STOCK INDEX FUTURES TRADING COLLECTION
“Using the TICK to identify the intraday trend” by David Bean (Active Trader, May 2006). 2 “Counterpunch stock index futures system" by Active Trader Staff (Active Trader, Nov. 2002) 7 “Extreme open-close days” by Xavier Maria Raj (Active Trader, April 2005). 9 “The Fibonacci Swing Filter” by Gomu Vetrivel (Active Trader, Feb. 2005). 13 “Trading the opening gap” by John Carter (Active Trader, Dec. 2004). 17 “Hitting the street: The S&P 500 futures' intraday reactions to economic reports” by David Bukey (Active Trader, May 2005). 21 “Sector vs. index: The single stock futures-Dow spread” by Keith Schap (Active Trader, Nov. 2005). 27 “Trading the basis: How stock index arbitrage impacts the market” by David Lerman (Active Trader, March 2003). 31 “Stock index spreads: S&P vs. Naz” by Keith Schap (Active Trader, May 2006). 35 “The multibar range breakout system” by Dennis Meyers, PH.D. (Active Trader, Jan. 2004). 39 “Following through in the S&Ps” by Thom Hartle (Active Trader, Dec. 2003). 44 “Getting in on follow-through days” by Thom Hartle (Active Trader, Jan. 2004). 49 “Follow-through in the E-Mini Nasdaq 100” by Thom Hartle (Active Trader, Aug. 2004). 54 “Up-down volume and next-day follow-through” by Thom Hartle (Active Trader, Dec. 2004). 60 “E-Mini morning reversal and afternoon breakout patterns” by Gomu Vetrivel (Active Trader, Jan. 2006). 66 “The telltale spread” by Thom Hartle (Active Trader, Nov. 2003). 70 TRADING Strategies
Using the TICK TO IDENTIFY THE INTRADAY TREND Analyzing TICK readings over the past five years provides the foundation for an intraday trend strategy.
BY DAVID BEAN
he TICK indicator measures than previous price). The TICK subtracts prices while 1,500 stocks were trading intraday momentum in the number of downticking stocks from lower than their previous prices, the New York Stock Exchange the number of upticking ones to gener- TICK value would be +500 (2,000-1,500). (NYSE) stocks by tracking ate a momentum snapshot of the market Traders typically use the TICK indicator the difference between upticking stocks at any given time. to gauge the level of buying or selling (lastT price higher than previous price) For example, if at 10 a.m. 2,000 stocks pressure throughout the day. If the TICK and downticking stocks (last price lower were trading higher than their previous reading is high, the market is showing “internal” strength, which is different FIGURE 1 FIVE-YEAR AVERAGE NYSE VOLUME (15-MINUTE INTERVALS) from the “outward” price movement. According to popular interpretation, The second-largest NYSE volume occurred in the first 15 minutes of trading, TICK levels that correspond with price which is a good time to determine the daily trend because price moves are action help confirm the market’s direc- more meaningful when backed by large volume. tion, but TICK values that diverge from price can warn of possible reversals. For example, a typical bullish signal occurs when the S&P 500 is climbing when the TICK is positive (or trending higher). However, if the S&P 500 is rising but the TICK turns negative (or trends lower), the rally could be nearing its end. (For more information on the TICK, see “TICK basics.”)
From analysis to trading This kind of analysis depends on logical- ly defining “high” or “low” TICK read- ings. The following study analyzed intraday TICK behavior in the past five years to find potentially bullish and bearish TICK levels. However, the resulting trade strategy also relied on NYSE volume analysis and price action to confirm the intraday trend and gener-
2 www.activetradermag.com • May 2006 • ACTIVE TRADER TABLE 1 FIVE-YEAR TICK STATS
The TICK has had a bullish bias over the past five years. Its aver- age daily high is nearly double its daily low, its average close every 15 minutes was +201, and it exceeded +300 nearly six times as often as it dropped below -300 (based on 15-minute intervals). ate trade signals. must take this upside bias into account. The focus was on the first 15 minutes The strategy’s bullish and bearish of the daily trade session because over thresholds are based on the TICK’s aver- TICK value the past five years the NYSE’s second- age close of +201 after 15 minutes. There Five-year high: +1,541 largest volume has occurred during this are thresholds for both high and low Five-year low: -1,495 period. Above-average TICK readings readings as well as for where the TICK generate buy signals at 9:45 a.m. ET. By closes. The high and low thresholds are Avg. daily high: +1,007 contrast, sell signals require below-aver- +750 and -350, which are approximately Avg. daily low: -673 age TICK readings along with down- +/-550 from the average close of +201; ward price moves (gaps or weakness) the closing TICK thresholds are +500 Avg. closing value within the first 15 minutes. and -100, which are approximately after 15 minutes: +201 The logic of this approach is that high- +/- 300 from the average close of +201. No. of 15-minute volume periods combined with price This means the TICK is bullish if it closes above +300: 12,855 moves and TICK readings in the same either reaches +750 within the first 15 direction help determine the trend for minutes of trading or closes above +500 No. of 15-minute the rest of the day. at 9:45 a.m. Similarly, the TICK is bearish closes below -300: 2,262 if it drops below -350 within the first 15 Trend clues at market’s open Figure 1 shows the NYSE’s average vol- ume of more than 3,700 stocks in 15- minute intervals from 9:30 a.m. to 4 p.m. TICK basics ET over the past five years. While vol- ume is highest in the last 15 minutes of he TICK is a very short-term (intraday) indicator that measures the trading, the second-highest volume bullish (upticking) or bearish (downticking) activity in NYSE stocks occurred in the first 15 minutes of the throughout the day. TIKI is the symbol for the same indicator calcu- regular session — from 9:30 a.m. to 9:45 lated on Dow Jones Industrial Average stocks; some data services also a.m. supply the TICK calculated on Nasdaq stocks. The day’s open and close stand out TThe TICK is a breadth indicator that gives traders an intraday look at the “inter- because institutional traders must exe- nal” strength or weakness of the market — that is, the strength or weakness cute large amounts of market-on-open beyond whether the overall market is up on a point or percentage basis. By com- and market-on-close orders; the price paring the number of stocks advancing to stocks declining, the indicator reflects moves that occur during these periods the market’s up or down momentum at a given moment. can leave clues about the market’s likely For example, if the S&P 500 index is up marginally but downticking stocks are direction. Although you can trade stocks consistently outnumbering upticking stocks (and the number of downticking and stock-index futures in the after- stocks is increasing, reflected by a downtrending TICK indicator), it is likely that hours electronic market, those markets only a relative handful of strong stocks are propping up the overall market. offer very little volume to offset posi- When buying completes in these stocks, a down move may result. tions against overnight breaking news Two contrarian uses of the TICK indicator are to look for divergence between while the U.S. stock market is closed for price and the indicator, and to use high or low TICK readings to identify momen- 17.5 hours. tum extremes (similar to how many traders use oscillators like the relative strength index or stochastics to locate overbought and oversold points). Defining TICK thresholds A divergence occurs when price makes a new high (or low) but the TICK Table 1 shows statistics behind the TICK makes a lower high (or higher low), failing to confirm the price move and warn- indicator’s historical behavior over the ing of a slackening of momentum and potential stall or reversal. A similar phe- past five years. Overall, the TICK had a nomenon would be a steady trend in the TICK that runs counter to the trend of bullish bias. The average daily TICK the market. Extreme high or low TICK readings sometimes accompany market high was nearly twice as large as the climaxes. daily low (+1,007 vs. -673). Also, the Because the TICK is a snapshot of the market at a given moment (and is thus TICK’s average close after 15 minutes very volatile), it can be deceptive. Because of this, the TICK is commonly was not only above zero (+201) but smoothed with a 10-period moving average to remove some of the “noise” and exceeded +300 almost six times as often better reveal the indicator’s direction and patterns. as it fell below -300. Buy and sell signals
ACTIVE TRADER • May 2006 • www.activetradermag.com 3 Strategy code Tradestation EasyLanguage Code yesterday’s 15-minute bars), the TICK’s close < -100, and TICK’s {Data1 is @ES.D or any of the following: @ER2.D, @YM.D, @NQ.D, @EMD.D high < +750, sell short for the next Data2 is $TICK. Both Data1 and Data2 are 15 minute charts – a custom ses- 15 minutes (until 10 a.m.) at sion should be built for @YM.D to trade between 8:30 am CST and 3:15 pm CST today’s open (limit). instead of starting at 7:20 am CST. *there are 27, 15 minute bars in the trading day} 3. If the close of the first 15-minute bar > the previous day’s close, the Inputs: R(5), L1(27); TICK’s low < -350, and the TICK’s If Time=945 and H of data2 > 750 and L of data2 > -350 Then Buy Next Bar at high < +750, sell short for the next market; 15 minutes (until 10 a.m.) at If Time=945 and C of data2 > 500 and L of data2 > -350 Then Buy Next Bar at yesterday’s close (stop). market; 4. If the close of the first 15-minute If Time=945 and Open > LowD(1) - 2*Average(Range,27) and L of data2 < -350 bar > the previous day’s close, the and H of data2 < 750 Then Sell Short Next Bar at OpenD(0) Limit; TICK’s close < -100, and the TICK’s If Time=945 and Open > LowD(1) - 2*Average(Range,27) and C of data2 < -100 high < +750, sell short the next 15 and H of data2 < 750 Then Sell Short Next Bar at OpenD(0) Limit; minutes (until 10 a.m.) at If Time=945 and C > C[1] and L of data2 < -350 and H of data2 < 750 Then Sell yesterday’s close (stop). Short Next Bar at CloseD(1) Stop; If Time=945 and C > C[1] and C of data2 < -100 and H of data2 < 750 Then 5. If the close of the first 15-minute Sell Short Next Bar at CloseD(1) Stop; bar < the open - the average range of all 27 of yesterday’s 15-minute If Time=945 and C>(O + Average(Range,27)) and L of data2 > -350 Then Buy bars and the TICK’s high < 750, Next Bar at market; then sell short at the market. If Time=945 and C<(O - Average(Range,27)) and H of data2 < 750 Then Sell Short Next Bar at market; Exit:
SetStopLoss(R*BigPointValue*Average(Range,L1)); 1. Stop-loss = R * contract’s point SetExitonClose; value * average range of all 27 previous 15-minute bars since the Strategy code can be copied at www.activetradermag.com/code.htm. same time yesterday. (R = multiplier that can be optimized for each market or risk preference; default minutes or closes below -100 at 9:45 a.m. TICK’s low > -350, buy at the = 5.) market . Trade rules 2. Exit on close if still in market. There are three long-entry and five 3. If the close of the first 15-minute short-entry rules. Although each rule is bar > the open + the average range Trade logic independent, meaning it could be tested (high - low) of all 27 of yesterday’s All eight signals are based on TICK individually, all eight rules are combined 15-minute bars, and the TICK’s behavior and price direction within the to make a single system designed to low > -350, buy at the market . first 15 minutes of trading. Two of the trade the S&P 500 E-Mini futures (ES). three long rules focus solely on exceed- The rules were also tested on the Russell Short entries (at 9:45 a.m. ET): ing TICK’s bullish thresholds and stay- 2000 E-Mini (ER2), Midcap 400 E-Mini ing above its bearish ones. Also, four of (EMD), Mini Dow (YM), and Nasdaq 1. If today’s open > yesterday’s low - the five short rules require TICK to pen- 100 E-Mini (NQ). (2 * the average range of all 27 of etrate the bearish levels as it stays below yesterday’s 15-minute bars), the the bullish ones. Long entries (at 9:45 a.m. ET): TICK’s low < -350, and the TICK’s The other two rules don’t wait for high < +750, sell short for the next either TICK threshold to be met. To trig- 1. If the TICK’s high > +750 and the 15 minutes (until 10 a.m.) at ger a buy signal, price must climb fur- TICK’s low > -350, buy at the today’s open (limit). ther than the average range of all of yes- market . terday’s 15-minute bars (long rule 3), or 2. If today’s open > yesterday’s low - price must drop the same distance 2. If the TICK’s close > +500 and the (2 * the average range of all 27 of before selling short (short rule 5).
4 www.activetradermag.com • May 2006 • ACTIVE TRADER However, these rules still require the example, if price climbs above yester- below yesterday’s close, the strategy TICK to remain above its average low day’s close by 9:45 a.m., it must drop sells short with a limit order at today’s (-350) or below its average high (+750), back to that point before the system sells open in the second 15 minutes. That gap, respectively. short with a stop order in the second 15 however, must be smaller than twice the The first four short rules must be exe- minutes of the trading session (until 10 average range of yesterday’s 15-minute cuted using stop or limit orders. For a.m.). Also, if the opening price gaps bars. The stop-loss depends on the average range of FIGURE 2 TRADE EXAMPLE yesterday’s 15-minute bars, The S&P 500 E-Mini fell slightly on Feb. 2, and the TICK low (-383) was bearish by 9:45 the contract’s point value, a.m. because it dropped below the lower threshold (-350). The system sold short at and a multiplier (R) to 1,284, and the S&P E-Mini sold off throughout the day — a gain of 12.75 points. adjust the stop size. If that stop-loss isn’t hit, the sys- tem holds the trade until the end of the day to let profits run.
Trade example Figure 2 shows a 15-minute chart of the March 2006 S&P 500 E-Mini futures (ESH06) on Feb. 2. The market dropped slightly at the open, and the TICK readings at 9:45 a.m. were low (-383), high (+125), and close (+99). The S&P 500 had a short bias because the TICK’s low was below the bearish threshold of -350 and its high was below the bullish level of +750. The system placed a limit order at 9:45 a.m. at the E-Mini’s opening price Source: Tradestation 8.1 (1,284.00), and the S&P 500
TABLE 2 OVERALL TEST RESULTS The strategy was profitable across the major indices in different time periods. All markets had a favorable percentage of gains, and all but one had average profits per trade of at least $54.72. However, the Nasdaq 100 didn’t perform as well.
Start No. of Profit Drawdown Percentage Avg. Profit Avg. Avg. Ratio date trades profitable profit per factor winning losing avg. win/ trade trade trade avg. loss E-Mini S&P 500 9/11/97 1,128 $67,237.50 $10,637.50 53.90% $59.61 1.33 $444.10 -$400.74 1.11 E-Mini Russell 2000 11/7/01 726 $42,990.00 $6,280.00 52.75% $59.21 1.33 $454.73 -$393.90 1.31 E-Mini Midcap 400 1/28/02 709 $38,800.00 $4,760.00 52.47% $54.72 1.35 $401.53 -$338.13 1.19 E-Mini Nasdaq 100 7/1/99 1,006 $14,160.00 $23,760.00 51.29% $14.08 1.05 $529.22 -$549.72 0.96 Mini Dow 7/28/02 579 $37,910.00 $3,520.00 56.82% $65.47 1.60 $307.39 -$259.10 1.19
5 www.activetradermag.com • May 2006 • ACTIVE TRADER TABLE 3 TEST RESULTS: JAN. 1, 2003 TO FEB. 1, 2006 Performance suffered slightly in this second test because the markets’ daily ranges narrowed in the past three years. However, most markets remained profitable even if you consider slippage and commission costs (not included).
Profit No. of Drawdown Percentage Avg. Profit Avg. Avg. Ratio trades profitable profit per factor winning losing avg. win/ trade trade trade avg. loss E-Mini S&P 500 $20,112.50 477 $3,012.50 53.67% $42.16 1.35 $304.35 -$270.09 1.13 E-Mini Russell 2000 $28,690.00 534 $6,280.00 52.81% $53.73 1.30 $444.01 -$392.36 1.13 E-Mini Midcap 400 $23,360.00 553 $4,760.00 52.80% $42.24 1.28 $363.97 -$325.18 1.12 E-Mini Nasdaq 100 $7,670.00 511 $3,530.00 51.86% $15.01 1.14 $231.25 -$228.13 1.01 Mini Dow $19,815.00 498 $3,520.00 55.22% $39.79 1.38 $262.56 -$241.43 1.09
hit this price between 9:45 a.m. and 10 Test results 3). Comparing Tables 2 and 3 shows that a.m., going short 0.25 points from the The TICK strategy was tested on histori- although the average profit per trade day’s high. The market sold off through- cal intraday price data going back at dropped in recent years, the average out the day, and the system exited at the least three years in the S&P 500 E-Mini trade is still large enough (at least close (1,271.25) for a 12.75-point gain. futures, Russell 2000 E-Mini, Midcap 400 $39.79) to make money after slippage The Russell 2000 E-Mini, Midcap 400 E-Mini, Mini Dow, and Nasdaq 100 E- and commission costs. (The Nasdaq 100 E-Mini, and mini Dow all took similar Mini. Table 2 (p. 5) shows results for E-Mini’s average profit of $15.21 was trades as each of these markets climbed each index in different time periods from the exception to this rule.) Average prof- back to the open and then dropped. No Sept. 11, 1997 to Feb. 1, 2006. its fell because the markets’ daily ranges trade was triggered in the Nasdaq 100 E- For comparison purposes, each index have decreased in recent years. Mini because this market didn’t trade was also tested over the same time peri- The system trades often — roughly back to the open. od — Jan. 1, 2003 to Feb. 1, 2006 (Table three times a week in each market over the past three years, or 500 trades in 750 trading days. Overall, the system caught roughly 10 percent of the S&P 500’s 50-day aver- Related reading age daily trend. For example, if the S&P E-Mini has a 10-point daily range, and “The Crown pattern” the system captures 10 percent of it, Active Trader , January 2004. then its average profit is one point Here’s a way to use some specific calculations to improve the odds of trading ($50). This roughly matches the sys- a variation of a classic chart pattern — on an intraday basis. tem’s average profit in the S&P 500 in both time periods. (As of Feb. 1, the “Intraday trading with the TICK” S&P E-Mini’s 50-day average range was Active Trader , April 2002. 9.84 points.) Find out how the TICK indicator can complement other trading tools in identi- fy low-risk trades. Here’s how one trader combines the TICK with support and Further research resistance analysis and retracement levels. One idea that deserves additional atten- tion is to sell rallies short when the TICK “Indicator insight: TICK/TIKI” signals a downtrend, or buy dips after it Active Trader , March 2001. signals an uptrend at 9:45 a.m. How to calculate and interpret the TICK, a popular short-term indicator that Instead of trading just one contract measures intraday buying and selling pressure. after any of the eight rules signal a trade, you could trade multiple contracts (e.g., You can purchase and download past articles at one for each signal). However, you’d www.activetradermag.com/purchase_articles.htm. have to limit short positions to three to balance the sizeÝ of long and short trades in the market.
6 www.activetradermag.com • May 2006 • ACTIVE TRADER FUTURES& OPTIONS Trading System Lab
EQUITY CURVE Counterpunch stock 3,000,000 index futures system 2,500,000
Markets: Stock index futures. 2,000,000
System logic: This is basically the same countertrend 1,500,000 system tested on the Dow Jones stocks in the equity Account Account balance ($) Trading System Lab. The only difference is the system 1,000,000 trades the futures markets in this test a little more aggressively: There are only three markets (the S&P 500, 500,000 Nasdaq and Dow futures), and the lower margin requirements of futures mean less money is tied up in 0 each position. 1/1/93 1/1/94 1/1/95 1/1/96 1/1/97 1/1/98 1/1/99 1/1/00 1/1/01 1/1/02 As a result, when a trade reaches an initial exit level (see Rules, below) the system will exit only one-third of the posi- determined by the following formula: tion; the remaining two-thirds will be exited upon reaching the sec- ond exit level. (By comparison, the stock system exited trades in CT = AC * PR / 4TR two equal portions.) However, the actual rules for where and when where to enter and exit are the same. AC = Available capital Two-thirds of the position is left open because the trailing stop PR = Percent risked generates profits that are a tad better and more reliable than the 4TR = Four times the true range for the day preceding the entry simple stop-loss exit. Had the stop-loss exit turned out to be the more reliable of the two, the relationships would have been Test period: January 1993 to July 2002. reversed. This is simply a way to make the most of the statistical traits of the system while limiting losses and locking in profits. Test data: Daily prices for the S&P 500, Nasdaq 100 and Dow (This approach was not used for the stock system because the same Jones Industrial Average futures contracts. $25 deducted for slip- relationship wasn’t as clear. Also, the original position is smaller for page and commission per contract traded. stocks, which makes trading in smaller and uneven-sized incre- ments, i.e., thirds or quarters, etc., less feasible.) Starting equity: $1 million (nominal).
Rules: Test results: The system did not fare as well on futures as it did 1. Go long tomorrow on the open if a) today’s close is below both on individual stocks. However, there are a few reasons for this yesterday’s close and the close of the previous week, b) yesterday’s that, when examined, make the results more understandable. (For close is below the previous day’s close and c) the close of the previous SAMPLE TRADES week is below the close of the week 10,400.00 before that. Dow Jones Industrial (DJ), daily L-trail 2. Exit one-third of the position with L-trail 10,200.00 a loss if the trade goes against you by L-trail L-trail L-trail 10,000.00 1 percent. Go long 3. Exit one-third of the position with Go long 9,800.00 a profit if the trade goes your way by L-trail 9,600.00 Go long Go long 4 percent. Go long 4. Exit two-thirds of the position L-trail 9,400.00 with a profit or loss if the trade Go long 9,200.00 moves 1.6 percent away from your Go short maximum open profit (i.e., use a trail- Go long Go short 9,000.00 ing stop 1.6 percent away from the 8,800.00 high of the trade). L-trail 8,600.00 5. Exit two-thirds of the position S-trail with a profit if the trade goes your 8,400.00 way by 4.5 percent. L-trail 6. Exit the entire position after eight S-target 8,200.00 days in the trade. 8,000.00
Reverse the rules for short trades. 7,800.00 Go long 7,600.00 Money management: Risk 6 percent Go long 20 27 June 10 17 24 July 8 15 22 29 August of available equity per market. The Source: Omega Research ProSuite number of contracts to trade (CT) is
7 www.activetradermag.com • November 2002 • ACTIVE TRADER DRAWDOWN CURVE aggressively, which also would have created smoother 1/1/93 1/1/94 1/1/95 1/1/96 1/1/97 1/1/98 1/1/99 1/1/00 1/1/01 1/1/02 equity growth. 0% Speaking of drawdown, note that both the maxi- mum drawdown and flat time for the test period are -5% not related to the current bear market. Instead, they are both a function of the limited trading opportunities in -10% the first part of the test period. Currently, the system is in a 20-percent drawdown, and although that is signif- -15% icant, and much more than most traders can tolerate, it -20% is a far cry from the 80-plus percent decline in equity for a buy-and-hold strategy in the Nasdaq 100 index. -25% Another way to improve the results could be to trade it on other futures markets as well, such as the -30% currencies, energies and interest rates. Because of the system’s short-term nature, it is not suitable for agri- -35% cultural commodities, which usually need longer trends to produce profits large enoughÝ to justify trad- one thing, the amazing results from the stock test make compar- ing (for non-professional traders). isons a little unfair.) The equity chart reveals the results for the futures markets real- ROLLING TIME WINDOW RETURN ANALYSIS ly didn’t start to take off until late 1997 — almost halfway through the testing period. The big reason for this is that up until late 1996, Cumulative 12 24 36 48 60 the S&P 500 was the only tradable market. Trading in the other two months months months months months contracts didn’t begin until late 1996 (Dow) and late 1997 Most recent: -8.30% 20.77% 26.18% 75.15% 89.69% (Nasdaq). If you look at only the second half of the test period, the Average: 9.10% 19.44% 31.22% 43.14% 55.41% estimated average annual return would probably be almost twice Best: 52.95% 86.74% 101.76% 135.61% 147.21% the 7.87 percent the complete system produced. Worst: -15.56% -22.47% -25.96% -17.60% -6.38% Adding other (foreign) stock indices to the mix probably would St. dev.: 15.03% 26.07% 37.05% 44.71% 46.18% have enhanced results even more by adding a bit of diversification, which would have kept the drawdowns lower. Trading more mar- Annualized 12 24 36 48 60 kets would also have allowed us to trade each market a little less months months months months months Most recent: -8.30% 9.90% 8.06% 15.04% 13.66% STRATEGY SUMMARY Average: 9.10% 9.29% 9.48% 9.38% 9.22% Best: 52.95% 36.36% 26.36% 23.89% 19.84% Profitability Trade statistics Worst: -15.56% -11.95% -9.53% -4.72% -1.31% End. equity ($): 2,067,431 No. trades: 1,258 St. dev: 15.03% 12.28% 11.08% 9.68% 7.89% Total return (%): 107 Avg. trade ($): 849 Avg. annual ret. (%): 7.87 Avg. DIT: 3.4 LEGEND: Cumulative returns — Most recent: most recent return from start to Profit factor: 1.17 Avg. win/loss ($): 15,166 (7,894) end of the respective periods • Average: the average of all cumulative returns Avg. tied cap (%): 3 Lrg. win/loss ($): 105,730 (57,373) from start to end of the respective periods • Best: the best of all cumulative returns from start to end of the respective periods • Worst: the worst of all cumulative Win. months (%): 48 Win. trades (%): 36.3 returns from start to end of the respective periods • St. dev: the standard devia- Drawdown TIM (%): 70 28.1 tion of all cumulative returns from start to end of the respective periods Max. DD (%): 30.4 Tr./Mark./Year: 21.9 Annualized returns — The ending equity as a result of the cumulative returns, raised by 1/n, where n is the respective period in number of years Longest flat (m): 44.6 Tr./Month: 10.9 Send Active Trader your systems LEGEND: End. equity ($) — equity at the end of test period • Total return If you have a trading system or idea you’d like tested, send it to (%) — total percentage return over test period • Avg. annual ret. (%) — us at the Trading System Lab. We’ll test it on a portfolio of average continuously compounded annual return • Profit factor — gross stocks or futures (for now, maximum 60 markets, using the last profit/gross loss • Avg. tied cap (%) — average percent of total available cap- 2,500 trading days), using true portfolio analysis/optimization. ital tied up in open positions • Win. months (%) — percentage profitable Most system-testing software only allows you to test one mar- months over test period • Max. DD (%) — maximum drop in equity • ket at a time. Our system-testing technique lets all markets Longest flat — longest period, in months, spent between two equity highs • share the same account and is based on the interaction within No. trades — number of trades • Avg. trade ($) — amount won or lost by the average trade • Avg. DIT — average days in trade • Avg. win/loss ($) the portfolio as a whole. — average winning and losing trade, respectively • Lrg. win/loss ($) — Start by e-mailing system logic (in TradeStation’s largest winning and losing trade, respectively • Win. trades (%) — percent EasyLanguage or in an Excel spreadsheet) and a short description winning trades • TIM (%) — amount of time there is at least one open posi- to [email protected] , and we’ll get back to you. Note: Each system must have a clearly defined stop-loss level tion for entire portfolio, and each market, respectively • Tr./Mark./Year — to risk trades per market per year • Tr./Month — trades per month for all markets and a suggested optimal amount per trade.
Disclaimer: The Trading System Lab is intended for educational purposes only to provide a perspective on different market concepts. It is not meant to recommend or promote any trading system or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Past performance does not guarantee future results; historical testing may not reflect a system’s behavior in real-time trading.
ACTIVE TRADER • November 2002 • www.activetradermag.com 8 TRADING Strategies
Extreme OPEN-CLOSE days Bars that close near their highs or lows can sometimes trick traders into thinking follow-through price action is likely. The following analysis incorporates the opening price and a few simple risk-control and exit rules to capture follow-through moves when they are most likely.
BY XAVIER MARIA RAJ
raders are always looking for clues regarding when of the day’s trading range (the high or low) and closes near the a price move is likely to follow through vs. stop in other extreme of the day’s range. We’ll refer to these as strong- its tracks. Short-term traders especially watch price closing and weak-closing bars. We’ll test these patterns to see behavior during a given trading system to deter- what kind of price action typically follows them, and if they mine whether to hold existing positions overnight or get out before the close. T FIGURE 2 STRONG CLOSE DAYS The relationships FIGURE 1 EXTREME BANDS between open and A strong-close day (SCD) opens in the lower band (the The upper band is the top 10 percent close prices is often bottom 10 percent of a price bar) and closes in the of the bar and the lower band is the used to gauge the upper band (the top 10 percent of the bar). bottom 10 percent of the bar. An momentum during a open or close that occurs in either of given trading peri- Russell 2000 index (RUT.X), daily these bands can be considered to be od. For example, a 550.00 in an extreme of the bar’s range. bar that opens and closes at roughly the same price in the 545.00 Upper band — top 10% of bar middle of a trading bar reflects balanced trading during that 540.00 period. A bar that follows several bars with higher highs 535.00 and lows and opens at a low price, trades much higher, and Strong close days 530.00 Lower band — bottom 10% of then closes back near bar the open, might imply the upside 525.00 momentum has evaporated and a downturn could be 520.00 imminent. The patterns we will analyze here 16 23 occur when price Source: TradeStation Source: TradeStation opens near one end
9 www.activetradermag.com • April 2005 • ACTIVE TRADER Strategy code
The following EasyLanguage code can be downloaded from the Active Trader Strategy Code page at www.activetradermag.com/code.htm . Code for other software platforms is also available. can be used as the basis for a trading strategy. Initial system test:
Defining strong and weak bars VAR:X(0),Y(0),R(0); R=RANGE; The first step is to define what consti- tutes strong- and weak-closing bars. To IF C>H-((R/10)) AND O
Russell 2000 index (RUT.X), daily Exit 500.00
Exit Exit 495.00
490.00
485.00 Buy Buy 480.00 Buy 475.00 Exit Exit Exit Short 470.00
Weak-close day 465.00 Short Buy 460.00 Buy Exit Buy 455.00
450.00 Exit July 7 14 21 21 28 Aug. 4 11 18 25 Source: TradeStation Source: TradeStation
ACTIVE TRADER • April 2005 • www.activetradermag.com 10 TABLE 1 INITIAL TEST: RUSSELL 2000 For such a simple set of trading rules, the test results were surprisingly good. Each market produced an average of six trades per month. Trade rules Performance summary: All trades Now we can design some simple rules based on this pattern to test our hypoth- Total net profit $361,845.97 esis: Gross profit $641,972.50 Gross loss ($280,126.53)
Total # of trades 637 Percent profitable 70.49 1. Go long the day after an SCD with Number winning trades 449 Number losing trades 188 a buy-stop order one tick above the high of the SCD. Largest winning trade $10,275.00 Largest losing trade ($12,200.00) 2. Go short the day after a WCD Average winning trade $1,429.78 Average losing trade ($1,490.03) with a sell-stop order one tick Ratio avg. win/avg. loss .96 Avg. trade (win & loss) $568.05 below the low of the WCD. 3. Exit all trades on the close. Max. consec. winners 13 Max. consec. losers 5 Avg. # bars in winners 0 Avg. # bars in losers 0 The logic is simple: An extremely Max. intraday drawdown ($21,050.02) strong or weak close implies further Profit factor 2.29 Max. # contracts held 500 movement in that direction the follow- Account size required $21,050.02 Return on account (%) 1,718.98 ing day, and a move beyond the range of the SCD or WCD confirms the up or Source: TradeStation down momentum. Figure 4 (p. 10) shows the signals gen- erated based on the strategy for the TABLE 2 INITIAL TEST: S&P 400 Russell 2000 index (RUT.X). Notice this period is dominated by rising prices, The S&P 400 produced fewer trades than the Russell 2000 (482 vs. 637). It and there were more SCDs than WCDs. had a lower (but still quite good) profit factor of 1.94 and a winning percent- For the most part, there was follow- age of 64 percent. through in the expected direction after both types of bars. Performance summary: All trades Total net profit $220,275.00 Initial test Gross profit $454,375.00 Gross loss ($234,100.00) These basic rules were tested on the Russell 2000 and S&P 400 Midcap Total # of trades 482 Percent profitable 64.11 (MID.X) indices over 10 years of daily Number winning trades 309 Number losing trades 173 data, from Jan. 1, 1994 to Aug. 29, 2003. The results for the Russell 2000 are Largest winning trade $9,150.00 Largest losing trade ($10,375.00) shown in Table 1 and the S&P 400 results Average winning trade $1,470.47 Average losing trade ($1,353.18) are in Table 2. Ratio avg. win/avg. loss 1.09 Avg. trade (win & loss) $457.00 The strategy yielded profit factors Max. consec. winners 11 Max. consec. losers 5 (gross profits divided by gross losses) of Avg. # bars in winners 0 Avg. # bars in losers 0 2.29 and 1.94 for the respective indices. The total number of trades generated Max. intraday drawdown ($24,525.00) were 637 for the Russell and 482 for the Profit factor 1.94 Max. # contracts held 1 S&P 400, or approximately six and five Account size required $24,525.02 Return on account (%) 898.17 trades per month, respectively. The win- ning percentage was around 70 percent Source: TradeStation for the Russell 2000 and 64 percent for the S&P 400 Midcap, respectively. Weak-close day (WCD) = Open > (High - Range/10) and These performance figures are quite respectable for such a Close < (Low + Range/10) simple, easy-to-execute strategy — especially considering that the parameters were unoptimized. Now let’s see if this basic Strong-close days suggest demand was high from the begin- performance can be enhanced with additional risk-control and ning of the trading session and continued to be robust until the profit-taking rules. closing bell; weak-close days indicate selling pressure was dominant from the start of the day until the close. Augmenting the approach Let’s hypothesize that because demand or supply was solid We conducted a second test using simple stop-loss and price through the end of the day, there will be some follow-through target rules. The stop-loss will be the midpoint of the SCD or movement the day after an SCD or WCD. WCD, and the profit target will be 10 index points above the
11 www.activetradermag.com • April 2005 • ACTIVE TRADER high of an SCD or below the low of a WCD: This trading approach could be applied without any help from a computer, and it lends itself to further modification and Stop-loss for long trade = Midpoint minus one tick experimentation. Stop-loss for short trade = Midpoint plus one tick Testing across a wide range of markets and experimenting Long target = High plus 10 points with different upper and lower bands, stop-lossÝ levels and Short target = Low minus 10 points profit targets are excellent departure points.
As was the case with the basic trading rules, these values are representative and have not been optimized. The definitions TABLE 3 ENHANCED SYSTEM TEST: RUSSELL 2000 and logic for the complete strategy are: The winning percentage declined for the Russell 2000 (as it did for the S&P 400), but the profit factor increased. D1 = Current day (the SCD or WCD) D2 = Next day Performance summary: All trades H1 = High of current day L1 = Low of current day Total net profit $446,884.48 M1 = Midpoint, or median price, of Gross profit $662,127.50 Gross loss ($215,243.02) current day Total # of trades 637 Percent profitable 68.45 1. Long Entry: On an SCD (D1) place Number winning trades 436 Number losing trades 201 a buy-stop order for the next Largest winning trade $4,975.50 Largest losing trade ($5,587.50) day (D2) at the high (H1) plus one Average winning trade $1,518.64 Average losing trade ($1,070.86) tick. Ratio avg. win/avg. loss 1.42 Avg. trade (win & loss) $701.55 2. Short Entry: On a WCD (D1) place a sell-stop order for the next Max. consec. winners 13 Max. consec. losers 5 day (D2) at the low (L1) minus one Avg. # bars in winners 0 Avg. # bars in losers 0 tick. 3. Long Exit: Place a stop-loss order Max. intraday drawdown ($14,725.52) at the median price (M1) minus Profit factor 3.08 Max. # contracts held 500 one tick. Account size required $14,725.52 Return on account (%) 3,034.76 4. Short Exit: Place a stop-loss order Source: TradeStation at the median price (M1) plus one tick. 5. Long Target: Place a limit sell TABLE 4 ENHANCED SYSTEM TEST: S&P 400 order at the high (H1) plus 10 points. Despite the lower winning percentage for both indices, the strategy was 6. Short Target: Place a limit buy more efficient: It produced more profit with lower drawdown. order at the low (L1) minus 10 points. Performance summary: All trades Total net profit $245,312.50 The performance for the two indices Gross profit $448,075.00 Gross loss ($202,762.50) after incorporating these stop-loss and target rules are shown in Tables 3 and 4. Total # of trades 482 Percent profitable 61.83 Notice that although the winning per- Number winning trades 298 Number losing trades 184 centages for each index declined (but both remained about 60 percent), their Largest winning trade $4,975.00 Largest losing trade ($8,875.00) respective profit factors increased to 3.08 Average winning trade $1,503.61 Average losing trade ($1,101.97) and 2.21, indicating the strategy became Ratio avg. win/avg. loss 1.36 Avg. trade (win & loss) $508.95 more efficient. Also notice the maximum Max. consec. winners 11 Max. consec. losers 5 drawdowns decreased in both cases. The Avg. # bars in winners 0 Avg. # bars in losers 0 number of trades remained the same. Max. intraday drawdown ($13,725.00) Simplicity and room Profit factor 2.21 Max. # contracts held 1 for experimentation Account size required $13,725.00 Return on account (%) 1,787.34 As is often the case, a simple trading idea produced some favorable results. Source: TradeStation
12 www.activetradermag.com • April 2005 • ACTIVE TRADER TRADING Strategies The Fibonacci SWING FILTER One way to filter market noise and focus on tradable price moves is to gauge price swings in terms of retracement percentages. This approach creates an adaptive trading system that adjusts to the market’s behavior.
BY G. VETRIVEL
rices move every second of every day, which term price fluctuations are removed from the data; the shorter means many, if not most, market fluctuations rep- the lookback period (e.g., 10 bars), the shorter the trend the resent random “noise” rather than meaningful average reflects. price moves. No matter how short the time frame Similar logic applies to defining Fibonacci price swings. A a trader operates on, some price action is simply irrelevant. breakout above or below the range of a Fibonacci-defined price PThe challenge is finding a way to filter out noise and identi- swing — for example, a 38.2-percent retracement of a previous fy tradable price moves in your chosen time horizon. There are move — can be considered the end of an existing trend or the many ways to accomplish this. Some traders require an initial beginning of a new trend, the magnitude of that trend being trade setup to be validated by a secondary rule, or filter, before dependent on the size of the price swings. This logic allows us acting upon the signal. Other traders approach the problem at to objectively determine market tops and bottoms. the source and attempt to smooth price data itself, so they This technique does not attach any particular significance to apply trading approaches to data that has already had its a single Fibonacci ratio and it does not have a fixed lookback “noise” removed. period, as does a moving average. The ratios (which can change The method outlined here presents a way to smooth data for each bar) are determined by the current market conditions, using Fibonacci-based price moves. This process consists of which makes the Fibonacci-swing approach an adaptive defining a price-swing structure that filters out shorter-term smoothing technique. Also, this approach avoids the problem price fluctuations so you react only when a trend of significant of lag that affects all moving averages (the longer the average, magnitude changes direction. the longer it takes to respond to changes in price direction). This Fibonacci-swing technique will be illustrated using a simple stop-and- reverse (SAR) strategy, which means FIGURE 1 DEFINING A TOP AND GOING SHORT when a long position is exited a new Bar 1 is the new high and a short trade is triggered when the current bar short position is simultaneously estab- (Bar 0) falls below the 50-percent level of Bar 2. lished, and vice versa. The strategy will then be tested on eight years of daily Russell 2000 E-mini (ER), daily price data in four stock indices. 1 2 595 0 Defining price swings with 38.2% Fibonacci ratios 590 The most common tool for smoothing 50% price data is the moving average, which 585 traders use to define trends and issue trade signals. For example, if price moves above a moving average, the 580 trend is considered up, while the oppo- site is true when price falls below the 575 moving average. The degree to which the data is smoothed and the length of the trend 570 depends on how long the moving aver- Bottom age is: The longer the lookback period 9 23 March 8 15 22 29 (e.g., 100 bars), the longer the trend the Source: TradeStation average represents and the more short-
13 www.activetradermag.com • February 2005 • ACTIVE TRADER FIGURE 2 DEFINING A BOTTOM AND GOING LONG Bar 1 is the new low and a long trade occurs when Bar 0 rises above the 38.2- percent retracement level of Bar 2 (measured from the bottom of Bar 2).
520 Calculating Fibonacci price swings Russell 2000 E-mini (ER), daily A Top The rules for calculating Fibonacci 515 swings for determining tops and bot- toms use the following definitions: 510 • Current bar = Bar 0; previous bar = Bar 1, etc. 505 • Fibonacci ratios used: 23.6 percent, 500 38.2 percent, 50 percent, 61.8 percent, 38.2% 78.6 percent and 87.5 percent. 23.6% 495 • Pairs of consecutive retracement 2 percentages are always used to define 1 0 490 price swings — i.e., 23.6 percent and 38.2 percent, 38.2 percent and 50 percent, etc. Bottom 485 Pairing 23.6 percent and 50 percent would be incorrect, for example. 19 May 6 13 20 27 June 10 17 Defining a top/beginning of a down swing: If Bar 1 retraces between 38.2 and Source: TradeStation 50 percent of Bar 2’s range (measured downward from Bar 2’s high), and the TABLE 1 S&P 500 TEST RESULTS low of Bar 0 is below the 50-percent level The tests produced an average of nearly 700 trades per market over eight (the midpoint) of Bar 2’s range, then the years of daily data, which lends credibility to the results. highest high between the previous bot- tom and Bar 0 (including Bar 0) is a top. Performance summary: All trades Other retracement ratios are applied Total net profit $662,375 Open position P/L $775 in a similar fashion. For example, if Bar 1 Gross profit $1,668,640 Gross loss $1,006,265 retraces between 50 and 61.8 percent of Total number of trades 771 Percent profitable 44.36% Bar 2, and the low of Bar 0 is below the Number of winning trades 342 Number of losing trades 429 61.8-percent level of Bar 2’s range (meas- ured downward from Bar 2’s high), then Largest winning trade $34,225 Largest losing trade $8,550.00 the highest high between the previous Average winning trade $4,879.06 Average losing trade $2,345.60 bottom and Bar 0 is a top. The same Ratio avg. win/avg. loss 2.08 Average trade (win and loss) $859.11 approach would be used for 23.6 percent Max. consecutive winners 6 Max. consecutive losers 8 and 38.2 percent, and so on. Avg. number of bars in winners 4 Avg. number of bars in losers 1 Figure 1 shows how a top is defined Max intraday drawdown $39,665 using this technique. The low of Bar 1 Profit factor 1.66 Max. number of contracts held 1 retraces between 38.2 and 50 percent of Account size required $39,665 Bar 2’s range, and Bar 0’s low is below the level of a 50-percent retracement of Source: TradeStation Bar 2. The top is the highest high between the previous bottom and Bar 0 (including Bar 0), Entry and exit rules which means Bar 1’s high is the top. The following rules are for the Fibonacci-swing trading system These rules are reversed to define lows. we will test on different stock indices: Defining a bottom/beginning of an up swing: If Bar 1 1. Enter long/exit short if Bar 0’s high is above the 38.2-per- retraces between 38.2 and 50 percent of Bar 2’s range (meas- cent level but below the 50-percent level of Bar 1’s range. Place ured upward from Bar 2’s low), and the high of Bar 0 is above a buy-stop order to exit the existing short position and enter the 50-percent level of Bar 2’s range, then the lowest low long at the 50-percent level of Bar 1’s range. between the previous top and Bar 0 is a bottom. Repeat these calculations for the different percentage pairs Similarly, if Bar 1 retraces between 50 and 61.8 percent of Bar to determine the range that captures the current retracement. 2, and the high of Bar 0 is above the 61.8-percent level of Bar 2’s 2. Enter short/exit long if Bar 0’s low is below the 61.8-per- range (measured upward from Bar 2’s low), then the lowest cent level but above the 50-percent level of Bar 1’s range. Place low between the previous top and Bar 0 is a bottom. a sell-stop order to exit the existing long position and enter Figure 2 (p. 14) shows the identification of a bottom using short at the 50-percent level of Bar 1’s range. 23.6 and 38.2 Fibonacci percentages: The high of Bar 1 retraced Repeat these calculations for the different percentage pairs between 23.6 percent and 38.2 percent of Bar 2 and the high of to determine the range that captures the current retracement. Bar 0 retraced more than 38.2 percent of Bar 2. The bottom is 3. Special outside bar condition: If there is an outside bar (a the lowest low between the previous top (Bar A) and Bar 0. As bar with a high above the previous high and a low below the a result, the low of Bar 1 is the bottom. previous low) or a gap bar (a low above the previous high or a Note: There cannot be two consecutive bottoms or tops. high below the previous low), place the buy-stop order at the high or the sell-stop order at the low.
ACTIVE TRADER • February 2005 • www.activetradermag.com 14 TABLE 2 RUSSELL 2000 TEST RESULTS The Russell 2000 posted the highest profit factor and winning percentage of all the indices. If the stop-orders are not hit the next day, the appropriate percentage pairs are Performance summary: All trades calculated on that day’s bar and new Total net profit $2,664.37 Open position P/L $5.06 orders are placed accordingly. For each Gross profit $3,807.75 Gross loss $1,143.38 bar, the system checks to see which per- Total number of trades 690 Percent profitable 52.03% centage pair applies to the current Number of winning trades 359 Number of losing trades 331 retracement. As a result, the percentages Largest winning trade $84.44 Largest losing trade $16.53 can change from bar to bar — e.g., 38.2- Average winning trade $10.61 Average losing trade $3.45 and 50-percent one day, 50- and 61.8-per- Ratio avg. win/avg. loss 3.07 Average trade (win and loss) $3.8614 cent the next and so on. Max. consecutive winners 11 Max. consecutive losers 6 When the price swing is moving up, Avg. number of bars in winners 4 Avg. number of bars in losers 1 ratios are calculated from the high to determine the long exits and short Max intraday drawdown $42.64 entries. Similarly, ratios are calculated Profit factor 3.33 Max. number of contracts held 100 from the low to determine the short exits Account size required $42.64 and long entries. Source: TradeStation Trade examples and test results Returning to Figure 1 (p. 13), because the low of Bar 1 retraced spanned eight years of daily price data –– from Jan. 1, 1997 to between 38.2 and 50 percent of Bar 2 (measured from the top of Oct. 25, 2004. Bar 2 down), enter a sell-stop order at the 50-percent level of The performance in these tables indicates the strategy is Bar 2. robust: It has a winning percentage rate of at least 40 percent, In Figure 2 (p. 14), because the high of Bar 1 retraced an average win/loss ratio of 2 and profit factor (gross prof- between 23.6 percent and 38.2 percent of Bar 2 (measured from it/gross loss) of 1.55 in all indices, except the Russell 2000, the bottom of Bar 2 up), enter a buy-stop order at the 38.2-per- which had exceptionally good performance and a profit factor cent level of Bar 2. of 3.33. Slippage and commission charges were not included. Because this is a stop-and-reverse strategy, the reverse The strategy produced more than 700 trades on average in orders act as trailing stops for the current positions. each index — more than 2,800 trades total. The high number of Tables 1, 2 , 3 and 4 show the results of tests conducted on trades adds credibility to test results — confidence in future the S&P 500 (SPX), Russell 2000 (RUTX), NIFTY (Indian NSE results is directly related to the number of samples in testing. Index), and Dow Jones Industrial Average (INDU). The test By comparison, positive results for a long-term trend-following
System code
The following TradeStation EasyLanguage code for the Fibonacci stop-and-reverse system can be copied at www.activetradermag.com/code.htm.
if l>=h[1] then Sell Short Next Bar at l-.05 stop;
if l
if h<=l[1] then Buy Next Bar at h+.05 stop;
if h>l[1] and h<=l[1]+(h[1]-l[1])*.236 then Buy Next Bar at l[1]+(h[1]-l[1])*.236+.05 stop; if h>l[1]+(h[1]-l[1])*.236 and h<=l[1]+(h[1]-l[1])*.382 then Buy Next Bar at l[1]+(h[1]-l[1])*.382+.05 stop; if h>l[1]+(h[1]-l[1])*.382 and h<=l[1]+(h[1]-l[1])*.5 then Buy Next Bar at l[1]+(h[1]-l[1])*.5+.05 stop; if h>l[1]+(h[1]-l[1])*.5 and h<=l[1]+(h[1]-l[1])*.618 then Buy Next Bar at l[1]+(h[1]-l[1])*.68+.05 stop; if h>l[1]+(h[1]-l[1])*.618 and h<=l[1]+(h[1]-l[1])*.786 then Buy Next Bar at l[1]+(h[1]-l[1])*.786+.05 stop; if h>l[1]+(h[1]-l[1])*.786 and h<=l[1]+(h[1]-l[1])*.875 then Buy Next Bar at l[1]+(h[1]-l[1])*.875+.05 stop; if h>l[1]+(h[1]-l[1])*.875 and h
15 www.activetradermag.com • February 2005 • ACTIVE TRADER TABLE 3 NIFTY INDEX TEST RESULTS One downside is that maximum consecutive losers outnumbered maximum consecutive winners in three of the four tests.
Performance summary: All trades strategy that produces only 50 trades over eight years of data will not be near- Total net profit $3,887.18 Open position P/L $28.55 ly as reliable as the statistics shown here. Gross profit $10,590.52 Gross loss $6,703.35 Total number of trades 729 Percent profitable 43.48% Smooth sailing Number of winning trades 317 Number of losing trades 412 This technique is not the only way to Largest winning trade $195.60 Largest losing trade $88.05 smooth data, but all smoothing or filter- Average winning trade $33.41 Average losing trade $16.27 ing methods share the same goal — to Ratio avg. win/avg. loss 2.05 Average trade (win and loss) $5.33 isolate the tradable moves in a marketÝ on Max. consecutive winners 6 Max. consecutive losers 12 the time frame you wish to trade. Avg. number of bars in winners 4 Avg. number of bars in losers 1 Max intraday drawdown $744.78 Profit factor 1.58 Max. number of contracts held 1,000 Account size required $744.78 Additional reading Source: TradeStation The following articles have more information about Fibonacci num- TABLE 4 DOW JONES INDUSTRIAL AVERAGE TEST RESULTS bers: The average winning trade/losing trade ratio was 2.00 for all four tests. “Technical Tool Insight: Performance summary: All trades Fibonacci ratios” Total net profit $17,416.55 Open position P/L $132.67 (Active Trader , April 2002, p. 78). Gross profit $52,101.54 Gross loss $34,684.98 This is a more detailed primer on the Total number of trades 767 Percent profitable 43.02% properties of Fibonacci numbers. Number of winning trades 330 Number of losing trades 437 Largest winning trade $1,423.27 Largest losing trade $337.60 “Absolute price projections” Average winning trade $157.88 Average losing trade $79.37 by Tom DeMark and Rocke DeMark Ratio avg. win/avg. loss 1.99 Average trade (win and loss) $22.71 (Active Trader , July 2004, p. 38). Max. consecutive winners 6 Max. consecutive losers 10 This article explores the authors’ Avg. number of bars in winners 4 Avg. number of bars in losers 1 unique application of Fibonacci Max intraday drawdown $1,253.21 ratios to determine potential price Profit factor 1.50 Max. number of contracts held 100 targets. Account size required $1,253.21 Return on account 1,389.76%
Source: TradeStation
The Fibonacci series
he Fibonacci series is a number progression in which For example, if a stock broke out of a trading range and each successive number is the sum of the two immedi- rallied from 25 to 55, potential retracement levels could be ately preceding it: 1, 2, 3, 5, 8, 13, 21, 34 and so on. calculated by multiplying the distance of the move (30 TAs the series progresses, the ratio of a number in the points) by Fibonacci ratios — say, .382, .50 and .618 — and series divided by the immediately preceding number then subtracting the results from the high of the price move. approaches 1.618, a number that is attributed significance In this case, retracement levels of 43.60 [55 - (30*.38)], 40 by many traders because of its appearance in natural phe- [55 - (30*.50)] and 36.40 [55 - (30*.62)] would result. nomena (the progression of a shell’s spiral, for example, as Similarly, after a trading range breakout and an up move well as in art and architecture, including the dimensions of of 10 points, a Fibonacci follower might project the size of the Parthenon and the Great Pyramid). The inverse, .618 the next leg up in terms of a Fibonacci ratio — e.g., 1.382 (.62), has a similar significance. times the first move, or 13.82 points in this case. Some traders use fairly complex variations of Fibonacci num- The most commonly used ratios are .382, .50, .618, .786, ber to generate price forecasts, but a basic approach is to use 1.00, 1.382 and 1.618. Depending on circumstances other ratios derived from the series to calculate likely price targets. ratios, such as .236 and 2.618, occasionally are used.
16 www.activetradermag.com • February 2005 • ACTIVE TRADER FUTURES& OPTIONS Trading Strategies
Trading the OPENING GAP Watching pre-market volume is a good way to determine whether to trade or fade the opening move.
BY JOHN CARTER and commodities do not act the same as markets to trade the opening gap those in “multi-item” instruments such because of the diversity of their compo- as stock indices because a news item will nent stocks. Both indices represent collec- control the entire market instead of just a tions of stocks from different industries portion of it. Earnings announcements, that are more likely to react independent- pening price gaps — the corporate scandals and other company- ly to news events. In the technology- distance between the reg- specific events can create gaps in a com- heavy Nasdaq, opening price gaps can ular-session opening price ponent stock’s chart that never get filled. take longer to fill because the majority of and the previous day’s Because of the unpredictable nature of the stocks will react similarly to news. closing price — are stomach-churning various events that can impact the price The key to trading opening gaps is Oevents when the market makes a big of an individual stock, they make poor being able to predict the likelihood a move against you, but they represent candidates for the opening-gap trade. particular gap will be filled. Dissecting low-risk trade opportunities if you know In contrast, stock index futures such as the market conditions that produce a which gaps are likely to be followed by the E-mini S&P (ES) or the mini-sized gap is as important as analyzing a gap predictable patterns. Dow (YM) are better candidates for itself. For example, an opening gap fol- In terms of the price behavior that fol- opening-gap plays because they consist lowing high pre-market cash trading lows opening gaps, not all markets are of multiple components that respond dif- volume can take weeks to get filled created equal. Gaps in individual stocks ferently to news. For example, although a because high volume increases the odds stock index futures contract may gap up the market will continue to move in the on a news item, there will be individual direction of the gap. TABLE 1 FILLING THE OPENING stocks within the index that will either Some of the biggest gaps are caused GAP: RAW DATA ignore the news or sell off. This weighs by major news events, such as the out- Between Jan. 15, 2002, through the index down and creates a trade break of a war, but gaps caused by minor February 2004 (528 occurrences), opportunity as the market fills the gap. news items are much more common. an average of 76 percent of all Generally, such gaps are smaller, fill opening gaps closed at some point The best markets for gap plays quickly (see Table 1) and can be “faded” during the same day. This is the The S&P 500 and the Dow are the best (the act of trading against the direction breakdown by day of week. Adding the pre-market volume filter TABLE 2 TRADE MANAGEMENT GUIDELINES increased the percentages. The higher the volume, the greater the likelihood the market will continue in the direction of the opening gap. As a result, no trade is taken when vol- Percentage of ume is above 70,000. Day gaps filled Pre-market volume Monday 65% in key stocks Position size Trade target Tuesday 77% Less than 30,000 Full size Exit entire position at gap fill Wednesday 79% Between 2/3 size Exit half at 50 percent of gap Thursday 82% 30,000 and 70,000 fill, half at gap fill Friday 78% Above 70,000 No “fade” trade No “fade” trade Source: Tradethemarkets.com Source: Tradethemarkets.com
17 www.activetradermag.com • December 2004 • ACTIVE TRADER of the gap) more effectively. Let’s look at of a positive earnings report from Intel the specific criteria for identifying those The strategy (INTC). On this day, pre-market volume gaps with the best chances of reversing. Figure 1 is a five-minute chart of the was below 30,000. mini Dow futures. You can use any time As a result, the appropriate trade is to The pre-market volume indicator interval — a one-minute, five-minute or immediately short the gap on the open The most important indicator for deter- 15-minute chart, etc. — as long as you using a full position size, as indicated in mining which opening gaps can be can view the opening. This means the Table 2. To keep things simple, we’ll use faded is the pre-market volume in a spe- chart must be set up to reflect the open- nine contracts as a full position, which cific set of stocks. ing and closing of the regular trading makes a two-thirds position six contracts Check the pre-market volume at 9:20 session, 9:30 a.m. to 4 p.m. ET (4:15 p.m. and a one-third position three contracts. a.m. ET (10 minutes before the regular for stock index futures prices). Many We will use a $100,000 account, which cash session opens) in the following traders are used to watching a separate means we are trading one contract for stocks: KLA-Tencor Corporation (KLAC), chart of the continuous 24-hour futures each $11,100 in the account for a full posi- Maxim Integrated Products, Inc. (MXIM), session, but of course, opening gaps tion. Although you can trade a mini Dow Novellus Systems, Inc. (NVLS) and Applied Materials, Inc. (AMAT). These FIGURE 1 THE OPENING GAP representative stocks were selected through a trial-and-error process. This 47-point-plus opening gap in the mini Dow futures was filled in the first If the market is really set up to move, hour of trading for a $235 per-contract profit. there will be significant volume in the cash market in pre-market trading. If the 9,830 Mini Dow futures (YM), five minute market is setting up for a “head fake” (a move in one direction that is quickly 9,820 Gap is filled for a 47-point reversed), pre-market volume will be 9,810 low, which reflects a lack of conviction in gain, or $235 per contract the move. This is the preferred setting (47 points x $5 per point). 9,800 for an opening-gap trade. If the pre-market stocks have each 9,790 traded less than 30,000 shares at this time, analysis of the prior 500 trading 9,780 days shows the opening gap, up or 9,770 down, had an 80-percent chance of fill- ing the same day. However, if the vol- 9,760 ume for each stock is between 30,000 and 70,000, the gap only has about a 60-per- 9,750 cent chance of filling that day, while the midpoint of the gap has an 85-percent 9,740 chance of being hit. 9,730 Finally, if the pre-market volume for each stock is above 70,000, the chances of 9,720 the gap filling that day drop to 30 per- cent. In these cases, you should ignore 9,710 the news and follow the direction of the gap. Table 2 provides guidelines for 10/15/03 9,700 using volume information to manage 11:00 12:00 13:00 14:00 15:00 9:00 10:00 trades. As the volume increases, the Source: eSignal position size shrinks and the profit-tak- ing becomes more conservative. If one stock has volume above 70,000 won’t show up. or E-mini S&P contract with only a few but the others are below the threshold, Figure 1 shows the first day in a set of thousand dollars, this trading plan con- check to see if the news pertains to this back-to-back earnings announcements trols risk by limiting exposure relative to company alone. If it does, ignore it. If the that caused opposite reactions in the the amount of available capital. news is not specific to the company, market. On the morning of Oct. 15, 2003, Use a 1:1.5 reward/risk ratio (risking trade the more conservative position. the Dow gapped up 47 points as a result 1.5 points to make 1 point) for gap trades
ACTIVE TRADER • December 2004 • www.activetradermag.com 18 FUTURES& OPTIONS Trading Strategies continued
FIGURE 2 THE DAY AFTER that are less than 40 mini Dow points or One day after the trade setup shown in Figure 1, the mini Dow contract . 4 E-mini S&P points For gaps larger opened lower, setting up a long trade. than these, use a 1:1 reward/risk ratio. In 9,800 the case of Figure 1, we would risk 47 Mini Dow futures (YM), five minute points to make 47 points. If the gap had 9,790 been 30 points, we would risk 45 points. Some traders might question an Gap filled for a 61-point approach that risks more than the poten- gain, or $305 per contract. 9,780 tial profit. Most beginning traders are taught to use a 3:1 reward/risk ratio, 9,770 risking 1 point to gain 3. They inevitably wonder why they are repeatedly 9,760 stopped out just before the market turns. In general, wider stops produce more winning trades; the key is to trade 9,750 only those setups with a better than 80- percent chance of winning. 9,740 The market sold off immediately after the bell, filling the opening gap within 9,730 an hour. Ironically, the next day IBM came out with a disappointing earnings report, knocking the market down on 9,720 . the open Figure 2 shows the resulting buy setup had just a small open loss at 9,710 one point, although many traders might have been stopped out on the pullback 10/16/03 9,700 around 11 a.m. ET. However, keep in mind the strategy is to maintain a 15:00 9:00 10:00 11:00 12:00 13:00 14:00 reward/risk ratio of 1:1, not to tighten Source: eSignal your stop when the market moves in your favor. If the stop had been hit, FIGURE 3 EMOTIONS TRIGGER GAP the loss would have been approxi- mately $305 per contract ($2,745 for The E-mini S&P futures made a downside opening gap on Aug. 2, 2004, on terrorist the nine-contract full position), not threats. The market spent most of the day filling the gap. including slippage and commis- E-mini S&P 500 continuous contract (ES), five minute sions. This loss is reasonable because 1,106 of the 80-percent success rate of the setup. 1,105 Close on 7/30/04: Using a tighter initial stop or trail- 1,103.75 ing stop would have turned this 1,104 position into a losing trade or, at 1,103 best, a breakeven trade. Using the risk parameters designed for this 1,102 trade setup allowed the position to remain open until the gap was filled 1,101 for a gain of 61 points. As a rule, using a trailing stop will negatively 1,100 affect the gap trade’s win/loss ratio. When the trade is executed, the 1,099 best thing a trader can do is to walk away and let the orders do their 1,098 work. This is the difference between professionals and amateurs: Pro- 1,097 fessionals won’t second-guess a trad- Open on 8/2/04: ing methodology, while amateurs are 1,097.00 1,096 constantly adjusting. 14:45 15:05 15:25 15:45 8/2 10:00 10:20 10:40 11:00 11:20 11:40 12:00 12:20 12:40 13:00 13:20 13:40 Ignore the reasons for the gap Source: TradeStation The size or cause of a gap has little
19 www.activetradermag.com • December 2004 • ACTIVE TRADER FIGURE 4 MULTIPLE GAPS impact on whether or not it will be filled. Figure 3 shows an example The first opening gap on this chart — which remained unfilled for the next six days — of emotions triggering an opening set up a short trade that was stopped out for a loss. Subsequent opening gap trades price gap when, on Aug. 2, the were more successful. market gapped down on the open Mini Dow September futures (YMU04), 15 minute 9,500 because the U.S. government 9,480 issued a terror warning the previ- Gap of +62 points ous day. There were rumors of a Gap of -52 points fills in 6 bars plan to blow up a large financial fills in 9 bars 9,460 institution. Short break of bear However, after a choppy first Gap of +13 points 9,440 flag. Target is gap half of the day, the market firmed, fills in 1 bar from 8/18 9,420 shorts got nervous and started cov- ering, and the gap was filled by 9,400 1:30 p.m. ET for a 6.75-point S&P E- mini profit ($337.50 per contract). 9,380
Relax and trade 9,360 Figure 4 shows a 15-minute chart Gap of +44 points fills in 9 bars of the September mini Dow futures 9,340 (YMU04) with an opening gap on Aug. 18 that did not get filled for 9,320 six trading days. (Other opening gaps occurred before price eventu- 9,300 ally filled the first gap.) On this Gap on 8/18 of +44 points fills on 8/25 9,280 day, the mini Dow gapped up a modest 44 points prior to the release of some economic numbers. 8/18 13:15 8/19 11:45 14:15 8/20 12:45 8/21 13:45 8/22 12:15 8/25 13:15 8/26 The pre-market volume was mod- Source: TradeStation est, between 30,000 and 70,000 shares for the key stocks, so the “cautious upside earnings revisions.” the rest of the day trending lower, filling appropriate step was to short a two- The market exploded to the upside and the gap and resulting in an 88-point gain, thirds-size position on the open. gapped right above key resistance. The or $440 per contract ($3,960). The market rallied, sold off a little just trade was to short the 62-point gap with prior to the economic numbers, and then a full-size position. Six bars later, the tar- A brief window of opportunity shot higher once the numbers were get was hit for a 62-point profit, or $310 The market’s nature is to prevent as released. Using the 1:1 reward/risk ratio per contract ($2,790). many people as possible from consis- resulted in a 44-point stop. The market During the afternoon session, the mar- tently making money, which is why it is never retraced to the gap’s midpoint ket traced out a bear flag pattern. With crucial for a trader to follow rules for level (where half the position could be the opening gap under the market still each type of trade setup. covered), and instead rallied right unfilled, the trade was to place a sell stop Gaps are the one moment of the trad- through the stop, producing a loss of at 9,392 to let the trend of the market ini- ing day where everyone has to show $220 per contract. For a two-thirds posi- tiate the trade based on a breakdown of their poker hand, and this creates a big tion (six contracts) the loss was $1,320. the flag. The entry stop was filled and the advantage for short-term traders. This move left an open gap below the risk point for the trade was above intra- Understanding the dynamics behind market. The next day the market opened day resistance at 9,455 . The target was the opening gaps is paramount to trading modestly lower, triggering a long trade Aug. 18 gap at 9,304. The market spent them successfully. Ý that resulted in a quick $65-per-contract profit ($585 total). The following day the Active Trader market opened 52 points lower and Related articles filled the gap a few hours later for a “Trading the overnight gap” by David Nassar, March 2001, p. 66 $260-per-contract profit ($2,340). The “Morning reversal strategy” by Bryan C. Babcook and Arthur Agnelli, next day, the market gapped up 44 May 2003, p. 36 points, triggering a short trade that came close to the stop-loss point, but eventual- “Technical Tool Insight: Gaps,” April 2003, p. 82 ly filled the gap for a $255-per-contract “Technical Tool Insight: Islands,” August 2002, p. 82 profit ($2,295). All these gaps followed light pre-market volume, so they were You can purchase past articles online at www.activetradermag.com/ executed with full positions. purchase_articles.htm and download them to your computer. On Aug. 22, 2003, Intel announced
ACTIVE TRADER • December 2004 • www.activetradermag.com 20 MARKET History
HITTING THE STREET: The S&P 500 futures’ intraday reactions to economic reports Highly anticipated economic news can send the market on a wild ride. This study looks at intraday patterns in the S&P E-mini surrounding FOMC announcements and the monthly job, CPI, GDP, and ISM reports.
FIGURE 1 ANNOUNCEMENT-DAY PRICE MOVES The S&P 500 index tends to climb in reaction to monthly ISM releases and FOMC inter- est-rate announcements, but it sank as the employment, GDP, and CPI reports hit the Street.
Average S&P 500 announcement-day performance (open to close), 2000 to 2005 0.50 BY DAVID BUKEY 0.40 0.30 0.20 rading off econom- 0.10 ic reports can be 0.00 frustrating because -0.10 the market’s reac- Average gain/loss Average (%) -0.20 tion to a bullish or bearish releaseT is often unpredictable or -0.30 short-lived. Initial rallies or sell- -0.40 offs can be quickly reversed because detailed economic releases take time to interpret. To pinpoint how the market Daily Daily benchmark ISM ISM increases (27) CPI CPI increases (49) ISM ISM decreases (32) GDP increases (31) GDP decreases (24)
tends to anticipate and respond announcements (41) Negative Negative reports (11) Unchanged Unchanged rates (22) Fed Fed rate changes (19) Overall scheduled Fed Overall ISM (61 reports) to major economic releases, we Overall CPI (61 reports) Overall GDP (61 reports) Flat Flat or dropping CPI (12) focused on the announcement days of five economic reports — Overall employment (61 reports) Fed interest-rate decisions, employment Positive reports (11) employment, Consumer Price Index (CPI), Gross Domestic Product (GDP), and the Institute of E-mini trades nearly 24 hours a day, announcement day for all five reports. Supply Management’s (ISM) manufac- allowing us to measure the market’s ini- Comparing the S&P’s pre-announce- turing index. tial reaction to the employment, CPI, ment price moves to its reaction to these The analysis measured the S&P 500 and GDP reports, which are released an reports revealed several compelling pat- index’s performance on these days over hour before the equities markets open. terns. However, before we dig into intra- the past five years and also tracked the (For brief descriptions of each report, see day tendencies, here’s a look at how the intraday price moves of the S&P 500 E- “Economic number summary.”) market behaved on the five announce- mini futures contract (ES) as these The study shows the S&P’s overall ment days. announcements hit the Street. The S&P daily and intraday behavior on
21 www.activetradermag.com • May 2005 • ACTIVE TRADER Economic number summary The five following sections provide short explanations of each economic report and its release schedule. For more information about each release, or visit the Web sites listed at the end of each section. The Fed and interest rates The Federal Open Market Committee (FOMC) holds eight scheduled meetings a year to decide whether to change its Fed Funds rate, which is the interest rate that member banks charge one another for overnight loans. The Fed typically Report day: cuts this target rate to stimulate economic growth and raises it to keep a lid on January 2000 to February 2005 inflation. After each meeting, the committee issues a statement around 1:15 To find out how the S&P 500 index p.m. CT that explains its decision and economic outlook — an event that began behaved when the five economic reports in 1994. were released, we studied its daily price (www.federalreserve.gov/fomc) moves from Jan. 3, 2000 to Feb. 4, 2005. Overall, we measured 285 distinct days: Jobs Monthly employment, CPI, GDP, and The Bureau of Labor Statistics (BLS) releases its employment report at 7:30 ISM announcements (61 reports each) a.m. CT the first Friday of each month. The report includes non-farm payrolls and 41 scheduled Fed interest-rate state- and the unemployment rate from the previous month. The bureau compiles ments. non-farm payrolls from its Current Establishment Survey (CES), which is a sam- Figure 1 shows the S&P’s average ple of nearly 400,000 individual businesses and government agencies repre- announcement-day performance for senting one-third of all non-farm payroll jobs. each report, according to various out- The unemployment rate comes from the bureau’s Current Population Survey comes, increases vs. decreases, etc., and (CPS), which polls roughly 60,000 households and measures the unemployed compares it to the daily benchmark, or (i.e., currently searching for work and available to work) as a percentage of typical daily market move since 2000. the civilian labor force (employed and unemployed). The S&P rallied in response to ISM (www.bls.gov/ces and www.bls.gov/cps) and Fed interest-rate announcements (0.29- and 0.16-percent average gains, Consumer Price Index (CPI) respectively), while it posted a small The CPI summarizes retail prices of goods and services and is released by the 0.03-percent average loss on employ- BLS in the middle of each month at 7:30 a.m. CT. The index includes items such ment-report days. In contrast, the S&P as clothes, furniture, and electronics, but it also tracks a variety of services sold off as the U.S. government released such as health care, education, and transportation. GDP and CPI statements (0.16- and 0.24- The bureau compiles its CPI-W and CPU-U (i.e., wage earners’ and urban) percent losses). indices from roughly 23,000 stores and 87 areas throughout the U.S. The gov- The index also climbed more than ernment uses the CPI-W to adjust social security payments, but traders track twice as much in response to dropping the urban index because it represents 87 percent of all consumers. ISM values than it did after increasing (www.bls.gov/cpi/home.htm) ones (0.48 vs. 0.23 percent) and tended to prefer Fed interest-rate changes — hikes Gross Domestic Product (GDP) or cuts — over unchanged rates (0.25 vs. The GDP measures the value of all the goods and services produced and sold in 0.08 percent). While the S&P fell an aver- the U.S. and divides it into four categories: consumption, investment, net age 0.33 percent on news of positive exports, and government expenditures. The Commerce Department’s Bureau of employment reports and edged 0.08 per- Economic Analysis (BEA) issues an initial, or advance, GDP estimate for the cent higher following a negative jobs prior quarter at 7:30 a.m. CT on a Thursday or Friday in the third or fourth picture, these tendencies are less reliable week of each quarter. because they only represent 11 The bureau releases two additional revisions (preliminary and final) in the announcement days each of 61 reports second and third months of each quarter, which include more-detailed eco- analyzed. nomic data. One of the three types of GDP reports hits the Street each month. Although the S&P fell slightly further (www.bea.gov/bea/dn/home/gdp.htm) in response to declining GDP estimates than increasing ones, differences in GDP Institute for Supply Management (ISM) survey and CPI reports had less of an effect than The institute’s monthly survey of more than 400 purchasing managers in 20 variations in ISM and FOMC announce- industries determines whether 10 aspects of manufacturing activity (new ments did. orders, production, employment, supplier deliveries, inventories, consumers’ inventories, commodity prices, order backlogs, new export orders, and Intraday patterns: scheduled imports) are rising, falling, or staying the same from the prior month. FOMC meetings The resulting Purchasing Managers Index (PMI) is a weighted summary of the To find out how the market fared sur- first five sections. PMI values greater than 50 suggest the manufacturing sector rounding report release times, we ana- (and the overall economy) is growing, while readings of less than 50 suggest lyzed the S&P 500 E-mini futures at 15- they are in decline. minute intervals from 7 a.m. to 3:15 p.m. (www.ism.ws)
ACTIVE TRADER • May 2005 • www.activetradermag.com 22 FIGURE 2 A DAY IN THE LIFE OF THE FED The S&P E-mini's gains tended to occur in the morning from the open of the stock market (8:30 a.m.) to lunchtime (12:30 p.m.). The futures contract fell as the Fed released its statement at 1:15 p.m., but then briefly reversed before falling lower in the trading day's final hour.
Average S&P E-mini behavior CT on announcement All 41 scheduled meetings on FOMC announcement days, days during Figure 1’s (p. 2000 to 2005 Rate changes (19) 21) five-year period. The remaining five fig- 0.20 Unchanged rates (22) ures show the S&P 0.15 futures’ average gains and losses in 15-, 30-, 60-, 0.10 75-, and 90-minute inter- vals before and after the 0.05 five economic reports hit the Street. Each time- 0.00 interval’s benchmark, or -0.05 typical price move, was
Average gain/loss Average (%) flat. -0.10 Figure 2 compares the S&P 500 E-mini’s average -0.15 performance before and 7:00 to 8:30 to 9:30 to 10:30 to 11:30 12:30 12:45 to 1:00 to A 1:15 1:30 to 1:45 to 2:00 to after all FOMC’s 41 8:30 9:30 10:30 11:30 to 12:30 to 12:45 1:00 1:15 to 1:30 1:45 2:00 3:15 scheduled statements, a.m. a.m. a.m. a.m. p.m. p.m. p.m. p.m. p.m. p.m. p.m. p.m. which the Fed released at 1:15 p.m. CT announcement time (A) 1:15 p.m., to its behavior around rate changes and unchanged rates. Over- all, the S&P futures lan- FIGURE 3 EMPLOYMENT REPORT guished from 7 to the 8:30 a.m. market open, but Overall, the S&P E-mini rose in anticipation of the jobs report before slumping while the then surged an average equities markets were open. Brief initial up or down moves in response to positive or nega- 0.12 percent in the fol- tive news tended to reverse before noon. lowing hour. The market continued to rally throughout the Average S&P E-mini behavior All 61 reports morning and more than on employment report days, Positive reports (11) doubled its first-hour 2000 to 2005 gain by 12:30 p.m. Negative reports (11) 0.20 However, the E-mini 0.15 traded sideways over the 0.10 next 30 minutes in antici- pation of the announce- 0.05 ment before sinking an 0.00 average 0.07 percent in -0.05 the 15 minutes leading -0.10 up to it. The contract respond- -0.15 ed to the FOMC’s deci- Average gain/loss Average (%) -0.20 sion regarding its Fed tar- -0.25 get rate with a pattern we -0.30 first found in our January 7:00 to 7:15 to A 7:30 to 7:45 to 8:00 to 8:30 to 9:00 to 10:00 11:00 12:00 to 1:00 to 2:00 to 2004 study of the Fed: It 7:15 7:30 7:45 8:00 8:30 9:00 10:00 to 11:00 to 12:00 1:00 2:00 3:15 tumbled 0.09 percent a.m. a.m. a.m. a.m. a.m. a.m. a.m. a.m. noon p.m. p.m. p.m. from 1:15 to 1:30 p.m., 7:30 a.m. CT release time (A) retraced those losses over the following 30 minutes, then resumed its initial
23 www.activetradermag.com • May 2005 • ACTIVE TRADER Average and median
he mean (or average) of a set of values is the sum of the values divid- downturn and dropped 0.13 percent ed by the number of values in the set. If a set consists of 10 numbers, between 2 and 3:15 p.m. add them and divide by 10 to get the mean. A comparison of each time interval’s TA statistical weakness of the mean is that it can be distorted by exception- average performance with its median ally large or small values. For example, the mean of 1, 2, 3, 4, 5, 6, 7, and 200 value (not shown) indicates that is 28.5 (228/8). Take away 200, and the mean of the remaining seven numbers extremely large individual moves exag- is 4, which is much more representative of the numbers in this set than 28.5. gerated these patterns slightly (especial- The median can help gauge how representative a mean really is. The medi- ly the E-mini’s pre-announcement rally), an of a data set is its middle value (when the set has an odd number of ele- yet both values are roughly in line with ments) or the mean of the middle two elements (when the set has an even each other, which confirms Figure 2’s number of elements). The median is less susceptible than the mean to distor- overall accuracy. (For an explanation of tion from extreme, non-representative values. The median of 1, 2, 3, 4, 5, 6, these two statistics, see “Average and 7, and 200 is 4.5 ((4+5)/2), which is much more in line with the majority of median.”) numbers in the set. Although the S&P E-mini moved in the same direction regardless of whether or not the Fed changed interest rates during eight of the 12 time intervals after the news emerged than when the Employment reports shown in Figure 2, the market was less committee announced interest-rate Figure 3 is similar to Figure 2 and com- volatile around rate changes than changes (0.27 vs. 0.12 percent from 7 pares the S&P E-mini’s average price unchanged rates. For example, S&P a.m. to 1:15 p.m., and 0.21 vs. 0.03 per- moves around 61 monthly employment futures gained more ground prior to cent from 1:15 to 3:15 p.m., respectively). reports since January 2000 to its per- unchanged rates and slipped further formance surrounding positive and neg- ative jobs announce- ments. On all announce- FIGURE 4 CPI RELEASES ment days, the S&P Overall, the futures market sank in reaction to CPI reports, except for a 30-minute rally futures climbed 0.05 per- from 9 to 10 a.m. Its biggest average drop occurred in the final 75 minutes of the day. cent from 7 to the 7:30 a.m. release time before relinquishing those gains Average S&P E-mini behavior All 61 reports in the first 15 minutes fol- on CPI announcement days, lowing the announce- 2000 to 2005 CPI increases (49) ment. The market continued 0.20 Flat or CPI declines (12) to slide throughout the 0.15 day despite trading side- ways from the 8:30 mar- 0.10 ket open to 9 a.m. and then edging higher 0.05 between 10 and 11 a.m. 0.00 Overall, the S&P E-mini fell during nine of the fig- -0.05 ure’s 10 post-announce- Average gain/loss Average (%) ment time intervals — a -0.10 0.16-percent average loss. Each time interval’s medi- -0.15 an value was in line with 7:00 to 7:15 to A 7:30 to 7:45 to 8:00 to 8:30 to 9:00 to 10:00 11:00 12:00 to 1:00 to 2:00 to 7:15 7:30 7:45 8:00 8:30 9:00 10:00 to 11:00 to 12:00 1:00 2:00 3:15 its average, which implies a.m. a.m. a.m. a.m. a.m. a.m. a.m. a.m. noon p.m. p.m. p.m. that Figure 3’s price moves are fairly reliable. 7:30 a.m. CT release time (A) While the E-mini’s behavior around strictly positive or negative jobs
ACTIVE TRADER • May 2005 • www.activetradermag.com 24 reports isn’t as helpful because of the small between how the S&P futures performed a.m.) seems fairly reliable. sample size (11 instances each), it demon- on jobs and CPI report days. The con- strates the market’s volatility on tract edged 0.03 percent higher in the GDP estimates announcement days. half hour prior to all CPI announce- Figure 5 shows the S&P E-mini’s aver- For example, the S&P futures climbed ments before it sold off 0.09 percent in age performance around all 61 GDP esti- prior to negative jobs data, but then the following 90 minutes. After a 60- mates (advance, preliminary, and final) plunged as the bearish news hit the minute rally from 9 to 10 a.m., the S&P announcements since Jan. 28, 2000, com- pared to its behavior sur- rounding GDP increases FIGURE 5 MONTHLY GDP REPORTS and decreases. Overall, the S&P futures The S&P E-mini gained ground as a GDP release approached, but then sold off as traders rose 0.05 percent, on aver- heard the latest estimate and continued to drop regardless of what it was. age, in the 30 minutes before the GDP’s 7:30 a.m. Average S&P E-mini behavior release, and then gave up All 61 GDP reports on GDP announcement days, those gains as traders 2000 to 2005 GDP increases (31) digested the data before (advanced, preliminary, and final estimates) the stock market opened — 0.10 GDP decreases (24) a distinct pattern that also appears around jobs and 0.05 CPI releases. Although the market didn’t sell off right at the 0.00 8:30 a.m. open, the E-mini sank throughout the -0.05 morning before reversing around lunchtime, and then resumed its plunge Average gain/loss Average (%) -0.10 from 1 to 3:15 p.m. — a 0.16-percent average loss. -0.15 While the E-mini’s medi- 7:00 to 7:15 to A 7:30 to 7:45 to 8:00 to 8:30 to 9:00 to 10:00 11:00 12:00 to 1:00 to 2:00 to an values are less bearish 7:15 7:30 7:45 8:00 8:30 9:00 10:00 to 11:00 to 12:00 1:00 2:00 3:15 than its averages from 9 a.m. a.m. a.m. a.m. a.m. a.m. a.m. a.m. noon p.m. p.m. p.m. a.m. to noon, both statis- 7:30 a.m. CT release time (A) tics move in line with each other in the late afternoon, which implies the selloff during the day’s final two periods is accurate. Street. When the stock market opened at fell again in the next hour before trading The market tended to gain more 8:30 a.m., however, the contract surged sideways from 11 a.m. to 2 p.m. The ground prior to news of GDP increases over the following two-and-a-half hours. day’s largest move (up or down) than declining ones and slid less In contrast, the E-mini followed the occurred as the E-mini sold off 0.10 per- between their 7:30 a.m. announcement opposite pattern around positive jobs cent in the final 75 minutes of the day. and the opening of the stock market an reports. Figure 4 is slightly misleading, how- hour later. At 8:30 a.m., the S&P futures ever, because each period’s median val- behaved as expected, climbing an aver- CPI releases ues (not shown) are flat. Although this age 0.07 percent in response to increas- Figure 4 (p. 24) shows the S&P E-mini’s discrepancy between average and medi- ing GDP estimates and falling 0.06 per- average gains and losses surrounding 61 an values also affects the S&P futures’ cent on bearish GDP news. However, the CPI reports over the past five years. Each behavior around CPI increases and flat E-mini’s brief rally in reaction to bullish time period also compares the market’s or dropping figures, its tendency to GDP reports didn’t last long. behavior around CPI increases to its per- trade higher before news of a rising CPI formance around flat or declining CPI and slip in the first 15 minutes after its ISM manufacturing index values. release (7:30 to 7:45 a.m.) as well as its Figure 6 shows the S&P futures’ average There are only minor differences slight drop an hour later (8:30 to 8:45 gains and losses before and after 61 ISM
25 www.activetradermag.com • May 2005 • ACTIVE TRADER reports from Jan. 3, 2000 to Feb. 1, 2005. Related reading The figure also tracks the contract’s per- formance surrounding news of rising These articles analyze how the S&P 500 behaves surrounding economic and declining ISM values. releases. The market remained flat from 7 to its 9 a.m. release when it dropped an aver- “The Fed effect,” Active Trader, January 2004, p. 20. age 0.06 percent in the following 15 min- utes. However, the E-mini regained its “Trading the monthly jobs report,” Active Trader, June 2004, p. 26. footing around 9:30 a.m. and then climbed 0.17 percent until noon. The “Gross Domestic Product (GDP) and the stock market,” Active Trader, S&P futures went nowhere in the early November 2004, p. 76. afternoon, but surged 0.14 percent in the final hour and 15 minutes of the day. (A “How the Consumer Price Index (CPI) affects the S&P 500,” Active Trader, comparison of average and median val- February 2005, p. 26. ues showed these intraday patterns are reliable.) You can purchase and download past Active Trader articles at: While the market edged 0.04 percent www.activetradermag.com/purchase_articles.htm higher as bullish ISM values hit the Street and sank 0.12 percent in reaction to ISM declines (as expected), the S&P rallied an average 0.53 percent in the six A comparison of the E-mini’s average usual after bearish ISM news. However, hours after ISM decreases. In contrast, and median values suggests that a few this discrepancy doesn’t change the fact the S&P futures gained just 0.03 percent, extremely large price moves skewed the that S&P figures had a more bullish on average, following ISM increases. market’s typical moves higher than response to dropping ISM reports than rising ones. FIGURE 6 ISM RELEASES Overall patterns The S&P futures market slumped surrounding the ISM release, but then regained ground 30 The S&P E-mini climbed minutes later and climbed until noon. The E-mini caught a second wind at 2 p.m. and rallied in anticipation of sched- toward the close. These upswings were larger following ISM declines. uled Fed statements, then adhered to a dis- tinct three-step pattern: Average S&P E-mini behavior All 61 reports selloff, reversal, and a 0.25 on ISM announcement days, close in the same direc- ISM increases (27) 0.20 2000 to 2005 tion as the original drop. 0.15 ISM decreases (32) The market also edged higher before 7:30 a.m. 0.10 monthly employment, 0.05 CPI, and GDP an- nouncements, then sank 0.00 as those statements were -0.05 released. Average gain/loss Average (%) -0.10 Finally, the S&P futures’ slump in the -0.15 first 15 minutes after an ISM report is misleading since the market tends to rally later in the day. Ý
7:00 to 8:30 to 8:45 to A 9:00 to 9:15 to 9:30 to 10:00 to 11:00 12:00 to 1:00 to 2:00 to 8:30 8:45 9:00 9:15 9:30 10:00 11:00 to 12:00 1:00 2:00 3:15 a.m. a.m. a.m. a.m. a.m. a.m. a.m. noon p.m. p.m. p.m. 9:00 a.m. CT release time (A)
ACTIVE TRADER • May 2005 • www.activetradermag.com 26 FUTURES Trading Strategies SECTOR VS. INDEX: The single stock futures-Dow spread Trading single stock futures against a stock index contract requires careful preparation, but it allows you to take advantage of areas of the market that are outperforming (or underperforming) the market.
Next, multiply the four stock prices by BY KEITH SCHAP In each of these situations, you can 100 shares to find the prices of single benefit from a spread in which you ini- contracts of each and sum these SSF con- tially sell mini-sized Dow futures and tract values. On May 2, the four futures buy the SSF contracts representing the contract dollar values were $2,355 for four computer companies. INTC1C, $7,651 for IBM1C, $2,523 for ingle stock futures (SSFs) MSFT1C, and $2,097 for HPQ1C. The open up interesting possibili- Structuring the spread trade sum of these is $14,626, shown in the ties for spread traders. The Structuring this kind of spread requires “Sum of single stock futures prices” col- OneChicago exchange offers special care. Because both the mini-sized umn. a large family of single stock futures con- Dow futures and the sector futures can To find the number of single stock Stracts, and you can structure interesting rally, you must size the sector position in futures contracts it will take to balance spreads between a stock index futures such a way that the stock index leg of the the dollar value of four mini-sized Dow contract, such as CBOT mini-sized Dow spread cannot overwhelm it. To do this, contracts, divide $205,700 (from the futures (YM), and SSF contracts repre- you make the sum of the dollar values of “Position dollar value” column) by senting a particular market sector within the four single stock futures legs approx- $14,626 to discover that you will need to that index. imately equal to the dollar value of the use 14.06 contracts of each of the four mini-sized Dow leg. single stock futures contracts. Because When one sector promises to Table 1 illustrates a good way to you cannot trade fractions of futures outperform the market accomplish this dollar value balance in a contracts, you must round to the nearest At times, your market research may alert spread between the June 2005 mini-sized whole number of contracts — in this you to the possibility that one market Dow futures (YMU05) and the four com- example, 14.06 becomes 14. sector may outperform the broad mar- puter-related SSFs that were in the mar- Finally, multiply the rounded num- ket. For example, the Dow Jones ket on May 2, 2005. (Note: OneChicago bers by $14,626 to find the dollar value Industrial Average (DJIA) contains four SSF ticker symbols consist of the stock of a position consisting of that number of computer-related stocks — Hewlett- symbol plus “1C” — e.g., INTC1C, contracts of each of the single stock Packard Co. (HPC), IBM Corp. (IBM), IBM1C, MSFT1C, and HPQ1C. Also, the futures (e.g., the $102,382 value of seven Intel Corp. (INTEC), and Microsoft SSF price is the stock price times 100.) contracts of each of the four computer Corp. (MSFT). You might believe: On that day, the YMU05 price was single stock futures comes close to 10,285, INTC was 23.55, IBM was 76.51, matching the $102,850 value of two stock • in a rallying market, this sector MSFT was 25.23, and HPQ was 20.97. index contracts). might rally more than the market The first column shows a possible The “Dollar value difference” column as a whole; number of mini-sized Dow contracts. subtracts the dollar value of the aggregate The second column shows the closing single stock futures position from the dol- • in a falling market, this sector price for the day in question. The lar value of the specified number of stock might rally; or, “Position dollar value” column multi- index futures. On May 2, 2005, the even- plies the futures quote by the contract’s numbered stock index contract positions • in a falling market, this sector $5 multiplier and by the number of con- offered the best matches. might fall less than the market tracts (e.g., 10,285 * $5 * 3 contracts = Obviously, when you sell mini-sized as a whole. $154,275). Dow futures, you are selling a certain
27 www.activetradermag.com • November 2005 • ACTIVE TRADER TABLE 1 TO FIND THE NUMBER OF SHARES OF THE FOUR COMPUTER STOCKS To use this strategy effectively, you need to size the SSF positions so the stock index leg of the spread doesn’t overwhelm it. To accomplish this, you make the sum of the dollar values of the four single stock futures legs approximately equal to the dollar value of the index leg. amount of exposure to these 5/2/2005 four computer stocks. For Number of CBOT Position Sum of Number of Position Dollar example, as of early May mini-sized Futures dollar single stock single stock dollar value 2005, Microsoft accounted for Dow contracts price value futures prices contracts value difference 1.9562 percent of the index 1 10,285 51,425 14,626 3.52 58,504 -7,079 total. Given the $51,425 cash equivalent value of the stock 2 10,285 102,850 14,626 7.03 102,382 468 index futures contract, this 3 10,285 154,275 14,626 10.55 160,886 -6,611 amounted to $1,005.98, which, 4 10,285 205,700 14,626 14.06 204,764 936 at $25.23 per share, is equiva- 5 10,285 257,125 14,626 17.58 263,268 -6,143 lent to approximately 40 shares of MSFT. The four con- 6 10,285 308,550 14,626 21.10 307,146 1,407 tracts of MSFT1C are equiva- 7 10,285 359,975 14,626 24.61 365,650 -5,675 lent to 400 shares, so you can 8 10,285 411,400 14,626 28.13 409,528 1,872 see that the short index 9 10,285 462,825 14,626 31.64 468,032 -5,207 futures leg of this spread neu- tralizes only a fraction of the 10 10,285 514,250 14,626 35.16 511,910 2,340 Microsoft part of the single stock futures side of the trade. In short, the fact that the FIGURE 1 INDEX VS. SECTOR: MAY 2 TO JULY 15 YMU05 leg contains some During two brief periods, the Dow futures outperformed the four computer SSFs, but exposure to these stocks is not a more frequently, the stocks outperformed the stock index. The spread between the problem. two widened considerably from June 24 to July 15. A snapshot of the opportunities The computer sector against the index Figure 1 shows the results of an 57,000 exercise similar to that present- YMU05 ed in Table 1. It covers the peri- 56,000 Computer od from May 2, 2005 to July 15, stocks 2005. The YMU05 line repre- 55,000 sents the daily index futures price multiplied by $5. The val- 54,000 ues for the line labeled “Computer stocks” are the sums of the four computer 53,000 stock prices multiplied by 352
(the sum of the share prices Balanced dollar values 52,000 multiplied first by 100, then by 3.52). The 3.52 May 2 spread 51,000 factor is constant for the period encompassed in the figure. 50,000 Notice that during two brief periods (May 2 to May 12 and
May 26 to June 8) the stock 5/2/05 5/9/05 6/6/05 7/4/05 index appears to have outper- 5/16/05 5/23/05 5/30/05 6/13/05 6/20/05 6/27/05 7/11/05 formed the four computer stocks. More numerous and obvious are the periods when the com- sector is only one possibility. Any of the anticipation of it widening, which will puter group outperformed the stock several stock groups contained in the happen whenever the computer group index. Consider especially the three- Dow 30 are likely to provide similar outperforms the total index. You want to week stretch from June 24 to July 15, trading opportunities for spreads of this sell the spread whenever you anticipate during which the spread between the kind. that an underperforming computer sec- two widened considerably. tor will narrow it. You buy or sell the The main thing to notice here is that Assessing possible results spread in terms of what you do with the trading opportunities abound, on either The logic of this spread is straightfor- sector leg. To buy the spread, you buy the side of the spread. Further, the computer ward: You want to buy the spread in appropriate number of SSF contracts for
ACTIVE TRADER • November 2005 • www.activetradermag.com 28 FUTURES Trading Strategies continued
TABLE 2 WHEN BOTH PARTS OF THE SPREAD RALLY shown in the “Single stock net” row. This illustrates how the long SSF-index spread might perform, assuming your That, less the $1,540 stock index market outlook in early May 2005 called for the computer sector to outperform futures loss, leaves a “Spread net” of the index. Given this outlook, suppose you had decided to buy this spread on $2,056. In this case, the stock market May 12 with the idea of unwinding it a week later. At May 12 prices, the spread as a whole rallied, but the computer ratio was 3.58, so you would have bought four contracts each of the computer sector rallied more. SSF futures for every one contract you sold of the Dow leg. Of course, these trades don’t Notice the Dow rallied 308 points during this week. “1 Contract” multiplies always perform according to our this result by $5 to show that one contract would have lost $1,540 on this price plans. Suppose on May 26 you move because it was sold initially. “Position” repeats this value because this is a believed these computer stocks were one-lot. likely to continue to outperform the Action Dow Action INTC1C IBM1C MSFT1C HPQ1C rest of the market and had again 5/12/05 Sell 1 10,218 Buy 4 24.84 72.62 25.00 20.15 bought the spread. At May 26 prices, the spread ratio would have been 5/19/05 Buy 1 10,526 Sell 4 26.01 77.16 25.92 22.51 3.45, so you would have bought three Result -308 1.17 4.54 0.92 2.36 contracts of each of the single stock 1 Contract -1,540 117.00 454.00 92.00 236.00 futures for each contract of mini-sized Position -1,540 468.00 1,816.00 368.00 944.00 Dow futures you sold (see Table 3). In this situation, the Dow lost 52 Single stock net 3,596.00 index points, which results in a $260 Spread net 2,056.00 gain for the short futures leg of the spread. Unfortunately, the long SSFs all lost — $1,344 total — so the spread TABLE 3 BEST LAID PLANS… lost $1,084 ($1,344 - $260). This example is a reminder that Trades don’t always go as planned. In this scenario, the short Dow leg posted spread trades contain speculative a $260 gain. Unfortunately, the long SSFs all lost — $1,344 total — so the risk. When your prediction concern- spread lost $1,084 overall. The most important factor here was not the ing spread widening or narrowing is falling market, though, but the fact that the spread narrowed because the not realized, these trades can lose. computer stocks fell more than the index. Keep in mind the crucial factor here is not the falling market. Rather, what Action Dow Action INTC1C IBM1C MSFT1C HPQ1C overturned this trade was the fact that 5/26/05 Sell 1 10,570 Buy 3 27.37 77.14 25.90 23.80 the spread narrowed because the 6/8/05 Buy 1 10,518 Sell 3 27.10 74.80 25.40 22.43 computer stocks fell more than the index. Result 52 -0.27 -2.34 -0.50 -1.37 As Figure 1 (p. 28) shows, in late 1 Contract 260 -27.00 -234.00 -50.00 -137.00 June all prices fell, but the spread Position 260 -81.00 -702.00 -150.00 -411.00 widened because the Dow fell more Single stock net -1,344.00 than the computer stocks. In such a case the profit would have come from Spread net -1,084.00 the short Dow leg of the spread but, again, the widening of the spread — not the direction of the prices — every one mini-sized Dow contract you trade based on a one-lot Dow leg. would have been the crucial factor. sell. To sell this spread, you sell the SSF Notice the Dow rallied 308 points dur- contracts and buy the index future. ing this week. “1 Contract” multiplies Focus on comfort, not slippage To illustrate how this spread might this result by $5 to show that one con- At the outset of the widening sequence perform, assume your market outlook in tract would have lost $1,540 on this price that began on June 24, mini-sized Dow early May 2005 called for the computer move because it was sold initially. futures were trading at 10,325, Intel at sector to outperform the index. Given “Position” repeats this value because $26.10, IBM at $74.01, Microsoft at $25.04, this outlook, suppose you had decided this is a one-lot. and Hewlett-Packard at $23.80. Based on to buy this spread on May 12 with the The four computer stocks all gained at these prices, the spread ratios would idea of unwinding it a week later. At least a small amount. “1 Contract” mul- have been those of Table 4, which abbre- May 12 prices, the spread ratio was 3.58, tiplies the gains by 100 to take these viates the process detailed in Table 1. so you would have bought four con- amounts up to futures contract size, and A look at the difference values seems tracts of each computer SSF future for “Position” multiplies each of the four to suggest the presence of significant every one contract you sold of the Dow SSFs by the number of contracts (4). The “slippage” in some of these position leg. Table 2 shows the details of this four SSFs would have gained $3,596, as sizes. This is more appearance than fact
29 www.activetradermag.com • November 2005 • ACTIVE TRADER TABLE 4 ROUNDING RATIOS once you get beyond the one-lot Dow At the beginning of the spread-widening sequence that began on June 24, position version. mini-sized Dow futures were trading at 10,325, Intel at $26.10, IBM at One way to check the fit of these $74.01, Microsoft at $25.04, and Hewlett-Packard at $23.80. One way to spread ratios is to contrast the results you check the fit of these spread ratios is to contrast the results you get using get using both the rounded and both the rounded and unrounded versions of the ratios. Although you can’t unrounded versions of the ratios. trade fractional contracts, this is a helpful way to demonstrate how little Granted, you cannot actually trade 3.47 rounding matters in most cases. or 34.66 contracts of single stock futures, Number of CBOT Unrounded Rounded Dollar value but this is a helpful way to demonstrate mini-sized Dow contracts ratios ratios difference how little this rounding matters in most cases. 1 3.47 3 6,940 Table 5 and Table 6 show the details of 2 6.93 7 -1,015 a trade that ran from June 24 to July 15, 3 10.40 10 1,975 2005. Table 5 shows the position results 4 13.86 14 -2,030 in terms of 10-lot index futures positions and 35-lot single stock futures positions. 5 17.33 17 4,910 Table 6 differs only in that it uses 34.66- 6 20.80 21 -3,045 lot single stock futures positions. The 7 24.26 24 3,895 results vary by only $423.64 ($27,060.00 - 8 27.73 28 -4,060 $26,636.36). The worst fit in Table 4 is the one for 9 31.19 31 2,880 the one-lot Dow leg of the spread, while 10 34.66 35 -5,075 the best-fit results from the two-lot Dow leg version. The results for the one-lot Dow leg versions vary by $585.62. The TABLE 5 CHECKING FOR SLIPPAGE — ROUNDED SPREAD RATIO results for the two-lot Dow leg ver- sions vary by $87.22. Actually, the dif- This shows the details of a trade that ran from June 24 to July 15, 2005. ferences for the two-lot and 10-lot Dow These calculations show the trade results in terms of a 10-lot index futures leg versions involve the same percent- position and 35-lot SSF position. age of error — 1.6 percent. This indicates that you can trade Action Dow Action INTC1C IBM1C MSFT1C HPQ1C whatever position size fits your budget 6/24/05 Sell 10 10,325 Buy 35 26.10 74.01 25.04 23.80 and your appetite for risk with reason- 7/15/05 Buy 10 10,656 Sell 35 28.30 82.38 25.79 24.94 able confidence of a satisfactory result. Result -331 2.20 8.37 0.75 1.14 The rounding of the single-stock futures position size does not intro- 1 Contract -1,655 220.00 837.00 75.00 114.00 duce debilitating slippage. Position -16,550 7,700.00 29,295.00 2,625.00 3,990.00 Single stock net 43,610.00 A word of caution Spread net 27,060.00 Satisfactory spread trading results depend crucially on you getting your market call right, of course. Like any spread trade, these stock index-single TABLE 6 CHECKING FOR SLIPPAGE — UNROUNDED SPREAD RATIO stock futures spreads are based on your market analysis and opinion. No These are the same calculations as Table 5, except 34.66-lot SSF positions are one is right every time, as Table 3 illus- used here. The results vary by only $423.64 ($27,060.00 – $26,636.36). trates. Action Dow Action INTC1C IBM1C MSFT1C HPQ1C These spreads involve another kind of risk that you must not overlook. 6/24/05 Sell 10 10,325 Buy 34.66 26.10 74.01 25.04 23.80 Even though the example trades 7/15/05 Buy 10 10,656 Sell 34.66 28.30 82.38 25.79 24.94 shown all involve screen traded con- Result -331 2.20 8.37 0.75 1.14 tracts, which many people think 1 Contract -1,655 220.00 837.00 75.00 114.00 reduce execution risk, these spreads use contracts traded on two Position -16,550 7,625.20 29,010.42 2,599.50 3,951.24 exchanges. This can, at times, cause Single stock net 43,186.36 timing problems. Carefully monitored, Spread net 26,636.36 however, this source of potential exe- cution risk should be manageable. Ý
ACTIVE TRADER • November 2005 • www.activetradermag.com 30 FUTURES& OPTIONS Strategies
TRADING THE BASIS: How stock index arbitrage impacts the market How can understanding stock index arbitrage help you time your trades better and avoid getting trapped in mispriced markets? Hint: It’s the basis that counts.
BY DAVID LERMAN
t first glance, learning about the somewhat arcane to mention a few mil- practice of program trading and “arbitrage” (cap- lion or so in capital — italizing on price discrepancies in related mar- they pounce. They will kets) may seem to be of little practical value for quickly buy as much the typical individual stock index futures trader. gold in New York as ATrue, knowledge of arbitrage activity, by itself, will not make possible and simulta- you a great trader — or even a good trader. However, it can neously sell it in make you a better trader. At the very least, it gives you a better London, pocketing the grasp of how the markets you trade function. Also, professional $2 per ounce price differential. S&P 500 futures and Exchange Traded Fund (ETF) traders pay Hundreds of arbs acting in concert around the world will close attention to arbitrage activity because its potential short- have an almost immediate impact on the market: Gold will term effects can mean the difference between profits and losses. quickly rise in New York and fall just as quickly in London One bit of practical trading information derived from pro- until the price differential disappears, or is so small an arb’s gram trading and arbitrage is the relationship (the “basis”) business costs would outweigh the possible profit. between S&P 500 futures and its underlying cash instrument, Because arbitrage seeks to exploit short-lived price discrep- the S&P 500 index. Here, we will explore the concept of basis ancies, a successful arbitrage trade carries almost no risk — and explain its importance to both stock index traders and pro- other than execution risk. Even though the trader would buy fessional arbitrage traders, or arbitrageurs (“arbs” for short). and sell immediately in both markets, there is a small chance that in the middle of the trade the market would move quick- Arbitrage ly against him or her and result in locking in a lower differen- Arbitrage is the simultaneous purchase and sale of similar or tial, or worse, a loss. It’s part of the business. But over time, a identical instruments (often in different geographical loca- skilled arbitrageur minimizes these events and can look for- tions) to take advantage of short-term price discrepancies. ward to a lucrative business. For example, gold trades in several major financial centers Stock index arbitrage (or index arbitrage) is a variation on around the world — New York, London, Paris, Hong Kong this theme, played out with baskets of stocks traded largely on and Tokyo. If gold were trading in New York for $330 per the New York Stock Exchange in the form of the S&P 500 index ounce and $332 per ounce in London, you could, in effect, buy (most S&P 500 stocks trade on the NYSE, but some are listed on gold in New York and immediately sell an equal amount in the the AMEX and the Nasdaq), and a futures contract that trades London market and profit $2 per ounce. in Chicago based on the index — the S&P 500 futures (SP). Why would the metal be $2 higher in London? Short-term Although arbitrage occurs with many stock indexes, activi- supply and demand fluctuations: Perhaps a European jeweler ty is particularly focused in the S&P 500 cash and futures mar- or metal fabricator placed a large order in the London market. kets because they are exceptionally deep and liquid. (ETFs This short-term demand may cause the price to rise in London such as SPY and QQQ are also used in arbitrage.) relative to New York or other financial centers. The next section will detail, step-by-step, how an index arbi- Throughout the world a cadre of gold traders watches their trage trade is executed and its effect on the market, taking into screens, waiting for such a moment. Armed with lightning-fast account fair value and basis (the futures premium or discount reflexes and state-of-the-art trade execution technology — not to the underlying cash), as well as buy and sell programs.
31 www.activetradermag.com • March 2003 • ACTIVE TRADER Fair value and basis point away from theoretical basis. For arbitrageurs to make a Fair value is the theoretical value of stock index futures at a profit, the actual basis has to increase (or decrease in some strate- particular time, given prevailing market conditions. gies) enough to cover an arbitrageur’s cost of doing business (the “hurdle rate”), which, in addition to interest rates, includes Theoretical fair value = cash index value [1 + (r – d)*(x/365)] commissions, trader salaries, equipment and telecom lines. where In our arb program example, using the 1.10 point theoretical R = Interest rate/financing costs fair basis as reference, no arb activity would begin until the D = Dividend yield on S&P cash basis widened to around 2.10 points — a “hurdle rate” of 1.0 X = Days to expiration of futures point. (Hurdle rates vary from firm to firm, but typically fall in the .75 to 1.25 point range.) For example, assume the following market conditions exist: What would cause the basis to widen that much? Again, like the New York-London gold example, it would be the result of March S&P 500 futures = 901.20 short-term supply and demand considerations. What if a large Cash S&P 500 index = 900.00 customer of a brokerage firm decided he wanted to gain expo- Days to futures expiration = 90 sure to the stock market via S&P 500 futures? If he put in a Interest rate/financing costs = 2.0 percent large enough buy order, say 500 to 1,000 contracts, the short- Dividend yield on S&P cash = 1.5 percent term demand would likely cause the S&P futures to begin to climb relative to the cash market. Once the discrepancy Given these numbers, the theoretical fair value of the futures increased to the point arbs could profit from it, an intricately contract is: linked set of events would be set into motion. After the large customer’s order hit the trading floor, here is Fair value = cash index value [1 + (r – d)*(x/365)] how the market might look: = 900.00 [1 + (.005)*(90/365)] = 900.00 [1.0012328] Actual value of S&P 500 futures = 902.20 (CME) = 901.10 Actual value of S&P 500 cash index = 900.00 (NYSE/AMEX/NASDAQ) Fair value itself isn’t of much use. It’s the premium or dis- Actual Premium or basis = 2.20 (above “hurdle rate”) count (how much the futures are trading above or below the cash index) that matters most. As previously mentioned, the At this point some of the best and the brightest on Wall “basis” is the difference between the futures price (either theo- Street would employ index arbitrage. They would purchase retical or actual) and the cash index price. Using the informa- the relatively cheap S&P 500 cash index, consisting mostly of tion from the fair value example, the theoretical (“fair”) and NYSE issues, and simultaneously sell the relatively expensive actual basis are calculated as: S&P 500 futures contracts at CME.
Theoretical premium/discount = Executing the trade fair value of futures – actual cash index value The precision required to pull off this kind of strategy is quite (“fair basis”) = 901.10 – 900.00 amazing. The futures side can be done rather quickly, because = 1.10 pt. premium it involves only one instrument, the S&P 500 futures contract. But how do arbs accurately buy all the S&P 500 component Actual premium/discount = stocks at the same time? actual level of futures – actual cash index value The answer is a system referred to as SuperDOT (Direct (“actual basis”) = 901.20 – 900.00 Order Turnaround System). The DOT system electronically = 1.20 pt. premium routes orders directly to specialist posts on the floor of the NYSE. At the press of a button, a firm can send an order to the In this case, the S&P 500 futures should be trading at a pre- NYSE for immediate execution. The system can be pro- mium of about 1.1 points above the cash index. This doesn’t grammed with customized lists of stocks, thus allowing a trad- mean they always will. In fact, most of the time the futures will er to buy or sell all 500 issues in the S&P 500 at once. (The fluctuate slightly above and below the theoretical fair basis Nasdaq issues can be executed using ECNs or other order- because of changes in order flow, supply and demand, and routing mechanisms.) volatility, among other factors. In reality, most firms don’t buy all 500 stocks in the index. Only when supply and demand fluctuations cause a large They have in-house research departments that put together shift away from the fair basis will arbitrage activity start to lists of less than 500 names that track (hopefully) the S&P 500 occur. In this example, the actual basis is 1.2 points, a mere .10 with close precision. If you look at a list of all the components
ACTIVE TRADER • March 2003 • www.activetradermag.com 32 FUTURES& OPTIONS Strategies continued
in the S&P 500, you would notice the last 50 to 100 names have of buying the cash basket of stocks and selling the futures. A a very small weighing on the overall index; the top 40 stocks “sell program” would involve selling the cash basket of stocks account for about 50 percent of the capitalization of the index. and buying the futures. However, you cannot simply divide How many shares of each component stock and how many $10 million in 500 equal installments; you must buy the stocks futures are bought and sold depends largely on the size of the in the exact proportion to their weighting in the index. “program.” Remember, index arbitrage falls under the heading For example, Microsoft (MSFT) is the largest stock in the of program trading. Most programs are in the $10 million to S&P 500, accounting for around 3.62 percent of the total index. $15 million range, but some are much larger. Therefore, an arb trader must spend 3.62 percent of his $10 mil- A $10 million index arbitrage “buy program” would consist lion ($362,000) on MSFT. If MSFT’s current price is $57, that
THE BASIS EDGE
he greatest benefit of understanding fair value, basis The caller’s market order to buy S&Ps hit right when the and index arbitrage lies in gauging the value of market was trading at 1412.00. He was filled at 1411.80—1.80 futures relative to the cash index. For the short-term points above the theoretical premium level. TS&P or E-mini S&P 500 futures trader, this is critical. Within minutes, arbitrageurs and traders came into the A few months back a trader called the CME complaining market to take advantage of a basis level that had taken a about his fill in the S&P 500 futures contract. His call was stroll too far from equilibrium. Skilled arb traders sold expen- routed to me at about 1:30 p.m. sive futures and bought cheap stock when the basis became too large, rapidly forcing prices back into line. The trader’s DL: “By any chance did this bad fill happen about 30 min- order hit the pit precisely when this activity began, producing utes ago?” an immediate loss of 1.80 points in the position ($450.00). Caller: “Yes, how did you know?” Was this really a poor fill, or was it more a result of bad DL: “By any chance did you put in a market order to buy timing that could have been prevented through familiarity futures?” with the pricing mechanisms in stock index futures contracts? Caller: “Yes. Again, nice guess.” Likely, it was the latter. By knowing futures were temporarily DL: “Did you know what the theoretical premium was expensive relative to the cash index, the trader could have when you placed your order?” delayed his order by just a few moments and the futures Caller: “No! I simply put in a market order to buy one June would have returned to their normal fair value. S&P 500 futures contract. What’s the point of all this?” However, merely knowing the theoretical value of the futures isn’t enough. You must know what the premium (or Here’s the point. At 1 p.m., the following prices were flash- basis) should be. In this example, the normal basis was 10. For ing on my screen: a brief moment it was 12 points — two points too high. Although cash and futures markets usually return to equi- June S&P 500 futures: 1410.10 librium quickly, extraordinary events may prevent this from June S&P 500 futures theoretical fair value: 1410.00 happening. Fed Chairman Alan Greenspan’s 50-basis point S&P 500 cash index: 1400.00 rate cut in January 2001 is a great example. Cash/futures theoretical basis: (fair value – cash) 10.00 Shortly after the announcement, both the regular and Cash/futures actual basis: (actual futures – cash) 10.10 E-Mini S&P 500 futures contracts rocketed higher. Because futures are nearly always more responsive than the underly- A few minutes later, around 1:05 p.m., a large buy order ing cash market, equities took a lot longer to catch up. The entered the pit and drove futures prices higher relative to the trader who waited for the normal premium to reappear would cash market. The following prices were then in effect: have missed out on a fabulous rally. If the market makes quick, violent moves up or down, wait- June S&P 500 futures: 1412.00 ing for fair value to reassert itself can result in costly lost June S&P 500 theoretical fair value: 1410.00 opportunities. But over the long run, consistently buying or S&P 500 cash index: 1400.00 selling futures one to two points above or below theoretical Cash/futures theoretical basis (fair value – cash) 10.00 basis is a prescription for poor trading results. Cash/futures actual basis (actual futures – cash) 12.00
33 www.activetradermag.com • March 2003 • ACTIVE TRADER means purchasing 6,351 shares of MSFT. General Electric (GE) the London Interbank Offered Rate) have consistently been is the second largest issue in the index, at about 3.1 percent of higher than the dividend yield of the S&P 500. Only a few years the index; 3.1 percent of $10 million is $310,000. At a price of ago, short-term rates were at 5.5 percent and the dividend yield $27, you’d have to buy 11,481 shares of GE. was 1.3 percent. You would continue in a similar fashion with the other Since Federal Reserve Chairman Greenspan’s aggressive cam- stocks in the index (or optimized portfolio). The list is pre-pro- paign to lower rates, short-term rates in the U.S. have — for the grammed and, using simple spreadsheets, the entire break- first time in recent history — declined below the yield on the down for the cash side of the arb trade can be calculated in S&P 500. With dividends yielding more than short-term rates, nanoseconds. the complexion of the fair value equation changes dramatically. Despite the ease of using the DOT system to buy the list of In our arb example, we used a 2-percent interest rate and 1.5- S&P 500 stocks, the futures side is even less cumbersome. If the percent dividend yield. Let’s calculate the fair value using March futures were priced at 902.20, the contract size (or con- today’s values of 1.4 percent (the 3-month LIBOR rate) and 1.8 tract notional value) would be $225,550 per contract (902.20 x percent (the dividend yield on the S&P 500 index). $250). If you buy $10 million of the cheap underlying cash bas- ket, you must sell $10 million of the relatively expensive Futures fair value = futures contracts to do the arbitrage correctly, and $10 million Cash [1 + (r – d)*(X/365)] = divided by $225,550 comes out to about 44 contracts. 900 [1 + (.014 - .018)*(90/365)] = At the same time the arb trader enters the order to purchase 899.11 (a .89-point discount) the basket of stocks, the trading desk will instruct their broker in the S&P 500 futures pit to sell 44 futures contracts, which at In other words, because dividend yields are higher than this moment are a bit overpriced because of short-term supply short-term rates, the market discounts the futures contract to and demand factors. take into account the yield pick-up by anyone who owned the In a matter of moments, the arb desk begins receiving cash vs. owning the futures. (Futures don’t pay dividends, but reports on the two transactions. As other arb traders execute to buy $225,000 worth of the S&P 500, you only have to put similar trades, the concerted selling and buying in futures and down the futures margin — around 7.5 percent — and the rest cash will force the rich 2.20-point premium back toward equi- of the money earns interest.) librium, or its theoretical value of 1.10. Similarly, if interest rates and dividend yields were identical, When (not if ) the premium falls back to normal levels, the then there would be no advantage to owning cash or futures entire trade could, in effect, be unwound. Unwinding such a and they would be priced identically, as was the case in trade takes equal skill. Some of these trades are offset in the November 1993 when three-month LIBOR and dividend yields future (which could mean minutes, hours, days or even were locked at 2.85 percent. weeks), while others remain on the books until expiration. At expiration, convergence will force the cash and futures con- Short-term trading guidepost tracts to trade at the same price. No matter where the market The relationship between index futures and their underlying ends up at expiration, the arbitrageur profits by whatever cash indices is an aspect of market behavior all traders should amount the premium level he sold at (2.20 points) exceeds the understand. Professional stock index traders constantly moni- theoretical premium (1.10 points), minus trading costs. tor such items as fair value and basis. Novices and even some more experienced traders sometimes ignore or forget these Vanishing premium? important issues. “The basis edge” (p. 33) provides a market For most of the history of the S&P 500 futures, the contract has example of how these issues played out in the market one day traded at a premium to its underlying index. In November 1993 several months ago. and, more recently, in mid-2002, the premium began to disap- It has been said a fool and his money are soon parted. Make pear. In fact, since fall 2002, the S&P futures have traded at a a habit of entering market orders to buy when S&P futures far consistent discount to the underlying cash. You need only look exceed their theoretical value and you will soon be parted from at the relationship between the S&P 500 dividend yield and your capital. Those who trade without knowing the “basics of interest rates to understand why. basis” risk poor executions and, ultimately, less-profitable trad- Since the introduction of S&P 500 futures in April 1982, ing. Ý short-term interest rates (as measured by three-month LIBOR,
ACTIVE TRADER • March 2003 • www.activetradermag.com 34 FUTURES Trading Strategies
STOCK INDEX SPREADS: S&P vs. Naz They aren’t often the subjects of spread trading, but the obvious connections and subtle differences of various stock index futures offer opportunities to play one market off the other.
BY KEITH SCHAP
tock index futures offer fertile which is derived from statistical analysis More specifically, from April 1 to Dec. fields for spread traders. of price changes. The informal definition 1, 2003, the S&P 500 rose 91.75 index Consider only the S&P 500 seems to result from little more than points, from 1,172.90 to 1,264.65, which and the Nasdaq 100. Apart casual observation of price charts to is a 7.82 percent change. The Nasdaq 100 from the obvious difference in the num- gauge which of two markets seems to be rose 234.95 index points, from 1,469.35 to Sbers of stocks they contain, the two bouncing around more. 1,704.30, which is a 15.99 percent change. indices vary considerably in terms of the Most stock market commentators This relationship between the volatili- size and type of their component compa- appear to favor the latter, informal defi- ty of the two indices seems to hold nies. As a result, it should not be surpris- nition. To see how much more volatile throughout the three-year period depict- ing they exhibit markedly different the Nasdaq 100 is than the S&P 500, con- ed in Figure 1. More recently, from July 1 volatility in response to economic stim- sider Figure 1. From April through to July 21, 2005, the S&P 500 rose 32.60 uli. December 2003, both indices trended index points (a 2.73 percent change), This would seem to lay the seeds of higher, but the Nasdaq 100 rose more while the Nasdaq 100 rose 111.35 index productive spread trading, but stock and its rise was choppier. points (a 7.47 percent change). index futures have gone largely untilled in this regard. FIGURE 1 S&P 500 AND NASDAQ 100 INDEX LEVELS Even when the S&P 500 and Nasdaq 100 indices respond the same way to Index responsiveness economic or political events, they do so to different degrees. This difference Even when the entire stock market is ral- can result in fruitful spread trades. From April through December 2003, both lying or losing ground, stock indices sel- indices trended higher, but the Nasdaq 100 rose more and its rise was dom move in concert. The S&P 500 and choppier. the Nasdaq 100 may both rise or fall, but their moves are likely to be of different magnitudes. Stock market commentators often say the Nasdaq 100 is more volatile than the S&P 500, which makes intuitive sense. After all, the various technology sectors have experienced dizzying rallies and gut-wrenching plunges in recent years. Also, smaller, newer companies seem able to react more quickly to events than older, larger companies. Index size is another factor. A major change in the prices of a few stocks will move a smaller index more than a larger index. The term “volatility” has both infor- mal and formal definitions. The formal definition is the one option traders use,
35 www.activetradermag.com • May 2006 • ACTIVE TRADER FIGURE 2 SECOND HALF S&P 500, NASDAQ 100, AND SPREAD RATIO
The top chart shows the S&P 500 and Nasdaq 100 prices from June 1 to Dec. 30, 2005. The bottom shows the ratio spread for this period, with lines added for the mean (average) spread value and one standard deviation above and below the mean. There’s a strong relationship between the spread and its mean: The spread wanders quite far from the mean, but it works back toward it. The difference between the volatilities of the two indices in this informal sense appears sufficient to motivate an interest in stock index futures spreads. Even when both markets respond the same way to economic or political events, they do so to different degrees. In addition, there are likely to be times when the two indices part company, directionally speaking. These events can lead to fruit- ful spread trades.
Structuring stock index spreads A good way to trade these two indices is by using mini stock index futures con- tracts. However, because of the difference in index values, it is necessary to struc- ture S&P 500-Nasdaq 100 spreads in terms of the dollar values of the contracts. Assume the September 2005 E-mini S&P 500 (ESU05) traded at 1,204.30 on June 2, 2005, while the September E-mini Nasdaq 100 (NQU05) traded at 1,568.95. The dollar value of ESU05 is the index level times $50, or $60,215.00, while NQU05 is the index level times $20, or $31,379.00. If anything, this conversion of index values into dollars makes the difference more pronounced, a situation that calls for “ratioing” the spread. To determine an appropriate spread ratio at the outset of any trade, divide the ES dollar value by the NQ dollar value. On June 2, 2005, this ratio was 1.9189 (60,215/31,379). This indicates a need, given this exam- ple, to trade 192 NQU05 contracts for work back toward it. The statistical phe- nomic drivers. This cointegration proper- every 100 ESU05 contracts. You can scale nomenon of “cointegration” accounts ty accounts for the mean-reverting ten- this down to whatever size conforms to for this. The basic idea is this: When you dency of all true spreads, and this is what your comfort level and trading budget. have two related but non-stationary makes spreads safer and more pre- A 10 ES to 19 NQ spread should perform variables, the difference will be station- dictable than outright futures positions. well, and even a 1 ES to 2 NQ spread can ary. Put another way, when two time When the ratio diminishes (or the generate a positive result. series trend together (which in this case spread narrows, which is the same The spread ratio also provides a con- will be two series of stock index futures thing), the Nasdaq 100 is outperforming venient way to track the spread. Figure 2 prices), the difference between the the S&P 500. Conversely, when the ratio (top) shows the S&P 500 and Nasdaq 100 trends will be relatively stationary. expands (the spread widens), the S&P prices from June 1 to Dec. 30, 2005, as Both time series can be trending in the 500 is outperforming the Nasdaq 100. well as the ratio for this period (bottom). same direction but at different rates, or These outperformances all involve gains The figure reveals a strong relation- one can be trending in one direction or losses in one index relative to the ship between the spread and its mean while the other trends in the other direc- other and can occur in different ways: (average). Even when the spread wan- tion. What matters is that both trends ders quite far from the mean, it tends to will be responding to the same set of eco- -Both indices rise but one rises more;
ACTIVE TRADER • May 2006 • www.activetradermag.com 36 FUTURES Trading Strategies continued
TABLE 1 BUYING THE SPREAD IN ANTICIPATION OF WIDENING SPREAD down to a size appropriate to any trad- During the month of this trade, ESU05 outperformed NQU05 by declining ing budget and comfort level, but any only 0.82 percent, while NQU05 fell 5 percent. Using a 100:192 ES to NQ scaling down of the ratio will require spread ratio would have earned $251,806.00. The number of contracts can be rounding the number of contracts, scaled down to fit any trading budget, but doing so will affect the results — which will affect the results. For exam- e.g., a 10:19 ratio would have generated a $24,867.00 return, and a 1:2 ratio ple, the 10 to 19 ratio would have gener- would have produced a $2,643.50 profit. ated a $24,867.00 return, and the 1 to 2 Action ESU05 Action NQU05 ratio would have produced a $2,643.50 profit. The 10 to 19 ratio performed 6/2/05 Buy 100 6,021,500.00 Sell 192 6,024,768.00 slightly worse than the 100 to 192 ratio, 7/1/05 Sell 100 5,972,250.00 Buy 192 5,723,712.00 while the 1 to 2 ratio performed slightly Result -49,250.00 301,056.00 better. As this illustrates, rounding can Spread net 251,806.00 work for you or against you, but in this case not to a deal-killing degree. The second situation developed from the end of September to the end of TABLE 2 SELLING THE SPREAD IN ANTICIPATION OF NARROWING SPREAD October 2005. Spread trading veterans point out the usefulness of charting Both the S&P 500 and Nasdaq 100 contracts rallied during this period, but these spreads. Once you have a chart, NQZ05 gained more than ESZ05 in both dollar and percentage terms (7.66 such as the ratio chart of Figure 2 (bot- percent vs. 3.7 percent, respectively). tom), you can examine chart features just Action ESZ05 Action NQZ05 as you would a more familiar price chart. Figure 2 seems to offer several 10/28/05 Sell 100 5,992,000.00 Buy 192 5,979,264.00 useful signposts — all of them pointing 11/17/05 Buy 100 6,214,000.00 Sell 192 6,437,376.00 to a narrowing of the spread. Result -222,000.00 458,112.00 First, the spread seemed to hit a ceil- Spread net 236,112.00 ing around Sept. 20. Then, it moved through a series of lower highs and lower lows. When the spread hit its third -Both indices fall but one falls less; or tions: early summer 2005, and then late lower high on Oct. 28, this might have -One index rises while the other falls. fall 2005. seemed the right time to sell the By early June, this spread had nar- December spread (sell ESZ05 and buy In the first two situations, the index rowed a great deal and had pushed NQZ05). that rises more or falls less outperforms down to well below its long-term mean On Oct. 28, with ESZ05 trading at the other. In the third situation, if the level. Like all true spreads, the ES/NQ 1,198.40 ($59,920.00) and NQZ05 trading S&P 500 rises while the Nasdaq 100 falls, spread tends to be mean reverting. at 1,557.10 ($31,142.00), the spread ratio the ratio will expand (the spread will Knowing this, early June may have was again 1.92. Suppose you made the widen) — the S&P 500 will gain relative seemed a good time to buy the spread, in trade by selling 100 ESZ05 and buying to the Nasdaq 100. The converse is also anticipation of the S&P 500 subsequently 192 NQZ05 and saw the ratio narrow to true: If the S&P 500 falls while the outperforming the Nasdaq 100. 1.85 by Nov. 17. Nasdaq 100 rises, the ratio will diminish Assume you bought the spread (long This amount of narrowing might have (the spread will narrow) — the Nasdaq ESU05 and short NQU05) with the two made this seem like a good time to close 100 will outperform the S&P 500. If you contracts trading at 1,204.30 ($60,215.00) out this trade. After all, both contracts look only at index levels, this might and 1,568.95 ($31,379.00), respectively. rallied during this period, but NQZ05 seem counterintuitive, but if you look at These dollar values would require a 100 gained more in both dollar and percent- dollar values, it should make sense. to 192 ratio of contracts (60,215/31,379 = age terms. ESZ05 climbed from 1,198.40 Following ordinary spread logic, you 1.9189). to 1,242.80, a 3.7-percent change, while want to buy the spread when you expect Now assume you exit the spread on NQZ05 soared from 1,576.10 to 1,676.40, it to widen and sell when you expect it to July 1 with ESU05 trading at 1,194.45 a 7.66-percent change. As Table 2 shows, narrow. In this case, you buy or sell in ($59,722.50) and NQU05 trading at the 100 to 192 version of this spread terms of what you do with the S&P 500 1,490.55 ($29,811.00). During this month, would have earned $236,112 on these leg. To buy the spread, you buy ES and ESU05 outperformed NQU05 in the sense assumptions. sell NQ. To sell the spread, you sell ES it suffered only a 0.82 percent decline and buy NQ. while NQU05 fell 5 percent. As a result, The ratio rationale the 100 to 192 spread would have earned Ratios seem to complicate trade plan- Trade scenarios $251,806.00 on these assumptions. Table 1 ning and monitoring, so it seems reason- To develop a sense of the opportunities summarizes the details of this trade. able to ask if it’s worth the trouble to use this spread can offer, consider two situa- Again, these ratios can be scaled them. Ratios are a good idea because if
37 www.activetradermag.com • May 2006 • ACTIVE TRADER Related reading TABLE 3 RIGHT ON THE MARKET, WRONG ON THE TRADE Other articles by If you believed NQZ05 would outperform ESZ05 in an anticipated rally, and Keith Schap: shorted the spread by selling one ESZ05 and buying one NQZ05, you would have been right about the market overall but the trade wouldn’t have “Implied volatility: An overlooked worked out. The 1:1 spread would have booked a $784.00 loss. tool for stock and futures traders” Active Trader , April 2006. Action ESZ05 Action NQZ05 Implied volatility is usually associ- 11/1/05 Sell 1 60,137.50 Buy 1 31,530.00 ated with options trading, but futures and stock traders can use 11/25/05 Buy 1 63,412.50 Sell 1 34,021.00 this information, too. Result -3,275.00 2,491.00 Spread net -784.00 “The hidden factor in treasury futures pricing” Active Trader , February 2006. TABLE 4 RIGHT ON THE MARKET, RIGHT ON THE TRADE — WITH A RATIO A look at some of the hidden factors impacting treasury futures If, instead of using the 1:1 spread ratio, you had sold the spread in a 1:2 prices. ratio or a 10-to-19 ratio, you would have gained $1,707.00 or $14,579.00, respectively. These are the results for the 10:19 ratio spread. “Trading the energy story Action ESZ05 Action NQZ05 with calendar spreads” 11/1/05 Sell 10 601,375.00 Buy 19 599,070.00 Active Trader , January 2006. Step back from the hype 11/25/05 Buy 10 634,125.00 Sell 19 646,399.00 surrounding the crude oil and Result -32,750.00 47,329.00 gasoline markets and discover how Spread net 14,579.00 analyzing futures spreads can pinpoint trading opportunities.
“Energy futures spreads” you trade this spread on a 1-to-1 basis, spread would have generated a Active Trader , December 2005. you can be right about which contract $14,579.00 gain. Table 4 displays the Discover what the spread market will outperform but lose money because details of the 10-to-19 spread. was saying about oil surrounding the larger dollar size of the S&P 500 con- The extra work the ratio entails seems Hurricane Katrina and learn how tract will overwhelm the Nasdaq 100 to pay off in obvious ways. to trade spreads when supply contract. disruptions loom. For a case in point, consider the mar- Going forward ket as it was on Nov. 1, 2005, when the Although spreads may be somewhat “Sector vs. index: The single entire stock market seemed poised to safer than outright trades, they are spec- stock futures-Dow spread” rally. Assume ESZ05 was trading at ulative endeavors subject to losses if Active Trader , November 2005. 1,202.75 ($60,137.50) and NQZ05 was your market forecast is incorrect. This Learn how to create a spread trading at 1,576.50 ($31,530.00). Assume brings up the matter of how you can between the Mini Dow and several further you believed NQZ05 would out- know exactly when to enter and exit single-stock futures, which can help perform ESZ05 in this rally and shorted these trades. you take advantage of areas that the spread by selling one ESZ05 and To put it bluntly — you can’t. may lead (or lag) the market. buying one NQZ05. When you chart a spread ratio, as in By Nov. 25, ESZ05 was trading at Figure 2, you can analyze the data as you “The TUT spread — an active 1,268.25 ($63,412.50), and NQZ05 was would any price series. When you locate spread for active traders” trading at 1,701.05 ($34,021.00). So far, a spread mean for some period of time Active Trader , October 2005. you would have been right about the rel- and determine a range of interest, such This trade shows how to profit from ative changes. ESZ05 rose 5.45 percent as plus and minus one standard devia- relationships between different while NQZ05 rallied 7.90 percent. tion, you are in a better position to esti- T-note futures contracts. Nonetheless, at this point the one-lot mate possible turning points than you spread would have booked a $784.00 might otherwise be. You can purchase past articles at loss (Table 3). In the final analysis, though, if you are www.activetradermag.com/ Suppose, given the same circum- looking for surefire signals, you are purchase_articles.htm stances, you had sold the spread in a 1- bound to suffer frustration. Nevertheless, and download them to your computer. to-2 ratio, or in a more accurate 10-to-19 approached with careful study and rea- ratio. The smaller spread would have sonable expectations, stock indexÝ spreads generated a $1,707.00 gain. The larger can produce gratifying results.
ACTIVE TRADER • May 2006 • www.activetradermag.com 38 ADVANCED Strategies
The multibar range BREAKOUT SYSTEM Breakouts of price channels can be profitable — if the volatility is there and you’re on the right side of the trade. This stop-and-reverse system tries to capture intraday trends in the S&P E-Mini contract by recognizing differences in the characteristics of up moves and down moves.
BY DENNIS MEYERS, PH.D. FIGURE 1 TRADESTATION CODE FOR THE MULTIBAR RANGE BREAKOUT SYSTEM
{Strategy: #MultiBarRangeBO} reakout systems are popular when markets are Input: n(45),bx(0.45),m(15),sx(0.45),XTime(1515); volatile. Such systems typically identify support vars: hhv1(h),llv1(l),hhv2(h),llv2(l),ii(0),xb(c),xs(c); and resistance levels when price has been moving in a range or channel, and enter trades when price hhv1=h; llv1=l; breaks out of either the up side or down side of a channel. for ii=1 to n-1 begin There are two simple ways to define support and resistance if h[ii]>hhv1 then hhv1=h[ii]; if l[ii]
39 www.activetradermag.com • January 2004 • ACTIVE TRADER However, the parameters for the buy signals will be TABLE 1 MULTIBAR RANGE BREAKOUT SYSTEM different than those for the sell signals, because of the PERFORMANCE SUMMARY, JULY 7 TO AUG. 1, 2003 propensity for markets to fall faster than they rise. The range for the last x bars will be defined as the highest The system triggered more short trades during the test, but pro- high of the last x bars (including the current bar) duced profits on long trades, as well. minus the lowest low of the last x bars (including the current bar). All trades Long trades Short trades The buy price is determined by adding a percentage Total net profit $4,912.50 $1,450.00 $3,462.50 of the range of the last n bars to the current close — the previously described volatility-adjusted technique. If Gross profit $6,637.50 $1,912.50 $4,725.00 the next bar’s price exceeds the buy price, the system Gross loss ($1,725.00) ($462.50) ($1,262.50) issues a buy signal. The sell price is determined by Profit factor 3.85 4.14 3.74 subtracting a percentage (a different percentage than the buy percentage) of the range of the last m bars from Open position P/L $0.00 $0.00 $0.00 the current close. If the next bar’s price falls below the sell price, the system issues a sell signal. Total number of trades 55 20 35 The resulting Multibar Channel Breakout system Percent profitable 58.18% 55.00% 60.00% will trade the S&P 500 E-Mini futures on an intraday Winning trades 32 11 21 basis using one-minute bars. The TradeStation Code is Losing trades 22 9 13 shown in Figure 1. Even trades 1 0 1 Multibar Channel Breakout rules Avg. trade net profit $89.32 $72.50 $98.93 This is a stop-and-reverse system, meaning it is always in the market: When a sell signal occurs, long trades Avg. winning trade $207.42 $173.86 $225.00 are exited and a short trade is entered; when a buy sig- Avg. losing trade ($78.41) ($51.39) ($97.12) nal occurs, short trades are exited and a long trade is Ratio avg. winning/ entered. These are the system’s parameters: avg. losing 2.65 3.38 2.32 ES = E-Mini price; Largest winning trade $700.00 $362.50 $700.00 BRange = the price range over the last n bars; Largest losing trade ($300.00) ($125.00) ($300.00) SRange = the price range over the last m bars; bx = the percentage multiplier of the BRange for Largest winner as buy signals; % of gross profit 10.55% 18.95% 14.81% sx = the percentage multiplier of the SRange for sell Largest loser as signals; % of gross loss 17.39% 27.03% 23.76% c = the current price; Net profit as buyCh = c + bx*BRange; % of largest loss 1,637.50% 1,160.00% 1,154.17% sellCh = c - sx*SRange Max. consecutive where winning trades 5 5 4 n = The number of lookback bars (including the cur- Max. consecutive rent bar) for buy signals. losing trades 5 2 3 m = The number of lookback bars (including the current bar) for sell signals. Avg. bars in total trades 134.96 45.8 185.91 Notice that not only are the percentage multipliers Avg. bars in for long (bx) and short trades (sx) different, the look- winning trades 166.88 69.18 218.05 back periods the system references for buys (n) and Avg. bars in sells (m) are also different. The trade rules are simple: losing trades 91.95 17.22 143.69
1. Buy rule: Buy the next bar at buyCh, stop. Max. drawdown 2. Sell rule: Sell the next bar at sellCh, stop. (intraday peak to valley) ($887.50) ($862.50) ($975.00) 3. Intraday bar exit rule: Exit the position on the Max. drawdown close (no overnight trades). (trade close to trade close) ($300.00) ($175.00) ($400.00) Although it may not be immediately obvious, this sys- Max. trade drawdown ($475.00) ($475.00) ($362.50) tem avoids the opening gap whipsaw problem — Source: TradeStation trades being triggered because of large gap openings
ACTIVE TRADER • January 2004 • www.activetradermag.com 40 TABLE 2 TRADE-BY-TRADE SUMMARY: JULY 7 TO AUG. 1, 2003 This list contains each trade in the test period. Overall, 58.18 percent of trades were profitable.
Entry Entry Entry Exit Exit Exit Bars Trade Trade Trade date time price ($) date time price ($) in trade $P&L max$Pft Time max$DD Time 7/7/03 10:36 Sell 1,003.75 7/7/03 12:35 1,002.50 119 $62.50 $175.00 12:06 ($12.50) 10:36 7/7/03 12:35 Buy 1,002.50 7/7/03 12:52 1,001.50 17 ($50.00) $0.00 12:35 ($50.00) 12:38 7/7/03 12:52 Sell 1,001.50 7/7/03 13:01 1,002.75 9 ($62.50) $25.00 12:55 ($62.50) 13:01 7/7/03 13:01 Buy 1,002.75 7/7/03 13:24 1,002.50 23 ($12.50) $37.50 13:23 ($25.00) 13:08 7/7/03 13:24 Sell 1,002.50 7/7/03 15:15 1,002.75 111 ($12.50) $87.50 14:22 ($112.50) 13:47 7/8/03 9:51 Sell 1,002.00 7/8/03 14:09 1,004.25 258 ($112.50) $62.50 11:21 ($175.00) 10:19 7/8/03 14:09 Buy 1,004.25 7/8/03 15:15 1,007.50 66 $162.50 $187.50 14:48 ($62.50) 14:11 7/9/03 9:33 Sell 1,007.75 7/9/03 15:15 1,001.00 342 $337.50 $525.00 11:03 $0.00 9:33 7/10/03 8:58 Sell 992.50 7/10/03 15:15 988.75 377 $187.50 $512.50 13:48 ($62.50) 9:04 7/11/03 9:05 Sell 993.25 7/11/03 15:15 997.75 370 ($225.00) $62.50 9:08 ($337.50) 11:23 7/14/03 9:54 Sell 1,012.25 7/14/03 15:15 1,002.75 317 $475.00 $575.00 14:46 ($112.50) 10:01 7/15/03 9:05 Sell 1,002.75 7/15/03 15:15 1,000.75 370 $100.00 $362.50 14:05 ($275.00) 9:46 7/16/03 8:48 Sell 1,000.50 7/16/03 12:10 993.25 202 $362.50 $625.00 10:12 $0.00 8:48 7/16/03 12:10 Buy 993.25 7/16/03 12:22 992.25 12 ($50.00) $0.00 12:10 ($50.00) 12:18 7/16/03 12:22 Sell 992.25 7/16/03 15:15 995.25 173 ($150.00) $187.50 14:30 ($150.00) 15:10 7/17/03 9:04 Sell 988.25 7/17/03 11:01 986.25 117 $100.00 $275.00 9:39 $0.00 9:04 7/17/03 11:01 Buy 986.25 7/17/03 11:02 983.75 1 ($125.00) $0.00 11:01 ($125.00) 11:02 7/17/03 11:02 Sell 983.75 7/17/03 15:15 980.50 253 $162.50 $337.50 14:01 ($25.00) 11:06 7/18/03 8:49 Sell 986.00 7/18/03 11:27 985.25 158 $37.50 $287.50 9:20 ($25.00) 9:02 7/18/03 11:27 Buy 985.25 7/18/03 12:02 985.50 35 $12.50 $62.50 11:31 ($12.50) 11:27 7/18/03 12:02 Sell 985.50 7/18/03 13:01 985.50 59 $0.00 $50.00 12:19 ($25.00) 12:03 7/18/03 13:01 Buy 985.50 7/18/03 14:35 991.50 94 $300.00 $375.00 14:11 $0.00 13:01 7/18/03 14:35 Sell 991.50 7/18/03 15:15 990.00 40 $75.00 $75.00 14:53 ($87.50) 14:41 7/21/03 8:32 Sell 988.00 7/21/03 15:15 978.25 403 $487.50 $700.00 14:10 ($12.50) 8:32 7/22/03 9:20 Sell 976.75 7/22/03 10:01 978.50 41 ($87.50) $112.50 9:50 ($87.50) 10:01 7/22/03 10:01 Buy 978.50 7/22/03 11:37 985.75 96 $362.50 $500.00 11:10 ($75.00) 10:18 7/22/03 11:37 Sell 985.75 7/22/03 14:37 987.25 180 ($75.00) $237.50 12:37 ($150.00) 14:02 7/22/03 14:37 Buy 987.25 7/22/03 15:15 986.75 38 ($25.00) $25.00 14:38 ($87.50) 14:49 7/23/03 8:35 Sell 986.25 7/23/03 12:51 984.75 256 $75.00 $412.50 11:16 $0.00 8:35 7/23/03 12:51 Buy 984.75 7/23/03 13:38 986.50 47 $87.50 $187.50 13:35 ($37.50) 12:55 7/23/03 13:38 Sell 986.50 7/23/03 14:27 986.75 49 ($12.50) $100.00 14:14 ($50.00) 13:39 7/23/03 14:27 Buy 986.75 7/23/03 15:15 987.75 48 $50.00 $62.50 15:13 ($62.50) 14:35 7/24/03 9:21 Sell 995.50 7/24/03 12:45 993.75 204 $87.50 $162.50 9:50 ($50.00) 10:27 7/24/03 12:45 Buy 993.75 7/24/03 13:10 994.25 25 $25.00 $62.50 12:57 $0.00 12:45 7/24/03 13:10 Sell 994.25 7/24/03 15:15 980.25 125 $700.00 $762.50 14:57 ($25.00) 13:11 7/25/03 8:43 Buy 982.50 7/25/03 9:01 983.25 18 $37.50 $150.00 9:00 ($37.50) 8:45 7/25/03 9:01 Sell 983.25 7/25/03 13:01 989.25 240 ($300.00) $375.00 9:52 ($337.50) 12:33 7/25/03 13:01 Buy 989.25 7/25/03 15:08 996.00 127 $337.50 $412.50 14:54 ($87.50) 13:25 7/25/03 15:08 Sell 996.00 7/25/03 15:15 997.00 7 ($50.00) $0.00 15:08 ($62.50) 15:12 7/28/03 8:33 Sell 995.50 7/28/03 12:37 996.50 244 ($50.00) $175.00 8:52 ($187.50) 10:29 7/28/03 12:37 Buy 996.50 7/28/03 12:57 996.25 20 ($12.50) $100.00 12:55 ($12.50) 12:37 7/28/03 12:57 Sell 996.25 7/28/03 15:15 993.50 138 $137.50 $187.50 14:42 ($87.50) 14:04 7/29/03 9:01 Sell 991.25 7/29/03 10:34 986.75 93 $225.00 $450.00 9:34 $0.00 9:01 7/29/03 10:34 Buy 986.75 7/29/03 11:28 992.00 54 $262.50 $450.00 10:58 ($12.50) 10:34 7/29/03 11:28 Sell 992.00 7/29/03 15:15 989.00 227 $150.00 $300.00 14:17 ($250.00) 12:33 7/30/03 8:34 Sell 990.00 7/30/03 11:38 989.25 184 $37.50 $275.00 10:32 ($37.50) 9:56 7/30/03 11:38 Buy 989.25 7/30/03 11:56 988.00 18 ($62.50) $0.00 11:38 ($62.50) 11:52 7/30/03 11:56 Sell 988.00 7/30/03 13:02 988.75 66 ($37.50) $62.50 12:19 ($50.00) 12:01 7/30/03 13:02 Buy 988.75 7/30/03 13:04 987.00 2 ($87.50) $0.00 13:02 ($87.50) 13:04 7/30/03 13:04 Sell 987.00 7/30/03 15:15 986.25 131 $37.50 $125.00 13:14 ($25.00) 14:21 7/31/03 9:00 Buy 995.75 7/31/03 11:20 1,001.25 140 $275.00 $387.50 10:14 ($400.00) 9:08 7/31/03 11:20 Sell 1,001.25 7/31/03 13:07 1,003.00 107 ($87.50) $37.50 11:40 ($112.50) 12:14 7/31/03 13:07 Buy 1,003.00 7/31/03 13:22 1,002.25 15 ($37.50) $12.50 13:19 ($50.00) 13:16 7/31/03 13:22 Sell 1,002.25 7/31/03 15:15 988.50 113 $687.50 $725.00 14:56 ($12.50) 13:22 8/1/03 8:46 Sell 983.50 8/1/03 15:15 979.50 389 $200.00 $300.00 9:35 ($125.00) 8:51 Source: Meyers Analytics, LLC
41 www.activetradermag.com • January 2004 • ACTIVE TRADER FIGURE 2 RIDING THE TREND During this period, the system caught one intraday uptrend, one intraday downtrend, and produced small losses on two signals when the market was flat.
September 2003 S&P E-Mini futures (ESU03), one-minute 1,010
Short Short 1,005
Buy 1,000
995
990 Buy Short
End 985 End of day of day exit exit 980
600 400 200 0 -200
7/30 9:11 9:33 9:55 10:17 10:39 11:01 11:23 11:45 12:07 12:29 12:51 13:13 13:35 13:57 14:19 14:41 8/1 Source: TradeStation that quickly reverse and stop out the position. With this sys- difficult to sustain more than a handful of consecutive losses, tem, if there is a gap on the opening bar, the buy and sell ranges we eliminated all cases that had more than five losing trades in are expanded and no trades are made until the buy and sell a row. Of the remaining test results, we chose the one that had ranges contract or the price breaks the expanded ranges. the highest total net profit and the lowest drawdown. The opti- Breaking the expanded ranges takes time and avoids the open- mization procedure produced the following system parame- ing gap whipsaw. ters:
Testing n = 45; The system was tested from July 7 through Aug. 1, 2003, using bx = 0.45; September 2003 E-Mini futures (ESU03) one-minute bars. A m = 15; wide range of parameter values was tested to find the optimal sx = 0.45; ones for the system. The parameter ranges tested for the initial optimization test were: Table 1 (p. 40) shows the performance summary for the four- week test period (slippage and commissions not included). n = 10 to 50 in steps of 5; Table 2 (p. 41) is a trade-by-trade summary of all the trades. bx = 0.4 to 1 in steps of 0.05; The average net profit per trade was $89 — well above slip- m = 10 to 50 in steps of 5; page and commissions for a typical S&P E-Mini trade. The sx = 0.4 to 1 in steps of 0.05; largest losing trade was $300, and the biggest intraday draw- down was $887. These losses are small compared to the total After the initial test, we had to choose one set of parameters net profit of $4,912. that produced the most realistic results. To avoid curve fitting, Figures 2 and 3 (p. 43) are one-minute charts of the S&P E- we eliminated all results that had profit factors (gross profit Mini that span July 31 to Aug. 1. The Multibar Range Breakout divided by gross loss) greater than 4.0, since such performance channels are superimposed on the price series, and all the buy was unlikely to be duplicated in the future. Also, because it is and sell signals are marked. Finally, the bottoms of Figures 2
ACTIVE TRADER • January 2004 • www.activetradermag.com 42 FIGURE 3 ONE DAY, ONE TRADE If no signal in the opposite direction is triggered, the system will stay in the same direction the entire day. All trades are exited at the close — no positions are held overnight.
September 2003 S&P E-Mini futures (ESU03), one-minute 1,002 1,000 998 996 994 992 990 Sell 988 986 End of day exit 984 982 980 978 End of 976 day exit
600
400
200
0
14:19 14:41 8/1 9:02 9:24 9:46 10:08 10:30 10:52 11:14 11:36 11:58 12:20 12:42 13:04 13:26 13:48 14:10 14:32 14:54
Source: TradeStation
and 3 include the bar-by-bar profit or FIGURE 4 DAILY PERSPECTIVES loss of each trade. The daily chart of the test period shows the system was able to profit on Figure 4 is a daily chart of the S&P E- both sides of the market when conditions shifted from uptrend to downtrend Mini futures from July 7 to Aug. 1, and to consolidation. shows the market moved up, down and sideways during this period. The system 1,015 was able to produce profits on both the September 2003 S&P E-Mini futures (ESU03), daily long and short sides of the market, and 1.010 aside from a streak of five losing trades near the outset of the test period, never 1,005 had more than three consecutive losses. The Multibar Channel Breakout sys- 1,000 tem’s positive performance warrants further investigation. If you consider fol- 995 lowing this system in real-time, pay close attention to how the real-time sta- 990 tistics compare to the hypothetical num- bers shown here. If the numbers begin to 985 deviate, another reviewÝ of the system parameters are in order. 980
975 7 14 21 28 Source: TradeStation
43 www.activetradermag.com • January 2004 • ACTIVE TRADER FUTURES& OPTIONS Trading Strategies
Following through IN THE S&Ps Strong closes and large ranges are often interpreted as signs of potential follow-through, but this study unveils another way to find out what today’s market action says about tomorrow’s.
FIGURE 1 DOMINANT UP VOLUME: 50-59.99 PERCENT BY THOM HARTLE When relative up volume was between 50 and 59.99 percent, all but two days made higher highs.
45 40 35 he basic law of supply and demand 30 drives price swings in the stock mar- 25 ket, and the prevalence of one or the other today can indicate what may 20 occur tomorrow. Although gauging whether sup-
Point +/- Point 15 ply or demand is dominating the market seems 10 T like it would be a simple process, there are, in 5 fact, several ways to accomplish this, as well as
0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 different ways to interpret the data. -5 Breadth studies — specifically, comparing the -10 Day New York Stock Exchange’s (NYSE) up volume (the total volume of those stocks trading above the previous day’s close) and down volume (the FIGURE 2 DOMINANT UP VOLUME: 60-69.99 PERCENT total volume of those stocks trading below the previous day’s close) statistics — have for years Only one day (14) with relative up volume between 60 and 69.99 been a popular way to determine the relative percent was followed by a lower high. dominance of demand or supply in stocks. Traditionally, technical traders have looked for 45 breadth to confirm the trend — i.e., rising up vol- 40 ume relative to down volume supports a rising 35 market; increasing down volume while the mar- 30 ket is rising is a sign of “internal” weakness. 25 In this case, we will use a shorter-term 20 approach and analyze the NYSE up-down vol-
Point +/- Point ume statistics at the close of the day to see if there 15 is any consistent follow-through price action in 10 the E-Mini S&P 500 futures the next day. The 5 period we analyzed was Aug. 20, 2002 to Aug. 27, 0
1 3 5 7 9 2003. 11 13 15 17 19 21 23 25 27 29 31 33 35 -5 Day Demand, supply and relative volume To get an idea of whether the relative volume
44 www.activetradermag.com • December 2003 • ACTIVE TRADER FIGURE 3 DOMINANT UP VOLUME: 70-79.99 PERCENT All but one day following days with 70 to 79.99 percent relative up offers any clues about market direction from one volume made higher highs, and the gains were, on average, smaller day to the next, we divided the end-of-day NYSE than those for the 50 to 59.99 percent and larger than the 60 to up- and down-volume figures, respectively, by 69.99 percent groups. the combined volume — that is, up volume/(up + down volume) and down volume/(up + down 45 volume). Unchanged volume was ignored. These 40 figures express up and down volume as percent- 35 ages of up plus down volume. 30 To gauge how much follow-through occurred 25 20 the next day, for days with dominant (i.e., greater 15 than 50 percent) up volume, we calculated the +/- Point 10 difference between the current close and the next 5 day’s high in the E-Mini S&P 500 (ES); for days
0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 with dominant down volume, we calculated the -5 difference between the current close and the next -10 day’s low. -15 Day The data was grouped in percentage ranges: 50-59.99 percent (dominant up volume or down volume), 60-69.99 percent, 70-79.99 percent and 80-89.99 percent. Figures 1 through 4 show the FIGURE 4 DOMINANT UP VOLUME: 80-89.99 PERCENT point gains from the current close to the next Except for one larger high-to-high gain, the moves following days day’s high when the market closed with domi- with 80 to 80.99 percent relative up volume were smaller than the nant up volume. Figures 4 through 8 show the preceding groups, and one day made a lower high. point losses from the close to the next day’s low for the days with dominant down volume. 45 For example, in Figure 1, the first up-volume 40 percentage reading (from Jan. 13, 2003) was 50.26 percent (which means the down-volume percent- 35 age was 49.74 percent). The E-Mini S&P closed at 30 924.00 that day. The next day’s high was 929.00, a 25 five-point gain that is shown by the first bar on 20 the chart. +/- Point 15 The up-volume percentage was between 50 10 and 59.99 percent 37 times. The 37th reading, 5 which occurred on April 10, 2003, was 59.91 per- 0 7 9 1 3 5 11 13 15 17 19 cent. The S&P E-Mini closed at 870.50 that day 21 23 25 -5 and made a high of 882.25 the next day, for an Day 11.75 gain (the final bar in Figure 1). Only two days made lower highs the day after posting rel- ative up volume in the 50-59.99 percent range. Overall, Figures dominant down-volume days. The question is how far the 1 through 8 show the E-Mini S&P has a notable tendency to fol- market ultimately follows through the next day in the direction low through the next day in the direction of the dominant rel- implied by the dominant relative volume. ative volume. One thing this analysis does not tell us, however, is whether Success rates the market first made the daily high or low the following day. Approaching things from the opposite perspective, Table 1 (p. The difference between the close and the next day’s low was 47) shows the number of times the market failed to trade at or not calculated for days with dominant up volume; nor was the above the previous day’s close (for dominant up-volume days) difference between the close and the following day’s high for or at or below the previous day’s close (for dominant down-
ACTIVE TRADER • December 2003 • www.activetradermag.com 45 FUTURES& OPTIONS Trading Strategies continued
FIGURE 5 DOMINANT DOWN VOLUME: 50-59.99 PERCENT
All days with relative down volume between 50 and 59.99 percent were followed by lower lows.
45 volume days). For example, two days with dom- 40 inant up volume in the 50-59.99 percent range 35 were followed by days that did not exceed the 30 previous day’s close. The remaining dominant up-volume groups each had only one day that 25 failed to exceed the previous day’s close. 20 Point +/- Point For the dominant down-volume days, the 15 market always dropped below the previous 10 day’s close in the 50-59.99 and 60-69.99 percent 5 groups; only one day failed to trade below the 0 previous close in the 70-79.99 percent group, 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 while two days failed in the 80-89.99 percent Day group. Table 2 shows the average and median price moves by group. The average is the total differ- FIGURE 6 DOMINANT DOWN VOLUME: 60-69.99 PERCENT ences divided by the number of occurrences. The median is the center value of a series of numbers. All days after relative down-volume readings between 60 and 60.99 For example, both the median and average of 1, percent made lower lows, but the average losses were smaller than 2, 3, 4 and 5 is 3; for 1, 2, 3, 4 and 25, the median those in the 50-59.99 percent group. would still be 3, while the average would be 7. If 45 the average is higher or lower than the median, the data is biased in that direction, which indi- 40 cates a few outliers, or out-of-character readings, 35 exist. In Table 2 the average rise after up-volume 30 dominant days for the 50-59.99 percent group 25 was 9.16 points, while the median was only 6.00, 20 indicating an upside bias.
Point +/- Point 15 In Figure 1 there are a few values that are four to five times the size of most of the other values. 10 For the dominant down-percentage values, the 5 number is larger, which is interesting because 0
1 3 5 7 9 the analysis period was not dominated by a bear 11 13 15 17 19 21 23 25 27 Day trend. For the 80-89.99 percent dominant up-volume group shown in Figure 4, most of the values cluster above and below 5 points, while a single FIGURE 7 DOMINANT DOWN VOLUME: 70-79.99 PERCENT value exceeds 40 points. This move occurred on One day (20) made a higher low in the 70-79.99 percent down-vol- Oct. 10, 2002, a reversal day after the S&P 500 ume group. made a new low for the three-year bear market. If we remove this value, the average move drops to 5.4 points and the median stays at 6 points. 45 Table 2 conveys the market is likely coming 40 out of congestion when the up or down volume 35 is in the 50-59.99 percent range because of the 30 more significant follow-through price move- 25 ment. 20 By comparison, when the up or down volume percentages reach 80 percent, the statistics imply 15 Point +/- Point the market has reached an overbought or over- 10 sold state — notice the follow-through in the 5 direction of the dominant volume is much lower. 0 However, just because the market has reached 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 -5 an overbought or oversold state does not mean Day the overall trend is reversing. The study only addresses the next day’s price behavior.
46 www.activetradermag.com • December 2003 • ACTIVE TRADER FIGURE 8 DOMINANT DOWN VOLUME: 80-89.99 PERCENT The increased number of small close-to-low moves and the presence of two days with higher lows suggest the market is oversold when relative down volume exceeds 80 percent. Another thing to consider is maximum favor- able excursion — the largest profitable price 45 move the market makes over the course of a trade 40 or observation period. Looking at the data, what 35 can we determine as to the degree of typical fol- 30 low-through price movement? Table 3 (bottom, 25 right) shows the percentage of times a price move 20
of a certain magnitude is hit — in this case, 2.5 +/- Point 15 points or more, 5 points or more and 7.5 points or 10 more. For the 2.5 point threshold, the success rates 5 are quite high and, not surprisingly, work their 0 1 3 5 7 9 -5 11 13 15 17 19 21 23 25 27 29 way lower for the larger price targets. Also, the Day downside targets have higher success rates, which were indicated by the higher averages for the down-volume percentages in Table 2. TABLE 1 FAILURE TO REACH CLOSE This shows the number of times the market failed to reach the closing price of dominant up- and down-volume days, broken down by percentage range. Markets move the most after Fail 50-59.99% 60-69.99% 70-79.99% 80-89.99% Up 2 1 1 1 days with mixed opinions — Down 0 0 1 2 that is, when the up or down TABLE 2 AVERAGE AND MEDIAN MOVES volume ratio is not far from Comparing the average and median point moves of the different ranges reveals certain directional biases. the 50-percent mark. Up 50-59.99% 60-69.99% 70-79.99% 80-89.99% Average 9.16 8.44 8.74 6.79 Median 6.00 7.38 8.50 6.00
The lowest success rate is 35 percent for the 7.5 target in the Down 50-59.99% 60-69.99% 70-79.99% 80-89.99% 80-89.99 percent up-volume group. This is another sign that Average 10.42 10.23 8.28 8.85 once market participants make a large commitment, the prob- Median 8.25 11.13 5.63 10.50 ability for higher prices in the near term declines. All the tables’ upper ranges are limited to 89.99 percent up or down volume because 90 percent or higher up or down vol- TABLE 3 HITTING THE MARKS ume is rare. It only occurred twice for dominant up volume (with follow-through of 11.75 and 3.25 points) and three times This table shows the percentage of time the market fol- for dominant down volume (follow-through of 2.75, 8.25 and lowed through with moves of 2.5, 5 and 7.5 points. 7.5 points). 2.5 points 50-59.99% 60-69.99% 70-79.99% 80-89.99% Putting it into action Up (%) 84 86 82 77 Down (%) 88 89 80 76 How can this information be incorporated into a trading plan? First, if you are holding a position in the E-Mini S&P futures 5 points 50-59.99% 60-69.99% 70-79.99% 80-89.99% with a profit going into the close and the up or down volume Up (%) 57 69 59 58 for the day confirms your trade (e.g., you are long and the up Down (%) 82 70 57 55 volume is dominant), you know from Table 3 there is a very high chance of getting at least an additional 2.5 points in the 7.5 points 50-59.99% 60-69.99% 70-79.99% 80-89.99% next session. Up (%) 49 50 56 35 Figure 9 (p. 48) is a 30-minute chart for Aug. 12 and 13, 2003. Down (%) 58 63 47 55 At the close on Aug. 12, the up-volume ratio was 76 percent and the E-Mini S&P closed at 990.00. The market traded an
ACTIVE TRADER • December 2003 • www.activetradermag.com 47 FUTURES& OPTIONS Trading Strategies continued
FIGURE 9 EXPECTED FOLLOW THROUGH
Relative up volume of 76 percent was followed by a 3.5-point high- to-high price move.
Continuous S&P 500 E-Mini The day session high additional 3.50 points higher the next day (as well (ES), 30-minute was 3.5 points higher as 3.00 points higher in the night session). On 992 Aug. 13, the market closed at 984.75, and the down volume dominated by just 56 percent. The Up volume at the 990 close was 76% next day, the low was 979.25, a difference of 5.5 points (see Figure 10). 988 Other factors Keep in mind the possibility of “artificial” issues 986 that could affect the outcome of trades based on this kind of analysis. For instance, in Figure 3, the 984 second to last reading was -7.75 points (the only negative value in the group), meaning the next 982 day’s high was 7.75 points below the current close. The up-volume ratio the previous day, March 21, 2003, was 79 percent. 980 However, March 21 was an option expiration day. Considering the market’s sustained upward 978 drive during the middle of March, the high rela- tive up volume was likely less the result of new 976 long-side positions than a function of traders cov- 8/12/03 8/13/03 8/14/03 ering bearish options positions. Source: Fibonacci Trader Conclusion This study does not comprise a trading system, FIGURE 10 DOWNSIDE FOLLOW THROUGH especially considering it does not measure how After posting 56-percent relative down volume, the S&P E-Mini fell far the market moves counter to the implied 5.5 points from the previous low. direction before reaching its peak value. In other words, although the statistics may Continuous S&P 500 E-Mini (ES), 30-minute indicate there is a 70-percent chance the E-Mini S&P will decline 5 points or more the day after 992 the down-volume ratio is between 60 and 69.99 percent, we do not know how much the market At the close, the down volume 990 tends to rally before reaching that target. If the was 56% average up move is, say, 9 points, it calls into question the wisdom of trying to capture a 5- 988 point down move. However, the tendencies out- lined here can be combined with tested setups and provide an additional input in deciding 986 whether to hold or exit at the close. This study indicates markets move the most 984 after days with mixed opinions — that is, when the up or down volume ratio is not far from the 50-percent mark. As everyone gets on board, 982 next-day follow through drops. The majority of players have spent their capital or given up on the trade, so the market is running out of fuel. 980 The next day’s low Finally, the generally higher average and was 5.5 points lower medians for the dominant down volume follow- 978 through levels are reminiscent of an old saying 8/13/03 8/14/03 8/15/03 from the pits: The market giveth and the locals Ý Source: Fibonacci Trader taketh away.
48 www.activetradermag.com • December 2003 • ACTIVE TRADER TRADING Strategies
Getting in on FOLLOW-THROUGH DAYS In a follow-up to last month’s article discussing the odds of next-day follow-through in the S&P futures, a trader looks at the realities of basing entries on this price behavior.
BY THOM HARTLE
ew things are as important to short-term traders as when New York Stock Exchange (NYSE) up volume or down “follow-through” — additional price action in the volume dominated the total volume (defined here as up vol- direction of the previous day’s (or days’) move. ume plus down volume, and not counting unchanged volume) In addition to analyzing price behavior (the level of the clos- for the day. Analyzing the period from Aug. 12, 2002, to Aug. ingF price, for instance), monitoring the relative strength of 27, 2003, (using continuous S&P 500 futures data) showed dom- either up volume or down volume can also provide an indica- inant up volume or down volume on a given day was, in fact, tion of the likelihood of follow-through in the stock market. in some circumstances a reliable measure of upside or down- “Following through in the S&Ps” ( Active Trader , December side follow-through the next day. 2003, p. 60) detailed the differences in price behavior after days The results were grouped according to the percentage of dominant volume on a given day. For example, if up volume account- FIGURE 1 50- TO 59.99-PERCENT UP-VOLUME DAYS ed for 58 percent of the total vol- The difference between the close and the next day’s high and low is sorted by which ume on a particular day, this day was established first, the low (on the left) or the high (on the right). Although the was grouped in the 50- to 59.99-per- S&P E-Mini made its daily high first 57 percent of the time, the moves from the pre- cent up-volume range; if the up vol- vious close to the high on those days were smaller than the moves from the previ- ume was 63 percent of the total vol- ous close to the low. ume, the day fell in the 60- to 69.99- percent range. The dominant 45 down-volume days were organized in similar ranges. 35 High established first The follow-through price move- 25 ment for each of these ranges was then characterized. For instance, 15 the average difference between the 5 closing price and the next day’s high for all instances in the 50- to -5 59.99-percent up-volume range was -15 9.16 points. There were only two instances (out of 37 total) when the -25 up volume was between 50 and -35 Low established first 59.99 percent of the total volume and the following day’s high was -45 not above the closing price.
Difference Difference btwn. close and high next or day’s low 1 2 3 4 5 6 7 8 9 10 1112 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 One of the basic implications of Close-to-high move Close-to-low move the analysis was that dominant up- volume or down-volume readings
49 www.activetradermag.com • January 2004 • ACTIVE TRADER TABLE 1 AVERAGE CLOSE-TO-HIGH AND CLOSE-TO-LOW MOVES FOR UP-VOLUME DAYS This breakdown of the price moves for the different dom- inant up-volume ranges reveals an interesting fact: The average up moves (from the close to the following high) rarely concluded a swing move — that is, there was usually were higher on those days the market made its daily low follow-through movement the next day in the same direction. before its daily high. However, the article also showed the higher the percentage of High (Avg.) Low (Avg.) dominant volume, the smaller the average follow-through move. This makes sense if we consider the market is com- 50-59.99% Up Low first 15.47 -6.22 posed of a relatively stable number of players on a day-to-day High first 4.36 -16.18 basis, and once the majority of traders and investors make 60-69.99% Up Low first 10.70 -4.86 their commitments (reflected by a high level of relative up or High first 7.00 -11.74 down volume), the market will run out of steam and lose 70-79.99% Up Low first 12.53 -4.91 momentum or retrace. High first 4.94 -16.16 Which came first: High or low? 80-89.99% Up Low first 10.20 -6.23 High first 4.28 -10.08 The previous month’s article analyzed the follow-through ques- tion in terms of exiting trades: Does the follow-through implied by a certain relative volume reading provide a good guide for TABLE 2 AVERAGE CLOSE-TO-HIGH AND CLOSE-TO-LOW getting out of a position immediately or staying in for addition- MOVES FOR DOWN-VOLUME DAYS al profits? The average close-to-low moves were generally bigger Other questions still need to be answered: Based on the rela- when the market made its daily high before its daily low. tive volume, can you enter a trade on the close in anticipation of The tendencies in Tables 1 and 2 suggest it may be worth- the average follow-through move (or some percentage of it) to while to consider a pullback strategy that goes long on the occur in the S&P 500 futures contract the following trading ses- follow-through day when price makes an intraday low, or sion? And more importantly, what would be the average risk? goes short when price makes an intraday high. There are two issues to consider here: First, if the market closed with a high percentage of up volume, how often does High (Avg.) Low (Avg.) the S&P reach (the next day) its high before making its low. If 50-59.99% Down Low first 15.57 -5.20 the market established the low first, going long on the previ- High first 4.88 -14.28 ous day’s close might not present such an attractive buying opportunity because you might have to suffer through an 60-69.99% Down Low first 14.82 -5.80 adverse market move before getting a chance to realize a prof- High first 4.38 -15.71 it. The opposite is true for down-volume days: You would pre- 70-79.99% Down Low first 13.87 -4.65 fer the follow-through day to hit its low before its high. High first 5.65 -11.92 Second, if the market does not first reach its high after a 80-89.99% Down Low first 14.24 -5.95 dominant up-volume day or its low after a dominant down- High first 6.85 -14.38 volume day, how much does the market tend to move against the expected trend? This will deter- mine how much risk you must FIGURE 2 60- TO 69.99-PERCENT UP-VOLUME DAYS assume to attain a potential reward. In the 60- to 69.99-percent up-volume group, the percentage of follow-through days Like the previous study, the fol- on which the market made its intraday high before the intraday low increased to 61 lowing analysis of S&P futures data percent. (including the Globex session) groups the data according to the 45 dominant relative volume level for the day in ranges of 50 to 59.99 per- 35 High established first cent, 60 to 69.99 percent, 70 to 79.99 25 percent and 80 to 89.99 percent. Then, for each range, we determine 15 how often the market first makes its 5 high or low on the following day. -5
The results -15 Figure 1 (opposite page) shows the difference between the close and -25 the next day’s high and low for the -35 Low established first 50-59.99 percent up-volume group, sorted by which price was estab- -45 Difference Difference btwn. close and high next or day’s low 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 lished first, the low (on the left) or the high (on the right). Close-to-high move Close-to-low move The up volume was between 50
ACTIVE TRADER • January 2004 • www.activetradermag.com 50 FIGURE 3 70- TO 79.99-PERCENT UP-VOLUME DAYS
The follow-through days were split evenly between those that made the intraday high first and those that made the intraday low first. percent of the time, and a 7.5-percent target was reached only 49 percent of 45 the time. 35 High established first The substantial difference between the 2.5 target (hit 84 percent of the time) 25 and a 5-point target (hit just 57 percent 15 of the time) makes sense in light of information in Table 1: When the high 5 did occur first (21 of the 37 days), the -5 average move was just 4.36 points. Figure 1 shows this as well. The high -15 occurred first on bars 17 through 37. We -25 can see how much smaller the green bars (representing the difference -35 Low established first between the high and the previous -45 day’s close) are in this group. Difference Difference btwn. close and high next or day’s low 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 Table 1 shows if the low occurred Close-to-high move Close-to-low move first, the average difference between the close and the low was -6.22 points, with the worst instance being -15.47 FIGURE 4 80- TO 89.99-PERCENT UP-VOLUME DAYS points (see Figure 1). So, if you were looking to take a 2.5-point profit from a The S&P E-Mini made its intraday high before its low 58 percent of the time, but long position, you had the possibility of those close-to-high follow-through moves were the smallest of any group. having to weather, on average, an adverse move more than twice the size 45 of your desired profit if the high did not occur first. 35 High established first Figures 2 through 8 show compara- 25 ble breakdowns of the remaining dom- 15 inant up-volume and down-volume ranges. Figure 2 (p. 50) reveals the high 5 occurred first 61 percent of the time in -5 the 60- to 69.99-percent up-volume group, a slight improvement over the -15 50- to 59.99-percent group. Also, the -25 difference between the close and the low (regardless of whether the high or -35 Low established first low occurred first) was better than the -45 50- to 59.99-percent group (-4.86 and - 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 Difference Difference btwn. close and high next or day’s low 11.74 vs. -6.22 and -16.18). This implies Close-to-high move Close-to-low move when the market closes with a higher degree of conviction — as indicated by greater relative up volume — the mar- and 59.99 percent on 37 days. The high occurred first on 21 (57 ket performs better the following day. percent) of those days and the low occurred first on the 16 Figure 3 shows the 70- to 79.99-percent up-volume group remaining days. When the high occurred first, the average dif- was split 50 percent between days the high occurred first and ference between the previous close and the high was 4.36 days the low occurred first. Figure 4, the 80- to 89.99-percent points. up-volume group, shows the high occurred first 58 percent of Tables 1 and 2 (p. 50) break down the average differences the time, but the average follow-through for the difference between the highs and the closes and the lows and the closes, between the close and the high was the lowest of the four according to whether the low occurred first or the high groups, implying the market is overbought when the up-vol- occurred first. ume percentage is this extreme.
Entering trades Down-volume days From here, it is easier to gauge the value of entering a trade on Figure 5 shows the 50- to 59.99-percent down-volume group. To the close based on the relative volume. “Following through in consider a short position on the close, we would look for evi- the S&Ps” showed that when the relative up volume was in the dence the low occurs before the high on the following days. 50- to 59.99-percent range, price hit a 2.5-point profit target 84 However the low occurred first only 42 percent of the time. percent of the time the next day; a five-point target was hit 57 (Perhaps this is a “hope springs eternal” phenomenon, in that
51 www.activetradermag.com • January 2004 • ACTIVE TRADER FIGURE 5 50- TO 59.99-PERCENT DOWN-VOLUME DAYS On days following dominant down-volume readings between 50 and 59.99 percent, the market made its intraday low before the intraday high only 42 percent of the the market tends to begin the day trad- time. ing to the upside, even thought the pre- vious day’s activity was slightly more 45 dominated by sellers, but then sets the 35 high for the day and falls back down.) High established first Figure 6, the 60- to 69.99-percent 25 down-volume group, is a little more 15 what you would expect, in that the low occurred first 52 percent of the time. 5 Table 2 shows the largest average drop (-15.71 points) for the down volume -5 group happened when the high was set -15 first in the 60- to 60.99-percent down- volume group. -25 Figure 7 (p. 53), the 70- to 79.99-per- -35 Low established first cent down-volume group, is also split -45 50-50 between the low or the high Difference btwn. close and high next or day’s low 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 being set first. However, if the low is set Close-to-high move Close-to-low move first, this group has the lowest average difference (-4.65 points) between the low and the previous day’s close. Finally, Figure 8 (p. 53), the 80- to FIGURE 6 60- TO 69.99-PERCENT DOWN-VOLUME DAYS 89.99-percent down-volume group, In this down-volume group, the percentage of days on which the low was established shows the low was hit first 66 percent first increased to 52 percent. of the time. This data appears to indi- cate likely follow-through the next day 45 — perhaps panic selling because of the amount of heavy selling the previous 35 High established first day. 25
Going the opposite direction: 15 Pullback possibilities? At this point, the likelihood of follow- 5 through movement in the direction -5 indicated by the dominant volume seems like a coin toss. If you used any- -15 thing but the 2.5-point target, the -25 potential reward was not worth the Low established first risk. -35 But what if you used a more classic -45 pullback approach of buying after the Difference btwn. close and high next or day’s low 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 low occurred first following a domi- Close-to-high move Close-to-low move nant up-volume day, or selling when the high occurred first after a dominant down-volume day, in anticipation of higher prices? up and down volume. Again, they are closely matched. The Figure 9 (p. 53) draws on some of the data from Tables 1 and fourth pair is from the 80- to 89.99-percent group. 2. Here we will look at the data from the perspective of buying Looking at all four pairs, it is interesting that the green bars are a pullback or selling a rally. The first green bar is the average somewhat lower from left to right, supporting the notion that up difference between the close and the high from the 50- to 59.99- volume represents new buying, and that as more commitments percent up-volume group for those days the low was made are made the follow-through the next day tapers off as capital is first. The first red bar is the absolute value of the average dif- spent. However, when the market is falling, the average move- ference between the close and the low for the days the high ment does not taper off in the same fashion because it doesn’t cost occurred first from the 50- to 59.99-percent down-volume anything to get out of a long position. group. The two bars are similar in height. Tables 1 and 2 also reveal something about the typical behav- The second pair of histograms represents the same price ior if the market fails to generate follow-through activity. For measurements from the 60- to 69.99-percent up- and down-vol- example, for the 70- to 79.99-percent up-volume group, the ume groups. Interestingly, the market appears to really drop average move from the close to the following high is 12.53 following a down volume day if the high is made first. points if the low occurs first; if the high occurs first, the average The third pair of histograms is from the 70 to 79.99 percent move from the close to the following day’s low is -16.16 points.
ACTIVE TRADER • January 2004 • www.activetradermag.com 52 FIGURE 7 70- TO 79.99-PERCENT DOWN-VOLUME DAYS Like its up-volume range counterpart, days in the 70- to 79.99-percent down-volume Additional research group were divided equally between days that made the intraday high first and days “Following through in the S&Ps” that made the intraday low first. (Active Trader , December 2003. 45 Past Active Trader articles can be High established first purchased and downloaded 35 directly to your computer 25 through our Web site….
15 This indicates there was a great 5 deal of capital committed the previ- -5 ous day and when the market topped out with little follow- -15 through (an average close-to-high move of just 4.94 points) when the -25 high occurred first, the selling pres- -35 Low established first sure overwhelmed whatever bid was still there. That is, a lot of
Difference Difference btwn. close and high next or day’s low -45 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 traders were easily forced out of Close-to-high move Close-to-low move positions placed the previous day. We see similar results from the 50- to 59.99-percent up-volume FIGURE 8 80- TO 89.99-PERCENT DOWN-VOLUME DAYS group. The kicker is this negative In this group, 66 percent of days established the intraday low first. price action following an up-vol- ume day is worse than that in Table 45 2, which shows the down-volume 35 High established first group statistics and is where we would expect larger numbers. This 25 is why one should never trade on 15 hope, and should always use stops.
5 The ins and outs The studies from this article and its -5 predecessor provide useful infor- -15 mation for trading plans. The first article discussed the potential -25 advantages of holding a position -35 Low established first until the next close rather than the current close if the volume statistics
Difference Difference btwn. close and high next or day’s low -45 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 supported it. The goal was only an additional 2.5 points of profit, like- Close-to-high move Close-to-low move ly to be hit. Here though, a critical compo- FIGURE 9 PULLBACK POSSIBILITIES nent to employing this volume analysis is factoring in the risk depending on whether the high While the green bars are somewhat lower the greater the or low comes first. The best opportunities probably are available percentage of up/down volume, the red bars do not follow a if you use some technical pattern setup or oscillator that can similar pattern. This supports the theory that buying tapers indicate there is a good probability the low or high for the ses- off as capital is spent, but selling remains constant because sion is occurring. This could then be acted upon in the context it doesn’t cost anything to get out of a long position. of the expected move derived from the dominant volume statis- 18.00 tics. 16.00 In addition, this work could be done in the framework of the 14.00 overall trend. For example, if the trend was up (based on just a 12.00 simple moving average), the previous day’s up volume was 62 10.00 percent of the total volume and the market was down on the day, 8.00 then look for an indication the low for the day is being established. 6.00 You likely have a very good risk-reward trade opportunity. 4.00 Finally, if the market fails to follow through in the anticipat- 2.00 ed direction and the high or low that occurs first is counter to 0.00 the anticipated direction (and is near the average values in
Avg. diff. Avg. btwn.close and high or low 50-59.99% 60-69.99% 70-79.99% 80-89.99% Tables 1 and 2), there is greater potential for a move in the C-H (when low C-L (when high opposite direction than a move in the expected direction. Ý occurs first) occurs first)
53 www.activetradermag.com • January 2004 • ACTIVE TRADER FUTURES& OPTIONS Trading Strategies
Follow-through in the E-MINI NASDAQ 100
Analyzing volume reveals small, but important, tendencies that can improve short-term trading performance.
FIGURE 1 ANALYSIS PERIOD BY THOM HARTLE The analysis period, which spanned 314 trading days, was dominated by an uptrend. E-mini Nasdaq 100 (NQ), daily 1,550
1,500 raders can gain insight into 1,450 the trend of the market by comparing the number of 1,400 stocks up on the day to those down on the day, a statistic called 1,350 breadth T. This kind of measurement is 1,300 sometimes referred to as a market 1,250 “internal” because it provides a perspec- tive on market dynamics not immedi- 1,200 ately apparent in “external” price action. 1,150 If many more stocks are up than down by the close, it implies demand for stocks 1,100 was strong that day. On the other hand, 1,050 if more stocks close lower on the day, it suggests sellers dominated trading and 1,000 the near-term outlook is negative. The 950 running total of the difference between the number of stocks trading higher and January 2003 April July October January 2004 those trading lower is the basis for the Source: CQG, Inc. advance-decline (A/D) line.
54 www.activetradermag.com • August 2004 • ACTIVE TRADER FIGURE 2 UP VOLUME: 50-59.99 PERCENT Of the days with up volume between 50 and 59.99 percent, only one was fol- lowed by a day that failed to trade above the closing price.
60
50
40
30
20
This statistic can be augmented with 10 the volume of stocks trading higher and lower, referred to as the advancing vol- 0 ume and declining volume. The logic of Follow-through price moves (points) -10 1 4 7
combining the number of stocks trading 10 13 16 19 22 25 28 31 34 37 higher or lower and the volume of those Trading session stocks is simple: A stock up 1 point on Source: Excel; data — eSignal volume of 100 million shares is making a stronger statement about the demand- FIGURE 3 UP VOLUME: 60-69.99 PERCENT supply situation than if it was up 1 point on only 10 million shares. The average follow-through move after days with up volume between 60 and The goal is to translate this logic into 69.99 percent was 15.46 points. tradable procedures. If there was a sign of strong demand yesterday, does that indicate anything for today, such as how 60 high the market might move relative to 50 yesterday’s close? Or, if the sellers dom- inated yesterday, how far might the 40 market fall today below yesterday’s close? 30 Using the end-of-day Nasdaq up-vol- ume and down-volume statistics, we 20 will calculate which was dominant (i.e., greater than 50 percent) — the ratio of 10 up volume/(up + down volume) or the 0 ratio of down volume/(up + down vol- ume). For example, on March 31, 2004, Follow-through price moves (points)
-10 1 4 7 the up volume was 669,250,000 shares 10 13 16 19 22 25 28 31 34 37 40 43 46 49 and the down volume was 1,112,473,000 Trading session shares. Because the down volume was Source: Excel; data — eSignal larger, the calculation is 1,112,473,000/ (669,250,000 +1,112,473,000) = 62.44 per- FIGURE 4 UP VOLUME: 70-79.99 PERCENT cent of the total up and down volume Each day following a 70- to 79.99-percent up-volume day traded above the (the volume of stocks unchanged on the previous closing price. day is not included). To see what kind of follow-through occurs in the market on days with dom- 60 inant volume, measure the difference between the closing price of the E-mini 50 Nasdaq 100 futures (NQ), including the night session, and the next day’s high. 40 For days down volume dominated, cal- culate the difference between the close 30 and the following day’s low. Next, group the volume-ratio read- 20 ings into percentile ranges and then sort the follow-through price action in each 10 group from lowest to the highest. For example, the groupings for dominant up Follow-through price moves (points) 0 1 4 7 volume and dominant down volume 10 13 16 19 22 25 28 31 34 37 40 43 46 49 used here will be 50-59.99 percent, 60- Trading session Source: Excel; data — eSignal
ACTIVE TRADER • August 2004 • www.activetradermag.com 55 FUTURES& OPTIONS Trading Strategies continued
FIGURE 5 UP VOLUME: 80-89.99 PERCENT
Each day following the days in this group traded above the previous day’s Figure 4 (p. 55) is the 70- to 79.99-per- close, but the moves were smaller than those in the other groups. cent group. The market traded above the previous close in every instance in this group, with an average follow-through 60 move of 12.86 points. The market moved at least 7 points above the previous day’s 50 close 70 percent of the time. However, although Figure 4 includes an “outlier” 40 (an extremely high or low value) gain of 48 points, it has only one other reading 30 larger than 30 points. The 60-69.99 group in Figure 3 shows a more consistent 20 upward bias, which is also reflected by its higher average reading. 10 The 80- to 89.99-percent follow-
Follow-through Follow-through price moves (points) through readings are shown in Figure 5. 0 In this group of 29 occurrences the aver- 1 3 5 9 11 13 15 17 19 21 23 25 27 29 age move was 11.14 points and the mar- Trading session ket moved 5.50 points or more 70 per- Source: Excel; data — eSignal cent of the time. Overall, the market followed through FIGURE 6 DOWN VOLUME: 50-59.99 PERCENT the next day (to some degree) the vast When down volume was between 50 and 59.99 percent, the market followed majority of the time when up volume through to the downside an average of 14.77 points. dominated the day’s activity. The market failed to trade above the previous close only four of 173 observations. 10 The instances with the highest domi- nant up-volume readings — i.e., the 0 over-70-percent and the over-80-percent groups — had less follow-through the -10 next day compared to the days the read- ings fell between 50 percent and 69.99 -20 percent. Although this might seem counterin- -30 tuitive, it supports the notion that there’s nobody left to buy following the kind of -40 good news that results in extremely high up-volume readings. Buyers do not have Follow-through Follow-through price moves (points) -50 an unlimited supply of capital to hold 1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 long positions in the markets. However, Trading session this does not indicate the market is about Source: Excel; data — eSignal to make a major reversal, as the analysis only looks at the next day’s price activi- 69.99 percent, 70-79.99 percent and 80- readings. Figure 2 shows there were 38 ty. 89.99 percent. sessions with up volume between 50 and Follow-through was greatest in the The analysis period for this study was 59.99 percent; only one of the days fol- 50- to 59.99-percent group. This implies Jan. 2, 2003, to March 31, 2004, a total of lowing these days failed to trade above that even though up volume was domi- 314 trading sessions (see Figure 1). the previous day’s close. The average nant, the market is closing with a rela- During this period the market was, for follow-through move for the days that tively mixed commitment of buyers and the most part, dominated by an uptrend traded above the close was 20.58 points, sellers. But when trader opinion is — a bias reflected in the analysis by a and the market moved 8.50 points or mixed, a trend emerges as participants total of 173 days with dominant up vol- more 70 percent of the time. adjust to create a more uniform market ume vs. 141 days with dominant down Figure 3 shows the 60- to 69.99-percent — either buyers or sellers conclude they volume. group, which contained 51 trading ses- were wrong and must exit the market or sions. The following day the market trad- switch direction. When there are more When up volume dominates ed above the close 48 times, with an aver- potential buyers still on the sidelines, the Figures 2 through 5 show the follow- age move of 15.46 points. Seventy percent resulting move will be larger when they through price moves in the E-mini of the time the market moved at least 7 eventually enter the market. Nasdaq 100 after dominant up-volume points above the previous day’s close.
56 www.activetradermag.com • August 2004 • ACTIVE TRADER FIGURE 7 DOWN VOLUME: 60-69.99 PERCENT The average downside follow-through move in this group was 13.92 points, slightly smaller than the 50- to 59.99-percent group.
10 When down-volume dominates Figures 6 through 9 show the break- 0 down of days dominated by down vol- ume. Figure 6 shows the 50- to 59.99- -10 percent down-volume group. Of 44 days, only two never traded below the -20 close the following day. The most extreme drop was a decline of 44 points, -30 and the average was 14.77 points. Seventy percent of the declines were 5 or -40 more points. Figure 7 shows the 60- to 69.99-per- Follow-through price moves (points) -50 1 3 5 7 9 cent group. Thirty-two of 34 sessions 11 13 15 17 19 21 23 25 27 29 31 33 traded below the close and one fell Trading session exactly to the close. The average drop Source: Excel; data — eSignal was 13.92 points and 70 percent of the declines were 5.50 or more points. FIGURE 8 DOWN VOLUME: 70-79.99 PERCENT Figure 8 is the 70- to 79.99-percent Each day in this group traded below the previous close, and the average group. There were 36 sessions, and the downside move was 14.75 points. market fell below the close the following day in every instance. The average decline was 14.75 points and the market 0 fell 6.50 points 70 percent of the time. The 80- to 89.99-percent group is -10 shown in Figure 9. There were 23 occur- rences and, like the 70- to 79.99-percent group, the market always followed -20 through the next day. The average drop was 11 points, and the market declined -30 by 6 points or more 70 percent of the time. -40 Up vs. down Follow-through Follow-through price moves (points) Table 1 (p. 58) summarizes the data -50 1 3 5 7 9 we’ve reviewed so far and allows us to 11 13 15 17 19 21 23 25 27 29 31 33 35 make some comparisons. As mentioned, Trading session the average follow-through buying the Source: Excel; data — eSignal day after dominant up-volume readings declines as the up-volume percentage FIGURE 9 DOWN VOLUME: 80-89.99 PERCENT rises — a sign the market runs out of buyers. The average downside follow-through move in this group was 11 points — the By comparison, the average follow- smallest of any of the down-volume groups. through decline after dominant down- volume days is rather stable between 0 groups — a difference of less than a point between the first three percentile groups. This indicates much of the sell- -10 ing is liquidation — that is, traders get- ting out of long trades. The fact is, the -20 cost of getting out of a position is mini- mal compared to the cost of establishing a position. -30 One way to explain this is that as the market moves higher, there needs to be -40 ongoing reasons for traders and
investors to continue to put on new long Follow-through price moves (points) -50 positions. Without more good news, the 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 market can run out of buyers. However, Trading session when prices are falling, lower prices Source: Excel; data — eSignal
ACTIVE TRADER • August 2004 • www.activetradermag.com 57 FUTURES& OPTIONS Trading Strategies continued
TABLE 1 DOMINANT UP-VOLUME DAYS VS. DOMINANT DOWN-VOLUME DAYS The size of the follow-through moves decreases as the percentage of the themselves can cause traders to cover dominant up volume increases. short positions — no additional bad news is needed. Up 50-59.99% 60-69.99% 70-79.99% 80-89.99% In addition to the average follow- Average 20.58 15.46 12.86 11.14 through move for each volume-ratio Median 18.00 12.75 12.00 9.00 group, Table 1 includes the median fol- low-through move. The median is the middle value in a data set and is less Down 50-59.99% 60-69.99% 70-79.99% 80-89.99% susceptible than the average to influ- Average -14.77 -13.92 -14.75 -11.00 ence from a handful of outlier values. That the average moves are larger than Median -11.50 -13.50 -11.00 -10.50 the median moves for each group Source: Excel; data — eSignal implies there are outliers skewing the averages higher, as evidenced by the final (largest) readings in Figures 2 TABLE 2 DOMINANT UP-VOLUME DAYS VS. DOMINANT DOWN-VOLUME DAYS, through 9, which tend to be much big- E-MINI S&P 500 ger than the rest of the moves on each chart. These are the comparable statistics from a previous study of NYSE volume The 50- to 59.99-percent up-volume and the E-mini S&P 500 futures. group had the largest average move Up 50-59.99% 60-69.99% 70-79.99% 80-89.99% (up or down) — more than 20 points. The next largest was the 15.46-point Average 9.16 8.44 8.74 6.79 average move from the 60- to 69.99- Median 6.00 7.38 8.50 6.00 percent up-volume group — a 25-per- cent drop from the 50- to 59.99-percent group. The 50- to 59.99-percent down- Down 50-59.99% 60-69.99% 70-79.99% 80-89.99% volume group declined only 14.77 Average -10.42 -10.23 -8.28 -8.85 points on average. It seems that when a market is con- Median -8.25 -11.13 -5.63 -10.50 solidating (as indicated by the up vol- Source: Excel; data — eSignal ume in the 50- to 59.99-percent range), there is a propensity for the market to move more to the upside — something FIGURE 10 90-PERCENT OR HIGHER VOLUME DAYS that might be affected by the uptrend that dominated the observation peri- There were only four days of either dominant up volume or down volume od. There were only 38 sessions in the greater than 90 percent. 50- to 59.99-percent category, while there were 102 sessions in the two 60- Dominant up volume Dominant down volume 79.99 percentile groups. The high num- 16.00 0.00 ber of observations (nearly a third of the total) from these two combined 14.00 -2.00 groups also is likely a result of the uptrend. 12.00 -4.00 For comparison, Table 2 shows sta- tistics from the “Following through in 10.00 -6.00 Active Trader the S&Ps” ( , December 8.00 -8.00 2003, p. 60), which discussed a similar study using the E-mini S&P 500 6.00 -10.00 futures contract and NYSE volume sta- 4.00 -12.00 tistics from Aug. 20, 2002 to Aug. 27, 2003. 2.00 -14.00 For the first three groups of domi- Follow-through Follow-through price moves (points) Follow-through Follow-through price moves (points) nant up- and down-volume groups — 0.00 -16.00 91.32% 91.70% 92.32% 94.32% 90.28% 90.77% 91.11% 91.53% 50-59.99 percent, 60-69.99 percent, 70- 79.99 percent — the number of occur- rences (not shown in the table) was Source: Excel; data — eSignal fairly close, ranging from a high of 37
58 www.activetradermag.com • August 2004 • ACTIVE TRADER to a low of 34 for the up-volume groups After a day with dominant down vol- and 33 to 27 occurrences for the down- Trading implications ume, traders do not need to change their volume groups. One important aspect of this study is up expectations based on the readings in The biggest difference between Tables markets trade differently than down the first three percentage-range groups 1 and 2 is that both of the 50-59.99 per- markets. Although it is impossible to because market participants are likely cent and 60-69.99 percent down-volume review the thoughts of market partici- liquidating existing positions. Although groups had the largest average price pants, it is plausible that markets move we don’t know to what degree the sell- moves in Table 2, while the 50- to 59.99- higher because traders place their bets ing is new short positions, it appears percent and 60- to 69.99-percent up-vol- on the long side (not necessarily day once a decline is underway, traders con- ume groups had the largest average trades), and the range of outcomes can tinue to liquidate positions as price falls price moves in Table 1. vary depending on the number of total — again, because there are no limita- This difference is most likely tied to players. But once a trader has placed a tions, such as required capital, to stop the stronger uptrend in the Table 1 long-side bet, that’s it. This could be why them from selling. review period compared to the mixed the average follow-through moves Most novice traders approach the market environment that existed during decline as the percentage of up volume markets as if there is some rigid process the Table 2 analysis period. Plus, using increases. that should work in all situations. the Nasdaq market, which contains The implications are twofold. First, However, trading can be compared to more technology and growth stocks than during the trading day volume ratios other endeavors in which changing con- the S&P 500 index, will attract more cap- can be observed on a live basis and high ditions dictate the appropriate steps to ital during favorable market conditions values imply solid momentum through- take. Sailors, for example, never assume because traders and investors are more out the day. For the next day, however, weather will stay the same. Just because comfortable with the risk associated day traders should consider lowering the sky is blue now, they still keep a with growth stocks. their expectations if the previous day’s lookout on the horizon for a potential Figure 10 shows the somewhat rare volume ratio was high. change in conditions. For traders, quan- occurrence of days when the up or down On the other hand, if the previous tifying conditions such as the typical volume level is 90 percent or greater. day’s up-volume ratio was in the 50- to market behavior following different vol- This only occurred four times each for 59.99-percent area, traders can raise their ume-ratio levels is a way to gauge the dominant up-volume and down-volume expectations for the current day, espe- weather of the market. After that, you days. Unfortunately, four observations cially if the news is good (unless of can develop procedures toÝ make the are not enough to draw any meaningful course the market has already made a most of different conditions. conclusions about market tendencies. significant move — i.e., greater than the average move for that group).
ACTIVE TRADER • August 2004 • www.activetradermag.com 59 TRADING Strategies
Up-down volume and NEXT-DAY FOLLOW-THROUGH What kind of trading is likely to occur today? Yesterday’s balance of up volume and down volume — and whether the market puts in the high or low of the day first — provides guidance in the Nasdaq 100.
BY THOM HARTLE FIGURE 1 STUDY PERIOD The study spanned Aug. 1, 2003, through Aug. 2, 2004 — a period that contained a great deal of sideways price action on the daily time frame.
n the stock market, traders look- E-mini Nasdaq 100 futures(NQ), daily ing for clues regarding today’s 1,550 probable direction sometimes look to yesterday’s price movement: Was the range particularly large or small? 1,500 DidI the market close strongly up or down? 1,450 Price is not the only factor to weigh. A day’s trading volume can provide addi- tional insight regarding subsequent mar- 1,400 ket action. But more than just the volume level (whether total volume is relatively high or low), the balance of up volume 1,350 (those stocks trading above their previ- ous closes) and down volume (those trading below their previous closes) can 1,300 be associated with certain next-day price patterns. “Follow-through in the E-mini Active Trader Nasdaq 100” ( , August 2004) 1,250 showed the results of this kind of analy- sis over a 314-day study period. The following study breaks down the 1,200 Nasdaq volume statistics in a slightly dif- Aug. Sept. Oct. Nov. Dec. 2004 Feb. Mar. Apr. May June July ferent way to forecast likely next-day price action in the E-mini Nasdaq futures Source: CQGNet (NQ). The analysis has three components: whether yesterday’s overall volume was dominated by up or of the day or the low of the day first. down volume; the distances between yesterday’s close and Before looking at the data, let’s walk through the basic defi- today’s high and low; and whether the market makes the high nitions and how the study was conducted.
60 www.activetradermag.com • December 2004 • ACTIVE TRADER FIGURE 2 LOW OR HIGH: WHICH OCCURRED FIRST? For the trading session starting July 30, 2004, the up-volume ratio was 65.79 percent. The next trading session began Sunday afternoon, Aug. 1, and ended Monday, Aug. 2. The session’s low (-15 points from the previous close) occurred first and the high (8 points from the previous close) occurred second.
E-mini Nasdaq 100 futures (NQ), 60-minute Nasdaq up and down volume High occurred second The study spanned Aug. 1, 2003, through Aug. 2, 2004, 1,410 (see Figure 1) and included the entire 24-hour Globex trading session for each day of the E-mini Nasdaq 100 futures. 1,405 First, the end-of-day Nasdaq up-volume and down- volume readings were translated into up-volume and 1,400 down-volume ratios that show what percentage of total volume is comprised of either up-volume or down-vol- ume. If the up volume was greater than the down vol- 1,395 ume, the day’s volume ratio was the up volume divided by the sum of up volume and down volume; if down volume was greater, the volume ratio was the down vol- 1,390 ume divided by the sum of up volume and down vol- Low occurred first ume. 75,000 For example, on July 30, 2004, the Nasdaq up volume 50,000 was 993,395,904 shares and the down volume was 25,000 516,633,600 shares. Because the up volume dominated August the day, the up-volume ratio is 993,395,904/(993,395,904 + 516,633,600) = .6579, or 65.79 percent. The next trading 30-8:30 1-15:30 21:30 3:30 2-8:30 session began Sunday afternoon, Aug. 1, and ended Source: CQGNet Monday, Aug. 2 (see Figure 2). The session’s low (-15 points from the previous close) occurred first and the high to the following low or high was determined. Tables 1 and 2 occurred second (8 points from the previous close). summarize these numbers for up-volume and down-volume The data was first grouped by dominant up volume or down days, respectively. volume in the following ranges: 50-59.99 percent, 60-69.99 per- For example, when dominant up volume was in the 60- cent, 70-79.99 percent, 80-89.99 percent and 90 percent or above. 69.99-percent range and the low occurred first the following Then the data was sorted by whether the low or high occurred day, the average difference between the close and the next first the following day. Finally, the average move from the close day’s low was -10.34 points and the difference between the
TABLE 1 DOMINANT UP-VOLUME DAYS: TABLE 2 DOMINANT DOWN-VOLUME DAYS: NEXT-DAY PERFORMANCE NEXT-DAY PERFORMANCE The more up-volume-dominated trading one day, the When down volume dominated trading, the average close- smaller the upside follow-through move the next day. to-low moves were fairly stable across the different per- Also, when the high occurred first the next day, the aver- centage ranges, regardless if the high or low came first. age difference between the close and the next day’s low The weaker the market, the stronger the counter-reaction was twice the difference as when the low occurred first. the next day before the market resumes the down move.
Up-volume Next day Avg. Avg. Down- Next day Avg. Avg. percentage close-to-high close-to-low volume close-to-high close-to-low move move percentage move move 50-59.99% Low occurs first 21.55 -7.32 50-59.99% Low occurs first 20.08 -7.72 High occurs first 7.20 -18.57 High occurs first 7.47 -20.62 60-69.99% Low occurs first 17.81 -10.34 60-69.99% Low occurs first 19.27 -6.77 High occurs first 9.43 -21.50 High occurs first 8.00 -17.53 70-79.99% Low occurs first 16.70 -8.86 70-79.99% Low occurs first 19.00 -7.85 High occurs first 10.06 -17.56 High occurs first 9.08 -21.04 80-89.99% Low occurs first 10.36 -8.21 80-89.99% Low occurs first 17.23 -6.47 High occurs first 6.86 -18.93 High occurs first 9.15 -21.05
Source: Data - eSignal Source: Data - eSignal
ACTIVE TRADER • December 2004 • www.activetradermag.com 61 FIGURE 3 UP VOLUME: 50-59.99 PERCENT Positive values show the difference between the close (represented by the zero value) and the next day’s high, while negative values show the differ- ence between the close and the next day’s low. cent — which signifies good demand — does the market tend to follow through 60.00 to the upside on this seemingly high level of optimism? Or does the market 50.00 fail to follow through because the capital High established first 40.00 available for buying has been exhausted? Finally, if there are observable tenden- 30.00 cies, what trading strategies can be 20.00 devised to take advantage of these situ- ations? 10.00 When up volume is dominant 0 Figures 3 through 6 summarize the per- Gains/losses -10.00 formance for the different dominant up- -20.00 volume ranges. The vertical lines at the approximate midpoints of these figures -30.00 separate instances when the low Low established first -40.00 occurred first the next day (left side) vs.
1 3 5 7 9 when the high occurred first the next 11 13 15 17 19 21 23 25 27 29 31 33 day (right side). Observations Figure 3 shows the results for the 34 days in 50-59.99-percent up-volume Source: Data - eSignal; charts - Excel range. The low occurred first 19 times and the high occurred first 15 times. close and the next day’s high was 17.81 be tied to the previous day’s volume Positive values show the difference points. ratio and whether the high or low occurs between the close (represented by the The point of this analysis is to see if first. For example, if the market closes zero line) and the next day’s high, while there are any market tendencies that can one day with up volume above 80 per- negative values show the difference between the close and the next day’s FIGURE 4 UP VOLUME: 60-69.99 PERCENT low. Table 1 shows when the low occurred Like the 50- to 59.99-percent group, the low occurred first slightly more first in the 50-59.99-percent group the often (16 of 30 times) than the high, but the average close-to-high move was average difference between the close and smaller. the next day’s low was -7.32 points, while the average difference between the 60.00 close and the next day’s high was 21.55 points. (This is reflected in Figure 3 in High established first that to the left of the vertical line, the 40.00 negative values are not as negative as they are to the right of the vertical line, 20.00 and positive values on the left are larger than the ones on the right.) If the high occurred first, the average move from 0 the close to the high was 7.20 points, and the average move from the close to the Gains/losses -20.00 next day’s low was -18.57 points. Low established first Figure 4 shows the 60-69.99-percent dominant up-volume group. Like the 50- -40.00 59.99-percent group, the low occurred first slightly more often (16 of 30 times) -60.00 than the high. Table 1 shows the average 1 3 5 7 9
11 13 15 17 19 21 23 25 27 29 difference between the close and the next day’s low for this group was -10.34 Observations points — a larger move than the corre- sponding figure for the 50-59.99-percent Source: Data - eSignal; charts - Excel up-volume group.
62 www.activetradermag.com • December 2004 • ACTIVE TRADER FIGURE 5 UP VOLUME: 70-79.99 PERCENT The low occurred first less than 50 percent of the time (22 of 46 instances), The difference between the close and and when it did, the average move from the close to the following high con- the next day’s high was 17.81 points, tracted slightly to 16.70 points. down from the 21.55 points in the 50- 59.99-percent group. When the high 60.00 occurred first, the average move from the close to the next day’s high was 9.43 High established first points, up slightly from the 50-59.99-per- 40.00 cent up-volume group. The average move to the next day’s low increased to 20.00 -21.50. Figure 5 shows the 70-79.99-percent group. The low occurred first less than 0 50 percent of the time (22 of 46
instances). Referring to Table 1, when the Gains/losses -20.00 low occurred first, the average move from the close to the following high con- Low established first tracted slightly to 16.70 points and the -40.00 average move from the close to the fol- lowing low was -8.86 points. -60.00
Figure 6 is the 80-89.99-percent group. 1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 The low occurred first just seven of 21 Observations times. When the low occurred first the average difference between the close and Source: Data - eSignal; charts - Excel the next day’s high was 10.36 points. The average difference between the close and the next day’s low was -8.21 points. FIGURE 6 UP VOLUME: 80-89.99 PERCENT The up-volume ratio exceeded 90 per- cent only one time (not shown); the next The low occurred first just seven of 21 times in this group and the average day’s high was 9.50 points above the difference between the close and the next day’s high was only 10.36 points. close and the low was -6 points below it.
What do the numbers mean? 20.00 A clear pattern emerges from these sta- High established first tistics: As the up-volume percentage 10.00 climbs, the average difference between the close and the next day’s high drops, 0 suggesting that as more capital is com- mitted to buying, there is less available -10.00 the next day to continue to push the market higher. -20.00 Another interesting point from Table 1 Low established first Gains/losses is when the high occurs first, the average -30.00 difference between the close and the next day’s low is twice the difference -40.00 when the low occurs first. Apparently, when price reverses the previous day’s -50.00
trend, market psychology shifts gears 1 2 3 4 5 6 7 8 9 dramatically. 10 11 12 13 14 15 16 17 18 19 20 21 Now let’s see what characteristics Observations emerge after days dominated by down volume. Source: Data - eSignal; charts - Excel
When down volume is dominant According to Table 2, when the low tance to the next day’s high was 20.08 Figure 7 (p. 64) shows the 35 occurrences occurred first, the average difference points. In comparison, when the high in the 50-59.99-percent down-volume between the close and the next day’s low occurred first, the average difference group. The low occurred first 18 times. was -7.72 points, while the average dis- between the close and the next day’s
ACTIVE TRADER • December 2004 • www.activetradermag.com 63 FIGURE 7 DOWN VOLUME: 50-59.99 PERCENT average low was -17.53 points, which is The low occurred first 18 of 35 times in the 50- to 59.99-percent down-vol- a smaller move than the average differ- ume group. ence (-20.62 points) between the close and the next day’s low in the 50-59.99- 50.00 percent down-volume group. Figure 9 (p. 65) is the 70-79.99-percent 40.00 down-volume group. There were 29 30.00 occurrences; 17 times the low occurred High established first first, and 12 times the high occurred first. 20.00 If the high occurred first, the average dif- 10.00 ference between the close and the next 0 day’s high was 9.08 points, but the aver- age difference between the close and the -10.00 next day’s low expanded to -21.04 Gains/losses -20.00 points. Figure 10 (p. 65) shows the 24 times -30.00 down volume was in the 80-89.99-per- Low established first -40.00 cent group. The low occurred first 14 times. If the high occurred first, the aver- -50.00 age difference between the close and the 1 3 5 7 9
11 13 15 17 19 21 23 25 27 29 31 33 35 next day’s low was -21.05 points, which Observations is the second largest move of this type from the down-volume groups. Source: Data - eSignal; charts - Excel The down-volume ratio exceeded 90 percent three times (not shown). The low occurred first two times, and the subse- FIGURE 8 DOWN VOLUME: 60-69.99 PERCENT quent highs were 25.50 and 9.50 points above the close, while the lows were -4 Of the 15 times the high occurred first, the average difference between the and -5 points below the close. The one close and the next day’s low was -17.53 points, which is a smaller move than time the high occurred first, the high the figure (-20.62 points) from the 50-59.99 percent down-volume group. was 13.50 points above the close and the low was -12 points below it. 50.00 Moderate volume dominance is 40.00 key High established first 30.00 Although many people tend to expect upside follow-through after a strong up- 20.00 volume day (and the opposite after a strong down-volume day), it appears 10.00 the market is more likely to follow 0 through when volume in a particular direction is more moderate. -10.00 This study revealed the largest moves
Gains/losses -20.00 took place in the direction of the trend when the low occurred first after a day -30.00 with dominant up-volume between 50 Low established first and 59.99 percent. As the up volume -40.00 percentage climbed, the average close- 1 3 5 7 9
11 13 15 17 19 21 23 25 27 to-high move shrank — 21.55, 17.81, Observations 16.70 and 10.36 points, respectively, for four percentage ranges. This indicates Source: Data - eSignal; charts - Excel the more money committed to the mar- ket one day, the less there is available for high was 7.47 points and the average the 60-69.99-percent down-volume it the next day and the less follow- difference between the close and the group. Of the 15 times the high occurred through price movement is likely to next day’s low was -20.62 points. first, the average difference between the occur. Figure 8 shows the 28 occurrences of close and the high was 8 points and the When down volume dominates, the
64 www.activetradermag.com • December 2004 • ACTIVE TRADER FIGURE 9 DOWN VOLUME: 70-79.99 PERCENT Of the 29 occurrences the low occurred first 17 times. If the high occurred first, the average difference between the close and the next day’s low was -21.04 points. If the high occurred first, the average 40.00 close-to-high move climbed as the down-volume percentage increased: 30.00 7.47, 8.00, 9.08 and 9.15. This suggests High established first 20.00 the weaker the market is one day, the stronger the upside counter-reaction is 10.00 the next day before the market resumes its down move. 0 Monitoring volume -10.00 First, pay attention to days when domi-
Gains/losses -20.00 nant up volume is in the 50-59.99-per- cent range, because those days tended to -30.00 precede nice uptrends the next day. Low established first -40.00 Also, as the dominant volume per- centage increases, the average close-to- -50.00 high move trails off even when the low 1 3 5 7 9
11 13 15 17 19 21 23 25 27 29 occurs first. This means the exuberance of high up-volume readings is some- Observations thing traders should use to take profits, Source: Data - eSignal; charts - Excel rather than add to their positions. Finally, if you’re uncomfortable with short selling, you won’t be able to take FIGURE 10 DOWN VOLUME: 80-89.99 PERCENT advantage of the fact that down-volume When the high occurred first, the average difference between the close and groups in general show a tendency to the next day’s low was -21.05 points — the second largest move of this type have goodÝ follow-through action the from all the down-volume groups. next day.
40.00
30.00 High established first 20.00 Additional Active 10.00 Trader reading 0 "Follow-through in the E-mini Nasdaq 100" by Thom Hartle , August 2004, p. 52
Gains/losses -10.00 "Nasdaq 100 volume and the QQQ" -20.00 by Thom Hartle , July 2004, p. 46 Low established first -30.00 "Getting in on follow-through days" by Thom Hartle , January 2004, p. 36 -40.00
1 3 5 7 9 "Following through in the S&Ps" 11 13 15 17 19 21 23 by Thom Hartle , December 2003, Observations p. 34 Source: Data - eSignal; charts - Excel You can purchase past articles online at (www.activetradermag. com/pur- tendencies are very different. First, the were -7.72, -6.77, -7.85 and -6.47 points, chase_articles.htm) and download average close-to-low move was relative- respectively. If the high occurred first, them to your computer . ly stable, regardless of whether the high the average close-to-low moves were or low occurred first. If the low came -20.62, -17.53, -21.04 points and -21.05 first, the average close-to-low moves points.
65 www.activetradermag.com • December 2004 • ACTIVE TRADER TRADING Strategies
E-MINI MORNING REVERSAL and afternoon breakout patterns Two simple ideas provide the basis for an intraday trading approach. System analysis sheds light on how the strategies perform and what you can do to get the most out of them.
BY GOMU VETRIVEL
he “mini” stock index exceeds the previous day’s high or low (8:30-9 a.m. CT), place a sell-stop order futures are popular intra- in early trading and then reverses. at yesterday’s high or the low of the first day markets with individ- Short Entry: If the market exceeds yes- 30-minute bar, whichever is lower. ual traders because of their terday’s high during the first 30 minutes Long Entry: If the market exceeds yes- high liquidity and smaller contract sizes. of trading of the regular trading session terday’s low during the first 30 minutes TThe following day-trading techniques were tested on the E-Mini Nasdaq 100 (NQ), E-Mini S&P 500 (ES), and E-Mini FIGURE 1 REVERSAL PATTERN Russell 2000 (ER2) futures contracts. The first morning reversal pattern was stopped out with a small loss when Morning reversals, afternoon the market made a new high for the day. The second reversal pattern was breakouts exited at the end of the day for a profit. The first intraday strategy is based on a reversal pattern and is executed in the first hour of trading. The logic is that the market often makes a big move in one direction in the first 30 minutes of the regular trading session but is unable to sustain it. This attempts to capitalize on any reversal that may develop. The second strategy uses a breakout pattern that is traded in the afternoon and is used in two situations. First, if a reversal signal doesn’t occur in the morning because the price action is one sided (up or down), the system will try to capture the existing daily trend by entering it in the afternoon. Alternately, if the market trades in a narrow range in the morning, the system will try to cap- ture an explosive move out of that range in the afternoon. Both strategies are based on 30-minute price bars.
Reversal pattern entry rules In reversal mode, trades are taken only between 9 and 9:30 a.m. CT. The strategy Source: TradeStation triggers a trade when the market
66 www.activetradermag.com • January 2006 • ACTIVE TRADER FIGURE 2 BREAKOUT PATTERN Because a reversal signal did not occur in the morning, a breakout of the day’s range is initiated at 1 p.m. CT. Here, a short trade was triggered and exited at 3 System code p.m. for a profit. The following TradeStation EasyLanguage code for the morning rever- sal/afternoon breakout strategy can be copied from www.activetrader- mag.com/code.htm. Programming code for other software platforms can be found there as well.
[LegacyColorValue = true];
var:x(0);
if entriestoday(d)<1 then begin if t>830 and t<930 then begin if highd(0)>highd(1) then Sell Short Next Bar at minlist(highd(1), l) stop; if lowd(0) if t>=1300 and t<1430 then begin Buy Next Bar at maxlist(h,highd(0)) stop; Sell Short Next Bar at minlist(l,lowd(0)) stop; end; end; Sell Next Bar at lowd(0) stop; Buy to Cover Next Bar at highd(0) stop; if t=1500 then begin Sell This Bar at c; Buy to Cover This Bar at c; end; of the regular trading session, place a end-of-day exit. buy-stop order at yesterday’s low or the high of the first 30-minute bar, whichev- Short stop-loss exit: If short, er is higher. place a buy stop-loss at the day’s high. Breakout pattern entry rules Source: TradeStation In breakout mode, trades are taken only Long stop-loss exit: If long, place between 1 to 2:30 p.m. CT and only if a a sell stop-loss at the day’s low. lower than the previous day’s high of reversal pattern has not triggered in the 678.30, a sell-stop order is placed at morning. The strategy triggers a trade All open trades are closed 3 p.m. CT. 677.30. This order was triggered during when the market pushes to a new daily the second 30-minute bar. The market high or low after 1 p.m. Only one trade is taken per day to then turned to the upside and the trade Short Entry : At 1 p.m., place a sell-stop minimize transaction costs, which sabo- was exited four bars later at 680.60 when order at the day’s low. A short position is tages many short-term trading strate- the market made a new high for the day taken if the market breaks the day’s low gies. No positions are carried overnight. — a loss of $330 per contract. any time between 1 and 2:30 p.m. The next day, July 29, a short trade Long Entry: At 1 p.m. place a buy-stop Trade examples was triggered at 684.20 when the market order at the day’s high. A long position On July 28, 2005, the high of the first 30- traded above the July 28 high on the first is taken if the market breaks the day’s minute bar in the E-Mini Russell 2000 30-minute bar and then reversed to trade high any time between 1 and 2:30 p.m. futures exceeded the previous day’s below the low of this bar. This time the high of 678.30, which established the reversal held and the position was exited Exits conditions for a short trade (Figure 1). at 3 p.m. at 681.30 for a profit of $290 per There are two types of exit rules used for Because the low of the first 30-minute contract. both strategies: a stop-loss exit and an bar (677.30) of the regular session was Figure 2 shows an example of an ACTIVE TRADER • January 2006 • www.activetradermag.com 67 TABLE 1 CUMULATIVE SYSTEM PERFORMANCE afternoon breakout trade in the E-Mini The system turned a profit on all three E-Mini futures contracts, with the Nasdaq 100 contract. On Aug. 10, 2005 a E-Mini Russell 2000 contract boasting the best performance. morning reversal signal did not occur, so buy-stop and sell-stop orders are placed at 1 p.m. at the day’s high (1,615.50) and the day’s low (1,602), respectively. The market broke out to the downside, trig- gering the sell order at 1,602. The trade was closed at 1,591.50 for a $210-per- contract profit. Testing the strategy The strategy was tested on the E-Mini S&P 500, E-Mini Russell 2000, and E- Mini Nasdaq 100 futures. All testing was performed on continuous contract data on the TradeStation 8 platform. The test period for the E-Mini S&P 500 and E-Mini Nasdaq 100 was Feb. 1, 2001 to Aug. 31, 2005. The E-Mini Russell 2000 test period spanned Aug. 1, 2002 to Aug. 31, 2005 (prior Russell data was lower quality because of lack of volume). The tests included one tick of slippage and $5 commission per trade, for a total cost per trade of $15. Table 1 shows the results were rela- tively consistent in all three indices for the test period as a whole. The E-mini Source: TradeStation Russell was the best-performing market in terms of dollar profit and winning percentage. FIGURE 3 DOWNTREND, UPTREND Overall, the system had an The first half of the four-year and six-month test period was skewed to the downside, average win percentage of while the second half was characterized by an overall uptrend. 50 percent and winning trade/losing trade ratio of 1.20. The system had a profit factor (gross profit divided by gross loss) of 1.48 in the E-Mini Russell 2000, 1.19 in the E-Mini S&P 500, and 1.20 in the E- Mini Nasdaq 100. These patterns com- prised a high-frequency system that triggered near- ly 180 trades per year. The tests produced more than 2,000 trades, which lends validity to the results. Digging deeper Table 2 (p. 69) sheds more light on the system’s per- formance, however, show- ing results for the first and second half of the test peri- od. The system performed Source: TradeStation much better in the first half 68 www.activetradermag.com • January 2006 • ACTIVE TRADER TABLE 2 FIRST HALF, SECOND HALF Breaking the test period into two halves shows the system earned most of its Related reading profit in the first two years and three months. The Nasdaq 100 actually lost money during the second half of the test period. "Morning reversal strategy" Active Trader , May 2003. Historical tests reveal the tendency of the major stock indices to revert to the previous day's closing price in the early minutes of the trading session. This strategy takes its cue from that bit of market behavior. "Inside days: Capturing short-term volatility moves" Active Trader , October 2001. A short-term trading strategy based on the breakout of an inside day's range. "Opening range breakout (ORB)" Active Trader , July 2003. This Trading System Lab tests an approach based on the breakout of a volatility-adjusted opening range. "Trading the opening gap" Active Trader , December 2004. Opening price gaps are stomach- churning events when the market makes a big move against you, but they represent low-risk trade opportunities if you know which gaps are likely to be followed by predictable patterns. You can purchase and download past Active Trader articles at www.activetradermag.com/pur- chase_articles.htm trade, and the short-trade net profit was approximately 1.5 times the net long trade profit. In the Nasdaq, the average short trade was more than six times the size of the average long trade and the short-trade net profit was more than seven times the net long-trade profit. Source: TradeStation Although the strategy appears slanted toward the short side, it would not be a than the second half. tributed to the performance difference. good idea to neglect the long side, as it is Figure 3 (p. 68) shows the S&P 500, One characteristic of the system is that impossible to know what will happen in Nasdaq 100, and Russell 2000 indices short trades accounted for more of the the future. from Feb. 1, 2001 through Aug. 2005. The overall profits than long trades. The ratio These breakout and reversal setups first half of the test period had more of the average winning trade to the aver- are simple to understand and easy to downward price action while the second age losing trade was larger for short implement. The results indicate the half was dominated by an uptrend. trades in all three markets. Also, in the strategy is more robust. The ideas on However, a lower overall market volatili- Russell and S&P, the average short trade which it is based leave room for furtherÝ ty level in the second half could have con- was roughly 1.5 times the average long experimentation and refinement. 69 www.activetradermag.com • January 2006 • ACTIVE TRADER TRADING Strategies The TELLTALE spread Analyzing the relationship between BY THOM HARTLE the E-Mini Nasdaq 100 and the E-Mini S&P 500 can indicate when the broad rend analysis of the stock market can take several forms: measuring an index’s percentage change market is making a genuine move over a period of time, comparing the index to a moving average and so on. Furthermore, some or when it’s faking people out. traders refer to tools such as the number of advancing stocks Trelative to declining stocks and volume to determine a particu- lar trend’s strength or weakness. Spread analysis, or measuring the TABLE 1 S&P 500 COMPOSITION price difference (or ratio) between two The S&P 500 consists of the 500 largest publicly traded companies measured stock indices, is another way to gauge by market cap. It is designed to reflect the broader market. the robustness of a move in the stock market. By identifying the typical rela- Top stocks Top groups tionship between two indices and recog- nizing when that relationship deviates General Electric 3.19% Financials 20.50% from its pattern, you can determine the Microsoft Corp. 3.06% Information technology 16.20% trend and identify potential reversals. Pfizer, Inc. 3.00% Health care 14.80% Also, although this approach is general- ly longer term, you can track the Exxon Mobil Corp. 2.67% Consumer staples 11.70% Nasdaq-S&P spread on an intraday basis Wal-Mart Stores 2.62% Consumer discretionary 11.10% to insure you are on the right side of Citigroup Inc. 2.45% Industrials 10.40% intraday trends. This study analyzes the relationship Johnson & Johnson 1.71% Energy 5.80% between two of the most popular stock American International Group 1.60% Telecom services 3.90% indices, the S&P 500 (SPX) and the IBM 1.59% Utilities 3.00% Nasdaq 100 (NDX), which also underlie the two most popular equity index Intel Corp. 1.51% Materials 2.70% futures contracts, the S&P 500 E-Mini (ES) and the Nasdaq 100 E-Mini (NQ), Source: Standard & Poor’s 6/30/03 traded at the Chicago Mercantile 70 www.activetradermag.com • November 2003 • ACTIVE TRADER TABLE 2 NASDAQ 100 COMPOSITION The Nasdaq 100 is comprised of the 100 largest companies trading on the Nasdaq (financial companies are excluded), based on market cap. The index is heavily weighted with technology stocks. Top stocks Top groups 1. Microsoft Corp. 10.15% 1. Computer & office equipment 28.39% 2. Intel Corp. 5.10% 2. Computer software/services 28.01% 3. Cisco Systems Inc. 4.49% 3. Telecommunications 11.69% Exchange (CME). We’ll use the spread 4. Amgen Inc. 4.28% 4. Biotechnology 11.45% between the S&P and Nasdaq 100 futures 5. QUALCOMM Incorporated 3.65% 5. Retail/wholesale trade 9.86% contracts in this analysis. 6. Dell Computer Corp. 3.24% 6. Health care 4.51% We’ll begin by looking at a longer-term use of the Nasdaq-S&P spread before 7. Comcast Corporation 3.07% 7. Services 3.16% shortening the time horizon and examin- 8. Oracle Corp. 2.82% 8. Manufacturing 1.94% ing ways to identify intraday trend 9. eBay Inc. 2.65% 9. Transportation 0.99% changes. 10. Nextel 2.48% Finding the market leader: Communications, Inc. S&P safe haven vs. Nasdaq growth The S&P 500 is a capitalization-weighted Source: www.nasdaq.com 6/30/03 index of companies with market caps (stock price multiplied by number of FIGURE 1 THE SPREAD PERSPECTIVE shares outstanding) in excess of $3 billion. The larger a company’s market capitalization, the more its stock Calculating the difference between the Nasdaq 100 E-Mini price affects the index value. futures (top) and the S&P 500 E-Mini futures (middle) results The S&P 500 is designed to reflect the risk and return in a spread chart (bottom) that shows when one index is characteristics of the broader, large-cap market. Table 1 outperforming the other. shows the top individual holdings and the group breakdown of the S&P 500. Nasdaq E-Mini (NQ), weekly The Nasdaq 100 is comprised of the 100 largest busi- 1,500 nesses, excluding financial companies, traded on the Nasdaq stock market exchange. The index uses a “mod- 1,250 ified capitalization-weighted” approach, by which stocks are weighted with a proprietary algorithm when- ever any stock represents more than 24 percent of the 1,000 index’s total market value, and/or the combined weight of all stocks with weightings of at least 4.5 percent exceeds 48 percent of the index’s total market value. Table 2 is a recent list of the top Nasdaq 100 indi- S&P 500 E-Mini (ES), weekly vidual stock holdings and a breakdown of its most Divergence between heavily represented groups. S&P 500 and Nasdaq 100 1,000 The Nasdaq 100 contains a much higher percentage of technology stocks than the S&P. Table 2 shows the 800 computer and office equipment industry group com- prises 28.39 percent of the Nasdaq 100, followed by the computer software/services group at 28.01 percent. NQ-ES spread, weekly The top group in the S&P 500 is financial stocks 300 (20.50 percent), followed by information technology (16.20 percent). In terms of growth stocks, the technol- 200 ogy industry offers far more opportunities than the financial services industry. Rising spread 100 Microsoft (MSFT) is the most heavily weighted indi- is bullish vidual holding in the Nasdaq 100 and the second most heavily weighted in the S&P 500. Because it accounts 0 for a large enough percentage in both indices, MSFT April July October 2003 April July has a relatively muted effect on the spread between the Source: CQG, Inc. two. ACTIVE TRADER • November 2003 • www.activetradermag.com 71 FIGURE 2 HIGHLIGHTING LEADERSHIP The growth-oriented Nasdaq 100 tends to lead the S&P to the upside as well as the downside. When it doesn’t, as was the Because of its large technology component, in an case at points C and F, this lack of leadership can result in expanding economy the Nasdaq 100 should lead (i.e., trend weakness in the overall market. rise at a faster rate than) the S&P 500 when the overall market is moving higher because more money man- G agers and investors will be attracted to the potential of 1,300 growth stocks. On the other hand, in a declining eco- D 1,250 nomic environment, financial services companies offer a safe haven for money (plus, many financial compa- 1,200 nies pay dividends). That will tend to pull money away A 1,150 from Nasdaq stocks and into S&P stocks. As a result, the Nasdaq 100 should lead the S&P when the market 1,100 Nasdaq E-Mini (NQ), daily is moving lower, as well. In other words, a bullish stock market is reflected by H an uptrending Nasdaq 100-S&P 500 spread (the E 1,000 Nasdaq 100 price minus the S&P 500 price). A bearish stock market will be characterized by a downtrending B 950 Nasdaq 100-S&P 500 spread. 900 Weekly perspective S&P 500 E-Mini (ES), daily Figure 1 (p. 71) shows the Nasdaq 100-S&P 500 rela- 300 tionship from the fourth quarter of 2002 into the second New high quarter of 2003. The top and middle charts show the 275 Nasdaq 100 E-Mini and S&P 500 E-mini futures, respec- F tively, while the bottom panel shows the spread 250 between the two. Both the Nasdaq 100 and the S&P 500 futures con- C 225 tracts reached new lows in October 2002. However, during the fourth quarter of 2002, the Nasdaq 100 NQ-ES spread, daily 200 embarked on a substantial rally, bettering its July 2002 21 1 12 19 27 2 9 16 23 1 14 21 28 1 high; the S&P 500, however, was unable to surpass its May June July Aug. summer (August) high. The Nasdaq-S&P spread jumped sharply higher, reflecting the Nasdaq 100’s Source: CQG, Inc. more accelerated rally. Both markets peaked in December 2002 and moved downward until February. Line A shows the Nasdaq 100 rising to slightly higher highs The Nasdaq-S&P spread made a slightly lower low in in May while the S&P 500 surpassed its early May highs by a January, just below its December low. As the S&P 500 moved wider margin (approximately 1.28 percent vs. .87 percent, lower, the spread started to climb again, reflecting the Nasdaq based on closing prices on May 6 and May 15). The spread (see 100’s outperformance relative to the S&P 500. The Nasdaq 100 line C) was flat between these two peaks, indicating the made the second low of a double bottom in March 2003, at Nasdaq 100 was no longer outperforming the S&P. This situa- which point both markets rallied into June. The developing tion was followed by a short correction into the week of May spread relationship signaled this period of strength in the over- 19. all market: The spread bottomed in October and began form- Moving forward, the Nasdaq 100 peaked in early June while ing a series of higher highs and higher lows, indicating a bull- the S&P 500 peaked in mid-June. This divergence, indicated by ish market environment based on the better performance of the the declining spread (line F), was part of another correction Nasdaq 100 relative to the S&P 500. that lasted until the end of the month. In July, the Nasdaq 100 surged to new highs, while the S&P Divergence on the daily time frame 500 made a lower high. This divergence preceded a correction In addition to gauging the relative strength of the indices when in the broader market. (Interestingly, though, the spread itself they are moving in the same direction, divergence between the surged to new highs, which reflects leadership on the part of Nasdaq 100 and S&P 500 on the daily time frame can signal the Nasdaq and should be a longer-term bullish sign.) potential market corrections. Figure 2 is a daily chart of the E- The spread does not necessarily indicate a correction is com- Mini Nasdaq 100, E-Mini S&P 500 and the spread between the plete; it does not wave a red flag. Nonetheless, there is value in two. being alerted to conditions that signal a potential correction. 72 www.activetradermag.com • November 2003 • ACTIVE TRADER FIGURE 3 INTRADAY INSIGHT Although intraday price data is more volatile than daily or weekly data, the Nasdaq-S&P spread relationship reflects the same dynamics. Here, the spread (bottom) pushed above its downtrendline before the Nasdaq or S&P futures did. Intraday applications On a very short-term basis, the Nasdaq-S&P spread can Nasdaq E-Mini (NQ), 30-minute 1,250 help keep you on the right side of intraday trends. The T1 same basic guideline holds, in that the Nasdaq 100 should lead the way, both up and down. 1,225 Although simple trend analysis, such as drawing trendlines, can help to spot changes, intraday spread 1,200 charts, like individual markets, are very volatile. For example, during the latter part of June 2003, the stock Support market was moving sideways. On July 1, the market broke key support levels, but S&P 500 E-Mini (ES), 30-minute the spread did not break its equivalent level. As the T1 990 market began to recover, and moved back up through 980 the previous broken support level, the spread broke the down trendline shown in Figure 3 . The Nasdaq 100 970 and the S&P 500 did not break their trendlines until Support later in the session. 960 NQ-ES spread, 30-minute Majority rules 250 Analyzing the Nasdaq 100-S&P 500 spread relationship T1 reflects the idea that if the majority of stocks are not ris- 240 ing — or, if the market-leading stocks are lagging the broader market — the trend may lack staying power. 230 The spread between the Nasdaq 100 and the S&P 500 can function as a gauge of how healthy or weak the 220 overall market is. If one of the major indices is not Support keeping pace, the spread will fail to make new highsÝ or 25 26 27 30 1 2-8:30 lows. In those situations, watch for a trend change. July Source: CQG, Inc. ACTIVE TRADER • November 2003 • www.activetradermag.com 73