When you strip it all down, this trading thing is really pretty straightforward. For any tradable security or commodity or currency or whatever, price goes up, price goes down or price goes sideways. Simple. Oh sure, trying to decide where its going next can be a little tricky at times, but still, you are ultimately dealing with just three possibilities. So if you had a three-headed coin you would have a one in three chance of being right at any given point in time. Unfortunately, three-headed coins are tough to come by, thus this whole “prediction thing” remains a bit of a puzzle. Nevertheless, there are ways to improve your odds. One trick is simply to recognize the fact that after price has moved sideways for an extended period of time, the likelihood that one of the other two possibilities is in the offing rises significantly. As a result, we reduce the most likely next event from three possibilities to just two.

Some Realities of Trading

Let’s consider a few other “realities” of trading.

- One reality of trading is that there are many possible ways to interpret the same situation and/or circumstances differently. In essence, that is what makes markets possible. If everyone looked at a given situation the same way, there would be no one to take the opposite side of your trade. If one guy (or gal) is buying and another is selling it is because they are interpreting a particular situation in different ways. One person expects the price to rise, the other expects the price to decline – or at the very least not to rise very much from present levels.

- Yet another reality of trading is that markets and individual securities occasionally enter into “consolidation” areas, or trading ranges, whereby the price of that security remains in a particular price range for a given period of time. These periods tend to frustrate most traders as they wish for the stock or commodity to move in their preferred direction, be it up or down. The good news is that – as yin follows yang – price consolidation is ultimately invariably followed by price movement either up or down.  

- Lastly, many investors perform better when they establish trading “rules” which help to guide their trading decisions by forcing them to interpret certain events in a particular pre-determined way – be it bullish, bearish or neutral. In this vein, some traders follow “rules”, others follow “guidelines." To apply general definitions to these terms, let’s say that “rules” tell a trader specifically what to do, “guidelines” simply highlight that certain conditions exist. For some traders, rules work best because they remove all emotion and personal biases from trading decisions. For others, guidelines work best because they give the trader some flexibility in determining and acting on specific trading decisions. All of this brings us to a method for determining when a market may go from “going nowhere” to “going somewhere."   

Moving in a Direction – or Not

If one accepts the premise that a security can only go up, down or sideways, then once a security experiences an extended period of going sideways, at some point it is going to go either up or down. So this leads to two fairly obvious questions:

- How does one define a “consolidation”?

- How do we know when a consolidation is over? (And additionally, what does one do about it?)

I have seen many ways to quantitatively identify “consolidation." Some are simple, others complex. This week let’s look at one from the “simple” category. Rather than relying on some fancy mathematical formula (not that I am above such a thing, mind you), let’s use a simple measure that can be observed on a chart. Here are the rules:

- Rule #1 - Using a weekly bar chart, the security touches a particular price for eight consecutive weeks.

- Rule #2 – once Rule #1 is met, then using a daily bar chart, within one week prior to Rule #1 being met or within two weeks following Rule #1 being met, the security starts or completes a period whereby it touches a particular price for eight consecutive days on the daily bar chart.     

Okay, that’s about as clear as mud. All of this likely requires a little bit more illustration in order to be understood. So let’s look at a couple of examples.

ProShares UltraShort Financials (SKF)

One of the exciting new developments in the world of exchange-traded funds [ETFs] is that advent of “short” funds, “leverage” funds and also “leveraged short” funds. These funds allow a trader to take a very aggressive bearish position on a given stock index or stock market sector. One such security is ProShares UltraShort Financials (SKF). As the name implies, buying this ETF affords you the opportunity to make two times the inverse of the movement of a given financial sector index. In other words, if the index of financial stocks that this ETF tracks falls 5%, this ETF will advance roughly 10%.

Chart 1 displays a weekly bar chart of SKF. You will notice that twice within the span of several months, SKF twice traded through a particular price for at least 8 consecutive weeks (actually in both cases it traded through the same price for an additional weeks, or 9 weeks total).

Chart 1
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In Chart 2 – a daily bar chart - we see what happened after the first 8-week consolidation in Chart 1. SKF completed an 8 trading day consolidation on 2/20/08. Shortly thereafter this ETF broke out above 117 and rallied non-stop to 140 in just a matter of days.

Chart 2 – SKF Daily Chart (Feb-Mar 2008)
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As you can see in Chart 1, on 5/16/08, SKF completed another 8 week consolidation period. In Chart 3 we can see that an 8-day price consolidation occurred concurrently on the daily bar chart. What followed was a sharp run to much higher prices. Less than two months later, SKF stood 110% higher.

Chart 3 – SKF Daily Chart (May-July 2008)
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Summary 

So are the “rules” that I have described herein destined to make you rich? Well, gee… that would be great, but there are clearly no guarantees for a variety of reasons.

First off, not every “signal” will be followed by a clear-cut breakout and sharp advance (or decline). Secondly, no indication is given as to whether the next nig move will be to the upside or the downside. In addition, when you actually enter a trade and exit said trade following the setup I have described is an entirely different topic requiring some further individual study and decision-making.

As always, however, the primary purpose of this column is to pass on ideas that seem to have merit and hold some promise. The premise behind the method I have described this week – that periods of prolonged consolidation (in this case a security passing through a given price for a minimum of eight consecutive periods on the weekly bar chart and eight consecutive periods on the daily bar chart) will be followed by periods of strong price movement, seems to make sense.

As always, time will tell.

To search for previous articles written by Jay Kaeppel, please click here.

Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site