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Attacking the Indices on Multiple Fronts

A good trading methodology for the stock indices should combine several methods of analysis. Here is a look at how fundamental, psychological and technical analysis can be used to develop a simple system for day trading the stock indices. One of the primary goals of any trading system should be the efficient allocation of capital. This setup is designed to make the most of limited time spent in the market by isolating trading entries to those that have greater follow through potential.

The psychological component of this strategy is the put to call ratio. It measures the level of bearish sentiment in the market. The more puts that are outstanding relative to the number of calls outstanding, the higher the bearish public sentiment is towards the market. There is a historical bias to the put side of this equation because investors buy puts as insurance against the market going down. The use of put options provides them with a level of comfort, thinking that their position is hedged. They don't want to offset their stocks and be forced to pay capital gains. The buying of put options accelerates as the market declines and fear sets in. Frequently, the put to call ratio is at its highest very near the bottom of the market's decline (4/22) and at its lowest as the market moves to new highs (June).

There are two technical components to this strategy. The first, measures the Volatility Index or, VIX. Typically, as the market rallies, or trends upward, volatility decreases because the market's participants are getting what they want. They want a sustainable upward trend. Slow and steady. The VIX index provides a good graphical depiction of this behavior. The VIX falls as the market climbs with predictable certainty (5/19 - end of series). Conversely, the VIX rallies sharply as the market's long participants rush to liquidate their positions (4/13 - 4/20). The negative correlation between the VIX and the stock markets can provide clues to the future direction of the indices themselves.

The psychological component of this methodology combines the previously mentioned indicators into a profile of public perception. The logic behind this setup is based on the notion that, "the small speculator is always wrong." What does the small speculator do? In the stock market, they initiate trades from the long side only, from an entry price that is too high, holds onto positions too long and gives up (capitulates) at the worst possible moment. In the options markets, they buy put options as the market declines and offset those options as the market rallies. The market has an uncanny knack for moving just beyond any individuals pain threshold before turning around and forcing the trader to smack themselves on the forehead and say, "I knew I shouldn't have gotten out!" This reinforces their resolve to hold out longer the next time they find themselves in the same position and ingrains this cyclical behavior.

In summary, as volatility declines, the public becomes complacent and comfortable with the predictability of the market. The daily ranges are smaller and, over time, the closes are higher. As this occurs, the put to call ratio declines. This setup contributes to the follow through as the market starts to fall and the fear of loss creeps in. Conversely, a market, with a high degree of uncertainty, is characterized by large daily ranges and very high put to call ratios. This is also characteristic of public investors trading reactively through their purchases of put options after the market has fallen substantially. This setup contributes to the follow through of a market elevating itself off of these lower levels.

The entry is, simply, a stop order based on a breakout of an average day's range for the last "x" number of days. This is the second technical aspect of the system. Several systems day trade the stock indices, profitably, based solely on various breakout calculations. However, using the previously mentioned setups, the winning percentage is higher than a breakout only, based system. Also, this setup limits the number of trades and increases trading efficiency. Ideally, this means more dollars earned per time spent in the market putting dollars at risk. This system is a good example of combining fundamental, technical and psychological analysis into a cohesive trading methodology.

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