Emini Trading Blog

Archive for the ‘momentum oscillators’ Category

Many years ago, early in my trading career, I began to gravitate from the straight support/resistance/volume trading systems and become interested in oscillators and other “exotic” indicators, as they were referred to at the time.  Of course, Welles Wilder’s ‘New Concepts in Technical Trading Systems” was often discussed.  The book was written in 1978.

I had not yet read the book.

So I went to the library to hunt down this book by arguably  the greatest technical analyst of our time.  I was, of course, expecting a large book with lavish charts and difficult to decipher language.  But I was determined to read the book and learn a little about this area of study that Wilder was making wildly popular, much to the chagrin of the old guard and Dow theorists.  Imagine my surprise when the librarian directed me to the book and it was a thinnish sort of thing, not much in the way of writing or explanation, and pretty heavy on mathematic formulae.

But what a book!  And Wilder’s insightful mind and thoughtful mathematic approach to trading is still resonating with traders today.  The book has six individual trading systems that Wilder proposed and briefly explained the rationale behind, which, at first glance, seemed less than impressive to me at the time.  You might recognize several of the names now, because they are just as relevant today as they ever were.

Wilder himself was an engineer, then a real estate broker, and finally found his groove in what then was the fairly new field of technical analysis.   Yes, this thin little book I got at the library contained some of the seminal work in technical analysis because in it, he explained the theory behind his indicators which include the Relative Strength Index (RSI), Directional Movement Indicator (DMI), Average True Range (ATR), Average Directional Index (ADX), and the often misunderstood Parabolic Stop and Reverse.  Many technicians consider these indicators to be the core of current technical analysis.

Thirty years later many traders have continued to use these indicators in their daily work and their popularity continues unabated, and traders have combined and cultivated the use of the indicators in ways Wilder never would have dreamed.  Even more impressive, these indicators are included in every software charting package I have ever used, which is a testament to their enduring popularity and accuracy.   Wilder wrote and imagined these concepts prior to the time of the truly versatile computer, which makes his achievement more impressive than ever.

With the quantification of market movement Wilder exposed the fundamental relationship between price action and the indicators ability to discern the subtle movement in prices.  By implication, he was able to quantify the emotions of fear and greed and the effect they had on price action.  These factors are still not fully understood, but are recognized as prime movers in the daily price action we all observe.

I would be remiss if I did not mention Wilder’s later work, which in my opinion, bordered on either the greatest fraud of all time or sheer lunacy.  He and Jim Sloman developed a theory of market behavior of a distinctly different flavor than his earlier work called the Delta Phenomenon.  Wilder tried, with some success, to convince his admirers that the markets were actually controlled by lunar-solar-earth cycles.  Based upon his past work, many individuals invested $35,000 a piece and he became (at least it is rumored) very wealthy.  There are still several websites proclaiming the Delta Phenomena as a ground breaking theory for investing.  Of course, Mr. Wilder and I would part ways on trading the markets based upon astrological observation.  To many technical traders, the Delta Phenomena dimmed the great intellectual light of Wilder’s work.  The Delta Phenomena is truly some unusual stuff.

Wilder’s early work is the stuff of brilliance, and I would recommend that every trader read the book, then learn the book, as a requisite to understanding modern day trading systems.  Of course, my enthusiasm for his Delta Phenomena is not quite as warm.  However, I feel to get a fair assessment of the man it is important, at least in summary form, to look at the body of work he produced, both good and high debatable.

Any trade in the futures market has essentially a binary outcome, the market either goes up or the market goes down. Of course, I am aware of the fact that you might well argue that the market stays the same and claim an anti-binary bias, but the fact of the matter is the market seldom, if ever, stays the same. Price movement is constant, especially in the scalping style of trading.

The problem arises with oscillators, which essentially measure market momentum. We are all aware that the price can easily, and often does, decline during a period of time that momentum oscillators show postive momentum. This is a constant problem traders face when trading with momentum based oscillators. We all want to trade with the trend, and I have a personal trading style that precludes any counter-trend trades. My psche simply can’t endure the relative success/failure rate on counter-trend trades. I will also freely admit that counter-trend trades can often be among the most profitable trades you can make. The problem arises when you take into consideration the relative failure rate, and/or false indications in the change of the trend. That being said, I usually strike an 89 period simple average line on my trading charts and ignore all trades above or below this line. It is a simple way to stay with the trend. It is a bit primitive, though.

As a general rule, I like to trade 233 tick charts, which, I realize, is a bit faster moving than some individuals prefer to proceed, but I have grown quite accustomed to idiosyncrasies of this chart configuration and usually profit handsomely for the information gleaned from tick charts. You can get a great idea as to the current volume in the market by how fast the bars fill. So I generally don’t chart volume, but glean the velocity of the market by the pace at which the bars fill. Incidently, I am a candlestick guy, for no particular reason other than I have always traded candlesticks.

But let us return to the inherent flaws in momentum oscillators in discerning price movement. Again, I reiterate that momentum in the market can appear to be positive, whiile the price is actually falling. This is a situation that often results in losing trades, and endless frustration for the trader. After all, one reasons that if the market is in an upward swing, how in the heck does the price action suddently veer to the negative?

The realization is a simple one: Price momentum and price action do not always have a positive correlation. Now this is a difficult, often impossible, concept for some traders to conceptualize.  My answer to the problem is a fairly simple one. I use dual time frame oscillators to chart my trades? On the one hand, I use a longer time frame oscillator to get a feel for the overall momentum of the market, and a shorter term oscillator to determine the the actual price action in the market. I have experimented for years with different settings to achieve optimal results, and for scalping I have become comfortable with a 60 period look back on the longer term oscillator and a 15 period look back on the shorter term oscillator. In effect, I get a good guage on both the momentum of the market and the price action in the market,

One quick note: I can notice when the momentum is falling and the price is falling and find it easier to pick up on trend reversals. While the system is not foolproof, it gives the trader an accurate picture of what is actually occuring in the market, and good information if he or she decides that taking that all-to-risky counter-trend trade has a decent probability for success. Myself, I usually wait until the trend has really changed before I jump into a trade, but great money, some of the best money, can be made for those who are not of the faint-of-heart and can bring themselves to trade against the trend.

The keep point of this discussion is simple: Momentum oscillators are essentially flawed because they are not great indicators of price action. Trade in a dual time frame setting and increase your chances for success in trend reversals.