Trading & Fading the Dow

08/20/2007 12:00 am EST

Focus:

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Options specialist Lawrence McMillan, editor of the Option Strategist, offers details on a tried-and-true system for profitably trading the Dow…

We want to revisit one of the systems that we first introduced in this newsletter in early 2006—the “Fade the Dow” System. The definition of the system is quite simple: if the Dow Jones 30 Industrials moves by 0.5% or more in a given day, then at the end of that day, take an opposing position. That is, if the Dow was down by 0.5% or more, then you’d buy “the Dow” at the end of that day (conversely if the Dow was up by 0.5% or more, you’d sell short “the Dow” at the end of the day).

Exit the position in this manner: 1) if you have a profit at the end of the first day, then take it and exit the trade, or 2) exit at the end of the second day, no matter what. When we first presented this data (Volume 15, No. 5—March 17, 2006), it was noted that the system made most of its profits after a Dow down day, and so it might be better to just take those signals.

I have personally been trading this system since then, and it has a good track record. But lately, it’s on a real roll. You may have noticed that the market—even though it has generally worked its way lower—has been experiencing an up day, down day, up day sort of pattern. In fact, from July 19th through August 3rd—a period of 12 trading days—the Dow was up or down 0.5% on 11 of them! The only day it wasn’t was July 25th. Of those 11 trades for the “Fade the Dow System,” ten were profitable.

The Dow itself lost 804 points during these 12 trading days, but the "Fade the Dow" system made 1,556 Dow points. In practice, it's best to trade this system with the Dow futures on the CBOT, although it could be traded with $DJX or DIA products-either the Diamonds ETF (AMEX: DIA) or options on either one. During the long steady rally from the middle of 2006 until the middle of 2007, the system lost money. But, that if you only faded the down moves, you would have been making money pretty consistently all along.

Of course, once the market enters a bearish mode—as it has of late—then fading moves in both directions is profitable. Hence, we might not want to conclude that only the down moves should be faded. Rather, we should try to factor in a market forecast as well. If the market is generally in a bullish trend, then only the down moves should be faded.”

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