Issue 28

June 2008
The publication for trading and investment professionals
www.technicalanalyst.co.uk
Dealing with Risk

Julian McCree of Erste Bank
Markets
Strategies
Automated Trading
Sector performance
in the S&P500
The predictive power

of fund flows
Overview of
execution algorithms
presents
Global Equities
Outlook and investment
strategies for global stocks
2008
26 June 2008
Chandos House
London W1
A premier event for trading and investment professionals

Bringing together leading experts in the field of
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various equity trading strategies such as trend
following and momentum investing in the
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Who should attend:
Topics covered:
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+ Hedge funds
+ Traders
+ Risk managers
+ Analysts
+ Brokers
+ Outlook for global stocks

+ VIX and market direction
+ Trend following strategies
+ Momentum investing
+ Issues in shorting stocks
Speakers include:
Charles Morris
HSBC Investments
Max Knudsen
PIA First
Antonio Manzini
UBS
Richard Ramyar
Lipper
Laurens Swinkels
Robeco
Robin Griffiths
Cazenove Capital
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WELCOME
Although a great deal is written in books and magazines (including this one) about
how to employ technical trading strategies, the subjects of risk and money management are often overlooked. As any successful trader will tell you, this is often
as important a subject as choosing a successful entry and exit strategy. In this
issue Julian McCree, a trader at Erste Bank, gives us his views on how trade management is best approached when combined with a technical trading strategy.
We also discuss the importance of funds flows and examine if data can be used to
predict market movements.
We hope you enjoy this edition of the magazine
Matthew Clements, Editor
CONTENTS 1 > FEATURES
JUNE
Managing Risk
Julian McCree of Erste Bank talks about
his approach to trade management.
S&P500 Outlook
Kamran Sheikh of Informa Global Markets
breaks down the S&P500 and gives
his outlook for its various sectors.
Fund Flows Data

We present a Deutsche Bank study that
looks to establish if weekly fund flows
data can be used to predict the markets.
2008 Global Markets Media Limited. All rights reserved. Neither this publication nor any part of it may be
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cannot accept liability for any errors or omissions that may appear or loss suffered directly or indirectly by any
reader as a result of any advertisement, editorial, photographs or other material published in The Technical
Analyst. No statement in this publication is to be considered as a recommendation or solicitation to buy or sell
securities or to provide investment, tax or legal advice. Readers should be aware that this publication is not
intended to replace the need to obtain professional advice in relation to any topic discussed.
June 2008
>36
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THE TECHNICAL ANALYST
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43
CONTENTS 2 > REGULARS

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MARKET VIEWS
S&P500 - Divergence in sector performance
Emerging Markets Outlook
Outlook for Crude Oil
04
10
12
TECHNIQUES
Volume - The voice of the market
The Predictive Power of Weekly Fund Flows
The ARMS Index
Trading Variations in Double Tops and Double Bottoms
16
19
28
32
INTERVIEW
Julian McCree, Erste Bank
36
RESEARCH UPDATE
41
BOOKS
The Encyclopedia of Candlestick Charts
Top Ten Books
43
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AUTOMATED TRADING SYSTEMS

Overview of Todays Algorithms:
Advanced Strategies for a Complex Marketplace
45
TRAINING DIARY
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ISSN(1742-8718)
June 2008
Market Views
June 2008
Market Views
S&P500
DIVERGENCE IN SECTOR PERFORMANCE
By Kamran Sheikh
Sector performance
After a notably weak start to the year by the entire market,
there has been a marked divergence in sector performance in
2008. While the S&P500 has lost only 2.90% (by 16 May)
after recovering from its early losses, sharp declines were
seen in sectors like Financials (-10.4%), Healthcare (-10.4%)
and Telecommunication (-8.1%). See Figure 1. On the other
hand some sectors outperformed the broader market, such as
Materials (+10.0%), Energy (+9.0%) and Consumer
Discretionary (+1.5%).
Historically out performance by the Energy Sector has
coincided with a decline in the broader market. The Energy
Sector also has a tendency to rally at the end of an expansion
in the economic cycle. While weight of the Energy sector
(and of course fuel prices) can be seen adversely affecting the
stock market, out performance the Materials and Consumer
Discretionary sectors is evidence of confidence in the economy via strong manufacturing and high levels of spending
on the luxury goods and services, respectively, even in the
current market conditions.
Despite the fact that the S&P Information Technology
Sector is still down 4% this year so far (16 May), the recent
breakouts on the Sector Index and the relative strength of
S&P500 charts is of significant importance as this sector has
an history of leading bull markets. Another positive development is the recent weakness of the Consumer Staples Index
relative to the S&P500. Historically Consumer Staples sector
is considered resilient to overall bearish stock market conditions and outperforms S&P500 during times of poor confidence in the economy. By contrast, it usually underperforms
during times of confidence. The recent deterioration in the
Sectors relative strength to the broader market, after a period of out performance in Q4 2007 and Q1 2008, is a positive signal for the stock market.
In this article we take a brief look at US stock market sectors. Since global stock markets are closely interconnected,
similar trends can be observed in other markets around the
globe.
Figure 1. S&P500 sector performance
Figure 2. S&P Energy Sector
Bullish energy sector

In light of rising fuel prices to fresh record highs (Figure 2),
it is not surprising that the Energy sector is making new all
time highs. The current bull market commenced in mid-2002
and regardless of a few corrective reactions, the overall trend
has been strong. The second half of 2007 witnessed high levels of volatility but the Index has held above the support
DESPITE SOME OVERBOUGHT CONDITIONS [IN THE

ENERGY SECTOR] NEITHER INDICATORS NOR THE CHART
STRUCTURE SHOW SIGNS OF REVERSAL
June 2008
Market Views
near 480 (2006 peak) during August and January dips. The
early April break above the trendline resistance near 580 was
followed by fresh all time highs. Despite some overbought
conditions, neither indicators nor the chart structure shows
any signs of reversal at this stage.
The Energy sector has been outperforming the S&P500
since late 2003. However, the out-performance significantly
accelerated following a break above the neckline of a double
bottom formation (Sep 2006-Jan 2007) in mid last year. The
relative strength chart is solidly entrenched within a bull
channel since early this year. We look for this trend to continue for the time being. A break below the channel support on
the relative strength charts would warn of diminishing interest in the Energy Sector and may be a positive sign for the
rest of the stock market.
The sector has been outperforming the S&P500 since

April 2007. However, the recent formation of a potential
head and shoulders top on the relative strength charts warns
of a possible reversal, though the outlook remains positive
while the S&P Industrial & S&P500 ratio is above the neckline at 0.24.
Figure 4. S&P Industrials Sector
Figure 3. S&P Information Technology Index
Technology a leading indicator

The Information Technology sector index is considered a
leading sector. Historically this sector has led bull markets in
past years and generally outperformed the broader market.
The index completed a classic text book head and shoulder
formation in early January (Figure 3). This was followed by a
sharp decline to probe below the formation objective at 340
within 3 weeks. Following a 3 month consolidation within a
tight 335-364 range, the index has completed a base, which
also coincides with a 5 month bear trendline break on the relative strength charts. The subsequent breaks above the trendline near 381, and the 200 day moving average close to 385,
corresponded with a rally on the relative strength charts. We
take this advance as a positive sign for the stock market in
general and the Information sector in particular.
Industrials outperform
Following a sharp decline in late January, the S&P Industrials
sector has formed a series of consecutive rising troughs and
peaks. A break above the 6 month trendline resistance (connecting October and December 2007 highs) near 341 and the
recent clearance of the 200 day moving average close to 349
exhibits underlying strength (Figure 4).
June 2008
Telecoms face resistance

The S&P Telecommunication Services sector advanced for
most of 2006 and 2007, outperforming the rest of the market before the index completed a double top formation upon
breach of the neckline at 159 late last year. The subsequent
decline was worse than the rest of the market as reflected on
the relative strength charts (Figure 5). Following a 3 month
basing, the index has shown some recovery, however the
trendline from the September peak and the 200 day moving
average near 160 offer tough resistance. The relative performance chart is exhibiting a fairly neutral outlook at this stage.
Figure 5. S&P Telecom Services Sector Index
Materials see new highs

The Materials sector index has been in an uptrend since mid
2006 and outperforming the broader market since late
2006. The second half of 2007 and early 2008 saw high
Market Views
decline after it registered a record high of 318.74 in June last

year (Figure 8). However, on the relative strength charts the
sector had started underperforming the S&P500 in January
2007, well before the sector index commenced decline. Since
registering a 4 year low at 226.50 in January, the index is consolidating within a slightly upward channel with relative performance to the S&P500 in a downward sloping channel.
Currently the sector index is just below the channel resistance
and the key 200 day moving average near 268. A clear break
above this area, along with a channel breakout on the corresponding relative strength charts, is required to trigger a rally
and avert risk of a reversal towards the recent lows.
Figure 6. S&P Materials Sector Index
levels of volatility but this did not have any significant affect
on the relative performance against the S&P500. The recent
advance has broken above the uptrend resistance line near
278 to make fresh record highs, with the relative performance
chart solidly entrenched in a bull channel implying sector
strength (Figure 6). We expect this trend to continue. Only a
breach of the series of higher troughs on the relative performance chart would raise concerns.
Healthcare potential downside
The early 2008 breach of the support at 282 completed a 10
month double top with a downside objective of 338 (Figure
7). Despite the recent broader recovery, the S&P Health Care
sector has failed to rally and current consolidation within a
potential bear flag formation warns of a risk of a further
breakdown towards the double bottom objective sited at 338.
Figure 8. S&P Consumer Discretionary Sector Index
The Consumer Staples sector has a history of outperforming the broader market during adverse conditions and underperforming during overall favourable stock market conditions. On the weekly relative performance charts (Figure 9) a
breakout above the 3 year bear trendline, which also coincided with completion of a 1 year base, was seen in November
last year. During the period from November to March,
despite a decline in the value of the index in line with the
broader market, the sector overall outperformed the
S&P500. However, since late March the index has failed to
rally along with the broader market resulting in a sharp
Figure 7. S&P Health Care Sector
The early January sharp rally on the relative performance

charts was halted at 0.31 and a steep reversal followed. The
under performance has accelerated since breach of the trendline in late February and the relative performance chart has
been entrenched within a bear channel since then.
Consumer Indices underperforming
The Consumer Discretionary sector index saw a 7 month
8
June 2008
Figure 9. S&P Consumer Staples Sector Index
Market Views
decline on the relative performance charts. The outlook of

the relative strength charts seems negative which may be a
precursor to a broader bull market.
Financials no sign of recovery
The S&P Financial sector index completed a double top formation in July 2007 (Figure 10). The relative performance
chart had already shown signs of warning upon completion
of a top area 4 months before the credit crunch started taking its toll in March last year. A sharp decline followed on
both the sector and relative performance charts. Despite
recent basing on the Financial Sector charts following the
March low at 302.82, the relative strength versus the S&P500,
which is still declining within a bear channel, has shown no
signs of improvement so far.
bull trendline. Since establishing a high in January following a

record high at 225 on the sector index chart, the relative
strength to the S&P500 is within a bear channel. Currently
the Utilities sector is forming a potential reverse head and
shoulders formation. A clear break above the horizontal
neckline near 209, along with a breakout from the bear channel resistance on the relative strength charts, would signal
continuation of the primary bull trend on both the index and
the relative performance chats.
Figure 11. S&P Utilities Sector
Figure 10. S&P Financial Sector Index
Utilities possible strength ahead

The Utilities sector has enjoyed an uptrend on the relative
performance charts from mid 2004 (Figure 11). Despite the
high volatility on the index chart in late 2007 and early 2008,
the relative performance versus the S&P500 on the longer
term charts is still in an uptrend and above the key 4 year
Kamran Sheikh is technical analyst with Informa

Global Markets in London.
AFTER A NOTABLY WEAK START TO

THE YEAR BY THE ENTIRE MARKET,
THERE HAS BEEN A MARKED
DIVERGENCE IN SECTOR
PERFORMANCE IN 2008
June 2008
Market Views
10
June 2008
Market Views
Emerging Markets Outlook

Using a mix of technical, fundamental and flow data,
Michael Hartnett gives his outlook for the emerging markets.
TA: Do you believe there is a decoupling between US

and Asian stocks and economies?
MH: You need to distinguish between macro decoupling and
asset price decoupling. There is very clear evidence of economic decoupling between the US and the BRIC and Asian
economies. In contrast asset prices are correlated. When the
US stock market falls, so do Asian stock markets. But the
negative hit is much smaller than it used to be.
TA: What is your view of the Chinese stock market?
MH: The Chinese market is oversold and investors are
underweight. We say trading buy. But a renewed secular
upswing in the Chinese stock market requires a sustained fall
in inflation.
TA: Do you think other markets apart from BRICs,
such as the frontier markets of central Asia, will offer
better opportunities?
MH: Frontier markets offer strong, uncorrelated returns.
The markets are undercapitalized and under owned, offer
strong economic growth potential, and are underleveraged
economies. Within Emerging Markets the BRIC markets will
retain the leadership.
TA: Which emerging markets do you think are overbought?
MH: Morocco, Egypt and Brazil are currently the most overbought relative to their 200 day moving average.
TA: Do any recent dips in emerging markets offer
good buying opportunities or are you expecting a
more sustained correction?
MH: We've been buyers since the Bear Stearns event but we
believe it's a bear market rally.
TA: Will a decline in export competitiveness viz-a-viz
a fall in the USD have a major impact? Where will it
its impact be felt most?
MH: Not for the commodity producers. They love a weaker
June 2008
dollar. And the Asian markets are benefiting from the strong
Euro. Indeed, while export growth from Asia to the US has
slowed over the past year, total Asian export growth has actually risen.
TA: What other markets or data do you think are useful as leading indicators for emerging market equities?
MH: Our best short term sentiment indicators are the Merrill
Lynch Fund Managers Survey and the EPFR fund flow data.
Emerging Markets are of course also highly correlated with
many other market indicators, such as commodities, the US
dollar, volatility and the S&P500.
TA: Re portfolio/country allocation, what are the key
factors in your decision-making process?
MH: We are always overweight markets with attractive valuations (cheap PEs) and large current account surpluses. The
latter implies high levels of savings and liquidity. If you can
get that cheap then you are onto a winner.
TA: Can you give us an idea of how you use EPFR
data? Are you looking to follow trends or spot potential reversals when the market is over-extended? How
good is EPFR data in helping you to do this?
MH: EPFR flow data helps us to identify inflexion points in
the equity market. We use flow data to develop trading rules
and make directional calls on emerging markets. The data is
very useful.
TA: What techniques do you use to fine-tune/time
your entries and exits? How and to what extent do
you use technical analysis?
MH: In addition to our flow and sentiment tools, we use
technical indicators such as 200 day moving averages and so
on to indicate breakouts and the extent to which markets are
overbought and oversold.
Michael Hartnett is Chief Global Emerging Markets Equity
Strategist at Merrill Lynch in New York.
11
Market Views
Outlook for
Crude Oil
12
June 2008
On 23 April this year,

Global Markets Media
held their first Oil
Market seminar in
London, covering all
aspects of the oil market from exploration
to changes in the
demand profile. Here
we summarise a few of
their conclusions and
ask whether oil prices
are set to continue on
their path upwards and
for how long.
Market Views
Do Current Oil Prices

Represent a Paradigm Shift?
Leo Drollas, Centre for

Global Energy Studies
We have probably seen the oil price
peak for the time being, unless there
are further supply disruptions or the
geopolitical scene suddenly deteriorates. Refinery margins are under some
pressure from slowing oil demand and
high crude prices amid worries about
an impending recession. Oil prices are
likely to stay above $100/bbl until the
third quarter but will tend to weaken
thereafter, requiring cuts by OPEC
early next year. In the longer term, oil
demand growth is likely to slow up
considerably due to high oil prices and
worries about the environment
OPEC will do its best to keep the oil
price above $60/bbl, but it will face
periods of excess capacity that will test
its cohesion and its resolution.
Crude Towards $200:
Fundamental and Technical
Drivers
Lars Steffensen,
Ebullio Capital Management
The days of talking about demand
destruction are over. This myth has
been busted. On the supply side,
OPEC wont deliver and non-OPEC
countries cant, and there is no end in
sight. US and Europe are not growing,
but they are still driving their cars

accounting for 65 to 75% of global
demand in the transport and petrochemical sectors. Moreover, emerging
economies dont see the real price
OPEC, China, India, Indonesia and
many others subsidize domestic consumption and cant stop for political
reasons. OPEC now believe that high
prices are needed to slow unrelenting
demand growth. Technically, there is a
firm uptrend and dips are being
bought, which means any retracement
is limited. One cannot be bearish until
subsidies are removed, resource
nationalism goes away, project delays
end, new supplies come to market and
supply/demand transmission is
restored. The only thing guaranteed is
volatility.
Oil as an Asset Class
Tim Guinness, Guinness Atkinson

In the long-term, the demand from
emerging economies provides a near
irresistible force which means we are
unlikely to see a real curbing of
demand without a $150-200 spike.
OPEC will seek to manage average
price up by $5/10 barrel per year. With
regards to the equity markets, energy
equities will return 50 150% over
next 5 years in a scenario which combines higher earnings from higher oil,
gas & coal prices (even after higher
government take) and multiple expansion. In the shorter-term, the oil price
is likely to correct to around $80 as oil
inventories are about right. Above all,
investment valuations remain attractive
for energy equities. The market is valuing stocks at $55-65 oil, well below
analysts forecasts of $70-80 and the
actual $102.5 year strip.
June 2008
The Changing Profile of

Demand
Eduardo Lopez,
International Energy Agency
High prices, coupled with worsening
economic prospects and milder winter
conditions are certainly affecting
OECD demand. Yet, in non-OECD
countries, demand has actually turned
out to be much higher than expected.
By 2012 non-OECD growth will be
about three times higher than the
OECDs. In general, when a manufacturing sector emerges, income per capita rises significantly and oil demand
takes off (as cars, flights, air conditioning etc become part of everyday life).
Empirically, the pace of demand
growth becomes very brisk between
$3000 and US$9,000 per capita. Its
notable that several non-OECD
economies are in or about to reach
that stage.
Our forecast is that transportation
fuels will account for the bulk of oil
demand and oil demand growth will
come from non-OECD countries.
Within the OECD, demand is sustained by North America which will
represent 53% of the total by 2012.
With regard to non-OECD countries,
Asian demand will account for 47%
and the Middle East for 19% of the
total. Biofuels are gaining much attention and are seen as an alternative for
expensive and polluting oil-based
transportation fuels. However, despite
speculator growth in a few countries
such as Brazil biofuels are likely to
account for less than 2% of global
product demand by 2012.
13
Market Views
Oil Prices: Are capacity constraints to blame?
Margaret Chadwick,
Oxford Petroleum Research
There are four key reasons to explain
why oil prices are so high: Upstream
supply rationing from OPEC, particularly in 2006-2007; strong demand for
transport fuels combined with a fullyutilised refinery upgrading capacity (in
relation to upgrading heating fuel to
transport fuel); A Q1 surge in middle
distillate demand caused by a cold snap
(with reference to the 14 large oil-consuming countries); and downstream
refinery bottlenecks. As such, in
2007/2008, Europes deficit soared and
China became a large importer. To
make matters worse, non-OPEC production has also been below expectations.
We also summarise below a few of the
key points in relation to conventional
and non-conventional oil reserves:
Geological Uncertainty and
Risk: Implications for
Hydrocarbon Resource
Assessment
Jonathan Redfern,
University of Manchester
The calculation and estimation of
reserves is complex and open to error
and interpretation. Generally for any
discovered prospect or field, three
14
cases are calculated depending on

increasing geologic certainty: Possible
(P3 10% probability); Probable (P2
50% probability); and Proven (P1
90% probability). Its often not clear
when numbers are quoted whether
they are talking about STOIP
(Standard Oil in Place, which includes
the sub-economic resources) or
Reserves/Resources (P1 to P3). Often
high hopes are not rewarded, as in the
case of Kenya and Mautania.
With regard to the calculation of
global resources, by using trends within mature basins its possible to estimate the ultimate recoverable reserves
expected (URR). Its a typical trend for
a basin to follow a fractal pattern, i.e.
to have a few very large fields at first
and many more smaller fields towards
the end of its life that produce from
smaller complex structures and stratigraphic traps
Convention oil and gas is defined
as hydrocarbons that flow freely, are
in accessible locations and do not
require complex and expensive technology to produce. Non conventional
oil and gas is everything else, including
deepwater oil and gas (although this
has started to be considered conventional in the last 5 to 10 years), heavy
oil, oil shale/sands, polar oil and gas,
coal bed methane, tight oil and gas
fields, biogenic gas, gas hydrates and
synthetic oil from gas. According to
BP, total proved oil reserves (P1) equal
1,208 thousand million barrels, enough
for 40 years demand at current consumption of 84 million barrels a day.
The Middle East accounts for 61.5%
of total proved reserves. According to
the US National Petroleum Counsel
(NPC), the mean estimate of remaining oil reserves (including mean estimates for new discoveries and growth
of existing reserves, but not including
non conventional oil) is 2,628 thousand million barrels, enough for 86
years at current consumption levels. As
regards global in-place oil resources, a
study in 1998 estimated a most likely
case of 14,960 thousand million barrels, including conventional and some
non-conventional resources but
excluding oil sands/shales. The quesJune 2008
tion is now how much of this can be

recovered?
There are 350 giant fields in the
world which hold 50-60% of current
world oil reserves, each containing
more than 500 million barrels in
reserves. The largest of which is
Ghawar in Saudi Arabia, discovered in
1938, which has 489 thousand million
barrels in place and 100 thousand million recoverable. With a reserve size of
100 million barrels considered very
good in many basins, to replace just
one Ghawar means we need to find
1100 new fields. So where is the
remaining big potential?
There are several areas which offer
potentially big fields. These are the
Canadian Oil Sands; Deepwater Gulf
of Mexico; Deepwater West Africa
and Brazil; Baltic/Russian Arctic; as
well as new exploration and production from the Middle East. The United
States government recently declared
Albertas oil sands to be proven oil
reserves. Consequently, the US
upgraded its global oil estimates for
Canada from five billion to 175 billion
barrels. Only Saudi Arabia has more
oil. The Tupi deepwater field in Brazil
is the biggest discovery since 2000 and
the largest ever in deep waters.
Petrogras believes Tupi may be Brazils
first of several new elephants, fields
of more than 1 billion barrels. Initially
Tupi will produce about 100,000 barrels a day but may ramp up to as much
as 1 million before 2020. Its monstrous, says Matthew Shaw, a Latin
American energy analyst at consultant
Wood Mackenzie.
An NPC Global Oil & Gas Study
concluded that global endowment is not
a limiting factor in future supply in the
near term. Constraints will come from
other sources technology, access,
deliverability, economics, geopolitics etc.
Small changes in recovery efficiency
(percentage of oil in place that will ultimately be produced) will have a globally
strategic impact upon the oil budget,
and the role of unconventional
resources will have a growing and profound impact as non conventional oil &
gas becomes conventional.
Techniques
16
June 2008
Techniques
volume
- the voice of the market
By Per-Erik Karlsson
like to think about volume as the

most powerful indicator I have on
my trading screen. Volume is driving price, not the other way around. So
who is actually moving the market? The
big volume traders such as the large
banks, hedge funds and market makers,
the so called smart money or professionals. They have much more information than most other traders, with
access to order books where they can
see stops, size of orders and who is
selling and buying.
These institutions trade large ticket
trades or a series of trades to engage in
the market and they have to pay more
attention to slippage and execution
than smaller players do. They get in and
out of the market in the most cost efficient way by buying into down moves
and selling into up moves. This often
gives them a better average entry price
since they are trading against the short
term momentum so they find it easier
to scale in large trades without getting
too much slippage.
Trading tricks
These large institutional traders will
also use various techniques to trick
other traders such as hunting for stops
and spiking the market up to make
other traders take bad long positions
while they build up shorts to slam the
market down. News events are often a
good time to play tricks and manipulate
the market and many times the market
will react unexpectedly when the actual

data is released. Keeping this in mind it
is now easy to see why volume is an
important indicator. It gives an indication of what price levels the large
traders get engaged at and how much
interest they have in higher or lower
prices.
Since the large traders are the ones
driving the market it can be an advantage to try and follow their lead. But
volume by itself is not really giving you
much to go by so you need to be able
to read the price chart in relation to
volume to really understand what is
going on. To be really effective one has
to pay attention to what the market has
been doing recently to put it all into
perspective.
High volume candles
You will see plenty of signals by examining the volume in relation to the price
action. Are the professionals showing
an interest in the up or down move or
are they aware of something that is
about to change so they are backing
away or even turning around their positions? One of the first things I look for
on a chart in order to see where the
professionals are showing interest is
extremely high volume candles. This is
important because the only way to get
an extreme high volume day is if there
are both sellers and buyers heavily
involved in the market. This tends to
happen at market tops and bottoms.
June 2008
The next thing is to look at what happened on those specific days. The key is
to try and figure out if the professionals are accumulating or distributing and
then try to play along with them. A
common misperception is that people
think weakness shows on down bars
and strength on up bars. Weakness will
always show first in an up bar and
strength will always show itself first on
a down bar. This is of course due to the
fact that at certain levels professionals
will turn their positions around or show
new interest. This will eventually lead
to a change in trend.
Reversals on extremely high
volume
A good example is the recent reversal
in the S&P 500 E-mini futures on the
17th of March (Figure 1). This was a
classic reversal formation and the chart
actually gave several signals that a low
was in the making. On 16th March the
volume was extremely high trading 3.87
million contracts, 64% more than the
20 day average at that time. The next
day it traded slightly less with 3.69 million contracts but still way above the 20
day average of 2.46 million. The significant clue was that the close on both
those days was some way off the lows.
The only way this can happen is if professionals are buying into the selling
and therefore creating extreme volume
and forcing the market off the lows.
High volume up bars closing off
17
Techniques
More strength, lack of interest by

professionals to sell the market
More buying by professionals the following

day, high volume up bar closing right at the
high, very wide bar.
Reversal - Closing off the highs on extreme volume
signals buying
Volume rising into low
Huge volume
Low volume vs. recent bars
Figure 1. S&P 500 Daily Continous Contract June 08
Selling, high volume up bars closing off the highs

More selling
Lack of interest on up bar
Weakness in the background

Lack of interest on up bar
Lack of
interest
More selling, up bar closing off the high, high volume
signs at the highs of October 2007

showing high volume up bars closing
off the highs. This suggests the professionals were lining up for a down move
selling into those highs. Then as it
drops lower at the beginning of
November you get the first confirmation that the market is weak because on
6th November the first lack of interest bar appears. Notice how short the
bar is and also the accompanying low
volume which is lower than the recent
bars and well below the 20 day average
volume. Then another one on 14th
January and the market dropped
sharply the next 7 trading sessions. On
2nd April the last lack of interest bar
appears and the market drops another
348 points in 3 days from that days
close to the low 3 days later.
The market will often react quite
quickly to these lacks of interest bars
and if you look at the Dax chart you
will see that the market moved lower on
all three occasions following lack of
interest during that down move from
October 07 to March 08. Failure by the
market to respond within a few bars is
a warning signal that something is not
right and the market might swing the
opposite way.
This reversal corresponds with the

S&P reversal on the above chart
Volume lower than resent bars
Again no interest
to participare in the
up move
Volume is lower than resent bars
Figure 2. Dax continous futures contract June 08
the highs represents selling. The next

big clue was the following day, the 18th
March, when the market rallied 52.50
points to close right at the high, trading
3.12 million contracts. For that to happen the professionals had to be buyers
the previous few days removing most
supply so the market could rise. Indeed
that is what happened as well with the
S&P rising 174 points in 34 days.
Lack of interest
Another thing I like to look for is what
18
I call lack of interest. If professionals

think prices are too high they will no
longer be interested in buying and
therefore volume could drop quite a lot
on up bars. I also want the bar to be
short because that further underlines
the lack of buying power. Figure 2
shows Dax futures where there are several signs of a lack of interest from professionals on the recent down trend
from October 2007 to the low on the
17th March 2008.
First you will notice several weakness
June 2008
Per-Erik Karlsson is head of trading

operations at Advantage Financial
in Switzerland.
Techniques
The Predictive
Power of Weekly
Fund Flows
By Bernd Meyer,
Joelle Anamootoo
and Ingo Schmitz
June 2008
19
Techniques
Money flows are the ultimate drivers of asset prices.

Against this backdrop it is not surprising to find that
data on fund flows has increasingly gained popularity as it has become more widely available. But it is
not just that money flows drive performance; good
performance of assets also tends to attract money
flows. Due to this interplay, fund flows tend to show
some inertia and as such should contain some
momentum information.
s Keynes said, the stock market is comparable to a

beauty contest whereby the person picking the most
popular candidate wins a prize: It is not a case of
choosing those [faces] which, to the best of ones judgment,
are really the prettiest We have reached the third degree
where we devote our intelligence to anticipating what average
opinion expects the average opinion to be. As such, an
investor is likely to gain by anticipating which assets, regions
or sectors will become the popular choices, which not necessarily reflect the best fundamentals. To the extent that the
trend in fund flows reflects investor action and behaviour,
this is likely to shed more information on market expectations regarding various asset classes as well as regions and
sectors.
In August 2006, we (the Equity Strategy research team at
Deutche Bank) looked at fund flow data in general and the
Emerging Portfolio Fund Research (EPFR) data in particular
(see Box 2), and analysed the predictive power of weekly
fund flow data, both for the direction of the equity market
and for the relative performance of regions. The key findings
from this research can be found in Box 1. The top line finding is that there is stronger evidence for predictive power
regarding the relative performance of regions than for the

market overall, but that there was no strong evidence that
flows lead performance in the following weeks. Simple
strategies that go long or short the asset based on the previous weeks direction of flows do not generally work.
Focusing on the changes in the direction of the flow rather
than the direction of the flows does not improve the predictive power for the market direction either.
However, including the Liquidity Pulse - a measure of rising or contracting liquidity momentum helps predict market direction. Extremely strong/weak readings of the
Liquidity Pulse should be seen as a negative/positive signal.
As such, we were able to develop profitable trading rules for
the market based on the combination of the direction of the
weekly fund flows, the direction of the average 4-week flow
and the Liquidity Pulse.
We also found that the relative strength of fund flows for
different regions contains explanatory power for subsequent
relative performance of the regions. Excluding transaction
costs, we find information ratios larger than 1. In our view,
this suggests that the relative strength of fund flows does
add value to models of regional equity allocation.
THE PROBABILITY THAT A POSITIVE INFLOW FOLLOWS A

POSITIVE INFLOW IS AROUND 68%. A NEGATIVE INFLOW
FOLLOWS A NEGATIVE INFLOW WITH 60% PROBABILITY.
20
June 2008
Techniques
Box 1: Key findings about the predictive power of weekly fund flows
We find no evidence of seasonal patterns in weekly fund flow, such as the rush in January, the sell off in the summer and
tax loss selling. In our view fund flow data therefore do not require seasonal adjustment.
Weekly fund flows show inertia as flows drive performance and performance leads flows. The average first-order autocorrelation coefficient is 0.27, with emerging market equity flows showing autocorrelation up to 0.54. The probability that a
positive inflow follows a positive inflow is around 68%. A negative inflow follows a negative inflow with 60% probability.
We observe a high (0.28) average contemporaneous correlation between weekly fund flows and equity market performance (as measured by the respective MSCI indices). We also find a strong positive correlation between performance and
lagged fund flows, providing clear evidence that performance leads flows. We do not find strong evidence that fund flows
lead performance in the following weeks.
In the bear market until March 2003 as well as in sideways markets the direction of fund flows in one week (or in 4
weeks on average) carries predictive power for subsequent performance. In a rising market the direction of fund flows
does not seem helpful and actually gives wrong signals on average. Hence, simple strategies that go long or short based
on the previous weeks direction of flows do not generally work.
Focusing on the changes in the direction of the flow rather than the direction of the flows does not improve the
explanatory power for the market direction.
Including the Liquidity Pulse, a measure of rising or contracting liquidity momentum, proves helpful for predicting the
market direction. We were able to develop trading rules for the market based on the direction of the weekly fund flows,
the direction of the average 4-week flow and the Liquidity Pulse that have worked for the regions for which we have the
longest history. Generally these strategies suggest to remain invested in the market unless all measures send a negative signal. Extremely strong/weak readings of the Liquidity Pulse should be seen as negative/positive signal. The May 2006 correction though was not predicted by these strategies.
Our cross-sectional analysis shows that the relative strength of fund flows for different regions contains explanatory
power for subsequent relative performance of the regions. Excluding transaction costs we find information ratios larger
than 1. Even if results after transaction costs are unlikely to be that positive, this suggests in our view that the relative
strength of fund flows does add value to models of regional equity allocation.
Finally a word of warning. One needs to be careful with any major conclusions as the earliest data available is from
January 2000. All data available for developed markets lies in the positive part of the current market cycle. In this market
cycle cheap money was available globally due to low interest rates in Japan, Europe and the US, which lead to a strong
appreciation in value of all asset classes. The data could be misleading and not reflect the true long-term fund flow picture. As no other data is available we can neither prove our findings to be right nor wrong. We believe however the data
can among other things be used to confirm economic or equity performance trends.
* Based on Deutsche Bank report Predictive power of weekly fund flows, 10 August 2006.
June 2008
21
Techniques
Liquidity Pulse a measure of liquidity

momentum
Our results suggested that neither the direction of flows in
one week (or its 4-week average) nor the change in the direction of flows, on their own, are sufficient to predict next
weeks equity market performance. We therefore had to test
measures that go beyond simply looking at the direction of
the flows. Liquidity momentum, i.e. a measure of rising or
contracting liquidity might prove helpful. Flows might still be
positive (negative) but the size of the inflows (outflows)
might already ease, indicating a declining (rising) investor
conviction. To measure liquidity momentum we introduced
the liquidity pulse.
equity funds, Asia-Ex Japan equity funds, EMEA equity

funds, emerging market bond funds and high yield bond
funds). Compared to the Emerging Markets Liquidity Pulse,
the Risky Fund Flows Liquidity Pulse captures the additional effect of the emerging bond and high yield bond markets.
Therefore the Risky Fund Flows Liquidity Pulse shows a
more complete picture of risky fund flows than the emerging markets equity liquidity pulse, and we believe that it is a
more valuable measure of investors willingness to invest in
risky assets, i.e. risk appetite.
3
Liquidity M o m entum Expanding
Liquidity M o m entum Expanding
2
1
-1
-2
Liquidity M o m entum C o nt rac ting
Jun-06
Apr-06
Feb-06
Dec-05
Oct-05
Aug-05
Jun-05
Apr-05
Feb-05
Dec-04
Oct-04
Aug-04
Jun-04
-3
Apr-04
Calculation of the Liquidity Pulse

The liquidity pulse compares the size of the current flow
(4-week average as % of NAV) with the average size of the
flow in the last 13 weeks. The relative size is given in standard deviation from the mean. As a momentum indicator it
gauges investors confidence in certain regions and the movement of momentum in those regions. A high liquidity pulse
indicates a liquidity momentum expansion as the asset class
in question is experiencing net inflow for many consecutive
weeks. This is an indication of above-average investor confidence in a certain region and generally indicates a strong performance for equity markets in the respective region. A liquidity pulse which is steadily increasing indicates an increase
in the amount of fund inflows into the region, and vice
versa.
We illustrate the output such that the light blue data points
are closely around the mean and show moderate changes in
momentum. The dark blue data points are more than one
standard deviation away from the mean and indicate periods
of strongly expanding or contracting liquidity momentum.
Source: Deutsche Bank Equity Strategy / EPFR
Figure 2. Risky Fund Flows Liquidity Pulse
Liquidity Pulse and equity market performance

When comparing the liquidity pulse data with equity performance, we observe common trends. Figure 3 shows the US liquidity pulse versus the US MSCI equity index performance
from April 2004 to July 2006. The trends of the liquidity pulse
and equity performance are similar during periods of consistent liquidity momentum expansion and contraction. This
makes the fund flows a reasonable momentum indicator.
However, what we also observe is that if liquidity momentum
is signaled to be very strong (or very weak) the subsequent
performance tends to be negative (or positive). This suggests
that the liquidity pulse becomes a contra indicator when
momentum has become too strong in either direction. We
find comparable results for the other regions.
-1
4%
-2
3%
2
2%
Liquidity M o m entum C o ntrac ting
1%
-3
Ju n-06
Apr-06
Feb-06
Dec-05
Oct-05
Au g-05
Ju n-05
Apr-05
Feb-05
Dec-04
Oct-04
Au g-04
Ju n-04
Apr-04
0%
0
-1%
-1
-2%
-3%
-2
-4%
The charts in Figures 1 and 2 illustrate the Developed

Equity Market Pulse (based on the fund flows for Western
Europe, the US and Japan) and the Risky Fund Flows
Liquidity Pulse (based on fund flows for Latin-American
22
June 2008
US L iquidity P uls e (l.h.s.)
Ju n-06
May -06
Apr-06
Mar-0 6
Ja n-06
Fe b-06
Dec -05
No v-05
Oc t-05
Se p-05
Ju l-05
Aug-05
Ju n-05
May -05
Apr-05
Mar-0 5
Ja n-05
Fe b-05
Dec -04
No v-04
Oc t-04
Se p-04
Ju l-04
Aug-04
Ju n-04
-5%
Apr-04
Figure 1. Developed Market Equity Liquidity Pulse
-3
May -04
Source: Deutsche Bank Equity Strategy / EPFR
Wee kly US MSCI Per formance (r .h.s .)
Source: Deutsche Bank Equity Strategy / EPFR, Factset
Figure 3. US Liquidity Pulse vs. weekly US MSCI Index

performance
Techniques
Box 2: A brief guide to fund flow data

We use Emerging Portfolio Fund Research (EPFR) fund flow data for several reasons:
Large universe. EPFR tracks a total of 8817 funds with a

different geographical focus and across different asset
classes. 7725 of these funds are equity funds (as of
August 2006)
Most of the funds under coverage are long only funds,
and only a minority of the included hedge funds has short
positions, but these are insignificant relative to total
investment value.
All the funds included are pure plays equity funds invest
only in equities, and bond funds invest only in debt securities, and not a mixture of both.
The funds are not generally exchange traded. Data on the

proportion of ETFs to non-exchange traded funds is limited, but according to EPFR it is negligible.
Investors are a mix of retail and institutional investors.

EPFR estimates that 70% of them are institutional, the
biggest ones being pension funds and insurance companies. Institutional investors account for most of those
investing in emerging market funds, but we see a higher
participation of retail investors for Western Europe and
US equity funds.
EPFR tracks mutual funds on a global basis compared to

some other providers of flow data, and presents the flow
of funds into geographical asset classes irrespective of
domicile. For instance, the flows into Western Europe
equity funds represent the amount deposited or withdrawn in funds investing in Western European equities
irrespective of where the funds are located. We believe
that this data is therefore more representative compared
to other data available which tend to only cover funds
located in the US.
Calculation of flows
On a weekly basis we obtain the raw data from EPFR, who
in turn obtain it each Wednesday from the respective fund
managers. EPFR releases the data on Thursday night, hence
the Weekly fund flows note we publish each Friday contains
very timely information.
The calculation of the weekly net flow is as follows:
Assets BoW = Total fund assets beginning of week

(as of prior Wednesday's market close)
Assets EoW = Total fund assets end of week

(as of current Wednesday's market close)
June 2008
Weekly Portfolio Change = (Assets BoW) x (Weekly performance of fund)*
Weekly net flow in local currency = Assets EoW Assets

BoW Weekly Portfolio Change
Weekly net flow in $ = Weekly net flow in local currency

x Average weekly forex
Weekly flow as % of NAV = Weekly net flows in dollars/Assets BoW in dollars using beginning of the week
exchange rate
The flow data table which features in our Weekly fund flows
note contains information on weekly flows, the 4-week average flow as well as the year-to-date net flow for all funds in
our universe. The 4-week moving average of the flows
smoothes the data as the weekly flows can at times be quite
volatile. Flow information is provided in absolute dollars
and as a percentage of total assets. The latter improves the
comparability of the flows across regions.
Focus on fund flow as a proportion of total assets
We recommend analysing fund flow data as a % of total
assets, rather than in dollar terms, because it provides a better comparison between regions:
First, funds investing in emerging markets, for instance,

tend to be smaller than those investing in developed markets such that weekly flows in dollar terms do not accurately reflect the flow momentum across regions.
Second, the size of net flows (in dollars) tends to change

with the development/index performance of the markets
which they track.
Third, EPFR has widened its coverage of fund flows over

time. For a better historical comparison, it is therefore
necessary to look at fund flows as a percentage of the
covered assets rather than in absolute terms.
Fourth, it is worth noting that the flows are provided in

dollar terms and are therefore dependant on foreign
exchange movements. As the dollar strengthens or weakens relative to the funds respective local currencies, we
could see some fluctuations in the overall funds which are
not the result of equity investor behaviour.
*change in NAV per share including any dividend distributions
23
Techniques
Trading strategies including the Liquidity Pulse

We now test trading strategies for individual regions based on
the direction of the 1-week flow in combination with the
direction of the average 4-week flow and the liquidity pulse.
The general idea is to stay invested in the market unless all
three indicators send a negative signal.
Strategy with strong/weak liquidity pulse as
a contra indicator
The first strategy uses the liquidity pulse at the top and the
bottom of the range as a contrarian indicator. This assumes
for example that if the momentum falls too much, it will hit
a lower boundary and rebound into positive territory, along
with equity performance. The same principle applies to very
high momentum. If the liquidity pulse lies above 1, it is taken
as a contrarian indicator and is a negative signal, if it lies
between 1 and 0 it is a positive signal, if it lies between 0 and
-1 it is a negative signal and if it is below -1 it is again a contrarian indicator and hence a positive signal. The data and
performance charts for our strategy for the emerging markets
are shown in Figure 4.
400
2. 10
350
1. 90
300
1. 70
We increased the boundaries of the liquidity pulse to 1.5x

standard deviation in order for the contrarian indicators to
react at more extreme levels. This way the strategy increased
the number of trades executed and for the emerging markets
increased its performance to 184%. The information ratio
though did not improve.
We applied the same strategy to all other regions. With the
Liquidity Pulse boundaries set to 1x standard deviation for
the Liquidity Pulse to become a contra indicator, a positive
excess return is generated for the US, Japan and the
Emerging Market with the information ratio ranging from
0.3 to 0.7. The main problem with this strategy is that it has
not worked well since 2003. While it seems to work well in a
bear market, it does not in a bull market. We believe the main
reason why the strategy does not work well for other regions,
is because for most regions we only have data available for
the bull market. We cannot back test this strategy for the bear
market period, and therefore cannot make any clear conclusions on its ability to outperform the bear market in any
regions other than the emerging markets.
Increasing the sensitivity of the strategy to the flow signals
decreases its overall performance, as does the introduction of
additional signals from flows into bond funds data or from
taking the difference of weekly flows. We cannot draw any
clear conclusions from the results obtained.
250
1. 50
200
1. 30
150
1. 10
100
Feb -06
Ma y-06
Nov -05
Aug-05
Feb -05
Ma y-05
Nov -04
Aug-04
Feb -04
Ma y-04
Nov -03
Aug-03
Feb -03
Ma y-03
Nov -02
Aug-02
Feb -02
Ma y-02
Aug-01
Nov -01
Feb -01
0. 90
Ma y-01
50
B enchmark (MS CI Emer ging Mar kets Index) (l.h. s .)

Portfolio (Trading S trategy F or Eme rging Ma rkets) (l.h.s .)
Outperformance (r .h. s.)
Figure 4. Trading strategy vs. benchmark (liquidity pulse

boundaries at 1x)
Strategy with only weak liquidity pulse as

a contra indicator
Our second strategy is similar to the one above but a liquidity pulse above 0 is taken as a positive signal, if it is between
0 and -1.5 it is taken as a negative signal and if it is below 1.5 it is taken as a contrarian indicator, and hence a positive
signal. Again we show the results for the emerging markets in
Figure 5. This strategy also outperforms the market considerably, but has the same limitations as above.
400
2. 10
350
June 2008
1. 70
250
1. 50
200
1. 30
150
1. 10
100
Feb -06
Ma y-06
Nov -05
Aug-05
Feb -05
Ma y-05
Nov -04
Aug-04
Feb -04
Ma y-04
Nov -03
Aug-03
Feb -03
Ma y-03
Aug-02
Nov -02
Feb -02
Ma y-02
Nov -01
Aug-01
0. 90
Feb -01
50
Ma y-01
The strategy outperformed the market from February 2001

to July 2006 by 72pp (study conducted August 2006) with an
information ratio of roughly 70% both based on annualised
weekly returns as well as on returns by calendar year. The
strategy rose by 154%, compared to 83% for the benchmark,
if all excess returns are reinvested. Note that the strategy has
in particular outperformed during a bear or sideways market.
Between 2001 and 2003 the trading strategy tended to outperform especially when the MSCI Index dropped, as it
picked up the signals and went short. It has non-negative
excess returns in 97.5% of the weeks, mostly because it stays
long most of the time. The problem however is that it has
not given many signals to trade since then and as a result did
not pick up the market correction in May 2006. The flow data
signals were not clear enough to be picked up by the trading
strategy. This trading strategy therefore has not outperformed the bull market since March 2003.
1. 90
300
B enchmark (MS CI Emer ging Mar kets Index) (l.h. s .)

Portfolio (Trading S trategy F or Eme rging Ma rkets) (l.h.s .)
Outperformance (r .h. s.)
Figure 5. Trading strategy vs. benchmark (liquidity pulse

boundaries at 1.5x)
Predictive power of fund flows for regional

allocation
Another question we wanted to answer is whether the
25
Techniques
relative strength of flows for different regions contains any

explanatory power for subsequent relative performance of
the regions.
We look at the six main regions covered by the fund flow
data: Western Europe, the US, Latin-America, Asia ex Japan,
Japan, and EMEA. The cross-sectional comparison of the
flows is based on the 4-week average flow as % of NAV for
the six regions. Each week we normalise these 6 observations
by calculating the cross-sectional z-score. z-scores are capped
at 2 to reduce the noise in the data. It is ensured though, that
the sum of the z-scores equals zero.
The benchmark is an equally weighted portfolio of the six
regions with weekly re-adjustment. The strategy takes active
bets relative to the benchmark with the size and the direction
of the active bet similar to the z-score of the flows times a
fixed multiplier. For example, if a region has a z-score of 1,
we add one percentage point, times the multiplier, to the initial weighting of 16.7% to that region. Therefore every week
we readjust our positions in all 6 regions around their initial
positions of 16.7%, depending on their respective z-score
26
June 2008
values. We use a multiplier 3, meaning that the absolute size

of the maximal active bet equals 6pp.
Our strategy outperformed the market in 2003, 2004, 2005
and marginally underperformed in 2006 (to 10 August 2006).
57.5% of the weekly excess returns have been positive. The
average annualized excess at 0.94% compared to the benchmark looks small, but with an even smaller tracking error of
0.74% the information ratio is 1.28. Fund reallocations of
151% of the portfolio size were needed annually, suggesting
that even including transaction costs an excess return can be
generated. The results suggest that the relative strength of
weekly fund flows can add value to models of regional equity allocation.
Bernd Myer, Joelle Anamootoo and Ingo Schmitz are
Equity Strategists at Deutsche Bank AG. This article is
based on their report Predictive power of weekly fund
flows (2006). For information on EPFR data visit
www.epfr.com.
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Techniques
The ARMS Index

We take a look at the famous ARMS index and try to establish how best to use the indicator when trading US stocks.
The Arms Index, otherwise know as the TRIN (short for
Trading Index), has traditionally been used as a short term
indicator for US stocks that uses daily price and volume data
to measure relative demand for rising and falling stocks. By
using data from all 2250 or so stocks listed on the NYSE, the
index acts, in effect, as a volume weighted ratio of rising
stocks versus falling stocks. This ratio can then be used as an
indicator of how buying or selling pressure in the market is
changing.
Although the ARMS Index is calculated using data from all
NYSE stocks, it can be refined to include just S&P or Dow
stocks. However, Richard Arms warns that the effectiveness
of the index is reduced when fewer stocks are used in its calculation. Moreover, despite its widespread use as a short
term indicator, Arms insists that the TRIN can be used for
long term analysis and that many of his clients are traditional long term fund managers and not necessarily just short
term intraday traders.
Arms today runs a consulting firm, ARMS Advisory, from
his base in Albuquerque, New Mexico specialising in providing TRIN based research to trading and investment houses.
Richard spoke to the Technical Analyst for this feature and
his views on using and interpreting the TRIN are included.
Figure 1.
28
June 2008
The ARMS Index

The ARMS Index is calculated using daily closing prices and
volume data from the New York Stock Exchange (NYSE).
The formula is familiar enough:
Number of
advancing stocks
ARMS Index =
Advances
Number of
declining stocks
the number of
close higher
Declines
the number of
close down
Advancing volume the volume of
Declining volume the volume of
Advancing
volume
Declining
volume
NYSE listed stocks that

NYSE listed stocks that
stocks closing higher
stocks ending low
The TRIN calculation produces an index that centres around

1.0, a value where the index is said to be neutral as advancing
and declining volume is equally spread over rising and falling
issues. Because of the nature of the formula, the index produced is counter-intuitive in nature in that if more volume is
going into stocks that are rising in price, the index falls
Techniques
June 2008
29
Techniques
WALL STREET TRADERS AND INVESTMENT

MANAGERS HAVE TRADITIONALLY USED THE
10 DAY MOVING AVERAGE
below 1.0 and visa versa. So if the index is above 1.0 then it
is said to be bearish for stocks and below 1.0 is bullish. This
is because even if, for example, the number of rising stocks
exceeds the number of declining stocks the index will rise if
this occurs on low or declining volume.
Using the TRIN
The index or line that this equation produces from daily data
is often used smoothed using a moving average. Indeed,
many references to using the TRIN are often made in terms
of its moving average.
However, beyond that the index is open to a great deal of
interpretation. Some users of TRIN tend to adopt their own
parameters as to which reading indicates a bullish or bearish
signal. Richard Arms himself recommends using the following moving averages for trading different time scales:
Short term: 4 day MA
Intermediate: 10 day MA
Medium term: 21 day MA
Long term: 55 day MA
(Note that 21 and 55 are both Fibonacci numbers).
Wall Street traders and investment managers have traditionally used the 10 day moving average for TRIN. This is
30
June 2008
probably because before the use of computers, it was an easier figure to work with.
Despite the index being considered bullish when it is below
1.0 and bearish when it is above 1.0, Richard Arms himself
concedes that the index appears to be most effective when
used as an overbought/oversold indicator. However, there is
no consensus on what constitutes overbought or oversold
conditions and furthermore, they depend on what moving
average of the index is being used. John Murphy states that
the TRIN can be used as a contrary indicator, especially in
intraday trading. A very high figure (strongly bearish) is therefore bullish as it indicates a turning point.
According to Katie Townshend chief market technician at
MKM Partners, a proprietary trading and research firm based
in Greenwich, Connecticut, the real value of the TRIN lies in
its application as a breadth indicator, as well as an overbought/oversold oscillator. Furthermore, the TRIN should
not be used in isolation but only when other indicators confirm it. I publish the TRIN reading on a daily basis in an
email to clients but only heed it when it reaches extremes.
Lately, a high extreme has been about >2.0 and a low extreme
has been about <0.5.
When it reaches a high extreme, which usually happens on
sharp down days, it can be considered an oversold reading
that suggests the next day or two will be more bullish.
Conversely, when it reaches a low extreme, which usually is
associated with strong up days, it can be considered an overbought reading that suggests the next day or two will be more
bearish, she says.
Techniques
Trading rules
Richard Arms recommended trading rules based on using the
TRIN as an overbought/oversold oscillator are as follows:
Moving Average
Overbought
(sell)
Short term (4 to 10 day)
<0.75
Medium term (21 day)
<0.85
Long term (55 day)
<0.90
Oversold
(buy)
>1.25
>1.10
>1.05
The TRIN suffers to some extent from a lack of consensus regarding not only which moving averages to use but
what readings of the index indicate a buy and sell signal. This
is a drawback because it suggests that the ideal parameters
may change as market conditions change so the optimal readings to use are likely to remain unknown at any particular
time.
THE INDEX ACTS AS A

VOLUME WEIGHTED
RATIO
OF RISING AND
FALLING STOCKS
In addition, there have been very few proper statistical
studies on the TRIN which is surprising given how popular
the index is often said to be. What does appear to be agreed
on is that using the index in its simplest form without a moving average, (buy<1.0, sell>1.0) does not produce profitable
results.
Robert Colby, a US based analyst who has written about
and backtested most (if not all) technical indicators* found
that the ARMS index has little predictive power for readings
between 0.523 and 1.444. However, extreme readings beyond
these were profitable with a one year holding period to a 99%
confidence level. Although Colby also cites the TRINs value
is being used as an overbought/oversold indicator, he also
says that extreme readings of the index in either direction
(above 1.444 and below 0.523) give a bullish reading.
Backtesting showed this result had a 99% confidence level
for a 1-year holding period although the number of signals
this strategy has generated since 2000 has gone up considerably, which calls into question whether it is still valid. The
low readings of the index are bullish because this usually
indicates a (oversold) reversal after the end of a decline or
bear market.
June 2008
The problem with these findings is that TRIN is usually

thought of as a short term indicator and used as such which
makes a one year holding period unrealistic. Colby states that
the 10 day simple moving average above 1.266 is very bullish
for a one year holding period to a 99% confidence level.
From this Colby proposes a greater than 1.266 rule. It
should be noted that these results are based on data before
2000.
Based on backtesting 16 years of data, for short term trading Colby recommends the following rule:
Buy: 11 day exponential moving average (EMA) > 0.8
Sell: 11 day EMA < 0.8
This strategy according to Colby would have returned
1640% for the S&P500 (with reinvested profits and no costs)
during the test period from 1984 to 2000, more than 80%
more than a buy and hold strategy (900% return).
Colby also cites the significance of a single days reading of
2.65 for the index. If the S&P500 had been bought on the
close of every day when the index was 2.65 or above over in
the 35 years before 2000, it would have yielded a profit 11 out
of the 12 instances it happened when held for one year.
Holding period
Although Colby sites a one year holding period in all his testing of TRIN and doesnt vary this, Kirkpatrick and
Dahlquist** insist that the holding period is crucial to the
profitability of the indicator. For example, with the >2.65
rule, although the signal only occurs every couple of years, if
the holding period is reduced from one year to two months
or less, the returns are some 100 times greater than a buy and
hold strategy. Kirkpatrick suggest the difficulty in establishing
these rules for the TRIN comes in applying short term indicators to long (one year) holding periods.
Other signals
According to other literature there are other signals that the
TRIN can generate. As Richard Arms explains, Apart from
the well known use of the index moving averages, I have
worked a great deal with moving average crossovers. The
best, I think, is the 21-day to 55-day. The 55 becomes the
baseline and the 21 indicates the extremes. Another simple
strategy is two consecutive days of the index over 2.0 which
has a very good record of calling important bottoms.
Richard ARMS new book, Stop and Make Money: How to Profit
in the Stock Market Using Volume and Stop Orders has recently
been published by Wiley.
*The Encyclopaedia of Technical Market Indicators
(McGraw Hill) by Robert Colby
**Technical Analysis (FT Press) by Charles Kirkpatrick and
Julie Dahlquist
31
Techniques
Trading Variations in Double

Tops and Double Bottoms
By Suri Duddella
Chart patterns like Double Tops and Head-and-Shoulders essentially convey the
same signal that of a trend reversal at the end of the pattern. Given the potentially important long-term Double Tops forming in the FTSE and S&P (see
Figures 1 and 2), we ask Suri Duddella to discuss the many variants of Double
Tops and Double Bottoms and to highlight some of their different trading rules.
Double Top and Double Bottom patterns are part of classic technical analysis. Double Top/Bottom patterns are
very common and form in all timeframes and in all instruments. These
patterns form when prices fail to make
new highs/new lows at significant previous levels. Double Top and Bottom
patterns are relatively reliable and easy
to trade. When Double Bottoms/Tops
fail, they may be signaling potential
Triple Top or Triple Bottoms patterns.
Double Top/Bottom patterns have several variants and these variations involve
different trading rules and different pattern recognition methods.
Formation of Double Top/
Bottom patterns
In active markets, Double Top/Bottom
patterns are found as the market works
up rapidly in a peak or trough accompa-
Figure 2.
Figure 1.
32
nied by high volume in the first stage.

Without any warning signs the market
reverses and retraces to a key support
level/resistance and stagnates for few
bars before rising/falling to the previous peak/trough with lesser volume in
the second stage. These two sharp
moves create the Double Top/Bottom
patterns and signal a potential reversal
of prior trends. In most Double Top or
Double Bottom patterns the two swing
peaks or troughs need not be equal and
the first or second peak or trough can
be higher/lower.
The preceding movement prior to the
Double Top/Bottom pattern formation signals whether the pattern is a
continuation or reversal pattern. If the
preceding movement is a long continued up/down trend prior to the first
peak/trough, the pattern may be signaling a reversal while if the preceding
June 2008
movement is a short trend, it may be

signaling a continuation pattern.
Markets making new highs/lows (at
least 40-bar) in the first peak/trough
may signal reversal patterns.
The size of the pattern or duration
of the interval between the two
peaks/troughs measures the success of
the pattern. A long duration between
the two peaks/troughs signals a high
possibility of reversal. The size of
the retracement (at least 15% from the
first swing) between the two
peaks/troughs also indicates the likelihood of pattern success. High volume
during the first peak/trough and lighter
volume in the second peak/trough followed again by higher volume during
the breakout/breakdown signals
greater probability of pattern success.
Double Top Trading Rules
Double Top patterns are recognized by
the two peaks with an intermediate
reaction swing low. After completion of
the second peak, prices trade below the
reaction low to signal a potential trade.
Trading Rules
Trade: A Double top pattern confirmation occurs at the breakdown level of
the swing low at the neckline. Enter a
short trade below the previous swing
low at the neckline (see Figure 3).
Target: The Double Top offers a
Techniques
chance of trading Double Tops and

Bottoms successfully. Most patterns
have some variation of their basic
structure (simple or complex) with different trading rules to their cousins in
the same group, but have the same
requirements as to volume action, price
movement and timing. Some examples
of Double Top and Bottom variants
are: Dragon Patterns, Trader Vics 2B
Top/2B Bottom, and Adam and Eve
patterns, which I briefly review here.
Figure 3.
Figure 4.
good risk/reward ratio. Measure the

distance between the top of the pattern
to the neckline for potential target range
from the trade entry (see Figure 4).
also has a good risk/reward ratio. The

first target would be 100% of the swing
range of the pattern. The second target
would be 127% to 162% of the depth
of the double bottom pattern (see
Figure 6).
Stop: Double tops also fail and form

triple or multiple top patterns. Usually
the failure occurs when prices reverse
and trade at the middle of the Double
top pattern range. Enter a stop order at
the middle of the pattern range to protect the trade.
Double Bottom Trading Rules
The Double Bottom pattern is a mirror
image of the Double Top. An extended
down trend results in new lows followed by a moderate rally from the first
bottom. After a brief rally the prices
attempt to test the first bottom again.
Failure to trade below the first-bottom
results in a second-bottom as prices
rally and reverse the prior trend. The
intermediate swing-high between the
two bottoms is called the reaction
swing-high. When price trades above
this reaction swing-high, it signals a
potential long trade.
Trading Rules
Trade: A Double Bottom can only be
traded after confirmation of the pattern
breakout. Confirmation of the pattern
occurs when prices close above the
neckline. Enter a long trade above the
high of the breakout bar from the neckline (see Figure 5).
Target: The Double Bottom pattern
Stop: Double Bottom patterns do fail.

This pattern failure occurs if the price
closes below the middle of the pattern
for multiple bars. Trading below the
bottom of the pattern could signal a
triple bottom. Place a stop order below
the middle of the pattern to protect the
trade.
Dragon Pattern (Figure 7)

Dragon patterns usually form at market
bottoms. Dragon patterns work in all
time-frames and in all market instruments. Like most Double bottom patterns, Dragon patterns present excellent
trading opportunities with low risk to
reward ratios. The Dragon pattern is
similar to the W pattern and the
Inverse Dragon pattern is similar to the
M pattern, albeit with different trading rules.
The Dragon pattern starts with a
Head formation and price declines
from the head level to form two legs of
the Dragon. These two legs in a
Dragon pattern usually form within 5%
to 10% of the price difference. The second leg gives a strong indication of
imminent reversal when it posts a key
Figure 5.
Figure 6.
Variations of Double Top/

Bottom patterns
Knowledge of the variations and their
trading rules dramatically increases the
reversal bar or a divergence in any oscillator indicators. The price rise in the
second leg is usually followed by a spike
in the volume. A trend line is drawn
June 2008
33
Techniques
Adam and Eve Patterns

(Figure 11)
Adam and Eve patterns are variations
of Double Top and Double Bottom
patterns. The trading rules are a little
more complex than for regular Double
Tops and Double Bottoms but consist of pattern trading rules similar to
Triangles, Pennants and Wedges. Inside
the Adam and Eve pattern, the Adam
part looks like a sharp spike or V
shape whereas the Eve pattern has a
round shape.
Figure 7.
Figure 8.
connecting the head of the Dragon to

the hump. When the price closes above
the trend line and is also confirmed by
price action or divergence in any oscillator, it signals a reversal. The second
confirmation of a Dragon pattern
occurs when the price closes above the
hump, 38% to 50% of the range from
the head to the low of the first leg.
back for a healthy retracement. After

retracement, the price tries to re-test the
new high or new low. When this test of
the new high or new low fails, and it does
not maintain the prices above the new
high or low, it signals a potential trend
reversal. This setup is very powerful and
signals the beginning of a correction.
Trade: Aggressive traders enter a long

trade when the price closes above the
trend line (see Figure 8). A better trade
entry may be when the price closes
above the hump level. Enter a long
trade a few ticks above the hump level.
Trader Vics 2B Top/Bottom

(Figures 9 & 10)
Principles of Professional Speculation written by Victor Sperandeo (Trader Vic),
analyzes one of the powerful
top/bottom reversal techniques. Trader
Vic describes this technique, "In an
uptrend, if prices penetrate the previous high,
but fail to carry through and immediately drop
below the previous high, the trend is apt to
reverse. The converse is true for a down
trend. This pattern is also called
spring.
The 2B pattern rule is when prices
make a new high or new low; they pull
34
Target:
Adam and Eve pattern
2B Sell Setup
1. New High
2. Pullback
3. Another bar Close above
Bar 1High
4. Mark Low of Bar 3. Wait for
Close below 4
5. Short below the Low of 4
6. Target Previous Swing Lows
Target: Targets are usually at 127% of

the second leg range and another target
is set near the Head level.
Stop: Place a stop order below the lowest low of the two legs.
Trade: Although these patterns are

easy to detect, a confirmation is needed
for successful trading. Double Bottoms
and Double Tops may continue to form
multiple tops and multiple bottoms.
Trades are entered in the direction of
the breakout/breakdown of the middle
spike between Adam and Eve structures.
Figure 9.
2B Buy Setup
1. New Low
2. Decent Retracement
3. Another bar close below Bar
1 Low
4. Mark High of Bar 3. Wait for
Close above 4.
5. Long above the High of 4
6. Target previous Swing
Highs
Figure 10.
June 2008
Techniques
formations are very profitable. The targets can be set at the previous swing
high/swing low of the first swing in the
Double Top or Double Bottom.
Subsequent targets would be set at the
next higher swing high or the next
lower swing low.
Stop: Adam and Eve patterns also fail.
Protect trades using the pattern high for
short trades and the pattern low for
long trades.
Conclusion
Most chart patterns have natural variations that require slightly different pattern detection methods and different
trading rules. Knowing these variations
and their trading rules greatly improves
any traders success when recognizing
the development of a pattern.
Figure 11.
Suri Duddella is the author of Trade Chart Patterns like the Pros. Suri has
been trading Futures and Equities markets full-time for over 13 years.
Contact suriNotes@gmail.com / www.suriNotes.com
June 2008
35
Interview
36
June 2008
Interview
INTERVIEW
Julian McCree is a trader at

Erste Bank in London with 15
years experience in the interest
rate, FX and commodity markets. He talks to the Technical
Analyst about his trading style
and approach to risk management.
TA: How is the current turmoil in the markets affecting
your trading performance?
JM: I have had a good year. Any trader needs to have something going on either in terms of volatility or strongly trending markets. To be honest, it helps to have a crisis in some
markets because to us this represents an opportunity to make
money.
TA: You have spoken often on the oil market. Have you
managed to exploit the recent rally?
JM: I have missed out on some of the very recent rally. The
rise in oil prices fits the pattern of other commodity markets
with the oil being in an acceleration phase now and the final
stages of the current bull market. With volatility being so
high it makes short and medium term trading difficult as the
risks and rewards have become too balanced to justify taking
a position. I think there are a number of people who didnt
foresee what is happening with oil prices now given the short
covering the market is seeing.
June 2008
37
Interview
TA: What is the basic philosophy behind your trading

strategies?
TA: Are there any particular markets that stand out as

offering good potential in the months ahead?
I prefer to trade with the trend. As regards the basic philosophy, I use the quote by William Eckhardt that appeared in his
section in Schwagers Market Wizards. He said one of the
most important facts about trading; that is, even if a trader
gets a trade wrong but has good risk management, theyll be
ok. This is because eventually theyll hit a home run and make
money. The crucial thing is not to miss the big moves. A trader can miss one or two but if he or she consistently misses
the big trends then they are finished as a trader.
JM: Well, lets look at the equity markets. They have enjoyed
a good couple of months although they have started to turn
down again recently. This may be a good buying opportunity.
I attach a great deal of importance to sentiment in my trading so its difficult to see how the stock markets can fall much
further from here when everybody I speak to is so negative
about the market. This means they must either be flat or close
to it.
MY BELIEF IS THAT
MARKETS ARE
ESTABLISHED FOR
THE BENEFIT OF THE
COMMERCIALS,
NOT THE
SPECULATORS
TA: Generally speaking, how do you come to a decision
when to trade? To what extent is it based on technical or
fundamental factors?
JM: My process, which is similar to that of Jake Bernstein, is:
Set-up, Timing and Management. What I call the set-up is
usually a combination of technical and fundamental indicators. Timing is then used to place a trade and finally, probably the most important part of the trade, management in
terms of trade and money management.
TA: Which markets do you trade? Are you free to trade
more or less any market you wish?
JM: Im a global macro trader and as long as it has a futures
market, I can trade pretty much what I want to as long as I am
active in the most liquid markets. This includes FX, commodities, interest rates and equity indices. Im also beginning to
look at ETFs because of the sectoral diversity that they offer.
38
June 2008
The stock markets that have the option of devaluing such as

the sterling and dollar markets are going to outperform those
that dont. Consequently, I can see the FTSE and US equity
markets outperforming the DAX.
TA: You have discussed the Commitment of Traders
report in several talks that you have recently given. How
do you use this in making trading decisions?
JM: I look at what the commercials are doing because this is
most important. Then I analyse sentiment and where the
market stands from the long term point of view. My belief is
that markets are established for the benefit of the commercials and not the speculators. For example, in the wheat market this year, huge price movements created margin calls for
the commercials. These calls would have been financed by the
banks previously but with the onset of the credit crunch, they
now have to be covered by the commercials themselves if
they want to carry on doing business. The commercials went
to the CFTC and complained that something had to be done
about the impact that speculators were having on the market.
As a result, the CFTC doubled the margin call on the market
and wheat prices fell sharply soon after.
This illustrates that the commercials are far more important
than the liquidity providers, i.e. the speculators. Looking at
the commercial positions gives you an idea of what the guys
who matter are thinking. I have some software that reads the
COT report for me and charts it so I can more easily see
where things are. This helps form part of my set-up.
TA: You have placed great emphasis on trade management and money management. Can you enlarge on your
approach?
JM: Trade management and money management are two
separate things. Trade management is about, do I add to my
position? If so, how much do I add considering what I see as
the overall market picture? This is based on what the charts
are telling me, how my positions are performing, do I pyramid my position, and where to place stop losses.
In my opinion, most traders tend to put their stop losses
Interview
June 2008
39
Interview
EVEN IF YOU GET A TRADE WRONG BUT

YOU HAVE GOOD RISK MANAGEMENT,
YOULL BE OK
too close. This tends to happen because they are over-geared.
If you are so highly geared that you are using a quarter of a
days range as a stop then you are probably going to lose
money. If you use the average true range of the last five days
multiplied by three and then add that to the low of today,
then this is more sensible. For most people this gives them
such a small position size that its unattractive. Most traders
arent interested in gains of 10% in the short to medium term
but are looking at 30% plus which is often unrealistic.
The incentive is always there to over-gear because there are
plenty of stories out there of how someone has converted
$1000 into $10,000 in six months. The fact is that a six month
track record doesnt mean much and doesnt prove that you
are a good trader and will make money in the future. For me,
trading success is probably 60% money management and
40% strategy. The latter comprises the entry and exit criteria
although I think the exit criteria are ultimately more important. In a trending market it is possible to make money by
buying the close everyday with a days range as a stop. This is
an entry strategy that is very simple. When to stop buying the
close and when to exit the position are much more difficult
decisions to make
TA: How do you determine what stop losses to use?
JM: I tend to use wider stop losses as it suits my trading style.
As a measure of volatility I use the 5 day average true range.
I can then use twice or three times that depending on market
conditions and other factors. The big advantage of having
wider stops is that it forces you to take a less geared position.
It also makes you pickier about your trades so you dont overtrade which is always a good thing.
Although setting the right stop losses is vital, I would stress
that of equal importance is how much capital is being used
each trade and the exit strategy. As I have said, too much
emphasis is placed on the entry. It is curious that in the extensive literature on trading available, money management and
the exit are topics which are rarely discussed despite them
being the most important ingredients of successful trading.
TA: What technical indicators do you think are most
valuable?
40
June 2008
JM: I especially like divergence because its an indicator of

sentiment and Im very sentiment focused. Jake Berstein and
Larry Williams have both done a lot of research into this area
and I pay a lot of attention to their forecasts and market
analysis. I also like the Welles Wilder Volatility Stop as its an
indicator of trend.
I think its important to recognize the best measures of market sentiment and then combine these with technical indicators. Without a sentiment overlay one could fall into the trap
of using technical indicators that are inappropriate for current market conditions.
TA: To what extent do you backtest your strategies?
JM: I consider backtesting to be very important and have
done a lot of work on various set ups involving pattern
recognition. However, I have two caveats when it comes to
testing: firstly, I believe it is important to avoid the temptation
to optimize. Just because a strategy has worked in the past
doesnt guarantee it will be effective in the future. Secondly,
has the nature of the market changed from the backtest period? For example, the advent of 24 hour markets has removed
a lot of the emotion that used to happen on the open and
close of a market. There would be heavy volumes at the
beginning and end of the day and the middle would be quite
quiet. These spikes in volume have been reduced by 24 hour
trading so the focus on the opening and closing prices has been
reduced. This means there are not as many gaps in price and
those that do exist are not as great as they used to be.
TA: Ultimately, does technical trading come down to
knowing when to use, and not to use, an indicator?
JM: Yes because with any indicator there are judgment calls.
Actually, I suspect that using technical analysis alone will not
provide sufficient information to trade and make money.
Nevertheless, give a good trader only an average indicator and
that individual should be able to make money from it. But
dont place too much emphasis on technical indicators;
remember, dont over-gear the position, keep stop losses
wide and have a philosophical basis behind all trading decisions. This paves the way for the trader to make money and
be successful.
Research Update
Ten Day Horizon for SMA

Moving averages are at their most effective when forecasting what will happen in
the next ten days, according to Camillo
Lento of Lakehead University in Canada,
who in one of his three papers mentioned in this section - has been examining the ability of simple moving averages
to forecast security returns. Five moving
average variants were used to develop a

forecasting model using OLS regression
for the DJIA, NASDAQ, TSX and CADUS exchange rate. The forecasting model
was compared to the random-walk model
without a drift and tested out-of-sample.
The results suggested that moving averages have no predictive ability on any of
TESTING COMBINATIONS
cludes that only the moving average

crossover and a few other trading rules
are able to outperform a buy-and-hold
strategy by themselves. However, he managed to generate excess returns by
employing a Combined Signal Approach
(CSA) which was statistically confirmed
through bootstrap simulations and
proven as robust through sub-period
analysis. The Combined Signal Approach
comprises three trading strategies: moving average crossovers; filter rules and
trading range break-out rules, whereby a
Academic studies of technical analysis are

often criticised for their simplistic
approach, tending to test one strategy at a
time rather than testing a strategy based
on a combination of studies and tools, as
is usually done in practice. The same
Camillo Lento has recognised this weakness and in another of his papers looks at
a combined signal approach to technical
analysis on the S&P500. Over a 59 year
period from 1950 to 2008 he con-
the four indices with a lag of 1 day.

However, moving averages explain
approximately 45% to 48% of the variation in the returns in the following 10
days and clearly outperform the randomwalk model. Most of the forecasting ability was derived from the MA (5, 150).
Lento, Camillo, Forecasting Security Returns
with Simple Moving Averages, (2008).
long (short) position is taken if two or
more of the total of 9 trading rules suggest a long (short) position. When x
equalled 2 or 4 (i.e. 2/9 or 4/9), the CSA
performed the best in terms of returns
after transaction costs. The CSA 2/9 was
particularly able to earn excess returns in
all three sub-periods with a relatively stable Sharpe Ratio.
Lento, Camillo, A Combined Signal Approach
to Technical Analysis on the S&P500,
(2008).
DOUBLING UP
TA in Asia
Another paper that looks at combining

signals focuses its attention on the commodity futures markets. According to an
Anglo-French team of researchers from
City University and EDHEC, momentum
signals and term structure signals generate
excess returns of 10.1% and 12.7%
respectively when implemented individually. Staggeringly, when combined into a
double-sort commodity-based tactical
trading strategy they produce a return of
21.0% which the authors calculate would
still be profitable net of transaction costs.
In terms of the rules, the momentum
strategies were based on 1, 3, 6 or 12
month ranking periods, whereby the portfolio goes long the highest quintile and
short the lowest quintile. The term structure strategies were based on going long
futures that are in a backwardated market
and short futures that are in a contangoed
market, whereby the strategy goes long
the quintile with the highest positive rollreturns and short the quintile with the
most negative roll-returns.
Technical trading rules work for the

Asian-Pacific equity markets. This is the
conclusion of Camillo Lento who has
carried out tests on nine technical trading
strategies in eight Asian-Pacific equity
markets for periods ranging from January
1987 to November 2005. The rules tested were moving average crossovers, filter
rules (momentum strategies) and trading
range break-out rules. His results show
that 56 out of the 72 (78%) trading rule
variants tested on all the data sets were
profitable after accounting for transac-
tion costs. The moving average

crossovers performed the best in general
and the MAC (1, 50) performed best in
particular generating annualised excess
returns of 1.8 to 32.6 percent. Subperiod
analysis, however, showed that many of
the rules were not robust and included
significant risk.
COMPLEX RULES
tion costs into account, they found that

the best rules for NASDAQ Composite
and Russell 2000 outperform the buyand-hold strategy in most in- and out-ofsample periods. They also found that
complex trading strategies are able to
improve on the profits of simple rules
and may even generate significant profits
from unprofitable simple rules.
Fuertes, Ana-Maria, Miffre, Joelle and Rallis,

Georgios, "Tactical Allocation in Commodity
Futures Markets: Combining Momentum and
Term Structure Signals", (April 2008).
Complex rules are more profitable than

simple ones. This is the conclusion of
Po-Hsuan Hsu and Chung-Ming Kuan
who looked at what they describe as a
more complete universe of trading
strategies. They tested the profitability of
these rules and strategies with four main
indices and found that significantly profitable simple rules and complex trading
strategies do exist in relatively young
markets (NASDAQ composite and
Russell 2000) but not in the data from
relatively mature markets (DJIA and
S&P500). Moreover, after taking transacJune 2008
Lento, Camillo, "Tests of Technical Trading

Rules in the Asian-Pacific Equity Markets: A
Bootstrap Approach", (2008).
Hsu, Po-Hsuan and Kuan, Chung-Ming,

"Reexamining the Profitability of Technical
Analysis with Data Snooping Checks, Journal
of Financial Econometrics, Vol. 3, No. 4, pp.
606-628, 2005.
41
Research Update
Stock Moves in World Cup

Its well documented that during World
Cup football competitions, the stress of
the fans of a losing country leads to
extreme phenomena, e.g. an increase in
heart attack rates, changes in workers
productivity, and so on. Two researchers
from Bar Ilan University and the Hebrew
University of Jerusalem show that alongside the local effect, the World Cup is also
associated with a long lasting global effect
in financial markets, i.e. with substantial
low returns in the US stock market.

Investigating eleven World Cup events
during a period of 41 years, reveals that
the average return on the US market over
the World Cup's global effect period (i.e.
about 40 trading days during and after the
games) is -6.25% (-46.6% annually!) relative to +1.27% (10.6% annually) corresponding to the all-days average return
for the same period length. These results
are statistically highly significant and sta-
IRRATIONAL
DIVERSIFICATION
Highs and Lows
Managers have a tendency to exclude

choice alternatives that are unattractive
when held in isolation, despite their
attractive diversification benefits,
according to a portfolio construction
experiment. Moreover, the two
researchers from Erasmus University in
the Netherlands found that there is a
tendency to divide available funds
equally between the remaining alternatives. This strategy is applied even if it
leads to allocations that are dominated
by first-order stochastic dominance.
Framing the decision problem to
emphasize potential diversification benefits leads to significantly improved allocations.
Trading volumes rise on price highs and

lows in a predictable manner, according
to two US-based researchers from
Rutgers University. Mizrach and Weerts
have established a positive relationship
between abnormal turnover and the
event of breaching n-day highs and lows.
The research, based on NASDAQ and
NYSE data, found that even after controlling for news about earnings, dividends, and analyst recommendations,
turnover rises on n-day highs and lows,
and is an increasing function of the time
frame n. Moreover, turnover persists
after the event day for at least two weeks,
positively for the highs and negatively for
the lows. As such, the researchers suggest
ignoring the trend when n-day highs are
Baltussen, Guido and Post, Thierry,

"Irrational Diversification: An Experimental
Examination of Portfolio Construction",
(December 2007).
ble under rigorous robustness checks.

Kaplanski and Levy suggest an investment strategy to exploit this effect, in
which one reduces equity exposure to
zero over the World Cups global effect
period.
Kaplanski, Guy and Levy, Haim, "The Global
Effect of the FIFA World Cup on the Stock
Market", (November 2007).
achieved (because of continuing

turnover/momentum effects) and being
contrarian on n-day lows. New lows provide abnormal returns for up to 6 trading
days.
Mizrach, Bruce and Weerts, Susan, "Highs and
Lows: A Behavioral and Technical Analysis",
(November 2007).
All papers are available from the Social Science Research

Network, SSRN, www.ssrn.com
PAIRS TRADING
Is it possible to improve on the Pairs
Trading strategy by introducing greater
complexity? In a paper entitled M of a
Kind, Marcelo Perlin of the ICMA
Centre, University of Reading, suggests a
multivariate version of pairs trading,
which tries to create an artificial pair for a
particular stock based on the information
of m assets, instead of just one. The performance of three different versions of
the multivariate approach was assessed
for the Brazilian financial market using
42
daily data from 2000 to 2006 for 57

assets. After taking into account transaction costs, performance was assessed
based on raw and excessive returns, beta
and alpha calculations, and the use of
bootstrap methods for comparing performance indicators against portfolios
built with random trading signals. The
main conclusion of the paper is that the
proposed version was able to beat benchmark returns and random portfolios for
the majority of the parameters. The perJune 2008
formance was also found superior to the

classic version of the strategy. Volatility is
quite high, however, but this is compensated for by high positive returns, and as
such the results are supported by positive
annualized sharpe ratios.
Perlin, Marcelo Scherer, "M of a Kind: A
Multivariate Approach at Pairs Trading"
(December 2007).
Book Review
THE ENCYCLOPEDIA OF
CANDLESTICK CHARTS
T
By Thomas N. Bulkowski
Published by Wiley
227 pages
ISBN 0470182016
80.00
here are relatively few books available on candlestick charting which is perhaps surprising given the popularity of the technique. By far the most famous author on the subject is Steve Nison with his famous book Japanese Candlestick Charting Techniques
(Prentice Hall) which is perhaps the definitive book on the subject. However, whenever a single volume tends to dominate a subject, there is often much to be gained from a fresh perspective.
Thomas Bulkowski is a US based trader who now runs a consultancy specialising in pattern
recognition research. His last book was the mammoth Encyclopaedia of Chart Patterns
(Wiley) which broke new ground in its exhaustive description and study of most of the well
know (and many lesser know) price patterns. This new book, focusing exclusively on candlestick formations, is in a similar vain.
Candlestick charting is really a subject in itself because a trader using this technique is for all
intents and purposes self sufficient from a TA perspective. Because there exists a candlestick
pattern for every market condition and situation, he or she has little need to adopt additional
technical analysis strategies, except perhaps for the odd moving average overlay. It is for this
reason that more research has been needed into the effectiveness (and profitability) of the
numerous candlestick patterns that exist.
Bulkowskis book contains in-depth coverage of around 100 candlestick patterns or signals.
Each chapter covers a single pattern and offers a detailed description, market examples, guidelines to identification and suggested trading techniques. These may include such analysis as to
whether a pattern works best as a continuation or reversal, how they perform when used with
moving averages, and if they provide effective signals prior to breakouts. For example, the Doji
is one of the best know candlestick formations. Bulkowski lists more then eight versions of
the Doji along with performance statistics, best trading conditions and even statistics on variations of the pattern, i.e Dojis with long upper shadow or short lower shadow. The publication of candlestick analysis to this extent is, to my knowledge, unique.
After having analysed almost 5 million candlesticks, Bulkowski also ranks the top 15 performing candlestick patterns in each of several different scenarios including best overall performance, bull market reversals, bull market continuation etc. Also included at the end of the
book is a very useful visual index of every candlestick pattern discussed in the main text.
Some readers may take issue with some of the authors testing statistical methods for each
pattern. While each pattern is backtested, it is done in fairly simplistic terms and doesnt go
into details of trade set-ups so excludes such statistics as the number of winning trades, P&L
and drawdowns from trading a particular pattern. Furthermore, he doesnt establish confidence
limits for his tests and look to establish if his results could have occurred by chance.
Despite these drawbacks, Bulkowskis book is undoubtedly a valuable addition to the limited literature available on candlestick charting and should become essential reading for any trader who uses candles on a regular basis.
June 2008
43
Book Review
TOP TEN BOOKS

7 Chart Patterns that
Consistently Make Money
Ed Downs
Published by Traders Library
ISBN: 1883272610
Swing Trading
Mark Rivalland
Published by Harriman
House
ISBN: 1897597193
Technical Analysis of the

Financial Markets
John Murphy
Published by NYIF
ISBN: 0735200653
The Definitive Guide to

Point and Figure
Jeremy du Plessis
House
ISBN: 1897597630
Come into My Trading

Room: A Complete Guide
to Trading
Alexander Elder
Published by Wiley
ISBN: 0471225347
The Complete Guide to

Point and Figure Charting
Heinrich Weber and Kermit
Zieg
House
ISBN: 1897597282
Martin Prings
Introduction to Technical
Analysis
Martin Pring
Published by McGraw Hill
ISBN: 0070329338
Ichimoku Charts
Nicole Elliott
House
ISBN: 1897597843
The UK Traders Bible:

The Complete Guide to
Trading the UK Stock
Market
Dominic Connolly
House
ISBN: 1897597398
Investors Guide to
Charting
Alistair Blair
Published by FT Prentice
Hall
ISBN: 0273662031
Source: Global-Investor.com. All of the above books are available from the Global Investor bookshop at a discount. Please
call +44 (0)1730 233870 and quote "The Technical Analyst magazine".
44
June 2008
OVERVIEW OF TODAYS ALGORITHMS:

ADVANCED STRATEGIES FOR A COMPLEX MARKETPLACE
By Harrell Smith
Over the past several years, structural, economic, technological and regulatory forces have fundamentally reshaped the global equity markets. In the
US and Europe, competition has increased, new types of execution venues have materialized, order sizes have plummeted and volumes have
surged. As a result, firms today face a global marketplace that is fractured, technology-driven and complex.
To help clients operate in this new trading environment, brokers and independent technology vendors have
rolled out increasingly sophisticated
trading tools. Among these are a growing number of algorithmic trading
strategies, ranging from basic algorithms such as VWAP and implementation shortfall to advanced strategies
that address more specific trading
requirements (i.e. sourcing liquidity
from crossing networks and dark pools,
automating share buybacks, etc.).
Virtually all leading broker dealers,
agency brokers and trading technology
vendors offer a full complement of
algorithms from which clients can
choose.
Unfortunately, the sheer number of
strategies out there can lead to confusion among end-users. Furthermore,
the names that brokers have bestowed
on their more advanced algorithms
may sound impressive, but in most
cases they have nothing to do with the
algorithms themselves. (If you have
never used EdgeTrades Sumo algorithm, Credit Suisses Guerilla or
Goldmans Port-X, you would be
hard pressed to explain exactly what
they do based on their names.) As
such, it is useful to examine the markets current crop of algorithms and

draw some distinctions based on their
complexity and type of problem they
seek to address.
Basic execution strategies
Only a few years ago, most brokers had
no more than three or four algorithms.
Among these were relatively standardized strategies that sought to return
executions tied to industry benchmarks
or provided simple slicing and dicing
services linear algorithms whose
value lay in automating simple but fairly repetitive tasks.
VWAP. The most well known algorithm in the market today. VWAP
(Volume Weighted Average Price)
attempts to execute an order along
the historical volume curve of the
selected security. The typical equity
volume curve for liquid securities is
called a smile as the most volume
tends to trade near the open and
close, and the least volume is traded
midday.
VWAP strategies are
designed to trade to the end of a set
period, so they have to manage the
inventory of the order to ensure that
there is always a suitable amount left
June 2008
to trade (based on historic trends).

Because of this constraint, VWAP is
not an appropriate strategy for securities with unpredictable volume
curves, or during periods of unusually high volatility.
TWAP. TWAP (Time Weighted
Average Price) executes an order
evenly over a user defined time period. Like VWAP, this strategy manages the inventory of the order
through to the end of the user
defined period. Unlike VWAP,
scheduling is done on an even basis
during the chosen period, rather
than trying to anticipate the volume
curve of the period as VWAP does.
TWAP gives an even exposure to a
chosen period, but runs higher risks
of market impact as it makes no
allowance for predicted volume
curve as VWAP does.
Inline/participate/percentage of
volume. Inline algorithms are also
fairly straightforward. They seek to
execute an order in line with the
market as a percentage of current
order book volume (as defined by
the user).
Implementation shortfall. An
implementation shortfall algo-
45
46
June 2008
NOT ALL DARK LIQUIDITY POOLS MAKE

THEMSELVES AVAILABLE TO BROKER
ALGORITHMS
rithm seeks to minimize the difference (also known as slippage)
between an orders decision price
(i.e. the price that prompted the
trader to submit the order) and the
actual execution price, while also
taking into account market impact.
As such, execution is normally
skewed towards the time the order
was submitted, creating a downward
sloping
participation
curve.
However, most implementation
shortfall algorithms allow the user to
enter different levels of aggressiveness, flattening or steepening the
curve.
Order routing strategies.
So-called smart order routing algorithms, or smart routers, are designed
to manage the execution of a single
order across numerous exchanges,
ECNs and ATSs, employing logic that
takes into account the characteristics of
each destination (e.g. displayed versus
hidden size, depth of book, speed, etc).
Recent structural and regulatory
changes have made smart routers
increasingly popular.
MiFID focused algorithms.
Firms in Europe have been touting
their smart routers as of late following the introduction of MiFID,
which has lead to increased market
fragmentation and a renewed focus
on best execution. In the US, the
introduction of RegNMS and the
Trade through rule forces market
centers to route orders to the public
market showing the NBBO, which
has taken some of the value out of
smart routers (with some exceptions,
notably for smart routers that seek

out non-displayed liquidity). MiFID,
however, does not define best execution so narrowly. Brokers can take
any number of factors into account
when establishing best execution
practices. As a result, MiFID
focused order types and algorithms
can offer clients significant value
added execution.
Dark/block/non-displayed liquidity algorithms. In the US, the
explosion of dark pools and crossing networks has lead brokers and
vendors to create a new class of
smart routers that help clients locate
block liquidity efficiently. It should
be noted, however, that not all dark
liquidity pools make themselves
available to broker algorithms. In
addition, while many broker dealers
have rolled out their own dark pools,
these are more accurately defined as
portals to brokers internalization
engines.
Advanced and highly specialized execution strategies.
This group of algorithms includes just
about any algorithm that does not fit
into one of groups above. Examples
include an algorithm from EdgeTrade
that automates share buybacks, taking
into account the regulatory requirements of this type of trade.
Algorithms designed for non-equity
asset classes, particularly FX, would
also fall into the advanced category.
(However, given the rapid uptake in
non-equity algorithmic trading, it will
not be long before these algorithms
become fairly common.)
June 2008
The markets are constantly evolving.

Liquidity is becoming more fractured,
volumes are on the rise, new regulatory
requirements are being introduced,
additional assets classes are moving
into the electronic medium, and technology is playing a greater role in the
trading process than ever before. In
response, brokers and vendors are
rolling out new algorithms to meet
their clients increasingly advanced
trading requirements. Of course, algorithms are only part of this toolset,
which also includes advanced pre- and
post-trade transaction cost analysis and
advanced trading systems that consolidate liquidity, allowing traders to access
any and all trading points from a single
trading interface. In todays environment, it is incumbent on firms to adopt
a range of tools that will let them navigate and exploit this new marketplace.
Harrell Smith is Head of Product

Strategy at Portware, LLC.
47
Training Courses
INTRODUCTION TO TECHNICAL ANALYSIS
Training with The Technical Analyst

The Technical Analyst offers a range of
exciting training courses for traders and
investment managers. We also offer
specialist in-house training on request.
The essential technical analysis course providing a thorough

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managers new to the subject.
20 August
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Course Details
SHORT TERM TRADING WORKSHOP (2 DAYS)
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Who Should Attend:
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Our very popular course for all market professionals looks at a

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22/23 October
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ADVANCED TECHNICAL ANALYSIS (2 DAYS)

Principal Trainer
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Trevor Neil became a
commodities trader at Merrill
Lynch in the mid 1970s
before going on to work
at LIFFE giving technical
analysis support to floor traders.
In 2000 he became head of technical
analysis at Bloomberg where he was
responsible for training and technical
analysis software development.
This highly regarded 2-day course provides in-depth training

in the most effective technical trading strategies for more
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21/22 August
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TA FOR THE PORTFOLIO MANAGER

Recognising that portfolio managers and analysts do not need the
kind of technical analysis used by day-traders and dealers, this
course concentrates on market timing from a longer-term point
of view. This course is designed to give a timing overlay for
fundamental decisions.
25/56 November London
FURTHER COURSES
PAIRS TRADING
1 October
London
DEMARK INDICATORS
13 November
London
AUTOMATED TRADING WORKSHOP

12 November
London
CERTIFIED TRADING SYSTEM DEVELOPER
Qualification & training in systems development
(see website for details)
Full course details can be found at: www.technicalanalyst.co.uk/training

For further information email: training@technicalanalyst.co.uk
Register online at: www.technicalanalyst.co.uk
or call: +44 (0) 207 833 1441
GET QUALIFIED IN TECHNICAL ANALYSIS

The Society of Technical Analysts (STA) represents and accredits
professional and private Technical Analysts operating in the UK
Originally established in the 1960s, the STA provides its members:

Education
Monthly lectures and regular teaching courses in technical analysis
Research
The STA Journal publishes research papers on TA techniques and approaches
Meetings
Provide members the opportunity to discuss technical approaches and markets
Representation The STA lobbies on behalf of analysts with data vendors, exchanges and regulators.
The STA represents the UK at the International Federation of Technical Analysts (IFTA)
Accreditation
The STA Diploma Exam is internationally recognised as a professional level qualification

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For more information on how to join and what is involved in passing

the STA Diploma exam, visit our website at: www.sta-uk.org or call
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AUTOMATED TRADING SYSTEMS

THE TECHNICAL ANALYST

THE TECHNICAL ANALYST

Figure 1. S&P500 sector performance

Figure 2. S&P Energy Sector

Bullish energy sector

DESPITE SOME OVERBOUGHT CONDITIONS [IN THE

THE TECHNICAL ANALYST

The sector has been outperforming the S&P500 since

Figure 4. S&P Industrials Sector

Figure 3. S&P Information Technology Index

Technology a leading indicator

Telecoms face resistance

Figure 5. S&P Telecom Services Sector Index

Materials see new highs

decline after it registered a record high of 318.74 in June last

Figure 8. S&P Consumer Discretionary Sector Index

Figure 7. S&P Health Care Sector

The early January sharp rally on the relative performance

THE TECHNICAL ANALYST

Figure 9. S&P Consumer Staples Sector Index

decline on the relative performance charts. The outlook of

bull trendline. Since establishing a high in January following a

Figure 11. S&P Utilities Sector

Figure 10. S&P Financial Sector Index

Utilities possible strength ahead

Kamran Sheikh is technical analyst with Informa

AFTER A NOTABLY WEAK START TO

THE TECHNICAL ANALYST

THE TECHNICAL ANALYST

Emerging Markets Outlook

TA: Do you believe there is a decoupling between US

THE TECHNICAL ANALYST

On 23 April this year,

for how long.

Do Current Oil Prices

Leo Drollas, Centre for

but they are still driving their cars

Tim Guinness, Guinness Atkinson

The Changing Profile of

THE TECHNICAL ANALYST

Oil Prices: Are capacity constraints to blame?

THE TECHNICAL ANALYST

cases are calculated depending on

tion is now how much of this can be

THE TECHNICAL ANALYST

like to think about volume as the

will react unexpectedly when the actual

More strength, lack of interest by

More buying by professionals the following