The following is an excerpt. For the complete article, see the December 2000 issue of Active Trader magazine.

Trading the momentum of market breadth

One of the best ways to keep track of the market’s true dynamics is to monitor its advancing and declining issues. Here’s a strategy that uses the momentum of advancing issues to time short-term trades.

By Mark Brown

The S&P tracking stock (SPY) and the S&P 500 futures contract probably are among the most difficult markets to trade. Statistics would most likely show the futures contract toward the top of a group of markets responsible for the quickest depletion of customer trading accounts.

Most short-term traders trade the S&P 500 markets using timeframes ranging from a single tick up to one hour. When trading in these shorter timeframes, it’s easy to become disoriented and lose track of the true market dynamics.

One tool many traders use to track “internal” market strength is a breadth indicator such as the advance-decline line (the running total of advancing NYSE stocks minus the declining stocks). The changes in the number of advancing or declining issues can offer a glimpse of market dynamics not immediately revealed by price action. For example, even if the market is rising, a declining advance-decline line may indicate these gains are being fueled by a progressively smaller number of stocks, in which case a correction or reversal may be imminent.

While breadth indicators are commonly used to gauge longer-term directional strength, intraday analysis of advancing or declining issues can be used to develop shorter-term trading strategies. Here, we’ll look at how measuring the momentum of advancing NYSE stocks on an hourly basis can be used to time trades.

Breadth of fresh air

It is well-known that the combined directional bias of the NYSE advancing, declining and unchanged issues lists are helpful in determining the overall direction of the S&P 500 index and S&P futures. Traditionally, studies have been based on either a combination of the advancing and declining issues (such as the advance-decline line described previously), or the advancing, declining and unchanged issues.

However, research suggests that you can gain the same benefit (and simplify your analysis in the process) by using only the advancing issues statistics. And just as many short-term traders use price momentum in their trading decisions, the “breadth” momentum can be used to trigger trades. In fact, the momentum of the advancing issues provides enough information to develop a profitable trading strategy that allows you to bypass the actual market prices.

One simple trading model based on this approach is the “Oddball S&P system,” which uses hourly readings from the NYSE advancing issues list. This timing model is based on the theory that in the short-term the S&P futures (and even the actual S&P index) and the market breadth may deviate from time to time, but they will nonetheless align themselves when large moves are made.

The original purpose behind this strategy was to use advancing/declining/unchanged numbers to identify high-volatility situations that showed the highest likelihood of having a directional bias. However, research and testing showed it was sufficient to use the advancing issues alone — not just as a filter, but also as a stand-alone trading strategy. In addition, as mentioned earlier, using only the advancing issues numbers makes the approach less complicated. As a very basic trading approach, this strategy also functions as an excellent benchmark against which to compare other systems.

Measuring momentum

The strategy is based on calculating the rate of change (ROC) of the hourly advancing issues number. ROC, which is an oscillator-type indicator, is the difference (or alternately, the ratio) between the current price and the price n periods in the past. For example, the five-day ROC would be the difference between today’s price and the price five days ago. On an hourly chart, the five-period ROC would be the difference between the current price and the price five bars (hours) ago. (For a more thorough discussion of the ROC indicator, see “Indicator Insight: Momentum and rate of change,” Active Trader, October, p. 82). Because there are seven hours in the trading day, a seven-period ROC of the advancing issues number was used in this strategy.

One way to construct an oscillator-based system is to trigger trades when the indicator crosses above and below the “zero” line (the median line that represents neutral momentum, when the current price is the same as the price n periods ago). But a better alternative is to use two separate indicator levels, or zones — one to initiate long trades and another to initiate all short trades.

A good initial setting is to set the buy level to 3 percent, and the sell level to 1 percent. That is, you buy as soon as the rate of change of the advancing issues is 3 percent higher than it was seven periods ago and sell as soon as it falls below 1 percent higher than it was seven periods ago. (See “Strategy snapshot,” below, for the precise formula for the indicator.) This means the system will always be in the market, either with a long or short position.

The indicator settings used here were selected to keep the strategy as straightforward and simple as possible for testing. Traders may, of course, experiment with other indicator settings to see if they produce better results. Similarly, a different oscillator-type indicator could be substituted for the ROC. The underlying system logic and trading approach would remain the same.

In short, the oddball S&P system works as follows:

•If the rate of change of the advancing issues is greater than the buy trigger level, buy the market.

•If the rate of change of the advancing issues is less than the sell trigger level, sell the market.

Every hour, on the hour

Because this system recalculates every hour on the hour, up to and including the close of the stock market at 4 p.m. EST, you will not be able to use the last reading of the day if you are trading the S&P 500 tracking stock (SPY). However, if you are trading the S&P futures, you will still be able to enter a trade based on the last reading because the futures market continues trading until 4:15 p.m. EST.

For either market, this also means that you will have to wait for the first reading at 10 a.m. EST to trade in the morning. But this is actually advantageous, because as so many professional traders point out, you should avoid trading immediately after the open because of the directionless volatility that often occurs before the market finds its direction and pace for the day.

This kind of trading strategy is strengthened by the fact that it is easy to monitor and execute, and it is based on one primary input. The one-hour timeframe was selected because it is outside of the typical short-term trader’s time horizon, and also because consistency is a key factor when implementing a mechanical model. It is easy to check your trades each hour on the hour, or to program your laptop, mobile phone or handheld computer to do so for you.

Also, only using one data point per hour also enhances the reliability of the model. Why? Because when you view an intraday chart and observe a bad price print it will most likely be the high or the low of the given bar. By eliminating all data points but the close, you also reduce the possibility of errors.

This is an excerpt. For the complete article, see the December 2000 issue of Active Trader magazine. Click here for the TradeStation code for this system.