The Parabolic Trigger for V Tops and Bottoms

Our previous article about using the ADX for V shaped tops and bottoms was surprisingly well received. We had a great deal of very favorable feedback from our members who experimented with it. This very valuable pattern seems to do an excellent job of spotting major turning points in almost any market from Palladium to Natural Gas to Soybeans or even Lumber. This pattern seems to work extremely well in almost all futures, stocks and even the hard to trade stock indexes.

Much like a kid with a new toy, we've been having fun scanning through our charts and finding all the important signals that have been generated. For example, when looking at the stock index charts we had some very timely and important signals that the strong bear market in stocks was finally reversing. Let's review very briefly the conditions that create the pattern we are looking for.

REVIEW OF SETUPS and TRIGGERS: For those of you who are new to our work, we strongly recommend a two step process for entries. The first step is to identify some "setup" conditions that tell us that an entry is near. The second step is the "trigger" that tells us we must enter the trade NOW.

Just to refresh your memory from the previous Bulletin, let me review the "setup" conditions that we are looking for. Remember that we are trying to anticipate important "V" shaped reversal patterns. We want to be able to trade as near as possible to major tops and bottoms. As most of you are aware, a major directional price move will cause the ADX to rise to a high level. Depending on the direction of the price movement, either the Plus DI or the Minus DI will also move to an unusually high level. As the market peaks the DI will begin to decline while the ADX is flat or still rising. Near the top (or bottom) the ADX will become the highest line and will be above both the Plus DI and the Minus DI lines. This is our "setup" and alerts us that an important change in direction is likely in the very near future. The relationship of the three lines with the ADX being the highest tells us that there has already been a very extended price move that is running out of gas.

FINDING A TIMELY TRIGGER: While studying the charts using our new ADX pattern we found that our setup conditions often occurred early and that our DMI triggers were sometimes a little bit late. We don't mind having the setup conditions occur early. After all, lead indicators are rare and very hard to find. However to make this entry pattern even more exciting we thought we would see if we could make the triggers occur sooner.

Now that we have our lead indicator in place we want to find a timely entry trigger that gets us started in the direction of the new trend that should just be getting started. In Bulletin 45 we suggested that the crossing of the Plus DI and Minus DI lines could be the entry trigger. Although this method is acceptable and produces excellent results we observed that there might be room for further improvement. In many cases, by the time the Plus and Minus DI have crossed some profits in the new direction have already been left behind.

After some trial and error we found that the Parabolic indicator did just what we wanted. We believe we can use the Parabolic indicator instead of the DMI crossovers to provide much more timely entry triggers.
      We have never liked the Parabolic stop and reverse (SAR) method as an independent trading system which was the intent of J. Welles Wilder, its originator. However we do like to use the Parabolic indicator for exits. As a system we find that the Parabolic reversal points occur much too frequently and this reversal system would drive us crazy with far too many false changes in direction. However the features of the Parabolic indicator that make it useful as an exit strategy are exactly what makes it the timely trigger we need for our ADX reversal pattern.          

The Parabolic indicator accelerates steadily as the prices trend until the reversal points are very, very close to the peak of the move. The stronger the trend the closer the Parabolic gets to the prices. That is exactly what we want. When the Parabolic indicator is close to the prices and we have fulfilled our ADX setup conditions we are all set for an outstanding trade. Even a very small countertrend move will now quickly cross the Parabolic and signal our timely entry.

AN IDEAL ENTRY PLUS AN ADD POINT: We view the marriage of the ADX setup with the Parabolic entry trigger as an ideal combination. The entries now occur in a much more timely fashion than when we relied on the DI crossovers for our trigger. In fact, once the Parabolic has been crossed we can use the DI crossover as a confirmation and add to our position. I don't normally believe in pyramiding positions but in this case we are trading a very reliable pattern that is designed to identify a major reversal in direction, so I think that adding to positions early is a very good strategy.

As you can probably tell, I really like this ADX and Parabolic entry technique and I think that we have a lot of good concepts working for us here. We have an early setup, a timely trigger and now we can use the delayed confirmation of the DI crossovers as a point to pyramid the position. You can't ask for much more than that for an entry strategy that does a great job of catching big moves early. Take a look at this pattern on your favorite market and give me your comments.

Contradictions in using ADX

          In our last article we described how the ADX works best when a move develops out of a basing pattern. Someone sent us a very courteous email questioning this strategy and reminded us of our "25 X 25"Bond system where we want the ADX to be above 20 before looking for an entry. He commented that by the time the ADX gets to 20 any move out of a base pattern may be over. He is absolutely right and I can see how there may appear to be some confusion on how the ADX should be applied. But there really isn't any contradiction if you understand that what we are trying to do with the ADX is very different in the two examples.

In the "25 X 25"strategy the ADX is used as an important "setup"condition that tells us when the trend is strong enough that we can confidently buy on weakness. However, when we describe the basing pattern strategy we are using the ADX as the actual entry trigger to buy on strength. There is a big difference in the buy on strength and buy on weakness strategies. In the basing pattern strategy a low level of the ADX is preferred because the rise in the ADX is the trigger. If the ADX is at 12 and starts rising we very well could miss the majority of the move if we waited for it to reach 20. With the ADX already at 20 or higher it might only be safe to buy on dips and of course that is exactly what the "25 X 25"bond strategy does.

To sum things up: there is no contradiction. To catch a move out of a base you should enter as soon as the ADX starts rising. Just compare today's ADX with yesterday's ADX and the faster it is rising the better. At this point the the lower the level of the ADX the better because we are buying on strength and the ADX is our entry trigger.

System Results Update
      By the way, our bond strategies have been making lots of money this year. Hope you are all trading them with real money. Back in February I had lots of critics calling and asking why we were offering long only bond systems when bonds were at 115 and that had to be the top. They said that they couldn't possibly go much higher than that and our long only results could not hold up in real trading. Now that the bonds are over 130 I am glad that we have the Serendipity system that does trade the short side because I suspect that we really are near the top. (Doesn't take a genius to make a dumb statement like that. I apologize.)          

The Big Dipper system has been long since July and has huge open profits even after having to be rolled forward from the September contract into December. The "25 X 25"system is not doing bad either. When is the last time you had a free system make that much money for you? And last but not least, lets not forget the "Little Dipper". According to my recollection the last seven trades were all winners and it could be more because I can't remember the last loser. Not too bad for out of sample trading results. REMEMBER: PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE SUCCESS. I'm not just saying that because I have to. I really believe it and so should you. The bull market in bonds has made us look smarter than we really are. Bull markets do that.

Good luck and good trading

Switch Time Frames For Better Exits

I just returned from a weeklong Trader's Camp hosted by Dr. Alexander Elder in a beautiful island nation in the South Pacific called Vanuatu. When I studied geography in school many years ago, Vanuatu was known as the New Hebrides islands. Vanuatu is located about 1,000 miles west of Fiji.

If you have read Elder's excellent book, Trading For A Living, you will recall that Dr. Elder is an advocate of using multiple time frames for trading both stocks and futures. For example, he suggests looking at the weekly chart to make sure that the weekly trend is firmly up before trading the long side of a market based on the daily chart patterns. This approach makes good sense and I highly recommend his book and his strategy.

While listening to Dr. Elder explain his multiple time frame strategy for entries, my thoughts wandered to the application of his ideas to my favorite subject - exits. One of my goals in trading is to find exit strategies that do a good job of protecting open profits. One method of accomplishing this goal is to simply move the daily stops closer once a specific profit objective has been reached. However, it might also make sense to simply switch to a chart with a shorter time frame once we have reached a reasonable profit objective.

Here is an example of how such a strategy might work. Let's say that we have been trading XYZ stock on an intermediate term basis using daily charts. The trade is working out very well and we now have six ATRs of open profit. (See previous Bulletins for an explanation of how to use Average True Range to set profit targets). Up to this point we have been using our well-known Chandelier trailing stop placed at 3 ATRs below the high point of the trade.

However, now that we have reached our primary profit objective we want to tighten up our stop to protect more of our profits. We could reduce our Chandelier stop from 3 ATRs to 2 ATRs and continue using the daily bars or we could switch our chart to one hour bars and continue to trail the Chandelier exit at 3 ATRs based on the intraday one-hour bars. The basic idea is to switch to a chart with a shorter time frame once we have reached our profit objective. This procedure should allow us to let our profits continue to run but we would be protecting our open profits with much closer stops by using the chart with a much shorter time frame.

      Combining our exit strategy with Dr. Elder's entry strategy would provide the following sequence: for entries we first examine the weekly chart and then use the daily chart to trigger the trade. Once we are ready to exit our trade we examine the daily chart and then trigger our exit using the hourly chart.          

Of course this strategy would require some extra work as well as the use of intraday data. The alternative would be to simply reduce the number of ATRs used to hang the Chandelier exit on the daily chart. Either way we do it, the logic is to move our stops closer once we have achieved a worthwhile trading profit.