A system is a set of rules for finding, entering, and exiting trades. Every serious trader has one or more systems. Compare this to a surgeon who has systems for performing operations. He doesn’t waste time and energy deciding whether to order anesthesia, where to make the cut, or how to find the sick organ. He follows a well-established routine, which leaves him free to think about strategic issues, finesse his technique, or deal with any complications.

Some people use strictly defined systems that leave very little room for personal judgment—we call them mechanical traders. Others use systems that leave plenty of room for personal decisions—we call them discretionary traders. There is a very thoughtful discussion on matching one’s personality type to various trading styles in Richard Weissman’s book Mechanical Trading Systems. Whatever approach you take, the key advantage of any system is that you design it when the markets are closed and you feel calm. A system becomes your anchor of rational behavior amidst the turbulence of the market.

It goes without saying that a proper system is written down. This needs to be done because it’s easy to forget some essential steps when stressed by live markets. Dr. Atul Gawande in his remarkable book The Checklist Manifesto makes a convincing case for using checklists to raise performance levels in a large variety of demanding endeavors, from surgery and construction to trading.

A mechanical trader develops a set of rules, back-tests them on historical data, and then puts his system on autopilot. Going forward, his software starts flashing orders for entries, target, and stops, and a mechanical trader is supposed to place them exactly. Whether he’ll stick to his plan or attempt to tweak or override those signals is another story, but that’s how the system is supposed to work.

An amateur feels relieved that a mechanical system, either his own or purchased from a vendor, will relieve him from the stress of decision making. Unfortunately, market conditions keep changing, and mechanical systems eventually get out of gear and start losing money. The market is not a mechanical entity that follows the laws of physics. It is a huge crowd of people acting in accordance with imperfect laws of mass psychology. Mechanical methods can help, but trading decisions must take psychology into account.

A professional trader with a mechanical system continues to monitor its performance like a hawk. He knows the difference between a normal drawdown and a period when a system goes out of gear and has to be shelved. A professional trader can afford to use a mechanical system precisely because he is capable of discretionary trading! A mechanical system is an action plan, but some degree of judgment is always required, even with the best and most reliable plans.

A discretionary trader approaches each day in the markets afresh. He tends to examine more factors than a mechanical trader, weigh them differently at different times, and be more attuned to changes in current market behavior. A good discretionary system, while giving you plenty of freedom, includes several inviolate rules, especially in the area of risk management.

Both approaches have pluses and minuses. On the plus side, mechanical trading can be less emotionally tense. You build your system, turn it on, and go about your life without watching every tick. On the minus side, these living and breathing markets have a sneaky way of changing their tunes and behaving differently from how they did when you built your system. The main plus of discretionary trading is the openness to fresh opportunities. Its biggest minus is that people’s judgment tends to slip under stress, when they become excited by greed or frightened by sharp moves.

In my experience, mechanical traders tend to deliver more steady results, but the most successful traders use discretionary methods. Your choice is likely to depend on your temperament. That’s how we make some of our most important decisions in life— where to live, what career to pursue, whom to marry. Our key choices stem from the innermost core of our personalities rather than rational thought. In trading, cooler and more obsessional people tend to gravitate toward mechanical trading, while themore swashbuckling types turn to discretionary trading.

Paradoxically, at the high end of performance, these two approaches begin to converge. Advanced traders combine mechanical and discretionary methods. For example, a friend who is a died-in-the-wool mechanical trader uses three systems in his hedge fund but keeps rebalancing capital allocated to each of them. He shifts millions of dollars from System A to System B or C, and back again. In other words, his discretionary decisions augment his systematic trading. I am a discretionary trader, but follow several strict rules that prohibit me from buying above the upper channel line, shorting below the lower channel line, or putting on trades against the Impulse system. These mechanical rules reduce the number of bad discretionary trades.

System Testing, Paper Trading, and the Three Key Demands for Every Trade

Before trading real money with a system, you need to test it, whether you developed it yourself or bought it from a vendor. This can be done in one of two ways. One is backtesting: apply your system’s rules to a stretch of historical data, usually several years’ worth. The other is forward-testing: trade small positions with real money. Serious traders begin with backtesting, and if its results look good, switch to forward-testing; if that works well, they gradually increase position size.

Looking at printouts of historical results is a nice start, but don’t let good numbers lull you into a false sense of security. The profit-loss ratio, the longest winning and losing streaks, the maximum drawdown, and other parameters may appear objective, but past results don’t guarantee the system will hold up in the real world of trading.

You may see a very nice printout, but what if, once you begin to trade real money, that system delivers five losses in a row? Nothing in your paper testing will have prepared you for that, but it happens all the time. You grit your teeth and put on another trade. Another loss. Your drawdown is deepening, and then the system flashes a new signal. Will you put on the next trade? Suddenly, an impressive printout looks like a very thin reed on which to hang the future of your account.

There is a cottage industry of programmers who back-test systems for a fee. Some traders, too suspicious to disclose their “sure-fire methods,” spend months learning to use testing software. In the end, only one kind of backtesting prepares you to trade—manual testing. It is slow, time-consuming, and cannot be automated, but it’s the only method that comes close to modeling real decision making. It consists of going through historical data one day at a time, scrupulously writing down your trading signals for the day ahead, and then clicking one bar forward and recording new signals and trades for the next day.

Begin by downloading daily price and volume data for your trading vehicle for a minimum of two years. Open a chart and, without looking, swing immediately to its very beginning. Open your spreadsheet, write down your system’s rules at the top of the page, and create columns for dates, prices, and signals. Open two windows in your analytic program—one for your weekly chart and its indicators, the other for the daily chart. The two most important keyboard keys for testing are <Alt> and <Tab> because they let you switch between windows and programs.

As you click forward, one day at a time, trends and trading ranges will slowly unfold and challenge you. At that point, you’ll be doing much more than testing a set of rules. Moving ahead one day at a time will test and improve your decision-making skills. This one-bar-at-a-time testing is vastly superior to what you can get from backtesting software.

How will you deal with gap openings, when the market leaps above your buy level or drops below your stop at the opening bell? What about limit moves in futures? Clicking forward one day at a time and writing down your signals and decisions will get you as close to real trading as you can without risking cash. It’ll keep you focused on the raw right edge of the market. You’ll never get that from a neat printout of a system test. Manual testing will improve your ability not only to understand the markets but to make decisions.

If one-bar-at-a-time testing shows positive results, start trading small positions with real money. These days, with brokerage commissions as low as $1 for buying or selling 100 shares, you can test your indicators and systems while risking tiny amounts. Be sure to keep good records, and if your real-money results continue positive, start increasing the size of your trades. Do it in steps, all the way up to your normal trade size.

Paper Trading

Paper trading means recording your buy and sell decisions and tracking them like real trades, but with no money at risk. Beginners may start out paper trading, but most people turn to it after getting beat up by the markets. Some even alternate between real and paper trades and can’t understand why they seem to make money on paper but lose whenever they put on a real trade. There are three reasons.

First, people are less emotional with paper trades, and good decisions are easier to make with no money at risk. Second, in paper trades, you always get perfect fills, unlike real trading. Third and most important, good trades often look murky when you consider them. The easy-looking ones are more likely to lead to problems. A nervous beginner jumps into obvious-looking trades and loses money, but paper trades the more challenging ones. It goes without saying that hopping between real and paper trades is sheer nonsense. You either do the one or the other.

Psychology plays a huge role in how your trades turn out, and that’s where paper trading fails to deliver. Pretend-trading with no money at risk is like sailing on a pond—it does little to prepare you for real sailing on a stormy sea.

There is only one good reason to paper trade—to test your discipline as well as your system. If you can download your data at the end of each day, do your homework, write down your orders for the day ahead, watch the opening and record your entries, then track your market each day, adjusting your profit targets and stops—if you can do all of this for several months in a row, recording your actions, without skipping a day—then you have the discipline to trade real money. An impulsive person who trades for entertainment will not be able to paper trade that way because it requires real work.

You may open an account with one of several websites set up for paper trading. Enter your orders, check whether they have been triggered, and write down those “fills.” Enter all paper trades in your spreadsheet and your trading diary. If you have the willpower to repeat this process daily for several months, then you have the discipline for successful real trading.

Still, there is no substitute for trading real money because even small amounts rev up emotions more than any paper trade. In recent years, I’ve had a front row seat watching traders progress from paper trading to profitable real-money trading. The discipline of submitting a weekly trade plan with entry, target, and stop gets people into the habit of being organized and focused. As their picks improve, they start earning performance bonuses in our weekly competition. 

At that point, I may receive an e-mail saying that while they’re doing well in the competition, their private trading lags behind. I tell them they’re on the right track and to continue what they’re doing. Sure enough, several months later their new skills migrate into real trading. Now they may write that their private trading is better than their performance in the competition. Sure—I reply—it’s because you pay more attention to real-money trades!

Speaking of trade setups, it’s essential to write down all relevant numbers before you enter a trade. You’re more objective before you put any money at risk; once in a trade, you’ll be tempted to give it “more room to run.” That’s how losers turn small drawdowns into disasters. I once consulted a man who refused to take a $200 loss until it ran into a $98,000 wipeout.

We’ll focus on risk and money management in a later chapter when I discuss the concept of “The Iron Triangle of risk control.” At this point, I only want to make clear that risk management is the essential part of serious trading. Forget the days when you would look at the ceiling and say, “I’ll trade 500 shares,” “I’ll trade a thousand shares,” or any other arbitrary number. Later in this book, you’ll learn a simple formula for sizing your trades, based on your account and risk tolerance.

At the time of this writing, I have three strategies that I trade. My favorite is a false breakout with a divergence. My second choice is a pullback to value during a powerful trend—that’s the strategy of the trade shown on the screen. Last, I occasionally “fade an extreme”—bet on a reversal of an overstretched trend. Each of these strategies has its rules, but the key point is this—I’ll only take a trade that fits one of them. No chasing of random cars for this old dog!

Three Key Demands for Every Trade

There are three essential angles that must be considered for every planned trade. We’ll briefly review them here and then elaborate on specific trading systems and risk management. The discipline of these three demands is essential for anyone serious about trading.

FIGURE  Three key demands for every planned trade.

Triple Screen Trading System

I developed this system and first presented it to the public in an April 1986 article in Futures magazine. I’ve been using it for trading since 1985, and it stood the test of time. I continue to tweak it, adding or changing minor features, but its basic principle remains unchanged: making trading decisions using a sequence of timeframes and indicators.

Triple Screen applies three tests or screens to every trade. Many trades that seem attractive at first are rejected by one or another screen. The trades that pass the Triple Screen test are much more likely to succeed.

The Triple Screen combines trend-following indicators on long-term charts with counter-trend oscillators on the intermediate charts. It uses special entry techniques for buying or selling short as well as tight money management rules. The Triple Screen is more than a trading system: it is a method, a style of trading.

Trend-Following Indicators and Oscillators

Beginners often look for a magic bullet—a single indicator for making money. If they get lucky for a while, they feel as if they discovered the royal road to riches. When the magic dies, amateurs give back their profits with interest and look for another magic tool. The markets are too complex to be analyzed with a single indicator.

Different indicators give contradictory signals in the same market. Trend-following indicators rise during uptrends and give buy signals, while oscillators become over-bought and give sell signals. Trend-following indicators turn down in downtrends and give signals to sell short but oscillators become oversold and give buy signals.

Trend-following indicators are profitable when markets are moving but lead to whipsaws in trading ranges. Oscillators are profitable in trading ranges, but give premature and dangerous signals when the markets begin to trend. Traders say: “The trend is your friend,” and “Let your profits run.” They also say: “Buy low, sell high.” But why sell if the trend is up? And how high is high?

Some traders try to average out the signals of trend-following indicators and oscillators, but those votes are easy to rig. Just as Republicans and Democrats in the United States keep redrawing electoral districts to create “safe” seats, traders keep selecting indicators that deliver the votes they want to see. If you use more trend-following tools, the vote will go one way, and if you use more oscillators, it’ll go the other way. A trader can always find a group of indicators telling him what he wants to hear.

Choosing Timeframes—the Factor of Five

Another major dilemma is that the trend of any trading vehicle can be both up and down at the same time, depending on what charts you use. A daily chart may show an uptrend, while a weekly chart shows a downtrend, and vice versa. We need a system to handle conflicting signals in different timeframes.

Charles Dow, the author of the venerable Dow Theory, stated at the turn of the twentieth century that the stock market had three trends. The long-term trend lasted several years, the intermediate several months, and anything shorter than that was a minor trend. Robert Rhea, the great market technician of the 1930s, compared these three trends to a tide, a wave, and a ripple. He recommended trading in the direction of the tide, taking advantage of the waves, and ignoring the ripples.

Times have changed, and the markets have become more volatile. Computers are cheap, or even free; live data have created better opportunities to capitalize on faster moves. We need a more flexible definition of timeframes. The Triple Screen trading system is based on the observation that every timeframe relates to the larger and shorter ones by approximately a factor of five.

Begin by asking yourself, what’s your favorite timeframe. Do you prefer working with the daily, 10-minute, or any other charts? Whatever timeframe is your favorite, the Triple Screen calls that the intermediate timeframe. The long-term timeframe is one order of magnitude longer. The short-term timeframe is one order of magnitude shorter. Once you select your intermediate timeframe, you may not look at it until you examine the longer-term timeframe and make your strategic decision there.

For example, if you want to carry a trade for several days or weeks, then your intermediate timeframe is likely to be defined by the daily charts. Weekly charts are one order of magnitude longer, and they’ll determine the long-term timeframe for you. Hourly charts are one order of magnitude shorter, and they’ll determine the short-term timeframe.

Day traders who hold their positions for less than an hour can use the same principle. For them, a 5-minute chart may define the intermediate timeframe, a 25-minute chart the long-term timeframe, and a 2-minute chart the short-term timeframe.

Triple Screen demands that you examine the long-term chart first. It allows you to trade only in the direction of the tide—the trend on the long-term chart. It uses the waves that go against the tide for entering positions. For example, when the weekly trend is up, daily declines create buying opportunities. When the weekly trend is down, daily rallies provide shorting opportunities.

First Screen—Market Tide

Triple Screen begins by analyzing the long-term chart, one order of magnitude greater than the one you plan to trade. Most traders pay attention only to the daily charts, with everybody watching the same few months of data. If you begin by analyzing weekly charts, your perspective will be five times greater than that of your competitors.

Begin by selecting your favorite timeframe and call it Intermediate. Do not even glance at your intermediate chart because it’ll prejudice you. Go immediately to the timeframe one order of magnitude longer—your long-term chart. That’s where you’ll make your strategic decision to be a bull or a bear. After that, return to the intermediate timeframe and start making tactical decisions, such as where to enter and where to place a stop.

If you make the mistake of looking at the daily chart first, you’ll be prejudiced by its patterns. First, make an unbiased decision on a long-term weekly chart before even glancing at the daily. The original version of Triple Screen used the slope of weekly MACD-Histogram as its weekly trend-following indicator. It was very sensitive and gave many buy and sell signals. 

Later I switched to using the slope of a weekly exponential  moving average as my main trend-following tool on long-term charts. After I invented the Impulse system, I began to use it for the first screen of Triple Screen. The Impulse system combines the best features of the previous two methods. It is not quite as jumpy as MACD-Histogram but is faster to react than the slope of an EMA.

FIGURE  Gold weekly, with 26- and 13-EMAs and MACD-Histogram (12-26-9).

The Impulse system doesn’t tell you what to do. It’s a censorship system that signals what you’re prohibited from doing. When the Impulse system is red, it prohibits you from buying. When it is green, it prohibits you from shorting. Glancing at a weekly chart when you want to buy, you have to wait until it stops being red. Glancing at a weekly chart when you want to sell short, you have to make sure it isn’t green. The blue Impulse permits you to trade either way.

Some traders use other indicators to identify major trends. Steve Notis wrote an article in Futures magazine showing how he used the Directional System as the first screen of Triple Screen. The principle is the same. You can use most trend-following indicators, as long as you analyze the trend on the weekly charts first and then look for trades on the daily charts only in that direction.

Screen One Summary: Identify the weekly trend using a trend-following indicator and trade only in its direction. A trader has three choices: buy, sell, or stand aside. The first screen of the Triple Screen trading system takes away one of those options. It acts as a censor who permits you only to buy or stand aside during major uptrends. It allows you only to sell short or stand aside during major downtrends. You have to swim with the tide or stay out of the water.

Second Screen—Market Wave

The second screen of Triple Screen identifies the wave that goes against the tide. When the weekly trend is up, daily declines point to buying opportunities. When the weekly trend is down, daily rallies point to shorting opportunities.

The second screen applies oscillators, described in a previous section, to the daily charts in order to identify deviations from the weekly trend. Oscillators give buy signals when markets decline and sell signals when they rise. The second screen of the Triple Screen allows you to take only those signals on the daily charts that put you in gear with the weekly trend.

Screen Two: Apply an oscillator to a daily chart. Use daily declines during weekly uptrends to find buying opportunities and daily rallies during weekly downtrends to find shorting opportunities. I like using Force Index, for the second screen, but other oscillators, such as RSI, Elder-ray, or Stochastic also perform well.

When the weekly trend is up, Triple Screen takes only buy signals from daily oscillators but doesn’t short their sell signals. The 2-day EMA of Force Index gives buy signals when it falls below its zero line, as long as it doesn’t fall to a new multi-week low. When the weekly trend is down, Force Index gives shorting signals when it rallies above its centerline, as long as it doesn’t rise to a new multi-week high.

Other oscillators, such as Stochastic and RSI, give trading signals when they enter their buy or sell zones. For example, when weekly MACD-Histogram rises but daily Stochastic falls below 30, it identifies an oversold area, a buying opportunity. When the weekly MACD-Histogram declines but daily Stochastic rises above 70, it identifies an overbought area, a shorting opportunity.

Third Screen—Entry Technique

The Third Screen is your entry technique, and here you have quite a bit of latitude. You can go to an even shorter time-frame, especially if you have live data, or you can use the same intermediate timeframe.

In the original Trading for a Living I recommended looking for a ripple in the direction of the market tide: buying a breakout above the previous day’s high for entering longs or shorting a breakdown below the previous day’s low for entering shorts.

FIGURE  Gold daily, with 26- and 13-EMAs and 2-day Force Index. 

The downside of that approach was that the stops were quite wide. Buying a breakout above the previous day’s high and placing a stop below that day’s low could mean a wide stop after a wide-range day, either putting a lot of money at risk or reducing position size. At other times, when the pre-breakout day was very narrow, placing the stop right below its low would expose that trade to the risk of being stopped out by market noise.

The breakout technique is still valid, but I seldom use it. With the wide availability of intraday data, I like to switch to 25-minute and 5-minute charts and use day-trading techniques for entering my swing trades. If you don’t have access to live data and need to place an order in the morning, before leaving for the day, I recommend an alternative approach which I call “an average EMA penetration.”

Almost every rally is penetrated by occasional pullbacks, and you want to measure how deeply those pullbacks drop below your fast EMA. Look at the daily chart for the past four to six weeks, and if it is in an uptrend, measure how deeply prices penetrate below their EMA during normal pullbacks.

FIGURE  Gold daily, with 26- and 13-EMAs. 
  • Calculate an average penetration
  • Subtract yesterday’s EMA level from today’s and add this number to today’s EMA: this will tell you where your EMA is likely to be tomorrow.
  • Subtract your average penetration from your estimated EMA level for tomorrow and place your buy order there. You’ll be fishing to buy at a bargain level, during a pullback—instead of paying a premium for buying a breakout.

An average downside penetration was $9.60. At the right edge of the screen, the 13-day EMA stands at $1,266. Deducting the recent average downside penetration from that number suggests that if today sees a spell of panic selling, we should place our buy order approximately $9 below the latest level of EMA. We can perform this calculation on a daily basis, until we finally get an opportunity to buy low. This is a much more peaceful approach than chasing runaway prices.

Triple Screen Summary

When the weekly trend is up and a daily oscillator declines, place a buy order below the fast EMA on the daily chart, at a level of an average downside penetration. Alternatively, place a buy order one tick above the high of the previous day. If prices rally, you will be stopped in long automatically when the rally takes out the previous day’s high. If prices continue to decline, your buy-stop will not be touched. Lower your buy order the next day to the level one tick above the latest price bar. Keep lowering your buy-stop each day until stopped in or until the weekly indicator reverses and cancels its buy signal.

When the weekly trend is down, wait for a rally in a daily oscillator and place an order to sell short above the fast EMA on the daily chart, at a level of an average upside penetration. Alternatively, place an order to sell short one tick below the latest bar’s low. As soon as the market turns down, you will be stopped in on the short side. If the rally continues, keep raising your sell order daily. The aim of a trailing sell-stop technique is to catch an intraday downside breakout from a daily uptrend in the direction of a weekly downtrend.

Triple Screen in Day-Trading

If you day-trade, you may select a 5-minute chart as your intermediate timeframe. Again, do not look at it, but go to a 25- or a 30-minute chart first, which will be your long-term chart. Make a strategic decision to be a bull or a bear on that longer-term chart, and then return to your intermediate chart to look for an entry and stop.

FIGURE On the left: AMZN 30-min chart with a 13-bar EMA and 12-26-9 MACD-Histogram. On the right: AMZN 5-min chart with a 13-bar EMA, 0.6% channel, and 2-bar Force Index.

A neat combination of timeframes for day-trading stocks is a set of 39- and 8-minute charts. The U.S. stock market is open from 9:30 a.m. to 4 p.m.—six and a half hours or 390 minutes. Using a 39-minute chart as your long-term screen neatly divides each day into 10 bars. Make your strategic decision there, and then drop down to a chart that’s 5 times faster—an 8-minute chart—for tactical decisions on entries and exits.

Don’t mash together too many timeframes. If you’re swing-trading, you can briefly use an intraday chart to time your entry, but then return to the daily charts. If you keep watching intraday charts, chances are they’ll shake you out of the trade prematurely. If you day-trade, then the weekly chart is not really relevant, but you may take a quick look at the daily chart. The rule is this: select your favorite chart, pair it with a long-term chart that is 5 times longer, and go to work.

Stops and Profit Targets

Proper money management is essential for successful trading. A disciplined trader takes his profits at targets, cuts losses short, and outperforms those who keep hoping and hanging on to bad trades. Before you enter a trade, write down three numbers: the entry, the target, and the stop. Placing a trade without defining these three numbers is gambling.

Triple Screen calls for setting profit targets using long-term charts and stops on the charts of your intermediate timeframe. If you use weekly and daily charts, set profit targets on the weeklies but stops on the dailies. When buying a dip on a daily chart, the value zone on a weekly chart presents a good target. When day-trading and using a 25-minute and a 5-minute pair, set the profit target on a 25-minute chart and the stop on a 5-minute chart. This helps you aim at the greater results, while holding down the risk.

The Triple Screen trading system calls for placing fairly tight stops. Since it has you trading in the direction of the market tide, it doesn’t give much room to losing trades. Get on with the tide—or get out.


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