You are on page 1of 3

B l o o m b e r g M a r ke t s

September 2001

TRADING TECHNIQUES

115

DeMarks Range Expansion Index is more timely than other oscillators.

AN IMPROVED TRADING TOOL


FOR FLUCTUATING MARKETS
By Lindsay Glass

C AT H A R I N E B E N N E T T

WHEN YOURE KEEPING track of the

movements of securities that are trading


in a narrow price range and looking for
signals to buy or sell, youre at a disadvantage if your technical analysis indicators are off the mark. Some technical
tools for securities that trade in a narrow
rangeknown as oscillatorshave flaws
that can decrease their effectiveness.
With that in mind, market technician Tom
DeMark created the TD Range Expansion
Index (TD REI), which can be used with
price patterns called Price Oscillator
Qualifiers (TD POQs) to gauge when to
get into or get out of a security.
DeMark was concerned about the
reliability of several existing oscillating
indicators because they tended to
smooth their calculations by using an
exponential approach. That approach left

the price impact of pasteven distantpastprice movements embedded in the


oscillator calculation.
In addition, these oscillators relied
heavily on price action just one day earlier. Oscillators also tended to focus on
price changes from one close to another
and largely ignored the days other

FIGURE 1
1 Type SP1 <Cmdty> GEG <Go> 5 <Go> 5 <Go> to see the TD REI indicator

applied to the Standard & Poors 500 Index futures contract.


2 From the TD REI graph, you can type 99 <Go> to copy the indicator to your

Graph Worksheet menu.

prices, such as the high, low or open.


To address these issues, DeMark calculated TD REI arithmeticallyrather
than exponentiallyto avoid both the
distortion of the exponential method
and its inherent smoothing effect. His
pricing study also
T i p B ox
looks back two days in
order to avoid newsFor details on the
or event-driven price
calculations
behind the Range
distortions that can
Expansion Index,
affect the underlying
type G <Help> 9
market for a single,
<Go> 4 <Go> 14
<Go> 3 <Go>.
previous day. Last, the
oscillator calculation is
based on the high and
low prices from the current trading day
and from two trading days ago, so it
takes more than just closing prices into
account.
THE NET EFFECT of these calculations is
to provide an oscillator that displays
extreme readingsboth mild and severe
in degreethat can be more reliably used
to decide when to trade the security
youre analyzing and that provides indications of trending prices.
Figure 1 shows a chart of the Standard
& Poors 500 Index futures contract, with
a price bar chart in the upper part of the
screen and the TD REI study at the bottom of the screen. The white line moving
up and down is the TD REI oscillator, the
red line is the oversold level (minus 40)
and the green line is the overbought level
(plus 40). The area between the overbought and the oversold areas is often
referred to as the neutral zone.
Any oscillator movement out of the
oversold zone into the neutral zone is generally regarded as a buy signal. Conversely, any oscillator movement out of the

116

B lo o m b e r g M a r k e t s
September 2001

TRADING TECHNIQUES

FIGURE 2
1 Type HAL US <Equity> G <Go>, type the number of the TD REI study and
press <Go> to see magenta blocks highlighting extended overbought and

oversold conditions in the stock of Halliburton Co.


2 In both instances, the price trend that created the severe conditions continued

after a short period of little up or down price action.

overbought zone into the neutral zone is


seen as a sell signal. A severe overbought
or oversold condition exists when the underlying oscillator has spent six or more
days in either of those zones, and a mild
reading is indicated when the oscillator
spends five or fewer days in one of those
zones. A severe reading suggests there is
a lot of momentum in the market, and so
a meaningful price reversal should not be
expected at that point in time. A mild
reading conveys the expectation for a
price reversal and movement in the opposite direction of the previous trend.
The mathematical construction of
other oscillators can cause them to produce entries that are out of sync with the
underlying price patterns. TD REI, however, can be effectively used with the price
patterns known as TD POQs.

the high of the previous day and then, at


some point in the day, trades higher than
the previous two highs. This is where the
trade is entered. In this case, the entry

POQS ARE TYPICALLY composed of three


price bars; our example uses daily bars.
In the case of oversold price action, day 1
(point A in figure 1) is a down close and
the oscillator is oversold. The subsequent
dayday 2 (point B)is an up close. On
day 3 (point C), the market opens below

closed higher for two more dayspoints


D and Eand moved a respectable 20
points from trade entry.
An example of a sell POQ is also
shown in figure 1 at points G, H and I. Day
1 at point G is an up close, and the REI
oscillator is overbought. Day 2, point H, is a

down close. At point I, day 3, the open is


above the low on day 2, but the price subsequently trades below this low and the
trade is executed. The market immediately
moved lower over the next few days and
closed 43 points lower than the entry level.
Those two examples of TD REI with
TD POQ applied are the most conservative
applications of these tools and should be
understood before you proceed to other
applications.
Points M, N and O in figure 1 demonstrate a looser variation of the TD studies
for a short trade. In this case, days 1 and
2 form at M and N, respectively, with day
1s REI indicator overbought. Day 2 closes
lower than day 1, and the first two days of
the qualifier pattern are well established.
The fulfillment of the basic qualifier
pattern requires an open higher than the
low of day 2 and a price range that
exceeds the lowest low from days 1 and 2
(point N), but the market fails to achieve
that level at the open.
In this more liberal application, however, as long as the open is above the day
1 low (point M), the short trade can still
be taken, because the range has not sufficiently expanded to dilute the trade
potential. A short tradeentered once
the contract falls below the low of day 1
(point M)moves about 40 points lower
over the next four days.
Another trading possibility and a still
more liberal POQ demonstration exists
when day 3 opens below both the low on
day 1 and the low on day 2. This price action occurs at points E, F and G in figure 1.
At point E, the market closes higher and
the REI is not overbought, but it can still
be considered day 1 in this case because
the oscillator moves into overbought territory on days F and G, activating setup
days E and F in this more liberal interpretation. At point F, the REI is overbought
and the market closes down. In this case,
the closing price may be lower than the
previous close or the open in order to
qualify for consideration. The first two
days of the POQ pattern establish themselves, but the open on day 3 falls below
the lows of both days 1 and 2.
The question arises, Can we still take

B l o o m b e r g M a r ke t s
September 2001

the short trade? In the most conservative


application of TD POQ, the short trade
would be postponed for two days, but aggressive traders can take a long position
for a short-term trade. Despite the setup
for the short tradedue to the open outside the range of the previous two days
the market has prematurely expanded its
trading and a long position captures the
upward bias for the day at point G. A long
position at the open moved 10 points
higher by the close and 13 points at the intraday high.
DeMark didnt just reconsider traditional oscillator construction and develop
a new way of reading oscillators; he also
devised a new approach to forecasting
price reversals. Traditionally, technical analysts had concentrated on divergence between price and momentum, but DeMark
chose instead to focus on duration, or the
time a security spends in the overbought
or oversold zones. DeMark says divergence is a symptom of duration and therefore of less importance in predictions of
price movements.
POSITIVE DIVERGENCE EXISTS when

prices make a new low but the underlying


oscillator fails to confirm with a corresponding new low in momentum. In this

instance, the downward momentum is


slowing faster than the price movement
and forewarns of a potential upward price
reversal. Conversely, negative divergence
exists when prices make new highs but
are unconfirmed by a similar new high in
the oscillator. When this condition exists,
the market is warning of a potential trend
reversal to lower prices.
While it sounds easy enough, the difficulty of trading with divergence becomes

oscillator readings. Two examples of severe oscillators are shown in figure 2.


Theyre marked by the magenta blocks
and overlay the oscillator in mid to late
April and mid June. In April, the oscillator
spent 15 days in overbought territory,
then experienced eight days of sideways
price action before responding to the
strong momentum and then trading up to
a new high for the existing price move.
Similarly, in June, the oscillator spent

DEMARK CHOSE TO FOCUS ON DURATION,


OR THE TIME A SECURITY SPENDS IN THE
OVERBOUGHT OR OVERSOLD ZONES.
clear when an indicator produces two,
three or four divergent signals in succession. Imagine taking a long trade on the
first sign of divergence and losing money
immediately and then taking the next
divergent signal and also guessing wrong.
Most traders would hesitate to take the
third trade setup, and even fewer would
consider, let alone execute, the fourth
trade signal, if it existed.
In figure 1, all overbought or oversold
oscillator levels are examples of mild

FIGURE 3
1 From the Halliburton TD REI graph, type 93 <Go> 1 <Go> 3 <Go> <Menu>

to add the Relative Strength Index technical study below the TD REI study.
The two studies gave conflicting signals in early May and late June.

10 consecutive days in oversold territory


forewarning of excessive downward momentum, which led to prices dropping
from the $40 zone toward the $30-pershare level. Conventional oscillators, such
as the Relative Strength Index shown in
figure 3, would have led to poor trade signals and, most likely, money-losing trades.
In this example, the periodicity of both
REI and RSI has been set at five to make
the comparison relevant.
On the second trading day of May,
a conventional RSI sell signal occurred
based on the close of $40.30point A in
figure 3. That close can be seen as the
lowest close in May. Similarly, at point B
on June 26, the five-day RSI crossed from
the oversold zone below the red 30 level
into the neutral zone and triggered a conventional buy signal. As with the short
sale in May, this trade location was very
unfavorable and could have been avoided
by use of the REI indicator.
No technical analysis study is foolproof, but by identifying specific levels of
overbuying or overselling with TD POQs
and by focusing on the duration of extreme price movements, youll find that TD
REI can markedly improve your markettiming methods.
LINDSAY GLASS is business analyst for technical
analysis and DeMark Indicators specialist at
Bloomberg in New York.
lglass@bloomberg.net

117

You might also like