New Concepts in Technical Trading Systems by J. Welles Wilder

Definitions

LOP is a low point. An LOP is a price bar's low which is less than the lows of both the prior and following price bars.

HIP is a high point. An HIP is a price bar's high which is greater than both the prior and following price bar highs.

SIP is a significant point. An SIP is either a HI SIP or LO SIP. A HI SIP is the highest price reached when in a long trade. A LO SIP is the lowest price made during a short trade.

SIC is a significant close. An SIC is the most favorable close made during a trade. When in a long trade, this would be a high SIC and for a short, a low SIC.

SAR is stop and reverse. An SAR occurs with any system which is always in the market. Every time a long trade exits, a short sale is immediately made. And when a short trade is closed out, a new long position is taken.

The two major types of trading systems are trend following and anti-trend. Their trade profiles are opposites. Trend trades produce large average profits, but low win rates. Anti-trend trade have low average profits, but high win rates.

Since neither system type works in both trending and non-trending markets, it's important to determine a market's trend. For this reason, Wilder created the Directional Movement Index, explained in Section IV. This indicator is designed to measure how strongly a market is trending.

But finding the trend of a market is only one part of the trading process. For a market to be profitable, it must have significant price moves, referred to as volatility. This subject is explored in Section III with the Volatility Index.

After finding the trend and volatility of a market, commissions and margin requirements need to be considered [This was written before today's low and no-cost commissions]. Section IX brings all these factors together with the Commodity Selection Index (CSI). The CSI shows you which commodities are likely to perform the best at the time they're rated.

Wilder calls this his favorite system for 2 to 3 week trades. The name describes the movement of the system's trailing stop. It traces a parabola as a function of time and price. This system works best in a trending market.

For most trailing stops, the only time they change, is when prices move in a trade's direction. If prices go sideways, a trailing stop maintains its position.

The Parabolic Time/Price System stop is unique. It keeps moving toward the current price, even when prices don't change. This trait of the Parabolic stop requires prices to continue to make a profit, or the trade is stopped out.

This is an SAR (stop and reverse) system. An SAR system is always in the market. The exit stop for one trade is also the entry for the reverse position. The initial price of the Parabolic stop is the SIP, the extreme price reached during the previous trade.

To find the SIP, start with a previous HI SIP in a general up trend or a LO SIP in a general down trend. From a HI SIP find the most significant down day within 4 days after the HI SIP or most significant up day following a LO SIP. Using this previous SIP along with the significant down or up day as an entry point, paper trade until stopped out. Then begin to trade the system for real.

The system stop formula after the first day is:
SAR₁ = SAR₀ + {AF x (EP₀ - SAR₀)}

SAR₁ = today's stop price.
SAR₀ = yesterday's stop.
AF = the acceleration factor.
EP₀ = the extreme trade price.

If yesterday was the first day of the trade, yesterday's SAR is only the SIP. The acceleration factor starts at 0.02 and increases by 0.02 each day a new extreme price is made. This is the highest price when in a long trade and the lowest price in a short trade. The acceleration factor continues to increase until it reaches 0.20, where it remains for the rest of the trade.

There's one exception to the SAR formula. If tomorrow's calculated price is within either of today's or yesterday's range, the SAR needs to be adjusted. In a long trade, put the SAR at the lower low of yesterday and today. When in a short trade, the adjusted SAR is the higher high of the two days.

You can vary the acceleration factor to avoid using the same stop price as other traders. It's suggested to keep it between 0.018 and 0.021. And the final value should be no greater than 0.22.

Before making a trade, it's important to know if there's enough price movement, called volatility, to make a profit. No volatility, no profit. But volatility is relative. Two markets may be volatile, but is one more volatile than the other? This was a question Welles Wilder wanted to answer.

An obvious indicator of volatility is a price bar's range. Normally, the daily range is the day's high price minus the low. But consider what happens when a commodity future gaps up or down its daily limit. The result is the high equal to the low, for a range of zero. Even price bars with smaller gaps, distort the comparison to price bars without gaps. To overcome this problem, Wilder created the concept of true range.

True Range is the largest of the following:

• Today's low price subtracted from today's high price.
• Yesterday's closing price subtracted from today's high price.
• Today's low price subtracted from yesterday's closing price.

The true range can be used to calculate the average market volatility over a given period. Wilder found a 14-day period gave the best performance when testing the Volatility Index.

Volatility Index
VI_Today = (13 x VI_Previous + Today's true range) / 14

The Volatility System takes the Volatility Index concept and applies it over 7 days instead of 14. It's a trend-following SAR (stop and reverse) system, so it's always in the market. Every exit from one trade becomes the entry for a new trade in the opposite direction.

The first step in the system is to calculate the 7 day Average True Range (ATR). Initially add up the true ranges for the previous 7 days and divide the total by 7. From that point on, the ATR is calculated by the following equation:

ATR_Today = (6 x ATR_Yesterday + Today's true range) / 7

The Volatility System uses the 7-day ATR multiplied by 3.0 to create a trailing stop. This stop is called the Average Range times Constant (ARC). Traders can choose to vary the multiplier constant from 2.8 to 3.1 and get similar results.

A trade is stopped out and reversed at 1 ARC value from the most favorable close during the trade, the SIC. For a long trade, the stop is 1 ARC subtracted from the SIC (highest close made during the trade). And when short, it's 1 ARC added to the SIC (lowest close during the trade).

Trend trading and anti-trend trading work best in opposite market conditions. Trend traders profit the most when prices move in one direction for an extended period. In contrast, when prices make short up and down swings, that's the best time for anti-trend traders.

The question these two market conditions pose, is how to define them. It's not an either/or situation. There are various degrees of trending between the extremes of straight line moves and volatile sideways markets. The concept of Directional Movement was designed to rate how strongly a market is, or is not, trending.

The concept measuring directional movement starts with Plus DM (+DM) and Minus DM (-DM). When a day's high exceeds the previous day's high, +DM is that positive price difference. Similarly, when a day's low is lower than the previous day's low, this is -DM. The value for -DM is the absolute difference of the lows, so both +DM and -DM are positive numbers.

Directional movement is considered either up (+DM), down (-DM), or zero. When both a day's high and low exceed the previous day's range, then the greater of the two price differences is the one used. If a day's high and low are both within the previous day's range, then both +DM and -DM are given a score of 0.

To make the price differences of directional movement meaningful, they are divided by the day's True Range (TR). This creates the Directional Indicator (DI) which is a measure of the percentage of the day's range which is either up, down, or zero.

+DI = +DM / TR
-DI = -DM / TR

True Range is the greatest of the following:

• Today's low price subtracted from today's high price.
• Yesterday's closing price subtracted from today's high price.
• Today's low price subtracted from yesterday's closing price.

The final form of the Directional Index is as a 14-day moving average. To create the first +DI and -DI values, add up the previous 14 days of +DM and -DM. Then divide each total by the sum of each day's True Range. After this first day, each new day's +DM, -DM, and TR is added to their previous total and one fourteenth of the previous total is subtracted.

The overall directional movement, what Wilder calls True Directional Movement, is the absolute difference between the +DI and -DI moving averages. An index (DX) of this value is made by dividing the difference of the two by their total. This gives a result with a possible range of 0 to 100.

A 14-day moving average of DX is used to smooth out its response and is referred to as the ADX. The ADX moving average is calculated in the same fashion as the other moving averages. 14 days of the DX are added and the total divided by 14. Afterwards, each new day's DX is added to 13 times the previous day's ADX and the total then divided by 14.

A final rating, the Average Directional Movement Index Rating (ADXR) is a smoothed version of the ADX. It's the average of today's ADX added to the ADX of 14 days prior.

The movement of the ADX shows the major trend's strength. The higher the rating, the stronger the trend. The difference between the peaks and valleys of the ADX indicate how large the trend reactions are. If the difference and duration between the ADX highs and lows are substantial, trend trading will be profitable in both directions.

The Directional Movement System is a trend following method which is always in the market. The signal to buy or sell is a crossing of the 14-day +DI and -DI. It's most profitable when the ADXR is above 25.

A buy is signaled when +DI₁₄ crosses above the -DI₁₄. The initial stop is the low of that day. During the trade, each time the +DI₁₄ drops below -DI₁₄, raise the stop to the low of this crossing day

Reverse and go short when stopped out. Similar to a long trade, the initial stop is the high price of the crossing day. The trailing stop is the high of each new day +DI₁₄ goes above -DI₁₄.

Welles Wilder defines momentum as either positive or negative price acceleration. When price closes either up or down more than the previous day's price change, he considers that to be momentum.

The Trend Balance System uses a change in momentum to signal a trade. The trades are short-term, lasting only a day or two.

This system gets its name from the point at which the two-day momentum factor changes direction. This balance point also shows what closing price to look for to enter a trade. Before a market closes for the day, the two previous momentum factors are known, as is the close from 2 days prior. With this information, it can be determined what the day's close would have to be to produce either a positive or negative momentum change.

The Relative Strength Index (RSI) is a momentum oscillator of recent price action. It can be used in a number of ways and is best analyzed when plotted on a price chart.

Calculating the Relative Strength Index (RSI)
The initial RSI divides the 14-day average of up closes by the 14-day average of down closes (RS) and adds 1 to this number. This sum is divided into 100 and the result subtracted from 100.

RSI = 100 - {100 / (14-day up close average / 14-day down close average)}

After the first day, the only change is how the up and down close averages are calculated. The previous day's average is multiplied by 13 and the day's up or down close, if either, is added to the appropriate total. Then each average is divided by 14 and this new up average is divided by the new down average as in the initial equation.

The Reaction Trend System is a dual system, with part trend-following and part anti-trend. It's a short-term system, with a trade every few days. The anti-trend component is designed to work in direction-less markets. If there's a sudden up or down move out of the previous trading range, then the trend-following part of the system takes over.

To use the system, first calculate four price points for the following day. These price points are combinations of each day's prices. The common factor is the day's average of the sum of high, low, and close (X = (high + low + close) / 3).

The calculations for tomorrow's price points:

B₁ (anti-trend buy price) = 2X - H
S₁ (anti-trend sell price) = 2X - L
HBOP (trend High Break Out Point) = 2X - 2L + H
LBOP (trend Low Break Out Point) = 2X - 2H + L

H = today's high price
L = today's low price

To trade the system, start in the anti-trend reaction mode. The reaction mode requires finding a significant high or low point in the previous 2 or 3 weeks. If it's a low, it's called a buy day ("B"). If the significant point is a high, then it's designated as a sell day ("S"). Each day following the significant point follows the sequence of "B", "O", "S", "B", "O", "S"… and so on.

If price goes through a breakout point, HBOP or LBOP, then the sequence needs to be adjusted. If it's a HBOP, it's a buy and the highest price reached during the trade is considered an "S" day. The usual sequence, "B", "O", "S"… is recorded for the following days. If the breakout is a LBOP, it's a short sale and the lowest day in the trade is labeled as "B" followed by the "O", "S", "B"… sequence.

The Swing Index is an attempt to define market swings numerically. Wilder came up with five of what he felt were the most important price differences from one day to the next. The result was the following equation:

Swing Index = 50 x [{(C₂ - C₁) + 0.5 x (C₂ - O₂) + 0.25 x (C₁ - O₁)} / R ] x K / L

C₁ = the first day's closing price.
O₁ = the first day's open price.
C₂ = the second day's closing price.
O₂ = the second day's open price.
H₂ = the second day's high price.
L₂ = the second day's low price.
K = the larger of the absolute values of H₂ - C₁ and L₂ - C₁.
L = the limit move of the commodity.

"R" is calculated in two steps. First, find the largest absolute value of H₂ - C₁, L₂ - C₁, and H₂ - L₂. If H₂ - C₁ is the largest value then R = (H₂ - C₁) - 0.5 x (L₂ - C₁) + 0.25 x (C₁ - O₁). If the largest value is L₂ - C₁, then R = (L₂ - C₁) - 0.5 x (H₂ - C₁) + 0.25 x (C₁ - O₁). If H₂ - L₂ is the largest value then R = (H₂ - L₂) + 0.25 x (C₁ - O₁).

The Accumulative Swing Index (ASI) is a running total of the Swing Index (SI). Like the SI, ASI can be either positive or negative. A positive ASI indicates a long-term up trend and if negative, a long-term down trend. Swings above and below zero show a non-directional market. Trend lines can be drawn across the ASI swing points and be used to confirm price chart trend lines.

The Swing Index System is a simple trend method using the ASI swing points. It buys and sells when previous high and low swing extremes are exceeded.

HSP (High Swing Point) = any day the ASI is higher than the previous day's ASI and the following day's ASI.
LSP (Low Swing Point) = any day the ASI is lower then the previous day's ASI and the following day's ASI.

The intent of the Commodity Selection Index (CSI) is to rate commodities based on their trading timeliness. It factors in directional movement, volatility, margin requirements and commissions.

CSI = ADXR x AR₁₄ x [(V / √M) x {1 / (150 + C)}] x 100

ADXR = the Average Directional Movement Rating (described in the Directional Movement chapter)
ATR₁₄ = the 14-day Average True Range (described in the Volatility Index chapter)
V = the value of a 1 cent move or the smallest dollar increment for ATR₁₄
M = the required margin dollar amount
C = the commission dollar cost

Welles Wilder says there are three elements to a proper trading plan. The plan should have a good system, the means to choose the right market at the right time, and sound money management. Most traders do fairly well on the first two requirements, but not as well with money management.

Wilder's money management method has two rules. Never use more than 15 percent of your account to margin one commodity. And never use more than 60 percent of your account for the total margin at one time.

He prefers to trade the 6 top CSI rated commodities and no more than 10 percent of his total capital on any single commodity.

It's well-known systems perform better in some types of markets than others. A major performance factor is the degree to which a market is trending. To resolve that issue, Wilder created the Directional Movement Index (DX) and the Average Directional Movement Index Rating (ADXR). He doesn't claim it's the best way to determine a trend, but it was the first to give a definitive answer.