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If you're like most traders, you probably have a few "tools," or strategies, in your investing tool kit that you feel comfortable using most of the time. However, sometimes the market hits you with challenges that your limited tool kit is incapable of dealing with. At Learning Markets, we know how important it is to be flexible so you can react to whatever the market throws at you. That's why each week in our "Strategy Talk" blog, we will be introducing you to a new tool, or strategy, that you can put in your investing tool kit so you will be prepared to take advantage of whatever trading opportunities come your way.
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Breaking Through

In 1949, Richard Donchian started the world's first managed futures fund. He used a simple method which was highly successful then and is similarly effective today. It is a methodology that is easily accessible to even a casual stock trader. The indicator he used (without the aid of computers or charts) was a simple breakout of the price above the highest high in the previous 20 days. This method of marking prices has been named after him by the indicator commonly referred to as the Donchian channel. On the Scottrade platforms, it goes by the simple name “Price Channel.” 
 
Buying a breakout from a 20-day price channel can follow these simple strategy steps:
 
1. In bullish market conditions, identify stocks where the price has closed above the upper band of the channel. 
2. Buy the stock at the next day’s open.
3. Trail a stop underneath the lowest low of the last 20 days.  
 
The method is simple enough, and Scottrade’s Smart Charts include a tool to track this price level for you. It can be found under the “Upper Indicators” pull-down menu as shown in the figure below. The Scottrader and Scottrade Elite platforms feature this tool as well.

Where to find the Price Channel Tool in Scottrade Smart Charts
 
As mentioned, one simple method for using a trailing stop with these breakout trades is to set your stop at the lowest price in the last 20 trading days. It is a very simple method and a remarkably effective one for strong trades that begin with a breakout. Results for this strategy vary over time. In strong trends, this trade captures most (but not all) of the move. In sideways channels with large ranges, this method can also be quite effective. However, in tight range stocks it can lead to ineffective whipsaw trades. The three figures below show examples of how the strategy plays out. 

IBM 1-year chart with Channel Breakout trades

HIG 1-year chart with Channel Breakout trades
 

LOW 1-year chart with Channel Breakout trades
 
In the first of these three figures, you can see that IBM, a stock more prone to a large sideways channel, showed reasonably good trades but also suffered a maddeningly unproductive trade due to an earnings report. A simple rule to take profit before earnings if your profits are more than four times your risk would have kept this loss from happening. But even without such a rule, the strategy still beats buy-and-hold trading for the length of the year.
 
In the second figure, Hartford Insurance Group (HIG) showed three nice trades during the past year, but did not outperform buy-and-hold in the process—at least not for the duration of that year. 
 
In the third figure, Lowe’s Corporation (LOW) shows two trades which actually outperform a buy-and-hold method of trading for that year.
 
The conclusion is that the method works well when you have a strongly trending stock, but less so if the stock moves in a choppy, indecisive fashion.
 
-by Gordon Scott, CMT, Learning Markets Analyst.
Posted by learningmarkets on Mar 12, 2013 6:31 PM CDT
When to Take Profit after Buying a Breakout
On January 15, Alaska Air Lines (ALK) was trading around $46 per share. I used that stock in a previous blog post as an example of how to employ a strategy of buying a breakout. Now as we approach the ides of March, it seems appropriate to discuss a strategy for taking profits when a breakout trade goes tremendously well, as they sometimes do.
 
In my opinion, the very best strategy for timing when to exit a breakout trade is to simply place a stop-loss order below the entry price and then gradually move it up as the trade progresses in your favor. This strategy may only win around 40 percent of the time, but when it does win, the gains make up for the losses over many such trades.
 
Occasionally, one or two trades out of thirty will experience a stunning and rapid rise in price. During such an event, many traders wonder if it wouldn’t be a good idea to take profits from the trade. Of course, the answer to whether that decision is the right one depends on whether taking profits early is part of a trader’s own trading strategy. If taking a profit is inconsistent with the rules of particular trader’s strategy, then it doesn’t matter what he observes in the markets—early profit taking would be the wrong thing to do. But if a trader is seeking for a profit-taking strategy to add to his regular trading rules, then the following approach might be useful for him to consider:
 
1. View the stock on a daily, 1-year chart.
2. Apply a Moving Average Envelope
3. Modify this study for a given number of days (anywhere between 18 to 24 can be used; 20 is used in the example graphic)
4. Modify the envelope’s percentage setting to be in between 6 and 12 depending on what the price action in the stock looks like over the past year.
5. If the price touches or crosses the upper-envelope line, then consider taking profit on the next day or two after this event.
  
To demonstrate this strategy, let’s look more closely at a chart of ALK, which I have updated since first using it two months ago (see figure below).
 
ALK – Daily Chart
 
The four points of interest in this chart explain the strategy as discussed. 
 
#1 – This dashed line is the previous resistance I mentioned in the previous blog post. At that time, ALK had just made a breakout above $45, setting up a target buying price as the stock came back to retest the breakout.
 
#2 – This stretch shows several days where the stock price dropped below $46 and came within one dollar of the breakout price. This example assumes that a trade was initiated from this point. As the price has continued higher, we now look to determine at what point we may need to take an early profit as a result of an unusually rapid rise in price.
 
#3 – After adding a Moving Average Envelope, we adjust the settings to get an idea of where the envelope represents resistance. By selecting a 20 period moving average with a 7 percent envelope measure, we find that the stock showed resistance twice when touching this line.
 
#4 – As of the last two days, ALK has closed well above the Envelope line, this represents a potentially worthwhile point at which to consider taking profit since the rate at which the stock price has risen is unusually fast. In the near future, the stock price may retrace a bit and allow a better re-entry.
 
-- By Gordon Scott, CMT, Learning Markets Analyst
Posted by learningmarkets on Mar 5, 2013 2:59 PM CST
How to Profit from Fluctuation
Whenever J.P. Morgan was asked what the market will do on the next day it opens, his response was invariably, "It will fluctuate." It seems like a pithy and obvious answer, but often investors overlook this reality. Traders astutely ask if there is a way to profit from such fluctuation. One famous trader and technical analyst attempted to develop a tool for doing just that, and he called it the “Ultimate Oscillator.”
 
Larry Williams developed the Ultimate Oscillator with the idea of tracking the trend of a stock over three different time frames (7, 14 and 28 are usually default), and compiling the calculation of all those time frames into one simple measure. The measure oscillates on a scale of 0 to 100 with marker lines at 70 and 30. 
 
A simple strategy for using the Ultimate Oscillator could be outlined as follows:
 
1. Set the three indicator time frames as 3, 11 and 43
2. Watch for a reading at or below 30
3. Enter a trade and place a stop loss 5 percent below the entry price
4. If stopped out, wait for a bullish divergence before re-entry
5. Take profit as oscillator reaches 70
 
Williams considered that the level of the oscillator line was less important than the divergence signals it made. The combined calculation of multiple time frames in the Ultimate Oscillator actually does a good job of generating clear divergence signals.  That’s the reason for step four in the strategy. Consider the example shown in the figure below.
 

FNSR – Daily Chart with Ultimate Oscillator
 
The example in this figure uses the stock of Finisar Corporation (FNSR) to demonstrate how the strategy works. FNSR is a useful example because the stock has moved in a sideways pattern during the last year. Here you can see that the Ultimate Oscillator signaled five times when prices has pushed so low as to be considered oversold when using 3, 11, and 43 as period measures for the indicator.
 
Following the strategy you would put a stop loss at five percent lower on each of these buy signals. Four out of five of these signals turn out to be profitable (marked by green circles on the indicator). However, pay close attention to the one that makes a loss. Once a trade makes a loss, you don’t attempt another entry until you see a bullish divergence. That means you’ll be watching for lower prices but higher low-points in the oscillator’s score.
 
As you can see from the figure, the buy signal that follows the bullish divergence turns out to be the best quality signal of the four winners. The combination of oversold and bullish divergence generates the ultimate trade from the Ultimate Oscillator.
 
-- By Gordon Scott, CMT, Learning Markets Analyst
Posted by learningmarkets on Feb 26, 2013 11:21 AM CST
When Markets Weaken
Sometimes the market shows signs of weakness and diverging signals just before making lower prices; however, at times it trends higher even after showing signals of weakness. What can a trader do when they see diverging indicators that show weakness in price? They can use a strategy of waiting for the trend line to break. The rules are simple:
 
1.     After you observe a divergence (this is the setup), then draw a trend line that connects the most recent lows (2 or more). The trend line should be twice to four times as long as the divergence length.
2.     When the price crosses the trend line, then and only then should you adjust or make a trade as if the trend had changed. Until this happens, maintain a bias in the original direction.
 
Divergence is an important concept to understand if you want to read chart prices in a way that prepares you for future trend changes. The concept of divergence is simple. but it takes a little practice to recognize divergences and then to know how to trade them. It’s actually easier to see divergences on a chart than to try to imagine them by reading a definition.  Divergences can be found on almost all oscillating indicators. They provide early warning clues about a pending trend change.

Here is an example of divergence:

Bank of America (BAC) – Bearish Divergence on a daily chart

In this example the Slow Stochastic indicator is shown below the chart to demonstrate the divergence. The divergence occurs as the price trades higher than a previous peak while the indicator fails to make a new higher mark in the same time frame. Two examples are marked in the most recent nine months on a daily chart. The first example (A) is measured by the gold-colored trend line. The dashed section of the line marks the time period after the divergence to watch out for a trend change. This time frame is approximately the same duration as the divergence between the two high prices.

You can see that during the first time frame the trend change did not occur. According to this strategy no trade would normally be entered, because the price never crossed the projected trend line in the time specified. This technique helps keep traders from prematurely trying to anticipate a trend change.

Traders often make this mistake whether by getting out of a position too soon or by trying to trade against the trend. With this strategy the trader can avoid the trap of jumping too early.

The second example shows the current divergence underway. Notice that this divergence is more lengthy than the previous one. This increases the likelihood of a trend change since the time frame for action is likewise increased. Waiting for the trend line to break is an excellent confirmation signal that can filter out false moves.

By Gordon Scott, CMT, Learning Markets Analyst
Posted by learningmarkets on Feb 19, 2013 3:12 PM CST
Trading on the Edge

Traders looking for ways to buy a carefully chosen dip or precisely time a sell order against a suspicious rally often look for a statistical edge that can give them a boost in results. One technique for building a mechanism to do so includes using two versions of the same indicator applied in two different time frames. As it turns out, the Aroon indicator is well suited to this task.
 
Here are the indicator settings and rules for a simple strategy to buy dips using Aroon indicators (you can sell rallies by turning this up-side down, so to speak):
 
1. Begin with an “Aroon” indicator set to 50 days
2. Add another “Aroon Oscillator” indicator set to 5 days
3. Watch for the 50-day Aroon indicator to show the UP line (colored green) above the DOWN line (colored red)
4. Bullish setup occurs when the 5-day Aroon Oscillator drops to -100, or below, while the 50-day UP line remains above 40 and above the DOWN line.
5. Enter at the opening price of the day after the setup day
6. Exit on stop loss four to five percent lower or …
7. Take quick profit after the 5-day Aroon Oscillator has either gone to 60 or higher then back to zero or…
8. Take longer trending profit as the Up line crosses below the DOWN line.
 
The Aroon indicator was developed by noted trading expert and author Tushar Chande, who named the indicator after the word for “dawn’s early light” in Sanskirt. He was hoping to find the very beginnings of a trend using this method. The indicator looks to see if the price has made a new x-day high, where x is a variable you choose—typically 14 or 25. 
 
The indicator then does something unique. It doesn’t keep track of where the price goes unless the price simply makes a new high. It deteriorates a set percentage (based on 1 divided by x) for each day that follows where a new high is not reached. The larger the number of days you choose for x, the longer the deterioration takes. Thus the indicator will spike higher and slowly move lower, creating its signature saw-tooth shape. The Aroon Oscillator employs similar calculations to create a running histogram of information. 
 
Chande intended the indicator to be used in a way that showed a progression of the price move, but many traders get confused by the subtleties of his technique and have trouble using the indicator profitably. The strategy described above is intended to build on the strength of the indicator’s calculations and buy when the stock has dipped back after a certain number of days. It does an excellent job of helping you recognize when a stock might have pulled back to a multi-day low within an upward trend.
 
The numbers of the strategy can be modified to fit a trader’s preference for length of trade, but a 9-to-1 or 10-to-1 ratio between the longer-term Aroon Oscillator and the shorter-term Aroon Oscillator makes for an excellent tool to identify the relative dips in price (see figure below for an example).
 

-- Gordon Scott, CMT, Learning Markets Analyst 
Posted by learningmarkets on Feb 12, 2013 2:07 PM CST
Upside Down Trading

Traders are always on the lookout for opportunity, even if they have to stand on their head to see it. Yesterday's market action is a perfect example of a circumstance in which traders could execute a strategy for trading a bullish divergence in a bearish move.
 
In today’s market, traders would look to use the strategy with inverse ETFs, stocks that go up when the market is going down. But the strategy primarily works with stocks that have been falling for a while and have now begun to rise. 
 
The rules of the strategy are as follows:
 
1. Look for a stock that has been trending downward for about a month or more.
2. Check the stock’s chart using an oscillating indicator, such as the Stochastic indicator or the Money Flow Index.
3. Look for a pattern of falling prices at a time when the indicator begins trending higher.
4. Make an entry on the stock and set a stop loss 1% below the lowest price traded during the previous week. 
 
For an example using a regular stock, we have to go back to last summer’s correction. You can observe the setup by looking at a chart of Sandisk (SNDK), shown in the following figure.

SNDK – Daily Chart from late spring 2012
 
On this chart, you can see that three oscillating indicators are shown for comparison. You can see for yourself which of the indicators shows divergences more clearly. Although all three do show a divergence, not all three of them make it obvious to an untrained eye. 
 
The stock price chart shows a pattern of declining prices from mid-April to June of that year. What you want to look for is a pattern in the way that the lowest points in the price trend correspond to the lowest points of oscillation in the indicators. When the indicator’s lowest points rise during a down trend in price, this is referred to as a divergence. 
 
All three of the indicators below the price above show divergence, but notice how the Fast Stochastic indicator shows only very subtle changes in its lowest levels during that time frame. By comparison the Slow Stochastic shows a better angle of rising lows. That makes it easier to see the divergence. But even easier still is the divergence clearly identifiable on the Money Flow Index (the lowest section of the figure). This oscillating indicator includes both price and volume action in its calculation, so it brings out the subtleties of the divergence earlier. 
 
Executing this strategy in the current market climate would best be done by identifying down trending ETFs. These funds may have begun to turn upward based on yesterday’s big move lower in the market. Should the market continue lower, inverse ETFs (such as SDS, TZA, FAX or SQQQ) would likely be usable for identifying bullish divergences on bearish stocks.
 
-- By Gordon Scott, Learning Markets Analyst
Posted by learningmarkets on Feb 5, 2013 6:44 PM CST
Searching for a Squeeze
One high-potential trading opportunity involves buying stocks likely to experience a "short squeeze." But finding such opportunities can be tricky. It helps to know what you are looking for and what results you can throw out. (By the way, if you don’t know what a short squeeze is, you can learn all about this topic by attending an upcoming Strategy Session webinar on this topic.)  
 
It is important to note that today’s post will simply discuss a methodology for finding these candidates, not for trading them. Just because a stock has the characteristics for creating a short squeeze doesn’t mean that you should simply buy it and cross your fingers. Any trading strategy should have a clear plan for where to buy, where to sell and how much to risk in the trade. 
 
Finding stocks that could be potential short-squeeze candidates is quite simple if you have a Scottrade account. The Stock Screener has useful tools to help you accomplish this purpose. Here is a methodology for using the screener to help you find stocks that might have the prospect of moving rapidly higher.
 
Step 1: On the Stock Screener, add the following three criteria under the category “Price Performance:”
 
• Share Price – greater than 5 and Less than 20
• 52 Week High/Low – less than 40 percent from the low
• Short Interest as Percent of Float – 20 percent or higher
 
Step 2: Once you have run this screen, sort the candidates by 5-day change so that those that have increased in price the most over the last 5 days will be at the top of your list.
 
Step 3: With the top moving stocks sorted on your list, click on the “Price Performance” tab to study the “10 Day vs 90 Day” column. This will point out which stocks have shown an exceptional increase in volume recently. Look for stocks with a number that is greater than 1 percent in this column.
 
Here is an example of the kind of stock you might find.
 

PETS – Daily Chart
 
Once you have identified a few potential short-squeeze candidates, put them in your watch list and look for an opportune time – based on your trading strategy – to enter a new bullish trade. If the short squeeze does end up playing out like you anticipate, you shouldn’t have to wait long for profits to appear.
 
-- Gordon Scott, CMT, Learning Markets Analyst
Posted by learningmarkets on Jan 29, 2013 11:51 AM CST
Using the ADX to Find the Beginning of a New Trend

Recently on a live, Friday-evening session of the Daily Market Commentary series, one attendee asked the question "How can you tell when a stock might be ready to break out of a sideways channel and begin an upward trend?" I thought about the answer to this question for quite a while afterward and decided that this topic deserved further discussion. 
 
Though there is no guarantee for being able to see the future through any technical indicator, there are certain indicators which can give worthwhile clues that may not be easily discernible to the human eye in a regular price chart.  The Average Directional Index (ADX) is one such indicator.
 
The ADX doesn’t give you a strategy for trading, implicitly, but rather a strategy that complements other trading strategies. If you are using any kind of a strategy that helps you identify trending trades (that is a trade that benefits from trending price action), then the ADX will help you to know whether the conditions are right for you to be taking the trade in the first place.
 
One simple rule for the ADX strategy is as follows: 
  • If the ADX level is above 20, consider looking for a trending trade
  • If the ADX is below 20, pass on the entry signal
This rule is a simplified form of using the ADX based on the writings of the man who developed it. Welles Wilder, a pioneering market technician, first described the indicator and its components in his book New Concepts in Technical Trading Systems back in 1978 when it was published. At that time, there were no computers to rapidly accomplish the calculations. It is interesting that even in this day of sophisticated technology, his work on this indicator remains as fresh as the day it was published.
 
The ADX attempts to aggregate subtle details of price movement over several time periods, minutes, hours, days or weeks (the number of periods is a variable setting). In particular it looks to gauge how much price movement is occurring beyond an average range of activity and which direction it seems to be moving. Within this calculation, some very interesting, and timely, observations can be discerned; namely, the build-up of a stock within a channel as it prepares to break out into a new trend.
 
Consider the example of Yahoo (YHOO) in the figure below. Not all stocks make such a clear example, but here you can see how it was that in the midst of YHOO’s year-long sideways range between $14.50 and $16.25, the ADX moved above 20 and made a definite upward trending move signaling the possibility of a breakout to come.

YHOO – ADX trend precedes a breakout from channel
 
Seeing this movement on YHOO's ADX could have given you the added confirmation you were looking for when deciding whether or not to en

This is a very simple example with more detail than I can effectively explain in this brief blog post. If the idea behind this indicator in interesting to you, attend the Strategy Session to be held this coming Thursday (January 24th) at 8 p.m. Eastern time, where we will have an in-depth discussion on the ADX.

To register, log in to Scottrade.com, click on the Knowledge Center tab, click on the Strategy & Commentary link in the left navigation and then click on the ADX Strategy Session link.
 
-- By Gordon Scott, CMT, Learning Markets Analyst.
 
Posted by learningmarkets on Jan 22, 2013 3:37 PM CST
Buying a Breakout

When a stock hits the highest price it has made in a year, many investors start feeling dizzy. If they are already holding the stock, they may assume that the price cannot possibly go higher and look for reasons to take profit. That assumption is usually not valid. While there is no guarantee a stock will go higher after breaking out to a new high, there is certainly no evidence that it will necessarily go lower. Being able to anticipate the profit-taking behavior of some investors creates a potentially profitable trading strategy based on buying a retest of the 52-week high breakout.
 
The strategy follows these steps:
 
1. In bullish market conditions, search for stocks that are trading at a 52-week high, but have also broken above a previous price level within the past 1 to 11 months
2. Watch for the stock to drop back to the previously broken price level within ten trading days after the breakout.
3. Buy the stock just above the previous breakout price
4. Place a stop below the previous breakout price (3 to 5% lower).
5. For a smaller, quick profit (one to two week trade): Take a quick profit if the stock rises back to its previous high in the last ten days, or  
6. For longer, bigger profits (one to six month trade): Trail the stop underneath the lowest low of the last 10 days.  
 
It is a simple, but effective strategy during bullish market conditions because investors predictably respond by taking profits on new breakout highs about 70 percent of the time. Consider the following example of Alaska Air Lines (ALK) in this figure.

ALK – Breakout and Retest with Strategy Steps marked
 
You may want to click on the chart to get a closer view of it; the numbers on the chart represent a location where each of the strategy steps is mentioned. The line on the chart above represents the previous high price for that year ($40). The price action on the chart shows how ALK moved above that previous high, but it also shows that investors apparently felt the need to take profit when the price moved above the high for the year. 
 
Notice also that before going higher, the stock price retreated a bit, but only to the $40 per share price. After returning to that level, the share price continued higher. ALK makes a good example, because, if you look closely, you can see its current price action has recently broken above its high of the previous month, thus setting up the proper conditions for this strategy. 
 
-- By Gordon Scott, CMT, Learning Markets Analyst.
Posted by learningmarkets on Jan 15, 2013 2:17 PM CST
Go with the Flow

Trading during 2013 is likely to be characterized by significant fluctuations in price action. That’s why using indicators that gauge the relative strength of current price action – like the Money Flow Index (MFI) – is likely to be useful this year. Before explaining this indicator, let’s discuss the strategy for using the MFI because it is rather simple.
 
Entry: Once the stock can be identified in an upward trend or in a defined channel, then any score below 40 on the MFI represents an opportunity to buy in at a relatively low price.
 
Profit Exit: Take profit after the MFI has risen above 75 and then begins to slip back below 75.
 
Loss Exit: Set a stop at a lower price than you bought the stock—an amount equivalent two times the Average True Range (ATR) for the stock you are studying.
 
Here is an example of how a stock might be measured using the MFI (see figure).
 

SLCA – Daily Chart with Money Flow Index below
 
You can see from the labels in the chart that the MFI index gives a lot of relevant information. (To see these labels better you may want to click to enlarge the graphic.) 
 
The first important label, “Prep” marks the indication that a trend change may be coming.  The MFI shows this by reaching a higher level than in the previous month – even at a time when the price has been trending downward as it makes a new, lower high point in the price fluctuation. 
 
About two weeks later the change in trend comes. About three weeks after that, the stock has made a new higher high price and higher low price. This point is marked by the label “Start.” From this point forward the stock is in an upward trend, and any movement below 40 represents an unusually low price level. 
 
As it turns out, the MFI dropped below 40 three times after the uptrend began. The three circles on the MFI line mark possible entry signals. The green lines mark potential profit taking signals. 
 
Not all trades using this method are winners. Performance on any technical indicator varies, but if you are a looking for a reliable indicator, the MFI is a good place to start.  The MFI uses the same base calculation as the Relative Strength Index (RSI). The RSI is considered by many professionals to be among the best technical indicators for determining a reliably low price within a given time period. It measures the speed and change of price movements by comparing the recent day’s price action against the average gain and average loss over a specified number of days. 
 
The MFI goes one step further and incorporates trade volume data, thus making it one of the few indicators to use both price and volume in its calculation. This gives the indicator a robustness not observed in many other technical indicators.
 
-- By Gordon Scott, CMT, Learning Markets Analyst
 
Posted by learningmarkets on Jan 8, 2013 3:24 PM CST
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Most Recent Comments

There are many things Elite does not have that other platforms do have. There is a thread in this forum named "Elite Wi...
by Rhode on How to Profit from Fluctuation
What does a a bullish divergence look like. This study does not seem to be on elite?
by leewan on How to Profit from Fluctuation
That's a great suggestion. We'll host a Strategy Session on this strategy so we can do a deep dive and show you how to fi...
by learningmarkets on Trading on the Edge
I agree. There is always going to be a failure rate, but if we can put the odds a little further in our favor by waiting fo...
by learningmarkets on When Markets Weaken
Nicely put. One of the best observations you state is the Trend Line being approx. 4 times longer than the Divergence...
by Rhode on When Markets Weaken



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