A myriad of technical indicators and methods are available in today’s age of instant market access and powerful trading software. Rather than help, however, the extreme levels of excess information can make trading a difficult undertaking if that information can’t be processed properly.
Popular trading approaches come and go, and in today’s stock market technical analysis currently is growing in popularity. There are many software programs that traders can use for analyzing the markets. Traders with all experience levels are backtesting ideas and methods that they hope will extract profits from the markets. One question all traders should ask, however, is if backtesting and developing a profitable trading system is such an easy route to profits, why doesn’t everyone have one by now?
While the promises of market pundits and trading software vendors may diverge on this matter, the truth is that while backtesting can create an optimum strategy for trading the markets of the past, many times these strategies fail at what really matters: trading the markets of the future.
A system that has been backtested and optimized will only perform as long as the parameters the market depicted during the testing period persevere. That is why some systems will perform well for a while and then collapse. The reason these trading systems break down is that market instruments, from commodities to equities, constantly go through mode changes within their respective trends, as well as shifts in fundamental supply and demand factors. The markets change constantly.
Because the markets involve human participation, human psychology is a key element to market movements. The effect of mass-market psychology on price is a difficult parameter to analyze for the simple reason that human interpretation of data and facts can and does produce significantly different conclusions among participants. Therefore, determining the future course of price trends is not and will never be an exact science. If it were, economists would be stock traders, and the Greeks would have cornered the olive oil market a long time ago.
The number of trading systems that have been developed over time is as many or more than the markets to trade. Some of these systems have been simple, and some have been enormously complex. Many times, the more complex systems attempt to solve the psychology component. Few, if any, have succeeded. For most traders, it’s better to acknowledge the unpredictable psychology component and devise strategies that trade around it and are not based on it.
We can do that by focusing on simpler systems. At the basic level, only two components are required in a system: an entry rule and an exit plan. No matter how complex or simple a system is, its main function is to determine when to buy and sell. Here, we will review a simple but effective entry and exit system devised for stock selection. It is a basic entry and exit tactic that uses moving averages (trend) and volume (liquidity flow).
FOLLOWING THE FLOW
Another important element to trading system success is market selection. If the stock you choose to trade is not in a defined trend, your chance of success is limited.
One of the quickest ways to find a market instrument that trends well is to look for one that performs strongly based on a moving average. We prefer to use Fibonacci numbers to set our slow and fast moving average levels. Here we use a 34-day SMA for our slower average and a 13-day for our faster moving average. “Steady mover” (right) is an example of just such a stock, in this case ISRG (Intuitive Surgical Inc.). It has an eight-month track record of a downtrend that has not gotten too far ahead of the moving averages. While it is not a guarantee that this specific equity will continue to trend into the future, we know that in its recent past, it trades within the confines of this moving average pair. That give us an edge.
The next indicator of a likely move is a volume spike. While moving averages may point to the right road to take — and the direction to travel — volume is the fuel that propels price changes. A volume surge of 300% to 500% should get your attention. While the first volume spike highlighted on “Steady mover” did not produce a new uptrend, it also did not precede a drastic selloff. Such a development should also get your attention. It’s a clue that price might be nearing a bottom. In this case, over the next three months, price continued in a downtrend, but a slowing rate of descent was observed.
During the month of March, price had finally stopped declining and began to move in a tight narrow range in line with the moving averages. Notice how small the bars were during that time and how sideways the action was. The dynamics suggested that price had finally reached equilibrium between buyers and sellers. A trade setup was in the making.
Around this same timeframe, the U.S. stock market had bottomed. Then, another volume spike occurred over a two-day period in April. This time, price was boosted higher. The difference was that price climbed above its moving average and the fast moving average crossed above the slow one. The most important aspect, however, was that within six trading days, price was trading at its four-month high. This is a significant milestone and a reliable buy signal. These three dynamics (price, volume and time), when combined at market bottoms, are an excellent indication of future price direction.
For the entry strategy there are two alternatives. Enter immediately or wait for a pullback to the moving averages. Whichever the choice, the most important aspect of entry is determining a stop loss in case you’re wrong. While there are many tactics that can be employed, a simple one that works well is to place a stop below the last important low. In this case, the April lows make sense due to being somewhat recent and a rather significant milestone.
Now that we are financially engaged in the market, we need to monitor the progress and move our stop each time a new high is made. Keep in mind that the new high is a time reference, not a price reference for the stop itself. When the high is set, the stop will move to below the last important low on the chart. “Stopping higher” (page 31) shows this dynamic in action. As the market makes new highs, the stop is moved to under the last important low point.
The next significant event took place in July where another volume spike produced a significant gap up in price. This is what is referred to as a “long-range day.” When a long-range day occurs with volume spikes, it is another favorite buy signal. This is the point where the market recognizes a major trend change has occurred and everyone wants in. This signal is the hardest to follow but is often the most rewarding. Few will follow this signal because of the sheer price increase that comes with it. One way to play it is to buy on any new high after a successful test of the moving averages.
Thanks to recent innovations in the exchange-traded fund (ETF) market, investors can participate in many commodity and stock industries as easily as they do individual equities. There are ETFs tied to numerous commodities, such as coal, oil, grains, gas, gold and currencies. Say you are bearish on conditions in Europe and believe the dollar will appreciate against the euro. To execute your plan, you decide to consider a double-short ETF on the euro. A double-short ETF will appreciate as the euro depreciates, but will do so at twice the rate. It also will lose money at twice the rate if the euro fails to move as expected.
“Up with the buck” (left) shows the same setup as with the ISRG example. There is a volume surge, a trend change and a four-month high taken out in three weeks of trading. The fast moving average crosses above the slow. Because currencies are some of the best-trending markets, this setup has a lot of potential.
To confirm, we can also look at a chart of an ETF that tracks the U.S. dollar. This can be seen in the second chart of “Up with the buck.” Look at the volume spikes that developed earlier and at the market bottom. Here, too, we seem to have a trend change in play. What we don’t have is a new three- or four-month high, suggesting that the momentum to the upside is not as strong as we’d like it to be. This doesn’t eliminate the trade completely, however. Each situation will have slight variations and must be taken into consideration.
There will be times when trends fizzle and you will be stopped out. This stresses the importance of market selection. You want to select an instrument that will generate not only a trend move, but momentum, as well. This is why the three- or four-month high and volume qualities are just as important as the moving average component. These clues indicate that there is potential momentum behind the upcoming move.
A trading system doesn’t have to be complex. It just has to be effective.
Bill Downey is an independent investor/trader who has studied technical analysis of gold and silver since the mid-1980s. Contact him at firstname.lastname@example.org or via www.goldtrends.net