FRED GOODMAN'S KEY INDICATORS
FOR INVESTMENT SUCCESS
The Technical Trading Model
Tuesday, February 12, 2003
Updated Thursday, November 11, 2004
Updated Monday, August 21, 2006
where it all comes together -- the grand synthesis of all Fred's
Technical analysis is a great way to use objective indicators
to bring scientific methods and disciplines to trading and investing.
But there has always been a nagging problem -- how does the technical
analyst integrate diverse indicators into a coherent decision about
- Which indicators
are most important?
- What do you do when
they contradict each other?
- How about when a
reliable indicator suddenly has a cold streak?
- How do you resolve
short-term and intermediate-term trends in the market?
My answer has been to
develop a comprehensive Technical Trading Model. It consists
of three modules:
- the intermediate-term
Summary Index as a way is synthesizing 29 diverse technical
indicators into a single "super indicator"
- the short-term
Quick Summary Index as a way of catching volatile shifts in
the technical condition of the market
- the Trend Indicator
as a way of translating the buy and sell signals from the SI and
the QSI into actual trading decisions, and
- the Low
Volatility condition in which the short-term Quick
Summary Index is ignored and only the intermediate-term indicator
is acted upon.
It all began in 1979
when -- having already been active in the stock market for 19 years
-- I had the idea that a group of indicators acting together, would
have much more significance than any of the components. To test
out this theory, I started looking at a summation of 8 broad
market barometers including the Dow, Dow volume,
S&P 500, NYSE, Value-Line and the futures
contracts traded on the last three. To remember these components,
I am now looking at a program I wrote in BASIC at that time, 23
I found merit in the
concept. But I didn't really bring it to fruition until I started
the Summary Index (or SI) in December, 1998, as a means
of generating my most important intermediate-term buy signals
and intermediate-term sell signals. Then last week I created
the Quick Summary Index (or QSI), as a way of integrating significant
short-term changes in the market's technical condition. Taken
together, the Summary Index and the Quick Summary Index have a most
impressive track record -- as you will see in a moment.
HOW DOES IT WORK?
Today the SI and the QSI include 29 indicators -- all
the ones I write about every day in my report, and more. Every day
I count the number of indicators that are bullish, bearish
For the Summary Index,
I smooth the counts with a simple smoothing algorithm, and
scale them to fit a consistent range of output values. The
smoothed, scaled net difference between each day's positive
and negative indicators is each day's Summary Index value.
For the Quick Summary
Index, I simply count each day's negative and total positive
indicators, and look at the raw value of both counts -- I
neither smooth, scale nor look at the net difference. Therefore,
the QSI is much more sensitive to short-term changes in the indicators.
The chart below, a
version of which has appeared daily in our reports for years, shows
the Summary Index in dark blue and the S&P 500 in maroon,
with all of the buy signals and sell signals produced during the
last 5 years as red and green triangles. The Quick Summary Index,
appears as a series of red and green spikes that pop up from time
to time above the 17 level on the scale of the Summary Index. The
QSI buy and sell signals appear as red and green triangles with
black borders around them.
| Summary Index of 29 Indicators
Through Tuesday, December 23rd >>Learn
HOW ARE BUY AND SELL
SIGNALS GENERATED? Buy signals are generated
when there is an extreme of negative indicators, and sell
signals are generated when there is an extreme of positive
It may seem paradoxical
that we would get a sell signal when there is a preponderance of
bullish indicators -- and a buy signal when there is a preponderance
of bearish ones. But it makes sense if you think of each indicator
as giving a valid buy or sell signal at a point in time -- but then
as time goes on, the effectiveness of the signal attenuates even
before it officially reverses.
Consider, for example,
a simple new high/new low indicator. When the number of new
highs suddenly picks up and the number of new lows starts to decline,
we are alerted that there has been a bullish change in the market.
This constitutes the indicator's buy signal. This is followed by
an acceleration in the number of new highs and a sharp drop in the
number of new lows that shows that we were right when we first noticed
the improvement and got the signal. However, that is not the buy
signal, just its confirmation. After that there is a period
during which the rate of change decreases, and that may or may not
turn into a sell signal -- it may just be a temporary pause. It
is not until the number of new highs starts declining and the number
of new lows starts rising that a sell signal is given.
The same is true for
many indicators. We look for a change in direction from an extreme
level as the buy or sell signal. Such a change reflects the
exhaustion of a move in one direction and the birth of a sustainable
move in the other. The period in between signals is simply confirmation.
ARE THE SPECIFIC RULES FOR BUY AND SELL SIGNALS?
Index buy signal is generated when the SI falls
below 4.5 and then rises back above 4.5. Conversely,
a Summary Index sell signal is generated when the
SI rises above 17.0 and then drops back below 17.0.
A Quick Summary Index
buy signal is generated when the total number of negative
indicators reaches 19, and then drops to 16 or below
-- or when the total number of positive indicators
falls to 3, and then rises to 7 or above.
A Quick Summary Index sell signal is generated when the
total number of positive indicators reaches 19, and
then drops to 16 or below -- or, when the total number of
negative indicators falls to 3, and then rises
to 7 or above.
HOW DO THE TWO INDICES
WORK TOGETHER? In my Technical Trading Model, Summary
Index buy and sell signals require no confirmation from the Quick
Summary Index. But not vice versa.
For a QSI buy
signal to be acted upon, there must already be an SI sell
signal in effect (otherwise the QSI buy signal would be meaningless)
-- and the SI must not be below the buy trigger level of 4.50 (which
means it's not on the verge of giving its own buy signal). For a
QSI sell signal to be acted upon, there must already be an
SI buy signal in effect -- and the SI must not be above the
sell trigger level of 17.00.
There are also rules
for ending a QSI buy or sell signal. When a QSI signal ends,
the SI signal then in force takes precedence. A QSI buy signal
ends if there is an SI sell signal; if the number of positive
indicators reaches 19, and then falls to 16 or below (unless at
the same time the SI is above 17); if the number of negative
indicators goes back above 17; or if the S&P 500 closes below
a trailing stop-loss set at 4% below the highest closing
level achieved following the QSI buy signal. A QSI sell signal
ends the same ways -- but the opposite.
TRADING ON THE BUY
AND SELL SIGNALS To turn the signals from the Summary
Index and the Quick Summary Index into actual trading decisions,
I rely on the Trend Indicator. The TI gives me the long-term
technical condition of the market, and determines how much risk
I am willing to take on a given signal from the SI or the QSI.
The Trend Indicator
is derived from the S&P 500 and its 200-day moving average, scaled
to fit the 4.5 and 17 trigger levels of the Summary Index. Based
on the position of the Trend Indicator, I can determine whether
the market is in a long-term uptrend, a downtrend, or one of two
Here are the four possible
states of the Trend Indicator:
1. Uptrend (green
sections in the chart above): When the Trend Indicator crosses
above the mid-line at 10.75, the market is in an uptrend.
2. Neutral-Up (blue
sections): When the Trend Indicator makes a high above 17 and
turns down, the trend is considered to be neutral following
an uptrend, or neutral-up.
(red sections): When the Trend Indicator drops below the mid-line
the trend is down.
4. Neutral-down (orange
sections): Once the Trend Indicator makes a low below 4.5 and
turns up the trend is considered neutral following a downtrend,
Research has shown that
Summary Index and Quick Summary Index buy and sell signals behave
very differently depending on which Trend Indicator state is in
force at the time the signals are given.
- As you'd expect,
the success rates and the highest average gains have been for
SI buy signals during Trend Indicator uptrends, and SI
sell signals during Trend Indicator downtrends.
- The worst success
rates and the lowest average gains -- indeed, they are losses
-- were for SI buy signals during Trend Indicator downtrends,
and SI sell signals during Trend Indicator uptrends.
Therefore, our Technical
Trading Model calls for putting more money at risk on buy and sell
signals that are in harmony with the current state of the Trend
Indicator -- and less money at risk, or none at all, when the signals
are in conflict. The table below shows the percentages of portfolio
value that we will allocate to equities -- either on the long side
or the short side -- in our two Technical Trading Model portfolios,
depending on the how the state of the Trend Indicator interacts
with SI and QSI buy and sell signals.
- Note that we put
200% equity at risk in the two situations that are technically
the strongest: SI buy signal during a Trend Indicator uptrend,
and SI sell signal during a Trend Indicator downtrend.
- We make up for that
by having lower-than-100% exposure the rest of the time. I calculate
that, over time, a strategy of trading the S&P500 this way
ends up with about the same overall risk as a buy-and-hold position
in the S&P 500.
Rules for Trading Low Volatility Markets
THE TRACK RECORD
Our Technical Trading Model -- using the buy and sell signals
of the Summary Index and the Quick Summary Index based on the state
of the Trend Indicator -- shows excellent performance in backtesting.
The actual levels of the Summary Index were produced in real time
during the periods indicated. The application of the SI's history
to this particular trading strategy has been optimized by backtesting.
Remember, neither past performance nor backtested performance are
a guarantee of future returns.
Combining the SI, the
QSI and the TI into a single Technical Trading Model from December
31, 1998 -- buying the S&P 500 at each buy signal and shorting
it at each sell signal -- has produced the excellent compound annual
returns shown in the chart below. Trading the NASDAQ 100 instead
has produced even better returns. See the paragraph below the chart
for important methodological disclosures.
The table below shows
a detailed breakdown of the track record of the Technical Trading
Model: This table is updated daily.
Here are the results
of the Summary Index and Quick Summary Index buy and sell signals,
assuming buying at every buy signal and shorting at every sell signal,
constructed from historical data based on the rules given above.
The following returns assume that the S&P 500 Index was traded
at its closing price the day of each signal. In practice, one would
have to wait until the following day to trade. No commissions or
other trading costs are considered. At the same time, there is no
interest income assumed on cash balances during sell signals. This
chart is updated daily.
you know, I'm a skeptic. So first, remember -- once again, past
performance is no guarantee of future returns. And remember that
your utilization of this and any other investment tool should depend
upon your understanding of the risks and upon your own financial
situation and experience.
Fred Goodman, CFP, is a fee-only
Certified Financial Planner based in Los Angeles. You can send him
your questions and comments via email at Fred@MarketMonograph.com.
The charts and commentary represent what Fred is thinking about
the market and thinking of doing for his own account and for accounts
he manages. There is no guarantee that you will profit from trading
as discussed herein. You may lose money and Fred assumes no responsibility
for what you do or do not do with this information.