Can we keep going higher forever?

My long gap fade this morning failed miserably. After I stopped out, I noticed some areas of resistance around the highs yesterday. Interesting. Maybe this rally is done. Who knows, but Adam Hewison has an interesting video about where we sit right now in the market. Here's what he Adam says:

"We owe trillions of dollars, but Crude oil is at $86 a barrel, the DOW, S&P, and NASDAQ are making new highs almost everyday and unemployment is officially at 9.7%.

Everything is great! Happy days are here again... Right?

So is the DOW, S&P, and NASDAQ all going to keep going higher forever? Or are the teachings of a dead mathematician going to reverse this juggernaut of a market?"

You can see his video here.

The Market's Line in the Sand

Adam Hewison has posted an interesting video on where he thinks the market is headed based on his study of the technical charts. He writes:

"To many technicians, it is very clear where the equity markets will reverse, and for those folks who don't follow the technicals, this is a key reversal area in the S&P 500, the NASDAQ, and the Dow."

"Currently the major trend remains positive for all the indices and we would only become negative on the these markets should the key levels I show you today, are broken."

You can see Adam's video here.

Using a Fibonacci grid from Friday to predict price action today

I wanted to point out the power that Fibonacci grids exert on the market by drawing a grid from Friday's lows and highs.

Fibonacci grids are not magic and they don't have some sort of hidden "power" over prices because of some mysterious use of number sequences. They work because patterns in the market continually repeat themselves over and over again. And they work because there are a lot of people (like me) who trade using Fibonacci grids.

I wanted to point out using a 5 minute chart of SPY how the action last week can effect price action this week. You'll notice that today's prices bounced around in Friday's range and often bounced off exact grid retracements (blue arrows). With knowledge that these areas will provide support and resistance to price movement, you arm yourself with a very powerful "predictive" capability that many traders out there aren't aware (or capable) of.

Fibonacci Extensions and Price Projection

Yesterday's action on SPY gave us some really good examples of how you can spend a few seconds drawing Fibonacci grids to give you an edge in figuring out where to enter a trade, where to place a stop, and where to exit your trade. There are entire books written about entries, exits and stop placement and most traders really struggle with all three causing psychological mistakes that diminish and even eliminate trading edges.

Fibonacci numbers aren't magic, but if used properly, they can give you the ability to avoid emotional pitfalls and help you make trading decisions that are based on data rather than feelings.

Let's go through yesterday's trade to see how drawing two Fibonacci grids could have have saved you racking your brain throughout a trade that lasted several minutes. This trade happened in the last hour of the trading day on January 26th.

On the first chart I've drawn a Fibonacci price retracement grid. There were a ton of reasons that this was a trade that was going to work. Price made a strong impulse down and then retraced to several moving averages which were all converging together creating a huge amount of resistance. It would have taken a lot for buyers to push price through that level. As price began its retracement, I drew the Fibonacci grid from the start of the impulse down to the end of the move.

A grid like this gives me an unemotional decision making tool. First I look for price to retrace to a Fibonacci number--preferably 50%. Next I look for indecision to appear in the form of a candle on the chart. A doji candle (the "cross" at the blue arrow) is often my trigger and one appeared and touched the 50% retracement. Next, I wait for price to run past the doji low (in this case) for my entry which happened in the next 5 minute candle. Notice there is no "freaking out" about the best entry--it's plotted for me on the chart.

Next I set my stop. Again, the Fibonacci grid does that for me. I know that if price breaks the 61.8% level that I was wrong about the trade and the odds of the trade continuing are greatly diminished. I placed my stop just beyond that level. Again, it's not based on a dollar amount or a "gut feel". I can see where the stop goes right on the chart.

Once the trade is triggered I spend another few seconds drawing a Fibonacci Price Extension. The price extension grid gives me my targets for the trade. I can choose whether I want to be aggressive or conservative in the targets I choose and the grid lays them out for me.

Notice in yesterday's action how price reacted to the different levels in the grid. I've highlighted them with blue arrows. Noticed how price paused at each level in the grid and then crashed through. You could have conservatively targeted the 61.8% level or gotten a little more aggressive at the 100% level (notice the pause there), or even gotten real aggressive and targeted the next two levels.

So, instead of racking your brain trying to manage this trade after you took it, you could just calmly draw a grid and place an order at the level that you feel comfortable with.

This is just one example of trades that are happening every day. Of course not every Fibonacci grid is going to work out this perfectly, but enough of them do to give you a distinct edge in your trading with emotionless entries, stops and targets.

I'm such a wimp

I was too wimpy to take a trade this morning that had really good odds of succeeding. $113.00 has been serving as support for SPY for the last couple of weeks, and I knew a break beneath it would result in a lot of people who are long the market getting stopped out.

But I still struggled taking the trade. I should have had an order already in and I was preparing to create one when price broke through $113.00. I tried several times to put in a limit order with no luck. Finally, my order triggered. When it did, I was more than $1,000 away from a decent stop. I started second guessing my trade and finally just quit the trade with a tepid $60 gain.

It's frustrating when you have an easy $1,000 (or more) and turn it into a small win or worse--a big loss.

I saw an great Elliot Wave developing on the one minute chart, and I still was too wimpy to get back in and instead took a simulated trade. Of course I made lots of money on that one.

We'll have to see if today develops into a decent trend day. It looks like we've got good odds of that happening.

Excellent Article about professional trading

Cause and Effect:
Thinking Differently for Traders and Investors

by

D.R. Barton, Jr.

When I was training to be a chemical engineer, decision making was quite “black and white”: Learn the rules of the physical world and then apply them. Learn how molecules combine and separate. Learn how mass and energy get transferred from place to place. Learn what is economical and what is not. And lastly, study hard and get good grades.

Once I was out and practicing engineering in the real world, things weren’t always so cut and dried. Outside influences often complicated things. The world of “black and white” became a world with many shades of grey. In a pristine lab environment (like back at school), molecules always combined the same way. But in the real world, contaminants could get in the system and reduce yields or create new and undesirable products altogether.

Equipment that was rated at “x” horsepower would always seem to run a little less efficiently because some field condition (normal wear, extra bends and turns, fluctuating temperature and humidity) would strip away efficiency.

In the end, the best engineers in the real world of processing plants were those who could deal most effectively with problems and conditions not found in the text book. And it will come as no surprise to most that raw intelligence was not directly correlated to success on the floor of a chemical plant. The best engineers had a certain savviness or what my Dad would call “horse sense” about the best engineers.

And I have found a very similar quality in the best traders and investors that I’ve gotten to know. They don’t have to be the most book-smart folks (though a few are), but they have a certain grounded grasp of the big picture that allows them to adapt, correct and continue with self-assured ease.

This group of characteristics that turns the average thinker into someone with good common sense or “street smarts” is somewhat difficult to sum up in a few sentences. But let’s look at some of these concepts or decision making loops that may be most easily modeled.

Trading Is Not Engineering or Accounting

Before we jump into some key decision making characteristics, let’s be clear on the differences between the learning paths for trading and the path for traditional knowledge-based professions like engineering, accounting or medicine.

I’ve often heard professional traders lament that those desiring to learn their craft see a few mouse clicks and some fairly elementary math and assume that they, too, can be consistently successful traders and investors in matter of days or weeks. Some pro traders will respond to this sentiment with a saying like, “A highly paid doctor or lawyer had to study for years before getting compensated handsomely. Who would expect to get paid like me after studying just a couple of weeks or months?”

And while part of that thought process is correct (the fact that there are knowledge based aspects to both trading and accounting), there is also a major fallacy in the argument.

Acquiring and demonstrating minimal proficiency in the basic knowledge set needed for engineering or accounting or law or medicine will lead to a well-paid position for the vast majority of participants. Not so for traders.

The learning path for a trader is more like that of a professional poker player. Demonstrating knowledge and proficiency in the basic skills only gets you a seat at the table, it doesn’t assure you of an income. While the poker-trading analogy isn’t perfect, their paths of progression are much more related than that of an doctor or an engineer and a trader.

Let’s look at one key area that makes trading very different from doctoring or engineering: the search for certainty or “What happens when you do everything right and it still turns out wrong?”

Doctors, engineers and indeed most professions live in a cause and effect world. If you do A, then a very high percentage of the time B will follow. There are notable exceptions, when a treatment doesn’t work or a product line gets contaminated, but by and large if you do the correct action, you get the correct result.

Trading is quite different. A trader can have the perfect set-up and entry, execute everything perfectly and still have the trade result in a loss. While traders lose money in this situation, that’s a problem perhaps but probably not the biggest problem. The largest problem for most people is the mental disconnect between cause (doing everything right) and effect (losing money). That result conflicts with their classical education which does not equip them with the tool set required for managing uncertain outcomes.

If we do things exactly right and still only get the desired result 60% of the time (or 50% or even 40% in long term trend following systems), traditional cause-and-effect thinking can easily make damaging conclusions. Since cause and effect seem only causally (no pun intended) related...

• The rules really aren’t good and don’t serve me.

• I no longer need to follow my rules exactly. (or at all)

• I can tweak the rules so I am in better control (or at least feel like I’m in control)

When a trade or group of trades doesn’t come out well, our typical human reaction to solve a problem kicks in. Almost all traders and investors tweak their systems and strategies prematurely, based on too little data (too small of a sample size). So many people have been trained in an education system that teaches us to solve a problem if we don’t get the desired outcome with pure cause and effect thinking. Dealing with highly complex systems with great levels of uncertainty is just not in most people’s basic educational background or experience.

So what?

The good news is that cause-and-effect thinking works in most areas of our personal and professional life. And it is deeply rooted in our need to be right. It does not, however, serve traders well.

A useful solution to overcome our mental “cause and effect” disconnect is simple to describe, but it’s very difficult to adopt for the long term: broaden your view of trading results. We must allow our trading and investing strategies to play out long enough to reach their expected profitability. Fretting and wringing your hands over the results of every trade is not very useful and can lead to premature judgments and tweaking.

Each trade should be evaluated ONLY in terms of whether or not we followed our trading rules without regard for the dollars and cents results. Reset your cause and effect decision process only after you have a group of 30 or 50 trades (or an even higher number if you trade more frequently). Then you can evaluate cause and effect on a statistically valid data set, not on any one trade or group of trades that have so many more outside influences than one can ever hope to control.

Reviewing only large data sets creates a discipline that serves several purposes:

• It reduces stress by telling our mind that no single trade matters very much, as long as we follow our rules.

• It reduces the variability of results over time because we’re only adjusting our system or strategy after an appropriate interval of time.

• It greatly increases the chances of profitability because we do fewer of the systematic things that cause losses.

No one trade is important (as long as you always respect your stop loss)—it is just a useful data point as part of the larger whole. Allow yourself and your strategy the luxury of time. And don’t be surprised if lower stress and greater profitability follow close behind.

Great Trading,

D. R.

About D.R. Barton, Jr.: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena. He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at "drbarton" at "iitm.com".

Disclaimer

Let it snow . . .

That's three feet of snow outside my trading desk window.

Narrow trading channel on SPY

It looked like we were going to get a powerful trend day after the "gap and go" this morning. I stopped out of a trend day trade in the late morning hours as price consolidated and then dropped through the support of the 20 EMA and the lower Bollinger Band. Losing comes with the territory (but it always sucks).

At the moment (1pm EST), it looks like we have formed a narrow trading range that continues to move down. We have yet to cross the 50 EMA. If we do, it's likely that the trend day bias is kaput.

If we break through the upper channel, we may have a powerful move up. It's wait and see time right now. Aggressive trading is probably a bad idea until things get resolved.

Using multiple timeframes to determine price structure

I think a lot of people (including me) were anticipating a powerful trend day today. We had a big gap that refused to fill even a little bit. A big downward impulse followed with new TICK lows.

A slight pullback occurred and then another downward thrust with a fresh new TICK low. Advancers outnumbered decliners by 2,300 at that point. All signs pointed to a trend day.

But price started oozing upward eventually breaching the 20 period moving average and is testing the upper Bollinger band as I write this.

What caused price to unexpectedly reverse and start heading upward?







Looking back a few days we can see a level of support that formed on the 30 minute chart.

Once the price of SPY reached that support level, it bounced and headed upward. It's still going up as I write this.

We'll have to see how powerful this level of support is. Will we get a "broken" trend day as price reverses.

Watching different time frames can help you to determine targets and stops and allows you to have an upper hand as price makes seemingly random moves.

Zack's Research Wizard results

Here are a couple of recent comments about Zacks's Research Wizard that are in response to my post a few weeks ago.

I'm guessing this is the same "Anonymous" who offered to post his return on a weekly basis:

During the past six weeks, one of my better strategies in RW selecting 8 stocks per week ran -9.5%, Fridays to Fridays, -14.5% of which was during the past three weeks. YTD, during the past 44 weeks the result was 137%, Fridays to Fridays, including staying in the market during the four volatile weeks in February, when I stayed out, triggered by the 4.5% drop in the DOW. As stated earlier, when you invest rigorously from Mondays' closes to Mondays' closes, your result ends up at about 75%-80% of the result RW shows you would have gotten. This result excludes the transaction cost of the 8 stocks in the portfolio, about half of them stay two weeks or longer in the portfolio.

It is relatively straightforward to test with RW under which market conditions the Zacks rank 1 and 2 stocks produce ineffective results. Jeremy Grantham's latest quarterly October newsletter spelled it out: "As we have demonstrated to our clients in earlier cycles, earnings estimates in particular merely follow the market up (not the other way around, as one would hope). So it is a law of nature that strong estimates will abound after a major market rally. The earnings and economic growth estimates in such cases are usually throwaways". Hence, when the market runs down in high volatility, I don't use RW to pick my stocks. During such a time, the earnings and growth estimates are usually throwaways as Grantham states. I estimate that to be about 30% of the past ten years. The onset of these periods do usually precurse themselves by a growing VIX and/or the first time that the DOW drops 4.5% or more in one day. For the rest, I find RW a money machine if you have the proper strategies and always buy and sell at Monday closes.

CWatts also chimed in with his own opinions about Research Wizard:

Scott, I totally agree: "There is a real lack of support for such an expensive product. I think it would really help to have a user forum available. Any sort of communication on a weekly basis would be great." What's with that? It makes no sense. I got into the Motley Fool Pro as a charter member and found the support was great. I wasn't so impressed with the profits their recommendations were providing. Still, I felt that support, encouragement and information was abundant from the Pro community and Fool staff. Zacks seems to say, "We've got your money. Now you're on your own." It is almost as though they are assuming they will have no return customers because they are doing nothing to foster loyalty. A community of Zacks Wizard users is really needed. If Zacks has no interest in fostering it, how can it be done?

I've had good weeks and bad weeks using the Zacks Wizard. But in the Last six weeks I've gotten creamed in excess of $50,000. Part of the problem is my own. After a couple bad weeks I decided to sit on the sidelines in cash for a little while, just in time to miss the biggest gain in months. I was up nearly thirty percent for '09 when I started using Zacks. I'm closer to 10% now. That hurts. But I can endure losses if I have solid assurance that the swcreens are accurate and you can make serious money if you are faithful to the program. But it seems to be hard to find anyone who has continued using the Wizard faithfully for several years. Do any of you know of independent careful critiques of the Wizard? I want to believe but I don't want to wipe out in the process.

Trend Day or Range Day?

The website Verticle Solutions provides a real time gauge with a proprietary alogorythm that determines whether the current day's structure indicates we are trending or in a range bound environment.

I look at it a couple of times a day as another way of monitoring market activity. It's an interesting tool and I like anything that has colors and arrows. I do like my gauges.

Every Kramer Entrance

Using TICK to plan your day

Today started with a gap of over 1% and good earnings news from Intel which are often catalysts for the formation of a trend day. Trend days can make your week or even your month if played correctly so it is important to be able to identify one early in the day so that you can take advantage of the easy pickings during the rest of the day.

If you just focused on price alone, you really have no indication that today is not a trend day (as of 12:00 pm EST). We had a large opening gap, and price hasn't crossed the 20 period moving average (green line). It seems that the bulls are in complete control, and the news is hailing DOW 10,000 before it even happens.

But when you look at market internals you'll see a different picture. The NYSE TICK is a great tool for understanding what is going on "behind the curtain".





I've posted a capture of the NYSE TICK which shows that caution should be taken in assuming this is a trend day. Usually on a trend day you'll see extreme readings on the TICK (above or below 1,000). The green line is +1,000 and the red line is -1,000. As you can see, the TICK has not reached extremes on either side of the spectrum. To me, it looks weighted on the sellers side, especially during the first couple hours of trading.

Currently, it looks like TICK is hovering around the "zero" line which indicates this day is more like a "range day" than a trend day. Using tools like the TICK can help you make better decisions about price structure and allow you to determine how aggressive you want to trade. On a trend day you want to go nuts and risk a lot to make a lot. On a range day, caution is the theme of the day and you should trade much more conservatively.

As always, it will be interesting to see how the day plays out.

Zack's Research Wizard

I haven't used Zack's Research Wizard for over two years and I haven't written about it in at least that long, but I consistently receive comments and questions about the product. Curiously, a Google search of Zack's Research Wizard lists StockPunk as second in rank under Zack's own website!

There are a many great discussions about the product on a couple of my posts. The best debate has probably gone on after I posted my opinion about the product after using it for 6 months. You can see the post and read the comments here.

I no longer use screening or buy individual stocks, but I still find the world of stock screening fascinating. My love for the markets and trading started with fundamental screening. I still enjoy reading Charles Kirk's posts about his Stock Screen Machine.

Recently, an anonymous commenter offered to post his impressive returns using Zacks Research Wizard. Here is his comment: I have four RW strategies that produce separately and combined a CAGR of ~75% over the past 10 years if you buy and sell the weekly selected stocks on Mondays at close. One of these strategies selects some 8 stocks each week. I am willing to send Scott this selection every Monday for the next three months so that he can publish those on his secured site while I will stay anonymous. If the DOW drops more than 4.5% on a day, we use this as a stop loss and stay out for the next 20 days.

I'd be up to posting his results on a weekly basis if other readers are interested. Let me know through the comments section of this post or through e-mail and I'll let the poster know that there are readers who are interested.

Using structure from yesterday to trade today

The day opened with a .30 gap in SPY which according to backtesting research has a pretty good chance of filling. Usually I'll attempt to fill any gap under 50 cents because gaps of that size have good edge and usually fill.

But today I decided to wait because of what happened yesterday. Many day traders trade only in the moment and ignore the previous day's (or even the previous hour's) action. However, the structure that sets up yesterday often continues into the next day as it did today.

Yesterday we got an excellent bear flag into resistance near the close. Not only was the 50 period exponential moving average acting as resistance, but price also stopped at the 61.8% Fibonacci retracement (see next chart).

The bear flag began its decent with a big down bar 25 minutes before the close, but as often is the case, some sort of buying programs clicked in and killed off the move in the closing minutes of the day.

The pattern still remained viable, and as we opened the day with a gap, you should have been hesitant to jump right in given the dominant bear flag that had formed into the close yesterday.

On this chart I've drawn the Fibonacci retracement which allows you to determine a stop loss for the bear flag (if you're wrong). In this case, your stop loss would have gone above the 61.8% retracement (slightly above 107.71). You could have entered after the doji formed 10 minutes after the open today.

To set your target you could have drawn a Fibonacci extension on yesterday's bear flag (next chart). You could target the 100% Fibonacci extension which would be the completion of the bear flag. Notice that price continued through the 100% extension and nipped the 138.2% extension.

Aggressive traders could have held on until they saw a reason to get out (that nearly engulfing up candle would have been a sign that it was time to leave the trade). Or you could have targeted 138.2% which would have been a successful target (to the penny).

This may all seem too complicated to perform in real-time, but I assure you, with a little practice, it becomes second nature. It just takes a few seconds to look over patterns and draw Fibonacci retracement and extension lines. The information they provide can dramatically increase your confidence to put on trades and to formulate realistic targets.

Many traders struggle with when to get into a trade and when to get out. By studying price structure you can really improve your execution and increase your accuracy. Understanding yesterday's price action is also invaluable when trying to understand the price action today.

A Guitar World video review of my buddy Gabi's hand-made amplifier.

http://www.gabtone.com/

AAII's Zweig Stock Screen Down 17.4% YTD

Occasionally I like to peruse my old haunting grounds to see how I would be doing if I still traded using stock screening techniques. As many of you know, the Zweig stock screen was my "bread and butter" for several years and it performed marvelously for several years averaging a 50% return for me each year. I was using a "tweaked" version of the screen that simply ranked the Zweig screen candidates by their 26 week relative strength (as compared to the S&P 500) using AAII's Stock Investor Pro.

I then chose the top 5 stocks listed in the screen (the screen averaged about 10) and bought them Monday morning. I held through the week without using any stop losses. I would re-evaluate the screen on Sunday and if any stocks dropped off the list, I would sell them Monday morning and replace them with new stocks that qualified for the top 5.

I sometimes held stocks for just a week, but in most cases, the stocks stayed on the screen for weeks and months at a time. It was a very simple way to trade using mechanical methods which allowed me to work full time during the day and still enjoy returns that handily beat the indexes. But things fell apart for the screen in 2008, and AAII's version of the screen lost 34% over the year. Before 2008, the screen's worst performance since 1998 had been a 17% gain in the awful market of 2002.

By mid-2008, I knew that I would have to change my trading strategy if I was going to be able to eventually trade for a living. A losing year just wouldn't cut it for paying the bills since I didn't have an abnormally large chunk of equity. So I made the switch to day trading which I felt gave me much more control over my trading and my equity curve.

I'm still learning, and the transition hasn't been easy by any means. The fast pace and emotional stress of trading intra-day takes its toll. It is much more complicated and requires a huge amount of effort, learning and dedication. I sometimes question the switch I made (as many of my readers have done). So once in a while, I'll "take a peak" at some of my former methods just to see how they're holding up.

I'll have to admit that I was completely surprised to see that the Zweig method has performed poorly this year--down 17.4% YTD. This is the type of environment where the stock screen usually thrives--an unrelenting bullish bias after the market bottoms out. In 2003 the unmodified screen returned 89% with monthly re-balancing.

That fact gives me pause that the rally we are seeing today doesn't necessarily indicate that happy days are here again. Something is not quite right fundamentally if the Zweig screen is down for the year after a 40% rally has taken place.

Nice Elliot Wave on SPY

Today's action provided several opportunities for profit, but more importantly a clean Elliot Wave pattern formed throughout the day. I like Elliot Wave patterns because they provide several important areas where traders can find an edge.

Understanding Elliot Wave patterns intra-day has helped me become a much more patient trader because they provide good entries, specific stop-loss areas, and logical targets. Take a look at the chart at the left (you can blow it up by clicking on it). The chart was captured about 30 minutes before the market closed.

You can see how the entire day unfolded into a "story" with predictive value--taking what most people see as random price movements and creating a sort of "crystal ball" that gives clues as to what will happen next.

I used to jump in on any pullback to a moving average. Now I try to wait for an ABC pullback to complete before I take a trade. Today, we got a pullback after a 3rd Elliot Wave (big number "3"). I wanted to take a trade as soon as price moved back to the 20 EMA. You'll notice that price bounced of the 20 and began heading upward. But I held off because I was expecting a larger wave 4 to form and I new that wave for usually created an ABC pattern.

The ABC corrective pattern did indeed form. If I had taken the trade too early, I probably would have stopped out--even with a stop comfortably below the 20EMA. Instead, the ABC pattern completed with a "hammer" candle forming off a bounce on the 50EMA. This provided a terrific trade with edge. A stop placed below the 50EMA with a target of the top of wave 3 is what Elliot Wave would suggest as a "wave 5" trade with a 2 to 1 risk/reward ratio.

You'll notice when that trade achieved its target that price continued to move up quickly as the sellers who were shorting ended up buying back their shares. I held my trade as their stops were triggered creating additional gains for the trade.

Stormtroopers 9/11

http://www.collegehumor.com/video:1920944

All day triangle on SPY

Over the past couple of weeks the indexes have really struggled to create good trading opportunities. They have often opened with a large impulse up or down and then consolidated for most of the day with very little movement.

Today has given us another example of this. From the opening bell, daytraders have had little opportunity. The gap didn't fade at all. Then we got some indecision and then a solid move down.

But that soon fizzled out and we got a retracement back to the 20 period moving average. After that price just bounced up and down most of the day as the Bollinger Bands narrowed.

On days like these, I try to find other things to do while I have the market "in the background". I'll often take a laptop with me while I work on the car or clean part of the house. A solid breakout might peak my curiosity, but as the market "coils" I'd rather be doing something productive than watching it compressing all day long.