Prop Trading Futures

Classical Chart Patterns

My approach to speculation can be defined as classical, in the sense that it has been adopted by commodity and stock speculators for the last nine decades.

For our analysis and trading we exclusively use monthly, weekly and daily charts. We look for classical chart formations of 10+ weeks and then we discretionary lay down trading setups. Why we’re doing so? Here are the main reasons:

  • Classical patterns have stood the test of time and are unsurpassed in terms of reliable tracking and analysis of price behaviors, even in today’s electronic markets and nanosecond trading environments.
  • Chart trading offers a good framework to build a trades and manage risk.
  • By just looking at daily charts we can manage a diversified portfolio made of several commodities, financial and forex pairs by working only a few hours a day.
  • Short term traders are increasing loosing the edge. Scalping and Intraday trading trading has become more and more difficult. We do not want to compete against algos.
  • Rigid criteria and filters often interfere with potential winning trades due to an inability to respond to “soft” information that has significant impact on market movements. That is why we believe that a mechanical trading system can hardly perform as well as a trained discretionary trader.

Position Trading vs. Short term trading

In the last ten years or so, with the spectacular growth of the internet and reduction of the barriers to short term trading, market participants have become increasingly short term focused.

Unfortunately (or fortunately, it depends from the perspective) the real challenge of discretionary short term trading is not the technology, but in our mind.

The shorter the holding period, the more noise traders are exposed to and the more closely they must monitor positions and market events. That increases their emotional reactivity to gains and losses.

Position trading, in appropriate markets and with the right approach, lowers the volume of trades and let you stay fresh and objective on the markets.

Studies (Lo, Repin, Steenbarger, 2005) show that “trading is likely to involve higher brain functions such as logical reasoning, numerical computation, and long term planning“.

There is a “neuroscientific evidence that automatic emotional response such as fear and greed (e.g. Responses mediated by the amygdala) often trump more controlled or “higher-level” responses (e.g. Responses mediated by the prefrontal cortex).

To the extent that emotional reactions “short-circuit” more complex decision-making faculties-for example, those involved in the active management of a portfolio of securities-it should come as no surprise that the result is poorer trading performances.”

So, if everyone else is trampling the same pile of day-trading and short term trading, why not go a bit further down the path to the fresher, less walked path of position trading?

Breakouts trading

Breakout trading consists in looking for narrow and long trading ranges where volatility has diminished and establish a position as the price breaks out of it, thereby taking advantage of a subsequent expected strong trend move. Trade breakouts is not an easy business because markets more often than not tend to reverse to the mean. Anyhow to the experience trader a breakout provides an edge and a framework around which builds a trading strategy.

What’re the dynamics behind a breakout?

The price of a security or a forex rate is set by two opposite forces, buyers and sellers. Buyers move prices higher until they encounter enough sellers that are motivated enough to step in and stop the advance. Sellers move prices lower until they encounter enough buyer that are motivated enough to step in and stop the decline.

A consolidation happens when there is a general agreement about the current market price. During a consolidation the two forces in the market overall are balancing each other. This situation can go on for minutes, hours, days… Years.

There is a third important force that moves the market and that can come into play at any moment. The third force is represented by those market participants that are on the sidelines, but at any moment can step in.

Going back to the price consolidation, at a certain point the balance comes to an end (for whatever reason). At that moment some of those traders that were on the sidelines and looking for an opportunity to buy or sell get “excited”, jump into the market and that small initial unbalance may get either sold or bought. The same excitement may also influence buyers and sellers that were already involved in the market during the consolidation range.

So, what happens next? Well, the market may either be in a stable equilibrium and the price falls back inside the range or inevitably in an unstable equilibrium and the slightest perturbation causes unstable equilibrium a sustained breakout.

In both cases the small perturbation has generated a lot of tensions. A lot of new actions and reactions. If you are a breakout trader you should live with this clear in your mind: jumping into a breakout is not like to  take a train that is leaving from the railway station! Is not that simple and mechanical.

Usually valid breakout happens on higher volume or open interest (in the futures market) because in all the revolution above mentioned there are all those traders that were on the sidelines, that now want to get involved in the disequilibrium for either speculate or hedge their underlying positions.

Prior to the breakout nobody knew what the third group of traders had their minds and how many do they were. They were not participating in the auction and there was not way for anybody to know what were their intentions before they got in. That is why you cannot forecast the market just looking at the past.

We classify breakouts in 4 categories:

  • If an unbalance on the upside get bought we talk about upside breakout.
  • If an unbalance gets sold we call it a downside breakout.
  • If the breakout is sold by a few and then bought by many with the prices getting back to the congestion range it is called a bear trap.
  • If the breakout is bought by few and then sold by many with the prices falling back to the congestion range it is called a bull trap.