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PDF made by Traderman Copyright © 1998, Coast Investment Software, Inc. and Joe DiNapoli ALL RIGHTS RESERVED. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the copyright holder. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the authors and the publisher arc not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. ISBN: 1-891159-04-6 Printed in the United States of America Warning and Disclaimer: In commodity trading, as in stock, and mutual fund trading, there can be no assurance of profit. Losses can and do occur. As with any investment, you should carefully consider your suitability to trade and your ability to bear the financial risk of losing your entire investment. It should not be assumed that the methods, techniques, or indicators presented in this book will be profitable or that they will not result in losses. Past results are not necessarily indicative of future results. Examples in this book are for educational purposes only. This is not a solicitation of any order to buy or sell. The information contained herein has been obtained from sources believed to be reliable, but cannot be guaranteed as to accuracy or completeness, and is subject to change without notice. The risk of using any trading method rests with the user. A portion of the above notice is from a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers. The NFA requires us to state that, "HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THE RESULTS MAY HAVE UNDER-OR-OVER COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN." The following notice applies when the names cited below are mentioned throughout the book. FibNodes, DiNapoli Levels, Oscillator Predictor, and D-Levels are trademarks of Coast Investment Software, Inc. Windows is a registered trademark of Microsoft Corporation.. Aspen Graphics is a trademark of Aspen Research Group, Ltd. TradeStation is a registered trademark of Omega Research, Inc., PowerEcitor is a trademark of Omega Research Inc. MetaStock is a trademark of Equis International. CQG TQ20/20 is a trademark of CCG, Inc. Market Profile is a registered trademark of CBOT. Advil is a registered trademark of American Home Products Corporation. Maalox and Pampers are registered trademarks of The Procter & Gamble Company. Grecian Formula is a registered trademark of Combe Inc. DEDICATION This book is dedicated to my Father and Mother, Joe and Olivia DiNapoli, without whose love, persistent guidance, and care, nothing would have been possible. ACKNOWLEDGMENTS The production of this book was a daunting task. Its completion would not have been possible without the help of many. My deepest appreciation and thanks to: Pat Prichard for her forbearance, diligence, love and strength. Lee and Dave Winfield for their generosity, their talent, and their time. Elyce Picciotti and Steve Roehl for their many technical skills and an attitude that allowed me to utilize them. Tim Slater, Nea! Hughes, and Dian Belanger for their unselfish guidance in making this project better. My wonderful students and clients for teaching me and encouraging me to begin this project. Dan, Hank, and Carl for adding life to these pages. Aspen Graphics™ for their permission to reproduce charts from their excellent graphics software. My peers, some who wish to remain anonymous, many of whom go unmentioned. Thank you for sharing your knowledge with me openly and without condition: Larry Pesavento, Jake Bernstein, Bill Williams, Steve Conlon, a Chicago floor manager whose name I have long since forgotten, but who was otherwise known as "God," and last but not least, Robert Krausz. V TABLE OF CONTENTS ABOUT THE TITLE xiv PREFACE or SO WHY THIS BOOK AND WHY NOW? xv SECTION 1: INTRODUCTION CHAPTER 1 TRADING METHODS JUDGMENTAL VS. NON-JUDGMENTAL TRADING SYSTEMS POSITION TRADING VS. INTRADAY TRADING 3 GENERAL DISCUSSION 3 LET'S DO A REALITY CHECK 4 NON-JUDGMENTAL TRADING APPROACHES 4 WOULDN'T IT BE NICE 4 THE REALITY ... 4 JUDGMENTAL TRADING APPROACHES 6 WOULD IT BE NICE 6 THE REALITY 6 SOME HISTORY 7 HEROES 8 SYSTEM FAILURE 8 APPRENTICESHIP 9 MORE ON JUDGMENTAL TRADING APPROACHES 10 SUMMARY 13 ASPECTS OF JUDGMENTAL TRADING 13 ASPECTS OF NON-JUDGMENTAL TRADING 13 ASPECTS OF NON-JUDGMENTAL AND JUDGMENTAL TRADING 14 POSITION TRADING VS. INTRADAY TRADING 15 DISADVANTAGES OF INTRADAY TRADING 16 ADVANTAGES OF INTRADAY TRADING 16 AN ALTERNATIVE 17 VI CHAPTER 2 PREREQUISITES, GROUND RULES AND DEFINITIONS ....19 TREND 19 DIRECTION . 25 MOVEMENT 25 FAILURE 25 LEADING INDICATORS... 27 LAGGING INDICATORS 27 LOGICAL PROFIT OBJECTIVES 29 TIME FRAME 29 CONFIRMED & UNCONFIRMED SIGNALS 29 MISTAKES 30 TRADING WELL 30 THE TRADING PLAN 30 SUMMARY 30 CHAPTER 3 THE ESSENTIAL COMPONENTS OF A SUCCESSFUL TRADING APPROACH 31 MONEY AND SELF MANAGEMENT 32 MARKET MECHANICS 33 TREND AND DIRECTIONAL ANALYSIS 34 OVERBOUGHT AND OVERSOLD ANALYSIS 34 MARKET ENTRY TECHNIQUES (LEADING INDICATORS) 34 MARKET EXIT TECHNIQUES (LEADING INDICATORS) 34 IMPORTANT POINTS TO NOTE 34 SECTION 2: CONTEXT CHAPTER 4: TREND ANALYSIS DISPLACED MOVING AVERAGES GENERAL DISCUSSION DISPLACED MOVING AVERAGES ADVANTAGES AND USE SPECIFIC VALUES DEFINED TIME FRAME APPLICABILITY FREQUENTLY ASKED QUESTIONS. ADVANCED COMMENTS .37 .37 .38 .38 .38 .38 ..39 .41 vii CHAPTER 5 TREND ANALYSIS MACD/STOCHASTIC COMBINATION 51 GENERAL DISCUSSION 51 PROGRAMS, PROGRAMMERS, AND PROBLEMS 51 WILL THE RIGHT STOCHASTIC STAND UP 52 LANE (RAW) STOCHASTIC 52 FAST STOCHASTICS 53 SLOW (PREFERRED) STOCHASTICS 54 MODIFIED MOVING AVERAGE 54 MODIFIED STOCHASTIC 55 THE STOCHASTIC 55 THE PREFERRED STOCHASTIC 55 MARKET-ALIGNED VS TIME-ALIGNED BARS 56 THE DATA SAMPLE 57 PROGRAMMERS AND UPGRADES 57 USING THE STOCHASTIC 59 IMPLEMENTING THE MACD (DEMA) STOCHASTIC COMBINATION 59 FREQUENTLY ASKED QUESTIONS 67 SUMMARY 69 CHAPTER 6 DIRECTIONAL INDICATORS 9 POWER PATTERNS FOR HIGH PROBABILITY TRADING SIGNALS 71 GENERAL DISCUSSION 71 THE "DOUBLE REPENETRATION" SIGNAL OR "DOUBLE REPO"....72 IMPORTANT POINTS TO NOTE 74 FREQUENTLY ASKED QUESTIONS 76 THE "DOUBLE REPO FAILURE" 86 FREQUENTLY ASKED QUESTIONS 87 THE "SINGLE PENETRATION" OR THE "BREAD AND BUTTER" SIGNAL 90 PATTERN FAILURES 94 ' THE "HEAD AND SHOULDER FAILURE" 94 THE "TRIANGLE BREAKOUT FAILURE" OR "OOPS" 97 "FADING POPULARITY" OR "THE VULTURES DELIGHT" 98 THE "RAILROAD TRACK" 98 "LOOL-ALIKES" 105 "STRETCH" 105 THE "FIB SQUAT" 105 FILTERING THE "FIB SQUAT" 108 FREQUENTLY ASKED QUESTIONS 109 viii CHAPTER 7 OVERBOUGHT & OVERSOLD OSCILLATORS: WHAT WORKS, WHAT DOESN'T, AND WHY 111 GENERAL DISCUSSION 111 THE STOCHASTIC 112 THEMACD 113 THE RELATIVE STRENGTH INDEX (RSI) 113 THE COMMODITY CHANNEL INDEX (CCI) 114 THE DETRENDED OSCILLATOR 115 USING THE DETRENDED OSCILLATOR 116 VOLATILITY BREAKOUT 121 IMPORTANT POINTS TO NOTE 124 THE OSCILLATOR PREDICTOR™ 127 SUMMARY 128 SECTIONS 3: CONTEXT CHAPTER 8 FIBONACCI ANALYSIS, BASIC 131 GENERAL DISCUSSION 131 A LITTLE HISTORY 132 DERIVATION 133 GUIDE POSTS 135 BASIC RETRACEMENT ANALYSIS UTILIZING THE TWO MAJOR RATIOS .382 AND .618 136 BASIC FIBONACCI EXPANSION ANALYSIS UTILIZING THE THREE MAJOR EXPANSION RATIOS .618, 1.0, AND 1.618 140 FREQUENTLY ASKED QUESTIONS 142 CHAPTER 9 DINAPOLI LEVELS™ 143 INTRODUCTION & CAUTIONS 143 ELLIOTT WAVE PRINCIPAL 144 DINAPOLI LEVELS™ 144 DEFINITIONS 145 MARKET SWING 145 REACTION NUMBER or POINT 145 FOCUS NUMBER 146 FIBNODEorNODE 146 OBJECTIVE POINT 146 ix CONFLUENCE 146 LINEAGE MARKINGS 147 LOGICAL PROFIT OBJECTIVE 147 AGREEMENT 147 FIB SERIES 148 DINAPOLI LEVELS OR D-LEVELS™ 148 EXAMPLES .-149 IMPORTANT POINTS TO NOTE 156 THE PROPORTIONAL DIVIDER.... 157 CHAPTER 10 DINAPOLI LEVELS™ 159 MULTIPLE FOCUS NUMBERS & MARKET SWINGS 159 MULTIPLE MARKET SWINGS 162 ADVANCED COMMENTS 165 EVEN MORE FOCUS NUMBERS 165 TIME FRAME'S IMPACT ON FOCUS NUMBERS 169 LESS IS MORE 170 PRUNING THE FIB SERIES: ELIMINATING INACTIVE FIBNODES 170 CHAPTER 11 TRADING WITH DINAPOLI LEVELS™ 173 GENERAL DISCUSSION 173 MOVING THE TIME FRAME ,...173 AN IDEALIZED TRADING EXAMPLE 176 ADVANCED COMMENTS 179 D-LEVEL™ EXPANSION ANALYSIS & LPOs 179 MORE ON STOP PLACEMENT 184 PRESENTATION 188 FIBNODES™ PRINTOUTS 189 DOW EXAMPLE 192 FIBNODES™ OBJECTIVE PRINTOUTS 194 AGREEMENT ON THE BOND CONTINUATION 195 HIDDEN D-LEVELS™ 197 ADVANCED COMMENTS 201 'USING FIBONACCI ANALYSIS TO DEFINE MARKET MOVEMENT. 203 CHAPTER 12 TYING IT TOGETHER A BASIC EXAMPLE 205 SCENARIO 1 207 SCENARIO 2 210 ADVANCED COMMENTS 211 NOW LET'S GET BACK TO REALITY 215 FREQUENTLY ASKED QUESTIONS 215 x CHAPTER 13 FIBONACCI TACTICS 217 GENERAL DISCUSSION 217 BONSAI: AN ENTRY AND STOP PLACEMENT TECHNIQUE 219 BUSHES: AN ENTRY AND STOP PLACEMENT TECHNIQUE 221 MINESWEEPER A: AN ENTRY AND STOP PLACEMENT TECHNIQUE 222 MINESWEEPER B: AN ENTRY AND STOP PLACEMENT TECHNIQUE 227 ENTRY TACTICS USED ON AN HOURLY S&P 228 THE TRADE CONTINUES 231 WASH AND RINSE: A CONFIDENCE BUILDER 234 FREQUENTLY ASKED QUESTIONS -.235 CHAPTER 14 AVOIDING A TYPICAL MISTAKE -.237 GENERAL DISCUSSION 237 YEARLY BOND EXAMPLE 237 THE BROADER PICTURE: D-LEVELS™ ANALYSIS AND REAL ESTATE MARKETS 242 A QUESTION 246 CHAPTER 15 MORE MARKET EXAMPLES 247 A LONG TERM SOYBEAN MEAL TRADE 247 GENERAL DISCUSSION 247 THE CONTEXT FOR THE TRADE 247 TRADE IMPLEMENTATION 249 THE TRADE CONTINUES 254 IMPORTANT POINTS TO NOTE 260 ADVANCED COMMENTS 260 WAS A MISTAKE MADE? 260 MORE EASY PICKENS 261 A SHORT TERM S&P TRADE 262 GENERAL DISCUSSION 262 TREND ANALYSIS 262 OVERBOUGHT AND OVERSOLD ANALYSIS 264 DIRECTIONAL ANALYSIS 264 TRADE IMPLEMENTATION 265 THE TRADE PSYCHOLOGY 267 HOW MARKET MECHANICS AFFECT THIS TRADE 268 ADVANCED COMMENTS 271 EPILOGUE 273 xi APPENDIX APPENDIX A CALCULATIONS AND CHART LOCATION FOR THE 3X3 DISPLACED MOVING AVERAGE 275 DEFINITION 275 EXAMPLE 275 APPENDIX B RUNNING FIBNODES™ AND TRADESTATION® AT THE SAME TIME 276 WINDOWS® 3.1 USERS 276 WINDOWS® 95 USERS , 276 APPENDIX C FIBNODES™ SETUP FOR ASPEN GRAPHICS™ USERS 277 WINDOWS® 3.1 277 WINDOWS® 95 278 TO OVERLAY FIBNODES™ ON ASPEN GRAPHICS™ 278 TO VIEW FIBNODES™ AND ASPEN GRAPHICS™ SIDE-BY-SIDE ("TILED" ON YOUR SCREEN) 278 APPENDIX D TRADESTATION® INPUTS TO SIMULATE STUDIES TAUGHT IN DINAPOLI LEVELS™ _...279 MOVING AVERAGE CONVERGENCE DIVERGENCE (MACD) 279 DISPLACED MOVING AVERAGES 279 DETRENDED OSCILLATOR 279 PREFERRED STOCHASTIC 280 . PREFERRED SLOW %D USER FUNCTION 280 „ PREFERRED STOCHASTIC INDICATOR 281 PREPROGRAMMED TRADESTATION® STOCHASTIC INDICATORS AND FUNCTIONS 281 xii APPENDIX E FORMULAS AND STUDIES 283 LANE FAST STOCHASTIC 283 FAST STOCHASTIC 283 FAST STOCHASTIC USING THE MODIFIED MOVING AVERAGE (MAV) FOR SMOOTHING 284 ' FAST STOCHASTICS 284 THE PREFERRED (SLOW) STOCHASTIC 284 MOVING AVERAGE CONVERGENCE DIVERGENCE (MACD) FORMULA 285 EXPONENTIAL MOVING AVERAGES 285 APPENDIX F FIBNODES™ 286 HOW FIBNODES WORKS 286 OPERATING SYSTEM 286 FIBNODES™ REQUIREMENTS 287 COST 287 FIBNODES™ FEATURES 288 APPENDIX G THE OSCILLATOR PREDICTOR™ 289 OPTION 1: USER SELECTS OSCILLATOR PROGRAM CALCULATES PRICE 289 THE OSCILLATOR PREDICTOR AS APPLIED TO THE SHORT TERM S&P TRADE 291 APPENDIX H SHORT TERM S&P TRADE, FROM CHAPTER 15, TIME & SALES, (AFTER THE "HEAT OF BATTLE") _294 APPENDIX I CONTINUOUS CONTRACT CREATION 295 APPENDIX J COAST INVESTMENT SOFTWARE, INC. PRODUCTS & SERVICES 296 BIBLIOGRAPHY 297 REFERENCE MATERIAL 298 ABOUT THE AUTHOR „ 301 xiii ABOUT THE TITLE: The term DiNapoli Levels was coined by an Australian copywriter doing pre-conference promotion work on one of my speaking tours in Asia. It seemed appropriate and the attendees thought the title gave them a good indication of what the presentation was about. I also have to thank my contemporaries John Bellinger (Bellinger Bands), Larry Williams (Williams %R), George Lane (Lane Stochastics), and numerous others for giving me the fortitude to proceed with such a title. In the final analysis, however, I have to admit that this title was given serious consideration only after a certain individual managed to call successive market highs and lows after himself and... not only survived but prospered in doing so. PREFACE If you want a bit of background before we get involved in all the technical matters, continue to read. Otherwise, you can jump right to CHAPTER 1 or even CHAPTER 2, without jeopardizing your understanding of my approach to trading. So why this book and why now? Or more broadly put, "Why would you reveal a trading method that really works? Why not just trade it? Aren't you afraid that if too many people use it, it won't work any more?" Reasonable questions that deserve answers. The short answer is that the markets have been kind to me, affording me considerable mobility and a comfortable life style. I was also recently faced with a life-threatening medical condition. Such an event gives one cause to think. Creating this book allows me to give something back. The long answer involves a bit of history. In 1986 I experienced a severe case of emotional and physical burnout, brought on by over-trading and lack of sleep. I squandered my health and well-being for money and accolades from my peers. I learned then that there were more important aspects to life than the next tick of the S&P. On counsel from my friend, Jake Bernstein, I took a shot at the lecture circuit. It was late in 1986 in Las Vegas at the Futures Symposium International. I was totally unprepared for the response of the attendees. The lectures were organized in two, one-hour segments, one in the morning and the other in the afternoon. I had been advised by one of the old time pros: "Give 'em an up, down, up, close, and buy. Keep it simple," he had said. "They won't understand or appreciate anything of value." "But that's not the way I trade," was my response. "So what," he muttered. I was surprised at his degree of cynicism. When I asked Jake, the event organizer, what he thought should be covered, his response was direct and simple. "Teach what you think you should. If the attendees don't like it, it's their loss." Well, that's exactly what I did. There were about 35 people in the morning workshop. Their interest was keen, their questions were intelligent and I thoroughly enjoyed sharing my knowledge. That afternoon I spoke again. This time, the room was filled to capacity. People commandeered chairs from the hallway and other rooms. They were sitting in the aisles, on the floor, some were on top of tables at the back of the room and there were perhaps another 50 people outside the door trying to get in. About 20 minutes into the lecture, an argument broke out between those who wanted a relatively simple question answered and those who wanted me to go on. Time was very limited, and it was all I could do to prevent a brawl. xv When the workshop was over, Pat my office manager, and George Damusis my programmer, were mauled for more information. Workshop attendees wanted anything they could get. We had our end-of-day graphics software (the CIS TRADING PACKAGE) which handled the trend and oscillator aspects of the lecture, but we had almost nothing on the style of Fibonacci analysis that I had taught. Fortunately we did have some FibNodc™ software manuals. These did a good job of teaching Fibonacci, DiNapoli-style, and along with a few beta copies of the software, everything was gone, and I mean gone! The next several years were loaded with speaking engagements, TV appearances, interviews, offers to manage money, possibilities to start a newsletter, fax services, and so on. While I welcomed the success, thoroughly enjoyed the teaching, and met some outstanding people along the way, it was all becoming a little overwhelming. I was also experiencing a gnawing fear that if what I had developed was overexposed, it could affect the market, my personal trading, and of course the trading of my students. To combat this possibility, I steadfastly refused to publish a book, manage money, publish any type of newsletter, or even to advertise! On three occasions I insisted on halting lectures in which there was unauthorized video taping going on. I even shelved a full video course shot at a two-day presentation sponsored by Coast in 1990, again fearing overexposure of the material. In an effort to maintain a reasonable balance, however, I created the FIBONACCI, MONEY MANAGEMENT AND TREND ANALYSIS in home trading course. I also continued development of the FibNodes™ software, and enhanced the CIS TRADING (graphics) PACKAGE. In addition, I offered some private seminars, where the number of attendees was strictly limited. I am going through this background history to make a couple of very important points. Unlike many of my colleagues, I believe the concern of overexposure of a trading methodology - even one that has judgment involved - is a valid and reasonable concern. There's also a philosophical point to be made. Any professional who tries to be all things to all people, and to produce products wherever there is demand, ultimately experiences burnout. That burnout is readily evidenced in his work. I prefer to retain my focus. Even with limited exposure, I was witnessing an effect in the market from about mid 1987 through 1990 which I believe was directly attributable to my lectures. While this effect was muted, it was nonetheless apparent. Let's be honest, if there's something good out there, it gets around. When it gets around, we need to be watchful. While its usefulness will remain significant, it is always possible that the implementation of the strategies may become more difficult. From about 1984 to 1987 the Fib analysis, coupled with the all-important context that I will teach in this book, was so incredibly accurate, it was scary. By late 1989, massive orders being set right on Fib retracements and objective points, with stops two or three ticks away, began to wreak havoc with the unqualified Fib players. While I could xvi compensate my own techniques for what I was observing, the casual Fib player was beginning to get hurt. If a lot of traders get on to something really good, the market will see to it that the majority will still lose. It has to be that way in order for the market to work.1 Fortunately, in December of 1989, Technical Analysis of Stocks & Commodities magazine published an article by some professor type with a doctorate in pure mathematics. He did a "study" on the validity of Fibonacci movements in the markets. The study "proved" by irrefutable, geometric, logic to any reasonable cerebral type, that the methodology of applying Fibonacci analysis to the markets just didn't work.2 I found out about this "authoritative" article while speaking at an economics conference in Chicago in 1989. I was with a good friend and client, a professional floor trader, when several attendees excitedly bounded toward us. The first individual was waving a copy of Stocks & Commodities magazine around, all excited about this article, that "thoroughly disproved" the subject matter of my upcoming lecture. When my client and I figured out what all the excitement was about, we simultaneously gave each other the trader's equivalent of a "high five." It's something like a war dance. The attendee was not a professional and couldn't comprehend our joy. Why would the Fibonacci Guru be happy about an article written in Stock & Commodities magazine, that maintained Fibonacci analysis didn't work? Of course, what we hoped as professionals, and what the newcomer couldn't fathom, was that our job as professional traders was about to become easier - hopefully a lot easier. Thanks to the difficulty the market was presenting the casual Fib player and that magazine article, over the next weeks and months, that's exactly what happened. So, for me, revealing my trading methodology was a balancing act between the negative effect such exposure might have, and the many, many, benefits that ensue from being recognized as an authority in one's field of expertise. Many of you who are now simply striving for that winning trade cannot imagine the doors that expert status in trading opens for you - not only here in the US, but all over the world! Starting around 1991, I began to shift my focus to Asia. The markets were ripping over there and I was getting constant input from clients located in Asia and elsewhere around the world that my methods were barbecuing the competition. I've always taught students to go where the profits were easiest and I had always wanted to be in Asia, so... I pulled the plug on all but the best speaking engagements in the US and set out on an exploration 1 Joe DiNapoli, FIBONACCI, MONEY M4NAGEMENT AND TREND ANALYSIS in home trading course (Coast Investment Software, Inc.). Herbert H. J. Riedel, "Do stock prices reflect Fibonacci ratios?" Technical Analysis of Stocks & Commodities, December 1989. xvii of all the wonders that collectively are Asia. As a professional, speaking in all the major centers, I was able to gain insight into the culture and to gather "competent information" on how the markets functioned in each of the countries I visited. It was a fascinating experience. Back in the US, clients were still finding their way to my door, but the numbers were manageable, and more importantly, the effect on the markets remained muted. Now, at this writing in 1997, things are looking pretty good for additional exposure of the material. There are a number of new Fibonacci experts, some, former students. There has been some good work done. There have also been a few, let's call them "unworkable" books on the subject. Consider this. If an "unworkable" book is written on Fibonacci analysis and people lose money attempting to employ its techniques - that's a good thing. Anything that attracts traders away from the utilization of the concept /// its proper form is an advantage to those who are skilled in how to employ it. There will be less "destructive" activity in price areas important to us. Everyone has his own idea on how this methodology should be applied. Everyone is doing something different with it. Plainly speaking, this has made it easier for me to trade and has made it possible for me to wrile this book. The simple truth is, the more people who teach a different or impractical use of Fibonacci analysis, the better it is for me - and for yoir. The idea that the whole concept will be denigrated entirely is a virtual impossibility. There are simply too many people making too much money trading it - if they know how to apply it properly. Aside from Fibonacci work, the marketplace abounds with new techniques and methods. There are eager new traders with eager new experts to teach, and brand new methods to be taught. TradeStation® and other software packages with their blind system-building techniques, put large numbers of orders in lots more places. All this is good news. It leads to the likely conclusion that a reasonable understanding of what is contained herein will pay big dividends. But beware! If this book catches on in a big way, and // it is widely followed (unlikely since there is work involved), over time there may be some consequences. If any methodology is spread too widely spread, the market typically will allow only those who study thoroughly and pay attention to nuances, to fully recognize its true potential and promise. In that respect, this approach is no different from others. xviit SECTION 1 INTRODUCTION This is a book about a comprehensive and modular trading approach that I have found to be prudent and highly effective. It is about the PRACTICAL application of Fibonacci ratios to investment markets. In order to implement these Fibonacci based strategies successfully, a considerable foundation and structured context must be put in place. The text contains 15 information-packed Chapters, a comprehensive set of Appendixes, and Reference material, as well as an orientation in the form of a Preface. Fibonacci techniques are not taught until Chapter 8, so that the ground work can be properly laid. If you choose to gallop ahead, it is my hope that you have already formulated a comprehensive context in which to use the powerful leading indicator techniques, referred to herein as DiNapoli Levels . CHAPTER 1 TRADING METHODS JUDGMENTAL VS. NON-JUDGMENTAL TRADING SYSTEMS POSITION TRADING VS. INTRADAY TRADING GENERAL DISCUSSION: Judgmental approaches call upon the trader to make decisions within a given criteria or context, while non-judgmental systems are strictly mechanical. The trading methodology I use involves judgment. It's the way I like to trade. I believe judgmental techniques have inherent advantages over non-judgmental techniques. Flexibility as inspired by the human mind, and the speed with which necessary adjustments can be made to respond to changing market conditions are two of the strongest reasons to trade using judgment. I know from teaching however, that many of you have preconceived notions about different approaches to trading that are inconsistent with reality. Since achievement in any field first involves some fundamental understanding, Tthought it might be in your best interest to spend a little time looking at certain realities of basic trading approaches. First we'll go through a reality check, then some history, so you can see why and how I have reached certain conclusions. We'll consider judgmental vs. non-judgmental trading methods then position vs. intraday trading approaches. 4 DiNapoli Levels REALITY CHECK: The Beach Boys had a song many of you should remember that began, " Wouldn't it be nice ...." It extolled the virtues and fun of constant companionship, where lovers could skip through the daisies to the never-never land of untold bliss. After not so many years, some of the Beach Boys themselves had to face the realities of married life, legal hassles in divorce court being one. Some who have avoided such a fate would privately admit that their former soul mates have become little more than dents in the bed next to them. Are things always that bad between expectation and reality? Of course not. With enough effort, we can hopefully end up somewhere in between. Likewise, such is the promise of both judgmental methods and non-judgmental trading systems. Let's look at non- judgmental trading systems first. NON-JUDGMENTAL APPROACHES: WOULDN'T IT BE NICE... 1. Once you have the development in place, your research and your work is over. Your trading system is fixed, stationary, and immutable. Stress is non-existent since the decision-making process is out of your hands and in the purview of a machine. Thorough and precise (hypothetical) testing techniques have left little to chance. Everything has been taken into consideration so your confidence is strong. 2. You can arrange for signals to be implemented by a hired trader or broker and thereby avoid the tedium of monitoring the markets yourself. 3. "It" - i.e. the "system," the "program," the "solution" - can generate an ' adequate income flow which will enable you to go to Fiji and stick your toes in the sand. Perhaps "it" can even pay the alimony and child support while you find a new soul mate to take the place of the dent in the bed. THE REALITY... 1. The work never ends. When system historical extremes are exceeded, you're back to tweaking, testing, and massaging the parameters. Chapter I Trading Methods 5 1 A. In fact, you better have two independent systems, or maybe three, or four, to even out the equity swings. Oh yes, there will not only be some tweaking and massaging, it's more likely that outright replacement of a system or two will occur, as one or the other goes sour altogether. IB. What about stress? You don't know stress until you experience pervasive impotence. You feel utterly helpless to effect results as you watch your system(s) dictate one absurd order after another. You just know that profit is going to evaporate and go to a loss. When that happens, you can't do anything but watch and obey the signals it generates. Hey Mack, pass the Maalox®, NOW! 1C. You learn that the $100 for slippage and commission you thought was extravagant, was in fact sorely inadequate. You forgot about limit moves, 40 tick runs without looking back, worst possible fill situations and.... The data you did the testing with was thought to be okay, but really wasn't all that good. Your confidence in your testing techniques is hitting new lows along with your account size. 2. The broker you have executing the trades seems to be missing entries on some of the biggest moves and ... why couldn 't he get that stop right! Or, the trader you hired can't help but put his vast experience (one year) to work "improving" what you have struggled so long to perfect. 3. The only way to get enough capital to properly fund four systems over the 15 futures contracts you have found necessary to trade for adequate system diversification, is to take in, and manage money. Now you have disclosure statements, CFTC (Commodities Futures Trading Commission) oversight, a staff, and more NFA (National Futures Association) compliance issues than you ever dreamed existed. You thought a corporate tax return was hard to comply with? Now the manure is so thick, you wonder if the daisies you planted will ever have an opportunity to germinate, much less see the light of day. 6 DiNapoli Levels WHAT ABOUT JUDGMENTAL APPROACHES? WOULDN'T IT BE NICE.. 1. You study under the best of the high-powered pros. You achieve a 90% win ratio through unexcelled market understanding. 2. You live where you want, trade when you want, and rid yourself of the employee hassles that have been bugging you for years. 3. You turn a modest amount of money, through skill and diligence, into a veritable mountain of pure financial muscle. You leave an ever-growing portion of it in a high-yielding money market account whose proceeds will allow you to zip off to Fiji when you choose to and... well, you know the rest of the story. THE REALITY... 1. You learn from one high-powered pro, then from another high-powered pro, and although you find some real benefit here and there, you're just never able to achieve quite what you expected. 1A. In fact, it's been years now, and after $30,000 in seminars, books, software, and trading courses, your profit is only barely able to cover your cost of overhead. You haven't been able to touch that $50,000 you're out from past trading losses! 2. If you can't find a way to get really profitable and hit a big home run, your savings will be gone in not so many months. You start wondering if you will become someone else's employee. 3. The stress and time demands of constantly focusing on that screen, being there for the open, and tangling with the overnight Globex session have you wondering if you'll ever get to the local beach. As for Fiji, is there a contract on them? What's the tick size and... where do Fijis trade? Chapter 1 Trading Methods 1 Okay, things aren't quite as rosy or quite as bad as what I've outlined above, but they easily can be. In fact, they can be worse! What follows are some unqualified observations from my direct involvement: the odyssey / have experienced. This recantation of events isn't hypothetical, it's real time living stated here, so you can see how I arrived at certain conclusions. Then, perhaps you can better decide for yourself where you might best fit in. SOME HISTORY: Around 1980 I decided to investigate the futures markets. The plan was to switch from the vehicles I had been trading to what I knew was the most demanding and potentially rewarding game in town. The timing of the switch had to do with my view of my station in life. By that time I was "well heeled" enough to take what I expected would be a rough transition. I also thought my knowledge level and trading expertise were at a point where this new challenge could be properly met. I quickly realized two things. It was a good thing I had waited until I was "well heeled" and the challenge was a bit more than I had anticipated. Here are the highlights of the odyssey, how I got started in, and eventually became successful at trading futures. After about a year of trading poorly, I managed a much sought-after meeting through a social contact with an extremely successful and reclusive CTA. This man was reputed to have made a bazzilian dollars over the past five years in agricultural futures. I wish I could describe this bizarre individual to you, but perhaps someone would recognize him, and one prerequisite for his tutelage was that I never reveal his identity. Of course, I never have. After a few pleasantries, this "cerebral" type began our get-together with a discussion of, "What if you were a Martian and you came to earth to trade commodities." Hmm.... "You look at this action, that action, another action, and so on. Not being able to speak English, you simply watch actions. Prices fluctuate." He went on, "You talk with your Martian friends about these actions and you wonder about appropriate reactions." I looked at him as if he were Moses holding the Commandments behind his back and musing about the fit of his sandals. After an hour of this much cloaked "benefit," I was so befuddled and confused I was willing to settle for which way soybeans might be going. Hopefully that information would allow me to get back the cost of my travel to see him! This man was the first of three mentors I was fortunate enough to have. Their kindness and willingness to share with me weighed heavily in my decision to begin teaching in 1986. So what was all this about Martians? It took me a while to figure it out, but he held the key to the gold box and he wasn't about to share it with a stranger whose intentions, interest, and sincerity were unknown. This meeting was the first of many that stretched over a period of about three years. I learned a lot from this man who traded strictly and 8 DiNapoli Levels competently from the basis of a non-judgmental system. But, strangely enough, none of what I learned was what I was after in that first meeting. He taught me that: 1. There are no absolute heroes, only heroes for a while. 2. All non-judgmental systems eventually fail (stop making money). Your hope is to be using one while it is working. 3. Excellent information can be gleaned from a true expert once trust, eligibility, and pre-requisites in your knowledge base are established. 4. Non-judgmental systems are lucky to achieve 50% winning trades, 30% is acceptable. 5. Trading a non-judgmental system is difficult and stressful. It requires tremendous concentration, diligence, and self discipline. 6. There is an awesome level of challenge, fulfillment, and discovery in the entire trading process. LET'S ELABORATE ON SOME OF THESE POINTS: 1. HEROES: It turns out my friend was a hero of truly epic proportions during the market moves of the 70s. His non-judgmental, fundamentally based, mathematical system was very cleverly put together. It fell apart, however, after the inflation peak of the late 70s, and after subsequent avenues of supplies (grains) opened up overseas. 2. SYSTEM FAILURE: With substantial personal resources, cash, and experience, he diligently proceeded with a staff and mainframes to replace what he had lost. One of the more interesting dead ends he explored was a detection of randomness, or lack thereof, to determine if a tradable trend existed. It was sort of like a Directional Movement Index gone mad. That one worked great for two years, then it stopped making money. When later it bombed out, it bombed out big. Through consultations with other traders, joint ventures and the like, he was funneled down the corridor of many of my other system-developing friends: i.e. that some form of volatility breakout Chapter 1 Trading Methods 9 system seems to best handle the test of time. As most would agree, however, these types of systems have a poor win/loss ratio and generally take significant funds to employ due to their diversification requirements. There was some additional hope gleaned from all this number crunching: i.e. some systems can last up to five or perhaps even 10 years before falling apart, and if you happen to get on to one of those early on, you can do awfully well, at least for a time. 3. APPRENTICESHIP: My naive idea that this individual would share his earned knowledge with me on our first encounter was absurd. That he would recognize my sincerity and my obvious worthiness was also absurd. It took years of doing for him, before he shared with me. He knew I needed to be ready to hear what he had to tell me. He also knew that when he told me what he knew, I would realize how little he knew. That's exactly what happened. When we reached that point, I went on. In the many encounters with bright and successful traders of fixed systems in the ensuing 16 years, I have not had reason to materially change what I had learned from my first mentor. During the time I was working with this man, I ran into my first really good trading tip, given to me by my second mentor. He was an extremely successful judgmental trader who, I think out of pity, told me to study Displaced Moving Averages. Of course, after telling me to study DMAs, he had to explain what they were. By doing so, he was finally able to get me out of his presence and go back to his mainframe. It seemed in those days the only truly successful traders I found all had mainframes and they were incredibly eccentric and reclusive. I'd spent less than 15 minutes with this person, but now I had a direction. Three years later when I compared the results of my research with his, the similarities were astonishing. It took another 15 minutes to compare our research. This was the second and final meeting I ever had with this man. Now I, too, had a profitable and reasonably consistent judgmental method to trade. The method wasn't all that hot however, about 50% winners, and it gave back a lot. Although I had a reasonable methodology, I was totally unsatisfied. Necessity being the mother of invention led to my first important independent discovery, the "Oscillator Predictor™," a true leading indicator. With it, I was able to capture profit and avoid risky entries. 10 DiNapoli Levels It wasn't until my third mentor told me about an Italian mathematician named Fibonacci1, that my techniques really began to click. Number three was also eccentric. He didn't own a mainframe and was anything but reclusive. This man was certainly the most dazzling trader I had ever met. Definitely judgmentally-based, I actually saw him nail down highs, lows, intermediate rally highs, intermediate retracement lows. You name it! His trading style went beyond any rational expectation I had ever entertained, and he did this live time while I watched him! It wasn't until he taught me what he was doing in one short * afternoon, that I discovered these techniques weren't nearly enough for consistent, profitable trading. As experience (time) robbed yet another hero from me, I saw him go from riches to rags, to insolvency, to debt. The Holy Grail sure seemed to have a lot of holes that needed mending. After many, many years of my own experience, the following hard-won conclusions make up the substance of the thread. JUDGMENTAL TRADING: 1. The most important trading tool you have is not your computer, your data service, or your methodology. IT'S YOU! If you're not right -you don't trade. 1A. Trading breaks are essential, particularly for intraday players. Three to seven day breaks every three to six weeks is what I have determined is best for me. IB. Take significant time off; about three to six months every year, if you trade intraday, at least one to three months if you trade daily-based or above. 1C. Four or five days a week spend at least one hour doing something you like that does not involve the markets or your computer. I like working with my hands, restoring cars or otherwise fixing or building things. ID. The definition of a professional is one who makes the least mistakes, not the one who makes no mistakes. If you make one serious mistake, take yourself off trading for three days. If you make three mistakes in a short time period (over two consecutive days), take yourself off trading for three days. 1 Leonardo de Pisa, was the son of Guilielmo Bonacci. In Italian, 'figlio' means 'son,' hence Tiglio Bonacci,' which was shortened through the years to Fibonacci. He was a preeminent mathematician of his time. Chapter 1 Trading Methods 11 1E. If you violate rule ID, give $100,000 to the person you dislike the most in the world. It may interest you to know that of the many traders I have trained, I have almost never seen anyone follow rule ID unless they were forced to (no margin). A mistake is defined in CHAPTER 2, under "Ground Rules and Definitions." Mistakes will be cited and clarified throughout this book. It's critical that you know if and when you make a mistake . 1F. If you have not been trading for 10 days or more, do not trade size (large positions) for at least one week. 1G. Separate yourself into two halves, the trader and the manager. The trader cannot trade without the express permission of the manager. The manager watches for crucial signs of "fitness," e.g. mistakes, irritability, stress in the trader's personal life, tell-tale black shading under the eyes, excessive flatulence. Get the idea? It is the manager's job to get the trader away from the phone before the disaster occurs. Just look at the Barings fiasco if you doubt the need for competent management. In the late 80s, a local I had trained who had achieved consistent and considerable profitability, began just as consistently, losing money. His personality seemed to be undergoing a change and it was obvious his personal life was under some stress. I first suspected drugs, but on further reflection I narrowed it down. One night when we were talking market and he was complaining bitterly about "unexplained" losses, I asked him how long it was before his new child was to be born. "Three months," he said, "and how the hell did you know?" By this time, you should be able to see the importance of being "fit" to trade. Systems or methods allowing for discretion are dependent on the quality of that discretion both in execution and size. If the discretion goes, you can wipe out in a week what it has taken you months to accumulate. 2. There are knowledgeable, honest, and sincere traders available who like to teach and have the qualifications to make themselves understood. Seek them out, get their material if you can afford it, and befriend them. Much of what they can offer to you in casual conversation will be invaluable to your success. Someone helped them. Approach them correctly and if they can, they will help you. 12 DiNapoli Levels 3. Judgmental trading can lead to incredibly favorable win/loss ratios. Don't let them go to your head. 3 A. If you attain dramatic profits very quickly, your ego can blow way out of proportion. Always remember you are only one trade away from humility. 4. During the trading decision-making time, you can afford no interruptions. None! Zero! If your office is in your home and you trade intraday, get a lock to separate yourself from anyone sharing the premises and use it. If this presents a problem with your wife or family, don't trade or get a different wife and family. One of my clients, a chiropractor, who traded out of his home in northern California, was warned about this repeatedly. This individual suffered a $40,000 loss when his wife casually walked over and dropped their infant in his arms just before a crop report. Experience can be a tough teacher but to many it's the only teacher. 5. The speed with which you can adapt to changing market conditions is considerably faster with a judgmental rather than a non-judgmental trading approach. This can prevent those huge drawdowns that can accompany blind (fixed) system failures. For those engineers who are reading this, consider a mechanical feedback system that dampens and focuses responses as a function of the speed of the transducers. If the feedback system is quick enough, it keeps up with the changes. But if it gets behind, it can go 180 degrees out of phase and tear itself up! It works the same with trading. 6. Trading a judgmental system is difficult, requires tremendous concentration, diligence, and self discipline. 7. There is tremendous challenge, fulfillment, and discovery in the entire trading process. The bottom line is that there are certain inherent advantages and disadvantages to either market trading approach. I have chosen the judgmental approach. It is largely a question of matching your talents, your psyche, your financial resources, and your objectives with the challenges and advantages cited above. There is no way I've ever seen of avoiding a lot of work and a lot of stress. Prepare yourself for it, or if it's too hot, get out of the kitchen now! Chapter 1 Trading Methods 13 SUMMARY: ASPECTS OF JUDGMENTAL TRADING TECHNIQUES: 1. You can benefit from an extremely flexible market approach. 2. You will have a highly flexible personal schedule. 3. You have the potential for dramatic gains (or losses) quickly. 4. You will have potentials for extremely favorable win/loss ratios. 5. There is an absolute necessity for strict personal management. 6. There is an absolute necessity for a separate and adequate trading environment. 7. Relatively "small" amounts of capital can be adequate to achieve your goals. 8. Your focus on relatively few markets is not only acceptable, but preferable. ASPECTS OF NON-JUDGMENTAL TRADING TECHNIQUES: 1. Poor win/loss ratios are the rule not the exception. 2. Historical hypothetical testing techniques are typically badly flawed for a wide variety of reasons. 3. Most non-judgmental systems ultimately fail; the aim is to attempt to use one while it's working. 4. Volatility breakout systems seem to best stand the test of time. 5. Multiple systems, traded over a wide variety of markets are necessary to smooth out the equity curve. 6. Relatively large amounts of capital are necessary for system and market i diversification, as well as for the inevitable drawdowns. 7. If system and market diversification is achieved, large amounts of capital are employable. °. Constant implementation of trading signals is essential, i.e. no breaks. 14 DiNapoliLevels 9. Locating adequate help to implement the system signals is a challenge in itself. ASPECTS OF NON-JUDGMENTAL AND JUDGMENTAL TRADING: 1. An excellent life style is attainable if trading goals are met. 2. Fulfillment, challenge, and discovery are possible outcomes of the trading experience. 3. Stress levels can lead to utter destruction of your psyche and physical self, if not properly managed. 4. Financial ruin will accompany a frivolous or ill-advised approach. 5. The work load is awesome and unending; it must be properly managed. 6. You will have the potential to meet, and have as friends and colleagues, some of the best and brightest individuals on the planet. Chapter I Trading Methods 15 POSITION TRADING VS. INTRADAY TRADING You not only have to decide whether to trade judgmentally or non-judgmentally, you also have to consider the time frame that best suits you. Then, you need to be sure the time period you have chosen is best for the approach you are using. With respect to applying the methodology this book teaches, it is easy. Essentially you apply the same general criteria to a five minute chart that you would apply to a monthly. Where you best belong is the tougher question. My experience indicates that it's suicidal for a new trader, operating off the floor, to trade intraday. What's "new?" "New" is anyone trading actively for less than one year. If you are a part time or casual trader, you had better give it three to five years before going to intraday trading. The better question is however: What's intraday? My definition would be a trader who is actively observing price action during the day and making decisions based on what he believes is unfolding at that time. A daily-based (or above) trader may choose an entry or exit point to be acted upon during the next day without being construed as being an intraday player. What's a position player? The true answer is, it depends on perspective. To a floor trader, the five minute trader is a position player. To a daily-based trader, a weekly-based trader is a position trader, and so on. For our purposes however, we'll consider a position trader as daily-based or above. As you drop the time frame, the decision making time is compressed and the stress is increased. As you drop the time frame, the number of decisions increase radically. You have seven times the number of decisions going from daily- to hourly-based, 12 times the number of decisions, going from hourly to five minute. The opportunity is certainly accelerated, but I wouldn't expect a savvy boxing promoter to put a promising newcomer into the ring with Mike Tyson, just to see if he could learn to handle the big time more quickly. After all, he might lose more than his ears in the process! 16 DiNapoli Levels DISADVANTAGES OF INTRADAY TRADING 1. You need experience - lots of it - with particular emphasis on order entry techniques and a thorough understanding of floor operations. 2. You need excellent brokerage and clearing services. 3. You have high overhead costs in software, quote delivery fees, equipment, and transaction costs. 4. So much of your time is taken up by the trading activity, you can't make money doing anything else. 5. Stress levels increase dramatically. ADVANTAGES OF INTRADAY TRADING 1. You can trade many more contracts with a given amount of capital. 2. You will have many more trading opportunities than a position trader. 3. If your trading capital is severely limited and you are otherwise qualified, you have trading opportunities that will allow for much closer stops. Obviously the typical range on a five minute bar is smaller than the typical range of a daily bar. This point is really a variation of #1. You should be able to restate the above to define the advantages and disadvantages of being a position trader. Chapter I Trading Methods 17 AN ALTERNATIVE: Given today's technology, there is a way to gain substantial benefits from a mix of the traditional paths. Here's how it works. Get delayed intraday quotes from a quality vendor and have the capacity to display the bars graphically on an intraday basis. You can use, let's say 30 & 60 minute time frames, to help make daily-based decisions that can be acted on during the next day. The idea is to come home after work and make your decisions in the relative calm of the evening with the added accuracy and flexibility of intraday charting capability. You can set stops, entries, and such to be acted on during the next day. It may even be possible to set up some contingency orders, depending on your work environment and/or brokerage relationships. The advantages are substantial. You avoid the need for excellent brokerage services and a thorough understanding of floor operations. You avoid expensive software, on-line feeds, and equipment. You can make money doing something else. You can trade somewhat more contracts and have far greater opportunity than a traditional position player, and have closer stops. The analysis of your trading opportunities will be thorough. What is most important, however, is that you will operate with less stress than an intraday player, giving you an opportunity to grow into the trading experience rather than to be intimidated by its nature and seeming unpredictability. These are the options; pick your poison. CHAPTER PREREQUISITES, GROUND RULES, & DEFINITIONS PREREQUISITES: 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 20 DiNapoli Levels 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 know your Time Frame, you are lost. CHART 2-1 Chapter 2 Prerequisites, Ground Rides & Definitions 21 CHART 2-2 CHART 2-3 22 DINapoli Levels 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. CHART 2-4 CHART 2-5 Chapter 2 Prerequisites, Ground Rules & Definitions 23 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. CHART 2-6 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. 24 DiNapoli Levels DAY 1 DAY 2 DISPLACED MOVING AVERAGE ON A DAILY CHART CHART 2-7 DISPLACED MOVING AVERAGE ON AN INTRADAY CHART CHART 2-8 Chapter 2 Prerequisites, Ground Rules & Definitions 25 DIRECTION: Direction is a concept, which like Trend, defines the Movement of the market, up or down. It differs from Trend in two important and distinctive ways. Firstly, Direction overrules Trend. That means if the Direction is up and the Trend is down, then the subsequent move of the market is expected and assumed to be up. We would interact with the market on that basis. Secondly, the criteria that determine Direction differ from those which determine Trend. Let me restate this point since the use of the term can seem confusing. Before reading this chapter, you had a concept of what the word Direction meant. You could look at a chart and say the Direction is this or the Direction is that. Forget your preconceived understanding of the word Direction. It will not serve you in the context of this discussion. When I speak of the Direction of the market, it will be specifically defined and the ensuing price action should be highly predictable. MOVEMENT: The Movement of the market is a term encompassing Direction and/or Trend. One could say the Movement is up because this or that Trend is up, or the Movement is expected to be down because of this or that Directional Indicator. If the criteria is insufficient to make a definitive statement about Trend or Direction, you cannot make a definitive statement about Movement. Indicators or patterns do not directly define Movement. Only Trend or Direction define Movement. FAILURE: Another term you may have to redefine, is my use of the word "Failure." If the market experiences a Failure, it too will be specifically defined and subsequent market action should be highly predictable. Your previous understanding or your definition of the word Failure will not apply in this context. Failures are forms of Directional Indicators. It is essential that you redefine some common terms, for in ten years of teaching traders, I have not found a better way to express these concepts. The concepts need explicit expression for thorough understanding. 26 DiNapoli Levels CHART 2-9 What is the Trend? Hyper Hank: Up, it's obvious, it's up! Let's buy it! Diligent Dan: / don't know. You have defined how we determine Trend, but none of the indicators you use are on the chart. What's the Direction? Hyper Hank: You 're nit-picking. Diligent Dan: Same answer, don't know. What's the Movement? Hyper Hank: Come on guys, let's buy it before we miss out on the move! Diligent Dan: Well, since Movement is dependent upon Trend or Direction, and since you haven 7 given us the information to determine either of these on the chart, I guess I can't say; but it sure looks like it's up. Chapter 2 Prerequisites, Ground Rules & Definitions 2 7 LEADING INDICATORS: A Leading Indicator is one that indicates, before the market gets there, where support or ' resistance is likely to manifest. These types of indicators are typically not taught. They are certainly not used properly. Of those Leading Indicators that are available, there are few that are of significant value. The two Leading Indicators I find to be excellent are Fibonacci Retracement and Expansion Analysis, and a derivative of a Detrended Oscillator I pioneered in the early 80s, the Oscillator Predictor™. An example of a Leading Indicator that I do not find particularly useful, is time cycles derived directly from market action. Others however, Walt Bressert, and Peter Eliades among them, have done some excellent work on this subject. Some Leading Indicators that I find marginally useful are astronomical (not astrological) dates and certain time forecasts derived from Fibonacci counts. Those indicators, of course, do not predict support at a certain price, but rather that support will manifest wherever the price happens to be, at a given time. LAGGING INDICATORS: A Lagging Indicator is one that requires market action before the indicator turns. It confirms support or resistance rather than predicts it. In short, it lags market action. Examples of Lagging Indicators are Displaced Moving Averages, Standard (non- displaced) Moving Averages, Stochastics, RSI, Trend lines, etc. At the risk of confusing the issue, it could be argued that certain of the above-mentioned indicators are coincident indicators, i.e. they indicate not before, not after, but simultaneous to market action. Understand that generally Leading Indicators are thought to be better than Lagging or coincident indicators, since they give you warning or precognition that certain steps should be taken. This is in contrast to confirmation that you should have done something yesterday or 15 minutes ago. Proponents, or teachers, of certain of these Lagging Indicators may see advantage in referring to them as Leading or coincident indicators to achieve a higher, perceived status for them. The truth, as I see it, is that one should use the best of both Leading and Lagging Indicators, and combine them in a way to achieve greatest success. Let's explore this idea a little more deeply. A reasonable case could be made that once a Trend line is formed, it, too, is a Leading Indicator, i.e. from that point on, any approach of price to that indicator could be viewed as potential support. 28 DiNapoli Levels TREND LINE CHART 2-10 The same can be said for the Trend containment capability of a Displaced Moving Average. POTENTIAL SUPPORT CHART 2-11 Chapter 2 Prerequisites, Ground Rules & Definitions 29 Okay, a case could be made. But why turn an excellent Lagging Indicator into a fair Leading Indicator as in the case of a DMA? Or why turn a fair Lagging Indicator (Trend line) into a poor Leading Indicator when we can use the best of both? We could get into more contradictions and semantics on the subject of Leading, Lagging, and coincident indicators as an intellectual exercise, but that's not the purpose of this book. We will have enough of a basis for an intelligent approach to what will follow so I'll leave the topic here. LOGICAL PROFIT OBJECTIVES: A Logical Profit Objective is an area of price where one is likely to find significant resistance to further Movement, e.g. significant orders placed against one's existing position. It is not a place to necessarily reverse your position, and there's no guarantee the market will stop its Movement if it gets there. Logical Profit Objectives are not price projections. They are simply price points where the probability of continued price Movement decreases substantially. Fibonacci Expansion Analysis creates price points where one can take a logical profit if the market gets there. As long as the Trend or Direction (Movement) is intact, they will be fulfilled. In a strongly running market, it is likely all profit objectives will eventually be achieved, usually after tradable retracements. It is not advisable or helpful to see these points as projections destined to be fulfilled. TIME FRAME: While there are essentially an infinite number of Time Frame charts one can use to trade, I choose 5, 30, and 60 minute, daily, weekly, and monthly. Occasionally I'll look at 1 or 3 minute charts, but getting below a 5 minute chart is asking for trouble, since you begin to butt heads with floor traders at those levels. As discussed earlier, the shorter the "world" you live in, the better your brokerage and clearing services must be. The reason I don't trade 7 or 19 minute charts, or a 25 minute Time Frame to "beat out" the 30 minute players (an absurd concept) will be covered in CHAPTER 5 (The MACD/Stochastic combination). CONFIRMED AND UNCONFIRMED: If all the evidence is in on a given signal, it is said to be Confirmed. If we are waiting for some last piece of evidence the technical signal is Unconfirmed. An example of a Confirmed signal would be the closing of a price above a given Moving Average. An -example of an Unconfirmed signal would be that same signal prior to the close. 30 DiNapoli Levels MISTAKE: A Mistake occurs only when you go against your Trading Plan, when you do something and you know better. A Mistake and a large loss may or may not occur simultaneously. In fact Mistakes can sometimes produce significant gains. If your Trading Plan is poorly defined, or you lack experience in the formulation of a Trading Plan, Mistakes will be hard to define. With experience, your Trading Plan will take form and Mistakes will be identifiable. It is critical to know when a large or small Mistake has been made, since the number and extent of Mistakes you make is the best way you can judge your progress - or lack of it. TRADING WELL: At certain times of the year we all do things better than at other times of the year. Whether it's your golf game or the way you interact with others, it's critical to be able to identify when things are flowing well. In golf, you can look at your score to get a measure of how well you are doing. In trading it's more difficult. Today's evaluation of profit and loss doesn't tell you much. You are Trading Well when you are following your Trading Plan. A trader who does not Trade Well is, by definition, making mistakes. If he does not take corrective action according to his Trading Plan, he will never leave the game with profit on a consistent basis. You can always change your Trading Plan if you don't realize acceptable profit, but if you don't Trade Well, you are lost! Sell grapefruit, build houses, or remain retired. Don't trade! TRADING PLAN: A Trading Plan is a set of rules by which your trading is governed. They can be formulated with some flexibility as in a judgmental trading approach, or with absolute rigidity as in a non-judgmental trading approach. Even a judgmental approach should contain as many rigid rules as possible, so you will know with near certainty when you are Trading Well (not making mistakes) and when you are not. SUMMARY: Now we have the building blocks for our foundation. In CHAPTER 3, I'll put the foundation firmly in place. All of the concepts taught in the remainder of this book will fit within the confines of this structure. CHAPTER 3 THE ESSENTIAL COMPONENTS OF A SUCCESSFUL TRADING APPROACH MY TRADING PLAN INCORPORATES THE KNOWLEDGE AND IMPLEMENTATION OF: 1. MONEY AND SELF-MANAGEMENT 2. MARKET MECHANICS 3. TREND AND DIRECTIONAL ANALYSIS (LAGGING AND COINCIDENT INDICATORS) 4. OVERBOUGHT/OVERSOLD EVALUATION 5. MARKET ENTRY TECHNIQUES (LEADING INDICATORS) 6. MARKET EXIT TECHNIQUES (LEADING INDICATORS) Let's take a closer look at each of these aspects individually and how they will be handled in this book. 32 DiNapoli Levels 1. MONEY AND SELF MANAGEMENT I've already alluded to certain critical self-management techniques in CHAPTER 1. There's a lot more that you need to know1. In the reference section, I've made mention of some alternative sources of information that may be useful to you. Finding good material on market psychology will likely be easier than getting good, practical money management material. Regarding successful personality profiles, I can add to the above reference material that successful traders are typically confident, self-made individuals, who can handle criticism and loss without defensiveness. There is no room in their minds for jealousy, envy, or emotional insecurity. It took me a long time to realize why nearly all my friends were traders and why I like being around traders so much. I don't know a better way to put it other than that they are real men and women. I'm not saying that traders must be perfect individuals. I am saying that the demands of this business substantially exceed those of other endeavors. If you suffer significantly from any of the personality flaws mentioned above, first iron out those flaws, then learn about trading specifics. In any discussion of personal management and significant amounts of money, I guess it would be fair to comment on the people you'll run into as a part of your trading experience. We all know that there are thieves and unscrupulous individuals in any field. Such individuals exist in this business as well. I can honestly say, however, that in almost 30 years in and around this industry, I've run into only two. One has been indicted and the other is likely to be at some point. Those thieves that exist on the floor are straightened out by their (floor) colleagues. The motivation to clean things up is not moral, it's practical. There is only so much money to go around. If someone consistently gets too much of it unscrupulously, the others perceive this person as a pariah and find very effective ways to rid themselves of his presence. 1 The FIBONACCI, MONEY MANAGEMENT, AND TREND ANALYSIS, in home trading course delves into the personality profile of successful traders. This portion of the taped discussion is approximately three hours long. It examines each aspect of successful thinking. More time is spent thoroughly covering money management techniques, an understanding of ruin (gambling) theory, as well as aberrant runs. The course explains how to handle margin during winning periods and losing periods. It discusses positive and negative expectation games and how your trading is defined by the nature of the methodology you are using. There is also a section that contains more basic information on how to open a futures trading account, how to choose a broker, and so on. Since these topics are well documented and thoroughly covered, they will not be repeated here. The appropriate audio portions referenced above, along with sections of the accompanying manual may be broken out of the full course. This way no one will feel forced into buying material that is perceived to be redundant. Chapter 3 The Essential Components 3 3 2. MARKET MECHANICS: I'm talking here about an understanding of the floor, of the actors on the floor, of order entry, floor rules, and practical issues...X'd trades for example2. If you were in the auto wholesale business and you didn't understand the insurance companies, the auctions, the dealers, the mechanics of the sealed bid, and such, how far would you get? If you were into real estate and you didn't understand the mechanics of financing and escrow procedures, how far would you get? I run into traders all the time who know nothing about the floor, yet they use the floor six times a day trying to make money. Wake up! You need a reality check! Know the mechanics behind the business at which you are attempting to make a living. In private seminars, I stress the importance of pit knowledge. I tell my students to get on the floor of the S&P for at least six hours. I want their legs to ache and I want them to see pit traders get spit on, trampled, and possibly even get into fights. I want them to feel the disappointment of the local who can't get an order off to close his profitable three-tick trade. I want my students to see the frustration of "out trades" in the making. Trading is a tough, risk management business. How can you manage a risk you are unaware of? How can you dispel misconceptions without experience? Floor traders are your colleagues. You do yourself a disservice when you make them your enemy. What if you're not an intraday trader? That's fine. You don't need to know anywhere near as much about the pit as someone who trades intraday. You do, however, need to know more than 90% of the people out there who think they are going to pay their bills out of their trading profits. You need to dispel misconceptions that act as a crutch for impractical behavior. This is a hot topic for me. When I designed my FIBONACCI, MONEY MANAGEMENT, AND TREND ANALYSIS in home trading course in 1988, I thought I had given the prospective trader everything he needed to get the job done. By relating a variety of personal experiences, I addressed this issue, but only so much could be done in a two-day workshop. I realized more needed to be done and I will endeavor to fill this void at some point in the future. I have identified the people I wish to have participate in such a work, but so far I have not been able to convince them to help me on this project. I will make constructive and appropriate reference to aspects of floor mechanics as we progress in this book. However I strongly recommend that you make it your business to seek out and befriend experienced traders, both on and off the floor. Once you have gained their trust, 2 Joe DiNapoli, "THE X'D TRADE (or Where's My Fill?)," Technical Analysis of Stocks & Commodities magazine, March 1995, page 88. 34 DiNapoli Levels they will freely discuss the anatomy of the floor and you will be rewarded for your efforts throughout your trading career. I hope you are not unduly disappointed with references to other sources of information regarding items one and two above. Be sure you check the bibliography and reference sections. The rest of the trading approach is fully and explicitly covered in the following pages. 3. TREND AND DIRECTIONAL ANALYSIS CHAPTERS 4, 5, & 6 4. OVERBOUGHT AND OVERSOLD EVALUATION CHAPTER 7 5. MARKET ENTRY TECHNIQUES (LEADING INDICATORS) CHAPTERS 8, 9, 10, 11 & 13 6. MARKET EXIT TECHNIQUES (LEADING INDICATORS) CHAPTERS 7, 8, 9, 10, & 11 IMPORTANT POINTS TO NOTE: While it is not a formalized part of my Trading Plan, I strongly recommend you complete trade evaluation summaries. This consists of a written evaluation or self-evaluation "diary", which enables you to gain perspective and reinforce the concept of Trading Well. The remaining chapters of the book will deal with implementation of my Trading Plan, using a variety of specific examples. SECTION 2 CONTEXT When I get into an aircraft, I like to see some gray hair on the Captain. It gives me confidence and puts a smile on my face as I settle down to my first drink. My assumption is that he's been around a while and likely to have seen some spooky times. It's no different with trading. The egotistical traders among us might hide the Grecian Formula®, but the experience is still there. We juggle dynamite when we trade futures. While a trader could certainly use the concepts taught in this book to enhance his magnesium-like glow, the purpose of this book is rather to allow a trader to profitably survive. Longevity in this arena tells you who's made the grade. By scrupulously identifying the CONTEXT of your trade, you know up front your risk/reward criteria. You know up front whether or not you wish to participate in a given trade or wait for the next opportunity which is always just around the corner. Remember... Loss of opportunity is preferable to loss of capital! CHAPTER TREND ANALYSIS DISPLACED MOVING AVERAGES GENERAL DISCUSSION: There are many types and varieties of Trend delineation techniques. Trend lines and Moving Averages are among the most commonly used. There are also Displaced Moving Averages, Moving Average Bands, Deviation Bands, MACD, RSI, Stochastics and so on. There are almost as many ways of defining "Trend" as there are traders. One of my better students (Ed Moore) uses Fibonacci techniques to define "Trend." In inexperienced hands this could be a way to turn a great Leading Indicator into a poor Lagging Indicator. In Ed Moore's case, there's enough experience to draw from to make this transition useful. Another old time pro I know simply looks at price either above or below the open, to establish an up or down Trend respectively. While I like the simplicity of this technique, I think there's a real lack of quality in this method. I use two specific methods for Trend delineation and only two. They are: 1. Displaced Moving Averages 2. The MACD/Stochastic combination. In this chapter, we will limit the discussion to Displaced Moving Averages. The MACD/Stochastic combination will be covered in CHAPTER 5. The more exotic techniques for defining market Movement (up or down) are contained in CHAPTER 6, Directional Indicators. 3 8 DiNapoli Levels If you haven't fully understood the term "Trend" as defined in CHAPTER 2, please restudy that section. If you are interested in how I came to use Displaced Moving Averages, you may refer to CHAPTER 1. DISPLACED MOVING AVERAGES Displacing a Moving Average forward in time offers several significant advantages to the trader. 1. It lets you know what the Trend delineation point or price number will be "N" number of periods ahead of time. Knowing where this point is, ahead of time, helps you to plan your market strategy. 2. By using the "proper" number of periods for calculation of the Moving Average and the "proper" displacement amount, DMAs tend to reduce whipsaws and "cup" or contain market action in ways that are very helpful to traders. 3. Certain DMAs are extremely useful in defining patterns, as shown in CHAPTER 6, Directional Indicators. After many years of research spent selecting the proper length and displacement amount, I have arrived at three DMAs. They are: - The 3 period simple Moving Average of the close, displaced forward three periods. - The 7 period simple Moving Average of the close, displaced forward five periods. - The 25 period simple Moving Average of the close, displaced forward five periods. For brevity, they will be shown as follows: 3X3 7X5 25X5 The periods I use are Daily, Weekly, and Monthly. Quarterly and Yearly periods work equally -well, but I seldom look at those Time Frames. I've been teaching the use of DMAs for over 11 years. I've answered hundreds of questions on the subject. Since the same questions come up time and again, I think it would be useful to review them. Chapter 4 Trend Analysis Displaced Moving Averages 39 FREQUENTLY ASKED QUESTIONS: What do you mean by "displaced forward in time" and how does this help reduce whipsaws? Rather than plotting a given Moving Average, calculated today, on today's date, you simply plot the identical value at a different, later date, hence the term "displaced." The displacement is on the time axis, not the price axis. For the visual learners among you, the arrow in the following chart shows that the same Moving Average is simply placed forward in time. All calculations remain identical. For the mathematical types, Appendix A contains a table showing the calculations and where the respective values are placed. CHART 4-1 40 DiNapoli Levels The next Chart 4-2A, shows a mathematically weighted Moving Average, (i.e. various "weights" given to different periods) plotted with no displacement. In other words, the chart shows a standard weighted Moving Average. The number of periods or the character of the weighting is not significant to the discussion. Chart 4-2B shows the identical Moving Average displaced forward five days. The displacement amount could have been two, three, 10, or minus 10 days, weeks, or months. It is as if you took a piece of tracing paper that had only the Moving Average on it (no price bars), and slid the Moving Average left or right horizontally the desired amount (displacement). Now, let's assume a basic Moving Average crossover, non-judgmental, always in the market system, where one would buy on close above the MA and sell below it on close. It's easy to see how many times one would have been whipsawed by the non-displaced MA as opposed to the Displaced MA. CHART 4-2A Chapter 4 Trend Analysis Displaced Moving Averages 41 CHART 4-2B For those of you who are attempting to build non-judgmental systems using Standard Moving Averages, try this additional variable and see if you get better results. ADVANCED COMMENTS: As with most observations in this business, there's the obvious and the insidious advantage to note. Obviously if you are whipsawed less often, you'll have a higher equity. Not so obvious is the real life factor of continuing to play the game. By the time most traders reached Q (for quit) as shown above in Chart 4-2A, they would have thrown in the towel and gone back to system development. Of course, this occurs just before the most profitable run on the chart. Point Q on Chart 4-2B has been relabeled to M for money because that is what will be made. The real life truth is that a trader trading off of Chart 4-2B is much more likely to be there for the big gains that are to follow! 42 DiNapoli Levels Even being whipsawed infrequently, as in Chart 4-3A, can leave an average trader with an emotional excuse not to reenter. Look at the profit you would have missed if the whipsaw in March gave you an excuse to stay out of the market. CHART 4-3A Wouldn't using a longer Moving Average period accomplish the same function of preventing whipsaws and keeping you in the market? Not really. Where a longer MA will likely provide fewer whipsaws, other properties change as well. See Chart 4-3A. Note how the displaced MA and the non-displaced MA approach one another when the market finally breaks. You maintain the same profit level, point P. Chapter 4 Trend Analysis Displaced Moving Averages 43 CHART 4-3B The profit differential on Chart 4-3B is a different matter. Here we have a longer term standard MA. It falls dramatically away from market action. Therefore, a non-judgmental system whose signals are based on crossing a MA on close to take an open profit (P2), is likely to give back significantly more than the shorter period DMA would give back (PI). How would you trade this? I wouldn't. Trading any given market will come only after this book has thoroughly covered all the aspects needed to trade. The examples contained herein are for your understanding of the segment covered. What did you mean about blowing (he price delineation point 'N' periods forward in time? The term 'N' refers to the displacement amount. If we're talking about daily periods, the 3X3 is displaced three days forward in time. You know the DMA value of the current day, two days, and three days ahead of time, i.e. the price point that will delineate trend. If there was no displacement (N=0) then you wouldn't even know until the close what the Moving Average value was for the current day, since you need that value to calculate the Moving Average. 44 DiNapoli Levels Years ago, traders used the opening price rather than the close to calculate the Moving Average value, so they would know ahead of the close what the MA was for the current day. I believe the first series of workshops I gave in 1986 and 1987 discussing the advantage of DMAs was instrumental in the demise of this practice. What about exponential MAs, weighted MAs, or "back-deviated Maxwell convoluted" MAs? Would they work better? Do the Displaced Moving Averages you use work in all markets? You're welcome to try them. I arrived at the DMAs cited above over a period of about two and a half years, cranking them out on a CPM based computer using an 8088 chip. I studied thousands of charts, in all manner of markets, in all types of conditions. I tried every kind of MA I could imagine and have programmed. In those days there was no commercially available software I was aware of that created DMAs. To accomplish this task I needed to create a graphics package that would displace a Moving Average. The result was the first incarnation of the CIS TRADING PACKAGE, programmed by George Damusis. My research revealed no advantage in more complicated DMAs, over simple DMAs. Therefore in keeping with my primary directive, i.e. keep everything as simple as possible, I stuck with simple DMAs. It's also useful to understand that I did not go through this optimization process, so popular with many of the computer junkies and cerebral types. Instead, I exhaustively examined market after market, to see what I, as an experienced trader, could live with emotionally and reasonably expect to be profitable. Could I do a better job today? I doubt it. More number manipulation power is not necessarily better. Besides, I doubt I'd have the fortitude to take on such a job today. Even if I were to make this single aspect of my Trend analysis technique 5% better, would it significantly influence the bottom line? I think not. As you will see, Trend analysis is filtered and acted upon by subsequent powerful techniques. Remember the old axiom, if it ain't broke, don't fix it. Don't misunderstand me on this point. Research is terrific. You can learn a lot from it, and you should try to improve on my work if you are so inclined. I would suggest to you, however, that you test your results across all the markets. The DMA values and calculation methods used should have universal applicability (overseas markets) as well as the ability to stand the test of time. Chapter 4 Trend Analysis Displaced Moving Averages 45 Below is a highly compressed chart of the daily UK long bond (gilt) with both the 25X0 and 25X5 shown. This chart illustrates price action in both trending and consolidating periods. Arrows have been placed at points where the 25X5 contained Trend but the 25X0 did not. CHART 4-4 You do not use Displaced Moving Averages on intraday charts. Why not? Don't they work? They work very well, but I have a technique that (for me) works better. It's the MACD/Siochastic combination. Many of my clients use DMAs on intraday charts and rave about their effectiveness. You, of course, are free to try them. They are simpler to employ than the MACD/Stochastic combination. 46 DiNapoli Levels The following chart shows how well an intraday 3X3 contains thrusting moves on the 30 minute S&P. CHART 4-5 So how do we define the "Trend"? Very simply. If the close is above the Displaced Moving Average you choose, the Trend is up. If the close is below it, the Trend is down. If you use DMAs to non-judgmentally enter or exit a market, I'd suggest giving it a tick or two, through the DMA on close, before acting, particularly on the longer term 25X5. What if the price is above it now, at mid-day, but yesterday's close was below it? In that case, the Confirmed Trend is down and the Unconfirmed Trend is up. Why do you use three value sets for the DMA? The 3X3 is for the short term and is extremely useful in thrusting markets. The 7X5 is a longer-based DMA that many have found useful in equity market analysis. The 25X5 is my long term DMA. Chapter 4 Trend Analysis Displaced Moving Averages 47 What if the closing price is below the 3X3, but above the 25X5? Then the short term Trend is Confirmed down and the long term Trend is Confirmed up. Below is an example of both DMAs on the daily German bond (bund). CHART 4-6 How you would react or how you would play this would depend upon what Time Frame player you were. If you were an hourly-based player, you would be very interested in the daily 3X3 and you'd be aware of the 25X5. If you were a weekly-based player, you would be interested in the 25X5 on the daily or perhaps the 3X3 on the weekly. One caveat here. If the weekly-based trader was aware of a Directional Indicator created from a daily-based 3X3, he would take notice. I'll explain this in detail in CHAPTER 6. Is it okay to take a position on an "Unconfirmed" signal? Absolutely, I do it all the time, but at the close of the period you had better have confirmation in the Direction of your assumptions or you say "adios" to the trade. If you do not, you have made a major Mistake. Also, on the subject of Mistakes, you never, 48 DiNapoli Levels ever, change the reason for a trade. If you entered a trade on the basis of some criteria and that criteria is negated, you don't look around for other criteria to justify your position. If you do, you have made a serious Mistake. Close the trade, and if you have other criteria to be in the trade, re-open it, on that basis. Pay the commission. The long term psychological considerations far outweigh the costs involved. Besides, once you're out of a trade and take a fresh look at it, the reentry criteria may not seem nearly as compelling. You referred to cupping market action. Is this really the same thing as minimizing whipsaws? Yes, one of the most common techniques misused by traders is that of tightening up on their stops too quickly. The idea sounds good, but most traders don't have good stop placement techniques in the first place, much less any idea about when to tighten them. Consider the following daily chart of the Canadian dollar. CHART 4-7 From March through the beginning of May, the market is primarily in a strong up Trend as defined by the 3X3. We would therefore be playing the long side, by buying dips, likely on an hourly chart, and selling at specific objectives. These dips and Objective Points are defined by Fibonacci work which will be covered later. Chapter 4 Trend Analysis Displaced Moving Averages 49 When we reach the top, we have a sustained break through the 3X3 to the downside and the 3X3 contains or "cups" the ensuing rally back toward the top. Look at the expanded view of the top, Chart 4-8. CHART 4-8 If we tightened our stops too quickly, after getting short on day A, we would be stopped out on day B or C. If we used the 3X3 as a guide to Trend delineation, we would have no reason to be concerned about our short position, unless we experienced a significant close back above the 3X3. In later chapters, we will cover stop placement techniques thoroughly. For now, what's important is that you understand that the 3X3 is giving the market an opportunity to breathe. The rally back toward the previous top provides a way for those who have provided market liquidity to the sellers, to unwind the long positions they have accumulated, and likely go short themselves. As you study the concepts defined in this book, you will plainly see that markets are stable and tradable if they have reactions to any significant price Movement. They are unstable and dangerous to trade if there are sustained and violent moves in only one Direction. this is due to the fact that those professionals who have provided liquidity to the markets are the wrong wave! CHAPTER TREND ANALYSIS MACD/STOCHASTIC COMBINATION GENERAL DISCUSSION: Like most traders new to the Stochastic, I was befuddled for a time by its movement, and dismayed by my initial attempts to use it. Fortunately the equipment I used at that time to display the Stochastic was the CQG TQ20/20™. I say fortunately, because the TQ used a modified type of Stochastic, rather than what was said to be the standard Lane Stochastic. Some time later I learned there were differences in Stochastic formulas. Had I attempted to apply this indicator using a different Stochastic formula than what was programmed in the TQ20/20™, my learning curve would have been much steeper. This is because the indicator would have been much more difficult to apply and interpret. PROGRAMS, PROGRAMMERS, AND PROBLEMS: At the risk of having your eyes glaze over from boredom or creating a brain embolism from strain, we're going to digress a bit and discuss some significant issues we, as traders, encounter while attempting to utilize trading tools. The Stochastic, and to a lesser extent the MACD, give us a perfect setting for this discussion. We'll consider the Stochastic first. George Lane1, the originator of the Stochastics, observed that the closing price within the range of a bar had significance relative to future price development. After considerable 1 George Lane, Investment Educators 52 DiNapoli Levels diligent effort, he derived a formula that quantified this belief. That seems straight forward and simple enough, but in the real world of trading software it's anything but straight forward and simple. There are disturbing variations of Stochastic formulas floating around and specified in reference material. Even talking with George himself who is one of the most knowledgeable, generous, and gentlemanly figures associated with the business, I have not found a simple means of getting from the original formula to what we as traders are faced with using now. So here's how we'll proceed. I will try not to bury you in complex math. There are a variety of equations in Appendix E for the mathematicians and programmers among you. I will also give you the option to skip ahead a few pages to the Preferred Stochastic, if your only interest is in knowing what I use. By doing so you will eliminate going through a somewhat tortured discussion. However, you will miss out on some of the issues we face utilizing trading software to make our trading decisions. As an outgrowth of George's work came a variety of terms: Lane Stochastic Raw Stochastic Fast Stochastic Slow Stochastic Modified Stochastic The Stochastic WILL THE RIGHT STOCHASTIC PLEASE STAND UP: When traders purchase a graphics package from let's say, Trade-Em-Quick Software Inc., we can see that they have "The Stochastic" available as one of their preprogrammed indicators. Great, we're happy, since that's one of the indicators that we've read about and want to use. But, which Stochastic is "The Stochastic"? If we don't know enough to ask some very pertinent questions to some hopefully informed and responsible sales people, we haven't any idea of what we are really getting! So, let's try to learn something about Stochastics and let's be worldly about software and how it is developed. LANE (RAW) STOCHASTIC: As far as I'm concerned, all Stochastics can rightfully be called the Lane Stochastic since they all emanated from George Lane's research. Lane Stochastics, i.e. all of the Stochastics we will discuss, have two lines: a fast moving line %K, and a slow moving line %D. There seems to be some agreement between the different Stochastics formulas for %K of the Fast Stochastic, sometimes referred to as the Raw Stochastic, so we'll start with it and I'll include the equation here. Chapter 5 Trend Analysis MACD/Stochastic Combination 53 %K, Fast (Raw)Stochastics: FIGURE 5-1 The calculation of %D, the slow line, is where a large number of the problems arise. The slow line %D, is a smoothed version of the fast line, but there are a variety of ways of smoothing a line. There's the number of periods we can use to smooth a line, as in a five period Moving Average, or a ten period Moving Average. Then, there's the type of Moving Average we can use. We could use a simple, or an exponential Moving Average for example. Since there are a variety of ways of smoothing a line, there are a variety of different Stochastics. FAST STOCHASTICS: If we use the formula in Figure 5-1 for %K and smooth it by using a three period modified Moving Average (MAV), we have the %D line of the Fast Stochastic. In George Lane's Stochastics article2, he used an example from the TQ20/20™, which used this type of smoothing of %K to create the % D line. The TQ was also programmed to use the same type of smoothing to create the Slow Stochastic referred to in Figure 5-3. FIGURE 5-2 Some software companies will use other smoothing methods, however, and still call the indicator the Fast Stochastic. 2 George Lane, "Lane's Stochastics," Technical Analysis of Stocks and Commodities, May/June 1984. %K=IOO[(C-Ln)/(Hn-Ln) where: C is the latest close Ln is the lowest low for the last n days Hn is the highest high for the last n days %D (of the Fast Stochastic) = 3 period MAV of %K (of the Fast Stochastic) 54 DiNapoli Levels SLOW ( PREFERRED) STOCHASTICS: Slow (Preferred) Stochastics are derived from Fast Stochastics. If we take the %D computed above and rename it to %K, and then smooth this line by using a three period modified Moving Average, we have the new slow, Slow Stochastic line, %D. These two lines make up the indicator called the Slow Stochastic, created by a modified Moving Average smoothing. This is what I use ("Preferred"). FIGURE 5-3 Some software companies will use other smoothing methods, however, and still call the indicator the Slow Stochastic. The formula for the modified Moving Average is shown below. The starting point (MAVt) is calculated identically to that of a simple Moving Average. MODIFIED MOVING AVERAGE (MAV):3 FIGURE 5-4 If a simple Moving Average is used instead of a modified Moving Average to perform the smoothing, you get a Slow Stochastic which is significantly less useful. In fact, I find it useless. 3 P.J. Kaufman, The New Commodity Trading Systems and Methods, (New York: John Wiley & Sons, 1987) %K (of the Slow Stochastic) = %D (of the Fast Stochastic)) %D (of the Slow Stochastic) = 3 period MAV of %K (of the Slow Stochastic MA Vt = MA Vt-1 + (Pt - MA Vt-1 )/n where: MAV t is the current modified Moving Average value MA Vt-1 is the previous modified Moving Average value Pt is the current price n is the number of periods Chapter 5 Trend Analysis MACD/Stochastic Combination 55 MODIFIED STOCHASTIC: If we start at the original agreed upon formula for the fast %K (Figure 5-1) and smooth that line by any means whatsoever, we have %K of the modified Stochastic. If we then take that %K line and smooth it by any means whatsoever, and call the result %D, we have the slow line of the modified Stochastic. It is likely you will find other definitions of the Modified Stochastic in reference material or software users manuals. THE STOCHASTIC: Display Trade-Em-Quick Software or Aspen Graphics™ or CIS TRADING PACKAGE or TradeStation® on your screen and there you have it, an indicator that is a Stochastic. What it is or how useful it is, is anyone's guess. Without diligent research, I wouldn't hope to define this term as the study it suggests can have such vastly different appearance, applicability and usefulness, depending on how the equations are manipulated in the software of your choice! THE PREFERRED STOCHASTIC: This is a new term. It is meant to reflect what / use and find of benefit. The equations cited above to produce the Slow Stochastic and the modified Moving Average achieve what I want. Other equations and references relating to the Stochastic are in Appendix E so as not to confuse this issue further. The last time I looked, my Preferred Stochastic was called the Slow Stochastic in CQG, Inc., Aspen™, and our own CIS TRADING PACKAGE. It was not available in TradeStation® as a preprogrammed indicator, but could be created by inputting the proper equations in so-called "Easy Language™"(Appendix D). MetaStock™ defaults do not produce the Preferred Stochastic. You can change the defaults in MetaStock™ without inputting equations, to create the Preferred Stochastic. When you study the examples of Stochastics on charts in this book, using the Aspen Graphics™ software, you will see the name Modified Stochastic rather than Slow Stochastic, even though Slow Stochastic is my Preferred Stochastic. Why? When I set up the study initially, I didn't trust that the programmers had computed the Slow Stochastics correctly. I therefore went to the Modified Stochastic study and set up the study myself, to duplicate what I knew were correct inputs. I then compared these values with what I • knew were correct: our own CIS TRADING PACKAGE. After I did that, I compared the specific Modified Stochastic I set up in Aspen with what Aspen called the Slow
