TD REBO Reverse

TD REBO REVERSE

Many trend-following traders enter the market based upon market momentum. We are no strangers to this market-timing approach, having developed numerous breakout and range expansion techniques during the 1970s to capitalize upon the inflationary trends existing in the markets and the economy during that period. In order to facilitate the research we conducted in this area, we created a market timing template which we referred to as TD REBO to represent Range Expansion BreakOut. By having such a structure at our disposal, we were able to research and apply numerous variations of momentum-based indicators. At the time we worked with this indicator format, most traders focused their attention upon very basic analytical approaches, such as moving averages and trendline analysis, to anticipate price trends. However, over the years, traders have become increasingly aware of this momentum-trading approach to market timing and we would venture a reasonable guess that currently well over 50 percent of all Commodity Trading Advisors (CTAs) use a similar approach to managing their portfolios.

Just to reinforce our initial observations that by adding a percentage of a specified price value—previous trading bar’s price range or series of price bars’ price ranges—to the current opening price level is effective, we invite you to examine how often the current price bar’s open is within a short distance from the current price bar’s high or low. In other words, it is not uncommon to witness the opening price occur within 10- to 20% of the current trading day’s high or low. The dilemma is determining what the current bar’s price range is in advance. In order to accomplish that prediction, a trader can use the previous bar’s price range as a proxy or an average of a series of price bars as a substitute. This process enables a trader to forecast a reasonable price range and then calculate a percentage of that range to establish possible low-risk buy or sell entry levels. This is one context in which to apply TD REBO as a trend follower. Another is to use the technique to anticipate possible reversal or trend exhaustion levels.

Without exception, those who apply techniques similar to TD REBO are trend followers, which was our original intention in creating TD REBO. However, we

Figure 9.5. The December 1998 British Pound exhausted its downside momentum at the TD Exit One low-risk entry level. At that level, a trader was presented not only with a low-risk trading possibility, but also a more profitable opportunity had the trader held the trade even longer.

found that, in the case of anticipating trend reversals, TD REBO can perform effectively as well. The features of its construction enable an option buyer to take advantage of an anticipated change in direction of the underlying security. In those instances in which an opening price exceeds a series of consecutive closing price levels, either upside or downside, and, consequently, the accompanying entry price level is exaggerated above a series of consecutive daily price range extremes, rare opportunities arise for a short-term trader to operate against the trend, rather than to anticipate its likely continuation.

Statistical information we compiled a number of years ago indicated that markets operated within a trading range 76 to 82 percent of the time. Of the other 18 to 24 percent, markets trended higher 12 to 16 percent of the time and trended lower 6 to 8 percent of the time. The reason market moves last longer to the upside than to the downside has to do with the psychology of traders. Buying is a cumulative process—traders like a market, so as the market rallies, their margin (and profits) allows them to add to their positions and purchase more, and news reinforces their decisions; whereas selling is generally a single-minded decision—traders don’t like the market, so they liquidate everything.

During periods of sideways market movement, a trend-following trader is always vigilant, awaiting a price breakout in which to participate. A consolidation phase requires one form of trading, while the breakout and subsequent trending phases require another. To differentiate between the valid and the invalid breakouts, we created TD REBO. We measured the typical or average thrust of the market 'over various time periods to determine a level which, when added to or subtracted from a subsequent trading day’s open, would qualify as a breakout. This exercise included multiplying the previous price bar’s true range by either 38.2 or 61.8 percent (or any other percentage with a reliable history of effectiveness) and then either adding this value to or subtracting it from the current price bar’s opening to establish a low-risk entry. This exercise reduced the possibility of false breakouts and indicated market momentum. As you can imagine, a trending market is a perfect environment for TD REBO. On the other hand, within a trading range market, oscillators, such as TD REI and qualifier TD POQ, which produce overbought and oversold readings and low-risk entry levels, are tradable indicators. Although TD REBO may not be suited for these trading-range markets, TD REBO hybrid TD REBO Reverse is effective in these environments and is also a valid indicator for option trading as well.

In order to apply TD REBO Reverse, we are looking for extreme conditions where the market activity can be labeled as oversold or overbought based upon the relative opening price level and entry price level versus a prior series of closes, a prior series of highs, and a prior series of lows, depending whether the anticipated move is up or down. The type of oversold or overbought condition required to initiate TD REBO Reverse is not defined by the position of an oscillator and its relationship to price activity. Rather, the type of oversold or overbought condition required to initiate TD REBO Reverse is determined by the relative relationship between a price period’s open and entry price versus the prior three price periods’ highs, lows, and closes. For example, in the case of a low-risk buy (call-buying) entry, if the current price bar’s open is above the previous three price bars’ closes and the entry price is above the prior three price bars’ highs, then buying at a price level which is calculated by multiplying the greater of the two previous price bars’ true ranges by a percentage—such as 61.8 or 38.2 percent—and adding that value to the current price bar’s open would be too aggressive. Instead of buying the presumed breakout, as a trend follower might do, this would present a selling (put- buying) opportunity. In other words, if the current bar opens greater than the close of each of the three prior price bars, and the entry price is greater than the high of each of the three prior price bars, then one would fade the perceived REBO upside breakout. Conversely, for a low-risk sell (put-buying) entry, if the current price bar’s open is below the previous three price bars’ closes and the entry price is below the prior three price bars’ lows, then selling (buying a put) at a price level which is calculated by multiplying the greater of the two previous price bars’ true ranges by a percentage—such as 61.8 or 38.2 percent—and subtracting that value from the current price bar’s open would be too aggressive. Instead of selling, or buying a put, upon the presumed breakout, as a trend follower might do, this would present a buying (call-buying) opportunity. In other words, if the current bar opens less than the close of each of the three prior price bars, and the entry price is less than the low of each of the three prior price bars, then one would fade the perceived REBO downside breakout.

Rather than add to or subtract from the current trading day’s open, we originally used the previous trading day’s close and used 161.8 percent as our multiplier instead of 38.2 and 61.8 percent. Figure 9.1 (Coffee March 1999) identifies the three instances in which the market exceeded the 161.8 percent TD REBO Reverse price levels and in each case they coincided with price exhaustion. We were satisfied with these and similar results but TD Fib Range better accomplished the goal of identifying potential trend reversals. Consequently, with TD REBO Reverse, we rely upon the opening price level as a reference and 161.8 percent as our multiplier. It is designed to identify those instances when the market has been strained intraday and is about to react.

Certainly, other qualifiers can be introduced as well to insure ideal disqualified entries and low-risk reversal candidates for option trading have been formed. We will highlight one. Due to the fact that TD REBO Reverse may not speak until the end of the trading day, we have developed a technique which gives us, as option day traders, the benefit of a full day’s trading. Specifically, it requires that once the preceding prerequisites for TD REBO Reverse are fulfilled and price closes above the TD REBO Reverse level upside or closes below TD REBO Reverse level downside, the trader should await the next trading day’s open. If the following day’s opening is below the close on the price bar of the TD REBO Reverse upside exhaustion breakout, then a low-risk selling (put-buying) opportunity exists for that trading day; and, conversely, if the following day’s opening is above the close of the TD REBO Reverse downside exhaustion breakout, then a low-risk buying (call-buying) opportunity exists for that trading day. In this example, nothing could be better for option day traders because they are able to initiate trading positions from the opening price level, provided it confirms the indication forecast the previous trading day. In other words, if the market is able to exceed the required percentage of the previous price bar’s true price range or the previous series of price bars’ true price range, then the market is vulnerable to a reversal in price, given all the prerequisites described previously, provided the next price bar’s opening price level confirms.

Another version of TD REBO Reverse respects unfilled price gaps and improves the results further. There is a distinction between price gaps and price laps. Price gaps occur when the low of the current price bar is greater than the high of the previous price bar or the high of the current price bar is less than the previous price bar’s low; while price laps occur when the low of the current price bar is above the prior price bar’s close but less than the prior price bar’s high, or the high of the current price bar is below the prior price bar’s close but greater than the prior price bar’s low. If the ingredients are there for a price reaction, particularly after a price gap, then we suggest awaiting the next trading day’s opening price level to determine whether the open has broken out in the correct direction, and then purchasing options. This also allows a trader to take advantage of a full trading day.

Figure 9.6 is a daily IBM bar chart. This chart of IBM identifies the raw version of TD REBO Reverse without additional qualifiers. The price bars are marked on those days in which the high or low exceeded the TD REBO Reverse level. Had a trader awaited the next trading day’s open to buy an option in order to insure that price would follow through, all the trades would have produced profits. By using the exhaustion TD REBO Reverse without this additional qualifier, other indicators would be required to confirm the trades.

In Fig. 9.7, the chart of March Cocoa 1999 identifies those days in which TD REBO Reverse indications were given and they were followed the succeeding day by an open in the direction of the reversal of trend. Options purchases could have been postponed until the next trading day’s open and held the balance of the trading day for a series of profitable day trades.

TD REBO Reverse is most decidedly antitrend and often occurs at the completion of a short-term move when the trend typically exhausts itself. Other qualifiers can be introduced for option trading but the beauty of this indicator is its simplicity. Once again, if one is day trading options, then it is more prudent to enter the option market as early as possible in the trading day.

Figure 9.6. This TD REBO Reverse example of IBM stresses the enhanced opportunity for day trading success if a trader is willing to postpone entry until the day following the indicator breakout level, provided the open of that trading day confirms the price reversal.

Figure 9.7. This chart of March 1999 Cocoa emphasizes the importance of deferring entry until the price bar succeeding the TD REBO Reverse indication on the chart. This enables a day trader to potentially participate in the entire trading day.