Dr Elder’s approach to trading

Dr Alexander Elder is one of the well known personalities in the retail trading circle. He has written extensively on retail trading and some of his approach and ideas are popularly used by many traders.

Some of his views and methodology are visited below.

How much to risk per trade?

Risk control is single handedly the most important portion of a successful trading venture. The 2% rule states that you should never risk more than 2% of your account equity on any single trade. If you have a $100,000 account, you should only be allowed to risk $2,000 on any single trade. If you had planned your entry, exit and permitted risk level, it will be easy to calculate how large your position should be. You just need to make sure that, when your stop loss order is hit in an event of adverse price movement, the amount of losses sustained should never be more than 2% of your account capital.

How much to risk your account or portfolio at any point in time?

Elder suggest that you should limit your risk to 6% of your account as a whole at any point in time. For example, you have a $100,000 account and risk $1,000 on every trade, you should not have more than 6 open positions at the same time. It will also be prudent to limit your maximum monthly loss to 6% as well. That means, if you have already had 3 losses which amounts to 3% of equity, you will only be allowed to open 3 more positions, risking another 3% of your account only.

Triple screen analysis

Dr Elder proposed analyzing the markets based on his triple screen trading system. Basically, you will analyze the markets over 3 different time frames. First, determine the timeframe that you are going to trade in and include another timeframe of a higher magnitude and another timeframe of a lower magnitude. For example, if you are looking to trade the daily timeframe, you will also look at the weekly timeframe which is of a magnitude higher and also the 4 hourly timeframe which is a magnitude lower. Now, if the weekly timeframe signals a macro up trend, you will look for long entries or buy setups in the daily timeframe while refining the exact entry point utilising the 4 hourly timeframe or any other timeframes of a lower magnitude than the dailies. These can be 1 hour, 15 mins or 5 mins charts.

Using technical tools

In choosing technical tools, it would be safe to limit yourself to a maximum of 5 different technical tools or indicators to prevent your chart from getting too cluttered and impair your judgment instead. Some suggestions are moving averages, moving average envelopes and MACD lines and histogram.

Moving averages are among the simplest to understand yet immensely useful indicators out there and which are mentioned many times in this blog as well. They are also incredibly versatile and can be used in many ways. First, its slope identifies the direction of change in the public’s mood. A rising moving average reflects bullish sentiments while a falling one reflects bearish sentiments.

Exponential moving averages are preferred over simple moving averages as they are more sensitive to price changes and momentum.

Moving average envelops or channels are simply 2 additional lines calculated by adding and subtracting a volatility number to a moving average to form a line above and a line below it which should contain most price movements. These can be simple adding and subtracting a simple percentage number to it or it can be a standard deviation of past price movements. This is the basis of the Bollinger Bands which commonly adds a +/- 2 standard deviation of price onto a 20 period EMA.

The MACD is a trend following momentum indicator that is comprised of 2 lines. The MACD is calculated by subtracting the 26 period EMA from the 12 period EMA. The second line is a 9 period EMA of the MACD, and is commonly called the ‘signal line’ and it acts as a entry trigger for buys and sells when it crosses above and below the MACD line respectively.

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