identifying divergence in technical analysis - Forex and Stock Traders

This is an article Todd prepared a few months ago on identifying divergence in technical analysis. I'm glad to share it here and hope that it is helpful.

____________________________________

When looking for divergence between price and an indicator (e.g.,

MACD, Stochastic, CCI, RSI) what we are looking for first is for the price to match or exceed the previous pivot high or low. (Any time MACD is mentioned, other oscillators can be substituted.)

Rule #1: If we have not established through price action either a new price extreme (e.g., a peak that is higher than the previous high or a valley that is lower than the previous low) or a double top or bottom (matching the previous price but not exceeding it) then there is no divergence, period, end of story. Price MUST meet this requirement before indicators can even be examined for the possibility of divergence.

It is the easiest if we examine just successive pivot highs or lows and only two extremes at a time. The pair must include the peak or valley representing the current price action. In other words, when price sets a new high, proceeds to do its normal pullback from that high, and then moves again to meet or surpass the earlier high, this is the time to look for divergence. In downward motion, the price must set a new low, pull up from that low, and then move down to the earlier level or lower. Only in these conditions is the first prerequisite met. Failure to meet or exceed the previous extreme invalidates searching for divergence.

Rule #2: When price has fulfilled #1, then draw the line from the recent price extreme backward to the price level that had previously set the high or low -- the one that current price action had to match or blow through to qualify for Rule #1. This only works on successive major peaks/valleys -- any little bumps or hills that price action went through between setting the extreme points are irrelevant to the purpose of this discussion.

Rule #3: Unless price action actually creates successive peaks/valleys instead of simply consolidating along a ceiling or a floor, looking for divergence is ineffective.

At such times, any curves seen in MACD or similar indicators are simply an indication that momentum has slowed down. They are not an illustration of reliable divergence.

Until a new peak/valley is formed, price can only do one of two things: consolidate in a range or reverse and pull back away from that resistance/support, perhaps to try again later to establish a new extreme. Only in the second scenario does the search for divergence provide any credible indication of imminent reversal.

Rule #4: When qualified peaks are established, then we are connecting the TOPS of those two price peaks. If valleys are set, then we connect the BOTTOMS of those valleys. It's an easy mistake to make to be drawing the "price-slope" line on the wrong side of the price action.

If we have established that price action has fulfilled these first requirements, then we can look at MACD and compare it to price.

Rule #5: Whether one's MACD contains one or two lines, we are examining the extreme points of the CURVES of the MACD's movement, not, in the case of MACD indicators with 2 lines, the relationship of one line to the other. This is another very common mistake.

Rule #6: On whichever side of the price action the line was drawn (on the top, from high to high, or underneath, from low to low), that is the side on which the lines must be drawn on the indicator. In other words, we are comparing the tops of the hills or the bottoms of the valleys on BOTH the price action AND the indicator.

Rule #7: The highs or lows that we use in the indicator are those that line up vertically with the price highs or lows.

Rule #8: Divergence is present only when the direction of the indicator-slope line differs from that of the price-slope line.

The three choices for direction are: ascending, descending, or flat. If the directions match instead of differ, the indicator is said simply to be "confirming price action."

Rule #9: If divergence is seen, but price has already reversed its direction for a while and then continued on its trend, that divergence should be considered to have been satisfied and one should wait for another successive high/low before again looking for divergence.

Rule #10: Divergence on longer timeframes is more powerful, but on shorter timeframes it is more immediate.

Looking for divergence is the most effective on charts of 15-minutes or greater. With the quick gyrations of the forex market, divergence indications on shorter timeframes is too-often satisfied too quickly and results in whipsaw action..

Pips ahoy!

Stick4Hire

Todd Fiegel

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New Exit Forex Trading Strategy - The ATR Ratchet By Chuck LeBeau

A New Exit Strategy - The ATR Ratchet By Chuck LeBeau

Recently I've been doing quite a bit of research on new systems for
stock trading. The research is on behalf of a new hedge fund that will
be starting later this year. The fund will be managed by Tan LeBeau LLC,
the company that funded this research project. After some serious
internal discussion about the advantages of keeping this new exit
strategy a company secret, the LLC has graciously given me permission to
share this discovery with our System Traders Club members. Here is a bit
of background on how the new exit strategy came about.

In the process of testing various exit strategies for our stock trading
systems we found that we needed a profit-taking exit that performed
somewhat along the lines of the Parabolic SAR but that could be made
more flexible and easier to code and apply. We found that the Parabolic
was hard to use because it was often on the opposite side of the market
from our trades or it was starting from a point that was too low for
what we wanted. After spending a great deal of time with the Parabolic
we decided it was not helpful for the particular systems we were
creating. As an alternative to the Parabolic exit we decided to test
some new exit ideas based on my extensive work and experience with the
Average True Range. After a great deal of tinkering and experimentation
we were pleased to learn that the new exit strategy worked surprisingly
well for profit taking and had many very useful features and
applications. I decided to name this new exit strategy the "ATR Ratchet".

The basic idea is quite simple. We first pick a logical starting point
and then add daily units of ATR to the starting point to produce a
trailing stop that moves consistently higher while also adapting to
changes in volatility. The advantage of this strategy over the original
Parabolic based exit is that when using the ATR Ratchet we have much
more control of the starting point and the acceleration. We also found
that the ATR based exit has a fast and appropriate reaction to changes
in volatility that will enable us to lock in more profit than most
conventional trailing exits.

Here is an example of the strategy: After the trade has reached a profit
target of at least one ATR or more, we pick a recent low point (such as
the lowest low of the last ten days). Then we add some small daily unit
of ATR (0.05 ATR for example) to that low point for each day in the
trade. If we have been in the trade for 15 days we would multiply 0.05
ATRs by 15 days and add the resulting 0.75 ATRs to the starting point.
After 20 days in the trade we would now be adding 1.0 ATRs (.05 times
20) to the lowest low of the last ten days. The ATR Ratchet is very
simple in its logic but you will quickly discover that there are lots of
moving parts that perform a lot of interesting and useful functions;
much more than we expected.

We particularly like this strategy because, unlike the Parabolic, the
ATR Ratchet can easily be implemented any time we want during the trade.
We can start implementing the stop the very first day of the trade or we
can wait until some specific event prompts us to implement a
profit-taking exit. I would suggest waiting to use the exit until some
minimum level of profitability has been reached because, as you will
see, this stop has a way of moving up very rapidly under favorable
market conditions.

The ATR Ratchet begins very quietly and moves up steadily each day
because we are adding one small unit of ATR for each bar in the trade.
However the starting point from which the stop is being calculated (the
10 day low in our example) also moves up on a regular basis as long as
the market is headed in the right direction. So now we have a constantly
increasing number of units of ATR being added to a constantly rising ten
day low. Each time the 10-day low increases our ATR Ratchet moves higher
so we typically have a small but steady increase in the daily stop
followed by much larger jumps as the 10 day low moves higher. It is
important to emphasize that we are constantly adding our daily
acceleration to an upward moving starting point that produces a unique
dual acceleration feature for this exit. We have a rising stop that is
being accelerated by both time and price. In addition, the ATR Ratchet
will often add substantial additional acceleration in response to
increases in volatility during the trade.

The acceleration due to range expansions is an important feature of the
ATR Ratchet. Because markets often tend to show wider ranges as the
trend accelerates the ATR will tend to expand very rapidly during our
best profit runs. In a fast moving market you will typically find many
gaps and large range bars. Because we are adding multiple units of ATR
to our starting point, any increase in the size of the underlying ATR
causes the stop to suddenly make a very large jump that brings it closer
to the high point of the trade. If we have been in the trade for forty
days any increase in the ATR will have a forty-fold impact on the
cumulative daily acceleration. That is exactly what we want it to do. We
found that when a market was making a good profit run the ATR Ratchet
moved up surprisingly fast and did an excellent job of locking in open
profits.

Keep in mind that this exit strategy is a new one (even to us) so our
experience and observations about it are still very limited. However I
am going to discuss a few observations about the variables that might
help you to understand and apply this exit successfully.

Starting Price: One of the nice features about the ATR Ratchet is that
we can start it any place we want. For example we can start it at some
significant low point just as the Parabolic does. Or we can start it at
a swing low, a support level, and a channel low or at our entry point
minus some ATR unit. If we wait until the trade is fairly profitable we
could start it at the entry point or even somewhere above our entry
point. The possible starting points are unlimited; use your imagination
and your logic to find a starting point that makes sense for your time
frame and for what you want your system to accomplish. Our idea of
starting the Ratchet from the x day low makes it move up faster than a
fixed starting point (as in the Parabolic) because the starting point
rises repeatedly in a strong market. If you prefer, you could just as
easily start the Ratchet at something like 2 ATRs below the entry price
and then the starting point would remain fixed. In this case the Ratchet
would move up only as the result of accumulating additional time in the
trade and as the result of possible expansions of the ATR itself.

When to Start: We can very easily initiate the exit strategy based on
time rather than price or combine the two ideas. For example, we can
start the exit only after the trade has been open for at least 10 days
and is profitable by more than one ATR. My general impression at this
point is that it is best to implement the ATR Ratchet only after a
fairly large profit objective has been reached. The ATR Ratchet looks
like a very good profit taking exit but I suspect it will kick you out
of a trade much too soon if you start it before the trade is profitable.

As I mentioned, one of the things I like best about the ATR Ratchet is
its flexibility and adaptability. Here is another idea on how to start
it. We can start it after fifteen bars but we don't necessarily have to
add fifteen ratchets. The logic for the coding would be to start the
Ratchet after 15 bars in the trade but multiply the ATR units by the
number of bars in the trade minus ten or divide the number of days in
the trade by some constant before multiplying the ATR units. This
procedure will reduce the number of ratchets, particularly at the
beginning of the trade when the exit is first implemented. Play around
with the ATR Ratchet and see what creative ideas you can come up with.

Daily Ratchet Amount: After testing it the daily Ratchet amount we chose
when we were first doing our research turned out to be much too large
for our intended application. The large Ratchet amount (percentage of
ATR) moved the stop up too fast for the time frame we wanted to trade.
After some trial and error we found that a Ratchet amount in the
neighborhood of 0.05 or 0.10 (5% or 10% of one 20-day average true
range) multiplied by the number of bars the trade has been open will
move the stop up much faster than you might expect.

As a variation on this strategy the very small initial Ratchet can
always be increased later in the trade once the profits are very high.
We could start with a small Ratchet and then after a large amount of
profit we could use a larger daily Ratchet increment. There are all
sorts of interesting possibilities.

ATR Length: As we have learned in our previous uses of ATR, the length
that we use to average the ranges can be very important. If we want the
ATR to be highly responsive to short term variations in the size of the
range we should use a short length for the average (4 or 5 bars). If we
want a smoother ATR with less reaction to one or two days of unusual
volatility we should use a longer average (20 to 50 bars). For most of
my work with the ATR I use 20 days for the average unless I have a good
reason to make it more or less sensitive.

Summary: We have just scratched the surface on our understanding of the
possibilities and variations of the ATR Ratchet as a profit taking tool.
We particularly like the flexibility it offers and we suspect that each
trader will wind up using a slightly different variation. As you can
see, there are many important variables to tinker with. Be sure to code
the Ratchet so it gets plotted on a chart when your are first learning
and experimenting with it. The ATR Ratchet is full of pleasant surprises
and the plot on the chart will quickly teach you a great deal about its
unusual characteristics.

Be sure to let us know if you come up with any exciting ideas on how to
apply it.

Good luck and good trading.

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Forex Tradinf System

*_"Screen One_*

/Apply trend-following indicators to the long-term chart and make a
strategic decision to trade long, short, or stand aside./ The original
version of Triple Screen used the slope of the weekly MACD-Histogram as
its weekly trend-following indicator. It was very sensitive and gave
many buy and sell signals. I now prefer to use the slope of a weekly
exponential moving average as my main trend-following indicator on
long-term charts. When the weekly EMA rises, it confirms a bull move and
tells us to go long or stand aside. When it falls, it identifies a bear
move and tells us to go short or stand aside. I use a 26-week EMA, which
represents half a year of trading. You can test several different
lengths to see which tracks your market best, as you would with any
indicator.

I continue to plot weekly MACD-Histogram. When both EMA and
MACD-Histogram are in gear, they confirm a dynamic trend and encourage
you to trade larger positions. Divergences between weekly MACD-Histogram
and prices are the strongest signals in technical analysis, which
override the message of the EMA."

Notes:

You can find some information about Divergences on a web site my friend
put together with help from Loren our resident Elder/Divergence Guru. As
Elder states: "Divergences between weekly MACD-Histogram and prices are
the strongest signals in technical analysis…" I don't know if there is a
way to program an EA to recognize a Divergence but if one could do it –
it would be a very powerful indicator!

One technique I recently witnessed by another successful trader was that
he used the MACD on 2 different time frames to verify a move – he was
trading off a 15 min chart – but used the 60 min MACD to verify the
move. If the 15 minute MACD showed a sell condition he would verify that
the 60 minute also had to show the sell signal as well. This might be
something to try on the TSD – if the MACD on the Weekly and the Daily
were in agreement it would signal a stronger signal.

*_"Screen Two_*

/Return to the intermediate chart and use oscillators to look for
trading opportunities in the direction of the long term trend. /When the
weekly trend is up, wait for daily oscillators to fall, giving buy
signal. Buying dips is safer than buying the crests of waves. If an
oscillator gives a sell signal while the weekly trend is up, you may use
it to take profits on long positions but not to sell short.

When the weekly trend is down, look for daily oscillators to rise,
giving sell signals. Shorting during upwaves is safer than selling new
lows. When daily oscillators give buy signals, you may use them to take
profits on shorts but not to buy. The choice of oscillators depends on
your trading style.

/For conservative traders/, choose a relatively slow oscillator, such as
daily MACD-Histogram or Stochastic, for the second screen. When the
weekly trend is up, look for daily MACD-Histogram to fall below zero and
tick up, or for Stochastic to fall to its lower reference line, they
give sell signals.

A conservative approach works best during early stages of major moves,
when markets gather speed slowly. As the trend accelerates, pullbacks
become more shallow. To hop aboard a fast-running trend, you need faster
oscillators.

/For active traders/ use the two-day EMA of Force Index (or longer, if
that's what your research suggests for your market). When the weekly
trend is up and daily Force Index rallies above zero, it flags a buying
opportunity.

Reverse these rules for shorting in bear markets. When the weekly trend
is down and the two-day EMA of Force Index rallies above zero, it flags
a buying opportunity.

Many other indicators can work with Triple Screen. The first screen can
also use Directional System or trendlines. The second screen can use
Momentum, Relative Strength Index, Elder-ray, and others.

The second screen is where we set profit targets and stops and make a
go-no go decision about every trade after weighing the level of risk
against the potential gain.

Set the stops. A stop is a safety net, which limits the damage from any
bad trade. You have to structure your trading in such a way that no
single bad loss, or a nasty series of losses, can damage your account.
Stops are essential for success, but many traders shun them. Beginners
complain about getting whipsawed, stopped out of trades that eventually
would have made them money. Some say that putting in a stop means asking
for trouble because no matter where you put it, it will be hit.

First of all, you need to place stops where they are not likely to be
hit, outside of the range of market noise (see SafeZone* on page 173).
Second, an occasional whipsaw is the price of long-term safety. No
matter how great your analytic skills, stops are always necessary.

You should move stops only one way – in the direction of the trade. When
a trade starts moving in your favor, move your stop to a break even
level. As the move persists, continue to move your stop, protecting some
of your paper profit. A professional trader never lets a profit turn
into a loss.

A stop may never expose more that 2% of your equity to the risk of loss
(see Chapter 7, "Money Management Formulas"). If Triple Screen flags a
trade but you realize that a logical stop would risk more than 2% of
your equity, skip that trade…."

*Elder gives a formula for his SafeZone system using an Excel spread
sheet. He recommends that you program this system into your software.

*_Screen Three_*

The third screen helps us pinpoint entry points. Live data can help
savvy traders but hurt beginners who may slip into day-trading.

/Use an intraday breakout or pullback to enter trades without real-time
data/. When the first two screens give you a buy signal (the weekly is
up, but the daily is down), place a buy order at the high of the
previous day or a tick higher. A tick is the smallest price fluctuation
permitted in any market. We expect the major uptrend to reassert itself
and catch a breakout in its direction. Place a buy order, good for one
day only. If prices break out above the previous days high, you will be
stopped in automatically. You do not have to watch prices intraday; just
give your order to a broker.

When the first two screens tell you to sell short (the weekly is down,
but the daily is up), place a sell order at the previous day's low or a
tick lower. We expect the downtrend to reassert itself and catch the
downside breakout. If prices break below the previous days low, they
will trigger your entry.

Daily ranges can be very wide, and placing an order to buy at the top
can be expensive. Another option is to buy below the market. If you are
trying to buy a pullback to the EMA, calculate where that EMA is likely
to be tomorrow and place your order at that level. Alternatively, use
the SafeZone indicator (see page 173) to find how far the market is
likely to dip below its previous day's low and places your order at that
level. Reverse these approaches for shorting in downtrends.

The advantage of buying upside breakouts is that you follow an impulse
move. The disadvantage is that you buy high and your stop is far away.
The advantage of bottom fishing is that you get your goods on sale and
your stop is closer. The disadvantage is the risk of getting caught in a
down side reversal. A "breakout entry" is more reliable, but profits are
smaller; a "bottom-fishing entry" is riskier, but the profits are greater….

…If you use weeklies and dailies to get in also use them to get out.
Once a live chart gives an entry signal, avoid the temptation to exit
using intraday data. Do not forget that you entered that trade on the
basis of weekly and daily charts, expecting to hold for several days. Do
not be distracted by the intraday chop if you are trading swings that
last several days…."

http://wwidetrader.blogspot.com

How to make money to Forex and Stock Market Investing. Personal Finance

Your money management stops belong in the market. They represent your
maximum allowable risk level, which you may not violate under any
circumstances. If your technical analysis stops are closer to the
market, you may hold them in your mind as you monitor prices and are
prepared to exit if those levels gets hit.

Here, I want to share with you two advanced methods for placing stops.
Try to program them into your software and test them on your market
data. Until now, I have never disclosed SafeZone to traders, except to
small groups in Trader's Camps, where I like to share my latest
research. It is my principle not to withhold information from my books.
I write as I trade and maintain my edge not by secrecy but by developing
new methods.

The SafeZone Stop

Once in a trade, where should you put your stop? This is one of the
hardest questions in technical analysis. After answering it, you'll face
an even harder one—when and where to move that stop with the passage of
time. Put a stop too close and it'll get whacked by some meaningless
intraday swing. Put it too far, and you'll have very skimpy protection.

The Parabolic System, described in "Trading for a Living", tried to
tackle this problem by moving stops closer to the market each day,
accelerating whenever a stock or a commodity reached a new extreme. The
trouble with Parabolic was that it kept moving even if the market stayed
flat and often got hit by meaningless noise.

The concept of signal and noise states that the trend is the signal and
the nontrending motion is the noise. A stock or a future may be in an
uptrend or a downtrend, but the noise of its random chop can obscure its
signal. Trading at the right edge is hard because the noise level is
high. I developed SafeZone to trail prices with stops tight enough to
protect capital but remote enough to keep clear of most random fluctuations.

Engineers design filters to suppress noise and allow the signal to come
through. If the trend is the signal, then the countertrend motion is the
noise. When the trend is up, we can define noise as that part of each
day's range that protrudes below the previous day's low. When the trend
is down, we can define noise as that part of each day's range that
protrudes above the previous day's high. SafeZone measures market noise
and places stops at a multiple of noise level away from the market.

We may use the slope of a 22-day EMA to define trend. You need to choose
the length of the lookback period for measuring noise level. It has to
be long enough to track recent behavior but short enough to be relevant
for current trading. A period of 10 to 20 days works well, or we can
make our lookback period 100 days or so if we want to average long-term
market behavior.

If the trend is up, mark all downside penetrations during the lookback
period, add their depths, and divide the sum by the number of
penetrations. This gives you the Average Downside Penetration for the
selected lookback period. It reflects the average level of noise in the
current uptrend. Placing your stop any closer would be self-defeation. E
want to place our stops farther away from the market than the average
level of noise. Multiply the Average Downside Penetration by
coefficient, starting with two, but experiment with higher numbers.
Subtract the result from yesterday's low, and place your stop there. If
today's low is lower than yesterday's, do not move your stop lower since
we are only allowed to raise stops on long positions, not lower them.

Reverse these rules in downtrends. When a 22-day EMA identifies a
downtrend, count all the upside penetrations during the lookback period
and find the Average Upside Penetration. Multiply it by a coefficient,
starting with two. When you go short, place a stop twice the Average
Upside Penetration above the previous day's high. Lower your stop
whenever the market makes a lower high, but never raise it.

I anticipate that SafeZone will be programmed into may software
packages, allowing the traders to control both the lookback period and
the multiplication factor. Until then, you will have to do your own
programming or else track SafeZone manually (See Table 6.1). Be sure to
calculate it separately for uptrends and downtrends.

Here are the rules for calculating the SafeZone using an Excel
spreadsheet. Once you understand how it works, try to program SafeZone
into your technical analysis software and superimpose its signals on the
chart. Compare the numbers from the spreadsheet and the trading
software. They should be identical; otherwise, you have a programming
error. Comparing results from the two software packages helps overcome
pesky programming problems.

Rules for Longs in Uptrends When the trend is up, we calculate SafeZone
on the basis of the lows because their pattern determines stop placement.

1. Obtain at least a month of data for your stock or future in
high-low-close format, as shown in Table 6.1 (lows are in column C
with the first record in row 3).
2. Test whether today's low is lower than yesterday's. Go to cell E4,
enter the formula =IF(C3>C4,C3-C4,0) and copy it down the length
of that column. It measures the depth of the downside penetration
below the previous day's range, and if there is none, it shows zero.
3. Choose the lookback period and summarize all downside penetrations
during the time. Begin with 10 days and later experiment with
other values. Go to cell F13, enter the formula =SUM(E4:E13), and
copy it down the length of that column. It will summarize the
extent of all downside penetrations for the past 10 days.
4. Mark each bar that penetrates below the previous bar. Go to cell
G4, enter the formula =IF(C4<C3,1,0) and copy it down the length
of that column. It will mark each downside penetration with 1 and
no penetration with 0.
5. Count the number of downside penetrations during the lookback
period, in this case 10 days. Go to cell H13, enter the formula
=SUM(G4:G13), and copy it down the length of that column. It will
show how many times in the past 10 days the lows have been violated.
6. Find the Average Downside Penetration by dividing the sum of all
downside penetrations during the lookback period by their number.
Go to cell I13, enter the formula =F13/H13, and copy it down the
length of that column. It will show the Average Downside
Penetration for each day, that is, the normal level of downside
noise in that market.
7. Place your stop for today at a multiple of yesterday's Average
Downside Penetration below yesterday's low. Multiply yesterday's
Average Downside Penetration by a selected coefficient, starting
at 2 but testing as high as 3, and subtract the result from
yesterday's low to obtain today's stop. Go to cell J14, enter the
formula =C13-2*I13, and copy it down the length of that column. It
will place a stop two Average Downside Penetrations below the
latest low. If today's low penetrates yesterday's low by twice the
normal range of noise, we bail out.
8. Refine the formula to prevent it from lowering stops in uptrends.
If the above formula tells us to lower our stops, we simply leave
it at the previous day's level. Go to cell K16, enter formula
=MAX(J14:J16), and copy it down the length of that column. It will
prevent the stop from declining for three days, by which time
either the uptrend resumes or the stops is hit.

Rules for Shorts in Downtrends

When the trend is down, we calculate SafeZone on the basis of the highs
because their pattern determines stop placement.

1. Obtain at least a month of data for your stock or future in
high-low-close format, as shown in Table 6.1 (highs are in column
B with the first record in row 3).
2. Test whether today's high is higher than yesterday's. Go to cell
L4, enter the formula =IF(B3>B4,B3-B4,0) and copy it down the
length of that column. It measures the height of the upside
penetration above the previous day's range, and if there is none,
it shows zero.
3. Choose the lookback period and summarize all upside penetrations
during the time. Begin with 10 days and later experiment with
higher values. Go to cell M13, enter the formula =SUM(L4:L13), and
copy it down the length of that column. It will summarize the
extent of all upside penetrations for the past 10 days.
4. Mark each bar that penetrates above the previous bar. Go to cell
N4, enter the formula =IF(B4<B3,1,0) and copy it down the length
of that column. It will mark each upside penetration with 1 and no
penetration with 0.
5. Count the number of upside penetrations during the lookback
period, in this case 10 days. Go to cell O13, enter the formula
=SUM(N4:N13), and copy it down the length of that column. It will
show how many times in the past 10 days the highs have been violated.
6. Find the Average Upside Penetration by dividing the sum of all
upside penetrations during the lookback period by their number. Go
to cell P13, enter the formula =M13/O13, and copy it down the
length of that column. It will show the Average Upside Penetration
for each day, that is, the normal level of upside noise in that
market.
7. Place your stop for today at a multiple of yesterday's Average
Upside Penetration above yesterday's high. Multiply yesterday's
Average Upside Penetration by a selected coefficient, starting at
2 but testing as high as 3, and add the result from yesterday's
high to obtain today's stop. Go to cell Q14, enter the formula
=B13-2*P13, and copy it down the length of that column. It will
place a stop two Average Upside Penetrations above the latest
high. If today's high penetrates yesterday's high by twice the
normal range of noise, we bail out.
8. Refine the formula to prevent it from raising stops in downtrends.
If the above formula tells us to raise our stops, we simply leave
it at the previous day's level. Go to cell R16, enter formula
=MIN(Q14:Q16), and copy it down the length of that column. It will
prevent the stop from rising for three days, by which time either
the downtrend resumes or the stops is hit.

To use SafeZone with your favorite stock or future during an uptrend,
begin by multiplying the average downside penetration by the factor of
three, and subtracting that from the low of the latest bar. Putting your
stop closer than the average level of noise means asking for trouble,
and even twice the average level is often too close. Once your system
identifies an uptrend, SafeZone starts following prices, getting you out
before the trend reverses. You can see that SafeZone stop as hit at
points A, B, C, and D, catching the bulk of the uptrend and avoiding
downdrafts.

The right edge of the chart illustrates why it is a good idea never to
hold a stock below its SafeZone level. JEC is in a free fall, wiping out
the profits of a month in just two days—a trader using SafeZone cashed
out early in the decline.

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