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7/23/2008
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Price Structure Analysis is a proprietary indicator that tracks the price action. There are no other factors such as monetary conditions or breadth factors involved in its calculation. This is pure price action, and it is an attempt to quantify and qualify the trend. The development of the Price Structure Analysis indicator took several years. However, the crystallizing moment was the bottom in stock prices that occurred in March, 2003. At this time, the stock market had an explosive move and became overbought very quickly. The market stayed overbought for a very long time. If you used traditional oscillators that gave you overbought or oversold readings, you probably sat on the sidelines for a long time missing a significant portion of the move. To myself, I thought there had to be a better way, and I believe the Price Structure Analysis indicator is a better way. Before getting to the construction of the indicator and how it compares to other methods of following the trend, let me explain why I think this is better. First, the Price Structure Analysis indicator does not use overbought and oversold conditions. The price action is viewed as a series of thrusts, pullbacks and pivots. If the market is strong or weak, the indicator will capture this action; if the market is intermediate, it will give you a neutral reading. In this way, all the Price Structure Analysis indicator does is monitor the price action. As you will see, this indicator is no holy grail, but it is better than moving averages, and it could function as a low risk, high reward system in its own right. How is the Price Structure Analysis indicator constructed? A Keltner channel is placed over the price bars and price bars are smoothed with a 5 bar moving average. If the 5 bar moving average of price trades outside the upper or lower Keltner band, then this is considered a significant thrust. If prices are moving upward, this up thrust will eventually pullback and a pivot point is formed. (A high pivot point is formed with lows on either side of it). This pivot point, which has traded outside the Keltner channel, is considered a significant pivot point. Significant pivot points are indicative of strong price action. After a downtrend, a significant up thrust and pivot point may indicate a reversal in the trend. A close above this significant pivot point indicates that the trend has changed, and it is now upward. Conversely, after an uptrend, a significant thrust downward through the Keltner channel suggests weakening of the trend. A close below this downward significant thrust or pivot point means that the trend has changed to being down. One other factor is used in the construction of the Price Structure Analysis indicator and that is a relative strength indicator is combined with the analysis of pivots and thrusts. This has the effect of balancing the price action especially when false moves above or below a significant pivot may occur or when the action is particularly sharp and “V” like. The point of the Price Structure Analysis indicator is to keep you in sync with the price action.
Looking at the NASDAQ and how the Price Structure Analysis indicator performed on the long side and short side is presented in Table 1. For long trades, a stop loss of 7% was utilized; on the short side a 2% stop loss produced the best results. On the long side, the Price Structure Analysis indicator does a nice job of capturing the major trends with minimal risk to one’s trading capital. On the short side, while the number of winning trades is not all that spectacular the relatively small stop loss keeps draw downs to a minimum. This system was essentially flat for much of the bull market, and it traded very profitably from 2000 onward capturing a majority of the down trend. Three factors probably account for the performance differences in this indicator on the long and short side and these are 1) the bull market from 1981 to 2000; 2) the upward bias to stock prices; 3) the nature in which stock prices fall (fear and sell off) versus the manner in which they rise (wall of worry and persistency).
With regards to the S&P500 the Price Structure Analysis indicator I use has a bit of a twist. First a relative strength indicator is calculated. This relative strength indicator compares the current price to prices over the past year; it is also front weighted so the more recent price action has a greater influence on the direction of the indicator. Once the relative strength is calculated, the concepts of Price Structure Analysis – thrusts and pivots- are applied to the indicator. The results of a long trading system utilizing the Price Structure Analysis for the S&P500 are presented in Table 2. As a trading system, utilizing Price Structure Analysis is profitable. But the advantages of using such a system become even greater when I combine these systems with indicators that measure monetary conditions, valuation, and sentiment. In general, investing with the wind at our backs and applying more efficient entry and exit strategies leads to very stable and profitable trading systems. Confirmation
The importance of confirmation cannot be overstated. Borrowing from Dow Theory, an advance in prices should be seen in all key sectors to maintain confidence in the sustainability of higher prices. With regards to the NASDAQ, I measure the relative strength of the NASDAQ100, the Biotechnology Index, and the Semiconductor Index. If all three sectors are showing positive relative strength then this is a buy signal; when all three turn negative, the position is liquidated. This is a pure trend following system designed to catch the majority of the price action, and like a trend following system, there are some big winners and a lot of little losers. The results of such a system are presented in Table 3. Learn more about the service
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