OIN SUBSCRIBER QUESTION:

"Do you still see much risk of a correction as the market has come back strongly since Monday? Maybe the recent sideways move was enough to correct the overbought market.

RESPONSE:

MORE ON PATTERN RECOGNITION:

I see the risk of another downswing as great enough for me to not want to buy more calls for example. Say I buy Nasdaq 100 (NDX) 1600 calls and assume (as I do) that there's still risk for a dip back to the low-1500 area. I also assume there's upside potential to 1700 relative to a risk for a dip back to the 1500 area. I don't like that risk to reward. It's close to 1 to 1, rather than the 3 to 1 that's an ideal. This is the kind of less than favorable risk to reward calculation for NEW positions that we see as a move progresses.

Going back to my "Pattern Recognition" Trader's Corner article I wrote on Tuesday (8/18), I'll point out some old and one new aspect to the pattern here as I see it and how it looks relative to similar prior patterns and the outcomes after THOSE patterns formed. I'll use the Nas Composite (COMP) this time.

Naming the prior patterns, plus this current one as 1, 2 and 3 as seen in the below COMP daily chart, there are commonalities in terms of the trend and pattern. 1-3 have common sideways patterns within an overall strong uptrend. All pauses in the trend came after overbought RSI readings occurred prior to the first corrective downswing AND after bullish sentiment got quite high.

There's another common pattern, not mentioned in my earlier article. Patterns 1 and 2 had the common price swings of a correction, that of a down move, another advance, followed by a final downswing. All, including pattern 3, broke under the prior trading range. Only pattern 2, so far, had the common formation of a deeper correction on the second downswing.

On balance, especially given the high extreme in bullishness of today (again), I'd say there remains a strong possibility of at least another downswing that carries back to the recent prior lows, if not lower still; e.g., to the 1900 area. Stay tuned on this outcome, versus say a strong move above some major resistance in the 2000 area in COMP.

There's also something to what our Subscriber said about the prior sideways move offsetting an overbought situation, especially if viewed on an HOURLY basis such as in my next chart.

TIME CORRECTIONS

I talk sometimes about a sideways move 'throwing off' an overbought condition. I think of this as a 'time' correction, as opposed to a 'price' correction such as where there's a 25-50% retracement of the prior advance. A sideways correction has buying and selling enough in balance that prices remain in a relatively narrow price range over some days, even weeks.

Below is an example of a correction over time, rather than price as seen in the COMP hourly chart below, with its recent rebound from an oversold condition in terms of the 21-hour RSI. COMP also bounced from its hourly up trendline.

KEEP IT SIMPLE STEVENS or 'KISS'

Actually we all know this as "Keep It Simple 'Stupid'"

I'm reprinting a portion of a Trader's e-mail comment to my colleague Linda Piazza as of interest in terms of a take on trading STRATEGY that pays homage to the KISS principle. I took a look at the call and put decisions that could have been made based on the described trading strategy for the past few months.

I could also have back-tested (in TradeStation) the described strategy as a trading 'system' but it seemed that the criteria may not have been applied in a strictly formula-based way. Plus I didn't have any 'stop loss' criteria to apply. Trend following methods like this one have the downside of getting 'whipsawed' unless it's only used as a GUIDELINE relative to a trader's experience.

ANOTHER SUBSCRIBER COMMENT:

... "Leigh Stevens once wrote an article extolling the virtues of simplicity and cautioning against making market analysis more complicated that it needs to be. I bought his book and proceeded to learn what I could about simplicity, and discovered the value of such notions. As a result, I long ago gave up pursuing complicated strategies and intricate hedging techniques in favor of simpler approaches. Most importantly, I also stopped trying to predict what markets were going to do in the future. I also ignore the financial news, pundits, gurus, and other market noise because such things are extremely dangerous to the health of one's trading account.

Instead, I now only look at what market prices are doing and have done in the very recent past. I have learned that market prices go up, until they don't, and go down, until they don't. Sometimes they trade within narrow ranges, until they don't. It does not matter one whit why prices move as they do (and as an individual trader, I am foreclosed from knowing); all I need to know is the current direction of price movement which is a much easier proposition.

Traders can learn current market direction with a couple of exponential moving averages on the 30 minute chart (indexes preferred) set on the close for 12 and 26 periods. When the 12-period is above the 26-period EMA, be long calls and stay long until the EMAs cross back at the end of any 30 minute bar; for downturns, be long in puts when the reverse is true. For additional confirmation, use the CCI (21 period).

As an example, see the 30 minute chart for MNX (CBOE Mini NDX) over the past 3 weeks [NOTE: up until 7/30]. The uptrend started in earnest at 10:30 AM on July 13 (2009), at about 142 and there's been an uninterrupted rise in prices since that time to the 162 level now, a nice 20-point move. If one had purchased a 145 or 150 August call on July 13, the gain would have been (and has been) most satisfying.

This simple method also is the key to "cutting losses short and letting winners run," something that lots of so-called gurus advocate. Trouble is, none of them ever describe how to do it. This is one reliable, very objective, free of emotion method of accomplishing it..."

MY COMMENTS:

There's a little more to the comments above, as the very profitable period described in the NDX mini calls(MDX) was when the market was in strong upside run. I went back to May to get a read on other periods when the market wasn't trending so strongly. It should be acknowledged that there were many periods of presumably getting into to calls based on an UPSIDE Crossover of the 12 and 26 period Exponential Moving Averages (EMA), only to followed relatively quickly by taking out puts based on a DOWNSIDE crossover. This is a classic 'whipsaw' period.

I'll comment before and after the 30 minute charts which I ran in the Nas Composite as my Nasdaq stand charts in to show the moving average crossover technique described by our trader friend. (I'm assuming that the actual trading vehicle was NDX or MNX calls or puts.) The trading principle is the same and the progression is from around May 12th to the current day (8/20).

When there's a red DOWN arrow on the chart, I presume that our Nasdaq position is in puts. When there's a green UP arrow, the presumption is that the position taken is in Nasdaq calls (e.g., NDX or MNX). I also want to preface my comments that the means of determining whether to be long or short the market, in calls or puts, is something I found interesting. I always try to learn any useful trading tips. How such ideas get put in actual practice varies a lot from trader to trader.

There's a fair amount of in and out trading implied by this 'system' back in May as seen above, with participation in 3 price swings that probably made up for losing trades and then some. The CCI or Commodity Channel Index as it was first called is an attempt to measure when a market is in a directional move. Buy/sell decisions are suggested when the CCC crosses above or below zero. Some will only initiate trades with a reading above +100 or below -100.

In almost all cases, seen in the above 30-minute COMP chart and the ones that follow, there did (always) appear to be CCI 'confirmation' of the upside or downside EMA crossovers. I'm not sure how much of a 'check' the CCI provides for taking or not taking a EMA crossover 'signal'!

Again in the June period shown below, there were at least 2-3 good sized moves, 2 in puts, 1 in calls that probably resulted in overall profitability if this system was followed 'mechanically'. Losing or break even trades also occurred due to premium inflation and lousy fills, 'slippage' on exiting due to delays in execution, etc.

This type of trading implies that someone can watch the market constantly unless it is actually set up as a system with 'automatic' execution which I understood at one time could be arranged at least as applied to stocks; e.g., with TradeStation Securities. Doing the same with calls and puts adds another whole layer of complexity to it and might not be able to be implemented as an 'automated' system. I myself don't want to and can't watch the market all day to be able to trade. I used to. I'm not knocking it but I'm no longer a professional trader.

As in any trend following system it only gets REALLY profitable when there is a strong TREND and there was one of course beginning around July 13th as mentioned already. This when the Nas Composite went from the 1750 area (NDX: 1420 area) to 1980-1990 (NDX: 1620) by the end of July. The chart below shows this period although not quite to July 30.

My last chart below brings us up to date (to 8/20). After the end of July until now we again get into a choppy period when following the moving average crossover system described only resulted in a couple of winning periods, which may or may not have (so far) offset the losing/break even trades.

All in all, the trading method described by our Trader is an interesting take on a systematic way of making trading decisions where there is no other input required but half-hour intraday charting and 2 Moving Averages; plus the use of the CCI for some added information. The use of the 12 and 26 period Exponential averages looks to be an insightful choice as applied to the 30-minute index charts.


GOOD TRADING SUCCESS!