Morning Matters: The Importance Of Bias

The concept of bias is really very simple. Either you want to be long stocks or you want to sell/short stocks. A big problem is traders and investors often fight the bias by trying to own stocks when the bias is negative or short stocks when the bias is positive. These scenarios tend to result in low probability trades.

Depending on one’s trading time frame, bias could range from 10 minute for an intraday trader to monthly for a long term investor like Warren Buffet. Bias has been perfected by Phil Erlanger over the years through his writings, videos and software Erlanger Chart Room.

Below are some comments on bias that we have pulled from a chapter that Phil wrote for Bloomberg in 2011 entitled New Frontiers In Technical Analysis: Effective Tools and Strategies For Trading & Investing. In the chapter Phil wrote, pretty quickly he gets to the heart of the matter about bias: Failing to determine bias is why most portfolio managers and traders go through periods where they dramatically underperform.

“The concept of Bias is such a simple one, but it is the critical step that most fail to consider. The chances of a positive long-term performance are greatly reduced without a disciplined approach to deciding which side of a market to trade.”

“We think of bias as the “Big Picture.” Is the condition of a market favorable to long trades or short trades? Generally, bias indicators are in a larger time frame than that which is used to trigger into a trade. For instance, indicators in a weekly or monthly interval are used to determine bias if a trader is using daily data to buy or sell.”

“Bias indicators are designed to specifically answer the question of taking long or short opening positions. If short selling is not a tactic that will be used, then the bias answers the question of taking a long or neutral stance in a particular market.”

“Trading or investing in the direction of bias indicators is our first strategic step.”

The next steps that Phil looks in the chapter are setups and triggers. We will tackle setups next week and triggers the week after. Soon Erlanger returns in the chapter to describing what he uses to track bias.

“The Displaced Moving Average Channel (DMA) is one of those indicators that, though simple in construction, are so powerful in application. A “displaced” moving average (DMA) is simply a normal moving average shifted to the right or left. A displaced moving average can be computed based upon a stock’s closing price, high price and/or low price. The DMA Channel involves two DMA averages. These two averages form a channel that makes any trend changing event clear, as well as illustrates the strength of a trend underway. The first average is a 6-period average of price highs displaced 4 places to the right. The second is a 6-period average of price lows displaced 4 places to the right. The DMA channel can be used on any time interval, but there must be price high and price low data available for each interval.”

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“A positive bias reflects times when only long trades are considered. If price moves above the DMA Channel, then the bias is positive. However, using the DMA Channel as a bias should be confined to intervals larger than one uses for triggers. For instance, if you are trading an index using triggers based on daily data, use weekly or monthly data to determine the bias. If you are trading on an intraday basis, than the daily DMA channel can be used to determine bias.”

Since we like to trade the market it makes sense to look at the S&P 500 on a monthly chart as we like to use daily triggers to time buys and sells on the market.

The S&P 500 moved back above its DMA channel in February of 2012 and has not looked back. Erlanger uses the end of the period to make a change to the bias as opposed to taking a signal that has turned mid period. This is a smart approach because it decreases being whipsawed.

If the DMA Channel is of interest to you, then we would direct you to Erlanger Chart Room to sign up for a free trial.

 

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