My Favorite Trading Indicator

05/02/2011 11:15 am EST


As one trader explains, the McClellan Oscillator is a preferred method for identifying market extremes, alerting traders to adjust their strategy in order to stay safe and trading with the trend.

As many readers may know from previous articles, I pay close attention to the McClellan Oscillator as a benchmark for when the market is becoming overbought or oversold.

While there are varying degrees of being overbought and oversold at varying time frames, the McClellan Oscillator is a great way for me to watch for short-term fluctuations in the markets. Other indicators like the put/call ratios, investor sentiment surveys, and stocks trading above their 40- or 50-day moving average indicators are also invaluable to my tool box, but are definitely used differently.

While I will even abstain from trading during certain extremes in these other indicators, I use the McClellan more as a warning that balance in the markets is starting to swing too far in a particular  direction.

Because it's more of short-term indicator, there will often be times when the markets will ignore the indicator (like any indicator, really), but the risk for taking a trade definitely increase as it swings to an extreme. Below is a current chart of the indicator:

Click to Enlarge

Notice the indicator spends most of its time between +150 and -150. Any time it gets above or below these levels, I will start to either get more defensive or more aggressive.

I typically won't stop taking trades unless multiple indicators are aligned in one direction. What I will do, though, is reduce my risk by adjusting my position sizing or shortening my time frames. I will also adjust where I place my stops or even which types of trades I will take as I recognize the type of risk that is present. A good example would be how I am treating this environment.

The easy money has been made when you think of the past two weeks. With the McClellan above +150 and Spyder Trust (SPY) up basically seven days in a row, I am getting much more aggressive in taking profits on any position that moves in my favor. There are still plenty of good looking set-ups, but rather than skipping them, I have been taking smaller positions.

I am also paying close attention to any correlations to other markets (or earnings momentum) that may shelter them from a typical move.

The markets can easily continue to push higher-as they did from December through March-but managing risk is my number-one priority, and I can get more aggressive after a couple of weak days within the larger uptrend.

The important thing is to never put yourself in a position of weakness by not realizing the risk.

By Joey Fundora, trader and blogger,

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