Trading for a Living, Using Stock Trading Signals

Trader Bob outlines his criteria for establishing the validity of a stock trading signal and demonstrates how a trading signal can be profitably integrated into a stock trading system.

What are stock trading signals? The answer is going to depend on who you ask.

For example dyed-in-the-wool contrarians might believe that a stock trading signal to sell stocks might be when Time Magazine runs a picture of a bull on its cover. A dyed-in-the-wool technical analyst on the other hand may look for certain stochastic numbers on a 30 minute bar chart to indicate when to buy a certain stock. And finally a dyed-in-the-wool 'fundamental' investor may consider certain financial numbers of the underlying business to be a trading signal.
So to this mix let me now add what I think is a true and usable definition of a stock trading signal. Let me give you an example of the kind of signal I like.

Take any given stock and look at all the daily bars for the past 10 days. Next subtract all the highs from all the lows to get all the daily ranges for each of the 10 daily bars and then calculate the average range for those ten days. Let's call this AVERAGE DAILY RANGE. Next divide each daily range by two to get the midpoint for each day. Now find the average midpoint for the 10 days. Let's call this AVERAGE MIDPOINT. Next take 125 % of the AVERAGE DAILY RANGE and add it to the AVERAGE MIDPOINT and that becomes our trading signal to buy tomorrow.

Thus we have created a signal using only two parameters, AVERAGE DAILY RANGE and AVERAGE MIDPOINT.

There are any numbers of ways to exit this trade, but again we want to keep it simple and limit our parameters. For example we may wish to put a stop loss on the average low and take profits on the average high plus 150% of the AVERAGE DAILY RANGE.

In any case I have created trading signals from the simplest ideas of market momentum theory and using the most limited number of parameters. And for this reason this little trading system will probably tame the randomness of short term stock market movements and it will probably make some money.

But in this article I am not trying to design a trading system. What I want to do here is simply to demonstrate my ideas of what constitutes a valid trading signal. In my view a
stock trading signal should embody the following:

1) A stock signal must be mathematical and precise in nature.

2) A stock signal must be programmable into a computer so the computer and not the trader can track the relevant markets and alert the trader to when the trading signal has been hit. This allows the trader to diversify and to trade many markets simultaneously.

3) Finally the trading signal must be of such a nature that it can be tested in all kinds of markets and in all kinds of market environments to establish its accuracy and validity.

Used in this manner objective stock trading signals form the backbone of our trading system development and become indispensable tools for profitable stock trading.