The following is an excerpt. For the
complete article, see the December 2000 issue of Active
Trader magazine.
Trading the momentum of market
breadth
One of the best ways to keep track of the
market’s true dynamics is to monitor its advancing and
declining issues. Here’s a strategy that uses the
momentum of advancing issues to time short-term trades.
By Mark Brown
The S&P tracking stock (SPY) and the
S&P 500 futures contract probably are among the most
difficult markets to trade. Statistics would most likely
show the futures contract toward the top of a group of
markets responsible for the quickest depletion of customer
trading accounts.
Most short-term traders trade the S&P
500 markets using timeframes ranging from a single tick up
to one hour. When trading in these shorter timeframes,
it’s easy to become disoriented and lose track of the
true market dynamics.
One tool many traders use to track
“internal” market strength is a breadth indicator such
as the advance-decline line (the running total of
advancing NYSE stocks minus the declining stocks). The
changes in the number of advancing or declining issues can
offer a glimpse of market dynamics not immediately
revealed by price action. For example, even if the market
is rising, a declining advance-decline line may indicate
these gains are being fueled by a progressively smaller
number of stocks, in which case a correction or reversal
may be imminent.
While breadth indicators are commonly used
to gauge longer-term directional strength, intraday
analysis of advancing or declining issues can be used to
develop shorter-term trading strategies. Here, we’ll
look at how measuring the momentum of advancing NYSE
stocks on an hourly basis can be used to time trades.
Breadth of fresh air
It is well-known that the combined
directional bias of the NYSE advancing, declining and
unchanged issues lists are helpful in determining the
overall direction of the S&P 500 index and S&P
futures. Traditionally, studies have been based on either
a combination of the advancing and declining issues (such
as the advance-decline line described previously), or the
advancing, declining and unchanged issues.
However, research suggests that you can
gain the same benefit (and simplify your analysis in the
process) by using only the advancing issues statistics.
And just as many short-term traders use price momentum in
their trading decisions, the “breadth” momentum can be
used to trigger trades. In fact, the momentum of the
advancing issues provides enough information to develop a
profitable trading strategy that allows you to bypass the
actual market prices.
One simple trading model based on this
approach is the “Oddball S&P system,” which uses
hourly readings from the NYSE advancing issues list. This
timing model is based on the theory that in the short-term
the S&P futures (and even the actual S&P index)
and the market breadth may deviate from time to time, but
they will nonetheless align themselves when large moves
are made.
The original purpose behind this strategy
was to use advancing/declining/unchanged numbers to
identify high-volatility situations that showed the
highest likelihood of having a directional bias. However,
research and testing showed it was sufficient to use the
advancing issues alone — not just as a filter, but also
as a stand-alone trading strategy. In addition, as
mentioned earlier, using only the advancing issues numbers
makes the approach less complicated. As a very basic
trading approach, this strategy also functions as an
excellent benchmark against which to compare other
systems.
Measuring momentum
The strategy is based on calculating the
rate of change (ROC) of the hourly advancing issues
number. ROC, which is an oscillator-type indicator, is the
difference (or alternately, the ratio) between the current
price and the price n periods in the past. For example,
the five-day ROC would be the difference between today’s
price and the price five days ago. On an hourly chart, the
five-period ROC would be the difference between the
current price and the price five bars (hours) ago. (For a
more thorough discussion of the ROC indicator, see
“Indicator Insight: Momentum and rate of change,”
Active Trader, October, p. 82). Because there are seven
hours in the trading day, a seven-period ROC of the
advancing issues number was used in this strategy.
One way to construct an oscillator-based
system is to trigger trades when the indicator crosses
above and below the “zero” line (the median line that
represents neutral momentum, when the current price is the
same as the price n periods ago). But a better alternative
is to use two separate indicator levels, or zones — one
to initiate long trades and another to initiate all short
trades.
A good initial setting is to set the buy
level to 3 percent, and the sell level to 1 percent. That
is, you buy as soon as the rate of change of the advancing
issues is 3 percent higher than it was seven periods ago
and sell as soon as it falls below 1 percent higher than
it was seven periods ago. (See “Strategy snapshot,”
below, for the precise formula for the indicator.) This
means the system will always be in the market, either with
a long or short position.
The indicator settings used here were
selected to keep the strategy as straightforward and
simple as possible for testing. Traders may, of course,
experiment with other indicator settings to see if they
produce better results. Similarly, a different
oscillator-type indicator could be substituted for the
ROC. The underlying system logic and trading approach
would remain the same.
In short, the oddball S&P system works
as follows:
•If the rate of change of the advancing
issues is greater than the buy trigger level, buy the
market.
•If the rate of change of the advancing
issues is less than the sell trigger level, sell the
market.
Every hour, on the hour
Because this system recalculates every
hour on the hour, up to and including the close of the
stock market at 4 p.m. EST, you will not be able to use
the last reading of the day if you are trading the S&P
500 tracking stock (SPY). However, if you are trading the
S&P futures, you will still be able to enter a trade
based on the last reading because the futures market
continues trading until 4:15 p.m. EST.
For either market, this also means that
you will have to wait for the first reading at 10 a.m. EST
to trade in the morning. But this is actually
advantageous, because as so many professional traders
point out, you should avoid trading immediately after the
open because of the directionless volatility that often
occurs before the market finds its direction and pace for
the day.
This kind of trading strategy is
strengthened by the fact that it is easy to monitor and
execute, and it is based on one primary input. The
one-hour timeframe was selected because it is outside of
the typical short-term trader’s time horizon, and also
because consistency is a key factor when implementing a
mechanical model. It is easy to check your trades each
hour on the hour, or to program your laptop, mobile phone
or handheld computer to do so for you.
Also, only using one data point per hour
also enhances the reliability of the model. Why? Because
when you view an intraday chart and observe a bad price
print it will most likely be the high or the low of the
given bar. By eliminating all data points but the close,
you also reduce the possibility of errors.
This is an excerpt. For the complete
article, see the December 2000 issue of Active Trader
magazine. Click
here for the TradeStation code for this system.
