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Silver – breaking the rules on a big picture bounce

Caution: the following post contains trading heresy and only the most experienced traders with established trading records should consider its contents potentially useful.

“You have to know the rules before you can break them” - apocryphal

Most trading instruction recommends a rigid adherence to the “rules” of a trading strategy. However the rise of algorithmic approaches to markets means more and more traders are taking a rules based approach. The effect is obvious in the performance of hedge funds and active managers. Opportunities are diminishing, and those that occur are less profitable.

For those who’ve made their bones as a trader a logical response is to look for opportunities that are rules based but flexible (yes, life is full of paradoxes). To stress the point, this is a highly dangerous idea for those yet to prove they can trade for consistent profits.

Traders disappointed with their ability to generate alpha over 2017 are no doubt considering the future. The method described below allows traders to take the position less executed – a trade that breaks the mechanical definition of a trading signal but remains consistent with the principal underlying that signal.

Here’s the weekly silver chart:

Note the breach of the lower Bollinger Band. The price may revert back up through the band, giving a classic buy signal. The problem is the widening of the bands (BB width at the bottom of the chart). This is a sign that price volatility is increasing, and negates the buy signal.

The logic of this is straightforward. When prices trade outside the BBs they are displaying moves that are further from the average than 95% of price moves. There is an increased likelihood they will move back towards the average price. However when volatility is increasing and the BBs are widening there is the potential for more extreme moves outside the bands, therefore the buy (in this case ) signal is cancelled.

Most rules based traders will therefore ignore this trade. But look at that width again. It has certainly turned upward, but only modestly so. Secondly, the potential reversion occurs at a key support level. The bounce off $15.60 looks meaningful.

Combining this near BB trade with a buy at support bends the rules of many trading plans. But it results in a trade less crowded. This could be more stable and profitable, and more experienced traders may consider a little rule bending a help in the current low volatility environment.

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