Today I want to discuss another technique for helping us improve performance and at the same time reducing the risk of getting caught in a Spike attack! Combining multiple timeframes.
The key to this technique is reducing both the $ risk as well as the time we have open risk exposure in the market. The sooner the risk is out of the trade the less we have to worry about a spike hitting our stop. Sure, a spike might still take us out of a perfectly legitimate trade, but at least it won’t cost us money from that time onwards.
A worked example
Let us consider hourly charts as our normal trading timeframe. So typically we would look for one of our setups on these hourly charts. When a setup occurs and we get an entry trigger we get into the market, place our stop a certain distance away and place an order for our first exit target.
As an example let us consider trading the S&P. Currently the average true range of an hourly bar is about 5 points (yes I know, miserable isn’t it!). Depending on the type of trade the initial risk might be anywhere between 1 and 3 ATRs for our stop placement. Let’s assume for this example that our initial risk is 2 ATRs. So in this case about 10 points.
Again for the sake of argument let’s assume that our first target is also 10 points at which point we will:
- Bank a small profit on 1/3rd of the position
- Tighten our stop on the balance to half its initial size
- Have a risk-free trade from that point on
Now we know that an average bar spans 5 points. Therefore even if the market moved immediately in our direction without any hesitation or bar overlap it would still take 2 hours before our first target is reached and we achieve that risk-free trade. In reality allowing for bar overlap it is more likely that it will be 3 hours before we finally get to lift the first piece of the trade. So our exposure in terms of spike risk is about 3 hours and that assumes it all goes perfectly to plan.
Adding a trigger timeframe
Now let’s consider using a second chart [ismember]say a 5 minute chart in combination with our normal timeframe. What we will do is wait for our normal hourly charts to provide a setup. But this time we will use a signal on a 5 minute chart as our entry trigger.
Let’s say our hourly chart is setting up a buy signal and we are waiting to trigger an entry. We now watch our 5 minute chart and wait for a short-term buy signal on that. If we get that buy signal, and only if, we enter the market initially as though we were trading just that 5 minute timeframe. In this case our risk on the trade is much lower. The average true range of a 5 minute bar is about 2 points not 5, so allowing for 2 ATRs our risk is just 4 points.
For our first target we can either use the first target on our normal timeframe, i.e. 10 points in this case. Or as an alternative we could use twice the initial risk on the trade, i.e. 8 points. We would lift 1/3 of our position as normal at our first target and at that point the balance of our trade would be completely risk free. This is without needing to tighten our stop as it is already in a better position than it would have been just trading on the single timeframe.
The remainder of the trade is managed on the usual hourly timeframe just as normal from that point onwards.
Benefits of multiple timeframes
Let us look at the advantages we have gained when operating this way:
Our first target is closer than it would normally have been and is therefore likely to be reached a bit sooner than normal. In this case maybe 2 hours instead of 3. Therefore we have reduced our time exposure to a spike attack by about a 20-30%.
Secondly we have reduced our initial risk on the trade by a whopping 60% so if we are unlucky and get taken out on a spike, or for that matter if the trade is simply an outright failure, our loss is considerably smaller than it would normally be. It must be recognised though that there will be a reduction in our percentage of winning trades as a result of using a tighter stop. However in our experience this reduction tends to be relatively small. Either a trade is only going to work or it isn’t. The best trades work immediately and give you no grief after entry!
The third thing we have achieved by using a second timeframe to trigger the entry is a dramatic improvement in our Risk/Reward Ratio. The smaller timeframe governs our risk and as we have already seen that risk is 60% lower than normal. However it is the normal hourly timeframe that still governs our potential reward and that is hardly impacted at all. Our first target is reduced by 20% however our second target and third target where we make the bulk of our money is not altered at all. Therefore we have achieved the risk of the 5 minute timeframe combined with the reward of the hourly timeframe. This improves our overall Risk/Reward Ratio by a factor of 2!
As mentioned earlier there will be a slight reduction in our overall winning percentage but it certainly is nothing like a factor of 2. Therefore our edge is improved considerably by combining two timeframes:
- Our overall profitability is increased
- Our exposure time to an adverse event causing a spike and stopping it out is reduced by 20-30%
- The cost of being stopped out in an adverse event is reduced by 60%.
So altogether this technique is one that offers many advantages. Not surprisingly improving that Risk/Reward Ratio is a theme common to the majority of the development projects being undertaken by myself and my colleagues this year. Looking at how you could use a second timeframe to trigger entries into your normal trades would be time very well spent.
Until next time, wishing you success in trading!
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