I’m undertaking a 1000-day reinvention project, blogging here daily to track my progress. In Saturday Reflections, I take time out to reflect.
Last week, I began looking at stock charts in earnest, in determining which tickers I would trade, usually with short puts, though I’d like to expand my trade types to be able to respond to different market regimes.
Today I want to review some ideas from Arthur Sklarew’s book Techniques of a Commodity Chart Analyst, first published in 1980. While Sklarew was writing about trading commodities, his work applies to analyzing stock or ETF charts as well. I’m using his approach to finding major and minor trends to help me identify candidates for selling puts.
Major and minor trends
Sklarew observes that asset prices move in zigzag patterns:
The earliest published technical comments on price movements were those of Charles Henry Dow, who created the original Dow Jones stock averages in 1897 and analyzed their price movements in the columns of the Wall Street Journal. His observation that a succession of ascending highs and scending lows was characteristic of a bull trend and that descending tops and descending bottoms were bearish, familiar as it may sound today, was quite an innovation at the time, and later became one of the main ingredients of the “Dow Theory.” The fact is that prices rarely move straight up or straight down. They usually waver and react along the way. The result is a series of waves or zigzags within the prevailing trend.
This zigzag formation is the foundation of all chart formations, and is kthe key to their forecasting value.
In analyzing a chart (for a commodity, in Sklarew’s case, or an equity or ETF in mine), one must first identify the minor trend and then the major.
Sklarew starts with the minor trend (after looking at daily patterns):
When the daily zigzag movements of a market show ascending highs and ascending lows the minor trend is upward…. Descending highs and descending lows define a minor downtrend…. [Personal] judgement must sometimes be used to evaluate the zigzag movements.
Let’s take a look at this recent chart for $QQQ, an ETF tracking the Nasdaq-100 index. Each candle on the chart is formed with the thick body indicating the opening and closing prices for one day, with wicks showing the intraday high and low. A red candle indicates the daily close was lower than the daily open and a green indicates a close higher than the open. The minor trend here is bearish, as you see progressively lower lows and lower highs over the last nine trading sessions.
To identify the major trend, you check if the minor trends are showing higher highs and higher lows, or the opposite:
Once the minor trend has been identified, it is relatively simple to identify the next larger trend, which we will call the “major” trend. Just as the minor trend was composed of the zigzag swings of daily ups and down days, the major trend is composed of the zigzag swings of the minor uptrends and minor downtrends. A succession of mionr up and down trends making higher tops and higher bottoms produces a major uptrend, while descending minor tops and bottoms identify a major downtrend.
The $QQQ chart above shows a major uptrend that may be in a reversing process into a major downtrend.
Sklarew writes of reversals:
In both major and minor trends, for an uptrend to reverse to a downtrend, the signal is most convincing when a high falls short of the previous high before the price drops below the previous low, since this results in a lower top and a lower bottom. Nevertheless, a downside penetration that comes from a higher top should also be considered valid as an indication of a downturn.
This is what I see in the $QQQ chart. In the previous major upswing, a low was reached where I’ve indicated the first yellow arrow. Moving to the right in time, you see a new low was reached where the second yellow arrow indicates, after a higher high. And moving forward in time the new high was lower as well.
Taking advantage of trends
Sklarew writes:
It cannot be repeated too often that the key to profits in commodity trading is identification of trend direction. The price move that one trades might be the trend of an hour, a day, a month, or a year, but to successfully buy low and sell high a trader must ride a trend.
As I’m evolving my own trading approach, I’m spending more time on analyzing trends. My favorite kind of trade right now is a short put. That’s where I sell a put contract for a premium. This means I have the obligation to sell a stock or ETF at a particular price, should the put option be exercised. Generally speaking I will not hold a short put until expiration and assignment. I intend to hold it only long enough for the premium to decrease enough that I can buy it back for less than I originally sold it, making a profit. For this to work, the underlying stock’s price must stay above the strike price of the option. So this is a bet on the stock price going up or at least not dipping too far. It is a neutral-to-bullish bet.
Ideally, I want to get into a short put right when a stock is about to have an upswing, because that means that the put will rapidly lose value, meaning I can buy it back for a quick profit.
My new approach is to identify stocks that are in major uptrends, and have just shown a swing down. If a stock zigzags down but there is upwards pressure on its price, it is likely to swing up in short order, as I’m hoping for.
How to find stocks for short puts
My current approach to finding stocks in major uptrends with a minor downswing is to search for tickers showing positive performance over one month and three months that also show a five-day RSI (relative strength indicator) below 50. I use a screener on TradingView to find these candidates, and then I analyze their charts individually.
Here is Morgan Stanley ($MS), surfaced from my screener. That last candle is pretty ugly! But this stock is still in a major uptrend until such time as it reaches a low lower than the prior minor trend’s low.
This is something I would consider selling a short put on because given its bullish major trend, there is currently a good probability it will make a turnaround soon. Even if it breaks through the prior low and reverses into a major downtrend, any downtrend will itself have some upswings, offering a chance to exit the short put with minor or no losses, and perhaps a little bit of profit.
The basis of trading
If you spend any time with technical analysis — analyzing and forecasting stock (or any asset) prices based on price and volume charts — you will quickly come across various named chart formations such as “cup and handle” or “double top” and so forth.
Sklarew writes of such chart formations:
As prices zigzag their way up, down, or sideways, their day-to-day movements trace out many formations or patterns on the charts. The observation and study of those patterns over the years has shown that certain of them tend to give reliable clues to the future direction of prices. Among the formations that are well-known to most chartists, I believe the most dependable are the head-and-shoulders tops and bottoms, sideways consolidations, rounding or “saucer” tops and bottoms, double tops and bottoms, expanding tops and bottoms, and flag patterns. Each one of these formations could be interpreted strictly on the basis of zigzag price swings, without labeling the formation with a name, and essentially the same trend forecast would be made. The recognition of a familiar formation, however, gives the chartist further assurance of a correct trend analysis.
Nevertheless, an undue concentration on chart formations without paying proper attention to their internal trend characteristics can lead one to see formations where they do not actualy exist. For a chart formation to have valid forecasting value, it must be composed of minor and daily trends that could themselves signal the next direction of the trend.
Sklarew gives an introduction to classic chart formations even while warning that the chartist should be careful to understand and analyze these as simply zigzag swings of daily, minor, and major trends.
I’m going to be sharing his chart formations in a later post but for today I have enough to absorb!