The Method Behind The Madness

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One of the longest lasting and truest principles behind the nature of markets is this: strongly trending markets pullback for a few days and then resume their trend. This principle has been proven and exploited over and over. Recently, I wrote about it in Hit And Run Trading with the 1-2-3-4 strategies (3 day pullbacks), and Larry Connors and Linda Raschke wrote about it in their book Street Smarts where they illustrate that strongly trending markets tend to pullback to their 20 day moving average before rising again. If you go through the body of trading literature on a historical basis you can find reference to this concept and as far back as the early 1900s, when W .D. Gann wrote about it.

What happens is that a strongly trending (runaway) market will take a few days rest before continuing its trend. This is especially true in the early stages of the move. The rest, or pause, will come in the form of sideways movement or a few down days (up days for downtrending markets). This comes mostly from individuals who were lucky enough ( or smart enough) to have bought at lower levels ( or , in downtrends, who had shorted at higher levels} and now wish to lock in their gains. However, this pullback, or rest, is also used by the momentum growth funds and traders as a way to accumulate more stock at lower levels (or, on the downside, unload stock at higher levels), therefore once again causing prices to move higher and creating, more momentum. How far these stocks run is absolutely impossible to predict hut the key is to climb aboard early and let the market go where it will go.

If you go back 100 years and look at stock prices (and in fact commodity prices) you will See this scenario play itself over and over and over. The age old question is, where do you enter the market to provide you with the highest possibility of profit while taking the lowest .degree of risk? I believe The 5 Day Momentum Method does the best most efficient job of answering this question. The 5 Day Momentum Method identifies only the strongest trending stocks and, with the use of an oscillator, pinpoints when the pullback will likely exhaust itself and the trend will resume.

Let's now move on to the mechanics and calculations needed to use this methodology.

The 5 Day Momentum Method utilizes two indicators to identify the correct entry-point measures the trend better than any other method (we will discuss Relative Strength in a moment). For those of you who are new, ADX stands for Average Directional Movement. The ADX measures the strength (not direction) of the trend. The higher the

ADX reading, the stronger the trend. The 5 Day Momentum Method only trades stocks , whose ADX reading is 35 or higher. This means we are only looking at stocks that are moving strong in one direction. To identify the direction, we use the ADX companion +DI and -DI. Simply, if the trend is up, the +DI will be greater than the -DI and if the trend is down, the -Dl will be greater than the +Dl. (If you are a bit confused, the examples will simplify this for you).

Therefore, if we are looking to buy into a strongly trending stock, its ADX reading must be 35 or higher (the calculation for ADX is in the appendix) and its +DI reading must be higher than its -DI reading. If we are looking to short a downtrending stock, the ADX reading must be 35 or higher and the -Dl reading must be greater than the +Dl reading.

ADX requires you to have a software program to do its calculations. Most graphing services provide this (a partial list is in the appendix) but if you cannot obtain this calculation, the next best choice of indicator to use is Relative Strength (RS) used by

Investors Business Daily. The RS readings identify how a stock has performed over the past 12 months versus other stocks. A reading of 99 means that the stock has outperformed 99% of all other stocks. Ideally, you want to only buy stocks with this method that have a RS reading of 95 or higher. This assumes you of being in the strongest uptrending stocks available. On the short side though, RS does not amply identify the tradable downtrending stocks. A very low RS reading (1-10) is usually associated with very low-priced, nearly bankrupt stocks. Also, we do not want to trade very low priced stocks due to their Jack of movement and therefore low RS is virtually useless for shorting purposes. One solution I may suggest is to look at the Falling Relative Strength List that Investors Business Daily provides of stocks recently trading under the RS 50 level and RS 30 level. These are stocks that are certainly sinking and they make good candidates to include in the short-selling universe.

The second indicator to complete our toolbox is stochastics. Stochastics are a mathematical formula (see appendix) that is based on the fact that as prices increase, closing prices tend to be closer to the upper end of the price range, and as prices drop, their close is usually near the bottom of the daily range. Conventional wisdom states that when readings get under 40 % the market is oversold and above 60 % the market is overbought. There are four components of stochastics -- Fast % K, Fast % D, Slow % K, and Slow % D. The only one we need to concern ourselves with is Fast % K. This is an extremely sensitive component, and it allows us to best measure overbought and oversold conditions. (A sidenote needs to be added --I have read and studied many hooks that attempt to teach people how to trade using stochastics and for the most part they are useless. The reason is that in strongly trending upmarkets, these oscillators will tell you the market is overbought, but unfortunately markets can remain this way for days and weeks (the reverse is true for downtrending markets). Traders get killed setting into these markets as they continue to rise.

If all this sounds complicated, it really is not. Once we look at the examples, the pieces will be easier to understand.

For The 5 Day Momentum Method we use an eight period Fast % K for our calculations. In uptrending markets, we want the Fast % K to drop to 40% or under. This means the market has pulled back (oversold) and there is a higher than average likelihood the market will again move higher. In downtrending markets, we want the Fast K % to climb to 60 % or higher. This means the market is overbought and the downtrend is likely to kick in again.

Again, if this is a bit difficult to understand, please be patient. I promise you that within 60 minutes it will be second nature to you.

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