TD Camouflage

TD CAMOUFLAGE

Many beginning traders believe that a group of trading syndicates control the price activity of stocks. In fact, when we first entered this business there were many claims by market commentators that an elite group of traders, known as market specialists, were able to manipulate stock prices and that it was best to trade defensively in order to avoid their maneuverings. Although we were skeptical of this widespread notion, we could understand the reason most traders carried this concern; after all, since these specialists operated the posts on the floor of the exchanges, all trades had to pass through their hands to be executed. By definition, the specialists provided liquidity to the markets during rallies, they provided supply and during declines, they provided demand. In other words, they operated against the trend. At that time, we were working with a large financial institution, where we would initiate large market positions. The greatest difficulty we encountered was in entering and exiting these sizable positions we had to sacrifice far too much to be a trend follower. Since it was impossible for us to buy after lows were recorded, just as it was impossible to sell after the completion of market tops, we attempted to mimic the specialists’ trading style in order to gain an edge over the trading public. Our trading attitude and outlook needed to change, and we became preoccupied with anticipating market trends.

In our formative market research years, the aura and mystique attached to the specialists were dominant in our trading background. Because of their trading style—buying weakness and selling strength—we always knew they were trading forces to reckon with. All limit orders to buy and sell were recorded in their trading books and it was their job to execute these trades as the market moved to these levels. Since we were a large financial institution who generated a significant amount of money in commissions, any time we arrived in New York our brokers would take us down on the floor so we could meet the various specialists and observe their trading. It was fascinating to see these individuals trade, and many of them were willing to share their specific trading styles. Surprisingly, it appeared that they were genuinely as concerned about large traders, such as ourselves, as we were of them. Friendships developed over time and we attempted to glean as much trading information as possible. However, not until we met one specialist in particular did we become aware of this group’s true trading style.

A number of years ago, we attended a trading seminar hoping to learn new approaches to trading the markets. Upon introducing ourselves to another attendee sitting at our table, we were surprised to learn that he was a specialist. We were confused—why would a specialist be at a seminar when he controlled the trading activities in various stocks? Supposedly, this secret club in which he was involved was composed of the wealthiest and most devious denizens of the marketplace. What we learned was a true revelation. This individual was in search of answers as well. Admittedly, all market orders in various stocks passed through his hands, so he had an advantage in that he was aware of what the trading public was doing. The specialists were successful when trading short term, but established trends, particularly the unrelenting stock market decline in 1974, eventually took their toll upon these traders’ accounts. He wanted to diversify his trading style to protect and insulate his company from risk. We shared trading techniques and it quickly became apparent that his role was strictly mechanical—all he was looking to do was to chip away one-eighth of a point of profit and earn a fixed fee for each transaction. He went into trading each day with no preconceived notions of the market—a clean trading slate, if you will—and then continuously operated against the trend of the day, content to make his money on a series of small, profitable trades. This was not what we envisioned a specialist doing. Trading propaganda had memorialized this group as the ultimate insiders. It turned out the only advantage they possessed was that they were responsible for establishing the opening price level by matching orders from buyers and sellers as they passed through their portals at the pit post on the floor of the exchange. By the time we became aware of this trading edge they had, we had already experimented with and concluded the importance of the market’s open price level as a key trading reference.

We mentioned earlier the unintended hoax perpetrated upon the financial community by the financial media. Specifically, every time a price change is reported by a quote machine, a business news announcement, or similar events, the movement is expressed in terms of the previous day’s closing price level versus the current price today. Early on in our careers, we learned quickly that yesterday’s close was history and a more realistic measurement of price change was defined by price movement from the current price bar’s open to the current price level. By relating the price change from the current price bar’s open to close, rather than relying upon the price change from yesterday’s close to today’s close, the distortions caused by overnight news developments are avoided. When I shared this trading theory with the specialist, he agreed with our trading approach, particularly when applied to day trading, and he confirmed that we had uncovered one of the secrets of trading successfully. Despite the fact that this discovery was made close to 30 years ago, its basis permeates most of our trading techniques. In fact, one indicator that we have created relies upon the relationship of closing price and opening price, as well as the conventional relationship of closing price to closing price relied upon by most traders. This combination of price comparisons resolves itself more often than not in favor of the opening price to closing price relationship. Because its existence is not obvious, we describe it as TD Camouflage.

TD Camouflage requires that, at a suspected market low, the current price bar’s low must be less than the previous price bar’s low and the current price bar’s close must be less than the previous price bar’s close, but at the same time the current price bar’s close must be greater than the current price bar’s open. Conversely, at a suspected market high, the current price bar’s high must be greater than the previous price bar’s high and the current price bar’s close must be greater than the previous price bar’s close, but at the same time the current price bar’s close must be less than the current price bar’s open. In each instance, the critical price relationship and comparison exists between the current bar’s open and close, whereas most traders concentrate upon the less important and relevant relationship between consecutive closes.

Now, if trading were this simple, the road to riches would be quick and worry-free. However, not all market reversals are accompanied by this important price pattern. Furthermore, there are times when TD Camouflage simply will not work. We have developed a couple of qualifiers to improve our chances for success. We invite you to experiment with and develop enhancements of your own to improve your trading performance with this indicator. Still, with any additional condition it does not preclude the possibility of a bad trade.

How do traders best apply TD Camouflage to day trade options? First of all, traders could execute their positions at the opening of the succeeding price bar following the formation of this price pattern. Should they be more inclined, traders could enter at the close the day the pattern is formed but then the trade would have to be held overnight. Since price has a tendency to gap at the opening the day after the pattern, it may be prudent to secure two trading positions—one at the conclusion of the pattern and the other at the next price bar’s opening price level. By awaiting the next price bar’s open, it helps avoid those trades in which the succeeding opening reverses the implications of that price pattern by opening below or above a low-risk buy (call purchase) or sell (put purchase) entry level, respectively. For example, if a possible low occurs and the next price bar’s open is below the low of the pattern day or, conversely, the opening price following a suspected high is above the high of the pattern day, then the trades should be canceled. This price pattern is also important when day trading on time intervals smaller than daily price charts, such as 30-minute charts and hourly charts.

Figure 9.8 of the CBOE Volatility Index (VIX) identifies two TD Camouflage patterns—the first a low-risk buy and the second a low-risk sell. The low-risk buy indication in the underlying index would correspond with a low-risk call-buying opportunity, and the low-risk sell indication in the underlying index would correspond with a low-risk put-buying opportunity. Note the low-risk buy day recorded a close greater than the open, a close less than the previous trading day’s close, and a low less than the prior trading day’s low. Conversely, the low-risk sell day recorded a close less than the open, a close greater than the previous day’s close, and a high greater than the previous trading day’s high.

Figure 9.9 of the S&P 500 March 1999 displays numerous TD Camouflage low- risk indications. In order to present all of these indications over this time period and also make them visible, we identified them with Xs on the chart. In each instance where a low-risk buy in the underlying S&P index occurred, thereby translating into a low-risk call-purchasing opportunity, the low-risk buy day’s low is less than the prior trading day’s low, its close is less than the prior trading day’s close, and its close

Figure 9.8. TD Camouflage is an important precursor to market reversals. This chart demonstrate the importance of the price relationship between open and close rather than close versus close.

Figure 9.9. An entire series of TD Camouflage opportunities appear on this chart of the March 1999 S&P. The ideal low-risk entries occur at the openings of the following price bars provided they confirm the directional change.

is above the open. At the same time, in each instance where a low-risk sell in the underlying S&P index occurred, thereby translating into a low-risk put-purchasing opportunity, the low-risk sell day’s high is greater than the prior trading day’s high, its close is greater than the prior trading day’s close, and its close is below the open.

Figure 9.10 illustrates various occurrences of TD Camouflage. See how deceptive one’s eyes can be by focusing only upon the relationship between consecutive closing prices and ignoring, at the same time, the relationship of the close to that same trading day’s open. It isn’t enough to have an up close versus the previous trading day’s close—it must be accompanied by a close above the open—likewise, it isn’t sufficient to record a down close versus the previous trading day’s close—it must be accompanied by a close above the open. The Xs on the chart reflect those instances in which both requirements were fulfilled.