Posts Tagged ‘stop signal’

05.01.2011 Post in Trading

Trading system structure

When developing a trading system a trader should focus on market behavior and market movement in particular. For this purpose we need to understand inner organization and life cycle of trend. Trader’s behavior and, as a result, price movement should be taken into consideration. Based on this, we can make a conclusion that markets consist of three trends. The first trend, the most continuous one, can last for several months and should be used to determine market direction for opening positions. The second trend is correction lasting for several days and determined by more sensitive indicators. The third market movement looks like a sideways trend between correction and main trend extension. This is the shortest trend continuing for one or two days. However, in this case the main trend will not be followed by correction, but by a new opposite trend. When looking for a point of entrance to the market, two or three trend indicators should give a sign to open a position. As to closing the position, an oscillator and a trend indicator should be used.

How to open a position

First, the system uses a less sensitive indicator with larger order to determine the major market direction. After the direction of the market in medium term is defined, the next target is to find a medium-term indicator giving signals within a long-term trend. Such signals usually appear after the correction of the major trend is over. Another series of signals will be required because the first intermediate signal of the medium-term trend will appear before the long-term indicator will allow the system to trade in this direction. In this case a trader should mind strict sequence of signals from indicators of various sensitivity. According to this sequence signals should appear in the following order: short-term, medium-term and long-term. As soon as the trend is defined, first intermediate and short-term signals will have already appeared, and receiving of repeated intermediate and short-term signals for several times within a long-term trend will be prior for the system.

There are lots of intermediate indicators including single and double moving averages, channel breakouts etc. The system usually does not allow for each of them, but rather uses them in the aggregate. As a result, the system is based on a combination of indicators, which can contradict with each other at worst. In such situation a trader should choose an indicator most suitable for him/her.

A position is opened by a market process activation followed by an intermediate signal. There is also certain choice of starting mechanism.

How to close a position

After determining the rules of opening a position it is essential to learn how to close it. However, this is an open question for most traders. The main trader’s target is to clearly define the end of the major trend or the beginning of the correction. Besides, a trader should gain control over him/herself when getting small profit or loss.

It is important to remember positions opened with the help of a signal are not always profitable since trend indicators can be mistaken. For this purpose a trades needs a stop signal that will determine the moment for the system to close a position. Stop signals are used to prevent a trader from money loss. Each experienced trader uses stop signals; those traders disregarding stop loss are condemned to failure, which is only a matter of time.

When trading goes in the estimated direction a trader should choose between getting quick but sure profit and further trading with hopes of larger profit. What should one do in this situation? One option supposes using trailing stop signals, another one suggests taking advantage of oscillators capable of predicting corrections and reversals of the trend.

How to use stop signals.

There are five types of the most popular stop signals:

1. Max stop loss. This signal is executed when the appointed share of initial funds or a fixed amount in an open position is lost.

2.  Trailing stop. When using this signal the position is closed when an appointed amount of current profit is lost; i.e. the stop signal follows the market and when the profit decreases by a certain amount all positions are closed automatically.

3. Profit target stop. This stop signal closes the position if certain predetermined profit is achieved.

4. Breakeven stop. This signal allows a trader to determine current profit level; when the market exceeds this level the price of opening the position appears a stop signal for exit. This is a way of insuring funds.

5. Inactivity stop. This signal is activated when the market cannot provide certain profit for the open position during a predetermined period of time.

In addition to the type of stop signal a trader should choose the size of the signal. Stop signals are divided into two categories: close and distant. Ideally, a stop loss should be located far enough to barely transcend accidental price movements, and close enough for convenient control over trading risks.

Proper use of oscillators and trend indicators

It is well known that trend indicators follow the market tendency. The very organization of indicators implies that they show past price dynamics; they indicate the beginning of a new trend only after it has already appeared, but do not predict it. This means that some time will be lost and the trend might change during this time, which can move the price in the undesirable direction. If a stop loss was not set, a trader would lose a part of profit.

In this case oscillators following a trend can be helpful. Unlike trend indicators, oscillators can be effectively used when there is no major trend and the market dynamics is limited by a quite narrow horizontal price corridor.

However, identification of market corridor limits is not the only function of oscillators. Combined with the analysis of price graphs while prevalence of a certain tendency, oscillators can predict short critical periods in the market activity called overbought or oversold market.

What requirements should be set when developing a trading system?

One of the major factors that should be taken into consideration is investment of psychological and financial resources. First, the ability of a trader to control his/her behavior and emotions has significant influence on the successfulness of trading and frequency of traded deals. A trading system employed by a trader does not become an independent program after a start; its work can be interrupted anytime at the trader’s will. Thus, the trading system must suit the temper of the trader using it.

Added by Anna Shubina ,
InstaForex Clients’ relationship manager