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

Stocks, mutual funds and ETFs: Defined cycles

Everything operates within a context. All creatures, human and otherwise, function within a life cycle. Husbands and wives operate within the context of a marriage. Employees work and create in an office environment. Athletes maneuver on the playing field. Armies engage one another on the field of battle.

The financial markets are no exception to the contextual analogy, especially when cycles of a defined time frame are involved. Each stock, index, commodity, mutual fund, or exchange-traded fund trades within a cyclical context from the smallest recordable cycles to the longest trends.

Each of the larger cycles also can act as a reference point, positive or negative, for the next smaller cycles. If a trader knows, for example, that the major trend, or “Reference Cycle,” in gold using monthly data is positive, then it is possible to go long each positive intermediate cycle uptrend using weekly data on the weekly “Trading Cycle” within the context of that next larger monthly Reference Cycle. As long as the larger, monthly trend in gold remains statistically and cyclically favorable, the trader can enter the market on the long side with the odds continuing to work in his favor. On the other hand, if there is no objective trend definition except from seat-of-the-pants chart analysis, the odds of losses can increase.

While many traders make use of trendlines and support and resistance levels to make entry and exit decisions, those tools can be error prone and subjective. More objective, indicator-based cycle analysis can help cut the odds of entering a potentially losing trade.

What is a cycle?

Most popular charting software, such as TradeStation, allows the user to choose a variety of charting formats to display data. Some investors use point and figure charts. Others like candlestick analysis. Still others like tick charts or volume charts. The discussion here will use time-defined bar charts, but the form of data presentation is really irrelevant as long as there is a larger Reference Cycle and a smaller Trading Cycle for trade executions.

While some might argue that the duration of a chart’s bar does not necessarily define the length of the overall trend, the analysis of any given data within the context of a trend is important. In other words, it’s harder to analyze a long-term bull market using daily data when our indicator works better with monthly data. Thus, when we suggest the “long-term” we are usually suggesting the use of monthly data; weekly data are for the intermediate cycle; daily data are for the short-term trend and intraday data for extremely short-term trading.

For example, we might choose to analyze intraday 60-minute data on the Trading Cycle within the context of the next larger daily, or Reference Cycle. Or, we may look at daily data within the framework of weekly, or intermediate-term data -- or weekly, or intermediate data, within the context of monthly, or major cycle data. We also might like to know, for informational purposes, the status of the smallest intraday five-minute trend within the context of the next larger 15-minute cycle. We might choose a 60-tick bar on S&P E-mini futures with our larger Reference Cycle set at 240 ticks. And so on. While the duration of the cycles can vary, the relationship of the cycles is what’s important.

A number of indicators can be used to analyze a given cycle in a specific issue. While some may rely on proprietary solutions, market tools such as stochastics, momentum, rate of change, the relative strength index, %R and so on, can be used one at a time or via joint confirmations to determine both the Reference and the Timing Cycle. Once the larger trend bias is determined, it is used as the reference point for the smaller Trading Cycle entries.

Finding the best cycle

A more appropriate description might be finding the “most profitable” cycle.

There is a truism about trading: The smaller the cycle, the more trading is generated, the greater the risk for slippage that leads to losses, the higher the commissions, and the greater the odds for committing errors.

Because the object of any trading methodology is to take the largest profit from a given move, the smaller cycles naturally afford less opportunity because of the shortness of their durations. A move that may only last for 20 minutes is, by definition, not going to afford a trader the profit potential of a move that may last 20 days, or 20 weeks.

Even though high-velocity intraday trading may be appealing to traders with the constitution to perform it, entering and exiting the market 50 or 100 times a day, let alone a few times, can be an exhausting endeavor, even if the procedure is fully automated. Even then, scalping small moves in the market is a tough game for private investors seeking to profit from market gyrations. As a general rule, most trading systems that engage in such activity do not follow trends so much as they enter the market looking to grab a quick profit via profit targets.

So, from a purely practical point-of-view, entering the market from a longer-term perspective not only lowers the risk of whipsaws and higher commissions, it allows the trader some luxury of time by allowing for more reasoned and deliberative trading. Such an indulgence will not necessarily guarantee profits, but it will help eliminate the frantic feeling that overtrading can generate.

The methodology

Suppose a trader’s research implies that gold could be on the verge of a longer-term rally. Because burgeoning federal debt coming from Governmentville ought to inevitably lead to inflation or, at the least, to some flight to safety, the trader intuits that gold could be a buy.

The trader could simply put on a long position in gold at the market and let it ride, while presuming that a trailing stop would take him out of the trade in the event the premise is incorrect. Trend lines could be drawn and support and resistance lines could be monitored for intersection points. Volume could be measured, while point-and-figure analysis could be used for price projections. Or, the trader could use time-cycle analysis to determine the likelihood of a rally in gold (see “Golden opportunity,” below).

Chart

Input Values

Using our gold example, suppose we determine the major cycle for gold is positive because slow stochastics and a simple 10-bar momentum of monthly data have both turned positive with the stochastics indicator closing above 0.50 and momentum above the zero line. At the same time, using weekly data, we have determined that the smaller weekly Timing Cycle intermediate-term trend is not only “oversold,” but both slow stochastics and momentum have been rising toward potential positive buy levels. We also note that the next smaller cycle, the “informational” 60-minute bar, is positive using both slow stochastics and momentum. At this point, we have a couple of options. First, we can draw a downward trendline on the daily cycle and visually monitor prices for an upside break of that line, or we can place a buy stop just above the downtrend and allow for an automatic entry in the event our stop is hit.

Another option would be to automate the above contextual procedure. Using various commercial trading applications, we could program our account to go long according to the Timing Cycle within the Reference Cycle context. The basic philosophy of using the next larger cycle Reference Cycle as the reference point for the smaller Trading Cycle trade entry is the issue.

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