DAILY PRICE RANGE – DAILY PRICE CHANGE RATIO ENTRY SIGNAL By Paul Doggett

When I think I am on the verge of a new trading technique, one of the first questions that I ask myself is this: “Will this technique work if I want to go short as well as go long?” A reader has asked this very question regarding the Daily Price Range – Daily Price Change Ratio or RCR for short. The same reader has asked, how do I find these types of set ups in the market. Let’s answer both questions.

First of all, let’s look at whether or not the RCR will work in falling markets as well as in rising markets.

If you try to apply the RCR as it appeared in this newsletter on 11 June 2011, in down markets, it won’t necessarily work in the way you expected. I have back tested using the same set of rules and found some short comings. For example, I rarely found a “down” day following a high volume down day that achieved a range-change ratio greater than 70%. I also found that setting the Stop at the intra-day high of the high volume day only got me whipsawed back out of the stock pretty quickly because the market bounces upward with more gusto than it drops.

There are probably several reasons for this. The main one as far as I am concerned with however, is that bull and bear markets are different in nature and therefore a Long strategy generally won’t work in reverse as a Short strategy because the emotions and the arousal traders feel in bull markets are different from those experienced in bear markets.

For example mildly bullish news often causes stock markets to rise, but mildly bearish news rarely cause markets to drop. Why is this? Well, generally speaking, studies on personality have shown that people are by and large, optimistic about most things. So it follows that traders typically look to the positive in all announcements. Besides, much of the literature in the market tells us that eventually the market will always head higher, so it ingrains the perception in the wider public that if you merely buy and hold, then by some magical law of nature, the market (and therefore your shareholdings) will inevitably rise in value over time.

But rather than get bogged down in a philosophical debate as to why bull and bear markets act differently, lets move on and show how the RCR can be applied in bear markets or in falling stocks rather than in rising stocks.

The only thing we need to do is to make a slight alteration to our first two rules. Just to recap from last week, we stated the following:

Rule #1: Find a high volume day. It must be on a day that has a positive or higher close based on the previous day’s closing price (it has to be an “up” day) and it must be the highest volume day for at least the past 5 consecutive trading days (inclusive).

Rule #2: The day after the high volume day must be an “up” day (the share price must end at breakeven or higher than the previous day’s closing price). This “up” day must have a daily price range and daily price change ratio greater than 70%. Fig 2 shows us Rules #1 and #2 being satisfied at the start of May, using ADY as an example.

In the Long strategy, we find a high volume day first, then look forward in time, to the next trading day to find an “up” day (when the closing price is equal to or higher than the previous day’s closing price).

We have to make some minor adjustments to Rules #1 and #2 in down markets or if we are intending to sell Short. Our original two rules change as follows:

Rule #1: Find a high volume day. It must be on a day that has a lower close than the previous day’s closing price and it must be the highest volume day for at least the past 5 consecutive trading days (inclusive). We use this day and the previous day (if it satisfies Rule #2 below) to calculate the RCR. This day must have a daily price range and daily price change ratio greater than 70%.

Rule #2: The day before the high volume day occurs, must also be a “down” day (the share price must end at breakeven or lower than the previous day’s closing price). In effect we have to look backwards from the High Volume day when we are dealing with falling markets or intending to sell short to satisfy rather than look forward from the High Volume day as we did when intending to go long.

We have to calculate the RCR. To do that we use the closing prices of the two bars to derive our Change figure and we get our Range by deducting the intra-day high from the intra-day low on our High Volume Day.

You will notice that the RCR comes to 69.4%. This does not quite meet our 70% minimum ratio. This example has been used however, to demonstrate the need for us to be flexible enough to accept a half a percent short fall. I could have simply used the JBH example taken from the 16 and 17 December 2009 (where the RCR was in excess of 100%) and never have brought the above example to your attention, but I think it is important to see where some leeway can be given because trading the market is not an exact science.

We now set our Stop-loss at the intra day high of the previous days price bar.

As I said earlier, I back tested the RCR technique using the original rules in down

markets and I was unable to satisfy Rules #1 and #2 for various reasons. But making the adjustments as outlined above, I had far more success with various stocks over various time frames ranging from 2007 – 2011.

In the above example, the RCR is now calculated using both days, pretty much as we showed in the previous article. Using our days shown in Fig. 4, our RCR calculation would look like this:

So now onto the second of the reader’s questions. “How do I find these stocks to

trade?”. Well in both instances I use an inbuilt feature of my charting program that allows me to do a search for the Daily Highest Volume changes. Once the top 50 tops in this category have been found by my program for me, I do an eyeball scan of them all, looking for price bars that appear likely to satisfy Rule #1 and Rule #2 at a glance. I then investigate further and calculate the RCR manually.

Secondly, as I trawl through and eyeball each individual stock my ASX200 watch list, I look out for price bars that appear likely to satisfy Rule #1 and Rule #2 and investigate further when I think I’ve found something.

When back testing this technique for both my own personal curiosity and for last weeks article, I randomly selected time frames and stocks. There was no rhyme or reason for it, but this is the best way to back test. Don’t attempt to deliberately seek out stocks or set ups that you think will prove your theory. Come up with your theory, then see if the market contains the evidence required to support your theory.

Through this process I found that the RCR technique, for those wanting to go Long in the market, favoured stocks that we coming off a low. It wasn’t planned; it was purely the direction that the development of the rules and the back testing sent me in.

To back test this technique in falling markets, I deliberately sort out stocks that were sold off from a relatively major peak. For example, the chart excerpts shown in Figs. 3 and 4 come from JBH, just after the stock peaked in mid-September 2010. Here is the chart from Sept 2010 – Jan 2011:

For those wanting a more recent example, I direct your attention to WOR, taking

particular note of the price bars and volume action on the Friday 29 and Thursday 28 of April 2011 in that order to see the RCR give a potential exit signal or a Short selling signal.

GLOSSARY: TRADING SYSTEM

The definition of a trading system or plan would be, a complete methodology on how and why we enter and exit a stock or commodity, including entry, exit, position sizing or money management and psychology.

These all must be combined and used with discipline to trigger our trading actions with confidence.

When markets get hard to trade, and the common indicators found in most software packages and books start to whipsaw or worse still fail altogether, traders start to question their whole methodology to trading, they start to explore new entry techniques that will ensure a better strike rate.