Practical Details

Jun 30, 2020
15 min read

Updated: Jul 3, 2020

There are several key principles that apply to all systems.

Disclaimer: content is summarised from Part 10 (Chapter 53- 56) of 'The New Trading for a Living: Psychology, Discipline, Trading Tools and Systems, Risk Control, Trade Management' by Alexander Elder

Will you be buying stocks that break out to new highs? Shorting double tops? Buying pullbacks? Looking for trend reversals? Select a method that makes sense to you & feels emotionally comfortable. Choose what appeals to you, what matches your abilities & temperament. Prior to using any scan, have a crystal-clear picture of what it should look for. Develop system & test it with a series of small trades to train your ability to follow signals. Feel certain to trade the pattern identified upon seeing it.

1. Setting Profit Targets

Plan entry level, profit target & stop for each trade to compare risk & reward. Reward:Risk ratio should be at least 2:1. Realistic profit target & firm stop helps in decision to take trades.

Clear target prices will prevent a trader from riding emotions of ups & downs of a trade which would lead to holding / adding to longs at the top & selling out near the bottom.

When calculating trade profit potential there is a paradox; longer expected holding periods have bigger profit potential but greater uncertainty. Technical analysis is reliable for shorter-term moves, but many shocks will occur in longer run. Holding period for position trades is measured in months / years. Swing trades are held for a few days / weeks. Day trades last minutes, rarely hours. MA & channels help set profit targets for swing trades; works for day-trades but pay more attention to oscillators & exit at first sign of a divergence against trade. Profit targets in position trading are usually set at previous S&R levels.

What is "Enough"

By getting “enough” each trade, achieve excellent results over time & stay in control. MAs, envelopes & S&R levels can show us what would be “enough” per trade.

Swing Trade Example: VRSN

Enter near a channel line & take profits in value zone between 2 MAs. This is a very reliable activity.

VRSN with 13- & 26-day EMAs, Impulse system & 4% envelope. MACD 12-26-9. (Chart by Stockcharts.com)

VeriSign Inc. (VRSN) developed a setup for “false breakout with a divergence” strategy. Last 3 days marked a, b, c. On “a” VRSN broke out & closed above Resistance (purple horizontal dashed line), while MACD-H could not rise above zero. On “b” VRSN shows "a" was a false upside breakout (aka upthrust). MACD-H ticks down, creating a bearish divergence, hence Elder immediately went short. VRSN dropped all day & closed lower. On "c", it tried to form a base, & since daily price was already in value zone, Elder decided it was "enough" & covered shorts. 82 cent profit on 3,000 shares brought in $2,460 before commissions. Could have made more by holding longer, but in swing trading, fast quarters are better than slow dollars. Taking profits in value zone reduces uncertainty & cuts duration of trade being at risk.

Day Trade Example: EGO

Buy a pullback into value zone during uptrend, with a profit target at upper channel line. Oscillator speeds up exit when market would not allow exit at initial target.

EGO 25- & 5-min charts with 13- & 26-bar EMAs, Impulse system & Autoenvelope. MACD 12-26-9. (Chart by TradeStation)

Eldorado Gold Corp. (EGO) with Triple Screen for day-trading & profit-taking. Strategic decision to buy EGO was taken on 25-min chart at (A), where MA turned up & Impulse system turned green (note false downside breakout on previous day).

Strategy “pullback to value” was executed on a 5-min chart. Prices gapped up at open, then pulled back into value zone at (B). Elder longed at $9.51 with initial target $9.75, near upper channel line on 25-min chart & stop at $9.37 (Reward:Risk 1.7)

Considered holding overnight as uptrend was strong but bearish divergence began to develop at (C) hence Elder placed order to sell at $9.75, but order was not filled as that was the high of the day. Prices drop from bearish divergence on a 5-min chart & Elder scrambled to lower sell order to $9.70 which was filled. 19-cent profit on 2,000 shares; $380 within hours.

Long Term Trade Example: IGOI

“Fallen angels” is scan that marks stocks which have fallen over 90% from peaks, stopped declining, bottomed out & slowly began to rise, thus they are likely to rally. Best time to look for “fallen angels” is when a bear market shows signs of bottoming.

Old bull market IGOI got badly mauled but stopped declining & began to rise. Weekly chart shows 2 prior attempts to return to multiyear peak area. Each of those rallies retraced just half of previous bear market.

Why it is hard to buy for the long haul: latest bottom was near $2 & if stop was placed there, risk per share is quite high causing a smaller trade size. Expected rally may take a few months or even years to get going. Volume of stock is low thus, if rally fizzles out, selling will be hard.

IGOI with 13- & 26-day EMAs, Impulse system & 4% envelope. MACD 12-26-9. (Chart by Stockcharts.com)

At right edge of, iGo Inc. (IGOI) trades slightly above $3 with a rising EMA confirming a new uptrend. Previous major top was above $60 (notice a kangaroo tail), 2 recent intermediate rallies fizzled out ($15 & $22; purple dashed lines). If this is start of a new bullish trend, set first profit target near $15 then, the next near $22.

2. Setting Stops

A trade without a stop is a gamble. Stops are essential for long-term survival & success. Markets train us not to use stops: buy a stock & set a stop that gets hit & stock reverses to rally after you exit with a loss. Getting repeatedly whipsawed like that disincentivises stops.

However, importance of stops is shown after large trades go bad, snowballing losses. Stops are a pain; but using them is a lesser evil than trading without them.

Focus on making stops more logical & less unpleasant. Elder has a chapter on intricacies of placing types of stops in his book "The New Sell and Sell Short"** (below is a mere summary)

Stops outside the Zone of “Market Noise”

Close stops will be activated by meaningless intraday swings while far stops lack protection. Market moves have 2 components: signal & noise. Signal is trend of stock. With uptrends, noise is daily range that protrudes below previous day’s low. With downtrends, noise is daily range that protrudes above previous day’s high.

SafeZone stops are described in detail in his book "Come into My Trading Room" page 173**. They measure market noise & place stops multiple noise levels away from the market. Use slope of a 22-day EMA to define trend. With uptrends, mark all downside penetrations of EMA during look-back period (10 to 20 days), add their depths & divide sum by no. of penetrations. This is the Average Downside Penetration for selected look-back period which reflects average level of noise in current uptrend. Place stops further away than average level of noise. Hence, multiply an average downside penetration 2x or greater.

With EMA downwards sloping, calculate SafeZone on basis of upside penetrations of previous bars’ highs. Count each upside penetrations during a selected time window & average that data to find Average Upside Penetration. Multiply it by a coefficient, starting with 3 & add that to high of each bar. Shorting near highs requires wider stops than buying near quiet, sold-out bottoms.

SafeZone does not replace independent thought. You have to establish look-back period & fine-tune coefficient to multiply average penetration, so that stop goes outside normal noise level.

When not using SafeZone, you may follow principle of calculating an average penetration against trend you are aiming to trade; & putting stop well outside zone of market noise.

No Stops at Obvious Levels

Most traders place stops slightly below recent lows, creating a target-rich environment for running of stops. Market has habit of quickly sinking back to those obvious lows, triggering stops before reversing & launching a new rally.

Place stops at non-obvious levels: closer to market / deeper below an obvious low. A closer stop lowers dollar risk but increases risk of a whipsaw. Deeper stop sidestep some false breakouts, but if hit more is lost.

Tighter stops for short-term swing trading & wider stops for long-term position trades. Note “Iron Triangle of risk control": wider stops demand a smaller trade size. Explore different systems for stops like Parabolic, SafeZone & Volatility stops. Note the most important principles: use stops & do not place them at obvious levels. Avoid placing stops at round numbers. E.g. buy at $80 do not stop at $78, but at $77.94. Let crowds take the first hit & perhaps your stop will remain untouched.

Use noisy behaviour to get a good entry into a trendfollowing trade. E.g. weekly trend is up, switch to daily & likely see that once every few weeks, it has a pullback below value zone. Measure depths of several recent penetrations below the slow EMA to calculate an average penetration. Place a buy order for next day at that distance below EMA & keep adjusting it every day.

1. Nic’s Stop

Named after Elder's friend, Nic Grove. With longs, place stop at second lowest low. If market slides to its second lowest low, it is almost certain to continue falling & hit the key low, where bulk of stops cluster. Get out with a smaller loss & lower slippage when markets drop to more visible lows. When shorting, place stop at level of second highest high.

Daily charts 13-day EMA, Impulse system & MACD-H 12-26-9. (Charts by Stockcharts.com)

On chart of The Coca-Cola Company (KO), we see a false downside breakout with bullish divergence. Impulse system turns from red to blue, permitting buying. We shall long.

Bar A: low was $37.10

Bar B: low was $37.05

Bar C: low was $36.89 (false downside breakout, exceeded low A by 21 cents).

Bar D: low was $37.14

Crowd sets stop below 36.89, but Nic’s stop will go to $37.04; a cent below second lowest recent low, bar B.

On chart of Intuitive Surgical, Inc. (ISRG), we see a false upside breakout with bearish divergence. Impulse system turns from green to blue, permitting shorting. We shall short.

Bar A: previous peak reached $447.50

Bar B: high was $444.99

Bar C: high was $447.75 (false upside breakout, exceeded bar A by 25 cents).

Bar D: high was $442.03

Crowd sets stop above $447.75, but Nic’s stop will go to $445.05: a few cents above second highest recent high, bar B

2. Kerry Lovvorn's Stops

Use Average True Range (ATR) stops. When entering during a price bar, place stop at least 1 ATR away from extreme of that bar. 2 ATR stop is even safer. You can use it as a trailing stop, moving it at every bar. Same principle: place stop outside zone of market noise.

1 advantage of trailing stops is that they gradually reduce amount of money at risk, allowing you to make new trades.

S&P 500 & a 20-day NH-NL Index. (Chart by TradeStation, programming by Kerry Lovvorn)

Spike Bounce signal occurs when 20-day NH-NL Index drops below -500, indicating bearish imbalance & then rallies above that level, showing bulls are coming back. Spike Bounce signals at green arrows. S&P bars are green while Spike Bounce signal is in effect & purple after it disappears. Red line trails 2 ATRs below highs of the bars.

Spike Bounce gives buy signals for entire market & chart trails each buy signal with a 2-ATR close-only stop (intraday crossovers do not count as market has to close below stop to activate it). Notice very productive signals (A)(B)(C). (D) resulted in a loss; there are no universally profitable signals.

Preventing a Winning Trade from Becoming a Loss

Before trading, plan level of protecting profits. E.g. profit target is $1,000, profit of $300 needs to be protected. Once open profit rises to $300, move stop to a breakeven level. This is “cuffing the trade”. Next, focus on protecting a portion of growing paper profit. Plan % to protect. E.g. plan that once breakeven stop is in place, a third of open profit will be protected. If open profit on rises to $600, move stop up, so that $200 profit is protected.

These levels are not set in stone. Choose % based on level of confidence in a trade & risk tolerance.

As trade moves in your favour, remaining potential gain shrinks, while risk (distance to stop) keeps increasing. As reward:risk ratio slowly deteriorates, begin reducing risk. Protecting a portion of paper profits keeps reward:risk ratio balanced.

Moving Stops Only in Direction of Trade

Failing to move stops upwards after a rally narrows your options when it drops: take a small loss right away & prepare to reposition later / continue to hold. (lowering of stops is not an option)

Logical thing to do when a trade starts acting badly is to accept a small loss & monitor that stock, ready to buy it again if it bottoms out.

Catastrophic Stops

Stops are a nuisance & often expensive but they will save your account. A “hard stop” is an order given to your broker. A “soft stop” is an order kept in your head, ready to be placed when needed. Beginners & intermediate traders must use hard stops. Pros with the discipline to exit when system says so may use a soft stop.

If you do not use hard stops on a regular basis, at least use a “catastrophic stop” for every trade. For A-trades draw a line on chart where you absolutely do not expect that stock to go. Place hard stop at that level & make it GTC: “good ’til cancelled”. After placing this catastrophic stop you may proceed with soft stops. Take relatively smaller losses, avoiding disaster.

Stops & Overnight Gaps

Massive slippage can occur if your stock gets hit by a major piece of bad news after market closes since it would open far below your stop.

Beginner & intermediate traders cannot do much in this situation. Coldly disciplined pros have an additional option: day-trade out of that stock. Pull your stop & after the stock begins trading, handle it as if it was a day-trade you bought at the first tick of that morning.

Opening gaps are often followed by bounces, giving nimble traders an opportunity to get out at a smaller loss. This doesn’t always happen & you may deepen losses instead.

Be sure to get out before the close. Damaged stock may bounce today, but tomorrow more sellers are likely to drive it lower.

3. Is This an A-Trade?

Performance in any field improves if you take tests as you recognise your strengths & weaknesses. Completed trades are given 3 grades from the market. Quality of entry & exit, & overall trade grade. When evaluating trades, most assume that amount of money made / lost reflects its quality. Money is important for plotting equity curve, but it is a poor measure of a single trade & it makes more sense to rate quality of trades with comparison to what was realistically available.

Grades

Buy Grade

Swing traders using weekly & daily charts should look for grades on dailies. Buy grade is based on location of entry relative to high & low of daily bar when bought. E.g. high of day $20, low $19 & bought at $19.25: buy grade of 75% . Elder considers buy grades of 50% & above to be very good

Sell Grade

E.g. high of day $20, low $19 & sold at $19.70: sell grade of 70%. Elder considers sell grades of 50% & above to be very good.

Trade Grade

Buy, Sell & Trade Grades

Good channels contain 90% to 95% of prices for past 100 bars. Use any no. of channels (just be consistent): parallel to EMA / Autoenvelope / Keltner / ATR channels. Channels contain normal price moves, with only extremes protruding. Dist. between upper & lower channel lines on day of trade represents a realistic max. of what is available to a swing trader. Shooting for a max. is a very dangerous game. A-trades are those that gain 30% or more of its channel height.

ADSK daily 13- & 26-day EMAs & 7% envelope. Impulse system with MACD-H 12-26-9. (Chart by Stockcharts.com)

Elder piggybacked from Spike pick for Autodesk, Inc. (ADSK). Strategy of “pullback to value”. ADSK recently staged a deeper than average pullback: notice false downside breakout at red arrow, followed by a successful retest at green arrow.

Day A Monday: high $52.49, low $51.75, upper channel line $53.87, lower $47.61 (need channel values to calculate trade grade on exit). Bought at $51.77. Buy grade = (52.49 − 51.77) / (52.49 − 51.75) = 97%.

Days B & C Tuesday & Wednesday: rally continues, start moving up stop.

Day D Thursday: high $54.49, low $53.39. Sold at $53.78. Sell grade = (53.78 − 53.39) / (54.49 − 53.39) = 35%. Trade grade = (sell − buy) divided by channel height = (53.78 – 51.77) / (53.87 − 47.61) = 32%.

Buy grade was unusually high & sell grade below average but overall trade grade was very good. Traded 200 shares, profit after commissions was less than $400.

Defining Your A-Trade & System

Define your ‘A-trade’. Elder's A-trades were a divergence coupled with a false breakout / pullback to value. If no A-trades on screen he goes for B-trades & C-trades on really slow days. A-trades do not guarantee profits but it sets you up better.

With advantage of waiting for excellent set ups as private traders, spam A-trades.

Plan which system is used for trading. Always ask yourself "Is this an A-trade?” according to your system. Snapshot of Elder's trade journal Strategy box (Sep 2013): main system is a “false breakout with a divergence”. Occasionally trade pullbacks to value; buying pullbacks during uptrends & shorting rallies in downtrends. He rarely trades against extremes, buying severely beaten down stocks / shorting stocks whose wild rallies are stalling. He only trades 1 of the 3 strategies. Systems unlike ideas, stay & grow better with age, as you learn how they perform under various conditions. Develop new strategies & drop others. See that the ones he uses are numbered 1, 4 & 7. System can be very mechanical / quite general, with just a few key principles, like his Triple Screen.

You need not copy his strategies. Trading is as personal as handwriting. Define a strategy comfortable to you, test it & find a chart that perfectly represents it. Print that chart & post it at your desk. Search for trades that looks like it.

False Downside Breakout with a Bullish Divergence

SLB daily with 13- & 26-day EMAs & 6% envelope. Impulse system with MACD-H 12-26-9. (Chart by Stockcharts.com)

Chart shows a near-perfect example of a swing trade strategy “01 FB + BD”: false breakout with a bullish / bearish divergence. Schlumberger, Ltd. (SLB) was in a well-established downtrend & reached a new low at (A). It looked like another bottom during a long slide. Elder looks at the entire circled area of MACD-H as a single bottom as it does not go above the zero line. At (B) picture is more interesting: MACD-H rallies above its zeroline. Weekly Impulse system (not shown) turns from red to blue, allowing buying. At (C), new low is reached but MACD declines to a shallower low, setting up for a bullish divergence. First blue bar after several red bars at (C) is where MACD-H ticks up, completing a bullish divergence. That bar also rallied & closed above downside breakout level (purple dashed line). Elder bought during that bar (vertical green arrow), without waiting for it to close, going long 2,000 shares at $60.80, with a stop at $59.12. 4 days later as prices approached upper channel line & level of previous top, Elder started taking profits. Sold 1,000 shares at $66.55 & the rest the next day at $67 (red arrows). Total of $11,950 before commissions in 5 trading days.

Find charts for stocks & futures that have completed bottom A & top B & are declining into what could become bottom C. All while weekly Impulse system allows buying.

4. Scanning for Possible Trades

Develop a trustworthy trading system. Then, look for trading candidates & ask: “Is this an A-trade?” Is this pick close to your ideal pattern? Scan by reviewing a group of trading vehicles & focusing on trading candidates. You may flip through multiple charts / have your computer run through that list.

Have realistic expectations for scanning. Good scans save time by bring up a group of candidates to focus on. Make the group bigger / smaller by loosening / tightening scan parameters.

Define stocks you want to find. E.g. trendfollowers who do not like chasing stocks may design a scan to find stocks with rising MA & latest price is only a small % above average. Elder likes looking for trading candidates on weekends. One approach with limited time is to examine Spikers’ picks for the week ahead (1 or 2 stocks to piggyback).

Alternative hard-working way consists of dropping all 500 components of S&P 500 into his software & run a scan for potential MACD divergences. Elder realised that a divergence was “an analog pattern”; clearly visible to a naked eye but hard to pick with digital processing. John Bruns built Elder a semiauto MACD divergence scanner. Instead of looking for divergences, it scans for patterns that precede divergences & delivers list of candidates to monitor.

Semiauto MACD Divergence Scanner

WFM daily with 13- & 26-day EMAs. Impulse system with MACD-H 12-26-9. Red dots: potential / actual bearish divergences. Green dots: potential / actual bullish divergences. (Chart by TradeStation, scanner by John Bruns/elder.com)

This semi-auto scan finds stocks with A & B of a potential divergence. As C (second top / bottom) begins to emerge, scan puts red dots above / green dots below the bar to alert possibility of a divergence. Chart of Whole Foods Market, Inc. (WFM) shows that a scanner is not an auto trade finder. It is a watchdog that alerts to possibility that market is ready to trade: long / short. With signal, trader needs to work up that stock to establish level at which divergence would be completed & write down entry, target & stop levels.

Running semiauto scan over weekly & daily charts of components of S&P 500 takes a minute, but real work begins when Elder reviews lists of bullish & bearish candidates delivered. First, compare size of bullish & bearish lists. E.g. scan for bullish divergences gave 4-5 candidates & 70-80 for bearish divergences. Imbalance shows a coming downturn, hence find some shorts. Elder reduces weekly list of trading candidates to 5 / 6 picks with most attractive patterns & best reward:risk ratios, to be traded during the week. "I have friends who can juggle 20 stocks at once; this can be done, but not by me & traders must know their limits.

Alternative “hardworking way”: scanning stock industry groups. E.g. expecting gold to reach important bottom; pull up list of all 52 gold stocks & 14 silver stocks for buying candidates. Find stocks with ideal patterns. Add negative rules when scanning many stocks. E.g. may omit stocks with average daily volume below half a million / a million shares. Their charts tend to be more ragged & slippage is worse in less actively traded stocks. May omit expensive stocks from scans for buying candidates & cheap stocks from scans for shorting candidates. It is a personal choice for levels to place price filters. Scanning is best left for pros. Learn to fish with just a few lines in the water before casting a broad net.