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Wiser Trader Stocks and Options Newsletter ______________________________________________________________________________
Issue No. 66 February 13, 2006 Prescott, Arizona Systems@WiserTrader.com ______________________________________________________________________________
1.0 Trading
The number of periods for the Williams %R has been increased from 10 periods to 28 periods to reflect a longer-term view as the market is likely to remain choppy for a while.
1.1 Settling In
Market performance is illustrated by the S&P 500 Index in Figure 1. In spite of recent choppiness and good volume, the rising wedge pattern continues to hold.
FIGURE 1
1.2 Trading with the Market
It was pointed out earlier how bull market health can be measured by the relative strength of risk takers as compared with more conservative investors. Risk takers are more interested in NASDAQ stocks while the conservative investor has more interest in large cap stocks in the S&P 500. The premise was that a healthy bull market is characterized by the NASDAQ percentage gains outpacing those of the S&P 500. The percentage change in the NASDAQ and S&P500 are plotted in Figure 2 on the left axis. Notice how they move in tandem with minor periodic changes in the distance between them. When they rise, the NASDAQ rises faster than the S&P 500. As they decline, the NASDAQ declines faster than the S&P 500. The NASDAQ changing faster than the S&P 500 directly affects the slope of the QQQQ to SPY ratio. The QQQQ/SPY ratio is plotted on the right axis.
FIGURE 2
The QQQQ/SPY ratio is quite erratic from day to day and is difficult to use as a trading guide. A simple modification can be made for short-term trading by plotting the daily change in the ratio, which is its first derivative d(Q/S), along with the 3-day average d(Q/S)_avg3, instead of the ratio itself. The first derivative and it 3-day average are plotted in Figure 3 using data from the right half of Figure 2.
The trading value of this information is found when one attempts to trade in the same direction as the major averages. When the first derivative and its 3-day moving average cross the zero axis, it is an indication that the NASDAQ (or QQQQ) is changing faster than the S&P 500 (or SPY). Consequently, the percentage change in both the NASDAQ and S&P 500 are subsequently seen to continue further in their current direction.
The rising of both lines above zero signals it is a good time to enter short-term trades on the long side, as long as the most recent move for NASDAQ and S&P 500 were both upward. More precisely, the derivative will trigger by crossing zero in a substantial manner while the 3-day average moving across zero is a confirmation. The trade remains open as long as both lines remain above zero. When the first derivative turns sharply back toward zero, it is time to get out of the trade. In many cases, this last signal gets you out of a long trade just before the NASDAQ and S&P 500 both drop substantially. However, there are cases of false signals caused by unpredictable 1-day spikes.
A similar set of reasoning can be applied for making trades on the short side when the most recent moves for NASDAQ and S&P 500 have been downward. When the first derivative and its 3-day moving average dip below zero, the major averages decrease further.
FIGURE 3
This technique is designed to let one know when major averages are continuing in the direction of trade or turning or against it. Right now, the first derivative has moved above zero while the 3-day average is waiting to confirm a continuation of Friday’s upward move. The technique requires more study and back testing to eliminate false signals.
2.0 Market Analysis
For all it movement this week, the market went nowhere. Suddenly investors are uncertain about rate increases. Last week most had already concluded that another rate hike was likely at the March 28 FOMC meeting. The market is obsessed with inflation and interest rate increases.
Key industry ETF’s in Table 2A are Biotech and Semiconductors, which confirm the NASDAQ. Transportation confirms the Dow Jones Industrial Average according to Dow Theory. Banking and Financials are confirming indicators for the S&P 500. Gold and Real Estate are respective indicators for the inverse health of the currency (inflation) and the capacity for consumer spending.
Table 2A Indices, Key Industry ETF’s and Sector SPDR’s
VTO Report on Market Sentiment Indicators
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