From the October 01, 2007 issue of Futures Magazine • Subscribe!

Using trend dynamics for day-trading profits

Take this unscientific personality test:

Do you get more satisfaction from fighting a market and being right or from flowing with a market and being right?

Is it easy for you to stay in cash when you do not see a good trade?

Is it easy for you to stay in a position if prices are moving sharply in your favor? Is it easy for you to stay in a position if prices are moving sharply against you?

As a day-trader, there is a degree of satisfaction in picking off tight trades, scalping a few ticks. There is also satisfaction in averaging in (profitably) as a market makes a sharp turn; you enter before the turn, at the turn, and after the turn. And there is satisfaction in snaking though a choppy market, profitably trading long and short. You have to be good.

But are you that good? Even if you are, how long can you stay that good? What about the mental fatigue? Think of your brain as a muscle. Muscle-memory may become a handicap. You may be so well trained to jump in and out — so skeptical of any price move — that when a market trends the entire day you are mentally unprepared to hold a position. However, these are the days with the greatest opportunity for profit.

A trend-trader (someone who holds a position for weeks or longer) may think of a day-trader as someone who is mentally unprepared to ride a trend. A day-trader may think of a trend-trader as someone who is mentally unprepared to play volatility. Now think of a trend-trader who appreciates the existence of one-day trends. Think of a day-trader who appreciates the existence of one-day trends. A good trend-trader learns to become a good day-trader, and a good day-trader learns to become a good trend trader.

Let’s focus on the second animal: the day-trader who learns to become a good trend-trader.

THE RIGHT STUFF?

To see if you have the makings of this day-trend trader, consider your answers on the personality test. Let’s take the first question. If you answered that you do indeed get more satisfaction from fighting a market and being right, think about what you are saying. Fighting uses energy. When you lose energy, you can lose focus. When you lose focus, at some point, you can make mistakes.

If you answered that you get more satisfaction from flowing with a market and being right, then you’re off to a good start. Riding a one-day trend helps you conserve, not lose energy. You are able to maintain your sense of timing. You are not tempted to jump out for the sake of taking a profit. You are ready to ride the price, to let the trend play out. Sometimes support and resistance will decide when a one-day trend ends. Sometimes the clock will decide; the day trend will end when the regular trading session ends.

Let’s take the second question. If you answered that it’s easy for you to stay in cash when you don’t see a good trade, then you’re on the right track, as long as you do not become paralyzed and remain on the sidelines. Staying in cash can create its own tension. When you are in cash, you need to ignore any urge to trade for the sake of trading and you may have to ignore a fear to trade.

For the third question, if you answered that it’s easy to stay in a position if prices are still moving sharply in your favor, that’s also good, as long as you do not become unbalanced or complacent. You need self-discipline. You need to suppress any urge to take a profit for the sake of doing so. You also need to suppress the phenomenon of zoning out, of seeing but not absorbing what is happening. Trends are like snakes. No matter how docile they may seem, they can still turn on you at any time. If you answered that it’s easy to stay in a position if prices are moving sharply against you, then you’re in denial.

You have zoned out and have become complacent about losing. Your confidence is so weak that you cannot accept exiting your position and admitting you made a bad trade.

Perhaps your answers reflected the following: “I get more satisfaction from fighting a market and being right. It is hard for me to stay in cash when

I do not see a good trade. It is hard for me not to take a profit for the sake of taking a profit. It is easy for me to stay in a position if prices move sharply against me.” If that’s the case, then you do not have the makings of a good day-trend trader. You prefer to fight rather than flow. You prefer to trade for the sake of trading, to take a profit for the sake of taking a profit and to avoid taking a loss because you cannot admit you made a mistake. You will fight a market but you will not “fight” your own negative impulses and fears.

Good day-trend traders prefers to flow rather than fight. They trade when it is time, take a profit when it is time and fight their own negative impulses and fears without fighting the market.

READING CHARTS

For the next test, consider several markets. The charts shown in “As the day-trend turns” (below) are one-day linear regression charts from Friday, June 29, 2007, the trading day after a Federal Reserve rate decision.

Chart (A) is the QQQQ, the Nasdaq 100 exchange-traded fund (ETF); (B) is SMH, the semiconductor ETF; (C) is SPY, the S&P 500 ETF; (D) is RKH, the regional bank ETF. The period in each chart is New York Stock Exchange’s (NYSE) regular trading hours, 9:30 a.m. to 3:00 p.m. EST.

Besides the price of the security, each chart also shows a lower line or buy-line, a centerline or mean, and an upper line or sell-line.

Now, take a piece of paper. Cover each chart. Slide your paper from left to right and paper trade. Answer honestly as to which markets you would have traded. Consider whether you would have gone long or short and how long you would have ridden each position.

Did you trade well? June 29, 2007 was a good day for one-day trends.

The Nasdaq 100, along with the semiconductor sector, the S&P 500 and the regional bank sector tracked one-day downtrends along a narrow, 45-degree linear regression channel from 10:30 a.m. to 3:00 p.m.

It might be easy to discredit June 29 as an anomaly, so see for yourself. As an exercise, pick any market’s daily high-low-close bar chart. Go back 30 days. Now go forward. Count the days when the price closed on or near its intraday high or low. If the 30-day period you selected reflects predominant tendencies over the long term, you’ll find that, on average, you will see a high or low close on four out of five days.

What this means is that day traders are presented with a steady diet of one-day trends. You will need to watch each day develop to sense where it will close, but you have just seen that prices do indeed tend to close on or near their intraday high or low.

For another example, consider what happened on the following trading day, Monday, July 2. “Another day in paradise” (below) includes the same four ETFs (QQQQ, SMH, SPY, RKH). These show the one-day price action on Monday, July 2. Once again, the period reflects NYSE regular trading hours, 9:30 a.m. to 4:00 p.m., which represent the highest liquidity periods for these ETFs.

The four ETFs demonstrate a direct relationship among them, meaning they moved in the same direction. Within the parameters of 9:30 a.m. to 4:00 p.m., all four were strong to steady. The cleanest one-day trends were set by SPY. The 9:30 a.m. open and the point at which SPY touched its one-day buy-line presented good entry levels.

If you did not know you were looking at a one-day chart, you might think you were looking at a daily, weekly or even a monthly chart.

The process of focusing on, looking for and trading one-day trends works. The strategy combines the best of day-trading and the best of trend trading. If riding a one-day trend suits you, you have an edge. If you want to learn how to use this trading strategy but do not feel mentally prepared to do so, then train yourself. Master yourself, then the markets. Now you have a training goal.

If you accept that the market price will tend to close on or near its intraday high or low on four out of five days, then you will understand the value of waiting for a one-day trend to develop. This will help you achieve the calmness, alertness and effective confidence to correctly identify a one-day trend, time your entry and ride the trade.

Richard L. Muehlberg uses linear regression channels and intermarket analysis to day trade his own account. He publishes a day trading diary on his Web site www.DayTradingWithLinesInTheSky.com. E-mail him at richardmue@yahoo.com.

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