From the January 01, 2010 issue of Futures Magazine • Subscribe!

Understanding stock market direction

DON’T BE AVERAGE

Average investors allow themselves to fall victim to this situation because they come into the market with no plan or method to trade. They buy on tips from their brother-in-law or because a stock is reputed to be a “good company.” These are not plans or methods. This is gambling.

For the skilled trader, there are tools that when combined with sound reasoning will serve as a guide on the Road to Mastery. These tools help the skilled trader avoid the emotional and financial extremes experienced by the herd; instead of being a victim of the manic behaviors of crowd psychology, you can exploit these extremes.

While these tools will help you make solid decisions, it is still hard to go against the crowd. Steel your emotions to act on reliable signals and discipline yourself to follow your rules. Crowds are often wrong. Being a follower in the markets usually leads to losses. This is harder than it appears because human beings are social animals, but by exercising self-discipline, we can move ahead of the curve.

This implies that successful trading requires the ability to act independently. Having a method or system that allows you to exploit an advantage helps, but ultimately even the greatest trading method won’t work if the trader ignores certain
underlying truths.

One solution is to use a trading tool that, by its nature, not only captures the short-term market moves but tends to give positive signals in line with the general market trend. While this seems at odds with what we just said, there is a difference between following the trend and following the general market consensus. Trends give signs of exhaustion before the larger trading community takes notice.

FOLLOW THROUGH DAYS

Bear markets usually end while business is still in a downtrend. The reason is that stocks are anticipating, or discounting, all economic, political and worldwide events months in advance. The stock market is a leading economic indicator, not a lagging indicator. As such, this is an excellent time to get on board. Not only are you getting in ahead of a big move, but you generally are doing so in concert with the general market trend before most of the investing public has picked up on it.

One of the best methods for spotting the bottom in the stock market is the O’Neil Follow Through Day (FTD). This method uses a combination of price action combined with volume to spot the bottom in the general market. It is based on statistical studies of the market going back almost 100 years.

At some point in the decline of the general market, it will attempt to rally. A rally attempt begins when a major market average closes higher after a decline that happened either earlier in the day or during the previous session. An example is if the S&P 500 falls 2% in the morning but then recovers later in the day and closes higher (see “FTD gives green light,” above) .

Now that a rally has been attempted, starting on the fourth day following the attempted rally, look for one of the major averages to follow through with a huge gain of at least 1% on heavy volume. An FTD should give the feeling of an explosive rally with what appears to be strong and decisive price action. The volume for that day should begin above average, as well as higher than the previous day’s volume.

The most powerful FTDs occur within four to seven days of an attempted rally. Occasionally, a FTD will occur on the second or third day, but in that scenario the first, second and third days must all be quite powerful, with a major average up 1.5% or more each session with heavy volume.

In general, larger averages, such as the S&P 500, are better proxies for the overall market than, say, the Dow Jones Industrial Average, which is only composed of 30 stocks.

GO EASY

A FTD doesn’t mean to go on a buying spree, but it does give the signal for intelligent speculation where you, as a trader, use a complimentary method of stock selection of high-quality stock candidates to begin hunting for good entries.

Also, no new bull market has ever started without a strong price and volume follow-through confirmation (see “The big move predicted," right). It pays to wait and listen to the market.

Spend time studying your charts and the market averages to perfect this. Practice is the best way to learn the mechanics of this or any method.

To be highly accurate in any pursuit, you must observe and analyze the objects themselves carefully. By studying this method in action, you will have a very powerful tool in your trading arsenal.

Note: For more on this method, see “How to Make Money in Stocks” by William O’Neil (Chapter 9).

Billy Williams is a 20-year veteran trader specializing in momentum trading in both stocks and options. Read his market commentary at www.StockOptionSystem.com

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