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Greetings, Pro-fundity team members -
12-12-03

At the bottom of the Guidepost, a full listing of this weeks picks are shown, in addition to the Charts via the Pick-link.

As a benefit of membership, you have access to all Guideposts (including Archived GP's) and Picks. If you miss a week or two for whatever reason, you will be able to go into the Historical Guidepost link to catch up with both the weekly guidepost and the 30 picks made for the week.

Greetings, fellow Pro-fundity team members.

1. In the world of physics, Newton described an eternal principle saying anything in motion will remain so, until some outside force intervenes. That is why we’re pulled to the right when we turn our car to the left. It takes force, effort, to change direction. The same is true in the stock market as far as its direction is concerned. If an increasing trend is in place, it will keep moving in that direction until some other force pushes the other way. In this lesson, we will examine and take advantage of this principle with what are called “Volatility Breakouts.”

2. We understand this principle by the term “Momentum,” accepting the fact that once a trend is placed in motion with enough momentum, it will continue. That is why the trend is said to be our friend. It gives us some degree of certainty about where the price is going, at least in the near term. The degree of that certainty depends on the force behind the move, how much of the market is participating. The bigger the ship, the more difficult it is to change direction. Of course we know there are such trends in all time frames, long, mid-, and short. Our particular brand of trading determines which of these are most important.

3. Now, what signals such a move, what kind of force will cause a change? It has always been one of two causes; a dramatic change in price activity (high volume trading of shares), or some external hiccup such as a news brief that catapults a company into boom or bust. Point: such causes can be either to the good (bullish) or to the bad (bearish). But the fact remains, it is just these kinds of energy explosions that will turn the ship in the water. So turned, we then await an equal force in the opposite direction. That is about as basic as it gets, in terms of market motion (momentum) in any time frame.

4. Next, how can we take advantage of the principle. The news catalyst is fraught with uncertainty. Insiders usually hold this information close to their chests, meaning any signal from that quarter will be lagging and difficult to use. However, price charts reveal abundant signals and leading information. Outbursts in volume activity can be measured directly by the range in which price trades. The high price minus the low price for the day equals the daily range. The same can be said for the weekly or hourly range, the difference between the high the low for the time period used. This is the indicator we will use for our first trading strategy, volatility breakouts.

5. Volatility is generally frowned upon in investment strategies. A price pattern that jumps around a lot reeks with uncertainty. The beta of a stock measures how its price changes relative to the market (S&P 500, for instance). High beta stocks are deemed to be higher risk. We will take the opposite view, seeing opportunity where price fluctuation abounds. For example, the following charts, taken from this weeks picks, show the principle in action. Notice the profound value of Bollinger Bands in identifying these points of change. Low-volatility (narrow BB’s) breed dramatic change! It is from this lull in the action that the greatest changes emerge.
   
   Fig. 1. Volatility changes pre-empt price change.
   
   Fig. 2. The quiet before the storm is shown by BB width.
   
   Fig. 3. Volume spikes occur with marked price change.

6. The explosive price changes coincide with increased ranges, the highs less the lows! But remember, this price action works in both directions, as the next pick shows.
   
   Fig. 4. Volatility change occurs in both directions.

7. Since price activity can work for or against us, we need some protective measure to lower risk. Look at the next pick to see how we might deal with this matter.
   
   Fig. 5. The character of a price pattern provides clues.

8. In this pick we find a momentum-kick in early October. It carries about 10% in the subsequent trend, then goes to sleep. The premise is another price kick is due from the narrow band in December. But how do we know whether it will be up or down? We don’t! The price is riding in the top half of the BB, which is positive. The odds are in our favor, but this is a classic case where money management comes to our rescue. We can place a protective stop and enter a long position now, or we can wait for some indication of an up-kick to confirm our premise. What you see in this series of charts is a basic volatility breakout strategy using no more than Bollinger Bands and your good sense. A lot of money has been made through the years in this manner. Since our discussion thus far has been limited to long positions, that is buying stocks in the hopes they will increase in price, the strategy works much better in a bull market, where the general trend is up. We are in such a market right now, which makes this even more attractive. As a case study, watch GUT in coming days and weeks to see where it goes. Also, look at charts with similar patterns yourself and make some paper-trading picks for further enlightenment. But watch what happens next as we mechanize the process!

9. Think carefully now as we try to automate this strategy. What clues might we use to flag opportunity? The Range! If the range increases above normal values that is the first clue. In previous lessons we have learned to use the ATR (average true range) to measure price volatility. For this strategy we’ll use a 10-day ATR as a volatility benchmark. If the range for a particular time period (day, week, hour) exceeds the ATR, that is a flag! If we get that flag, the next question is did the price go up or down? If it goes up we buy, if not we keep our money. What an easy set of questions. However, this simple routine begs the questions;
   
   • How much of an increase in range is significant?
   • How much of an increase in price should we use as a buy-target?
   • And most important, how far below the buy-price should we place our protective stop?

10. That is a boodle of questions! Consider the multitude of different ways to try as we buy or paper-trade stocks for days, weeks, or months into the future. It is overwhelming. However, smart-money uses the computer to do the heavy work, at great expense. Now you can do the same with your Pro-fundity subscription. For example, PTS-5 is available in Advanced Tools for your continued enjoyment. This is going to be fun. Go to the PTS-5 site, look carefully at the options available, enter setup-parameters of your choice and press Control – a (Ctl a ) together. This is an Excel spreadsheet driven by macros that will calculate the performance for a set of tickers. Look at the results, modify your “Design Set” and run it again, and again, and again…
    
    Fig. 6. PTS-5, Volatility Breakout setup.

11. Ten tickers have already been loaded from this week’s picks. That is, you can just analyze these picks over and over to get a feel for the program. For example, the following picture shows the performance table after you have executed the program. When you press the Control key and the “a” character at the same time, give the program time to execute. Some PC’s will be faster than others. Just recognize the tremendous amount of work being done for us. In this example, a Design-Set was selected. The three variables for the Design Set are shown here:
    
    Fig. 7. Variables used with PTS-5.

12. The next table shows the result of the first Design Set chosen. The selected variables are entered in the Blue cells, in this case Y (0%, 10%, 20%), Z (1.0, 3.0, 5.0) and X (0.5). After the numbers are entered in the blue cells, Ctl a executes. The resulting yields for each of the nine cells of this matrix provide direction for the next trial. In this case, higher-Z gave better results, Y didn’t make much difference, and we don’t know what X did.
    
    Fig. 8. Performance result-1.

13. For our next trial, lets change the parameters as shown below; Y (1%, 10%, 20%), Z (3.0, 4.0, 5.0) and X (0.6), with the results shown.
    
    Fig. 9. Performance result-2.

14. In this second example, yields for the set of ten tickers is more consistent for the chosen variables. But think what this tell us. There is a range of values that give the set of tickers a good yield. But how about the individual stocks? The next chart shows a portion of the matrix where the different ticker yields are not all rosy. That is the value of running ten at a time. The is no way we can pick 10 winners at a time, every time. The reality is we will all have losers. This exercise allows us to see how important is it to limit losses, using sound losses. The X variable is how close to the price channel we place the stop. By cutting losses short, the winners pull the average to an attractive level.
    
    Fig. 10. Individual ticker performance in the matrix for example in Fig. 8.

15. There you have it, the philosophy behind the volatility breakout, why it works and two ways to execute: Bollinger Bands and a mechanical technique. Whether you’re attracted to one or the other, the point remains that this is a very reliable strategy for trading volatility. Enjoy.
    Click here for a new look at PICK PERFORMANCE
    12-12-03 Pick Selection:

    Main Picks:
    ADPT,ELK,GWR,KNSY,PEI,PLL,PPC,PRST,RNT,SHFL
    Breakouts:
    BEL,BPT,GW,KEX,PETD,PVX,REP,SJT,SORC,XEC
    QuickPicks:
    AMZ,CMCO,CURE,GLB,GLT,IPSU,MCS,NTST,RBC,SBSE

    For detail and followup on Pro-fundity Tradescape,
    find the link on "Advanced Trading Tools" on the home page.

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