THE TRADERS’ MAGAZINE SINCE 1982

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MARKET Timing
With Pairs Logic
Using the stress indicator 10

Fading The
Big Moves
How to gauge them 16

Expansions &
Contractions
Identify trading setups 22

Trend Switching
With ETFs 26

INTERVIEW
Guy Cohen 32

reviewS
n MetaStock XIII
n Insiders Guide To
Trading Weekly Options
MARCH 2014
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 CONTENTS MARCH 2014, Volume 32 Number 3

10 Timing The Market INTERVIEW

With Pairs Logic 32 Trading Like An Insider
TIPS
by Perry Kaufman With Guy Cohen
Fundamentally different strate- Guy Cohen is a leading innova-
gies, drawing from a broad set tor in financial trading. He is the
of markets, will offer better risk creator of the options volatility in-
protection during times of market dicator (OVI) and the FlagTrader
stress than any one strategy. Here’s and OptionEasy trading tools. He REVIEWS
an overview of a timing method is the author of several best-selling 42 • MetaStock XIII
and its mechanics. trading books, a successful private Product review: Trading platform
trader, and a trading coach. We
FEATURE ARTICLE spoke with him about ways to 46 • Insiders Guide To Trading
16 Fading The Big Moves keep abreast with market momen-
Weekly Options
tum, mistakes traders make, and Product review: A four-DVD set;
by Ashot Hakobyan how he uses data.
Whenever we see a big move in weekly option & live trading course
the markets, it’s bound to catch our
attention. But how do we protect 37 Futures For You DEPARTMENTS
our capital during such big moves, by Carley Garner
or better yet, profit from them? Here’s how the futures market 6 Opening Position
Find out here. really works. 8 Letters To S&C
25 †Traders’ Glossary
21 Q&A 38 Navigating Price Mountains 45 Futures Liquidity
by Don Bright by Thomas Bulkowski 49 Books For Traders
This professional trader answers When stock prices start climbing 50 Traders’ Tips
a few of your questions. or forming a price mountain, it’s
tempting to want to get in on the 56 Trade News & Products
action. But should you buy a stock 57 Advertisers’ Index
22 Expansions & Contractions, that’s forming a mountain?
Part 1 57 Editorial Resource Index
by Dirk Vandycke 59 Classified Advertising
Every trader wants to be able to 40 A Fundamental Lesson 59 Traders’ Resource
predict price moves, but we know For The Technically Minded
that’s impossible. Instead, focus on by Matt Blackman
finding high-probability setups and For decades, there have been two
manage them well. In this first part major schools of thought when
of a three-part series, we’ll look at it comes to stocks: fundamental
how to identify these setups. analysis and technical analysis.
Here, we look at how the two
methodologies can work together.
26 Trend Switching With ETFs
by Moshé Prince
Given the volatility in the markets,
AT THE CLOSE
you need to know when to get into 62 The DJIA Is A Fata Morgana
a trade and when to get out. The by Wim Grommen
use of ETFs has made this easier. Here’s an interesting perspective on
the oldest stock index in the US.
31 Explore Your Options
by Tom Gentile TIPS
This article is the basis for Traders’ Tips
n Cover: William L. Brown
Got a question about options? this month.
n Cover concept: Christine Morrison
Copyright © 2014 Technical Analysis, Inc. All rights reserved. Information in this publication must not be stored or reproduced in any form without written permission from the publisher. Technical Analysis
of Stocks & Commodities™ (ISSN 0738-3355) is published monthly with a Bonus Issue in March for $89.99 per year by Technical Analysis, Inc., 4757 California Ave. S.W., Seattle, WA 98116-4499. Periodicals
postage paid at Seattle, WA and at additional mailing offices. Postmaster: Send address changes to Technical Analysis of Stocks & Commodities™ 4757 California Ave. S.W., Seattle, WA 98116-4499 U.S.A.
Printed in the U.S.A.

4 • March 2014 • Technical Analysis of Stocks & Commodities

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 March 2014
2006 • Volume
Volume 32,
24,Number
Number33
O
Opening POSITION
PENING Position

The Traders’
The Traders’ Magazine
MagazineTMTM

As
EDITORIAL
EDITORIAL
[email protected]
[email protected]

O
Editor in Chief Jack K. Hutson
Editor
EditorinJayanthi
Chief Jack K. Hutson
Editor Jayanthi
Gopalakrishnan
Gopalakrishnan
goes January,
nce again we got asoreminder
goes the of restjust
of
the year — that’s what they
Managing Editor Elizabeth M.S. Flynn
Production
ProductionManager
Manager Karen
KarenE.E.Wasserman
Wasserman how sensitive the financial markets say,
Art
Art Director
Director Christine
ChristineMorrison
Morrison anyway.
are. We And saw given
a major the selloff
bullish in rally
thewe’ve
Japanesehad
Graphic
GraphicDesigner
Designer Wayne
SharonShaw
Yamanaka since 2009, all eyes should
markets, which — as expected — triggered have been on thea
markets in January. We are now coming into
Editorial
Staff Intern
Writer Emilie
Dennis Rommel
D. Peterson
Technical Writer
Webmaster Han J.David
Kim Penn
domino effect on markets throughout the
Staff Writers Dennis D. Peterson, Bruce Faber
Contributing Editors John Ehlers,
five years
world. Addof recovery
disappointingin the equity
earnings markets,
numbers yet
Webmaster
Anthony Han J.Ph.D.
W. Warren, Kim we’re still not seeing any spectacular
from US corporations and you have a situa- growth
ContributingWriters
Contributing
Anthony
EditorsDon
W. Warren,
John Ehlers,
Bright, KevinBulkowski,
Thomas Lund,
in thethat
tion underlying economy.
just got worse. Therestarted
So what hasn’toff beenas
Martin Pring, Barbara Ph.D.
Star, Markos Katsanos
Contributing Writers Don Bright, Thomas Bulkowski, much in the way of job or wage
a strong year ended up correcting, and rather growth, and
although
rapidly. Iwe haveadmit
seen that
somealthough
recoverycorrec-
in the
Martin Pring, Adrienne Toghraie
OFFICE OF THE Publisher
must
Publisher Jack K. Hutson
housing market, it’s still not
tions are healthy for any market, when you growing at thehave a 2% drop, it gets you thinking.
pace it should be. We are also approaching the end of the quantitative easing (QE)
OFFICE OF THE PUBLISHER
Industrial Engineer Jason K. Hutson
Publisher Jack K. Hutson Prior to the Federal Reserve’s FOMC meeting, I usually take a look at the yield
Project Engineer Sean M. Moore
Credit Manager Linda Eades Gardner
Controller Mary K. Hutson
days, and even though QE didn’t improve anything, it acted
curve. At present, it’s looking a little flat, and given that the general consensus as a catalyst and took
Industrial Engineer Jason K. Hutson
Project Engineer Sean M. Moore
the markets higher.
is that the Fed is going to tighten at their January 31st meeting, I am concerned
Accounting Advertising Sales
Assistants Jane Leonard that
Sothewhatyieldis curve
driving may thebemomentum
heading in in thethe equity of
direction markets? Could itAnd
being inverted. be that
if that the
Controller Mary4757 California Ave. S.W.
K. Hutson
Seattle, WA 98116-4499 market internals are changing? Is there something
were to happen, that would not be a good sign for the US economy. I’m not going on that we are not seeing?
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dangerous,to go because
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period. Butwegiven
should thatbe
seeing,
almost anything can happen, it doesn’t hurt to expect the worst. If nothing else,to
then it’s all the more likely we could be caught unaware. Maybe it’s time
4757 California Ave. S.W.
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different perspective. If you have narrowed your focus
Advertising Sales
National Sales Summer
Manager Davis W. Schramm
Edward to just the markets you trade, perhaps you should look “outside the box” and focus
Classified & Web Sales Chris J. Chrisman on other variables. For example, if you only trade equities, perhaps you should start

So
Circulation looking at the action in the option markets. In our interview this month, which begins
Production Coordinator Karen Moore
Subscription & Order Service 1 800 832-4642
CIRCULATION
1 206 938-0570 Fax 1 206 938-1307 on page 32, withGuy that in mind,
Cohen you can see why
of FlagTrader.com it’s important
discusses to design
the importance of akeeping
trading
Subscription &[email protected]
Order Service 1 800 832-4642
1 206 938-0570 Fax 1 206 938-1307 system that gets you out of the market at the
an eye on the activity in the option markets even if you don’t trade options. And itright time. When access to
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doesn’t have to involve any complex calculations. It could be as simple as keepingit
the markets is easy, the number of options available increases. This makes
[email protected]
Subscription
Subscription Sales
Manager Carmen
SeanHale
M. Moore
Assistant Subscription Manager Sheila Peterson
important
an to be thorough
eye on option volatility. with the different types of orders, front-end software, and
Subscription Sales Website trading systems that are out there. Lee Leibfarth, in his article “The Automated

Y
Agnes Dimaano, Tina Row
http://www.traders.com
Staff members mayWEBSITE
be emailed through the Internet
Daytrader” starting on page 22, addresses the various options that are available and
using first initial plus last name plus @traders.com
http://www.traders.com how you can take advantage of them.
Staff members may be emailed through the Internet But ou can measure
before getting to market momentum
the stage of placing using a variety
that trade, youof indicators, but regardless
need to understand the
market you are trading. You should be able to do so after reading Paolo includes
of which indicators you use, you still must have a trading plan that a
using first initial plus last name plus @traders.com
Pezzutti’s
Author­i­za­tion to pho­to­copy items for inter­nal or per­sonal strategy to protect your positions. In “Fading The Big
“Understanding Market Structure.” The markets follow different behavior pat- Moves” by Ashot Hakobyan
beginning on page
need16 toof this issue,ifyou will find trending,
out about in a statistical technique you
use,Authorization
or the inter­naltoorphotocopyper­sonal use itemsof spe­
forcinternal
ific cli­ents, is grant-
or personal
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use,byor Tech­
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cal Anal­or y­sis, Inc. for use
personal users ofreg­ is­teredclients,
specific with the is terns, and you determine it is volatile, a trading range, moving
Cop­ y r
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is paidOnline:
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trades, we tend to think there isButzero probability
just thethat
firstwe’ll
step.lose
Youall wehave
earned.
50¢ per page to CCC, 222 Rosewood Drive,
those organ­ iz
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Danvers, MA 01923. Online: http://www.copyright.com. For the correct trading technique. that’s still to have
license by CCC, a sep­ ar
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those organizations that have been granted a photocopy
arranged.
license by The CCC,fee code forsystem
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tem
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68 •• March 2006••Technical
March2014 TechnicalAnalysis
Analysisof ofStocks
STOCKS&&Commodities
COMMODITIES
 daily chart of the AUDUSD that uses a
The editors of S&C invite readers to submit their opinions and information on subjects
50-day EMA, but the five-day SMA of the
relating to technical analysis and this magazine. This column is our means of communi-
daily highs & lows has been changed to
cation with our readers. Is there something you would like to know more (or less) about?
an eight-day version. The large candle
Tell us about it. Without a source of new ideas and subjects coming from our readers, this
wicks reveal lots of intraday range,
magazine would not exist.
seemingly necessitating a wider channel
Email your correspondence to [email protected] or address your correspondence
to avoid too many early stopouts — at
to: Editor, Stocks & Commodities, 4757 California Ave. SW, Seattle, WA 98116-4499. All
least to my eyes. You can experiment
letters become the property of Technical Analysis, Inc. Letter-writers must include their full
with different moving average lengths
name and address for verification. Letters may be edited for length or clarity. The opinions
for the channel and the trend filter to see
expressed in this column do not necessarily represent those of the magazine.—Editor
whether that works better on the markets
that you typically follow.
SWING TRADING end of the trading session.
Editor, Really, you can use the system on STARTING A TRADING FIRM
I enjoyed Donald Pend- any time frame and the same principle Editor,
ergast’s article on swing would apply. Again, the important idea I am interested in becoming a licensed
trading in the December with the system is to first visually identify trader and opening my own trading firm.
2013 issue (“Swing Trad- stocks and ETFs that consistently make I have developed trading algorithms and
ing With Three Indica- sustained, smooth swing and/or trending strategies for both short-term and long-
tors”). I have a question regarding his moves. term strategies. I have some questions I
entry points. They actually occur the am hoping you can help with.
day after the breakout, since in rule 1, he MORE ON SWING TRADING • What are the prerequisites for becoming
states, “Go long when the price exceeds Editor, a licensed securities trader?
the upper moving average of the previous Thank you for the interesting article by • What is the process for obtaining the
trading session.” Is that correct? I just Donald W. Pendergast Jr. about swing proper “series” license to trade stocks,
wanted to clarify. trading in the December 2013 issue commodities, and currencies?
Gary (“Swing Trading With Three Indica- • Are there minimum education require-
tors”). Has the author tried the method ments? If so, what are they?
Author Donald Pendergast replies: on forex? I had a look at it and it seems • What is a hedge fund and how does
Thanks for reading. Yes, if using daily to work very well on the daily time that differ from a trading firm?
price bars, then using the previous bar’s frame. The forex market often trends, Carey
closing value of the moving average (of and I understood from the article that
the highs or lows) will result in fewer liquid and trending markets are needed We suggest visiting the SEC website at
whipsaws and false signals as compared for this method to work properly. sec.gov and the FINRA website at finra.
to using the current intrabar value for Gianluca org for information on series licenses.
the moving average, which will fluctuate You can also visit the NFA website at nfa.
until the close of the trading session. You Author Donald Pendergast replies: org for information on futures trading
may be able to get a better entry price Thanks for your comments. In theory, and regulations. Here is a rundown of
by entering before the bar closes, but the method may produce positive results those websites and what is stated there
you may also be entering a trade that on markets that make smooth, relatively about licenses or registrations.
otherwise would not be confirmed at the nonvolatile swings. In Figure 1 I show a • US Securities And Exchange Commis-
sion (SEC) — www.sec.gov
Individuals who want to enter the
securities industry to sell any type of
securities must take the Series 7 exam-
ination—formally known as the General
Securities Representative Examination.
Individuals who pass the Series 7 are eli-
gible to register with all self-regulatory
organizations to trade.
• Financial Industry Regulatory Author-
ity (FINRA) — www.finra.org
The Financial Industry Regulatory Au-
thority (FINRA) administers the Series
7 examination. For more information,
FIGURE 1: AUD/USD. This sample daily chart of the AUDUSD uses a 50-day EMA, but the five-day SMA of the visit FINRA’s website where you can
daily highs & lows has been changed to an eight-day version. learn about the Series 7 exam and its

8 • March 2014 • Technical Analysis of Stocks & Commodities

 LETTERS
qualification and registration process.
• National Futures Association (NFA) I work hard at my trading and
— www.nfa.futures.org want a platform that works as
With certain exceptions, all persons and
hard as I do. That’s why
organizations that intend to do business
as futures professionals must register
under the Commodity Exchange Act.
I chose NinjaTrader.
It not only lets me execute like
There are no minimum educational a pro - their Ecosystem,
requirements per se to trade or to run support and training have
a business, but you do have to pass the me thinking like a pro too.
exams to obtain various licenses, such as
the Series 7. A Series 7 license is required
if you work with general public to solicit
their funds and invest their money, since
this involves selling them securities. For
some career options, certain designa-
tions or credentials can be helpful or
required (such as obtaining a Certified I may not be a pro,
but I trade like one.
Financial Planner [CFP] designation
in order to practice as a CFP).
Starting a trading firm requires some
of the same steps as would take to launch
any company, plus the additional required
compliance measures. You would need to
Professional traders move through the
incorporate your firm in the appropriate markets with confidence and precision.
jurisdiction; you would need a corpo-
rate account established with a stock or NinjaTrader’s extensive video library, partner
futures brokerage; and legal counsel is
recommended, someone with experience
Ecosystem and live training webinars provide
in the financial markets arena. you with the foundation to become a more
There are alternatives to starting your
own trading firm. For those who seek to confident trader. Our award winning software
trade in a formal structure without actu-
ally starting or running a firm (and all
lets you execute trades with professional
that it entails) may wish to investigate be- precision, and the best part is that getting
coming a trader in a proprietary trading
firm (although careful vetting is recom- started with NinjaTrader is FREE.
mended to avoid unscrupulous ones and
unfavorable situations) or trading as an
individual in commercial trading rooms So what are you waiting for?
(see our December 2013 S&C article,
“Identifying Successful Futures Trading
Start trading like a pro today!
Rooms” by Dean Handley for more on
ways to investigate these resources).
ninjatrader.com/TASC
A hedge fund is a type of fund. It’s a
pooled investing fund, usually a private
partnership, that uses a combination of
long & short positions and sometimes
apazones.com 1patternforallmarkets.com fxcm.com
unconventional and illiquid investments.
Hedge funds may face less regulation
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individuals or from other funds.

March 2014 • Technical Analysis of Stocks & Commodities • 9

 Release The Stress!

Timing The Market With Pairs Logic

Fundamentally different strategies, drawing from a broad set time, so that buying the weaker and selling the stronger is
LISA HANEY

of markets, will offer better risk protection during times of a high-probability trade. In my 2010 book Alpha Trading,
market stress than any one strategy, regardless of the mar- I introduced the stress indicator as a method for timing the
kets selected for the portfolio. In this article, you will get an entries & exits into pairs trades (see Figure 1).
overview of a timing method that you can implement in your But there are practical problems with traditional pair trading:
trading, followed by the mechanics of that system.
n It can be difficult to sell short one leg of the pair.
by Perry Kaufman n A high correlation between two stocks or a stock and an

A
index assures success but will cause profits to be small.
rbitrage is one of the great financial strategies, and
The net profit can also be small because of competition
pair trading, which is relative value arbitrage, ranks
n
with commercial traders, since it’s a popular method.
high on the list of all-time successes. The premise is
that two related stocks will only diverge for a short n Retirement accounts don’t allow short sales.
10 • March 2014 • Technical Analysis of Stocks & Commodities
 TRADING SYSTEMS

To avoid short sales of individual stocks, you can substitute Co-integration is the preferred method of measurement,
an index, preferably the SPY (SPDR S&P 500). For retirement but it’s more complicated. It identifies two markets that are
accounts, you can use the ProShares Short S&P 500 (SH), moving in the same general direction but with somewhat
which is the inverse S&P 500 or ProShares Ultra Short S&P random interim moves.
500 (SDS), the double-leverage inverse S&P, to avoid short I am going to take a simpler approach by assuming that most
trading. But the index is less volatile than an individual stock of the stocks in the S&P 500 are correlated to the S&P 500
and the net profits from a pairs trade that is long a stock and index (in this case, the SPY). I justify that because of the S&P
short the index will be smaller — most often, too small. arbitrage. When the cash SPX diverges from the futures SP,
traders will buy one and sell the other to bring the relationship
Long bias back in line. If they are buying the SPX, they actually buy
Enter the long bias in stocks. If we look at the breakdown in all, or almost all, of the stocks in the S&P index. Even when
performance of the pairs trade, we see that the gains are almost there’s a stock such as Raytheon, which can move opposite
always in the long stock position rather than the short sale. It’s to the overall market, I still buy it along with all other stocks.
not hard to believe because there is a clear long bias in stocks. That should benefit a pairs trade.
Over time, stock prices are higher (with certain exceptions), Based on that assumption, I’ll apply the pairs strategy to a
so you would expect the long trades to be profitable. Then wide range of stocks on one side and the SPY on the other,
why not just take the long leg when there is an entry signal taking only the long stock leg and hedging when the trend of
into a pairs trade? SPY turns down. When it’s done, I’ll sort through the results
The returns per share would be much larger, but the problem and choose the stocks I want to trade since not all stocks
occurs when the market is in crisis. That is, you can’t be sure qualify.
that the trade will exit when the S&P drops 40% as it did in
2008. The trade remains long while the individual stock is Timing using the stress indicator
weaker than the index. The profile of mean-reversion trading The timing of entries and exits will use the stress indicator,
is that there are many small profits and a few very large losses which I developed just for this purpose. It is simply a stochastic
(also called a short options profile). You need to find a way indicator applied three times as follows:
to avoid those large losses.
1. To the stock (S)
Hedging with the SPY or SDS 2. To the index (I)
The answer is to hedge, or sell, the index when the trend of the
3. To the difference in the
index turns down. It’s a technique called portfolio insurance.
stochastic values of (1)
The amount hedged is equal to the volatility (risk) of the daily
and (2)
profits/losses of the stock position, or the accumulated stock
positions of more than one timing trade. In this article, only By doing this, you are able to find the points where the stock
a single 60-day trend will be used for hedging, but you may is oversold relative to the SPY. You lose the absolute volatility,
find it better to use more than one trend. For example, you which may help sort out which trades are likely to be most
could hedge half of the risk on each of two trends of different profitable, but we can address that when we select stocks for
calculation periods. the portfolio. The formula for the n-day stress indicator is:
By protecting your position when the overall market turns
down, you easily avoid large losses during bear markets. The 1 (Stochastic (S)t) = 100 × (St – Lowest(S,n))/(Highest(S,n)
final picture however, will show that in the long run, the hedge – Lowest(S,n))
may produce a slight net loss because the accumulated profits
2 Stochastic(I)t = 100 × (It – Lowest(I,n))/(Highest(I,n)
from only shorts in the S&P is not generally a good strategy.
– Lowest(I,n))
The benefit only comes during a crisis, when there is a massive
selloff in the S&P. For those who care about risk & reward, 3 Stresst = 100 × (Dt – Lowest(D,n))/(Highest(D,n)
as I do, the information ratio (annualized returns divided by – Lowest(D,n))
annualized risk) will be better when using the hedge, although
the total returns will usually be lower. where:
n = calculation period of the stochastic, set at 60 to maxi-
The mechanics: choosing the pairs mize the returns
Traditional pair trading requires that you qualify the two stocks
that will make up the pair. This is most often done with either Lowest and highest are functions that return the highest and
correlations or co-integration. Correlations are familiar to most lowest values of a data series over the past n days.
traders; a simple test is performed using the returns of both
stocks. You want the result to be (approximately) above 0.30 Dt = Stochastic(S)t – Stochastic(I)t
but below 0.70, so that the two stocks are clearly related but
not tracking too closely. The stock is overbought relative to the index when D is high,
March 2014 • Technical Analysis of Stocks & Commodities • 11
 TradeStation
Figure 1: stress indicator. Here you see the stress indicator in red (bottom panel), the price chart of Hess (HES) in the top pane, and the price chart of SPY in the
middle panel. The buy signals occur when the stress indicator falls below 10 and exits when it rises above 50.

and it’s oversold when D is low. I’ll set those thresholds at of trades and net returns. Some EasyLanguage code for the
90 and 10. By setting them wider you can isolate fewer, more stress function and the pair-trading strategy can be found in
extreme cases. There is always a tradeoff between the number sidebar “EasyLanguage Code For Stress Function And Pair-
Trading Strategy.”
By using the stress indicator for traditional pair trading,
you can buy the stock and sell the index when the value falls
Noisy indicators below 10. You can sell the stock and buy the index when it’s
above 90. However, in this strategy, you’re only going to buy
delay your analysis the stock when it’s oversold relative to the index. You exit the
trade when the stress indicator moves above 50, indicating a
return to normal. Figure 1 shows the individual stochastics
plus the stress indicator applied to Hess (HES) and SPY.
The numbers that are under the buy signals (Bzone) are the
number of shares.
Jurik algorithms How much do you buy?
deliver low lag, Assuming I have no leverage for stock trades, I will allocate
low noise analysis the same fixed amount to each market that I trade, say $5,000,
then divide that investment by the current price. In that way,
Tools for: TradeStation, AmiBroker, Investor/RT, MultiCharts, NeuroShell Trader, Facebook (FB) at $50 would get 100 shares and Apple (AAPL)
eSignal, NeoTicker, Tradecision, TradingSolutions, MATLAB, Ninja Trader, at $500 would get only 10. The volatility of those two stocks
may not be quite the same as this 10:1 ratio, but it’s the sim-
Genesis TradeNavigator, Market Delta, Extreme charts, DLLs for custom software

plest and most effective choice. Since the holding period of

the trades tends to be about eight days, I won’t rebalance the
For Windows XP, Vista, 7, 8, & Server
both 32 and 64 bit !! position size.

Jurik Research The gains are almost always

in the long stock position,
of Stocks and Commodities Reader's Choice Award because there is a clear
2010 -- 2011 -- 2012
long bias in stocks.
www.jurikres.com • 800-810-3646 • 719-686-0074

12 • March 2014 • Technical Analysis of Stocks & Commodities

 TRADING SYSTEMS

EasyLanguage code for Stress Function stocksize = investment/close;

and Pair-Trading Strategy buy (“Bzone”) stocksize shares next bar at market;
newbuy = true;
indexpos = 0;
Stress function
end
{ PJK_Stress
{ exit conditions }
Copyright 2013, P.J.Kaufman. All rights reserved. }
else if marketposition <> 0 then begin
inputs: period(numericsimple); if minpriceOK = false then begin
vars: stoch1(0), stoch2(0), diff(0), range1(0), range2(0), sell (“Minrule”) all shares next bar at market;
stressvalue(0); indexpos = 0;
end
stressvalue = 50; else if stress >= exitlevel then begin
stoch1 = 50; sell (“Xrule”) all shares next bar at market;
stoch2 = 50; indexpos = 0;
{ raw stochastics for price1 and price2 } end
range1 = highest(high,period) - lowest(low,period); else if stoploss <> 0 and close/entryprice - 1 < -stoploss
range2 = highest(high of data2,period) - lowest(low of then begin
data2,period); sell (“Stop”) all shares next bar at market;
If range1 <> 0 and range2 <> 0 then begin indexpos = 0;
stoch1 = (close - lowest(low,period))/range1; waitforreset = true;
stoch2 = (close of data2 - lowest(low of data2,period))/range2; end;
{ difference in stochastics } end;
diff = stoch1 - stoch2;
{ stress indicator } { enter index hedge if trend is down }
range1 = highest(diff,period) - lowest(diff,period); if hedgeper <> 0 and indexpos = 0 and (newbuy or
If range1 <> 0 then stressvalue = 100*(diff - lowest(diff, period))/ marketposition <> 0) then begin
range1; if indextrend < indextrend[1] then begin
end; { calculate hedge amount }
PJK_Stress = stressvalue; stockvol = stddev(stockchange,hedgeper);
indexvol = stddev(indexchange,hedgeper);
Pairs1 { if index vol is higher then ratio is less than 1 }
{ PJK Pairs1 indexsize = stocksize*hedgeratio*stockvol/indexvol;
This program uses the stock price (input 1) and index price (input 2) indexpos = -1;
and produces stock signals and stock PL output. end;
The combined result of stock and hedge, plus other detail for tracking end;
the trade, are output in a report to
“c:\ \pairs1_PL.csv” } { index trend turns up then remove hedge }
if indexpos <> 0 and indextrend > indextrend[1] then begin
inputs: momper(60), entrylevel(10), exitlevel(50), minprice(3.00), indexpos = 0;
stoploss(0.10), hedgeper(60), hedgeratio(0.50), corrfilter(0.20), indexsize = 0;
investment(5000), stockcost(8); end;

vars: stress(0), stocksize(0), minpriceOK(true), ix(0), adate(" "), { the minimum price filter prevents using stocks that have gone
stockPL(0), negative due to back-adjusting splits }
indexPL(0), combPL(0), todaystockPL(0), todayindexPL(0), todaystockPL = marketposition*stocksize[1]*(close - close[1]);
todaycombPL(0), indextrend(0), indexsize(0), indexpos(0), if stocksize[1] <> stocksize[2] then todaystockPL = todaystockPL
stockchange(0), indexchange(0), stockvol(0), indexvol(0), - stockcost;
newbuy(false), waitforreset(false), minpricedays(5); todayindexPL = indexsize[1]*indexpos[1]*(close of data2 - close[1]
of data2);
stress = PJK_stress(momper); if indexsize[1] <> indexsize[2] then todayindexPL = todayindexPL
stockchange = close/close[1] - 1; - stockcost;
todaycombPL = todaystockPL + todayindexPL;
indexchange = close of data2/close[1] of data2 - 1;
stockPL = stockPL + todaystockPL;
indextrend = average(close of data2,hedgeper);
indexPL = indexPL + todayindexPL;
newbuy = false;
combPL = combPL + todaycombPL;
if marketposition = 0 then begin
adate = ELdatetostring(date);
stocksize = 0;
indexsize = 0;
if currentbar = 1 then begin
indexpos = 0;
print(file(“c:\Pairs1_PL.csv”), “Date,CombPL,StockPL,IndexPL,
end;
stockpos,indexsize,indextrend,indexsize,indexpos,newbuy”);
end;
if waitforreset and stress > 50 then waitforreset = false;
print(file(“c:\Pairs1_PL.csv”), adate, “,” ,combPL:8:0,”,”,stockPL:
{ set minimum price condition } 8:0,”,”,IndexPL:8:0,
minpriceOK = true; “,”, stocksize*marketposition:8:2, “,”, indexsize*indexpos:8:2,
for ix = 0 to minpricedays begin “,”, indextrend:6:2, “,”, indexsize:6:2, “,”,
if close[ix] < minprice then minpriceOK = false; indexpos:3:0, “,”, newbuy);
end;
—PJK
{ min price must occur n times in a row to start and end }
if marketposition = 0 and waitforreset = false and stress <= This code can be found in the Subscriber Area of our website for copy-
entrylevel and minpriceOK then begin ing & pasting at http://technical.traders.com/sub/sublogin.asp.

March 2014 • Technical Analysis of Stocks & Commodities • 13

 TRADING SYSTEMS

Some examples
10000 There are many examples of
8000 good performance and some bad,
which is the way with most strat-
6000 egies when they are applied to a
4000 CombPL broad set of markets. The chart
in Figure 2 for Hess (HES) and
2000 StockPL the chart in Figure 3 for Apple
0 IndexPL (AAPL) show favorable results,
while Figure 4 shows mixed
-2000 results for Wal-Mart (WMT).
-4000 Profits and losses are net of $8
per trade. In each case, the red
-6000 line shows the stock profit or
loss (P/L), the green line is the
2

3
8

1
9/0

9/0

9/0

9/0

9/0

9/0

9/1

9/1
9/0

9/0

9/1

9/1 SPY P/L, and the blue is the

4/2

4/2

4/2

4/2

4/2

4/2

4/2

4/2
4/2

4/2

4/2

4/2

Figure 2: hess (HES) vs. spY. Here you see that the stock’s profit/loss (P/L) outperformed the index and combined combined result.
P/L. To see the bigger picture, I
tested 145 stocks from Janu-
ary 1, 2005, selected as having
higher-than-average volatility
and liquidity, but not consider-
ing any correlation to the SPY.
I applied the exact same rules to
each stock, net of costs. Figure 5
shows the stock trades without
the hedge. In all, 65% of the
markets tested were profitable,
the best by 700%. Considering
that some stocks are not good
candidates, I believe this shows
robustness.

The SPY hedge

Hedging is an inde-
pendent process based
FIGURE 3: Apple (AAPL) VS. SPY. AAPL stock also showed favorable results when trading using the stress indicator. entirely on the trend of
the major index, the
S&P 500. In order to
2000 limit the number of
hedges to what I would call major
1500 moves, I will apply a simple 60-
1000 day moving average to the SPY.
Those of you who are more ambi-
500 CombPL tious could try two averages, a
StockPL 60-day and 120-day, placing half
0 the hedge on each one.
IndexPL
The hedge is set when the
-500
trend of the SPY turns down and
-1000 you are holding a long position
in one or more stocks. The idea
-1500 behind it is that it’s going to be
difficult to net a profit from a
3
2
1
0
9
7

8
6
5
4
3
2

9/1
9/1
9/1
9/1
9/0
9/0

9/0
9/0
9/0
9/0
9/0
9/0

long position in any stock when

4/2
4/2
4/2
4/2
4/2
4/2

4/2
4/2
4/2
4/2
4/2
4/2

FIGURE 4: WAL-MART (WMT) VS. SPY. Here you see mixed results, with the index P/L sometimes doing better than the the overall market is selling off.
stock and combined P/L. At other times, the combined P/L did worse than the index P/L. In addition, I haven’t discussed
14 • March 2014 • Technical Analysis of Stocks & Commodities
FIGURE 5. TRADE RESULTS. Here you see the percentage returns of 145 stocks over eight years as a test of the timing method, net of $8.00 commissions.

any exit from the trade except when the stress indicator moves exited with another open trade. This will keep your money
above 50, so I could be stuck in a long position while the stock active. Of course, not all stocks are good candidates because
market heads south. of their past performance or low volatility, so you have to
The size of the hedge is based on the risk of the underlying have some form of selection. Even the simple act of favoring
stock position compared to the SPY. the stocks with higher volatility will go a long way toward
beating the overall market.
Hedge position size = (stock position × stock volatility/index volatility) × hedge ratio It’s possible to create a dynamic
portfolio by scanning the results
where: of selected stocks, but that process
is a discussion for another article.
Stock position = Number of shares in the current long position in stocks
Meanwhile, try to find enough trad-
Stock volatility = Standard deviation of stock returns over 60 days (the hedge period) ing signals to keep your portfolio
Index volatility = Standard deviation of index returns over 60 days active.
Hedge ratio = 1.00 to be fully hedged, 0.50 to be hedged 50%
Perry Kaufman is the author of Trad-
Note that you may choose to hedge less than the full risk ing Systems And Methods and Alpha Trading. He has been the
by setting the hedge ratio. I recommend that hedging 50% of managing director and general partner of investment funds
the risk is enough to avoid large drawdowns and reduces the and the chief architect of their strategies. He is president of
negative impact of the hedge during other times. KaufmanSignals.com, a website that offers subscriptions to
trading strategies and portfolios. He may be contacted via his
Stop-loss website, www.KaufmanSignals.com, or by email at Perry@
Although I personally dislike using stop-losses, this strategy kaufmansignals.com.
requires one. Consider that the exit occurs when the stock,
which was oversold, rallies more than the SPY, pushing the Further reading
stress indicator above 50. But what if the stock continued to Alexander, Carol [2001]. Market Models: A Guide To Financial
decline relative to the overall market, and the market is still Data Analysis, John Wiley & Sons.
in an uptrend? What if the stock was Enron or some other Kaufman, Perry J. [2013]. Trading Systems And Methods +
company that was imploding due to mismanagement? You Website, 5th ed., John Wiley & Sons.
would have no exit. [2011]. Alpha Trading: Profitable Strategies That
The only alternative is to use a crisis stop, which I have Remove Directional Risk, John Wiley & Sons.
set at a 20% decline in price from the entry point. On tests of
about 150 stocks, this improved total performance and avoided The code given in this article is available at the Subscriber
disaster. Area at our website, www.Traders.com, in the Article Code
Once you have exited, you must wait for the stress indicator area.
to go back above 50 before entering another trade.
See our Traders’ Tips section beginning on page 50 for com-
Maximizing your returns mentary and implementation of Kaufman’s technique in various
Mean-reversion strategies usually have many trades held for a technical analysis programs. Accompanying program code
relatively short time, so that you’re in the market only about can be found in the Traders’ Tips area at Traders.com.
20% of the time. Leaving money idle 80% of the time will
severely reduce your returns. If you’re trading a portfolio
of $25,000, you will need to scan the stocks and find the
best five trades at any time, then replace any trade that has
March 2014 • Technical Analysis of Stocks & Commodities • 15
16 • March 2014 • Technical Analysis of Stocks & Commodities
 MOMENTUM TRADING

Losing Luster?

Fading The Big Moves

Whenever we see a big move in the markets, it’s bound What are the odds of a big move?
to catch our attention. But how do we protect our capital There are some momentum and stochastic indicators you
during such big moves, or better yet, profit from them? can use with fading trades. Markets present several trad-
Find out here. ing opportunities for fading the big moves. You will see

B
in what follows that the probability of a market move at
ig moves in financial markets invariably draw the least n times as large as its largest pullback is exp(-n+1).
attention of analysts and traders. Analysts face For example, almost two out of 100 market moves are
the task of explaining such moves, which often at least five times as large as their largest pullback. Of
challenge market theories. In recent decades, analysts course, if you are trading in daily or weekly time frames,
have developed advanced models to accommodate the you may not see many moves of such magnitude, and for
anomalies in the market return distributions — that is, the some markets, you may never see such a move. However,
fat tails — to which the big moves are often attributed. to a market maker or high-frequency trader, such moves
Although theories are being constantly improved, present two to three trades every week in every traded
traders still have to embrace the reality of big moves and security.
come up with strategies to help protect them against those In order to derive the probability of big moves, as
moves or, better yet, try and profit from them. Typically, well as the trading statistics of fading and following
if a big move confirms your technical and fundamental the moves, I use the concept of Ideal Trader, which I
view of the market, you’re going to follow that move; presented in my January 2014 Stocks & Commodities
otherwise, you’re going to trade against the move (that article. In the last section, I’ll give a brief review of the
WILLIAM L BROWN

is, fade the move). Weaknesses in these big moves can concept and detail its application to quantitative analysis
potentially develop into a sizeable pullback or even a of trading the big moves.
complete reversal.
The win ratio
First, what qualifies as a big move? In Figures 1 and 2
by Ashot Hakobyan you see some examples of big moves in different time frames

General Electric Company (NYSE: GE), monthly

45

40

35
Adjusted for dividends and splits

30
Close price, US dollars

25

20

15

10

0
Sep 93 Sep 95 Sep 97 Sep 99 Sep 01 Sep 03 Sep 05 Sep 07 Sep 09 Sep 11 Sep 13

Figure 1: EXAMPLE OF BIG MARKET MOVE. Big moves have heights much larger than the largest drawdown during the moves, so they represent large reward-
to-risk ratios.

March 2014 • Technical Analysis of Stocks & Commodities • 17

 MOMENTUM TRADING

Gazprom (MCX: GAZP), hourly

170

160

150
Close price, RF Rubles

140

130

120

110

100
17 Jun 13 27 Jun 13 10 Jul 13 22 Jul 13 1 Aug 13 14 Aug 13 26 Aug 13 5 Sep 13 18 Sep 13 30 Sep 13 10 Oct 13 23 Oct 13 5 Nov 13 15 Nov 13 28 Nov 1 3

Figure 2: EXAMPLE OF BIG MARKET MOVE. On this hourly chart of Gazprom (GAZP), the big moves have a reward-to-risk ratio of between four and nine.

and markets. The two characteristics of market moves in gen- generic strategy, there can be only two outcomes of fading
eral are the height of the move (the absolute or relative price the trade:
difference between its highest & lowest points) and the largest
n Win of size W when the profit limit is reached, or
pullback during the move. These characteristics represent the
maximum potential profit that you could make on the move n Loss of size V when the stop-loss order is triggered.
and the maximum risk of such an ideal trade.
Unlike regulars, the big moves have heights much larger than The schematics of the trading setups for bearish big moves
their largest pullback, which means they have large reward- are the mirror of those in Figure 3.
to-risk ratios. This is why when you are developing trading One of the most frequently used statistics of any trading
strategies, you need to give the big moves special consideration. strategy is the win ratio, which is the ratio of the number of
Keep in mind that these big moves don’t have to be continuous; winning trades to the total number of trades. In the long run, the
they can include gaps and jumps. win ratio converges to the probability of win. This probability,
Fading of the big moves is only an entry technique; to make as I will detail in the last section, can be derived directly from
a complete trading strategy, I am going to add to the short-sell the probability distribution of Ideal Trader’s profits.
entry at level B (as shown in Figure 3 for a bullish move), a The resulting probability of win is V/(W+V) for fading the
stop-loss at level A, and a profit-taking limit at level C. In this big moves, which confirms our logical reasoning. For example,
if the stop-loss size V and profit limit W are equal, there is an
equal chance of reaching either the stop-loss or profit limit. As
the size of the stop-loss V increases, the probability of triggering
the stop is reduced, thus increasing the probability of win.

Profit expectancy
As you can see, the probability of win
depends on the ratio V/W, which is
exactly the risk/reward ratio of this
strategy. In Figure 4 you see the prob-
ability plot for a range of values of the
risk/reward ratio. With fixed sizes of
win and loss, as in this strategy, the
profit expectancy is calculated as the win size times the prob-
FIGURE 3: Schematics of trading the big market moves. Depend- ability of win, less the loss size times the probability of loss.
ing on the direction of the trade relative to the direction of the move (fading
or following), levels A and C are either stop-loss or profit-taking limit levels for Using the probability of win V/(W+V), the probability of loss
the entries (or exits) at level B. The two distinct cases (a) and (b) depict either W/(W+V), and the fixed sizes of win W and loss V, the resulting
the winning or the losing trade. profit expectancy comes to zero.
18 • March 2014 • Technical Analysis of Stocks & Commodities
 1

0.9
Instead of enduring draw­
downs, you could minimize
0.8
them without changing the
overall profit expectancy of
0.7

0.6
your trading.
Probablity of win

0.5

0.4

0.3
Following the big moves
Instead of fading the big moves, you might be inclined to trade
0.2 in their direction. Referring to Figure 3, for bullish moves this
0.1 means going long at the entry level B; placing the stop-loss at
0
level C; and setting the profit-taking limit at level A. Figure 5
0 1 2 3 4 5 6 7 8 9 10 summarizes the differences in the trading setups of fading versus
Risk/reward ratio
following the big moves. Note that the winning size in the case of
FIGURE 4: PROBABILITY OF WIN. The probability of win in fading the big moves is R/ following the big moves is a fixed V and the loss is a fixed W.
(1+R), where R is the risk-to-reward ratio (stop-loss size to profit limit size). It is impossible The profit expectancy of following the big moves is zero,
to win by taking zero risk (leftmost point in chart); it is equally likely to win or lose if the risk just as in fading the big moves. The profit variance also
is equal to the reward; and it becomes certain to win if the risk grows infinitely.
remains the same, that is, WV. The only changed statistic is
the win ratio, W/(W+V), since the winning case is now case
This means that in the long run, before taking into account (b) in Figure 3 and the losing case is (a). It is also important
trading costs (margin interest, spreads, commissions, fees, and to note the difference in the types of orders used for the two
so on) you should expect zero profit from fading the big moves strategies (Figure 5). This difference affects the slippage and
using any fixed stop-loss and profit limit sizes. While the profit spread components of the final profit calculations. Stop-entry
expectancy is a constant, the variance is WV; it is proportional orders produce larger slippage on average than limit orders;
to the stop-loss and profit limit sizes. stops also lose the spread, while limits can capture it if there
Note that the derived profit expectancy and probability of is direct access to the order book.
win are without regard to what the reasons were (fundamental The more fundamental difference between fading and follow-
and/or technical) for fading the big move or how big the move ing the big moves is in the risk/reward ratio. In fading moves,
was. In other words, this strategy’s statistics do not depend on traders are willing to take larger risks for smaller rewards,
the previous price dynamics. Further, the choice of the stop or compared to when they are following moves. The higher risk
limit sizes doesn’t affect the profit expectancy. It only affects is compensated by lower probability of loss. As a result, the
the probability of win and the profit variance. profit expectancies of both strategies are equal.

Entry Strategy Exit Strategy Fading as an exit strategy

Fading Following Fading Following Big moves can be used to exit a position, take some profit
Entry / exit order Sell short Buy Sell Cover short or loss, and wait for a pullback to reenter the position. In
Order type Limit Stop Limit Stop such setups, level B in the schematics of Figure 3 would be
the exit level; level A would be the stop-entry level at which
Entry / exit B B B B
to catch the runaway trend; and C would be the limit entry
Stop-loss / Reentry A C A C
level for reentering the long position. Conversely, these
Profit limit / Reentry C A C A levels could also be used for exits from short positions and
Win size W V W V reentry. The setup details are shown in Figure 5.
Loss size V W V W If either fading or following the big moves is used as an exit
Win probability V/(W+V) W/(W+V) V/(W+V) W/(W+V) strategy, the loss and win of such strategies are interpreted
as the difference in profit between just holding the position
Loss probability W/(W+V) V/(W+V) W/(W+V) V/(W+V)
and exiting with subsequent reentry. Although the win and
Profit expectancy 0 0 0 0
loss here do not have the same real meaning as with the
Profit variance WV WV WV WV entry strategies, it still pays to know their probabilities and
Win case a b a b overall profit expectancy, as these statistics modify those
Loss case b a b a of the main trading strategy.
The probability of win in fading and following the big
FIGURE 5: TRADING SETUP AND STATISTICS. Here you see the reference levels for each
trading strategy’s setup (A, B, and C), the win or loss sizes (V and W), and the two cases [(a) moves as exit strategies are V/(W+V) and W/(W+V), respec-
and (b)] for big bullish moves. tively; their profit expectancies are zero and the variances
March 2014 • Technical Analysis of Stocks & Commodities • 19
 MOMENTUM TRADING

are WV. The zero profit expectancies mean fixed stop-loss and profit limit multiplied
that in the long run, exiting and reentering by their probabilities V/(W+V)W2+W/
your positions by either fading or following Stop-loss (W+V)V2 = WV; the standard deviation
the big moves will not change your main E is the square root of WV.
trading profit expectancy.
While the profit expectancy is un- Keep up with
changed, the nonzero variance WV means V
momentum
reduced drawdown on your main strategy’s The probability of large
equity curve. This comes from an observa- E moves in the markets is
tion that a big move against your position simply the probability
E
means a large drawdown in your trading of Ideal Trader’s profit
Sell short entry

account and potentially its ruin. Instead of n times the target

of enduring the drawdown, you could W minimum profit. This
trade the big move and thus minimize the probability comes im-
drawdown without changing the overall Profit-taking limit plicitly from mapping the big moves
profit expectancy of your trading. to Ideal Trader’s trades, assuming the
target minimum profit parameter of Ideal
The fine print Trader is equal to the largest drawdown
The imaginary ideal trader is allowed to in the big move. In this article, you have
place orders in the past and capture the FIGURE 6: Stepwise application of Ideal Trader seen how quantitative analysis of trading
maximum profit from any market move concept to derive probability of loss in fading against high-momentum market moves
the big moves. At each step, the probability of advancing
larger than a target minimum profit. The to the new high without triggering the profit-taking limit is provides simple formulas for the win
resulting profit distribution of Ideal Trader evaluated. At the last step, the probability of reaching the
ratio, expectancy, and variance.
is exponential, with the mean equal to twice stop-loss level without falling to the profit-taking limit level
the target minimum profit. gives the probability of loss sought. Ashot Hakobyan is a private trader,
One of the practical applications of the trading systems analyst & developer, and
concept is evaluation of trading strategies without simulation. trading signal provider. He has been a system architect, consul-
To evaluate the strategy of fading the big moves, Ideal Trader tant, lecturer, and research fellow for academia, governments,
must be applied stepwise as shown in Figure 6. At the first and private enterprises in Australia, Europe, and Armenia. He
step, the probability of reaching a new high a small distance may be reached at [email protected].
E away from the entry level is equal to the probability of Ideal
Trader’s profit of size W+E or more. Assuming the minimum Further reading
target profit W, that probability is exp(-E/W). Hakobyan, Ashot [2014]. “The Benefit Of Hindsight,” Tech-
In the second step of the calculation, the probability of nical Analysis of Stocks & Commodities, Volume 32:
reaching the next high at 2E from the entry level is equal to January.
the previous probability multiplied by the probability of Ideal Kaufman, Perry J. [1998]. Trading Systems And Methods, 3d
Trader’s profit of size W+2E or more. Changing the assump- ed., pp. 126–158, John Wiley & Sons (first published in
tion of the minimum target profit to W+E, the probability is 1978; currently in its 5th edition as Trading Systems and
exp(-E/W) times exp(-E/(W+E)). Methods + Website).
Continuing the steps iteratively for each new high at distance Murphy, John J. [1999]. Technical Analysis Of The Financial
kE from the entry level, for k running from 1 to V/E, the final Markets, New York Institute of Finance.
probability of reaching the stop-loss level is the product of the Olver, Frank W.J., Daniel W. Lozier, Ronald F. Boisvert, and
probabilities of Ideal Trader’s profits W+kE or more. Assuming Charles W. Clark [2010]. NIST Handbook Of Mathematical
the minimum target profit W+(k–1)E at each step k, the final Functions, Cambridge University Press.
probability is the product of exp(-E/(W+(k–1)E)) for all k. Pezzutti, Paolo [2005]. “Short-Term Strategies: Fading The
The resulting probability is exp(ψ(W/E) – ψ((W+V)/E)). Gap,” Traders.com Advantage, August 15.
It involves a special function di-gamma (also known as the Rachev, Svetlozar T., Christian Menn, and Frank J. Fabozzi
psi function, which is the derivative of the natural logarithm [2005]. Fat-Tailed And Skewed Asset Return Distributions,
of gamma function). With the step size E reaching zero, the John Wiley & Sons.
limiting probability becomes much simpler, W/(W+V). Note ‡See Traders’ Glossary for definition
that this is the probability of loss V in the strategy of fading
the big moves; the probability of win is V/(W+V).
Having calculated the probabilities of win and loss, and with
the fixed sizes of win W and loss V, the profit expectancy of the
system is simply V/(W+V)W–W/(W+V)V = 0. The variance
of the profits & losses is then the sum of the squares of the
20 • March 2014 • Technical Analysis of Stocks & Commodities
 Q&A
SINCE YOU ASKED
Confused about some aspect of trading? Professional trader Don Bright of Bright
Trading (www.stocktrading.com), an equity trading corporation, answers a few of
your questions. To submit a question, post your question to our website at http://
Message-Boards.Traders.com. Answers will be posted there, and selected questions
will appear in a future issue of S&C.

Don Bright of Bright Trading

What Good Are They? sales. This information is released one of) a certain retailer and short another
Mr. Bright, I have been trading for a hour before the markets open (that is, retailer in the same sector. Then, by using
couple of years — not much, but mostly at 8:30 am ET), and the data is for the these public releases, along with other
equities, which I know your firm special- month just prior. This report is published fundamental and technical data, traders
izes in. It seems that nearly every day around the 10–15th of the month (for can make an educated business plan on
there are economic numbers released the previous month, as just noted). As where and when to enter and exit the
by the government and other sources. information valued by traders and trad- various pairs.
The financial TV shows seem to expect ing firms, this information ranks very Another big event is the Federal
everyone to know what these various high on the list. The data comes from Reserve meetings — and the release of
releases are and how they should be the Census Bureau of the Department the Federal Open Market Committee
viewed. I don’t mind saying that I really of Commerce. Raw data can be found (FOMC) minutes and forecasts/changes
don’t know much about any of these sup- at http://www.census.gov/retail/. in interest rates. This is an especial fa-
posedly big-news items. I can understand This information is a measure of the vorite of mine. When this data is first re-
the unemployment rate, sort of, but they total receipts of retail stores. Traders leased, we generally see a comparatively
seem to discount even that when it ap- use this in their evaluation of the retail big move in the market, either up or down.
pears to be improving. Would you be sector. This is further broken down by Then, after traders and economists have
able to give me and other readers a short the type of stores (department stores, had time to actually read all the released
primer on some of these releases? warehouse stores, discount stores, and so information, the index may reverse itself,
Glad to try to help out. I will say that on). I’m sure you’ve noticed that virtually adding from a few minutes to an hour
you’re not the first, nor will you be the all stocks are put into a sector, as well of increased activity and volatility. It is
last, to be confused by all these indica- as sub-sectors. If you’re trading Macy’s, always good to provide shares or futures,
tors. And you might notice that many for example, you would check to see if and buy them back (or vice versa).
get revised a month later anyway, so, you their results are on par with the sector. I find the free site http://biz.yahoo.
might think, “What good are they?” If they’re not — that is, if Macy’s were com/c/e.html to be extremely helpful,
Way back when I worked as an accoun- underperforming — then you might want since it provides dates and times of the
tant in a public accounting firm, I was to adjust your overall position. various releases. In addition, you can
tasked with filing government reports I’ll give you a few websites you can go to www.investopedia.com for more
for some of our clients. This was my first use as references at the end of this col- detailed explanations of the various
exposure to just how much information umn that will help you find many of the economic indicators.
gets reported by US (and global) busi- myriad of indicators that we use in our Here’s a short list: Treasury budget,
nesses. We would report increases or trading. But first, let me try to explain retail sales, retail sales ex-auto, export
decreases in physical inventory of raw how much credence we place on the prices ex-ag(riculture), import prices
materials and finished goods. We would numbers, and how we play them. First, ex-oil, business inventories, PPI and CPI
report the current personnel information, you need to find out what the consensus (Producer Price Index and Consumer
and, when asked, our outlook for the number is, much like when you review Price Index), crude oil inventories, initial
future year (for sales, productivity, and earnings results for a specific company. (unemployment) claims, and continuing
things like that). (For example, a company may report a claims.
Now, fast-forward to the current day 10% increase in sales and profits but still There are many more, but I think you
with the massive amount of information go down in price if the consensus was get the idea. In trading, information is
available and shared on a minute-by- estimating a 20% increase). king, and how we interpret that infor-
minute basis. Of course, the computer Many of my traders trade correlated mation can be the difference between
and the Internet has really ramped pairs (which I’ve written about previ- profits and losses.
things up. ously in this column). That is to say,
Let’s start with an easy one, retail they will be long (that is, own shares
March 2014 • Technical Analysis of Stocks & Commodities • 21
 The Calm Before The Storm

Expansions & Contractions

Part 1
Every trader wants to be able to predict price moves. But we dream to be able to predict price moves. As that is impossible,
BRIAN TAYLOR

know that it’s impossible to do so. Instead, focus on finding the next best thing is try to find high-probability setups and
high-probability setups and manage them well. In this first handle them with correct position sizes and the right aptitude
part of a three-part series, we’ll look at how to identify these for risk management. One way to find high-probability setups
profitable setups. is to look for divergences.

by Dirk Vandycke Expansion and contraction

Before you start to look at divergences, you need to be aware

A
part from the use of derivatives, perhaps the only way to that they are closely connected with the contraction and ex-
make money in the markets is in the difference between pansion of market prices. You may have noticed that price
the price at which a position was opened and the price at ranges contract before they expand. I call this the tsunami
which it was closed. It is every technical analyst’s wildest effect — similar to how the sea recedes prior to the devastat-
22 • March 2014 • Technical Analysis of Stocks & Commodities
 TRADING SETUPS

ing wave that follows. In the same way, volatility and daily Intrinsic divergences point to divergency of time series with
range shrink before a stock starts running, thereby sucking all themselves, when looking at them from the time dimension.
liquidity out of the market. Tsunamis, however, are far rarer The frequency analysis of time series and intrinsic divergence
than price expansions and the often subsequent trends. The in the frequency spectrum is also underresearched, but that is
question is, can we detect a tsunami before it floods us? beyond the scope of this article. In this article series, I will be
Any good divergence indicator will need to monitor contrac- looking at intrinsic time divergence.
tion as a precursor to expansion. It is the contraction prior to the Last but not least, there’s the problem of indicators need-
expansion that will lead you to detect future price movement. ing parameters that need to be hardwired with their usage in
systems. We need adaptive, parameter-less, and objective
A divergent look at divergence indicators. That’s one of the main efforts put into the ChartMill
There are two ways to look for divergences. One is by view- indicators, the ChartMill bull/bear being one (pair) of them.
ing charts visually to look for price, volume, or any indica-
tor making higher or lower tops and bottoms, while having Ra(n)ging bull
another indicator do the opposite. Let’s say price is moving If you want to detect deviating behavior by
to a new high while volume is declining. This is considered looking at intraday behavior, the place to
a negative divergence. Typically, indicators are compared start is to know what normal behavior is and
with price to spot divergences. So when price takes out a how you can quantify it. Contractions usu-
previous low while an oscillator at the same time shows a ally take place because of a lack of interest
higher bottom, it is generally considered bullish and called a (volume) and the accompanying shrinking
positive divergence. of daily range (volatility). Expansions are
The second way to look for divergences is to build an indi- characterized by increasing volume but
cator that measures divergences in its own right, that is, one more so perhaps by the surge in the daily price range due to
where you don’t compare two different time series. This is illiquidity. When you see this happen, it suggests that, at that
usually done by subtracting two different time series. In the moment, the consensus about the future value deviates greatly
case of a negative divergence, the difference will grow, and from the current price. This results in the start of an outbreak
in a positive divergence, the difference will become smaller. and the ignition of a possible new trend or the firing up of an
All kinds of tricks are then applied to this difference, such as existing one after some consolidation. Be aware, however,
mirroring it around its x-axis to show increases in the case of that volatility can increase or decrease while prices trend.
positive divergence and decreases for negative divergences. This is one of the problems I mentioned when it comes to
Looking at the time difference between two time series detecting divergences.
comes with its share of problems. For example, both can go There are several ways to quantify volatility. In this article
higher, but one of them can go higher much quicker, which I am going to use a simple technique to measure volatility —
would increase the difference as well. Another problem is that the true range over a certain time period. This is the average
this suggests that divergence and correlation are two different range over that period but adjusted for gaps. I will define it a
things. So if you measure one properly, it doesn’t necessarily little differently, because I need a few intermediate numbers
imply that the other is measured correctly. (the end number will be the same, nevertheless).
Then of course — and this is minor — there’s something odd The true range is the difference between the true high and
about how a divergence is referred to as positive or negative. the true low. The true high is the highest of either the high
It suggests a directional dimension that doesn’t necessarily of the period or the previous period’s close (which will be
have to exist. You may want it to exist depending on your higher in the case of a gap down). The true low, likewise, is
position, but one indicator cannot be good and bad at the defined as the lowest of either the period’s low or the previous
same time. Thus, you need to have one indicator for bullish period’s close (which will be lower in the case of a gap up).
signals and another for bearish signals. You need to have a This way, I add any gaps from the previous period’s close to
pair of indicators, not just one. the range of the price period:
Yet another problem with the classical solutions is that
they aim to measure what I will call extrinsic divergences. True high = THi = max(closei–1,highi)
In extrinsic divergences, you try to capture a divergence True low = TLi = min(closei–1,lowi)
taking place between two different time series. Popular as True range = TRi = THi – TLi
they may be, extrinsic divergences are marginally reliable.
Average true range = ATRi = SMA(TR,20)
This may be because of the way they are being quantified
rather than their nature of being measured between two time
series. But people tend to look for divergences, implying Volatility can be quantified as the moving average of true
they are already in progress as soon as they start seeing them. range or ATR over a certain number of periods (typically 20). At
That’s probably why extrinsic divergences are so popular. In first glance, the ATR’s momentum, measured as the difference
comparison to extrinsic divergence, little research seems to between the ATR at two distinct times, appears to be a favorable
be done (nor has been done) toward intrinsic divergences. candidate for measuring contraction. But there’s more.
March 2014 • Technical Analysis of Stocks & Commodities • 23
 TRADING SETUPS

Your objective should

be to spot divergences
before they materialize
into price runs or drops
in price.

calculate the relative close

location (RCL) as:

Closei – TLi
RCLi =
TRi
Figure 1: expansive urge on trending days. Here you see a scatterplot of high-return days on random stocks in function If the close is at the high
and there is no gap down,
of their expansive urge. It seems both measures are closely related. Strong percentage gains or losses correlate with high or low
expansive urge.
the value of RCL will be 1.
If the close is at its low and
Future expansion and true divergence there has been no gap, the RCL will be zero.
Your objective should be to spot divergences before they Note that contrary to most sources, I use the true high and
materialize into price runs or drops. You want to catch a low instead of the mere low and high. This means that I am
window of opportunity seasoned with probabilities before it looking for an indication/divergence in the expansion that takes
becomes clear to anyone what is happening and the window place. You can find this divergence in the deviant behavior
closes. Hence, you want to look for cumulating intraperiod of the normally strong correlation between trend days, the
divergences. The best way to do this is to look for some in- expansion, and the close location value (CLV).
teresting facts about trending days. I’ll define the expansive urge value (EU) of a period as:
On days when there’s a lot of conviction in price moving
in one direction (trending days), there’s a strong correlation Closei – Openi
between the urge to expand and where the period closes in EUi =
TRi
the range. This is not a new idea. There are many indicators
that measure this, and several traders use some principle to This key performance for a period looks at what fraction
measure where the close is in relation to a period’s range. I of a period’s true range was bridged between its open and
its close. You will have to
look at extreme values to
understand this metric. If a
stock’s period opens at the
true low and closes at the
true high, the EU will be
one (at least if there was no
opening gap left open by the
close). If, instead, a stock
opens at the true high and
closes at the true low, the
period’s EU will be -1.
Take a look at Figure 1,
which is a plot of a random
set of stocks. On the x-axis
is each period’s return at
the close against the previ-
Figure 2: stocks tend to close near extremes on high-trending days. Here you see RCL values scattered with
ous period’s close. On the
EU values for random stocks. Only high-return periods were plotted. It’s clear from the chart that stocks tend to close at their high/
low on expansive periods directed by the trend for that period. y-axis is the EU value. So

24 • March 2014 • Technical Analysis of Stocks & Commodities

each point on the plot represents the day-to-day return and Alpha — Premium that an investment portfolio earns above
its expansive range of a period. I only withheld the periods of a given point of reference; a measure of stock performance
those stocks that showed more than or less than a 5% return. independent of the market.
Because of this, all points between -0.30 and +0.30 disap- Arbitrage — The simultaneous purchase and sale of two dif-
peared on the y-axis. So on strong trending days, the close ferent, but closely related, securities to take advantage of a
is near the extreme of the period that’s located at the same disparity in their prices. fat tail
side as where the move was going. For example, on any day Average True Range — A moving average of the true range.
raking in more than 5%, the close tends to be at the period’s Chi Square — A statistical test to determine if the patterns
true high. Does this mean that the EU could be a possible exhibited by data could have been produced by chance.
indicator of trending days, next to high returns and, with it, The chi-square test with Yates’s correction using two-way
correlated with the RCL value? statistics for decline vs. advance is:
The chart in Figure 2 shows that the EU could be an in- 2
k o j – e j – 0.5
dicator of trending days. In this chart, the same periods are x2 = Σ ej
scattered by their EU value on the x-axis and their RCL value j=1

on the y-axis. Again, you will notice that the upper-right and where:
lower-left corners of the graph are populated by points. This oj = actual observed frequency of test
suggests that the RCL tends towards 1 as the EU moves to 1, ej = expected or theoretical frequency of test.
while it moves toward to zero when the EU is near -1. This (Also: Test of statistical significance or confidence of the
means that high-trending (expansive) days tend to close at expected mean and standard deviation.)
the period’s extreme toward the direction of the trend. This Debit Spread — The difference in value of two options,
is the true high for a strong up day and the true low for a where the value of the long position exceeds the value of
strong down day. the short position.
Exchange-Traded Funds (ETFs) — Collections of stocks that
There’s more to it are bought and sold as a package on an exchange.
In the second part of this three-part series, I’ll look at a moving Fade — Selling a rising price or buying a falling price. A trader
window to look for such expansive days and count those that fading an up opening would be short, for example.
diverge from what you would normally expect. This will help Greeks — Jargon; a loose term encapsulating a set of risk
to arrive at truly intrinsic divergence. Stay tuned! variables used by option traders.
One-Tailed T-Test — A statistical test of significance for a
Dirk Vandycke is actively and independently studying the distribution that changes its shape as N gets smaller; based
markets since 1995 with a focus on technical analysis, mar- on a variable t equal to the difference between the mean
ket dynamics and behavioral finance. He writes articles on of the sample and the mean of the population, divided by
a regular basis and develops software partly available at his a result obtained by dividing the standard deviation of the
co-owned website, www.chartmill.com. Holding master de- sample by the square root of the number of individuals in
grees in both electronics engineering and computer science, the sample.
he teaches software development and statistics at a Belgian Implied Volatility — The volatility computed using the actual
university. He’s also an avid reader of anything he can get his market prices of an option contract and one of a number
hands on. He can be reached at [email protected]. of pricing models. For example, if the market price of an
option rises without a change in the price of the underlying
Further reading stock or future, implied volatility will have risen.
Vandycke, Dirk [2013]. “The Chartmill Pair Trading — Taking a long position and a short position
Value Indicator, Part 3” Technical on two stocks in the same sector, creating a hedge.
Analysis of Stocks & Commodities, Relative Strength — A comparison of the price performance
Volume 31: March. of a stock to a market index such as the Standard & Poor’s
[2013]. “The Chartmill Value 500 stock index.
Indicator, Part 2” Technical Analysis Strangle — The purchase or sale of an equivalent number of
of Stocks & Commodities, Volume puts and calls on an underlying stock with the same expira-
31: February. tion date but a different exercise price. Usually, the put has
[2013]. “The Chartmill Value a low strike price and the call has a higher strike price.
Indicator,” Technical Analysis of T-Test — A statistical test of significance for a distribution that
Stocks & Commodities, Volume changes its shape as N gets smaller; based on a variable t
31: January. equal to the difference between the mean of the sample and
‡Chartmill.com the mean of the population divided by a result obtained by
dividing the standard deviation of the sample by the square
‡See Editorial Resource Index root of the number of individuals in the sample.

March 2014 • Technical Analysis of Stocks & Commodities • 25

 TRADING TECHNIQUES

there are tools available that you

can use to get out of trades at the
right time. As the market changes
with the times — or changes the
times — you must be flexible to
know when an old process no lon-
ger works. These days, following
trends without being aware that
the market may go in the opposite
direction seems to be the tried and
true method. But some would ar-
gue that the buy & hold approach
is the only way to invest.
Everyone has a right to his or
her opinions, and I have mine.
One thing, however, that will
never change is that the market
is volatile and you need to know
when to get in and when to get
out. If it were only that easy,
everyone would be doing it!
Fortunately, with ETFs — and I
am not talking about the typical
ETFs — the odds have moved
a bit more in your favor. I am
talking about the inverse ETFs,
which track the market when it’s
going down. Succinctly, when the
market goes down, you can make
money conventionally in a down

COLLAGE/NIKKI MORR
market. You don’t have to mess
with options, or puts, or shorting
the stocks with different trading
parameters than trading ETFs.
ETFs trade like an individual
stock; the ones I track are liquid
Trends And Seesaws and diverse. Being that they are a

Trend Switching With ETFs

fund and not an individual stock,
there is a lot less impact to the ETF
by corporate malfeasance or when
the guidance shows misprojected
earnings. Most certainly, the im-
Given the volatility in the markets, you need to know when to get into a trade and when pact could be huge to the overall
to get out. The use of ETFs has made this easier. Find out how. stock price of an individual stock
when a CEO steps out of line.
by Moshé Prince
What is trend

T
rend switching and trigger switching are the foundation of a successful trading/in- switching?
vesting strategy in exchange traded funds (ETFs). I know there is a line of thinking Basically, trend switching is made
out there that says buy & hold is the way to go, but in my opinion, the days of buy up of four components. They are
& hold are over. After decades of trial and error, I have found that buy & hold has as follows:
had merely a modicum of success. 1. Know when to identify a
market trend
ETFs to the rescue
2. Recognize when that trend
Do you have the stomach to watch an unnecessary loss of more than 30% to 40% in your
has completed
portfolio at any given time and to wait out a recovery? Luckily, you don’t have to because
26 • March 2014 • Technical Analysis of Stocks & Commodities
 Stockcharts.com
Figure 1: SPY VS. SH. Here you see that the SPY and SH move in opposite directions.

3. See that a new trend is under way these funds are made up of the 500 stocks in the S&P 500,
4. Take action to best support an appropriate trade. they breed solid diversity. More important, they move op-
posite to each other, as you can see from the charts in Figure
What is important is to know when the trend is ready to 1. Theoretically, you would be long the SPY during a bull
switch direction so you are not left behind in the possibility market and long the SH during a bear market.
of a money-making opportunity. Knowing when to get in and Two ETF pairs that I track closely in my trading are the
when to get out of the market is a fundamental that sometimes ProShares Ultra Gold (UGL)/ProShares Ultra Short Gold
gets overlooked. There are several indicators and tools you (GLL) and Direxion Daily Financial Bull 3X Shares (FAS)/
can use that will help you identify ongoing trends or when
there is a switch in trends.

Some examples Know when the trend is

An example of the diversity in an ETF can be
seen between the SPY, which is the upside 1X
ready to switch direction
Beta S&P 500 ETF, and the SH, which is the so you are not left behind.
ProShares Short 1X Beta to SPY and tracks the
downside market to the S&P 500. Since both
March 2014 • Technical Analysis of Stocks & Commodities • 27
 Figure 2: UGL VS. GLL. Whether gold is moving up or down, you can make money on it by trading this ETF pair.

Direxion Daily Financial Bear 3X Shares (FAZ). Using an that time, I entered a position in GLL since the shorter period
exponential moving average (EMA) crossover system, you can EMA crossed above the longer EMA and stayed in that posi-
see from Figure 2 that I would have entered a long position in tion till July 2012 when there was an indication of a trend
UGL in January 2012 and stayed there till March 2012, when change. If both ETFs show nondirectional movement in the
the trend showed signs of turning. This was indicated when markets I will stay in cash. I would enter a long position in
the shorter-period EMA crossed below the longer EMA. At UGL in mid-August 2012.
A similar scenario took place with the FAS/FAZ pair of
ETFs (Figure 3). It is clear that the two move opposite each
other. You can be long the FAS during a bull market and long
Knowing when to get in the FAZ during a bear market.
and when to get out of the Some individuals and large funds have built healthy fortunes
utilizing ETF pairs. It is not an easy task by any means, but
market is a fundamental that it is more doable than ever. Opportunities to realize benefits
sometimes gets overlooked. with 75–85% accuracy are entirely possible, but given that
there are no guarantees in the stock market, you still need to
follow a well-thought-out plan.
28 • March 2014 • Technical Analysis of Stocks & Commodities
IF A STOCK FALLS IN THE MARKET
AND YOU’RE NOT THERE TO HEAR IT,
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 FIGURE 3. WHEN ONE MOVES UP, THE OTHER MOVES DOWN. When your indicators tell you the trend will be switching, move your positions to the other ETF in
the pair.

Watch the seesaws Moshé Prince developed the trigger switching system and
Don’t forget to identify your risk tolerance. specializes in ETFs and market timing. He may be reached
That alone can take you down many different at www.trendswitchingsystems.com.
roads. With a solidly executed road map, your
opportunity to succeed goes up exponentially Further reading
once you define how much success you truly Prince, Moshé, and Brian Scollick [2013]. “Trading ETF
want to achieve. The road could be bumpy with more risk Pairs,” Technical Analysis of Stocks & Commodities,
than you can expect if you have not done your homework. Volume 31: January.
Along with increasing your level of stock market knowledge, ‡Stockcharts.com
learning about and venturing into ETFs can be a powerful
and worthwhile journey. As with anything, you have to do ‡See Traders’ Glossary for definition
it the right way. ‡See Editorial Resource Index

30 • March 2014 • Technical Analysis of Stocks & Commodities

 Explore Your Options
Got a question about options? Tom Gentile is the chief option strategist at Optionet-
ics (www.optionetics.com), an education and publishing firm dedicated to teaching
investors how to minimize their risk while maximizing profits using options. To
submit a question for our Explore Your Options column, post it to our website at
http://Message-Boards.Traders.com. Answers will be posted there, and selected
questions will appear in a future issue of S&C.

Tom Gentile of Optionetics

AND THE MOST IMPORTANT RULE FOR A simple trade using a call option especially near expiration.
OPTION TRADERS IS… might be the right idea here, so you look
Having just returned from another at the option quotes for calls that are in- 2. Exercise your rights. One way to
seminar, I ran across a situation that I’ve the-money, as they tend to have less time deter limit orders on the way out of
encountered before on many occasions: value and move like a stock. April is the a trade is to simply exercise the op-
A student who has some type of great shortest time frame that works with your tions, and then sell the stock, which
short-term system decides he wants to analysis, but it’s 96 days from expiration. can virtually eliminate the slippage
start trading options on it. The problem The stock looks safe enough, so let’s as- on the exit. The only problem here is
is one that many of us run into when we sume we want to price out the April 60 that you might suffer some overnight
get started with options. Imagine this call options (Figure 2). risk, as the option exercised to stock
scenario: You spot a great opportunity, put If you were to buy the April 60 call may take some time. One way to over-
on a low-risk trade, and execute your plan. options for 6.70, this would give you cost come this is to short the stock before
The stock moves the way you expect it to, and risk of $670 per contract. Then, if the exercise, eliminating the overnight
but when you get out, either the trade lost stock goes up to a price of $68.55, the calls risk. The only problem here comes if
money or made very little. You followed would be worth 8.55 points, or a theoretical the option you are trying to short isn’t
all the rules to ensure your trade would profit of 1.85. But wait, there’s a problem! on the short sell list.
work. What happened? Chances are, you The current bid/ask spread on this spread
were trading illiquid options with a wide is $1.60! This is an insane spread! Even 3. Penny Pilot program. In January
spread between the bid & ask. if we make our target, much, if not all, 2007, the Chicago Board Options Ex-
If you’re not looking at how liquid of your profits would be eaten up in the change (CBOE) started a program to
your options are, even the best-laid plans spread. So much for your plans. So how reduce the bid/offer spread on options
can fall apart. This is especially true for can you avoid these types of problems of certain liquid stocks. The minimum
spread traders. As an example, take a look with options? increments for all classes in the Penny
at the stock of Church & Dwight (CND) Pilot program are:
in Figure 1. 1. Remember the golden limit rule. • $0.01 for all option series below $3
CND is trading just shy of $66 per share, Placing limit orders on options will (including LEAPS)
moving in an upward direction based on reduce your spread risk, thereby shav- • $0.05 for all option series $3 and
the current swing pattern. Using Elliott ing the difference between the bid & above (including LEAPS) 

wave theory, you look at the previous offer on options you intend to buy or • For QQQQs, the minimum incre-
Wave 4 and note that the recent low of sell. This works well with wide spreads ment will be $0.01 for all option
$65 seems to be holding and the target when entering orders, but when you series.
of $68.55 looks good. want to exit, this can be difficult,
Basically, this means the
options in this program are
5 the most efficient and have the
Integrated Investor (Hubb Financial)

68.55
3 tightest bid/ask spreads. I limit
most of my option trading to
30 Jan

1 4
27%
this list, due to its liquidity.
You can find out more about
Optionetics.COM

2 these options and get a full list

at https://www.cboe.org/hybrid/
pennypilot.aspx.
Figure 2: check out those Good (and liquid) trading!
spreads! The current bid/ask spread
Figure 1: will the upward move continue? Using Elliott wave theory, on the April 60 call option is $1.60.
you look at the previous Wave 4, and note that the recent low of 65 seems to be
holding and the target of 68.55 looks good.

March 2014 • Technical Analysis of Stocks & Commodities • 31

 INTERVIEW

Ahead Of The Crowd

Trading Like An Insider

With Guy Cohen
Guy Cohen is a leading innovator in financial trading. He is the creator of the
options volatility indicator (OVI) and the FlagTrader and OptionEasy trading
tools. He is the author of the best-selling trading books The Insider Edge, Options
Made Easy, The Bible of Options Strategies, and Volatile Markets Made Easy.
With a master’s in business administration in finance from the Cass Business
School of London, he trades both stocks and options using his academic back-
ground as the foundation for his trading methods. He has extensive experience
in trading and analyzing both the US and UK derivatives and stock markets.
Cohen is a successful private trader and also a trading coach. Based on
years of research, planning, and development, his firm produces sophisticated
mathematical models with which to approach the markets.
He can be reached through his website at www.ovitradersclub.com or via
email at [email protected].
Stocks & Commodities Editor Jayanthi Gopalakrishnan interviewed Guy
Cohen via telephone and email on January 8, 2014 on ways to keep abreast
with market momentum, mistakes traders make, and how he uses data.

Once you know that smart

Guy, please tell us a little about Yes, pretty much. Actually, the real investors are building a posi-
yourself and what attracted you to reason was because it was feared as tion, you can follow them,
the financial markets. How did you the most difficult elective and I just as long as you have a well-
get interested in them? wanted to challenge myself. I didn’t
I was always interested in the finan- really believe I could do it, so I thought constructed trading plan.
cial markets, even as a teenager. From a I should give it a try. At that time, I
professional standpoint, I got into finance was in the mood to take on any chal-
while I was specializing in commercial lenge, and the bigger, the better. That In your book The Insider Edge, you
real estate in London. My original idea was really what it came from. write that you like to look for price
and plan was to combine my commercial breakouts. How do you find the stocks
real estate training with finance in order After you did that, did you start trad- that will have the likelihood of a poten-
to become a property developer. ing for yourself or were you employed tial breakout?
I completed my City exams in London, by a firm? That’s done through specific algo-
which is the equivalent of the tests a I started trading for myself, but I rithms. I designed algorithms to find
person must take in the US to work on needed the software to show me what stocks that are consolidating near the
Wall Street, and then I got an MBA in my positions were at any time. To help pressure levels that would constitute a
finance at Cass Business School, where me understand them better, I took a very breakout.
I took the options elective. From that visual approach to options. The entire
point, I started developing software for software was designed around a visual You say that chart patterns are very
my own option trading. At the time, output of risk profiles and the greeks. important. Why are they important,
option-trading software was somewhat Thus, it gave me a feel for what I was and which ones are the most important
primitive and didn’t do what I needed, doing visually, on literally more than to look for in order to identify these
so I started building my own software 60 strategies. My application was doing breakouts?
application, and then was compelled to it better than what was available at the There are three main components to
keep going. time…and there’s nothing like building my overall strategy — the right chart
something for yourself to accelerate your patterns, the right indicators, and a good
Why options? Was it just because of understanding of it. trading plan.
your academic background? There are particular chart patterns that
32 • March 2014 • Technical Analysis of Stocks & Commodities
are important. The reason that some chart pattern (which in itself can be bullish) find that many traditional indicators are
patterns are important for the way that I with a consolidation at the end. I also irrelevant because they are highly subjec-
trade is because they are telling me a story. look for consolidations that are occurring tive and liable to unpredictable changes
Everything I look at must be explaining the in the context of a broader pattern such due to the changeability of market behav-
transactions that are actually happening. as a head & shoulders pattern. The main ior. They often have subjective built-in
The principal aim is to hitch a ride with point is that the pattern itself has to be parameters, which different traders set
a stock that is moving. If the transaction telling you a story of pent-up demand or in different ways. This is why the whole
activities are suggesting position building pent-up supply that is now at a pressure thing becomes too subjective. The more
in a particular stock, you can surmise that level. That’s the key. subjective you are with your analysis, the
the price is likely to continue moving in And then I add something else to less consistent your trading will be.
that direction. I want to hitch a ride on that the mix, the options volatility indicator For me, the indicators and chart pat-
move. I’m not looking to buy at the lows (OVI), which is an indicator I created. terns must relate and correlate directly to
and sell at the highs, because I believe Again, I’m only looking for patterns that actual transactions. Then it’s a matter of
that’s a thankless task. What I’m look- convey the reality of buying & selling following where the transaction money
ing to do is grab a ride on a stock that’s activity. is going, and going about it with a robust
already moving and that looks likely to trading plan.
continue to move. You mentioned there are three main I believe using indicators such as
That’s established by a combination of components to your overall strategy. moving averages and moving average
factors. The first factor is by the chart pat- Besides chart patterns, you also look at convergence/divergence (MACD) as
tern itself. There are only a couple of chart indicators. We all know that indicators actual buy or sell signals is flawed and
patterns I’m looking for. I’m looking for tend to be lagging, but yet, they contain contributes to a lot of the failures that
consolidation patterns; that can include useful information. traders encounter in trading the financial
your basic flags, pennants, or triangles. It Sometimes they contain useful infor- markets. What I and my students like
also can include cup & handles, because mation; I’m of the view that most indica- to do — and we’ve done this based on
cup & handles are effectively just a bowl tors do not contain useful information! I mathematical research — is to dig deeper

NO SCREEN IS BIG ENOUGH FOR

EVERYTHING WE HAVE TO OFFER.

PERIOD.

StockCharts.com
Stock Charts.com
Simply the Web’s Best Financial Charts

Maarch 2014 • Technical Analysis of Stocks & Commodities • 33

 tory (Figure 1) and I need the share price a leading indicator. The way we use it
to be consolidating just below a bullish prior to a break­out makes it leading. It’s
break­out level. In this way, the share not based on historical data; it’s based
price and the share options are telling me on current data. We use it in conjunc-
the same story, that is, that real money tion with a consolidation pattern, which
is accumulating for this stock. makes it a leading indicator prior to a
For a bearish trade, I need the OVI potential breakout.
to be consistently inside the negative
territory and the share price consolidat- I take it that looking at the option
ing just above a bearish break­out level. transactions is what led you to create
Again, the narrative of stock and option the OVI indicator. Why is it important
transactions must be consistent. for a stock trader to look at option
transactions?
Can you give us an overview of the OVI? We’ve found it to be highly significant.
How does it give the trader an edge? First of all, you don’t have to trade or
into the quality of transactions that are The OVI is an indicator derived even understand options to use the OVI
occurring with a particular stock issue. from option transactions. It essentially indicator. The OVI is presented as a
We do look at the chart patterns of the shows the sentiment of option traders very simple line that ranges between -1
stock price itself, but we also look at the as evidenced by actual transactions. and +1. It gives you good information
option transactions under the radar. By However, it must be used alongside regarding option activity. It tells you what
analyzing the option transactions with stock price behavior so you get the full issues the advanced, savvy investors are
the OVI, we have been far more con- picture of what is going on. We’re look- potentially accumulating positions in.
sistent and methodical in our approach ing for overwhelming evidence of mass Once you know that smart investors are
and far less subjective. In fact, we can position building on both sides. This is building a position, you can then follow
be entirely objective about the way we distinct from situations where there’s them, provided your trading plan is one
can look at things. This makes things far evidence of significant hedging, which that’s well constructed. That’s what we’re
more consistent, as a result. we don’t want. looking to do.
If we trade in the direction of likely We’re looking for the evidence of ac-
How do you use these patterns and position-building activity, then we’re cumulation of position building, both in
indicators to identify breakouts? more likely to make money. This is our the stock chart and in the options. One
For a bullish trade, I need the OVI to edge. doesn’t necessarily work without the
be consistently inside the positive terri- The OVI is not a lagging indicator; it’s other. We don’t look at the OVI by itself.
We have to have the confirmation from
what’s actually going on with the stock
price, as well.

I found your story very interesting about

how you created the OVI. Could you
share that with us?
Yes. The OVI came as a result of years
of looking at option chains. Without re-
ally thinking about it, I was visualizing
a line that was going up and down. If I
looked at a particular stock every day
for several weeks, I would remember it
from the several days before because I
could only focus on one or two stocks at
a time. I would therefore get a clear idea
as to the strength of option sentiment for
a particular stock and I’d also be looking
at the charts. It was only when one of
FLAGTRADER.COM

my students asked me why I was getting

certain things right so often that I con-
sciously realized that I was constructing
Figure 1: POSITIVE OVI. Here you see that when the option volatility index (OVI) is in positive territory, there an image of the option transactions in
is a clear upward trend in price. my mind while linking it with the price
34 • March 2014 • Technical Analysis of Stocks & Commodities
chart on the screen. So it then sprang to
mind, “Why don’t we create a line that
represents option transactions?”
Obviously, in practice this was a
challenge because option data is dirty,
awkward, vast, and not all of it is going
to be relevant to successful trading. It
took a long time because the OVI is a
very sophisticated indicator, but the end
deliverable is highly relevant and very
easy to interpret.

I thought it was very interesting how in

your book you explained the various pat-
terns you look at. For example, a certain
stock could be hitting a resistance level
and you look at the OVI and various other
factors. Only when all of them are con-
firming do you actually place a trade. You
mentioned that you don’t enter about 50%
of the trades that you consider because
they don’t actually break out.
That’s right, and that brings us to the
third component of the way we trade,
which is the actual trading plan. Orders
are only executed if a breakout occurs.
Over 50% of our orders are not executed
because there is no price breakout; this price breakout in the direction I want to what gives the institutions an edge.
eliminates a large proportion of trades the stock to be traveling in, and I don’t They’ve got sophisticated mathematical
that would have been losers. trade a stock just before an important models. That’s what was required for us
Think about it: If 50% of the trades news event relating to it, for example, to create the OVI. As I mentioned earlier,
that you would have made end up not earnings. This dramatically reduces the option data is very fiddly. A lot of it is un-
activating because they would have lost, chance of being trapped and gapped. reliable and it’s tough to interpret. We’ve
then you’ve significantly shifted the odds Risk is also managed by way of posi- been accumulating this data for many
in your favor because you haven’t entered tion sizing for each trade in relation to years and we have a lot of experience
those trades that would’ve turned out to your overall trading bank and the amount with it. Then it was a question of building
be losers. You achieve this by designing a of leverage you’re using. a model with mathematical relevance.
robust trading plan that has well-defined We’re doing things in an institutional
entry & exit levels. These levels typically The institutions always seem to have the way, and that has required institutional
get hit when moves have a better chance edge because they get information well brains and an institutional budget.
of resulting in a bankable profit. I think a ahead of the rest of us. Is it true that This took years of research, planning,
major strength in our trading plan is that the OVI indicator was your attempt to and development. Once all that was
many of our orders won’t get filled. get that edge as a retail trader? done, we knew we had something that
The trading plan dictates how and Yes, but there are other reasons as was very valuable. And it has recently
when to enter and exit. We enter on a been proven mathematically.
price break­out. We exit at either a pre-
determined initial stop-loss when it’s a Traders sometimes refuse to accept
loser, or a graduated trailing stop when the fact that they can be wrong. That
we’re profitable. For profitable trades, we actually is one of the biggest hurdles
calculate several profit levels, at which for traders. They know how to enter
points the trailing stop calculation is positions, but they just don’t know
adjusted. how to exit them. Is there any way that
traders can overcome this thinking, or
Is that how you manage your risks? is it just a matter of accepting that they
Yes, the trading plan itself mitigates sometimes can be wrong?
many potential risks. I only enter on a Being wrong is part of trading. The
Maarch 2014 • Technical Analysis of Stocks & Commodities • 35
 are mathematically based. That’s the How long have you been trading?
® method we have followed; we’ve gone I think I put on my first trade when I
from using observation to mathematical was a teenager, but I don’t think I would
proof. An individual trader has to accept call myself a trader at that point. I’d say
that they will be right some of the time I’ve been a “trader” for about 15 years.
and wrong some of the time, and then But even then, there’s been a steep
they should go with a model of trading learning curve because I’ve added more
that skews the odds in their favor. The sophistication and more mathematics to
NeuroShell Trader beauty of the stock market is that you can what I was doing before. Every year that
Intelligent Power actually do that. You can’t really do that
in Las Vegas, but you can do that with
goes by I think, “I wish I knew then what
I know now.” There’s always something
stocks. It requires patience, it requires that I’m learning, and that’s why I’ve
discipline, and it requires sticking to a always been able to improve our methods
method that’s valid. The problem is that incrementally.
most traders are using methods that aren’t
valid in the first place. What are you doing now?
They’re seduced by big promises and I’m currently building a model that we
fanciful techniques. There are some re- hope will become a fund. We recently had
ally wacky ones out there, and they can an independent external review by a Wall
be very seductive to an inexperienced Street quantitative analyst to evaluate
11 years in a row! trader. the OVI specifically and our method of
trading it. The assessment has been very
www.NeuroShell.com What about overtrading or putting too encouraging, so we’re now creating more
much money into positions? sophisticated mathematical models to start
301.662.7950 That can work both ways. Many such a fund that will have its foundations
fortunes have been made by someone in the methods we’ve just discussed.
“backing up the truck” into what they As a result, I’ve also been able to
skill is to be right in a bigger way than thought would be a great investment, bring improvements to my student trad-
you’re wrong, whether that’s by having and it turned out well. But it can also go ers who have access to my OVI trading
more winners than losers, or bigger win- the other way; it can go wrong as well. tools. I trade with them, hold webinars,
ners than losers in their various combina- I think many of us who have made big workshops, and continue to develop
tions and permutations. You’ve just got money in the stock market did at some the software for my students, who are
to accept the fact that you are going to be point back up the truck into something a valued resource because they give
wrong on some trades. If you’re a fortune that really did well for us. The key, valuable feedback. Some of the ideas
teller, then you’d be on a tropical island though, is getting that decision right. that I’ve manifested owe their roots to
by now living the good life. What you Murphy’s law is bound to go against communications with my students. It’s an
need to do — and what rarely happens amateurs in such a situation. A balanced important part of the creative process.
— is you need to use proper, methodical, portfolio and a methodical approach is
mathematically-based formulas to get ultimately what you really want. That Thank you for speaking with us, Guy.
your edge. Unfortunately, in the stock said, once in a while, there may be good
market, there are just too many weird reason to invest a bigger allocation into a Further reading
and wonderful techniques that promise particular issue where all the signals have Cohen, Guy [2005]. The Bible Of Options
a lot and deliver very little. lined up, provided you manage your risk Strategies, FT Press.
The reason the institutions largely properly. This should only happen with a ____ [2012]. The Insider Edge, Wiley
make money is because their methods decent amount of experience, though. Trading.
____ [2013]. Options Made Easy, 3d
ed., FT Press.
____ [2012]. Volatile Markets Made
The reason the institutions largely make money is Easy, FT Press.
Gopalakrishnan, Jayanthi [2005]. “Which
because their methods are mathematically based. Options Strategy Should You Use?
That’s the method we have followed; we’ve gone Guy Cohen Tells You,” interview,
from using observation to mathematical proof. Technical Analysis of Stocks &
Commodities, Volume 23: August.

36 • March 2014 • Technical Analysis of Stocks & Commodities

 FUTURES FOR YOU
INSIDE THE FUTURES WORLD
Want to find out how the futures markets really work? Carley Garner is the senior
strategist for DeCarley Trading, a division of Zaner Group, where she also works
as a broker. She authors widely distributed e-newsletters; for your free subscription,
visit www.DeCarleyTrading.com. Her books — Currency Trading In The Forex
And Futures Markets; A Trader’s First Book On Commodities; and Commodity
Options — were published by FT Press. To submit a question, post your question
at http://Message-Boards.Traders.com. Answers will be posted there, and selected
Carley Garner
questions will appear in a future issue of S&C.

STRANGLING FOR PROFITS? (PART 3) reality, trading futures strangles is a dif- market. Going into the session, the 30-year
If strangle traders can make money regard- ficult way to make money, because what is bond had established a trading range be-
less of market direction, doesn’t it provide inevitable in the long run can be chaotic in tween 129’13 and 128’23. On the heels of
the best odds of success? the short run. For example, markets often the employment report, bonds plunged to
In the previous two issues, I addressed experience “false breakouts”; in such a a low of 128’01; this was enough to elect
the pros and cons of trading option scenario, the futures price will move the sell stops below support and likely put
strangles. This month, we’ll focus on the above or below the current consolidation many futures strangles traders into short
strategy of placing futures strangles. pattern, but prices then quickly reverse at positions near 128’20. However, unless
Futures strangles differ dramatically precisely the most inopportune time for a the trader was extremely quick to take a
from option strangles in that the reference breakout trader. In theory, the momentum profit, he likely found himself in a losing
to “strangle” applies to the trade entry or- of exceeding support or resistance levels proposition. Within minutes, the selling
ders rather than the trade itself. To illustrate, should provide an extension of the move, dried up and a rally ensued; prices made
an option strangle is a strategy in which a but in reality. we often see the buying or their way to 129’17. This was just enough
trader holds open, and opposite, positions selling dry up. It only takes a few of these to elect the buy stops of any trader looking
in calls & puts with the same underlying mishaps to frustrate a trader and cause for a bullish breakout. In this scenario, a
asset; those trading futures strangles are significant financial damage to a specula- futures strangle trader could have easily
placing opposite orders to enter a futures tive account. sustained a loss of close to $1,000 per
contract with the intention of being filled One of the biggest mistakes futures contract in a short period of time.
on only one of them. This makes sense, strangle traders make is placing their buy In my opinion, the biggest drawback of
because a trader cannot be long and short and sell stops ahead of a major announce- a futures strangle strategy is in the entry
the same instrument simultaneously, but ment. For grain traders, this might be a method. By nature of a stop order, the trader
he can be positioned to attempt to profit USDA report, or for financial futures trad- is entering the market after prices have
from either a rally or a decline should one ers, it might be the monthly employment already moved considerably in the desired
of them materialize. report. In either case, the market is poised direction. Simply put, this is a strategy in
Specifically, a futures strangle involves for massive volatility. When traders look which traders attempt to buy high and sell
the placement of a buy stop order above the back at the daily charts, price may appear higher, or sell low and buy lower. I’m more
current market price, and a sell stop order to have a clean break in one direction or of a buy low, sell high kind of gal.
below. If you are not familiar with a stop the other on days when such events take To recap this three-part discussion on
order, it is simply one in which a trader will place, but what they fail to realize is that the various types of strangles, short option
buy a futures contract if the market rallies the ultimate post-announcement direction strangles tend to offer the best odds of suc-
to the stated price, or sell a futures contract is rarely the same as the initial knee-jerk cess on a per-trade basis, but they sacrifice
if it falls to the stated price. Traders typi- reaction. Further, it isn’t out of the ques- the luxury of theoretically unlimited profit
cally place their stop orders at, or beyond, tion for the market to temporarily break potential. Long option strangles, on the
support & resistance levels in the hope that out in one direction, then reverse course other hand, provide the comfort of limited
a breakout of the range will elect one of to break out on the other side, only to see risk and potentially unlimited reward, but
his stop orders. In other words, the trader prices revert back to their starting point they come with dismal odds of success.
is anticipating a big move in one direction and settle near unchanged. Accordingly, Similarly, futures strangle traders face a
or the other and believes he can profit from traders are often whipsawed into large significant amount of risk at the hands of
the momentum of a breakout. losses in minutes, or even seconds, during market volatility in exchange for catching
On paper, futures strangles appear to sessions that pose event risk. the rare, but potentially fierce, breakout
be a promising strategy; after all, a range- An example of this took place on Decem- moves.
bound market will eventually break out of ber 6, 2013, when the employment report
the pattern in one direction or the other. In triggered massive volatility in the Treasury
March 2014 • Technical Analysis of Stocks & Commodities • 37
 L
et me tell you a fictitious
story about Basketcase
Bob. On August 28, 2000,
he bought stock in Intel
(INTC) and received a fill at $75.81,
the very high for the day, the year,
and for the history of the stock. I
show his theoretical purchase in
Figure 1 (point A). At that time,
the stock market was soaring, espe-
cially semiconductor stocks, and he
wanted a part of the action.
When he checked the stock
on October 11, 2000 about six
weeks later (point B), the stock
had bottomed at $35. “It’s down
too far now. As soon as I get my
money back, I’m selling,” he said
to himself. Perhaps you have
uttered similar words in similar
circumstances. If others buy near
the same price, and sell as soon as
they get their money back, their
collective behavior forms a chart
pattern called a double top. That
is two peaks near the same price
with a decline afterward.
Let’s return to Basketcase Bob.
Question 1: How long will it be,
on average, before he gets his
money back? I’ll answer that in
a moment. Until then, consider
another trade at point D on the
chart in Figure 1.
The stock bottomed at $12.95
(C) and at point D is trading at
$34.51. “The stock has nearly

CHRISTINE MORRISON
tripled from the low,” Basketcase
says. “It’s on a roll. Since it hit $75
once before, I know it can climb
that far. I’m buying more.”
The substantial rise to and de-
See You At The Top cline from peak A is what I call

Navigating
a price mountain. Question 2:
Should we depend on price return-
ing to the top of a price mountain

Price Mountains
anytime soon?
The answers to the two questions
are similar. Let’s take a closer look
at how I answered them.

When stock prices start climbing or forming a price mountain, it’s tempting to Price mountain
want to get in on the action. But should you buy a stock that’s forming a mountain? research
I programmed my computer to find
stocks that doubled within three
by Thomas Bulkowski years from a low price above $3
38 • March 2014 • Technical Analysis of Stocks & Commodities
 CHARTING

INTEL Corporation (Semiconductor, INTC)

Bought here A

D
B

Tom Bulkowski
C

Figure 1: price mountain. Here you see a typical example of a stock that soared to its all-time highs only to plunge significantly lower shortly afterward.

and then dropped by half. Those are arbitrary limits; I chose

$3 as a minimum to exclude stocks with a large number of Only 65% of the samples had
stock splits (the historical price is too low) or those trading
near bankruptcy (in both cases, small price moves can mean
price return to the peak of the
a huge percentage change). price mountain.
I used a database of 516 stocks that I follow on a daily basis
and excluded all data before January 1990. The test ended in
early August 2013.
I found 756 non-overlapping samples (meaning one price Visual Guide To Chart Patterns and the Evolution Of A Trader
mountain must end before the next begins). Only 65% of the trilogy. His website, www.ThePatternSite.com, is dedicated to
samples had price return to the peak of the price mountain at price pattern research and includes more than 600 pages of
the time the study ended. free articles on price patterns and market behavior.
How long will it be, on average, before Basketcase Bob gets
his money back? Answer: at least six years (since it could be Further reading
more years until the remaining 35% return to the old high). Bulkowski, Thomas N. [2013]. Visual Guide To Chart Pat-
Should you depend on price returning to the top of a price terns, Bloomberg Press.
mountain anytime soon? No. In many cases, such as for INTC _______ [2013]. Fundamental Analysis And Position Trading:
(which is still waiting after 13 years to recover), it could be Evolution Of A Trader, John Wiley & Sons.
years before the stock posts a new all-time high. _______ [2013]. Swing And Day Trading: Evolution Of A
If you see a price mountain in a stock that you are interested Trader, John Wiley & Sons.
in buying, look elsewhere for a more promising situation. _______ [2013]. Trading Basics: Evolution Of A Trader, John
Wiley & Sons.
S&C Contributing Writer Thomas Bulkowski (who may be ‡Tom Bulkowski
reached via email at [email protected]) is a private investor ‡See Traders’ Glossary for definition
and trader with more than 30 years of market experience and ‡See Editorial Resource Index
considered by some to be a leading expert on chart patterns. He
is the author of several books including four new ones in 2013:
March 2014 • Technical Analysis of Stocks & Commodities • 39
 TRADER’S NOTEBOOK

A Fundamental Lesson For

The Technically Minded
For decades, there have been two major schools of thought and the present and then ordered these markets from the most
when it comes to stocks. First came the fundamental analysts, strongly earnings-driven to the weakest using the ratio of price
who believe that stock prices are a product of revenues and gains divided by the expansion in the PE multiples. Bulls showing
earnings. Then came the technicians, who believe that all they the smallest PE expansions (that enjoyed the greatest earnings
need to know is contained in stock charts. Here, we look at how growth) were considered the most fundamentally driven. I show
the two methodologies come together. his results in the table in Figure 1.
As you can see in Figure 1, bull markets in which earnings
by Matt Blackman growth was more closely aligned with price growth suffered

L
smaller subsequent corrections. In other words, rallies accom-
ike many investors, I began to play the markets believing panied by the greatest earnings growth held up better in correc-
that if you found companies with strong balance sheets, a tions than those where investors bid stock prices up higher than
good product, and strong management team, you would earnings would otherwise dictate.
make money. But one challenge quickly became evident: Earn- Compare the 1974–80 bull market with the one from 2002–07.
ings lagged stock prices most of the time. When the economy The first experienced a PE expansion of 2.2 versus an expansion
slowed down, earnings often gave little or no warning before of 7.8 for the second. In the ensuing corrections, the 1981 reces-
stock prices fell. Relying on balance sheets to determine trade sion saw stock prices fall by 27% compared to a drop of more
entries & exits tended to get you in well after the move was over than double (57%) from 2007–09.
and out too late to avoid the pain.
Charting the results
Do fundamentals really matter? For the sake of clarity, the period from 1960 to present was
An article on the Wall Street Rant blog titled “Is This Bull charted using Robert Shiller’s monthly data. The chart in
Market Fundamentally Driven?” sought to help answer this Figure 2 compares the S&P 500 to earnings. It shows there is
question. “Fundamentally driven bull markets should rely more a link, albeit a loose one, between earnings and stock price. At
on cyclically adjusted earnings growth and less on investors’ times, like at the end of the 2001–02 recession and the end of
willingness to pay ever-increasing multiples on those earnings,” the 2003–07 bull market, earnings led. At other times, such
the author posited. as the peak in 2001 and bear market trough in 2003, earnings
But do they? To explore this question in detail, I used the moved with stock price. Investor sentiment or some other factor
cyclically adjusted price/earnings (PE) ratio data from Robert appeared to determine whether stock prices followed or moved
Shiller’s website. He separated out bull markets that experienced coincidently with earnings.
at least 100% gains without a 20% correction between 1930 To examine the relationship more closely, I next compared

Bull markets over 100% without a 20% correction

Start date End date Starting Ending Shiller Shiller PE S&P Price change / Subsequent
Shiller PE PE expansion % change PE expansion bear market
(Bull Fundamental Ratio) loss
10/03/1974 11/28/1980 7.8 10.0 2.2 125.6 58.2 27%
06/13/1949 08/02/1956 13.6 19.2 5.6 267.1 47.7 22%
04/28/1942 05/29/1946 8.1 16.5 8.3 157.7 18.9 28%
06/01/1932 09/07/1932 4.9 11.0 6.1 111.6 18.4 41%
08/12/1982 08/25/1987 6.2 18.8 12.6 228.8 18.1 34%
12/04/1987 03/24/2000 12.2 45.8 33.5 582.2 17.4 49%
www.wallstreetrant.com

02/27/1933 07/18/1933 6.9 14.9 8.0 120.6 15.0 34%

10/09/2002 10/09/2007 20.0 27.8 7.8 101.5 13.0 57%
03/09/2009 1/22/2014 11.9 25.61 13.71 176.7 12.89 ?
03/14/1935 03/10/1937 10.0 22.8 12.8 131.6 10.3 54%
Figure 1: Bull Market Rankings Based On Stock Price Change Divided By PE Expansion. Bull markets with the highest bull fundamental ratios
were considered fundamentally stronger since stock price increases were accompanied by comparable earnings growth versus markets in which the stock prices
greatly exceeded earnings growth.

40 • March 2014 • Technical Analysis of Stocks & Commodities

 TRADER’S NOTEBOOK

the relative strength of S&P 500 earnings to

the S&P 500 index. As the chart in Figure S&P 500 vs. SPX Earnings
3 shows, earnings outperformed stock price SPX
more frequently from 1960 to 1980 than later, Earnings
when earnings experienced a bear market,
consistently falling relative to price.
During the 1982–2000 bull market, inves-

www.econ.yale.edu/~shiller/data.htm
tors were more optimistic about the future of
stocks — earnings appeared to matter less.
Earnings grew relative to stock prices dur-
ing the 1987 bear market and more modestly
from 1992–95. But other than brief periods in
2001–02 and 2008–09, stock prices appreci-
ated well ahead of earnings for most of this Figure 2: Monthly Data FOR The S&P 500 Index (left-hand side) vs. SPX earnings (right-
period. But this euphoria came at a cost. hand side). At the end of the 2001–02 recession and the end of the 2003–07 bull market, earnings led.
What is evident from Figure 3 is that the
At other times, such as the peak in 2001 and the bear market trough in 2003, earnings moved with stock
price.
“irrational exuberance” in the 1990s caused
stock prices to rise quicker than earnings, an
emotion for which investors paid in 2001–02
S&P 500 vs. Earnings/SPX
with a correction of nearly 50%. Evidence Earnings rising faster
suggests that investors did not appear to than stock prices
Stock prices rising faster
have learned their lesson in the 2003–07 bull than earnings
market. It was associated with an even greater
disconnect in which stock prices were bid up
well above earnings, followed by an even more
severe bear market drop.
What should concern traders and inves-
tors is that the 2009 bull market has so far
demonstrated weaker fundamental growth
as evidenced by PE expansion of 11.1 (so far).
Figure 3: Monthly data for the S&P 500 Index with the relative strength of SPX
If the numbers in Figure 1 prove a reliable earnings (earnings divided by the SPX). Earnings outperformed stock price more frequently from
guide, this puts us on track for a 50%+ correc- 1960–80 than later, when earnings experienced a bear market, consistently falling relative to price. Reces-
tion when the euphoria finally subsides. This sions are shown by the gray vertical bars.
view is further substantiated by the 1935–37
bull, which experienced levels of government stimulus similar But perhaps the biggest lesson of all is that although it may
to what we have had recently. Stock prices in the late 1930s were be possible to ignore earnings fundamentals for months or even
pushed up to unsustainable levels, and a very painful correction years, the more out of whack stock prices become relative to earn-
in excess of 50% followed. ings, the more painful and protracted the aftermath. And this is
a lesson that investors, all too quickly, tend to forget.
Lessons learned...or not
There are a number of lessons to be learned from this exercise. Matt Blackman is a full-time trader and financial writer. He assists
First, it takes far less earnings ($0.06) to “buy” a one-point gain clients get published in the financial media and with market and cli-
on the S&P 500 today than it did in the 1970s when each point ent newsletters. He earned the Chartered Market Technician (CMT)
SPX gain required $0.40–0.60 in earnings. Some might argue designation and a B.Sc. (honors) degree from Simon Fraser University.
that this gain is due to inflation, but why are stock prices more You can follow Blackman’s latest trading ideas and market comments
prone to inflation than earnings? How much of a factor were the on Twitter at www.twitter.com/RatioTrade.
unlimited series of quantitative easing programs in pumping
stock prices to new highs over the last decade? How long can Suggested reading
this trend continue before the next fundamental reversion to the Short, Doug [2013]. “Is This Bull Market Fundamentally Driven?”
mean reckoning day? Earnings/SPX relative strength (red line in http://advisorperspectives.com/dshort/commentaries/Is-Bull-
Figure 3) appears to be at, or at least near, some sort of bottom. Market-Fundamentally-Driven.php
It can’t go any lower than zero. Lesson two is that fundamentals • http://aida.wss.yale.edu/~shiller/
appear to be less important over the short term — stock prices
often move higher due to investor enthusiasm and hope than Current and past articles from Working Money, The Investors’ Magazine,
can be found at Working-Money.com.
based on relative earnings — and this trend has been going on
for decades.
March 2014 • Technical Analysis of Stocks & Commodities • 41
 product review

MetaStock Pro XIII

Figure 1: cloud for daily qqq. As the large letters at the top left indicate, this chart shows past performance. The y-axis is price percentage change and the x-axis is
the number of days after the event. For this screen capture, there were 34 times the event “stochastics overbought” occurred. The red seen at the left-hand side of the chart
indicates that in the first few days, 80% of the time (using the probability scale on the right, which shows that red corresponds to 80), price was basically unchanged.

METASTOCK MetaStock version 12 is the addition of conditions are true, that is, the oscillator is
4548 Atherton Drive, Suite 200 a feature called the Forecaster. trending down and prices are continuing
Salt Lake City, UT 84123 The idea of the Forecaster is to assess up, you have an event. When you use the
Phone: sales 800 508-9180; technical the predictive ability of various indica- Forecaster, you have to select a security
support 801 265-9998 tors. There are 67 choices. Some of the you want to analyze, and the Forecaster
Email: [email protected], indicators are used in multiple ways, goes to work to tell you how each of the
[email protected] so the number of unique indicators is 67 performed.
Internet: www.metastock.com approximately 26. There are several The second problem is this: Given
Product: Trading platform hurdles Forecaster had to get over to that you have a set of discrete samples,
System requirements: Windows 7 or accomplish this task. because there are a limited number of
8; 4GB RAM minimum, 8 GB RAM The first hurdle is best explained by times an event occurs, how do you create
recommended; 1.6 GB disk space; what the Forecaster is not. It is not a something that at least has the appearance
high-speed Internet connection means to find the best trading system. of being continuous? To solve this, Fore-
Price: $100/month, $960/year, or When you look in the Forecaster library caster starts by using two parameters:
$1,395 for a permanent copy to get a detailed explanation of how an price percentage change and the number
indicator is used, it may sound like a trade of days after an event. Remember that
by S&C Staff entry setup. That is true to some extent, an event is simply when one of the 67
but the reason MetaStock chose to use choices is true. Forecaster maps each of

M
etaStock Pro XIII (also referred the word event is that an event simply these pairs onto a two-dimensional grid
to as MSPro13-Forecaster) is the means that the description in the library whose axes are percentage change and
latest version of a full-featured has become true on a particular day, and days after the event. In fact, this is the
product that has been delivering out- at the moment, only daily calculations grid you see in Figure 1.
standing analysis capabilities for more are made. Now, picture in your mind a topo-
than 30 years. The software is installed on An example of an event is the Chaikin graphical grid of points you created by
your computer and is designed to support AD Oscillator Negative Divergence. each of the events. Assign a value of 1 to
real-time intraday or end-of-day (EOD) The descriptor in the library reads: “The each point and then let the point be the
trading. It uses the MetaStock XENITH Chaikin AD Oscillator is trending down source of a ripple as though you had cast
datafeed, which provides quotes and ro- (lower consecutive peaks) and prices are a stone into a still pond. Each point cre-
bust access to news. The big change from continuing up.” Thus, when the latter two ates a ripple, and the ripples sometimes
42 • March 2014 • Technical Analysis of Stocks & Commodities
Figure 2: event chart for daily qqq. The price chart for QQQ is shown with yellow arrowheads above and below prices. The arrowheads indicate where a specific
event took place. The highlighted text in Figure 3 is the specific event. There are two tabs at the upper left: one tab to show the events and the other to show the cloud (Figure
1). The light blue histogram below price is volume. You can zoom in by putting your cursor on the left end of the blue calendar graphic on the bottom and dragging it to the
right. When you choose Forecaster, the initial prompt lets you define your date range.

meet and sometimes not. Forecaster uses divergence discussed earlier, the equity think that the arrows are indicating long
a Gaussian normal distribution to create was unchanged (that is, 0% change on and short entries. The arrowheads are
the ripple and thus can fill in between the the first day after the event), then you simply the point in time when the event
data points right down to each pixel. Let’s would see bright yellow at the left. The was true. If the title of the event doesn’t
take a look at a typical display. blue you see so prominently in Figure ring a bell, you can click on a library
1 is telling us that 40–50% of the time, tab at the top and get an explanation.
Forecast cloud this was the percentage change. Sometimes the library explanations need
Figure 1 shows the results of the cal- Who might find this data particularly some more explaining. The resource that
culations discussed earlier. The cloud interesting? Who has a keen interest in was used in creating the events was the
is shown using days after the event on knowing what the probable price of a stock book Technical Analysis From A To Z
the x-axis and percentage change on the might be? The answer is option traders. by Stephen Achelis, so using that book
y-axis. It’s obvious that each pixel has Look at Figure 1 again. What you are seeing could be a valuable reference.
been calculated. is the range of price-change history for a Figure 3 has a left-hand description and
Notice how the hues in the cloud particular event. Now we’ll try seeing this a right-hand report. The report will tell
subtly change. If you look to the right of from a slightly different angle. you how many times the event occurred
the cloud, you’ll see a scale going from and give you statistical information, since
zero to 100. If you keep in mind you Events it is possible to calculate a standard de-
are seeing past performance, you realize The chart in Figure 2 shows where events viation and mean for each day after the
that the color reflects how often the pair occurred. Figure 3 shows the tables that event. In the example in Figure 2, there
days after the event and the percentage appear directly below the screen capture were 34 occurrences of the event, then
change overlapped with other pairs. in Figure 2. Thus, Figure 2 is showing day one after the event has 34 samples,
For example, if for every instance of a where the highlighted event in Figure 3 day two after the event has another 34
specific event, like the Chaikin negative occurred. It’s easy to look at Figure 2 and occurrences, and so on: thus, there are
sufficient samples for
each day after the
event to calculate a
mean and standard
deviation. It’s not clear
if the Forecaster has a
“reasonableness” test
for a sufficient number
of samples to calculate
a mean and standard
deviation. A chi square
test would suggest
12 samples; thus, for
our example, 34 is
Figure 3: Event Tables. The highlighted text in the left hand table corresponds to the events shown in Figure 2. Events are sorted by
the number of occurrences, with the highest number of occurrences at the top. The report at the right provides statistical data for the selected more than sufficient.
event. Click on a left hand description to select a particular event for viewing on the price chart. You also get an appropriate report. However, Forecaster
March 2014 • Technical Analysis of Stocks & Commodities • 43
 product review

Figure 4: Daily QQQ With Cloud. To create this screen capture, the blue calendar at the bottom was dragged to the right to zoom in on the last two years. Next, a
doubleclick of the most recent event brings up the cloud. Note that in the header, the conditions are spelled out.

does calculate a margin of error that is histograms showing GDP growth for with SectorStat and EcoStat, you have
based on the number of samples. The 10 countries. a powerful product.
fewer number of samples results in a
higher margin of error. Thus, users are In with the new Further reading
informed of how accurate the statistics Forecaster is definitely a clever tool. In Achelis, Stephen B. [2000]. Technical
might be. addition to Forecaster, SectorStat, and Analysis From A To Z, 2d ed., McGraw-
Suppose you want to see what a cloud EcoStat, you can access local quote Hill. Also hosted online by MetaStock
project might be from a particular event. data, that is, data on your hard drive, at http://www.metastock.com/customer/
resources/taaz/.
All you have to do is click on the ar- and EOD users now get hourly snap-
Peterson, Dennis [2013]. “MetaStock Pro
rowhead of your choice and a cloud is shots on daily bars. A lot of thought has
12,” product review, Technical Analysis
shown (Figure 4). gone into the creation of version 13 of of Stocks & Commodities, Volume
Since you might have some condi- MetaStock Pro. The biggest new feature, 31: January.
tions of your own that you would like to Forecaster, provides some unique insight ‡MetaStock
see, you may be interested to know that into the behavior of a fairly wide class ‡See Editorial Resource Index
MetaStock plans to offer a Forecaster of indicators, and when you combine it
with the ability to write your own event
code. There are some other features worth
looking at as well, such as SectorStat,
which provides breadth calculations on
10 different sectors as well as the entire
market. For example, you can choose
to have an advancer–decliner breadth
calculation done on the stocks in the
XLK technology sector. Another feature
is EcoStat that gives the economic data
for a number of different countries.
You access the data by choosing File,
then Open, and then selecting layouts.
You’ll find that there are 70+ layouts. The
first layout in the list is the all business
cycle (Figure 5), which consists of 10

You can get some unique

insight into the behavior of Figure 5: “All Business Cycle” Layout. Requesting the “all business cycle” layout resulted in 10 charts
a wide class of indicators. with GDP growth shown as a histogram for 10 different countries. Italy is in the upper left-hand corner and the US
is in the lower right. The “all business cycle” is just one of 70+ layouts available.

44 • March 2014 • Technical Analysis of Stocks & Commodities

 FUTURES LIQUIDITY

T
rading liquidity is often over- very high volumes. The greatest number three-year period. Thus, all numbers in
looked as a key technical of dots indicates the greatest activity; this column have an equal dollar value.
measurement in the analysis futures with one or no dots show little Columns indicating percent margin
and selection of commodity activity and are therefore less desirable and effective percent margin provide
futures. The following explains how to for speculators. a helpful comparison for traders who
read the futures liquidity chart pub- Courtesy of CBOT wish to place their margin money ef-
lished by Technical Analysis of Stocks ficiently. The effective percent margin
& Commodities every month. is determined by dividing the margin
value ($) by the three-year price range of
Commodity futures contract dollar value, and then multiply-
The futures liquidity chart shown be- ing by one hundred.
low is intended to rank publicly traded
futures contracts in order of liquidity. Stocks
Relative contract liquidity is indicated Trading liquidity has a significant ef-
by the number of dots on the right-hand fect on the change in price of a secu-
side of the chart. rity. Theoretically, trading activity can
This liquidity ranking is produced by serve as a proxy for trading liquidity
multiplying contract point value times All futures listed are weighted equally and equals the total volume for a given
the maximum conceivable price motion under “contracts to trade for equal dol- period expressed as a percentage of the
(based on the past three years’ historical lar profit.” This is done by multiplying total number of shares outstanding. This
data) times the contract’s open interest contract value times the maximum pos- value can be thought of as the turnover
times a factor (usually 1 to 4) for low or sible change in price observed in the last rate of a firm’s shares outstanding.

Trading Liquidity: Futures

Commodity Futures Exchange % Margin Effective Contracts to Relative Contract Liquidity
% Margin Trade for Equal
Dollar Profit
E-Mini S&P 500 GBLX 4.2 10.0 5 ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••>>
10-Year T-Note CBOT 1.2 12.9 17 ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••>
T-Bond CBOT 2.6 15.4 9 •••••••••••••••••••••••••••••••••••••••••••••
E-Mini Nasdaq 100 GBLX 3.0 6.7 6 ••••••••••••••••••••••••••••••••••••••••••••
S&P 500 Index CME 4.2 10.0 1 ••••••••••••••••••••••••••••••••••••••••
5-Year T-Note CBOT 0.6 14.2 37 ••••••••••••••••••••••••••••••••••••••
Corn CBOT 12.7 12.9 9 ••••••••••••••••••••••••••••••••••••
Ultra T-Bond CBOT 3.1 12.3 5 •••••••••••••••••••••••••••••••••••
Gold COMEX 7.3 13.4 3 •••••••••••••••••••••••••••••••
Japanese Yen CME 2.3 5.9 4 ••••••••••••••••••••••••••••••
Silver COMEX 10.5 7.0 1 ••••••••••••••••••••••••••••
Crude Oil WTI NYMEX 5.2 24.7 10 ••••••••••••••••••••••
Sugar #11 ICE-US 9.4 6.8 8 •••••••••••••••••••••
Soybeans CBOT 7.2 17.9 7 ••••••••••••••••••••
Natural Gas NYMEX 5.7 10.1 8 •••••••••••••••••
Euro FX CME 1.5 13.1 10 •••••••••••••••
Cotton #2 ICE-US 5.6 3.6 3 ••••••••••••
CBOE S&P 500 VIX CFE 8.9 3.9 6 ••••••••••••
DJIA mini-sized CBOT 3.4 9.1 6 ••••••••••••
Wheat CBOT 11.5 16.8 10 ••••••••••
E-Mini S&P Midcap GBLX 3.3 7.1 3 ••••••••••
Coffee ICE-US 11.4 6.9 3 •••••••••
Australian Dollar CME 1.9 7.4 9 ••••••••
High Grade Copper COMEX 6.3 16.3 6 •••••••
Soybean Oil CBOT 7.4 12.6 14 ••••••
Gasoline RBOB NYMEX 5.5 17.1 5 ••••••
2-Year T-Note CBOT 0.1 12.9 81 ••••••
Canadian Dollar CME 1.2 7.2 13 ••••••
CBOT Chicago Board of Trade, Division of CME
British Pound CME 1.3 12.7 18 ••••••
CFE CBOE Futures Exchange
Soybean Meal CBOT 6.5 19.1 14 •••••
Live Cattle CME 2.4 8.5 12 ••••• CME Chicago Mercantile Exchange
Swiss Franc CME 1.6 5.5 5 ••• COMEX Commodity Exchange, Inc. CME Group
Heating Oil NYMEX 4.8 32.1 10 ••• GBLX Chicago Mercantile Exchange - Globex
Nasdaq 100 CME 3.0 6.7 1 ••• ICE Intercontinental Exchange-Futures
KCBT Red Wheat KCBT 8.0 13.5 10 •• ICE-EU Intercontinental Exchange-Futures - Europe
Eurodollar CME 0.1 45.1 257 •• ICE-US Intercontinental Exchange-Futures - US
Platinum NYMEX 5.3 16.6 8 •• KCBT Kansas City Board of Trade
Cocoa ICE-US 7.0 16.3 17 •• MGEX Minneapolis Grain Exchange
Lean Hogs CME 3.8 16.1 22 • NYMEX New York Mercantile Exchange
Mexican Peso CME 5.9 37.2 33 • WCE Winnipeg Commodity Exchange
Palladium NYMEX 7.0 24.5 9 •
Spring Wheat MGEX 10.6 12.8 8 •
DJIA CBOT 3.4 9.1 3 •
Canola WCE 6.3 10.4 37 •
U.S. Dollar Index ICE-US 1.6 15.8 23 • 1403
Trading Liquidity: Futures is a reference chart for speculators. It compares markets “Relative Contract Liquidity” places commodities in descending order according to
according to their per-contract potential for profit and how easily contracts can be bought how easily all of their contracts can be traded. Commodities at the top of the list are easi-
or sold (i.e., trading liquidity). Each is a proportional measure and is meaningful only est to buy and sell; commodities at the bottom of the list are the most difficult. “Relative
when compared to others in the same column. Contract Liquidity” is the number of contracts to trade times total open interest times a
The number in the “Contracts to Trade for Equal Dollar Profit” column shows how volume factor, which is the greater of:
many contracts of one commodity must be traded to obtain the same potential return In volume
as another commodity. Contracts to Trade = (Tick $ value) x (3-year Maximum Price 1 or exp –2
In 5000
Excursion).

March 2014 • Technical Analysis of Stocks & Commodities • 45

 product review

Insiders Guide To
Trading Weekly Options
SIMPLEROPTIONS.COM Several unexpected bonuses come other ways to approach trading the same
Phone: 512 266-8659 with this course. In preparation for tak- high-probability pattern setup. But here,
Email: [email protected] ing the course, participants were given the focus is on strategies that involve
Internet: www.SimplerOptions.com/ pre-course homework assignments in the selling, rather than the buying, of an
weekly the form of videos and PDF files. In that option in order to put time decay in the
Product: A four-DVD set; weekly way, both novice and more experienced trader’s favor.
option plus live trading course option traders could begin more or less There’s no need for exotic option
Price: $1,997; contact SimplerOptions on the same page. Along with videos that combinations when a few basic strategies
for special pricing explain the indicators that Carter uses in will do. The course identifies when it’s
the course, the homework assignments best to use a simple vertical spread, when
by Barbara Star, PhD also included viewing the recordings to use an iron condor or a butterfly, and
of two full-length courses Carter has even when to place naked option trades.

T
raders who have ever delved into the taught in the past. One is titled Beginners Along with which days of the week to
world of option trading soon found Guide To Options Trading and the other initiate and exit those strategies, Carter
themselves mired knee-deep in the is The Ultimate Guide To Spreads. An suggests which strategies to use if you
greeks, implied volatility, complicated additional video shares insights about have a small account and which are better
math, and dozens of trading strategies. the mental aspects of trading that were for larger accounts.
John Carter began his Simpler­Options. gained after a week-long gathering of Rather than use the same strategy in all
com website and trading education room business and investing leaders invited situations, Carter outlines a step-by-step
to help reduce the confusion by making to stay at famous entrepreneur Richard method for evaluating a potential trade to
stock and index options much easier to Branson’s private island. All these videos determine which strategy is best. Many
understand and more profitable to trade. and PDFs are provided as part of the times, more than one strategy can be
He brings that same philosophy to his Insiders Guide DVD set. applied, and the trader may choose the
new DVD course, Insiders Guide To one or ones that fit comfortably within
Trading Weekly Options. Strategies his or her skill level, time availability,
Although best known for his intraday Before discussing trade setups, Carter risk tolerance, and account size.
and swing trading of stocks and futures, sets the stage by focusing on trader
Carter began trading stock options psychology and self-limiting mental/ Finding the stocks
while still in college. The DVD course emotional barriers. According to Carter, and setups
applies his years of experience to the the setups are simple, but the ability to With so many weekly options available,
fast-growing world of weekly stock overcome unresolved inner conflicts or how do you select the ones to trade?
options. His mission: to share what he behavioral patterns that undermine suc- Carter shares the criteria he uses to
has learned about what works and what cess are more complicated. He identifies find the cream of the crop. And, once
doesn’t. His goal: to teach participants several trading realities that need to found, it’s possible to sort through the
how to think more like a market maker be taken into account and the mindset same stocks week after week with only
and less like a speculator so they can gain needed to succeed. an occasional visit to the sites that list
consistent success as traders of weekly Most weekly option methods involve all the stocks with weekly options. His
options. selling options rather than buying them. list of key stocks is included with the
The set of four DVDs contains the That’s the approach used for this course course.
recordings of a four-day course that as well. But surprisingly, Carter starts As a first step in determining a setup,
Carter taught in September 2013. The off with the one (and only) time that he advocates looking at the broad market
first DVD covers theory and trading he advocates buying weekly options, to help decide which types of option
strategies. The other three DVDs are revealing the components of a price and strategies can be eliminated immediately
recordings of live trading sessions that indicator pattern that create the “perfect (Figure 1). Then he selects those stocks
took place the following week as both storm” for a high-probability directional that follow the broad market and show a
he and the online participants put into trade that can overcome time decay and specific price pattern. Instead of buying a
practice the concepts and strategies that potentially make large profits. call or a put, he suggests several different
were taught. He then proceeds to identify several ways to create the option strategies that
46 • March 2014 • Technical Analysis of Stocks & Commodities
carry good profit potential. With
the help of a Fibonacci ratio, it’s
even possible to identify an entry
and likely target price.
For the indicator pattern, Carter
relies heavily on an indicator
that identifies price volatility and
direction. The indicator, which is
free on the thinkorswim platform,
incorporates three indicators that
are readily available in most chart-
ing packages. The course includes
an instructional video that explains
how to create and interpret the
indicator.

TRADESTATION
Pattern plus math
leads to success Figure 1: nasdaq index. Checking the direction of the larger index is a first step in deciding which weekly option
With options, there is no escaping strategies to select and which to eliminate.
the need to involve some math; pat-
terns alone are not enough to select
the strike price. Fortunately, the math that Participants watch as he demonstrates duces an additional indicator that draws
Carter teaches doesn’t require the com- how to check the option chain for the specific support & resistance levels on
plex juggling of the greeks. When math correct strike price, the appropriate op- the price charts. While not essential for
is necessary, there is only one number tion strategy, the number of contracts trading weekly options, the indicator
to know. Then, depending on the option in relation to account size, and how to does help to better define price targets
strategy selected, it is a simple matter to place the order. and price areas for favorable trade en-
subtract or add that number to the current The commission costs to trade options tries. Unfortunately, it is a proprietary
stock price in order to pick a strike price can seriously erode the potential profit- indicator that must be purchased from
that puts the odds squarely on your side. ability of a trade and can make some SimplerOptions.com and is not included
He contends that in some situations, it good-looking trades not worth taking. in the price of the course.
is possible to combine the math with a Carter explains the minimum amount
specific pattern to construct a trade that of premium he looks for and suggests Trade management
offers both a 90% winning probability ways to create spreads that provide both For Carter, weekly option trading is not
and a profitable return. safety and an acceptable return. a “set it, forget it, let it expire worth-
At various points during the three live less, and pick up your profits” game. A
Live trading daytrading sessions, he places trades us- probability of winning is just that — a
Theory is one thing, but implementing it ing a mix of the option methods taught probability, not a certainty. Any number
correctly in real time is another. While in the theory class. The trades are taken of factors can and do occur overnight and
the strategy DVD provides an overview to illustrate ways that produce a better throughout the week that can quickly
of the selection and trade management of credit profit and a better reward-to-risk erase a profit and produce a large loss. He
weekly options, the live trading sessions scenario, or to demonstrate concepts such says, “Anyone can get into a trade, but
deal with the actual placement of trades as laddering and pinning. He provides hardly anyone knows how to manage it
and the day-to-day decision-making rules to better ensure that traders are the correctly. Trade management will make
involved in managing and exiting an recipient, and not the victim, of time or break you as a trader.” So, once you
ongoing trade. decay. are in a trade, it’s important to be aware
Carter stresses the importance of fol- Once participants have a good grasp of the trades that are active, and plan for
lowing a game plan and waiting for a of the preferred setup, Carter shows a the worst as well as the best scenario.
valid setup. The participants learn how modified version that identifies poten- The job of the option trader is to man-
to distinguish between clean chart setups tially good trades. These setups can be age risk. Carter equates it to a football
and sloppy setups. He teaches how to applied to various time frames, includ- team needing to defend its goal line. In
determine when to get into a stock that ing intraday price charts for very active option trading, the strike price is the goal
is moving and when not to chase it. He traders and weekly price charts for those line, and to be successful, it is necessary
initiates several trades based on the traders unable to watch the markets to know in advance where to begin your
simple pattern-plus-math procedure that throughout the day. defense. A plan of action to adjust and
was taught during the theory class. During the live trades, Carter intro- defend the position has to occur before
March 2014 • Technical Analysis of Stocks & Commodities • 47
 product review

One focuses on how to find and trade

“Anyone can get into a trade but stocks with high short interest. The
other is a longer-term trade he calls an
hardly anyone knows how to manage elephant trade, which has the potential
it correctly. Trade management will to turn a small investment into a large
make or break you as a trader.” winning trade.
Perhaps the best bonus is Carter’s
teaching style. Throughout the course,
he writes notes that summarize the points
the strike price is touched. This is such In addition to changing or closing he is stressing, the answers to questions
an important topic that a document titled out positions on option-expiration day, from participants, and the trades he has
“Defending Trades” is included with the Carter finds those stocks that still have taken. These class notes are then com-
course. some good premium early in the day and piled into a text file that is available on
Carter devotes a large portion of the shows how it is possible to make money the DVD, a real time saver when wanting
live trading sessions to demonstrating scalping options. That day also serves as to review information.
in real time those methods that reduce the beginning of planning for trades to
risk. Participants learn the point at which take the following week. He provides an Being consistent pays
to become concerned about a potential overview of how he structures his trading From the onset, John Carter makes it
breach and a few easy-to-apply solutions. week. Part of his planning includes mak- clear that among the many possible op-
They also learn which option strategies ing sure that whether he makes money tion strategies available to traders, he is
do not need defending and which require or loses money for the week, he pays sharing the ones he has found that work
more defensive attention. He identifies himself by transferring funds out of his the best for him. They are the techniques
the one thing traders can do to remove trading account and into a non-trading he uses week in and week out to increase
risk either on the day before or the day account. his equity curve.
of expiration. For him, the beauty of using spreads
He offers a general rule of thumb for More bonuses is that each trader can tailor the trades so
the best time to take profit and when it Carter suggests using an option-friendly they fall within acceptable risk param-
is probably safe to let the option expire platform. Although many good option eters for the size of the account being
worthless. Equally valuable is the use of platforms exist, he uses the thinkorswim traded and the comfort level of the trader.
a simple calculation that reveals when platform in this course. Two videos come It isn’t necessary to take an inordinate
the risk to wait for an option to expire with the course that demonstrate the basic risk and blow out a trading account.
worthless far outweighs the gains. In and more advanced trading and analytical However, trading options does require
some cases, failure to deal with the risk features of the program. a reliable methodology. According to
leaves traders vulnerable to being as- Before ending the final trading day, Carter, “In trading, consistency is every-
signed a stock they do not want to own. Carter discloses two other trading ideas. thing. If you can’t get consistent, there’s
no point in doing it.” This course provides
the ingredients needed to attain that con-
sistency with a reliable pattern, plan, and
method of trade management.
Sneak Barbara Star, PhD, is a frequent
preview … contributor of articles and reviews to
Stocks & Commodities. Currently, she
trades part-time and provides individual
The Detrend Is Your Friend Developing Your Own Trading Plan
instruction and consultation to those
by Martha Stokes by Solomon Chuama
Here’s how you can use a detrending indicator Here’s an example of how you can execute interested in the technical analysis of the
to identify cycle deviations. your own trading system based on current financial markets. She lives in Woodland
market analysis. Hills, CA and can be reached at 818
Interview with Dan Zanger 224-4070 or by email at star4070@
by Matt Blackman 2014 Readers’ Choice Awards aol.com.
On trading, the markets, and doing what Presenting the results of the 20th annual
works: an interview with Dan Zanger of Readers’ Choice Awards poll of favorite prod- ‡Insiders Guide To Trading Weekly Options
ChartPattern.com. ucts and services. . (SimplerOptions.com)
‡TradeStation (TradeStation Securities)
...coming in the 2014 Bonus Issue!

48 • March 2014 • Technical Analysis of Stocks & Commodities

The following selection of book descriptions represents a sampling of recent book low guidelines for people who only trade
releases in the investing field. Books described here may be from some of the ma- stocks in their spare time to supplement
jor book publishers as well as some independent book publishers. These are not their income. It fills the niche of providing
critical reviews or editorial evaluations, but rather a brief look at the book market-
those trading strategies that may be best
place to help keep readers up to date on new or recent book offerings.
suited for part-time traders, who don’t have
the time to fully dedicate their attention to
The Master Trader: The almanac combines more than a cen- the markets. It includes guidance on pre-
Birinyi’s Secrets To tury’s worth of data, statistics, and trends. It market studies and studies people can use
Understanding The can alert the reader to little-known market before they leave for work in the morning,
Market + website patterns and tendencies to help with fore- and provides tips for trading at your desk
( 352 pages, $ 60 casting market trends. Stock Trader’s Al- while working. The book purchase includes
hardcover, $39.99 manac has been published for more than online access to the author’s proprietary
ebook, 2013, ISBN 40 years. trading system. The author is the cofound-
978-1-118-77473-1) er of SharePlanner, a financial website on
by Laszlo Birinyi, Trading For Dum- daytrading, swing trading (both long and
published by John mies, 3d edition short), and exchange traded funds.
Wiley & Sons. Along with stories from his (408 pages, $26.99
more than 40 years of trading, this book sof tcover, 2013, Jim Cramer’s Get
provides guidance on trading and invest- ISBN 978 -1-118 - Rich Carefully (433
ing, including group rotation and market 68118 -3 ) by M i - pages, $29.95 hard-
cycles; seasonal factors in investing; which chael Griffis and cover, 2013, 978-
indicators are actually indicative and which Lita Epstein, pub- 0-399-16818-5)
are merely descriptive; and sentiment and lished by John Wi- by James J. Cra-
how to track it. The book helps the reader ley & Sons. Trading For Dummies is for in- mer, published by
answer such questions as what the market vestors at all levels who are looking for a Blue Rider Press, a
will likely do if the “spiders” (SPYs) are up clear guide to trading stocks in any type member of Penguin
by 1% in pre-trading, and whether to buy of market, whether up or down. It is also Group. In this book,
or sell when a stock reports better-that-ex- for traders with experience who are look- Jim Cramer uses his thirty-five years of ex-
pected earnings. It includes chapters and ing for new methods to enhance the profit- perience as a Wall Street veteran and host
details on technical analysis and where it ability of their investments. This book helps of CNBC’s “Mad Money” television pro-
fails; the business of Wall Street; trading the reader learn to analyze stocks, trends, gram to create a guide for high-yield, low-
indicators; anecdotal data; and price gaps. and indicators, as well as to set a buy-and- risk investing in a recovering economy sce-
The website associated with the book fea- sell range beforehand to decrease risk in nario as we are in now. Cramer outlines a
tures data sourcing and a video. any type of market. It stresses the practice plan designed to make money without tak-
of position trading; performing technical ing large risks. Drawing on his deep knowl-
Stock Trader’s Alma- analysis on a company’s performance; and edge of the stock market as well as on the
nac 2014 (192 pag- utilizing research methods that enable the mistakes and successes he experienced
es, $ 50 sof tc over, trader to strategically select both an entry & himself on the way to his own fortune, Cra-
2013, ISBN 978-1-118- exit point before a stock is purchased. This mer explains — in layman’s language —
65945-8) by Jeffrey new edition features updated stock charts, how an individual can accumulate wealth in
A. Hirsch and Yale position-trading tips and techniques, and a prudent, methodical way as long as he or
Hirsch, published by fresh ways to analyze trends and indica- she begins sooner rather than later. In his
John Wiley & Sons. tors. It also includes a new chapter on high- own inimitable style, Cramer’s book pro-
Published every year frequency trading. vides unwaffling straight talk, offering gen-
since 1968, the Stock Trader's Almanac is eral wisdoms as well as specifics. He high-
a practical investment tool with a wealth of The Part-Time Trad- lights possible individual and sector plays,
information organized in calendar format. er: Trading Stock As and identifies long-term investing themes.
This annual resource with its in-depth anal- A Part-Time Venture The book demonstrates how an individual
yses and insights has been a mainstay for + website (240 pag- can develop the disciplines needed to im-
money managers, traders, and investors es, $ 60 hardcover, plement these long-term investing themes.
over the years. The almanac contains his- 2013, ISBN 978-1-118-
torical price information on the stock mar- 65005 -9 ) by Ryan FURTHER INFORMATION
ket; provides monthly and daily reminders; Mallory, published by www.us.penguingroup.com
and highlights seasonal trading opportuni- John Wiley. This book www.wiley.com
ties and dangers. provides practical advice and easy-to-fol-

March 2014 • Technical Analysis of Stocks & Commodities • 49

 For this month’s Traders’ Tips, the focus is
Perry Kaufman’s article in this issue, “Tim-
ing The Market With Pairs Logic.” Here we
present the March 2014 Traders’ Tips code
with possible implementations in various
software.
Code for TradeStation is already provid-
ed in Kaufman’s article. Subscribers will
find that code at the Subscriber Area of
our website, www.Traders.com. (Click on
“Article Code” from the S&C menu.) Presented here is an
overview of possible implementations for other software.
Traders’ Tips code is provided to help the reader imple-
ment a selected technique from an article in this issue.
The entries are contributed by various software develop-
ers or programmers for software that is capable of cus-
tomization.
Readers will find the March 2014 Traders’ Tips code
and formulas at our website, Traders.com, in the Traders’
Tips area. Here, you can read some discussion of the
Figure 1: TRADESTATION. Here is a daily chart of Hess (HES) with the indicator
technique’s implementation by the Traders’ Tips contribu- and strategy applied.
tors as well as some example charts.
To locate Traders’ Tips at our website, www.Traders.
com, click on the link on our main menu at the top of the Stoch1 = 50 ;
Stoch2 = 50 ;
homepage, or scroll down to the “Current articles” section
and click on the Traders’ Tips tab. { raw stochastics for price1 and price2 }
Range1 = Highest( High, Period ) - Lowest( Low, Period ) ;
Range2 = Highest( High of Data2, Period)
- Lowest( Low of Data2, Period ) ;

if Range1 <> 0 and Range2 <> 0 then

begin
F TRADESTATION: MARCH 2014 TRADERS’ TIPS CODE Stoch1 = ( Close - Lowest( Low, Period ) ) / Range1 ;
In “Timing The Market With Pairs Logic” in this issue, Stoch2 = ( Close of Data2
author Perry Kaufman discusses a trading system that buys - Lowest( Low of Data2, Period ) ) / Range2 ;

and sells stocks when they are oversold and overbought rela- { difference in stochastics }
tive to an index. The author has supplied the TradeStation Diff = Stoch1 - Stoch2;
EasyLanguage strategy code as well as the required custom { stress indicator }
Range1 = Highest( Diff, Period ) - Lowest( Diff, Period ) ;
function mentioned in the article. We have additionally created if Range1 <> 0 then
an indicator named PJK_TSMStress based on the author’s StressValue = 100 * ( Diff - Lowest( Diff, Period ) ) / Range1 ;
function, to display the stress level as shown in Figure 1 of end ;
Kaufman’s article. In addition to backtesting the strategy in a Plot1( StressValue, "Stress" ) ;
TradeStation chart, remember that you can use TradeStation’s Plot2( Stoch1 * 100, "D1 Stoch" ) ;
Portfolio Maestro product to quickly backtest on a portfolio Plot3( Stoch2 * 100, "D2 Stoch" ) ;
Plot4( OBLevel, "OverBought" ) ;
of symbols of your choice. Plot5( OSLevel, "OverSold" ) ;
Following is the EasyLanguage code for the PJK_TSMStress Plot6( NormalLevel, "Normal" ) ;
indicator:
To download the EasyLanguage code, please visit our
{ Based on PJK_Stress function TradeStation & EasyLanguage support forum. The code can
Copyright 2013, P.J.Kaufman. All rights reserved. }
inputs: be found at http://www.tradestation.com/TASC-2014. The
Period( 60 ), ELD filename is “_TASC_PJK_PAIRS.ELD.”
OBLevel( 90 ), For more information about EasyLanguage in general please
OSLevel( 10 ),
NormalLevel( 50 ) ; see http://www.tradestation.com/EL-FAQ.
variables: A sample chart showing the PJK_TSMStress indicator is
Stoch1( 0 ), shown in Figure 1.
Stoch2( 0 ),
Diff( 0 ), This article is for informational purposes. No type of trading or
Range1( 0 ), investment recommendation, advice, or strategy is being made, given,
Range2( 0 ), or in any manner provided by TradeStation Securities or its affiliates.
StressValue( 0 ) ; —Doug McCrary
TradeStation Securities, Inc.
StressValue = 50 ; www.TradeStation.com

50 • March 2014 • Technical Analysis of Stocks & Commodities

 F METASTOCK: MARCH 2014 TRADERS’ TIPS CODE
Perry Kaufman’s article in this issue, “Timing The Market
With Pairs Logic,” describes his stress indicator and how to
use it in pair trading. The MetaStock code for this indicator
based on his article is shown here:
Stress:
s1c:= Security("SPY",C);
s1l:= Security("SPY",L);
s1h:= Security("SPY",H);
Prd:= Input("Stoch Periods", 1, 100, 10);
R1:=(HHV(H,prd)-LLV(L,prd));
r2:= (HHV(s1h,prd)-LLV(s1l,prd));
ST1:= (C-LLV(L,prd))/r1;
ST2:= (s1c-LLV(s1l,prd))/r2;
diff:= ST1-ST2;
Sr1 := HHV(diff,prd)-LLV(diff,prd);
Stress := If(SR1<>0,100*((diff-LLV(diff,prd))/SR1), PREV);
stress;
Figure 2: CQG. Here is an example of the study using Hess Corp. (HES). 100 * ST1;
100 * ST2

—William Golson
MetaStock Technical Support
www.metastock.com
F CQG: MARCH 2014 TRADERS’ TIPS CODE
For this month’s Traders’ Tip, we’re providing CQG code for
the stress function based on Perry Kaufman’s article in this
issue, “Timing The Market With Pairs Logic.”
F Thinkorswim: MARCH 2014 TRADERS’ TIPS CODE
CQG code for the study In “Timing The Market With Pairs Logic” in this issue, author
/*Stress Function, P.J. Kaufman*/ Perry Kaufman explains how to backtest the idea of hedging
/*Raw Stochastics for Price1 and Price2*/ with an index-based ETF. Based on his article, we have created
Data2:= S.US.SPY; two new strategies and a new study for thinkorswim users in
Range1:= HiLevel(@,period,0) - LoLevel(@,period,0);
Range2:= HiLevel(Data2,period,0) - LoLevel(Data2,period,0); our proprietary scripting language, thinkScript. One strategy
Stoch1:= (Close(@) - LoLevel(@,period,0))/Range1; is for the equity and the other strategy is for the ETF.
Stoch2:= (Data2 - LoLevel(Data2,period,0))/Range2; A sample chart is shown in Figure 3.
To download the two strategies and the study, simply visit
/*Difference in Stochastics*/
Diff:= Stoch1-Stoch2; the following three links:

/*Stress Indicator*/ For the equity strategy, see http://tos.mx/u2Srym

Range1S:= HiLevel(Diff,period,0) - LoLevel(Diff,period,0); For the ETF strategy, see http://tos.mx/TO4llT
StressValue:= 100*(Diff - LoLevel(Diff,period,0))/Range1S; For the study, see http://tos.mx/XRJgvr

The study has one parameter, period, which may be

configured in the “modify study parameters” window after
the study has been applied to a chart in CQG. An example
of the study applied to Hess (HES) is depicted in the chart
shown in Figure 2.
To discuss this study or download a component PAC that
includes complete formula code, please visit CQG Forums
and CQG Workspaces. Our team of expert product specialists
can advise you on the usage, application, and code for the
study.
Trading and investment carry a high level of risk, and CQG, Inc. does not
make any recommendations for buying or selling any financial instruments. We
offer educational information on ways to use CQG trading tools, but it is up
to our customers and other readers to make their own trading and investment
decisions or to consult with a registered investment advisor.
—CQG, Inc.
www.CQG.com Figure 3: THINKORSWIM

March 2014 • Technical Analysis of Stocks & Commodities • 51

 Figure 4: WEALTH-LAB. Here is a sample Wealth-Lab 6 chart illustrating application
of the system’s rules on a daily chart of HES (middle pane). An SPY chart is shown
in the upper pane, and the stress indicator is plotted in the bottom pane.

You can adjust the parameters within the edit studies window
to fine-tune your variables. Figure 5: AMIBROKER. Here is a daily chart of HES with a daily chart of SPY in
—thinkorswim the middle pane and Perry Kaufman’s stress indicator (red) in the bottom pane.
A division of TD Ameritrade, Inc.
www.thinkorswim.com
range2 = HHV( High2, period ) - LLV( Low2, period );
stoch1 = ( Close - LLV( Low, period ) )/range1;
stoch2 = ( Close2 - LLV( Low2, period ) )/range2;
VarSet("sstoch1", 100 * stoch1 );
VarSet("sstoch2", 100 * stoch2 );
F WEALTH-LAB: MARCH 2014 TRADERS’ TIPS CODE
In this issue, Perry Kaufman’s article “Timing The Market diff = stoch1 - stoch2;
range1 = HHV( diff, period ) - LLV( diff, period );
With Pairs Logic” promises an interesting new take on pair return 100 * ( diff - LLV( diff, period ) )/range1;
trading. As discussed in the article, combining Kaufman’s }
stochastic-derived intermarket stress indicator with a few clear momper = 60;
position-sizing and risk-management rules lays the foundation Hedgeper = 60;
for a long-only market timing system.
SetForeign("SPY");
To execute the trading system that we are providing in // store index data in High2/Low2/Close2 variables
Wealth-Lab strategy code, Wealth-Lab users will need to install High2 = High;
Low2 = Low;
(or update to) the latest version of our TASCIndicators library Close2 = Close;
from the extensions section of our website if they haven’t RestorePriceArrays();
already done so, and restart Wealth-Lab.
stress = PJKStress( High2, Low2, Close2, momper );
The Wealth-Lab code is also shown at the Stocks &
Commodities website at www.traders.com in the Traders’ Plot( stress, "Stress", colorRed, styleThick );
Plot( sstoch1, "Stoch1", colorGreen );
Tips area. Plot( sstoch2, "Stoch2", colorBlue );
A sample chart showing the stress indicator on Hess is in
Figure 4. —Tomasz Janeczko, AmiBroker.com
—Eugene, Wealth-Lab team www.amibroker.com
MS123, LLC, www.wealth-lab.com

F NEUROSHELL TRADER: MARCH 2014

TRADERS’ TIPS CODE
The stress indicator described by Perry Kaufman
F AMIBROKER: MARCH 2014 TRADERS’ TIPS CODE
in his article in this issue (“Timing The Market With Pairs
In “Timing The Market With Pairs Logic” in this issue, author
Logic”) can be easily implemented with a few of NeuroShell
Perry Kaufman presents a pair-trading technique based on his
Trader’s 800+ indicators. Simply select new indicator from
new stress indicator. A ready-to-use AmiBroker formula for
the Insert menu and use the indicator wizard to set up the
implementing the stress indicator is presented here. To display
following indicator:
the indicator, input the formula into the formula editor and
press “apply indicator.” Stress indicator:
A sample chart is shown in Figure 5. SimpleStoch%K( Sub( Stoch%K(High,Low,Close,60),Stoch%K
(SPDRS High,SPDRS Low,SPDRS Close,60) ),60 )
function PJKStress( High2, Low2, Close2, period )
{ To implement the stock-trading side of the pair, simply
range1 = HHV( High, period ) - LLV( Low, period );
select new trading strategy from the Insert menu and enter

52 • March 2014 • Technical Analysis of Stocks & Commodities

 F i g u re 7 : A I Q ,
MATCHMAKER SET-
UP. Here is the setup
used to get a list of
stocks in the NASDAQ
100 that are highly cor-
related to the NDX.

Figure 6: NEUROSHELL TRADER. This NeuroShell Trader chart displays the stress Figure 8: AIQ,
Indicator and corresponding stock trades. RESULTING LIST.
Here are sample
the following in the appropriate locations of the trading results of running
the setup shown in
strategy wizard: Figure 7.

BUY LONG CONDITIONS: [All of which must be true]

A<B(Stress Indicator,10)
open positions, which would have to be computed separately
LONG TRAILING STOP PRICES: and then entered daily as an input before the daily report is
TrailPrice%(Trading Strategy,20)
run once the hedge rule becomes true.
SELL LONG CONDITIONS: [All of which must be true] To get a correlated list of stocks that show good correlation to
A>B(Stress Indicator,50) the index of choice (I used the NDX), AIQ has a MatchMaker
POSITION SIZING METHOD: Fixed Dollar: 5,000.00 Dollars
module that will quickly generate a list of stocks that show
significant correlation to an index. In Figure 7, I show the
To implement the hedge signal and calculate the size of the MatchMaker setup I used to quickly get a list of stocks in
hedge, simply select new indicator from the Insert menu and the NASDAQ 100 that were highly correlated to the NDX.
use the indicator wizard to create the following indicators: In Figure 8, I show the results (part of which are hidden).
After highlighting the ones desired for a list, simply click on
Hedge Signal: And2( A<B( Avg(SPDRS Close,60), Lag( the “data manager” button and a list is created, which is then
Avg(SPDRS Close,60), 1)), Or2( A>B( Long Entry Signal: Trading used to run the tests.
Strategy, 0), A>B( Position(Trading Strategy,0), 0)))
—Richard Denning
Hedge Size: Mul3( Divide(5000,Close), 0.5, Divide( Stnd- [email protected]
Dev( Sub( ROC(Close,1), 1), 60), StndDev( Sub( ROC(SPDRS for AIQ Systems
Close,1), 1), 60)))

Users of NeuroShell Trader can go to the Stocks & F TRADERSSTUDIO: MARCH 2014
Commodities section of the NeuroShell Trader free technical TRADERS’ TIPS CODE
support website to download a copy of this or any previous The TradersStudio code based on Perry Kaufman’s article in
Traders’ Tips. A sample chart is shown in Figure 6. this issue, “Timing The Market With Pairs Logic,” is provided
—Marge Sherald, Ward Systems Group, Inc. at the following websites:
301 662-7950, [email protected]
www.neuroshell.com • www.TradersEdgeSystems.com/traderstips.htm
• www.TradersStudio.com → Traders Resources → Traders Tips

The following code file are provided in the download:

F AIQ: MARCH 2014 TRADERS’ TIPS CODE • Function PK_STRESS — returns the Kaufman stress value
The AIQ code based on Perry Kaufman’s article in • Function COUNTOF — returns the number of times a rule is
this issue, “Timing The Market With Pairs Logic,” is true in a set lookback period
provided at www.TradersEdgeSystems.com/traderstips.htm. • System PK_PAIRS — system to go long stocks based on the
The code I am providing will backtest only the long trading stress indicator
and will not test the hedging portion of the system. For live • System PK_STRES_HEDGE — system that is to be used with
trading, I provided a manual input for the total value of the the PK_PAIRS system for hedging

March 2014 • Technical Analysis of Stocks & Commodities • 53

 Figure 9: TRADERSSTUDIO. This shows the log equity curve and the
underwater percent drawdown curve over the test period of 1/1/2000 to
1/8/2014 using the NASDAQ 100 list of stocks, the NDX index for pairing,
and the QQQ ETF going short for hedging.
FIGURE 11: UPDATA. Here is a sample pair-trading strategy for the SPY index/USB
• TradePlan EqualDollar_HedgeTASC — tradeplan that runs the UN equity. The stress indicator is shown in the middle pane.
two systems with equal dollars invested per trade.

I set up the code on the NASDAQ 100 list of stocks and on “Timing The Market With Pairs Logic” by Perry Kaufman
used the NDX index for pairing. I also set up the hedge using in this issue. The strategy is available for download from www.
the QQQ ETF going short on the hedge signals. If trading an ninjatrader.com/SC/March2014SC.zip.
IRA account, the hedging system can be switched to use an Once it has been downloaded, from within the NinjaTrader
inverse ETF. I used the QQQ for testing because it has more Control Center window, select the menu File → Utilities →
data than the inverse ETFs. In Figure 9, I show the log equity Import NinjaScript and select the downloaded file. This file
curve and the underwater percent drawdown curve over the test is for NinjaTrader version 7 or greater.
period 1/1/2000 to 1/8/2014. Until 2011, the max drawdowns You can review the strategy source code by selecting the
were in the 14% area but in 2011 the max drawdown incurred menu Tools → Edit NinjaScript → Strategy from within the
was 22.7%. The compound annual return over the test period NinjaTrader Control Center window and selecting the “Timing
was 14.9%. With Pairs” file.
Please note that the code I have provided differs from the A sample chart implementing the strategy is in Figure 10.
author’s code in that the tradeplan compounds the results, so —Raymond Deux & Patrick Hodges
NinjaTrader, LLC, www.ninjatrader.com
that the size is adjusted upward as the equity grows, and the
hedge does not use the volatility adjustment.
—Richard Denning
[email protected] F UPDATA: MARCH 2014 TRADERS’ TIPS CODE
for TradersStudio This month’s Traders’ Tip is based on “Timing
The Market With Pairs Logic” by Perry Kaufman. In his article,
Kaufman develops a correlated pair-trading system for use
across fundamentally different markets to better mitigate risk
F NINJATRADER: MARCH 2014 TRADERS’ TIPS CODE across a portfolio. The key indicator in this system seeks to
We have implemented a strategy for NinjaTrader users based identify when both spread legs are at maximum divergence,
and enters reversion trades at these points.
The Updata code for this article is in the Updata library and
may be downloaded by clicking the custom menu and system
library. Those who cannot access the library due to a firewall
may paste the code shown here into the Updata custom editor
and save it. A sample chart is shown in Figure 11.
—Updata support team
[email protected], www.updata.co.uk

F TRADING BLOX: MARCH 2014

TRADERS’ TIPS CODE
Figure 10: NINJATRADER. This screenshot shows the TimingWithParis strategy
applied to a daily chart of the stock HES (while SPY is the second symbol internal In “Timing The Market With Pairs Logic” in this issue, author
to create the pair). Perry Kaufman presents his stress indicator and a pair-trading
54 • March 2014 • Technical Analysis of Stocks & Commodities
strategy. For the Trading Blox code that replicates these strate-
gies, visit the Trading Blox forum at http://www.tradingblox.
com/forum/viewtopic.php?t=10172.
—Trading Blox
tradingblox.com

F TRADE NAVIGATOR: MARCH 2014

TRADERS’ TIPS CODE
Based on “Timing The Market With Pairs Logic” by Perry Kauf-
man in this issue, we have created the special file “SC201403”
that Trade Navigator users can download to make it easy to
implement Kaufman’s technique.
To download the file, click on Trade Navigator’s blue
telephone button, select download special file, then erase the FIGURE 12: TRADE NAVIGATOR, STRESS INDICATORS. Here is a sample chart of
word “upgrade” and type in SC201403, and click the start AAPL showing the three stress functions (the PJK stress indicator, the stress function
button. When prompted to upgrade, click the yes button. If range 1, and stress function range 2).
prompted to close all software, click the continue button. Your
library will now download.
This library contains all the indicators discussed in
Kaufman’s article as well as a template called “timing the
market with pairs.” This prebuilt template can be overlaid
onto a chart by opening the charting dropdown menu, then
selecting the templates command, then selecting the template.
This template, when applied to a stock chart, will contain the
stock’s price in the upper pane, the SPY price in the central
pane for comparison, and the three stress indicators in the FIGURE 13: TRADE
lower pane (Figure 12). NAVIGATOR, CHART
The TradeSense code for the indicators follows: SETTINGS. Here is
the chart settings
window showing how
PJK STRESS
to edit inputs.
&range1 := Highest (High , period) - Lowest (Low , period)
&range2 := (Highest (High , period) - Lowest (Low , period)) Of
"spy"
&stoch1 := (Close - Lowest (Low , period)) / &range1
&stoch2 := (Close - Lowest (Low , period)) Of "spy" / &range2 verify button. You may be presented with an add inputs pop-
&diff := &stoch1 - &stoch2 up message if there are variables in the code. If so, click the
&range11 := Highest (&diff , period) - Lowest (&diff , period)
IFF (&range11 <> 0 , 100 * (&diff - Lowest (&diff , period)) / yes button, then enter a value in the default value column. If
&range11 , 0) all is well, when you click on the function tab, the code you
entered will convert to italics. Finally, click the save button
STRESS FUNCTION RANGE 1
&range1 := Highest (High , period) - Lowest (Low , period) and type a name for the indicator.
&range2 := (Highest (High , period) - Lowest (Low , period)) Of
"spy"
&stoch1 := (Close - Lowest (Low , period)) / &range1
Editing a chart
&stoch1 * 100 Once you have created the indicators, you can insert the in-
dicators onto your chart by opening the charting dropdown
STRESS FUNCTION RANGE 2
&range1 := Highest (High , period) - Lowest (Low , period)
menu, select the “add to chart” command, then on the indica-
&range2 := (Highest (High , period) - Lowest (Low , period)) Of tors tab, find your named indicator, select it, and click on the
"spy" “add” button. Repeat this procedure for the other indicators
&stoch2 := (Close - Lowest (Low , period)) Of "spy" / &range2
&stoch2 * 100 as well if you wish.
If you need assistance with recreating the chart template
Creating a Function settings (Figure 13) discussed here, contact our technical
To set up these indicators manually, click on the edit dropdown support by clicking on the live chat tool located under Trade
menu and open the trader’s toolbox (or use CTRL+T) and click Navigator’s help menu and also near the top of our homepage,
on the functions tab. Next, click new and a “new function” www.TradeNavigator.com, or call our technical support at
dialog window will open. In its text box, input the code for (719) 884-0245 during our business hours. Happy trading!
—Robert Giacolono
one of the above indicators. Ensure there are no extra spaces Genesis Financial Technologies
at the end of each line. When this is completed, click on the 719 884-0245, www.TradeNavigator.com

March 2014 • Technical Analysis of Stocks & Commodities • 55

 FIGURE 14: EXCEL, Profit & Loss. This view shows the stock, index, and hedged combination.

F MICROSOFT EXCEL: MARCH 2014 TRADERS’ TIPS CODE

In “Timing The Market With Pairs Logic” in this issue, au-
thor Perry Kaufman shows an accessible approach to relative
value arbitrage.
His stress indicator shows us when a given equity is oversold
relative to the overall market as represented by the SPY (SPDR
S&P 500). This is treated as a buy opportunity.
The stress indicator also shows when the equity no longer
holds an advantage relative to the market. This is one of three
possible exit triggers for the equity holdings.
Finally, Kaufman shows us a method that may be used to
control overall risk by scaling into trades against the index as
a hedge to the equity transaction (Figure 14).
Figure 15 shows a sample chart illustrating the stress indicator
plotted alongside the SPY and a sample stock (HES).
The spreadsheet file for this Traders’ Tip can be downloaded FIGURE 15: EXCEL, STRESS INDICATOR AND HES vs. spy. This chart shows
from www.traders.com in the Traders’Tips area. To successfully
the stress indicator for the pair HES vs. SPY.

download it, follow these steps:

—Ron McAllister
• Right-click on the Excel file link, then Excel and VBA programmer
[email protected]
• Select “save as” to place a copy of the spreadsheet file on
your hard drive.

Stocks & Commodities MAGAZINE list of products gathered by the editors of make decisions about which products to
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www.Traders.com. ers’ Choice Awards were launched 20
The Readers’ Choice poll is based on a years ago with the goal of helping readers Continued on page 58

56 • March 2014 • Technical Analysis of Stocks & Commodities

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March 2014 • Technical Analysis of Stocks & Commodities • 57

 Continued from page 56

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March 2014 • Technical Analysis of Stocks & Commodities • 59

 AT THE CLOSE
Continued from page 62
index value with the old index value is impossible to make decline. In fact, the manner in which the DJIA is maintained
with any validity. It’s like comparing the taste of the fruits in actually creates something that resembles a pyramid scheme.
a fruit cocktail when the number of different fruits and their All goes well as long as companies are added that are in their
distinctive flavors keep changing. Let me explain what this takeoff or acceleration phase in place of companies in their
means for our analysis of the DJIA. stabilization or degeneration phase.
On October 1, 1928, when the DJIA was enlarged to 30
The five transition phases constituents, the calculation formula for the index was changed
On one hand, generally speaking, the companies that are to take into account that the shares of companies in the index
removed from the index are in either the stabilization or degen­ split on occasion. It was determined that, to allow the value
eration transition phases, of which there are five, namely: of the index to remain constant, the sum total of the share
values of the 30 constituent companies would be divided by
1. The pre-development phase, in which the present status 16.67 (the Dow divisor) as opposed to the previous 30.
does not visibly change On October 1, 1928, the sum value of the shares of the 30
constituents of the Dow 30 was $3,984, which was then divided
2. The takeoff phase, in which the process of change starts by 16.67 rather than 30, thereby generating an index value of
because of changes to the system 239 (3,984 divided by 16.67) instead of 132.8 (3,984 divided
by 30), representing an increase of 80% overnight. This action
3. The acceleration phase, in which visible structural
had the affect of putting dramatically more importance on the
changes — social, cultural, economical, ecological, and
absolute dollar changes of those shares with the greatest price
institutional — influence each other
changes. But it didn’t stop there.
4. The stabilization phase, in which the speed of sociologi­ On September 1929, the Dow divisor was adjusted yet
cal change slows down and a new dynamic is achieved again. This time, it was reduced even further down to 10.47
through learning as a way of better accounting for the change in the deletion
and addition of constituents back in October 1928 which, in
5. The degeneration phase, which can be recognized by effect, increased the October 1, 1928 index value to 380.5
the saturation of the market and increasing competi­ from the original 132.8 for a paper increase of 186.5%. From
tion. Only the strongest companies can withstand the September 1929 onward (at least for a while), this adjustment
competition or take over their competitors. had the affect of putting even that much more importance on
the absolute dollar changes of those shares with the greatest
False appreciation of the DJIA explained changes.
On the other hand, companies in the takeoff or acceleration
phase are added to the index. This greatly increases the chances How it contributed to the crash of 1929
that the index will always continue to advance rather than From the analyses and explanations I just presented, it is
evident that the dramatic adjustments to the Dow
divisor (coupled with the addition or deletion of
constituent companies according to which transition
phase they were in) were major contributors to the
dramatic increase in the DJIA from 1920 until Oc­
tober 1929 and to the subsequent, dramatic decrease
in the Dow 30 from then until 1932, notwithstanding
the economic conditions of the time.

DJIA is a “fata morgana”

In many charts of the price indexes, the y-axis is a
fixed unit, which is also the way it usually is with
charts displaying stock values, since the unit shows
a number of points. However, this is far from rep­
resenting prices truthfully. An index point is not a
fixed unit in time and does not have any historical
significance. An index is calculated on the basis of a
set of shares. Every index has its own formula, and
the formula gives the number of points of the index.
However, the set of shares changes regularly. For a
new period, the value is based on a different set of
“I’d like enough money so I could afford to shares. It seems very strange that these different sets
give it to politicians and run the country.” of shares are represented as the same unit. In less
60 • March 2014 • Technical Analysis of Stocks & Commodities
 AT THE CLOSE
Nike, and Visa.
Alcoa has dropped from $40 in 2007 to
$8.08. Hewlett-Packard has dropped from $50 in 2010 to
An index point is not a fixed unit $22.36. Bank of America has dropped from $50 in 2007
to $14.48.
But Goldman Sachs Group, Nike, and Visa
in time and does not have any rose 25%, 27%, and 18%, respectively, in 2013.
historical significance.
September 20, 2012: UnitedHealth Group (UNH) replaced
Kraft Foods. Kraft Foods was split into two companies and
was therefore deemed less representative and no longer
than 10 years, 12 of the 30 companies (that is, 40%) in the suitable for the DJIA. The share value of UnitedHealth
DJIA were replaced. Over a period of 16 years, 20 companies Group had risen by 53% for two years before inclusion
were replaced, a figure of 67%. This meant that over a short in the DJIA.
period, we were left comparing a basket of today’s apples
with a basket of yesterday’s pears. June 8, 2009: Cisco and Travelers replaced Citigroup and
Even more disturbing is that with every change in the set of General Motors. Citigroup and General Motors have
shares used to calculate the number of points, the formula also received billions of dollars of US government money to
changes. This is done because the index, which is the result survive and were not representative of the DJIA.
of two different sets of shares at the time the set is changed,
must be the same for both sets at that point in time. The index September 22, 2008: Kraft Foods replaced American Interna­
graphs must be continuous lines. For example, the DJIA is tional Group. American International Group was replaced
calculated by adding the shares and dividing the result by a after the decision of the government to take a 79.9% stake
number. Because of changes in the set of constituents and in the insurance giant. AIG was narrowly saved from
the splitting of shares, the divider changes continually. At destruction by an emergency loan from the Fed.
the moment, the divider is 0.15571590501117, but in 1985,
this number was higher than 1. Thus, an index point at two February 19, 2008: Bank of America and Chevron replaced
different points in time is calculated in different ways: Altria Group and Honeywell International. Altria was split
into two companies and was deemed no longer suitable
DJIA (1985) = (x1 + x2 +...+ x30) / 1 for the DJIA. Honeywell was removed from the DJIA
because the role of industrial companies in the US stock
DJIA (2014) = (x1 + x2 +...+ x30) / 0.15571590501117 market had declined in recent years, and Honeywell had
the smallest sales and profits among the participants in
In the 1990s many shares were split. To make sure the result the DJIA.
of the calculation remained the same, the number of shares
and the divisor changed. An increase in share value of one April 8, 2004: Verizon Communications, American In­
dollar of the set of shares in 2014 results in 6.4 times more ternational Group, and Pfizer replaced AT&T, Eastman
points than in 1985. That in the 1990s many shares were split Kodak, and International Paper. AIG shares had increased
is probably the cause of the exponential growth of the DJIA. more than 387% in the previous decade and Pfizer had an
Say the DJIA is at 16,437 points. If we used the 1985 formula, increase of more than 675% behind it. Shares of AT&T
it would be at 2,559 points. and Kodak, on the other hand, had decreases of more
The most remarkable characteristic is of course the than 40% in the past decade and were thus removed
constantly changing set of shares. Generally speaking, the from the DJIA.
companies that are removed from the set are in a stabiliza­
tion or degeneration phase. Companies in a takeoff phase or Real truth or fictional truth?
acceleration phase are added to the set. This greatly increases Does this mean the number of points that the DJIA now gives
the chance that the index will rise rather than go down. This is us is “fictional truth” or “real truth”? If it’s fictional truth, then
obvious, especially when this is done during the acceleration the value of the DJIA says absolutely nothing about the state
phase of a transition. From 1980 onward, seven information, that the economy or society is in with respect to the past. A
communications, and technology (ICT) companies (3M, better guide would be to look at the number of people in society
AT&T, Cisco, HP, IBM, Intel, and Microsoft), the engines of who use food stamps today – now that is the real truth.
the tech revolution, plus five financial institutions —which
always play an important role in every transition — were Wim Grommen is a guest contributor to http://www.Finan-
added to the DJIA. cialArticleSummariesToday.com, which describes itself as“a
site/sight for sore eyes and inquisitive minds,” and to www.
From 2000: Winners in, losers out munKNEE.com, which goes by the slogan“It’s all about
September 23, 2013: Hewlett-Packard, Bank of America, MONEY.”
and Alcoa were replaced by Goldman Sachs Group,
March 2014 • Technical Analysis of Stocks & Commodities • 61
 AT THE CLOSE
in. Changes in the basket of
shares in the DJIA, changes
in the formula, and stock
splits during the takeoff
and acceleration phases of
industrial revolutions are
perfect transition indicators.
The similarities of these
indicators during the last
two industrial revolutions
are fascinating, but they’re
also a reason for concern. In
fact, a historical chart of the
DJIA (Figure 1) is a classic
example of “fictional truth”
— that is, a fata morgana,
so to speak.

Its history
The DJIA was first pub­
lished in 1896, when it had
just 12 constituents and was
a simple price average in

NIKKI MORR
which the sum total value
of the shares of the 12
constituents were simply
The Complexity Of It All divided by 12. The shares
with the highest prices had
The DJIA Is A Fata Morgana the greatest influence on the
movements of the index
Here’s an interesting perspective on the oldest stock index in the US. as a whole. In 1916, the
Dow 12 became the Dow
The Dow Jones Industrial Average (DJIA) is the only stock market index that encompasses the 20, with four companies
second and third US industrial revolutions. Calculating indexes such as the DJIA and showing being removed from the
this index in a historical graph is a useful way to show which phase the industrial revolution is original 12 and 12 new
companies being added.
by Wim Grommen In October 1928, the Dow
20 became the Dow 30, but
the calculation of the index
was changed to be the sum
of the value of the shares of
the 30 constituents divided
by what is known as the
Dow divisor.
While the inclusion
of the Dow divisor may
have seemed very straight­
forward, it was — and still
is — anything but. Why
so? Because every time
the number of companies
or specific constituents
change in the index, then
any comparison of the new
Figure 1: djia OVER the last two industrial revolutions. During the last few years, the increases in the Dow Jones
Industrial Average have accelerated significantly. Continued on page 60

62 • March 2014 • Technical Analysis of Stocks & Commodities

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