Hedge vs Spec

Hedge vs. Spec:

Trading Strategies Based on
The Reversal System

© Martin A. Armstrong

One of the purposes of our Technical Trading Seminars over the years has been to illustrate how to develop your own trading techniques using the numbers provided on the daily and weekly reports. The recommendations provided in those reports are not the most aggressive strategies one can employ using the Reversals. In fact, the use of the Reversal system for hedging or aggressive speculation is totally different from conservative speculation.

The Reversal System maps out the market into areas of key support and resistance. If we look at the S&P 500 at the high in 1987, the Reversal System had mapped out the key levels to watch. The Daily Bearish Reversals were cluttered between 330 and 318. Then the major Weekly Bearish Reversals laid at 303 and a Double Reversal at 28610. There were no other Reversals to be found on the Daily or Weekly levels after 28610. The next level of Reversals began at 18100 on the Monthly model.

The Reversals System defined two gap areas: 318-303 and 286-181. Electing all the Daily Bearish Reversals brought us to the beginning of this first gap 318-303. Since there was nothing within that price area, it is logical to assume that eventually the market will gravitate down to fill that gap trying to find support which would then start again at 303. Once the price activity worked its way through that area penetrating 286, then another gap was encountered. This necessitated a move to the 181 level, which, in fact, occurred with the October ’87 low forming at 18130.

If we look at gold, the same equivalent weekly zone of support to that of the S&P’s 303-286 stood at $280.50 to $279.20. A gap followed that area down to the Monthly levels at $192.10 and $192.40. The 1985 low stopped on the Weekly levels forming the bottom precisely at $280.50. Had a weekly closing below $280.50 transpired, there would not have been much choice other than a panic decline to the $192 area.

These are only two examples of this “mapping” of key target areas within a market at major highs and lows. When we are dealing with minor highs and lows, the same mapping procedure unfolds but the gaps are more orderly. This is the majority of the time in price activity and therefore it is this strategy we will discuss here.

Let us set up a series of Reversals in gold as follows: 482, 454, 425, 398, 376, 342, 336, 320, 303, 280, 192. One strategy would be to sell on the execution of each Reversal and cover on the next. This would be used for more aggressive speculators and hedgers. Those looking for less aggressiveness and trading activity would sell upon execution of the Reversals and cover only when the corresponding Bullish Reversal is executed.

First, we will examine strategies for entering the market. For example, if 482 were a Weekly Bearish Reversal, then two possible orders can be implemented to establish a position in the market.
Entry Strategies:

1) Use a “Sell Stop Close Only” at 481.50. Stop limits are advisable — usually $5 in gold or 100–150 points in the S&P depending upon volatility.

2) Use an “Intraday Sell Stop” at 480.90 with a Protective Buy Stop Close Only at 482. 50. In addition, an “Intraday Protective Buy Stop” should be placed above the next whole number or previous week’s high which ever is lower. If the previous week’s high was 494 then use the whole number 490 placing the stop at 490.60.
Strategy 1 has some risks associated with it. During extreme volatility the order may not be elected. The market could close sharply lower beyond the limit. Strategy 2 will handle an extremely volatile period very well by getting you into a short position close to the key target area. But during quiet periods, a market could slightly penetrate the Reversal intraday and still close above it at the end of the day, thus avoiding execution. This poses some limited risks of loss when intraday penetration proves to be only a false move.

The above examples are the two primary methods of using the Reversal System for entering a market. They are simple to implement in most markets. However, in some markets you may find a broker who refuses to take “Stop Close Only” orders, particularly in bonds. Although this is not an official order for bonds, there are brokers who will accommodate such orders to get the business. Of course, this will be difficult or impossible for anything less than 5 lots.

The second strategy is the most important. Often traders find that entering the market is easy – when to get out offers the real problem. Many allow a profitable trade to run very short-term while inexperienced traders will allow their losing trades to run until the pain becomes too great. This is typical for beginning traders because one of the most difficult things for many of us is to admit when they are wrong. One hard and fast rule of thumb is to cut losses quickly and allow profitable trades to run until it starts to move more than 1% against you from the last highest profit point. This rule of thumb works well in normal markets but it will be a 50/50 bet during panic situations such as the Panic of ’87. In the case of panic, only forecasting methods and the Reversal system will survive. If you waited for a 1% move up from the low, your fill might have been 25% or better away from the low. Panics are not known for providing good fills or orderly trades. Exiting strategies are the most important because they involve a lot more emotion to overcome than entry positions. Upon entry, confidence is usually high but upon exits, confidence can be the last thing on your mind.

Exit Strategies:

1) Cover the position on the next Reversal using an MIT (Market If Touched Order). For example, if you are short from the 482 level and the next Bearish Reversal is 454, use an MIT at 455 or 456 to buy back the short position. Re-enter the market using the entry strategy most appropriate with the 454 Reversal. Continue this strategy from Reversal to Reversal until the market stops.

2) Each new low produces a Bullish Reversal. Likewise, each new high produces a corresponding Bearish Reversal. Exit the market if the corresponding Reversal is executed. For example, if a short was taken near the 482 level and the market drops to the 458 area, a Protective Buy Stop Close Only must be placed slightly above the Bullish Reversal generated from the new low at 458. Let us assume this Reversal was 463. Two strategies would be possible.

2a) Use 463.50 “Protective Buy Stop Close On/y”. This is recommended for normal volatility.

2b) Use either the next whole number or previous week’s high as long as they are above 463. Place an “Intraday Protective Buy Stop” at 470.60 on the whole number basis. Also use the “Protective Buy Stop Close Only” at 463.50 on an OCO basis (One Cancels The Other). OCO is important! Otherwise, you could be stopped out of the short position and find yourself long at the end of the day. In addition, if the intraday stop is elected, you must then enter a “Sell Stop Close Only” at 462.50. This would re-establish the short position if the move to the upside proves to be false at the end of the day. The big risk is getting whipped in and out of the market Potentially, if volatility is very high, you could create a losing day trade being stopped out at the 470 area and back in at 462. On the other hand, if the market is truly reversing trend then being stopped out at 470 when the market closes at 480 would be viewed as a blessing. This added protection during highly volatile periods is worth it when forecasts for a major turning point exist.

The Reversal System has historically worked better than any other system we have seen for defining the gaps within a market. Most of the time when one level is penetrated, the market price activity will continue to the next available Reversal. Normal markets have Reversals evenly dispersed above and below the current price activity. It is when large gaps exist between levels that we find greater potential for panic. Simply put, when Reversals are evenly dispersed, there are a greater number of support and resistance levels to penetrate. This requires more energy within the system to great a panic situation. But when Reversals are clustered together in particular areas leaving gaps between them, then price movement can become much more erratic.

These are the main strategies, which work well with the Reversals for both conservative and aggressive speculation or hedging. Stepping in and out at each Reversal as it is approached seems logical and easy to implement. However, keep in mind that this Reversal system works best under extreme volatility rather than the opposite. The greater the panic the higher the accuracy. That means simply that some of the best calls take experience, confidence and above all, guts. When this system has been infallible, it has always come at the peak in emotional stress exists for either exiting or entering a market.

Of course additional strategies remain possible beyond these basic concepts. However, they are best suited for the truly experienced hedger or speculator. They involve reverse strategies and some finessing rules as well.