Trading System
Face the Day Armed with a GAME PLAN When it comes to trading for a living,
investors fall into three categories:
- Those that have a trading system
- Those that are developing a trading system
- Those that never believed in utilizing a specific trading system . . . and
are still explaining to their spouse how they lost all of their trading capital
The point of this, of course, is to emphasize the importance of facing each
trading day with a game plan and a trading system. A very large part of that
game plan involves having a specific trading system or setup, and, more
importantly, a trading methodology in which to apply to each trading system or
setup. Without this combination, a trader is like a wounded antelope in the
center of a lion pride, where it is not a question of "if" the antelope is going
to get whacked, but rather of "when." For a trader without a trading system, the
possibility of ruin it not a question of "if." It's only a matter of "when."
I utilize 8 trading systems in my daily trading routine. One of the simplest
and most effective is one I call the "5 Minute Multi-Pivot Play" trading system,
which is a trading system I utilize on the mini-sized Dow futures. I also use a
similar trading system for the emini S&P, emini Nasdaq and emini Russell
futures. For the sake of simplicity, I will focus on the mini-sized Dow trading
system in this article.
The main advantage of this trading system is that it is price-based as
opposed to a indicator-based trading system. By the time most of the trading
software generate a buy or a sell signal, the move is already well under
way. By following this price-based methodology, there are many instances where I
get into a trade before the indicator-based trading system traders, and I
usually end up handing off my position just as a buy or sell signal is being
generated on a stochastic or other oscillator type trading system. I do follow a
2, 4, and 13 period exponential moving average as well as a 7 period RSI on each
5 minute chart. I don't use these for signals; I use these to see when these
lagging trading
software are creating buy and sell signals so I know when the "crowd" is
jumping in.
Before we look at how to use the trading system, let's look at its main
components:
24 Hour Pivot Levels
First off, let's talk about the pivots: how they are created and how I use
them. There is no big mystery or secret to the pivots. This trading
software is readily available and have been around for a long time. These
are support and resistance levels calculated by floor traders using a simple
mathematical formula. These levels became widely known and have moved off floor.
Today many day traders are aware of them and try to use them, but in my
experience they are using them incorrectly. To add to the confusion, there are
different formula versions and different time frames that are used when
calculating pivots. So, to get started, let's look at what I use, which is one
of the standard pivot formulas:
R3: R1 + (High - Low)
R2: Pivot + (High - Low)
R1: 2x Pivot - Low
PIVOT: High + Low + Close/3
S1: 2x Pivot - High
S2: Pivot - (High - Low)
S3: S1 - (High - Low)
R = Resistance
S = Support
Once a day trader has this formula, then the key data that is needed is the
high, low and close of the previous session. For my own day trading, I like to
utilize 24 hours worth of data, and therefore I use the 24 hour session from
4:15 PM Eastern to 4:15 PM Eastern. Once I get this high/low/close, I plug these
into an excel spreadsheet with the formulas listed above. This information
generates 7 important levels for the next trading day: a central pivot, then 3
levels above (R1, R2, and R3) and 3 levels below (S1, S2 and S3). The central
pivot has the most weight of the 7 levels. In addition to these daily levels, I
also utilize weekly levels (calculated using the high/low/close of the previous
week) and monthly levels (calculated using the high/low/close of the previous
month). On days where the action is volatile, creating a trading range of over
150 points in the mini-sized Dow or 15 points in the emini S&P, I will also
utilize "midpoints." These are literally the half-way point between each of the
daily pivot levels. Once the pivots are created and drawn, they will resemble
the chart in Figure 1.
Figure 1 shows a trading system on a 5-minute chart of the CBOT mini-sized Dow contract with its corresponding Daily, Weekly, and Monthly pivot levels.
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Figure 1 shows a 5-minute chart of the CBOT
mini-sized Dow contract with its corresponding Daily, Weekly, and Monthly pivot
levels.
It is rare when a stock index hits its R3 or S3 levels, as that is the
extreme of the range. This is important to know because if a market rallies to
R2 or a sells off to S2, that usually ends up being the dead high or the dead
low of the day. This knowledge will help temper a trader's emotions and keep
them on track to follow this trading system.
That said, let's take a look at my rules for my trading system while trading
the pivots.
Basic Methodology of the Multi-Pivot Strategy:
- 1) I am looking for trades against the pivots. My ideal
trades are fades against these levels. If we are rallying up to a pivot level,
then I am either already long and am looking for an exit, or I'm flat and I'm
looking to initiate a new short position.
For example, the markets rally to a daily level, and I short the move. Or a
market sells off to a daily level, and I buy the move. I don't wait for the
moving averages or the RSI to confirm the action. Instead, I set up the orders
based on the price action. Ideally, I will get MA confirmation at least 20-30
minutes after I place the trade, if not sooner. In truth, the trader can trade
this system without the MA confirmations " I just like to see them turn in my
direction after I'm in a trade. I know this is when most traders are just now
getting in the trade " way too late!
Figure 2 shows a 5-minute chart of the CBOT mini-sized Dow contract with trading system entry and exit levels.
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Figure 2 shows a 5-minute chart of
the CBOT mini-sized Dow contract with the trading system entry and exit levels.
On Friday, January 16 the price action on the chart is showing 3 trading
system setups.
- As the markets rally to the midpoint near 10565, I set up a short, with my
target being the daily pivot that is sitting below at 10529, "plus 3 points" -
something I will talk about in my next trading system rule.
- On a move to the pivot, I close out my short, and end up going long, with my
target being the midpoint.
- After hitting the midpoint, I close out my long, and reverse and go short,
with my target being the daily pivot once again.
Now that we have the basic idea, let's go over entry points and stops.
- 2) I enter and exit trades by placing limit orders or buy
stops/sell stops + or - 3 points from the multi pivot levels trading
software.
The orders are + 3 or -3 points depending on what
side of the pivot the market is trading on. The idea is to be "first in line."
For example, if one of the levels is 10500 and we are rallying up to that level
and I am already long, I will place a sell order to exit at that level -3
points, which is 10497. If the market was falling to a pivot at 10400 and I am
short, then my target is the pivot + 3 points, or 10403. I use this +/- 3 points
for entries, stops and targets. The idea is to be "in front of the pivot" and be
first in line to get in or out. On days when I am using the "midpoint" between
the daily levels, I just use the actual midpoint pricing level for buys and
sells against the midpoints (instead of + or - 3 points).
- 3) My initial stop is almost always 20 points, never less
than that.
If I place a day trade and it is near the overnight
highs or lows, say 25 points away, then I will use that level as my stop. 95% of
the time however it is just a 20 point stop. I do not aggressively trail my
stops in this trading system.
Figure 3 shows a 5-minute chart of the CBOT mini-sized Dow contract with trading system entry, exit and stop levels.
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Figure 3 shows a 5-minute chart of the
CBOT mini-sized Dow contract with trading system entry, exit and stop levels.
Figure 3 trading system shows entry levels with their corresponding stops in
place.
- When I was filled at my short at the midpoint 10565 I immediately placed a
20 point stop at 10585.
- A long at the weekly level 10532 + 3 at 10535 would mean that the trader
place an immediate 20 point stop at 10515. The stop is based on the trader's
entry level, not the pivot level.
I'm not a big fan of aggressively
trailing stops in a trading system. However, if we get close to my target,
usually within 5 points, I will move my stop to the next level + or - 3 points
"on the far side." This means if I am long, I would bring my stop to the
previous pivot - 3 points, which would set up a "breakeven " 6" play.
Figure 4 shows a 5-minute chart of the CBOT mini-sized Dow contract with trading system entry, exit and trailing stop levels.
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Figure 4 shows a 5-minute chart of the CBOT mini-sized Dow contract
with system entry, exit and trailing stop levels. Figure 4 shows an example of
where to move up a stop.
- Here we have our original 20 stop from our long entry on a decline to the
weekly pivot + 3 points.
- When the market gets within 5 points of my target, I move up the stop up to
the same pivot I used as my entry level and subtract 3 points. In this trading
system case, the entry pivot was the green dotted line, which is one of the
weekly levels. So my stop is 3 points below that level, which is 6 points below
my entry (since my entry was weekly pivot + 3 points).
- 4) After 2 losers in a row I quit for the day.
This seems like a simple rule, but it is hugely important. The
whole idea of this trading system is to keep the trader's losses small so he can
live to fight another day. With this trading system, if the trader's first two
trades of the day are losers, then he is down 40 points, or $200 per contract
traded. This is very reasonable and will prevent a trader from having a killer
drawdown day where emotions run rampant, causing overtrading.
- 5) With this trading system, I trade 1 contract for each
$12,500 in my account. For accounts I manage, I trade 1 contract for each
$25,000 in the account.
Technically, the trader could use very
aggressive margin rules and trade 10 contracts for each $10,000 that he has. The
problem with this is, if he has two losers in a row, he just lost $2,000, or 20%
of his account in one day. Losing $200 on a $12,500 account equates to a -1.6%
loss of equity. Losing $200 on a $25,000 account equates to a -0.08% loss of
equity. The whole key to online futures trading
is managing equity swings. If a trader loses 20%, then he has to make 25% to get
back to breakeven. One of the biggest mistakes I see new traders make is
doubling or tripling up from their original plan. The reasons are all emotional
based, and all it means is that a trader's account is now a disaster waiting to
happen. A trader can be right 5 times in a row, but if he continues to pyramid
and add contracts, he only has to be wrong once to suffer a huge loss. Decide
how many contracts to trade and stick to that trading system on each and every
trade!
- 6) Ignore new trading system setups between 12:00 Noon ET
and 2:00 p.m. ET.
If I am in a trade, I will stay in it and
keep my parameters on. However, if I am flat heading into this time frame, I
will not initiate new trades. Why? This is the dead zone of the day. The
institutions are done trading until after 2:00 p.m. ET because there is not
enough volume to handle their orders during the afternoon. The resulting price
action is choppy, and the only people who benefit from this are brokers, as
traders overtrade their accounts, giving back all of their profits they made in
the morning. In this trading system, I've found one of the best ways to improve
a person's profitability is to not let them trade during this time of the day.
Summary
Those are the trading systems and rules I follow. What is nice about this
trading system is that the trader doesn't have to watch it very closely once he
is in a position. I'm not an aggressive trailer of stops. I like to get in a
position, set my parameters, and then focus on other things. Depending on the
trader's work situation, he could do this at the office, especially on the West
Coast. He could set alerts for the key levels, and then when the markets
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