Featured Article

Chop and Slop

Brandon Wendell
Instructor, CMT

A student recently emailed me to ask if I knew of an indicator or tool that could identify high quality trading environments versus choppy, unpredictable ones. Such an indicator would be valuable since many traders tend to overtrade when the markets become volatile and choppy. What do I mean by choppy? Well, it would be a trendless environment where sharp, fast movements in both directions are present. It is where it seems difficult, if not impossible, to identify the potential direction of price movement, and it is what we have been experiencing in the markets a lot recently.

Unfortunately, I do not know of a chop and slop indicator. However, when we are looking to trade, we want to focus on proper entries at supply and demand zones and trade in the direction of the dominant trend. Perhaps a trend indicator such as a moving average could be of use to identify when trading should be okay and when we would be best to stay out of the markets.

A moving average is a summary of the previous closing prices and an indication of the prevailing trend. When that average is sloping upward, then the average closes were higher and the trend is presumed to be up. When the average is pointed downward, then the trend is bearish and shorting positions should be looked at. If the average is moving sideways, then the security is trendless and should be avoided for trading purposes.

bwendell 20120110 - stockschart20120110aFigure 1

To make a chop and slop indicator, you need to set a rule based on past performance of price versus a moving average. Watch how price performed during previous bullish, bearish, and trendless periods. You could set a rule that if price closes above the moving average for X periods, then you are in a bullish trend and should focus on buying. If the price is closing below the average, then you are likely to profit by shorting. A choppy environment would be indicated by a number of crossings of price over the moving average within a certain time frame. You would have to experiment on your own to determine the minimum number of crossings.

bwendell 20120110 - stockschart20120110bFigure 2

The drawback to using the moving average on the time frame in which you are trading is that it is a lagging indicator. You would not see a bullish trend signaled by the indicator until after you left the demand zone and the optimal entry point for your trade. Similarly, a bearish trend would also be noted by the moving average well after leaving the best entry for a short at the supply zone.

So, how can we use these moving averages in our trading if they are lagging? We can apply them to the larger time frame that will influence the one we are trading on. In previous articles, “Proper Perspective” and “Proper Perspective Part 2,” I discussed the need to view larger time frames so that we can ensure that we are trading in the direction that has the highest probability for success.

There is no perfect moving average to use for all securities. There are some more popular ones that can be used, or you can experiment with different ones to see which ones work best for your trading. If I am looking to trade intraday on a five minute chart, then I can apply a moving average to the 30 minute chart to see what the dominant trend is. If price is rising above an upward sloping moving average, then the trend is bullish and looking for long positions on pullbacks to demand in the five minute chart would be best.

bwendell 20120110 - stockschart20120110cFigure 3

If the 30 minute is down based on falling prices and a declining moving average, then shorting rallies to supply in the five minute time frame has better chances for success. But if price on the 30 minute chart is slashing back and forth through the moving average, then there is not a dominant trend for the smaller time frames to follow and you are likely to see chop and slop.

We still enter at supply and demand for our trading and should not deviate from that. But trading with the dominant trend is something that should protect our capital by filtering out unnecessary trades that cost money and commissions. We want to trade safely at all times and give ourselves the best chance for success.

– Brandon Wendell bwendell@tradingacademy.com

This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.