Cycles and Technicals: A Profitable Pair

Article excerpt

A complete trading plan should have at least three levels: General market assessment, trading entry timing and post-trade position management. Here, we look at timing and post-trade management strategies for a larger methodology that trades around macro-level shifts in major cycles.

A good timing mechanism can provide an extra edge for a trader's technical analysis toolkit. One solid approach is cycle analysis. This can be useful for timing short-term counter trends from one to several days that occur with regularity, and for pinpointing the beginning of longer-term trends.

Indeed, cycles are flexible. With some adjustment, we can expand on a core concept to develop both a day-trading strategy and an options straddle strategy for short- and long-term positions. see "Market timing with cyclical analysis," September 2005.

The theory behind using cycles for market timing is nothing new. Several trading methodologies have employed that type of analysis. Some of them have been based on regular fundamental cycles such as seasonal supply and demand, underlying business cycles or even phases of the moon. Others, such as Market Profile, which aims to identify development of price patterns in distinct phases, and the Elliott Wave Principle, which looks for a series of up and down swings as part of a longer term price move, are based on cycles of variable and indeterminate length.

Another approach is to combine many different cycles. On any given day, two or more of those cycles could generate a buy or sell signal, but often there is only one of them involved. Although it may appear that having multiple cycles coincide to generate a trade would portend a bigger price swing, empirical evidence does not suggest that any such correlation exists.

BEYOND THE FORECAST

Having a forecasting model does not create a complete trading approach. Bad trading habits and unsound money management can still spell certain doom, even when a trader is equipped with the most in-depth analysis. Backtesting and paper trading are prudent components in developing a trading plan. Still, traders must avoid the pitfall of curve fitting; no substitute exists for experience in placing and managing trades.

"Light me up" (right) shows a oneminute Japanese candlestick chart for the March 2006 futures contract on the euro forex market on Jan. 9, 2006. Two moving averages of the close for the bar are plotted: a four-bar average in red (fast) and a nine-bar average in blue (slow).

Cycle analysis combined with evidence of a potentially overbought rally on the daily candlestick chart generates a sell signal for that date. Entering on the regular session open at 7:20 a.m., marked by the first blue vertical line (A), would require risking at least 10 ticks, or $125 per contract. The crossing of the fast moving average under the slow moving average at 8:39 a.m. provided another entry point as the price tested a level of resistance established earlier in the day just above 1.2135.

The second blue vertical line (B) marks a level to take profits as the fast moving average crosses above the slow moving average. The third vertical line (C) marks where the price returns to the opening range of the regular session and then the fast moving average once again crosses under the slow moving average. That would be the logical place to again go short, if you had moved your protective stop to lock in profits and were therefore flat at that point in time. The fourth blue line (D) marks another level with a moving-average crossing marking a point for taking profits.

For markets with a 7:20 a.m. open, it is best to wait to initiate a trade until after 7:30 on days when important reports are released. Although it may involve sacrificing entering the trade at the best price, you will avoid having the market move through a protective stop in the event of an unexpected report.

Backtesting this approach on the euro forex futures generates 175 trades for the past year. …