Bulls and Bears Fight Over S&P500

The stock market is often said to be a fight between the bulls and the bears.   Technical analysis aims to help traders understand market behavior by studying the price action which is akin to the tracks left by the various market animals.

In last week’s market action, we can see the bull and the bear squaring off as two powerful and infrequent “tracks” showed up on the S&P 500.

Representing the bulls, we see a MACD positive divergence on the daily chart of the S&P 500, as shown in the StockFinder screenshot on the left.

Representing the bears, we have a Death Cross on the daily chart of the S&P 500, as shown in the StockFinder screenshot on the right.

Of course, as traders the battle is of more than abstract interest — our success depends on siding with the winners as much as possible and protecting ourselves from losses when we find ourselves on the wrong side of the trade.
 
To find out more, here are three complimentary resources:
 
Focus on MACD with my Las Vegas MoneyShow video
 
Learn about Golden Cross and Death Cross in my other video archive from Las Vegas
 
As general resource, check out TraderPlanet.com   It provides market commentary, charts and quotes, news, educational videos, live webcasts and many more services absolutely free of charge.  I will be a contributing writer to TraderPlanet very soon. If you register with TraderPlanet.com, as a thank you gift, you’ll immediately receive access to their trading ebook library, where you can select among several trading topics and authors. Register here: http://www.traderplanet.com/freebooks/636

On Knowing When To Sell

SPY Sell and Hold Signals

I want to share a couple key ideas with you.  I just answered all the write-in survey questions from the recent MoneyShow and if there was one theme, it was “how to know when to sell?”

The truth is that there is no one-size-fits all answer to that question because it depends on your goals and outlook. 

This particular moment in the market illustrates that really well.  (See chart above)  Short-term strategies such as price crossing the 20-day moving average and even intermediate-term strategies such as MACD Divergence have long since given a “sell” signal. The aggressive traders among us – myself included — have sold short and are now watchful of an opportunity to cover.

 I also follow a longer-term long-only strategy for my retirement funds.  The SPY below its 200-day MA tells me not to buy.  But is it a sell signal?  No, according to the 50/200 MA pair because the 50 MA has not crossed down through the 200 MA to give the Death Cross signal.    

 How will it play out this time?  I don’t know.  What I do know is how the strategies mentioned above have performed over the last fourteen years.  That data helped me to make the decisions about which signals to follow and with what capital.

 This brings me to the other frequently-asked question at the show:  “What is BackTesting Report?”

 BackTesting Report started as a series of e-books about the historical performance of various technical indicators and trading strategies.  I began the work because I wanted to know – for my own trading – what I might get out of these strategies, and which I might use for buy/sell decisions.

 BackTesting Report has expanded beyond the reports to videos but the concept is still the same:  to provide the data  to understand the trade-offs between the various technical strategies and pick the best strategy.

What about you?  How do you know when to sell?

Moving Averages as WorkHorses

Today I want to quote international economist & trader Barbara Rockefeller:

Moving Averages are the workhorses of technical analysis.  Just about everybody starts out in technical analysis with moving averages, and some traders never see a need to look into any other technique — that’s how successful moving averages can make your trading.

Of course, the proof is in the pudding.  That’s why I’m backtesting moving averages and other popular technical analysis tools. 

(BacktestingBlog is an Amazon Associate. )

Stock Buy Signals

Here is part 2 about stock entry strategy or the buying process.   The previous article talked about stock screening, which is the background investigation to select a pool of candidate stocks to buy when the time is right.   The trigger or market timing signal is the topic of this article.   

 Why You Need to Time Your Entry

Once you have a universe of candidates, you need an entry signal or trigger.  Stocks can sit around looking good enough to buy for a long time, and you need a discrete event to say “Buy Now”.  Hard experience has taught me that “when I have time to complete research” and “when I feel excited about stocks” are not the best entry conditions.    In retrospect, it was usually a price extreme that got me pumped enough to research stocks and hit the buying point.   I’ve found that exercising the judgement to pick a better entry point can be more financially rewarding than just jumping in.     Personally, I suspect that even a random entry point would be better than emotion-driven buying, and backtesting can help identify strategies that do better than random.

 How To Time Your Entry

I see three broad categories that can be used as in entry signal: news events, clock or calendar events, and price events, especially as indicated by objective technical analysis.   Let’s compare them.

 News Events

If you’re new to the stock market, reacting to news events may seem the most natural thing in the world.  However, a little experience shows that the market anticipates and prices in news before it happens.  This is called discounting.  As an example, remember the recent situation with Steve Jobs and Apple.   It follows the saying, “Buy the rumor, sell the news”, only in reverse because bad news is what moves the market lately.   Here’s what happened:  Amid rumors of Jobs’ recurring illness, the price of AAPL declined, all the while Apple insisted Jobs was healthy.   Then Jobs announced that he was taking a medical leave of absence.   If the rumor of illness prompted a decline, then one might think that the news of his departure would tank the stock – he has had an unquestionable impact on the company, after all.    What actually happened, though, is that AAPL traded down to a new 52 week low in after-hours trading on January 14, the day of Jobs’ departure.  The following day, the price opened low, but regained most of it to close at near the high of the day.  Price bounced around the lows for 3 days, and then began an ascent that ended 3 weeks and 30% later.   The market had already priced in the news and the reaction went in the opposite direction, as it often does.    The upshot of this example is that it is difficult, if not impossible, to form an objective strategy around the news because the news may be priced into the market and always must be subjectively interpreted.

 Calendar Events

The second type of entry signals, clock and calendar events, are more objective than the news, but that’s not saying they’re 100% reliable.   Some of the people who use this category of signals are

  • day-traders who never hold overnight
  • pro traders who only hold overnight
  • investors following the adage to “sell in May and go away”
  • small-cap investors who show up in December
  • commodity traders following the seasonal fundamentals
  • and those folks who mine the charts looking for the dates when a stock almost always seems to go a certain way

Some of the calendar-driven moves truly are driven by the calendar. Others are due to coincidence, while still others are illusion.  Backtesting – either automatically or by manually checking the charts – can weed out the pretenders by determining which have been profitable in the past, and that is a useful first step.    I think you owe it to yourself to take it one step further and look for a plausible cause for the move rather than betting good money on a pattern that came about by chance.

Technical Indicator Signals

 The same can be said of technical indicator signals – you need to understand why they work — plus you need to make sure they are objective.   Aronson’s book makes a good case for using objective indicators rather than relying on subjective information for trading decisions.   A signal is objective if there is no “wiggle room” in describing it, if any two people always see it the same way (not like pattern recognition) and/or you could program it into a computer.  Elder’s first book gives good descriptions of technical indicators grounded in crowd behavior.  

 You can also think through the implications of the strategy.   For example, consider the trend-following strategy of buying when price hits a new high.   A new high doesn’t guarantee that the price will keep going, but all runaway stocks had to make new highs along the way.   A good thing to know is how many stocks making new highs go on to make a profit for investors holding for, say, one year.   Backtesting is one good way to estimate this info.   Sign up for email alerts to find out when new highs will be featured in BackTesting Report.             

Backtesting can also help us overcome our human tendency to become overconfident in a signal because we can easily spot on a chart the times that the signals worked and all too easily overlook the false signals.   A false signal is where the signal comes but the stock price doesn’t go in the expected direction long enough for the trader to profit.  It’s expensive to learn about false signals and our little foibles of human cognition in live trading.

The previous article used the example of price above the moving average to illustrate a potential stock screen.  A corresponding signal using moving averages is price crossing the moving average, or moving averages crossing each other.    They offer objective, discrete events to replace emotional guesswork with rational decision-making.  To find out more, check out the BackTesting Report MA Buy Signal package.

Updated on 3/17/09 to add: (BacktestingBlog is an Amazon Associate. )

Updated on 3/19/09 to add: (Author has a position in stocks mentioned in this article. )

Stock Screens and Signals

With a rally coming together over the past week, I want to review two distinct and important elements of the buying process.   Before I jump in, let me say that I don’t claim to know if this is The Time to buy or not.  I do want to give you two steps to consider when making that decision for yourself.   They are:

  • Screening for candidate stocks
  • Signaling the time to buy (and sell)

This first, stock screens, is more time invariant – a fancy way of saying the list doesn’t change much day to day. In fact, you may not want to change you stock list much year to year as there is a lot to be said for getting to know a handful of stocks inside and out.   If you’re like me, you itch to scan a huge number of stocks to see offer up the best opportunities.   Of course, you can do both.  I have my screeners delivering new stocks every day and I also have my favorites that I’ve gone back to so many times over the years that I am part of the reason support and resistance works because I know from memory what is a low buying price and when to take the money and run.    On the other hand, a decidedly Bad Idea is obsessively returning to a stock on which you lost thinking that it “owes you”.  This is where an objective plan can really save you.

Sit down at a quiet time and think through the things you want in your candidate stocks.    I consider three categories:  practical matters, fundamentals, and technical screens.   Other folks might want to consider social values, or what their friends say, or worldwide demographics.    I have a hard time making the last three objective myself.

On the bare-bones practical side:

  •             Volume is a very measurable criterion that is almost pointless to test.   You need enough volume to get in and out.  Period.  I like to see at least 500,000 shares traded per day.
  •             Price is another area where it’s very easy to be objective – at least at the extremes.   If you want to be a penny stock trader – great!  Go be the best.   But most people choose $1, $5, or $10 and say it’s as low as they go.  
  •             Your risk limits drive a price/volatility limit.   If you risk only 2% of your account per trade (and that’s being generous), you can’t get into any stock with an average true range bigger than that amount.

Do fundamentals matter or is the sum total of available information reflected in the price?   You will have to make your own decision on that, dear reader, because the fundamental data I had at my disposal last I looked was not clean enough to make a good determination.    Even so, I do use fundamentals as a tie-breaker for the times when I get too many signals at once.   Then I’ll take the signals on the stocks with fundamentals (and story) to my liking.  A better way is to refine the objective rules to come up with just the right number of stocks to fit your account.

Technical stock screens are an important component of your plan.  They can and should be tested thoroughly.   First define what you want, say stocks in an uptrend, or beaten down stocks, or stocks trading in a nice range, whichever.  Then figure out which tool from technical analysis delivers the best candidates for your needs.  This means know how well the various technical analysis tools have performed.  This applies whether you are picking the short list of stocks you will grow with for the next couple years, or setting up a daily screen.   If it’s done right, your technical stock screener can give a solid list of candidates.   Remember, the point is not to go out and buy all of these right away, but instead to stalk them for the right time to make your move.

 For example, a moving average can function as a stock screener, where stocks above the moving average are said to be in an up-trend and stocks below the moving average are said to be in a downtrend.   Many experts recommend buying only stocks which are above their moving average, although some will say you can capture more of the move by getting in well below the averages.  Of course the advice varies on which length of moving average and what you use may depend on whether you have a short- or long-term outlook.    Click here to order your copy of the BackTesting Report on moving average stock screens and find out which moving averages have potential and which have not proven out as a stock screener.

 This post talks about screens stocks to build a candidate list that is bigger than you can use at any one time.   The examples — price, volume, above/below moving averages — showed objective, testable tactics that can identify out a candidate list.  But the stock screener doesn’t pinpoint the time to buy.   For that we need a more precise entry signal which I’ll discuss in the next article.

BackTesting Moving Averages

Why Moving Averages

As a trader or investor, the only reason to investigate moving averages is to gain knowledge to increase profits. Like many other technical indicators, moving averages are meant to help us objectively tell the market status at any given time. This helps us see through the emotions of the day and make rational decisions, which we’re told will lead to greater profits and/or fewer losses over the long run. Moving averages (MAs) smooth the series of prices for a stock. MAs are most often used to identify the trend of market direction, and are classed as a trend-following indicator. This doesn’t mean that MAs are only for long-term investors – short term traders use them also. Moving averages can be used to screen stocks for good candidates, signal buying opportunities, and offer sell signals.

Why Backtest – A Story

The goal of backtesting is to find out if moving averages really do lead to better results and what are the most promising ways to apply MAs. Let me tell you a short story. While I was putting together the results for one of the moving average BackTesting Report issues, I happened to visit a friend. At her house, I came across some reading material from a well-advertised discount stock broker. In it was an article that advising its customers to use a particular moving average length applied in a certain way to get the best results. I had my comprehensive tests right in front of me and I can tell you that broker’s method did not get the best results although they did mention a MA length that is useful in other ways. I had in my hand test results that showed that the way that broker applied the moving average had a win rate worse than the baseline when tested on 7147 stocks over 14 years of stock market data. Clearly the broker wasn’t running that kind of testing. It’s up to the customers – us! – to fend for ourselves and find out what works versus what doesn’t.

How to Calculate MAs

When backtesting moving averages, the first decision is how to calculate the moving average. Do you want a simple moving average (SMA)? Or something designed to track price better such as an exponential moving average (EMA)? You might consider an experiment to compare the win rates of the two different averages. I did just that a couple years ago, and while I don’t have the results to publish, I came away with the notion that it didn’t make a big difference whether I chose SMA or EMA — just pick one and use it consistently. So for this project, I choose to use simple moving averages because I see them mentioned in commentary most often. To actually do the calculation, I relied on the built-in function which came with TradeStation. (The choice of backtesting engine is another decision which is general enough to write about in another post.)

How to Use MAs

Next you need to pin down how exactly you want to apply moving averages. How will you interpret the relationship between price and moving average? What rules will you use to decide when to buy and sell? You don’t have to read long about stocks before coming across a bullish reference to a stock trading above its 200-day moving average or its 50-day moving average, or even the 10- or 20-day MA. Or advice about buying stocks as they cross their 50-day or 200-day moving average. These are important rules to test in the backtesting engine. And then there’s the moving average crossover – a classic method of technical analysis. That makes three distinct ways of using moving averages to test.

Going more in-depth, some trading texts talk about the slope of a moving average. If you hark back to algebra and consider the MA as a line, to find its slope you would pick two points on the line and apply the usual formula ((x2-x1)/(y2-y1)). This brings up the question of how far apart to pick the two points which can make a difference to results. Really, since the MA is being used to identify the trend, we just want to know if it is sloping up or down. Then we can simplify the whole calculation by noticing that if the price is above the moving average, it must be pulling the average up, and a price below the MA pulls it down. Thus another reason to test the efficacy of price above the moving average.

Parameter settings

Once you decide on how to use the MAs, you need to pick a selection of various lengths to test. Beware of over-optimizing. Somewhere out there is a guy with backtesting results showing 3895% gain or whatever using just the right moving average. Too bad he doesn’t know what MA will produce those results in the future. That said, you need to try more than one length to make sure that your results aren’t a fluke. Stick with defaults settings or the ones you hear about most in the media. Finding the one perfect parameter setting is not going to make you rich. Finding a cluster of good, robust settings just might do you a great deal of good though.

As a practical matter when backtesting allow enough data lag before measuring. All tests must begin measuring at the same place for apples-to-apples comparison among different MA lengths. For example, if you’re testing a 200-day moving average, it will take the first 200-days of data to calculate the first point of that moving average. That means that the first day you could possibly have a signal is 200-days into the data set. To make a fair comparison with, say, the 10-day moving average, you need to make sure not to count any signals from the 10-day moving average before the 200-day is ready to go. Fortunately TradeStation has a way to set the “Maximum number of bars study will reference” in “Properties for All” strategies which forces the backtesting engine to wait that long before tabulating data.

More Profit from Buying or Selling?

Moving average rules, and in particular moving average crossover rules, are often discussed as a reversal system. This means that one signal, say the MAs crossing upwards is a buy signal and then its opposite, say MA lines crossing down, is not only a sell signal but also the trigger to go short. Theoretically, that’s just fine but many people are not interested in shorting the market. They are looking for techniques to help them buy and maybe sell. Even a person who regularly sells and sells short might use different techniques for buying and selling. For these reasons, it’s wise to test the buy signals separately from the sell signals.

This poses a dilemma because it’s hard to evaluate a buy signal in isolation. One way to do this is to use timed exits – that is, exit the trade or sell the stock after a certain amount of time elapses. I chose to run each backtest three times with three different times exits because different people have different styles and different needs. To produce backtesting results useful to swing traders, I exit after 2 days. To model position traders, 20 days. To meet the needs of active investors, backtesting holds each position for 200 days. This gives a way to isolate the buy signals and find out just how useful the moving average is to stock buyers of various temperaments.

Need to Define Goodness

One more very important thing to consider if you are backtesting moving averages to find out how well they do in the stock market: How will you know what is good? You need objective criteria for success. That means identifying the key statistics such as win rate, expectancy, hypothetical equity gains, etc. It also means setting standards for acceptable performance in each of these areas.

An example illustrates why this is important and why it’s not as easy as it first appears. Say your tests show a win rate of 55% for a particular indicator. That may might not be so good if, say, 62% of all stocks went up during the same period of time. Or if only 25% of stocks rose during that time period, your 55% win rate would be spectacular. What is good depends on how it compares to baseline market performance under the same conditions.

You can download a free copy of the BackTesting Report Baseline issue by clicking here.

Test Set

For a meaningful backtest, you need to have enough data to make a statistically valid comparison. At the minimum, that means 30 trades. Even if you are trading just one instrument – just one stock or just one currency pair – I think it’s important to test your trading strategy on many different instruments to prove its robustness. I went over the top with an extremely large test set — 7147 stocks over 14 years — to make sure my results would apply in a wide variety of market conditions.

You can get your copy of my backtesting reports on moving average buy signals by clicking here.