The “Fuzzy” Trading Method Every Trader Should Know

12/14/2010 9:00 am EST

Focus: STRATEGIES

I want to introduce you to an important concept today called Taylor Rhythm Trading. This may not be of interest to every trader because it is an extremely abstract and “fuzzy” concept—you will no doubt find great difficulty applying this with any degree of precision. However (and this is a big however), this is one of the most important concepts I know and it provides the foundation for my approach to each trading day.

In the early 1950’s, George Douglas Taylor, a grain trader on the CBOT, wrote a book that is now published as The Taylor Trading Technique. Though it is worth your time to read the original, you should be forewarned that this is one of the most poorly written documents in the English language! It is an extremely difficult read. Linda Raschke, a frequent speaker at the Traders Expos, has been a major advocate of Taylor’s work, and she has written several articles that are much easier to read and understand than the original book.

Taylor observed a pattern in grain and stock prices that he formalized into a system that he called the Book Method. In short, Taylor’s pattern was that the market tended to go up in a trend day, which he called the buy day. The next day in the cycle was the sell day, which usually exceeded the high of the buy day, but did not follow through and closed under the buy day’s high. On the last day of the cycle, the sell short day, the market trended down strongly, which set up the next buy day.


Click to Enlarge

There are numerous refinements and important details to Taylor’s system, but the core ideas are the three-day rhythm, and measuring average swings in a market to get some idea of what your reasonable profit targets might be. Taylor also had a fairly convoluted set of rules for pushing the cycle back and forward to get it to fit prices better, but, in my opinion, this is a needless complication if you are using the pattern conceptually.

As a further refinement, he did note that there were variations of the basic pattern. For instance, in strong trends, the pattern was often two buy days in a row (B, B, S, SS, etc.). Again, it is probably not important to catalog every variation, and it’s far more important to understand the underlying concept.

Based on my observations from many years of trading, Taylor’s core ideas ring true. Rather than getting lost in the details of his system, I try focus on what I believe is the driving principle: That a trend day in a market will usually be followed by a consolidation day, and, if the trend day was strong, the extreme of the trend (high for uptrend, low for downtrend) will usually be slightly exceeded the following day.

Many people will be tempted to enter with the previous trend on those days (paying above the high of a previous strong uptrend day, for instance), but that is, on balance, a losing trade. If you understand the Taylor Rhythm, you will expect consolidation the following day, rather than a follow-through trend day. Also, I tend to think of the Taylor Rhythm as more symmetrical (a four-day cycle), expecting as a general rule that a “cover shorts” day follows a sell short day.

The Taylor Rhythm is simply a large-scale expression of the concept of markets alternating between trends and trading ranges. Rather than trying to apply it with strict systematic rules, I treat this as a large-scale framework, and find that it gives me a great edge in my mental gameplan for each trading day.

By Adam Grimes, trader, SMB Capital

Related Articles on STRATEGIES