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What is Trade Risk Management?
Trade Risk Management is a technical methodology for identifying
overbought and oversold markets and then using a contrarian
trading strategy to trade those markets with reduced risk.
With the introduction of Trading Signals, Trade Risk Management
offers an approach to identifying overbought/oversold trading
opportunities along with actual buy and sell signals!.
In addition to a buy or sell signal we can now also evaluate
the quality of such signals. This, we believe to be something
new. There are many services that provide traders with systems
that give buy and sell signals. But, to our knowledge, no
service actually provides their customers with a service that
evaluates the quality of their signals based on probability
bands. With other services it's buy here, sell here. Nothing
more said.
At Trade Risk Management you'll find charts for stock markets
around the world, international world currencies, spot prices
(including the base metals of the London Metal Exchange) and
commodity futures prices. If there is a special time series
you would like to see displayed on a regular basis, or have
any comments about improvements to the website, please email
me. I look forward to hearing from you.
What are Trading Signals?
Chart 1
To get a better idea of what Trading Signals
are, focus your attention on the image displayed in Chart
1 above.
Trading Signals are based on the idea that buy/sell signals
are generated when the price crosses above and below a trendline.
Usually, this trendline is a moving average or some exponential
smoothing of the prices. But, in TRM's Trading Signals this
trendline (always displayed in red!) is calculated
according to a proprietary algorithm. Nevertheless, the use
of the red trendline conforms to customary crossover usage.
Thus, when the price moves above the red trendline we have
a buy signal and when the price falls below the red trendline
we have a sell signal.
Notice also that the current price is displayed in the box
toward the bottom of the chart. Also, the latest buy or sell
price is displayed. This buy/sell price is simply the current
value of the red trendline. As we will see later this value
can also double as a stop loss point.
In addition to the prices and red trendline you will notice
that we also display a set of the Sigma Bands. Note that these
Sigma Bands are not the same Sigma Bands that appear on TRM's
Sigma Band chart. These Sigma Bands are designed to respond
faster to changes in both price and momentum. The Trading
Signal chart shows the position of the current price in relation
to the bands. Thus, in each case, we see if the price is overbought
or oversold, as defined in terms of probability.
Finally, notice that the box also contains some comments
and warning messages. These messages refer to the "quality"
of the buy or sell signal. We'll discuss these messages in
detail later on in the FAQ.
What are the benefits of the new Trading
Signals?
The new Trading Signals are designed to give frequent buy
and sell signals. In addition, our new Trading Signals are
designed to show where the buy/sell signal occurs within relation
to the Sigma Bands and to show what is happening with momentum
when the buy or sell signal occurs. This then gives us the
ability to judge the quality of the buy and sell signals.
After all, not every signal can be expected to result in a
successful trade. However, with the ability to judge the quality
of the signal the trader has a better chance of being on the
winning end of a good trade and also a better chance of avoiding
being on the losing end of a bad trade.
What are the differences between Signal
Bands and Trading Signals?
There are two main differences between Signal Bands and Trading
Signals. First, the original Signal Bands were designed to
give the trader an entry point into an overbought or oversold
market based on the overbought/oversold conditions indicated
by the Sigma Bands chart. The new Trading Signals are more
of a stand alone chart. In fact, the Sigma Bands that are
displayed are not the same Sigma Bands shown on our Sigma
Bands chart. They are designed to react faster to changes
in the underlying prices. The trader may act on a buy or sell
signal with the new chart without actually consulting the
original Sigma Bands chart, although this is not advisable.
The other big difference between the two charts is the original
Signal Bands attempts to give an entry point but no exit point.
The new Trading Signals give both. The new Trading Signals
track a buy or sell signal as it is unfolding. Once the buy
or sell signal occurs the algorithm switches mode and tracks
the next sell or buy signal. This process toggles back and
forth indefinitely.
What is the "Fundamental Rule"?
The "Fundamental Rule" simply says
"The further away the price is from the solid, neutral
trendline the higher the profit potential."
The reason the Fundamental Rule is important is because it
allows the trader to spot situations when a trade can be initiated
in either an overbought or oversold region. Prices are naturally
distributed around the solid, neutral trendline on the Sigma
Band chart. The distributions of the price deviations from
this solid neutral trendline are naturally bell shaped in
appearance. Overbought and oversold regions are defined as
the "tails" of this bell shaped curve. The probabilities
associated with the tails are very low. Thus, when prices
move into the tails, that is, the overbought or oversold regions,
then prices will naturally migrate back to regions of higher
probability, that is, toward the solid, neutral trendline.
What messages are displayed on the chart?
There can be as many as three lines of messages included
in the Trading Signals chart. The first line is always the
same. It tells you what the current price is along with the
latest buy or sell information. As stated before, when the
price moves from below to above the red trendline we have
a buy signal and the buy point is the value of the red trendline.
Similarly, when prices move from above to below the red trendline
we have a sell signal and the sell point is the value of the
red trendline.
The second and third line can vary depending of the quality
of the buy or sell signal. The messages are one of three types:
"Notes", "Warnings", and "Danger".
A "Note" is simply a notational message informing
the trader that the signal is occurring under normal circumstances.
A "Warning" message is a message informing the trader
that a signal is occurring under less than optimal circumstances.
Finally, a "Danger" message is informing the trader
that the buy or sell signal is occurring under very undesirable
circumstances. Chart 4 below illustrates all three types of
messages.
What does the first message line say?
The first line always gives information about the trade.
First, it gives us the current close or settlement price for
the market the chart pertains to. It then gives the buy or
sell price that is currently in effect. This is the price
at which the price crossed over the red trendline. The third
value is the current value of the red trendline. It can be
used as a stop loss point. More will be said about this later.
What are "note" messages?
Chart 2
"Note" messages are designed to be information
messages concerning the buy or sell signal. When a signal
occurs it can occur under negative conditions or it can occur
under conditions that the trader would expect to see happen.
For example, ideally a sell signal occurs when the price is
in an overbought region. One could then expect to see a confirmation
message informing the trader that such a signal has occurred.
This is a "note" message. Chart 2 above illustrates
the "note" message for a successful sell signal
in the Copper market.
What are "warning" messages?
Chart 3
"Warning" messages are designed to be actual warnings
that a buy or sell signal has occurred under less than optimal
trading conditions. For example, suppose a buy signal is generated
when prices are close to the solid, neutral trendline. Ideally,
a buy signal should occur when prices are below the -2 Sigma
level. If the buy signal occurs well above the -2 Sigma level,
then a warning message notifying the trader of the less than
ideal buying conditions, is generated.
Warning messages are generated to simply let the trader know
that something may be wrong. The trader can still act on them.
It's a judgment call. For example, suppose a sell signal occurs
with prices coming down from above the +2 Sigma level? Since
the sell signal occurs below the +2 Sigma level a warning
message could appear. However, if the same signal had occurred
just above the +2 Sigma level then a "note" message
would have been generated. Under these conditions a trader
may indeed want to take a sell position. Again, it's a judgment
call.
Chart 3 illustrates this condition. Notice that the sell
signal occurs at around +1.5 Sigma. This could be a good sell
signal. But, because the sell signal occurred below +2 Sigma
the trader gets a warning message. It's the trader's decision
to act or not act on this signal.
What are "danger" messages?
Chart 4
"Danger" messages are designed to be extreme warnings
that a buy or sell signal has occurred under very dangerous
trading conditions and should be questioned by the trader.
For example, suppose a buy signal is generated when prices
are in the overbought region, that is, above +2 Sigma. Ideally,
a buy signal should occur when prices are below the -2 Sigma
level. If the buy signal occurs when prices are in the +2
Sigma level, then a "danger" message is generated.
Essentially, a buy signal has occurred when the trader would
expect a sell signal.
Chart 4 illustrates a bad sell signal. Notice the sell signal
occurs below the -2 Sigma level, that it, in the oversold
region. Why would one want to sell something that is oversold?
Not surprisingly, a "Danger" message is displayed.
And as it turns out the sell signal was a false sell signal.
Sugar prices gave a buy signal within a couple of trading
sessions and now Sugar prices are well above their -2 Sigma
level.
Traders should always take "danger" messages very
seriously. Danger messages are designed to keep the trader
from making bad mistakes.
What about momentum analysis!!??
In our analysis of Sigma Bands we have always stressed the
importance of momentum analysis. Nothing has changed here.
Momentum analysis is designed to keep the trader out of bad
trades and to help identify successful buy or sell signals.
In momentum analysis we monitor the relationship between
the red and black momentum lines displayed at the bottom part
of the chart. Consider, as an example, the red and black momentum
lines at the bottom part of the chart labeled "Chart
1" above. Notice, that when the buy signal occurs, that
is, at the time when the green ellipse occurs, the red momentum
line has converged to the black momentum line. In this case
the two momentum lines have simply converged, not actually
crossed. Ideally, we would like to see the red momentum line
move above the black momentum line.
Ideally, when a buy signal occurs we see the red momentum
line over black momentum line. This confirms that momentum
is strengthening. This is what the trader should look for.
When a buy signal occurs look for strengthening momentum.
When a sell signal (a red ellipse) occurs look for weakening
momentum. In Chart 1, the two momentum lines are converging
at a sufficient rate that one can conclude the red momentum
will remain above the black momentum line during the buy signals
lifetime.
Ideally we should always see the red momentum line cross
the black momentum line as a buy or sell signal is occurring.
However, in practice this does not always happen. So, if the
red and black momentum lines have not actually crossed then
look to see if they are at least getting closer and closer
to each other. In other words, are the two momentum lines
"converging?" Converging momentum lines can be a
good sign that prices are preparing to reverse direction.
But be careful here. Converging momentum lines are not as
good an indicator as momentum lines that have actually crossed.
Just how close should the lines be? That's a judgment call.
In Chart 1 above the red and black momentum lines are converging.
So the trader needs to decide if this is a good buy signal.
As it turns out it was an excellent buy signal and well worth
the risk. But, again it is a judgment call.
Notice in Chart 2 that we have an excellent example of a
good sell signal. When the sell signal occurs the red momentum
line has dropped below the black momentum line. This helps
confirm the validity of the sell signal, which turned out
to be an extremely profitable trade.
The trader should always be concerned when a buy or sell
signal occurs with the momentum lines getting further apart.
Diverging momentum lines usually indicate that the prices
may continue in the direction the momentum is already indicating.
What about stop loss points?
There are those who hate stop loss orders, do not use them
and recommend no one else use them. On the other hand there
are those who swear by them and would not think of trading
without them. We take the view that it's up to the individual
trader to decide for themselves where stop loss orders fit
into their trading strategies.
We don't actually use any kind of special algorithm to compute
a stop loss point. However, we define buy and sell signals
by the value of the red trendline. When prices cross the red
trendline it is a buy or sell signal. Therefore, one could
consider the current value of the red trendline as a stop
loss point. For example, suppose one is in a buy position.
Then the current value of the red trendline could easily be
used as the current stop loss point. If the price were to
drop below this point it would automatically trigger a clearing
of the position. Does one then also want to turn around and
use the same red trendline value to initiate a sell position?
That, of course, is up to the trader. Again, it's a judgment
call.
Notice on Chart 1 above that the first line ends with the
words "trend @". This is the current value of the
red trendline and could be used as a stop loss point, if one
so chooses.
What kind of signals should I look
for when I want to buy?
If you're looking to buy the first thing to look for is the
present price in relation to the Sigma Bands. Ideally, prices
should be below the -2 Sigma level or at least close to the
-2 Sigma level. Remember, the Fundamental Rule tells you that
the profit potential increases the further below the solid
trendline the current price is. So if the buy signal were
to occur at the -3 Sigma level it would be better than a buy
signal at the -2 Sigma level.
The next thing to look for is the actual buy signal itself.
Has it occurred or is it so close to occurring that you're
willing to assume the risk that it will occur? Never buy if
it appears that a sell signal is eminent.
Finally, check to see if momentum is going your way. If you're
going to buy you should feel comfortable that momentum is
strengthening. Without momentum going in your direction the
profit potential could be very disappointing. Chart 1 illustrates
these ideas.
What kind of signals should I look
for when I want to sell?
If you're looking to sell the first thing to look for is
the present price in relation to the Sigma Bands. Ideally,
prices should be above the +2 Sigma level or at least close
to the +2 Sigma level. Remember, the Fundamental Rule tells
you that the profit potential increases the further above
the solid trendline the current price is. So if the sell signal
were to occur at the +3 Sigma level it would be better than
a sell signal at the +2 Sigma level.
The next thing to look for is the actual sell signal itself.
Has it occurred or is it so close to occurring that you're
willing to assume the risk that it will occur? Never sell
if it appears that a buy signal is eminent. Chart 2 illustrates
these ideas.
Finally, check to see if momentum is going your way. If you're
going to sell you should feel comfortable that momentum is
weakening. Without momentum going in your direction the profit
potential could be very disappointing.
Don't be too precise in
your selections!
TRM's Trading Signals will be giving you many buy and sell
signals. It will be up to you to filter out which signals
you choose to act on. But in our discussion on what criteria
you should use to make decisions, things can get a bit "fuzzy",
such as buying or selling outside the +/- 2 Sigma level. For
example, suppose that prices are just at the 1.95 Sigma level?
Should you act then? It's up to you but don't be too exact.
Prices may not go any higher and you may be getting a good
sell signal. So use some judgment here. Things are not that
absolute that prices MUST satisfy the criteria. There will
be many good buy and sell signals you may pass up if you become
too literal. Use some judgment here!
Important Disclaimer
In the world of Technical Analysis software developers speak
of "buy" and "sell" signals. This is simply
terminology that has been adopted to denote signals associated
with price crossover points. These buy or sell signals are
not actual recommendations to buy or sell. They are simply
crossover points and it is up to the individual traders to
decide for themselves whether to act of these signals. Use
the signals at your own risk!
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