If you want to talk “performance”, it’s pretty tough to beat that of biotech stocks in recent years. A quick glance at Figure 1 – a monthly bar chart for ticker IBB, the iShares biotech ETF – is sure to leave many investors shaking their heads wondering “how the heck did I not get in on that?”

Figure 1 – Ticker IBB Monthly (Courtesy: AIQ TradingExpert)

It doesn’t get much better than that.

Are the Good Times Really Over for Biotech?

Still, perspective is always in the eye of the beholder (no wait, that’s “beauty”.  Well, you get the idea). A glance at Figure 2 – a daily bar chart for IBB – clearly shows a stock that has lost momentum and seemingly “run out of steam”.

Figure 2 – Ticker IBB Daily with MACD and Rate-of-Change indicators (Courtesy AIQ TradingExpert)

So is this finally “The Top” for biotechs? Well, it’s possible. But as a good little trend-follower, there is at least one other way to view recent biotech action.

A Buying Opportunity in Biotech?

Figure 3 displays ticker IBB along with my RSI Everything Indicator and a 200-day moving average. RSI Everything readings of -32 or less have highlighted a number of good buying opportunities in the recent past.

Figure 3 – Ticker IBB with 200-day moving average and RSI Everything readings under -32 (Courtesy AIQ TradingExpert)

Sometimes the -32 reading has been a little “early” and a further decline followed. But on many occasions the -32 reading proved to be an excellent time to buy biotech.

Factoring in Seasonalilty

Biotech stocks (with performance measured using Fidelity Select Biotech, ticker FBIOX) have showed a tendency to perform well between the end of the 5th trading day of April and the 4th trading day of June.

The growth of $1,000 invested in ticker FBIOX only during this period since 1989 appears in Figure 4.

Figure 4 – Growth of $1,000 invested in ticker FBIOX from April Trading Day 5 through June Trading Day 4 (1989-present)

What To Do, What To Do?

The clear take away from the information shown so far is simple: there is no way to know for sure if the recent top in biotech was “the Top” or if the recent decline is a buying opportunity. But given the recent history of IBB and the slightly favorable seasonal trend, there is a way to play for a trader who at the very least feels that biotech is not about to collapse”

Figures 5 and 6 are generated from www.OptionsAnalysis.com and display a strategy known as a “bull put spread” using options on ticker IBB. Two important points should be made up front:

1. This is not a “Recommendation”. It is intended to serve only as an example of “one way to play the game.”

2. Options on ticker IBB have some seriously wide bid/ask spreads. This trade assumes that, a) a limit order was used and managed to get filled, b) at the midpoint of bid/ask spread for the two options used in the trade.

*This trade involves selling the June 315 put and buying the June 305 put.

*The profit potential for a 1-lot is $150 (or 17.65%)

*The maximum risk is $850

*As this is written ticker IBB is trading at $344.81 and the breakeven price for this position is $313.50.

Figure 5 – IBB June 315-305 Bull Put Spread (Courtesy: www.OptionsAnalysis.com)

Figure 6 – IBB June 315-305 Bull Put Spread (Courtesy: www.OptionsAnalysis.com)

While the maximum risk on this trade is $850, a close look at Figure 6 reveals that a trader could presumably cut is or her loss at a much lower amount. For example, if a trader decided to exit the position if IBB falls under say $330, the expected loss would be somewhere between $75 and $225, depending on whether the break occurs later or sooner.

A trader could also consider giving biotech a “wider berth” and hold on unless and until IBB drops below the 315 strike price.    In that case the risk would be roughly $400 (Reminder for Traders: these are decisions that should be made BEFORE you enter a trade, not during the “heat of battle”).

Summary

The reason that markets “fluctuate” is because different investors and traders can view the exact same situation in different ways. As we have seen here, it is possible to make a good case that the long, large advance in biotech stocks has finally run out of steam. It is also possible to make a good case that the recent decline in biotech stocks is just another buying opportunity.

We have also seen that it can be possible – via the use of options – to make money as long as biotech stocks don’t completely come apart.

At least, that’s how I see it.  How about you?

Jay Kaeppel  
Chief Market Analyst at JayOnTheMarkets.com and AIQ TradingExpert Pro (http://www.aiq.com) client
http://jayonthemarkets.com/

For the record, this is not a “new” article. I have posted something very similar to this at various venues a few times since 2004. Still, I have found that none of this stuff ever seems to become “outdated.” I think this is because despite the quantum leap in trading knowledge and computer power in recent times, that pesky thing known as “human nature” remains relatively unchanged. So, repeating now:

One useful exercise for all traders and investors is once in awhile to go back to “basics”. To wit:

While I am very much an advocate of systematic trading, success or failure ultimately comes down to what goes on between the ears. So consider the following thoughts …

Too many traders enter the markets without the slightest realistic idea as to how they will succeed in the long run. Does that sound like a plan for success?

It is essential to trade in a manner that fits your own personality.

There is no “one best way” to trade.

The question that needs to be answered is simply what approach works best for you.

Some traders operate best using a very short-term timeframe. Others operate best using a very longtime timeframe. It is critical to understand your own preference. If you can’t bring yourself to hold a trade for more than a few days, it does you no good to use a longer-term trading approach. Likewise, if you have developed a successful longer-term approach and/or don’t have time to watch a quote screen, it is a mistake to try to day trade.

If you develop some set criteria for entering trades, and if you have some realistic reason to expect this criteria to generate good returns over time, and you follow that criteria consistently, you give yourself the best chance for success.

Your answer to the question “what criteria will I use to exit a trade at a loss” may have more of an impact on your ultimate success or failure as a trader than any other single factor.

The truest thing to know about trading is that there will be losing trades, and that you must be prepared to deal with them, both financially and psychologically.

The key to long term trading success is to select some method that you will use when you have money on the line and then to stick to it once you are actually trading.

Whenever you hear a successful trader say “what you need to do in order to succeed is…” what they should be saying is “what I need to do in order to succeed is…” What you need to do in order to succeed may be different. Likewise it is your responsibility to determine which ideas from other traders are useful to you and which are not (Warning: it’s not always an easy process).

Forming a comprehensive trading plan is your first step toward trading success.

Successful traders learn that the ability to identify the current trend is far more useful than a thousand predictions.

Most successful traders focus first on controlling risk, rather than on how much money they plan/hope to make. In other words, they take care of the losing trades, and the winning trades take care of themselves.

In the final analysis, proper risk control is ultimately what separates the winning traders from the losing traders.

The goal in trading is to make money of course. However, one tradeoff that needs to be considered is the relationship between total profitability and the volatility experienced along the way. If the day-to-day volatility is too great, this will often result in a trader “pulling the plug” at exactly the wrong time.

The ultimate goal is to maximize profitability while minimizing risk. This does not happen by chance. It takes planning, execution and discipline.

Your absolute #1 priority as a trader is to be able to come back and be a trader again tomorrow – never take any risk that might endanger that possibility.

The costliest mistakes in trading are usually made when the pain of losing money (and/or the fear of losing more money) becomes too great. Bottom line: never risk too much at one time.

If you “bet the ranch.” prepare to have your trading account “buy the farm.”

The most cruel paradox in trading is that short-term success can sow the seeds for long-term failure. Beware the trader who has unexpected success and then believes he or she has developed “the touch.”

If you decide that you will exit a particular trade if and when a certain set of criteria is met, then that is exactly what you need to do. The specific chain of events that cause your exit criteria to be met are completely irrelevant.

The markets do not know that you or long or short and do not move in a particular way simply to inflict pain upon you personally. It just seems that way sometimes.

The markets will frustrate you and inflict pain upon you from time to time. This is simply a fact of trading life. The real trick is to not inflict pain upon yourself.

When you succumb to fear or greed or ego, you become your own worst enemy. Knowing yourself as well as you do, do you really want you as your worst enemy?

Too many traders spend too much time saying things like “I should have gotten in sooner,” or “I should have held on longer,” “I can’t believe that stock reversed the minute I got out,” etc., etc., etc. The cure for this is to focus solely on the action of the market from the time you enter the trade until the time you exit the trade. What happened before you got in and after you got out is not important.

Another paradox: it is important to analyze your approach from time to time to see what’s working and what’s not. However, the danger is that if you are constantly tinkering with your existing approach, you may never truly develop the confidence you need to have in it in order to stick with it when the going gets tough.

In the long run, it is not any prediction you might make about what will happen next that will make the biggest difference in your success or failure, but rather how you react when things don’t go the way you expect them to.

Second-guessing a trading decision is the single most simple act in all of trading.

Make no mistake about it, letting a profit run can be a very difficult thing to do psychologically. However, if you are using a longer-term method – which requires at least an occasional “big winner” to offset a lot of small losses, it is imperative to avoid taking profits too soon. Remember the word “discipline.”

Likewise, watching a trade continue to pile on profits after you have exited prematurely is one of the most painful experiences in all of trading.

A lack of discipline can destroy even the most talented and well-prepared trader.

In the end, you – and you alone – are ultimately responsible for your own trading success or failure. Remind yourself of this from time to time.

Working past a really bad trading experience can be very difficult. The key is to understand and accept the simple fact that this is part of life as a trader and to not allow a bad experience to have a negative residual effect on your subsequent trades.

The great paradox of option buying:

Lesson A) to maximize your return on any single trade, buy an inexpensive out-of-the-money option.

Lesson B) to maximize your return in the long rung avoid lesson A.

To put it another way, to make money in the long run, avoid trying to make all the money in the world in the short run.

In choosing which option to buy an option buyer must decide which is more important to him or herself – greater upside potential (out-of-the-money) or a higher probability of profit (further in –the-money). There is no exact right or wrong answer. The problem is that too many traders never ask the question. They simply go for the greatest leverage.

In the long run, due to the negative effect of time decay, option buyers generally are better off reducing their leverage and buying options with some intrinsic value, rather than just buying cheap out-of-the-money options.

The questions you need answers for:
* What is my reason for entering this trade?
* What is my objective in entering this trade?
* What is my maximum profit potential and what is the probability of achieving it?
* What is my maximum risk and what is the probability of achieving that?
* Will I need to adjust this position?
* If so, at what point do I need to adjust and what type of adjustment will likely be required?

Am I going to be able to keep track of this trade closely enough to avoid any potential disasters?

If you don’t have answers for these questions before entering a particular trade, this should be your warning not to take the trade in the first place.

Jay Kaeppel  
Chief Market Analyst at JayOnTheMarkets.com and AIQ TradingExpert Pro (http://www.aiq.com) client
http://jayonthemarkets.com/

EDITORS NOTE: The AIQ Expert Design Studio file for Jay’s RSI Everything part 1 and part 2 can be downloaded from here.  

In RSI Everything (Part 1) I detailed two indicators respectively dubbed “RSIAll” and “RSIROC”.  These two indicators make up half of a combined indicator I refer to as “RSI Everything”.

In Part 2 I will detail the last 2 RSI based indicators and then add them together to create one – OK, for lack of a better phrase – “Mega”  RSI indicator.  Traders may consider each of the four indicators separately, or combine them into one indicator as I do a little later in this piece.

Measure #3. RSIq2

I am not exactly how I came to name this one RSIq2, but for better or for worst there you have it.  The initial calculations for this RSI variation are very similar to those for RSIROC detailed in Part 1.  The primary difference is that this indicator uses a traditional 14-day RSI day window, and it adds an additional calculation to the mix at the end.  The AIQ code for the RSIq indicator appears below followed by the gist of it in English.

ThreeDayROCRSI14 is (RSI14-valresult(RSI14,3)).

RSIPlusROCRSI14 is (RSI14-50)+ThreeDayROCRSI14.

RSIROC14 is (expavg(RSIPlusROCRSI14, 2)).

RSI14mid50 is RSI14-50.

RSIq2 is (RSIROC14+RSI14mid50)*2.

In some semblance of English:

Line 1 subtracts the 14-day RSI value of 3 days ago from today’s 14-day RSI value (to essentially factor the trend of the 14-day RSI into the mix).

Line 2 subtracts 50 points from today’s 14-day RSI and then adds in the value calculated in line 1. (this creates an indicator that fluctuates above and below zero rather than using 50 as the midpoint as with the traditional RSI).

Line 3 creates a two-day exponential moving average of values calculated each day in Line 2 (i.e., yesterday’s RSIROC14 value is multiplied by 0.6667 and today’s RSIROC14 value is multiplied by 0.3333 and the two values are added together to create today’s RSIROC14 value.

Line 4 once again subtracts 50 from today’s 14-day RSI value.

Line 5 simply adds together the values calculated in Lines 3 and 4 and then multiplies the sum by 2 to arrive at the RSIq2 value.

An example of RSIq2 plotted again an actual security appears in Figure 1.

  Figure 1 – Ticker SPY with RSIq2 indicator (Courtesy: AIQ TradingExpert Pro)

In general, readings below -64 in an uptrend signal a potentially oversold situation and readings above 64 in a downtrend signal a potentially overbought situation.  But as with all of these indicators, traders are encouraged to experiment with different “cutoff” values and also with various entry triggers.

Measure #4. Tom DeMark’s Range Expansion Index (TDREI)

Tom Demark is a well known analyst and system and indicator developer.  One limitation of the RSI indicator is that if price moves up or down the RSI will fluctuate even if price movement is not very meaningful.  DeMark’s REI is an attempt to reduce the influence of price movements that are little more than “noise”.  Rather than just noting the change in price from close to close each day, REI compares the high or low of certain days to the high or lower of certain other previous days to update the indicator value each day.  The AIQ code for TDREI is as follows:

Hitoday is [high].

H2 is val([high], 2).

H5 is val([high], 5).

H6 is val([high], 6).

Lotoday is [low].

L2x is val([low], 2).

L5 is val([low], 5).

L6 is val([low], 6).

Closetoday is [close].

C7 is val([close], 7).

C8 is val([close], 8).

TD1 is [high] – h2.

TD2 is [low] – l2x.

TD3 is iff(([high] >= l5 or [high] >= l6) and ([low] <= h5 or [low] <= h6), 1, 0).

TD4 is iff((h2 >= c7 or h2 >= c8) and (l2x <=c7 or l2x <=c8), 1, 0).

TD6 is td1 + td2.

TD5 is iff((td3 + td4) >=1, td6, 0).

TD7 is abs(td1) + abs(td2).

TDREI is ((td5 + valresult(td5, 1) + valresult(td5, 2) + valresult(td5, 3) + valresult(td5, 4)) / (td7 + valresult(td7, 1) + valresult(td7, 2) +valresult(td7, 3) + valresult(td7, 4))) * 100.

I am not going to attempt to explain the REI calculations.  If you want to know the particulars please follow this link: www.Google.com.  Then type in DeMark Range Expansion Index.

Figure 2 displays ticker XLF with the REI indicator plotted below.

Figure 2 – Ticker XLE with DeMark’s REI indicator (Courtesy: AIQ Trading Expert Pro)

As with the previous indicators I’ve discussed the general idea is about the same – i.e., negative readings within an uptrend signal potential buying opportunities, positive readings within a downtrend signal potential shorting opportunities.

RSI Everything

So we have now detailed four different (albeit similar) RSI based indicators.  Typically the next question many traders will ask is “which one is the best to use for trading?”  And in fact some traders may have better success focusing on one of the four indicators rather than combining them as we are about to do next.  But the reality is that each indicator gives its fair share of excellent trading signals and its fair share of just plain wrong trading signals.  So for the purposes of this exercise instead of trying to “choose” we will instead “combine.”

The indicator I call RSIEverything is calculated simply by summing the daily value for each of the following indicators and dividing by four:

*RSIAll-50

*RSIROC

*RSIq

*REI

The first two were detailed here and the second two are detailed above.

Figures 3 through 6 display RSIEverything plotted against a handful of various securities. 

Figure 3 – Ticker XLE with RSI Everything (Courtesy AIQ TradingExpert Pro)

Figure 4 – Ticker SPY with RSI Everything (Courtesy AIQ TradingExpert Pro)

Figure 5 – Ticker TLT with RSI Everything (Courtesy AIQ TradingExpert Pro)

 Figure 6 – Ticker WYNN with RSI Everything (Courtesy AIQ TradingExpert Pro)

Summary

As with any oscillator the bad news is that there is no one magic cutoff value that – once reached – guarantees that a price reversal is imminent.  Still, much money can be made by “buying the pullback in an advance’ and/or shorting the rally in a decline.

Looking for a buying opportunity when:

1) Price is above the 200-day moving average and;

2) RSI Everything is below ???  -32?  -48?  -64?

Appears to make sense.  So does looking for a shorting opportunity when:

1) Price is below the 200-day moving average and;

2) RSI Everyting is above +32? +48? +64?

The key questions for a trader to answer are “what indicator cutoff values to use to signal an opportunity” and “enter immediately or wait for a reversal or a breakout above the latest high (or the latest 2-day high”?  etc.

Which reminds me to mention:

Jay’s Trading Maxim #65: Getting an indicator to signal “buy” or “sell” is the easy part. In the long run, how and when you actually enter into a new trade and how you manage that trade once entered is what separates the winners from the losers.

Jay Kaeppel  
Chief Market Analyst at JayOnTheMarkets.com and AIQ TradingExpert Pro (http://www.aiq.com) client
http://jayonthemarkets.com/

A long time ago a friend of mine worked for a professional sports franchise.  However, as low man on the totem pole he didn’t make a lot of money.  So to supplement things he got a job at a small local television station as the Producer for a show that featured local bowling on Sunday mornings.  No, seriously.  And he wasn’t the only guy trying to “make it.”  The guy who was hired as the actual on air broadcaster had aspirations too.  So he would routinely treat each frame as something akin to the ninth inning of the seventh game of the World Series.  As a result he sometimes went a little overboard on the hyperbole.  To wit:  One day when the “local legend” – a woman who had won every local bowling title and award that was ever created – stepped up to the line with her ball in hand, the broadcaster intoned for all (roughly 12) viewers to hear, “Anything that you can do with a bowling ball, this woman has done!”

My poor friend almost peed his pants.

Anyway, the only reason I bring this up is that as a still non-recovering “numbers geek” (“Hi, my name is Jay”), I sometimes feel like “anything you can do with a couple of numbers, I’ve done it.”  One case in point is the simple RSI (Relative Strength Index) indicator. Created by Welles Wilder I’m guessing 40 some odd years ago, this simple oscillator has helped to trigger roughly a bazillion trades.  But some of us are not content to leave well enough alone.  And so for better or worse we torture the darn thing until it is “different” (and hopefully – though not necessarily – better, for “better” is in the eye of the beholder).  So (True Confession Time) I have an indicator I follow that I’ve called RSI Everything (for reasons that will become painfully obvious very soon), which combines four, um, variations, on the venerable RSI.  i will cover the first two in this article .

There are many ways to calculate these things but in this article I will be including code from AIQ Expert Design Studio.  Not much in the way of “rocket science” so the indicators can be easily adapted by those of you using one of the roughly twelve bazillion other charting packages available these days.

Measure #1. RSIAll

Figure 1 displays ticker AAPL with the 2-day, 3-day and 4-day RSI indicators drawn below the bar chart with the values for each appear in the lower right hand corner. 

Figure 1 – AAPL with 2-day, 3-day and 4-day RSI indicators (Courtesy: AIQ TradingExpert Pro)

In a nutshell, the 2-day is more sensitive than the 3-day and the 3-day is more sensitive than the 4-day.  Most traders pick their “favorite” day window and stick with it.  Nothing wrong with that.  But RSIAll is calculated simply by taking the latest value for the 2-day, 3-day and 4-day RSI and dividing by three.  This appears in Figure 2.

Figure 2 – AAPL with RSIAll indicator (Courtesy: AIQ TradingExpert Pro)

In a nutshell, low RSIAll readings within an uptrend are considered “bullish”, while high RSIAll reading within a downtrend are considered “bearish.”  Of course, the trick is defining how low is “low” and how high is “high”.  As with most indicators there are no “magic numbers.”  That being said, 15 on the oversold side and 85 on the overbought side are probably a good place to start.

The AIQ Code for RSIAll is as follows:

Define days2 3.

U2 is [close]-val([close],1).

D2 is val([close],1)-[close].

AvgU2 is ExpAvg(iff(U2>0,U2,0),days2).

AvgD2 is ExpAvg(iff(D2>=0,D2,0),days2).

RSI2 is 100-(100/(1+(AvgU2/AvgD2))).

Define days3 5.

U3 is [close]-val([close],1).

D3 is val([close],1)-[close].

AvgU3 is ExpAvg(iff(U3>0,U3,0),days3).

AvgD3 is ExpAvg(iff(D3>=0,D3,0),days3).

RSI3 is 100-(100/(1+(AvgU3/AvgD3))).

Define days4 7.

U4 is [close]-val([close],1).

D4 is val([close],1)-[close].

AvgU4 is ExpAvg(iff(U4>0,U4,0),days4).

AvgD4 is ExpAvg(iff(D4>=0,D4,0),days4).

RSI4 is 100-(100/(1+(AvgU4/AvgD4))).

RSIAll is (RSI2+RSI3+RSI4)/3.

Measure #2. RSIROC

OK, for the record RSIROC is an abbreviation of another indicator I concocted with an even more arcane name titled RSIROCExpAve.  The code (and a relatively weak attempt at an explanation in English) follows below:

ThreeDayROCRSI is (RSI3-valresult(RSI3,3)).

RSIPlusROCRSI is (RSI3-50)+ThreeDayROCRSI.

RSIROC is (expavg(RSIPlusROCRSI, 2)).

So what is that all about?  This indicator basically builds in the 3-change in the RSI indicator itself to measure the momentum of RSI.  OK, here goes:

Line 1 subtracts the 3-day RSI value from 3 days ago from today’s 3-day RSI value.

Line 2 subtracts 50 points from today’s 3-day RSI and then adds in the value calculated above.

Line 3 creates a two-day exponential moving average of values calculated each day in Line 2 (i.e., yesterday’s RSIROC value is multiplied by 0.6667 and today’s RSIPlusROCRSI value is multiplied by 0.3333 and the two values are added together to create today’s RSIROC value.

Example:

-Yesterday’s RSIROC value was 45

-Today’s 3-day RSI is 30

-3-day value three days go was 60 then:

ThreeDayROCRSI = (30-60) or -30

RSIPlusROCRSI is (30-50) + (-30) = -50

RSIROCExpAve is ((45 * 0.6667) + (-50 * 0.3333) = 13.33

Ticker GOOG with the RSIROC indicator plotted appears in Figure 3. 

Figure 3 – Ticker GOOG with indicator RSIROC (Courtesy: AIQ TradingExpert Pro)

In a nutshell, the higher above 0 the RSIROC reading the more overbought the security in question, and the lower below 0 the RSIROC reading the more oversold the security in question.  Readings of +60 or more and -60 or less seem like reasonable areas of “extreme” readings.  The most likely use for this indicator is to look for low readings when price is above the 200-day moving average (as a potential buying opportunity) and for high trading when price is below the 200-day moving average (as a potential shorting opportunity).

n RSI Everything Part 2 I will detail the other two parts of the indicator and how the pieces go together.

In the meantime, don’t try anything crazy with a bowling ball.

Jay Kaeppel  

Jay has published four books on futures, option and stock trading. He was Head Trader for a CTA from 1995 through 2003. As a computer programmer, he co-developed trading software that was voted “Best Option Trading System” six consecutive years by readers of Technical Analysis of Stocks and Commodities magazine. A featured speaker and instructor at live and on-line trading seminars, he has authored over 30 articles in Technical Analysis of Stocks and Commodities magazine, Active Trader magazine, Futures & Options magazine and on-line at www.Investopedia.com.