STOCK INDEX FUTURES TRADING COLLECTION

“Using the TICK to identify the intraday trend”

by David Bean (Active Trader, May 2006). 2
“Counterpunch stock index futures system"
by Active Trader Staff (Active Trader, Nov. 2002) 7
“Extreme open-close days”
by Xavier Maria Raj (Active Trader, April 2005). 9
“The Fibonacci Swing Filter”
by Gomu Vetrivel (Active Trader, Feb. 2005). 13
“Trading the opening gap”
by John Carter (Active Trader, Dec. 2004). 17
“Hitting the street: The S&P 500 futures' intraday reactions to economic reports”
by David Bukey (Active Trader, May 2005). 21
“Sector vs. index: The single stock futures-Dow spread”
by Keith Schap (Active Trader, Nov. 2005). 27
“Trading the basis: How stock index arbitrage impacts the market”
by David Lerman (Active Trader, March 2003). 31
“Stock index spreads: S&P vs. Naz”
by Keith Schap (Active Trader, May 2006). 35
“The multibar range breakout system”
by Dennis Meyers, PH.D. (Active Trader, Jan. 2004). 39
“Following through in the S&Ps”
by Thom Hartle (Active Trader, Dec. 2003). 44
“Getting in on follow-through days”
by Thom Hartle (Active Trader, Jan. 2004). 49
“Follow-through in the E-Mini Nasdaq 100”
by Thom Hartle (Active Trader, Aug. 2004). 54
“Up-down volume and next-day follow-through”
by Thom Hartle (Active Trader, Dec. 2004). 60
“E-Mini morning reversal and afternoon breakout patterns”
by Gomu Vetrivel (Active Trader, Jan. 2006). 66
“The telltale spread”
by Thom Hartle (Active Trader, Nov. 2003). 70
 TRADING Strategies

Using the TICK

TO IDENTIFY THE INTRADAY TREND
Analyzing TICK readings over the past five years provides
the foundation for an intraday trend strategy.

BY DAVID BEAN

T he TICK indicator measures

intraday momentum in
New York Stock Exchange
(NYSE) stocks by tracking
the difference between upticking stocks
(last price higher than previous price)
and downticking stocks (last price lower
than previous price). The TICK subtracts
the number of downticking stocks from
the number of upticking ones to gener-
ate a momentum snapshot of the market
at any given time.
For example, if at 10 a.m. 2,000 stocks
were trading higher than their previous
FIGURE 1 FIVE-YEAR AVERAGE NYSE VOLUME (15-MINUTE INTERVALS)
The second-largest NYSE volume occurred in the first 15 minutes of trading,
which is a good time to determine the daily trend because price moves are
more meaningful when backed by large volume.
prices while 1,500 stocks were trading
lower than their previous prices, the
TICK value would be +500 (2,000-1,500).
Traders typically use the TICK indicator
to gauge the level of buying or selling
pressure throughout the day. If the TICK
reading is high, the market is showing
“internal” strength, which is different
from the “outward” price movement.
According to popular interpretation,
TICK levels that correspond with price
action help confirm the market’s direc-
tion, but TICK values that diverge from
price can warn of possible reversals. For
example, a typical bullish signal occurs
when the S&P 500 is climbing when the
TICK is positive (or trending higher).
However, if the S&P 500 is rising but the
TICK turns negative (or trends lower),
the rally could be nearing its end. (For
more information on the TICK, see
“TICK basics.”)

From analysis to trading

This kind of analysis depends on logical-
ly defining “high” or “low” TICK read-
ings. The following study analyzed
intraday TICK behavior in the past five
years to find potentially bullish and
bearish TICK levels. However, the
resulting trade strategy also relied on
NYSE volume analysis and price action
to confirm the intraday trend and gener-

2 www.activetradermag.com • May 2006 • ACTIVE TRADER


ate trade signals.
The focus was on the first 15 minutes
of the daily trade session because over
the past five years the NYSE’s second-
largest volume has occurred during this
period. Above-average TICK readings
generate buy signals at 9:45 a.m. ET. By
contrast, sell signals require below-aver-
age TICK readings along with down-
ward price moves (gaps or weakness)
within the first 15 minutes.
The logic of this approach is that high-
volume periods combined with price
moves and TICK readings in the same
direction help determine the trend for
the rest of the day.
Trend clues at market’s open
Figure 1 shows the NYSE’s average vol-
ume of more than 3,700 stocks in 15-
minute intervals from 9:30 a.m. to 4 p.m.
ET over the past five years. While vol-
ume is highest in the last 15 minutes of
trading, the second-highest volume
occurred in the first 15 minutes of the
regular session — from 9:30 a.m. to 9:45
a.m.
The day’s open and close stand out
because institutional traders must exe-
cute large amounts of market-on-open
and market-on-close orders; the price
moves that occur during these periods
can leave clues about the market’s likely
direction. Although you can trade stocks
and stock-index futures in the after-
hours electronic market, those markets
offer very little volume to offset posi-
tions against overnight breaking news
while the U.S. stock market is closed for
17.5 hours.
Defining TICK thresholds
Table 1 shows statistics behind the TICK
indicator’s historical behavior over the
past five years. Overall, the TICK had a
bullish bias. The average daily TICK
high was nearly twice as large as the
daily low (+1,007 vs. -673). Also, the
TICK’s average close after 15 minutes
was not only above zero (+201) but
exceeded +300 almost six times as often
as it fell below -300. Buy and sell signals
ACTIVE TRADER • May 2006 • www.activetradermag.com
TABLE 1 FIVE-YEAR TICK STATS
The TICK has had a bullish bias
over the past five years. Its aver-
age daily high is nearly double its
daily low, its average close every
15 minutes was +201, and it
exceeded +300 nearly six times as
often as it dropped below -300
(based on 15-minute intervals).
must take this upside bias into account.
The strategy’s bullish and bearish
thresholds are based on the TICK’s aver- TICK value
age close of +201 after 15 minutes. There Five-year high: +1,541
are thresholds for both high and low
readings as well as for where the TICK Five-year low: -1,495
closes. The high and low thresholds are Avg. daily high: +1,007
+750 and -350, which are approximately
Avg. daily low: -673
+/-550 from the average close of +201;
the closing TICK thresholds are +500 Avg. closing value
and -100, which are approximately after 15 minutes: +201
+/- 300 from the average close of +201.
No. of 15-minute
This means the TICK is bullish if it
closes above +300: 12,855
either reaches +750 within the first 15
minutes of trading or closes above +500 No. of 15-minute
at 9:45 a.m. Similarly, the TICK is bearish closes below -300: 2,262
if it drops below -350 within the first 15
T
TICK basics
he TICK is a very short-term (intraday) indicator that measures the
bullish (upticking) or bearish (downticking) activity in NYSE stocks
throughout the day. TIKI is the symbol for the same indicator calcu-
lated on Dow Jones Industrial Average stocks; some data services also
supply the TICK calculated on Nasdaq stocks.
The TICK is a breadth indicator that gives traders an intraday look at the “inter-
nal” strength or weakness of the market — that is, the strength or weakness
beyond whether the overall market is up on a point or percentage basis. By com-
paring the number of stocks advancing to stocks declining, the indicator reflects
the market’s up or down momentum at a given moment.
For example, if the S&P 500 index is up marginally but downticking stocks are
consistently outnumbering upticking stocks (and the number of downticking
stocks is increasing, reflected by a downtrending TICK indicator), it is likely that
only a relative handful of strong stocks are propping up the overall market.
When buying completes in these stocks, a down move may result.
Two contrarian uses of the TICK indicator are to look for divergence between
price and the indicator, and to use high or low TICK readings to identify momen-
tum extremes (similar to how many traders use oscillators like the relative
strength index or stochastics to locate overbought and oversold points).
A divergence occurs when price makes a new high (or low) but the TICK
makes a lower high (or higher low), failing to confirm the price move and warn-
ing of a slackening of momentum and potential stall or reversal. A similar phe-
nomenon would be a steady trend in the TICK that runs counter to the trend of
the market. Extreme high or low TICK readings sometimes accompany market
climaxes.
Because the TICK is a snapshot of the market at a given moment (and is thus
very volatile), it can be deceptive. Because of this, the TICK is commonly
smoothed with a 10-period moving average to remove some of the “noise” and
better reveal the indicator’s direction and patterns.
3
 Strategy code
Tradestation EasyLanguage Code yesterday’s 15-minute bars), the
TICK’s close < -100, and TICK’s
{Data1 is @ES.D or any of the following: @ER2.D, @YM.D, @NQ.D, @EMD.D high < +750, sell short for the next
Data2 is $TICK. Both Data1 and Data2 are 15 minute charts – a custom ses- 15 minutes (until 10 a.m.) at
sion should be built for @YM.D to trade between 8:30 am CST and 3:15 pm CST today’s open (limit).
instead of starting at 7:20 am CST.
*there are 27, 15 minute bars in the trading day} 3. If the close of the first 15-minute
bar > the previous day’s close, the
Inputs: R(5), L1(27); TICK’s low < -350, and the TICK’s
If Time=945 and H of data2 > 750 and L of data2 > -350 Then Buy Next Bar at high < +750, sell short for the next
market; 15 minutes (until 10 a.m.) at
If Time=945 and C of data2 > 500 and L of data2 > -350 Then Buy Next Bar at yesterday’s close (stop).
market;
4. If the close of the first 15-minute
If Time=945 and Open > LowD(1) - 2*Average(Range,27) and L of data2 < -350 bar > the previous day’s close, the
and H of data2 < 750 Then Sell Short Next Bar at OpenD(0) Limit; TICK’s close < -100, and the TICK’s
If Time=945 and Open > LowD(1) - 2*Average(Range,27) and C of data2 < -100 high < +750, sell short the next 15
and H of data2 < 750 Then Sell Short Next Bar at OpenD(0) Limit; minutes (until 10 a.m.) at
If Time=945 and C > C[1] and L of data2 < -350 and H of data2 < 750 Then Sell yesterday’s close (stop).
Short Next Bar at CloseD(1) Stop;
If Time=945 and C > C[1] and C of data2 < -100 and H of data2 < 750 Then 5. If the close of the first 15-minute
Sell Short Next Bar at CloseD(1) Stop; bar < the open - the average range
of all 27 of yesterday’s 15-minute
If Time=945 and C>(O + Average(Range,27)) and L of data2 > -350 Then Buy bars and the TICK’s high < 750,
Next Bar at market; then sell short at the market.
If Time=945 and C<(O - Average(Range,27)) and H of data2 < 750 Then Sell
Short Next Bar at market; Exit:

SetStopLoss(R*BigPointValue*Average(Range,L1)); 1. Stop-loss = R * contract’s point

SetExitonClose;
Strategy code can be copied at www.activetradermag.com/code.htm.
minutes or closes below -100 at 9:45 a.m.
Trade rules
There are three long-entry and five
short-entry rules. Although each rule is
independent, meaning it could be tested
individually, all eight rules are combined
to make a single system designed to
trade the S&P 500 E-Mini futures (ES).
The rules were also tested on the Russell
2000 E-Mini (ER2), Midcap 400 E-Mini
(EMD), Mini Dow (YM), and Nasdaq
100 E-Mini (NQ).
Long entries (at 9:45 a.m. ET):
1. If the TICK’s high > +750 and the
TICK’s low > -350, buy at the
market.
2. If the TICK’s close > +500 and the
TICK’s low > -350, buy at the
market.
3. If the close of the first 15-minute
bar > the open + the average range
(high - low) of all 27 of yesterday’s
15-minute bars, and the TICK’s
low > -350, buy at the market.
Short entries (at 9:45 a.m. ET):
1. If today’s open > yesterday’s low -
(2 * the average range of all 27 of
yesterday’s 15-minute bars), the
TICK’s low < -350, and the TICK’s
high < +750, sell short for the next
15 minutes (until 10 a.m.) at
today’s open (limit).
2. If today’s open > yesterday’s low -
(2 * the average range of all 27 of
value * average range of all 27
previous 15-minute bars since the
same time yesterday. (R = multiplier
that can be optimized for each
market or risk preference; default
= 5.)
2. Exit on close if still in market.
Trade logic
All eight signals are based on TICK
behavior and price direction within the
first 15 minutes of trading. Two of the
three long rules focus solely on exceed-
ing TICK’s bullish thresholds and stay-
ing above its bearish ones. Also, four of
the five short rules require TICK to pen-
etrate the bearish levels as it stays below
the bullish ones.
The other two rules don’t wait for
either TICK threshold to be met. To trig-
ger a buy signal, price must climb fur-
ther than the average range of all of yes-
terday’s 15-minute bars (long rule 3), or
price must drop the same distance
before selling short (short rule 5).

4 www.activetradermag.com • May 2006 • ACTIVE TRADER

However, these rules still require the example, if price climbs above yester- below yesterday’s close, the strategy
TICK to remain above its average low day’s close by 9:45 a.m., it must drop sells short with a limit order at today’s
(-350) or below its average high (+750), back to that point before the system sells
open in the second 15 minutes. That gap,
respectively. however, must be smaller than twice the
short with a stop order in the second 15
The first four short rules must be exe- average range of yesterday’s 15-minute
minutes of the trading session (until 10
cuted using stop or limit orders. For a.m.). Also, if the opening price gaps bars.
The stop-loss depends
on the average range of
FIGURE 2 TRADE EXAMPLE yesterday’s 15-minute bars,
The S&P 500 E-Mini fell slightly on Feb. 2, and the TICK low (-383) was bearish by 9:45 the contract’s point value,
a.m. because it dropped below the lower threshold (-350). The system sold short at and a multiplier (R) to
1,284, and the S&P E-Mini sold off throughout the day — a gain of 12.75 points. adjust the stop size. If that
stop-loss isn’t hit, the sys-
tem holds the trade until
the end of the day to let
profits run.

Trade example
Figure 2 shows a 15-minute
chart of the March 2006
S&P 500 E-Mini futures
(ESH06) on Feb. 2. The
market dropped slightly at
the open, and the TICK
readings at 9:45 a.m. were
low (-383), high (+125), and
close (+99). The S&P 500
had a short bias because the
TICK’s low was below the
bearish threshold of -350
and its high was below the
bullish level of +750.
The system placed a
limit order at 9:45 a.m. at
the E-Mini’s opening price
Source: Tradestation 8.1 (1,284.00), and the S&P 500

TABLE 2 OVERALL TEST RESULTS

The strategy was profitable across the major indices in different time periods. All markets had a favorable percentage of gains,
and all but one had average profits per trade of at least $54.72. However, the Nasdaq 100 didn’t perform as well.

Start No. of Profit Drawdown Percentage Avg. Profit Avg. Avg. Ratio
date trades profitable profit per factor winning losing avg. win/
trade trade trade avg. loss
E-Mini S&P 500 9/11/97 1,128 $67,237.50 $10,637.50 53.90% $59.61 1.33 $444.10 -$400.74 1.11
E-Mini Russell 2000 11/7/01 726 $42,990.00 $6,280.00 52.75% $59.21 1.33 $454.73 -$393.90 1.31
E-Mini Midcap 400 1/28/02 709 $38,800.00 $4,760.00 52.47% $54.72 1.35 $401.53 -$338.13 1.19
E-Mini Nasdaq 100 7/1/99 1,006 $14,160.00 $23,760.00 51.29% $14.08 1.05 $529.22 -$549.72 0.96
Mini Dow 7/28/02 579 $37,910.00 $3,520.00 56.82% $65.47 1.60 $307.39 -$259.10 1.19

5 www.activetradermag.com • May 2006 • ACTIVE TRADER

TABLE 3 TEST RESULTS: JAN. 1, 2003 TO FEB. 1, 2006

Performance suffered slightly in this second test because the markets’ daily ranges narrowed in the past three years.
However, most markets remained profitable even if you consider slippage and commission costs (not included).

Profit No. of Drawdown Percentage Avg. Profit Avg. Avg. Ratio

trades profitable profit per factor winning losing avg. win/
trade trade trade avg. loss
E-Mini S&P 500 $20,112.50 477 $3,012.50 53.67% $42.16 1.35 $304.35 -$270.09 1.13
E-Mini Russell 2000 $28,690.00 534 $6,280.00 52.81% $53.73 1.30 $444.01 -$392.36 1.13
E-Mini Midcap 400 $23,360.00 553 $4,760.00 52.80% $42.24 1.28 $363.97 -$325.18 1.12
E-Mini Nasdaq 100 $7,670.00 511 $3,530.00 51.86% $15.01 1.14 $231.25 -$228.13 1.01
Mini Dow $19,815.00 498 $3,520.00 55.22% $39.79 1.38 $262.56 -$241.43 1.09

hit this price between 9:45 a.m. and 10 Test results 3). Comparing Tables 2 and 3 shows that
a.m., going short 0.25 points from the The TICK strategy was tested on histori- although the average profit per trade
day’s high. The market sold off through- cal intraday price data going back at dropped in recent years, the average
out the day, and the system exited at the least three years in the S&P 500 E-Mini trade is still large enough (at least
close (1,271.25) for a 12.75-point gain. futures, Russell 2000 E-Mini, Midcap 400 $39.79) to make money after slippage
The Russell 2000 E-Mini, Midcap 400 E-Mini, Mini Dow, and Nasdaq 100 E- and commission costs. (The Nasdaq 100
E-Mini, and mini Dow all took similar Mini. Table 2 (p. 5) shows results for E-Mini’s average profit of $15.21 was
trades as each of these markets climbed each index in different time periods from the exception to this rule.) Average prof-
back to the open and then dropped. No Sept. 11, 1997 to Feb. 1, 2006. its fell because the markets’ daily ranges
trade was triggered in the Nasdaq 100 E- For comparison purposes, each index have decreased in recent years.
Mini because this market didn’t trade was also tested over the same time peri- The system trades often — roughly
back to the open. od — Jan. 1, 2003 to Feb. 1, 2006 (Table three times a week in each market over
the past three years, or 500 trades in 750
trading days.
Overall, the system caught roughly
10 percent of the S&P 500’s 50-day aver-
Related reading age daily trend. For example, if the S&P
E-Mini has a 10-point daily range, and
“The Crown pattern” the system captures 10 percent of it,
Active Trader, January 2004. then its average profit is one point
Here’s a way to use some specific calculations to improve the odds of trading ($50). This roughly matches the sys-
a variation of a classic chart pattern — on an intraday basis. tem’s average profit in the S&P 500 in
both time periods. (As of Feb. 1, the
“Intraday trading with the TICK” S&P E-Mini’s 50-day average range was
Active Trader, April 2002. 9.84 points.)
Find out how the TICK indicator can complement other trading tools in identi-
fy low-risk trades. Here’s how one trader combines the TICK with support and Further research
resistance analysis and retracement levels. One idea that deserves additional atten-
tion is to sell rallies short when the TICK
“Indicator insight: TICK/TIKI” signals a downtrend, or buy dips after it
Active Trader, March 2001. signals an uptrend at 9:45 a.m.
How to calculate and interpret the TICK, a popular short-term indicator that Instead of trading just one contract
measures intraday buying and selling pressure. after any of the eight rules signal a trade,
you could trade multiple contracts (e.g.,
You can purchase and download past articles at one for each signal). However, you’d
www.activetradermag.com/purchase_articles.htm. have to limit short positions to three to
balance the size of long and short trades
in the market.Ý

6 www.activetradermag.com • May 2006 • ACTIVE TRADER

FUTURES & OPTIONS
Trading System Lab
Counterpunch stock EQUITY CURVE

index futures system

3,000,000

2,500,000

Account balance ($)

Markets: Stock index futures. 2,000,000

System logic: This is basically the same countertrend 1,500,000

system tested on the Dow Jones stocks in the equity
Trading System Lab. The only difference is the system 1,000,000
trades the futures markets in this test a little more
aggressively: There are only three markets (the S&P 500,
500,000
Nasdaq and Dow futures), and the lower margin
requirements of futures mean less money is tied up in
0
each position. 1/1/93 1/1/94 1/1/95 1/1/96 1/1/97 1/1/98 1/1/99 1/1/00 1/1/01 1/1/02
As a result, when a trade reaches an initial exit level
(see Rules, below) the system will exit only one-third of the posi- determined by the following formula:
tion; the remaining two-thirds will be exited upon reaching the sec-
ond exit level. (By comparison, the stock system exited trades in CT = AC * PR / 4TR
two equal portions.) However, the actual rules for where and when where
to enter and exit are the same. AC = Available capital
Two-thirds of the position is left open because the trailing stop PR = Percent risked
generates profits that are a tad better and more reliable than the 4TR = Four times the true range for the day preceding the entry
simple stop-loss exit. Had the stop-loss exit turned out to be the
more reliable of the two, the relationships would have been Test period: January 1993 to July 2002.
reversed. This is simply a way to make the most of the statistical
traits of the system while limiting losses and locking in profits. Test data: Daily prices for the S&P 500, Nasdaq 100 and Dow
(This approach was not used for the stock system because the same Jones Industrial Average futures contracts. $25 deducted for slip-
relationship wasn’t as clear. Also, the original position is smaller for page and commission per contract traded.
stocks, which makes trading in smaller and uneven-sized incre-
ments, i.e., thirds or quarters, etc., less feasible.) Starting equity: $1 million (nominal).

Rules: Test results: The system did not fare as well on futures as it did
1. Go long tomorrow on the open if a) today’s close is below both on individual stocks. However, there are a few reasons for this
yesterday’s close and the close of the previous week, b) yesterday’s that, when examined, make the results more understandable. (For
close is below the previous day’s
close and c) the close of the previous SAMPLE TRADES
week is below the close of the week
Dow Jones Industrial (DJ), daily 10,400.00
before that.
2. Exit one-third of the position with L-trail L-trail 10,200.00
a loss if the trade goes against you by L-trail
L-trail L-trail 10,000.00
1 percent. Go long
3. Exit one-third of the position with Go long 9,800.00
a profit if the trade goes your way by L-trail
Go long Go long 9,600.00
4 percent. Go long
4. Exit two-thirds of the position L-trail 9,400.00
with a profit or loss if the trade Go long 9,200.00
moves 1.6 percent away from your
Go short
maximum open profit (i.e., use a trail- Go long Go short 9,000.00
ing stop 1.6 percent away from the
8,800.00
high of the trade).
5. Exit two-thirds of the position L-trail 8,600.00
S-trail
with a profit if the trade goes your 8,400.00
way by 4.5 percent. L-trail
6. Exit the entire position after eight S-target 8,200.00
days in the trade. 8,000.00

Reverse the rules for short trades. 7,800.00

Go long
7,600.00
Money management: Risk 6 percent Go long
20 27 June 10 17 24 July 8 15 22 29 August
of available equity per market. The
Source: Omega Research ProSuite
number of contracts to trade (CT) is

7 www.activetradermag.com • November 2002 • ACTIVE TRADER

 DRAWDOWN CURVE aggressively, which also would have created smoother
1/1/93 1/1/94 1/1/95 1/1/96 1/1/97 1/1/98 1/1/99 1/1/00 1/1/01 1/1/02 equity growth.
0% Speaking of drawdown, note that both the maxi-
mum drawdown and flat time for the test period are
-5% not related to the current bear market. Instead, they are
both a function of the limited trading opportunities in
-10% the first part of the test period. Currently, the system is
in a 20-percent drawdown, and although that is signif-
-15%
icant, and much more than most traders can tolerate, it
is a far cry from the 80-plus percent decline in equity
-20%
for a buy-and-hold strategy in the Nasdaq 100 index.
-25%
Another way to improve the results could be to
trade it on other futures markets as well, such as the
-30% currencies, energies and interest rates. Because of the
system’s short-term nature, it is not suitable for agri-
-35% cultural commodities, which usually need longer
trends to produce profits large enough to justify trad-
one thing, the amazing results from the stock test make compar- ing (for non-professional traders).Ý
isons a little unfair.)
The equity chart reveals the results for the futures markets real-
ROLLING TIME WINDOW RETURN ANALYSIS
ly didn’t start to take off until late 1997 — almost halfway through
the testing period. The big reason for this is that up until late 1996, Cumulative 12 24 36 48 60
the S&P 500 was the only tradable market. Trading in the other two months months months months months
contracts didn’t begin until late 1996 (Dow) and late 1997 Most recent: -8.30% 20.77% 26.18% 75.15% 89.69%
(Nasdaq). If you look at only the second half of the test period, the Average: 9.10% 19.44% 31.22% 43.14% 55.41%
estimated average annual return would probably be almost twice Best: 52.95% 86.74% 101.76% 135.61% 147.21%
the 7.87 percent the complete system produced.
Worst: -15.56% -22.47% -25.96% -17.60% -6.38%
Adding other (foreign) stock indices to the mix probably would
St. dev.: 15.03% 26.07% 37.05% 44.71% 46.18%
have enhanced results even more by adding a bit of diversification,
which would have kept the drawdowns lower. Trading more mar-
Annualized 12 24 36 48 60
kets would also have allowed us to trade each market a little less months months months months months
Most recent: -8.30% 9.90% 8.06% 15.04% 13.66%
Average: 9.10% 9.29% 9.48% 9.38% 9.22%
STRATEGY SUMMARY
Best: 52.95% 36.36% 26.36% 23.89% 19.84%
Profitability Trade statistics Worst: -15.56% -11.95% -9.53% -4.72% -1.31%
End. equity ($): 2,067,431 No. trades: 1,258 St. dev: 15.03% 12.28% 11.08% 9.68% 7.89%
Total return (%): 107 Avg. trade ($): 849
Avg. annual ret. (%): 7.87 Avg. DIT: 3.4 LEGEND: Cumulative returns — Most recent: most recent return from start to
Profit factor: 1.17 Avg. win/loss ($): 15,166 (7,894) end of the respective periods • Average: the average of all cumulative returns
from start to end of the respective periods • Best: the best of all cumulative returns
Avg. tied cap (%): 3 Lrg. win/loss ($): 105,730 (57,373)
from start to end of the respective periods • Worst: the worst of all cumulative
Win. months (%): 48 Win. trades (%): 36.3 returns from start to end of the respective periods • St. dev: the standard devia-
Drawdown TIM (%): 70 28.1 tion of all cumulative returns from start to end of the respective periods
Max. DD (%): 30.4 Tr./Mark./Year: 21.9 Annualized returns — The ending equity as a result of the cumulative returns,
raised by 1/n, where n is the respective period in number of years
Longest flat (m): 44.6 Tr./Month: 10.9
Send Active Trader your systems
LEGEND: End. equity ($) — equity at the end of test period • Total return If you have a trading system or idea you’d like tested, send it to
(%) — total percentage return over test period • Avg. annual ret. (%) —
us at the Trading System Lab. We’ll test it on a portfolio of
average continuously compounded annual return • Profit factor — gross
stocks or futures (for now, maximum 60 markets, using the last
profit/gross loss • Avg. tied cap (%) — average percent of total available cap-
ital tied up in open positions • Win. months (%) — percentage profitable 2,500 trading days), using true portfolio analysis/optimization.
months over test period • Max. DD (%) — maximum drop in equity • Most system-testing software only allows you to test one mar-
Longest flat — longest period, in months, spent between two equity highs • ket at a time. Our system-testing technique lets all markets
No. trades — number of trades • Avg. trade ($) — amount won or lost by share the same account and is based on the interaction within
the average trade • Avg. DIT— average days in trade • Avg. win/loss ($) the portfolio as a whole.
— average winning and losing trade, respectively • Lrg. win/loss ($) — Start by e-mailing system logic (in TradeStation’s
largest winning and losing trade, respectively • Win. trades (%) — percent EasyLanguage or in an Excel spreadsheet) and a short description
winning trades • TIM (%) — amount of time there is at least one open posi- to editorial@activetradermag.com, and we’ll get back to you.
tion for entire portfolio, and each market, respectively • Tr./Mark./Year — Note: Each system must have a clearly defined stop-loss level
trades per market per year • Tr./Month — trades per month for all markets and a suggested optimal amount to risk per trade.

Disclaimer: The Trading System Lab is intended for educational purposes only to provide a perspective on different market concepts. It is not meant to recommend or
promote any trading system or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Past performance does not
guarantee future results; historical testing may not reflect a system’s behavior in real-time trading.

ACTIVE TRADER • November 2002 • www.activetradermag.com 8

 TRADING Strategies

Extreme OPEN-CLOSE days

Bars that close near their highs or lows can sometimes trick
traders into thinking follow-through price action is likely.
The following analysis incorporates the opening price and
a few simple risk-control and exit rules to capture
follow-through moves when they are most likely.

T
BY XAVIER MARIA RAJ

raders are always looking for clues regarding when of the day’s trading range (the high or low) and closes near the
a price move is likely to follow through vs. stop in other extreme of the day’s range. We’ll refer to these as strong-
its tracks. Short-term traders especially watch price closing and weak-closing bars. We’ll test these patterns to see
behavior during a given trading system to deter- what kind of price action typically follows them, and if they
mine whether to hold existing positions overnight or get out
before the close.
The relationships FIGURE 2 STRONG CLOSE DAYS
FIGURE 1 EXTREME BANDS between open and A strong-close day (SCD) opens in the lower band (the
The upper band is the top 10 percent close prices is often bottom 10 percent of a price bar) and closes in the
of the bar and the lower band is the used to gauge the upper band (the top 10 percent of the bar).
bottom 10 percent of the bar. An momentum during a
open or close that occurs in either of given trading peri- Russell 2000 index (RUT.X), daily
these bands can be considered to be od. For example, a 550.00
in an extreme of the bar’s range. bar that opens and
closes at roughly the
same price in the 545.00
Upper band — top 10% of bar middle of a trading
bar reflects balanced
trading during that 540.00
period. A bar that
follows several bars
with higher highs 535.00
and lows and opens
at a low price, trades
much higher, and 530.00
Strong close days
Lower band — bottom 10% of then closes back near
bar the open, might
imply the upside 525.00
momentum has
evaporated and a
downturn could be 520.00
imminent.
The patterns we
will analyze here 16 23
occur when price
Source: TradeStation Source: TradeStation
opens near one end

9 www.activetradermag.com • April 2005 • ACTIVE TRADER


can be used as the basis for a trading
strategy.
Strategy code
The following EasyLanguage code can be downloaded from the Active Trader
Strategy Code page at www.activetradermag.com/code.htm. Code for other
software platforms is also available.
Initial system test:

Defining strong and weak bars VAR:X(0),Y(0),R(0); R=RANGE;

The first step is to define what consti-
tutes strong- and weak-closing bars. To
do this, we’ll use “bands” that capture
the top and bottom 10 percent of a price
bar. The upper band is the top 10 per-
cent of the bar and the lower band is the
bottom 10 percent of the bar (see Figure
1). An open or close that occurs in either
of these bands can be considered to be in
an extreme of the bar’s range.
A strong-close day (SCD) opens in the
lower band and closes in the upper band
(Figure 2). Similarly, a weak-close day
(WCD) opens in the upper band and
closes in the lower band (Figure 3).
These days can be defined as follows:
Strong-close day (SCD) = Open <
(Low + Range/10) and Close > (High -
Range/10)
FIGURE 3 WEAK-CLOSE DAYS
IF C>H-((R/10)) AND O<L+((R/10)) THEN X=1 ELSE X=0;
IF C<L+((R/10)) AND O>H-((R/10)) THEN Y=1 ELSE Y=0;
IF X=1 THEN Buy Next Bar AT H+.05 STOP;
IF Y=1 THEN Sell Short Next Bar AT L-.05 STOP;
Sell This Bar AT C;
Buy to Cover This Bar AT C;
Revised system test:
VAR:X(0),Y(0),R(0); R=RANGE;
IF C>H-((R/10)) AND O<L+((R/10)) THEN X=1 ELSE X=0;
IF C<L+((R/10)) AND O>H-((R/10)) THEN Y=1 ELSE Y=0;
IF X=1 THEN Buy Next Bar AT H+.05 STOP;
IF Y=1 THEN Sell Short Next Bar AT L-.05 STOP;
Sell This Bar AT C;
Buy to Cover This Bar AT C;
Sell Next Bar AT MEDIANPRICE-.05 STOP;
Buy to Cover Next Bar AT MEDIANPRICE+.05 STOP;
Sell AT ("P1") Next Bar H+10 LIMIT;
Buy to Cover AT ("P2") Next Bar L-10 LIMIT;

A weak-close day (WCD) opens in the

upper band and closes in the lower band.
FIGURE 4 BASIC TRADE SIGNALS
Russell 2000 index (RUT.X), daily
In most cases, SCDs and WCDs were followed by price movement in the
expected direction.

Russell 2000 index (RUT.X), daily Exit

500.00

Exit 495.00
Exit

490.00

485.00
Buy Buy
480.00
Buy
475.00
Exit
Exit Exit
Short 470.00

Weak-close day 465.00

Short Buy
460.00
Buy
Exit Buy 455.00

450.00
Exit
July 7 14 21
21 28 Aug. 4 11 18 25
Source: TradeStation Source: TradeStation

ACTIVE TRADER • April 2005 • www.activetradermag.com 10

 TABLE 1 INITIAL TEST: RUSSELL 2000
For such a simple set of trading rules, the test results were surprisingly
good. Each market produced an average of six trades per month.
Trade rules
Performance summary: All trades Now we can design some simple rules
based on this pattern to test our hypoth-
Total net profit $361,845.97 esis:
Gross profit $641,972.50 Gross loss ($280,126.53)

Total # of trades 637 Percent profitable 70.49 1. Go long the day after an SCD with
Number winning trades 449 Number losing trades 188 a buy-stop order one tick above
the high of the SCD.
Largest winning trade $10,275.00 Largest losing trade ($12,200.00) 2. Go short the day after a WCD
Average winning trade $1,429.78 Average losing trade ($1,490.03) with a sell-stop order one tick
Ratio avg. win/avg. loss .96 Avg. trade (win & loss) $568.05 below the low of the WCD.
3. Exit all trades on the close.
Max. consec. winners 13 Max. consec. losers 5
Avg. # bars in winners 0 Avg. # bars in losers 0 The logic is simple: An extremely
Max. intraday drawdown ($21,050.02) strong or weak close implies further
Profit factor 2.29 Max. # contracts held 500 movement in that direction the follow-
Account size required $21,050.02 Return on account (%) 1,718.98 ing day, and a move beyond the range of
the SCD or WCD confirms the up or
Source: TradeStation down momentum.
Figure 4 (p. 10) shows the signals gen-
erated based on the strategy for the
TABLE 2 INITIAL TEST: S&P 400 Russell 2000 index (RUT.X). Notice this
period is dominated by rising prices,
The S&P 400 produced fewer trades than the Russell 2000 (482 vs. 637). It and there were more SCDs than WCDs.
had a lower (but still quite good) profit factor of 1.94 and a winning percent- For the most part, there was follow-
age of 64 percent. through in the expected direction after
both types of bars.
Performance summary: All trades

Total net profit $220,275.00 Initial test

Gross profit $454,375.00 Gross loss ($234,100.00) These basic rules were tested on the
Russell 2000 and S&P 400 Midcap
Total # of trades 482 Percent profitable 64.11 (MID.X) indices over 10 years of daily
Number winning trades 309 Number losing trades 173 data, from Jan. 1, 1994 to Aug. 29, 2003.
The results for the Russell 2000 are
Largest winning trade $9,150.00 Largest losing trade ($10,375.00) shown in Table 1 and the S&P 400 results
Average winning trade $1,470.47 Average losing trade ($1,353.18) are in Table 2.
Ratio avg. win/avg. loss 1.09 Avg. trade (win & loss) $457.00 The strategy yielded profit factors
Max. consec. winners 11 Max. consec. losers 5 (gross profits divided by gross losses) of
Avg. # bars in winners 0 Avg. # bars in losers 0 2.29 and 1.94 for the respective indices.
The total number of trades generated
Max. intraday drawdown ($24,525.00) were 637 for the Russell and 482 for the
Profit factor 1.94 Max. # contracts held 1 S&P 400, or approximately six and five
Account size required $24,525.02 Return on account (%) 898.17 trades per month, respectively. The win-
ning percentage was around 70 percent
Source: TradeStation for the Russell 2000 and 64 percent for
the S&P 400 Midcap, respectively.
Weak-close day (WCD) = Open > (High - Range/10) and These performance figures are quite respectable for such a
Close < (Low + Range/10) simple, easy-to-execute strategy — especially considering that
the parameters were unoptimized. Now let’s see if this basic
Strong-close days suggest demand was high from the begin- performance can be enhanced with additional risk-control and
ning of the trading session and continued to be robust until the profit-taking rules.
closing bell; weak-close days indicate selling pressure was
dominant from the start of the day until the close. Augmenting the approach
Let’s hypothesize that because demand or supply was solid We conducted a second test using simple stop-loss and price
through the end of the day, there will be some follow-through target rules. The stop-loss will be the midpoint of the SCD or
movement the day after an SCD or WCD. WCD, and the profit target will be 10 index points above the

11 www.activetradermag.com • April 2005 • ACTIVE TRADER

high of an SCD or below the low of a WCD:
Stop-loss for long trade = Midpoint minus one tick
Stop-loss for short trade = Midpoint plus one tick
Long target = High plus 10 points
Short target = Low minus 10 points
This trading approach could be applied without any help from
a computer, and it lends itself to further modification and
experimentation.
Testing across a wide range of markets and experimenting
with different upper and lower bands, stop-loss levels and
profit targets are excellent departure points.Ý

As was the case with the basic trading

rules, these values are representative and
have not been optimized. The definitions TABLE 3 ENHANCED SYSTEM TEST: RUSSELL 2000
and logic for the complete strategy are:
The winning percentage declined for the Russell 2000 (as it did for the S&P
D1 = Current day (the SCD or WCD) 400), but the profit factor increased.
D2 = Next day
Performance summary: All trades
H1 = High of current day
L1 = Low of current day Total net profit $446,884.48
M1 = Midpoint, or median price, of Gross profit $662,127.50 Gross loss ($215,243.02)
current day
Total # of trades 637 Percent profitable 68.45
1. Long Entry: On an SCD (D1) place Number winning trades 436 Number losing trades 201
a buy-stop order for the next Largest winning trade $4,975.50 Largest losing trade ($5,587.50)
day (D2) at the high (H1) plus one Average winning trade $1,518.64 Average losing trade ($1,070.86)
tick. Ratio avg. win/avg. loss 1.42 Avg. trade (win & loss) $701.55
2. Short Entry: On a WCD (D1) place
a sell-stop order for the next Max. consec. winners 13 Max. consec. losers 5
day (D2) at the low (L1) minus one Avg. # bars in winners 0 Avg. # bars in losers 0
tick.
3. Long Exit: Place a stop-loss order Max. intraday drawdown ($14,725.52)
at the median price (M1) minus Profit factor 3.08 Max. # contracts held 500
one tick. Account size required $14,725.52 Return on account (%) 3,034.76
4. Short Exit: Place a stop-loss order Source: TradeStation
at the median price (M1) plus one
tick.
5. Long Target: Place a limit sell TABLE 4 ENHANCED SYSTEM TEST: S&P 400
order at the high (H1) plus 10
points. Despite the lower winning percentage for both indices, the strategy was
6. Short Target: Place a limit buy more efficient: It produced more profit with lower drawdown.
order at the low (L1) minus 10
points. Performance summary: All trades

Total net profit $245,312.50

The performance for the two indices
Gross profit $448,075.00 Gross loss ($202,762.50)
after incorporating these stop-loss and
target rules are shown in Tables 3 and 4. Total # of trades 482 Percent profitable 61.83
Notice that although the winning per- Number winning trades 298 Number losing trades 184
centages for each index declined (but
both remained about 60 percent), their Largest winning trade $4,975.00 Largest losing trade ($8,875.00)
respective profit factors increased to 3.08 Average winning trade $1,503.61 Average losing trade ($1,101.97)
and 2.21, indicating the strategy became Ratio avg. win/avg. loss 1.36 Avg. trade (win & loss) $508.95
more efficient. Also notice the maximum
Max. consec. winners 11 Max. consec. losers 5
drawdowns decreased in both cases. The
Avg. # bars in winners 0 Avg. # bars in losers 0
number of trades remained the same.
Max. intraday drawdown ($13,725.00)
Simplicity and room Profit factor 2.21 Max. # contracts held 1
for experimentation Account size required $13,725.00 Return on account (%) 1,787.34
As is often the case, a simple trading
idea produced some favorable results. Source: TradeStation

12 www.activetradermag.com • April 2005 • ACTIVE TRADER

 The Fibonacci SWING FILTER
TRADING Strategies

One way to filter market noise and focus on tradable price

moves is to gauge price swings in terms of retracement
percentages. This approach creates an adaptive trading

P
system that adjusts to the market’s behavior.

BY G. VETRIVEL

rices move every second of every day, which term price fluctuations are removed from the data; the shorter
means many, if not most, market fluctuations rep- the lookback period (e.g., 10 bars), the shorter the trend the
resent random “noise” rather than meaningful average reflects.
price moves. No matter how short the time frame Similar logic applies to defining Fibonacci price swings. A
a trader operates on, some price action is simply irrelevant. breakout above or below the range of a Fibonacci-defined price
The challenge is finding a way to filter out noise and identi- swing — for example, a 38.2-percent retracement of a previous
fy tradable price moves in your chosen time horizon. There are move — can be considered the end of an existing trend or the
many ways to accomplish this. Some traders require an initial beginning of a new trend, the magnitude of that trend being
trade setup to be validated by a secondary rule, or filter, before dependent on the size of the price swings. This logic allows us
acting upon the signal. Other traders approach the problem at to objectively determine market tops and bottoms.
the source and attempt to smooth price data itself, so they This technique does not attach any particular significance to
apply trading approaches to data that has already had its a single Fibonacci ratio and it does not have a fixed lookback
“noise” removed. period, as does a moving average. The ratios (which can change
The method outlined here presents a way to smooth data for each bar) are determined by the current market conditions,
using Fibonacci-based price moves. This process consists of which makes the Fibonacci-swing approach an adaptive
defining a price-swing structure that filters out shorter-term smoothing technique. Also, this approach avoids the problem
price fluctuations so you react only when a trend of significant of lag that affects all moving averages (the longer the average,
magnitude changes direction. the longer it takes to respond to changes in price direction).
This Fibonacci-swing technique will
be illustrated using a simple stop-and-
reverse (SAR) strategy, which means FIGURE 1 DEFINING A TOP AND GOING SHORT
when a long position is exited a new Bar 1 is the new high and a short trade is triggered when the current bar
short position is simultaneously estab- (Bar 0) falls below the 50-percent level of Bar 2.
lished, and vice versa. The strategy will
then be tested on eight years of daily Russell 2000 E-mini (ER), daily
price data in four stock indices. 1
2 595
Defining price swings with
0
38.2%
Fibonacci ratios 590
The most common tool for smoothing 50%
price data is the moving average, which
traders use to define trends and issue 585
trade signals. For example, if price
moves above a moving average, the 580
trend is considered up, while the oppo-
site is true when price falls below the
575
moving average.
The degree to which the data is
smoothed and the length of the trend 570
depends on how long the moving aver- Bottom
age is: The longer the lookback period 9 23 March 8 15 22 29
(e.g., 100 bars), the longer the trend the
Source: TradeStation
average represents and the more short-

13 www.activetradermag.com • February 2005 • ACTIVE TRADER

 FIGURE 2 DEFINING A BOTTOM AND GOING LONG

Bar 1 is the new low and a long trade occurs when Bar 0 rises above the 38.2-
percent retracement level of Bar 2 (measured from the bottom of Bar 2).

Calculating Fibonacci price swings Russell 2000 E-mini (ER), daily 520

The rules for calculating Fibonacci A Top

515
swings for determining tops and bot-
toms use the following definitions: 510
• Current bar = Bar 0; previous bar =
Bar 1, etc. 505
• Fibonacci ratios used: 23.6 percent,
38.2 percent, 50 percent, 61.8 percent, 38.2% 500
78.6 percent and 87.5 percent. 23.6% 495
• Pairs of consecutive retracement 2
percentages are always used to define 490
1 0
price swings — i.e., 23.6 percent and 38.2
percent, 38.2 percent and 50 percent, etc. Bottom 485
Pairing 23.6 percent and 50 percent
would be incorrect, for example.
19 May 6 13 20 27 June 10 17
Defining a top/beginning of a down
swing: If Bar 1 retraces between 38.2 and Source: TradeStation
50 percent of Bar 2’s range (measured
downward from Bar 2’s high), and the TABLE 1 S&P 500 TEST RESULTS
low of Bar 0 is below the 50-percent level
The tests produced an average of nearly 700 trades per market over eight
(the midpoint) of Bar 2’s range, then the
years of daily data, which lends credibility to the results.
highest high between the previous bot-
tom and Bar 0 (including Bar 0) is a top. Performance summary: All trades
Other retracement ratios are applied
Total net profit $662,375 Open position P/L $775
in a similar fashion. For example, if Bar 1
Gross profit $1,668,640 Gross loss $1,006,265
retraces between 50 and 61.8 percent of
Total number of trades 771 Percent profitable 44.36%
Bar 2, and the low of Bar 0 is below the
Number of winning trades 342 Number of losing trades 429
61.8-percent level of Bar 2’s range (meas-
ured downward from Bar 2’s high), then Largest winning trade $34,225 Largest losing trade $8,550.00
the highest high between the previous Average winning trade $4,879.06 Average losing trade $2,345.60
bottom and Bar 0 is a top. The same Ratio avg. win/avg. loss 2.08 Average trade (win and loss) $859.11
approach would be used for 23.6 percent Max. consecutive winners 6 Max. consecutive losers 8
and 38.2 percent, and so on. Avg. number of bars in winners 4 Avg. number of bars in losers 1
Figure 1 shows how a top is defined Max intraday drawdown $39,665
using this technique. The low of Bar 1 Profit factor 1.66 Max. number of contracts held 1
retraces between 38.2 and 50 percent of Account size required $39,665
Bar 2’s range, and Bar 0’s low is below
the level of a 50-percent retracement of Source: TradeStation
Bar 2. The top is the highest high
between the previous bottom and Bar 0 (including Bar 0), Entry and exit rules
which means Bar 1’s high is the top. The following rules are for the Fibonacci-swing trading system
These rules are reversed to define lows. we will test on different stock indices:
Defining a bottom/beginning of an up swing: If Bar 1 1. Enter long/exit short if Bar 0’s high is above the 38.2-per-
retraces between 38.2 and 50 percent of Bar 2’s range (meas- cent level but below the 50-percent level of Bar 1’s range. Place
ured upward from Bar 2’s low), and the high of Bar 0 is above a buy-stop order to exit the existing short position and enter
the 50-percent level of Bar 2’s range, then the lowest low long at the 50-percent level of Bar 1’s range.
between the previous top and Bar 0 is a bottom. Repeat these calculations for the different percentage pairs
Similarly, if Bar 1 retraces between 50 and 61.8 percent of Bar to determine the range that captures the current retracement.
2, and the high of Bar 0 is above the 61.8-percent level of Bar 2’s 2. Enter short/exit long if Bar 0’s low is below the 61.8-per-
range (measured upward from Bar 2’s low), then the lowest cent level but above the 50-percent level of Bar 1’s range. Place
low between the previous top and Bar 0 is a bottom. a sell-stop order to exit the existing long position and enter
Figure 2 (p. 14) shows the identification of a bottom using short at the 50-percent level of Bar 1’s range.
23.6 and 38.2 Fibonacci percentages: The high of Bar 1 retraced Repeat these calculations for the different percentage pairs
between 23.6 percent and 38.2 percent of Bar 2 and the high of to determine the range that captures the current retracement.
Bar 0 retraced more than 38.2 percent of Bar 2. The bottom is 3. Special outside bar condition: If there is an outside bar (a
the lowest low between the previous top (Bar A) and Bar 0. As bar with a high above the previous high and a low below the
a result, the low of Bar 1 is the bottom. previous low) or a gap bar (a low above the previous high or a
Note: There cannot be two consecutive bottoms or tops. high below the previous low), place the buy-stop order at the
high or the sell-stop order at the low.

ACTIVE TRADER • February 2005 • www.activetradermag.com 14

 TABLE 2 RUSSELL 2000 TEST RESULTS

The Russell 2000 posted the highest profit factor and winning percentage of
all the indices.
If the stop-orders are not hit the next
day, the appropriate percentage pairs are Performance summary: All trades
calculated on that day’s bar and new Total net profit $2,664.37 Open position P/L $5.06
orders are placed accordingly. For each Gross profit $3,807.75 Gross loss $1,143.38
bar, the system checks to see which per- Total number of trades 690 Percent profitable 52.03%
centage pair applies to the current Number of winning trades 359 Number of losing trades 331
retracement. As a result, the percentages
Largest winning trade $84.44 Largest losing trade $16.53
can change from bar to bar — e.g., 38.2-
Average winning trade $10.61 Average losing trade $3.45
and 50-percent one day, 50- and 61.8-per-
Ratio avg. win/avg. loss 3.07 Average trade (win and loss) $3.8614
cent the next and so on.
When the price swing is moving up, Max. consecutive winners 11 Max. consecutive losers 6
ratios are calculated from the high to Avg. number of bars in winners 4 Avg. number of bars in losers 1
determine the long exits and short Max intraday drawdown $42.64
entries. Similarly, ratios are calculated Profit factor 3.33 Max. number of contracts held 100
from the low to determine the short exits Account size required $42.64
and long entries.
Source: TradeStation
Trade examples and test results
Returning to Figure 1 (p. 13), because the low of Bar 1 retraced spanned eight years of daily price data –– from Jan. 1, 1997 to
between 38.2 and 50 percent of Bar 2 (measured from the top of Oct. 25, 2004.
Bar 2 down), enter a sell-stop order at the 50-percent level of The performance in these tables indicates the strategy is
Bar 2. robust: It has a winning percentage rate of at least 40 percent,
In Figure 2 (p. 14), because the high of Bar 1 retraced an average win/loss ratio of 2 and profit factor (gross prof-
between 23.6 percent and 38.2 percent of Bar 2 (measured from it/gross loss) of 1.55 in all indices, except the Russell 2000,
the bottom of Bar 2 up), enter a buy-stop order at the 38.2-per- which had exceptionally good performance and a profit factor
cent level of Bar 2. of 3.33. Slippage and commission charges were not included.
Because this is a stop-and-reverse strategy, the reverse The strategy produced more than 700 trades on average in
orders act as trailing stops for the current positions. each index — more than 2,800 trades total. The high number of
Tables 1, 2 , 3 and 4 show the results of tests conducted on trades adds credibility to test results — confidence in future
the S&P 500 (SPX), Russell 2000 (RUTX), NIFTY (Indian NSE results is directly related to the number of samples in testing.
Index), and Dow Jones Industrial Average (INDU). The test By comparison, positive results for a long-term trend-following

System code
The following TradeStation EasyLanguage code for the Fibonacci stop-and-reverse system can be copied at
www.activetradermag.com/code.htm.

if l>=h[1] then Sell Short Next Bar at l-.05 stop;

if l<h[1] and l>=h[1]-(h[1]-l[1])*.236 then Sell Short Next Bar at h[1]-(h[1]-l[1])*.236 -.05 stop;
if l<h[1]-(h[1]-l[1])*.236 and l>=h[1]-(h[1]-l[1])*.382 then Sell Short Next Bar at h[1]-(h[1]-l[1])*.382-.05 stop;
if l<h[1]-(h[1]-l[1])*.382 and l>=h[1]-(h[1]-l[1])*.5 then Sell Short Next Bar at h[1]-(h[1]-l[1])*.5-.05 stop;
if l<h[1]-(h[1]-l[1])*.5 and l>=h[1]-(h[1]-l[1])*.618 then Sell Short Next Bar at h[1]-(h[1]-l[1])*.618-.05 stop;
if l<h[1]-(h[1]-l[1])*.618 and l>=h[1]-(h[1]-l[1])*.786 then Sell Short Next Bar at h[1]-(h[1]-l[1])*.786-.05 stop;
if l<h[1]-(h[1]-l[1])*.786 and l>=h[1]-(h[1]-l[1])*.875 then Sell Short Next Bar at h[1]-(h[1]-l[1])*.875-.05 stop;
if l<h[1]-(h[1]-l[1])*.875 and l>l[1] then Sell Short Next Bar at l[1]-.05 stop;
if l<=l[1] then Sell Short Next Bar at l-.05 stop;

if h<=l[1] then Buy Next Bar at h+.05 stop;

if h>l[1] and h<=l[1]+(h[1]-l[1])*.236 then Buy Next Bar at l[1]+(h[1]-l[1])*.236+.05 stop;

if h>l[1]+(h[1]-l[1])*.236 and h<=l[1]+(h[1]-l[1])*.382 then Buy Next Bar at l[1]+(h[1]-l[1])*.382+.05 stop;
if h>l[1]+(h[1]-l[1])*.382 and h<=l[1]+(h[1]-l[1])*.5 then Buy Next Bar at l[1]+(h[1]-l[1])*.5+.05 stop;
if h>l[1]+(h[1]-l[1])*.5 and h<=l[1]+(h[1]-l[1])*.618 then Buy Next Bar at l[1]+(h[1]-l[1])*.68+.05 stop;
if h>l[1]+(h[1]-l[1])*.618 and h<=l[1]+(h[1]-l[1])*.786 then Buy Next Bar at l[1]+(h[1]-l[1])*.786+.05 stop;
if h>l[1]+(h[1]-l[1])*.786 and h<=l[1]+(h[1]-l[1])*.875 then Buy Next Bar at l[1]+(h[1]-l[1])*.875+.05 stop;
if h>l[1]+(h[1]-l[1])*.875 and h<h[1] then Buy Next Bar at h[1]+.05 stop;
if h>=h[1] then Buy Next Bar at h+.05 stop;

15 www.activetradermag.com • February 2005 • ACTIVE TRADER

 TABLE 3 NIFTY INDEX TEST RESULTS
One downside is that maximum consecutive losers outnumbered maximum
consecutive winners in three of the four tests.

strategy that produces only 50 trades Performance summary: All trades

over eight years of data will not be near- Total net profit $3,887.18 Open position P/L $28.55
ly as reliable as the statistics shown here. Gross profit $10,590.52 Gross loss $6,703.35
Total number of trades 729 Percent profitable 43.48%
Smooth sailing Number of winning trades 317 Number of losing trades 412
This technique is not the only way to Largest winning trade $195.60 Largest losing trade $88.05
smooth data, but all smoothing or filter- Average winning trade $33.41 Average losing trade $16.27
ing methods share the same goal — to Ratio avg. win/avg. loss 2.05 Average trade (win and loss) $5.33
isolate the tradable moves in a market on Max. consecutive winners 6 Max. consecutive losers 12
the time frame you wish to trade.Ý Avg. number of bars in winners 4 Avg. number of bars in losers 1
Max intraday drawdown $744.78
Profit factor 1.58 Max. number of contracts held 1,000
Account size required $744.78

Additional reading Source: TradeStation

The following articles have more

information about Fibonacci num- TABLE 4 DOW JONES INDUSTRIAL AVERAGE TEST RESULTS
bers:
The average winning trade/losing trade ratio was 2.00 for all four tests.
“Technical Tool Insight: Performance summary: All trades
Fibonacci ratios”
Total net profit $17,416.55 Open position P/L $132.67
(Active Trader, April 2002, p. 78).
Gross profit $52,101.54 Gross loss $34,684.98
This is a more detailed primer on
the Total number of trades 767 Percent profitable 43.02%
properties of Fibonacci numbers. Number of winning trades 330 Number of losing trades 437
Largest winning trade $1,423.27 Largest losing trade $337.60
“Absolute price projections” Average winning trade $157.88 Average losing trade $79.37
by Tom DeMark and Rocke DeMark Ratio avg. win/avg. loss 1.99 Average trade (win and loss) $22.71
(Active Trader, July 2004, p. 38). Max. consecutive winners 6 Max. consecutive losers 10
This article explores the authors’ Avg. number of bars in winners 4 Avg. number of bars in losers 1
unique application of Fibonacci Max intraday drawdown $1,253.21
ratios to determine potential price Profit factor 1.50 Max. number of contracts held 100
targets. Account size required $1,253.21 Return on account 1,389.76%

Source: TradeStation

The Fibonacci series

T he Fibonacci series is a number progression in which

each successive number is the sum of the two immedi-
ately preceding it: 1, 2, 3, 5, 8, 13, 21, 34 and so on.
As the series progresses, the ratio of a number in the
series divided by the immediately preceding number
approaches 1.618, a number that is attributed significance
by many traders because of its appearance in natural phe-
nomena (the progression of a shell’s spiral, for example, as
well as in art and architecture, including the dimensions of
the Parthenon and the Great Pyramid). The inverse, .618
(.62), has a similar significance.
Some traders use fairly complex variations of Fibonacci num-
ber to generate price forecasts, but a basic approach is to use
ratios derived from the series to calculate likely price targets.
For example, if a stock broke out of a trading range and
rallied from 25 to 55, potential retracement levels could be
calculated by multiplying the distance of the move (30
points) by Fibonacci ratios — say, .382, .50 and .618 — and
then subtracting the results from the high of the price move.
In this case, retracement levels of 43.60 [55 - (30*.38)], 40
[55 - (30*.50)] and 36.40 [55 - (30*.62)] would result.
Similarly, after a trading range breakout and an up move
of 10 points, a Fibonacci follower might project the size of
the next leg up in terms of a Fibonacci ratio — e.g., 1.382
times the first move, or 13.82 points in this case.
The most commonly used ratios are .382, .50, .618, .786,
1.00, 1.382 and 1.618. Depending on circumstances other
ratios, such as .236 and 2.618, occasionally are used.

16 www.activetradermag.com • February 2005 • ACTIVE TRADER

FUTURES & OPTIONS
Trading Strategies
Trading the OPENING
Watching pre-market volume is a good way to determine whether
to trade or fade the opening move.
O
BY JOHN CARTER
pening price gaps — the
distance between the reg-
ular-session opening price
and the previous day’s
closing price — are stomach-churning
events when the market makes a big
move against you, but they represent
low-risk trade opportunities if you know
which gaps are likely to be followed by
predictable patterns.
In terms of the price behavior that fol-
lows opening gaps, not all markets are
created equal. Gaps in individual stocks
TABLE 1 FILLING THE OPENING
GAP: RAW DATA
Between Jan. 15, 2002, through
February 2004 (528 occurrences),
an average of 76 percent of all
opening gaps closed at some point
during the same day. This is the
breakdown by day of week. Adding
the pre-market volume filter
increased the percentages.
Percentage of
Day gaps filled
Monday 65%
Tuesday 77%
Wednesday 79%
Thursday 82%
Friday 78%
Source: Tradethemarkets.com
17
GAP
and commodities do not act the same as
those in “multi-item” instruments such
as stock indices because a news item will
control the entire market instead of just a
portion of it. Earnings announcements,
corporate scandals and other company-
specific events can create gaps in a com-
ponent stock’s chart that never get filled.
Because of the unpredictable nature of
various events that can impact the price
of an individual stock, they make poor
candidates for the opening-gap trade.
In contrast, stock index futures such as
the E-mini S&P (ES) or the mini-sized
Dow (YM) are better candidates for
opening-gap plays because they consist
of multiple components that respond dif-
ferently to news. For example, although a
stock index futures contract may gap up
on a news item, there will be individual
stocks within the index that will either
ignore the news or sell off. This weighs
the index down and creates a trade
opportunity as the market fills the gap.
The best markets for gap plays
The S&P 500 and the Dow are the best
TABLE 2 TRADE MANAGEMENT GUIDELINES
The higher the volume, the greater the likelihood the market will continue
in the direction of the opening gap. As a result, no trade is taken when vol-
ume is above 70,000.
Pre-market volume
in key stocks Position size
Less than 30,000 Full size
Between 2/3 size
30,000 and 70,000
Above 70,000 No “fade” trade
Source: Tradethemarkets.com
www.activetradermag.com • December 2004 • ACTIVE TRADER
markets to trade the opening gap
because of the diversity of their compo-
nent stocks. Both indices represent collec-
tions of stocks from different industries
that are more likely to react independent-
ly to news events. In the technology-
heavy Nasdaq, opening price gaps can
take longer to fill because the majority of
the stocks will react similarly to news.
The key to trading opening gaps is
being able to predict the likelihood a
particular gap will be filled. Dissecting
the market conditions that produce a
gap is as important as analyzing a gap
itself. For example, an opening gap fol-
lowing high pre-market cash trading
volume can take weeks to get filled
because high volume increases the odds
the market will continue to move in the
direction of the gap.
Some of the biggest gaps are caused
by major news events, such as the out-
break of a war, but gaps caused by minor
news items are much more common.
Generally, such gaps are smaller, fill
quickly (see Table 1) and can be “faded”
(the act of trading against the direction
Trade target
Exit entire position at gap fill
Exit half at 50 percent of gap
fill, half at gap fill
No “fade” trade
of the gap) more effectively. Let’s look at
the specific criteria for identifying those
gaps with the best chances of reversing.
The pre-market volume indicator
The most important indicator for deter-
mining which opening gaps can be
faded is the pre-market volume in a spe-
cific set of stocks.
Check the pre-market volume at 9:20
a.m. ET (10 minutes before the regular
cash session opens) in the following
stocks: KLA-Tencor Corporation (KLAC),
Maxim Integrated Products, Inc. (MXIM),
Novellus Systems, Inc. (NVLS) and
Applied Materials, Inc. (AMAT). These
representative stocks were selected
through a trial-and-error process.
If the market is really set up to move,
there will be significant volume in the
cash market in pre-market trading. If the
market is setting up for a “head fake” (a
move in one direction that is quickly
reversed), pre-market volume will be
low, which reflects a lack of conviction in
the move. This is the preferred setting
for an opening-gap trade.
If the pre-market stocks have each
traded less than 30,000 shares at this
time, analysis of the prior 500 trading
days shows the opening gap, up or
down, had an 80-percent chance of fill-
ing the same day. However, if the vol-
ume for each stock is between 30,000 and
70,000, the gap only has about a 60-per-
cent chance of filling that day, while the
midpoint of the gap has an 85-percent
chance of being hit.
Finally, if the pre-market volume for
each stock is above 70,000, the chances of
the gap filling that day drop to 30 per-
cent. In these cases, you should ignore
the news and follow the direction of the
gap. Table 2 provides guidelines for
using volume information to manage
trades. As the volume increases, the
position size shrinks and the profit-tak-
ing becomes more conservative.
If one stock has volume above 70,000
but the others are below the threshold,
check to see if the news pertains to this
company alone. If it does, ignore it. If the
news is not specific to the company,
trade the more conservative position.
ACTIVE TRADER • December 2004 • www.activetradermag.com
of a positive earnings report from Intel
The strategy (INTC). On this day, pre-market volume
Figure 1 is a five-minute chart of the was below 30,000.
mini Dow futures. You can use any time As a result, the appropriate trade is to
interval — a one-minute, five-minute or immediately short the gap on the open
15-minute chart, etc. — as long as you using a full position size, as indicated in
can view the opening. This means the Table 2. To keep things simple, we’ll use
chart must be set up to reflect the open- nine contracts as a full position, which
ing and closing of the regular trading makes a two-thirds position six contracts
session, 9:30 a.m. to 4 p.m. ET (4:15 p.m. and a one-third position three contracts.
for stock index futures prices). Many We will use a $100,000 account, which
traders are used to watching a separate means we are trading one contract for
chart of the continuous 24-hour futures each $11,100 in the account for a full posi-
session, but of course, opening gaps tion. Although you can trade a mini Dow
FIGURE 1 THE OPENING GAP
This 47-point-plus opening gap in the mini Dow futures was filled in the first
hour of trading for a $235 per-contract profit.
9,830
Mini Dow futures (YM), five minute
9,820
Gap is filled for a 47-point
9,810
gain, or $235 per contract
(47 points x $5 per point). 9,800
9,790
9,780
9,770
9,760
9,750
9,740
9,730
9,720
9,710
10/15/03 9,700
11:00 12:00 13:00 14:00 15:00 9:00 10:00
Source: eSignal
won’t show up. or E-mini S&P contract with only a few
Figure 1 shows the first day in a set of thousand dollars, this trading plan con-
back-to-back earnings announcements trols risk by limiting exposure relative to
that caused opposite reactions in the the amount of available capital.
market. On the morning of Oct. 15, 2003, Use a 1:1.5 reward/risk ratio (risking
the Dow gapped up 47 points as a result 1.5 points to make 1 point) for gap trades
18
 FUTURES & OPTIONS
Trading Strategies continued

FIGURE 2 THE DAY AFTER

that are less than 40 mini Dow points or
One day after the trade setup shown in Figure 1, the mini Dow contract 4 E-mini S&P points. For gaps larger
opened lower, setting up a long trade. than these, use a 1:1 reward/risk ratio. In
9,800 the case of Figure 1, we would risk 47
Mini Dow futures (YM), five minute
points to make 47 points. If the gap had
been 30 points, we would risk 45 points.
9,790
Some traders might question an
Gap filled for a 61-point
approach that risks more than the poten-
gain, or $305 per contract. 9,780 tial profit. Most beginning traders are
taught to use a 3:1 reward/risk ratio,
9,770 risking 1 point to gain 3. They inevitably
wonder why they are repeatedly
stopped out just before the market
9,760
turns. In general, wider stops produce
more winning trades; the key is to trade
9,750 only those setups with a better than 80-
percent chance of winning.
9,740 The market sold off immediately after
the bell, filling the opening gap within
9,730
an hour. Ironically, the next day IBM
came out with a disappointing earnings
report, knocking the market down on
9,720 the open. Figure 2 shows the resulting
buy setup had just a small open loss at
9,710 one point, although many traders might
have been stopped out on the pullback
9,700 around 11 a.m. ET. However, keep in
10/16/03
mind the strategy is to maintain a
15:00 9:00 10:00 11:00 12:00 13:00 14:00 reward/risk ratio of 1:1, not to tighten
Source: eSignal your stop when the market moves in
your favor. If the stop had been hit,
FIGURE 3 EMOTIONS TRIGGER GAP the loss would have been approxi-
mately $305 per contract ($2,745 for
The E-mini S&P futures made a downside opening gap on Aug. 2, 2004, on terrorist the nine-contract full position), not
threats. The market spent most of the day filling the gap. including slippage and commis-
sions. This loss is reasonable because
E-mini S&P 500 continuous contract (ES), five minute 1,106 of the 80-percent success rate of the
setup.
Close on 7/30/04: 1,105 Using a tighter initial stop or trail-
1,103.75 ing stop would have turned this
1,104
position into a losing trade or, at
best, a breakeven trade. Using the
1,103
risk parameters designed for this
1,102
trade setup allowed the position to
remain open until the gap was filled
1,101 for a gain of 61 points. As a rule,
using a trailing stop will negatively
1,100 affect the gap trade’s win/loss ratio.
When the trade is executed, the
1,099 best thing a trader can do is to walk
away and let the orders do their
1,098 work. This is the difference between
professionals and amateurs: Pro-
1,097 fessionals won’t second-guess a trad-
Open on 8/2/04: ing methodology, while amateurs are
1,097.00 1,096 constantly adjusting.

Ignore the reasons for the gap

14:45 15:05 15:25 15:45 8/2 10:00 10:20 10:40 11:00 11:20 11:40 12:00 12:20 12:40 13:00 13:20 13:40

Source: TradeStation
The size or cause of a gap has little

19 www.activetradermag.com • December 2004 • ACTIVE TRADER

 FIGURE 4 MULTIPLE GAPS
impact on whether or not it will be
filled. Figure 3 shows an example The first opening gap on this chart — which remained unfilled for the next six days —
of emotions triggering an opening set up a short trade that was stopped out for a loss. Subsequent opening gap trades
price gap when, on Aug. 2, the were more successful.
market gapped down on the open 9,500
Mini Dow September futures (YMU04), 15 minute
because the U.S. government
issued a terror warning the previ- 9,480
Gap of +62 points
ous day. There were rumors of a Gap of -52 points fills in 6 bars
plan to blow up a large financial fills in 9 bars 9,460
institution.
However, after a choppy first Short break of bear 9,440
Gap of +13 points
flag. Target is gap
half of the day, the market firmed, fills in 1 bar
from 8/18 9,420
shorts got nervous and started cov-
ering, and the gap was filled by
9,400
1:30 p.m. ET for a 6.75-point S&P E-
mini profit ($337.50 per contract). 9,380

Relax and trade 9,360

Figure 4 shows a 15-minute chart Gap of +44 points fills in 9 bars
of the September mini Dow futures 9,340
(YMU04) with an opening gap on
Aug. 18 that did not get filled for 9,320
six trading days. (Other opening
gaps occurred before price eventu- 9,300
ally filled the first gap.) On this Gap on 8/18 of +44 points
fills on 8/25 9,280
day, the mini Dow gapped up a
modest 44 points prior to the
release of some economic numbers. 8/18 13:15 8/19 11:45 14:15 8/20 12:45 8/21 13:45 8/22 12:15 8/25 13:15 8/26
The pre-market volume was mod- Source: TradeStation
est, between 30,000 and 70,000
shares for the key stocks, so the “cautious upside earnings revisions.” the rest of the day trending lower, filling
appropriate step was to short a two- The market exploded to the upside and the gap and resulting in an 88-point gain,
thirds-size position on the open. gapped right above key resistance. The or $440 per contract ($3,960).
The market rallied, sold off a little just trade was to short the 62-point gap with
prior to the economic numbers, and then a full-size position. Six bars later, the tar- A brief window of opportunity
shot higher once the numbers were get was hit for a 62-point profit, or $310 The market’s nature is to prevent as
released. Using the 1:1 reward/risk ratio per contract ($2,790). many people as possible from consis-
resulted in a 44-point stop. The market During the afternoon session, the mar- tently making money, which is why it is
never retraced to the gap’s midpoint ket traced out a bear flag pattern. With crucial for a trader to follow rules for
level (where half the position could be the opening gap under the market still each type of trade setup.
covered), and instead rallied right unfilled, the trade was to place a sell stop Gaps are the one moment of the trad-
through the stop, producing a loss of at 9,392 to let the trend of the market ini- ing day where everyone has to show
$220 per contract. For a two-thirds posi- tiate the trade based on a breakdown of their poker hand, and this creates a big
tion (six contracts) the loss was $1,320. the flag. The entry stop was filled and the advantage for short-term traders.
This move left an open gap below the risk point for the trade was above intra- Understanding the dynamics behind
market. The next day the market opened day resistance at 9,455. The target was the opening gaps is paramount to trading
modestly lower, triggering a long trade Aug. 18 gap at 9,304. The market spent them successfully.Ý
that resulted in a quick $65-per-contract
profit ($585 total). The following day the
market opened 52 points lower and Related Active Trader articles
filled the gap a few hours later for a “Trading the overnight gap” by David Nassar, March 2001, p. 66
$260-per-contract profit ($2,340). The
next day, the market gapped up 44 “Morning reversal strategy” by Bryan C. Babcook and Arthur Agnelli,
points, triggering a short trade that came May 2003, p. 36
close to the stop-loss point, but eventual- “Technical Tool Insight: Gaps,” April 2003, p. 82
ly filled the gap for a $255-per-contract
“Technical Tool Insight: Islands,” August 2002, p. 82
profit ($2,295). All these gaps followed
light pre-market volume, so they were You can purchase past articles online at www.activetradermag.com/
executed with full positions. purchase_articles.htm and download them to your computer.
On Aug. 22, 2003, Intel announced

ACTIVE TRADER • December 2004 • www.activetradermag.com 20

 MARKET History

HITTING THE STREET:

The S&P 500 futures’ intraday reactions
to economic reports
Highly anticipated economic news can send the market on a wild ride.
This study looks at intraday patterns in the S&P E-mini surrounding FOMC
announcements and the monthly job, CPI, GDP, and ISM reports.

FIGURE 1 ANNOUNCEMENT-DAY PRICE MOVES

The S&P 500 index tends to climb in reaction to monthly ISM releases and FOMC inter-
est-rate announcements, but it sank as the employment, GDP, and CPI reports hit the
Street.

T
Average S&P 500 announcement-day performance (open to close), 2000 to 2005
0.50
BY DAVID BUKEY 0.40
0.30
Average gain/loss (%)

0.20
rading off econom- 0.10
ic reports can be 0.00
frustrating because -0.10
the market’s reac-
-0.20
tion to a bullish or bearish
release is often unpredictable or -0.30
short-lived. Initial rallies or sell- -0.40
offs can be quickly reversed
Overall ISM (61 reports)
ISM increases (27)
ISM decreases (32)

Overall CPI (61 reports)

Overall scheduled Fed

Overall GDP (61 reports)

Daily benchmark

Overall employment (61 reports)

Positive employment reports (11)
Negative reports (11)

GDP increases (31)

GDP decreases (24)

CPI increases (49)

Flat or dropping CPI (12)
announcements (41)
Fed rate changes (19)
Unchanged rates (22)

because detailed economic

releases take time to interpret.
To pinpoint how the market
tends to anticipate and respond
to major economic releases, we
focused on the announcement
days of five economic reports —
Fed interest-rate decisions,
employment, Consumer Price
Index (CPI), Gross Domestic
Product (GDP), and the Institute of E-mini trades nearly 24 hours a day, announcement day for all five reports.
Supply Management’s (ISM) manufac- allowing us to measure the market’s ini- Comparing the S&P’s pre-announce-
turing index. tial reaction to the employment, CPI, ment price moves to its reaction to these
The analysis measured the S&P 500 and GDP reports, which are released an reports revealed several compelling pat-
index’s performance on these days over hour before the equities markets open. terns. However, before we dig into intra-
the past five years and also tracked the (For brief descriptions of each report, see day tendencies, here’s a look at how the
intraday price moves of the S&P 500 E- “Economic number summary.”) market behaved on the five announce-
mini futures contract (ES) as these The study shows the S&P’s overall ment days.
announcements hit the Street. The S&P daily and intraday behavior on

21 www.activetradermag.com • May 2005 • ACTIVE TRADER


Report day:
January 2000 to February 2005
To find out how the S&P 500 index
behaved when the five economic reports
were released, we studied its daily price
moves from Jan. 3, 2000 to Feb. 4, 2005.
Overall, we measured 285 distinct days:
Monthly employment, CPI, GDP, and
ISM announcements (61 reports each)
and 41 scheduled Fed interest-rate state-
ments.
Figure 1 shows the S&P’s average
announcement-day performance for
each report, according to various out-
comes, increases vs. decreases, etc., and
compares it to the daily benchmark, or
typical daily market move since 2000.
The S&P rallied in response to ISM
and Fed interest-rate announcements
(0.29- and 0.16-percent average gains,
respectively), while it posted a small
0.03-percent average loss on employ-
ment-report days. In contrast, the S&P
sold off as the U.S. government released
GDP and CPI statements (0.16- and 0.24-
percent losses).
The index also climbed more than
twice as much in response to dropping
ISM values than it did after increasing
ones (0.48 vs. 0.23 percent) and tended to
prefer Fed interest-rate changes — hikes
or cuts — over unchanged rates (0.25 vs.
0.08 percent). While the S&P fell an aver-
age 0.33 percent on news of positive
employment reports and edged 0.08 per-
cent higher following a negative jobs
picture, these tendencies are less reliable
because they only represent 11
announcement days each of 61 reports
analyzed.
Although the S&P fell slightly further
in response to declining GDP estimates
than increasing ones, differences in GDP
and CPI reports had less of an effect than
variations in ISM and FOMC announce-
ments did.
Intraday patterns: scheduled
FOMC meetings
To find out how the market fared sur-
rounding report release times, we ana-
lyzed the S&P 500 E-mini futures at 15-
minute intervals from 7 a.m. to 3:15 p.m.
ACTIVE TRADER • May 2005 • www.activetradermag.com
Economic number summary
The five following sections provide short explanations of each economic report
and its release schedule. For more information about each release, or visit the
Web sites listed at the end of each section.
The Fed and interest rates
The Federal Open Market Committee (FOMC) holds eight scheduled meetings a
year to decide whether to change its Fed Funds rate, which is the interest rate
that member banks charge one another for overnight loans. The Fed typically
cuts this target rate to stimulate economic growth and raises it to keep a lid on
inflation. After each meeting, the committee issues a statement around 1:15
p.m. CT that explains its decision and economic outlook — an event that began
in 1994.
(www.federalreserve.gov/fomc)
Jobs
The Bureau of Labor Statistics (BLS) releases its employment report at 7:30
a.m. CT the first Friday of each month. The report includes non-farm payrolls
and the unemployment rate from the previous month. The bureau compiles
non-farm payrolls from its Current Establishment Survey (CES), which is a sam-
ple of nearly 400,000 individual businesses and government agencies repre-
senting one-third of all non-farm payroll jobs.
The unemployment rate comes from the bureau’s Current Population Survey
(CPS), which polls roughly 60,000 households and measures the unemployed
(i.e., currently searching for work and available to work) as a percentage of
the civilian labor force (employed and unemployed).
(www.bls.gov/ces and www.bls.gov/cps)
Consumer Price Index (CPI)
The CPI summarizes retail prices of goods and services and is released by the
BLS in the middle of each month at 7:30 a.m. CT. The index includes items such
as clothes, furniture, and electronics, but it also tracks a variety of services
such as health care, education, and transportation.
The bureau compiles its CPI-W and CPU-U (i.e., wage earners’ and urban)
indices from roughly 23,000 stores and 87 areas throughout the U.S. The gov-
ernment uses the CPI-W to adjust social security payments, but traders track
the urban index because it represents 87 percent of all consumers.
(www.bls.gov/cpi/home.htm)
Gross Domestic Product (GDP)
The GDP measures the value of all the goods and services produced and sold in
the U.S. and divides it into four categories: consumption, investment, net
exports, and government expenditures. The Commerce Department’s Bureau of
Economic Analysis (BEA) issues an initial, or advance, GDP estimate for the
prior quarter at 7:30 a.m. CT on a Thursday or Friday in the third or fourth
week of each quarter.
The bureau releases two additional revisions (preliminary and final) in the
second and third months of each quarter, which include more-detailed eco-
nomic data. One of the three types of GDP reports hits the Street each month.
(www.bea.gov/bea/dn/home/gdp.htm)
Institute for Supply Management (ISM) survey
The institute’s monthly survey of more than 400 purchasing managers in 20
industries determines whether 10 aspects of manufacturing activity (new
orders, production, employment, supplier deliveries, inventories, consumers’
inventories, commodity prices, order backlogs, new export orders, and
imports) are rising, falling, or staying the same from the prior month.
The resulting Purchasing Managers Index (PMI) is a weighted summary of the
first five sections. PMI values greater than 50 suggest the manufacturing sector
(and the overall economy) is growing, while readings of less than 50 suggest
they are in decline.
(www.ism.ws)
22
 FIGURE 2 A DAY IN THE LIFE OF THE FED

The S&P E-mini's gains tended to occur in the morning from the open of the stock market
(8:30 a.m.) to lunchtime (12:30 p.m.). The futures contract fell as the Fed released its
statement at 1:15 p.m., but then briefly reversed before falling lower in the trading day's
final hour.

Average S&P E-mini behavior CT on announcement

on FOMC announcement days, All 41 scheduled meetings
days during Figure 1’s (p.
2000 to 2005 Rate changes (19) 21) five-year period.
The remaining five fig-
0.20 Unchanged rates (22) ures show the S&P
0.15 futures’ average gains
and losses in 15-, 30-, 60-,
0.10 75-, and 90-minute inter-
Average gain/loss (%)

vals before and after the

0.05 five economic reports hit
the Street. Each time-
0.00 interval’s benchmark, or
typical price move, was
-0.05
flat.
-0.10 Figure 2 compares the
S&P 500 E-mini’s average
-0.15 performance before and
7:00 to 8:30 to 9:30 to 10:30 to 11:30 12:30 12:45 to 1:00 to A 1:15 1:30 to 1:45 to 2:00 to after all FOMC’s 41
8:30 9:30 10:30 11:30 to 12:30 to 12:45 1:00 1:15 to 1:30 1:45 2:00 3:15 scheduled statements,
a.m. a.m. a.m. a.m. p.m. p.m. p.m. p.m. p.m. p.m. p.m. p.m. which the Fed released at
1:15 p.m. CT announcement time (A) 1:15 p.m., to its behavior
around rate changes and
unchanged rates. Over-
all, the S&P futures lan-
FIGURE 3 EMPLOYMENT REPORT guished from 7 to the 8:30
a.m. market open, but
Overall, the S&P E-mini rose in anticipation of the jobs report before slumping while the then surged an average
equities markets were open. Brief initial up or down moves in response to positive or nega- 0.12 percent in the fol-
tive news tended to reverse before noon. lowing hour.
The market continued
to rally throughout the
Average S&P E-mini behavior All 61 reports
morning and more than
on employment report days,
Positive reports (11) doubled its first-hour
2000 to 2005
gain by 12:30 p.m.
0.20 Negative reports (11)
However, the E-mini
0.15 traded sideways over the
0.10 next 30 minutes in antici-
pation of the announce-
0.05
ment before sinking an
Average gain/loss (%)

0.00 average 0.07 percent in

-0.05 the 15 minutes leading
-0.10 up to it.
The contract respond-
-0.15
ed to the FOMC’s deci-
-0.20 sion regarding its Fed tar-
-0.25 get rate with a pattern we
-0.30 first found in our January
7:00 to 7:15 to A 7:30 to 7:45 to 8:00 to 8:30 to 9:00 to 10:00 11:00 12:00 to 1:00 to 2:00 to 2004 study of the Fed: It
7:15 7:30 7:45 8:00 8:30 9:00 10:00 to 11:00 to 12:00 1:00 2:00 3:15 tumbled 0.09 percent
a.m. a.m. a.m. a.m. a.m. a.m. a.m. a.m. noon p.m. p.m. p.m. from 1:15 to 1:30 p.m.,
7:30 a.m. CT release time (A) retraced those losses over
the following 30 minutes,
then resumed its initial

23 www.activetradermag.com • May 2005 • ACTIVE TRADER

 T
Average and median
he mean (or average) of a set of values is the sum of the values divid-
downturn and dropped 0.13 percent ed by the number of values in the set. If a set consists of 10 numbers,
between 2 and 3:15 p.m. add them and divide by 10 to get the mean.
A comparison of each time interval’s A statistical weakness of the mean is that it can be distorted by exception-
average performance with its median ally large or small values. For example, the mean of 1, 2, 3, 4, 5, 6, 7, and 200
value (not shown) indicates that is 28.5 (228/8). Take away 200, and the mean of the remaining seven numbers
extremely large individual moves exag- is 4, which is much more representative of the numbers in this set than 28.5.
gerated these patterns slightly (especial- The median can help gauge how representative a mean really is. The medi-
ly the E-mini’s pre-announcement rally), an of a data set is its middle value (when the set has an odd number of ele-
yet both values are roughly in line with ments) or the mean of the middle two elements (when the set has an even
each other, which confirms Figure 2’s number of elements). The median is less susceptible than the mean to distor-
overall accuracy. (For an explanation of tion from extreme, non-representative values. The median of 1, 2, 3, 4, 5, 6,
these two statistics, see “Average and 7, and 200 is 4.5 ((4+5)/2), which is much more in line with the majority of
median.”) numbers in the set.
Although the S&P E-mini moved in
the same direction regardless of whether
or not the Fed changed interest rates
during eight of the 12 time intervals after the news emerged than when the Employment reports
shown in Figure 2, the market was less committee announced interest-rate Figure 3 is similar to Figure 2 and com-
volatile around rate changes than changes (0.27 vs. 0.12 percent from 7 pares the S&P E-mini’s average price
unchanged rates. For example, S&P a.m. to 1:15 p.m., and 0.21 vs. 0.03 per- moves around 61 monthly employment
futures gained more ground prior to cent from 1:15 to 3:15 p.m., respectively). reports since January 2000 to its per-
unchanged rates and slipped further formance surrounding positive and neg-
ative jobs announce-
ments. On all announce-
FIGURE 4 CPI RELEASES ment days, the S&P
Overall, the futures market sank in reaction to CPI reports, except for a 30-minute rally futures climbed 0.05 per-
from 9 to 10 a.m. Its biggest average drop occurred in the final 75 minutes of the day. cent from 7 to the 7:30
a.m. release time before
relinquishing those gains
Average S&P E-mini behavior in the first 15 minutes fol-
All 61 reports
on CPI announcement days, lowing the announce-
2000 to 2005 CPI increases (49) ment.
0.20 The market continued
Flat or CPI declines (12)
to slide throughout the
0.15 day despite trading side-
ways from the 8:30 mar-
0.10 ket open to 9 a.m. and
Average gain/loss (%)

then edging higher

0.05
between 10 and 11 a.m.
0.00
Overall, the S&P E-mini
fell during nine of the fig-
-0.05 ure’s 10 post-announce-
ment time intervals — a
-0.10 0.16-percent average loss.
Each time interval’s medi-
-0.15 an value was in line with
7:00 to 7:15 to A 7:30 to 7:45 to 8:00 to 8:30 to 9:00 to 10:00 11:00 12:00 to 1:00 to 2:00 to
its average, which implies
7:15 7:30 7:45 8:00 8:30 9:00 10:00 to 11:00 to 12:00 1:00 2:00 3:15
a.m. a.m. a.m. a.m. a.m. a.m. a.m. a.m. noon p.m. p.m. p.m.
that Figure 3’s price
moves are fairly reliable.
7:30 a.m. CT release time (A) While the E-mini’s
behavior around strictly
positive or negative jobs

ACTIVE TRADER • May 2005 • www.activetradermag.com 24

reports isn’t as helpful because of the small between how the S&P futures performed a.m.) seems fairly reliable.
sample size (11 instances each), it demon- on jobs and CPI report days. The con-
strates the market’s volatility on tract edged 0.03 percent higher in the GDP estimates
announcement days. half hour prior to all CPI announce- Figure 5 shows the S&P E-mini’s aver-
For example, the S&P futures climbed ments before it sold off 0.09 percent in age performance around all 61 GDP esti-
prior to negative jobs data, but then the following 90 minutes. After a 60- mates (advance, preliminary, and final)
plunged as the bearish news hit the minute rally from 9 to 10 a.m., the S&P announcements since Jan. 28, 2000, com-
pared to its behavior sur-
rounding GDP increases
FIGURE 5 MONTHLY GDP REPORTS and decreases.
Overall, the S&P futures
The S&P E-mini gained ground as a GDP release approached, but then sold off as traders rose 0.05 percent, on aver-
heard the latest estimate and continued to drop regardless of what it was. age, in the 30 minutes
before the GDP’s 7:30 a.m.
Average S&P E-mini behavior release, and then gave up
All 61 GDP reports those gains as traders
on GDP announcement days,
2000 to 2005 GDP increases (31) digested the data before
(advanced, preliminary, and final estimates) the stock market opened —
0.10 GDP decreases (24) a distinct pattern that also
appears around jobs and
0.05
CPI releases.
Although the market
didn’t sell off right at the
Average gain/loss (%)

0.00 8:30 a.m. open, the E-mini

sank throughout the
-0.05
morning before reversing
around lunchtime, and
then resumed its plunge
-0.10 from 1 to 3:15 p.m. — a
0.16-percent average loss.
-0.15
While the E-mini’s medi-
7:00 to 7:15 to A 7:30 to 7:45 to 8:00 to 8:30 to 9:00 to 10:00 11:00 12:00 to 1:00 to 2:00 to an values are less bearish
7:15 7:30 7:45 8:00 8:30 9:00 10:00 to 11:00 to 12:00 1:00 2:00 3:15 than its averages from 9
a.m. a.m. a.m. a.m. a.m. a.m. a.m. a.m. noon p.m. p.m. p.m. a.m. to noon, both statis-
tics move in line with each
7:30 a.m. CT release time (A)
other in the late afternoon,
which implies the selloff
during the day’s final two
periods is accurate.
Street. When the stock market opened at fell again in the next hour before trading The market tended to gain more
8:30 a.m., however, the contract surged sideways from 11 a.m. to 2 p.m. The ground prior to news of GDP increases
over the following two-and-a-half hours. day’s largest move (up or down) than declining ones and slid less
In contrast, the E-mini followed the occurred as the E-mini sold off 0.10 per- between their 7:30 a.m. announcement
opposite pattern around positive jobs cent in the final 75 minutes of the day. and the opening of the stock market an
reports. Figure 4 is slightly misleading, how- hour later. At 8:30 a.m., the S&P futures
ever, because each period’s median val- behaved as expected, climbing an aver-
CPI releases ues (not shown) are flat. Although this age 0.07 percent in response to increas-
Figure 4 (p. 24) shows the S&P E-mini’s discrepancy between average and medi- ing GDP estimates and falling 0.06 per-
average gains and losses surrounding 61 an values also affects the S&P futures’ cent on bearish GDP news. However, the
CPI reports over the past five years. Each behavior around CPI increases and flat E-mini’s brief rally in reaction to bullish
time period also compares the market’s or dropping figures, its tendency to GDP reports didn’t last long.
behavior around CPI increases to its per- trade higher before news of a rising CPI
formance around flat or declining CPI and slip in the first 15 minutes after its ISM manufacturing index
values. release (7:30 to 7:45 a.m.) as well as its Figure 6 shows the S&P futures’ average
There are only minor differences slight drop an hour later (8:30 to 8:45 gains and losses before and after 61 ISM

25 www.activetradermag.com • May 2005 • ACTIVE TRADER

reports from Jan. 3, 2000 to Feb. 1, 2005.
The figure also tracks the contract’s per-
formance surrounding news of rising
and declining ISM values.
The market remained flat from 7 to its
9 a.m. release when it dropped an aver-
age 0.06 percent in the following 15 min-
utes. However, the E-mini regained its
footing around 9:30 a.m. and then
climbed 0.17 percent until noon. The
S&P futures went nowhere in the early
afternoon, but surged 0.14 percent in the
final hour and 15 minutes of the day. (A
comparison of average and median val-
ues showed these intraday patterns are
reliable.)
While the market edged 0.04 percent
higher as bullish ISM values hit the
Street and sank 0.12 percent in reaction
to ISM declines (as expected), the S&P
rallied an average 0.53 percent in the six
hours after ISM decreases. In contrast,
the S&P futures gained just 0.03 percent,
on average, following ISM increases.
Related reading
These articles analyze how the S&P 500 behaves surrounding economic
releases.
“The Fed effect,” Active Trader, January 2004, p. 20.
“Trading the monthly jobs report,” Active Trader, June 2004, p. 26.
“Gross Domestic Product (GDP) and the stock market,” Active Trader,
November 2004, p. 76.
“How the Consumer Price Index (CPI) affects the S&P 500,” Active Trader,
February 2005, p. 26.
You can purchase and download past Active Trader articles at:
www.activetradermag.com/purchase_articles.htm
A comparison of the E-mini’s average usual after bearish ISM news. However,
and median values suggests that a few this discrepancy doesn’t change the fact
extremely large price moves skewed the that S&P figures had a more bullish
market’s typical moves higher than response to dropping ISM reports than
rising ones.

Overall patterns
FIGURE 6 ISM RELEASES

The S&P futures market slumped surrounding the ISM release, but then regained ground 30 The S&P E-mini climbed
minutes later and climbed until noon. The E-mini caught a second wind at 2 p.m. and rallied in anticipation of sched-
toward the close. These upswings were larger following ISM declines. uled Fed statements,
then adhered to a dis-
tinct three-step pattern:
Average S&P E-mini behavior All 61 reports selloff, reversal, and a
0.25 on ISM announcement days, close in the same direc-
2000 to 2005 ISM increases (27) tion as the original drop.
0.20
ISM decreases (32) The market also edged
0.15
Average gain/loss (%)

higher before 7:30 a.m.

0.10 monthly employment,
0.05 CPI, and GDP an-
nouncements, then sank
0.00
as those statements were
-0.05 released.
-0.10 Finally, the S&P
futures’ slump in the
-0.15 first 15 minutes after an
ISM report is misleading
since the market tends to
rally later in the day.Ý

7:00 to 8:30 to 8:45 to A 9:00 to 9:15 to 9:30 to 10:00 to 11:00 12:00 to 1:00 to 2:00 to
8:30 8:45 9:00 9:15 9:30 10:00 11:00 to 12:00 1:00 2:00 3:15
a.m. a.m. a.m. a.m. a.m. a.m. a.m. noon p.m. p.m. p.m.
9:00 a.m. CT release time (A)

ACTIVE TRADER • May 2005 • www.activetradermag.com 26

FUTURES
Trading Strategies
SECTOR VS. INDEX:
The single stock futures-Dow spread
Trading single stock futures against a stock index contract requires careful
preparation, but it allows you to take advantage of areas of the market that are
outperforming (or underperforming) the market.
S
BY KEITH SCHAP
ingle stock futures (SSFs)
open up interesting possibili-
ties for spread traders. The
OneChicago exchange offers
a large family of single stock futures con-
tracts, and you can structure interesting
spreads between a stock index futures
contract, such as CBOT mini-sized Dow
futures (YM), and SSF contracts repre-
senting a particular market sector within
that index.
When one sector promises to
outperform the market
At times, your market research may alert
you to the possibility that one market
sector may outperform the broad mar-
ket. For example, the Dow Jones
Industrial Average (DJIA) contains four
computer-related stocks — Hewlett-
Packard Co. (HPC), IBM Corp. (IBM),
Intel Corp. (INTEC), and Microsoft
Corp. (MSFT). You might believe:
• in a rallying market, this sector
might rally more than the market
as a whole;
• in a falling market, this sector
might rally; or,
• in a falling market, this sector
might fall less than the market
as a whole.
27
In each of these situations, you can
benefit from a spread in which you ini-
tially sell mini-sized Dow futures and
buy the SSF contracts representing the
four computer companies.
Structuring the spread trade
Structuring this kind of spread requires
special care. Because both the mini-sized
Dow futures and the sector futures can
rally, you must size the sector position in
such a way that the stock index leg of the
spread cannot overwhelm it. To do this,
you make the sum of the dollar values of
the four single stock futures legs approx-
imately equal to the dollar value of the
mini-sized Dow leg.
Table 1 illustrates a good way to
accomplish this dollar value balance in a
spread between the June 2005 mini-sized
Dow futures (YMU05) and the four com-
puter-related SSFs that were in the mar-
ket on May 2, 2005. (Note: OneChicago
SSF ticker symbols consist of the stock
symbol plus “1C” — e.g., INTC1C,
IBM1C, MSFT1C, and HPQ1C. Also, the
SSF price is the stock price times 100.)
On that day, the YMU05 price was
10,285, INTC was 23.55, IBM was 76.51,
MSFT was 25.23, and HPQ was 20.97.
The first column shows a possible
number of mini-sized Dow contracts.
The second column shows the closing
price for the day in question. The
“Position dollar value” column multi-
plies the futures quote by the contract’s
$5 multiplier and by the number of con-
tracts (e.g., 10,285 * $5 * 3 contracts =
$154,275).
www.activetradermag.com • November 2005 • ACTIVE TRADER
Next, multiply the four stock prices by
100 shares to find the prices of single
contracts of each and sum these SSF con-
tract values. On May 2, the four futures
contract dollar values were $2,355 for
INTC1C, $7,651 for IBM1C, $2,523 for
MSFT1C, and $2,097 for HPQ1C. The
sum of these is $14,626, shown in the
“Sum of single stock futures prices” col-
umn.
To find the number of single stock
futures contracts it will take to balance
the dollar value of four mini-sized Dow
contracts, divide $205,700 (from the
“Position dollar value” column) by
$14,626 to discover that you will need to
use 14.06 contracts of each of the four
single stock futures contracts. Because
you cannot trade fractions of futures
contracts, you must round to the nearest
whole number of contracts — in this
example, 14.06 becomes 14.
Finally, multiply the rounded num-
bers by $14,626 to find the dollar value
of a position consisting of that number of
contracts of each of the single stock
futures (e.g., the $102,382 value of seven
contracts of each of the four computer
single stock futures comes close to
matching the $102,850 value of two stock
index contracts).
The “Dollar value difference” column
subtracts the dollar value of the aggregate
single stock futures position from the dol-
lar value of the specified number of stock
index futures. On May 2, 2005, the even-
numbered stock index contract positions
offered the best matches.
Obviously, when you sell mini-sized
Dow futures, you are selling a certain
 TABLE 1 TO FIND THE NUMBER OF SHARES OF THE FOUR COMPUTER STOCKS
To use this strategy effectively, you need to size the SSF positions so the stock index leg
of the spread doesn’t overwhelm it. To accomplish this, you make the sum of the dollar
values of the four single stock futures legs approximately equal to the dollar value of
the index leg.

amount of exposure to these 5/2/2005

four computer stocks. For Number of CBOT Position Sum of Number of Position Dollar
example, as of early May mini-sized Futures dollar single stock single stock dollar value
2005, Microsoft accounted for Dow contracts price value futures prices contracts value difference
1.9562 percent of the index
1 10,285 51,425 14,626 3.52 58,504 -7,079
total. Given the $51,425 cash
equivalent value of the stock 2 10,285 102,850 14,626 7.03 102,382 468
index futures contract, this 3 10,285 154,275 14,626 10.55 160,886 -6,611
amounted to $1,005.98, which, 4 10,285 205,700 14,626 14.06 204,764 936
at $25.23 per share, is equiva-
5 10,285 257,125 14,626 17.58 263,268 -6,143
lent to approximately 40
shares of MSFT. The four con- 6 10,285 308,550 14,626 21.10 307,146 1,407
tracts of MSFT1C are equiva- 7 10,285 359,975 14,626 24.61 365,650 -5,675
lent to 400 shares, so you can 8 10,285 411,400 14,626 28.13 409,528 1,872
see that the short index
futures leg of this spread neu- 9 10,285 462,825 14,626 31.64 468,032 -5,207
tralizes only a fraction of the 10 10,285 514,250 14,626 35.16 511,910 2,340
Microsoft part of the single
stock futures side of the trade.
In short, the fact that the FIGURE 1 INDEX VS. SECTOR: MAY 2 TO JULY 15
YMU05 leg contains some
During two brief periods, the Dow futures outperformed the four computer SSFs, but
exposure to these stocks is not a
more frequently, the stocks outperformed the stock index. The spread between the
problem.
two widened considerably from June 24 to July 15.
A snapshot
of the opportunities The computer sector against the index
Figure 1 shows the results of an 57,000
exercise similar to that present- YMU05
ed in Table 1. It covers the peri- 56,000
Computer
od from May 2, 2005 to July 15, stocks
2005. The YMU05 line repre- 55,000
Balanced dollar values

sents the daily index futures

price multiplied by $5. The val-
54,000
ues for the line labeled
“Computer stocks” are the
sums of the four computer 53,000
stock prices multiplied by 352
(the sum of the share prices 52,000
multiplied first by 100, then by
3.52). The 3.52 May 2 spread 51,000
factor is constant for the period
encompassed in the figure.
Notice that during two brief 50,000
periods (May 2 to May 12 and
5/2/05

5/9/05

5/16/05

5/23/05

5/30/05

6/6/05

6/13/05

6/20/05

6/27/05

7/4/05

7/11/05

May 26 to June 8) the stock

index appears to have outper-
formed the four computer
stocks. More numerous and
obvious are the periods when the com-
puter group outperformed the stock
index. Consider especially the three-
week stretch from June 24 to July 15,
during which the spread between the
two widened considerably.
The main thing to notice here is that
trading opportunities abound, on either
side of the spread. Further, the computer
sector is only one possibility. Any of the
several stock groups contained in the
Dow 30 are likely to provide similar
trading opportunities for spreads of this
kind.
Assessing possible results
The logic of this spread is straightfor-
ward: You want to buy the spread in
anticipation of it widening, which will
happen whenever the computer group
outperforms the total index. You want to
sell the spread whenever you anticipate
that an underperforming computer sec-
tor will narrow it. You buy or sell the
spread in terms of what you do with the
sector leg. To buy the spread, you buy the
appropriate number of SSF contracts for

ACTIVE TRADER • November 2005 • www.activetradermag.com 28

FUTURES
Trading Strategies continued

TABLE 2 WHEN BOTH PARTS OF THE SPREAD RALLY

shown in the “Single stock net” row.
This illustrates how the long SSF-index spread might perform, assuming your That, less the $1,540 stock index
market outlook in early May 2005 called for the computer sector to outperform futures loss, leaves a “Spread net” of
the index. Given this outlook, suppose you had decided to buy this spread on $2,056. In this case, the stock market
May 12 with the idea of unwinding it a week later. At May 12 prices, the spread as a whole rallied, but the computer
ratio was 3.58, so you would have bought four contracts each of the computer sector rallied more.
SSF futures for every one contract you sold of the Dow leg. Of course, these trades don’t
Notice the Dow rallied 308 points during this week. “1 Contract” multiplies always perform according to our
this result by $5 to show that one contract would have lost $1,540 on this price plans. Suppose on May 26 you
move because it was sold initially. “Position” repeats this value because this is a believed these computer stocks were
one-lot. likely to continue to outperform the
Action Dow Action INTC1C IBM1C MSFT1C HPQ1C rest of the market and had again
5/12/05 Sell 1 10,218 Buy 4 24.84 72.62 25.00 20.15 bought the spread. At May 26 prices,
the spread ratio would have been
5/19/05 Buy 1 10,526 Sell 4 26.01 77.16 25.92 22.51 3.45, so you would have bought three
Result -308 1.17 4.54 0.92 2.36 contracts of each of the single stock
1 Contract -1,540 117.00 454.00 92.00 236.00 futures for each contract of mini-sized
Dow futures you sold (see Table 3).
Position -1,540 468.00 1,816.00 368.00 944.00
In this situation, the Dow lost 52
Single stock net 3,596.00 index points, which results in a $260
Spread net 2,056.00 gain for the short futures leg of the
spread. Unfortunately, the long SSFs
all lost — $1,344 total — so the spread
TABLE 3 BEST LAID PLANS… lost $1,084 ($1,344 - $260).
This example is a reminder that
Trades don’t always go as planned. In this scenario, the short Dow leg posted spread trades contain speculative
a $260 gain. Unfortunately, the long SSFs all lost — $1,344 total — so the risk. When your prediction concern-
spread lost $1,084 overall. The most important factor here was not the ing spread widening or narrowing is
falling market, though, but the fact that the spread narrowed because the not realized, these trades can lose.
computer stocks fell more than the index. Keep in mind the crucial factor here is
not the falling market. Rather, what
Action Dow Action INTC1C IBM1C MSFT1C HPQ1C overturned this trade was the fact that
5/26/05 Sell 1 10,570 Buy 3 27.37 77.14 25.90 23.80 the spread narrowed because the
6/8/05 Buy 1 10,518 Sell 3 27.10 74.80 25.40 22.43 computer stocks fell more than the
index.
Result 52 -0.27 -2.34 -0.50 -1.37
As Figure 1 (p. 28) shows, in late
1 Contract 260 -27.00 -234.00 -50.00 -137.00 June all prices fell, but the spread
Position 260 -81.00 -702.00 -150.00 -411.00 widened because the Dow fell more
Single stock net -1,344.00 than the computer stocks. In such a
case the profit would have come from
Spread net -1,084.00 the short Dow leg of the spread but,
again, the widening of the spread —
not the direction of the prices —
every one mini-sized Dow contract you trade based on a one-lot Dow leg. would have been the crucial factor.
sell. To sell this spread, you sell the SSF Notice the Dow rallied 308 points dur-
contracts and buy the index future. ing this week. “1 Contract” multiplies Focus on comfort, not slippage
To illustrate how this spread might this result by $5 to show that one con- At the outset of the widening sequence
perform, assume your market outlook in tract would have lost $1,540 on this price that began on June 24, mini-sized Dow
early May 2005 called for the computer move because it was sold initially. futures were trading at 10,325, Intel at
sector to outperform the index. Given “Position” repeats this value because $26.10, IBM at $74.01, Microsoft at $25.04,
this outlook, suppose you had decided this is a one-lot. and Hewlett-Packard at $23.80. Based on
to buy this spread on May 12 with the The four computer stocks all gained at these prices, the spread ratios would
idea of unwinding it a week later. At least a small amount. “1 Contract” mul- have been those of Table 4, which abbre-
May 12 prices, the spread ratio was 3.58, tiplies the gains by 100 to take these viates the process detailed in Table 1.
so you would have bought four con- amounts up to futures contract size, and A look at the difference values seems
tracts of each computer SSF future for “Position” multiplies each of the four to suggest the presence of significant
every one contract you sold of the Dow SSFs by the number of contracts (4). The “slippage” in some of these position
leg. Table 2 shows the details of this four SSFs would have gained $3,596, as sizes. This is more appearance than fact

29 www.activetradermag.com • November 2005 • ACTIVE TRADER

 TABLE 4 ROUNDING RATIOS

once you get beyond the one-lot Dow At the beginning of the spread-widening sequence that began on June 24,
position version. mini-sized Dow futures were trading at 10,325, Intel at $26.10, IBM at
One way to check the fit of these $74.01, Microsoft at $25.04, and Hewlett-Packard at $23.80. One way to
spread ratios is to contrast the results you check the fit of these spread ratios is to contrast the results you get using
get using both the rounded and both the rounded and unrounded versions of the ratios. Although you can’t
unrounded versions of the ratios. trade fractional contracts, this is a helpful way to demonstrate how little
Granted, you cannot actually trade 3.47 rounding matters in most cases.
or 34.66 contracts of single stock futures,
Number of CBOT Unrounded Rounded Dollar value
but this is a helpful way to demonstrate
mini-sized Dow contracts ratios ratios difference
how little this rounding matters in most
cases. 1 3.47 3 6,940
Table 5 and Table 6 show the details of 2 6.93 7 -1,015
a trade that ran from June 24 to July 15, 3 10.40 10 1,975
2005. Table 5 shows the position results
4 13.86 14 -2,030
in terms of 10-lot index futures positions
and 35-lot single stock futures positions. 5 17.33 17 4,910
Table 6 differs only in that it uses 34.66- 6 20.80 21 -3,045
lot single stock futures positions. The 7 24.26 24 3,895
results vary by only $423.64 ($27,060.00 -
$26,636.36). 8 27.73 28 -4,060
The worst fit in Table 4 is the one for 9 31.19 31 2,880
the one-lot Dow leg of the spread, while 10 34.66 35 -5,075
the best-fit results from the two-lot Dow
leg version. The results for the one-lot
Dow leg versions vary by $585.62. The
TABLE 5 CHECKING FOR SLIPPAGE — ROUNDED SPREAD RATIO
results for the two-lot Dow leg ver-
sions vary by $87.22. Actually, the dif- This shows the details of a trade that ran from June 24 to July 15, 2005.
ferences for the two-lot and 10-lot Dow These calculations show the trade results in terms of a 10-lot index futures
leg versions involve the same percent- position and 35-lot SSF position.
age of error — 1.6 percent.
This indicates that you can trade Action Dow Action INTC1C IBM1C MSFT1C HPQ1C
whatever position size fits your budget 6/24/05 Sell 10 10,325 Buy 35 26.10 74.01 25.04 23.80
and your appetite for risk with reason- 7/15/05 Buy 10 10,656 Sell 35 28.30 82.38 25.79 24.94
able confidence of a satisfactory result.
The rounding of the single-stock Result -331 2.20 8.37 0.75 1.14
futures position size does not intro- 1 Contract -1,655 220.00 837.00 75.00 114.00
duce debilitating slippage. Position -16,550 7,700.00 29,295.00 2,625.00 3,990.00

A word of caution
Single stock net 43,610.00
Satisfactory spread trading results Spread net 27,060.00
depend crucially on you getting your
market call right, of course. Like any
spread trade, these stock index-single TABLE 6 CHECKING FOR SLIPPAGE — UNROUNDED SPREAD RATIO
stock futures spreads are based on
your market analysis and opinion. No These are the same calculations as Table 5, except 34.66-lot SSF positions are
one is right every time, as Table 3 illus- used here. The results vary by only $423.64 ($27,060.00 – $26,636.36).
trates.
Action Dow Action INTC1C IBM1C MSFT1C HPQ1C
These spreads involve another kind
of risk that you must not overlook. 6/24/05 Sell 10 10,325 Buy 34.66 26.10 74.01 25.04 23.80
Even though the example trades 7/15/05 Buy 10 10,656 Sell 34.66 28.30 82.38 25.79 24.94
shown all involve screen traded con- Result -331 2.20 8.37 0.75 1.14
tracts, which many people think
1 Contract -1,655 220.00 837.00 75.00 114.00
reduce execution risk, these spreads
use contracts traded on two Position -16,550 7,625.20 29,010.42 2,599.50 3,951.24
exchanges. This can, at times, cause Single stock net 43,186.36
timing problems. Carefully monitored, Spread net 26,636.36
however, this source of potential exe-
cution risk should be manageable.Ý

ACTIVE TRADER • November 2005 • www.activetradermag.com 30

FUTURES & OPTIONS
Strategies
TRADING THE BASIS:
How stock index arbitrage impacts the market
How can understanding stock index arbitrage help you time your trades better
and avoid getting trapped in mispriced markets?
Hint: It’s the basis that counts.
A
BY DAVID LERMAN
t first glance, learning about the somewhat arcane
practice of program trading and “arbitrage” (cap-
italizing on price discrepancies in related mar-
kets) may seem to be of little practical value for
the typical individual stock index futures trader.
True, knowledge of arbitrage activity, by itself, will not make
you a great trader — or even a good trader. However, it can
make you a better trader. At the very least, it gives you a better
grasp of how the markets you trade function. Also, professional
S&P 500 futures and Exchange Traded Fund (ETF) traders pay
close attention to arbitrage activity because its potential short-
term effects can mean the difference between profits and losses.
One bit of practical trading information derived from pro-
gram trading and arbitrage is the relationship (the “basis”)
between S&P 500 futures and its underlying cash instrument,
the S&P 500 index. Here, we will explore the concept of basis
and explain its importance to both stock index traders and pro-
fessional arbitrage traders, or arbitrageurs (“arbs” for short).
Arbitrage
Arbitrage is the simultaneous purchase and sale of similar or
identical instruments (often in different geographical loca-
tions) to take advantage of short-term price discrepancies.
For example, gold trades in several major financial centers
around the world — New York, London, Paris, Hong Kong
and Tokyo. If gold were trading in New York for $330 per
ounce and $332 per ounce in London, you could, in effect, buy
gold in New York and immediately sell an equal amount in the
London market and profit $2 per ounce.
Why would the metal be $2 higher in London? Short-term
supply and demand fluctuations: Perhaps a European jeweler
or metal fabricator placed a large order in the London market.
This short-term demand may cause the price to rise in London
relative to New York or other financial centers.
Throughout the world a cadre of gold traders watches their
screens, waiting for such a moment. Armed with lightning-fast
reflexes and state-of-the-art trade execution technology — not
31
to mention a few mil-
lion or so in capital —
they pounce. They will
quickly buy as much
gold in New York as
possible and simulta-
neously sell it in
London, pocketing the
$2 per ounce price differential.
Hundreds of arbs acting in concert around the world will
have an almost immediate impact on the market: Gold will
quickly rise in New York and fall just as quickly in London
until the price differential disappears, or is so small an arb’s
business costs would outweigh the possible profit.
Because arbitrage seeks to exploit short-lived price discrep-
ancies, a successful arbitrage trade carries almost no risk —
other than execution risk. Even though the trader would buy
and sell immediately in both markets, there is a small chance
that in the middle of the trade the market would move quick-
ly against him or her and result in locking in a lower differen-
tial, or worse, a loss. It’s part of the business. But over time, a
skilled arbitrageur minimizes these events and can look for-
ward to a lucrative business.
Stock index arbitrage (or index arbitrage) is a variation on
this theme, played out with baskets of stocks traded largely on
the New York Stock Exchange in the form of the S&P 500 index
(most S&P 500 stocks trade on the NYSE, but some are listed on
the AMEX and the Nasdaq), and a futures contract that trades
in Chicago based on the index — the S&P 500 futures (SP).
Although arbitrage occurs with many stock indexes, activi-
ty is particularly focused in the S&P 500 cash and futures mar-
kets because they are exceptionally deep and liquid. (ETFs
such as SPY and QQQ are also used in arbitrage.)
The next section will detail, step-by-step, how an index arbi-
trage trade is executed and its effect on the market, taking into
account fair value and basis (the futures premium or discount
to the underlying cash), as well as buy and sell programs.
www.activetradermag.com • March 2003 • ACTIVE TRADER
Fair value and basis
Fair value is the theoretical value of stock index futures at a
particular time, given prevailing market conditions.
Theoretical fair value = cash index value [1 + (r – d)*(x/365)]
where
R = Interest rate/financing costs
D = Dividend yield on S&P cash
X = Days to expiration of futures
For example, assume the following market conditions exist:
March S&P 500 futures = 901.20
Cash S&P 500 index = 900.00
Days to futures expiration = 90
Interest rate/financing costs = 2.0 percent
Dividend yield on S&P cash = 1.5 percent
Given these numbers, the theoretical fair value of the futures
contract is:
Fair value = cash index value [1 + (r – d)*(x/365)]
= 900.00 [1 + (.005)*(90/365)]
= 900.00 [1.0012328]
= 901.10
Fair value itself isn’t of much use. It’s the premium or dis-
count (how much the futures are trading above or below the
cash index) that matters most. As previously mentioned, the
“basis” is the difference between the futures price (either theo-
retical or actual) and the cash index price. Using the informa-
tion from the fair value example, the theoretical (“fair”) and
actual basis are calculated as:
Theoretical premium/discount =
fair value of futures – actual cash index value
(“fair basis”) = 901.10 – 900.00
= 1.10 pt. premium
Actual premium/discount =
actual level of futures – actual cash index value
(“actual basis”) = 901.20 – 900.00
= 1.20 pt. premium
In this case, the S&P 500 futures should be trading at a pre-
mium of about 1.1 points above the cash index. This doesn’t
mean they always will. In fact, most of the time the futures will
fluctuate slightly above and below the theoretical fair basis
because of changes in order flow, supply and demand, and
volatility, among other factors.
Only when supply and demand fluctuations cause a large
shift away from the fair basis will arbitrage activity start to
occur. In this example, the actual basis is 1.2 points, a mere .10
ACTIVE TRADER • March 2003 • www.activetradermag.com
point away from theoretical basis. For arbitrageurs to make a
profit, the actual basis has to increase (or decrease in some strate-
gies) enough to cover an arbitrageur’s cost of doing business
(the “hurdle rate”), which, in addition to interest rates, includes
commissions, trader salaries, equipment and telecom lines.
In our arb program example, using the 1.10 point theoretical
fair basis as reference, no arb activity would begin until the
basis widened to around 2.10 points — a “hurdle rate” of 1.0
point. (Hurdle rates vary from firm to firm, but typically fall in
the .75 to 1.25 point range.)
What would cause the basis to widen that much? Again, like
the New York-London gold example, it would be the result of
short-term supply and demand considerations. What if a large
customer of a brokerage firm decided he wanted to gain expo-
sure to the stock market via S&P 500 futures? If he put in a
large enough buy order, say 500 to 1,000 contracts, the short-
term demand would likely cause the S&P futures to begin to
climb relative to the cash market. Once the discrepancy
increased to the point arbs could profit from it, an intricately
linked set of events would be set into motion.
After the large customer’s order hit the trading floor, here is
how the market might look:
Actual value of S&P 500 futures = 902.20 (CME)
Actual value of S&P 500 cash index = 900.00
(NYSE/AMEX/NASDAQ)
Actual Premium or basis = 2.20 (above “hurdle rate”)
At this point some of the best and the brightest on Wall
Street would employ index arbitrage. They would purchase
the relatively cheap S&P 500 cash index, consisting mostly of
NYSE issues, and simultaneously sell the relatively expensive
S&P 500 futures contracts at CME.
Executing the trade
The precision required to pull off this kind of strategy is quite
amazing. The futures side can be done rather quickly, because
it involves only one instrument, the S&P 500 futures contract.
But how do arbs accurately buy all the S&P 500 component
stocks at the same time?
The answer is a system referred to as SuperDOT (Direct
Order Turnaround System). The DOT system electronically
routes orders directly to specialist posts on the floor of the
NYSE. At the press of a button, a firm can send an order to the
NYSE for immediate execution. The system can be pro-
grammed with customized lists of stocks, thus allowing a trad-
er to buy or sell all 500 issues in the S&P 500 at once. (The
Nasdaq issues can be executed using ECNs or other order-
routing mechanisms.)
In reality, most firms don’t buy all 500 stocks in the index.
They have in-house research departments that put together
lists of less than 500 names that track (hopefully) the S&P 500
with close precision. If you look at a list of all the components
32
FUTURES & OPTIONS Strategies continued
in the S&P 500, you would notice the last 50 to 100 names have
a very small weighing on the overall index; the top 40 stocks
account for about 50 percent of the capitalization of the index.
How many shares of each component stock and how many
futures are bought and sold depends largely on the size of the
“program.” Remember, index arbitrage falls under the heading
of program trading. Most programs are in the $10 million to
$15 million range, but some are much larger.
A $10 million index arbitrage “buy program” would consist
THE BASIS EDGE
T he greatest benefit of understanding fair value, basis
and index arbitrage lies in gauging the value of
futures relative to the cash index. For the short-term
S&P or E-mini S&P 500 futures trader, this is critical.
A few months back a trader called the CME complaining
about his fill in the S&P 500 futures contract. His call was
routed to me at about 1:30 p.m.
DL: “By any chance did this bad fill happen about 30 min-
utes ago?”
Caller: “Yes, how did you know?”
DL: “By any chance did you put in a market order to buy
futures?”
Caller: “Yes. Again, nice guess.”
DL: “Did you know what the theoretical premium was
when you placed your order?”
Caller: “No! I simply put in a market order to buy one June
S&P 500 futures contract. What’s the point of all this?”
Here’s the point. At 1 p.m., the following prices were flash-
ing on my screen:
June S&P 500 futures: 1410.10
June S&P 500 futures theoretical fair value: 1410.00
S&P 500 cash index: 1400.00
Cash/futures theoretical basis: (fair value – cash) 10.00
Cash/futures actual basis: (actual futures – cash) 10.10
A few minutes later, around 1:05 p.m., a large buy order
entered the pit and drove futures prices higher relative to the
cash market. The following prices were then in effect:
June S&P 500 futures: 1412.00
June S&P 500 theoretical fair value: 1410.00
S&P 500 cash index: 1400.00
Cash/futures theoretical basis (fair value – cash) 10.00
Cash/futures actual basis (actual futures – cash) 12.00
33
of buying the cash basket of stocks and selling the futures. A
“sell program” would involve selling the cash basket of stocks
and buying the futures. However, you cannot simply divide
$10 million in 500 equal installments; you must buy the stocks
in the exact proportion to their weighting in the index.
For example, Microsoft (MSFT) is the largest stock in the
S&P 500, accounting for around 3.62 percent of the total index.
Therefore, an arb trader must spend 3.62 percent of his $10 mil-
lion ($362,000) on MSFT. If MSFT’s current price is $57, that
The caller’s market order to buy S&Ps hit right when the
market was trading at 1412.00. He was filled at 1411.80—1.80
points above the theoretical premium level.
Within minutes, arbitrageurs and traders came into the
market to take advantage of a basis level that had taken a
stroll too far from equilibrium. Skilled arb traders sold expen-
sive futures and bought cheap stock when the basis became
too large, rapidly forcing prices back into line. The trader’s
order hit the pit precisely when this activity began, producing
an immediate loss of 1.80 points in the position ($450.00).
Was this really a poor fill, or was it more a result of bad
timing that could have been prevented through familiarity
with the pricing mechanisms in stock index futures contracts?
Likely, it was the latter. By knowing futures were temporarily
expensive relative to the cash index, the trader could have
delayed his order by just a few moments and the futures
would have returned to their normal fair value.
However, merely knowing the theoretical value of the
futures isn’t enough. You must know what the premium (or
basis) should be. In this example, the normal basis was 10. For
a brief moment it was 12 points — two points too high.
Although cash and futures markets usually return to equi-
librium quickly, extraordinary events may prevent this from
happening. Fed Chairman Alan Greenspan’s 50-basis point
rate cut in January 2001 is a great example.
Shortly after the announcement, both the regular and
E-Mini S&P 500 futures contracts rocketed higher. Because
futures are nearly always more responsive than the underly-
ing cash market, equities took a lot longer to catch up. The
trader who waited for the normal premium to reappear would
have missed out on a fabulous rally.
If the market makes quick, violent moves up or down, wait-
ing for fair value to reassert itself can result in costly lost
opportunities. But over the long run, consistently buying or
selling futures one to two points above or below theoretical
basis is a prescription for poor trading results.
www.activetradermag.com • March 2003 • ACTIVE TRADER
means purchasing 6,351 shares of MSFT. General Electric (GE)
is the second largest issue in the index, at about 3.1 percent of
the index; 3.1 percent of $10 million is $310,000. At a price of
$27, you’d have to buy 11,481 shares of GE.
You would continue in a similar fashion with the other
stocks in the index (or optimized portfolio). The list is pre-pro-
grammed and, using simple spreadsheets, the entire break-
down for the cash side of the arb trade can be calculated in
nanoseconds.
Despite the ease of using the DOT system to buy the list of
S&P 500 stocks, the futures side is even less cumbersome. If the
March futures were priced at 902.20, the contract size (or con-
tract notional value) would be $225,550 per contract (902.20 x
$250). If you buy $10 million of the cheap underlying cash bas-
ket, you must sell $10 million of the relatively expensive
futures contracts to do the arbitrage correctly, and $10 million
divided by $225,550 comes out to about 44 contracts.
At the same time the arb trader enters the order to purchase
the basket of stocks, the trading desk will instruct their broker
in the S&P 500 futures pit to sell 44 futures contracts, which at
this moment are a bit overpriced because of short-term supply
and demand factors.
In a matter of moments, the arb desk begins receiving
reports on the two transactions. As other arb traders execute
similar trades, the concerted selling and buying in futures and
cash will force the rich 2.20-point premium back toward equi-
librium, or its theoretical value of 1.10.
When (not if) the premium falls back to normal levels, the
entire trade could, in effect, be unwound. Unwinding such a
trade takes equal skill. Some of these trades are offset in the
future (which could mean minutes, hours, days or even
weeks), while others remain on the books until expiration. At
expiration, convergence will force the cash and futures con-
tracts to trade at the same price. No matter where the market
ends up at expiration, the arbitrageur profits by whatever
amount the premium level he sold at (2.20 points) exceeds the
theoretical premium (1.10 points), minus trading costs.
Vanishing premium?
For most of the history of the S&P 500 futures, the contract has
traded at a premium to its underlying index. In November 1993
and, more recently, in mid-2002, the premium began to disap-
pear. In fact, since fall 2002, the S&P futures have traded at a
consistent discount to the underlying cash. You need only look
at the relationship between the S&P 500 dividend yield and
interest rates to understand why.
Since the introduction of S&P 500 futures in April 1982,
short-term interest rates (as measured by three-month LIBOR,
ACTIVE TRADER • March 2003 • www.activetradermag.com
the London Interbank Offered Rate) have consistently been
higher than the dividend yield of the S&P 500. Only a few years
ago, short-term rates were at 5.5 percent and the dividend yield
was 1.3 percent.
Since Federal Reserve Chairman Greenspan’s aggressive cam-
paign to lower rates, short-term rates in the U.S. have — for the
first time in recent history — declined below the yield on the
S&P 500. With dividends yielding more than short-term rates,
the complexion of the fair value equation changes dramatically.
In our arb example, we used a 2-percent interest rate and 1.5-
percent dividend yield. Let’s calculate the fair value using
today’s values of 1.4 percent (the 3-month LIBOR rate) and 1.8
percent (the dividend yield on the S&P 500 index).
Futures fair value =
Cash [1 + (r – d)*(X/365)] =
900 [1 + (.014 - .018)*(90/365)] =
899.11 (a .89-point discount)
In other words, because dividend yields are higher than
short-term rates, the market discounts the futures contract to
take into account the yield pick-up by anyone who owned the
cash vs. owning the futures. (Futures don’t pay dividends, but
to buy $225,000 worth of the S&P 500, you only have to put
down the futures margin — around 7.5 percent — and the rest
of the money earns interest.)
Similarly, if interest rates and dividend yields were identical,
then there would be no advantage to owning cash or futures
and they would be priced identically, as was the case in
November 1993 when three-month LIBOR and dividend yields
were locked at 2.85 percent.
Short-term trading guidepost
The relationship between index futures and their underlying
cash indices is an aspect of market behavior all traders should
understand. Professional stock index traders constantly moni-
tor such items as fair value and basis. Novices and even some
more experienced traders sometimes ignore or forget these
important issues. “The basis edge” (p. 33) provides a market
example of how these issues played out in the market one day
several months ago.
It has been said a fool and his money are soon parted. Make
a habit of entering market orders to buy when S&P futures far
exceed their theoretical value and you will soon be parted from
your capital. Those who trade without knowing the “basics of
basis” risk poor executions and, ultimately, less-profitable trad-
ing.Ý
34
FUTURES
Trading Strategies

STOCK INDEX SPREADS:

S&P vs. Naz
They aren’t often the subjects of spread trading, but the obvious connections
and subtle differences of various stock index futures offer opportunities
to play one market off the other.

S
BY KEITH SCHAP

tock index futures offer fertile which is derived from statistical analysis More specifically, from April 1 to Dec.
fields for spread traders. of price changes. The informal definition 1, 2003, the S&P 500 rose 91.75 index
Consider only the S&P 500 seems to result from little more than points, from 1,172.90 to 1,264.65, which
and the Nasdaq 100. Apart casual observation of price charts to is a 7.82 percent change. The Nasdaq 100
from the obvious difference in the num- gauge which of two markets seems to be rose 234.95 index points, from 1,469.35 to
bers of stocks they contain, the two bouncing around more. 1,704.30, which is a 15.99 percent change.
indices vary considerably in terms of the Most stock market commentators This relationship between the volatili-
size and type of their component compa- appear to favor the latter, informal defi- ty of the two indices seems to hold
nies. As a result, it should not be surpris- nition. To see how much more volatile throughout the three-year period depict-
ing they exhibit markedly different the Nasdaq 100 is than the S&P 500, con- ed in Figure 1. More recently, from July 1
volatility in response to economic stim- sider Figure 1. From April through to July 21, 2005, the S&P 500 rose 32.60
uli. December 2003, both indices trended index points (a 2.73 percent change),
This would seem to lay the seeds of higher, but the Nasdaq 100 rose more while the Nasdaq 100 rose 111.35 index
productive spread trading, but stock and its rise was choppier. points (a 7.47 percent change).
index futures have gone largely untilled
in this regard. FIGURE 1 S&P 500 AND NASDAQ 100 INDEX LEVELS
Even when the S&P 500 and Nasdaq 100 indices respond the same way to
Index responsiveness economic or political events, they do so to different degrees. This difference
Even when the entire stock market is ral- can result in fruitful spread trades. From April through December 2003, both
lying or losing ground, stock indices sel- indices trended higher, but the Nasdaq 100 rose more and its rise was
dom move in concert. The S&P 500 and choppier.
the Nasdaq 100 may both rise or fall, but
their moves are likely to be of different
magnitudes.
Stock market commentators often say
the Nasdaq 100 is more volatile than the
S&P 500, which makes intuitive sense.
After all, the various technology sectors
have experienced dizzying rallies and
gut-wrenching plunges in recent years.
Also, smaller, newer companies seem
able to react more quickly to events than
older, larger companies.
Index size is another factor. A major
change in the prices of a few stocks will
move a smaller index more than a larger
index.
The term “volatility” has both infor-
mal and formal definitions. The formal
definition is the one option traders use,

35 www.activetradermag.com • May 2006 • ACTIVE TRADER

 FIGURE 2 SECOND HALF S&P 500, NASDAQ 100, AND SPREAD RATIO

The top chart shows the S&P 500 and Nasdaq 100 prices from June 1 to Dec.
30, 2005. The bottom shows the ratio spread for this period, with lines
added for the mean (average) spread value and one standard deviation above
and below the mean. There’s a strong relationship between the spread and
its mean: The spread wanders quite far from the mean, but it works back
toward it.
The difference between the volatilities
of the two indices in this informal sense
appears sufficient to motivate an interest
in stock index futures spreads. Even
when both markets respond the same
way to economic or political events, they
do so to different degrees. In addition,
there are likely to be times when the two
indices part company, directionally
speaking. These events can lead to fruit-
ful spread trades.

Structuring stock index spreads

A good way to trade these two indices is
by using mini stock index futures con-
tracts. However, because of the difference
in index values, it is necessary to struc-
ture S&P 500-Nasdaq 100 spreads in
terms of the dollar values of the contracts.
Assume the September 2005 E-mini
S&P 500 (ESU05) traded at 1,204.30 on
June 2, 2005, while the September E-mini
Nasdaq 100 (NQU05) traded at 1,568.95.
The dollar value of ESU05 is the index
level times $50, or $60,215.00, while
NQU05 is the index level times $20, or
$31,379.00.
If anything, this conversion of index
values into dollars makes the difference
more pronounced, a situation that calls
for “ratioing” the spread. To determine
an appropriate spread ratio at the outset
of any trade, divide the ES dollar value
by the NQ dollar value. On June 2, 2005,
this ratio was 1.9189 (60,215/31,379).
This indicates a need, given this exam-
ple, to trade 192 NQU05 contracts for work back toward it. The statistical phe- nomic drivers. This cointegration proper-
every 100 ESU05 contracts. You can scale nomenon of “cointegration” accounts ty accounts for the mean-reverting ten-
this down to whatever size conforms to for this. The basic idea is this: When you dency of all true spreads, and this is what
your comfort level and trading budget. have two related but non-stationary makes spreads safer and more pre-
A 10 ES to 19 NQ spread should perform variables, the difference will be station- dictable than outright futures positions.
well, and even a 1 ES to 2 NQ spread can ary. Put another way, when two time When the ratio diminishes (or the
generate a positive result. series trend together (which in this case spread narrows, which is the same
The spread ratio also provides a con- will be two series of stock index futures thing), the Nasdaq 100 is outperforming
venient way to track the spread. Figure 2 prices), the difference between the the S&P 500. Conversely, when the ratio
(top) shows the S&P 500 and Nasdaq 100 trends will be relatively stationary. expands (the spread widens), the S&P
prices from June 1 to Dec. 30, 2005, as Both time series can be trending in the 500 is outperforming the Nasdaq 100.
well as the ratio for this period (bottom). same direction but at different rates, or These outperformances all involve gains
The figure reveals a strong relation- one can be trending in one direction or losses in one index relative to the
ship between the spread and its mean while the other trends in the other direc- other and can occur in different ways:
(average). Even when the spread wan- tion. What matters is that both trends
ders quite far from the mean, it tends to will be responding to the same set of eco- -Both indices rise but one rises more;

ACTIVE TRADER • May 2006 • www.activetradermag.com 36

FUTURES
Trading Strategies continued

TABLE 1 BUYING THE SPREAD IN ANTICIPATION OF WIDENING SPREAD

During the month of this trade, ESU05 outperformed NQU05 by declining
only 0.82 percent, while NQU05 fell 5 percent. Using a 100:192 ES to NQ
spread ratio would have earned $251,806.00. The number of contracts can be
scaled down to fit any trading budget, but doing so will affect the results —
e.g., a 10:19 ratio would have generated a $24,867.00 return, and a 1:2 ratio
would have produced a $2,643.50 profit.
Action ESU05 Action NQU05
6/2/05 Buy 100 6,021,500.00 Sell 192 6,024,768.00
7/1/05 Sell 100 5,972,250.00 Buy 192 5,723,712.00
Result -49,250.00 301,056.00
Spread net 251,806.00
TABLE 2 SELLING THE SPREAD IN ANTICIPATION OF NARROWING SPREAD
Both the S&P 500 and Nasdaq 100 contracts rallied during this period, but
NQZ05 gained more than ESZ05 in both dollar and percentage terms (7.66
percent vs. 3.7 percent, respectively).
Action ESZ05 Action NQZ05
10/28/05 Sell 100 5,992,000.00 Buy 192 5,979,264.00
11/17/05 Buy 100 6,214,000.00 Sell 192 6,437,376.00
Result -222,000.00 458,112.00
Spread net 236,112.00
-Both indices fall but one falls less; or tions: early summer 2005, and then late
-One index rises while the other falls. fall 2005.
By early June, this spread had nar-
In the first two situations, the index rowed a great deal and had pushed
that rises more or falls less outperforms down to well below its long-term mean
the other. In the third situation, if the level. Like all true spreads, the ES/NQ
S&P 500 rises while the Nasdaq 100 falls, spread tends to be mean reverting.
the ratio will expand (the spread will Knowing this, early June may have
widen) — the S&P 500 will gain relative seemed a good time to buy the spread, in
to the Nasdaq 100. The converse is also anticipation of the S&P 500 subsequently
true: If the S&P 500 falls while the outperforming the Nasdaq 100.
Nasdaq 100 rises, the ratio will diminish Assume you bought the spread (long
(the spread will narrow) — the Nasdaq ESU05 and short NQU05) with the two
100 will outperform the S&P 500. If you contracts trading at 1,204.30 ($60,215.00)
look only at index levels, this might and 1,568.95 ($31,379.00), respectively.
seem counterintuitive, but if you look at These dollar values would require a 100
dollar values, it should make sense. to 192 ratio of contracts (60,215/31,379 =
Following ordinary spread logic, you 1.9189).
want to buy the spread when you expect Now assume you exit the spread on
it to widen and sell when you expect it to July 1 with ESU05 trading at 1,194.45
narrow. In this case, you buy or sell in ($59,722.50) and NQU05 trading at
terms of what you do with the S&P 500 1,490.55 ($29,811.00). During this month,
leg. To buy the spread, you buy ES and ESU05 outperformed NQU05 in the sense
sell NQ. To sell the spread, you sell ES it suffered only a 0.82 percent decline
and buy NQ. while NQU05 fell 5 percent. As a result,
the 100 to 192 spread would have earned
Trade scenarios $251,806.00 on these assumptions. Table 1
To develop a sense of the opportunities summarizes the details of this trade.
this spread can offer, consider two situa- Again, these ratios can be scaled
down to a size appropriate to any trad-
ing budget and comfort level, but any
scaling down of the ratio will require
rounding the number of contracts,
which will affect the results. For exam-
ple, the 10 to 19 ratio would have gener-
ated a $24,867.00 return, and the 1 to 2
ratio would have produced a $2,643.50
profit. The 10 to 19 ratio performed
slightly worse than the 100 to 192 ratio,
while the 1 to 2 ratio performed slightly
better. As this illustrates, rounding can
work for you or against you, but in this
case not to a deal-killing degree.
The second situation developed from
the end of September to the end of
October 2005. Spread trading veterans
point out the usefulness of charting
these spreads. Once you have a chart,
such as the ratio chart of Figure 2 (bot-
tom), you can examine chart features just
as you would a more familiar price
chart. Figure 2 seems to offer several
useful signposts — all of them pointing
to a narrowing of the spread.
First, the spread seemed to hit a ceil-
ing around Sept. 20. Then, it moved
through a series of lower highs and
lower lows. When the spread hit its third
lower high on Oct. 28, this might have
seemed the right time to sell the
December spread (sell ESZ05 and buy
NQZ05).
On Oct. 28, with ESZ05 trading at
1,198.40 ($59,920.00) and NQZ05 trading
at 1,557.10 ($31,142.00), the spread ratio
was again 1.92. Suppose you made the
trade by selling 100 ESZ05 and buying
192 NQZ05 and saw the ratio narrow to
1.85 by Nov. 17.
This amount of narrowing might have
made this seem like a good time to close
out this trade. After all, both contracts
rallied during this period, but NQZ05
gained more in both dollar and percent-
age terms. ESZ05 climbed from 1,198.40
to 1,242.80, a 3.7-percent change, while
NQZ05 soared from 1,576.10 to 1,676.40,
a 7.66-percent change. As Table 2 shows,
the 100 to 192 version of this spread
would have earned $236,112 on these
assumptions.
The ratio rationale
Ratios seem to complicate trade plan-
ning and monitoring, so it seems reason-
able to ask if it’s worth the trouble to use
them. Ratios are a good idea because if

37 www.activetradermag.com • May 2006 • ACTIVE TRADER

 Related reading
TABLE 3 RIGHT ON THE MARKET, WRONG ON THE TRADE Other articles by
If you believed NQZ05 would outperform ESZ05 in an anticipated rally, and Keith Schap:
shorted the spread by selling one ESZ05 and buying one NQZ05, you would
have been right about the market overall but the trade wouldn’t have “Implied volatility: An overlooked
worked out. The 1:1 spread would have booked a $784.00 loss. tool for stock and futures traders”
Active Trader, April 2006.
Action ESZ05 Action NQZ05 Implied volatility is usually associ-
11/1/05 Sell 1 60,137.50 Buy 1 31,530.00 ated with options trading, but
futures and stock traders can use
11/25/05 Buy 1 63,412.50 Sell 1 34,021.00
this information, too.
Result -3,275.00 2,491.00
Spread net -784.00 “The hidden factor in treasury
futures pricing”
Active Trader, February 2006.
TABLE 4 RIGHT ON THE MARKET, RIGHT ON THE TRADE — WITH A RATIO A look at some of the hidden
factors impacting treasury futures
If, instead of using the 1:1 spread ratio, you had sold the spread in a 1:2
prices.
ratio or a 10-to-19 ratio, you would have gained $1,707.00 or $14,579.00,
respectively. These are the results for the 10:19 ratio spread.
“Trading the energy story
Action ESZ05 Action NQZ05 with calendar spreads”
11/1/05 Sell 10 601,375.00 Buy 19 599,070.00 Active Trader, January 2006.
Step back from the hype
11/25/05 Buy 10 634,125.00 Sell 19 646,399.00 surrounding the crude oil and
Result -32,750.00 47,329.00 gasoline markets and discover how
Spread net 14,579.00 analyzing futures spreads can
pinpoint trading opportunities.

“Energy futures spreads”

you trade this spread on a 1-to-1 basis,
you can be right about which contract
will outperform but lose money because
the larger dollar size of the S&P 500 con-
tract will overwhelm the Nasdaq 100
contract.
For a case in point, consider the mar-
ket as it was on Nov. 1, 2005, when the
entire stock market seemed poised to
rally. Assume ESZ05 was trading at
1,202.75 ($60,137.50) and NQZ05 was
trading at 1,576.50 ($31,530.00). Assume
further you believed NQZ05 would out-
perform ESZ05 in this rally and shorted
the spread by selling one ESZ05 and
buying one NQZ05.
By Nov. 25, ESZ05 was trading at
1,268.25 ($63,412.50), and NQZ05 was
trading at 1,701.05 ($34,021.00). So far,
you would have been right about the rel-
ative changes. ESZ05 rose 5.45 percent
while NQZ05 rallied 7.90 percent.
Nonetheless, at this point the one-lot
spread would have booked a $784.00
loss (Table 3).
Suppose, given the same circum-
stances, you had sold the spread in a 1-
to-2 ratio, or in a more accurate 10-to-19
ratio. The smaller spread would have
generated a $1,707.00 gain. The larger
spread would have generated a
$14,579.00 gain. Table 4 displays the
details of the 10-to-19 spread.
The extra work the ratio entails seems
to pay off in obvious ways.
Going forward
Although spreads may be somewhat
safer than outright trades, they are spec-
ulative endeavors subject to losses if
your market forecast is incorrect. This
brings up the matter of how you can
know exactly when to enter and exit
these trades.
To put it bluntly — you can’t.
When you chart a spread ratio, as in
Figure 2, you can analyze the data as you
would any price series. When you locate
a spread mean for some period of time
and determine a range of interest, such
as plus and minus one standard devia-
tion, you are in a better position to esti-
mate possible turning points than you
might otherwise be.
In the final analysis, though, if you are
looking for surefire signals, you are
bound to suffer frustration. Nevertheless,
approached with careful study and rea-
sonable expectations, stock index spreads
can produce gratifying results.Ý
Active Trader, December 2005.
Discover what the spread market
was saying about oil surrounding
Hurricane Katrina and learn how
to trade spreads when supply
disruptions loom.
“Sector vs. index: The single
stock futures-Dow spread”
Active Trader, November 2005.
Learn how to create a spread
between the Mini Dow and several
single-stock futures, which can help
you take advantage of areas that
may lead (or lag) the market.
“The TUT spread — an active
spread for active traders”
Active Trader, October 2005.
This trade shows how to profit from
relationships between different
T-note futures contracts.
You can purchase past articles at
www.activetradermag.com/
purchase_articles.htm
and download them to your computer.

ACTIVE TRADER • May 2006 • www.activetradermag.com 38

 ADVANCED Strategies

The multibar range BREAKOUT SYSTEM

Breakouts of price channels can be
profitable — if the volatility is there
and you’re on the right side of the
trade. This stop-and-reverse system
tries to capture intraday trends in
the S&P E-Mini contract by recognizing
differences in the characteristics
of up moves and down moves.

B
BY DENNIS MEYERS, PH.D.
FIGURE 1 TRADESTATION CODE FOR THE MULTIBAR
RANGE BREAKOUT SYSTEM

{Strategy: #MultiBarRangeBO}
reakout systems are popular when markets are
Input: n(45),bx(0.45),m(15),sx(0.45),XTime(1515);
volatile. Such systems typically identify support
vars: hhv1(h),llv1(l),hhv2(h),llv2(l),ii(0),xb(c),xs(c);
and resistance levels when price has been moving
in a range or channel, and enter trades when price
hhv1=h; llv1=l;
breaks out of either the up side or down side of a channel.
for ii=1 to n-1 begin
There are two simple ways to define support and resistance
if h[ii]>hhv1 then hhv1=h[ii]; if l[ii]<llv1 then llv1=l[ii];
levels for price channels. In both cases, it is first necessary to
end;
define a lookback period. The first way is to use the highest
value1=hhv1-llv1;
high and the lowest low of the lookback period. The second
way is to determine the range of each bar (high minus low) and
hhv2=h; llv2=l;
add that range (or a percentage of it) to, or subtract it from, the
for ii=1 to m-1 begin
current close.
if h[ii]>hhv2 then hhv2=h[ii]; if l[ii]<llv2 then llv2=l[ii];
In either case, the upper and lower boundaries represent the
end;
price channel. One advantage to the second method is it better
value2=hhv2-llv2;
reflects the volatility of the market — it will expand and con-
tract as the volatility changes.
xb= c + (Value1 * bx);
Breakout strategies require the market to be in a high-volatil-
xs= c - (Value2 * sx);
ity period; a trade will become profitable only if it continues to
move in the direction of the breakout. Volatility and emotion go
if time<XTime then begin
hand in hand. As volatility increases, traders have to cope with
if marketposition<=0 then Buy Next Bar xb stop;
more risk; hence, the more emotional the market becomes. This
if marketposition>=0 then Sell Short Next Bar xs stop;
is often reflected by the fact markets fall faster than they rise.
end;
In the following system, the channel is determined by using
the range of the price bars in the lookback period. A breakout
if XTime<>0 then SetExitOnClose;
above or below the channel’s resistance or support creates buy
or sell signals.

39 www.activetradermag.com • January 2004 • ACTIVE TRADER

 However, the parameters for the buy signals will be TABLE 1 MULTIBAR RANGE BREAKOUT SYSTEM
different than those for the sell signals, because of the PERFORMANCE SUMMARY, JULY 7 TO AUG. 1, 2003
propensity for markets to fall faster than they rise. The
range for the last x bars will be defined as the highest The system triggered more short trades during the test, but pro-
high of the last x bars (including the current bar) duced profits on long trades, as well.
minus the lowest low of the last x bars (including the
current bar). All trades Long trades Short trades
The buy price is determined by adding a percentage
of the range of the last n bars to the current close — the Total net profit $4,912.50 $1,450.00 $3,462.50
previously described volatility-adjusted technique. If Gross profit $6,637.50 $1,912.50 $4,725.00
the next bar’s price exceeds the buy price, the system Gross loss ($1,725.00) ($462.50) ($1,262.50)
issues a buy signal. The sell price is determined by
Profit factor 3.85 4.14 3.74
subtracting a percentage (a different percentage than
the buy percentage) of the range of the last m bars from Open position P/L $0.00 $0.00 $0.00
the current close. If the next bar’s price falls below the
sell price, the system issues a sell signal. Total number of trades 55 20 35
The resulting Multibar Channel Breakout system Percent profitable 58.18% 55.00% 60.00%
will trade the S&P 500 E-Mini futures on an intraday
Winning trades 32 11 21
basis using one-minute bars. The TradeStation Code is
shown in Figure 1. Losing trades 22 9 13
Even trades 1 0 1
Multibar Channel Breakout rules
This is a stop-and-reverse system, meaning it is always Avg. trade net profit $89.32 $72.50 $98.93
in the market: When a sell signal occurs, long trades Avg. winning trade $207.42 $173.86 $225.00
are exited and a short trade is entered; when a buy sig- Avg. losing trade ($78.41) ($51.39) ($97.12)
nal occurs, short trades are exited and a long trade is
Ratio avg. winning/
entered. These are the system’s parameters:
avg. losing 2.65 3.38 2.32
ES = E-Mini price; Largest winning trade $700.00 $362.50 $700.00
BRange = the price range over the last n bars; Largest losing trade ($300.00) ($125.00) ($300.00)
SRange = the price range over the last m bars;
bx = the percentage multiplier of the BRange for Largest winner as
buy signals; % of gross profit 10.55% 18.95% 14.81%
sx = the percentage multiplier of the SRange for sell Largest loser as
signals; % of gross loss 17.39% 27.03% 23.76%
c = the current price;
Net profit as
buyCh = c + bx*BRange;
% of largest loss 1,637.50% 1,160.00% 1,154.17%
sellCh = c - sx*SRange
Max. consecutive
where winning trades 5 5 4
n = The number of lookback bars (including the cur-
Max. consecutive
rent bar) for buy signals.
losing trades 5 2 3
m = The number of lookback bars (including the
current bar) for sell signals. Avg. bars in
total trades 134.96 45.8 185.91
Notice that not only are the percentage multipliers Avg. bars in
for long (bx) and short trades (sx) different, the look- winning trades 166.88 69.18 218.05
back periods the system references for buys (n) and
Avg. bars in
sells (m) are also different. The trade rules are simple:
losing trades 91.95 17.22 143.69
1. Buy rule: Buy the next bar at buyCh, stop. Max. drawdown
2. Sell rule: Sell the next bar at sellCh, stop. (intraday peak to valley) ($887.50) ($862.50) ($975.00)
3. Intraday bar exit rule: Exit the position on the
Max. drawdown
close (no overnight trades).
(trade close to trade close) ($300.00) ($175.00) ($400.00)
Although it may not be immediately obvious, this sys- Max. trade drawdown ($475.00) ($475.00) ($362.50)
tem avoids the opening gap whipsaw problem —
Source: TradeStation
trades being triggered because of large gap openings

ACTIVE TRADER • January 2004 • www.activetradermag.com 40

 TABLE 2 TRADE-BY-TRADE SUMMARY: JULY 7 TO AUG. 1, 2003
This list contains each trade in the test period. Overall, 58.18 percent of trades were profitable.
Entry Entry Entry Exit Exit Exit Bars Trade Trade Trade
date time price ($) date time price ($) in trade $P&L max$Pft Time max$DD Time
7/7/03 10:36 Sell 1,003.75 7/7/03 12:35 1,002.50 119 $62.50 $175.00 12:06 ($12.50) 10:36
7/7/03 12:35 Buy 1,002.50 7/7/03 12:52 1,001.50 17 ($50.00) $0.00 12:35 ($50.00) 12:38
7/7/03 12:52 Sell 1,001.50 7/7/03 13:01 1,002.75 9 ($62.50) $25.00 12:55 ($62.50) 13:01
7/7/03 13:01 Buy 1,002.75 7/7/03 13:24 1,002.50 23 ($12.50) $37.50 13:23 ($25.00) 13:08
7/7/03 13:24 Sell 1,002.50 7/7/03 15:15 1,002.75 111 ($12.50) $87.50 14:22 ($112.50) 13:47
7/8/03 9:51 Sell 1,002.00 7/8/03 14:09 1,004.25 258 ($112.50) $62.50 11:21 ($175.00) 10:19
7/8/03 14:09 Buy 1,004.25 7/8/03 15:15 1,007.50 66 $162.50 $187.50 14:48 ($62.50) 14:11
7/9/03 9:33 Sell 1,007.75 7/9/03 15:15 1,001.00 342 $337.50 $525.00 11:03 $0.00 9:33
7/10/03 8:58 Sell 992.50 7/10/03 15:15 988.75 377 $187.50 $512.50 13:48 ($62.50) 9:04
7/11/03 9:05 Sell 993.25 7/11/03 15:15 997.75 370 ($225.00) $62.50 9:08 ($337.50) 11:23
7/14/03 9:54 Sell 1,012.25 7/14/03 15:15 1,002.75 317 $475.00 $575.00 14:46 ($112.50) 10:01
7/15/03 9:05 Sell 1,002.75 7/15/03 15:15 1,000.75 370 $100.00 $362.50 14:05 ($275.00) 9:46
7/16/03 8:48 Sell 1,000.50 7/16/03 12:10 993.25 202 $362.50 $625.00 10:12 $0.00 8:48
7/16/03 12:10 Buy 993.25 7/16/03 12:22 992.25 12 ($50.00) $0.00 12:10 ($50.00) 12:18
7/16/03 12:22 Sell 992.25 7/16/03 15:15 995.25 173 ($150.00) $187.50 14:30 ($150.00) 15:10
7/17/03 9:04 Sell 988.25 7/17/03 11:01 986.25 117 $100.00 $275.00 9:39 $0.00 9:04
7/17/03 11:01 Buy 986.25 7/17/03 11:02 983.75 1 ($125.00) $0.00 11:01 ($125.00) 11:02
7/17/03 11:02 Sell 983.75 7/17/03 15:15 980.50 253 $162.50 $337.50 14:01 ($25.00) 11:06
7/18/03 8:49 Sell 986.00 7/18/03 11:27 985.25 158 $37.50 $287.50 9:20 ($25.00) 9:02
7/18/03 11:27 Buy 985.25 7/18/03 12:02 985.50 35 $12.50 $62.50 11:31 ($12.50) 11:27
7/18/03 12:02 Sell 985.50 7/18/03 13:01 985.50 59 $0.00 $50.00 12:19 ($25.00) 12:03
7/18/03 13:01 Buy 985.50 7/18/03 14:35 991.50 94 $300.00 $375.00 14:11 $0.00 13:01
7/18/03 14:35 Sell 991.50 7/18/03 15:15 990.00 40 $75.00 $75.00 14:53 ($87.50) 14:41
7/21/03 8:32 Sell 988.00 7/21/03 15:15 978.25 403 $487.50 $700.00 14:10 ($12.50) 8:32
7/22/03 9:20 Sell 976.75 7/22/03 10:01 978.50 41 ($87.50) $112.50 9:50 ($87.50) 10:01
7/22/03 10:01 Buy 978.50 7/22/03 11:37 985.75 96 $362.50 $500.00 11:10 ($75.00) 10:18
7/22/03 11:37 Sell 985.75 7/22/03 14:37 987.25 180 ($75.00) $237.50 12:37 ($150.00) 14:02
7/22/03 14:37 Buy 987.25 7/22/03 15:15 986.75 38 ($25.00) $25.00 14:38 ($87.50) 14:49
7/23/03 8:35 Sell 986.25 7/23/03 12:51 984.75 256 $75.00 $412.50 11:16 $0.00 8:35
7/23/03 12:51 Buy 984.75 7/23/03 13:38 986.50 47 $87.50 $187.50 13:35 ($37.50) 12:55
7/23/03 13:38 Sell 986.50 7/23/03 14:27 986.75 49 ($12.50) $100.00 14:14 ($50.00) 13:39
7/23/03 14:27 Buy 986.75 7/23/03 15:15 987.75 48 $50.00 $62.50 15:13 ($62.50) 14:35
7/24/03 9:21 Sell 995.50 7/24/03 12:45 993.75 204 $87.50 $162.50 9:50 ($50.00) 10:27
7/24/03 12:45 Buy 993.75 7/24/03 13:10 994.25 25 $25.00 $62.50 12:57 $0.00 12:45
7/24/03 13:10 Sell 994.25 7/24/03 15:15 980.25 125 $700.00 $762.50 14:57 ($25.00) 13:11
7/25/03 8:43 Buy 982.50 7/25/03 9:01 983.25 18 $37.50 $150.00 9:00 ($37.50) 8:45
7/25/03 9:01 Sell 983.25 7/25/03 13:01 989.25 240 ($300.00) $375.00 9:52 ($337.50) 12:33
7/25/03 13:01 Buy 989.25 7/25/03 15:08 996.00 127 $337.50 $412.50 14:54 ($87.50) 13:25
7/25/03 15:08 Sell 996.00 7/25/03 15:15 997.00 7 ($50.00) $0.00 15:08 ($62.50) 15:12
7/28/03 8:33 Sell 995.50 7/28/03 12:37 996.50 244 ($50.00) $175.00 8:52 ($187.50) 10:29
7/28/03 12:37 Buy 996.50 7/28/03 12:57 996.25 20 ($12.50) $100.00 12:55 ($12.50) 12:37
7/28/03 12:57 Sell 996.25 7/28/03 15:15 993.50 138 $137.50 $187.50 14:42 ($87.50) 14:04
7/29/03 9:01 Sell 991.25 7/29/03 10:34 986.75 93 $225.00 $450.00 9:34 $0.00 9:01
7/29/03 10:34 Buy 986.75 7/29/03 11:28 992.00 54 $262.50 $450.00 10:58 ($12.50) 10:34
7/29/03 11:28 Sell 992.00 7/29/03 15:15 989.00 227 $150.00 $300.00 14:17 ($250.00) 12:33
7/30/03 8:34 Sell 990.00 7/30/03 11:38 989.25 184 $37.50 $275.00 10:32 ($37.50) 9:56
7/30/03 11:38 Buy 989.25 7/30/03 11:56 988.00 18 ($62.50) $0.00 11:38 ($62.50) 11:52
7/30/03 11:56 Sell 988.00 7/30/03 13:02 988.75 66 ($37.50) $62.50 12:19 ($50.00) 12:01
7/30/03 13:02 Buy 988.75 7/30/03 13:04 987.00 2 ($87.50) $0.00 13:02 ($87.50) 13:04
7/30/03 13:04 Sell 987.00 7/30/03 15:15 986.25 131 $37.50 $125.00 13:14 ($25.00) 14:21
7/31/03 9:00 Buy 995.75 7/31/03 11:20 1,001.25 140 $275.00 $387.50 10:14 ($400.00) 9:08
7/31/03 11:20 Sell 1,001.25 7/31/03 13:07 1,003.00 107 ($87.50) $37.50 11:40 ($112.50) 12:14
7/31/03 13:07 Buy 1,003.00 7/31/03 13:22 1,002.25 15 ($37.50) $12.50 13:19 ($50.00) 13:16
7/31/03 13:22 Sell 1,002.25 7/31/03 15:15 988.50 113 $687.50 $725.00 14:56 ($12.50) 13:22
8/1/03 8:46 Sell 983.50 8/1/03 15:15 979.50 389 $200.00 $300.00 9:35 ($125.00) 8:51
Source: Meyers Analytics, LLC

41 www.activetradermag.com • January 2004 • ACTIVE TRADER

 FIGURE 2 RIDING THE TREND
During this period, the system caught one intraday uptrend, one intraday downtrend, and produced small losses on two
signals when the market was flat.

September 2003 S&P E-Mini futures (ESU03), one-minute

1,010

Short
Short 1,005

Buy 1,000

995

990
Buy Short

End 985
End of day
of day exit
exit 980

600
400
200
0
-200

7/30 9:11 9:33 9:55 10:17 10:39 11:01 11:23 11:45 12:07 12:29 12:51 13:13 13:35 13:57 14:19 14:41 8/1
Source: TradeStation

that quickly reverse and stop out the position. With this sys-
tem, if there is a gap on the opening bar, the buy and sell ranges
are expanded and no trades are made until the buy and sell
ranges contract or the price breaks the expanded ranges.
Breaking the expanded ranges takes time and avoids the open-
ing gap whipsaw.
difficult to sustain more than a handful of consecutive losses,
we eliminated all cases that had more than five losing trades in
a row. Of the remaining test results, we chose the one that had
the highest total net profit and the lowest drawdown. The opti-
mization procedure produced the following system parame-
ters:

Testing
The system was tested from July 7 through Aug. 1, 2003, using
September 2003 E-Mini futures (ESU03) one-minute bars. A
wide range of parameter values was tested to find the optimal
ones for the system. The parameter ranges tested for the initial
optimization test were:
n =10 to 50 in steps of 5;
bx = 0.4 to 1 in steps of 0.05;
m = 10 to 50 in steps of 5;
sx = 0.4 to 1 in steps of 0.05;
After the initial test, we had to choose one set of parameters
that produced the most realistic results. To avoid curve fitting,
we eliminated all results that had profit factors (gross profit
divided by gross loss) greater than 4.0, since such performance
was unlikely to be duplicated in the future. Also, because it is
n = 45;
bx = 0.45;
m = 15;
sx = 0.45;
Table 1 (p. 40) shows the performance summary for the four-
week test period (slippage and commissions not included).
Table 2 (p. 41) is a trade-by-trade summary of all the trades.
The average net profit per trade was $89 — well above slip-
page and commissions for a typical S&P E-Mini trade. The
largest losing trade was $300, and the biggest intraday draw-
down was $887. These losses are small compared to the total
net profit of $4,912.
Figures 2 and 3 (p. 43) are one-minute charts of the S&P E-
Mini that span July 31 to Aug. 1. The Multibar Range Breakout
channels are superimposed on the price series, and all the buy
and sell signals are marked. Finally, the bottoms of Figures 2

ACTIVE TRADER • January 2004 • www.activetradermag.com 42

 FIGURE 3 ONE DAY, ONE TRADE
If no signal in the opposite direction is triggered, the system will stay in the same direction the entire day. All trades
are exited at the close — no positions are held overnight.

September 2003 S&P E-Mini futures (ESU03), one-minute 1,002

1,000
998
996
994
992
990
Sell 988
986
End of
day exit 984
982
980
978
End of 976
day exit

600

400

200

14:19 14:41 8/1 9:02 9:24 9:46 10:08 10:30 10:52 11:14 11:36 11:58 12:20 12:42 13:04 13:26 13:48 14:10 14:32 14:54

Source: TradeStation

and 3 include the bar-by-bar profit or FIGURE 4 DAILY PERSPECTIVES

loss of each trade.
The daily chart of the test period shows the system was able to profit on
Figure 4 is a daily chart of the S&P E-
both sides of the market when conditions shifted from uptrend to downtrend
Mini futures from July 7 to Aug. 1, and
to consolidation.
shows the market moved up, down and
sideways during this period. The system
September 2003 S&P E-Mini futures (ESU03), daily 1,015
was able to produce profits on both the
long and short sides of the market, and
1.010
aside from a streak of five losing trades
near the outset of the test period, never
1,005
had more than three consecutive losses.
The Multibar Channel Breakout sys-
1,000
tem’s positive performance warrants
further investigation. If you consider fol-
995
lowing this system in real-time, pay
close attention to how the real-time sta-
990
tistics compare to the hypothetical num-
bers shown here. If the numbers begin to 985
deviate, another review of the system
parameters are in order. Ý 980

975
7 14 21 28
Source: TradeStation

43 www.activetradermag.com • January 2004 • ACTIVE TRADER

FUTURES & OPTIONS
Trading Strategies

Following through
IN THE S&Ps
Strong closes and large ranges are often interpreted as signs
of potential follow-through, but this study unveils another way
to find out what today’s market action says about tomorrow’s.

BY THOM HARTLE

T
FIGURE 1 DOMINANT UP VOLUME: 50-59.99 PERCENT

When relative up volume was between 50 and 59.99 percent, all but
two days made higher highs.

45
40
he basic law of supply and demand
35
drives price swings in the stock mar-
30
ket, and the prevalence of one or the
25
Point +/-

other today can indicate what may

20
occur tomorrow. Although gauging whether sup-
15
ply or demand is dominating the market seems
10
like it would be a simple process, there are, in
5
fact, several ways to accomplish this, as well as
0
different ways to interpret the data.
11
13
15
17
19
21
23
25
27
29
31
33
35
37

-5
1
3
5
7
9

Breadth studies — specifically, comparing the

-10 Day New York Stock Exchange’s (NYSE) up volume
(the total volume of those stocks trading above
the previous day’s close) and down volume (the
FIGURE 2 DOMINANT UP VOLUME: 60-69.99 PERCENT total volume of those stocks trading below the
previous day’s close) statistics — have for years
Only one day (14) with relative up volume between 60 and 69.99 been a popular way to determine the relative
percent was followed by a lower high. dominance of demand or supply in stocks.
Traditionally, technical traders have looked for
45 breadth to confirm the trend — i.e., rising up vol-
40 ume relative to down volume supports a rising
35 market; increasing down volume while the mar-
30 ket is rising is a sign of “internal” weakness.
In this case, we will use a shorter-term
Point +/-

25
approach and analyze the NYSE up-down vol-
20
ume statistics at the close of the day to see if there
15
is any consistent follow-through price action in
10 the E-Mini S&P 500 futures the next day. The
5 period we analyzed was Aug. 20, 2002 to Aug. 27,
0 2003.
11
13
15
17
19
21
23
25
27
29
31
33
35

-5
1
3
5
7
9

Demand, supply and relative volume

Day

To get an idea of whether the relative volume

44 www.activetradermag.com • December 2003 • ACTIVE TRADER

 FIGURE 3 DOMINANT UP VOLUME: 70-79.99 PERCENT
All but one day following days with 70 to 79.99 percent relative up
offers any clues about market direction from one volume made higher highs, and the gains were, on average, smaller
day to the next, we divided the end-of-day NYSE than those for the 50 to 59.99 percent and larger than the 60 to
up- and down-volume figures, respectively, by 69.99 percent groups.
the combined volume — that is, up volume/(up
+ down volume) and down volume/(up + down 45
volume). Unchanged volume was ignored. These 40
figures express up and down volume as percent- 35
ages of up plus down volume. 30
To gauge how much follow-through occurred 25
Point +/-

the next day, for days with dominant (i.e., greater 20

15
than 50 percent) up volume, we calculated the
10
difference between the current close and the next
5
day’s high in the E-Mini S&P 500 (ES); for days
0
with dominant down volume, we calculated the
11
13
15
17
19
21
23
25
27
29
31
33
-5
1
3
5
7
9
difference between the current close and the next -10
day’s low. -15 Day
The data was grouped in percentage ranges:
50-59.99 percent (dominant up volume or down
volume), 60-69.99 percent, 70-79.99 percent and
80-89.99 percent. Figures 1 through 4 show the FIGURE 4 DOMINANT UP VOLUME: 80-89.99 PERCENT
point gains from the current close to the next
Except for one larger high-to-high gain, the moves following days
day’s high when the market closed with domi-
with 80 to 80.99 percent relative up volume were smaller than the
nant up volume. Figures 4 through 8 show the
preceding groups, and one day made a lower high.
point losses from the close to the next day’s low
for the days with dominant down volume.
45
For example, in Figure 1, the first up-volume
percentage reading (from Jan. 13, 2003) was 50.26 40
percent (which means the down-volume percent- 35
age was 49.74 percent). The E-Mini S&P closed at 30
Point +/-

924.00 that day. The next day’s high was 929.00, a 25

five-point gain that is shown by the first bar on 20
the chart. 15
The up-volume percentage was between 50
10
and 59.99 percent 37 times. The 37th reading,
5
which occurred on April 10, 2003, was 59.91 per-
cent. The S&P E-Mini closed at 870.50 that day 0
11

13

15

17

19

21

23

25
7

and made a high of 882.25 the next day, for an -5

1

Day
11.75 gain (the final bar in Figure 1). Only two
days made lower highs the day after posting rel-
ative up volume in the 50-59.99 percent range. Overall, Figures dominant down-volume days. The question is how far the
1 through 8 show the E-Mini S&P has a notable tendency to fol- market ultimately follows through the next day in the direction
low through the next day in the direction of the dominant rel- implied by the dominant relative volume.
ative volume.
One thing this analysis does not tell us, however, is whether Success rates
the market first made the daily high or low the following day. Approaching things from the opposite perspective, Table 1 (p.
The difference between the close and the next day’s low was 47) shows the number of times the market failed to trade at or
not calculated for days with dominant up volume; nor was the above the previous day’s close (for dominant up-volume days)
difference between the close and the following day’s high for or at or below the previous day’s close (for dominant down-

ACTIVE TRADER • December 2003 • www.activetradermag.com 45

FUTURES & OPTIONS
Trading Strategies continued
FIGURE 5 DOMINANT DOWN VOLUME: 50-59.99 PERCENT

All days with relative down volume between 50 and 59.99 percent
were followed by lower lows.

45 volume days). For example, two days with dom-

40 inant up volume in the 50-59.99 percent range
35 were followed by days that did not exceed the
previous day’s close. The remaining dominant
30
up-volume groups each had only one day that
Point +/-

25
failed to exceed the previous day’s close.
20 For the dominant down-volume days, the
15 market always dropped below the previous
10 day’s close in the 50-59.99 and 60-69.99 percent
5 groups; only one day failed to trade below the
previous close in the 70-79.99 percent group,
0
while two days failed in the 80-89.99 percent
11
13
15
17
19
21
23
25
27
29
31
33
1
3
5
7
9

Day group.
Table 2 shows the average and median price
moves by group. The average is the total differ-
FIGURE 6 DOMINANT DOWN VOLUME: 60-69.99 PERCENT ences divided by the number of occurrences. The
median is the center value of a series of numbers.
All days after relative down-volume readings between 60 and 60.99
For example, both the median and average of 1,
percent made lower lows, but the average losses were smaller than
2, 3, 4 and 5 is 3; for 1, 2, 3, 4 and 25, the median
those in the 50-59.99 percent group.
would still be 3, while the average would be 7. If
the average is higher or lower than the median,
45
the data is biased in that direction, which indi-
40
cates a few outliers, or out-of-character readings,
35 exist. In Table 2 the average rise after up-volume
30 dominant days for the 50-59.99 percent group
was 9.16 points, while the median was only 6.00,
Point +/-

25
20 indicating an upside bias.
In Figure 1 there are a few values that are four
15
to five times the size of most of the other values.
10
For the dominant down-percentage values, the
5 number is larger, which is interesting because
0 the analysis period was not dominated by a bear
trend.
11

13

15

17

19

21

23

25

27
1

Day
For the 80-89.99 percent dominant up-volume
group shown in Figure 4, most of the values
cluster above and below 5 points, while a single
FIGURE 7 DOMINANT DOWN VOLUME: 70-79.99 PERCENT
value exceeds 40 points. This move occurred on
One day (20) made a higher low in the 70-79.99 percent down-vol- Oct. 10, 2002, a reversal day after the S&P 500
ume group. made a new low for the three-year bear market.
If we remove this value, the average move drops
to 5.4 points and the median stays at 6 points.
45 Table 2 conveys the market is likely coming
40 out of congestion when the up or down volume
35 is in the 50-59.99 percent range because of the
30 more significant follow-through price move-
25
ment.
Point +/-

By comparison, when the up or down volume

20
percentages reach 80 percent, the statistics imply
15
the market has reached an overbought or over-
10 sold state — notice the follow-through in the
5 direction of the dominant volume is much lower.
0 However, just because the market has reached
an overbought or oversold state does not mean
11

13

15

17

19

21

23

25

27

29

-5
1

Day
the overall trend is reversing. The study only
addresses the next day’s price behavior.

46 www.activetradermag.com • December 2003 • ACTIVE TRADER

 FIGURE 8 DOMINANT DOWN VOLUME: 80-89.99 PERCENT
The increased number of small close-to-low moves and the presence
of two days with higher lows suggest the market is oversold when
relative down volume exceeds 80 percent.
Another thing to consider is maximum favor-
able excursion — the largest profitable price 45
move the market makes over the course of a trade 40
or observation period. Looking at the data, what 35
can we determine as to the degree of typical fol- 30
low-through price movement? Table 3 (bottom,

Point +/-
25
right) shows the percentage of times a price move
20
of a certain magnitude is hit — in this case, 2.5
15
points or more, 5 points or more and 7.5 points or
more. 10
For the 2.5 point threshold, the success rates 5
are quite high and, not surprisingly, work their 0
way lower for the larger price targets. Also, the -5

11

13

15

17

19

21

23

25

27

29
1

9
Day
downside targets have higher success rates,
which were indicated by the higher averages for
the down-volume percentages in Table 2. TABLE 1 FAILURE TO REACH CLOSE
This shows the number of times the market failed to
reach the closing price of dominant up- and down-volume

Markets move the most after days, broken down by percentage range.
Fail 50-59.99% 60-69.99% 70-79.99% 80-89.99%
days with mixed opinions — Up
Down
2
0
1
0
1
1
1
2

that is, when the up or down

volume ratio is not far from
TABLE 2 AVERAGE AND MEDIAN MOVES
Comparing the average and median point moves of the

the 50-percent mark.

different ranges reveals certain directional biases.

Up 50-59.99% 60-69.99% 70-79.99% 80-89.99%

Average 9.16 8.44 8.74 6.79
Median 6.00 7.38 8.50 6.00

The lowest success rate is 35 percent for the 7.5 target in the Down 50-59.99% 60-69.99% 70-79.99% 80-89.99%
80-89.99 percent up-volume group. This is another sign that Average 10.42 10.23 8.28 8.85
once market participants make a large commitment, the prob- Median 8.25 11.13 5.63 10.50
ability for higher prices in the near term declines.
All the tables’ upper ranges are limited to 89.99 percent up
or down volume because 90 percent or higher up or down vol- TABLE 3 HITTING THE MARKS
ume is rare. It only occurred twice for dominant up volume
(with follow-through of 11.75 and 3.25 points) and three times This table shows the percentage of time the market fol-
for dominant down volume (follow-through of 2.75, 8.25 and lowed through with moves of 2.5, 5 and 7.5 points.
7.5 points).
2.5 points 50-59.99% 60-69.99% 70-79.99% 80-89.99%
Putting it into action Up (%) 84 86 82 77
How can this information be incorporated into a trading plan? Down (%) 88 89 80 76
First, if you are holding a position in the E-Mini S&P futures
with a profit going into the close and the up or down volume 5 points 50-59.99% 60-69.99% 70-79.99% 80-89.99%
for the day confirms your trade (e.g., you are long and the up Up (%) 57 69 59 58
volume is dominant), you know from Table 3 there is a very Down (%) 82 70 57 55
high chance of getting at least an additional 2.5 points in the
next session. 7.5 points 50-59.99% 60-69.99% 70-79.99% 80-89.99%
Figure 9 (p. 48) is a 30-minute chart for Aug. 12 and 13, 2003. Up (%) 49 50 56 35
At the close on Aug. 12, the up-volume ratio was 76 percent Down (%) 58 63 47 55
and the E-Mini S&P closed at 990.00. The market traded an

ACTIVE TRADER • December 2003 • www.activetradermag.com 47

FUTURES & OPTIONS
Trading Strategies continued

FIGURE 9 EXPECTED FOLLOW THROUGH

Relative up volume of 76 percent was followed by a 3.5-point high-

to-high price move.

Continuous S&P 500 E-Mini The day session high

additional 3.50 points higher the next day (as well (ES), 30-minute was 3.5 points higher
as 3.00 points higher in the night session). On 992
Aug. 13, the market closed at 984.75, and the
down volume dominated by just 56 percent. The Up volume at the 990
close was 76%
next day, the low was 979.25, a difference of 5.5
points (see Figure 10).
988

Other factors
Keep in mind the possibility of “artificial” issues 986
that could affect the outcome of trades based on
this kind of analysis. For instance, in Figure 3, the 984
second to last reading was -7.75 points (the only
negative value in the group), meaning the next
982
day’s high was 7.75 points below the current
close. The up-volume ratio the previous day,
March 21, 2003, was 79 percent. 980
However, March 21 was an option expiration
day. Considering the market’s sustained upward 978
drive during the middle of March, the high rela-
tive up volume was likely less the result of new
976
long-side positions than a function of traders cov- 8/12/03 8/13/03 8/14/03
ering bearish options positions.
Source: Fibonacci Trader

Conclusion
This study does not comprise a trading system, FIGURE 10 DOWNSIDE FOLLOW THROUGH
especially considering it does not measure how
After posting 56-percent relative down volume, the S&P E-Mini fell
far the market moves counter to the implied
5.5 points from the previous low.
direction before reaching its peak value.
In other words, although the statistics may
Continuous S&P 500 E-Mini (ES), 30-minute
indicate there is a 70-percent chance the E-Mini
S&P will decline 5 points or more the day after 992
the down-volume ratio is between 60 and 69.99
percent, we do not know how much the market At the close,
the down volume 990
tends to rally before reaching that target. If the
was 56%
average up move is, say, 9 points, it calls into
question the wisdom of trying to capture a 5- 988
point down move. However, the tendencies out-
lined here can be combined with tested setups
and provide an additional input in deciding 986
whether to hold or exit at the close.
This study indicates markets move the most
984
after days with mixed opinions — that is, when
the up or down volume ratio is not far from the
50-percent mark. As everyone gets on board, 982
next-day follow through drops. The majority of
players have spent their capital or given up on
the trade, so the market is running out of fuel. 980
The next day’s low
Finally, the generally higher average and was 5.5 points lower
medians for the dominant down volume follow-
through levels are reminiscent of an old saying 978
8/13/03 8/14/03 8/15/03
from the pits: The market giveth and the locals
taketh away.Ý
Source: Fibonacci Trader

48 www.activetradermag.com • December 2003 • ACTIVE TRADER

 TRADING Strategies

Getting in on FOLLOW-THROUGH DAYS

In a follow-up to last month’s article discussing the odds of next-day
follow-through in the S&P futures, a trader looks at the realities of basing
entries on this price behavior.

BY THOM HARTLE

F ew things are as important to short-term traders as

“follow-through” — additional price action in the
direction of the previous day’s (or days’) move.
In addition to analyzing price behavior (the level of the clos-
ing price, for instance), monitoring the relative strength of
either up volume or down volume can also provide an indica-
when New York Stock Exchange (NYSE) up volume or down
volume dominated the total volume (defined here as up vol-
ume plus down volume, and not counting unchanged volume)
for the day. Analyzing the period from Aug. 12, 2002, to Aug.
27, 2003, (using continuous S&P 500 futures data) showed dom-
inant up volume or down volume on a given day was, in fact,
tion of the likelihood of follow-through in the stock market. in some circumstances a reliable measure of upside or down-
“Following through in the S&Ps” (Active Trader, December side follow-through the next day.
2003, p. 60) detailed the differences in price behavior after days The results were grouped according to the percentage of
dominant volume on a given day.
For example, if up volume account-
FIGURE 1 50- TO 59.99-PERCENT UP-VOLUME DAYS ed for 58 percent of the total vol-
The difference between the close and the next day’s high and low is sorted by which ume on a particular day, this day
was established first, the low (on the left) or the high (on the right). Although the was grouped in the 50- to 59.99-per-
S&P E-Mini made its daily high first 57 percent of the time, the moves from the pre- cent up-volume range; if the up vol-
vious close to the high on those days were smaller than the moves from the previ- ume was 63 percent of the total vol-
ous close to the low. ume, the day fell in the 60- to 69.99-
percent range. The dominant
45 down-volume days were organized
in similar ranges.
Difference btwn. close and next day’s high or low

35 High established first The follow-through price move-

25 ment for each of these ranges was
then characterized. For instance,
15 the average difference between the
5 closing price and the next day’s
high for all instances in the 50- to
-5 59.99-percent up-volume range was
-15 9.16 points. There were only two
instances (out of 37 total) when the
-25 up volume was between 50 and
-35 Low established first 59.99 percent of the total volume
and the following day’s high was
-45 not above the closing price.
1 2 3 4 5 6 7 8 9 10 1112 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37
One of the basic implications of
Close-to-high move Close-to-low move the analysis was that dominant up-
volume or down-volume readings

49 www.activetradermag.com • January 2004 • ACTIVE TRADER

 TABLE 1 AVERAGE CLOSE-TO-HIGH AND CLOSE-TO-LOW
MOVES FOR UP-VOLUME DAYS
This breakdown of the price moves for the different dom-
inant up-volume ranges reveals an interesting fact: The
average up moves (from the close to the following high)
rarely concluded a swing move — that is, there was usually were higher on those days the market made its daily low
follow-through movement the next day in the same direction. before its daily high.
However, the article also showed the higher the percentage of
High (Avg.) Low (Avg.)
dominant volume, the smaller the average follow-through
move. This makes sense if we consider the market is com- 50-59.99% Up Low first 15.47 -6.22
posed of a relatively stable number of players on a day-to-day High first 4.36 -16.18
basis, and once the majority of traders and investors make 60-69.99% Up Low first 10.70 -4.86
their commitments (reflected by a high level of relative up or High first 7.00 -11.74
down volume), the market will run out of steam and lose 70-79.99% Up Low first 12.53 -4.91
momentum or retrace. High first 4.94 -16.16

Which came first: High or low? 80-89.99% Up Low first 10.20 -6.23
High first 4.28 -10.08
The previous month’s article analyzed the follow-through ques-
tion in terms of exiting trades: Does the follow-through implied
by a certain relative volume reading provide a good guide for TABLE 2 AVERAGE CLOSE-TO-HIGH AND CLOSE-TO-LOW
getting out of a position immediately or staying in for addition- MOVES FOR DOWN-VOLUME DAYS
al profits?
The average close-to-low moves were generally bigger
Other questions still need to be answered: Based on the rela-
when the market made its daily high before its daily low.
tive volume, can you enter a trade on the close in anticipation of
The tendencies in Tables 1 and 2 suggest it may be worth-
the average follow-through move (or some percentage of it) to
while to consider a pullback strategy that goes long on the
occur in the S&P 500 futures contract the following trading ses- follow-through day when price makes an intraday low, or
sion? And more importantly, what would be the average risk? goes short when price makes an intraday high.
There are two issues to consider here: First, if the market
closed with a high percentage of up volume, how often does High (Avg.) Low (Avg.)
the S&P reach (the next day) its high before making its low. If
the market established the low first, going long on the previ- 50-59.99% Down Low first 15.57 -5.20
ous day’s close might not present such an attractive buying High first 4.88 -14.28
opportunity because you might have to suffer through an 60-69.99% Down Low first 14.82 -5.80
adverse market move before getting a chance to realize a prof- High first 4.38 -15.71
it. The opposite is true for down-volume days: You would pre- 70-79.99% Down Low first 13.87 -4.65
fer the follow-through day to hit its low before its high. High first 5.65 -11.92
Second, if the market does not first reach its high after a
80-89.99% Down Low first 14.24 -5.95
dominant up-volume day or its low after a dominant down-
High first 6.85 -14.38
volume day, how much does the market tend to move against
the expected trend? This will deter-
mine how much risk you must FIGURE 2 60- TO 69.99-PERCENT UP-VOLUME DAYS
assume to attain a potential reward.
Like the previous study, the fol- In the 60- to 69.99-percent up-volume group, the percentage of follow-through days
lowing analysis of S&P futures data on which the market made its intraday high before the intraday low increased to 61
(including the Globex session) percent.
groups the data according to the
45
dominant relative volume level for
Difference btwn. close and next day’s high or low

the day in ranges of 50 to 59.99 per- 35 High established first

cent, 60 to 69.99 percent, 70 to 79.99
25
percent and 80 to 89.99 percent.
Then, for each range, we determine 15
how often the market first makes its
5
high or low on the following day.
-5
The results -15
Figure 1 (opposite page) shows the
difference between the close and -25
the next day’s high and low for the -35 Low established first
50-59.99 percent up-volume group,
sorted by which price was estab- -45
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36
lished first, the low (on the left) or
the high (on the right). Close-to-high move Close-to-low move
The up volume was between 50

ACTIVE TRADER • January 2004 • www.activetradermag.com 50

 FIGURE 3 70- TO 79.99-PERCENT UP-VOLUME DAYS

The follow-through days were split evenly between those that made the intraday
high first and those that made the intraday low first. percent of the time, and a 7.5-percent
target was reached only 49 percent of
45
the time.
Difference btwn. close and next day’s high or low

35 High established first The substantial difference between

the 2.5 target (hit 84 percent of the time)
25
and a 5-point target (hit just 57 percent
15 of the time) makes sense in light of
information in Table 1: When the high
5
did occur first (21 of the 37 days), the
-5 average move was just 4.36 points.
Figure 1 shows this as well. The high
-15
occurred first on bars 17 through 37. We
-25 can see how much smaller the green
Low established first bars (representing the difference
-35
between the high and the previous
-45 day’s close) are in this group.
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 Table 1 shows if the low occurred
Close-to-high move Close-to-low move first, the average difference between
the close and the low was -6.22 points,
with the worst instance being -15.47
FIGURE 4 80- TO 89.99-PERCENT UP-VOLUME DAYS points (see Figure 1). So, if you were
looking to take a 2.5-point profit from a
The S&P E-Mini made its intraday high before its low 58 percent of the time, but
long position, you had the possibility of
those close-to-high follow-through moves were the smallest of any group.
having to weather, on average, an
adverse move more than twice the size
45 of your desired profit if the high did not
Difference btwn. close and next day’s high or low

35 occur first.
High established first
Figures 2 through 8 show compara-
25 ble breakdowns of the remaining dom-
15 inant up-volume and down-volume
ranges. Figure 2 (p. 50) reveals the high
5 occurred first 61 percent of the time in
-5 the 60- to 69.99-percent up-volume
group, a slight improvement over the
-15 50- to 59.99-percent group. Also, the
-25 difference between the close and the
low (regardless of whether the high or
-35 Low established first low occurred first) was better than the
-45 50- to 59.99-percent group (-4.86 and -
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 11.74 vs. -6.22 and -16.18). This implies
Close-to-high move Close-to-low move when the market closes with a higher
degree of conviction — as indicated by
greater relative up volume — the mar-
and 59.99 percent on 37 days. The high occurred first on 21 (57 ket performs better the following day.
percent) of those days and the low occurred first on the 16 Figure 3 shows the 70- to 79.99-percent up-volume group
remaining days. When the high occurred first, the average dif- was split 50 percent between days the high occurred first and
ference between the previous close and the high was 4.36 days the low occurred first. Figure 4, the 80- to 89.99-percent
points. up-volume group, shows the high occurred first 58 percent of
Tables 1 and 2 (p. 50) break down the average differences the time, but the average follow-through for the difference
between the highs and the closes and the lows and the closes, between the close and the high was the lowest of the four
according to whether the low occurred first or the high groups, implying the market is overbought when the up-vol-
occurred first. ume percentage is this extreme.

Entering trades Down-volume days

From here, it is easier to gauge the value of entering a trade on
the close based on the relative volume. “Following through in
the S&Ps” showed that when the relative up volume was in the
50- to 59.99-percent range, price hit a 2.5-point profit target 84
percent of the time the next day; a five-point target was hit 57
Figure 5 shows the 50- to 59.99-percent down-volume group. To
consider a short position on the close, we would look for evi-
dence the low occurs before the high on the following days.
However the low occurred first only 42 percent of the time.
(Perhaps this is a “hope springs eternal” phenomenon, in that

51 www.activetradermag.com • January 2004 • ACTIVE TRADER

 FIGURE 5 50- TO 59.99-PERCENT DOWN-VOLUME DAYS
On days following dominant down-volume readings between 50 and 59.99 percent,
the market made its intraday low before the intraday high only 42 percent of the
the market tends to begin the day trad- time.
ing to the upside, even thought the pre-
vious day’s activity was slightly more 45

Difference btwn. close and next day’s high or low

dominated by sellers, but then sets the
35 High established first
high for the day and falls back down.)
Figure 6, the 60- to 69.99-percent 25
down-volume group, is a little more
what you would expect, in that the low 15
occurred first 52 percent of the time. 5
Table 2 shows the largest average drop
(-15.71 points) for the down volume -5
group happened when the high was set -15
first in the 60- to 60.99-percent down-
volume group. -25
Figure 7 (p. 53), the 70- to 79.99-per- -35 Low established first
cent down-volume group, is also split
50-50 between the low or the high -45
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33
being set first. However, if the low is set
Close-to-high move Close-to-low move
first, this group has the lowest average
difference (-4.65 points) between the
low and the previous day’s close.
Finally, Figure 8 (p. 53), the 80- to FIGURE 6 60- TO 69.99-PERCENT DOWN-VOLUME DAYS
89.99-percent down-volume group,
In this down-volume group, the percentage of days on which the low was established
shows the low was hit first 66 percent
first increased to 52 percent.
of the time. This data appears to indi-
cate likely follow-through the next day
45
— perhaps panic selling because of the
Difference btwn. close and next day’s high or low

amount of heavy selling the previous 35 High established first

day.
25
Going the opposite direction:
Pullback possibilities?
15

At this point, the likelihood of follow- 5

through movement in the direction
-5
indicated by the dominant volume
seems like a coin toss. If you used any- -15
thing but the 2.5-point target, the
-25
potential reward was not worth the Low established first
risk. -35
But what if you used a more classic
pullback approach of buying after the -45
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27
low occurred first following a domi- Close-to-high move Close-to-low move
nant up-volume day, or selling when
the high occurred first after a dominant
down-volume day, in anticipation of higher prices? up and down volume. Again, they are closely matched. The
Figure 9 (p. 53) draws on some of the data from Tables 1 and fourth pair is from the 80- to 89.99-percent group.
2. Here we will look at the data from the perspective of buying Looking at all four pairs, it is interesting that the green bars are
a pullback or selling a rally. The first green bar is the average somewhat lower from left to right, supporting the notion that up
difference between the close and the high from the 50- to 59.99- volume represents new buying, and that as more commitments
percent up-volume group for those days the low was made are made the follow-through the next day tapers off as capital is
first. The first red bar is the absolute value of the average dif- spent. However, when the market is falling, the average move-
ference between the close and the low for the days the high ment does not taper off in the same fashion because it doesn’t cost
occurred first from the 50- to 59.99-percent down-volume anything to get out of a long position.
group. The two bars are similar in height. Tables 1 and 2 also reveal something about the typical behav-
The second pair of histograms represents the same price ior if the market fails to generate follow-through activity. For
measurements from the 60- to 69.99-percent up- and down-vol- example, for the 70- to 79.99-percent up-volume group, the
ume groups. Interestingly, the market appears to really drop average move from the close to the following high is 12.53
following a down volume day if the high is made first. points if the low occurs first; if the high occurs first, the average
The third pair of histograms is from the 70 to 79.99 percent move from the close to the following day’s low is -16.16 points.

ACTIVE TRADER • January 2004 • www.activetradermag.com 52

 FIGURE 7 70- TO 79.99-PERCENT DOWN-VOLUME DAYS
Like its up-volume range counterpart, days in the 70- to 79.99-percent down-volume Additional research
group were divided equally between days that made the intraday high first and days
“Following through in the S&Ps”
that made the intraday low first.
(Active Trader, December 2003.
45 Past Active Trader articles can be
Difference btwn. close and next day’s high or low

High established first purchased and downloaded

35
directly to your computer
25 through our Web site….

15
This indicates there was a great
5 deal of capital committed the previ-
ous day and when the market
-5
topped out with little follow-
-15 through (an average close-to-high
move of just 4.94 points) when the
-25
high occurred first, the selling pres-
-35 Low established first sure overwhelmed whatever bid
was still there. That is, a lot of
-45 traders were easily forced out of
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
Close-to-high move Close-to-low move positions placed the previous day.
We see similar results from the
50- to 59.99-percent up-volume
FIGURE 8 80- TO 89.99-PERCENT DOWN-VOLUME DAYS group. The kicker is this negative
In this group, 66 percent of days established the intraday low first. price action following an up-vol-
ume day is worse than that in Table
45 2, which shows the down-volume
Difference btwn. close and next day’s high or low

35 High established first group statistics and is where we

would expect larger numbers. This
25 is why one should never trade on
hope, and should always use stops.
15

5 The ins and outs

The studies from this article and its
-5
predecessor provide useful infor-
-15 mation for trading plans. The first
article discussed the potential
-25 advantages of holding a position
-35 Low established first until the next close rather than the
current close if the volume statistics
-45 supported it. The goal was only an
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29
additional 2.5 points of profit, like-
Close-to-high move Close-to-low move ly to be hit.
Here though, a critical compo-
nent to employing this volume
FIGURE 9 PULLBACK POSSIBILITIES
analysis is factoring in the risk depending on whether the high
While the green bars are somewhat lower the greater the or low comes first. The best opportunities probably are available
percentage of up/down volume, the red bars do not follow a if you use some technical pattern setup or oscillator that can
similar pattern. This supports the theory that buying tapers indicate there is a good probability the low or high for the ses-
off as capital is spent, but selling remains constant because sion is occurring. This could then be acted upon in the context
it doesn’t cost anything to get out of a long position. of the expected move derived from the dominant volume statis-
18.00
tics.
In addition, this work could be done in the framework of the
Avg. diff. btwn.close and high or low

16.00
14.00
overall trend. For example, if the trend was up (based on just a
12.00
simple moving average), the previous day’s up volume was 62
10.00
percent of the total volume and the market was down on the day,
8.00
then look for an indication the low for the day is being established.
6.00
You likely have a very good risk-reward trade opportunity.
4.00
Finally, if the market fails to follow through in the anticipat-
2.00
ed direction and the high or low that occurs first is counter to
0.00
the anticipated direction (and is near the average values in
50-59.99% 60-69.99% 70-79.99% 80-89.99% Tables 1 and 2), there is greater potential for a move in the
C-H (when low C-L (when high opposite direction than a move in the expected direction. Ý
occurs first) occurs first)

53 www.activetradermag.com • January 2004 • ACTIVE TRADER

FUTURES & OPTIONS
Trading Strategies

Follow-through in the E-MINI

NASDAQ 100
Analyzing volume reveals
small, but important,
tendencies that can improve
short-term trading
performance.

T
FIGURE 1 ANALYSIS PERIOD BY THOM HARTLE
The analysis period, which spanned 314 trading days, was dominated by an
uptrend.
E-mini Nasdaq 100 (NQ), daily
1,550

1,500 raders can gain insight into

1,450
the trend of the market by
comparing the number of
1,400 stocks up on the day to
1,350 those down on the day, a statistic called
breadth. This kind of measurement is
1,300 sometimes referred to as a market
1,250 “internal” because it provides a perspec-
tive on market dynamics not immedi-
1,200 ately apparent in “external” price action.
1,150 If many more stocks are up than down
by the close, it implies demand for stocks
1,100 was strong that day. On the other hand,
1,050 if more stocks close lower on the day, it
suggests sellers dominated trading and
1,000 the near-term outlook is negative. The
950 running total of the difference between
the number of stocks trading higher and
January 2003 April July October January 2004 those trading lower is the basis for the
Source: CQG, Inc. advance-decline (A/D) line.

54 www.activetradermag.com • August 2004 • ACTIVE TRADER

 FIGURE 2 UP VOLUME: 50-59.99 PERCENT
Of the days with up volume between 50 and 59.99 percent, only one was fol-
lowed by a day that failed to trade above the closing price.

60

Follow-through price moves (points)

50

40

30

20

This statistic can be augmented with 10

the volume of stocks trading higher and
lower, referred to as the advancing vol- 0
ume and declining volume. The logic of
combining the number of stocks trading -10
higher or lower and the volume of those

10

13

16

19

22

25

28

31

34

37
Trading session
stocks is simple: A stock up 1 point on
Source: Excel; data — eSignal
volume of 100 million shares is making
a stronger statement about the demand-
FIGURE 3 UP VOLUME: 60-69.99 PERCENT
supply situation than if it was up 1 point
on only 10 million shares. The average follow-through move after days with up volume between 60 and
The goal is to translate this logic into 69.99 percent was 15.46 points.
tradable procedures. If there was a sign
of strong demand yesterday, does that
indicate anything for today, such as how 60
high the market might move relative to
Follow-through price moves (points)

50
yesterday’s close? Or, if the sellers dom-
inated yesterday, how far might the 40
market fall today below yesterday’s
close? 30
Using the end-of-day Nasdaq up-vol-
ume and down-volume statistics, we 20
will calculate which was dominant (i.e.,
greater than 50 percent) — the ratio of 10
up volume/(up + down volume) or the
0
ratio of down volume/(up + down vol-
ume). For example, on March 31, 2004, -10
the up volume was 669,250,000 shares
1

10

13

16

19

22

25

28

31

34

37

40

43

46

49
and the down volume was 1,112,473,000 Trading session
shares. Because the down volume was Source: Excel; data — eSignal
larger, the calculation is 1,112,473,000/
(669,250,000 +1,112,473,000) = 62.44 per- FIGURE 4 UP VOLUME: 70-79.99 PERCENT
cent of the total up and down volume
Each day following a 70- to 79.99-percent up-volume day traded above the
(the volume of stocks unchanged on the
previous closing price.
day is not included).
To see what kind of follow-through
occurs in the market on days with dom- 60
inant volume, measure the difference
Follow-through price moves (points)

between the closing price of the E-mini 50

Nasdaq 100 futures (NQ), including the
night session, and the next day’s high. 40
For days down volume dominated, cal-
culate the difference between the close 30
and the following day’s low.
Next, group the volume-ratio read- 20
ings into percentile ranges and then sort
the follow-through price action in each
10
group from lowest to the highest. For
example, the groupings for dominant up
0
volume and dominant down volume
1

10

13

16

19

22

25

28

31

34

37

40

43

46

49

used here will be 50-59.99 percent, 60- Trading session

Source: Excel; data — eSignal

ACTIVE TRADER • August 2004 • www.activetradermag.com 55

FUTURES & OPTIONS
Trading Strategies continued
FIGURE 5 UP VOLUME: 80-89.99 PERCENT
Each day following the days in this group traded above the previous day’s Figure 4 (p. 55) is the 70- to 79.99-per-
close, but the moves were smaller than those in the other groups. cent group. The market traded above the
previous close in every instance in this
group, with an average follow-through
60
move of 12.86 points. The market moved
Follow-through price moves (points)

at least 7 points above the previous day’s

50 close 70 percent of the time. However,
although Figure 4 includes an “outlier”
40 (an extremely high or low value) gain of
48 points, it has only one other reading
30 larger than 30 points. The 60-69.99 group
in Figure 3 shows a more consistent
20 upward bias, which is also reflected by
its higher average reading.
10 The 80- to 89.99-percent follow-
through readings are shown in Figure 5.
0 In this group of 29 occurrences the aver-
age move was 11.14 points and the mar-
1

11

13

15

17

19

21

23

25

27

29
Trading session
ket moved 5.50 points or more 70 per-
Source: Excel; data — eSignal cent of the time.
Overall, the market followed through
FIGURE 6 DOWN VOLUME: 50-59.99 PERCENT the next day (to some degree) the vast
When down volume was between 50 and 59.99 percent, the market followed majority of the time when up volume
through to the downside an average of 14.77 points. dominated the day’s activity. The market
failed to trade above the previous close
only four of 173 observations.
10 The instances with the highest domi-
nant up-volume readings — i.e., the
Follow-through price moves (points)

0 over-70-percent and the over-80-percent

groups — had less follow-through the
-10 next day compared to the days the read-
ings fell between 50 percent and 69.99
-20 percent.
Although this might seem counterin-
-30 tuitive, it supports the notion that there’s
nobody left to buy following the kind of
-40 good news that results in extremely high
up-volume readings. Buyers do not have
an unlimited supply of capital to hold
-50
long positions in the markets. However,
1

10

13

16

19

22

25

28

31

34

37

40

43

Trading session this does not indicate the market is about

Source: Excel; data — eSignal to make a major reversal, as the analysis
only looks at the next day’s price activi-
69.99 percent, 70-79.99 percent and 80- readings. Figure 2 shows there were 38 ty.
89.99 percent. sessions with up volume between 50 and Follow-through was greatest in the
The analysis period for this study was 59.99 percent; only one of the days fol- 50- to 59.99-percent group. This implies
Jan. 2, 2003, to March 31, 2004, a total of lowing these days failed to trade above that even though up volume was domi-
314 trading sessions (see Figure 1). the previous day’s close. The average nant, the market is closing with a rela-
During this period the market was, for follow-through move for the days that tively mixed commitment of buyers and
the most part, dominated by an uptrend traded above the close was 20.58 points, sellers. But when trader opinion is
— a bias reflected in the analysis by a and the market moved 8.50 points or mixed, a trend emerges as participants
total of 173 days with dominant up vol- more 70 percent of the time. adjust to create a more uniform market
ume vs. 141 days with dominant down Figure 3 shows the 60- to 69.99-percent — either buyers or sellers conclude they
volume. group, which contained 51 trading ses- were wrong and must exit the market or
sions. The following day the market trad- switch direction. When there are more
When up volume dominates ed above the close 48 times, with an aver- potential buyers still on the sidelines, the
Figures 2 through 5 show the follow- age move of 15.46 points. Seventy percent resulting move will be larger when they
through price moves in the E-mini of the time the market moved at least 7 eventually enter the market.
Nasdaq 100 after dominant up-volume points above the previous day’s close.

56 www.activetradermag.com • August 2004 • ACTIVE TRADER

 FIGURE 7 DOWN VOLUME: 60-69.99 PERCENT
The average downside follow-through move in this group was 13.92 points,
slightly smaller than the 50- to 59.99-percent group.

10
When down-volume dominates

Follow-through price moves (points)

Figures 6 through 9 show the break- 0
down of days dominated by down vol-
ume. Figure 6 shows the 50- to 59.99- -10
percent down-volume group. Of 44
days, only two never traded below the -20
close the following day. The most
extreme drop was a decline of 44 points, -30
and the average was 14.77 points.
Seventy percent of the declines were 5 or
-40
more points.
Figure 7 shows the 60- to 69.99-per-
-50
cent group. Thirty-two of 34 sessions

11

13

15

17

19

21

23

25

27

29

31

33
traded below the close and one fell Trading session
exactly to the close. The average drop Source: Excel; data — eSignal
was 13.92 points and 70 percent of the
declines were 5.50 or more points. FIGURE 8 DOWN VOLUME: 70-79.99 PERCENT
Figure 8 is the 70- to 79.99-percent
Each day in this group traded below the previous close, and the average
group. There were 36 sessions, and the
downside move was 14.75 points.
market fell below the close the following
day in every instance. The average
decline was 14.75 points and the market 0
fell 6.50 points 70 percent of the time.
Follow-through price moves (points)

The 80- to 89.99-percent group is -10

shown in Figure 9. There were 23 occur-
rences and, like the 70- to 79.99-percent
group, the market always followed -20
through the next day. The average drop
was 11 points, and the market declined -30
by 6 points or more 70 percent of the
time.
-40
Up vs. down
Table 1 (p. 58) summarizes the data
-50
we’ve reviewed so far and allows us to
1
3
5
7
9
11
13
15
17
19
21
23
25
27
29
31
33
35
make some comparisons. As mentioned, Trading session
the average follow-through buying the Source: Excel; data — eSignal
day after dominant up-volume readings
declines as the up-volume percentage FIGURE 9 DOWN VOLUME: 80-89.99 PERCENT
rises — a sign the market runs out of
buyers. The average downside follow-through move in this group was 11 points — the
By comparison, the average follow- smallest of any of the down-volume groups.
through decline after dominant down-
volume days is rather stable between
0
groups — a difference of less than a
Follow-through price moves (points)

point between the first three percentile

groups. This indicates much of the sell- -10
ing is liquidation — that is, traders get-
ting out of long trades. The fact is, the
-20
cost of getting out of a position is mini-
mal compared to the cost of establishing
a position. -30
One way to explain this is that as the
market moves higher, there needs to be
-40
ongoing reasons for traders and
investors to continue to put on new long
positions. Without more good news, the -50
market can run out of buyers. However,
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23

Trading session
when prices are falling, lower prices
Source: Excel; data — eSignal

ACTIVE TRADER • August 2004 • www.activetradermag.com 57

 FUTURES & OPTIONS
Trading Strategies continued

TABLE 1 DOMINANT UP-VOLUME DAYS VS. DOMINANT DOWN-VOLUME DAYS

The size of the follow-through moves decreases as the percentage of the themselves can cause traders to cover
dominant up volume increases. short positions — no additional bad
news is needed.
Up 50-59.99% 60-69.99% 70-79.99% 80-89.99% In addition to the average follow-
Average 20.58 15.46 12.86 11.14 through move for each volume-ratio
Median 18.00 12.75 12.00 9.00 group, Table 1 includes the median fol-
low-through move. The median is the
middle value in a data set and is less
Down 50-59.99% 60-69.99% 70-79.99% 80-89.99% susceptible than the average to influ-
ence from a handful of outlier values.
Average -14.77 -13.92 -14.75 -11.00
That the average moves are larger than
Median -11.50 -13.50 -11.00 -10.50 the median moves for each group
Source: Excel; data — eSignal implies there are outliers skewing the
averages higher, as evidenced by the
final (largest) readings in Figures 2
TABLE 2 DOMINANT UP-VOLUME DAYS VS. DOMINANT DOWN-VOLUME DAYS, through 9, which tend to be much big-
E-MINI S&P 500 ger than the rest of the moves on each
chart.
These are the comparable statistics from a previous study of NYSE volume The 50- to 59.99-percent up-volume
and the E-mini S&P 500 futures. group had the largest average move
Up 50-59.99% 60-69.99% 70-79.99% 80-89.99% (up or down) — more than 20 points.
The next largest was the 15.46-point
Average 9.16 8.44 8.74 6.79 average move from the 60- to 69.99-
Median 6.00 7.38 8.50 6.00 percent up-volume group — a 25-per-
cent drop from the 50- to 59.99-percent
group. The 50- to 59.99-percent down-
Down 50-59.99% 60-69.99% 70-79.99% 80-89.99% volume group declined only 14.77
Average -10.42 -10.23 -8.28 -8.85 points on average.
It seems that when a market is con-
Median -8.25 -11.13 -5.63 -10.50
solidating (as indicated by the up vol-
Source: Excel; data — eSignal ume in the 50- to 59.99-percent range),
there is a propensity for the market to
move more to the upside — something
FIGURE 10 90-PERCENT OR HIGHER VOLUME DAYS that might be affected by the uptrend
that dominated the observation peri-
There were only four days of either dominant up volume or down volume od. There were only 38 sessions in the
greater than 90 percent. 50- to 59.99-percent category, while
there were 102 sessions in the two 60-
Dominant up volume Dominant down volume 79.99 percentile groups. The high num-
ber of observations (nearly a third of
16.00 0.00
the total) from these two combined
groups also is likely a result of the
Follow-through price moves (points)

Follow-through price moves (points)

14.00 -2.00
uptrend.
12.00 -4.00 For comparison, Table 2 shows sta-
10.00 -6.00 tistics from the “Following through in
the S&Ps” (Active Trader, December
8.00 -8.00 2003, p. 60), which discussed a similar
study using the E-mini S&P 500
6.00 -10.00
futures contract and NYSE volume sta-
4.00 -12.00 tistics from Aug. 20, 2002 to Aug. 27,
2003.
2.00 -14.00 For the first three groups of domi-
nant up- and down-volume groups —
0.00 -16.00
91.32% 91.70% 92.32% 94.32% 90.28% 90.77% 91.11% 91.53% 50-59.99 percent, 60-69.99 percent, 70-
79.99 percent — the number of occur-
rences (not shown in the table) was
Source: Excel; data — eSignal fairly close, ranging from a high of 37

58 www.activetradermag.com • August 2004 • ACTIVE TRADER

to a low of 34 for the up-volume groups
and 33 to 27 occurrences for the down-
volume groups.
The biggest difference between Tables
1 and 2 is that both of the 50-59.99 per-
cent and 60-69.99 percent down-volume
groups had the largest average price
moves in Table 2, while the 50- to 59.99-
percent and 60- to 69.99-percent up-vol-
ume groups had the largest average
price moves in Table 1.
This difference is most likely tied to
the stronger uptrend in the Table 1
review period compared to the mixed
market environment that existed during
the Table 2 analysis period. Plus, using
the Nasdaq market, which contains
more technology and growth stocks than
the S&P 500 index, will attract more cap-
ital during favorable market conditions
because traders and investors are more
comfortable with the risk associated
with growth stocks.
Figure 10 shows the somewhat rare
occurrence of days when the up or down
volume level is 90 percent or greater.
This only occurred four times each for
dominant up-volume and down-volume
days. Unfortunately, four observations
are not enough to draw any meaningful
conclusions about market tendencies.
ACTIVE TRADER • August 2004 • www.activetradermag.com
Trading implications
One important aspect of this study is up
markets trade differently than down
markets. Although it is impossible to
review the thoughts of market partici-
pants, it is plausible that markets move
higher because traders place their bets
on the long side (not necessarily day
trades), and the range of outcomes can
vary depending on the number of total
players. But once a trader has placed a
long-side bet, that’s it. This could be why
the average follow-through moves
decline as the percentage of up volume
increases.
The implications are twofold. First,
during the trading day volume ratios
can be observed on a live basis and high
values imply solid momentum through-
out the day. For the next day, however,
day traders should consider lowering
their expectations if the previous day’s
volume ratio was high.
On the other hand, if the previous
day’s up-volume ratio was in the 50- to
59.99-percent area, traders can raise their
expectations for the current day, espe-
cially if the news is good (unless of
course the market has already made a
significant move — i.e., greater than the
average move for that group).
After a day with dominant down vol-
ume, traders do not need to change their
expectations based on the readings in
the first three percentage-range groups
because market participants are likely
liquidating existing positions. Although
we don’t know to what degree the sell-
ing is new short positions, it appears
once a decline is underway, traders con-
tinue to liquidate positions as price falls
— again, because there are no limita-
tions, such as required capital, to stop
them from selling.
Most novice traders approach the
markets as if there is some rigid process
that should work in all situations.
However, trading can be compared to
other endeavors in which changing con-
ditions dictate the appropriate steps to
take. Sailors, for example, never assume
weather will stay the same. Just because
the sky is blue now, they still keep a
lookout on the horizon for a potential
change in conditions. For traders, quan-
tifying conditions such as the typical
market behavior following different vol-
ume-ratio levels is a way to gauge the
weather of the market. After that, you
can develop procedures to make the
most of different conditions.Ý
59
 TRADING Strategies

Up-down volume and

NEXT-DAY FOLLOW-THROUGH
What kind of trading is likely to occur today?
Yesterday’s balance of up volume and down
volume — and whether the market puts in
the high or low of the day first — provides
guidance in the Nasdaq 100.

I
BY THOM HARTLE
FIGURE 1 STUDY PERIOD

The study spanned Aug. 1, 2003, through Aug. 2, 2004 — a period that
contained a great deal of sideways price action on the daily time frame.

n the stock market, traders look- E-mini Nasdaq 100 futures(NQ), daily
ing for clues regarding today’s 1,550
probable direction sometimes look
to yesterday’s price movement:
Was the range particularly large or small? 1,500
Did the market close strongly up or
down?
Price is not the only factor to weigh. A 1,450
day’s trading volume can provide addi-
tional insight regarding subsequent mar-
ket action. But more than just the volume 1,400
level (whether total volume is relatively
high or low), the balance of up volume
1,350
(those stocks trading above their previ-
ous closes) and down volume (those
trading below their previous closes) can
1,300
be associated with certain next-day price
patterns. “Follow-through in the E-mini
Nasdaq 100” (Active Trader, August 2004)
1,250
showed the results of this kind of analy-
sis over a 314-day study period.
The following study breaks down the
1,200
Nasdaq volume statistics in a slightly dif-
Aug. Sept. Oct. Nov. Dec. 2004 Feb. Mar. Apr. May June July
ferent way to forecast likely next-day
price action in the E-mini Nasdaq futures Source: CQGNet
(NQ). The analysis has three components:
whether yesterday’s overall volume was dominated by up or of the day or the low of the day first.
down volume; the distances between yesterday’s close and Before looking at the data, let’s walk through the basic defi-
today’s high and low; and whether the market makes the high nitions and how the study was conducted.

60 www.activetradermag.com • December 2004 • ACTIVE TRADER

 FIGURE 2 LOW OR HIGH: WHICH OCCURRED FIRST?

For the trading session starting July 30, 2004, the up-volume
ratio was 65.79 percent. The next trading session began Sunday
afternoon, Aug. 1, and ended Monday, Aug. 2. The session’s low
(-15 points from the previous close) occurred first and the high
(8 points from the previous close) occurred second.

E-mini Nasdaq 100 futures (NQ), 60-minute

Nasdaq up and down volume
The study spanned Aug. 1, 2003, through Aug. 2, 2004, High occurred second
1,410
(see Figure 1) and included the entire 24-hour Globex
trading session for each day of the E-mini Nasdaq 100
futures. 1,405
First, the end-of-day Nasdaq up-volume and down-
volume readings were translated into up-volume and
1,400
down-volume ratios that show what percentage of total
volume is comprised of either up-volume or down-vol-
ume. If the up volume was greater than the down vol- 1,395
ume, the day’s volume ratio was the up volume divided
by the sum of up volume and down volume; if down
volume was greater, the volume ratio was the down vol- 1,390
ume divided by the sum of up volume and down vol- Low occurred first
ume.
75,000
For example, on July 30, 2004, the Nasdaq up volume
50,000
was 993,395,904 shares and the down volume was
25,000
516,633,600 shares. Because the up volume dominated
the day, the up-volume ratio is 993,395,904/(993,395,904 August
+ 516,633,600) = .6579, or 65.79 percent. The next trading 30-8:30 1-15:30 21:30 3:30 2-8:30
session began Sunday afternoon, Aug. 1, and ended Source: CQGNet
Monday, Aug. 2 (see Figure 2). The session’s low (-15
points from the previous close) occurred first and the high to the following low or high was determined. Tables 1 and 2
occurred second (8 points from the previous close). summarize these numbers for up-volume and down-volume
The data was first grouped by dominant up volume or down days, respectively.
volume in the following ranges: 50-59.99 percent, 60-69.99 per- For example, when dominant up volume was in the 60-
cent, 70-79.99 percent, 80-89.99 percent and 90 percent or above. 69.99-percent range and the low occurred first the following
Then the data was sorted by whether the low or high occurred day, the average difference between the close and the next
first the following day. Finally, the average move from the close day’s low was -10.34 points and the difference between the

TABLE 1 DOMINANT UP-VOLUME DAYS: TABLE 2 DOMINANT DOWN-VOLUME DAYS:

NEXT-DAY PERFORMANCE
The more up-volume-dominated trading one day, the
smaller the upside follow-through move the next day.
Also, when the high occurred first the next day, the aver-
age difference between the close and the next day’s low
was twice the difference as when the low occurred first.
NEXT-DAY PERFORMANCE
When down volume dominated trading, the average close-
to-low moves were fairly stable across the different per-
centage ranges, regardless if the high or low came first.
The weaker the market, the stronger the counter-reaction
the next day before the market resumes the down move.

Up-volume Next day Avg. Avg. Down- Next day Avg. Avg.
percentage close-to-high close-to-low volume close-to-high close-to-low
move move percentage move move
50-59.99% Low occurs first 21.55 -7.32 50-59.99% Low occurs first 20.08 -7.72
High occurs first 7.20 -18.57 High occurs first 7.47 -20.62
60-69.99% Low occurs first 17.81 -10.34 60-69.99% Low occurs first 19.27 -6.77
High occurs first 9.43 -21.50 High occurs first 8.00 -17.53
70-79.99% Low occurs first 16.70 -8.86 70-79.99% Low occurs first 19.00 -7.85
High occurs first 10.06 -17.56 High occurs first 9.08 -21.04
80-89.99% Low occurs first 10.36 -8.21 80-89.99% Low occurs first 17.23 -6.47
High occurs first 6.86 -18.93 High occurs first 9.15 -21.05
Source: Data - eSignal Source: Data - eSignal

ACTIVE TRADER • December 2004 • www.activetradermag.com 61

 FIGURE 3 UP VOLUME: 50-59.99 PERCENT
Positive values show the difference between the close (represented by the
zero value) and the next day’s high, while negative values show the differ-
ence between the close and the next day’s low. cent — which signifies good demand —
does the market tend to follow through
to the upside on this seemingly high
60.00
level of optimism? Or does the market
50.00 fail to follow through because the capital
High established first available for buying has been exhausted?
40.00
Finally, if there are observable tenden-
30.00 cies, what trading strategies can be
devised to take advantage of these situ-
20.00
ations?
Gains/losses

10.00
When up volume is dominant
0
Figures 3 through 6 summarize the per-
-10.00 formance for the different dominant up-
volume ranges. The vertical lines at the
-20.00
approximate midpoints of these figures
-30.00 separate instances when the low
Low established first occurred first the next day (left side) vs.
-40.00
when the high occurred first the next
day (right side).
1

11

13

15

17

19

21

23

25

27

29

31

33
Observations Figure 3 shows the results for the 34
days in 50-59.99-percent up-volume
Source: Data - eSignal; charts - Excel range. The low occurred first 19 times
and the high occurred first 15 times.
close and the next day’s high was 17.81 be tied to the previous day’s volume Positive values show the difference
points. ratio and whether the high or low occurs between the close (represented by the
The point of this analysis is to see if first. For example, if the market closes zero line) and the next day’s high, while
there are any market tendencies that can one day with up volume above 80 per- negative values show the difference
between the close and the next day’s
FIGURE 4 UP VOLUME: 60-69.99 PERCENT low.
Table 1 shows when the low occurred
Like the 50- to 59.99-percent group, the low occurred first slightly more first in the 50-59.99-percent group the
often (16 of 30 times) than the high, but the average close-to-high move was average difference between the close and
smaller. the next day’s low was -7.32 points,
while the average difference between the
60.00 close and the next day’s high was 21.55
points. (This is reflected in Figure 3 in
High established first
that to the left of the vertical line, the
40.00 negative values are not as negative as
they are to the right of the vertical line,
20.00 and positive values on the left are larger
than the ones on the right.) If the high
occurred first, the average move from
Gains/losses

0 the close to the high was 7.20 points, and

the average move from the close to the
-20.00 next day’s low was -18.57 points.
Figure 4 shows the 60-69.99-percent
Low established first
dominant up-volume group. Like the 50-
-40.00
59.99-percent group, the low occurred
first slightly more often (16 of 30 times)
-60.00 than the high. Table 1 shows the average
difference between the close and the
1

11

13

15

17

19

21

23

25

27

29

next day’s low for this group was -10.34

Observations points — a larger move than the corre-
sponding figure for the 50-59.99-percent
Source: Data - eSignal; charts - Excel
up-volume group.

62 www.activetradermag.com • December 2004 • ACTIVE TRADER

 FIGURE 5 UP VOLUME: 70-79.99 PERCENT
The low occurred first less than 50 percent of the time (22 of 46 instances),
The difference between the close and and when it did, the average move from the close to the following high con-
the next day’s high was 17.81 points, tracted slightly to 16.70 points.
down from the 21.55 points in the 50-
59.99-percent group. When the high 60.00
occurred first, the average move from
the close to the next day’s high was 9.43 High established first
points, up slightly from the 50-59.99-per- 40.00
cent up-volume group. The average
move to the next day’s low increased to 20.00
-21.50.
Figure 5 shows the 70-79.99-percent Gains/losses
group. The low occurred first less than 0
50 percent of the time (22 of 46
instances). Referring to Table 1, when the -20.00
low occurred first, the average move
from the close to the following high con- Low established first
tracted slightly to 16.70 points and the -40.00
average move from the close to the fol-
lowing low was -8.86 points. -60.00
Figure 6 is the 80-89.99-percent group.
The low occurred first just seven of 21
1

10

13

16

19

22

25

28

31

34

37

40

43

times. When the low occurred first the
average difference between the close and
the next day’s high was 10.36 points. The
average difference between the close and
the next day’s low was -8.21 points.
The up-volume ratio exceeded 90 per-
cent only one time (not shown); the next
day’s high was 9.50 points above the
close and the low was -6 points below it.
46
Observations
Source: Data - eSignal; charts - Excel
FIGURE 6 UP VOLUME: 80-89.99 PERCENT
The low occurred first just seven of 21 times in this group and the average
difference between the close and the next day’s high was only 10.36 points.

What do the numbers mean? 20.00

A clear pattern emerges from these sta- High established first
tistics: As the up-volume percentage 10.00
climbs, the average difference between
the close and the next day’s high drops, 0
suggesting that as more capital is com-
mitted to buying, there is less available -10.00
the next day to continue to push the
Gains/losses

market higher. -20.00

Another interesting point from Table 1 Low established first
is when the high occurs first, the average -30.00
difference between the close and the
next day’s low is twice the difference -40.00
when the low occurs first. Apparently,
when price reverses the previous day’s -50.00
trend, market psychology shifts gears
dramatically.
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21

Now let’s see what characteristics Observations

emerge after days dominated by down
volume. Source: Data - eSignal; charts - Excel

When down volume is dominant According to Table 2, when the low tance to the next day’s high was 20.08
Figure 7 (p. 64) shows the 35 occurrences occurred first, the average difference points. In comparison, when the high
in the 50-59.99-percent down-volume between the close and the next day’s low occurred first, the average difference
group. The low occurred first 18 times. was -7.72 points, while the average dis- between the close and the next day’s

ACTIVE TRADER • December 2004 • www.activetradermag.com 63

 FIGURE 7 DOWN VOLUME: 50-59.99 PERCENT
average low was -17.53 points, which is
The low occurred first 18 of 35 times in the 50- to 59.99-percent down-vol-
a smaller move than the average differ-
ume group.
ence (-20.62 points) between the close
and the next day’s low in the 50-59.99-
50.00 percent down-volume group.
Figure 9 (p. 65) is the 70-79.99-percent
40.00
down-volume group. There were 29
30.00 occurrences; 17 times the low occurred
High established first first, and 12 times the high occurred first.
20.00
If the high occurred first, the average dif-
10.00 ference between the close and the next
day’s high was 9.08 points, but the aver-
Gains/losses

0
age difference between the close and the
-10.00 next day’s low expanded to -21.04
points.
-20.00
Figure 10 (p. 65) shows the 24 times
-30.00 down volume was in the 80-89.99-per-
Low established first cent group. The low occurred first 14
-40.00
times. If the high occurred first, the aver-
-50.00 age difference between the close and the
next day’s low was -21.05 points, which
1
3

5
7

11
13

15

17
19

21
23

25
27
29

31
33
35
is the second largest move of this type
Observations
from the down-volume groups.
Source: Data - eSignal; charts - Excel The down-volume ratio exceeded 90
percent three times (not shown). The low
occurred first two times, and the subse-
FIGURE 8 DOWN VOLUME: 60-69.99 PERCENT quent highs were 25.50 and 9.50 points
above the close, while the lows were -4
Of the 15 times the high occurred first, the average difference between the
and -5 points below the close. The one
close and the next day’s low was -17.53 points, which is a smaller move than
time the high occurred first, the high
the figure (-20.62 points) from the 50-59.99 percent down-volume group.
was 13.50 points above the close and the
low was -12 points below it.
50.00
Moderate volume dominance is
40.00
key
High established first
30.00 Although many people tend to expect
upside follow-through after a strong up-
20.00 volume day (and the opposite after a
strong down-volume day), it appears
10.00
the market is more likely to follow
0 through when volume in a particular
Gains/losses

direction is more moderate.

-10.00 This study revealed the largest moves
took place in the direction of the trend
-20.00
when the low occurred first after a day
-30.00 with dominant up-volume between 50
Low established first and 59.99 percent. As the up volume
-40.00 percentage climbed, the average close-
to-high move shrank — 21.55, 17.81,
1

11

13

15

17

19

21

23

25

27

16.70 and 10.36 points, respectively, for

Observations
four percentage ranges. This indicates
Source: Data - eSignal; charts - Excel the more money committed to the mar-
ket one day, the less there is available for
high was 7.47 points and the average the 60-69.99-percent down-volume it the next day and the less follow-
difference between the close and the group. Of the 15 times the high occurred through price movement is likely to
next day’s low was -20.62 points. first, the average difference between the occur.
Figure 8 shows the 28 occurrences of close and the high was 8 points and the When down volume dominates, the

64 www.activetradermag.com • December 2004 • ACTIVE TRADER

 FIGURE 9 DOWN VOLUME: 70-79.99 PERCENT
Of the 29 occurrences the low occurred first 17 times. If the high occurred
first, the average difference between the close and the next day’s low was
-21.04 points.
If the high occurred first, the average
40.00 close-to-high move climbed as the
down-volume percentage increased:
30.00 7.47, 8.00, 9.08 and 9.15. This suggests
High established first the weaker the market is one day, the
20.00
stronger the upside counter-reaction is
10.00 the next day before the market resumes
its down move.
0
Gains/losses

-10.00
Monitoring volume
First, pay attention to days when domi-
-20.00 nant up volume is in the 50-59.99-per-
cent range, because those days tended to
-30.00 precede nice uptrends the next day.
Low established first Also, as the dominant volume per-
-40.00
centage increases, the average close-to-
-50.00 high move trails off even when the low
occurs first. This means the exuberance
of high up-volume readings is some-
1

11

13

15

17

19

21

23

25

27

29
Observations
thing traders should use to take profits,
Source: Data - eSignal; charts - Excel
rather than add to their positions.
Finally, if you’re uncomfortable with
short selling, you won’t be able to take
FIGURE 10 DOWN VOLUME: 80-89.99 PERCENT advantage of the fact that down-volume
When the high occurred first, the average difference between the close and groups in general show a tendency to
the next day’s low was -21.05 points — the second largest move of this type have good follow-through action the
from all the down-volume groups. next day. Ý

40.00

30.00
High established first

Additional Active
20.00

10.00 Trader reading

Gains/losses

0 "Follow-through in the E-mini Nasdaq

100" by Thom Hartle, August 2004,
-10.00 p. 52
"Nasdaq 100 volume and the QQQ"
-20.00
by Thom Hartle, July 2004, p. 46
Low established first
-30.00 "Getting in on follow-through days"
by Thom Hartle, January 2004, p. 36
-40.00
"Following through in the S&Ps"
by Thom Hartle, December 2003,
1

11

13

15

17

19

21

23

Observations
Source: Data - eSignal; charts - Excel
tendencies are very different. First, the
average close-to-low move was relative-
ly stable, regardless of whether the high
or low occurred first. If the low came
first, the average close-to-low moves
were -7.72, -6.77, -7.85 and -6.47 points,
respectively. If the high occurred first,
the average close-to-low moves were
-20.62, -17.53, -21.04 points and -21.05
points.
p. 34
You can purchase past articles online
at (www.activetradermag. com/pur-
chase_articles.htm) and download
them to your computer.

65 www.activetradermag.com • December 2004 • ACTIVE TRADER

 TRADING Strategies

E-MINI MORNING REVERSAL

and afternoon breakout patterns
Two simple ideas provide the basis for an intraday trading approach. System
analysis sheds light on how the strategies perform and what you can do to get the
most out of them.

T
BY GOMU VETRIVEL

he “mini” stock index exceeds the previous day’s high or low (8:30-9 a.m. CT), place a sell-stop order
futures are popular intra- in early trading and then reverses. at yesterday’s high or the low of the first
day markets with individ- Short Entry: If the market exceeds yes- 30-minute bar, whichever is lower.
ual traders because of their terday’s high during the first 30 minutes Long Entry: If the market exceeds yes-
high liquidity and smaller contract sizes. of trading of the regular trading session terday’s low during the first 30 minutes
The following day-trading techniques
were tested on the E-Mini Nasdaq 100
(NQ), E-Mini S&P 500 (ES), and E-Mini FIGURE 1 REVERSAL PATTERN
Russell 2000 (ER2) futures contracts.
The first morning reversal pattern was stopped out with a small loss when
Morning reversals, afternoon the market made a new high for the day. The second reversal pattern was
breakouts exited at the end of the day for a profit.
The first intraday strategy is based on a
reversal pattern and is executed in the
first hour of trading. The logic is that the
market often makes a big move in one
direction in the first 30 minutes of the
regular trading session but is unable to
sustain it. This attempts to capitalize on
any reversal that may develop.
The second strategy uses a breakout
pattern that is traded in the afternoon
and is used in two situations. First, if a
reversal signal doesn’t occur in the
morning because the price action is one
sided (up or down), the system will try
to capture the existing daily trend by
entering it in the afternoon. Alternately,
if the market trades in a narrow range in
the morning, the system will try to cap-
ture an explosive move out of that range
in the afternoon. Both strategies are
based on 30-minute price bars.

Reversal pattern entry rules

In reversal mode, trades are taken only
between 9 and 9:30 a.m. CT. The strategy
Source: TradeStation
triggers a trade when the market

66 www.activetradermag.com • January 2006 • ACTIVE TRADER

 FIGURE 2 BREAKOUT PATTERN

Because a reversal signal did not occur in

the morning, a breakout of the day’s
range is initiated at 1 p.m. CT. Here, a
System code short trade was triggered and exited at 3
p.m. for a profit.
The following TradeStation EasyLanguage code for the morning rever-
sal/afternoon breakout strategy can be copied from www.activetrader-
mag.com/code.htm. Programming code for other software platforms can
be found there as well.

[LegacyColorValue = true];

var:x(0);

if entriestoday(d)<1 then begin

if t>830 and t<930 then begin
if highd(0)>highd(1) then Sell Short Next Bar at
minlist(highd(1), l) stop;
if lowd(0)<lowd(1) then Buy Next Bar at maxlist(lowd(1),
h) stop;
end;

if t>=1300 and t<1430 then begin

Buy Next Bar at maxlist(h,highd(0)) stop;
Sell Short Next Bar at minlist(l,lowd(0)) stop;
end;
end;

Sell Next Bar at lowd(0) stop;

Buy to Cover Next Bar at highd(0) stop;

if t=1500 then begin

Sell This Bar at c;
Buy to Cover This Bar at c;
end;

of the regular trading session, place a end-of-day exit.

buy-stop order at yesterday’s low or the
high of the first 30-minute bar, whichev-
er is higher.
Breakout pattern entry rules
In breakout mode, trades are taken only
between 1 to 2:30 p.m. CT and only if a
reversal pattern has not triggered in the
morning. The strategy triggers a trade
when the market pushes to a new daily
high or low after 1 p.m.
Short Entry: At 1 p.m., place a sell-stop
order at the day’s low. A short position is
taken if the market breaks the day’s low
any time between 1 and 2:30 p.m.
Long Entry: At 1 p.m. place a buy-stop
order at the day’s high. A long position
is taken if the market breaks the day’s
high any time between 1 and 2:30 p.m.
Exits
There are two types of exit rules used for
both strategies: a stop-loss exit and an
Short stop-loss exit: If short,
place a buy stop-loss at the
day’s high.
Source: TradeStation
Long stop-loss exit: If long, place
a sell stop-loss at the day’s low.
All open trades are closed 3 p.m. CT.
Only one trade is taken per day to
minimize transaction costs, which sabo-
tages many short-term trading strate-
gies. No positions are carried overnight.
Trade examples
On July 28, 2005, the high of the first 30-
minute bar in the E-Mini Russell 2000
futures exceeded the previous day’s
high of 678.30, which established the
conditions for a short trade (Figure 1).
Because the low of the first 30-minute
bar (677.30) of the regular session was
lower than the previous day’s high of
678.30, a sell-stop order is placed at
677.30. This order was triggered during
the second 30-minute bar. The market
then turned to the upside and the trade
was exited four bars later at 680.60 when
the market made a new high for the day
— a loss of $330 per contract.
The next day, July 29, a short trade
was triggered at 684.20 when the market
traded above the July 28 high on the first
30-minute bar and then reversed to trade
below the low of this bar. This time the
reversal held and the position was exited
at 3 p.m. at 681.30 for a profit of $290 per
contract.
Figure 2 shows an example of an

ACTIVE TRADER • January 2006 • www.activetradermag.com 67

TABLE 1 CUMULATIVE SYSTEM PERFORMANCE
afternoon breakout trade in the E-Mini
The system turned a profit on all three E-Mini futures contracts, with the Nasdaq 100 contract. On Aug. 10, 2005 a
E-Mini Russell 2000 contract boasting the best performance. morning reversal signal did not occur, so
buy-stop and sell-stop orders are placed
at 1 p.m. at the day’s high (1,615.50) and
the day’s low (1,602), respectively. The
market broke out to the downside, trig-
gering the sell order at 1,602. The trade
was closed at 1,591.50 for a $210-per-
contract profit.

Testing the strategy

The strategy was tested on the E-Mini
S&P 500, E-Mini Russell 2000, and E-
Mini Nasdaq 100 futures. All testing was
performed on continuous contract data
on the TradeStation 8 platform.
The test period for the E-Mini S&P 500
and E-Mini Nasdaq 100 was Feb. 1, 2001
to Aug. 31, 2005. The E-Mini Russell 2000
test period spanned Aug. 1, 2002 to Aug.
31, 2005 (prior Russell data was lower
quality because of lack of volume). The
tests included one tick of slippage and $5
commission per trade, for a total cost per
trade of $15.
Table 1 shows the results were rela-
tively consistent in all three indices for
the test period as a whole. The E-mini
Source: TradeStation
Russell was the best-performing market
in terms of dollar profit
and winning percentage.
FIGURE 3 DOWNTREND, UPTREND
Overall, the system had an
The first half of the four-year and six-month test period was skewed to the downside, average win percentage of
while the second half was characterized by an overall uptrend. 50 percent and winning
trade/losing trade ratio of
1.20. The system had a
profit factor (gross profit
divided by gross loss) of
1.48 in the E-Mini Russell
2000, 1.19 in the E-Mini
S&P 500, and 1.20 in the E-
Mini Nasdaq 100.
These patterns com-
prised a high-frequency
system that triggered near-
ly 180 trades per year. The
tests produced more than
2,000 trades, which lends
validity to the results.

Digging deeper
Table 2 (p. 69) sheds more
light on the system’s per-
formance, however, show-
ing results for the first and
second half of the test peri-
od. The system performed
Source: TradeStation
much better in the first half

68 www.activetradermag.com • January 2006 • ACTIVE TRADER

 TABLE 2 FIRST HALF, SECOND HALF
Breaking the test period into two halves shows the system earned most of its
profit in the first two years and three months. The Nasdaq 100 actually lost
money during the second half of the test period.
Source: TradeStation
than the second half.
Figure 3 (p. 68) shows the S&P 500,
Nasdaq 100, and Russell 2000 indices
from Feb. 1, 2001 through Aug. 2005. The
first half of the test period had more
downward price action while the second
half was dominated by an uptrend.
However, a lower overall market volatili-
ty level in the second half could have con-
69
tributed to the performance difference.
One characteristic of the system is that
short trades accounted for more of the
overall profits than long trades. The ratio
of the average winning trade to the aver-
age losing trade was larger for short
trades in all three markets. Also, in the
Russell and S&P, the average short trade
was roughly 1.5 times the average long
www.activetradermag.com • January 2006 • ACTIVE TRADER
Related reading
"Morning reversal strategy"
Active Trader, May 2003.
Historical tests reveal the tendency
of the major stock indices to revert
to the previous day's closing price
in the early minutes of the trading
session. This strategy takes its cue
from that bit of market behavior.
"Inside days: Capturing
short-term volatility moves"
Active Trader, October 2001.
A short-term trading strategy based
on the breakout of an inside day's
range.
"Opening range breakout (ORB)"
Active Trader, July 2003.
This Trading System Lab tests an
approach based on the breakout of
a volatility-adjusted opening range.
"Trading the opening gap"
Active Trader, December 2004.
Opening price gaps are stomach-
churning events when the market
makes a big move against you, but
they represent low-risk trade
opportunities if you know which
gaps are likely to be followed by
predictable patterns.
You can purchase and download
past Active Trader articles at
www.activetradermag.com/pur-
chase_articles.htm
trade, and the short-trade net profit was
approximately 1.5 times the net long
trade profit. In the Nasdaq, the average
short trade was more than six times the
size of the average long trade and the
short-trade net profit was more than
seven times the net long-trade profit.
Although the strategy appears slanted
toward the short side, it would not be a
good idea to neglect the long side, as it is
impossible to know what will happen in
the future.
These breakout and reversal setups
are simple to understand and easy to
implement. The results indicate the
strategy is more robust. The ideas on
which it is based leave room for further
experimentation and refinement. Ý
 TRADING Strategies

The TELLTALE spread

T
Analyzing the relationship between BY THOM HARTLE

the E-Mini Nasdaq 100 and the E-Mini

S&P 500 can indicate when the broad rend analysis of the stock market can take several
forms: measuring an index’s percentage change
market is making a genuine move over a period of time, comparing the index to a
moving average and so on. Furthermore, some
or when it’s faking people out. traders refer to tools such as the number of advancing stocks
relative to declining stocks and volume to determine a particu-
lar trend’s strength or weakness.
Spread analysis, or measuring the
TABLE 1 S&P 500 COMPOSITION price difference (or ratio) between two
The S&P 500 consists of the 500 largest publicly traded companies measured stock indices, is another way to gauge
by market cap. It is designed to reflect the broader market. the robustness of a move in the stock
market. By identifying the typical rela-
Top stocks Top groups tionship between two indices and recog-
nizing when that relationship deviates
General Electric 3.19% Financials 20.50% from its pattern, you can determine the
Microsoft Corp. 3.06% Information technology 16.20% trend and identify potential reversals.
Pfizer, Inc. 3.00% Health care 14.80% Also, although this approach is general-
ly longer term, you can track the
Exxon Mobil Corp. 2.67% Consumer staples 11.70% Nasdaq-S&P spread on an intraday basis
Wal-Mart Stores 2.62% Consumer discretionary 11.10% to insure you are on the right side of
intraday trends.
Citigroup Inc. 2.45% Industrials 10.40%
This study analyzes the relationship
Johnson & Johnson 1.71% Energy 5.80% between two of the most popular stock
American International Group 1.60% Telecom services 3.90% indices, the S&P 500 (SPX) and the
Nasdaq 100 (NDX), which also underlie
IBM 1.59% Utilities 3.00%
the two most popular equity index
Intel Corp. 1.51% Materials 2.70% futures contracts, the S&P 500 E-Mini
(ES) and the Nasdaq 100 E-Mini (NQ),
Source: Standard & Poor’s 6/30/03 traded at the Chicago Mercantile

70 www.activetradermag.com • November 2003 • ACTIVE TRADER

 TABLE 2 NASDAQ 100 COMPOSITION

The Nasdaq 100 is comprised of the 100 largest companies trading on the
Nasdaq (financial companies are excluded), based on market cap. The index
is heavily weighted with technology stocks.
Top stocks Top groups
1. Microsoft Corp. 10.15% 1. Computer & office equipment 28.39%
2. Intel Corp. 5.10% 2. Computer software/services 28.01%
3. Cisco Systems Inc. 4.49% 3. Telecommunications 11.69%
Exchange (CME). We’ll use the spread 4. Amgen Inc. 4.28% 4. Biotechnology 11.45%
between the S&P and Nasdaq 100 futures 5. QUALCOMM Incorporated 3.65% 5. Retail/wholesale trade 9.86%
contracts in this analysis.
6. Dell Computer Corp. 3.24% 6. Health care 4.51%
We’ll begin by looking at a longer-term
use of the Nasdaq-S&P spread before 7. Comcast Corporation 3.07% 7. Services 3.16%
shortening the time horizon and examin- 8. Oracle Corp. 2.82% 8. Manufacturing 1.94%
ing ways to identify intraday trend
changes. 9. eBay Inc. 2.65% 9. Transportation 0.99%
10. Nextel 2.48%
Finding the market leader: Communications, Inc.
S&P safe haven vs. Nasdaq growth
The S&P 500 is a capitalization-weighted Source: www.nasdaq.com 6/30/03
index of companies with market caps
(stock price multiplied by number of FIGURE 1 THE SPREAD PERSPECTIVE
shares outstanding) in excess of $3 billion. The larger a
company’s market capitalization, the more its stock Calculating the difference between the Nasdaq 100 E-Mini
price affects the index value. futures (top) and the S&P 500 E-Mini futures (middle) results
The S&P 500 is designed to reflect the risk and return in a spread chart (bottom) that shows when one index is
characteristics of the broader, large-cap market. Table 1 outperforming the other.
shows the top individual holdings and the group
breakdown of the S&P 500.
Nasdaq E-Mini (NQ), weekly
The Nasdaq 100 is comprised of the 100 largest busi- 1,500
nesses, excluding financial companies, traded on the
Nasdaq stock market exchange. The index uses a “mod-
ified capitalization-weighted” approach, by which 1,250
stocks are weighted with a proprietary algorithm when-
ever any stock represents more than 24 percent of the 1,000
index’s total market value, and/or the combined weight
of all stocks with weightings of at least 4.5 percent
exceeds 48 percent of the index’s total market value.
Table 2 is a recent list of the top Nasdaq 100 indi- S&P 500 E-Mini (ES), weekly
vidual stock holdings and a breakdown of its most Divergence between
heavily represented groups. S&P 500 and Nasdaq 100 1,000
The Nasdaq 100 contains a much higher percentage
of technology stocks than the S&P. Table 2 shows the
computer and office equipment industry group com- 800
prises 28.39 percent of the Nasdaq 100, followed by the
computer software/services group at 28.01 percent. NQ-ES spread, weekly
The top group in the S&P 500 is financial stocks 300
(20.50 percent), followed by information technology
(16.20 percent). In terms of growth stocks, the technol- 200
ogy industry offers far more opportunities than the
financial services industry. Rising spread
Microsoft (MSFT) is the most heavily weighted indi- is bullish 100
vidual holding in the Nasdaq 100 and the second most
heavily weighted in the S&P 500. Because it accounts 0
for a large enough percentage in both indices, MSFT April July October 2003 April July
has a relatively muted effect on the spread between the Source: CQG, Inc.
two.

ACTIVE TRADER • November 2003 • www.activetradermag.com 71

 FIGURE 2 HIGHLIGHTING LEADERSHIP

The growth-oriented Nasdaq 100 tends to lead the S&P to the

upside as well as the downside. When it doesn’t, as was the
Because of its large technology component, in an case at points C and F, this lack of leadership can result in
expanding economy the Nasdaq 100 should lead (i.e., trend weakness in the overall market.
rise at a faster rate than) the S&P 500 when the overall
market is moving higher because more money man- G
agers and investors will be attracted to the potential of 1,300
growth stocks. On the other hand, in a declining eco- D
1,250
nomic environment, financial services companies offer
a safe haven for money (plus, many financial compa- 1,200
nies pay dividends). That will tend to pull money away A
1,150
from Nasdaq stocks and into S&P stocks. As a result,
the Nasdaq 100 should lead the S&P when the market 1,100
is moving lower, as well. Nasdaq E-Mini (NQ), daily
In other words, a bullish stock market is reflected by H
an uptrending Nasdaq 100-S&P 500 spread (the E 1,000
Nasdaq 100 price minus the S&P 500 price). A bearish
stock market will be characterized by a downtrending 950
B
Nasdaq 100-S&P 500 spread.

Weekly perspective
900
S&P 500 E-Mini (ES), daily
Figure 1 (p. 71) shows the Nasdaq 100-S&P 500 rela-
300
tionship from the fourth quarter of 2002 into the second
New high
quarter of 2003. The top and middle charts show the
275
Nasdaq 100 E-Mini and S&P 500 E-mini futures, respec-
tively, while the bottom panel shows the spread F
250
between the two.
Both the Nasdaq 100 and the S&P 500 futures con- C 225
tracts reached new lows in October 2002. However,
during the fourth quarter of 2002, the Nasdaq 100 NQ-ES spread, daily 200
embarked on a substantial rally, bettering its July 2002
21 1 12 19 27 2 9 16 23 1 14 21 28 1
high; the S&P 500, however, was unable to surpass its May June July Aug.
summer (August) high. The Nasdaq-S&P spread
jumped sharply higher, reflecting the Nasdaq 100’s Source: CQG, Inc.
more accelerated rally. Both markets peaked in
December 2002 and moved downward until February. Line A shows the Nasdaq 100 rising to slightly higher highs
The Nasdaq-S&P spread made a slightly lower low in in May while the S&P 500 surpassed its early May highs by a
January, just below its December low. As the S&P 500 moved wider margin (approximately 1.28 percent vs. .87 percent,
lower, the spread started to climb again, reflecting the Nasdaq based on closing prices on May 6 and May 15). The spread (see
100’s outperformance relative to the S&P 500. The Nasdaq 100 line C) was flat between these two peaks, indicating the
made the second low of a double bottom in March 2003, at Nasdaq 100 was no longer outperforming the S&P. This situa-
which point both markets rallied into June. The developing tion was followed by a short correction into the week of May
spread relationship signaled this period of strength in the over- 19.
all market: The spread bottomed in October and began form- Moving forward, the Nasdaq 100 peaked in early June while
ing a series of higher highs and higher lows, indicating a bull- the S&P 500 peaked in mid-June. This divergence, indicated by
ish market environment based on the better performance of the the declining spread (line F), was part of another correction
Nasdaq 100 relative to the S&P 500. that lasted until the end of the month.
In July, the Nasdaq 100 surged to new highs, while the S&P
Divergence on the daily time frame 500 made a lower high. This divergence preceded a correction
In addition to gauging the relative strength of the indices when in the broader market. (Interestingly, though, the spread itself
they are moving in the same direction, divergence between the surged to new highs, which reflects leadership on the part of
Nasdaq 100 and S&P 500 on the daily time frame can signal the Nasdaq and should be a longer-term bullish sign.)
potential market corrections. Figure 2 is a daily chart of the E- The spread does not necessarily indicate a correction is com-
Mini Nasdaq 100, E-Mini S&P 500 and the spread between the plete; it does not wave a red flag. Nonetheless, there is value in
two. being alerted to conditions that signal a potential correction.

72 www.activetradermag.com • November 2003 • ACTIVE TRADER

 FIGURE 3 INTRADAY INSIGHT

Although intraday price data is more volatile than daily or

weekly data, the Nasdaq-S&P spread relationship reflects the
same dynamics. Here, the spread (bottom) pushed above its
downtrendline before the Nasdaq or S&P futures did. Intraday applications
On a very short-term basis, the Nasdaq-S&P spread can
Nasdaq E-Mini (NQ), 30-minute 1,250 help keep you on the right side of intraday trends. The
same basic guideline holds, in that the Nasdaq 100
T1
should lead the way, both up and down.
1,225 Although simple trend analysis, such as drawing
trendlines, can help to spot changes, intraday spread
1,200 charts, like individual markets, are very volatile. For
example, during the latter part of June 2003, the stock
Support market was moving sideways.
On July 1, the market broke key support levels, but
S&P 500 E-Mini (ES), 30-minute the spread did not break its equivalent level. As the
T1 990 market began to recover, and moved back up through
the previous broken support level, the spread broke the
980
down trendline shown in Figure 3 . The Nasdaq 100
970 and the S&P 500 did not break their trendlines until
Support later in the session.
960

NQ-ES spread, 30-minute Majority rules

250 Analyzing the Nasdaq 100-S&P 500 spread relationship
T1 reflects the idea that if the majority of stocks are not ris-
240 ing — or, if the market-leading stocks are lagging the
broader market — the trend may lack staying power.
230 The spread between the Nasdaq 100 and the S&P 500
can function as a gauge of how healthy or weak the
220 overall market is. If one of the major indices is not
Support keeping pace, the spread will fail to make new highs or
lows. In those situations, watch for a trend change. Ý
25 26 27 30 1 2-8:30
July
Source: CQG, Inc.

ACTIVE TRADER • November 2003 • www.activetradermag.com 73