Strategy 2008

Keep it simple, stupid!

Sometimes you just don't see the things that are in plain sight.

Back when I first began actively trading stocks and knew very little about technical analysis, I seemed to make money hand over fist. In 2003, for example, I nearly doubled the value of my trading portfolio, increasing its value 192%. Two years later and supposedly smarter, in 2005 I lost 43%. That was followed by two years of modest profits (2006, 2007), and so far in 2008 I find myself digging out of a very deep hole, being down 34% on the year-to-date.

Desperate to find some winning stocks, I spent the weekend going through the charts in all my watch lists and for past trades.

Most of the charts I saved for the last couple of years have included three indicators:

  • Percentage price oscillator (PPO)
  • Relative strength indicator (RSI)
  • Average directional index (ADX)

It was always a struggle to know how to weight each one and what to do if they gave off different signals.

As I scanned through the charts there was a sudden clap of thunder, a flash of light, and an insight crystalized in my mind! The peaks and valleys in many of the charts correlated much more closely to the histogram of the PPO than they did to the ADX on which I had been placing so much reliance.

12-day MA — 26-day MA
26-day MA
PPO calculation from 12- and 26-day moving averages

The PPO is calculated by taking the difference between two moving averages (usually 12 days and 26 days) and turning that into a percentage so it can be compared across stocks of different values. If you plot the PPO value on a chart, the plot line oscillates above and below the axis. When the price is changing rapidly, the PPO line rises or falls steeply; when the price changes more slowly, the PPO line flattens out.

Here's a good example:

6-month chart for Accuray 6-month chart for Accuray

The black line is a plot of the PPO value. The red line is a shorter-term average of the PPO value (usually 9 days) used as a signal line. When the two lines cross it signals a shift between bullish and bearish sentiment.

The histogram (in blue) shows the difference between the PPO and the signal line.

What got my attention in the ARAY chart was the points at which the PPO line and signal line cross and diverge sharply (red vertical lines). These also mark points of substantial price difference. They aren't generally at the extreme high and low prices of the cycle, but they are pretty close.

What if?

What if one were to use those cross-over points as buy and sell signals?

Cross-overs as buy/sell signals

For the six months shown in the ARAY chart, one could have taken four positions, 2 short and 2 long, and made a profit on each! The key would be to make the trades at the points where the PPO line and signal line diverge/converge sharply.

What if I just used the PPO and forgot about the others (ADX, RSI)?

The new and improved strategy

Screen

Look for stocks that meet the following criteria:

· Average daily volume greater than 50,000 shares
Make sure of being able to get in or out quickly
· Closing price between $5 and $15
Avoid really low-price stocks and limit exposed capital (500 x $15)
· PPO line has crossed the signal line in the past two or three days (histogram value beyond ± .3)
Make sure the crossover is recent, and divergence is obvious

Happily, StockCharts.com allows me to create scans that will accomplish this screening painlessly.

From the results of the screen choose for the watch list those with clear up/down cycles and where the divergence points in the PPO plot are most obvious. Stocks trending up or down will be much better candidates than those moving sideways in a channel.

Trading

· Buy (or sell short) just after the PPO line has crossed the signal line and the divergence is obvious.

· Sell (or buy to cover) when the PPO line obviously converges toward the signal line. In no case hold the position after the cross-over with obvious divergence.

Applying the strategy

I looked at the current and most-recently closed holdings in my portfolio to see how those trades stack up in light of this new strategy. It was not a pretty picture!