Sunday, March 2, 2008

Following The Trend - Trading the Price

"Trading is simple, but it is not easy." John Carter, in Mastering The Trade.

The above statement is perhaps the greatest truth that can be made about trading, but why is it not easy? The answer is plainly that we do not believe what we see. We are inundated with more information than we can process by various financial news media, financial advisers, websites and blogs. We don't trust our own perceptions. As a beginning trader one certainly should not trust one's own views. A mentor is needed. Unfortunately, finding the right mentor or trading information is extremely difficult. A review of Mark Hulbert's Hulbert's Financial Digest shows why this is true. Out of hundreds of advisory newsletters, only a small fraction consistently produce profitable results. A trader could spend years bouncing around from advisor to advisor hopelessly trying to find a winner. However, there is a better way, and that is to take responsibility for one's own trading decisions by learning to trade for oneself.

In 2002, after substantial losses in the tech meltdown, I decided that I would learn to trade for myself. Since I didn't know who to believe, the only course of action that seemed reasonable at the time was to test all the trading methods and approaches that I could find. It was readily apparent to me that while paper trading does yield some insight, and I advise that everyone backtest and paper trade a new method, ultimately it does not demonstrate the value of the method. The trader must put money on the line. I did this over and over again until the winning strategies began to emerge. Fortunately, I realized the value of risk management, and although I continued to lose money in the process, my losses were relatively small.

What I found truly amazed me. The best strategies and methods are the ones that are the simplest. They are the ones that are the most robust. For the intellectually oriented individual, the desire to get ahead of the crowd by devising more and more complex systems can be tempting. Yet, the results just do not prove this out in my opinion and experience.

So, how simple can it be? Well, quite simple.

The method for this month is Trading the Price. Every method boils down to the following three steps:

1. Determine the trend.
2. Plan entries and exits.
3. Execute the plan.

For the stock markets, we will determine the trend by looking at the monthly prices. If the market is trading below the low of the most recent swing high month, then the trend is down. If it is trading above the high of the most recent monthly swing low, then the trend is up.

One can wait for the end of month close to confirm a change in trend, or use one of the following:

1. If the market has a daily close above the high of the most recent monthly swing low on
above average volume ( at least 30% above the 50 day average ) and the price gain is
at least 1% and preferably 1.7%, the trend has changed from down to up.
2. If the market has a weekly close above the high of the most recent monthly swing low
on an increase in volume from the prior week, the trend has changed from down to up.

Reverse for a change from up to down. The same principle applies to the weekly trend using daily bars.

When the trend changes, we can take a position immediately or wait for a confirmation. The confirmation can be a continuation day on increasing volume and expanding range or a retest followed by a renewal of the new trend whether using the daily or weekly bars. Subsequent entries and exits should be made using the weekly trend.

Using the above approach, we can examine the QQQQs from November to see the results and the current state of the market.

On 11/9/07 the Qs closed below the October low with a loss of -3.34% and well above average volume. This indicated that a change in trend had occurred. Since the decline from the high had been substantial, it would have been prudent to wait for a retracement and a new weekly sell signal to take a position. The Qs rallied but still closed the month below the October low, confirming the change in trend.

On 12/17/07 the Qs closed below the low of the week ending 12/14/07, but volume was well below average. Therefore it would have been prudent to wait for a weekly close to confirm the signal. On 12/21/07 the Qs closed above the low of the week ending 12/14/07, so the signal was not confirmed. On 1/2/08 the Qs closed below the lows of the weeks ending 12/14/07 and 12/28/07. Although volume was only average, the fact that the high of the week ending 12/28/07 was a lower swing high was sufficient to confirm the signal. Therefore, it would have been prudent to go short on 1/3/08 at 50.40, which amazingly was the same as the entry from the VLA System. The signal was again confirmed on the weekly close of 1/4/08, so one could have also gone short on the close of 1/4/08 at 48.41 or the open of 1/7/08 at 48.40.

Since that point, there has not been a single daily or weekly close above the high of the swing low week of 1/25/08 at 45.87 indicating significant weakness. The trade remains open and short from 50.40.

The weekly swing high from the 1/23/08 low occurred on 2/1/08 at 45.88. The low of the week was 43.57. There was a failed continuation signal on 2/6/08. The week failed to close below 43.57. However, on 2/29/08 the Qs closed below 43.57 for the day and week on above average daily volume and increasing weekly volume confirming a continuation short signal.

At this point only a high-volume daily close above 45.88 or a weekly close above 45.88 on increasing weekly volume would negate this signal. Although a close above 44.53, last week's high, would be enough to exit for a stop loss. One note of caution here is that the only other indexes to confirm the above signal are the Nasdaq Composite and the SOX (The SMH did not). Therefore, before adding to an existing short signal or taking a new short position, it would be prudent to wait for continuation in the other indexes, particularly the SP-500, DJ-30 and Russell 2000. This fits with the close calls in the VLA and Cabot's Tides systems.

From a seasonal perspective, March 1 is typically positive. So it may be Tuesday or Wednesday before the markets continue downward. Given this, a lower close on Monday would be particularly bearish.

I have tried to present this analysis in as much detail as possible so that the decision making process can be clear. I am sure that a chart or two would be helpful. I hope the reader will bear with me until I learn how to insert charts and spreadsheets.

You can see from the above that there is no evaluation of chart patterns, moving averages, breadth, sentiment, fundamentals, or cycles required to read the price trend. Just an understanding of how to interpret the monthly and weekly swing highs and lows with a bias toward trading with the monthly trend.

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