Evaluating Buy and Sell Signals

Charles Kirk answered a number of questions from members of KirkReport.com in the Friday Mailbag. I want to expand on one particular question about AbleTrend and how it compares to InVivo stops by providing a study case as to how we evaluate buy and sell signals.

I know many people confuse InVivo stops with Welles Wilder’s Parabolic SAR or a number of other indicators that look similar. I’m sorry about that, but there are only so many ways to plot stops on a chart.

Given that they have to be highly visible and users must be able to easily distinguish between buy and sell stops, there are only a couple of ways for anyone to configure how the stops are displayed. But the outward appearance is about the only thing InVivo stops have in common with any other tool out there. Let’s take a look at some examples.

InVivo Universal Stops vs. eASCTrend 6

AbleTrend 7 is the new name for what used to be eASCTrend 6 not long ago. One of my clients paid nearly $5,000 for the software and no longer uses it, so I was able to access the latest version of eASCTrend 6 released in March 2008. Presumably it works the same way as AbleTrend 7.

eASCTrend 6: $SPX Daily Chart on Default Settings

The chart above looks slightly different than the one submitted to KirkReport.com. I simply applied the default settings and left it at that.

InVivo Universal Stops: $SPX Daily Chart on Default Settings

Next, I applied InVivo Universal Stops with default UniversalStop = True. Traders that wish to use tighter stops can manually select a different setting.

One thing I must tell you after trading for a lifetime is that it may feel right to use tighter stops. It feels like a more proactive approach to limit losses to the smallest possible amount but as usual, good trading practices are frequently counterintuitive in that a tighter stops come with a lot of baggage.

A tight stop means more whipsaw. A tight stop means more trades, slippage and commissions. A tight stop makes it more difficult to capitalize on a trend.

The answer is to put in the right stop and trade a smaller position size. This way, you can trade more stock symbols, diversify your trading portfolio in order to have more irons in the fire.

The Mystery of the Missing Dots

Technical analysis is frequently mocked and it doesn’t help that many books and vendors use well-chosen examples. One thing that has always bothered me is how easy it is to fool the naked eye.

FNM Daily Chart Displayed at AbleTrend Website

The chart posted to their website looks good and well, except the point of having stops is that they MUST be plotted for every bar.

FNM Daily Chart Displayed at AbleTrend Website

What happened to the stop for this bar?

FNM Daily Chart Displayed at AbleTrend Website

What happened to the stop for that bar?

FNM Daily Chart Displayed at AbleTrend Website

Where are the stops for all those bars? Is there some stealthy PhotoShop magic happening here?

eASCTrend 6: FNM Daily Chart on Default Settings

Using the default settings to plot the chart gives us some insight into where those missing stop dots might be, but an even bigger can of worms is opened: the stops are in different places. If charts posted to the vendor’s website are not based on default settings, then what are they? How will users know when to change the settings? Is this a well-chosen example?

Qualifying The Trade

Trading stocks may not be rocket science, but it takes some experience to find the right ones. I’ll defer to Mr. Kirk on the stock selection process because I only know about the easy stuff: momentum trading. Let’s see what AbleTrend tells users.

ADM Daily Chart Displayed at AbleTrend Website

AbleTrend users are advised to look for “frequent change in color of T1 and T2″ to indicate a sideways market.

InVivo Swing Trading Tools: ADM Daily Chart on Default Settings

Our members use relative momentum indicators to help identify stocks as they strengthen or weaken against an appropriate broad index. In the case of ADM, we could clearly see that even as ADM made a new high in late-April, the upward momentum had waned (yellow and red bars instead of green) relative to the S&P 500 Index for several months before the breakdown.

InVivo Swing Trading Tools: ADM Daily Chart on Default Settings

We fast forward the ADM chart to the present day so that you can see how InVivo Universal Stops did along the way. Remember, what you see is what you get. You will never have to fool around with any settings to duplicate our charts.

You’ll notice that in mid-July, ADM made a bounce in the downtrend that was big enough to stop out short positions. That is fine, but make no mistake about going long. The price bars were not green. The RMI Histogram is red while the grey threshold line was below zero. Any long position with RMI indicators in this configuration should be considered a quick hit and run scalp — a bounce in a downtrend — something that should not be attempted by novice traders because it is known as “catching the falling knife”.

Over the past several weeks, price bars have been mostly colored yellow while the RMI Histogram is exhibiting a divergence in that while price went lower, ADM is beginning to outperform the S&P 500 Index. Experienced traders can take this information and evaluate it further to see if conditions are present for a tradeable bottom, perhaps a spike bottom. They can also use the blue stop dot above as a buy stop — a close above $24.10 — to enter another quick scalp on the long side.

For additional factors that might help your analysis, see ADM: Feast or Famine?

In Conclusion

You can see that while there are limited options to display stops on a chart, what’s under the hood is not created equal. While the dots can be used by anybody to set a trailing stop for an existing position, one should make buy and sell decisions based on additional factors such as relative momentum, a defined trade setup, market sentiment, etc.

Your stock selection skills will be a big determinant of your success. Stocks should be carefully selected and the trade setup must be qualified. Ultimately, using an appropriate position sizing strategy manages risk and helps lower your risk of ruin.

Last, but not least, AbleTrend stops for TradeStation cost $4,995. That’s a lot of money for just an indicator.