By Martin Pring
In a very brief but informative article in the January 1991 issue of Technical Analysis of Stocks and Commodities, Arthur Merrill considered the question of whether the degree of volatility in the stock market is a useful indication of the market’s future course. Based on a 10-year study, he wrote that day-to-day volatility does have good “crystal ball” characteristics, and there is no reason that Merrill’s conclusions could not apply to other types of markets of even individual stocks.
Testing for a 1-day ROC, Merrill multiplied the result by 1,000 to create a meaningful scale. The data were also smoothed by a 33% exponential moving average, which roughly corresponds to a 5-week time span. He then tested for unusually high an low date points using the standard deviation method above and below the mean. The indicator proved correct 70% of the time in predicting 13- and 26- week periods. The accuracy rate for the 52-week period was 78%.
One of the key problems faced by all traders is whether the security they have chosen to be involved with will experience trending or trading range characteristics. The distinction is very important. A trading-range market would be attacked by selling into an overbought reading and buying into an oversold one. Short positions would be initiated with an overbought condition and covered with an oversold one. On the other hand, if it is known ahead of time that a market is likely to trend, greater emphasis could be placed on trend-following devices such as moving averages and trendlines with less significance on oscillators.
After all, if you believe that a market will continue to rally, why make trading decisions based on a momentum indicator that is likely to undergo several negative divergences with the price before the final peak?
Of course, there is no precise way to foresee with any consistency whether a market is likely to fall into either the trending or trading range. However, in New Concepts in Technical Trading Welles Wilder outlines an approach that tries to determine at least when a market is likely to break out of a trading range. He calls it the “Directional Movement System.” The objective of the system is to categorize a number of different markets or stocks by their trending characteristics. The directional movement system measures each security on a scale of 0 to 100. Those with likely trading-range characteristics are ranked at the lower end of the range and those with trending-range characteristics at the higher end. Knowing where a specific security may fall enables you to decide intelligently whether to trade the stock from a trending or trading range perspective. Any security that falls into either extreme offers good opportunities for low-risk profits because trading tactics can be adapted to suit the indicated characteristics. Those securities that fall in the middle would be ignored. Since all securities alternate between trading and trending range characteristics, the system is dynamic because it monitors these characteristics on a continual basis.
Most approaches in my book, Martin Pring on Market Momentum, explain how various technical systems work, but the directional movement approach tries to match the right system to the likely market action. In other words, if we apply a particular system to a market it’s rather like trying to ski regardless of whether it’s summer or winter, which is really putting the cart before the horse. The Directional Movement System, on the other hand, tries to tell us what the prevailing season is likely to be, so we can decide whether to get out the skis (momentum indicators) or the sail boat (e.g. moving averages).
Excerpted from Martin Pring on Market Momentum, 1993