The “Three Up, Three Down” Trading Strategy (Part 1)

06/22/2009 11:57 am EST

Focus: STRATEGIES

Timothy Morge

President, MarketGeometry.com

Every Monday morning, an hour before the US futures markets officially open, the Chicago Mercantile Exchange sponsors a free, live pre-market session that features me charting various markets while other traders watch via the Internet. We call it the “Market Maps” pre-market session, and the goal is to allow traders and those learning to trade the opportunity to watch a professional trader and money manager prepare for his trading day. I generally cover charts of three or four currency pairs, gold, oil, and a grain market, as well as charts from the US stock market index futures and the US 30-year bond futures.

The original goal of this Monday morning pre-market session was to simply point out what market had been hot the week before, and then, while those attending watched me prepare, point out what markets I felt would likely give the best trading opportunities in the days to come. But two things have changed this general outline: 1) I began offering the same service Tuesday through Friday mornings when it was clear there was a demand for this service; and 2) As I did this day after day for six or seven weeks, it slowly began to evolve into a daily pre-market session filled with market analysis, but with an emphasis on teaching the people who were regularly attending some trading tips and techniques. In many ways, it has become a daily mentoring session for most of the people who attend, and of course, the sessions that were originally designed to average from 15 to 30 minutes now typically run well over an hour—but that's because I am having fun and teaching what I love!

I am a professional trader and money manager and that is my day-to-day focus—it's how I make my living. Most of what I use in my trading is “old school.” You won't find any squiggly computer-generated lines on the bottom of my charts. Instead, I base my trading on time-tested methods that depend on the actual structure of the market, the building blocks that make up the trends and ranges within any given market. My methods focus on identifying those building blocks and taking advantage of their repetitive nature.

I am fortunate to be in what one dear friend at the CME called the “giving back period” of my life. I love to teach, and teaching other traders about the markets—the way others taught me when I was starting out—let's me complete the circle of life. You learn from others, you master your craft, you prosper, and you give back to the community that allowed you to prosper. The community cannot be sustained unless those who prosper give back to the community. In my family, and in Chicago, where I grew up, I was always taught this was the natural way of life.

Let me share with you just how rewarding this can be. This past week, in the Monday Market Maps session, and then again on Tuesday morning, during the subscription Market Maps session, I spent a great deal of time showing traders how to use a very old technique called “Three Drives to the Top, Three Drives to the Bottom.” This technique originated from farmers keeping hand-drawn grain market charts in the 1800's and early 1900's. They found a few patterns that helped them time the hedging of their crops, allowing them to maximize the profits they made when selling their harvested grain or hedging the value of the grain growing in their field by using futures contracts on the US exchanges. One the easiest to use and most reliable was the “1-2-3 Drive” formation. At some point in the mid-1930's, a few farmers sat around a table in Kansas and put together a few of these easily recognized formations, as well as some very simple instructions about using them, into a loose leaf collection and made them available to other farmers, generally through their local farmers bureau, for a very small fee (I believe one of the copies I had originally sold for $15).

Over the years since this information was published by farmers as a simple guide to help each other hedge the value of their grain crops, several well-known analysts have taken this information and put their own name on it, put a few fancy twists on it, and re-named the basic techniques to include either their own name or something that would eventually be associated with them. Again, I was taught to always give credit where credit is due. One of my early mentors would tell me "A student that honors his teacher honors himself.” My father would have told me “Don't steal other people's work! If someone taught you how to do something, make sure you tell other people who taught you!”

But even worse than not attributing the original work to these farmers, the well-known analysts have put rigid rules around this very simple technique, each trying to give it their own twist. And when computers showed up on the scene, people tried to make it computer generated and did curve fitting using computer modeling. In the end, this very simple, yet powerful technique that can be done on the back of an old, brown paper bag with a pencil has been renamed over and over and reworked to the point where it has been out of favor for quite some time. So I stripped away the layers of dirt, dust, and old paint and went back to the original material. Then I started showing traders how to use this simple technique as part of their everyday set of charting tools. Let's take a look at “Three Drives” in all its original glory on a chart:

chart
Click to Enlarge

This is a crude oil chart, using bars that are each $1.90 in range from top to bottom. You can see that I marked three trading ranges on this chart and only one of them is a traditional horizontal trading range. Most traders do not realize that trading ranges often have a positive or negative slope. If these sloped trading ranges are wide enough to be traded, I call them “rolling chops.” They are viable, easily spotted trading ranges and that's what first caught the eyes of the farmers many years ago as they watched daily grain prices unfold on their hand-drawn charts (probably drawn on old brown paper bags!).

The really nice ranges unfold to the point where the top has been tested three times (“Three Drives to the Top”), and the bottom has been tested three times (“Three Drives to the Bottom”). It's easy to connect the tops and connect the bottoms, though if you have an eye for trading ranges, you can connect the tops or bottoms after two of them form and anticipate the third test. I call the line that connects the three tests the “Three Drives Line,” but that's just a fancy name for a line that connects the tops or bottoms. Once you have the range outlined, you have two choices: 1) If the range is wide enough to trade, you can trade it in the direction of the trend (buy against the bottoms in an up-sloping range and take your profit as price approaches the top of the sloped range; do the opposite if it is a down sloping range); or 2) You can wait until price breaks above the third drive to the top or breaks below the third drive to the bottom and then find a way to enter in the direction of the newly emerging trend. If you were a farmer 80 or 100 years ago, you would either hedge your grains at the top of the sloped range formation, or if you hadn't hedged and price broke out to the upside, you'd wait to hedge because grains were likely heading higher. If it broke below the “Three Drives Line,” you'd run to the grain elevator and hedge your crops because grain prices were likely heading lower!

More tomorrow in Part 2. Read Part 2 | Read Part 3 | Read Part 4 | Read Part 5

Timothy Morge

timmorge@gmail.com
www.medianline.com
www.marketgeometry.com

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