on Sunday night, so the market opened on the downside and began tomelt down. By noon it was down 115 Dow points and over 13 OEX points.The premium in the S&P futures can be used to illustrate the level of panicin the market: at the low of the day, the S&P Index (cash) was down 13.67points; but the futures were down 19.90 and trading at a discount of 6.80!In early afternoon, however, the market began to stabilize, and then it rallied heavily. Eventually, the Dow closed down 21 points on the day, whileOEX was down only 2.42, and the S&P futures only lost 1.70 by day’s end.
364
TRADING SYSTEMS AND STRATEGIES
Another violent reversal day occurred on July 19, 1995, when technology stocks sold off heavily. The Dow dropped 134 points at its nadir, andOEX was down almost 16 points. There wasn’t the same level of panic inthe 1995 sell-off as there had been in the 1992 sell-off, however, as theS&P futures never even came close to trading at a discount all day. Onceagain, the market was able to stabilize and rally. On this day, it didn’t comeall the way back, but the Dow did manage to regain over 70 points from itslows by day’s end. OEX, SPX, and the S&P futures all managed to rallybetween eight and nine points from their intraday lows.
The TICKI system will get you “in” on these reversals if theyoccur or the first on second TICKI signal. But you might be concerned about missing out on a good trade on days that reverse direction after more than two or three programs in one direction. By therule for limiting losses on the TICKI system in one day, you would bestanding aside and would miss the reversal. On the two major reversal days described just previously, there were repeated sell programsbefore the market eventually stabilized and rallied. Anyone tradingthe TICKI system would have taken two small losses during themorning and then would have been idle for the remainder of the day.In order to be able to trade reversals after a large move, I havedefined the following corollary to the TICKI system and used it withgood success throughout the years: after having sustained two consecutive losses with the TICKI system, reenter the market if itreverses by 1.75 off its extreme point.Example: The market has been selling off, and you have attempted to buyit twice after sell programs. However, both attempts were unsuccessful. Themarket then continues to sell off even more, perhaps under the influence ofmore sell programs.However, by early afternoon, the market stops going down and beginsto rally. Suppose that the low on the S&P futures at that time was 551.00.If the S&Ps then rise to 552.80, you would buy the market under this reversal corollary.
Similarly, to the upside, if you were forced to take two consecutive losses by the TICKI system as buy programs repeatedly entered
THE TICKI DAY-TRADING SYSTEM
365
the market, then you would use the reversal corollary if the S&Ps fellby 1.80 from their ultimate daily high.• Once a position is taken under the reversal corollary, youshould stop yourself out if the futures subsequently move tonew highs (if you are short) or new lows (if you are long).• If you are not stopped out, close the position at the end of theday.I have also found the 1.80-point reversal to be useful in takingprofits on a TICKI trade. For example, if you are short the S&Psbecause of a TICKI signal and they then trade down substantially,you have a nice unrealized profit. If the futures then rally 1.80 pointsfrom their low, you would cover your short futures and take yourprofit. I wouldn’t use this type of reversal to go long also, just tocover the short as a sort of trailing stop.Note: A 1.80-point reversal worked well when S&P futures weretrading somewhere near 500, but it needed to be changed when thefutures rallied to 1000. There are two ways you can make this adjustment. One is by trial and error: if you notice that you are tradingmany more reversals than you used to, or if you are missing out onalmost all reversals, your reversal point needs to be changed. Theother approach would be to use a reversal of about one-third of onepercent of the S&P’s value. The second approach is more dynamicand is the preferred approach.There are a few other pertinent facts about the TICKI system. Itwill generally give you about one trade a day, on average, althoughthe trades tend to come somewhat in bunches. Some weeks may bevery dull, with only a little program activity; in those weeks, youwould only have perhaps two or three trades. However, in a morevolatile, trading-oriented market, you may get more trades, perhapsas many as 8 to 10 in a week.As for profitability, I can only relate my personal experience,since I don’t know of any database that contains historic intraday values of TICKI. The system generates slightly over 50 percent winners,where the average winning trade is about 70 percent more than theaverage losing trade. Finally, it should be noted that it is very time-
366
TRADING SYSTEMS AND STRATEGIES
consuming to trade this system, since you virtually have to be “glued”to your quote machine when the system is trading. For that reason, itis not feasible for many traders.
A SHORT-TERM TRADING SYSTEMA short-term trading system has a slightly longer time horizon—usually a matter of at least several days to as much as several weeks—ascompared to the intraday nature of the TICKI System described inthe preceding section. This short-term system is based on detectingextremely overbought and oversold levels in the stock market, byusing the number of advancing issues and the number of decliningissues on a daily basis. When there is too large a preponderance ofadvancing issues over declines, the market becomes overbought, andthis system looks to go short (or buy puts). Similarly, when there aretoo many declines, the market becomes oversold, and the systemlooks to go long.There are many ways to view the advance–decline line, but generally most of them use the net of daily advances minus daily declinesas the starting point. This system does, as well. The crux of the system depends on calculating a momentum oscillator each day. Theoscillator itself is rather simple to compute and can be done at homeby any reader, as long as he has a starting point.Here are the specifics:1. Subtract NYSE declines from advances = net advances.2. Multiply yesterday’s exponential moving average by 0.9, andadd it to 0.10 times today’s net advances.Stated as a formula, the daily oscillator value isM1 = 0.9 * M0 + 0.1 * (Advances – Declines)where M0 = yesterday’s oscillator valueAdvances = number of advancing issues on the NYSE todayDeclines = number of NYSE declining issues today
A SHORT-TERM TRADING SYSTEM
367
For example, if the oscillator closed with a value of 100 yesterday, and today there were 1,200 advances and 900declines, then the new oscillator value would be 120:M1 = 0.9 * 100 + 0.1 * (1,200 – 900) = 120because M0 = 100; Advances = 1,200; Declines = 900.This type of computation is called an exponential moving average. In calculating an exponential moving average, we take a certainpercentage of “yesterday’s number” and add 1.0 minus that percentage of today’s values. In the preceding example, we are using 90percent and 10 percent, which gives a heavier weight to past dataand only a 10 percent weight to today’s data. We can change themixture by using 80 percent and 20 percent, or 75 percent and 25percent, and so forth.All that is required to begin calculating this oscillator for yourselfis to know the value of M1 on any day and use the formula. McMillanAnalysis Corp. will freely give the value of M1 to anyone whorequests it via e-mail to info@Optionstrategist.com.The oscillator, as just defined, generally ranges between about+200 and –200. These are considered to be the “normal” values.Whenever the oscillator exceeds that range, however, you shouldtake notice, for the market has become overbought or oversold.The actual rules for entering a trade are very simple:1. If the oscillator is less than –200, the market is oversold.• Once it is oversold, buy the market at the close on the daythat the oscillator climbs back above –180.2. If the oscillator is greater than +200, then the market is overbought.• Once it is overbought, sell the market at the close on theday that the oscillator falls back below +180.This is a very reliable way of determining overbought and oversoldconditions in the stock market. It has worked well for many years. Itusually marks an intermediate-term turning point in the market. However, in some cases, it only identifies short-term movements.
368
TRADING SYSTEMS AND STRATEGIES
In the ferocious rally that consumed the first half of 1995, the oscillatorbecame overbought by exceeding the +200 level in May. At that time, theDow had rallied 220 points in under a month. The oscillator remained overbought for eight consecutive trading days, while the market pushed another40 points higher. Finally, the oscillator fell back below +180 and the Dowdropped 81 points in one day. However, that was the end of the decline,and the Dow went on to much higher highs over the course of the year.
On the other hand, the oscillator signals can also sometimesidentify major turning points that last for months.In late 1994, the market had been selling off rather steadily between September expiration and late October. At the time that the oscillator fellbelow –200, the Dow was down about 100 points from its Septemberhigh. However, a succession of negative days followed, as there were consistently more declines than advances on most days. Over the next 35 trading days, the oscillator remained below –200 on 26 of those days. At itsworst, it fell to –454. During those 35 days, the Dow lost another 180points. Eventually, when the oversold condition subsided, the buy signalwas generated in mid-December 1994, and the Dow rallied 1,200 pointsover the next nine months.
So this oscillator is useful in getting into a market that has shortterm trading potential and may have even intermediate-termprospects. We have given the entry criteria but have not specifiedhow to exit the trade. Obviously, if we use too close a stop, we willnot be able to capitalize on the intermediate-term moves. Conversely, if we use too wide a stop, we will not profit when the marketmoves only a short distance in our favor and then reverses.We ran a number of scenarios through the computer in order tooptimize the results. The general scenario was that we wanted totrade the OEX with these signals. The system was to have a stop-losspoint to begin with; but if OEX went in our favor, we would use atrailing stop to lock in profits. Furthermore, partial profits would betaken at two fixed points—one-third of the position being sold ateach partial profit point. With these criteria, the system was furtherrefined by setting the size of the stops and the partial profit points. It
A SHORT-TERM TRADING SYSTEM
369
turns out that these points were best set in terms of percent of OEX,rather than fixed distances.This is the system that tested best in the computer simulation,although individual traders may want to modify it to their own tastes:1. Set the initial stop to be 2 percent of the value of OEX at thetime the trade is entered. For example, if OEX was 500 anda buy signal was generated, the initial stop-loss sell pointwould be at 490 (500 minus 2 percent of 500).2. Sell one-third of your position to take partial profits if OEXmoves 2 percent in your favor.3. Sell another one-third of your position to take partial profitsif OEX moves another 2 percent in your favor. Thus, if OEXwas at 500 to begin with, you would take partial profits at510 and again at 520.4. Whenever you begin to take partial profits, from then on usea trailing stop of 2 percent of the value of OEX at that time.Raise the trailing stop each time OEX closes higher. Thus, ifOEX was initially bought at 500, and then rose to 510, partial profits would be taken and the stop would be raised to499.80 (98 percent of 510).Using these criteria, the results shown in Table 5.1 wereachieved, by year. The maximum gain was 38.6 points, while themaximum loss was 18.3 points. The median trade was a gain of5.30 OEX points. The longest time any trade lasted was 155 calendar days, while there were six trades that were stopped out after oneday. The median holding period was 23 days.The reason that we used OEX for the purposes of the simulationwas the limited risk of owning options. We could trade either S&P500 futures or OEX options. The median gain of about three OEXpoints is enough to produce profits using either vehicle, assuming thatif we’re trading options, we buy at- or slightly in-the-money options.
Monitoring the Oscillator IntradayIn certain cases, you can improve the entry point by anticipating thesignals. In order to anticipate the signal, you need to observe the
370
TRADING SYSTEMS AND STRATEGIESTable 5.1RESULTS ACHIEVED BY THE SHORT-TERMTRADING SYSTEMYear
Signals Profitable
Net Result in OEX Points
19841985198619871988198919901991199219931994199519961997199819992000200120022003Totals
5 of 66 of 75 of 55 of 94 of 82 of 54 of 75 of 54 of 44 of 56 of 123 of 97 of 119 of 1210 of 155 of 105 of 106 of 109 of 145 of 12109 of 176 (62%)
+15.7+35.4+35.5+8.8–2.8– 4.3+15.0+58.3+41.7+28.3+56.3–15.7+34.7+160.7+85.2+40.0+72.8+110.2+94.8+27.0+896.6
relationship between advances and declines in the afternoon of thepertinent trading day. Even if the broad market moves late in theday, it is often unable to effect much change on the relationship ofadvances and declines. This is true because many smaller and less liquid stocks make their initial moves in morning trading and won’t follow a large market reversal much in the afternoon. As an example,assume that the Dow is down 30 and that declines outnumberadvances by 800 issues in late afternoon. Even if the Dow rallies tounchanged or maybe even slightly positive levels, declines will stilldominate at the end of the day—not by 800 issues certainly, but
A SHORT-TERM TRADING SYSTEM
371
probably by several hundred anyway. Obviously, the depth of someof the declines will not be as great at the close as when the Dow wasdown 30, but most of the stocks will still wind up losing groundon the day. This fact can be useful in anticipating signals from thisoscillator.Going into any trading day, you know what level of advancesand declines will produce a signal. For example, if the oscillator is at+220 the end of a trading day, then you know what level ofadvances and declines will produce a sell signal on the next tradingday. The next day’s oscillator will be the net advances plus 0.90 *200 (= net advances + 198). It is obvious that if there are 180 moredeclines than advances, you will subtract at least 18 (10 percent of–180) from 198, and you will get the desired 180 to trigger the signal. So when the next trading day begins, you can look for thatlevel. For example, if declines are outnumbering advances by 500issues or more, and it is midafternoon, it is likely that the sell signalwill be confirmed. Thus, you might decide to establish your positionat that time—a few hours early.The 81-point one-day decline in the Dow, mentioned in a previous example, is a classic case in favor of anticipating the signal. The oscillator hadclosed at 201 the previous night. Ninety percent of 201 is 180.90. So, onthe next day, if declines outnumbered advances by any amount, a sell signalwas going to ensue. By 1:00 P.M., the Dow was down about 35 points, anddeclines were swamping advances by about 800 issues. It was fairly apparent that the advancing issues would not be able to recover. I bought puts atthat time. The subsequent late-afternoon rout drove the Dow to its 81-pointloss, making the put purchase very profitable. As was often the case thatyear (1995), market declines were fierce but short-lived. The entire downmove had taken place in that one day.
Another use of monitoring the signal, intraday, is illustrated bythe following example. In this particular situation, which can occur inextremely fast-moving markets, the oscillator becomes overbought oroversold intraday but doesn’t hold those levels for the close of trading. Technically, then, you do not have a trading signal. However, asa practical matter, a short-term trade may be at hand, even though itdoesn’t conform to the system in the strict sense.
372
TRADING SYSTEMS AND STRATEGIES
In October 1995 the market was selling off rather swiftly (that sell-off, bythe way, had been correctly signaled by an oscillator signal in midSeptember). On October 9, the Dow closed down 43 points, and the oscillator stood at –147.18. The next day, the market was under tremendouspressure and was down 67 points at midday. Declines outnumberedadvances by about 1,300 issues at that time, so the intraday calculation ofthe oscillator would have shown it to be well into oversold territory with areading of about –262 (0.9 × –147.18 + 0.1 [–1,300] = –262.46).At that point, the market began to rally as tech stocks recovered rapidlyfrom their lows; the tech stocks had been the market leaders for most of1995, so their movements were important to the market as a whole. As therally progressed, shorts began to cover, and the Dow nearly recovered all ofits lost ground. It closed down only five points on the day. Meanwhile, thedifferential between advances and declines shrank also, although, as waspointed out earlier, it is virtually impossible for that many declines to turninto advances in the afternoon of any trading day. In any case, at the close,declines only outnumbered advances by about 500 issues. Therefore, theoscillator value at the close of trading was about –182.46, not in oversoldterritory.So, even though a buy signal was not generated by our rules (the oscillator never closed below –200, which is the first criterion), it was fairly obvious that the market had been deeply oversold at midday. Moreover, thelarge reversal rally was obviously impressive, bringing the Dow 62 points upoff the lows. So, was a buy signal generated by the intraday action, or wasmore selling due because the oscillator closed just above the oversold –200level? In this particular case, the Dow rallied another 73 points over thenext three days. Thus, the intraday buy signal was correct.
The point that can be drawn from this example is that the oscillator can be used for confirmation of an intraday move. You mighthave been tempted to buy the market anyway, based on the largereversal move in the Dow (62 points from the low). However, thefact that the oscillator had penetrated so deeply into oversold territory during the day, and had then risen out of oversold territory bythe end of the day, was good confirmation that the selling pressurewas over and that a short-term upward move was probable.This is not to say that you have a buy signal every time the oscillator penetrates the oversold level intraday and then closes outsideof it. However, when you have a concomitant market reversal, as in
A SHORT-TERM TRADING SYSTEM
373
the preceding example, then the intraday oscillator acts as a confirming indicator. Obviously, similar scenarios can be constructedfor intraday overbought situations when the oscillator is near the+200 level.The oscillator has had some very wide swings in recent years.Figure 5.1 shows the history of the oscillator from late 1998 throughearly 2004. It is interesting that this time period encompasses notonly the all-time low reading for the oscillator (during the October“massacre” of 1998) but also the all-time high reading (during thespring of 2003, when the market just continued to rally day after dayon very positive breadth).There are some other interesting points that stand out. Therewere two extremely oversold conditions in 2001 and 2002. The firstoccurred in the selling that took place after the terrorists attacks on9/11/2001. The second was in July, as the bear market was endingits steep decline during that month. Neither was quite as negative asOctober 1998, but they were certainly close.Figure 5.1OSCILLATOR: 1998–2004All-time highOverbought
Positivedivergence
Oversold
Date
12/29/03
08/19/03
04/09/03
11/26/02
07/19/02
03/11/02
10/26/01
06/13/01
02/01/01
09/21/00
05/12/00
Extremely oversold01/03/00
08/24/99
04/15/99
All-time low12/02/98
10008006004002000–200–400–600–800–1000–1200
374
TRADING SYSTEMS AND STRATEGIES
Also look closely at what happened after that, in 2002. The market actually made a slightly lower low in October 2002 (not shownon chart), but the oscillator did not. It reached deeply oversold levels,but it did not exceed the July low. Hence, that was a positive divergence—the market made a new low, but the oscillator registered ahigher reading. This can be interpreted as a long-term buy signal—and indeed it was, eventually. Furthermore, the broad marketreturned to the same levels in March 2003, as the war in Iraqloomed. Yet, the oscillator made still another higher reading. Sothere was a sequence of three points that showed the oscillator making a positive divergence. The bull market that followed was a verystrong one.Finally, one other longer-term view can be obtained from theoscillator: if the oscillator gets extremely overbought, it is very positive for the market (and if it gets extremely oversold, that’s negative).Consider the action in 2003, from April onward. The oscillator spentthe better part of a year above +200—actually exceeding +600 onmany days. Those readings broke the old records quite easily. Yetthe market continued to climb higher and higher. There is an oldadage that a bull market is very overbought at its inception—andthat’s a good thing. This oscillator picture certainly confirms that.Furthermore, the oscillator was below –200 for a long time inJune and July of 2002, yet it was no time to be a hero and jump injust because the market was oversold. The market continued todecline, day after day, getting more and more oversold. It was necessary to wait for the buy signal to actually occur before one could buy.In fact, a good rule of thumb for all traders is this: “Overboughtdoes not mean ‘sell,’ nor does oversold mean ‘buy.’” Rememberingthat one rule will keep you out of trouble in strongly trending markets. Don’t fight the trend even if it is clearly overdone. As JohnMaynard Keynes said, “The market can remain irrational longer thanyou can remain solvent.”
Problems with the Advance–Decline LineIn July 2001, we began to notice a discrepancy between the market’s behavior and the NYSE advance–decline line. Specifically, the
A SHORT-TERM TRADING SYSTEM
375
advance–decline line was making new highs, yet the market was languishing. In fact, we had sell signals from several of our indicators,and it was obvious that the market was struggling. Yet, bullishcommentators repeatedly invoked the positive nature of theadvance–decline line as a harbinger of a bull market to come. Thisseemed strange to us, but they were right—the advance–declineline was making new highs. About the same time, Richard Russell,publisher of the Dow Theory Letter, noted that nearly half of theissues trading on the NYSE were not stocks—they were warrants,preferreds, funds, and so on. Moreover, a large number of thesewere interest-rate related and were thus distorting the NYSEadvance–decline figures.Why should interest-rate-related issues distort the figures? Becauseinterest rates were falling all during 2001 and were making thoseissues advance, thereby creating more advances on the NYSE than a“stocks only” measure would have shown. The NYSE does actuallypublish an “operating companies” advance–decline figure on their website, but it is not disseminated to the news media or to data suppliers.At this point, we decided to do our own research. Realizing that wehave a ready-made database of stock data — all the stocks on whichlisted options are traded (over 3,000 of them) — we decided to use thatdata to construct our own “stocks only” advance–decline figures.At the time (July 2001) the contrast was startling. It is shown inFigure 5.2. The upper line on that graph is the common NYSEadvance–decline line. You can see that it was trading at new yearlyhighs. However, the bottom line is the one constructed by using onlythe optionable stocks to create an advance–decline (the “stocks only”advance–decline line). It is moving downward! Hence, there was ahuge discrepancy between the two.We were sure that the “stocks only” line was more reflective ofthe true state of the market. So we endeavored to find out why thisdiscrepancy was occurring. One reason was that the Federal ReserveSystem (Fed) had been lowering interest rates since early 2000 (pointA on the chart, Figure 5.2). However, that alone could not explainthings. Moreover, the fact that 48 percent of the issues on the NYSEare not stocks isn’t the real reason, either.A little history might be appropriate. Apparently, about half theissues on the NYSE have not been stocks since the late 1940s
376
TRADING SYSTEMS AND STRATEGIESFigure 5.2NYSE ADVANCE–DECLINE LINEFed begins to lowerinterest rates.
Decimalizationbegins in full.
BRatio
NYSE A–D Line
A“Stocks Only” A–D Line
J F M A M J J A S O N D J F M A M J J A20002001
(preferreds account for most of the difference). Moreover, the Fedhad certainly lowered interest rates at times in the past, and yet theadvance–decline line had not behaved in such an opposite manner tothe truth. Thus, there was no reason why those two factors would becausing this discrepancy in July and August of 2001.It turns out that they were contributing factors, of course; but thereal culprit was decimalization, which had been phased in early in2001 and completed by the spring of 2001. Consider this scenarioas to why decimalization was (and still is) a problem. Suppose that a
A SHORT-TERM TRADING SYSTEM
377
preferred stock is trading at $40 per share. Moreover, suppose thatthe bond market is up 12 ticks today (that’s 12⁄32, or 3⁄8 —less thanhalf a point). While that’s a nice little rally in bonds, in the daysbefore decimalization, it wouldn’t entice anyone to pay up to 401⁄ 8for that preferred stock. That would have been too large a yieldadjustment. However, in the days of decimalization, someone mightpay up to 40.01 or 40.02 for the preferred stock, thus qualifying itas an advancing issue. While we addressed this issue early on, tradersare still grappling with it. For example, some have suggested eliminating issues that only advance or decline by a few cents. They claimthat produces a “truer” figure.To date, interest rates have not really risen, and so the positivebias of the NYSE advance–decline line persists. However, wheninterest rates finally start to rise, the opposite will happen: the NYSEadvance–decline line will underperform the “stocks only” line, forthen the interest-rate-related issues will be declining.This problem with the advance–decline line affects every technicalindicator that uses market breadth as a factor. This include the ArmsIndex (named after its inventor, Richard Arms), for example, whichcertainly had its share of seemingly “strange” readings during the2001–2002 period. We are concerned, of course, with how the problem affects our oscillator. It is a simple matter to compute the oscillator using “stocks only” advances and declines, rather than NYSEadvances and declines. In fact, we constructed a trading system basedon the “stocks only” oscillator— one similar to the system presentedearlier in this chapter. As one might suspect, a similar system usingthe “stocks only” data produced better results, because the distortionscaused by the NYSE advances and declines were not present.I don’t think you should ignore the NYSE figures completely, butyou should be aware that they may be suspect on days when interestrates have a big move. In fact, we currently keep both oscillators ona routine basis, and we supply the “stocks only” data in all of thenewsletters that we publish.There has been a request by technicians for the NYSE to publishadvance–decline numbers based only on “operating companies.” Butthey have ignored that request (or the media have) for quite sometime, so I wouldn’t expect to see it anytime soon.
378
TRADING SYSTEMS AND STRATEGIES
INTERMARKET SPREADSIn option terminology, we usually think of a spread as being long oneoption and short another option, with both options having