Technical Principles

 (Lies, Damned Lies and Statistics)

 The most successful trading strategy of all time is to trade with the trend. FX rates are highly trended, and once you have identified a trend, you can ride it up or down. 

 The most basic trend identification technique is the two-moving average model. When a 10-day moving average crosses a 20-day moving average to the upside, you have an uptrend. If you always buy on the upside crossover and always sell on the downside crossover, you have a moving average trading system. While it will, by definition, lags, it is still the most successful basic trading system. Figuring out how many days to put in the two moving averages is another subject, but as trading principles go, nothing beats the two moving average crossover.

 This is so basic that we feel almost foolish mentioning it, but you’d be surprised how many fancy advanced models fail to start with the simple question—“Is the price rising or falling?”

 Once you spend a few hundred hours looking at moving averages, you realize that steeply sloping moving average lines are (1) more reliable and (2) more profitable than weakly sloping lines. WD Gann, one of the pioneers of technical analysis, believed that a trendline sloping at a 45 degree angle was the most stable and desirable. And it seems to be true, although we haven’t tested it in any systematic way, that too steep a rise results in a more violent pullback when the pullback comes (and there is always a pullback), while a weakly sloping line is more often subject to a pullback that turns into a trend reversal.

 Linear Regression Trendline

 The linear regression is the purest form of  trendline we can draw. We say “pure” because it is an arithmetic calculation that entails no judgment by the person preparing the chart. A linear regression is the line that minimizes the distance between itself and a series of prices, in this case the close. Anyone drawing a linreg off a high or a low will get the same line.

 There’s the clue that that a linear regression line involves some judgment—the starting and ending points. You can draw different linregs on any chart depending on your starting and ending point.  Mathematically, they are all “scientifically correct” but of course to the trader, they have very different meanings.  See the figure below.

A linreg drawn arbitrarily from the left hand side of the chart tot the last data point is sloping a little upward. A linreg drawn from the high to the next obvious high slopes downward. A linreg drawn from the lowest low to the most recent highest high is a steep uptrend, almost exactly 45 degrees, in fact.

No one linreg is correct. They are all correct. We find in practice, however, that it’s most useful to draw linregs from an obvious low to a succession of highs, or from low to low, or the opposite for a downtrend.

Going back to the question of slope, we have the tools to measure slope, but that only adds a veneer of scientific respectability to what is still a subjective representation of trendedness. In the figure below, we drew a series of linear regressions from the bar that has the first lower high in a series of higher highs. You can see the trend losing slope with every passing day until the linreg line slopes downward.

This is useful to identify that the pullback in occurring, but laborious, and only makes the same point that we can see from plain old bar-reading, that despite the price making higher highs, it is also making lower closes and with the close under the open.  Those two bar characteristics more than offset the higher highs.

The next figure shows a 5-day measure of slope itself in the top window. Clearly the price series was already losing slope before it peaked. This is only a little useful (as a warning to tighten stops) but doesn’t give a buy/sell signal itself. When the slope indicator spikes up, then you have confirmation of what the upside breakout bar is telling you, higher high and close at high (buy).

Another way of depicting the shift in slope and thus trendedness is with an indicator (brilliantly called  the linear regression indicator in Metastock). This is a moving average of several days worth of linreg readings, in this case 5 days. On the next figure you can see that the indicator goes flat on that first day with a lower high, but then tracks the prices. The usefulness of this indicator lies in accepting the assumption that when the close is under the indicator, the price will have a tendency to rise to the indicator, and vice versa. If the close is under the indicator, it will drag the indicator down tomorrow. You can use the indicator to help set stops and targets.

If linregs are useful to keep your head screwed on straight, linreg channels are even better.

LinReg Channels

 (to be continued)