Since we are going to be looking for the beginning of trends, we are, by definition, going to be looking at reversals in the markets. First and foremost the trader has to distinguish between whether a particular trade is picking a turn in the market or picking the edges of a correction within a larger trend. The former is trickier than the latter; the former also occurs less frequently than the latter. Both occur across several time horizons in the market, so the next thing the trader must determine is what time horizon he is operating in: short-term trader (scalper), swing trader, or intermediate-term trader. The following sections discuss the rules for applying the Model to each of these time horizons. This example will demonstrate the procedure for the long side of the market. Obverse instructions apply for the short side.
Scalpers
For day traders who apply the Model on a short time-frame, extreme readings in the DSI data are used as a yellow flag indicator for a potential trade. The extreme reading will serve as an alert that the market is primed for a reversal. The market is in a chaotic state and is likely to reverse course, provided the appropriate activity by the
OTFT materializes during the next day's trading session. That "appropriate activity" is range extension.
When the DSI is 20 percent or lower, the scalper will go long on buying range extension the following day, placing a stop under the low of the day. Let's call the day he enters the trade Day 1. After the close of Day 1, the DSI will be reported. If the DSI has jumped above 50 percent, the trader must be careful because the measured move through the parabola is not unfolding. The jump in the DSI is too much, too soon. Remember, if the DSI jumps back across the mid-point, it may have neutralized the extreme bearishness and any range extension down will likely meet with success in terms of resuming the down-trend. This is not to say that the market will necessarily reverse back to the downside again; range extension will determine that. Rather, it is an alert that if selling range extension occurs on Day 2, the scalper should exit the trade on that selling. The market may in subsequent days still unfold to the upside; it just may not do so in a manner which corresponds to his time horizon; the scalper doesn't have the luxury of waiting around to find out.
However, if buying range extension occurs on Day 2, the market is still primed to the upside. Increasing sentiment is being combined with buying activity and the market is trending higher in the short term. As soon as the buying range extension occurs on Day 2, the stop is moved up to just below the lows of Day 2. If those intra-day lows are taken out, a neutral intra-day has formed, selling is present, and the market may reverse back to the downside. Once again, the short-term trader doesn't have the luxury of waiting around to find out. He needs things to unfold pretty much according to script, otherwise he needs to be out of the market.
If at the end of Day 1 the DSI registers in the extreme bullish territory of 80 percent or more, the market is likely to be entering a trading range and the trader needs to have no selling range extension—and ideally to have buying range extension—in subsequent days in order to stay with the trade.
If on Day 2 the DSI increases but not above the 50 percent level, the extreme bearishness of the previous trend hasn't been neutralized per se. The slowly changing mix of expectations permits the more orderly progression up the parabola.
The goal of the scalper is to catch the edge of the short-term parabola so as to benefit when the short term begins to influence the longer-term parabola. This isn't going to happen every time. Sometimes the trades are going to fizzle out after a day or so. Sometimes the trade is going to get stopped out on the same day it was entered. But that is part of trading anyway and certainly part of trading in the short-term time horizon.
Stop Strategy. The dollar amount of exposure a trader is willing to take on has to be determined on a case-by-case basis and is commensurate with the trader's account size and exposure tolerance. But the starting point is that the trader is only going to be willing to risk x amount of dollars per trade. Then, using the strategy previ-ously outlined, this dollar amount will dictate how many contracts the trader can trade on any particular position. So, in order to make full use of the Model in the short-term strategy, it is best to have a plan to vary one's volume depending on the situation.
When an extreme reading alerts the trader to a possible opportunity he is going to go with range extension the next day. On that day, Day 1, if the initial balance is relatively narrow, the trader is going to trade a multiple number of contracts. If the initial balance is wide, the number of contracts will be relatively few. In the ideal un-folding of the trend from the reversal, the market is going to have a normal day, or even better, a normal variation day or trend day in the direction of your trade.
The reason you trade lower volume on the wide initial balance day is three-fold:
1. The large distance between range extension triggering a trade and the stop at the other end of the initial balance equates to a large dollar amount of exposure.
2. On narrow initial balance days the market is set up for a possible trend day, so it would be highly profitable to have more volume on such a day.
3. The big price move may have served to neutralize the extreme expectations (sentiment reading)—but you'll only know after the close when the survey is conducted.
Therefore, the trader is well advised to vary his volume so that he is trading lightly when the market may not be poised to move a great deal, positioned more heavily when it is, and risking the same dollar amount in both situations.
Caveats. Several years ago some studies were done to refine the definition of range extension in order not to place too much emphasis on a single tick exceeding the initial balance period. Basically, the results were that in order to avoid a fake-out, 4 ticks of range extension were necessary to qualify as range extension. Scalpers may be more comfortable using this definition of range extension, but I don't want to get too involved in trying to "fit" the methodology to all past data. I only mention it in passing for particularly conservative traders. Again, trading is like any business and some judgment is involved in all decision-making. I'm not going to try to computerize this because I don't think a business can be run by computer.
Another caveat is that for bonds and currencies, this signal is generated only if the Profile registers range extension up and if the overnight session high is also taken out. That is, if the DSI is at < 20 percent in the bonds and the market gets range extension up the next day does not exceed the previous night session high, no signal is generated. Only if range extension and the overnight highs were exceeded would a signal be given. (Obviously, this works in reverse for extreme bullish readings.) This means that situations are going to occur which have wide parameters, but that's just the nature of trading and the nature of markets sometimes. If the stop loss price is too far away for your loss tolerance, then you simply don't play. That is another benefit of the stop loss strategy previously described.
Swing Traders
For the swing trader operating with a slightly longer time horizon than the term trader, entry into the market is essentially the same as that used by the short-term trader. Because the swing trader has more time to let the market unfold, his exit strategy is designed to give the market a little more time than the scalper uses.
The swing trader will leave the stop under the low of Day 1 until a subsequent day gets selling range extension. This is viewed as the sellers' attempt to test the market on the downside. If they are unsuccessful in their attempt to push the market down, after the close of the day which got this selling range extension, the trader will move his stop to just under that day's low. While this strategy may result in getting knocked out of more trades at a loss, it will also give the market a chance to unfold into a trend by gradually moving through the parabola.
The intermediate-term trader might use the entry strategies previously outlined to enter the market, but ideally he is looking for a day which marks a change in direction for the market to start building a new LTMA chart and begin to monitor for imbalance.
From that LTMA chart he is going to match up any imbalance of activity with extreme readings in the BC, as an indication that the market is getting ready to develop a new trend and progress through the parabola. The trades he enters will be less mechanical
and more judgmental in terms of establishing a position as the imbalance builds and the BC starts down the parabola—perhaps led by the DSL
This means he will be looking for a nonfacilitation of trade day like a non-trend day, a neutral day, a trend day failure, or a 3-1 exhaustion day from which to start a new LTMA chart—especially if this occurs on an extreme reading in the DSL The phenomenon might be likened to cognitive dissonance. Everyone is bullish, but the speculative buyers (OTFB) are no longer coming into the market (a non-trend day), or else the buyers are failing (a buying day which does not facilitate trade, or trend-day failure), or exhaustive buying (3-1 exhaustive day). These are also the types of action which occur at the edges of trading ranges, as dictated by the BC, and especially when the DSI is at an extreme.
From the extreme readings in the BC (or the 50 percent level when that constitutes a relative extreme as previously described) as the trend begins to unfold, the BC will move in the same direction as the imbalance on the LTMA chart and progress through the parabola. As the market moves through the parabola and when the BC is in the Coherent Market part of the Model but not yet in the extreme reading zone, the market is poised to continue its trend; any market activity (range extension) opposite the intermediate-term trend direction is taken in stride and perceived as a breather for the market. It is only when the sentiment numbers are in the extreme that the opposite market activity creates a reversal in the trend. Other activity against the trend is seen as the normal progression.
In the course of the intermediate-term trend unfolding, invariably the short-term trend is going to reach a top as marked by an extreme in the DSI and range extension against the intermediate-term trend. The intermediate-term trader may decide to exit the market in that range extension. However, given his longer-term horizon, he is likely to give the market the benefit of the doubt, so to speak, and wait to see if the market is going to unfold in the Area 1-2-3-4 pattern previously described. Alternatively, he will use the shorter-term strategies previously mentioned to monitor the market.
If Market Vane has extreme bullish readings but the LTMA chart is forming the top of Area 2 as evidenced by an increase in selling activity (i.e., a 3-R day, a neutral day, a non-trend day, a 3-1 day at the top which does not facilitate trade), then the market is entering a chaotic state and the trader is going to go short on that close, or the open the next day, or on range extension down the next day. As with all business decisions, this requires some judgment.
Let's take a look at some actual market examples to help develop that judgment.
The next four chapters take four markets, one at a time, and examine how the Model applied during the time period when this book was being written: December 1995 through August 1996. As stated at the outset of the book, examples used to illustrate certain points would be taken at random, rather than seeking out the perfect example or creating fictitious examples.
An important distinction must be made before proceeding to the examples.
Analysis is not a trading methodology. The markets can be analyzed to death; it's called analysis paralysis. No approach is going to perfectly convey the conditions of the market all the time—nor is that a trader's goal. The trader's goal is to protect trading capital and increase that capital through the judicious application of analysis.
This does not mean one will always have a trade to make, nor does it mean that the Model will give instructions each and every day. Instead, the Model will alert you to times when conditions make it advantageous to enter the market and when it is propitious to stay out. In the end, that is all one can ask of a methodology.
The Model is a method of analyzing the market, but strategy varies according to the time horizon of the trader. Sometimes a trade is going to be triggered and sometimes it is not. Most of all, since one of the premises of the book is that all
markets are the same, one must apply the Model as a decision-making tool, not a computerized mechanical system. A restaurant cannot be run by a computer system, nor can a farm, nor can a Fortune 500 company. In each of these, as well as in trading, decisions must be made.