Monday, October 29, 2012

Part 2 "Back Testing Theory"

MetaStock SPRS Series - Week 92 - TechniTrader® Stock Discussion for MetaStock Users - Part 2 "Back Testing Theory" - October 29, 2012
By: Martha Stokes C.M.T.


Last week we discussed the flaws and risk of a data set that has encountered a significant shift or change for Back Testing theories. Another good example of a major change of market structure that skews the data set and thereby giving false readings on Back Testing is the elimination of the “Uptick Rule.”

In 2005 after intense lobbying by special interest market participant groups, the SEC agreed to run a pilot test program on a few big blue chip stocks to see whether the Uptick Rule for selling short should be eliminated.

The Uptick Rule had been in place for decades and had been part of the reform of the stock market after the catastrophic collapse of 1929. The Uptick Rule for those of you who are new, required that the price of a stock “tick up” before any sell short order could be executed. The theory behind the Uptick Rule was that this prevented massive sell-offs that plummeted the price of a stock in seconds, as occurred in the 1929 stock market crash.

The argument from some market participant groups who actively traded short term, was that the Uptick Rule was an outdated rule that was no longer needed due to the huge volume and liquidity that the new market participant groups provided.

The test was run for 6 months and at the end of that time the SEC did eliminate the Uptick Rule for selling short. But alas, there were problems in the test study.

First of all the group of stocks chosen were big blue chip stocks, and not any small caps. Blue chip stocks are held for charter by many mutual funds and pension funds, and are held in trust by hedge funds, other funds for ETFs, and other derivatives. So the bulk of the institutional holdings for blue chip stocks are long term holds. Smaller lot investors also tend to hold these stocks for the long term. So the actual amount of short term trading, including selling short is significantly less percentage wise than a small cap stock.

The conclusion that the Uptick Rule was no longer necessary due to the high liquidity of the markets was a flawed due to the lack of inclusion of smaller cap stocks.

In addition, the market conditions at the time of the testing period were not speculative. The market was in a platform market condition with most stocks moving sideways in tighter action. This too affected the conclusions of the test.

Since the elimination of the Uptick Rule massive sell-offs have occurred. The most notable was the May Flash Crash of 2010 when a HFT algorithm went haywire. And again in 2012 with the Knight Corporation trading disaster of bad trade executions, that nearly bankrupted Knight in a few minutes.

Although curbs and other regulating computer generated monitoring are in place, the fact remains that the Uptick Rule elimination has caused the sell side of the market to experience steeper and faster price action.

This one change has had a ripple effect across the stock market. You can see it in the charts, and you may experience it in your trading.

The SEC always uses “Forward Testing” and is currently testing a new sub-penny order processing created by the NYSE for retail traders. But unless the data set is complete and relevant to current conditions, it can be a flawed test.

“Back Testing” is far more flawed in concept and scope than “Forward Testing” because it includes data that is no longer relevant due to massive changes in market structure. Be careful when you use Back Testing, to only include relevant data in your data set.

Trade wisely,

Martha Stokes, C.M.T.
Member of Market Technicians Association
Master Rated Technical Analyst: Decisions Unlimited, Inc.
Instructor and Developer of TechniTrader® Stock Market Courses
http://technitrader.com
MetaStock Partner

©2012 Decisions Unlimited, Inc.

Disclaimer: All statements, whether expressed verbally or in writing are the opinions of TechniTrader, its instructors and or employees, and are not to be construed as anything more than an opinion. Student/subscribers are responsible for making their own choices and decisions regarding all purchases or sales of stocks or issues. At no time is any stock or issue on any list written or sent to a student/subscriber by TechniTrader and its employees to be construed as a recommendation to buy or sell any stock or issue. TechniTrader is not a broker or an investment advisor it is strictly an educational service.

Monday, October 22, 2012

Back Testing 52 Week High Theory

MetaStock SPRS Series - Week 91 - TechniTrader® Stock Discussion for MetaStock Users - Back Testing 52 Week High Theory - October 22, 2012
By: Martha Stokes C.M.T.


I was a speaker at the Las Vegas MetaStock Users Conference on October 13th. During my training session a couple of important questions were asked by the attendees that I did not have time to answer to my satisfaction.

I am going to answer those questions here in this forum so that everyone can read the answers.

Question posed: There is a study out that used “Back Testing” to derive a theory about where the institutions are buying the heaviest. The theory was that since 52 week highs had higher volume, that this must be where institutions buy into stocks.

My answer to that question was no, not in the current market conditions with the current market structure. The person asking was bewildered as he believes that back testing is irrefutable evidence. But there is an obvious flaw in the theory most traders are unaware of, due to a lack of understanding that has occurred regarding the market structure in recent years.

What is immediately apparent to me as a cycle theorist, is a critical error in the original back testing data set.

An absolute rule in science and cycles is that in order for an accurate test of any theory, the data and conditions must be relatively consistent and the same throughout the entire set of data. If conditions alter during the data set used, then the testing method and theories will be skewed and inaccurate.

Let’s examine the Back Testing Method first to determine if indeed the back testing supplied an accurate set of data on which to make this assumptive theory. The question I am posing then is this, “Did the conditions of the stock market, the market participant groups, the number and type of groups, and how they bought and sold stocks remain constant for 40-50 years back in time from today?” A major change during the period of time, will cause the data to be skewed and the back test results inaccurate.

If we go back in time 50 years from the year 2012, we are starting the test data around 1962. In that decade, the Dow Theory of 3 market participants was still intact. The informed investors which are the investment banks, wealthy individuals, and corporations controlled about 50% of all the market activity. Mutual Funds were just beginning to be popular again, after the huge Mutual Fund debunking in the 1920’s when Mutual Funds were first invented and sold heavily.

In the 1970’s the markets were stalled in a wide range bound pattern going nowhere. Mutual Fund investing slowed, but the market participant groups remained intact as Charles Dow’s theory had stated.

There were no pension funds allowed in the market in the 1960’s and 70’s.

That means that 50% of all the activity in the market was the small lot investor and odd lot investor. Remember there were no day traders, no retail traders, no small funds, no HFTs, no institutional traders as there are today. Investing was mostly long term. The Dow Theory clearly defined that the informed investors which are the banks, corporations and wealthy individuals started the bull market, and the buying by the average and odd lot investors was toward the end of the bull market.

By the early 1980’s Pension Funds had finally won their battle with Congress and pension funds entered the stock market. This created the bull market of the 80’s and it changed the matrix of the market participant cycle. However these were all still long term investments with very limited and constrained short term trading for all fiduciary funds. That means all during the first 2 decades of the back testing for the theory was primarily long term investing either by a fund or by a small investor.

The ratio of 50% informed and 50% uninformed held into the 80’s, so for the first 2 ½ -3 decades the data set is reasonably accurate for back testing up to that time, but then in the late 80’s changes commenced.

In the late 80’s and early 90’s floor traders took PC computers and started trading against their market maker employers. They became the institutional and professional traders market participant group we know today. Their short term trading activity did not alter the balance much, perhaps 2-5% at most.

In 1990 there were still no online brokers, or short term retail trading. It was all professional floor traders who had access to the exchanges and understood how the intraday action worked. At this time the speculative activity of the markets increased to some extent. Small lot investors began to lose market share. Their activity dropped from 55% of the daily market activity to 45%. The shift of balance between the “informed” and “uninformed” had started. What once had been an evenly balanced market was now more professional activity than average investor activity. Volumes started to increase in 1994 as PC computers and online brokers became popular.

But it wasn’t until 1998, a pivotal year for the stock market structural changes, that the balance between the average investor and the professional aka “informed” side of the market shifted dramatically. In the Roth IRA Bill was a little known rider that eliminated the “Rule of 3” that had been in place since the pension funds had been allowed into the market. With the elimination of the “Rule of 3” and the deregulation of the banks merging commercial and investment banking, the entire market structure changed almost overnight.

Now the balance between the professional side and the average investor/retail trader shifted even more, with 70% of the market activity now professional and 30% average investor/retail trader. The high volumes of shares traded on stock charts that can be seen during the 1998-2000 are dramatic. In addition there are now 8 levels of Market Participants, far more than the three Dow identified.

By 2005 High Frequency Trading had begun adding the final 9th Market Participant. This encouraged more Dark Pool activity which is an off the exchange transaction by giant funds, the largest funds in the market. Dark Pool activity does not go through the exchanges but is done “Over the Counter.” These are the largest orders used by any market participant and this is another major change to the market conditions and structure. In doing so, the professional side of the market dominance increased to 80% while the average investor and retail trader activity dropped to 20%.

The initial analysis of the data set, therefore provides clear evidence that the data set included in the back testing theory of 52 week highs as a buy entry point for institutions is flawed. Conditions, market structure, and market participants change significantly during the data set period, which has skewed the statistics for this theory. The data set used is not reliable due to the major changes in the market structure from 1998-2012. These changes were not small or insignificant, these changes altered the entire market structure including, how orders were processed, and the volume activity on which the “Back Testing 52 Week High Theory” was based.

Trade wisely,

Martha Stokes, C.M.T.
Member of Market Technicians Association
Master Rated Technical Analyst: Decisions Unlimited, Inc.
Instructor and Developer of TechniTrader® Stock Market Courses
http://technitrader.com
MetaStock Partner

©2012 Decisions Unlimited, Inc.

Disclaimer: All statements, whether expressed verbally or in writing are the opinions of TechniTrader, its instructors and or employees, and are not to be construed as anything more than an opinion. Student/subscribers are responsible for making their own choices and decisions regarding all purchases or sales of stocks or issues. At no time is any stock or issue on any list written or sent to a student/subscriber by TechniTrader and its employees to be construed as a recommendation to buy or sell any stock or issue. TechniTrader is not a broker or an investment advisor it is strictly an educational service.

Monday, October 15, 2012

Volume and Accumulation/Distribution

MetaStock SPRS Series - Week 90 - TechniTrader® Stock Discussion for MetaStock Users - Volume and Accumulation/Distribution - October 15, 2012
By: Martha Stokes C.M.T.


All too often retail traders are either chasing stocks that are already running, or having a knee jerk reaction to news, events, or sudden price shifts.

To be consistently successful a retail trader needs to learn to anticipate price action BEFORE price actually moves. That means setting aside the notion that price indicators are the most important indicators to use.

In today’s automated market with Dark Pools, High Frequency Traders and other automated orders triggered by computers rather than humans, patterns form that volume and accumulation/distribution indicators expose that are not visible in pure price and time indicators.

The stock chart below is a good example. DIS has been in a moderate uptrend, very sustainable for many months. This actually was a wonderful position hold stock rather than a swing trade due to how price behaved.



Chart 1

Price looks like it could continue up indefinitely and price indicators are still confirming upside action. However, there are subtle signals in volume and accumulation/distribution indicators that warn before price starts to weaken, that the upside is moving on smaller lot activity versus giant fund accumulation. Whenever this occurs entering the stock is higher risk, because the smaller lots have limited buying power and their buying is often at highs and speculative in nature. That triggers HFTs and profit taking which can result in a steep retracement or correction. The weakness in volume based indicators are rounding tops, lower highs, and weakening volume patterns.

The short term trend has weakened and is moving sideways, as volume entering the stock is now predominantly smaller lots. Large lot activity subsided a while ago and TTQA is exposing smaller funds buying.

Understanding who is in control of price will help you choose better entries and avoid high risk trades. This stock is shifting sideways due to a weakening of volume and accumulation/distribution patterns. Quiet accumulation ceased some time ago.

The risk now is from profit taking by larger lots who entered at the bottom. As smaller funds rush to buy due to sell side market participant recommendations, the dark pools may decide to take some profits.

Being able to anticipate weeks ahead of price shifts helps reduce whipsaw trades, weaker entries, and lower profits.

Trade wisely,

Martha Stokes, C.M.T.
Member of Market Technicians Association
Master Rated Technical Analyst: Decisions Unlimited, Inc.
Instructor and Developer of TechniTrader® Stock Market Courses
http://technitrader.com
MetaStock Partner

©2012 Decisions Unlimited, Inc.

Disclaimer: All statements, whether expressed verbally or in writing are the opinions of TechniTrader, its instructors and or employees, and are not to be construed as anything more than an opinion. Student/subscribers are responsible for making their own choices and decisions regarding all purchases or sales of stocks or issues. At no time is any stock or issue on any list written or sent to a student/subscriber by TechniTrader and its employees to be construed as a recommendation to buy or sell any stock or issue. TechniTrader is not a broker or an investment advisor it is strictly an educational service.

Monday, October 8, 2012

Trade Management Part 1: Stop Losses

MetaStock SPRS Series - Week 89 - TechniTrader® Stock Discussion for MetaStock Users - Trade Management Part 1: Stop Losses - October 8, 2012
By: Martha Stokes C.M.T.


Any time I hear a trader say they don’t use stop losses because they “don’t work” I know immediately that the trader is using one of the old-fashioned, outdated stop loss strategies.

As a trader you need to remember that the stock market and all the other financial markets are continually evolving, changing as they adapt to new technology.

In the past decade there has been unprecedented technology changes to the internal structure of the stock market. That has caused changes to the Market Participant Groups, and its cycle has changed due to the new groups that have emerged that were not present a decade ago.

So you really need to consider if the information you are getting from the internet, websites, gurus, news media, technical analysis books, periodicals, etc is CURRENT or outdated.

One of the most common problems retail traders face is that they are unwittingly using outdated theories, strategies, and trading systems. If you are having troubles with stop losses then you are either using an outdated strategy OR you are not setting the stop loss properly for your trading style, the trading strategy you are using, and the chart patterns for that stock.

In the “old days” when retail trading first began and online brokers first emerged on the internet providing online trading services to mostly day traders, a percentage stop loss was promoted.

This came from the even more archaic stop loss approach used in the 20th century for longer term investments.

In those days, there were no PC computers so there were no charting programs like we have today. The stock market was a fundamental market, so a percentage stop loss for the average investors made sense. Since no average investor had even heard about technical analysis, a percentage stop loss was the easiest way to protect the investor from a catastrophic loss.

Nowadays, a percentage stop loss merely invites whipsaw action due to those who use that common and popular stop loss strategy to trade against you.

The most popular stop loss percentages were either 8 or 10%. Since only a scarce few professionals were using technical analysis, these stop losses worked reasonably well during the 20th century but for most retail traders nowadays percentages pose huge risk. In fact the percentage stop loss increases risk because there are Algorithms searching for such cluster orders.

Cluster orders are orders that ‘cluster’ around a certain price point unnaturally. These are prime targets for automated orders based on algorithms designed to find these clusters and trade against them.

Let’s use IBM a company that is ever popular and with which most every trader is familiar.

Where should you place your stop loss?

Archaic convention says 8-10%. So let’s use the 10% to be “on the safe side” or more conservative.

That would put you at about 185-186 right smack in the middle of the sideways action. If the stock retests the short term low, then your stop would be taken out as so often occurs.


Chart 1

For longer holds you need to be under strong support, not above weak support where the 10% stop loss places you. You are smack in the way at 10% and yes your stop would be taken out on a sudden collapse of this stock.

For a long term hold the support level is actually way below where the first round of quiet distribution occurred, way down around $150.

Percentage stop losses are an outdated antiquated strategy. If you are still using this old-style stop loss you need to update your methodology. Use a current stop loss technique that works with the modern automated marketplace, the more diverse groups of market participants, and the technical as well as fundamental aspects of trading.

If you are a technical trader and you are using percentage stop losses, you are using a fundamental method for stop losses. The two do not go together.

If you don’t use stop losses at all OR worse “have it in your head,” then you are gambling.

At some point, you will take a catastrophic loss.

Stop losses are part of trade management, risk management, and common sense trading.

Trade wisely,

Martha Stokes, C.M.T.
Member of Market Technicians Association
Master Rated Technical Analyst: Decisions Unlimited, Inc.
Instructor and Developer of TechniTrader® Stock Market Courses
http://technitrader.com
MetaStock Partner

©2012 Decisions Unlimited, Inc.

Disclaimer: All statements, whether expressed verbally or in writing are the opinions of TechniTrader, its instructors and or employees, and are not to be construed as anything more than an opinion. Student/subscribers are responsible for making their own choices and decisions regarding all purchases or sales of stocks or issues. At no time is any stock or issue on any list written or sent to a student/subscriber by TechniTrader and its employees to be construed as a recommendation to buy or sell any stock or issue. TechniTrader is not a broker or an investment advisor it is strictly an educational service.

Monday, October 1, 2012

The Changing Price Patterns in Technical Analysis

MetaStock SPRS Series - Week 88 - TechniTrader® Stock Discussion for MetaStock Users - The Changing Price Patterns in Technical Analysis - October 1, 2012
By: Martha Stokes C.M.T.


One aspect of changes to the Market Structure that many retail traders do not realize is that internal operations, procedures, market participant groups, order processing systems, changes to order execution, SEC rules and regulations on trading, etc. change due to new technologies. The financial markets have been adopting new technologies over the past several years, AND there have been numerous changes to rules and regulations by the SEC and Congress. These changes affect the price patterns you will see on a chart.

Often times, retail traders are stuck back in the 1970’s - 80’s with outdated technical analysis patterns that either have changed dramatically due to all the changes in market structure, OR do not form often anymore.

As the markets change and adapt so too do the millions of people who buy and sell stocks. One area that has changed dramatically in recent years is how, when, and where bottoms develop, complete, and their patterns.

It used to be that you could count on the basic bottoming patterns from the early technical analysis books written 20-40 years ago.

  1. Inverse Head and Shoulder bottom
  2. Bowl bottom
  3. Triple bottom
  4. Double bottom
  5. V bottom
That basically was all the bottoms that formed. But in recent years new forms of bottoming patterns are emerging along with the traditional bottoms. As a retail trader, it is critical to also be able to recognize these both to avoid selling short in a bottom AND to be able to reap the potential profits of the fast runs out of certain types of bottoms.

The chart following is just one example of a new kind of bottom formation. It is actually a platform, which is a very precise sideways pattern with consistent highs and consistent lows. Price falls rapidly to a low, then the sideways action commences with highs and lows that stay within a precise and narrow range. This differs from a bowl shape as the bottom is not round. Nor is it a double or triple bottom, which are wider ranges in price and have inconsistent highs and lows. This precision style bottom is actually more of a U shape, a variation of the V with the same velocity and momentum action on the down side and upside. This one happens to also have gaps which are far more common these days than in years past.


Chart 1

All of these changes have occurred due to the different market participant groups, how they buy stocks in bottoms, and which market participants actually create this kind of bottom.

With the advent of Dark Pools, the off-the-exchange and over the counter large lot order processing trading platforms, this type of bottom is becoming more common. It is easy to miss during its development and many times swing style sell short traders may assume the stock is going to head down further, when they should actually be trying to enter prior to the move up.

Recognizing the new technical patterns that are forming in the modern automated marketplace is a critical aspect of keeping current with what is going on in the stock market. Technical analysis and technical patterns will continue to change as the market structures change.

Trade wisely,

Martha Stokes, C.M.T.
Member of Market Technicians Association
Master Rated Technical Analyst: Decisions Unlimited, Inc.
Instructor and Developer of TechniTrader® Stock Market Courses
http://technitrader.com
MetaStock Partner

©2012 Decisions Unlimited, Inc.

Disclaimer: All statements, whether expressed verbally or in writing are the opinions of TechniTrader, its instructors and or employees, and are not to be construed as anything more than an opinion. Student/subscribers are responsible for making their own choices and decisions regarding all purchases or sales of stocks or issues. At no time is any stock or issue on any list written or sent to a student/subscriber by TechniTrader and its employees to be construed as a recommendation to buy or sell any stock or issue. TechniTrader is not a broker or an investment advisor it is strictly an educational service.