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Wiser Trader Stocks and Options Newsletter ______________________________________________________________________________
Issue No. 77 May 10, 2006 Prescott, Arizona Systems@WiserTrader.com ______________________________________________________________________________
1.0 Trading
This is a supplemental issue due to a temporary disruption for a key information channel this past weekend. Updated watchlists are included with a follow-up on the definition of directivity.
1.1 Directivity
Recent momentum studies are intended to provide a broad statistical understanding of market movement. Broad market behavior accounts for more than half of a stock’s movement and influences the effect of stop loss settings on profits. While these ongoing studies can be expected to improve market timing over several weeks to months, the studies are not expected to result in a truly predictive capability in the short term. Perhaps that will happen later.
Each major index focuses on a relatively narrow market segment. The DOW focuses on blue chips that comprise about 25% of the S&P 500; the S&P focuses on large caps consisting of about 25% financials and 15% technology; the NASDAQ focuses on technology; the Russell 2000 on small caps; and the NYSE Composite on common stocks. The 5-index momentum indicator consists of the average Williams %R for all five indices. Momentum represents an overbought market condition when the indicator tends toward zero. An oversold market condition is represented by indicator values that tend toward -100. This momentum indicator is not a predictor of eminent market movement. It simply denotes whether a market is in a condition of being either overbought or oversold.
Momentum indicators and oscillators make use of the idea that each market move is an overreaction. When the market reacts to a positive or negative stimulus, it typically overshoots its point of neutral equilibrium. Overreaction results in a counter reaction in the opposite direction. Hence, the market cannot rest in equilibrium. Two important results have come out of recent back testing. The first is that the probability of the market moving in the same direction two or more days in a row is about 45%. The probability of it moving in the same direction three or more days in a row is 19%, 4 or more days 7% and 5 or more days 2%. The second important result from the study is that the 200-day simple moving average (SMA) for the 5-index Williams %R is -42, indicating a verifiable long term upward market bias. This ever-changing historical average of -42 is in contrast to a neutral level of -50 that would be predicted by a supposed efficient market with purely random movement. Normally, for a single index or stock, the neutral level is -50, representing neither overbought nor oversold. In the case for the broader market, the average bias is upward.
The two results above can be used to define a term called directivity. Directivity anticipates how the 5-index Williams %R is likely to return toward its long term average. Of course, it will inevitably overshoot the equilibrium position. However, the initial reactive move has three components, the direction of movement, its magnitude and the rate of movement. The return movement is like a stretched rubber band that has been released. This rate of movement depends not only on how much the rubber band is stretched but also on the initial tension, as measured by how tightly the momentum indicators of all five indices are grouped. Statistics show that the most sudden market moves occur when the five momentum indicators are tightly grouped. Therefore, directivity should be determined based on both the range, as well as, the difference between the indicator value and its 200-day SMA. The range is just the difference between the maximum and minimum values for the five index momentum values from which the indicator is composed.
Directivity is arbitrarily defined to vary from +1 to -1. A value of zero indicates that market momentum is at its 200-day average. A value of -1 indicates an overbought market where all five indicator values equal zero and the market is poised to move sharply downward to reach equilibrium. A directivity value of +1 indicates an oversold market where all five indicator values equal -100 and the market is poised to move sharply upward to reach equilibrium.
Geometrically, directivity is inversely proportional to the sum of the distances of a point from the upper and lower right corners of the chart. Directivity is given by,
All of this information is computed automatically in an Excel spreadsheet where XLQPlus gathers intraday and 3-month data for the 5 indices and continuously updates it in a chart as shown in Figure 1 below. The spreadsheet, called Index Momentum, is available as a free download.
FIGURE 1
Some Statistics
A 30-unit move from -50 to -80 or from -50 to -20 is substantial and requires either that all 5 indices move together or that the range of values be decreased by laggards catching up with the leaders. About 85% of successful indicator movements from -50 to -80 and from -50 to -20 involved a decrease in range. About 48% of failed down crossings and 53% of failed up crossings involved an increase in range.
Down Movements from -50 to -80:
About 49% of down movements of -50 reached -80. About 60% of these completed the move in 1 day and 90% completed it in 3 days. The -50 crossing point range is between -25 and -50 about 73% of the time. About 18% of down movements involved, a range of -10 to -25 and 9% involve a range of -50 to -100. Additional details are given in Table 1A.
TABLE 1A Down Movements from -50 to -80
Up Movements from -50 to -20:
About 58% up movements of -50 reached -20. About 46% of these completed the move in 1 day and 92% in completed it 3 days. The -50 crossing point range is between -25 and -50 about 42% of the time. About 31% of up movements involve a range of -10 to -25 and 27% involve a range of -50 to -100. Additional details are given in Table 1B.
TABLE 1B Up Movements from -50 to -20
A Review of the Indicator versus Range Chart in Figure 1
To reduce the need to refer back to past newsletter issues, this is a review of how to interpret the chart in Figure 1. Although the magnitude of the range is a positive value, there is a benefit of symmetry in representing it as a negative value in a Cartesian coordinate system. Let us begin a discussion of crossing the -50 Williams %R neutral level by pointing to the green diagonal construction lines radiating from the origin at the upper right. The positive slopes of these green lines represent ratios of indicator to range (DI/DR) with values from 0.2 to 5. In a falling market, the data is bracketed by the red construction lines radiating from the lower right corner, having slopes of -0.2 to -5. Due to symmetry, data points in the upper and lower half of the chart behave the same way regarding the respective green and red construction lines.
Pairs of adjacent red and green construction lines form three shaded quadrilateral areas. Due to symmetry, we can refer to each region by simply using the magnitudes of the slopes of the bracketing lines, without regard to their algebraic signs.
By far the largest number of -50 crossings occurs in the middle region bounded by DI/DR ratio magnitudes from 1 to 2. From January 4, 2004 to the present, about half of all neutral crossings occur by passing through this region. Range values at the -50 indicator line run from 25 to 50 in this region.
The region on the left, bracketed by DI/DR ratio magnitudes from 0.5 to 1 has about a quarter of all crossings. This region involves wide values of range and often results in the indicator becoming very erratic. Range values at the -50 indicator line run from 50 to 100 in this region.
The region on the right, bracketed by DI/DR ratio magnitudes from 2 to 5 also has about a quarter of crossings. This region involves narrow values of range accompanied by extremely large and sudden movements across the -50 neutral level. Range values at the -50 indicator line run from 10 to 25 in this region.
In view of the symmetrical geometry of the chart, it is a geometrical requirement that the indicator cannot cross the -50 neutral line in either direction unless the magnitude of DI/DR is greater than 0.5. DI/DR ratios having a magnitude less than 0.2 cannot occur due to mathematical considerations. In one example, if the range is equal to -100, the most negative value for the average Williams %R occurs when four of the indices are at -100 and one index is at zero. The resulting average indicator value is -80. In the same example, the least negative value for the average Williams %R occurs when four of the indices are at zero and one index is at -100. The resulting average indicator value is -20.
Historically, one can see that, except for brief excursions for DI/DR ratio magnitudes greater than 5, all the data lies within in a region bounded by DI/DR ratios ranging from 0.2 to 5. The brief exceptions are met with the indicator snapping back, to reverse its recent movement. Historically, the indicator does not cross the -50 neutral line outside this range.
2.0 Market Analysis
All ten major sectors advanced this week accompanied by a slight lowering of treasury yields. Advances were led by blue chips. Employment data indicated a continued strong economy without inflation fostering wage increases. This gave more hope that the Fed would reach the end of rate tightening sooner rather than later.
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 Housing 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
The VIX and VXN volatility indexes are listed in Table 2B.
Table 2B Volatility
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Table 2C
Market Summary
Industries are listed according to the Dow Jones Classification System