The Logical Trader: Applying a Method to the Madness / Edition 1Hardcover (2024)

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The Logical Trader

John Wiley & Sons

Chapter One

When you go in for your annual physical, the doctor takes your blood pressure, listens to your heart and lungs, draws some blood, etc. Based on all these indicators, the doctor makes a determination about how healthy you are. Now, assume that the patient drops dead right there on the examination table. The patient has no pulse! Then it doesn't matter what the cholesterol level was, right? No pulse ... no life.

I use this analogy to explain the ACD methodology. In trading, you'll be looking at a variety of factors, including pivots, moving averages, and so forth. But there will always be one underlying factor-like the patient's pulse-without which everything else becomes meaningless. That pulse is the ACD factor. It doesn't matter whether 64 out of 65 indicators are a go for a trade. If the ACD is the one missing indicator, then there is no trade.

So what is this ACD and what's it all about? ACD is the name I've given to my trading methodology, which can be applied to virtually any commodity, stock, or currency as long as there is sufficient volatility and liquidity. The basic premise of ACD is to plot particular price points, which we'll discuss in depth, in relation to the opening range. As I mentioned in the Introduction, I have traded using ACD for nearly 20 years and I still use it today. I'vetaught it to thousands of other people over the past 15 years who in turn have adapted it to suit their own trading styles and parameters. My point is that ACD has a proven track record, not only for me, but also for numerous other professional traders. Therefore, it can be incorporated into your trading system to help you plot out and execute your trading strategy.

But before we go any further, I must state that trading is an inherently risky endeavor and therefore not suitable for everyone. Any investment in derivatives or stocks may put you at risk of losing an amount even greater than your original investment. (See the full Disclaimer in the front of this book.)

My purpose in this book is not to sell you on trading, but to show you the methodology that I, as well as others whom I have trained, have used. As you go through this book, keep a pen and a pad of paper handy so you can follow along with the trading examples. Whether you're a novice trader or you've been at this for a while, I believe you'll find that the ACD system has something for you and your style of trading.

The Opening Range

ACD starts with the concept of the opening range. The opening range is the initial time frame of trading for a stock, commodity, currency, bond, or other financial derivatives at the start of each new trading session. For stocks, the opening range time frame is generally the first 20 minutes of the day, meaning if Stock X trades from 30.00 to 30.75 in the first 20 minutes of the day, that is the opening range to be used in the ACD system for that particular day. However, if a stock has a delayed opening, you must take the first 20 minutes of active trading.

In commodities, the length of time used for the opening range varies from 5 minutes to 30 minutes, depending upon an individual trader's time horizon. Some commodity futures contracts open using a monthly rotation at the start of the trading day. When this occurs, I use that initial trading period-from the time the contract for a particular month is opened and then closed temporarily while the next month opens-as the opening range. Alternatively, if you're a short-term day-trader in a particular commodity, you may decide that the opening range you'll use is five minutes-particularly if you trade on the floor. Or if you day-trade upstairs, you might choose a 10- to 15-minute opening range, or a longer time frame-such as 20 to 30 minutes -if you typically take a position in a market that has a longer trade duration. (See our current list of opening range time frames in the Appendix.) The key is to define the time period for the opening range and then be consistent when you trade using that time period.

There is one other important consideration about the opening range, and that is making sure it's based on its domicile market. What do I mean by that? If you're trading natural gas futures, then you know the domicile market is the New York Mercantile Exchange. That's where the opening is established. But if you were trading, say, Japanese yen, then the opening of the U.S. currency markets wouldn't apply. Rather, you'd have to look to the opening of the Japanese markets. The same applies with a foreign-domiciled commodity such as North Sea Brent crude oil. In stocks, for example, the opening range for UK-based Vodaphone (VOD) is in London, which would be approximately 3:00 A.M. to 3:20 A.M. New York time, even though the stock also trades in the United States. The same thing occurs with American Depository Receipts (ADRs) representing foreign stocks that trade on U.S. exchanges. The true opening range is established in the domicile market.

I discovered this years ago the proverbial hard way when I tried to apply the ACD system to some foreign currencies and bonds. I couldn't figure out why the system wasn't working at first and then I realized that the United States wasn't the primary market for these instruments. Therefore, I had to look to the opening in the market where these commodities, currencies, and bonds are based.

Once you have identified the opening range, this price range is an important reference point for your trading strategy. Here's why.

If you subscribe to the random walk theory, which states that the market's movements are random and totally unpredictable, then the opening range would not be any more important than any other price level during the trading day. Right? For example, crude oil trades from 9:45 A.M. Eastern time until 3:10 P.M. Eastern Time. If you divided that day into 10-minute intervals, you'd have 32 parcels of time (and 5 minutes left over). So, each 10-minute time interval would account for roughly 1/32 of the market activity.

Using random walk theory, you'd expect that the opening range (established in the first 10 minutes of trading) would be the high 1/32 of the time, or it would be the low 1/32 of the time. Therefore, random walk theory would dictate that 1/16 of the time the opening range would be either the high or the low.

Now, what if I told you that in volatile markets-not static, and not necessarily trending markets-the opening range tends to be the high or the low 17 to 23 percent of the time? Would that get your attention? Yes. Because this observation would tell you that the opening range being at the high or the low of the day roughly one-fifth of the time is what we call statistically significant. In complete layman's terms, this means the opening range is not just another 10-minute interval out of 32 of them in the trading day. It has more weight than any other time interval.

Let's take another example. Let's say that you divide the trading day up into roughly 64 five-minute intervals. Random walk theory would state that the opening, five-minute range would be the high 1/64 of the time or the low 1/64 of the time. So it would be either of those extremes 1/32 of the time. However, in volatile markets, that five-minute opening range is actually the high or the low of the day about 15 to 18 percent of the time. So instead of about 3 percent of the time, as random walk theory would predict, the first five minutes of the trading day turns out to be the high or the low 15 to 18 percent of the time. Again, this is statistically significant. And, from a trader's perspective, if you knew that something was going to market the high or the low 15 percent of the time, you'd want to know that. Right?

Further, if you take a look at the other 5- or 10-minute intervals in the trading day, the opening range price extremes are repeated a miniscule percentage of the time. That means once the opening range is put in, the market returns to that price range only on rare occasions-far less than the random walk theory would predict. Thus, here's the first concept of the ACD methodology:

So what do you do with that information? As a trader and a student of the market, I believe the opening range to be statistically significant. Thus, I constructed a trading model based on breakouts of the opening range on the premise that once this occurs, the market is likely to continue in that direction. These breakouts are determined using a time and price filter that is applied to the opening range. As you'll learn in this chapter, once you have defined the opening range, you can determine your A points at which to establish a short or long position, as well as the B, C, and D points. First, let's take a look at the starting point-Point A.

Point A

For the purpose of this exercise, let's say you are day trading crude oil, of the U.S. variety, with its primary market for futures at the New York Mercantile Exchange (Nymex). As a pit trader, you decide that your opening range is the first five minutes of trading. On this particular day, the opening range for crude oil is 25.60 to 25.70. Thus, the opening range has been established. Let's mark it down in a graph (see Figure 1.1).

Based on this opening range, the A point to enter a long or short position is plotted above or below the opening range, based on set variables. These variables are based on our own proprietary research, the process of which I won't share with you except to say that the ACD values are based on the volatility measurements of a particular stock, commodity, or financial derivative. (Please see the table in the Appendix that gives the current A values for several commodities and stocks, along with current opening range time frames.)

Using our example of crude oil, the A points are plotted 7 to 8 ticks above or below the market. Figure 1.2 shows how it would look.

If the market were to immediately trade above the opening range and reach the price level of 25.77 to 25.78-and trade there for a period of time equivalent to half the opening range time frame-then the market has established an A up. Thus, if the market traded up to 25.77 to 25.78 and stayed there for 2 1/2 minutes (half the five-minute time frame for the opening range), you would establish a long position/bias above 25.77 to 25.78.

Conversely, if the market immediately traded below the opening range to 25.53 to 25.52 and traded there for 2 1/2 minutes, the market would have established an A down. At this point, you would establish a short position/bias below 25.53 to 25.52.

Remember, on any given day you can have either an A up or an A down. The A level is determined when (and if) the market trades above or below the opening range. If the market goes up to 25.77 to make an A up, then there is no A down, even if the market turns around and trades below the opening range.

As you plot the various price reference points, you must ask yourself at all times where you'd get out if you were wrong. After all, if you were to go into business, wouldn't you want to know how much capital you needed to invest and how much you'd be at risk for? Trading must be treated the same way. When you make a trade, you must know where your exit point is if the market turns against you, and how much you would stand to lose if that happened. That's where the B level comes in. Once you have established an A-up or down-your stop for getting out of an unprofitable trade is B. The B level, where you would be bias neutral, is delineated by the opening range.

In other words, using the example above, if you established a long position above 25.77 to 25.78 and then the market broke immediately and traded lower, your stop to exit the trade would be at the lowest end of the opening range, or in this case 25.60. Conversely, if you went short below 25.53 to 25.52, your stop to exit the trade would be the highest end of the opening range, or 25.70.

Keep in mind when exiting any trade that the price at which you want to get out may not be where you will be filled. Slippage -the difference between your target price and the price at which your order is filled-is a reality in the market. Slippage can be small or significant depending largely upon market conditions.

As you follow the ACD system, remember that it is symmetrical. The strategy for the upside (a long position) is the mirror opposite of the strategy for the downside (a short position).

Let's assume that the market did reach the A target on the upside, which I call making an A up. In the example we just used, the market traded up to 25.77 to 25.78, stayed above this level for more than 2 1/2 minutes, and you went long at, say, 25.79. You stayed long all the way to 26.10, at which you exited the trade profitably. Now, the market trades lower and falls below the opening-range low of 25.60. What do you do? The answer is you do nothing.

In this case, the market has made an A up and now is trading below the opening range, which is Point B, at which your bias is neutral. The next step is to wait for the next ACD signal for a new bias, in this case for the market to trade to Point C.

Point C

Once an A has been made, the next probable entry point in the ACD system is Point C. Point Cs are calculated (just like As) based upon a certain number of ticks above or below the opening range. In the example of crude oil, As are 7 to 8 ticks above or below the market. Point Cs in crude oil are 11 to 13 ticks above or below the market. (A reference list of our current values to calculate Point Cs on various stocks and commodities also can be found in the Appendix.) As you'll see, for commodities the price differential to calculate a Point A is different than that to calculate a Point C. For a stock, however, the differential to calculate a Point A or a Point C is the same. Now take a look at our trade graph in Figure 1.3.

Using this example, what would happen if the market traded all the way to the C down point? Point C is the crossover point at which your bias shifts from bullish to bearish, or vice versa. Here, if the market traded down to 25.49 to 25.47 and traded at or below that level for 2 1/2 minutes (half the length of time of the opening range) you would establish a short position/bias.

If you establish a short position below Point C, what's the first thing you must ask yourself: Where will you get out if you are wrong? Just as with Point A, the stop for Point C coincides with the opening range. If you have a C down, the stop-known as Point D-would be 1 tick above the top of the opening range (see Figure 1.4.)

Excerpted from The Logical Trader by Mark B. Fisher Excerpted by permission.
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