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Monday, September 3, 2012 - 08:00
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Monday, September 3, 2012 - 08:00
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Monday, September 3, 2012 - 08:00

An Indicator With a 110-Year Record Success Says 'Buy'

Monday, September 3, 2012 - 8:00am

Today, I want to cover a popular market ETF that is a strong buy based on a momentum indicator that most traders ignore and a bullish chart pattern. While few traders follow this momentum indicator, it has a backtested history of consistent success since 1900.

Traders should never rely on a single indicator in their analysis. They should use at least two indicators, and each indicator should be independent of the other. A very simple but useful analysis can be done with a short-term momentum indicator that is used to time entries when the chart pattern is bullish.

There are a number of different momentum indicators and almost any of them can be used effectively. But some will provide more timely signals than others, and my favorite momentum indicator for timely buy signals is Williams Percent Range (%R). The formula for this indicator is similar to the formula used for the more widely followed stochastic indicator. But there is only one line used in the %R indicator and it can be used as a way to time trades and as a way to define the trend.

Because there is only one line used instead of two as in stochastics, there is less delay in the signals of %R. The calculation is done directly on the price rather than a moving average of the price like the relative strength index (RSI) or moving average convergence divergence (MACD) uses. This factor also contributes to the timeliness of %R compared to more widely used indicators.

For market timing signals, Bollinger Bands can be added to %R. Bollinger Bands are drawn to include all of the normal market action. When the indicator is outside of the bands, we have a sign that something unusual is happening in the market. In the case of %R, when the indicator falls below the lower band, the market is unusually weak. When the indicator bounces back above the lower band, it is a buy signal.

Four recent signals are shown in the chart of SPDR S&P 500 (NYSE: SPY) below. Each would have been profitable in the short term.

Backtesting shows that SPY has been higher a month after this signal about 60% of time since SPY started trading. These buy signals are seen an average of five times a year, and holding SPY only in the month following a buy signal would dramatically lower your risk by about 80% when compared to a buy-and-hold investor.

The Dow Jones Industrial Average offers more than 110 years of history for testing, and the buy signals show very similar results over that time frame -- about 60% of the trades are winners and risk is reduced by about 80% when compared to a buy-and-hold strategy.

We can also use %R to determine the direction of the trend. Using a weekly chart, if %R is above 50, then the price is in an uptrend, and downtrends are in place when the indicator falls below 50. This is shown in the chart below. We can also see that the indicator generally reverses direction before prices do, offering a warning that the trend is about to change.

With %R at about 58 on the weekly chart, the trend is up. On the daily chart, the indicator is on a buy signal, and that indicates SPY is likely to continue moving higher into late September.

The price pattern for SPY is bullish and allows us to develop a price objective. During the past five months, SPY has been forming a rounding bottom pattern or a cup-and-handle. Different traders will see different patterns in most charts, but both of the possible patterns in this case have the same price target of about $153, about 8.2% above the current price of SPY.

To manage risk, traders can use a stop-loss of $140. This is very close to the current price, but it is the low of the day when the %R signal was given. If the price closes below that level, the signal no longer applies to the market and a larger loss is likely.

Action to Take --> Look for a good entry-level point on shares of SPY with a stop-loss call at $140 with an initial price target of $153.

Michael J. Carr does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.