{"id":202155,"date":"2024-02-08T08:03:22","date_gmt":"2024-02-08T13:03:22","guid":{"rendered":"https:\/\/ibkrcampus.com\/?p=202155"},"modified":"2024-02-08T10:27:23","modified_gmt":"2024-02-08T15:27:23","slug":"chart-advisors-catching-the-falling-knife","status":"publish","type":"post","link":"https:\/\/www.interactivebrokers.com\/campus\/traders-insight\/chart-advisors-catching-the-falling-knife\/","title":{"rendered":"Chart Advisors: Catching the Falling Knife"},"content":{"rendered":"\n<p>By\u00a0<a href=\"https:\/\/links.investopedia.com\/u\/click?_t=36ba8fa8372241d58b3bfc06997a4332&amp;_m=832950035db04f3b865efeb1e0a1d089&amp;_e=6NshxCKGII6-8LRFiEpHAG-UhKERIkYLloyT9-vAu7uIGrVFB7x-hbHXvDD5iC6VElv_zcQN22U5FcWz8dnBEXRvm2Pv8Ia8h0AAb5rG02IlGbHBpgn48KDUR367RWGKQYr-KWeYU4u0x-WrxY4wfTW8ViXAnKXLxP11xkWXT4ItmuQGwftxjFzsE3epm9phLnfF40bWziN2L6U9zpfgm1-PNQ4dOBJ8zb62fqOy9ysGqfYf3WL-r0jG_eSrfOqS5TLxpd9ExhKk205BnWy-mAsE1Fg7wWbwHeAaJXdb9hwaamC_isPioXiYiWtM_vTuqu8yh-VSclqQA49XX5a8rLXRDKsotWdG0CLSP8qdutmApA30l6tQo4U6wRbjjD0_O8ley0h1-JJ7cNKMgEvLqZH3-u9Q4HTyQIY7N5wPJEjIqlVBGatp4-li7Vh76RhqekfN6tVtrvM36TxIaN85w6ibZn6A8J7iyU2gEbBFzDw%3D\" target=\"_blank\" rel=\"noreferrer noopener\">Mathew Verdouw, CMT, CFTe<\/a><\/p>\n\n\n\n<p><em>Investopedia is partnering with CMT Association on this newsletter. \u00a0The contents of this newsletter are for informational and educational purposes only, however, and do not constitute investing advice. The guest authors, which may sell research to investors, and may trade or hold positions in securities mentioned herein do not represent the views of CMT Association or Investopedia. Please consult a financial advisor for investment recommendations and services.<\/em><\/p>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-1-mean-reverting-signals\">1\/ <strong>Mean Reverting Signals<\/strong><\/h2>\n\n\n\n<p>So far in this series, we\u2019ve been looking at long term general market conditions with an overall bullish sentiment coming through. Today, I want to shift gears and review a mean-reversion technical indicator that we\u2019ve created and look at some short-term signals.<\/p>\n\n\n\n<p>Mean Reverting trading is not for the faint hearted. Some liken it to catching a falling knife \u2014 you may do it successfully many times but you can also get cut up really badly if you don\u2019t know what you\u2019re doing. They are short-term trading signals, not long-term allocations to a portfolio. Although if the decision has already been made to add a name to your portfolio, a mean-reverting signal is a great entry to ensure the position is profitable from the start.<\/p>\n\n\n\n<p>One way to alleviate the risk is to make sure that we stick to the foundations of Technical Analysis. One of the of the most enduring and important foundations is Dow Theory and two rules that are relevant to mean-reversion trading are:<\/p>\n\n\n\n<ol class=\"wp-block-list\">\n<li>Always trade in the direction of the Primary Trend<\/li>\n\n\n\n<li>Use Volume to confirm if a move against the Primary Trend is a temporary correction or a change in the Primary Trend.<\/li>\n<\/ol>\n\n\n\n<p>The CMT program is a great way to get these core foundations locked in to all you do.<\/p>\n\n\n\n<p>Rule 1 will tell us that we only take the Mean Reverting signal if we are confident that the Primary Trend is still valid.<\/p>\n\n\n\n<p>Rule 2 tells us that we can look at volume to determine if there is growing support for a change in trend. If volume was growing into a mean-reversion signal, it could be confirming a change in trend and we\u2019d need to be very careful. What we want to see is a general declining of volume into the signal.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-2-optex-bands\">2\/ <strong>Optex Bands<\/strong><\/h2>\n\n\n\n<p>Optex Bands is an indicator that we built to capture high probability mean-reversion trades. (Optex was a shortening of \u201cOptuma Extremes\u201d since we were capturing extreme deviations).<\/p>\n\n\n\n<p>They are built using Market Profile\u2014a concept that has been in use since the 1980s. We have a full explanation of the calculation at\u00a0<a href=\"https:\/\/www.optuma.com\/kb\/optuma\/tools\/optuma-extreme-tools\/optex-bands\">https:\/\/optuma.com\/optex<\/a><\/p>\n\n\n\n<p>You can see the Optex Bands in Chart 1. The black line is the \u201cRatio\u201d line and it is a volatility adjusted measure of how far price is deviating away from the point of balance on the chart.<\/p>\n\n\n\n<p>The dynamic zones are the extreme zones. They are also calculated using Market Profile techniques.<\/p>\n\n\n\n<p>The theory here is that an extreme move in any direction has a high probability of reverting. The more extreme the move, the higher the probability.<\/p>\n\n\n\n<figure class=\"wp-block-image size-large is-resized\"><img decoding=\"async\" width=\"1100\" height=\"588\" data-src=\"\/campus\/wp-content\/uploads\/sites\/2\/2024\/02\/08.02-1-1100x588.png\" alt=\"\" class=\"wp-image-202156 lazyload\" style=\"--smush-placeholder-width: 1100px; aspect-ratio: 1100\/588;width:1450px;height:auto\" data-srcset=\"https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2024\/02\/08.02-1-1100x588.png 1100w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2024\/02\/08.02-1-700x374.png 700w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2024\/02\/08.02-1-300x160.png 300w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2024\/02\/08.02-1-768x410.png 768w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2024\/02\/08.02-1-1536x821.png 1536w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2024\/02\/08.02-1.png 1920w\" data-sizes=\"(max-width: 1100px) 100vw, 1100px\" src=\"data:image\/svg+xml;base64,PHN2ZyB3aWR0aD0iMSIgaGVpZ2h0PSIxIiB4bWxucz0iaHR0cDovL3d3dy53My5vcmcvMjAwMC9zdmciPjwvc3ZnPg==\" \/><\/figure>\n\n\n\n<p>In Chart 1, I have also added Green Arrows when the Optex Ratio enters the Blue extreme over-sold zone and Red Arrows when the Optex Ratio enters the Red extreme over-bought zone.<\/p>\n\n\n\n<p>They are not perfect signals\u2014no signal ever is\u2014but when coupled with Dow\u2019s rules of \u201cTrade with the Primary Trend\u201d they do yield some good results.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-3-russell-3000-optex-signals\">3\/ <strong>Russell 3000 Optex Signals<\/strong><\/h2>\n\n\n\n<p>While it is great practice to go through charts looking for trading candidates, it\u2019s so much better when we can have the computer do the work for us. In Chart 2 we have scanned for any name in the Russell 3000 that has an Optex Long Signal (as of Feb 7).<\/p>\n\n\n\n<p>I\u2019ve also included in the Watchlist the Monthly Change in price (which as you\u2019d expect is down) and the Yearly Change. I really prefer to see positive yearly numbers as it give me more confidence that the security is in an uptrend giving a higher probability that this will be a good mean-reversion trade. If the Monthly is also up (eg Essent Group) then that really interests me.<\/p>\n\n\n\n<p>Finding the candidates is only step 1. We would need to review the chart and make sure that we are confident that we are not breaking Dow\u2019s rules and that we are willing to take on the risk associated with this trade.<\/p>\n\n\n\n<p>Remember! No technical signal is a guarantee of success but as a concept, this type of Mean Reverting signal can be helpful to find trading candidates. Watch these names over the coming days and weeks and see what you think.<\/p>\n\n\n\n<figure class=\"wp-block-image size-large\"><img decoding=\"async\" width=\"1100\" height=\"585\" data-src=\"\/campus\/wp-content\/uploads\/sites\/2\/2024\/02\/08.02-2-1100x585.png\" alt=\"\" class=\"wp-image-202157 lazyload\" data-srcset=\"https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2024\/02\/08.02-2-1100x585.png 1100w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2024\/02\/08.02-2-700x372.png 700w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2024\/02\/08.02-2-300x160.png 300w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2024\/02\/08.02-2-768x408.png 768w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2024\/02\/08.02-2-1536x817.png 1536w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2024\/02\/08.02-2.png 1920w\" data-sizes=\"(max-width: 1100px) 100vw, 1100px\" src=\"data:image\/svg+xml;base64,PHN2ZyB3aWR0aD0iMSIgaGVpZ2h0PSIxIiB4bWxucz0iaHR0cDovL3d3dy53My5vcmcvMjAwMC9zdmciPjwvc3ZnPg==\" style=\"--smush-placeholder-width: 1100px; aspect-ratio: 1100\/585;\" \/><\/figure>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-4-rrg-confirmation\">4\/<strong>RRG Confirmation<\/strong><\/h2>\n\n\n\n<p>We already discussed the Relative Rotation Graph earlier in this weeks posts. In Chart 3, I have added these scan results (those names with an Optex Signal) to a Daily and Yearly RRG.<\/p>\n\n\n\n<p>As you would expect, the Daily RRG has all these names under-performing the benchmark. The Yearly RRG, however, is highlighting that some of the names are in solid out-performance territory and those are the one that I am most interested in.<\/p>\n\n\n\n<figure class=\"wp-block-image size-large\"><img decoding=\"async\" width=\"1100\" height=\"585\" data-src=\"\/campus\/wp-content\/uploads\/sites\/2\/2024\/02\/08.02-3-1100x585.png\" alt=\"\" class=\"wp-image-202158 lazyload\" data-srcset=\"https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2024\/02\/08.02-3-1100x585.png 1100w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2024\/02\/08.02-3-700x372.png 700w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2024\/02\/08.02-3-300x160.png 300w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2024\/02\/08.02-3-768x408.png 768w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2024\/02\/08.02-3-1536x817.png 1536w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2024\/02\/08.02-3.png 1920w\" data-sizes=\"(max-width: 1100px) 100vw, 1100px\" src=\"data:image\/svg+xml;base64,PHN2ZyB3aWR0aD0iMSIgaGVpZ2h0PSIxIiB4bWxucz0iaHR0cDovL3d3dy53My5vcmcvMjAwMC9zdmciPjwvc3ZnPg==\" style=\"--smush-placeholder-width: 1100px; aspect-ratio: 1100\/585;\" \/><\/figure>\n\n\n\n<p>Technical Analysis is more about building a case to support the trade rather than blindly taking trades. In 28 years of working with our clients, the determining factor between those who are successful and those who aren\u2019t is their ability to focus on acceptable risk.<\/p>\n\n\n\n<p>Mean-Reverting trades are risky, but we minimize the risk by following the foundations and using valid money management rules.\u00a0<\/p>\n\n\n\n<p>&#8212; <\/p>\n\n\n\n<p>Originally posted February 8th 2024<\/p>\n","protected":false},"excerpt":{"rendered":"<p>Mean Reverting trading is not for the faint hearted. Some liken it to catching a falling knife \u2014 you may do it successfully many times but you can also get cut up really badly if you don\u2019t know what you\u2019re doing. <\/p>\n","protected":false},"author":186,"featured_media":202156,"comment_status":"open","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[18,6,8,9,22,23,26,3],"tags":[8354,10068,16672,938,6687,15817,5853,4766,16059,7036],"contributors-categories":[13686],"class_list":{"0":"post-202155","1":"post","2":"type-post","3":"status-publish","4":"format-standard","5":"has-post-thumbnail","7":"category-macro","8":"category-north-america","9":"category-region","10":"category-securities","11":"category-stocks","12":"category-technical-analysis","13":"category-text-articles","14":"category-traders-insight","15":"tag-casy","16":"tag-dole","17":"tag-esnt","18":"tag-intc","19":"tag-iwv","20":"tag-metc","21":"tag-mtsi","22":"tag-rrc","23":"tag-rrg","24":"tag-stwd","25":"contributors-categories-investopedia"},"pp_statuses_selecting_workflow":false,"pp_workflow_action":"current","pp_status_selection":"publish","acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO Premium plugin v26.9 (Yoast SEO v27.3) - https:\/\/yoast.com\/product\/yoast-seo-premium-wordpress\/ -->\n<title>Chart Advisors: Catching the Falling Knife<\/title>\n<meta name=\"description\" content=\"Mean Reverting trading is not for the faint hearted. 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