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 postmortem 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 a RUT and SPY March bear call spreads. After our analysis 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 open the 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 the RUT and SPY bear call spreads, 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; however, it 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. 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. 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 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.