A charting strategy is essential because it increases objectivity and improves the odds of success. A basic chart strategy is similar to basic black jack strategy. In his classic book, Beat the Dealer, Edward Thorp, lays out a basic black jack strategy with a set of rules to improve the odds. Once players master basic strategy, they can move on to card counting and such to further improve performance. Similarly, a basic chart strategy lays the foundation for a systematic approach to chart analysis by removing some of the guess work and improving consistency.
Chart strategy starts with the market regime and the long-term trend for the underlying security. I want to be long stocks and looking for bullish setups when the Market Regime (page here) is bullish and out when the Market Regime is bearish. In bull markets, I want to focus on stocks (ETFs) with uptrends, as defined by simple indicators and price analysis. For ETFs with uptrends, I want to look for bullish continuation patterns, pullback patterns and oversold conditions. These are the setups. Once these setups materialize, I want to get granular and look for short-term reversal signals.
Today’s article explains my basic chart strategy. First, I cover the performance characteristics and signals for the Trend Composite, a trend-following indicator. Second, I describe the chart setups and oversold conditions in the short-term timeframe. And third, I turn to short-term timing using breakouts, candlesticks and StochRSI.
Keep It Simple…
John Bollinger used to run a markets list group where members exchanged ideas on making money in the markets using technical analysis. He always added this note at the end of his messages:
When you come to the end, you arrive at the beginning.
It probably paraphrases T.S. Eliot’s famous quote:
We shall not cease from exploration, and the end of all our exploring will be to arrive where we started and know the place for the first time.
This is basically how the journey goes with technical analysis, trading and investing. We start simple because we are learning the basics. As we learn and progress, we try more complicated strategies and experiment with indicators or strategies. After much trial, error and time, we gravitate back to simpler strategies that focus on the basics. The journey is also full circle because we arrive pretty much where we started.
The more inputs and the more complicated a strategy, the less likely it will work in the future. We can curve fit a strategy to find out what worked in the past, but this does not guarantee it will work in the future. Simpler strategies with fewer inputs and minimal curve fitting have a better chance of working in the future.
The Trend Composite aggregates signals in five trend-following indicators set on the 125-day timeframe (six months). These include Bollinger Bands, Keltner Channels, StochClose, CCI-Close and Moving Average Direction. See this article for more details on Trend Composite.
Characteristics of Trend Signals
Before looking at the Trend Composite as a trend indicator, let’s explore the nature of trend-following and signal performance. A successful strategy does NOT work all of the time. There are periods when it works (generates profits) and doesn’t (generates losses). The equity curve may go from the lower left to the upper right (rise), but there will be drawdowns and periods of underperformance along the way. These unavoidable for us mere mortals.
There are many trend-following indicators, but they all have similar performance characteristics. First and foremost, trend signals lag. Don’t expect to nail the bottom or get out at the top. Second, trend signals generate win rates of 50% at best, and usually in the 40% area. Thus, we can expect four of ten signals to generate profits. Third, there will be whipsaws. This is perhaps the biggest reason the win rate is below 50%. We never know which signal will result in a whipsaw or loss, and we never know which signal will catch a big trend. Fourth, trend signals generate profits over time because a few good trends pay for the whipsaws. The average profit from a winner is generally three times the average loss. We need to learn to live with the losses.
The image below shows Trend Composite buy (green arrow) and sell (red arrow) signals for the Healthcare SPDR (XLV) since 2007. The strategy buys when the Trend Composite turns positive and sells when the Trend Composite turns negative. There were lots of whipsaws, a few good uptrends and some dodged downtrends. Preserving capital during a downtrend is also part of the process.
For reference, I ran an all signals backtest (1/1/2007 to 1/31/2022) for Trend Composite signals using 97 ETFs with trading history to at least 2007. This means the system took every buy/sell signal for every ETF. Trend Composite signals produced a 44% win rate. The Average Gain was 19%, the Average Loss was 4.6% and the Profit Factor was 3.12 (without dividends). Profit Factor is the total profits divided by total losses. The average winning signal lasted 256 days and the average losing signal lasted 50 days.
Long-term Trend Identification
Now let’s put the Trend Composite to work on the chart. The long-term trend is the single most important factor because it sets my trading bias. Long-term is, of course, relative because it can be five years for macro investors and one month for day traders. My sweet spot for the long-term trend is the four to six month timeframe. This timeframe is long enough to absorb corrections that can last two to three months and short enough to capture a meaningful price change before it is too late.
I am using two things for long-term trend identification: price analysis and the Trend Composite. First, the chart below shows SPY with some Trend Composite signals. The whipsaws are shaded blue, the buy signals have green arrows and the sell signals have red arrows.
The Trend Composite is part of the
TIP Indicator Edge Plugin for StockCharts ACP
As much as I like the Trend Composite, it is still a trend-following indicator and all trend-following indicators whipsaw when the trend bends or flattens. This is where some basic price chart analysis can help. Higher highs and higher lows denote an uptrend, while lower highs and lower lows denote a downtrend.
The chart below shows the Insurance ETF (KIE) with higher highs and higher lows from July to February (green trendlines). Despite an upward trajectory in prices, the Trend Composite turned negative twice, and then back to positive. These are whipsaws. Like a QB calling an audible, chartists may sometimes want to call a “visual” based on basic chart analysis. Note that KIE did not break a prior low during this uptrend.
The Momentum Composite aggregates signals in five momentum indicators. RSI(10) is oversold below 30 and overbought above 70. 20-day StochClose is oversold below 5 and overbought above 95. CCI Close (20) is oversold below -200 and overbought above +200. %B (20,2) is oversold below 0 and overbought above 1. Normalized ROC (10) is oversold below -3 and overbought above +3. Normalized ROC is the 10-day absolute price change divided by ATR(10). -3 means three of the five indicators are oversold and +3 means three of the five are overbought.
The Momentum Composite and StochClose are part of the TIP Indicator Edge Plugin for StockCharts ACP. Click here for more details.
Oversold Alerts and Short-term Setups
Once the trend is up, we then look for oversold conditions and short-term bullish setups. Trend Composite signals are not very frequent and trends can extend for several months. Traders, therefore, need a strategy to find setups within an ongoing uptrend. These setups can be used for active trading or for investing by accumulating within an ongoing trend.
The Momentum Composite is used to find short-term oversold conditions within a bigger uptrend. The chart below shows the Trend Composite as positive and the green arrows show when the Momentum Composite dips to -3 or lower (oversold). This oversold condition serves as an alert to watch for a short-term bullish continuation pattern.
A continuation pattern can be short-term (one to four weeks) or even medium-term (four to twelve weeks). Flags, pennants and small falling wedges are short-term, while triangles, rectangles, ascending triangles, falling wedges and falling channels are medium-term. Once an ETF becomes oversold and then forms a bullish continuation pattern, watch for a breakout to signal an end to this pullback and a resumption of the bigger uptrend.
Falling flags and falling channels look the same, as do pennants and triangles. The only difference is the timeframe. Flags and pennants are shorter in duration (one to four weeks), while the others are longer. The example below shows a 3-week pennant/triangle, a 9-week triangle in September-October and a 3-week flag in late February early March. In general, I find 1-2 week patterns too short and prefer patterns that extend at least three weeks.
Candlesticks and Short-term Reversals
My charting objective is to find bullish setups and signals within bigger uptrends. This means ignoring bearish setups, patterns and signals when the bigger trend is up. This is also why I view bearish candlesticks as NOISE when the bigger trend is up. Bullish candlestick patterns, on the other hand, are useful when the bigger trend is up and a setup is in play.
This next chart gets very granular. When there is a setup or oversold alert in play on the bar chart, we can then turn the candlestick chart to look for a short-term bullish catalyst. This could be a bullish candlestick pattern or reversal, a StochRSI pop, a gap-surge or a combination.
StochRSI(10) is the 10-period Stochastic Oscillator applied to RSI(10). This means it is an indicator of an indicator and it captures the momentum of momentum. After the Momentum Composite becomes oversold, a StochRSI move above .80 signals a short-term momentum pop that can jumpstart a breakout. It basically means there was a surge in RSI(10).
The patterns on the chart above are pretty obvious: falling wedges, flags and pennants. The candlestick chart above shows the StochRSI pops above .80 (blue arrows). Keep in mind that the Momentum Composite needs to become oversold before looking for StochRSI pops. These pops coincided with pattern breakouts in some cases. Sometimes a pattern is not visible and we only have the StochRSI pop or a candlestick reversal to work with. The example below shows the Insurance ETF (KIE) when the Momentum Composite dips to -3 or lower (green arrows) and StochRSI then pops above .80 (blue arrows).
I chose StochRSI(10) to increase sensitivity, as opposed to StochRSI(14). I could even use StochRSI(5), but I found this setting to be way too jumpy. There is no right or wrong answer. I am just looking for an indicator that will signal a short-term jump in momentum. Chartists can consider the Commodity Channel Index (10) or the classic Stochastic Oscillator (14,3) as well.
Conclusions and Final Thoughts
Even though chart analysis is pretty subjective, we can increase objectivity and improve our odds with a systematic approach. Such an approach does not need to be complicated. In fact, the simpler the better. Simpler strategies have a better chance of working in the future and it is easier to avoid analysis paralysis. The chart strategy and indicators presented here fit my trading style and objectives. Yours may be different.
Try to look at the chart as objectively as possible and consider a decision tree of sorts. Is the long-term trend up or down? If down, then move to the next chart. If the long-term trend is up, then ask yourself if there is a clear bullish setup in play? If not, then exercise some patience or move to the next chart. If there is a bullish setup in play, then use short-term analysis to identify a bullish catalyst for the signal.
Before acting on a signal or bullish catalyst, make sure to plan out your trade and then trade according to that plan. Consider your position size, timeframe and exit strategy. Big positions can lead to big headaches and less diversification. For timeframe, decide upfront if you are in it for the long-term trend or simply as a trade. Your exit strategy will likely depend on your timeframe. Traders will use profit targets, trailing stops or a combination of the two. Investors will use trend signals or a market regime change as part of an exit strategy.