Counter Trend Trading ....A useful tool

Dr.Elder

It was a time when the cold war between Soviet Union and United States at it's peak. A Russian army ship was passing near the coastline of Africa in the middle of the night. Everyone in the ship was either relaxing or sleeping after a hard day, except one. A Russian Army doctor, a Psychiatrist, has something in his mind that nobody knew in the ship. He was about to flee. When the  time was right , he jumped off of the ship and started to swim towards the beach. Soon enough his companions become aware and followed him. Luckily he could manage to make it to the United States embassy and got a political asylum. He was only 23 at that time. Later he became a well known mentor and writer of many successful books about trading like "Trading For a Living " , "Come into my trading room " , "Sell and Sell short " etc. Yes, I am talking about Dr. Alexander Elder.  


His methods and techniques are well known in  trading field and many trader use his tools successfully , sometime after tweaking it a bit here and there. He says that the trading is about three M's . Mind , Method and Money. We will discuss strictly about method today.

There are mainly four technical indicators he uses for his trading decision : 

1) Two exponential moving averages , 13 and 26 periods.
2) MACD lines with MACD histogram , Standard settings i.e 12,26  and signal 9.(Just google it if you are confused).
3)Auto envelope.
4)Force Index.

Moving averages and MACD histogram is two awesome indicators to set a filter in your decision making process. Dr. Elder calls this an "Impulse System". The rules are simple and straightforward. 

• If the slope of the 13 period EMA and MACD Histogram both are pointing up then you are not allowed to short sell a stock. The signal is Green. These two indicators are showing that the impulse of the stock is up and it may go higher.
• If the slope of both 13 EMA and MACD Histogram are pointing Down then you are not allowed to go long. The Signal is Red. The  Stock is most likely fall from here so don't buy.
• If one is going opposite direction of the other , that is , when EMA is going up and MACD Histogram is going down then or vice versa then the impulse is neutral and the signal is blue. It means you may take a trade on both sides long or short.

  Look at the chart below:

         

I have painted the bars according to the above rule. On the chart , 13 Period EMA is shown by Dark Brown colour. On the lower pane it is MACD Histogram. See when both the indicators are pointing up , the bars are painted green , and when  both pointing down bars are red. Blue bars are denoting that one indicator is going opposite of the other.  

  
Always go to the higher timeframe and apply this impulse system to decide what to do. Suppose you trade on a daily chart , then go to a weekly chart and see what impulse system is telling you. If its green on weekly chart then don't short if its red don't go long.
Similarly if you trade on a 5 min chart , go to a 25 min chart and apply this system. 

Force index is an indicator which was discovered by Dr. Elder himself. It is very easy to calculate. Force index shows the pressure of volume in  buying and selling for a given period.

                   Raw Force index = (today's close -yesterday's close)*volume
                   Force Index = 2 period Ema of Raw force index.

On the lowest pane , its force index with dark brown colour. A reading above 0 is a bullish sign. Also a divergence with price is an early warning that the underlying trend is getting weak and its a good time to enter for a counter trend trade. Market condition is also vital to keep an eye on.


Auto envelope is a band around price that shows short term probable highs and lows. It is not a standard deviation band so less volatile than one. Auto envelope is good for gauging when to take profit. If price trades near or above upper band its a good time to take profit. Also it is better to avoid buying near or above  upper band and sell near or below lower band as these areas often are short term highs and lows. Take a look at the picture.

Auto envelope

  

  








The black band is auto envelope. See how this band holds 90% of the price action inside it and when price reaches up or down extreme it sometime is a short term high or low.

A promising trade can be spotted with a MACD divergence and preferably a Force index divergence with the price.

So, suppose we trade on a daily chart. If the Impulse of weekly chart is blue or green , and on the daily chart also the impulse is blue or green and there is a MACD divergence with preferably a force index divergence with price and the price is not near its upper band of auto envelope, then it is a good long candidate. Vice versa for a short candidate. After a few days practice you will be able to spot good opportunities. Just don't trade large in the beginning. Trust me you will make a few mistakes, and if you trade large these mistakes will be very expensive. 
   
Dr. Elder has created some other useful indicators like Market thermometer, safezone stops , bull power bear power ..etc. We are grateful to Dr. Elder for these indicators.

Metastock Code for Auto Envelope:

pds:=Input("EMA periods",1,252,21);
pdsBak:=Input("lookback periods",1,252,42);
x:=Input("use: Open=1, High=2, Low=3, Close=4, WClose=5",1,5,4);
plot:=Input("[1]AutoEnvelope, [2]Long signals, [3]All signals",1,3,1);
delay:=Input("Entry/Exit signals delay",0,5,0);


x:=If(x=1,O,If(x=2,H,If(x=3,L,If(x=5,WC(),C))));


Avg:=Mov(x,pds,E);
hiAvg:=HHV(H,pdsBak);
loAvg:=LLV(L,pdsBak);
shift:=
 Mov(If(hiAvg>Avg,hiAvg-Avg,Avg-loAvg),pds,E);
UpperBand:=Avg+shift;
LowerBand:=Avg-shift;


In:=Cross(x,LowerBand);
Out:=Cross(x,UpperBand);
Init:=Cum(In+Out>-1)=1;
InInit:=Cum(In)=1;
flag:=BarsSince(Init OR In)
 <BarsSince(Init OR Out)+InInit;
signals:=Ref((InInit AND Alert(InInit=0,2)
  OR flag AND Alert(flag=0,2))
   -(flag=0 AND Alert(flag,2)),-delay);


If(plot=1,UpperBand,If(plot=2,signals,In-Out));
If(plot=1,Avg,If(plot=2,0,0));
If(plot=1,LowerBand,If(plot=2,signals,In-Out))