How to trade-Part 3 Complete guide for intermediate traders
PTS provides simple examples on how to clearly identify favourable markets for your trading style. Internalize these methods if you want to win
This training page questions on market selection and signal to noise
Contents: Shows several methods of
market selection, explanations of the how and why trending markets are
good for you.
Still here? Good choice. After this page there will be a fun trading
game to enjoy before moving to a basic trading strategy
Take some inspiration from this video of two methods in a combination. Note how both need to be in position for a trade. Winners are allowed to run.
The lower indicator is the Precision Index
Oscillator and PLA Dynamical Moving average.
The Precision Index Oscillator known as
Pi-Osc detects bottoms and these are bought when PLA Dyanmical
signals a trend change to up.
This is something you can use once you raise
your trading education to a good level.
Begin part three of the beginners guide.
I have sufferred great pains to learn all these points, you
get them free.
Lets get started.
The method of instrument selection for trend following (
How to choose what to trade and what to avoid )
If you grasp the concepts in this section it will make a
huge difference to your performance in the long run even if
you end up choosing a different style for your bread and
butter trading.
Unfortunately this is the
hardest point to convey to others. As most comment that I have
a gift that they do not have. This is of course complete
rubbish, it is more likely that they are too lazy to seek the
best instruments. We all have eyes and those eyes see exactly
the same things. So the first thing to explain to you is to
see what you see, not to see what you want to see. Listen to
your subconscious mind when it tells you that something is
wrong. If I had not grasped this important factor which came
to me by self education and relentless system testing, then I
would never have achieved the huge returns I made.
Learn to read the charts and understand good and bad price
action
Lesson 1. The trend is your
friend and randomness - unpredictability - noise are your
enemies.
Below there are two charts shown over
the exact same time period. Please take a long hard look at
each one.
ff
Consider which example appears to be more suitable for
trend following?
You can decide this
by looking at some obvious factors.
1. The range of the
highest and lowest prices in the two charts
2. The
ferocity of the movements that go in the OPPOSITE direction to
the main trends.
3. The perceived predictability of the
movements
Question 1
Which instrument is more suitable for trend following
trading? Assume bid - offer spread is equal for both
If you noticed that one of the examples is many times more
suitable than the other you can be pleased with your visual
cortex for helping you see it.
Factor 1
One chart has a high to
low range of approximately 200 to 800 which gives us a simple
ratio of volatility. 800 / 200 = 4. Compared to the other
example which has a high low range of 160 to 360 . Which gives
a volatility ratio of 360 / 160 = 2.25. So for factor 1 we can
see there is more movement in chart 1 than in chart 2 ( 4 /
2.25 ) = 1.7 times more to be exact.
Factor 2
One chart has many many swings which are contrary to the
direction of the trend and all these moves will cause you to
lose money. The other example has smaller swings against the
major trends and there are less of them. This means less
chance of your stop loss getting hit and more chance of riding
a big trend and making a big profit.
Factor 3
One chart is clearly more predictable than the other. If
you cannot see which one it is then you will never be a good
trader so for this there will be another question. Considering
that many people find sticking to a trend somewhat difficult
it pays to notice that if you are riding a rising trend which
increases each week, your are much more likely to able to stay
with it ( correct procedure ) right up to the end of it. But
if you get on board a horrible chopping volatile trend then it
is psychologically much harder to ride through it and the
stress levels felt will be much greater as your money is
gaining and losing with more ferocity.
Question 2
Which instrument in the chart
ABOVE is more predictable?
Think about the benefits of selecting
more predictable instruments to trade.
1. You will be
right more often therefore make more profits.
2. You can
use tighter stops and achieve better risk reward ratios
3. Your account will be less volatile and suffer smaller draw
downs
4. You will be less stressed and more relaxed.
Example 1 has a huge amount of "noise" compared to example
2. Higher noise means you get a lower signal to noise ratio.
High signal to noise ratios are exactly what trend following
systems need to perform well. See below.
What is
noise?
Noise
is dangerous to you when trading as noise means a wider stop
has to be used therefore your trade size will need to be
reduced to keep risk levels to a sensible level.
Low noise
means tighter stops can be used which means a bigger trade can
be placed without increasing the risk from entry price to your
stop loss.
Noise is the fluctuation within the major
trend. The major trend is the signal.
Here is a simple
formula which will stand you in good stead for assisting you
in instrument selection for the rest of your trading days.
Signal divided by Noise = Signal to Noise raito ( SN
ratio)
In the above stylised example the red line
representing the signal or major trend is going up from 115 to
142 giving us a signal of 142-115 = 27 and the noise at the
maximum point of deflection is ranging from 119 to 132 which
gives us noise of 13.
Signal 27 / Noise 13 = SNr of
2.07
In trend following it is wise to seek instruments
which have a high historical average signal to noise ratio.
Lesson 3. The spread is wide? Don't
dismiss the market for this reason.
Please pay full attention to this section as understanding it
is vital to understand it.
Think it through carefully
as you read. I have explained above that "noise" is the enemy
of the trend following trader.
So let us consider the
conditions that lead to high or low noise market behaviour.
Noise is caused by day traders - scalpers ( people who try
to steal a few points in a few seconds or minutes)
The people are not trend following traders and are looking for
an adrenaline rush experiences as a primary objective and 95%
of them will be regularly losing money from their foolish
activities and they are creating NOISE.
Think about
this, which of the example bid ask prices below are more
likely to attract the people mentioned above?
Question 3
Which market
instrument is most likely to have a high noise and low signal
due to attracting day traders and scalpers?
Remember
these people want to be in and out of the trade with a fast
profit.
Think now about the opposite situation. Remember you
are looking for a market which is going to be trending and not
suffering from high noise output. You will pay a little more
initially for the wider spread but will have more chance of
getting a relaxing ride on a long trend.
Question 4
Which market instrument is
most likely to have institutional clients and long term
investors buying it for a long term trade?
Remember these people want to be in for a long period of
time and might hold their position for several years or more.
They do not care about paying a bit more in costs as they
believe the instrument will make a big prolonged movement.
Basically the point I am trying to get over to you here is
that the moves in wider spread instruments are typically much
more reliable and real.
In contrast to
this the noise levels in tight spread instruments cause a huge
amount of "false moves". I have added a pair of charts to make
this point crystal clear.
Chart 1 below
has a spread which is 189-189.5 ( in a percentage this is
around a quarter of a percent )
Chart 2 below has a spread which is wider at
108-19 ( in percentage this is just under 1 percent)
Question 4
Which
market of the two above is more favourable to trend following?
From my perspective I am always shocked that most
people ( even highly intelligent ones ) never seem to get this
point, they just cannot see past the first deception of paying
a higher deal cost as being a barrier to profits. True it is a
barrier to profit, but once you balance it up with the amount
of money you will lose on all the false moves generated by
high noise and tight spread instruments you just have to get
it. Don't you?
Well saying it as it really is, if you
don't get it now you might as well resign yourself to being a
losing trader for most of your trading life.
I have
enjoyed 13 straight years of positive returns from 25% per
anum to 16,000% per anum because I understand this point.
Lesson 4. The spread is tight? Think it is good to
trade? Think again!
There are many many markets
in the stock market. The tightest spread can be found in Forex
( foreign exchange ) otherwise known as FX.
For
this reason forex is full of noise. In percentage terms the
movements in forex compared to stocks and futures are usually
very low. Whilst the low cost to entry is appealing to most in
the same way that a cheap holiday appeals more than an
expensive holiday, the same points above apply to these FX
markets.
PENNYWISE IS OFTEN POUND
FOOLISH
Of course there are times when
these markets will go into a smooth and long lasting trend,
just as the Swiss franc did before pegging to the euro. Indeed
I actually jumped on that nice trend in the franc and did very
well from it. But most of the time these choppy markets will
not be worth a second glance as there is often more noise than
there is signal.
This means lots of whipsaw losing
trades and not many trends. If you don't believe me then do
your research on spread versus range.
Look at
the highest high over 1 year and deduct the lowest low for 1
year. This gives the range. Then compute the size of the
largest contra trend noise movements. Divide range by noise
and compare different types of markets.
For a more detailed explanation of the benefits of
understanding signal to noise see the information here
If you have a questions then please send me an email
I hope you got the points above.
EVERYTHING
THAT GOES WRONG IN YOUR TRADING IS YOUR FAULT -
LEARN TO BE ACCOUNTABLE-
ACCEPT
RESPONSIBILITY FOR YOUR OWN MISTAKES - OR YOU WILL FAIL.
Congratulations If you understood all the points above. Hold on...Before you head over to part
3.
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About
Precision Trading Systems was founded in 2006
providing high quality indicators and trading systems for a wide range of
markets and levels of experience.
Supporting NinjaTrader, Tradestation and
MultiCharts.
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PPage updated July 8th 2023 from
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