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MARCH 2014

MARKET Timing With Pairs LOgic Fading The Big MOVes

Using the stress indicator 10

How to gauge them


EXpansiOns & COntractiOns
With ETFs

Identify trading setups

22 26 32

Trend Switching INTERVIEW
Guy Cohen


Trading Weekly Options
MARCH 2014

n MetaStock XIII n Insiders Guide To



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10 Timing The Market With Pairs Logic

MARCH 2014, Volume 32 Number 3


by Perry Kaufman Fundamentally different strategies, drawing from a broad set of markets, will offer better risk protection during times of market stress than any one strategy. Here’s an overview of a timing method and its mechanics.

32 Trading Like An Insider With Guy Cohen


16 Fading The Big Moves

by Ashot Hakobyan Whenever we see a big move in the markets, it’s bound to catch our attention. But how do we protect our capital during such big moves, or better yet, profit from them? Find out here. by Don Bright This professional trader answers a few of your questions.

Guy Cohen is a leading innovator in financial trading. He is the creator of the options volatility indicator (OVI) and the FlagTrader and OptionEasy trading tools. He is the author of several best-selling trading books, a successful private trader, and a trading coach. We spoke with him about ways to keep abreast with market momentum, mistakes traders make, and how he uses data. by Carley Garner Here’s how the futures market really works. by Thomas Bulkowski When stock prices start climbing or forming a price mountain, it’s tempting to want to get in on the action. But should you buy a stock that’s forming a mountain?

42 • MetaStock XIII Product review: Trading platform 46 • Insiders Guide To Trading Weekly Options Product review: A four-DVD set; weekly option & live trading course

37 Futures For You


21 Q&A

38 Navigating Price Mountains

22 Expansions & Contractions, Part 1
by Dirk Vandycke Every trader wants to be able to predict price moves, but we know that’s impossible. Instead, focus on finding high-probability setups and manage them well. In this first part of a three-part series, we’ll look at how to identify these setups.

40 A Fundamental Lesson For The Technically Minded
by Matt Blackman For decades, there have been two major schools of thought when it comes to stocks: fundamental analysis and technical analysis. Here, we look at how the two methodologies can work together.

6 Opening Position 8 Letters To S&C 25 †Traders’ Glossary 45 Futures Liquidity 49 Books For Traders 50 Traders’ Tips 56 Trade News & Products 57 Advertisers’ Index 57 Editorial Resource Index 59 Classified Advertising 59 Traders’ Resource

26 Trend Switching With ETFs

by Moshé Prince Given the volatility in the markets, you need to know when to get into a trade and when to get out. The use of ETFs has made this easier. by Tom Gentile Got a question about options?


62 The DJIA Is A Fata Morgana

31 Explore Your Options

by Wim Grommen Here’s an interesting perspective on the oldest stock index in the US.
This article is the basis for Traders’ Tips this month.


n Cover: William L. Brown n Cover concept: Christine Morrison

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4 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs

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March 2014 2006 • Volume Volume 32, 24,Number Number3 3


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goes January, soreminder goes the of rest of nce again we got a just the year — that’s what they say, how sensitive the financial markets anyway. the selloff bullish in rally we’ve had are. We And saw given a major the Japanese since 2009, all eyes should have been on the markets, which — as expected — triggered a markets in January. We are now coming into domino effect on markets throughout the five years of recovery in the equity markets, yet world. Add disappointing earnings numbers we’re still not seeing any spectacular growth from US corporations and you have a situain the underlying economy. There hasn’toff been tion that just got worse. So what started as much in the way of job or wage growth, and a strong year ended up correcting, and rather although we have seen that some recovery in the rapidly. I must admit although correchousing market, it’s still not growing at the tions are healthy for any market, when you have a 2% drop, it gets you thinking. pace it should be. We are also approaching the end of the quantitative easing (QE) Prior to the Federal Reserve’s FOMC meeting, I usually take a look at the yield days, and even though QE didn’t improve anything, it acted as a catalyst and took curve. At present, it’s looking a little flat, and given that the general consensus the markets higher. is that the Fed is going to tighten at their January 31st meeting, I am concerned that Sothe what is curve driving the momentum the equity of markets? Could it be that the yield may be heading in in the direction being inverted. And if that market internals are changing? Is there something going on that we are not seeing? were to happen, that would not be a good sign for the US economy. I’m not That could prove toare be going dangerous, if recessionary we’re not seeing what we should be suggesting that we to go because through a period. But given that seeing, then it’s all the more likely we could be caught unaware. Maybe it’s time almost anything can happen, it doesn’t hurt to expect the worst. If nothing else,to look at the markets from different perspective. If you have narrowed your focus it helps to preserve your a capital. to just the markets you trade, perhaps you should look “outside the box” and focus on other variables. For example, if you only trade equities, perhaps you should start looking at the action in the option markets. In our interview this month, which begins with that in mind, you can see why it’s important to design trading on page 32, Guy Cohen of FlagTrader.com discusses the importance of a keeping system that gets you out of the market at the right time. When access to an eye on the activity in the option markets even if you don’t trade options. And it the markets is easy, the number of options available increases. This makes it doesn’t have to involve any complex calculations. It could be as simple as keeping important to be thorough with the different types of orders, front-end software, and an eye on option volatility. trading systems that are out there. Lee Leibfarth, in his article “The Automated Daytrader” starting on page 22, addresses the various options that are available and how you can take advantage of them. can measure market momentum using a variety of indicators, but regardless But ou before getting to the stage of placing that trade, you need to understand the of which indicators you use, you still must have a trading plan that a market you are trading. You should be able to do so after reading Paolo includes Pezzutti’s strategy to protect your positions. In “Fading The Big Moves” by Ashot Hakobyan “Understanding Market Structure.” The markets follow different behavior patbeginning on page 16 this issue, will find trending, out about in a statistical technique you terns, and you need toof determine ifyou it is volatile, a trading range, moving can incorporate into your trading plan so your winners don’t turn into losers. It’s a strongly in one direction, or moving but not with much momentum. good habit to cultivate; whenever we experience a number of consecutive winning Only when you know what the structure of the market is will you be able to apply trades, we tend to think there is zero probability we’ll all wehave earned. the correct trading technique. But that’s just thethat first step.lose You still to have discipline, Don’t let as your profits blind you to what may be really happening in the markets. you will find out after reading this month’s Technical Analysis of Always aware of what interview is going on so you be prepared for theyou worst. Good STOCKSbe &C OMMODITIES with Kencan Tower. Only then will be able to trading! know when to exit.



Here’s to smart trading! Jayanthi Gopalakrishnan, Editor Jayanthi Gopalakrishnan, Editor

6 Analysis of of STOCKs && COMMODITIEs 8• • March March2014 2006••Technical Technical Analysis STOCKS COMMODITIES

The editors of S&C invite readers to submit their opinions and information on subjects relating to technical analysis and this magazine. This column is our means of communication with our readers. Is there something you would like to know more (or less) about? Tell us about it. Without a source of new ideas and subjects coming from our readers, this magazine would not exist. Email your correspondence to [email protected] or address your correspondence to: Editor, STOCKs & COMMODITIEs, 4757 California Ave. SW, Seattle, WA 98116-4499. All letters become the property of Technical Analysis, Inc. Letter-writers must include their full name and address for verification. Letters may be edited for length or clarity. The opinions expressed in this column do not necessarily represent those of the magazine.—Editor

SWING TRADING Editor, I enjoyed Donald Pendergast’s article on swing trading in the December 2013 issue (“Swing Trading With Three Indicators”). I have a question regarding his entry points. They actually occur the day after the breakout, since in rule 1, he states, “Go long when the price exceeds the upper moving average of the previous trading session.” Is that correct? I just wanted to clarify. GARY Author Donald Pendergast replies: Thanks for reading. Yes, if using daily price bars, then using the previous bar’s closing value of the moving average (of the highs or lows) will result in fewer whipsaws and false signals as compared to using the current intrabar value for the moving average, which will fluctuate until the close of the trading session. You may be able to get a better entry price by entering before the bar closes, but you may also be entering a trade that otherwise would not be confirmed at the

end of the trading session. Really, you can use the system on any time frame and the same principle would apply. Again, the important idea with the system is to first visually identify stocks and ETFs that consistently make sustained, smooth swing and/or trending moves. MORE ON SWING TRADING Editor, Thank you for the interesting article by Donald W. Pendergast Jr. about swing trading in the December 2013 issue (“Swing Trading With Three Indicators”). Has the author tried the method on forex? I had a look at it and it seems to work very well on the daily time frame. The forex market often trends, and I understood from the article that liquid and trending markets are needed for this method to work properly. GIANLUCA Author Donald Pendergast replies: Thanks for your comments. In theory, the method may produce positive results on markets that make smooth, relatively nonvolatile swings. In Figure 1 I show a

daily chart of the AUDUSD that uses a 50-day EMA, but the five-day SMA of the daily highs & lows has been changed to an eight-day version. The large candle wicks reveal lots of intraday range, seemingly necessitating a wider channel to avoid too many early stopouts — at least to my eyes. You can experiment with different moving average lengths for the channel and the trend filter to see whether that works better on the markets that you typically follow. STARTING A TRADING FIRM Editor, I am interested in becoming a licensed trader and opening my own trading firm. I have developed trading algorithms and strategies for both short-term and longterm strategies. I have some questions I am hoping you can help with.

• What are the prerequisites for becoming a licensed securities trader? • What is the process for obtaining the proper “series” license to trade stocks, commodities, and currencies? • Are there minimum education requirements? If so, what are they? • What is a hedge fund and how does that differ from a trading firm?


We suggest visiting the SEC website at sec.gov and the FINRA website at finra. org for information on series licenses. You can also visit the NFA website at nfa. org for information on futures trading and regulations. Here is a rundown of those websites and what is stated there about licenses or registrations. • US Securities And Exchange Commission (SEC) — www.sec.gov
Individuals who want to enter the securities industry to sell any type of securities must take the Series 7 examination—formally known as the General Securities Representative Examination. Individuals who pass the Series 7 are eligible to register with all self-regulatory organizations to trade. The Financial Industry Regulatory Authority (FINRA) administers the Series 7 examination. For more information, visit FINRA’s website where you can learn about the Series 7 exam and its

• Financial Industry Regulatory Authority (FINRA) — www.finra.org

FIGURE 1: AUD/USD. This sample daily chart of the AUDUSD uses a 50-day EMA, but the five-day SMA of the daily highs & lows has been changed to an eight-day version.

8 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs

• National Futures Association (NFA) — www.nfa.futures.org
With certain exceptions, all persons and organizations that intend to do business as futures professionals must register under the Commodity Exchange Act. qualification and registration process.

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There are no minimum educational requirements per se to trade or to run a business, but you do have to pass the exams to obtain various licenses, such as the Series 7. A Series 7 license is required if you work with general public to solicit their funds and invest their money, since this involves selling them securities. For some career options, certain designations or credentials can be helpful or required (such as obtaining a Certified Financial Planner [CFP] designation in order to practice as a CFP). Starting a trading firm requires some of the same steps as would take to launch any company, plus the additional required compliance measures. You would need to incorporate your firm in the appropriate jurisdiction; you would need a corporate account established with a stock or futures brokerage; and legal counsel is recommended, someone with experience in the financial markets arena. There are alternatives to starting your own trading firm. For those who seek to trade in a formal structure without actually starting or running a firm (and all that it entails) may wish to investigate becoming a trader in a proprietary trading firm (although careful vetting is recommended to avoid unscrupulous ones and unfavorable situations) or trading as an individual in commercial trading rooms (see our December 2013 S&C article, “Identifying Successful Futures Trading Rooms” by Dean Handley for more on ways to investigate these resources). A hedge fund is a type of fund. It’s a pooled investing fund, usually a private partnership, that uses a combination of long & short positions and sometimes unconventional and illiquid investments. Hedge funds may face less regulation than some other fund types but you typically need an established track record to be able to solicit capital investments from individuals or from other funds.

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March 2014

• Technical Analysis of STOCKs & COMMODITIEs • 9

Fundamentally different strategies, drawing from a broad set of markets, will offer better risk protection during times of market stress than any one strategy, regardless of the markets selected for the portfolio. In this article, you will get an overview of a timing method that you can implement in your trading, followed by the mechanics of that system.

Timing The Market With Pairs Logic
n n

Release The Stress!

time, so that buying the weaker and selling the stronger is a high-probability trade. In my 2010 book Alpha Trading, I introduced the stress indicator as a method for timing the entries & exits into pairs trades (see Figure 1). But there are practical problems with traditional pair trading: It can be difficult to sell short one leg of the pair. A high correlation between two stocks or a stock and an index assures success but will cause profits to be small. The net profit can also be small because of competition with commercial traders, since it’s a popular method. Retirement accounts don’t allow short sales.


by Perry Kaufman rbitrage is one of the great financial strategies, and pair trading, which is relative value arbitrage, ranks high on the list of all-time successes. The premise is that two related stocks will only diverge for a short



10 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs



To avoid short sales of individual stocks, you can substitute an index, preferably the SPY (SPDR S&P 500). For retirement accounts, you can use the ProShares Short S&P 500 (SH), which is the inverse S&P 500 or ProShares Ultra Short S&P 500 (SDS), the double-leverage inverse S&P, to avoid short trading. But the index is less volatile than an individual stock and the net profits from a pairs trade that is long a stock and short the index will be smaller — most often, too small.


Enter the long bias in stocks. If we look at the breakdown in performance of the pairs trade, we see that the gains are almost always in the long stock position rather than the short sale. It’s not hard to believe because there is a clear long bias in stocks. Over time, stock prices are higher (with certain exceptions), so you would expect the long trades to be profitable. Then why not just take the long leg when there is an entry signal into a pairs trade? The returns per share would be much larger, but the problem occurs when the market is in crisis. That is, you can’t be sure that the trade will exit when the S&P drops 40% as it did in 2008. The trade remains long while the individual stock is weaker than the index. The profile of mean-reversion trading is that there are many small profits and a few very large losses (also called a short options profile). You need to find a way to avoid those large losses.

Co-integration is the preferred method of measurement, but it’s more complicated. It identifies two markets that are moving in the same general direction but with somewhat random interim moves. I am going to take a simpler approach by assuming that most of the stocks in the S&P 500 are correlated to the S&P 500 index (in this case, the SPY). I justify that because of the S&P arbitrage. When the cash SPX diverges from the futures SP, traders will buy one and sell the other to bring the relationship back in line. If they are buying the SPX, they actually buy all, or almost all, of the stocks in the S&P index. Even when there’s a stock such as Raytheon, which can move opposite to the overall market, I still buy it along with all other stocks. That should benefit a pairs trade. Based on that assumption, I’ll apply the pairs strategy to a wide range of stocks on one side and the SPY on the other, taking only the long stock leg and hedging when the trend of SPY turns down. When it’s done, I’ll sort through the results and choose the stocks I want to trade since not all stocks qualify.


The timing of entries and exits will use the stress indicator, which I developed just for this purpose. It is simply a stochastic indicator applied three times as follows: 1. To the stock (S) 2. To the index (I) 3. To the difference in the stochastic values of (1) and (2) By doing this, you are able to find the points where the stock is oversold relative to the SPY. You lose the absolute volatility, which may help sort out which trades are likely to be most profitable, but we can address that when we select stocks for the portfolio. The formula for the n-day stress indicator is: 1 (Stochastic (S)t) = 100 × (St – Lowest(S,n))/(Highest(S,n) – Lowest(S,n)) 2 Stochastic(I)t = 100 × (It – Lowest(I,n))/(Highest(I,n) – Lowest(I,n)) 3 Stresst = 100 × (Dt – Lowest(D,n))/(Highest(D,n) – Lowest(D,n)) where: n = calculation period of the stochastic, set at 60 to maximize the returns Lowest and highest are functions that return the highest and lowest values of a data series over the past n days. Dt = Stochastic(S)t – Stochastic(I)t The stock is overbought relative to the index when D is high,
March 2014


The answer is to hedge, or sell, the index when the trend of the index turns down. It’s a technique called portfolio insurance. The amount hedged is equal to the volatility (risk) of the daily profits/losses of the stock position, or the accumulated stock positions of more than one timing trade. In this article, only a single 60-day trend will be used for hedging, but you may find it better to use more than one trend. For example, you could hedge half of the risk on each of two trends of different calculation periods. By protecting your position when the overall market turns down, you easily avoid large losses during bear markets. The final picture however, will show that in the long run, the hedge may produce a slight net loss because the accumulated profits from only shorts in the S&P is not generally a good strategy. The benefit only comes during a crisis, when there is a massive selloff in the S&P. For those who care about risk & reward, as I do, the information ratio (annualized returns divided by annualized risk) will be better when using the hedge, although the total returns will usually be lower.


Traditional pair trading requires that you qualify the two stocks that will make up the pair. This is most often done with either correlations or co-integration. Correlations are familiar to most traders; a simple test is performed using the returns of both stocks. You want the result to be (approximately) above 0.30 but below 0.70, so that the two stocks are clearly related but not tracking too closely.

• Technical Analysis of STOCKs & COMMODITIEs • 11

FIGURE 1: StRESS INDICAtOR. Here you see the stress indicator in red (bottom panel), the price chart of Hess (HES) in the top pane, and the price chart of SPY in the middle panel. The buy signals occur when the stress indicator falls below 10 and exits when it rises above 50.

and it’s oversold when D is low. I’ll set those thresholds at 90 and 10. By setting them wider you can isolate fewer, more extreme cases. There is always a tradeoff between the number

Noisy indicators delay your analysis

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of trades and net returns. Some EasyLanguage code for the stress function and the pair-trading strategy can be found in sidebar “EasyLanguage Code For Stress Function And PairTrading Strategy.” By using the stress indicator for traditional pair trading, you can buy the stock and sell the index when the value falls below 10. You can sell the stock and buy the index when it’s above 90. However, in this strategy, you’re only going to buy the stock when it’s oversold relative to the index. You exit the trade when the stress indicator moves above 50, indicating a return to normal. Figure 1 shows the individual stochastics plus the stress indicator applied to Hess (HES) and SPY. The numbers that are under the buy signals (Bzone) are the number of shares.


For Windows XP, Vista, 7, 8, & Server
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Assuming I have no leverage for stock trades, I will allocate the same fixed amount to each market that I trade, say $5,000, then divide that investment by the current price. In that way, Facebook (FB) at $50 would get 100 shares and Apple (AAPL) at $500 would get only 10. The volatility of those two stocks may not be quite the same as this 10:1 ratio, but it’s the simplest and most effective choice. Since the holding period of the trades tends to be about eight days, I won’t rebalance the position size.

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The gains are almost always in the long stock position, because there is a clear long bias in stocks.

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12 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs



Stress function
{ PJK_Stress Copyright 2013, P.J.Kaufman. All rights reserved. } inputs: period(numericsimple); vars: stoch1(0), stoch2(0), diff(0), range1(0), range2(0), stressvalue(0); stressvalue = 50; stoch1 = 50; stoch2 = 50; { raw stochastics for price1 and price2 } range1 = highest(high,period) - lowest(low,period); range2 = highest(high of data2,period) - lowest(low of data2,period); If range1 <> 0 and range2 <> 0 then begin stoch1 = (close - lowest(low,period))/range1; stoch2 = (close of data2 - lowest(low of data2,period))/range2; { difference in stochastics } diff = stoch1 - stoch2; { stress indicator } range1 = highest(diff,period) - lowest(diff,period); If range1 <> 0 then stressvalue = 100*(diff - lowest(diff, period))/ range1; end; PJK_Stress = stressvalue;

stocksize = investment/close; buy (“Bzone”) stocksize shares next bar at market; newbuy = true; indexpos = 0; end { exit conditions } else if marketposition <> 0 then begin if minpriceOK = false then begin sell (“Minrule”) all shares next bar at market; indexpos = 0; end else if stress >= exitlevel then begin sell (“Xrule”) all shares next bar at market; indexpos = 0; end else if stoploss <> 0 and close/entryprice - 1 < -stoploss then begin sell (“Stop”) all shares next bar at market; indexpos = 0; waitforreset = true; end; end; { enter index hedge if trend is down } if hedgeper <> 0 and indexpos = 0 and (newbuy or marketposition <> 0) then begin if indextrend < indextrend[1] then begin { calculate hedge amount } stockvol = stddev(stockchange,hedgeper); indexvol = stddev(indexchange,hedgeper); { if index vol is higher then ratio is less than 1 } indexsize = stocksize*hedgeratio*stockvol/indexvol; indexpos = -1; end; end; { index trend turns up then remove hedge } if indexpos <> 0 and indextrend > indextrend[1] then begin indexpos = 0; indexsize = 0; end; { the minimum price filter prevents using stocks that have gone negative due to back-adjusting splits } todaystockPL = marketposition*stocksize[1]*(close - close[1]); if stocksize[1] <> stocksize[2] then todaystockPL = todaystockPL - stockcost; todayindexPL = indexsize[1]*indexpos[1]*(close of data2 - close[1] of data2); if indexsize[1] <> indexsize[2] then todayindexPL = todayindexPL - stockcost; todaycombPL = todaystockPL + todayindexPL; stockPL = stockPL + todaystockPL; indexPL = indexPL + todayindexPL; combPL = combPL + todaycombPL; adate = ELdatetostring(date); if currentbar = 1 then begin print(file(“c:\Pairs1_PL.csv”), “Date,CombPL,StockPL,IndexPL, stockpos,indexsize,indextrend,indexsize,indexpos,newbuy”); end; print(file(“c:\Pairs1_PL.csv”), adate, “,” ,combPL:8:0,”,”,stockPL: 8:0,”,”,IndexPL:8:0, “,”, stocksize*marketposition:8:2, “,”, indexsize*indexpos:8:2, “,”, indextrend:6:2, “,”, indexsize:6:2, “,”, indexpos:3:0, “,”, newbuy);


{ PJK Pairs1 This program uses the stock price (input 1) and index price (input 2) and produces stock signals and stock PL output. The combined result of stock and hedge, plus other detail for tracking the trade, are output in a report to “c:\ \pairs1_PL.csv” } inputs: momper(60), entrylevel(10), exitlevel(50), minprice(3.00), stoploss(0.10), hedgeper(60), hedgeratio(0.50), corrfilter(0.20), investment(5000), stockcost(8); vars: stress(0), stocksize(0), minpriceOK(true), ix(0), adate(" "), stockPL(0), indexPL(0), combPL(0), todaystockPL(0), todayindexPL(0), todaycombPL(0), indextrend(0), indexsize(0), indexpos(0), stockchange(0), indexchange(0), stockvol(0), indexvol(0), newbuy(false), waitforreset(false), minpricedays(5); stress = PJK_stress(momper); stockchange = close/close[1] - 1; indexchange = close of data2/close[1] of data2 - 1; indextrend = average(close of data2,hedgeper); newbuy = false;

if marketposition = 0 then begin stocksize = 0; indexsize = 0; indexpos = 0; end; if waitforreset and stress > 50 then waitforreset = false; { set minimum price condition } minpriceOK = true; for ix = 0 to minpricedays begin if close[ix] < minprice then minpriceOK = false; end; { min price must occur n times in a row to start and end } if marketposition = 0 and waitforreset = false and stress <= entrylevel and minpriceOK then begin


This code can be found in the Subscriber Area of our website for copying & pasting at http://technical.traders.com/sub/sublogin.asp.
March 2014

• Technical Analysis of STOCKs & COMMODITIEs • 13


10000 8000 6000 4000 2000 0 -2000 -4000 -6000
4 2 3 5 6 7 2 8 9 0 9/0 9/0 9/0 9/0 9/0 9/0 1 9/1 9/0 9/0 9/1 4/2 4/2 4/2 4/2 4/2 4/2 9/1 4/2 4/2 4/2 4/2 4/2 4/2 9/1 3


CombPL StockPL IndexPL

FIGURE 2: HESS (HES) vS. SpY. Here you see that the stock’s profit/loss (P/L) outperformed the index and combined P/L.

There are many examples of good performance and some bad, which is the way with most strategies when they are applied to a broad set of markets. The chart in Figure 2 for Hess (HES) and the chart in Figure 3 for Apple (AAPL) show favorable results, while Figure 4 shows mixed results for Wal-Mart (WMT). Profits and losses are net of $8 per trade. In each case, the red line shows the stock profit or loss (P/L), the green line is the SPY P/L, and the blue is the combined result. To see the bigger picture, I tested 145 stocks from January 1, 2005, selected as having higher-than-average volatility and liquidity, but not considering any correlation to the SPY. I applied the exact same rules to each stock, net of costs. Figure 5 shows the stock trades without the hedge. In all, 65% of the markets tested were profitable, the best by 700%. Considering that some stocks are not good candidates, I believe this shows robustness. Hedging is an independent process based entirely on the trend of the major index, the S&P 500. In order to limit the number of hedges to what I would call major moves, I will apply a simple 60day moving average to the SPY. Those of you who are more ambitious could try two averages, a 60-day and 120-day, placing half the hedge on each one. The hedge is set when the trend of the SPY turns down and you are holding a long position in one or more stocks. The idea behind it is that it’s going to be difficult to net a profit from a long position in any stock when the overall market is selling off. In addition, I haven’t discussed


FIGURE 3: ApplE (AAPL) VS. SPY. AAPL stock also showed favorable results when trading using the stress indicator.

2000 1500 1000 500 0 -500 -1000 -1500
9/0 9 9/1 0 2 3 4 5 6 7 8 1 4/2 4/2 4/2 4/2 4/2 4/2 4/2 4/2 4/2 4/2 4/2 4/2 9/1 9/0 9/0 9/0 9/0 9/0 9/0 9/0 9/1 9/1 2 3

CombPL StockPL IndexPL

FIGURE 4: WAL-MART (WMT) VS. SPY. Here you see mixed results, with the index P/L sometimes doing better than the stock and combined P/L. At other times, the combined P/L did worse than the index P/L.

14 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs

FIGURE 5. TRADE RESULTS. Here you see the percentage returns of 145 stocks over eight years as a test of the timing method, net of $8.00 commissions.

exited with another open trade. This will keep your money active. Of course, not all stocks are good candidates because of their past performance or low volatility, so you have to have some form of selection. Even the simple act of favoring the stocks with higher volatility will go a long way toward beating the overall market. It’s possible to create a dynamic Hedge position size = (stock position × stock volatility/index volatility) × hedge ratio portfolio by scanning the results of selected stocks, but that process where: is a discussion for another article. Stock position = Number of shares in the current long position in stocks Meanwhile, try to find enough tradStock volatility = Standard deviation of stock returns over 60 days (the hedge period) ing signals to keep your portfolio Index volatility = Standard deviation of index returns over 60 days active. Hedge ratio = 1.00 to be fully hedged, 0.50 to be hedged 50% Perry Kaufman is the author of TradNote that you may choose to hedge less than the full risk ing Systems And Methods and Alpha Trading. He has been the by setting the hedge ratio. I recommend that hedging 50% of managing director and general partner of investment funds the risk is enough to avoid large drawdowns and reduces the and the chief architect of their strategies. He is president of negative impact of the hedge during other times. KaufmanSignals.com, a website that offers subscriptions to trading strategies and portfolios. He may be contacted via his STOp-lOSS website, www.KaufmanSignals.com, or by email at [email protected] Although I personally dislike using stop-losses, this strategy kaufmansignals.com. requires one. Consider that the exit occurs when the stock, which was oversold, rallies more than the SPY, pushing the FURThER READING stress indicator above 50. But what if the stock continued to Alexander, Carol [2001]. Market Models: A Guide To Financial decline relative to the overall market, and the market is still Data Analysis, John Wiley & Sons. in an uptrend? What if the stock was Enron or some other Kaufman, Perry J. [2013]. Trading Systems And Methods + company that was imploding due to mismanagement? You Website, 5th ed., John Wiley & Sons. would have no exit. [2011]. Alpha Trading: Profitable Strategies That The only alternative is to use a crisis stop, which I have Remove Directional Risk, John Wiley & Sons. set at a 20% decline in price from the entry point. On tests of about 150 stocks, this improved total performance and avoided The code given in this article is available at the Subscriber disaster. Area at our website, www.Traders.com, in the Article Code Once you have exited, you must wait for the stress indicator area. to go back above 50 before entering another trade. See our Traders’ Tips section beginning on page 50 for comMAXIMIZING yOUR RETURNS mentary and implementation of Kaufman’s technique in various Mean-reversion strategies usually have many trades held for a technical analysis programs. Accompanying program code relatively short time, so that you’re in the market only about can be found in the Traders’ Tips area at Traders.com. 20% of the time. Leaving money idle 80% of the time will severely reduce your returns. If you’re trading a portfolio of $25,000, you will need to scan the stocks and find the best five trades at any time, then replace any trade that has any exit from the trade except when the stress indicator moves above 50, so I could be stuck in a long position while the stock market heads south. The size of the hedge is based on the risk of the underlying stock position compared to the SPY.
March 2014

• Technical Analysis of STOCKs & COMMODITIEs • 15

16 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs


Fading The Big Moves B
Whenever we see a big move in the markets, it’s bound to catch our attention. But how do we protect our capital during such big moves, or better yet, profit from them? Find out here. ig moves in financial markets invariably draw the attention of analysts and traders. Analysts face the task of explaining such moves, which often challenge market theories. In recent decades, analysts have developed advanced models to accommodate the anomalies in the market return distributions — that is, the fat tails — to which the big moves are often attributed. Although theories are being constantly improved, traders still have to embrace the reality of big moves and come up with strategies to help protect them against those moves or, better yet, try and profit from them. Typically, if a big move confirms your technical and fundamental view of the market, you’re going to follow that move; otherwise, you’re going to trade against the move (that is, fade the move). Weaknesses in these big moves can potentially develop into a sizeable pullback or even a complete reversal. There are some momentum and stochastic indicators you can use with fading trades. Markets present several trading opportunities for fading the big moves. You will see in what follows that the probability of a market move at least n times as large as its largest pullback is exp(-n+1). For example, almost two out of 100 market moves are at least five times as large as their largest pullback. Of course, if you are trading in daily or weekly time frames, you may not see many moves of such magnitude, and for some markets, you may never see such a move. However, to a market maker or high-frequency trader, such moves present two to three trades every week in every traded security. In order to derive the probability of big moves, as well as the trading statistics of fading and following the moves, I use the concept of Ideal Trader, which I presented in my January 2014 STOCKs & COMMODITIEs article. In the last section, I’ll give a brief review of the concept and detail its application to quantitative analysis of trading the big moves.

Losing Luster?




by Ashot Hakobyan

First, what qualifies as a big move? In Figures 1 and 2
you see some examples of big moves in different time frames

General Electric Company (NYSE: GE), monthly
45 40 35 Close price, US dollars Adjusted for dividends and splits 30 25 20 15 10 5 0 Sep 93 Sep 95 Sep 97 Sep 99 Sep 01 Sep 03 Sep 05 Sep 07 Sep 09 Sep 11 Sep 13

FIGURE 1: EXAMPLE OF BIG MARKET MOVE. Big moves have heights much larger than the largest drawdown during the moves, so they represent large rewardto-risk ratios.
March 2014 • Technical Analysis of



Gazprom (MCX: GAZP), hourly
170 160 150 140 130 120 110 100
17 Jun 13 27 Jun 13 10 Jul 13 22 Jul 13 1 Aug 13 14 Aug 13 26 Aug 13 5 Sep 13 18 Sep 13 30 Sep 13 10 Oct 13 23 Oct 13 5 Nov 13 15 Nov 13 28 Nov 1 3

FIGURE 2: EXAMPLE OF BIG MARKET MOVE. On this hourly chart of Gazprom (GAZP), the big moves have a reward-to-risk ratio of between four and nine.

Close price, RF Rubles

and markets. The two characteristics of market moves in general are the height of the move (the absolute or relative price difference between its highest & lowest points) and the largest pullback during the move. These characteristics represent the maximum potential profit that you could make on the move and the maximum risk of such an ideal trade. Unlike regulars, the big moves have heights much larger than their largest pullback, which means they have large rewardto-risk ratios. This is why when you are developing trading strategies, you need to give the big moves special consideration. Keep in mind that these big moves don’t have to be continuous; they can include gaps and jumps. Fading of the big moves is only an entry technique; to make a complete trading strategy, I am going to add to the short-sell entry at level B (as shown in Figure 3 for a bullish move), a stop-loss at level A, and a profit-taking limit at level C. In this

generic strategy, there can be only two outcomes of fading the trade:
n Win n Loss

of size W when the profit limit is reached, or of size V when the stop-loss order is triggered.

The schematics of the trading setups for bearish big moves are the mirror of those in Figure 3. One of the most frequently used statistics of any trading strategy is the win ratio, which is the ratio of the number of winning trades to the total number of trades. In the long run, the win ratio converges to the probability of win. This probability, as I will detail in the last section, can be derived directly from the probability distribution of Ideal Trader’s profits. The resulting probability of win is V/(W+V) for fading the big moves, which confirms our logical reasoning. For example, if the stop-loss size V and profit limit W are equal, there is an equal chance of reaching either the stop-loss or profit limit. As the size of the stop-loss V increases, the probability of triggering the stop is reduced, thus increasing the probability of win. As you can see, the probability of win depends on the ratio V/W, which is exactly the risk/reward ratio of this strategy. In Figure 4 you see the probability plot for a range of values of the risk/reward ratio. With fixed sizes of win and loss, as in this strategy, the profit expectancy is calculated as the win size times the probability of win, less the loss size times the probability of loss. Using the probability of win V/(W+V), the probability of loss W/(W+V), and the fixed sizes of win W and loss V, the resulting profit expectancy comes to zero.


FIGURE 3: SCHEmatICs of tRaDING tHE bIG maRkEt movEs. Depending on the direction of the trade relative to the direction of the move (fading or following), levels A and C are either stop-loss or profit-taking limit levels for the entries (or exits) at level B. The two distinct cases (a) and (b) depict either the winning or the losing trade.

18 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs

1 0.9 0.8 0.7 Probablity of win 0.6 0.5 0.4 0.3 0.2 0.1 0
0 1 2 3 4 5 6 7 8 9 10

Instead of enduring drawdowns, you could minimize them without changing the overall profit expectancy of your trading.
Instead of fading the big moves, you might be inclined to trade in their direction. Referring to Figure 3, for bullish moves this means going long at the entry level B; placing the stop-loss at level C; and setting the profit-taking limit at level A. Figure 5 summarizes the differences in the trading setups of fading versus following the big moves. Note that the winning size in the case of following the big moves is a fixed V and the loss is a fixed W. The profit expectancy of following the big moves is zero, just as in fading the big moves. The profit variance also remains the same, that is, WV. The only changed statistic is the win ratio, W/(W+V), since the winning case is now case (b) in Figure 3 and the losing case is (a). It is also important to note the difference in the types of orders used for the two strategies (Figure 5). This difference affects the slippage and spread components of the final profit calculations. Stop-entry orders produce larger slippage on average than limit orders; stops also lose the spread, while limits can capture it if there is direct access to the order book. The more fundamental difference between fading and following the big moves is in the risk/reward ratio. In fading moves, traders are willing to take larger risks for smaller rewards, compared to when they are following moves. The higher risk is compensated by lower probability of loss. As a result, the profit expectancies of both strategies are equal.


Risk/reward ratio

FIGURE 4: PROBABILITY OF WIN. The probability of win in fading the big moves is R/ (1+R), where R is the risk-to-reward ratio (stop-loss size to profit limit size). It is impossible to win by taking zero risk (leftmost point in chart); it is equally likely to win or lose if the risk is equal to the reward; and it becomes certain to win if the risk grows infinitely.

This means that in the long run, before taking into account trading costs (margin interest, spreads, commissions, fees, and so on) you should expect zero profit from fading the big moves using any fixed stop-loss and profit limit sizes. While the profit expectancy is a constant, the variance is WV; it is proportional to the stop-loss and profit limit sizes. Note that the derived profit expectancy and probability of win are without regard to what the reasons were (fundamental and/or technical) for fading the big move or how big the move was. In other words, this strategy’s statistics do not depend on the previous price dynamics. Further, the choice of the stop or limit sizes doesn’t affect the profit expectancy. It only affects the probability of win and the profit variance.

Entry / exit order Order type Entry / exit Stop-loss / Reentry Profit limit / Reentry Win size Loss size Win probability Loss probability Profit expectancy Profit variance Win case Loss case Entry Strategy Fading Sell short Limit B A C W V V/(W+V) W/(W+V) 0 WV b a Following Buy Stop B C A V W W/(W+V) V/(W+V) 0 WV b a Exit Strategy Fading Sell Limit B A C W V V/(W+V) W/(W+V) 0 WV b a Following Cover short Stop B C A V W W/(W+V) V/(W+V) 0 WV b a


FIGURE 5: TRADING SETUP AND STATISTICS. Here you see the reference levels for each trading strategy’s setup (A, B, and C), the win or loss sizes (V and W), and the two cases [(a) and (b)] for big bullish moves.

Big moves can be used to exit a position, take some profit or loss, and wait for a pullback to reenter the position. In such setups, level B in the schematics of Figure 3 would be the exit level; level A would be the stop-entry level at which to catch the runaway trend; and C would be the limit entry level for reentering the long position. Conversely, these levels could also be used for exits from short positions and reentry. The setup details are shown in Figure 5. If either fading or following the big moves is used as an exit strategy, the loss and win of such strategies are interpreted as the difference in profit between just holding the position and exiting with subsequent reentry. Although the win and loss here do not have the same real meaning as with the entry strategies, it still pays to know their probabilities and overall profit expectancy, as these statistics modify those of the main trading strategy. The probability of win in fading and following the big moves as exit strategies are V/(W+V) and W/(W+V), respectively; their profit expectancies are zero and the variances
March 2014 • Technical Analysis of



are WV. The zero profit expectancies mean that in the long run, exiting and reentering your positions by either fading or following the big moves will not change your main trading profit expectancy. While the profit expectancy is unchanged, the nonzero variance WV means reduced drawdown on your main strategy’s equity curve. This comes from an observation that a big move against your position means a large drawdown in your trading account and potentially its ruin. Instead of enduring the drawdown, you could trade the big move and thus minimize the drawdown without changing the overall profit expectancy of your trading.

Stop-loss E

fixed stop-loss and profit limit multiplied by their probabilities V/(W+V)W2+W/ (W+V)V2 = WV; the standard deviation is the square root of WV.
MOMENTUM The probability of large moves in the markets is simply the probability of Ideal Trader’s profit of n times the target minimum profit. This probability comes implicitly from mapping the big moves to Ideal Trader’s trades, assuming the target minimum profit parameter of Ideal Trader is equal to the largest drawdown in the big move. In this article, you have seen how quantitative analysis of trading against high-momentum market moves provides simple formulas for the win ratio, expectancy, and variance.



E E Sell short entry

W Profit-taking limit

The imaginary ideal trader is allowed to place orders in the past and capture the FIGURE 6: StEpwIsE applICatIoN of IDEal TRaDER maximum profit from any market move CoNCEpt to DERIvE pRobabIlIty of loss IN faDING tHE bIG movEs. At each step, the probability of advancing larger than a target minimum profit. The to the new high without triggering the profit-taking limit is resulting profit distribution of Ideal Trader evaluated. At the last step, the probability of reaching the is exponential, with the mean equal to twice stop-loss level without falling to the profit-taking limit level gives the probability of loss sought. the target minimum profit. Ashot Hakobyan is a private trader, One of the practical applications of the trading systems analyst & developer, and concept is evaluation of trading strategies without simulation. trading signal provider. He has been a system architect, consulTo evaluate the strategy of fading the big moves, Ideal Trader tant, lecturer, and research fellow for academia, governments, must be applied stepwise as shown in Figure 6. At the first and private enterprises in Australia, Europe, and Armenia. He step, the probability of reaching a new high a small distance may be reached at [email protected] E away from the entry level is equal to the probability of Ideal Trader’s profit of size W+E or more. Assuming the minimum FURTHER READING target profit W, that probability is exp(-E/W). Hakobyan, Ashot [2014]. “The Benefit Of Hindsight,” TechIn the second step of the calculation, the probability of nical Analysis of STOCKs & COMMODITIEs, Volume 32: reaching the next high at 2E from the entry level is equal to January. the previous probability multiplied by the probability of Ideal Kaufman, Perry J. [1998]. Trading Systems And Methods, 3d Trader’s profit of size W+2E or more. Changing the assumped., pp. 126–158, John Wiley & Sons (first published in tion of the minimum target profit to W+E, the probability is 1978; currently in its 5th edition as Trading Systems and exp(-E/W) times exp(-E/(W+E)). Methods + Website). Continuing the steps iteratively for each new high at distance Murphy, John J. [1999]. Technical Analysis Of The Financial kE from the entry level, for k running from 1 to V/E, the final Markets, New York Institute of Finance. probability of reaching the stop-loss level is the product of the Olver, Frank W.J., Daniel W. Lozier, Ronald F. Boisvert, and probabilities of Ideal Trader’s profits W+kE or more. Assuming Charles W. Clark [2010]. NIST Handbook Of Mathematical the minimum target profit W+(k–1)E at each step k, the final Functions, Cambridge University Press. probability is the product of exp(-E/(W+(k–1)E)) for all k. Pezzutti, Paolo [2005]. “Short-Term Strategies: Fading The The resulting probability is exp(ψ(W/E) – ψ((W+V)/E)). Gap,” Traders.com Advantage, August 15. It involves a special function di-gamma (also known as the Rachev, Svetlozar T., Christian Menn, and Frank J. Fabozzi psi function, which is the derivative of the natural logarithm [2005]. Fat-Tailed And Skewed Asset Return Distributions, of gamma function). With the step size E reaching zero, the John Wiley & Sons. limiting probability becomes much simpler, W/(W+V). Note ‡See Traders’ Glossary for definition that this is the probability of loss V in the strategy of fading the big moves; the probability of win is V/(W+V). Having calculated the probabilities of win and loss, and with the fixed sizes of win W and loss V, the profit expectancy of the system is simply V/(W+V)W–W/(W+V)V = 0. The variance of the profits & losses is then the sum of the squares of the
20 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs


SINCE YOU ASKED Confused about some aspect of trading? Professional trader Don Bright of Bright Trading (www.stocktrading.com), an equity trading corporation, answers a few of your questions. To submit a question, post your question to our website at http:// Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C.
Don Bright of Bright Trading

WHaT Good ARe THey? Mr. Bright, I have been trading for a couple of years — not much, but mostly equities, which I know your firm specializes in. It seems that nearly every day there are economic numbers released by the government and other sources. The financial TV shows seem to expect everyone to know what these various releases are and how they should be viewed. I don’t mind saying that I really don’t know much about any of these supposedly big-news items. I can understand the unemployment rate, sort of, but they seem to discount even that when it appears to be improving. Would you be able to give me and other readers a short primer on some of these releases? Glad to try to help out. I will say that you’re not the first, nor will you be the last, to be confused by all these indicators. And you might notice that many get revised a month later anyway, so, you might think, “What good are they?” Way back when I worked as an accountant in a public accounting firm, I was tasked with filing government reports for some of our clients. This was my first exposure to just how much information gets reported by US (and global) businesses. We would report increases or decreases in physical inventory of raw materials and finished goods. We would report the current personnel information, and, when asked, our outlook for the future year (for sales, productivity, and things like that). Now, fast-forward to the current day with the massive amount of information available and shared on a minute-byminute basis. Of course, the computer and the Internet has really ramped things up. Let’s start with an easy one, retail

sales. This information is released one hour before the markets open (that is, at 8:30 am ET), and the data is for the month just prior. This report is published around the 10–15th of the month (for the previous month, as just noted). As information valued by traders and trading firms, this information ranks very high on the list. The data comes from the Census Bureau of the Department of Commerce. Raw data can be found at http://www.census.gov/retail/. This information is a measure of the total receipts of retail stores. Traders use this in their evaluation of the retail sector. This is further broken down by the type of stores (department stores, warehouse stores, discount stores, and so on). I’m sure you’ve noticed that virtually all stocks are put into a sector, as well as sub-sectors. If you’re trading Macy’s, for example, you would check to see if their results are on par with the sector. If they’re not — that is, if Macy’s were underperforming — then you might want to adjust your overall position. I’ll give you a few websites you can use as references at the end of this column that will help you find many of the myriad of indicators that we use in our trading. But first, let me try to explain how much credence we place on the numbers, and how we play them. First, you need to find out what the consensus number is, much like when you review earnings results for a specific company. (For example, a company may report a 10% increase in sales and profits but still go down in price if the consensus was estimating a 20% increase). Many of my traders trade correlated pairs (which I’ve written about previously in this column). That is to say, they will be long (that is, own shares
March 2014

of) a certain retailer and short another retailer in the same sector. Then, by using these public releases, along with other fundamental and technical data, traders can make an educated business plan on where and when to enter and exit the various pairs. Another big event is the Federal Reserve meetings — and the release of the Federal Open Market Committee (FOMC) minutes and forecasts/changes in interest rates. This is an especial favorite of mine. When this data is first released, we generally see a comparatively big move in the market, either up or down. Then, after traders and economists have had time to actually read all the released information, the index may reverse itself, adding from a few minutes to an hour of increased activity and volatility. It is always good to provide shares or futures, and buy them back (or vice versa). I find the free site http://biz.yahoo. com/c/e.html to be extremely helpful, since it provides dates and times of the various releases. In addition, you can go to www.investopedia.com for more detailed explanations of the various economic indicators. Here’s a short list: Treasury budget, retail sales, retail sales ex-auto, export prices ex-ag(riculture), import prices ex-oil, business inventories, PPI and CPI (Producer Price Index and Consumer Price Index), crude oil inventories, initial (unemployment) claims, and continuing claims. There are many more, but I think you get the idea. In trading, information is king, and how we interpret that information can be the difference between profits and losses.

• Technical Analysis of STOCKs & COMMODITIEs • 21

Expansions & Contractions
Part 1
Every trader wants to be able to predict price moves. But we know that it’s impossible to do so. Instead, focus on finding high-probability setups and manage them well. In this first part of a three-part series, we’ll look at how to identify these profitable setups. dream to be able to predict price moves. As that is impossible, the next best thing is try to find high-probability setups and handle them with correct position sizes and the right aptitude for risk management. One way to find high-probability setups is to look for divergences.

The Calm Before The Storm


by Dirk Vandycke part from the use of derivatives, perhaps the only way to make money in the markets is in the difference between the price at which a position was opened and the price at which it was closed. It is every technical analyst’s wildest


Before you start to look at divergences, you need to be aware that they are closely connected with the contraction and expansion of market prices. You may have noticed that price ranges contract before they expand. I call this the tsunami effect — similar to how the sea recedes prior to the devastat-

22 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs


ing wave that follows. In the same way, volatility and daily range shrink before a stock starts running, thereby sucking all liquidity out of the market. Tsunamis, however, are far rarer than price expansions and the often subsequent trends. The question is, can we detect a tsunami before it floods us? Any good divergence indicator will need to monitor contraction as a precursor to expansion. It is the contraction prior to the expansion that will lead you to detect future price movement.


There are two ways to look for divergences. One is by viewing charts visually to look for price, volume, or any indicator making higher or lower tops and bottoms, while having another indicator do the opposite. Let’s say price is moving to a new high while volume is declining. This is considered a negative divergence. Typically, indicators are compared with price to spot divergences. So when price takes out a previous low while an oscillator at the same time shows a higher bottom, it is generally considered bullish and called a positive divergence. The second way to look for divergences is to build an indicator that measures divergences in its own right, that is, one where you don’t compare two different time series. This is usually done by subtracting two different time series. In the case of a negative divergence, the difference will grow, and in a positive divergence, the difference will become smaller. All kinds of tricks are then applied to this difference, such as mirroring it around its x-axis to show increases in the case of positive divergence and decreases for negative divergences. Looking at the time difference between two time series comes with its share of problems. For example, both can go higher, but one of them can go higher much quicker, which would increase the difference as well. Another problem is that this suggests that divergence and correlation are two different things. So if you measure one properly, it doesn’t necessarily imply that the other is measured correctly. Then of course — and this is minor — there’s something odd about how a divergence is referred to as positive or negative. It suggests a directional dimension that doesn’t necessarily have to exist. You may want it to exist depending on your position, but one indicator cannot be good and bad at the same time. Thus, you need to have one indicator for bullish signals and another for bearish signals. You need to have a pair of indicators, not just one. Yet another problem with the classical solutions is that they aim to measure what I will call extrinsic divergences. In extrinsic divergences, you try to capture a divergence taking place between two different time series. Popular as they may be, extrinsic divergences are marginally reliable. This may be because of the way they are being quantified rather than their nature of being measured between two time series. But people tend to look for divergences, implying they are already in progress as soon as they start seeing them. That’s probably why extrinsic divergences are so popular. In comparison to extrinsic divergence, little research seems to be done (nor has been done) toward intrinsic divergences.

Intrinsic divergences point to divergency of time series with themselves, when looking at them from the time dimension. The frequency analysis of time series and intrinsic divergence in the frequency spectrum is also underresearched, but that is beyond the scope of this article. In this article series, I will be looking at intrinsic time divergence. Last but not least, there’s the problem of indicators needing parameters that need to be hardwired with their usage in systems. We need adaptive, parameter-less, and objective indicators. That’s one of the main efforts put into the ChartMill indicators, the ChartMill bull/bear being one (pair) of them. If you want to detect deviating behavior by looking at intraday behavior, the place to start is to know what normal behavior is and how you can quantify it. Contractions usually take place because of a lack of interest (volume) and the accompanying shrinking of daily range (volatility). Expansions are characterized by increasing volume but more so perhaps by the surge in the daily price range due to illiquidity. When you see this happen, it suggests that, at that moment, the consensus about the future value deviates greatly from the current price. This results in the start of an outbreak and the ignition of a possible new trend or the firing up of an existing one after some consolidation. Be aware, however, that volatility can increase or decrease while prices trend. This is one of the problems I mentioned when it comes to detecting divergences. There are several ways to quantify volatility. In this article I am going to use a simple technique to measure volatility — the true range over a certain time period. This is the average range over that period but adjusted for gaps. I will define it a little differently, because I need a few intermediate numbers (the end number will be the same, nevertheless). The true range is the difference between the true high and the true low. The true high is the highest of either the high of the period or the previous period’s close (which will be higher in the case of a gap down). The true low, likewise, is defined as the lowest of either the period’s low or the previous period’s close (which will be lower in the case of a gap up). This way, I add any gaps from the previous period’s close to the range of the price period: True high = THi = max(closei–1,highi) True low = TLi = min(closei–1,lowi) True range = TRi = THi – TLi Average true range = ATRi = SMA(TR,20) Volatility can be quantified as the moving average of true range or ATR over a certain number of periods (typically 20). At first glance, the ATR’s momentum, measured as the difference between the ATR at two distinct times, appears to be a favorable candidate for measuring contraction. But there’s more.
March 2014


• Technical Analysis of STOCKs & COMMODITIEs • 23


Your objective should be to spot divergences before they materialize into price runs or drops in price.
calculate the relative close location (RCL) as: RCLi =
FIGURE 1: EXPANSIVE URGE ON TRENDING DAyS. Here you see a scatterplot of high-return days on random stocks in function of their expansive urge. It seems both measures are closely related. Strong percentage gains or losses correlate with high or low expansive urge.

Closei – TLi TRi


Your objective should be to spot divergences before they materialize into price runs or drops. You want to catch a window of opportunity seasoned with probabilities before it becomes clear to anyone what is happening and the window closes. Hence, you want to look for cumulating intraperiod divergences. The best way to do this is to look for some interesting facts about trending days. On days when there’s a lot of conviction in price moving in one direction (trending days), there’s a strong correlation between the urge to expand and where the period closes in the range. This is not a new idea. There are many indicators that measure this, and several traders use some principle to measure where the close is in relation to a period’s range. I

If the close is at the high and there is no gap down, the value of RCL will be 1. If the close is at its low and there has been no gap, the RCL will be zero. Note that contrary to most sources, I use the true high and low instead of the mere low and high. This means that I am looking for an indication/divergence in the expansion that takes place. You can find this divergence in the deviant behavior of the normally strong correlation between trend days, the expansion, and the close location value (CLV). I’ll define the expansive urge value (EU) of a period as: EUi = Closei – Openi TRi

This key performance for a period looks at what fraction of a period’s true range was bridged between its open and its close. You will have to look at extreme values to understand this metric. If a stock’s period opens at the true low and closes at the true high, the EU will be one (at least if there was no opening gap left open by the close). If, instead, a stock opens at the true high and closes at the true low, the period’s EU will be -1. Take a look at Figure 1, which is a plot of a random set of stocks. On the x-axis is each period’s return at the close against the previFIGURE 2: STOCKS TEND TO CLOSE NEAR EXTREMES ON HIGH-TRENDING DAyS. Here you see RCL values scattered with ous period’s close. On the EU values for random stocks. Only high-return periods were plotted. It’s clear from the chart that stocks tend to close at their high/ y-axis is the EU value. So low on expansive periods directed by the trend for that period.

24 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs

each point on the plot represents the day-to-day return and its expansive range of a period. I only withheld the periods of those stocks that showed more than or less than a 5% return. Because of this, all points between -0.30 and +0.30 disappeared on the y-axis. So on strong trending days, the close is near the extreme of the period that’s located at the same side as where the move was going. For example, on any day raking in more than 5%, the close tends to be at the period’s true high. Does this mean that the EU could be a possible indicator of trending days, next to high returns and, with it, correlated with the RCL value? The chart in Figure 2 shows that the EU could be an indicator of trending days. In this chart, the same periods are scattered by their EU value on the x-axis and their RCL value on the y-axis. Again, you will notice that the upper-right and lower-left corners of the graph are populated by points. This suggests that the RCL tends towards 1 as the EU moves to 1, while it moves toward to zero when the EU is near -1. This means that high-trending (expansive) days tend to close at the period’s extreme toward the direction of the trend. This is the true high for a strong up day and the true low for a strong down day.

Alpha — Premium that an investment portfolio earns above a given point of reference; a measure of stock performance independent of the market. Arbitrage — The simultaneous purchase and sale of two different, but closely related, securities to take advantage of a disparity in their prices. fat tail Average True Range — A moving average of the true range. Chi Square — A statistical test to determine if the patterns exhibited by data could have been produced by chance. The chi-square test with Yates’s correction using two-way statistics for decline vs. advance is:

x2 =


In the second part of this three-part series, I’ll look at a moving window to look for such expansive days and count those that diverge from what you would normally expect. This will help to arrive at truly intrinsic divergence. Stay tuned! Dirk Vandycke is actively and independently studying the markets since 1995 with a focus on technical analysis, market dynamics and behavioral finance. He writes articles on a regular basis and develops software partly available at his co-owned website, www.chartmill.com. Holding master degrees in both electronics engineering and computer science, he teaches software development and statistics at a Belgian university. He’s also an avid reader of anything he can get his hands on. He can be reached at [email protected]


Vandycke, Dirk [2013]. “The Chartmill Value Indicator, Part 3” Technical Analysis of STOCKs & COMMODITIEs, Volume 31: March. [2013]. “The Chartmill Value Indicator, Part 2” Technical Analysis of STOCKs & COMMODITIEs, Volume 31: February. [2013]. “The Chartmill Value Indicator,” Technical Analysis of STOCKs & COMMODITIEs, Volume 31: January.
‡See Editorial Resource Index

where: oj = actual observed frequency of test ej = expected or theoretical frequency of test. (Also: Test of statistical significance or confidence of the expected mean and standard deviation.) Debit Spread — The difference in value of two options, where the value of the long position exceeds the value of the short position. Exchange-Traded Funds (ETFs) — Collections of stocks that are bought and sold as a package on an exchange. Fade — Selling a rising price or buying a falling price. A trader fading an up opening would be short, for example. Greeks — Jargon; a loose term encapsulating a set of risk variables used by option traders. One-Tailed T-Test — A statistical test of significance for a distribution that changes its shape as N gets smaller; based on a variable t equal to the difference between the mean of the sample and the mean of the population, divided by a result obtained by dividing the standard deviation of the sample by the square root of the number of individuals in the sample. Implied Volatility — The volatility computed using the actual market prices of an option contract and one of a number of pricing models. For example, if the market price of an option rises without a change in the price of the underlying stock or future, implied volatility will have risen. Pair Trading — Taking a long position and a short position on two stocks in the same sector, creating a hedge. Relative Strength — A comparison of the price performance of a stock to a market index such as the Standard & Poor’s 500 stock index. Strangle — The purchase or sale of an equivalent number of puts and calls on an underlying stock with the same expiration date but a different exercise price. Usually, the put has a low strike price and the call has a higher strike price. T-Test — A statistical test of significance for a distribution that changes its shape as N gets smaller; based on a variable t equal to the difference between the mean of the sample and the mean of the population divided by a result obtained by dividing the standard deviation of the sample by the square root of the number of individuals in the sample.
March 2014




o j – e j – 0.5 ej


• Technical Analysis of STOCKs & COMMODITIEs • 25


Trend Switching With ETFs
Given the volatility in the markets, you need to know when to get into a trade and when to get out. The use of ETFs has made this easier. Find out how.

Trends And Seesaws


by Moshé Prince rend switching and trigger switching are the foundation of a successful trading/investing strategy in exchange traded funds (ETFs). I know there is a line of thinking out there that says buy & hold is the way to go, but in my opinion, the days of buy & hold are over. After decades of trial and error, I have found that buy & hold has had merely a modicum of success.

there are tools available that you can use to get out of trades at the right time. As the market changes with the times — or changes the times — you must be flexible to know when an old process no longer works. These days, following trends without being aware that the market may go in the opposite direction seems to be the tried and true method. But some would argue that the buy & hold approach is the only way to invest. Everyone has a right to his or her opinions, and I have mine. One thing, however, that will never change is that the market is volatile and you need to know when to get in and when to get out. If it were only that easy, everyone would be doing it! Fortunately, with ETFs — and I am not talking about the typical ETFs — the odds have moved a bit more in your favor. I am talking about the inverse ETFs, which track the market when it’s going down. Succinctly, when the market goes down, you can make money conventionally in a down market. You don’t have to mess with options, or puts, or shorting the stocks with different trading parameters than trading ETFs. ETFs trade like an individual stock; the ones I track are liquid and diverse. Being that they are a fund and not an individual stock, there is a lot less impact to the ETF by corporate malfeasance or when the guidance shows misprojected earnings. Most certainly, the impact could be huge to the overall stock price of an individual stock when a CEO steps out of line.


Basically, trend switching is made up of four components. They are as follows: 1. Know when to identify a market trend


Do you have the stomach to watch an unnecessary loss of more than 30% to 40% in your portfolio at any given time and to wait out a recovery? Luckily, you don’t have to because
26 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs

2. Recognize when that trend has completed


FIGURE 1: SPY VS. SH. Here you see that the SPY and SH move in opposite directions.

3. See that a new trend is under way

4. Take action to best support an appropriate trade. What is important is to know when the trend is ready to switch direction so you are not left behind in the possibility of a money-making opportunity. Knowing when to get in and when to get out of the market is a fundamental that sometimes gets overlooked. There are several indicators and tools you can use that will help you identify ongoing trends or when there is a switch in trends.

these funds are made up of the 500 stocks in the S&P 500, they breed solid diversity. More important, they move opposite to each other, as you can see from the charts in Figure 1. Theoretically, you would be long the SPY during a bull market and long the SH during a bear market. Two ETF pairs that I track closely in my trading are the ProShares Ultra Gold (UGL)/ProShares Ultra Short Gold (GLL) and Direxion Daily Financial Bull 3X Shares (FAS)/


An example of the diversity in an ETF can be seen between the SPY, which is the upside 1X Beta S&P 500 ETF, and the SH, which is the ProShares Short 1X Beta to SPY and tracks the downside market to the S&P 500. Since both

Know when the trend is ready to switch direction so you are not left behind.
March 2014

• Technical Analysis of STOCKs & COMMODITIEs • 27


FIGURE 2: UGL VS. GLL. Whether gold is moving up or down, you can make money on it by trading this ETF pair.

Direxion Daily Financial Bear 3X Shares (FAZ). Using an exponential moving average (EMA) crossover system, you can see from Figure 2 that I would have entered a long position in UGL in January 2012 and stayed there till March 2012, when the trend showed signs of turning. This was indicated when the shorter-period EMA crossed below the longer EMA. At

Knowing when to get in and when to get out of the market is a fundamental that sometimes gets overlooked.
28 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs

that time, I entered a position in GLL since the shorter period EMA crossed above the longer EMA and stayed in that position till July 2012 when there was an indication of a trend change. If both ETFs show nondirectional movement in the markets I will stay in cash. I would enter a long position in UGL in mid-August 2012. A similar scenario took place with the FAS/FAZ pair of ETFs (Figure 3). It is clear that the two move opposite each other. You can be long the FAS during a bull market and long the FAZ during a bear market. Some individuals and large funds have built healthy fortunes utilizing ETF pairs. It is not an easy task by any means, but it is more doable than ever. Opportunities to realize benefits with 75–85% accuracy are entirely possible, but given that there are no guarantees in the stock market, you still need to follow a well-thought-out plan.


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Market volatility, volume and system availability may delay account access and trade executions. Offer valid through 4/30/14. Minimum funding (within 60 days) of $2,000 required (up to 500 commission-free Internet-equity, ETF or options trades). Contract, exercise and assignment fees still apply. See Web site for details and other restrictions/conditions. TD Ameritrade reserves the right to restrict or revoke this offer at any time. This is not an offer or solicitation in any jurisdiction where we are not authorized to do business. Mobile leadership claim based on analysis of publicly available competitor data concerning number of mobile users and daily average revenue trade levels. TD Ameritrade, Inc., member FINRA/SIPC/NFA. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2014 TD Ameritrade IP Company, Inc. All rights reserved. Used with permission.

FIGURE 3. WHEN ONE MOVES UP, THE OTHER MOVES DOWN. When your indicators tell you the trend will be switching, move your positions to the other ETF in the pair.

Don’t forget to identify your risk tolerance. That alone can take you down many different roads. With a solidly executed road map, your opportunity to succeed goes up exponentially once you define how much success you truly want to achieve. The road could be bumpy with more risk than you can expect if you have not done your homework. Along with increasing your level of stock market knowledge, learning about and venturing into ETFs can be a powerful and worthwhile journey. As with anything, you have to do it the right way.


Moshé Prince developed the trigger switching system and specializes in ETFs and market timing. He may be reached at www.trendswitchingsystems.com.


Prince, Moshé, and Brian Scollick [2013]. “Trading ETF Pairs,” Technical Analysis of STOCKs & COMMODITIEs, Volume 31: January.
‡See Traders’ Glossary for definition ‡See Editorial Resource Index

30 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs

Explore Your Options
Got a question about options? Tom Gentile is the chief option strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question for our Explore Your Options column, post it to our website at http://Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C.
Tom Gentile of Optionetics

AND THE MOST IMPORTANT RULE FOR OPTION TRADERS IS… Having just returned from another seminar, I ran across a situation that I’ve encountered before on many occasions: A student who has some type of great short-term system decides he wants to start trading options on it. The problem is one that many of us run into when we get started with options. Imagine this scenario: You spot a great opportunity, put on a low-risk trade, and execute your plan. The stock moves the way you expect it to, but when you get out, either the trade lost money or made very little. You followed all the rules to ensure your trade would work. What happened? Chances are, you were trading illiquid options with a wide spread between the bid & ask. If you’re not looking at how liquid your options are, even the best-laid plans can fall apart. This is especially true for spread traders. As an example, take a look at the stock of Church & Dwight (CND) in Figure 1. CND is trading just shy of $66 per share, moving in an upward direction based on the current swing pattern. Using Elliott wave theory, you look at the previous Wave 4 and note that the recent low of $65 seems to be holding and the target of $68.55 looks good.

A simple trade using a call option might be the right idea here, so you look at the option quotes for calls that are inthe-money, as they tend to have less time value and move like a stock. April is the shortest time frame that works with your analysis, but it’s 96 days from expiration. The stock looks safe enough, so let’s assume we want to price out the April 60 call options (Figure 2). If you were to buy the April 60 call options for 6.70, this would give you cost and risk of $670 per contract. Then, if the stock goes up to a price of $68.55, the calls would be worth 8.55 points, or a theoretical profit of 1.85. But wait, there’s a problem! The current bid/ask spread on this spread is $1.60! This is an insane spread! Even if we make our target, much, if not all, of your profits would be eaten up in the spread. So much for your plans. So how can you avoid these types of problems with options? 1. Remember the golden limit rule. Placing limit orders on options will reduce your spread risk, thereby shaving the difference between the bid & offer on options you intend to buy or sell. This works well with wide spreads when entering orders, but when you want to exit, this can be difficult,

especially near expiration. 2. Exercise your rights. One way to deter limit orders on the way out of a trade is to simply exercise the options, and then sell the stock, which can virtually eliminate the slippage on the exit. The only problem here is that you might suffer some overnight risk, as the option exercised to stock may take some time. One way to overcome this is to short the stock before exercise, eliminating the overnight risk. The only problem here comes if the option you are trying to short isn’t on the short sell list. 3. Penny Pilot program. In January 2007, the Chicago Board Options Exchange (CBOE) started a program to reduce the bid/offer spread on options of certain liquid stocks. The minimum increments for all classes in the Penny Pilot program are: • $0.01 for all option series below $3 (including LEAPS) • $0.05 for all option series $3 and above (including LEAPS) 
 • For QQQQs, the minimum increment will be $0.01 for all option series. Basically, this means the options in this program are the most efficient and have the tightest bid/ask spreads. I limit most of my option trading to this list, due to its liquidity. You can find out more about these options and get a full list at https://www.cboe.org/hybrid/ pennypilot.aspx. Good (and liquid) trading!


3 1 2

68.55 30 Jan



FiGure 1: Will the upWard moVe Continue? Using Elliott wave theory, you look at the previous Wave 4, and note that the recent low of 65 seems to be holding and the target of 68.55 looks good.

FiGure 2: CheCK out those spreads! The current bid/ask spread on the April 60 call option is $1.60.

March 2014

• Technical Analysis of STOCKs & COMMODITIEs • 31


Trading Like An Insider With Guy Cohen
Guy Cohen is a leading innovator in financial trading. He is the creator of the options volatility indicator (OVI) and the FlagTrader and OptionEasy trading tools. He is the author of the best-selling trading books The Insider Edge, Options Made Easy, The Bible of Options Strategies, and Volatile Markets Made Easy. With a master’s in business administration in finance from the Cass Business School of London, he trades both stocks and options using his academic background as the foundation for his trading methods. He has extensive experience in trading and analyzing both the US and UK derivatives and stock markets. Cohen is a successful private trader and also a trading coach. Based on years of research, planning, and development, his firm produces sophisticated mathematical models with which to approach the markets. He can be reached through his website at www.ovitradersclub.com or via email at [email protected] STOCKs & COMMODITIEs Editor Jayanthi Gopalakrishnan interviewed Guy Cohen via telephone and email on January 8, 2014 on ways to keep abreast with market momentum, mistakes traders make, and how he uses data. Guy, please tell us a little about yourself and what attracted you to the financial markets. How did you get interested in them? I was always interested in the financial markets, even as a teenager. From a professional standpoint, I got into finance while I was specializing in commercial real estate in London. My original idea and plan was to combine my commercial real estate training with finance in order to become a property developer. I completed my City exams in London, which is the equivalent of the tests a person must take in the US to work on Wall Street, and then I got an MBA in finance at Cass Business School, where I took the options elective. From that point, I started developing software for my own option trading. At the time, option-trading software was somewhat primitive and didn’t do what I needed, so I started building my own software application, and then was compelled to keep going. Why options? Was it just because of your academic background? Yes, pretty much. Actually, the real reason was because it was feared as the most difficult elective and I just wanted to challenge myself. I didn’t really believe I could do it, so I thought I should give it a try. At that time, I was in the mood to take on any challenge, and the bigger, the better. That was really what it came from. After you did that, did you start trading for yourself or were you employed by a firm? I started trading for myself, but I needed the software to show me what my positions were at any time. To help me understand them better, I took a very visual approach to options. The entire software was designed around a visual output of risk profiles and the greeks. Thus, it gave me a feel for what I was doing visually, on literally more than 60 strategies. My application was doing it better than what was available at the time…and there’s nothing like building something for yourself to accelerate your understanding of it.

Ahead Of The Crowd

Once you know that smart investors are building a position, you can follow them, as long as you have a wellconstructed trading plan.
In your book The Insider Edge, you write that you like to look for price breakouts. How do you find the stocks that will have the likelihood of a potential breakout? That’s done through specific algorithms. I designed algorithms to find stocks that are consolidating near the pressure levels that would constitute a breakout. You say that chart patterns are very important. Why are they important, and which ones are the most important to look for in order to identify these breakouts? There are three main components to my overall strategy — the right chart patterns, the right indicators, and a good trading plan. There are particular chart patterns that

32 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs

are important. The reason that some chart patterns are important for the way that I trade is because they are telling me a story. Everything I look at must be explaining the transactions that are actually happening. The principal aim is to hitch a ride with a stock that is moving. If the transaction activities are suggesting position building in a particular stock, you can surmise that the price is likely to continue moving in that direction. I want to hitch a ride on that move. I’m not looking to buy at the lows and sell at the highs, because I believe that’s a thankless task. What I’m looking to do is grab a ride on a stock that’s already moving and that looks likely to continue to move. That’s established by a combination of factors. The first factor is by the chart pattern itself. There are only a couple of chart patterns I’m looking for. I’m looking for consolidation patterns; that can include your basic flags, pennants, or triangles. It also can include cup & handles, because cup & handles are effectively just a bowl

pattern (which in itself can be bullish) with a consolidation at the end. I also look for consolidations that are occurring in the context of a broader pattern such as a head & shoulders pattern. The main point is that the pattern itself has to be telling you a story of pent-up demand or pent-up supply that is now at a pressure level. That’s the key. And then I add something else to the mix, the options volatility indicator (OVI), which is an indicator I created. Again, I’m only looking for patterns that convey the reality of buying & selling activity. You mentioned there are three main components to your overall strategy. Besides chart patterns, you also look at indicators. We all know that indicators tend to be lagging, but yet, they contain useful information. Sometimes they contain useful information; I’m of the view that most indicators do not contain useful information! I

find that many traditional indicators are irrelevant because they are highly subjective and liable to unpredictable changes due to the changeability of market behavior. They often have subjective built-in parameters, which different traders set in different ways. This is why the whole thing becomes too subjective. The more subjective you are with your analysis, the less consistent your trading will be. For me, the indicators and chart patterns must relate and correlate directly to actual transactions. Then it’s a matter of following where the transaction money is going, and going about it with a robust trading plan. I believe using indicators such as moving averages and moving average convergence/divergence (MACD) as actual buy or sell signals is flawed and contributes to a lot of the failures that traders encounter in trading the financial markets. What I and my students like to do — and we’ve done this based on mathematical research — is to dig deeper



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Maarch 2014 • Technical Analysis of


tory (Figure 1) and I need the share price to be consolidating just below a bullish break­ out level. In this way, the share price and the share options are telling me the same story, that is, that real money is accumulating for this stock. For a bearish trade, I need the OVI to be consistently inside the negative territory and the share price consolidating just above a bearish break­ out level. Again, the narrative of stock and option transactions must be consistent. Can you give us an overview of the OVI? How does it give the trader an edge? The OVI is an indicator derived from option transactions. It essentially shows the sentiment of option traders as evidenced by actual transactions. However, it must be used alongside stock price behavior so you get the full picture of what is going on. We’re looking for overwhelming evidence of mass position building on both sides. This is distinct from situations where there’s evidence of significant hedging, which we don’t want. If we trade in the direction of likely position-building activity, then we’re more likely to make money. This is our edge. The OVI is not a lagging indicator; it’s

a leading indicator. The way we use it prior to a break­ out makes it leading. It’s not based on historical data; it’s based on current data. We use it in conjunction with a consolidation pattern, which makes it a leading indicator prior to a potential breakout. I take it that looking at the option transactions is what led you to create the OVI indicator. Why is it important for a stock trader to look at option transactions? We’ve found it to be highly significant. First of all, you don’t have to trade or even understand options to use the OVI indicator. The OVI is presented as a very simple line that ranges between -1 and +1. It gives you good information regarding option activity. It tells you what issues the advanced, savvy investors are potentially accumulating positions in. Once you know that smart investors are building a position, you can then follow them, provided your trading plan is one that’s well constructed. That’s what we’re looking to do. We’re looking for the evidence of accumulation of position building, both in the stock chart and in the options. One doesn’t necessarily work without the other. We don’t look at the OVI by itself. We have to have the confirmation from what’s actually going on with the stock price, as well. I found your story very interesting about how you created the OVI. Could you share that with us? Yes. The OVI came as a result of years of looking at option chains. Without really thinking about it, I was visualizing a line that was going up and down. If I looked at a particular stock every day for several weeks, I would remember it from the several days before because I could only focus on one or two stocks at a time. I would therefore get a clear idea as to the strength of option sentiment for a particular stock and I’d also be looking at the charts. It was only when one of my students asked me why I was getting certain things right so often that I consciously realized that I was constructing an image of the option transactions in my mind while linking it with the price

into the quality of transactions that are occurring with a particular stock issue. We do look at the chart patterns of the stock price itself, but we also look at the option transactions under the radar. By analyzing the option transactions with the OVI, we have been far more consistent and methodical in our approach and far less subjective. In fact, we can be entirely objective about the way we can look at things. This makes things far more consistent, as a result. How do you use these patterns and indicators to identify breakouts? For a bullish trade, I need the OVI to be consistently inside the positive terri-


FIGURE 1: POSITIVE OVI. Here you see that when the option volatility index (OVI) is in positive territory, there is a clear upward trend in price.

34 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs

chart on the screen. So it then sprang to mind, “Why don’t we create a line that represents option transactions?” Obviously, in practice this was a challenge because option data is dirty, awkward, vast, and not all of it is going to be relevant to successful trading. It took a long time because the OVI is a very sophisticated indicator, but the end deliverable is highly relevant and very easy to interpret. I thought it was very interesting how in your book you explained the various patterns you look at. For example, a certain stock could be hitting a resistance level and you look at the OVI and various other factors. Only when all of them are confirming do you actually place a trade. You mentioned that you don’t enter about 50% of the trades that you consider because they don’t actually break out. That’s right, and that brings us to the third component of the way we trade, which is the actual trading plan. Orders are only executed if a breakout occurs. Over 50% of our orders are not executed because there is no price breakout; this eliminates a large proportion of trades that would have been losers. Think about it: If 50% of the trades that you would have made end up not activating because they would have lost, then you’ve significantly shifted the odds in your favor because you haven’t entered those trades that would’ve turned out to be losers. You achieve this by designing a robust trading plan that has well-defined entry & exit levels. These levels typically get hit when moves have a better chance of resulting in a bankable profit. I think a major strength in our trading plan is that many of our orders won’t get filled. The trading plan dictates how and when to enter and exit. We enter on a price break­ out. We exit at either a predetermined initial stop-loss when it’s a loser, or a graduated trailing stop when we’re profitable. For profitable trades, we calculate several profit levels, at which points the trailing stop calculation is adjusted. Is that how you manage your risks? Yes, the trading plan itself mitigates many potential risks. I only enter on a

price breakout in the direction I want the stock to be traveling in, and I don’t trade a stock just before an important news event relating to it, for example, earnings. This dramatically reduces the chance of being trapped and gapped. Risk is also managed by way of position sizing for each trade in relation to your overall trading bank and the amount of leverage you’re using. The institutions always seem to have the edge because they get information well ahead of the rest of us. Is it true that the OVI indicator was your attempt to get that edge as a retail trader? Yes, but there are other reasons as

to what gives the institutions an edge. They’ve got sophisticated mathematical models. That’s what was required for us to create the OVI. As I mentioned earlier, option data is very fiddly. A lot of it is unreliable and it’s tough to interpret. We’ve been accumulating this data for many years and we have a lot of experience with it. Then it was a question of building a model with mathematical relevance. We’re doing things in an institutional way, and that has required institutional brains and an institutional budget. This took years of research, planning, and development. Once all that was done, we knew we had something that was very valuable. And it has recently been proven mathematically. Traders sometimes refuse to accept the fact that they can be wrong. That actually is one of the biggest hurdles for traders. They know how to enter positions, but they just don’t know how to exit them. Is there any way that traders can overcome this thinking, or is it just a matter of accepting that they sometimes can be wrong? Being wrong is part of trading. The

Maarch 2014 • Technical Analysis of



NeuroShell Trader Intelligent Power

11 years in a row!

are mathematically based. That’s the method we have followed; we’ve gone from using observation to mathematical proof. An individual trader has to accept that they will be right some of the time and wrong some of the time, and then they should go with a model of trading that skews the odds in their favor. The beauty of the stock market is that you can actually do that. You can’t really do that in Las Vegas, but you can do that with stocks. It requires patience, it requires discipline, and it requires sticking to a method that’s valid. The problem is that most traders are using methods that aren’t valid in the first place. They’re seduced by big promises and fanciful techniques. There are some really wacky ones out there, and they can be very seductive to an inexperienced trader. What about overtrading or putting too much money into positions? That can work both ways. Many fortunes have been made by someone “backing up the truck” into what they thought would be a great investment, and it turned out well. But it can also go the other way; it can go wrong as well. I think many of us who have made big money in the stock market did at some point back up the truck into something that really did well for us. The key, though, is getting that decision right. Murphy’s law is bound to go against amateurs in such a situation. A balanced portfolio and a methodical approach is ultimately what you really want. That said, once in a while, there may be good reason to invest a bigger allocation into a particular issue where all the signals have lined up, provided you manage your risk properly. This should only happen with a decent amount of experience, though.

How long have you been trading? I think I put on my first trade when I was a teenager, but I don’t think I would call myself a trader at that point. I’d say I’ve been a “trader” for about 15 years. But even then, there’s been a steep learning curve because I’ve added more sophistication and more mathematics to what I was doing before. Every year that goes by I think, “I wish I knew then what I know now.” There’s always something that I’m learning, and that’s why I’ve always been able to improve our methods incrementally. What are you doing now? I’m currently building a model that we hope will become a fund. We recently had an independent external review by a Wall Street quantitative analyst to evaluate the OVI specifically and our method of trading it. The assessment has been very encouraging, so we’re now creating more sophisticated mathematical models to start such a fund that will have its foundations in the methods we’ve just discussed. As a result, I’ve also been able to bring improvements to my student traders who have access to my OVI trading tools. I trade with them, hold webinars, workshops, and continue to develop the software for my students, who are a valued resource because they give valuable feedback. Some of the ideas that I’ve manifested owe their roots to communications with my students. It’s an important part of the creative process. Thank you for speaking with us, Guy.

www.NeuroShell.com 301.662.7950
skill is to be right in a bigger way than you’re wrong, whether that’s by having more winners than losers, or bigger winners than losers in their various combinations and permutations. You’ve just got to accept the fact that you are going to be wrong on some trades. If you’re a fortune teller, then you’d be on a tropical island by now living the good life. What you need to do — and what rarely happens — is you need to use proper, methodical, mathematically-based formulas to get your edge. Unfortunately, in the stock market, there are just too many weird and wonderful techniques that promise a lot and deliver very little. The reason the institutions largely make money is because their methods


The reason the institutions largely make money is because their methods are mathematically based. That’s the method we have followed; we’ve gone from using observation to mathematical proof.
36 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs

Cohen, Guy [2005]. The Bible Of Options Strategies, FT Press. ____ [2012]. The Insider Edge, Wiley Trading. ____ [2013]. Options Made Easy, 3d ed., FT Press. ____ [2012]. Volatile Markets Made Easy, FT Press. Gopalakrishnan, Jayanthi [2005]. “Which Options Strategy Should You Use? Guy Cohen Tells You,” interview, Technical Analysis of STOCKs & COMMODITIEs, Volume 23: August.

INSIDE THE FUTURES WORLD Want to find out how the futures markets really work? Carley Garner is the senior strategist for DeCarley Trading, a division of Zaner Group, where she also works as a broker. She authors widely distributed e-newsletters; for your free subscription, visit www.DeCarleyTrading.com. Her books — Currency Trading In The Forex And Futures Markets; A Trader’s First Book On Commodities; and Commodity Options — were published by FT Press. To submit a question, post your question at http://Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C.

Carley Garner

STRANGLING FOR PROFITS? (PART 3) If strangle traders can make money regardless of market direction, doesn’t it provide the best odds of success? In the previous two issues, I addressed the pros and cons of trading option strangles. This month, we’ll focus on the strategy of placing futures strangles. Futures strangles differ dramatically from option strangles in that the reference to “strangle” applies to the trade entry orders rather than the trade itself. To illustrate, an option strangle is a strategy in which a trader holds open, and opposite, positions in calls & puts with the same underlying asset; those trading futures strangles are placing opposite orders to enter a futures contract with the intention of being filled on only one of them. This makes sense, because a trader cannot be long and short the same instrument simultaneously, but he can be positioned to attempt to profit from either a rally or a decline should one of them materialize. Specifically, a futures strangle involves the placement of a buy stop order above the current market price, and a sell stop order below. If you are not familiar with a stop order, it is simply one in which a trader will buy a futures contract if the market rallies to the stated price, or sell a futures contract if it falls to the stated price. Traders typically place their stop orders at, or beyond, support & resistance levels in the hope that a breakout of the range will elect one of his stop orders. In other words, the trader is anticipating a big move in one direction or the other and believes he can profit from the momentum of a breakout. On paper, futures strangles appear to be a promising strategy; after all, a rangebound market will eventually break out of the pattern in one direction or the other. In

reality, trading futures strangles is a difficult way to make money, because what is inevitable in the long run can be chaotic in the short run. For example, markets often experience “false breakouts”; in such a scenario, the futures price will move above or below the current consolidation pattern, but prices then quickly reverse at precisely the most inopportune time for a breakout trader. In theory, the momentum of exceeding support or resistance levels should provide an extension of the move, but in reality. we often see the buying or selling dry up. It only takes a few of these mishaps to frustrate a trader and cause significant financial damage to a speculative account. One of the biggest mistakes futures strangle traders make is placing their buy and sell stops ahead of a major announcement. For grain traders, this might be a USDA report, or for financial futures traders, it might be the monthly employment report. In either case, the market is poised for massive volatility. When traders look back at the daily charts, price may appear to have a clean break in one direction or the other on days when such events take place, but what they fail to realize is that the ultimate post-announcement direction is rarely the same as the initial knee-jerk reaction. Further, it isn’t out of the question for the market to temporarily break out in one direction, then reverse course to break out on the other side, only to see prices revert back to their starting point and settle near unchanged. Accordingly, traders are often whipsawed into large losses in minutes, or even seconds, during sessions that pose event risk. An example of this took place on December 6, 2013, when the employment report triggered massive volatility in the Treasury
March 2014

market. Going into the session, the 30-year bond had established a trading range between 129’13 and 128’23. On the heels of the employment report, bonds plunged to a low of 128’01; this was enough to elect the sell stops below support and likely put many futures strangles traders into short positions near 128’20. However, unless the trader was extremely quick to take a profit, he likely found himself in a losing proposition. Within minutes, the selling dried up and a rally ensued; prices made their way to 129’17. This was just enough to elect the buy stops of any trader looking for a bullish breakout. In this scenario, a futures strangle trader could have easily sustained a loss of close to $1,000 per contract in a short period of time. In my opinion, the biggest drawback of a futures strangle strategy is in the entry method. By nature of a stop order, the trader is entering the market after prices have already moved considerably in the desired direction. Simply put, this is a strategy in which traders attempt to buy high and sell higher, or sell low and buy lower. I’m more of a buy low, sell high kind of gal. To recap this three-part discussion on the various types of strangles, short option strangles tend to offer the best odds of success on a per-trade basis, but they sacrifice the luxury of theoretically unlimited profit potential. Long option strangles, on the other hand, provide the comfort of limited risk and potentially unlimited reward, but they come with dismal odds of success. Similarly, futures strangle traders face a significant amount of risk at the hands of market volatility in exchange for catching the rare, but potentially fierce, breakout moves.

• Technical Analysis of STOCKs & COMMODITIEs • 37

Navigating Price Mountains
When stock prices start climbing or forming a price mountain, it’s tempting to want to get in on the action. But should you buy a stock that’s forming a mountain? by Thomas Bulkowski
38 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs

See You At The Top

et me tell you a fictitious story about Basketcase Bob. On August 28, 2000, he bought stock in Intel (INTC) and received a fill at $75.81, the very high for the day, the year, and for the history of the stock. I show his theoretical purchase in Figure 1 (point A). At that time, the stock market was soaring, especially semiconductor stocks, and he wanted a part of the action. When he checked the stock on October 11, 2000 about six weeks later (point B), the stock had bottomed at $35. “It’s down too far now. As soon as I get my money back, I’m selling,” he said to himself. Perhaps you have uttered similar words in similar circumstances. If others buy near the same price, and sell as soon as they get their money back, their collective behavior forms a chart pattern called a double top. That is two peaks near the same price with a decline afterward. Let’s return to Basketcase Bob. Question 1: How long will it be, on average, before he gets his money back? I’ll answer that in a moment. Until then, consider another trade at point D on the chart in Figure 1. The stock bottomed at $12.95 (C) and at point D is trading at $34.51. “The stock has nearly tripled from the low,” Basketcase says. “It’s on a roll. Since it hit $75 once before, I know it can climb that far. I’m buying more.” The substantial rise to and decline from peak A is what I call a price mountain. Question 2: Should we depend on price returning to the top of a price mountain anytime soon? The answers to the two questions are similar. Let’s take a closer look at how I answered them.



RESEARCH I programmed my computer to find stocks that doubled within three years from a low price above $3



INTEL Corporation (Semiconductor, INTC)
Bought here A


FIGURE 1: PRICE MOUNTAIN. Here you see a typical example of a stock that soared to its all-time highs only to plunge significantly lower shortly afterward.

and then dropped by half. Those are arbitrary limits; I chose $3 as a minimum to exclude stocks with a large number of stock splits (the historical price is too low) or those trading near bankruptcy (in both cases, small price moves can mean a huge percentage change). I used a database of 516 stocks that I follow on a daily basis and excluded all data before January 1990. The test ended in early August 2013. I found 756 non-overlapping samples (meaning one price mountain must end before the next begins). Only 65% of the samples had price return to the peak of the price mountain at the time the study ended. How long will it be, on average, before Basketcase Bob gets his money back? Answer: at least six years (since it could be more years until the remaining 35% return to the old high). Should you depend on price returning to the top of a price mountain anytime soon? No. In many cases, such as for INTC (which is still waiting after 13 years to recover), it could be years before the stock posts a new all-time high. If you see a price mountain in a stock that you are interested in buying, look elsewhere for a more promising situation. S&C Contributing Writer Thomas Bulkowski (who may be reached via email at [email protected]) is a private investor and trader with more than 30 years of market experience and considered by some to be a leading expert on chart patterns. He is the author of several books including four new ones in 2013:

Only 65% of the samples had price return to the peak of the price mountain.

Visual Guide To Chart Patterns and the Evolution Of A Trader trilogy. His website, www.ThePatternSite.com, is dedicated to price pattern research and includes more than 600 pages of free articles on price patterns and market behavior.


Bulkowski, Thomas N. [2013]. Visual Guide To Chart Patterns, Bloomberg Press. _______ [2013]. Fundamental Analysis And Position Trading: Evolution Of A Trader, John Wiley & Sons. _______ [2013]. Swing And Day Trading: Evolution Of A Trader, John Wiley & Sons. _______ [2013]. Trading Basics: Evolution Of A Trader, John Wiley & Sons.
‡Tom Bulkowski
‡See Traders’ Glossary for definition ‡See Editorial Resource Index

March 2014 • Technical Analysis of




A Fundamental Lesson For The Technically Minded
For decades, there have been two major schools of thought when it comes to stocks. First came the fundamental analysts, who believe that stock prices are a product of revenues and earnings. Then came the technicians, who believe that all they need to know is contained in stock charts. Here, we look at how the two methodologies come together. and the present and then ordered these markets from the most strongly earnings-driven to the weakest using the ratio of price gains divided by the expansion in the PE multiples. Bulls showing the smallest PE expansions (that enjoyed the greatest earnings growth) were considered the most fundamentally driven. I show his results in the table in Figure 1. As you can see in Figure 1, bull markets in which earnings growth was more closely aligned with price growth suffered smaller subsequent corrections. In other words, rallies accompanied by the greatest earnings growth held up better in corrections than those where investors bid stock prices up higher than earnings would otherwise dictate. Compare the 1974–80 bull market with the one from 2002–07. The first experienced a PE expansion of 2.2 versus an expansion of 7.8 for the second. In the ensuing corrections, the 1981 recession saw stock prices fall by 27% compared to a drop of more than double (57%) from 2007–09.


by Matt Blackman

ike many investors, I began to play the markets believing that if you found companies with strong balance sheets, a good product, and strong management team, you would make money. But one challenge quickly became evident: Earnings lagged stock prices most of the time. When the economy slowed down, earnings often gave little or no warning before stock prices fell. Relying on balance sheets to determine trade entries & exits tended to get you in well after the move was over and out too late to avoid the pain.



An article on the Wall Street Rant blog titled “Is This Bull Market Fundamentally Driven?” sought to help answer this question. “Fundamentally driven bull markets should rely more on cyclically adjusted earnings growth and less on investors’ willingness to pay ever-increasing multiples on those earnings,” the author posited. But do they? To explore this question in detail, I used the cyclically adjusted price/earnings (PE) ratio data from Robert Shiller’s website. He separated out bull markets that experienced at least 100% gains without a 20% correction between 1930

For the sake of clarity, the period from 1960 to present was charted using Robert Shiller’s monthly data. The chart in Figure 2 compares the S&P 500 to earnings. It shows there is a link, albeit a loose one, between earnings and stock price. At times, like at the end of the 2001–02 recession and the end of the 2003–07 bull market, earnings led. At other times, such as the peak in 2001 and bear market trough in 2003, earnings moved with stock price. Investor sentiment or some other factor appeared to determine whether stock prices followed or moved coincidently with earnings. To examine the relationship more closely, I next compared

Bull markets over 100% without a 20% correction
Start date End date Starting Shiller PE
7.8 13.6 8.1 4.9 6.2 12.2 6.9 20.0 11.9 10.0

Ending Shiller PE
10.0 19.2 16.5 11.0 18.8 45.8 14.9 27.8 25.61 22.8

Shiller PE expansion
2.2 5.6 8.3 6.1 12.6 33.5 8.0 7.8 13.71 12.8

S&P % change
125.6 267.1 157.7 111.6 228.8 582.2 120.6 101.5 176.7 131.6

Price change / PE expansion
(Bull Fundamental Ratio)

Subsequent bear market loss
27% 22% 28% 41% 34% 34% 57% ? 54%

10/03/1974 06/13/1949 04/28/1942 06/01/1932 08/12/1982 12/04/1987 02/27/1933 10/09/2002 03/09/2009 03/14/1935

11/28/1980 08/02/1956 05/29/1946 09/07/1932 08/25/1987 03/24/2000 07/18/1933 10/09/2007 1/22/2014 03/10/1937

58.2 47.7 18.9 18.4 18.1 17.4 15.0 13.0 12.89 10.3


FIGURE 1: BULL MARKET RANKINGS BASED ON SToCK PRICE CHANGE DIVIDED BY PE EXpANSIoN. Bull markets with the highest bull fundamental ratios were considered fundamentally stronger since stock price increases were accompanied by comparable earnings growth versus markets in which the stock prices greatly exceeded earnings growth.

40 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs


the relative strength of S&P 500 earnings to S&P 500 vs. SPX Earnings the S&P 500 index. As the chart in Figure SPX 3 shows, earnings outperformed stock price Earnings more frequently from 1960 to 1980 than later, when earnings experienced a bear market, consistently falling relative to price. During the 1982–2000 bull market, investors were more optimistic about the future of stocks — earnings appeared to matter less. Earnings grew relative to stock prices during the 1987 bear market and more modestly from 1992–95. But other than brief periods in 2001–02 and 2008–09, stock prices appreciFIGURE 2: MoNTHLY DATA FOR THE S&P 500 INDEX (LEfT-HAND SIDE) VS. SPX EARNINGS (RIGHTated well ahead of earnings for most of this HAND SIDE). At the end of the 2001–02 recession and the end of the 2003–07 bull market, earnings led. period. But this euphoria came at a cost. At other times, such as the peak in 2001 and the bear market trough in 2003, earnings moved with stock What is evident from Figure 3 is that the price. “irrational exuberance” in the 1990s caused stock prices to rise quicker than earnings, an S&P 500 vs. Earnings/SPX emotion for which investors paid in 2001–02 Earnings rising faster with a correction of nearly 50%. Evidence than stock prices suggests that investors did not appear to Stock prices rising faster have learned their lesson in the 2003–07 bull than earnings market. It was associated with an even greater disconnect in which stock prices were bid up well above earnings, followed by an even more severe bear market drop. What should concern traders and investors is that the 2009 bull market has so far demonstrated weaker fundamental growth as evidenced by PE expansion of 11.1 (so far). FIGURE 3: MoNTHLY DATA foR THE S&P 500 INDEX WITH THE RELATIVE STRENGTH of SPX If the numbers in Figure 1 prove a reliable EARNINGS (EARNINGS DIVIDED bY THE SPX). Earnings outperformed stock price more frequently from guide, this puts us on track for a 50%+ correc1960–80 than later, when earnings experienced a bear market, consistently falling relative to price. Recessions are shown by the gray vertical bars. tion when the euphoria finally subsides. This view is further substantiated by the 1935–37 But perhaps the biggest lesson of all is that although it may bull, which experienced levels of government stimulus similar to what we have had recently. Stock prices in the late 1930s were be possible to ignore earnings fundamentals for months or even pushed up to unsustainable levels, and a very painful correction years, the more out of whack stock prices become relative to earnings, the more painful and protracted the aftermath. And this is in excess of 50% followed. a lesson that investors, all too quickly, tend to forget. LESSONS LEARNEd...OR NOT There are a number of lessons to be learned from this exercise. Matt Blackman is a full-time trader and financial writer. He assists First, it takes far less earnings ($0.06) to “buy” a one-point gain clients get published in the financial media and with market and clion the S&P 500 today than it did in the 1970s when each point ent newsletters. He earned the Chartered Market Technician (CMT) SPX gain required $0.40–0.60 in earnings. Some might argue designation and a B.Sc. (honors) degree from Simon Fraser University. that this gain is due to inflation, but why are stock prices more You can follow Blackman’s latest trading ideas and market comments prone to inflation than earnings? How much of a factor were the on Twitter at www.twitter.com/RatioTrade. unlimited series of quantitative easing programs in pumping stock prices to new highs over the last decade? How long can SUGGESTEd REAdING this trend continue before the next fundamental reversion to the Short, Doug [2013]. “Is This Bull Market Fundamentally Driven?” http://advisorperspectives.com/dshort/commentaries/Is-Bullmean reckoning day? Earnings/SPX relative strength (red line in Market-Fundamentally-Driven.php Figure 3) appears to be at, or at least near, some sort of bottom. It can’t go any lower than zero. Lesson two is that fundamentals • http://aida.wss.yale.edu/~shiller/ appear to be less important over the short term — stock prices often move higher due to investor enthusiasm and hope than Current and past articles from Working Money, The Investors’ Magazine, can be found at Working-Money.com. based on relative earnings — and this trend has been going on for decades.
March 2014

• Technical Analysis of STOCKs & COMMODITIEs • 41



MetaStock Pro XIII

FIGURe 1: cLoUD foR DaILY QQQ. As the large letters at the top left indicate, this chart shows past performance. The y-axis is price percentage change and the x-axis is the number of days after the event. For this screen capture, there were 34 times the event “stochastics overbought” occurred. The red seen at the left-hand side of the chart indicates that in the first few days, 80% of the time (using the probability scale on the right, which shows that red corresponds to 80), price was basically unchanged.

METASTOCK 4548 Atherton Drive, Suite 200 Salt Lake City, UT 84123 Phone: sales 800 508-9180; technical support 801 265-9998 Email: [email protected], [email protected] Internet: www.metastock.com Product: Trading platform System requirements: Windows 7 or 8; 4GB RAM minimum, 8 GB RAM recommended; 1.6 GB disk space; high-speed Internet connection Price: $100/month, $960/year, or $1,395 for a permanent copy


by S&C Staff

etaStock Pro XIII (also referred to as MSPro13-Forecaster) is the latest version of a full-featured product that has been delivering outstanding analysis capabilities for more than 30 years. The software is installed on your computer and is designed to support real-time intraday or end-of-day (EOD) trading. It uses the MetaStock XENITH datafeed, which provides quotes and robust access to news. The big change from

MetaStock version 12 is the addition of a feature called the Forecaster. The idea of the Forecaster is to assess the predictive ability of various indicators. There are 67 choices. Some of the indicators are used in multiple ways, so the number of unique indicators is approximately 26. There are several hurdles Forecaster had to get over to accomplish this task. The first hurdle is best explained by what the Forecaster is not. It is not a means to find the best trading system. When you look in the Forecaster library to get a detailed explanation of how an indicator is used, it may sound like a trade entry setup. That is true to some extent, but the reason MetaStock chose to use the word event is that an event simply means that the description in the library has become true on a particular day, and at the moment, only daily calculations are made. An example of an event is the Chaikin AD Oscillator Negative Divergence. The descriptor in the library reads: “The Chaikin AD Oscillator is trending down (lower consecutive peaks) and prices are continuing up.” Thus, when the latter two

conditions are true, that is, the oscillator is trending down and prices are continuing up, you have an event. When you use the Forecaster, you have to select a security you want to analyze, and the Forecaster goes to work to tell you how each of the 67 performed. The second problem is this: Given that you have a set of discrete samples, because there are a limited number of times an event occurs, how do you create something that at least has the appearance of being continuous? To solve this, Forecaster starts by using two parameters: price percentage change and the number of days after an event. Remember that an event is simply when one of the 67 choices is true. Forecaster maps each of these pairs onto a two-dimensional grid whose axes are percentage change and days after the event. In fact, this is the grid you see in Figure 1. Now, picture in your mind a topographical grid of points you created by each of the events. Assign a value of 1 to each point and then let the point be the source of a ripple as though you had cast a stone into a still pond. Each point creates a ripple, and the ripples sometimes

42 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs

FIGURe 2: eVeNt cHaRt foR DaILY QQQ. The price chart for QQQ is shown with yellow arrowheads above and below prices. The arrowheads indicate where a specific event took place. The highlighted text in Figure 3 is the specific event. There are two tabs at the upper left: one tab to show the events and the other to show the cloud (Figure 1). The light blue histogram below price is volume. You can zoom in by putting your cursor on the left end of the blue calendar graphic on the bottom and dragging it to the right. When you choose Forecaster, the initial prompt lets you define your date range.

meet and sometimes not. Forecaster uses a Gaussian normal distribution to create the ripple and thus can fill in between the data points right down to each pixel. Let’s take a look at a typical display.

think that the arrows are indicating long and short entries. The arrowheads are simply the point in time when the event was true. If the title of the event doesn’t ring a bell, you can click on a library tab at the top and get an explanation. FORECAST CLOUD Sometimes the library explanations need Figure 1 shows the results of the calsome more explaining. The resource that culations discussed earlier. The cloud was used in creating the events was the is shown using days after the event on book Technical Analysis From A To Z the x-axis and percentage change on the by Stephen Achelis, so using that book y-axis. It’s obvious that each pixel has could be a valuable reference. been calculated. Figure 3 has a left-hand description and Notice how the hues in the cloud a right-hand report. The report will tell subtly change. If you look to the right of you how many times the event occurred the cloud, you’ll see a scale going from and give you statistical information, since it is possible to calculate a standard dezero to 100. If you keep in mind you EVENTS are seeing past performance, you realize The chart in Figure 2 shows where events viation and mean for each day after the that the color reflects how often the pair occurred. Figure 3 shows the tables that event. In the example in Figure 2, there days after the event and the percentage appear directly below the screen capture were 34 occurrences of the event, then change overlapped with other pairs. in Figure 2. Thus, Figure 2 is showing day one after the event has 34 samples, For example, if for every instance of a where the highlighted event in Figure 3 day two after the event has another 34 specific event, like the Chaikin negative occurred. It’s easy to look at Figure 2 and occurrences, and so on: thus, there are sufficient samples for each day after the event to calculate a mean and standard deviation. It’s not clear if the Forecaster has a “reasonableness” test for a sufficient number of samples to calculate a mean and standard deviation. A chi square test would suggest 12 samples; thus, for our example, 34 is FIGURe 3: EVeNt TaBLes. The highlighted text in the left hand table corresponds to the events shown in Figure 2. Events are sorted by the number of occurrences, with the highest number of occurrences at the top. The report at the right provides statistical data for the selected more than sufficient. However, Forecaster event. Click on a left hand description to select a particular event for viewing on the price chart. You also get an appropriate report.
March 2014

divergence discussed earlier, the equity was unchanged (that is, 0% change on the first day after the event), then you would see bright yellow at the left. The blue you see so prominently in Figure 1 is telling us that 40–50% of the time, this was the percentage change. Who might find this data particularly interesting? Who has a keen interest in knowing what the probable price of a stock might be? The answer is option traders. Look at Figure 1 again. What you are seeing is the range of price-change history for a particular event. Now we’ll try seeing this from a slightly different angle.

• Technical Analysis of STOCKs & COMMODITIEs • 43


FIGURe 4: DaILY QQQ WItH CLoUD. To create this screen capture, the blue calendar at the bottom was dragged to the right to zoom in on the last two years. Next, a doubleclick of the most recent event brings up the cloud. Note that in the header, the conditions are spelled out.

does calculate a margin of error that is based on the number of samples. The fewer number of samples results in a higher margin of error. Thus, users are informed of how accurate the statistics might be. Suppose you want to see what a cloud project might be from a particular event. All you have to do is click on the arrowhead of your choice and a cloud is shown (Figure 4). Since you might have some conditions of your own that you would like to see, you may be interested to know that MetaStock plans to offer a Forecaster with the ability to write your own event code. There are some other features worth looking at as well, such as SectorStat, which provides breadth calculations on 10 different sectors as well as the entire market. For example, you can choose to have an advancer–decliner breadth calculation done on the stocks in the XLK technology sector. Another feature is EcoStat that gives the economic data for a number of different countries. You access the data by choosing File, then Open, and then selecting layouts. You’ll find that there are 70+ layouts. The first layout in the list is the all business cycle (Figure 5), which consists of 10

histograms showing GDP growth for 10 countries.

with SectorStat and EcoStat, you have a powerful product.


Forecaster is definitely a clever tool. In addition to Forecaster, SectorStat, and EcoStat, you can access local quote data, that is, data on your hard drive, and EOD users now get hourly snapshots on daily bars. A lot of thought has gone into the creation of version 13 of MetaStock Pro. The biggest new feature, Forecaster, provides some unique insight into the behavior of a fairly wide class of indicators, and when you combine it


Achelis, Stephen B. [2000]. Technical Analysis From A To Z, 2d ed., McGrawHill. Also hosted online by MetaStock at http://www.metastock.com/customer/ resources/taaz/. Peterson, Dennis [2013]. “MetaStock Pro 12,” product review, Technical Analysis of STOCKs & COMMODITIEs, Volume 31: January. ‡MetaStock
‡See Editorial Resource Index

You can get some unique insight into the behavior of a wide class of indicators.

FIGURe 5: “ALL BUsINess CYcLe” LaYoUt. Requesting the “all business cycle” layout resulted in 10 charts with GDP growth shown as a histogram for 10 different countries. Italy is in the upper left-hand corner and the US is in the lower right. The “all business cycle” is just one of 70+ layouts available.

44 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs

rading liquidity is often overlooked as a key technical measurement in the analysis and selection of commodity futures. The following explains how to read the futures liquidity chart published by Technical Analysis of STOCKs & COMMODITIEs every month.


very high volumes. The greatest number of dots indicates the greatest activity; futures with one or no dots show little activity and are therefore less desirable for speculators.
Courtesy of CBOT


The futures liquidity chart shown below is intended to rank publicly traded futures contracts in order of liquidity. Relative contract liquidity is indicated by the number of dots on the right-hand side of the chart. This liquidity ranking is produced by multiplying contract point value times the maximum conceivable price motion (based on the past three years’ historical data) times the contract’s open interest times a factor (usually 1 to 4) for low or

three-year period. Thus, all numbers in this column have an equal dollar value. Columns indicating percent margin and effective percent margin provide a helpful comparison for traders who wish to place their margin money efficiently. The effective percent margin is determined by dividing the margin value ($) by the three-year price range of contract dollar value, and then multiplying by one hundred.


Trading Liquidity: Futures

All futures listed are weighted equally under “contracts to trade for equal dollar profit.” This is done by multiplying contract value times the maximum possible change in price observed in the last

Trading liquidity has a significant effect on the change in price of a security. Theoretically, trading activity can serve as a proxy for trading liquidity and equals the total volume for a given period expressed as a percentage of the total number of shares outstanding. This value can be thought of as the turnover rate of a firm’s shares outstanding.

Commodity Futures Exchange % Margin Effective Contracts to Relative Contract Liquidity % Margin Trade for Equal Dollar Profit E-Mini S&P 500 GBLX 4.2 10.0 5 ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••>> 10-Year T-Note CBOT 1.2 12.9 17 ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••> T-Bond CBOT 2.6 15.4 9 ••••••••••••••••••••••••••••••••••••••••••••• E-Mini Nasdaq 100 GBLX 3.0 6.7 6 •••••••••••••••••••••••••••••••••••••••••••• S&P 500 Index CME 4.2 10.0 1 •••••••••••••••••••••••••••••••••••••••• 5-Year T-Note CBOT 0.6 14.2 37 •••••••••••••••••••••••••••••••••••••• Corn CBOT 12.7 12.9 9 •••••••••••••••••••••••••••••••••••• Ultra T-Bond CBOT 3.1 12.3 5 ••••••••••••••••••••••••••••••••••• Gold COMEX 7.3 13.4 3 ••••••••••••••••••••••••••••••• Japanese Yen CME 2.3 5.9 4 •••••••••••••••••••••••••••••• Silver COMEX 10.5 7.0 1 •••••••••••••••••••••••••••• Crude Oil WTI NYMEX 5.2 24.7 10 •••••••••••••••••••••• Sugar #11 ICE-US 9.4 6.8 8 ••••••••••••••••••••• Soybeans CBOT 7.2 17.9 7 •••••••••••••••••••• Natural Gas NYMEX 5.7 10.1 8 ••••••••••••••••• Euro FX CME 1.5 13.1 10 ••••••••••••••• Cotton #2 ICE-US 5.6 3.6 3 •••••••••••• CBOE S&P 500 VIX CFE 8.9 3.9 6 •••••••••••• DJIA mini-sized CBOT 3.4 9.1 6 •••••••••••• Wheat CBOT 11.5 16.8 10 •••••••••• E-Mini S&P Midcap GBLX 3.3 7.1 3 •••••••••• Coffee ICE-US 11.4 6.9 3 ••••••••• Australian Dollar CME 1.9 7.4 9 •••••••• High Grade Copper COMEX 6.3 16.3 6 ••••••• Soybean Oil CBOT 7.4 12.6 14 •••••• Gasoline RBOB NYMEX 5.5 17.1 5 •••••• 2-Year T-Note CBOT 0.1 12.9 81 •••••• Canadian Dollar CME 1.2 7.2 13 •••••• CBOT Chicago Board of Trade, Division of CME British Pound CME 1.3 12.7 18 •••••• CFE CBOE Futures Exchange Soybean Meal CBOT 6.5 19.1 14 ••••• CME Chicago Mercantile Exchange Live Cattle CME 2.4 8.5 12 ••••• COMEX Commodity Exchange, Inc. CME Group Swiss Franc CME 1.6 5.5 5 ••• GBLX Chicago Mercantile Exchange - Globex Heating Oil NYMEX 4.8 32.1 10 ••• ICE Intercontinental Exchange-Futures Nasdaq 100 CME 3.0 6.7 1 ••• ICE-EU Intercontinental Exchange-Futures - Europe KCBT Red Wheat KCBT 8.0 13.5 10 •• ICE-US Intercontinental Exchange-Futures - US Eurodollar CME 0.1 45.1 257 •• KCBT Kansas City Board of Trade Platinum NYMEX 5.3 16.6 8 •• MGEX Minneapolis Grain Exchange Cocoa ICE-US 7.0 16.3 17 •• NYMEX New York Mercantile Exchange Lean Hogs CME 3.8 16.1 22 • WCE Winnipeg Commodity Exchange Mexican Peso CME 5.9 37.2 33 • Palladium NYMEX 7.0 24.5 9 • Spring Wheat MGEX 10.6 12.8 8 • DJIA CBOT 3.4 9.1 3 • Canola WCE 6.3 10.4 37 • U.S. Dollar Index ICE-US 1.6 15.8 23 • 1403 Trading Liquidity: Futures is a reference chart for speculators. It compares markets “Relative Contract Liquidity” places commodities in descending order according to according to their per-contract potential for profit and how easily contracts can be bought how easily all of their contracts can be traded. Commodities at the top of the list are easior sold (i.e., trading liquidity). Each is a proportional measure and is meaningful only est to buy and sell; commodities at the bottom of the list are the most difficult. “Relative Contract Liquidity” is the number of contracts to trade times total open interest times a when compared to others in the same column. The number in the “Contracts to Trade for Equal Dollar Profit” column shows how volume factor, which is the greater of: many contracts of one commodity must be traded to obtain the same potential return In volume 1 or exp –2 as another commodity. Contracts to Trade = (Tick $ value) x (3-year Maximum Price In 5000 Excursion). March 2014 • Technical Analysis of


pRoDUCt ReView

Insiders Guide To Trading Weekly Options
SIMPLEROPTIONS.COM Phone: 512 266-8659 Email: [email protected] Internet: www.SimplerOptions.com/ weekly Product: A four-DVD set; weekly option plus live trading course Price: $1,997; contact SimplerOptions for special pricing Several unexpected bonuses come with this course. In preparation for taking the course, participants were given pre-course homework assignments in the form of videos and PDF files. In that way, both novice and more experienced option traders could begin more or less on the same page. Along with videos that explain the indicators that Carter uses in the course, the homework assignments also included viewing the recordings of two full-length courses Carter has taught in the past. One is titled Beginners Guide To Options Trading and the other is The Ultimate Guide To Spreads. An additional video shares insights about the mental aspects of trading that were gained after a week-long gathering of business and investing leaders invited to stay at famous entrepreneur Richard Branson’s private island. All these videos and PDFs are provided as part of the Insiders Guide DVD set. other ways to approach trading the same high-probability pattern setup. But here, the focus is on strategies that involve the selling, rather than the buying, of an option in order to put time decay in the trader’s favor. There’s no need for exotic option combinations when a few basic strategies will do. The course identifies when it’s best to use a simple vertical spread, when to use an iron condor or a butterfly, and even when to place naked option trades. Along with which days of the week to initiate and exit those strategies, Carter suggests which strategies to use if you have a small account and which are better for larger accounts. Rather than use the same strategy in all situations, Carter outlines a step-by-step method for evaluating a potential trade to determine which strategy is best. Many times, more than one strategy can be applied, and the trader may choose the one or ones that fit comfortably within his or her skill level, time availability, risk tolerance, and account size.


by Barbara Star, PhD

raders who have ever delved into the world of option trading soon found themselves mired knee-deep in the greeks, implied volatility, complicated math, and dozens of trading strategies. John Carter began his Simpler­ Options. com website and trading education room to help reduce the confusion by making stock and index options much easier to understand and more profitable to trade. He brings that same philosophy to his new DVD course, Insiders Guide To Trading Weekly Options. Although best known for his intraday and swing trading of stocks and futures, Carter began trading stock options while still in college. The DVD course applies his years of experience to the fast-growing world of weekly stock options. His mission: to share what he has learned about what works and what doesn’t. His goal: to teach participants how to think more like a market maker and less like a speculator so they can gain consistent success as traders of weekly options. The set of four DVDs contains the recordings of a four-day course that Carter taught in September 2013. The first DVD covers theory and trading strategies. The other three DVDs are recordings of live trading sessions that took place the following week as both he and the online participants put into practice the concepts and strategies that were taught.


Before discussing trade setups, Carter sets the stage by focusing on trader psychology and self-limiting mental/ emotional barriers. According to Carter, the setups are simple, but the ability to overcome unresolved inner conflicts or behavioral patterns that undermine success are more complicated. He identifies several trading realities that need to be taken into account and the mindset needed to succeed. Most weekly option methods involve selling options rather than buying them. That’s the approach used for this course as well. But surprisingly, Carter starts off with the one (and only) time that he advocates buying weekly options, revealing the components of a price and indicator pattern that create the “perfect storm” for a high-probability directional trade that can overcome time decay and potentially make large profits. He then proceeds to identify several


AND sETUPs With so many weekly options available, how do you select the ones to trade? Carter shares the criteria he uses to find the cream of the crop. And, once found, it’s possible to sort through the same stocks week after week with only an occasional visit to the sites that list all the stocks with weekly options. His list of key stocks is included with the course. As a first step in determining a setup, he advocates looking at the broad market to help decide which types of option strategies can be eliminated immediately (Figure 1). Then he selects those stocks that follow the broad market and show a specific price pattern. Instead of buying a call or a put, he suggests several different ways to create the option strategies that

46 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs


LEADs TO sUCCEss FiGUre 1: nAsDAQ inDeX. Checking the direction of the larger index is a first step in deciding which weekly option With options, there is no escaping strategies to select and which to eliminate. the need to involve some math; patterns alone are not enough to select the strike price. Fortunately, the math that Participants watch as he demonstrates duces an additional indicator that draws Carter teaches doesn’t require the com- how to check the option chain for the specific support & resistance levels on plex juggling of the greeks. When math correct strike price, the appropriate op- the price charts. While not essential for is necessary, there is only one number tion strategy, the number of contracts trading weekly options, the indicator to know. Then, depending on the option in relation to account size, and how to does help to better define price targets and price areas for favorable trade enstrategy selected, it is a simple matter to place the order. subtract or add that number to the current The commission costs to trade options tries. Unfortunately, it is a proprietary stock price in order to pick a strike price can seriously erode the potential profit- indicator that must be purchased from that puts the odds squarely on your side. ability of a trade and can make some SimplerOptions.com and is not included He contends that in some situations, it good-looking trades not worth taking. in the price of the course. is possible to combine the math with a Carter explains the minimum amount specific pattern to construct a trade that of premium he looks for and suggests TRADE MANAGEMENT offers both a 90% winning probability ways to create spreads that provide both For Carter, weekly option trading is not a “set it, forget it, let it expire worthand a profitable return. safety and an acceptable return. At various points during the three live less, and pick up your profits” game. A LIVE TRADING daytrading sessions, he places trades us- probability of winning is just that — a Theory is one thing, but implementing it ing a mix of the option methods taught probability, not a certainty. Any number correctly in real time is another. While in the theory class. The trades are taken of factors can and do occur overnight and the strategy DVD provides an overview to illustrate ways that produce a better throughout the week that can quickly of the selection and trade management of credit profit and a better reward-to-risk erase a profit and produce a large loss. He weekly options, the live trading sessions scenario, or to demonstrate concepts such says, “Anyone can get into a trade, but deal with the actual placement of trades as laddering and pinning. He provides hardly anyone knows how to manage it and the day-to-day decision-making rules to better ensure that traders are the correctly. Trade management will make involved in managing and exiting an recipient, and not the victim, of time or break you as a trader.” So, once you are in a trade, it’s important to be aware ongoing trade. decay. Carter stresses the importance of fol- Once participants have a good grasp of the trades that are active, and plan for lowing a game plan and waiting for a of the preferred setup, Carter shows a the worst as well as the best scenario. valid setup. The participants learn how modified version that identifies poten- The job of the option trader is to manto distinguish between clean chart setups tially good trades. These setups can be age risk. Carter equates it to a football and sloppy setups. He teaches how to applied to various time frames, includ- team needing to defend its goal line. In determine when to get into a stock that ing intraday price charts for very active option trading, the strike price is the goal is moving and when not to chase it. He traders and weekly price charts for those line, and to be successful, it is necessary initiates several trades based on the traders unable to watch the markets to know in advance where to begin your defense. A plan of action to adjust and simple pattern-plus-math procedure that throughout the day. During the live trades, Carter intro- defend the position has to occur before was taught during the theory class.
March 2014

• Technical Analysis of STOCKs & COMMODITIEs • 47


carry good profit potential. With the help of a Fibonacci ratio, it’s even possible to identify an entry and likely target price. For the indicator pattern, Carter relies heavily on an indicator that identifies price volatility and direction. The indicator, which is free on the thinkorswim platform, incorporates three indicators that are readily available in most charting packages. The course includes an instructional video that explains how to create and interpret the indicator.

pRoDUCt ReView

“Anyone can get into a trade but hardly anyone knows how to manage it correctly. Trade management will make or break you as a trader.”
the strike price is touched. This is such an important topic that a document titled “Defending Trades” is included with the course. Carter devotes a large portion of the live trading sessions to demonstrating in real time those methods that reduce risk. Participants learn the point at which to become concerned about a potential breach and a few easy-to-apply solutions. They also learn which option strategies do not need defending and which require more defensive attention. He identifies the one thing traders can do to remove risk either on the day before or the day of expiration. He offers a general rule of thumb for the best time to take profit and when it is probably safe to let the option expire worthless. Equally valuable is the use of a simple calculation that reveals when the risk to wait for an option to expire worthless far outweighs the gains. In some cases, failure to deal with the risk leaves traders vulnerable to being assigned a stock they do not want to own. In addition to changing or closing out positions on option-expiration day, Carter finds those stocks that still have some good premium early in the day and shows how it is possible to make money scalping options. That day also serves as the beginning of planning for trades to take the following week. He provides an overview of how he structures his trading week. Part of his planning includes making sure that whether he makes money or loses money for the week, he pays himself by transferring funds out of his trading account and into a non-trading account.

One focuses on how to find and trade stocks with high short interest. The other is a longer-term trade he calls an elephant trade, which has the potential to turn a small investment into a large winning trade. Perhaps the best bonus is Carter’s teaching style. Throughout the course, he writes notes that summarize the points he is stressing, the answers to questions from participants, and the trades he has taken. These class notes are then compiled into a text file that is available on the DVD, a real time saver when wanting to review information.



Carter suggests using an option-friendly platform. Although many good option platforms exist, he uses the thinkorswim platform in this course. Two videos come with the course that demonstrate the basic and more advanced trading and analytical features of the program. Before ending the final trading day, Carter discloses two other trading ideas.

Sneak preview …
The Detrend Is Your Friend
by Martha Stokes Here’s how you can use a detrending indicator to identify cycle deviations.

From the onset, John Carter makes it clear that among the many possible option strategies available to traders, he is sharing the ones he has found that work the best for him. They are the techniques he uses week in and week out to increase his equity curve. For him, the beauty of using spreads is that each trader can tailor the trades so they fall within acceptable risk parameters for the size of the account being traded and the comfort level of the trader. It isn’t necessary to take an inordinate risk and blow out a trading account. However, trading options does require a reliable methodology. According to Carter, “In trading, consistency is everything. If you can’t get consistent, there’s no point in doing it.” This course provides the ingredients needed to attain that consistency with a reliable pattern, plan, and method of trade management. Barbara Star, PhD, is a frequent contributor of articles and reviews to STOCKs & COMMODITIEs. Currently, she trades part-time and provides individual instruction and consultation to those interested in the technical analysis of the financial markets. She lives in Woodland Hills, CA and can be reached at 818 224-4070 or by email at [email protected] aol.com.
‡Insiders Guide To Trading Weekly Options (SimplerOptions.com) ‡TradeStation (TradeStation Securities)

Developing Your Own Trading Plan

by Solomon Chuama Here’s an example of how you can execute your own trading system based on current market analysis.

Interview with Dan Zanger

by Matt Blackman On trading, the markets, and doing what works: an interview with Dan Zanger of ChartPattern.com.

2014 Readers’ Choice Awards

Presenting the results of the 20th annual Readers’ Choice Awards poll of favorite products and services. .

...coming in the 2014 Bonus Issue!
48 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs

The following selection of book descriptions represents a sampling of recent book releases in the investing field. Books described here may be from some of the major book publishers as well as some independent book publishers. These are not critical reviews or editorial evaluations, but rather a brief look at the book marketplace to help keep readers up to date on new or recent book offerings.

The Master Trader: Birinyi’s Secrets To Understanding The Market + website ( 352 pages, $ 60 hardcover, $39.99 ebook, 2013, ISBN 978-1-118-77473-1) by Laszlo Birinyi, published by John Wiley & Sons. Along with stories from his more than 40 years of trading, this book provides guidance on trading and investing, including group rotation and market cycles; seasonal factors in investing; which indicators are actually indicative and which are merely descriptive; and sentiment and how to track it. The book helps the reader answer such questions as what the market will likely do if the “spiders” (SPYs) are up by 1% in pre-trading, and whether to buy or sell when a stock reports better-that-expected earnings. It includes chapters and details on technical analysis and where it fails; the business of Wall Street; trading indicators; anecdotal data; and price gaps. The website associated with the book features data sourcing and a video. Stock Trader’s Almanac 2014 (192 pages, $ 50 sof tc over, 2013, ISBN 978-1-11865945-8) by Jeffrey A. Hirsch and Yale Hirsch, published by John Wiley & Sons. Published every year since 1968, the Stock Trader's Almanac is a practical investment tool with a wealth of information organized in calendar format. This annual resource with its in-depth analyses and insights has been a mainstay for money managers, traders, and investors over the years. The almanac contains historical price information on the stock market; provides monthly and daily reminders; and highlights seasonal trading opportunities and dangers.

The almanac combines more than a century’s worth of data, statistics, and trends. It can alert the reader to little-known market patterns and tendencies to help with forecasting market trends. Stock Trader’s Almanac has been published for more than 40 years. Trading For Dummies, 3d edition (408 pages, $26.99 sof tcover, 2013, ISBN 978 -1-118 68118 -3 ) by M i chael Griffis and Lita Epstein, published by John Wiley & Sons. Trading For Dummies is for investors at all levels who are looking for a clear guide to trading stocks in any type of market, whether up or down. It is also for traders with experience who are looking for new methods to enhance the profitability of their investments. This book helps the reader learn to analyze stocks, trends, and indicators, as well as to set a buy-andsell range beforehand to decrease risk in any type of market. It stresses the practice of position trading; performing technical analysis on a company’s performance; and utilizing research methods that enable the trader to strategically select both an entry & exit point before a stock is purchased. This new edition features updated stock charts, position-trading tips and techniques, and fresh ways to analyze trends and indicators. It also includes a new chapter on highfrequency trading. The Part-Time Trader: Trading Stock As A Part-Time Venture + website (240 pages, $ 60 hardcover, 2013, ISBN 978-1-11865005 -9 ) by Ryan Mallory, published by John Wiley. This book provides practical advice and easy-to-folMarch 2014

low guidelines for people who only trade stocks in their spare time to supplement their income. It fills the niche of providing those trading strategies that may be best suited for part-time traders, who don’t have the time to fully dedicate their attention to the markets. It includes guidance on premarket studies and studies people can use before they leave for work in the morning, and provides tips for trading at your desk while working. The book purchase includes online access to the author’s proprietary trading system. The author is the cofounder of SharePlanner, a financial website on daytrading, swing trading (both long and short), and exchange traded funds. Jim Cramer’s Get Rich Carefully (433 pages, $29.95 hardcover, 2013, 9780-399-16818-5) by James J. Cramer, published by Blue Rider Press, a member of Penguin Group. In this book, Jim Cramer uses his thirty-five years of experience as a Wall Street veteran and host of CNBC’s “Mad Money” television program to create a guide for high-yield, lowrisk investing in a recovering economy scenario as we are in now. Cramer outlines a plan designed to make money without taking large risks. Drawing on his deep knowledge of the stock market as well as on the mistakes and successes he experienced himself on the way to his own fortune, Cramer explains — in layman’s language — how an individual can accumulate wealth in a prudent, methodical way as long as he or she begins sooner rather than later. In his own inimitable style, Cramer’s book provides unwaffling straight talk, offering general wisdoms as well as specifics. He highlights possible individual and sector plays, and identifies long-term investing themes. The book demonstrates how an individual can develop the disciplines needed to implement these long-term investing themes. FURTHER INFORMATION www.us.penguingroup.com www.wiley.com

• Technical Analysis of STOCKs & COMMODITIEs • 49

For this month’s Traders’ Tips, the focus is Perry Kaufman’s article in this issue, “Timing The Market With Pairs Logic.” Here we present the March 2014 Traders’ Tips code with possible implementations in various software. Code for TradeStation is already provided in Kaufman’s article. Subscribers will find that code at the Subscriber Area of our website, www.Traders.com. (Click on “Article Code” from the S&C menu.) Presented here is an overview of possible implementations for other software. Traders’ Tips code is provided to help the reader implement a selected technique from an article in this issue. The entries are contributed by various software developers or programmers for software that is capable of customization. Readers will find the March 2014 Traders’ Tips code and formulas at our website, Traders.com, in the Traders’ Tips area. Here, you can read some discussion of the technique’s implementation by the Traders’ Tips contributors as well as some example charts. To locate Traders’ Tips at our website, www.Traders. com, click on the link on our main menu at the top of the homepage, or scroll down to the “Current articles” section and click on the Traders’ Tips tab.

FiGUre 1: TRADESTATION. Here is a daily chart of Hess (HES) with the indicator and strategy applied. Stoch1 = 50 ; Stoch2 = 50 ; { raw stochastics for price1 and price2 } Range1 = Highest( High, Period ) - Lowest( Low, Period ) ; Range2 = Highest( High of Data2, Period) - Lowest( Low of Data2, Period ) ; if Range1 <> 0 and Range2 <> 0 then begin Stoch1 = ( Close - Lowest( Low, Period ) ) / Range1 ; Stoch2 = ( Close of Data2 - Lowest( Low of Data2, Period ) ) / Range2 ; { difference in stochastics } Diff = Stoch1 - Stoch2; { stress indicator } Range1 = Highest( Diff, Period ) - Lowest( Diff, Period ) ; if Range1 <> 0 then StressValue = 100 * ( Diff - Lowest( Diff, Period ) ) / Range1 ; end ; Plot1( StressValue, "Stress" ) ; Plot2( Stoch1 * 100, "D1 Stoch" ) ; Plot3( Stoch2 * 100, "D2 Stoch" ) ; Plot4( OBLevel, "OverBought" ) ; Plot5( OSLevel, "OverSold" ) ; Plot6( NormalLevel, "Normal" ) ;

F TRADESTATION: MARCH 2014 TRADERS’ TIPS CODE In “Timing The Market With Pairs Logic” in this issue, author Perry Kaufman discusses a trading system that buys and sells stocks when they are oversold and overbought relative to an index. The author has supplied the TradeStation EasyLanguage strategy code as well as the required custom function mentioned in the article. We have additionally created an indicator named PJK_TSMStress based on the author’s function, to display the stress level as shown in Figure 1 of Kaufman’s article. In addition to backtesting the strategy in a TradeStation chart, remember that you can use TradeStation’s Portfolio Maestro product to quickly backtest on a portfolio of symbols of your choice. Following is the EasyLanguage code for the PJK_TSMStress indicator:
{ Based on PJK_Stress function Copyright 2013, P.J.Kaufman. All rights reserved. } inputs: Period( 60 ), OBLevel( 90 ), OSLevel( 10 ), NormalLevel( 50 ) ; variables: Stoch1( 0 ), Stoch2( 0 ), Diff( 0 ), Range1( 0 ), Range2( 0 ), StressValue( 0 ) ; StressValue = 50 ;

This article is for informational purposes. No type of trading or investment recommendation, advice, or strategy is being made, given, or in any manner provided by TradeStation Securities or its affiliates. —Doug McCrary TradeStation Securities, Inc. www.TradeStation.com

To download the EasyLanguage code, please visit our TradeStation & EasyLanguage support forum. The code can be found at http://www.tradestation.com/TASC-2014. The ELD filename is “_TASC_PJK_PAIRS.ELD.” For more information about EasyLanguage in general please see http://www.tradestation.com/EL-FAQ. A sample chart showing the PJK_TSMStress indicator is shown in Figure 1.

50 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs

F METASTOCK: MARCH 2014 TRADERS’ TIPS CODE Perry Kaufman’s article in this issue, “Timing The Market With Pairs Logic,” describes his stress indicator and how to use it in pair trading. The MetaStock code for this indicator based on his article is shown here:
Stress: s1c:= Security("SPY",C); s1l:= Security("SPY",L); s1h:= Security("SPY",H); Prd:= Input("Stoch Periods", 1, 100, 10); R1:=(HHV(H,prd)-LLV(L,prd)); r2:= (HHV(s1h,prd)-LLV(s1l,prd)); ST1:= (C-LLV(L,prd))/r1; ST2:= (s1c-LLV(s1l,prd))/r2; diff:= ST1-ST2; Sr1 := HHV(diff,prd)-LLV(diff,prd); Stress := If(SR1<>0,100*((diff-LLV(diff,prd))/SR1), PREV); stress; 100 * ST1; 100 * ST2

FiGUre 2: CQG. Here is an example of the study using Hess Corp. (HES).

F CQG: MARCH 2014 TRADERS’ TIPS CODE For this month’s Traders’ Tip, we’re providing CQG code for the stress function based on Perry Kaufman’s article in this issue, “Timing The Market With Pairs Logic.”
CQG code for the study /*Stress Function, P.J. Kaufman*/ /*Raw Stochastics for Price1 and Price2*/ Data2:= S.US.SPY; Range1:= HiLevel(@,period,0) - LoLevel(@,period,0); Range2:= HiLevel(Data2,period,0) - LoLevel(Data2,period,0); Stoch1:= (Close(@) - LoLevel(@,period,0))/Range1; Stoch2:= (Data2 - LoLevel(Data2,period,0))/Range2; /*Difference in Stochastics*/ Diff:= Stoch1-Stoch2; /*Stress Indicator*/ Range1S:= HiLevel(Diff,period,0) - LoLevel(Diff,period,0); StressValue:= 100*(Diff - LoLevel(Diff,period,0))/Range1S;

—William Golson MetaStock Technical Support www.metastock.com

F Thinkorswim: MARCH 2014 TRADERS’ TIPS CODE In “Timing The Market With Pairs Logic” in this issue, author Perry Kaufman explains how to backtest the idea of hedging with an index-based ETF. Based on his article, we have created two new strategies and a new study for thinkorswim users in our proprietary scripting language, thinkScript. One strategy is for the equity and the other strategy is for the ETF. A sample chart is shown in Figure 3. To download the two strategies and the study, simply visit the following three links:
For the equity strategy, see http://tos.mx/u2Srym For the ETF strategy, see http://tos.mx/TO4llT For the study, see http://tos.mx/XRJgvr

The study has one parameter, period, which may be configured in the “modify study parameters” window after the study has been applied to a chart in CQG. An example of the study applied to Hess (HES) is depicted in the chart shown in Figure 2. To discuss this study or download a component PAC that includes complete formula code, please visit CQG Forums and CQG Workspaces. Our team of expert product specialists can advise you on the usage, application, and code for the study.

Trading and investment carry a high level of risk, and CQG, Inc. does not make any recommendations for buying or selling any financial instruments. We offer educational information on ways to use CQG trading tools, but it is up to our customers and other readers to make their own trading and investment decisions or to consult with a registered investment advisor.

—CQG, Inc. www.CQG.com

March 2014 • Technical Analysis of


FiGUre 4: WEALTH-LAB. Here is a sample Wealth-Lab 6 chart illustrating application of the system’s rules on a daily chart of HES (middle pane). An SPY chart is shown in the upper pane, and the stress indicator is plotted in the bottom pane.

You can adjust the parameters within the edit studies window to fine-tune your variables.
—thinkorswim A division of TD Ameritrade, Inc. www.thinkorswim.com

FiGUre 5: AMIBROKER. Here is a daily chart of HES with a daily chart of SPY in the middle pane and Perry Kaufman’s stress indicator (red) in the bottom pane. range2 = HHV( High2, period ) - LLV( Low2, period ); stoch1 = ( Close - LLV( Low, period ) )/range1; stoch2 = ( Close2 - LLV( Low2, period ) )/range2; VarSet("sstoch1", 100 * stoch1 ); VarSet("sstoch2", 100 * stoch2 ); diff = stoch1 - stoch2; range1 = HHV( diff, period ) - LLV( diff, period ); return 100 * ( diff - LLV( diff, period ) )/range1;

F WEALTH-LAB: MARCH 2014 TRADERS’ TIPS CODE In this issue, Perry Kaufman’s article “Timing The Market With Pairs Logic” promises an interesting new take on pair trading. As discussed in the article, combining Kaufman’s stochastic-derived intermarket stress indicator with a few clear position-sizing and risk-management rules lays the foundation for a long-only market timing system. To execute the trading system that we are providing in Wealth-Lab strategy code, Wealth-Lab users will need to install (or update to) the latest version of our TASCIndicators library from the extensions section of our website if they haven’t already done so, and restart Wealth-Lab. The Wealth-Lab code is also shown at the STOCKs & COMMODITIEs website at www.traders.com in the Traders’ Tips area. A sample chart showing the stress indicator on Hess is in Figure 4.
—Eugene, Wealth-Lab team MS123, LLC, www.wealth-lab.com


momper = 60; Hedgeper = 60; SetForeign("SPY"); // store index data in High2/Low2/Close2 variables High2 = High; Low2 = Low; Close2 = Close; RestorePriceArrays(); stress = PJKStress( High2, Low2, Close2, momper ); Plot( stress, "Stress", colorRed, styleThick ); Plot( sstoch1, "Stoch1", colorGreen ); Plot( sstoch2, "Stoch2", colorBlue );

—Tomasz Janeczko, AmiBroker.com www.amibroker.com

F AMIBROKER: MARCH 2014 TRADERS’ TIPS CODE In “Timing The Market With Pairs Logic” in this issue, author Perry Kaufman presents a pair-trading technique based on his new stress indicator. A ready-to-use AmiBroker formula for implementing the stress indicator is presented here. To display the indicator, input the formula into the formula editor and press “apply indicator.” A sample chart is shown in Figure 5.
function PJKStress( High2, Low2, Close2, period ) { range1 = HHV( High, period ) - LLV( Low, period );

F NEUROSHELL TRADER: MARCH 2014 TRADERS’ TIPS CODE The stress indicator described by Perry Kaufman in his article in this issue (“Timing The Market With Pairs Logic”) can be easily implemented with a few of NeuroShell Trader’s 800+ indicators. Simply select new indicator from the Insert menu and use the indicator wizard to set up the following indicator:
Stress indicator: SimpleStoch%K( Sub( Stoch%K(High,Low,Close,60),Stoch%K (SPDRS High,SPDRS Low,SPDRS Close,60) ),60 )

To implement the stock-trading side of the pair, simply select new trading strategy from the Insert menu and enter

52 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs

F i G U re 7 : A I Q , MATCHMAKER SETUP. Here is the setup used to get a list of stocks in the NASDAQ 100 that are highly correlated to the NDX.

FiGUre 6: NEUROSHELL TRADER. This NeuroShell Trader chart displays the stress Indicator and corresponding stock trades.

the following in the appropriate locations of the trading strategy wizard:
BUY LONG CONDITIONS: [All of which must be true]
A<B(Stress Indicator,10)

FiGUre 8: AIQ, RESULTING LIST. Here are sample results of running the setup shown in Figure 7.

TrailPrice%(Trading Strategy,20)

SELL LONG CONDITIONS: [All of which must be true]
A>B(Stress Indicator,50) POSITION SIZING METHOD: Fixed Dollar: 5,000.00 Dollars

To implement the hedge signal and calculate the size of the hedge, simply select new indicator from the Insert menu and use the indicator wizard to create the following indicators:
Hedge Signal: And2( A<B( Avg(SPDRS Close,60), Lag( Avg(SPDRS Close,60), 1)), Or2( A>B( Long Entry Signal: Trading Strategy, 0), A>B( Position(Trading Strategy,0), 0))) Hedge Size: Mul3( Divide(5000,Close), 0.5, Divide( StndDev( Sub( ROC(Close,1), 1), 60), StndDev( Sub( ROC(SPDRS Close,1), 1), 60)))

open positions, which would have to be computed separately and then entered daily as an input before the daily report is run once the hedge rule becomes true. To get a correlated list of stocks that show good correlation to the index of choice (I used the NDX), AIQ has a MatchMaker module that will quickly generate a list of stocks that show significant correlation to an index. In Figure 7, I show the MatchMaker setup I used to quickly get a list of stocks in the NASDAQ 100 that were highly correlated to the NDX. In Figure 8, I show the results (part of which are hidden). After highlighting the ones desired for a list, simply click on the “data manager” button and a list is created, which is then used to run the tests.
—Richard Denning [email protected] for AIQ Systems

Users of NeuroShell Trader can go to the STOCKs & COMMODITIEs section of the NeuroShell Trader free technical support website to download a copy of this or any previous Traders’ Tips. A sample chart is shown in Figure 6.
—Marge Sherald, Ward Systems Group, Inc. 301 662-7950, [email protected] www.neuroshell.com

F TRADERSSTUDIO: MARCH 2014 TRADERS’ TIPS CODE The TradersStudio code based on Perry Kaufman’s article in this issue, “Timing The Market With Pairs Logic,” is provided at the following websites:
• www.TradersEdgeSystems.com/traderstips.htm • www.TradersStudio.com → Traders Resources → Traders Tips

F AIQ: MARCH 2014 TRADERS’ TIPS CODE The AIQ code based on Perry Kaufman’s article in this issue, “Timing The Market With Pairs Logic,” is provided at www.TradersEdgeSystems.com/traderstips.htm. The code I am providing will backtest only the long trading and will not test the hedging portion of the system. For live trading, I provided a manual input for the total value of the

The following code file are provided in the download:

• Function PK_STRESS — returns the Kaufman stress value • Function COUNTOF — returns the number of times a rule is true in a set lookback period • System PK_PAIRS — system to go long stocks based on the stress indicator • System PK_STRES_HEDGE — system that is to be used with the PK_PAIRS system for hedging
March 2014 • Technical Analysis of


FiGUre 9: TRADERSSTUDIO. This shows the log equity curve and the underwater percent drawdown curve over the test period of 1/1/2000 to 1/8/2014 using the NASDAQ 100 list of stocks, the NDX index for pairing, and the QQQ ETF going short for hedging.

• TradePlan EqualDollar_HedgeTASC — tradeplan that runs the two systems with equal dollars invested per trade.

FIGURE 11: UPDATA. Here is a sample pair-trading strategy for the SPY index/USB UN equity. The stress indicator is shown in the middle pane.

I set up the code on the NASDAQ 100 list of stocks and used the NDX index for pairing. I also set up the hedge using the QQQ ETF going short on the hedge signals. If trading an IRA account, the hedging system can be switched to use an inverse ETF. I used the QQQ for testing because it has more data than the inverse ETFs. In Figure 9, I show the log equity curve and the underwater percent drawdown curve over the test period 1/1/2000 to 1/8/2014. Until 2011, the max drawdowns were in the 14% area but in 2011 the max drawdown incurred was 22.7%. The compound annual return over the test period was 14.9%. Please note that the code I have provided differs from the author’s code in that the tradeplan compounds the results, so that the size is adjusted upward as the equity grows, and the hedge does not use the volatility adjustment.
—Richard Denning [email protected] for TradersStudio

on “Timing The Market With Pairs Logic” by Perry Kaufman in this issue. The strategy is available for download from www. ninjatrader.com/SC/March2014SC.zip. Once it has been downloaded, from within the NinjaTrader Control Center window, select the menu File → Utilities → Import NinjaScript and select the downloaded file. This file is for NinjaTrader version 7 or greater. You can review the strategy source code by selecting the menu Tools → Edit NinjaScript → Strategy from within the NinjaTrader Control Center window and selecting the “Timing With Pairs” file. A sample chart implementing the strategy is in Figure 10.
—Raymond Deux & Patrick Hodges NinjaTrader, LLC, www.ninjatrader.com

F NINJATRADER: MARCH 2014 TRADERS’ TIPS CODE We have implemented a strategy for NinjaTrader users based

F UPDATA: MARCH 2014 TRADERS’ TIPS CODE This month’s Traders’ Tip is based on “Timing The Market With Pairs Logic” by Perry Kaufman. In his article, Kaufman develops a correlated pair-trading system for use across fundamentally different markets to better mitigate risk across a portfolio. The key indicator in this system seeks to identify when both spread legs are at maximum divergence, and enters reversion trades at these points. The Updata code for this article is in the Updata library and may be downloaded by clicking the custom menu and system library. Those who cannot access the library due to a firewall may paste the code shown here into the Updata custom editor and save it. A sample chart is shown in Figure 11.
—Updata support team [email protected], www.updata.co.uk

FiGUre 10: NINJATRADER. This screenshot shows the TimingWithParis strategy applied to a daily chart of the stock HES (while SPY is the second symbol internal to create the pair).

F TRADING BLOX: MARCH 2014 TRADERS’ TIPS CODE In “Timing The Market With Pairs Logic” in this issue, author Perry Kaufman presents his stress indicator and a pair-trading

54 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs

strategy. For the Trading Blox code that replicates these strategies, visit the Trading Blox forum at http://www.tradingblox. com/forum/viewtopic.php?t=10172.

—Trading Blox tradingblox.com

F TRADE NAVIGATOR: MARCH 2014 TRADERS’ TIPS CODE Based on “Timing The Market With Pairs Logic” by Perry Kaufman in this issue, we have created the special file “SC201403” that Trade Navigator users can download to make it easy to implement Kaufman’s technique. To download the file, click on Trade Navigator’s blue telephone button, select download special file, then erase the word “upgrade” and type in SC201403, and click the start button. When prompted to upgrade, click the yes button. If prompted to close all software, click the continue button. Your library will now download. This library contains all the indicators discussed in Kaufman’s article as well as a template called “timing the market with pairs.” This prebuilt template can be overlaid onto a chart by opening the charting dropdown menu, then selecting the templates command, then selecting the template. This template, when applied to a stock chart, will contain the stock’s price in the upper pane, the SPY price in the central pane for comparison, and the three stress indicators in the lower pane (Figure 12). The TradeSense code for the indicators follows:
PJK STRESS &range1 := Highest (High , period) - Lowest (Low , period) &range2 := (Highest (High , period) - Lowest (Low , period)) Of "spy" &stoch1 := (Close - Lowest (Low , period)) / &range1 &stoch2 := (Close - Lowest (Low , period)) Of "spy" / &range2 &diff := &stoch1 - &stoch2 &range11 := Highest (&diff , period) - Lowest (&diff , period) IFF (&range11 <> 0 , 100 * (&diff - Lowest (&diff , period)) / &range11 , 0) STRESS FUNCTION RANGE 1 &range1 := Highest (High , period) - Lowest (Low , period) &range2 := (Highest (High , period) - Lowest (Low , period)) Of "spy" &stoch1 := (Close - Lowest (Low , period)) / &range1 &stoch1 * 100 STRESS FUNCTION RANGE 2 &range1 := Highest (High , period) - Lowest (Low , period) &range2 := (Highest (High , period) - Lowest (Low , period)) Of "spy" &stoch2 := (Close - Lowest (Low , period)) Of "spy" / &range2 &stoch2 * 100

FIGURE 12: TRADE NAVIGATOR, STRESS INDICATORS. Here is a sample chart of AAPL showing the three stress functions (the PJK stress indicator, the stress function range 1, and stress function range 2).

FIGURE 13: TRADE NAVIGATOR, CHART SETTINGS. Here is the chart settings window showing how to edit inputs.

verify button. You may be presented with an add inputs popup message if there are variables in the code. If so, click the yes button, then enter a value in the default value column. If all is well, when you click on the function tab, the code you entered will convert to italics. Finally, click the save button and type a name for the indicator.


To set up these indicators manually, click on the edit dropdown menu and open the trader’s toolbox (or use CTRL+T) and click on the functions tab. Next, click new and a “new function” dialog window will open. In its text box, input the code for one of the above indicators. Ensure there are no extra spaces at the end of each line. When this is completed, click on the


Once you have created the indicators, you can insert the indicators onto your chart by opening the charting dropdown menu, select the “add to chart” command, then on the indicators tab, find your named indicator, select it, and click on the “add” button. Repeat this procedure for the other indicators as well if you wish. If you need assistance with recreating the chart template settings (Figure 13) discussed here, contact our technical support by clicking on the live chat tool located under Trade Navigator’s help menu and also near the top of our homepage, www.TradeNavigator.com, or call our technical support at (719) 884-0245 during our business hours. Happy trading!
—Robert Giacolono Genesis Financial Technologies 719 884-0245, www.TradeNavigator.com

March 2014 • Technical Analysis of


FIGURE 14: EXCEL, Profit & Loss. This view shows the stock, index, and hedged combination.

F MICROSOFT EXCEL: MARCH 2014 TRADERS’ TIPS CODE In “Timing The Market With Pairs Logic” in this issue, author Perry Kaufman shows an accessible approach to relative value arbitrage. His stress indicator shows us when a given equity is oversold relative to the overall market as represented by the SPY (SPDR S&P 500). This is treated as a buy opportunity. The stress indicator also shows when the equity no longer holds an advantage relative to the market. This is one of three possible exit triggers for the equity holdings. Finally, Kaufman shows us a method that may be used to control overall risk by scaling into trades against the index as a hedge to the equity transaction (Figure 14). Figure 15 shows a sample chart illustrating the stress indicator plotted alongside the SPY and a sample stock (HES). The spreadsheet file for this Traders’ Tip can be downloaded from www.traders.com in the Traders’Tips area. To successfully download it, follow these steps:
• Right-click on the Excel file link, then • Select “save as” to place a copy of the spreadsheet file on your hard drive.

FIGURE 15: EXCEL, STRESS INDICATOR AND HES vs. spY. This chart shows the stress indicator for the pair HES vs. SPY.

—Ron McAllister Excel and VBA programmer [email protected]

Stocks & Commodities MAGAZINE Readers’ Choice Award RESULTS Results for the 20th annual Technical Analysis of STOCKs & COMMODITIEs magazine Readers’ Choice Awards (RCA) poll will be announced in the 2014 Bonus Issue of STOCKs & COMMODITIEs, to be mailed to current subscribers in late February. Voting ended on December 31, 2013 at www.Traders.com. The Readers’ Choice poll is based on a

list of products gathered by the editors of STOCKs & COMMODITIEs, with space for write-in votes. The products and services relate to technical analysis and trading and fall across 20 different categories or so, including data services, brokerages, trading platforms, analytical software, artificial intelligence software, training services, and more, as well as favorite S&C article from the past year. The STOCKs & COMMODITIEs Readers’ Choice Awards were launched 20 years ago with the goal of helping readers

make decisions about which products to buy of the many available, by providing information about what other readers have indicated they find useful in their trading. The Bonus Issue will be mailed to subscribers and also will be available at select newsstands. Thank you to all the S&C subscribers who took the time to vote. Stay tuned for the results!

Continued on page 58

56 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs



Fidelity.com/trading 3 5 29 7
TradeStation . . . . . . . . . . . . . . . . . . . 12 Chartmill.com . . . . . . . . . . . . . . . . . . 24 StockCharts.com . . . . . . . . . . . . . . . . 27 Integrated Investor (Hubb Financial) . . . . . 31 Optionetics.com . . . . . . . . . . . . . . . . . 31 Tom Bulkowski . . . . . . . . . . . . . . . . . 39 WallStreetRant.com . . . . . . . . . . . . . . . 40 www.econ.yale.edu/~shiller/data.htm . . . . 41 MetaStock . . . . . . . . . . . . . . . . . . . . 42 SimplerOptions.com . . . . . . . . . . . . . . 46 CQG . . . . . . . . . . . . . . . . . . . . . . . . 51 thinkorswim . . . . . . . . . . . . . . . . . . . 51 Wealth-Lab . . . . . . . . . . . . . . . . . . . . 52 AmiBroker . . . . . . . . . . . . . . . . . . . . 52 NeuroShell Trader . . . . . . . . . . . . . . . . 52 AIQ . . . . . . . . . . . . . . . . . . . . . . . . 53 TradersStudio . . . . . . . . . . . . . . . . . . 53 NinjaTrader . . . . . . . . . . . . . . . . . . . . 54 updata . . . . . . . . . . . . . . . . . . . . . . 54 Trading Blox . . . . . . . . . . . . . . . . . . . 54 Trade Navigator / Genesis Financial . . . . . 55

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• Technical Analysis of STOCKs & COMMODITIEs • 57

Continued from page 56

BOLLINGER BANDS SEMINAR ON DVD A new two-DVD set from John Bollinger condenses two days of material from a seminar into eight hours of presentations. The seminar was held for the 30th anniversary of the development of the Bollinger Bands technique. The DVD material teaches the basics of Bollinger Bands, as well as some of Bollinger’s new work and trading systems utilizing the bands. It also teaches volume indicators, and technical analysis techniques. John Bollinger developed Bollinger Bands in the 1980s in an effort to create fully adaptive trading bands. Thirty years later, many traders use Bollinger Bands as a tool for assessing expected price action. Bollinger Bands can be applied in any financial market, including equities, forex, commodities, and futures, and the bands can be used in most time frames from very short-term periods to hourly, daily, weekly, or monthly.

Brooks is a professional trader with 27 years of experience and is the author of several books and articles on trading. The course focuses on reading price action and seeks to help individual traders become more consistently profitable traders. A live trading room is also offered for $99/month at www.BrooksPriceAction. com. The trading course offers a 30-day money-back guarantee. NEW CHARTING MOBILE APP FOR ANDROID AbleSys has released WinTick Charts as a mobile app for Android users. With this release, users can now access AbleTrend trading signals anywhere and anytime via either desktop or mobile device. WinTick Charts can be used for any market — stocks, futures, commodities, forex, or bonds, and covers US, European, Asian, and other markets. Prices start at $39.95/month. For 18 consecutive years, AbleSys’ AbleTrend product has received awards in STOCKs & COMMODITIEs magazine’s annual Readers’ Choice Awards.

index, forex, and bitcoin data. Charts work in any modern browser on any device and require no installation. Unique features of TradingView include the ability to publish charts with analysis to the gallery, or send instant chart snapshots to social networks such as Twitter, StockTwits, and Facebook. Published analysis cannot be changed or deleted unless the whole user profile is removed, and published charts carry a play button. The play button fills in data that occurred after the chart was published, and allows onlookers to see how predictions played out. Other social features include a real-time chat and trader profiles. Users can purchase PRO or PROREALTIME subscriptions for extra features and real-time data from other US exchanges.


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58 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs




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You can find a wealth of information on the Internet for nearly any subject imaginable, including investing, trading, and the financial markets. You can even find a good amount on technical analysis. We contacted companies that offer services to traders over the Internet as well as financial website developers and asked them to fill out an online survey form to describe their Internet site. At our website in the Traders’ Resource area of Traders.com, you’ll find a database of the data we collected. The listed online services may offer charting, price quotes, and financial news and information; others offer a more specialized service that may be useful to investors and traders. Features may include stock screening, articles,

discussion forums, online support, and more.


1. FreeStockCharts.com 2. interactivebrokers.com 3. StockCharts.com 4. ChartPattern.com 5. ablesys.com 6. Working-Money.com 7. eSignal.com 8. QCharts 9. Traders.com Advantage 10. eSignal Learning


In addition to the online trading services listing at Traders.com, you’ll also find listings of other tradingrelated products and services such as brokerages, data services, courses and seminars, software, publications, trading systems, and more. We hope this will help you learn about products to help in your trading endeavors. To reach the Traders’ Resource area of our website, just click on the Traders’ Resource link from Traders. com. Then follow the online trading services category link, or use the search feature to find products or services with specific attributes in this or other categories.

Worden Brothers, Inc. Interactive Brokers StockCharts.com, Inc. ChartPattern.com AbleSys Corporation Technical Analysis, Inc. eSignal / Interactive Data eSignal / Interactive Data Technical Analysis, Inc. eSignal / Interactive Data

These are the 10 online trading services viewed most often on the Traders’ Resource website, where each company is listed in order of clicks received. This is not an editorial rating or ranking. For more information on specific products and services, try checking store.Traders.com for archived S&C product reviews.

The information in Traders’ Resource is the most accurate at the time of posting and is subject to change. Because the vendors posting to Traders’ Resource are responsible for their own listing, Technical Analysis, Inc. declines any and all liability for any representations made by the businesses and individuals listed. Nor can Technical Analysis, Inc. endorse any business or individual listed on Traders’ Resource. Technical Analysis, Inc. makes no warranties, express or implied, as to the accuracy and reliability of claims herein. You agree to release Technical Analysis, Inc., together with its respective employees, agents, officers, directors and shareholders, from any and all liability and obligations whatsoever in connection with or arising from your use of Traders’ Resource. If at any time you are not happy with the information posted to Traders’ Resource or object to any material within Traders’ Resource, your sole remedy is to cease using it. This list is updated frequently. If you are aware of a business that should be listed, please email us at [email protected]

March 2014

• Technical Analysis of STOCKs & COMMODITIEs • 59

Continued from page 62

decline. In fact, the manner in which the DJIA is maintained actually creates something that resembles a pyramid scheme. All goes well as long as companies are added that are in their takeoff or acceleration phase in place of companies in their stabilization or degeneration phase. On October 1, 1928, when the DJIA was enlarged to 30 constituents, the calculation formula for the index was changed to take into account that the shares of companies in the index split on occasion. It was determined that, to allow the value of the index to remain constant, the sum total of the share values of the 30 constituent companies would be divided by 16.67 (the Dow divisor) as opposed to the previous 30. On October 1, 1928, the sum value of the shares of the 30 constituents of the Dow 30 was $3,984, which was then divided by 16.67 rather than 30, thereby generating an index value of 239 (3,984 divided by 16.67) instead of 132.8 (3,984 divided by 30), representing an increase of 80% overnight. This action had the affect of putting dramatically more importance on the absolute dollar changes of those shares with the greatest price changes. But it didn’t stop there. On September 1929, the Dow divisor was adjusted yet again. This time, it was reduced even further down to 10.47 as a way of better accounting for the change in the deletion and addition of constituents back in October 1928 which, in effect, increased the October 1, 1928 index value to 380.5 from the original 132.8 for a paper increase of 186.5%. From September 1929 onward (at least for a while), this adjustment had the affect of putting even that much more importance on the absolute dollar changes of those shares with the greatest changes.

index value with the old index value is impossible to make with any validity. It’s like comparing the taste of the fruits in a fruit cocktail when the number of different fruits and their distinctive flavors keep changing. Let me explain what this means for our analysis of the DJIA.


On one hand, generally speaking, the companies that are removed from the index are in either the stabilization or degeneration transition phases, of which there are five, namely: 1. The pre-development phase, in which the present status does not visibly change 2. The takeoff phase, in which the process of change starts because of changes to the system 3. The acceleration phase, in which visible structural changes — social, cultural, economical, ecological, and institutional — influence each other 4. The stabilization phase, in which the speed of sociological change slows down and a new dynamic is achieved through learning 5. The degeneration phase, which can be recognized by the saturation of the market and increasing competition. Only the strongest companies can withstand the competition or take over their competitors.


On the other hand, companies in the takeoff or acceleration phase are added to the index. This greatly increases the chances that the index will always continue to advance rather than


From the analyses and explanations I just presented, it is evident that the dramatic adjustments to the Dow divisor (coupled with the addition or deletion of constituent companies according to which transition phase they were in) were major contributors to the dramatic increase in the DJIA from 1920 until October 1929 and to the subsequent, dramatic decrease in the Dow 30 from then until 1932, notwithstanding the economic conditions of the time.


“I’d like enough money so I could afford to give it to politicians and run the country.” 60 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs

In many charts of the price indexes, the y-axis is a fixed unit, which is also the way it usually is with charts displaying stock values, since the unit shows a number of points. However, this is far from representing prices truthfully. An index point is not a fixed unit in time and does not have any historical significance. An index is calculated on the basis of a set of shares. Every index has its own formula, and the formula gives the number of points of the index. However, the set of shares changes regularly. For a new period, the value is based on a different set of shares. It seems very strange that these different sets of shares are represented as the same unit. In less

An index point is not a fixed unit in time and does not have any historical significance.
than 10 years, 12 of the 30 companies (that is, 40%) in the DJIA were replaced. Over a period of 16 years, 20 companies were replaced, a figure of 67%. This meant that over a short period, we were left comparing a basket of today’s apples with a basket of yesterday’s pears. Even more disturbing is that with every change in the set of shares used to calculate the number of points, the formula also changes. This is done because the index, which is the result of two different sets of shares at the time the set is changed, must be the same for both sets at that point in time. The index graphs must be continuous lines. For example, the DJIA is calculated by adding the shares and dividing the result by a number. Because of changes in the set of constituents and the splitting of shares, the divider changes continually. At the moment, the divider is 0.15571590501117, but in 1985, this number was higher than 1. Thus, an index point at two different points in time is calculated in different ways: DJIA (1985) = (x1 + x2 +...+ x30) / 1 DJIA (2014) = (x1 + x2 +...+ x30) / 0.15571590501117 In the 1990s many shares were split. To make sure the result of the calculation remained the same, the number of shares and the divisor changed. An increase in share value of one dollar of the set of shares in 2014 results in 6.4 times more points than in 1985. That in the 1990s many shares were split is probably the cause of the exponential growth of the DJIA. Say the DJIA is at 16,437 points. If we used the 1985 formula, it would be at 2,559 points. The most remarkable characteristic is of course the constantly changing set of shares. Generally speaking, the companies that are removed from the set are in a stabilization or degeneration phase. Companies in a takeoff phase or acceleration phase are added to the set. This greatly increases the chance that the index will rise rather than go down. This is obvious, especially when this is done during the acceleration phase of a transition. From 1980 onward, seven information, communications, and technology (ICT) companies (3M, AT&T, Cisco, HP, IBM, Intel, and Microsoft), the engines of the tech revolution, plus five financial institutions —which always play an important role in every transition — were added to the DJIA. Nike, and Visa.
Alcoa has dropped from $40 in 2007 to $8.08. Hewlett-Packard has dropped from $50 in 2010 to $22.36. Bank of America has dropped from $50 in 2007 to $14.48.
But Goldman Sachs Group, Nike, and Visa rose 25%, 27%, and 18%, respectively, in 2013. September 20, 2012: UnitedHealth Group (UNH) replaced Kraft Foods. Kraft Foods was split into two companies and was therefore deemed less representative and no longer suitable for the DJIA. The share value of UnitedHealth Group had risen by 53% for two years before inclusion in the DJIA. June 8, 2009: Cisco and Travelers replaced Citigroup and General Motors. Citigroup and General Motors have received billions of dollars of US government money to survive and were not representative of the DJIA. September 22, 2008: Kraft Foods replaced American International Group. American International Group was replaced after the decision of the government to take a 79.9% stake in the insurance giant. AIG was narrowly saved from destruction by an emergency loan from the Fed. February 19, 2008: Bank of America and Chevron replaced Altria Group and Honeywell International. Altria was split into two companies and was deemed no longer suitable for the DJIA. Honeywell was removed from the DJIA because the role of industrial companies in the US stock market had declined in recent years, and Honeywell had the smallest sales and profits among the participants in the DJIA. April 8, 2004: Verizon Communications, American International Group, and Pfizer replaced AT&T, Eastman Kodak, and International Paper. AIG shares had increased more than 387% in the previous decade and Pfizer had an increase of more than 675% behind it. Shares of AT&T and Kodak, on the other hand, had decreases of more than 40% in the past decade and were thus removed from the DJIA.


Does this mean the number of points that the DJIA now gives us is “fictional truth” or “real truth”? If it’s fictional truth, then the value of the DJIA says absolutely nothing about the state that the economy or society is in with respect to the past. A better guide would be to look at the number of people in society who use food stamps today – now that is the real truth. Wim Grommen is a guest contributor to http://www.FinancialArticleSummariesToday.com, which describes itself as“a site/sight for sore eyes and inquisitive minds,” and to www. munKNEE.com, which goes by the slogan“It’s all about MONEY.”
March 2014


September 23, 2013: Hewlett-Packard, Bank of America, and Alcoa were replaced by Goldman Sachs Group,

• Technical Analysis of STOCKs & COMMODITIEs • 61

in. Changes in the basket of shares in the DJIA, changes in the formula, and stock splits during the takeoff and acceleration phases of industrial revolutions are perfect transition indicators. The similarities of these indicators during the last two industrial revolutions are fascinating, but they’re also a reason for concern. In fact, a historical chart of the DJIA (Figure 1) is a classic example of “fictional truth” — that is, a fata morgana, so to speak.


The DJIA Is A Fata Morgana
Here’s an interesting perspective on the oldest stock index in the US. The Dow Jones Industrial Average (DJIA) is the only stock market index that encompasses the second and third US industrial revolutions. Calculating indexes such as the DJIA and showing this index in a historical graph is a useful way to show which phase the industrial revolution is by Wim Grommen

The Complexity Of It All

The DJIA was first published in 1896, when it had just 12 constituents and was a simple price average in which the sum total value of the shares of the 12 constituents were simply divided by 12. The shares with the highest prices had the greatest influence on the movements of the index as a whole. In 1916, the Dow 12 became the Dow 20, with four companies being removed from the original 12 and 12 new companies being added. In October 1928, the Dow 20 became the Dow 30, but the calculation of the index was changed to be the sum of the value of the shares of the 30 constituents divided by what is known as the Dow divisor. While the inclusion of the Dow divisor may have seemed very straightforward, it was — and still is — anything but. Why so? Because every time the number of companies or specific constituents change in the index, then any comparison of the new
Continued on page 60

FiGURE 1: djia OVER tHE LaSt tWo iNdUStRiaL REvoLUtioNS. During the last few years, the increases in the Dow Jones Industrial Average have accelerated significantly.

62 • March 2014 • Technical Analysis of STOCKs & COMMODITIEs


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