October 2005

Trading Tip:

In this article I will discuss three topics:  The Price Histogram study, the Virgin POC option for that study, and a method for trading with the Virgin POC that I call the Universal Method.  You can see a record of recent trades here:   http://www.enthios.com/blog.htm

Price Histogram

The Price Histogram is my favorite tool for two reasons:  It is intuitive, and it is extremely effective.  There is no hocus pocus or mathematical wizardry; no need for exponentials, or smoothing, or weighting.  The Price Histogram simply shows you what you should be able to see with the naked eye: where the market was most "comfortable" trading, over any given period.  It is also rare among technical indicators because it is leading, not lagging.  It is a leading indicator because it tells you, quite far in advance, where the market is likely to turn.  Moving averages and oscillators cannot predict; they can only suggest, and never in advance, that the market is overbought or oversold.  Lagging indicators are also notoriously bad at keeping you out of sideways chop.

Traditionally, the Price Histogram study (or others, sometimes referred to as a Market Profile) has been applied to a 30-minute chart to provide a histogram of market activity for one day.  Unless I am looking far back in time, I prefer a 5-minute chart because it is more precise.  The chart below shows a 5-minute Price Histogram study.

The histogram on the left side of the chart is drawn during the day in five-minute increments.   The length of each horizontal line in the histogram represents the amount of time that the market spent at that corresponding price.  Thus if the market spends a great amount of time at a particular price, the histogram line for that price will be longer.  The longest line in the histogram is the one price where the market spent the most amount of time. It is called the Point of Control or, alternatively, the Control Point.  Most traders refer to it as the 'POC' for short.

In this chart, you can see that the POC lies at 1183.   The beauty of the Price Histogram is that even if it was not there, you could probably still look at the chart and guess that the most amount of time was spent in the region of 1182~1184.

What is significant about the POC?  Traders collectively remember it, consciously or subconsciously.  That's all.  No math needed.  And the more time that the market trades at a particular price, the longer - or greater - that memory.  Psychologically, the POC acts as a center of gravity.  In this chart, the POC for October 12, 2005 was 1183.  Let's scroll down and look at what happened on both the day before, and the day after, October 12.

This next chart shows what happened on the day before, and after, October 12.  It is an excellent, albeit ideal, illustration of the power of the Price Histogram.  Don't worry.  I will also show you what can go wrong.

The POC on 10/11 was 1193.  Even without the histogram and the POC line, you should be able to see that the market spent most of the day in the 1191~1193 band.  At the end of the day, the market closed almost 5  points below the POC. Overnight it gapped down slightly but then, for whatever reason, started to head back up.  It is important to recognize that we cannot predict whether the market will go up or down.  We can only be reasonably sure that as the market moves closer to a POC line, the gravitational "pull" of that line increases. What happens when prices hit the line?  The same that happens to any object with weight when it comes into contact with the source of gravity: it bounces.   If it bounces hard enough - as in a tennis ball hitting a tennis racket - it will return very quickly from whence it came.  On the morning of October 12 you can see that the market moved back up to touch the previous day's POC.   Bullish traders tried to push it beyond, but not for long: that is the strength of the POC.   This also illustrates that the POC is not exact; most people familiar with price action are aware that when prices reach a turning point - be it a previous high, low, or congestion range - that point usually will not act as an exact ceiling or floor.  What happens at that point depends very much upon the players in the market at that point in time, and that means that what happens is random.  Some traders may try to move the market higher by buying.   If the collective "will" of the market is in agreement, then the market will move past the POC.   This does not happen often.  Because it does not happen often, astute traders can turn that knowledge into a profitable trading system.   That is exactly what I have done.   What usually happens instead is that the market may try to move past but then the buyers will dissipate, and sellers will take over.

Notice in the above chart that the exact same event occurred on October 13.  The market closed below the POC, then moved back up the following day. When prices hit the POC, buyers turned to sellers and the market turned back down. 

Point of Control Formation

The histogram tends to form a bell curve, although it is not always symmetrical.  Because it is "turned sideways", it more closely resembles a pennant.  If the pennant has a sharp "tip" protruding off to the right, that indicates that prices traded for a long time in a relatively limited range and so the "gravitational pull" of the resulting POC will be quite strong.  If the pennant has a blunt tip, then the POC is not well defined and should be treated accordingly.  Sometimes a pennant can have two tips, one just slightly lesser than the other.  In this case, although the indicator only shows one POC, there are two POC's.  Therefore it is helpful to pay attention to the actual shape of the histogram and draw your conclusions accordingly.

The Virgin POC

A 'Virgin' POC is one that has not been touched by prices on subsequent days.  It is a term that I came up with but its significance was first brought to my attention by a friend, Jim Swartz, who some of you may know as NQoos.  The logic is simple: as described above, a POC acts as a center of gravity for the market.  As prices move towards a POC, its gravitational pull becomes greater.  Two things happen:  the likelihood of prices moving towards that POC increases, and the likelihood of the market bouncing, or reversing, at that point increases.  But what happens after prices hit the POC, retrace, then move on through?  In that case, the POC is no longer virgin.  Psychologically, the market no longer sees it as a significant support or resistance pivot.  Traders may still see the prices that originally formed the POC as a congestion zone, but they will also note that prices moved through that congestion, and so it has been 'broken.'  It is no longer virgin.  It is less dependable as a turning point.  Again, there is no hocus pocus to this; it is just simple common sense.

The 'Virgin POCs' option in the Price Histogram study draws the POC line to the right until such a time as it is visited by prices, at which point it is no longer Virgin.  The significance of the Virgin POC (or "VPC", as I call it) is shown clearly in the 30-minute chart (below) that shows the Price Histograms for each day over the past five months.

The black circles show where a VPC clearly and obviously acted as a price attractor and reversal point.  In addition, many other VPC's on this chart also acted as support/resistance but you would have to consult the individual intraday chart to see the price action.  In the next section, we will look at several examples of intraday action relative to a Virgin POC from a previous day.

So how can we trade with this knowledge?  If prices move up toward a Virgin POC from below, you could simply short the VPOC.  If prices move down toward a Virgin POC from above, you could simply buy the POC.  I am a bit more cautious.  I look for confirmation from lagging indicators.  In this case, it does not hurt that they are lagging indicators, because they are used to confirm a leading indicator.  For this I use an oscillator.  It really does not matter which oscillator you use: MACD, CCI, RSI, and Stochastic will all tell you when the market is overbought or oversold, or at least when it is beginning to 'turn.'   Of course, they will not tell you with any confidence whatsoever, whether the market will actually turn.  That confidence comes from the Virgin POC.

I use a stochastic as my oscillator.  Rather than using the cross of the %K through the  %D line, instead I look at the %K lines on two separate stochastic studies: a very slow one, and a fast one.  I use 81 as the moving average for the slow stochastic, and 9 as the moving average for the fast stochastic.  When the slow stochastic is above the 65 band, then a cross of the 9 stochastic from above signals a short.  When the slow stochastic is below the 35 band, then a cross of the 9 stochastic from below signals a long.

I have created an Alert Study that places an arrow on the chart and generates a warning sound, whenever the fast stochastic crosses the slow from below and the slow is below 35, or when the fast stochastic crosses the slow from above and the slow is above 65.

On October 20, the S&P E-mini opened at 1197.75.  The next chart below shows what I call the "Natural Trading Range" (NTR):   bound by a Virgin POC above, and a Virgin POC below, the open price.  It was posted at the beginning of the day, as a sort of "road map" for the trading day. We have no idea whether the market will go up or down.  We only know that as prices approach ONE of the two Virgin POC's, that VPC will act as a price attractor and will pull prices towards it.  Will prices be pulled all the way to a VPC?  Maybe. Maybe not.  We may have to wait two days. All we know is that if prices touch a VPC, then look at the lagging stochastic oscillators to confirm trade entry.  Our leading indicator, the Natural Trading Range created by the Virgin POC's, tells us we will either look for longs in the 1178 area, or for shorts in the 1211.25 area.

It was not until 3:28 pm that prices finally hit the VPC below.  When prices hit the VPC, I did not go long.  Instead, I checked to see that the slow stochastic (pink) was below 35.  Then I waited for the fast stochastic to cross up.  That was my signal to go long.  The dotted line shows the intended direction of the trade.

I tend to be conservative, so I use various trade management techniques. One is to observe the Keltner bands.  Keltner Bands are simply a moving average of the average trading range. They tell you when prices are within the average range, and when they are outside of it.  For me, it is common sense that when prices move to the other end of the average trading range, I should take at least half of my profit there, as shown below.  This was a quick trade; six points in six minutes.

I then look to exit the remaining amount when the slow stochastic has reached above 65 and the fast stochastic crosses down, generating a sell signal.  Note I only use this to exit the trade.  I would not take a short unless it was at a VPC.

Trade management is also important.  Once I take a profit on the first half at the Keltner band, I will move my stop to break-even.  The following trade illustrates how the break-even stop comes in handy:

That is the Universal Method, in a nutshell.  Of course, the astute trader will employ judicious trade management.  It pays to keep a record of all trades, and not just the trades, but what happens during a trade: the high point and low point, as well as the time of day, the Keltner band touches, and anything else that is relevant.  With this information organized in a spreadsheet, you can optimize both your stops and your targets.  You can also determine which times of day are most effective, and when not to trade.  You can also determine whether certain days of the week are less effective than others.  Knowing where the optimum stop lies is very important.  Here is an example of the practical application of this knowledge:

It is said that markets have personalities.  I agree, but feel it’s more helpful to think of markets having mood swings.  It also helps to view markets as living, breathing entities with a personality akin to someone with a bipolar condition.  The markets rest and are at peace, then suddenly erupt and run in one direction until they exhaust themselves, then rest again.  Technically speaking, markets move from periods of range contraction to range expansion, and back again.

The mind of a trader cycles from the analytical phase, searching for potential, to the stalking phase, and once a trade is opened, back to the analytical phase to determine when the trade should be closed out.  Whether scalping ranges or trend trading, it is important to be able to identify turns in a market.  Measuring the range of individual bars can help.

The range of a bar is defined as the difference between the high and the low.  A Narrow Range (NR) bar is a price bar with the smallest range of all the bars in the look back period.  With the correct settings applied to the proper timeframes, flagging these bars can be very useful for identifying turning points.

Chasing a market that has already turned and is in the range expansion phase is difficult and dangerous.  It is certainly less profitable and higher risk than catching a market right at the turn.  But of course, most traders shudder at the thought of catching market turns or 'picking tops and bottoms.'

All that is required to catch market turns is keeping in mind a fundamental concept about price action:  Range Expansion follows Range Contraction.  So with that rule firmly anchored in your mind, you tune the tools you already know and are comfortable with to the price action to help identify high probability setups.  And finally, you develop entry techniques and a money management strategy that minimizes drawdown when external market forces move the market contrary to the signal given.

This article is about using one tool, the Narrow Range Bar flag.  It can help identify market turns and will compliment any trend or range trading system.

How To Incorporate NR Bars Into Your Trading

To get used to seeing and identifying NR bars I would recommend applying the study to your larger timeframe charts and just observing them for awhile.  Continue using what already works for you and see when the NR bars compliment the setups you already use.  They can be used as a stand-alone setup, however you should already be competent at reading price action before you attempt to use them this way.

Ensign NR7 Properties

The most popular NR Bar setting is 7, followed by 4.  My back study work has confirmed that 7 is the best compromise between getting a signal too early or late.  However, you really should experiment and determine this for yourself so you’re comfortable with the setting.

The NR bar flag is an option within the Donchian Channel study.  You will need to apply it to your charts first and then open the Donchian Channel properties window.

The first property window displayed below shows how to apply the study as an NR7 paint bar.  (This is the preferred method because your eye needn’t move off the bar under construction to see what’s happening.  The less a trader needs to focus on and think about during the day, the more efficient the trader will be.)  The bar paints the unique color selected in the marker color panel, if it’s an NR bar.  Typically, all bars open as NR bars, but as the bar range expands the bar will change to the normal color.  If you use multiple paint bar studies, make sure the NR bar study is last in the objects list, otherwise, it will be overwritten and never paint.

The second properties window shows how to apply the NR7 bar study as a marker.  It may be necessary to use a marker if you use multiple color bar studies, as some studies won’t allow a second color bar study to over paint it.

If you are familiar with the Candlestick chart analysis, you will remember the admonition given by Steve Nisson that not all Candlestick patterns are signals all of the time.  For example: a doji is only important at extremes.  In the middle of a range bound market, doji’s appear frequently and are typically meaningless.  This is true of NR7 bars as well and is why it is best not to use this study on very small timeframes.  The dilemma of 'knowing' when to view a Candlestick pattern as meaningful, also presents itself with flagged NR bars.

So, how does one "know" when a bar pattern is meaningful or not?

The answer lies in understanding how to use Multiple Timeframe Analysis (MTFA).  Essentially, you look for a large timeframe setup, then negotiate the entry on a small timeframe where you will be able to catch the price action trend reversal easily, which also translates into a safe entry, even if eventually the market tells you that this isn’t the turning point.  Mastering this, regardless of one’s system or setups will supercharge your trading.  Here is one example:

NR bars represent a pause in the price action.  Meaningful NR bars occur during retracements and at the end of range expansion moves.

In the charts above, you’ll see two timeframes. In the larger 2700T timeframe on the left you’ll see that a directional move is underway.  Note the NR bars at points 1 and 2, flagged by the black dot above the bars.  At point 1, the price action begins a retracement as it approaches a resistance area (last swing high).  The NR bar represents a pause in the retracement.  Just prior to the completion of that 2700T NR bar dial down to the 900T.  The entry is the break of the first bar in the direction of the trend in the 2700T.  More experienced traders can negotiate the trade on a very small timeframe such as a 50T or smaller.

At point 2 in the 2700T timeframe, we again see a pause (NR bar) in the move.  Just prior to the completion of that 2700T bar dial down to the 900T.  A NR bar is just a pause in the directional move and very frequently precedes a turn in the market.  It is not necessary that a NR bar be the bar that the market turns on.  It can come a few bars before.  It’s just a warning signal to start watching.  The entry is the break of the first 900T bar in the counter trend direction.  Again, more experienced traders can negotiate the trade on a very small timeframe.

Price action in the upper timeframe must confirm, ultimately, by making a price action trend reversal before another period of range expansion can be expected, as seen in the range-expansion / range-contraction chart at the beginning of the article.  However, it’s usually safe to enter on a lower timeframe price action trend reversal because you’ll be positioned early in the move.  Remember, a small hiccup in a larger timeframe can be quite a move in a lower timeframe.  This allows you to get your stops to breakeven quickly so even if there isn’t a market turn, you can safely negotiate the entry and in all likelihood get a nice scalp out of it.

Good luck.  If you have any questions feel free to post them to the emini_traders_anonymous Yahoo group board and I’ll answer them as time permits.

I want to thank you once again for making things so "easy" in Ensign Windows.  The chart shows my favorite use of the parallel channel draw tool.   In seconds I have all of the lines including the extensions which makes it easy to stay focused on the price action.  The October upgrade with the chart specific candlestick settings is a big improvement.  The other changes make Ensign more intuitive for the new user.  Keep up the great work and again thanks so much for all you do.  It is appreciated by many.