A Discounted View

Over the past year, investors have been lulled into a complacent state by the exceptional returns in the market accompanied by low volatility in price action. However, as of Tuesday the S&P 500 (SPX) experienced its largest recent one-day drop of -1.09%. Daily Perspective On the daily chart today’s drop in SPX is clearly defined as it deviates from the uptrend that has formed since the beginning of 2018. While we navigate through earnings season, the gap-down in SPX represents a meaningful difference in sentiment among market participants relative to the rest of January. As constituents of SPX continue reporting earnings, expectations are being repriced into the index. In the meantime, there are some noticeable developments on the daily chart . For example, the gap lower was so pronounced that the daily Relative Strength Index (RSI) finally closed below its overbought level which SPX had maintained throughout all of January 2018. At the very least this sign...

Harry Markowitz, the founder of Modern Portfolio Theory, once said that “diversification is the only free lunch.” Decades since his seminal work in developing mean-variance efficient portfolios that maximize return for a given level of risk, this adage still holds true in most market environments. It is common practice for fund managers to diversify among asset classes based on Markowitz’s findings. However, diversification with his methods can be taken one step further .  While diversifying your account in all suitable asset classes is worthwhile, a trader can also diversify an account with different trading styles which will create uncorrelated return streams. For example, Perry Kaufman suggests that a well-diversified trader has an ideal mix of three, maybe four, unique strategies. Generally speaking, these three trading styles can be categorized as Trend Following , Mean Reversion , or  Pattern Recognition . Furthermore, styles can be differentiated by time horizon....

Executing sound risk management principles in your trading is essential to having any chance of investment survival. If one position is sized too large and generates an enormous loss, this can be catastrophic to your account as well as your psychology as a trader. Fortunately, there are methods you can learn that will protect your account. In The New Trading for a Living , Dr. Alexander Elder proposes a method for controlling risk at the position level which he calls the 2% Rule. This guideline states that the total risk in any position cannot exceed 2% of the current month-end account value. For example, if you have $100,000 in your account at the end of the previous month, the 2% Rule limits your maximum risk on any trade to $2,000. That is, risk is defined as the dollar value of the difference between your purchase price and stop loss and cannot exceed 2% of the account value under this rule. Be sure to not confuse 2% with the total position size. While 2% may seem sm...

At the moment, there may be some bullish divergence  emerging in the daily chart of the S&P 500 (SPX) and Russell 2000 (RUT). Divergence between a price and an oscillator can be a reliable harbinger of future price moves. Since the beginning of 2016 SPX has been in a strong, sustained downtrend. However, a pivot low was formed in the middle of January and now it appears as though another price pivot could be establishing itself in the beginning half of February. Granted, the price action year to date has formed a series of lower-lows which is often interpreted as a bearish sign. Yet, when there is bullish divergence in a price-based indicator it often leads to a swift reversal of prior price action. For example, in the chart below it can be seen how the price trend of SPX has diverged from that of two of its oscillators. That is, the oscillators have formed potential higher-highs since the beginning of 2016. This could be indicative of impending bullish price action in the...

In trading, controlling the risk in a portfolio is determined by position sizing.  Most trading firms employ a fixed fractional contract position sizing method.  Under this methodology, positions are determined using the following formula: Fixed fractional bet sizing: Amount risked per trade = closing equity * fixed percentage risked per trade (e.g. 25bps) Once the Fixed-Fractional Contract Position Sizing Formula has been used to calculate the amount of risk to put on with a trade (in dollar terms), the Risk-Basis Position Sizing method is employed to determine how many shares or contracts of an instrument to buy or sell.  The Risk-Basis Position Sizing method considers the risk for each security, where risk per share is the entry price minus the stop-loss point.  It divides the total risk allowance (e.g. 25bps in dollar terms) by the risk per share to determine the number of shares to trade.  Legendary systems and Trend Following trader Ed Seykota o...

After the August 2015 sell-off the broad-based indexes found support and pivoted higher before month-end. However, by the latter half of September 2015 more selling pressure came into the market pushing the price of the S&P 500 Index (SPX) down to a near retest of its August 2015 lows while moving the value of the Russell 2000 Index (RUT) to new lows.  Even though the price action of these two indexes differed, the behavior of each respective Moving Average Convergence Divergence (MACD) Indicator was the same. Specifically, both MACD’s formed a higher low in late September 2015 after the August 2015 low was formed. Given the aforementioned similarities, MACD conveyed a powerful underlying message. In the case of RUT we observe that divergence formed between the lows of the price and the lows of the MACD lines. That is, as RUT formed a lower-low by the end of September 2015 its MACD was making a higher-low which is indicative of future price strength. MACD is categorized as a ...