Welcome to TradingEducation.com!

The Market Thrivor’s Secret Weapon

There comes a time in every novice trader’s life when he or she makes a fateful realization.

In the early stages of a trader’s career, considerable effort is expended looking for the best system. For most, this occurs during the first three years as the trader scans the literature, takes countless seminars, reads a long list of books, chooses a charting program and then sets out to either find or create the system best suited for his or her personality and trading style. Fantasies of retiring from the day job and living the life of trader Riley spur him or her on.

But then reality begins to invade the dream. Except for short periods of raging bullishness, the market shows no favoritism, tolerates neither large egos nor low self-confidence and knows no mercy. Emotions, both good and bad, become an expensive handicap. Falling into the myriad of traps, tricks and feints will allow the market to take your money quicker than the Artful Dodger.

Sometime between the first six months and three years, the aspiring trader finally realizes that there is no such thing as a Holy Grail for trading. With this, the trader’s focus changes and a level of maturity develops. Those in the game to get rich quick become disenchanted with the trading losses. Gambling addicts tire of the research involved and gravitate back toward the slot machines and black jack tables in search of easier money. They are the trading dropouts. Those left have either been truly bitten by the bug or have yet to hit their loss pain threshold.

THREE TRADER TYPES
This brings up a very interesting point. Get to know really successful traders and you’ll discern a critical quality. They are perpetual students of the market; they know it intimately and understand its idiosyncrasies. They respect the fact that the market cannot be fooled and that it keeps them honest with themselves – they are the market thrivors.

Unlike the dropouts who mistakenly believe that there is no way to win and the survivors who doggedly stick to a trading system through thick and thin with mediocre results, the thrivors are open to change and tweak their systems as new and better information, techniques or relationships are discovered. They win because they play by the market’s rules, practice money management and follow a strict trading plan. They have learned the hard way how costly it can be to cheat in any one of these areas.

Thrivors are also disciplined and have the ability to get into the trading zone when they work. While survivors learn to avoid big loses but never get to the point of making big money, thrivors learn to love the process, not just the end result. They develop a passion for the markets and through passion they find the strength and determination to do what must be done.

The very best traders are also not blindly focused on any single stock, market or discipline. They are neither pure technicians nor straightforward fundamentalists. They have learned to use what works. They are true intermarket experts.

THE WORLD’S A MARKET STAGE
Search the Internet for the term “intermarket analysis” and two pioneers appear predominantly: John J. Murphy and Louis B. Mendelsohn.

Coined in a 1991 book by Murphy, the term described the impact that different asset classes exerted upon one another. In a June 1991 article in Stocks & Commodities, Murphy discusses how after more than 20 years of studying markets, he began to move away from traditional single-market analysis. Murphy became aware of the interactions that occurred between the commodities, stocks and bonds (see Figures 1 through 5). Not long after, he incorporated the interplay between currencies and the other three asset classes. It was the beginning of a new career for him.

Figure 1: Relationship between two single markets is obvious here, showing the highly correlated Dow Industrial Average (DJIA) and S&P500 (SP) from 1998 through 2005.

Figure 2: This chart shows the relationship between different asset classes, stocks (S&P500) and bonds (10-Year Treasury Notes) from 1998 to 2005. As John Murphy has noted, bonds and stocks decoupled and began moving in opposite directions in 1998 due to the deflation threat that arose in the wake of the 1997 Asian currency crisis. The two asset classes recoupled, moving in the same direction again once the deflation threat ended in late 2003.

Figure 3: Here’s a correlation between stock indexes in different sectors: the S&P500 and Nasdaq 100.

Figure 4: Here we see two indexes in different countries affecting one another – the S&P500 and Nikkei 255.

Figure 5: Here’s the interplay again between two different asset classes, the S&P500 and US Dollar index.

Though his books, newsletters, lectures and seminars, John Murphy and other intermarket analysis proponents proved not only the power but also the necessity of intermarket analysis. But like the path to trading success, understanding relationships and actually making money from them usually involves a gargantuan leap. With hundreds of markets and asset classes affecting one another, how does the trader perform the translation into a trading strategy that can be applied?

Searching for an answer to this question has driven Louis Mendelsohn. A pioneer in the trading software industry and founder of Market Technologies, his primary focus has been “a multidimensional method of analysis known as synergistic market analysis, which uses artificial intelligence, including neural networks, to synthesize technical, fundamental and intermarket data,” according to a 1993 S&C article. More commonly, this analysis has been referred to as neural network technology.

What is neural network technology? Based on research of the human brain, it is software designed to function like the brain in that is has the capacity to “learn” from past experiences through observation and pattern matching. In short, the software is able to change over time as relationships change. This quality is critical to any trading system, since markets are not static. The challenge increases exponentially when intermarket relationships are added to the equation.

How can a software program incorporate multiple markets into indicators that are easy to read and use?

In Mendelsohn’s case, the answer is a program called VantagePoint, which combines neural networks and intermarket relationships producing a set of lines with the appearance of moving averages and indicators that resemble oscillators. But unlike moving averages and oscillators that both lag the market, the crossover lines on VantagePoint are not restricted to permutations of high, low, open and close. What makes this program unique is that these indicators utilize an array of up to nine other correlated markets. The goal is to create leading instead of lagging indicators.

Let’s take a look at the Standard & Poor’s 500 futures as an example. By plugging in the S&P500 futures’ most recent contract, the program uses the open, high, low, close, volume, and open interest readings from it along with the same six datapoints from the following markets.

Dow Jones Industrial Average
Dow Jones Utilities Average
Nasdaq 100 Index
U.S. Dollar Index
Nikkei 225 Index
S&P500 Index
10-Year US Treasury Notes
2-Year US Treasury Notes
NYSE Composite Index

While the weighting given each issue and the way the neural network function handles the data is not public knowledge, the fact that all these markets play a role in determining the direction of the S&P Index (as well as the S&P500 emini contract) will be news to many traders. See Figure 6.

Figure 6 – Daily chart of the S&P500 showing the actual 10-day (blue) moving averages in the main chart window. The lower subgraph shows the differences between the actual and predicted short five-day (cyan) and 10-day (magenta) moving averages with values generated by the program as well as the predicted neural index value of either zero or one. A long position is called for when all three lower subgraph indicators are positive and a short or long exit when they are negative and index value is zero. The lower subgraph indicators also act as overbought and oversold indicators and extreme values signal caution.

Most traders know how to read a moving average crossover and oscillator. When the shorter-period moving average crosses above the longer-period one, it’s a buy. When it crosses below, it’s a sell or exit. When an oscillator (lower subgraph figure 6) reaches an upper extreme, it signals an overbought condition. At lowest extremes, the security or issue is oversold. Divergence, a powerful signal generated by oscillators, works equally well in the case of the Predicted five-day and 10-day moving average differences in the lower subgraph.

THE POINT OF IT ALL?
I wrote this article to show the value of using inputs outside of the traditional single market open, high, low, close and volume. Equally important is the idea of not limiting focus to a single market. Any system that is to provide reliable signals long term must have the ability to reference data from global markets in multiple asset classes. If for nothing else, this will be the lesson for which John Murphy will always be remembered.

The good news? The solution does not have to be complicated. VantagePoint is a case in point. Thanks to the power of modern computers, those gifted with a capacity for observation and ability to translate those observations into a charting or spreadsheet program will find the answer.

For those who prefer the manual approach, there are some good intermarket newsletters to help the trader stay current on what is happening in the four asset classes. Type “intermarket newsletter” or “intermarket analysis newsletter” into your Internet search engine to find a list of resources.

Whatever your preference, the good news is that once you have a solution, it will put you in a class of market thrivors who make the lion’s share in the markets and have a very good time in the process!

Matt Blackman is a technical trader, author, reviewer, keynote speaker and regular contributor to S&C and a number of other trading publications and investment/trading websites in North America and Europe. He writes weekly and monthly market letters. Matt is a Market Technicians Association (MTa) affiliate, a Canadian Society of Technical Analysts member and is enrolled in the Chartered Market Technicians (Cmt) program. He is also a consultant to Market Technologies, LLC. He can be reached at matt@tradesystemguru.com

SUGGESTED READING
Hartle, Thom [1991]. “John Murphy: Intermarket Analysis,” Technical Analysis of Stocks & Commodities, Volume 9: June.
______ [1988]. “An Interview with Louis Mendelsohn,” Technical Analysis of Stocks & Commodities, Volume 6: August.
Mendelsohn, Lou [1993]. “Preprocessing Data for Neural Networks,” Technical Analysis of Stocks & Commodities, Volume 11: October.
______ [1993]. “Using Neural Networks for Financial Forecasting,” Technical Analysis of Stocks & Commodities, Volume 11: December,
Murphy, John J. [1991]. Trading Strategies for the Global Stock, Bond, Commodity and Currency Markets, John Wiley & Sons.
______ [2004]. Intermarket Analysis – Profiting from Global Market Relationships, John Wiley & Sons.

Charts courtesy of VantagePoint Intermarket Analysis Software (http://www.tradertech.com)

Contact Matt Blackman.