Trading Tactics: Weekly Reversals & The Dow — Part 1

01/31/2008 12:00 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

One of the more reliable technical signals I have noticed over the years are weekly reversals, especially in major market averages such as the Dow Jones Industrials. With a stock market under pressure for the latter half of 2007 and early 2008, I wanted to share some thoughts on how one might use these formations to find and execute trades on the short side.

Figure 1
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It is important to realize that no matter whether you are trading full-time, or spending just an hour or so a day, establishing a routine is very important and can make the difference between success and failure. I have always started preparing for the week ahead over the weekend, as it began when I was trading full-time and has carried over to today, even though I now spend very little time looking at the markets during the day. Having a systematic process helped me to develop a strategy for the week ahead. In the stock market, I have generally found identifying near-term tops to be easier than near-term bottoms, and part of this can be attributed to weekly candle formations. What do I look for? My favorite is finding a week when the market makes a new rally high, but then closes lower, as this allows one to identify a clear place for a stop, and when the market is neutral to slightly overbought, the odds of a two-three week correction are quite good. Of course, if there is evidence of a more significant top then one can expect much more.

The Dow’s rally the week of July 16-20, 2007 was a case in point as the Dow moved to a new high above 14,000 (the high was 14,022) but then closed down for the week, point 1. This suggested that the market would at least see a 2-4% decline over the next several weeks. A common challenge for traders is deciding on what markets to trade and how many markets one can competently follow. For part-time traders, it is best to keep the universe small. So, for this example, based on the Dow Industrials, I will analyze the 30 Dow stocks. The first step in this process is to isolate the stocks where the RSI3 is neutral, i.e. above 55. For those who have not read my articles on this indicator, it is a three-period MA of a five-period RSI, and works well as a short-term momentum and overbought/oversold indicator. The second criteria I use in the scan is to select stocks where the weekly MACD-His is lower than it was the previous week. The table below shows the results of the scan that was run after the July 20th close.

Figure 2

Table 1
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Figure 2
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The largest weekly percentage decline in the MACD-His value occurred in McDonalds (MCD), so lets look at this chart first as the July 20th close, point 1, shows that MCD had a narrow range $53.22-$51.82 and closed below the open. The RSI3 was at 65 and had formed lower highs, line a, a negative sign. The most straightforward entry strategy would be to sell on the opening the following Monday with a stop above $53.22. I typically use a value 0.5% above the high which would have been at $53.48 for MCD. Of course this could be adjusted to one’s own individual risk tolerance level. The stock opened the following Monday at $52.65 and declined for the next month, reaching a low of $46.64. During this period, it never made it back above the opening level, and in the second part of this article, I will take a look at some methods that could be used to fine tune the exits.

Figure 3

Figure 3
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Another example was Caterpillar as its RSI3 and MACD-His, line a, were both declining as it closed July 20th at $83.27. The range for the week was $87-$78.26. CAT gapped lower the following Monday, opening at $82.47, and a stop could have been used at the prior week’s high ($87) plus 0.5% or $87.43. Still not too bad as the risk was a bit over $6 per share for an $80+ stock. Four weeks later, CAT hit the $70.59 level before closing the week at $72.64. Table 1 also includes the closing prices for the other Dow stocks that were selected in the scan and their range for the next four weeks. Now granted this was a pretty sharp market decline; but still, it is worth noting that over the next four weeks not many of the stocks managed to get above their July 20th closing levels.

Figure 4

Figure 4

Now, let’s look at the weak close in the Dow Industrials on October 19th as it settled at 13,522 which was down 571 points or a bit over 4% (point 2). You should note that the previous week the Dow did make a new high at 14,198 before closing just bit lower. The size of the red bar the week of the 19th, however, can make one cautious about just “selling the open” as the risk seemed as though it might be too high. In reality, this generally would not be the case, but nevertheless, the fear factor would leave many traders on the sidelines and frustrated as the market declined. An alternative entry mode might make it easier to “pull the trigger,” and though the risk would be lower, a fill could not be guaranteed. Here is an alternative approach. Take the range of the down bar for the Dow, this would have been 14,118 – 13,511 = 607, then take 1/3 of this (202) and add it to the low, giving you 13,511+202 = 13,713, which would be your sell level. The suggested stop would still be 0.5% above the highs at approximately 14,189. Now some would use 50% of the range but, in my experience, the 50% level is often not hit. In this example, the next week’s range in the Dow, point 3, was 13,811 to 13,407. The following week, the high was 13,962 and then the Dow dropped more sharply over the next three weeks.

Table 2

Figure 5
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The table above shows the Dow stocks that were selected via the scan. Of course those with negative and declining MACDs would be the leading candidates, so let’s take a look at a few examples. Since the overall sentiment was negative for the financial stocks, American Express (AXP) would have been a reasonable choice. The RSI3 was just barely above 55, at 57, while the MACD-His pattern was more negative. On the chart you will notice that the MACD-His moved back above the zero line for one week before reversing back to negative the week of October 19th (circle a) as AXP closed at $57.11. The week’s range was wide at $63.50-$57.06 therefore 33% of the difference would be $2.12. The suggested entry was, therefore, $57.06 +2.12 = $59.18 with a stop above $63.81. This proposed sell level was hit over the next two weeks as the highs were $61 and $61.55 respectively. As the chart indicates the decline accelerated into year-end.

Figure 6
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Honeywell was another standout choice based on the numbers as the MACD showed the largest weekly percentage drop after American Express. Once again, the October 19th bar is indicated by point 2. The RSI3 had turned lower on the 19th and the MACD-His, after failing to move above the zero line, dropped further into negative territory. The range the week of the 19th was $62-$57.24, therefore using the 33% formula, the sell level would have been $58.83 with a stop $62.31. Over the next three weeks, HON rebounded making a high of $61.07, before turning lower.

Also on the October 19th list were McDonalds (MCD) and Caterpillar (CAT), which we covered in the first part of the article, so let us go back to those charts and see what happened in October. McDonalds, Fig. 2, had a very narrow range the week of the October 19th (point 2) from $57.35 to $55.93. No matter whether you sold at the 33% level of $56.40, or on the opening at $56.03, the stop at $57.64 was hit by the end of the following week. Things worked out better in Caterpillar (CAT), which had a much wider range, closing near the lows at $73.25 with a weekly range of $80.10-$72.80. Therefore, the 33% sell level would have been at $75.23 with a stop at $80.50. With a $75.98-$71.63 range the next week the sell level was hit as CAT formed lower highs for the next four weeks.

In Part Two of this article I will continue the discussion of this trading approach and also share some ideas of what profit taking strategies might be used to further enhance the performance.

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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