Price Action Analysis

Over the past two years, I have spent many hours (many) making communion with the world of trading and investing.  I build software for a hedge fund, and currently work in HF and Options Market Making.  So I decided to take my financial knowledge to the next level two years ago, and immerse myself in everything related to investing and trading.  I have studied topics such as portfolio theory, CAPM, the efficient frontier, options, forex, futures, commodities, candlesticks, you name it.  I have built my own trading strategy platform and charting package, and I have actually been part time trading, and mostly I remain net positive with my trades.  But I have recently been trying to move deeper into the options trading space, and realized after a rather hit and miss trading record, that it ultimately starts and ends with price action.  Let me explain…

Indicators

I think I started like every newbie, shoving as many pretty indicators onto a chart, hoping to some how work out when to trade or not trade.  There are literally hundreds of indicators, and I naively thought, “surely theres a way to spot a trade from these indicators”.  So I created a project for myself, and built a number of indicators in a framework I now use as part of my backtesting platform.  And I may be off-base right now as I write, but I believe there is only one technique that comes from indicators which is hard to see in the price action, and that is divergence.  Some people swear by the stochastics indicator (or similar) to spot oversold and overbought situations, but while these may work if you catch them on a good day, they are not reliable enough to part with hard earned cash.  For example, the problem with stochastics is that it works well in trading ranges to spot reversals, or a trend that has a choppy zig-zag path, but, if you follow it blindly (which you absolutely shouldnt but I know some that do), then at some point you will lose money.  Sometimes that zig is more of a zag, and you went long when you should have stayed by the side.  And sometimes you get the zig and  it was a zig, and you get the zag and it was a zag, but in the end the house wins.  The best technique for indicators is divergence, which I will cover elsewhere, and I believe that is largely it.

What that leaves us with, is price action and volume.  Most indicators are built by looking at either price or volume, looking at possibly past data, and then producing something in the present that is a derivative of the raw price/volume data.  Because of this derivation process, most indicators are also known as lagging indicators, and while there are some supposed to be non-lagging, they too offer little edge in my view.   What does this all mean, really? For me it means its ok to have your favorite indicators, and to use them in your trading, but they must always be guide posts pointing to something, and that something is the unfolding shape and behavior being expressed in the price action itself.

Stochastics and Divergence

Heres a quick example of divergence, and also how even this can be a tricky trade.  Take a look at the image below of the SP500 Spyder ETF (SPY).

SPY and Stochastics Indicator

The latest trade day is April 26th, 2010.  Price has made a higher high, and the stochastics indicator looks like it hasnt made a higher high, though it is not a massive signal – it is only slightly below.  But at this stage, we can only use a signal once we see a lower high printed, because this would form our pivot point high in the price action.  Normally when a higher high in price is not met with a higher print in an indicator, the two are diverging, suggesting a weakening in momentum (nothing else!).  To be really safe we would need to look at how the following day unfolded before looking at the signal more closely.  Right now all it is saying is, look deeper.

A clear divergence unfolding?

Breaking this chart down,there are three gray lines drawn.  First, we clearly made a higher high in price action, which is a new pivot high because the next day (last day shown in the chart) makes a lower high.  Now we can be more sure when looking at the stochastics indicator, and we see clearly that it definitely did NOT make a new high – the price went higher, stochastics went lower.  Do we have a divergence then? What do you think? Yes, the price and indicator went in opposite directions here, but do we have a trading signal? Lets say you were long (you owned SPY) and you saw this, what would you do? Hold, Sell or Buy More? Is it too hard to tell, even with this? I would say yes.  We could be just having a bit of a sell off day, but is that a reason to close out a trade?  A problem with divergence still, is that you can have it when it means nothing, and you can have it when it means run for the hills! And you can also have no divergence at all when you must still run for the hills – this is the key reason why reliance on indicators is a problem.

Any more indications?

The image above is interesting – notice price has started to follow an upward path.  So was this a minor sell off day? I added volume to this chart, does it help you? Volume is actually one of the key indicators that is not lagging. Well in the following diagram I am showing some gray lines – which ones do you use?

Which lines to use?

OK so clearly the volume highs are sloping downward, but we see price is rising.  However at this point, since the sell off day happened, no new high has been made, but new higher lows have been made.  The sloping down line is useful because it is telling us that price is at this stage not sloping up.  The lower price line, which shows the path of the lows of each bar, is showing that they are making higher lows. Since higher lows are being made, and since we normally draw a trend line connecting the lows, does this mean we are back on track and this is just a minor correction?

The point of all of this is to highlight that the reality is the stochastics offered a pointer to something, but was not a trading signal in and of itself.  Yet new traders, and I did this,spend too much time (in my opinion) trying to work out how to take these signals, and link them with other indicators in a way to decide to get out (or in) depending on where the divergence happens (bullish or bearish for example).  If you sold back when I posed the question, unless this is a tax-free retirement account, you just created a taxable event.  Depending on how long you had SPY in your holdings, this could be a pricey mistake if you did sell and this was a false signal.  And I know people who would actually have gone long on this day shown, because the stochastics gray line crosses over the pink line – crossovers indicate possible buy signals.

If you still owned SPY on this last day, you should have been aware that volume was sloping down, because volume is a crucial part of a traders toolset (more so in my view than stochastics and other indicators).  Not only that, we have a price pattern unfolding, called a Pennant.  A little secret at this stage is that I prefer chart patterns over indicators because they are right there within the price action, but they are still dangerous if viewed in isolation.  We have here whats called a Bullish Pennant, because it is an almost symmetrical triangle that has formed with lower highs and higher lows, and it has happened as part of the upward bull trend that was happening.  BUT, the problem with this pattern is that it has the word Bullish in it,and it can be easy to think this means this is a good bullish pattern that means price will probably move upward and onward, in a bullish fashion.   My own experience with this formation is that:

  • First price can go either way.
  • Second, that it will often be sharp (though not always).
  • Third, place a sell short order below the recent lows – if price tanks we could ride that.
  • Fourth, place a buy limit order above the last high  – if price shoots up we could ride that too.
  • Fifth, a high probably trade at this point is to trade volatility and buy a Straddle (a call and put option combined, to take advantage of the possible SHARP direction of price action when/if it breaks).

At this point, let me tell you that while hindsight is a good thing, I would not be in the market right now except for buying the straddle.  A Pennant can go either way, volume is sloping down which is not good for a bullish continuation, we did have a stochastics divergence, though I wouldnt be using that to base my trade decision on.  And another key point is that when we had the main sell off day, that was sharp enough to break below the previous swing point low of the 19th of April.  This is possible because the 3 days after, on the 22nd, a new higher low was created, just before the 27th when we had the sell off.  One reason the sell off on the 27th breached the 19th swing point low could very well have been because bullish traders had put stop loss orders just below the low of the 22nd, while bears placed short trades below the low of the 22nd too.  Both would cause an influx of sell orders pushing price down.  At the same time, the low of the 19th, while breached on the 27th, has held – nothing has fallen below this area/zone for the following 4 days to where we are now in the chart.   We havent at this stage had a re-test of this lower support area.

In the diagram above I have highlighted a number of things, but notice the red lines – I am showing here the left and right side of a minor head and shoulders chart pattern.  The head and shoulders pattern is actually a top reversal pattern, meaning you see it when the market has topped out after a large bull run.  Its a reversal pattern, meaning its the point of price turning back on itself – a bear trend or at least a consolidation phase.  And this is to be clear, not a massive example of pattern formation (see here: head and shoulders).  But if you look closely, it is a head and shoulders shape that price action has made.  Price action.  There is so much that price itself is telling us, along with volume.  We had the long bull run, now we have the start of something,and the key is that price is telling us enough such that the attuned price action trader would know this is probably a time to step aside and wait.

Set a Buy, a Sell or Something else?

The chart setup has got some great trades in it, none of which we need an indicator for.

Nice trade setups

The image shows the trades.  When you go long at points 1 and 2,you would setup a stop-loss at the opposite numbers depending on your risk tolerance.  This formation has some good trade opportunities.  Just doing stock trading, you would tie up your income and go long or short depending on the move.  You would actually setup your orders ahead of time,waiting for the move, and be ready to take evasive action if required, though the stop loss orders would be part of your trades.

Thirteen days later, a major fallout happens as the head and shoulders reversal pattern played out – getting out of the market if long was definitely the right idea back around the 27th.  Now, if you had gone short the market you would be sitting on a nice return.

To explain the next piece I need to use the ThinkOrSwim software, and it shows the prices differently because it uses different market data than Amibroker, which is the tool used for all of the other charts (it is using Yahoo daily prices).  On the day we were looking at trading, we would have set a sell-short order at about $118.  Assume you had $10k to risk on the trade.  You could basically sell short 84 shares.  On the close of the day in the chart, you would be looking at a price of $107.67, a difference of $118-$107.67 or $10.33 per share, which would be a nice $867 profit, or 8.67% return.

Instead however, assume you spent that $10k on buying a straddle.  You could have purchased 10 contracts of the May 119 Call/Put Straddle for for only $3950.  Thats 1000 shares for $3950!  On the day shown, with 1 day to expiry, you would be sitting on a profit of $7,840, or 198% return (!)  You could have purchased 20 contracts, and made a profit of $13,8555.  Thats the power of using price action with options…..and of course, the elephant in the room with options is that the risk can be high that you lose everything.  The key is to increase the probabilities in our favor by reading price action well, using good position sizing and money management, and not getting distracted by the zillions of indicators out there…

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