The benefits of buying into an uptrend on dips and selling into a downtrend on rallies are probably obvious. If we compare the dips and rallies approach to entering on breakouts we can see that the "dips" entry strategy allows us to enter at cheaper prices with less risk and more profit potential. That is a nice combination of benefits. In this Bulletin we will share some of our conclusions from our many hours of research on how to identify these potentially profitable opportunities.
First, the strategy is going to work best if there is a trend. (Lets simplify things by using examples only for the long side. Unless otherwise noted you can assume the procedure for selling short is just the opposite.) Trend identification is a big topic in its own right but for our purposes we don't have to come up with anything fancy. The direction of a moving average or the relationship of two moving averages will work just fine. We could also take a simple momentum approach and require that the close today must be a minimum amount higher than it was X days ago. For example, we might want the close to be more than three ATRs higher than the close twenty days ago. When we were at Dr. Elder's Trader Camp he recommended that stock traders should look for both a rising 22 week moving average and a rising 22 day moving average. That's an excellent suggestion. We have found that the specific method of identifying the direction of the trend is not critical to the success of the system. In fact we have used a different method of measuring the trend in each of our systems. If you already have a favorite definition of trend by all means use that.
Once the direction of the trend is established we need to go to work on defining a "dip". Now here is a valuable tip: The stronger the trend the smaller the dips. This seems obvious once it is pointed out but we see too many traders overlooking this important concept. They typically want to get long in an uptrend when some oscillator like RSI or Stochastics is "oversold". We have found that oscillators only reach oversold levels when the market is weak or trendless. The ideal "dip" entry is a very small dip in a very strong uptrend. These ideal trades have the lowest risk and the highest profit potential.
Fortunately we don't necessarily have to know the exact strength of the trend because we can define a minimum definition of "dip" so that we can catch small dips as well as any bigger dips. This procedure will allow us to catch the ideal trades as well as those highly profitable trades that are less than ideal. The most important point to remember here is that if we demand too great a dip we will be missing some of the best trades.
Here are a just few ideas on how we might define a minimum dip:
1. The close today (or the low today) is 1 ATR or more below the close (or the high) 3 or 4 days (or bars) ago.
2. The RSI has declined 10 points or more from its high 3 or 4 days ago.
3. The low of the last 2 or 3 days has gone below the 7 day moving average.
4. A recent low has penetrated below some moving average of lows.
5. Some oscillator like RSI or Stochastics has gone below a threshold level (like 50 or 60). Remember: We don't expect it to reach oversold levels.
6. The Plus DI (part of the ADX indicator) has declined some amount from its peak.
7. The Minus DI has risen some amount from its low.
8. The slope of a short term moving average has turned down.
I'm sure that with a little thought you could add extensively to this list. It is important to understand that we do not necessarily enter once the dip has reached the minimum level. We think that we can obtain a higher percentage of winning trades by waiting for some entry "trigger" that will signal that the "dip" is over and that the prevailing up trend has resumed. The minimum "dip" is merely a setup condition and we want some indication of strength to actually initiate the trade.
Here are a few possible entry triggers:
1. Place a buy stop at yesterday's high.
2. Place a buy stop at X points or some fraction (0.4?) of ATR above tomorrow's open.
3. Place a buy stop some unit of ATR above the lowest low of the last 3 days.
4. Enter if the close tomorrow is X points above the open.
5. Enter when the close is the highest close of the last 3 days.
6. Enter on a higher close when the daily range has expanded. (Today's True range is greater than the 3 day ATR.)
7. After an inside day enter at the high of two days ago.
8. Enter on a stop at the 3-day moving average of the highs.
There are lots of possibilities but you will notice that in each of these situations we are not trying to buy on the lows. What we want to see is some evidence that the correction is over and that the trend has resumed. This form of trigger along with our reliable identification of the underlying trend will give our trades a very high probability of success. Many skeptics assume that our systems obtain unusually high winning percentages from excessive optimization. We believe the high winning percentages are obtained from the sound logic of making sure that we are headed in the right direction at the very beginning of each trade. If we are making sure that the short, intermediate and long term trends are all going in our favor we should expect to have our trades showing profits right from the start. Whether or not they are profitable when we exit will eventually depend on the quality of our exit strategies.
In addition to the contribution to a high winning percentage our entry triggers also allow us to take advantage of setting our "dip" levels at the minimum. Very often our entry will not be triggered until the dip has gone well below the minimum level. You will notice that we have not tried to forecast the exact low of the dip. We will be happy to initiate the trade at any level once the minimum has been reached.
If you are a day trader reading this Bulletin simply substitute the word "bars" whenever I have referred to "days". Very short term day traders may want to go ahead and enter "at the market" once the minimum threshold has been reached because the system as described will be giving up some potential profits waiting for signs of strength to trigger the entry. When you are trading short term you need to maximize the profits, perhaps at the expense of sacrificing a few points off the winning percentage. Longer-term traders are better off taking the recommended entry triggers and maximizing their profits by using more patient exits.
In a future Bulletin we will present some ideas on how to measure the actual strength of the trend rather than just the direction. Once the strength of the trend is measured then perhaps we can adjust our entries to make them even more accurate. We will also share some of our work on distinguishing between dips and trend reversals. Although we are not yet as proficient at this as we would like to be we have made enough progress to incorporate a filter into the Millennium ED System that helps us to avoid some dips that turned out to be reversals. We would hope to make more progress in this area as our research continues.
First, the strategy is going to work best if there is a trend. (Lets simplify things by using examples only for the long side. Unless otherwise noted you can assume the procedure for selling short is just the opposite.) Trend identification is a big topic in its own right but for our purposes we don't have to come up with anything fancy. The direction of a moving average or the relationship of two moving averages will work just fine. We could also take a simple momentum approach and require that the close today must be a minimum amount higher than it was X days ago. For example, we might want the close to be more than three ATRs higher than the close twenty days ago. When we were at Dr. Elder's Trader Camp he recommended that stock traders should look for both a rising 22 week moving average and a rising 22 day moving average. That's an excellent suggestion. We have found that the specific method of identifying the direction of the trend is not critical to the success of the system. In fact we have used a different method of measuring the trend in each of our systems. If you already have a favorite definition of trend by all means use that.
Once the direction of the trend is established we need to go to work on defining a "dip". Now here is a valuable tip: The stronger the trend the smaller the dips. This seems obvious once it is pointed out but we see too many traders overlooking this important concept. They typically want to get long in an uptrend when some oscillator like RSI or Stochastics is "oversold". We have found that oscillators only reach oversold levels when the market is weak or trendless. The ideal "dip" entry is a very small dip in a very strong uptrend. These ideal trades have the lowest risk and the highest profit potential.
Fortunately we don't necessarily have to know the exact strength of the trend because we can define a minimum definition of "dip" so that we can catch small dips as well as any bigger dips. This procedure will allow us to catch the ideal trades as well as those highly profitable trades that are less than ideal. The most important point to remember here is that if we demand too great a dip we will be missing some of the best trades.
Here are a just few ideas on how we might define a minimum dip:
1. The close today (or the low today) is 1 ATR or more below the close (or the high) 3 or 4 days (or bars) ago.
2. The RSI has declined 10 points or more from its high 3 or 4 days ago.
3. The low of the last 2 or 3 days has gone below the 7 day moving average.
4. A recent low has penetrated below some moving average of lows.
5. Some oscillator like RSI or Stochastics has gone below a threshold level (like 50 or 60). Remember: We don't expect it to reach oversold levels.
6. The Plus DI (part of the ADX indicator) has declined some amount from its peak.
7. The Minus DI has risen some amount from its low.
8. The slope of a short term moving average has turned down.
I'm sure that with a little thought you could add extensively to this list. It is important to understand that we do not necessarily enter once the dip has reached the minimum level. We think that we can obtain a higher percentage of winning trades by waiting for some entry "trigger" that will signal that the "dip" is over and that the prevailing up trend has resumed. The minimum "dip" is merely a setup condition and we want some indication of strength to actually initiate the trade.
Here are a few possible entry triggers:
1. Place a buy stop at yesterday's high.
2. Place a buy stop at X points or some fraction (0.4?) of ATR above tomorrow's open.
3. Place a buy stop some unit of ATR above the lowest low of the last 3 days.
4. Enter if the close tomorrow is X points above the open.
5. Enter when the close is the highest close of the last 3 days.
6. Enter on a higher close when the daily range has expanded. (Today's True range is greater than the 3 day ATR.)
7. After an inside day enter at the high of two days ago.
8. Enter on a stop at the 3-day moving average of the highs.
There are lots of possibilities but you will notice that in each of these situations we are not trying to buy on the lows. What we want to see is some evidence that the correction is over and that the trend has resumed. This form of trigger along with our reliable identification of the underlying trend will give our trades a very high probability of success. Many skeptics assume that our systems obtain unusually high winning percentages from excessive optimization. We believe the high winning percentages are obtained from the sound logic of making sure that we are headed in the right direction at the very beginning of each trade. If we are making sure that the short, intermediate and long term trends are all going in our favor we should expect to have our trades showing profits right from the start. Whether or not they are profitable when we exit will eventually depend on the quality of our exit strategies.
In addition to the contribution to a high winning percentage our entry triggers also allow us to take advantage of setting our "dip" levels at the minimum. Very often our entry will not be triggered until the dip has gone well below the minimum level. You will notice that we have not tried to forecast the exact low of the dip. We will be happy to initiate the trade at any level once the minimum has been reached.
If you are a day trader reading this Bulletin simply substitute the word "bars" whenever I have referred to "days". Very short term day traders may want to go ahead and enter "at the market" once the minimum threshold has been reached because the system as described will be giving up some potential profits waiting for signs of strength to trigger the entry. When you are trading short term you need to maximize the profits, perhaps at the expense of sacrificing a few points off the winning percentage. Longer-term traders are better off taking the recommended entry triggers and maximizing their profits by using more patient exits.
In a future Bulletin we will present some ideas on how to measure the actual strength of the trend rather than just the direction. Once the strength of the trend is measured then perhaps we can adjust our entries to make them even more accurate. We will also share some of our work on distinguishing between dips and trend reversals. Although we are not yet as proficient at this as we would like to be we have made enough progress to incorporate a filter into the Millennium ED System that helps us to avoid some dips that turned out to be reversals. We would hope to make more progress in this area as our research continues.
