I received some pertinent questions over the weekend and created a post to share the answers. My email responses were not as detailed as in this post, which provides more color and examples. The first question deals with the StochClose ranking and how to use it. This answer will also highlight six broad trading strategy groups. Second, I will differentiate between StochClose and Smoothed RSI65 as trend following indicators. Third, I will show some examples and strategies for using the Chandelier Exit. And finally, we will put SPY to the test using three trend indicators.
How can I use the StochClose Rankings for the Core ETF List?
This question got me thinking about strategies in general. While there are a zillion different strategies, I think we can break strategies down into six major groups. Yes, there probably more, but this is a good start.
- Momentum (buy highest rank and sell when rank drops)
- Trend-Following (buy/sell trend signals)
- Mean-Reversion (buy pullbacks and sell bounces)
- Chart Patterns (buy bullish patterns and set stops)
- Volatility (buy low volatility and sell high volatility)
- Hybrid (combination of strategies)
These groups, of course, can be broken down further, but I will keep it simple for this Q&A and expand on this topic in the future.
The StochClose Rankings can be part of a momentum strategy that buys the strongest ETFs and sells when they drop below a certain threshold. Such a strategy was put forth in part 2 of the series on the StochClose indicator. All five parts can be found on the Premium page.
A typical momentum strategy might by the top 10 ETFs and sell when they drop below a certain threshold in the rankings. The rotation example suggested selling when the ETF drops out of the top 20 (out of 50 total ETFs). The sold ETF would be replaced by the highest ranking ETF, which is not already part of the portfolio. The image below shows the ranking table with the blue line separating the 20th place (FINX) from the 21st place (VIG).
The challenge with rotation strategies is that an ETF can drop out of the top 20 and still be in a strong uptrend. The ETF drops out of the top 20 because other ETFs are starting to outperform. However, the ranking drop could be a mere consolidation or pullback within an uptrend. For example, the Cyber Security ETF (HACK) dropped out of the top 20 on the rankings, but is still in an uptrend and StochClose is still above 90.
A pure momentum strategy would simply follow the rules and let the chips fall where they may. A hybrid strategy might wait for more evidence before selling. The modest decline in HACK looks like a normal pullback after a breakout and new high.
The chart above its linked to a comparable chart from StockCharts that uses the Full Stochastic (125,5,1) as a substitute for StochClose. It is not exactly the same because the normal Stochastic uses the intraday high and low in its calculation.
StochClose or Smoothed RSI65 for Trend-Following?
StochClose is detailed in part 1 of the StochClose strategy series. Smoothed RSI65 was featured in a video presentation to the CMT Association.
Short Answer: I prefer StochClose for ETFs and Smoothed RSI65 for stocks.
StochClose acts as a volatility-adjusted momentum/trend indicator and this works better for a broad basket of ETFs, such as the All Weather 50 List. StochClose has just as much chance of getting above 90 for the Aggregate Bond ETF (AGG) as it does for the Software ETF (IGV). IGV clearly has more volatility than AGG, but this does not affect StochClose values. Note that StochClose values reflect the location of the close relative to the closing high and low over a specific period.
Smoothed RSI65, which is the 5-day SMA of 65-day RSI, is also a trend-momentum indicator, but it does not dampen volatility or act as a volatility-adjusted indicator. This is important when choosing stocks for a portfolio because we want the stocks with the most juice (volatility). DTE Energy (DTE) is a utility stock with low volatility and Apple (AAPL) is a tech stock with higher volatility. Smoothed RSI65 is better at capturing volatility that can lead to outperformance.
And finally, preliminary testing confirms that StochClose (125,5) works better for ETFs than stocks. Similar, Smoothed RSI65 works better for stocks than ETFs. I will write a series on Smoothed RSI65 in the coming months.
Using the Chandelier Exit and setting the parameters?
The Chandelier Exit (20,2) is used to set a trailing stop based on the 20-day high. The stop is set two ATR(20) values below the 20-day high (ATR(20) x 2). Chartists can widen the stop by increasing the parameters, especially the ATR multiplier. The default setting at StockCharts is Chandelier (22,3). There is not much difference between 22 and 20, but I opted for 20 because this is four weeks.
I think trailing stops are best used for discretionary trading based on chart setups. Personally, I have not had much success with trailing stocks when backtesting trading strategies. Thus, trailing stops can be used when trading pennants, flags, falling wedges, falling channels, support bounces and such.
Most recently, I suggested Chandelier Exits for the Home Construction ETF (ITB) and Gold Miners ETF (GDX). The GDX trailing stop used Chandelier (20,3) because it was more volatile than ITB, which was set at Chandelier (20,2). The chart below shows GDX breaking out of a falling flag and the Chandelier (20,3) matching with the low prior to the breakout. This low marks a typical stop because a close below would negate the breakout.
The stop triggered when GDX fell sharply, but notice that a mean-reversion setup materialized with this decline. One trader’s exit is another’s entry because pattern trading is different than mean-reversion trading. The mean-reversion setup materialized because the ETF retraced around 50% of the prior advance and RSI(14) fell into the 40-50 zone.
The next chart shows the Chandelier Exit continuing to work for ITB. The ETF formed a pennant in June and broke out in early July. The low just before the breakout could be used as the initial stop-loss. This low also coincides with the level of the Chandelier Exit (20,2) at the time (blue line). ITB continued higher after the breakout and the Chandelier is following price higher because it rises along with the 20-day high.
There is no magic level for Chandelier Exits, or any indicator for that matter. In general, I try to set the initial Chandelier Exit so it lines up with the low just before the breakout, provided it is not too low. A trailing stop works great when volatility is low and prices trend. Trailing stops get hit and whipsaws occur when volatility is above average, which may be the case with GDX.
What indicator do you Prefer for Broad Market Timing?
There are a lot of trend-following indicators out there and there are at least three floating around on trendinvestorpro.com: StochClose (125,5), Smoothed RSI65 and the 200-day SMA. So which one is best. Well, it depends. As noted above, I prefer StochClose for ETFs and RSI65 for stocks. When it comes to broad market timing, however, the evidence favors the humble 200-day SMA.
Before looking at historical results, note that SPY is up just 3.7% per year (sans dividends) over the last 20.5 years (1/1/2000 to 7/1/2020). The returns improve to 5.65% per year when we add dividends. As the chart below shows, the first ten years were the lost decade as SPY went nowhere from 2000 to 2010 and endured two bear markets. The returns of the last twenty years occurred in the last ten years and these include the March 2020 crash.
The S&P 500 and the S&P 500 SPDR (SPY) are my preferred vehicles for broad market timing and the 200-day SMA is my preferred indicator for timing these two. But not just the 200-day SMA. Instead of using closing prices for crossover signals, I smooth the close with a 5-day SMA to reduce whipsaws. The table below shows the performance metrics for buy-and-hold and three indicators. Buy/Sell the 5/200-day cross. Buy StochClose (125,5) cross above 60 and sell cross below 40. Buy Smoothed RSI65 cross above 51 and sell cross below 49. The 5/200 cross is clearly the best.
This indicator works for pretty good for the S&P 500 and SPY, and even better with the Nasdaq 100 and QQQ. Large-caps seem to like 200-day SMAs. Perhaps this is because the 200-day is the most widely used long-term moving average among institutions. In other words, it is kind of a self-fulfilling prophecy. The 5/200 cross does not work very well with the S&P MidCap 400 SPDR, S&P SmallCap 600 SPDR or Russell 2000 ETF. Mid-caps and small-caps have different price characteristics than large-caps. The test below started a year later (3/15/2001) because IJR and IWM did not start trading until May 2000 and did not have 200-day SMAs until March 2001.
