2-PERIOD ROC

This chapter should really be titled "Pinball-Part 2!" Instead of using a one-period rate of
change, we are going to use a 2-period rate of change. We will then calculate a short term pivot
point to tell us when the 2-period rate of change is going to flip from a buy to a sell or vice versa.
This pivot then tells us whether we want to go home long or short by the close on a fresh signal
change. It is best used in conjunction with Taylor's swing trading methodology. Before we
continue, let's review the main principles of Taylor's trading technique. Taylor observed that the
market tended to make a swing high or swing low every two to three days. The market would
alternate between this buying pressure and selling pressure, which could then be captured by
entering a position on one day and taking it off the next. Thus, a market could be traded back
and forth systematically regardless of the overall trend or fundamental outlook. Taylor labelled
the days as a "buy" day "sell'' day, or "sell short" day, and gave each one specific rules for entry.
We are going to concentrate on the rules for a buy day and a sell short day. A buy day sets up
after the market has sold off for one to two days. (In a downtrend, the market might need one
more additional day to sell off.) The ideal buy day opens on its low and closes on its high. In the
morning, a buy day should find support at the previous day's low. Sometimes it will make a
slightly higher low or a lower low, but this test (i.e., the low made first on the buy day) is what
defines the support level. This then allows us to see our risk point where we can place a
protective stop and to enter a long position. After a buy day entry, we monitor the market to see
if it closes higher than its opening. If it does, we will carry the trade home overnight. The market
should not make new lows in the afternoon after we bought it. If it does, we will be stopped out
since our morning support stop will have been penetrated. If the trade is a winner, we will look to
exit the next day. The ideal spot to exit is above the high of our entry day. The trade is trying to
take advantage of the tendency for morning follow-through as demonstrated in the test profiles
we looked at for the 80-20's days. On a sell-short day, the market should make its highs first in
the morning. The previous day's high is the resistance level that the sell-short day then tests.
The sell-short day does not have to exceed the previous day's high; it may make a lower high. If
the market makes a morning test of the previous day's high and reverses, we will go short "at
the market and put a stop just above this test point. If the trade closes with a profit, we carry the
trade home overnight and look to exit the following day. If it starts to make new highs in the
afternoon, our stop will take us out. The market will then probably close higher and it would be
better to try, shorting the market the next day (hopefully at higher levels) than to carry a losing
trade home overnight. This is the essence of Taylor's trading method. The most important
concepts are looking for morning tests (just as in Turtle Soup), and trading off morning reversals
(just as the 8020's bars do). Concentrating on just one entry or exit each day is much easier
psychologically than day trading which has the stress of monitoring both the entry and the exit
on the same day. Carrying winning trades home overnight is a good habit you should form.
What is amazing are the additional profits which can be made playing for the next morning's
follow-through. The biggest obstacle people have in using Taylor's methodology is figuring out
which day should be a buying day and which one should be a shorting day. As we've said,
Taylor kept a rigid mechanical trading book, but he also had all sorts of quirky rules for shorting
on buying days and vice versa. We do not want to get that complicated. Voila le 2-period
rate-of-change! A short-term pivot point can be calculated which will tell us when the 2-period
rate of change is going to change direction. We want to be long by the close if the price is
trading above this pivot point and short by the close if the price is below this pivot point. We will
then look to exit the next day. This is how you calculate the short-term pivot point for the
2-period rate of change: 1. 2. 3. Subtract today's close from the close two days ago (not
yesterday but the day before). Thus, close (day one) - close (day three) equals the 2-period rate
of change. Add this number to yesterday's closing price (day two). This will be our short-term
pivot number. We want to go home long if we have been on a sell signal and the price then
closes above this pivot number. We will look to short if the 2-period rate of change flips from a
buy to a sell and the price is going to close below the short-term pivot number. This is what a
worksheet would look like:

Let's walk through the calculation. The difference between the close on 11-1 (588.25) and the
close two days ago on 10-30 (586.70) was 1.55. This number is added to the close on 10-31 to
come up with a short-term pivot of 585.40 which will be used to monitor the close on 11-2. Since
the signal was already long" coming into 11-2, we would only be looking to go short on a close
below the pivot. The next day, 11-2, the price closed at 592.35-higher than the pivot-so, we did
not go home short. On 11-3, the price closed at 592.50-below the previous day's pivot of 596.60
and a new short signal. Thus we would go home short, looking to exit the next day. Let's look at
some chart examples and observe how this indicator highlights the two to three day market
cycles.
The arrows on the chart show the days where the 2-period rate of change reversed direction. If
you had entered on the close of a fresh "flip" and exited on the close the following day, you
would have been profitable on 8 out of 11 trades. Although we do not recommend trading this
way on a mechanical basis, you can see how this is a useful tool for deciding whether you want
to be a buyer or a seller the next day.

In both discretionary trading and mechanical trading, you will have unavoidable losers (point 1).
There will also be small windfalls (point 8). Notice how nicely Taylor's rhythm sets up. Point
2-buy day, exit the next day. Point 3-sell short day, exit the next day Point 4-buy day, exit the
next day. Point 5-sell short day, exit the next day, etc. On balance, this is a winning
methodology.
The same three-day cycle also works in equities. Notice that the profits from the buy days are
smaller in a downtrend, yet they are still profitable on average. This stock also has a wide daily
trading range which makes it a good candidate for active, short-term trading. LINDA: I felt that
the 2-period rate of change had to be mentioned in this book because I have been trading with it
for so long. I use it in all markets, but I use it only as a guideline. It is a very noisy oscillator and
is prone to whipsaw action at times in flat quiet markets (for example, when the ADX is less than
16). I have spent many years studying it and observing its nuances, and you can do the same.
However, I would not recommend that beginning traders pay too much attention to it because it
gives many false signals in quiet markets and encourages a trader to make too many marginal
trades. It is also not an appropriate tool in a strong-trending market (for example, when the ADX
is greater than 30 and still rising.) Both this indicator and the Momentum Pinball work best in
nice choppy markets or after a runaway move has already occurred. Learn first to recognize
when a market has good volatility and daily range. Then think about applying Taylor's rules in
conjunction with the short-term pivot point demonstrated above. Short-term momentum
functions also serve as a departure point for use in mechanical trading systems. The studies
presented in the Appendix show that this indicator provides a statistically significant edge. All
the tests are run with just one variable. Apply a longer term trend indicator, a volatility filter, and
a money-management algorithm, and you have a fine mechanical trading system!