The three pillars of trading are psychology (market sentiment), methodology and risk management. All three have to be in place to have a complete strategy. This is besides the need to have sufficient capital in your trading account and a proper business plan as to what you would expect to achieve from your trading business.
Traders use charts to see the historical prices and then identify certain repeating patterns and support and resistance areas. They use these identifiers to help project future activity. Charts are useful for decoding past activity and speculating that similar responses will unfold in the future when such patterns or areas of support or resistance are encountered.
Many traders believe that if they have a good robust trading system, it should be sufficient to make money. However, even if you have a system that generates signals that are 90% accurate, you must protect against the 10% that are wrong.
This leads to the most important problem for traders – their own heads. Trader psychology is the most difficult aspect of trading because people cannot and do not change easily. We are all hard wired to behave in certain ways and depending on our life experiences, habits are formed leading to certain behavioral patterns that repeat. It is these patterns of behavior that need to be modified or adapted to trading situations in order to allow us to become better traders. The need is for a strategy or methodology that is robust and that can be applied in a disciplined and consistent manner. Each time we make a trade in accordance with our plan, we build confidence and reinforce good trading habits, which ultimately leads to profits.
Let’s take a practical example and work through it to see what our thought processes need to be.
For this exercise, we will ignore fundamentals and apply our knowledge and information gleamed from charts. The price chart is the ultimate objective opinion as to the value of any instrument. It reflects at any given time the price at which buyers and sellers are prepared to transact. A chart does not prognosticate the future, even though traders believe that chart patterns and cycles are predictive and will use them to calculate the probability of a future move.
The most important piece of information on the chart is the current price bar. The current bar (or candlestick) indicates the high or maximum bull strength, the low or maximum bear strength for the period that the bar is representing. Where the price closes on the bar is where the bulls and bears have settled their differences. Thus, the closing price of the bar is the final arbiter of the market’s perception of value at that time.
If we constantly compare the price action in each bar to an average price, say a 13-day exponential moving average and measure the aggressiveness of bulls and bears each period in comparison to this average. Using this, we may be able to estimate the likelihood of whether the bulls or the bears are in control and back this dominant group accordingly. We want to be on the side of the winners, or the strongest fighters, and go with the flow. That is why it is so difficult to buck a trend. It is also why trends continue beyond their normal course and form bubbles or over-reactions and why most traders who arrive late to the trend lose money.
Back in the late 1980s I met a very interesting man, Dr Alexander Elder in his office in Queens. For those of you who might know of him, he is a Russian born psychiatrist with a passion for trading. He is the author of a book called Financial Trading. His knowledge of human behavior led him to develop an interesting indicator that is quite useful as the basis of a system of analysis to determine market sentiment, and also a useful way to generate entry and exit signals. I have added a couple of indicators to his and present below how a screen set up would look using this method.
The system consists of 4 parts.
1. A “candlestick” chart with an envelope channel set to 13 periods. The outer bands of the envelope are calculated at a 2 standard deviation from center.
2. A 2-period RSI with plot guides set at 90% and 10%
3. Elder Bull set to a 13 period exponential moving average
4. Elder Bear set to a 13 period exponential moving average
(The Elder Bull Power is calculated as the High – EMA)
(The Elder Bear Power is calculated as the Low – EMA)
What we are trying to achieve with this system is to determine when the bulls become more aggressive than the bears and visa-versa. Then, we take a trade in the same direction as the stronger of the two groups. We also note the trend direction by using the slope of the channel as an indicator. If the slope is positive, the trend is up and if the slope is negative then the trend is down.
However, the trend is only our friend until it ends, so we need some mechanism to alert us that it could possibly be ending. To this end, a count of the waves, in combination with support and trend lines, can be helpful to size up market sentiment and to ‘guestimate’ where there is a likelihood of bears or bulls gathering.
In Chart 2, we see that the trend is positive because there is an up-slope. The candle before the vertical line is a doji cross indicating that the bears and bulls are tied, the RSI is above 90% and the Elder Bull indicator is diverging from the price, i.e. it is decreasing as the price is increasing. This indicates that the bulls are losing steam.
This is an excerpt from Nov 2011 issue of Forex Journal.
