#1

Your free trading system is enclosed. We call it the ―25x25‖ Bond System. Please don’t be misled by the
fact that this system was free. We think it is an excellent bond futures system that is very valuable. This
system was recently developed to be used as one of several new systems to be traded in our managed
account program that specializes in interest rate futures. Here is an explanation of why we have made this
most unusual offer and provided you with this valuable trading system.

You have received this trading system as a sample of our work and an example of the type of systems we
plan to offer for sale to members. We hope that you will carefully read the enclosed information and
consider joining us and becoming a Charter Member of the System Traders Club. While the club is still in
its infancy, your participation and input can help us to make this new organization as useful and valuable
as we would all like it to be. Here are a few thoughts about what we have in mind for the future of the
club.

As you may know from our book, COMPUTER ANALYSIS OF THE FUTURES MARKET, we are firm
believers in the many benefits of trading on a systematic basis. However, good systems are not easily
developed without years of experience and a thorough knowledge of the process and pitfalls. As you
might expect, some knowledgeable professionals build good systems and never sell them, preferring to
keep their trading methods a closely guarded secret. They look forward to deriving their income from
trading their own capital or by operating as CTAs trading other people’s money. Another group of
professionals build trading systems for resale; usually finding it necessary to charge thousands of dollars
for each system to make up for the time and money spent in the development of the system and the
substantial expense of advertising and marketing their systems in national publications and mass
mailings.

We have been developing and refining trading systems for our own use since 1989 and until now have
never made any of our systems public. From time to time we have tried to share some knowledge and
helpful ideas at occasional seminars but we have never published or marketed a complete trading system
as such. Now we propose to offer some of these systems to investors who prefer to do their own trading.

Since we developed these systems for our use in managing money, we were very careful to use logical
methods that can easily be implemented in actual trading. We also include a generous deduction for
commissions and slippage because we know we must encounter these costs in real trading. Because these
trading systems were developed in the course of operating our CTA business, we have already expensed
our research and development costs. With the development costs eliminated we intend to keep the cost of
marketing the systems as low as possible so that we can offer the systems to members at prices far below
industry standards. The System Traders Club will enable us to offer our trading systems to a select and
knowledgeable group of traders without spending a lot of money on mass mailings and advertising to
people who have no interest in ever buying or trading a system.

Unlike the popular book or record of the month clubs, members of the System Traders Club will not be
obligated to buy any systems from us. Membership would simply indicate that you were seriously
interested in systems trading and that you were interested in receiving periodic mailings from us
describing the various systems we offer for sale. Because our systems will be sold at very modest prices
we would hope that members will be pleased with their results and buy several systems over a period of
time. (Why not use the ―25 x 25‖ Bond trading system we have enclosed and if it makes money for you,
use some of the profits to buy more systems from us.) Note: There is no assurance that this system or any
system we offer will be profitable in the future. You should also be aware that futures trading entails risk
of loss and is not suitable for everyone.

When we offer and describe a new trading system to our select group of club members, we intend to set
new standards in truthful disclosure and client satisfaction. You can be assured that we won’t be offering
any ―holy grail‖ systems with promises of wealth beyond your wildest dreams. We won’t be offering any
undisclosed black or grey box systems either. The details and logic of every system will be fully
disclosed. We plan to ―tell it like it is‖ and insure that our club members receive more than they expect
from us.

We intend to start the disclosure before the system is purchased. Prior to

ordering a trading system we want our members to have a thorough and detailed understanding of the
historical trading results and the logic behind each system. In addition to abundant and comprehensive
historical test data we will be providing narrative comments about each system including our personal
opinion of each system’s particular strengths and weaknesses. We will also include some suggestions on
how the system can be customized or tailored to suit your individual preferences and give you a realistic
idea of how much capital you might need to successfully implement the system. We intend to provide all
of this information before you order any system so you won’t be buying an unknown system based on
exaggerated performance claims and outrageous marketing hype. We will offer many carefully designed
systems and our members won’t be expected to buy them all, just the ones that they can actually use and
feel comfortable with.

In addition to an assortment of well researched trading systems we intend to provide our members with
other outstanding services and benefits for free or at costs well below present industry standards. To make
certain our mailings to members are welcome and not discarded into the junk mail pile, we intend to
include articles containing useful information and knowledge about how trading systems should be
developed, tested, analyzed, traded and monitored. We will also be discussing our newest systems and
topics of interest relating to our personal system building procedures. Club members would be
encouraged to send in articles, comments, trading experiences and to ask questions.

We would hope to use the newsletter to develop an interactive relationship with the club members and
encourage their participation in educating and learning from fellow club members. We would expect that
members would purchase and trade some of the systems that we develop and perhaps share their
experiences and suggestions for improvements with us and fellow members. We also intend to provide
club members with expert consulting, programming and custom built systems at reasonable prices
whenever they need such services.

For the time being there is absolutely no charge to become a Charter Member of the System Traders Club.
Furthermore there is absolutely no obligation to buy any products or services. However we do have a
favor to ask: Help us to provide quality products and services that might be of interest to you by carefully
filling out the enclosed questionnaire and giving us your best thoughts on how we can make the club most
beneficial to you. Also please note that once the club is up and running we may have to limit membership
or charge a fee to new members. Please take advantage of this window of opportunity and join now as a
Charter Member while membership is free.

Good luck and good trading.

#2 The Case for Multiple Systems

We were pleasantly surprised and nearly overwhelmed by the interest expressed in the traders
club idea. Mailing the responses has kept us busy for several weeks and we have worn a path
between our office and the post office. We are especially grateful for the many favorable
comments about our "tell it like it is" marketing approach and the many kind words about our
book. We hope you will be pleased to hear that our publisher tells us the book is considered a
classic and has asked us to work on a second edition. Computer Analysis of the Futures Market
(2nd edition) should be released late this year.

Thank you all for your enthusiastic support. We promise to do our best to live up to your
expectations.

THE CASE FOR MULTIPLE SYSTEMS

Our original philosophy about trading systems has changed considerably over the last year or
two. We once believed that the best trading results were obtained by employing one system that
traded all markets long and short. Then we spent years of research developing such a system. We
produced an ADX based system that traded all markets long and short with identical parameters
and showed outstanding test results. The system was then traded with millions of dollars and
performed quite well for several years. Then it abruptly started producing losses rather than
profits. Our research into the causes of the decline in performance led us to conclude that it was
not realistic to expect one system to be able to perform well in all markets under all market
conditions.

Like generations of traders before us we had somehow assumed that the answer to good trading
could be found in creating that one great system. Looking back now we wonder why we ever
made such an illogical assumption. No one system can be expected to perform well under all
conditions. In addition, in order to perform well across a wide range of markets the system often
has to compromise outstanding performance in particular markets. The consequence of this
approach is to employ a system that barely works in many markets yet isn't outstanding in any.
Typical "do all" systems average about 30% to 40% winning trades and produce long and severe
drawdowns that eventually become unsustainable.

Consider now the merits of multiple systems: We would obviously start with a trend following
system for the big trends. But we must also have a system that works well when there are no
trends. We would trade systems where the profits are taken at target points and have systems that
patiently let the profits run. We could design systems for long only and short only. We could
have systems with tight stops and systems with wide stops. When we were trading we would
have long term, intermediate term and short term systems all running at the same time. We could
even use systems that day trade.

Why do we try to make one system do everything? What's the point? Why not design systems for
very specific purposes and specific markets? Once a system's purpose is clearly and precisely
defined it becomes much easier to create very sound logic for the system. Each part falls into
place precisely without needing to compromise.

Ten years ago it might have been operationally impractical to attempt to operate multiple
systems. But with today's sophisticated technology any trader with a computer can easily run as
many systems as they have capital to support.

Knowledgeable traders have long been aware of the advantages of diversification among
markets. Now a few innovative professionals are also reaping the rewards of diversification
among systems. In fact a few very large and well known CTAs are currently trading more than a
hundred systems at a time. The idea makes good sense.

However, we believe that for the multiple system approach to work as intended the systems need
to be carefully matched to avoid duplication and overlapping trades. For example, when we
designed the "25 X 25" and "Big Dipper" bond systems, we were careful to design them so they
are unlikely to enter the market at the same time because they both trade on an intermediate time
frame. The "Little Dipper" was designed to trade on a very short term time frame.Because the
systems were designed for a very specific purpose, buying a strong bond market on dips, we
were able to achieve very impressive historical results using simple logic. If we had to worry
about trading the short side of the corn market with the same system, the problems in developing
such a system would have compounded and we would not have been able to produce the same
results.

Now many system traders are going to argue that single purpose systems are prone to
optimization. This may well be true, but it could also be argued that single purpose systems can
produce excellent results without the need for optimization, whereas multi-market multipurpose
systems are so difficult to produce that the designers must resort to optimization to obtain
acceptable historical results.

One of the problems we faced with our long term trend following system was low trading
frequency which tended to make our performance erratic and prone to peaks and valleys. In order
to take advantage of our statistical "edge" we might have to complete thirty or forty trades. Using
along term trend following system it could easily take a year or two to generate this many trades
even with multiple markets. However a combination of good systems should produce a more
statistical meaningful number of trades over a much shorter time period. Therefore the trading
results should be noticeably more consistent and dependable. Ask yourself: Would you rather be
trading one multi purpose trend following system with a low percentage of winners or trading
several high percentage multiple systems: Systems designed to follow trends, buy and sell
corrections, trade within a range, profit from small and large trends, and trade long and short
with equal accuracy. We believe that a combination of properly designed systems, each with a
specific purpose, should substantially out perform conventional "do everything" systems.

We can envision the time when savvy traders will insist on operating several carefully designed
systems for every market they trade. Where will all these systems come from? We hope they will
come from the Traders Club.

QUESTIONS FROM MEMBERS :

My results when testing the 25 X 25 system are different than yours. Why is that?

We have had this question from several members and so far we have been able to help each of
them match our test data. In most cases the difference was that the member was not testing using
" day session only" data. In a few cases the member was not using data in a format that allowed
for prices and ticks in 32nds. In one or two cases the starting dates and maxbarsback were
slightly different. Once these differences were resolved the test results were nearly identical.

You mention that your testing was done using day session data only, so I presume the values of
the variables were optimized for the day session only. If, later, I want to trade the Globex, can I
safely use the same values for the variables, or should I re-optimize them?

We don't like trading the Globex or similar markets that sometimes suffer from a lack of
liquidity and frequently show odd prices that can distort our indicators. If you were to look at the
combined data including the Globex, the opening of Tuesday's market is really the Monday
trading on Globex. This distorts the logic of the system and has nothing to do with optimization.
We want to buy when the day session prices are strong and we don't care what the Globex does.
We also try to design systems that are practical to trade in real time so we avoid night sessions,
24 hour markets, and foreign markets because we want to "have a life" as the saying goes.

We believe that systems are as likely to be robust as the logic is sound. We don't rely on nearly
as much optimization as you might think. In fact I am sure you could optimize our systems and
produce better historical than we have, but this would be unlikely to improve the real time
trading.

The primary reason we run optimizations is to insure that our chosen parameters fall in the
middle of a broad range of profitable values and to make sure that we haven't accidentally
stumbled into a curve fit that has little hope of success in the future.

Sound logic is much more important to us than optimized test results. The best insurance of a
profitable system is sound logic, not historical test results no matter how carefully they have
been obtained.

Can the bond systems be operated using SuperCharts?

Yes. We are going to provide the code on a floppy disk so it can be input into SuperCharts. Let
us know if you need a copy.

Will these bond systems also work on the short side?

The test results on the short side aren't particularly encouraging , however the logic of the system
should be valid in either direction. As we all know, the bond market has had a sustained period
of rising prices so the historical results of any two sided systems are not going to look very
favorable from the short side. Because of the obvious data bias we know that any declines have
turned out to be buying opportunities.

If we were to go back and create a short side system that did well over the test data it might not
be the best system to use during a sustained period of declining prices. Because of the rising
trend in our test data any short side system that tested well would have to take profits rather
quickly. However a short side system that lets profits run might prove to be the best system if we
get into a sustained downward trend. We will work on generating short side systems for bonds,
and try to come up with one logical short term system and one logical intermediate term system.

Do the bond systems work in any other markets?

Yes, but not as well as in bonds. Looking at results in other markets is a

good method of out of sample testing. Because these systems are simple and the logic is sound, it
is not surprising that they may produce acceptable results in some other markets.

To test the bond systems in markets other than bonds, use the same setup rules and in the case of
the "25 X 25" system convert the 18 ticks entry trigger to a fraction of Average True Range.
Then use that value as the entry trigger in the other markets. For example, if we assume that 18
ticks is about .6 of one ATR we can buy Soybeans at the previous close plus .6 of one Soybean
ATR. (We usually suggest using 50 days of data to calculate the ATRs.) Fortunately the
parameters of the systems are so robust that we have a very wide margin of error on exactly how
many points we use for the entry trigger.

One of our members in Europe enthusiastically reported that he has obtained positive test results
using the "25 X 25" system in world wide financial markets including Canadian, Italian and
German Bonds, and the DAX and Hang Seng stock indexes. He is testing both long and short. To
adapt the system to these markets he has simply taken the "25 X 25" system and changed the
entry trigger to .75 of a ten day ATR and changed the $2500 stop to 2 or 3 ATRs depending on
the market. He also reports that his version of the system has tested particularly well on U.S. T
Note futures.

You might want to run a market by market optimization to make sure whatever parameters you
have selected for the entry fall in the middle of a broad range of profitability.

SYSTEM DESIGNERS TOOL BOX

This will be the first article of a series featuring various techniques we have found to be useful in
developing trading systems.

THE CHANDELIER EXIT: We have often advocated the importance of good exits and this is
one of our favorites. The exit stop is placed at a multiple of average true ranges from the highest
high or highest close since the entry of the trade. As the highs get higher the stop moves up but it
never moves downward. (For future reference please note that we almost always give our
examples from the long side and if there are any difference on the short trades we will try to
point them out.)

Example of Chandelier Exit:

Exit at the highest high since entry minus 3 ATRs on a stop.
Or exit at the highest close since entry minus 2.5 ATRs on a stop.

Application: We like the Chandelier Exit as one of our primary exits for trend following systems.
(The name is derived from the fact that the exit is hung downward from the ceiling of a trade.)
This exit is extremely effective at letting profits run in the direction of a trend while still offering
some protection against any reversal in trend. In fact our research and that of our friend Dr. Van
Tharp has shown that this exit is so effective that we can literally enter markets at random and if
we use this exit the results over time are likely to be profitable. (If you don't believe us just test it
yourself over a handful of markets.) In general the best values for the ATR in most markets
ranges between 2.5 and 4.0.

BOND SYSTEMS SCOREBOARD

As of the date of this bulletin the "25 X 25" and "Little Dipper" bond systems have been out of
the market for a while because the trend does not meet the requirements for our long only
trading. (The filters are working as intended and turn off the systems as the market heads down.)

The Big Dipper, which as the name implies, was designed to enter after bigger declines, gave an
entry signal on March 23rd and is presently long the June contract at a price of 120.30.

HELP WANTED

We are looking for several knowledgeable and experienced brokers who specialize in systems
trading and who own TradeStation or similar software and are willing to assist our members with
their trading. These brokers must be willing to provide members with special services and
accommodations that are not generally available to the public. Brokers who qualify will be
placed on a list of recommended brokers that will be sent to those club members who contact us
and specifically request broker referrals. (Member information will not be given to brokers. The
club member must initiate any broker contact.)

SOURCES OF INFORMATION

Many of you are already members of Club 3000 which has been around for many years. If you
haven't seen this publication you should look into it. The members write the articles and there are
lively discussions on various trading topics. (Not very technical.) Fred Kastead has taken over
from Bo Thunman as editor and is doing a good job of keeping this well loved publication going.
For subscription info contact Fred at 616 623-8235 or email him at Club3000@juno.com (As I
recall the cost to subscribe is less than $100 per year.)

If you are a serious computer buff and TradeStation user who wants to share information about
software and coding you should try the Omega newsgroup. To subscribe just send a message to:
Omega-digest-request@eskimo.com There is no charge but you will spend a lot of time sorting
and deleting hundreds of junk messages (mostly Omega bashing) and savoring the occasional
nuggets of useful information.

WORK IN PROGRESS

Many of you will be pleased to learn that we are working on a short term S&P system. We have
also been working on a system for Crude Oil and a short side system for the T Bonds. If you
have other requests please pass them along.

GOOD LUCK AND GOOD TRADING!

Chuck

#3 – Assembling a System from

Interchangeable Parts
Chuck LeBeau's System Traders Club
BULLETIN Vol. 1 Number 3 May/June 98

Table of Contents:
Traders Toolkit:Assembling a system from interchangable parts:
Traders Toolkit: The Volatility Entry

FUTURES TRUTH

Many of our members have suggested that our systems should be evaluated by John Hill's respected
publication: Futures Truth. We thought this was an excellent idea and we are pleased to report that the last
issue of Futures Truth featured reports on the "25 X 25" Bond System as well as the Big and Little Dipper
Bond Systems. Editor John Hill commented:

"The rules for these systems are unique and quite simple. His approach to successful system trading is
quite refreshing. He makes a sound argument for trading multiple systems. Different systems for different
market phases. The prices for his systems range from $200-350 which is very reasonable. You systems
traders would be making a mistake if you don't at least get some literature from Mr. LeBeau and see what
he is all about."

John went on to caution that the performance results in the reports of the Bond systems had the benefit of
hindsight and that he would begin tracking the systems on a real time basis in the future. John devoted a
total of four pages plus a front page editorial to his review of our bond systems. When I phoned him to
thank him for featuring our systems, John was very enthusiastic and supportive of our Club idea. To help
the Club along he generously offered any of our STC members a $50 discount on a one year subscription
to Futures Truth. This means that STC members would pay only $100 per year instead of the usual $150.

This was a very generous limited time offer by John and we hope many of you will take him up on it. You
can contact Futures Truth by phone at (82 692-0273.

We hope to get other publishers and vendors to make similar bargains available to STC members in the
future. As the Club grows (now more than 750 members) perhaps we can become a large enough
consumer group to command discounts on many other items of value to Club members. Please let me
know if there are any particular firms I should approach with this idea.

SOME ASSEMBLY REQUIRED

Just as we did in the previous Bulletin, we want to continue passing along ideas for ingredients of trading
systems. But before we do that we thought it might be a good idea to establish a basic framework and
background information so that we can communicate our trading ideas in the proper context.

We view the process of creating a system much like Henry Ford viewed the building of automobiles. We
start with interchangeable parts and then assemble them step by step much like an assembly line. When
we discover a part of a system that performs a particular function especially well, we save it and store it in
our "parts warehouse" so that we can take it out and use it whenever we need a part to perform that
particular function. Each individual part of the system should be well tested and proven capable of
performing its required role in a logical fashion.

Now lets assume that these parts are all sitting around in our system parts warehouse. When we want to
build a new trading system we can't just start throwing various parts together randomly. We need a
framework and the parts need to be assembled onto the framework in the correct order. Here is an outline
of how we view this assembly process.

STEP I: Market Selection. We need to be able to select the best markets to trade at any given time. We
want to focus our trading attention on those markets that offer a high level of liquidity and a high level of
potential profitability. Good markets will have a combination of high trading volume, clear direction, and
enough volatility to make potential trading profits worth the risk and expense of trading.

STEP II: System Selection. We want to have a wide choice of systems and we need to know how to select
the right system for the current market conditions. We want to have long term, short term and
intermediate term systems to choose from. We also want to have trend following and counter trend
systems available. We want to be capable of buying dips or following strength. We need enough systems
in our systems inventory to take advantage of whatever market conditions currently prevail and be able to
change systems promptly if those conditions should change.

STEP III: Entry selection. We view the entry process as having three logical functions that will require us
to assemble three or more important parts from our system parts warehouse.

A. Direction identifiers. Tell us if the market we have selected is going up, down or sideways.

B. Setups. Alert us when a good trading opportunity is getting near.

C. Triggers. Signal us that the best time to enter the trade is right now.

STEP IV: Exit Selection. We also view the exit process as consisting of several logical functions that will
require us to assemble even more parts from our warehouse.

A. Risk control exits. Usually some fixed dollar amount or "worst case" stop order is necessary to clearly
limit our maximum loss and protect our trading capital.

B. Trailing exits. These useful exits gradually move in our favor as the market moves in our favor and
reduce our initial risk level so that our "worst case" stops are no longer exposed. If the market moves far
enough some profits are eventually locked in.

C. Trend reversal exits. These exits signal us when there is an indication that the direction may have
changed and our logic for entering the trade is no longer valid.

D. Profit protection exits. Once the trade has become sufficiently profitable, these logical exits keep our
profitable trades from turning into losers.

E. Profit taking exits. Large profits eventually must be taken. These critical exits try to take profits as near
as possible to the point of maximum potential profit.

There you have our philosophy about the process of building trading systems. Now when we offer
Traders Club members an ingredient of a system we will also suggest where we think it fits into our
recommended framework for assembling a system. This should help everyone to get the most value out of
the ideas we will be presenting.

For example in our last bulletin we offered the "Chandelier Exit". We suggested this versatile exit as one
of our first ideas because it fits so well into all of the exit categories and it has been thoroughly
researched. It can be used as a trailing exit, a risk control exit, a trend reversal exit, and a profit taking
exit. If you were building a system that could have only one exit strategy, the Chandelier Exit would be a
good choice. Other exits can perhaps do a better job of one particular task or another but few of them can
do so many tasks so well as the Chandelier Exit.

In fact, we recommend that you use the Chandelier Exit as your basic benchmark for all of your exits.
Start with it and then see if you can improve on the results by employing multiple exits which have more
specific goals.

SYSTEM DESIGNERS TOOL BOX

The Volatility Entry

CATEGORY III C. -- ENTRY TRIGGER

This simple entry is generally one of the most reliable entry triggers for trend following systems. It's
always a good first try when you are looking for a trend following trigger that produces better than
random results. It is usually implemented by adding a percentage of the Average True Range to the close
of the previous bar or to the open of the current bar.

For example we could design a simple but effective entry statement that says: "Buy when the price
reaches the previous days close plus .70 of the 20 day Average True Range." (The .70 value is just an
example, not a recommendation. The number of days to use in calculating ATR should usually be set at
20 or more or else the entry trigger can become too sensitive due to brief periods of unusually low
volatility.)

This entry trigger seems to be more reliable than most triggers because it would require that prices make a
strong directional move precisely as we are entering the market. Of course we wouldn't be entering at the
cheapest price but we would be entering after a move that showed the market definitely had confirmed its
direction. We would have to sacrifice some potential profitability (buying cheaper) for the higher
reliability of getting into the market only when our selected market is moving strongly in the direction we
expect it to.

The most common application of this entry is to measure from the previous close but we have a slight
preference for applying it from the open.. We find that moves from the open tell us a lot about what the
market is likely to do over the short run. You should always test it both ways. There are probably many
other ways of applying this entry trigger (from the previous day's high or low for example) but we haven't
had the time to explore all the possibilities.

Combine the Volatility Trigger with the Chandelier Exit and you have the basic ingredients of a primitive
trend following system. As primitive as this system might seem it can often serve as a useful benchmark.
Plug in your favorite values for the ingredients and try it on a market or two. Then use these results as a
benchmark and see if you can improve the results with other ideas and other systems.

This will give you some way of measuring your progress and a method of evaluating other ideas you
come up with. How does your latest idea compare with the simple Volatility/Chandelier benchmark?

Coding the Chandelier Exit

Several members have inquired about how to code the Chandelier Exit described in the Vol. 1 #2 Club
Bulletin. Since I'm not a programmer I put out some calls for help. Quoted below is a suggested solution
for TradeStation users provided to us by my good friend Terence Tan in Singapore:

MAX TRADE HIGH & MIN TRADE LOW USER FUNCTIONS

1. Create a User Function called "MaxTradeHigh", with the following code:

If marketposition 1 then MaxTradeHigh = -999999;

If marketposition = 1 and H > MaxTradeHigh[1] then MaxTradeHigh = H;

2. Create a User Function called "MinTradeLow", with the following code:

If marketposition -1 then MinTradeLow = 999999;

If marketposition = -1 and L s in a program, just reference the User Function names directly, e.g. Exitlong
MaxTradeHigh -3 * Average (TrueRange,10) stop;

Once you define the User Functions, you never need to duplicate the code in any system when you need
to code the Chandelier Exit.
The code is slightly different (improved) from the version I sent previously so that it works for reversing
systems that need to go from long to short directly or vice versa, and also works for those possible
negative prices in a continuous data series. Please let me know if you have any further questions or
difficulties.
Best regards, Terence Tan

ELA CODE AVAILABLE

Thanks to David Elden who has been helping us with some of our programming, we can now offer
TradeStation and SuperCharts users the ELA code for our three bond systems. Along with the code we
also provide simple instructions on how to load the systems into the Omega products. Contact us by email
if you own one of the systems and want the zip file (no charge) or send $10 to cover postage and handling
if you want us to mail you the disk version.

SYSTEMS WANTED

Please send us your ideas for systems. Let us polish up the your idea and turn it into a complete system
with our best inputs. The final system can be given to STC members for free if you are willing or it can be
offered for sale at a reasonable price (your choice). We can also do custom system design and consulting
if you want us to help you with a proprietary system that will not be made public. We can also help new
CTAs get started.
SHARING INFORMATION

Read any good books or articles? Found any systems on the net? Please bring them to our attention. We
are always on the lookout for new information to pass along to members.

QUESTIONS AND ANSWERS

The following question was submitted to me via Dr. Van Tharp's web site
(www.iitm.com). STC members should enjoy browsing this very interesting site and playing some of Dr.
Tharp's money management and trading games. It's educational and it's free.

Question: What is the best way to create a system that I can backtest in SuperCharts? The entry signals I
am using are like Elder Rays and Five Day Momentum. I exit on big range days or at resistance lines.

Answer: Regardless of what software or indicators you are using I would suggest you build and test your
system one part at a time. Here are the basics:

The first part to test of course is the entry. Test your proposed entry method with simple time-triggered
exits that simulate the time period you want to trade. For example exit after 3 days, 5 days, 10 days and
20 days.
Pay no attention to the dollar amount of gains or losses at this point.. All you want to see is that your
entry method is getting you started in the right direction at the right time.

At this point you should have better than 55% winning trades with these simple exits or your entry
method is no good. You can flip coins and get 50% winners so why settle for anything less from your
system. Concentrate on getting the highest possible percentage of winners with the timed exits. Your
profitability, drawdown and the other measures of your system will eventually be improved by adding
much more logical exits.

After you have an entry method that works better than flipping coins you need to add several exits, each
serving a different purpose. For starters you need a risk control exit that limits your worst loss. Don’t
worry if this is a fairly big number. You won’t expect your worst loss to get hit very often, if ever. Your
other exits should prevail and limit your loses most of the time.

Assuming that your system is intended to be a trend following system, you also need a trailing exit that
gradually reduces risk and locks in profits as the market moves in your direction. (Your resistance lines
for example.)

Finally you need a method to lock in large profits. Once you have a profit of X amount or more you can
exit using your big range days or a much closer set of resistance lines.
Do you have any questions we can help with? If you do, just email them to us . We will try our best to
answer promptly.

WORK IN PROGRESS
In addition to designing more trading systems we are formulating plans for an exciting new web site for
the Traders Club. You will be hearing more about this in future issues of the Club Bulletin.

#4 – Various Topics
Chuck LeBeau's System Traders Club
BULLETIN Vol. 1 Number 4 July/August 98

Table Of Contents:
Informative Letter from Mr. Edward Borasky( Various Topics)
Traders Toolkit:Adaptive Channel Breakout Using Adx( with code)

Visit Us At http://www.traderclub.com

Our new web site is still under construction but several pages of it are already functional. We anticipate
that the web site will soon replace the mail as our primary method of communication with club members.
We have made it easy for you to keep track of the progress of our work at the new site. Just open the
home page and then go immediately to the "What's New" page where you will find a daily log of our
latest improvements and additions to the site.

The System Traders Club continues to grow by leaps and bounds and we now have more than a thousand
members from nearly forty different countries. We have done very little advertising lately so most of our
new members are coming from referrals. We wish to sincerely thank all of you who have told your
friends and associates about the club. Because we have been providing all of the Club Bulletins and the
"25 X 25" Bond system for free we have spent thousands of dollars on postage, printing and mailing
expense. The enthusiastic interest in the Club is very gratifying but it has caused us to spend a great deal
more money than we had ever anticipated. Communicating via our new web site will be cheaper and
faster and should allow us to continue to provide many services for free. (Our sincere thanks to Robins
Trading Company for generously offering to pay us for an ad on the back page of the Bulletin. Their ad
helps to cover some of our postage expense.)

Perhaps the biggest advantage of the web site is that it will allow the members to easily and quickly
communicate with us and also with one another in our Members To Members Forum.
Getting all of the web pages up and running will take some time and may in fact become one of those
never ending projects. However, I think all of you will be pleased to see how much progress we have
made in a very brief period of time.

If things go as planned you may now be reading the last Bulletin to be distributed by regular mail. Make
sure we have your current email address because we plan to send the next Bulletin electronically. Most of
you sent us your email address on your membership application. If there is any doubt just send us an
email message containing your name, city, and preferred email address and we will promptly put it into
the computer. If you don't have email please let us know and we will continue sending you our
information by regular mail.

Please visit the web site soon and give us any comments and suggestions about what you would like to
see there. This is your club and this is your site. Lets all work together to make it something really useful.
Now is obviously the best time to give us your ideas.

Members To Members

The pipeline has been opened and the flow of information has begun. In this issue you will find several
valuable contributions from club members.

Have you got an idea for a system? Do you have some useful information to pass along to fellow club
members? Is there a product or service you would recommend? One of the universities here in California
has a motto: "Freely you received; freely give." This motto should apply to the exchange of information
within the club. The price we are asking for this valuable newsletter is your participation.

If you are a new trader you can participate by asking questions. There will be many other members who
will benefit once we track down and publish an answer. If you are an experienced trader and systems
developer please share some of your hard earned knowledge. We aren't asking you to give away your best
trading secrets if you think it might have an impact on your trading results. Some idea or insight from you
might be just what another member needs to solve a problem. Our members will be very grateful for your
contribution.

The club is off to a magnificent start, lets all try to keep the momentum growing and establish a pattern of
participation that will benefit us all in the future.

From Riccardo In Italy

I have been developing trading systems for more than 8 years and I think I know many techniques to
exploit the market but many little details can make a big difference in our results. It seems that I never
stop learning because the markets are such a challenge and I welcome every opportunity to participate in
the sincere sharing of ideas. I appreciate your work is in this direction.

Here is an idea I would like to share. Have a nice day. Riccardo

Riccardo's system: This is a trend following system based on an adaptive channel breakout. It is the same
system I teach in my technical analysis courses in Italy.

The length of the channel is a function of the trend: Strong trend = few days in channel. Weak trend
(choppy market) = more days in channel. X represents the number of days of the channel breakout. X =
150/ADX(14 bars)

To implement the buy and sell breakout signals simply follow these instructions:

BUY HIGHEST(HIGH, X) + 1 POINT STOP;

SELL LOWEST(LOW,X) - 1 POINT STOP;

This is the most basic version of the system and it is employed as a reversal system without stops. There
are just two variables and both the length of the ADX and the level of the 150 numerator can be
optimized.

We need to use a more complex version of the system when X is less than 1 or greater than 40. Here is an
example:

INPUTS: LEVEL(100), LENGTH(14);

VALUE1 = INT(LEVEL / ADX(LENGTH));

IF VALUE1 > 30 THEN VALUE1 = 30;

IF VALUE1 bers in any particular field? Can we post a best time and method to contact you? Do you
want to exchange ideas on a particular market or trading strategy?

5. There are also some topics that we would like to hear about but do not intend to publish. If you have
had a good or bad experience with a product or vendor we would like to know about it privately. We may
share this information if one of members should make a personal inquiry. We don't want our publication
or web site to become a vendor bashing forum. There are already other publications for that.

Questions From Members

Question regarding multiple signals: Perhaps some of the members could give me their opinions on this
question: If one is trading multiple, separate long and short trading systems on one market and receives

(a) both long and short entry signals the same day, does one execute both signals or does one let them
cancel each other? and
(b) more than one entry signal in the same direction (long or short) on the same day, does one execute
only one signal or does one treat it as an opportunity to "double up"?
Editors Comment: Tough question. Not sure there is any right or wrong answer. Do any of our members
have an opinion they would like to share with us?

Your question reminded me of a paragraph in an interview in Futures magazine. (July 98 page 98.) Here
is a quote from this interview with Dan Byrnes, a very successful CTA:

"Byrnes' system includes six trend-following components, such as volatility-adjusted breakouts and
methods that enter existing trends on momentary pullbacks. Each component acts as a mini-system,
giving signals to buy, sell or be flat. To determine actual positions, the signals are netted out. For
example, if a strategy trading two contracts says buy and a strategy trading three contracts says sell,
Byrnes sells one contract. If both say buy, he buys five."

I personally would like to have a filter or tie breaker for this specific situation that would only allow
trades in one direction on any given day. Our plan for multiple systems is to design them so that they turn
on and off automatically so that there is only one direction being traded at a time. For example let's say
that we select the 20 day moving average as our filter. If the prices are below the MA then the short
system is turned on and the long system is turned off.

Regarding (b) where you have multiple signals in the same direction on the same day, I would assume
that the systems are designed to be traded over different time frames and I would take both the trades with
the understanding that one position will have a short term exit strategy and the other will have a long term
exit. It is quite possible that the short term trade will be a winner and reduce the risk on holding the long
term trade. This seems to me to be an ideal situation rather than a problem. If both systems trade the same
time frame I would probably pick the system with the highest percent winners and skip the other signal.

I would be very interested in hearing from our members on this thought provoking question. I hope many
of you will respond because this is a question that needs to be properly resolved if we are to implement
our plan of trading multiple systems per market.

Question regarding system results: When developing systems, is it important that the system is useful in
every market? I feel that reliability of a system over different markets is a sign that it is better "prepared"
for the future than one created on the historical data of a specific market.

Editors Comment: Remember that having sound logic in a system is often more important than the details
of the historical performance. When trying to take a system designed for one market and apply it to
another market first take a look at the logic in the rules of the system and see if that logic should also
apply to the new market.

If the logic should apply and the system doesn't work, then look for some bias in the price data. Compare
the price data of the first market with the data of the second market. Does one market have a strong bias
to the upside while the other has a bias to the downside? Does your system have a direction bias that
causes it to work in one market and not in the other? Is one market extremely volatile while the other
market is orderly? Try to see on a trade by trade basis what is happening in each market and understand
why the system works or fails on each trade.

You should also review each element of your system and see if there is any way to make the system more
adaptive to changing market conditions. For example is there any parameter expressed in dollars that
could be changed to a percentage of the price or to a multiple of the Average True Range?

Examine the details of the rules of the system and make certain that all of the parameters are as robust as
possible. Does the system perform well only if the moving average is exactly 34 bars or does it perform
well with any moving average between 10 and 50? If the parameters are very robust with a wide margin
for error the system should perform well on any market with similar data.

Consider the second market as your out of sample testing. Don't expect the results to match very closely
but they should both be profitable. If not, perhaps there is a flaw in the logic of the system or it has been
overly fit to the first set of data.

Let's not forget that markets can be substantially different in nature because of the variety of forces that
influence prices. A large contract that is an index of many prices like the S&P would obviously be
expected to have substantially different characteristics than a small contract single commodity like corn. I
wouldn't lose any sleep if my corn system didn't work in S&Ps and vice versa Hope this helps.

A Lengthy But Very Informative Letter From M. Edward Borasky

Dear Mr. LeBeau:

First of all, I'm honored to become a charter member of the System Traders Club. Your book is the best
book on trading system design on the market. (Editors note: Thanks Ed. Flattery will get your letters
published.)

Second, I'd like to invite your members to visit my web page, http://www.teleport.com/~znmeb especially
my bibliography at http://www.teleport.com/~znmeb/biblio.shtml

And third, you have my permission to print all or parts of this letter in your bulletin. I hope I can
contribute some ideas in the future as well.

A little background: I am a computer scientist / applied mathematician with over 35 years of experience. I
got interested in computational finance in the early 1980s. I started with options pricing theory, then
portfolio theory and finally mechanical technical trading systems. I was a fairly active stock and stock
option trader in 1991 and 1992, but my approach was fundamental rather than technical.

Currently I design and analyze systems and I enter contests from time to time, but I'm not an active
futures trader. My current "trading" is monthly asset allocation in my 401(K) at work.

My favorite trading system: point and figure charting. I have my own variant which I call micro point and
figure. At one time I had automatically generated point and figure charts on my web page, but I shut the
program down when the CFTC proposed requiring system vendors to register as CTAs. Even though I
was technically exempt because I was not charging a fee, I did not want to risk a lawsuit. I have also done
extensive simulations of Donchian's N-day channel rule.

Hardware and software: I don't own any software specifically for trading. I prefer to write my own
software in conventional high-level programming languages or spreadsheets. My main computer is an
HP100LX Palmtop PC, an 8 Mhz 80186 running DOS 5.0. Most of my programs are in Perl. For
example, the Donchian simulations were done in Perl on the HP100LX. These simulations were described
in the Spring 1997 Perl Journal; the code is available on their web site at

http://orwant.www.media.mit.edu/tpj/programs/Issue_5_Futures/

For high-speed simulations on large data sets I use Forth, a very fast and compact environment well-
suited to the HP100LX. And for plotting results I use the HP100LX built-in Lotus 1-2-3 spreadsheet. For
historical simulation, I use Pinnacle Data linked contracts, and for my trading contest entries I use free
end-of-day data from the Internet.

Measures of system performance: ah, where to begin? For managed money, I'll defer to Jack Schwager's
outstanding book, "Managed Futures." For my own simulations, I use a two-step process. First, I simulate
the system taking into account as best possible limit days, gap openings, unables and rollover trades.
However, I do *not* include an allowance for commission and slippage in this step. I collect a trade log
for each simulation which gives for each trade the position, long or short, the date and price the trade was
entered, the date and price of exit, how many trading days the trade was in place and the profit or loss as a
dollar value. Technically this last result is unnecessary; it can be computed in the post-processing step
from the other numbers. Then I post-process the trade logs extensively.

The article in the Perl Journal shows some simple statistics. Commissions and slippage are deducted in
the analysis phase; that way I can test a number of different values without having to rerun the time-
consuming simulation. The main performance measure I look at is the histogram of the profit/loss values
after deducting the commission and slippage. This is probably the most informative picture of
performance.

For example, from the mean and standard deviation of the profit/loss values adjusted for commissions and
slippage, I can determine the probability that the system actually is profitable -- that it has a positive
expectation. Another process I sometimes apply to the trade logs is called bootstrap simulation. With
bootstrap simulation, I can

estimate the probability distributions (histograms) of important parameters like drawdowns.

One comment on the bulletins: they should be dated. I'm still thinking about your change in philosophy
noted in Bulletin #2. While the case for multiple *diversified* systems is a strong one (again, see
Schwager's "Managed Futures"), it's not clear to me without seeing the details exactly how well
diversified your systems are. There are only four of them and three trade the same contract!

I've spent a lot of time dissecting Jack Schwager's recent writings, especially "Managed Futures" and his
interview in the Commodity Traders Consumer Report (June 1996). His approach makes a lot of sense to
me as a statistician. I think for a large CTA like Wizard Trading a diversified portfolio of market-system
combinations is the only way to go.

The last time I looked at their web page, Wizard was trading 60-odd contracts. They're a little less
specific about what systems they use but I believe they're mostly long-term trend-following. Louis Lukac,
the other principal at Wizard, is a big fan of Donchian's channel rule; it always seems to test well against
other well-known techniques.

One thing Schwager said in the CTCR interview is that he tests systems on broad ranges of parameters
over many years of data for many contracts, then trades all of them, except perhaps the obvious stinkers
like a two-day Donchian channel. You are right that this produces a "system that barely works in many
markets yet isn't outstanding in any."

But it does produce a system with a positive expectation. If he's got the computer power and the
programming talent he ought to be able to make this approach work. In addition, he views managed
futures as part of a portfolio that includes stocks and bonds.

When we look at the task of a lone individual trader with, say, $25K or less, however, a very different
strategy is required. As Kelly Angle pointed out in "Technical Analysis of Stocks and Commodities"
some time ago, a "small" trader can't really diversify as much as needed. The only thing that really makes
sense at this end of the scale is something like Alexander Elder's Triple Screen.

In Elder's system, you trade only in the direction of the long-term trend, enter on a stop in the direction of
the trend after a reversal with a

protective stop very close to your entry. Your 25x25 system conforms to this philosophy to a certain
extent. I would call it a quadruple screen; it trades only long because of the long-term uptrend in T-bonds,
trades when the ADX indicates an uptrend and enters after a short-term decline on a buy stop.

Incidentally, the long-only approach based on the "historical" uptrend in bond prices (downtrend in long-
term interest rates) is a perfect example of hindsight bias. You're betting that this trend will continue and
given a ten-year backtest it will take ten years for you to find out that this trend has changed!

When it comes to mixing systems, for example the 25x25, Big Dipper and Little Dipper, what matters is
the *correlations* between them. You designed them "so they are unlikely to enter the market at the same
time," It takes more than that, though, to have uncorrelated systems. For example, they are all trading the
same contract and backtested on the same data.
One of the things I'm currently working on is a correlation analysis package for my own use. I'm not sure
when it will be ready, but I'm willing to offer it to the club. You will need Perl, which is readily available
(and free!) for both Windows and UNIX. Trying to code something like this in Easy Language is a major
task; I'm not even sure it's possible. There are so many things you can do in a conventional programming
language compared to a trading package that I'm frankly surprised that these packages sell as well as they
do.

Other random musings and opinions:

1. I like the System Designers Tool Box. Since I like to design my own systems, it is a real help. I think
there are better tools for trend detection than ADX, but it does appear to be useful.

2. Although I don't currently trade options or use them, I am *convinced* that traders who don't use
options are missing out. At the very least, implied volatility from options prices is an important and
worthwhile indicator.

3. My sense as a mathematician is that there *has* to be a better way to analyze futures trading systems
than brute-force simulation on past price data. After all, futures prices satisfy the same partial differential
equations that are used in options pricing theory, one of the most successful branches of economics and
finance. I can't think of a single field in economics with a better predictive record.

4. Along those lines, there needs to be a portfolio theory for futures trading. The closest thing I've seen is
Schwager's "Managed Futures" and some of the writings of Ralph Vince.

It isn't clear to me, for example, why one should be better off managing a portfolio of *market-system
combinations* than managing a portfolio of raw futures and options. It can be shown that futures and
options, along with the underlying commodity or financial instrument and risk-free borrowing and
lending, form a complete set of building blocks from which one can construct any feasible return
distribution.

5. While the evidence for nonlinearity in financial markets is strong, there is still little evidence for that
very specific type of nonlinear behavior known as chaos. People who claim to be using "chaos theory" in
their trading systems are probably not exploiting an edge over the markets but the credibility of their
customers.

M. Edward Borasky (Received via email)

Ed, I did visit your web site and I encourage members to visit it as well. You obviously put a lot of work
into it and I intend to put a link to your site on our links page. I hope you will be among the first to help
us launch the Forum section on our new web site by giving us more of your thoughts and stimulating
some discussion.

Thanks to all for their contributions to this Bulletin. As you can see, its getting bigger and better as the
Club grows.
I've been busy working on the web site and some new trading systems but I promise to have another
Toolbox article in the next issue.

Good luck & good trading

#5 – ADX Has Its Limitations

Chuck LeBeau's System Traders Club
Vol. 1 Number 5 Sept. 24, 1998

Table Of Contents:
Free Classifieds Announcement
Comment by Chuck: CNBC Features System Traders
Serendipity Bond System Announcement
Traders Toolkit: Adx Has It's Limitations:
Chuck Appearing in Raleigh NC.

NEW WEBSITE IS VERY POPULAR:

Our website has been up and running for a while and there has been lots of traffic.(2,000 -
10,000 hits a day) We have tried to post some useful information and make the site as user
friendly as possible. The HOME page and the FORUM page are getting the most interest.

FREE CLASIFIED ADS ON OUR WEBSITE:

One of our members suggested we have a classified ad section on the web site and we think this
is a great idea. Brokers and vendors would have to pay for their ads but individuals and non-
profit entities would be able to post their ads for free. For example if someone had used books or
courses on trading that they wanted to sell. Or perhaps someone wants to buy or sell a used copy
of SuperCharts. We could even do some job listings. Lots of possibilities. The classifieds will be
found at http://traderclub.com/Classifieds.htm Make web history and be the first to post a
classified ad on our site.

CNBC PLUGS SYSTEM TRADERS:

As I'm writing this paragraph I'm listening to CNBC on my TV and they are doing a special
feature on systems traders. The good news is that the CNBC coverage is very favorable but the
bad news is that it is really dumb. I'm surprised at how little they know about systems trading.
For example they imply that systems traders are out surfing (now showing video footage of
teenagers surfing) while their high powered main frame computers run "high tech moving
average systems" to trade the markets. I'm laughing out loud here. Wish it were that easy! I'm
really surprised that they think you need a main frame computer to do moving averages. Shows
you how uninformed they are. Fortunately they did imply that systems traders as a group fared
very well recently (not sure where they got that info) while other investors were losing big
money. At least their coverage put a very favorable spin on systematic trading. Maybe it will
help generate more interest in our web site so we can help educate the public as to what systems
trading is really all about.

BULLETIN FREQUENCY SHOULD INCREASE SOON:

In the past we've been trying to mail out a Bulletin about once every two months. Now that we
can distribute our Bulletins so easily via email we've decided that we should be doing the
Bulletins more frequently. (This electronic publishing is wonderful.) Lots of what used to be in
the Bulletins is now available live on our web site so the Bulletins will usually be shorter now.

AT LONG LAST, A BOND SYSTEM FOR THE SHORT SIDE:

Due to the upward bias in our historical bond data we were beginning to think the short side was
impossible. Fortunately we were persistent and after months of trying and many wastebaskets
full of lousy test results we finally figured it out. Not surprisingly the breakthrough was in
finding the proper exits and the resulting system is quite simple (the best kind). We named the
system SERENDIPITY because we set out to create a short side system and also discovered an
excellent long side system in the process. We think the Serendipity system will be able to trade
both sides very nicely. You can find the performance details on the web site at
http://traderclub.com/systems_serendipity.htm

TRADERS TOOLKIT: ADX HAS IT'S LIMITATIONS:

(I'm referring to Welles Wilders Average Directional Index in case you are a "newbie".) After
many years of extolling the virtues of the ADX in articles and lectures all over the world I have
become closely associated with this indicator. That's fine with me and I don't mind being
considered the resident expert on ADX. It is an excellent measure of trendiness and a good
indicator to be linked with.

However, I think it is a mistake to try and over work or become too dependent on any one
indicator. If you were going to build a house you would need more than one tool and you
wouldn't try to do it with just a hammer. The same is true of building systems. The ADX can be
a very valuable tool if used correctly but it has some major shortcomings that everyone should be
aware of: We all know that the ADX is slow. This is because of all the smoothing in the formula.
The basic ingredients are smoothed and then the results are smoothed again. For example I think
it takes more than 30 bars of data to calculate a 14 bar ADX. This smoothing makes the ADX
slow but there is an even greater problem than just the speed of the indicator. The logic of
measuring directional movement makes the ADX very reliable at certain times and very
unreliable at other times.

A rising ADX is a reliable indication of a trend when there has been an extended sideways
period before the trend gets started. Before all the high tech computer mumbo jumbo we used to
simply refer to this sideways period as a "basing pattern". The ADX is most effective when it
begins to rise from a low level (low = 15 or less). This low level on the ADX indicates that there
has been a basing pattern for a while. This interpretation is contradictory to those users of the
ADX who want to see the ADX cross above a specified threshold (usually 20 or 25) to indicate
that a trend is underway. This technique would make the ADX even slower and means you
would be confirming a trend and entering your trade long after the basing pattern was broken.
But even if you were late due to your method of interpreting the ADX, following the ADX after
a base pattern is still quite reliable. The potential problem I want to bring to your attention in this
article is the action of the ADX after major peaks and valleys.

The logic of the ADX is best visualized as measuring directional movement over a moving
window of data on a bar chart. If we have sideways data in the window followed by recent
trending data (lets think of rising prices but it could be the reverse), the rising prices would show
directional movement relative to the sideways data at the beginning of our window. The ADX
would promptly rise and call our attention to the fact that there is now a direction in prices that
should continue for a while.

However, if the prices rise for an extended period and then begin to fall sharply (a typical
scenario) we now have a window of data that shows rising prices followed immediately by
falling prices. The ADX formula measures the rising prices in the window and compares them
with the declining prices in the window. Because the two trends are about equal they cancel each
other and the ADX does not detect any net directional movement. The ADX now begins to
decline indicating that it is finding no net directional movement in the period measured by the
window.

As the window moves forward, eventually the older rising price data falls outside the back of the
window so that the window now contains only the more recent downward price movement. The
ADX suddenly begins to rise rapidly because the data window at this point contains only one
trend. The problem with this new signal is that the downward trend in prices has been underway
for quite some time and only now has the ADX finally begun to rise. This is obviously not a
good point to be entering a trade to the short side. We are probably nearer the end of the trend
than the beginning.

Remember that the ADX works best after a basing period and is unreliable after a "V" bottom or
top.
That"s all for now. I'll continue this discussion of the ADX in our next bulletin which should be
out very soon.

Remember to visit the website often and participate in our FORUM discussions. Post anything
you like that may be of interest to fellow club members. Also please feel free to forward this
bulletin to a friend and invite them to visit our web site at http://traderclub.com

SPECIAL ANNOUNCEMENT !!!!!

Chuck Le Beau will be speaking at a Seminar being conducted by Dr Van K.Tharp October 23 -
25 in Cary NC. near Raleigh. The Seminar is titled " How to Develop a Winning Trading System
that Fits You" (Advanced Workshop) As a special benefit to Traders Club Members, mention
that you are a member of the Traders Club and receive a $150.00 discount on the cost of the
Seminar. For enrollment information and details go to
http://www.iitm.com/seminars/ii06002.htm

#6 – Contradictions in Using
ADX
Chuck LeBeau's System Traders Club
BULLETIN Vol. 1 Number 6 Oct. 1, 1998

Table of Contents:

Article by Chuck " Contradictions in Using ADX "

System Results Report

Contradictions in using ADX:

In our last bulletin we described how the ADX works best when a move develops out of a basing pattern.
Someone sent us a very courteous email questioning this strategy and reminded us of our "25 X 25"Bond
system where we want the ADX to be above 20 before looking for an entry. He commented that by the
time the ADX gets to 20 any move out of a base pattern may be over. He is absolutely right and I can see
how there may appear to be some confusion on how the ADX should be applied. But there really isn't any
contradiction if you understand that what we are trying to do with the ADX is very different in the two
examples.

In the "25 X 25"strategy the ADX is used as an important "setup"condition that tells us when the trend is
strong enough that we can confidently buy on weakness. However, when we describe the basing pattern
strategy we are using the ADX as the actual entry trigger to buy on strength. There is a big difference in
the buy on strength and buy on weakness strategies. In the basing pattern strategy a low level of the ADX
is preferred because the rise in the ADX is the trigger. If the ADX is at 12 and starts rising we very well
could miss the majority of the move if we waited for it to reach 20. With the ADX already at 20 or higher
it might only be safe to buy on dips and of course that is exactly what the "25 X 25"bond strategy does.

To sum things up: there is no contradiction. To catch a move out of a base you should enter as soon as the
ADX starts rising. Just compare today's ADX with yesterday's ADX and the faster it is rising the better.
At this point the the lower the level of the ADX the better because we are buying on strength and the
ADX is our entry trigger.

System Results Update

By the way, our bond strategies have been making lots of money this year. Hope you are all trading them
with real money. Back in February I had lots of critics calling and asking why we were offering long only
bond systems when bonds were at 115 and that had to be the top. They said that they couldn't possibly go
much higher than that and our long only results could not hold up in real trading. Now that the bonds are
over 130 I am glad that we have the Serendipity system that does trade the short side because I suspect
that we really are near the top. (Doesn't take a genius to make a dumb statement like that. I apologize.)

The Big Dipper system has been long since July and has huge open profits even after having to be rolled
forward from the September contract into December. The "25 X 25"system is not doing bad either. When
is the last time you had a free system make that much money for you? And last but not least, lets not
forget the "Little Dipper". According to my recollection the last seven trades were all winners and it could
be more because I can't remember the last loser. Not too bad for out of sample trading results.
REMEMBER: PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE SUCCESS.
I'm not just saying that because I have to. I really believe it and so should you. The bull market in bonds
has made us look smarter than we really are. Bull markets do that.

Ideas needed:
I would like to remind members that they are encouraged to share their thoughts and ideas with the Club.
Don't be bashful. This is your club and I want to hear from you either privately via email or publicly on
our FORUM page. I don't want to be the only one voicing opinions here. I'll be the first to admit that I
don't have all the answers and I don't aspire to "guru"status. We've got too many of those already.

Check out our FORUM page and post something, even if its a simple question, comment or observation.
We don't need or expect any Pulitzer prize winning narratives. Just be relaxed and positive and try not to
say anything that you might regret.

#7 Indicators Ad Infinitum
I frequently receive messages asking for my opinion about the relative value of this new indicator vs that
new indicator. I am very flattered by the assumption that I can immediately rank all the known indicators
on a scale of one to ten and then provide meaningful insight on their relative value. Those that ask for this
information are sometimes disappointed when I am unable to respond appropriately by perhaps replying
that I am certain indicator A is twice as good as indicator B. Unfortunately the truth is I do not spend
much of my time researching new indicators nor do I believe that indicators can be compared in this
fashion.

Regarding new indicators in general, in my opinion the world of technical analysis has too many
indicators already and it doesn't need any more indicators without purpose. Everyone wants to add more
indicators and more confusion. Why? I think that every new indicator should be required to come with an
explanation of why it was created. What specific problem does it solve? Any new indicator that solves a
particular problem should then be welcomed with open arms. Any indicator that was designed simply to
be different is less than worthless. It does nothing but add to the existing confusion and serves to distract
us from indicators that have proven value. Everyone should realize that in this business we keep score
based solely on profits. There are no style points or bonuses for originality.

The new indicator questions I receive usually go something like this: "I just read about Joe Guru's new
Joe Guru #62 which he calls the Joe Guru Upside Down Inside Out Infinitely Smoothed Fractal
Precipitator with Semi Log Analysis and a Twist of Lime. Do you think this a good indicator?" (By the
way, have you noticed that Gurus always have to put their names on their indicators. I think its just some
Guru thing. Perhaps a grasp for immortality. In any case, let's forget about the Guru's annoying insistence
on naming indicator after indicator after themselves and get back to trying to objectively assess the value
of the indicator itself.) "Is it a good indicator?" was the simple question.

The answer, however, is not as simple as the question. For example: Do I think moving averages are good
indicators? Yes, as trend identifiers and setups, I think they are wonderful. Do I think moving averages
are awful? Yes, I have tested enough of them as entry triggers to state that they are indeed awful. I could
go on and on, indicator by indicator. Most indicators are valuable when applied to certain limited tasks
and also very poor at many other tasks.

We should keep in mind that indicators are not systems and they should not be evaluated in the same
manner as a system might be evaluated. Indicators are nothing more than problem solving tools and there
are many problems to be solved when designing a good system. Our favorite indicator may solve one of
these problems perfectly but may have no value whatsoever when applied to the next problem. It is true
that, in theory, you can take any indicator and make a system out of it. But the result, even with the best
indicator, is usually a mediocre system. It seems to me that using this procedure assumes that you already
know the answers without ever having defined the problems. Just for fun, the next time you are in the
local drug store, go to the pharmacist and ask "What is your best prescription?" Tell me what kind of
response you get.

Another aspect of ranking and comparing indicators is that indicators are difficult to test objectively
unless you isolate their use to a particular function and then test them for their usefulness according to
how well they perform that single function. For example you will remember that in our book we tested a
lot of indicators as entry triggers and found that most of them were lousy. This doesn't mean they are
lousy indicators. It simply means that they are lousy when used as entry triggers. Unfortunately most
traders assume that the only function of an indicator is to use it as an entry trigger.

I think that if we begin to think of indicators as problem solving tools and not as systems they will begin
to take on a new life and new meaning. There is no "best"or "worst" or "better than". There are trading
problems that need to be solved and there are indicators that provide us a choice of solutions. The best
indicator is the indicator that, at this moment, provides the best solution to the problem at hand. As we
continue to put the pieces of our system together we will be faced with other problems and today's
solution may not be the best solution for tomorrow's problem.

The next time you are building a system, don't start by asking: What indicator am I going to use? Instead
begin by breaking down the trading process into a series of clearly identifiable problems. Then use your
knowledge of various indicators to find the tool that does the best job of solving each problem. I'll bet the
indicator you select is not going to be the super duper Guru namesake of the month.

*********************************

Enclosed is a message from Sam Tennis (Vista Research and Trading) that I thought might be useful to
many of our members.
To my special friends...

Below are the URL addresses for three questions (or perhaps answers) that might be of some interest to
you. Please feel free to pass this message on to any friends who might desire this information..

There is also a message from Glen Larson, President of Genesis Financial Data Services, for anyone who
purchased the historical data CD from Omega Research.

The Bulletins on the Omega web page...

Information on the Y2K compliance issue from the Omega Research Customer Support Manager.

The CBOT has added new Project A - Electronic Treasury Bond future symbols that will trade over
Project A and electronically during the regular trading hours.

Daylight Savings Time & The Omega Server

Information on all of these important topics can be found at:

*********************************

The following message was posted on our Forum page but I thought it was important so I am posting it
again in the Bulletin to make sure everyone gets to read it. The original message was to Sam Tennis.

From: Glen Larson

Subject: RE: posting
Date: Wed, 30 Sep 1998 16:00:13 -0600

Attention Omega Research Continuous Contract CD Purchasers:

Recently, Genesis Financial Data Services and Omega Research had a cross marketing agreement of the
Genesis Continuous Contract CD. Due to several factors, this agreement was terminated.

Genesis had been sending corrections, data updates and software updates to Omega to be implemented in
releases to the purchasers of the Continuous Contract CD. Since these updates were not implemented on
any of the CD shipped by Omega, Genesis would like to replace the Omega/Genesis Continuous Contract
CD at no charge.

Purchasers of the Omega Continuous Contract CD need to contact Genesis to obtain an RMA to return
the original CD for the refresh. Users can reach us at 800-808-3282. When the user sends back the old
CD, a refreshed CD will be sent out at no charge. The refreshed CD will be current when shipped.
Returns must have a valid RMA or they will not be accepted.

Since we did not receive the names of the purchasers of the Omega
Continuous Contract CD, we would like to have this message passed around to persons who might have
purchased the Omega Continuous Contract CD.

If any users have any questions, complaints, suggestions etc., please feel
free to contact me at glarson@gfds.com .

Thank you for your time.

Glen Larson
President
Genesis Financial Data Services

****************************

Don't forget that I will be speaking at Dr. Van Tharp's Seminar October 23 -25 in Cary NC. near Raleigh.
Hope to see some of you there.

The Seminar is entitled " How to Develop a Winning Trading System that Fits You" (Advanced
Workshop) As a special benefit to Traders Club Members, mention that you are a member of the Traders
Club and receive a $150.00 discount on the cost of the Seminar. For enrollment information and details
go to Dr. Tharps website at

http://www.iitm.com/seminars/ii06002.htm

***************************

I will also be speaking at the TAG seminar in Las Vegas at the MGM Grand Hotel, November 20 thru 22
. Traders Club members attending will receive three free audio tapes. I will post more details in the next
Bulletin. http://www.telerateseminars.com

That's the end of Bulletin #7

Good luck and good trading

Chuck
#8 Dealing with Excessive
Volatility
The recent volatility in the stocks, bonds, and currencies have created opportunities and problems for
traders. Brief periods of excessive volatility are nothing new and we all need to have a high volatility
contingency plan that allows us to deal with these conditions in a rational and objective manner.

You never want to just skip trades arbitrarily. This is a bad idea and can quickly become a costly habit. I
have a rule of thumb that I try to apply in cases of high volatility that helps me to decide if I should enter
a trade in a high volatility situation. I should warn you that this rule sometimes saves me money and it
sometimes costs me big profitable trades. The primary benefit of the rule is that it is
objective and disciplined. The rule keeps me from just guessing and agonizing over what to do in
situations where the volatility is obviously extreme. The rule has some inherent logic that helps me to
quantify "extreme" volatility on a system by system and market by market basis.

The rule is that if the recent daily range is greater than the money management stop you are using, you
don't do the trade. The logic is that our money management stops should be outside the range of what
normally happens in one day. To have stops closer than that is to be inside the "noise level" where you
can get randomly stopped out for no good reason. Once the market settles down to where the range
between the high and low is less than the amount of your stop you could then enter the trade and safely
place your stop.

Now let me give you a specific example. We just took a quick but big loss on a Yen trade today and it is
now set up for a new trade tomorrow. The range over the last day or two, as we all know, has been far
beyond normal, several times more than our protective stop loss. The trade for tomorrow should be
skipped because of the volatility rule described above. If you like, the trade can be entered at a later date
when the average true range is less than our stop.

This volatility rule applies to all systems and markets. It does not come into play very often and it is not
something we just made up for the Yen. I have found it to be a valuable rule that I have used for years to
limit my exposure in times of excessive volatility.

Please keep in mind that high volatility is an opportunity for unusually large profits as well as losses and
if you skip a big winner you will certainly regret it. For those with more than adequate capital an
alternative solution is to reduce the position size and arbitrarily change the money management stop to a
much bigger number on a temporary basis. If you can afford losses of this size this might be a better
solution because you would avoid being stopped out needlessly and you would still be able to participate
in the big winners. Based on past experience I would say that as a minimum a stop of about two recent
average true ranges would be required. Obviously this would be a huge dollar amount to be risking in Yen
or S&Ps right now.

Good luck and good trading.

Chuck

#9 Messages from Members

Regarding Volatility
(Messages may be slightly edited in some cases. Names are used only when writer has given permission.)

*************
Hello Chuck:

I guess we have all been thoroughly humbled by seeing our phenomenal bond profits evaporate while
waiting for n day trailing stops to be hit. I've been doing some experiments to see how profits can be
locked in when bonds behave like soybeans, and I have come up with some simple additions to the code
for the systems which improve profits considerably. You might like to check these changes out.

One change is to add your volatility filter tip for the 7-11 Yen system to the code. For the Yen, add the
entry condition: AvgTrueRange(2)suffer a huge hit which can undo months (years?) of good work.
Fallout over the next week from hedge funds going sour (and having to unwind further) is going to be a
real test of market levels and volatility. Your message was a good public service and timely reminder to
all.

Regards,
P.C.

*************
Greetings Chuck,

I'm watching the Dec Bonds this morning and it's painful to give up $6000.00 in profit as I watch the
trade slip toward the losing column.
Have you tested any other exits for the 25X25 system that would protect some of the profits? As you can
probably tell, I'm a hard-nosed system follower. I'm sure you know the game, as soon as the pain gets too
high I exit a position prior to the exit stop and the market starts moving in a profitable direction again. I'm
determined not to do that in this case. I think my trailing stop is around 126-10 on the Dec Bonds, that
equates to about an 8,000.00 equity swing. A bit "stout" for my way of trading. I look forward to hearing
your thoughts on the matter.

Regards
H.F.

*************
Regarding Special Bulletin

My approach is to make stops depend on "percentiles" of the recent true range. That is, you take the past
59 days' true range values and sort them from lowest to highest. The reason I use 59 is that the percentiles
are easy to calculate. The nth value is the n/60th percentile. For example, the lowest true range is the
1/60th percentile and the highest true range is the 59/60th percentile. The median is the middle value, the
30th. The 90th percentile is the 54th value. So let's assume you want a stop that will only be hit 10 percent
of the time and be missed 90 percent of the time. That's the 90th percentile, which is the 54th value in the
list! If you're a little more gun-shy, take the 75th percentile, which is the 45th Value. If you're are real
risk-lover, go for the 95th percentile, the 57th value. I think you want to use the true range rather than the
high minus low because that accounts for overnight risk.
M. Edward Borasky) http://www.teleport.com/~znmeb
*************
Comments from Chuck

The logic of the "25 X 25" exits is that if there is a sustained trend, the longer you hold the position the
greater the profit should be. Holding for a minimum of 25 days or more, in times of normal volatility,
seems to produce worthwhile profits most of the time and forces some badly needed patience which most
traders seem to lack.
However, this logic is admittedly flawed when we get into periods of abnormal volatility. It is the amount
of profit and not the duration of the trade that should always be our goal. The "25 X 25" system badly
needs an additional exit so that when a particular level of profit has been reached the stop will tighten
regardless of how many days in the trade. (Isn't hindsight wonderful.)

However it is important that we all remember that the huge open profits that existed in the recent trades
were obtained only because smaller profits were not taken. You can't have big open profits if you make it
a practice of taking small or medium sized profits. The trick is to give enough room at the beginning of a
trade to let the open profits accumulate. Our strategy obviously did this very well. However the error was
in not protecting those substantial open profits once they had been achieved.
I think we can improve the exit by simply adding a measure of profitability so that once that level has
been reached we move the stops up regardless of the holding period. This would allow us to hold for an
adequate period in normal markets yet it would also allow us to protect the big profits in the abnormal
markets. I'll work on version 1.1 of the "25 X 25" system with this improved exit strategy and post it so
all of you can download it. We will announce the completion and availability of the new version of this
free system in a subsequent Bulletin.

*************
Don't forget that I will be speaking at Dr. Van Tharp's Seminar October 23 -25 in Cary NC. near Raleigh.
I will be seeing some of you there.
The Seminar is entitled " How to Develop a Winning Trading System that Fits You" (Advanced
Workshop) As a special benefit to Traders Club Members, mention that you are a member of the Traders
Club and receive a $150.00 discount on the cost of the Seminar. For enrollment information and details
go to Dr. Tharps website at
http://www.iitm.com/seminars/ii06002.htm

*************
COMING ATTRACTIONS

In our next BULLETIN we will begin a series of articles about using Average True Range. I will be
speaking on this topic at the 20th Annual TAG conference in Las Vegas November 21st, 22nd, and 23rd.
I thought our Traders Club members might enjoy reading a preview of my lecture notes.

For information about the TAG conference (highly recommended) visit their web page at http:// www.
telerateseminars.com

*************

Chuck

st
#10 Average True Range (1
Article)
Average True Range is an indespensable tool for designers of good trading systems. It is truly a
workhorse among technical indicators. Every systems trader should be familiar with ATR and its many
useful functions. It has numerous applications including use in setups, entries, stops and profit taking. It is
even a valuable aid in money management.

The following is a brief explanation of how ATR is calculated and a few simple examples of the many
ways that ATR can be used to design profitable trading systems.
How to calculate Average True Range (ATR).

Range: This is simply the difference between the high point and the low point of any bar.

True Range: This is the GREATEST of the following:

1. The distance from today's high to today's low
2. The distance from yesterday's close to today's high, or
3. The distance from yesterday's close to today's low

True range is different from range whenever there is a gap in prices from one bar to the next.

Average True Range is simply the true range averaged over a number of bars of data.

To make ATR adaptive to recent changes in volatility, use a short average (2 to 10 bars). To make the
ATR reflective of "normal" volatility use 20 to 50 bars or more.

Characteristics and benefits of ATR.

ATR is a truly adaptive and universal measure of market price movement.

Here is an example that might help illustrate the importance of these characteristics:

If we were to measure the average price movement of Corn over a two day period and express this in
dollars it might be a figure of about $500.00. If we were to measure the average price movement of a Yen
contract it would probably be about $2,000 or more. If we were building a system where we wanted to
use the set appropriate stop losses in Corn and Yen we would be looking at two very different stop levels
because of the difference in the volatility (in dollars). We might want to use a $750 stop loss in Corn and
a $3,000 stop loss in Yen. If we were building one system that would be applied identically to both of
these markets it would be very difficult to have one stop expressed in dollars that would be applicable to
both markets. The $750 Corn stop would be too close when trading Yen and the $3,000 Yen stop would
be too far away when trading Corn.

However, let's assume that, using the information in the example above, the ATR of Corn over a two day
period is $500 and the ATR of Yen over the same period is $2,000. If we were to use a stop expressed as
1.5 ATRs we could use the same formula for both markets. The Corn stop would be $750 and the Yen
stop would be $3,000.

Now lets assume that the market conditions change so that Corn becomes extremely volatile and moves
$1,000 over a two day period and Yen gets very quiet and now moves only $1,000 over a two day period.
If we were still using our stops as originally expressed in dollars we would still have a $750 stop in Corn
(much too close now) and a $3,000 stop in Yen (much too far away now). However, our stop expressed in
units of ATR would adapt to the changes and our new ATR stops of 1.5 ATRs would automatically
change our stops to $1500 for Corn and $1500 for Yen. The ATR stops would automatically adjust to the
changes in the market without any change in the original formula. Our new stop is 1.5 ATRs the same as
always.
The value of having ATR as a universal and adaptive measure of market volatility can not be overstated.
ATR is an invaluable tool in building systems that are robust (this means they are likely to work in the
future) and that can be applied to many markets without modification. Using ATR you might be able to
build a system for Corn that might actually work in Yen without the slightest modification. But perhaps
more importantly, you can build a system using ATR that works well in Corn over your historical data
and that is also likely to work just as well in the future even if the nature of the Corn data changes
dramatically.

More to come in our next Bulletin

*******************

MORE MEMBER FEEDBACK ON VOLATILITY

(See special Bulletin #

The Babcock Exit

I think it's great that you and some subscribers are responding to this problem. Although I don't know
how to program the following trailing stop I thought it is worthy of your consideration. The source of the
stop methodology is Bruce Babcock from whom I have purchased a couple of systems.

Basically his approach to a trailing stop would be to set a percentage of profit that one would like to retain
after a certain level of profits is reached. For example, in the bonds you would set it up to retain 25% for
every $1000 or maybe $1500 worth of closed profit.

The code would be written such that each person could set their own risk parameters by adjusting the
retention percentage and/or the dollar increment level. I find this approach more comfortable to my
trading logic than using an average true range approach because Bruce's method will work even if the
market retraces without an abnormal increase involatility.

Best regards,

Steve Billis

********
A Timely Warning from Rick Saidenberg

BEWARE!

In part of Richard Sheeler's note, he suggests optimizing with the Trade Station % Trailing Stop.
BEWARE! This stop leads to historical results which will not match the trades you will get while
following the system real-time. This situation occurs when a LongExit occurs on the same bar when the
high satisfies the floor; or when a ShortExit occurs on the same bar when the low satisfies the floor.

Rick Saidenberg

*******

Response from Chuck

Thanks Rick

No. This is different from Bouncing ticks.

% Trail Stop In historical testing, for a long exit, TS uses the high of a bar to calculate the trail stop exit
level. It then reports the exit price on that same bar calculated from the high. In real-time, for a long exit,
as soon as the Floor level is reached, TS places a stop to exit the trade - this is before the completion of
the current bar (In Tools-Options-System, you can set how frequently the trail stop is recalculated). If the
market turns down enough to hit the trail stop, TS stops you out of the trade correctly. However, if the
market subsequently turns up to make a new high for the bar, the historical test will show an exit at a
higher price.

Bouncing Ticks
TS uses only the OHLC data for historical testing. So whenever there is more than one trade in a bar
(entry and exit count separately), since TS does not resolve to the tick, TS is prone to giving historical
results which do not match the results in real-time. Bouncing Ticks is for historical testing. It is an
attempt to guess the sequence of ticks in one bar. It only makes an assumption, so it is never precise. In
order to be confident in a historical test, there must be a maximum of one trade in each bar. This may
require writing code so a system can operate on a small enough timeframe so each bar contains a
maximum of one trade.

Rick Saidenberg

***************

New System on the Horizon

We are almost finished working on a Bond system designed to trade in sideways markets. The
"Sidewinder" Bond System is designed to complement our existing bundle of Bond Systems. We expect
to announce the release of this new system very soon. Our research to date looks very encouraging.

That's all for now. Many thanks to all those that contributed ideas and
comments. Your help makes my job much easier.

Good luck and good trading

Chuck

nd
#11 Average True Range (2
Article)
This is the second in a series of articles about using Average True Range. In our first article in Bulletin 10
we explained how ATR is calculated and gave an overview of its many uses and benefits. In this article
we will show some
specific examples of how using ATR can help to make our systems more robust.

First lets look at a simple buy only system for Corn without using ATR. Here are the rules:

1. Buy Corn whenever it rises 4 cents per bushel from the opening price.
2. Take a profit whenever the profit reaches 18 cents per bushel.
3. Take a loss whenever the loss reaches 6 cents per bushel.

Now lets build the same system using ATR. (Assume that the 20 day ATR is 6 cents).

1. Buy when the price rises 0.666 ATRs from the open.
2. Take a profit when the profit reaches 3 ATRs.
3. Take a loss whenever the loss reaches 1 ATR.

We have the original system and a modified version that has substituted ATR for the important variables.
The two systems appear to be almost identical at this point. They both will enter and exit at the same
prices. Now let's
assume that the market conditions change and the Corn market becomes twice as volatile so that the ATR
is now 12 cents per day instead of 6 cents. Here is a comparison of the original system and the ATR
system:

1. The original entry of 4 cents per bushel from the open is now too sensitive. It will generate too many
entry signals since the daily range is now 12 cents instead of only six cents.

However, the entry expressed as 0.666 ATRs will adjust automatically and will now require the price to
move 8 cents per bushel to enter. The frequency and reliability of our entries remains the same as before.

2. The original profit objective of 18 cents per bushel is much too close for a market that is now moving
12 cents per day. As a result the profits will be taken too quickly and our original system will be missing
many opportunities
to make much bigger profits than usual.

However the profit target expressed as 3 ATRs has automatically expanded the profit objective per trade
to 36 cents per bushel. Significantly larger profits are now being realized by the ATR system as a result of
the increased
volatility.

3. The original stop loss of 6 cents per bushel will now be hit frequently in a market that is moving 12
cents per day. If you combine these frequent stop loss exits with the overly frequent entries being
generated, you have a classic ―whipsaw‖ situation and we can expect to encounter a severe string of
losses. Our original system is now failing because the market conditions have changed. We need to fix it
or abandon it in a hurry.

However lets look at our ATR version of the system. The stop loss expressed as 1 ATR now sets our stop
farther away at 12 cents so it isn’t being hit any more frequently than before. We continue to have the
same percentage of winning trades only the winning trades are much larger than before thanks to an
increased profit objective. Our ATR system has a nice series of unusually large winning trades and is
currently making a new equity peak. The ATR system now looks better than ever.

In our example, the proper application of ATR has made the difference between success and failure.

In our next bulletin we will look at a few more of the many ways we can apply ATR in our trading
systems.

*********

I will be speaking about ATR at the 20th Annual TAG conference in Las Vegas November 21st, 22nd,
and 23rd. For information about the TAG conference (highly recommended) visit their web page at http://
www. telerateseminars.com

***********

As previously announced I recently spoke at Dr. Van Tharp’s workshop for Advanced System
Development. As always his workshop was well attended with a broad cross section of traders ranging
from nearly new beginners to experienced floor traders and hedge fund managers trading millions of
dollars. Dr. Tharp’s new book Trade Your Way to Financial Freedom is now available and I recommend
it highly. It may be hard to take a book with such a title
seriously but I can assure you the book is much better than the title would lead you to believe. This book
contains some very sound and insightful material that should be welcomed by serious traders regardless
of their methodology. I think that you will find Van’s work on money management, or ―position sizing‖
as he prefers to call it, particularly valuable. The book was published by McGraw Hill and is not yet
available in local bookstores. I’m sure you can obtain it from Dr. Tharp by visiting his website at
http://www.iitm.com/ or order it from my old friend Ed Dobson at Traders Press
(phone 1 800 927-8222) or go to http://www.traderspress.com/

*********

Good luck and good trading

Chuck

#12 Changing the 25x25

System Exit
After the last big run up in bonds we observed that the logic of the "25 X 25"Bond System exits needed
some improvement. The system was operating on the assumption that in a trending market the longer we
hold a position the greaterthe profit. The exit strategy was intended to more or less force us to hold
positions at least 25 days or more.

The problem we discovered was that after the recent buy signal we had a huge profit after only 12 days
and the stop was still too far away. Our original logic was flawed because we equated time in the trade
with profitability rather than simply measuring profitability directly.

Big profits need to be protected regardless of how long it takes to obtain them. As usual the fix was easy
once the problem was defined. We simply added an additional exit that moves the stop up as soon as we
have 5 Average
True Ranges of profit. This is not a curve fit for one event. There were several other times in our
historical data where this exit was needed. The logic of the exits makes much more sense now. We should
have spotted this flaw earlier because we want all of our systems to be as logical as possible. We
continuously emphasize that the logic of a system is much more important than the historical performance
data.

Here is the additional line of code that will convert the previous system into version 2.0:

if c> entryprice + (5 * AvgTrueRange(45)) then exitlong lowest(low,2) stop;

New code including this change as well as new performance data are available at
http://www.traderclub.com/25.htm
Good luck and good trading

Chuck

#13 Average True Range

rd
(3 Article)
This is the third in a series of articles about using Average True Range. In our first article in
Bulletin #10 we explained how ATR is calculated and gave an overview of its many uses and
benefits. In Bulletin #12 we showed some
specific examples of how using ATR can help to make our systems more robust. In this Bulletin
we will show some of our favorite applications of ATR as part of our entry logic.

Sample Applications of ATR as an entry tool:

Entry Setups: (Remember, entry setups tell us when a possible trade is near.
Entry triggers tell us to do the trade now.)

Range contraction setup: Many technicians have observed that big moves often emerge from
quiet sideways markets. These quiet periods can be detected quite easily by comparing a short
period ATR with a longer period ATR. For example if the 10 bar ATR is only .75 or less of the
50 period ATR it would indicate that the market has been unusually quiet lately. This can be a
setup condition that tells us an important entry is near.

Range expansion setup: Many technicians believe that unusually high volatility means that a
sustainable trend is underway. Range expansion periods are just the opposite of the range
contraction periods. Range expansion
periods can be measured by requiring that the 10 bar ATR be some amount greater than the 50
period ATR. For example the 10 bar ATR must be 1.25 or more times the 50 period ATR.

If you are concerned about the apparent contradiction of these two theories we could easily
combine them. We could require that a period of low volatility be followed by a period of
unusually high volatility before looking for our entry.

Dip or rally setup: Lets assume that we want to buy a market only after a dip or sell it only after a
rally. We could tell our system to prepare for a buy entry whenever the price is 3 ATRs or more
lower than it was five days ago. Our setup to sell on a rally would be that we want to sell short
only when the price is 3 ATRs or more higher than it was five days ago. The choice of 3 ATRs
and five days is simply an example and isn’t necessarily a recommended choice of parameters.
You will have to figure out the proper parameters on your own depending on the unique
requirements of your particular system.

Entry Triggers:

Volatility Breakout: This theory assumes that a sudden large move in one direction indicates that
a trend in the direction of the breakout has begun. Normally the entry rule goes something like
this: Buy on a stop if the price rises 2 ATRs from yesterday’s close. Or sell short on a stop if the
price declines 2 ATRs from the previous close. The general concept here is that on a normal day
the price will only rise or fall 1 ATR or less from the previous close. Rising or falling 2 ATRs is
an unusual occurrence and indicates that something out of the ordinary has influenced the prices
to cause the breakout. The inference is that whatever caused this breakout has major importance
and a new trend is beginning.

Some volatility systems operate by measuring the breakout in points rather than units of ATR.
For example the system may require that the Yen must rise 250 points from the previous close to
signal a breakout to the upside. Systems measuring points rather than units of ATR may need
frequent reoptimization to stay in tune with current market conditions. However, breakouts
measured in units of ATR should not require reoptimization because, as we previously
explained, the ATR value contracts and expands with changing market conditions.

Change in direction trigger: Lets assume that we want to buy a dip in a rising market. We
combine the dip or rally setup described above with an entry trigger that tells us the dip or rally
may be over and the primary trend is resuming.

The series of rules might read something like this: If the close today is 2.0 ATRs greater than the
40 day moving average (this condition establishes that the long term trend is still up) and the
close today is 2 ATRs or more below the close seven days ago (this condition establishes that we
are presently in a dip within the uptrend) then buy tomorrow if the price rises 0.8 ATRs above
todays low. This entry trigger shows that we have rallied significantly from a recent low and that
the dip is probably over. As we enter the trade the prices are again moving in the direction of the
major trend.

As you can see, the ATR can be a most valuable tool for designing logical entries. In our next
article we will discuss using ATR in our exit strategies and give some interesting examples.

**********
Attention MetaStock users

We are making plans to support MetaStock and provide our systems in MetaStock format as well
as TradeStation. We will announce when this is available.
***********

I’ll be seeing many of you at the TAG conference in Las Vegas later this month. If any of you
would like to make an appointment for a consulting conference please send me a message. We
offer help in solving your systems
trading problems (system logic, not programming) on an hourly fee basis.
Respond to Chuck@traderclub.com or traderclub@aol.com

***********

Thanks to everyone for the enthusiastic messages and referrals. We receive most of our new
members from referrals by our members and we sincerely appreciate your support in making the
Club grow. Your postings in newsgroups,
mail lists, user groups, etc. are also very helpful.

We will be making some changes in the web site soon. Please visit often and send us any ideas
on how to make it better.

***********

IMPORTANT: Please keep us updated on your email address changes. If you are reading
Bulletins on the website instead of receiving them directly as they are published it means we
don’t have your current email address. When sending email updates please be sure to include the
following:
1. Your full name
2. Your old email address so we can delete it.
3. Your new email address so we can add it.
4. Information regarding the effective date of the change.

Whenever we send out a Bulletin we receive far too many mail returns. We accumulate these
returns and delete these address from our active email files. If your mailbox is full or there are
temporary problems with your server we
may delete your address because your mail is being returned as undeliverable.

You should be hearing from us about every week or two. If you don’t hear from us be sure to
check in and give us your current email address so we can confirm that you are still on our active
list. For your convenience the home
page of the website will soon have a link to a simple form to update your email address.

********

That’s all for now.

Good luck and good trading

Chuck
#14 Average True Range For
Exits
This is the fourth in a series of articles about using Average True Range. In our first article in Bulletin
#10 we explained how ATR is calculated and gave an overview of its many uses and benefits. In Bulletin
#12 we showed some specific examples of how using ATR can help to make our systems more robust. In
Bulletin #13 we showed some of our favorite applications of ATR as part of our entry logic.

In this Bulletin we will show how ATR can help us achieve more accurateexits.

ATR EXIT TARGETS: Perhaps the most valuable of all application of ATR is to use it to define profit
objectives. If we were to run some tests to define profit objective in terms of dollars we could probably
find a particular dollar amount that produced acceptable results when reviewing historical data. Just as an
example, let's assume that we run some optimizations to find the best level at which to take profits in a
particular market and we find that the best number is $1250. Although this amount may produce
acceptable results on a historical basis it is not always the best solution to the problem.

When the market is quiet and there is little volatility our profits are likely to fall well short of our $1250
objective. However when the market is volatile and trending strongly our potential profit might be much
greater than $1250. The $1250 level is simply a not so happy medium that is usually either too large a
target or too small a target.

On the other hand if we measure our profit objective in terms of ATR we have a much more robust and
logical solution. Lets assume that we run our tests again looking for units of ATR instead of dollars.
Assume our research shows us that our best profit objective is now expressed as 4 ATRs. In a normal
market 4 ATRs might be equal to $1250, the same as our dollar denominated target. However in a quiet
market 4 ATRS might only be $800. The advantage of our ATR research is that while our original $1250
target is no longer obtainable because of the quiet market conditions the ATR target has adapted to the
change in volatility and can still be achieved.

Increases in volatility produce an even more dramatic effect. Let's assume that the market is suddenly
streaking in one direction because of some important news. Our 4 ATRs is now $5,000. Wouldn’t it be a
shame if our system was taking profits of $1250 when the market is willing to give us $5,000 or more.

In addition to setting profit objectives, ATR can also be very helpful in placing trailing stops. Here are
two examples that you may recall from discussions on the FORUM page and past BULLETINS.

THE CHANDELIER EXIT: We have often advocated the importance of good exits and this is one of our
favorites. The exit stop is placed at a multiple of average true ranges from the highest high or highest
close since the entry of the trade. As the highs get higher the stop moves up but it never moves
downward.

Examples:

Exit at the highest high since entry minus 3 ATR on a stop.

Exit at the highest close since entry minus 2.5 ATR on a stop.

Application: We like the Chandelier Exit as one of our exits for trend following systems. (The name is
derived from the fact that the exit is hung downward from the ceiling of a market.)

This exit is extremely effective at letting profits run in the direction of a trend while still offering some
protection against a major reversal in trend. In fact our research has shown that this exit is so effective
that you can enter futures markets at random and if you use this exit the results over time will be
profitable. (If you don't believe us just try it.) When used for long term trend following the best values for
the ATR in most markets ranges somewhere between 2.5 and 4.0.

THE YO YO EXIT: This exit is very similar to the Chandelier Exit except that the ATR stop is always
pegged to the most recent close instead of the highest high. Since the closes move higher and lower, the
stop also moves up and down (hence the Yo Yo name). Although this stop appears similar to the
Chandelier Exit the logic is quite a bit different. The Yo Yo Exit is a classic volatility stop that is intended
to recognize an abnormal adverse price fluctuation that occurs in one day. This abnormal volatility is
often the result of a news event or some important technical reversal that is likely to signal the end of a
trend. This logic makes the YO YO exit very effective and we seldom regret being stopped out whenever
this exit is triggered.

We should caution you that the Yo Yo stop should never be our only loss protection because if the price
moves slowly against our position the Yo Yo stop also moves away each day and, in theory, the stop may
never be hit.

Combining the exits: The Yo Yo and the Chandelier exits work best when used together. The Chandelier
Exit is typically set at 3 ATRs or more from a high point and never lowered; therefore it will protect us
against any gradual reversal of trend. The Yo Yo exit is typically set at only 1.5 to 2.0 ATRs from the
most recent close and will protect our position from unusual one day spikes in volatility. When used
together the operative stop each day would be whichever of the two stops is closest.

Money Management Advice: When using any stops based on multiples of ATR we should keep in mind
that volatility can quickly expand to where our risk is greater than we intended. We do not want to
unknowingly exceed the risk limitations dictated by our money management scheme so we should also
have a "worst case" dollar based stop available or be prepared to reduce our position size quickly as the
ATR values expand. When should we reduce our position size and when should we implement our fixed
dollar stop?

If we are on the right side of the volatility expansion it may not be wise to reduce our position size just as
the trade is beginning to do what we hoped for. For this reason I prefer to implement the dollar based stop
on profitable positions rather than reducing the size of winning positions prematurely. We obviously want
to have big positions in our winners and small positions in our losers. Therefore it would make sense to
reduce our position size only if the volatility is increasing in a trade that is going against us. Once
extremely large profits have been achieved, positions can safely be reduced without sacrificing too much
in the way of potential profits.

By now we hope you have begun to appreciate the value of ATR in designing systems. There are still
more uses for ATR that we have yet to discuss (Keltner Bands for example). We hope to have additional
articles about ATR sometime in the future. In the meantime we hope this series of articles has stimulated
some creative thinking about the many uses of ATR. Lets us know if you come up with more creative
ideas on how to apply this wonderful technical tool.

**********

I’ll be seeing many of you at the TAG conference in Las Vegas this weekend.

Be sure to say hello.

***********

Thanks again to everyone for the enthusiastic messages and referrals. Most of our new members come
from referrals by members who recommend the Club to their friends and associates. We sincerely
appreciate your support in making the Club grow.

Be sure to check out the new FORUM page Dave Elden has been working on.

We have a new FORUM which we will be integrating into the website very soon. It is much more
configurable and user friendly than the one we have been using and it is something that we can grow with.
We are not deleting any of the posts from the original Forum. We are hoping to move a few selected posts
out of the old forum and into the new one and eventually develope an archive for the old posts. This will
take some time, so please continue your discussions on the new FORUM when it comes online. We thank
you for your patience while we are making these changes. We had no idea that the FORUM would be so
popular and we are trying to make positive changes to keep up with the expanding traffic.

Lets try to promote the idea of members helping members. I think we will all benefit. Don’t be afraid to
ask questions or post topics that will stimulate discussions.

***********

NEW SYSTEM: We should be announcing the availability of a very interesting new system in the next
day or two. As soon as everything is ready we will send out an e-mail and have the usual information
posted on the web site.
In the meantime please review the discussion of ADX in Bulletin #5. The new system is the result of our
research on solving the "V" pattern limitations of ADX discussed in that Bulletin. We think we have
made a technical breakthrough with this new system which solves a problem that has been nagging us for
years. We are excited and we think you will be too when you see the results of the system.

That’s all for now.

Good luck and good trading

Chuck

#15 Elaborating on Our

Multiple Systems Concept
Only a handful of members have been with us since the very beginning of the Club last February so I
thought it would be worthwhile to repeat and clarify some of our logic in suggesting that multiple systems
might be a worthwhile approach to trading.

In the past the typical approach was to simply take one systematic approach and apply it to one or more
markets. Because of the potential for major profits per trade the majority of knowledgeable traders were
naturally attracted to trend following strategies. Richard Donchian and many of the pioneers of technical
analysis were advocates of trend following and they as well as many professional trading advisors were
able to generate profitable historical results to substantiate their preference for this style of trading. The
giant inflationary trends of the 70s made these early trend followers rich and the world of technical
analysis was thoroughly convinced that trend following was obviously and conclusively the most
profitable way to trade.

In more recent times the so-called Turtle System is a good example of this basic approach. A simple but
effective trend following system applied to many different markets with highly disciplined money
management (the true secret of their success) does indeed provide a profitable equity curve over time as
the Turtles and many other professional traders have clearly demonstrated.

In the last few years the absence of inflation and the coordination of worldwide economic policies has, in
our opinion, resulted in fewer trends than in the past. As trend following profits have become less
frequent the trend followers have sought diversification by adding more global markets to their ever-
expanding portfolios.

However it takes a great deal of capital to diversify over so many different markets and long term trend
following in general is typified by frequent and very substantial drawdowns, with the Turtles and other
professionals being no exception. The frequent losses in the non-trending markets can only be offset by
catching some occasional winning trades of huge proportions. Unfortunately only extremely broad
diversification can offer a trend follower any assurance of participating in those rare markets where the
big winners are found. As a result of this increased need for market diversification the most successful of
modern traders have large staffs of employees working around the clock frantically trading markets all
over the world.

All of this effort at diversification is predicated on the assumption that we must take one system and then
find as many markets as we can to trade with it. The search for this one system that successfully trades all
markets has often been alluded to as the elusive ―Search for the Holy Grail.‖ Having tried the ―one system
trades all‖ approach for several years with limited diversification and limited success we began searching
for a better way to trade and we think we have found it. We intend to trade multiple systems in multiple
markets.

We have long been advocates of looking at markets as having three directions rather than just two. We
view markets as being up, down or sideways. To carry that logic one step further we have also observed
that the characteristics of the markets in each direction are distinctly different. Markets going up tend to
follow a generally orderly pattern that is much different from a market that is going down and the
sideways patterns are not anything at all like the up and down trends. With this perception in mind, why
should we try to trade up, down and sideways markets with the same system? To be sure, it can and has
been done. We did it ourselves with a simple ADX system but only with very limited efficiency.

Wouldn’t it make more sense to design several systems that were each very specific in their application?
For example we can easily design systems that work well in a rising market and these simple systems can
perform that limited task in a surprisingly efficient manner. We can also design these long-only systems
to include a simple on/off switch so that when the market is not rising they automatically shut down and
no longer generate trading signals. We wouldn’t want to be trading an up-only system in a down market
would we? A little bit of common sense goes a long way in this business of trading.

In a down market we would want to be trading a system that goes short and was capable of taking
advantage of our perception of what a down market usually looks like. In our experience down markets
tend to be quicker and more violent so profits need to be taken faster than those we might take in a rising
market. The old adage of letting profits run is a policy best employed in rising markets. After all, no
commodity markets ever go to zero. (However, the bearishness in commodities we have experienced for
the last year or two might have some of us wondering if zero is really out of the question in some
markets.) There is certainly no question in my mind that the upside in any tangible commodity is much
less bounded than the downside, so it makes perfect sense to let our long side profits run while taking our
short side profits much sooner.

Sideways markets on the other hand require an entirely different strategy for both entries and exits. When
a market is in a trading range there is seldom anything to be gained by letting profits run in either
direction because they will only turn into losses. Since our profits are limited by the boundaries of the
trading range, the entries need to be as precise as possible and we need a high percentage of winning
trades to make up for occasional losses that are large relative to our limited gains.
We have little doubt that there is great logic and justification for having different systems for up, down
and sideways market conditions. Over time we intend to create and employ multiple trading strategies in
multiple markets. We seek to become diversified in our systems as well as diversified in our markets.

We are now very close close to achieving our goal of creating a complete multiple system package for the
bond market. As an example of our grand scheme lets briefly look at where each of our bond systems fits
into our strategy as we trade from the beginning to the end of a complete price cycle.

Starting at the bottom of the cycle, the Phoenix system is designed to begin trading the long side while the
trend, by most definitions, is still down. If this bottom-picking system is correct and the market reverses
direction and begins trending upward as anticipated, then the ―25 X 25‖ system and the Big and Little
Dipper systems will recognize the confirmed uptrend and start buying dips of varying magnitude within
the strengthening uptrend. It is very likely that the Phoenix system will still be patiently long with a nice
profit while these other system are beginning to identify and buy various dips in the trend.

At this point we would hope to have more than one long position. In our experience, a well established
uptrend is one of the lowest risk and potentially profitable market types to be trading. These very orderly
markets present an ideal situation for carrying multiple positions. Throughout the uptrend the Little
Dipper is trading the short term price swings, the ―25 X 25‖ system and the Big Dipper are trading the
intermediate swings and the Phoenix system is patiently riding the longer term trend. Not only are we
trading multiple strategies but we are also trading the uptrend over multiple time frames.

As our price cycle moves on and the market changes its trend and goes into a broad consolidation or
perhaps shows evidence of a downtrend, the long only systems shut down and the Serendipity and
Sidewinder systems, which trade both long and short, will automatically begin selling rallies and buying
dips. These two systems take over as our dominant strategies because they were specifically designed to
profit from sideways or downtrending markets. If the bond market resumes the previous up trend the long
only systems will automatically reactivate. If the market continues downward the Serendipity and
Sidewinder systems will continuously be selling short on rallies as the market declines. Finally after a
sharp and sustained down move completes the cycle the Phoenix system will try to pick another bottom
and the cycle starts anew.

As you can see, it was not our intent to simply design six or seven systems that could make money in
bonds. The intent of our multiple system approach is to be constantly trading with only those systems that
are most appropriate for the current market conditions in bonds. Each system has its assigned mission and
each plays an important role in the grand scheme.

How well will this multiple strategy work? We can’t say with any certainty, but the idea makes sense to
us and the historical results are very promising. But the proof as always lies somewhere in the future. The
combined historical results of our bond systems can now be viewed on our web site at:

http://traderclub.com/systems_bondscombined.htm
In our next Bulletin we will discuss and give some practical advice on how to manage positions when
trading multiple systems.

#16 Managing Positions

When Using Multiple Systems
In our last Bulletin we presented our reasoning for using multiple systems in multiple markets in order to
produce more consistent profits and to generate a smoother equity curve. In this Bulletin we will address
some of the practical aspects of controlling our position sizes when employing this strategy.

When using multiple strategies/systems in one market we are inevitably faced with the question of how
many positions to trade and what to do when long and short trades appear at the same time. Many
potential problems can be reduced if the systems are designed to integrate well so that one type of system
will be turning off just as a different type of system is turning on. It is certainly not that difficult to devise
rules that will serve to eliminate most of the contradictory trading signals.

For example we can require that prices be above a specified moving average in order to initiate buy
signals and below that same moving average to generate signals to sell short. Although such a rule might
appear to avoid contradictory signals it is not foolproof. It is possible that an existing long position
initiated at prices above the specified moving average might still be in place when a new entry is signalled
in the opposite direction as a result of prices having drifted below the moving average. In this instance we
have an open long position and a new signal to sell short.

Although it is theoretically possible to have two or more accounts and hold both long and short positions
at the same time, the common solution is to simply trade the net position. Two longs and a short is a net
position of one long. A long and a short is a net position of no contracts. The large CTAs who are trading
multiple systems usually trade net positions and some of them easily operate 50 or more systems at a
time.

Another possibility with the multiple position strategy is to operate with a limited exposure in terms of the
maximum number of contracts traded at one time. For example, assume we wanted to trade all six of our
bond systems and never have more than three contracts on at one time. For starters, the design of the bond
systems makes it unlikely that we would ever have more than three positions in the same direction. But
let's assume that it does happen and we are holding three long positions and a fourth system kicks in and
says to go long again. We could choose to operate on a first come basis and simply ignore the fourth
signal. However, as the designer of these systems I believe there might be a better solution.

I would suggest trading on the basis of giving priority to the most recent signal. If we were long three
contracts and got a signal to go long again, I would switch the oldest open position and trade it as though
it were the new signal. Lets say that we are long on systems A, B, and C. Then system D gives a buy
signal. No new trade is entered and we operate the exits as though we are long in systems B, C and D.

The reason I prefer this method is because I know the effort that is put into designing the pre-entry setups
for each system. These pre-entry setups are designed to give us an accurate reading of market conditions
just as we enter each trade. These pre-entry conditions not only tell us the direction (up, down or
sideways) but often tell us the present strength of the directional trend and the best time frame to be
trading right now. By switching from the old position in system "A" into the new position in system "D",
we will gain the benefit of using system "D's exit strategy which is most likely to be in tune with current
market conditions. I like to call this process "System Updating". There is no order needed or entered with
our broker to "Update" our systems. We simply stop placing exit orders for system A and commence
placing exit orders for system D instead.

Another possibility is to limit our open positions to one long term strategy and one short term strategy so
that we can monitor all six systems without having more than two positions on at one time. If we have
one long term position on we will only enter a second position when it is a short term entry signal. All
additional long term signals are ignored or we employ the "Updating" technique described above.

As you can see, trading six systems at once does not require that we ever have six positions on at any
time. In fact the specific intent designed into the multiple bond strategies is to never have more than one
or two positions on at one time unless we are in a strong bull market where trading is easy and usually
very low risk. In that ideal market environment we want to have as many positions on as our capital and
system signals will allow. If the systems operate as designed we might have as many as four open
positions under these ideal conditions. Any more than that would be very unlikely and easily handled.

In summary, the systems themselves should take care of most of the position sizing automatically. But in
case we want to limit our exposure or use other position sizing methods there are many ways of applying
logical and creative strategies that will limit our open positions to whatever number we desire. We have
only illustrated a few of the many possibilities.

******************

Webmasters Report

Trade by trade reports for all the systems are now available in a zip file. If you want to download them
use this url: http://traderclub.com/files/tbyt.zip [21k]
This file is composed of seperate reports for each system so you can use the data on your local machine.
The reports are also available on the website, as a link on each systems description page if you would
rather browse them online.

Other Web News:

The Forum has been getting alot of attention recently and we are responding with some changes soon to
make it even easier to use. There are some new posts particularly the One System All Markets thread that
have been very interesting. In general people seem to be getting used to the new format.
In Case You Didnt Know Dept:

All of the past Bulletins are available in zip format. These are html files that contain the text of each
bulletin, You can download this file here for viewing offline : http://traderclub.com/bulletins/bulletin.zip
[59k]

as always email me with your suggestions and comments

David Elden
mailto:webmaster@traderclub.com

**************************

That’s all for now.

Good luck and good trading

#17 Measuring Exit Efficiency

Those of you who have read our book and followed our work over the years will quickly recognize that
we have long been outspoken advocates of the importance of good exits. In our opinion exits are much
more important than entries yet the majority of new traders spend most of their time seeking the ideal
entry strategy as if this would solve all of their problems.

In the System Building workshops that I teach with Dr. Tharp, we play an exit game where everyone
enters a series of trades at the same point and then implements their own exit strategy as prices are
reported to the group. After about ten quick trials of this game the results typically range from one
extreme to the other. A few traders make a lot of money, a few lose a lot of money and most fall
somewhere in between. It would be rare for any two players to have the same results. The point of this
simple exercise is to illustrate the effect of exits on our trading results. Everyone has identical entries yet
the outcome of the simulated trading always ranges from big losses to big profits.

The same is true in actual trading. Exits determine the outcome of our trading and have more impact on
the results than any other factor. Yes, exits are even more important than money management (position
sizing). Not even the best money management strategy can make a losing system into a winner but a
minor change in the exit strategy can work miracles. We quickly discovered this years ago when
attempting our first tests of indicators. We found that even a slight variation of the exit strategy used in
the testing would affect the number of trades, the size of the winners and losers, the percentage of
winners, the drawdown and the total profitability. We set out to test entries but quickly learned that in
most cases we were testing exits because the entries had little if anything to do with the results.
We eventually began isolating, as best we could, our testing of entries and exits. We now test entries
based solely on the percentage of winning trades, exiting after a specified number of bars. This method of
testing entries is based on our conclusion that the only purpose of entry timing is to get the trade started in
the right direction as accurately as possible. Everything that happens after that has nothing to do with the
entry because the outcome of the trade is now in the hands of our exit strategies. We want our entries to
accomplish only one purpose and that is to get our trades started in the right direction as quickly as
possible and this function is easy to measure. The higher the winning percentage after a few bars the
better the entry. But how do we measure the efficiency of our exits? How can we tell if one exit is better
than another? What is a good exit? What is a bad exit? Which is better: exit A or exit B?

To try and quantify the relative merit of various exits we created the Exit Efficiency Ratio and contributed
an article on this topic to Futures Magazine several years ago. (I'm trying to get this Bulletin out today
and I am sorry that I don't have the specific reference for the article in front of me. I'll find it and post it
on the FORUM page.)

For those of you using Rina/Omega's Portfolio Maximizer software you should be aware that the Exit
Efficiency Ratio that we wrote about is not the same calculation presently used in Portfolio Maximizer.
Here is our original version of the Exit Efficiency Ratio.

You need to start by keeping or creating a record of your winning trades. You must also keep a record of
the total number of bars in the trade from entry to exit. As an example, lets assume that we made a
profitable trade that lasted 12 bars from entry to exit and the trade captured $1500 of gross profit.

The next step is to go back and look at our entry point and 24 bars of data after our entry. Our theoretical
holding period is now twice the actual holding period. We then use perfect hindsight to identify the best
possible exit point within this theoretical holding period. Don't be shy, pick the absolute best tick for the
theoretical exit and compute the theoretical gross profit. In this case lets assume that somewhere in the
period we could have exited the trade with a $2500 profit at the absolute high point of the theoretical
trade.

The Exit Efficiency Ratio is then calculated by dividing the actual gross profit by the theoretical gross
profit. We divide 1500 by 2500 to arrive at an Exit Efficiency Ratio of 60%. This tells us that we actually
captured 60% of the profit that might have been possible for this trade.

The Portfolio Maximizer formula for exit efficiency measures only the efficiency during the actual
holding period. I'm sure this is for practical reasons because the trade by trade listing used for most
calculations would not include data outside the range of the holding period.

When calculating the best theoretical exit point, the doubling of the holding period is critical to evaluating
the exit fairly because most traders err on the side of exiting their profitable trades much too soon. By
extending the theoretical holding period beyond the actual exit bar we can see if this was the case. In our
example we exited the actual trade after 12 bars and lets assume that the ideal exit point was on the 20th
bar. If we only measured the bars in the actual trade our ideal exit point might have been on the 12th bar
where we closed out our trade just as we were climbing to a new peak. Measuring only the duration of the
actual trade would credit us with an exit that was 100% efficient. The tendency of any calculation based
only on the bars during the trade would be to reward us for exits prior to the peak and to penalize you for
exits after the peak that might have been more profitable than the earlier exit. By doubling the holding
period in our theoretical calculation of the ideal exit point we can easily see if we closed out any of our
trades too soon.

We typically use a combination of exit strategies and by giving each of our exits a name we can evaluate
our exits individually or as a complete exit package. Some exits (like the Yo Yo exit) score better than
others but since this can not be the only exit in a system we must evaluate the combination of exits as well
as each individual exit.

***********

IN THE WORKS

We are just now finishing up the documentation on a new system for trading the Yen. (No name yet.) We
hope to make the new system available early next week. Look for an e-mail with complete details.

***********

That's all for now. Thanks for all the kind messages via e-mail.

Please accept our sincere best wishes for a happy and healthy Holiday Season.

Good luck and good trading.

#18 Drawdown
Happy New Year from all of us at the System Traders Club. We hope you had a good holiday.

Drawdown is a topic that is seldom discussed in depth because everyone assumes that its meaning is
obvious and that they understand how it should be used in evaluating or capitalizing a trading system. Of
all the statistics used in evaluating a trading system's performance I have found that Drawdown, however
it might be defined, is a very unreliable statistic at best.

First lets look at how Drawdown is commonly calculated and expressed. This varies widely throughout
the industry and even varies within Omega products. For example in TradeStation and SuperCharts,
MaxDrawdown is calculated from a position's entry point and not from a position's peak. If we start a
trade, which at some point achieves an open profit of $1,000, and then later close it out at a loss of $500,
TradeStation and SuperCharts will record a Drawdown of only $500. However, Omega's Portfolio
Maximizer would look at the same data and record a Drawdown of $1,500 which is more in line with
general industry practice and is the method by which the CFTC and NFA require Commodity Trading
Advisors and Pool Operators to calculate Drawdown.

At first glance one might assume that the CFTC/NFA calculation is fairer, or at least more conservative,
but that isn't necessarily the case because the regulators require that drawdown be expressed in percentage
numbers rather than in dollars. Ask a CTA for their maximum drawdown and you will receive an answer
like "35%" not XXX dollars. This makes the size of the drawdown as much dependent on the size of the
account at its peak as it is on the size of the decline in equity. A $10,000 drawdown from an equity peak
of $100,000 is 10% and the same $10,000 drawdown from an equity peak of $200,000 would be only 5%.
Using this formula it would also mean that a trader who never had a loss would still report a drawdown
because the giveback of open profits is included as "Drawdown". Omega's Portfolio Maximizer uses this
method to calculate Drawdown and it differs substantially from the way that TradeStation and
SuperCharts calculate Drawdown.

Even if we assume that we understand which specific Drawdown calculation we are looking at and know
how it was calculated, the meaning and application of this statistic are still very suspect. Let's use the
trade by trade report of three systems as an example.

System "A" begins trading and has the following closed out trades (we only need a very small sample to
illustrate our point):

Loss of $500
Loss of $250
Gain of $2,000
Loss of $500
Gain of $2,500
Gain of $1,000

Using the TradeStation formula this system would have a MaxDrawdown of $750. Keep in mind that if
the first trade started out as a $1500 open profit at some point before it was closed out at a $500 loss, the
Portfolio Maximizer formula would have recorded the drawdown on this trade as $2,000 not $500.
However, lets keep our examples as simple as possible and record the MaxDrawdown for system "A" as
$750 (the results of the first two losses, $500 plus $250) as it would show in TradeStation.

Now lets look at the trades for system "B":

Loss of $500
Gain of $2,000
Gain of $2,500
Loss of $500
Gain of $1,000
Loss of $250

Using the TradeStation formula this system would have a MaxDrawdown of $500.

As our final example, lets look at system "C":

Gain of $1,000
Gain of $2,500
Gain of $2,000
Loss of $500
Loss of $500
Loss of $250

Using the TradeStation formula this system would have a MaxDrawdown of $1250.

All three systems made $4,250 and had 50% winning trades. The size of the average winners and losers
was identical, as was the Profit Factor (Gross Profits of $5500 divided by Gross Losses of $1250).
However, the MaxDrawdown, Account Size Required and Return on Account would all vary
substantially.

Which system is best? Which system has the best risk to reward ratio? How should each system be
capitalized? Which system is most likely to have the smallest drawdown in the future? In our opinion A,
B, and C are all the same system and there is no way to differentiate between them.

Our sample of trades is purposely small but it wouldn't matter much if it were 300 trades instead of only
six. In our opinion the sequence of trades in the future will be random and the only valid way to estimate
possible drawdowns would be to scramble a large sample of trades and redistribute them randomly. The
result might then be expressed as something like this: "Based on a starting capital of $100,000 there is a
28% probability of a drawdown of 50% given 10,000 trials." This drawdown study would require a
program that would accept the trade by trade output and then perform a "Monte Carlo" simulation that
would redistribute the trades in a different sequence over many trials. Even then our real time experience
with drawdowns will be impossible to quantify with any accuracy. The best we can do is to find a range
of probabilities and hope that our actual experience falls somewhere within that range.

We know of at least one program that was developed to do this type of drawdown simulation. It is not
currently offered for sale but if we can persuade the developer to offer it to our members at a reasonable
price we will make it available. There may be other programs that can do this simulation as part of a
bigger package but they are generally quite a bit more expensive than the specific software we have in
mind.

When building our trading systems we assume that our members would prefer systems that have
relatively small historical drawdowns. However we believe that the percentage of winning trades and the
size of the winners vs. losers are a much better indication of what to expect in the future than the
historical Drawdown statistics viewed out of context. This is one of the reasons you will find that our
systems generally emphasize a high winning percentage. In our experience a high winning percentage is
the factor that most helps us to control drawdowns.

To summarize, we can not afford to ignore data related to Drawdowns, but we must be very careful how
much we rely on this information. As we have attempted to illustrate in this Bulletin, historical
Drawdown data tells us very little about what to expect in the future. We suggest that when you look at
this data you consider it for the limited value it might have; but don't ever count on it. Of all the
performance data we might review, Drawdown and the data calculated from it (Account Size and Return
on Account) appear to be the least reliable.

**************************************************

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Webmasters Report

We are continuing to improve and upgrade our website in order to make it better and easier to use. There
are several new projects underway that we hope to have completed in the near future. One is a self
moderating classifieds section. This will allow you to post your own classified advertising and will
require no intervention by us, and will be incorporated into the Forum as a topic area. There are other
changes coming to the forum as well and as soon as they are up and running we will make a general
announcement and let you know about it.

We have streamlined our join process, so that all a new visitor to the site needs to do is enter their email
address into a form and they are registered as a member. If you know of anyone who would benefit from
the website please feel free to introduce them to us by forwarding them this bulletin or sending they our
url.

We have added complete System Results Reports to all systems that trade Long and Short. Previously we
only had the combined results reporting on the systems pages. Also you will find a link on each system
page to the complete Trade by Trade Report for the System.

As always please feel free to email me with comments, suggestions, or questions regarding the website
David Elden
webmaster@traderclub.com

#19 Indicators are Not Systems

In addition to participating in the discussions on our own FORUM page, we spend a great deal of time
monitoring various newsgroups and web sites that deal with trading and technical analysis. One of the
popular topics of course is the relative value of various technical indicators. For example someone might
ask: "Which is better, MACD or Bollinger Bands?" Or simply: "Which is more profitable: ADX or CCI?"

The implication of these questions is that indicators are being confused with trading systems. We think it
is important to understand that technical indicators are best thought of as being merely small parts of a
system and not systems in and of themselves. A typical comment like: "I tried Indicator X and found it
was worthless." makes no sense at all. Or, "I tried ADX and found that it was excellent." These
statements imply that an indicator was tested as though it were a system.

In our eyes there are no good or bad indicators. Indicators are best thought of as tools for solving specific
trading related problems. One indicator may be an excellent way to solve one particular problem and the
same indicator can be of no value in solving a different problem. The value of any indicator depends on
its application. As system developers we must avoid sweeping judgmental evaluations that might
conclude that indicator A is better than indicator B. Our task is to learn which indicators can best solve
particular problems and make certain that we apply whatever indicator is appropriate for the task at hand.

Every indicator has its strengths and weaknesses depending on how it is applied. For example we have
found that moving averages are poor entry triggers but excellent directional indicators. The fact that the
five-day moving average is above the twenty day moving average may be a reliable indication that the
trend is up but it doesn't mean that we want to buy immediately. On the other hand an upward range
expansion might be an excellent entry trigger but have no value in telling us the direction of the
underlying trend. If we combine these indicators so that we go long in a market where the five-day
moving average is above the twenty-day moving average immediately upon an upward range expansion,
then we are getting into the construction of a viable system. However if we bought or sold every range
expansion or 5/20 moving average crossover we would quickly conclude that these indicators had no
value.

David Lucas and I are presently working on a second edition of our book, Computer Analysis of the
Futures Market. Perhaps our original book contributed to some of the misunderstanding about indicators.
As you may recall, in our first edition we tested many popular technical indicators as entry triggers and
concluded that almost all of them were useless for this task. At that time most technicians approached
technical indicators as though the only purpose for an indicator was to be a stand-alone entry trigger.
After many years of continuous analysis and research we have learned that indicators have many different
applications and that they should not be judged or compared solely on their value as entry timing
techniques.
We have learned that indicators should be viewed as tools and not systems but we also need to understand
something basic about using tools. If we tried to hammer a nail with a saw we might discard the saw as a
useless tool. If we tried to cut a board with a hammer we might conclude that a hammer was a useless
tool. Once this is understood our task is to learn which trading tools can be used to solve which trading
problems and quit trying to find, buy or invent the best possible indicator. The "best" indicator is simply
the one that solves the immediate trading problem at hand and that problem rarely requires another entry
trigger. Instead of looking at indicators as entry triggers we must give more thought to using indicators as
setups that define market conditions prior to entry and to using indicators that can help us improve our
exits. In our opinion the world of technical analysis already has more indicators than we know how to use
and the recent proliferation of indicators without a purpose merely add to the confusion. I would suggest
that anyone planning to introduce a new indicator should clearly state its intended purpose and application
and show some test results that indicate is possible effectiveness at the assigned task.

In terms of need and practical value I would most like to see an indicator that would help in selecting
which markets are most likely to trend strongly in the next few months. I suspect that there might be some
merit in an indicator that measures and incorporates both volatility and directional movement. If there are
any mathematicians among our members that would like to have a crack at developing such an indicator
please keep me advised of your progress.

In the weeks to come we will try to share some insight on which indicators we think work best on specific
problems that we typically encounter when building a trading system. Our knowledgeable members can
also help. If you have found any indicators that work well on particular problems please share some of
your knowledge with us privately by e-mail or publicly on our Forum page. Here are just a fewexamples
of what would be helpful: We are looking for setups that indicate sideways markets. We are looking for
setups that are predictive of increasing volatility. We are looking for exit setups that tell us when to
tighten our exit stops. We are looking for an indicator that might be helpful on telling us how soon to
implement a break-even stop. We are looking for short-term patterns that are good entry or exit triggers.

Or perhaps you have isolated a problem that we have failed to mention and have an indicator that solves
that problem. In a nutshell, what we are looking for is a matching of indicators with the problems that
they can solve. We don't want to hear that the X indicator is a great indicator or that the X Indicator is
better than the Y Indicator. Let's start sharing information about indicators on a very task specific basis
and we will all become better traders.

That's all, Good Luck and Good Trading

Chuck LeBeau
#20 Aiming for the Right
Target in Trading
I thought the following article by Walter Downs was worth passing along to all our members. Hope you
enjoy it as much as I did.

Chuck

Aiming for the Right Target in Trading

By
Walter T. Downs

When trading goes right, it can be a great feeling. When trading goes wrong it can be a nightmare.
Fortunes are made in a matter of weeks and lost in a matter of minutes. This pattern repeats itself as each
new generation of traders hit the market. They hurl themselves out of the night like insane insects against
some sort of karmic bug-light; all thought and all existence extinguished in one final cosmic "zzzzzzt".
Obviously, for a trader to be successful he must acknowledge this pattern and then break it. This can be
accomplished by asking the right questions and finding the correct answers by rational observation and
logical conclusion.

This article will attempt to address one question:

"What is the difference between a winning trader and a losing trader?"

What follows are eleven observations and conclusions that I use in my own trading to help keep me on
the right track. You can put these ideas into table form, and use them as a template to determine the
probability of a trader being successful.

OBSERVATION # 1

The greatest number of losing traders is found in the short-term and intraday ranks. This has less to do
with the time frame and more to do with the fact that many of these traders lack proper preparation and a
well thought-out game plan. By trading in the time frame most unforgiving of even minute error and most
vulnerable to floor manipulation and general costs of trading, losses due to lack of knowledge and lack of
preparedness are exponential. These traders are often undercapitalized as well. Winning traders often
trade in mid-term to long-term time frames. Often they carry greater initial levels of equity as well.
CONCLUSION:

Trading in mid-term and long-term time frames offers greater probability of success from a statistical
point of view. The same can be said for level of capitalization. The greater the initial equity, the greater
the probability of survival.

OBSERVATION # 2

Losing traders often use complex systems or methodologies or rely entirely on outside recommendations
from gurus or black boxes. Winning traders often use very simple techniques. Invariably they use either a
highly modified version of an existing technique or else they have invented their own.

CONCLUSION:

This seems to fit in with the mistaken belief that "complex" is synonymous with "better". Such is not
necessarily the case. Logically one could argue that simplistic market approaches tend to be more
practical and less prone to false interpretation. In truth, even the terms "simple" or "complex" have no
relevance. All that really matters is what makes money and what doesn't. From the observations, we
might also conclude that maintaining a major stake in the trading process via our own thoughts and
analyses is important to being successful as a trader. This may also explain why a trader who possesses no
other qualities than patience and persistence often outperforms those with advanced education, superior
intellect or even true genius.

OBSERVATION # 3

Losing traders often rely heavily on computer-generated systems and indicators. They do not take the
time to study the mathematical construction of such tools nor do they consider variable usage other than
the most popular interpretation. Winning traders often take advantage of the use of computers because of
their speed in analyzing large amounts of data and many markets. However, they also tend to be
accomplished chartists who are quite happy to sit down with a paper chart, a pencil, protractor and
calculator. Very often you will find that they have taken the time to learn the actual mathematical
construction of averages and oscillators and can construct them manually if need be. They have taken the
time to understand the mechanics of market machinery right down to the last nut and bolt.

CONCLUSION:

If you want to be successful at anything, you need to have a strong understanding of the tools involved.
Using a hammer to drive a nut in to a threaded hole might work, but it isn't pretty or practical.

OBSERVATION # 4

Losing traders spend a great deal of time forecasting where the market will be tomorrow. Winning traders
spend most of their time thinking about how traders will react to what the market is doing now, and they
plan their strategy accordingly.
CONCLUSION:

Success of a trade is much more likely to occur if a trader can predict what type of crowd reaction a
particular market event will incur. Being able to respond to irrational buying or selling with a rational and
well thought out plan of attack will always increase your probability of success. It can also be concluded
that being a successful trader is easier than being a successful analyst since analysts must in effect
forecast ultimate outcome and project ultimate profit. If one were to ask a successful trader where he
thought a particular market was going to be tomorrow, the most likely response would be a shrug of the
shoulders and a simple comment that he would follow the market wherever it wanted to go. By the time
we have reached the end of our observations and conclusions, what may have seemed like a rather inane
response may be reconsidered as a very prescient view of the market.

OBSERVATION # 5

Losing traders focus on winning trades and high percentages of winners. Winning traders focus on losing
trades, solid returns and good risk to reward ratios.

CONCLUSION:

The observation implies that it is much more important to focus on overall risk versus overall profit,
rather than "wins" or "losses". The successful trader focuses on possible money gained versus possible
money lost, and cares little about the mental highs and lows associated with being "right" or "wrong".

OBSERVATION # 6

Losing traders often fail to acknowledge and control their emotive processes during a trade. Winning
traders acknowledge their emotions and then examine the market. If the state of the market has not
changed, the emotion is ignored. If the state of the market has changed, the emotion has relevance and the
trade is exited.

CONCLUSION:

If a trader enters or exits a trade based purely on emotion then his market approach is neither practical nor
rational. Strangely, much damage can also be done if the trader ignores his emotions. In extreme cases
this can cause physical illness due to psychological stress. In addition, valuable subconscious trading
skills that the trader possesses but has no conscious awareness of may be lost. It is best to acknowledge
each emotion as it is experienced and to view the market at these points to see if the original reasons we
took the trade are still present. Further proof that this conclusion may have validity can be seen in even
highly systematic traders exiting a trade for no apparent reason, and pegging a profitable move almost to
the tick. Commonly, this is referred to as being "lucky" or being "in the zone".

OBSERVATION # 7
Losing traders care a great deal about being right. They love the adrenaline and endorphin rushes that
trading can produce. They must be in touch with the markets almost twenty-four hours a day. A friend of
mine once joked that a new trader won't enter a room unless there is a quote machine in it. Winning
traders recognize the emotions but do not let it become a governing factor in the trading process. They
may go days without looking at a quote screen. To them, trading is a business. They don't care about
being right. They focus on what makes money and what doesn't. They enjoy the intellectual challenge of
finding the best odds in the game. If those odds aren't present they don't play.

CONCLUSION:

It is important to stay in synch with the markets, but it is also important to have a life outside of trading. It
is a rare individual who can do anything to excess without suffering some form of psychological or
physical degradation. Successful traders keep active enough to stay sharp but also realize that it is a
business not an addiction.

OBSERVATION # 8

When a losing trader has a bad trade he goes out and buys a new book or system, and then he starts over
again from scratch. When winning traders have a bad trade they spend time figuring out what happened
and then they adjust their current methodology to account for this possibility next time. They do not
switch to new systems or methodologies lightly, and only do so when the market has made it very clear
that the old approach is no longer valid. In fact, the best traders often use methodologies that are endemic
to basic market structure and will therefore always be a part of the markets they trade. Thus the possibility
of the market changing form to the extent that the approach becomes useless, is very small.

CONCLUSION:

The most successful traders have a methodology or system that they use in a very consistent manner.
Often, this revolves around one or two techniques and market approaches that have proven profitable for
them in the past. Even a bad plan that is used consistently will fair better than jumping from system to
system. This observation implies that stylistic foundations of a trader's market approach must be in place
before consistent profitability can occur.

OBSERVATION # 9

Losing traders focus on "big-name" traders who made a killing, and they try to emulate the trader's
technique. Winning traders monitor new techniques that come on the trading scene, but remain unaffected
unless some part of that technique is valuable to them within the framework of their current market
approach. They often spend much more time looking at how the market seeks and destroys other traders
or how traders destroy themselves. They then trade with the market or against other traders as these
situations arise.

CONCLUSION:
Once again, we can note that the individuality of a trader and his comfort level and knowledge regarding
his system are far more important than the latest doodad or Market guru.

OBSERVATION #10

Losing traders often fail to include many factors in the overall trading process that affects the probabilities
of overall profit. Winning traders understand that winning in the markets means "cash flow". More cash
must come in than goes out, and anything that effects this should be considered. Thus a winning trader is
just as thrilled with a new way to reduce his data-feed costs or commissions as he is with a new trading
system.

CONCLUSION:

ANYTHING that affects bottom line profitability should be considered as a viable area of study to
improve performance.

OBSERVATION #11

Losing traders often take themselves quite seriously and seldom find humor in market analysis or the
trading environment. Successful traders are often the funniest and most imaginative people you will ever
meet. They take joy in trading and are the first to laugh or relate a funny story. They take trading
seriously, but they are always the first to laugh at themselves.

CONCLUSION:

Its no wonder that one of the first things psychiatrists test for when treating a patient is whether or not the
patient has any sense of humor about his affliction. The more serious the tone of the individual, the more
likely that insanity has set in.

SUMMARY OF CONCLUSIONS AND OBSERVATIONS

Both winning and losing traders consider trading a game. However, winning traders take the game not as
a diversion but as a vocation which they practice with an intensity and dedication that rivals the work
ethic of a professional athlete. Since the athletic metaphor seems appropriate, I will sum up on that note.

If trading were a game like basketball perhaps novice traders would realize more readily that what
appears as effortless ease of the professional trader in sinking three-point shots is in fact the product of
endless hours spent shooting hoops in deserted back yards and empty playgrounds.

As in sports, the governing factors are internal and external. We deal with the market and ourselves. Both
are like weapons and they can be used proactively or destructively. Each and every trade should be taken
with professional care and planning
In order to bring these observations home in an even more compelling form, lets add an element of
ultimate risk to life and limb and say that our "sport" is more like target practice with a handgun. While it
is certainly important to hit the target, it is more important to make sure the gun isn't pointed directly at
ourselves when we pull the trigger.

Minute differences in how we take aim in the markets can have amazing impact on the final outcome. The
difference is clear: One method is accurate target practice. The other is Russian Roulette.

#21 Systems – Buy

Them or Build Them?
SYSTEMS - BUY THEM OR BUILD THEM?

Since we offer systems for sale one might assume that we would suggest
that systems should be purchased rather than built from scratch.
Actually we are very strong advocates of building your own system if you
are capable of doing so.

One of the reasons that we make this recommendation is that we believe

it is important that trading systems should fit the needs and
preferences of the user. A system may appear to have excellent
performance data but another trader may consider one trader's favorite
system as completely worthless. It seems that everyone has a different
level of comfort when it comes to following a particular system and the
comfort level increases dramatically if you are personally involved in
the planning and research that produces the system.

In addition to comfort levels and other psychological issues,

preferences for systems may vary because the resources of traders will
vary. For example some traders have very large amounts of capital to
work with while other may have much smaller amounts to put at risk. Due
to differences in capital or risk tolerances these traders may require
different systems. In addition to the amount of capital available there
are other resources that may influence the choice of systems. Some
traders have many hours a day available and want to trade for a living
while others have very demanding occupations and limited time to devote
to trading. Many systems traders have extensive experience with
computers and a great deal of knowledge about programming. But on the
other hand, many of us will have little knowledge and experience in this
technical field. Some systems traders have many years of actual trading
experience and others are admitted novices. Some traders have access to
the newest and most expensive hardware and prefer to receive real time
price data while many traders will find they can trade well using less
sophisticated equipment and simple end of day data.

We could continue with additional examples of important differences

among traders that might influence their preference in trading systems
but the point has been made. The advantages of building your own
trading system might be compared to the advantages of owning a tailor
made suit as opposed to buying one off the rack. If you build your own
system you can tailor it to your exact specifications so it fits your
preferences and resources.

However, just as most of us would not consider making our own clothing,
designing and testing a trading system is a task that may not be
appropriate or realistic for everyone. Assuming that you have the
necessary knowledge and resources to create your own system there are
still many obstacles to overcome. For one thing there is the
frustration of investing in equipment, software and data only to find
that most of our best ideas don't work. It would not be an exaggeration
to reveal that ninety nine percent of our research winds up in the
wastebasket. Also keep in mind the value of your time because until a
system is completed you will be working hundreds of hours for less than
minimum wages. There are no shortcuts so you had better enjoy the
entire process.

However the benefits of building the system yourself can be substantial

and we think the benefits are worth the effort. You will know and
understand the logic behind each step in the system. The knowledge
gained in the testing process should give you confidence in the system
so that you will have the necessary discipline to follow the system
correctly when it comes time to start trading it with real money. The
testing process should also give you a "feel" for the system that will
help you to sense when it is not performing as intended. If necessary
you will also have the ability to fine tune the system based on your
real time experience. We believe that over the long run the discipline
and confidence of the system operator have a great deal to with
determining the ultimate success of any system. By creating the system
yourself you are most likely to trust it and operate it correctly.

We suggest that you should seriously consider building your own systems
if you can satisfy most of the following criteria:
1. You enjoy challenges and have a knowledge of the commitment required
to excel at anything. If you have been an outstanding success at any
endeavor then you already understand commitment. In particular we
believe that success at competitive games like bridge, chess,
backgammon, poker and other pastimes requiring discipline, patience and
strategy would be a good indication that you can build a good system and
operate it successfully.

2. You own or are prepared to purchase a testing platform (like

TradeStation or something similar) and will spend the time required to
learn how to operate it.

3. You understand how to program the software you will be using or you
are willing to pay a professional programmer to assist you. If you do
not have a programming background you will find that there is nothing
easy about Omega's so-called Easy Language. If you have no programming
experience and decide to hire a programmer you should study enough about
the programming to enable you to communicate with your programmer. As a
minimum you need to be able to express your ideas in "if / then"
statements.

4. You need to have studied some basics on testing procedures and know
how to analyze and evaluate the test results. Some training in
statistical analysis would be very helpful.

5. You will need a source of clean historical data and the software to
convert the data to the format that will be used in testing. For
example you may want to convert the data to continuos back-adjusted
contracts. There are other popular formats for historical data and you
should know which format is appropriate for the testing and type of
system you will be creating.

6. You have spent some time clearly defining exactly what you want from
your system. You need to list and prioritize these desired
characteristics because they will guide your research.

7. You must have an abundance of time and patience. Picture yourself as

Thomas Edison setting out to invent the light bulb. Will you have the
commitment and patience to keep trying one element after another to find
the one that works? (As an example, we have been working on S&P trading
systems for years and we have yet to come up with one that we would be
willing to trade. We are still trying.)
8. Can you be truthful with yourself and analyze your test results
without letting your natural optimism cloud your judgment. (However, if
you are not an optimist you are automatically disqualified.)

If you feel that you satisfy most of the criteria listed above you can
be confident that you are capable of building your own system. However,
if you have any second thoughts about your qualifications and your
enjoyment of the process of building a system, you might consider buying
one of ours. At $250 each they may seem like a bargain.

************************************************************************

#22 Take Control

In my mind, control is an important issue that has a great deal to do with
understanding the process of trading and doing it successfully. There many
parts of the trading process where exercising control is relatively easy and
other parts of the process where control is much more difficult. For
example, the entry into a trade is a point where we are very much in
control. We set the conditions and the market must meet our conditions or
we will simply refuse to participate. This is clearly the point in the
trading process where we can exercise maximum control.

I can recall attending some lectures many years ago by George Lane (of
stochastic indicator fame) when he revealed to the audience a list of items
that he wanted to see before he entered a trade. His pre-entry checklist
had twenty-seven conditions on it. Being a skeptic of complex trading
strategies I don't recall what any of these twenty seven items were except
I'm sure at least one of them was the stochastic indicator. At the point of
carefully reviewing his checklist George was very much in control of the
situation and if the market didn't do exactly what he wanted he didn't
trade.

As I often point out in my lectures, entries are the easy part of trading.
This is because each of us has maximum control at this point. We can
exercise as much or as little control as we like. George Lane can require
every one of his twenty-seven criteria and I can require my usual two setups
and a trigger condition. However the control situation changes drastically
once we enter the trade. Our ability to control all the elements of the
trade now becomes much more difficult and far from absolute. Once we enter
a futures trade we know that we must exit that trade within a limited period
of time or we are going to be in trouble because the contract will expire.
Even stock traders who don't need to be concerned about expiring contracts
must exit their positions correctly if they wish to maximize their profits.

Exits are much more difficult than entries because we can not simply reverse
the entry process and require that the market do thus and such. Once we are
in the trade George Lane and I can both throw our lists out the window
because we can no longer dictate our terms to the market. The market is now
in control and we must be prepared to react to whatever the market does.
The market can do anything it wants once we have entered our trade and we
can be assured that the market doesn't care what conditions might be on our
list or what our preferences might be. Once we enter the trade we are at
the mercy of the market the market operates according to its own list and
that list of possibilities is much larger than George Lane's meager list of
twenty-seven items. The market's options are limitless. It can do anything
it wants whenever it wants and somehow we must be prepared to deal with it.
Where is our control now?

As we hold our trade we must be prepared for big moves against us and big
moves in our favor. (Surprisingly the big moves against us are much easier
to deal with than the moves in our favor. We will talk more about this in
just a minute.) Among the market's limitless possibilities are gaps,
reversals, limit moves, whipsaws, and perhaps worst of all, boring sideways
action that makes us wish we were trading something else. The market may
present us with inside days, outside days, reversal days, key reversal days,
high volume days, low volume days, expanding ranges, contracting ranges,
acceleration, and deceleration. We can be faced with days that are so big
that the chart looks like a propeller on the end of a stick or days that are
so small they just look like dots.

Because we have to be prepared for all this and more, it should be no wonder
that our exit strategies are often much more complex than our entry
strategies. We need to have solutions ready for any problem the market
might send our way. As I mentioned earlier, the losses are rarely the
problem because we can control those by simply setting a loss point and
closing out the trade if the loss point is hit. Here again we are facing an
issue of control and it is comforting to know that we do have a great deal
of control over our losses. If we want to design a system where the average
loss is $487.50 it wouldn't be difficult. We can absolutely control the
size of our losses and we must be certain that we do.

All of our exit strategies have to be carefully planned to be certain that

we control what can be controlled. First we must recognize and understand
what can be controlled and then we must make certain that we exercise
whatever control we have. It may be comforting to know that we can strictly
control losses but it is extremely discomforting to realize that we have
very little control of our profits. If we have a $500 profit, how do we
make it become a $1000 profit? Unfortunately holding on to the trade longer
gives us no assurance that we will eventually have a $1,000 profit.

In this instance we have very little control but let's see what we can do
with the control that we do have. Although the amount of profits can not be
controlled in the sense of our somehow forcing them to be larger, they can
be controlled in the sense that we don't have to let them become smaller or
turn into losses. Those of you who have purchased any of our systems will
appreciate that locking in open profits at various levels is important to
the success of our trading strategies. You will notice that in the "25 X
25" Bond System (free on the web site) we use a very tight channel to help
lock in profits after twenty-five days or after five Average True Ranges of
profit. We can't control the market and force it to give us five ATRs of
profit, but if it does we can make sure that we keep most of it. Protecting
our open profits is definitely within our control.

When conceptualizing a new trading system and when going through the design
and testing routine, be alert to issues of control. Look for what you can
control and make sure that you are controlling it to your benefit. Look at
what you can not control and as a minimum have some plan that will minimize
any possible damage. Thinking about control will make you a better trader
and implementing control will make your systems trade better.

We have received numerous requests for a summary of the 1998 System

Performance data. Here it is. We apologize for the delay.

Summary of trades closed out in 1998 (Cumulative data is since 1988. $100
per trade deducted for slippage and commissions)

HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN INHERENT

LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO
NOT
REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT ACTUALLY BEEN
EXECUTED, THE RESULTS MAY HAVE UNDER-OR-OVER COMPENSATED FOR THE
IMPACT, IF
ANY, OF CERTAIN MARKET FACTORS SUCH AS LACK OF LIQUIDITY. SIMULATED
TRADING
PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED
WITH
THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT
WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. PAST
PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Bond 25 X 25 Gained$3,725.00
Bond Big Dipper Gained$4,800.00
Bond Little Dipper Gained$6,060.00
Bond Serendipity Gained$937.50
Bond Sidewinder Lost($1,387.50)
Bond Phoenix Gained$17,818.75

Combined Bond Systems $31,953.75

7 - 11 YenGained $2,825.00
First Sword YenGained $17,000.00
Combined Yen Systems $19,825.00

Wildcat Crude OilLost ($1,110.00)

All Systems Combined $50,658.75

Want more details? The 1998 trade by trade results for all of the systems
have been posted on the web site.

Got to http://traderclub.com/systems.htm

You can download the trade by trade reports for all of our systems in text
format.

Go to http://traderclub.com/files/tbyt.exe

We are also in the process of updating our cumulative performance data on

the SYSTEMS pages so that it will reflect data through 1998.

C0MING ATTRACTIONS

We are hard at work finishing the final documentation on a new S&P trading
system. You should be receiving an announcement about the new system in the
next few days.

Good luck and good trading.

#23 Long Trades vs.
Short Trades
Perhaps because we offer several long-only systems we have often been asked if there is a difference in
trading the long side of a market vs. trading the short side. I think most experienced futures traders would
quickly agree that there are inherent differences between trading long versus trading short. These
differences might be well worth considering when developing the logic for a trading system. Listed below
are just a few of the many differences that I have observed over many years of trading. Please keep in
mind that these differences are simply my personal observations and not the result of any academic study.

1. Uptrends generally tend to be longer in duration than downtrends. Specifically, many technicians have
observed that a typical uptrend seems to last about twice as long as a typical downtrend. We can only
theorize about logical explanations of why this might be the case. Perhaps the most significant reason for
the persistence of uptrends is that on a long-term historical basis we have been doing the majority of our
trading in an inflationary environment. It is true that the rate of inflation has been reduced over recent
years thanks to Federal Reserve monetary policies that presume that any inflation is bad but, in spite of
the Fed.'s best efforts, inflation still persists. The debate, if any, is merely over the current rate. Even
though we now have less inflation rather than more inflation, over any extended period of time it would
be a safe bet that prices are likely to be higher rather than lower. There will always be occasional periods
of declining prices but the lows will probably be getting steadily higher over the long run.

2. Uptrends generally tend to be more orderly and less volatile than downtrends. We would surmise that
this orderliness is because traders are typically more comfortable and optimistic when trading the long
side of a market. The public's preference for the long side isn't as illogical as it may seem at first glance.
After all, the price of a physical commodity can rise almost infinitely while the price on the down side is
obviously limited at something above zero. I can remember stories many years ago about the onion
futures market where prices actually appeared to be going to zero. Eventually someone figured out that
the price was so cheap that they could take delivery of the onions and then throw them away in order to
sell the empty bags at a profit. Short side profits in the physical commodity markets are definitely limited
even though they may be very substantial at times. However, because the profits on the long side appear
to have unlimited potential, long-side traders are more likely than short-side traders to employ pyramiding
strategies that use open profits to fund more buying. Contrary to what most of us were taught in
Economics 101; rising prices serve to increase demand and perpetuate the existing uptrend. On the other
hand, because short side profits are limited, pyramiding as prices decline would be less attractive.

3. Uptrends tend to end in spikes with high volatility while downtrends tend to end in flat areas with low
volatility. Because there is no limit to how far prices can become extended on the upside and the
previously mentioned pyramided positions can become very large, there are likely to be huge long
liquidations once prices have peaked. On the downside positions are seldom pyramided and the taking of
limited profits is done more steadily throughout the decline. As a result there are rarely huge positions
remaining to be liquidated as the market reaches bottom. Bull markets tend to attract traders and the
liquidity increases as the prices rise. On the down side the low prices and lack of volatility tend to make
traders look for rising markets with more opportunity and more liquidity.

Keep in mind that these are very general observations relating specifically to physical (non-financial)
futures markets and the same logic does not necessarily apply to securities or financial markets. For
example if you go long in Yen futures you are also short dollars and if you go long in Eurodollar interest
rates you know that if they go up to 100 it means that interest rates are at zero. However many financial
markets, like the stock indexes, do have an obvious upside bias.

Once we have a general idea of some of the basic difference between rising and falling markets we need
to use that knowledge to improve the design of our trading systems. Here are a few of the
accommodations to market direction that purchasers of our systems may have observed.

1. We sometimes design systems that trade only from the long side. Because we are using a multiple
systems approach we don't need every system to trade in both directions. The long side is usually easier
and more profitable. In fact, who says the short side is necessary at all? As long as our long-only system
stays out of trouble when prices are declining (easily done) we can wait for the uptrends. There are plenty
of markets to trade; why not trade the easy ones.
2. When designing a system that trades in both directions we sometimes make our long-side entries easier
to trigger which results in more long trades than shorts. We are intentionally building in a long side bias.
Many traders will not agree with this built-in bias but we think it makes sense because we have many
good reasons to prefer the long side.
3. When designing exit strategies in a system that trades in both directions we often let profits run further
on the long side. Since we expect the short side profits to be limited we are quicker to take a profit once
our short position has adequately rewarded us for the risk we took. On the long side we prefer to try and
let the profits run. Systems do not have to be symmetrical (same parameters long and short) and it can be
logical to have different rules and parameters for the short side.
4. There may be price levels where it does not make sense to go short. For example, sugar has traded as
high as 63 cents per pound and as low as about 1.5 cents per pound. Would we really want to go short at 2
cents per pound? The risk is obviously much greater than the potential reward. Minimum price levels for
shorting can easily be built into any system.

In addition to the technical observations we have passed along there are also fundamental
(supply/demand) considerations that influence the trading characteristics of longs and shorts. Perhaps we
will discuss these fundamental issues in another Bulletin.

In summary we think there is a good case for treating the long side of markets differently than the short
side. Entries and exits do not have to be symmetrical and we do not have to trade both long and short. I
obviously favor the long side but I know traders who specialize in trading only the short side because they
believe the moves on the downside produced quicker profits. Although these traders disagree on which
side is best, they agree that the characteristics are different. We would be interested in hearing your views
and observations about trading long and short. Post your comments right here in the Forum.

Good Luck and good Trading

#24 Benefits of Systems with High

Winning Percentages
If you have reviewed the systems that we offer for sale you will find that these systems tend to have a
high percentage of winning trades. This is no accident. Although it is not essential for a system to have a
high winning percentage in order to make money, there are many advantages for those systems where the
frequency of profitable trades exceeds the losers. Here are a few of our observations on this important
subject.

1. Systems with a high winning percentage are much more rewarding psychologically. No one enjoys
losing. Everyone enjoys winning. Systems that encounter frequent losers and rely on occasional big
winners to make money are not enjoyable to trade. Unfortunately the moral of the trader is not a
performance measurement that typically appears on a historical performance summary but perhaps it
should be. Strings of losses are demoralizing regardless of your attitude or experience. Strings of profits
are always fun and build confidence and self-esteem as well as building your bankroll.

We often hear about excellent systems that are abandoned by their operators in spite of a long-term record
of profitability. These tend to be trend following type systems with a low winning percentage. It would
take the faith and patience of Gandhi to trade some of these systems in spite of their appealing long-term
track records. It should not be surprising that most traders fail.

2. Systems with a high winning percentage are likely to have lower drawdowns. Assuming that the worst
case loss on a per trade basis is strictly limited, as it should be, abnormal drawdowns are most likely to be
caused by a long string of trades wherein there are very few winners. Large drawdowns are rarely the
result of a long string of consecutive losses. Drawdowns are most likely to be caused by the absence of
regular profits. Perhaps I am saying the same thing two different ways but I think there is a difference.
For example six losses in a row followed by a winner and another six losses in a row is likely to produce
a larger drawdown than ten losses in a row. Obviously the higher the winning percentage the less
likelihood of stringing together a long series of trades with only occasional winners. Of all the historical
performance factors that we can evaluate, the winning percentage is most likely to be predictive of the
possibility of large drawdowns. If we can design a system that has a low average loss and a high winning
percentage we are looking at a system that should be very drawdown resistant.

3. Systems with a high winning percentage reinforce discipline. How often have we heard stories of
traders who are following a system and after a series of losses decide to skip a trade only to have that
skipped trade turn out to be a big winner? This is not the trader's version of an urban legend horror story.
It actually happens very frequently. If we are trading a system with a low percentage of winners, it
becomes increasingly tempting to start skipping trades. Lets assume we are trading a system that only has
30% winning trades. Since the odds appear to favor our skipping trades we will tend to be rewarded for
our lapses in discipline. For a while we will benefit from skipping trades until we inevitably skip the big
winner. That is usually when the system is abandoned because, having skipped the winner, we aren't
about to jump back in to experience the next string of losses.

On the other hand, if our system has a high percentage of winning trades, we shouldn't be tempted to start
second-guessing the system. We know up front that if we skip a trade the odds are that we will be
skipping a winner. The favorable odds of the system will help us to maintain the necessary discipline to
operate the system exactly as it was designed.

4. Systems with a high winning percentage require less diversification. The typical trend following
system is extremely dependent on finding markets where a very large trend will occur. These large trends
are relatively rare and to make certain that we are in the right market at the right time we must diversify
our trading among many markets because we can't afford to miss one of those big trends. By diversifying
as much as possible we are more likely to catch the big trend that makes back all of our losses and
rewards us with a profit. However, in spite of what some portfolio strategists would have us believe
diversifying a low percentage system actually increases the likelihood of a major drawdown rather than
decreasing it.

However if we are trading a system with a high winning percentage we have much less need for
diversification. And if by careful design our high percentage system is also capable of catching big trends,
we have the best possible scenario. After all, there is no logical reason that a system with a high winning
percentage can't also have big winning trades now and then. It all depends on the effectiveness of our exit
strategy. Of course, diversification will still benefit our high percentage strategy but it will be an optional
enhancement rather than a necessity.

5. Systems with a high winning percentage require less capital to operate. If we need less capital to
survive drawdowns and less capital for diversification, it follows that we need less capital to start trading
the system. Also, with a high winning percentage we can be more optimistic about starting with less
capital and using our profits to build up our capital prior to any major drawdown.

6. Systems with a high winning percentage are easier to troubleshoot. Imagine a low percentage system
where long strings of losses are the norm. How many losses will it take to get your undivided attention
and tell you that something is seriously wrong? Too many, I suspect.

Now imagine a system with a very high percentage of winners. Almost any series of losses is going to be
out of the ordinary and will quickly attract our attention. Hopefully we will be able to perform a prompt
review of the system and correct any faults while we still have some capital left. Unfortunately if we are
trading a low percentage system we could run out of capital before we realize that our low percentage
system has deteriorated even further.
As you can see we are strong advocates of systems with high winning percentages. In our opinion there is
no excuse for designing a system with a low percentage of winners. We contend that it's not really
difficult to design a system with a solid winning percentage if you focus on that statistic and make it a
requirement. Too often system designers tend to focus entirely on total profitability. Many times this
emphasis tends to result in letting profits run too long (curve fitted profit exits) and perhaps using stops
that are too close. Both of these preferences will hurt the winning percentage and degrade the system. On
the other hand, if we set out to have a high winning percentage we can obtain it without sacrificing much,
if anything, in the way of profits and we will create a system that is extremely "user friendly" and reliable.
We will discuss more of the details about our system building preferences and procedures in future
Bulletins.

Do you have comments or opinions about the importance of winning percentages? Share your views or
ask questions on the FORUM.

************
I have been invited to help Dr. Van Tharp with an Advanced System Building Workshop on April 30
through May 2 in Raleigh, N.C.

For information on Dr. Tharp's workshops go to his web site at http://www.iitm.com.

Obviously since I am an instructor I am not an unbiased evaluator but I have been working with Dr. Tharp
for many years and I have a very high regard for his sincerity, his knowledge, and the quality of his work.
The seminars are pretty expensive but most attendees are advanced traders and professionals who come
back for more. Before I was teaching with Dr. Tharp, Tom Basso was helping him. Tom is now managing
more than $500 million and is highly regarded in the futures industry. Many of Van's students have
become successful CTAs.

My honest opinion is that he offers excellent training if you can afford it and plan to be a full time or
professional trader. If not, you will get a lot out of his new book Trade Your Way to Financial Freedom.

*************
New System Coming

We are finishing up the documentation on a new system for trading the NYFE. We should be putting out
an announcement soon and posting the usual data on the web site.

************

Do you enjoy our Bulletins and the information on our web pages? As we have explained in previous
Bulletins, not everyone should buy or use a trading system and we don't expect everyone to support the
Club by buying trading systems. A few of our members have voluntarily sent us donations and suggested
that the Club maintain its objectivity and independence and not accept advertising or sponsorship. We
have gratefully accepted these donations and we would encourage other members who benefit from our
information to contribute a small amount from time to time to help support our educational efforts. In the
spirit of "shareware" we are happy to distribute our information on a regular basis without charge. You
can contribute or not as you wish and you are welcome to the information regardless. We hope you will
pick up an idea or two that helps you to be a better trader. In the meantime, we wish to express our thanks
to those who have already contributed. Your spirit and generosity is sincerely appreciated.

That's all for now.

Good Luck and Good Trading

Chuck

#25 If It Ain’t Broke, Should

We Fix It?
If It Ain't Broke, Should We Fix It?

When should a trading system be changed or abandoned? This is an important question with many
possible answers.

The disclosure documents of most professional trading advisors (CTAs) indicates that trading will cease
when the program offered has declined by 50% or more. This popular industry standard for professionally
managed accounts is often applied to systems as well. If you are using conservative position sizing and
find that you are losing 50% of your starting capital, something is obviously wrong and trading should
cease. However we would strongly advocate that this is a classic case of "locking the barn after the horses
are gone". Our goal, obviously, should be to avoid losing 50% in the first place. To accomplish this our
systems need to be monitored closely on a regular basis regardless of whether they are winning or losing.

There are many ways to evaluate system performance on an on-going basis. However we must get out of
the mindset of thinking that we only need to look at our losses to point out weaknesses. We also need to
spot weaknesses in our profitable trades. After all, we stand to gain much more by improving our winning
trades than by improving our losing trades. For example, assuming that our system has more winners than
losers and that our winners are larger than our losers, then we stand to gain more by increasing the size of
our winners by 10% than by reducing the size of our losses by 10%. Hopefully the losing trades are
always tightly controlled and we certainly don't expect to trade without encountering our share of losses
from time to time. However, anything out of the ordinary in the way of losses deserves close scrutiny. We
especially want to look for patterns in our losses. We once were able to make a substantial improvement
in a system by observing that any four-day pattern of low volatility would draw our Average True Range
based stops in too close and create whipsaws. Once we spotted the pattern and identified the cause of our
whipsaw problem, the solution was easy.

Also, in addition to evaluating both winners and losers, we must also be alert to spot missed trades. If the
market is presenting repeated opportunities that our system is frequently missing, we need to look into our
system's entry logic and see if there is some way to participate in a higher percentage of these potentially
profitable situations. Perhaps our system should contain more than one set of entry conditions or maybe
we need to develop a separate system to capitalize on the opportunities we are missing. It is generally
easier to work with two systems than to try and make one system do everything.

In addition to routine trade by trade reviews we also need to be aware of our attitude about trading a
system. We should always be trading with an attitude of confidence and optimism. Once we start thinking
about skipping trades or thinking that the next trade is likely to be a loser it is a sign that our system might
need some improvement. Sometimes even a change that deteriorates the historical profitability is worth
considering if it will improve our morale. It is extremely unfortunate whenever a good system must be
abandoned simply because the trader lacks the confidence to implement it correctly. Rather than to begin
second-guessing a system it is much better to go into the system and see what is creating the stress and
then modify the system accordingly.

We have been describing various situations that might prompt us to modify our system but we must also
guard against our temptation to implement changes needlessly. All systems go through periods of
adversity and our best and worst periods are always ahead of us. One of the advantages of trading on a
systematic basis is that we can go back and review historical trading results and get a realistic idea of
what to expect in the way of adversity. For example if we have just experienced four losing trades in a
row it might put these trades into better perspective if we knew that there were several historical periods
with six losses or more and that the system always recovered from these losing trades within three months
or less. The primary reason we provide historical trade by trade results with all of our systems is so that
our clients can go back and review them and get a good feel for what to expect in the way of adversity.
The importance of the historical trading record is not in the precise results and statistical ratios, which will
probably never be duplicated. As a trader it is important to realize that we are always in the process of
either making new highs or suffering a drawdown. Neither event should be given too much significance.

We should make a practice of reviewing our trading systems on a regular basis regardless of whether they
are winning or losing. Late last year many of our members may recall that we made a modification in our
"25 X 25" Bond system. ( You can view the Bulletin regarding this change here
http://traderclub.com/discus/messages/107/119.html ) This improvement was not prompted by an
unusually large loss or a series of losses. Quite the contrary; we modified and improved the system
simply as the result of closely observing an unusually profitable trade. The modification did nothing to
improve the historical results but it was very logical and we expect that it may improve the results in the
future. As I write this Bulletin we are in the process of making a minor change in the newly released
Prudent S&P system. Much like the change in the "25 x 25" this change was prompted by the exceptional
profitability of our very first trade since releasing the system. (Buyers of the Prudent system should be
receiving an upgraded version in the next few days.) My purpose in pointing out this revision is not to
draw attention to the excellent start by this system but to highlight the importance of carefully studying
and reviewing your profitable trades as well as your losers. You will also note that we practice what we
preach in terms of reviewing our systems on a continuing basis.

When reviewing our trades on a regular and frequent basis we should be aware of the importance of
maintaining an adequate sample size to keep the trading in the proper perspective. For example, when
calculating the winning and losing percentages we must be sure to look at twenty or thirty trades or more.
To conclude that our system is losing 80% of the time because four out of the last five trades were losses
is not very relevant if the system has actually made money on twenty out of the last thirty trades. Recent
trade experience can be very significant however if it can help us spot a pattern and identify a recurring
problem. There is clearly no need to wait for twenty losses if we can see what the problem is after only
four or five losses (or one profit). Be aware however that using small samples to change our system can
be misleading and we may create even more problems than we solve. We must be sure to test our
proposed improvements and ideas over an adequate period of data. Implementing changes that eliminate
those last four losses can be a big mistake if the testing over the last ten years of data shows that our "fix"
has a severe negative impact on the historical results. Also be aware that maintaining correct logic within
our system is as critical when repairing or improving the system as it was when we designed the system in
the first place. Sound logic must always take precedence over statistical reports. Whatever we do must
make sense in addition to being statistically sound. Don't settle for changes that just happen to improve
the results without any rhyme or reason behind them.

#26 The Serendipity Entry

Because we prefer to get our trades started in the right direction as soon as possible we spend a great deal
of time experimenting with various setup conditions and entry triggers. If the setup conditions are
favorable we will often trigger the entry on the long side of our trades based on an upward excursion from
the opening price. We find that measuring favorable movement from the opening price rather than from
the previous close tends to produce reliable entry signals that offer a high probability of success. This
particular method of getting new trades started in the right direction is one of our personal favorites and it
has been used as the entry trigger in several of our systems.

Late one evening while testing entry triggers on a new system we inadvertently coded the entry so that we
would enter TOMORROW based on a specified price excursion from TODAY’S OPEN. We had
originally intended to have the system enter tomorrow as the price moved upward from tomorrow’s open.
However the mis-coded entry that was based on today’s open worked much better than we expected and it
substantially out-performed our intended entry trigger. Our initial reaction to the outstanding test results
was one of skepticism and we naturally assumed that this entry trigger might have been a mere fluke. We
feared that perhaps we had simply stumbled into an accidental curve fit. However when we tested this
entry method on other systems and with other setup conditions it continued to perform admirably.
Because our discovery of this entry method was quite accidental we named it the Serendipity Entry
Trigger and we immediately began to investigate to see if there was any logic behind the entry that might
explain why it seemed to work so well in our tests.

After carefully studying the patterns of the Serendipity Entry Trigger we concluded that it is particularly
effective because it is a trigger that is based on two days of cumulative price movement rather than the
typical one day or less of price movement that we would normally measure.
For the sake of this discussion, let’s assume that our specific entry trigger is to buy the bonds
TOMORROW on a stop that is 20/32 above TODAY’S OPEN. Now if we look carefully at the
relationship of today’s close relative to today’s open it helps us to better understand what will be required
tomorrow to trigger an effective entry signal. If today is a strong day with a close that is well above the
opening then we will be able to enter quickly tomorrow on just a small amount of favorable price
movement. In fact if the close today is 20 or more points above the opening today then we are very likely
to be stopped into our new trade immediately on tomorrows opening.

Our first chart illustrates a strong setup day where the close is well above the open. Because the close was
strong and well above the open, there was very little upward price movement required for our Serendipity
Entry Trigger on the following day.

However, on our second chartthe market closes very weak on the setup day and this weakness places our
entry trigger well out of reach for the following day.

On our third chart we show a setup day with a close at mid-range but well above the day’s open. The
Serendipity Entry now requires a fairly strong move on the following day in order to initiate the new trade
but the trigger is easily within reach.

In our opinion, the Serendipity Entry Trigger works so well because it is almost like adding an element of
hindsight into the entry process. The precise sequence of price action on the setup day becomes an
important part of the final trigger mechanism.

We could of course simply require that the setup day be a strong day as a pre-entry condition. However
the Serendipity Trigger is more adaptive and robust than a setup condition because it is flexible enough to
occasionally permit an entry even though the setup day is weak. A weak setup day can occasionally be
followed by an abnormally strong entry day and the Serendipity Trigger would still allow us to enter on
this strength. If we were to use a more conventional entry trigger and make a strong setup day a pre-entry
condition there would be no entry signal on the following day even though the market showed remarkable
strength.

The Serendipity Trigger offers an important operational advantage as well as contributing to improved
timing. When using the conventional trigger that is based on tomorrow’s opening price, our exact entry
point cannot be calculated until after the opening trade has been posted. However one of the benefits of
the Serendipity Trigger is that the exact entry order is available the day prior to the entry and our stop
order can be placed prior to the opening.

We have added the Serendipity Entry Trigger to our Toolbox of entry methods and it was employed as
part of our entry strategy in the Serendipity Bond system. We hope that our Traders Club members will
find this unique entry trigger to be a very practical and profitable trading tool.
Conventional Entry Code

Buy("Long Entry") Open Tomorrow + 20 points stop;

Serendipity Entry Code

Buy("Long Entry") Open + 20 points stop;

All of the charts and the Easy Language code can be found in the Traderclub Toolkit
http://traderclub.com/toolkit.htm

---------------------------------------------------------

MTA Conference

We enjoyed participating in the Market Technician's Association 24th Annual conference in Manhattan
Beach, Calif. last weekend. At the conference we presented a discussion of various exit strategies that was
very well received by a large and enthusiastic audience. Apparently the subject of exits continues to be
generally neglected in technical circles and our contribution to the knowledge in this field was very much
appreciated by this knowledgeable group of technicians. We will post some of our graphs and lecture
notes on the web site and discuss some of the exit strategies in future Bulletins.

---------------------------------------------------------

Traders Club Forum

http://traderclub.com/discus/board.html

We would like to encourage our members to participate actively in our Forum section of the web site. We
receive a copy of every message posted and we would be happy to respond to questions and comments in
the Forum as often as possible. The Forum is self-perpetuating and the more it is used the more valuable
it becomes to everyone. Please set aside a few minutes and make a point of posting a question, a comment
or an idea on the Forum in the next few days. We need to push it up to a critical level so that we will be
assured of having many new and interesting messages every day. You would be amazed at how much
excellent material has been posted there already. Post anything you like and don't worry about being
flamed or criticized. We seem to have a very friendly group.

Good Luck and Good Trading

#27 Discretionary Trading Vs.
Systematic Trading
A recent discussion on the Forum inspired me to select this issue as a subject for a Bulletin. Let's start
with my definitions of discretionary and systematic.

I picture a discretionary trader as one who visually analyzes data and arrives at trading decisions with
some form of discipline. The term discretionary does not necessarily mean that the trader is shooting from
the hip or acting on impulse. A typical discretionary trader tries to arrive at a decision after considering
great many factors and probably acts in a fairly predictable pattern that might somehow be computerized
given enough time and effort. The typical discretionary trader that I have known looks at chart patterns, a
few favorite indicators, and perhaps adds some form of fundamental information and overlays all of this
with a personal opinion or bias about the general direction of prices.

I picture a systematic trader as one who has a fixed set of rules that can be implemented by a computer or
delegated to a trading assistant for implementation and the trader, the computer and the assistant will all
know and agree when a trade should be made.

If the discretionary trader is well disciplined (and most of the successful ones are highly disciplined) it
doesn't seem to me that there is a great deal of difference in the two approaches. The discretionary trader
can perhaps react better than a computer when there is some important news or unusual market
occurrence. The extent of this apparent advantage will, of course, vary from trader to trader depending on
their intelligence, knowledge, experience and discipline. In most cases I would expect that a good
discretionary trader would out perform a good systematic trader. However, in most cases I would expect
the average systematic trader to easily outperform the average discretionary trader.

In fact several years ago I saw a comparison of the performance of discretionary CTAs (commodity
trading advisors) and systematic CTAs. The comparison of results over many traders and many years of
data clearly favored the systematic traders as a group but a very small number of discretionary traders
produced results that were not matched by the systematic traders. The discretionary traders had a very
wide range of results varying from terrific to terrible while the systematic trader ranged from pretty good
to pretty bad. When the results of each group were combined and averaged the systematic traders had
noticeably higher returns than the discretionary traders did. However before we reach any conclusions of
our own, lets examine some of the pros and cons of each approach.

The discretionary trader has a great advantage in terms of flexibility and adaptability. The human mind is
still capable of analyzing and interpreting vast amounts of data. However the result of that analysis will
vary widely depending on the experience and market knowledge of the trader. Emotions and various
biases can easily come into play. Fear, hope and greed can distort objectivity. As a group, discretionary
traders tend to take profits too quickly and they are often reluctant to take losses in a timely manner.
Other personal factors can also come into the picture. Divorce, illness, a death in the family or other
stress-creating situations can obviously impair the decision making process. A discretionary trader can
also be unduly influenced by a bad or good series of trades. After six losses in a row the discretionary
trader may be reluctant to implement the seventh trade. After six profits in a row the trader may let their
guard down and fail to implement their usual thorough analysis and risk control. Unlike systematic
traders who can test ideas over historical data discretionary traders have a benchmark problem in terms of
expectations. How many losses in a row should a discretionary trader expect? How will a discretionary
trader know when to quit or change their strategy? What do you do if you are a discretionary trader and
things are going wrong? How big a drawdown should a discretionary trader expect or tolerate?

Systematic trading has many advantages but it also has its share of problems. Mechanical trading systems
tend to have a difficult time adapting to changes in markets and one of the few certainties in trading is that
markets tend to change over time. There are also potential market disruptions that systems may not be
prepared to handle. Market crashes, wars, political events, natural disasters and the weather are just a few
of the variables that can temporarily create problems for a systematic trader. Most systems are designed to
trade well in a specific type of market environment. For example, a trend following system is unlikely to
do well in a non-trending market environment. A counter-trend system is unlikely to do well in a strong
trending market.

However systems can be tested over historical data and some idea of trading activity, risk, potential profit
and a system's ability to function in various market environments can be crudely estimated. Even though
historical testing is not very reliable even when done properly it does give a trader a general idea of what
to expect. If for example we know that the system is likely to have eight losses in a row we may not
become overly concerned if we have five losses in a row. The system's ability to identify the next trading
opportunity is not influenced by the results of the last few trades. Our computer's decision-making ability
is not influenced by fear, hope and greed, the flu, or a hang-over. Historical trading results can help us to
design money management strategies to maximize profit potential and to control risk.

The choice of trading approaches is a very personal one. Either approach can be made to work or fail.
There is some skill and market knowledge required in either method and they are not necessarily mutually
exclusive. A trader can easily use both methods. Many discretionary traders run systems and treat them as
just another source of information. They may or may not act on the signals based on other factors they
wish to consider. Some systems traders switch systems on and off based on their opinions or market
outlook or apply some discretion on which trades to skip or implement.

As we mentioned at the beginning of the Bulletin, we have a discussion of this topic going on our Forum.
Stop by to give us your views and see what other members have to say.

http://traderclub.com/cgi-bin/discus/show.cgi?18/227.html

In the works:

We have started a new book about exit strategies. Pass along any ideas you might have.
mailto:chuck@traderclub.com

We have an updated version of the Serendipity Bond System that will be distributed in the next day or
two.

We are working on new systems for S&Ps, Wheat. Swiss Francs, and British Pounds.

We plan to offer our Trading Signals service in the next month or two. The STC Beta Topic on the Forum
is where we have been testing our distribution technology.

We are now posting Commitment of Traders Charts on the Forum every 2 weeks when the data is
released. Carl Berkey is generously supplying the charts.
http://traderclub.com/cgi-bin/discus/show.cgi?18/188.html

Please visit our Forum and participate in the discussions or just lurk and view the information and
opinions posted there. We had more than 130,000 hits on our web site last month. Drop in and say hello.

http://traderclub.com/discus/board.htm

That's all for now

Good Luck and Good Trading

Chuck

#28 Identifying Market

Conditions
We have been having some very interesting discussions on our Forum. One of the threads that I have
found to be particularly interesting recently is on the subject of
Curve Fitting/ Over-optimization at http://traderclub.com/cgi-bin/discus/show.cgi?18/45

I was about to post a response to one of the many excellent messages in this thread when I decided that
this rather lengthy response might make an interesting Bulletin.

-----------
Snip from message from Kevin Morgan on 6/27/99 - Kevin stated:

"My conclusion is simple. We need to focus on two things:

1. A typography of market conditions.
2. Effective trading methods for each. "

--------

An excellent post, Kevin. Thanks. I agree. Lets tackle first things first. Let’s try and work out a concise
breakdown of market conditions and once we have done that we can try to find ways to identify and then
trade each condition.

I would propose that market conditions can be defined using three elements: direction and slope are the
two I am most positive about. The third possibility is either volatility or orderliness, or perhaps both. I
would like to have some help on this from our members so feel free to jump in and agree or disagree and
contribute any ideas. Consider my ideas as just a place to start.

Direction = up, down or sideways. I think it is important to think of sideways as a direction when
describing market direction. Here is a sample of how this logic might appear:

Upward Direction
A. Upward with low slope (Direction is up but slope is low. The market is moving up gradually.)
B. Upward with high slope (Direction is up and slope is steep. The market is moving up rapidly.)

Now I believe that we might want to add another factor that would further define the conditions. That
factor would relate to the size of the short-term deviations from the general slope.

Lets assume that we are moving upward so that a trend line under the lows points upward at about a
twenty degree angle. If we now draw an approximately parallel line along the highs, the trendline along
the highs could be close to the trendline of the lows or it could be far away. The space between the
trendlines could be referred to as the amount of short-term volatility or disorderliness. If the lines are
close together we will describe the slope as ―orderly‖ and if the lines are far apart we will describe the
slope as ―disorderly‖.

I doubt if I would actually want to use trendlines to measure or identify these conditions but it helps in
visualizing what I want to describe. As you can easily tell, I’m not a mathematician. I’m simply trying to
paint a verbal picture that we can use to describe various market conditions. Our outline of market
conditions would now look like this:

Upward Direction
A. Upward with low slope (Direction is up and the market is moving gradually.)
1. Orderly (We will call this ―Condition 1‖. )
2. Disorderly (We will call this ―Condition 2‖)

B. Upward with high slope (Direction is up and the market is moving rapidly.)
1. Orderly (We will call this ―Condition 3‖)
2. Disorderly (We will call this ―Condition 4‖)

Sideways Direction (No slope to measure. Our trendlines are both moving sideways.)
A. Orderly (We will call this ―Condition 5‖)
B. Disorderly (We will call this ―Condition 6‖)

Downward Direction
A. Downward with low slope (Direction is down and the market is moving gradually.)
1. Orderly (We will call this ―Condition 7‖)
2. Disorderly (We will call this ―Condition 8‖)

B. Downward with high slope (Direction is down and the market is moving down rapidly.)
1. Orderly (We will call this ―Condition 9‖)
2. Disorderly (We will call this ―Condition 10‖)

There you have it. We have identified ten different market ―conditions‖ that will have major impact on
the results of various trading systems. (Actually I am going to add an eleventh condition called
―Unknown‖ or ―None of the above.‖) Next we need to figure out how to identify each of these conditions
systematically and incorporate that analysis into our trading systems. Send us your ideas and suggestions
for code and indicators that would identify each condition. Here is a review of the eleven conditions:

Condition 1 = Market is moving upward gradually in a narrow channel.

Condition 2 = Market is moving upward gradually in a wide channel.
Condition 3 = Market is moving upward sharply in a narrow channel.
Condition 4 = Market is moving upward sharply in a wide channel.
Condition 5 = Market is moving sideways in a narrow channel.
Condition 6 = Market is moving sideways in a wide channel.
Condition 7 = Market is moving downward gradually in a narrow channel.
Condition 8 = Market is moving downward gradually in a wide channel.
Condition 9 = Market is moving downward sharply in a narrow channel.
Condition 10 = Market is moving downward sharply in a wide channel.
Condition 11 = Unknown or none of the above.

Come join us in our Forum discussions. We want to have the best discussions for traders on the web. We
think we are getting there. http://www.traderclub.com/discus/board.html

Good Luck and Good Trading

Chuck

#29 Importance of Exits

First in a Series of Articles About Exits

Part one: Importance of Exits

The outcome of every trade is dependent on the exit. If we enter in a timely fashion and then exit poorly,
the trade is likely to be a loss. If our entry happens to be poor but our exit is good we might still salvage a
profit. The exits, not the entries, determine the outcome of our trades. This lesson about exits is easily
demonstrated. Take any entry strategy and begin combining it with different exit strategies. You will
quickly see that we can change the results dramatically by making only minor adjustments to the exits. In
fact it becomes nearly impossible to tell if an entry is any good because the results are so exit dependent.
Bad exits can make a good entry look bad and good exits can make a bad entry look good.

When testing the validity of an entry method it is best to begin by simply exiting the trades after a number
of bars. If you do anything more creative than this simple exit you will find that you are really testing
your exits, not your entries. If you change the exits while attempting to test an entry strategy the results
will vary so much depending on the exits selected that you will find that you can not make any valid
assumptions about the reliability of the entry. When combined with the right exit the entry strategy looks
great. When combined with the wrong exit the same entry looks terrible.

The purpose of an entry is to get the trade started in the right direction. To test the effectiveness of an
entry we simply measure what percentage of the time it gets our trade started in the right direction. For
example if we have entry "A" that has 60% winning trades after five days it is better than an entry "B"
that has only 45% winners after five days.

You will notice that we made no comparison of risk or profitability in picking the best entry. What if
entry "A" lost money and entry "B" made money? Is entry "A" still better? The answer is "Yes" because
the purpose of an entry is merely to get the trade started in the right direction. After that everything else is
dependent on the exits. Entry "B" just happened to make more money because of the particular exit we
selected for the test. We can easily adjust our exits and we will find that entry "A" will consistently make
more money than entry "B" because it gets the trades started in the right direction more often. To
maximize our profit we need to combine the right entry with the right exit.

In our book, Computer Analysis of the Futures Market, we tell an amusing anecdote about a trader who
seemed a bit loony because he used a Coke bottle with a broken radio antennae sticking out of it to
receive trading advice from other planets. This advice, like most trading advice, was only related to the
entries. When the voice from the Coke bottle told him to enter a trade he would come back to my desk
and want to put the trade on right away saying something like: "They are buying soy beans on Mars, buy
some beans for me".

The other traders sitting around the board room would overhear these frantic orders and became quite
interested in this strange trading advice. Naturally they were quick to make fun of the trader when he was
losing but they didn't have much to say when he was winning. The trader with the Coke bottle eventually
learned that to avoid ridicule he had to take his losses quickly and hold on to his winners as long as
possible. His trading steadily improved and he wound up being a surprisingly good trader. Obviously, his
reliance on trading advice from other planets had nothing to do with his success. His entries were no
better or worse than random but he had learned to be very good at his exits.

We should do the same.

Note: If you haven't read it recently, now would be a good time to review Bulletin #22 which deals with
the issue of "control". Controlling exits is much more difficult than entries.

Go here: http://traderclub.com/cgi-bin/discus/show.cgi?107/135

***************

Signals Service scheduled to begin in September

We have many Club members that do not own TradeStation or do not have access to an end of day data
service. To make the results of our systems available to as many traders as possible we are going to
implement a Signals Service that will provide a daily e-mail to subscribers that will go out each evening
with the trading signals for the following day. The e-mail will include the output of all of the systems
including any possible entries and the operative stops on any open positions. We will also track the
system results and provide roll over instructions and any other information that might be needed. As a
backup, in case the e-mail message is not received, subscribers will be able to go to the web site and
access a private page that will include all the information from the most recent e-mails. You may have
already noticed a Beta Test area where we have been testing this information for several months.

To make things even easier, we will also be working with some brokers who will also be receiving the
signals and can help implement trades on behalf of our subscribers. We can also send copies of our
messages to a broker of your choice who must agree not to disclose the information to non-subscribers.

We plan to offer the Signals Service at $150 per month payable quarterly. If you might be interested in
this service or have any questions or suggestions please send us an e-mail and we will be happy to keep
you advised of our progress and plans. We are not presently accepting subscriptions so there is no
obligation if you just want to let us know you might be interested or want to offer a suggestion or two.

Respond to mailto:signals@traderclub.com

All questions and comments are welcome. Clients who already own our systems will be allowed to
subscribe to this service at a nominal cost as a means of double checking and verifying their data.

****************

That's all, Good Luck and Good Trading

Chuck

#30 The Money

Management Exit
Part Two: The Money Management Exit

In Bulletin #29 we emphasized the importance of exits in general and pointed out that it is the exits and
not the entries which actually determine the outcome of our trades. Now that we have established the
importance of exits we will be more specific and write about various types of exits. Probably the simplest
and most critical exit is the money management exit or the classic "stop loss". This is the exit that protects
our trading capital and prevents ruin.

To trade futures and other leveraged investments without a money management stop is certain ruin. Well-
known trader and author Victor Niederhoffer lost tens of millions of dollars of his client's money when he
traded his fund down to zero and some twenty-million beyond. No surprise there. The inevitable outcome
of an investment with this ill-fated trader was clearly determined years ago when Niederhoffer wrote:

"I have never used stops, even to bail myself out. Somehow, having a fixed rule to exit provides my
adversaries too great an advantage. " - Victor Niederhoffer, from "The Education of a Speculator", page
376

Niederhoffer's demise was no surprise to industry professionals. The only speculation was on how long it
would take for him to go bust. To his credit, he lasted longer than was generally expected. Niederhoffer's
paranoia about money management stops is not uncommon among naive beginners but it is an attitude
that is rarely seen among seasoned professionals. The first priority in trading must always be to preserve
our trading capital from the risk of catastrophic ruin. Everything else becomes secondary to this objective.

Note carefully how we have stated this goal. We did not say that our goal was to eliminate or reduce the
risk of loss. Reasonable losses are an integral part of the trading process. Good traders accept losses as a
cost of doing business. In fact I have observed that good traders probably take more losses than bad
traders do. The critical issue in this discussion is the size of the losses that are acceptable. Catastrophic
losses must be avoided at all costs and these losses are easily avoided by always employing a simple
money management stop.

Niederhoffer mistakenly assumed that he was such a good trader that he could violate the cardinal rule of
trading and not use money management stops. The truth is that good traders actually need money
management stops more than bad traders do. Bad traders are going to fail very quickly whether they use
money management stops or not while good traders will survive and prosper indefinitely. The better and
longer you trade the more likely that you will eventually encounter a potentially catastrophic event.

The money management stop commits a trader to a pre-defined loss point that a trader can accept and the
stop will allow him to exit a losing trade unemotionally. The trader who uses a money management stop
knows from the outset that he can only give the trade a limited amount of room to move against him, and
after that, he will cut his losses by exiting the trade according to his plan. This is a tremendous
psychological advantage. Having a fixed point to exit a trade with a loss removes a great deal of stress in
dealing with any losing position. The trader with his stop in place always knows exactly when he has to
exit and avoids the pain of having to watch the loss grow larger and larger day after day.

This psychological advantage of money management stops also helps the trader before he takes a trade.
Suppose the system called for us to take a trade in a specific market tomorrow, and we had an unknown
and unlimited potential for loss. No knowledgeable trader would be willing to take such a trade. However,
if you have a money management stop and know exactly what the worst loss could be beforehand, it is
psychologically much easier to pull the trigger and confidently enter that trade. We already know and are
prepared for the worse case scenario and we have determined that the amount of risk is acceptable to us.
Money management stops give the trader the benefit of a worst loss estimate on any trade. This
knowledge gives us the confidence to enter the trade and the psychological preparation to accept the loss
should it occur. Of course money management stops may not always predict the exact amount of the
worst loss, since markets can sometimes gap against the position and cause a much larger loss than
planned. However in most cases the money management stop is a reasonable indication of the worst loss
likely in a trade.

Over the course of this series of articles about exits we will describe a few of the basic money
management stops that all traders should be familiar with. We will describe the basic Dollar Stop in this
Bulletin and describe other recommended Money Management stops in subsequent bulletins.

The Dollar Stop: The simplest money management stop is a stop that is positioned a fixed dollar amount
away from the entry price of a trade. Dollar stops are easy to implement and most trading software allow
for easy incorporation of dollar stops into any trading system. Simple as this may sound, there are
incorrect and correct ways to use a dollar stop in your systems.

The incorrect way to use dollar stops is to figure the maximum amount you can afford to lose in the trade,
and then set the dollar stop accordingly. Unfortunately, the market does not make adverse price
movements based on how much money you can afford to lose.

The correct way to set dollar stops is to use market characteristics and system testing statistics to
determine its placement. For instance, dollar stops should not be placed too close to the markets because
random price movement will cause the trade to be stopped out prematurely. Neither should dollar stops be
placed too far away from the market, since that means you are willing to take a much larger loss than is
necessary. In our experience, dollar stops should be placed based on some volatility measure of the
market. For instance, if the average daily range of a market is $1,000, it is recommended that the dollar
stop on that market should be at least $1,000 if not more. This amount should keep the stop out of the
random price movements while maintaining its function of capital preservation. Again, it must be stressed
that adequate system testing and analysis must precede the implementation of any dollar stop to ensure
proper performance.

It is important to understand the volatility characteristics of the market you are trading and not to blindly
use a fixed dollar stop for all markets, nor even for a single market if that market has changing volatility
characteristics. The challenge then is to develop money management stops that are adaptive to current
market volatility conditions.

In our next Bulletin we will discuss the use of Adaptive Money Management stops.

************

I apologize to those who have tried to contact us over the last two or three weeks and received no
response. There was a sudden illness and death in the family (my mother) and I have not been at work for
several weeks. I am back at the office now and will be catching up as fast as I can. I'll also be responding
to many of the recent messages on the Forum page.

*********

Signals Service Update: Thanks to David Elden's continued work during my absence the Signals Service
is still on schedule for a September 1st launch date. We will be putting out a special message with
subscription details in the next few days.

If you are interested in this service respond to mailto:signals@traderclub.com

****************

That's all, Good Luck and Good Trading

Chuck
#31 Preparing for Dangerous
Reports and ―Price Shocks‖
Third in a Series of Articles about Exits

Exits - Preparing for Dangerous Reports and "Price Shocks"

Although we were scheduled to continue our series on exit strategies with a Bulletin about adaptive
money management stops, I wanted to interject this Bulletin with a brief bit of advice about handling
important reports and potential "price shocks" when trading. This topic was brought sharply to mind only
last Friday when the monthly employment report caused the bonds to rally more than a full point in just a
few minutes. I thought it would be best to write this Bulletin while the subject was still fresh on my mind.

On Thursday's close we were short the September bonds in the Sidewinder Bond system and we told our
Signals Service subscribers to exit the short position on the opening Friday and avoid going through the
report. This advice proved to be quite timely because the bond market rallied well over a point from the
opening once the employment report was released. We received some thanks for the timely advice and
many hearty congratulations for correctly forecasting the direction of the report which most bond market
observers anticipated would be bearish. The truth is that we made the correct decision without any
forecasting. I thought that an explanation of the logic that lead to this timely profit-saving decision would
be a valuable lesson to our members who are concerned about trading during reports. Here is our general
philosophy about handling reports and news events that may impact our positions. We think it is sound
and practical advice learned from more than thirty-five years of futures trading experience.

If we are holding a position in a long-term trend-following system we will usually ignore reports unless
they are expected to be of such impact that our protective stops will become useless in their critical role of
preserving our trading capital. The most dangerous reports are usually those that are issued while the
markets are closed and result in overnight price gaps that leap over our protective stops and cause losses
much greater than we are prepared for. If a dangerous gap-creating report such as we have just described
is scheduled, we will exit our position prior to the report and then perhaps re-enter the trade after the
report data and its impact on the market is known. The logic of this exit strategy is simple. We are always
willing to forego windfall profits in order to avoid catastrophic losses. In the long run the probabilities are
that half of these dangerous reports would go in our favor and the other half would go against us. This
might lead us to assume that an exit procedure for reports will have no impact on our trading but this
would be a very mistaken conclusion. Since the outcome of these reports is a 50-50 proposition, by
making it a policy to sidestep the danger we do nothing to reduce our profitability but we manage to
dramatically reduce our risk. The advantages of avoiding potential gap-making reports is very obvious.
We are greatly reducing our exposure to catastrophic risk without any reduction in our profit potential. I
wish all trading decisions were as simple as this.

Last Friday's employment report was not of the dangerous gap-making, stop-hopping variety and had we
not already been in a profit-taking mode in an expiring contract that needed to be liquidated soon we
would have held through the report and relied on our system stops to get us out of the trade. However,
since our open profits were modest and we needed to liquidate the September position very soon in any
case it seemed clear that we had little to gain by gambling on the short term impact of this report.
Successful trading is about profiting from our "edge" or the advantage offered by our system. Gambling
on the outcome of reports has nothing to do with successful trading.

It is interesting to note that the employment report last Friday was expected to be bearish and the bond
market declined sharply on Thursday in anticipation of a bearish Friday morning employment report.
However, when a report is expected to be bearish, this bearish sentiment adds substantially to the risk of a
bullish report. Because a bearish report is already factored into the market, any bullish report would be a
big surprise. This is exactly what happened and we were not suckered into holding our position through a
report whose potentially bearish impact had already been factored into the prices by Thursday's decline.
The more the outcome of a report appears to be forecast or "in the market" the more dangerous it
becomes. If a report is expected to be very bearish and it turns out to be only modestly bearish, the market
is likely to rally on the bearish report. If the anticipated bearish report turns out to be neutral the market is
likely to rally strongly and if the report is actually bullish the market will rally by leaps and bounds. Its
almost a no-win proposition to be holding a short position through a report that is widely expected to be
bearish. If the report is indeed bearish as predicted there will be little reaction and many traders who were
on the short side will take their profits on the bearish news thereby dampening the impact of the report.
The most dangerous reports are almost always the ones where the outcome seems to be well known
before the report is issued.

Like most professional traders we keep an eye out for various reports that may have an impact on our
positions. In most cases we simply ignore them. However when we are near an entry or an exit point we
will carefully analyze the situation and take measures to reduce our risk. If there are major news events
pending that might create large overnight price gaps we will move to the side lines. Our "edge" is
intended to give us an advantage in normal markets. Trying to forecast major news events and dangerous
gap producing reports is for gamblers, not system traders.

Had the employment report on Friday been bearish instead of bullish we would still argue that our
decision to exit on the open prior to the report was the correct decision. There was no forecasting or astute
market analysis involved. We simply applied tried and true risk-reduction techniques and got lucky
(which mysteriously seems to happen 50% of the time).

***********

Thanks to all of you who have been active on our FORUM the last month or two. The traffic there has
increased substantially over the last few weeks and we have one of the best discussion groups available
for traders anywhere on the web. Paul Lasky who wrote a very informative article in the August issue of
Futures magazine has shared some very interesting ideas with our Forum participants. If you haven't
visited the Forum on a regular basis you are missing out on a lot of worthwhile discussions. Check it out
and join us. http://traderclub.com/discus/board.html
************

The Traders Club Signals Service is up and running. Our first week was off to a very good start where it
really counts (the bottom line). If you would like more information about the STC Signals Service go
here: http://www.traderclub.com/signals.htm After our announcement last week in which we also
announced the 1999 Systems Results Report we had a request for an Equity Chart of 1999 trades. We
now have this chart online at: http://www.traderclub.com/systems1999results.htm This chart and the
results on this page are updated after every closed trade.

We have also posted a Combined 10 year historical portfolio with Equity chart of all 14 of the Traders
Club Systems. This data is up to date to September 1, 1999. You can view it here:
http://traderclub.com/systems_combined_all.htm

************

Speaking engagements: We have several appearances scheduled over the next few months. Go here for
information and details: http://www.traderclub.com/events.htm

************

Last but not least: I wish to thank all of you who sent personal messages regarding the recent death in the
family. Your kind words were very touching and very much appreciated. Thank you one and all.

I'm back in the office and nearly caught up on things. Don't hesitate to contact me if you need.

Good Luck and Good Trading

Chuck

#32 Adaptive Money

Management Stops
This is the Fourth Article in a Series of Articles About Exits

Exits - Adaptive Money Management Stops

In order to study and develop money management stops that are adaptive to current market volatility, it is
necessary to move away from the standard dollar stops and examine other ways to place the protective
stop based on some measure of market volatility.

One starting point is to use the price action itself to determine the stop placement. For instance, the lowest
low or highest high of the last X number of days could be used as a money management stop. We call this
a Channel Stop. The Channel Stop is very adaptive to current market conditions, since it changes with
trendiness and with volatility. The Channel Stop is further away from the market in times of higher
volatility and higher trendiness and closer to the market in times of lower volatility and lower trendiness.
This stop is also based on strong logic: we already know that a breakout of a significant highest high or
lowest low will often signal an important trend reversal. Therefore our stop-loss placed at a highest high
or lowest low point provides a valid technical reason to exit a losing trade.

However one possible disadvantage of this stop is that in a strongly trending market, the stop may be
placed too far away. Reflecting the strength of the trend the market might have moved a significant
distance from its previous highs or lows. On the other hand, during non-trending periods, the stop may be
placed much closer to the markets. As you can see, the actual dollar value of the stop would vary
considerably depending on where prices have moved from their last high or low point. This variation
might make dollar estimates of the risk per trade difficult to predict until it is actually time to enter the
market.

Another adaptive strategy would be to use significant support and resistance levels to define the money
management stop position. One could use a significant pattern in the market, such as a pivot low or pivot
high, as the position for a money management stop. The advantage of using price and technical points to
determine the position of the money management stop is that the stop is placed in a logical position,
where adverse price movement exceeding the stop would constitute a logical reason for terminating the
trade.

Another way of adjusting money management stops is to use a measure of the current market volatility.
We could use the Average True Range over a period of time or the Standard Deviation of prices over a
period of time and multiply that by a factor to determine how far away the stop should be placed from our
entry price. One of our favorite stops is to simply take the Average True Range over a number of days
and to multiply that by a factor and place the stop at that distance from the entry point of a trade. To avoid
random price movement, it would be recommended to place the stop more than one Average True Range
from the entry price. The advantage of using a stop determined by Average True Range is that it is highly
adaptive to current market conditions. The distance from our entry point to the stop would increase in
periods of high market volatility, and decrease in periods of lower volatility. In actual practice we have
found that most problems with the ATR stop tend to arise when the short term average true range
becomes unusually small and our tight stops cause us to be whipsawed. To avoid these dreaded whipsaws
we calculate both a short term ATR (3 or 4 days) and a longer term ATR (15 or 20 days) and we always
set our stops using whichever of the two ATRs is the largest. This allows the stops to move away quickly
but prevents them from moving in too close after a few unusually quiet days. (See Bulletin #14 for a
discussion of ATR exits. See Bulletin #10 for instructions on how to calculate ATR.)

Another version of an adaptive money management stop would be to use the Standard Deviation of the
past prices as the measure of price volatility. For example, the standard deviation of a past number of
closing prices may be calculated, multiplied by a factor, and the money management stop could be placed
at this distance away from the entry price. The rationale of this stop is similar to the Average True Range
stop. The goal is to place the stop out of the reach of random price movements yet cut our losses when
prices move away from our entry by a significant amount.

Adaptive stops that change with market volatility have a significant role in money management. The
dollar amount of the potential loss can quickly be calculated before we enter the trade and we can be
confident that the size of the potential loss is appropriate for the current market conditions. As an
example, suppose our system calls for the placement of a stop at 1.5 times the 20-day Average True
Range from our entry point. If we were trading the S&P 500 market back in 1990 where one Average
True Range was only $1,250 in dollar terms we would have been placing our stops $1,875 away from the
entry point. Now suppose we had an account of $100,000, and we were willing to risk 10% of our capital
on each trade. Based on the volatility in 1990 we would have been trading 5 contracts, thereby risking
$9,375 of our capital. Now suppose we are in 1999 trading the same system, and one Average True Range
in the market is $5,600. This would call for a stop of $8,400. If we were still trading the same $100,000
account with a 10% risk tolerance, we could now trade only 1 contract. As you can see, the adaptive
money management stop is an excellent guide to managing risk during periods of changing market
volatility.

In our next article about exits we will discuss various types of trailing exits.

**********

We are now offering a Free Trial of our Signals Service to any member who would like to sample the
service. Fill out the brief form and we will send you the signals generated by our Trading Systems by
email every evening for a limited time.

To sign up for the free trial go here: http://www.traderclub.com/signals_freetrial.htm

If you want more information about the Signals Service go here: http://www.traderclub.com/signals.htm

**********

Speaking engagements: We have several appearances scheduled over the next few months.

Chuck will be speaking at the Futures West '99 Conference & Expo in Long Beach on Saturday, October
2nd, 1999.

Chuck will be assisting Dr. Van K. Tharp in his workshop "How to Develop a Winning Trading System
That Fits You". October 15 -17 1999 (This is billed as the Advanced workshop.)
Chuck will be a featured speaker at this year's Technical Analysis Group (TAG) Conference at the MGM
Grand Hotel in Las Vegas. Chuck's topic this year will be: "A New Look at Exit Strategies". Nov 19 - 22
1999

For information and details go here: http://www.traderclub.com/events.htm

**********

That's all for this time

Good Luck and Good Trading

Chuck

#33 Are Your Money Management

Stops Too Large or Too Small?
This is the Fifth Article in a Series of Articles About Exits

Exits - Are Your Money Management Stops Too Large or Too Small?

by Chuck LeBeau and Terence Tan

It seems that Money Management stops are either too close and subject to frequent whipsaws or too far
away and expose our capital to large losses. From the results of our testing, we have concluded that most
systems would benefit from the inclusion of relatively large money management stops.

At first thought it would seem that the closer the stops and the smaller the losses, the lower the expected
drawdown. However, this seemingly logical assumption does not hold up in testing. In almost all cases
the wider stops result in a higher winning percentage and a lower drawdown. Smaller stops appear to be
psychologically attractive, but may actually deteriorate system performance because they are susceptible
to frequent "whipsaws" caused by random and insignificant price movements. On the other hand, large
stops may also be psychologically attractive because they are activated less frequently, and systems with
large stops generally tend to have a higher percentage of winning trades. However, the down side is that
large stops force the trader to occasionally suffer rather large losses which, although infrequent, can be
psychologically difficult to accept as well. Is there a compromise solution to this problem?

We believe there is. An interesting phenomenon we have observed from our research is that it is often
possible to tighten the money management stop a short period after the initial trade entry. It has been our
preference to allow the trade some latitude to work out in the beginning and this is best accomplished
with a relatively large money management stop during the first few days of the trade. However, after a
specific number of days the money management stop can often be reduced to a much smaller amount. For
instance, if we have a $5,000 stop upon entering a trade on the S&P 500 futures market, and this is an
uncomfortably large loss to take, it may be possible to leave the $5,000 stop in place only for the first few
days, and then tighten the stop to $2,500 for the remainder of the trade. The chances of being stopped out
late in the trade with a $5,000 loss have been reduced, although it is always possible that a large adverse
price movement in the first few days could still stop us out with the maximum loss. The exact stop
amounts and the time of implementation would have to be determined by computer and statistical analysis
of the system's characteristics. In some trend-following systems, we have found that we can benefit
substantially by implementing a larger stop in the beginning of a trade, and then reducing the original stop
by 50% or more once the trade is underway.

This technique of tightening stops after a few days in the trade has a sound basis: we know that the
predictiveness of a trade entry indicator declines as the trade moves out into the future. In most cases an
entry indicator has a better chance of predicting the price movement in the next 2 days than in the next 2
weeks. Starting off a trade with a large money management stop allows the trade sufficient room to work
in the right direction, since it corresponds to a period of high confidence in the entry indication. As the
trade moves out into the future, the confidence of the entry indication declines, so we tighten up the stop
to reflect decreasing confidence in the trade.

Other possibilities for dealing with the problem of large stops also exist. Stops such as breakeven stops or
profit protection stops that over-ride the money management stop can easily be implemented in later
stages of the trade. Once these stops are activated, the possibility of taking the large original stop loss is
substantially reduced or eliminated. These and other techniques will be fully discussed in subsequent
chapters.

Conclusion

Proper understanding and implementation of the money management stop is vital to a trader's survival.
The stop effectively limits the maximum loss that may be sustained in a trade, which in turn contributes to
the all-important goal of preservation of capital. Trading without a money management stop is to allow
for a high chance of catastrophic loss in your account.

The importance of the Money Management stop is aptly summed up by Jack Schwager with this
statement from his book, The New Market Wizards: "If you can't take a small loss, sooner or later you
will take the mother of all losses."
*********

Webmasters Report

We are in the process of adding a new feature to the Systems pages on our website. We are enhancing the
Equity chart on our Systems pages with an animation which shows the historical entries and exits plotted
on a year by year continuos contract futures chart. You can now see exactly where the entries and exits
took place for each trade listed on the trade by trade report. The animation will cycle through each chart
for the year and then return to the main Equity chart and start over.

We have also supplied a set of links at the bottom of each chart which you can use if you want to study
any particular year. Clicking on 1994 for instance will launch a smaller browser window with the 1994
chart for that system. So far we have charts for 10 of the 16 systems completed, and the remaining ones
(the Bond Systems) should be up and running before the end of the week.

This exciting new display is up and running and you can go there now. Start on the Systems page and
then pick any system (except bonds for now) to see the new charts.
http://www.traderclub.com/systems.htm

We have also added a small form on the Links page, so that if you want to propose a new link for us to
add you can do so very easily. If you would like to recommend a site that is trading related or something
of use to our members we will be happy to add it to our links page, http://www.traderclub.com/links.htm

Please feel free to contact us with any suggestions and comments about the website. We want to make it
as user friendly and useful to you as we can. mailto:webmaster@traderclub.com

#34 Trailing Stops

This is the Sixth Article in a Series of Articles About Exits

Trailing Stops

By Chuck LeBeau and Terence Tan

Now that we have taken the necessary precautions to avoid catastrophic losses by using disciplined
money management stops, it is appropriate to concentrate on strategies that are designed to accumulate
and retain profits in the market. When properly implemented these strategies are intended to accomplish
two important goals in trade management: they should allow profits to run, while at the same time they
should protect open trade profits.

While their application is extremely wide, we do not believe that trailing stops are appropriate in all
trading circumstances. Most of the trailing exits we will describe are specifically designed to allow profits
to run indefinitely. Therefore they are best used with trend following type systems. In counter-trend
trading, more aggressive exits are more suitable. The ―when you’ve got a profit, take it‖ philosophy
works best when you are trading counter-trend, since the anticipated amount of profits is limited.
However, to take quick profits in a trend is usually an exercise in frustration: we exit the market with a
small profit only to watch the huge trend continue to move in our direction for days or months after our
untimely exit. We therefore recommend using different exit strategies based on the underlying market
condition. We will discuss the more aggressive exits later; for now we will concentrate on exits designed
to accumulate large profits over time.

A thorough understanding of trailing stops is critical for trend-following traders. This is because trend
following is typically associated with a lower percentage of profitable trades; which makes it particularly
important to capture as much profit as possible when those large but infrequent trends occur. Typical
trend followers make most of their profits by capturing only a few infrequent but very large trends, while
managing to cut losses effectively during the more frequent sideways markets.

The rationale behind the use of the trailing stop is based on the anticipation of occasional extremely large
trends and the possibilities of capturing substantial profits during these major trends. If the entry is timely
and the market continues to trend in the direction of the trade, trailing stops are an excellent exit strategy
that can enable us to capture a significant portion of that trend.

The trailing stops we will describe in this and following articles have similar characteristics that are
important to understand as we use them to design our trading systems. Effective trailing stops can
significantly increase the net profits gained in a trend-following system by allowing us to maximize and
capture large profitable trades. The ratio of the average winning trade to the average losing trade is
usually improved substantially by the use of trailing stops. However there are some negative
characteristics of these stops. The number of profitable trades is sometimes reduced since these stops may
allow modestly profitable trades to turn into losers. Also, occasional large retracements in open trade
profits can make the use of these stops quite difficult psychologically. No trader enjoys seeing large
profits reduced to small profits or watching profitable trades become unprofitable.
The Channel Exit

The simplest process for following a trend is to establish a stop that continuously moves in the direction
of the trend using recent highest high or lowest low prices. For example, to follow prices in an uptrend, a
stop may be placed at the lowest low of the last few bars; for a downtrend, the stop is placed at the highest
high of the last few bars. The number of bars used to calculate the highest high or lowest low price
depends on the room we wish to give the trade. The more bars back we use to set the stop, the more room
we give the trade and consequently the larger the retracement of profits before the stop is triggered. Using
a very recent high or low point enables us to take a quick exit on the trade.

This type of trailing stop is commonly referred to as a ―Channel Exit‖. The ―channel‖ name comes from
the appearance of a channel formed from using the highest high of X bars and the lowest low of X bars
for short and long exits respectively. The name also derives from the popular entry strategy that uses these
same points to enter trades on breakouts. Since we are focusing on exits and will be using only one
boundary of the channel, the term ―channel‖ may be a slight misnomer, but we will continue to refer to
these trailing exits by their commonly used name.

For most of our examples we will assume that we are working with daily bars but we could be working
with bars of any magnitude depending on the type of system we are designing. A channel exit is
extremely versatile and can work equally well with weekly bars or five-minute bars. Also keep in mind
that any examples referring to long trades can be equally applicable to short trades.

The implementation of a channel exit is very simple. Suppose we have decided to use a 20-day channel
exit for a long trade. For each day in the trade, we would determine the lowest low price of the last 20
days and place our exit stop at that point. Many traders may place their stops a few points nearer or
further than the actual low price depending on their preferences. As the prices move in the direction of the
trade, the lowest price of the last twenty days continually moves up, thus ―trailing‖ under the trade and
serving to protect some of the profits accumulated. It is important to note that the channel stop moves
only in the direction of the trade but never reverses direction. When prices fall back through the lowest
low price of the last twenty days, the trade is exited using a sell stop order.

The first and obvious question to answer about channel exits is how many bars to use to pick the exit
point. For example, should we set our stop at the lowest low of 5 days or the lowest low of 20 days, or
some other number of days? The answer depends on the objectives of our system. A clearly stated set of
objectives for the system is always very helpful at these important decision points. Do we want a long-
term system with slow exits or do we want a short-term system with quicker exits? A longer channel
length will usually allow more profits to accumulate over a long run if there are big trends. A shorter
channel will usually capture more profits if there are smaller trends. In our research, we have found that
long-term systems generally work well with a trailing exit at the lowest low or the highest high of the last
20 days or more. For intermediate term systems, use the lowest or highest price of between 5 to 20 days.
For short-term systems, the lowest or highest price of between 1 to 5 days is usually optimal.

Trailing stops with a long-term channel accumulate the largest open profits if there is a sustained trend.
However this method will also give back the largest amount of open profits when the stop is eventually
triggered. Using a shorter channel can create a closer stop in order to preserve more open trade profits. As
can be expected, the closer stop often does not allow profits to accumulate as nicely as the longer channel,
and often causes us to be prematurely stopped out of a large trend. However, we have noticed that a very
short channel length of between 1 to 3 bars is still highly effective in trailing a profitable trade in a
runaway trend. The best type of channel exit to use in a runaway trend is a very short channel, for
example 3 bars in length. We have observed that this exit in a strong trend often keeps us in a trade until
we are close to the end of the trend.

It appears that there is a conflict of exit objectives here. A longer channel length will capture more profit
but give back a large proportion of that profit; a shorter channel length will capture less profit, but protect
more of what it has captured. How can we resolve this issue and create an exit that can both accumulate
large profits, as well as protect these profits closely? A very effective exit technique calls for a long-term
channel to be implemented at the beginning of the trade with the length of the channel gradually
shortened as larger profits are accumulated. Once the trade is significantly profitable, or in a strongly
trending move, the goal is to have a very short channel that gives back very little of the large open profit.

Here is an example of how this method might be implemented. At the beginning of a long trade, after
setting our previously described money management stop to avoid any catastrophic losses, we will trail a
stop at the lowest low of the last 20 days. This 20-day channel stop is usually far enough from the trade to
avoid needless whipsaws and keep us in the trade long enough to begin accumulating some worthwhile
profits. At some pre-determined level of profitability, which can be based on a multiple of the average
true-range or some specific dollar amount of open profit, the channel length can be shortened to take us
out of the trade at the lowest low of 10 days. If we are fortunate enough to reach another higher level of
profitability, like 5 average true ranges of profit or some other large dollar amount, we can shorten the
channel further so that we will exit at the lowest low of 5 days. At the highest level of profitability,
perhaps a very rare occurrence, we might even be able to place our exit stop at the previous day’s low to
protect the great profit we have accumulated. As you can see, this strategy allows plenty of room for
profits to accumulate at the beginning of a trade and then tightens up the stops as profits are accumulated.
The larger the profits, the tighter our exit stop. The more we have, the less we want to give back.

There is another way of improving the channel exit that is worthwhile to discuss: this is to contract (or
expand) the traditional channels using the height of the channel, or some multiple of the average true
range. How this might work is as follows: Supposing you are working with a 20-day channel exit. First
you calculate the height of the channel, as measured by the distance between the highest 20-day high and
the lowest 20-day low. Then you contract the channel by increasing the lowest low value and decreasing
the highest high value previously obtained to determine the exit points. For instance, in a long trade, you
could increase the lowest low price by 5% of the channel height or 5% of the average true range, and use
that adjusted price as your exit stop. This creates a slightly tighter stop than the conventional channel.
More importantly, it allows you to execute your trade before the multitude of stops that are already placed
in the market at the 20-day low.

The last point can be considered an important disadvantage of the channel exit. The channel breakout
methods are popular enough to cause a large number of entry and exit stops to be placed at previous
lowest low and highest high prices. This can cause a significant amount of slippage when attempting to
implement these techniques in your own trading. The method of adjusting the actual lowest low or highest
high price by a percentage of the overall channel height or the average true range is one possible way to
move your stops away from the stops placed by the general public and thereby achieve better executions
on your exits.

That's all for this time

Good Luck and Good Trading

#35 Trailing Stops – The
Chandelier Exit
In Bulletin #34 we discussed the Channel Exit which trails a stop based on previous LOW points. In this
Bulletin we will discuss a stop placement strategy that trails our stop based on previous HIGH points.

The Chandelier Exit hangs a trailing stop from either the highest high of the trade or the highest close of
the trade. The distance from the high point to the trailing stop is probably best measured in units of
Average True Range. However the distance from the high point could also be measured in dollars or in
contract based points.

Here are three simple examples: (As usual we will use long side examples. Simply reverse the logic for
short trades.)

1. Place a stop at the highest high since we entered the trade minus three Average True Ranges. 2. Place a
stop at the highest high of the trade minus $1500.00. 3. Place a stop at the highest high of the trade minus
150 points.

The value of this trailing stop is that it moves upward very promptly as higher highs are reached. The
Chandelier name seems appropriate and should help us to remember the logic of this very effective exit.
Just as a chandelier hangs down from the ceiling of a room, the Chandelier Exit hangs down from the
high point or the ceiling of our trade.

The reason we prefer to use units of Average True Range to measure the distance from the high to our
stop is that the ATR is applicable across markets and is adaptive to changes in volatility. We can use the
same formula to trade corn, yen, coffee, or stocks. If the trading ranges expand or contract our stop will
automatically adjust and move to the appropriate level continuously staying in tune with changing market
conditions. (Members who are not already familiar with the many valuable applications of Average True
Range should be sure to review Bulletins #10, 11, 13, and 14.)

In Dr. Van K. Tharp's excellent book, Trade Your Way to Financial Freedom, he refers to a study he
conducted to demonstrate that an effective exit strategy could produce profits even with random entries.
We were not surprised to see that the exit methodology he used to produce the profitable test results
across a diversified portfolio of futures markets was the Chandelier Exit. (Tharp used three ATRs trailing
from the highest or lowest close and used a ten-day exponential moving average to calculate the ATR.)

Protecting Open Profits

When we discussed the Channel Exit in Bulletin #34 we suggested that at the beginning of a trade we
should use a wide stop and then, as profits are accumulated, tighten the stop by reducing the number of
bars in the Channel. The same profit-protection logic can be applied using the Chandelier Exit. At the
beginning of a trade the distance to the stop in most futures markets should probably be in the
neighborhood of 2.5 to 4 Average True Ranges. As the trade becomes increasingly profitable we can
bring the stop closer by reducing the units of ATR from the high to our stop.

Let's assume that we started with 3 ATRs at the beginning of the trade. After we have reached our first
profit level we might tighten the stop to trail the high point at only 1.5 ATRs. After the second profit level
is reached we might want to tighten the trailing stop to only one ATR. We have had good results with
some highly profitable trades by trailing exits as close as a half an ATR. We have found that some
markets have better trending characteristics than others and we prefer to adjust the trailing stops on a
market by market basis so there is no universal formula that we would recommend. The important
message we want to convey is that to capture the maximum profit potential of trend-following trades the
trailing stops need to be tightened as significant profits are accumulated.

Keep in mind that although the highs used to hang the Chandelier move only upward the changes in
volatility can shorten or lengthen the distance to the actual stop. If you want to see less fluctuation in the
stop distance use a longer moving average to calculate ATR. If you want the stop placement to be more
adaptive to changing market conditions, use a shorter moving average. We normally use about twenty
bars to calculate the ATR unless there is a specific reason to adjust it. In our experience the use of very
short averages (3 or 4 bars) for the ATR can often create problems when there are brief periods of small
ranges that tend to bring the stops too close. These abnormally close stops may cause us to exit
prematurely. If we want to have a short and highly adaptive ATR without risking placing stops that are
too close, we can calculate a short average and a longer average (maybe four bars and twenty bars) and
use the average that produces the widest stop. This technique allows our stops to move away quickly
during periods of high volatility without the risk of being unnecessarily whipsawed during brief periods
of low volatility.

Combining the Channel Exit and the Chandelier

We like to start our trades with the trailing Channel Exit and then add the Chandelier Exit after the price
has moved away from our entry point so that the open trade is profitable. The Channel Exit is pegged at a
low point and does not move up as new profits are reached. The Channel Exit will move up only when
enough time has passed that the previous low is dropped from the data period of the channel. The Channel
Exit moves up very gradually over time but it does not move up relative to any recent highs that are being
made. This is why we need the Chandelier Exit in place to make sure that our exits are never too far away
from the high point of the trade.

By combining the two exit techniques we can use the Channel Exit as an appropriate stop that very
gradually rises at the beginning of the trade. However if the trade makes a run in our favor the prices will
quickly move very far away from our slowly trailing Channel Exit. Once we are profitable we need to
have a better exit that protects more of our profit. At this point it would make sense to switch to the
Chandelier Exit which will rise instantly whenever new highs are reached. This valuable feature of the
Chandelier makes it one of our most logical exits from our profitable trades.
As you can see, the Chandelier Exit is a very useful tool. However coding the Chandelier Exit in
TradeStation is not necessarily a straightforward matter. For the convenience of our members we are
posting the TradeStation code on our web site at:

http://www.traderclub.com/toolkit.htm#chandelier

That's all for this time

Good Luck and Good Trading

Chuck

#37 How to Buy on Dips

and Sell on Rallies
Entries - How to Buy on Dips and Sell on Rallies

Those members who have purchased our systems will quickly acknowledge that we have a fondness for
trading systems that go long on dips and short on rallies. We have developed at least one system with that
strategy in each of the markets we trade. In the S&P market and the Bond market we have developed
more than one system that takes this preferred approach.

The benefits of buying into an uptrend on dips and selling into a downtrend on rallies are probably
obvious. If we compare the dips and rallies approach to entering on breakouts we can see that the "dips"
entry strategy allows us to enter at cheaper prices with less risk and more profit potential. That is a nice
combination of benefits. In this Bulletin we will share some of our conclusions from our many hours of
research on how to identify these potentially profitable opportunities.

First, the strategy is going to work best if there is a trend. (Lets simplify things by using examples only
for the long side. Unless otherwise noted you can assume the procedure for selling short is just the
opposite.) Trend identification is a big topic in its own right but for our purposes we don't have to come
up with anything fancy. The direction of a moving average or the relationship of two moving averages
will work just fine. We could also take a simple momentum approach and require that the close today
must be a minimum amount higher than it was X days ago. For example, we might want the close to be
more than three ATRs higher than the close twenty days ago. When we were at Dr. Elder's Trader Camp
he recommended that stock traders should look for both a rising 22 week moving average and a rising 22
day moving average. That's an excellent suggestion. We have found that the specific method of
identifying the direction of the trend is not critical to the success of the system. In fact we have used a
different method of measuring the trend in each of our systems. If you already have a favorite definition
of trend by all means use that.

Once the direction of the trend is established we need to go to work on defining a "dip". Now here is a
valuable tip: The stronger the trend the smaller the dips. This seems obvious once it is pointed out but we
see too many traders overlooking this important concept. They typically want to get long in an uptrend
when some oscillator like RSI or Stochastics is "oversold". We have found that oscillators only reach
oversold levels when the market is weak or trendless. The ideal "dip" entry is a very small dip in a very
strong uptrend. These ideal trades have the lowest risk and the highest profit potential.

Fortunately we don't necessarily have to know the exact strength of the trend because we can define a
minimum definition of "dip" so that we can catch small dips as well as any bigger dips. This procedure
will allow us to catch the ideal trades as well as those highly profitable trades that are less than ideal. The
most important point to remember here is that if we demand too great a dip we will be missing some of
the best trades.

Here are a just few ideas on how we might define a minimum dip: 1. The close today (or the low today) is
1 ATR or more below the close (or the high) 3 or 4 days (or bars) ago. 2. The RSI has declined 10 points
or more from its high 3 or 4 days ago. 3. The low of the last 2 or 3 days has gone below the 7 day moving
average. 4. A recent low has penetrated below some moving average of lows. 5. Some oscillator like RSI
or Stochastics has gone below a threshold level (like 50 or 60). Remember: We don't expect it to reach
oversold levels. 6. The Plus DI (part of the ADX indicator) has declined some amount from its peak. 7.
The Minus DI has risen some amount from its low. 8. The slope of a short term moving average has
turned down.

I'm sure that with a little thought you could add extensively to this list. It is important to understand that
we do not necessarily enter once the dip has reached the minimum level. We think that we can obtain a
higher percentage of winning trades by waiting for some entry "trigger" that will signal that the "dip" is
over and that the prevailing up trend has resumed. The minimum "dip" is merely a setup condition and we
want some indication of strength to actually initiate the trade.

Here are a few possible entry triggers: 1. Place a buy stop at yesterday's high. 2. Place a buy stop at X
points or some fraction (0.4?) of ATR above tomorrow's open. 3. Place a buy stop some unit of ATR
above the lowest low of the last 3 days. 4. Enter if the close tomorrow is X points above the open. 5.
Enter when the close is the highest close of the last 3 days. 6. Enter on a higher close when the daily range
has expanded. (Today's True range is greater than the 3 day ATR.) 7. After an inside day enter at the high
of two days ago. 8. Enter on a stop at the 3-day moving average of the highs.

There are lots of possibilities but you will notice that in each of these situations we are not trying to buy
on the lows. What we want to see is some evidence that the correction is over and that the trend has
resumed. This form of trigger along with our reliable identification of the underlying trend will give our
trades a very high probability of success. Many skeptics assume that our systems obtain unusually high
winning percentages from excessive optimization. We believe the high winning percentages are obtained
from the sound logic of making sure that we are headed in the right direction at the very beginning of
each trade. If we are making sure that the short, intermediate and long term trends are all going in our
favor we should expect to have our trades showing profits right from the start. Whether or not they are
profitable when we exit will eventually depend on the quality of our exit strategies.

In addition to the contribution to a high winning percentage our entry triggers also allow us to take
advantage of setting our "dip" levels at the minimum. Very often our entry will not be triggered until the
dip has gone well below the minimum level. You will notice that we have not tried to forecast the exact
low of the dip. We will be happy to initiate the trade at any level once the minimum has been reached.

If you are a day trader reading this Bulletin simply substitute the word "bars" whenever I have referred to
"days". Very short term day traders may want to go ahead and enter "at the market" once the minimum
threshold has been reached because the system as described will be giving up some potential profits
waiting for signs of strength to trigger the entry. When you are trading short term you need to maximize
the profits, perhaps at the expense of sacrificing a few points off the winning percentage. Longer-term
traders are better off taking the recommended entry triggers and maximizing their profits by using more
patient exits.

In a future Bulletin we will present some ideas on how to measure the actual strength of the trend rather
than just the direction. Once the strength of the trend is measured then perhaps we can adjust our entries
to make them even more accurate. We will also share some of our work on distinguishing between dips
and trend reversals. Although we are not yet as proficient at this as we would like to be we have made
enough progress to incorporate a filter into the Millennium ED System that helps us to avoid some dips
that turned out to be reversals. We would hope to make more progress in this area as our research
continues.

Chuck

#38 Discretionary Traders

Discretionary Traders - Don't Talk About Your Open Positions

In browsing around the web I often encounter discussions of the merits of a particular trade and opinions
about the direction of a market. I know that the traders who voice these opinions have good intentions and
much of the discussions could be helpful to the person receiving the information. (Some of these
discussions are on our Forum.) However the provider of the opinion must be very careful that he doesn't
start believing too strongly in his position because he has made the mistake of going public with it.

This is an important psychological issue that I seldom see discussed. Taking losses is always difficult and
the reluctance to promptly acknowledge that we are on the wrong side of the market is probably the single
most costly error a trader can make. Even under the best of conditions we hate to take losses. Publicly
advocating a particular trade or the direction of a market just makes being wrong all the more painful and
harder to accept. If we make it a policy to go around advocating the merits of our trades it will only make
it harder to recognize when we are wrong.

Many years ago when I was a young futures broker at E. F. Hutton and Company, the firm decided that it
would be a good idea to send our commodity research analysts on the road whenever they came up with a
well researched idea that appeared to have great potential. Let's assume for a minute that our sugar analyst
has decided that sugar is going to make a big move to the upside over the next six months. After
publishing his research he would be sent from city to city where he would speak at meetings for brokers
and clients suggesting why everyone should be buying sugar. At first the analyst road shows seemed like
a great idea. The clients received the benefit of hearing about a well-researched idea straight from the
analyst himself and also had the opportunity to ask questions and engage the analyst in a discussion of the
details of the sugar market. The clients enjoyed the meetings and a lot of new commodity business was
generated as a result.

However, it turns out that the objectivity of the analysts was completely lost after the story had been told
and the bullish scenario presented a dozen times or more. The analyst felt obligated to the firm and to the
clients. The firm had spent a lot of money to send the analyst on the road and to host these meeting all
over the country. As a result of the meetings the clients now knew the analysts by name and his personal
and professional reputation was clearly on the line. This analyst was now committed and he was going to
be bullish on sugar regardless of what happened in the market or what new information came to light.
From the point of the tours onward the analyst would only look for information to support his opinion. To
ever admit that he was wrong would be such public humiliation that the analyst would tend to ignore any
contrary information and would stick to his original position through thick and thin. We eventually
learned that the talented Hutton research analysts did a much better job when they were free to change
their minds as new facts were revealed without the pressure and responsibility generated by their repeated
espousing of a particular position on a specific trade.

Discretionary traders should learn from this example and avoid discussing their open positions or their
opinion about the direction of a market. It will only distort their objectivity and make it harder to take a
loss promptly when that is the best course of action. Losses that only we know about are tough enough
but losses that everyone knows about become much harder to stomach and we tend to postpone our exits
in hope that the market will eventually turn around and prove us right. Remember that the best
discretionary traders are usually very neutral about their positions and tend to take their guidance from the
price action and the flow of new information. Its OK to listen to others talk about their positions but don't
make it a habit of discussing your open trades. It will only cost you money, especially if you repeat your
opinions often enough that you might actually start believing what you are saying.

Fortunately, systematic traders seldom get married to a position. They enjoy the luxury of being able to
blame the system if a trade doesn't work out. Since there is little personal attachment to any trade, the
psychological problems of systematic trader are much different than those of discretionary traders. But
even systematic traders have their share of psychological problems. Perhaps we can discuss some of these
problems in a future Bulletin.
That's All for now,

Chuck Le Beau

#39 Some Practical Thoughts

About Money Management
We get a lot of questions about various complex money management (MM) formulas and our preferences.
We don't comment on this subject very often because money management is such a personal issue that it
would be impossible to give any universal advice that would be specific enough to have value. Everyone
seems to have different goals and tolerances for risk, not to mention varying amounts of capital for
trading.

However we do have some basic thoughts and opinions that might be helpful in picking a suitable MM
strategy that will help you to become a winner.

Be careful about trying to use formulas that are designed to optimize the returns. In my experience I have
found that the most successful traders, over the long run, are not seeking to maximize their returns. The
best traders are always seeking to carefully control their risks and to achieve as much consistency as
possible. They look for methods to achieve consistent returns with low drawdowns and they are willing to
accept smaller returns in the process. My policy has always been to worry about the risk and the
consistency first and then to accept whatever returns that prudent approach will allow. I'm sure I will
never win any trading contests and I have never bothered to enter one. In my opinion, no one should ever
trade like the winner of a trading contest. I apologize for getting off on a different subject here. Lets get
back on track and talk about trading in the only contest that matters - the trading that you do every day.

In recent years the strategy of risking a small percentage of capital on each trade has become quite
popular and deservedly so. This MM strategy, often referred to as fixed fractional trading, reduces our
dollar amount of risk as we experience losses and increases our risk level as we earn profits. The
possibility of ever going to zero with such a strategy is virtually nonexistent. However this strategy has an
inherent weakness that tends to constantly work against us. If we assume an equal number of winners or
losers in a sequence this popular strategy produces net losses if the winners are not larger than the losers.
To keep things very simple lets just look at a series of five wins followed by five losses with the wins
being equal to the amount we risk. Lets also keep the math really simple and begin with starting capital of
100 and risk 5% of our current capital on each trade. I think that most traders would assume that if they
had five losers followed by five winners they would be even. Unfortunately that is not the case.

Here are the numbers: Risk is always 5% of current capital. (I'm going to round the numbers to two
decimals.)
Capital $ Risk W/L Account balance
100.0 5.00 L 95.00
95.00 4.75 L 90.25
90.25 4.51 L 85.74
85.74 4.29 L 81.45
81.45 4.07 L 77.38

OK we are already tired of losing. Let's have five winners in a row and see if we can get our money back.

Capital $ Risk W/L Account balance

77.38 3.87 W 81.25
81.25 4.06 W 85.31
85.31 4.27 W 89.58
89.58 4.48 W 94.06
94.06 4.70 W 98.76

As you can see we had an equal number of winners and losers yet somehow we lost money. Perhaps it is
because we had bad luck and got started in the wrong direction. Lets reverse the sequence of trades so that
we start out on a winning streak instead of losing. Maybe that will help.

Capital $ Risk W/L Account balance

100.00 5.00 W 105.00
105.00 5.25 W 110.25
110.25 5.51 W 115.76
115.76 5.79 W 121.55
121.55 6.08 W 127.63

Looks good so far. Starting off with winners looks much better than starting with losses. But now we
have five losers coming up.

Capital $ Risk W/L Account balance

127.63 6.38 L 121.25
121.25 6.06 L 115.19
115.19 5.76 L 109.43
109.43 5.47 L 103.96
103.96 5.20 L 98.76

Hmmm. It doesn't seem to matter if we start out with a string of winners or a string of losses. Somehow
we wound up losing the same amount of money either way.

Obviously we don't have a very good system at work here but it is not a losing system. With the proper
MM strategy we should break even. Our winning trades are only equal to our risk and to have a winning
system the winners need to be bigger than the losers. We are winning on only half of our trades and we
would be profitable if we could win on more than half. Even though our system is not a good one you
would think that it would at least be a breakeven proposition (we haven't included any costs) because the
winners are always equal to the amount at risk and we win 50% of the time. That sounds like a breakeven
system, doesn't it? But if we employ the popular money management strategy of risking a fixed
percentage of our current capital we manage to turn the system into a loser. However, if we risked a fixed
dollar amount on each trade the system results would improve and we would break even.

The fixed percentage of risk approach to MM is a good one because it keeps us from going broke and it
compounds our profits rapidly. Both of those are desirable characteristics but we need to be aware that
they come at a price. We should realize that our recovery from drawdowns might not be as fast as we
would like and that we can give back profits even faster than we made them.

One strategy that can help solve the problem of giving back the profits too rapidly is to periodically sweep
some of the profits out of the account and place them in some other place where they are adding to our
diversification and reducing our risk. Now and then we should take some of the profits out and spend
them on something that improves our quality of life. This important step gives the dollars at stake a new
meaning and boosts our morale tremendously. What is the point of winning and losing and accumulating
profits only to give them back at some later date? If we make it a practice to routinely sweep some of the
profits our account will continue to grow but it will be compounding at a slower rate than if we left our
profits at risk. However if we stumble into a losing streak we will be glad that we took out some of the
profits and reduced our bet size.

If we are good traders and we make it a practice to withdraw some of our profits on a regular basis we
will eventually reach the point where we have taken out more than we started with. There are very few
traders, particularly in futures, who can claim that they have truly beaten the market. Until you have taken
out more than you started with the market can still beat you. Trading futures is a zero sum game and
winners are few and far between. Taking out profits now and then rather than getting carried away trying
to optimize the gains to infinity is contrary to what is being taught these days. Everyone is obsessed with
finding formulas to optimize the returns. We need to remember that the trader who has the optimum gains
today could easily be tomorrow's biggest loser. That is a game we don't need to play.

I think we all need to take a step or two back and look at the big picture. Trading is not really just a game.
The money is real. Lets make sure that we are true winners and not just habitual players. Take some
profits now and then and put them out of harms way. When we have done this I can assure you that the
game is a lot more fun and our trading will improve. Nothing builds confidence like knowing for sure that
you are indeed a winner.

*****

Chuck Needs Some Help

We have been busy doing research on stock trading systems. We think that stock traders, particularly in
these volatile markets, might benefit from some of our trading experience and attention to exits. In order
to offer these systems for sale we need to present some kind of track record. That is not as easy as it
sounds. Our systems work well on a lot of stocks but not all of them. It is very easy to select stocks where
the system works just fine but that would not be a fair representation. As you would expect we want to
make sure we fairly represent our research. We want to present the results of the systems over some group
of stocks that will fairly illustrate the results without using hindsight in the selection. We want to show
both winners and losers. We would welcome suggestions from members as to how we can fairly represent
the results of a stock trading system. Please send me an e-mail if you have any ideas. You can send your
ideas to me directly at Traderclub@aol.com. I will also start a thread on the Forum at
http://www.traderclub.com/discus/board.html

Any help would be appreciated. If we use your idea of how to express the historical performance results
we will be happy to send you a complimentary copy of the first trading system.

#40 Why Use Multiple

Exits?

A recent message from one of our members questioned our use of multiple exits and the fact that the exits
in a particular system were very complex and would sometimes move closer to the prices and then
suddenly move farther away. The member questioned whether the exits were working properly and
wondered about the logic of having so many different exit strategies operating within one system. I sent
the member a brief reply and promised to write a Bulletin that explained our philosophy and procedures
about the use of multiple exits in more detail.

When we develop trading systems the entry is usually just a few lines of code but the exit strategies and
coding are often very complex. We may have a system with only one very simple entry method and that
system may have a dozen or more exit strategies. The reason for devoting so much effort and attention to
achieving accurate exits is that over our many years of trading we have come to appreciate both the
importance and the difficulty of accurate exits.

Entries are easy. Before we enter any trade we know exactly what has occurred up to that point and if
those conditions and events are satisfactory according to the rules of our system we can generate a valid
entry signal. Entries are easy because we are able to set all the conditions and the market must conform to
our rules or nothing happens. However, once we have entered a trade anything can happen. Now that we
are in the market the possible scenarios for what might happen to our open position are endless. It would
be extremely naïve to expect to hope to efficiently deal with all possible trading events with only one or
two simple exit strategies. However, that seems to be the common practice and, in fact, many popular
trading systems simply reverse the entry rules to generate their exits.

We believe that good exits require a great deal of planning and foresight and that simple exits will not be
nearly as efficient as a series of well planned exits that allow for a multitude of possibilities. Our exit
strategies need to accomplish a series of critical tasks. We want to protect our capital against any
catastrophic losses so we need a dependable money management exit that limits the size of our loss
without getting whipsawed. Then if the trade is working in our favor we would like to move the exit
closer so that the risk to our capital is reduced or eliminated. As soon as possible we need to have a
"breakeven" exit in place that prevents our profitable trade from turning into a loss.

In most of our systems, our goal is to maximize the size of our profit on each trade so we do not simply
take a small profit once we see it. This goal means that we need to implement an exit strategy that
protects a portion of our small profit while allowing the trade to have the opportunity to become a much
bigger profit. If the trade went in our favor every day the exits could be greatly simplified but
unfortunately that is not the way markets typically trade. We have to allow room for some minor
fluctuations on a day to day basis. In order to facilitate our objective of maximizing the profit of each
trade, in some cases we may decide to move our exit point farther away to avoid getting stopped out
prematurely. For example, lets look at our Yo Yo exit that is based on the theory that we never want to
stay in a position after a severe one-day move against us. (See Bulletin number 14 for an explanation of
the Yo Yo exit.)

This highly efficient exit is based on measuring the amount of price movement from the previous day's
close. For example we may want to exit immediately if the adverse price movement reaches one and a
half Average True Ranges from the previous close. This volatility-based exit will move away indefinitely
as the result of a series of adverse closing prices caused by days where the price moved against us but our
volatility trigger was never quite reached. Obviously an exit that can move away from prices indefinitely
is no use at all in limiting the size of our losses so the Yo Yo exit must always be used in conjunction
with other exit strategies that do not move away. Now that we have implemented the Yo Yo exit to
protect our trade from a severe one-day reversal in direction, we have still not addressed the question of
taking profits. So far, we have exits in place to protect from large losses, to lock in a break-even point and
to get us out on a sudden trend reversal but we still have not addressed the important issue of taking some
profits on the trade.

We like to shoot for big profits and the bigger the profits become the closer we like to protect them. This
strategy calls for multiple profit-taking exits. If we have a $1,000 profit we might want to protect 50% of
it and be willing to give back $500 of our open profit. We can place an exit at $500 above our entry price.
This will allow us to hold the position in the hope that the profit will grow. However if we have a $10,000
open profit I'm sure we wouldn't want to give back 50% of that. Also, let's hope that our exit stop is not
still sitting back there at $500 above our entry price. For best results our exits need to adjust at various
levels of profitability.
Many traders have asked us about the robustness of a system that has a many exit rules. The general
perception is that a system with fewer rules is likely to be more robust. However I would disagree with
applying that common belief without careful thought. Look at the exits in these two over-simplified
systems:

System A:
Use a $1500 money management stop. (Limits loss to $1500.)
When profit reaches $5,000, exit with a stop at entry plus $4500.

System B:
Use a $1500 money management stop. (Limits loss to $1500.00)
When profit reaches $1,000, exit with a stop at entry price.
When profit reaches $2,000, exit with a stop at entry plus $1,250.
When profit reaches $3,500, exit with a stop at entry plus $2,500.
When profit reaches $5,000, exit with a stop at entry plus $4500.
When profit is greater than $7,500 exit with a stop at the previous day's low.

Some system traders might argue that since system A has fewer rules it should be more robust (most
likely to work in the future.) We would suggest that system B is much more likely to work in the future
even though it has more rules. System A is not going to make any money at all if the open profit never
reaches $5,000. Once the profit exceeds $5,000 the only exit is at the $4,500 level. System A is very
limited in what it is prepared for. It either makes $4,500 or it loses $1500.

As you can see, system B is obviously prepared for many more possibilities. It is conceivable (but not
likely) that system A may somehow produce better test results on a historical basis because of an
accidental (or intentional) curve fit. However, we would much rather trade our real money with system B.
Simpler is not always better when it comes to exit planning.

#41 Doubly Adaptive

Profit Objectives
Having well-planned profit objectives is the best way to maximize closed-out profits. The tendency is to
either take profits too soon or too late and most traders tend to err on the side of taking profits too soon.
Taking a quick profit always feels good and helps to maintain our winning percentage because these
"nailed-down" profits will never turn into losses. However, taking profits too soon can be one of the most
costly of all possible mistakes.
It has been argued that profits in trading (especially in futures) are possible because the distribution of
prices is not normal and is not a typical bell-shaped curve. The tail on the right hand side tends to be
surprisingly thick indicating that unexpectedly large profits are possible. The opportunity for large profits
comes our way more often than one might expect. However if we went for big profits on every trade we
would also be making a big mistake. Major profit opportunities are the exception not the rule.

In very general terms there are two ways of having an advantage or "edge" in trading. One is to have
gains much larger than losses and the other is to have more winners than losers. To succeed as traders we
need to do our best to maximize both the percentage of winners and the size of the winners. These two
worthy goals appear to be mutually exclusive. If we take the quick small profits we can have a good
winning percentage but we eliminate any possibility of more substantial profits. However, if we fail to
take some of the small profits they may well turn into losses.

Wouldn't it be ideal if we could know when it was best to take small profits and when it was best to hold
patiently for big profits?

In previous Bulletins we have discussed the advantages of using profit objectives expressed in units of
Average True Range. To quickly summarize that discussion, the ATR expands and contracts with the
volatility of the market. In a quiet market a profit objective of 2 ATRs might bring us a profit of $600. In
a very volatile market, two ATRs of profit might be $1400 or more. By expressing our profit goals in
terms of ATRs instead of fixed dollar amounts we make them highly adaptive to what is going on in the
market in terms of variations in volatility. However, what we will propose in this Bulletin goes a big step
beyond that highly recommended procedure.

We have done a great deal of research using the Average Directional Index (ADX) that leads us to believe
it is possible to vary our exit strategy to stay in tune with the trendiness of the market as well as the
volatility. By having a doubly adaptive profit-taking strategy we can happily accept small profits when
that is the best the market has to offer or we can change the strategy and hold out for unusually large
profits when those opportunities are known to be present.

Volatility as measured by ATR is obviously important but daily volatility does not always relate to
direction and trendiness. It is quite possible that we can have lots of big ranges in a market that is merely
going sideways or we could have small ranges in a market that is highly directional. It is the correct
combination of directional price movement and volatility that will allow us to maximize our profits in
relation to what is happening in the market at any given time. For the best possible results we want to
combine our knowledge of ATR and ADX.

As we have described in previous Bulletins, ADX tells us the underlying strength of any trend. When the
trend is strong the ADX will rise. When the trend is weak the ADX will decline. This is true in stocks as
well as in futures. It also applies in downtrends as well as in uptrends. A rising ADX means a
strengthening trend and a declining ADX means a weakening trend.

Let's go back to our earlier example where our plan was to take our profits at the 2ATR level. With this
adaptation to volatility we are counting on the changes in volatility to produce large profits and small
profits based on a constant target of two ATRs of profit. However we can go a step further and get even
better results. Under our new plan, when the ADX is declining we will reduce our expectations and accept
profits of only 1.5 ATRs instead of two. And when the ADX is rising we will double our expectations and
wait for profits of 4 ATRs instead of 2. Now we are adapting our exit strategy to both the current
volatility and to the amount of trendiness in the market we are trading. As you might expect the difference
in results is dramatic because our profit-taking strategy is doubly adaptive.

The logic of this strategy should be obvious. When the market is not trending strongly we improve our
results by reducing our profit expectations and maintaining our winning percentage. When the market is
trending strongly we know it is time to abandon our small profit targets and time to take advantage of
some unusually large profit opportunities.

The examples of 1.5 ATRs as a profit target in a non-rending market and 4 ATRs as a profit target in a
strong trending market are just broad guidelines and we need to vary these parameters depending on the
particular market and type of system we are operating. Short-term systems may require smaller objectives
and long-term systems may require much larger objectives.

We suggest you start with a 20 day ATR and a 14 to 18 day ADX. Play around with the units of profit
and see what a dramatic improvement you can make in your trading results by combining ADX and ATR.

#42 Trading Messages

from Mars
Systems Traders Club members who have read our book or who have attended a few of our lectures will
immediately recognize this headline as the subject of one of our favorite trading stories. A recent
marketing campaign by INO.com to sell the videotape of our presentation at last year's TAG conference
featured a bold headline about this story and we have received many inquiries from members asking what
it was all about. The marketing headline reads: "Find Out How One Trader Made a Fortune in the
Markets Using a Coke Bottle and Messages from Mars"

Many of our members have never heard this story. It happens to be a true story, which contains a very
valuable trading lesson that has influenced my trading for many years now. We thought the story might
make an interesting topic for this Bulletin. Here is the story:

Back in the late 1960s I was a young commodity broker at E. F. Hutton and Company. Our office was a
brand new high-tech office (for its time) which was considered the "flagship office" for E. F. Hutton. In
this office about thirty brokers and as many clients shared one very large boardroom and there were no
private offices. The brokers had elegant and expensive desks and the clients had a comfortable seating
area in the front of the office where they could hang out and watch the tapes and monitor our state of the
art commodity "clacker board".

Sitting at my desk near the front of the boardroom I could read my Wall Street Journal and keep track of
the commodity markets without looking at the board. By just listening to the rhythm and tempo of the
mechanical clicks as the prices changed I could easily tell when anything important was going on because
the tempo of the clicks would increase noticeably.

Just in front of my desk were a half dozen comfortable sofas facing a high mahogany paneled wall with
the tapes and the "clacker board". A gallery of traders, mostly retired "old timers" who were trading real
commodities like grains and pork bellies, lounged around on the sofas plotting their charts and talking
about life and the markets. They typically arrived early to get a good seat in their usual spot and then
spent the day trading, exchanging commentaries and offering unsolicited advice to one another on any
subject. For the most part they were a very sociable group who would take coffee breaks together and
greeted each other on a first name basis. These traders enjoyed the elegant atmosphere and treated our
well-appointed boardroom as their private men's club. (Were you aware that women were not allowed to
trade commodities back in those days? My how times have changed!)

However, one of these "old timers" kept to himself and was not interested in becoming a member of the
friendly and often boisterous social circle. He usually sat quietly by himself intently watching the price
changes on the commodity board and holding an old glass Coca-Cola bottle up near his ear. The vintage
shaped Coke bottle had been emptied many years before and now contained only a 12-inch tube of bent
and broken radio antennae which extended awkwardly out of the top of the bottle.

Keep in mind that in the 1960s no one had yet heard of cell phones so the purpose of this Coke bottle was
a real mystery to everyone. When the trader would talk to the bottle from time to time all the heads would
turn and the traders nearby would try to listen to the conversation. But the trader spoke very softly and no
one was able to eavesdrop on his conversations with the bottle.

The traders knew that the fellow with the coke bottle was a client of mine and eventually a representative
of the group came to me and explained that they were extremely puzzled about this guy and his Coke
bottle and asked me if I knew what was going on. I didn't know the purpose or meaning of the Coke bottle
but I was as curious as anyone was and I promised I would find out. The next time the client came back to
my desk I promptly placed his order and then politely asked him about the Coke bottle.

With a serious expression and no embarrassment he explained to me that the Coke bottle was an inter-
planetary communication device that had been given to him by aliens. He said that the aliens were very
interested in our commodity markets and they often gave him trading advice from their various
observation points on other planets. He said that he had just had a message from Mars and they were
buying soybeans so he had also purchased soybeans. After revealing his unique trading methodology he
returned to his seat and resumed his whispered conversations with the Coke bottle.

As soon as I revealed my discovery of the meaning of the Coke bottle to the other traders, all attention
was immediately focused on the Coke bottle trader and the soybean market. The soybean market
proceeded to go the wrong way and the trade from Mars was eventually closed out at a loss. The other
traders were had no sympathy and were quick to begin ridiculing the the trader and poke fun at his beliefs.
The next trade however turned out to be a big winner and the Coke bottle trader went from sofa to sofa
telling his story and pointing to the clacker board while waiving his Coke bottle and bragging about the
profitability of his most recent message from outer space. Because he was making money now his
previous critics had to endure his bragging about his success on the current winning trade.

As time went on and a few winning and losing trades later a clear pattern of behavior began to emerge.
The Coke bottle trader was ridiculed unmercifully on his losing trades but was able to get his revenge and
the last laugh during the winning trades. This trader might have been a little bit crazy but he wasn't stupid.
He soon learned that his only defense against ridicule was to hold on to winning trades as long as possible
and to quickly get out of his losses. As long as he was sitting on his sofa with a winning trade no one
could tell him he was crazy and make cruel jokes about his messages from Mars. In fact while he was
winning he was quick to wander around the room and ridicule the methods of the other traders who were
not making as much money as he was. He displayed the profits in his trading account as hard evidence of
the validity of his methods and offered copies of his statements as irrefutable proof that he was getting
valuable advice from his alien contacts. Who could argue when his advice from other planets was
obviously working?

As a young broker this experience and the first hand observation of the Coke bottle trader who suddenly
became profitable gave me my first important lesson about the importance of exits. I knew the entry
signals had nothing at all to do with his success. His batting average was not any better than that of any
other trader. However, this crazy old trader seemed to be able to make money consistently while other
traders with more "sanity" and more valid entry methods were losing. Before long I was able to recognize
that this man had become a successful trader simply by his efforts to avoid ridicule. He knew that he was
vulnerable during his losing trades so he closed them out very promptly. His winning trades became his
shield against the ridicule of the other traders and he kept his winners much longer than before his
unorthodox methods were revealed.

In the many years since this experience I have encountered many claims of success for entry methods that
probably have even less validity than the Coke bottle messages. I have learned to look only briefly at the
entries of winning traders and to examine their exit strategies very carefully. I am very fortunate that more
than thirty years ago I learned from the Coke bottle trader that success in trading depends on our exits and
not our entries.
#43 Moving Average Crossovers
May Not Be the Best Entry
Signals
There are many ways of using moving averages to trade but by far the most common method is to trade
when a short-term moving average crosses over a longer term moving average. For example, if the 10-day
MA crosses above the 30-day MA we typically assume that we have a new buy signal.

Let's stop for a minute and think about what exactly is occurring at the point of a crossover. When the 10-
day MA and the 30-day MA are at the same price, the trend is not nearly as clear as it should be. What we
are really observing at the crossover point is that the average of the last 30 prices is exactly the same as
the average of the last 10 prices. If we are looking for trends to trade, this equal relationship of the two
moving averages is not a reliable or logical indication of a trend. In an upward trending market the
average prices over the last 10 days should be much higher than the average of the last 30 days. By
implementing new trades at crossover points we are limiting our trading to points that may not clearly
reflect what we should be doing. For best results in a trend-following system we want to be trading when
the trend is clear and reliable; not when the trend is confused and questionable.

Instead of trading at crossovers we should be implementing our trades when the moving averages are
parallel or when the short-term moving average is moving farther away from the longer-term moving
average. Perhaps the short term MA should remain a minimum of some units of Average True Range
above the longer term MA for several days. I believe that this procedure would give us more reliable and
more frequent entry signals in the direction of the prevailing trend, which is exactly what we want. To
identify the most reliable trends we want to see the slopes of various moving averages all moving steadily
in the same direction and not crossing back and forth.

Take a look at a chart of any market with a strong trend. You will see that the moving averages are not
crossing back and forth repeatedly. They will be moving in the same general direction in a more or less
parallel fashion. Now look at a chart of a non-trending market. As this market moves sideways the
moving averages will be crossing back and forth very frequently. Look at the implications of this simple
examination of the charts. If we are trading the crossovers we will be trading most frequently in non-
trending markets and trading most infrequently in strongly trending markets. Is that what we want? No,
it's obviously not what we want. We want just the opposite. We want frequent entry opportunities in
trending markets and we want to avoid as many trades as possible in non-trending markets.

The error in the logic of trading moving average crossovers also extends to some interpretations of
MACD (Moving Average Convergence and Divergence) and DMI (Directional Movement Indicator). If
we are looking at MACD we want to see both lines (each line reflects a moving average relationship)
moving in the same direction. We don't want to see them crossing. When looking at DMI we want to see
the Plus DI lines and the Minus DI lines moving in opposite directions and definitely not crossing.
Remember, when the Plus DI and the Minus DI lines intersect it is telling us that the market is in balance
and has no direction; the amount of upward and downward directional movement are exactly equal. What
makes our favorite indicator, the ADX, so effective is that it rises only when the Plus DI and the Minus
DI are moving in opposite directions and the distance between the two indicators is widening.

With a little thought and effort I'm sure we can design some reliable entry signals that are based on
moving averages but avoid the typical crossover signals. For example we could measure the slope of
several moving averages and when all the averages slope upward we would have a buy signal.

We could also measure the distance between several moving averages and implement our trades when the
averages are all headed in the same direction but start getting farther apart. This procedure would give us
a series of entry signals within the same original trend. This should provide an excellent entry and re-
entry strategy.

Give these suggestions some thought and see what ideas you come up with. Post your comments and
ideas on our FORUM at http://www.traderclub.com/discus/board.html. I'm sure we will have an
interesting discussion.

Chuck Le Beau's System Traders Club

#44 Switch Time Frames for

Better Exits
I just returned from a weeklong Trader's Camp hosted by Dr. Alexander Elder in a beautiful island nation
in the South Pacific called Vanuatu. When I studied geography in school many years ago, Vanuatu was
known as the New Hebrides islands. Vanuatu is located about 1,000 miles west of Fiji.

If you have read Elder's excellent book, Trading For A Living, you will recall that Dr. Elder is an
advocate of using multiple time frames for trading both stocks and futures. For example, he suggests
looking at the weekly chart to make sure that the weekly trend is firmly up before trading the long side of
a market based on the daily chart patterns. This approach makes good sense and I highly recommend his
book and his strategy.

While listening to Dr. Elder explain his multiple time frame strategy for entries, my thoughts wandered to
the application of his ideas to my favorite subject - exits. One of my goals in trading is to find exit
strategies that do a good job of protecting open profits. One method of accomplishing this goal is to
simply move the daily stops closer once a specific profit objective has been reached. However, it might
also make sense to simply switch to a chart with a shorter time frame once we have reached a reasonable
profit objective.

Here is an example of how such a strategy might work. Let's say that we have been trading XYZ stock on
an intermediate term basis using daily charts. The trade is working out very well and we now have six
ATRs of open profit. (See previous Bulletins for an explanation of how to use Average True Range to set
profit targets). Up to this point we have been using our well-known Chandelier trailing stop placed at 3
ATRs below the high point of the trade.

However, now that we have reached our primary profit objective we want to tighten up our stop to protect
more of our profits. We could reduce our Chandelier stop from 3 ATRs to 2 ATRs and continue using the
daily bars or we could switch our chart to one hour bars and continue to trail the Chandelier exit at 3
ATRs based on the intraday one-hour bars. The basic idea is to switch to a chart with a shorter time frame
once we have reached our profit objective. This procedure should allow us to let our profits continue to
run but we would be protecting our open profits with much closer stops by using the chart with a much
shorter time frame.

Combining our exit strategy with Dr. Elder's entry strategy would provide the following sequence: for
entries we first examine the weekly chart and then use the daily chart to trigger the trade. Once we are
ready to exit our trade we examine the daily chart and then trigger our exit using the hourly chart.

Of course this strategy would require some extra work as well as the use of intraday data. The alternative
would be to simply reduce the number of ATRs used to hang the Chandelier exit on the daily chart. Either
way we do it, the logic is to move our stops closer once we have achieved a worthwhile trading profit.

*******
Notes On Bear Markets

One of the best ways to gauge a bear market is to observe the reaction to good and bad news. In a bear
market the averages go down even when the news is good. (For example, look what happened the last
time the Fed cut interest rates.) We will know that the bear market is finally over when we observe the
market reacting favorably to good news. In the meantime, we can take some consolation in the fact that at
the present rate of decline we will soon be at zero. At least at that level we should be able to safely
resume trading stocks from the long side.

#45 ADX for V Tops and

Bottoms
We have often described how the ADX (J. Welles Wilder's Average Directional Index) can be a useful
tool for measuring the strength of trends. (Please review Bulletins 5 and 6 if you are not familiar with our
recommended use of ADX.) To briefly summarize our previous advice, we have found that when the
ADX begins to rise it is telling us that a strong trend is developing. A rising ADX has proven to be a
particularly reliable indicator after a market has been going sideways for a while and then begins to trend.
For best results, the ADX should begin its rise from a low level (less than 15 or 20) because the low level
of the ADX indicates that a sideways basing pattern has been formed. Most of our applications of the
ADX strategy have been predicated on finding these highly profitable patterns where a trend suddenly
emerges after an extended sideways period.

Unfortunately not all trends begin with a sideways pattern. There are many V tops and V bottoms that our
rising ADX strategy fails to capture. In a V pattern the ADX rises and then peaks out and declines. The
ADX does not begin rising again in time to catch the change in direction in a timely fashion. By the time
the ADX falls and then begins to rise again a major portion of the new trend will have already been
completed. As we have pointed out in our previous Bulletins, any entry on a rising ADX that was not
preceded by an extensive sideways period is not a very reliable pattern.

Recently in our research on using the ADX for trading stocks we have observed another ADX pattern that
we believe shows great promise. This new ADX pattern signals very timely entries that allow us to profit
from possible tops and bottoms that are V shaped.

Here is how these V shaped top and bottom patterns can easily be recognized:
1. Make sure that your plot of the ADX also includes the plot of the Plus DI and the Minus DI. The
pattern begins when the ADX is above both the Plus DI and the Minus DI. Most often when the ADX is
above both the Plus and Minus DI the ADX will be at a high level, perhaps greater than 30 or 35. The
high level of the ADX indicates that the previous trend was a very strong one. Now we are going to try
and catch the reversal of that strong trend.
2. With the ADX at a high level and declining, look for a crossing of the Plus DI and Minus DI. If the
Minus DI crosses above the Plus DI it indicates that a strong up market has ended and weakness has set
in. If the Plus DI crosses above the Minus DI it indicates that a strong downtrend has ended and a new
uptrend can be expected.
3. These reversal patterns should be entered only as the market moves in the new direction. (We suggest
that you use stops for entry triggers.) Once you have entered the trade you should expect a substantial
move in the new direction.
4. Be sure to use a stop loss at the recent low or high of the previous trend. Be willing to make more than
one attempt to catch the new trend. (Sometimes the Plus and Minus DI will cross back and forth more
than once before the new trend emerges.)

We have found that this simple pattern identifies major changes in direction in almost any market.
However you should be aware that the change of direction pattern we have described is not as reliable as
the typical rising ADX pattern that starts with a basing action. However the trades that do work are
exceptionally profitable and we know of no other method that is as timely at catching major changes in
direction. Most traders take a great deal of personal satisfaction in quickly recognizing major changes in
direction. This simple entry method can produce some truly outstanding trades and provides a welcome
change from typical trend following strategies.
Our Phoenix Bond system uses this technique to identify major bottoms in the bond market. The same
system also spots bottoms in individual stocks. To catch major tops we simply reverse the logic. Just put
up some charts with the ADX and look for the pattern we have described in this Bulletin. We think you
will be very surprised at its accuracy. Give us your comments and observations on the Forum.

Good luck and good trading.

#46 The Parabolic Trigger for V

Tops and Bottoms
Our previous Bulletin #45 about using the ADX for V shaped tops and bottoms was surprisingly well
received. We had a great deal of very favorable feedback from our members who experimented with it.
This very valuable pattern seems to do an excellent job of spotting major turning points in almost any
market from Palladium to Natural Gas to Soybeans or even Lumber. This pattern seems to work
extremely well in almost all futures, stocks and even the hard to trade stock indexes.

Much like a kid with a new toy, we've been having fun scanning through our charts and finding all the
important signals that have been generated. For example, when looking at the stock index charts we had
some very timely and important signals that the strong bear market in stocks was finally reversing. Let's
review very briefly the conditions that create the pattern we are looking for.

REVIEW OF SETUPS and TRIGGERS: For those of you who are new to our work, we strongly
recommend a two step process for entries. The first step is to identify some "setup" conditions that tell us
that an entry is near. The second step is the "trigger" that tells us we must enter the trade NOW.

Just to refresh your memory from the previous Bulletin, let me review the "setup" conditions that we are
looking for. Remember that we are trying to anticipate important "V" shaped reversal patterns. We want
to be able to trade as near as possible to major tops and bottoms. As most of you are aware, a major
directional price move will cause the ADX to rise to a high level. Depending on the direction of the price
movement, either the Plus DI or the Minus DI will also move to an unusually high level. As the market
peaks the DI will begin to decline while the ADX is flat or still rising. Near the top (or bottom) the ADX
will become the highest line and will be above both the Plus DI and the Minus DI lines. This is our
"setup" and alerts us that an important change in direction is likely in the very near future. The
relationship of the three lines with the ADX being the highest tells us that there has already been a very
extended price move that is running out of gas.

FINDING A TIMELY TRIGGER: While studying the charts using our new ADX pattern we found that
our setup conditions often occurred early and that our DMI triggers were sometimes a little bit late. We
don't mind having the setup conditions occur early. After all, lead indicators are rare and very hard to
find. However to make this entry pattern even more exciting we thought we would see if we could make
the triggers occur sooner.
Now that we have our lead indicator in place we want to find a timely entry trigger that gets us started in
the direction of the new trend that should just be getting started. In Bulletin 45 we suggested that the
crossing of the Plus DI and Minus DI lines could be the entry trigger. Although this method is acceptable
and produces excellent results we observed that there might be room for further improvement. In many
cases, by the time the Plus and Minus DI have crossed some profits in the new direction have already
been left behind.

After some trial and error we found that the Parabolic indicator did just what we wanted. We believe we
can use the Parabolic indicator instead of the DMI crossovers to provide much more timely entry triggers.

We have never liked the Parabolic stop and reverse (SAR) method as an independent trading system
which was the intent of J. Welles Wilder, its originator. However we do like to use the Parabolic indicator
for exits. As a system we find that the Parabolic reversal points occur much too frequently and this
reversal system would drive us crazy with far too many false changes in direction. However the features
of the Parabolic indicator that make it useful as an exit strategy are exactly what makes it the timely
trigger we need for our ADX reversal pattern.

The Parabolic indicator accelerates steadily as the prices trend until the reversal points are very, very
close to the peak of the move. The stronger the trend the closer the Parabolic gets to the prices. That is
exactly what we want. When the Parabolic indicator is close to the prices and we have fulfilled our ADX
setup conditions we are all set for an outstanding trade. Even a very small countertrend move will now
quickly cross the Parabolic and signal our timely entry.

AN IDEAL ENTRY PLUS AN ADD POINT: We view the marriage of the ADX setup with the Parabolic
entry trigger as an ideal combination. The entries now occur in a much more timely fashion than when we
relied on the DI crossovers for our trigger. In fact, once the Parabolic has been crossed we can use the DI
crossover as a confirmation and add to our position. I don't normally believe in pyramiding positions but
in this case we are trading a very reliable pattern that is designed to identify a major reversal in direction,
so I think that adding to positions early is a very good strategy.

As you can probably tell, I really like this ADX and Parabolic entry technique and I think that we have a
lot of good concepts working for us here. We have an early setup, a timely trigger and now we can use the
delayed confirmation of the DI crossovers as a point to pyramid the position. You can't ask for much
more than that for an entry strategy that does a great job of catching big moves early. Take a look at this
pattern on your favorite market and give me your comments.

Good luck and good trading.

#47 A New Exit Strategy –
the ATR Ratchet
Recently I've been doing quite a bit of research on new systems for stock trading. The research is on
behalf of a new hedge fund that will be starting later this year. The fund will be managed by Tan LeBeau
LLC, the company that funded this research project. After some serious internal discussion about the
advantages of keeping this new exit strategy a company secret, the LLC has graciously given me
permission to share this discovery with our System Traders Club members. Here is a bit of background on
how the new exit strategy came about.

In the process of testing various exit strategies for our stock trading systems we found that we needed a
profit-taking exit that performed somewhat along the lines of the Parabolic SAR but that could be made
more flexible and easier to code and apply. We found that the Parabolic was hard to use because it was
often on the opposite side of the market from our trades or it was starting from a point that was too low
for what we wanted. After spending a great deal of time with the Parabolic we decided it was not helpful
for the particular systems we were creating. As an alternative to the Parabolic exit we decided to test
some new exit ideas based on my extensive work and experience with the Average True Range. After a
great deal of tinkering and experimentation we were pleased to learn that the new exit strategy worked
surprisingly well for profit taking and had many very useful features and applications. I decided to name
this new exit strategy the "ATR Ratchet".

The basic idea is quite simple. We first pick a logical starting point and then add daily units of ATR to the
starting point to produce a trailing stop that moves consistently higher while also adapting to changes in
volatility. The advantage of this strategy over the original Parabolic based exit is that when using the ATR
Ratchet we have much more control of the starting point and the acceleration. We also found that the
ATR based exit has a fast and appropriate reaction to changes in volatility that will enable us to lock in
more profit than most conventional trailing exits.

Here is an example of the strategy: After the trade has reached a profit target of at least one ATR or more,
we pick a recent low point (such as the lowest low of the last ten days). Then we add some small daily
unit of ATR (0.05 ATR for example) to that low point for each day in the trade. If we have been in the
trade for 15 days we would multiply 0.05 ATRs by 15 days and add the resulting 0.75 ATRs to the
starting point. After 20 days in the trade we would now be adding 1.0 ATRs (.05 times 20) to the lowest
low of the last ten days. The ATR Ratchet is very simple in its logic but you will quickly discover that
there are lots of moving parts that perform a lot of interesting and useful functions; much more than we
expected.

We particularly like this strategy because, unlike the Parabolic, the ATR Ratchet can easily be
implemented any time we want during the trade. We can start implementing the stop the very first day of
the trade or we can wait until some specific event prompts us to implement a profit-taking exit. I would
suggest waiting to use the exit until some minimum level of profitability has been reached because, as you
will see, this stop has a way of moving up very rapidly under favorable market conditions.

The ATR Ratchet begins very quietly and moves up steadily each day because we are adding one small
unit of ATR for each bar in the trade. However the starting point from which the stop is being calculated
(the 10 day low in our example) also moves up on a regular basis as long as the market is headed in the
right direction. So now we have a constantly increasing number of units of ATR being added to a
constantly rising ten day low. Each time the 10-day low increases our ATR Ratchet moves higher so we
typically have a small but steady increase in the daily stop followed by much larger jumps as the 10 day
low moves higher. It is important to emphasize that we are constantly adding our daily acceleration to an
upward moving starting point that produces a unique dual acceleration feature for this exit. We have a
rising stop that is being accelerated by both time and price. In addition, the ATR Ratchet will often add
substantial additional acceleration in response to increases in volatility during the trade.

The acceleration due to range expansions is an important feature of the ATR Ratchet. Because markets
often tend to show wider ranges as the trend accelerates the ATR will tend to expand very rapidly during
our best profit runs. In a fast moving market you will typically find many gaps and large range bars.
Because we are adding multiple units of ATR to our starting point, any increase in the size of the
underlying ATR causes the stop to suddenly make a very large jump that brings it closer to the high point
of the trade. If we have been in the trade for forty days any increase in the ATR will have a forty-fold
impact on the cumulative daily acceleration. That is exactly what we want it to do. We found that when a
market was making a good profit run the ATR Ratchet moved up surprisingly fast and did an excellent
job of locking in open profits.

Keep in mind that this exit strategy is a new one (even to us) so our experience and observations about it
are still very limited. However I am going to discuss a few observations about the variables that might
help you to understand and apply this exit successfully.

Starting Price: One of the nice features about the ATR Ratchet is that we can start it any place we want.
For example we can start it at some significant low point just as the Parabolic does. Or we can start it at a
swing low, a support level, and a channel low or at our entry point minus some ATR unit. If we wait until
the trade is fairly profitable we could start it at the entry point or even somewhere above our entry point.
The possible starting points are unlimited; use your imagination and your logic to find a starting point that
makes sense for your time frame and for what you want your system to accomplish. Our idea of starting
the Ratchet from the x day low makes it move up faster than a fixed starting point (as in the Parabolic)
because the starting point rises repeatedly in a strong market. If you prefer, you could just as easily start
the Ratchet at something like 2 ATRs below the entry price and then the starting point would remain
fixed. In this case the Ratchet would move up only as the result of accumulating additional time in the
trade and as the result of possible expansions of the ATR itself.

When to Start: We can very easily initiate the exit strategy based on time rather than price or combine the
two ideas. For example, we can start the exit only after the trade has been open for at least 10 days and is
profitable by more than one ATR. My general impression at this point is that it is best to implement the
ATR Ratchet only after a fairly large profit objective has been reached. The ATR Ratchet looks like a
very good profit taking exit but I suspect it will kick you out of a trade much too soon if you start it before
the trade is profitable.

As I mentioned, one of the things I like best about the ATR Ratchet is its flexibility and adaptability. Here
is another idea on how to start it. We can start it after fifteen bars but we don't necessarily have to add
fifteen ratchets. The logic for the coding would be to start the Ratchet after 15 bars in the trade but
multiply the ATR units by the number of bars in the trade minus ten or divide the number of days in the
trade by some constant before multiplying the ATR units. This procedure will reduce the number of
ratchets, particularly at the beginning of the trade when the exit is first implemented. Play around with the
ATR Ratchet and see what creative ideas you can come up with.

Daily Ratchet Amount: After testing it the daily Ratchet amount we chose when we were first doing our
research turned out to be much too large for our intended application. The large Ratchet amount
(percentage of ATR) moved the stop up too fast for the time frame we wanted to trade. After some trial
and error we found that a Ratchet amount in the neighborhood of 0.05 or 0.10 (5% or 10% of one 20-day
average true range) multiplied by the number of bars the trade has been open will move the stop up much
faster than you might expect.

As a variation on this strategy the very small initial Ratchet can always be increased later in the trade
once the profits are very high. We could start with a small Ratchet and then after a large amount of profit
we could use a larger daily Ratchet increment. There are all sorts of interesting possibilities.

ATR Length: As we have learned in our previous uses of ATR, the length that we use to average the
ranges can be very important. If we want the ATR to be highly responsive to short term variations in the
size of the range we should use a short length for the average (4 or 5 bars). If we want a smoother ATR
with less reaction to one or two days of unusual volatility we should use a longer average (20 to 50 bars).
For most of my work with the ATR I use 20 days for the average unless I have a good reason to make it
more or less sensitive.

Summary: We have just scratched the surface on our understanding of the possibilities and variations of
the ATR Ratchet as a profit taking tool. We particularly like the flexibility it offers and we suspect that
each trader will wind up using a slightly different variation. As you can see, there are many important
variables to tinker with. Be sure to code the Ratchet so it gets plotted on a chart when your are first
learning and experimenting with it. The ATR Ratchet is full of pleasant surprises and the plot on the chart
will quickly teach you a great deal about its unusual characteristics.

Be sure to let us know if you come up with any exciting ideas on how to apply it.

Good luck and good trading.

#48 Valuable Tools for Traders
– the RSI
In our past Bulletins we haven't written much about one of our favorite trading tools, the Relative
Strength Index (RSI). As most of our members are aware, the RSI is a popular overbought -oversold
oscillator. Stock traders must be careful not to confuse this indicator with the "relative strength" that is
used to compare the strength of one stock with another or with an index. The RSI oscillator is another
invention of J. Welles Wilder, the originator of ADX and many other valuable trading tools.

The RSI calculates the ratio of "up closes" to "down closes" over the period of time selected (usually 14
bars) and expresses the results as an oscillator with a scale of 0 to 100. Readings above 70 are commonly
thought to indicate an overbought condition while readings below 30 are believed to indicate an oversold
condition.

The RSI indicator is included in most charting software packages but the formula is very simple if you
needed to calculate it by hand or in a spreadsheet.

RSI = 100 - (100/ 1 +RS) where RS equals the average of up closes of the last n (14?) bars divided by the
average of down closes of the last n bars.

Here are two of our favorite applications of this valuable tool.

1. Defining dips in an uptrend. A "dip" occurs when the RSI declines by 10 (or more) points from a recent
peak that was at a high level. For example, a drop from 80 to 70 or less would qualify as a dip as would a
decline from 90 to 75. In our experience we have found that most RSI dips tend to be 25 points or more
but in very strong trends (our favorite) the dips tend to be of a lesser magnitude. Our measurement of 10
OR MORE will work in either type of market. Once a "dip" has been defined we can either buy at the
market or wait for some sign of a reversal. It is often a good idea to also consider and limit the minimum
level that the RSI reaches on the "dip". If the RSI declines too far without reversing we have probably
seen a market top, not a dip.

2. Defining rallies for profit taking. Once we have been in a trade long enough to accumulate a
worthwhile profit it often makes sense to exit on strength rather than waiting to be stopped out on
weakness. For example, once we have at least two ATRs of profit we want to be ready to exit whenever
the RSI reaches 75 or more. (I prefer to use 75 and 25 as thresholds rather than the more popular 70 and
30 levels.) This strategy of exits on strength will tend to maximize our profits over the short run but may
not be as effective as a trailing stop over the long run. However, if you are trying to trade effectively over
short time frames it often makes sense to exit on strength rather than on weakness. This is particularly
true for day traders who do not have the option of letting profits run indefinitely. Once the RSI reaches 75
or more we have the option of closing out the trade "at the market" or watching closely for the first sign
of a change in direction. A lower close or a close lower than the open seem to work well for this purpose.

Other popular applications of the RSI can be found in our book (starting on page 124). As is true of most
indicators, the RSI can be much more effective when its application is combined with a quick glance at
the ADX. Typically the RSI indicates an oversold condition whenever it rises above 75 and many
counter-trend traders look to sell short at this point. This procedure would be a very big mistake if the
ADX were rising. When the ADX is rising, the RSI will tend to move more or less sideways at the high
levels rather than reversing direction as it would normally be expected to do. Instead of breaking to the
downside the market being tracked will remain overbought and will persistently continue to make new
highs. Entering a counter-trend trade simply because the RSI indicates an overbought or oversold
condition is a big error if the ADX is rising.

We would also caution our members about using the RSI level as a filter for entries. Many traders will not
enter a new buy order if the RSI indicates an overbought condition. Most of the time this is an effective
entry filter that avoids buying just before the market is ready to correct an abnormal price excursion.
However, this procedure would be a very big mistake if the ADX were rising. When the ADX is rising,
many of the best entry signals come when the RSI is at a high level. Our research indicates that
eliminating these entries would reduce the profitability of the trading strategy substantially.

We believe that the RSI is a valuable trading tool that belongs in every trader's toolbox. Take the time to
study it and become familiar with its many helpful applications.

Be sure to let us know if you come up with any exciting ideas on how to apply it.

Good luck and good trading.

#49 The STC RSI Stock

Trading System
Our Bulletin number 48 about using RSI sparked some very interesting discussion on our FORUM. One
of the messages suggested that buying stocks when the RSI was below 25 and then selling them when the
RSI went above 45 produced some excellent historical results, particularly in the Dow stocks.

I thought I would check it out and ran some historical tests. Lo and behold it worked remarkably well. I
immediately observed that there was the makings of a viable system here. All it needed was a little
refinement.

After a few days on tinkering I came up with a version of the system that I think is worth trading. Since
our members on the FORUM originated the basic system, I thought I would also pass along my work on
this system so that all of our members might benefit.

Here are the stock trading rules I came up with:

ENTRY: When the 14-day RSI is 25 or less, enter an order to buy tomorrow on a stop at today's close
plus some small amount. Use a couple of cents or .02 units of Average True Range above the previous
close. We need to avoid buying on weakness because it's a bit like trying to catch a falling safe. When the
RSI is at a low level the stock is likely to be gapping lower and falling apart to the downside and we don't
want to buy that much weakness. So to avoid buying on further weakness we require that we must buy
only on a price above today's close. That requirement keeps us out of a lot of trouble.

PROFIT TAKING: Take profits when the 14-day RSI recovers and closes at any level above 45. Just sell
the next day on the open. Closing out the trade at such a low level on the RSI seems counter-intuitive but
it works. What tends to happen is that the RSI can often recover quickly and gap well above 45 so that we
are often taking the profits at levels much greater than 45. I tried a lot of other levels trying to increase the
profits on the winners but selling above 45 makes the most money.

LOSS PROTECTION: After the trade has been open for four days or more exit on any day that the RSI
closes lower than yesterday. Just sell the next day on the open. This is our equivalent of loss protection. If
we have been in a trade for four days or more and the RSI has not recovered to 45 we don't want to hold it
while the RSI declines again.

I tested the simple system described above on a portfolio of 28 stocks from 1987 through October 2001.
In this more or less random portfolio there were some Dow stocks plus a few stocks with more volatility.
The results were generally acceptable but there were some particular results that I thought were truly
amazing.

First the typical performance results from buying $10,000 worth of stock on each signal with no
compounding:

Total net profit: $255,557 Number of trades: 1849 Winning trades: 1124 (60%) Losing trades: 725 (40%)
Average winning trade: $489 Average losing trade: $406 (Ratio avg. win/avg. loss 1.21) Maximum
consecutive winners: 18 Maximum consecutive losers: 8 Average bars in winners: 3.5 Average bars in
losers: 4.4 Largest intraday drawdown: $28,820 (This occurred in October 1987) Profit factor (Gross
profits divided by gross losses) 1.87 Sharp ratio: 1.12

Now these results are pretty good overall but what really got my attention was a couple of additional
calculations that are provided in my BEHOLD software. We like to look at the number of rolling 2month
windows and see how many 12-month periods were possible. (After the first eleven months each new
month provides a new12-month period to be examined.) There were 161 of those 12-month windows in
our test and every one of them was profitable. This system did not have a single 12- month period where
it lost money. That is truly remarkable. Although the biggest intraday drawdown was in October 1987 (no
surprise) the system actually finished that month with a big profit. This is a system that seems to be able
to take advantage of market weakness.
Another measurement that got my attention was the percentage of bars in the market and the dollars
returned per day in the market (based on buying $10,000 worth of stock). This system is not in the market
very often; it had trades on only 7% of the bars. But it returned a profit of $35.64 for every bar in the
market. To put this number in perspective, any return of $10 per day or more on a $10,000 investment is
considered very good.

Now as always, there are a few warnings. When testing stocks that have been back adjusted for splits it is
nearly impossible to factor in commissions with any accuracy so no commissions or slippage are included
in these results. But we are trading stocks now for a penny a share or less and commissions should not
have a big impact because the system trades very infrequently. (About 4 trades per year per stock.) If we
deduct a few thousand dollars from our results to cover costs the results are still very acceptable.

This system has no fixed dollar stop loss so the potential loss on any trade is unlimited. For this reason
you would want to trade very small positions relative to your total capital (a good idea in any case). That
way if you took a big hit on one trade it would represent a very small percentage of your capital. In our
historical testing the largest losing trade was $3,239.

We think this RSI based system deserves further examination. We intend to incorporate a version of it on
our StreakingStocks web site (www.StreakingStocks.com). We like the way it takes advantage of buying
during periods of extreme market weakness. If we combine this system with a good trend-following
system that can make money when the market is strong we should be able to make money on a very
consistent basis.

Test the system yourself and see what you think. If you come up with any improvements please let us
know.

Good luck and good trading.

#50 Year-end Trading

Considerations
One of the primary requirements for successful technical trading is adequate liquidity. As much as
possible we need to trade in markets where the price action is orderly and the flow of orders is substantial.
This requirement is true regardless of the size of our personal transactions. We want to confine our
trading to active markets where large transactions by other traders do not distort prices.

Most traders assume that if they are trading small positions then market liquidity doesn't matter. They fail
to understand that they need to be concerned about the orders of the large traders who may make
decisions based on a variety of factors that may have nothing to do with the current price action. If we are
trading a small position we don't want our stops to be triggered by a large trader who suddenly decides to
enter a market order or has a large stop order triggered.

Here are specific liquidity thresholds that I have found to be helpful over the years:

1) In futures markets there should be a minimum of 20,000 contracts of open interest and at least 5,000
contracts of average daily volume.
2) In securities there should be a minimum of 500,000 shares of average daily volume.

There are also important liquidity concerns over holidays, especially the period between Christmas and
New Years. For many years I had a personal rule that I would not trade futures in the period between the
last Friday before Christmas and the first business day after New Year's day. Then for a two-year period
this policy seemed to cost some money in missed profits so I decided to abandon the policy the following
year. This decision proved to be a big mistake.

The following year was 1994 and on December 28th I was holding hundreds of profitable currency
positions on the CME. Suddenly, for no obvious reason, the direction of the currencies reversed sharply
and our stops were hit and my orders were filled at unbelievably bad prices. I had positions in Yen, D-
Marks and Swiss Francs and all of the stops got hit at the same time and the fills were just terrible. The
worst was the Yen executions. I encountered 130 points of slippage on more than two-hundred Yen
contracts. When I contacted the exchange to voice my outrage I was told that due to the holiday schedule
most of the usual pit traders were on vacation. I was told that there were only seven traders in the Yen pit
when my stops were hit. To make matters worse, the pit traders were unable to lay off their trades in the
cash market because the bank traders were also "on holiday".

Not only was it an expensive lesson but it was particularly painful because it was a lesson I had already
learned from many years of experience. I had violated one of my own rules and I paid the price. Those
bad currency trades on December 28th turned a slightly profitable year into a losing year.

Another lesson to be learned from this experience is the need for consistency. If I had traded over the
holidays on a consistent basis year in and year out I would have made a little more profit in the years prior
to 1994. However by changing tactics I encountered the worst possible out come. I missed the profits and
experienced a nearly catastrophic loss in 1994. Had I followed either tactic consistently I would have
been much better off.

Needless to say I have reverted to my previous policy of not carrying any open futures positions from the
Friday before Christmas until the trading day after NewYears.

I'm not sure how important this rule might be to stock traders but I am inclined to think that the holiday
period would be a good time to take a break and relax. Then we can return to the markets refreshed and
with a clear head after the beginning of the year. Not only will we have more time to spend with our loved
ones over the holidays, we will probably come out dollars ahead over the long run.
Year-end performance notes: We frequently receive messages asking how our systems have performed
over recent data. Many of our members are apparently not aware that updated performance data is posted
on the web site on the Systems page. Just click on "Reports" and you can download this data in Excel
format.

Here is a quick commentary on system performance in 2001.

The stock index systems performed poorly. There seemed to be a bullish bias to the trading and the
increased volatility was a problem. We are currently working on some improvements in the stock index
systems starting with the Piranha system.

The Bond and Eurodollar systems performed very well. The Big Dipper system had six winners out of
seven trades. The Little Dipper had seven winners out of ten trades. The Phoenix System had three
winners out of four trades. The Serendipity System was profitable and the Sidewinder System had six
winners out of seven trades. The Millennium ED system had seven winners out of nine trades.

The Crude Oil systems fared poorly. (They do best when prices are rising. They should do well next
year.)

The currency systems were mixed. Two out of the three Yen systems were down slightly (the profitable
one was the First Sword System). The Crossbow Swiss System was a standout and six out of seven trades
were profitable (not counting the open winner we are still holding). The Swiss Franc systems received
unusually high rankings from Futures Truth this year. Please note that past performance is not necessarily
indicative of future performance. Futures trading involves risk and may not be suitable for all investors.

As you know, our system are very inexpensive (only $250 each) and we usually have an annual year-end
sale so now is a good time to look into buying those that might interest you. Until January 15th you can
buy any three systems for $500. If you want to buy more than three systems the additional systems are
only $150 each.

That's all for now. Best Wishes for the New Year!

#51 the Case for Dynamic

Portfolio Selection
It seems that system performance is often directly related to market selection. A system that works well in
bonds and currencies may fail miserably in sugar and soybeans. The same is true when trading stocks. In
our New York Workshop with Dr. Elder I helped the students design a system for Microsoft that failed
when we tested it on Proctor and Gamble. I'm sure these examples come as no surprise to veteran system
traders. Portfolio selection has always been a problem. Even advocates of "one system for everything"
will have to admit that there are huge variations in performance from market to market with even the best
of so-called "universal" systems.

Unfortunately the typical solutions to the portfolio selection process are fraught with peril. One solution is
to blindly trade everything in a broadly diversified portfolio and hope that the profitable markets make up
for the losers. This solution results in large drawdowns and wasted capital tied up trading in non-
productive markets. (Show me a system that can make money in live cattle, soybeans, S&Ps, cocoa and
British Pounds and I'll become a willing convert to a "one system fits everything" approach.)

Another solution is to drop all the "bad markets" and just trade the good ones. This is simply a form of
curve fitting markets to systems. One obvious problem with this approach is that we don't really know
which markets will be the good ones in the future. When I was running my CTA business we had one
system and we used it to trade everything. We debated whether we should include live cattle in our
portfolio because the historical results of our trend following system in the meats were dismal. We finally
decide to throw live cattle into the portfolio just so we would be represented in the meats in case
something caused them to trend some day. Also, as bad as the live cattle contract was, it was still better
than trading live hogs or pork bellies. We started trading with a portfolio of fifteen futures markets and
guess what market was the most profitable in our first year of trading? Sure enough, it was live cattle.
Also, over the next few years the British Pound went from being one of our best markets to one of our
worst.

Since we don't really know which markets will perform best in the future, a static portfolio, no matter
how carefully selected, may not be the best solution. Imagine if we could somehow identify and then
quantify market characteristics that made a market "good" and then include only markets that are
presently exhibiting those desired characteristics in our dynamic portfolio. When British Pounds were
exhibiting desirable characteristics they would move into the portfolio. When they started whipsawing
back and forth they would be tossed out of the portfolio until they started trending again. We might trade
sugar only once every seven or eight years and catch the big winning trends without having to suffer
through the day to day losses of having this difficult market in the portfolio every year.

I know this idea may sound like a "pipe dream" but I think it can be done if we put our collective minds to
it. Let's brainstorm a bit here and see where it takes us. I think that certain vital market characteristics can
be measured and quantified if we simply give it some careful thought. Hopefully this Bulletin will prompt
an active discussion on this topic in our FORUM. Your ideas and suggestions are welcome. Up to now
I've spent more time on figuring out the problem and the benefits of solving it than I have on finding the
solution.

It seems to me that the important characteristics that we want to measure relate directly to volatility and
trendiness. The smoothness of the trend is also a characteristic that would be helpful to measure. We
might also want to measure volume and open interest because "good" markets have a way of attracting
traders.

We must also keep in mind that not all systems are based on trend-following and what may be a "good"
market for trend following may be a "bad" market for counter-trend trading strategies. Therefore some
objective ratings of trendiness and volatility are what we need so that we can collect information and then
use that information as needed to match the market characteristics with the proper systems.

We also must rely on a major assumption. We must assume that the characteristics that we are identifying
will persist for a period of time long enough for us to apply a system that will take advantage of those
characteristics. It would be no advantage to merely identify markets that we should have been trading in
the past. However, if those markets also produced desirable trading characteristics for a period in the
future we would be making a major breakthrough in the evolution of systematic trading. It has been my
observation over many years of trading that the desirable characteristics we are searching for do persist
for a long enough period for us to identify them and then trade them profitably. I envision a situation
where we can add a market to our portfolio and keep it in the portfolio for at least a year or two. I also
envision markets that are excluded for five or six years and then added back into the portfolio as they
produce good trading opportunities..

My first thought on a solution would be to study and measure range and momentum over various time
frames. Time must be an important element of anything we measure. Since we may have systems that
trade over a variety of time frames it would be pointless to measure only one time frame. We need to
decide those time frames that we want to measure. We also need to decide exactly how to measure range
and momentum. My first reaction is to measure in units of Average True Range and then convert the
Average True Range to dollars to provide additional information about volatility. For example, if the
ATRs are too small in terms of dollars the market may not be one that we would want to include in the
portfolio. However, if and when the ATRs expand the market would move into our dynamic portfolio.

Here is a sample of the format that I envision. For now I'm going to call it the "Market Characteristics
Matrix (MCM)".

Characteristic A: Perhaps trendiness? (Scale of 1 to 10)

Time frame x = 7
Time frame y = 5
Time frame z = 6

Characteristic B: Perhaps range? (Scale of 1 to 10)

Time frame x = 8
Time frame y = 6
Time frame z = 5

Characteristic C: Perhaps volatility? (Scale of 1 to 10)

Time frame x = 4
Time frame y = 3
Time frame z = 5

Characteristic D: Perhaps volume? (Scale of 1 to 10)

Time frame x = 9
Time frame y = 8
Time frame z = 7

Characteristic E: Perhaps smoothness of trend?

And so on.

There are many obvious items that need to be decided. What are the other characteristics that we might
want to measure? What are the time frames we want to measure? How do we set our scale for each
characteristic? Do we total the results or do we isolate particular items relative to the system we intend to
trade?

Once we have finished this "Market Characteristics Matrix (MCM)" we could pick a system and run the
system and run the MCM on past data. We would want to calculate the MCM on markets that have
performed well and those that have performed poorly to see if we can isolate those characteristics that
determine the success of our system. Once we know the characteristics we need we can select the markets
that currently display those characteristics and we have the beginning of a dynamic portfolio that can be
updated as needed.

I hope that this will be the first of a series of articles on this topic. I encourage our knowledgeable
members to start contributing ideas and opinions on this topic via the FORUM. I think we can come up
with something that may benefit us all.

Good luck and good trading.

#52 Combining RSI and

ADX
Now that I am spending seven hours a day doing trading for the new hedge fund I haven't had much time
for research or writing new Bulletins. However a comment in one of the trading newsgroups that I
monitor got me thinking about the potential benefits of combining our knowledge of RSI and ADX into a
simple system. Both the ADX and RSI are valuable trading tools and a combination of the two would
seem to offer some interesting possibilities. I like to use the RSI primarily as an indicator for buying on
dips in an uptrend. The ADX is my primary indicator of trend strength.

Here are a few ideas on how the two indicators might compliment each other in a system that "knows"
when to enter on strength and when to buys on dips. (I'm only going to use the long side for examples but
the logic should apply to short trades as well.)

When the ADX is rising it usually indicates that a strong trend is underway. In many cases waiting for
any sizeable dip would be costly because the market could run away and the dip entry would be too late to
maximize our profits. In this case we must enter on strength. To make this idea into a simple trading rule
we might state that if the ADX is rising (and we have some indication it is rising because an uptrend is
underway) we will buy whenever the RSI is below some very high threshold like 85. This rule would give
us a very prompt entry in most cases and the result would be almost identical to simply trading whenever
the ADX is rising which seems to be a good idea. The RSI has little, if any, benefit in this situation except
it might occasionally keep us from buying into an extremely overbought market where the RSI was above
85. In this case a slight delay on the entry might be prudent.

The RSI, however, can play a much more important role when the ADX is flat or declining. In this case
the rule would be that when the ADX is not rising we should postpone our entry until the RSI is below
some more typical threshold like 45 or 50. Since the ADX is not giving us a signal that the trend is
unusually strong we would need some additional indicator to show that the market has some minimal
amount of upward direction. Otherwise we would not be buying a dip within the framework of an
uptrend. Something simple like an upward sloping 20-bar moving average might work in this application.

Now that we have combined the ADX and RSI for our entries we might also want to combine them for
our exits. When a market is rising but the trend is not particularly strong any spike in the RSI represents a
good opportunity to take a profit. For example when trading in stocks the 9-bar RSI rising above 75 or 80
often signals that a correction is imminent. If the market trend is not unusually strong we would probably
be happy with taking our profit on strength rather than waiting to get stopped out on weakness. However
if the ADX is rising we might want to risk a correction in hopes of riding the trend even further. In this
case when the ADX was rising we would ignore the RSI signal to take our profit. However, once our
patience has allowed us to accumulate a very substantial open profit we might be best served by acting on
the next RSI signal and nailing down the big winner. Also, when the ADX is rising it would not make
much sense to be buying at a high RSI level and also selling at a high RSI level. We would be in and out
of our trades almost immediately. Therefore we need to ignore the RSI extremes until our profit has had a
chance to accumulate.

In summary, the important concept to remember is that our knowledge of the ADX can make the RSI a
much more useful trading tool. When the ADX is rising the RSI tends to get overbought and it can often
remain overbought for a surprising length of time. On the other hand when the ADX is flat or declining
any spike to the upside in the RSI is an opportunity to nail down a profit. Conversely, any spike to the
downside can be a potentially profitable entry point.

Here is the logic of a simple little system based on this discussion. (Just the rules in text form, you will
have to do your own coding.) The parameters selected have not been tested or optimized. For example the
20-day moving average is just a number I picked out of the air. This is enough information to get you
started and you can vary the rules to make the system trade over whatever time frame you prefer.

Long Entries:

1. The 20-bar moving average must be rising.

2. If the ADX is rising (ADX today is 0.20 or more higher than yesterday) then buy if the 14 bar RSI is
less than 85.
3. If the ADX is not rising (ADX today is not 0.20 higher than yesterday) then buy if the 14 bar RSI is
less than 50. Here is where you can influence the frequency of trading. For more trades use a higher
threshold like 60. For fewer trades use a lower threshold like 40.

Long Exits

1. If the ADX is not rising (ADX today is not 0.20 higher than yesterday) then sell (long exit) if the 9-bar
RSI is greater than 75.
2. If the ADX is rising (ADX today is 0.20 or more higher than yesterday) and the open profit is greater
than (pick some amount - maybe 4 ATRs or some unit of price) then sell if the 9-bar RSI is greater than
75.
3. You need some additional exit rule for the losing trades. Use your favorite loss-limiting exit or you
might want to exit when the price goes below the 20-dat moving average or when the 20-day moving
average turns down. (See entry rule 1.)

Good luck and good trading.

#53 What We Do Know for

Sure
While chatting with one of our members recently I casually remarked that I had often observed that
markets tend to go down much faster than they go up. He suggested that it would be a good idea to test
that popular assumption. He then proceeded to run a few simple tests on a broad portfolio of futures
markets using various length moving averages and reported back that his results did not support the
conclusion that markets go down faster than they go up. His conclusion was that most futures markets
were surprisingly symmetrical and his study indicated that they actually went up and down at
approximately the same rate. (In fact I think his study showed that the grain markets tended to go up
faster than they went down.)

Although I am a bit wary of the moving averages testing method used in this particular test our very
interesting discussion got me to thinking about how little we know for sure about the nature of the
markets we trade. We tend to take a lot of information at face value and build systems around critical
assumptions that may have very little basis in fact. What do we really know about the markets we trade?
Probably not nearly as much as we think we know.

I think that this Forum would be the ideal place to start a discussion about what we know "for sure" about
the nature of the markets. What simple statements about the markets can we actually prove? For example,
I recall having seen an academic study many years ago that showed that futures markets do have big
trends (particularly on the up side). The professors who did the study offered proof in the form of a study
of the distribution of prices which produced an abnormally thick tail on the positive side of the curve. I
was impressed that someone had offered some statistical proof of an assumption that futures traders have
been relying on ever since I can remember. Trend following works because it is based on a valid and
provable assumption. (If any members can recall or retrieve this study and post it here I would greatly
appreciate the help.)

Now I would propose that we use the knowledge and resources of our members to make a list of what we
know "for sure". There are members of this group who are well disciplined in statistical testing methods
that might be able to prove or disprove any assumptions we propose.

I think we need three groups to do this research effectively. The first group can offer simple statements of
what they believe to be true about the nature of the markets. This group does not have to be very
experienced or have any testing skills or software. They will simply ask important questions or make a
statement and throw it on the table for discussion and research. The second group will need to have
programming skills and access to testing software so they can try to prove or disprove each statement.
The third group would evaluate the testing procedures to see if the research was done in a manner that
offered conclusive proof. We need to be careful and take a hard look at the "proof" that might be offered
to make sure it really does prove what we are testing. The researchers will have to be willing to submit
tests that may be rejected as flawed but we will all be indebted to them for their hard work. Eventually we
will begin to accumulate a valuable list of truths about the markets.

I will offer a couple of statements that might serve to get things started. I'm hoping that some of our more
knowledgeable and talented members will try to figure out how to test these assumptions and post their
findings here. We should prepare to have the results challenged and discussed.

1. Prices go down faster than they go up. (Suggestion on testing - look at price excursions in both
directions and measure slope or rate of change.)
2. Prices are serially correlated over the short run. For example: Up moves are followed by more up
moves. Down moves are followed by further down moves.
3. Prices tend to return to the mean. (Are statements 2 and 3 mutually exclusive?)

Right now our list of what we know "for sure" is empty. Let's see how hard it is to expand the list. Please
offer additional suggestions on what we think we know about the markets.

Good luck and good trading.

#54 Frequency of Trading is

Critical
When building or evaluating trading systems the many benefits of systems that trade very
frequently are often overlooked. A system that trades frequently has many advantages over less
active systems that appear to be more desirable because they have better performance ratios.

If a strategy is profitable the more it trades the more money we should make. I apologize for
stating what should be obvious but you would be surprised at how often I hear discussions about
selecting systems with the highest level of "expectancy" or highest "profit factor" without
relating these measurements to the system's trading frequency. Simply stated, our goal should be
to show the most profit with the least amount of risk and trading frequency plays a critical role in
maximizing profitability and controlling our risk.

Trading frequency represents opportunity for profit. The more opportunities we can find the
more profit we should expect. For example, a strategy that has a very high profit factor of 4
(profit factor is total profits divided by total losses) may not produce as much profit as a more
active system that has a profit factor of only 2. Since the strategy with the lower profit factor is
profitable and it has many more opportunities it may easily produce more total profit than the
system with the much higher profit factor.

Active systems should give us a higher confidence level when analyzing our test data. In addition
to increasing total profits, a very active system gives us much more data to analyze when doing
our preliminary research. If we have a long-term trend-following strategy that produces only 50
trades over five years of data our positive results may not be nearly as reliable as the results from
analyzing a more active strategy that produced 1000 trades over the same data sample. I would
be willing to bet that the system with the larger sample of trades is more likely to produce
profitable results in the future because our level of confidence must relate to the number of
samples in our testing.

Active systems should produce more reliable results and a smoother equity curve. If we flip a
coin only ten times our odds of having 50% heads and 50% tails are not very good. However if
we flip the coin one thousand times we are likely to come much closer to obtaining 50% heads
and 50% tails. The same logic applies to our real-time trading. If we have a large sample of real
trades then our results should come closer to our expectations than if we only have a one or two
trades. The active system will approach our expectations much quicker than the system that
trades infrequently. If we have 50 or more trades per month with a good system we might
reasonably expect to be profitable every month. However if we have a system that is only
producing two or three trades per month then our monthly results will less predictable and
inconsistent. The infrequent trading system might be expected to produce a profit every year but
it would not be realistic to expect it to show a profit every month because the sample size in a
month will be very small.
Here is a quick summary:

1. Active systems give bigger samples in testing which make the test results more reliable.
2. Active systems have more opportunity for profits and should produce more total profit over
time.
3. Active systems should produce a smoother equity curve.
When setting your goals for a trading system you should give trading frequency a high priority
even if it means that some of the usual performance measurements may suffer.

How to increase trading frequency:

1. Use quicker parameters for entries. Trading frequency can usually be increased in a system by
using more sensitive (usually shorter) parameters for the indicators that determine the entries and
exits.
2. Be aggressive when taking profits. Quicker exits that lock in profits will tend to increase the
number of trades but may reduce the average profit per trade. That trade-off may prove to be
worthwhile and may substantially increase the total profit over the long run.
3. Trade multiple markets. Diversification among markets should produce more trades and more
consistent results.
4. Trade multiple systems. Adding more trading systems will increase the activity level. Use as
many systems as you believe to be practical in terms of available capital and as many systems as
you can accurately monitor.
5. Trade multiple time frames. A system that works well on daily charts may also produce
positive results on hourly charts or weekly charts. Don't make the mistake of assuming that only
one time frame must be used.

Here are a few final thoughts.

Drawdowns: I have found that adjusting a system to be more active will almost always increase
the size of the drawdowns. However in many cases the larger drawdowns are simply the result of
having a much larger sample size over the period being tested. If you perform a Monte Carlo
simulation on a system that trades infrequently you will observe that larger drawdowns become
more likely as the number of trades in the simulation increases. This means that your test data on
the inactive system is showing an unrealistic drawdown that is probably lower than what you
might expect to actually experience when trading that system over the long run. If you don't have
a program to perform Monte Carlo simulations and you are analyzing a system that trades
infrequently you should double the size of the historical drawdown to give you a more realistic
idea of what to expect in real trading with a larger sample size.
Increased costs: Trading more often will increase your trading costs in terms of commissions and
slippage. Be sure to factor in realistic costs when doing your testing. The idea of trading
frequently is to make more money. At some point increased trading will begin to reduce your
total profitability. You should know where that point of diminishing returns kicks in.

I'm not a mathematician but I think that system traders need a formula for comparing systems
that includes the frequency of trading. (For example: Expectancy times frequency or Profit
Factor times frequency.) Any other suggestions?

Direction is Key to Using ADX

Correctly
I have been trading with Wilder’s Averaged Directional Index (ADX), sometimes known as the
Directional Movement Indicator (DMI), for more than twenty years and have written and
lectured about my findings throughout the world. I would hope that my public fondness for this
indicator has contributed to its increasing popularity among knowledgeable technicians.
However I continue to see evidence that the ADX is not well understood and is often used
incorrectly. In this brief article I would like to point out a very common misconception about
ADX and explain how to correctly interpret the vital information provided by this most valuable
technical tool.

As most technicians already know, the ADX is an indicator that measures trendiness. But to do
its job most effectively it needs to be interpreted correctly. Unfortunately the inventor, J. Welles
Wilder Jr., got our basic understanding of his ingenious indicator off to a bad start by explaining
that the level of the ADX is what we need to be concerned with. If you are acquainted with
Wilder’s book, New Concepts in Technical Analysis that first introduced the ADX/DMI and I
asked you: ―Which is more predictive of a trending market; an ADX of 20 or an ADX of 30?‖
You would probably not hesitate to respond that the higher level of 30 would obviously be more
predictive of trendiness than the lower level. However that is not necessarily correct because it
is not the level of the ADX but its direction that provides the predictive information we seek.
An ADX of 20 that is rising steeply is much more predictive of trendiness than an ADX of 40
that is flat or declining. Traders and technicians need to understand that regardless of the
absolute level of ADX, if it is sloping upward the market is increasing its trendiness and if the
ADX is declining the market is losing trendiness.

Once this vital distinction between the level of the ADX and the direction of ADX is understood
we can carry this directional logic an important step further. An ADX that is rising rapidly is
more predictive of trendiness than an ADX that is rising slowly. Let’s get into some specifics
now. In my experience with ADX using Wilder’s default period of 14 bars I have found that any
upward movement from the previous bar of 0.25 or greater is significant and tells us that a trend
is underway. If the change from the previous bar is greater, say 0.50 or more, then that higher
rate of change indicates that an even stronger trend is in place. In fact I have observed that many
of the strongest and longest lasting trends will start with a rise in the ADX of 1.00 or more from
bar to bar.

Unfortunately a few of the popular software providers, MetaStock in particular, follow Wilder’s
original instructions which called for rounding the ADX to the nearest whole number. Rounding
causes serious problems when trying to measure the critical rate of change. For example a
significant upward move from 25.05 to 25.35 leaves the rounded ADX unchanged at 25 while an
insignificant move from 25.45 to 25.55 jumps the ADX a whole point from 25 to 26. To use the
ADX correctly we must carry the calculations out to at least two decimal places. I have pointed
out this problem to the folks at MetaStock numerous times over the years and as far as I know
they have yet to revise their formula. Fortunately most other software providers now carry their
calculations out to the required two or three decimal places and there are many places on the web
where ADX can be obtained for free.

I primarily rely on the ADX for entry signals and have not found it to be of much value after the
trade has been initiated. Exit strategies generally require more precise timing than the slow
moving ADX can provide. The ADX is a very robust indicator and I have had good results using
ADX setting as short as 7 bars and as long as 30 bars. The fact that the ADX produces good
results regardless of its exact parameter setting is a tribute to its robustness and reliability.
Reliable indicators should work well over a wide range of settings. Beware of indicators that
require very precise parameter setting to work effectively.

Here are a few more tips that may be helpful to users of ADX:

Profit targets: When the ADX is rising you should be applying trend-following strategies and
looking for fairly substantial profits of four Average True Ranges or more. When the ADX is
flat or declining then trend following strategies will fail. Under these conditions you will need to
find another market where the ADX is rising or switch strategies and apply short term counter-
trend methods with profit targets of only 1.5 ATRs or less.

Major trend reversals: When the ADX is above 35 and it is higher than either the Plus DI or
the Minus DI then extreme caution is in order because many important trend reversals occur at
these extremes. When the ADX is above both the Plus DI and the Minus DI I suggest using a
very sensitive indicator (such as the Parabolic) to quickly signal a possible change in the primary
direction. This technique can identify many major tops and bottoms particularly in stock index
markets.

I hope that this brief article will help you get better results with my favorite technical indicator. I
don’t know how anyone can trade without looking at ADX before they trade. It provides critical
information that all traders can use.

A PowerPoint presentation about ADX is available at no charge if you send an email request to
me at clebeau2@cableone.net .

What’s Your Exit Strategy?

Too many investors have been advised that a policy of buy and hold is the best way to invest for
the long run. The advice is typically: ―Just buy a good stock and hold on as long as you can. The
market will take care of you.‖ Well, the stock market has not been taking care of investors for
quite a few years now. Instead, the market is taking stock investors on a wild stomach-churning
ride—and there is no telling where it will end. Investors are getting sick along the way and are
unsure that there will be anything left when the ride is over.

Buy and hold is failing as an exit strategy because it encourages a wait-and-hope outlook among
investors and does nothing to provide badly needed control of gains and losses. Buy and hold
may not be dead as an exit strategy, but if it’s not dead, it should be on its way to a better life
somewhere far from these volatile markets.
WHERE’S THE PLAN?

The most obvious problem with buy and hold is that it is not a strategy at all. It is, in fact, the
absence of any logical plan to protect profits and limit losses. A buy-and-hold approach
sacrifices any semblance of control and relies on luck and hope rather than planning and control.

Back when the stock market was less volatile, a buy-and-hold approach was less stressful, and
the decision to buy and hold was reinforced by a rising market that masked the fatal flaws that
are inherent in the ―sit tight and cross your fingers‖ school of investing. Record-high levels of
volatility have clearly exposed the critical flaws of holding in spite of market conditions.

Buy-and-hold investors are now wishing they had followed better advice. The advice that they
really needed to hear was ―Get your head out of the sand and take control of your exits!‖

LOCK YOUR PROFITS

Like most simple sounding investment advice, taking control of exits is much easier said than
done. However, the rewards are well worth the effort. Gains on winning stocks will be locked in,
and losses on bad investment choices will be limited. Investing will become a much more
rewarding journey, and investors will enjoy peace of mind along the way.

Unfortunately, investors never have as much control over their investments as they might like, so
we must ensure that they strictly control what is in their power. For example, if an investor
bought shares of John Deere at $40 in 2006. It’s now early in 2008 and the shares have more
than doubled as they approach $100 (see Figure 1). Can he or she control the price of the shares
and implement some strategy that will make the shares go to $120 for an even bigger gain?
Obviously not.
Investors have absolutely no control over the upside price action. The investor has to accept and
protect whatever profits the market gives him or her.

If the stockholder is unable to control the size of the gains, what then can he or she control? The
downside. Although the investor can never make the price go up from $80 to $120, he or she
certainly can make sure to not be holding Deere shares if they go down to $40 or less.

Now, one might oversimplify this issue of control and conclude that investors can control losses
but that they have no control over gains. That’s mostly true but, fortunately, not entirely. Even
though stockholders cannot push prices higher, once the market has handed them a gain they can
make sure that it is not taken away or allowed to turn into a loss. Investors can and should
carefully protect their profits. Here’s how.

TRAIL YOUR EXITS

A well-conceived plan of trailing exits should include effective logic for the exits and the
discipline to implement the plan.

KNOW YOUR STOP POINT

A common problem plaguing traders is a lack of discipline. The reluctance to sell stocks at a loss
is a well-known problem for investors. Academics commonly refer to this reluctance as the
―disposition effect‖ and many studies show that investors are much more willing to exit a stock
at a profit than at a loss.

Overcoming the ―disposition effect‖ requires planning, even before the stock is purchased. The
decision process in buying a stock should always include an analysis of where the stock would
be sold if it goes down. Once the downside exit point has been determined, then the risk of the
purchase can be quantified.

In general, the best policy is to give the initial exit plenty of room (more risk) but balance the
increased risk by buying a smaller number of shares (less risk). Using a wider initial exit point
will tend to improve the percentage of winning trades at the cost of enduring larger losses.

Research shows that cutting losses too closely can hurt overall performance much more than the
effect of accepting slightly larger losses in order to increase the winning percentage.

If the exit is planned in advance, it will be much easier to implement and investors will not feel
like they made a hasty decision under the pressure of a falling market. Also, having a plan to buy
the stock back if it changes direction to resume an uptrend is helpful—and makes the decision to
exit on weakness much easier.

Nothing is wrong with selling a stock to protect capital and then buying back the same stock if
the price starts increasing again. The knowledge that the exit may only be a temporary protective
action can make the decision to sell more comfortable and improve an investor’s exit discipline.
If a stock runs away to the upside after an exit, the fault is in not being prepared to buy it back,
and it is a mistake to fault the exit in hindsight. The decision to sell to protect capital when a
stock is falling is always correct, regardless of the price action that follows.

POPULAR TRAILING EXITS

Most trailing exits are simple calculations, using previous low points that trail beneath the
current price level. Here are a few examples of popular trailing exits:

1. A trailing dollar amount per share.

2. A trailing percentage of the share price.

3. A trailing moving average of the previous prices.

4. A trailing lowest low of the previous X number of days.

5. A trailing support level based on chart analysis.

THE PROBLEM

The critical flaw in these and many other exit strategies is that they fail to adjust to changes in
the volatility of the underlying stock. All traders know that stocks go up and down and that much
of this price action is absolutely meaningless. Market technicians often refer to these random
price movements as ―noise.‖ If investors set their trailing exits too close, then they are likely to
get kicked out of a position for no valid reason. Selling too soon and then seeing the stock
resume its uptrend is known as a whipsaw, and is one of the main reasons that a prudent policy
of trailing exits is abandoned.

Investors hate to be whipsawed and would rather subject their capital to severe loss than to
experience an occasional missed opportunity. However, missing a substantial up move after an
exit is not the fault of the exit. The exit has the purpose of protecting against a significant loss,
and the exit should not be faulted for doing its job.

If a substantial move up happens to follow an exit, then any loss of opportunity is the result of
failing to implement a re-entry plan.

However, investors do not want to exit unnecessarily, even if they have a logical re-entry plan in
place. To avoid unnecessary exits and the dreaded whipsaw, they need to have trailing exits that
adjust to changes in the volatility of the underlying stock.

If the back-and-forth randomness in a stock is $2 and investors trail an exit at $1 below the price,
then they will surely exit simply because the exit is inside the current level of ―noise.‖ Instead of
protecting capital, they will be wasting it by exiting on random price action rather than exiting to
avoid significant weakness and the beginning of a downtrend that is likely to continue.
A trailing exit is most effective when it adapts to changes in volatility and moves closer or
further away to remain just beyond the reach of randomness.

USE ATR

Randomness can best be measured by calculating a simple formula of average true range (ATR),
or investors could use a more complicated formula measuring standard deviations. I have found
that keeping things simple usually produces the best results, so I recommend the average true
range (see Figure 2). ATR is the largest of:

1. Today’s high, minus today’s low.

2. Today’s high, minus yesterday’s close.

3. Today’s low, minus yesterday’s close.

A LITTLE BACKGROUND

Average true range was first introduced by J. Welles Wilder Jr. in his 1978 book New Concepts
in Technical Trading Systems, and this useful measurement has been enthusiastically embraced
by market technicians. ATR is widely used in a variety of trading applications and has proven to
be particularly helpful as a measurement of volatility applied to the task of measuring
randomness. ATR is a favorite tool for continuously adjusting trailing exits to avoid the current
level of randomness.

In 2008 and throughout the modern era of stock market investing, increasing levels of volatility
have created a nightmare situation for investors concerned about risk. Buy-and-hold investors
have suffered the most, but more prudent investors using trailing exits have been equally
frustrated.

In the recent crashing market, any prudent exit strategy has been rewarded, and in this
environment even setting simple trailing exits that do not adjust for volatility would have
avoided many catastrophic losses.

But exits that do not adjust for randomness will very likely prove to be a costly mistake in the
volatile rising market that is most likely to follow the present decline. High volatility appears to
be here to stay and nonadaptive exits will surely result in whipsaw after whipsaw as the market
recovers in the future.

ATR IN ACTION

However, if traders set their trailing exits in units of ATR, they can participate in any market
recovery without the fear of getting unnecessarily stopped out by exits that are much too close. If
the average daily volatility is 20 percent or more (as it is now in a surprising number of stocks),
it would not make sense to use a trailing exit of only 10 percent (see Figure 3).

The best policy in these volatile conditions is to move the exits outside the randomness by at
least two or three ATRs and trade a much smaller position to balance the increased risk of the
wider exits. When the market settles down and the volatility contracts, then an exit expressed in
units of ATR will move closer and reduce the level of risk. Once the risk is reduced, then
position sizes can be expanded to a normal level without the fear of abnormal losses (see Figure
4).
PUTTING IT ALL TOGETHER

• Control what can be controlled. Investors cannot force prices to go up, but they can avoid
riding prices down.

• Traders can and should control risk by implementing a strategy of trailing exits that will avoid
substantial and catastrophic losses. Buy and hold as we know it is dead. It was killed by extreme
volatility and unacceptable levels of risk.

• Any trailing exit strategy must adapt to changes in volatility to avoid needless whipsaws.
Average true range is a valuable tool to make the exits adaptive.

• If occasional whipsaws do occur, traders must have a strategy to re-enter the market to avoid
missing substantial profit opportunities.

• The current highly volatile market presents opportunity, but risk must always be limited. Use
trailing exits based on ATR and keep positions small if the exits are wide. If volatility decreases,
then position sizes can easily be increased as exits move closer.

• Before investors purchase stocks, they must have a plan to exit and to re-enter if required.

• Traders have to muster the confidence and discipline to follow their plans.

Investors can take control of their investments for higher profitability, lower risk and some badly
needed peace of mind.

Chuck LeBeau is the director of quantitative analytics at SmartStops.net. He has been investing
for more than 40 years and is the co-author of Computer Analysis of the Futures Markets. He
was a brokerage firm executive for more than 20 years and has managed both a hedge fund and a
commodity fund. He has lectured to thousands of investors throughout the world and is best
known as an authority on technical indicators, particularly as applied to exit strategies.

Originally published in the February 2009 issue of Stocks, Futures, and Options Magazine.

How to Avoid Big Declines

Using Market Timing
A very comprehensive study of the Dow Jones Industrials caught my eye recently and I want to
share some thoughts and conclusions based on the data in the study. The data I will be referring
to is from a study encompassing more than 100 years of daily data on the Dow Jones Industrial
Average (Black Swans and Market Timing: How Not To Generate Alpha, by Javier Estrada,
International Graduate School of Management, Barcelona, Spain). The data presented in this
study begins on December 31, 1899 and ends on December 31, 2006. In total, the study
encompasses 29,190 trading days. I have highlighted the data about avoiding the worst days,
since it’s usually ignored:

 1) A $100 investment at the beginning of 1900 turned into $25,746 by the end 2006, and
delivered a mean annual compound return of 5.3%.
 2) Missing the best 10 days reduced the terminal wealth by 65% to $9,008, and the mean
annual compound return one percentage point to 4.3%. But avoiding the worst 10 days
increased the terminal wealth by 206% to $78,781, and the mean annual compound return
by more than one percentage point to 6.4%.
 3) Missing the best 20 days reduced the terminal wealth by 83.2% to $4,313, and the
mean annual compound return to 3.6%. But avoiding the worst 20 days increased the
terminal wealth by 531.5% to $162,588, and the mean annual compound return to 7.2%.
 4) Missing the best 100 days reduced the terminal wealth by 99.7% to just $83 ($17 less
than the initial capital invested), and reduced the mean annual compound return to
−0.2%. But avoiding the worst 100 days increased the terminal wealth by a staggering
43,396.8% to $11,198,734, and more than doubled the mean annual compound return to
11.5%.

The author of this study concludes that these outlier days in either direction (the so-called ―Black
Swans‖) are so rare that it would be impossible for market timers to capture or avoid them.

I strongly disagree.
First, let’s look at what it is we want to do with market timing. Do we want to capture the
positive Black Swans or simply avoid the negative Black Swans? It would seem obvious that we
would want to do both, but if we had to choose only one course of action, it’s clear that we can
derive the most benefit from avoiding the negative Black Swans—so let’s start with that. Let’s
see if we can avoid big declines using market timing.

As director of quantitative analytics at SmartStops.net I recently directed a ten-year study of the

stocks in the S&P 500 Index. The study was intended to measure the various peak-to-valley
drawdowns of each of the 500 stocks. Any drawdown of 15% or more was identified and
measured. Since this article is focused on big drawdowns (the Black Swans), we will only look at
peak-to-valley declines of 60% or more. Here is the data:

 1) Of the 500 stocks, 267 of them had experienced a drawdown of 60% or more.
 2) 175 of them had experienced a drawdown of 70% or more.
 3) 105 of them had experienced a drawdown of 80% or more
 4) And 51 of them had experienced a drawdown of 90% or more.
 5) The average of the largest drawdown of the 500 stocks was 61.67%.

Those numbers might seem high at first glance, but they are actually understated by quite a bit.
The drawdown study ended in May of 2008 and we all know that the market has gone down a
great deal since then; clearly, the magnitude of the drawdowns would be even greater if the same
study were conducted today. Also, as in any long-term study of a group of stocks, the results are
skewed by ―survivorship bias.‖ There were a lot of stocks that might have been in the S&P 500
ten years ago, but for one reason or another they are no longer in the current index. Some of
those stocks have declined to zero and are not included in the study.

Having looked at the nature of the problem, let’s get back to the task at hand. Can market timing
help us to avoid these drawdowns? Yes, it definitely can. A logical application of trailing stops
would have avoided most of the big declines. Here are the results using the SmartStops trailing
exits that are available for free on our web site:

 1) Of the 500 stocks, only four of them had declines of 60% or more.
 2) There were no stocks that had declines of 70%, 80% or 90%.
 3) The average of the largest drawdown of the 500 stocks was 22.58%

Now I must admit that I think that our SmartStops trailing exits are more sophisticated and
effective than most trailing exits because the SmartStops are adjusted daily for trend direction
and changes in volatility. However, any serious effort at limiting the drawdowns with
conventional trailing stops would certainly have had a very positive effect in reducing the
magnitude of these declines. As the quoted Black Swan study clearly shows, the avoidance of
big declines improves performance very significantly. Here is a reminder of how that works:

 1) It takes a gain of 150% to recover from a 60% decline.

 2) It takes a gain of 333% to recover from a 70% decline.
 3) It takes a gain of 500% to recover from an 80% decline.
 4) It takes a gain of 900% to recover from a 90% decline.
 5) It takes a government bailout to recover from any decline greater than 90%.

Skeptics of market timing usually argue that efforts to avoid big down moves will result in
missing the biggest up moves. However I have never seen a study that shows any evidence to
support that preposterous assumption. If you limit your losses and are willing to enter on strength
you should not miss any major up trends. With a little planning and effort, you can capture the
Black Swans on the up side—and avoid the Black Swans on the down side.

Using Direction to Fine Tune

your Indicators
Do you have your RSI and Stochastics thresholds set at 70/30 or 80/20? Do you have your
Keltner ATR Bands set at equal distances on either side of the moving average in the center? If
so you can easily improve the accuracy of your indicators by adjusting them to reflect the
direction of the market.

Before we show our examples let's make sure that the logic of adjusting the indicators for
direction is clear. If we use the default thresholds of 70 and 30 for RSI we are requiring equal
moves in either direction to identify "overbought" and "oversold" conditions. These default
settings would be correct in a sideways market. But what if the market has a direction? If the
direction of the trend is up we can assume that the excursions to the downside will not be as
great or as often as the excursions to the upside.

Now if the trend is up we would want to favor buying dips using our RSI thresholds. However
because the trend is up we are much less likely to reach the lower default setting which we would
expect to be accurate only in sideways conditions. In a rising market we need to raise our lower
threshold to make it easier for us to find buy signals. Instead of using the default thresholds of
70/30 we would want to change the thresholds to 70/40 to make it easier to find entry signals that
favor the direction of the trend.

Let's look at a recent chart of Google (GOOG | Quote | Chart | News | PowerRating).
With the default settings at 70 and 30 we fail to get an entry signal after the RSI low about
January 20th.

Now let's see what happens when we adjust the RSI thresholds according to direction. We will
use a fast and a slow moving average to show the direction.
As we can see on the chart we now have a clear oversold entry signal on our 14-period RSI
indicator that did not show up using the symmetrical default settings of 70 and 30.

Now let's examine the GOOG chart using a fast stochastic to indicate overbought and oversold
levels.

Closely examining the Google chart with the stochastic indicator allows us to discuss an
important point. Does moving the thresholds according to direction do any harm? As far as I can
tell it doesn't hurt. In the chart above we would have had an entry signal with the standard 80/20
thresholds because we dipped below 20. But we still got the same entry signal with the threshold
at 30 so what's the harm? Under many conditions the adjusted threshold will generate profitable
entries that the default settings will miss. On the other hand the adjusted thresholds will never
miss signals that get down to the unadjusted threshold. Unless you are concerned about
generating false buy signals in an uptrend (not likely), adjusting the indicators can only improve
performance.

Another indicator that I am fond of using for entries is the Keltner band strategy that places
bands a number of ATRs (average true ranges) either side of a moving average.
In the chart above we can see that the wider band (2 ATRs) just barely caught the buy signal. If
we had adjusted the band to 1.5 ATRs the penetration would have been much more obvious and
it would have done no harm to use the tighter channel.

It seems obvious that we can benefit from adjusting the indicators for direction so that we can
have more trades entered in the direction of the trend. But each of these indicators has two
variable inputs. For example when we adjust the RSI from the default of 70/30 to 70/40 in a
rising market, shouldn't we adjust both thresholds upward to 80/40?

Not necessarily. The logic is to make the entry signals easier and therefore more frequent in the
direction of the trend. The other side of the threshold is not part of that process unless we are
going to use it to reverse directions and trade against the prevailing direction. That's a risky
strategy that I would not recommend. It is directly counter to our logic in adjusting the indicator
to make it easier to enter in the direction of the trend. Adjusting the upper threshold farther away
would only slightly lessen the likelihood of generating trades against the trend. In a strong
uptrend we would expect to see many penetrations of the upper threshold even if we adjust it.
The problem we are trying to solve with our adjustments is to make it easier to generate more
entries in the correct direction.

However, moving the upper threshold farther up might help if it is going to be used as an aid to
profit taking because it would tend to provide slightly larger profits than a lower threshold. The
choice of what to do with the non-entry side of the threshold will depend on what you intend to
do when it is penetrated. If you have confidence in the direction of the trend you would ignore
entries in the opposite direction.
The logic of adjusting entries to favor a particular direction can be applied to many trading
strategies. Let's take the famous Turtle 20-day breakout strategy for example. In a prevailing
uptrend a 10 or 15 day breakout would work better than 20. If you were trying to buy in a
prevailing downtrend (like the current stock market) you would be better off waiting for a 30 or
40 day breakout. Take a look at your favorite indicators and think about how you can fine tune
them to favor the primary direction of the market.