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A Review of Market Timing Indicators

J slept and dreamed that life was beauty; I woke and found that life was duty.

ellen sturgis hooper

As we all know, the quintessential issue in futures trading is timing. No matter how valuable a forecast may be, timing is the critical variable. There is a distinct and vast difference between a market forecast and market timing, and there is a distinct difference between a "feeling" or a "hunch" and actual market timing. Timing is quasi-scientific. A hunch and a feeling are emotional. Although they may be based on some internal sense of logic, they are not sufficiently operational or mechanical for use by the day trader. Hence, they must be discarded. They have no place in the repertoire of the day trader. Eliminate them from your bag of tricks. They will not serve you well.

This chapter is dedicated exclusively to a review of the major timing indicators that are popular among day traders. E.L. Thorndike, the "father" of American learning psychology, stated that there are millions of things a person can do wrong but only a handful of things that are right. Hopefully, this chapter will help you weed out some of the wrong or ineffective things while directing you to those that can make you money as a day trader.

My brief review includes an example of each indicator, as well as my evaluation of its pros and cons. I will not discuss the methods of calculating these indicators. This information is available in virtually any good book on technical market analysis. Although I may ruffle some feathers by making negative comments about your favorite indicators, 1 can only be objective within the scope of my experience and research as a day trader.

Traditional Moving Average Indicators (MA)

Whether you use one, two, or three moving averages, the concept is generally the same. Either the market price must close above or below its MA to signal a buy or a sell, or the MAs themselves must change their relationship to one another in order to signal a trade. A sample chart showing three MAs and buy/sell signals on an intraday chart is shown in Figure 2-1.

The Good News. Traditional MA indicators tend to do extremely well in major trends both on an intraday and longer-term basis. They will make you a lot of money when a major trend begins.

The Bad News. Traditional MA indicators give many false (i.e., losing) signals. They will often get you into a move well after it has started, and when a change in trend occurs, they will often get you out after you have given back a considerable amount of your profit.

Hence, such moving averages tend to be very inaccurate and often have considerable drawdown as well as many consecutive losing trades. Figure 2-1 shows the buy (B) and sell (S) signals generated by this method on a 5-minute S&P 500 chart. As you can see, the performance of the signals is marginal. There are numerous trades within the time frame of a day, all costly in terms of commission and slippage. Only the last trade of the day appears to be profitable. This is typical of MA intraday systems. They tend to trade too often, and they create too much "heat" (losses) and often very little "light" (profits).

Solutions. Some of the problems with moving averages can be decreased as follows: Figure 2-1. Triple MA timing (4, 9, 18 period) on an intraday chart. Buy (B) and sell (S) signals marked accordingly.

ж Use a weighted, exponential, smoothed, or displaced MA.

ж Use a different MA length to exit a trade than you use to enter a trade.

ж Use different MA lengths for stop losses.

ж Use another indicator to confirm or negate MA signals.

Variations on the Theme of Moving Averages

There are many variations on the theme of moving averages. These include MA-based oscillators such as the MACD (moving average convergence/divergence), the MAC (moving average channel), and various high/low MA combinations. A thorough discussion of the MAC method can be found in The Compleat Day Trader. (The MACD was specifically designed for S&P trading by Gerald Appel, while the MAC is my brainchild.)

These variations on the MA tend to be more accurate and more sensitive than simple MA combinations of the closing price. The MAC can also be used to determine concise support and resistance levels. This approach can be very helpful to the day trader who wishes to trade very actively in the direction of the trend.

The Bad News. There is a tendency, as with many MA-based systems, to give back too much profit once a change in trend has developed. This is true of all lagging indicators.

Solutions. Here are some suggestions as to how one might overcome the limitations of MA-based indicators:

ж Use a shorter combination of MA lengths for exit. Hence, exit will be triggered before the MAs indicate a reversal in trend.

ж Use another indicator to confirm the MA signals.

ж Use another indicator that is not MA-based for exiting positions.

ж Develop a trailing stop loss plan that will enhance exit while not significantly diminishing system accuracy