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A trading system consists of a set of rules a trader uses to inject discipline into the process leading up to a trading decision. A timing model simply codifies the trading rules into computer code of some kind, mechanically applies the rules to a price index, and generates buy and sell signals, allowing the trader to avoid the tedium of the initial screening process. It is important for the trader to understand how the signals are generated and their likely duration, so that each signal's viability can be evaluated prior to taking action. To that end, this article explains mechanics and theory behind the Decision Point Thrust/Trend Model (T/TM).
This discussion is specific to the S&P 500 (SPX), although the model is applied to other major indexes as well. The discussion assumes the use of daily-based charts and data. The timing signals discussed apply to the intermediate-term (weeks to months).
In my past work with timing models I have tried to use the same set of indicators to identify both tops and bottoms, but the theory behind the T/TM recognizes that, since tops and bottoms form differently, different tools must be used to identify each one. For example, with stock indexes, bottoms are most often characterized by sharp, spiky formations resulting from rapid reversals in trend, whereas, tops are generally rounded and take longer to complete than bottoms.
The other important concept behind the T/TM is that the closer an indicator is to raw price movement, the better it is likely to perform. Indicators derived from breadth, volume, and sentiment are useful for confirming price movement and analyzing market condition, but we buy and profit from price movement, so our decision tools should be as closely connected to price movement as possible.
The Thrust/Trend Model is so named because it has a Thrust Component for detecting bottoms and generating BUY signals, and a Trend Component for detecting tops and generating SELL signals. There is also a Long-Term Component, which determines whether the T/TM signal should be SELL or NEUTRAL. (Neutral means that market exposure is eliminated -- fully hedged or in cash.)
The Thrust Component generates a T/TM BUY signal whenever (1) the SPX PMO (Price Momentum Oscillator) is above its 10-EMA and (2) the SPX PMM Percent Buy Index is greater than its 32-EMA. Both of these conditions must exist in order for a TTM BUY signal to be generated. Further, a Thrust Component BUY signal always generates a T/TM BUY signal.
The PMM Percent Buy Index expresses the percentage of individual stocks in the S&P 500 Index that are on PMM buy signals. A sharp increase in the percentage of PMM buy signals (sufficient to move the index above its 32-EMA) is solid, price-related evidence that sufficient upside thrust is developing to initiate a new rising trend. We also require that the PMO for the SPX be above its 10-EMA as a way of confirming that actual price movement of the SPX reflects the same strength as the internal indication of PMM buy signals suggests.
The reason we use both PMM and PMO input for the Thrust Component is that the PMM is weighted toward smaller-cap stocks in the SPX, and the PMO is weighted toward the large-cap stocks in the SPX. By requiring each to confirm the other we reduce the number of false signals that can be generated by short-term spurts by only one group. If either the PMO or PMM BUY signals fail, the Thrust Component reverts to a SELL signal.
The Trend Component consists of the SPX daily 20-EMA and 50-EMA. For a new T/TM BUY signal to be maintained the Thrust Component must remain on a BUY signal until the Trend Component confirms the BUY signal. This occurs when 20-EMA crosses up through the 50-EMA. If the Thrust Component BUY signal fails prior to the Trend Component confirmation, the T/TM switches back to a SELL or NEUTRAL signal, depending upon the status of the Long-Term Component. The Trend Component cannot generate a T/TM BUY signal on its own. It can only confirm and maintain the T/TM BUY signal generated by the Thrust Component.
Once the Trend Component has confirmed the BUY signal, the Thrust Component becomes irrelevant. As long as the SPX 20-EMA remains above the SPX 50-EMA, the TTM will remain on a BUY signal. A T/TM SELL signal is generated when the SPX 20-EMA crosses down through the SPX 50-EMA and when the Thrust Component is not on a BUY signal. The Trend Component cannot independently generate a new T/TM BUY signal. It can only confirm and maintain a BUY signal initiated by the Thrust Component. This requirement reduces the incidence of false BUY signals from moving average waffling during sideways price movement, and it assumes that valid Trend Buy Signals will ultimately be confirmed by the Thrust Component.
The Long-Term (LT) Component * consists of the daily 50-EMA and 200-EMA, which generate LT BUY and SELL signals when the 50-EMA crosses through the 200-EMA. The Long-Term Component is mostly irrelevant except on the day that the Thrust or Trend Component changes to a SELL signal. If the LT Component is on a SELL signal on the day (1) the Thrust Component changes to a SELL signal, or (2) if the Thrust Component swtiches to SELL while the Trend Component is on a SELL, the T/TM also changes to a SELL signal. If the conditions described in (1) and (2) occur on a day when the LT Component is on a BUY signal, the T/TM changes to NEUTRAL. We do not apply the long-term trend screen to T/TM BUY signals because doing so would neutralize the Thrust Component of the T/TM.
Simply put, T/TM BUY signals can only be generated by the Thrust Component, which provides early detection of important price bottoms. Once the Trend Component confirms the Thrust Component BUY signal, T/TM SELL signals are normally generated by the Trend Component, the stability of which only responds to actual price deterioration and minimizes overreaction to short-term corrections. T/TM SELL signals may also be generated by failure of the Thrust Component BUY signal while the Trend Component is still on a SELL. The actual T/TM signal cannot change to SELL unless the LT signal is a SELL on the same day Thrust or Trend Component SELL signals are generated.
The weakness of the Thrust Component is that it is an internal momentum indicator, and it can generate SELL signals when momentum begins to fade, often long before there is an actual price top. The Trend Component will ALWAYS respond to actual price movement, but it is usually too slow to react at bottoms. The Long-Term Component prevents whipsaw losses that can result from generation of T/TM SELL signals during long-term bull trends. Working together, each component compensates for the weakness of the other.
APPROPRIATE RESPONSE TO SIGNALS
The Thrust/Trend Model signals provide us with objective information about intermediate-term market direction, as well as a rationale for taking certain actions. Signals should NEVER be interpreted as an excuse to go 100% long or short. Signals are generated as a reaction to price movement, and price movement in a certain direction sufficient to generate a signal may also be sufficient to temporarily exhaust momentum in that direction as well.
New signals can be thought of as an initiation thrust that has changed the trend of the market. If, after we examine the charts, we think the T/TM has generated a rational signal, we next look to our Tracker reports and chart books for opportunities to exploit the new trend. For example, if the T/TM generates a new BUY signal, a review of chart books containing stocks, funds, or ETFs covering a broad range of sectors should reveal a large number of immediate or developing opportunities to open long positions. Those opportunities should be exploited on a time table that accommodates and adheres to the rules of your personal trading system for entering new positions.
When I refer to developing opportunities, I mean, for example, those charts where we can see the initial reaction to the broad market change of trend, but where there is still other action (like a retest) necessary to complete the setup.
If immediate and developing opportunities to exploit the new trend are not found in abundance, the T/TM signal should be considered suspect. Please think about that. The signal tells you what kind of opportunities you should expect to find. If you don't find lots of them, something is wrong. It may simply be necessary to wait for the market to complete a counter trend reaction before really good setups begin to appear; however, it is also possible that the signal is an overshoot and actually marks the end of a correction in the longer-term trend.
The Thrust/Trend Model is driven by price movement and uses separate methodologies to identify tops and bottoms. It is a mechanical, reality-based tool for identifying changes in the medium-term trend. Possible short-term positions should be gleaned from a group of securities covering a broad range of sectors, and they should be opened in concert with the trend when trading discipline indicates that the timing is appropriate.
The chart below displays all the elements of the SPX T/T Model so that you can get a general idea of the relationships involved. Daily charts of T/TM components are available to all subscribers. T/TM signals for several major indexes and sectors are available in the Decision Point Alert Daily Report.
The general principals used in the construction of the T/TM -- using thrust detection tools to identify bottoms, trend tools to identify tops, and a long-term screen for SELL signals -- should be considered in the development of any trading strategy.
* Dr. Alexander Elder introduced the important concept of using a long-term screen in trading models in his book Trading For A Living.