Trading Strategy

On July 31, 2010 in my "Volatility" post I mentioned "Overall, I would say that you may find a number of technical indicators that suggest possibility of up move. My technical analysis tells me that this possibility exists as well, yet, so far, I do not see the indexes gonging higher their June 21st and July 27th highs." Taking look back at the past week, we had relatively quiet and side-way trading with exception of strong up move on Monday's morning and strong swing down and up on Friday. The S&P 500 index stuck in side-way action exactly at its high seen on June 21st, 2010; the Nasdaq 100 index - a little bit below and the DJI index a little bit about.

Now, by analyzing indexes I would say that the situation is mixed at this point. From one side on the longer-term charts we have decrease in volatility which would suggest the possibility of up-move. From other side we started to see negative divergence on many technical indicators - when price moves up and makes new high, yet an indicator either moves side-way or moves in opposite direction.

If I would analyze all technical indicators I would say that, because of the side-way trading over the last 5 days, 50% of technical indicators are neutral and could be interpreted either as bullish or bearish, 25% of indicators are bullish and the rest 25% are bearish. The one may ask how a trader can make a decision in such situation. The main challenge of technical analysis that the stock market never gives you 100% clear signals. There are always some technical indicators that favor up-move and some technical indicators that favor bearish trading. The challenge is to define what indication is more important at given period of time.

In the current situation, even I more bearish (because of negative divergence I see on many charts), I would say that (as in most cases of side-way trading) a simple strategy could be used. Every side-way trading defines upper and lower lines of side-way corridor. If upper line of side-way corridor (high on August 4) is broken - odds would favor bullish trading. If lower line of side-way corridor (low on August 6) is broken - odds would favor the bears. Until then conservative approach on my opinion would be to remain in cash.

Simple Trading Strategy

A few weeks ago I promised to take a look at the longer-term charts and longer-term technical analysis. I think it's time to check the general stock market trend. It is my strong believe that a trader, no matter what he/she trades, has time on time to apply technical analysis to the longer-term index charts (Dow Jones Industrials, S&P 500, Nasdaq100 charts) and to evaluate the current stock market stage in order to adjust or change used trading strategy.

A trader can develop and have permanent trading system (set of technical indicators and rules that generates trading signals). Yet, if a strategy of using this system is not adjusted to the general stock market stage then, no matter how good a trading system is, this trader risks to face the system failure sooner or later. The stock market is a live creature. It is in the constant move, it is in the constant change and it is in the constant adapting to the new trading rules, to the new generations of traders, new values of the society, etc. If you are looking for some "Golden Trading System" that require no studying, no monitoring, no work, but just sitting on the couch and calculating a profit then instead of becoming a trader you should spend your money on beer and recreations - at least you receive emotional satisfaction.

There are several examples of simple trading strategies that adjust a system to the longer-term stock market trend. I just want to mention a few of them as a reference to my point of importance of longer-term technical analysis.

Simple Trading Strategy Example #1:

If the longer-term trend could be defined as an up-trend then the strategy of using trading system can put more weighting on "Buy" signals:

• ignore weak "Sell" signals and trade only strong and confirmed "Sell" signals to open a short position;
• trade all "Buy" signals, including the weak ones;
• have a tighter stop-loss strategy when short trade is opened;

Controversially, when the longer-term trend could be defined as a down-trend a trading strategy of using a system could be emphasized on using "Sell"’ signals

• ignore weak "Buy" signals and trade only strong and confirmed "Buy" signals to open a long position;
•  trade all "Sell" signals, including the weak ones;
•  have a tighter stop-loss strategy when long trade is opened;

If the results of the analysis show that the stock market is in a sideway move then a trader may apply equal weighting to "Buy" and "Sell" signals – treat them in the same way.

Simple Trading Strategy Example #2:
(even simpler than the previous strategy)

Stop trading and stay in cash when the longer-term stock market trend could be defined as down-trend and go back in to the stock market when the stock market is in the up-trend.

Selection of a trading strategy depends on what you trade, how you trade (how many trades you made) and how much you trade (how much you invest into a trade). It is essential time on tine to take a look on the general market picture and see where the longer-term trend is going. If you have longer-term technical analysis behind your trading strategy then the odds your trading system is successful are much higher.

In my next post I'll try to show my personal view on the longer-term technical analysis with a reference to theS&P 500 chart.

Technical Analysis

In my last "Trading Strategy" post on November 8, 2009 I have mentioned a possibility of the indexes (Nasdaq 100, S&P 500, DJI, etc) stacking in a sideway action at their October's high levels. The next day, on Monday November 9, 2009 we still had a strong advance and since then the rest of the week we may see that the indexes have been trading mainly sideway (see the S&P 500 chart below): the S&P 500 index exactly at its October's high levels, the Nasdaq 100 index a few points higher and the DJI index has made new 13-month high.

The S&P 500 Chart with elements of technical analysis:
Selling/Buying Volume Oscillator, Advance/Decline Oscillator, MarketVolume Oscillator,
MACD, RSI, Stochastics, McClellan Oscillator, Average True Range in Percents.

In technical analysis it is common to take a look at the history, and from the history you may see that in majority cases sideway trading at new high level ends with a correctional move down. As a rule during this sideway trading you may see strong bearish signals. If you take a look at the chart (S&P 500 chart above) you would see that on Thursday, November 12, 2009 all technical indicators (except volatility indicators) have generated strongly bearish signals. Yet, on the next trading day (Friday, November 13, 2009) the indexes bounced up from their lower level of the sideway corridor (see the same chart above).

Last week I mentioned: "At that time (in September and October) the indexes have been moving sideways for several trading days … we may see some sideway action at this level again ... If the market starts to move sideways the odds are high that the technical indicators will become bearish." That is what we saw on charts: sideway move and bearish signals on Thursday. However, in the same post I have brought some reasons why I would not consider these bearish indications as strong signals, and why I would rather consider waiting. There were two main reasons why I would avoid trading short at that moment: a) no high volume during the up-move and b) no increase in volatility.

Absence, of high volume during up-move indicates that this up-move was not strong enough to generate greedy buying when investors start to rush into the stock market with the hope to jump into "the last wagon of the running train" - as a rule such action leads to a misbalanced in the supply/demands and at least to the short-term correction down. Absence of increase in volatility indicates that the current sideway move did not generated any panic among traders which suggest there were no increase in the number of bearish traders as well. These two reasons kept me last week from trading short, and the same two reasons still keep me out of it.

Right now technical indicator on the major index charts (S&P 500, DJI and Nasdaq 100 charts) are mixed. You may see Bullish indicators as well as some indicators remain bearish:

 - SBV (Selling Buying Volume) Oscillator is moving sideways at this moment which is a neutral sign. Yet, the bullish volume (accumulated since November 4, 2009) still could be considered as a force which is strong enough to push the stock market down into a correction.

 - The absence of the Bullish volume surges (no green MVO) suggests the higher odds of further up move.

 - The advance/decline oscillator is almost flat, yet, it moves up from its most recent low which could be considered as modestly bullish signal.

 - The same as A/D Oscillator, MACD is almost flat, yet, it is moving up from its recent low which is bullish sign, on the other hand it is still in the negative area which could be considered as bearish sign. Overall, MACD could be considered bearish with tendency to become Bullish.

 - General RSI direction is down and this is bearish sign in technical analysis.

 - General Stochastics direction is up and this is a bullish sign in technical analysis.

-  McClellan Oscillator is still in the negative territory which is bullish, yet, it is very close to cross the center (zero) line which in technical analysis is considered as a "Buy" signal.

 - ATR remains on the same level and this is very nice indication (as already mentioned above) of bullish sentiment."

Overall, I would consider technical analysis mixed at this point of time. There is still an existence of a danger of a correction down. At the same time, some technical indicators push me to believe that even if we see a correction it should not be a very strong move down, unless I see at least changes in volatility sentiment (increase in volatility). At the same time indication of resuming of up-move are not strong enough to be strongly Bullish.

I am not stating that I am always right, and that my technical analysis is perfect. I am just trying to share my thoughts about current stock market sentiment and possible development of a future market trend. It helps me to put my thoughts in the order and I hope it may help somebody in avoiding a mistake that can become "financial suicidal". I would rather recommend doing your own technical analysis and checking all my statements by yourself before even considering to follow them.

Trading Strategy

Those who follow my blog should remember what I said a week ago in the "Advance/Decline" post on November 1, 2009: "Yes, if we take a look at major technical indicators (beside volume and advance/decline) we will see that almost all of them are bearish and suggest the higher odds of further decline. However, I would not be very sure in this and personally I do not hold any short position right now. Yes, we still may see some decline, however based on my experience working with volume and advance/decline data I would consider possibility of coming reversal and I would monitor index charts more closely for bullish signals that may confirm my analysis."

Now, you may see that indeed extremely low advance decline readings in the S&P 500 index indicate coming reversal and uptrend. If you take look at the hourly index charts (S&P 500, Nasdaq 100 and DJI) you will see that already on Monday November 2, 2008 by the end of the trading session MACD and Stochastics have became Bullish, shortly after the market open on November 3, 2009 Advance/Decline Ratio and RSI became Bullish and by the end of the trading session on the same day McClellan Oscillator and SBV Oscillator indicated Bullish sentiment.

Strong up move during the rest of the week has pushed S&P 500 and Nasdaq 100 indexes to their high levels on September 17-23, 2009 and DJI index to its high on October 16-22, 2009. At that time (in September and October) the indexes have been moving sideways for several trading days. Furthermore, I would say that we may see some sideway action at this level again. Actually, we already started to see slowdown in the recent rally up and some of the technical indicators started to show tendency to become bearish. If the market starts to move sideways the odds are high that the technical indicators will become bearish. However, personally, if this is a case and technical analysis starts to generate bearish trading signals I would not wait for a strong correction. There are several main reasons why:

 - The recent correction has generated high volume surges at its support level, yet we have not seen any increase in volume during the resent recovery. Furthermore, I may say that the recent recovery did not generated waves of greedy buying which could change a supply/demand balance.

 - The market becomes less volatile which could be clearly seen on the VIX index (volatility index) decline. As a rule a decline in volatility suggest that the market becomes more stable and higher odds of up-move.

 - During the recent decline we saw twice the S&P 500 hitting extremely low advance/decline readings (on October 28 and October 30, 2009). This suggests that the marker became strongly oversold at its support level. So far I do not see any indication of market becoming overbought.

Overall I would say, yes, if technical analysis starts to generate bearish signals we may see some sideway move and even a correction; however I would not consider the bearish trading signals as a reason to open a short trade in the current market stage. One of the conservative and safe trading strategy when the longer-term trend could be defined as bullish could be described in two simple rules:

Rule #1: Open a long trade when you see Bullish signals;

Rule #2: Stay in cash and wait for Bullish signals when you see Bearish signals.

Stop-Loss Trading Strategy

Many traders face a question what strategy to use in order to protect portfolio from big losses. In most cases this question is narrowed to a selection of a stop-loss strategy. A stop-loss strategy choice is very important, yet, is very confusing and can put even an experienced trader in a corner. The problem is that there is no straight answer on what system to use. A stop-loss selection completely depends on a selected trading vehicle, a personal trading style, risk tolerance, invested money and in addition it depends on the stock market itself.

I will try to go through some of the factors that may affect the stop-loss strategy.

1. Selected Trading Vehicle: Depending on what you trade, a stop-loss would be different. If you are buying and selling stocks 2-5% stop-loss could be sufficient for your trading system. However if you are buying options then 2-5% stop level could be hit very easily and you could be willing to look for 20-50% stop-level. If you trade uncovered options you could even think about setting stop-loss above 100% of the premium received. Even if you are trading stocks the stop-loss level could greatly differ from stock to stock. More volatile stocks would require bigger-stop-loss than the less volatile stocks.

2. Personal Trading Style: There are different trading system and different trading styles. Some traders are buying equities for long-term investments of pension funds and they make one trade per one-two years. These traders could be ready to set stop-loss to 10% and above. On the other hand a short-term trader who makes 5 trades per week may not be willing to risk setting stop-loss bigger than 1%.

3. Risk Tolerance: Twenty years old trader may lose everything and he/she still will have time to make some money and come back to trading and investing. However if you are close to retirement you should know the edge when it is better to get out of a game. If you are seventy years old you could be willing to set tighter stop-loss than.

4. Invested Money: If you have only $2,200 on your account and you invest all of them on margin ($4,400) in one trade, your stop-loss should be below 5%. Otherwise you risk losing more than $200 in a single trade and you may lose your ability of trading on margin. At the same time a trader who invest a $1,000 into a trade and who has $100K on the account could be ready to lose all 100% of the invested money (all $1,000).

5. Stock Market: The market condition is the most important factor that many traders skip. The market has periods of different volatility. During a steady uptrend, as a rule, the market is less volatile than during a recession and the market is extremely volatile during a stock market crash. It is logical to adjust a stop-loss trading strategy to the market volatility. It is unusual situation when the long-term uptrend (when market is less volatile) to see bigger than 2% DJI index moves within a single session. Furthermore, a short-term DJI trader would be looking for tighter than 2% stop-loss. At the same time, during a recession when market is more volatile the odds are very good for bigger than 2% DJI moves up and down within a single session and the same short-term trader, who is brave enough to trade in volatile market, could be willing to consider less tight stop-loss.

As you see stop-loss selection is not as easy as it seems from the first view. A lot of factors should be considered and there is no straight answer. Each trader has to find it out by him/herself. A trader should not copy any other trader - what works well for one trader does not necessary will be good for another trader. You can and you should look what other traders do, but not mimic them. If you decided to use somebody's style, learn it first and then use your knowledge to build your own trading strategy or adjust existing one to you personal trading needs. Do your own homework and do not think that your trading system is invincible and you will never have a negative trade.

Leading and Lagging Techical Indicators

Short Description: some answer on subject of what technical studies to use.

The technical indicators (studies) could be divided into several categories by the type of data they are based on: price based indicators, volume based indicators, advance/decline (or Breadth) indicators and combined indicators that are based on price and volume or price and advance/decline data. The other way to classify technical indicators is to classify them by the way they are used in technical analysis.

There are three basic ways to use indicators in the analysis and a category that would cover each particular indicator depends on what this indicator indicates or what type of signals it generates:

1. Leading Technical Indicators – indicators that signal possible trend reversal in the future;

2. Lagging Technical Indicators – indicators that follow changes in the trend which also called trend-following indicators;

3. Informational Technical Indicators – indicators that do not predict nor follow a trend, but describe market, index or traded security. The examples of such indicators could be ATR, VIX and other studies are used to measure volatility, ADX that is used to measure strength of a trend and define sideway markets, etc.

In many sources you may find that the main role of technical analysis is to generate buy and sell signals. Based on the classification above I would say that this definition of technical analysis purpose is somewhat misleading since the informational studies which are used in analysis do not generate "Buy/Sell" signals. I would rather say that the purpose of the technical analysis is to analyze the current market or stock condition in relation to the past. After that, the result of technical analysis could be used in a trading system to generate "Buy/Sell" signals and most likely a good trading system would use technical studies from each category defined above.

A good trading system would use the leading indicators to signal a possible change in a trend. However, there is no 100% guarantee that after a leading indicator generates a signal you will see a reversal. As an example, a volume surge during the price decline signals possible change in supply/demand balance and following reversal move up. However, it does not tell you when it could happen: in 5 min, in an hour, in a day, etc. At the same time there could be situation when signals generated by leading indicators could be ignored – in our example of volume – the small volume surges could be ignored if stock or market is in strong up or down trend.

Now, we came to the lagging (trend following) indicators. They could be used alone, however, by itself lagging indicators could generate fake signals or generate signal when it is too late to open or close a trade. The best way to use them is in combination with leading indicators: a leading indicator generates signal about possible trend reversal and then lagging indicator confirms this reversal. In this trading strategy a trade is opened only after a lagging indicator confirms previously generated signal by a leading indicator. Al other situations when only one of the indicators signals a reversal are simply ignored. A trading system based on this strategy allows applying more sensitive setting to lagging indicators (by alone it would be considered very risky) and open a trade closer to reversals.

The last group of technical studies delivers important information used in technical analysis to adjust leading and lagging indicators setting as well as modify trading strategy in accordance to the current market condition. For instance ATR (Average True Range) is used in technical analysis to measure market (when applied to indexes) and security (when applied to a single security) volatility. It is usual that in highly volatile market we may witness rapid and strong changes in a trend. In this case a trader could be willing to adjust his/her indicators to be more sensitive (lower bar period setting, go to lower timeframe…). On the other hand in quiet market it could be good idea to set bigger lag (increase bar period setting, move to higher timeframe) and make indicators to generate signals with some delay. The ADX (Average Directional Index) could be another example of using informational indicators. ADX by itself does not generate signals at all -it tells only whether market/stock is in strong trend, weak trend or flat market. Based on the results of ADX analysis a trader may adjust a trading strategy and for instance trade only “Buy” short-term signals in longer-term strong up trend and trade only "Sell" signals in longer-term strong down-trend, and trade both signals during weak or sideway trend.

As you may see there are different technical indicators and as a rule professional analysts always use combination of them. Analysis of one indicator, sooner or later, may lead to the disappointment that this indicator is bad. My opinion is that there are no bad technical indicators - there could be only an incorrect way they are used. If you are looking for technical indicator that would generate stable positive return all the time I would recommend you do not waste your time but spend it rather on learning several technical studies that would help you to see the complete picture and not just some part of it.

Simple Trading Strategy

Nice day. What can I say, see my last "Short-term Technical Analysis" post. Pressure of the longer-term oversold levels pushed the market strongly higher. Today, shortly after the market open all short term technical indicators were extremely bullish and the stock market (all indexes - DJI, Nasdaq 100, S&P 500 and other) recovered in the strong rally.

There is a golden rule "never play against a trend", yet, I have never seen anyone who would explain what does it mean and how it could be used on practice. In my understanding this rule could be used in building a simple trading strategy: ignore signals generated by shorter term indicators if they suggest to trade against the longer term indicators and trade only those shorter term signals which go along with longer term technical indicators.

If based on the technical analysis of 1-year chart a trader have made an assumption that this chart suggest that the market is heavily oversold, then this trader may say that all signals generated by the 60-day chart (shorter term chart) to open a short trade (signals to sell short) should be ignored, while any bullish indication (signals to buy) on the 60-day chart could be used to open a long position. This is my interpretation of the "never play against a trend" rule.

I could be wrong, yet I do not understand those traders who build their trading systems based on one timeframe only. For me it's walking in the "dark room". That is why I analyze several timeframes simultaneously.