CMT Level 2

Kirkpatrick and Dahlquist, CMT2, Chapter 17

by Steve Kern on July 12, 2015

Chapter 17: Short-Term Patterns

Kirkpatrick and Dahlquist, CMT2 Chapter 15

by Steve Kern on July 12, 2015

Chapter 15: Bar Chart Patterns

Kirkpatrick and Dahlquist, CMT2 Chapter 13

by Steve Kern on July 12, 2015

Part III: Trend Analysis
Chapter 13: Breakouts, Stops, and Retracements

Chapter Objectives
- Understand what a breakout is
- major methods of identifying a breakout
- purpose of entry and exit stops
- major methods of setting entry and exit stops
Intro
Breakouts
- How Is a Breakout Confirmed?
- Close Filter
  - There’s usually no confirming evidence until after the close of trading
  - Odds of a false breakout are greater with just an intra-bar penetration
    - but the entry can be protected with a nearby stop
  - Least risky confirmation – wait for the closing price to see if the penetration was just due to an intra-bar exogenous occurrence that had little longer-term meaning.
- Point or Percent Filter
  - Establish a breakout zone either a certain number or fraction of points or percentage beyond the breakout level
  - The most commonly used is a 3% rule, a level 3% from the ideal breakout point.
- Time
  - If the penetration remains outside the breakout zone for a certain time, it must be real.
  - Usual time period is two bars, but can be any length of time.
  - Price must remain beyond, or at least close beyond, the breakout level for the required number of bars.
  - Combination of the time rule and the close rule uses both rules.
    - requires penetration and close beyond the breakout level, and then a second bar in which the price penetrates even further beyond the breakout level.
    - in a breakout down, the close must be below the breakout level and the next bar must have a trade below the previous bar’s low for confirmation of the breakout down.
- Volume
  - Increased volume of trading often occurs with a breakout
  - other market players are acting in the direction of the new trend
  - there is sufficient power behind the penetration
  - Jiler observes but can’t explain why, that volume can dramatically decline on a breakout, and the breakout is still valid.
  - Usually, volume then increases as the trend develops
- Volatility
  - Previous price rules don’t account for price volatility.
  - A more volatile stock can have a more significant price move without signaling a breakout
  - A filter rule that uses some arbitrary point or percentage rule is likely to be broken by a highly volatile security before a true breakout occurs.
  - Three means of calculating volatility are most often used:
    - beta
      - calculation of the standard deviation of a price relative to a market proxy (usually S&P500)
      - not useful in commodities because commodities have little useful correlation to the stock market or commodity average
      - beta’s use has diminished over the years
      - underlying assumption that it is a valid measure of risk has been questioned
      - beta’s one advantage: it eliminates the trend of the market from the volatility calculation
    - standard deviation of price
      - basis for most option and other derivatives models and uses the complete set of prices over some past period in time.
      - disadvantage: includes the trend of the security in its calculation
      - the breakout filter must use the volatility of the trend and not include the trend itself.
        
        otherwise, a strongly trending stock with little volatility about its trend would have a higher filter than a flat-trending stock with wide fluctuations about its mean.
    - Average True Range (ATR)
      - derivation of the Average Range (which is the average of the difference between each bar high and low over some past period).
      - ATR devised by Wilder
      - ATR = average of the True Range bar’s close
      - ATR includes whatever effect a price gap between bars might have on the security’s volatility.
      - The True Range is the greatest of:
        
        The difference between the current bar high and low
        
        The absolute value of the difference between the prior bar close and the current bar high
        
        The absolute value of the difference between the prior bar close and the current bar low
      - ATR = average of the True Range over some time period
      - ATR depends solely on the price of the security
      - ATR not influenced by any other average or security. ATR is pure to the security’s own action.
      - ATR includes the recent trend only so far as the trend has had an effect on the range of prices
      - ATR is an excellent measure of volatility and is used in many indicators as well as breakout and stop-loss formulas.
      - As a price filter for confirmation of a breakout, by including a multiple of the ATR, the breakout level is adjusted for the volatility of the security.
      - ATR filter expands and contracts over time as price volatility changes.
      - If price volatility increases, daily True Ranges will expand, and the ATR will be larger, making it less likely to have a false breakout from increased price volatility.
      - Highly volatile security will have a wider filter to account for its likelyihood of making false breakouts just because of its higher volatility.
      - Low volatility security will have a narrow filter that will trigger the breakout with only a minimum deviation from its usual range.
- Pivot Point Technique
  - method of determining likely support and resistance levels
  - widely used by day traders to establish potential price ranges for the day
  - used as confirmation for breakouts
  - uses previous bar’s high, low, and close to establish support and resistance levels for the current bar.
  - some formulas use the open as well
  - pivot points for the current bar are calculated from price points derived from the previous bar
  - The theory: as time goes on, the effect of past prices on current prices diminishes. Thus the most recent, previous bar’s action is the best predictor of the current bar’s action.
    - Example (Kaufman, 1998)
      - P (pivot point) = (High previous bar + Low previous bar + Close previous bar) /3
      - R1 (first resistance) = (2 x P) – High previous bar
      - S1 (first support) = (2 x P) – High previous bar
      - R2 (second resistance) = (P + High previous bar – Low previous bar)
      - S2 (second support) = (P = High previous bar + Low previous bar)
  - Use of this formula is questionable, because so is the logic behind it.
  - Self-fulfilling: many intraday price reversals occur at pivot points because so many tradres use them probably.
  - More reliable: use previous week or month action to establish current expected resistance and support levels
    - The formula is essentially a measure of the previous day’s volatility projected into the following day.
  - Alternative pivot point calculations
    - Tom DeMark
      - Developed a means of predicting support and resistance based on adding the relationship between the open and close price
    - Woodie’s and Camarilla pivot point formulas
  - Not one of these methods seems to be consistent or accurately estimate future support or resistance levels.
Can a Breakout be Anticipated?
- Often volume is a clue that a breakout is about to occur
- volume often accompanies the trend
- an increase in volume with a trend is supportive of that trend
- when prices are oscillating beneath a resistance zone and volume increases on every small up leg and decreases with every small down leg, the odds favor that the price will eventually breakup through the resistance zone
- slightly rising lows in a trading range accompanied by increasing volume on the rallies points to a higher probability of an upward breakout through resitance
Stops
- stop order is an order to buy or sell once a specific price has been reached
- What are Entry and Exit Stops?
  - Can be used to enter or exit a position
  - protective stops
  - trailing stops
- Changing Stop Orders
  - Changing stops against the trend show the investor is losing discipline and reacting to emotional pressures
  - Many investors and traders place stops too close to the current price of the security in which they have a position, causing whipsaws
  - A defensive stop is a protection device, not necessary for short-term trading.
  - Allow the stop some “breathing room.”
  - Wait for a retracement
- What Are Protective Stops?
- What Are Trailing Stops?
  - Trailing Stops Using a Trend Line
  - Trailing Stops Using Parabolic SAR
    - SAR = “Stop and Reversal”
    - Developed by Welles Wilder (1978)
    - Initially intended as a trading system because it required a long or short position.
    - Has become a breakout confirmation rule
    - Has become an excellent, but sometimes very sensitive stop rule
    - The Parabolic is calculated by using an “acceleration factor” that incrasesa as the price moves along its trend
    - The stop level follows a parabolic curve
    - Weakness: doesn’t include the security’s volatility
      - therefore subject to many whipsaws.
    - Weakness: The acceleration factor is arbitrary and requires some testing for each security to find the best level with the least whipsaws
  - Trailing Stops Using Percentage of Gain
- What Are Time Stops?
- What Are Money Stops?
- How Can Stops Be Used with Breakouts?
- Using Stops When Gaps Occur
- Waiting for Retracement
- Calculating a Risk/Return Ratio for Breakout Trading
- Placing Stops for a False (or “Specialist”) Breakout
Conclusion
Review Questions

Kirkpatrick and Dahlquist, CMT2 Chapter 10

by Steve Kern on July 12, 2015

Part II: Markets and Market Indicators
Chapter 10: Flow of Funds

Chapter Objectives
- Understand why knowledge of the flow of funds is important to determining stock market valuation
- Understand why liquidity plays an important role in potential stock market valuation
- Be familiar with measurements of market liquidity
- Understand the relationship between Federal Reserve policy and the cost of funds
Intro
Funds in the Marketplace
- Intro
- Money Market Funds
- Margin Debt
- Secondary Offerings
Funds Outside the Security Market
- Household Financial Assets
- Money Supply
  - Measurements of the Money Supply
  - Money supply relative to the total value of the stock market
- Bank Loans
The Cost of Funds
- Short-Term Interest Rates
- Long-Term Interest Rates (or Inversely, the Bond Market)
- Money Velocity
  - Measure of how fast money turns over in the economy
  - ratio of personal income to M2
  - related to inflation (the faster money circulates, the more pressure on prices)
  - leading indicator of long-term interest rates (because it reflects inflationary pressure)
  - Ned Davis Research
    - When money velocity (monthly figure) rises above its 13-month moving average, the stock market has advanced 3.4% per annum on average
    - When money velocity declines below its 13-month moving average, the stock market has advanced 10.1% per annum.
    - Inflationary pressures from increased money velocity put a damper on stock market prices
- Misery Index
  - Economist Arthur Okum – 1960’s, during President Johnson’s administration
  - Inflation + High Unemployment = “Stagflation”
  - Stagflation measures the social and economic cost of high inflation and high unemployment.
  - Misery index can be calculated for any country by summing inflation and unemployment rates
  - Original Misery Index became the “American Misery Index” = inflation + unemployment + interest rates
  - Trading system: Whenever the American Misery Index falls by 0.3 points buy the DJIA, and whenever the index rises by 3.2 points, sell the DJIA. Trading accuracy of this system = 75% favorable and gain is more than buy-and-hold by 4%.
Fed Policy
Fed Policy Futures
The Federal Reserve Valuation Model
Three Steps and a Stumble
Yield Curve
- The yield curve as a forecast of stock market direction
Conclusion
Review Questions

Kirkpatrick and Dahlquist, CMT2 Chapter 7

by Steve Kern on July 12, 2015

Part II: Markets and Market Indicators
Chapter 7: Sentiment

Chapter Objectives
- Understand what the term “sentiment” means
- Understand the concept of contrary opinion
- Be familiar with methods for measuring sentiment of uninformed and informed market players
Intro
- Market sentiment
  - the psychology or emotions of market participants
  - investor psychology
    - Fear, pessimism
    - hope, overconfidence, greed
- What is Sentiment?
  - Theory of Contrarian Investing
- Market Players and Sentiment
  - Neurochemistry Effect on Human Thinking
- How Does Human Bias Affect Decision Making
  - Investors Are Their Own Worst Enemies
    - Buy low sell high – seldom happens
    - Beating the market is almost impossible to do, but yet almost everyone thinks he can do it
    - Everyone knows panic selling is a bad idea, but it’s observed very often after earnings reports
    - Everyone knows that Wall Street strategists can’t predict what the market is about to do, but investors still hang on every word from the financial pundits who prognosticate on TV
    - Everyone knows that chasing hot stocks or mutual funds is a bad idea yet millions of investors do it.
    - Our brains drive us to do things that make no logical sense– but make perfect emotional sense.
  - Crowd behavior
    - People tend to conform to their group
    - The taking of an opposite opinion is sometimes difficult and dangerous
    - People do not like rejection or ridicule and will stay quiet to avoid such pressure
    - People often meet hostility when going against a crowd
    - People gain confidence by extrapolating past trends, even when doing so is irrational, so they tend to switch their opinions slowly.
    - People feel secure in accepting the opinions of others, especially “experts” and tent to believe the establishment will take care of them.
  - Why is is important to understand that investor emotion and bias affect investment decisions?
    - Helps technical analyst profit by spotting market extremes
    - Technical analysts must remember that they are subject to the same human biases as other investors
      - human biases are so strong that even those who recognize them still are affected by them and must constantly fight against them
      - Must be certain not to “see” patterns that do not really exist.
    - Crashes
      - panics
    - Bubbles
      - Part of the non-randomness discussed in Chapter 4: “The Technical Analysis Controversy.”
      - Bubbles occur infrequently, but more than would be expected in an ideal random walk model.
    - Books on the History of Manias and Panics (links might be to newer editions)
Crowd Behavior and the Concept of Contrary Opinion
- Sameness of thinking is a natural attribute. So it takes practice to get into the habit of throwing your mind into directions that are opposite to the obvious.
- Obvious thinking: or thinking the same way everyone else is thinking, commonly leads to wrong judgements and conclusions.
- When everyone thinks alike, everyone is likely to be wrong. (Neill, 1997, p1.)
- When individuals think by themselves, they can be very logical and reasonable, but when joined with a crowd, they tend to let certain cognitive biases affect their decision making.
- The problem with implementing a contrarian strategy:
  - Prices trend (Dow Theory)
  - When prices trend upward we want to be in a long position, riding the trend
  - The goal of understanding sentiment is to discern when that trend is losing energy and will reverse.
  - Find a way in which to quantify which direction the majority of market players is headed and to question whether there is enough remaining energy to keep the market moving in that direction.
  - As long as players still have money to invest in the market, their optimism will drive prices higher.
  - It is only when players are fully invested that their optimism will not be accompanied by security purchases.
  - At this point, the market is at an excess, and the trend often ends.
  - To quantify these excesses, the technical analyst uses publicly available data to construct indicators of emotional excess.
How Is Sentiment of Uninformed Players Measured?
- Intro
- Sentiment Indicators Based on Options and Volatility
- Option Trading and Sentiment
- Using Put/Call Ratios to Gauge Sentiment
  - ISE Sentiment Index and the S&P 500
  - Combining put/call ratios with futures premium to gauge sentiment
- Volatility and Sentiment
- Using Volatility to Measure Sentiment
  - The S&P 500 and VIX
- Combining Put/Call Ratio and Volatility
- Polls
- Advisory Opinion
  - Advisory opinion– Percentage bullish/[percentage bullish + percentage bearish]
  - Advisory opinion with monetary component
- American Association of Individual Investors
  - American Association of Individual Investors bulls and bears
- Consensus Bullish Sentiment Index
- Market Value
- The Sentix Sentiment Index
- Consumer Confidence Index
  - The Consumer Confidence Index (1967-2010)
- Other Measures of Contrary Opinion
- Buying and Selling Climaxes
- Mutual Fund Statistics
- Mutual Fund Cash as a Percentage of Assets
  - The mutual fund cash/assets ratio appears to be only a marginal indicator of uninformed sentiment
- Rydex Funds
- Marginal Balances
  - When uninformed investors are most optimistic, they have placed most of their capital in the market and may buy stocks on margin to leverage their position.
  - But more recently, margin debt reflects professional speculators and might not be as useful as before.
  - Taking away more usefulness from margin debt for forecasting is the ability through derivatives of holding positions outside the requirements for margin, which apply to banks.
- Money Market Fund Assets
- Relative Volume
- Uninformed Short Selling
- Odd-Lot Short-Selling
- Unquantifiable Contrary Indicators
  - Eccentric Sentiment Indicators
- Historical Indicators
- How is the Sentiment of Informed Players Measured?
- Insiders
- Sell/Buy Ratio
- Investors Intelligence Method
- Secondary Offerings
- Large Blocks
- Commitment of Traders (COT) Reports
Sentiment in Other Markets
- Treasury Bond Futures Put/Call Ratio
- Treasury Bond COT Data
- Treasury Bond Primary Dealer Positions
- T-Bill Rate Expectations by Money Market Fund Managers
- Hulbert Gold Sentiment Index
Conclusion
Review Questions