From the December 01, 2007 issue of Futures Magazine • Subscribe!

Market relationships key to price moves

The day trader who understands that markets are connected has an edge. This trader can use that edge to avoid being blindsided, zero in on good trades and time trades more precisely.

For example, knowing what gold is doing can make you a better Nasdaq day trader. Following the Nasdaq 100, S&P 500, 30-year bonds, euro, gold and crude oil can make you better day trader in any one, or in any combination, of these markets. Following the movement of the semiconductor, regional bank, retail, basic materials and oil services equity sectors will raise your skill another notch. In principle, following any combination of interconnected markets or sectors should improve your bottom line.

That is, if you follow these markets correctly.

Following a market means knowing precisely where that market is along a series of interconnected price channels. It also means knowing exactly which markets are moving in the same or opposite direction and which markets are running in front of a combination of markets or running to catch up. Dig for relational patterns. A good day trader is able to mentally process contradictory input, paradoxical input, sudden input and changing input under the pressure of short time frames.

If your brain can work fast, you can day trade. The danger in day trading is not its inherent speed but the inability of some traders to think quickly. These traders assume the deficiency is a fault of the markets and not a fault of their own.

RELATIONSHIPS IN ACTION

In the trading days leading up to and surrounding the Federal Reserve’s June 28, 2007, interest rate decision, each of the following relationships happened. Bonds rallied as equities broke. Equities rallied as bonds broke. Equities rallied as bonds rallied. Gold collapsed as equities edged higher. Then, equities collapsed. Equities surged as gold churned, and then gold surged. The euro surged, and then bonds surged.

Traders who stayed on top of specific and general situations had an edge. They avoided being blindsided. They identified profitable trades and tightened their timing. The challenge is to maintain situational awareness and ride the relational patterns and changes.

The Nasdaq 100, S&P 500, bonds, euro, gold and crude oil were volatile on Wednesday, June 27; Thursday, June 28; and Friday, June 29. The general business press expected the Fed to leave rates unchanged. The press was right. The Fed left rates unchanged and its decision was a non-event. So, how did a non-event stimulate so much volatility?

This is the nature of markets. Even when an outcome is known, markets test the limits of a price. Traders who watch relationships understand the concept of testing. These traders are able to trade with precision. Traders who do not understand relationships can become disoriented. In simple terms, disoriented traders can act emotionally. Emotion drives exaggeration, which drives the testing process. Precise traders take advantage of this emotion.

One tool for tracking this price exploration process is a linear regression channel. A simple trendline uses a single line. The line connects the lows in an uptrend or highs in a downtrend. Channel lines use a pair of parallel lines. They work the same in an uptrend and downtrend. A linear regression channel uses a trio of lines. It inserts a centerline between a pair of channel lines. The center line is the mean. Equidistant from the center line is the buy line and the sell line. The upper line is the sell line. The bottom line is the buy line. The idea is that the price will oscillate around the mean. When it moves too far in one direction, it will regress (return) to the line in the middle.

In the days leading up to the Fed decision, the Nasdaq 100 broke hard. Then on June 27 it surged off its intraday 11-day buy-line. On the day of the Fed’s decision, the Nasdaq 100 put in a bull trap; the price rallied, then regressed to the mean. The day after, on June 29, the Nasdaq 100 churned violently: the price tested above and below the mean then returned to the mean (see the first chart in “A regressing situation”).

Now add three more perspectives. The other charts in “A regressing situation” are a one-day chart of QQQQ, the Nasdaq 100 exchange-traded fund (ETF) using the regular trading hours (9:30 a.m. to 4 p.m. EST) for the New York Stock Exchange (NYSE); an intraday three-day chart of the Nasdaq 100 September 2007 futures; and an intraday 11-day chart of the Nasdaq 100 September futures. Note how liquidity can affect price movements. NYSE regular hours represent the time during which U.S.-based liquidity, in general, reaches a high point each trading day. The three-day and 11-day periods are subjective and based on experimentation in the markets.

Over time, a linear regression channel will adapt as the price changes. The distance between the sell line and buy line may increase or decrease. The angle of the channel may change. The lines themselves, however, by design, will remain straight. Notice the Nasdaq 100 ETF rallied off its one-day buy-line after the bond market closed. Notice on the three-day chart how the market broke sharply to the buy line then rallied just as sharply. Notice on the 11-day chart it broke to the mean then rallied.

Looking back at the 30-day chart, however, the price action could be described as confused. With all four charts out in front, though, the precision factor would have been amplified. Still, something else was impacting the Nasdaq 100. There was logic behind the break and rally.

“Bank on it” (above) shows the intraday 11-day charts for the S&P 500 and the regional bank ETF, or RKH, as of June 29. RKH has a tendency to drive the S&P 500.

RKH tested resistance at its 11-day sell line. At the same time, a surge in the S&P 500 was blunted and reversed at its own sell line. Compare this action to the 11-day Nasdaq chart. RKH warned that the Nasdaq was vulnerable. On June 29, dominant traders grouped RKH, the S&P 500 and the Nasdaq 100 together. This is not something a trader fights.

The answer was in the bond and euro futures charts (see “Two more views,” below). During the early hours on June 29, the euro currency surged. This forced bonds higher, which, in an inverse relationship, drove RKH lower, which drove the S&P 500 lower, which undermined the Nasdaq 100.

Looking now at the 11-day S&P 500 and bond charts, over the course of the period shown, there were times when the S&P 500 and bonds moved in the same direction and times when the two moved in the opposite direction. At times, the S&P 500 led. At times, bonds led. Relational patterns can persist or reverse. They can change suddenly.

Two other key pieces of this intermarket puzzle are gold and crude oil (see “Slick and Shiny,” above). On June 29, gold imitated RKH and the S&P 500. In effect, gold confirmed that the Nasdaq 100 was vulnerable, giving credence to the axiom that if you want to day trade the Nasdaq 100, that you should watch gold. On June 26, gold led equities lower. Gold collapsed early. On June 26, in a direct relationship, the S&P 500 and the Nasdaq 100 followed gold lower. Here, gold warned Nasdaq day traders. What helped gold recover on June 27? Its 11-day buy-line and a surge in crude oil prices supported it. Crude also drove OIH (the oil services ETF) higher, which carried the S&P 500 higher.

LONG WAY AROUND

This demonstration should offer new insight into why the Nasdaq 100 broke on June 26, rallied on June 27, churned on June 28 and churned violently on June 29. Markets are connected, and regardless of how you trade, if you do not understand that basic concept, you are losing out on a fresh perspective on why markets move how they do.

Indeed, even watching more than 40 charts would not be out of the ordinary, staying aware of one-day trends, swings and longer-term trends. The key is to have them arranged and organized so that you can follow them without being overwhelmed. Do not overload yourself, but do not leave too much information on the table. While many people may erroneously tell you that making money in the markets is easy, it’s not. The approach described here works, but it requires a considerable commitment of time and practice.

Relationships among markets are an algorithm that can persist or reverse. Relationships also can change suddenly. They change because markets are a collective of constantly shifting buyers and sellers. Markets are collision zones of different skill levels and knowledge bases. The why of economic relationships is dynamic, just as the why behind all essentially human relationships is dynamic. The job of a day trader is to wait for and trade these shifting, interconnected patterns and be ready to exploit them when they are ripe.

Dig for relational patterns, not reasons. If you dig for reasons, you may become biased and fight a price movement when the relationship has changed. If you dig for patterns, more likely you will remain neutral. More likely you will be able to flow with a rally, a break or a sudden change. And flowing with the markets, rather than fighting them, is a much more profitable way to trade.

Richard L. Muehlberg uses linear regression channels and intermarket analysis to day trade his own account. He publishes a day trading diary on his Web site www.daytradingwithlinesinthesky.com.com. E-mail: richardmue@yahoo.com.

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