PREREQUISITES, GROUND RULES, & DEFINITIONS

You should understand that this is not a book on basic technical analysis. It is a book about a modular and comprehensive trading approach that I have found to be both prudent and highly effective. Although I always attempt to start a discussion at a base level of assumed understanding, it is presumed that you have a working knowledge of certain well-known technical tools. If you do not understand Moving Averages, Stochastics, MACD, RSI, and the general appearance of price vs. time charts, there are a number of books listed in the reference section which you should consult before proceeding any further.

GROUND RULES AND DEFINITIONS:

Before we can hope to arrive at an understanding of my trading methodology, we have to be sure we're on the same page, i.e. that certain terms and concepts mean the same thing to both of us. To emphasize the specific meaning I attach to each of the defined terms, they will be capitalized throughout the text, i.e. Trend, Direction, Movement, and so on.

TREND:

A favorite question I ask when teaching is, "What is the current Trend of the S&P, bonds, or whatever?" Invariably I get the response, "Up, down, or sideways." Seldom am I

asked, "In what Time Frame?" The question, "What's the current Trend of...?", without specifying the Time Frame is meaningless.

Below is a series of four charts. Let's use the Displaced Moving Average (DMA) overlaid on these charts as a Trend delineator. The length and type of this DMA is not the relevant issue. Our definition of Trend is the relevant issue. If we define an up Trend as a close above this DMA, and a down Trend as a close below this DMA, you can see the variety of Trend statements we can get on the close of the same day, February 28th. The bonds are in an up Trend on the 15 minute chart, but in a down Trend on the daily. The Trend is down weekly-based, but up monthly-based. If your trading methodology uses Trend as a part of its defining characteristic and you don't knowyour Time Frame, you are lost.

Furthermore, if I predefine the Trend by a set of indicators or by other criteria, I cannot make the determination of what the Trend is without the required criteria, regardless of how a chart may appear subjectively. Consider the following two charts. They are both daily segments of the monthly chart shown above. Chart 2-5 is shown without our predefined Trend indicator, the DMA. It would be easy to say the daily Trend is up, if you looked only at the sample of data shown in Chart 2-5.

According to our definition of Trend, however, (Chart 2- 6), this is merely a reaction in an ongoing down Trend. Perhaps you feel that given a longer data sample, you could have subjectively determined the Trend accurately in this case. Perhaps you could have. What about the next chart? What about the self-doubt you may encounter in the heat of action, and what about your ability to pull the trigger?

I use two Trend indicators and only two. They are Displaced Moving Averages and the MACD/Stochastic combination. Without them, I will not attempt to comment on the Trend.

My objective is to structure your thinking. One key to making a good judgmental trading method is to make as much of it as possible, non-judgmental.

When the market is going sideways, it is commonly said to be in congestion or without a Trend. The way I define Trend leaves little room for the term "congestion." It takes no leap of consciousness to see that congestion on a daily chart could be dramatically trending in another Time Frame, e.g. the intraday world. In the daily Chart 2-7 we have closing prices meandering above and below our Trend indicator. On the intraday Chart 2- 8, using an increased vertical range, and the same inputs for the DMA, we have a solid Trend apparent. Unless there is some significant Movement in the market, I'm not interested in trading. Boring, meandering markets don't interest me. If shortening the Time Frame doesn't present a Trend, I simply stay away. Other methods that will help you to define "congestion," if you have trouble grasping the concept, will be covered in subsequent chapters.