Use these market indicators to predict stock moves

Commentary: Break out the Bollinger Bands, MACD and other trading tools

MIAMI, Fla. (MarketWatch) — Is it possible to predict what the stock market will do next?

After months of research and interviews with dozens of traders and investors, here are a few lessons worth sharing:

Study sentiment surveys

Two useful contrarian indicators, the American Association of Individual Investors (AAII), and The Investors Intelligence Sentiment Survey (II), measure the mood of investors. When these two surveys get frothy (over 60% bullish or bearish), it’s a signal the markets are becoming extreme. That’s when many traders consider doing the opposite of the crowd.

Although these sentiment surveys can’t precisely time the market, both have had uncannily reliable records of forecasting tops and bottoms. For example, in March 2009, these surveys were signaling extreme pessimism — which happened to coincide with the lows on the Standard & Poor’s 500-stock index and the Dow Jones Industrial Average. As you may recall, people back then were running for the exits, frantically selling stocks for the safety of cash or bonds.

The reason sentiment surveys work is that humans almost always overreact when the market hits extremes. Therefore, if you only rely on your emotions to trade or invest, more than likely, you’ll get it wrong. Suggestion: look for long-term trends in the sentiment surveys, not just one week’s results.

Use market indicators

In addition to using sentiment surveys, most traders use one or more indicators plotted on a chart to help determine market direction. They primarily use them to increase the probabilities that a specific trade will be successful. It also helps with entries and exits. Even investors and professional money managers routinely refer to indicators for an unbiased second opinion.

Based on the research I did for my recent book, All About Market Indicators (McGraw-Hill, 2010), here are a few trader favorites:

Moving Averages: Helps to determine if a trend has ended or begun.

MACD: Trend-following momentum indicator.

New High/New Low: Tracks stocks that are making new highs or new lows.

Bollinger Bands: Helps traders identify overbought or oversold conditions

RSI or Stochastics: Helps traders determine if a stock or market is overbought or oversold.

Arms Index (TRIN): Helps traders identify overbought or oversold conditions.

Advance-Decline Line: Helps traders measure how many stocks are participating in a rising or falling market.

CBOE Put/Call ratio and ISEE Call/Put ratio: Contrarian indicators that track the buying and selling of options.

VIX: Measures fear in the stock market by tracking implied volatility of call and put options.

Can these indicators predict what the market will do next? The answer depends on the time period: the shorter the period, the easier it is to have correct predictions. While no indicator can tell you with 100 % certainty what will happen in the future, they can give important clues.

What indicators can’t do

Even though indicators are useful for anticipating short-term direction, no one can consistently predict the market’s highs and lows and attach a date to it. The market’s Holy Grail is still elusive, but many are still looking. Even if you’re armed with a handful of reliable indicators, it’s nearly impossible to predict the unexpected, for example, when the price of oil or interest rates will rise, or when the next war may erupt.

For traders with short-term mindsets, indicators are invaluable. Long-term investors, however, may find many technical indicators less than helpful.

A few years ago, I spoke to Peter Lynch, bestselling author and legendary mutual fund manager. I asked him if it’s possible to predict the market and he replied: “I’ve been trying to get next year’s Wall Street Journal for 40 years. I’d pay an extra dollar for it.

“I’d love to know what will happen in the future,” he said. “I have no idea what the market will do over the next one or two years. What I do know is that if interest rates go up, inflation will go up and the stock market will go down. I also know that historically about once every two years the market has a decline of between 10% and 20%. These are called corrections. Perhaps one out of three of these corrections will turn into a decline of 20% or greater. These are called bear markets.

“If you understand what you own, you’re in good shape,” Lynch said “If you don’t know what you own, and don’t understand what a company does and it falls in half, what do you do? Call the psychic hotline? If you understand clearly what the company does and you understand who the competitors are, and the market goes down and the stock goes down, you don’t panic.”

Observe human behavior

Finally, if you study booms and busts throughout history, you’ll recognize that although many stocks come and go, human behavior never seems to change. At market bottoms, people ignore or fear the stock market. At the very top, they can’t get enough of it.

While you’re waiting for the eventual top or bottom, you might consider the advice of renowned trader Jesse Livermore.

Livermore said that after years of making and losing money, he discovered one of the secrets to being a successful trader: Be bullish in a bull market and bearish in a bear market.

This is excellent advice except for one problem — are we in a bull or bear market? Perhaps some readers will have an answer.

Forecasts for 2011: Opportunities and pitfalls

What may be ahead for the economy and stock market in 2011? We asked three respected investment professionals with long forecasting track records to share their thoughts on possible long-term and short-term market opportunities—as well as the potential pitfalls.

A positive economic outlook

Bernard Baumohl, chief global economist at The Economic Outlook Group and author of “The Secrets of Economic Indicators” (Pearson Prentice Hall, 2007), laid out the most positive 2011 economic scenario of the experts we interviewed. “We are looking at a 3½% GDP growth  for  2011, which would be the fastest the economy has grown in six years,” he says. Based on this projection, he believes the Dow Jones Industrial Average could end the year at 13,007, a 12.4% gain; the S&P 500® Index at 1,485, an 18% gain; and Nasdaq Composite Index at 2,963, an 11.7% gain.

He sees Fed moves as the primary driver of these healthy gains. “The enormous amount of fiscal and monetary stimulus coming out of Washington is beginning to have a positive impact on the economy. I do not believe the full QE2 (quantitative easing) will even be necessary.”

While Dr. Sung Won Sohn, professor of economics at California State University, agrees the economy will grow in 2011, he thinks it “will do so at a painstakingly lethargic rate.” At this early stage of an economic recovery, it should be growing at a faster pace than at 3% or below, he says. “That is the primary reason why I think the jobless rate will be stuck at a high level. The economy will continue to struggle, and some segments such as housing will go into a double-dip recession.”

Potential pitfalls: Fed moves

Although Sohn believes the Fed has been successful thus far, he believes there may be pitfalls ahead. “The real challenge is when the Fed’s exit strategy comes,” he cautions. “If they exit too late, it causes inflation. If they exit too soon, they’ll  push the economy into another recession.”

Baumohl also agrees there could be potential problems. “Bond watchers are nervous that the Fed is overshooting the economy as they proceed with QE2,” he says. “The Fed and the bond market are involved in a delicate dance. It is very nuanced.” He believes yields on the 10-year Treasuries are starting to creep up because the bond market is worried about future inflation. “It’s something to be concerned about,” he adds.

It is essential, Baumohl says, that the Fed continuously calm the bond market. “The Fed’s pumping out more and more funds to bring unemployment down—even though the economy showing new vigor agitates the bond market. “Given all that monetary stimulus, this is precisely the time the Fed should reaffirm its commitment on keeping inflation expectations low,” he says. “If they do that, they will sooth the bond market and we’ll see yields relatively low.”

Stock suggestions for 2011

Because the economy is not growing that strongly, Sohn is staying on the conservative side. “I think you should choose good, healthy companies that you know and that have reasonable dividends.”

He is also putting the emphasis on stocks primarily because bond yields are low, but are starting to go up.

Fred Hickey, Barron’s roundtable member and editor of The High-Tech Strategist newsletter, no longer thinks that stocks are cheap, and he believes they are riskier than a year ago. “Sentiment numbers are high and could go higher,” he also points out. “Excessive bullishness tells you to be leery of having aggressive long positions in stocks right now.”

Nevertheless, he has stayed out of the short side. “In a money-printing environment, it’s difficult to short. If I had to be in stocks, I’d be in large cap, dividend-paying stocks that are underperforming and unloved.” He also likes gold stocks, believing that the gold bull market has been going on for almost 11 years, but still has further to go.

Baumohl, on the other hand, suggests that investors allocate 70% to equities, evenly split between foreign and U.S. stocks. He also recommends that investors reduce their exposure to fixed income (cash or short-term bonds) to 20% and says the final 10% can be invested in precious metals.

Potential threats

Even with the most optimistic forecast, reality often gets in the way, and sometimes when it’s least expected. “I can draw a scenario where we have a crash,” Baumohl says. “For example, let’s say a major war breaks out with Iran and they block the Strait of Hormuz, and oil shoots to $150 a gallon. What do you think will happen to the stock market?”

Another source that could cause market volatility is if the European financial crisis gets out of control. “That can scare off a lot of investors who fear the contagion could spread to U.S. banks,” Baumohl says. “Lenders here would suffer new losses and reduce loans. Credit will dry up and hurt the economy.”

Sohn is concerned that in Europe, the problems are “not being solved but being pushed around. I expect economic conditions in the U.S., although not exciting, are going to be better than in Europe or Japan.”

Sohn says China could also contribute to volatility. “China is the locomotive that is pulling the world economy forward, but they are trying to slow down their economy because of concerns with inflation and property bubbles. The question is whether they can engineer a soft landing.”

Bond warning signs

Hickey is studying the bond market for potential danger signs. “If the bond market backs up so much that it tightens on its own, or if the Fed even hints they are raising rates, I would consider getting out,” he says. “We are so dependent on the Fed’s juice that if they are not printing, I’d be thinking about shorting.”

Baumohl agrees that if the Fed overshoots on the monetary side, “everyone will sell their bonds quickly because bond prices drop rapidly. We would see yields on the 10-year Treasuries spike to 5% midyear,” he says. “If they go above 6%, it could endanger the economy. If the Fed is perceived as being behind the curve, no one wants to be the last out the door.” Investors who fear the higher Treasury yields will move into cash or foreign equities rather than U.S. stocks and bonds.

Nevertheless, Baumohl says, “If bond yields go up gradually in response to a stronger economy, you’ll see more investors move out of fixed income and into equities. Our assumption, and the key to our 3½% forecast, is the Fed will be successful in calming the bond market and prevent a more harmful spike in yields.”

The almighty dollar

The dollar will probably play a major role in the equity markets. As the United States continues to engage in quantitative easing, Sohn says, “the value of the dollar will continue to depreciate, although against the euro and yen it might strengthen.”

Sohn also notes that many countries are purposely depreciating their own currencies. “I don’t think that many leaders are looking at the overall global picture, but are more concerned with their own domestic political situation,” he notes.

Baumohl, on the other hand, believes the dollar will weaken just enough to help the stock market in the second half of 2011.

2011: cautiously optimistic

Although 2011 could be an extremely profitable year, the warning signs should cause investors and traders to be cautious. It’s definitely not a year where you can afford to let your guard down. For example, many will be watching how QE2 evolves in 2011 and whether the increased liquidity affects the stock market.

In addition, investors and traders want to be aware of new investment opportunities. For example, during the last quarter of 2010, eighteen new non-leveraged exchange-traded funds (ETFs) were introduced, and many more are in registration waiting for approval. The new Congress is also likely to make a number of regulatory changes that could affect your investments.

Michael Sincere is the author of All About Market Indicators (McGraw-Hill, 2010), Understanding Options (McGraw-Hill, 2006), and Understanding Stocks (McGraw-Hill, 2003).

Six trading lessons from speculator Jesse Livermore

Commentary: Stock operator’s reminiscences useful in today’s market

MIAMI, Fla. (MarketWatch) — If you ask traders to choose the most influential trading book, more than likely, they’ll mention Reminiscences of a Stock Operator by Edwin LeFevre. This book describes the experiences of one of the world’s greatest stock speculators, Jesse Livermore.

Many of the anecdotal lessons included in the book are well known to experienced traders. For example: the market is always right; don’t over-trade; never argue with the tape; use stop losses, and always trade with the primary trend of the market.

Almost anyone can learn the mechanics of trading. It’s the psychological pitfalls that make trading one of the most challenging activities. No matter your skill level, it’s important to remember and obey the rules of engagement — another word for discipline.

With that in mind, this book contains dozens of important lessons. Here are a few of my favorites:

1. Learn how to lose

Livermore (speaking through the fictional character of Larry Livingston) complains how he’s made a series of trading mistakes that cost him a lot of money, although he wasn’t completely wiped out. The losses, he admits, were painful but educational:

“There is nothing like losing all you have in the world for teaching you what not to do,” he says. “And when you know what not to do in order not to lose money, you begin to learn what to do in order to win.”

After going broke three times in less than two years, Livermore has this advice: “Being broke is a very efficient educational agency.” He says that you learn little from your winners because they often take care of themselves. It’s the losers that will teach you lessons to last a lifetime. And as long as you don’t make the same mistake twice, you always have the opportunity to trade another day.

2. Learn how to sit tight

After a wild and lengthy rollercoaster ride as a speculator, Livermore believes he has found the secret to his success. It’s obvious he’s excited by this discovery, which he eagerly shares:

“After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: it never was my thinking that made the big money for me. It was always my sitting. Got that? My sitting tight!

“It is no trick at all to be right on the market,” he adds. “I’ve known many [traders] who were right at exactly the right time, and began buying or selling stocks when prices were at the very level that should show the greatest profit. And their experience invariably matched mine; that is, they made no real money out of it. [Traders] who can both be right and sit tight are uncommon. I found it one of the hardest things to learn. But it is only after a stock operator has firmly grasped this that he can make the big money.”

3. Learn to take a small loss early

Of all the lessons of the stock market, taking losses is one of the hardest for most people. Maybe it’s the need to be right, or refusing to admit they’re wrong, but many people refuse to sell for a loss. Here’s how Livermore put it: “A loss never bothers me after I take it. I forget it overnight. But being wrong, not taking the loss, that is what does the damage to the pocketbook and to the soul.”

Later, he elaborates what he learned: “Always sell what shows you a loss and keep what shows you a profit. That was so obviously the wise thing to do and was so well known to me that even now I marvel at myself for doing the reverse.”

4. Learn to ignore tips and gifts

If there is anything that Livermore hated, it was tips. He preferred to trade alone based on his own strategies and analysis, but when he did listen to tips, it almost always caused him grief. “Tips! How people want tips!” he noted. “They crave not only to get them but to give them.” Livermore said that trading on tips cost him hundreds of thousands of dollars, especially the kind casually given on the street by uninformed acquaintances. “I know from experience that nobody can give me a tip or a series of tips that will make more money for me than my own judgment.”

Unfortunately, even Livermore was vulnerable to tips from well-meaning friends. “Against ordinary tips you cannot guard. For instance, a lifelong friend sincerely desires to make you rich by telling you what he has done, and that is to buy and sell some stocks. His intent is good. If the tip goes wrong, what can you do?”

In addition to warning people not to trade based on tips, Livermore says you should not use the market to pay for bills or gifts. “There isn’t a [trader] on Wall Street who has not lost money trying to make the market pay for an automobile or a bracelet or a motorboat or a painting. I could build a huge hospital with the birthday presents that the tight-fisted stock market has refused to pay for. In fact, of all the hoodoos in Wall Street, I think the resolve to induce the stock market to act as a fairy godmother is the busiest and most persistent.”

5. Study underlying market conditions and trend

Much of Livermore’s success came from observing people, individual stocks, and the overall market. Here’s how he put it: “I have found that experience is apt to be a steady payer in this game and that observation gives you the best tips of all.” And, according to Livermore, “Not even a world war can keep the stock market from being a bull market when conditions are bullish, or a bear market when conditions are bearish. And all a [trader] needs to know to make money is to appraise conditions.” The importance of studying general market conditions was one of his greatest discoveries, he claimed.

Livermore also had an Eureka moment when he discovered the value of following the market trend. “Obviously, the thing to do was to be bullish in a bull market and bearish in a bear market. Sounds silly, doesn’t it? But I had to grasp that general principle firmly before I saw that to put it into practice really meant to anticipate probabilities. It took me a long time to trade on those lines.”

6. Learn how to buy and sell stocks

Livermore explained some of the methods he used to buy and sell stocks. One of his methods was to buy as soon as a stock made a new high, which he said will almost certainly bring him profits. Later, he elaborates: “I have often said that to buy on a rising market is the most comfortable way of buying stocks. Now, the point is not so much to buy as cheap as possible or go short at top prices, but to buy or sell at the right time.” He adds that he scales into or out of a stock as it rises or falls.

Livermore closely studied prices for clues to market direction. “Prices, as we know, will either move up or down according to the resistance they encounter. For purposes of easy explanation we will say that prices, like everything else, move along the line of least resistance.”

He warns, however, that although this method sounds easy, you always have to guard against your natural impulses: fear; hope; greed, and, most important, a swelled head.

Parting advice

Many of the lessons included in the book are as useful today as when it was first published in 1923. Livermore, a true legend in his own time, didn’t need to prove to anyone that he was right about the market. He said that the proof could be found in his broker’s statement at the end of the month.

Although there is no time to include all of the lessons Livermore learned during his career, I leave you with this: Livermore often said that when the market was being uncooperative, he’d take a vacation. He put it this way: “It was the kind of market in which not even a skunk could make a scent.”

Trading 2010: Testing what worked

During the last one, three, and five years, the market has taken many traders and investors on a roller-coaster ride, providing many opportunities to make or lose money. As the year ends, it can be fascinating and educational to look back at how various trading strategies performed.

One powerful method that many traders use to gain an edge is backtesting. Backtesting allows traders to gain insights into which of the hundreds of strategies worked or fell short. By using the basic tools in Fidelity’s Wealth-Lab Pro,® you can use these strategies as a starting point—before experimenting, tweaking, or creating your trading system. Of course, while understanding what happened in the past can be educational, it does not guarantee future results.

The top strategies: Making the most of volatility

Fidelity’s Kent Thacker, director of brokerage products, backtested all of the 30 trading strategies that come preprogrammed into Wealth-Lab Pro® against the stocks in the S&P 500® Index over the last one, three, and five years through October 31, 2010. For this test, he assumed an investment of $10,000 per trade, no stop losses, and included commissions.

The rocky road of the last few years provided lots of opportunities, and the volatility made winners of some trading strategies, but created challenges for others. In the past year, countertrend strategies were top performers. These strategies are designed to recognize when a significant downtrend has occurred and attempt to profit as the stock moves back up. All three of the top performing strategies in the 12 months through October 31 were countertrend strategies: Neo Master, CMO Signals, and RSI Agita (see below for more detailed explanations of the strategies).

Over a longer term, a number of other strategies did well, including several dip buying strategies—which attempt to get into a stock after a sharp decline and profit on the pullback. For the three- and five-year periods, RSI, LLS, Dip Buyer and 3×2 system took top spots based on net profit.

Interestingly, in a similar study conducted at the end of 2009, the Moving Average Crossover Strategy was a top performer on a five-year basis, along with the RSI Agita and LDL2 systems. The increased volatility has created whip-saws for Moving Average Crossover investors. That has helped to move its performance down into the middle of the pack among the tested strategies.

“This kind of a strategy actually has only about a 40% win rate for the trades, meaning the majority of trades don’t work out. That win rate is caused by false breakouts where the cross could happen and then cross right back under,” says Thacker. “So you get quite a few smaller losses and some large losses, but the winners have a much larger average size—that helps the performance. But increased volatility could reduce that number of winning trades and reduce the size of the average profit.”

The hypothetical backtest results:

2010-1

Past performance is no guarantee of future results. All results for illustrative purposes only. Results according to WealthLab Pro,® based on $10,000 trades for the 12, 36, and 60 months through October 31, 2010 using all the component stocks in the S&P 500 Index.

2010-2

Past performance is no guarantee of future results. All results for illustrative purposes only. Results according to WealthLab Pro,® based on $10,000 trades for the 12, 36, and 60 months through October 31, 2010 using all the component stocks in the S&P 500 Index.

2010-3

Past performance is no guarantee of future results. All results for illustrative purposes only. Results according to WealthLab Pro,® based on $10,000 trades for the 12, 36, and 60 months through October 31, 2010 using all the component stocks in the S&P 500 Index.

Understanding the categories

Before we analyze the results, let’s look at the most important categories. First, net profit is the total amount of money the strategy hypothetically made during the time period. Although the strategies were ranked by net profit, there are other factors to consider before choosing a trading strategy.

For example, many traders believe winning percentage is extremely important. Strategies with high winning percentages will draw down less of your capital, and are considered easier to follow, because there are fewer losses. Another important category is the total number of trades. No matter how high the net profit, if the number of trades is excessive, not only is it time consuming, but it can generate a lot of commissions.

Another important category to consider is maximum drawdown, which is simply the point where you take your greatest loss.

Professional trader Pascal Willain, author of Value in Time: Better Trading Through Effective Volume (Wiley, 2008), explains how to use drawdown: “It’s a personal decision how much blood you’re ready to put in the fight,” he quips. “The maximum drawdown for my trading position is usually 8%, but on strong stocks that I’m confident about, I could allow 20% drawdown. If the drawdown is too high, I usually avoid that strategy.” He does point out, however, that a stop loss will usually reduce a high drawdown. “If you’re still losing money even with a stop loss, then there could be a problem with the strategy.”

In the above table, the date of the maximum drawdown for the three- and five-year period was November 20, 2008, when the Dow Jones Industrial Average (DJIA) closed at 7,552. If the drawdown is unusually high, it’s suggested you reevaluate the strategy, or use stop losses. More than likely, most people cannot realistically stick with a strategy that is losing more than 20%.

Understanding the strategies

1. Relative Strength Index (RSI) Agita

Strategy: This strategy includes the word, Agita, which comes from the Latin word agitare, or to stir up. One of the goals of this strategy is to take your profits early, before you get too anxious. Normally, when RSI, using a 14-day time period, reaches 70 (overbought), you think about selling. When RSI reaches 30 (oversold), you consider buying. This strategy was designed to take profits early, at the 55 level, just as it crosses the centerline, rather than at the 70 level.

Analysis: This strategy customizes the RSI parameters. The lesson: When using a backtesting program, it’s recommended that you experiment with different parameters until you find one that works for you. This strategy forces you to take profits early, and RSI Agita soundly beat buy-and-hold during the three- and five-year periods.
2. LDL2

Strategy: This is a technical trading strategy that attempts to buy stocks that have dipped. The system tries to enter at oversold levels and exit when the overreaction has subsided and the stock has leveled off. To calculate an oversold condition, the strategy sets an entry limit price by adding together the low and the close of the current bar, dividing it by 2, and then multiplying that by .94 to get the limit price. Once a position is established, it is sold after two days.

Analysis: Although LDL2 performed well in the three- and five-year backtests, it didn’t do as well during the last year. One possible reason is that this strategy outperforms in extreme conditions. While the market has been rocky at times during the past year, the overall trend has been up. One complaint about this strategy is the excessive number of trades you have to make. Nevertheless, LDL2 beat buy-and-hold during the three- and five-year periods, but not over the past year.
3. Neo Master

Strategy: Neo Master uses the Chande Momentum Oscillator, a range-bound (from +100 to –100) technical indicator that attempts to capture stock momentum. Neo Master buys after nine consecutive bars (a bar equals one day) where the closing price is less than it was four bars ago.

Analysis: Although Neo Master ranked high in our backtest, you’ll end up trading each symbol on the S&P 500 at least three times, which some may consider excessive. Nevertheless, Neo Master beat buy-and-hold during a three-year period, but didn’t outperform over the one- and five-year periods.
4. CMO Signals

Strategy: The CMO, like the Neo Master, uses the Chande Momentum Oscillator. Using this strategy, the system tries to enter when prices are lower, and sells when the oscillator says the stock is overbought or hits a 10% profit target, whichever comes first.

Analysis: Similar to a buy-on-the-dip strategy, CMO Signals is designed to buy when stocks are lower. It also sells when the stocks are overbought and emotions are extreme, helping traders to avoid getting greedy.
5. Dip Buyer

Strategy: Dip Buyer is one of the simplest strategies in Wealth-Lab Pro. You buy when a stock goes down by 8%, and sell it after holding it for one day. If, for example, a stock plunges by more than 8% at the open, you’d buy and hold for one day.

Analysis: Dip Buyer, like CMO Signals, attempts to buy overreaction and sell quickly, hoping to capture a bounce-back. Although it’s not the highest performer, its low drawdown and high winning percentage may make this an attractive strategy. “Sometimes the simple strategies work the best,” Thacker points out.

2010-42010-5

An intriguing trading strategy: Gap Filler

Strategy: With this strategy, you buy the day after there is a gap of 8% or more during the day (not at the opening). You then hold the position until the gap is filled.

Analysis: Sometimes, looks can be deceiving. Although not included in the top five, the Gap Filler strategy has a lot of potential. Why? When we studied the results, Gap Filler had the highest winning percentage (86%), one of the lowest drawdowns, and a very low number of trades (645) when compared with other strategies.

Although Gap Filler performed well, the downside is that there are no guarantees the stock will snap back to fill the gap. Therefore, you could be holding an open position for months, if not years. Nevertheless, traders who want to make fewer trades and end with higher winning percentages might want to take a closer look at this promising strategy.

The Bandwagon Strategy: Still in the basement

Strategy: Using Average True Range (ATR) as its main indicator, Bandwagon attempts to measure a security’s volatility over a certain period. The system enters the position, long or short, and instantly calculates an exit point.

Analysis: For the second year, the Bandwagon strategy was the least successful strategy for the three- and five-year periods, although it did perform a little better during the past year. Still, the buy-and-hold strategy outperformed the Bandwagon during the previous one, three, and five years. If you use a strategy that ends up in the bottom, it’s recommended you learn why. While many strategies have different merits, it’s important to understand how they react to different markets: A strategy that disappoints during one market cycle may outperform in another.

Backtesting basics
Although backtesting can’t guarantee future profits, it’s similar to finding the starting point on a roadmap. That is why many traders believe so strongly in backtesting. For example, Willain does overall market backtests, sector backtests, and stock-by-stock backtests. “Backtesting is extremely useful,” he says. “It allows you to see how your strategy worked in the past, and whether you get a positive probability.” The challenge, Willain admits, is finding an environment that is similar to the current market situation. “If it’s not the same environment, the possibility of success could be lower.”

If you learn that a strategy performs well on a backtest, you can use this information to investigate further. It’s also recommended that you work with a group of strategies than just one or two. Trader and author Toni Turner also suggests: “No matter what rule-based strategy you choose, the strategy should be combined with your tolerance for risk, the goals and objectives you wish to accomplish, and a sensible management plan.”

Three holiday indicators to bring you cheer

Commentary: Gifts from the market, whether you’re naughty or nice

BOCA RATON, Fla. (MarketWatch) — After exposing the popular Hemline Index as an old-fashioned myth, I decided to take a closer look at a trio of well-known but misunderstood holiday indicators: The Santa Claus Rally, the January Effect, and the January Barometer.

Can these indicators predict the market’s future, or is it just wishful thinking?

Although everyone wants to believe in miracles, especially during the holidays, hope alone won’t make the market go up. And yet, some of these indicators have been extraordinarily reliable in the past.

Here comes the Santa Claus Rally

According to market lore, the stock market is destined to surge from Christmas until the beginning of the New Year. As a result, many investors rely on the magic of the so-called Santa Claus Rally to stuff their portfolios.

The theory is that optimistic money managers restock their portfolios with financial goodies fueled by bullish investors and year-end bonuses, causing the market to rise. Believers in this theory also surmise that the majority of market pessimists have taken the week off.

Although naysayers are often skeptical of the Santa Claus Rally, MarketWatch columnist Mark Hulbert says there is strong historical support for this seasonal pattern, which “has the best risk-adjusted performance of any timing system I have tracked over the last two decades,” he writes.

Jeffrey Hirsch, editor in chief of the bestselling Stock Trader’s Almanac, confirms the validity of the Santa Claus Rally. “The market has had an average gain of 1.5 % during the last five days of the year and the first two days” of the new year, Hirsch says. On the other hand, if the market is spooked during that week, “there might be more ominous market forces at play,” he warns. “If Santa fails to call, bears may come to Broad and Wall.”

The January Effect

In the early 1980s, University of Chicago graduate student Donald Keim, now a professor of finance at the Wharton School of the University of Pennsylvania, observed that small stocks outperform large stocks in January more than in other months. The idea was that individuals and large institutions sold stocks at the end of the year and bought back in January. This pattern continued for nearly every year from the late 1920s through the late 1980s.

Eventually, this idea turned into the so-called January Effect, coined by Keim. The theory: if small-cap stocks outperform large-cap stocks in January, it could be a good year for the stock market. If small-cap stocks underperform large-cap stocks in January, it could be a bad year.

Although many financial reporters still write about this pattern, it has lost much of its power over the last decade. Fortunately, there is another seasonal phenomenon that is more reliable than the January Effect.

The January Barometer

Often confused with the January Effect is the January Barometer, devised by Yale Hirsch in 1972. The theory: Whatever happens to the Standard & Poor’s 500-stock index (CME:INDEX:SPX) in January will set the mood for the rest of the year. “As January goes, so goes the year,” says Hirsch.

The rules are simple:

1.If the S&P is up in January, the market is likely to have an up year.

2.If the S&P is down in January, the market is likely to have a flat or down year.

Although the January Barometer has had a 78.3 % accuracy rate since 1950, according to Hirsch, it does have flaws. “It’s had six major errors during this time, and will probably be wrong in 2010,” Hirsch concedes. “Like any short-term timing system, it can be influenced by random events.”

Nevertheless, he points out that the S&P’s 16 % correction from April to July confirms the pattern; i.e. every down January is followed by a new or continuing bear market, a 10 % correction, or a flat year.

Although no one is suggesting that you make big bets based solely on the results of these holiday indicators, they can provide important clues. In addition to doing insightful analysis and research, astute traders and investors also measure the mood of the market using technical, sentiment, and economic indicators.

No matter what side of the market you’re on, many pros believe that January is still the most important month of the year, especially during that first week. Therefore, with the holidays quickly approaching, it might be useful to mark January on your calendar now.

Hemline Index falls out of fashion

Commentary: Watch prices, not skirt lengths, to gauge the economy

hemline

Model: Kira Alvarado
Photographer: Sean Murdock

BOCA RATON, Fla. (MarketWatch) — Of the hundreds of market indicators used by traders and investors to help predict the market’s direction, one style never seems to fall out of fashion — but it should.

The Hemline Index, first observed by economist George Taylor in 1926, predicts the market’s future by the way women dress. It works like this: when women’s hemlines (the line formed by the outside of a skirt) are shorter, women are taking more risks and spending, which is good for the economy and the stock market. Longer hemlines, in contrast, are a negative sign for the economy.

I’ve been amazed at the number of financial reporters, fashion editors, and professional fund managers who are enamored with the Hemline Index. For almost 85 years, thousands of articles have been written about this indicator..

After doing extensive research for my book, All About Market Indicators, I needed to find out if the popular but obscure Hemline Index really works. Is it a valid indicator or a silly myth?

Project runway

I began my research by attending two fashion events in Miami Beach: Mercedes-Benz Fashion Week and Funkshion Fashion Week. These shows are the real deal, and include the latest fashions by emerging and well-known designers. Sports celebrities, movie stars, and the news media also attend the shows along with dozens of models. I wondered: is this why so many financial reporters write about the Hemline Index?

At one of the shows, I approached a tall model, Kira Alvarado, who wore an extremely short dress by designer Casey Levan. This had to be a good sign for the economy. “Excuse me,” I interrupted, pointing to her chic outfit, “but do you think your hemline can predict what the stock market will do?”

She gave me a confused look. “I don’t see how that’s possible.”

“It’s a theory that’s been around for 85 years,” I explained. “It’s called the Hemline Index.”

“I never heard of it.”

I continued to interrogate her. “Would you agree that short hemlines are the most current style?”

“In South Beach the style is always short,” Alvarado replied with a smile. “That’s what people want.”

I got it. In Miami Beach, at least, the Hemline Index is completely immaterial.

The price is right

To learn the truth about this intriguing indicator, I needed to talk to a fashion expert, preferably from New York. Luckily, I ran into Stephanie Solomon, a professional Bloomingdale’s buyer and authority on women’s fashion. She told me some heartbreaking news. “The Hemline Index is a silly myth that has outlived its usefulness.”

“You mean the indicator is dead?” I asked.

“I hope so,” Solomon quickly replied.

She explained that the length of a woman’s hemline has little to do with the economy or the stock market. Back in the 1920s, hemline length was based on how much fabric was available, and not on the shopper’s mood or desire to take risks.

I asked her if the bright and bold new designs at the fashion shows meant that the economy was improving. Perhaps this was a leading indicator.

“Those are only trends,” she explained, “just like high or low hemlines, and people will always purchase trends. It never falters. But there is no correlation between trends and what is going on in the economy.”

“Is there anything in fashion that will help you make economic forecasts?” I asked.

“Absolutely,” she said, “but you have to follow price. During a recession, if you don’t have a lot of money, you’ll buy the lowest price in the color of the moment. And when the economy is flush, you’ll buy the same color but spend more money.” She says that fashion insiders also know it’s a recession because women stop buying designer clothes.

By the time I got home that night, I realized that financial reporters, including myself, have to stop writing about the fun but insignificant Hemline Index. You took us on a marvelous ride, George Taylor, but your ritzy indicator is not in vogue anymore. Maybe his creation was a good-natured gag. If so, he confounded a lot of people.

Introducing: The Fashion Indicator

Fortunately, I thought of a replacement, which I’m calling The Fashion Indicator. How does it work? Rather than study trends such as hemlines or color schemes, you watch shoppers, analyze clothing prices, and talk to designers for insights into how much money is being spent. It takes more investigative work but it’s much more useful. When designer labels become popular and people spend more money on clothes, it could be a very good year for the economy.

I decided to test out my new indicator by attending another fashion show. Because the Hemline Index is no longer valid, perhaps The Fashion Indicator can help predict which way the stock market is headed. What did I learn from my indicator? (I’ll let you know as soon as I complete my research.)

How to invest when the market is against you

Commentary: Stay atop the cycle and don’t get gored by the herd

By Michael Sincere and Pascal Willain

BOCA RATON, Fla. (MarketWatch) — Like the hapless souls who boldly race bulls through the streets of Pamplona, Spain, unsuspecting people charge down Wall Street without fully appreciating its unpredictable and dangerous terrain. Although eager to participate, many end up getting gored by the herd.

In fact, one of the most popular contrarian methods of beating the market is doing the opposite of the herd: buy when there’s blood in the street, or sell when the crowd is celebrating.

Since we’re always fascinated by what the crowds are thinking, we created our own version of the Investor Sentiment Survey (Justin Mamis created an original version back in the 1990s).

The idea is if you can identify what the majority of investors are feeling, you could get clues to where the market is headed next.

figure_1

Investor sentiment cycle

Last week, Charles Kirk, owner of The Kirk Report, sent a questionnaire to 100 professional traders based on another version of the sentiment cycle.

According to the results of Kirk’s informal poll, most of the pros who responded think we’re at a crucial crossroads in the market: 37% believe investors are in denial or fear, which could set the stage for a nasty fall. And 63% believe that we’ve bottomed out, which could turn into a monster rally.

The most probable is we’re in the “disbelief” stage, especially if we continue to move higher this week.

Several of our favorite market indicators also have generated buy signals. For example, the S&P 500 (CME:INDEX:SPX) crossed its 200-day moving average into positive territory. In addition, MACD crossed its signal line, another positive sign.

And yet, although many technicians acknowledge the positive signals, several appear suspicious of this latest rally. They just don’t seem convinced this is the real deal, suggesting that the market could be in a trading range, and not a bull market. Adding to the bull side, however, the National Bureau of Economic Research claims the 18-month slump, the longest recession since the Great Depression, has ended.

On the other hand, sentiment surveys are turning much more positive, suggesting that you may want to do the opposite. For example, the latest reading of Investors Intelligence and the AAII Sentiment Survey are leaning towards the bullish side. If these surveys surpass 60% in either direction, this can be a deadly accurate contrarian indicator. As the market moves higher, and as people get more bullish, a reversal could be in the making.

Market mayhem

Everything seems so positive that we’re wondering if the market has a trick or two waiting for us in time for Halloween. Because we’re prepared for anything, including a really frightening prospect, we created a third market cycle, the Doomsday Scenario. It could play out something like the scenario in the chart below:

howto2

Right now, the market is doing the opposite of what many people expect. Some have thrown up their hands in frustration and won’t look. The cruelest cut of all would be a never-ending tug-of-war between the bulls and the bears, with no clear winner.

And yet, old-time market watchers say they have never seen a market quite like this. Some blame it on the “flash crash,” which was the first hint some strange stuff was going on behind the scenes. This isn’t their father’s stock market.

We don’t claim to have definitive answers of where this conflicted market is going next. All we can do is point to the signals so you can make up your mind what to do. We will leave you with this suggestion:

If you want to avoid getting gored by the herd, you may have to sit and patiently wait for opportunities. Jesse Livermore gave this advice in Reminiscences of a Stock Operator: “After spending many years in Wall Street and after making and losing millions of dollars, I want to tell you this: It never was my thinking that made the big money for me. It was always my sitting. Got that? My sitting tight!”

But while you’re sitting tight, don’t ever forget what Sergeant Phil Esterhaus, from the hit television series, Hill Street Blues, said to the cops and detectives at roll call: “Hey, let’s be careful out there.”

Michael Sincere is the author of All About Market Indicators (McGraw-Hill, 2010) and Understanding Options(McGraw-Hill, 2006). Pascal Willain is the author of Value in Time: Better Trading through Effective Volume (Wiley Trading, 2008) and owner of the website, www.effectivevolume.com.

Key market-timing indicators are bearish

Commentary: Warning signs posted up and down Wall Street

By Michael Sincere and Pascal Willain

BOCA RATON, Fla. (MarketWatch) — With so many market indicators giving mixed signals, it’s no wonder that many traders and investors are confused about where the stock market may go next. Some predict a complete collapse of the financial markets while others believe we’ll have a mildly bullish run.

We’ll try to clear up some of the confusion by looking at signals from a handful of indicators. These signals are only guidelines and should not be construed as actionable trades.

Although there are hundreds of indicators, we chose a few of our favorite longer-term indicators. The first two are relatively easy to use and interpret.

Oldie but goodie: Moving averages

Even those who usually don’t follow technical indicators pay attention to moving averages. Looking at the Standard & Poor’s 500-stock index on a six-month daily chart, you can see that SPX is below the 50-day and 200-day moving averages. This does not bode well for the market. The market has indeed started a new downtrend which is defined as consecutive lower highs and lower lows.

We can also see that both the 50-day moving average (points 1 and 4) and the 200-day moving average (points 2 and 3) have been acting as important resistance levels on bounces. This tends to indicate that these averages are closely watched and most probably are included in many automatic computer-trading algorithms.

Prognosis: Bearish

Follow the trend: Ichimoku clouds

The Ichimoku cloud is a good trend-following indicator. A support cloud is colored in green while a resistance cloud is in red. A bullish trend is broken when the daily cloud’s lower limit is broken.

We can see that point 1 offered good support for the uptrend because the price could not break below. This offered a good probability for a bounce. However, the bounce could not decisively break the upper limit of the cloud (point 2). As you can see, the next down leg pierced through the lower limit of the cloud (point 3), which confirmed an emerging downtrend.

This downtrend was confirmed at point 4 and 5, which offered resistance in consecutive bounces. The red cloud can now be a good guide for a future downtrend. For example, it will be interesting to see if the reversal of July 19 will bounce at point 6 on the Ichimoku cloud or will pierce through it to start a new uptrend.

Note: Look for a break of the upper limit of the red bearish cloud, which would suggest the downtrend is broken, favoring the long side.

Prognosis: Bearish

Advanced note: Some traders may consider shorting the market if a bounce stalls at point 6 on the lower limit of the cloud.

Experienced traders: Floor levels pivot points

Many experienced traders follow pivot points to identify support and resistance levels. Pivot time periods could be daily, weekly, monthly, quarterly, semester, or yearly. The strongest signals occur when pivots of different time frames converge. The longer the time frame, the more important the pivot might be. For each of these time frames, we can easily build three resistance and three support levels.

A quick pivots analysis on the S&P 500 shows that WR1 (weekly resistance level 1) at 1088.45 converges with the 50 MA at 1089.07. These are set in pink-colored horizontal lines. We can also see that the quarterly and semester pivots are converging at 1092.95.

These strong resistance levels will be difficult to break and some traders may take short positions around these. On the other hand, by looking at the green-colored lines, we can see that the strongest support levels are offered by the yearly pivots at 970.76 and the convergent quarterly and semester support levels 1 at 966.96. These are areas that could mark the end of the downtrend.

Prognosis: The floor pivot levels indicate the path of least resistance, which, at this writing, was down to around 970. The risk/reward ratio is the ratio between a stop loss level that would be set at around 1100 and a target at around 970.

If a trader entered the short trade at 1080, it’s possible to gain 110 points but lose 20 points, which makes an acceptable risk/reward ratio of 1:5.5. The closer to the strong resistance zone you can short, the best risk/reward the trade will offer. On the basis of the present downtrend, the 970 target could be reached around mid to end of August.

Back to the future: Volume

Because of the inclusion of high-frequency traders, volume rules have changed. It has been reported that these traders, using high-speed computers, are responsible for as much as 70 percent of volume on some days. As a result, it’s not always easy to determine the exact amount of supply and demand by short-term traders.

One method we use is a proprietary tool, Effective Volume, which analyzes volume on any security for clues as to market direction. We often apply Effective Volume on the ProShares UltraShort S&P 500, a double-inverse exchange traded fund (ETF).

Why use SDS? It is widely traded, especially by institutional traders. In fact, inverse ETFs are used by institutions to either play a downtrend or hedge long positions. When institutional investors detect that money is moving back into the markets, they often cover their SDS short position, which can be seen and acted upon.

In the figure below, we see that large investors such as hedge funds and institutions have anticipated a reversal of the SDS price downtrend both before June 18th and before July 13th. At the right of the figure (red dotted arrow), the general accumulation pattern on SDS started to reverse, indicating that institutional investors might be nervous about a possible market bounce during this volatile earnings season (remember this is an inverse ETF).

Prognosis: Institutional investors appear worried about a strong bounce being under development, even though their general tendency is to prepare for more downside.

Are all signals go?

Based on the results of the above indicators, we expect further downside over the next one to three months. Obviously, market breadth can change based on a number of factors such as breaking news, economic conditions, and improving fundamentals.

It’s also essential to look at other indicators that might contradict these results. Ultimately, you’ll need to make an objective diagnosis based on the facts. Use indicators for clues as to future market direction rather than relying on personal feelings and emotions.

Let’s not forget that trading is not a game but an investment based on probabilities. An attractive risk/reward ratio does not eliminate the risk altogether. Professional traders are quick to get out of a trade that does not develop in the expected direction and always favor limiting risk over increasing profits.

Michael Sincere is the author of several trading and investing books including All About Market Indicators(McGraw-Hill, 2011). Pascal Willain is the author of Value in Time: Better Trading through Effective Volume (Wiley Trading, 2008) and owner of the website, www.effectivevolume.com.

The 'X-factor' in options trading

Commentary: Understanding the mystery of implied volatility

By Michael Sincere and Mark Wolfinger

BOCA RATON, Fla. (MarketWatch) — One reason why options have a reputation for being so difficult is a mysterious concept called “implied volatility.” This is the unknown factor built into the price of an option.

But before you can understand implied volatility, it helps to know how options are priced.

First, the option premium, or price, is made up of several factors, including the price of the underlying stock, the strike price, how much time is left to expiration, interest rates, dividends, option type (put or call) and the “X-factor”: the volatility of the underlying stock; or more specifically, the estimated future volatility of the underlying stock.

When trying to calculate how much an option is worth, use the following formula:

Option price (or premium) = Intrinsic Value + Time Value. For example: $6.50 = $6 + $.50

The option premium, or price, consists of two factors, intrinsic value and time value. In this example, the intrinsic value is $6. Intrinsic value is simply another way of saying an option is “in-the-money.”

If you exercised the option today, and then eliminated the resulting stock position from your account, that is how much cash you would collect. Out-of-the-money options have zero intrinsic value. The intrinsic value is immune to time decay.

Calculating intrinsic value is easy. Here is the formula for call options: Stock Price – Strike Price = Intrinsic Value. For example: $91 – $90 = $1 (Stock is $91 and the strike price is $90).

So when you hear option traders say that an option has intrinsic value, it simply means their option is in-the-money.

Time is money

In addition, when pricing options, you also have an important factor called “time value.” This is simply what is left over from the option premium after deducting the intrinsic value. Anyone who buys or sells options knows about the importance of time value. As soon as you buy an option, time becomes your enemy. The closer it gets to expiration, the more rapidly the price deteriorates. (In contrast, if you sell an option, such as when writing a covered call, time is your friend. Option sellers are very comfortable with time deterioration.)

Now, let’s say you’re ready to buy a call option and calculate the intrinsic value of the XYZ option at $1 (for example, $91 stock price- $90 strike price = $1 intrinsic value). There is a month left to expiration and the question is: How much time value should be included in the option premium?

Here’s the intriguing part: when you look at the price of similar options (same stock price, same strike price and expiration date, but a different underlying stock), you discover a wide range of prices. The options appear similar, yet the option prices tell us that something is affecting the premium. That something is the X-factor — volatility.

For instance, the call option for stock A may be trading near $1 when a similar-looking option for stock B may be trading near $4 (or more). Why is the $4 call so expensive? It’s all due to that X-factor.

When a stock has been volatile, or is expected to be volatile due to a pending news announcement, its option prices are higher. That’s because option buyers earn a profit when the stock makes a big move. When such a move is anticipated, buyers pay higher prices (and sellers demand higher prices). When a small stock-price change is anticipated, options are priced much lower.

The option price is swayed by the estimated volatility that is plugged into the option-pricing model used by market makers, who establish bid and ask prices for all options. They use calculators to determine option prices.

Calculating option values requires the use of a complex formula. Fortunately, you can find an options calculator on theChicago Board Options Exchange (CBOE) or Option Industry Council (OIC) Web sites. The calculator is based on the famous Black-Scholes model and is easy to use.

Volatility strategies

Volatility is considered the most important factor when pricing options. Other factors are known, but volatility must be estimated. Yet not everyone uses the same estimate, and that causes options to appear inexpensive to some traders and costly to others.

At a basic level, volatility measures the movement of a stock over a specified time. It is that elusive factor which can cause you to overpay for options and lose money even when correctly predicting both the direction of the underlying stock and the timing.

This common situation is extremely frustrating for the novice trader who does not understand the concept of implied volatility. Too often, the novice pays too much for his or her options and loses money.

Rule No. 1: Do not overpay. Use an options calculator to determine implied volatility. To make the calculation, enter other parameters such as the stock price, strike price, interest rate, dividends, and expiration date, and option type (put or call). The calculator does the rest. Next, decide if you are willing to pay that implied volatility to purchase options (or accept that implied volatility when selling).

In simple terms, implied volatility represents a feeling of urgency that traders have about certain options. More exciting stocks have high implied volatility, and you must pay more. Less-exciting stocks have a lower implied volatility, so they’re cheaper. During volatile markets, implied volatility, and thus option prices, often skyrocket.

There are a number of option strategies that involve volatility. First, you can buy or sell options based on your assessment of current implied volatility.

Second, you can “buy or sell volatility.” In other words, base the trade on profiting from a change in implied volatility, rather than on a change in the stock price. This is a concept used by sophisticated traders.

A basic understanding of implied volatility can help you decide how much to pay for options, and that’s a good tool to have during volatile markets.

Michael Sincere is the author of Understanding Options (McGraw-Hill, 2006) and All About Market Indicators(McGraw-Hill, 2011). Mark Wolfinger writes a daily blog, http://blog.mdwoptions.com.