Spotting Tops

One of the really good clues that the indicies were topping out was found in internal volume numbers.  The blue oscillator is called four volume.  It’s a combined average based on the up/down volume ratios of the Dow, S&P, Nasdaq, and Russel 2000.  The area marked in yellow shows a divergence.  As the S&P pushed to a one year high the market’s internal volume was not confirming the move up.  The prior weeks had consistent selling during the opening hour.  That was a clue that big money was bailing.

One Year Lows

The question now is whether this is a change in trend or a spot for dip buying.  Bank of America is one of the leading NYSE stocks.  It and several banks compose more than 50% of NYSE trading volume.

Using linear regression we can see BAC is at a one year low and looks due for a bounce:

BAC 1yr

However, the two year channel still shows plenty of room to the downside.  The overriding bear market is clearly visible:

BAC 2yr

Lastly, the five year channel appears more bullish with upside potential:

BAC 5yr

There is no definitive way to know where the market is heading.  In the short-term many stocks look poised for a bounce.  Spotting sector trends with linear regression is often useful.  Right now banks, retailers, and gold miners look poised to resume upward gains.  The leading names like BAC, M, and FCX are mean reversion candidates.

Taken out of a pool of over 400 names here is a list of 70 bounce candidates.  They are at or near one year linear regression lows.  To see so many names at a range extreme is quite compelling.

Gallery of 70 Longs

Using mean reversion these stocks should return to a median price.  Is a one year low a good bounce point?  Not if the market is preparing for a two or three sigma move down.

Inflection Point Update

This strategy is similar to one used in Oct. 2009  (see story).  Back then a handful of stocks were at 60 day lows.  Here is where those 14 longs sit as of Friday’s close:

The maximum profit/time was 5 days after entry.  That exit earned 13% or $19,000.  A more patient exit was three months later.  At the peak this portfolio reached $40,000 profit.  Holding from Oct. 2, 2009 until Jan. 19, 2010 would have seen those gains.  Without profit stops the last three days of selling wiped out $14,000.

Retail HOLDRS

Here is a five year chart of the RTH:

We can see price is near the first regression line.  Volume is also getting thin as price pushes higher.  This is a good clue to look for other inflection points in retail names.  Current names in the Retail HOLDRs.

Nine Month vs. Two Year

Right now it appears the nine month and two year channels are in play.  There are many retailers near nine month lows.  Macy’s is one example:

The caveat is the broader market.  Right now retailers are a mixed bag.  Many of the smaller names are at two year highs, and several of the larger names are near nine month lows.  Also, dip buyers have been getting weaker.  What has been consistent is to short stocks as they near two year channel highs.

Looking at Macy’s on a two year chart shows a clear downtrend.  It’s also at a one sigma regression line.  So the question is:  Does Macy’s rally to the upper channel or slide back to the middle?

Timing

So the trick is to find that slice of time where you have a 95% chance of being right.  Mean reversion traders look for price near high/low channel lines. Price matching on multiple time frames can provide some great low risk entries.

Gallery of 37 Retail Names

Here is what a scan of 113 retailers produced.

Retailers for Xmas

A list of 37 names near various inflection points.  The two year charts trump the nine month charts for longer term swing trades.  Hopefully this will be useful to you in your trading.

Wishing you a wonderful winter season!  -GTM

Finance is a closed system.  It’s not run by a perpetual motion machine.  So the famous up arrow always stalls somewhere.  What we want to know is just where is price in relation to time? The probability of price correcting back to an average value eventually becomes more and more certain.

The chart above is that last two years of the Dow using linear regression.  Here’s a list of the current Dow 30 names.  Out of those thirty companies some are stronger and some are weaker.  So this isn’t a definitive science.  It’s an art, but it is finally a spot to take notice.  Let’s dig more into linear regression to see why it can be so useful.

68-95-99.7 Rule

In statistics, the 68-95-99.7 rule, or three-sigma rule, or empirical rule, states that for a normal distribution, nearly all values lie within 3 standard deviations of the mean.

About 68% of the values lie within 1 standard deviation of the mean (or between the mean minus 1 times the standard deviation, and the mean plus 1 times the standard deviation). In statistical notation, this is represented as: μ ± σ.

About 95% of the values lie within 2 standard deviations of the mean (or between the mean minus 2 times the standard deviation, and the mean plus 2 times the standard deviation). The statistical notation for this is: μ ± 2σ.

Nearly all (99.7%) of the values lie within 3 standard deviations of the mean (or between the mean minus 3 times the standard deviation and the mean plus 3 times the standard deviation). Statisticians use the following notation to represent this: μ ± 3σ.  (Wikipedia)

Timing

So the trick is to find that slice of time where you have a 95% chance of being right. Year to date we are approaching a two standard deviation move in three months. Mean reversion traders look for price near high/low channel lines. Price matching on multiple time frames can provide some great low risk entries.

Here’s the Dow for the last two months.  You can see it’s in a nice up trend, but the larger two year trend is going to put pressure on this short term trend.  There’s obviously wiggle room here.

Catching a reversal near an extreme is key.  Like after a 200 point Dow day.  Two weeks ago there were 22 stocks aligned at 20/40/60 day lows.  Three months of price coalesced into a single inflection point. From that list the 14 cleanest charts were picked.  And these weren’t cherry picked later.  These names all came from charts posted here on October 1st (see gallery). This method made 13% in a week.  Going long the Friday after a -200 point drop (see story) was a low risk strategy using linear regression.

Went long Friday’s open on Oct. 2nd and sold at the close on the next Friday:

Referring back to the two month Dow chart we see there was still plenty of upside after the Oct. 2nd push off the lower channel.  Price ran back to the median line and moved higher.  However, holding two weeks into the next Friday’s close on Oct. 16th did nothing for the portfolio.

Trailing every name that made more than $500 profit with a $500 stop would have grossed $16,000 in one week.  That left only RIMM and CAKE as open positions.  The risk of holding for one extra week would not have made much of a difference.  The ultimate intraday high of this portfolio was $20,000 which happened five minutes before the close on Thursday the 15th.  Good luck timing that exit!

Note: these are examples of trading a mean reversion strategy.  They are theoretical and not trading advice.

Sixty Names

Going through two year charts tonight shows a ton of potential shorts coming. A push or another 200 point day to put the market near the top of the two month channel would be an ideal setup.  The more time frames that line up the better odds for a reversal.  A scan of roughly 400 active stocks shows there are sixty near two year highs:

Gallery of 60 Stocks Near Two Year Highs

At or very close to two year channel highs:

BLK IOC CLNE BZH JADE SRZ PCLN GOOG BAC GE CAT CBI SLB

Just hit two year line and failed:

BIDU WDC WYNN

Pattern to Watch

The stock NTES has already completed a move we’re looking for.  Price reached a two year high, failed, then returned to the median line in a clean trend with a clear exit.

NTES 2 year

Price tested the two year high twice then failed back towards the median line.

NTES 20 day

This one month chart is an example of how to stay in the trend. Price failed on every one sigma test with a nice clean exit on the lower channel.

NTES 3 month

Using 20/40/60 day LR lines shows an inflection point to short the stock. The spike above the channel was a great low risk entry. The spike below was a great exit.

Note: There is an art to the best time frame entry using this trading style. Also, shorter term channels adjust constantly. There’s wiggle room on the sixty names. What LR channels clearly show is the trend and where price lies within that trend.

Shorting the extreme high/low is often a low risk entry. The odds of price gaining more momentum to push above a two year channel are less than the odds of price reverting back to an average.  Mean reversion is going to come into play soon with every major index. Because there are so many names setting up this points to shorting certain highs as a very good risk/reward.

As stated before there are no guarantees in the market.  It can do anything at any time.

Valid at close Wed. Oct 7th

Clues to Exit

So where do we exit these trades?  The first is break even profit stops.  Some of these names are barely holding on after a three day push in the overall market.  It’s prudent to put tight reins on them and not let a small gain turn into any kind of loss.  The bigger profits can be given wiggle room.  When price runs back to the median line of your preferred time period a profit stop should be tightened.  The optimal exit is when price runs to the top of the channel.  Look at FCX:

For short term swing trades the 20 day channel is very useful.  A tight profit stop here at the top of the channel is often ideal.

Shorting Gold Miners

Using this method several gold miners look ready to go short: AEM TLR VGZ THM and KGN are all at new year highs.  The trick is getting price and time to align for maximum profit and minimum risk.  Let’s look at AEM:

YTD

Price is near the top of the year to date LR2 channel. It's a 2 sigma move that should come back down, but there's some wiggle room.

60 Day

The lowest risk entry would be around $76 at the top of the channel. On a smaller time frame there's much more finesse to maximize the setup.

More Names for this Week

Keep an eye on FCX.  It’s a great industry leading stock that will give clues to how gold and the miners will trade.  The following names might be a little early to short.  They are junior players that all made new highs today.  Gold is a very difficult sector to trade and there’s lots of wiggle room.  On the first sign of weakness these low risk trades could turn into quick profits.

KGN

THM

TLR

VGZ

Caution

These are probabilities not known outcomes.  The market can do anything at any time.  This concept assumes there will not be major news events or supply/demand shocks to upset the concept of mean reversion.  The odds of price retreating from range extremes outweighs the risk of shock events.  However, a maximum loss market stop is always necessary to protect one’s capital.  It’s vital to use concrete money management discipline.  Many swing traders will not risk more than 2% of their cash per week.  If you’ve got $50,000 taking a $1,000 draw down is the max loss per week.  That’s the cutoff point.  It proves the trading edge for that week is wrong.

Twenty-two Names

Out of a couple hundred active stocks today there are 22 names sitting on 60 day LR2 lines. This means they’ve had a 2 standard deviation move down and should return to the middle of their price channel. Half the names line up cleanly on all three (30/60/90 day) time frames. There are also several (not as clean) at the 50day sma. This is a clue that we either resume business as usual tomorrow, or early next week, or this is a major trend change. From this scan there are few juicy shorts other than these same names. Often the best swing shorts are stocks at their lower channel line.

We’re looking for a return into the channel or acceleration out of it. It’s make it or break it time!

See Chart Gallery

Cleanest symbols: CAKE HIG LEN LNN LVS LZB MA OII TNA V ZN
50day smas: DVN EGO FCX OII TNA

Examples

Here you can see all 3 time frames line up: 90bar 60bar 30bar

V didn't close cleanly on the line, but that's one fat hammer on x2 avg volume. Looks like a strong reversal might come.

Linear Regression Channels

Parallel and equidistant lines are drawn two standard deviations above and below a Linear Regression trendline. The distance between the channel lines and the regression line is the greatest distance that any one closing price is from the regression line. Regression Channels contain price movement, the bottom channel line provides support and the top channel line provides resistance. Prices may extend outside of the channel for a short period of time but when prices remain outside the channel for a longer period of time, a reversal in trend may be indicated.  (Prophet.Net TA Glossary)

Watching oil last week there were many names that looked overextended.  We’re talking about short-term trading here.  Using a 50% linear regression channel can give us an idea of just how far price has gone.  The beauty of LR channels is price reverting to the mean.  There is finesse on entering with the most powerful time frame, but these give high probability setups.

The previous Friday RIG closed above a three month channel line.  Then it collapsed on Monday with a gap down open.  That was a missed trade.  Tuesday gave another opportunity to short RIG at the close and it worked on today’s open.

So on Tuesday it couldn’t close above the prior high, even with volume coming in.  There is a divergence in OBV on the 60 day chart, which trumps the 10 day trend in on balance volume.  The larger time frame also shows declining volume with higher prices.  Usually a good warning sign.

Here is the intraday chart for reference.  Price tested the prior day’s close and immediately failed.  It was fast easy money.  Low risk traders took their profits.  Does RIG have more downside potential?  It’s probable, but the easy trade is now over.

ThinkScripter Indicators

If you use the ToS platform visiting ThinkScripter is a must.  The /ES chart uses these indicators:

http://www.thinkscripter.com/2009/05/13/four-volume/
http://www.thinkscripter.com/2009/03/12/previous-days-regular-hours-highlowclose/
http://www.thinkscripter.com/2009/02/23/tick-trin-indicator/
Heikin-Ashi bars

S&P 500

This chart should be fairly self-explanatory.  One of the things that stands out is the Four Volume divergence.  As the market was pushing higher, after the FOMC “no change” announcement, internal volume was turning down.  This was a very good clue to look for a reversal.  A low risk countertrend entry was to short at the 1075.75 pivot. Heikin-Ashi bars are useful for staying in the trend or seeing a trend more clearly.

Using LR channels we’d know that TNA was getting overdone and could look to long TZA soon.  Check out that hammer on TNA’s weekly chart.  The small yellow circle is from Sept. 1st when TNA touched the lower three month channel (see chart).  That coincides with the median line on the entire price history channel.  Pretty sweet huh!

Here’s the TZA intraday chart for trading FOMC news.  The first entry was right off a Person’s Pivot.  The tick high at 1300 also gave a low risk countertrend entry.  The sharp upturn on CCI was also a good clue to get long.  Lastly we see Alexander Elder’s famous “kanagroo tail” pattern.  That’s four strong signals to get in the trade.