Trading Systems

Jun 23, 2020
21 min read

Updated: Jul 3, 2020

A Trading System is a set of rules for finding, entering, & exiting trades.

Disclaimer: content is summarised from Part 7 (Chapter 38 - 41) of 'The New Trading for a Living: Psychology, Discipline, Trading Tools and Systems, Risk Control, Trade Management' by Alexander Elder

1. System Testing, Paper Trading, & 3 Key Demands for Every Trade

Mechanical & Discretionary Trading

Have 1 or more systems. Follow a well-established routine, to be free to think about strategic issues. Mechanical traders use strictly defined systems that leave little room for personal judgment. Discretionary traders use systems that leave plenty of room for personal decisions. Whatever approach, the key advantage of any system is that when the markets close, you feel calm. A system becomes your anchor of rational behaviour amidst the turbulence of the market. A proper system is written down as it is easy to forget some essential steps when stressed by live markets. Checklists raise performance levels in a large variety of demanding endeavours, for surgery, construction & trading.

Mechanical Trading

A mechanical trader develops a set of rules, back-tests them on historical data, then puts his system on autopilot. He places orders exactly as shown as his software flashes orders for entries, target, & stops. Amateurs feel relieved that a mechanical system reliefs him from the stress of decision making. Unfortunately, market conditions change with mass psychology, & mechanical systems eventually get out of gear hence, start losing money. Mechanical methods can help, but trading decisions must take psychology into account.

Even with a mechanical system, one must monitor its performance like a hawk. Know the difference between a normal drawdown & a period when a system goes out of gear & has to be shelved. A pro trader can afford to use a mechanical system as he is capable of discretionary trading. A mechanical system is an action plan, but some degree of judgment is always required. Pro for mechanical trading: can be less emotionally tense due to less involvement. Con: markets continuously change

Discretionary Trading

A discretionary trader tends to examine more factors than a mechanical trader, weigh them differently at different times, & is more attuned to changes in current market behaviour. A good discretionary system, gives freedom & has several strict rules, especially for risk management.

Pro for discretionary trading: openness to fresh opportunities. Con: people’s judgment tends to slip under stress, with greed / fear from sharp moves.

Combination

Mechanical traders tend to deliver more steady results, but the most successful traders use discretionary methods. Choice likely depends on your temperament, on how you make decisions in life; where to live, what career to pursue, whom to marry. Our key choices stem from the innermost core of our personalities rather than rational thought. In trading, cooler & more obsessional people turn to mechanical trading, while more daring types turn to discretionary trading.

Advanced traders combine both. E.g. Elder's friend is a deeply ingrained mechanical trader who uses 3 systems in his hedge fund but keeps rebalancing capital allocated to each of them. He shifts millions of dollars from System A to B or C, & back again. His discretionary decisions augment his systematic trading. Elder himself is a discretionary trader, but he follows several strict rules preventing him from buying above upper channel line, shorting below the lower channel line & placing trades against the Impulse system. These mechanical rules reduce no. of bad discretionary trades.

Backtesting

Backtesting is to apply system rules to historical data, usually several years. Forward-testing is to trade small positions with real money. Serious traders first backtest, then if results look good, switch to forward-tests; if that works well, gradually increase position size. Note that profit-loss ratio, longest winning & losing streaks, maximum drawdown, & other parameters may appear objective, but past results may not hold up in the real world.

Only manual backtesting prepares you to trade; it is slow, time-consuming, & cannot be automated, but it is the only method that comes close to modelling real decision making.

How to Manually Backtest

Download daily price & volume data for your trading vehicle for a min. of 2 years (for futures you may use continuous contracts). Open a chart &, without looking, swing immediately to its very beginning. Open your spreadsheet, write down your system’s rules at the top of the page, & create columns for dates, prices, & signals. Open 2 windows in your analytic program—1 for weekly chart & its indicators, the other for daily chart. As you click forward, 1 day at a time, trends & trading ranges will slowly unfold & challenge you. Moving ahead 1 day at a time tests & improves decision-making skills.

How will you deal with gap openings, when the market leaps above your buy level / drops below your stop at the opening bell? What about limit moves in futures? Clicking forward 1 day at a time & writing down your signals & decisions will get you as close to real trading as you can without risking cash. It’ll keep you focused on the raw right edge of the market.

Paper Trading

Paper trading: Record buy & sell decisions then track them like real trades, with no money at risk. Beginners may start out paper trading. There are 3 reasons why some make money on paper but not in practice. First, people are less emotional with paper trades as there is no money at risk; thus they make better decisions. Secondly, you always get perfect fills in paper trading, unlike real trading. Thirdly, a nervous beginner jumps into obvious-looking trades & loses money, but does paper trading for more challenging ones.

Paper trading cannot replicate the psychology behind actual trading hence the only reason to paper trade is to test your discipline & system. Discipline to trade real money is developed if one can download data at the end of each day, do homework, write down orders for the day ahead, watch opening & record entries, track market each day, adjusting profit targets & stops, recording actions in spreadsheets & trading diary, for several months without skipping a day.

It is essential to write down all relevant numbers before entering a trade as you are more objective before putting any money at risk; once in a trade, you’ll be tempted to give it “more room to run.”

Elder has 3 strategies that he trades. False breakout with a divergence, a pullback to value during a powerful trend & occasionally “fade an extreme”—bet on a reversal of an overstretched trend. He only takes a trade that fits 1 of these 3.

3 Key Demands for Every Trade

3 key demands for every planned trade.(Source: SpikeTrade.com)

(A) Trade setup: 3 key numbers for every trade: entry, target & stop. Before entering, decide how much to pay, risk & expect to gain. Ratio of potential reward:risk should normally be better than 2:1. Only deviate from this rule if technical signals are very strong. Target needs to be realistic.

(B) Risk management: Before entering, decide how much to risk on the trade. Divide that amount by risk per share (dist. from your entry to your stop). This gives no. of shares to trade.

2. Triple Screen Trading System

Elder developed this this system in 1986 & its basic principle remains unchanged: make trading decisions using a sequence of timeframes & indicators.

3 tests / screens are applied to every trade. Trades that pass the Triple Screen test are more likely to succeed.

Triple Screen combines trend-following indicators on long-term charts with counter-trend oscillators on intermediate charts. It uses special entry techniques for buying / shorting & tight money management rules.

Trend-Following Indicators & Oscillators

Markets are too complex to be analysed with a single indicator. Different indicators give contradictory signals. Trend-following indicators rise during uptrends & give buy signals but oscillators become overbought & give sell signals. Trend-following indicators turn down in downtrends & give short signals but oscillators become oversold & give buy signals. Trend following indicators are profitable when markets move but they lead to whipsaws in trading ranges. Oscillators are profitable in trading ranges, but give premature & dangerous signals when markets begin to trend.

Traders tend to select indicators that deliver signals they want to see. The Triple Screen trading system filters out disadvantages of trend-following indicators & oscillators, while preserving their strengths.

Choosing Timeframes: the Factor of 5

Trend of any trading vehicle can be simultaneously up & down, depending on timeframe of charts used be it the daily chart, weekly chart, etc.

Triple Screen trading system uses the time factor of 5 (refer to notes under "5. Time") Triple Screen calls your desired timeframe the intermediate timeframe. The long-term timeframe is 1 order of magnitude longer while short-term timeframe is 1 order of magnitude shorter. Triple Screen demands that you examine the long-term chart first.

E.g. you want to carry a trade for several days / weeks, then your intermediate timeframe is likely to be defined by daily charts. Weekly charts are 1 order of magnitude longer, & will determine the long-term timeframe for you.

For day traders, a 5-minute chart may define the intermediate timeframe, a 25-minute

chart the long-term timeframe, & a 2-minute chart the short-term timeframe.

Note that when the weekly trend is up, daily declines create buying opportunities & when the weekly trend is down, daily rallies provide shorting opportunities.

First Screen: Market Tide

First analyse the long-term chart, 1 order of magnitude greater than the one you plan to trade. Avoid looking at the chart you plan to trade on to remain unbiased. At the long-term chart, make your strategic decision to be a bull / bear. Then return to the intermediate timeframe to make tactical decisions like where to enter & where to place a stop.

Elder uses slope of weekly EMA as his main trend-following tool on long-term charts for Triple Screen. His Impulse system combines best features of both weekly EMA & weekly MACD-H. It is not as jumpy as MACD-H but is faster to react than slope of EMA.

Impulse system colours every bar green when bullish, red when bearish, & blue when neutral. Impulse system does not tell you what to do. It is a censorship system that signals what you are prohibited from doing. When red, do not buy. When green, do not short. Blue permits you to trade either way.

Some traders use other indicators to identify major trends. Steve Notis uses Directional System as first screen of Triple Screen. Principle is the same: Use trend-following indicators, analyse the trend on the weekly charts before looking for trades on the daily charts only in that direction.

A trader has 3 choices: buy / sell / stand aside. First screen of the Triple Screen trading system takes away 1 of those options.

Gold weekly, with 26- & 13-EMAs & MACD-Histogram (12-26-9). (Chart by Stockcharts.com)

Slope of MACD-H is defined by relationship between latest 2 bars. Indicator flashes a buy signal with an upslope & a sell signal with a downslope. Best buy signals occur when slope turns up from below its center-line. Best sell signals occur when slope turns down from above its center-line

When slope of MACD-H turns up at (A)(C)(E) either long / stand aside. When slope turns down at (B)(D) either short / stand aside.

Note that buy signals at (A)(E) are better than at (C) as signal at (C) occurs above center-line. At right edge, uptrend is very strong as (E) came from a bullish divergence: a double-bottom of prices (A)(E) + much shallower 2nd bottom of the indicator.

Second Screen: Market Wave

Second Screen identifies the wave that goes against the tide.

Second screen applies oscillators to daily charts to identify deviations from weekly trend. Oscillators give buy signals when markets decline & sell signals when markets rise. Second screen of the Triple Screen allows you to only take signals on the daily charts that puts you in gear with the weekly trend.

Apply an oscillator to a daily chart. Use daily declines during weekly uptrends to find buying opportunities & daily rallies during weekly downtrends to find shorting opportunities. Elder uses Force Index but states that RSI, Elder-ray, & Stochastic also performs well.

2-day EMA of FI gives buy signals when it falls below its zero line & does not fall to a new multi-week low.

Stochastic & RSI gives trading signals when they enter buy / sell zones. E.g. when weekly MACD-H rises but daily Stochastic falls below 30 (oversold area), it gives a buy signal. When weekly MACD-H declines but daily Stochastic rises above 70 (overbought area), it gives a sell signal.

Gold daily, with 26- and 13-EMAs and 2-day Force Index. (Chart by Stockcharts.com)

FI marks buying opportunities when it falls below its center-line & selling opportunities when it rises above its center-line. When weekly trend is up (at green horizontal bar), only take buy signals from daily oscillator for entering longs. When weekly trend is down (at red horizontal bar), only take sell signals from daily oscillator for entering shorts.

Notice a bullish divergence & false downside breakout before start of the uptrend (at diagonal green arrow). At right edge of the screen, Gold is flying, along with most gold stocks. Elder actively buys them, but not Gold ETFs. (it is common for Gold ETFs to be left behind)

Third Screen: Entry Technique

You can go to a shorter time-frame if you have live data / you can use the same intermediate timeframe for entry.

1. You may buy upside breakouts above previous day’s high for entering longs / short downside breakdowns below previous day’s low for entering shorts. But, stops are wide which puts a lot of money at risk / reduces position size. Also, when the pre-breakout day is very narrow, placing the stop right below its low would expose the trade to the risk of being stopped out by market noise.

2. Elder prefers to switch to 25-min & 5-min charts & use daytrading techniques for entering swing trades.

3. Alternatively use “an average EMA drop.” Almost every rally is affected by pullbacks. E.g. daily chart for past 4-6 weeks shows uptrend then, measure how far prices drop below their EMA during normal pullbacks.

Calculate an average drop from EMA:

■ Subtract yesterday’s EMA level from today’s & add this number to today’s EMA to see where EMA is likely to be tomorrow.

■ Subtract average drop from estimated EMA level for tomorrow & place buy order there. Buy at a bargain level, during a pullback rather than after a breakout.

These rules are for buying during an uptrend. Reverse them for selling short in downtrends. Note that downtrends tend to move twice as fast as uptrends.

Gold daily, with 26- and 13-EMAs. (Chart by Stockcharts.com)

Zooming into the previous chart on Gold, we can sharpen Triple Screen buy signals by not waiting for the 2-day FI signal. Use its declines below zero as alerts, then place buy orders below value, using an "average EMA drop".

Prices dipped below fast EMA (red line) on 4 occasions. Average downside penetration was $9.60. At right edge of the screen, 13-day EMA is $1,266. Deducting recent average downside penetration from that number suggests that if today sees a spell of panic selling, place buy order at ~ $9 below latest level of EMA. Perform this calculation on a daily basis, until there is an opportunity to buy low.

Triple Screen Summary

When weekly trend is up & a daily oscillator declines, place a buy order below fast EMA on the daily chart, at a level of an average downside penetration. Or, place a buy order 1 tick above yesterday's high. If prices rally, you will be stopped in long once rally takes out the yesterday's high. If prices continue to decline, buy-stop is not touched.

Lower buy order the next day to level 1 tick above the latest price bar & repeat till stopped in / till the weekly indicator reverses & cancels buy signal.

When weekly trend is down & daily oscillator rallies, place a sell short order above fast EMA on the daily chart, at a level of an average upside penetration. Or, place a sell short order 1 tick below yesterday's low. If prices decline, you will be stopped in on the short side. If rally continues, keep raising your sell order. Aim of a trailing sell-stop technique is to catch an intraday downside breakout from a daily uptrend in the direction of a weekly downtrend.

Triple Screen in Day-Trading

Day traders may select 5-min chart as intermediate timeframe. Decide at 25/30-min chart (long-term chart) to be a bull / bear. Then, return to 5-min chart for entry & stop. A neat combination of timeframes for day-trading stocks is 39 & 8-min charts. U.S. stock market is open from 9:30 a.m. to 4 p.m. (390 min). Using a 39-minute chart neatly divides each day into 10 bars. Decide to be a bear / bull there, then use an 8-min chart (5 times faster) for entries & exits.

Do not use too many timeframes. Swing traders can briefly use an intraday chart to time your entry, but then return to the daily charts. Watching intraday charts too much may shake you out of the trade prematurely. Day traders may take a quick look at daily chart. Rule is to select your favourite (intermediate) chart & pair it with a long-term chart that is 5 times longer.

AMZN 30-min chart with a 13-bar EMA & 12-26-9 MACD-Histogram. + AMZN 5-min chart with a 13-bar EMA, 0.6% channel, & 2-bar FI. (Charts by Stockcharts.com)

AMZN is popular due to its volatility & liquidity. Long-term chart whose every bar represents 30 min defines long-term trend. As it rises, we turn to a short-term chart where each bar represents 5 min. When its 2-bar FI dips below zero, there is an opportunity to buy at a lower price. A channel containing ~95% of all prices helps set profit targets.

Stops & Profit Targets

A disciplined trader takes profits at targets, reduces losses, & outperforms those who hang on to bad trades. Before entering a trade, write down 3 numbers: entry, target & stop.

Triple Screen calls for setting profit targets using long-term charts & stops on the charts of intermediate timeframe. E.g. profit targets on weekly & stops on daily.

When buying a dip on a daily chart, value zone on a weekly chart presents a good target.

Triple Screen trading system calls for placing fairly tight stops. As it has you trade in the direction of the market tide, there is not much room to losing trades.

3. Impulse System

Idea was to find stocks & futures with bullish inertia & bullish power & long them. To find stocks & futures with bearish inertia & power & short them.

Slope of fast EMA is a good measure of inertia. A rising EMA reflects bullish inertia, falling EMA reflects bearish inertia. Slope of MACD-H reflects power of trend. If its latest bar is higher than the previous bar / less deep than the previous bar, slope of MACD-H is rising, & power increases. If latest bar of MACD-H is lower than the previous one, then slope declines, & power decreases. When using MACD-H to define power, it doesn’t matter whether it’s above / below zero.

If both indicators are rising, bar is green, bullish. If indicators are falling, bar is red, bearish. If indicators move against each other, bar is blue, neutral. Automatic system caught every single trend, but it got whipsawed during trading ranges, where it constantly changed between green & red.

Elder then realised it was not an automatic trading system but it was a censorship system, telling the user what not to do. If either weekly / daily bar was red, do not buy. If either weekly / daily bar was green, do not short.

It keeps traders out of trouble. Impulse system forces traders to wait until it no longer prohibits an entry in the planned direction. It also helps traders recognise when a trend starts weakening & suggests an exit.

■ EMA rising & MACD-Histogram rising (especially below zero) = Impulse is green, bullish.

Shorting prohibited. Buying / standing aside permitted.

■ EMA falling & MACD-Histogram falling (especially above zero) = Impulse is red, bearish.

Buying prohibited. Shorting / standing aside permitted.

■ EMA rising & MACD-Histogram falling = Impulse is blue, neutral. Nothing is prohibited.

■ EMA falling & MACD-Histogram rising = Impulse is blue, neutral. Nothing is prohibited.

Entries

Green & red bars show when inertia & power point in the same direction. At a green bar, uptrend is accelerating. At a red bar, downtrend is in full swing.

Fast EMA & MACD-H may stay in gear for only a few bars, which is when the market travels fast: the impulse is on!

Before using Impulse system, remember Triple Screen’s insistence on analysing markets in long-term (5 times more than intermediate) timeframe to be a bull / a bear. Then, use the Impulse system for permitted entry points on long / short positions. Short-term momentum traders can buy when both timeframes turn green & take profits when 1 of them fades to blue. When catching market turns, best trading signals are given by the loss of green / red colours. If a stock is falling, but analysis indicates that a bottom is near, monitor the Impulse system on weekly & daily charts. If 1 of them is red, downtrend is still in force & buying is prohibited. Buying is permitted when both timeframes stop being red. (prevents trader from buying too soon, while market is still declining)

If analysis indicates stock is forming a top & is about to turn down, examine Impulse system on weekly & daily charts. If 1 of them is green, uptrend is still alive, shorting is prohibited. Shorting is permitted when green disappears from both timeframes (ensures trades are in gear with the market, not against it) Shorter timeframes, have more sensitive signals: Impulse on daily changes colours before weekly does.

Programs for technical analysis have “conditional formatting” which allows traders to colour price bars / candles depending on slope of EMA & MACD-H.

Test & look for the EMA lengths / MACD settings that work best in your market. A day trader can program sound alarms to monitor colour changes in several markets without being glued to the screen.

SSYS weekly with 13-& 26-week EMAs, 12-26-9 MACD-H & Impulse system (Chart by Stockcharts.com)

Impulse system can sharpen technical / fundamental methods of finding trades. Stratasys, Inc. (SSYS) is a leader in the additive manufacturing industry. Green arrows mark bars right after red bars. Red prohibits buying. Best time to buy is right after red’s disappearance. Those green arrows pick one intermediate bottom after another. Having an objective method provides confidence to buy once a decline halts.

Impulse system also suggests good areas for profit taking at red arrows which point to blue bars that occur after a series of green bars far away from value. They show that bulls are choking up, hence one should cash out.

Exits

Short-term momentum traders, close out trades once colour of Impulse system stops supporting direction of trade, even in 1 of 2 timeframes. When buy signal disappears, take profits. Reverse procedure in downtrends: cover shorts once Impulse system stops being red, even in 1 of 2 timeframes. Impulse system encourages cautious entry but fast exit. Beginners do the opposite; jump into trades & take forever to exit.

Swing traders may stay in a trade, even if 1 of 2 timeframes turn blue. When longing & 1 timeframe turns red, sell. When shorting & 1 timeframe turns green, cover short position. Impulse system helps find order in market's chaos. Enter when a trend pattern emerges & exit when it starts to sink back into chaos.

4. Channel Trading Systems

Recall that support is where buyers buy with greater intensity than sellers sell & resistance is where sellers sell with greater intensity than buyers buy. Channels show where to expect S&R in the future. Channels identify buying & selling opportunities whilst avoiding bad trades. "Prices oscillate above & below value.” (finding from mathematician Benoit Mandelbrot) We have a trading system if we accept this mathematical finding & if we have means to define value & measure an average oscillation. We will need to buy below value & take profits at value / short above value & cover at value. Value is in the zone between a short MA & a long MA. We can use channels to find normal & abnormal oscillations.

2 Ways to Construct a Channel

We may construct a channel by plotting 2 lines parallel to MA: 1 above, 1 below. We may vary dist. between channel lines depending on market volatility (standard deviation channels). A symmetrical channel, centered around a MA, is useful for trading stocks & futures. A standard deviation channel (aka Bollinger bands) are good for trading options. Channels mark boundaries between normal & abnormal price action. It is normal for prices to stay inside a well-drawn channel, & only unusual events push them outside. Market is undervalued below its lower channel line & overvalued above its upper channel line.

Symmetrical Channels

Using 2 MA, slower MA will be the backbone of the channel. E.g. with 13-day & 26-day EMAs, draw channel lines parallel to 26-day EMA. Width of channel depends on coefficient selected by trader. Coefficient is usually expressed as a % of EMA level.

When setting a channel, start with 3% / 5% of EMA & keep adjusting values until a channel contains ~ 95% of all price data the past 100 bars (~ 5 months on daily chart). Only extreme prices will protrude. Volatile markets require wider channels. Cheaper stocks tend to have higher coefficients than expensive ones. Long-term charts require wider channels. As a rule of thumb, weekly channel coefficients are 2x larger than daily.

Mass Psychology

EMA reflects average consensus of value in its time window. When prices are near MA, market is fairly valued. When prices decline near lower channel line, market is undervalued. When prices rise to upper channel line, market is overvalued.

When prices fall below MA, bargain hunters step in. Their buying & bear short covering stops declines & lifts prices. When prices rise above MA, sellers take profits on long positions / go short which caps the rise. When market sinks to the bottom, its mood is about to improve. When market rises to peak, it is about to start calming down.

Upper channel line shows where bulls are exhausted, lower channel line shows where bears are exhausted. If a rally shoots out of a channel & prices close above it, uptrend is very strong. When rally fails to reach upper channel line, it shows that bulls are weaker (reverse applies to downtrends). Elder's friend Kerry Lovvorn plotted 3 sets of channels around MA. 3 channels are set at 1,2 & 3 ATRs away from MA (width). Normal moves stay within 1-ATR channels, while extreme moves go outside of 3-ATRs, indicating a reversal is near.

Channels help us remain objective, while others get swept up in mass bullishness / bearishness. When prices rally to upper channel line, prepare to sell. When prices drop near lower channel line, prepare to buy.

Euro futures, with 26- & 13-day EMAs, the Impulse system, & Autoenvelope. (Chart by Tradestation)

March 2014 Euro futures (ESH14). Elder prefers futures as he feels they are more transparent & true than murky forex deals. Warren Buffet refers to stock market as a manic-depressive fellow, & his description applies to non-equity markets. We see Euro swinging above & below value. Market has become manic when it rises above upper channel line at (M), & depressed when it falls below lower channel line at (D). Buffett observes that trouble with traders is that they want to buy when market is manic & sell when market is depressed. Channels help to diagnose market’s mania & depression. Elder says to never buy above upper channel line / sell short below lower channel line. Though a runaway trend may be missed, safety is greatly increased. At right edge, another (M) is about to develop.

RSOL daily with 21-day EMA, 1 2 & 3-ATR channels, MACD-H 12-26-9, & Impulse system. (Chart by Tradestation)

Real Goods Solar, Inc. (RSOL)

(A): Warning. Prices stab outside +3 ATRs. Uptrend has reached an extreme.

(B): Sell. Prices could not hold above +2 ATRs. Take profits on longs.

(C): Alert. Decline stopped at -2 ATRs. Sign of bottoming.

(D): Alert confirmed. Prices holding above -2 ATRs. Bottom is being built.

(E): Buy. False downside breakout reaches -3 ATRs & rejects that low.

(F): Warning. Prices stab outside of +3 ATRs. Watch if +2 ATRs will hold.

(G): Warning. Prices stab outside of +3 ATRs. Watch if +2 ATRs will hold.

(H): Warning. Prices stab outside of +3 ATRs. Watch if +2 ATRs will hold.

(I): Sell. Prices could not hold above +2 ATRs. Take profits on longs.

Trading Rules

Amateurs tend to buy upside breakouts & short downside breakouts. Pros trade against breakouts. Most breakouts are exhaustion moves that are soon aborted. Short upside breakouts that stall & buy when a downside breakout returns into range. Breakouts can produce huge gains when a new major trend blows out of a channel, but in the long run it is better to trade against them.

Most breakouts are false & followed by reversals, hence channel lines mark attractive zones for entry against breakouts, with profit targets in value zone.

May use MA channels alone / combine it with other techniques. Gerald Appel uses these rules for trading with channels:

1. Draw MA & build a channel around it. When a channel is relatively flat, market is usually a good buy near bottom of its trading channel & a good sell near top.

2. When trend turns up & channel rises sharply, upside penetration of upper channel line shows strong bullish momentum. Hence you will likely have 1 or more chances to sell in area of highs that are being made. It is normal for market to return to MA after upside penetration, hence a buying opportunity. Cash out on longs when market returns to top of channel. (reverse works during sharp downtrends). Breakout below lower channel line shows pullback to MA is likely, offering opportunity to sell short. Cover shorts when prices return to lower channel line.

Best trading signals are given by a combination of channels & other technical indicators. Indicators give strong signals when diverging from prices. Manning Stoller combined channels & divergences:

1. Sell signal given when prices reach upper channel line while indicator like MACD-H, traces a bearish divergence. Shows weakening bulls when prices overextend.

2. Buy signal given when prices reach lower channel line while an indicator traces a bullish divergence. Shows weakening bears when prices are already low. Analyse markets in multiple timeframes. Look for buys on dailies when prices are rising on weeklies. Look for shorts on dailies when prices decline on weeklies.

3. Go long in value zone when channel rises, & take profits at upper channel line. Go short in value zone when channel falls, & take profits at lower channel line.

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

Months of action in Six Flags Entertainment Corporation (SIX).

(A): Prices reach lower channel line, new record low of MACD-H suggests low will be retested / exceeded.

(B): Channel line rejected. Rally is likely.

(C): Prices reach upper channel line & recoiled. Reversal is likely.

(D): Buy. Prices reach lower channel line, while MACD-H traces bullish divergence between (A) & (D), with a break at (C).

(E): Price reach upper channel line, new record high of MACD-H suggests high will be retested / exceeded.

(F): Pullback to value completed; MACD-H breaks below zero, setting up a possible bearish divergence. Still may buy to ride back to prior high.

(G): Sell & sell short. Prices reach upper channel line, while MACD-H traces a bearish divergence between (E) & (G), with a break at F.

Standard Deviation Channels (Bollinger Bands)

Unique feature of width changing with market volatility. Trading rules will differ from regular channels.

1. Calculate a 21-day EMA.

2. Subtract 21-day EMA from each closing price to obtain all deviations from average.

3. Square each of the deviations & get their sum (total squared deviation)

4. Divide total squared deviation by EMA length (average squared deviation)

5. Take square root of average squared deviation (standard deviation)

A band becomes wider when volatility increases, vice versa. Major market moves tend to erupt from flat bases. Bollinger bands identify transitions from quiet to active markets. They are useful for options as option prices are largely driven by swings in volatility. Narrow bands: buy when volatility is low & they are cheap. Wide bands: write (sell) options when volatility is high & they are expensive. Pros write (sell) options.