John Fitzgerald Kennedy
There are several different methodologies that a stock investor can use in the quest for profits.
TIMING INDICATORS, SYSTEMS, AND METHODS
Many investors are uncertain about the difference between a timing indicator, a trading system, a trading method, and a trading technique. The following definitions will help you understand these terms as they are used in stocks.
Timing Indicators
A timing indicator is also known as a timing signal. Investors use timing signals and indicators as strategies and alerts so they will know when a stock should be bought or sold. The accuracy or effectiveness of a timing signal is a function of the underlying validity of the idea on which the indicator is based. If the timing signal you decide to use is based on a completely arbitrary idea, such as how many times a day you stop at stop lights, your timing signal will be less effective than if it is based on something that has to do with stock price or volume fluctuations.
If my timing indicator is to buy a stock every time it goes down a certain number of points from the previous daily closing price, then the results of what I do will be a function of how well this strategy works. There are literally thousands of ideas on which timing indicators and signals are based. We will be teaching you a number of these so that you can decide which ones you prefer to use in your investment strategy.
Traders and investors use timing indicators in order to increase their probability of success in the stock market. All too often traders use timing indicators that are essentially ineffective. Many timing indicators are about as accurate as a coin toss. In other words, their success is questionable. Most of the timing indicators used yield results that are little better than what might be achieved by guessing. The average investor is unaware of this since most popular books teach timing indicators without giving you an idea or even an estimate of how well they work.
Timing indicators are very useful tools. However, if they are to be used to their fullest potential, they must be integrated into trading systems. The next section discusses the trading systems and their relation to timing indicators.
Trading systems.
A trading system is so named because it is totally systematic. It contains specific rules that are operationally defined, precise, and capable of being implemented by anyone who is familiar with the rules of the system. A trading system contains rules for market entry, market exit, and risk management.
The rules are designed to cover virtually every possibility and, if implemented in the prescribed fashion, should allow the trader to reproduce historical performance as long as the system was designed to produce realistic results. If used correctly, trading systems should also yield the same results regardless of the trader. If two traders make exactly the same decisions because they are using the same system to make those decisions, their end profits or losses should be the same.
Some investors feel that trading systems are too rigid, or that they do not allow the individual to exercise his or her common sense and/or expe-
rience when making investment decisions. This, of course, begs the ques-tion as to whether investors have common sense, whether common sense is an asset in the markets, and whether experience is of any value when it comes to trading decisions. All of these issues are matters of opinion and have been hotly debated among professionals for many years.
In the case of the beginning investor, it is better to assume that the system is correct. Unless your system has given you a signal that is an obvious, glaring error, you should follow the indications of your system to a tee. Sticking strictly to the rules of the trading system of your choice is very beneficial, because it allows you to easily identify where the system has failed. When you stray from your system, pinpointing your mistakes becomes harder to do, as you have to review your own thought process. Scrutinizing a mechanical system in which exact results can be reproduced is always easier than scrutinizing your own thoughts and feelings, which are hardly tangible to begin with.
Trading methods. A trading method is a combination of timing signals
loosely organized and implemented according to a variety of relatively
general rules. The investor determines when to buy and sell based on his
or her rules, yet these rules are often neither highly specific, nor are they
sufficiently thorough. However, people who use trading methods can make
money.
Using a trading method instead of a trading system does mean that a certain amount of subjectivity will enter into your investment decisions. Depending on whether you believe that subjectivity is an asset or a liability in trading, you will find the use of a trading method either desirable or unacceptable. In recent years, trading methods have come to be known as “proprietary trading.” In using this approach, the trader uses a trading method (as opposed to a trading system).
Again, we recommend that you use a trading system as opposed to a trading method. The degree of subjectivity that trading methods allow is not appropriate for beginning investors. Some experts would argue that so much subjectivity in making decisions about investments is not appropri-
ate for anyone. In any case, trading on instinct is always significantly riski-
er than trading using a system, if for no other reason than the fact that when all is said and done, you may not know where you made your mistakes.
TYPES OF TIMING INDICATORS
Timing indicators are divided into three main categories:
• Leading indicators are indicators that tend to give you buy or sell
signals before a stock makes its turn.
In a sense they forecast a top or a bottom; however, they do not forecast specific price levels or duration of a move. In theory, there are many supposedly leading indicators; however, in practice there are few that truly lead the markets.
We consider leading indicators to be the most useful for the
beginning investor or trader. This is because they allow ample time
for you to prepare to make your investment. When applying leading
indicators to stocks, remember that your indicator is telling you that
a move is going to happen. If you look at your stock charts and
expect to see that a move has already begun, you will most likely not
see it.
Leading indicators seem to offer the investor the best of all worlds. However, there are drawbacks when using such indicators. One major problem occurs because it is easy to buy a stock too early. Exposure to
price fluctuations that occur before the beginning of the indicated up or down trend may cause you to bail out early. If you are only willing to take a certain amount of risk in a particular investment, and have
bought early because you are using a leading indicator, you may be stopped out of your trade, and thus lose all potential for profit.
• Time current indicators tend to turn higher or lower at about the
same time that a stock does.
There are many such indicators. They can be very helpful in
making long-term investments, and we consider such indicators practically as useful as leading indicators.
The time current indicator should not expose you to as much of
the pre-move price fluctuations as the leading indicator does. However, decisions about buying and selling must be made quickly with time current indicators, as the stock should be making its move at the same time that you take your position.
• Lagging indicators are those that lag behind stock movements.
Such indicators are like the tail on a kite; the market moves, and
the lagging indicator moves after it. These indicators are also known
as trend-following indicators since they follow trends and do not
attempt to forecast them. Using lagging indicators to make decisions
about buying and selling leaves you with a particular disadvantage,
because you will be buying and selling after the tops and bottoms of
market trends.
Using lagging indicators for the long term is still an effective and acceptable method of investing. If you are positioning yourself for moves that may take a year or a number of years to develop, lagging indicators can help you be confident that you have bought or sold into a real trend. Still, if you are late in taking your position and you enter as the trend is turning in the opposite direction, you may
become a victim of the dreaded “whipsaw effect.”
By this we mean you will be buying at tops and getting out at
bottoms—clearly a losing strategy. Hence, lagging indicators must be chosen carefully as a function of their characteristics, or they must be used in conjunction with other indicators that will mitigate this inherent limitation.
The goal in using a lagging indicator is that the trader or investor
will be able to profitably grab a significant portion of a trend before
the indicator changes direction again. In strong bull or bear markets,
leading indicators do excellent work; however, in sideways markets
or markets in transition they tend to lose money and suffer from low
accuracy.
Price over Time Equals Timing
While most traders throughout the world use price as the indicator of
whether to buy or sell a stock, we believe that the price of a stock is not
nearly as important as the timing of your transaction. In other words, we
feel that the investor need not be as concerned about the price of a stock as
much as the timing of market entry and exit. Timing is the all-important
variable.
While many traders and investors are good at discerning the trend of a market, their timing is often poor. Although such people may be able to tell you that a stock will move in a given direction, they themselves oftentimes have a hard time profiting from their knowledge since their market entry and exit are timed incorrectly. They may buy too late or too early or they may sell too late or too early. This is very likely due to a lack of experience in using timing when getting in and out of trades.
Price is important to the long-term investor. However, good timing can overcome the importance of price. Investors and traders alike must move with the existing trend rather than against it. After all, prices that are cheap tend to get cheaper while prices that are expensive tend to become more expensive (both up to a point). Trends tend to continue in their current direction. That is, a stock is more likely to continue moving in one direction (up or down), rather than reverse that movement.
Opinions as to the importance of both price and timing vary markedly. In reality, an investment and/or trading approach that combines both elements is likely to be more productive and profitable in the long run than a one-sided approach. The coming together of time and price is very important. The investor who can understand and use both price and time effectively is likely to be consistently profitable.
The concept of time and price confluence, when used as a trading sys-
tem, is a significant and effective approach for making money. While the concept is valid, putting it into practice is a different issue entirely
Numerous systems and methods have been developed for the sole purpose of putting this concept into practice.
Someone who buys at support as prices decline in an existing uptrend, is attempting to harness the power of this approach. The same is true when one sells short at resistance. In other words, the investor is attempting to combine price with time by selling at a given price after seeing the market rally or buying at support when a market declines. Being able to discern the trend and the price at which to take a position is a powerful tool that should be mastered, or at least understood, by even the smallest investor.
In order to know exactly when to buy and sell, you will need to be able to define the following variables:
• Trend. What is the current trend? Is the trend up, down, or sideways?
How “strong” is the trend? Is there a way to quantify the trend? What
is the “quality” of the trend? Is the market moving sharply higher
with considerable rapidity and magnitude or is the trend slow and
steady?
• Support. If the trend is up, is there a way to determine where a stock
should stop its decline when it goes down (temporarily) during a per-
vasive uptrend? Can a specific price be determined and, if so, how?
• Resistance. If the trend is down, is there a way to determine where a
stock should stop its rally when it goes up (temporarily) during a per-
vasive downtrend? Can a specific price be determined and, if so,
how?
The fact is that all three can be ascertained with relative ease. For the time being, suffice it to say that specific methods for doing so will be presented. Our intent at this juncture is simply to introduce you to the concept. Here, then, are some methods for determining trends and/or entry/exit points. In each case we will explain the method as well as its assets, liabilities, and variations. An example of each technique will be provided in chart form.
There are numerous books on technical analysis that can explain these approaches in considerable detail. The explanations offered herein are necessarily cursory and are provided only as a general background to the systems and methods we will discuss in later chapters.
AN EXAMINATION OF BASIC TIMING INDICATORS
Given the plethora of trading systems, timing indicators, and methods available to the trader, it is reasonable to expect that most readers will be overwhelmed by the number of choices. Often the amount of available information in texts or online is insufficient to help you make a decision.
In the long run you are left to make decisions on your own. And, all too often, these decisions cannot be made without reference to historical performance. As you can imagine, this poses a formidable challenge to the newcomer. But this is no surprise. All too often information about what works or what doesn’t work in the markets is not available to the public in spite of all the books, seminars, and courses that are available.
Hopefully, the explanations that follow will help elucidate for you the indicators and methods that we feel work best and under what circumstances. We will give you an evaluation of their assets and liabilities, all based on our experience in the stock and commodity markets.
Moving Average Indicators (MAs): Traditional and Advanced
Whether you use one, two, or many MAs, the concepts and applications are essentially similar. Either the market price must close above or below its MAs to signal a buy or a sell, or the MAs themselves must change their relationship to one another in order to signal a trade. Richard Donchian popularized this approach in the 1950s although it was probably being used well before then.
In the typical MA-based system, signals are generated in either of several ways:
• Price closes above or below its MA. Closing above the MA is con-
sidered a buy signal whereas closing below the MA is considered a
sell signal.
• In the case of multiple MAs, the approach signals buy or sell signals
when the various lengths of MAs cross one another.
• In the case of MAs of closing/opening, or high or low prices, signals
are generated when crossovers of the MAs occur as defined by the
theory or method.
Assets.
Traditional MA indicators tend to do extremely well in major trends. They can make you a lot of money after a major trend has started if you are able to hold on to your position. MAs are lagging indicators since they give signals after a market has made its turn. There are numerous variations on the theme of the MA—some more effective and responsive than others. Most computer trading systems allow you to use different mathematical formulations of the MA (that is, weighted, exponential, smoothed, displaced, centered, and so on).
Figure shows a stock chart with various moving averages plotted against it. Note the rather large differences. MAs can also be used to deter-
mine trend. In the traditional approach, price above its MA indicates an
uptrend, whereas price below its MA indicates a downtrend. In the example provided (Figure 6-1) the stock is in a downtrend after having crossed below its MA. It remains in an uptrend. Note that in February, the stock was in a downtrend after falling below all of its moving averages. One thing you will observe, without a doubt, is that moving averages are lagging indicators, as previously stated. Therefore, if you use moving averages in the traditional sense, be prepared to get in and out after a stock has already made its high or low. At times, late entry and/or exit can be very costly.
Liabilities. These indicators tend to give many false (that is, losing) signals. They will often get you into a move well after it has started, and when a change in trend occurs, they will often get you out after you have given back a considerable amount of your profit. Such moving averages tend to be inaccurate and often have considerable drawdown as well as numerous consecutive losing trades.
Solutions.
Some of the problems with moving averages can be minimized as follows:
• Use a weighted, exponential, smoothed, or displaced MA.
• Use a different MA length to exit a trade than you use to enter a
trade.
• Use different MA lengths for buy signals and sell signals.
• Use another indicator to confirm or negate an MA.
• Or, use an adaptive MA (AMA). A more recent addition to the MA
arsenal, the AMA tends to be more responsive to price changes by
using several variables. To accomplish this, the AMA uses an efficiency ratio (ER) and smoothing constant.
Variations on the Theme of Moving Averages
There are many variations on the theme of moving averages. These include MA-based oscillators such as the MACD, the MA Channel, and various high and/or low MA combinations.
Assets.
These variations on the MA tend to be more accurate and more
sensitive than simple MA combinations of the closing price. The MACD
was specifically designed for S&P trading by Gerald Appel while the
Moving Average Channel (MAC) is our own creation. Figure 2 shows
a daily chart (also AFFX as in Figure 1) with the MACD. Buy-and-
sell signals on the MACD are generated when the two MACD lines
cross one another.
Liabilities. There is a tendency, as with many MA-based systems, to give back too much profit once a change in trend has developed. This is true of all lagging indicators.
Solutions.
Here are some suggestions as to how one might overcome the limitations of MA-based indicators:
• Use a shorter combination of MA lengths for exit. Hence, exit will
be triggered before the MAs indicate a reversal in trend.
• Use another indicator to confirm the MA signals.
• Use another indicator that is not MA-based for exiting positions.
• Develop a trailing stop-loss plan that will enhance exit while not sig-
nificantly diminishing system accuracy.
Stochastics (SI) and the Relative Strength Index (RSI)
Dr. George Lane popularized the Stochastic Indicator (SI) and its use. The Relative Strength Index (RSI) is very similar to the SI. The difference is that SI has two values; RSI has only one. Computing a moving average of the first SI value derives the second SI value. Both indicators are often used to indicate theoretically “overbought” or “oversold” conditions. They may both be used as timing indicators as well as indicators of so-called overbought and oversold conditions.
Figure 3 shows the daily AT&T (T) chart with a stochastic and an RSI. There are various methods and interpretations of the SI and RSI. SI signals are shown on the chart (Figure 3). Note that there are many different methods of using RSI and SI for the purpose of finding trends, buy signals, and sell signals.
Those included on Figure 3 are not being touted as the best. They are merely included as examples for informational and introductory purposes. As you can see, both indicators can generate numerous signals. The num-
ber of signals can be adjusted by changing the length of the indicators.
Assets.
Both the RSI and SI have considerable sex appeal. By this, we mean they look good on a chart. They tend to identify tops and bottoms quite well. They are also useful in timing provided one uses the appropriate crossover areas for timing trades.
Liabilities. The concepts of “overbought” and “oversold” are not useful and often misleading. Frequently markets that are overbought continue to go considerably higher while markets that are oversold continue to go considerably lower.
Solutions
• Don’t use the SI and RSI for determining overbought or oversold
conditions. Use these indicators as timing methods when the readings cross
above or below certain values. You might also consider the use of RSI and SI
with other timing indicators.
• Use the SI “POP” method that may be helpful in trading moves that
occur in overbought and oversold territory.
• Another method of using the RSI and SI is to exit trades using a
shorter SI or RSI indicator length than was used for entry.
Chart Patterns and Formations
These methods are based on the traditional techniques as proposed by Edwards and Magee as well as other tools such as those developed by W. D. Gann, George Bayer, and R. N. Elliott. There are many different chart for-
mations and various outcomes possible for each. They require a good deal of study and are, at times, quite intricate as well as subjective. The commodity trading literature is rich with methods and systems based on these patterns.
Assets
• These methods are highly visual. In other words, you can draw lines
on a piece of paper, or you can examine patterns visually, and see
what should be done.
• The methods don’t necessarily require a computer.
• They can easily be learned by almost anyone. Frequently the pre-
scribed actions are specific once you have completed the necessary
interpretation of the chart patterns.
• The methods are usually quite logical. Hence, they have a good deal
of face validity.
Liabilities
• In most cases these methods are highly subjective and difficult to test
for accuracy.
• The Gann and Elliott methods have been known and used by traders
for many years; however, there is considerable disagreement, even
among experts, as to what patterns exist at any given point in time
and, in fact, how these patterns should be traded.
Solutions.
A possible solution would be to use the methods in conjunction with other timing that is more objective and operational.
Parabolic
This is a method that is based on a mathematical formula derived from the parabolic curve. It provides the trader with two values each day, a “sell number” and a “buy number.” These serve as sell stops and buy stops. Penetration of the buy number means to go long and close out the short, while penetration of the sell number means to close out long and go short.
Figure 4 shows the daily Priceline.com (PCLN) chart with the parabolic indicator. As you can see, there were two signals.
Assets
• The parabolic indicator is totally objective. It can be used as a
mechanical trading system with risk management methods.
• It provides a buy and sell stop daily and is therefore capable of
changing orientation from long to short very quickly.
Liabilities
• Parabolic can get “whipsawed” badly in sideways or highly volatile
markets.
• Parabolic can catch some very large moves; however, it has many of
the same limitations that are inherent in the use of traditional moving
averages.
Solutions
• Use parabolic with other indicators that are not necessarily based on
price, that is, volume and/or open interest.
• Use shorter-term time frames for exiting parabolic trades.
• Since parabolic in its pure form is an “always in the market” system,
you may be able to adapt it by specifying certain conditions in which
it goes into a neutral state (in other words, no position).
Directional Movement Indicator (DMI) and Average Directional Movement Indicator (ADX)
These are unique indicators based on reasonable solid theories about market movement. They are calculated with relative ease and may be used either objectively as part of a trading system, or as trend and market strength indicators.
DMI—Directional Movement Indicator. The Directional Movement Indicator (DMI) was developed by Wells Wilder. The indicator is used to determine if a stock is “trending” or “not trending.” DMI has three values: the +DI, the -DI, and the ADX, which we will discuss next. Wilder suggests that you buy when the +DI crosses above the -DI. He suggests short sales when the +DI crosses below the -DI. ADX is a smoothed version of the directional movement.
ADX—Average Directional Movement Index (a Derivative of DMI).
ADX is a derivative of the directional movement indicator. It measures the
strength of a market trend, not its direction. The higher the ADX, the more
“directional” the market. The lower the ADX, the less “directional” the
market. ADX does not measure whether a stock is rising or falling. The
Overbought/Oversold (OB/OS) parameter sets boundaries on the strength
or weakness of the trend, rather than on the strength or weakness of the
stock itself.
Figure 5 shows an application of the ADX, on a daily Brocade Communications (BRCD) chart.
Assets.
These methods are not based on effete concepts or market myths. They are well worth investigating for development into trading systems. The ADX and DMI are not used by many traders. Their main focus is on the strength of a trend and, as a result, is somewhat different in its approach. Both timing methods can be very helpful when used in conjunction with other timing indicators.
Liabilities.
ADX and DMI tend to lag somewhat behind market tops and bottoms. As a result, they can give signals that may be somewhat late.
Solutions
• Use these indicators in conjunction with other indicators that are
based on different theoretical understandings of the markets. The
DMI difference is a variation on the DMI. It is the indicator I recommend
for DMI analysis.
• Use a derivative of the DMI or ADX as part of your method. In other
words, compute a moving average of the ADX or the DMI and use
the moving average to develop more accurate timing.
These indicators are actually one and the same in the final analysis. Although they are derived using different mathematical operations, their output is the same in terms of highs, lows, and trends. I believe that both momentum and ROC have been ignored and underrated as trading indicators and as valid inputs for trading systems.
When momentum crosses above its zero line from a negative reading, a stock is considered to be in a bull trend. When momentum crosses below zero from a positive reading, the stock is considered to be in a bull trend. Momentum can be used in any time frame (that is, daily, intraday, weekly, and so forth). Figure 6 illustrates one application of momentum, yet there are many more.
Assets
• These indicators are very adaptable. They can be used not only as
indicators but they can also be developed into specific trading sys-
tems with risk management.
• They can be used with other indicators such as a moving average of
the momentum.
Liabilities.
Both indicators lag market turns to a given extent. As a result, they tend to be a little late at tops and bottoms.
Solutions.
Momentum and rate of change indicators can be plotted against their own moving averages in order to reduce the time lag of signals.
Accumulation Distribution and Its Derivative
This indicator is one of the more important ones for the stock trader. All market movements are a function of the ongoing struggle between those who are bullish and those who are bearish. While the bulls have buying power behind them, the bears have the power of selling pressure.
As long as buyers and sellers remain in balance with no group having clear control, prices remain in limbo, oscillating back and forth but not exhibiting any clear direction. At some point, however, one group gains a clear upper hand, and the trend makes a concerted move in that direction.
For many years, traders have attempted to find a method that would give insight as to the focus of control in a market. Clearly, if we can know which group is in “control,” we can either buy or sell accordingly with a relatively high degree of probability that we will be right.
By “control” I mean the “balance of power.” The question as to whether the bulls or the bears are “in control” of a market is an important one, particularly for the day trader. If we know that the bulls are in control of a market then we will do well to buy on declines, knowing that the market is likely to recover from its drop. Buying on declines is not a simple matter. There are specific points at which we will want to buy on declines in a market that is in firm control of the bulls. These will be delineated in our discussion of support and resistance.
In a market that is controlled by the bears, rallies will be relatively short lived as sellers overpower buyers and the market returns to its declining trend. By control we do not mean to imply that there is an actual group of buyers or sellers who are conspiring to control the direction of a market. By control we mean essentially “balance of power.” In such a market we will want to be sellers at resistance.
In a perfect world we would like to see markets follow our model or theory as closely as possible. While this would simplify our task as traders, it would likely mean an end to free markets since virtually every market trend and trend change would be predictable and there would, therefore, be no markets. Yet, we know that this is not the case.
Given the imperfect state of affairs in the stock and futures markets, it would be advantageous to have available to us any indicators or systems that will reveal the balance of power in a given market. For the stock trad-
er, such a method would likely prove very profitable if correctly employed.
How could such a method work and what measure of buying or selling power can we use to assist in our task as day traders? Theoretically, as a stock that has been in a bull trend begins to move sideways or makes an abrupt top, a change of control is taking place as the bears gain the upper hand over the bulls. One interpretation is that selling pressure outweighs buying power. Prices begin to turn lower, yet there is likely advance indication that this is about to happen.
During and prior to a sideways phase, the bears are “distributing” contracts to the bulls. The bulls eventually reach a point where their cumulative buying can no longer sustain an uptrend, and the market drops as the bears continue their selling. Hence, we call this phase distribution. Note the left-hand portion of the chart in Figure 7, using the accumulation-distribution indicator. It shows distribution prior to a large decline followed by a lengthy period of accumulation.
At a market bottom the reverse holds true. Accumulation takes place as bulls gain the upper hand, overpowering selling by the bears. In theory, buying power outweighs the selling pressure. There is cumulatively more buying than selling. Eventually the balance is overcome as buying demand outpaces the supply of selling and the market surges higher. The bulls gain firm control, and prices move higher.
Theoretically, the bulls are slowly but surely gaining control of the market during the bottoming or “accumulation” phase. Figure 8 illustrates both conditions using the accumulation-distribution indicator in Cisco Systems (CSCO).
In spite of our wonderful theories and their face validity, stocks do not always conform to their ideal situations. At times a stock will change trend almost immediately and seemingly without notice. Purists will argue that in such cases markets do give advance warnings but that the signs are subtle. We agree. But note that if the signs cannot be found, then the theory, no matter how seemingly valid, will not help us.
The Advance/Decline Indicator
What we have just described for you is the theory of accumulation and distribution. The theory is simple, reasonable, logical, and easy to understand. The difficult part is finding methods, indicators, and/or technical trading systems that will allow traders to take advantage of the hypothetical constructs both on a longer-term and day-trade basis.
One such indicator is the Advance/Decline (A/D) oscillator originally developed by Larry Williams and James J. Waters in 1972. Their article entitled “Measuring Market Momentum” appeared in the October 1972 issue of Commodities Magazine. It introduced their A/D oscillator.
The purpose of the oscillator was to detect changes in the balance of power from buyers to sellers and vice versa. Calculation of the A/D oscillator is a relatively simple matter. A thorough explanation and critical evaluation of the A/D oscillator can be found in The New Commodity Trading Systems and Methods.
The A/D oscillator is also available in preprogrammed form on many of the popular software analysis systems such as Commodity Quote Graphics (CQG) and TradeStation. The formula for calculating A/D can be obtained either in the original Williams’ and Waters’ article or the Kaufman book (cited above).
Using the A/D Oscillator
There are several potential applications of the A/D oscillator for position and day trading. They range from the artistic and interpretive to the mechanical and objective. While our application may not be as scientific as one would like, our efforts are in the correct direction. One method we have worked with extensively is to buy and sell based on when the A/D oscillator crosses above and below the zero line. See Figure 9 for an example of what can happen when A/D falls below zero.
All too often a stock will move higher and higher while the A/D is in
negative ground and vice versa. Such situations not only confuse the trader into thinking that the theory is incorrect but they are also costly since they produce losses.
Yet another limitation of the A/D and, indeed, of all oscillators, is that they can frequently move back and forth above and below the zero line numerous times before a sustained trend emerges. Traders who buy and sell on such frequent crosses above and below the zero line will suffer numerous repeated losses, not to mention the cost of commissions and slippage. But there’s a way to overcome this serious limitation.
The Advance/Decline Derivative (ADD)
The word derivative means exactly what it says. It is a value that is derived by a mathematical manipulation of another value. In other words, the first derivative of any number is a new number that is derived from the initial number. If, for example, I have a 24-period moving average as my original value and then I calculate a 20-day moving average of the 24-period moving average, then the 20-day moving average is the first derivative of the 24-period moving average.
If I calculate a moving average of the A/D oscillator, then the moving average I calculate is termed the first derivative of the A/D since it is derived from the A/D value. One purpose of calculating a derivative is to smooth the values of the original data. Our purpose is to do this as well as to use the derivative value and the A/D value for generating signals that will help overcome the limitations of the A/D oscillator when used alone (as mentioned earlier).
As presented here, the ADD method is objective but not entirely systematic. In order to use it as a system you will need to add a risk management stop-loss and/or a trailing stop-loss (if you prefer). This will make the method useful as a system. Naturally, you will want to trade the ADD in active and volatile markets only.
The ADD method also has potential for use in day trading. The ADD is a highly versatile indicator lending itself for use in all time frames. Traders interested in using this approach are encouraged to research it more thoroughly as a trading system with risk management rules before using it extensively for day trading. As an example of how the ADD generates signals, see Figures 10 and 11. Each shows the ADD with signals on stock charts of Amazon.com.
Other Technical Indicators
Perhaps you did not find your favorite indicators included in the section above. Know that what you just read is intended to serve as a general introduction. There is much more technical information to follow. If we consider all of the timing indicators that have been developed over the years, as well as the many variations on the theme of these signals, there are literally thousands of possibilities that confront the day trader.
While it’s true that the vast majority of these indicators are either useless or specious, there are some that can prove very valuable to the stock day trader. Our goal is to alert you to those, which we believe to be effective and, moreover, to show how they can be used. In the chapters that follow we will employ some of the indicators discussed above as the core of specific trading systems and methods. We hope these will assist you in your goal of day trading for profits.
ELEMENTS OF AN EFFECTIVE STOCK TRADING SYSTEM
This is the highest and most specific level of trading approaches. As noted in my previous discussion on trading systems, a trading system provides features that make it preferable to all other methods of trading. An effective system will tell you which stock to trade, when to buy, when to sell, how much to risk, and much more. While some traders prefer to use indicators and methods as opposed to systems, we believe that using a system will give you the greatest odds of success.
Here are the essential elements that an effective stock day-trading system must contain (as a point of information, these factors also apply to trading systems that seek to capture longer-term moves as well):
• It contains purely objective rules for market entry and exit.
• It contains risk management rules such as stop-loss and trailing stop-
loss.
• It tells you which stocks to trade, and when to trade them.
• It can be back-tested to test its validity using the indicated rules.
• Its signals are not subject to interpretations—they are operational,
totally objective, specific, and repeatable.
• Historical back-test performance provides key statistics and hypothet-
ical results.
• Different traders should be able to get exactly the same signals using
similar inputs.
There are other fine details that characterize a trading system; however, those indicated above are the most important. Clearly the good news about trading systems is that they can be implemented specifically and without interpretation. The bad news for many stock day traders is that they are unable to follow a trading system due to their lack of discipline.
They would much rather wallow in subjective indicators than have the self-confidence and self-discipline to trade a mechanical system. This book will present several day-trading systems for stocks; yet no matter how good they may look on paper or in back-testing, they will prove totally useless or even unprofitable to the trader who lacks discipline and consistency.
SUPPORT AND RESISTANCE CONCEPTS
Perhaps the single most valuable tool that a day trader can possess is the ability to determine support and resistance. My working definition of support as it applies to trading is as follows: the price level at which a market is expected to halt its declining trend and from which prices are expected to move higher at best or sideways at worst.
As you can see, this is a purely pragmatic definition. It is tailor-made
to the task at hand. But we hasten to add here that support, in and of itself,
is not particularly useful unless it is combined with knowledge of the exist-
ing trend. In an uptrend, the support level or area of a stock is likely to halt
a short-term decline within the existing trend. Market technicians have
developed numerous ways in which to determine support. The most com-
mon of these is to draw support trend lines under the price of a stock.
While this can be effective, it is too subjective and often fails to provide
sufficient information.
Other methods for determining support are based on percentage retracements, moving averages, previous highs and lows, reversal levels, waves, angles, Fibonacci numbers, market geometry, and a host of other methods, some seemingly logical and others that smack of superstition or magic.
We will avoid most of the common and popular methods in favor of
several that I have developed over the past thirty years, which I believe to
be highly effective. However, we do not expect you to merely take my
word as gospel. We suggest that you critically evaluate my methods by
watching them and seeing for yourself whether they can be helpful to you
in your trading.
As an example of support, consider Figure 12. This figure shows a daily chart of Corr Therapeutics (CORR) with my calculated support line. You will notice how the price of this stock continues to “bounce” off support. This is the ideal way in which a valid support line should work in an uptrend.
Conversely, resistance is an important consideration in a downtrending market. Resistance is defined as follows for our purposes: the price level at which a market is expected to halt its upward trend and from which prices are expected to move lower at worst or sideways at best.
As in the case of support, there are literally hundreds of ways for deter-
mining resistance that traders have developed. The vast majority of them
are ineffective. Yet we must remember that the use of resistance (and sup-
port) is typically part of a trading method and not always systematic.
Hence, the availability to make money using resistance and support is, to
a great extent, a function of the trader’s skill level and experience. Figure
6-13 shows an example of how prices act when they hit resistance in a
downtrend.
THE VALUE OF DAY TRADING WITH SUPPORT AND RESISTANCE
Support and resistance are valuable tools for the day trader. Knowing support and resistance levels, as well as the existing trend, can allow the day trader to accomplish the following goals:
• To buy, at or near support, in an uptrending market and to take profit
either at a predetermined objective or at resistance
• To sell short, at or near resistance, in a downtrending market and to
take profit either at a predetermined objective or at support
• To avoid markets that are either trendless or whose trading range is
insufficient to allow reasonable intra-day price movement
• To buy a market when it overcomes resistance and, therefore, to go
for a larger profit inasmuch as the uptrend is likely to remain strong
since resistance has been overcome
• To sell a market when it falls below support and, therefore, to go for
a larger profit since the downtrend is likely to remain strong now that
support has been penetrated
In order to achieve these goals the trader will need to know, as precisely as possible, and with as much accuracy as possible the current trend, the current support level, the current resistance level, and when a change in trend has taken place.
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