Wiser Trader Stocks and Options Newsletter
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Issue No. 84 July 10, 2006 Prescott, Arizona Systems@WiserTrader.com
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1.0 Trading
Most traders will tell you that market timing is very difficult. Short-term traders use technical analysis to take a general approach to market timing.
1.1 Market Timing
The 5-index Williams %R in Figure 1A is composed of the average Williams %R for the DOW, S&P 500, NASDAQ Composite, Russell 2000, and NYSE Composite. This indicator is useful as a proxy for the momentum of the broader market. While market momentum is irregular, there are distinct periods that favor either long or short trades based on the presumption that 50% of a stock’s move is based on how the major averages move, 25% is based on fundamentals and 25% is based on a stock’s technical indicators.
FIGURE 1A
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© 2006 Desert Mountain Systems, LLC. Members of wisertrader.com are neither licensed brokers nor licensed advisors. Trades discussed represent recommendations made by the editor for the wisertrader.com portfolio. The newsletter and web site are for information only and should not be considered as personal advice. While it is believed that the posted information is factual, mistakes can be made in transcription. Investors should trade stocks only after verifying all information and consulting with a licensed broker or adviser. Desert Mountain Systems markets third party trading systems but has no other affiliation with trading system companies. |
The trick is to choose stocks whose fundamentals and technical indicators are consistent with the direction of trade and to time each trade such that the stock’s momentum is synchronized with that of the broader market. Increasing market momentum favors long trades and buying call options while decreasing market momentum favors short trades and buying put options. This approach is straightforward during periods when the cyclical change in market momentum is regular and well behaved. However, when the market is choppy, as it has been recently, implementation can prove difficult. Until recently, major shifts in broader market moment occurred every 2 to 3 weeks. Figure 1B shows how since late May, momentum transitions were interrupted by a sharp reversals.
FIGURE 1B
It has been observed that such reversals have a distinct historical probability, depending on the current 5-index indicator value. Using the data from Figure 1A, a pair of tables were prepared that show the historical tendency of indicator movement without a reversal for up and downward moves. Currently the momentum indicator is moving downward. Its last closing value was -42, which just happens to coincide with its 200 day SMA. The historical probability of the indicator moving from -42 to -50 without a reversal is between 72 and 81%, based on information in Table 1A. The probability of it reaching -80 without a reversal is between 40 and 43%.
In this context, a reversal is defined by the indicator changing direction and moving back across its starting point. Historical probabilities less than 50% are highlighted in yellow in the table. A general point of interest is that when the indicator drops below -20, there is only a 50% probability (highlighted in red) that it will reach -50 without a reversal. Yet, starting from -20, the probability that it reaches -30 without a reversal is 80%. Likewise, the probability of continuous downward moves in small increments without a reversal is quite high while that for large moves is low.
Table 1A
Historical Probability of 5-index Indicator Downward Movement without a Reversal
|
Down |
Downward Movement Destination Point |
||||||||
|
Starting |
|
||||||||
|
Point |
-20 |
-30 |
-40 |
-50 |
-60 |
-70 |
-80 |
-90 |
-95 |
|
-5 |
69% |
63% |
53% |
41% |
34% |
25% |
16% |
16% |
0% |
|
-10 |
77% |
68% |
55% |
45% |
40% |
32% |
19% |
17% |
11% |
|
-15 |
80% |
80% |
56% |
46% |
44% |
35% |
28% |
22% |
13% |
|
-20 |
100% |
80% |
63% |
50% |
48% |
41% |
33% |
28% |
20% |
|
-25 |
|
84% |
66% |
52% |
48% |
41% |
33% |
28% |
21% |
|
-30 |
|
100% |
77% |
59% |
52% |
43% |
36% |
30% |
23% |
|
-35 |
|
|
87% |
65% |
58% |
47% |
40% |
33% |
25% |
|
-40 |
|
|
100% |
72% |
62% |
47% |
40% |
33% |
24% |
|
-45 |
|
|
|
81% |
68% |
51% |
43% |
36% |
26% |
|
-50 |
|
|
|
100% |
84% |
62% |
53% |
42% |
31% |
|
-55 |
|
|
|
|
94% |
67% |
54% |
42% |
31% |
|
-60 |
|
|
|
|
100% |
68% |
52% |
40% |
30% |
|
-65 |
|
|
|
|
|
78% |
60% |
46% |
32% |
|
-70 |
|
|
|
|
|
100% |
76% |
57% |
39% |
|
-75 |
|
|
|
|
|
|
88% |
63% |
47% |
|
-80 |
|
|
|
|
|
|
100% |
74% |
47% |
|
-90 |
|
|
|
|
|
|
|
100% |
100% |
Table 1B shows similar historical probabilities for rising momentum. After some inspection, it should be clear that the two tables are not symmetrical. The market has a distinct upward bias. Historical probabilities of upward moves without reversals is typically higher than for down moves without reversals.
Table 1B
Historical Probability of 5-index Indicator Upward Movement without a Reversal
|
Up |
Upward Movement Destination Point |
||||||||
|
Starting |
|
||||||||
|
Point |
-80 |
-70 |
-60 |
-50 |
-40 |
-30 |
-20 |
-10 |
-5 |
|
-95 |
100% |
86% |
62% |
52% |
48% |
33% |
24% |
19% |
14% |
|
-90 |
87% |
71% |
53% |
50% |
50% |
39% |
32% |
24% |
13% |
|
-85 |
95% |
77% |
48% |
53% |
53% |
47% |
44% |
35% |
23% |
|
-80 |
100% |
82% |
61% |
57% |
55% |
48% |
45% |
36% |
25% |
|
-75 |
|
93% |
70% |
61% |
59% |
55% |
52% |
43% |
30% |
|
-70 |
|
100% |
74% |
62% |
60% |
53% |
51% |
43% |
30% |
|
-65 |
|
|
88% |
71% |
67% |
55% |
53% |
43% |
29% |
|
-60 |
|
|
100% |
76% |
73% |
59% |
53% |
45% |
31% |
|
-55 |
|
|
|
86% |
82% |
65% |
57% |
49% |
35% |
|
-50 |
|
|
|
100% |
93% |
74% |
61% |
52% |
37% |
|
-45 |
|
|
|
|
96% |
72% |
59% |
46% |
31% |
|
-40 |
|
|
|
|
100% |
76% |
60% |
45% |
31% |
|
-35 |
|
|
|
|
|
91% |
73% |
53% |
35% |
|
-30 |
|
|
|
|
|
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