Wednesday, May 9, 2007

Cliffnotes For Offense And Defense

"So much of what you do physically happens because you've thought about it and mentally prepared for it."

Dan Fouts
Hall-of-fame Quarterback
San Diego Chargers

This is a very simple statement that in the fast paced world of investing and trading can often go unheeded. It is easy to get caught up in "today's" news and become drawn into the latest talking points by so many of the news outlets that bombard us at an ever increasing rate. Getting caught up in the heat of the battle is something that happens to everyone from time to time, but it is important to take a step back and regain the macro perspective. It is important to always have a goal and to not let emotions and hope take us away from our game plan. If a goal is to make x% return in the first half of the year, it is important to review these goals periodically or when they are met. At times we can set our goals higher, in others a dose of realism is need to get the ship back on course. No matter the situation, it is important to know when to be aggressive and when to be cautious. This can be determined by the market just as much as by our own personal management style. The key is to have a plan in advance, but be flexible enough to adapt to the environment without losing sight of the objective and goals.

This is a chart of the S&P 500 Index from the start of 2007. A simple idea can be applied to create a type of map for where the market is and where it might go. In an earlier article about gaining intra day direction from the opening range, this concept was applied on a smaller time frame. In this chart the High of the first three days of 2007(1429.42) is compared to the low of the first three days of 2007(1405.75). This gives us an opening range of 23.67. This is a key number now for the year, it will be the basis for what size swings can be expected.

The next step is to add 23.67 to the high of the opening range and subtract 23.67 from the low of the opening range. This gives +1 swing up 1453.09 and -1 swing down 1382.08. Both of these levels are marked by the red dashed line. We will do the same thing again with these numbers, adding the opening range width to give us +2 and -2 swing levels. This is repeated until more levels are complete.

-2= 1358.42 Green
-1= 1382.08 Red
+1= 1453.09 Red
+2= 1476.76 Green
+3= 1500.43 Blue
+4= 1524.10 Red

These levels act as targets once the market is out of the opening range. When these levels are reached, it is important how the market acts. They often act as resistance when first encountered and after time can turn into support levels for the next move. This year the S&P 500 reached +1 Swing up, but could not sustain prices above that level. When weakness in the Chinese market carried over to the U.S. market, the market moved back down to the opening range, and went right through it. It tried to find some support at the lower part of the opening range, but more selling caused it to complete the -1 Swing down. This level ultimately acted as support, and the move back up to test the lower end of the opening range was under way. Often during this move back up to the opening range, there is a fair amount of short covering and the move can carry right to the top of the opening range.

We tested the top of the opening range and then made a series of rallies towards the upper swing levels. Once the market hit the +2 Swing level, it tested this level before making the +3 Swing level move. The market is now above the +3 Swing level, and will test this level over the next few days. If it can hold, and this system is true, then 1524 area is the next upside target. If the market can not hold the +3 Swing level,then look how the market reacts when it approaches the previous swing levels. It should set up some trades, both long and short, with defined stops and targets.

Having a map of where the market has been can help in developing a trading plan and goals for the rest of the year. This is not an end all and be all system, but it is a helpful chart to print out and draw the levels for future reference. Below are a couple other charts with the same system applied.


Advance/Decline moving average is pointing to some weakness.

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