Automated Trading Systems

sept/oct 2006 The publication for trading and investment professionals www.technicalanalyst.co.uk Automated Trading Systems First steps in model building Minimising drawdowns Algorithmic execution Institutional Fund Flows Institutional investors adopt defensive strategy Interview John Bollinger discusses his bands and the markets Drummond Geometry A powerful tool for trend analysis

The world is your oyster. (Plus plenty of options if you re allergic to seafood.) The extensive range of ishares exchange traded funds gives you access to markets across the globe. Choose global benchmarks in developed economies. Add emerging markets such as Brazil, China and Korea into the mix. Explore beyond geography into asset classes, style products, high yield and inflation-linked products. A world of opportunity awaits you, with ishares. Institutional enquiries: +44 (0)20 7668 8007 or www.ishares.net or ISHARES <GO> Trade the world with This advertisement is intended for institutional investors who subscribe to The Technical Analyst magazine. It is directed at persons having professional experience in matters relating to investments, and it relates to investments which are only available to, and will only be engaged in with, such investment professionals. Persons who do not have professional experience in matters relating to investments should not rely on this advertisement. This advertisement has been issued by Barclays Global Investors Limited ( BGI ), which is authorised and regulated by the Financial Services Authority in the United Kingdom ( FSA ). ishares plc and The Exchange Traded Fund Company plc (the Companies ) are investment companies with variable capital incorporated in Ireland and are authorised by the Financial Regulator in Ireland. The ishares funds are authorised by the Financial Regulator in Ireland. Any application for shares in any fund is on the terms of the relevant prospectus. The ishares funds may not be registered in your jurisdiction. In particular, none of the shares has been or will be registered under the United States Securities Act of 1933, or as an investment company under the 1940 Act, or the laws of any of the states of the United States, and, therefore, may not be offered or sold, directly or indirectly, in the United States or to or for the account of any U.S. Person, as defined by the 1933 Act, except pursuant to an exemption form, or in a transaction not subject to, the regulatory requirements of the 1933 Act, the 1940 Act and any applicable state security laws. In addition, the Companies have not been, nor will they be, qualified for distribution to the public in Canada as no prospectus for the Companies has been filed with any securities commission or regulatory authority in Canada or any province or territory thereof. This document is not, and under no circumstances is to be construed, as an advertisement, or any other step in furtherance of a public offering of shares in Canada. No person resident in Canada for the purposes of the Income Tax Act (Canada) may purchase or accept a transfer of shares in the Companies unless he or she is eligible to do so under applicable Canadian or provincial laws. This advertisement is not intended to constitute an offer to sell or a solicitation of an offer to buy shares of any fund, nor shall any such shares be offered or sold to any person in any jurisdiction in which an offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. BGI and/or its affiliated companies and/or their employees may, from time to time, hold shares in the funds included in this publication or any underlying shares held within the funds, and may as principal or agent buy or sell the funds or securities. Copies of the relevant prospectus can be obtained from www.ishares.net or by calling +44 (0)20 7668 8007. ishares is a trademark owned by Barclays Global Investors N.A. 2006 Barclays Global Investors Limited. All rights reserved.

WELCOME In this issue we are proud to launch a new section devoted to automated trading systems. Our aim is to bring to our readers the latest research and market developments in all areas of automated trading, from model building and testing through to algorithmic execution strategies. Technical analysis often plays an important role in the development of trading models and automated strategies, and so we believe these new pages will be an exciting addition to the publication. We hope you enjoy this issue of the magazine. Matthew Clements, Editor CONTENTS 1 > FEATURES SEPT/OCT Drummond Geometry An original trend following technique developed by legendary trader, Charles Drummond. >16 Interview John Bollinger "If someone comes up with a new indicator, there's no point in concealing the maths behind it" >34 NEW section on trading models and algorithmic execution. >40 2006 Clements Biss Economic Publications Limited. All rights reserved. Neither this publication nor any part of it may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of Clements Biss Economic Publications Limited. While the publisher believes that all information contained in this publication was correct at the time of going to press, they cannot accept liability for any errors or omissions that may appear or loss suffered directly or indirectly by any reader as a result of any advertisement, editorial, photographs or other material published in The Technical Analyst. No statement in this publication is to be considered as a recommendation or solicitation to buy or sell securities or to provide investment, tax or legal advice. Readers should be aware that this publication is not intended to replace the need to obtain professional advice in relation to any topic discussed. > > September/October 2006 THE TECHNICAL ANALYST 1

See X_TRADER 7. Now with X_STUDY charting and analytics. At least 50% of the electronic volume on the world s top four futures exchanges _ goes through TT s X TRADER order entry platform. - From a trader s viewpoint, that speaks for itself. Harris Brumfield, CEO Veteran Trader www.tradingtechnologies.com

"80% of the total value traded in Single Stock Futures is institutional" Allan Thomson, JSE director of trading Do company directors make smart investors? 12 24 CONTENTS 2 > REGULARS Editor: Matthew Clements Managing Editor: Jim Biss Advertising & subscriptions: Louiza Charalambous Marketing: Vanessa Green Events: Adam Coole Design & Production: Paul Simpson The Technical Analyst is published by Clements Biss Economic Publications Ltd Unit 201, Panther House, 38 Mount Pleasant, London WC1X 0AN Tel: +44 (0)20 7833 1441 Web: www.technicalanalyst.co.uk Email: editor@technicalanalyst.co.uk SUBSCRIPTIONS Subscription rates (6 issues) UK: 160 per annum Rest of world: 185 per annum Electronic pdf: 49 per annum For information, please contact: subscriptions@technicalanalyst.co.uk ADVERTISING For information, please contact: advertising@technicalanalyst.co.uk PRODUCTION Art, design and typesetting by all-perception Ltd. Printed by The Friary Press ISSN(1742-8718) INDUSTRY NEWS MARKET VIEWS EUR/USD: Further gains ahead US Stocks: Brighter outlook for medium term EXCHANGE FEATURE Johannesburg Stock Exchange TECHNIQUES Drummond Geometry & trend analysis Institutional fund flows: A different approach to volume Directors' deals: Early signals for the stock market Wyckoff method confirms 14,400 target for DJIA A technical approach to pairs trading INTERVIEW John Bollinger of Bollinger Capital Management SOFTWARE Updata Technical Analyst for Bloomberg BOOK REVIEW The Investor's Guide to Active Asset Allocation by Martin Pring AUTOMATED TRADING SYSTEMS Building a trading model: First steps Trading models: Minimising drawdowns Algorithmic execution: Technology is key 04 07 09 12 16 20 24 29 31 34 36 38 40 42 46 September/October 2006 THE TECHNICAL ANALYST 3

Industry News ASPEN GRAPHICS NOW USING BLOOMBERG DATA Aspen Research Group, the US based technical analysis software provider, is now offering its Aspen Graphics charting package in a format that can be powered by Bloomberg Data. This means that any Bloomberg field that has historical data can be integrated into an Aspen formula to chart or quote that field's value. Aspen are also offering up to 299 separate buy/sell alerts via an audible alarm, pop up window, text window or text message New indicator for CBOT's Market Profile A professor from Western Illinois University has developed a trading system based on the CBOT's Market Profile. Professor Thomas Drinka, who was the first - and remains the only - academic to offer courses in Market Profile as part of a curriculum, and who is supported by the CBOT, believes he has an important new set of indicators to add to the technical analysis toolkit. The Profile Directional Index, which he developed with one of his students, consists of two algorithms - the Buying-and-Selling Index and the Price Index. Together they are used to generate risk-accounted trading signals. Of the 40 agricultural futures that were included in beta testing, Professor Drinka says that trading signals were over 70% accurate for 37 futures and in the case of 17 futures, 100% accurate. Professor Drinka is seeking a business partner to help in commercial development. Email: TP-Drinka@wiu.edu for test results and further details. INTERBANK FX LAUNCHES AUTOMATED TRADING PLATFORM US based FX trading platform, Interbank FX, has launched its new automated trading platform, Expert Advisors. The company claims its platform is one of the few in the world that offer the ability for clients to automate their trades by programming their own algorithms into the system. Expert Advisor notifies the users of buy and sell opportunities, backtests trading strategies and can also execute orders automatically. Written in MetaQuotes Language II, the company say little or no programming experience is required to use the platform. A step-by-step guide is provided in the MQLII users manual. 4 THE TECHNICAL ANALYST September/October 2006

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Here s an intriguing question with a simple answer: Name the analyst who: Published specific gold and silver forecasts for 22 years during one of the metals most historically baffling periods, Correctly called nearly every major turn and trend during that entire time, and Now offers that complete body of work for public scrutiny and your personal education? Robert Prechter. How to Forecast Gold and Silver, Bob s 15th book, really does tell a story. All markets do, but this story is unique. It also reminds you of what matters and what does not when you think about the markets you follow. This is not some abstract How To book, using pristine drawings of an idealized world. It is a tale that shows How It Was Done in real market, in real time, for two decades. The book includes every single chart in its original form, exactly as subscribers saw them. No trader or technician s library is complete without this exciting metals saga. It s like sitting next to an expert while he forecasts the market you re watching. That s how you ll learn to do it yourself. Go to www.elliottwave.com/wave/gsbta for details. 483 pages, Large 8 1/2 x 11 format Praise from Experts Robert Prechter has been right on target for almost the whole of the gold bear market, having called previous major turning points almost to the exact dollar, which is a feat I believe to be unequalled by any other forecaster (and I read most of them). - Australian Investors Digest I ve been reading Bob s thoughts on gold for over four years. After a while you conclude he must be reading next year s newspapers. - A Non-Random Walk Elliott wave forecasting has enabled Prechter to make some remarkably accurate calls. In January of last year, for example, he predicted gold would soon peak at just over $500 an ounce. It hit $511 on Feb. 15 and within two weeks fell to $408. - Money Magazine To order by phone, call EWI Customer Service at 800-336-1618 or 770-536-0309 (from outside U.S.) and mention code: TA

Market Views EUR/USD FURTHER GAINS AHEAD by Thomas Anthonj Short term outlook Following a classic 3-step A-B-C consolidation pattern from the last major top at 1.2980 in June down to the last major bottom at 1.2460 in July, we see the odds clearly in favour of a resumption of the bigger up-trend for the euro (see Figure 1). This will require decisive breaks above the last Fibonacci resistances (76.4 %) at 1.3045 and at 1.3185 to eliminate the head-and-shoulders formation. A trend line break at 1.2705 however, would delay a straight attack on the last 1.2980 top and would call for a slightly deeper setback to 1.2640 or 1.2570 (61.8/76.4 % of the last advance) before a resumption of the up-trend. Only a break below 1.2570 would offer significant downwards potential towards a massive support zone that stretches from 1.2405 (internal 50%) to 1.2325/1.2265 (potential wave (1) top/internal 61.8%), to trend line support at 1.2205. If this fails then we'd only have the last Fibonacci supports (76.4%) at 1.2100 and 1.1955 to prevent a complete meltdown. Such a break would confirm that a bigger C- leg down (in blue) is unfolding, which would target around 1.1000. The odds are still in favour of a straight resumption of the bigger EUR up-trend as long as short term support between 1.2705 and 1.2570 stands firm. Long term outlook The fact that the market bottomed out at the 38.2 % retracement of 1.1635 (calculated from the 0.8350 low) and went on to form a series of sub-counts on the way up to 1.2980 raised some doubts as to whether this was the right shoulder of a head-and-shoulders pattern (Figure 2). The double-top that formed at the potential left shoulder at 1.2930 means the bigger picture remains unclear. However, we see a positive bias prevailing as long as Figure 1. September/October 2006 THE TECHNICAL ANALYST 7

Market Views Figure 2 IF THE TREND LINE SUPPORT AT 1.2205 FAILS THEN WE'D ONLY HAVE THE LAST FIBONACCI SUPPORTS AT 1.2100 AND 1.1955 TO PREVENT A COMPLETE MELTDOWN. an internal 50 % retracement at 1.2405 and an internal wave (1) top at 1.2325 are not broken. Below 1.2325, only trend line support at 1.2170 and the last Fibonacci-support at 1.1955 could prevent the resumption of the bigger consolidation targeting 1.1010 to 1.0765 (50% of old bottom) in a corrective C- leg down (in blue). On the upside, we see Fibonacci projections at 1.3715 and 1.4210 although it would require stabilization above 1.3185 (76.4% of the 1.3665-1.1640 decline) to eliminate the last doubts that this is not just a counter-trend rally within a bigger downconsolidation or within a new downtrend. Thomas Anthonj is a technical analyst at ABN Amro. 8 THE TECHNICAL ANALYST September/October 2006

Market Views US STOCKS BRIGHTER MEDIUM TERM OUTLOOK by Riccardo Ronco Short term view The S&P500 is challenging its May resistances in the 1,300-1,320 area (Figure 1). While prices have been able to climb back to their respective 50 and 200 day moving averages, they have done so on lower volume from the 2 billion shares peak seen in mid July. Higher prices on lower volume are not usually good in technical analysis: such patterns indicate investors are less and less keen to pay higher prices and this is a leading indicator of weakness. The NASDAQ Composite has rallied nicely off its 2,025 relative low but it is now facing its 200 day moving average at 2,225. Volume has declined with each passing week since July for this market as well. The contraction in volume has affected both the advancing and declining 10-day volume indicators calculated for the NYSE and NAS- DAQ Composite. The good news is that this rally has not generated a spike Figure 1. in optimism and our short-term indicators are not overbought. Several internal indicators like the VIX in the 12-13 area are quite compressed to allow further upside in the stock market in the short-term. Put/call ratios The 10-day S&P100 put/call ratio is another indicator that we have found to be very useful when trying to understand what the smart money is doing. The S&P100 put/call ratio is a contrarian indicator in a similar way to the "Equity only" put/call ratio: the difference is in whom is trading what. S&P100 (OEX) options are mostly traded by large investors to hedge their portfolios while retail investors tend to speculate on single stocks. Higher prices in the stock market are usually associated with lower put/call ratios and vice versa. Sometimes this perfect inverted correlation breaks down for the S&P100, specifically near 2-3 month tops in the market. Since late July the S&P100 put/call ratio has rallied together with prices, suggesting the chances of a medium-term top are high. Recent examples were seen in May this year and September 2005. When considering sentiment indicators like the American Association of Individual Investors data, any beneficial effects of a double spike in pessimism (as seen in the AAII weekly figures in mid June and mid July) have run their course (4-6 weeks upside is the average rally). The conclusion in the short-term is for a gentle pullback into a lateral congestion phase: I would look for a retracement to the 1,280-1,260 range on the S&P500 and 2,140-2,100 on the NASDAQ Composite. Medium term view The medium term outlook is more optimistic for the following reasons: 1. 2. 3. The NYSE Advance/Decline line is still strong while the NASDAQ line continues to be weak because of the tech-aversion that is still palpable amongst investors Since early August the number of stocks making fresh 52-week new highs has been consistently higher than those making 52-week new lows Liquidity in US mutual funds (according to the most recent Investment Company Institute data) has risen in the last two month rally. Hence there are resources to support the market in case of a decline and we are far from September/October 2006 THE TECHNICAL ANALYST 9

Market Views Figure 2. those worrying levels of low cash as seen in early 2000. The stock market also remains cheap when a comparsion is made between the S&P500 yield and the 10-year T- note yield (Figure 2). Crashes usually occur either when valuations are overstretched (as in 1987) or when investors are throwing in the towel following one or two years of declining prices. We are not in any of the above two situations. The nearest parallel we can find is late 1994 to early 1995. Then higher prices in equities were followed by an even higher level of cheapness in our spread due to the fact that prices were not able to keep up with the pace seen in earnings. A lateral consolidation followed and the same should happen this time. A stronger bond market is going to support the market and not vice versa. Meanwhile, a more traditional technical indicator like the Moving Average SINCE EARLY AUGUST THE NUMBER OF STOCKS MAKING FRESH 52-WEEK HIGHS IS CONSISTENTLY HIGHER THAN THOSE MAKING 52-WEEK NEW LOWS. Divergence/Converge (MACD) calculated on the monthly S&P 500 triggered a sell signal at the end of August. However we have a flat move on this indicator that could lead to a lateral consolidation rather than to a sharp correction into the usual seasonal September-October lows. Another positive element is the extremely oversold condition of tech stocks vs. the NYSE Composite: our weekly momentum indicator in the above chart is flashing a positive signal, as was seen in October 2004 and May 2005, suggesting a market more resilient than we imagine. Riccardo Ronco is technical analyst at Friedman Billings Ramsey. The views and opinions expressed above may be subject to change at any given time. Individuals are advised to seek professional guidance prior to making any investments. The value of investment may fluctuate. Past performance is not an indication of future performance. 10 THE TECHNICAL ANALYST September/October 2006

GET QUALIFIED IN TECHNICAL ANALYSIS The Society of Technical Analysts (STA) represents and accredits professional and private Technical Analysts operating in the UK Originally established in the 1960s, the STA provides its members: Education Research Meetings Monthly lectures and regular teaching courses in technical analysis The STA Journal publishes research papers on TA techniques and approaches Provide members the opportunity to discuss technical approaches and markets Representation The STA lobbies on behalf of analysts with data vendors, exchanges and regulators. The STA represents the UK at the International Federation of Technical Analysts (IFTA) Accreditation The STA Diploma Exam is internationally recognised as a professional level qualification in Technical Analysis For more information on how to join and what is involved in passing the STA Diploma exam, visit our website at: www.sta-uk.org or call us on +44 7000 710207

Exchange Feature SOUTH AFRICA'S JSE by Matthew Clements Just prior to the Technical Analyst's recent Johannesburg conference, I paid a visit to the Johannesburg Stock Exchange at it's impressive new building in the heart of Johannesburg's financial district to meet with their director of trading, Allan Thomson. He explains how the South African market is now seeing spectacular growth in the market for single stock futures, a development spearheaded by the exchange. MC: What are the recent developments at the exchange? AT: In the past few years we have seen the assimilation of the South African Futures Exchange (SAFEX) within the JSE in 2001, and in 2005, the launch of our interest rate market, Yield-X, and de-mutualisation with the subsequent listing of the exchange on its main board this June. The exchange is currently engaged in a significant project to revamp most of its IT systems including new trading and clearing systems for all JSE markets. Last but not least is the continued growth in single stock futures (SSFs) trading. MC: How has the market for SSFs grown in recent years? Allan Thomson AT: The growth of the market has seen volumes rise from almost nothing five years ago to 8,000,000 contracts a month by mid 2006. We are now the third largest market globally for single stock futures after Eurex and India. Having started with 4 shares in 1999, we now have 249 listed contracts worth R64bn in 2005. As yet, we don't have data for 2006 but it will show a significant increase on this figure. However, we know that SSFs are now approximately 30% of total JSE trade. Finally, we mustn't forget that the market for SSFs is also growing globally with new listings on the Spanish MEFF, UK's 12 THE TECHNICAL ANALYST September/October 2006

Exchange Feature LIFFE and One Chicago. MC: What has been the impetus for the market growth? AT: The growth of single stock futures market in South Africa is the result of several factors: a healthy private investor market, a well development fund management and capital markets sector plus effective product promotion by the JSE. We have spent the past several years actively developing the domestic market for single stock futures and SSFs are now well established in the retail market. This reflects not only the work the exchange has done to develop the market but also the depth and sophistication of the South African equity markets. MC: What are the specific benefits of trading SSFS? AT: The major benefits of exchange traded SSFs is that they can be shorted and there is no counterparty risk. Also, users can enjoy greater exposure via the gearing offered by the futures and lower costs than trading the underlying shares. MC: Who are the primary users of SSFs, the retail or institutional markets? AT: Through the JSE's marketing efforts, SSFs were launched very much with the retail and private investor market in mind, but the institutional side of the business now dominates by far. Although 80% of volume traded is on the retail side, 80% of the total value traded in SSFs is institutional. Unit trusts are now using SSFs extensively although legislative changes where needed here first before that could happen. MC: Who are the major players in the market? AT: The major domestic players are Nedbank who started as the market maker for SSFs. All banks now trade the futures although Standard Bank now has its own online trading facility. Other big players include Investec from the wholesale side and RMB who market make exclusively to fund managers and other members. MC: How are SSFs commonly used? For hedging or speculation? AT: That's very difficult to ascertain because we don't ask our customers what they use them for. Institutional users include equity traders, asset managers and hedge funds and their application of SSFs is probably split 50:50 between the two. Unit trusts, for example, use them both as a hedging tool and for yield enhancement. The retail market is more speculative but there is a hedging use in this sector as well. From a hedging perspective, SSFs allow risk reduction by protecting a share portfolio against movements in the underlying market. Speculators, on the other hand, have no intention of ever delivering the underlying and simply look to exploit movements in the futures price although this, of course, is based on movements in the underlying. MC: Are there any specific trading strategies that can be used when trading SSFs? AT: From a technical analysis perspective, it goes without saying that when trading a highly geared product such as SSFs on a short-term basis, technical analysis is a tool which many traders use. Technical analysts usually use the data of the underlying share in order to draw their trading conclusions. They then use the SSF to obtain their exposure in that share. Liquidity can be sporadic which does have some implications for how they are traded. The top 40 SSFs are liquid contracts but we now list 249 futures and a lot of the trades at the lower end of the liquidity spectrum are structured transactions. However, if there is insufficient liquidity in the future then you can look at the underlying share to analyse the market. MC: How far out do the contracts go? AT: The contracts go out as far as anybody wants them to. We have contracts going out to 2010 but obviously most of the liquidity is in the near contracts which are rolled over as expiry approaches. September/October 2006 THE TECHNICAL ANALYST 13

Exchange Feature The new JSE building in Sandton MC: What competition is there between the market for SSFs and exchange traded funds (ETFs) which you also offer? AT: There is definitely competition, as well as from CFDs. There are important differences though. From a speculative point of view, SSFs can offer more flexibility than exchange traded funds, because you can go short. SSFs offer you gearing and exposure. ETFs are basically long only instruments. MC: What is the JSE approach to electronic trading? AT: All five of the JSE's Markets (Main Equity Market, AltX, Equity Derivatives, Agricultural Derivatives and Yield-X) all operate on central electronic order books. The exchange believes in ensuring maximum transparency with efficient price formation. Members have access to the market and may also offer their clients access through DMA (Direct Market Access) type facilities. The equities market and AltX use the London Stock Exchange platform run, and operated, out of London on behalf of the JSE. MC: What is the state of platform connectivity to the exchange? AT: Members mainly connect via dedicated lines into the JSE in South Africa. As indicated, all the trading systems are being replaced during 2007. The equities will be replaced with the LSE's new platform and the derivatives and Yield- X markets will also be replaced using the existing local supplier. MC: How has the JSE adjusted to the growth of electronic and automated trading in recent years? AT: A lot of automated trading is coming through the exchange and the high volume associated with such trading has caused some problems for us, as it has for many other exchange platforms. This is simply because of insufficient bandwidth. We need to publish realtime single stock futures prices on our screens as the underlying price changes and this is very demanding on our systems. However, the platform and IT systems are currently being upgraded and this process will be completed over the next few months. This will be a major development for the exchange and a big advantage for our customers. It also sets us up for the future as trading volumes grow and the South African markets continue to develop. 14 THE TECHNICAL ANALYST September/October 2006

Techniques 16 THE TECHNICAL ANALYST September/October 2006

Techniques DRUMMOND GEOMETRY: AN ALTERNATIVE APPROACH TO TREND ANALYSIS Drummond Geometry (DG) is a form of market analysis developed by Canadian trader Charles Drummond. It is both a trend-following and a congestion-action methodology using projected charts to map future market activity. A London based fund manager, running a North American fixed income portfolio says, "I have been using Drummond for around 14 years and there is no question that it is profitable for me. Having tested moving averages, Elliott Waves and such like, these haven't worked as well although that's partly a matter of trading style compatibility. Drummond works well at spotting market turns and has a consistency that's hard to match whether you are trading on a daily, weekly or monthly basis. The backtesting that I have done shows around a 65 percent reliability for the studies." The key elements of Drummond Geometry include a combination of the following three basic categories of trading tools and techniques: A series of short-term moving averages (PLdot) Short-term trend lines Multiple time-period overlays The PLdot (Price Line dot) can be applied to any commodity, future or stock and is a short-term moving average based on three bars of data which captures the trend/non-trend activity of the time frame being charted. The Figure 1. S&P 500 PLdot from the last three bars is plotted as a dot or line on the next bar to appear. PLdot is calculated from the average of the high, low, and close of the last three bars. The PLdot The PLdot plots successive dots on price bars forming a series of points which describe the consensus of market activity for the three latest bars (or time periods). The PLdot moves in a straight line when the market is in a trend, but moves horizontally across the page in congestions. Its sensitivity to markets trends means it is very quick to register the change of a market out of congestion into trend as well as to a trend that is ending. Figure 1 shows the weekly S&P 500 with the PLdot moving in a relatively straight line horizontally across the page on bars 3, 4, 5, 6, 7 and 8. Then we see a short down trend and following that the dots move in a straight line upward for the last 5 bars of the chart. The tendency of the PLdot to move in a straight line can be helpful in monitoring a trend. A basic strategy to use for PLdot is to trade with the trend if the market is on one side of the dot. In Figure 1 we see the close of the bar on alternating sides of the PLdot in bars 4, 5 and 6. This indicates the market is in congestion. In bars 6, 7, 8 and 9, we see closes below the PLdot indicating trending activity to the downside. In bars 10 through 14 we see each bar close above the PLdot, indicating a trend to the upside. September/October 2006 THE TECHNICAL ANALYST 17

Techniques Trend reversals Figure 2 shows the daily T-Bond futures with two trend reversals. From bars 3 and 4 we saw the market in a down-trend and the PLdots were above the close of each bar. The trading strategy would be to sell resistance. But by bar 5 we saw the market close above the PLdot and this marked the end of the down-trend. As the market moved into the up-trend, the PLdot switched sides; we do not see a close on the under side of the dot until bar 12 when the close moved decisively under the PLdot and the trend is over. From bars 5 to 12 the strategy is to buy support. Note that the dots move in a straight line until the trend is over. As Figure 2 illustrates, prices often move away from the PLdot, but then come back to it. The pattern in Figure 3 is called the "Return to the PLdot" and is a very simple, tradable pattern. The trick is to know exactly when prices are actually far from the dot. On this chart we see a number of bars marked with the "Return to the PLdot" yellow marker. When prices move far away from the dot, the trader would be alert to signs that the market will turn and return to the PLdot. Thus in the fourth full bar we see that the market is far away from the PLdot, but in the next nine bars we see good examples of Figure 2. T-Bond future this tendency for price to return to the vicinity of the PLdot. In each of these situations the trader would take a position against the trend by going short at the apex of the bar. The PLdot push Another observation based on the THE KEY IS TAKING THE LOW TIME FRAMES FOR SMALL RISK AND THEN IDENTIFYING WHEN A TREND BEGINS ON A HIGHER TIME FRAME ON THE DAILY CHARTS. SHAUN DOWNEY, CQG PLdot is the "PLdot Push." In this pattern, when a trend is underway, the PLdots seem to be pushing the bars in the direction of the trend, either upwards or downwards, depending on the direction of the move. If the dots push strongly, they create a very strong trend; if they sometimes lose energy, the trend weakens. Figure 4 is a quarterly chart of the S&P500 where we see the "PLdot Push" pattern at work in a strong uptrend. The PLdot gives traders a great deal of support in trending markets. When an up-trending market retraces to the area of the PLdot the trader goes long or adds to his long position. When in a down-trending market the trader goes short or adds to his short position. When the market moves to a position far away from the dots, the trader takes partial profits or reverses position, depending on his or her trading style. Thus in Figure 4 we can see that the trader could initiate or add to a long position at any time that the market retraced to the PLdot. The concept also holds for the "live dot" as well, as shown in the last two bars on the chart. (The "Live dot" is an advanced concept in Drummond Geometry that indicates the point on the current bar where the PLdot for the next bar is forming.) Short term trend lines The second element of DG is the use of short-term, two-bar trend lines. Like the PLdot these short-term trend lines are projected into the future where they indicate points of interest on the first upcoming bar - the future bar that has yet to trade. The "Drummond Lines" indicate areas of energy termination where the market it likely to stop its movement. Figure 5 shows five price bars for the DJIA. The trend is defined and supported by the PLdots while the Drummond termination lines forecast the extremes of the bars. The green areas above and below bar five show the support and resistance zones. These zones are defined by the Drummond Lines (marked in turquoise). Although it is obviously very helpful to know where support and resistance will form in the upcoming bar, this 18 THE TECHNICAL ANALYST September/October 2006

Techniques I HAVE BEEN USING DRUMMOND FOR 14 YEARS AND THERE IS NO QUESTION THAT IT IS PROFITABLE FOR ME. A LONDON BASED PORTFOLIO MANAGER Figure 3. Return to the PLdot information alone is not enough to trade successfully. As with any other trading techniques, the key question is, will the support or resistance hold or break? The coordination of support and resistance in different timeframes is the third major tool of DG. Shaun Downey, chief technical analyst at charting provider, CQG, lectures on Drummond Geometry and comments, "The key is taking the low time frames for small risk and then identifying when a trend begins on a higher timeframe on the daily charts. Normally the monthly highs and lows are made early in the month in a trend and getting that nailed is one of the key moments. There really shouldn't be any time when you don't identify a trend and then be able to ride it". This will be the subject of a future article. Figure 4. The PLdot push There are over 200 Drummond Geometry studies available on TradeStation. For additional information please contact Ted Hearne at www.tedtick.com. All Tedtick information is subject to copyright. Figure 5. September/October 2006 THE TECHNICAL ANALYST 19

Techniques INSTITUTIONAL FUND FLOWS: A DIFFERENT APPROACH TO VOLUME by Rob Brand Many traders and analysts incorporate some form of volume analysis in their decision-making. Volume takes various forms, but one that is as yet still little used but is rapidly coming to the fore is institutional fund flows. This article looks at how one particluar flows indicator, published by State Street, can be used to help anticipate market movements in global equity markets. Flow analysis: the underlying idea As the term indicates, institutional fund flows are the volumes that are traded by investment managers, such as asset managers and pension funds. In many cases, the large asset managers are the driving force behind share price movements since they hold huge positions and may take time to get into a particular sector or stock. In other words, if the institutional investors head in a particular direction, this is likely to have the effect of driving up share prices on account of the large volumes traded over an extended period of time. The question that arises however is, how can we know what the large institutions are buying and selling? In order to answer this question we need to turn to the stockbrokers. They act for the institutional investors and settle a high proportion of all institutional equity transactions. Such brokers include The Bank of New York and State Street. State Street is the worldwide administrator of over 11 trillion dollars, representing 15% of the total volume of tradable securities. Therefore, they are eminently well placed to measure the flows generated by asset managers. Every month, State Street Global Markets research draws up a report with a detailed analysis of institutional players' equity flows. State Street Global Markets measures the aggregate volume by calculating the balance of purchases minus sales in each equity sector (see Figure 1). This is termed the Equity Flow Indicator (EFI), or "flows" for short. The EFI shows whether institutional investors are in fact making purchases or sales with the flows being subdivided into countries, sectors and regions. This makes it possible to respond to the sectoral choices made by institutional investors in certain regions. Do flows have predictive value? The question naturally arises as to whether the flows have predictive value. Over the past ten years, State Street Global Markets has analysed the flows of institutional investors. If the flows were to be random, the expectation would be for an average flow (purchasing or selling) to last two months (see Figure 1). In fact, the flows last much longer on average, thus suggesting that they have an effect on the market. The ability to identify a trend reversal in the cumulative flows in the sectors at an early stage can be highly profitable. An example of the cumulative flows in the Telecom sector is shown in Figure 2. The pale line shows the cumulative flows: institutional investors are clearly making net sales in telecom sector shares. The dark line shows the relative performance of the sector in relation to the world index. A reversal in the flow trend is often associated with a turnaround in relative performance. This is exceptionally useful for investors in a position to make use of sector rotation. Tim Viner, at State Street Global Markets adds, "We make portfolio recommendations using the EFI indicator. For example, if we see a flow change then we consult other factors such as valuation, earnings momentum and technicals. If they support the message from flows then we adjust our position. It is essentially a top down approach". What are the flows saying at this point? We now know that flows can have predictive value, which begs the question as to what the flows are saying at this point. In order to obtain more insight into the flows, State Street Global Markets publishes daily "Tornado" charts (see Figure 3). This chart shows the flows over three periods: the last week, the last month and the last six months. In this way, the analyst obtains an insight into the flows and it is possible to respond in good time to a flow turnaround. The flows for the energy sector, for example, are declining for all three time periods. This indicates that institutional investors are making heavy sales in energy shares, although this is not yet reflected in the relative performance of the energy sector, which is still positive. Apart from the notable outflow in the energy sector, the Tornado chart also indicates that institutional investors are buying shares in the consumer staples, telecom and utilities sectors. These flows clearly indicate that institutional investors are engaged in risk-averse positioning. This picture is further confirmed by the large flows out of 20 THE TECHNICAL ANALYST September/October 2006

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Techniques months: underperformance by the US and outperformance by Europe. What does stand out is the strong outflow from emerging markets, one of the regions in the State Street Global Markets model. This outflow is however limited to the most recent week and month so that it remains to be seen whether the six-monthly indicator will also be negative. A fall in emerging markets is also often associated with a weaker economic climate, which would be consistent with the other flow signals. Figure 1. Average monthly flow per sector (Source: State Street Global Markets, MSCI) the Consumer Discretionary and information technology sectors, both notably cyclical sectors that are expected to do well when the economy is strong. It is therefore clear from the flows that institutional investors are switching out of cyclical sectors into more defensive ones. As noted, three sectors stand out: consumer staples, telecommunications and utilities. The cumulative flows in these three sectors are depicted in Figure 4. The strong inflows into these three sectors clearly indicates that the Institutions have become less confident about the economy. Needless to say, State Street Global Markets also breaks the flows down by region. This can provide a particular advantage for investors seeking to take advantage of regional effects. The flows within the regions are interesting in themselves: positive for Europe and negative for the US, (see Figure 5). This is consistent with the relative performance of the two regions in recent Figure 2. Cumulative flows and relative performance in the Telecom sector (Source: State Street Global Markets, MSCI) Regime analysis In order to give the analysis further substance, State Street Global Markets also conducts a regime analysis. This analyses the relationship between the flows and a number of fundamental factors such as dividend yield, beta, earnings growth expectations and relative valuation. The advantage of this additional analysis is that apart from the signals we obtain from the flows, we also derive an impression of the kinds of shares being bought and sold by institutions. This increases the insight into the strategy behind the sectoral and regional allocation and can ultimately tell us something about the market in general. A good example of a fundamental factor is the beta. This measures the sensitivity of a share or sector in relation to the market. Investors are prepared to buy high beta shares if they have positive expectations of the market. Investors therefore seek to position themselves cyclically in order to benefit from their positive outlook. The flows have already allowed us to establish that Institutions are buying shares in the consumer staples, telecom and utilities sectors. That in itself already tells us that they are positioning themselves more defensively. It is now of interest to examine whether the regime analysis provides the same picture. The regime analysis of the flows indicates that investors are selling shares with strong earnings growth expectations and a high beta. Additionally, the 22 THE TECHNICAL ANALYST September/October 2006

Technique flows also reveal that shares with a high dividend yield and a low relative valuation are being bought the most heavily. Is this logical? The answer is an emphatic yes, for the more defensive positioning of equity portfolios by institutional investors is often associated with the buying of shares with a (safe) dividend yield and a low valuation. The former factor may be clear, but the latter (valuation) is noteworthy - not so much because a value strategy in times of uncertainty is not a smart one, but particularly because this value strategy is something that has been around for a long time in equity markets. Since the end of 2002, a value strategy (i.e. low PE) has generated a higher return than a growth strategy (high PE). Analysts expected this trend to come to an end this year; the flows therefore suggest the contrary. Conclusion Institutional fund flows offer a different and useful angle on volume. The flows are able to provide us with a timely warning of a possible trend reversal in the different sectors. In the case of an investor pursuing active policies in respect of regions and sectors, the flows are an excellent aid to making such allocation decisions. The flows are telling us at the present time to be cautious about the equity market and to adopt a defensive portfolio allocation. Figure 3. Tornado chart (Source: State Street Global Markets, MSCI) Figure 4. Cumulative flows for the Staples (Source: State Street Global Markets, MSCI) Rob Brand is a Chartered Market Technician (CMT) and employed as portfolio manager at ABN Amro Figure 5. Tornado chart (Source: State Street Global Markets, MSCI) September/October 2006 THE TECHNICAL ANALYST 23

Techniques 24 THE TECHNICAL ANALYST September/October 2006

Techniques DIRECTORS DEALS: EARLY SIGNALS FOR THE STOCK MARKET by Michael Tindale Common sense tells us that there is nobody better placed to value a company than the people who run it. So, can tracking the trades of directors lead to greater investment returns? Some institutional investors are sceptical so few use the data systematically as part of their investment process. In the case of director buying, most fund managers will take a cursory look at headline trading activity (such as shown in Figure 1) and may use it to harden their attitude to a particular stock but relatively few use it to instigate a trade or even as a trigger for further analysis. However, attitudes appear to be changing. Citigroup recently produced a ground-breaking research article which posed the questions; 'Are UK Directors Smart Investors?' As one of the authors, Andy Moniz says, "Company directors are excellent market timers; they purchase shares on short-term weakness and sell on strength. Purchases potentially convey private information to the market that hasn't already been discounted." Most attention tends to focus on director buying since, to put it crudely, it is the job of fund managers to find stocks that will outperform rather than the converse. A common belief is that director selling takes place for a multitude of reasons rather than a firm conviction than the shares are likely to perform badly. As a result selling activity is perceived as a poor indicator. However, Andy Moniz disagrees. "While companies with directors' sales, on average, do not under-perform, we find the share prices subsequently drift with the market." Khuram Chaudhry at Merrill Lynch monitors aggregate director trades as a bellwether of market sentiment. He puts it more plainly. "History shows company directors have a good track record of buying low and selling high." Using selective criteria Our analysis of UK trading activity since 1999 bears out both views and proves that following director trading activity has intrinsic value. The results show that selling is less indicative than buying but both can lead to out-performance. However, these results are only achieved by excluding the majority of trades and focussing on those that meet certain criteria. The move to more quantitative investment strategies over recent years has opened the door to the inclusion of director trading activity as a commonly used measure in its own right. For example, stockbroker Martin Currie uses it as one of a number of factors in their Dynamic Stock MatrixTM (DSM). The proprietary DSM is primarily a means of measuring stocks using more traditional quantitative factors such as Price/Earnings ratios and other fundamentals. Each factor carries a weighting which feeds into an overall stock score which is used for screening. Thereafter, more traditional methods are used for deeper analysis; this will include closer scrutiny of director trading activity if it shows up as a significant factor. Quantitative methods such as this rely heavily on the quality of the data fed into them which is why a rigorous reporting method is essential. For example, an acquisition of shares by a director may be for a multitude of reasons even if the issuer describes it as a buy. Directors buy due to contractual commitments, reinvestment of dividends, vesting of options, or a subscription under a rights issue. These acquisitions should not carry the same weight as a discretionary purchase made on the market. Even where a buy shows up as discretionary, there are sometimes mitigating circumstances. An incoming director for example is more likely to be buying to demonstrate commitment to the firm rather than because he has some insight that the stock is particularly undervalued at the time. A more obvious secondary factor is the size of the trade, the more money risked the stronger the conviction. However, our evidence suggests that this is a less reliable measure of the significance of a trade than the percentage change in holding. For example, here are two trades from this month at Aim-listed stock: 1st September John Corre (Chairman) bought 100,000 at 8p bringing his holding to 100,000. 5th September Foo Katan (Chief Executive) bought 126,000 at 12p bringing his holding to 19million. Significance rating Though the trade by John Corre was worth only 8,000, we gave it a significance rating of 70 on a 0 to 100 scale. This is because the change in holding (infinite) was much higher than it was in the subsequent trade (1%). We rated the second trade at 40 even though September/October 2006 THE TECHNICAL ANALYST 25