Post by TradingForGod on Aug 17, 2004 10:02:39 GMT -5
Last time we looked at how to identify a trending market and some basic strategies for how to trade in that environment. Today we are going to look at what to do, or NOT do, when the market is in congestion. As I said last time, commodities are in congestion between 75%-80% of the time by some estimates. Even though stocks trend much more often, it’s still a good idea to know how to identify congesting markets and how to trade them effectively.
To review, the way I determine whether a market is trending or not is to look at the moving averages (MAs) and the Average Directional Index (ADX). If the 3 MAs are all sloping the same way, chances are the market is trending. If the ADX is positively sloped and between 20 and 40, the market is trending and the trend is strengthening. If the ADX is positively sloped but below 20, a trend MAY be forming. If the ADX is negatively sloped from high numbers, an existing trend is in danger of reversing. And if the ADX is below 20 with a flat or negative slope there is no discernible trend.
As I said last time, most traders place trades assuming the market is going to continue in the direction of the recent price action. That obviously implies that they expect the “trend” to continue. However, if the market is not trending per the criteria described above this type of strategy usually results in traders getting “chopped up”, meaning they wind up buying the highs and selling the lows multiple times as the market moves around the average more or less randomly. If this discussion does nothing other than help you stay away from markets like that, then hopefully that will help improve your trading performance and result in higher average returns. It will also keep you from tying up precious capital on stocks that are not going anywhere. However, for the bold and the brave, there are ways to trade non-trending markets that can profit from an ABSENSE of trend. To discuss that though, I first need to talk about another indicator that I use, the Bollinger Bands.
Bollinger Bands get their name from John Bollinger, who popularized them. You probably have seen him on CNBC or other financial shows. You would think that because it is named after him, the Bollinger Bands must be something really special, but there is nothing exotic about this indicator. It simply uses basic statistics to graph “volatility bands” around the price action. Let me explain. In statistics there is a function called the “standard deviation”. The formula for it is not really important here, but the meaning of it is. The standard deviation (StD) measures the degree of dispersion or spread in a data set. The more spread out the data is, the higher the “volatility”, the larger the StD. If you take a set of data and perform this function on it, assuming a large enough data sample and a “normal distribution” of the data, about 2/3 of all the data will fall in a range one StD above and below the average of that data. For instance, let’s say that the average price of some stock over a period of time is $25, and the standard deviation of that stock is $3. That means that statistically 67% of the time prices will be between $22 and $28. Simple enough, right? Also, statistically about 95% of the data will be within two StD of the average. And about 99.5% of all the data will be within 3 StD of the average.
The Bollinger Band (BB) indicator makes use of these statistics to establish an expected range of price action around a mean (average). The default conditions in most software are 20 periods for the data considered and two standard deviations. I have done a little optimization work that suggests a longer averaging period and tighter StD criteria are a little better, but for our purposes we are going to use the basic indicator criteria here. To calculate the BB we first calculate the 20-period MA and the StD deviation of the closes over that same time. Again, the software will do this. We just have to look at the results. The BB indicator graphs the average of the data and “boundary lines” two StD above and below the average. Based on statistics, 95% of all the data should fall within the upper and lower bands. As time passes we get a new MA with each period and the StD changes as we consider just the last 20 closes for the calculation. As the dispersion, the volatility increases and decreases over time, the width of the bands increase and decrease to compensate so that theoretically 95% of the data stays within the bands whether the volatility is high or low.
So how can you use BBs to trade? Well first, and MOST importantly, all BB trades are counter to the recent price action. In other words, you sell strength and buy dips. That is the opposite of trend trading in which the entries are always in the direction of the prevailing trend. That means you only use this tactic when you are sure the market is NOT trending. The basic strategy when trading in congestion is to wait until prices are at the outer bounds of recent price action (i.e. at the BBs) and trade counter to the movement looking for prices to return to at least the mean. I generally liquidate BB trades when they reach the mean because most of the gain will have been achieved by then. If prices continue to move to the opposite BB, I may have given up some potential gain but by then I am looking to set a trade in the opposite direction anyway. That trading style is a personal preference though. Some people wait for prices to move toward the opposite band before liquidating.
Let’s look at MSFT (below) to see how BBs work. I have included the ADX again so we can see when the market is trending. Starting back in March, note how MSFT rode right down the lower band as it trended strongly lower. That’s one of the biggest things to watch about trading against the BBs…if the market is trending you will get run over. Even though most of the price action was above the lower BB, it was falling so rapidly that any sale would have resulted in a loss if held more that just a few hours. So watch the ADX. If it indicates a trending market, don’t use a congestion-bases strategy (again, duh). Prices rallied up to the upper BB in early April while the downtrend was eroding. This provided an ideal short entry because it was against the upper BB while a downtrend (albeit a weakening one) was still in place. So you were trading against the short term price action, but IN the direction of the prevailing trend. This one was an almost lay down hand. Prices fell into the mean (yellow line) for a good exit opportunity. The market traded sideway with little opportunity for over a month before beginning to rally again in early June. Note that as prices rallied, the ADX turned up from very low levels. You might have tried to trade against the upper BB for a few days in mid-June, and could even have made some decent money intra-day. But the rising ADX would have negated any selling ideas by 6/14, and in fact the MA work would have suggested going long instead. Note how the BB served as resistance all the way up into late June, but the band was steeply rising. That’s another thing to watch for. BB trades almost always work better when the band you are trading against is flat. If it is sloping in the direction opposite the trade you are considering, beware. The bands gave a great buying opportunity in early July similar to the sale in early April. MSFT fell back to the lower band while the uptrend was still in place, though weakening. In fact, you would have had two or three chances to buy at the lower band (note it was flat) and sell into the MA. The explosive top on 7/21 was too volatile to trade, but the narrow range the next day MIGHT have been a short. I don’t think I would have had the guts to try it though because of the ADX was still over 20. Since then prices have dropped as MSFT has detrended. It gave a buying opportunity on 8/6, but did not rally high enough to sell out at the mean. Even though ADX is not showing a trend yet, MA structure is bearish now, so having a long on at this point is problematic. So chances are a BB trade from last week would have been scratched a couple of days ago.
So there you have it. That’s the congestion trading strategy. You can also use the BBs as a profit taking point on trend-based trades. As we have pointed out, prices generally stall for some kind of pull-back end in a trending environment. But you would want to replace any positions quickly in strong trends. Only really aggressive, short-term traders should attempt this type of position management.
Tomorrow, we’ll complete the series on the basics by looking at two oscillators that I use to try to figure out when the market is “overbought” and “oversold”. After that, we’ll be looking at actual markets. Yippee!
May all your trades be winners. God Bless.
TFG
To review, the way I determine whether a market is trending or not is to look at the moving averages (MAs) and the Average Directional Index (ADX). If the 3 MAs are all sloping the same way, chances are the market is trending. If the ADX is positively sloped and between 20 and 40, the market is trending and the trend is strengthening. If the ADX is positively sloped but below 20, a trend MAY be forming. If the ADX is negatively sloped from high numbers, an existing trend is in danger of reversing. And if the ADX is below 20 with a flat or negative slope there is no discernible trend.
As I said last time, most traders place trades assuming the market is going to continue in the direction of the recent price action. That obviously implies that they expect the “trend” to continue. However, if the market is not trending per the criteria described above this type of strategy usually results in traders getting “chopped up”, meaning they wind up buying the highs and selling the lows multiple times as the market moves around the average more or less randomly. If this discussion does nothing other than help you stay away from markets like that, then hopefully that will help improve your trading performance and result in higher average returns. It will also keep you from tying up precious capital on stocks that are not going anywhere. However, for the bold and the brave, there are ways to trade non-trending markets that can profit from an ABSENSE of trend. To discuss that though, I first need to talk about another indicator that I use, the Bollinger Bands.
Bollinger Bands get their name from John Bollinger, who popularized them. You probably have seen him on CNBC or other financial shows. You would think that because it is named after him, the Bollinger Bands must be something really special, but there is nothing exotic about this indicator. It simply uses basic statistics to graph “volatility bands” around the price action. Let me explain. In statistics there is a function called the “standard deviation”. The formula for it is not really important here, but the meaning of it is. The standard deviation (StD) measures the degree of dispersion or spread in a data set. The more spread out the data is, the higher the “volatility”, the larger the StD. If you take a set of data and perform this function on it, assuming a large enough data sample and a “normal distribution” of the data, about 2/3 of all the data will fall in a range one StD above and below the average of that data. For instance, let’s say that the average price of some stock over a period of time is $25, and the standard deviation of that stock is $3. That means that statistically 67% of the time prices will be between $22 and $28. Simple enough, right? Also, statistically about 95% of the data will be within two StD of the average. And about 99.5% of all the data will be within 3 StD of the average.
The Bollinger Band (BB) indicator makes use of these statistics to establish an expected range of price action around a mean (average). The default conditions in most software are 20 periods for the data considered and two standard deviations. I have done a little optimization work that suggests a longer averaging period and tighter StD criteria are a little better, but for our purposes we are going to use the basic indicator criteria here. To calculate the BB we first calculate the 20-period MA and the StD deviation of the closes over that same time. Again, the software will do this. We just have to look at the results. The BB indicator graphs the average of the data and “boundary lines” two StD above and below the average. Based on statistics, 95% of all the data should fall within the upper and lower bands. As time passes we get a new MA with each period and the StD changes as we consider just the last 20 closes for the calculation. As the dispersion, the volatility increases and decreases over time, the width of the bands increase and decrease to compensate so that theoretically 95% of the data stays within the bands whether the volatility is high or low.
So how can you use BBs to trade? Well first, and MOST importantly, all BB trades are counter to the recent price action. In other words, you sell strength and buy dips. That is the opposite of trend trading in which the entries are always in the direction of the prevailing trend. That means you only use this tactic when you are sure the market is NOT trending. The basic strategy when trading in congestion is to wait until prices are at the outer bounds of recent price action (i.e. at the BBs) and trade counter to the movement looking for prices to return to at least the mean. I generally liquidate BB trades when they reach the mean because most of the gain will have been achieved by then. If prices continue to move to the opposite BB, I may have given up some potential gain but by then I am looking to set a trade in the opposite direction anyway. That trading style is a personal preference though. Some people wait for prices to move toward the opposite band before liquidating.
Let’s look at MSFT (below) to see how BBs work. I have included the ADX again so we can see when the market is trending. Starting back in March, note how MSFT rode right down the lower band as it trended strongly lower. That’s one of the biggest things to watch about trading against the BBs…if the market is trending you will get run over. Even though most of the price action was above the lower BB, it was falling so rapidly that any sale would have resulted in a loss if held more that just a few hours. So watch the ADX. If it indicates a trending market, don’t use a congestion-bases strategy (again, duh). Prices rallied up to the upper BB in early April while the downtrend was eroding. This provided an ideal short entry because it was against the upper BB while a downtrend (albeit a weakening one) was still in place. So you were trading against the short term price action, but IN the direction of the prevailing trend. This one was an almost lay down hand. Prices fell into the mean (yellow line) for a good exit opportunity. The market traded sideway with little opportunity for over a month before beginning to rally again in early June. Note that as prices rallied, the ADX turned up from very low levels. You might have tried to trade against the upper BB for a few days in mid-June, and could even have made some decent money intra-day. But the rising ADX would have negated any selling ideas by 6/14, and in fact the MA work would have suggested going long instead. Note how the BB served as resistance all the way up into late June, but the band was steeply rising. That’s another thing to watch for. BB trades almost always work better when the band you are trading against is flat. If it is sloping in the direction opposite the trade you are considering, beware. The bands gave a great buying opportunity in early July similar to the sale in early April. MSFT fell back to the lower band while the uptrend was still in place, though weakening. In fact, you would have had two or three chances to buy at the lower band (note it was flat) and sell into the MA. The explosive top on 7/21 was too volatile to trade, but the narrow range the next day MIGHT have been a short. I don’t think I would have had the guts to try it though because of the ADX was still over 20. Since then prices have dropped as MSFT has detrended. It gave a buying opportunity on 8/6, but did not rally high enough to sell out at the mean. Even though ADX is not showing a trend yet, MA structure is bearish now, so having a long on at this point is problematic. So chances are a BB trade from last week would have been scratched a couple of days ago.
So there you have it. That’s the congestion trading strategy. You can also use the BBs as a profit taking point on trend-based trades. As we have pointed out, prices generally stall for some kind of pull-back end in a trending environment. But you would want to replace any positions quickly in strong trends. Only really aggressive, short-term traders should attempt this type of position management.
Tomorrow, we’ll complete the series on the basics by looking at two oscillators that I use to try to figure out when the market is “overbought” and “oversold”. After that, we’ll be looking at actual markets. Yippee!
May all your trades be winners. God Bless.
TFG
