Get Better Signals from Your Charts

07/13/2012 7:00 am EST

Focus: STRATEGIES

An expert at NetPicks.com shares a few strategies designed to reduce profit-harming "noise" to generate the best trade entries.

Part of the challenge of trading is seeing market intentions for what they really are. Unfortunately (and kind of fortunately), markets rarely go from point A to point B in a straight line.

If you’re objective is to capitalize on such a move, then you’re going to need some way of identifying whether any counter move is purely "noise," or if it’s that the move is really breaking down and the tide is about to turn.

From my perspective as an intraday trader looking at ultra short-term trades through to day-long trades, I view little as truly "noise." Different time frames are acting in various ways depending on many variables, but what they’re doing isn’t really random—it’s just not always clear, or more importantly, helpful to you.

Just because a trader sees some action and either doesn’t understand it or isn’t comfortable with it, does not mean it’s random. Temporary changes to the market’s operation such as when economic releases are due or around options expiration dates are often the culprit. Other times it might be that participants are reacting to unexpected comments from key political or economic figures.

Noise can occur in several ways. We usually look top down, and so noise is only ever really considered on shorter periods than the ones we’re currently trading. It can be relatively fast back-and-forth movement in a temporary range, or it can be sharp movement on a retracement against the overall trend. However, in all cases these price fluctuations can make us question our interpretation of the market and cause premature exits.

You might for example, see a quick move against your position and get out for what you believe to be still a decent profit. The only thing is, once you sit back and look again at your charts, it really didn’t warrant an exit based on what it actually did, and then it proceeds to thunder on in the direction of your trade.

Why is this bad? You took something on the trade at least, and you protected yourself from a break, right? Well, it’s bad for a number of reasons. You’re minimizing your profits and having a detrimental effect on your risk-reward over the long run. Also, you’re seeing the market either take off without you or getting back in at a price where your risk is greatly increased.

There are a number of ways to decrease the psychological impact of noise on your trading. Clearly, running an algorithmic strategy is one way, where there’s a set of rules that a computer will follow. But for individual traders who execute orders themselves, the issue is very real, whether or not they are trading a rigid system.

Two different approaches can be easily incorporated. The first is by charting or running a volatility-based stop, where you have clearly defined boundaries as to where you should remain in the trade and where you should exit. This could be something as simple as an average true range (ATR) stop, for example. Although I like this method, there’s still the possibility of seeing the noise and preempting the trade.

The second is by changing what you are looking at altogether. There are several different types of charts which are designed to eliminate price fluctuations in this way. Kagi, Heiken Ashi, Renko, Point & Figure are all examples of these. The great thing about using these chart types to monitor is that you remove price fluctuations which you might feel are irrelevant.

I’ve prepared a really quick video, showing a standard 1-minute, a 10t Reversal and a 10t Renko chart for the Russell 2000 future, side-by-side for comparison. Showing how the charts form in a video hopefully will make things a little clearer and give you an idea of whether or not you’d find them useful to your own trading.

The Renko is a chart where you add a “brick” only when a specific number of ticks have been traded either higher or lower than the last. The new “brick” is printed only on the side which has traded the complete “brick” size.

A reversal chart is simple enough too. The bar only closes when the specified number of ticks have traded in the opposite direction. A new bar is then started from the last extreme of the last, and then that also continues until a full reversal of the correct number of ticks has taken place.

However your account for market fluctuations, timeframe oscillations or noise, it’s critical to recognize that you’ll have to deal with it in your everyday trading. If you can’t hold a position through this type of activity, you’ll never be able to consistently run your winners.

Watch this video to see the Renko chart in action:

This article was written by the staff at NetPicks.com.

Related Articles on STRATEGIES