Roc Rate Of Change Trading Rules Taylor

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This chapter should really be titled "Pinball-Part 2!" Instead of using a one-period rate of change, we are going to use a 2-period rate of change. We will then calculate a shortterm pivot point to tell us when the 2-period rate of change is going to flip from a buy to a sell or vice versa. This pivot then tells us whether we want to go home long or short by the close on a fresh signal change. It is best used in conjunction with Taylor's swing trading methodology.

Before we continue, let's review the main principles of Taylor's trading technique.

Taylor observed that the market tended to make a swing high or swing low every two to three days. The market would alternate between this buying pressure and selling pressure, which could then be captured by entering a position on one day and taking it off the next. Thus, a market could be traded back and forth systematically regardless of the overall trend or fundamental outlook. Taylor labelled the days as a "buy" day, "sell'' day, or "sellshort" day, and gave each one specific rules for entry.

We are going to concentrate on the rules for a buy day and a sell short day. A buy day sets up after the market has sold off for one to two days. (In a downtrend, the market might need one more additional day to sell off.)

The ideal buy day opens on its low and closes on its high. In the morning, a buy day should find support at the previous day's low. Sometimes it will make a slightly higher low or a lower low, but this test (i.e., the low made first on the buy day) is what defines the support level. This then allows us to see our risk point where we can place a protective stop and to enter a long position.

After a buy day entry, we monitor the market to see if it closes higher than its opening. If it does, we will carry the trade home overnight. The market should not make new lows in the afternoon after we bought it. If it does, we will be stopped out since our morning support stop will have been penetrated. If the trade is a winner, we will look to exit the next day. The ideal spot to exit is above the high of our entry day. The trade is trying to take advantage of the tendency for morning follow-through as demonstrated in the test profiles we looked at for the 80-20's days.

On a sell-short day, the market should make its highs first in the morning. The previous day's high is the resistance level that the sell-short day then tests. The sell-short day does not have to exceed the previous day's high; it may make a lower high. If the market makes a morning test of the previous day's high and reverses, we will go short "at the market and put a stop just above this test point. If the trade closes with a profit, we carry the trade home overnight and look to exit the following day. If it starts to make new highs in the afternoon, our stop will take us out. The market will then probably close higher and it would be better to try, shorting the market the next day (hopefully at higher levels) than to carry a losing trade home overnight.

This is the essence of Taylor's trading method. The most important concepts are looking for morning tests (just as in Turtle Soup), and trading off morning reversals (just as the 8020's bars do). Concentrating on just one entry or exit each day is much easier psychologically than day trading which has the stress of monitoring both the entry and the exit on the same day. Carrying winning trades home overnight is a good habit you should form. What is amazing are the additional profits which can be made playing for the next morning's follow-through.

The biggest obstacle people have in using Taylor's methodology is figuring out which day should be a buying day and which one should be a shorting day. As we've said, Taylor kept a rigid mechanical trading book, but he also had all sorts of quirky rules for shorting on buying days and vice versa. We do not want to get that complicated.

Voila le 2-period rate-of-change! A short-term pivot point can be calculated which will tell us when the 2-period rate of change is going to change direction. We want to be long by the close if the price is trading above this pivot point and short by the close if the price is below this pivot point. We will then look to exit the next day.

This is how you calculate the short-term pivot point for the 2-period rate of change:

1. Subtract today's close from the close two days ago (not yesterday but the day before). Thus, close (day one) - close (day three) equals the 2-period rate of change.

2. Add this number to yesterday's closing price (day two).

3. This will be our short-term pivot number. We want to go home long if we have been on a sell signal and the price then closes above this pivot number. We will look to short if the 2-period rate of change flips from a buy to a sell and the price is going to close below the short-term pivot number.

This is what a worksheet would look like:

Date

Close

2-Period ROC

Short-Term Pivot

Go Home

10-30

586.70

10-31

583.85

\

11-1

588.25

1.55

585.40 long

11-2

592.35

8.50

596.75 long

11-3

592.50

4.25

596.60 short

11-6

591.30

-1.05

591.45 ! short

11-7

588.20

^.30

587.00 short

11-8

594.10

2.80

591.00 ; long

Let's walk through the calculation. The difference between the close on 11-1 (588.25) and the close two days ago on 10-30 (586.70) was 1.55. This number is added to the close on 10-31 to come up with a short-term pivot of 585.40 which will be used to monitor the close on 11-2. Since the signal was already 'Iong' coming into 11-2, we would only be looking to go short on a close below the pivot. The next day, 11-2, the price closed at 592.35-higher than the pivot-so, we did not go home short. On 11-3, the price closed at 592.50-below the previous day's pivot of 596.60 and a new short signal. Thus we would go home short, looking to exit the next day.

Let's look at some chart examples and observe how this indicator highlights the two to three day market cycles.

EXHIBIT 8.1 S&P-December 1994

EXHIBIT 8.1 S&P-December 1994

The arrows on the chart show the days where the 2-period rate of change reversed direction. If you had entered on the close of a fresh "flip" and exited on the close the following day, you would have been profitable on 8 out of 11 trades. Although we do not recommend trading this way on a mechanical basis, you can see how this is a useful tool for deciding whether you want to be a buyer or a seller the next day.

[6/1 16/5 ¡6/7 16/12 [6/19 16/26 |7/3 ¡7/6 [7/10 [7/17 [7/24 Day

In both discretionary trading and mechanical trading, you will have unavoidable losers (point 1). There will also be small windfalls (point 8). Notice how nicely Taylor's rhythm sets up. Point 2-buy day, exit the next day. Point 3-sell short day, exit the next day Point 4-buy day, exit the next day. Point 5-sell short day, exit the next day, etc. On balance, this is a winning methodology.

EXHIBIT 8.3 Micron Technologies (MU)-1995

The same three-day cycle also works in equities. Notice that the profits from the buy days are smaller in a downtrend, yet they are still profitable on average. This stock also has a wide daily trading range which makes it a good candidate for active, short-term trading.

LINDA:

I felt that the 2-period rate of change had to be mentioned in this book because 1 have been trading with it for so long. I use it in all markets, but I use it only as a guideline. It is a very noisy oscillator and is prone to whipsaw action at times in flat quiet markets (for example, when the ADX is less than 16). I have spent many years studying it and observing its nuances, and you can do the same. However, I would not recommend that beginning traders pay too much attention to it because it gives many false signals in quiet markets and encourages a trader to make too many marginal trades. It is also not an appropriate tool in a strong-trending market (for example, when the ADX is greater than 30 and still rising.)

Both this indicator and the Momentum Pinball work best in nice choppy markets or after a runaway move has already occurred. Learn first to recognize when a market has good volatility and daily range. Then think about applying Taylor's rules in conjunction with the short-term pivot point demonstrated above.

Short-term momentum functions also serve as a departure point for use in mechanical trading systems. The studies presented in the Appendix show that this indicator provides a statistically significant edge. All the tests are run with just one variable. Apply a longer-term trend indicator, a volatility filter, and a money-management algorithm, and you have a fine mechanical trading system!

PART TWO RETRACEMENTS

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