As a professional floor trader at the Chicago Board of Figure 1 Trade, I have studied many trading

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1 Article Text Copyright (c) Technical Analysis Inc. 1 Stocks & Commodities V. 4:5 ( ): A mechanical trading system by William F. Eng A mechanical trading system by William F. Eng As a professional floor trader at the Chicago Board of Figure 1 Trade, I have studied many trading techniques. Some work and some don't. Most trading techniques work with the one missing element that we all need discipline. I preface this article with this caveat because I am of the firm belief that the best system, without minimal discipline, will fail. I have derived a very good approach to trading the markets and have seen this fail when others have used it because they lacked the discipline to follow it. Independent of your approach, you must have discipline. The approach described here is simple, and its simplicity gives it a tremendous amount of elegance. My system is based on swing charts. My first exposure to swing charts was in a technical analysis class taught by a William D. Gann technique instructor. The beauty of using swing charts lies not in the fact that you, the trader, can determine when you should position in the direction of a breakout of a price boundary, either upside or downside, but in the fact that such price boundaries can be used as stop loss limit points. Therein lies the utility of swing charts. They may not flag you as to when you should take profits, but they will definitely indicate when you should, and must, take limited losses on bad trades. My experience in the trading pit and off-floor trading has shown me one absolute rule that must never be violated: take losses quickly and trade again, or take them slowly and be forced out of the business. In my own consulting business, I tell people the alternatives. Market folklore tells the trader what to do; it seldom, if ever, tells the ramifications if actions are not taken. The swing charts will help the trader on planning exit points, and they will show the trade's exact risk exposure. Swing charts are often misused. They should not be used to enter trades per se, but rather to determine when to exit bad trades. One should say, "I initially use swing charts to limit losses, and then, and only then, will I use them to enter markets." What exactly are swing charts and how do I use them? Swing charts are derived from daily bar charts. The rules for the creation of swing charts based on daily bar charts are simple. Swing charts are basically lines used to connect the following daily bars: highs to other highs, lows to other lows, a high to two consecutive lows, or a low to two consecutive highs. Here is an example of how I construct a two-day swing chart. Starting on any day, the chartist connects the top of that day to the top of the next day if the next day has a higher high and a higher bottom (see Figure 1). This continues until a day occurs in which the bottom is lower than the previous day's bottom and no higher high is made. This is a flag indicating that, possibly, the trend is about to change. No connecting swing lines are drawn from the uppermost high to this observed low point yet. However, if the very next day shows a lower bottom and a lower high, then a swing chart line is drawn from the last point of entry. In other words, if there are two consecutive days of lower lows without higher highs, then the swing chart line is drawn to connect these two lows, thereby giving an uppermost reversal point. The connecting swing chart line is now connected to the next lower low until another two-day reversal occurs. This, then, is a two-day swing chart. You may also create other length swing charts. Instead of using two days' reversal points, you may use

2 FIGURE 1: Copyright (c) Technical Analysis Inc.

3 three consecutive days' higher highs or lower lows, or even four days ad absurdum. The use of the longer length swing charts becomes academic after about three time segments are analyzed for reversal points. For our purposes, the two-day swing chart will be used. The trading approach is to buy the breakout of a previous reversal swing to the downside, or sell the breakdown of a previous reversal swing to the upside. The stop loss limit order would be placed at the previous swing reversal point. Thus, immediately upon entry of a position, the trader will know the exact point to take the maximum loss on that trade based on the previous swing chart reversal point. Most trading techniques work with the one missing element that we all need discipline. However, I have implemented other time frame swing charts to help define my exit points to a risk exposure of no more than 10 bond tics. I use 15-minute swing charts and hourly swing charts. The 15-minute swing charts are created in the same manner as the daily swing charts are created; I connect the higher highs of each 15-minute bar until there are two lower lows of the two consecutive 15-minute time segments. This swing chart gives the short-term trend. In a similar manner I create hourly swing charts, again connecting the higher highs of each hourly time segment until the lower lows appear, in which case I reverse the direction of the swing lines. When following bonds, I will keep swing charts of three different time durations: 15-minute swing charts, hourly swing charts, and daily swing charts. This is a lot of work, but you can't expect easy money with minimal time allotment. The daily swing chart indicates what the long-term trend is: I will not initiate trades against the direction of this long-term trend. However, I will close out trades against this direction. For example, if the long-term trend is decidedly bullish, and based on the fact that the daily swing chart made a two-day reversal bottom and has been making higher highs for some time, I will not sell short. I will, however, sell out my longs when other sell signals appear. Keeping the hourly swing chart helps verify the continuation of the long-term trend. If the daily chart is bullish, I will remain bullish if the hourly chart is bullish. If the daily chart is bullish and the hourly chart turns bearish, I stand, look, and listen. Long position trades are not initiated on this basis until the hourly chart again turns bullish. If other indicators, e.g., moving averages, time cycles, oscillators, etc., indicate a price reversal or time (cycle) reversal, I may even use the sell signal generated by the hourly swing chart to go short with a stop loss limit order above the previous hourly swing chart top. This trade is relatively risky since the daily, and therefore long-term, swing chart is still bullish. If the long-term swing chart says bullish and the hourly swing chart says bullish, look for the 15-minute swing chart to break out above its previous high before initiating long positions. I will place a mental buy stop above the previous 15-minute swing chart top. This trade is the least risky of all mentioned trades. The trader has three confirmations: the long-term trend is up, the hourly trend is up, and the 15-minute trend just broke through a previous resistance level. My best trades have been trades based on confirmations such as these. The stop on this trade would be based on the previous reversal bottom of the 15-minute chart. Since the 15-minute chart is of such short duration, it is highly probable that the stop loss point will be only several tics away, hence there are very limited losses on these trades. Once the market price starts to move away from the 15-minute swing chart reversal point, observe the hourly swing chart to find a reversal point and Article Text Copyright (c) Technical Analysis Inc. 2

4 Article Text Copyright (c) Technical Analysis Inc. 3 Stocks & Commodities V. 4:5 ( ): A mechanical trading system by William F. Eng then move the stop limit a tic away from that reversal point. This is a very simple approach, nothing esoteric, and definitely very mechanical. Whipsaws do occur with this approach, but they are limited in loss because of the use of 15-minute swing charts for stop loss limit points. To illustrate the discussion to this point, I have duplicated three on-line charts through the courtesy of Tradecenter. Figure 2 is a daily bar chart of the March Treasury Bond Contract from January 17, 1986 to February 19, Look at how a two-day swing chart is created from this daily bar chart. On the start date of this two-day swing chart, January 18 (point A), a line is drawn from the bottom connecting with the high of January 22 (point B). This is done because the two days following the start of the swing chart have two consecutive higher highs. Granted the January 18 low is lower than the previous day's low, the swing chart line is drawn upwards because I am looking for a potential reversal point. On January 23 and 24, bonds traded lower. January 24 and 25 did not give two lower lows so they are ignored. On January 27 (point C), the high exceeded the previous swing high (B). Therefore, the swing chart line from the high of January 22 is drawn to connect this high (C). The swing chart line is drawn to connect the next higher highs until there are two days of consecutive lower bottoms. The upside swing line top reached on February 4 (D) was reversed and drawn down because the next two days' bottoms were consecutively lower. The swing line is now drawn to connect the lower bottoms. In February 7, the final low (E) was made and the two following days showed higher highs (F) and higher bottoms (G). The swing line low is now drawn to connect the tops of February 11 and 12 and any high of any single day following. On February 13, I received my first buy signal based on the two-day swing chart (H). Breaking above 86.24, which was the previous swing top high made on February 4, I looked to be a buyer on weakness as opposed to being a seller on strength. Now look at what the hourly swing chart (Figure 3) indicates. Please flip to the charts and study Figure 3. Having followed the swings on this chart, I observe that on the last hour of February 11, the bonds (K) took out the previous two-hour swing top made on the same day in the second hour of trading (J). The hourly swing chart confirms that I must be a buyer also. Finally, look at the 15-minute chart (Figure 4) which indicates at what price the bond should be bought. The previous two chart types, the daily and the hourly, indicated whether or not the bond should be bought or sold. Now, the 15-minute chart indicates at what price it should be bought. On February 11, the last 15-minute segment of the 15-minute swing chart took out the previous swing highs by reaching point P at price In the closing 15-minute segment of February 11, a purchase was made at A stop sell order was entered a tic under the previous swing chart bottom at price (point Q). The stop is at Risk on this trade was 12 bond tics, or $375. The bonds closed on that day at 86.05, a closing profit of one tic. The bonds opened lower on February 12, but failed to take out the sell stop at Had it sold down to 85.24, I probably would not have been stopped out. I use good brokers who will only fill my sell stop if the market is offered at my sell stop price. There was a nervous moment when it traded to 85.25, but no lower. For a good portion of the day, the market rallied and then sold off to point S, at From there the bonds rallied to a close of (T). At this closing point, the long-term two-day swing chart, the

5 FIGURE 2: Chart reprinted courtesy of Trade Center

8 intermediate hourly swing chart, and the short-term swing chart were all bullish. The hourly chart also had a swing chart bottom at point Q, 85.25, which was not taken out. I stayed long. The swing charts will help the trader on planning exit points, and they will show the trade's exact risk exposure. The next day, February 13, the bonds gapped up and in the process took out the swing chart top at point R, Now, the stop was moved to one tic under point S, which was the swing chart bottom of Risk was now 10 tics because the entry point was at and the stop was at In fact, the 15-minute swing chart indicated an additional upside breakout of the swing top towards the close of the day. I could have pyramided by buying another contract at the stop, but there are inherent problems with this scheme, and you would be better off not doing any pyramiding. To continue the illustration, I moved the stop from to a tic under point T, which was the swing chart bottom of Since the bond was purchased at 86.04, and the sell stop limit was now 86.19, there was no longer a risk, but a guaranteed profit of 15 tics. I now rested easier. On February 14, the bonds gapped up at a price of and never retraced. Rip roaring bull markets! From point U at 87.18, the bonds sold off to point V, a swing chart bottom of Once the reversal exceeded 87.18, I moved the sell stop to 87.09, a tic under the swing chart bottom of point V. The guaranteed profit was now 37 tics since the bond was bought at and can be stopped at Looking over the daily and hourly swing charts, you'd discover that there were no swing chart reversals generated in the long-term chart, intermediate chart, or short-term chart. Therefore, I continued to be bullish. The bonds ground up more upside real estate and closed at on February 14. Still no sell signal was given. At this point, since the open one lot trade had shown a profit of over 60 + tics in three days, I started to look for more short-term sell signals to take a profit. On February 18, the bonds opened higher, but sold off. Strict adherence to the swing charts would not get us out since the stop at was not caught. However, I started to look for reasons to move my stop higher. At point W, 87.27, the bonds stopped selling off and rallied. Once the reversal took place, I moved the stop from to 87.26,a tic under point W, and guaranteed a profit of 54 tics if the stop were caught. Otherwise, the profits were allowed to run. The bonds rallied into new highs by a tic to and closed at On February 19, the bonds gapped down and sold off to a low of (X) and reversed. The latest sell stop had been moved to For the sake of ending this article, lets assume that my broker was a bit off and I did get stopped out on the swing low. That left me with a 54 tic profit in five days on one contract. The maximum risk was 12 tics. This gives a risk/reward ratio of better than 1 to 4.5. What can you do that is better? In conclusion, I have demonstrated how three different time duration swing charts are used to confirm the validity of each other's signals. With practice, you will develop conviction in the use of this technique in your trading. However, I would warn you that you should give yourself more than a one-tic leeway in placement of stops. This is because most of you will try this technique and, as we all know, the market will go where the most orders are. And if most of the orders are where the stops are placed... William F Eng is a 1971 graduate of Northwestern University and did his MBA studies at the University Article Text Copyright (c) Technical Analysis Inc. 4

9 of Chicago. He started his financial career at H. S. Kitnis, then went on to the First National Bank of Chicago. His trading career started in 1974 at the MidAmerica Commodity Exchange. He has been a member of the Midwest Stock Exchange, Special Member of the Chicago Board of Options Exchange, Commodity Options Member of the Chicago Board of Trade (CBOT), Index and Energy member of the CBOT, and is currently an Associate Member of the CBOT He is founder of Financial Options Consultants, (312) Copyright (c) Technical Analysis Inc. 5