Stocks&commodities S&c 03-2017

THE TRADERS’ MAGAZINE SINCE 1982

VIX Or Historical Volatility? Use this unique approach to size your positions

8

S&P Fuel Gauge

Measuring a rally’s energy 14

Grand Illusion

Is the economy as strong as it looks?

GAUGING Buy & Sell Pressure Here’s a faster RSI

22

26

INTERVIEW

Gavin McMaster, options trader

PRODUCT review n NinjaTrader 8 (part 2) MARCH 2017

36

www.traders.com

MARCH 2017

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CONTENTS 7 The Reality Of REITs

by Leslie N. Masonson Interested in learning more about using exchange traded funds (ETFs) in your trading? This time, we look at ETFs made up of real estate investment trusts (REITs)— what they are, the change that occurred in 2016, and a closer look at the more than 30 US REIT ETFs listed today.

FEATURE ARTICLE

8 VIX Or Historical Volatility?

by Perry J. Kaufman Position sizing is an often overlooked variable when it comes to strategizing your trades. There are different ways to decide how big your positions should be and here we look at a unique approach to size your positions using volatility.

14 S&P Fuel Gauge: An Introduction

by Chris Evans Ever thought about how much energy a rally in the S&P 500 has? Here’s a technique that could help measure that energy and may even give you an edge.

18 This Butterfly Wears Kevlar by John A. Sarkett Butterflies are a well-known options trading strategy. But here’s one that’s a little different.

22 The Grand Illusion

by Tim W. Wood, CPA Is the economy as strong as it looks? The charts may suggest the economy is strong but the real answer lies between the price bars. Let’s take a peek.

MARCH 2017, Volume 35 Number 3

26 Buy & Sell Pressure And A Faster RSI

by Tushar S. Chande, PhD Most of you are familiar with the relative strength index (RSI), but are you taking full advantage of it? Here, we deconstruct the RSI to lead to a more intuitive and symmetrical gauge of buying and selling pressure and a more responsive indicator.

41 Explore Your Options

by Tom Gentile Got a question about options?

48 Golden Cross Breakouts

TIPS by Ken Calhoun In this monthly column on trading breakouts, this professional trader shows how you can use the “golden cross” on a chart as an entry signal for swing trades.

31 Futures For You

by Carley Garner Here’s how the futures market really works.

32 About Those Binary Options

by Gail Mercer Whether you’re a scalper, an intraday trader, or a longer-term trader, binary options can provide several types of trading opportunities and can work in any type of market condition. What are they and how can you trade them?

35 Q&A

by Rob Friesen This professional trader answers a few of your questions.

INTERVIEW

36 Gavin McMaster: Living Life As An Options Trader

by Jayanthi Gopalakrishnan You don’t have to be an aggressive trader to make it as an options trader, says this “master” of options trading. Gavin McMaster specializes in income trading using options and likes to focus on short volatility strategies. He believes that patience in waiting for the best setups is the key to successful trading. We decided to find out more.

AT THE CLOSE

60 Successful Trader Must-Haves

by Claudio Demb Emotions can wreak havoc on our trading lives. The first step toward combating them is to be aware of their existence.

PRODUCT REVIEW 42 • NinjaTrader 8 (Part 2) Trading platform for active equity, futures, and forex traders.

DEPARTMENTS 6 49 50 57 57 58 59 59

Opening Position †Traders’ Glossary Traders’ Tips Advertisers’ Index Editorial Resource Index Futures Liquidity Classified Advertising Traders’ Resource

This article is the basis for TIPS Traders’ Tips this month.

n Cover: Brian Taylor n Cover concept: Brian Taylor/Christine Morrison

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4 • March 2017 • Technical Analysis of Stocks & Commodities

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March 2017 • Volume 35, Number 3

Opening Position

The Traders’ MagazineTM

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U

ncertainty begets risk, which is what gives markets their mysterious character. You never know what the market will do next. If you expect something, it’s most likely to do the opposite. All the more reason to approach the markets each day with an open mind. The bull market cycle that started in 2009 is going to celebrate its eighth birthday in March 2017. No matter how many times it looked like it had made its peak, it bounced back and continued its bullish ride. Bears are always saying how the market is way overvalued, and they’re correct. In spite of the high valuation, volatility, overall, has been quiet. If you look at the CBOE Volatility Index (VIX) you’ll see that although there were a few spikes, the index has generally maintained low levels. The same goes for the number of corrections since 2009. Relatively speaking, they have been few. So, just looking at these variables, the indications show no signs of any panic. But maybe that doesn’t mean anything. We have a new administration in Washington, which brings with it a certain amount of uncertainty. But that’s nothing new to traders, who thrive in an environment of uncertainty. In fact, the more uncertainty, the better it is for traders.

As

a trader, you have a unique relationship with the market. You still have to be fully aware of what the markets are doing, regardless of whether you have positions open or not. In other words, you need to feel the pulse of the markets so you can find opportunities that give you the returns you want. And you have to be able to recognize the signals that tell you that things could go awry any time soon. Each one of us is different and we each have our own way of interpreting the markets. As an example, some traders feel the pulse of the markets through the VIX. When the VIX is high and stays high, they feel that something big is about to happen. Others may feel the number of buyers vs. sellers is a great indicator to show a shift in market behavior. And if you’re not attached to an indicator, I encourage you to look at historical charts and look at previous market peaks or troughs to see how the market behaved in the months prior to the high or low. Was volatility high? Were corrections more frequent? Were there divergences between price movement and indicators? Get to know the markets, understand them, feel them. Then approach them knowing fully well they are mysterious and could easily wipe you out.

6 • March 2017 • Technical Analysis of Stocks & Commodities

Jayanthi Gopalakrishnan, Editor

Miami Downtown Richard Cavalleri/Shutterstock

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pointed in their outstanding price appreciation. Build powerful NA R EIT retrading systems in search has shown that from 1972 to MINUTES 2015, equity REITs without coding have delivered a 12.0% total return, which compares favorably to 10.3% for the S&P 500 by Leslie N. Masonson ® index. Furthersure you’re familiar with the term REIT, or real more, according estate investment trust. They were created by to JPMorgan Asan act of Congress known as the Real Estate set Management, Investment Trust Act of 1960. A REIT is simply REITs were the www.NeuroShell.com a common stock fund similar to a mutual fund that buys or top performer of 301.662.7950 finances real estate property or mortgages. They are often 10 standard asset publicly traded on stock exchanges but many are non-public. classes from 2000 Three well-known benchmarks are the Dow Jones Equity All through year-end REIT Index (REI), the MSCI US REIT Index (RMZ), and 2015. Actually, they were the number one performer in eight the Cohen & Steers Realty Majors Portfolio Index (RMP). of those 16 years, which is quite an accomplishment. In their analysis, they found that REITs had an average REIT properties typically consist of hospitals, large shopping malls, office buildings, hotels, nursing homes, storage facili- annual return of 12.0% during this period, compared to large ties, apartments, warehouses, and mortgages. However, most caps, which averaged 4.1%, and small caps, which averaged 6.6%. Most investors would not have guessed this outcome if REITs usually focus on only a single property type. asked which asset category would be the best asset class for such a long time period. The devil is in the details With the phenomenal growth of the real estate sector over REIT investors receive periodic annual dividends that are the past few decades, there were dissubject to taxes as ordinary income, but cussions among industry participants can also receive a return on capital and Largest REITs by Market Cap about potentially separating real estate some long-term capital gains. REITs Company Ticker Symbol from the financial market sector, which provide higher income than TreasurSimon Property SPG consists mostly of money center and ies, impressive total returns compared regional banks, diversified financial, to the S&P 500 index, and other major Public Storage PSA insurance, consumer finance, and averages. Real estate is a separate asset Prologis PLD capital markets. It was no surprise class in addition to stocks and bonds, so General Growth Properties GGP that on September 1, 2016, real estate adding it to a portfolio reduces risk by Welltower Inc. HCN stocks were removed from the financial providing more diversification. Ventas VTR sector of the GICS (Global Industry REITs can be bought or sold at any Avalon Bay Communities AVB Classification Standard) and placed in time during the day in a liquid market Equity Residential EQR their own category. However, mortgage without difficulty. Since REITs are Boston Properties BXP REITs remained exclusively in the required to distribute their taxable financial sector. income as dividends to shareholders, it Vornado Realty Trust VNO is not surprising that these vehicles are FIGURE 1: THE LARGEST ONES. They encompass The S&P 500 index contains 26 owned by investors looking for a solid regional shopping centers, outlet malls, storage units, REITs. The S&P 400 mid-cap index high-quality apartment communities, senior housing, high income stream of dividends and healthcare infrastructure, industrial development, and has 35 REITs, and the S&P small-cap growth potential. And investors over office properties. Most REIT ETF portfolios contain all the past decade have not been disap- or some of these companies. Continued on page 46 Are you interested in learning more about using exchange traded funds (ETFs) in your trading? Leslie N. Masonson, an active ETF trader, is president of Cash Management Resources, a financial consulting firm that focuses on ETF strategies. He is the author of Buy—Don’t Hold: Investing With ETFs Using Relative Strength To Increase Returns With Less Risk; and All About Market Timing, as well as Day Trading On The Edge. His website is www.buydonthold.com, where he writes a weekly blog. To submit topics for future columns, reach him at [email protected].

source: NAREIT

I’m

March 2017

• Technical Analysis of Stocks & Commodities • 7

8 • March 2017 • Technical Analysis of Stocks & Commodities

OPTIONS

The Equalizer

VIX Or Historical Volatility? Position sizing is an often overlooked variable when it comes to strategizing your trades. There are different ways to decide how big your positions should be and here we look at a unique approach to size your positions using volatility.

you are counting on those trades being better. If you knew that, you would only take those trades and skip all the others.

Enter volatility Volatility is like a volcano—quiet for long periods, irst, let’s agree that always trading 100 and then violent eruptions. To use volatility successshares, or one futures contract, isn’t as good fully, traders need to know which one—historical as varying your position size based on price (HV) or implied (IV)—is best. Historical volatility is volatility. If you don’t agree, my first example measured from actual prices, while implied volatility will show why it’s a problem. Until then, I’m going (also tracked as the VIX index) comes from options to assume that we’ll use volatility. When markets are pricing. I would like to think that IV would be more quiet, positions will be larger; when they are volatile, accurate because it represents what traders are willpositions will be smaller. The key here is: How big ing to pay today rather than the lagging calculation and how small? represented by historical prices. You won’t really The principle behind correct position sizing is called know unless you try using it. volatility parity, that is, you equalize the volatility of The chart in Figure 1 compares the long-term hiseach trade, which in effect equalizes the risk, more or torical and implied volatility (on the left) and 2008 less. There are more sophisticated ways to equalize on the right. The bigger picture makes it appear that risk, but volatility parity is much simpler and gets you both methods produce close to the same values, but a 90% of the solution. closer look at 2008 shows the differences. Historical By equalizing the risk of each trade, you give each volatility continues to increase after implied volatility trade an equal opportunity to affect the results. From has flattened. But this pattern is not always the case. that you can conclude you’ve maximized diversifi- IV can spike on surprising news, then disappear the cation. If you concentrate your investment in a few next day when that news turns out to be only a rumor. markets and trade larger positions in terms of risk, HV would show only a small change.

F

Historical and Implied Volatility 120

100

100

80

80

60

60

40 20

40

0

20

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /23 6/23 6/23 6/23 6/23 6/23 6/23 6/23 6/23 6/23 6/23 6/23 6/23 6/23 6/23 6/23 6/23 6 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 BRIAN TAYLOR

Volatility Comparison, Jul-Dec 2008

120

VIX

0

07/01/2008

08/01/2008

Historical volatility (annualized)

09/01/2008

10/01/2008

Implied volatility

11/01/2008

12/01/2008

Historical volatility

FIGURE 1: COMPARISON OF Historical AND implied volatility. The chart on the left looks at historical and implied volatility from 2000 to 2016. The chart on the right looks only at 2008. The bigger picture makes it appear that both methods produce close to the same values, but a closer look at 2008 shows the differences.

by Perry J. Kaufman March 2017

• Technical Analysis of Stocks & Commodities • 9

Test

Cap

1

No

2

All PL

Long PL

Short PL

All PF

Long PF

Short PF

17,756

11,851

Yes

12,272

3

No

4 5

Comments

5,905

2.14

2.84

1.64

100 shares, unbounded

8,878

3,394

1.97

2.76

1.44

Most stocks are 10K

12,103

9,006

3,096

1.92

2.74

1.39

Size by price

No

1,029,655

785,402

244,253

2.30

3.50

1.51

Size by ATR unbounded

No

10,133

7,248

2,884

2.03

2.82

1.49

Inverse VIX

FIGURE 2: RESULTS OF FIVE SIZING TESTS USING SPY FROM 2000. For some of these tests, the exposure (position size times the entry price) is limited to $10,000; in others there is no limit.

2. 100 shares with a cap at $10,000 in exposure, so that any trade that costs more than $10,000 for 100 shares will be reduced to a $10,000 investment. 3. Size by price, that is, divide the investment of $10,000 by the current stock price. That assures that the exposure is always $10,000. 4. Size by average true range (ATR) of price. The ATR is the maximum of the high–low range, but extended to the previous close if there was a gap. This test allows any number of shares, not limited by the investment of $10,000. For a stock with low volatility, the exposure can be very large. 5. Sizing using the reciprocal of the VIX, so that an implied volatility of 70% would be interpreted as a 30% position (1–IV, but not less than zero); that is, as the volatility increases, the position size decreases. Any VIX value over 100% results in a position size of zero.

Both HV and IV have their good and bad characteristics, which makes it difficult to decide intellectually which would be a better choice for sizing. HV has a noticeable lag because it is based on a 20-day average. IV can be unreliable and erratic.

Variations on position sizing

If we use one share or one futures contract for each trade, then those markets with higher prices and/or more volatility will overwhelm the performance of other markets with low volatility. If we’re trading futures, crude oil will always have larger gains and losses per trade than eurodollars, yet eurodollars and other interest rates have been far more profitable over many years, with less risk. Using TradeStation’s EasyLanguage for testing, we apply a 120-day moving average to the ETF SPY. I know that this moving average is profitable over time, so it will be a better basis for seeing the changes caused by various methods of sizing. The table in Figure 2 shows the results of the tests, both the dollar profits and the profit factor (PF is the gross profits divided by the gross losses). For some of these tests, the exposure (position size times the entry price) is limited to $10,000; in others there is no limit. The position sizing will be calculated five different ways: 1. 100 shares for all trades. This allows positions to be greater than the investment of $10,000 when the price of SPY is above 100.

The chart in Figure 3 shows the position sizing based on these five scenarios. Tests 1 through 3, which are displayed on the left, show the number of shares. In test 3, the position size decreases as the price of SPY increases, which makes it look similar to the SPY prices, but upside-down. In tests 4 and 5, you have very large position sizes because volatility can be low. It’s not the position size that is important here, but the pattern. Rather than declining as in test 3, the position sizes fluctuate up and down in a more cyclic way. The

Comparison of Allocations, Tests 1, 2, and 3 160 140 120 100 80 60 40 20 0

Pattern of Allocations, Tests 4 and 5 2500

1200

2000

1000 800

1500

600

1000

400

500

0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 00 00 00 00 00 00 00 00 00 00 01 01 01 01 01 01 01 6/2 /26/2 /26/2 /26/2 /26/2 /26/2 /26/2 /26/2 /26/2 /26/2 /26/2 /26/2 /26/2 /26/2 /26/2 /26/2 /26/2 2 / 06 06 06 06 06 06 06 06 06 06 06 06 06 06 06 06 06

T1 100 Shares

T2 100 Shares (capped)

T3 Size by price

200

0

0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 00 00 00 00 00 00 00 00 00 00 01 01 01 01 01 01 01 3/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 2 / 06 06 06 06 06 06 06 06 06 06 06 06 06 06 06 06 06

Implied volatility

0

Historical volatility

Figure 3: SIZING Comparison. Tests 1–3 on the left show the number of shares. On the right, tests 4–5 show relative changes in position sizes. The actual number of shares won’t matter, only the relative change in the position size.

10 • March 2017 • Technical Analysis of Stocks & Commodities

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The principle behind correct position sizing is called volatility parity, that is, you equalize the volatility of each trade, which in effect equalizes your risk, more or less. pattern of tests 4 and 5 are similar, with a few added spikes in test 4 that do not appear in test 5.

Which is better?

These tests were designed to show the ideal returns of each choice rather than the practical application, where the size is limited by the investment. In the first two tests, using 100 shares means that a few trades taken under high volatility might have large gains or large losses, overwhelming many trades that occur at low volatility. In Figure 2 you see a summary of the results. Intuitively, you expect the returns from the long positions to be better than the shorts because of the upward bias of the stock market. Still, the shorts were all profitable, which is a good outcome. Trades that can be profitable on both the long and short side show that the timing is good. Tests 1 and 2: 100 shares, without and with capping Tests 1 and 2 both trade 100 shares, but test 1 doesn’t care if the 100 shares give an exposure of $500 or $100,000. The higher price of the SPY in the more recent years will have greater value and will influence the results to a much greater degree. In 1998 the SPY traded at 80 and now trades at about 220. The five-year bull market that followed the financial crisis will have a greater impact than the bear markets of 2001 and 2008. That creates a poor portfolio risk profile because lower-priced stocks may be performing well but are overwhelmed by losses in a high-priced stock. Even though the profit factor of 2.14 is high, I see this case as highly risky because it can be distorted by a few big trades. In addition, you need an increasingly larger investment to keep trading. In 2000 the SPY traded at 150, so 100 shares

would cost $15,000. In mid-2016 it was 220, an investment of $22,000 per trade. When you cap the exposure in test 1 to $10,000 per trade, which gives each trade equal impact, the results drop and are far less attractive. Trades when SPY was under 100 will still have smaller representation, but any trading priced over 100 will have its size reduced. As an aside, we can infer from this that trades in SPY have been better at higher prices. Test 3: Size by price This is the most common way of sizing that achieves equal risk in a simple way. The per-trade investment of $10,000 is divided by the current price of SPY to get the number of shares. When you use this method for trading, you should avoid stocks priced under $5. They are more volatile and erratic, plus the position sizes expand rapidly as the price falls under $5. The results were nearly identical to test 2 because that test had all trades that were entered when SPY was over 100 reduced to a total exposure of $10,000. That was most of the trades. Test 4: Real volatility parity This is an interesting test because it is the ideal case, that is, money-is-no-object case of volatility parity. Each trade size creates exactly the same risk as every other trade. This means that the position sizes are very large during low volatility, and very small during high volatility. The long profit factor of 3.50 is far above the others, showing that, in theory, true equal risk is the best way to trade. On the downside, it takes more than $1 million to trade this way. Test 5: Using implied volatility This is where I thought implied volatility could outperform historical volatility by a large factor. Instead, it produced an average result. My experience with this is that implied volatility jumps up quickly, avoiding the lag in historical volatility. But then it also disappears quickly when nothing happens. That results in a lot of false volatility spikes. It may also be that my formula for turning the VIX price

Cumulative Profits, Tests 1, 2, and 3 25000

Cumulative Profits, Tests 4 and 5 1400000 1200000 1000000 800000 600000 400000 200000 0 -200000

20000

Test 5

15000 10000 5000 0 -5000

0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 00 00 00 00 00 00 00 00 00 00 01 01 01 01 01 01 01 3/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 2 / 06 06 06 06 06 06 06 06 06 06 06 06 06 06 06 06 06

T1 PL

T2 PL

T3 PL

Test 4

12000 10000 8000 6000 4000 2000 0 -2000 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 00 00 00 00 00 00 00 00 00 00 01 01 01 01 01 01 01 3/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 /23/2 2 / 06 06 06 06 06 06 06 06 06 06 06 06 06 06 06 06 06

T5 PL

T4 PL

FIGURE 4: volatility parity is the best solution. On the left, test 1 outperforms tests 2 and 3 (which overlap each other), but this is unrealistic because the investment size exceeds the limit of $10,000 per trade. In this case, test 3 is the most practical. Test 5, using implied volatility, has some unacceptable rallies and drawdowns from 2008 to 2010. Test 4 gives the best results overall, but the investment size varies enormously, making it impossible to implement.

12 • March 2017 • Technical Analysis of Stocks & Commodities

(or volatility) into a sizing factor could be flawed. It is simply F = 100 – VIX or zero, whichever is larger. So when volatility is very high we have no shares. In reality, VIX has averaged 21% over time, and most values stay in the range 13% to 30%, rarely going over 50%. But the sizing using VIX should be different from using price. It would have cut size dramatically during 2008 and would have increased significantly during the long bull rally that followed.

Visualizing

the results Sometimes numbers aren’t enough. In Figure 4 you see the cumulative profits for each of the five tests. On the left, test 1 outperforms tests 2 and 3 (which overlap each other), but is unrealistic because the investment size exceeds the limit of $10,000 per trade. From these tests you would conclude that test 3 is the most practical. Tests 4 and 5 (on the right) are more difficult to interpret because position sizes have been allowed to exceed the $10,000 investment. Here you are looking for the smoothness of the returns. This shows that test 5, using implied volatility, has some unacceptable rallies and drawdowns from 2008 to 2010, while using the ideal volatility parity sizing based on historical volatility (test 4) gives the best results overall. Unfortunately, with test 4 the investment size varies enormously, making it impossible to implement. However, it does prove that, theoretically, volatility parity is the best solution.

Making the choice

Except for test 5, which uses IV, the others are extremely close. As a final measurement, I calculated the ratio of the total profits divided by the standard deviation of the daily profits and losses, a reward-to-risk ratio similar to the Sharpe ratio. Results are shown in the table in Figure 5. To be practical, test 3 is the easiest choice because you simply divide the investment per stock by the current price. While test 2 may have a slight edge because it trades smaller exposure when the value of 100 shares is less than $10,000, it wouldn’t apply to SPY now. Given a choice, I always prefer simpler. Test 1

Test 2

Test 3

Test 4

Test 5

0.577

0.546

0.540

0.596

0.462

Perry Kaufman is a trader and financial engineer. He is the author of many books on trading and market analysis, including Trading Systems And Methods, 5th ed. (with the first edition published in 1978 as a seminal book in the field of technical analysis), and A Guide To Creating A Successful Algorithmic Trading System (2016). For questions or comments, please go to www.kaufmansignals.com.

Further reading

Kaufman, Perry J. [2013]. Trading Systems And Methods, 5th ed., Wiley. [2015]. A Guide To Creating A Successful Algorithmic Trading System, Wiley. [2003]. A Short Course In Technical Trading, Wiley. [1995]. Smarter Trading, Wiley. [2014]. “A Better Trend,” Technical Analysis of StockS & commoditieS, Volume 32: April. [2014]. “Timing The Market With Pairs Logic,” Technical Analysis of StockS & commoditieS, Volume 32: March.

FIGURE 5: REwaRd-to-RIsk RatIos FoR all tEsts. Test 3 is the easiest choice because you simply divide the investment per stock by the current price. Test 2 may have a slight edge because it trades smaller exposure, but because the value of 100 shares is less than $10,000, it wouldn’t apply to SPY now. March 2017

• Technical Analysis of StockS & commoditieS • 13

Is Your Tank Half Full?

S&P Fuel Gauge: An Introduction

T

by Chris Evans he performance of the S&P 500 can tell you a lot about global asset returns. If it goes up materially, then bonds usually fall, and if it goes down, bonds usually rise. If it goes up, traders prefer currencies like the Australian dollar over, say, the Japanese yen. If you start your trading day with an advantage or appropriate bias, then you would know how to

14 • March 2017 • Technical Analysis of Stocks & Commodities

hedge or add to your positions. If you knew there was no skew in likely returns in the S&P, then you could take the day off and go to the gym or, even better, a trip to Bermuda.

Here’s the reality

Your challenge is to measure the potential energy available to make the market rally. It has little to do with recent momentum or the consensus view you hear and read about. In fact, if you go with what you hear in the media, you may end up buying after a bout of weakness. If you buy into a trend, you can only do it if the conditions are right. Here’s how I look for the right conditions. To measure energy, I have to be confident that I know all

S&P500:MATTZ90/GAUGE: RFVECTORS/ SHUTTERSTOCK/COLLAGE: NIKKI MORR

Ever thought about how much energy a rally in the S&P 500 has? Here’s a technique that could help measure that energy and may even give you the edge you’re looking for.

TRADING STRATEGY

250 A Occurrences

the forces that matter in the short term that lead to rallies. I must then prove that there is forecasting value in the index. I use a daily timeframe and to the extent that a high index level persists, I may be able to hold onto a long position for one to 10 days. It can augment a shorter-term trading method, but it may not help if you have a monthly perspective.

200 150 100 50 0

There are three parts to the index: 1. fear 2. time since the last period of weakness 3. interest rates. It is simply axiomatic that when investors are afraid, we want to be buying. When everyone is happy or complacent, we can wait to enter. If the market got hit and many investors were forced out of the market, a special window, which I refer to as a “trauma window,” opens. When this window opens, you can buy it ahead of those people before they get back in, which ultimately they will all do. Finally, it is generally true that lower interest rates help equity valuations and force people out of lower-yielding bonds and into stocks.

How is it behaving?

The energy index ranges between zero and 100 with a mean of 52 and a median of 50. I break it up into two components— bonds and fear. I adjust both for volatility and where the index stands in the trauma window. It is not normally distributed, which means it doesn’t cling to a mean with comparatively few readings at the extremes. It is also not particularly sticky. If you get a huge short-term rally or if bonds fall precipitously due to some central bank announcement, this index can swing quickly from bullish levels to bearish ones. If you have just come out of a period of severe weakness, the index will persistently stay in bullish territory. The distribution looks similar to what you see in Figure 1. Next, I’ll look at the parts separately to see their independence and volatility (Figure 2). You can see that bonds and fear are not connected or correlated. Bonds as a factor are more volatile than the fear factor. Since I am able to see the daily levels of both, I will be able to run scenario tests to see prospective gains when the two parts are opposing one another. And when both factors are at attractive levels, I may also prefer to take long positions. The chart in Figure 3 displays the index. It’s easy to see how the sum of the two parts creates the aggregate—there is no special weighting system. I allow each component to rise slightly above 100 to make it possible to get a total that is greater than 100 for the index. In such cases, I set the index to its maximum of 100. That’s why the distribution has an abnormal number of readings equal to 100.

Filter it

The next step is to look at performance to see if the index is helping to avoid lousy returns from your long positions and

0– 1 10 0 –1 15 5 –2 20 0 –2 25 5 –3 30 0 –3 35 5 –4 40 0 –4 45 5 –5 50 0 –5 55 5 –6 60 0 –6 65 5 –7 70 0 –7 75 5 –8 80 0 –8 85 5 –9 90 0 – 95 95 –1 00

Where’s the energy?

Index Range

Figure 1: AN S&P FUEL GAUGE. The energy index ranges between zero and 100 with a mean of 52 and a median of 50. The distribution looks similar to what you see here. 2,100.00

2,100.00

2,050.00

2,050.00 2,042.75

2,000.00

2,000.00

1,950.00

1,950.00

1,900.00

1,900.00

1,850.00

1,850.00

50.00 40.00 30.00 20.00 10.00 70.00 60.00 50.00 40.00 30.00 20.00 10.00

50.00 40.00 30.00 20.00 14.62 10.00 70.00 60.00 50.00 40.00 40.28 30.00 20.00 10.00

Fear

Bonds Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

’16

Feb

Mar

Apr

FIGURE 2: BONDS VS. FEAR. The two are not correlated and neither are they connected. Bonds, as a factor, are more volatile than the fear factor. 2,100.00

2,100.00

2,050.00

2,050.00 2,040.50

2,000.00

2,000.00

1,950.00

1,950.00

1,900.00

1,900.00

1,850.00

1,850.00 100.00 90.00 80.00 70.00 60.00 50.00 50.02 40.00 30.00 20.00

100.00 90.00 80.00 70.00 60.00 50.00 40.00 30.00 20.00 Jun

Jul

Aug

Sep

Oct

Nov

Dec

’16

Feb

Mar

Apr

FIGURE 3: A LOOK AT THE DAILY CHART.

good returns from your short positions. I’ll start by looking at the long positions. From the table in Figure 4, you can see that if you buy S&P futures at ever-higher index levels, your average daily returns rise and the numbers of instances fall. The relationship is not perfect since there are some extreme cases of volatility in this 10-year history. I don’t expect a perfectly smooth beta in this regression. You can also see that if you wait for higher index readings to

Keep one eye on the road and the other on the S&P 500 fuel gauge, and you can work yourself up to lead the pack. March 2017

• Technical Analysis of Stocks & Commodities • 15

Filter >90 >85 >80 >75 >70 >65 >60 >55 >50 >45 >40 >35 >30 >25 >20 >15 >10 >5

Total Ret 277.00 529.25 506.50 905.00 769.00 1028.25 1023.70 1061.25 949.50 947.95 1168.45 1235.20 1123.45 1099.50 992.25 687.75 542.50 508.25

# Instances 183 244 345 430 533 633 751 894 1053 1249 1467 1655 1781 1876 1996 2097 2139 2148

Avg Ret 1.514 2.169 1.468 2.105 1.443 1.624 1.363 1.187 0.902 0.759 0.796 0.746 0.631 0.586 0.497 0.328 0.254 0.237

FIGURE 4: BUY POSITIONS. If you buy S&P futures at ever higher index levels you see your average daily return rise and the number of instances fall. You can also see that if you wait for higher index readings to buy you lose opportunity and it is quite possible that you may not get such an attractive level in your desired time frame.

Filter <50 <45 <40 <35 <30

Total Return -459.00 -406.45 -566.20 -746.20 -503.70

# Instances 1077 877 661 476 361

Avg Return -0.426 -0.463 -0.857 -1.568 -1.395

<25 <20 <15 <10

-460.25 -433.75 -94.75 -5.25

262 138 40 8

-1.757 -3.143 -2.369 -0.656

FIGURE 5: IS IT TIME FOR THAT ROAD TRIP? Low readings in the index almost guarantee a mediocre return. This data set includes a 50% rally in the market overall with a 50% loss from its starting point.

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

>40 94 174 160 207 171 181 220 144 95 39

>45 89 151 127 161 158 155 193 122 74 29

>50 87 129 95 129 135 138 167 98 60 23

>55 83 110 84 107 109 123 145 77 43 19

>60 79 94 70 88 81 106 126 69 27 17

>65 75 83 54 72 66 94 105 56 17 17

>70 71 75 40 59 56 82 84 44 14 13

FIGURE 6: HOW OFTEN DO YOU GET HIGH READINGS? This is a good metric to know just so you can have an idea of how often you need to be long to get sufficient returns.

16 • March 2017 • Technical Analysis of Stocks & Commodities

buy your positions, you lose opportunity and it is possible that you may not get such an attractive level within your desired timeframe. Everyone must pick their own threshold. The table in Figure 5 shows that low readings in the index almost guarantee a mediocre return. This dataset includes a 50% rally in the market overall with a 50% loss from its starting point. There are lots of high- and low-volatility periods to study. Even with the rally, it’s clear that you need to wait till index levels are low before you buy. It is certainly true that even in raging bull markets, if the index is low, high positive returns are rare and you are more likely to earn meager returns.

Make it cleaner

If the market is rallying up and you are not long, you may worry that you will not be able to reap the returns others are seeing. You want to jump in even though the price level (and the index) seems high. The table in Figure 6 shows you by year how often you get high readings. There are 250 trading days in a year, so if you get, say, 80 trading opportunities, then you are long about one third of the time, which may be sufficient. The table in Figure 7 shows how much money you would have made each year filtered by index level. The flaw with this table is that it fails to show you what the market offered as a return during the period. You can see, for example, significant declines in early 2010 followed by gains, so that for the year, the market and index gave you a positive result. Nevertheless, you should not just blindly use the fuel index. There are a sufficient number of cases where the index was bullish, but the market was in a state of transitioning into a bear market, which was the case in 2010 and 2014. A bear market test is needed so that if the index does break down, it needs to reset to lower levels. As you see weakness in a market that is in a strong rally, you may find yourself getting more bullish, but if it breaks down below a certain threshold, you will have to abandon hope, at least for a while. But then again, the markets have a tendency to mean-revert, which is why it’s always a good idea to use stops. Another thing you can do is wait for the index to give you an attractive

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

>40 18.50 -93.25 278.45 77.50 120.00 131.00 434.50 94.75 188.00 78.75

>45 14.50 94.25 108.45 -38.25 45.25 64.75 391.50 15.75 298.25 37.75

>50 32.00 58.50 86.25 -13.50 -67.50 72.75 335.75 108.25 333.50 66.00

>55 51.25 70.75 96.50 -44.50 128.50 134.00 297.25 48.75 319.25 30.25

>60 33.25 93.25 108.00 -78.30 86.00 191.25 194.00 21.00 332.75 113.25

>65 11.75 120.50 132.50 -17.50 132.50 213.50 179.00 -9.25 222.75 113.25

>70 15.25 51.00 165.75 14.75 49.50 172.75 181.50 -27.25 161.25 77.50

FIGURE 7: HOW MUCH DID YOU MAKE EACH YEAR? You can see there were sufficient declines during 2010 but you can’t determine how much of a return you made in a specific year.

600

An index that helps project equity returns might also indicate when to buy or reduce bond exposure, since bonds, in the short run, are extremely negatively correlated to the S&P contract. From Figure 10 you can see that the average bond return over this 10-year period is 0.027 points per day. There has been a huge upward tilt in bond prices. Notice how as the index reaches bullish levels, the returns on bonds fall precipitously. Even if you only trade bonds, you still can use this index to manage your exposure or duration.

Top it up with forex

You may not have a strong feeling for how the euro or the British pound may be affected by an S&P rally, but you know there are some reliable associations between the S&P index and the foreign exchange markets. The Japanese yen has been a place of refuge during periods of western turmoil and the Australian dollar is a commodity producer that outperforms during good economic times or when the S&P rallies. Let’s look at the Australian dollar but adjust for the general direction of the US dollar by dividing by the price of

-200 -400 -600

-20

0

20

40

60

80

100

120

Interval Range Midpoint

FIGURE 8: LOOKING AT A NARROWER RANGE. The size of each bubble is proportionate to the number of occurrences. Each range band is 10 points. The most reliable levels where all the points are significantly above zero occur when the index range midpoints are >= 60. 2000 1500

Cum ES

Cum System

1000 500 0 -500

08

/07 12 /200 /28 7 05 /200 /22 7 10 /200 /13 8 03 /200 /09 8 07 /200 /30 9 12 /200 /21 9 05 /200 /17 9 10 /201 /07 0 03 /201 /02 0 07 /201 /25 1 12 /201 /14 1 05 /201 /08 1 09 /201 /27 2 02 /201 /21 2 07 /201 /16 3 12 /201 /05 3 05 /201 /01 3 09 /201 /23 4 02 /201 /13 4 07 /201 /08 5 11 /201 /27 5 /20 15

-1000

FIGURE 9: S&P 500 VS. TRADING ONE ES CONTRACT WITH VARYING POSITION SIZES. You can see there are some severe pullbacks. That’s because you must be long through all markets. The nice thing is that the drawdown is 40% lower and the total number of points earned is almost three times greater.

the euro (Figure 11). I do this so I can see the underlying behavior of the Australian dollar without the macro effect. For this, I would use the following rules: 1. Buy the A$/EC cross if the index is > 65 2. Short the A$/EC cross if the index is < 35. If the index is between 65 and 35, you wouldn’t take a position. Continued on page 45 18 16 14 12 10 8 6 4 2 0 -2 -4

Filter >40 >50 >60 >70 >80 >90

Avg Ret 0.032 0.019 0.011 0.006 0.012 -0.004

FIGURE 10: WHAT ABOUT BONDS? The average bond return over this 10-year period is .027 points per day. Notice how as the index reaches bullish levels the returns on bonds fall precipitously. Even if you only trade bonds, you still can use this index to manage your exposure.

A$/EC

/20 0 /12 7 /2 03 007 /07 /2 08 008 /28 /2 02 008 /24 /2 08 009 /18 /2 02 009 /11 /2 08 010 /06 /2 01 010 /31 /2 07 011 /26 /2 01 011 /19 /2 07 012 /12 /2 01 012 /03 /2 06 013 /28 /2 12 013 /20 /2 06 013 /18 /2 12 014 /10 /2 06 014 /04 /2 11 015 /25 /20 15

Boost the octane with bonds

0

/21

You know where the index stands every day, and with that information, how can you figure out if the index is trending or not? The filters I discussed will not work since they are grouping all outcomes above or below a threshold, and that dataset may include many better or worse conditions than the current one. What you need to do is view the performance within a narrow band around the current level of the index. The most reliable levels where all the points are significantly above zero occur when the index range midpoints are >= 60 (Figure 8). Each range band is 10 points and the size of each bubble is proportionate to the number of occurrences. I shall resist the temptation here to create a simple trading system using the index. The index can be used just for risk control but allow me this indulgence. Let’s say you were forced to own the S&P contract. You can never be flat but you can own the contract in proportion to the level of the index. The position quantity will be set at index/50 so the average position over 10 years equals close to one—1.03 to be precise. Let’s compare that with the S&P 500. You can see from Figure 9 that there are still some severe pullbacks. That’s because you must be long through all markets but the drawdown is 40% lower and the total number of points earned is almost three times greater.

200

09

Don’t forget your daily tune-ups

03

reading and then apply a shorter-term (for example, hourly bars) trend-following system that can only buy. If it sees a breakout to the upside, then you enter a long position. If the hourly chart breaks down, you exit and wait for the next opportunity.

Total S&P Points Earned

400

FIGURE 11: TRADING THE AUSSIE/EURO CROSS. There’s a relationship between the S&P500 and just about everything, including currencies. Study those relationships and see how you can take advantage of them. March 2017

• Technical Analysis of Stocks & Commodities • 17

up advising the firm on how to make it even better. His professional management experience includes both domestic and foreign tours of duty at IBM, Petrie Stores, PriceWaterhouseCoopers, and Unisys. He presently serves as an options consultant to hedge, mutual, and pension fund money managers, as well as teaching options trading at a new mentoring operation.

Get Your Bullet-Proof Vest On

This Butterfly Wears Kevlar

Butterflies are a well-known options trading strategy. But here’s one that’s a little different.

In

by John A. Sarkett the history of options trading, Jim Riggio goes “way back.” He started trading more than two decades ago. He was among thinkorswim’s first 100 clients; trained as an engineer, with degrees in computer science and information management, he admired their advanced platform so much he became a broker there, and wound

18 • March 2017 • Technical Analysis of Stocks & Commodities

All the while, there was one constant: He was trading options himself, for his own account, and all the while honing, perfecting, and striving to perfect his methods. The passion never subsided through the serpentine path of ups and downs that every veteran trader knows. Capital preservation became his focus and is what makes his approach somewhat different. Everyone talks about capital preservation; Riggio builds his unique strategies around it. “I realized,” he says, “in my 20 years of trading options, almost every beat-down that I ever received was because of some combination of my short gamma and short vega. Since I, like most options traders, collect time premium (positive theta), I used to think that my short gamma and short vega were just things that I would have to accept. Which I did. Until the implosion of 2008, when I made it my life’s mission to collect theta without, or at least with drastically reduced, gamma and vega risk.” Thus, the Kevlar butterfly was born. The name came not from Riggio himself but from a student, who, on grasping its power and efficacy, said,

Butterfly: butterfly hunter/yellow kevlar: horban iryna/ shutterstock/collage: christine morrison

The story behind Kevlar

options

“Wow, this butterfly can survive huge market Profit/Loss by Change in SPX Index Price $ moves ... it’s like the butterfly is wearing 90000 +610% T+37 81000 +550% a Kevlar jacket or something.” The name T+19 72000 T+0 +490% stuck. (Kevlar is the near-indestructible 63000 +430% synthetic fiber used in helmets and bul54000 +370% letproof vests.) 45000 +310% Most butterfly traders start with short 36000 +250% strikes at-the-money (ATM). Most every 27000 +180% options textbook or trainer depicts the but18000 +120% terfly that way. The Kevlar butterfly is notably 9000 +61% different. It starts with a below-the-money 0 0% (BTM) butterfly that shows negative delta -9000 -61% -18000 -120% but neutral or positive gamma. So in that -27000 -180% sense, it can be viewed as “bearish.” -36000 -250% But there’s more, much more to the method -45000 -310% than that, and it can generate profits in up 1832.50 1867.50 1902.50 1937.50 1972.50 2007.50 2042.50 2077.50 2112.50 2147.50 2182.50 2217.50 2252.50 2287.50 -10.9% -9.2% -7.5% -5.8% -4.1% -2.4% -0.7% +1.0% +2.7% +4.4% +6.1% +7.8% +9.5% +11.2% markets as well. Its success is based on a profound respect for the destructive capabili- FIGURE 1: Low IV and steep put skew. Here you can see that puts well below-the-money are expenties of vega and gamma: “The Kevlar’s risk sive compared to puts at-the-money (ATM). In this case, a symmetrical, below-the-money (BTM) butterfly management methodology will exchange is paired with a deep in-the-money (ITM, with at least 60 delta) call. theta (collecting time premium) for reduced risk (gamma near zero and drastically lower short vega when He has two distinctly different approaches for the two main IV is low). This had become an obsession of mine. If deltas market environments: low implied volatility (IV) (mode 1) are under control, gamma is near zero, and vega is not too and high implied volatility (mode 2). short when IV is low, the market is going to have a harder To determine low versus high IV, he looks at a VIX chart for time defeating me.” the past year. Which quartile are we in, he asks: 0-25, 26-50, With a dash of self-deprecation that gives his online dis- 51-75, 76-100? The skews he gets from a proprietary source. courses appeal, he says: “Some people have called me paranoid Many platforms provide these as well: in thinkorswim, for about the options market, to which I reply, ‘I may be paranoid, example, go to Trade ➞ All Products ➞ Product Depth ➞ but that doesn’t mean the market is not still trying to take my Options. Change the filter from “All” to “Puts,” and change the view to show implied volatility (“Impl Vol”). Under Setup money away.’” Currently, he is sharing the ins and outs of the Kevlar but- ➞ Application Settings ➞ Calculations, you can change which terfly at Capital Discussions, a new trade education and alert volatility calculation method is reflected (such as volatility service featuring several top mentors he cofounded with op- smile or individual implied volatility). To his method, which volatility environment he is in at a tions veteran Tom Nunamaker. given time makes a significant difference. Once he determines where we are in the volatility universe, he feels confident to How he trades it Riggio’s vehicle of choice is the monthly SPX. He aims for move to create a position. In Figure 1 you see the risk curve no more than one or two adjustments per cycle, and he targets of mode 1, where volatility is low and the put skew is steep. 5% to 10% gains per trade on a $50,000 account with less Note that puts well below-the-money are expensive compared than 5% loss. He will scale into and out of trades. Target exit to puts at-the-money (ATM). In this case, Riggio creates a time occurs at about 14 days to expiration (DTE), but this is symmetrical, below-the-money (BTM) butterfly paired with flexible. He explains: “The reason is that the risk, especially a deep in-the-money (ITM, with at least 60 delta) call. In the the gamma risk, is much, much more as you get closer to SPX, he uses 100-point wings such as 1900/2000/2100. In Figure 2 you see a risk curve of mode 2, or a highexpiration. I would prefer to take my measly 5% to 10% and go home … and start the next trade with 60 to 80 days to volatility environment and normal-to-flat put skew. In this scenario, Riggio puts on a below-the-money (BTM) put broken expiration.” Indeed, in the Riggio schema, gamma is crucial. Riggio wing butterfly (BWB). The upper strike is usually 25 points watches it like the proverbial hawk and he does whatever it above SPX price. This position has much more negative vega. Here, the spacing is a right wing that is 75 points above the takes to keep it low. All this seems sound and reasonable enough, but what short strike, and the left wing is 100 points lower. If the SPX makes his approach unique is the entry scenario about which is 2050, then the BWB is put on at 1900/2000/2075. There’s he is quite particular: operative entry elements are a) volatil- no long call this time. ity and b) skew. It is best to enter both models on down days where implied While other traders ignore these, he focuses on them like volatility is up. While it’s easier to trade all one type, for exa laser. ample, all puts, he will employ iron butterflies (short put credit March 2017

• Technical Analysis of Stocks & Commodities • 19

$

120K

Profit/Loss by Change in SPX Index Price

110K 100K 90K

+240%

T+56 T+28 T+0

+220% +200% +180%

80K

+160%

70K

+140%

60K

+120%

50K

+98%

40K

+79%

30K

+59%

20K

+39%

10K

+20%

0K

0%

-10K

-20%

-20K

-39%

-30K

-59%

-40K

-79%

-50K

-98%

-60K

-120%

1604.40 1639.40 1674.40 1709.40 1744.40 1779.40 1814.40 1849.40 1884.40 1919.40 1954.40 1989.40 2024.40 2059.40 2094.40 2129.40 2164.40 -16.2% -14.4% -12.6% -10.7% -8.9% -7.1% -5.3% -3.4% -1.6% +0.2% +2.0% +3.9% +5.7% +7.5% +9.4% +11.2% +13.0%

FIGURE 2: High IV and normal-to-flat put skew. In this scenario, a below-the-money (BTM) put broken wing butterfly is put on. The upper strike is usually 25 points above SPX price. This position has much more negative vega. Here, the spacing is a right wing that is 75 points above the short strike, and the left wing is 100 points lower.

spread under a short call credit spread) to generate credits and conserve capital. The Kevlar butterfly mitigates risk by having a negative delta and a flat T+0 line. He says: “In a market decline, the S&P 500 market price must travel through my profit zone to get to my risk zone. This gives the Kevlar a strong defensive position for a market selloff,” he says. Offense sells tickets, he says, but defense wins championships.

Managing positions

While he is fairly rigid about entry, his adjustments are managed by the options greeks. To lift his T+0 (today’s profit-loss sum), he employs a variety of tools to flatten the profit peak and generate credits. These might include “condorizing” his position with additional credit spreads, moving his position up or down, or just adding long puts or calls. Veteran trader that he is, Riggio has a visceral reaction for how fast a profit can turn into a loss in an otherwise “brilliant” options strategy, so his first “adjustment” can be as simple as taking a trade off when it reaches approximately 10% profit, either entirely or by partials. For example, if a butterfly has 6 x 12 x 6 contracts, he might take off 2 x 4 x 2. If he feels motivated to stay in a position—which, by the way, is a function of the math, not a “feeling”—he will look at a large variety of what ifs including but not limited to leaving the position as is, selling calls, selling put condors (balanced or unbalanced), adding put or credit verticals, and more. What are his “rules?” He is not comfortable with the concept of “rules,” per se, and tells why: “It is beyond naive to think that if you can get the perfect set of rules you will conquer the options game. Anyone who learns sound options trading skills and who masters risk management methodology should be able to become a profitable options trader. “It is all about understanding the tradeoffs when you are making decisions. I could put together a very, very long list 20 • March 2017 • Technical Analysis of Stocks & Commodities

of rules ... for all the market conditions that I can think of, such as ... price, price trend, speed of price move, greeks (today), greeks (in one week from now), strikes, expiration cycle, days to expiration, implied volatility, skew, term structure, kurtosis, trade configurations, tape reading, knowing when you should be scared, and so on. These factors would all vary for every option structure. For example, if we had an existing broken wing butterfly with 100 points left wing vs. 75 right wing ... and when to adjust with a symmetrical 25 wide wing put condor vs. a 25/40 point asymmetrical condor ... and this would be different if the center was 25 vs. 50 points below the current SPX point ... and this would be different if the Brexit vote or US elections were tomorrow ... and this would be different if ... Do you get my point? There are just too many potential ifs.”

Trade smart

“I could write 100,000 rules, and the next day, something will happen in the market that I will need to write another 20 rules ... and following that, another 30 rules ... and the week after that ... well, you get the picture.” For clients, he winnows down this mass of potentiality to a simple, specific recommendation, sent out by email and text as a real-time trade alert. And his platform keeps score with a documented trade record and cumulative equity curve. “We are transparent,” he says simply. Most recently, while this piece was being written, in his current live trade, he elected to do that simplest and easiest adjustment: “This old geezer is going to close the Oct Kevlar, pick up my piggy bank, get a glass of lemonade, go to the bathroom (if I am going to get out of my rocking chair, why waste the trip), and then go and sit back in my rocking chair with my measly 10% profit for the month.” Self-deprecating, humorous, but with decades of options wisdom stuffed into one pithy statement, he says: “I know I’m not smarter than the market.” Which is why he puts on Kevlar garb when he ventures into it. And advises others exactly how to do the same. Continued on page 25

Anyone who learns sound options trading skills and who masters risk management methodology should be able to become a profitable options trader.

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Scottrade, Inc. Member FINRA / SIPC (“Scottrade”) is the introducing broker on your account with Interactive Brokers LLC (“IB”). IB and Scottrade are separate and unaffiliated companies. Options involve risk and are not suitable for all investors. Detailed information on the risks associated with options can be found by downloading the Characteristics and Risks of Standardized Options and Supplements (PDF) from The Options Clearing Corporation at http://www.optionsclearing.com/about/publications/character-risks.jsp, ordering it by phone at 1-888-OPTIONS or requesting a copy by visiting www.optionseducation.org.

Too Much Braun

Is the economy as strong as it looks? The charts may suggest the economy is strong but the real answer lies between the price bars. Let’s take a peek.

A

by Tim W. Wood, CPA rising stock market—it gives us a warm, fuzzy feeling; it puts us in a state of complacency because it makes us think that everything is going to be just fine. In reality, that may not be the case. And here’s why.

Getting too inflated

I believe economic issues began in 2000 and have only been made worse. The world economy is in a systemic crisis and we are in a stock market bubble that has resulted from attempts to resuscitate the underlying economy. In spite of equities’ push to a new high in 2007 and again in 2016–2017, I have held all along that the secular bull market peaked in 2000 along with the underlying economy. The first attempt at stimulating the economy and resurrecting the secular bull market came in the wake of the decline 22 • March 2017 • Technical Analysis of Stocks & Commodities

into the 2002 four-year cycle low. Those efforts resulted in what was, at the time, the longest cyclical extension since the inception of the Dow Jones Industrial Average (DJIA) in 1896, which in turn resulted in a banking crisis, a commodity bubble, and a housing bubble. Then, when the extended cycle finally began to roll over, the end result was the worst financial crisis seen since the Great Depression. Yet the response to the worst financial crisis since the Great Depression was an even more extreme version of the same policies that helped create the problem in the first place. Those resuscitation efforts have, for the most part, failed to stimulate the economy and have instead created an equity bubble. In 2015, the equity markets began what is still a ginormous topping process. After the initial decline into the August 2015 low, I expected there would be false bottoms and false rallies. Since the topping process first began in 2015, there have been four intermediate-term advances, with the most recent carrying the market to yet another new high, and there have been three intermediate-term declines with the fourth pending as of January 2017. Admittedly, I did not anticipate the extent or duration of these rallies being what they have

Bear: DOUBLE BUBBLE/WORLD CURRENCIES: GRINGOS4/ SHUTTERSTOCK/COLLAGE: CHRISTINE MORRISON

The Grand Illusion

cycles

been. However, the duration of S&P 500 2300 2200 these rallies has not changed 2100 the fact that the advance out of 2000 1900 the 2009 low has been the most 1800 1700 extended cyclical advance 1600 1500 since 1896. 1400 1300 In spite of the duration of the 1200 1100 overall advance out of the 2009 1000 900 low or the four intermediate4 800 term advances that have fol700 4 4 600 4 lowed in the wake of the August 500 400 4 2015 low, there has still been 300 4 200 no meaningful effect on the Bullish/Price Volume Characteristics Bearish/Price Volume Characteristics 4 100 associated with the Secular Bull Market associated with the Secular Bear Market 0 underlying technical or funda25000 mental data, much less in the 20000 underlying economy. The three 150000 intermediate-term declines 10000 5000 and recoveries in 2015–2016 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 0 caused great confusion while creating an environment of FIGURE 1: SECULAR BULL AND BEAR MARKETS. On this chart of the S&P 500 you see that between 1982 and 2000, volume expanded as price rose and contracted on the declines, which is bullish behavior. The bullish price/volume relationenormous complacency. In light of the new high that ship began to change after 2000 to one that was more typical of secular bear markets. has followed in the wake of the election, a recent Gallup poll reports US economic confidence which again is indicative of a secular bear market rally. Even levels to be at the highest levels ever recorded. Many are call- with the additional post-election parabolic advance, volume ing this move a “breakout.” I called it a “fakeout” that may has continued to shrink. likely prove to be the biggest bull trap of all time and which I Since the inception of the DJIA in 1896, the four-year cycle think is also likely to leave the market positioned for a nasty has historically averaged 48.11 months. The point of these multiyear unwinding process in which the 2009 lows could charts is to show you that even though we have seen two of the most extended four-year cycle advances in stock market potentially be revisited. history, the price/volume behavior remains bearish. Thus, in spite of the most coordinated global intervention efforts in Will the bubble pop? I’m going to take a moment and step back to look at the the history of the stock market, which are still ongoing, these bigger picture so you can get an idea of what to expect for efforts have failed to change this underlying basic price/volume the inevitable unwinding. Overall, this is still part of a very behavior, even with the most recent four intermediate-term advances. large, ugly top. I’ll first look at a chart of the S&P 500 (Figure 1). In their 1948 book Technical Analysis Of Stock Trends, Edwards & The bigger picture emerges Magee wrote that in a bull market, volume increases when Even though we have seen not one but two of the longest fourprices rise and dwindles as prices decline; in a bear market, year cycles in history, I maintain that we have been operating volume increases when prices drop and dwindles as prices in a secular bear market since 2000. But given that we have recover, which is a very basic technical principle. seen new highs, what difference does it make whether we call In Figure 1 you can see that between 1982 and 2000, vol- these two extended four-year cycle advances bull markets or ume expanded as price rose and contracted on the declines, rallies within a bear market? The result will be the same, which was clearly bullish behavior. This goes in line with the underlying secular bull market that was prevalent during that time period. Now look how the bullish price/volume relationship began to The advance out of the change. Volume began to expand as price declined into the 2002 2009 low has been the most low, and it began to contract as price moved into the extended extended cyclical advance 2007 four-year cycle top. As prices moved down into the 2009 since the inception of the extended four-year cycle low, you see that volume expanded. Following that low, the bearish volume behavior was further Dow Jones Industrial Average confirmed. The declines into the 2010, 2011, and 2015 lows in 1896. also confirmed this. But then in 2015–2016, as price began going parabolic into those tops, volume continued to shrink, March 2017

• Technical Analysis of Stocks & Commodities • 23

right? Wrong! The difference is that, like M2 Velocity the extended rally into the 2007 top, it 220 220 was not organic. It was manufactured 215 215 and it lacks the underlying foundation 210 210 205 205 of secular bullish volume. The extended 200 200 advance into the 2007 top was a manufac195 195 tured, synthetic event that imploded, and 190 190 while the current advance has stretched 185 185 further than ever imagined, my belief 180 180 all along has been that this time will be 175 175 even worse. 170 170 Next, I’ll look at the money supply 165 165 160 160 (M2). On the velocity of M2 chart in 155 155 Figure 2, you can see a divergent top that 150 150 occurred in conjunction with the 2000 145 145 top in equities, which clearly telegraphed 140 140 the peak in the underlying economy and which I feel was also suggestive of the FIGURE 2: Velocity of Money. A divergent top occurred in conjunction with the 2000 top in equities, secular bull market top. These two pieces which clearly telegraphed the peak in the underlying economy. This could suggest a secular bull market top. But what about the continued contraction in M2 velocity that has reached the lowest levels since the inception of data are related. I want to point out that the liquidity of this data in 1959? campaign policies associated with the 2002 to 2007 extended four-year cycle What’s next? were able to positively influence the velocity of M2 in that it I have several points to make in regard to these charts. did turn up in early 2003. This upturn then peaked in early 2006, ahead of the extended four-year cycle top in October 1. The evidence clearly suggests that the secular bull market 2007. Then there’s the upturn that was seen in association with and the economy peaked in 2000. the 2009 four-year cycle low and the collapse that followed. 2. It has been the deflationary forces surrounding these There’s a continued contraction and the lowest levels since secular tops back in 2000 that the Money Masters have the inception of this data in 1959. In spite of what economists been fighting ever since. say, my belief is there has been no economic recovery. In fact, 3. These charts show that the monetary policies in associait has been just the opposite. tion with the most extended two four-year cycles in the history of the US stock market have not had a positive I also want to look at the job participation rate (JPR) data, impact on the most basic underlying technical conditions which can be found in Figure 3. When you tie velocity of M2 and job participation to volume characteristics of the market and other technical 68.0 68.0 Labor Force Data data, the bigger picture begins to come 67.5 67.5 into focus. I want to point out that the 67.0 67.0 66.5 66.5 JPR peaked in 2000, along with the stock 66.0 66.0 market and the initial contraction of the 65.5 65.5 65.0 65.0 velocity of M2. Interesting how that 64.5 64.5 works! This is all related. Here too, note 64.0 64.0 that the liquidity campaign associated 63.5 63.5 63.0 63.0 with the 2002 to 2007 extended four-year 62.5 62.5 cycle did positively influence this data 62.0 62.0 in that it finally found a bottom in late 61.5 61.5 61.0 61.0 2004 and there was an upturn into late 60.5 60.5 2006. It is also interesting to note here 60.0 60.0 59.5 59.5 that the peak in late 2006 followed the 59.0 59.0 April 2006 peak in the velocity of M2. 58.5 58.5 Makes sense, doesn’t it? But now look at 58.0 58.0 57.5 57.5 what has happened in conjunction with the extended four-year cycle advance out 3: THE BIGGER PICTURE COMES INTO FOCUS. Job participation rate (JPR) peaked in 2000, along of the 2009 low. It collapsed, which is FIGURE with the stock market and the initial contraction of the velocity of M2. Note also that the peak in late 2006 folconsistent with the velocity of M2 chart lowed the April 2006 peak in the velocity of M2 and the collapse that followed. See how it is consistent with the velocity of M2 chart in Figure 2 and the price/volume characteristics seen in Figure 1. and the price/volume characteristics. 1959 1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17

24 • March 2017 • Technical Analysis of Stocks & Commodities

Noisy indicators delay your analysis

of the market or the economy itself. 4. While the recent four-year cycle has been more extended than the cycle into the 2007 top, these manipulative efforts have been even less effective on the underlying economy than they were in conjunction with the advance into 2007.

Jurik algorithms deliver low lag, low noise analysis

So not only has there been a diminishing return, but these policies may have failed with regard to the underlying economy. These efforts have not affected the price/volume characteristics of the stock market and they have now made matters even worse in that they have left the equity markets in a massive and unsustainable bubble. In short, it has all gone to equities, which has served as camouflage for the underlying economy.

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Accept reality

Throughout the extended advance into the 2007 top, reinflation efforts were only making matters worse. In my opinion, efforts to extend this advance are not only making matters worse, but this time I think it will be far worse than the extension of the previous cycle that led to the 2007 top. This extended advance first began trying to peak in 2015, and now with the latest advance following the election, along with the associated complacency and optimism, I feel this is the most dangerous stock market environment since the inception of the DJIA in 1896. It has been a “grand illusion” and the market has served as camouflage for the continued deterioration of the underlying economy. The ongoing evidence that we are in a massive topping process is telling us that the global monetary policies are now failing with respect to the markets. No amount of twisting or manipulating of any other data changes or negates this data. The bottom line is that there has been no economic recovery. Like the extended advance into the 2007 four-year cycle top, this entire advance has been a manufactured event within the context of a secular bear market, and this time, the bubble is even bigger. While most don’t see it, this bubble is very large and we are in a very ugly topping process. I believe the consequences of this extended advance are going to come

Jurik Research

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with an extremely heavy price. The post-election advance has generated maximum complacency. Don’t be fooled. Tim Wood is the author of the newsletter Cycles News And Views. He can be reached via his website, cyclesman.com, by email at [email protected], or by phone at 504 2089781.

Further reading

Edwards, Robert D., and John Magee [1948]. Technical Analysis of Stock Trends. Wood, Tim [2016]. “The Reckoning,” Technical Analysis of Stocks & Commodities, Volume 34: March. ‡MetaStock

‡See Editorial Resource Index

options

SARKETT/THIS BUTTERFLy WEARS KEVLAR Continued from page 20

John A. Sarkett is the author of Option Wizards: Real Life Success Stories From The Financial Markets And Market Mentors (http://option-wizard.com). He writes frequently for the financial press and has been a contributor to STOCKS & COMMODITIES magazine since 1995. Sarkett may be reached at [email protected]. More on Jim Riggio and veteran options trader and educator Tom Nunamaker can be found at http://capitaldiscussions.com and http://kevlartrade.com.

further readinG

Sarkett, John A. [2017]. “A Road Trip With Options Supertraders,” Technical Analysis of StockS & commoditieS, Volume 35: February. †See Traders’ Glossary for definition

March 2017

• Technical Analysis of Stocks & Commodities • 25

Buy & Sell Pressure And A Faster RSI Most of you are familiar with the relative strength index (RSI), but are you taking full advantage of it? Here, we deconstruct the RSI to lead to a more intuitive and symmetrical gauge of buying and selling pressure and a more responsive indicator.

M

by Tushar S. Chande, PhD

any novice and even intermediate traders have told me over the years that they find the ever-popular relative strength index (RSI) indicator confusing. The RSI is an oscillator plotted on a scale of zero to 100, and is typically used as an overbought/oversold indicator, which means that it is used to signal impending reversals in direction. However, during strong trends, the RSI can remain at “extreme” levels, either high or low, for the duration of the trend, and thus, it’s not precise as an indicator of impending reversals. This is partly due to range compression, which I will discuss later in this article.

Digging deeper

Even expert technicians have expressed their concern about the smoothing built into the indicator. In brief, calculations begin by separating daily changes into absolute values separated by days on which a market (or stock) closes up on the day or down on the day, so that there 26 • March 2017 • Technical Analysis of Stocks & Commodities

The trouble with

range compression The complaint arises because the intermediate ratio, relative strength, is calculated using relatively long EMAs, which therefore have a long memory (that is, they need a lot of data to stabilize and are heavily influenced by old data) and make the RSI practically unresponsive as the length of the lookback period increases. I have previously proposed a solution to this problem via the stochastic RSI or stochRSI. A bigger problem is that because the RSI is plotted on a fixed 0–100 scale, as opposed to an open scale with no upper or lower limit, there is massive range compression at the extremes, or the

BUY GRAPHIC: HANOHIKI/CHART HAND CLOUD: RA2STUDIO/ SHUTTERSTOCK/COLLAGE: CHRISTINE MORRISON

A Quicker Reaction

are two columns of positive numbers, one showing today’s close minus yesterday’s close (changes on up days or zero), and the other featuring yesterday’s close minus today’s close (changes on down days or zero). These two columns of positive numbers are then smoothed using a variation of exponential moving averages, whose length can be estimated as twice the length of the lookback period minus one. So, for the 14-day period popular everywhere, a 27day exponential average (EMA) is used to smooth the data in the two columns. In an intermediate calculation step, the smoothed data is next used to compute the ratio of the up-day average to the down-day average (called the relative strength). This ratio is then converted into an oscillator on a 0–100 scale.

Indicators

area of the most interest. Visualize the two columns of daily close-to-close changes described earlier as buying pressure or selling pressure. If there is strong selling pressure, the absolute daily close-to-close changes on down days will be much greater than the close-to-close changes on up days. So the ratio of selling pressure to buying pressure could be 10:1 or greater (and vice versa). Imagine a stock that surges on strong earnings, with strong buying over many days as investors follow through. In this case, the proportion of buying to selling pressure, that is, the ratio of the average of up-day close-to-close changes to the average of the down-day close-to-close changes, could move from 3:1 to 12:1, a 300% increase, and yet the RSI would only shift from 75.0 to 92.31, a mere 23% increase. As a short-term trader, you would rather be alerted to the 300% increase in buying pressure than a 23% increase in RSI. The range compression gets even more extreme as the ratio of buying pressure to selling pressure increases. In defense of the design of the RSI, it is a brilliant and practical solution to the problems of its time, when computers were uncommon and data were plotted by hand. In order to speed up hand calculations, the use of moving averages that required just one row to be calculated anew each day was most convenient, even essential. Similarly, the ability to plot RSI data on a fixed 0–100 scale greatly simplified the problem of updating a large number of charts by hand. However, today we can rework the problem to overcome these computational or charting challenges.

Understanding RSI calculations

I’ll illustrate the quirks of the RSI calculations using a few simple calculations. First, I show the smoothing factors built into the calculations (see Figure 1). The first column shows a range of lookback periods ranging from six to 42 days incremented in steps of two days. The smoothing factor corresponding to each length of RSI is simply an inverse of the length (see column 2). The equivalent length of the corresponding EMA is shown in column 3, using the usual formula that the index of the EMA is given by (2/ (L+1)), where L is the length of the average. Clearly, if you want the RSI to respond more quickly to market changes, you can shorten the length, or simply change the type of moving average used to calculate the smoothed quantities used in the calculations. In Figure 2, I illustrate the range compression feature of RSI calculations by constructing a series of hypothetical values for the up-closes and down-closes EMA. I first vary the up-closes EMA from 10 to 1 in steps of 1, while keeping the down-closes EMA fixed at 1 (see columns 1 and 2, and the first 10 rows in Figure 2). I compute the relative strength (RS) by taking the ratio of the values in the first two columns. The fourth column converts the RS values into the equivalent RSI values using the formula RSI = (1-(1/(1+RS))*100. Note the range compression: When the RS increases from 1:1 to 10:1, the RSI only increases from 50 to 91, approximately. The range compression also works similarly on the downside. For example, when the

RS decreases from 1 to 0.1, a 10-times drop, the RSI itself drops from 50 to 9 or so. The fixed range has two effects: nonlinear range compression, and asymmetric values. First, when the range compression is nonlinear, the greater the difference between the up-closes and down-closes averages, which is precisely when the indicator should be drawing your attention to that stock or market. Second, though the displacement from the center is symmetric, the numeric readout Up-closes EMA

Length of RSI

Smoothing Factor

Effective Length of EMA

6

0.16667

11

8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42

0.12500 0.10000 0.08333 0.07143 0.06250 0.05556 0.05000 0.04545 0.04167 0.03846 0.03571 0.03333 0.03125 0.02941 0.02778 0.02632 0.02500 0.02381

15 19 23 27 31 35 39 43 47 51 55 59 63 67 71 75 79 83

FIGURE 1: SMOOTHING BUILT INTO THE RELATIVE STRENGTH INDEX (RSI). The smoothing factor seen in column 2 is an inverse of the length of the RSI.

Down-closes Relative Strength Relative Strength EMA (RS) Index (RSI)

10

1

10.0000

90.91

9 8 7 6 5 4 3 2 1 1 1 1 1 1 1 1 1 1

1 1 1 1 1 1 1 1 1 2 3 4 5 6 7 8 9 10

9.0000 8.0000 7.0000 6.0000 5.0000 4.0000 3.0000 2.0000 1.0000 0.5000 0.3333 0.2500 0.2000 0.1667 0.1429 0.1250 0.1111 0.1000

90.00 88.89 87.50 85.71 83.33 80.00 75.00 66.67 50.00 33.33 25.00 20.00 16.67 14.29 12.50 11.11 10.00 09.09

FIGURE 2: RANGE COMPRESSION IN RSI CALCULATIONS. When the RS increases from 1:1 to 10:1, the RSI only increases from 50 to 91, approximately. When the RS decreases from 1 to 0.1, a 10-times drop, the RSI itself drops from 50 to 9 or so. March 2017

• Technical Analysis of Stocks & Commodities • 27

stockcharts.com

Up-closes Down-closes EMA EMA

Relative Strength

RSI - Relative Chande Buy/Sell Strength Index Pressure (CBSP)

10

1

10.0000

90.91

10

9 8 7 6 5 4 3 2 1 1 1 1 1 1 1 1 1 1

1 1 1 1 1 1 1 1 1 2 3 4 5 6 7 8 9 10

9.0000 8.0000 7.0000 6.0000 5.0000 4.0000 3.0000 2.0000 1.0000 0.5000 0.3333 0.2500 0.2000 0.1667 0.1429 0.1250 0.1111 0.1000

90.00 88.89 87.50 85.71 83.33 80.00 75.00 66.67 50.00 33.33 25.00 20.00 16.67 14.29 12.50 11.11 10.00 9.09

9 8 7 6 5 4 3 2 1 -2 -3 -4 -5 -6 -7 -8 -9 -10

to selling pressure, that is, buy/sell pressure or BSP. I use the following formulas: If RS < 1, CBSP = -1/RS and If RS >= 1, CBSP = RS. You can just as easily rewrite the CBSP using the RSI values directly as follows: If RSI < 50, then CBSP = (0.01*RSI-1)/(0.01*RSI), else (RSI >= 50), then CBSP = (0.01*RSI)/(10.01*RSI)

With this formulation, CBSP < 0 when RSI < 50, and CBSP > 0 when RSI >=50, and the sign indicates which is greater—the buying or selling pressure. In Figure 3 I show how the RSI values can be converted into BSP values using the same synthetic data as in Figure 2. First, when you compare columns FIGURE 3: BUY/SELL PRESSURE CONVERTED FROM RSI FIXED SCALE TO OPEN SCALE. The open scale tells you instantly the relative magnitudes of the two pressures, and the sign 3 and 5, note that BSP is the same as RS when the RS is >=1, but is equal to -1/RS when RS is < 1. The tells you which is greater. convenience of this definition is that now you get an is not. For example, a 4:1 upside ratio or 1:4 downside ratio open scale and symmetric values of buy/sell pressure that produces a similar 30-point deviation from the center line at instantly communicate the relative magnitudes of buying or 50, but the readout is 80 or 20, not symmetric as 4:1 or 1:4. selling pressure. For example, from the first line, when the Thus, the RSI numerical values are not intuitively related to RS=10 and buying pressure is 10 times the selling pressure, BSP =10. Symmetrically, from the last line, when the selling the force of buying or selling pressure. pressure is 10 times the buying pressure, BSP = -10. Thus, the open scale instantly tells you the relative magChande buy/sell pressure (CBSP) I would like to convert the usual RSI calculations away from nitudes of the two pressures, and the sign tells you which is the fixed scale into an open scale to get away from range greater. This is a more intuitive formulation of buying and compression and get a symmetric readout. I would also like selling pressure, and gets closer to the natural price action. I to signal if buying pressure exceeds selling pressure or vice will now apply these calculations to a few real-life examples to appreciate their implications. versa. Recall that in the core RSI calculations, the RS = (up-day average)/(down-day average). Rather than visualize the ratio The 2015 rally in Dupont (DD) as relative strength, I look at it as a ratio of buying pressure In the fourth quarter of 2015, Dow 30 component Dupont (DD) had been falling steadily, past the Chinese revaluation selloff in August into October. Then, as the rest of the market rebounded in October, 90 DD gapped higher, and rallied hard through early 70 50.79 December, ending with an exhaustion gap. In Fig30 10 ure 4 you see a chart of the DD price action along 74 with the 14-day RSI in the upper panel. Observe 72 70 how the RSI values remained above 70 for more 68 66 than 45 days as DD trended higher. 65.42 64 I reproduced the RSI calculations from Figure 62 60 4 in an Excel spreadsheet (see Figure 5) to pro58 56 vide the bridge to a later discussion. The ending 54 value, on December 31, 2015, is 50.79, which is 52 the same in Figure 4. Thus, I can cross-check my 50 48 calculations against a commercial package for 46 completeness. I can now use the RSI calculations Jul 8 13 20 27 Aug 10 17 24 Sep 8 14 21 28 Oct 12 19 26 Nov 9 16 23 Dec 7 14 21 28 FIGURE 4: BUY/SELL PRESSURE IN DUPONT (DD). Dupont rallied in late 2015 and the RSI in Figure 5 and compare them directly to buy/sell pressure calculations (see Figure 6). stayed above 70 for more than 45 days. 28 • March 2017 • Technical Analysis of Stocks & Commodities

Dupont: 14-day RSI with Wilder’s Smoothing

Dupont Rally captured via Wilder’s RSI and Chande Buy/Sell Pressure

Dn Ref

Wilder’s RSI

100

Wilder’s Relative Strength Index (RSI)

90 80

60 50 40 30 RSI = 50.79

11

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3

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CBSP Surging

1 0 15

15 12

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FIGURE 6: WILDER’S RSI VS. BUY/SELL PRESSURE. The values are consistent with those in Figure 3. The buying pressure was 10 times the selling pressure (values above 10) with RSI greater than 90 just before DD flattened out in mid-November. The acceleration in CBSP values makes the buying pressure more obvious than the flattening out seen in RSI values.

should be expected since I am using a larger fraction of the incoming data (0.13 vs. 0.07) to update the new value for the moving averages used to calculate the relative strength.

The spill in Kimberly Clark

The shares of Kimberly Clark (KMB) had a bit of a spill in late 2016. These defensive stocks have been following the bond market lower, after bonds peaked in the immediate aftermath of the “Brexit” scare. I show in Figure 8 how the selling pressure reached -4, with the RSI in the range below 20, as is expected from Figure 3. The CBSP instantly communicates selling pressure four times the buying pressure, whereas the RSI readout is merely an oversold condition below 30. Thus, when you compare the pressure of buying

Dupont: RSI with Wilder’s vs. Standard EMA Smoothing RSI Standard EMA Smoothing

/2 0

10

/0 7

/2 0 /3 0

The rapid acceleration in buying pressure is more intuitively obvious in Figure 6, even as the RSI values begin to flatten out, topping out above 90 for BSP > 10, as can be expected from the calculations in Figure 3. I’ll now briefly revisit the internals of RSI smoothing. Wilder’s formulation does not quite follow the usual EMA formula. For example, for a 14-day RSI, it adds 1/14 of the new value to 13/14 of old value, instead of adding 2/15 of the new value to 13/15 of the old value to compute the updated averages. This subtle change slows down the RSI computations. I compared the RSI values during the DD rally using the two different smoothing schemes in Figure 7. The “proper” EMA formulation, denoted by “standard EMA smoothing” in Figure 7, responds more quickly than the Wilder formulation, which

09

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FIGURE 5: 14-DAY RSI WITH WILDER’S SMOOTHING. Here, the RSI calculations were reproduced in an Excel spreadsheet. The RSI value of 50.79 on December 31, 2015 is the same as in Figure 4.

15

0

0 /30

9

80

10

09

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RSI Flattening

90

10

Kimberly Clark: RSI vs. CBSP (1:4 Selling Pressure)

Wilder’s RSI

RSI

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FIGURE 7: WILDER’S RSI VS. STANDARD EMA SMOOTHING. The RSI calculation using the standard EMA formula reacts faster because it uses a larger proportion of new data to update its internal moving averages. The more responsive RSI can be quite attractive to short-term traders.

Relative Strength Index (RSI)

80

09 /3 10 0/20 /0 1 10 1/20 6 /0 1 10 2/20 6 /0 1 10 3/20 6 /0 1 10 4/20 6 /0 1 10 5/20 6 /0 1 10 6/20 6 /0 1 10 7/20 6 /0 1 10 8/20 6 /0 1 10 9/20 6 /1 1 10 0/20 6 /1 1 10 1/20 6 /1 1 10 2/20 6 /1 1 10 3/20 6 /1 1 10 4/20 6 /1 1 10 5/20 6 /1 1 10 6/20 6 /1 1 10 7/20 6 /1 1 10 8/20 6 /1 1 10 9/20 6 /2 1 10 0/20 6 /2 1 10 1/20 6 /2 1 10 2/20 6 /2 1 10 3/20 6 /2 1 10 4/20 6 /2 1 10 5/20 6 /26 16 /20 16

Relative Strength Index (RSI)

100

09 /30 /20 15 10 /07 /20 15 10 /14 /20 15 10 /21 /20 15 10 /28 /20 15 11 /04 /20 15 11 /11 /20 15 11 /18 /20 15 11 /25 /20 15 12 /02 /20 15 12 /09 /20 15 12 /16 /20 15 12 /23 /20 15 12 /30 /20 15

microsoft excel

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Chande Buy/Sell Pressure with Wilder Smoothing

Up Ref

FIGURE 8: RSI CALCULATION AND CBSP. The selling pressure here is four times the buying pressure, giving a CBSP reading of -4, intuitively clarifying that the stock is under significant selling pressure. The RSI readout at about 20 merely shows an oversold condition. Thus, the CBSP gives symmetrical readings (4:1 or 1:4, that is, +4 or -4) for the intensity of buying or selling pressure. March 2017

• Technical Analysis of Stocks & Commodities • 29

Chande Buy/Sell Pressure (Graph with open circles)

RSI

NFLX: RSI with Wilder’s Smoothing and Standard EMA Smoothing Standard EMA RSI

RSI Wilder Smoothing

Buy/Sell Pressure with Wilder vs. Standard EMA Smoothing

UP Ref

Standard EMA CBSP

100 Chande Buy/Sell Pressure with different internal smoothing

90 80 70 60 50 40 30 20 10

6 5 4 3 2 1 0

09

/3 10 0/20 /0 16 10 1/20 /0 16 10 2/20 /0 16 10 3/20 /0 16 10 4/20 /0 16 10 5/20 /0 16 10 6/20 /0 16 10 7/20 /0 16 10 8/20 /0 16 10 9/20 /1 16 10 0/20 /1 16 10 1/20 /1 16 10 2/20 /1 16 10 3/20 /1 16 10 4/20 /1 16 10 5/20 /1 16 10 6/20 /1 16 10 7/20 /1 16 10 8/20 /1 16 10 9/20 /2 16 10 0/20 /2 16 10 1/20 /2 16 10 2/20 /2 16 10 3/20 /2 16 10 4/20 /25 16 /20 16

0

FIGURE 9: PRICE JUMPS AND RESPONSE TIME. The 20% or so jump in NFLX in a single day was heavily damped in the RSI calculations using the Wilder smoothing formula. However, using the standard exponential moving average formula led to a faster response from the resulting RSI.

The open scale instantly tells you the relative magnitudes of the buying and selling pressures, and the sign tells you which is greater, making it a more intuitive formulation of buying and selling pressure, and closer to the natural price action. or selling, the CBSP gives a more intuitive readout of which side is dominating and by how much.

A surge in Netflix

Traders and investors rewarded Netflix (NFLX) with a 20% or so jump in stock price when the company’s performance exceeded expectations in October 2016. The sudden one-day jump in price shows the lags due to the smoothing built into RSI calculations. I first compared the standard 14-day Wilder RSI calculations to the RSI calculations using a standard 14day EMA (see Figure 9). It is clear that the Wilder smoothing built into the RSI is less responsive than the usual definition of an EMA. The corresponding buy/sell pressure calculations can be seen in Figure 10. Once again, the calculations using the regular EMA formula respond much more quickly. This intuitively shows that the buying pressure is six times greater than selling pressure. This is easier to absorb than just an RSI reading above 70, which merely indicates an overbought condition.

Variations on the ever-popular RSI

The ever-popular RSI indicator is used in many situations, for both systematic and discretionary trading. Users can now add a couple of variations to their menu. One, they can use a different smoothing scheme, to get a more responsive RSI. 30 • March 2017 • Technical Analysis of Stocks & Commodities

09 /3 10 0/20 /0 1 10 1/20 6 /0 1 10 2/20 6 /0 1 10 3/20 6 /0 1 10 4/20 6 /0 1 10 5/20 6 /0 1 10 6/20 6 /0 1 10 7/20 6 /0 1 10 8/20 6 /0 1 10 9/20 6 /1 1 10 0/20 6 /1 1 10 1/20 6 /1 1 10 2/20 6 /1 1 10 3/20 6 /1 1 10 4/20 6 /1 1 10 5/20 6 /1 1 10 6/20 6 /1 1 10 7/20 6 /1 1 10 8/20 6 /1 1 10 9/20 6 /2 1 10 0/20 6 /2 1 10 1/20 6 /2 1 10 2/20 6 /2 1 10 3/20 6 /2 1 10 4/20 6 /25 16 /20 16

Relative Strength Index (RSI)

Wilder Smoothing

7

FIGURE 10: BUY/SELL PRESSURE WITH WILDER VS. STANDARD EMA SMOOTHING. The Chande buy/sell pressure (CBSP) calculations using the regular exponential average definitions responded more quickly to the one-day jump in NFLX than the CSBP calculations using the Wilder smoothing method. The CBSP intuitively shows the sudden surge in buying pressure, and shows that it is many times the selling pressure.

Or they can recast it as Chande buy/sell pressure to get a symmetric, open-scale variant that instantly summarizes the relative magnitudes of buying or selling pressure. Remember that because the core calculations are closely related, the “shape” of the variations will look alike, though the numerical readouts will differ. Tushar Chande, PhD, MBA, has two decades of experience trading the futures markets as a CTA and hedge fund head of research. He is the developer of numerous widely used original technical indicators such as VIDYA, CMO, and AROON. He is the author or coauthor of several books on technical analysis. His website, ETFmeter.com, offers trend analysis of more than 1,200 ETFs, stocks, and international indexes, and buy/sell pressure data. Users can build and rebalance risk-managed ETF portfolios.

Further reading

Chande, Tushar, and Stanley Kroll [1993]. “Stochastic RSI And Dynamic Momentum Index,” Technical Analysis of Stocks & Commodities, Volume 11: May. Chande, Tushar [2001]. Beyond Technical Analysis, 2d ed., John Wiley & Sons. , and Stanley Kroll [1994]. The New Technical Trader, John Wiley & Sons. [2016]. “When Is Berkshire Hathaway Stock Good Value?” Technical Analysis of Stocks & Commodities, Volume 34: Bonus Issue. ‡StockCharts.com

‡See Editorial Resource Index

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, where she also works as a commodity broker. She has written multiple books on futures and options trading, the latest is titled Higher Probability Commodity Trading. Garner also authors widely distributed e-newsletters; for your free subscription visit www. DeCarleyTrading.com. To submit a question, email her at [email protected] or via www.DeCarleyTrading.com. Selected questions will appear in a future issue of S&C.

ES OPTIONS Why trade ES options, and not the SPX or SPY options? I’ve been asked on multiple occasions why I recommend S&P 500 options trades using the emini S&P futures options (ES) traded on the Chicago Mercantile Exchange (CME) rather than equity products such as the SPX or SPY. The truth is, I am a futures and options broker who deals solely in futures contracts and options on futures contracts. But besides the fact that options on futures are in my comfort zone and are the “bread and butter” of my business, there are some compelling reasons to trade emini stock index options and bypass the equity market versions. Around-the-clock market access The primary argument for trading emini S&P 500 options versus the stock market version, SPX, is that the futures options trade 23 hours per day. Accordingly, it is possible to exit them at any time of the day or night, with the exception of the daily closure between 4 pm and 5 pm Central Time. This can be particularly helpful if there is some sort of event risk while the stock market is closed. For instance, on election night, traders holding long SPX puts wouldn’t have been able to exit their position as the S&P futures plunged 100 points, but those trading futures options would have had the opportunity to lock in a profit on that Tuesday night before the monster post-election rally started on the following Wednesday morning. Similarly, they might have even had the foresight to go long calls in the overnight session while those waiting for the stock exchange open would have been chasing a rally that was already underway. It’s

simple: Just because the stock exchanges are closed doesn’t mean financial markets around the world—and, therefore, emini S&P 500 futures prices—aren’t moving. Preferable tax treatment Options on futures traders enjoy a 60/40% blend between long-term and short-term capital gains rates on all trades regardless of how long they were held or which particular instruments are used. This is a significant advantage for active traders because most stock products require a trade be held for more than a year to be eligible for the discounted long-term capital gains rate.

Traders who trade options on futures stand to potentially get more bang for their buck when they are right in their speculations. That said, the SPX is one of the few stock products treated in this manner. I’m not a tax expert, nor am I an equity options expert, but I do believe the SPX options are afforded the same 60/40 blended tax rate under the IRS Section 1256 provision. You’ll need to consult with your tax advisor for the details, but it is my understanding that SPY options do not qualify for this. Nevertheless, the tax benefit for futures options traders extends beyond tax rates to the hassle of reporting gains and losses. An emini S&P options trader, unlike an SPX or SPY options trader, is not obligated to March 2017

Carley Garner

report each individual trade to the IRS. Instead, he receives a 1099 with a lump sum of profit or loss. That single figure is reported on the trader’s taxes. Lower barriers to entry and access to option-selling strategies Most equity brokers require their clients to apply separately for access to trade options. Further, being granted the ability to sell options is generally reserved for those with sizable speculative accounts. For instance, most stockbrokers seem to want at least $100,000 in a trading account before option-selling strategies are a possibility (although some brokers will allow it in a $50,000 account). In any case, traders are expected to put up at least five figures to trade short options and spreads in the stock market. Futures options traders, on the other hand, are granted cheap and easy access to short options and options spread trading. For instance, my brokerage service allows options spread trading with as little as $2,500, but for naked option selling, we prefer to see upwards of $10,000. In any case, it is a clear advantage for smaller traders to venture into options on futures. Lower margin for less capital Options on futures traders are provided portfolio margining regardless of account size. This means that traders who sell strangles are not charged full margin for both the short call and the short put because they can only lose money on one side of the trade. In other words, portfolio margining takes into account all positions held by the trader, determines Continued on page 47

• Technical Analysis of Stocks & Commodities • 31

Two Outcomes Or None

About Those Binary Options

Y

by Gail Mercer ou have probably heard the term binary options, but what are they really? They’re different from traditional options and if you aren’t all that familiar with them, now’s your chance to get to know them better. Before jumping into all the different opportunities they provide, I’ll start with a review of what binary options are.

32 • March 2017 • Technical Analysis of Stocks & Commodities

What are they?

While there are three binary options providers (Canton LP, CME, and Nadex) that are designated by the Commodity Futures Trading Commission (CFTC) as contract markets in the US, in this article, I’ll use the Nadex binary options since they offer several choices when it comes to expirations and markets (futures, commodities, and forex markets). Binary options are short-term expiration contracts that provide a limited risk and limited payout environment for traders. The maximum payout on any binary option is $100. Risk is always limited to the price paid on entry. If the binary option indicative price expires in-the-money (ITM), the full payout is received ($100). The actual profit is $100 minus price paid on entry.

rawpixel.com/shutterstock

Whether you’re a scalper, an intraday trader, or a longer-term trader, binary options can provide several types of trading opportunities and can work in any type of market condition. What are they and how can you trade them? Find out here.

OPTIONS

The binary option consists of a strike statement that shows the following:

A

• instrument • price statement • expiration date and time.

> 1.2688

Sell -

> 1.2678

Sell 1.75

The binary option ladder chart in Figure 1 identifies the following information:

> 1.2668

• Point A—Instrument and expiration time • Point B—Strikes closest to price for the specified time period (6 am–8 am EST). On the GBPUSD, there are always nine strikes offered for the two-hour expiration • Point C—Indicative price, which is used as the expiration • Point D—Date and time axis.

> 1.2648

Sell 8.00

> 1.2658

Sell 18.00

C

1.26391

Sell 32.25

> 1.2638

Sell 49.00

> 1.2628

Sell 65.25

> 1.2618

12:00

16:00

20:00

Dec 14

D

Sell 78.75

04:00

B Buy 6.00 Buy 8.00 Buy 14.25 Buy 24.50 Buy 38.75 Buy 55.50 Buy 71.75 Buy 85.00

08:00 expiry

FIGURE 1: Binary Option Ladder, GBPUSD. On this binary option ladder chart of the GBPUSD, you see the instrument, price statement, expiration date, and expiration time.

Choosing risk levels

A trader with a bias to the upside on the GBPUSD believes the binary option statement will be true at expiration. If the trader believes the statement will be true at expiration, then he clicks on the blue button to buy. The risk is limited to the price identified on the blue button (unless the trader modifies the price using a limit order). Using Figure 1, the long opportunities with risk and profit potential are:

the trader believes the statement will be false at expiration, then he clicks on the red button to sell. The risk is limited to the maximum payout minus the price shown on the red button (unless the trader modifies the price using a limit order). Using the earlier example, the binary short opportunities are: • The > 1.2658 strike is considered DITM because price is trading at least two strikes under it. Risk is limited to $82.00 ($100 minus $18.00). The profit potential would be $18.00.

• The > 1.2618 strike is the deep ITM (DITM) option, as price is trading at least two strikes above this level. The risk is $85 with a profit potential of $15 ($100 minus $85).

• The > 1.2648 strike is considered ITM because price is trading at least one strike under it. Risk is limited to $67.75 ($100 minus $32.25). The profit potential would be $32.25.

• The > 1.2628 strike is the ITM option, as price is trading at least one strike above this strike. The risk is $71.75 and the profit potential is $28.25 ($100 minus $71.75).

• The > 1.2638 strike is the ATM because price is currently trading at this strike level. Risk is limited to $51.00 ($100 minus $49.00). The profit potential would be $49.00.

• The > 1.2638 strike is the at-the-money (ATM) option, as price is currently trading at this level. The risk is $55.50 strike and the profit potential is $44.50 ($100 minus $55.50).

• The > 1.2628 strike is the OTM because price is trading above this strike level. Risk is limited to $34.75 ($100 minus $65.25). The profit potential would be $65.25.

• The > 1.2648 strike is the out-of-the-money (OTM) option, as price is currently trading below this strike level. The risk on this option is $38.75 and the profit potential is $61.25 ($100 minus $38.75). • The > 1.2658 strike (also OTM). The risk is limited to $24.50 and the profit potential is $75.50 ($100 minus $24.50).

• The > 1.2618 strike (also OTM). Risk $21.25 ($100 minus $78.75). The profit potential would be $78.75.

When trading binary options, traders can never lose more than what they paid on entry.

A trader with a bias to the downside on the GBPUSD believes that the binary option statement will be false at expiration. If March 2017

• Technical Analysis of Stocks & Commodities • 33

In addition, because there are several expirations available at any given time, the trader could also have chosen additional two-hour binaries, as well as daily expiration, since Nadex offers multiple daily expirations on the forex pairs. For example, there is also a 7 am, 11 am, 3 pm, 7 pm, and 11 pm daily expiration, providing traders with even more opportunities.

they paid on entry. In this case, if the trader entered the five long positions described earlier using only the two-hour binary options from 6 am–8 am and trading only one contract each, the results would be what you see in the table in Figure 3. Of course, the trader could have entered a single binary option or any multiple of the binary options you see in Figure 3 plus any of the daily or weekly options that were offered at the time. Binary options are also great for trending markets because the trader can simply build positions throughout the day, using different option strikes as well as weekly expirations that end on Friday. And if markets are moving sideways, traders can limit their trades to either ITM or ATM strikes.

GBPUSD - 15 min

teChniCal analysis and

binary options Technical analysis in the simplest of terms Slow Stochastic is a mathematical approach to creating visual tools for forecasting the direction of prices using historical data points. It is this forecasting ability of technical analysis, combined with the power of 22:00 23:00 12/14 01:00 02:00 03:00 04:00 05:00 06:00 limiting risk, that makes binary options FIGURE 2: dIvERGEncES BEtWEEn IndIcatOR ideal for technical analysts. Take the case and pRIcE. when you look at this chart of the of divergences between indicator and price GBpusD with the slow stochastic indicator, you see that price was making lower lows while the lean toWard simple as an example. The chart of the GBPUSD in Figure 2 slow stochastic was making higher highs. this When trading binary options, keep these indicates that an upside move is likely indicates that a position to the upside was divergence two points in mind: and you could take a position that supports an more likely because as price was making upside price movement. lower lows, the slow stochastic was making • For long positions, the indicative price higher lows—also known as divergence. needs to expire one tick greater than Plus, the close of the price was greater the strike price. than the open, providing further confirmation that the market • For short positions, the indicative price needs to expire would likely go up. equal to or less than the strike price. When trading leverage accounts, traders hesitate to enter these types of trades because the trade is going against the Gail Mercer, founder of TradersHelpDesk, is a trader, mentrend (known as countertrend trading). If price were to spike tor, author, and speaker residing in North Carolina. She has down, then the trader could lose more than he anticipated as over 15 years of experience in trading and in the developprice could jump over the stop price, which is why margins ment of custom indicators. She is experienced in trading are required. However, that cannot happen with binary options futures, forex, and binary options using volume analysis as and therefore, margins are not required. Remember, when well as divergence. She can be reached via email at gm@ trading binary options, traders can never lose more than what tradershelpdesk.com. Strike (GBPUSD) 1.2618 1.2628 1.2638 1.2648 1.2658 totals

Risk ($) 85.00 71.75 55.50 38.75 24.50 275.50

Gross Profit ($) Exchange Fee ($) 15.00 1.80 28.25 1.80 44.50 1.80 61.25 1.80 75.50 1.80 224.50

9.00

Net Profit ($) 13.20 26.45 42.70 59.45 73.70

ROI (%) 16 37 77 153 300

215.50

78*

FIGURE 3: tRadInG tHE tWO-HOUR BInaRy OptIOnS FROM 6 aM–8 aM. here you see the results of trading five long positions, one contract each. *total roi% is based on total net profit/total risk.

34 • March 2017 • Technical Analysis of StockS & commoditieS

Further reading

Mercer, Gail [2016]. “Choosing A Binary Option Provider,” Technical Analysis of StockS & commoditieS, Volume 34: November.

‡NADEX

†See Traders’ Glossary for definition ‡See Editorial Resource Index

Q&A SINCE YOU ASKED Confused about some aspect of trading? Professional trader Rob Friesen, president & COO of Bright Trading (www.stocktrading.com), an equity trading corporation, answers a few of your questions. To submit a question or suggest a topic, email him at [email protected], or 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. Rob Friesen

A dollar saved becomes a dollar made When I present on topics such as “trade some and hold some,” as was the subject of my column in this magazine last month, I have invariably been asked, “Well, what about stop-losses?” One of the benefits of spread trading is the distribution of capital over a range, by chosen methodology, allowing a dollar-cost-averaging approach to hedged trading. Not having to be right on a single bet provides a reasonable level of comfort. One of the problems with spread trading is that which provides comfort also creates anxiety when the layers have been applied and things are not going swimmingly, in that you find yourself swimming against the current. Anyone who has traded pairs or equity spreads of any kind has experienced the symbols in that spread drifting apart from each other. This presents an opportunity that is even better than your original starting point. Your plan may have included this foresight through running each potential scenario ahead of time and planning your future trades. In previous columns, I have spent quite a bit of time on this and suggested this as a process, method, and discipline. The philosophy of spread trading would be to have capital available, that the bet size would be in keeping with logical risk management formulas, and that you would capture that window of opportunity as the spread moves to outlier regions. By definition, the mean-reverting opportunity would only improve as the spread continues farther from the main distribution areas. This brings up two questions.

1. Why would anyone want to stop out a unit or layer of capital after putting it on under such advantageous conditions? 2. Does a pair trade need or require that you plan for and utilize a stop-loss? The answer is actually … yes … no … it depends. It depends on what the position size is relative to your capital and the statistical edge. The position size might be so small that a stop-loss seems unwarranted.

Anyone who has traded pairs or equity spreads of any kind has experienced the symbols in that spread drifting apart from each other. This presents an opportunity that is even better than your original starting point. • Would you use fixed stops, trailing stops, time-based stops, or are you responding to any new information, or any change in the validity of the trade? The general rule with leverage would be to utilize some form of stop-losses. So we have a quandary in spread trading—that stretched-out price, which provides a great opportunity to get in for the potential profit, is also flashing red lights of warning of exponential potential losses. March 2017

What we desire in mean-reverting trades is like the first line of the song “Spinning Wheel” by Blood, Sweat & Tears: “What goes up, must come down.” But something that needs to be considered is from the second line: “Spinning wheel got to go round.” Applied to pairs or spread trading, that line would say to me: “Is this a oneoff, or single-opportunity trade, or is it compoundable? If it is a trade that can be repeated frequently, then it is treated differently than a trade you have identified for this particular moment in time that might never present itself again. Traders would be less likely to require a stop-loss with pattern-based spreads that have a significant statistical opportunity to work it over a specified range, by keeping capital sliced into layers and distributing that up to their maximum planned-for capital. This is as we have shared in the past in this column—harvesting the noise. Back to the “hook” of this month’s column: A dollar saved becomes a dollar made. I touched on it in the February 2017 issue when I wrote, “Let’s discuss a technique for managing a pair going against you.” I went on to explain the approach: Using the last in, first out (LIFO) accounting method for your pair, subtract a layer to reduce the losses of a pair trending against you by making the effort to reestablish that pair at a much better price. Use all your skills and indicators to place that bet when conditions are suitable. In this case, a dollar saved will become that dollar made when and if the spread travels once again in the direction of your bias. You may find it is warranted to remove all layers Continued on page 45

• Technical Analysis of Stocks & Commodities • 35

INTERVIEW

Patience Is A Virtue

Gavin McMaster: Living Life As An Options Trader You don’t have to be an aggressive trader to make it as an options trader, says this “master” of options trading. After learning as much as he could about trading options, Gavin McMaster decided to take the task into his own hands and start trading options. He didn’t spend a single day working at a trading desk for a financial firm, although the thought did cross his mind. McMaster even went on to get a master’s degree in applied finance and investment, but admits that didn’t help him learn anything about trading options. He now specializes in income trading using options, is very conservative in his style, and believes that patience in waiting for the best setups is the key to successful trading. He likes to focus on short volatility strategies. McMaster has written five books on options trading, available from Amazon. You can read more from him at his blog at OptionsTradingIQ.com. He resides in Melbourne, Australia with his family. Stocks & Commodities Editor Jayanthi Gopalakrishnan communicated with Gavin McMaster via email in January 2017 to find out more about his options trading journey. Gavin, tell us a little bit about yourself and how you got interested in the financial markets. My earliest memory about the financial markets is from primary school—I think you call it elementary school in the US—and a fictional story my teacher told. It was about an investor who bought a stock that went from $1 to $999 and he was greedy and refused to sell. Sure enough, the stock fell back down to zero and this fictional investor was back to where he started. From then on, I was fascinated with the financial markets, so it is no surprise that I ended up in this industry. My parents were also a big factor. They bought me $2,000 worth of some telecommunications shares in the mid1990s. I was around 13 or 14 at the time. I remember checking the newspaper each day to see how the shares had performed the previous day. From there I started watching other stocks each day and really developed a fascination for the stock market. I wanted to be a stock broker when I grew up because I thought that was the

only job available having to do with financial markets. And did you end up becoming a stock broker or did you turn to something else? Once I got a bit older, I realized I didn’t want to become a stock broker. They are just glorified salesmen. I didn’t want to be pushing stocks on people in return for a commission, so I decided to go at it on my own. You’re a self-directed trader but you’re also a self-taught options trader. Can you tell us how you started learning to trade options? I first learned about options in 2004 from a small book I got from the Wall Street Journal called Guide To Understanding Money And Investing. It had the typical basic info on stocks, bonds, mutual funds, and indexes. But it also had a section on options. I always knew people could make money when the markets went down, but up until then, I didn’t really know how it was done. I knew you could short a stock, but I also knew that was difficult

36 • March 2017 • Technical Analysis of Stocks & Commodities

Having a written trading plan is not only important, it’s impossible to succeed without one. to do and could be risky. So when I first learned about options, I was hooked. What was it about options that you liked so much? I liked the flexibility. When I was first learning about options, I read a booklet that described 26 core strategies. There was so much flexibility in the way you could trade. You could do bullish, bearish, neutral, synthetics, ratio spreads, and volatility trades. I was like a kid in a candy store learning all these different ideas. Trading stocks is so boring in comparison because you can only be long, short, or in cash. Not a lot of flexibility there. I read a countless number of books and started trading in 2004. And then in 2007 I started trading credit spreads and iron condors. The ability to generate income without having to pick the direction of a

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There is no substitute for experience and the only way to get that is to get in the market and make some real-money trades. You learn from your mistakes. stock appealed to me. At that point I went back to school and completed a bachelor’s degree in financial markets, then a master’s in applied finance and investment. In one of the master’s courses, there was a subject that covered options. Reading through the course material, I realized I already knew everything in the course through my own reading and research. What led to the decision to go back to school? I had a real thirst for knowledge and also wanted to get some more qualifications under my belt. I don’t regret it, but I don’t think getting a master’s has really helped me that much, either. The program of courses was great for getting some qualifications behind me, but it didn’t teach me anything about trading. It taught the theory, but theory is nothing until you put it into practice and have real money on the line. Why do you think that is? There is only so much you can learn from a book. There is no substitute for experience and the only way to get that is to get in the market and make some real-money trades. You learn from your mistakes. I paid my fair share in “tuition” to the market via losing trades. In my first options trade, I bought a put on a retail stock. The only reason I chose that stock and that put option was because it was cheap. That trade cost me only $200. Needless to say, the trade was a bust and I lost 100% on that one. I also had some big losses in 2008–2009 as the market crashed. I made very amateur trades, didn’t manage risk, and didn’t have a proper trading plan. I was “winging it”

thinking that I knew more than I actually did. I didn’t understand how important a written trading plan is. I figured I didn’t need it, as I could keep everything in my head. I’ve since realized that having a written-down trading plan is not only important, but it’s impossible to succeed without one.

Who were your mentors or people you looked up to while you were learning? Tony Sizemore had the biggest influence on my trading. Actually, I first learned about him in an article in this magazine [see “Sizing Up For Success” in the further reading section at end], and I remember that some of the concepts he talked about just blew my mind. It really opened up a whole new world to me. I was a member of his trading room for over a year and that really accelerated my learning curve. As you were trading options, what are some things you came across that you may not have learned about in books you read or from people you learned from? One of the most important metrics I follow is the concept of delta dollars. No one else really seems to talk about it. It’s simply the position delta multiplied by the underlying price. It helps me know the dollar exposure I have at any given time. I find it a really useful number in terms of deciding when to adjust options trades. Also, Sizemore is big on “managing by the greeks,” and this has influenced

38 • March 2017 • Technical Analysis of Stocks & Commodities

my trading as well. Having rules around delta/theta ratios and vega/theta ratios is very important in managing risk. How are these ratios related to risk? The greeks and their ratios tell me what my exposure is to price and volatility. If those exposures get outside my comfort zone, it’s an indication that I need to cut risk. What mistakes taught you the most? One particular mistake sticks out in my mind. I had a position in NDX that was too large for my portfolio size. I was stubborn, though, and didn’t think the market could continue moving upwards, since it was already pretty extended. The next morning, the Fed announced more QE (quantitative easing) and the Nasdaq opened about 2% higher. Unfortunately, I was leaving for vacation that day, so I was scrambling, trying to sort out this trade while my wife was packing for me. I should have just closed the trade then and there, but I adjusted it and kept it open. This was a Friday and I was stressed the whole day while we were traveling because I couldn’t really check the markets. I also wouldn’t have access to my account on the following Monday, so I was stressed the entire weekend and it really ruined our weekend away. My wife was very understanding about it but I could tell she was disappointed. From that experience, I learned not to let my exposure get too big, and never have open trades when going on vacation. Well, small ones might be okay! When you look back, what changes did you make to your trading that led you to become the trader you are today? There are a couple of things that come to mind. One is learning to be patient. Once I learned that you don’t have to be in the markets all the time, I became a much better trader. Rather than trying to force things, I now wait for my perfect setups. I actually really enjoy those times when I’m out of the markets because I can completely relax, and if stocks tank, it doesn’t affect me and it gives me an opportunity to take

advantage of the panic. The other is to not take on too much risk. I trade pretty conservatively these days and I much prefer it that way. My equity curve is smoother and I sleep better at night. What do you look at when making your trading decisions? Do you look at chart patterns, fundamental data, indicators? I’m definitely more technical than fundamental. I have a watchlist and each weekend I’ll check short-term and long-term charts. I don’t trade directionally very often, but when I do, I’m more of a mean-reversion trader than a trend trader. For an options trade, I’ll check a 12-month chart of implied volatility to see where the underlying sits currently compared to the recent past. I really like using Bollinger Bands to see if an underlying is undergoing contraction or expansion. If a stock has had a long period of price contraction, I like to get long vega and hope that it makes a big move and vice versa.

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What do you trade—options on equities, futures, indexes? I trade options on equities and indexes. Mostly, I’ll just trade the indexes. That’s because I don’t like the risk of a stock making a big move after earnings or an unexpected news item, unless I’m trading long volatility. But I tend to be more short volatility. How many trades, on average, do you do in a week? I only place about two to three trades per week. I prefer to trade less often but with bigger size. My theory is that two to three big trades are much easier to adjust than 20 to 30 smaller trades if

NinjaTrader 8 is always FREE to use for advanced charting, strategy backtesting and trade simulation. things go pear-shaped. When you say “pear-shaped,” what do you mean? Ha-ha, I think that’s a British expression. It just means when things go wrong/bad.

I don’t trade directionally very often, but when I do, I’m more of a meanreversion trader than a trend trader.

When you consider trading something, how do you decide what strategy to apply? I’ll take a look at the charts and also volatility. Based on what I see, I’ll form an opinion on where I think the underlying March 2017

might go over a certain timeframe and also what volatility might do. From there I have six core strategies that I use and I’ll choose the most appropriate one. What variables do you consider before placing a trade? Other than the technical factors, I’ll look at strike placement, position size, the greeks, days to expiry, profit target, stop-loss, and I’ll have a plan in place for adjustments. What type of strategies do you like to trade and why?

• Technical Analysis of Stocks & Commodities • 39

The main characteristics I think are necessary are patience, discipline, and the desire to succeed. My core strategies are iron condors, trapdoors (which are a variation on the condor that I developed), butterflies, diagonals, strangles, and the wheel. I think of the wheel as covered calls on steroids. In a nutshell, the wheel is a systematic way to trade covered calls but you do it as part of a long-term strategy. In fact, I’ve described the strategy and others, such as trapdoors, on my blog at optionstradingiq.com. I separate my capital into trading capital and long-term capital. The wheel is a great long-term trade, so I can put that on and not think about it too much. For the trading capital, I generally want to be pretty neutral. I find directional trading can be difficult. Condors and trapdoors are great for that. The trapdoor is similar to a condor but moves a lot slower and requires less maintenance and less adjustments. However, I don’t like having these on when the market has had a strong run up. That’s where diagonals and the bearish butterfly come in. So the strategies kind of complement each other nicely. What type of risk management strategies do you apply? I have a number of rules based on the delta dollars metric and making sure my exposure doesn’t get above a certain level in relation to my capital. I also have other rules regarding the greeks, both in terms of individual

positions and my portfolio as a whole. Adding in some long volatility trades when the VIX is low is another strategy that helps avoid large drawdowns in the event of a sharp selloff.

What led you to teach others to trade options? I’ve always enjoyed teaching others. Even from some of my early jobs as a kid, I always felt comfortable training new staff and it’s something that comes naturally to me. I also get a real buzz when I explain something to a trader and I can see the light bulb go off. A lot of traders have told me I have a knack for taking difficult-to-understand concepts and breaking them down into easy-todigest chunks. Trading can be a lonely business and I’ve met so many great people through teaching options, and I love chatting with other traders over email, Skype, and online. None of my friends trade, so teaching options has allowed me to develop an amazing network of traders that I talk to regularly. What are some common misconceptions new traders have about trading options? Probably the main one is expectations about returns. I get a lot of emails along the lines of, “Is it possible to make 10% per month?” I tell them, if you’re aiming for a massive return, you have to take on a massive amount of risk. That’s just Finance 101. People need to be realistic. Most beginners will not be successful at first. They will probably make a lot of mistakes.

Warren Buffett averages about 15– 20% per year, so if a beginner expects to make more than that, they are doing better than Buffett and most hedge funds. How likely is that for a beginner? Not very. What is necessary for someone to become a successful options trader? The main characteristics I think are necessary are patience, discipline, and desire. Patience to wait for the right setups, discipline to have a plan and stick to it, and desire, because if you don’t have a burning desire to succeed, you won’t make it through the hard times, and there will be hard times.

Further reading

McMaster, Gavin [2014]. Bullsh*t-Free Guide To Option Volatility: Making Sense Of Market Mayhem, IQ Financial Services, LLC. [2013]. Bullsh*t-Free Guide To Butterfly Spreads: Your Ultimate Guide To Butterfly Spreads Plus 7 Unusual Variations, IQ Financial Services, LLC. [2014]. 37 Quickfire Lessons In Trading Options: 10 Years Of Trading Experience Compacted Into Easy To Digest Lessons, IQ Financial Services, LLC. Morris, Kenneth M., and Virginia B. Morris [2004]. The Wall Street Journal Guide to Understanding Money & Investing, 3d edition, Lightbulb Press and Dow Jones & Co. Sarkett, John A. [2009]. “Sizing Up For Success,” Technical Analysis of Stocks & Commodities, Volume 27: December. †See Traders’ Glossary for definition

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40 • March 2017 • Technical Analysis of Stocks & Commodities

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 coauthored 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://MessageBoards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C. Tom Gentile

long leg and the one you sell is the short leg. You would “open” both options at the same time on the same order ticket and your broker should charge you only one commission, as this is one spread, not two separate options trades. You would sell-to-open the short leg or the February 17, 2017 $1,530 call for $47.65 (all prices are based off the mid-price shown). You don’t want to end up with a naked call position with substantial risk and you also want to hedge/ reduce risk so you would buy-to-open the long leg or the February 17, 2017

With both debit and credit spread strategies, you are predefining your risk and predefining your max profit potential on the trade. $1,525 call for $50.35. The difference in premiums is $2.70 ($50.35 - $47.65 = $2.70). This is your max risk/cost in the trade. The most a spread option trade of this nature can make is the amount of the spread or difference between the strikes. In this case, the strikes are $5 wide so

the most you could make is $5.00 per contract. The $5 potential profit is offset by the cost of the spread trade, which is the difference in the premiums already calculated at $2.70. The max reward potential for this call debit spread is $2.30. For that to happen, PCLN must be above the short leg strike price of $1,530 at expiration. With PCLN in-the-money (ITM) at expiration, it is likely the execution of the two strikes will take place where the markets buy the stock from you at $1,530. The account should execute your buying PCLN at $1,525, making that $5 per contract offset by the $2.70, leaving the profit of $2.30 all on a percontract basis in the account. It should happen without the actual purchase and sale of the amount to buy and sell shares taking place so that no requirements of all that capital and commissions will take place. Recognize PCLN is already above the short leg strike. As long as it stays above $1,530, this trade should be able to realize max profit potential. I will now show you an example of a put credit spread on PCLN. The goal of this trade is the same in that you want to be profitable. You can anticipate PCLN Continued on page 44

www.tomsoptiontools.com

Debit spreads or credit spreads … which is best? Many people ask me this question about debit and credit spreads: “I hear one makes money and the other costs money. Is that true?” In a way, that is correct, but it’s not as cut-and-dried as you may think. Credit means you are generating a credit to the account. Technically, you could say the credit or money brought in to the account is money made, but realize that this money must remain tied up until the trade is either closed or expiration happens. The credit received to the account isn’t money you can take right now and go buy birthday gifts with, because the trade is still open. Consider money credited to the account like money being held in escrow. Debit means you have incurred a debt. You spent money to open the position. The money you spent is your cost and is the most amount of money you will have at risk on the trade. With both option strategies, you are predefining your risk and predefining your max profit potential on the trade. This is different from the straight call or put buyer who has more profit potential but less of a probability of success than the spread trader. The question becomes, which one should you trade? I will take a look at an example of both spreads on the stock of The Priceline Group, Inc. (PCLN). I will look at a call debit spread and a put credit spread. Both mean I am anticipating a moderate or greater price move higher in the stock. Note that if you anticipate the stock going down, you would do the reverse spread strategies, that is, a put debit spread or a call credit spread. In Figure 1 you see details of a call debit spread. The option you buy is the

FIGURE 1: PCLN February 1530/1525 Call Debit Spread. The strikes are $5 wide so the most you could make is $5.00 per contract. The $5 potential profit is offset by the cost of the spread trade, which is the difference in the premiums already calculated at $2.70. The max reward potential for this call debit spread is $2.30. March 2017

• Technical Analysis of Stocks & Commodities • 41

product review

NinjaTrader 8 Part 2

NINJATRADER, LLC 1422 Delgany Street, Suite 400 Denver, CO 80202 Phone: 312 262-1289 Fax: 312 329-9888 Internet: www.ninjatrader.com Requirements: Minimum requirements are Windows Vista (SP2) w/platform update, Windows 7, 8, or 10, Windows Server 2008 w/platform update, Windows Server 2008 R2 or later; 1 gigahertz (GHz) or faster 32-bit or 64-bit processor; 2 GB RAM; Microsoft. NET Framework 4.5; screen resolution of 1024x768; DirectX10 compatible graphics card. Product: Trading platform for active equity, futures, and forex traders. Price: Always free use for advanced charting, strategy backtesting, and strategy simulation. For live trading in your brokerage account, purchase it for $999 (or four monthly payments of $299); lease it for $600 annually, $330 semiannually, or $180 quarterly; free through a NinjaTrader brokerage account. by Jayanthi Gopalakrishnan

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ast month in part 1, I reviewed some of the many features of NinjaTrader 8 and ended by saying that this month I would cover the strategy development features and some of the advanced order-handling features. As mentioned in the first part, there are so many features available in NT8 that it’s impossible to cover all its features in a review. My objective here is to scratch the surface enough to reveal to you the powerfulness, efficiency, and flexibility of NT8. The platform will meet the needs of active traders, whether you’re a long-term or short-term trader, and whether you trade equities, futures, options, or forex. There’s something in it for everyone and the nice thing is you can take advantage of the free trial to find out more about the platform.

Developing strategies

One feature that packs a punch to the NT8 platform is NinjaScript. For programming novices, it may take some time to master but once you do, it opens up a world of infinite possibilities. NinjaScript is based on the C# programming language, which makes it very versatile. You access NinjaScript via the Ninja­ Script editor. NT8 has a lot more .NET plug-ins than previous versions did. On the right-hand side of the window you’ll see the explorer panel, which lists all the code that is currently available to users. You’ll notice it’s organized into several folders to make everything easy to find. In Figure 1 you see an example of the NinjaScript editor. I selected the simple moving average crossover strategy, and the code is displayed in the Script­Editor window. If you open up the folders listed in the explorer window, you’ll see that you have a number of code sets to choose from. If you still prefer to create your own script, you can do that as well. All you have to do is right-click on any of the indicators listed in the explorer window and select new strategy, or you can open up a new strategy builder window and

start building your own strategy. As with all windows in NT8, you can have different tabs along the bottom, which gives you the ability to work on different scripts. In NT8, it almost seems as though you have no limits in what you can do with NinjaScript. It goes well beyond creating trading strategies and gives you the opportunity to create custom bar types, chart types, custom drawing tools, import types for importing historical data, your own optimizer engines, and even Super DOM columns, among other things. You can also integrate NinjaScript with Visual Studio. This allows you to debug NinjaScript objects while they’re running, and that means you can test your programs right then and there. If you’re a programmer, you’ll know this is a big bonus. If you’ve never written code or done any programming but want to give it a go, you can use the Strategy Builder, which walks you through developing your own strategies. It takes a while to get the hang of it but the nice thing is that tech support is readily available via support forums, the help desk, and online tutorials.

FIGURE 1: NINJASCRIPT EDITOR. NinjaTrader offers a number of code sets to choose from. Here you see the code for a simple moving average crossover strategy.

42 • March 2017 • Technical Analysis of Stocks & Commodities

Backtesting

Once you’ve developed a trading strategy that has been debugged and runs, your next step is to backtest it. How well has it done in the past? You can find out by running tests using historical data. Open up the strategy analyzer and select your parameters from the settings panel on the right-hand side (Figure 2). You can choose the type of backtest you’d like to perform, that is, standard, optimization, walk-forward optimization, or multiobjective optimization. You also select a strategy, strategy parameters, data series, timeframe, and so on. Once you’ve selected all the parameters, hit the run button. When the test is complete you’ll be able to see the performance results of your strategy. For example, Figure 2 displays an analysis of the moving average crossover system applied to the March emini futures contract using the % analysis option, which is just one of the many different ways you can analyze the performance of your strategy. You may prefer to view the performance results graphically, and as you may have guessed, there are different ways to graphically view strategy performance results. In the bottom half of the StrategyAnalyzer window in Figure 2, the maximum drawdown is displayed graphically. And you have the ability to create your own performance metrics using NinjaScript. Here’s where you see how thoughtful the technology behind NT8 is. One of the drawbacks of backtesting in general is that the results are not necessarily realistic since commissions, fills, and slippage aren’t factored in. But in NT8 under setup in the settings panel, you can choose to include commissions, whether you want conservative or liberal order fills, and factor in some slippage. I also want to bring your attention to the break at EOD option that is available in the settings panel. If this is selected, it means the bar will end at the close. If it’s not selected, the bar will continue to form beyond the close until the bar ends. Some traders will need to know when the market closed, especially if their strategy is based on the closing price. Others may, depending on what type of strategy they are developing, prefer to wait till the bar

FIGURE 2: STRATEGY ANALYZER. There are many options when it comes to backtesting your strategy and analyzing its performance. And you have different ways to view the performance. Here you see the results of maximum drawdown in both a table and graphical format.

completes even if it’s after the close. Here again, you see how NT8 caters to the needs of all types of traders.

Advanced trade

the basic order entry parameters, you can set your stop-losses, your profit targets (you can set several), and stop strategies. And yes, you have the ability to create a custom stop strategy where you can set your auto breakeven points and auto trailing stops. You can save your custom stop strategy as a template and apply it to any order you want to place. There are several other options for creating your custom ATM such as auto chase, which allows you to define your chase limits with options such as selecting your target chase, chase if touched, and your chase limit. There’s also the option of selecting a stop limit for a stop-loss, market if touched for profit, and shadow strategy. Shadow strategy is a method of simulating an ATM and

management Now that you have a strategy that has been backtested and are happy with its performance, you’re now ready to place your trades. NinjaTrader supports several online brokers and through them you can place trades automatically, semiautomatically, or any number of different ways. NT8 has made great strides in their Advanced Trade Management (ATM) feature to make trading through the platform much easier and more efficient than before. Managing trades is an important and necessary task for all traders and, once again, NT8 has incorporated tremendous flexibility when it comes to trade management. AT M can be accessed through the order entry window. You can create your custom ATM strategy from the dropdown menu available on FIGURE 3: CUSTOM ATM STRATEGY. There’s a ton of flexibility when it comes to managing your positions at the time you place them and after a position is open. the ATM strategy You can set your stop-losses, profit targets, and stop strategy. You have the ability option (Figure 3). to create a custom stop strategy where you can set your auto breakeven points From here, besides and auto trailing stops. March 2017

• Technical Analysis of Stocks & Commodities • 43

being able to forward-test it. Once you select your parameters, typically, you’re going to enforce these at the time you place your order. But what if you only have a split second to place a trade? When you’re in such a situation, NT8 has a solution for you. It allows you to apply an ATM to an open and unprotected position. Once you create an ATM, you save it as a template. To apply the ATM, go to the control center, then to positions, right-click on the open position, and select apply ATM strategy. Another feature worth mentioning is the alerts feature. In previous versions of NT you needed to program the alerts, but in NT8 there’s an alert feature that allows you to set up conditions and actions. You can access this from the chart window and set more than one condition. So if a

condition is met you can create an action, which can be either in the form of a sound or a popup. You can also share the alert via social media, and submit an entry or exit order tied to the alert.

Managing trades is an important and necessary task for all traders, and NT8 has incorporated tremendous flexibility when it comes to trade management.

Just the tip of the iceberg

As you may have guessed by now, NT8 may appear to be similar to its previous iteration but really there’s more to it than meets the eye. One of the unique characteristics of NT8 is the stellar support behind the product. NinjaTrader listened to their customers and redeveloped their platform based on what customers told them they need and want. The result is a trading platform with a lot of thought behind it and with something that meets the needs of any type of trader.

Jayanthi Gopalakrishnan is Editor of Stocks & Commodities.

Further reading

Gopalakrishnan, Jayanthi [2017]. “Ninja­ Trader 8, part 1,” product review, Technical Analysis of Stocks & Commodities, Volume 35: February. ‡NinjaTrader

‡See Editorial Resource Index

explore Your options

GENTILE

Continued from page 41

moving higher just like in the call debit spread. The primary distinction between the two is that you are generating a credit into the account of a specific amount versus incurring a cost or having an outlay of capital to start. The option you buy is the long leg and the one you sell is the short leg. You would open both options at the same time on the same order ticket and your broker should charge you only one commission as this is one spread, not two separate option trades. See Figure 2 for an example of a put credit spread. You would sell-to-open the short leg or the February 17, 2017 $1,530 put for $42.00 (all prices are based off the midprice shown). You don’t want to end up with a naked put position with substantial risk and you also want to hedge/reduce risk so you would buy-to-open the long leg or the February 17, 2017 $1,525 put for $39.80. The difference in premiums is $2.20 ($42.00 - $39.80 = $2.20). This is your max profit potential in the trade. Another distinction of the credit spread versus the debit spread is that as long as PCLN is higher than the short leg strike

FIGURE 2: PCLN FEBRUARY 1530/1525 PUT CREDIT SPREAD. Here, the difference in premiums is $2.20 ($42.00 - $39.80 = $2.20). This is your max profit potential in the trade.

price of $1530, things should work out for the best for this trade. There is no need to have a transaction or execution of the options. Think about it. If PCLN is above $1,530 at expiration, would anyone need to exercise their right to put you to stock or make you buy it at $1,530 when they can sell it to the open market for a higher price? Not likely. Therefore, you would not have to have the account exercise the right to put the stock to anyone or sell it for $1,525. Both options expire and the account then gets to realize that credit amount of $2.20 per contract. The credit and the debit from a risk-toreward standpoint is basically the same. That is why you will hear some say there really isn’t a difference. When they say that, it is from the risk-to-reward view of

44 • March 2017 • Technical Analysis of Stocks & Commodities

when both spreads use the same strikes and expiration. The debit spread I discussed can potentially earn $2.30 per contract and the credit spread can potentially earn $2.20 per contract. This means the risk for both is close to the same as well. Other than that, the debit spread tends to need a slight or moderate directional move more often than the credit spread does. So when you are looking at spreading your risk, ask yourself which one makes the most sense for your personality. All things equal, there’s not much difference except whether or not you hold the money or pay the money for the spread. In the end, it’s about risk and reward once the exit is made.

Q&A FRIESEN

Continued from page 35

except your original core layer, which you maintain, using it for information. Then reestablish the capital when appropriate, or occasionally, you may find you have to exit the core layer as well, as there is often a new driver or catalyst that is affecting one or both stocks of your pair. Allow me to expand on this subject. This procedure is a form of stop-loss but also is in line with “trade some, hold some.” In pairs trading for a multilayer approach, we use LIFO. If you put on three layers, you would take off the last layer in a profitable situation first. Or when you need to start reducing position, the same rules apply. Money has been saved. Capital has been shelved. This capital can be redeployed. Here’s an example. If you put on a layer at 1.00, 2.00, and 3.75 and realized there were forces pushing it farther out, you could take off the 3.75 layer at, say, 4.00 and wait. Book that 0.25 loss on that layer. Later, the ducks could line up for you to reestablish. Your spread has deflected off 5.00 and is on its way back down. You take the trade at 4.75 going with that retracement. It reaches 4.00 and seems stable. You are going through news during this time and see a pertinent piece of information that slightly increases risk—hence, the reason the spread went out. Of course, the spread went out before the news was

posted and when the news came out, the spread started its retracement. With the increased risk you are now aware of, you decide to take off the 4.75 layer at 4.00, as it seemed to stabilize there. Next, the pair goes back out to 4.50, and you see a new range developing. You put on your trade at 4.50 and then it drops to 3.75. Let’s add it up. You are still holding your original two layers and still view the spread to have future mean-reverting value. You lost $0.25 on the third layer,

Once a range gets broken, it often trades in a new range, returning to predictable patterns. then reestablished that layer to make $0.75, and then took another roll of production to make yet another 0.75. You are profitable on the overall management of the third layer now by 1.25. The trading of the new range could continue for days, weeks, or months. In a perfect world, the spread comes back down and you eventually profit on the layer at 2.00 and then the 1.00. Remember LIFO. What could happen, or what often happens to traders, especially the ones who have no management plan for layers after they established them, is they add, sit, and stare at the screen, only to capitulate at the worst possible times. This will also happen for traders who

have not set a maximum allocation of capital. It is a different experience for those who proactively manage risk, are willing to reduce systematically, and still be committed to the original plan, working it with discipline. In my experience with equity pairs, once a range gets broken due to a catalyst, it often trades in a new range, returning to predictable patterns. It may be months before it returns to where it came from. It’s tragic that many traders abandon the pair and make nothing from all the activity. After taking all that pain, they aren’t committed to gain. A one-off pair trade may look different than the distribution over a range. That type of pair may receive only one allocation of capital, and the trade is for a particular expectation. It considers the risk, reward, probabilities (expected value formula), and has a time duration. On this type of trade, many traders risk 1.00 to make 3.00 or greater. A pair or spread structure like this mimics a single-stock trade in terms of directional implications. Traditional fixed stops and trailing stops could be utilized. The trader would have need of pair trading tools in order to monitor and manage positions in this way. Risk management is a priority for any type of trader, and intelligent planning with complete rules can make a significant difference to any trader in the outcomes and the bottom line.

TRADING STRATEGY

EVANS / S&P FUEL GAUGE Continued from page 17

Having this information gives you a tremendous advantage even though there are many other variables that affect such currency cross rates.

AND YOU HAVE A FULL TANK

This type of trade governs many, if not all, market relationships. Face it: We are in a low-yield environment and we could see a slow-growing equity market, which could tempt us to pick stocks blindly without considering the existence of volatility in the S&P 500 index. High volatility could slice through all your gains and that could lead you to desperately hedge your

positions when the S&P 500 is at poor levels. Keep an eye on that S&P gauge and when it has risen to an attractive level, put on those risk-on positions and plan your next vacation. Chris Evans is an independent research provider. He has worked as a global macro portfolio manager for various hedge funds in London and New York. He currently offers fuel gauge updates and a weekly research blog to subscribers. He may be reached via his website at www.paratradesystems.com.

March 2017

• Technical Analysis of Stocks & Commodities • 45

Ticker Symbol

VNQ

IYR

ICF

RWR

XLRE

Inception Date

9/23/2004

6/12/2000

1/29/2001

4/23/2001

10/8/2015

Total Assets

$32.8B

$3.91B

$3.47B

$3.30 B

$2.37B

Net Expense Ratio

0.12%

0.44%

0.35%

0.25%

0.14%

30-day SEC Yield

4.04%

4.21%

3.50%

4.42%

4.22%

147

126

30

100

29

45.05%

38.85%

48.79%

46.54%

N.A.

No. of Holdings 3-Yr.Return

MASONSON / The Reality Of REITs Continued from page 7

Benchmark

RMZ

REI

RMP

REI

RE Select

Avg. Daily Volume

5.14M

9.40M

426,000

377,000

2.64M

0.80

0.82

0.77

0.81

1.41

Equity Beta

index has 32 REITs. Thus, the creation of REIT ETFs was a simple matter of selecting from this universe or additional exchange listings. The top 10 REITs by market capitalization are listed in Figure 1.

source: Etfdb.com, www.etf.com

Comparison of REIT ETFs (As of December 20, 2016)

With low expense ratios, tax efficiency, and instant liquidity, REIT ETFs offer investors a high level of dividend income and capital appreciation potential.

FIGURE 2: COMPARING THE LARGEST REIT ETFs. Five similar ETFs are compared here. VNQ is the leader of the pack in terms of assets under management, the number of holdings, and the lowest expense ratio.

Reit ETF choices

STOCKCHARTS.COM

ETFs brought a new dimension to REIT distribution that has broadened their appeal to investors and traders. There are now over 30 US-listed ETF REITs. With low expense ratios, tax efficiency, and instant liquidity, REIT ETFs offer investors a high level of dividend income and capital appreciation potential. Based on the recent change in the GICS classification mentioned earlier, State Street Global Advisors’ Financial Select SPDR (XLF) removed the REITs in that portfolio. The new SPDR sector was called the Real Estate Select SPDR (XLRE) that holds 29 REITs and real estate management and development companies. There are now 11 sector SPDR ETFs. REIT ETFs range from pure US real estate to global real estate, developed markets, and US mortgages. Most REITs have a fairly concentrated portfolio. The top four ETF REITs have nearly $42 billion in assets under management. They invest over 95% of their money in commercial, specialized, and residential

properties. Specialized REITs can have investments in land, prisons, data centers, movie theatres, and casinos. The Vanguard REIT Index Fund (VNQ) has assets of $32.5 billion, accounting for 77% of the assets of the top four issuers. Other smaller REIT ETFs focus on particular niches such as small cap, global super dividend, equal-weight, Asia, global quality, and long-term care, among others. Figure 2 compares the top REIT ETFs by asset size. They include Vanguard REIT Index (VNQ); iShares Cohen & Steers REIT (ICF); iShares US Real Estate ETF (IYR); SPDR Dow Jones REIT (RWR); and Real Estate Select Sector SPDR Fund (XLRE). Clearly, VNQ is the behemoth in size. IYR has the highest daily trading volume at 9.4 million shares while RWR has the lowest volume at 377,000 shares, but offers the highest yield. ICF and the new XLRE have only 30 and 29 holdings, respectively. ICF has the lowest beta but the highest threeyear return at 48.79% which is a desirable combination of characteristics. Interestingly, XLRE had the highest beta at 1.41 but did not have the highest return. Probably the small

FIGURE 3: HOW DID THEY PERFORM? Viewing four ETFs over a 12-year period from September 29, 2004 to December 29, 2016 shows that VNQ and ICF had nearly identical results and were the leaders.

46 • March 2017 • Technical Analysis of Stocks & Commodities

number of stocks (29) in the portfolio negatively impacted the beta.

Performance comparison

According to www.etfscreen.com, among the ones that they track, the top-performing REITs for the one-year period ended December 21, 2016 are KBWY (+28.40%), SRET (+21.82%), MORT (+20.64%) and REM (+19.75%). This compares to the five ETFs mentioned earlier: VNQ (+7.74%), IYR (+6.71%), RWR (+5.83%), ICF (4.34%), and XLRE (+3.05%). So even when investing in REITs, segments of the REIT market outperform at different times. Using relative strength analysis on the above-mentioned website can assist investors in finding the outperformers over the past one, three, and six months as well as one year. Figure 3 compares the price performance of four ETFs (excluding XLRE because of its short life) from September 29, 2004 (earliest common date) through December 29, 2016. VNQ (red color) led the way up with a 167.29% gain, followed by ICF (pink) up 164.14%, then RWR (green) at 150.99%, and finally IYR (blue) at 138.96%. Based on the performance and other characteristics, VNQ is the top performer. With its massive assets under management (AUM) and low expense ratio, no wonder it continues to gather the most assets of all other ETFs. Notably, it didn’t come public until September 23, 2004 compared to the other ETFs that had three to four years’ lead time to garner assets. For active traders looking to daytrade REITs with leverage, there are four ETFs available. Direxion introduced leveraged bull and bear real estate ETFs in July 2009. They are Direxion Daily Real Estate Bull 3x Shares (DRN) and Direxion Daily Real Estate Bear 3x Shares (DRV). Both have expense ratios of 0.95%. ProShares offers double-leverage ETFs with ticker symbols URE and SRS, bullish and bearish, respectively. Traders are cautioned to fully understand how to use these vehicles and understand all the risks before using them. Check the websites of these ETF providers for more information.

For more comprehensive information on REITs in general, I recommend a recently published book titled The Intelligent REIT Investor. Based on the REIT performance over the last 16 years, investors and traders should definitely consider placing a portion of their capital in this unique sector. Of course, due diligence is necessary, so visit the ETF’s website and look at the top 10 REIT holdings. Obtain complete financial information including credit rating, quarterly and annual reports, press releases, and other critical information. Also, check out the ETF’s Morningstar rating to know what you are buying. And don’t forget to bring up 10-year, five-year, and one-year charts with a few moving averages, MACD, and RSI indicators to determine the timing of the purchase.

Further reading

Krewson-Kelly, Stephanie, and R. Brad Thomas [2016]. The Intelligent REIT Investor: How To Build Wealth With Real Estate Investment Trusts, Wiley. Masonson, Leslie N. [2017]. “ETF Factor-Based Investing,” Technical Analysis of Stocks & Commodities, Volume 35: January. [2016]. “ETF Sector Investing,” Technical Analysis of Stocks & Commodities, Volume 34: November. [2016]. “ETF Perspectives,” Technical Analysis of Stocks & Commodities, Volume 34: September. • • • • • • • • •

www.etf.com www.etfscreen.com www.etfdb.com www.REIT.com www.vanguard.com us.spders.com www.iShares.com/Low-Cost/ETFs www.statestreetspdrs.com/SPDRs www.wiley.com ‡StockCharts.com

FUTURES FOR YOU a net risk level, and then levies a margin requirement accordingly. Stock options traders might or might not be granted portfolio margining by their broker but those who are generally have in excess of $100,000 in their trading account.

or against you. But the reality is, options on futures traders stand to potentially get more bang for their buck when they are right in their speculations. That’s because emini S&P futures options are written against an already leveraged product. Naturally, the options are generally more expensive but they are priced that way for a reason—they can really move!

More leverage We all know that leverage is a doubleedged sword in that it can work for you

Mo’ better Trading SPX or SPY options is convenient for those with substantial capital

GARNER

Continued from page 31

March 2017

but that doesn’t mean they are the best “option.” The emini S&P futures options give you the ability to take action during the overnight trading session, which could be a game changer. Plus, the ease of market access for smaller traders opens the door to trading strategies that were once reserved for the “big boys.”

• Technical Analysis of Stocks & Commodities • 47

TRADING ON MOMENTUM

Golden Cross Breakouts A “golden cross” on a chart is typically defined as when the 50-day moving average crosses above the 200-day moving average, seen as a bullish sign. In this monthly column on trading breakouts, this professional trader shows how you can use this pattern as an entry signal for swing trades. by Ken Calhoun

Step 2: You may enter your trade anytime after this crossover signal is seen.

henever you are looking for swing trading breakout entries, it helps to use the same signals that institutional traders follow. One of the most popular patterns is the “golden cross,” in which a 50-period simple moving average (SMA) line crosses above a 200-period SMA. In this month’s column, you will see how to trade this useful breakout swing trading pattern.

Step 3: As long as both SMA lines remain uncrossed in an uptrend, you keep your position open. Close your position once a trailing stop of two points or more is taken out, as seen on December 13, 2016 at $59 per share. Alternatively, you could use a trailing stop at the 50 SMA level, especially for longer-term swing or position trades. (In the chart in Figure 1, that would be $54.)

W

Swing Trading the Golden Cross Entry When the 50-period SMA breaks above the 200-period SMA, it signifies a major short-term trend reversal. This can help identify swing trading breakout entries when combined with price action patterns such as bullish cups, ascending triangles, and increasing volume. It is important to note that golden crosses, like most technical trading patterns, should not be used in isolation. Instead, you should combine them with other breakout entry signals.

esignal

Step 1: Look for a 90-day daily candlestick chart in which a 50-period SMA line crosses above a 200-period SMA line. In the chart of Spirit Aerosystems Holdings, Inc. (SPR) in Figure 1, you see this occurred on October 20, 2016.

Insights: Why this technique works

The golden cross is particularly effective because it combines the shorter-term 50 SMA momentum signal with the longerterm major 200 SMA trendline. This combination provides a breakout confirmation signal because it uses both short- and long-term trendlines working together.

Trade management tips

One of the keys to using moving average signals successfully, as with most of the breakout patterns you learn about in this Step-by-step action plan column, is to visually scan for charts with wide trading ranges. Here’s how you can start using this strategy with your swing You can see that this chart has nearly 20 points of range ($43 trades: to $61 on a 90-day chart). Price action also follows a classic 45-degree angle breakout trend pattern. Further, note how cleanly defined the trend is—it is not a choppy, uncertain chart. The more up-and-down oscillations a chart has, the tougher it is to trade profitably. The cleaner, more in-focus the chart is, the easier it is to trade, as you can see in Figure 1. As with all of our professional swing and intraday charts, it is best to use this strategy with stocks and ETFs priced in the $20–$70 per share range, because these charts tend to have stronger, more sustainable trends that you can trade. This strategy should not be used with cheap, risky penny stocks or stocks priced under $10 per share, due to the high risk and choppiness of these poor trading instruments. You will often see strong upside price action following golden crosses, Figure 1: TRADING USING THE Golden Cross. Here you enter a swing trade when the 50-period simple moving average (SMA) crosses above the 200-period SMA. Note that the exit takes place after the two-point because institutional traders use this same pattern to put on large block trades. trailing stop is hit. 48 • March 2017 • Technical Analysis of Stocks & Commodities

Ken Calhoun is a producer of trading courses, a live trading room, and video-based training systems for active traders. He is a UCLA alumnus and is the founder of TradeMastery. com, an educational resource site for active traders.

Further reading

Mustapha, Azeez [2016]. “Golden Cross And Death Cross,” Technical Analysis of Stocks & Commodities, Volume 34: September. See our Traders’ Tips section beginning on page 50 for commentary on implementation of Calhoun’s technique in various technical

At-the-Money—An option whose strike price is nearest the current price of the underlying deliverable. Black-Scholes Option Pricing Model—A model developed to estimate the market value of option contracts. Bollinger Bands—Developed by John Bollinger. Bollinger Bands widen during increased volatility and contract in decreased volatility, and when broken, are an indication that the trend is powerful and may continue in that direction. Butterfly Spread—A sideways market strategy using all calls or puts, designed to profit from a stock trading in a specific range. Calendar Spread—Also known as a time spread or horizontal spread, calendar spreads exploit differences in time value between options. Call—A contract that gives the buyer of the option the right but not the obligation to take delivery of the underlying security at a specific price within a certain time. Condor—Essentially, a butterfly spread with two different strikes that make up the body of the option. Covered Call—Selling a call option while holding an equivalent in the underlying tradable. Covered Write—Writing a call against a long position in the underlying stock. By receiving a premium, the writer intends to realize additional return on the underlying common stock or gain some element of protection (limited to the amount of the premium less transaction costs) from a decline in the value of that underlying stock. Credit Spread—The difference in value of two options, where the value of the one sold exceeds the value of the one purchased. Debit Spread—The difference in value of two options, where the value of the long position exceeds the value of the short position. Delta—The amount by which the price of an

Use the golden cross on stocks and ETFs priced in the $20–$70 per share range, because these charts tend to have stronger, more sustainable trends that you can trade. analysis programs. Accompanying program code can be found in the Traders’ Tips area at Traders.com.

option changes for every dollar move in the underlying instrument. Delta-Hedged—An options strategy that protects an option against small price changes in the option's underlying instrument. These hedges are constructed by taking a position in the underlying instrument that is equal in magnitude but opposite in sign (+/-) to the option's delta. Delta Neutral—This is an "options/options" or "options/underlying instrument" position constructed so that it is relatively insensitive to the price movement of the underlying instruments. This is arranged by selecting a calculated ratio of offsetting short and long positions. Delta Position—A measure of option price vs. the underlying futures contract or stock price. Gamma—The degree by which the delta changes with respect to changes in the underlying instrument’s price. Greeks—A loose term encapsulating a set of risk variables used by options traders. Historical Volatility—How much contract price has fluctuated over a period of time in the past; usually calculated by taking a standard deviation of price changes over a time period. Implied Volatility—The volatility computed using the actual market prices of an option contract and one of a number of pricing models. For example, if the market price of an option rises without a change in the price of the underlying stock or future, implied volatility will have risen. In-the-Money (ITM)—A call option whose strike price is lower than the stock or future's price, or a put option whose strike price is higher than the underlying stock or future's price. For example, when a commodity price is $500, a call option with a strike price of $400 is considered in-the-money. Iron Butterfly—The iron butterfly spread is a limited risk, limited profit trading strategy March 2017

Near-the-Money—An option with a strike price close to the current price of the underlying tradable. Out-of-the-Money (OTM)—A call option whose exercise (strike) price is above the current market price of the underlying security or futures contract. For example, if a commodity price is $500, then a call option purchased for a strike price of $550 is considered out-of-the-money. Premium—The price a buyer pays to an option writer for granting an option contract. Put—A contract to sell a specified amount of a stock or commodity at an agreed time at the stated exercise price. Straddle—The purchase or sale of an equivalent number of puts and calls on an underlying stock with the same exercise price and expiration date. Strangle—The purchase or sale of an equivalent number of puts and calls on an underlying stock with the same expiration date but a different exercise price. Usually, the put has a low strike price and the call has a higher strike price. Strike Price—The price per unit at which the holder of an option may receive or deliver the underlying unit; also known as the exercise price. Vega—The amount by which the price of an option changes when the volatility changes. Vertical Spread—A stock option spread based on simultaneous purchase and sale of options on the same underlying stock with the same expiration months but different strike prices. Volatility — A measure of a stock’s tendency to move up and down in price, based on its daily price history over the last 12 months. Volatility Index — A widely used measure of market risk. Sometimes referred to as the “investor fear gauge.” Zeta—The percentage change in an options price per 1% change in implied volatility.

• Technical Analysis of Stocks & Commodities • 49

TRADING ON MOMENTUM

Golden Cross Breakouts A “golden cross” on a chart is typically defined as when the 50-day moving average crosses above the 200-day moving average, seen as a bullish sign. In this monthly column on trading breakouts, this professional trader shows how you can use this pattern as an entry signal for swing trades. by Ken Calhoun

W

henever you are looking for swing trading breakout entries, it helps to use the same signals that institutional traders follow. One of the most popular patterns is the “golden cross,” in which a 50-period simple moving average (SMA) line crosses above a 200-period SMA. In this month’s column, you will see how to trade this useful breakout swing trading pattern.

Swing Trading The golden CroSS enTry When the 50-period SMA breaks above the 200-period SMA, it signifies a major short-term trend reversal. This can help identify swing trading breakout entries when combined with price action patterns such as bullish cups, ascending triangles, and increasing volume. It is important to note that golden crosses, like most technical trading patterns, should not be used in isolation. Instead, you should combine them with other breakout entry signals.

Step-by-Step action plan Here’s how you can start using this strategy with your swing trades:

48 •

•

S

&c

Step 1: Look for a 90-day daily candlestick chart in which a 50-period SMA line crosses above a 200-period SMA line. In the chart of Spirit Aerosystems Holdings, Inc. (SPR) in Figure 1, you see this occurred on October 20, 2016. Step 2: You may enter your trade anytime after this crossover signal is seen. Step 3: As long as both SMA lines remain uncrossed in an uptrend, you keep your position open. Close your position once a trailing stop of two points or more is taken out, as seen on December 13, 2016 at $59 per share. Alternatively, you could use a trailing stop at the 50 SMA level, especially for longer-term swing or position trades. (In the chart in Figure 1, that would be $54.)

inSightS: Why thiS technique WorkS

The golden cross is particularly effective because it combines the shorter-term 50 SMA momentum signal with the longerterm major 200 SMA trendline. This combination provides a breakout confirmation signal because it uses both short- and long-term trendlines working together.

trade management tipS One of the keys to using moving average signals successfully, as with most of the breakout patterns you learn about in this column, is to visually scan for charts with wide trading ranges. You can see that this chart has nearly 20 points of range ($43 to $61 on a 90-day chart). Price action also follows a classic 45-degree angle breakout trend pattern. Further, note how cleanly defined the trend is—it is not a choppy, uncertain chart. The more up-and-down oscillations a chart has, the tougher it is to trade profitably. The cleaner, more in-focus the chart is, the easier it is to trade, as you can see in Figure 1. As with all of our professional swing and intraday charts, it is best to use this strategy with stocks and ETFs priced in the $20–$70 per share range, because these charts tend to have stronger, more sustainable trends that you can trade. This strategy should not be used with cheap, risky penny stocks or stocks priced under $10 per share, due to the high risk and choppiness of these poor trading instruments. You will often see strong upside price action following golden crosses, because institutional traders use this same pattern to put on large block trades.

For this month’s Traders’ Tips, the focus is Ken Calhoun’s article in this issue, “Golden Cross Breakouts.” Here, we present the February 2017 Traders’ Tips code with possible implementations in various software. The code for the following Traders’ Tips selections is posted here:

• Traders.com  Home–S&C Magazine  Traders’ Tips The Traders’ Tips section is provided to help readers 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 2017 TRADERS’ TIPS CODE In “Golden Cross Breakouts” in this issue, author Ken Calhoun describes his methodology for trading using the popular chart pattern commonly known as the golden cross. He defines the golden cross as a 50-period simple moving average crossing above a 200-period simple moving average. The author suggests using this indicator in conjunction with other price-action patterns. The TradeStation platform has many built-in indicators that can be evaluated along with the golden cross. Here, we are providing TradeStation EasyLanguage code for a golden cross strategy based on the author’s concepts. We have also included an indicator that can be used in the TradeStation Scanner application to help identify trading opportunities. Indicator: Golden Cross Breakouts // TASC MAR 2017 // Golden Cross Breakouts // Ken Calhoun inputs: FastLength( 50 ), SlowLength( 200 ), MaxBarsSinceCross( 10 ), MinPercentRange( 25 ) ; variables: FastAvgValue( 0 ), SlowAvgValue( 0 ), BarsSinceCross( 0 ), PercentRange( 0 ) ; FastAvgValue = Average( Close, FastLength ) ; SlowAvgValue = Average( Close, SlowLength ) ; PercentRange = 100 * ( Highest( High, FastLength ) Lowest( Low, FastLength ) )/ Close ; if FastAvgValue > SlowAvgValue then BarsSinceCross += 1 else BarsSinceCross = 0 ; Plot1( BarsSinceCross ) ;

50 • March 2017 • Technical Analysis of Stocks & Commodities

Figure 1: TRADESTATION SCANNER. Here, the golden cross breakout strategy is applied to a daily chart of Blackstone Group LP along with a TradeStation Scanner results list of candidate symbols. if BarsSinceCross > 0 and BarsSinceCross <= MaxBarsSinceCross and PercentRange >= MinPercentRange then Alert ; Strategy: Golden Cross Breakouts // TASC MAR 2017 // Golden Cross Breakouts // Ken Calhoun inputs: FastLength( 50 ), SlowLength( 200 ), TrailAmountDollars( 2 ), BreakoutLookBack( 20 ), VolumeMultRequired( 1.5 ) ; variables: FastAvgValue( 0 ), SlowAvgValue( 0 ), BarVolume( 0 ), AvgVolume( 0 ), BreakOutPrice( 0 ), EntryOK( false ), MP( 0 ), TT( 0 ) ; MP = MarketPosition ; TT = TotalTrades ; FastAvgValue = Average( Close, FastLength ) ; SlowAvgValue = Average( Close, SlowLength ) ; if BarType >= 2 and BarType < 5 then BarVolume = Volume else BarVolume = Ticks ; AvgVolume = Average( BarVolume, FastLength ) ; if FastAvgValue crosses over SlowAvgValue then begin BreakOutPrice = Highest( High, BreakoutLookBack ) ; EntryOK = true ;

end ; if MP <> MP[1] or TT <> TT[1] or FastAvgValue crosses under SlowAvgValue then EntryOK = false ; if EntryOK and Close > BreakOutPrice and BarVolume >= AvgVolume * VolumeMultRequired then Buy next bar at Market ; if Close crosses below FastAvgValue then Sell next bar at Market ; SetStopShare ; SetDollarTrailing( TrailAmountDollars ) ;

To download the EasyLanguage code for the indicator and strategy, please visit our TradeStation and EasyLanguage support forum. The code can be found here: https://community.tradestation.com/Discussions/Topic.aspx?Topic_ ID=147651. The ELD filename is “TASC_MAR2017.ELD.” For more information about EasyLanguage in general, please see http://www.tradestation.com/EL-FAQ. A sample chart is shown in Figure 1.

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 METASTOCK: MARCH 2017 TRADERS’ TIPS CODE Ken Calhoun’s article in this issue, “Golden Cross Breakouts,” presents a trading system based on a popular pattern. The MetaStock formulas that implement the buy and sell signals for the pattern are given here: Buy signal Cross( Mov( C, 50, S), Mov( C, 200, S) )

Figure 2: TC2000. Here is a chart of FOX showing the daily timeframe. The golden cross column shows checkmarks on stocks with golden crossovers in the last 10 days. The column properties show the golden cross condition and the condition for price being between $20 and $70.

We used the new scan columns and enhanced formula language in version 17 to scan for stocks between $20 and $70 where the 50-day simple moving average has crossed up through the 200-day moving average within the last 10 days. The formula for the golden cross uses the new “XUP” function in the custom formula language: XUP(AVGC50,AVGC200,10). This returns “true” when AVGC50 (50-period simple moving average) was less than AVGC200 10 days ago and it is now greater than AVGC200. The sample chart in Figure 2 shows the golden cross (point 1) that occurred six days previous. Using the simulated trading features in TC2000, we entered a long position of 100 shares of FOX at $29.01 and set a trailing stop at the 50-day moving average (point 2). You can try the simulated trading yourself at www. TC2000.com. —Patrick Argo Worden Brothers, Inc. www.TC2000.com

Sell signal bsig:= Cross( Mov( C, 50, S), Mov( C, 200, S) ); ssig:= Cross( Mov( C, 200, S), Mov( C, 50, S) ); stop:= C - 2; trade:= If( PREV<=0, If( bsig, stop, 0), If( ssig, -1, If( L < PREV, -2, Max(PREV, stop)))); trade < 0

—William Golson MetaStock Technical Support www.metastock.com

F TC2000: MARCH 2017 TRADERS’ TIPS CODE The golden cross breakout strategy described by Ken Calhoun in his column in this issue titled “Golden Cross Breakouts” can be easily applied in TC2000 version 17 using the new EasyScan columns and enhanced custom formula language.

F eSIGNAL: MARCH 2017 TRADERS’ TIPS CODE For this month’s Traders’ Tip, we’ve provided the study GoldenCrossBkout.efs based on the formula described in Ken Calhoun’s article in this issue, “Golden Cross Breakouts.” In it, the author presents a strategy of trading the golden cross, which is when the 50-day moving average crosses above the 200-day moving average. The eSignal 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 3. To discuss this study or download a complete copy of March 2017

• Technical Analysis of Stocks & Commodities • 51

Figure 3: eSIGNAL. Here is an example of the GoldenCrossBreakout study plotted on a daily chart of Spirit AeroSystems Holdings (SPR).

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 Traders.com in the Traders’ Tips area.

—Eric Lippert eSignal, an Interactive Data company 800 779-6555, www.eSignal.com

F THINKORSWIM: MARCH 2017 TRADERS’ TIPS CODE In “Golden Cross Breakouts” by Ken Calhoun in this issue, we get a lesson on a classic market condition with some in-depth

Figure 4: THINKORSWIM. Here, the GoldenCrossBreakoutsLE strategy is shown on a six-month daily chart of Spirit Aerosystems (SPR).

52 • March 2017 • Technical Analysis of Stocks & Commodities

information. The idea of the article is that these well-understood tools and rules can be used with new strategies. We took this strategy and built it using our proprietary scripting language, thinkscript. We have made the loading process extremely easy. Simply click on the link http://tos. mx/szjMnh and then choose to view thinkScript strategy. In Figure 4, you can see the GoldenCrossBreakoutsLE strategy added to a six-month daily chart of Spirit Aerosystems (SPR). Based on Calhoun’s article, when the 50-day moving average (the blue line) crosses above the 200-day moving average (the pink line), it is a buy signal. The strategy on thinkorswim charts start calculating the trade from this point. We have also added the prebuilt TrailingStopLX strategy to help chartists understand about taking profits or protecting capital. See the article in this issue for more details on the strategy.

—thinkorswim A division of TD Ameritrade, Inc. www.thinkorswim.com

F WEALTH-LAB: MARCH 2017 TRADERS’ TIPS CODE The golden cross system for swing trading described by Ken Calhoun in his article in this issue, “Golden Cross Breakouts,” can be recreated in Wealth-Lab entirely from the building blocks known as rules in a drag-and-drop manner. No coding is required. Figure 5 illustrates the necessary conditions and the order in which they should be stacked. When you combine the rules as shown in Figure 5, the system will exit with a dollarbased trailing exit or after an opposite event—the crossunder of 50-day and 200-day moving averages (MAs). To add more interactivity, click a nearby parameter to expose it as a parameter slider. This way, its value can be changed by dragging the slider on the bottom-left part of the screen. When you run the system on the chart of a single stock (as opposed to a multisymbol portfolio), Wealth-Lab automatically and conveniently applies changed parameters

Figure5: WEALTH-LAB. Here is a guideline for setting up the example system using drag-and-drop rules.

Figure6: WEALTH-LAB. Here, the system is applied to a matching ETF (PFF).

so you have a chance to see how entries and exits change interactively on the chart. On a closing note, to apply the system to stocks of a different price range, you might want to either replace the rule with a percent-based or ATR-based trailing stop, or simply change the trailing dollar value. A sample chart implementation is shown in Figure 6. —Eugene, Wealth-Lab team www.wealth-lab.com

F AMIBROKER: MARCH 2017 TRADERS’ TIPS CODE In “Golden Cross Breakouts” in this issue, author Ken Calhoun shows a simple swing trade strategy based on the golden cross pattern, which is 50-period simple moving average (SMA) crossing over a 200-period SMA. A ready-to-use AmiBroker formula is presented here that replicates the chart shown in the article with the moving averages and trading system with the golden cross entry and two-point trailing stop. A sample chart is shown in Figure 7.

Figure 7: AMIBROKER. Entry and exit points are shown with arrows on a daily candlestick chart of SPR (Spirit Aerosystems) with 50/200 day moving averages, replicating the chart from Ken Calhoun’s article in this issue.

F NEUROSHELL TRADER: MARCH 2017 TRADERS’ TIPS CODE A golden cross breakout trading system such as the one described by Ken Calhoun in “Golden Cross Breakouts” in this issue can be easily implemented in NeuroShell Trader. 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: [all of which must be true] Avg Crossover Above (Close, 50, 200) LONG TRAILING STOP PRICES: TrailPricePnts( Trading Strategy, 2)

If you have NeuroShell Trader Professional, you can also

AmiBroker code: sm = MA( C, 50 ); lm = MA( C, 200 ); GoldenCross = Cross( sm, lm ); // Buy when GoldenCross occurs Buy = GoldenCross; Sell = 0; // exit by stop only // trailing stop based on close prices ApplyStop( stopTypeTrailing, stopModePoint, 2, False ); Equity( 1 ); // evaluate stops // charts Plot( C, "Price", colorDefault, styleCandle ); Plot( sm, "MA50", colorRed ); Plot( lm, "MA200", colorBlue ); // buy/sell arrows PlotShapes( IIf( Buy, shapeUpArrow, 0 ), colorGreen, 0, L ); PlotShapes( IIf( Sell, shapeDownArrow, 0 ), colorRed, 0, H );

—Tomasz Janeczko, AmiBroker.com www.amibroker.com

Figure 8: NEUROSHELL TRADER. Here is a sample NeuroShell Trader chart showing the golden cross trading system for SPR. March 2017

• Technical Analysis of Stocks & Commodities • 53

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. Users of NeuroShell Trader can go to the Stocks & Commodities section 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 8. —Marge Sherald, Ward Systems Group, Inc. 301 662-7950, [email protected] www.neuroshell.com

F AIQ: MARCH 2017 TRADERS’ TIPS CODE The AIQ code based on Ken Calhoun’s article in this issue, “Golden Cross Breakouts,” can be found at www.TradersEdgeSystems.com/traderstips.htm. I tested the author’s system using the NASDAQ 100 list of stocks from the year 2000 through 1/11/2017. I also coded an alternative exit that held positions much longer. Figure 9 shows the author’s system and exit, and Figure 10 shows the same golden cross entry but with my alternative exit. My alternative exit has the following rules:

Figure 9: AIQ. Here are sample summary test results for the strategy described in Ken Calhoun’s article in this issue.

1) Sell when the 50-day moving average crosses through the 200-day moving average, or 2) Sell using a profit-protect type of trailing stop set to trigger when profit is greater than or equal to 15%, then exit if profit drops to 1% (do not let a profit of X% turn into a loss). The alternative exit significantly extended the average holding period from 32 calendar days to 304 calendar days and reduced the number of trades from 7,782 to 936. The ROI and reward-to-risk ratio were both better with the alternative exit. !GOLDEN CROSS BREAKOUTS !Author: Ken Calhoun, TASC March 2017 !Coded by: Richard Denning, 1/8/17 !www.TradersEdgeSystems.com !INPUTS: len1 is 50. len2 is 200. stopamt is 2. minPrice is 5. maxPrice is 70. SMA1 is simpleavg([close],len1). SMA2 is simpleavg([close],len2). GoldenCrossUp if SMA1 > SMA2 and valrule(SMA1<SMA2,1). Golden if SMA1 > SMA2. PriceOK if simpleavg([close],10) >=minPrice and simpleavg([close],10)<=70. Buy if Golden and PriceOK.

54 • March 2017 • Technical Analysis of Stocks & Commodities

Figure 10: AIQ. Here are sample summary test results for the same entries as in Figure 9 for the golden cross strategy but using my alternative exit rules.

Sell if Golden=0 or [close] < {Position High Price}-stopamt. Buy1 if Golden and PriceOK. Sell1 if Golden=0. !and use built-in profit protect[1,15]

Again, the code and EDS file can be downloaded from www. TradersEdgeSystems.com/traderstips.htm. —Richard Denning [email protected] for AIQ Systems

Figure 11: TRADERSSTUDIO. Here is a sample equity curve trading 200 shares of each of the NASDAQ 100 list of stocks from March 2000 through June 2016.

F TRADERSSTUDIO: MARCH 2017 TRADERS’ TIPS CODE The TradersStudio code based on Ken Calhoun’s article in this issue, “Golden Cross Breakouts,” can be found at www. TradersEdgeSystems.com/traderstips.htm. The following code file is provided in the download: System: GOLDEN_X—A system that buys on golden cross up and sells on golden cross down. Figure 11 shows the equity curve trading 200 shares of each of the NASDAQ 100 list of stocks from March 2000 through June 2016. I did not use the two-point trailing stop for this test. The code is shown here: 'GOLDEN CROSS BREAKOUTS 'Author: Ken Calhoun, TASC March 2017 'Coded by: Richard Denning, 1/8/17 'www.TradersEdgeSystems.com Sub GOLDEN_X(len1, len2, stopamt, minPrice, maxPrice) 'INPUTS: 'len1 = 50 'len2 = 200 'stopamt = 2 'minPrice = 20 'maxPrice = 70 Dim SMA1 As BarArray Dim SMA2 As BarArray Dim Golden,PriceOK SMA1 = Average(C,len1) SMA2 = Average(C,len2) Golden = SMA1 > SMA2 PriceOK = Average(TSCLose,10)>=minPrice And Average(TSCLose,10)<=maxPrice If Golden And PriceOK Then Buy("LE",1,"",Market,Day) If Golden=0 Then ExitLong("LX","",1,"",Market,Day) 'If C < (Highest(C,BarsSinceEntry,0))-stopamt Then ExitLong("LX stop","",1,"",Market,Day)

Figure 12: NINJATRADER. The GoldenCrossBreakout strategy displays the long entry for the crossing of the 50 SMA over the 200 SMA on the SPR daily chart for October 2016.

F NINJATRADER: MARCH 2017 TRADERS’ TIPS CODE The golden cross breakout strategy, as discussed in “Golden Cross Breakouts” by Ken Calhoun in this issue, is available for download at the following links for NinjaTrader 8 and NinjaTrader 7: NinjaTrader 8: www.ninjatrader.com/SC/March2017SCNT8.zip NinjaTrader 7: www.ninjatrader.com/SC/March2017SCNT7.zip Once the file is downloaded, you can import the strategy into NinjaTader 8 from within the Control Center by selecting Tools → Import → NinjaScript Add-On and then selecting the downloaded file for NinjaTrader 8. To import into NinjaTrader 7, from within the Control Center window, select the menu File → Utilities → Import NinjaScript and select the downloaded file. You can review the strategy’s source code in NinjaTrader 8 by selecting the menu New → NinjaScript Editor → Strategies from within the Control Center window and selecting the GoldenCrossBreakout file. You can review the strategy’s source code in NinjaTrader 7 by selecting the menu Tools → Edit NinjaScript → Strategy from within the Control Center window and selecting the GoldenCrossBreakout 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 12. —Raymond Deux & Patrick Hodges NinjaTrader, LLC www.ninjatrader.com

End Sub

—Richard Denning [email protected] for TradersStudio March 2017

• Technical Analysis of Stocks & Commodities • 55

F UPDATA: MARCH 2017 TRADERS’ TIPS CODE Our Traders’ Tip for this month is based on Ken Calhoun’s column in this issue, “Golden Cross Breakouts.” In the article, Calhoun proposes that this classical technical analysis setup be used in conjunction with other filters, such as rising volume, to better identify trends with the potential for persistence, with the suggestion that ETFs in the $20–$70 range are those products with better potential. The Updata code for this 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 a firewall may paste the code here into the Updata custom editor and save it. A sample chart is shown in Figure 13. FIGURE 13: UPDATA. Here is an example of the golden cross breakout system applied to daily chart of Spirit Aerosystems Holdings Inc. (SPR).

NAME Golden Crossover System Parameter "Period 1" #PERIOD1=50 Parameter "Period 2" #PERIOD2=200 INDICATORTYPE TOOL DISPLAYSTYLE 2LINES PLOTSTYLE LINE RGB(255,0,0) PLOTSTYLE2 LINE RGB(0,255,0) SHOWEQUITYCURVE FOR #CURDATE=#PERIOD2 to #LASTDATE IF HASX(MAVE(#PERIOD1),MAVE(#PERIOD2),UP) COVER BUY ELSEIF HASX(MAVE(#PERIOD1),MAVE(#PERIOD2),DOWN) SELL SHORT ENDIF @PLOT=MAVE(#PERIOD1) @PLOT2=MAVE(#PERIOD2) NEXT

—Updata support team [email protected] www.updata.co.uk

F MICROSOFT EXCEL: MARCH 2017 TRADERS’ TIPS CODE In “Golden Cross Breakouts” in this issue, author Ken Calhoun explains the workings of a simple trend-following trading system based on the golden cross chart formation. For any given security, you may not find more than one golden cross in any given year, and some years you may not find any. Thus, you should expect to scan quite a few securities to find one. But when you do find one, it can provide an interesting ride, as demonstrated by the Spirit Aerosystems Holdings example given in Figure 1 of Calhoun’s article in this issue. As I write this in the middle of January 2017, I have access to a few more bars of data than were available when Calhoun produced Figure 1 for his article. So we can see a bit more of how this example played out (Figure 14). The golden cross signals a buy with the 50-bar average crossing above the 200-bar average on 10/20/2016. 56 • March 2017 • Technical Analysis of Stocks & Commodities

In this trading simulation, we buy at the open of the next bar. The price hits our two-point trailing stop on 12/13/2016 and we sell at the open of the next bar. The Excel spreadsheet I have created for this issue (and which is posted for you at the Stocks & Commodities magazine website at www.Traders.com in the March 2017 Traders’ Tips area) is set up to process 2,500 bars, or just short of 10 years of historical data. The transaction summary tab shown in Figure 15 shows that in that period, there were six trades including a couple of nice wins, a couple of so-so wins, and a couple that lost a bit. Gotta love those trailing stops! Figure 16 takes a closer look at the 6/11/2009 trade, which began with a signal on 06/10/2009. The signal bar was very nearly the highest bar on the chart, and things moved downhill from there. The trailing stop pulled us out of this one. That was pretty much at the same point that a stop based on the 50-bar average would have hit.

Suggestions

There are several keys to using the golden cross indicator: • Access to 200-plus bars of recent historical data for a lot of symbols • A mechanism to scan across this symbol universe and flag symbols showing a golden cross signal in the last several days. This may be a very small number of symbols much of the time • Really good money management / position sizing for any trades taken based on this indicator • Strict adherence to the stop-loss. For those who are not shy about taking short positions, Continued on page 62

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Editorial Resource Index National Association of Real Estate Investment Trusts (reit.com/nareit) . . . . . 07 etfdb.com . . . . . . . . . . . . . . . . . . . 46 StockCharts.com . . . . . . . . . . . . . . 46 MetaStock . . . . . . . . . . . . . . . . . . . 23 Microsoft Excel . . . . . . . . . . . . . . . . 27 NADEX (nadex.com) . . . . . . . . . . . . 33 TomsOptionTools.com . . . . . . . . . . . . 41 NinjaTrader . . . . . . . . . . . . . . . . . . 42 eSignal (Interactive Data) . . . . . . . . . . . . 48 TradeStation . . . . . . . . . . . . . . . . . 50 TC2000 (Worden Brothers, Inc) . . . . . . . . . 51 thinkorswim . . . . . . . . . . . . . . . . . . 52

Wealth-Lab . . . . . . . . . . . . . . . . . . AmiBroker . . . . . . . . . . . . . . . . . . . Neuroshell Trader (Ward Systems Group) . . AIQ . . . . . . . . . . . . . . . . . . . . . . . TradersStudio . . . . . . . . . . . . . . . . . Updata . . . . . . . . . . . . . . . . . . . . .

52 53 53 54 55 56

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March 2017

• Technical Analysis of Stocks & Commodities • 57

FUTURES LIQUIDITY

T

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 contract’s 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 firm’s shares outstanding.

Trading Liquidity: Futures

Commodity Futures Exchange % Margin Effective Contracts to Relative Contract Liquidity % Margin Trade for Equal Dollar Profit S&P 500 E-Mini (Mar ‘17) GBLX 4.6 18.6 2 ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••>> 10-Year T-Note (Mar ‘17) CBOT 1.3 15.3 7 •••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••> Crude Oil WTI (Mar ‘17) NYMEX 6 5.8 1 •••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••> Russell 2000 Mini (Mar ‘17) ICEUS 4.7 14.5 2 •••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• 5-Year T-Note (Mar ‘17) CBOT 0.8 17.6 13 •••••••••••••••••••••••••••••••••••••••••••••••••••••••••• Ultra T-Bond (Mar ‘17) CBOT 3.9 17.7 2 •••••••••••••••••••••••••••••••••••••••••••••••••••••••• T-Bond (Mar ‘17) CBOT 2.9 15.8 2 •••••••••••••••••••••••••••••••••••••••••••••••••• Euro FX (Mar ‘17) CME 2.7 9.1 2 •••••••••••••••••••••••••••••••••••••••••••• Gasoline RBOB (Mar ‘17) NYMEX 7.1 6.9 1 ••••••••••••••••••••••• Natural Gas (Mar ‘17) NYMEX 7.7 8.2 2 •••••••••••••••••••••• Nasdaq 100 E-Mini (Mar ‘17) GBLX 4.3 12.6 2 •••••••••••••••••••• Soybeans (Mar ‘17) CBOT 5 11 3 ••••••••••••••••••• ULSD NY Harbor (Mar ‘17) NYMEX 6 6.3 1 •••••••••••••••••• British Pound (Mar ‘17) CME 5 13.9 2 ••••••••••••••• 2-Year T-Note (Mar ‘17) CBOT 0.3 15.7 18 •••••••••••••• Eurodollar (Dec ‘17) CME 0.1 10.4 20 ••••••••••••• Corn (Mar ‘17) CBOT 5.4 12.9 9 •••••••••••• Gold (Feb ‘17) COMEX 5.5 33.9 3 ••••••••• Dow Indu 30 E-Mini (Mar ‘17) CBOTM 4.2 17.9 3 •••••••• Japanese Yen (Mar ‘17) CME 4.5 30.1 4 •••••••• High Grade Copper (Mar ‘17) COMEX 3.7 13.1 4 ••••••• S&P Midcap E-Mini (Mar ‘17) GBLX 4.3 14.8 1 ••••••• Silver (Mar ‘17) COMEX 7.5 24.5 3 ••••••• Sugar #11 (Mar ‘17) ICEUS 8.1 16.2 6 ••••••• Wheat (Mar ‘17) CBOT 5.2 7.1 4 ••••••• Live Cattle (Apr ‘17) CME 4.2 9.3 3 ••••• Soybean Meal (Mar ‘17) CBOT 5.8 11.9 4 ••••• Australian Dollar (Mar ‘17) CME 2.9 11.6 4 •••• Canadian Dollar (Mar ‘17) CME 2.5 11 4 •••• Lean Hogs (Apr ‘17) CME 4.7 5.2 3 •••• Mexican Peso (Mar ‘17) CME 8.3 12.3 4 •••• CBOT Chicago Board of Trade, Division of CME Coffee (Mar ‘17) ICEUS 6.3 13.3 2 ••• CFE CBOE Futures Exchange Cotton #2 (Mar ‘17) ICEUS 5.4 16.9 6 ••• CME Chicago Mercantile Exchange Hard Red Wheat (Mar ‘17) KCBT 4.5 4.8 3 ••• COMEX Commodity Exchange, Inc. CME Group U.S. Dollar Index (Mar ‘17) ICEUS 2 9.4 3 ••• GBLX Chicago Mercantile Exchange - Globex Cocoa (Mar ‘17) ICEUS 8.3 14.8 6 •• ICE-EU Intercontinental Exchange-Futures - Europe Crude Oil Brent (F) (Mar ‘17) NYMEX 6 5.4 1 •• ICE-US Intercontinental Exchange-Futures - US Feeder Cattle (Mar ‘17) CME 5.7 6.4 1 •• KCBT Kansas City Board of Trade Platinum (Apr ‘17) NYMEX 5.4 9.9 3 •• MGEX Minneapolis Grain Exchange Soybean Oil (Mar ‘17) CBOT 3.8 13.3 12 •• NYMEX New York Mercantile Exchange Swiss Franc (Mar ‘17) CME 3.2 14 2 •• 30-Day Fed Funds (Apr ‘17) CBOT 0.1 10.1 25 • Brazilian Real (Feb ‘17) CME 8.7 19.4 5 • New Zealand Dollar (Mar ‘17) CME 3.5 16.7 4 • 1703 Palladium (Mar ‘17) NYMEX 5.2 13.5 2 • 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).

58 • March 2017 • Technical Analysis of Stocks & Commodities

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Exchanges With the explosion of exchanges around the world and the increasing poaching of products between exchanges, traders should be aware of all the places where trading opportunities occur. No longer bound by national borders or even physical locations, exchanges can be no more than a box in the corner of an office. Differen­tiation comes in the form of product, volume, speed, pricing, and investor protections. Look for an exchange with extensive trade documentation so that disputes can be resolved quickly and with quick reference to events. Since more and more alternatives are rapidly becoming available, don’t be afraid to direct your business to the exchange of your choice. The plethora of investor choice is forcing a rapid decline in transaction costs already, and exchange monopolies are a thing of the past. Use the listing of exchanges in the Trad-

ers’ Resource database at our website to find the websites of the exchanges handling your tradable, then go to the site to get the specifics of the trading vehicle. Better yet, get several equivalent products at several exchanges and be sure your broker can direct your business to the venue of your choice.

TRADERS' RESOURCE

LINKS

Traders’ Resource at Traders.com

In addition to our listing of exchanges at Traders.com, you’ll also find listings of other trading-related products and services such as software, publications, courses and seminars, brokerages, data services, trading systems, and more. We hope this will help you learn about products to help in your trading endeavors. To reach the Traders’ Resource area of our website, just click on the Traders’ Resource link from Traders.com. Then follow the category link for exchanges, or use the search feature to find products or services with specific attributes in this or other categories.

The information in Traders’ Resource is the most accurate at the time of posting and is subject to change. Because the vendors posting to Traders’ Resource are responsible for their own listing, Technical Analysis, Inc. declines any and all liability for any representations made by the businesses and individuals listed. Nor can Technical Analysis, Inc. endorse any business or individual listed on Traders’ Resource. Technical Analysis, Inc. makes no warranties, express or implied, as to the accuracy and reliability of claims herein. You agree to release Technical Analysis, Inc., together with its respective employees, agents, officers, directors and shareholders, from any and all liability and obligations whatsoever in connection with or arising from your use of Traders’ Resource. If at any time you are not happy with the information posted to Traders’ Resource or object to any material within Traders’ Resource, your sole remedy is to cease using it. This list is updated frequently. If you are aware of a business that should be listed, please email us at [email protected].

March 2017

• Technical Analysis of Stocks & Commodities • 59

The Invisible Force

How often have you sat at your trading desk with a solid plan that you want to follow and how often, after placing a trade, have you deviated from that plan? Emotions can wreak havoc on our trading lives and there’s nothing you can do to make them disappear. The first step toward combating them is to be aware of the existence of emotions.

I

by Claudio Demb

am tempted to start with the end and give away the punch line. So here it goes: Psychology is destiny. I agree that it sounds very categorical, and whether or not this is true doesn’t really matter. You still have to go through the motions. As a good friend of mine often said, “Not everything is psychological.” I know that what he said is true, but to be fair, he had to learn to deal with his emotional issues in order to become a good trader.

What does it really take?

If not everything is psychological, then what are the other 60 • March 2017 • Technical Analysis of Stocks & Commodities

necessary elements to become a successful trader? To answer this question could lead into a long academic discussion. You could say that the psychological lens is a very powerful element, but right in this statement lies the first problem. We can reference a psychological “lens,” but do you actually see your emotions or do you feel them? You don’t see your emotions. You feel them, and that can be a problem when it comes to trading. But that doesn’t mean emotions are all bad. It is much easier to see things that are concrete or tangible. Numbers are an example of something that is concrete. Feelings are extremely important, but since you cannot see them, it can be difficult to understand and accept them. It is not unusual for people to believe they have control over their actions. They can speak clearly about their methods and trading plans. But when feelings kick up in high gear, it is very possible to do something totally different, sometimes even take a 180-degree turn from the original plan. To sum it up, we think we know, we believe we have a solid plan, but there is some invisible force that takes over, uninvited, that helps us to depart from our plan.

ESD PROFESSIONAL/shutterstock

Successful Trader Must-Haves

at the close

Not all is lost

Just because emotions are intangible, it doesn’t mean you are helpless. There’s hope. With practice, patience, help, and time you can get a handle on your emotions. Taking the step to being aware of what is going on and even anticipating what you might feel as the trade unfolds is an indication that you are on the right track. It’s a sign that you are no longer blinded by your feelings. To go into the nitty-gritty details about all that is involved in working with a fellow trader on his or her psychological issues would be a lengthy project. Even if I were to miraculously do it in a couple of pages, it won’t be much use since every person is unique. The twists and turns that one trader takes will not apply to those of another trader. But there are some key ingredients such as time, commitment, trust, hard work, and exposure to vulnerabilities that affect all of us.

tory signals. Before you know it, you are underwater and you need to think fast. You were bullish and dead sure about your long position, but the market is telling you the opposite. Who are you going to listen to?

What you see

Know what you’re dealing with

I will now shift gears and move on to a more concrete, easyto-see subject. Getting back to the title of this article, what are the essential traits a successful trader must have? This list may not be all-inclusive but for sure will include the ones that are beyond any questioning. First, a trader must have a passion for trading. Anything less will not suffice. You have to have the bug to the point that you cannot resist its call. Otherwise you will not be able to withstand the grueling demands it requires. On the surface, trading looks easy. In fact, it’s almost seductive, but that is just an illusion. The reality is that it is very difficult. So passion is one of the must-haves to be a successful trader. You also need some smarts with numbers. It’s not that you need to be a mathematical wizard, but you need to have some comfort with numbers. You need to be able to analyze data and be able to identify elucidating patterns and think abstractly. Another necessity is dedication and focus. You must be willing to sit down and work at it. You need mental flexibility, almost like having the agility of a wild animal. That may sound esoteric but just think about this for a moment: Say you’re trading with your best trading idea and it is getting contradic-

We think we know, we believe we have a solid plan, but there is some invisible force that takes over, uninvited, that helps us to depart from our plan.

In situations like these, you need an innate ability to withstand negative feelings. Oftentimes, way more than you would like, many trades won’t go as planned, losses will mount, and you will need the mental fortitude to keep going. This will keep happening so you need to be able to act quickly. And having that agility is what makes you a successful trader. It’s not about how much you make on a trade or how many winning trades you have. It’s about being aware and able to act quickly to keep your drawdowns to a minimum. Claudio Demb has been an independent trader and investor for over 20 years. He is a practicing psychiatrist and lives with his family in Brookline, MA. He may be reached via email at [email protected].

Further reading

Demb, Claudio [2017]. “How Feelings Influence Your Trading,” Technical Analysis of Stocks & Commodities, Volume 35: January.

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When learning technical analysis, traders tend to look for perfection instead of looking at how perfection is created. Here’s a technique that could give you a deeper insight into the relationship between time and price. March 2017

by Mircea Dologa

When applying Elliott wave counts to your charts, one of the challenges is knowing which trend to use. Here is an approach that could help you identify which to use. Coming soon! • Technical Analysis of Stocks & Commodities • 61

Figure 14: EXCEL, Golden cross trade. A two-point trailing stop was hit on 12/13/2016, and a 50-day moving average stop would have hit on 01/12/2017.

Continued from page 56

the death cross indicator is the exact mirror of the golden cross indicator. You would sell when the 50-bar average crosses below the 200-bar average and buy back when the two-point stop-loss hits. Because the death cross alternates with the golden cross, there were five or six death cross signals buried in the data used to create my list of sample transactions. The spreadsheet file for this Traders’ Tip can be downloaded from www.traders.com in the Traders’ Tips area. To successfully download it, follow these steps:

Figure 15: EXCEL, EXAMPLE transactions SUMMARY. Over the course of nine years, we find six golden cross events, including a couple of nice wins.

• Right-click on the Excel file link (“GoldenCrossBreakout.xlsm”), then • Select “save as” to place a copy of the spreadsheet file on your hard drive.

—Ron McAllister Excel and VBA programmer [email protected]

Figure 16: EXCEL, One of the small-loss trades. A strategy based on the golden cross makes for an interesting, simple trading system.

62 • March 2017 • Technical Analysis of Stocks & Commodities

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