Mechanical Trading

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Mike Charness Combines Discretion With Mechanical Trading
Wednesday October 27th 1999, 9:35 AM

Mike Charness combines discretionary trading with several mechanical guidelines,
looking to take positions when these indicators are in sync.

By Allen Sykora

While Michael Charness is a discretionary trader, he tries to limit the amount of discretion by also using certain mechanical guidelines. He considers it important to have more than just one or two techniques to make sure they "work well together."

He favors Japanese candlestick charting and tends to take on positions in multiples of three, capturing profits on two when certain objectives are met, but letting the third run with a trailing stop in order to benefit from the really big price moves.

Charness is a longtime trader who has moved from the stock to futures markets, currently focusing mainly on the S&P 500 futures. He became the principal instructor for The Trading Tutor Course when founder Arthur Ullrich retired in the spring of 1999.

"The trick with using indicators is not to depend on any one," Charness said. "Don't just be using moving averages, and don't just be using RSI (Relative Strength Index). The key is taking the key indicators that work well together, so when the things you look at are all in sync, or almost all in sync, you know you've got a high probability of follow-through in price action. We try to integrate them, rather than relying on just one or two.

"We use candlesticks to look at price bar action. Then we use a number of indicators to try and filter those and determine the market context, so we can figure in advance what are the highest-probability, lowest-risk trades. Most of the indicators we use are choice settings of off-the-shelf indicators."

These include RSI, MACD, moving averages, ADX and others.

"The more conditions we're looking for that line up, the higher the probability of follow-through in the price action," said Charness. "We like RSI to come out of an extreme back toward a central tendency. In trending periods, we like bounces off of moving averages. We like ADX to give the indication that a market is not in a choppy mode and is well trending. We use indicators to look for divergence, if we're going to look for a counter-trend trade."

He considers Japanese candlestick price charting "much easier" to follow than the more traditional bar charts.

"They're not used enough, because traders are afraid of candlesticks," he said. "They are used to seeing open, high, low and close bars on everything. Candlesticks are so much more descriptive.

"I think traders are also scared of candlesticks because they see books that have hundreds of patterns and figure they'll never be able to memorize them all. But in reality, there is probably only a half dozen or so patterns that are high probability, very repetitive and easy to see, where it doesn't take a genius to be able to follow them."

His style is to trade three contracts at a time in the S&P 500 futures. He will exit two of the positions when the market hits a pre-established target, but will hang onto a third, using a trailing stop. "That way if the market keeps going and running away, you're still in," he explained.

Then traders don't have to worry about "kicking themselves" if they exit a trade and the market moves much farther in their favor than they had thought possible. "Both technically and psychologically, I think that's a lot easier to do than trading a single lot."

Charness will finally exit this third contract when the market finally turns and touches off his trailing stop. At times, he might tighten this stop, if he suspects the market is about to reverse rather than simply retrace, such as if the RSI reading becomes too extreme.

Charness keeps track of the major economic reports, but otherwise relies mainly on technical factors rather than fundamentals.

"If there is a report that comes out during the GLOBEX session before the day session, I understand that may drive early action," he said. "If there is a report coming out at midsession that may be a major mover, I may stay on the side and not take a chance being on the wrong side of it. That's especially important in the S&Ps and bonds. But other than keeping track of reports and their potential to move the market, I'm not really doing fundamental analysis. I'm making my trading decisions based on technical price action."

While Charness currently favors the S&P 500 futures, he will also enter the bond futures and has dabbled in currency futures.

"For day trading, if you can tolerate the intensity, I think the S&P is the ideal market," Charness said. "It has lots of liquidity, lots of movement and you know very quickly whether you're right or wrong, because the market gives you immediate feedback."

He tends to avoid the thinner futures markets, regardless of whether position or day trading. He also considers the Chicago markets "more friendly to the off-floor traders" than those in New York.

Charness received an undergraduate business degree from the University of Phoenix and a master's in business administration from the University of Southern California. He then spent some 20 years in the aerospace industry, mostly in southern California, in data processing, manufacturing and quality assurance. He eventually worked his way into senior management positions.

He started a software firm, developing software licensed to other companies on a royalty basis. The proceeds gave him the "comfort capital" he needed to try his hand at trading.

Charness started out day trading in stocks, looking for momentum plays. He later turned to futures, which is now his main focus.

"I started reading all I could, going to seminars, and started developing my own techniques, taking the best elements I could from different techniques from different traders," he said. "I started programming my own computer-based mechanical systems."

While he was having success, he was also looking for a way to trade "where I didn't have to sit in front of a computer" all day. "I wanted a methodology that was more flexible, reading price action in a more interactive way and could be adapted to the market as it changed," he continued. "I wanted a discretionary method that had mechanical elements."

That's when he tried Ullrich's Trading Tutor Course on the recommendation of an associate. Charness paper traded these methods for a couple of months while also real-money trading his own techniques, and was happy with the results when he began putting his money on the line. He then traded Ullrich's methods for three years, before taking over as principal instructor when Ullrich eased into retirement. Their trading operation is outlined on the web site

At one point, Charness cut back to trading just three half days a week. "One of the things that is a key to a successful trader's lifestyle is to have free time to enjoy life, and not have a typical 40-hour-a-week job," he said. But since he became the principal instructor for Trading Tutor, he is back to trading around four days a week, as long as he's in the office anyway.

When he was trading on a more limited basis, Charness would look at the overnight GLOBEX screen trading activity first thing in the morning before deciding whether he would take positions when the pit session opened.

"I would look to get a feel for whether it's been very active or very quiet," he said. "If it has been active, then usually it means there is either follow-through or a reversal, but good movement one way or the other, when the day session opens."

He will also review the previous day's activity to see whether prices were in a narrow range. If so, he feels there is a likelihood for breakout action the next day, making it a good time to trade.

As an example of the flexibility in the trading system he is currently using, he noted that Ullrich at one time traded 12 to 15 times a day, before cutting back to around six to eight a day just before he retired. Charness, meanwhile, tends to take an average of four S&P trades a day.

"I tend to be more mechanically oriented but with an element of discretion," he said. "That's one of the wonderful things about the method--you can really tailor it to your own personal preferences."

Away from the office, Charness enjoys driving his red 1984 Ferrari--the same year and model driven by actor Tom Selleck in the TV series Magnum, P.I.- on country roads and around a race track. He doesn't race competitively, but he and his friends rent a track periodically for the fun of running their cars at high speeds. His enthusiasm for the markets shows at the track; his Alabama license plate reads "I trade."

He also enjoys travel, particularly adventure travel including activities such as SCUBA diving, whitewater rafting and hiking.

When asked what has helped him succeed over the years, Charness commented: "Reading books and going to courses are fine. But it helps a lot to have a mentor you can ask questions about what is happening in the market, things you've done right and things you've done wrong, day by day, so you can really learn."

Also, he added, "patience and discipline are incredibly important. Day traders often feel they have to be in the market all of the time. They need patience to wait for a high-probability, low-risk set-up. That can really save your wallet. You need discipline to follow whatever rules you have established for yourself."

Some of the students he has worked with have actually taken their trading rules and posted them on a wall over their monitors as a checklist.

Besides advising novices to obtain good reference books, avoid "overtrading" and work with somebody who uses a trading style they want to emulate, Charness emphasized the importance of using stop losses. He looks for key technical levels to place stops, rather than using a strict dollar amount.

"We're looking to make the stop logical, looking for where we don't expect the price to go, unless we're wrong about our presumptions," he said. "If you can't do that within a reasonable amount of points or dollars, then you should just wait for another set-up and don't take more risk than you've pre-established that you're willing to take."

He also recommends paper trading before somebody risks his or her money. And in the case of day traders, he advised them as a next step to use a "simulated broker" before finally entering the market for real. He was referring to services where beginners can use a broker who will give a realistic fill and let them get used to the mechanics of trading, such as handling tickets, before they put their money on the line.

"That's not as important for position trading. But for day trading, you need to word the orders properly, get the timing down and get realistic fills."