Pit Bull

by Martin Schwartz

  P. Q. Wall Forecast, Inc. (New Orleans, LA); 1-900-SUN-LIGHT ($2 per minute) for updates at 10:10, 12:30, 3:00, 5:00, intraday; call 1-800-259-0088 for monthly newsletter with interim bulletins and/or daily telephone update. For day traders as well as longer-term investors. Uses a variety of both short- and long-term techniques, including cycles, projections, and ranges on the Dow. Trades only on the Dow.

  Stan Weinstein’s Global Trend Alert—Detecting Opportunities for the Institutional Investor; 1-800-868-STKS; monthly. He does an overview of the market, as well as a stage analysis of the S&P 500 and secondary stocks, most vulnerable S&P 500/secondary stocks, group stage rating scan, most promising groups, global analysis, stage analysis of foreign fund/foreign ADRs. A stage analysis attempts to determine which stage a stock is in: basing, uptrend, top formation, downtrend—and splits each of these four stages into three substages.

  The Chartist (Seal Beach, CA); editor: Dan Sullivan; published every three weeks. Has an actual cash account, current market comments, and a trader’s portfolio.

  Crawford Perspective. Telephone update on Monday, Wednesday, and Friday and special updates on the other days if there is a move of one hundred points on the Dow. Newsletter published monthly focuses on gold, S&P 500, and bond futures.

  Dick Davis Digest—Investment Ideas from the Best Minds on Wall Street (Fort Lauderdale, FL); biweekly; 954-467-8500. Publishes comments from leading thinkers in the investment community about individual stocks, mutual funds, and market direction.

  Daily faxes:

  Schaffer on Sentiment; Investment Research Institute; 1-800-448-2080; http://www.options-iri.com

  Cowen Morning Call

  Bear Stearns Morning Comments

  Mark Cook; 8333 Maplehurst Avenue, East Sparta, OH 44626; 330-484-0331

  Dick West’s Morning Comment

  Red Light, Green Light: Allowing the Trend to Be Your Friend

  The ten-day exponential moving average (EMA) is my favorite indicator to determine the major trend. I first learned about this valuable tool from Terry Laundry (see www.amshar.com). I prefer the EMA over a straight ten-day moving average, or any other arithmetic average, because it emphasizes the most recent events, giving me a faster signal of when to buy or sell. With a straight ten-day moving average, each day is weighted equally, at 0.10. You start by taking the most recent ten days’ data, adding them up, and dividing by 10. Then on the eleventh day, add that day’s data, subtract the first day’s data, add them up, and divide by ten. Day after day, repeat the same process.

  The exponential moving average (EMA) that I use weights the most recent data point at 0.18, and the previous day’s EMA 0.82. So it is much more sensitive to the last data point, crucial for a short-term trader. I call this “red light, green light” because it is imperative in trading to remain on the correct side of the moving average to give yourself the best probability of success.

  On the floor of my office are two huge charts, four feet wide by ten feet long and growing. The first is a record of the Dow at hourly intervals. I keep another chart of the New York Composite on a closing basis and the ten-day EMA, with the MTO (Magic T Oscillator) charted below it (see Exhibit II). The ten-day EMA bounces along the page in dotted black. Whenever the New York Composite is above the ten-day exponential moving average, I draw it in as a solid green line. When it dips below, the line turns solid red. When you’re trading above the ten-day, you have the green light; the market is in a positive mode and you should be thinking buy. Conversely, trading below the average is a red light. The market is in a negative mode and you should be thinking sell. That doesn’t mean you should never buy when you have a red light, but if you do, it is critical that you have an extremely good intellectual reason for taking that position.

  The hardest point to make a trade is when the price of the issue is hovering at the value of the moving average. This is the point that offers the maximum profit potential, but also has the greatest risk. Even though you can experience whipsaws, the profit potential in a trend move can be enormous. For instance, the market could be trading for several days below the EMA and then start heading back up, getting closer to the EMA. If it is able to close over it, this is often the beginning of a trend change and you are one of the first people to ride the young, new, and powerful positive trend. But often, the EMA is a repellent and the price action will turn back down once it has kissed the EMA from below. It is the spot where things are hanging in the balance.

  I use this approach when trading futures and stocks. Every day after the close I write down that day’s ten-day EMAs for the S&P 500, New York Composite, OEX, XMI, bond, Eurodollar, and S&P futures. I get these numbers off my FutureSource machine, which calculates and graphs the EMA for me.

  So my moving averages are the key to being on the right side of the trade: going long when the market is in positive mode. The next step is picking an entry point and risk amount. What I am usually looking for is a turn, an inflection point—and it is at this point where your moneymaking opportunity is greatest, because you’re one of the first traders to identify the change in trend. I use channel lines and oscillators to help me pick levels and identify these situations. FutureSource does the calculations, and I have set up the parameters. I look at 120-, 60-, and 30-minute time frames. Pictorially, you have the price bars with one channel line above and one below; the bands are 1 percent above and below the ten-period moving average. I liken it to a rubber band being stretched too far—it eventually has to snap back. For example, if I’m in positive mode, and the price gets close to the lower band, I am looking to buy. This is not an exact science, but the channels provide good entry levels.

  Exhibit II

  The ten-day exponential moving average gives the latest event a 0.18 weighting compared to a 0.10 weighting for an arithmetic average. The way to start this moving average is to add up the last ten price closes, which will produce what would normally be thought of as an arithmetic moving average. Then weight this total with a multiplier of 0.82. Then take the eleventh result and give it a weighting of 0.18 and add the two together. You have now started a ten-unit exponential moving average. To move forward, take your new calculated exponential moving average and again weight it at 0.82 and take the twelfth result and weight it at 0.18 and sum the two. For example:

  Date

  New York Exchange Composite Close

  9/2/97

  482.90

  9/3/97

  483.71

  9/4/97

  485.11

  9/5/97

  484.64

  9/8/97

  485.78

  9/9/97

  486.69

  9/10/97

  480.63

  9/11/97

  477.06

  9/12/97

  483.30

  9/15/97

  482.60

  9/16/97

  493.69

  9/17/97

  493.21

  9/18/97

  495.41

  9/19/97

  496.56

  Step 1: Calculate the ten-day moving average. Sum 9/2/97-9/15/97 and divide by 10.

  4832.42 / 10 = 483.242

  Step 2: Multiply this value by 0.82.

  483.242 × 0.82 = 396.25844

  Step 3: Take the eleventh day’s (9/16/97) result and give it a weighting of 0.18.

  493.69 × 0.18 = 88.8642

  Step 4: Add the values from steps 2 and 3 together.

  396.25844 + 88.8642 = 485.12264, rounded to 485.12

  This is the ten-day exponential average for 9/16/97.

  To get the ten-day EMA for 9/17/97:

  Step 5: multiply the previous day’s EMA by 0.82.

  485.12 × 0.82 = 397.7984

  Step 6: Take the newest value (9/17/97) and multiply that by 0.18.

  493.21 × 0.18 = 88.7778

  Step 7: Add the values from steps 5 and 6 together.

  397.7984 + 88.7778 = 486.5762, rounded to 486.58.

  This is the ten-day EMA for
9/17/97.

  This process is repeated after each day, so the ten-day EMA for 9/18/97 =

  (486.58 × 0.82) + (495.41 × 0.18) = 488.17

  It will take about ten days of calculations to smooth the results to the ongoing existing true ten-day exponential moving average. In order to make it more useful, I would recommend going back at least twenty days when the data are available to get the proper smoothing. This will produce a more reliable tool to utilize immediately in your trading.

  How I Play Stocks

  I’ve developed a routine over the years. I’m a get-your-hands-dirty type of guy in my approach to preparation; I absolutely have to see and feel the numbers—charting the price action of seventy stocks daily and keeping large graphs of my daily indicators updated by hand, after calculating several mathematical ratios. The trade-off is time.

  Each weekend, I get two chartbooks sent to my house by express mail. The first is Standard and Poor’s Trendline Daily Action Stock Charts (212-208-8000). S&P Trendline has the daily charts for more than 700 companies, each going back 1½ years. I draw in trend lines and support areas for over 150 of those companies that catch my eye. I do this to get a feel for what industries and companies are doing well. On the front cover of the chartbook I make notes like “oils strong,” “large cap techs weak.” While many traders have computers that run industry analysis, I have to do it by hand to really feel changes in institutional money flow. I also make a one-page compilation of the companies that I drew trend lines for, listing the support area beside its ticker symbol.

  Then I go through my second chartbook, which is custom-made for me and provided by Security Market Research (SMR; 303-494-8035). The chartbook has the daily price action and proprietary oscillators for seventy large-cap companies that I watch, plus indexes like Dow Jones Industrial Average (DJIA), Dow Jones Transportation Average (DJIT), S&P 500 (SPX), New York Composite (NYA), and NASDAQ Composite. Every three months, I change a few names that appear more interesting, but the list contains an excellent representation of all the major industries—mainly large-capitalization household names with high liquidity like Compaq, Coca-Cola, Merck, and Chase Manhattan.

  On each page, I draw several support and resistance lines for that company and look at the oscillators at the bottom. The support lines connect important lows, and will indicate a price level where a fall in a stock’s price could slow down and/or reverse. Resistance lines connect important highs and indicate areas where the price is likely to fall back down. Because I am a short-term trader, I use the highs and lows from the previous week or two to draw in aggressive trend lines as well. I circle the major nearby area of support on the price axis and write that level on a one-page sheet alongside its ticker symbol and the direction of the short-term oscillator. I fax this sheet to my assistant, who then enters the support levels on her computer. When these levels are touched during the trading day I make a decision if I want to take the trade. This preparation allows me to react quickly when prices are moving fast.

  I play the OEX and SPX options when I want to play a little longer-term strategy. Longer term for me might be a few days to a week. The options are less liquid and slower moving than the futures. I will buy way out of the money puts with an expiration three months into the future (for example, December 900 SPX puts when the SPX is currently trading at 910). Often I turn to options when I am frustrated with the stress and volatility of the futures. If I have a longer-term idea, buying the options allows me to sit with it and let things play out a little longer. When I go long puts or calls at least I have a defined risk (the cost of the options) whereas in futures the risks can be more extreme due to the high leverage. Sometimes I like to trade the bond futures when I have a strong technical setup.

  In terms of buying and selling stocks: above all else, I’m a trader, not an investor. My SMR chartbook of seventy large-cap names reflect the companies I focus on. I need the liquidity and volatility that these names provide. Because my scope is so short term, I’m in and out for a point or two on a 10,000 to 20,000 share position. If an idea isn’t panning out in a day or two, I jump ship. Because I play large, I don’t want the risk of riding a stock down $3, and because I am playing the larger, more volatile names, $3 is oftentimes less than the daily range. I also don’t pick the weak and downtrodden. I look for temporary weakness in strong stocks to buy, which is the same idea as the rubber band having to snap back and why drawing all my trend lines and writing the support levels out are so important. My assistant sets alarms on the computer with the support list I give her; if the price dips into the support area, she notifies me and I look to buy if I have a green light and like the looks of the chart. If a company is trading below a major trend line, I stay away. With the strength of the market over the past several years, I use the futures to go short, rather than shorting individual stocks.

  How I Play Futures

  Since they were first introduced, the S&P futures have been my meat and potatoes. I trade them day in and day out. To monitor the futures action, I go through two sets of charts printed out from my FutureSource machines. I get all my futures data from FutureSource (1-800-678-6333). I have four monitors stacked up two on top of the other and have twenty “pages” that are preprogrammed to display the charts that I like to look at. My assistant prints out the pages each weekend featuring different studies over different time periods (2-, 30-, 60-, and 120-minute, daily, weekly, and monthly) for different futures contracts (S&P 500, Eurodollar, currencies, bond, U.S. dollar index, CRB index, and crude oil). I draw trend lines on these to help refine my sense of how the individual futures markets are doing. Also by checking the exponential moving averages I try to determine whether the different futures markets are in a positive or negative mode. The old axiom about the trend being your friend is best acted upon by owning futures above the exponential moving average and shorting those below.

  Exhibit III

  The second set of charts contains the weekly chart for each of the futures markets that I look at. This allows me to take a step back and view the longer-term trends.

  After reviewing all of these futures charts, I take a five-by-eight index card and record various channel lines, bands that are 1 percent above and below the ten-period moving average, for S&P futures and bond futures (see Exhibit III). Based on these levels I record average buy and sell levels for the next trading day. All of these “pregame” notes allow me to respond with courage during the heat of the battle the next day. It is this preparation that makes me strong when my emotions are telling me to panic.

  How I Handle Program Trading

  Program trading is the scourge of the common trader. I call it “Nintendo Vegas,” because it now produces in any given week 15 to 20 percent of the daily trading volume on the New York Stock Exchange. After the dramatic fall in the market averages in October 1987 there was a groundswell to do away with program trading because of its mindless effect on a vulnerable stock market. Eventually, point collars were introduced to limit the destruction that can be done on any given day. The large wire houses (brokerage firms) that participated that October day in 1987 vowed not to participate in these heinous activities again. But as time has passed and greed has returned to the arena, most of the players have crept back into the casino. Fifteen to 20 percent of the Big Board’s daily volume is big business, and money and power always prevail on Wall Street.

  Still, there are ways to survive and prosper even in the face of all this might. You must know the trend of the market and wait and wait for these technocrats to drive the market averages deep into your channel lines. In addition to using Mark Cook’s extremes with TIKI and TICK, you counterattack by taking a contrary position to the mechanically driven direction of the market, hoping you are at an artificial extreme that will lead to a profitable trade. Like any good warrior, you lie in wait until these people conduct their mindless malevolence and you counterattack with a contrary position, always using a well-disciplined stop loss.

  This is the wa
y I’ve been able to adapt. While I dislike having to use these guerrilla trading tactics, the great challenge is to continually adjust my skills to ever-changing market conditions. I have done this successfully by adding new tools to my methodology and continuing the stern discipline of stop losses, channel lines, and moving averages.

  Tricks of the Trade

  When I was in the first grade, the teacher asked each of us what we wanted to be when we grew up. I said, “a detective.” This investigative nature has carried through into adulthood. I love searching for clues, synthesizing tons of unrelated data, and arriving at a logical conclusion. While these observations are not entirely scientific, they are things that I’ve seen repeatedly over the years. I do not usually use these observations independent of my other tools and analysis, but I definitely factor them into my decision-making process when they occur.

  Technical indicators that show me low-risk entry points for high probability trades are at the core of my methodology. But I am always intensely searching for patterns, setups, recurring themes, no matter how small, to help further swing the odds in my favor on a given trade.

  Gaps in Charts

  These are important tools that I use to trade stocks in particular and futures, too, when they happen. Gaps are instances when an issue opens significantly higher or lower than the previous day’s price and maintains that level throughout the day (see Exhibit IV). This usually happens on a news announcement or an event that catches investors off guard. On a price chart this shows up as a gap. If the gap is not filled in two or three days, it’s a strong signal to take a position in the direction of the gap. The change in perception can sometimes last for a long time and be a very good source of trading ideas.