Forex | FX Operator | Currency Trading

Article from: Come To My Trading Room by Alexander Elder

Traders all over the world squint at their charts, trying to recognize pat­terns, and let their imaginations run wild. Statistical studies, however, consistently confirm only one pattern—the tendency of prices to fluctu­ate above and below value. Markets may be chaotic most of the time, but their overbought and oversold conditions create islands of order that provide some of the best trading opportunities. Markets swing between elation and despair, and we can make money from those moods.

Channels are technical tools that help us take advantage of market swings. We draw them parallel to the moving average in the inter­mediate timeframe, usually daily. A well-drawn channel contains ap­proximately 95% of recent prices. Its upper line represents the manic and the lower line the depressive moods of the market.

If we buy value near a rising moving average, we can sell mania in the vicinity of the upper channel line. If we go short near a falling mov­ing average, we can cover at the depressed level near the lower chan­nel line. Channels provide attractive targets for profit taking.

People say that a neurotic is a person who builds castles in the clouds, a psychotic lives in them, and a psychiatrist is the fellow who collects the rent. Channels help us collect rent from what drives most investors crazy—the relentless swings of the markets. The idea is to buy normalcy and sell mania or go short normalcy and cover depression.

Straight channels or envelopes work better for profit taking than standard deviation channels, or Bollinger bands. Those bands grow wide when volatility rises and narrow when it declines. They help options traders, who depend heavily on volatility, but those of us who trade stocks or futures are better off with straight channels.

Channels are for traders, not investors. If you want to invest in a $10 stock and ride it to $50, channels are not for you. Exits from invest­ments or very long-term trades are based on the fundamentals or such long-term technical signals as the reversals of a 26-week moving aver­age. Envelopes or channels work best when you trade relatively short-term swings between undervalued and overvalued levels.

If you buy near a rising EMA, place a sell order where you expect the upper channel line to be tomorrow. If the upper channel line has been rising a half a point a day for the past few days and closed at 88 today, then you can place a sell order at 88.50 for tomorrow. Adjust this number every day as the channel moves higher or lower.

Whenever I teach a group how to use channels for profit taking, someone raises a hand and points to an area where prices overshot their channel. Taking profits at that channel line would have caused us to miss a large part of a rally. What can I say? This system is good but not perfect. No method, except for hindsight, nails down all tops and bottoms. Robert Prechter, who used to be a famous market analyst, put it well when he said, “Traders take a good system and destroy it by try­ing to make it into a perfect system.”

If a trend is very strong, you may want to ride swings a little farther. Sell half of your position when prices hit the upper channel line, but use your judgment to dance out of the second half. You may monitor intraday prices and sell on the first day when they do not make a new high. Use your judgment and skills, but do yourself a favor—give up the idea of nailing tops. Greed is a very expensive emotion.

If a rally is weak, prices may begin to sink without reaching their upper channel line. There is no law that says the market must become manic before returning to value. Force Index can help measure the strength of a rally. When the two-day Force Index rises to a new high, it confirms the power of bulls and encourages you to hold until prices hit the upper channel line. If the two-day Force Index traces a bearish divergence, it shows that the rally is weak and you better grab profits fast.

An A trader is someone who takes 30% or more out of a channel. That is a little more than half the distance from the moving average to the channel line. Even if you buy slightly above the moving average and sell below its upper channel line, you can be an A trader and profit handsomely. Channels help catch normal tops and bottoms, and you can become very rich by steadily raking in normal profits. Channels help set up realistic profit targets. Amateurs swing between fantasy and reality, making most decisions in the realm of fantasy. They dream of profits and avoid unpleasant thoughts about possible losses. Since stops force us to focus on losses, most traders resist using them.

A friend told me she needed no stops because she was an investor. “At what price did you buy that stock?” I asked. She had gotten in at 80 and now it was at 85. “Would you still hold it if it fell back to 80?” She said she would. “What about 75?” She said she would probably buy more. “What about 70?” She winced. “What about 55? Would you still want to own it?” No, no, she vigorously shook her head. “Well, then you need a stop somewhere above 55!”

I recently had dinner with a lawyer who obtained inside information that a certain penny-stock company was about to announce a strategic partnership with a telecom giant. Questions of legality and morality aside, he put most of his money into that stock at an average price of

16.5 cents a share. Once the announcement came out, his stock ran upto $8, but by the time he told me his secret over a tray of sushi, it was down to $1.50. He had no stop. I asked him whether he would con­tinue to hold if his stock slid to 8 cents, half of what he paid. He was shocked and promised to put in a stop at $1. Did he do it? Probably not. It is easier to dream and close one’s eyes to reality.

You must put in a stop immediately after entering a trade and start moving it in the direction of that trade as soon as it starts moving in your favor. Stops are a one-way street. When long, you may raise, but never lower them. When short, you may lower but never raise them. Only losers say, “I’ll give this trade a little more room.” You already gave it all the room it needed when you placed your stop! If a stock starts moving against you, leave your stop alone! You were more rational at the time you placed it than you are today, with prices hov­ering and threatening to hit it.

Investors must reevaluate their stops once every few weeks, but traders have a harder job. We must recalculate our stops every day and move them often.

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3.21 Copyright (C) 2007 Alain Georgette / Copyright (C) 2006 Frantisek Hliva. All rights reserved."

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