Are small caps about to move?

This is the time of year one would expect relative quiet in the markets. After all, don’t all the big traders vacation in the Hamptons or the Caymans?

The seasonal charts of most of the major indexes and ETFs generally show no net bias over the next several weeks. This means there is no track record of strong net gains or losses this time of year. The word ‘net’ means ‘on average’. Of course there were individual years with notable gains or losses, but on average, there has been little net movement in the major indexes and ETFs over the next several weeks.

As I mentioned in this weeks’ StockQuirks The Week Ahead commentary, Notes for the week of August 6, 2012, the NASDAQ Composite, and the Russell 2000, do have slight positive seasonal patterns showing. We all know the overall market has a good track record in the fall (yes, even with 1987 and 2008 factored in). But the NASDAQ and Russell 2000 seasonal charts show that institutional traders may start accumulating smaller cap stocks before buying picks up on the big-name issues. I will focus on the IWM here. It is the ETF based on the Russell 2000, an index of small-cap stocks.

Chuck Hughes has won the World Champion Trader title seven times in recent years. His stock picking approaches are covered in countless web articles, YouTube videos, and books. The trading championships were real-money contests and Chuck is the only trader who publishes his actual trade statements and tax filings. The most interesting point about his successful trading approach is the simplicity of it. He is a trend-follower and he consistently generates impressive results.

Chuck’s primary determination of the trend is by using a 50-day Exponential Moving Average (EMA) and a 100-day EMA. When the 50-day EMA is above the 100-day EMA he considers the stock in an up-trend. When the 50-day EMA is below the 100-day EMA the stock is in a down-trend. He follows other indicators to further refine trade entry and exit. But his backtesting and actual trading results of the 50/100-Day EMA System show even short-term traders will benefit by trading in the direction of the indicated trend. (Chuck can be seen explaining his 50/100-Day EMA System at Chuck Hughes: The Fail Safe “EMA” System)

The 50/100-Day EMA System applied to the IWM generally shows long trending periods between crossovers. For example, in October 2008, IWM’s 50-day EMA crossed below the 100-day, confirming a sharp downward movement was occurring. When the 50 crossed above the 100 in May of 2009, it confirmed a strong up-trend that didn’t end until June of 2010.

50/100 EMA system on IWM, 2008-2010

You wouldn’t typically use the 50/100 crossover to enter a trade. Other indicators would function better for timing trade entry. You can use it to exit a trade as it provides a clear indication the trend has changed. It can also be used as a trade filter. When the 50-day EMA is above the 100-day EMA you should avoid bearish positions, and when the 50 is below the 100 you should avoid bullish positions. This simple filtering technique usually raises the success rate of directional trades.

In the chart above we see the 50/100 relationships gave a nice indication of the overall IWM trend during those two years. Moving up to the past two years, the 50/100 system continued to work well for indicating which side of the market you should have been on.

50/100 EMA system on IWM, 2010-2012

Looking back over all of IWM’s history (and most other stocks, indexes, and ETFs), the 50/100 relationship provided an simple, reliable way to determine which side of the market you should have been on. When you get nice, sharp crossovers, and stay in for most of the trend, certain option strategies can produce outstanding returns.

However, notice the past two months of IWM’s EMA’s – they are generally moving sideways without clean crossovers. In sideways phases any moving average crossover system will be vague. It is time to find other ways to analyze IWM. However, from looking at IWM history I know that any sideways phase is usually short, typically followed by a strong directional movement.

Looking at the daily chart and drawing trend lines I see that IWM trended down into June, rebounded during July, and now appears to be within another downtrend:

Daily IWM chart with recent trends
Chart courtesy of Worden – www.worden.com

I really want to wait for the 50/100 system to give a strong long or short indication. Then I will consider a larger option position, or layering-on of contracts. Until then, I want to focus on low-risk/decent-reward trades using small positions and tight stops. If a good chart pattern exists I can play a break-out, then add-on when the 50/100 confirms the trend.

IWM closed Friday near the top of the recent down-trending channel. IWM may stay in the down-trending channel for a while more, it may turn around and start forming an up-trending channel, or it may take off strongly either up or down.

My trade plan is to consider a small bullish trade if IWM closes above say 80 (that’s above the down-trending channel and the previous week’s high), especially if it is accompanied by high volume. I will consider a small bearish trade if IWM closes below say 76 (that’s below the down-trending channel and the previous week’s low), especially if it is accompanied by high volume. If the trend continues, and the 50/100 EMA’s form a confirmation, then I will consider adding to the positions and riding them (rolling-over if necessary) until the 50 crosses the 100 in the opposite direction.

All information is for educational purposes only.
Copyright StockQuirks, LLC. All rights reserved.

Article below submitted by Gregg Harris, of StockQuirks.com : a site dedicated to helping professional traders increase their odds of success.

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