Lessons from the Pros

Options Article

Which Trend Is the Correct One?

When analyzing multiple time frames there can often be confusion. Two different time frames of the same underlying could show us completely differing trends.  They are both accurate, for they both show the same price action, yet they can be contradictory. In such case, the question arises: “Which trend is the correct one?”

In order to figure out which trend to trust when dealing with the technical analysis of multiple time frames, we ought to have a clear focus. Let me statistically, mathematically, and visually illustrate the point by setting three unambiguous parameters.

The First Parameter

The most common parameter is the evaluation of how much an underlying has moved up or down for the year. Rather than blindly trusting the TV gurus, we can, with a few clicks quickly verify those stats thrown at us. On the monthly chart we can use a vertical line to locate the December’s monthly bar; from its close to the current price, we can then measure the percentage change for the current year. At the time of this writing, with the second quarter of 2012 just ended; the following were the statistics for each of the four major ETFs. The QQQ, or the NASDAQ tracking ETF is up the most since the last year. The second on the table below is the SPY, or S&P 500’s ETF with a significant 8.25% increase. The third one, IWM which tracks the Russell 2000, was up nearly as much as the SPY.  Both of them, the SPY & IWM are up about 8%; yet that is not the case with the Dow Jones Industrial Average, DIA which is up barely over 5%.

Ticker % increase
QQQ 14.34%
SPY 8.25%
IWM 7.9%
DIA 5.5%

Figure 1

The point of knowing this statistical data is connected to our future expectations when trading. The QQQ most likely could move up the most in the short term, while the Dow might more easily lead us to the downside. These mathematical numbers in isolation from the environment might not mean much, unless the assumption is made that at the end of last year money was invested in these products and after the point of entry, the market has moved up in the percentage points provided in Figure 1. On the bigger time frame these same statistics do not have much validity; therefore, a new set of parameters needs to be introduced.

The Second Parameter

At one point during the current calendar year these same four instruments were trading HIGHER than where they closed at the end of Qt2. Could it be that they are on the way up, approaching once again those very same highs? Moreover, if they do, should we not then be more cautious? If the answers to both of these questions were affirmative then perhaps we should consider some less bullish strategies. Possible choices would be Bear Call spreads or, if already owning the underlying, selling calls into the resistance created at the double top. Pulling up the charts and marking  the previous Highs on it brings the awareness closer to us that there is the possibility of a double top.  Keep in mind that the first retest of those highs is more likely to fail to break out to the upside.

Being an option trader forces one to be consciously aware of both dimensions: price and time. An option trader who is long, does not have the luxury of time that an equity trader has. Often stock traders without a stop loss, say: “It will come back, so I’ll wait.” Notice that the time reference made is indefinite. For an option trader the time to expiry is set in stone. Likewise, an option trader who has sold an option has the same issue burning at the back of his or her mind. Therefore, get as good as possible on the technicals and their possible timing.

The Third Parameter

The third, and the last, parameter takes into consideration the big picture. It looks at the 2007 highs versus the 2009 lows on the monthly chart. When these two points are marked Fibonaccis are utilized to measure the current price in relationship to those extremes.

Ticker Fib 07 Recovery
QQQ 130% Recovered
IWM 89% Failed
DIA 83% Failed
SPY 77% Failed

Figure 2

Going over each statistic; assuming that a trader has gone long at the highest point of 2007 and held the position without stop losses through the major downturn, as many people did, then the trader holding on to the QQQ would be currently content. Not only would the trader get back all of his invested capital but also the same capital would be actually up an additional 30%. Once again, in both figures we are seeing the pattern that the NASDAQ related products are the strongest. Why would that be the case? It could be simply because of the fact that they have already gone through the survival of the fittest type of elimination earlier in the millennium after the burst of the tech bubble. The next three are nowhere near 100% recovery. The IWM is the strongest amongst the three weakest ones; and the SPY is by far the weakest on this bigger (2007 to present) time frame; whereas Figure 1 is showing (the shortest time frame – just the last six months) the Dow as the weakest.

After we have gathered all these stats for the larger time frame we can then make some rational observations. For instance, the QQQ on either time frame appears to be the safest choice for the upside. Meanwhile, on the smaller time frame, the weakest one to the downside would be the Dow.  On the larger time frame the SPY shows a lot of relative weakness.

In conclusion, the trend of the time frame that we are trading is the correct choice for us. Within that trend there could be corrections, also known as retracements or pullbacks. Yet as long as we are on the correct side of the order flow that we are trading, we should be fine. Do the right things and good things shall happen to you. Have a great summer trading.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.