Option Investor
Trader's Corner

Three Little Things

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There are 3 indicators in ADDITION to price action and patterns (e.g., double bottoms, etc.) that I've used since before the '87 crash, to identify significant bottoms in the market. One of these 3 simple ('little') indicators doesn't work for tops; tops are hard enough to pinpoint, at least in bull market trends, so you have to work extra hard to time tops. More on my three indicators after a little digression on market timing to begin with! Thanks to Michael Lewis (author of Liar's Poker, the book and many fine market-related articles).

Many market participants, money managers and analysts don't believe that you can "time" the market anyway. The efficient market theory holds that because the news (impacting the market) is random and the market reacts or adjusts so quickly to it, that you had best buy sector or index funds rather than try to 'beat' the market by your own trading or by hiring a Wall Street gunslinger (money manager).

Today for example: I know that many, if not most market watchers will assume that it was talk from a Fed official that triggered this market turnaround and ostensibly that was the 'reason'. However, the market gave signs days before this 'news' came out that an upside reversal was coming. All this upside reversal needed was a 'TRIGGER' and you could have been in calls BEFORE that triggering event/news.

In 1900, a French graduate student named Louis Bachelier completed a dense thesis called Theory of Speculation, in which he concluded that prices follow a random walk; that is, no information about past prices enables a trader to predict future ones. Bachelier described the market as an "aggregate of speculators" who "at a given instant can believe in neither a market rise nor a market fall, since, for each quoted price, there are as many buyers as sellers."

In the early 1960s, the efficient-markets hypothesis finally took off, thanks first to Paul Samuelson, who reminded everyone of Bacheliers paper, and then to Eugene Fama, who tested it against actual U.S. market data. Fama discovered that the Frenchman had got it exactly right back in 1900: A person could learn no useful information about future stock market prices by examining past performance. Chart reading, graph plotting, momentum analysis, and all the rest of the more esoteric Wall Street techniques for predicting stock-price movements were hokum. Fama went further: No public information at all is of any use to a trader trying to beat the market. Balance-sheet analysis, industry insight, articles in the Wall Street Journal, a feel for the character of a C.E.O.; these are all a complete waste of the investors time, as whats already known is factored into stock prices too quickly to act on it, and what isnt known is inherently unpredictable.

"The true news is random," says Burton Malkiel, a Wall Street banker turned Princeton professor, who published the most famous book on the efficient-markets hypothesis, "A Random Walk Down Wall Street". Burton said that..."That's what people had trouble grasping. It's not that stock prices are capricious. It's that the news is capricious."

The random walk/efficient markets theorists do admit that there are superior stock pickers, who over the long haul, can outperform or way outperform the market averages; e.g., Warren Buffet. Then there are people like Peter Lynch, who had a stellar record managing his Magellan fund, although his hand-picked successor could not outperform the benchmark S&P. Then there is the world of great traders who have made tons of money for decades; some of these guys (I don't know any women, although there must be some) are private investors/speculators and they don't and will never have a 'public' record. They are not the types that seek public recognition, only to beat the market and make money consistently. This group seems to contradict the above statements, but no doubt the true random-walk believers would have a rebuttal to what I'M saying.

I would agree that great traders and investors are like world-class athletes in that there are VERY few of them. This doesn't mean that a good number of speculators can't make money IF they have effective methods and discipline. Some will time or try to time the market, some will do other creative things that involve a good notion of what range a stock or index is likely to trade in order to collect or pocket premium, and so on. My interest is in predicting or timing the 2-3 day to 2-3 week price swings and I tend to write mostly about how one can use technical inputs to do that. No doubt, a person is happiest who sticks to his/her passion and areas of past success.

From my bag of tricks, I've seen over and over that there are 3 technical type indictors that, when in synch and confirmed by price action, are strong indications to be positioned on the call or bullish side.

'Sentiment' is just a fancy way of saying that there is almost always a certain extreme, relative to the past 12 to 18 months or even years longer, in bearishness before a bottom and bullishness before a top among traders and investors. I measure market outlook or sentiment by the daily volume ratios of CBOE equities calls versus puts; this is my 'call/put' ratio and it excludes index options trading volume plus divides daily call volume BY put volume. It works because it reflects a lot of individual trading decisions and is more immediate/real than 'surveys'.

When #1 is joined by the #2 indicator, evidence grows that the market is setting up for an upside reversal.

I use the 13-day Relative Strength Index to measure extremes in terms of the intermediate trend of 2-3 weeks to 2-3 months. More on this in the current chart examples coming up.

When my #3 indicator joins #1 and #2 indicators, the evidence is coming in strongly to get ready for a big rebound.

When 1,2 and 3 indicators are in synch, I tend to view this as a trade I can go in 'heavier' on, although still within the bounds of money management rules; e.g., not committing 100 percent of my account on one trade. Moreover, the use of effective stops is always my advice. (In a recent Index Trader column I recommended buying DJX January calls (slightly out of the money is my preference) if the Dow traded down to the 12,800 area which it did (twice) and with a stop/exit point on the trade at 12750 in INDU. The intraday low of day before yesterday in the Dow was 12743. Today's close: 13289! My stop would have 'worked' on a CLOSE-only basis and I only lightened up some at my exit point. I don't regret having a somewhat lesser profit today, as today's close could have been 12289; unlikely, but I adhere to risk points rather than risk letting a loss run. I also try to buy at extremes, so I can work with tighter stops and have a sizable risk to reward potential.)

There is an old saying about 'volume precedes price' and you see this in stocks when there's a volume surge at a bottom, followed by a turn higher in prices in subsequent days and weeks. Someone in the know starts buying an undervalued stock and they are also willing to buy on upticks to accumulate their position. Up volume is a very good if not the BEST test of buying interest in the market. For whatever reasons and I won't try to explain them and I'm not sure I COULD (except that its the way the market works with 'weight'), if you measure the two markets total daily up volume on a 10-day average, bottoms will tend to follow after those 10-day averages reach certain reoccurring levels and then turn UP.
My chart examples will show this.

I have this habit of always showing my sentiment indicator with the S&P 100 (OEX), but this is not because these call to put volume readings only pertain to this index. My indicator works as a general market-timing indicator with some important characteristics that need to be understood.

This indicator is a CONTRARIAN indicator: when many or most are bullish, be wary of a top; when many or most are bearish, look for a bottom.
Extremes in bullish or bearish sentiment need only be a 1-day affair; I use a 5-day moving average often (not below) just to give an idea of the trend in sentiment as measured by this indicator. Most important, reversals tend to occur AFTER the extremes, specifically tending to occur 1-5 trading days after a sentiment extreme. Monthly expirations days, such as the last one, don't generally invalidate an extreme CPRATIO reading.

A top could come on the SAME day as the indicator, which happened in fact in late-October. After the early-October bullish extreme reading at the red down arrow (CPRATIO line registered at or above the 'overbought', extreme bullishness level), the top came 5 days later. The same for the last reading at or below the 'oversold', extreme bearishness as noted at the green up arrow: the bottom came exactly 5 trading days later.

What I start to look for after signs that traders have gotten to key extremes in bullishness or bearishness ('too much' or unrealistic for how far a move can/will go before a reaction sets in), I then want to pay attention to where the major indexes are in terms of the 13-day RSI (Relative Strength Index), which is another way to measure 'overbought' or 'oversold' levels in terms of how far a move has carried without a significant counter-trend move.

Indicator # 2

One problem or perceived problem with this Indicator is that an index or stock can and will hit oversold (or overbought) extremes multiple times. This isn't a big obstacle if you are using tandem indicators. The question here is, was the S&P 500 (SPX) shown below, hitting an oversold level in the same time frame as an extreme in bearish sentiment. Absolutely, it was just the 3rd time! Moreover, SPX was declining on rising 'relative strength' so to speak, as highlighted by the DIVERGING trendlines: one following prices lower in the last 7-10 trading sessions, one showing RSI lows that were on a rising trend. This is a classic bullish price/RSI divergence pattern.

As is most often the case, we can look to the STRONGEST index in the current market cycle to best gauge where the overall market may be bottoming in terms of momentum indicators like the Relative Strength Index (RSI) indicator. A very telling story was provided by the action of the Nasdaq 100 (NDX) index in terms of the 13-day RSI. There was a SINGLE 1-day extreme in the area that I find defines 'oversold' (between 30-33) and this was followed by 'basing' action thereafter as prices went sideways, showing good buying interest on dips around and under the 2000 level.

If you took the basing action as what it was, as something likely to precede a good-sized rally especially given what was showing with indicators #1 and 2, you got positioned in NDX calls BEFORE the sharp jump higher when premiums expanded like gangbusters; when the sellers immediately jacked up the premiums by so much it will take a big further move higher just to break even!

Last but not least is:

Again, Nasdaq being the key mover of late, its 10-day moving average of daily exchange advancing (UP) volume made its volume indicator the key one in terms of my last key market timing indicator. The contraction of the 10-day up volume average to below the 300-500 million share zone happened recently (see below), for the second time since August, and was followed by an upturn yesterday that PRECEDED today's big rally. This turn up made this the last of my 3 key indicators to get in synch and was consistent with the potential S&P double bottoms and the basing in NDX around 2000. All of these things said GO.

The NYSE 10-day up volume figures seen below were less straight-forward in their predictive value than the Nasdaq, but this market also formed a picture perfect double bottom. The key here from study of my last chart and its comments is that the 10-day Up volume average was rising and prices finally were bound to follow suit. The key final 'timing' aspect were all the other indicator and price patterns. Volume preceded price as they say. The S&P stocks bottomed in terms of buying interest (i.e., volume patterns), but prices took some time to follow suit.


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