Wednesday, January 3, 2007

Trading Methodology

My trading methodology is systematic, as opposed to subjective.

I do not “read” Charts based on traditional indicators, which are, by definition, lagging and open to some of the biases identified by cognitive psychology. My analysis is based on defined, quantitative and repetitive patterns that are integrated within a “context” based on systematic technical conditions. Before going through the tools/parameters I use, let’s first cover what I see as my analitical edge.

Technical analysts argue that since the most knowledgeable and sophisticated participants are actively trading in the markets, the current price trend is the most accurate assesment of future supply and demand. In addition to this, the technical analyst recognizes that the psychology of the participants often leads to a “self-feeding” process that may push prices to an extreme in value. This “mass psychology” factor is a common trait in all markets, countries or moments in history. It is my belief that on top of trying to identify what the main trend is within a given timeframe (typical trend-following approach), my methodology helps me to make an accurate diagnosis of the balance of power between Bulls and Bears at any given time. This diagnosis helps me to assess what the probability is that the current trend will continue or stabilize or even reverse.

The essence of the methodology is based on identifying the inertia of a market (its trend or lack of thereof) and the strength of this trend (its momentum) within a given timeframe.

To achieve this, I have developed my own indicator, the “Strength Index” which, together with a traditional Exponential Moving Average, indicates me both what the trend is and its strength in the “Strategic Window” (Daily bar charts for swing trading).

In the “Tactical Window”, which is always 1 timeframe shorter (about one fifth of the number of hours a market is open during a normal trading day), my objective is to decide whether the price is trading at an attractive value or not.

Finally, in the “Now Moment Window” (about 1 fifth of the Tactical Window), I look for systematic price patterns that will give me an entry signal.

The trading process is always the same :

If the Strategic Window indicates that the trend is up/down and that the momentum is strong/weak, I look at the Tactical Window to find out where the current price trades in relation to its "fair" value. With the help of a 3 standard deviations around an Exponential Moving Average, and oscillators, I look for price zones that present good value to go long/short this market.

The Now Moment Window is then used as the Entry Screen. A set of systematic conditions has to be fulfilled to trigger an entry.

Stop-loss is set below/above the last significant low/high area.

Price objectives are defined by the 3 standard deviations bands in the Tactical Window.

Positions are taken only if the Risk/Reward is superior to 1/1,5.

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