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THE TRADERS MAGAZINE SINCE 1982

Fundamental
Analysis
And forex trading

Moving Averages
Some finer properties

10
16

Trading System
Design
A statistical approach
for better predictability

News Sentiment
Data for retail traders

28
32

INTERVIEW

Les Masonson of Cash


Management Resources

REVIEW

36

n OptionStrategist.com (part 2)

MARCH 2015

www.traders.com

MARCH 2015

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FIND MORE ideas that fit your strategy.

FILTERS
Markets
Uptrend Stocks

Technicals

Options

3% on 15% Higher Vol

DESCRIPTIONS

Symbol

Last

Chg

% Chg

Bid

Ask

Volume

DEC

5.22

1.232

30.89

5.20

5.23

9,148,849

RTF

56.70

5.04

9.76

55.90

57.95

354,664

1.05

0.10

10.53

1.04

1.05

20,110,933

LDPE
RMA

10.78

0.85

8.56

10.70

10.72

81,673,172

BTS

1.22

0.08

7.02

1.21

1.22

1,475,961

NABP

5.30

0.22

4.33

4.64

5.39

4,299,779

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CONTENTS
10 Trading Forex:
Fundamental Analysis

by Imran Mukati
Forex traders need to keep an eye
on fundamental data such as interest rates, central bank policies, and
economic data. Here in part 5 of
this six-part series, well take an
in-depth look at these fundamental
variables.

15 Q&A

by Don Bright
This professional trader answers
a few of your questions.

FEATURE ARTICLE

16 Moving Averages:
Some Finer Properties

by Giorgos E. Siligardos, PhD


Find the answers here to common
questions about different types of
moving averages.

23 Futures For You

by Carley Garner
Heres how the futures market
really works.

24 MACD-Suitable Stocks

by Kevin Luo
Trading signals generated by
the crossover of Gerald Appels
moving average convergence/
divergence and signal lines are
popular and simple to use. Do they
work for all stocks in all market
conditions? Find out here.

MARCH 2015, Volume 33 Number 3

28 Trading System Design:


A Statistical Approach

TIPS

by John F. Ehlers and Ric Way


Heres how to start with the basics
and determine if an identifiable
event has a statistical edge in predicting future pricesbefore you
even start to build a trading system.

32 News Sentiment

by Stephen Massel
News data, which has long been the
province of institutional traders, is
now making its way into the hands
of retail traders. Heres a look at
how you can incorporate this data
into your trading strategies.

INTERVIEW

36 Using ETF Momentum


Strategies With
Les Masonson

by Jayanthi Gopalakrishnan
Leslie Masonson is president of
Cash Management Resources,
a financial consulting firm that
he founded in 1987. Masonsons
44-year career has spanned trading, investing, financial advisory
services, bank operations management, teaching, and corporate cash/
treasury management consulting.
We spoke with him about trading and investing in ETFs using
momentum strategies.

REVIEW
44 OptionStrategist.com (Part 2)
Product review: The Option
Strategist newsletter and its
related services

DEPARTMENTS

6 Opening Position
8 Letters To S&C
22 Traders Glossary
47 Traders Tips
55 Trade News & Products
56 Futures Liquidity
57 Advertisers Index
57 Editorial Resource Index
58 Books For Traders
59 Classified Advertising
59 Traders Resource

42 Explore Your Options

by Tom Gentile
Got a question about options?

AT THE CLOSE

62 Play The Markets


And Keep Your Day Job

by Azeez Mustapha
Not ready to be a full-time trader?
Heres a high-probability, part-time
trading strategy that will help you
master the markets before you
commit to it full time.

TIPS

This article is the basis for


Traders Tips this month.

n Cover: Wlliam L. Brown


n Cover concept: Christine Morrison

Copyright 2015 Technical Analysis, Inc. All rights reserved. Information in this publication must not be stored or reproduced in any form without written permission from the publisher. Technical Analysis
of Stocks & Commodities (ISSN 0738-3355) is published monthly with a Bonus Issue in March for $89.99 per year by Technical Analysis, Inc., 4757 California Ave. S.W., Seattle, WA 98116-4499. Periodicals
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Printed in the U.S.A.

4 March 2015 Technical Analysis of Stocks & Commodities

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March 2006 Volume 24, Number 3


March 2015 Volume 33, Number 3

Opening
PENING P
Position
OSITION
O

The Traders Magazine TM


The Traders MagazineTM
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those risks.
Take
it one step at a time. Its the small steps
that will lead to success in the long run.

8 March 2006 Technical Analysis of STOCKS & COMMODITIES


6 March 2015 Technical Analysis of Stocks & Commodities

Jayanthi Gopalakrishnan,
Editor
Jayanthi Gopalakrishnan,
Editor

NOTICE OF CLASS ACTION SETTLEMENT


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other important documents, at www.nymextassettlement.com (Settlement Website) or by calling toll free 1-866-778-9470.
Whats This About?
The lawsuit claims that Defendants Optiver US LLC, Optiver Holding B.V., Optiver VOF, Christopher Dowson, Bastiaan van Kempen, and
Randal Meijer (Defendants) caused and aided and abetted the causation of artificial prices of certain futures contracts on the New York
Mercantile Exchange from March 2-26, 2007, inclusive, by amassing dominant NYMEX trading at settlement (TAS) contract positions and
offsetting such positions through NYMEX futures contracts transactions in the opposite direction of the TAS positions during the closing period
for the futures contracts at the end of the day. Defendants deny any wrongdoing that Plaintiffs allege in the lawsuit and maintain that they have
complied with their legal obligations.
The Court did not decide which side is right. But both sides agreed to the Settlement to resolve the case and get benefits to potentially affected
market participants. The two sides disagree on how much money could have been won if the Plaintiffs had prevailed at trial.
What Does the Settlement Provide?
Under the Settlement, Defendant Optiver US agreed to pay $16.75 million into a Settlement Fund. If the Court approves the Settlement,
potential Settlement Class Members who qualify and send in valid Proof of Claim forms will receive a share of the Settlement Fund, after it is
reduced by the payment of certain expenses. The Settlement Agreement, available at the Settlement Website, describes all of the details about the
proposed Settlement.
The exact amount each qualifying Settlement Class Member will receive from the Settlement Fund cannot be calculated until
(1) the Court approves the Settlement; (2) certain amounts identified in the full Settlement Agreement are deducted from the Settlement Fund;
and (3) the number of participating Class Members and the amount of their Allowed Claims are determined. In addition, each Settlement Class
Members share of the Settlement Fund will vary depending on the information the Settlement Class Member provides on their Proof of Claim
form. Generally, however, if you bought, sold or held more contracts, you will get more money. And if you bought, sold or held fewer contracts,
you will get less money.
The number of claimants who send in claims varies widely from case to case. If less than 100% of the Settlement Class sends in a Proof of
Claim form, you could get more money.
How Do You Ask For a Payment?
If you are a Settlement Class Member, you may seek to participate in the Settlement by submitting a Proof of Claim to the Settlement
Administrator at the address below postmarked no later than August 3, 2015. You may obtain a Proof of Claim on the Settlement Website or by
calling the toll free number referenced above. If you are a Settlement Class Member but do not file a Proof of Claim, you will still be bound by
the releases set forth in the Settlement Agreement if the Court enters an order approving the Settlement Agreement.
What Are Your Other Options?
If you dont want to be legally bound by the Settlement, you must exclude yourself by April 14, 2015, or you wont be able to sue, or continue
to sue, Defendants about the legal claims in this case. If you exclude yourself, you cant get money from this Settlement. If you stay in the
Settlement, you may object to it by April 27, 2015. All objections to or requests to be excluded from the Settlement must be made in accordance
with the instructions set forth in the formal Mailed Notice. The Mailed Notice available at www.nymextassettlement.com explains how to
exclude yourself or object.
The Court will hold a Fairness Hearing in this case (In re: Optiver Commodities Litigation, Case No. 1:08-cv-06842-LAP) on May 19, 2015,
at 1:00 p.m. in Courtroom 12A, United States Courthouse, 500 Pearl Street, New York, NY 10007, to consider whether to approve
the Settlement and a request by the lawyers representing all Settlement Class Members (Lovell Stewart Halebian Jacobson LLP,
Lowey Dannenberg Cohen & Hart, P.C., and Robins Kaplan Miller & Ciresi L.L.P.) for an award of attorneys fees of no more than one-third
(i.e., 33 1/3%) of the Settlement Fund for investigating the facts, litigating the case, and negotiating the Settlement, and for reimbursement of
their costs and expenses in the amount of no more than approximately $275,000. The lawyers for the Settlement Class may also seek additional
reimbursement of fees, costs and expenses in connection with services provided after the Fairness Hearing. These payments will also be deducted
from the Settlement Fund before any distributions are made to the Settlement Class.
You may ask to appear at the Fairness Hearing, but you dont have to. For more information, call toll free 1-866-778-9470, visit the
Website www.nymextassettlement.com, or write to IN RE OPTIVER COMMODITIES LITIGATION SETTLEMENT, c/o A.B. DATA, LTD.,
PO BOX 170500, MILWAUKEE, WI 53217-8091.

The editors of S&C invite readers to submit their opinions and information on subjects
relating to technical analysis and this magazine. This column is our means of communication with our readers. Is there something you would like to know more (or less) about?
Tell us about it. Without a source of new ideas and subjects coming from our readers,
this magazine would not exist.
Email your correspondence to Editor@Traders.com or address your correspondence
to: Editor, Stocks & Commodities, 4757 California Ave. SW, Seattle, WA 98116-4499. All
letters become the property of Technical Analysis, Inc. Letter-writers must include their full
name and address for verification. Letters may be edited for length or clarity. The opinions
expressed in this column do not necessarily represent those of the magazine.Editor

SUPERSMOOTHER OSCILLATOR
AND EXCEL SPREADSHEET
Editor,
I really enjoyed John
Ehlers article Whiter Is
Brighter in your January
2015 issue. He has a way
of translating unfamiliar
concepts into something useful to us.
And the results and final equation prove
that out.
The articles pseudocode of b1 in the
calculation for the SuperSmoother uses

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angles for the cosine. To code it using


radians, for example, in Excel, the cell
pseudocode for the tunable constant b1
would look like this:
b1 =
2*a1*COS(RADIANS
(1.414*3.14159/BandEdge))
Also, Ron McAllisters spreadsheet
that he presented in the Traders Tips
section of that same issue contains a
small error in it: In cell A21, where he
computes the tunable constant a1, he
gives: =EXP(-1.414*3/A19), where
the 3 should instead be pi (3.14159). I
noticed this when my tunable constants
for BandEdge=20 did not exactly agree
with his.
For those readers wanting to know
the exact values of the SuperSmoother tunable constants when BandEdge=20, so that they can check out
their own formulations, they are:
a1=0.8008, c2=b1=1.5623, c3=-0.6413
and c1=0.0790. Note that c1+c2+c3 =
1.0000.
Don Kraska
Author John Ehlers replies:
I am glad you enjoyed my article Whiter
Is Brighter in the January 2015 issue and that you appreciate my efforts
to bring a little science to this art of
trading.
It is my custom to write an exponential
moving average (EMA) in the form:
Output = a*Input + (1-a)*Output[1];

Written this way, you can check by


inspection that the two coefficients of the
equation sum to unity. This means the
EMA is guaranteed to have unity gain at

8 March 2015 Technical Analysis of Stocks & Commodities

zero frequency. However, if I additionally


multiply the input by K, then I simply give
the EMA a gain of K at zero frequency.
In a nutshell, that is what I did in the
article. I just changed the terminology
to make the philosophical point, and the
scale factor is irrelevant.
My shift in terminology produced a
one-bar difference as the expression
for the white spectrum. But a one-bar
difference produces a 6 dB increase in
the high-pass filter gain at the Nyquist
frequency. I then added a zero of transmission to the one-bar difference filter
at the Nyquist frequency to mitigate the
filter gain (in effect, noise gain) at that
spectral point.
I think the really important part of my
article is that the pink noise shape of
the market data spectrum must be leveled
if analysts are to make reasonable filters
and indicators.
Editor: Ron McAllisters revised spreadsheet that adds the pi function is available at our website, www.traders.com,
in the TradersTips area for our January
2015 issue.
To reach the Traders Tips area at our
website, choose the Traders Tips menu
item from the HomeS&C button on our
homepage at www.traders.com.
SUGGESTIONS
Editor,
Please try to publish one or two recommendations on stocks, commodities,
forex, and indexes in every issue, if
possible.
The best way to do so would be to ask
the author of an article to recommend a
security or two at the end of his or her
article using the same method or trading
setup he or she is writing about. This would
quickly filter out real traders with life experience versus writers with no practical
war-zone experiences, per se.

LETTERS
Please ask the articles authors to
provide some backtesting and verifiable
results on their recommended trade setup
as well. This would cement the deal for the
writers own reputations and personas.
A few but solid actionable recommendations each month from your contributing writers would make your magazine
much more appealing to the financial
junta than the typical financial magazine
that offers only repetitive, boring articles
on topics like MACD, SMA, EMA and
any other trading setups.
This would also help writers to work
hard and write something compelling
that back their observations, theories,
and data, not just plain old dry articles
without much meat. Thank you.
Jack Mirza
Thank you for your feedback and your
suggestions. Since we are an educational,
how-to magazine on technical analysis,
our objective is to help people to learn
to trade using technical trading tools
or systems. That has been our focus in
Technical Analysis of Stocks & Commodities magazine since its inception.
We try to present trading systems or
ideas for trading setups with backtesting
results when possible. We try to ensure the
reader will be able to see the logic in an
idea presented, and be able to replicate
the strategy for implementation or for
further testing.
But our mission is also to provide a
variety of material in every issue, for
all different levels of traders. Not every
article can present a tradable system with
backtesting results. Some articles are
designed to help introduce basic concepts
to new or next-generation traders.
As an aside, wed remind readers that
regardless of whether or not an author
can provide backtest results on his
method, system, or idea, we encourage
readers to perform their own backtests
to their own satisfaction. That is the only
way to become comfortable with a system
or strategy, and that is what we preach.
We try to provide the tools to do this,
including the ready-to-use code provided
by software developers in our Traders
Tips section each month to implement
a selected strategy discussed in that issue. While its important for a reader to

be able to glance at an article to see if


he feels its worth pursuing for himself,
its also important to understand that
most approaches will only work in some
markets some of the time. Its imperative
that the trader change his approach when
something stops working.
Our online publication, Traders.com
Advantage, contains some content that
may be more in line with what you are
suggesting, since Traders.com Advantage
articles often discuss a specific stock, index, ETF, or forex pair. Brief analyses are
often provided based mainly on technical
analysis, and the authors sometimes suggest securities to trade. We publish articles
on a daily or weekly basis in Traders.com
Advantage, which makes them timelier
than in a print publication.
Thank you again for taking the time
to write; we value feedback from our
readers.Editor

March 2015

RETHINKING DIVERSIFICATION
Editor,
I really enjoyed Dirk
Vandyckes article in
the January 2015 issue,
Rethinking Diversification. Well written,
clear, and to the point.
Thanks to him for sharing his thoughts
in this article. Looking forward to reading part 2.
MC
Readers will find part 2 of Dirk Vandyckes two-part series on risk in our
February 2015 issue. The article is titled
Fine-Tuning Your Risks.Editor
Errata: NINJATRADER FILE
In the January 2015 Traders Tips section, NinjaTraders Traders Tip refers
to an incorrect filename. The download
for the universal oscillator technique
can be found at www.ninjatrader.com/
SC/January2015SC.zip, not www.ninjatrader.com/SC/January2014SC.zip.

Technical Analysis of Stocks & Commodities 9

ust as in equity trading,


there are two basic approaches to formulating
forex trading strategies. In my previous articles in this series, I already
introduced you to technical analysis.
Its counterpart is fundamental
analysis, which looks at issues like
interest rates, central bank policies,
and economics to make trading
decisions. In this way, it is similar
to dissecting the financial statements of a company when deciding
whether to buy its stock.

Necessary & Useful

Trading Forex:
Fundamental Analysis
Part 5

their place
Because of the nature of the underlying mechanics, fundamental
analysis is geared more for longerterm trading. Technical analysis
tends to be more appropriate for
short-term trading. However, it
is possible to combine aspects of
both. For example, fundamentals
might indicate the future course a
currency is likely to take; the only
question would be the exact timing
of the move. Technical indicators
can provide the signals to show
when that movement is beginning.
In some cases, collective trader
psychology might mean following
the technical indicators even when
the underlying fundamentals dont
justify the price movement.
As an example, billionaire hedge
fund mogul George Soroswho is
famous for, among other things,
making fantastically profitable
trades on the Thai baht and the
British pound, earning a $1 billion
profit on a $10 billion trade on the
latter currencybet billions on
gold in 2010. Even though he knew
that the fundamentals pointed to a
bubble in gold prices, the technical indicators showed that traders
were nevertheless flocking to buy,
and he made money buying the
upward trend.

Forex traders need to keep an eye on fundamental data such as interest rates, central
bank policies, and economic data. In part 5 of this six-part series, well take an in-depth Central banks
look at these fundamental variables.
and interest rates
One important factor that distinby Imran Mukati
guishes forex from equities is the
10 March 2015 Technical Analysis of Stocks & Commodities

MAGHEN BROWN

Fundamentals have

FOREX FOCUS

existence of central banks. While companies


Interest Rate
Demand (Borrowers)
Supply (Lenders)
(Shortfall)/Surplus
1%
$1,000
$50
($950)
take actions intended to affect the price of their
2%
$600
$100
($500)
stock, in most cases they have little power to
3%
$500
$200
($300)
affect it substantially; the market makes those
4%
$400
$400
$0
5%
$200
$500
$300
decisions. A currency, however, is not just
6%
$100
$600
$500
something to be traded in the marketplace; it
Figure
1:
different
levels
of
demand
for
borrowing
at
different
interest
rates.
is the economic lifeblood of a country. ValuHere you see hypothetical numbers to show you how much borrowers are willing to borrow and how much
ations that are too strong or weak have real commercial banks have available to lend at different interest rate levels.
and important impacts on the economy, so
each central bank is charged with governing
its currency.
(if they can get one at all) since they are a higher risk.
First, Ill talk about who the players are. Just about every
There are varying levels of demand for money (loans) at
country has a central bank, but you wont be trading every different interest rates. If you want to borrow money to buy
currency. The central banks that govern the majors are:
a boat, remodel your house, or expand your business, and the
bank tells you the interest rate will be 18%, you will probably
n US Federal Reserve
decide that borrowing simply isnt worth the cost. Instead,
n European Central Bank
youll save up the money (and savings rates, by the way, will
probably be quite generous) or just forgo whatever it is you
n Bank of Japan
were going to purchase with the loan.
n Bank of England
But what if the bank is lending at 0.5%? If you can get a loan
at that rate, youll probably sign up right away. After all, thats
n Reserve Bank of Australia
nearly free money! So what we find is that there are different
n Swiss National Bank.
levels of demand for borrowing at different interest rates.
Look at the table in Figure 1 for some hypothetical numDont assume that central banks are focused solely on currency bers. Here you see how much borrowers are willing to borrow
valuestheir responsibilities are much more complex than (demand) and how much commercial banks have available to
that. The US Federal Reserve (the Fed) has by law a dual lend (supply) at each interest rate level. Remember that banks
mandate: to maximize employment while controlling infla- are taking deposits from savers and using that money to make
tion. (The Feds standard for controlled inflation, by the way, loans. However, a bank cant loan out everything it has. Cenis 2% to 3%.) At the end of the day, any central bank wants its tral banks establish reserve requirements, which dictate what
nations economy to grow as fast as possible while minimizing proportion of its deposits a commercial bank has to have on
negative economic effects like bubbles (consider the effects hand as cash or other liquid assets, like securities.
of the popping of the US housing bubble in 2008); recessions
If a bank has $1 billion in deposits and the reserve reor depressions; and inflation or deflation. Basically, they are quirement is 10%, the bank cant loan out more than $900
looking for the Goldilocks standard in their economynot million; it must keep at least $100 million. This, by the way,
too hot, not too cold, but just right.
is another tool in the central bankers toolbox. Adjusting reThere is one major tool that central banks use to pursue serve requirements up or down can free up more money for
these goals, which is normally labeled monetary policy. loans or reduce whats available, causing money to flow into
Informally you may hear it called setting interest rates, but or out of the economy. Its also part of what caused the 2008
this is misleading in that the central bank doesnt simply say, financial crisis. Some of the liquid assets commercial banks
This is the new rate, despite the impression you might get were holding as part of their reserves were mortgage-backed
from the news media in the wake of, for example, a meeting securities (MBSs). When it became clear that no one really
of the Federal Reserve Open Market Committee (FOMC). knew how many bad mortgages were rolled into those MBSs
The reality is more complex.
and therefore what they were worth, the banks no longer knew
Understand that an interest rate is basically the price of what they had in reserves. Their response was to hold onto
moneyspecifically, the price to borrow it. In simple terms, their cash by basically stopping all lending.
if you are a saver, you give your money to a bank. The bank,
Going back to the table, 4% is the hypothetical equilibrium
which will be using your funds to make loans, pays you a cer- ratethe rate at which commercial banks have as much money
tain interest rate. If you are a borrower, the bank will charge to lend as people and companies want to borrow. While banks
you a certain interest rate as well. That rate is, needless to might love to make even more loans at 1%, 2%, or 3%, since
say, quite a bit higher than what the saver is receiving. Part their profit margins are basically the same at each rate, they
of the difference is what the bank uses to cover its expenses dont have the reserves to do so.
and make a profit; another part is a risk premiuman amount
Enter the central bank, which, among other things, acts as a
paid to cover the risk that some borrowers will fail to repay bank for banks. Central banks charge interest to commercial
their loans by making up those losses. Thats why a person or banks for loans as well. If they are loaning at 1%, commercial
a company that is a poor credit risk will pay more for a loan banks might need to charge 3% or 4% to be profitable. But
March 2015

Technical Analysis of Stocks & Commodities 11

Fundamentals in the news

You should make it a habit to


know the central bank targets
for GDP growth and inflation in
each country whose currency
you plan to trade.

if the central bank cuts the rate it charges banks to 0.5% or


0.25%, suddenly the commercial banks can loan money at
1% or 2% and still be profitable. In essence, the central bank
makes up the shortfall in the available lending pool, which
pumps money into the system and drives rates down. Increasing rates works in just the opposite manner.
Why dont central banks just leave rates low all the time,
encouraging borrowing and therefore causing the economy
to expand constantly? Well, theres a little matter of inflation.
When more money enters the system, it means people and
companies can make more purchases, which means there
are more dollars competing for basically the same amount of
goods. It also means expanding companies need to hire more
workers, and with more competition for basically the same
number of workers, wages start rising. This drives inflation,
which, if it gets out of control, is very hard to rein in and can
destroy an economy. However, a certain amount of inflation
is a necessary evil, because it comes along with a growing
economy. You might have wondered earlier why the Fed has
an inflation target of 2% to 3%. Wouldnt zero inflation be
better? It might seem like a great thing, but it would mean a
stagnant economy. Inflation tends to be low or nonexistentor
even turns negative into deflationduring recessions.
That leads us to the concept of real and nominal interest
rates. The nominal rate is the official or declared rate. Lets
say that its 5%. However, if you are lucky enough to earn 5%
on your money, that wont be your actual growth in terms of
purchasing power. Thats because inflation eats away at the
value of your dollar (or your euro, or your pound, or your franc)
each year, reducing how much it can buy. So if the inflation
rate is 3% while the interest rate is 5%, the real interest rate
or the actual increase in purchasing power is only 2%.
Clearly, what matters in trading is the real rate. A currency
with a nominal rate of 6% might look great until you find out
that the inflation rate is 5%, at which point the one with a 4%
nominal rate but only 1.5% inflation looks a lot better. Because
interest rate and inflation conditions are likely to differ from
country to country, there is trading value in the differences. If
the real rate on the yen is 1% while the Swiss franc has a real
rate of 2%, holding the franc will be more profitable thanks
to the 1% differential. In other words, it becomes practical to
borrow yen to buy the franc. Since the franc is more attractive, traders will tend to flock to it over the yen, which means
the price will rise.
12 March 2015 Technical Analysis of Stocks & Commodities

Fundamental analysis relies heavily on


the news. Governments, central banks,
and independent entities like the Conference Board, which produces the monthly
US Consumer Confidence Index, are
constantly announcing economic data.
Central bankers also announce policy
decisions; in the US, analysts who follow the Federal Reserve
and parse its announcements are nicknamed Fed watchers.
Because the US dollar is so important in the forex markets, US
economic data is king. The top five information groups, ranked
beginning with the highest significance to forex trading, are:
n

Nonfarm payroll report

Retail sales

International trade reports

Federal Reserve policy decisions

Consumer Price Index.

Just as analysts do with corporate earnings announcements


in the equity markets, observers will anticipate specific economic numbers prior to the release of the data. This provides
an opportunity to play the news based on how the actual
numbers compare to the expectations. If the numbers come
out as expected, the currency is likely to be flatany buying
or selling attributable to the data has already been done. This
is known as pricing the data into the market. If, however, the
numbers are better or worse than expected, you can expect
to see buying or selling (respectively) as traders adjust their
positions accordinglyand sometimes, frantically.
Naturally, there are two ways to play economic data announcements and other news: proactive or reactive. Proactive
trading means placing your trades beforehand, in expectation
of what will happen once the news is released. This is most
useful when you have reason to believe the actual numbers will
not match the expectation (usually called the consensus); you
can be in position to profit when the currency price comes to
you in reaction to the news. While this is the more profitable
approach, it is also much more difficult and will produce some
losses on those occasions when you are inevitably wrong. Reactive trading merely follows the news and trades based on what
was released. In this case, you can use limit orders above and
below the current trading range so that you can take a long
position should the news be positive and the currency rise, or
a short position should it be negative and the currency fall.
Be aware that because trading volume picks up substantially
just before and after such announcements, a phenomenon
known as slippage will occur. This is a condition in which
prices change so quickly that it becomes difficult to enter a
trade at exactly the price you intended. In order to reduce trading volume and mitigate slippage, brokers tend to increase the
spreads on trades around the time of significant announcements.
By raising the price of forex trades temporarily, brokers try

to keep casual traders out of the market and limit activity to


those who are serious about trading the news.

Economic fundamentals

for forex trading


As we said in the introduction, fundamental analysis usually
takes a longer view of trading. That is because many of the
economic factors that affect currency valuations are slowermoving. The first factor is economic growth. Determining
whether an economy is growing (or contracting) and how
quickly means measuring its size, and the size of an economy
is measured by its gross domestic product (GDP). GDP is
composed of four elements:
n

Consumption

Investment

Government spending

International trade balance.

Consumption is essentially consumer spending, which as


weve heard over and over is the largest component of the US
economyabout 70%. Investment is not the type of investment
represented by buying stocks and bonds (or currency pairs);
rather, it is capital investmentthe purchase of assets, like
factories and machinery, by companies. Government spending is self-explanatory, and the international trade balance
is simply the value of exports minus the value of imports.
(The trade balance can either add to or subtract from GDP.
The US has run a trade deficit for many years, meaning we
import more than we export; major exporters like China run
a trade surplus.)
Once we measure the size of an economy, it becomes possible to measure it each year and determine the net change.
An expanding economy is a great thing, but obviously that
doesnt happen every year. If the economy contracts for two
(or more) consecutive quarters, it is said to be in a recession.
Growth rates of 2% to 4% have been typical for the US, which
is a mature economy, but younger expanding economies like
that of China may grow from 7% to 9% or even more each
year. Remember, an economy that is hot and growing fast will
produce a good bit of inflation, and for that reason, central
banks in emerging nations are often quite comfortable with
6% and 7% inflation rates.
Speaking of inflation, just as there are nominal and real
interest rates, there is nominal and real GDP growth. Just
because the economy grew at a rate of 5% last year doesnt
mean 5% more goods and services were produced. If inflation
was 3%, those goods and services increased in price 3%, but
the same quantity was produced. Real GDP growth would be
only 2% in this case.
GDP growth and interest rates have an inverse relationship.
That means that as interest rates rise, GDP growth will fall.
Less money being borrowed means less expansion of companies and fewer new companies, and therefore less economic
activity. Conversely, central banks lower interest rates in order

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to spur economic growth. All of this is done with one eye on
the inflation rate to make sure it doesnt get out of hand.
You should make it a habit to know the central bank targets for
GDP growth and inflation in each country whose currency you
plan to trade. Some very important economic data announcements wont mean nearly so much to you if you dont.
The international trade balance is important as well. In
discussing the basics of forex, one of the reasons for currency trading I mentioned was the exchange of currencies
by multinational companies. To recap, a US company that
manufactures in China and sells in Europe has to trade dollars
for yuan to pay workers and suppliers in China (a transaction
that pushes down the value of the dollar) and trade euros for
dollars to bring profits home (which pushes up the value of
the dollar). All of these many transactions each day have a
real collective impact on the prices of currencies, so it can be
expected that a country with a large trade deficit will tend to
have a weaker currency.
The existence of a trade deficit isnt necessarily a bad thing in
and of itself. Successful and strong economiesthe US topping
the listroutinely run such deficits. This is in part because
profits from transactions taking place in foreign countries
arent included in the balance-of-trade calculation. However,
the period-to-period change in trade deficits will still tend to
affect currency values simply because of the unavoidable need
to exchange one for another, as outlined earlier.
Central banks manage the relative strength of their currency
against others because overly strong and weak currencies have
negative economic effects. International trade is one of the
main arenas where this is the case. A strong currency makes
March 2015

Technical Analysis of Stocks & Commodities 13

FOREX FOCUS

a nations exports more expensive in its customer nations.


When talking about Germany selling Mercedes cars in the
US, a vehicle that costs 20,000 euros (wholesale, of course!)
costs $26,000 when the euro is worth $1.30 but $32,000 when
the euro is worth $1.60.
The reduced buying power of the dollar against the euro
means US consumers cant afford as many euro-denominated
goods, and European exports to the US will fall. Thats not
good for European companies that are exporters! This is why
China goes to great lengths to keep its currency value low.
Its economy relies on exports, so it wants its products to be
cheap in every country to which it sells its goods. Of course,
a currency cant be allowed to get too weak, or that nations
consumers wont be able to afford things that are imported
and every country imports something. In the US, a big one is
oil, which can get more expensive the weaker the dollar gets.
Since American consumers (who are also voters) get up in
arms about high gasoline prices, the Fed has to keep the dollar
strong enough to keep oil prices at least somewhat in check.
Clearly, then, central bank policies are an important component of currency values over the short and long terms, and bear
a close watch. Capital flows or movement of money between
countries also bear watching. These flows can take a few different forms. The obvious one is what takes place in the various
financial marketsstocks, bonds, and forex. But money can
also flow into a country via direct investment such as when a
foreign company builds a factory, mine, or distribution center
there, and by acquisitions of domestic companies by foreign
buyers. The flow of capital into a country will generally cause
its economy to expand and its currency to appreciate.
Finally, it is important to consider political stability. This
can mean many things, from orderly government transitions
that is, via fair and open elections rather than coups or rigged
electionsand consistent government policies to the lack of
conflict internally or with neighbors. Investors like predictability, so countries that have a reputation of arbitrary actionslike
the nationalization of industries or government confiscation
of foreign assetswill suffer. Investors either wont do business there at all, or if they do, they will demand a heavy risk
premium. This reduced demand for the currency in question
will drive its value down.
Speaking of political stability, on that note Ill close with
the mention of the US dollar and its resilience as a reserve
currency. Many pundits have long made noise about how the
dollar would gradually disappear as the worlds primary reserve
currencyone of the factors that makes it so dominant in the
forex markets. First it was forecast to be replaced by the yen until
the Japanese economy hit the doldrums in the early 1990sa
result of demographics, specifically its aging population. As its
population gets even older, Japans economic woes will grow,
not fade away, so the yen is no longer a candidate.
Next it was the euro, the currency of the collective of European Union countries. But the 2008 financial crisis revealed
the cracks in the euros foundation, namely that weaker
economies in the European periphery (think Ireland, Greece,
and Portugal as examples) were enjoying interest rates in the
14 March 2015 Technical Analysis of Stocks & Commodities

bond markets that resulted from the strength of their wealthier


northern neighbors, like Germany and France. That strength
was based on assumptions that stronger EU nations would
bail out weaker ones should the need ever arise, which it did.
That bailout is taking place nowup to a point. The danger
is that if larger but still-troubled economies like Spain or
Italy run into crisis, the bailout costs will be so high as to
probably be unsustainable. That would severely damage the
euro or end it altogether.

The US dollar

still reigns
So it was that even after the credit
rating of US sovereign debt was
downgraded in 2011, and even after
the Fed repeatedly printed money
to dump into the economy, rates on
US Treasury notes fell to historic
lows of under 2%. Despite all the
hand-wringing over the years about
the US dollar, when push came
to shove, the flight to quality still
landed on US shores. While no one
can guarantee the future, let this
serve as an important lesson that the
chorus of experts you hear on a
daily basis wont always be right.

Imran Mukati is the Managing Director of fixed income


securities at Fairbridge Capital Markets, Inc. He may be
reached via http://www.linkedin.com/imranmukati or via
email at imukati@fairbridge.com.

Further reading

Mukati, Imran [2014]. Trading Forex: Understanding The


Basics (Part 1), Technical Analysis of Stocks & Commodities, Volume 32: November.
[2014]. Trading Forex: Markets & Trading (Part 2),
Technical Analysis of Stocks & Commodities, Volume
32: December.
[2015]. Trading Forex: Charting Your Way (Part 3),
Technical Analysis of Stocks & Commodities, Volume
33: January.
[2015]. Trading Forex: More On Charting (Part 4),
Technical Analysis of Stocks & Commodities, Volume
33: February.

Q&A
SINCE YOU ASKED
Confused about some aspect of trading? Professional trader Don Bright of Bright
Trading (www.stocktrading.com), an equity trading corporation, answers a few of
your questions. To submit a question, post your question to our website at http://
Message-Boards.Traders.com. Answers will be posted there, and selected questions
will appear in a future issue of S&C.
Don Bright of Bright Trading

Note to readers
I want to thank Rob Friesen (president and
COO of Bright Trading) for his help with
this column for the last couple of months.
His contributions are always appreciated.
I was dealing with some health issuesI
had a second heart valve replacement
in November 2014. The procedure appears to be a success. I want to thank
our readers for their emails of support.
Im looking forward to a much healthier
2015. A sincere thanks to all.
Now, digging into some recent questions, here is one paraphrased from two
similar questions from readers:
MAKING SENSE OF THE
PROGNOSTICATIONS
Mr. Bright, at the start of every year I
just shake my head in disbelief when I
suffer through stock market predictions
from a variety of experts. I see complete 180-degree comments from many
pundits, sometimes within the same
organization. Do you or any of your
traders use any of these prognostications
with any benefit?
Traders, news organizations, and the
ever-increasing list of forums, chat rooms
or similar servicessome free while
some not even worth that, and some
who get away with charging sometimes
exorbitant monthly or annual feesnever
cease to crack me up (while they laugh
all the way to the bank). I have to laugh,
or else my sympathy or empathy for their
audience will cause tears.
I am writing this column in early
January 2015, which youll be reading
sometime in March. I thought, What the
heck! Rather than reviewing predictions
from last year, which you can easily do,
why not toss a few out for 2015 that you
can check against what really happens.

Before you do the exercise of checking


reality against predictions, let me say that
professional traders of my acquaintance
do read and even pass along many of
these thoughtsif it fits their own biased
agenda. Much like our current political
climate, many traders, too, only get their
information from sources they tend to
agree with. But let me tell you this: Traders who make a good living (with a few
exceptions) will digest the information
and then do their own homework to come
up with something simplethat is, by developing their own analysis tools from an
objective viewpoint. This sounds simple,
but similar to the way people tend to feel
right in their political views, many
traders tend to give a result from some
prejudice. Bulls and bears, obviously,
tend to only see good or bad.

Many traders only get


their information from
sources they tend to
agree with.
I like the idea of jotting down alternative narratives and then creating some
simple ifthen statements to help determine the possible results from whichever
side you see as the most likely to occur.
At the same time, calculate the then result
if things go badly.
I am going to paraphrase some market
forecasts from various sources, purposely
without credit or labels. My idea is not
to see who might be right or wrong but
simply to make a point about the vast
disparity in thinking. Here are the narratives Im going to track:
1. Total return: 10%12%, or even a
little higher.
March 2015

2. Bullish, but not wildly bullish. Total


return: 6%10%. Not bad.
3. Total return: 8%a decent amount
of upside from here.
4. Total return: somewhere between
-5% and 5%.
5. Great returns, less stable conditions.
6. The S&P could gain 10% with a
2% dividend that will give a total
return of 12%.
7. Last year I predicted a stock meltupgrowth would return and up
wed go. That prediction was off
by one year. The market will be a
surprise in 2015, going higher before
leveling off in the third quarter.
8. I expect more of the sameinterest
rates dragging the bottom, averageto-poor job creation with part-time
jobs leading the way, more good
stock performance, but with unpredictable and unexplainable panic
selloffs and volatility.
9. US stocks will be down 5% for the
year.
10. A more negative outlook for the
year, including a prediction of global
deflation. The Fed will return to
quantitative easing.
11. The market has been long for so
long. I think well have our first
correction in 2015.
Pick the predictions you like from
abovenot really!and see how that
goes, or do the research, prepare your own
ifthen statements, and have a successful 2015. As for me and my team, well
continue to play offense and defense by
responding to the what is vs. the what
might be.

Technical Analysis of Stocks & Commodities 15

16 March 2015 Technical Analysis of Stocks & Commodities

TRADING TECHNIQUES

Know Thy Weapons

Moving Averages:
Some Finer Properties
What is the difference between the 10-period of a
five-period moving average and a 15-period moving average? Does the sum of moving averages
equal the moving average of the sum? How does
the smoothing of a ratio differ from the ratio of
smoothing? How can you algorithmically calculate
the weights of a smoothing procedure? Find the answers to such technical questions here.

ll technical analysts eventually engage in creating their own indicators and methods. And
they all eventually use some kind of smoothing
method to filter out noise. Various moving average
methods can be used to smooth a series of values. In
this article, I will discuss four interesting properties
of simple and exponential moving averages (hereafter referred to as SMAs and EMAs, respectively).
These two averaging methods are the most popular
in the technical analysis world, and their weighting
scheme is simple, so they have clear and nice properties. Those who aspire to create indicators should
find the concepts discussed here useful.
I will denote the n-period simple and exponential
moving averages of an indicator P as
SMAn(P), and
EMAn(P), respectively.

WILLIAM L. BROWN

Moreover, MAn(P) will denote either SMAn(P) or


EMAn(P).
Linearity
The first property of SMAs and EMAs worth remembering has to do with the way they treat the addition

of indicators and products of numbers with indicators.


Heres a more precise look at the properties.
First property
If P and Q are indicators and t is a constant number,
then:
SMAn (t P + Q) = t SMAn(P) + SMAn(Q)
and
EMAn (t P + Q) = t EMAn(P) + EMAn(Q)
This property can easily be proved with basic mathematics.
Example
Say you want to smooth the typical price (TP) using a five-period EMA. The TP has the following
formula:

where H, L, and C represent the high, low, and close


of a bar, respectively. It doesnt make a difference
whether you take the five-period EMA of TP or sum
the five-period EMAs of H, L, and C and then divide
the sum by three. That is,

Commutative property
You may not realize it, but in successive smoothing,
using either an SMA or an EMA (or both) can change
the order of averages without affecting the outcome.

by Giorgos E. Siligardos, PhD


March 2015

Technical Analysis of Stocks & Commodities 17

Second property
If P is an indicator, then
MA1n (MA2k(P)) = MA2k(MA1n(P))
where MA1n and MA2k are SMAs or EMAs.
Example
If you want to smooth the closing price (C) three successive times using a five-period EMA, a 10-period
SMA, and a 15-period SMA, then you can do it in
whatever order you want, since all orders will have
the same result. For example, taking the 5-EMA of
the 10-SMA of the 15-SMA of C is exactly the same
as taking the 15-SMA of the 10-SMA of the 5-EMA
of C. That is,
EMA5(SMA10(SMA15(C))) =
SMA15(SMA10(EMA5(C)))

Figure 1: weighting schemes of successive ema smoothings. The weighting scheme of


five successive 15-period EMA smoothings is shown using different colors. EMA(15) is the weighting
scheme of the 15-period EMA, EMA(15,15) is the weighting scheme of the 15-period EMA of the
15-period EMA, and so on. The weights are expressed as percentages of their total sum of 100% and
they are the y coordinates in the graph. The x coordinates are the ages of the weights in ascending
order from right to left.

Like linearity, commutative properties in successive


smoothing can be proved using simple mathematics,
but it is a tedious task. If you only want to grasp the
underlying reasons behind why this property holds
using a simple approach, try proving that:
SMA2(SMA3(P)) = SMA3(SMA2(P))
Its simple.

Weighting effect in

successive smoothing
What is the effect of successive smoothing of an indicator? The most logical answer would be that you
would end up with an extremely smooth version of the
indicator. Well, thats true, but how does successive
smoothing differ from, say, increasing the period of
single smoothing? For example, what is the difference
between EMA5(EMA10(P)) and EMA15(P)?
Let me cut to the chase and give you the answer in
simple terms.

Figure 2: weighting schemes of successive Sma smoothings. Similarly here, this chart
illustrates the percentage weighting scheme of five successive five-period SMAs as a function of age.
For comparison purposes, the weighting scheme of the 25-period SMA is also shown.

18 March 2015 Technical Analysis of Stocks & Commodities

Third property
Successive application of MAs in an indicator creates a
smoothed version of the indicator, where the percentage
weighting scheme as a function of age of data resembles
the shape of a bell. The more MAs applied and the
higher their period, the smoother the indicator you get
and the more widespread, symmetric, short, and chubby
the bell-shaped weighting scheme becomes.
In Figures 1 & 2, you see examples of the weighting
schemes of successive smoothing five repeated times
using 15-period EMAs and five-period SMAs, respectively. The weights are expressed as percentages of their
total sum, which is 100%. In Figure 1, the EMA(15)

is the weighting scheme of EMA15(P), the EMA(15,15) is the


weighting scheme of EMA15(EMA15(P)), the EMA(15,15,15)
is the weighting scheme of EMA15(EMA15(EMA15(P))), and so
on. The weights are sorted in ascending order of age from right
to left so that the weight corresponding to age zero (which is
the weight put to the most recent value of the indicator P) is the
rightmost one. Similar notation is used for the case of SMAs in
Figure 2. For comparison purposes, there is also the weighting
scheme of SMA25(P) in Figure 2 [denoted as SMA(25)]. This
general rule of bell-shaped weighting scheme also holds for successive smoothing using combinations of SMAs and EMAs.
What does the change in shape of the weighting scheme show
as new smoothings are applied? Does the change in shape make
sense? It does, because the basic function of moving averages
is to raise the contribution (weights) of old data at the cost of
the contribution (weights) of the younger data. In effect, the
more EMAs or SMAs you apply on top of one another, the
more the older values appear in the calculations (thus getting
comparably bigger weights) and the newer data gets comparably
smaller weights.
This has the effect of a bell shape in the weighting (as a
function of their age), which moves like a wave to the left as
new EMAs or SMAs are applied. Moreover, as the span of ages
having significant percentage weights increasesdue to the
involvement of more and more indicator values as new MAs
are appliedthe bell becomes wider, relatively chubbier, and
its maximum height becomes shorter.

Calculating the weights

In the cases you have seen so far, the weights depend only on the
time instances in terms of age (and not on other factors like the
values of some indicator or the volume of shares). For example,
let P0, P1, P2 be the values of indicator P where the subscript
denotes the age of its values (P0 is its most recent value, P1 is
its value one bar ago, P2 is its value two bars ago, and so on).
Lets consider the EMA3(EMA3(P)), which is the three-period
EMA of the three-period EMA of the indicator P. It is profound
that the value of EMA3(EMA3(P)) for the latest bar (that is, for
the bar of age zero) eventually equals a sum of type:
w0P0 + w1P1 + w2P2 +

(Equation 1)

where the weights w0, w1, w2 are constant numbers independent


of the values of P. These weights are not greater than 1; their total
sum is 1, and they represent the contribution of the respective Ps
value to the creation of EMA3(EMA3(P)). For example, you can
see that w0 = 0.25 or 25%, w1 = 0.25 (or 25%), and w2 = 0.1875
(or 18.75%), so 25% of the latest value of EMA3(EMA3(P)) is
attributed to the most recent value of P (which is P0), another
25% of the latest value of EMA3(EMA3(P)) is attributed to the
value of P one bar ago (which is P1) and another 18.75% of the
latest value of EMA3(EMA3(P)) is attributed to the value of P
two bars ago (which is P2).
It is when the weights of a smoothing procedure depend
on only the time instances in terms of age (like in the previ-

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ous example) that you can create stable charts like those of
Figures 1 & 2. If you create a smoothing procedure that can
be eventually formulated in a weighting scheme like the one
of equation 1, where the weights depend only on the age of
data, you can use a spreadsheet program like Excel to calculate
and visualize the weights via charts no matter how complex
your procedure is. To accomplish this, you create an artificial
indicator P such that all its values are zero, and you write the
formulas that dynamically calculate your smoothing function
from Ps values. If you now change the value of P0 to 1, then
the last value of your smoothing function will be equal to w0.
Thats because, as you can see in equation 1, when P0 equals
1 and all other older values of P equal zero, then the last value
of the smoothing function equals w0. So you copy this w0 and
paste it somewhere else in your spreadsheet. You then again
set P0=0 and proceed to set P1 equal to 1. This will make the
last value of your smoothing function equal to w1. You copy w1
and paste it below w0. By setting P1 back to zero and setting P2
equal to 1, you can get the value of w2 and put it below w1. If
you continue this way, you will be able to get all the weights
of your smoothing procedure and chart them as a function of
their age. In fact, this is the way the charts of Figures 1 & 2
were constructed. Using this technique, you can also verify
the first and second properties stated earlier.
Unfortunately, since this approach requires repeated substitution of values and copying & pasting, you will need to
use macros in Excel if you want to calculate a large number
of weights for various cases of successive smoothing. For
educational purposes, the file succ_EMA_weights.xlsm,
March 2015

Technical Analysis of Stocks & Commodities 19

sidebar Figure 1: the four sections of the spreadsheet. The Excel spreadsheet is divided into four sections and has a button labeled calc weights to call
the macro, which will calculate the weights for all ages.

Using Excel To Calculate The SMOOTHING Weights

Excel is a simple and quick solution for the calculation and


visualization of the distribution of weights in a smoothing
method. In Sidebar Figure 1 you see a screenshot of the
spreadsheet used to create the chart in the articles Figure
1. The spreadsheet is divided into four sections and offers a
button to call a macro.
Section 1 is where you enter the desired periods for the five
successive EMAs in the green cells. The respective alphas for
the periods are automatically calculated below the periods according to the standard formula: alpha =2/(period+1).
Section 2 contains the functions that calculate the successive EMAs values in descending order of age for an indicator whose values are in the indicator values column. The
spreadsheet assumes 88 historical values for the indicator so

that the 88th value (the one that has an age of 88) is the oldest
and the 0th value is the newest. All values of the indicator are
initially set to zero. When only the 0th value (in terms of age)
of the indicator becomes 1, then the 0th values (in terms of age)
of EMAsthat is, the newest values of EMAswill become
equal to the EMAs weights for age zero (namely, w0). Similarly,
when only the first value of the indicator becomes 1, then the
0th values of EMAs will become equal to the EMAs weights
for age 1 (namely, w1) and, generally, when only the kth value
of the indicator becomes 1, then the 0th values of EMAs will
become equal to the EMAs weights for age k (namely, wk).
Section 3 offers a quick way to calculate the weights of
EMAs for an age. When you enter the age directly into the cell
labeled age, the value of the indicator for that age in section
2 becomes 1 automatically, and the second row of section 3
labeled weight is populated with the weights of the EMAs (in
alignment with section 1) for that age, which
are exactly those in the last row of the table
of section 2.
Section 4 and button: When you click the
button labeled calc weights, a macro runs
in the background that repeatedly changes
the age in section 3 starting from zero and
increasing by 1 until it gets to 88. For every
change in age, the macro copies the weight
row of section 3 and pastes it in the table of
section 4, populating it from the top cell and
down. The table of section 4 is linked to a chart
that offers a visualization of the weights like
the one in Sidebar Figure 2. The labels of the
chart are automatically updated according to
the periods of section 1 as soon as the button is clicked. In Sidebar Figure 2, you can
see the chart that corresponds to the data in
Sidebar Figure 1.

sidebar Figure 2: charting the weights. As soon as you click the calc weights button, both the section 4 and its linked chart are updated. The chart shown here is based on the inputs and calculated weights
of Sidebar Figure 1.

20 March 2015 Technical Analysis of Stocks & Commodities

The Excel spreadsheet discussed here can be


downloaded from the Subscriber Area at our
website, www.traders.com, in the Article Code
area, as well as from http://traders.com/files/
succ_EMA_weights.xlsm.zip.

which I used to create the chart in Figure 1, is provided in the


Subscriber Area of www.traders.com (as well as from http://
traders.com/files/succ_EMA_weights.xlsm.zip). It works in
Excel version 2007 and above, and you need to enable macros
to make the calculations. You can find out more details in the
sidebar Using Excel To Calculate The Smoothing Weights.

Smoothing ratios

of indicators
Ratios of indicators are widely used in
technical analysis, mostly as a way to
produce normalized percentage values.
George Lanes stochastics oscillator is
such an example. I will now introduce
the fourth property of MAs (which deals
with smoothing indicator ratios) using a
hypothetical example. Suppose you want to divide indicator
P by the positive indicator Q so that you get a new indicator
P/Q. This new indicator has proved to be erratic and you want
a smoothed version of it using, say, a three-period SMA. You
have two options:

Option 1
Calculate the three-period SMAs of P and Q separately and
then divide them:

Option 2
Simply take the three-period SMA of P/Q; that is:

All technical analysts eventually


use some kind of smoothing
method to filter out noise.

where more weight is given to the values of P/Q, where Q is


larger. Similarly,

results in a modification of

where, again, more weight is given to the values of P/Q,


where Q is larger.
The mathematically inclined might want to try and see that
the underlying reason for this property is the same one that
makes the harmonic mean give less significance to high-value
outliers. If you dont understand this peculiar connection, dont
get discouraged. Here is how you can get an idea of why the
fourth property holds in this hypothetical example: If P0, P1,
P2 are the three most recent values of P, and Q0, Q1, Q2 are the
three most recent values of Q (where, as usual, the subscripts
denote the age of the values), then the SMA3 assigns equal
weights to the three most recent values. More precisely, the
latest values of SMA3 for P and Q are:
SMA3(P) = 1/3 P0 + 1/3 P1 + 1/3 P2

Technical analysts would consider the first option as a realistic solution, since it allows for occasional and isolated zero
values for Q (it is more difficult for SMA3(Q) to be zero than
for Q to be zero) but if Q is always nonzero, then either of the
two options could be chosen. So what is the difference between
these two smoothing options and how can you determine which
one better suits your preferences? The answer lies in the fourth
property for MAs:
Fourth property
If P and Q are indicators and Q is positive, then the formula

results in a modification of

and
SMA3(Q) = 1/3 Q0 + 1/3 Q1 + 1/3 Q2
Using simple algebra, you can see that:

(Equation 2)

where:

(Equation 3)

for i = 0, 1, 2.
It is clear from equation 2 that the latest value of SMA3(P)/
SMA3(Q) is just a weighted average of P/Q, where all three
March 2015

Technical Analysis of Stocks & Commodities 21

The basic function of moving


averages is to raise the
contribution (weights) of old data
at the cost of the contribution
(weights) of the younger data.
wis have the same denominator. Consequently, the numerator
Qi in equation 3 is the one that determines the relative sizes of
the wis. As a result, the higher the Qi (in relation to the other two
values of Q), the higher the weight wi for P/Q and the higher
the contribution of the ith value of P/Q (in terms of age) to the
latest value of SMA3(P) / SMA3(Q).
Which of the two smoothing options best suits your purposes? By choosing SMA3(P/Q), you assign equal weights
to the three most recent values of P/Q, whereas by choosing
SMA3(P)/SMA3(Q), you demand that the weights in the three
most recent values of P/Q are analogous to the sizes of the
respective values of Q.
Note that charts like those in Figures 1 & 2 cannot be constructed for SMAk(P)/SMAk(Q) or EMAk(P)/EMAk(Q), since
the weights of P/Q are not determined purely from the time
instances in terms of age; they are also affected by the values of
Q. As new price data and new values of P and Q are introduced,
the weights assigned to the values of P/Q will change according
to the relative sizes of the values of Q among each other.

Smoother is easier

This article may differ from other technical analysis articles


in that it doesnt promote a specific trading style or system.
My main purpose here is to make the aspiring creator of new
indicators familiar with four interesting properties of simple and

Commodity Channel IndexDeveloped by Donald Lambert, this


price momentum indicator measures the price excursions from
the mean.
Exponential Moving AverageA variation of the moving average, the
EMA places more weight on the most recent closing price.
Harmonic MeanAn average obtained by taking the reciprocal of the
arithmetic mean of the reciprocals of a set of nonzero numbers.
One of the three Pythagorean means, where the harmonic mean is
always the least of the three means. Since it tends toward the least,
compared to the arithmetic mean, it can help mitigate the impact
of large outliers.
Heuristic MethodProblem-solving approached by trying out several
different methods and comparing which provides the best solution.
In behavioral finance, trial-and-error learning leading to the use of
rules of thumb for decisions.
High-Pass Frequency FilterA detrending filter that lets pass the
high-frequency noise and rejects low-frequency trend. Implemented
by first applying a low-pass filter to the data, then subtracting the
filtered data from the original data.
Noisy SignalA signal in which the effects of random influences can22 March 2015 Technical Analysis of Stocks & Commodities

exponential moving averages and give you a way to calculate the


distribution of weights algorithmically for some moving average
cases. The first two properties may save you some time when
you try different combinations of ideas, whereas the other two
uncover the effects of successive smoothing and the effect of
separate smoothing of numerator and denominator in ratios so
you can know beforehand what kind of smoothing you can use
with respect to how you want your final indicator to react.
SMAs and EMAs are widely used smoothing methods. If
this article has increased your knowledge about these methods,
then it has fulfilled its purpose.
Giorgos Siligardos holds a doctorate in mathematics and a
market maker certificate from the Athens Exchange. He is a
financial software developer, coauthor of academic books in
finance, a frequent contributor to this magazine, and scientific
contributor in the Department of Finance and Insurance at
the Technological Institute of Crete. Material from his course
writings on derivatives has been used in educational enchiridia
for bank managers. His academic website is http://www.tem.
uoc.gr/~siligard and his current views on the markets can be
found at http://market-calchas.blogspot.gr/. He may be reached
at siligard@tem.uoc.gr.
The Excel spreadsheet referenced in this article is available at the
Subscriber Area at our website, www.traders.com, in the Article Code
area. The spreadsheet is also downloadable from http://traders.com/
files/succ_EMA_weights.xlsm.zip.

Further reading

Siligardos, Giorgos E. [2013]. The Average Age Of Averages,


Technical Analysis of Stocks & Commodities, Volume
31: April.
Excel (Microsoft Corp.)

See Editorial Resource Index

not be dismissed.
OptimizationA methodology by which a system is developed with
rules tailored to fit the data in question precisely.
OutlierA value removed from the other values to such an extreme
that its presence cannot be attributed to the random combination
of chance causes.
Relative Strength Index (RSI)An indicator invented by J. Welles
Wilder and used to ascertain overbought/oversold and divergent
situations.
SmoothingSimply, mathematical technique that removes excess
data variability while maintaining a correct appraisal of the underlying trend.
Probability Density FunctionA graph showing the probability of
occurrence of a particular datapoint (price).
Probability Distribution FunctionA function whose integral over
any set gives the probability that a random variable has values in
this set. Describes the relative likelihood for a random variable to
take on a given value.
Find more terms defined in the Traders Glossary at Traders.com.

FUTURES FOR YOU


INSIDE THE FUTURES WORLD
Want to find out how the futures markets really work? Carley Garner is the senior
strategist for DeCarley Trading, a division of Zaner Group, where she also works
as a broker. She authors widely distributed e-newsletters; for your free subscription, visit www.DeCarleyTrading.com. Her booksCurrency Trading In The Forex
And Futures Markets; A Traders First Book On Commodities; and Commodity
Optionswere published by FT Press. To submit a question, post your question at
http://Message-Boards.Traders.com. Answers will be posted there, and selected
questions will appear in a future issue of S&C.

oil, he is essentially selling dollars, that


is, exchanging dollars for crude. If this
were pairs trading, it might be identified
as a symbol such as USD/CL. Youve
probably concluded that a trader who
sells oil is buying the USD.
Keep in mind that it is only possible
to value one asset if you have an asset
to compare it with. This concept is true
in our daily lives; when we buy a gallon
of milk at the grocery store, we are, in
essence, selling our dollars.
It is interesting to note that the value
of crude oil priced in gold, rather than
the US dollar, has been relatively stable
for decades. In 2014, the price of crude
oil per ounce of gold changed very little.
Accordingly, it appears as though the
price of the dollar is precisely why crude
oil has fallen.
This theory is corroborated by weakness in other commodity markets such as
the grains, metals, and natural gas. Agricultural products such as corn and wheat
underwent historical bear markets as the
greenback marched higher. Similarly, the
high-flying natural gas market in early

2014 quickly succumbed to pressure,


forcing prices under $3.00. Although
the relationship between grains and the
currency market isnt as absolute as that
between crude oil and the dollar, it is
difficult to argue the correlation doesnt
exist. Once again, grain buyers are also
dollar sellers.
Of course, there are additional factors
that weighed on pricing. For starters, the
US Energy Information Administration
(EIA) consistently reported increases
in crude oil stocks, creating what some
referred to as a supply glut. On the
demand side of the equation, slower
growth in China and economic weakness
in European nations resulted in a change
of heart in the energy sector.
In my opinion, the second predominate
influence of crude oil in 2014 was simply
trader emotion and margin call issues.
Specifically, crude oil speculators began
the year with near-record bullish positions. As these formerly bullish traders
were being forced to exit their holdings
Continued on page 43

QST Desktop

OPPOSITES ATTRACT
Some are blaming the 2014 crude oil
collapse on the strength of the US dollar;
what are your thoughts?
The hideous decline in crude oil during the latter half of 2014 was the result
of several factors at work; however, I
believe the biggest role player was the
currency market. At the time of this writing, the correlation between crude oil and
the greenback was hovering near 91%.
In other words, in roughly nine out of
10 occasions, the price of crude oil had
moved in the opposite direction as the
dollar (during a 180-day dataset). Thus,
any significant repricing in the dollar vs.
other major currencies has a profound
impact on crude oil.
A quick look at the chart in Figure 1
tells a profound story of the relationship
between crude oil and the US dollar. In
July of 2014, the greenback found footing
and forged a sharp rally; crude oil simultaneously peaked and fell precipitously.
It is difficult to argue that each market is
moving independently of the other.
Some believe crude oil prices react to
the dollar simply because oil is priced
globally in terms of the greenback. Thus,
as the dollar strengthens, crude oil feels
more expensive to foreign buyers driving
the demand and value lower. Further, a
higher greenback means it takes fewer
dollars to buy the same amount of underlying crude oil, thus lowering the asking
price for the commodity.
Another way to look at it is similar to
trading the forex markets, that is, trading
assets as pairs. If a trader buys the US
dollar, he is simultaneously selling another currency; and vice versa. We dont
think of commodities as trading in pairs,
but we should. When a trader buys crude

Carley Garner

Figure 1: crude oil vs. us dollar. On this weekly chart you can see that in July 2014, the US dollar forged
a sharp rally. Crude oil simultaneously peaked and fell.
March 2015

Technical Analysis of Stocks & Commodities 23

Gauging Momentum

MACD-Suitable Stocks
by Kevin Luo

The

moving average convergence/divergence (MACD)


signal line crossover is a popular technical indicator
used by many traders and investors. The MACD
was developed by Gerald Appel in the 1960s and is readily
found in trading platforms of all types. It generates trading
signals upon crossovers of its MACD and signal lines. The
method is considered simple to use; however, many have doubts
about how effective the method is. To find out whether the
technique works, I conducted a backtest on a large portfolio
of stocks traded on the major exchanges. The results of the
backtest will help determine the level of effectiveness of the
MACD method.

Heres what I found

In the study, I selected approximately one third or 1,816 stocks


traded on the NYSE and NASDAQ for the backtest. These
24 March 2015 Technical Analysis of Stocks & Commodities

stocks met the following selection criteria:


1. Are common stock
2. Trading at $2.00 or higher
3. Had continuous historical daily data (date, open, high, low,
and close) from January 1, 2005 to August 31, 2014
4. Had no data errors, such as unadjusted price data from
stock splits.
My objective in backtesting using this process was to
produce test summary statistics from the simulated trades
(long trades only) of a portfolio of stocks. The scale of the
backtesting is sufficient to make a reasonable conclusion about
the effectiveness of MACD. The parameter setting used is the
default at 12/26/9 (12-day EMA, 26-day EMA for MACD
line, and nine-day EMA of MACD for the signal line). This
study employs the MACD signal line crossover method as the
trading rules for the backtesting.
A buy takes place when an upward crossover occurs. A sell
takes place when a downward crossover occurs. For calculation consistency and standardization, the close prices on the
crossover days are used as the buy or sell price. For example,

ARROWS: Zmiter/COLLAGE: JOAN BARRETT

Trading signals generated by the crossover of Gerald Appels


moving average convergence/divergence and signal lines are
popular and simple to use. Do they work for all stocks in all
market conditions? Find out here.

Intrendstocks.com

Figure 1: MACD Signal line crossover. The up arrow points to an upward crossover while the down arrow points to a downward crossover.

in Figure 1, the up arrow points to an upward crossover, while it is unlikely to make a profit over time on a portfolio of
the down arrow points to a downward crossover, which is randomly selected stocks using only the MACD signal line
the crossover immediately after the upward crossover. The crossover strategy.
buy happens on the up arrow day and the sell occurs on the
Why was the MACD signal line crossover method inefdown arrow day. The close prices on these days are recorded fective in the backtest? The methodology should not take the
as the entry and exit price, respectively. The difference be- entire blame, because markets are not static. In fact, no study
tween the exit price and the entry price is the simulated result has proved that a technical method works on all stocks all the
computed in percentage terms. Using a custom-built stock time. Trading a group of randomly selected stocks using the
analysis system, I ran the backtest and analyzed all trades in MACD or any other simple technique is unlikely to generate
the 1,816 stocks.
The summary of the backtesting results for the portfolio can be seen in the
table in Figure 2. The value displayed
in the fourth column of the table shows
that from January 1, 2005 to August Figure 2: backtesting summary statistics for selected stocks. The annualized profit/loss for the
31, 2014, for the 1,816 stocks, the an- MACD from January 1, 2005 to August 31, 2014 was only 1.45%.
nualized profit/loss was only 1.45%. I
calculated this profit/loss figure based
on an equal-weighted approach, that is,
the same weight was assigned to each
of the stocks in the portfolio regardless
of stock prices. I used the following FIGURE 3: PRICE STATISTICS ON SIGNAL DAYS. The crossovers for signal days are the ones with the larger price
movements.
equation:
Annualized profit/loss = Total profit/loss

/ Number of stocks

/ Time period (or 9.7 years)
The results of this backtest showed that the MACD method
did not produce a meaningful return. The finding suggests

The selected stock groups


show significant improvements
in profitability.

a meaningful profit over time.


Methods are available to improve your results. One approach is to select suitable stocks. Its an approach designed
to make the MACD method more effective without revising
the MACD setting or directly incorporating other technical
indicators into the technique.
How do you identify suitable stocks? One way is to connect
to the root of the MACD. The MACD is considered a trending
momentum indicator. In the table in Figure 3, the statistics from
the backtesting process show that the crossover, or signal days,
are the ones with the larger price movements. On the entry
signal day, the average close high/low, expressed as closetoday
closeyesterday in percent, is 2.18% (column 2) compared to 0.44%
March 2015 Technical Analysis of

Stocks & Commodities 25

FIGURE 4: TREND CHART. Here you see the isolated up and downtrends for Alcoa Inc. (AA).

Stocks with greater trend range and


number of uptrends are considered
suitable for MACD trading and could
be sought for further analysis.

What does this


tell you?

This suggests that the MACD


was developed with the intention
to catch the uptrend movements
by taking a long position when
the upside momentum surges
and exiting the position when the
(in column 3) on average for a typical uptrend day (Ill discuss downside momentum moves in. If this assumption can be
stock trends later). On the exit day, the average close high/low confirmed, it means the characteristics of an uptrend must be
is -1.92% (column 4) compared to -0.55% (column 5) daily, related to the trading performance of the MACD.
Mathematically, if the entry price remains the same, then
on average, during a typical downtrend.
the higher the exit price, the
greater the profit. It is reasonable to assume that this price
range from the entry to the
exit is positively related to
the stock trend range. The
next step is to confirm the
existence of such a relationship. To establish the connection, I need information on
stock trends.
FIGURE 5: RANK OF TREND CHARACTERISTICS. When the trend ranges of a stock are found to be suitable for MACD
To understand the charactrading, selecting the stocks with a higher number of uptrends produces the greater profit. Stocks with greater trend ranges
teristics of a price trend, it is
and number of uptrends are considered MACD-suitable stocks.
necessary to first isolate all
stock trends from the raw
datasets. In this study, there
are two types of trends: An
uptrend is recognized when
the uptrend range is measured at or greater than 20%.
A downtrend is recognized
when the downtrend range is
FIGURE 6: BACKTESTING SUMMARY FOR THE TOP-RANKED STOCKS. The selected stock groups had much better
measured at 20% or greater.
profitability results. The highest-ranked stocks had the highest return.
26 March 2015 Technical Analysis of Stocks & Commodities

INDICATORS

In Figure 4 you see the isolated trends for Alcoa Inc. (AA).
The software, which was used in the backtesting, is capable
of isolating the stock trends. After the trends of 1,816 stocks
were isolated, the trend range traits can be summarized. The
software outputs and exhibits the statistics of trend range and
number of uptrends for the period that is being studied (see the
table in Figure 5). The number of uptrends statistic (column
3) is considered as important as trend range. It refers to the
trend count for a specific stock. If the trend ranges of a stock
are suitable for MACD trading, then the higher values for
the number of uptrends produce the greater profit. Therefore,
stocks with greater trend range and number of uptrends are
considered suitable for MACD trading and could be sought for
further analysis. In order to pick out stocks fitting that description from the 1,816 stocks, each stock was ranked according
to uptrend range and number of uptrends. The higher rank is
given to the stocks with the greater trend range and number of
uptrends combination (column 4). The rank number is merely
for sorting stocks.
I used three groups of stocks. Group 1 contains the top-25
ranked stocks. Group 2 holds 25 stocks ranked from 26 to 50.
Group 3 includes 25 stocks ranked from 51 to 75. The stocks
are mutually exclusive but are considered to be the more suitable stocks for the MACD signal line crossover method. The
expectation is that group 1 outperforms group 2, and group 2
outperforms group 3 in the backtesting because of the rank
levels. After the software implemented the tasks of reorganizing and summarizing the backtesting results according
to the three groups, it resulted in the statistics you see in the
table in Figure 6.
Comparing these results with the initial backtesting results,
it is clear that the selected stock groups show significant improvements in profitability (column 5) over the 1.45% profit
generated from the random portfolio of 1,818 stocks (Figure
2). If you look at the average profit & loss per trade in column
6, youll see that group 1 has the highest return, followed by
group 2, then group 3. This indicates a positive relationship
between the ranking and MACD profit. There was only one
unprofitable stock in group 2. All other stocks generated profits
in the backtests (columns 78).

It works

A given technical indicator is popular for a reason: It works


when it is properly used. By understanding of basics of the
MACD signal line crossover method, I have established,
through this study, that there is a positive relationship between the method and traits of a stock trend, trend range,
and number of uptrends. The successful confirmation of the
relationship in turn helps to find suitable stocks that can be
used for MACD backtesting. This approach translates to a
significant improvement in the effectiveness of the crossover
method. More important, it is easy to implement.
Kevin Luo is an independent technical analysis researcher
who focuses on automated price trendrelated analysis and
generation of trading strategies. He and his project partners
have developed an automated trend analysis and backtesting system for high- and low-frequency trading. He may be
reached via email at kxluopub@gmail.com.

Further reading

Appel, Gerald [1979]. The Moving Average Convergence/


Divergence Method, Traders Press.
Pankhania, Ajay [2013]. Muscle Up Those Averages, Technical Analysis of Stocks & Commodities, Volume 31:
September.
Star, Barbara [1994]. The MACD Momentum Oscillator,
Technical Analysis of Stocks & Commodities, Volume
12: February.
Intrendstocks.com

See Editorial Resource Index

Sneak preview
Coming soon!
Dissecting Warren Buffetts
Macro BuySell Indicator
by Matt Blackman
When it comes to investing, the Oracle of
Omaha usually plays his cards close to his
chest. But here is one favorite indicator
that he has been willing to share.

Spatial Pattern-Recognition Skills


by Martha Stokes
Theres more to chart patterns than merely
identifying them. Find out how you can see
relationships between candlestick bars
and patterns to better asses what price is
likely to do.

2015 Readers Choice Awards


Stocks & Commodities
presents the 2015 Readers
Choice Awards for products
and services that our subscribers find useful, in more
than 20 categories.

March 2015 Technical Analysis of

Stocks & Commodities 27

Judging By The Numbers

Heres how to start with the basics and determine if an


identifiable event has a statistical edge in predicting future
pricesbefore you even start to build a trading system.

by John F. Ehlers and Ric Way


any trading systems begin with indicators, and because
of that, the question you should be asking is, What do
indicators indicate? The correct answer is that most of
the time, they dont indicate much. Indicators are just
specialized filters.

Visible sieves

Some indicators, like the commodity channel index (CCI),


relative strength index (RSI), and stochastic, are basically
first-order high-pass filters that remove the longer wave
components of the prices and display them as oscillators.
Other indicators, like moving averages, are basically smoothing filters that remove the high-frequency components and
28 March 2015 Technical Analysis of Stocks & Commodities

aliasing noise. Of course, there are combinations of the two


kinds of filters. The basic question still remains whether
shaping the price data by filtering has any predictive power
regarding future prices.
Other trading systems involve setups, such as, Buy when
the current close is below the close nine days ago and the
last four closes have been consecutively lower and the high
27 days ago is higher than the current high by at least the
square root of 1.618. Clearly, such a setup is heuristic and
may or may not be true for future prices. Candlestick patterns and chart patterns also fall into the broad category of
setups. The trick here, again, is to determine whether these
setups have predictive power regarding future prices.
Still other trading systems attempt to predict the direction
of future prices by correlation with other leading indicators.
For example, every trader has heard that volume leads price.
Such correlations would be nice if they were correct for long
enough to make a trading system profitable.
The process of trading system design is very much like quan-

Peshkova, SHUTTERSTOCK/adaptation: NIKKI MORR

Trading System Design:


A Statistical Approach

tum mechanics, in that an entity is described by a probability


density, and a future state can only be estimated statistically. In
this article, we will show you how to start with some basics to
see if an identifiable event has the statistical edge in predicting
future prices before you even start to build a trading system.
Once you identify a predictive event, then it is a simple matter to move on to designing a robust trading system. We will
illustrate the entire process with an example.

Price predictors

The process of designing a trading system starts with measuring prices into the future from any identifiable event. Our
own bias is that we have noted a more or less monthly cycle
in most market data, particularly in index futures. It is comforting to note that this cycle activity is consistent with the
fundamental observation that most companies have to make
their numbers on a monthly basis. A monthly cycle implies a
movement consisting of 10 days up and then 10 days down.
With this consideration, we start with the presumption that
we want to predict the prices 10 days into the future.
Since we are constrained to work with actual data, we shift
the point of reference 10 days back in history as the point of
occurrence of the event. In EasyLanguage, variables are stacked
for reference in the code. For example, Close Close[9] means
the price increase over the last 10 days with reference to the
closing prices. In sidebar EasyLanguage Code To Test The
Predictability Of An Event, you see how we measure the
prediction from the time of the event.
The test code begins by expecting an event that happened 10
bars ago. This tester is general, and the event can be anything
that is describable by computer code. The crossing of two
moving averages is just one example. Given that an event has
occurred, the percentage increase or decrease in prices over
the next 10 bars is computed, ending with the current closing
price. This percentage price, referenced to the closing price 10
bars back, is assigned to the variable FuturePrice. FuturePrice
is limited to be between -10% and +10%. After limiting the
range, FuturePrice is rescaled to vary from zero to 100 so that
the FuturePrice can be contained in one of 100 bins. The plan
is to accumulate the number of occurrences of a FuturePrice
in each of the bins over the entire span of the price data series.
We use 10 years of data to create a statistically meaningful
sample size. At the end of the data, the number of occurrences
in the bins creates a probability distribution function of the
prices 10 bars into the future from the event.
We also provide a quick measure of the average percentage
future price by measuring the center of gravity (CG) of the
probability distribution function. If the probability distribution function outline were cut out of a piece of paper, the CG
would be the place along the horizontal axis where the outline
would balance. The general procedure of a function in X and
Y coordinates is to sum the XY products and also sum all
the Y values. The ratio of these sums gives the CG. Since
the X dimension is centered at 50, the 50 is removed so that
plotting the CG gives a sense of the zero profit point. The CG
and ebb & flow are plotted below the barchart as successive

EasyLanguage Code To Test


The Predictability Of An Event
Vars:
Event(false),
FuturePrice(0),
I(0),
CG(0),
Denom(0);
Arrays:
PredictBin[100](0);
{>>>>>>>>> Code for Event Goes Here <<<<<<<<<<}
If Event Then Begin
FuturePrice = 100*(Close - Close[9]) / Close[9]; //Future is referenced to 10 bars back
If FuturePrice < -10 Then FuturePrice = -10; //Limits lower price to
-10%
If FuturePrice > 10 Then FuturePrice = 10; //Limits higher price
to +10%
FuturePrice = 5*(FuturePrice + 10);
//scale -10% to +10%
to be 0 - 100
End;
//Place the FuturePrices into one of 100 bins
If FuturePrice <> FuturePrice[1] Then Begin
For I = 1 to 100 Begin
If FuturePrice > I - 1 and FuturePrice <= I Then PredictBin[I] =
PredictBin[I] + 1;
End;
End;
//Measure center of gravity as a quick estimate
CG = 0;
Denom = 0;
For I = 1 to 100 Begin
CG = CG + I*PredictBin[I];
Denom = Denom + PredictBin[I];
End;
CG = (CG/Denom-50)/5;
Plot1(CG);
If LastBarOnChart Then Begin
For I = 0 to 100 Begin
Print(File(C:\PDFTest\PDF.CSV), .2*I - 10, ,, PredictBin[I]);
End;
End;

events are encountered.


The probability distribution function can be viewed by charting it in Excel. We created a folder on our computer named
C:\PDFTest. When the last bar on the chart is encountered,
a text file named PDF.CSV is created in this folder. It is then
a simple matter to view the probability distribution function
by importing this file into Excel and plotting it as a vertical
bar chart.

Example

A specific example of testing an event for predictability will


undoubtedly make the process clearer. In a previous article
titled Predictive Indicators published in the January 2014
issue of Technical Analysis of Stocks & Commodities
magazine, we demonstrated that a stochastic indicator could
March 2015

Technical Analysis of Stocks & Commodities 29

TRADING SYSTEMS

Predictability Test Of A Stochastic Trading System

A Simple Stochastic Trading System

Vars:
Event(false),
FuturePrice(0),
I(0),
CG(0),
Denom(0);

Inputs:
StocLength(8),
Threshold(.3),
TradeLength(14),
PctLoss(3.8);

Arrays:
PredictBin[100](0);
//>>>>>>>>>> Start Event Code
Inputs:
StocLength(10);
Vars:
HiC(0),
LoC(0),
Stoc(0);

Vars:
HiC(0),
LoC(0),
Stoc(0);
HiC = Highest(Close, StocLength);
LoC = Lowest(Close, StocLength);
Stoc = (Close - LoC) / (HiC - LoC);
If Stoc Crosses Under Threshold Then Buy Next Bar on Open;
If Barssinceentry >= TradeLength Then Sell Next Bar on Open;
If Low < EntryPrice*(1 - PctLoss /100) Then Sell Next Bar on Open;

HiC = Highest(Close, StocLength);


LoC = Lowest(Close, StocLength);
Stoc = (Close - LoC) / (HiC - LoC);
If Stoc[9] Crosses Under 0.2 Then Event = true Else Event = false;
//<<<<<<<<<<<< End Event Code
If Event Then Begin
FuturePrice = 100*(Close - Close[9]) / Close[9]; //Future is referenced to 10 bars back
If FuturePrice < -10 Then FuturePrice = -10; //Limits lower price
to -10%
If FuturePrice > 10 Then FuturePrice = 10; //Limits higher price
to +10%
FuturePrice = 5*(FuturePrice + 10);
//scale -10% to +10%
to be 0 - 100
End;
//Place the FuturePrices into one of 100 bins
If FuturePrice <> FuturePrice[1] Then Begin
For I = 1 to 100 Begin
If FuturePrice > I - 1 and FuturePrice <= I Then PredictBin[I] =
PredictBin[I] + 1;
End;
End;
//Measure Center of Gravity as a quick estimate
CG = 0;
Denom = 0;
For I = 1 to 100 Begin
CG = CG + I*PredictBin[I];
Denom = Denom + PredictBin[I];
End;
CG = (CG/Denom-50)/5;
Plot1(CG);
If LastBarOnChart Then Begin
For I = 0 to 100 Begin
Print(File(C:\PDFTest\PDF.CSV), .2*I - 10, ,, PredictBin[I]);
End;
End;

be the kernel of a successful trading system if the turning


points were anticipated rather than waiting for confirmation.
We will reinforce that assertion in our example.
Our example will create an event when the simple stochastic
swings between zero and one. The turning point for a long entry
30 March 2015 Technical Analysis of Stocks & Commodities

Once you identify a predictive


event, then it is a simple
matter to move on to designing
a robust trading system.
occurs when the stochastic crosses under a threshold of 0.2,
because crossing this threshold anticipates the price turning
up. The complete code for the example is shown in the sidebar
Predictability Test Of A Stochastic Trading System.
The basic stochastic indicator is just the current closing price
less the lowest closing price over the length of the indicator,
normalized to the difference between the highest closing price
and the lowest closing price over the length of the indicator.
The event occurs when the stochastic 10 bars ago crosses
under the 0.2 threshold.
When we applied this indicator to 10 years of the S&P
futures continuous contract using a 10-bar long stochastic
indicator, we found that the CG plotted to be 1.09% at the
end of the 10-year period. This relatively high 10-year average profit leads us to examine the probability distribution
of predicted prices. This probability distribution function is
shown in Figure 1.
Since the event of the stochastic crossing under a threshold
is shown to be substantially predictive, we can now proceed to
write a trading system that trims the performance by adjusting
the length of the stochastic and the precise threshold level that
works best, and by limiting losing trades with a stop-loss.

Example trading system

In the sidebar A Simple Stochastic Trading System you will


find the complete EasyLanguage code for our example stochastic trading system. When we optimize performance over 10
years of the S&P futures continuous contract, we find that the

Percent price gain after event


Figure 1: probability distribution function. A stochastic indicator crossing under a 0.2 threshold is highly predictive of
future prices.

Testing, testing

Equity ($)

We have outlined a procedure for the


successful development of trading
systems using a statistical approach.
We have developed a code testbed
that can assess whether the prices
will statistically increase or decrease
over 10 bars after an event. The event
itself is completely general as long
as it can be described in code. The
event can show whether prices will go
up (signaling long position trades) or
whether prices will go down (signaling
short position trades). Once a predictive event has been determined, it can
then be written into a trading strategy,
Trade number
whose parameters can be trimmed to
Figure 2: equity growth. Here you see the equity growth curve over 10 years for the stochastic system.
optimize performance.
The testbed can also be used to
assess whether an event is robust
across a number of stock or futures symbols. The testbed The code given in this article is available at the Subscriber Area at
works on a basis of sample bars of data. Therefore, the testbed our website, www.traders.com, in the Article Code area.
is equally applicable to any sample rate, including intraday See our Traders Tips section beginning on page 47 for commentary
data or even equitick bars.
and implementation of John Ehlers & Ric Ways technique in variS&C Contributing Editor John Ehlers is a pioneer in the use
of cycles and DSP techniques in technical analysis. He is
president of MESA Software. MESASoftware.com offers the
MESA Phasor Futures strategy. He is also the chief scientist
for StockSpotter.com, which offers stock trading signals based
on indicators and statistical techniques.
Ric Way is an independent software developer specializing
in programming algorithmic trading signals in C#. He may
be reached at ricway@live.com.

ous technical analysis programs. Accompanying program code can


be found in the Traders Tips area at Traders.com.

Further reading

Ehlers, John [2014]. Predictive Indicators, Technical Analysis


of Stocks & Commodities, Volume 32: January.
StockSpotter.com, MESASoftware.com
See Traders Glossary for definition
See Editorial Resource Index

March 2015

Technical Analysis of Stocks & Commodities 31

www.StockSpotter.com

Occurrences

best stochastic length is


eight rather than 10. The
threshold to be crossed is
0.3 rather than 0.2. The
best length of trade is 14
rather than the 10 bars
into the future used in
the prediction test. We
have also limited losing
trades to be no more
than 3.8%.
The equity growth over
10 years of our stochastic system is shown in
Figure 2. Pretty impressive for a really simple
system! And we dare
say its superior to most
commercially available
trading systems.

A New Frontier

News data, which has long been the province of institutional


traders, is now making its way into the hands of retail traders.
Heres a look at how you can incorporate this data into your
trading strategies.

We

by Stephen Massel

all know that news moves the markets, but what is


less easy to determine is exactly how the market
will react immediately after the news event as
well as later, once market participants have had a chance to
digest and analyze the news in more detail. The algorithmic
interpretation of these news events and more detailed news
stories has long been the province of the hedge funds, which

32 March 2015 Technical Analysis of Stocks & Commodities

have the resources to spend on research & development in


this specialized area. However, as with most advanced technological developments, there comes a time when it becomes
more widely available. The use of news analytics and news
sentiment has reached this point, and more and more traders
are now gaining an edge by using news data.

Quantifying news

The development of trading strategies based on traditional


technical analysis using price action, volume, fundamental
economic data, and derived indicators relies on backtesting for
performance evaluation. The backtesting is based on historical
data that, of course, has all the news known to the market at
the time backed in. This is all well and good, but would it not

VICTOR MARCHAND KERLOW

News Sentiment

be better if news could be quantized and decoupled from the


history? This would allow an additional dimension of detail
(in the same way as trade volume is separate) affecting price
action. This would also allow the strategy to react and adapt
to real-world market events, rather than rely on a purely statistical representation of backed-in news events.
In this article I will detail how traders can now access this
news data and incorporate it into their trading strategies. The
focus will not be on the high-speed receipt of news, as the
advantage there lies with the high-frequency trading firms
operating in time frames of micro and nano seconds, with
whom the average trader cannot compete.

What is news sentiment?

The amount of news stories that are broadcast or published


by multiple media outlets on the economy as a whole, on
individual companies, and on global geopolitical events
continues to rise. Making sense of all this datafiltering out
whats relevant and important, and to what extentused to
be the job of large investment houses research departments.
However, with the advent of digitization of news content,
advanced computing, and language interpretation techniques,
this data can now be effectively and quickly analyzed. The
programs that analyze this data are often referred to as news
sentiment algorithms. They use advanced natural language
heuristics and statistical techniques to quantize the news
from various sources. This is a multistep process running
in real time that involves:
n

Inputting news from single or multiple sources (for


example, broadcast TV channels, market data vendors
newsfeeds, RSS web feeds, Internet blogs, etc.). These
feeds can provide purely news headline and content
(text) or additionally include metadata tags (for example,
topic, company name, sentiment score, etc.)

Digitizing and formatting the data for processing

Parsing the datalooking for specific keywords, sentences, phrases, and so on

Applying weightings to the parsed data based on context, uniqueness, occurrences, extremeness of language,
and so on, and generating a positive or negative value
based on market impact, relevance, etc. (this step and
the previous step are really the secret sauce, where the
algorithm really earns its salt)

Consolidating all values and providing a news sentiment value for the specific news event. Results can be
categorized as required (for example, macroeconomic,
company/country/industry-specific, and so forth).

This sentiment data is provided throughout the day in close


to real time, and often with additional metrics, such as:
n

News sentiment (a negative, zero, or positive value representing news on a scale of bad to good)

Traders can now access


news data and incorporate it
into their trading strategies.

News flow (a zero or positive value, representing the


number of news events or stories interpreted)

Z-score (a negative, zero, or positive value, representing


statistical relevance of the sentiment value above or below
the average)

A news link (a URL link to the underlying news story).

The key to success, of course, is the way the algorithm interprets the news text together with a strategy for managing
duplication. The good news is that you do not need to create
these algorithms yourself; the resultant news sentiment data
is now becoming more widely available, and ultimately the
best way to test its efficacy will be to create a strategy and
analyze its effectiveness.

Applying it to your trading

News sentiment data can be of great assistance in various ways.


A discretionary trader can use it as an additional indicator, the
portfolio manager or investor can use it to keep track of news
events affecting his holdings, and as I mentioned earlier, it can
be incorporated into an automated strategy for backtesting.
Ill review each of these areas in some more detail.

Portfolio management

Any portfolio manager or investor will be interested in specific


news pertaining to their holdings. Keeping up with all the
news, especially for large portfolios, can be an overwhelming task. News sentiment can be of great benefit here, where
a news sentiment feed can alert the manager to news events,
on a per-company or industry basis. This can be achieved by
simply having two or three additional metrics associated with
each holding, namely news sentiment, flow, and z-score. The
manager can then quickly get a high-level view of the news
affecting his holdings, and can be alerted to any elevated
activity. He can then dig down into the specific news articles
from various sources to more fully understand the potential
impact on his holdings. This automated method of highlighting
relevant news saves a huge amount of time in manually scanning various news media, and its suitable to mobile devices
for a manager on the move.

Strategy development

There are two main applications of sentiment data in


strategy development. You can either use it as the primary
driver and create a strategy around it directly, or use it as a
filter for an existing strategy. In either case, when using this
March 2015 Technical Analysis of

Stocks & Commodities 33

StockNewsSentiment.com

With the advent


of digitization of
news content, this
data can now be
effectively and
quickly analyzed.

Figure 1: identifying support levels. The stock price finds itself at trendline support at the same time that the
short-term news sentiment trend turns positive.

history for your purposes.


As with any other data, news
sentiment data can be used to drive
a range of indicators available in
todays trading platforms. One of
the most common ones is the basic
moving average indicator, which can
be used to gauge short-term news
trends. For an existing strategy, this
could be used as a filter to improve
performance. Lets say you have a
short-term strategy that holds positions for a few days or weeks. You
could decide to only enter a new
position at the start of a positive news
trend and avoid entering positions on
bad news. The potential uses of this
data, including flow and z-score, are
literally limitless and can provide a
significant edge in your strategies.

Discretionary trading

Figure 2: channel support. The price is approaching a channel support line with decreasing volume at the same
time that the news sentiment trend reaches extreme negative levels.

data, one of the first considerations is to ensure the volume


of data matches your expectations.
News sentiment typically provides a single value per news
story; this may be of great interest in itself, depending on the
magnitude of the value. However, for a trading strategy you will
want to make sure there is sufficient data for your time frame
and style of trading. For example, when daytrading, if your
news sentiment value starts the day off at zero and cumulatively
builds during the day, you may not have sufficient data in the
morning session to make a valid trade decision. Smaller stocks,
including some within the S&P 500, will not have news every
day, whereas macroeconomic or broader categories of news
sentiment will have much greater flow. For strategy development
and backtesting, you will also want to ensure there is sufficient
34 March 2015 Technical Analysis of Stocks & Commodities

As in strategy development, sentiment data can be effective as a decision support tool in discretionary
trading. Like with any other indicator,
there is no silver bullet, but any additional evidence to support a trade can
sometimes prove very helpful. Here
are some examples of its use.

Example 1: Below the Advanced Micro Devices Inc. (AMD)


chart in Figure 1 is a plot of AMD daily news sentiment (white
line) and the five-day moving average (bar chart). The stock
finds itself at trendline support the same time as the short-term
news sentiment trend turns positive. Here, news sentiment was
useful in assisting the decision with regard to whether there
might be a bounce at support.
Example 2: In the chart in Figure 2, the stock price of Exxon
Mobil Corporation (XOM) is approaching a channel support
line with decreasing volume the same time as the news sentiment trend reaches extreme negative levels.

Example 3: In the chart of Coach


Inc. (COH) in Figure 3 you see several examples of price approaching
support & resistance levels at the
same time that the short-term news
trend changes direction.
Example 4: In Figure 4 you see extreme positive news sentiment trend
events for Duke Energy Corporation
(DUK) highlight significant turning
points.

Sources of news

sentiment data
News sentiment data in various
forms is available from several
sources, and of course at various
prices. Here are some specialist news
sentiment data providers:
n

Dragonfish (StockNewsSentiment.com, dragonfishgroup.


com)

Opfine (opfine.com)

FinSents (finsents.com)

FIGURE 3: SUPPORT & RESISTANCE LEVELS. Price approaches support & resistance levels at the same time that the
short-term news trend changes direction.

Ravenpack (sentimentnews.
com)
Dow Jones (http://new.
dowjones.com/products/djnews/news-machine-analysis/)
Thomson Reuters (http://
www.machinereadablenews.
com/p-sentiment-indices.php)
Bloomberg (bloomberg.com/
professional/news-research/
news/)

FIGURE 4: TURNING POINTS. Extreme positive news sentiment highlights significant turning points in the stock price.

Trading by news

With the increase of news sentiment data availability, the opportunities now exist for individual traders to utilize this data
in their strategies and trading decisions and for investors to be
quickly alerted to important news events affecting their holdings. Furthermore, this sentiment data can now be obtained
at a fraction of the cost of paying for an expensive newsfeed
from the traditional big vendors. This is one more example of
technology that was once only available to the large trading
firms, but is now becoming available to individuals to bring
their trading up to a more sophisticated level.

and trading strategy development/testing company. He can


be reached via his website at www.dragonfishgroup.com.

Further reading

Cameron, John [2013]. Market Mobs, Technical Analysis


of Stocks & Commodities, Volume 31: August.
StockNewsSentiment.com (Dragonfish LLC)
See Editorial Resource Index

Stephen Massel has been developing strategies and indicators


and trading futures & options for more than 18 years. He is
cofounder of Dragonfish LLC, a news sentiment data provider
March 2015 Technical Analysis of

Stocks & Commodities 35

INTERVIEW

Dont Get Caught Unaware

Using ETF Momentum Strategies


With Les Masonson
Leslie N. Masonson is president of Cash Management Resources, a financial
consulting firm that he founded in 1987. Masonsons 44-year career has spanned
trading, investing, financial advisory services, bank operations management,
teaching, and corporate cash/treasury management consulting. He was a financial
advisor for six years offering investment management services to retail clients of
large financial institutions.
Masonson has authored books on cash management, daytrading, market timing,
and relative strength investing using ETFs. He also writes book reviews for Futures
magazine and has written product reviews for this magazine. His website is www.
buydonthold.com and he can be reached at lesmasonson@yahoo.com.
Stocks & Commodities Editor Jayanthi Gopalakrishnan spoke with him on
January 5, 2015 about trading and investing in exchange traded funds (ETFs)
using momentum strategies.
I expected to get into the investment
management business after receiving
my masters degree in January 1970, but
none of the brokerage houses or banks
were hiring. So I ended up working
for Irving Trust Company as a quality
control analyst. I then managed a number of operational departments before
departing to become a cash management
consultant at the Bank of America. I then
joined Citibank for seven years, where
I focused on providing fee-based cash
management consulting services to the
banks large corporate clients. Thereafter, I started my own cash management
consulting firm and worked in that
specialty for 17 years.
After that I decided to put my investment knowledge into practice by becoming a financial advisor for six years. After
conferring with hundreds of people
who were looking for financial advice,
I learned that the vast majority of them
had a very limited knowledge of the stock
market and financial matters.
Youre a big believer in the buy-donthold strategy, which is contrary to what
most advisors tell their clients to do, as
far as long-term stock investments are

36 March 2015 Technical Analysis of Stocks & Commodities

Buying & holding is


hazardous to your wealth
because you have to sit
through the bear markets,
which can be emotionally
and financially draining.
concerned. Why the buy-dont-hold
approach?
After spending thousands of hours
researching the markets over decades,
Ive come to the conclusion that buying & holding individual stocks is too
dangerous and too risky a strategy for
investors. First of all, you have to be smart
or lucky enough to buy a portfolio of the
right stocks or your performance will not
be good. Just look at what happened to
the popular nifty fifty growth stocks
such as Eastman Kodak, IBM, Polaroid,
and Xerox of the 1960s and 70s. Their
prices exploded until they ran into the
crushing 197374 bear market.
Buying & holding is hazardous to your
wealth because you have to sit through the
bear markets, which can be emotionally

WORLD MAP: PILart/NYSE STOCK EXCHNAGE: LUCIANO MORTULO/SHUTTERSTOCK

Les, why dont you start by telling us a little bit about yourself
and how you got interested in
the financial markets.
Ive been interested in the stock markets since 1957 when my grandmother
gave me a few shares of PanAm Airways
for my 13th birthday. From that point on
I started reading about the markets, even
though there were only a few books in my
local library. I also traveled to Manhattan
to visit the NYSE and AMEX visitors
galleries during my summer breaks from
junior high school. I opened a brokerage
account for minors and I also attended a
few stockholder annual meetings in the
NYC area for companies that I owned.
Those were both interesting learning
experiences. After high school, I received
my college degreesa BBA in Finance
and Investments from the City College
of New York and an MBA in Operations
Research from Bernard M. Baruch College. My masters thesis title was Statistical Evaluation of the Relative Strength
Concept of Common Stock Selection.
After performing the research for my
thesis, I was convinced that using a relative strength momentum strategy would
be a viable investing approach.

and financially draining. We experienced


this in the 200002 bear market when
the S&P was down 49.1%, and then again
during the 200709 crash when the S&P
was down 56.7%. So weve had two
devastating bear markets in a 10-year
time frame, and well have more down
the road, just based on history. These
bear markets will continue to crush
peoples portfolios and they wont be
happy about it, and they may sell at the
bottom, which is what many investors
usually do. Many investors, especially
those over 55, cannot afford to lose so
much money when they most need it. If
you have a 50- to 80-year time horizon,
then perhaps buy & hold will work for
you. But that is not realistic for most
people. Defensive investing is the way
to avoid the big bear markets.
Second, the typical investor does not
have the financial training or skill to
evaluate the stock he/she is considering.
Even CFPs, CFAs, and CPAs are not
experts at assessing the risk and value of
companies they cover. That is why over
their careers they make costly mistakes
or errors of judgment and recommend
stocks they should not have. So how is
the average person without the training
going to do better?
Third, I believe that using market
timing or relative strength analysis with
ETFs is a solid, risk-averse way to invest
and trade. Ive written a book on each of
these subjects with complete information, aimed at self-directed investors who
can consider the strategies I recommend.
In my lastest book, Buy DONT Hold,
I provide a strategy with specific rules

for investing in a portfolio of ETFs that


takes the emotion out of the equation. I
also have a website, www.buydonthold.
com, that supports the book and provides
a weekly report on the strategy free of
charge. Im also a big user of charting
and technical analysis.
Because of these reasons, I feel that the
most viable investing method is to use a
mechanical, nonemotional approach. By
using a specific time-tested strategy (as
delineated in my books or one developed
by the investor) with a handful of technical indicators, investors can limit their
risk and protect their principal. The key
to successful long-term investing is to
protect your principal from devastating
bear markets. That can be accomplished
using any number of simple strategies.
Whether I use market timing or relative
strength analysis, I know that it will
definitely not do as well as the market
averages during bull markets because
the strategy may have premature exits
and late entries. The goal is to capture
the majority of the uptrends and miss
most of the downtrends. Over the long
haul and during down markets, these
strategies will save your nest egg. So
thats why I dont believe in buying &
holding in individual stocks. Its just
too risky. People dont understand that
buying & holding is not a strategy at
all; its just hoping for the best. If they
have individual securities and use buy
& hold, I wish them luck.
You mentioned that you use a controlled and systematic strategy for your
trading. You follow a specific plan. One
of the keys to that plan is to first determine your true risk tolerance. How
does somebody go about doing that and
does it affect how they trade?
Determining your level of risk is critical to your investing and trading success.
Without developing specific parameters
to protect your principal, the odds are

38 March 2015 Technical Analysis of Stocks & Commodities

that you may go bankrupt. The majority of the risk tolerance questionnaires
used by financial advisors typically ask
five to 10 questions that tend to be very
weak in determining an investors true
risk level. I found that the website www.
riskprofiling.com, which uses a questionnaire that people can fill out (at no cost,
to determine their own risk) is one good
source. Its a psychometric test that is
closer to reality in determining risk than
those tests used by most advisory, bank,
and brokerage firms.
In addition to taking this test, one good
way to determine your risk parameter is
to look back at your actions and feelings
during the last big market decline that
you experienced. After carefully assessing how you reacted to this market
meltdown, you should have a pretty good
idea of your personal loss percentage that
will be acceptable in the future, allowing
you to sleep at night. It could be a 10%
or 20% decline, for example. If investors
say to themselves that they dont want
to risk more than 10 or 15%, that is fine,
but they better use stop-loss or stop-limit
orders, if at all possible, to take them
out of the market and not second-guess
it or change those percentages as the
market declines further. Unfortunately,
you cant put stop-loss orders on mutual
funds. You can place them on stocks and
ETFs. So if you own mutual funds, then
you or your advisor will have to watch
them carefully. The minute the price hits
your mental stop, sell it, because youll
be surprised and unhappy if you dont.
Think of what would happen if the market
crashes and you failed to act according
to your own plan.
Whether someone is a trader or investor, it is critical that an exit strategy
always be in place to protect principal.
Most of the top traders use stop orders
since they know a high percentage of
their trades may go against them. The key
is to take small losses, which should be
counteracted by large gains in positions
going their way.
What indicators do you use to determine when the market is in a trend?
The indicators I use are laid out in
BuyDont Hold (BDH) and at my
website www.buydonthold.com. My goal

is to be in tune with the trend. I use four


indicators to determine when to be in or
out of the market, which I refer to as the
BDH Dashboard. When three or more
of them are on buy signals, I go long the
market using the five top-ranked ETFs
based on their six-month relative strength
out of universe of 52 predetermined
ETFs. When one or none of the indicators are on buy signals, then I sell all five
ETFs. Its as simple as that.
First of all, I use the daily Nasdaq
Composite index to determine the market
trend. Thats the most volatile of the big
three indexes and the one that usually
leads the market in both directions. The
first indicator used on this index is the
100-day simple moving average (SMA).
When the indexs price moves above the
SMA, it triggers a buy signal and vice
versa. As a second indicator, I use that
index with the moving average convergence/divergence (MACD). When there
is a positive crossover on the MACD,
that is considered a buy signal on that
indicator. But if the crossover is negative,
it is a sell signal.
My third indicator is the American Association of Individual Investor (AAII)
weekly investor sentiment survey. I use
the sentiment index and look for the
extremesmore than 50% bulls or less
than 25% bulls. A sell signal on this
indicator occurs when it reaches a level
of 50% or more bullish reading and then
drops below that level in a subsequent
week. A buy signal occurs when it falls
below 25% and then rises above that
level in a subsequent week.
My last indicator is the Nasdaq Summation Index (NASI). I overlay a five-day
exponential moving average (EMA) on
the daily price chart of the index and plot
the MACD indicator. A buy signal on
this indicator is generated when there
is a positive daily crossover of the fiveday EMA by the index coupled with a

positive MACD crossover. They must


confirm each other to be considered a
signal change.
On December 8, 2014, there was a
sell signal on the Dashboard. So I went
into 2015 with a 100% cash position. In
2014 the BDH strategy earned 13.63%
while the Nasdaq Composite gained
13.4%, the S&P 500 gained 11.4%, and
the Dow Jones Industrial Average gained

7.5%. And during 2014, the Dashboard


was out of the market for 178 days or
48.8% of the year, greatly reducing
market risk. The beauty of my system
is that the Dashboard can be out of the
market between 2550% of the time
during the year and still post decent
risk-adjusted performance. Remember,
if youre not in the market you have no
risk at that time. But that means you

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Technical Analysis of Stocks & Commodities 39

By using a specific time-tested strategy


with a handful of technical indicators,
investors can limit their risk and protect
their principal.

will miss some of the upside, but thats


part of risk management. During bull
markets youre not going to capture all
of the upside as the indicators need time
to reverse to the upside. The best part of
the Dashboard strategy is that it pays off
big time in a big bear market. Youll be
out of the market and stay out until the
market reverses higher. Thats the key
to building wealth.
Weve had a huge bull market since
March 2009. It may have potentially
peaked the last week of 2014. Looking
ahead to 2015, no one knows where the
market will end the year. The perennial
forecasters are projecting an 810%
market advance, as they do almost every
year. One positive for 2015 is that it is
the third year of the Presidential election
cycle, which has had a positive historical
track record. Another positive is that
years ending in 5 have had a good
track record as well. These positives are
nice to keep in mind, but the question
is whether they will kick in this year.
And no one knows the answer to that at
year-end 2014.

You read our


publications. Now
write for them, too!
If you are knowledgeable about
technical indicators, charting,
trading systems, money
management, intraday trading,
trading psychology, options,
cycles...and more... wed like to
hear from you!

Click on CONTACT US at Traders.com


for more information.

You mentioned a few exchange traded


funds. Why do you prefer trading them
to individual stocks?
Stocks are dangerous by themselves.
If you pick a stock that is a winner, then
thats tremendous. But the odds are
against you. For example, there was a
study done on over 8,000 stocks from
19832006. They looked at the stocks
on the Nasdaq Composite, the American
Stock Exchange, and the New York Stock
Exchange, including delisted stocks, and
found that over the total life of that period,
only 25% of the stocks provided all of
the return, and 75% did not participate
in the uptrend.
Even in big bull markets there are
many stocks that have negative performance. Thats why its difficult to pick
stocks individually. Mutual funds really
are not the way to go either because of
their high internal expensesabout
1.23% for equity fundsand their endof-day-pricing. Thats why I love to
use ETFs. Theyre passive indexes, low
cost, transparent, very liquid, and can
be traded during the day. The nice thing
is that you have a wide choice of ETFs
in all asset classes. They dont usually
declare capital gains because theyre not
actively trading.
Another positive for ETFs is you can
invest in an inverse fund. You can buy
an inverse fund of an index and go long.
There are over 1,700 ETFs to choose
from, and the value of the total ETF world
is $2 trillion, so they have really grown
in the past couple of years. Theyre going
to knock out mutual funds at some point.
It may take 10 or 15 years but I think itll
happen. ETFs are a great product.
Theyre much better than mutual funds.
In the past year 79% of the active managers
didnt even beat their own benchmarks,
according to Morningstar, and interestingly, only 13% of those who were tracking

40 March 2015 Technical Analysis of Stocks & Commodities

large-cap stocks beat their benchmark


this year. And anyone who holds them is
paying those internal fees all the time. So
I use ETFs with my strategies.
Then of course with ETFs, you have the
option of being able to rotate among
sectors.
Yes, my BDH strategy rotates into ETFs
in different sectors. I use relative strength
to identify the strongest sectors using a
preselected universe of 52 ETFs, which
are listed on my website and ranked each
week. Each week they are ranked based
on their six-month price performance, and
the five strongest ones are purchased and
held until the Dashboard has a sell signal,
or their individual stop-limit order is hit,
or they drop below rank 20, whichever
criteria is met first.
Each week I look at the four indicators
for any signalsbuy or sell. When there
is a majority in one direction, then that
results in a Dashboard buy or sell signal.
Over time, I expected to only get three
or four Dashboard signals a year, but in
2014 there were five buy and five sell
signals because of the market choppiness.
In a nice, trending market, you will have
fewer signals.
There really is no perfect indicator or
trading system.
Absolutely correct. The BDH Dashboard is not a perfect system, but it hopefully will capture most of the gains while
minimizing the losses. There is no perfect
system, and if you were talented enough
to develop one, it will probably decay over
time because the markets change.
Speaking of changing markets, are
there any significant changes that
you have noticed in the markets of
late compared to what they were a few
decades ago?
Yes, there have been many significant

changes in the last decade. These include


lower trading commissions; availability of
free, powerful trading platforms as well
as charting and backtesting software; the
global nature of the markets; the impact
of the Federal Reserve and foreign central
banks; and information explosion.
Today, global political, economic,
banking, and financial events filter their
way back to the US instantly and impact
our markets. This was certainly not the
case 10 years ago. The social media explosion has also had its impact on certain
stocks, as true and untrue stories circulate
around the world in seconds.
Another major change has been the
commission structure reduction. More
than a decade ago I was paying $45 to
trade and a few hundred dollars a month
for real-time data. Now Im paying about
half a cent in one of my brokerage accounts, and with another brokerage account Im paying $5 to trade any amount
of shares. Most of the large firms, such
as E*Trade, Fidelity, and TD Ameritrade have advanced trading software
and platforms coupled with real-time
data for no charge with certain account
minimums, and they keep updating and
improving their offerings.
The availability of powerful trading
and backtesting software has given traders and investors the ability to analyze

their ideas and strategies in seconds.


Ten years ago this capability was just
in its infancy.
You said you have 52 ETFs listed on your
website. How did you select them?
Anyone can see these ETFs by going to
my website or to one of my links at www.
etfscreen.com/buydonthold. Theyre
broad-based indexes representing seven
categories: fixed income, commodities,
international, sectors, styles, currencies,
and inverse funds. Most have high daily
volume and are liquid with low bidask
spreads. I select five of the strongest
ETFs and hold them until they have a
sell signal based on a stop limit or a
dashboard sell or if they drop below
rank 20 out of 52.
Any last thoughts?
Investing successfully is all about
protecting your principal from future
devastating bear markets. The next few
decades will most likely not match the
performance of the 1950s, 1980s, and
1990s for many reasons.
Therefore, investors need another way
of investing to eliminate all the noise and
not concentrate on what others are saying or what their opinions are about the
future trend of the market. If you look at
the forecasts of market participants, es-

pecially many financial advisors, pundits


on Wall Street, or economists, youll find
theyre usually completely wrongtheir
predictions will tend to head in the opposite direction. Take the forecasts from
prominent prognosticators for 2014 as an
example. Most economists thought that
interest rates were going to go up, but that
didnt happen. They thought the price of
oil would go up but that clearly didnt happen. They thought the dollar was going
to go down, but it went up. So why pay
attention to someones forecast? Its not
going to help you make money.
Thus, it is important to use a rulebased, logical approach such as relative
strength to have the odds in your favor.
Anyone who uses my website has free
access to an ETF relative strength strategy. Theres no work for anyone to do to
gather updated information, as I do all
the work and provide the links. They can
view the strategy and the weekly update
of the Dashboard indicators and follow it
if they want to. The reason I developed
the blog was to back up my book, and
provide self-directed investors with a
conservative investing approach with
proper risk safeguards. The question is,
When will the next bear market occur?
No one knows, but the Dashboard will be
there to help determine when to sellnot
at the top, but close to it. Thats worth
its weight in gold.

Further reading

Masonson, Leslie N. [2010]. Buy, DONT


HoldInvesting with ETFs Using
Relative Strength To Increase Returns
With Less Risk, FT Press.
_____ [2011]. All About MARKET
TIMING: The Easy Way To Get
Started, 2d ed., McGraw-Hill.
_____ [2011]. Profiting From ETF
Rotation Strategies In Turbulent
Markets (Kindle edition only), FT
Press.
_____ [2014]. StockCharts University,
Quick-Scan, Technical Analysis of
Stocks & Commodities, Volume
32: April.
www.buydonthold.com, lesmasonson@
yahoo.com

If elected, I promise to do my darndest to keep money in politics!


March 2015

Technical Analysis of Stocks & Commodities 41

Explore Your Options


Got a question about options? Tom Gentile started his trading career on the floor
of the American Stock Exchange in 1994. He has appeared on many financial TV
and radio shows, as well as hosting a weekly talk show himself, and has co-authored
many books on the markets. He can be found at www.tomgentile.com. To submit a
question for Tom Gentile, post it to our website at http://Message-Boards.Traders.
com. Answers will be posted there, and selected questions will appear in a future
issue of S&C.
Tom Gentile

PROTECTING YOUR SMALLER STOCK


PORTFOLIO
How do I hedge 10 shares of Google?
Years ago, my answer would have been,
Get 90 more shares, then we can talk.
But as of last year, that all changed with
the introduction of mini options. It has
now been a year since this product was
introduced, and I typically wait a year
before trading anything new. Lets visit
this small section of options to see
if it might be a good fit for the smaller
trader.
In March 2014, the CBOE launched
a new product for the smaller investor
looking to hedge odd-lot securities called
mini options. What are they, how have
they performed during the past year, and
who is most likely to benefit from using
these options?
Each regular-sized equity option contract gives the buyer the right, but not
the obligation, to buy 100 shares of the
underlying asset at a set price for a set
time. Regular options have many strike
prices above and below the stock price.
Regular options could have as little as
one week to expiration, or as long as a
few years. A mini option represents 1/10th
of the value of a regular-sized option.
Thus, a mini option contract is good for
10 shares of stock and is in many ways
similar to the standardized options.
Before you go out and analyze your
odd-lot portfolio on every stock that
you might own, mini options have most
of their volume in Apple Inc. (AAPL),
Amazon.com Inc. (AMZN), Google Inc.

(GOOG), SPDR Gold Shares (GLD),


and SPDR S&P 500 ETF (SPY). These
mini options, like the standardized ones,
offer various strike prices and the same
expiration dates. In this regard, they
are similar to their bigger brother, but
smaller. So right off the top of my head,
who is the trader or investor thats best
suited to benefit from mini options? The
odd-lot investor!
This is the person like my motherin-law (lets call her MIL) who buys 10
shares of GOOG, because thats all she
wants to buy in her portfolio. She likes
to buy and hold GOOG a month before
earnings and then sell after earnings.
At todays price, 10
shares of GOOG
is valued at more
than $5,000. That
might not be much
to you, but to her it
represents a lot of
money. With mini
options, she now has
several strategies to
hedge this particular position if she
intends on keeping
it longer than a few
days. These would
include:

and simultaneously sell one mini


option contract with one month to
expiration on GOOG at $500, and
collect premium for the sale, which
at the time of this writing, was $30.
She now has $30 of protection for
her GOOG shares, and even if the
stock were to stay at $500, she keeps
the amount of money collected at
expiration. Bad news is that she has
capped the reward to the amount of
premium collected, so if at earnings,
GOOG jumps to $600 a share, she
is obligated to sell the stock at $500.
Keep in mind that the chart in Figure
1 shows 100 shares of GOOG and one

Covered call
optionsMIL
could purchase
her 10 shares of
GOOG at $500

Figure 1: Covered Call Options. This strategy gives you the protection but caps the reward to the amount of premium collected.

42 March 2015 Technical Analysis of Stocks & Commodities

Explore Your Options

full-size option contract; the mini is


1/10th the cost and risk.
Married put optionIn this case,
MIL could protect her 10 shares of
GOOG with a mini option purchase
of GOOG puts. If she bought one mini
option with one month to expiration at
a strike price of $500, she would end
up paying a little less than 10 points
of protection for her GOOG stock.
This is to protect $5,000 of stock for
30 days. The good news is twofold:
If GOOG has good earnings and the
stock jumps to $600, she gains 100
points on the stock, and even though
the put protection cost less than $10,
she still nets out 90 points of profit.
If the companys earnings arent up
to expectations and the stock falls by
100 points, the put she bought gives
her the right to sell GOOG at $500.
In this case, protection that cost 10
points saves her 100 points if the stock
drops below $500. The drawback here
would be if GOOG were to stay in a
sideways range. This then costs her
unneeded protection, but still gives

peace of mind.
You can see the
risk graphs with
the full option
contracts in Figure 2, so deduct
90% off the prices to get an idea of
what your costs
and risks are with
10 shares of stock
and a mini option.
Collarstrategy
This involves a
combination of
the two strategies discussed
buying the stock,
Figure 2: Married put options. This strategy gives you the protection and the
buying a put, and possibility of higher rewards. The problem would be if the stock moved sideways.
selling a call simultaneously. This strategy takes but you dont hear about them much. If
the positives and negatives of the two youre a small trader, dont let this disstrategies, and it protects the stock, courage you. Minis are a great way to
but the rewards are minimal.
start learning how to trade options.
Good trading!
Minis started out with a lot of fanfare,

FUTURES FOR YOU


GARNER / FUTURES FOR YOU
Continued from page 23

(selling long futures positions) due to


a lack of conviction or funding, prices
were forced lower in a dramatic nature.
The panic was real, and it resonated

into the financial markets, causing junk


bonds and energy stocks to plummet.
Oftentimes, human emotion interferes
with natural market fundamentals. In
such times, prices can overshoot equilibrium, or even logical, levels. Eventually,
the panic subsides and prices revert to a
March 2015

more realistic level; in my view, this is


a likely scenario in 2015.
QST Desktop (Quick Screen Trading)

Technical Analysis of Stocks & Commodities 43

product review

OptionStrategist.com
Part 2
McMILLAN ANALYSIS CORP.
PO Box 1323
Morristown, NJ 079621323
Phone: 800 724-1817
Fax: 973 328-1303
Email: info@optionstrategist.com
Website: www.optionstrategist.com
Price: Various products and services are
available. See website for details.

by S&C Staff
ere in the second part of this twopart review, well discuss The
Option Strategist newsletter and
other products and services offered by OptionStrategist.com.

Option strategist

newsletter
The newsletter comes out biweekly and
has an update called the hotline in between
those weeks. It is typically 12 pages long
and contains a wealth of information. It
starts out with educational material such as
an explanation of a specific strategy. There
will often be examples to help explain the
item under discussion.
The newsletter has specific areas it
covers in every publication. Following the
educational/informative feature article is a
table of follow-up actions as required for
each open position. Next is a section titled
sentiment indicators in which a stock market
outlook is given based on various technical
indicators, followed by sections on index
options & volatility skewing, extremes in
sentiment, and putcall ratios (Figure 1).
Specific trading recommendations may or
may not be given. Various relevant charts
are included, followed by a discussion of the
current state of the volatility in derivatives
markets.

Software products

OptionStrategist.com offers five different


software packages. Well look at two of
them. The first one is The Expected Return
Calculator. What it attempts to do is tell you,
44 March 2015 Technical Analysis of Stocks & Commodities

putcall ratio charts

Figure 1: putcall ratio charts. When new buy signals are generated from the putcall ratio extremes, a chart is provided in OptionStrtegist.com.

over a large number of trades, what your


expected profit or loss might be for an option position. The key statement here is
a large number of trades. Any one trade
might be a profit or a loss. It is only after a
number of trades that you can reasonably
talk about average profit or loss. There
are three inputs to the calculation. The
first, and arguably the most important,
is the historical volatility of the underlying. Volatility is free on a weekly basis
from OptionStrategist.com. Follow the
path ProductsAnalysis ToolsFree
Analysis ToolsData or go to http://
www.optionstrategist.com/calculators/
free-volatility-data. What is impressive
about the data is that the table includes
futures, indexes, and stocks.
The use of percentage in conjunction
with the composite implied volatility is
the type of sophisticated approach typical
of OptionStrategist.com because you
want to know where implied volatility is
relative to prior calculations of implied
volatility.
If you dont want to wait a week for
volatility calculations, you can subscribe
to the Strategy Zone, which supplies the
data on a daily basis, but it also includes
much more, such as trading candidates
for covered writes; naked put sales;
straddle buys; and calendar spreads.
A wide array of volatility data is also
included, along with a daily midday
market commentary; more than 200

putcall ratio charts; volatility charts; a


probability calculator; and back issues
of McMillans newsletters. The best
thing is that all of this is in the Strategy
Zone that goes for $195/year if you
sign up for a yearly subscription with
autorenewal.
The expected return calculator has
been set up to require manual inputs, and
there are several sources of data that are
free and readily available. There is no
datafeed service you need to purchase.
When you open the expected return calculator, you are presented with a screen

similar to what you see in Figure 2 that


allows you to make inputs. Under the
label securities are a couple of lines
one for the underlying and one for the
option. The volatility on the line for
the underlying is historical volatility.
The next line below is for the option,
and the volatility needed here is the
implied volatility. The option line lets
you specify a series of options so you
can see what would happen with spreads.
In this example, a -1 has been input for
the quantity of options to identify selling the option. A dropdown menu lets

Figure 2: Expected Return Calculator. Here you see the editor tab. This screen is used to provide inputs for
the option position you want evaluated. At the top are the points in time you want to determine your potential profit/loss.
Below that is the securities information. You can input either put or call and add several more options so you can evaluate
spreads. Historical volatility is used for the underlying line, and implied volatility is used for the option line.
March 2015

Technical Analysis of Stocks & Commodities 45

CHARTING THE
STOCK MARKET
The Wyckoff Method

Edited by Jack K. Hutson


208 pages, 6x9 inches,
chart illustrations, indexed
$14.95 plus shipping & handling.
ISBN: 978-0-938773-06-1

Charting The Stock Market


describes and illustrates one of the
best pioneering technical analysis
methods. This book takes the
reader step by step through the
Wyckoff method: first, the basic
principles; second, examples of the
method applied to the bond market;
third, an outline of the steps to put
the method to use. Details of the
Wyckoff method covered in this
book include:
Point & figure charting
Trends
Relative strength and weakness
Stop orders
Forecasting
Wave charts & intraday
Group stock behavior
Stock selection criteria
Price/volume chart reading &
analysis

Order toll-free: 800-832-4642


Online: www.traders.com

4757 California Ave. SW, Seattle, WA 98116 206 938-0570

FIGURE 3: Expected Return Calculator Plot. This is a standard option profit/loss graph. Assuming a lognormal
distribution of prices and using volatility, this screen lets the calculator estimate profit/loss. The black line corresponds to
the option expiration date, while the blue and purple lines correspond to the two data points from your input.

Different option trading strategies are covered


for novice and intermediate-level option traders.
you input several options, thus allowing
spreads to be created.
After inputting the data, you can choose
the plot tab from the upper left-hand
corner. This will plot the familiar option
profit/loss chart similar to what you see in
Figure 3. In the upper left-hand corner is
a legend that changes as you move your
cursor to different underlying prices.
If you are looking for another way
to arrive at implied volatility other than
through the newsletter, OptionStrategist.
com also offers the Option Calculator 2.0
(Figure 4). The inputs are straightforward,
with the primary ones being strike price,
stock price, and stock price historical
volatility. The calculator uses a BlackScholes model to calculate implied
volatility. It will also show you the option
greeks for a large combination of stock
and strike prices.

Educational materials

One of the offerings by OptionStrategist.


com is a home study video package that
46 March 2015 Technical Analysis of Stocks & Commodities

consists of 16 seminars by Lawrence


McMillan. The seminars cover novice, intermediate, and advanced option trading.
One of the approaches that McMillan uses
is to give examples, and when possible
he provides charts or diagrams to keep
the material interesting while still being
highly informative. Different option trading strategies are covered for novice and
intermediate-level option traders.

Summary

OptionStrategist.com consists of a
wealth of option-related information.
Besides offering ongoing educational
material through The Option Strategist
newsletter, there is a wealth of educational material. There are over 10 different video packages and McMillan has
also authored several books. Software
is available that lets you input your
own data so you can see the effect of
changes. All in all, its an impressive set
Continued on page 54

For this months Traders Tips, the focus is


John Ehlers & Ric Ways article in this issue,
Trading System Design: A Statistical Approach. Here, we present the March 2015
Traders Tips code with possible implementations in various software.
Code in EasyLanguage is already provided
by Ehlers & Way in their article, which S&C subscribers
will find in the Subscriber Area of our website:

Traders.com HomeS&C Magazine


S&C Article Code

The code for the Traders Tips section is posted here:

Traders.com HomeS&C Magazine


Traders Tips

(Or from Traders.com, scroll down to the current articles


section and click on the Traders Tips tab.)
The Traders Tips section is provided to help the reader
implement a selected technique from an article in this issue or another recent issue. The entries here are contributed by software developers or programmers for software
that is capable of customization.

F TRADESTATION: MARCH 2015 TRADERS TIPS CODE


In Trading System Design: A Statistical Approach in this
issue, authors John Ehlers & Ric Way outline a procedure for
the development of trading systems using a statistical approach.
In the article, they create a set of data that they analyze using
Microsoft Excel spreadsheet software. They have provided
TradeStation EasyLanguage code for an indicator to help
create the data for analysis, as well as a simple test strategy
to demonstrate the process.
To download the EasyLanguage code, please visit our
TradeStation and EasyLanguage support forum. The code for
this article can be found here: http://www.tradestation.com/
TASC-2015. The ELD filename is _TASC_StatisticalApproach.ELD.
For more information about EasyLanguage in general,
please see http://www.tradestation.com/EL-FAQ.
A sample chart is shown in Figure 1.

Figure 1: TRADESTATION. Here is an example of a simple stochastic system


applied to a daily chart of the emini S&P 500 (ES), based on John Ehlers & Ric
Ways article in this issue.

The study contains formula parameters that may be configured through the edit chart window (right-click on the chart
and select edit chart). A sample chart is shown in Figure
2.
To discuss this study or download a complete copy of
the formula code, please visit the EFS Library Discussion
Board forum under the forums link from the support menu
at www.esignal.com or visit our EFS KnowledgeBase at
http://www.esignal.com/support/kb/efs/. The eSignal formula
script (EFS) is also available for copying & pasting from the
Stocks & Commodities website at www.traders.com in the
Traders Tips area.
Eric Lippert
eSignal, an Interactive Data company
800 779-6555, www.eSignal.com

This article is for informational purposes. No type of trading or


investment recommendation, advice, or strategy is being made, given,
or in any manner provided by TradeStation Securities or its affiliates.
Doug McCrary
TradeStation Securities, Inc.
www.TradeStation.com

F eSIGNAL: MARCH 2015 TRADERS TIPS CODE


For this months Traders Tip, were providing the formula
SimpleStocTrSystem.efs based on the formula described in
John Ehlers & Ric Ways article in this issue, Trading System
Design: A Statistical Approach.

Figure 2: eSIGNAL. Here is an example of the simple stochastic system on a chart


of the S&P 500 emini futures contract (ES).
March 2015 Technical Analysis of

Stocks & Commodities 47

Highest HiC = Highest.Series(Close, StocLength);


Lowest LoC = Lowest.Series(Close, StocLength);
DataSeries Stoc = (Close - LoC) / (HiC - LoC);

for(int bar = GetTradingLoopStartBar(1); bar < Bars.
Count; bar++)
{
if (IsLastPositionActive)
{
Position p = LastPosition;
if ( bar+1 - p.EntryBar >= TradeLength )
SellAtMarket( bar+1, p, Timed );
else
if( Low[bar] < p.EntryPrice*(1.0 - PctLoss /100d) )
SellAtMarket(bar+1, p, Stop);
Figure 3: WEALTH-LAB. This chart shows the US market bubble of the 2010s on
a monthly chart of the S&P 500 index (^GSPC).

F WEALTH-LAB: MARCH 2015 TRADERS TIPS CODE


In their article in this issue, Trading System Design: A Statistical Approach, authors John Ehlers & Ric Way outline a
statistically valid procedure for the successful development of
trading systems, providing a testbed for assessing whether the
price will increase or decrease over n bars after an event.
From our point of view, it might be optimal to prove the
conclusion regarding the robustness of the example system
by using a different subset of data that includes a bear market, given that the in-sample period of 10 years used to optimize the system on was a strong bull market (Figure 3).
The code for Wealth-Lab based on Ehlers & Way's code
follows:
Wealth-Lab 6 strategy code (C#)
using System;
using System.Collections.Generic;
using System.Text;
using System.Drawing;
using WealthLab;
using WealthLab.Indicators;
namespace WealthLab.Strategies
{
public class EhlersMar2015 : WealthScript
{
private StrategyParameter paramStoc;
private StrategyParameter paramThresh;
private StrategyParameter paramLength;
private StrategyParameter paramLoss;
public EhlersMar2015()
{
paramStoc = CreateParameter(StocLength, 8, 1, 100, 1);
paramThresh = CreateParameter(Threshold, 0.3, 0.1, 0.9, 0.1);
paramLength = CreateParameter(TradeLength, 14, 1, 50, 1);
paramLoss = CreateParameter(PctLoss, 3.8, 0.5, 15.0, 0.5);
}

protected override void Execute()
{
int StocLength = paramStoc.ValueInt, TradeLength =
paramStoc.ValueInt;
double Threshold = paramThresh.Value, PctLoss =
paramLoss.Value;

48 March 2015 Technical Analysis of Stocks & Commodities

}
else
{
if( CrossOver( bar, Stoc, Threshold ) )
BuyAtMarket( bar+1 );
}
}
}
}
}

Eugene, Wealth-Lab team


MS123, LLC
www.wealth-lab.com

F NEUROSHELL TRADER:
MARCH 2015 TRADERS TIPS CODE
The simple stochastic trading system described by
John Ehlers & Ric Way in their article in this issue, Trading
System Design: A Statistical Approach, can be easily implemented with a few of NeuroShell Traders 800+ indicators.
Simply select New Trading Strategy from the insert menu
and enter the following in the appropriate locations of the
Trading Strategy Wizard:
BUY LONG CONDITIONS: CrossBelow(Stoch%K(High,Low,
Close,5),30)
LONG TRAILING STOP:

PriceFloor%(Trading Strategy,3.8)

SELL LONG CONDITIONS: BarsSinceFill>=X(Trading Strategy,14)

If you have NeuroShell Trader Professional, you can also


choose whether the parameters should be optimized. After
backtesting the trading strategy, use the detailed analysis button to view the backtest and trade-by-trade statistics for the
strategy.
You can also create another trading strategy using the center of gravity indicator referenced in the article along with a
one-period lag of the same indicator called the trigger. Both
indicators are part of Ehlers Cybernetic Analysis add-on
for NeuroShell Trader.
BUY LONG CONDITIONS: Center of Gravity > Center of Gravity Trigger
SELL LONG CONDITIONS: Center of Gravity < Center of Gravity Trigger

Figure 4: NEUROSHELL TRADER. This NeuroShell Trader chart displays the simple stochastic
trading system as well as a trading system based on Ehlers center of gravity indicator.

Users of NeuroShell Trader can go to the Stocks & Comsection of the NeuroShell Trader free technical
support website to download a copy of this or any previous
Traders Tips.
A sample chart is shown in Figure 4.
modities

Marge Sherald, Ward Systems Group, Inc.


301 662-7950, sales@wardsystems.com
www.neuroshell.com

F AIQ: MARCH 2015 TRADERS TIPS CODE


The AIQ code based on John Ehlers & Ric Ways article
in this issue, Trading System Design: A Statistical
Approach, is provided at:
www.TradersEdgeSystems.com/traderstips.htm
!TRADING SYSTEM DESIGN: A STATISTICAL APPROACH
!Author: John Ehlers, TASC March 2015
!Coded by: Richard Denning 1/12/2015
!www.TradersEdgeSystems.com
!STOCHASTIC TRADING SYSTEM FROM ARTICLE:
!INPUTS:
StocLength is 8.
Threshold is 0.3.
TradeLength is 14.
PctLoss is 3.8.
!SYSTEM CODE:
HiC is Highresult([Close], StocLength, 0).
LoC is Lowresult([Close], StocLength, 0).
Stoc is ([Close] - LoC) / (HiC - LoC).
Buy if Stoc < Threshold and valrule(Stoc >= Threshold,1).
PD is {position days}.
PEP is {position entry price}.
ExitLong if PD - 1 >= TradeLength or [Low] < PEP*(1-PctLoss/100).

Figure 5: AIQ. Here is the strategys EDS backtest summary for trading the NASDAQ
100 list of stocks over the period from 2009 through 1/13/2015.

Figure 5 shows the EDS backtest summary for trading the


NASDAQ 100 list of stocks using the authors stochastic system over the period 2009 through 1/13/2015.
Richard Denning
info@TradersEdgeSystems.com
for AIQ Systems

F TRADERSSTUDIO: MARCH 2015


TRADERS TIPS CODE
The TradersStudio code for John Ehlers & Ric
Ways article in this issue, Trading System Design: A Statistical Approach can be found at:
www.TradersEdgeSystems.com/traderstips.htm
www.TradersStudio.com Traders Resources Traders Tips

The following code file is provided in the download:


System: EHLERS_SYSTEMS: A long-only system that uses
daily data and the stochastic indicator for entries.

Figure 6 shows an equity curve for this stochastic system


trading one contract per trade of the S&P 500 full-sized futures contract from 1982 to 2014 using data from Pinnacle
Data Corp. Slippage & commission of $100 per round-turn
trade were subtracted from each trade.
'TRADING SYSTEM DESIGN: A STATISTICAL APPROACH
'Author: John Ehlers, TASC March 2015
'Coded by: Richard Denning 1/12/2015
'www.TradersEdgeSystems.com
'Stochastic trading system from article:
Sub EHLERS_SYSTEMS(StocLength, Threshold, TradeLength,
PctLoss)
Dim HiC As BarArray
March 2015 Technical Analysis of

Stocks & Commodities 49

Figure 7: NINJATRADER. This screenshot shows the SimpleStochastic strategy applied to


a daily emini S&P futures continuous chart in NinjaTrader.
Figure 6: TRADERSSTUDIO. Here is a sample equity curve trading the stochastic
system one contract per trade of the S&P 500 full-sized futures contract from 1982
to 2014.
Dim LoC As BarArray
Dim Stoc As BarArray
If BarNumber=FirstBar Then
'StocLength = 8
'Threshold = .3
'TradeLength = 14
'PctLoss = 3.8
HiC = 0
LoC = 0
Stoc = 0
End If

menu Tools Edit NinjaScript Strategy from within the NinjaTrader Control
Center window and selecting the SimpleStochastic file.
NinjaScript uses compiled DLLs that
run native, not interpreted, which provides you with the highest performance
possible.
A sample chart implementing the strategy is shown in Figure 7.
Raymond Deux and Dave Ingram
NinjaTrader, LLC
www.ninjatrader.com

HiC = Highest(Close, StocLength, 0)


LoC = Lowest(Close, StocLength, 0)
Stoc = (Close - LoC) / (HiC - LoC)
If CrossesUnder(Stoc, Threshold) Then
Buy(LE, 1, 0, Market, Day)
End If
If BarsSinceEntry -1>= TradeLength Then
ExitLong(LX_time, , 1, 0, Market, Day)
End If
If Low < EntryPrice*(1 - PctLoss /100) Then
ExitLong(LX_loss, , 1, 0, Market, Day)
End If
End Sub

Richard Denning
info@TradersEdgeSystems.com
for TradersStudio

F NINJATRADER: MARCH 2015 TRADERS TIPS CODE


The SimpleStochastic strategy presented in John Ehlers &
Ric Ways article in this issue, Trading System Design: A
Statistical Approach, has been made available for download
at www.ninjatrader.com/SC/March2015SC.zip.
Once it has been downloaded, from within the NinjaTrader
Control Center window, select the menu File Utilities
Import NinjaScript and select the downloaded file. This file
is for NinjaTrader version 7 or greater.
You can review the strategy source code by selecting the
50 March 2015 Technical Analysis of Stocks & Commodities

DETAIL FROM Figure 7

F UPDATA: MARCH 2015 TRADERS TIPS CODE


Our Traders Tip for this month is based on the
article by John Ehlers & Ric Way in this issue, Trading System
Design: A Statistical Approach. In it, the authors develop a
statistical methodology for the predictability of an eventin
this case, the crossing of a stochastic threshold level. By offsetting entry times and measuring the effect this has on overall
profitability in the intervening period given price direction, a
probability distribution function can be created.
The Updata code based on the article is in the Updata Library and may be downloaded by clicking the custom menu
and system library. Those who cannot access the library due
to firewall issues may paste the code shown here into the Updata custom editor and save it.
A sample chart implementation is shown in Figure 8.
'AStochasticSystem
DISPLAYSTYLE 2LINES
INDICATORTYPE TOOL
COLOUR RGB(0,0,200)
COLOUR2 RGB(0,0,200)
PARAMETER Stochastic Period #STOCHPERIOD=14
PARAMETER Threshold @THRESHOLD=0.3
PARAMETER Hold Period #HOLDPERIOD=14
PARAMETER Stop Loss % @STOP=3.8
NAME STOCHASTIC SYSTEM [ #STOCHPERIOD | @
THRESHOLD | #HOLDPERIOD | @STOP ]
@UPPER=0

FIGURE 8: UPDATA. Here is an example chart of the simple stochastic entry system
as applied to the cash S&P 500 index.

@LOWER=0
@STOCH=0
@ENTRYPRICE=0
FOR #CURDATE=#STOCHPERIOD TO #LASTDATE
@UPPER=PHIGH(CLOSE,#STOCHPERIOD)
@LOWER=PLOW(CLOSE,#STOCHPERIOD)
@STOCH=(CLOSE-@LOWER)/(@UPPER-@LOWER)
'STOCHASTIC ENTRY
IF HIST(@STOCH<@THRESHOLD,1) AND ORDERISOPEN=0
BUY OPEN
@ENTRYPRICE=OPEN
ENDIF
'TIME EXIT
IF ORDEROPENFOR>=#HOLDPERIOD
SELL CLOSE
ENDIF
'% STOP EXIT
IF HIST(LOW<@ENTRYPRICE*(1-(@STOP/100)),1)
SELL OPEN
ENDIF
@PLOT=@UPPER
@PLOT2=@LOWER
NEXT

Updata support team


support@updata.co.uk
www.updata.co.uk

F AMIBROKER: MARCH 2015 TRADERS TIPS CODE


In Trading System Design: A Statistical Approach in this
issue, authors John Ehlers & Ric Way present a way to find
out whether signals generated by a given indicator have a
statistical edge.
Listing 1 presents AmiBroker Formula Language (AFL)
code that produces a profitability distribution chart for a simple
statistic crossover system. One can replace the event variable
with any other system to test its statistical edge. When code is
used in AmiBrokers exploration mode, it produces an extra

Figure 9: AMIBROKER. Here is an AmiBroker exploration chart showing a sample


profitability distribution for the stochastic indicator crossing under 0.2 using hourly SPY
data. Note that hourly data and a significantly larger dataset produces a distribution
that more closely resembles a classic bell curve than the chart that was shown in
Ehlers & Ways article.

tab(s) with a profitability distribution chart for each symbol


separately. To use the formula, type the code into the formula
editor and press send to analysis to perform an exploration.
As you can see from Figure 9, using more data (in this case,
hourly) produces a smoother chart than what was presented
in the article.
LISTING 1
Range = 10;
HiC = HHV( Close, Range );
LoC = LLV( Close, Range );
Stoc = ( Close - LoC ) / ( HiC - LoC );
Lookback = Range - 1;
Event = Ref( Cross( Stoc, 0.2 ), -Lookback );
PctGainRange = 3; // defines % gain range for X axis
FuturePrice = ROC( Close, Lookback );
// keep values in range
FuturePrice = Min( PctGainRange, Max( -PctGainRange, FuturePrice ) );
// map range to to 0..100
FuturePrice = Round( 100 * ( FuturePrice + PctGainRange )/
( 2 * PctGainRange ) );
PredictBin = 0;
for( i = 0; i < BarCount AND BarCount > 100; i++ )
{
if( Event[ i ] ) PredictBin[ FuturePrice[ i ] ]++;
}
chartname = "Probability distribution " + Name();
XYChartSetAxis(chartname, "[%gain]", "[n]" );
for( i = 0; i < BarCount AND i <= 100; i++ )
{
XYChartAddPoint( chartname, "",
( i * 2 * PctGainRange / 100 - PctGainRange ),
PredictBin[ i ], colorGreen );
}

Tomasz Janeczko, AmiBroker.com


www.amibroker.com
March 2015 Technical Analysis of

Stocks & Commodities 51

FIGURE 10: EXCEL, Event testing controls and trading controls. This shows the specification for one stochastic event definition on the left under the heading
predictive event testing controls.

F MICROSOFT EXCEL:
MARCH 2015 TRADERS TIPS CODE
In their article in this issue, Trading System Design: A Statistical Approach, authors John Ehlers & Ric Way show us a
statistical approach to determine if an event we can define to
a computer has any value as a future price predictor.
Once we have determined the size and shape of such an
event, we can build trading rules around the event and construct a system to follow those rules.
In the article, the authors use a simple stochastic crossunder as the event and look ahead a number of bars to determine
a percentage change after the event.
Run this logic against 10 or more years of historical data,
accumulate the events you find as well as the percent change
values associated with the events, and you can then use a
center of gravity (weighted average) calculation to assess the
predictive power of the event. The premise here is that the

more positive the CG value, the better your event is likely to


be for trading long positions.
Figure 10 shows the specification for one such stochastic event definition on the left under the heading predictive
event testing controls. The corresponding event count by
price gains chart with a marker for the calculated center of
gravity is shown under the price chart.
Controls specifying a slightly different size and shape of
our event to be used in the simplified trading system appear
under the heading trading system controls. A summary of
the trading results for this control set can be found in the
lower-left corner.
Calculations for predictive event testing and center of gravity determination can be found in the columns to the right of
the price chart, as shown in Figure 11.
Figure 12 shows the calculations for the trading system.
These are located in columns yet farther to the right of those

FIGURE 11: EXCEL, Predictive Event Computations. Calculations for predictive event testing and center of gravity determination can be found in the columns to
the right of the price chart.

52 March 2015 Technical Analysis of Stocks & Commodities

shown in Figure 11.


As described in the article, selecting the correct combination of specifications for our predictive event
can be a trial & error process. In the
spreadsheet I am providing, I have
included a rudimentary mechanism
to assist with the tedious business of
evaluating an array of event parameter choices to find the combination
that generates the most promising
FIGURE 12: EXCEL, Trading decisions. This shows the calculations for the trading system.
center of gravity value.
Figure 13 shows this mechanism on
the PredictiveEventScenarioTester tab of the
workbook. Filling in the
values in blue defines the
envelope of events we
want to look at. In this
case, we are set up to look
at all stochastic lookback
lengths from eight to 18
bars; use threshold values
from 0.1 to 0.35 in steps
of 0.05; and try lookahead periods from five
to 18 bars, inclusive.
When you click the
13: EXCEL, Finding a Good Set of Event Parameters. On the PredictiveEventScenarioTester tab of the workrun button, the VBA code FIGURE
book, I have included a rudimentary mechanism to assist with evaluating an array of event parameter choices to find the combination
behind the button cycles that generates the most promising center of gravity value.
through all possible combinations of these values
one at a time. The results
area keeps track of the
looping process.
The results are sorted
from highest to lowest
on the center of gravity
value, and the three control values for this best
setting are used to set the
CalculationsAndCharts
(Figure 10) predictive
event controls.
The TradingSystem
Evaluator tab shown in
Figure 14 serves the same FIGURE 14: EXCEL, Finding a Good Set of Event Parameters (Contd.). The TradingSystemEvaluator tab serves
purpose for evaluating the same purpose for evaluating sets of trading system controls. Here, control values from the best equity value row are used to
sets of trading system set the CalculationsAndCharts trading system controls.
controls. Control values
from the best equity value row are used to set the Calcula- fications as being their best choice. I think one of the reasons
tionsAndCharts trading system controls.
for this difference can be found in the trading summary in
Trading results for a given scenario can be seen on the the bottom left of Figure 10: Not every event/entry signal
transaction summary tab shown in Figure 15.
participates in a trade. Many are ignored because a trade is
You will find that the automated event evaluator and the already in progress. So while each of these ignored events
trading evaluator usually come up with different event speci- contributed to a center of gravity computation, they do not
March 2015 Technical Analysis of

Stocks & Commodities 53

contribute independently to the equity value. Moreover, stoploss processing of a trade may prevent an event entry from
reaching the potential contribution that was recognized in the
event evaluator CG calculation.
The spreadsheet file for this Traders Tip (EventPredictabilityTester.xlsm) can be downloaded from www.traders.
com in the Traders Tips area. To successfully download it,
follow these steps:

Right-click on the Excel file link (EventPredictabilityTester.


xlsm), then
Select save as or save target as to place a copy of the
spreadsheet file on your hard drive.
Ron McAllister
Excel and VBA programmer
rpmac_xltt@sprynet.com

FIGURE 15: EXCEL, Trade Details. Trading results for a given scenario can be seen on the transaction summary tab.

PRODuCT REvIEW /
OPTIONSTRATEGIST.COM
Continued from page 46

of information and tools to make you a


better option trader.

FURTHER READiNg

Gopalakrishnan, Jayanthi [2002].


Options Volatility With Lawrence
McMillan, interview, Technical
Analysis of StockS & commoditieS,
Volume 20: February.
S&C Staff [2015]. OptionStrategist.
com (Part 1), product review, Technical Analysis of StockS & commoditieS, Volume 33: February.
OptionStrategist (McMillan Analysis
Corp.)
See Editorial Resource Index

FIGURE 4: OPTION CALCULATOR 2.0. Inputs are made to the top two lines, with the result being a matrix of premium
prices for put & call strike prices and stock price combinations. If you click on any one cell of the matrix, the greeks shown
below will change. The implied window (seen as the window overlaying the lower two thirds of this screen capture) is
used to calculate implied volatilities. A series of six input rectangles are there for you to input premium prices for various
strikes depending on whether you have chosen the call or put radial in the upper left. After making the inputs, the matrix
is populated with implied volatilities and the greeks.

54 March 2015 Technical Analysis of Stocks & Commodities

NEW WEBSITE FOR MARKET


DATA ANALYSIS
John Ehlers, a Contributing Editor to
this magazine, has announced the release
of his new MesaSoftware.com website.
MESA Software specializes in analyzing
market data using advanced DSP techniques. He takes a scientific approach in
developing filters, indicators, and trading
systems and then uses statistics to verify
performance. Ehlers stated mission is to
provide cutting-edge scientific tools for
traders. Among these tools are technical
papers and seminars available for free
download at the website. His MESA Phasor Futures trading strategy is described
at his StockSpotter.com website.
Editors note: Readers will find an
article by John Ehlers & Ric Way in this
issue, Trading System Design: A Statistical Approach, beginning on page 28.

MesaSoftware.com, StockSpotter.com
Stock-Picking Service Adds
Option TRADING
With subscribers in 50 countries, Gorilla
Trades is a global online subscriber
service since 1999 providing news and
professional insights into the stock market. Stock picks are listed regularly on a
menu of both new and existing investments for consideration, based on subscribers individual investment objectives
and risk tolerance. The service provides
updated stop-loss levels and upside targets

weekly. Subscribers are directed to use


the five-times-weekly subscriber portfolio
named GorillaPicks as a guideline for
investment decision-making. More than
6,000 stocks are sifted through daily to
match each of the 14 technical indicators
for potential growth. Recently, an option
idea of the week feature was introduced
for more aggressive investors. A 30-day
free trial is available.

GorillaTrades.com
NEW TREND SYSTEM
Trading Alchemy has released its new
Alchemy TrendCatcher System, which
includes tools for entry triggers, bigger
trend filters, and market reversal alerts.
Alchemy TrendCatcher seeks to identify market trends and displays what it
construes to be low-risk entry points. Its
self-adaptive trailing stops seek to help
minimize the initial risk while staying
with the trend for longer moves. The
built-in trend detector measures market
strength. With its new trend filter, the
trend-confirmation method seeks to help
eliminate whipsaws while filtering out
a significant amount of noise when the
market is in a nontrending, consolidating
phase. It attempts to capture a majority of
big market moves.
The systems new market reversal alerts
generate warning signals that tell the user
when to tighten up stops as well as when to
exit all positions. The added entry triggers
confirm momentum changes, seeking to
increase the probability of entering into
the right direction of the market.

giving them access to more than one million


ready-to-use strategies. Each of the strategies are complete systems with entry, exit,
and management rules. Bloodhound allows
the user to vet the strategies on 27 years of
historical data and a set of historical metrics
to ensure the strategy will be robust going
forward. Users can choose to implement
any of the strategies via direct integration
with optionsXpress, a subsidiary of Charles
Schwab & Co. Users are also able to modify
any strategy or develop their own using a
point & click interface.
A free trial is available as well as a
discount for the professional subscription
level by using the promomotion code
bh2015.

BloodhoundSystem.com
PACKAGES of INDICATORS
PivotHunter.com was formed by seven
traders with more than 50 combined years
of experience in chart analysis. The indicators offered by PivotHunter are designed
to discern action between price velocity
and order flow. Indicators are named after fictitious scenes with characters that
represent the unfolding chart action (for
example, three indicator packages include
sheriffs, kings, or cavalry). Elements of
analysis include money flow, velocity
checks, and a heatmap. A live charting
room is available.

TradingAlchemy.com
collection of strategies
Bloodhound Investment Research states
its goal is to give users the tools to turn them
into their own hedge fund manager by
March 2015

PivotHunter.com

Technical Analysis of Stocks & Commodities 55

FUTURES LIQUIDITY

rading liquidity is often overlooked as a key technical


measurement in the analysis
and selection of commodity
futures. The following explains how to
read the futures liquidity chart published by Technical Analysis of Stocks
& Commodities every month.

very high volumes. The greatest number


of dots indicates the greatest activity;
futures with one or no dots show little
activity and are therefore less desirable
for speculators.
Courtesy of CBOT

Commodity futures

The futures liquidity chart shown below is intended to rank publicly traded
futures contracts in order of liquidity.
Relative contract liquidity is indicated
by the number of dots on the right-hand
side of the chart.
This liquidity ranking is produced by
multiplying contract point value times
the maximum conceivable price motion
(based on the past three years historical
data) times the contracts open interest
times a factor (usually 1 to 4) for low or

three-year period. Thus, all numbers in


this column have an equal dollar value.
Columns indicating percent margin
and effective percent margin provide
a helpful comparison for traders who
wish to place their margin money efficiently. The effective percent margin
is determined by dividing the margin
value ($) by the three-year price range of
contract dollar value, and then multiplying by one hundred.

Stocks

All futures listed are weighted equally


under contracts to trade for equal dollar profit. This is done by multiplying
contract value times the maximum possible change in price observed in the last

Trading liquidity has a significant effect on the change in price of a security. Theoretically, trading activity can
serve as a proxy for trading liquidity
and equals the total volume for a given
period expressed as a percentage of the
total number of shares outstanding. This
value can be thought of as the turnover
rate of a firms shares outstanding.

Trading Liquidity: Futures

Commodity Futures
Exchange % Margin
Effective
Contracts to
Relative Contract Liquidity

% Margin Trade for Equal




Dollar Profit
E-Mini S&P 500
GBLX
3.8
10.2
5
>>
10-Year T-Note
CBOT
1.1
20.8
26
>
T-Bond
CBOT
2.3
15.3
9

Ultra T-Bond
CBOT
2.5
11
5

Euro FX
CME
1.7
8.1
6

Japanese Yen
CME
2.6
4.6
3

E-Mini Nasdaq 100


GBLX
2.6
6.3
5

Corn
CBOT
13.8
11.9
8

Russell 2000 Mini


ICEUS
3.8
10
4

S&P 500 Index


CME
3.8
10.2
1

5-Year T-Note
CBOT
0.6
17.4
44

Gold
COMEX
7
18.2
4

Soybeans
CBOT
9.3
11.3
5

Crude Oil WTI


NYMEX
10.7
7.5
3

Sugar #11
ICEUS
9
13
15

Gasoline RBOB
NYMEX
11
6.8
2

Natural Gas
NYMEX
8.7
6.8
5

Australian Dollar
CME
2
6.1
7

DJIA mini-sized
CBOTM
3.1
10
7

Heating Oil
NYMEX
8.7
8.4
3

Wheat
CBOT
12.1
15.8
9

E-Mini S&P Midcap


GBLX
3.1
8.1
3

British Pound
CME
1.4
10.4
15

2-Year T-Note
CBOT
0.1
23.2
144

Canadian Dollar
CME
1.3
5.2
9

Cotton #2
ICEUS
8.6
12.4
9

Soybean Meal
CBOT
8.3
11.8
8

Soybean Oil
CBOT
8.6
11.3
13

Coffee
ICEUS
8
20.8
8

Nasdaq 100
CME
2.6
6.3
1

Swiss Franc
CME
1.5
10.7
9

CBOT
Chicago Board of Trade, Division of CME
U.S. Dollar Index
ICEUS
1.4
8.7
12

CFE
CBOE Futures Exchange
CBOE S&P 500 VIX
CFE
6.2
14.7
22

CME
Chicago Mercantile Exchange
Crude Oil Brent (F)
NYMEX
10.3
6.2
2

COMEX
Commodity Exchange, Inc. CME Group
Eurodollar
CME
0.1
53
296

GBLX
Chicago Mercantile Exchange - Globex
Hard Red Wheat
KCBT
8.7
13.4
10

ICE-EU
Intercontinental Exchange-Futures - Europe
Lean Hogs
CME
4.9
5.7
8

ICE-US
Intercontinental Exchange-Futures - US
Live Cattle
CME
2.2
8.3
12

KCBT
Kansas City Board of Trade
Mexican Peso
CME
6.5
28.4
24

MGEX
Minneapolis Grain Exchange
Cocoa
ICEUS
6.4
20.8
21

NYMEX
New York Mercantile Exchange
DJIA
CBOT
3.1
10.2
3

Palladium
NYMEX
6.7
23.4
8

Spring Wheat
MGEX
11
14.5
8


30-Day Fed Funds
CBOT
0
89.4
823

1503
Canola
WCE
5.9
11.5
40
Trading Liquidity: Futures is a reference chart for speculators. It compares markets Relative Contract Liquidity places commodities in descending order according to
according to their per-contract potential for profit and how easily contracts can be bought how easily all of their contracts can be traded. Commodities at the top of the list are easior sold (i.e., trading liquidity). Each is a proportional measure and is meaningful only est to buy and sell; commodities at the bottom of the list are the most difficult. Relative
Contract Liquidity is the number of contracts to trade times total open interest times a
when compared to others in the same column.
The number in the Contracts to Trade for Equal Dollar Profit column shows how volume factor, which is the greater of:
many contracts of one commodity must be traded to obtain the same potential return
In volume
1 or exp
2
as another commodity. Contracts to Trade = (Tick $ value) x (3-year Maximum Price
In 5000
Excursion).

56 March 2015 Technical Analysis of Stocks & Commodities

Free Information From Advertisers


Advertiser

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Stocks & Commodities

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StockCharts.com

Software

How to reach us
For questions, address changes, or
ordering information for Technical
Analysis of Stocks & Commodities
magazine and its online publications:

02, 63

Store.Traders.com, Traders.com

NinjaTrader.com/Commissions

Editorial Resource Index


Microsoft Excel . . . . . . . . . . . . . . . . . 20

AIQ . . . . . . . . . . . . . . . . . . . . . . . . 49

QST Desktop (Quick Screen Trading) . . . . . . 23

TradersStudio . . . . . . . . . . . . . . . . . . 49

Intrendstocks.com . . . . . . . . . . . . . . . 25

NinjaTrader . . . . . . . . . . . . . . . . . . . 50

TradeStation . . . . . . . . . . . . . . . . . . . 29

updata . . . . . . . . . . . . . . . . . . . . . . 50

StockSpotter.com . . . . . . . . . . . . . . . 31

AmiBroker . . . . . . . . . . . . . . . . . . . . 51

MESASoftware.com . . . . . . . . . . . . . . 31

www.MetaQuotes.net . . . . . . . . . . . . . 60

StockNewsSentiment.com (Dragonfish LLC) . 34


www.BuyDontHold.com . . . . . . . . . . . . 36
Toms Trading Room, LLC . . . . . . . . . . . 42
OptionStrategist.com . . . . . . . . . . . . . 44
eSignal (Interactive Data) . . . . . . . . . . . . . 47
Wealth-Lab . . . . . . . . . . . . . . . . . . . 48
Neuroshell Trader (Ward Systems Group) . . . 48

For more information about our advertisers, go to Traders.com/reader where


you will find the alphabetized list of this months advertisers. For reference, the
list is also printed above along with the corresponding page number for each ad.
Just follow the simple directions below and the advertisers will get your requests
the same day!
Step 1: Go to Traders.com/reader and
scroll through the list of our current months
advertisers.

Or write to us at:
4757 California Ave. SW,
Seattle, WA 98116-4499.

Do your magazines arrive tattered


and torn? Polybagging of magazines
(domestic delivery) is available for
$6/year.
Single back issues from the current
year (subject to availability) are $8
prepaid. Subscribers have access to
our digital archive of all past articles.
Individual articles can be purchased
from the Online Store at our website,
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Editorial feedback
We always want to know more about
the needs of our readers: What kinds of
articles would you like to see more of?
What do you find useful? Address your
written questions and comments to editor@traders.com or to: Editor, Stocks
& Commodities, 4757 California Ave
SW, Seattle, WA 98116-4499. Sorry, we
cannot perform research on individual
financial questions not related to this
magazine and we cannot respond to
all mail. Letters or emails containing
questions or information that other
readers may enjoy or that relate to
our articles or technical analysis topics may be published in our Letters to
S&C column.
Join us on Facebook
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and Advertisers Indexes, go to: Traders.com/reader/. These indexes are
published solely as a convenience. While every effort is made to maintain
accuracy, last-minute changes may result in omissions or errors.

March 2015

Technical Analysis of Stocks & Commodities 57

The following selection of book descriptions represents a sampling of recent book


releases in the investing field. Books described here may be from some of the major book publishers as well as some independent book publishers. These are not
critical reviews or editorial evaluations, but rather a brief look at the book marketplace to help keep readers up to date on new or recent book offerings.

Doug Kass On The


Market: A Life On
TheStreet (44 pages, $29.95 hardcover, 2014, ISBN 9781-118-89298-5) by
Douglas A. Kass
with a foreword by
James J. Cramer,
published by Wiley.
This book offers investment advice and
guidance from this renowned trader. Kass
distills his years of experience as a hedge
fund manager and infamous short seller
to share the theory, technique, and intuition that built his reputation and his portfolio. Anecdotes about interactions with
Wall Streets most famous names, including Warren Buffett, Jim Cramer, and Leon
Cooperman, highlight tricks of the trade,
value investing insight, and thoughts on
shorting the market. Kass is a CNBC regular and was a 2013 Buffett Bear roundtable
participant. In this book, Kass lists things
to know when evaluating a possible long or
short investment, and things you may not
be doing to optimize your portfolio. He also
describes how he thinks a stock should be
properly shorted and discusses what fund
managers dont often discuss.
www.wiley.com

No One Loves Your Money Like You


Do: The Ultimate Retirement Planning
Guide For Business Owners And Private
Practitioners (256 pages, $25 softcover, 2014, 978-0-071-83936-5) by James
Jackson, published
by McGraw-Hill. This
book provides retirement investing advice for high-networth professionals
such as physicians,
attorneys, and entrepreneurs, who may
enjoy a good income
and nest egg but who may have large, illiquid assets in the form of their practice as

well as possible partnership agreements


to navigate. Jackson distills his decades of
experience as a Certified Financial Planner
(previously a practicing dentist) into practical, friendly advice for those who need a
hand in planning their retirement.
mhprofessional.com

The Intelligent Option Investor: Applying


Value Investing To The World Of Options
(304 pages, $45 hardcover, 2014, ISBN
9780071833653) by
E r i k Ko b aya s h i Solomon, published
by McGraw-Hill Professional. A company's worth is precisely the amount of
wealth it will generate
on behalf of its owners over its economic life. Using this principle as a touchstone,
Kobayashi-Solomon shows that in the vast
majority of cases, valuing a stock requires
the answer to only three questions: How
fast will revenues grow? How efficiently
will the firm translate revenues into profits?
What proportion of the profits needs to be
reinvested in the short term, and how much
will those investments help owners in the
medium term? Kobayashi-Solomon is the
founder and principal of IOI LLC and the
director of research for YCharts Inc. Previously, he served as a market strategist for
Morningstar and as co-editor of the Morningstar OptionInvestor newsletter. In addition to publishing sector and stock-specific reports for YCharts, he has expertise in
corporate valuation, option investing strategies, and risk-control issues.
mhprofessional.com

Dual Momentum Investing: An Innovative


Strategy For Higher Returns With Lower
Risk (216 pages, $50 hardcover, November 2014, ISBN 978-0071849449) by Gary
Antonacci, published by McGraw-Hill Professional. Dual Momentum Investing details the authors own momentum invest-

58 March 2015 Technical Analysis of Stocks & Commodities

ing method, which


combines US stock,
non-US stock, and
aggregate bond indexes into a formula
designed to increase
profits and lower risk.
The model he presents combines relative-strength momentum and absolute momentum to try to
take advantage of intramarket trends while
avoiding large drawdowns. His methodology, which he supports with research, is designed to pick up on major changes in relative strength and market trend. The book
describes the various forms of price momentum and why they work. Antonacci has
expertise in modern portfolio theory and
optimization. In 1990, he founded Portfolio
Management Consultants, which advises
private and institutional investors on asset
allocation, portfolio optimization, and advanced momentum strategies.

http://dualmomentum.net,
http://mhprofessional.com

Mystifying Square, Divine Proportions: Natures Black Box (276 pages, $150 ebook,
November 2015, ISBN 9781742984827)
by Pauline NovakReich, published by
Port Campbell Press.
This volume traces
W.D. Ganns time
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March 2015

Technical Analysis of Stocks & Commodities 59

AT THE CLOSE
overall direction of price movement and can be applied to charts of any time frame. Generally, when
the tendency and pressure of a market is to the upside,
the market will be higher than the SMA. The 90-period
SMA is a great technical analysis tool when it comes
to gauging the overall price movement. If the market
moves above it on a daily chart, you would look for
a strategic entry point that is in line with this type of
price movement.
Once you are confident of the direction of the FIGURE 1: GOING SHORT. A bearish candle opened above but closed below the SMA(30). The following
market, you need to employ the proper entry tactic day, a short entry was made.
to play the market. For part-time traders, its good
to move to a higher time frame chart even though
the higher time frame chart may generate fewer
trading signals.

www.metaquotes.net

Continued from page 62

Steps in using the strategy

Step 1: Glance at your chart and identify the supply


& demand zones. These are areas that price has tested
and retested at least three times in the past. The smart
money generally pays attention to these zones. They
watch these levels and react to them.
Step 2: Follow only the line of least resistance. This
will stack the odds in your favor and will increase the
probability of your survival. For example, in a bear FIGURE 2: BUYING THE BULLISH USDCAD. A trigger candle opened below the SMA(30) and later closed
market, you would orient yourself with the bears, above it. On the following day, a long position was opened. You can see that a demand zone has been marked
because that would be the line of least resistance.
below the entry scene. The target was hit on the third day.
Step 3: Be aware of the factors that contribute to reliable signals and how to take advantage of those signals. You also
need to limit losses with stops, since trades can move against you.
It is important that you not overcomplicate things when looking
for entry signals. Since youre trading part time, your objective
should be to spend less time analyzing the markets.

Details of the strategy


Strategy type: Trend-following
Suitability: Part-time traders
Time horizon: Daily charts
Indicator 1: 30-period SMA
Indicator 2: 90-period SMA

Interpretation of formation
of indicators: A bull market is
identified when the 30-period
SMA is above the 90-period
SMA. The logic is reversed
for a bear market.

Long entry: In a bull market, when the price has gone below the
30-period SMA, you would need to wait for price. (I use candlestick charts, so I wait for a candle to close above the SMA before
going long.) This candle must be of considerable length, but not
too long. I look for a bullish engulfing candle without shadows,
commonly referred to as marubozu. If it opens below the SMA
(30) and closes above it, Ill ignore the signal. But when a bullish
candle with shadows opens below the shorter SMA and closes
above it, Ill pay attention to the signal.
Short entry: In a bear market, when the price has moved above
the SMA(30), you would need to wait for a candle to close below
the SMA(30) before going short. Again, this candle must be of
considerable length. For example, when a bearish marubozu candle
opens above the shorter SMA and closes below it, Ill ignore the
60 March 2015 Technical Analysis of Stocks & Commodities

signal. But when a bearish candle with shadows opens above the
shorter SMA and closes below it, then Ill pay attention to it.

Instruments: If you trade the currency markets, you can sift through
30 pairs and crosses to find reliable signals. I recommended trading
pairs and crosses with a spread of 15 pips or less.
Stop-loss: When going long, put a stop at the low of the trigger
candle. Conversely, when going short, put a stop at the high of
the trigger candle.
Take profit: Set an initial target for each trade. If youre trading
forex, then set it at 300 pips. Since this is not a short-term trading
system, you would not need to go for small profits. In some cases,
some moves may be significant enough, giving you a nice gain. It
is best to leave an open position until an exit condition is met.
Exit rule: Make use of optimal breakeven and trailing stops.
This exit rule takes you out of an unfavorable position. You
can also adapt it to make you stay in a risk-free profitable trade
while you run your gains.

Some recent trades

To help you better understand this trading method, I


have provided some examples. The SMA(30) is the
blue line and the SMA(90) is the green line. I have
identified the supply & demand zones with the two
horizontal lines. The red vertical line on the left shows where
I took a signal, which is placed on the candle that serves as a
trigger. The red vertical line on the right shows where I made an
exit. I didnt consider spreads in any of these examples.

AT THE CLOSE
Example 1
On November 14, 2011, a bearish candle opened
above but closed below the SMA(30) on the daily
chart of the EURUSD (Figure 1). The following day,
a short entry was made. The supply zone is marked
above this candle by two parallel horizontal red lines.
Some candles which preceded this trigger candle had
repeatedly tested this area.
Instrument: EURUSD
Order: Sell
Entry date: 11/15/2011
Entry price: 1.3600
Stop-loss: 1.3792
Trailing stop: 1.3450

Take profit: 1.3300


Exit date: 11/25/2011
Exit price: 1.3300
Status: Closed
Profit/loss: 300 pips

FIGURE 3. CAPITALIZING ON THE BEARISH EURAUD. In early November 2011, the SMA(30) crossed
below the SMA(90). About 10 days later, a bearish candle triggered a short signal and the EURAUD was
sold short on the following day.

Example 2
On September 19, 2011, on the daily chart of the USDCAD, a trigger candle opened below the SMA(30)
and later closed above it (Figure 2). On the following
day, I opened a long position. I identified a demand
zone below the entry point. The target was hit on
the third day.
Instrument: USDCAD
Order: Buy
Entry date: 9/20/2011
Entry price: 0.9900
Stop-loss: 0.9805
Trailing stop: 1.0050

Take profit: 1.0200


Exit date: 9/22/2011
Exit price: 1.0200
Status: Closed
Profit/loss: 300 pips

FIGURE 4: TAKING A LOSS ON THE NZDUSD. A trigger candle was formed on May 20, 2011 and a long
trade was opened on the following day. The market reversed and hit the stop-loss before it went in the
expected direction.

Example 3
In early November 2011, the SMA(30) crossed below the SMA(90) on the daily chart of the EURAUD (Figure
3). More than 10 days later, a bearish candle triggered a short
signal and I sold short the EURAUD on the following day. The
supply zone is well above the entry point, and that suggested
a strong short signal.
Instrument: EURAUD
Order: Sell
Entry date: 11/30/2011
Entry price: 1.3250
Stop-loss: 1.3469
Trailing stop: 1.3100

Take profit: 1.2950


Exit date: 12/21/2011
Exit price: 1.0200
Status: Closed
Profit/loss: 300 pips

Example 4
There are times when this strategy may not work, in which
case youll have to honor the stop-loss and never run the loss
beyond your initial stop. A trigger candle was formed on May
20, 2011 on the daily chart of NZDUSD (Figure 4), and I opened
a long trade the following day. The market reversed and hit the
stop-loss before it went in the expected direction. If the stop
was wider I may not have been stopped out and instead would
have profited handsomely. But as a matter of discipline, never
widen your stop, because a reversal can be the beginning of a
long-term move in the opposite direction. Instead, take your
loss and look forward to the next trade.
Instrument: NZDUSD
Order: Buy
Entry date: 5/23/2011
Entry price: 0.7930
Stop loss: 0.7904
Trailing stop: N/A

Take profit: 0.8230


Exit date: 5/23/2011
Exit price: 0.7904
Status: Closed
Profit/loss: -26 pips

Conclusion

Trading involves making swift decisions. The minute


you start hesitating, you overanalyze and are unable
to place your trades at the right time. The sooner
you see a good signal on your chart, the sooner you
should be able to react and open a position. The more
complicated you make a trading signal, the more analysis you
would need to do before you can open a position.
To emerge as a consistently surviving trader, you need to put
your investments to good use. You need to constantly assess
data, analyze it, and do something sensible out of that. In the
end, you are responsible for your decisions, and the more time
you spend doing this, the more competent you will become. The
strategy I have described here is simple and worth trying.
Azeez Mustapha is a professional forex trader, an analyst at
instaforex, a blogger at ADVFN.com, and a freelance author.
His articles have been published at itulglobalforex.blogspot.
com, and in TRADERS magazine. He can be reached via email
at atazeez.mustapha@analytics.instaforex.com.

Further reading

Mustapha, Azeez [2014]. Beating The Currency Markets,


Technical Analysis of Stocks & Commodities, Volume
31: September.
[2014]. Recovering Your Fortune, Technical Analysis
of Stocks & Commodities, Volume 32: June.
Metaquotes.net
March 2015

Technical Analysis of Stocks & Commodities 61

AT THE CLOSE
The strategy and

Dont Quit Just Yet

Play The Markets


And Keep Your Day Job
Not ready to be a full-time trader? Heres a high-probability, part-time trading strategy
that will help you master the markets before you commit to it full time.

To

be a winning trader, you need to master a discrete edge. But how do you gain that
edge, especially if you are a part-time trader? Whenever you analyze the markets
objectively, each trade you make will be of some benefit. Some of the most competent analysts are able to pinpoint winning signals constantly and control risk. Your
ability to sight winning conditions is what will make a world of difference.

Can you trade and keep your day job?

Some traders maybe youre one of them keep their jobs while using trading systems
that allow them to trade on a part-time basis. Such traders would not use short-term strategies,
since that would require that they stay glued to their screen most of the day. The trading
systems that are well suited to part-time traders are usually longer term in nature.
Even those who have transitioned to trading full time have realized that they do not
necessarily have to spend more time trading than when they were trading part time. True,
there are part-time traders who make as much money as full-time traders; in fact, some
even make more than full-time traders. In addition, some traders mindsets prohibit them
from watching their computer screen all day long since they may go livid watching their
fortunes contract and expand.

by Azeez Mustapha
62 March 2015 Technical Analysis of Stocks & Commodities

The strategy I am going to discuss is


one I have applied to the forex markets. It requires charts of a time frame
higher than one or 30 minutes since
it is designed for those who trade on
a part-time basis. Youll notice I use
supply & demand zones in this system.
The concept of supply & demand zones
may be unfamiliar to you, but its not
necessary to know it to make trading
decisions. The zones are merely guidelines that you will be able to visually
identify on a chart.
Part-time traders should examine major moves and conscientiously anticipate
high-probability trades so they can benefit from those moves. The various price
zones may be used as a compass to assist
you in locating high-probability signals
and exit areas. Perceiving the overall
direction of the market is invaluable.
For example, in a northbound market,
if you had entered a long position at
the previous peak you would be ahead.
Similarly, entering a short position at the
previous trough of a southbound market
will put you ahead.
Whenever a consolidation zone materializes, its a good idea to stay out of
the markets. This is also true when a
countertrend move occurs. One of the
earliest signals of a countertrend move
is the violation of a crucial price zone.
When that happens, its an indication
that the market may reverse or it could
result in a state of price equilibrium.
Although this is nothing unusual, it is
necessary for you to be confident about
the general direction of price moves.
Of course, not all positions would go
in the forecasted direction, but having
a system that requires you to spend
a short period of time analyzing and
making decisions is something well
suited for the part-time trader.

Chaotic hullabaloo

The simple moving average (SMA)


sometimes gets distorted because of erratic data. This would normally indicate
that the sellers are dominant, but that
could quickly change. You need to be
aware of such erratic movements in data
so as not to be caught unaware.
The SMA is useful in gauging the
Continued on page 60

WELDER: PHOTOSTOCK10/PLAN POLE: WELF AARON/COLLAGE: nikki morr

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