In March 2010 the Monthly Cash Thru
Options (MCTO) options advisory service had a loss that was caused by a strong and relentless
UP-trend lasting for 50 trading days. After this loss, we spent a lot of time
performing a post mortem of the March 2010 cycle to better understand what we were
seeing and thinking at that time when we made the decision on Feb 26th to open
our RUT and SPY March bear call spreads. Once we understood what happened,
we took action and strengthened our trend and trend reversal analysis capabilities to reduce the probabilities
of getting hit again with a loss from a strong trending market. This
article summarizes our refined trend analysis methodology.
Below shows the point where the MCTO
team decided to to start opening our March bear call spreads. From our analysis at
that time in mid February, we thought there was a good chance that the market
would hit resistance at the 50 day simple moving average (SMA) and then start to
trade range bound and sideways. Moreover, many of the macro-economic indicators were looking either weak, or just ok. Thus, we made
a decision to jump in and open our RUT and SPY bear call spreads at at this
time, which was around Feb 26th. We can see from the chart below that the SPY
pulled back, looking like it was going to hit resistance at its 50 day SMA,
bounced off of its 100 day SMA and then rallied for 47 trading days forcing us
to close-out all
of our bear call spreads and causing a loss.
First we need to understand the
big-picture trend of the market - i.e. whether the "tide is coming in" and
raising all boats, or if the "tide is going out" and lowering all boats.
One resource we now utilize is to monitor volume-based data and proprietary volume-based oscillators
to provide us early visibility of the prevailing trend, or
trend reversals. (These are not our proprietary indicators, but indicators
supplied by a 3rd party company that focuses on volume based data on the major
US indexes) Below is a 1.5 year chart with 1 day bars, and 7 volume based
indicators. The 1.5 year chart provides insight into 3 to 6
week trends. For more on how to read this chart and associated
volume-based indicators please visit the
volume-based chart tutorial. Most experienced traders will agree that
volume based indicators can provide early predictions of future changes in
price; i.e. change in buying or selling volume for a stock or index
happens first, and the change in price of the same stock or index will usually
follow. From the below chart, we see that this volume based indicator
gave a "go long" bullish signal on Feb 15th (first green vertical line
representing when the SBV Oscillator crossed above the red trigger line) and gave an additional "go long"
signal in Feb 26th (second green vertical line representing when the MACD had a
bullish crossover), and Feb 26th was just about the time when made a
decision whether to open our bear call spreads or to wait longer.
Next, we take a look at the
Advance/Decline line, the Advance/Decline volume line and the new highs/new lows
line, all on the NYSE Composite Index, and each respective MACD to provide further hints if "momentum"
is building in a stock or index. Many times we'll see this momentum
building before the price of the stock or index starts to move.
NYSE Advance-Decline Analysis
- The $NYAD, and its associated MACD, represents the number of
advancing stocks less the number of declining stocks on the NYSE composite index.
Looking back to our loss in March 2010, as of Feb 8th the 12 day simple
moving average (SMA) of the Advance-Decline line (blue line in the
top chart) started to climb. Additionally, the MACD
on the $NYAD had a bullish crossover where the black line crossed above the
red trigger line, thus making the blue MACD histogram go into positive
territory. This is an early sign that the NYSE, and probably the
entire market, was starting to build silent positive momentum. Note
how the price based Relative Strength indicator didn't bottom out until
March 4th. In general, most price based indicators are not good
predictors of trend reversals.
NYSE Advance-Decline Volume Analysis
- The $NYUD measures the volume behind all advancing stocks, and
subtracts the volume behind all declining stocks. (Using the NYSE
composite index) Volume studies on the Advance/Decline line can be
very good early predictors of upcoming trends and trend reversals.
The MACD on the $NYUD provides further predictive power. As of
Feb 9th, the 12 SMA (blue line on top chart) started to increase and the
MACD blue histogram also went into positive territory as early as Feb 8th.
NYSE New Highs-New Lows- The $NYHL
uses the NYSE composite index and subtracts the new lows
from the new highs and plots this data daily. As of Feb 11th, the MACD
on the NYHL turned positive telling us that positive momentum was building
in the NYSE index. The 8/22 day EMA didn't have a bullish crossover
until Feb 26th or so, but when it did, this provides further confirmation of
a trend reversal. Moreover, because the Advance/Decline indicators
along with the volume based indicators were showing a lot of strength early
on, this told us that the upcoming trend could be strong.
We then look at the major indexes, like the DOW and S&P 500, to see
if the 8 day EMA has crossed above or below the 22 day EMA. In this
case the S&P 500 index had a bullish crossover around Feb 16th, (light blue
line crossed above the olive line) telling us that there was a
reasonable probability that the market was transitioning into an UP trend.
For more on the 8/22 EMAs please click
here. In addition to the 8/22 EMA bullish crossover, the
volume based indicators such as OBV and A/D were showing strength, but in
general, most of the price based indicators, like the Relative Strength
Index shown below, lag and don't give us early predictions of an upcoming
Finally, we'll look at the parabolic SAR
indicator on a few of the major indexes to see if it also has
changed direction and is predicting a trend reversal.
This concludes the analysis that we
perform weekly, which provides us the best chance of predicting how strong or
how long a prevailing trend will last, and gives the earliest indication
possible of a trend reversal. This trend based information will ultimately
help us time our entries and exits to improve profits and reduce risk.