Buying The Lows, Selling The Highs

The fastest and most risk-free way to make money in the markets is to identify a change of trend in a market as early as possible, take your position (long or short), ride the trend, and close your position before or shortly after the trend reverses again. Any market professional will tell you that it is impossible to buy at the lows and sell at the highs . . . consistently; but with practice, it is very possible to catch 60 to 80% of many intermediate-term and long-term market movements.

In spite of well-reasoned arguments in favor of trend following, Sperandeo's observation is lost on few traders. Even those who use trend-following trading methodologies engage in a constant effort to catch their trends earlier and earlier, and "ride them out" until later in the process. While trend followers are exhorted to appreciate the way that trend-following strategies will help them capture the "meat in the middle" of a trend, the temptation to try and eat both the first hors d'oeuvre on the appetizer tray as well as the last piece of cake on the dessert cart remains a constant challenge.

If we take traders like Sperandeo and Paul Tudor Jones at their word, the key is to develop not only a method of identifying trends, as Sperandeo's chapter goes on to discuss, but also a systematic way of determining the difference — for example — between a temporary high in the course of a market advance that will take prices even higher, and a real peak in price action — one that indicates the trend has reversed and lower prices are to come.

ELLIOTT WAVE APPROACHES

One of the great attractions of the Elliott wave methodology is that it lends itself — in a trading and investing context — both to top and bottom picking, as well as trend following. That the former has been emphasized by Elliotticians and non-Elliotticians at the expense of the latter is a reflection not so much of Elliott wave theory as of traders' and investors' desire to perform the perennial coup de grâce of buying cheap and selling dear.

This dilemma is presented when trader Marty Schwartz in his book Pit Bull describes a poignant scene between himself and Elliott wave expert Robert Prechter during a Market Technicians Association meeting back in 1989. Schwartz finds himself trying to convince Prechter that even if his wave counts continue to point toward a major breakdown in the stock market, as long as the market still seems to be going up, why not take advantage of the trend?

According to Schwartz, Prechter never took him up on the suggestion. Robert Prechter himself reflected on his early bearishness in one of his recent books, View From The Top Of The Grand Supercycle, recalling:

The stock market recovery after 1990 was so sluggish that it barely caught up with the return from Treasury bills from the 1987 high through 1994. From 1995 through 1999, though, was entirely another matter, as blue chips and "momentum" stocks, caught in a mania, outpaced every other investment. I was not along for the ride.

And in another essay:

In retrospect, I can see many ways that I could have handled the period better so as to have stayed with the trend longer. On the other hand, everything is easy in retrospect. It's the future that's always such a pesky challenge.

All the same, any criticism of the (over)use of Elliott wave methodology's capacity for picking tops and bottoms in markets should not obscure the fact that, like the zigzag indicator and various swing trading strategies to be mentioned later, Elliott wave can be an effective tool in determining imminent trend changes. Robert Fischer, in his book Fibonacci Applications And Strategies For Traders, spends time discussing how to parse basic trading setups from Elliott wave counts.

Using Fibonacci ratios and tenets of Elliott wave methodology such as "wave 3 must be longer than wave 1" and "in an uptrend, wave 4 should not go lower than the bottom of wave 2," Fischer is able to make projections as to the extent of fifth and final waves in uptrends and downtrends. Elsewhere, he observes that the three-wave corrections in Elliott wave methodology present a number of different trading approaches based on whether an investor is focused on being "invested as much as possible, trying to never miss a trend," or prefers to "wait for safer entry points" offered by corrections of 50% or more.

TESTS OF SUPPORT AND RESISTANCE

One of Sperandeo's favorite methods for spotting tops and bottoms in markets is the 2B test, which I have written about for Traders.com Advantage. Essentially, the 2B test is based upon the notion that buy- and sell-stops are often placed just outside of a market's recent trading extremes. Sperandeo's method presumes that when a market makes a new high or low, follow-through in the direction of the new high or low is necessary to convince the short-term trader or investor that the new higher high or lower low is valid. If there is no follow-through, then Sperandeo believes that more often than not (or, at least, more profitably than not) it is a sign the market cannot handle the new price extreme and is likely to reverse. While acknowledging "it is essential that you admit defeat quickly if the trade moves against you" when it comes to trading on 2B criteria, Sperandeo nevertheless is confident that the 2B setup is a valuable one:

I have never done a rigorous test to determine how often the 2B indicator accurately predicts changes in trend, and I don't need to. Even if it works just one in three times (and I'd lay money that it's more), I would still make money by trading on it, especially in the intermediate-term trend. The reason is that a 2B allows you to catch almost the exact top or bottom, and thus sets up a great risk-reward scenario.

Sperandeo's 2B is similar in many ways to the "Turtle Soup" setup that Laurence Connors discussed in Street Smarts, co-authored with swing trader Linda Bradford Raschke. As Connors describes it, his discovery of the Turtle Soup method of trading tops and bottoms came as a sort of inversion of a popular (and successful) trend-following strategy:

It came about over a matter of time. I attempted (unsuccessfully) to trade breakouts of momentum growth stocks as taught by William O'Neil in Investors Business Daily. I was frustrated, though, at how many times I got stopped out before a big move occurred. And being a short-term, high-percentage trader, I didn't enjoy the drawdowns. Also, I had read the Turtles' methodology and learned that their system was also plagued by false breakouts.

What Connors developed is remarkably similar in spirit to Sperandeo's 2B test. For taking long positions, Connors looks for a 20-day low. The previous 20-day low must have occurred at least four trading days ago. In other words, we have a 20-day low and then, after at least four trading days, we have a lower 20-day low. When the market moves below the low of the previous 20-day low, the Turtle Soup methodology calls for an entry buy-stop five to 10 ticks above the previous 20-day low. A protective stop is called for one tick beneath the entry day low. For taking short positions, simply reverse the process. Connors has even developed a variant on this setup: Turtle Soup Plus One, which calls for an entry buy-stop to be placed on the day following the lower, 20-day low day instead of on the same day.

Figure 1: Turtle Soup Plus One on an intraday, hourly chart. After the lower, 20-bar low on September 11, a long entry is triggered during the subsequent hour when the Standard & Poor's 500 trades above the low of the previous 20-bar low from September 10. The S&P 500 moves from about 1010 to over 1030 some 20 bars later.

After I published an article about the 2B test, Working Money contributor Matt Blackman contacted me and asked if I had ever investigated how indicators, oscillators, and even candlesticks might be used to intensify the signals provided by the 2B test. For example, a 2B test or Turtle Soup setup that was marked by a bearish engulfing candlestick at the top of an advance, or by a hammer at the bottom of an advance, might help reinforce a trader's or investor's decision to take a countertrend position. Blackman's insight has stayed with me since, and this discussion of picking tops and bottoms in trending markets seems like an opportunity for those who are curious to put his concept to work.

USING DIVERGENCES

Another way of spotting tops and bottoms is by using divergences in oscillators. Although I have been attached lately to Linda Bradford Raschke's 3/10 oscillator (also discussed in Street Smarts), I believe that most of the popular oscillators such as MACD (moving average convergence/divergence), RSI (relative strength index), and stochastics are capable of providing the same sort of divergences. I have found these divergences to be especially helpful in marking turning points in trends, including the formation of Elliott wave counts down to the hourly chart level. As John Murphy writes of divergences in his classic book on technical analysis, Technical Analysis Of The Futures Markets:

The third, and possibly the most valuable, way to utilize oscillator analysis is to watch for divergences. A divergence describes a situation when the oscillator line and the price line diverge from one another and start to move in opposite directions. In an uptrend, the most common type of oscillator divergence . . . occurs when prices continue to rise, but the oscillator fails to confirm the price move into new highs. This is often an excellent warning of a possible rally failure and is called a bearish, or negative, divergence.

Often, these "rally failures" represent not just failures but real turning points in the market. When combined, for example, with an Elliott wave methodology that categorizes market swings into greater and lesser degrees, a trader or investor can often anticipate a likely change in trend, as well as the extent to which that reversal will represent a movement in the opposite direction.

Consider the Standard & Poor's 500 on an intraday (hourly) basis in the last few weeks of September 2003. The market was moving up from the lower end of a trading channel that had endured for much of the summer. After rallying through August 20, the market turned and began to decline. Given the choppiness the market had exhibited since early June, a trader or investor could have been forgiven for believing that this was just another "chop" in the market. However, as the hourly S&P 500 drifted down late in August, it managed to form a positive divergence in its oscillator, suggesting both that the market would not continue down any further and that an upswing of some significance was actually likely. From an August 26th close of 967 to the close a week later on September 3, the S&P 500 gained 57 points.

Figure 2: A positive divergence in the oscillator anticipated the rally at the end of August into September. A negative oscillator divergence hinted at the early September market declines.

Consider also the case of the negative divergence early in September. After its late August rally, the S&P 500 began moving more or less sideways in early September. Then, on September 8, the market jumped up to a new high since March. At the same time, however, the 3/10 oscillator failed to confirm the new high and, instead, moved observably lower. This negative divergence suggested that the S&P 500 had made a top on September 8 and that lower prices going forward were likely. Within five trading days, the S&P 500 had fallen from its September 8th high of 1032 to as low as 1008.

FROM TOP TO BOTTOM

In some respects, it is a false dichotomy to segregate technical traders and investors into trend-following and top- and bottom-picking camps. While there are obviously some traders and trading systems built to exploit the market in one of these ways to the exclusion of the other, note that even as Sperandeo wrote about picking tops and bottoms in a market, he did so in the context of being able to "catch 60% to 80% of many intermediate-term and long-term market movements." Swing traders such as Laurence Connors — whose tolerance for drawdowns, like that of many short-term traders, is small — may choose the high-percentage, frequent trading life over the longer pull of riding a trend. But his methods, such as Turtle Soup and Turtle Soup Plus One, are clearly applicable to both approaches to trading the markets.

Similarly, as Murphy observed, there are several different ways to use oscillators — and there are more oscillators out there (and more being developed every other month, or so it seems!) than most traders and investors know what to do with. The essential task is to find not only an indicator or oscillator (or set of indicators or oscillators) that a trader understands and feels comfortable with, but also find an oscillator that helps provide some sort of anticipatory edge — either because of the way it leads the market or because of the definitiveness with which it signals market divergences.

It is the latter category that has encouraged me to become more familiar with Raschke's 3/10 oscillator. But again, the important thing is not so much which oscillator is chosen, but how well a trader or investor gets to know that oscillator after it has been selected.

The temptation to top and bottom pick markets will be with traders and investors forever. What trader does not look at a price chart and find his or her eye slowly moving toward some peak or trough, while thinking, "What could I have known that would have allowed me to sell that top or buy that bottom?"

Keeping in mind not only the tools for picking tops and bottoms, but also the limitations of those tools, is one way that traders and investors of all kinds can find themselves answering that question both confidently and profitably.

David Penn may be reached at DPenn@Traders.com.

SUGGESTED READING

Fischer, Robert [1993]. Fibonacci Applications And Strategies For Traders, John Wiley & Sons.

Murphy, John [1986]. Technical Analysis Of The Futures Markets, New York Institute of Finance/Prentice Hall.

Nison, Steve [1994]. Beyond Candlesticks, John Wiley & Sons.

Prechter, Robert R. [2001]. View From The Top Of The Grand Supercycle, New Classics Library.

Schwartz, Martin [1999]. Pit Bull: Lessons From Wall Street's Champion Day Trader, HarperBusiness.

Sperandeo, Victor [1991]. Methods Of A Wall Street Master, John Wiley & Sons.

_____ [1994]. Principles Of Professional Speculation, John Wiley & Sons.

Charts courtesy TradeStation

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.