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DOW THEORY


Trends And The 4% Solution

02/12/02 03:34:25 PM PST
by David Penn

Can you improve your odds of buying bottoms and selling tops? Use both trend-following and momentum-shift approaches to learn when to hold 'em and when to fold 'em.

From a technical perspective, there are two general schools of thought when it comes to buying and selling stock. The first is that a position should be entered only when the stock has begun a trend (that is, a series of higher highs and higher lows — an uptrend — or a series of lower highs and lower lows — a downtrend). This, the trend-following school, believes that the easiest way to take profits from the marketplace is to wait for a reliable trend to begin, and to ride that trend until clear and convincing evidence develops that it has ended.

Trend traders readily admit that they rarely, if ever, buy at the bottom or sell at the top. In some ways, trend-following is a conservative, albeit profitable, trading technique, because it avoids the risks inherent in attempting to pick bottoms in falling markets (referred to as "catching a falling knife") or tops in rising markets. A trend trader would rarely buy a long position in a stock that has been declining steadily for a period of days, weeks, or months. To the trend trader, the only correct approach to dealing with a stock in a downtrend is to either short it (that is, borrow the stock and sell it, then buy it back at a lower price later and restore it to the lender) or ignore it.

In the same way, a trend-follower would not readily sell a stock that had been climbing for days, weeks, or months. Seeking to maximize profits, a trend-follower would stay long in the stock (a buy and hold) or, under some circumstances, consider adding to current holdings. Only after the stock began to level off or decline would the trend-follower consider "taking something off the table" — selling some of the position to lock in gains.

THE BIG MO

For all the success of the trend-following model — most of the more widely used, successful trading systems are based to one degree or another on such — there is another prominent approach to trading and investing. This technique, which also has long-term success, relies on major shifts in momentum to provide signals to buy or sell a stock or index. Momentum approaches generally aim to catch the beginnings (or endings) of any given stock price move, and are used by traders and investors interested in catching bottoms when prices are falling and tops when prices are rising.

Trading and investing approaches that seek bottoms and tops in this way tend to be more volatile in terms of returns than trend-following approaches; momentum strategies will often signal buying or selling opportunities on momentum shifts that are initially powerful, but ultimately short-lived. In such cases, momentum-shift traders and investors can find themselves zigging when they should be zagging, chasing after a market that always seems to be on the other side. Such a scenario often occurs when prices are trending. For example, a countertrend rally — a short-term uptrend in an intermediate downtrend or a short-term downtrend in an intermediate uptrend — may signal a momentum trader to enter a position, but it will quickly go against him once the countertrend rally is over.

However, the better momentum strategies make up in up periods what they lose in down periods. With effective money management (either built into the strategy or applied to an otherwise effective momentum approach), momentum-based strategies have a tremendous advantage when it comes to catching big market moves early.

The classic example of this is after a selloff. Imagine a stock or index that has been trending downward gradually over a period of time. The trend-follower is likely doing very well riding prices down (if short, many investors may be in cash during such a downtrend), while the momentum trader could be losing out any time a strong countertrend rally occurs. Yet when this stock finally hits bottom and begins to reverse, the momentum investor or trader could get a buy signal and go long. On the other hand, the trend-follower would be waiting for signs that a new uptrend has developed. Because the most sizable moves often come at the beginning of a trend, the momentum-follower might be long for some time before the trend-follower gets a signal to buy.

TRENDS AND MOMENTUM

Before comparing trend-following and momentum-shift following investing and trading, I should emphasize that when I refer to "momentum," I am referring to shifts in momentum. Once momentum shifts, a new trend is likely under way and most momentum followers take profits quickly, employ a trailing stop, or switch to a trend-following methodology to improve their gains.

Let me compare one each of my favorite trend-following and momentum-shift methodologies (the 30-day price channel and the 4% weekly change model) to the same stock. This should show the benefits and drawbacks of each approach individually and leads to the larger, more important, point: a combination of trend-following and momentum-shift approaches will help investors and traders get into profitable stocks sooner, stay in winning trades and investments longer, and get out of losing positions faster when prices begin to shift the wrong way.

The 30-day price channel is one helpful way of determining when prices have entered a trend. The 30-day price channel graphically shows the development of new highs and lows as well as any other indicator; it keeps track of relevant highs and lows as well. These highs and lows are often areas of significant support and resistance, suggesting major moves when penetrated. As the 30-day price channel in the QQQ chart reveals (Figure 1), a pattern of higher highs and higher lows began to give way over summer 2000. Even though the first major new low did not occur until mid- to late October 2000, prices dipped below the lower band of the 30-day price channel near the end of September.

This might have been considered an initial sell (or cash) signal for a trend-follower, and a profitable one at that. The QQQ was at 87 in September 2000 and fell to 60 by the end of November before a significant retracement — about 20% — occurred, a drop of 31% in all. Post-retracement, another downside 30-day price channel breakdown occurred in late December (with another major countertrend rally in January).

Figure 1: The 4% weekly change rule provides an early short signal as the Nasdaq 100 topped out in September 2000.

How might a momentum-shift indicator, one that sought to measure the reaction from the highs during the summer of 2000, have fared over the same period? Using a shift of 4%, plus or minus, in the weekly closing price as our sign of a momentum shift, the first sell signal in the QQQ came on Friday, September 8, about three weeks before the price channel signal. However, because of the volatility of the downturn, the 4% rule would also have suggested a pair of losing, countertrend trades on the long side in late October and early December.

Ironically, the next profitable 4% signal came during the same countertrend rally in January. This coincidence of the 4% rule being profitable at the times when the 30-day price channel approach is up against a sizable retracement suggests the benefits that might come from combining the two strategies: a momentum-shift indicator to provide the signal that a major move may be under way, and a trend-following indicator that helps confirm the direction of the move as well as suggest points of support and resistance as the move continues.

THE 4% SOLUTION

One way of taking advantage of the best of both the 30-day price channel and the 4% weekly change rule is to use the 4% rule as an early alert to a possible market move, and the 30-day price channel as a way of confirming the new trend as well as locating effective areas for placing protective stops. The combination helps mask the deficiencies of each. Trend-followers can take advantage of — or side-step — powerful, countertrend rallies, while momentum-shift followers can better learn when a major market move is for real.

During the major rally in US equities that occurred in the wake of the September 11th terrorist attack, the benefits of a combined 30-day price channel and a 4% weekly change rule became manifest. Using the QQQ as an example again (see Figure 2), we can see that the Nasdaq 100 bottomed on the September 21st open at 27.40. The 4% weekly change rule suggested a long position on October 8, with the QQQs trading at 31.13. By the time the 30-day price channel acknowledged the countertrend rally, the QQQs had already tacked on 21% by the November 8th close (one month after the 4% weekly change rule long signal).

A new 30-day high was recorded on November 19 at 40.50, and still another new 30-day high was recorded weeks later on December 5 at 42.90. Each successive 30-day high could be considered a potential area of support and thus a reasonable place to put a protective stop to lock in gains. Depending on the volatility of the stock or index or the risk tolerance of the trader/investor, a tighter (most recent 30-day high/low) or looser (penultimate 30-day high/low) stop could both be appropriate.

Figure 2: Two weeks after the 4% rule's buy signal, the price channel breakout confirmed the new uptrend.

There is nothing magical in the 4% figure. Marty Zweig and Ned Davis, who respectively popularized and discovered the 4% weekly change rule, have suggested that both 3% and 5% could work equally well, although a lower number would increase the number of signals and a higher number would decrease the number of signals, generally speaking. Historical data going back to 1965 suggests that the more volatile indexes tend to outperform less volatile indexes. Zweig himself reached the same conclusion in his evaluation of the Value Line index from 1965 to 1985. My review of the 4% weekly change rule from 1985 to the present showed an almost 3 to 1 outperformance with the Nasdaq compared to the Standard & Poor's 500.

What may seem magical is merely the result of marrying two effective trading/investing approaches that complement each other well — avoiding late entry, yet having a check against staying in losing situations for too long. If the post-September 11th rally — one that took the QQQ up 45% from September 24 to December 5 — had not made a new 30-day high (penetrating the top band of the price channel), the move might not have been as substantial as it initially appeared with the 4% weekly change call. Such confirmation (or lack thereof) helps provide confidence that the longs will stay up, the shorts (or cash) profitable, or the positions are closed — until the inevitable next opportunity presents itself.

David Penn is a Staff Writer for Stocks & Commodities.

SUGGESTED READING

Pring, Martin J. [1998]. Introduction To Technical Analysis, McGraw-Hill.

Zweig, Martin [1994]. Winning On Wall Street, Warner Books.

MetaStock (Equis International)

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David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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Seattle, WA 98116
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E-mail address: DPenn@traders.com

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