- 1999: Volume 8, No. 6 Combining Tactical and Strategic Ideas in Trading

Trading is like chess. A successful player is able to accurately assess the position on the board, and to gauge the psychological mettle of his opponent. Victory is gained by implementing a positional and tactical plan. Positional strategy is the accumulation of small advantages in terrain and the positioning of available forces in advantageous locations. Tactical play is a direct assault on the opposing army, usually highlighted by sacrificial combinations in which the attacking player is willing to give up material in order to gain a decisive advantage. In trading, a long-term trader can be thought of as a positional strategist. He builds a strong position and holds it an extended period of time. Short-term traders are the tacticians of the market place. Their methods revolve around a short-term sacrifice of equity in expectation of gaining an advantage sufficient to gain back the equity risked as well as a reasonable and consistent profit. In this article, we will combine the two approaches in a cohesive trading plan to make sure that we hold an edge over the market.

Opening Play: Guidelines for Holding an Edge

To begin with, here are four guidelines that can be used to make sure that an edge exists:

• Guideline #1: Never trade without a mathematical edge. The building of a mathematical edge is the statistical validation of a trading model. While this testing does not prove conclusively that success may continue to exist in the future, it does prove that in the past the approach was successful. This is an important step in building confidence in the system and in the determination of how much risk a trader might face in implementing the chosen trading tactic.
• Guideline #2: Act on what others do instead of reacting to what others do. Understanding why market participants become bullish or bearish allows us to build an active rather than reactive tactic for the market. This allows us to trade the market in anticipation of an impending crowd reaction. Bar patterns are often used for this purpose in order to determine short-term market psychology.
• Guideline #3: Don't do anything stupid. Logical trading means looking for logical reasons why our approach may or may not work.
• Guideline #4: Keep it simple. Simplicity is the cornerstone of any sound trading plan. Recognition of the set-up, timely action and proper execution are necessary if the trader is to be successful. A plan that has many exceptions, or is hard to recognize or implement won't work in the long run.

Positional Market Play: Determining the Trend

Before a trader can consider trading he must define concepts of market movement that are applicable to his style of trading. These concepts of style usually take the form of patterns or indicators, but invariably, one of the key components of all methodologies is the concept of "trend." Unfortunately, each trader tends to develop his own subjective meaning of what a trend is. This makes testing impossible. In order to overcome this, I came up with a theory of mathematical and logical absolutes that could be used for testing: in an uptrend, new highs breed other new highs and new higher closes breed higher closes. Higher highs coupled with higher closes increase the tendency for the market to keep moving upward. In a downtrend, new lows breed other new lows and new lower closes breed additional lower closes. Lower lows coupled with lower closes increase the tendency for the market to keep moving downward.

For an uptrend to be in effect the last price occurrence in the market must be: today's High equals the Highest high of "n" trading sessions, and today's close must be greater than yesterday's close.

For a downtrend to be in effect, the last price occurrence in the market must be: today's low equals the lowest low of "n" trading sessions, and today's close must be less than yesterday's close.

Figure 1

S&P 500 TREND TEMPLATE. This template creates a series of thrusts that can be counted. An uptrend condition can only remain true if an opposing downtrend condition does not occur and a downtrend condition can only remain true if an opposing uptrend condition does not occur. The template also has logical links to observations such as Dow and Elliott wave theory.

As can be seen in Figure 1, an uptrend condition can only remain true if an opposing downtrend condition does not occur and a downtrend condition can only remain true if an opposing uptrend condition does not occur. This template creates a series of thrusts that can be counted. This makes all phases of the trend quantified and testable. The template also has logical links to observations such as Dow and Elliott wave theory.

For testing purposes, the value used for "n" was five, or the highest high of five trading periods. The statistical testing shown in Figure 2 was designed to calculate the odds of a second through fifth occurrence of the condition before an opposing condition could occur. The results were then compared to the odds of what would normally be considered random chance. The results exceeded the probabilities of random occurrence to a degree that merits further study.

Figure 2
TREND TEMPLATE VS. RANDOM CHANCE. Testing of the trend template in upward and downward trends showed a variance that far exceeded random probability.

UPTREND
Market	Occurrence 2	Occurrence 3	Occurrence 4	Occurrence 5
U.S. Bonds Coffee S&P 500 Swiss Franc Soybeans Crude Oil B. Pound	81% 69% 77% 74% 69% 71% 69%	55% 44% 55% 55% 55% 55% 55%	41% 25% 39% 43% 34% 36% 35%	33% 19% 29% 29% 17% 26% 25%
Average	72%	53%	36%	25%
DOWNTREND
Market	Occurrence 2	Occurrence 3	Occurrence 4	Occurrence 5
U.S. Bonds Coffee S&P 500 Swiss Franc Soybeans Crude Oil B. Pound	70% 74% 71% 61% 71% 65% 61%	47% 58% 41% 41% 49% 45% 39%	30% 43% 23% 32% 34% 26% 28%	15% 29% 14% 21% 22% 19% 20%
Average	67%	45%	30%	20%
TREND TEMPLATE VS. RANDOM CHANCE
Market	Occurrence 2	Occurrence 3	Occurrence 4	Occurrence 5
TEMPLATE CHANCE	69.50% 25%	49% 12.50%	33% 6.25%	22.50% 3.13%
Variance	44.50%	36.50%	26.75%	18.87%

Tactical Market Play: Market Entry

A chess tactician is more than willing to sacrifice material, but only when he is able to calculate that the sacrifice is justified. Traders should think the same way. A market should be entered only if the trader knows that he has an edge. By using our trend template, we can establish that a mathematical edge exists in our favor. All that remains is to gauge market psychology by looking for patterns within the trend states in order to determine market entry. These patterns can be collected and added to a "trading library" that gives the trader instant access to a series of high probability market occurrences.

The first pattern we will look at calls for a range contraction and an open and close that are close together. The range of the current trading bar must be the smallest range of the last three trading periods and the open and close must be roughly equal. Figure 3 shows a graphical example of what the pattern looks like. Psychologically, the range contraction and equal open and close indicates a point of indecision in the market. Since we know that the odds favor a continuation in the direction of our trend template, we can enter the market here. Entry is completed by going long at the high of the current bar when the trend is up and short at the low of the current bar when the trend is down. Figure 4 shows the pattern as it appears in the context of our trend counts. Figure 5 shows another example of the pattern in action. In each case the trade is taken in the direction of the trend counts found in our trend template.

Figure 3
PATTERN #1. The range of the current trading bar must be the smallest range of the last three trading periods and the open and close must be roughly equal. In accordance with our trend template, entry is completed by going long at the high of the current bar when the trend is up and short at the low of the current bar when the trend is down.

Figure 4

PATTERN #1 WHEAT. Our first pattern occurs during the third thrust of a downward trend. Entry is completed by going short at the low of the current bar.

Figure 5

PATTERN #1 U.S. TREASURY BONDS. Our first pattern occurs during the second thrust of an upward trend. Entry is completed by going long at the high of the current bar.

The second pattern looks for two inside days in a row. An inside day is a trading day whose range has a high that is less than the high of the previous trading day and a low that is greater than the low of the previous trading day. Figure 6 shows a graphical example of what the pattern looks like. Psychologically, this pattern also shows indecision in the market and once again we will look for the market to continue in the direction of our trend bias. Figure 7 shows the pattern as it appears in the context of our trend counts. Again, the trade is only taken in the same direction as the trend template.

Figure 6
PATTERN #2. Two inside bars occur one after the other. In accordance with our trend template, entry is completed by going long at the high of the current bar when the trend is up and short at the low of the current bar when the trend is down.

Figure 7

PATTERN #2 COMEX SILVER. Our second pattern occurs during the first thrust of a downward trend. Entry is completed by going short at the low of the current bar.

Summary

By using a trend template to define overall positional strategy and bar patterns to determine psychology and tactical market entry, we can develop a trading plan that is both simple and logical. Following this market approach goes a long way towards removing subjective judgements that can be harmful to one's trading capital.

Walter T. Downs is a private fund trader and market analyst. He is president of CIS Trading Co., a firm dedicated to the research and development of innovative market techniques. He is the author of Trading for Tigers: High Probability Trading Tactics for Stocks, Futures and Options published by Downs Market Consulting. For information on how to order this book, see the ad on page 18 of this issue. He can be reached via his Website at http://www.tacticalmarkets.com or E-mail walt@3oaks.com.