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Trader's Corner

BELLWETHERS; also, On Balance Volume (OBV)

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OIN SUBSCRIBER QUESTION: 
I have your 5-18-05 (Trader's Corner) article "Achieving More Winning Traders: Systems Trading, Part 2", but I can't remember reading Part I. Can you tell me what date this Trader's Corner article was written so I can read it?

RESPONSE: 
Part 1 actually was not titled 'Systems Trading' at the top of the column. It is within my 5/11/05 Trader's Corner article, titled "Getting more winning trades". The lion's share of that column is the section sub-titled "TRADING SYSTEMS; Part 1". I began the discussion of this topic there. 

I'm afraid my effort was only an introduction to this area as well as some of the rationale for devising and testing your own trading ideas in a systematized trading strategy; e.g., a 'system' generating buy/sell 'signals', plus commonly, an exit strategy for losing trades, etc. 

Software that does this, such as the one I know TradeStation, the premier player in this field, can be quite worthwhile to use. Even if you only use it to test winning and losing percentages from using various indicator settings, as well as which indicator variables (e.g., 'length' or optimal levels for 'overbought' or 'oversold') make for the most winning trades. 

System Trading Part 1, as part of my 5/11 Trader's Corner, is found in the online OI Newsletter by clicking here 

System Trading Part 2, which comprises my 5/18 Trader's Corner article is found in the online OI Newsletter by clicking here


BELLWETHERS  

I have a number of recurring themes that I write about ('a broken record'?!) and one is the idea of stocks or indices that are bellwethers for the major market indices; e.g., the S&P 500 (SPX) and the Nasdaq Composite (COMPWh

When we think of a bell ringing as signaling danger or as something to stop and pay attention, this idea is also meaningful in relation to trading the market. There is the concept of a bellwether stock or a bellwether sector, that by ITS price action, can tip us off ahead of or AS a top or bottom is forming in the major indexes. 

In the Nasdaq, there are certain companies and market sector (e.g., semiconductor stock sector SOX index) indexes that by virtue of their size or relative importance will be virtual "stand-ins" for, or will be closely linked to, a market index or average. 

I use the example in my book (Essential Technical Analysis) of the earliest bellwether index I know of - the role the Dow Transportation average (TRAN) plays as a related or linked average, to the Dow Industrials (INDU) -- if one average or the other fails to accompany the other to a new high or low, this is a bullish or bearish divergence. Note here that the action of the bellwether can be a bullish omen; e.g., if TRAN resists falling to a major new low along with INDU. 

I've often written about the idea of where an Indicator, such as the Relative Strength Index (RSI) fails to also make a new high, or low, relative to what is happening with the price of the Index itself; such divergences are often tip offs to an impending top or bottom. Having a good idea that a top, or bottom, is forming is one of the most helpful things that can occur in terms of buying index puts or calls before the market breaks sharply from the existing trend. 

An example of a bearish Price/RSI Divergence is seen to the left in the S&P 100 (OEX) chart below ...

OEX fell to a new relative low around the middle of April, but at the time, the RSI was at higher low. This made for a bullish tip off to a possible (price) bottom and upside reversal.

In this situation seen above, the RSI acted in a manner similar to a "bellwether", but the main use of the term is to refer to a stock or an index that may be indicative for a possible similar turning point or reversal in the main averages. 

The idea for a key stock or index that acts as a bellwether is that a bellwether goes, "so goes the market". 

For example, Cisco Systems (CSCO) has been for a number of years, and I think still is, a bellwether stock in the Nasdaq. Intel Corp (INTC) tends to be another one, as is the Philadelphia Semiconductor Index (SOX).

CSCO, along with Microsoft Inc. (MSFT) and Intel, accounted at one time for nearly 25% of the entire value of the Composite Index. I'm not sure what the percentage is today, but its significant. 

Size is not the only criteria for assuming a "bellwether" status. As important, it should be a company that represents the leading edge business that exemplifies that exchange in the case of Nasdaq, the need for internet and communications hardware has kept Cisco still in a forefront position in necessary tech equipment. 

Besides a key individual stock like Cisco, a related stock index that is also a bellwether for Nasdaq especially, is the Russell 2000 (RUT). 

I like to look at bellwether stocks also for the something added they give namely that I can study volume for it. Volume is a good secondary indicator for example, a drive to a new high is accompanied by a decline volume trend LOOK OUT. 

NEXT CHART: Cisco (CSCO) versus the Nasdaq 100 (NDX)  

There were ways that Cisco's price action, even though the stock has been languishing for some time, that tipped off key turning points in the Nasdaq 100. The two are compared below ...

While the Nasdaq 100 (NDX) was in a strong up move over August of '04 to December/early-January, Cisco (CSCO)was in a lackluster sideways trend or trading range. At the point where CSCO made an approximate double top (circled, left), NDX still could have been considered to be going strong. Well, after CSCO topped out or hit the top of its range, NDX made a final top and began a long slide down. 

During the rally that developed in from the April ('05) lows, CSCO actually broke out or pierced its down trendline first, as can be seen lower right in the chart above, providing a clue that the NDX pullback to under 1450 was likely to be minor, before a strong rally continued. 

Intel (INTC) + Volume, versus the Nasdaq 100 (NDX)

The bellwether tech stock Intel (INTC) made a "V" bottom low in April and rallied strongly before the broader Nas 100 got into gear. Accompanied the rally was a strong move higher in On Balance Volume (OBV). I'll have more to say about what OBV measures shortly. 

Needless to say, here at least, price and volume patterns in INTC were providing an indication to get positioned in NDX calls while the Index was still 'basing'; such so-called basing action could have been interpreted as a consolidation before another down swing. This was a much less likely interpretation due to the price and volume action of bellwether INTC.

A bellwether stock and related index will sometimes have the same technical pattern. Sometimes it will not follow the index higher or lower, which does not mean in and off itself that you would exit index options because of what the stock is doing. It's those occasion where the bellwether stock makes a top or bottom ahead of the index that tend to be the most valuable. The points where the bellwether is a leading "indicator" can occur at a key turn or shift in the trend. 

About the OBV Indicator - 
On Balance Volume is a cumulative running volume figure that adds LL the volume on an up date and subtracts ALL the trading volume n down day. If there is more trading volume on up days then here s on down days, OBV rises. What we are concerned with is the direction of line, up or down, not the actual number. 

This indicator uses daily stock trading volume for its construction. The insight it makes furthered Charles Dows concept that volume should INCREASE in the direction of the dominant trend. On-Balance Volume provides some further assessment of this idea. 

Semiconductor Index (SOX) as a bellwether for the NASDAQ  

One of the best sector bellwethers for the Nasdaq is the Semiconductor Index (SOX). It made a clear cut top in late-November, well ahead of the final top in the Nasdaq 100 (NDX). If you werent accumulating NDX puts, don't blame it on the lack of warning (for a top) provided by the bellwether SOX index. 

An outstanding bellwether 'signal' provided by the SOX for the broader NDX, was its double bottom. While you could have had some doubt that Nasdaq was making a bottom around 1400 (even though NDX seemed to be 'basing' and had completed a 2/3rds retracement), this pattern was not as "strong" technically as a double bottom, which is what had formed in SOX. A good "bellwether" in this instance! 

BLUE CHIP BELLWETHERS 

For the NYSE Composite Index (NYA), the Dow 30 Average (INDU) and the S&P Indices, a key bellwether stock is General Electric (GE). This company is a major player in major areas of activity in the mainstream economy (e.g., power, appliances, etc.) that is represented by these averages. 

Bellwether stocks, just like bellwether indexes, will tend to "confirm" new highs or lows; i.e., both will go to new high or new low for the price move underway. If instead, the bellwether "diverges" from the index, it's not a good sign for the continuation of the index trend for much longer. 

There are some noteworthy comparisons to be made between GE and the OEX in the next chart...

GE made a top ahead of the OEX in December, suggesting some trouble ahead for the Index, but both the stock and the index of which its part did make new highs; that's the key point. The real DIVERGENCE (a bearish one) was that GE by far failed to confirm the new high that the OEX made in March. This was a clue to the steep multiweek OEX decline that was to follow. 

During the March-April decline of the S&P 100, GE has gone sideways as seen in the chart above, as stock has had a lengthily period of a relatively narrow trading range (defined by the two parallel dashed level lines). The recent breakout above the top end of that 'rectangle' pattern in GE was a confirming bullish pattern relative to the rebound in the OEX. 

BACK IN 2004  
While the S&P 100 (OEX) was making a double, then triple top in 
February March 2004, GE was in a definite downtrend, suggesting that OEX would reverse to the downside at some point and probably 
reverse significantly lower at that. 

If traders were wondering if OEX was going to break out to the 
upside at the blue arrow within the circle, as the Index popped 
up above the down trendline on two days running NOT! at least 
based on what GE was doing as it never got close to doing the 
same. 

Last but not least, is a note about the break below the 200-day moving average seen twice in the stock in the above chart, but not in the Index. The first break (see circled price action in GE) was showing such weakness that it was doubtful that the OEX was going to get far in its rally after that. 

The apparent breakout move in OEX above its down trendline seen in the chart above, had no similar breakout pattern that occurred in GE, suggesting that that particular OEX rally was not going to gain traction.

With such a key bellwether (GE), widely held in fund portfolios, to not be able to get back above the most widely watched moving average (200-day), is suggestive of what institutional money is doing, which is a major factor in moving the overall market.

The action in bellwether GE stock provided some useful clues to what the OEX was going to do ahead in the instances discussed. 

Dow Transportation average (TRAN) as a sometimes bellwether for the Dow 30 (INDU)  

The Dow Transportation Average (TRAN) will sometimes make a very key bullish or bearish divergence from the Dow 30 (INDU), as happened back in the fall (Oct. '04) when TRAN did NOT confirm the new INDU low (at the yellow circle). In fact the Transports were in a very strong steady uptrend, which continued after the INDU low, foretelling the very strong rebound in the Dow that followed.

While bellwether action is not the be all/end all of chart analysis, comparison of bellwether price and volume action to the major indices, ALONG with other factors (patterns and indicators), will sometimes provide a key clue to an upcoming trend reversal. And, that's when they prove their use as ONE of our trading tools. 

Good Trading Success! 

NOTE - 
Please send any technical and Index-related questions for possible use in my next Trader's Corner article to support@optioninvestor.com with 'Leigh Stevens' in the Subject line. 

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