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What is Trade Risk Management?
Trade Risk Management is a technical methodology for
identifying overbought and oversold markets and then using
a contrarian trading strategy to trade those markets with
reduced risk. With the introduction of Trading Signals,
Trade Risk Management offers an approach to identifying
overbought/oversold trading opportunities along with actual
buy and sell signals!.
In addition to a buy or sell signal we can now also evaluate
the quality of such signals. This, we believe to be something
new. There are many services that provide traders with
systems that give buy and sell signals. But, to our knowledge,
no service actually provides their customers with a service
that evaluates the quality of their signals based on probability
bands. With other services it's buy here, sell here. Nothing
more said.
At Trade Risk Management you'll find charts for stock
markets around the world, international world currencies,
spot prices (including the base metals of the London Metal
Exchange) and commodity futures prices. If there is a
special time series you would like to see displayed on
a regular basis, or have any comments about improvements
to the website, please email me. I look forward to hearing
from you.
What are Trading Signals?
Chart 1
To get a better idea of what Trading Signals
are, focus your attention on the image displayed in Chart
1 above.
Trading Signals are based on the idea that buy/sell signals
are generated when the price crosses above and below a
trendline. Usually, this trendline is a moving average
or some exponential smoothing of the prices. But, in TRM's
Trading Signals this trendline (always displayed
in red!) is calculated according to a proprietary
algorithm. Nevertheless, the use of the red trendline
conforms to customary crossover usage. Thus, when the
price moves above the red trendline we have a buy signal
and when the price falls below the red trendline we have
a sell signal.
Notice also that the current price is displayed in the
box toward the bottom of the chart. Also, the latest buy
or sell price is displayed. This buy/sell price is simply
the current value of the red trendline. As we will see
later this value can also double as a stop loss point.
In addition to the prices and red trendline you will
notice that we also display a set of the Sigma Bands.
Note that these Sigma Bands are not the same Sigma Bands
that appear on TRM's Sigma Band chart. These Sigma Bands
are designed to respond faster to changes in both price
and momentum. The Trading Signal chart shows the position
of the current price in relation to the bands. Thus, in
each case, we see if the price is overbought or oversold,
as defined in terms of probability.
Finally, notice that the box also contains some comments
and warning messages. These messages refer to the "quality"
of the buy or sell signal. We'll discuss these messages
in detail later on in the FAQ.
What are the benefits of the new Trading
Signals?
The new Trading Signals are designed to give frequent
buy and sell signals. In addition, our new Trading Signals
are designed to show where the buy/sell signal occurs
within relation to the Sigma Bands and to show what is
happening with momentum when the buy or sell signal occurs.
This then gives us the ability to judge the quality of
the buy and sell signals. After all, not every signal
can be expected to result in a successful trade. However,
with the ability to judge the quality of the signal the
trader has a better chance of being on the winning end
of a good trade and also a better chance of avoiding being
on the losing end of a bad trade.
What are the differences between Signal
Bands and Trading Signals?
There are two main differences between Signal Bands and
Trading Signals. First, the original Signal Bands were
designed to give the trader an entry point into an overbought
or oversold market based on the overbought/oversold conditions
indicated by the Sigma Bands chart. The new Trading Signals
are more of a stand alone chart. In fact, the Sigma Bands
that are displayed are not the same Sigma Bands shown
on our Sigma Bands chart. They are designed to react faster
to changes in the underlying prices. The trader may act
on a buy or sell signal with the new chart without actually
consulting the original Sigma Bands chart, although this
is not advisable.
The other big difference between the two charts is the
original Signal Bands attempts to give an entry point
but no exit point. The new Trading Signals give both.
The new Trading Signals track a buy or sell signal as
it is unfolding. Once the buy or sell signal occurs the
algorithm switches mode and tracks the next sell or buy
signal. This process toggles back and forth indefinitely.
What is the "Fundamental Rule"?
The "Fundamental Rule" simply says
"The further away the price is from the solid,
neutral trendline the higher the profit potential."
The reason the Fundamental Rule is important is because
it allows the trader to spot situations when a trade can
be initiated in either an overbought or oversold region.
Prices are naturally distributed around the solid, neutral
trendline on the Sigma Band chart. The distributions of
the price deviations from this solid neutral trendline
are naturally bell shaped in appearance. Overbought and
oversold regions are defined as the "tails"
of this bell shaped curve. The probabilities associated
with the tails are very low. Thus, when prices move into
the tails, that is, the overbought or oversold regions,
then prices will naturally migrate back to regions of
higher probability, that is, toward the solid, neutral
trendline.
What messages are displayed on the chart?
There can be as many as three lines of messages included
in the Trading Signals chart. The first line is always
the same. It tells you what the current price is along
with the latest buy or sell information. As stated before,
when the price moves from below to above the red trendline
we have a buy signal and the buy point is the value of
the red trendline. Similarly, when prices move from above
to below the red trendline we have a sell signal and the
sell point is the value of the red trendline.
The second and third line can vary depending of the quality
of the buy or sell signal. The messages are one of three
types: "Notes", "Warnings", and "Danger".
A "Note" is simply a notational message informing
the trader that the signal is occurring under normal circumstances.
A "Warning" message is a message informing the
trader that a signal is occurring under less than optimal
circumstances. Finally, a "Danger" message is
informing the trader that the buy or sell signal is occurring
under very undesirable circumstances. Chart 4 below illustrates
all three types of messages.
What does the first message line say?
The first line always gives information about the trade.
First, it gives us the current close or settlement price
for the market the chart pertains to. It then gives the
buy or sell price that is currently in effect. This is
the price at which the price crossed over the red trendline.
The third value is the current value of the red trendline.
It can be used as a stop loss point. More will be said
about this later.
What are "note" messages?
Chart 2
"Note" messages are designed to be information
messages concerning the buy or sell signal. When a signal
occurs it can occur under negative conditions or it can
occur under conditions that the trader would expect to
see happen. For example, ideally a sell signal occurs
when the price is in an overbought region. One could then
expect to see a confirmation message informing the trader
that such a signal has occurred. This is a "note"
message. Chart 2 above illustrates the "note"
message for a successful sell signal in the Copper market.
What are "warning" messages?
Chart 3
"Warning" messages are designed to be actual
warnings that a buy or sell signal has occurred under
less than optimal trading conditions. For example, suppose
a buy signal is generated when prices are close to the
solid, neutral trendline. Ideally, a buy signal should
occur when prices are below the -2 Sigma level. If the
buy signal occurs well above the -2 Sigma level, then
a warning message notifying the trader of the less than
ideal buying conditions, is generated.
Warning messages are generated to simply let the trader
know that something may be wrong. The trader can still
act on them. It's a judgment call. For example, suppose
a sell signal occurs with prices coming down from above
the +2 Sigma level? Since the sell signal occurs below
the +2 Sigma level a warning message could appear. However,
if the same signal had occurred just above the +2 Sigma
level then a "note" message would have been
generated. Under these conditions a trader may indeed
want to take a sell position. Again, it's a judgment call.
Chart 3 illustrates this condition. Notice that the sell
signal occurs at around +1.5 Sigma. This could be a good
sell signal. But, because the sell signal occurred below
+2 Sigma the trader gets a warning message. It's the trader's
decision to act or not act on this signal.
What are "danger" messages?
Chart 4
"Danger" messages are designed to be extreme
warnings that a buy or sell signal has occurred under
very dangerous trading conditions and should be questioned
by the trader. For example, suppose a buy signal is generated
when prices are in the overbought region, that is, above
+2 Sigma. Ideally, a buy signal should occur when prices
are below the -2 Sigma level. If the buy signal occurs
when prices are in the +2 Sigma level, then a "danger"
message is generated. Essentially, a buy signal has occurred
when the trader would expect a sell signal.
Chart 4 illustrates a bad sell signal. Notice the sell
signal occurs below the -2 Sigma level, that it, in the
oversold region. Why would one want to sell something
that is oversold? Not surprisingly, a "Danger"
message is displayed. And as it turns out the sell signal
was a false sell signal. Sugar prices gave a buy signal
within a couple of trading sessions and now Sugar prices
are well above their -2 Sigma level.
Traders should always take "danger" messages
very seriously. Danger messages are designed to keep the
trader from making bad mistakes.
What about momentum analysis!!??
In our analysis of Sigma Bands we have always stressed
the importance of momentum analysis. Nothing has changed
here. Momentum analysis is designed to keep the trader
out of bad trades and to help identify successful buy
or sell signals.
In momentum analysis we monitor the relationship between
the red and black momentum lines displayed at the bottom
part of the chart. Consider, as an example, the red and
black momentum lines at the bottom part of the chart labeled
"Chart 1" above. Notice, that when the buy signal
occurs, that is, at the time when the green ellipse occurs,
the red momentum line has converged to the black momentum
line. In this case the two momentum lines have simply
converged, not actually crossed. Ideally, we would like
to see the red momentum line move above the black momentum
line.
Ideally, when a buy signal occurs we see the red momentum
line over black momentum line. This confirms that momentum
is strengthening. This is what the trader should look
for. When a buy signal occurs look for strengthening momentum.
When a sell signal (a red ellipse) occurs look for weakening
momentum. In Chart 1, the two momentum lines are converging
at a sufficient rate that one can conclude the red momentum
will remain above the black momentum line during the buy
signals lifetime.
Ideally we should always see the red momentum line cross
the black momentum line as a buy or sell signal is occurring.
However, in practice this does not always happen. So,
if the red and black momentum lines have not actually
crossed then look to see if they are at least getting
closer and closer to each other. In other words, are the
two momentum lines "converging?" Converging
momentum lines can be a good sign that prices are preparing
to reverse direction. But be careful here. Converging
momentum lines are not as good an indicator as momentum
lines that have actually crossed. Just how close should
the lines be? That's a judgment call.
In Chart 1 above the red and black momentum lines are
converging. So the trader needs to decide if this is a
good buy signal. As it turns out it was an excellent buy
signal and well worth the risk. But, again it is a judgment
call.
Notice in Chart 2 that we have an excellent example of
a good sell signal. When the sell signal occurs the red
momentum line has dropped below the black momentum line.
This helps confirm the validity of the sell signal, which
turned out to be an extremely profitable trade.
The trader should always be concerned when a buy or sell
signal occurs with the momentum lines getting further
apart. Diverging momentum lines usually indicate that
the prices may continue in the direction the momentum
is already indicating.
What about stop loss points?
There are those who hate stop loss orders, do not use
them and recommend no one else use them. On the other
hand there are those who swear by them and would not think
of trading without them. We take the view that it's up
to the individual trader to decide for themselves where
stop loss orders fit into their trading strategies.
We don't actually use any kind of special algorithm to
compute a stop loss point. However, we define buy and
sell signals by the value of the red trendline. When prices
cross the red trendline it is a buy or sell signal. Therefore,
one could consider the current value of the red trendline
as a stop loss point. For example, suppose one is in a
buy position. Then the current value of the red trendline
could easily be used as the current stop loss point. If
the price were to drop below this point it would automatically
trigger a clearing of the position. Does one then also
want to turn around and use the same red trendline value
to initiate a sell position? That, of course, is up to
the trader. Again, it's a judgment call.
Notice on Chart 1 above that the first line ends with
the words "trend @". This is the current value
of the red trendline and could be used as a stop loss
point, if one so chooses.
What kind of signals should I look
for when I want to buy?
If you're looking to buy the first thing to look for
is the present price in relation to the Sigma Bands. Ideally,
prices should be below the -2 Sigma level or at least
close to the -2 Sigma level. Remember, the Fundamental
Rule tells you that the profit potential increases the
further below the solid trendline the current price is.
So if the buy signal were to occur at the -3 Sigma level
it would be better than a buy signal at the -2 Sigma level.
The next thing to look for is the actual buy signal itself.
Has it occurred or is it so close to occurring that you're
willing to assume the risk that it will occur? Never buy
if it appears that a sell signal is eminent.
Finally, check to see if momentum is going your way.
If you're going to buy you should feel comfortable that
momentum is strengthening. Without momentum going in your
direction the profit potential could be very disappointing.
Chart 1 illustrates these ideas.
What kind of signals should I look
for when I want to sell?
If you're looking to sell the first thing to look for
is the present price in relation to the Sigma Bands. Ideally,
prices should be above the +2 Sigma level or at least
close to the +2 Sigma level. Remember, the Fundamental
Rule tells you that the profit potential increases the
further above the solid trendline the current price is.
So if the sell signal were to occur at the +3 Sigma level
it would be better than a sell signal at the +2 Sigma
level.
The next thing to look for is the actual sell signal
itself. Has it occurred or is it so close to occurring
that you're willing to assume the risk that it will occur?
Never sell if it appears that a buy signal is eminent.
Chart 2 illustrates these ideas.
Finally, check to see if momentum is going your way.
If you're going to sell you should feel comfortable that
momentum is weakening. Without momentum going in your
direction the profit potential could be very disappointing.
Don't be too precise in
your selections!
TRM's Trading Signals will be giving you many buy and
sell signals. It will be up to you to filter out which
signals you choose to act on. But in our discussion on
what criteria you should use to make decisions, things
can get a bit "fuzzy", such as buying or selling
outside the +/- 2 Sigma level. For example, suppose that
prices are just at the 1.95 Sigma level? Should you act
then? It's up to you but don't be too exact. Prices may
not go any higher and you may be getting a good sell signal.
So use some judgment here. Things are not that absolute
that prices MUST satisfy the criteria. There will be many
good buy and sell signals you may pass up if you become
too literal. Use some judgment here!
What are Curvilinear Envelopes?
The curvilinear envelope (see the chart below) is an
approach to cycle analysis originally suggested by J.
M. Hurst in his 1970 ground breaking book "The Profit
Magic of Stock Transaction Timing". Here one sees how
the data fluctuates between a set of inner and outer envelopes.
The inner envelope represents the dominant cycle plus
trend in the data. The outer envelope represents the trend
after the cycle is removed. If one has an idea which way
the envelopes are moving, one has a pretty good idea of
the direction of the prices, since the data always remains
nominally within the envelopes.
Chart 5
The cycle at the bottom of the graph is based on computations
using the inner and outer envelopes. The "len=..." is
the average length of the cycle displayed (the calculations
are made based on the average time difference between
one low point to next low point).
What are Sigma Bands™?
The Sigma Bands™ chart (see the chart below) is
an indication of the overbought/oversold nature of prices.
The dark center line through the data is a long term trend
line.
Chart 6
The three lines above and below this trend line are the
1, 2 and 3 standard deviations of the percent change
of the actual data from the trend line. Anytime the data
deviates above or below two standard deviations from the
trend line, an extreme condition starts to take place
(a condition that only occurs 2% of the time!), and the
probabilities for a reversal start to increase dramatically.
It's at these extreme conditions a trader can consider
taking contrarian positions that provide minimal risk
and high profit potential.
NOTE: It is the Sigma Bands™ chart which is
the key to minimal risk trading. Following the rules to
be stated later one will be able to use the Sigma Bands™
charts (along with the other charts) to take positions
in the market where the prices remain overbought or oversold
less than 2% of the time!
What are Cycle Decomposition Charts?
Chart 7
The cycle decomposition chart (see the chart above) is
conceptually very simple. Simply add the values of all
the sinusoidal type waves displayed below the price action,
to the trend line passing through the original time series,
and one gets the original time series to within a small
random variation. In addition, Sigma Bands™ calculations
similar to the ones discussed above are included. As before,
these bands give the trader an indication of overbought/oversold
conditions. In addition, as we'll see later, the red trend
line passing through the data is extremely important,
so be sure not to overlook it.
What are Signal Bands?
The signal band charts are used to help pinpoint when
to actually enter a position based on when the Sigma Bands™
charts are alerting you to an overbought or oversold position.
Chart 8
Like the Sigma Bands™ the signal band
charts have a trendline and three sigma lines above and
below the trendline. However, they are not used in the
same way. Notice that both charts show a red line running
through the prices. It's this red line that is of importance
in the signal band chart. In the Sigma Bands™ the
red line is of very little importance. What you most look
for in the signal bands is when the prices are ready to
cross this red line (very much like a signal crossover
system using moving averages).
Note: You have probably noticed that
the charts show "Sigma Bands™" for both
Sigma Bands™ and signal bands. This is because signal
bands are actually Sigma Bands™ of shorter duration.
They are based on a preset parameter. For signal bands
the control parameter is 21 periods, for Sigma Bands™
the parameter is 250 periods. So for daily data signal
bands are based on 21 days, or one trading month, and
Sigma Bands™ are based on 250 days, or one year.
What do I look for in the curvilinear envelopes?
For this discussion please refer to the sample curvilinear
chart provided above and duplicated below.
Chart 9
A number of points need to be made concerning the curvilinear
envelope charts:
- The overall expected path for future prices, based
on present data, is displayed, so one does not have
to guess. The envelopes are designed so that the prices
remain within the bands. Thus, depending on the direction
of the bands, the price is expected to fluctuate within
the bands.
- The wave that is displayed below the envelopes is
the dominant cycle in the price. Always watch the amplitude
of this wave. If this amplitude "damps out", it is an
indication that the cycle is dissipating its energy
and the trend will dominate. If such a situation
occurs the envelope charts will cease to show wave behavior,
and the charts will look very choppy.
- You must watch the charts every day! The algorithms
are adaptive and very sensitive to changes in
market conditions and will reassess conditions very
quickly when the need arises. Daily monitoring of
all three charts is absolutely imperative, especially
when one is considering taking a position, or is in
a position!
What do I look for in the cycle decomposition
charts?
For this discussion please refer
to the sample cycle decomposition chart provided above
and duplicated below. As with the curvilinear charts,
a number of points need to be made concerning the cycle
decomposition charts:
Chart 10
- The cycle decomposition chart displays the extensions
of the individual waves (in red) and its cumulative effect
on the price (in blue). Consequently it is not necessary
to try to manually add the waves to get a price forecast.
- Always monitor the direction of the predicted red trend
line passing through the prices, and be very careful taking
positions that go against it! If the extrapolated trend
is sideways, then playing the cyclic action is acceptable.
However, if the red trend line is trending steeply up
or down, then playing a cycle contrary to the direction
of this trend is risky at best.
- By monitoring the amplitudes of the individual
waves one can get an idea what cycles are dominating the
price action now and in the future. The waves with the
largest instantaneous amplitudes are the dominate cycles.
Watch how their amplitudes expand and contract. Also,
watch how the dominate waves "rotate". At times one or
two waves will have large amplitudes. Then, over time,
these waves will loose their amplitude strength and other
waves will grow in amplitude.
What do I look for in the Sigma Bands™
Charts?
For this discussion please refer to the sample Sigma
Bands™ chart provided above and duplicated below.
As with the curvilinear charts and cycle decomposition
charts, a number of points are in order:
Chart 11
- Of the four charts, it is the Sigma Bands™
chart which is the most important!
- The first thing that the Sigma Bands™ tell us
is when a price is probably overbought or oversold. The
bands represent standard deviations of the percent deviation
of prices from nominal levels. Thus, when the prices are
outside the plus and minus two Sigma Bands™, the
price is correspondingly overbought or oversold. It is
at these times that prices are at levels for a probable
reversal.
- The second piece of information is contained in comparing
the red and black lines located below the prices and their
Sigma Bands™ (these are referred to as the red momentum
and black momentum lines). Whenever you see a divergence
taking place between the red and black momentum lines,
it is typically accompanied by a significant price move,
either up or down. Conversely, if the two lines are practically
on top of each and the bands are moving sideways, this
situation typically corresponds to a period of sideways,
damped out price motion for the most part. When, the two
lines are on top of each other, and the bands are moving
sideways, it is an indication that prices will follow
a trendless path. Prices will tend to drift within the
plus/minus two Sigma Bands™. Finally, if the red
line starts to diverge from the black line momentum, this
indicates possible accelerating prices, whether up or
down, depending on whether the red momentum is pulling
above and away or declining faster than the black momentum
line.
- As with most momentum indicators, when the price declines
or advances are not being confirmed by new highs or new
lows in the momentum, a reversal is indicated. For example,
notice the decline in October, 2002 tested the July, 2002
low. However, the momentum was not confirming this decline
and the prices were again touching the minus two sigma
levels! Needless to say, the prices for the Dow Jones
Industrials are now significantly higher. This is the
kind of technical chart situation that dreams are made
of. If one had bought one Dow Jones futures contract,
the minimal profit potential was 500 points or $5000!
- The red line passing through the prices is the difference
between the closing price and the red line below the sigma
bands™. It can be used as a secondary buy signal,
much like moving averages are used; i.e., when the price
penetrates to the upside, buy, and when the price penetrates
to the downside, sell.
What do I look for
in the Signal Band Charts?
For this discussion please refer to the sample signal
band chart provided above and duplicated below. As with
the curvilinear charts and cycle decomposition charts,
a number of points.
Chart 12
- The signal band charts serve only one purpose; namely,
to give an advanced buy or sell signal. The idea behind
this strategy is very similar to the trading technique
using a moving average. There, when the price falls below
a moving average one sells and when the prices rise above
the moving average one buys. The red line running through
the prices serves the same purpose as a moving average.
Keep in mind however that the red line through the prices
is NOT a moving average.
- Unlike the standard moving average crossover, we have
an added advantage. Specifically, we can also watch when
the red momentum line (at the bottom of the chart) crosses
above and below the corresponding black momentum line.
This crossover typically happens one day before the corresponding
price crossover. Notice, for example, in the signal band
chart for the Dow Jones Industrial Average, the red momentum
line crossed over the black momentum line just one day
before the corresponding price. The price crossover was
enormous, but don't expect that kind of behavior in general.
- The crossover signals should only be used when the other
charts are indicating either an overbought or oversold
condition. Notice, on the above chart, for example, that
a number of crossovers resulted in whipsawing. This you
want to avoid by using the crossover technique only when
extreme conditions are in play to begin with. Then, the
probabilities increase dramatically that the buy or sell
signal will be a valid one.
What is "Momentum Inversion"?
Simply put, "momentum inversion" is when the red and
black momentum lines on the Sigma Bands™ charts
cross each other. The chart below illustrates momentum
inversion occurring at the top of the bull market
in the NASDAQ. When everyone was convinced the NASDAQ
was going up forever, the Sigma Bands™ were telling
a far different story.
Chart 13
Notice how the red momentum line had fallen below the
black momentum line as the NASDAQ was making new highs.
That's classic momentum breakdown. In addition,
the NASDAQ was approaching plus three sigma(!), an extremely
overbought condition. Prices in excess of two sigma and
momentum inversion showing momentum breaking down. This
is one of the two ideal set of conditions for a short
(or at least an exit from this market).
Naturally, for a buy condition you would
look for momentum inversion in reverse; i.e., the red
momentum moving above the black momentum line with
prices below minus two Sigma. When the red momentum is
crossing the black momentum to the upside it indicates
the momentum is getting stronger. With prices below minus
two Sigma the likelihood for a price reversal is extremely
high. One should get out of any short positions and consider
going long!
Watch out for the "blowout!"
The last few weeks of July, 2002 were a dismal time for
many on Wall Street. The Dow Jones Industrial Average
was not only making new lows but there was also much "doom
and gloom" on the Street. Was the world coming to an end?
Take a look at the Sigma Bands™ chart below.
Chart 14
On July 24, 2002 the Dow made a new low and then an intraday
reversal. But notice where the new low occurred. When
the new low occurred the Dow was below minus FOUR
sigma!!! When prices reach such extremes a "blowout"
is said to have occurred. It is rare indeed but when it
happens it presents a golden opportunity for profits to
be made; that is, for those with the nerve (and the money!)
to take a contrary position! Before the Sigma Bands™
charts came along it was practically impossible to spot
a blowout and consequently making money during one was
a high risk endeavor to say the least. But with Sigma
Bands™, not only can one can spot a blowout, but
now can identify the proper entry point for taking a position.
Only Sigma Bands™ can give this kind of confidence.
Is momentum confirming price?
There are two types of momentum analysis. One is "momentum
inversion". The other is price/momentum confirmation.
Take a look again at the Sigma Bands™ chart below.
Chart 15
On October 9, 2002 the Dow was actually testing the old
low made earlier in July when it bounced off minus four
Sigma. The second drop was at minus two Sigma, a very
good sign indeed. However, momentum inversion was NOT
occurring (although the red and black momentum lines were
converging). Should you have bought? The answer is "yes!"
Why? Because even though the prices were making new lows
the red momentum line was not confirming the price decline.
In other words the prices were dropping at slower a rate.
With prices at minus two Sigma the likelihood of continuing
to drop were decreasing. Time to buy!!
It goes without saying that the reverse situation holds.
If the prices are rising to plus two Sigma levels and
the momentum is not confirming, then look out! The plus
two Sigma level is probably a very good level to consider
taking a short position.
How do I spot probable sideways movement?
Sideways movement is the curse of trading. Buy low, sell
high is the rule and when the range between the high and
low is small there's very little if any money to be made.
So how does one spot sideways movement? Take a look at
the chart below.
Chart 16
Examine the period between the end of July, 2002 and
the beginning of November, 2002. There are three observations
to be made. First, the price rarely got beyond minus one
Sigma and plus one Sigma, a variation of only three and
half points. There's no big money to be made here. Second,
notice that the Sigma Bands™ are moving sideways.
In other words there's no real trend. Finally, observe
the red and black momentum lines. They're practically
on top of each other!! When the red and black momentum
lines are on top of each other the cycles have dissipated
their energy and the prices will follow the trend. There
will be very little price deviation from the trend line,
so the prices will remain with plus/minus one Sigma. The
trend will dominate!! So if the trend is sideways and
there's no price variation, you have sideways movement!
In summary, always look for the situation where the red
and black momentum lines start to fall on top of each
other. In such a case, unless the trend is in a strong
direction, its best to stay out. A trendless, low variation
market is a waste of time.
When do I go long?
It is important to realize that one must wait for buying
or shorting opportunities. One cannot always be in the
market. You must wait for the right time!!! With that
in mind here are the rules for taking a long position.
See the charts below for an illustration of the points.
Chart 17
Chart 18
- Use the cycle decomposition chart to verify that the
price is at a bottom and moving up, or, that the forecasted
bands are at least bottoming out and preparing to move
up. On the cycle decomposition chart for the Dow the projected
bands are bottoming out. Even though they're still moving
down, the rate of decent is slowing down. The projected
future is UP
- On the Sigma Bands™ chart verify that the prices
are at least down to the minus two Sigma level. For our
sample chart the Dow is actually at minus 4 Sigma!
- If the prices are well below minus three Sigma one need
not consider anything more. You're looking at a blowout
and extreme conditions like this are the best of times.
Go long! However, if the prices are only around the minus
two Sigma then some momentum analysis needs to be taken
into consideration.
- Momentum analysis takes one of two forms. Verify that
either the red momentum line has crossed above (or is
at least converging to) the black momentum line, or, the
red momentum line is not confirming the price decline.
If either one of these conditions is taking place then
the long position is a low risk long. If the price is
around the minus three sigma level the risk is even less
than minus two Sigma.
When the above conditions are right use the signal
band chart to prepare for a buy entry point.
When do I go Short?
- Use the cycle decomposition chart to verify that the
price is at a top and moving down or that the forecast
bands are at least topping out and preparing to move down.
- On the Sigma Bands™ chart verify that the prices
are at least up to the plus two Sigma level.
- If the prices are well above plus three Sigma one need
not consider anything more. You're looking at a blowout
and extreme conditions. However, if the prices are only
around the plus two Sigma then some momentum analysis
needs to be taken into consideration.
- Momentum analysis takes one of two forms. Verify that
either the red momentum line has crossed below (or is
at least converging to) the black momentum line or the
red momentum line is not confirming the price increase.
If either one of these conditions is taking place then
the short position is a low risk trade. If the price is
around the plus three Sigma level the risk is even less
than plus two Sigma.
- When the above conditions are right use the signal band
chart to prepare for a short entry point.
When do I exit a Position?
It is always difficult to decide when to take profits,
but the Sigma Bands™ charts can help in making a
decision. The first thing is to set an initial target
for taking profits. Take a look at the two charts below.
Chart 19
Chart 20
The basic rule for setting the initial target
for taking profits is this: The initial price target for
taking profits is the zero Sigma value at the time
the position is taken!! For the NASDAQ one can expect
the price to drop back to 4408; for the Dow, look for
a rise to the 8937 level.
These are the initial target levels!!! It is important
to reassess your position daily. If the momentum is going
your way, stay with the position. However, once the price
approach the initial target its important to watch momentum.
If it appears that momentum is strong and increasing then
you may decide to stay with the position in hopes of a
rise to plus one Sigma or better. You have no guarantee
that this will occur! It is reasonable to assume the
prices will go back to the zero Sigma level because prices
"gravitate" to nominal prices. However, prices
tend to stay nominal. So unless the momentum is
going your way, in a big way, take your profits!
When do I Stay out of Market?
The rule for staying out of a market is
simple: Stay out if the conditions for going in do
not apply!!! In other words, it there is no long or
short opportunity, then stay out. Always wait for the
opportunities. Don't chase a market. Don't try to predict
a market. Just wait for the price extremes and then ride
the price back to the zero Sigma line, and take your profits.
Some Closing Thoughts.
- Always look for confirmation between the four different
types of charts! Each chart is generated using a different
methodology, and consequently will give different assessments
of future price action. Look for when they are in agreement.
- Always take an intramarket point of view.
No market stands on its own. The stock market, for example,
is affected by the bond market, the dollar, and crude
oil prices, just to name a few. The bond market can be
affected by the Euro Currency. The Euro can be affect
by crude oil prices. Always study all charts related
to the market you're interested in!
Important Disclaimer
In the world of Technical Analysis software developers
speak of "buy" and "sell" signals.
This is simply terminology that has been adopted to denote
signals associated with price crossover points. These
buy or sell signals are not actual recommendations to
buy or sell. They are simply crossover points and it is
up to the individual traders to decide for themselves
whether to act of these signals. Use the signals at your
own risk!
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