20 EMA Article by Bo Yoder

[brownsfan019 17]

I thought this was a timely article considering the discussion we've had in this thread.

 

Link to Article

 

Don’t Get Thrashed by ’08’s Storm

 

October 2008

By Bo Yoder

 

The year 2008 has proven to be difficult for many in the active trader community. A quick glance at a daily chart of Standard & Poor’s Depository Receipt (SPDR), an exchange-traded fund that tracks the S&P 500 Index, shows an extremely chaotic year, characterized by extraordinary whipsaws and consistent overlapping volatility.

 

As Figure 1 shows, 2008 started out with a precipitous decline ending in high-volume capitulation. Unlike every other capitulation event I have experienced during my trading career, the capitulation lows of 2008 formed without leaving a hammer candlestick formation on the daily chart. After capitulation, the markets rallied to test areas of moving-average resistance but utterly failed to react to the moving averages themselves.

 

 

Instead, traders hacked and gasped their way through a zone of overlapping price action that gave many false signals of bullish or bearish intent. These pattern failures caused me a great deal of stress as I was forced to continually reposition myself as the line of least resistance wavered from bull to bear and back again.

 

The market then rolled lower out of that congestion phase and retested the lows to form the double bottom that has so far delivered a sustainable bottom. For a classical pattern-recognition trader, this double bottom remains the only legitimate, classic price pattern that has formed in 2008 (as of this writing in late May). After the double bottom formed, traders experienced a rally with higher highs and higher lows. However, these pullbacks formed in a manner that generated losses for most traditional pullback trading strategies.

 

This chaotic price action has decimated the accounts of many beginning traders and has spawned a new generation of what I term “skeptical cynics.” These traders have a shelf full of books and a mind teaming with course-taught strategies that have utterly failed to produce in 2008. Beginning traders feel frustrated and betrayed by the educational sources in the industry and, thus, have adopted a blameful attitude toward their trading programs.

 

Perhaps it is the widespread dissemination of classical trading techniques that has eroded their edge, but in my opinion, the true culprit is the black-box trading system. I believe that much of the order flow on Wall Street is generated by statistically based trading models. As a discretionary trader, I feel again and again that I am trading against computers, not humans, as I navigate through the chaotic markets this year.

 

Humans act and react to psychological trigger points, while computer-based trading models react to statistical anomalies, mathematically derived overbought or oversold indicators and momentum-based measures. It is this opinion that has caused me to abandon many of my core trading strategies and has put me back into the lab as I develop new ideas for the 2008 market environment.

 

Go Deep or Go Shallow

 

If you agree that this year has been mostly devoid of valid, classical trading patterns, then what is an active trader to do? In my experience, when one timeframe ceases to deliver a consistent edge, a trader has two choices: go deep or go shallow. If the daily charts are chaotic and prone to failure, then dropping down to a weekly level can often produce consistency. It takes much more time and liquidity for a reversal to form on a weekly chart, and this extreme depth acts as a filter during times of chaotic daily action. In a choppy and chaotic market, the weekly price patterns will be few and far between, but their reliability will not be marred.

 

However, position trading on weekly charts, although profitable, can’t deliver the consistent stream of income that is critical to the professional trader. For the professional trader, weekly or monthly profitability is a strong focus. Therefore at present, I believe that dropping into the intraday markets is the best way to regain consistency in one’s equity curve.

 

All active-trading strategies are based on exploitation of some market constituency. Day traders exploit the inexperience of other market participants and provide liquidity to the swing- and position-trading communities. Swing traders exploit the technical inexperience of the investing community and the lack of agility of many large market participants. No matter what style or timeframe is in focus, the profitable trader accumulates inventory so that he or she may mark and sell it to other market participants for a profit. Sometimes a trader is exploiting the mistakes other market participants make through greed or fear; sometimes a trader is exploiting the movement of large groups, sectors or market constituencies.

 

The intraday trading style that is working best for me in today’s environment is focused directly on exploiting the predictable order flow of the technical analysis community. So many traders use traditional technical analysis as their method of trade generation. Any time the markets form a traditional buy or sell setup on a five-minute chart, it can be assured that a powerful surge of order flow is about to hit the market. Although a trading strategy targeting this near-guaranteed order flow cannot generate the large windfall profits that swing or position trading can garner, it does offer a steady “grinding” trading style that can produce results despite chaotic price action.

 

My instrument of choice is the E-mini S&P 500 futures contract, and my three-step setup is simple, conservative and repeatable:

 

1. Identify the areas of support and resistance that are deemed the most significant to the trading community.

 

2. Accumulate inventory as close to support or resistance as possible.

 

3. Distribute inventory into the surge of buying that follows a traditional technical buy/sell signal.

 

 

In Action

 

The three stages of my market-making trading strategy are shown unfolding in Figure 2. During that period, the market was strongly bullish and had just finished a sustained rally. I realized that many active traders missed the move and would be looking for any test of support as a buying opportunity. Because the majority of S&P day traders use the five-minute chart as their base timeframe, I planned to focus on it as I analyzed potential areas of support.

 

 

The 20-period exponential moving average is perhaps the most widely followed indicator in the technical analysis arsenal. It acts as a roving area of support or resistance, and a pullback support within the context of an uptrend known as the “Holy Grail trade.” This trend-continuation pattern is often the first one taught by the educational community, and therefore, I assumed with certainty that any pullback to the 20-period exponential moving average (green line) would trigger a strong bullish constituency to initiate buy orders.

 

Eventually, the market pulled back toward the moving average just as I had hoped, and I executed No. 2 of my market-maker trade. By accumulating inventory as close to support as possible, I bought on the assumption that a test of the 20-period exponential moving average would provoke bullish interest. If the moving average broke, then my opinion about support would be unproven, and it would be time to take a stop loss and move on to the next trading opportunity. Experience has taught me that a two-point arbitrary stop works well when I am making a market in the E-mini S&P 500. So as soon as my buy order was filled, I initiated a stop-market sell order two points below my fill price.

 

As the market responded to support, a reversal candlestick formed on the five-minute chart. Because I was market making, my goal for the trade was simply to distribute my inventory into the surge of buying that followed a traditional technical buy/sell signal. Most intraday traders base their buy/sell triggers on the highs or lows of the last candlestick. As the highs of the five-minute reversal candlestick broke, the “crowd” received its setup trigger, and buy orders began to flood in.

 

As soon as the traditional five-minute setup was triggered, I began watching the time and sales window with absolute focus. Like listening to a piece of music, I watched the tape for a change in key or tempo that would let me know the surge of buying was running out of steam. As soon as I saw the short-term momentum generated by the buy signal begin to fade, I took profits and began looking for the next market-making opportunity.

 

Distilled to its most essential principals, this market-making style delivers an edge because I am buying against support before confirmation exists. The majority of active traders wait for confirmation, and in doing so are forced to pay me a one- to four-point premium for the privilege. By choosing to trade in this manner, I am assuming risk the majority deems uncomfortable and am taking profits once others believe the market is offering “a sure thing.”

 

Just Another Morning

 

Figure 3 shows a fairly typical morning for my market-maker trading strategy. In this session, the market sold off, rallied, then whipsawed down violently after the release of a series of economic numbers at 10 a.m. After this period of sharp selling finally exhausted itself, the market began to bounce. At this point, I once again identified moving-average resistance as the area the active-trading community would deem most significant. I entered aggressively as resistance was tested and initiated the same two-point arbitrary stop.

 

 

As the lows of the five-minute reversal candlestick broke, the active-trading community surged in to initiate short positions as the market fell on strong momentum. I was able to capture close to three points in profit on that trade, then flip my bias and begin making a market to the long side as price tested the 200-period simple moving average (blue line).

 

Once again, I entered aggressively as support was tested and, due to the downward momentum, was able to bid one tick below the moving average for my fill. Once again, I used a two-point arbitrary stop loss, and took profits as soon as the buying frenzy (triggered by the hammer candlestick) began to wane. This trade produced two points, bringing the profit total for that morning to five points.

 

Typically, another two to four trades are taken throughout the day, with at least one or two of those being losers as the targeted support or resistance failed without a five-minute “setup” forming.

 

A market-making approach is not an easy way to take profits from the intraday action. This trading style takes patience and discipline, and can be extraordinarily boring if the market is not producing tests of traditional support or resistance. However with a bit of skill and experience, this type of intraday trading approach can deliver a strong, positive expectancy with extremely high win rates. This “sell-to-the-setup” strategy can be modified for use on 15- and 30-minute charts or day charts, which allows traders to shift timeframes in order to adapt to the current market environment.

 

This market-making approach to intraday trading has been highly effective in helping my consulting clients regain their consistency in this chaotic market environment, and I hope it does the same for you!

 

Bo Yoder (BoYoder.com) is a trader, author and consultant to the financial industry on matters of trading and risk management. Yoder is a featured speaker at international seminars and industry expos for active traders. His latest book, Optimize Your Trading Edge, was released by McGraw-Hill in early 2008.

 

 

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Bo has 2 books available on Amazon for anyone interested:

Optimize Your Trading Edge: Increase Profits, Reduce Draw-Downs, and Eliminate Leaks in Your Trading Strategy (Hardcover)

 

Mastering Futures Trading : An Advanced Course for Sophisticated Strategies that Work (Hardcover)

[Kiwi 16]

An interesting article from a guy who does seem to be an honest teacher of simple principles. One thing the first picture illustrates that Bo doesn't raise is that although his mas just form a chop zone, key support and resistance regions still provide profitable opportunities to trade.

 

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[firewalker 10]

Interesting article... for me personally not because of the EMA 20 (because I don't use indicators but no offense to anyone who does), but because an experienced trader like Bo Yoder talks about people seeing their edge being eroded throughout the course of this year !

 

I'm curious how many traders from TL have had similar issues as those described in the article. The author mentions one thing which has been imo important to keep in mind during this year of sharp drops and bear rallies: being very flexible in taking a position from a bullish or bearish point of view.

 

However, why would the 'classic' principles of supply & demand be any different this year from other years? Personally, I had a pretty rough time during the summer 'doldrums' but that might have been more down to what has been reportedly a period with unusual liquidity and the lowest volume in over 5 years. Next to that, I don't see anything out of the ordinary, except the obvious rise in volatility but that's a cyclical phenomenon...

[Bearbull 10]

Well BF, this all just confirms what we have been reiterating all along, the laws of Supply/Demand, Effort/Result, Cause/Effect as illustrated by Wyckoff nearly 100yrs back remain immutable, however they reveal how traders interact in the marketplace and are not setups. Traders have to put in time and effort to construct strategies/tactics to exploit those interactions. They can accomplish this task with simple approaches and make it complicated with layers of jargon.

Have to admit that I have not read Bo Yoder's work, but have observed the pattern with 20ema manifestating time and again on most markets and all timeframes for over 12years now but as is stated it is a simple setup but not easy to implement as it requires immense patience and discipline. Folks would rather resort to complex ways of illustrating price action and esoteric ways of engaging in bar by bar analysis;)

[brownsfan019 17]

BB,

I think you need to write a book or something. Very eloquent w/ your wording.

 

:thumbs up:

[brownsfan019 17]

The most interesting part for me was how he starts to build a position when a retest is possible. An interesting idea although not sure I could do it. I'm one of the guys he's talking about that likes to see the confirmation before entering.

[timokrates 10]

The most interesting part for me was how he starts to build a position when a retest is possible. An interesting idea although not sure I could do it. I'm one of the guys he's talking about that likes to see the confirmation before entering.

 

Maybe this is a stupid question, but what would be the confirmation in case of the long trade? A higher high?

 

I found the tape reading aspect interesting. Does anybody use this tool for exits or even entries?

[brownsfan019 17]

Maybe this is a stupid question, but what would be the confirmation in case of the long trade? A higher high?

 

 

Depends on what you decide is the confirmation. As a candle trader, I'm looking for some sort of bullish price action. Bearbull prefers hammers/inv hammers.

[Kiwi 16]

Depends on what you decide is the confirmation. As a candle trader, I'm looking for some sort of bullish price action. Bearbull prefers hammers/inv hammers.

 

This is a good point brownsfan.

 

An interesting one for me because I am concerned that after this bottom we will get a dramatic reduction in market participation and return to the daily ranges (and maybe lower liquidity) of 2002/3 or earlier. In this case waiting for price confirmation may give up too much of the move (I like markets with a daily range of 60-100 points to give me profitable price action).

 

In this case we may need to anticipate reversal at the mas/s&r more rather than wait for price confirmation. I am thinking about scaling in strategies in case my preferred markets contract significantly. I found this to be the case with N225 up until the recent increase in volatility and suspect it is true whenever daily ranges drop into the 30-40 point range.

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Edited October 17, 2008 by Kiwi

[brownsfan019 17]

That's an excellent point Kiwi. Something I've been thinking about myself. If we assume that the ranges will contract, using the above mentioned system there seems to be a few options:

 

1) As Bo mentions, enter into trades assuming your S/R (in this case pullbacks to the 20 EMA) will hold.

 

2) Bring in your profit targets.

 

Good comment though Kiwi. Possibly could discuss in another thread if there's interest.

[firewalker 10]

An interesting one for me because I am concerned that after this bottom we will get a dramatic reduction in market participation and return to the daily ranges (and maybe lower liquidity) of 2002/3 or earlier. In this case waiting for price confirmation may give up too much of the move (I like markets with a daily range of 60-100 points to give me profitable price action).

 

It seems inevitably we'll return to lower levels than these... Let's just hope we don't get the extremely tight daily ranges that some markets experienced in February last year (for example ES daily range 8-10 points :shocked:)

[daedalus 10]

It seems inevitably we'll return to lower levels than these... Let's just hope we don't get the extremely tight daily ranges that some markets experienced in February last year (for example ES daily range 8-10 points :shocked:)

 

Pssh... i remember trading a 4pt range in the ES during easter back in '07 I think... that was horrendous! I agree with you! I like the increased moves I just wish it would calm down just a bit.

 

Something akin to the movement we were seeing in May would be a nice happy medium in my book.

[bathrobe 10]

Great article, thanks for posting