THE NEW TRADING OF A LIVING
THE IMPULSE SYSTEM
The idea for the Impulse system came to me in the mid-1990s. I woke up in the middle of the night in a faraway hotel and sat up bolt upright in bed with the thought that I could describe any market move in any timeframe, using only two criteria: inertia and power. By combining them, I could find stocks and futures with both bullish inertia and bullish power and trade them long. I could also find stocks and futures with both bearish inertia and power and sell them short.
A good measure of the inertia of any trading vehicle is the slope of its fast EMA. A rising EMA reflects bullish inertia, while a falling EMA reflects bearish inertia. The power of any trend is reflected in the slope of MACD-Histogram. If its latest bar is higher than the previous bar or less deep than the previous bar, then the slope of MACD-Histogram is rising, and the power is pushing up. If the latest bar of MACD-Histogram is lower than the previous one, then the slope is declining, and the power is pushing down. When we use MACD-Histogram to define power, it doesn’t matter whether it’s above or below zero: what matters is the relationship of the last two bars of MACD-Histogram.
It is relatively simple to program most software packages to color price bars or candles using the Impulse system. If both indicators are rising, the bar is green—bullish. If both are falling, the bar is red—bearish. When the two indicators move against one another, that bar is blue—neutral.
At first, I anticipated making this system automatic—buy green, short red, and cash checks on all colors. Backtesting the Impulse system threw cold water on that idea. The automatic system caught every single trend, but it got whipsawed during trading ranges, where it kept flipping between green and red.
I set the Impulse system aside, but kept thinking about it. A few years later it dawned on me: this wasn’t an automatic trading system—it was a censorship system! It didn’t tell me what to do—it told me what not to do. If either weekly or daily bar was red—no buying allowed. If either weekly or daily bar was green—no shorting permitted.
FIGURE The colors of the Impulse system.
- EMA rising & MACD-Histogram rising (especially below zero) = Impulse is green, bullish. Shorting prohibited, buying or standing aside permitted.
- EMA falling & MACD-Histogram falling (especially above zero) = Impulse is red, bearish. Buying prohibited, shorting or standing aside permitted.
- EMA rising & MACD-Histogram falling = Impulse is blue, neutral. Nothing is prohibited.
- EMA falling & MACD-Histogram rising = Impulse is blue, neutral. Nothing is prohibited.
And that’s how I’ve been using the Impulse system ever since. It keeps me out of trouble. I may develop my trading plans based on any number of ideas, signals, or indicators—and then the Impulse system forces me to wait until it no longer prohibits an entry in the planned direction. In addition, the Impulse system helps me recognize when a trend starts weakening and suggests an exit.
Green and red bars of the Impulse system show when both inertia and power are pointing in the same direction. At a green bar, bulls are in charge and the uptrend is accelerating. At a red bar, bears are dominant and the downtrend is in full swing. A fast EMA and MACD-Histogram may stay in gear with each other for only a few bars, but that’s when the market travels fast—the impulse is on!
Before you start applying the Impulse system to your favorite market, remember the Triple Screen’s insistence on analyzing markets in more than one timeframe. Select your favorite timeframe and call it intermediate. Multiply it by five to define your long-term timeframe. If your favorite chart is daily, analyze the weekly chart first and make a strategic decision to be a bull or a bear. Use the Impulse system to decide when you’re permitted to enter long or short positions.
- If you’re a short-term momentum trader, you can buy as soon as both timeframes turn green and take profits as soon as one of them fades to blue.
- When trying to catch market turns, the best trading signals are given not by green or red but by the loss of green or red colors.
If a stock is falling, but your analysis indicates that a bottom is near, monitor the Impulse system on weekly and daily charts. If even one of them shows red, the downtrend is still in force and buying is not permitted. When both timeframes stop being red, they allow you to buy.
If you think that a stock is forming a top and is about to turn down, examine the Impulse system on both weekly and daily charts. If even one of them is green, it’s a sign that the uptrend is still alive, and no shorting is permitted. When the green disappears from both timeframes, you may start shorting.
The shorter a timeframe, the more sensitive its signals: the Impulse on a daily chart almost always changes colors ahead of the weekly. When day-trading, the 5-minute chart changes colors ahead of a 25-minute chart. If my studies show that the market is bottoming and getting ready to turn up, I wait until the daily chart stops being red and turns blue or even green; then I start watching the weekly chart, which is still red. As soon as it turns from red to blue, it allows me to buy. This technique saves me from buying too soon, while the market is still declining.
I use the same approach to shorting. When I think that a top is forming and the ndaily Impulse stops being green and turns blue or even red, I closely monitor the weekly chart. As soon as it loses its green color, it permits me to go short. Waiting for both timeframes to lose the color that is contrary to my plan helps ensure that I trade in gear with the market and not against it.
FIGURE SSYS weekly with 13- and 26-week EMAs, 12-26-9 MACD-Histogram and the Impulse system.
Remember, the Impulse system is a censorship system. It doesn’t tell you what to do—but it clearly tells you what you’re not allowed to do. You’re not supposed to go against the censor. Many programs for technical analysis include a feature called “conditional formatting.” It allows you color price bars or candles depending on the slope of the EMA and MACD-Histogram. A brilliant programmer in Chicago named John Bruns used this feature when he included the Impulse system in tool kits we call elder-disks1.
If you use a platform that doesn’t permit conditional formatting, you can still use the Impulse system. Simply observe the slopes of the EMA and MACD-Histogram: their combination will tell you what should be the color of the latest bar. If you know how to program, you can add more features to the Impulse system. You can test different EMA lengths or MACD settings, looking for those that work best in your market. A day trader can program sound alarms to monitor color changes in several markets without being glued to the screen.
If you’re a short-term momentum trader, close out your trade as soon as the color of the Impulse system stops supporting the direction of your trade, even in one of the two timeframes. Usually, the daily MACD-Histogram turns ahead of the weekly. When it ticks down during an uptrend, it shows that the upside momentum is weakening. When the buy signal disappears, take profits without waiting for a sell signal.
Reverse this procedure in downtrends. Cover shorts as soon as the Impulse system stops being red, even in one of the two timeframes. The most dynamic part of the decline is over, and your momentum trade has fulfilled its goal. The Impulse system encourages you to enter cautiously but exit fast. This is the professional approach to trading. Beginners tend to do the opposite; jump into trades and then take forever to exit, hoping for the market to turn their way.
A swing trader may stay in a trade, even if one of the timeframes turns blue. What he should never do is stay in a trade against the color. If you’re long, and one of the timeframes turns red, it is time to sell and go back to the sidelines. If you’re short, and the Impulse system turns green, it signals to cover your short position. The Impulse system helps identify islands of order in the ocean of market chaos by showing when the crowd, usually so aimless and disorganized, becomes emotional and starts to run. You enter when a trend pattern emerges and exit when it starts to sink back into chaos.
Channel Trading Systems
Market prices tend to flow in channels, like rivers in their valleys. When a river touches the right edge of its valley, it turns left. When it touches the left rim of its valley, it turns right. When prices rally, they often seem to stop at an invisible ceiling. Their declines seem to stop at invisible floors. Channels help us anticipate where those support and resistance levels are likely to be encountered.
Support is where buyers buy with greater intensity than sellers sell. Resistance is where sellers sell with greater intensity than buyers buy. Channels show where to expect support and resistance in the future. Channels help identify buying and selling opportunities and avoid bad trades. The original research into trading channels was conducted by J. M. Hurst. The Profit Magic of Stock Transaction Timing.
The late great mathematician Benoit Mandelbrot was hired by the Egyptian government to create a mathematical model of cotton prices—the main agricultural export of that country. After extensive study, the scientist made this finding: “prices oscillate above and below value.” It may sound simple, but in fact it’s profound.
If we accept this mathematical finding and if we have the means to define value and measure an average oscillation, we’ll have a trading system. We’ll need to buy below value and take profits at value or sell short above value and cover at value. We have already agreed that value is in the zone between a short and a long moving averages. We can use channels to find normal and abnormal oscillations.
Two Ways to Construct a Channel
We may construct a channel by plotting two lines parallel to a moving average: one above and another below. We may also vary the distance between the channel lines depending on that market’s volatility.
A symmetrical channel, centered around a moving average, is useful for trading stocks and futures. A standard deviation channel is good for those who trade options.
Channels mark the boundaries between normal and abnormal price action. It is normal for prices to stay inside a well-drawn channel, and only unusual events push them outside. The market is undervalued below its lower channel line and overvalued above its upper channel line.
Earlier we’ve discussed using a set of two moving averages for trading. With such a pair, use the slower one as the backbone of your channel. For example, if you use 13-day and 26-day EMAs, draw your channel lines parallel to the 26-day EMA.
The width of a channel depends on the coefficient selected by the trader. This coefficient is usually expressed as a percentage of the EMA level.
Upper Channel Line = EMA + Channel Coefficient • EMA
Lower Channel Line = EMA − Channel Coefficient • EMA
When setting a channel for any market, start with 3% or 5% of the EMA and keep adjusting those values until a channel contains approximately 95 percent of all price data for the past 100 bars, about five months on a daily chart. This is similar to trying on a shirt: you look for the one that fits not too loose or too tight, with only your wrists and neck sticking out. Only the extreme prices will protrude outside of a well-drawn channel.
Volatile markets require wider channels, while quiet markets require more narrow channels. Cheaper stocks tend to have higher coefficients than expensive ones. Long-term charts require wider channels. As a rule of thumb, weekly channel coefficients are twice as large as daily ones.
I used to plot channels by hand until my programmer wrote an add-on for several software packages called an Autoenvelope. It automatically plots correct channels for any trading vehicle in any timeframe. It’s included on elder-disks for several popular programs.
An exponential moving average reflects the average consensus of value in its time window. When prices are near their moving average, the market is fairly valued. When they decline near the lower channel line, the market is undervalued. When prices rise to the upper channel line, the market is overvalued. Channels help find buying opportunities when the market is cheap and shorting opportunities when the market is dear.
When prices fall below their moving average, bargain hunters step in. Their buying as well as short covering by bears stops declines and lifts prices. When prices rise above value, sellers see an opportunity to take profits on long positions or go short. Their selling caps the rise.
When the market sinks to the bottom of a depression, its mood is about to improve. Once it rises to the height of its mania, it’s about to start calming down. A channel marks normal limits of mass optimism and pessimism. The upper channel line shows where bulls run out of steam, while the lower channel line shows where bears become exhausted.
FIGURE Euro futures, with 26- and 13-day EMAs, the Impulse system, and Autoenvelope.
At the upper channel line, bears have their backs against the wall as they fight off the bulls. At the lower channel line, bulls have their backs against the wall and fight off the bears. We all fight harder when our backs are against the wall, and that’s why channels tend to hold.
If a rally shoots out of a channel and prices close above it, it shows that the uptrend is exceptionally strong. When a rally fails to reach the upper channel line, it is a bearish sign, as it shows that bulls are becoming weaker. The reverse applies to downtrends.
My friend Kerry Lovvorn finessed this idea by plotting not one but three sets of channels around a moving average. The width of his channels is driven by Average True Ranges1. His three channels are set at one, two, and three ATRs away from the moving average. Normal moves tend to stay within 1-ATR channels, while only extreme moves go outside of 3-ATRs, indicating a reversal is near.
Channels help us remain objective, while other traders get swept up in mass bullishness or bearishness. When prices rally to the upper channel line, you see that mass bullishness is being overdone, and it’s time to think about selling. When prices drop near the lower channel line and everyone turns bearish, you know that it’s time to think about buying instead of selling.
FIGURE RSOL daily with 21-day EMA and 1-, 2-, and 3-ATR channels, MACD-Histogram 12-26-9, and the Impulse system.
Amateurs like to bet on long shots—they tend to buy upside breakouts and short downside breakouts. When an amateur sees a breakout, he expects riches from a major new trend.
Professionals, on the other hand, tend to trade against deviations and for a return to normalcy. The pros know that most breakouts are exhaustion moves that are soon aborted. That’s why they like to fade breakouts—trade against them, selling short as soon as an upside breakout stalls and buying when a downside breakout starts returning into the range.
Breakouts can produce spectacular gains when a major new trend blows out of a channel, but in the long run it pays to trade with the pros. Most breakouts fail and are followed by reversals, which is why channel lines mark attractive zones for entering trades against breakouts, with profit targets in the value zone.
You can use moving-average channels as a stand-alone trading method or combine it with other techniques. Gerald Appel, a prominent market researcher and money manager in New York, recommended these rules for trading with channels:
- Draw a moving average and build a channel around it. When a channel is relatively flat, the market is almost always a good buy near the bottom of its trading channel and a good sell near the top.
- When the trend turns up and a channel rises sharply, an upside penetration of the upper channel line shows very strong bullish momentum. It indicates that you will probably have one more chance to sell in the area of the highs that are being made. It is normal for the market to return to its moving average after an upside penetration, offering an excellent buying opportunity. Sell your long position when the market returns to the top of the channel.
This also works in reverse during sharp downtrends. A breakout below the lower channel line indicates that a pullback to the moving average is likely to occur, offering another opportunity to sell short. When prices return to the lower channel line, it is time to cover shorts.
The best trading signals are given by a combination of channels and other technical indicators. Indicators give some of their strongest signals when they diverge from prices. A method for combining channels and divergences was described to me by the late Manning Stoller.
1. A sell signal is given when prices reach the upper channel line while an indicator, such as MACD-Histogram, traces a bearish divergence. It shows that bulls are becoming weak when prices are overextended.
2. A buy signal is given when prices reach the lower channel line while an indicator traces a bullish divergence. It shows that bears are becoming weak when prices are already low.
We must analyze markets in multiple timeframes. Look for buys on the daily charts when prices are rising on the weeklies. Look for shorting opportunities on the dailies when prices are sinking on the weekly charts.
3. Go long near the moving average when the channel is rising, and take profits at the upper channel line. Go short near the MA when the channel is falling, and take profits at the lower channel line.
When a channel rises, it pays to trade only from the long side, buying in the value zone which lies between the fast and slow moving averages, and then selling at the upper channel line. When a channel declines, it pays to short in the value zone and cover at the lower channel line.
FIGURE SIX daily with 26- and 13-day EMAs, 6% channel, MACD-Histogram 12-26-9, and the Impulse system.
Standard Deviation Channels (Bollinger Bands)
The unique feature of these channels is that their width changes in response to market volatility. Their trading rules differ from those of regular channels.
- Calculate a 21-day EMA.
- Subtract the 21-day EMA from each closing price to obtain all the deviations from the average.
- Square each of the deviations and get their sum to obtain the total squared deviation.
- Divide the total squared deviation by the EMA length to obtain the average squared deviation.
- Take the square root of the average squared deviation to obtain the standard deviation.
These steps, outlined by Bollinger, have been included in many software packages.A band becomes wider when volatility increases but it narrows down when volatility decreases. A narrow band identifies a sleepy, quiet market. Major market moves tend to erupt from flat bases. Bollinger bands help identify transitions from quiet to active markets.
These bands are useful for options traders because option prices are largely driven by swings in volatility. Narrow Bollinger bands help you buy when volatility is low and options are relatively cheap. Wide bands help you decide to write options when volatility is high and options are expensive.
When we return to options in the following chapters, you’ll read that buying options is a losers’ game. Professional traders write options. Wide Bollinger Bands can signal when to be more active with your writes. If you trade stocks or futures rather than options, it’s better to use regular channels as profit targets; trading is hard enough without trying to shoot at a moving target, such as a Bollinger Band.