What do people use technical trading to tell them? That depends if you are looking at markets or individual securities. For markets, technical indicators can illuminate whether a market is over, under or fairly valued. It can give signals as to good times to change asset allocation from one market to another. These might be mentioned in the literature as good entry or exit points. Technical indicators might give you information as to how far a market is likely to run in one direction or another, i.e. how far it is likely to go up in this cycle or go down.
For individual securities, technical indicators are used for many of the same purposes. The most common use is for signals to buy or sell a stock. Most of the others are signals that such a moment may be approaching and that the security should be monitored more closely. Technical indicators can also assist in knowing where to set stop loss orders and where to target your take profit orders.
A TREND-FOLLOWING TRADING APPROACH:
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One of the difficulties associated with trend-following trading systems is that they usually involve entering and exiting trades with "stop" orders. For example, let's say you are currently out of the market. The trend-following system you might be using would probably have you enter a long position at a price higher than the current one. Or if you are currently in a short position, you might be required to exit the short position and simultaneously enter a long position at a price higher than the current price. The philosophy of most trend-following systems is to try to "catch the train before it leaves the station" (but not TOO soon!) and stay on it until it has reversed directions and starts to go the other way. Stop orders work like this. First, if you are to go long, the order is placed at a price ABOVE the current price. If you are to go short, the order is placed at a price BELOW the current price. Obviously, if you were to place a limit order under such circumstances, it would get executed immediately. If the market reaches a stop order price, it changes to a MARKET order and is then executed as quickly as possible. Unfortunately, if the market is moving fast, your order may not get executed until a significant change AGAINST you has occurred. This is called "slippage" and the slippage cost is doubled if you are using a stop and reverse system. With a stop and reverse system, you are always in the market. You go from short to long or long to short. This slippage can be pretty significant of a thing. If you have ever watched bond prices change on a real time monitor when a surprising economic report came out, you know just what I mean. Slippages of 10 tics ($312.50 on bond futures) are not unusual, and I've seen worse (unfortunately). To compound this problem, a "fast market" and a fist full of stop orders seems to be more of a temptation to cheat than some floor brokers can withstand. A stop order in a fast market is like a blank check made out to the floor broker who executes your order. He has a wide range of fill prices he can give you, and plenty of time to find "help" from another trader, since he can blame slowness of reporting your order execution on "how busy things were" during the fast market. In all fairness, I guess I should assume that most floor brokers are usually honest and that trying to get an order done in a fast bond market must really be difficult. Having been a daily participant in these types of markets, I have seen stop loss orders "butchered" at times in fast market conditions. Anyone following the Yen or that has a misfortune to be the recipient of one of these trashings will readily agree to this. As a LOCAL in those trading pits, we try to take advantage of those wicked price swings by "fading" the moves and taking the other side of those orders. Usually it works out fine (for the LOCALS) but not always. (I can recall buying 40 contracts after an 80 point break and watching it break ANOTHER 80 points. I got out of the last 10 contracts 60 POINTS lower, racking up a $17,000 loss!) As far as it being a tempting playground for shady brokers, this is certainly possible but probably not that likely. Those brokers are more concerned with getting the order filled (with NO back tics) to save their own hides. These brokers are still "held" in fast market conditions, so you will see some VERY UGLY fills! "Stop limit" orders aren't the answer, either. Some exchanges won't accept them, and you stand a chance of not getting your order executed at all, while the market surges past your stop order price.
While all of this still doesn't mean that trend-following systems can't make money, it certainly does encourage us to search for a trading technique that utilizes orders that aren't exposed to these kinds of real world problems. You want to find an approach that will ALWAYS give you good fills working WITH a broker's way of doing business. Using limit orders (even mentally trailing 15% limit orders) is one way of achieving this. If you are wanting to go long with a limit order, you want prices to DROP to an advantageous price while prices are still ABOVE that price. If prices drop THROUGH that price and continue to go below it, the broker at least owes you the trade at your limit price... period. You MIGHT even get it at a lower price (but don't hold your breath...) since your order would be a limit price "or better" order. (Isn't it interesting that when markets drop rapidly below your buy limit price, that the floor broker always seems to get the orders done in time to give you your limit price? Aha! Maybe THAT'S where the other trading side of his "help," which I mentioned earlier, comes from!). If you want to trade with limit orders placed before prices actually "reach your price," you will probably be trading with a "reaction" trading system. A reaction trading system is one in which you want prices to drop down to a price at which you want to buy or rise to a price at which you want to (sell) short. It's perfect for limit orders! Frequently, these limit order prices occur during quiet markets too.
An interesting trading approach that has been useful to me recently is the "Martingale" money management scheme. The Martingale technique was originally used (generally unsuccessfully, but not always) by gamblers. It involves increasing your "bet" when you lost and continuing to increase it while you continue to be losing, until you finally win. The increases are designed so that when you do eventually win, you more than recover your losses and actually achieve a net win for the series of bets. The simplest form of a Martingale scheme involves doubling your bet each time you lost, while playing roulette or some other "two-result" (or fairly close to two results) game, like flipping a coin. No matter how many losses you experience, when you do finally win, you achieve a net win of the original bet of the series of your successive bets. The obvious problem with this approach is that the size of your bets increases rather rapidly, and it is very possible to hit the limit of your available capital, or the "house's" bet limit on the game you're playing even more rapidly. You also can expend rather large amounts of money betting a series (say $5000) trying to win back your initial bet (say $10), which should call into question the sanity of such an effort in the first place. And with most games, successive strings of losses don't mean a thing. If you have had 36 straight losses while flipping a coin, the chances of it coming up against you the next time are still 50%. Actually, I've seen a lot of traders go "belly up" trying this method. One reason: Most traders "Eat like a mouse and crap like an elephant." They will let the losers "run" while not taking advantage of a good position by getting out way too early. Fear and greed. Plus, many traders cannot handle larger positions as well as they can smaller ones. Better to wipe your fanny and try again. Remember, there is ALWAYS another train leaving the station in the morning! (Enough cliches?)
But markets aren't like that. The more prices drop, the more incentive there is for buying to come in, "bottom-feeding" back into the market and make prices turn back up. So it is not really like flipping coins then, is it? Markets tend to move in (somewhat orderly) waves, with retracements of previous moves averaging out about 50% (or so). To fulfill the need for a reaction type trading system and to incorporate some kind of Martingale approach in the trading, I have been researching a number of trading systems. One that looks very promising involves the use of look-ahead envelopes. The system is not an exhaustively researched, finished product by any means, but it is worth my describing to you further, and it is worth your considering. Maybe you can even come up with some ideas for improving it.
I'll explain how this promising trend-following trading approach works in my next comment on this blog, along with addressing some additional technical analysis principles which are important for us to understand. Hang on and have some further patience with me. There's still a bunch left for us to consider!
Posted by: Bob Hansell | March 1, 2006 11:55 PM | Permalink to Comment