Trading Tactics – Weekly Reversals & The Dow – Part 2

02/07/2008 12:00 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

In the first part of this article (link to part one), I discussed the importance of weekly reversal formations in the Dow Jones Industrials and how they could be used to isolate trading opportunities in the stocks that make up the Dow Industrials. As part of the strategy or method we introduced, some suggested methods of determining an entry point as well as an initial protective stop. In the second part, I would like to expand on the topic by giving some suggested ways of closing out positions as well as adjusting the protective stop.

Figure 1
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The premise for this trading approach first requires a negative weekly reversal in the Dow Industrials. Once this occurs, a scan is run on the Dow Industrial stocks to select stocks to sell short. Part one of the article concluded by examining the reversal that occurred during the week ending on October 19, 2007 (points 1 and 2). Once such a formation was observed, then a scan was run on all the Dow stocks to find those stocks that had a weekly RSI3 above 55 and an MACD-His lower than it was the prior period. Once these stocks were identified, then two different entry methods were discussed. The first was to establish a short position on the opening the following Monday with a stop 0.05% above the previous week’s high. The second method suggested was establishing short positions in the following manner: take 1/3 of the previous range and add it to the low to determine the level at which to sell, also using a stop 0.05% above the prior week’s high. This is illustrated above as the reversal is indicated at point 1, and the sell level was hit the next two sessions before the Dow turned lower.

Now let’s take a look at the weekly close on December 14, 2007 (point a) where the Industrials made a high of 13,780 before closing at 13,339. The week’s low was at 13,321, so the range was 13,780-13,321 and 1/3 of the range was 153. The suggested entry level was therefore at 13,321+153 = 13,474, which is noted on the chart. This level was just missed by a fraction the following week as the high was 13,473 but was hit the week ending December 28, 2007 as the high was 13,563. The stop at 0.05% above the 13,780 high would have been at 13,849, this level was not hit.

Figure 2
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The daily chart of the Dow above shows the action during this period in more detail as the Friday close on December 14th is identified by point a. This coincides with the break of the uptrend in the RSI3, line 1, and the daily MACD-His was also then declining. I have also left the sell level at 13,474 on the chart as well as the suggested stop at 13,849. As the Dow rallied into the sell area at 13,474, the RSI3 just moved back to test its former uptrend (line 1) and moved just above the 65-level before turning lower. Both the formations in the daily RSI3 and MACD also favored the short side. So once short positions are established – what next?

I have found, as have many other traders and analysts, that taking a position that can be divided into two or three parts is a good strategy. The reason for this is that we can all remember trades that we have felt very comfortable with that reached a first price objective, but instead of taking some profits, we just stuck with them only to have the market reverse against us. Let’s face it, successful trading, as you have heard many times, is 80% in your head and much of that, in my opinion, has to do with confidence. All of the common trading mistakes can weaken your confidence and make it harder to recover. In this example, if you had multiple positions established at 13,474 then once the Dow got back to 13,092 (the prior low from December 18th) that would have been a good time to close out at least 1/3 of your position. On a break of this low, the stop could have been lowered to just above the December 26th high of 13,563.

What were reasonable targets for the rest of the position? In Fig. 2, I have shown the downside Fibonacci projections from the rally from the low at 12,724 (Nov. 26th) to the high at 13,780 (December 11, 2007). Taking 1.618 times this distance and then subtracting from the December 11th highs gives you a target at 12,100, which was reached on January 18, 2008. This type of analysis is how I determine a level at which to close out at least another 1/3 of the position with a trailing stop, possibly above the prior week’s high on the remainder of the position.

Table 1

The table above shows the results of the scan that was done on the Dow stocks after the close on December 14th. As you can see, eight of the Dow 30 stocks met the scan criteria. Intel (INTC) shows the largest percentage decline in the MACD, and even though it had one of the lower RSI3 levels, it still would have been a favored choice.

Figure 3

Figure 3
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The weekly chart of INTC shows that even though it was moving higher, the RSI3 was declining (line 1). As before, the December 14th close is labeled ‘point a’. The MACD-His had turned negative the week of November 14th and had not been able to move back above the zero line even though INTC was edging higher. The range for the week of December 14th was $27.88 to $26.19. Therefore, using the proposed 1/3-rule, the sell level would have been at $26.75 with a stop at $28.02. The sell level was easily exceeded over the next two weeks (point b), as INTC made a high of $27.74. This rebound was followed by a very sharp decline.

Figure 4

Figure 4
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On the daily chart of INTC you can see that it declined for one more day after the December 14th close (point a) before it began a five-day rally back to near-term resistance. The rally was strong enough to take the daily RSI3 back to the 65 level and the MACD-His just into positive territory. You will recall from the weekly chart (Figure 3) that the weekly studies were negative or declining. The recommended sell level is identified by the dashed line. Once the December lows at $25.38 were broken, lowering the stop to just above the late December rebound highs at $27.47 was a good idea. The violation of these lows would have also been a logical place to take profits on a third of the position. Using Fibonacci projections calculated based on the rally from point 1 to 2, the 1.618 projection came in just above $22. It was exceeded on January 11th. The further Fibonacci target of $18.50 (2.618 projection) was hit on January 22nd. At this low, you will note, that both the daily RSI3 and MACD-His did form slight positive divergences.

Figure 5
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For our last example, I will take a look at Procter & Gamble (PG) as its MACD-His reading saw the second largest weekly percentage change the week of December 14th. That week, PG reached a high of $75.18 then closed at $73.90, in close proximity to the lows at $73.76. PG had been making higher highs on the weekly chart for five weeks (line 1) but the RSI3 had formed lower highs (line 2). A similar negative divergence was evident in the MACD-His (line 3). Once again using the 1/3 formula the sell level would have been at $74.23 with a suggested stop at $75.66. The high over the next two weeks was $74.46 as the sell level was easily hit before PG began to drop. If you had instead tried to sell on a 50% rebound, the sell level at $74.47 would have not been hit.

Figure 6
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The reason to sell was even more compelling on the daily chart as PG declined for a few more days after December 14th before staging a weak rebound. The daily technical studies reflected deterioration as the RSI3 had a series of lower highs (line 1). A short-term negative divergence was also evident on the daily MACD-His (line 2), and it was below zero when the sell level was hit. Determining a first target in this case was more difficult as the most reasonable level would have been the lows formed in October and November in the $70 area. For the Fibonacci projections, I used the October 30th low at $67.90 and the December 12th high at $75.18. The 1.618 downside projection was at $63.50, a level that was reached on January 22nd and 23rd. The daily chart shows that PG rebounded from this low, so a trailing stop could have been used on the rest of the position as no positive divergence was evident on the daily chart.

I hope this example of a systematic approach using some of the indicators I have previously discussed will encourage you to try and refine this methodology or to apply a similar approach to another market or time series. The main advantage I feel is the relatively small risk that one has on any one position. This allows for a number of losing trades before any serious damage is done to your trading account.

As always I welcome your feed back on these articles and I can be contacted at tomaspray@intershow.com. I would also appreciate any suggestions you may have for future articles.

Tom Aspray, professional trader and analyst, serves as video content editor for InterShow''s MoneyShow.com Video Network. Mr. Aspray joined InterShow full time in June of 2007 where he also does other editorial work for the site, including the bi-weekly trading lessons and the weekly charts to watch. Mr. Aspray has written widely on technical analysis and has given over 60 presentations around the world. Over the years, he has applied his methodologies not only to the stock and commodity markets but also the global markets, mutual funds, and foreign exchange. Many of the technical indicators that Mr. Aspray wrote about in the 1980s, such as the MACD, have since gained worldwide acceptance. He was originally trained as a biochemist but began using his computer expertise to analyze the financial markets in the early 80s. As a consultant, Mr. Aspray wrote daily institutional reports for firms such as Fleming Jardine and Barings Bank and was noted by the Wall Street Journal as one of the "top bond market technicians."

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