caoy2003's  Instablog

Most of people do not understand how the market moves. Following financial news does not help at all, because in short term, market is determined by traders' buying and selling behavior.

Here I present you a simple but solid trend following method to quantitatively track the market movement. It is kind of technical analysis, but not traditional one, it is more of a solid science.

I want to share with you, because i like to discover the world, the market. I want more people to be able to understand the market.

I developed this method in 2010. The idea is trigger by Chuck LeBeau and Terence Tan' Chandelier Exit Trailing stop. I did more above theirs, as I find the Percentage trailing stop is a magic gauge of market movement. I never see similar work anywhere else. I even started a personal blog to introduce my idea, in Chinese.

Next, I will use DOW JONES etf (DIA) Jan2011-Jul2012 as example. SPX500 etf (SPY) is also applicable. Of course other technical indicators e.g. EMA(exponential moving averages) helps, but i will exclusively discuss trading stop here.

To keep it short, the technical indicator is this:

1) draw daily close price of DIA (CLOSE)

2) draw 2% trailing stop line (TSP), meaning that closing price is always no more than 2% far from the TSP. and TSP is monotone (monotonically increasing when long or decreasing when short)

The basic decision rule is:

if close is above tsp, then bullish

if close is below tsp, then bearish

watch out for :

1) volatility surge (when volatility surge, i.e. close touches or even breaks tsp, it normally indicates trend reversal is going to happen, e.g. market top/bottom)

2) double top/bottom pattern

3) false break out (when the trend is too strong, e.g. strong bull market, price dropping upon or a bit below the tsp will immediately popped up by dip buying investors, thus quickly recovers and reaches new high. Otherwise, it normally indicates trend will reverse soon)

Let me keep the words short, and show you figures to illustrate the ideas. The following figure is DIA Jan2011-Jul2012. daily close price (blue) and 2% trailing stop (red). I circled out double tops/bottom with yellow color.

If you see the close is above tsp, and keeps distance with tsp, it means market volatility is low, which also indicates strong trend.

Market reversal happens when volatility surges, i.e. close starts to touch TSP often or even breaks tsp. WHY? because TSP is the percentage trailing stop, meaning closing price is always no more than 2% far from the TSP. Think about it !

Big investors mark to market their profit/loss, and track their equity curves, thus tsp has big implication to them. So you should look out for it as well.

(click to enlarge)