Trading Pure Price Action

BY GARY SMITH

©2000, reprinted with permission from Active Trader Magazine

POP QUIZ — THE MOST VALUABLE TOOL FOR THE SHORT-TERM TRADER IS:

A) A PRICE CHART

B) A COMPLEX TECHNICAL INDICATOR

C) HIGH-SPEED COMMUNICATIONS

D) NONE OF THE ABOVE

Maverick short-term trader Gary Smith, who has averaged $14,000 per month in profits over the last three years, will choose D every time. Find out how he takes consistent profits out of the stock market.

Many traders look at me with a skeptical eye when I tell them how I trade the stock market for a living. That’s because I’m totally opposed to perceptual filters like charts, oscillators, waves, cycles, moving averages, and all the other approaches and systems traders typically use to understand price behavior. To add insult to injury, I also believe all the glitzy computer equipment and software so frequently advertised for traders is unnecessary.

For me, less is more. I believe in trading pure price action — market behavior you can see and do not have to measure by traditional (and often lagging) analytical tools. My trading has evolved to the point that if I had to, I could make my trading decisions based solely on halfhourly quotes of the Dow, S&P 500, Nasdaq 100 and Russell 2000 cash indices.

A year ago, in fact, I had to do just that as I helped a friend move across country. For an entire week, I did not have access to CNBC, the World Wide Web or any of the financial publications I usually rely on for information. I survived solely by making frequent phone calls to get updates on my cash indices. But my trading did not suffer: I actively traded and made $10,000.

So, you may ask, how profitable has this simplistic trading style been over the years? Starting with a $2,200 account in the spring of 1985, I have methodically parlayed my trading skills and capital in such a way that over the past three years (ending December 1999), I’ve averaged over $14,000 in monthly trading profits.

Successful trading is about quickness, flexibility and reacting to market action as it is occurring, not after the fact when it can easily be quantified and identified by the analytical horde. That is why over the years I have gravitated toward trading pure price action. This simply translates into being in sync with the rhythm of the market — and that rhythm is its momentum.

Key short-term trading patterns

My trading methodology is based on several short-term momentum patterns that keep me attuned to the market’s rhythm. These are outlined below and followed by real-life trading examples that show how they capture significant price moves.

While these patterns are all short-term techniques, they can sometimes develop into bigger trades. I trade all my momentum and divergence patterns with the expectation they will result in immediate further strength (or weakness) over the next few trading days. If this price strength continues, so much the better.

V-bottoms: V-bottom reversals occur intraday when the Dow has been down the entire trading session (as much as .75 percent from its previous close) and then makes a furious comeback, closing either near the unchanged level or, preferably, up for the day. The later in the day the reversal occurs, the more significant it is.

I instinctively trade V-bottom reversals if the Dow closed down the previous day or if it has been in a recent downtrend. Vbottom reversals that occur after a strong up day or during a period of rising prices are much less important.

Late-day surges: This pattern is closely related to the V-bottom. Late-day price surges normally occur during the last two- to two-and-a-half hours of choppy and non-trending trading days. A lateday price surge should take the Dow to a close of at least .5 percent above the prior day’s close. Like V-bottom reversals, this pattern is most significant when it comes after a down day or a period of declining prices.

Extreme momentum days: Extreme momentum days are just that — trading days of out-of-the-ordinary price action that has not occurred for the past several months. This type of momentum day is normally followed by a continuation in the direction of the thrust.

Weekend patterns: Some of my more reliable momentum patterns over the years have been Friday-to-Monday patterns. Greater-than-average strength on a Friday is often followed by more strength on Monday (or Tuesday, if Monday is a trading holiday). Conversely, extremely weak price action on a Friday typically leads to more weakness on Monday. I buy on the close of any Friday when the Dow and Nasdaq 100 both close up .5 percent or more.

A Friday-to-Monday momentum break pattern occurs when extreme strength or weakness Friday does not carry over to Monday. These weekend momentum break patterns are highly significant and indicate short-term trend changes.

One-percent selling days: A 1-percent true-selling day occurs when, after a period of rising prices (at least seven to 10 trading days), the cash Dow, S&P, Nasdaq 100 and Russell 2000 indices all close down 1 percent or more on the same trading day. Such days often are “trend busters” — harbingers of serious price declines.

I use a little leeway in defining such selling days. For example, if three of the four indices are sharply lower — say, down 1.5 percent to 2 percent or more — but one index is down only .75 percent to 1 percent, I would still interpret that as a true-selling day. Any index down less than .75 percent invalidates the true-selling day because it indicates buying interest in at least one segment of the market (in an otherwise extremely weak overall market).

Divergence patterns: Divergence patterns are my favorite technique because they have made me the most money over the years. Divergences (when one market or indicator goes in one direction and another market or indicator goes the opposite direction) between the Dow, S&P, Nasdaq 100 and Russell 2000 indices tell me where money is flowing and which sector I should be trading.

Market selection

Before looking at specific trade examples, let’s first discuss a couple of the nutsand- bolts issues: what to trade and how to time entries and exits.

There are a number of vehicles you can use to trade these patterns — individual stocks, equity shares like the SPDRs, DIAs or QQQs, stock index futures, stock index options or mutual funds. In the following trading examples, it really does not matter which trading weapon would have been used — they all can be effective in exploiting the types of price action I have described.

Regardless of your preferred trading vehicle, the challenge remains the same — understanding price behavior and being in sync with the momentum of the market. In the end, what you trade boils down to your individual risk tolerances and preferences. In the past I have traded stocks, equity and index options, and stock index futures. But at this point in my trading career, I make most of my money trading mutual funds, partly because of their trend persistency compared to other trading vehicles.

Entry, exit and risk control

I am a close-of-the-day trader, which means my trading decisions are based on the entire day’s trading action. I make my trades right before the close of trading. In the past, I used to trade intraday. However, my trading account is hundreds of thousands of dollars to the better since I’ve moved beyond intraday trading in favor of close-of-the-day trading.

This approach has allowed me to capture much more of the gains from the great bull market of the past decade than darting in and out on a daily basis.

As mentioned earlier, my price patterns are short-term and are intended to exploit immediate further strength (or weakness) over the next few trading days. As a trader, I never cut my profits short or set price objectives. My sell criterion is very simple: If the expected strength fails to materialize the next trading session, I exit my position on the close — no hoping, praying or wishing.

Once I am in a profitable trade, I will add to that position as the market moves in my favor. This is a scale-up trading strategy I learned from master traders such as Jesse Livermore and Nicholas Darvas.

On initial purchases, I do not risk more than 1 percent to 2 percent of account equity. Then, if the trade moves in my favor, I will add to my position on each 1 percent to 2 percent incremental price advance.

Livermore and Darvas also believed in trailing their stops as prices rose, so once the market retraced a certain percentage from their highs, they were taken out with a profit. I usually get out if the market moves 3 percent to 4 percent off any recent high since I have been in. If these percentages seem like I don’t give the market much room for error, it is because I focus on trading mutual funds moving upward in tight, rising channels with few or no reactions along the way. (This part of my strategy is one of the key elements of my success.)

In the trenches

Enough of the explanations. Here are some real-life examples that illustrate how to trade these momentum and divergence patterns.

Weekend break: The Dow had been in correction mode from August through mid-October 1999, declining more than 11 percent. This correction reached its nadir with a 266-point (2 percent) decline Friday, Oct. 15. Doom and gloom pervaded the Street after the close that Friday, with forecasts of another sharp decline and a break of the critical 10,000 level on Monday, Oct. 18.

But a funny thing happened when the market re-opened that Monday: Instead of suffering follow-through selling, the Dow chopped around most of the day, flipping between positive and negative territory (see Figure 1, above). Then, in the last 90 minutes of trading, the Dow shot up 116 points, closing ahead 96 points for the session.

It was a classic example of the Friday to Monday momentum break pattern. Coming after a period of declining prices, Oct. 18 marked a major bottom in the market and launched a rally that resulted in the Nasdaq 100 gaining 57 percent by the end of the year.

Over the years, Friday-to-Monday momentum break patterns have marked several significant lows. Both the Fridayto- Monday momentum break patterns of April 14, 1997, and Jan. 12, 1998, led to 30 percent advances in the major indices over a period of a few months. Other Friday-to-Monday momentum break patterns have led to smaller, but still significant, price moves.

As with any of my trading patterns, I trade Friday-to-Monday momentum break patterns instinctively. Trading is not about analyzing or rationalizing, it is about being quick, flexible and capable of reacting to changes in the market.

On Oct. 18, 1999, however, I was not quick or flexible. I was psychologically unable to make the trade because I got bogged down in bearish analysis. That was my loss: The Dow rallied nearly 300 points the following two trading days. (The lesson: Even experienced traders need to be vigilant about adhering to sound trading practices. You have to be able to execute your game plan to profit from it.) Fortunately, another trading pattern — extreme price momentum — got me in the market on Thursday, Oct. 21.

Momentum extreme: On that Thursday, the Nasdaq 100 dropped more than 60 points in the first hour of trading. (This was a reaction to some adverse news that technology giant IBM announced after the previous day’s close.) Beginning with the second hour of trading, the Nasdaq 100 gradually traded higher throughout the day (trade not pictured).

Then, in the last hour of trading, it surged upward to close 10 points higher on the day. I found this type of extreme daily momentum in the tech-heavy index especially significant because IBM was getting pummeled in trading on the NYSE. As a result of its extreme price momentum off the morning lows and also its divergence with IBM and the Dow (which closed lower by 94 points), I took a position before the close in the INVESCO Technology fund.

As I expected, prices rallied the next day (Oct. 22) and then traded sideways for a few days. But on Wednesday, Oct. 27, this time in the Dow, another momentum pattern triggered — the late-day price surge.

Surging market: On this day, the Dow had been trading around the break-even level for most of that session when it suddenly broke out and staged a 100 -point rally in the last hour (see Figure 2, above). This also was a day when the Dow Jones Utilities index was making one of it best advances in several years.

Buoyed by the late-day price surge in the Dow and the out-of-the-ordinary price action in the Utilities, I increased my technology fund position before the close on Oct. 27. The Dow rallied more than 300 points the following two days, with technology leading the way.

While this would have been a completely acceptable two-day trade, I continued (as I do whenever I am in a winning position) to increase my technology mutual fund position as the Nasdaq 100 and other tech-related indices moved steadily higher over the next two months.

Mixed signals: My favorite patterns are divergences between the Dow, S&P, Nasdaq 100 and Russell 2000 indices. By telling you which sectors — large cap, technology or small cap — are the strongest, divergences provide a good indication of where you should put your money.

Table 1 (below) shows the performance of the Dow and the Nasdaq 100 for the seven trading days from Oct. 28 through Nov. 5, 1999. At the time, a one- point move in the Nasdaq 100 equaled a 4.23- point move in the Dow (computed by dividing the Dow by the Nasdaq 100).

It was pretty obvious beginning Oct. 28 where the strength was in the market and, hence, where to be invested — the Nasdaq 100 and technology sector. This divergence between the Nasdaq 100 and the large-cap stocks was particularly notable Oct. 29, when the Nasdaq 100 rose the equivalent of 412 Dow points. It also was very glaring Nov. 2 when the Dow closed down for the day in the face of a strong Nasdaq 100.

Many traders began backing away from the Nasdaq 100 around the time shown in Table 1 because most traditional technical indicators were flashing “overbought” signals. However, the extreme divergence between the Nasdaq 100 and the rest of the market suggested something very big was brewing. And far from being overbought, the Nasdaq 100 rocketed ahead another 900-plus points from the close of trading Nov. 5 through the end of December.

The rule regarding diverging markets is to always buy the strong market. If you find yourself in a sector that suddenly begins to diverge negatively from the other indices, get out as quickly as possible and re-deploy your capital in the sector diverging positively.

A classic example of negative divergence occurred in early April 1999. As shown in Table 2 (below), there was a vicious rotation out of tech stocks and into large-cap Dow and value stocks beginning April 12. I was in technology during this rotation and exited part of my position on April 12 and the remainder on April 13.

I repositioned myself in the value sector of the market. As it turned out, the Dow and other value stocks continued soaring through the month, while technology went nowhere.

Catching the bottom: The V-bottom upside reversal pattern does not occur very often, but when it occurs, get ready for some fireworks. The last notable Vbottom reversal I traded was the major market bottom of Oct. 8, 1998. That day marked the culmination of the summer meltdown, which took most indices 20 percent or more off their summer highs.

It looked like the market was about to fall deeper into the abyss that day, opening lower and continuing to plummet (see Figure 3, above). By 2 p.m. EST the Dow was down 274 points, or almost 4 percent. Around that time, I had to leave home to conduct some personal business, never imagining I would soon be moving money into the market. But when I returned home near the end of the trading session, the Dow had made a miraculous turnaround. Right before the close it briefly pushed into positive territory, then drifted back to close marginally lower, down only 9 points.

Even though I was bearish, I had no choice but to trade this pattern. Although I doubted it was a bottom, I thought there would have to be some carryover buying. That is, in fact, how the situation unfolded: The Dow rallied 235 points over the next four trading days.

Again, this would have been another great short-term trade, but this 235- point rally was luckily only a prelude to the explosion that was about to occur. On Thursday, Oct.15, shortly before 3 p.m., the Fed unexpectedly lowered the discount rate. After the surprise Fed announcement, the Dow surged a stunning 220 points during the last 60 minutes of trading and closed up 330 points for the day.

This was another example of extreme price momentum — the kind of out -ofthe- ordinary price action that invariably leads to much larger gains in the days and, sometimes, weeks ahead. Some traders, intimidated by extreme momentum, retreat to the sidelines awaiting price pullbacks that never occur. As with all my trading patterns, whenever I see an extreme momentum day, I don’t think, analyze, or reason — I simply buy. From the close of Oct. 15, the Dow ran up another another 900 points through the end of the year.

The short side: I have only one sellside momentum pattern — the 1- percent true-selling day. True selling for me is when all the indices — the Dow, S&P, Nasdaq 100 and Russell 2000 — concurrently decline 1 percent or more on the same trading day. Although this is my least reliable trading pattern — most likely because of the historical upward bias in stock prices — it nevertheless has given me some excellent sell signals.

For example, the summer 1998 top on July 21 came in the form of a 1- percent true-selling day. Another 1-percent trueselling day occurred two days later on July 23. Usually, I will sell up to 50 percent of my position on an initial true selling day, and the remainder of my position on a second true selling day (or if prices continue trending down). After closing out my remaining positions on July 23, the Dow sank nearly 1,600 points through the end of August.

Incidentally, my 1-percent true-selling day pattern also got me out of the market in mid-October 1997, when two such days occurred back-to-back on October 16 and 17. That effectively ended the spring and summer rally in technology and small caps, and enabled me to avoid the mini-crash of October 27 (as well as the weakness leading up to that debacle). However, because the 1-percent true-selling day is my least accurate pattern, there have been occasions when I have exited only to reenter a day or two later when one of my other momentum patterns kicked in on the upside.

The patterns we have analyzed share several common traits: They are simple, based purely on easily observable price action and easy to trade. By focusing on price action and momentum, and avoiding perceptual filters like charts and indicators that can adversely influence trade decisions, I have been able to develop short-term strategies that identify highly profitable trade opportunities in the stock market.

“Keep it simple” may be a shop-worn trading concept, but it has been a philosophy I have actively, and profitably, practiced for years.