near a low and sell near a high plays out. Both types of traders have very convincing arguments as to why their approach is superior. Yet, interestingly, in the long run, one of the best approaches might just involve melding these two seemingly disparate methods together. Often, the simple solution is the best one. A Combined Approach
The key to successfully combining trend-following and countertrend techniques is twofold:

1. Identify a method that does a reasonably good job of identifying the longer-term trend
2. Identify a countertrend method that does a good job of highlighting pullbacks within the longer-term trend 

While finding an optimum approach may take some time and effort, highlighting the potential usefulness of this concept can be done using some very simple techniques.
Combining the Two Approaches: Step No.1 – Identify the Longer-Term Trend
In Figure 1 you see a stock chart with the 200-day moving average of closing prices plotted. From a trend-following point of view we can simply state that if the latest close is above the current 200-day moving average then the trend is "up" and vice versa.

Figure 1: Price with 200-day moving average

Source: ProfitSource

However, for our purposes here we are not looking for a trend-following method that will necessarily trigger actual buy and sell signals. We are simply trying to pin down the prevailing trend. Therefore, we will now add a second trend-following filter. In Figure 2 you can see that we have also added the 10-day and 30-day moving averages.

Figure 2: Price with 10-day, 30-day and 200-day moving averages

Source: ProfitSource

So now our rules will be as follows:
1. If the 10-day moving average is above the 30-day moving average AND the latest close is above the 200-day moving average, then we will designate the current trend as "up".
2. If the 10-day moving average is below the 30-day moving average AND the latest close is below the 200-day moving average, then we will designate the current trend as "down". (Learn how to calculate a metric that improves on simple variance. Check out Exploring The Exponentially Weighted Moving Average.)
Combining the Two Approaches: Step No.2 - Adding a Countertrend Indicator
There are literally dozens and dozens of potential countertrend indicators that one might choose to use. For our purposes, since we are looking for short-term pullbacks within an overall longer term trend, we will use something very simple and relatively short-term in nature. This indicator is simply referred to as the oscillator. The calculations are simple:
A = the 3-day moving average of closing prices
B = the 10-day moving average of closing prices
The oscillator is simply (A – B)
In Figure 3, we see the same price chart as in Figures 1 and 2 with the oscillator plotted below the price action. As the underlying security dips in price, the oscillator drops below zero and vice versa.

Figure 3: Price with 3/10 oscillator

Source: ProfitSource

Combining the Two Approaches: Step No.3So now let's actually combine the two methods we have described so far into one method. In Figure 4, see once again the same bar chart as in the previous three Figures. On this one we see the 10-day, 30-day and 200-day moving averages plotted on the price chart with the oscillator displayed below.

Figure 4: Looking for oscillator reversals to the upside in an established uptrend

Source: ProfitSource

What an alert trader should be looking for is instances when:

1. The 10-day moving average is above the 30-day moving average
2. The latest close is above the 200-day moving average
3. Today's oscillator is above yesterday's oscillator AND; 
4. Yesterday's oscillator value was both negative and below the oscillator value two days ago.

Completion of this set of criteria suggests that a pullback within a longer-term uptrend may have been completed and that prices could be set to move higher. The aforementioned criteria presents a scenario in which the trend suggests that the stock is due to continue its upward momentum, yet the investor will not be purchasing shares at the very peak of the cycle.
The Drawbacks
There are many potential caveats associated with the method described in this piece. First and foremost is that no one should assume that the described method will generate consistent trading profits. It is not presented as a trading system, only as an example of a potential trading signal generation method. The method itself is simply an example of just one way to combine trend-following and countertrend indicators into one model. And while the concept is entirely sound, a responsible trader would need to test out any method before using it in the marketplace and risking actual money. In addition, there are other extremely important considerations to take into account that go well beyond just generating entry signals.
Other relevant questions to ask and answer before employing any trading approach are:

• How will positions be sized?
• What percentage of one's capital will be risked?
• If and where to place a stop-loss order?
• When should you take a profit?

The Bottom Line
This is just a sampling of considerations that a trader must take into account before beginning to trade any particular method. Nevertheless, with those caveats firmly in mind, there does appear to be some merit in the idea of combining trend-following and countertrend methods in an effort to buy at the most favorable times while still adhering to the major trend in play. (The moving average is easy to calculate and, once plotted on a chart, is a powerful visual trend-spotting tool. For further reading, see Simple Moving Averages Make Trends Stand Out.)

by Jay Kaeppel (Contact Author | Biography)

Jay Kaeppel is a trading strategist with Optionetics, Inc. and writes a weekly column, Kaeppel's Corner for optionetics.com. Kaeppel has been active in financial markets for over two decades. He was the head trader at a CTA for 8 years and a trading system and trading software developer for 15 years. As an author, Kaeppel has published three books on trading, "The Four Biggest Mistakes in Option Trading" (1998), "The Four Biggest Mistakes in Futures Trading"(2000), "The Option Trader's Guide to Probability, Volatility and Timing"(2002) and "Seasonal Stock Market Trends: The Definitive Guide to Seasonal Stock Market Trading"(2009). He has written over 25 articles for magazines, such as Stocks and Commidities and Active Trader.

Get A Trading Referee And Improve Your Performance

One of the most talked about traits that traders need is disciple. Discipline is a quality that can be created by the individual internally, but can also be fostered by an external source. All traders will benefit from increased discipline, as being able to stick to a profitable strategy is what will allow them to be successful over the long term.

Also, being disciplined in following a particular method of trading will allow the trader to know when a method of trading is or isn't working. Every investor must follow their specific trading strategy rather than just speculating without a solid basis. If a trader lacks discipline and consistently flip-flops between methods, it is very hard to isolate which methods are successful and which aren't. This is where the "trading referee" comes in. The referee is an external entity that forces us to comply with our methods. This makes us more accountable to our own system, and does not require the hard internal work which may be needed in order to change our normal personality. (Do-it-yourself trading can be very rewarding - both psychologically and for your wallet. For more information, see Create Your Own Trading Strategy.)
What is a Trading Referee?It can be anyone in our life whom we trust and whom will hold us accountable for our actions. This person needs to be someone who will not accept excuses for us not following the determined approach. In other words, a referee cannot be someone who is a push over, will be biased or always agree with you, or someone who is not responsible enough to check on your trading. Essentially, the referee serves as system of checks and balances for our strategy.
The referee's aim is to make sure that you, the trader, are following your trading plan. Your trading plan should be a method of trading which is tested, consistent and proven to be profitable over the long run. Therefore, it is a referee's goal to make you follow that system, thus helping ensure your long-term profitability. It is a requirement that the person be able to see you trade (or have access to your trading records). Going through results should be done together; this again will require trust on the part of the trader.
A referee, whether it is a friend, a spouse, colleague or girlfriend/boyfriend, will make you answer for the decisions you are making. They will force to answer why you are taking certain actions, and how those actions relate to your trading plan. When you stop following your trading plan under your own will, this person is there to give you support and make sure that you do not deviate from the initial goal. After all, this is not about the trader proving he or she is right, it is about being profitable. (From picking the right type of stock to setting stop-losses, learn how to trade wisely. Read, Day Trading Strategies For Beginners.)
"Create" Your Trading RefereeIt is important that this individual understands capital markets and the basics of investing. As well, your trading referee will need to know about your methods for trading. Here are some steps to follow to make sure your referee will actually make you follow through with your trading plan. (A successful trading referee must be familiar with concepts such as risk. To learn more, refer to Matching Investing Risk Tolerance To Personality.)

• Approach or ask someone you think will be a suitable candidate. This should be someone you see regularly, preferably while you are trading, or who you can sit down with on a regular basis to go over your trades. You can also serve as the referee for your overseer - such a method ensures constant interaction and proper process evaluation.
  
  
• Make sure that person knows that it is imperative for him to question you on your trades and to ask why certain actions are being taken. This makes another person feel responsible, therefore it does help if this person has an interest in your success.
  
  
• Fill in the referee on your trading method and why it works. Simplify your methods for them so that they can see how the method works, the logic behind it and the sequence of events that must unfold for you to enter, set stops, take profit and then exit.
  
  
• Take a proactive approach and share your trading time with your referee. Having the person review your trades with you afterwards is more reactive and, while effective, does not prevent the deviations from the trading plan at the time they are occurring.
  
  
• Set up a rewards and punishment. Having someone look over your shoulder may be motivation enough to follow your own trading rules, but sometimes a little extra incentive may do the trick. Often, the incentive for following a plan is the money made; therefore, we need to be creative in finding ways to punish ourselves for not following the plan. One idea is that you need to give the money you make on winning trades, which were not based on your plan, to your referee. This works because you should have never been in the trade in the first place, and it takes away the incentive for making trades which are not included in your desired strategy. Be creative and come up with a structure for dealing with all contingencies.

Professional traders are forced to answer to other traders and superiors for the actions they take. This results in a much more disciplined environment. It is the responsibility of the firm (and the trader) to make sure that traders are following the methods outlined. When traders deviate, there are consequences. For individual traders, having a referee simply allows performance with the same discipline promoted in successful trading firms.
ConclusionTrading is a tough game, especially when we go at it completely alone. It can be of benefit to invite someone else into our trading experience who will force us to comply with our own methods. The benefits are numerous, not the least of which is the proper execution of a profitable trading plan we took the time to research and develop. (This is a step-by-step approach to determining, achieving and maintaining optimal asset allocation. See 4 Steps To Building A Profitable Portfolio.)

by Cory Mitchell (Contact Author | Biography)

Cory Mitchell is an independent trader specializing in short- to medium-term technical strategies. He is the founder of www.vantagepointtrading.com, a website dedicated to free trader education and discussion. After graduating with a business degree, Mitchell has spent the last five years trading multiple markets and educating traders. He has been widely published and is a member of the Canadian Society of Technical Analysts and the Market Technicians Association.

4 Steps To Creating A Better Investment Strategy

It is no secret that behind every successful investment manager there is a written, measurable and repeatable investment strategy. However, many investors jump from one trade to another, putting little effort into creating and measuring their overall strategies.

Read on to learn four questions that, when answered, will help you create a better investment strategy. The following questions will help you create an investment strategy that is written, measurable and backed by your own strong beliefs. This will lead to more consistent investment performance and help you mitigate emotional investment decisions. Most importantly, it will help you avoid a scattered portfolio of individual investments that, when looked at as a whole, have no overall theme or objective.

• Can you write down your investment strategy as a process?To quote the late Dr. W. Edwards Deming, a world famous author and management quality consultant, "If you can't describe what you are doing as a process, you don't know what you are doing." Like anything that requires a disciplined process, it is important to write down your investment strategy. Doing this will help you articulate it. Once your strategy is written, you should look over it to make sure that it matches your long-term investment objectives. Writing down your strategy gives you something to revert back to in times of chaos, which will help you avoid making emotional investment decisions. It also gives you something to review and change if you notice flaws, or your investment objectives change. If you are a professional investor, having a written strategy will help clients better understand your investment process. This can increase trust, mitigate client inquiries and increase client retention.
  
• Does your investment strategy contain a belief about why investments become over or undervalued? If so, how do you exploit that?This question could relate to whether or not you believe that investment markets are efficient. Ask yourself, "What makes me smarter than the market? What is my competitive advantage?" You may have special industry knowledge or subscribe to special research that few other investors have. Or, you may have beliefs about exploiting certain market anomalies, like buying stocks with low price-to-earnings ratios. Once you have decided what your competitive advantage is, you must decide how you can profitably execute a long-term trading plan to exploit it.
  Your trading plan should include rules for both buying and selling investments. Also, keep in mind that your competitive advantage can eventually lose its profitability simply by other investors implementing the same strategy. On the other hand, you may believe that investment markets are completely efficient, meaning that no investor has a consistent competitive advantage. In this case, it is best to focus your strategy on minimizing taxes and transaction costs by investing in passive indexes. (To read more on market efficiency and market anomalies, see What Is Market Efficiency?, and Making Sense Of Market Anomalies.)
  
• Will your investment strategy perform well in every market environment? If not, when will it perform the worst?There is an old saying on Wall Street, "The market can remain irrational longer than you can remain solvent." Good investment managers know where their investment performance comes from, and can explain their strategy's strengths and weaknesses. As market trends and economic themes change, many great investment strategies will have periods of great performance followed by periods of lagging performance. Having a good understanding of your strategy's weaknesses is crucial to maintaining your confidence and investing with conviction, even if your strategy is temporarily out of vogue. It can also help you find strategies that may complement your own. A popular example of this would be mixing both value and growth investing strategies.
  
• Do you have a system in place for measuring the effectiveness of your investment strategy?It is difficult to improve or fully understand something that you do not measure. For this reason, you should have a benchmark to measure the effectiveness of your investment strategy. Your benchmark should match your investment objective, which in turn, should match your investment strategy.
  Two common types of investment benchmarks are relative and absolute benchmarks. An example of a relative benchmark would be a passive market index, like the S&P 500 Index or the Barclays Aggregate Bond Index. An example of an absolute benchmark would be a target return, such as 6% annually. Although it can be a time consuming process, it is important to consider the amount of risk you are taking relative to your investment benchmark. You can do this by recording the volatility of your portfolio's returns, and comparing it to the volatility of your benchmark's returns over of periods of time. More sophisticated measures of returns that adjust for risk are the Treynor Ratio and the Sharpe Ratio. (For more on risk adjusted returns please read, Understanding Volatility Measurements and Measure Your Portfolio's Performance.)

ConclusionSun Tzu, an ancient Chinese military general and strategist, once said, "Tactics without strategy is the noise before defeat". Sun Tzu knew that having a well thought out strategy before you go into battle is crucial to winning. Good money managers have a clear understanding of why investments are over and undervalued, and know what drives their investment performance. If you are going to battle against them everyday in investment markets, shouldn't you? Great trades may win battles, but a well-thought-out investment strategy wins wars.
For related reading, see Disciplined Strategy Key To High Returns and Create Your Own Trading Strategies.

by David Allison (Contact Author | Biography)

David L. Allison is vice president and the founding partner at Allison Investment Management LLC, an investment advisory firm offering managed accounts to high-net-worth investors and institutions. He received a bachelor's degree from the University of North Carolina at Wilmington where he majored in finance. He currently holds the Series 7 and Series 66. David has earned both the Chartered Financial Analysts (CFA) and the Certificate in Investment Performance Measurement (CIPM) designations. He is an advisor to CFA Institute serving on the CIPM Examination Review Panel. He is a member of the CFA Institute, the CIPM Association, the North Carolina Society of Financial Analysts (NCSFA), and the CFA Society of South Carolina, where he currently serves as President. In addition, he is First Chair on the Coastal Carolina University Wall College of Business Finance Advisory Board. Securities are offered though Triad Advisors, Inc. Member FINRA & SIPC

Range Bar Charts: A Different View Of The Markets

Nicolellis range bars were developed in the mid 1990s by Vicente Nicolellis, a Brazilian trader and broker who spent over a decade running a trading desk in Sao Paulo. The local markets at the time were very volatile, and Nicolellis became interested in developing a way to use the volatility to his advantage. He believed price movement was paramount to understanding and using volatility. He developed Range Bars to take only price into consideration, thereby eliminating time from the equation. Nicolellis found that bars based on price only, and not time or other data, provided a new way of viewing and utilizing the volatility of the markets. Today, Range Bars are the new kid on the block, and are gaining popularity as a tool that traders can use to interpret volatility and place well-timed trades. (For a primer on technical analysis, check out the Technical Analysis Tutorial.)

Calculating Range BarsRange bars take only price into consideration; therefore, each bar represents a specified movement of price. Traders and investors may be familiar with viewing bar charts based on time; for instance, a 30-minute chart where one bar shows the price activity for each 30-minute time period. Time-based charts, such as the 30-minute chart in this example, will always print the same number of bars during each trading session, regardless of volatility, volume or any other factor. Range Bars, on the other hand, can have any number of bars printing during a trading session: during times of higher volatility, more bars will print; conversely, during periods of lower volatility, fewer bars will print.  The number of range bars created during a trading session will also depend on the instrument being charted and the specified price movement of the range bar. Three rules of range bars:

• Each range bar must have a high/low range that equals the specified range.
• Each range bar must open outside the high/low range of the previous bar.
• Each range bar must close at either its high or its low.

Settings for Range BarsSpecifying the degree of price movement for creating a range bar is not a one-size-fits-all process. Different trading instruments move in a variety of ways. For example, a higher priced stock such as Google (Nasdaq:GOOG) might have a daily range of seven dollars; a lower priced stock such as Research in Motion (Nasdaq:RIMM) might move only a percentage of that in a typical day. It is common for higher priced trading instruments to experience greater average daily price ranges. Figure 1 shows both Google and Research in Motion with 10 cent range bars. One half of the trading session (9:30am - 1:00pm EST) for Google can barely be compressed to fit on one screen since it has a much greater daily range than Research in Motion, and therefore many more 10 cent range bars are created.

Figure 1: These charts compare two trading instruments' daily activity shown with 10 cent range bars. Notice how the Google chart has many more 10 cent range bars than Research in Motion. This is due to the fact the Google typically trades in a greater range. Only half of the trading session for Google could be squeezed into the upper chart; the entire trading session for Research in Motion appears in the bottom chart.

Google and Research in Motion provide an example for two stocks that trade at very different prices, resulting in distinct average daily price ranges. It should be noted that while it is generally true that high-priced trading instruments can have a greater average daily price range than those that are lower priced, instruments that trade at roughly the same price can have very different levels of volatility as well. While we could apply the same range bar settings across the board, it is more helpful to determine an appropriate range setting for each trading instrument. One method for establishing suitable settings is to consider the trading instrument's average daily range. This can be accomplished through observation or by utilizing indicators such as average true range (ATR) on a daily chart interval. Once the average daily range has been determined, a percentage of that range could be used to establish the desired price range for a range bar chart. (Learn more about the ATR in Measure Volatility With Average True Range.) Another consideration is the trader's style. Short-term traders may be more interested in looking at smaller price movements, and, therefore, may be inclined to have a smaller range bar setting. Longer-term traders and investors may require range bar settings that are based on larger price moves. For example, an intraday trader may watch a 10 cent (.01) range bar on McGraw-Hill Companies (MHP). This would allow the trader to watch for significant price moves that occur during one trading session. Conversely, an investor might want a one dollar (1.0) range bar setting for McGraw-Hill (MHP). This would help reveal price movements that would be significant to the longer-term style of trading and investing.
Trading with Range BarsRange bars can help traders view price in a "consolidated" form. Much of the noise that occurs when prices bounce back and forth between a narrow range can be reduced to a single bar or two. This is because a new bar will not print until the full specified price range has been fulfilled. This helps traders distinguish what is actually happening to price. Because range bar charts eliminates much of the noise, they are very useful charts on which to draw trendlines. Areas of support and resistance can be emphasized through the application of horizontal trendlines; trending periods can be highlighted through the use of up-trendlines and down-trendlines. Figure 2 shows trendlines applied to a .001 range bar chart of the euro/US dollar forex pair. The horizontal trendlines easily depict trading ranges, and price moves that break through these areas are often powerful. Typically, the more times price bounces back and forth between the range, the more powerful the move may be once price breaks through. This is considered true for touches along up-trendlines and down-trendlines: the more times price touches the same trendline, the greater the potential move once price breaks through.

Figure 2: This .001 range bar chart of EUR/USD illustrates the effectiveness of applying trendlines to range bar charts.

Figure 3 illustrates a price channel drawn as two parallel down-trendlines on a 1 range bar chart of Google. We have used a 1 range bar here (where each bar equals $1 of price movement) which does a better job of eliminating the "extra" price movements that were seen in Figure 1 using a 10 cent range bar setting. Since some of the consolidating price movement is eliminated by using a larger range bar setting, traders may be able to more readily spot changes in price activity. Trendlines are a natural fit to range bar charts; with less noise, trends may be easier to detect. (For more on channels, see Channeling: Charting A Path To Success.)

Figure 3: This 1 Range Bar chart of Google illustrates a price channel created by drawing parallel down-trendlines. The move to the upside was substantial once price broke above the channel.

Interpreting Volatility with Range BarsVolatility refers to the degree of price movement in a trading instrument. As markets trade in a narrow range, fewer range bars print, reflecting decreased volatility. As price begins to break out of a trading range with an increase in volatility, more range bars will print. In order for range bars to become meaningful as a measure of volatility, a trader must spend time observing a particular trading instrument with a specific range bar setting applied. Through this careful watching, a trader can notice the subtle changes in the timing of the bars and the frequency in which they print. The faster the bars print, the greater the price volatility; the slower the bars print, the lower the price volatility. Periods of increased volatility often signify trading opportunities as a new trend may be starting.   ConclusionWhile range bars are not a type of technical indicator, they are a useful tool that traders can employ to identify trends and to interpret volatility. Since range bars take only price into consideration, and not time or other factors, they provide traders with a new view of price activity. Spending time observing range bars in action is the best way to establish the most useful settings for a particular trading instrument and trading style, and to determine how to effectively apply them to a trading system.

Premier Stochastic Oscillator Explained

The premier stochastic oscillator (PSO) is a technical indicator based on George Lane's stochastic oscillator. The PSO differs in that it is normalized to register neutral values at zero, resulting in greater sensitivity to recent, short-term price moves. Additionally, the PSO is calculated using a double exponential moving average that creates a smoother and more even response to market changes. Figure 1 illustrates how the two stochastic oscillators respond differently to market changes. 

Tutorial: Exploring Oscillators And Indicators

Figure 1: This chart shows both the premier stochastic oscillator and a standard stochastic oscillator applied to the e-mini Russell 2000 futures contract.

History of the PSOThe PSO was first introduced by technical analyst Lee Leibfarth in the August 2008 issue of the Technical Analysis of Stocks & Commodities. Stochastic oscillators have long been used to help traders and investors identify areas where trend changes are likely. Leibfarth developed the PSO to take advantage of a standard stochastic oscillator's strengths, while enhancing it to become more reactive to market activity. The result is a faster indicator that provides earlier signals for potential trend changes. (To get a better understanding of the traditional stochastic oscillator, check out Exploring Oscillators and Indicators: Stochastic Oscillator.)
Calculating the PSOBefore looking into the calculations of the PSO, it is helpful to understand the logic behind a standard stochastic oscillator. The classic stochastic oscillator measures price momentum by comparing a trading instrument's current price to a price range specified in a lookback period (the number of periods from which price data are collected). For example, if the range is between $60-70 and the current price is $67.50, then the price is at 75% of the range.
The goal of a stochastic oscillator is to figure out where price has been, and anticipate where price is headed. This is achieved by determining if price bars are closing close to their highs or lows. When prices are closing nearer to bar highs, it is indicative of an uptrending market. Conversely, when prices are closing nearer to bar lows, it signifies a down-trending market. The basic calculation for the main value of a standard stochastic oscillator (%K) is:

%K = 100 X [(C – Ln) / (Hn – Ln)]

Where

• C = the most recent closing price
• n = the lookback period
• Ln = the low of the n previous price bars
• Hn = the highest price during the same n period

The premier stochastic oscillator normalizes the standard stochastic oscillator by applying a five-period double exponential smoothing average of the %K value, resulting in a symmetric scale of 1 to -1. The PSO calculation, then, is:

PSO = (exponential value (S) – 1) / (exponential value (S) + 1)

Where

• S = 5-period double smoothed exponential EMA ((%K – 50) * .1)
• %K = 8-period stochastic oscillator

(Note: The TradeStation EasyLanguage code for the premier stochastic oscillator is available at www.PowerZoneTrading.com.)
Interpreting the PSOThe PSO appears as a curving line with four horizontal lines that represent threshold levels. These threshold levels are customizable; that is, the levels can be changed by the user to adapt to individual trading styles and instruments. Figure 2 shows the PSO, appearing on a sub-chart below the price chart, with the four different threshold levels.  

Figure 2: A chart of the e-mini Russell 2000 futures contract showing the PSO and its four threshold levels.

The threshold levels are important to the indicator because they can be used to identify areas where market reversals are expected to occur. As the curved line meanders up and down, it crosses above and below the threshold levels. The "outer" thresholds, at the very top and very bottom, represent the extremes, or areas that are overbought (the top line) or oversold (the bottom line). When the PSO moves above the upper or below the lower, price will be expected to pullback.
The "inner" thresholds are placed near the zero line and can be utilized as a transitional area to spot pullbacks and short-term reversals. As the PSO returns from overbought and oversold areas, price has a tendency to accelerate towards the zero line and reverse. This transitional area (between the inner thresholds) can be useful in spotting short-term reversals. (Read more on these types of setups in Ride The RSI Rollercoaster.)
Trading with the PSOThe PSO can be used to anticipate changes in market direction. With the ability to change where the threshold levels appear, the PSO is adaptable to different trading styles. The PSO can easily be incorporated into a counter-trend type strategy since it is used to identify changes in market direction. The following are suggested uses for the PSO, understanding that each trader or investor would need to adjust the indicator to suit his or her needs.
Outer Threshold SetupsOuter threshold setups form when the PSO crosses out of the outer limits and then returns. As previously mentioned, price has a tendency to pullback and then return to overbought or oversold areas. This can provide a good entry point to:

• Go long when the PSO crosses below the upper threshold (0.9 in this example) after it has already crossed above the threshold. A short-term reversal may occur where price returns to the extreme overbought territory.
  
• Go short when the PSO crosses above the lower threshold (-0.9 in this instance) after it has already penetrated the lower threshold. Again, a short-term reversal may occur as prices make another push lower.

 

Figure 3: This chart of the e-mini Russell 2000 futures contract shows potential long (buying) positions using both the outer and inner thresholds.

Inner Threshold SetupsInner threshold setups that can be identified when the PSO comes from the outer thresholds and accelerates towards the center (zero) line. This can present an opportunity to:

• Go long when the PSO comes from overbought areas (0.9 in this instance) and crosses the inner threshold level (0.2 in this example). Unlike the outer threshold setups, the PSO does not need to re-cross the threshold level to trigger the setup.
• Go Short when the PSO returns from an oversold region (-0.9 in Figure 3) to the inner threshold level (in this example, -0.2). (Note: the Go Short example is not shown in Figure 3)

Figure 3 shows a chart with long setups highlighted, using both the outer and inner threshold examples. For short trades, the logic can be reversed. Please note the premier stochastic oscillator is not a strategy; rather, it is an indicator that can be used as part of a trader's or investor's toolbox. As with any market analysis tool, this indicator needs to be optimized to fit each trader's style and preferred trading instrument. (These tools put the market - and any evaluations - in your hands. Check out Economic Indicators For The Do-It-Yourself Investor, and you might also want to read World's Wackiest Stock Indicators.)
ConclusionThe classic stochastic oscillator has been used since the 1950s by traders and investors to anticipate areas where the market may change direction. The classic and premier stochastic oscillator are based on price movement that occurs within the price bar itself – whether bars are closing nearer to their highs or lows – to determine which way the market is heading. The premier stochastic oscillator creates a smoother, faster reacting Stochastic that can help traders and investors determine areas where direction changes are probable – sooner than a standard stochastic – enabling participants to catch a bigger part of a move. (The futures market is a lot less scary when these indicators are used to establish current trends. See Master Futures Trading With Trend-Following Indicators for more.)

Weighted Moving Averages: The Basics

Over the years, technicians have found two problems with the simple moving average. The first problem lies in the time frame of the moving average (MA). Most technical analysts believe that price action, the opening or closing stock price, is not enough on which to depend for properly predicting buy or sell signals of the MA's crossover action. To solve this problem, analysts now assign more weight to the most recent price data by using the exponentially smoothed moving average (EMA). (Learn more in Exploring The Exponentially Weighed Moving Average.)

An ExampleFor example, using a 10-day MA, an analyst would take the closing price of the 10th day and multiply this number by 10, the ninth day by nine, the eighth day by eight and so on to the first of the MA. Once the total has been determined, the analyst would then divide the number by the addition of the multipliers. If you add the multipliers of the 10-day MA example, the number is 55. This indicator is known as the linearly weighted moving average. (For related reading, check out Simple Moving Averages Make Trends Stand Out.)

Many technicians are firm believers in the exponentially smoothed moving average (EMA). This indicator has been explained in so many different ways that it confuses students and investors alike. Perhaps the best explanation comes from John J. Murphy's "Technical Analysis Of The Financial Markets", (published by the New York Institute of Finance, 1999):

The exponentially smoothed moving average addresses both of the problems associated with the simple moving average. First, the exponentially smoothed average assigns a greater weight to the more recent data. Therefore, it is a weighted moving average. But while it assigns lesser importance to past price data, it does include in its calculation all the data in the life of the instrument. In addition, the user is able to adjust the weighting to give greater or lesser weight to the most recent day's price, which is added to a percentage of the previous day's value. The sum of both percentage values adds up to 100.

For example, the last day's price could be assigned a weight of 10% (.10), which is added to the previous days' weight of 90% (.90). This gives the last day 10% of the total weighting. This would be the equivalent to a 20-day average, by giving the last days price a smaller value of 5% (.05).

Figure 1: Exponentially Smoothed Moving Average

Source: Tradestation

The above chart shows the Nasdaq Composite Index from the first week in Aug. 2000 to June 1, 2001. As you can clearly see, the EMA, which in this case is using the closing price data over a nine-day period, has definite sell signals on the Sept. 8 (marked by a black down arrow). This was the day that the index broke below the 4,000 level. The second black arrow shows another down leg that technicians were actually expecting. The Nasdaq could not generate enough volume and interest from the retail investors to break the 3,000 mark. It then dove down again to bottom out at 1619.58 on Apr. 4. The uptrend of Apr. 12 is marked by an arrow. Here the index closed at 1,961.46, and technicians began to see institutional fund managers starting to pick up some bargains like Cisco, Microsoft and some of the energy-related issues. (Read our related articles: Moving Average Envelopes: Refining A Popular Trading Tool and Moving Average Bounce.)

by John Devcic (Contact Author | Biography)

John Devcic is a freelance writer, market historian and private speculator. After investing in a mutual fund right out of high school and losing his initial investment of $350, Devcic began to believe he could do better with his money then the so-called experts could. Over the years a healthy and sometimes unhealthy obsession with how the markets work and how they worked in the past has made Devcic a true market historian. He reminds himself at all times that the market - while ever-changing – always seems to repeat itself.

Know Your Counterparty When Day Trading

As day traders, it is important to remember that when making trades intraday it is highly likely that you will transact against another day trader or a designated market maker - and their algorithms. This can result in frustration for inexperienced traders because they fail to realize that the other party has a contrary interest and motive for the transaction. By making a transaction there is now a possibility that the counterparty may take steps to make you lose on your trade so that they may gain. While the market is by no means a one-on-one battle, seeing what kinds of players a trader may encounter on a particular trade and in a particular environment can help them better understand how they can improve their own trading.

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The Trading EnvironmentsTraders will often trade in certain market environments. While the environment can change due to events that may occur, when a particular environment is in play it is highly likely you will encounter certain types of traders. While there are other trading environments, the following are the most common trader types who will trade within them. After knowing what kind of environment we are trading in, we can then understand with whom we are likely transacting. Also, when the environment shifts we can be aware of what types of traders - or associated algorithms - are likely to enter that market. (If you can multi-task and enjoy a good challenge, this lucrative career could be a perfect fit Hotshots Needed For Commodity Trading Advisor Positions.) High Volume, Low VolatilityThese markets are characterized by relatively small intraday movements, large bids and offers at each price level and relatively high volume.
In this type of environment, there are several usual participants:

• Designated Market Makers (DMM)These participants' main function is to provide liquidity to the market, yet they also attempt to the profit from the market. They have massive market clout, and will often be a substantial portion of the visible bids and offers displayed on the books. Profits are made by providing liquidity and collecting ECN rebates, as well moving the market for capital gains when circumstances dictate a profit may be capturable.
  
  
• Liquidity Traders
  These are non-market makers who generally have very low fees and capture daily profits by adding liquidity and capturing the ECN credits. As with market makers they may also make capital gains by being filled on the bid (offer) and then posting orders on the offer (bid) at the inside price or outside the current market price. These traders may still have market clout, but less so than market makers.
  
  
• Technical TradersIn almost any market, there will be traders who trade based on chart levels, whether from market indicators, support and resistance, trendlines or chart patterns. These traders watch for certain conditions to arise before stepping into a position; in this way, it is likely they can more accurately define the risks and rewards of a particular trade. At commonly known technical levels, the liquidity traders and DMM may become technical traders. Although not always in the way expected - DMM may falsely trigger technical levels knowing large groups of traders will be affected, thus churning large amounts of shares. (Learn more in our Technical Analysis Tutorial.)

High Volume, High VolatilityThese markets are characterized by relatively large intraday movements, small bids and offers at each price level and relatively high volume.
In this type of environment there are several usual participants:

• DMM (see above)These are present, but will be less involved at each price level. They may still do large volume, but are less obvious on the book compared to the low volatility stocks.
  
  
• Momentum Traders
  There are different types of momentum traders. Some will stay with a momentum stock for multiple days (even though they only trade it intraday) while others will screen for "stocks on the move," constantly attempting to capture quick sharp movements in stocks during news events, volume or price spikes. These traders typically exit when the movement is showing signs of slowing. (This type of strategy demands controlled decision making, requiring a continual refinement of entry and exit techniques, read Momentum Trading with Discipline.)
  
  
  
• Arbitragers
  Using multiple assets, markets and statistical tools, these traders attempt to exploit inefficiencies in the market or across markets. These traders may be small or large, although certain types of arbitrage trading will require large amounts of buying power to fully capitalize on inefficiencies. Other types of "arbitrage" may be accessible to smaller traders such as when dealing with highly correlated instruments and short-term deviations from the correlation threshold.
  
  
• Technical Traders
  Just as with the high volume, low volatility stocks, technical traders can be found in almost any market.

Low Volume and Low/High VolatilityThe main characterization of these stocks is low volume. Even though there may be few transactions those transactions may take place over a large price area, or a small price area.

• DMM
  These traders may be visible on low-volume and low-volatility stocks attempting to collect ECN rebates on transactions that do occur. On low-volume but high-volatility stocks, the DMM may be less visible on the books (small orders).
  
  
• Liquidity Traders
  They may also be in these environments, but while they provide liquidity on the ECN books, they will also attempt to make a momentary gain on the shares to compensate for the low liquidity risk. (Discover how two groups work together to keep the market functioning properly. See Traders And Investors' Roles In The Marketplace.)
  
  
• Other Day Traders
  They are unlikely to be in this environment, unless there is a large volume and price spike to capture their attention or a statistical anomaly is significant enough to offset potential low liquidity risks.

Know Your CounterpartyHaving an idea of your potential counterparty in a given environment can provide insights into how the market is likely to act based on your presence/orders/transactions and other similar style traders. A DMM, for example, is unlikely to continually add liquidity as the price moves against them indefinitely. At some point, they attempt to re-capture lost capital gains. A market maker cannot last long losing money.
In high-momentum environments, momentum is likely to continue beyond what many expect because of the nature of trader that is attracted. Momentum brings in more momentum traders, creating a further price catalyst. Price movement catalysts are also often technical levels.
While not everyone is a technical trader, being aware of major market signals that many other traders watch (such as a 50-day or 200-day moving average, pivot points or major support/resistance) can provide important information. As mentioned before, certain types of traders will exploit the fact that many traders are watching these levels. Day traders must be aware of the potential impact the technical level may have, as well as realize that the level may be exploited to churn shares before the technical level creates the actual price movement expected from such a technical level. (Learn one of the most common methods of finding support and resistance levels Using Pivot Points for Predictions.)
Also, when trading securities that have strong positive or negative correlations with other securities or asset classes, it is important to be aware of those correlations as well as when those correlations are breaking down, and possibly attracting the attention of arbitragers.
When we can begin to see our counterparty's intentions, we can align our strategy to theirs or attempt to exploit the common tactics of the counterparty.
SummaryNot all stocks are the same because the traders are not the same. Understanding what potential counterparties are in a stock can help provide valuable insights. High-volume, low-volatility stocks are dominated by market makers and liquidity providers as well as some technical traders. High-volume, high-volatility names will have market makers, technical traders, momentum traders and may attract arbitragers.
Low volume stocks are likely to see market makers and liquidity providers, although they trade for capital gains as well due to the spreads and low liquidity risk. Being aware of the styles of these traders can aid day traders in understanding their counterparty by creating an accommodating strategy or strategies designed to exploit common actions of the counterparty. (From picking the right type of stock to setting stop-losses, learn how to trade wisely, check out Trading Through A Market Maker Vs. An ECN and Day Trading Strategies For Beginners.)

by Cory Mitchell (Contact Author | Biography)

Cory Mitchell is an independent trader specializing in short- to medium-term technical strategies. He is the founder of www.vantagepointtrading.com, a website dedicated to free trader education and discussion. After graduating with a business degree, Mitchell has spent the last five years trading multiple markets and educating traders. He has been widely published and is a member of the Canadian Society of Technical Analysts and the Market Technicians Association.

Getting Through The Rough Patches In Trading

Filed Under: Active Trading

Economies have continual ups and downs, and traders ride the corresponding market waves along with everyone else. Some times are more profitable than others based on how the market is acting and reacting to the sentiment of the times, but regulation and technology also play a role. A downturn in trading profitability may not be tied to a particular strategy or to the trader's discipline, but it could be linked to how the trader is able to participate in the market place, and whether their particular methods and ways of thinking will survive in an evolving trading world. Rough patches will likely occur in all traders' careers; how someone handles the main obstacles that may occur will very likely determine if they continue as a trader or not.
(Tutorial: Stock Picking Strategies.)

Common Obstacles

• Starting Out
  When one begins trading, it can be rough. Often, the first year in trading is enough to deter a trader from continuing on the journey. Uncertainty and lack of confidence is common.
  
  
• Major Shifts in the Market Dynamic
  Traders who trade through several market cycles may experience rough patches as they are forced to transition between different market types – volatile, sedate, up trends, down trends, ranging etc.
  
  
• Regulatory Changes
  Changes in how the market is allowed to operate can affect traders greatly, nullifying certain strategies or increasing trading costs (cost reductions are rarely a problem for traders).
  
  
• Technological Changes
  Technology continues to advance, and along with it so does trading. The transition from trading floor to computer and broker to direct access creates many contingency problems for some traders while providing opportunity for others.

Coming to Terms with the ObstacleUltimately, a trader must decide if an obstacle is worth overcoming. He must not fight the reality of the situation, but instead accept it and work with it, or cease to trade. Not accepting a change in the market will very likely result in a further deterioration in performance.

Take for instance the decimalization of U.S. stocks in 2001. This resulted in smaller spreads and changed the landscape of how certain traders traded the market. For some, it may have increased their profitability, but at the time certain traders such as scalpers may have seen a significant decline in profits as making the spread made them one cent as opposed to one-eighth of a dollar. A trader either accepted and adapted, or was forced out of the market.

Changes such as these, as well as new regulations and technological changes need to be addressed candidly by the trader. Each trader must admit this is the way it is and then ask: "Given this, how will I adjust my strategies going forward, and is it worth changing?" In a hypothetical scenario that a tax was placed on short-term trades, some short-term traders may be forced into an alternative style of trading. Such a transition may not be desired by the trader as they like to trade because of their trading style.

A trader may also realize that they only wish to trade in certain market types. If they make money in trending markets, but lose money in ranging markets, they have two options: learn to trade a ranging market or trade only when there is a strong visible trend. (To learn more, see Trading Trend Or Range?)

Thus, if traders accept the obstacle, they can logically work out new strategies if they wish to move forward. If they decide it is not feasible to move forward, they can save themselves from throwing good money after bad. Not accepting a change in the market will very likely result in deteriorating performance.
Overcoming the ObstacleOnce traders have accepted and decided it is feasible to move forward, they must overcome the rough patch. Sometimes, this will only be a matter of time, but there are ways to speed up the process.

• Starting Out
  When one begins trading, there are many things to learn. Frustration at this point is part of the process. It is at this point that a trader can minimize frustration and hopefully losses by building a thorough trading plan for how trades will be entered, managed and exited. By trading with a structured plan, the trader can then see what areas of the trading plan need work and they can begin to improve them.
  
  
• Shifting Markets
  Markets are continually in transition from uptrend to downtrend to ranging and any combination thereof. The best way to transition from market to market is to accept that changes occur, and not get tied to believing that a certain trend or certain range will last forever. A trader must adapt. Set out guidelines for when a ranging strategy will be used, and when trending strategies will be used. Also, lay out at what points those transitions occur.

Whether regulatory changes or technological changes, the trader must accept that change is a reality. From adversity often comes opportunity, and what at first appears to be a negative may in fact be a positive. The trader must look at ways in which such changes are creating opportunities. By addressing how the changes would have affected their own psychology and thus their trading practices, they can assume that others will be influenced in the same way. This can create a profitable opportunity as some participants will continue to fight against the changes, losing money, which can become a profit for the trader who adapts.
SummaryNo matter what the reason for a rough patch in trading, traders need to accept the reality of the current market dynamic and situation, not fight against it. Failing to adapt or trying to impose a way of trading that is not suited to the current market often results in rough patches. Declining profits (or increasing losses) do occur at times as traders transition between strategies or adapt to circumstances, yet these times can be minimized by accepting the situation, building a plan for transitioning and by looking for opportunities in occurrences that are likely to have sweeping affects on many traders. (For more tips, check out 6 Asset Allocation Strategies That Work.)

by Cory Mitchell (Contact Author | Biography)

Cory Mitchell is an independent trader specializing in short- to medium-term technical strategies. He is the founder of www.vantagepointtrading.com, a website dedicated to free trader education and discussion. After graduating with a business degree, Mitchell has spent the last five years trading multiple markets and educating traders. He has been widely published and is a member of the Canadian Society of Technical Analysts and the Market Technicians Association.

When Not To Trade

While the search for the ideal trading method or system takes up a large portion of a trader's research time, it may be worth noting that, while these are important elements of trading, there is one element which is arguably even more important - knowing when not to trade. During certain market conditions even the best systems can break down, and very few strategies will work in all trading environments. Thus preservation of capital during times of low profit probability is paramount in achieving excellent returns. Profiting handsomely on one, several or a string of trades matters little if the trader continues to trade when conditions do not warrant such action, and the profits are ultimately lost.
TUTORIAL: Stock Picking Strategies

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Why "Not Trading" is Important
Experienced traders know when to "sit on their hands." They realize that trading during times that do not suit their trading style can cut deeply into profits, or create a sizable deficit that will need to be regained. New traders, often in their enthusiasm, begin to trade more as losses mount. Instead of stepping back, they step into the market trying to make back losses. Trading when conditions warrant it is prudent, but it becomes a problem when a trader begins to try to find more trades to make up for losses. Often these trades are outside of the trading plan and are low-probability trades, based on hope and not on solid analysis. (Sound familiar? Check out Tips For Avoiding Excessive Trading for advice.)
Knowing Your SystemDifferent systems perform well in different types of market environments. Some will experience peak profitability in choppy markets, others will perform well in trending markets and others in long-term ranging markets. For each system that performs well in a respective market, other systems may perform very poorly.
Thus, it is up to the trader to know and understand a system, and what type of market caters to the system being profitable. Volatile markets may hurt a "scalper" who generally scalps the markets for small profits but the increased volatility exposes them to a larger risk. A choppy or ranging market will hurt a strategy that attempts to isolate only long-term trends – the environment is likely to trigger multiple false signals.
It becomes imperative that traders are able to decipher when it is a high probability time to trade, and when it is not. High probability times include times when the overall market is exhibiting characteristics that compliment the strategy. Low probability times are when the market is showing behaviors which are not congruent with the system that is to be implemented. The following examples will help visually show how certain environments create high and low profit probabilities using different strategies. Not all trading systems can be discussed, but hopefully the trader can extrapolate from the examples how they can avoid in certain market conditions in order to increase their own profitability (or reduce the amount of losses).
Examples of When Not to TradeThe first example comes from the Dow Jones Industrial Average. The uptrend was strong until late January, 2010 when the trend line was broken. The fall resulted in short-term downtrend. A rally occurred breaking the short-term downtrend line. From the chart we can see a short-term trendline drawn (and one horizontal resistance level), one of which will be broken shortly due to the small price range where they converge.

Figure 1: Dow Jones Industrial Average, Daily Chart

Source: Free Stock Charts (http://www.freestockcharts.com)

When trendlines are consistently being broken, it can be hard to implement a trend-following system. The time frame covered here is short term for investors, but long term for swing traders. Yet the principles apply to whatever time frame a trader trades on. Markets that are whipsawing but not making new significant highs or lows (for the time frame) show indecision and that a trend=following system is likely to see a number of losing trades if the current dynamic continues. No damage is done by waiting for a clear signal that a trend has once again emerged.
In this case, waiting for a horizontal resistance line above 10,400 to be broken would indicate a higher probability that at least the short-term uptrend is in play. For the downtrend to be renewed in this the market would need to go below the lows just under 9,900. If price remains inside this price range a longer-term trend trading strategy will not make a profit. (For more, see our article on Support And Resistance Reversals.)
Figure 2 looks at the EUR/USD which started a strong downtrend in late 2009. Towards early January, 2010 the selling in the euro stalled and the currency pair entered a more ranging environment. A trader may have been tempted to start range trading this pair during such a time, and a few profitable trades may have been made, but ultimately the EUR/USD was still trending and the range trade strategy would have been short lived on this time frame; the pair resumed its downtrend in late January.

Figure 2: EUR/USD, Daily

Source: Free Stock Charts(http://www.freestockcharts.com)

In this case, the trader should have marked the range on their chart and been aware of the overall trend playing out. When the range was broken the trader could then exit their range trades (if they had implemented a range trade strategy) and implement a trend trading strategy once the re-established trend was confirmed – downward breakout, pullback and then resumed its move down. For both range traders and trend traders, in this chart example there were points in time where their methods would have experienced low and high probability chances of success. (Learn more in The Anatomy Of Trading Breakouts.)
SummaryFrom these examples we see that it is important to be aware of what is occurring now, but also to be able to transition our strategies to accommodate changing market conditions. This can be done by changing strategies to suit the current environment, or a longer or shorter time frame can be looked at to help us gauge whether we should be trading or not. Traders must know their trading plan and trading systems, and know under what type of conditions they perform well and perform poorly. When conditions arise where they are likely to perform poorly, traders must exercise discipline and cease trading. (For more on this topic, see Disciplined Strategy Key To High Returns.)

by Cory Mitchell (Contact Author | Biography)

Cory Mitchell is an independent trader specializing in short- to medium-term technical strategies. He is the founder of www.vantagepointtrading.com, a website dedicated to free trader education and discussion. After graduating with a business degree, Mitchell has spent the last five years trading multiple markets and educating traders. He has been widely published and is a member of the Canadian Society of Technical Analysts and the Market Technicians Association.

Double Exponential Moving Averages Explained

Traders have relied on moving averages to help pinpoint high probability trading entry points and profitable exits for many years. A well-known problem with moving averages, however, is the serious lag that is present in most types of moving averages. The double exponential moving average (DEMA) provides a solution by calculating a faster averaging methodology.
Tutorial: Moving Averages 

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History of the Double Exponential Moving AverageIn technical analysis, the term moving average refers to an average of price for a particular trading instrument over a specified time period. For example, a 10-day moving average calculates the average price of a specific instrument over the past 10 ten days; a 200-day moving average calculates the average price of the last 200 days. Each day, the look-back period advances to base calculations on the last X number of days. A moving average appears as a smooth, curving line that provides a visual representation of the longer-term trend of an instrument. Faster moving averages, with shorter look-back periods, are choppier; slower moving averages, with longer look-back periods, are smoother. Because a moving average is a backward looking indicator, it is lagging. The double exponential moving average (DEMA), shown in Figure 1, was developed by Patrick Mulloy in an attempt to reduce the amount of lag time found in traditional moving averages. It was first introduced in the February 1994, Technical Analysis of Stocks & Commodities magazine in Mulloy's article "Smoothing Data with Faster Moving Averages".  (For a primer on technical analysis, take a look at our Technical Analysis Tutorial.)

Figure 1: This one-minute chart of the e-mini Russell 2000 futures contract shows two different double exponential moving averages; a 55-period appears in blue, a 21-period in pink.

Source: Tradestation

Calculating a DEMAAs Mulloy explains in his original article, "the DEMA is not just a double EMA with twice the lag time of a single EMA, but is a composite implementation of single and double EMAs producing another EMA with less lag than either of the original two."
In other words, the DEMA is not simply two EMAs combined, or a moving average of a moving average, but is a calculation of both single and double EMAs.
Nearly all trading analysis platforms have the DEMA included as an indicator that can be added to charts. Therefore, traders can use the DEMA without knowing the math behind the calculations and without having to write or input any code.
Comparing the DEMA with Traditional Moving AveragesMoving averages are one of the most popular methods of technical analysis. Many traders use them to spot trend reversals, especially in a moving average crossover, where two moving averages of different lengths are placed on a chart. Points where the moving averages cross can signify buying or selling opportunities.
The DEMA can help traders spot reversals sooner because it is faster to respond to changes in market activity. Figure 2 shows an example of the e-mini Russell 2000 futures contract. This one minute chart has four moving averages applied:

• 21-period DEMA (pink)
• 55-period DEMA (dark blue)
• 21-period MA (light blue)
• 55-period MA (light green)

Figure 2: This one-minute chart of the e-mini Russell 2000 futures contract illustrates the faster response time of the DEMA when used in a crossover. Notice how the DEMA crossover in both instances appears significantly sooner than the MA crossovers.

Source: Tradestation

The first DEMA crossover appears at 12:29 and the next bar opens at a price of $663.20. The MA crossover, on the other hand, forms at 12:34 and the next bar's opening price is at $660.50. In the next set of crossovers, the DEMA crossover appears at 1:33 and the next bar opens at $658. The MA, in contrast, forms at 1:43, with the next bar opening at $662.90. In each instance, the DEMA crossover provides an advantage in getting into the trend earlier than the MA crossover. (For more insight, read the Moving Averages Tutorial.)
Trading With a DEMAThe above moving average crossover examples illustrate the effectiveness of using the faster double exponential moving average. In addition to using the DEMA as a standalone indicator or in a crossover setup, the DEMA can be used in a variety of indicators where the logic is based on a moving average. Technical analysis tools such as Bollinger bands, moving average convergence/divergence (MACD) and triple exponential moving average (TRIX) are based on moving average types and can be modified to incorporate a DEMA in place of other more traditional types of moving averages.
Substituting the DEMA can help traders spot different buying and selling opportunities that are ahead of those provided by the MAs or EMAs traditionally used in these indicators. Of course getting into a trend sooner rather than later typically leads to higher profits. Figure 2 illustrates this principle - if we were to use the crossovers as buy and sell signals, we would enter the trades significantly earlier when using the DEMA crossover as opposed to the MA crossover.
Bottom LineTraders and investors have long used moving averages in their market analysis. Moving averages are a widely used technical analysis tool that provides a means of quickly viewing and interpreting the longer term trend of a given trading instrument. Since moving averages by their very nature are lagging indicators, it is helpful to tweak the moving average in order to calculate a quicker, more responsive indicator. The double exponential moving average provides traders and investors a view of the longer term trend, with the added advantage of being a faster moving average with less lag time. (For related reading, take a look at Moving Average MACD Combo and Simple Vs. Exponential Moving Averages.)

Trailing-Stop Techniques

In all forms of long-term investing and short-term trading, deciding the appropriate time to exit a position is just as important as determining the best time to enter into your position. Buying (or selling, in the case of a short position) is a relatively less emotional action than selling (or buying, in the case of a short position). When it comes time to exit the position your profits are staring you directly in the face, but perhaps you are tempted to ride the tide a little longer, or in the unthinkable case of paper losses, your heart tells you to hold tight, to wait until your losses reverse. (Find out more, in The Stop-Loss Order - Make Sure You Use It.)
IN PICTURES: 6 Ways To Make Better Options Trades
But such emotional responses are hardly the best means by which to make your selling (or buying) decisions. They are unscientific and undisciplined. Many overarching systems of trading have their own techniques for determining the best time to exit a trade. But there some general techniques that will help you identify the optimal moment of exit, which ensures acceptable profits while guarding against unacceptable losses.

Watch: Stop Loss Order

Momentum-Based Trailing StopThe most basic technique for establishing an appropriate exit point is the trailing-stop technique. Very simply, the trailing stop maintains a stop-loss order at a precise percentage below the market price (or above, in the case of a short position). The stop-loss order is adjusted continually based on fluctuations in the market price, always maintaining the same percentage below (or above) the market price. The trader is then "guaranteed" to know the exact minimum profit that his or her position will garner. This level of profitability the trader will have previously determined based on his or her predilection toward aggressive or conservative trading.

Deciding what constitutes appropriate profits (or acceptable losses) is perhaps the most difficult aspect of establishing a trailing-stop system for your disciplined trading decisions. Setting your trailing-stop percentage can be done using a relatively vague approach (which is closer to emotion) rather than precise precepts.

A vague consideration, for example, might maintain that you wait for certain technical or fundamental criteria to be met before setting your stops. For example, a trader might wait for a breakout of a three to four-week consolidation and then place stops below the low of that consolidation after entering the position. The technique requires the patience to wait for the first quarter of a move (perhaps 50 bars) before setting your stops.

In addition to necessitating patience, this technique throws fundamental analysis into the picture by introducing the concept of "being overvalued" (a rather relative concept if I have ever heard of one) into your trailing stops. When a stock begins to exhibit a P/E that is higher than its historical P/E and above its forward one to three-year projected growth rate, the trailing stops are to be tightened to a smaller percentage - the stock's apparent state of being overvalued may indicate a reduced likelihood of additional realized profits.

The overvalued situation is muddied even further when a stock enters a "blow-off" period, wherein the over valuation can become extreme (certainly defying any sense of rationality) and can last for many weeks or even months. By rolling with a blow-off, aggressive traders can continue to ride the train to extreme profits while still using trailing stops to protect against losses. Unfortunately, momentum is notoriously immune to technical analysis, and the further the trader enters into a "rolling stop" system, the further removed from a strict system of discipline he or she becomes. (Learn some practical applications of stops, in A Logical Method Of Stop Placement.)

The Parabolic Stop and Reverse (SAR)While the momentum-based stop-loss technique described above is undeniably sexy for its potential for massive ongoing profits, some traders prefer a more disciplined approach suited for a more orderly market (the preferred market for the conservative-minded trader). The parabolic stop and reverse (SAR) technique provides stop-loss levels for both sides of the market, moving incrementally each day with changes in price.

The SAR is a technical indicator plotted on a price chart that will occasionally intersect with price due to a reversal or loss of momentum in the security in question. When this intersection occurs, the trade is considered to be stopped out, and the opportunity exists to take the other side of the market.

For example, if your long position is stopped out, which means the security is sold and the position is thereby closed, you may then sell short with a trailing stop immediately set opposite (parabolic) to the level at which you stopped out your position on the other side of the market. The SAR technique allows one to capture both sides of the market as the security fluctuates up and down over time.

The major proviso on the SAR system relates to its use in an erratically moving security. If the security should fluctuate up and down quickly, your trailing stops will always be triggered too soon before you have opportunity to achieve sufficient profits. In other words, in a choppy market, your trading commissions and other costs will overwhelm your profitability, as meager as it will be.

The second proviso relates to the use of SAR on a security that is not exhibiting a significant trend. If the trend is too weak, your stop will never be reached, and your profits will not be locked in. So the SAR is really inappropriate for securities that lack trends or whose trends fluctuate back-and-forth too quickly. If you are able to identify an opportunity somewhere between these two extremes, the SAR may just be exactly what you are looking for in determining your levels of trailing stops. (Learn more, in Trailing-Stop/Stop-Loss Combo Leads To Winning Trades.)

Conclusion
Deciding how to determine the exit points of your positions depends on how conservative you are as a trader. If you tend to be aggressive, you may determine your profitability levels and acceptable losses by means of a less precise approach like the setting of trailing stops according to a fundamental criteria. On the other hand, if you like to stay conservative, the SAR may provide a more definite strategy by giving stop loss levels for both sides of the market. The reliability of both the techniques, however, are affected by market conditions, so do take care to be aware of this when using the strategies.