Trade the Markets, by John Carter

Welcome to the Chicago Board of Trade (CBOT) Trading Lessons CD-ROM. My name is John Carter, and I've been trading actively for 17 years, since I was a sophomore in high school, and full time since 1996. I am President of Trade the Markets, Inc., www.tradethemarkets.com, a financial markets information company I founded in 1999. I am also a CTA (Commodity Trading Advisor) and principle of Razor Trading, a money management firm. The daily picks from the newsletters I write each day are auto-traded for clients at a number of brokers. In other words, I make my living trading. I have found the CBOT mini-sized Dow to be a great futures contract to trade, especially for people who are just starting out trading futures. By just starting out, I mean anyone who has been trading actively for less than five years. Having said that, I'm finding more and more CTAs and money managers taking advantage of all the benefits the CBOT mini-sized Dow has to offer. The volume is very "thick" which means that large orders can be placed with minimal slippage, and it also means that a trader can move in and out of this contract quickly and efficiently. In addition, I like to use CBOT mini-sized Dow options to get positioned for larger market "swing" moves. I'm also finding many trading opportunities with the recently launched full-sized electronically traded CBOT electronic 100 oz. Gold and 5,000 oz. Silver contracts, as well as the options now available on these contracts. And of course there are some nice plays available on one of my old favorites, the CBOT 30-Year Bond futures. I will be discussing specific plays in all of these markets in these trading lessons.

I've had the opportunity to work with a lot of traders, and I've found that many of them live in a state of constant flux, stuck between two worlds that combine both the best and worst that trading has to offer. On the one hand, individual traders can move in and out of markets with an ease and efficiency larger funds can only dream of. Traders have the freedom to carve out specific niches for themselves that a huge pension fund could never achieve or duplicate. However, with so much freedom comes a price: The markets cannot protect a trader from him or herself. An individual trader, unlike a fund manager, is unsupervised and has the freedom to act unchecked in any way that they choose. This freedom typically reinforces bad habits, and the net result is a market that moves and thrives in such a way as to prevent as many people as possible from consistently making money. This is why it is imperative for a trader to find a group of high probability setups to follow. Once the setups are discovered, it is then up to the trader to have the discipline to follow a specific set of rules for both entries and exits. Traders that do this have an edge over everyone else, and a higher probability of success. Traders who have a low probability of success generally rely on their own gut feelings to manage a position. The bottom line is that traders who have developed a set of rules to trade by have a chance at doing this full time for a living. Those that don't bother to develop a set of rules become fresh meat for the rest of us!

It shouldn't be surprising to hear that I learned all of this through the best teacher that the market has to offer: extensive pain and suffering. My father, a broker with Morgan Stanley, got me started trading options when I was a sophomore in high school. I continued to trade actively through high school and into college. I quickly developed a very consistent approach to my trading: I would routinely turn a $10,000 account into the high five or low six figures over the course of a year. I would then buy myself a piece of rental property and a couple of nice gizmos. Then I would sit back and decide what other bigger and better things I wanted to buy. Once I figured that out, I would go back to trading. Armed with these visions of "bigger and better things," I would dive back into the markets. A peculiar thing would then happen to me: I would tend to give back the rest of my trading account in less than a month, and I would have to start again from scratch. This happened not once but three times. The most memorable trade happened right out of college, when I was able to give back most of a $150,000 trading account in less than a week (that's what happens when you buy 200 OEX Puts at $7.20 and sell them a week later for 75 cents). Luckily I did have enough real estate at this point that I could sell one of the properties to raise a new trading stake.

This caused me to go on "the trader's quest." I threw out all of my indicators and started fresh with a clean chart. I visited with other traders, those that had been successful doing this for over 20 years, through many different market conditions. The thing that struck me when visiting their offices is that they all had very simple systems, but where they excelled was in their trading methodology. During these visits, there were two things that were pounded into me:

1. You can know a market better than any other trader alive, but if you apply the wrong trading methodology to that market, you will lose money.
2. You can know more about technical analysis than any other trader alive, but if you are trading the wrong market for your personality, you will lose money.

This was a real eye opener on both counts, and I have found that the CBOT mini-sized Dow is a great market to trade for many people's personalities. This is something I will talk more about later.

There was something else about these visits that also rang a bell with me. It took me a while to figure it out, but I finally got it: Whenever I focused on the setups and not the results, I did fine. Whenever I focused on the results and not the setups, I got killed. Why is this? Once I got my hands on a decent sized trading account, I would start to think of things like, "I want to turn this account into a million dollars." Instead of focusing on the setups, I would focus on making a million dollars. This caused me to jump into the trading habits that ruin all traders: betting it all on one trade, not using a stop because the trade "had to work out," and focusing on making a million bucks instead of the trade setup. Once I realized this, I started to do two things differently: First, I started taking any profits out of my trading account at the end of each week. This kept me focused on producing a steady income, as opposed to making a grand killing. Second, I started a competition among the various setups I used. This way I could measure the performance of each of my setups at the end of each month. The setups that made money, I kept using. The setups that lost money, I dumped.

This was incredibly important to my trading. The only way I could keep my competition going was to execute my trade setups the same way each and every time. Anytime I deviated from a standard setup, I would mark this down in my trading journal as an "impulse trade." I kept track of the performance on these too. After about six months of tracking my impulse trades (wow, this market is going higher, I have to get in), I realized that they were not making me any money. I fired my impulse trade and learned to stick with my setups. Once this started to work consistently, I began focusing on trading full time, and I haven't looked back. A large part of my transition was mental and developing what I call a "professional state of mind," something I will talk more about in section 6.

These trading lessons were created for the active trader, and is a collection of strategies presented in both written form and through videos that I currently use in my own trading. I discuss exact entry, exit and stop loss levels for all of these setups. Day traders who utilize this CD-ROM will learn why relying on indicators alone is a losing game, discover specific strategies to get into a trade early, and learn the differences of knowing when to bail, and knowing when to hang on for the ride. Swing traders will learn how to set aside their prejudices and let the trade take them in when price action confirms that it would be a good move to do so. While this CD-ROM is aimed at full time traders, there are setups throughout this guide that will work for individuals who are working full time and are only able to trade part time. This is what I did for a number of years, and it does have advantages if done correctly.

My favorite intraday trading strategies are all utilized mainly on the CBOT mini-sized Dow futures. However, I also have some favorite strategies that I utilize for CBOT Electronic 100 oz. Gold and 5,000 oz. Silver futures, as well as the CBOT U.S. 30-year Treasury Bond. In these trading lessons, I will spend some time discussing the futures markets and how they work. This is for novices who have never traded futures - my approach will take the mystery out of them. From there, I will talk about why I prefer trading the CBOT mini-sized Dow over stocks, E-mini S&P, and the E-mini Nasdaq. After this section, I will then talk about my main intraday and swing trading strategies. I hope this knowledge will help improve your own trading program the same way it has improved mine.

Trading is the most deceptive profession in the world. A person cannot walk into an airport, jump into a 747, and take off down the runway without any prior training. Yet people will routinely open an account and start trading without any guidance whatsoever. For me, the biggest difference in my trading occurred when I learned to ignore my brain and just focus on a handful of good setups. Once I learned the setups, the next challenge was to have the discipline to follow them the same way, each and every time. I did this by recording my trading activity and focusing on the results for each setup. Although I can't stand over your shoulder and help you with your discipline, I can show you the setups that I use to trade for a living. If you are unfamiliar with the futures market, be sure to read the next section (Section 2) on how futures markets work. Otherwise you can jump right into the setups. Let's get started.

This is the question I get asked most often by other traders who are not familiar with the futures markets. I started off as a stocks and options trader, so I know what you are thinking. They're scary, right? Yet in my experience, once you understand and then trade futures, you never go back to stocks.

Think of this as a "quick blurb" that will help you better understand the futures markets. This is by no means comprehensive—there are entire books written on the subject. However, if you have traded only stocks, the futures markets are probably a mystery and maybe even a little menacing. Yet if you have already learned the importance of strict money management, you will really appreciate what futures trading has to offer. Typically, once people try trading futures, they simply stop trading stocks. The ease of entry on both the long and the short sides and the ability to focus on a few markets instead of hundreds of stocks makes them a refreshing change to the world of stocks. Here is how they work:

First off, there are many types of futures contracts. You can trade anything from Copper to Coffee, from Stock Indexes to Silver, or from Pork Bellies to Palladium. Don't worry about most of these for now. At some point, after you become comfortable with trading a handful of these, you may want to look at more of them. But I know many traders who have traded one market all of their trading lives and are doing quite well, thank you. These are the main futures markets that I follow:

1. CBOT mini-sized Dow (YM)
2. E-mini S&P (ES)
3. E-mini Nasdaq (NQ)
4. Full-sized 100 oz. Gold (ZG)
5. Full-sized 5,000 oz. Silver (ZI)
6. 30-year U.S. Treasury Bond (ZB)

Note that some of these are "mini" and some of these are "full-sized." There are full-sized contracts on the Dow (DJ), S&P 500 (SP) and Nasdaq (ND), but these are pit traded and I prefer to trade the smaller "mini" electronic contracts. Why? Because of the transparency and immediacy of electronic trading. The new full-sized 100 oz. Gold and 5,000 oz Silver electronic contracts are a refreshing change from the old pit traded Gold (GC) and Silver (SI) contracts. Again, I much prefer to trade the electronic version of these contracts over the pit traded versions. There are also CBOT mini-sized Gold (YG) and mini-sized Silver (YI) electronic contracts which are good to trade. The fact that CBOT has both full and mini-sized Gold and Silver futures simply means you have a choice to trade the contract more appropriate for your account size. The important thing to remember for the off floor (as in the Exchange's trading floor) trader is to focus on electronic contracts instead of pit traded contracts. Electronic fills are instantaneous and the markets fully transparent, leveling the playing field for all participants.

In addition, the trend in volume appears to be flowing out of the pit contracts and into the electronic contracts. The electronics are where the action is, and that is where you want to be trading. To get charts on the above contracts, you will have to tell your quote vendor that you want to add quotes from the CME (for the ES and NQ) and the CBOT (for the Dow, Bonds, Gold and Silver). CBOT Advantage, CBOT's data product, offers a two-week free trial for quotes and charting that you can use to check out both markets without plunking down any money. By the way, the word "E-mini" is branded by the CME (Chicago Mercantile Exchange), which is why you see "mini-sized Dow" instead of "E-mini Dow" because it trades on the CBOT (Chicago Board of Trade), which is a different exchange.

Although I follow YM, ES and NQ, I prefer trading YM. I will talk about why I prefer trading it in the next section. Here is a video that shows you how to find additional information regarding the futures contracts you want to trade. This will help you leap frog ahead of any other beginning traders.


CBOT Introduction

Key Points: How Do Futures Work?

1. First off, when you buy a futures contract, you are not physically buying anything. This is simply a way to participate in the price movement of the market of your choice. If you think a market is going to move 10 points, you can buy a futures contract, long or short, and make money on the move if it goes in your direction. Also, if you own a stock index futures contract that expires, you are not going to get a bunch of stock certificates dumped on your doorstep. The expired contract will be converted to cash, and you will see the cash in your account.
2. For price movement: If you have 1 contract in the E-mini S&P, and it moves 1 point (i.e., from 1032.75 to 1033.75) that translates into $50 in your profit and loss (P&L). For the E-mini Nasdaq, a 1 point move equates to $20. For the CBOT mini-sized Dow, a 1 point move is $5.00. So, if you buy 3 S&Ps, and you get 10 points, that is $50 x 10 points x 3 contracts = $1500.00. For the Nasdaq and the Dow, it is the same thing, except you would use $20 per point on the Nasdaq and $5.00 per point on the CBOT mini-sized Dow.

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Figure 2.1 shows a CBOT mini-sized Dow trade with 10 contracts. In the above chart, a 27 point move in the CBOT mini-sized Dow with 10 contracts is $1350.00.

 

1. Of course, this goes both ways so money management is the absolute key to trading futures. It is imperative that you know your stop before you start, and you stick to it no matter what. In futures trading, hoping and praying can lead to ruin. However, the nice thing about futures is that they are so quick and the fills so clean that you can get stopped out, then a few seconds later you are right back in. You can't be afraid to take small losses, period. Reentry is only a commission away.
2. Electronic contracts were set up specifically for traders: They are super liquid and fills are instantaneous.
3. If you think the market is going to breakout, you can buy a stock like INTC and watch it sit there while the market roars on without you. You were right on the market—but your stock pick didn't move with the market. With CBOT mini-sized Dow futures you are trading the market. It is what it is. There are no games.
4. You can short on a downtick—this makes a huge difference in trying to get filled during a breakdown. If you short KLAC "at the market" on a breakdown, you may not get filled for 20 cents until it has an uptick. If you short the futures "at the market" on a breakdown, you get a quick fill at the current market price. With stocks, you had "bullets" for a while where you could set these up with your broker and short a stock on a downtick. Unfortunatley, these were recently removed.
5. I used to be a big trader of OEX options for day trades. After trading futures, I stopped trading OEX options. The spreads and premium of options now looks ridiculous. Where else can you be dead right on an intraday move and still lose money? The OEX options market! Although I do use options for swing trading, I wouldn't day trade them with a 10 foot pole. Not when the CBOT mini-sized Dow futures are so clean and efficient.
6. You can do most of your trades "at the market" and get good fills, unlike stocks and especially unlike options.
7. For stocks, you need $25,000 to day trade. For futures you can open an account with $5,000 (or less) and day trade. There is no "day trading" rules or classifications.
8. To buy one of the futures contracts discussed in these trading lessons, you need about $2,000 in your account. This varies by broker, and can be lower, but this is an average. This "deposit" money required by a broker before you can start trading is called margin, and you can think of it like putting down a 3% down payment on a house. So if you have a $10,000 account, you can buy 5 contracts, and sometimes more by utilizing lower intraday margin rates. However, for money management purposes, I heartily recommend giving some thought to how many contracts you trade in your account. This is a critical part of your trading plan. Just because you can trade 5 contracts in a $10,000 account doesn't mean you should! I typically trade 1 contract for every $10,000 to $15,000 that is in my account. This way your account swings will not be as severe, and you will be able to trade with a level head. One trader friend of mine trades 1 contract for every $50,000 in his account. He makes money and is never stressed out. For managed accounts, I usually trade 1 contract for each $25,000 in the account. Conversely, I've seen programs that say to take a $5,000 account and trade 5 contracts, and by doing this you can make six figures a year. This is insane and you would be better off donating that $5,000 to charity, because you will lose it all trading it that way. There are few guarantees in the futures industry, but losing all of your money trading with this much "maxed out" margin is the one sure bet available today.
9. There are now futures on stocks. Using Single Stock Futures traded in the U.S. at OneChicago as swing trades in combination with index futures is a great way to trade and hedge your bets. Although some of the symbols have low actual volume, the "real volume" is based on that of the underlying stock. If you want to buy 100 contracts (1 contract = 100 shares of stock), and you put in a limit order in between the bid and the offer, you will get a nearly instantaneous fill.
10. With futures, at the end of the year you don't have to list each individual futures trade like you do stocks for your U.S. tax return. You get a 1099 form from your broker with your total profit or loss for the year. All you put on your tax return is that number on the 1099. That is much easier and much less time consuming than listing out every trade, like you have to do with stocks. And the good news is taxes! For stocks, you have to hold them over a year to get classified at the cheaper "long term gain" rate. For futures, you get a 1099 that says, for example, $20,000 in gains for the year. Of this, 60% of the money is treated as long term gains (lower tax rate) and 40% at the short term rate. This is the "60/40" rule. This rule holds true even if you go flat at the end of every trading day.
11. You can trade futures in your IRA. This means you can short stocks in your IRA (Single Stock Futures) or the indexes, which you are not allowed to do in a regular IRA. To set up your IRA for trading futures, you need to first go through a Trust Company set up specifically to do this. What you then do is open an account with the Trust Company, and then they will wire the funds to your futures broker. This way it stays classified as an IRA and you don't have to pay taxes on any gains. Not every futures broker is experienced with this. If you are interested in doing this, be sure to work with a broker that has done this before. It is one way to bring diversification to a portion of your retirement funds.
12. Each stock index futures vehicle has four contracts that are traded each year: March (H), June (M), September (U) and December (Z). You will want to trade the closest month, as that is where the volume is concentrated. For example, if today is February 15, 2005, then the closest month is the March 2005 contract. To get a quote for the March 2005 contract on the CBOT mini-sized Dow, you would enter in the symbol, month and year. In this case, that would be YM (symbol), H (Month = March), 05 (Year = 2005). The full symbol would be YMH05. This is for TradeStation. For Esignal it would be YM H5. Each quote service is a little different. When one contract expires, you just start trading the next contract out. TIP: The stock index futures expire the same day as options expiration, on the third Friday of the month they are being traded in. However, you will want to start trading the next month out the week before expiration, as all of the volume will switch to the next month on Thursday of the preceding week. Bonds actually switch three weeks early. Each contract is a little different. If you aren't sure, just ask your broker, write it down and put it next to your PC (or email CBOT or CME to find out what you need to know, if it's not already listed on their websites). This way you will never mess this up. Also, because these are futures contracts expiring at different dates in the future, there is always a price difference between two contracts based on the market's expectation of where each contract will settle. While the March 2005 contract might say 10686 for the CBOT mini-sized Dow, the June contract might say something like 10694. Also note there is usually a 10 to 20 point different between the CBOT mini-sized Dow futures price and the Dow Jones Industrial Average^SM cash price. There is a very complicated explanation for this involving "fair value" and "future price projects" and yada, yada, yada. Bigger picture this it is just something to be aware of. Keep this in mind as you are switching contracts and calculating pivots.

That's the basics. The key is to just get comfortable with your futures broker layout. Do some "paper trades" on their simulator to get a feel of the system, and when you start out, just trade one contract to get a feel of how it works. You will make mistakes, and a mistake on 1 lot is a lot cheaper than a mistake on 10 lots or more. If you have never used a futures broker before, be sure to talk to other traders to check out rates, levels of service, and so forth.

If you want some more "Futures 101" reading, the CBOT has a publication called "Trading In Futures - An Introduction" that you can read online or order for free, plus there's an online interactive tutorial available in the education area of www.cbot.com.

Let's now take a look at why the CBOT mini-sized Dow is my favorite futures contract to trade.

Now that we have covered Futures 101, let's take a look at why I prefer to trade the CBOT mini-sized Dow (YM) over the ES or NQ, and, for that matter, individual stocks and options.

In its simplest form, the markets rise on a day-to-day basis because current demand for stocks exceeds current supply. This has nothing to do with being in a secular bear market, a cyclical bull market, high P/E ratios or Maria Bartiromo's choice of a necklace. This has everything to do with what traders are willing to pay for a stock or market today.

It doesn't matter if demand is falsely created by a hedge fund "taking the street" (buying large amounts of a single stock to drain a market maker of its inventory, forcing them to buy it back at a higher price). Or a squeeze that whacks shorts and forces them to cover, or a rumor that a biotech stock is being cornered by Martha Stewart. Demand is demand and that is what drives markets higher. The inverse is equally true: If there is too much supply in the market, prices will fall. Although supply and demand can be more difficult to measure with a single stock, it is very easy to measure with a popular index such as the Dow^SM. This is why I feel strongly that one of the best contracts out there to trade for both beginning and professional traders is the Chicago Board of Trade's mini-sized Dow futures contract. The specific reasons are as follows:


Bang for the Buck
For disciplined traders who use live stops, the leverage in trading CBOT mini-sized Dow futures over stocks is a huge plus.


Better Spreads than the E-mini S&P and E-mini Nasdaq
The CBOT mini-sized Dow has the same specifications as the popular E-mini S&P contract:

1. 1 point in the E-mini S&P = about 10 points in the mini-sized CBOT Dow
2. 1 point in the E-mini S&P = $50; 10 points in the CBOT mini-sized Dow = $50

Figure 3.1
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Figure 3.1 shows movement in the Dow and S&P over the exact same time frame. The Dow has moved 13 points lower (from the high at point 1 to the low at point 2), and during this same time, the S&P has moved 1.5 points lower.


The Dow moved lower in thirteen 1 point increments. However, the S&P made a similar move in 6 quarter point increments. A quarter point on the S&P = about 2.5 points on the Dow. This is a huge different in the spread!

The key here is that a trader will get picked off on stop runs less frequently if he or she uses the CBOT mini-sized Dow over the E-mini S&P. Why is this? Again, the E-mini S&P moves 1 point in 4 quarter point increments. The CBOT mini-sized Dow will move an equivalent 10 points in ten 1 point increments, giving the trader six extra places to place a stop or target. This is a huge advantage over trading the E-mini S&P and will save a trader a lot of money over the course of a trading career. By trading the CBOT mini-sized Dow, the trader is essentially cutting the spread by 60 percent. That money goes straight into the trader's pocket. In addition, due to the spread, you will get your stops picked off more in trading the S&Ps on stops that are placed equivalently on YM. I will show specific examples of this in Section 5. The spread is even worse in the NQ. Whereas the S&Ps will move 1 point in 4 quarter point jumps, the Nasdaq will move the same 1 point in 2 half point jumps.

This goes back to what I talked about earlier in "trading the right market for your personality or trading method." My Multi-Pivot system (one of the strategies I will talk about) works good on the S&Ps, but it works great on the CBOT mini-sized Dow, because of the way the market is "built" and the way it moves.


Liquidity

Although perfect for the smaller retail trader, the CBOT mini-sized Dow has caught fire and now has the liquidity to move size, chalking up daily trading volume of well over 100,000 contracts per day. In trading, volume begets volume, and YM will continue to expand even more as traders, commodity trading advisors and managed funds take advantage of the trading advantages for this contract.

Figure 3.2
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Figure 3.2 shows weekly volume growth in the CBOT mini-sized Dow since its inception.


Keeping on the Path of Least Resistance

A trader can watch the 30 stocks in the Dow to get a very good idea of how the index is acting or is going to act. I like to place all 30 Dow stocks in a window and have them automatically sorted from strongest to weakest each day on a Net % Change basis. Getting a feel for all 500 stocks in the S&P 500 at a glance is as impossible.

Figure 3.3
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Figure 3.3 shows all 30 Dow Stocks sorted by the Net % change. With this I can glance at it and see that 22 out of the 30 of the stocks are red (down on the day). This filter gives me a clean, easy downward or upward bias to the market as I can watch more stocks going red, or going green, as the markets start to fall apart or try to improve.

If a trader currently is in an individual stock, he can have all kinds of outside influences move the price. Maybe insiders are dumping their own stock. Maybe an analyst has just issued an upgrade while his trading department is dumping shares off to an unsuspecting public. Maybe the company is giving positive forward guidance as its last hope to stave off bankruptcy proceedings. The factors affecting an individual stock are endless.

However, when investors in general want to sell stocks, the Dow reacts by heading south. If they want to buy, the Dow spurts green. The "Dow effect" encompasses individual investors, hedge funds, program traders and arbitrage traders. In addition, the Dow moves actively in all buy and sell programs. Supply and demand at its finest - this is what makes the CBOT mini-sized Dow futures contract such a beautiful instrument to trade. This, combined with the much tighter spreaders than the ES or NQ contract, make it the best contract to trade for intraday trading.

Now that we have covered how futures work, and why I like to trade the CBOT mini-sized Dow, section 4 will discuss why you should diversify your trading into precious metals and bonds, and then we'll start looking at my trading strategy.

There is one very good reason to know how the Gold, Silver and Bond markets work, and that reason can be summed up in one word: OPPORTUNITY. Although the Dow is one of my favorite markets to trade, there are plenty of times when it is stuck in a trading range, going nowhere.

As you can see in the chart below, while the Dow was stuck in a trading range over a period of four months in 2004, Gold, Silver and Bonds all had nice, very tradeable up trends. Although the chart below is based on a daily timeframe over the course of nearly half a year, the same thing happens on all time frames, from the 1 minute chart to the weekly chart. While one market is chopping, another market is trending. Traders have the best opportunity to make money in markets that are trending. By watching all four markets, you can rotate your trades into the markets that have the best trends, and stay out of the markets that are chopping around.

Daily Chart Comparing Dow, U.S. Treasury Bond,Gold
and Silver Markets from July to November, 2004

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Gold: Trading Where the Action Is

By trading gold, you will be in good company. No other market in the world has the universal appeal of the gold market. For centuries, gold has been coveted for its unique blend of rarity, beauty, and near indestructibility. Nations have embraced gold as a store of wealth and a medium of international exchange, and individuals have sought to possess gold as insurance against the daily fluctuations of paper money. Gold is also a vital industrial metal, as it is an excellent conductor of electricity, is extremely resistant to corrosion, and is one of the most chemically stable of the elements, making it critically important in electronics and other high-tech applications. That's all well and good, right? But as a trader, all I really care about is if the market in question provides good trading opportunities. Over the last several years gold has become a great market to trade with plenty of volatility and trending price action.

One of the biggest questions I get regarding these other markets is a simple, yet essential question: How do they work in regards to my P&L? If I buy gold and it goes up $4.00 an ounce, how much money did I just make? Let's take a look.

CBOT full-sized 100 oz. Gold Futures

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CBOT mini-sized 33.2 Gold Futures

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As you can see in the charts above, a $1.00 per ounce move in CBOT full-sized 100 oz. Gold results in a $100.00 per point per contract move, while a $1.00 per ounce move in CBOT mini-sized 33.2 oz. Gold results in a $33.20 per point per contract move on your P&L. Both contracts are great to trade, and the decision on whether or not to trade the full-sized Gold depends largely on your account size. If you are trading a smaller account (under $25,000) it is probably better to stick with the CBOT mini-sized Gold.


Silver: Great Volatility

Silver has attracted man's interest for thousands of years. In ancient times, silver deposits were plentiful on or near the earth's surface. Relics of ancient civilizations include jewelry, religious artifacts, and food vessels formed from the durable, malleable metal. In 1792, silver assumed a key role in the United States monetary system when Congress based the currency on the silver dollar, and its fixed relationship to silver. Silver was used for the nation's coinage until its use was discontinued in 1965. At the turn of the century, an even more important economic function was emerging for silver, that of an industrial raw material. Today, silver is sought as a valuable and practical industrial commodity as well as an appealing investment. The largest industrial users of silver are the photographic, jewelry, and electronic industries. Again, this is all well and good right? But as a trader, can we do anything with this market? The answer is a resounding yes.

Later in these lessons, I will be showing examples of specific plays with silver, but for now let's make sure we understand how it works in relation to the P&L.

CBOT full-sized 5000 oz. Silver Futures

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CBOT mini-sized 1000 oz. Silver Futures
http://www.cbot.com/cbot/docs/56046.gif

As you can see in the charts above, a 14 cent per ounce move in CBOT full-sized 5000 oz. Silver results in a $50.00 per cent per contract move, while a 14 cent per ounce move in CBOT mini-sized 1000 oz. Silver results in a $10.00 per cent per contract move on your P&L. Like gold, both contracts are great to trade, and the decision on whether or not to trade the full-sized Silver depends largely on your account size. If you are trading a smaller account (under $25,000) it is better to stick with the CBOT mini-sized Silver.

Interest rate futures were pioneered by the CBOT in 1975 in response to a growing market need for tools that could protect against sharp and frequent swings in the cost of money. U.S. Treasury 30-year Bond futures were first introduced, followed by futures on 10-year, 5-year, and 2-year U.S. Treasury Notes. Over the past two decades, contract volume has grown to unprecedented levels, reflecting the growth of the underlying instruments and profound changes in the marketplace. U.S. Treasury futures prices are global interest rate barometers, reflecting moves in national and international rates, and are available to the public immediately. At times of high correlation to the equity markets, bond prices will respond in the same way the general markets respond to critical day analysis. Critical days predict short term trend changes and are valuable for timing entry or exit or for short term trading strategies.

If you focus primarily on the stock market, it is critical that you become familiar with bonds. The bond market dwarfs the equity markets. Therefore it is important to know when money is flowing out of bonds or into bonds. The bond markets and the stock markets also have an interesting relationship. Sometimes, they move directly opposite, during periods of portfolio reallocation. This happens when huge funds have to sell stocks and buy bonds to readjust the percentage of capital invested in each. During these times, new highs in the bond market lead to new lows in the stock market, and thus bonds become a great leading indicator. In addition, bonds, in and of themselves, provide many great trading opportunities, which we will be discussing later in these lessons. For now, let's make sure we understand how they work in regards to your P&L.

U.S. 30-Year Treasury Bonds

http://www.cbot.com/cbot/docs/56053.gif

In the bonds, a move of 1/32 = $31.25. So a move of 4 ticks is $125.00, which is just like making 25 points in the CBOT mini-sized Dow.

Now that we understand how all of these different markets work, and the trading opportunities they represent, let's jump in and look at some specific setups that can be used on these markets.

For those of you who learn better with pictures and sound, click on the video to hear more about how these contracts work in terms of your P&L.

CBOT Contract Specs

Lets get started with the strategies

When it comes to executing a specific setup, traders generally fall into three categories:

1. Those that know the setup like the back of their hand, but fail to make money due to a flawed trading methodology
2. Those that know the setup better than their spouse's bad habits, but fail to make money because the setup is being used on the wrong market
3. Those that know the setup better than the varied plot lines on Alias, but fail to make money because of poor money management

The point of this, of course, is to emphasize the importance of establishing a trade setup from a three-pronged approach. In addition to the actual setup, there also needs to be a foundation from which to operate the setup. This foundation consists of the following: The trading methodology, the money management technique, and the knowledge of the best markets to trade for that particular setup. In other words, it's a lot more than just "what's the entry?" Without this additional data, a trader is like wounded antelope in the center of a lion pride, where it is not a question of "if" the antelope is going to get whacked faster than a newly discovered FBI informant within the Mafia, but rather of "when." For a trader without this three-pronged approach to their trade setups, the possibility of ruin is not a question of "if." It's only a matter of "when."

I utilize 8 setups in my daily trading routine. My first, favorite, and the one that determines my trading for the rest of the day, is based on the opening gap.

Each day in the market there is one opportunity that represents the lowest-risk trade available, and that is the opening gap. Gaps occur when the next day's regular cash session opening price is greater or lower than the previous day's regular cash session close, creating a "gap" in price levels on the charts, similar to that space we see each night between David Letterman's two front teeth.

However, when it comes to gaps, not all markets are created equal. Gaps in "single item" markets do not act the same as gaps in "multi-item" markets. Examples of "single-item" markets include bonds, currencies, grains and energies. These markets are made up of a single component, and a news item on this single component controls the entire market, instead of just a portion of it. On the other hand, a "multi-item" market such as CBOT mini-sized Dow makes a great candidate for gap plays, because there are individual components of this index that will respond differently to various news items. This means that, although the market may gap up on a news item, there will be individual stocks within the index that will either ignore the news or sell off on the news, weighing the index down and creating an opportunity for the market to fill its gap.


Dow Gaps Are Best

Although the Dow is the best "gap" market to trade, the individual components of this index do not set up consistently for these plays. Individual stocks are like politicians, in that each day they can produce a fresh skeleton from the proverbial closet. Earnings announcements, corporate scandals and insider deals can create gaps in price that never get filled. Due to the unpredictable nature of the individual stock, they make poor candidates for gap fills. Along these same lines, the Nasdaq market is heavily weighted towards technology, and gaps in price can take longer to fill as the technology news of the day plays out. In addition, the S&P 500 has such a broad array of stocks, that it can make it more difficult to get a clean gap fill. In the end, the Dow represents a small group of large, individual stocks from different industries, and it is therefore the best market to play when it comes to gaps.

The magic of gaps is that they are like an open window, and like all windows, at some point they are going to be closed. The key, then, is to be able to accurately predict when the day's gap (window) is going to be filled (closed). What is as important as analyzing the gap itself is analyzing the market conditions that produce the gap. The reason for the gap is immaterial. What matters is the pre-market volume. For example, a professional gap with high pre-market volume can take weeks to get filled. Much more common are gaps that are news reactions or fishing expeditions. These are smaller in nature, fill quickly and can be faded regularly.

The question, then, is if I ignore the reason for the gap, what is it that I'm looking for that determines whether or not I will take the setup? The key action I am watching is the pre-market volume in a specific set of cash stocks. I particularly like to watch KLAC, MXIM, NVLS, and AMAT. What I'm looking for is the pre-market volume in these stocks as of 9:20 a.m. Eastern time, 10 minutes before the regular cash session open. If these stocks are trading under 30,000 shares each at this time, the gap (up or down) has an 85% chance of filling that same day. However, if it jumps up to 50,000 shares each, the gap only has about a 60% chance of filling that same day. On these particular days, the midpoint of the gap has an 85% chance of being hit, so I do take this into account on these particular days. Finally, if the pre market volume jumps to over 70,000 shares each, the chances of the gap filling that same day drop to 30%. Why does this work? Think about it when comparing a car driving on an empty tank of gas versus a full tank of gas. If the market is really set up to move, then there will be real volume coming into the cash market. If the market is just setting up a head fake, then the volume in the cash market will be low, as there won't be any conviction in the move. Ignore the news and follow the money. Here is how I use this information to manage my trades:

<table border="1" cellpadding="0" cellspacing="0" width="631"> <tbody> <tr> <td valign="top" width="257">

Pre-Market Volume in Key Stocks

</td> <td valign="top" width="112">

Position Size

</td> <td valign="top" width="262">

Target Parameters

</td> </tr> <tr> <td valign="top" width="257">

Less Than 30,000

</td> <td valign="top" width="112">

Full Size

</td> <td valign="top" width="262">

All at Gap Fill

</td> </tr> <tr> <td valign="top" width="257">

Between 30,000 – 70,000

</td> <td valign="top" width="112">

2/3 Size

</td> <td valign="top" width="262">

1/3 at 50% of Gap Fill, 1/3 at Gap Fill

</td> </tr> <tr> <td valign="top" width="257">

Greater Than 70,000

</td> <td valign="top" width="112">

No Trade

</td> <td valign="top" width="262">

No Trade

</td> </tr> </tbody> </table>

The Strategy

This set of rules is based on a low pre-market gap. If the volume is moderate, then I will utilize the above parameters accordingly.

THIS IS A FADE PLAY. I WILL BUY A GAP DOWN, AND SHORT A GAP UP.

TRADING RULES FOR GAP DOWN BUYS (SELLS ARE REVERSED)

1. 9:30 a.m. Eastern time and stops at 4:15 p.m. Eastern time. This is so you can view the gaps (you can't see these if your chart is set to 24 hours!)
2. A gap must be at least 10 YM points (otherwise pass).
3. Check premarket volume to see if it is low or moderate, time of which would cause a trade to be initiated.
4. When the regular cash market opens at 9:30 a.m. Eastern time, buy the YM at the market.
5. Once filled, set up a protective sell stop with the following parameters:
   1. For gaps that are under 40 YM points, use a 1 ½:1 risk reward ratio. (Example, for a 20 point gap, use a 35 point stop).
   2. For gaps that are over 40 YM, use a 1:1 risk reward ratio (Example, for a 45 point gap, use a 45 point stop).

6. Target is the gap fill (market goes to unchanged on the day)
7. Do not trail stops!
8. If stopped out, the gap play is over for the day.
9. If neither target or stop is not hit by the closing bell, exit your position at the market.
10. There are a few modifications I will make based on my analysis of premarket volume, which I will discuss in a moment.

Relax and Trade the Gap

Let's look at a video that shows a couple of examples of actual gap plays.

Actual Gap Plays

As you can see from these two back to back gaps, the entire key is to keep that risk stop in place and not get nervous or antsy and start trailing those stops! Let's look at some more written examples and charts:

Figure 5.1

http://www.cbot.com/cbot/docs/56055.gif

1. In Figure 5.1, the CBOT mini-sized Dow contract closes at 9717 on October 14.
2. On October 15, the opening trade at 9:30 a.m. Eastern time is 9762, producing an opening gap of +45 points. I "fade the gap" right at the open and short YM at the market. My protective stop is 45 points away from my entry, at 9807, and my target is the gap fill, which is the previous day's close at 9717.
3. The gap fill is complete once the price levels reach the previous days close. This occurs 35 minutes after the opening bell.

Figure 5.2

http://www.cbot.com/cbot/docs/56065.gif

1. In Figure 5.2, the market closes at 9704 on October 15.
2. The opening trade at 9:30 a.m. Eastern time on October 16 is 9645, creating a 59 point gap down. I place a stop at 9586.
3. Many people who play gaps would get stopped out right here, as they trail up their stop to breakeven to protect gains. For these people, the gap play is now over (see Figure 5.3).
4. Yet by holding onto this play with parameters that were made especially for gaps, I end up staying in profitable trades that shake many other traders out. The reason for this is they are using blanket type parameters for every play, instead of utilizing specific parameters that are tailored for specific plays. Although many gaps fill within the first hour, many can take a couple of hours or more. I like to set the parameters and focus on something else while the market "does its thing."

Figure 5.3

http://www.cbot.com/cbot/docs/56066.gif

Most beginning traders are taught by their brokers to use 3:1 risk reward ratios, risking one point to get three points. As the traders wonder why they always get stopped out just before the market turns, their broker is tallying up commissions generated on the day. In general, wider stops produce more winning trades. They key with wider stops, of course, is to only play setups that have a greater than 80-percent chance of winning. The gap play I'm describing, with the parameters that I use, has a greater than 80 percent chance of winning. What is important to remember for gap plays is that an active program of trailing stops will negatively affect your win/loss ratio. Once the parameters are set in place, the best thing a trader can do is to walk away and let the orders do their job. Although tweaking is a good thing to do when giving a car a tune up, tweaking the parameters of a gap trade will not work.

One important thing to remember: If 80 percent of these plays win, that means 20percent of them lose. I actually like losing trades for one main reason—this leaves an "open gap" in the markets. An open gap is like a magnet, and there is an 80 percent chance that the markets will fill than gap within 10 trading days. Whenever the markets leave an open gap, I mark that level on a Post-It Note and place it on my computer. Let's take a look at an example in this next video.

Here is a link that will launch a four fminute video on your screen. In it you will hear me talk about gaps, with a few example plays.

Gaps Examples

The example of that last 62 point gap in the video you just watched is my favorite type of gap. I called it the "Bahamas Gap" as it represents a low-stress trade. The gap fills quickly and is a pleasing move in which to participate. It should be noted that gaps of under 10 Dow points are not worth playing.

Let's take a look in more detail at the video you just watched. As I've already said, I always love it when you have these "open windows" out there in the markets. As you saw in the last video, they act as black holes, eventually sucking prices back to their gapping levels. You always want to be conscious of where the open gaps are located, and I like to use a chart like the one posted below to give me a continuous visual reference. As you can see, the gaps will come back and get filled at some point. Now, let's take another look at the chart I used in the video:

Figure 5.4 Multiple Gap Plays
http://www.cbot.com/cbot/docs/56067.gif

This chart was traded using a $100,000 account, and utilizing 9 contracts for a full position. On August 18, we gapped up a modest 44 points in the Dow prior to some economic numbers, as seen in the prior video. I short at the open. We rallied, sold off into the economic numbers, and then shot higher once the numbers were released. I had a 66-point stop, and the markets rallied just through that level, producing a loss of $330 per contract, or $2,970.

I head into the next trading day knowing there is now a "black hole" gap below. I can actually hear the sucking sound. The next day we have a modest low volume 13 point gap higher that works out quickly, for $65 per contract ($585). The day after, we get a nice 52 point gap lower that takes a few hours to fill, but creates few headaches, for $260 per contract ($2,340). The next day we get a 44 point gap higher that comes close to our stop but eventually fills the gap for $255 per contract ($2,295). Finally on August 22 we get the "sucker gap" when Intel announces "cautious upside earnings revisions." The market explodes and gaps up 62 points, right into key resistance.

I short the gap, as the pre-market volume is again low. Six bars later, my target is hit for 62 points or $310 per contract ($2,790). The sucking sound of the black hole below is getting louder. During the afternoon session we get a bear flag consolidation. I set up a "sell stop" at 9392 to let the market take me into a breakdown of that flag formation. I get the fill and set my stop above intraday resistance at 9455. My target is the 8/18 "black hole gap" at 9304. The market spends the rest of the day on its hands and knees, dry heaving, trying to hold back the internal pressure. This pressure proves to be too much and the market eventually falls over. I hold my position over the weekend and Monday morning the markets quickly fill the gap for an 88-point gain or $440 per contract ($3,960).

These are a series of great trades, and I encourage you to watch the video again to see how they operate.

Gaps are the one moment of the trading day where everyone has to show their poker hand, and this creates the single biggest advantage for the short-term trader.

Understanding the psychology behind the gaps is paramount to playing them successfully on a daily basis. The gaps are so powerful that many traders make a nice living playing these set ups alone. The key is to know how they work and to develop a solid methodology and set of rules to trade them. After reading this article, the serious trader will have a better foundation for a plan to trade the markets successfully on a full-time basis: a proven set up to play, markets that best fit that set up and a plan of action to maximize the play. That is pretty much everything the trader needs to survive and thrive in this greatest of professions.

Trading the markets is the greatest job in the world. There are no bosses offering contradictory instructions and, even better, no employees to baby sit. Each year thousands of people flock to the markets like lemmings to the sea. Yet, many fewer than that manage to avoid flinging themselves over the proverbial cliff. How does a trader break away from the herd and ease into a consistently profitable trading routine? The key to staying profitable consists of sticking to the following three concepts:

1. Staying in the Right Frame of Mind
2. Keeping on the Path of Least Resistance
3. Knowing What to do When Things go Wrong

Staying in the Right Frame of Mind

In a moment we will look at a very easy and potentially very profitable strategy to trade the CBOT CBOT mini-sized Dow. Before utilizing this or any strategy, however, a trader first must create the optimal mindset for executing trades. This is very similar to the "chicken-and-egg" theory: Without a professional state of mind, a trader simply cannot produce consistent profits over the long haul. In a similar vein, without that egg, the future existence of the chicken is over!

Being a professional is all about maintaining a state of mind, and a trader is never going to make consistent money until he or she achieves that frame of reference from which to operate. Here are five nuggets of wisdom that I've learned over the years to help establish the right frame of mind:

1. Professional traders focus on limiting risk and protecting capital. Amateur traders focus on how much money they can make on each trade. Professionals always take money away from amateurs.
2. Embracing your opinion leads to losses. When a trader rationalizes a decline by saying things like, "they are just shaking out weak hands here," or "the market makers are just fishing for stops," then the trader is embracing his own opinion instead of listening to the market. This is also called "being an amateur" and leads to a one-way revolving door called financial ruin.
3. Amateur traders turn into professional traders once they stop looking for the "next great technical indicator" and start controlling their risk on each trade.
4. In reality, traders are not trading stocks, futures or options. They are trading other traders. Be aware of the psychology and emotions behind the person who is taking the opposite side of your trade.
5. Professional traders actively take small losses, and they do so because they know their most important job is to protect their capital. After all, re-entry is only a commission away. Amateurs resort to hope to save their trades. In life, hope is a powerful and positive thing. In trading, hanging onto a trade based only on hope is very similar to a trader spending the rest of his life filling holes in rotten teeth when he has no skill as a dentist. In other words, it ain't pretty.

Once you get in the right frame of mind, you will be in a much better position to execute trades in a professional, and therefore profitable, manner.

Now let's take a look at discovering which side of the market to trade. Here's the key: Professional traders do not care about being on the short side or the long side of the market. They care about being on the right side.


Keeping on the Path of Least Resistance

The finely tuned art of technical analysis involves a process similar to a jury weighing the presented evidence during a trial and then deciding upon an outcome. By the same token, my final trading decisions must be backed by evidence, not by emotion. The stronger the evidence, the greater the likelihood that a specific price action may occur. By contrast, the stronger the emotion, the stronger the likelihood that a trader is about to imprint the exact high or the exact low of the day. Based on this, I use a very simple technical system to trade the CBOT mini-sized Dow futures. Before we look at this, let's take a step back and see how I view the big picture each trading day:

Moving Averages

As the above video shows, before the trading day starts, I always like to glance at the larger time frames first. The key to consistent profits is to trade on the path of least resistance. The path of least resistance starts from the larger time frames and moves down through the ranks to the smallest time frames. Think of the weekly chart as a thousand pound weight on your chest. Then think of the five-minute chart as a Two-pound weight on your chest. Which is going to create more pressure on your body? It is ridiculous to try to move the two-pound dumbbell without taking into account the larger 1,000- pound weight bearing down on top of it.

During the week of May 2, 2003, the weekly chart experienced an upside moving average crossover and it hasn't looked back. I don't care how many books are being published that discuss the coming doom of the world economies. I don't care how overbought we are. I don't care how many traders are flaunting their superiority in that they would never go long stocks in this environment (Bearish geniuses in 2003 were almost as common as bullish geniuses in 1999). What matters to me is this: Is the current big picture perspective one based on too much supply or too much demand? This weekly chart makes it crystal clear that, as of this writing in early Jan 2005, current demand for Dow stocks continues to exceed the current supply. Sure, half of this demand is from frantic short covering, but that doesn't matter. Again, demand is demand. Period. By glancing at the charts I showed you in the video, I know to spend most of my energy focusing on the long side. I will keep any shorts I initiate on a tight leash. I will follow this procedure until this situation reverses itself and the 9 period moving average is trading below the 18 period moving average on the weekly chart. Until that happens, there isn't much point in fighting the trend. That is a losing game.

For the trading day I'm about to show you, I jotted down the following information based on the Weekly, Daily, and 60 minute charts I showed you in the video. This gives me an idea of where the "heavy pressure" is located. I use a table like this:

<table border="1" cellpadding="0" cellspacing="0"> <tbody> <tr> <td valign="top" width="136">

Time Frame

</td> <td valign="top" width="233">

Pressure Heading into the Day

</td> <td valign="top" width="137">

Pressure Amount

</td> </tr> <tr> <td valign="top" width="136">

Weekly

</td> <td valign="top" width="233">

Demand

</td> <td valign="top" width="137">

1000 pounds

</td> </tr> <tr> <td valign="top" width="136">

Daily

</td> <td valign="top" width="233">

Demand

</td> <td valign="top" width="137">

200 pounds

</td> </tr> <tr> <td valign="top" width="136">

60-Minute

</td> <td valign="top" width="233">

Supply

</td> <td valign="top" width="137">

25 pounds

</td> </tr> <tr> <td valign="top" width="136">

1five-minute

</td> <td valign="top" width="233">

Changes Intraday

</td> <td valign="top" width="137">

6 pounds

</td> </tr> <tr> <td valign="top" width="136">

five-minute

</td> <td valign="top" width="233">

Changes Intraday

</td> <td valign="top" width="137">

2 pounds

</td> </tr> </tbody> </table>

But how can this information be used, heading into the trading day? If we had demand across the board, I would focus more on long setups off the five-minute chart, passing on most of the short setups. However, this picture represents a great intraday setup. With the weekly and daily pressure up and knowing that these charts represent huge amounts of buying pressure, I know not to expect a market meltdown and that a decline to daily support levels should hold. With the 60-minute in a sell, I can expect that move to support to occur. On a day like this, I would take both long and short setups off the five-minute chart.

Before I discuss the specific trades taken off the five-minute chart, I would like to briefly discuss my scalping account and how I use it.


My Scalping Account

A scalping account is utilized to catch intraday moves, and to go home flat at the end of each trading day. In my scalping account, my goal is to make one-half of one percent of my equity each trading day - on a $100,000 account that is $500 a day. This is net after commissions. I also use daily dollar stops: I stop trading for the day if I make 4 percent or if I lose 2 percent of my equity. In my personal scalping account, one of the setups I use is to initiate trades off the five-minute charts using a simple crossover moving average buy/sell and short/cover system. The setup is as follows: A 9-period and 18-period simple moving average (SMA), utilizing a bar chart that changes to green during an upside crossover, and changes to red during a downside crossover. For coloring the bars, this is a canned featured in many charting programs. In Tradestation, go to "insert analysis technique" then choose "paint bar." From there choose "moving average crossover." From "inputs" I add in the 9 and 18 period moving averages for fast/slow lengths, and type in green for Up Color and leave red as the Down Color. Once I set this up, I noticed that many of the trades will naturally occur as the markets head into a key support or resistance level. In this way I am generally selling resistance and buying support, but only on confirmation from the crossovers. This is a "go with the flow" trading process and I take all signals, except that I avoid initiating new trades between 12:00 p.m. and 2:00 p.m. Eastern time. This is called the "chop zone" for a reason. In addition to being a simple system that avoids information overload, this method focuses on the current supply and demand situation, period. And keeps a trader on the path of least resistance. The most effective trading setups are simple in nature. Now let's take a look at the five-minute chart and the setups it provided for this trading day:

Figure 6.1

http://www.cbot.com/cbot/docs/56156.jpg

Figure 6.1 is a five-minute chart of the CBOT mini-sized Dow


The above figure represents the intraday trading chart utilizing the five-minute time frame. In this chart, the first crossover occurs about 1five-minutes after the open of regular trade, with the 9-period SMA (dotted line) crossing the 18. Supply is exceeding demand, so the market is heading lower. I short on the crossover, then double the number of contracts I want to trade on my execution platform. This is so that when the moving averages cross back up again, I execute a trade that covers my short and simultaneously goes long. By cutting out the noise, turning off the TV and focusing on the current supply and demand situation, the trader will be on the path of least resistance for the great majority of the time. On this particular day, the system executed the following trades:


<table border="1" cellpadding="0" cellspacing="0"> <tbody> <tr> <td valign="top" width="82">

Signal

</td> <td valign="top" width="62">

Entry

</td> <td valign="top" width="62">

Exit

</td> <td valign="top" width="75">

Points

</td> <td valign="top" width="137">

$ Per One Contract

</td> </tr> <tr> <td valign="top" width="82">

Short

</td> <td valign="top" width="62">

9261

</td> <td valign="top" width="62">

9164

</td> <td valign="top" width="75">

+97

</td> <td valign="top" width="137">

+$485.00

</td> </tr> <tr> <td valign="top" width="82">

Long

</td> <td valign="top" width="62">

9164

</td> <td valign="top" width="62">

9232

</td> <td valign="top" width="75">

+68

</td> <td valign="top" width="137">

+$340.00

</td> </tr> <tr> <td valign="top" width="82">

Short

</td> <td valign="top" width="62">

9232

</td> <td valign="top" width="62">

9186

</td> <td valign="top" width="75">

+46

</td> <td valign="top" width="137">

+$230.00

</td> </tr> <tr> <td valign="top" width="82">

</td> <td valign="top" width="62">

</td> <td valign="top" width="62">

</td> <td valign="top" width="75">

</td> <td valign="top" width="137">

</td> </tr> <tr> <td valign="top" width="82">

Totals

</td> <td valign="top" width="62">

</td> <td valign="top" width="62">

</td> <td valign="top" width="75">

+211

</td> <td valign="top" width="137">

+$1055.00

</td> </tr> </tbody> </table>

Although this system is deceptively simply, it is very clean about keeping a trader on the right side of the trend. Trades can be set up on all time frames, and there are, of course, ways to maximize this system utilizing a few other indicators. A very effective addition is the Keltner Channels with a 3.0 average true range. Keltner Channels are similar to Bollinger Bands in that they will form what looks like a moving average trading channel on your chart. With this "channel" in place, a trader can get out of his position if prices hit one of the upper or lower bands of the channel, instead of waiting for the next crossover to liquidate. If I get out of a position when it hits a Keltner Channel, I still wait for the next crossover to initiate my next position. Keltner Channels are canned indicators that are available on most charting systems. Traders are notorious for tweaking systems, and that is a good "tweak" for this system. However, it also works fine without them. The biggest mistake I see people making with this crossover system is they use stops that are too tight and they are too aggressive about trailing them. I place a 50 point stop in the YM and I don't trail it at all. Trailing a stop on this setup will almost always get you out at a bad price. Let the system do the work.


When Things Go Wrong: Exchange Crashes

We've covered my first two topics, Staying in the Right Frame of Mind, and Keeping on the Path of Least Resistance. Now, let's take a look at the third, Knowing What to do When Things go Wrong. Because as sure as the sun is going to rise tomorrow, things will go wrong!

On Thursday, May 1, 2003, the Chicago Mercantile Exchange crashed at 11:40 a.m. Eastern time, and trading in the E-mini S&Ps was halted at the 905.00 level. They were still halted at the end of the day, even though the big contracts rallied strongly to close at the 915.00 level. Globex did not reopen until the next morning. A lot of people were stuck short with E-mini S&Ps during this time, including myself. What to do? Many newbies froze. "I had no idea what to do," said Scott Sether, a private trader from St. Paul, MN. "I've been trading E-mini S&Ps for about six months, and to be honest I was like a deer caught in the headlights. My broker told me he would keep me posted on when they would reopen. All I know is I couldn't get out of my trade until the next morning. I was short ten contracts and I lost $6,500."

Many traders were stuck short this day. The floor traders knew this. How did they react? Sometimes a picture is worth a thousand words. Imagine the floor traders as a bunch of sea gulls. Then picture the traders who were stuck short as a recently unguarded sack lunch on the beach. Get the picture? When the CME finally reopened the next morning, traders who were stuck short ended up having to swallow some sizeable losses. The key, of course, is for traders to know about their available choices if something like this occurs in the future.

In this instance, Scott could have hedged by going long two of the big S&P contracts. However, it turned out that his broker is one of the many "e-brokers" out there that only trades electronic futures and does not trade any open outcry products. Scratch that idea. In addition, if a trader was short only a couple of E-mini S&Ps, it would not have been appropriate to hedge with the bigger contract (one big contract = five minis). So what to do?

In this instance, Scott could have gone long the CBOT mini-sized Dow, which is what I did. Once I was alerted to the trading halt, I immediately went long an equivalent number of CBOT mini-sized Dow contracts on the CBOT. Once completed, because of the high correlation between the Dow and S&P, I was perfectly hedged through whenever trading would again resume, which turned out to be the next morning.

http://www.cbot.com/cbot/docs/56069.jpg

When it became evident that the market was going to "kill the shorts" who were stuck, I continued to pile on additional contracts to my CBOT mini-sized Dow trade. Not only did I completely hedge my losses in the E-mini S&P, I made nice profits on every long CBOT mini-sized Dow I owned over and above my hedge amount. By the time the CME opened the next morning, the S&P had rallied more than 15 points. What turned out to be a disaster for the unprepared trader turned into a windfall for traders who were prepared for the worst-nightmare scenario.

It is important to be aware of the different choices a trader has each day. Awareness brings empowerment and the ability to turn the inevitable glitch on an exchange into a powerful trading opportunity.

There is a ton of information out there, and many traders get easily confused on what to use and how to use it properly. By getting in a professional state of mind and by focusing on trading the CBOT mini-sized Dow, a trader has the best of both worlds – an easy view of the current supply and demand situation and a clean instrument with which to trade that information. This simple system will keep the trader from second guessing himself, will keep a person on the path of least resistance, and will keep losses small while allowing winners a chance to run. And that's about everything the trader needs to make a living at this greatest business in the world.

One of the simplest and most effective position entry techniques I use is based on what I call multi-pivot levels. The main advantage of this system is that it is price-based as opposed to indicator-based. By the time most indicators generate a buy or a sell signal, the move is already well under way. By following this price-based methodology, there are many instances where I get into a trade before the indicator-based traders, and I usually end up handing off my position just as a buy or sell signal is being generated on a stochastic or other oscillator type system. This is also a good system if you don't have time to stare at the charts all day long, or have a penchant for chasing the market higher and lower. Playing the pivots automatically creates trader discipline because the entries and exits are pre-determined before the trading day even starts.

There is no big mystery or secret to the pivots. They are readily available and have been around for a long time. These are support (S) and resistance (R) levels calculated by floor traders using a simple mathematical formula. These levels became widely known and have moved off floor. Today many traders are aware of them and try to use them, but in my experience they are using them incorrectly. To add to the confusion, there are different formula versions and different time frames that are used when calculating pivots. So, to get started, let's look at what I use, which is one of the standard pivot formulas:

<table class="noborder_tableleft" align="center" border="0" cellpadding="0" cellspacing="0" width="300"> <tbody> <tr> <td nowrap="nowrap" valign="bottom" width="300"> R3: R1 + (High - Low)

</td> </tr> <tr> <td nowrap="nowrap" valign="bottom" width="300"> R2: Pivot + (High - Low)

</td> </tr> <tr> <td nowrap="nowrap" valign="bottom" width="300"> R1: 2x Pivot – Low

</td> </tr> <tr> <td nowrap="nowrap" valign="bottom" width="300"> PIVOT: High + Low + Close/3

</td> </tr> <tr> <td nowrap="nowrap" valign="bottom" width="300"> S1: 2x Pivot – High

</td> </tr> <tr> <td nowrap="nowrap" valign="bottom" width="300"> S2: Pivot - (High - Low)

</td> </tr> <tr> <td nowrap="nowrap" valign="bottom" width="300"> S3: S1 - (High - Low)

</td> </tr> </tbody> </table>

Once a trader has this formula, then the key data that is needed is the high, low and close of the previous session. For my own trading, I like to utilize 24 hours worth of data to capture the highs and lows. However, I will use settlement prices for the close, as this is the closing price that matters.

CBOT Settlement

Once I get this high/low/close data, I plug it into an excel spreadsheet with the formulas listed above. This information generates seven important levels for the next trading day: a central pivot, then three levels above (R1, R2, and R3) and three levels below (S1, S2 and S3). The central pivot has the most weight of the seven levels. In addition to these daily levels, I also utilize the midpoints between these levels (you can also go through and add the weekly and monthly levels to provide additional target levels). It is important to note that it is extremely rare when a stock index hits its R3 or S3 levels. This is important to know because if a market rallies to R2 or a sells off to S2, that usually ends up being the exact high or the exact low of the day. This knowledge will help temper a trader's emotions and keep them on track to follow this system.

The Strategy

This is a fade play. I'm looking to buy pullbacks to pivot levels or sell rallies to pivot levels in teh direction of the prevailing trend.

Trading rules for pivot buys (sells are reversed):

 

1. Set up an intraday chart that shows 24-hours worth of data, so you can view any overnight highs and lows. Insert the pivots and the midpoints onto your chart.
2. The first pivot play is done in conjunction with a price gap. If there is a price gap down, then buy a decline into the closest pivot level. If there isn't a playable gap (over 10 YM points), then wait until 9:45 a.m. Eastern time to initiate the first play.
3. I wait for the markets to penetrate a pivot level, moving up at least halfway to the next pivot level, then I set up a bid to buy the first retracement back to the first violated pivot level.
4. I enter my trades with limit orders only. I Place orders "just in front of" the pivot. For YM I use 3 points. For example, if you are trading the YM, and the pivot level is 10000, then I would buy a decline to 10003 and short a rally to 9997. Sometimes the pivot will be an odd number, such as 10003.68. In this case I always round in the direction of the trade. So, if I'm bidding for a long, I will round 10003.68 to 10004, and my bid will be 10007 for a long and 10001 for a short. My stops and targets, then, would be "just in front of" these appropriate long and short levels.
5. Once filled, place an order to close the first half at the next pivot level, and the second half at the pivot level after that, using the same "just in front of" parameters.
6. I place a 20 point stop for the YM.
7. If the first target is hit, move up the stop to your entry level pivot, minus the "just in front of" fractions discussed in rule #3. For example, if you get in to a YM long position at 10003, and the pivot is at 10000, then your new stop would be 9997 once the first target is hit.
8. If I am in a trade at the market close, and neither my stop or target has been hit, I will close my position out "at the market" at 4:10 p.m. Eastern time.
9. I don't initiate any new positions after 3:30 p.m. Eastern time, but I will manage existing positions into the close.
10. The markets never have a sustained move above R3 or below S3. If we trade to those levels, I will always fade the move.
11. If I get two losers in a row, I'm done with pivots for the day.

Figure 7.1
http://www.cbot.com/cbot/docs/56070.gif

1. In Figure 7.1, the CBOT mini-sized Dow futures open mixed and begin selling off early in the session. I place an order to short the next rally to midpoint at 10118, but I don't get filled. Once we break down through the Daily Pivot, I move my order to short down to 10091. This time I get filled, and I place a stop at 10111 and an order to cover half my position at 10069. I'm filled on the first half of my order, and I then move my stop down to 10097. My next target is 10041.
2. My next target is hit and I'm now flat.
3. The market continues to move lower and tests the next pivot level. I place an order to short at the pivot level above, right at 10035. The market is acting really slow. I put my orders in place and go grab some lunch. By the time I get back I'm still not filled, which is why I absolutely love the low volume August trading. It takes a couple of hours but I end up getting filled later in the afternoon. I place a stop at 10055 and my first target is 10015. This target is hit quickly and I move my stop down to 10041.
4. My second target is hit at 9988 and I'm now flat. Since the market continues to trend lower, I place a bid to short at the next overhead pivot level and I place an offer at 10008.
5. The market trades right up to this level but I don't get filled. When the market collapses I move my offer down to 9982, but this doesn't get filled either.

Figure 7.2
http://www.cbot.com/cbot/docs/56071.gif

 

1. In Figure 7.2, the markets open mixed and rally into the midpoint at 10189. I set up to buy the first pullback and I place an order at 10163. We come very close to this level, but not quite, and I don't get filled. The market rallies through the next pivot level, and I move my bid up to 10192. The market doesn't even look back and keeps on going, moving up through yet the next pivot level.
2. I move up my bid against to 10221. This time I get filled and place a stop at 10201 and my first target is 10238. The first target is hit quickly and I move up my stop to 10215.
3. My second target is hit at 10261 and I am now flat.
4. The market rallies and I place an order to buy at 10267. I don't get filled and the market closes near its highs.

Figure 7.3
http://www.cbot.com/cbot/docs/56072.gif

1. In Figure 7.3, the Dow gaps down and I place in a bid at 10077. I get filled and place a stop at 10057 with my first target at 10090. My first target is hit and I move up my stop to 10071.
2. The Dow continues to rally and my second target is hit at 10104.
3. I place an order at 10096 in order to buy the next pullback. I get filled and place a stop at 10076. The market slows to a crawl for the next hour and nothing happens. Then momentum begins to pick up and I'm out of my first half at 10104. I raise my stop to 10090.
4. My second target is hit at 10118.
5. The Dow continues to rally to the next pivot level. I place an order to buy a pullback at 10124. I don't get filled.
6. The market pushes higher to the next level and I raise my bid to 10144. I get filled and place a stop order at 10124 with my first target at 10157. My first target is hit quickly and I raise my stop to 10138.
7. My second target is hit at 10171 and I am now flat. The market continues to rally to the Daily R3. This is a rare event! The markets hardly ever get through R3, and I always fade initial moves to these levels. I place an order to short at 10185. I am filled and place a stop at 10205. The markets push up to 10200 and fade into the close. Since neither of my parameters are hit, I cover at 4:10 p.m. Eastern time at 100176.

The pivot levels work so well in this regard for three reasons:

 

1. The first, and most obvious, is that a lot of traders watch these daily levels, so there is a self-fulfilling prophecy involved. The same can be said for Fibonacci Levels, but they do not hold nearly as well as the pivots. Why? I elaborate on this in the next two points.
2. On the floor, it is a trader's goal to grab two points in the S&P 500 and get out, or 20 points in the Dow and get out. The floor traders all operate in a big circle, with the longer term players in the center of the circle, and the newer players on the outskirts. In its purest form, the traders in the center will get in on a trade, let's say it's a long, and then sell their position to the guys on the outside of the circle. What happens is that the traders on the outside, by the time they see the market moving, are the last ones in the pit to get in on the move. If they are lucky, they will then be able to turn around and sell it to the public. As the guys on the outside are selling to the public and closing positions, the guys in the center are selling to the public and opening new short positions. And the cycle renews itself like this throughout the day. This causes a specific dynamic in the markets, generating specific cycles of speed and rest on an intraday basis. They focus on the pivot levels to base their entries and to also gauge market action. The pivots play on this in that they are spaced out to catch these "patches of momentum." A Dow Pivot is usually 30-50 points apart, and this is the type of movement that perpetuates the cycle I just described. Like a hawk, the floor traders in the center of the circle are catching half this move, dumping it, and waiting for the next level to be hit.
3. One of the main reasons these pivots work has to do with the vast majority of inexperienced traders out there. The floor traders start a trade, and the inexperience of most traders causes the momentum that finishes a trade. How? Because the average trader relies on a lot of different "indicators," they are getting in and out of their positions way too late, which causes losing trades and a specific cycle of market movement as their stop placement slowly and steadily increases the velocity of market movement in the direction of their stops. Indicators are just that, an "indication." This is like your girlfriend slapping you across the face, and you taking it as an "indication" that she might be angry with you! If it takes a slap across the face to realize this, then you are following the wrong indicators. By the way, all market indicators are the wrong indicators, as they are all lagging. Price action is pure. This over reliance on indicators by the majority of traders is what helps this system to work. By the time the average trader gets a buy signal, the pivot play is almost over and users of this system will be selling their position to the indicator-based trader. Then the subsequent reversal that takes place is because of all the stop losses sitting out there, like trout sunning themselves on top of a lake . . . easy targets for the hawks who come swooping down from overhead. The market pauses, drifts down, and picks up steam and rips through all of the stop losses, pausing when the run is over. This "pause" generally happens at a pivot level. It's where the floor traders are beginning to accumulate their next position for the next cycle of play.

Now knowing how this cycle works, let's take a look at a video of a live trading day where I played the pivots, where I sold half at the next pivot level and used a trailing 8 and 21 period exponential moving averages to trail the second half of my position.

CBOT Pivot 1

I've worked with many traders, and one of the things they find most valuable is to look at exactly the same chart I'm looking at throughout the trading day. In this next video, I discuss a recent day of trading that focuses on the pivots, but also combines my discussions regarding moving averages and gaps, as well as utilizing some of my own indicators. Let's take a look at the trading we did in the CBOT mini-sized Dow on Friday, January 7, 2005, using the pivots in the video.

CBOT Pivot 2

Summary

The pivot levels work mainly because of the psychology pain/pleasure cycle that perpetuates the markets each day. Traders who follow only indicators will buy a position when it is halfway to three-quarters the way off its pivot, and it is these traders who provide the stop losses to perpetuate the next cycle of market movement. If you rely only on indicators for your entries, instead of using the price action of the pivots, you will get in and out of these cycles too late, and you won't make any money trading.

What is nice about this system is that a trader doesn't have to watch it very closely once he or she is in a position. I'm not an aggressive trailer of stops. I like to get in a position, set my parameters, and then focus on other things. Depending on a trader's work situation, he could do this at the office, especially on the West Coast of the U.S., and especially if he had an order system that automatically bracketed trades. This way you can place the parameters, and then go to the next meeting or appointment. Let the parameters baby-sit the position. This is much better as well because it takes human emotion out of the equation.

I like to focus part of my trading day on scalp plays, where I'm jumping in and out of the market with a little piece here, and a little piece there. However, I also like to focus a part of my time on catching potentially bigger intraday moves, as well as multi-day and multi-week moves. What I'll do is focus on scalp plays in one account, and use a second account for swing plays. The "Squeeze Play" is a diverse setup that can be used for both scalp plays and swing trades.

The Squeeze Play takes advantage of "quiet periods" in the market when volatility has decreased significantly, and the market is building up energy for its next major move higher or lower. This indicator was introduced to me by my trading partner, Hubert Senters, and it has become an integral part of my own trading plan. These quiet periods are identified when Bollinger Bands narrow in width to the point that they are trading inside of Keltner Channels (I just use the default settings on TradeStation for both of these indicators). This marks a period of reduced volatility and signals that the market is taking a breather, building up steam for its next move.

I use this signal on various time frames. On the CBOT mini-sized Dow, for example, a squeeze on a two-minute chart can move 10-20 YM points, on a five-minute chart 30-50 points, and on a daily chart, several hundred points. The kicker, of course, is that the smaller the time frame, the more frequent the signals. A two-minute chart may fire off 3-5 signals in a day, while the daily chart will fire off 6-7 signals over the course of an entire year.


The Strategy

This is a momentum play. I will buy strength and sell weakness.

Trading rules for buys (sells are reversed):

 

1. Set up a 24-hour chart so the overnight activity can be accounted for in this indicator setup.
2. The "heads up" on this indicator is the first black dot. This is not a trade signal, but a "heads up" that a trade signal is setting up.
3. The signal on the indicator is the first gray dot after a series of black dots (this will be shown in detail in the charts that follow).
4. Once the first gray dot appears after a series of black dots, I go long if the histogram is above zero. Once the signal fires, I just place a market order. This is a momentum play and I don't want to be messing around with limit orders that may not get filled.
5. For day trades, I place the following minimum money management stops. If the stop is also near a key price support level, I will take that into consideration and adjust accordingly. For example, if my entry is 1104.00 on the S&Ps and the Daily Pivot is at 1101.75, I would move my stop to just below that pivot level to 1101.50, for a stop of 2.50 instead of 2.00. I find that nine times out of ten, I just use the default stop.
   1. Dow: 20 points
   2. Bonds: 7 ticks
   3. Gold: 1.50
   4. Silver: 50 cents

6. For swing plays and position trades (taken off the daily charts) I place the following stops. I take into consideration the same key levels as discussed in number 4.

    

   1. Dow: 150 points
   2. Bonds: 35 ticks
   3. Gold: 10.00
   4. Silver: 1.00

7. My target is based purely on the momentum of the trade. Once the momentum signal starts to weaken, I get out of the trade at the market.
8. I don't trail stops.

Lets look at some example trades.

Figure 8.1
http://www.cbot.com/cbot/docs/56073.gif

 

1. The chart in Figure 8.1 shows how to set up the elements of this play into whatever time frame you want to view. For intraday trading, I like to watch the five-minute chart. You can watch the one- and two-minute charts, but generally these signals are not as powerful as the five-minute signal, though they are tradeable. The Keltner Channel is the pair of thick black lines and are set at the default parameters of on TradeStation of 20 and 2. The Bollinger Bands are the thinner, gray lines and are set at the default settings of 20 and 1.5. At the bottom is a 12 period (on the close) momentum oscillator. At point 1, you can see that the Bollinger Bands have gone inside the Keltner Channels. This indicates that the market is going into a quiet period, and it is a "heads up." This is not a signal – just a heads up that when the Bollinger Bands pop back out, it will be time to take a trade. Here you can see that the Bollinger Bands have come back outside the Keltner Channels. It is time to take a trade.
2. If the momentum oscillator is above zero at this point, I go long. If it is below zero at this point, I go short. I don't mess around with limit orders. I just jump in at the market. This is just an example of what triggers the entry and exits. I will look at specific plays in a moment.

Figure 8.2
http://www.cbot.com/cbot/docs/56074.gif

 

1. One of the things Hubert did was turn all of the things in the first chart in Figure 8.2 into an easy to read indicator, which is what I now use. You can see on the bottom when the Bollinger Bands go inside the Keltner Channels, the dots turn black. This is a heads up that the markets have entered a quiet period.
2. At this point the Bollinger Bands come back out of the Keltner Channels. Since the Momentum Oscillator is above zero, this is a long signal. On the indicator, this is measured by when the dots turn back to gray after being black. When I see that first gray dot, that is my signal to take a trade. Then, if the histogram is above the zero line, I go long, and if it is below the zero line, I go short. Again, this is just to show you how the indicator works. In the next examples I will go over some actually plays. I prefer to take off all of the "clutter" that is on the price chart and just use the indicator. But now you know how the indicator works.

Figure 8.3
http://www.cbot.com/cbot/docs/56075.gif

 

1. On the two-minute chart of the CBOT mini-sized Dow in Figure 8.3, we get a black dot a little after 10:00 a.m. Eastern time. This is a signal that the Bollinger Bands have narrowed and are now trading inside of the Keltner Channels. I know when I get the next gray dot, I will have a trade signal. In this case, the gray dot happens right away. Usually there is more than one black dot, but once in a while it will just have the single instance, and that's ok. I find it is best to just take the signal when they come. Humans tend to mess up their trading when they try to out think their positions. When the next gray dot appears, the histogram is above zero, so I place an order to buy YM at the market. I am filled at 10164. I place a 20 point stop at 10144. My target is open as I'll be waiting for the momentum to falter as my exit signal.
2. The market pushes higher and I'm watching the histogram. As long as it makes higher highs, I stay in the trade. When it makes its first lower high, I will get out. At 10:30 a.m. Eastern time we get a lower high on the histogram and I exit at the market. I'm out at 10198 for a gain of +34 points.

Figure 8.4
http://www.cbot.com/cbot/docs/56076.gif

1. In Figure 8.4, on June 28, the markets traded in a tight range all morning, creating a long series of black dots on the 5 minute YM chart. Remember, the black dots indicate that during this time frame, the Bollinger Bands are trading inside of the Keltner Channels, marking a period of very low volatility. A little after 1:30 p.m. Eastern time the first gray dot appears. The histogram is below zero, so I take a short at the market. I'm filled at 10426 and I place a 20 point stop at 10442.
2. The goal is to stay in the trade as long as the histogram is making lower lows (or in the case of a long, higher highs). It makes its first higher low nearly two hours later, and I exit at the market (if you were just watching the momentum oscillator, you would exit as it starts to turn higher). I'm out at 10325 for a gain of +101 points.

Figure 8.5
http://www.cbot.com/cbot/docs/56077.gif

1. In Figure 8.5, on September 10, the five-minute squeeze on YM fires off. About an hour earlier there was a single gray dot, and I went long here. However, the very next dot went back to black. This means that the Bollinger Bands came out of the Keltner Channels, then went right back in. This is a rare occurrence, but when it happens, I just get out and wait for a solid signal. In this case I was in and out and lost 6 YM points. About 50 minutes later we get the setup again and the dots turn gray. For this next trade, with the histogram above zero, I go long and place a 20 point stop. I am in at 10263 and I place a stop at 10243.
2. The histogram continues to move higher until 1:30 p.m. Eastern time, at which point it starts to lose momentum. I cut the position loose at 10309 for a gain of +46 points.

Figure 8.6
http://www.cbot.com/cbot/docs/56078.gif

1. In Figure 8.6, a little after 10:00 a.m. Eastern time on July 1, the first gray dot appears on the five-minute YM chart. The histogram is below zero, so I go short at the market. My entry 10402.
2. The markets drift down and the histogram begins to level off. The markets continue to make lowers lows and suddenly the selling accelerates, pushing the histograms down deep into their range territory. They begin to bottom out around 11:20 a.m. Eastern time and I cover at the market. I'm out at 10312 for a gain of +90 points.

Figure 8.7
http://www.cbot.com/cbot/docs/56082.gif

1. In Figure 8.7, on September 2, the five-minute YM chart goes into alert status around 1:15 p.m. Eastern time. Six black dots appear, showing that the Bollinger Bands are trading inside the Keltner Channels. When the next gray dot appears at 1:50 p.m. Eastern time, the histogram is above zero so I go long at the market. I am filled at 10183. I place a 20 point stop at 10163.
2. The market cruises higher and the histogram begins to start making lower lows at 3:30 p.m. Eastern time. I exit at the market and am out at 10278 for a gain of +95 points. Not every five-minute squeeze ends up with a big move like this, but I've found that when there is a big move, it is generally kicked off by a squeeze on the five-minute chart. I have a rule in trading that says, "Never fight the direction of the five-minute squeeze!" It supersedes all of my other intraday trading rules and setups.

Figure 8.8
http://www.cbot.com/cbot/docs/56084.gif

1. We looked at a lot of five-minute squeezes on YM, so I wanted to look at a daily squeeze as well. In Figure 8.8, at the end of November, the daily YM went into "black dot mode", and I awaited the next gray dot. We got it on December 1, and since the histogram was above zero, I went long shortly after the open and got filled at 9804. I placed a stop at 9654, 150 points below.
2. The YM rallied into early January and started losing momentum during the second week of the New Year. I exited on January 9, soon after the open at 10506 for a gain of +702 points.

Daily Squeezes and Options on the CBOT mini-sized Dow

I like to use the daily squeeze to set up option plays on the CBOT mini-sized Dow. This way I can be positioned for bigger moves that occur when the daily squeeze fires off, but still be able to intraday trade in the same account without offsetting my position. Let's take a quick look at a video that shows how to use options and the daily squeeze together.

CBOT mini-sized Dow Squeeze


Using the Squeeze for Gold and Silver

The squeeze also works great for the CBOT 100 oz. Gold and 5,000 oz. Silver futures contracts, as well as the CBOT mini-sized Gold and Silver contracts. I watch the daily as well as the intraday charts on these contracts, always alert for the next squeeze signal to fire off.

CBOT Gold Squeeze

CBOT Silver Squeeze


Using the Squeeze for the U.S. 30-Year Treasury Bonds

The squeeze is also one of my favorite ways to play the U.S. 30-year Treasury Bond futures. I will use this on both daily and intraday charts. Let's look at some static charts, and then we'll watch another video.

Figure 8.9
http://www.cbot.com/cbot/docs/56086.gif

1. I love using the five-minute squeeze on the YM, but it works on other markets as well. In Figure 8.9 is a chart of the U.S. 30-year Treasury Bonds. Around 11:30 a.m. Eastern time the dots turn black, signaling that we are entering into a period of very low volatility. About 90 minutes later we get a gray dot, and since the histogram is above zero, I go long at the market (Point A). I'm filled at 111 9/32 (Point C). I place a 7-tick stop at 111 2/32 (if you aren't familiar with bonds, 1 tick is $31.25. So if you lose seven ticks, that equates to $218.75, or approximately 44 YM points).
2. The momentum starts to peter out about forty minutes later, and when the histogram makes a lower high (Point B), I exit at the market. I'm out at 111 11/32 for a gain of +2 ticks (Point D). At one point I was up 10 ticks on the trade (the equivalent of 63 YM points) but the market rolled over quickly, which can happen. What's more important is to stay in the signal until it ends. This way when a big move happens you will be able to stay in the trade and let your profits run.

Figure 8.10
http://www.cbot.com/cbot/docs/56087.gif

1. On this five-minute chart in Figure 8.10 of the U.S. 30-year Treasury Bonds, we go into "black dot" territory around 10:45 a.m. Eastern time, and I set back and wait for the next gray dot to appear. This happens a little after 12 Noon Eastern time (Point A) and since the histogram is below zero, I short at the market. I'm filled at 110 30/32. I place a stop at 111/5/32 (If you are not familiar with bonds, each point goes up to 31/32. When it goes to 32/32 it becomes a new point. For example, when bonds are at 110 31/32 and they move up 1 tick to 110 32/32 this reads as 111, and so on).
2. The momentum to the downside builds and bonds sell off. Once the histogram makes a higher low (Point B), I cover my short at the market and I'm out at 110 26/32 for a gain of +4 ticks.
3. Around 1:30 p.m. Eastern time we go back into "black dot mode" and I get prepared for my next trade. About 45 minutes later we get our first gray dot (Point C) and since the histogram is below zero I short at the market. I'm in at 110 21/32. I place a stop at 110 28/32.
4. Bonds sell off and move lower into the close. I cover at the first higher low at Point D and I'm out at 110 16/32 for a gain of +5 ticks. The market rolled over again quickly thereafter and closed on its lows.

Figure 8.11
http://www.cbot.com/cbot/docs/56088.gif

1. On this daily chart of the U.S. Treasury 30-year Bonds in Figure 8.11, we can see that these markets consolidated heavily for nearly a month during most of April 2003. When the first gray dot appeared after this consolidation (Point A), I went long and was filled at 113 13/32 (Point C). Because this is a daily chart, I give the trade more room and use a 35 tick stop at 112 10/32. Bonds rally through the entire month of May, finally losing momentum in June.
2. Bonds get nearly as high as 122 before crashing on economic news (Point D). That kicks off a lower histogram reading (Point B), and I exit at the market at the end of that day, getting out at 119 31/32 for a gain of + 6 18/32, or the equivalent of a +1,312 point move in YM.

Summary

Squeezes show me when the markets go into quiet mode. The only reason markets go into quiet mode is because they are building up energy for their next major move. I like to be on the alert for this move, and of course on the alert for the direction of the move. With the squeeze, I have a clear indication of when to take the trade, and once I'm in, I just don't mess with the trade. When it starts to lose momentum it is pretty clear, and that is the signal I use to get out.

In watching the markets over the years, I've observed that most reversals take place after three consecutive higher closes, or three consecutive lower closes, and this tendency is valid for all times frames. The key to this setup is that it is based on consecutive "closes" and not just intraday or daily high and low price action for an individual bar. In other words, the highs and lows are not important. I'm not interested in three higher price highs or three lower price lows. I want to see where the action settles or closes, as that is where the rubber meets the road.

The hard way to follow this play, especially intraday, is to stare at the charts and keep track of consecutive lower or higher closes until you get three in a row. This can cause a person to go bug-eyed, as well as insane, and is recommended only for those who get a thrill from "the little things in life." I'm not a big fan of staring at charts and would be a prime candidate for the mental hospital if I did this with the naked eye. Instead, I've developed a simple indicator in TradeStation that will "paint" the first bar in the sequence after the third bar has met the criteria for a signal. Once I see the paint bar, I just place a market order and I'm in the trade. Even better, I set up an audio alert so that if I'm down the hall, I'll hear the signal and come back to my computer to place the trade. This works when I'm on the phone with my wife as well, though she has yet to appreciate the importance of the signal and my urgent need to hang up in the middle of our conversation. Such is the life of a trader.

Here is how it works: I am watching the charts and I get three bars in a row that make higher closes. At the close of the third consecutive bar, my paint bar appears on the chart, and it is marked over the first bar in the sequence of third bars. I place an order to go long at the market. To get out of this long position, I just wait for three consecutive lower lows to occur, and that will be my signal to exit the trade, and potentially go short. Although this is a very easy trade to execute, it may not make sense right out of the gate. Don't worry, if this sounds a little unclear, we will be looking at some charts soon enough.

I use this signal on various time frames. For scalping the CBOT mini-sized Dow, Gold, Silver and U.S. 30-year Treasury Bond futures, I like to use the 144 tick chart and the five-minute chart. For swing trades, I will use both sixty-minute and daily charts.


The Strategy

THIS IS A MOMENTUM REVERSAL PLAY. I WILL BUY A REBOUND AFTER A SELLOFF UPON CONFIRMATION AND SHORT A PULLBACK AFTER A RALLY UPON CONFIRMATION.

TRADING RULES FOR BUYS (SELLS ARE REVERSED):

1. Set up a 24-hour chart on intraday charts so the overnight activity can be accounted for in this indicator setup. This can be used on all time frames. The larger the time frame, the larger the parameters and potential move. For daily charts I will use the regular session hours.
2. After three consecutive higher closes, go long at the market, at the close of the third bar in the sequence.
3. The trade is valid until you get three consecutive lower closes, at which point you would exit the trade. If the market is still open for an intraday trade, you can simultaneously exit a long and establish a new short position. If I'm in an intraday trade (fifteen-minute chart or smaller) and the market closes before giving an exit signal, I will exit at the market 4:10 p.m. Eastern time.
4. For time frames that are sixty-minutes and above, I will stay in them overnight and exit at the next signal. This could be the next day for a sixty-minute chart, and it could be a month later for daily charts.

Figure 9.1

http://www.cbot.com/cbot/docs/56090.gif

1. In Figure 9.1, in this daily chart of the CBOT mini-sized Dow futures, a long signal occurs on August 10, which paints the August 6 bar.
2. I go long at the close of August 10, and I'm filled at 9916. I'm now waiting for the next reversal signal in order to exit the trade.
3. The next signal hits on September 7, nearly a month later.
4. I'm out at 10278 for a gain of +362 YM points.

Figure 9.2

http://www.cbot.com/cbot/docs/56092.gif

1. This is a good example of a play for people with insomnia, or who are living in a time zone overseas that is contusive to this type of trading. In Figure 9.2, on October 1, a reversal signal setup on the U.S. 30-year Treasury Bonds in the wee hours of the U.S. night.
2. I'm working on my newsletter late at night (the pros and cons of writing a nightly newsletter), and I take the short. I'm filled at 112 1/32. I will stay in the trade until the next reversal signal.
3. A few days later I get a reversal signal on October 4.
4. I cover at 111 8/32 for a gain of 25/32. For those of you who are not familiar with bond pricing, 1/32 = $31.25. So a move of 25/32 = 781.25 per contract.

Figure 9.3

http://www.cbot.com/cbot/docs/56095.gif

1. I wanted to use this last example in Figure 9.3 to show how I would flow in and out of positions intraday, going both long and short. The first signal on October 6, in YM, was painted at 10:35 a.m. Eastern time.
2. This means, of course, that I am going short at the close of the last bar in the sequence of three bars, which is 10176.
3. The next reversal is noted on the chart at point #3.
4. I cover at 10169 and simultaneously go long. The easy way to do this is to double the amount of contracts you are trading on your exit order. So, if you are long 10 contracts, then you place an order to sell 20 contracts in order to exit your 10 long contracts, and at the same time establish a new position that is short 10 contracts. The next signal occurs at point #5. I go long at 10186 and simultaneously go short at this same level. The next signal occurs at point #7. I cover my short at 10173 and go long at the same level.

Figure 9.4

http://www.cbot.com/cbot/docs/56096.gif

1. Figure 9.4 is a good example of a swing play on the CBOT 100 oz. Gold contract. On November 4, there is a buy signal on the daily charts, and I go long at 433.00.
2. The market moves steadily higher, without much in the way of pullbacks. Finally, on December 7, I get a reversal signal and I'm out at 453.70, a profit of $20.70 per contract, or $2070.00.

This also works great on the 100 oz. Gold intraday, as well as the 5,000 oz Silver contract. Take a look at the following video for example plays in the CBOT mini-sized Dow, Gold, Silver and U.S. 30-year Treasury Bonds.

CBOT Example Plays

In Summary

This setup is especially useful for traders who like to try to buy bottoms or short tops. While it is foolish to short a stock just because its "too high," or buy a market because its "too low," its fine to short that high flyer or buy that all out loser once you get a reversal confirmation with this signal. It doesn't mean that the exact highs or the exact lows are in place, but it does mean that there has been a temporary shift in power, and it is your signal to step in and establish a position. Whether this is an intraday reversal on a five-minute chart, or a total market reversal off a daily chart, the concept is exactly the same. In addition, this play is based on pure price action, and I appreciate its simple and effective nature.

The best intraday trades take place when a trader is able to catch the major portion of an intraday reversal. One of the best ways to do this is with a specific price pattern that we call bricks. We call them "bricks" because the price pattern that is formed looks like a bunch of building blocks that have been placed on top of a regular bar chart. These building blocks are formed on the chart due to specific price action. A series of three consecutive higher closes will form an "up" brick, and a series of three consecutive lower closes will form a "down" brick.

If you have a hard time pulling the trigger, this is a good play to use with BUY STOP and SELL STOP orders, as you will see in a moment. If you don't have a hard time pulling the trigger, then you can just wait for the signal and then go in at the market. This is one of those plays that is difficult to explain, but easy to show. In this case, a picture is worth at least 1000 words. Let's go through the trading rules and then go over a couple of actual plays.


The Strategy

THIS IS A MOMENTUM REVERSAL CONFIRMATION PLAY.

TRADING RULES FOR BUYS (SELLS ARE REVERSED):

1. Set up a 24-hour time frame on an intra-day chart so the overnight activity can be accounted for in this indicator setup. This is best used on smaller time frames, typically under five minutes.
2. Once a market shifts direction, count backwards to the third brick in the formation.
3. Then draw a horizontal line across the top of this third brick back.
4. Once the price action breaks above this horizontal line, go long.
5. Hubert and I use this setup on the CBOT mini-sized Dow, and we both manage this trade differently, so I will go over both of our methods. For Hubert, he places a 10 point stop from the entry. Then when he is up 10 points, he sells half his position, and moves his stop to breakeven -3 (so if his entry was 10545, then his new stop is 10542). If the market goes up another 10 points, he sells a quarter of his position, and then moves up his stop 6 points to breakeven +3 (so if his original entry was 10545, his new stop is 10548). He then hangs onto his last quarter of the position to exit at his discretion. This typically involves a move that accompanies an extreme tick reading.
6. For myself, I will get into the same trade and use a 20 point stop. I will exit half my position at +15 points, and then stay in the trade until there is a brick that has formed in the opposite direction. I don't trail the stops. Both methods have worked well for us, and this is a good example of how different traders can take the exact same setup and modify the trading methodology to fit their own particular personality.

Let's take a look at some actual plays:

Figure 10.1

http://www.cbot.com/cbot/docs/56100.gif

1. On this two-minute chart of the CBOT mini-sized Dow futures in Figure 10.1, a long signal occurs around 1:00 p.m. Eastern time when the price action reverses and crosses above the horizontal line created by the third brick back in the series. The "up" bricks are blue, and the "down" bricks are red.
2. In this instance, YM rallies up to 10689. Our entry is at 10629. Hubert is using a 10 point stop and I'm using a 20 point stop. Hubert exits half at 10639, a quarter at 10649 and the remainder at 10675 when YM comes up against key resistance. I exit the first half at 10644, and I stay in the second half until the bricks reverse and I'm out at 10672.

Figure 10.2

http://www.cbot.com/cbot/docs/56101.gif

1. On this two-minute chart of the CBOT mini-sized Dow futures in Figure 10.2, a short signal occurs around 11:00 a.m. Eastern time, when the price action reverses and crosses below the horizontal line created by the third brick back in the series.
2. In this instance, YM declines to 10646 before reversing. Our entry is at 10704. Hubert's stop is 10 points, while mine is 20 points. Hubert exits half at 10694, a quarter at 10684 and the remainder at 10668 when YM sells off through key support on an extreme tick reading. I exit the first half of my position at 10689 and exit the second half at 10658 when the market reverses and generates a new brick long signal.

The brick plays can take a little while to understand exactly how they work. Hubert has put together a video that shows how bricks work in more detail, as well as discusses additional sample plays.

A Brick Example with Additional Sample Plays

In Summary

This setup is great when trying to catch an intraday reversal. Too many traders try to do this but end up getting burned. They short the market and it just keeps going higher, or they buy the market and it gets flattened. There is no reason to try to catch the exact high or the exact low in a market move. That involves too much risk and has a low probability of success. With this confirmation signal, a trader will be made aware of when the move is confirmed to be over, and still be able to catch the "meat of the move."

I’ve talked a lot about different setups in these trading lessons, and if there is one thing that can be said about trading, it is that everyone is a genius in hindsight. It is very easy to look at the price history of a particular market and say, “You should have bought here” or “You should have sold there.” So the big question I get is, “What about when the market is really open and things are happening in real time? What do you do? What do you look at? How do you make your decisions?” I’ve found it helps traders to watch how we trade the markets real time. It gives them a feel of what we look at, how we react, and so forth. That said, we’ve attached a video that shows an hour’s worth of unedited live trading.

Video boston15

This is a big file, so it may take a few minutes to get going. If you would like to fast forward it to the actual plays, they take place at the following intervals: 15:30, 39:56, and 55:34. These numbers refer to the minutes and seconds, and can be found in the lower right hand corner of the video.

This should give you a better idea of what happens when the rubber meets the road, as the trading decisions are made in real time – without the benefit of hindsight.

Who We Are.

Trade The Markets was founded by John Carter in 1999, and is an online provider of short-term financial market commentary designed for both swing and intraday trading of stocks, options and futures. We focus on the power of short-term price movements to produce steady profits. We are just as likely to be long as we are short. Utilizing leading software and core trading techniques, our strategy for stocks is to scan through thousands of price charts each trading day. For futures trading, most of our intraday trading techniques are focused in the CBOT mini-sized Dow, Gold and Silver, as well as the U.S. Treasury 30-year Bond futures. We apply a combination of technical analysis, pattern recognition, and market outlook to discover short-term, high probability trading opportunities in these and other markets.


Who Are the People Behind Trade The Markets?

Everyone who contributes to Trade The Markets is a full time trader who either had the benefit of learning to trade from a successful mentor, or graduated from the school of hard knocks—losing money every way imaginable before developing their own successful trading rules. We all trade full time for a living, and most of work with managed funds and accounts. This website was the natural outcome of posting trades with each other, and the desire to help out others who want to give trading a shot. By posting our research to the site each evening, and by calling out live trades in our audio live trading rooms, we are helping ourselves because it forces us to do a full night’s worth of research each evening, and gives us an extremely disciplined approach to the markets. We're also helping our members and have shown that we can also save traders valuable time--when you are running short on time, we still do a full night's worth of research and post our findings and specific trading ideas for the next day.


What’s The Different Between Your Stuff and Others?

There are four things we specialize in that make us stand out from the crowd: Entry and Exit Point Focus, Real Track Records, Education, and Accountability. We are a "no-hype" site that focuses on what works over the short term. And we post all of our trades, the good, the bad, the great, and the ugly, so you can evaluate for yourself how we do in all market conditions.


Our Services.

We offer three newsletters that focus on stocks, options and futures. We also have a live audio trading room where our voices come out through your computer speakers, and we are able to share the charts we are using live with our members. In there, we discuss our trading philosophy and record our trades as they happen, in real time. The newsletters are generally published five days a week and have intra-day updates. Each focuses on a particular area of the markets. Each newsletter provides market commentary, a model trading portfolio, trading ideas with specific entry, exit, and stop loss price levels, and tips on how to find these trades on your own. Our typical holding period is a few days to a few weeks, making it ideal for part time traders who don’t have time to sit in front of their computers monitoring the markets all day.

If you click on the link below, you will see a recent example of our “E-mini & Single Stock Futures Newsletter” where we focus on setting up swing trades in the CBOT mini-sized Dow, Single Stock Futures, U.S. 30-year Treasury Bonds, and other markets.

View the PDF below:

TTM Emini SSF

In the Live Audio Trading Room, we focus mostly on intraday trading of the CBOT mini-sized Dow. The Live Audio Trading Room is geared towards active, full time traders and it has been a huge hit with our members.

The link below will hook you up to a video that talks more about our philosophy and backgrounds, as well as some information about our newsletters, trading room, and opportunities for further education and experience.

About Us Video!

Free two week trials are available for everyone at our site, www.tradethemarkets.com. By logging into the live trading room, you will be able to ask questions “free” for two weeks. This is a great way to get any questions asked about this tutorial. However, please confine your questions to between 12:00 Noon – 2:00 p.m. Eastern time, as we are trading the rest of the time. Room membership is limited, and you must be voted into the room by the existing members if you wish to stay beyond the two weeks.

If you have any questions regarding any of the trading strategies presented here, please feel free to contact me at [email protected], or call us toll free at 888-898-8118. If you have any questions regarding the CBOT mini-sized Dow, Gold, Silver or U.S. 30-year Treasury Bond contracts, feel free to contact the CBOT at [email protected].

This is a great article.

Almost covers everything he has in his book exept for $tiki, $tick and $trin monitoring. John Carter is truly a genius and trades in the simplest manner.

I use a few of his techniques in trading.

Trade Setups
1. Gap (Daily Charts)
2. Squeeze Play (Daily Charts)
3. Price Action using Momentum Reversal (Daily Charts)

I'm thinking of integrating weekly and monthly pivot points for my daily charts to see if its possible for me to get good trade setups. These i use when I trade ES and YM.

very good article! thanks a lot

Excelent article, thank you.