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

Stocks, mutual funds and ETFs: Defined cycles

The strategy unfolds

Despite our best efforts, there will be times when we put on a trade that is destined to be whipsawed. For example, we might go long the S&P E-mini at 1208.50 and then watch the trade sink to 1207.50 before our system signals kick in to confirm an exit even though the trade saw the contract rally to 1210 before it began to fade. One way to handle that problem is to dedicate a portion of the entire trade to a predetermined profit target.

Without a pre-determined profit target, we could go long 12 contracts of gold at 882.80 on the minor cycle (daily data) within the context of the intermediate-term Reference Cycle (weekly data). The top of the rally on that short-term trade ultimately hits 915, but the combined stochastics and momentum indicators do not reverse to negative until gold hits 890 on the pullback and ultimate reversal. With less than eight points finally realized on a straight entry/exit trade, the results would be positive but disheartening because of the profit left on the table.

One solution is to have a target price 25 points above the buy level on one-half of the position so that a profit on at least one-half of the trade would be generated even if the other half of the trade generates a less desirable profit.

In the example just cited, the trader would have made $25 on six contracts and another $7.20 on the second half, for an average profit of $16.10 on the entire 12 contracts. In other words, the gold trader was able to take a big chunk out of that trade with the profit target. Another strategy would be to divide the trade into three parts with two of the portions allotted for two different profit targets. Profit targets are created after the trader visually observes the historical volatility of an issue to determine the best levels for targets.

Countertrend moves

All long-term bull and bear moves begin with smallest cycle reversals. From the tiniest intraday cycles, a major trend begins. Eventually, after the minor and intermediate trends have turned, the major cycle kicks in and the new trend is confirmed. Such was the case after the March 2009 lows in the stock market. Such will be the case yet again when that bull trend is over and the smallest cycles turn down again, first.

In effect, each longer-term reversal begins as a countertrend move. While there may be clues that what is to become the previous trend may be wearing itself out, each countertrend move in that trend has ultimately failed and has simply re-asserted the larger trend. But as a new major cycle unfolds, what was previously a countertrend move will become part of the trending moves in, say, a new bull market.

As a consequence, it is important for the trader to identify the difference between trending moves and countertrend moves when making trading commitments. That is the job of our Reference Cycle, the larger cycle that determines the overall bias of the smaller Trading Cycle.

For example, if the Reference Cycle, using monthly data, is positive, the smaller weekly Trading Cycle will have a net long bias of 100%, while each countertrend move will only have a sell, or short sales, bias of 50%. Thus, if a trader adopts an always long or always short strategy, a countertrend move would demand only a 50% commitment. That means that each time the Trading Cycle goes long within the context of a positive Reference Cycle, we would buy 10 corn contracts. Each time a countertrend signal is generated we would only be short five corn, knowing that we want, at some point, to be partially short in the event the market turns on that larger cycle to positive and we want some exposure until that larger cycle is statistically defined.

If a trader does not want to risk the potential for whipsaws on any countertrend move, and they can happen, then only longs in the direction of a larger Reference Cycle long or shorts in the direction of a Reference Cycle short should be used. But the trader would have to accept that the first move in the major reversal would be missed because the trader would have presumed, by definition, that the start of the next larger cycle reversal was countertrend in nature.

Trading in the real world

Regardless of the cyclical context that a trader ultimately chooses, the cycle the trader ultimately picks to execute trades must develop within the context of the next larger cycle. The premise applies to any market or financial instrument that can be tracked via price quotes.

So let’s take a look at some historical examples.

Corn: Daily Timing Cycle with Weekly Reference Cycle (see “Grain gains,” below)

Part of the grain complex, corn futures can afford the active trader opportunities on the smaller cycles. Corn generated a weekly Reference Cycle sell signal the week ending May 21, 2004. Thereafter, and as long as that signal held negative, trades on the short side of the market offered potential for profits.

The first such opportunity presented itself on June 4, 2004, at 625-6/8. The trade lasted until the middle of August when slow stochastics and momentum turned positive to indicate the position at 564 should be covered for a gain of just under 10%.

Chart

Soybeans: Daily Timing Cycle with Weekly Reference Cycle (see “Buying beans,” below)

Another member of the grain and oilseed complex, soybeans, generated a Reference Cycle buy signal the week ending May 25, 2007. The biggest opportunities thereafter followed on Aug. 23, 2007, Oct. 11, 2007, and Feb. 4, 2008, with appropriate Timing Cycle sell signals on Oct. 5, 2007, Jan. 22, 2008 and March 7, 2008, for a gain of just under 40% in about six months.

Chart

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