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).
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.
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.
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%.
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.
Gold: Weekly Timing Cycle with Monthly Reference Cycle (see “Golden opportunity,” below)
The great gold bull market that began in mid-2001 has afforded the savvy investor many opportunities on the long side over the better part of the past decade. Using the contextual strategy with the long-term Reference Cycle as the primary “filter” and the short-term Timing Cycle for entries, gold provided two major Reference Cycle positive signals, one in February 2002 and the other in February 2009. While that uptrend has provided a number of intermediate, or weekly, Timing Cycle entry points, it is helpful to extract a recent trading opportunity from the uptrend to demonstrate yet again how the Contextual Cycle concept operates.
Notice in the chart that gold on the Monthly Reference Cycle generated a major buy on May 29, 2009. A little over a month later, the Weekly Timing Cycle within the context of that larger trend generated a buy signal at $943.90 an ounce.
The trade ran until Jan. 29, 2010, with a negative reversal at $1,085 for a gain of just under 15% in about six months. Once again, a great deal of subjectivity was eliminated by simply allowing defined timing cycles to stipulate entry and exit points.
1929-1932 bear market in equities: Weekly Timing Cycle with Monthly Reference Cycle (see “Dow, 1929,” below)
For investors looking for a classic example of contextual and statistically defined market cycles, the Great Crash initiated in October 1929 is one of the best. That bear market resulted in a devastating selling spree that was not recouped by the Dow Jones Industrial Average until the early 1950s. It ultimately led to the Great Depression. But for those traders, such as the legendary Jesse Livermore, who were astute enough to participate in that great bear market on the downside, the rewards were phenomenal.
The Great Crash began with sharp selling after the September 1929 highs and culminated in the mid-November 1929 intermediate-term lows. At that November low, however, the monthly Reference Cycle had turned negative to suggest that any strength was probably developing within the context of a major cycle downtrend. Indeed, after the early November lows developed, index prices began to rally and there were calls from many pundits, including some Wall Street bankers, that the worst was over and the economy had resumed its upward advance. Unfortunately, that was not the case. The market rallied until mid-April 1930. A weekly Timing Cycle sell signal was generated in early June and the major decline resumed.
The Timing Cycle sell signal of June 6, 1930, was followed by a countertrend cover of a short sale on Feb. 27, 1931, for a net gain of nearly 28%. Following a brief countertrend rebound that lasted for two months until early April 1931, the Timing Cycle then generated another short sale the week ending April 17, 1931, that remained on the sell side until Aug. 12, 1932, and at the nadir of the bear market for a gain of just over 60%.
The Great Crash of 1929-1932 consisted of two statistically determined downtrends, identified by the Weekly Timing Cycle in the 2-1/2-year-old bear market. The profit created from two short sales approached 90% at a time in American history when the unemployment rate was headed for 25% and Central Park in New York City was filling with acres of homeless people living in tents.
Top to bottom
While there will continue to be nearly unlimited methodologies and philosophies on how to take profits out of the markets, one strategy that allows the trader to objectively quantify market cycles statistically compares a shorter-term Trading Cycle that operates within the defined time frame of a larger Reference Cycle. In other words, a Daily Trading Cycle can be compared to a larger Weekly Reference Cycle. Or perhaps a Weekly Trading Cycle to a Monthly Reference Cycle. And so on.
While it’s possible to insert a variety of indicator combinations into the analytical equation beyond the slow stochastics and momentum indicators we have used in this study, the point is that statistically defined time cycles and their symbiotic relationship can create profit potential. In other words, the two indicators, slow stochastic and momentum, are only two possibilities among many a trader might pick before developing strategies in this contextual sphere. A strategy using more than two indicators is also possible.
What is essential is understanding that the interplay of the two cycles, Timing and Reference, can eliminate much of the subjectivity that comes from straight chart analysis where a trader might attempt to identify entry and exit points based on the observation of trend lines, support and resistance levels, and so on.
Because emotion and the potential for paralysis in the face of decisions that must be made can be a giant hurdle for many traders, a methodology such as Contextual Cycle Analysis that removes subjectivity from the decision-making process can be a valuable tool.
Robert McCurtain is a technical analyst, market timer and private investor based in New York City. He can be reached at email@example.com.