Trading Lessons
By Tom Aspray, Senior Editor, MoneyShow.com
Using reference points from monthly charts, traders can identify more effective stop levels and stay with major trend moves much longer, thus increasing their profits.
In over 30 years of looking at charts of stock and commodity market indices, I have often been struck in hindsight by the lengthy trending periods that are evident in some markets. Over the years, I have sought to improve not only in identifying the market turns, but also improving my ability to catch larger portions of these trends.
From my own experience and the observations of others, there seems to be a familiar pattern. An investor or trader will often catch the start of a good market trend and may capture most of the first major market swing. However, once the market has a significant correction, they will often lose interest or move on to another market. Therefore, they will often miss the next major part of the trend, which is often even larger than the first.
I have had the most success in identifying the major market trends by using monthly charts and technical studies. The monthly on-balance volume (OBV) for gold completed its bottom in 2002 and has stayed positive for the past ten years. The writing of my regular monthly column on the Dow stocks has further reinforced the importance of not only the monthly patterns, but also the monthly price ranges.
In my opinion, a poor entry price causes the most damage to an account, and that is why I strongly emphasize calculating the risk on every position. The combination of tight monthly ranges, monthly chart formations, and monthly OBV has helped me to identify some good recent opportunities.
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Two of these recent examples include Microsoft Corp. (MSFT) and The Coca Cola Co. (KO). I have focused only on the monthly bars so that the tight ranges are easier to see.
MSFT traded in about a $4 range for the last five months of 2011 with the low of $23.79 coming in August. The stock closed at $25.96 on December 31, 2011, then gapped higher to start off 2012, opening at $26.55. It closed January at $29.53 and made a high in April of $32.95.
The Coca Cola Co. (KO) also was locked in a tight range from December 2011 through February 2012. The December 2011 low was $65.88 and the high in January was $70.71. The range in February was even tighter ($67.42 to $69.98), but KO then surged in March to close near the highs at $74.10. For both MSFT and KO, the initial stops were placed beneath monthly lows.
So how can monthly charts be used by both investors and traders? One approach I have been examining is to use the prior month’s high or low as a stop level. Long positions would be favored based on bullish signals from the OBV, and stops would be based on the prior month’s low.
As I have said in the past, I do not recommend using a stop at the actual high or low, but instead suggest using a level that is half of one percentage point, or 0.005%, above or below the monthly range. In these examples, the actual low will be put in parentheses.
One of the stock market’s best trending periods in the past 15 years was from late 1994 through the middle of 1998. This chart of the Spyder Trust (SPY) covers this period.
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In December 1994, SPY formed a doji (a sign of indecision), and in January 1995, SPY closed above the prior month’s high and the OBV turned positive. The ETF closed the month at $46.84, and longs would have been established on the February opening at $46.91.
For the month of February, the stop would have been at $45.23 ($45.45 was January’s low). SPY closed higher in February, and so for March, the stop was at $46.53 ($46.76 was February’s low). For the purposes of this discussion, I will consider the position stopped out, as the low during the first week of March was $46.53.
The monthly OBV was positive, so new longs would be established on a move above the prior month’s high. SPY opened April 1995 at $49.83, so new longs should have been established at that time.
SPY did not make a new monthly low until January 1996, when the December stop at $59.95 ($60.26 was December’s high) was broken when January’s low was $59.33. This would have amounted to a 20% gain in eight months.
In February 1996, the January high of $63.36 was exceeded, and for the next five months, SPY edged higher. In July 1996 (point 3), the June stop at $65.48 was hit (June’s low was $65.81) when SPY had a low that month of $60.06.
Just two months later, in September 1996, new longs would have been established when SPY moved above the prior month’s high of $67. This position would not have been stopped out until March 1997 (point 3) when the stop at $76.73 ($77.12 was March high) would have been hit once SPY dropped as low as $75.25.
The monthly OBV was still confirming the price action and was above its weighted moving average (WMA), so when SPY moved above the April high at $80.69 in May, it was a signal to go long. The stop should have been at $72.94 (April low was $73.31). This would have been a risk of 9.2%.
This long position was held until October 1997 (point 4) when the September stop at $89.80 ($90.25) was triggered. On this correction, the OBV dropped sharply but did hold above the rising weighted moving average.
Two months later, in December 1997, the November high at $99 was exceeded. This signal was reversed in January 1998 (point 5) when the December stop at $91.90 ($92.37) was hit.
SPY opened February 1998 at $99.91, which was above the January high. On these new longs, a stop at $90.46 (0.005% under the January lows at $90.91) would have been used.
This position would have been held until August 1998, point 6, when SPY dropped below the July stop at $110.75 ($111.31). A new buy signal was generated in October 1998 at $107 (not shown) and was not stopped out until May 1999. SPY closed the year at $123.31.
Over the three-year period, these eight trades would have netted almost 70% of the potential gain if one simply bought on the opening in 1995 and sold on the last day of 1998. There were eight trades and 75% of them were profitable.
Let’s now examine how this translates to other markets. Most think of the forex market as being particularly volatile, and a high percentage of forex traders fail. One common complaint is that many have difficulty placing their stops.
NEXT: Using Monthly Highs and Lows to Trade Forex
Therefore, I wanted look at how using the monthly highs and lows as stops would work in the Euro FX futures. For over 25 years, I have found that the OBV is a very useful tool for forecasting the moves in the currency markets. In this example, I will be using the weekly OBV and its weighted moving average as a trigger.
The chart covers the period from March 2009 through March 2012. The last seven months have been particularly interesting, as the euro came under pressure last summer when concerns grew over Greece’s debt burden.
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The OBV dropped below its weighted moving average in June, and the lower lows in July started a new downtrend in the OBV. At the end of July, volume rallied back to its now-flat weighted moving average, which is a classic topping formation. The first week of August, the uptrend in the OBV, line c, was broken, confirming a new sell signal.
The euro opened the following week at 1.4256, and a stop at 1.4620 (0.005% above the July high of 1.4547) would have been used on short positions. The euro came quite close to this stop when it made a high on August 29 at 1.4553.
The weekly OBV stayed below its weighted moving average for the next seven months, as it formed a series of lower highs and lower lows until the week ending March 23, when the weekly OBV moved back above.
FX traders should also note that the weekly OBV did a good job of catching the euro’s decline from November 2009 through May 2010. Even if trading the spot FX market, keeping an eye on the volume in the currency futures is a good idea.
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On the daily chart of the euro futures, the break of weekly OBV support and the confirmation of a new downtrend is identified by point 1. Those who use the OBV will not be surprised to see that the euro continued to edge higher for two weeks before dropping sharply. The weekly OBV can often be a very good leading indicator.
For the next five months, the euro stayed well below the stop (red line), as calculated from the prior month’s high, which is indicated on the chart.
Then, on February 9, 2012, the euro had a high 1.3325 (point 2) and just above the stop at 1.3301, which was derived from January’s monthly high of 1.3237. After a sharp setback, the euro continued to rally, eventually reaching a high of 1.3487.
As noted in this April 4 column, the technical action now suggests that the rebound in the euro is over and that the rally from the January lows was just a pause in the downtrend. The flag formation is consistent with a continuation pattern.
Using the monthly stop method, those short could use a stop at 1.3457, which is calculated from the March high of 1.3391.
For some FX traders, a stop half of one percentage point above the monthly high might be too wide, and in this example, a stop that was one quarter of a percent above the month’s high would not have altered the results. For April, that would mean a stop of 1.3424, which is 33 pips lower.
NEXT: An Alternative Way to Apply This Concept
An alternative way to apply the same concept would be to use the monthly pivot levels instead of the monthly high or low. If the OBV or other technical measures were positive, then a stop would be used half of one percent below the monthly pivot. Conversely, on short positions, a stop one half of one percent above the monthly pivot would be used.
This weekly chart of Apple, Inc. (AAPL) shows the powerful recent rally, which clearly qualifies as a trending move. The week before Christmas, AAPL closed at $403.33, which was well above the prior five-week highs. The first week in January, AAPL closed at $422.40, which was above both the November and December 2011 highs.
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The monthly pivot for January was $397.26, and half of one percent below that would have been $395.27.
Over the past four months, AAPL has only come close to its monthly pivot once (in early March) when it made a low of $516.22. The monthly pivot was at $514.68, so the adjusted stop based on this pivot would be $512.10. For April, the pivot is at $579.07, so an adjusted stop at $576.17 could be used. Apple has not made a lower monthly low since October 2011.
For a good example of how this might be applied in a downtrending market, we can take a look at NetFlix, Inc. (NFLX), which had an historic decline in the second half of 2011.
By the end of July 2011, the monthly pivot for July at $260.17 had been broken. On short positions, the August pivot stood at $274.08, so a stop at $275.48 (half of one percentage point above) could have been used for a stop.
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In September, the monthly pivot was $235.95 (adjusted to $237.12), which was just barely exceeded on the first day of September when the high was $238.50. Of course, NFLX continued to plunge, hitting a low in early December of $62.37.
NFLX stayed below its monthly pivot after September 1 and up to December 12, when the monthly pivot stop at $73.95 ($73.58) was exceeded.
If instead using monthly highs for NFLX, the short position would not have been stopped out until January 4, when the stop based on December’s monthly high of $77.97 was exceeded.
So how can you apply this monthly analysis to your trading or investing? I hope most of you keep a written record, or journal, of your market analysis. I think it will definitely pay off in the long run.
Each month, this record should include the month’s high and low for each of the markets you are following. Every month, compare the new numbers with the prior month’s ranges. This should be done not only for markets in which you are already invested, but also for those you are watching.
As an example, there are two sector ETFs, the Select Sector SPDR - Consumer Staples (XLP) and the Select Sector SPDR - Health Care (XLV), that I think will look attractive after a decent correction.
For XLP, the March low was $32.87, and for XLV, it was $35.68. Therefore, these are the levels that I am now watching, and if prices drop to these levels, I will be looking at these ETFs more closely to determine potential buy opportunities.
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