Newsletter
November 19, 2005
The Best Laid Plans
Market & Sector Review
This Week's Economic Reports
Samuel Adams, father of the American Revolution: "It is therefore recommended ... to set apart Thursday the eighteenth day of December next, for solemn thanksgiving and praise, that with one heart and one voice the good people may express the grateful feelings of their hearts and consecrate themselves to the service of their divine benefactor ..."-November 1, 1777 (adopted by the 13 states as the first official Thanksgiving Proclamation)
The Best Laid Plans
Many traders will say that they just can't seem to stick with their trading plan. You may develop a viable trading plan only to abandon it impulsively. Why? What is it that goes wrong? Most often the problem is the plan is to vague, parts are missing and when a plan is incomplete it is very hard to follow and execute. Many newer traders experience additional concerns, the thoughts and emotions that are experienced when the plan is actually executed. The best plans are developed when one is calm and clear-headed, usually long before the plan is to be executed. Strategies are clearly specified, yet when the plan is executed later on, a barrage of emotions may be experienced, and these emotions, if left unchecked, can thwart the best laid plans.
Emotions can color and change our perspective. When you develop a plan during the quit evening it makes perfect logical sense. Then the market opens the next morning and everything suddenly looks different. Perspective's can change very quickly and for many reasons. Perhaps you are preoccupied about other unrelated problems or for some reason you are suddenly worried about money. Your child's tuition is due, or you need a new car, or it's hot and stuffy in your office, or you are just weary and groggy for no apparent reason. It could be that the markets are just behaving more erratically than you had anticipated. Whatever the feelings, or the reasons for them they influence your thoughts and perceptions. What should you do? That varies from trader to trader. Some will stand aside and wait for their mood to improve. Many seasoned traders, who have seen it all and aren't easily fazed, may ignore their feelings and continue on. A newer trader however may be easily shaken. It is at this time that trading errors are made or trading plans abandoned entirely.
Fortunately there are preventative measures you can take. First and foremost, develop a clearly defined trading plan, knowing exactly when you will enter and what signals indicate that you should exit. Focus all your energy on executing the plan. I know this is easier said than done. When you are emotionally distracted your psychological resources are at their limit and you have few resources left to execute your trade. This is not the time to re-think your plan. Probably the best solution is to limit your attention to executing your trading plan as you have it outlined. Don't second guess it. Think of it as trading as if you were a soldier. When soldiers are ready to fight, they don't question their skills. They don't worry about whether they are unprepared. They are ready to fight an opponent, and need to focus only on winning, and just do it. And that's what you should do just execute your plan under the stressful conditions. There's no reason not to. You factored in the risks up front when you outlined your plan and you know deep down that you can't experience any real harm should the plan fail this time. In many ways, your fate is already determined. if you choke under the pressure, you may mess it all up. If it's a loser, there's nothing you can do. If it was meant to be a winner, however, and you let your emotions fowl up your plan, then you have lost one of the trades that may have been one of the winners across a series of trades. And from a purely statistical vantage point, you want to win on every possibility that you could have. That means executing your plan rather than abandoning it. The best-laid plans can be ruined if you don't execute them properly. But if you clearly define your plan and focus solely on executing it, you'll trade profitably in the long run.
Market & Sector Review
This week, as a follow up to last weeks discussion on relative strength and linear regression, I am proud to present, Waveslider's (one of our members I have come to know and respect) follow up dissertation on using relative strength data for stock selection entitled: "Methods for using Relative Strength Analysis." If you would like to first review his last article Using Relative Strength Readings for Stock and Index Selection Click Here! Since I was introduced, years ago, to relative strength analysis by "Investors Business Daily", I have used it in one form or another in my own analysis for stock selection. In addition, since I have come to know Waveslider over the last several months I have also become enamored with his top down approach, while our time frames are different, I have personally used what he talks about below. It is a very affective way to break down the market to determine just where the potential action lies. What everyone needs to understand, as traders, regardless of you time frame, is simply this, what good is a bull market if you are in the wrong stocks. During bull markets or perhaps I should say rally phases you want to maximize your return by utilizing the strongest stocks not the weaker ones.
As was stated in last weeks letter, the TC2005 database left out one level of sector analysis, i.e. Basic Materials; Consumer Goods; Financial; Healthcare; Industrial Goods; Services; and Technology. Their sectors for Conglomerates and Utilities are fine as presented. This week we have organized the Media General Groupings to include those Major Sectors, as well as the sub-sectors mentioned last week and of course industry groupings. What this means is simply this: now you can compare all Basic Materials Stocks against one another as well as all Metals & Mining stocks for instance. Now when you go to compare, you may enter as your search criteria the new broader based listings as well as the TC2005 sectors (those ending in 0), the report generated will display all stocks in those sectors and sub-sectors, the output will be listed in descending order by their Relative Strength Percentile Ranking. Over the next several months we will be researching other databases utilizing sector breakdowns other than Media General in order for those not using TC2005 to examine sector charts. In addition research will continue on the best and most relevant data, as well as exactly how it should be presented without becoming too confusing. In other words look for changes to occur from time to time, as we see fit.
Methods for using Relative Strength Analysis
By Waveslider
As a follow-up to the installment on Relative Strength analysis, this article will discuss methods and considerations for stock selection using the theories discussed previously. While those reading this will range in the time frame they trade, these ideas can be applied to all time frames, to all indices and stocks which are related to the broader market (i.e. the S&P 500, NYSE composite, etc.). Once again (using a long position as an example) what we are seeking to do is be involved only in the strongest sectors in the market, since this is the place where accumulation is taking place by institutions.
The first concept that should be addressed is the value of viewing multiple time frames. The tools we will discuss are very powerful and valuable, but a complete analysis requires looking at the time frame one level higher than the one being traded. Relative strength analysis will tell you where accumulation/distribution is going on, but these trends do not last forever. We need to know when a blow-off or major bottom is taking place to avoid being on the wrong side, and multiple time frame analysis takes care of this issue.
Fortunately, these cases are pretty easy to spot. Take for example, if you are trading a daily time, look at the weekly time frame. What you don't want to see is any kind of high volatility spike that closes below the halfway point of the bar. In candlestick analysis this bar has a few names: shooting star, morning star, etc. Understand that this event doesn't mean the trend is over necessarily, but it does mean that supply has temporarily caught up with demand, and there will be a reversal or a consolidation. In either case - you discard the situation and move on.
What you do want to see in your higher time frame analysis are signs of trend continuation or low volatility. In the first case you might be getting involved as the trend is in motion, in the second case you should be watching and waiting for what you are expecting to happen. In both cases you should see your relative strength line either flat or rising.
Don't spend too much time staring at the higher time frame. The red flag should stand out to you; if it doesn't then you have a candidate. Scanning for relative strength should be a process that makes your stock selection more efficient, so that you don't need to spend as much time on analysis. Get to know the red flags and if they're there just throw that chart out for now, avoid at all costs falling in love with a stock or sector. Unless you have some inside information, this will just burn you 9 times out of 10. There aren't that many Google cases out there, believe it!
Using the scanning tools (Editor's Note: Index, Group, & ETF - Relative Strength Tables) is a very useful way to narrow your focus on where money is flowing. What we are going to look at are just 2 measures, and these measures will cut down the universe of stocks to a short list so that you can look at just a few charts and determine where you want to be. Remember, in top down analysis you should be looking for entry into these stocks when the broader market gives you a signal. When this signal fires you will be entering the strongest stocks in the market.
The two tools we will discuss both involve the relative strength reading between two markets. Simply calculated, this formula is: MARKET #1 divided by MARKET #2 where Market #1 is the market being traded. There are 2 levels here, comparing the index against the broader market, and the actual stock against the index. So you are actually going to be doing this process twice.
Relative Strength Calculations against the Broad Market NYSE Index:
Using the calculation mentioned above we derive a cumulative and real-time perspective of the market. The cumulative measure is a linear regression line measuring the strength of the relative strength calculation. This is helpful in making an analysis of the strength of the market being examined during the past month versus other markets. Theoretically, the market with the highest measure has been the strongest market over the past month. This is a lagging indication, but nonetheless it is important because it means there was accumulation here, so when the market continues in the same direction this market has a good probability of resuming its strength and its out-performance.
Next, we look at the here and now. This is the measurement that measures the deviation from a linear regression line of relative strength. Here we look for a short-term opportunity. What I like to see is a strong linear regression reading and a weaker (not too weak!) deviation calculation. As was discussed in the last article, in a strong trend there is an abrupt sell-off that shakes out the weaker hands, then the trend resumes.
This is not the only method to use with these calculations. The proper thing to do is look at the broader market to tell you what to look for. In other words, the signal you are given by the broader market should fit with the relative strength readings you are using. For example, if the broader market has been selling off hard and just about every sector is participating, when you get your signal from the broader market you probably want the opposite from your deviation calculation. If the market you are looking at is deviating positively from the linear regression line of relative strength while the rest of the market is selling off, this is actually a good thing. You don't want to buy pullbacks in this situation, because when the market turns, money will continue pouring into this sector and will likely not even pause.
So, quite simply, if you are a trader looking at daily time frames this is the routine for screening:
- Start with looking at the indices and their relationship to the broader market make a short list with maybe 3 sectors that stand out to you.
- Then go to those sectors and do the same thing, finding stocks which are outperforming their sectors. 6-10 stocks in each sector leave you with 20-30 stocks to watch the next day.
- If your signal in the broader market does what it should, then the stocks that are responding to the broader market are the ones to go with!
Relative Strength analysis makes sense and it works. As you fit it into your own trading style you will learn the nuances and find what works for you. Also remember nothing is perfect, and relative strength readings are just a tool, there is nothing magic about it. A market with strong relative strength is prone to the same shakeouts and fake outs as the rest of the market. The extra edge it gives you is that if your analysis is correct, when the market resumes direction you will have a trade that outperforms the market - and that is a good objective!
I hope you have enjoyed, understand, and appreciate this members contribution. If you begin working with the various reports and output available to you here, in a very short while you will become used to them, understand them, and be directed to the area's of interest in a very short period of time. Take a moment and check out the new sector, sub-sector, and group output pages, I think you like the new look and differences. You owe it to yourself!
This Week's Economic Reports
Have A Great Week!
Bill
Disclaimer: Trading in securities, of any type, may not be suitable for all individuals. The contents of this newsletter are not a solicitation to buy or sell securities. The opinions expressed are solely that of the author. You must do your own research, contact your own financial advisor for suitability of any investments. Data gathered is from sources believed to be reliable, but NO guarantee as to their accuracy is made.
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