Friday, September 3, 2010

About fakeout analysis

Bull fakeout is an event, when smarts generate a quick trend-change in order to load more puts cheap, then drag market downward.
On 1-day chart fake brakeout is a maximum 2x2-4 trading days of action. Beginning of this trap starts like a bearish exhaustion (first 2-4 days).

They buy calls, then use relatively low volumes at the end of their bear cycles and drive prices upwards with a smashing bull volume insertion (please read my related analysis here and here ).

Then, when others realize and want to ride the formed bull, smarts pass their cheap-bought calls to masses, buy puts chap and sink market leaving others loosing their money again.

In an event of normal trend-change they start the usual pass-over cycle with much higher volumes as they load more and more calls. They already passed the majority of their calls, and they don't want and don't letmarket go down enforcing short side to buy to cover spirals prices higher.
Smarts then let market run the bull into it's highes sentiment levels, when puts are extremely cheap and then they do the opposite of the bull-breakout preparation. This whole thing repeats again and again...

Let's define fakeouts:
Bull fakeout: Main trend is down, fakeout is a quick upward change then market continues down.
Bear fakeout: Main trend is up, fakeout is a quick downward change then market continues up.

How can we check whether we are in a normal bull-switch or in the middle of the fakout game of the big guys?

In order to understand the basics of bull-fakeout investigation I need to give some understanding about the principal of volume-based TA studies and give some understanding of MarketVolume charts.

Volume is the number of a share or a buch of shares (indexes) traded in a given time frame. Volume-based studies give an information about the intensity of trade. In each trading time frame there is a selling and buying volume. Sellers pass their stocks (or other financial instruments) to buyers. There is always a buyer for a given selling event, the question is the price of that transaction.

If there are more buyers than sellers, sellers have an option to choose buyers offer higher prices. If there are more sellers, then buyers have the option to choose the cheapest offer.

Market characteristics has a cyclic nature. Let's start from a bullish recovery. At the end of a bear market the number of buyers are small, they can buy stocks cheap. As more and more participants join to the bull side, prices are higher as bullish side is surging. Everyone, even granma and granpa thinks it's time to jump and buy. At the end of the bullish cycle there are few bears only, puts are cheap.
On a given point of the bullish surge, smarts start to switch their positions in a very cautious manner masses cant' recognize in prices.Actually in most of case prices go higher and higher.
At this poin, aggregated volume oscillators show this weakening bullish volume surge.
This is the point when things start to be suspicious for a volume analyst.

This is the point when smarts prepare for a change. At a given point bulls want to take a profit will not find buyers ready to buy on higher prices. This is the moment when the number of buyers is very low and number of sellers is huge. Smarts already full with puts and they can enjoy shorting the market. Prices face down dramatically. Last bulls loose.

This is the moment, when remaining buyers will tell the price, and sellers have no option.  Now, all the bulls want get rid of their stocks and take profit. There is no buyer on their offered price, so they put they offer lower, it repeats while a buyer is comfortable with that price. This is a bear market. Now everyone joins to the bearish side, puts are being bought, short-selling is in ful steam. More and more seller means surging bearish volume.
At a given moment, bearish surge starts to weaken, however prices continue to fall. This is the moment, what we call bearish volume exhaustion, a possible bull trend change. Now stocks and calls are cheap and smarts buy them in small installments in order to prepare for the bullish turn, and they leave bear side gradually.This is the begining of the bull cycle.
And alll the same starts again and again...

Surge observation

We can observe these volume surges from 1-minutes of accumulation to years of accumulated volumes. Story is always the same, only price fluctuation is different.

It's a trader's decision which time-frame will be chosen.
For amateurs I suggest to use mid-term (several weeks to several months) or short-term (few days or weeks) time frame. Trading in lower time frame needs experience, therefore recommended only for professionals. Very low time frames (5 min, 1-min, less) are traded by algorithm-based computers as it needs constant,  concentration, risk analysis and margin calculation.

This blog deals with Mid-term and short term analysis and trade. It carries less profit, and lower risk.


As I told, I am using Marketvolume in this blog as I did not find other volume-based tool available free for my readers. (free availability means 30 days and only some of their indicators available)

After discussing cycles and volume  surges, let's see what Marketvolume indicators can give us in order to monitor volume surges and detect anomalies can help to identify possible trend changes can help us to separate ourselves from masses and follow smarts.

On the chart above you can see price candles, volume bars as basic information.
Under date bar, you can see SBV histogram, SBV oscillator, SB Volume and MVO oscillator

SBV histogram has two lines. TA reading logic is very similar to MACD, however calculation is totally different. You can see volume surge intensity (bar histo), current market trend (blue signal advance means bullish, red signal advance means bearish market) and possible trend change (signal cross).

SBV oscillator is an area-type indicator. When area is green, majority of bulls rule, when area is red, bears rule the market. The intensity of current surge reflects to the value of this indicator. You can read the surging phase (divergece from zero) and the weakening phase (convergence to zero) of the current cycle from its value
This oscillator has two Oscillator signal lines, one in negative territory, one is in the positive side.
Critical point is a cross of oscillator line and signal line at weakening oscillator phase.

MV selling buying  volume indicator This is the most confusing indicator for beginners and most liked indicator for experienced ones. This indicator shows buying volume (green) and selling volume (red). I suggest beginners to concentrate to the volume crosses. Most probably that gives a confirmation of the trend change.

MVO oscillator This oscillator is an area oscillator. This indicator tries to locate the most intensive part of the given cycle. It starts giving signal when unusual intensity detected and eliminates as the intensity eliminates.
Signal is green at bull, read at bear.  This indicator gives valuable information to start heavy market participation and gives signal to change our bets lower level at signal exhaustion. Also if this oscillator gives opposite signal just right after the exhaustion, it's a trend change confirmation as well.

Trading system

So, let's build a very simple trading system:
We will try to locate the end of a bearish market and allocate the end of the bull market. We will use two of these indicators only, SBV histogram and SBV oscillator.
Our system:
1. Detect bear market.
2. Wait for SBV oscillator exhaustion signal. (value line crosses signal line). BUY
3. Keep position on bull market,.
4. Wait for SBV oscillator bull exhaustion signal (value line crosses signal line). SELL
5. Go to 1

1. IF bull exhaustion detected (point 4) but, instead of bear turn, value of  SBV oscillator remains in positive area, make a BUY when SBV oscillator value line in bull surging phase crosses positive signal line.

Let's see how it works, running two backtests:

You can see two backtests in a merged chart.

On the upper side of the indicators (above MV selling-buying volume indicator)  I had no space to highlight all the trades according to our trading system, but I am sure as you follow the oscillator and indicator line, you will clearly see the trading points. Normal trades signaled with yellow, redundant (fakeout bear) trades signaled with pink callouts.

Upper indicators are set up to be more sensitive therefore result more trades and fake ones. It's still a nice money you can make by using this trading system, but we can fine tune that.

Below MV selling - buying volume indicator you can see less trades and less fakeouts.
We can reach this by giving different setup parameters to our indicators.
Indicators below have longer period setups. It results a less volatile indicator giving less trade signals, in turn, we will have less profit.

When both short period (above) and long period (below) setup oscillators give trading signals, that will filter us the fake trades.
Changing oscillator setups detect longer periods in same timeframe is the first method to perform fakeout-check.

Other possibilities:
a. Using different time-frames in our TA. For e.g. if we make trading decisions  using 1-day charts, we need to use 2-days charts in order to validate our trading signals. If 1-day trading signal matches or close to the2-day trading signals, that trading signal is valid. Shorter time frame is more sensitive, than longer, therefore we can filter former's fake signals
b. Using MV Oscillator. If MVO gives signal, and that signal ends with an immediate swap to the other side of zero line, (red from green or opposite) then we have one more signal it's not a fakeout.

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