"Water shapes its course according to the nature of the ground over which it flows; the soldier works out his victory in relation to the foe whom he is facing. Therefore, just as water retains no constant shape, so in warfare there are no constant conditions."
Sun Tzu

Sunday, September 4, 2011

How Dr. Alexander Elder Inspired my Trading

My current summer read is "The New Sell and Sell Short" from Dr. Alexander Elder. I have read his earlier books, but this one is a great refresher and expands on the shorting topic. In this post, however, I do not want to discuss the book but rather highlight, which elements of Dr. Elder's philosophy I have adopted to my trading.

Overall I have to admit that probably 80% of my trading style is based on Elder's strategy. I tweaked his approach here and there to fit my view of the markets. In a nutshell, the Elder approach is a swing trading strategy that buys stocks at value when they are close to a moving average and sells when prices are extended, which means that the stock is trading at a distance to the average. Of course, there are a lot of nuts and bolts to it, and I encourage aspiring swing traders to study Elder's work. When I read his books, the approach immediately made a lot of sense to me: buying at value and selling when everybody wants to own a stock seemed to be so logical. Also, the strategy is in essence a mean-reversion approach. Mean-reversion is a market anomaly, which has been observed by academic research.

Here are some of the Elder tools I'm using:

  • Trading on multiple time frames: making strategic decisions on the weekly chart, tactical decisions on the daily.
  • EMA channels on the daily chart to define value and over/underpriced zones.
  • MACD indicator to evaluate when a trend is weakening
  • Elder's Force Index to indicate when bulls/bears are loosing power
  • New High/Lows to evaluate market breadth
  • Money management rule: Elder recommends 2% of capital per position. I'm using 1%, though with a different technique to calculate stop prices.
Some tools I'm using in addition to Elder:
  • Relative strength against an underlying index. I want to own stocks that act stronger than the overall market. Relative strength can also show early warning signs when divergences occur.
  • Equity put/call ratio for a look into overall sentiment.
  • A different scanning process. Elder is starting with industry groups and then boils down to individual stocks. I run technical trend scans and look at the chart of every S&P 500 stock twice a month to find stocks which match the patterns in my playbook (believe it or not, there are just five patterns in my playbook. Ten, if you add the short side. Out of the five patterns, there are two major ones that I actively trade, the other ones are either "niche" patterns or still in the "development phase".
  • Scaling out of positions: it seems like I'm using scaling much more actively than he does. However, I'm still fine tuning this technique. 
  • Modified risk and stop price calculation: since I'm trying to trade in the second half of the day and I'm not using hard stops, I need to incorporate the volatility into my risk calculation.
If you are looking at my standard daily charts, you can obviously find many Elder elements. Again, the major difference is probably the additional relative strength:

Note that I'm not using the Elder Impulse System, which is a different way of coloring the bars. Reason is that I want to limit myself in the number of indicators on the chart ("keep your chart clean") and I'm already at the maximum number of items that I feel comfortable with.

Overall, the Elder approach has greatly benefited my trading. Even though the strategy is relatively simple, it took me years to really learn it and to eliminate basic mistakes. Maybe that's the time it takes because there are many behaviors that need to sink in and become automatic in order to get constantly profitable. Even though I'm OK with my trading results, there is still room for improvement and there are several areas I'm currently working on.