People are often impressed at first acquaintance with chartism. If you look at a bunch of charts, you may see, in retrospect, many patterns that seem to have aworkeda. But, as with fundamental a.n.a.lysis, what works with hindsight is neither here nor there. It makes no more sense to ask whether charts aworka than it does to ask whether homeopathic medicine works, or allopathic medicine, or psychoa.n.a.lysis or fundamental a.n.a.lysis. The only thing that matters is whether a tool works for you, or for your doctor, shrink or money manager.
Not being what could be described as a chartist, I just want to set out here those aspects of price a.n.a.lysis which I have found to be helpful in currency tradinga" those which work for me. Since there are many charts in Currency Bulletin, casual and cursory readers have sometimes wrongly thought CBas approach to forecasting was price-based. Some of the charts provided in CB are indeed included to allow the reader to atake the patientas temperaturea. But their main purpose over time has been to demonstrate relationships between currency movements and various other afundamentala data, such as money supply, inflation, interest yields, trade, economic activity et al.
In the special case of the relationship between price and IMM open interest, we are trying to discern a feedback process. In this, the daily price movements in the lMM contracts are used to help interpret the significance of the speculative open interest in order to see if speculation holds any implications for currency prices. Are you with me? This isnat what you would call achart a.n.a.lysisa, though you might call it atechnical a.n.a.lysisa. But there are things that are which all of us can use in the currency markets for our profit. Here are the cherries in chart a.n.a.lysis.
Using Trends
The first is what Iave called the trend-line imperative. You all know the cliches. aThe trend is your frienda and aa trend is a trend till it endsa. Well, in the tautological rhyme lies a nugget of gold, which may alone explain the superior performance of the futures funds (mainly trending systems) over time. Markets, we are told, only trend 15% of the time (the rest of the time they are ranging); but by definition, when they are trending is when the big moves happen. Moreover the big moves are quite often made in a narrow range, which can surprisingly often be defined at an early stage in the move.
Thatas the cherry in trend1ollowing systems. They are useful when, and only when, you have been able to define a more or less narrow trend channel early on. All the rest of the time they are useless.
Of course itas only with hindsight that we are able to know we have defined a trend channel early on. Pure trend-following approaches that use only price will be constantly whipsawed by ranging markets and ill-defined trends. Thatas not news: trend followers are aright for the trend and wrong at each enda. They know this, and they expect to make a lot of small losses along with a few big wins. But there is this difference between a trenda" following system and a pin, namely that on those occasions when the market offers a clearly defined trend, the trendline imperative keeps the system in, whereas a pin lets you out half-way along.
The trendline imperative, letas be clear, says that you must stay with a trend until itas broken. Thatas all it says. It does not say you must get out when the trend is broken: in that event it simply no longer applies. Trends have no predictive value: they just prescribe ano actiona in certain circ.u.mstances. The golden nugget lies in the fact that trends often run on much further than we can possibly imagine a"and much further than we can predict on the basis of the most perfect afundamentala a.n.a.lysis. So on those occasions when you happen to be riding a well-defined trend, you have a special advantage if you adhere strictly to the trendline imperative. It may be this small statistical advantage which has enabled some disciplined trend-followers to abeat the marketa over long periods. If it does nothing else, the imperative removes fear and greed from the equation while itas operative.
We shall consider later the question whether markets tend to trend because that is their nature a"or whether some markets trend more than would be statistically normal. It is certain that the dollar did trend in a remarkably well-defined fashion in the 1980s a"though that means nothing for the future.
Unlike pure chartists, we have other tools than price for a.n.a.lysing the currencies. How do we make use of trends? Answer: we cherry-pick. We dona t use trends a" or any other aspects of charting (see below) a" unless we see the cherry hanging there. In other words, if as a result of our independent a.n.a.lysis we hold a position which subsequently develops into a well-defined trend, then we can take advantage of the trend line imperative a"to hold us in a winning trade which we might otherwise leave too early. On the odd occasions when this happens we hope to pin down the statistical advantage.
Consensus Realism
A lot of currency partic.i.p.ants use charts a"perhaps because the fundamentals have proved so confusing to so many for so long. It pays to recognise this. If certain price patterns producesome kind of consensus among the players, we shall not only not fight it: we shall try and profit from it. This approach to charting has been labelled aconsensus realisma. It acknowledges that some patterns that chartists think have predictive value can be in a way selfa" fulfilling.
The more obvious the pattern, the more realistic we should be about not standing in its way. One thinks first of the big-ticket items like the ahead and shoulders*a reversal, and the abreak-out*a from long consolidation ranges.
Given independent tools of a.n.a.lysis, we are not going to initiate positions in the event we should see such patterns formed. But if we already have a contrary position, we would consider closing it quickly; and if we have an aligned position, we would let it run until any chart-driven thrust that might develop ran out of steam. In any event, we would be on the look-out for the extreme of the chartist thrust, in order to go contrary.
The chart above depicts the big head and shoulders pattern in the D-Mark, at the peak of the dollaras great bull market in 1985. The break of the aneckline*a at DM 2.97 clearly signalled a get out of the waya .But the break down to DM 2.85 amid extreme bearishness of the dollar shouted for a contrarian trade, going long of the dollar for the ride back to DM 2.97a" ahead of the famous New York Plaza meeting, when the dollar was once again ready to follow the line of least resistance, which was obviously down. Without hindsight, no kidding. Note that the dollar retraced all the way back to the original neckline break of DM 2.97, blowing away all the short-term traders who waited for the break to sell it.
Patterns that Work
Chart patterns that work, as I say, are the ones that work for you. The test, as always, is the bottom-line profit and loss account, not hindsight. Very few work for me. But there are a few exceptional souls who have pa.s.sed the bottom-line test over long periods of time using nothing but chart patterns. Doubtless they bring to the party an acute market sense that has nothing to do with charts, as well as great discipline.
Since the advent of computers, quite a lot of work has been done on the predictive validity of price patterns. The conclusion of this work has been that price patterns taken as a whole, do not have predictive value a"at least this was the conclusion in the 1960s, when academics came to agree that prices traced out a random walk. This conclusion has not been publicly disproved. But more recently it has come to be recognised that changes in volatility can be predictive. In particular, significant increases in volatility tend to coincide with turning points. The Mint Group, for one, makes no secret of the fact that it uses volatility as an early warning indicator of trend changes in its computerised trend-following systems.
Speaking only for the currency markets, there are 3 patterns a.s.sociated with volatility which can be useful to us, I think.
1) The key reversal* .This pattern is highlighted in a single bar stroke in the chart below, which ill.u.s.trates all three apatterns that worka .Itas a simple formula which is easier seen than described. A price reaches a new high (or low) during the day; but its closing price is lower (or higher, if the trend is down); and its daily range is outside that of the previous day. Strictly speaking, the key reversal applies to futures* prices; and a anew higha (or a new low) is defined as a new high for specific futures contract, like the IMM June Yen. This pattern is more often seen at an extreme than in mid-trend, on the evidence of the dollar parities of the past decade. In terms of psychology, this must be that familiar moment when late speculators are capitulating to the trend with some abandon, while existing position-holders are cashing in at prices they barely hoped for. It is most reliable as a turning point when volatility is greatest.
The akey reversala is either apparent as a move that happens in one day (a key day reversal*) or in a week (a key week reversal*). Itas most reliable when the range on the single key reversal day encloses the range for an entire week a"as happened in June 1989 (see chart). On the rare occasions when that happens, pay attention. Itas a cherry worth picking.) 2) aTrampolininga*. I think this term may have been invented by David Fuller, editor of FullerMoney. Volatility sometimes shows, as depicted in the chart above, in several violent bounces; and again this is a pattern which seems to occur more often at extremes than in mid-trend a" in other words they are bounces from a floor or off a ceiling. Again, itas worth paying attention to. The above chart ill.u.s.trating key reversals is also a good example of trampolining.
3 ) Island reversal. Another pattern that seems to occur more often at extremes than mid-way, this pattern is a great favourite of chart followers. So aconsensus realistsa will give it due weight. It has more in common with the key reversal than with the trampoline, but may not be too reliable in the currency markets a"if only because the price agapsa that cause an island reversal only exist in the IMM, not in the 24 hour interbank market. Psychologically, you could say that when you see a trading area being left behind like this, the trend is aexhausteda. New speculators have plunged into a vacuum and are easily countered by older positions moving out.
When we see any of the above patterns confirming an original diagnosis that a trend is due for reversal on the basis of our sentiment gauges, we can sit up and take notice.
Most of the other patterns beloved of chartists consist of breakouts of one form or another from consolidation* areas. The realist will keep an eye ou t for such patterns because of their self-fulfilling power. They seem to me mostly to be patterns which work better in retrospect than in real time, but I believe they can be helpful for timing when they confirm an existing a.n.a.lysis. The breakouts in the Swiss franc and D-Mark in mid-1990 are examples a"though note that the DM offered a trap (a afalsea breakout) in May. The wella" defined, short consolidations include the awedgea*, the aflaga* and the apennanta*, patterns that are well described by their names.
In all these cases what is happening in theory is that a phase of uncertainty is being resolved in one direction or another.
Support and resistance levels can have validity because of the number of people who believe in them. But they may be of more use to very short-term traders than to those trading the multi-week moves.
Of the charting systems developed by R. N. Elliot* (aElliot Wavea) and W. D. Gann* and I know-not who else, all one can say is ause them if they consistently help you make money, but watch out that you donat fool yourselfa. The bottom line is what counts.
Finally, if currencies tend to trend in narrow channels more often than they should do by pure chance, why should this happen? What can be going on? Obviously, any move starts with an imbalance between supply and demand for whatever reason. Once started, a familiar process is liable to takeover a" namely that those who are congenitally disposed to buy rises and sell falls are drawn to the market, in increasing numbers.
Included among these will be trend-following chartists; and there may be a further phenomenon which comes into play here. Many price-based players are highly sensitive to risk-reward figuring. They are on the lookout for situations which allow them a tightly limited loss a"normally controlled by a stop* order a"with an open-ended profit potential. Such a situation occurs when a rising price has eased to the bottom of its up trend channel (or when a falling price blips to the top of its channel). At this point it seems to offer a very low risk play for the trend-follower: the price cannot fall more than x points without breaching its trend channel, in which case the simple trend-follower wants to be out of it anyway.
Consequently there may be an unusual concentration of speculative buyers right near the point which defines the trend a"and a certain absence of sellers, since so many traders would not dream of selling while the trend is intact. Thus the trend perpetuates itself: and the easiest route for it to take is a channel, with a well-defined southern border, if itas an uptrend, or northern border if itas a downtrend.
Those then are some of the cherries to be found in price a.n.a.lysis. Thereas no doubt that they can help us, not only in corroborating our a.n.a.lysis of the underlying trend, but also in alerting us, at times, to the need to re-examine the equation. Looking for inspiration in charts does have the advantage that it puts the right brain* (the right-hand hemisphere of the brain) to work: and most inspired trading decisions come from a balanced interaction between the left, a.n.a.lytical side and the right, pattern-recognising side.
In so far as we do use price patterns and open interest patterns to help us trade, we are using what is generally called atechnical a.n.a.lysisa. Thatas fine: letas use any tools that help us trade.
Now itas time to turn from a.n.a.lysis and forecasting to actual trading.
PART II.
Introduction.
aItas difficult enough to develop a method that works. It then takes experience to believe what your method is telling you. But the toughest part is turning a.n.a.lysis into money.a Robert Prechter Forecasting is one thing: trading is another. Here are four proven rules for turning good forecasts into good profits. They can be used as a sort of checklist for regular consultation.
1) Know your reasons . if we know what weare doing, we make a trade for a reason or reasons. We must define the reason and keep it in mind; and if it is no longer valid we must get out, no matter what.
2) Know your risk. we win some we lose some. But we must know exactly how much we can lose on any trade. We win by winning, but we get wiped out by losing too much.
3) Know your time-frame. we trade for a reason. But prices fluctuate and adverse fluctuations are the hazard to our position. We must know our own time-horizon so that we can distinguish those fluctuations that are random from those that challenge our rationale.
4) Know your self . do we really want to win? Why are we trading in the first place? Do we tend to be too early or too late? What risk can we handle? Can we cut losses? We cannot win until we know who we are.
Winning in financial markets is a state of mind, or so it seems to judge by the accounts of those who have been successful in building great fortunes, with consistency , over long periods of time. Paradoxically, the man to whom the greatest debt is generally acknowledged by successful traders is Jesse Livermore a"the legendary trader who thrived in the early part of this century. The reason for his fame is the account of his trading experiences that survives in the cla.s.sic Reminiscences of a Stock Operator by Edwin Lefevre a"a book which has perhaps been more influential than any other single book on financial markets. The paradox is that Jesse Livermore, one of the most admired traders that ever lived, failed so utterly in acc.u.mulating lasting wealth that he blew his brains out in the menas room of the Sherry N ethera" lands hotel in New York. H e knew it all, except for risk- management.
We get some idea of the mental att.i.tudes required by great traders in anecdote and historical accounts, of men such as Jim Fisk, Jay Could, Bernard Baruch, Richard Wyckoff, Warren Buffet and the odd Rothschild and Rockefeller. One of the most valuable accounts ever a.s.sembled a" Market Wizards by Jack Schwager a"appeared in 1989: a brilliant series of interviews with many of the great traders of today. If you do nothing else, you must read the above two books.
The Big Hitters by Kevin Koy, published by Intermarket is also valuable for two or three chapters. This, and The Alchemy of Finance by the master-investor George Soros, are of interest because they cover trading in currencies as well as securities and commodities.
CHAPTER SEVEN.
aI began to realise that the big money must necessarily be in the big swing.a Reminiscences of a Stock Operator In forecasting, we try to be right: in trading we try to do right. Your reason for making a trade dictates your time horizon ; your stake is dictated by the risk you yourself can handle. you can take pot-luck in financial markets. or you can decide, once and for all, that you will never, ever, trade without defining your reason, your time-frame and your risk. This is something we can all do just by deciding so. Getting to know ourselves may take time.
Markets fluctuate and their fluctuations subject us to fear a" fear of loss or fear of loss of profits. Fear is probably our chief enemy when it comes to translating forecasts into profits. Some would say greed, or hope, is an equally dangerous enemy. Anyway, these emotions of fear and hope are the means by which the market takes our money away.
Of course it is really we who rob ourselves: when I say the market takes our money away, I mean this. The currency markets, remember, are a zero-sum game*: total wins are exactly balanced by total losses. But it quite often happens that a big majority of partic.i.p.ants share the same forecasts (in the case of a bullish or bearish consensus). Since the majority cannot win, many of those with the right forecast have to be outwitted. They are outwitted by the marketas price mechanism which ensures that prices are distorted by fear and hope in such a way that losses balance gains. The losses are sustained by those who succ.u.mb to their emotions.
Price has to be the ultimate test of our strategies. Hopefully our reason for making a trade will be more often right than wrong. But even when it is right, we shall suffer adverse price fluctuations; and we have constantly to try and ensure that we are not tricked out of the good positions by arandoma adverse fluctuations a"which is the marketas vocation. We have all been tricked out of good positions by adverse price movements. We probably all have also had the experience of making a calculated currency switch and more or less forgetting about it. As often as not when we remember the position again months later, we find it has worked out very well. We did the right thing for the right reason: and we were not tricked out for the wrong reason a"because we werenat looking! By not focusing on the adverse fluctuations we did not worry about them. This apparently accidental strategy is something we can emulate intentionally.
It helps to run through the above checklist as soon as we diagnose fear at work. If we do, we shall find out that most often of all, what is wrong is that we have forgotten our time-frame* , or that our time-frame has been twisted out of synch with our reason for holding a position. Having forgotten our time-frame, we have forgotten what we originally knew a"namely that we couldnat rule out quite significant adverse random fluctuations.
For example we might have been long of the Yen in August 1990, on the expectation of ma.s.sive repatriation of foreign a.s.sets by j.a.panese investors a"and then scared out of our position by a set-back (which proved very temporary) on the jump in the price of oil. The jump in oil prices had nothing to do with our reason for holding Yen and did nothing to negate it. Also we must a.s.sume that changes in oil prices and the like are instantly discounted in the currency markets; the effects may be unfortunate but they donat affect the argument for holding our position. Finally, our price horizon for a rise in the Yen was measured in months; it was not based on a temporary perception of the market-place, like the knee-jerk reaction to oil prices, but on a physical event, namely big demand for the j.a.panese currency by j.a.panese inst.i.tutions.
This is one of the distinctions we must always be making a"between perceptions and actual physical events. If our position has been taken in the expectation of certain events taking place over time, it doesnat make sense to abandon it because of a temporary change of mood.
Partic.i.p.antsa time-frames
The princ.i.p.al market-makers in the currencies are the major banksa dealing desks and the seat-holders in the futures markets: their time frame has to be measured in intra-day terms, if only because they have to close their books, as a rule, at the end of each day. Listen to Tom Baldwin a local in the Chicago bond pit, describing how he is selling (as an intra-daytrader) when Salomon Bros, or whoever, comes in to trade in size: awhen the market gets strongest a" when it may be at a top a"large-sized orders come in to buy and the brokers look to me, and I sell to thema (from The Big Hitters by Kevin Koy). Tom Baldwin made a virtue of the fact that his time-frame was different from that of commercial operators.
Commercial hedging operators have their time horizons dictated largely by delivery dates and payment dates for goods and services. In both these cases the time-frame is imposed on the partic.i.p.ants by what we might call exogenous circ.u.mstances, which have nothing to do with the rhythms of the marketas natural fluctuations.
Your freedom to choose your time-frame is too valuable to lose. Investors and margined speculators, on the other hand, can choose their own time-frames. This is one of their positional advantages, to use a favourite notion of Larry Hite* , one of the founders of Mint Investment Corp* a"one of the largest of the futures fund operators. Investors and speculators can choose. Obviously it makes sense to choose time frames which match any natural rhythms that can be discerned in the currency markets. And there are several.
The basic unit in all markets is of course the trading session; but the currencies being genuine 24-hour markets, we could say the basic unit is the day. The day is best measured from 7 a.m. London time a"the start of the European trading day. Why? Because Europe (London in particular) is the biggest currency trading centre and because the start of the European day overlaps for an hour or two with trading in Tokyo (the second biggest trading centre) along with Hong Kong, Singapore and other useful markets. Thus the hour from 7-8 London time can be seen as a sort of daily fixing* of the major currency parities: it is usually the most active hour in the 24. And note that this hour quite often includes the extreme price, if the new day marks a change of direction.
But the day is too small a unit to be a useful time frame for most speculators. The smallest useful time frame, I think, is one week a"or 5 trading days a"being the unit of the smallest normal correction to the minor multi-week move. And the multi-week move is the basic unit of interest to the speculator.
Market Time Cycles
It is a long-observed phenomenon of the currencies that turning-points most often occur at weekends a"that is on Fridays or Mondays. In the old days a" in the early 1980s when the financial markets were much preoccupied by the release of the US money supply figures on Fridays (n.o.body pays any attention to them now), this phenomenon was so evident that Currency Bulletin dubbed it athe weekend reversal rulea. But the weekend reversal rule has continued to operate usefully ever since.
What it means is that we measure off the multi-week advances and corrections in the underlying trend in whole weeks. Over the years one has noticed that some numbers occur more often than others. Common numbers for duration of the prevailing trend are 3,6 and 12 weeks a"sometimes 9 weeks: for corrections 1,2,3 and 6 weeks. Price cycles being afractala, as noted, we often see major movements progressing in similar monthly units a"3,6 and 12-month segments being more common than other numbers.
You wouldnat expect perfection in such numbers games. The issue is whether they are useful. And I have found they are a"not just because the numbers have recurred with statistically significant regularity. Perhaps the divisions are useful just as much as a discipline for monitoring the progress of trend movements. When weave had a 4-week move, we are not expecting it to reverse, because it is historically improbable. Lt will not reverse if it turns out to be a 5,6, 9-week move or whatever: it will only reverse if it turns out to be a 4-week move! Anyway, the point is that this weekly monitoring can help you stay in a a gooda trend a"which means to stay with your underlying rationale when it is proving correct: There is another strange frequency in the currency markets. Sceptical readers who are used to prejudging events rather than deciding them on the basis of the empirical evidence can skip here. The currencies a"and no other markets as far as I can see a"are unusually susceptible to the lunar cycle, or more specifically to full moons. Perhaps the reason why currency traders should be susceptible to an outside influence of this sort is that they are peculiarly short of certainties about what makes currencies move.
The effect of the full moon on humans and other animals is well doc.u.mented. Your local police station knows with great certainty it will be more than usually busy on full moon days and nights a"not just with homicidal lunatics (full moon killers), but with a whole gamut of deviant behaviour having in common only that it occurs regularly at full moon season. People donat howl, but they do strange things at full moon a"lunatic things. Read Moon Madness by Paul Katzeff, if you want more background: also Krafft-Ebingas The Psychopathology of s.e.x .
The amazing story of the march of science through history has not been about the acquisition of knowledge so much as about the realisation of the extent of manas ignorance and of the near infinity of what there is to know. Each new major scientific atrutha has displaced an earlier atrutha a"only to be displaced again in its turn, or sometimes not displaced but reduced to insignificance. As Robert Pirsig* put it in his masterpiece Zen & the Art of Motorcycle Maintenance* , published in 1974: athere it was, the whole history of science, a clear story of continuously new and changing explanations of old factsa some scientific truths seemed to last for centuries, others for less than a year .a The trouble with the intricate and astonishingly accurate system put in place by Isaac Newton to explain the physical world is that it persuaded subsequent generations to look for the truth in things that were capable of proof (or rather being incapable of disproof, as Karl Popper suggested). But there are more things in heaven and earth: the parts the Newtonian mentality can reach are a small, and perhaps not very important, part of the whole. It doesnat reach to human behaviour patterns that are geared to the lunar cycle.
aLoonya Behaviour
The point of departure is the fact that for the past 10 years, short-term, multia" week extremes in the currency markets have coincided with full moons in a way that could not possibly be explained by chance. More significantly, this coincidence was noted in Currency Bulletin as long as 7 years ago. In other words this is not an interpretation that has been fitted to the past: one has been observing the phenomenon being confirmed in areal timea over many years. (The chart below is not specially selected: it is simply the latest period available to me as I write. In it, the full moons are marked with a hollow blob; and the new moons with a solid blob. When they occur at weekends, which is obviously quite often, I have tried to place them between Friday and Monday).
Translating this observation into a trading rule is not easy. Full moons arenat always accompanied by turning points: and turning points by no means always come at full moons, of course. Moreover, if the rule has been working well over several lunar cycles, it has a way of suddenly falling apart: possibly it self-destructs because many traders have noticed the occurrence and are trying to antic.i.p.ate it. You have been warned. Study the chart at leisure: one of the conclusions you may draw is that once a trend is manifestly in full swing, the moon has little impact.
Active traders have little to lose and possibly much to gain by observing the following maxim: distrust price action ahead of a full moon, trust the action after it. On full moon days, cut back trading positions to core positions if prices have shown a clear-cut trend ahead of the full moon: other things equal, re-instate only if the trend is seen to continue on the second day after full moon. If prices have been trending sideways before the full moon take no action, but watch the direction of the next two days for guidance.
The influence of the full moon may only be felt for about 3 days beforehand and 5 days after; and it has been most visible in the D-Mark and SF dollar parities. But as you can see from the chart, there has often been a two week cycle running from full moon through new moon and back a"a cycle which has sometimes been uncannily reliable for months on end. Rationalise it as you please: the impression is that market action tends to be primitive, dim and emotional before full moons, and more collected and rational after them; and that there is sometimes a periodicity in currency fluctuations which can be almost as reliable as the tide! If this continues to be so, we will have an edge if we exploit the phenomenon. And successful trading is not about being a genius, but about constantly exploiting athe little edgea .As the legendary futures trader Richard Dennis* put it: aIf you take something which has a 53% chance of working each time, over the long term there is a 100% chance of it working.a
Using astopsa*
One of the surest ways of losing the edge is to allow your own calculated time frame to be swallowed up in the ainstantisma and emotionalism of the marketas daily fluctuations. They have nothing to do with us. Let them be someone elseas problem.
Once we hold a position, we have only one problem, which is deciding when our reason for holding it no longer applies. The danger to our rational judgement in this matter is that an adverse price movement will panic us out. What will happen is that we will use our potential loss as an excuse to justify abandoning the position, when the real reason is fear. The conventional solution to this problem is the astop-lossa limit. Itas useful but itas not a panacea.
What we have to watch out for is that we donat use stops as a crutch a" to absolve us from the responsibility of making a wrong trade. Peter Steidlmayer* has put it at its most forcible: aif you ask me, people who are using stops are using a crutch or buying insurance, like in blackjack. If you donat have the confidence that youare right, donat make the trade. What happens is that people who use stops end up making more trades because they feel they have this crutch that they are leaning against. aWell, itas only going to cost me five centsa. Those att.i.tudes are copoutsa (The Big Hitters). Even if we donat go all the way with Peter Steidlmayer, we must be clear in our minds that if a stop is. .h.i.t, it has to be because we have made a wrong trade.
Steidlmayeras position is that ausing stops is absolutely ridiculousa. But you need a crutch if youare lame; and some of the most successful traders have got on best with this crutch.
We win some and we lose some, letas always remember. The conventional idea of the stop-loss is to provide an automatic way of ejecting ourselves from the losers a" one that eliminates the danger that we shall be wrong-footed by feara or hope. It follows that the stop must be placed at the point where price action will have apparently proved us wrong a"i.e. other forces than the ones we diagnosed are dominating the market. So our stop will be set far enough away not to be hit by random fluctuations. It must not be hit if our script is right, only if it is wrong.
The stop will be set in the light of the volatility of the currency we are dealing in, and will be dictated by our time horizon. We can use mental stops: we donat have to put the stop with athe marketa. But we must decide our stop level before we put on the position a"not least because the stop defines the size of our position: if your stop is 5% away from your entry point, and you do not wish to risk more than 2% of funds on this particular trade, then you can only put 40% of funds on that position.
The stop would stand (normally) unless the price moves in the right direction. In that event it is appropriate to move the stop along in line with the price movement a"a acrawling stopa* some people call this or atrailing stopa. Again, you try to place the stop where it wonat be hit.
Should we use target stops for profit-taking, as well as limit stops to limit losses? Answer, sometimes. CBas sentiment gauges are designed to pinpoint extremes, so it makes no sense to set targets at the outset when a position is initiated: such targets are guesswork, or worse. By contrast, when a turning point has been located by means of our sentiment gauges, a target stop can make a lot of sense. Markets have a way of getting especially volatile at turning points. We sometimes see atrampolininga* (page 64), and a"very often see double tops and double bottoms. So, in the event that a price has reacted sharply from an extreme, you can set a target stop near that extreme a" and this one you should leave with the market (instruct your broker or bank), specifying agood till cancelleda (GTC*), and amarket if toucheda (MIT*), if you like.
Market Lore