www.TradingEducation.com     l     Read Past Issues     l     Advertise With Us      

This month I am going to spend my time talking about the Predicted Neural Index. According to Market Technologies, the entire backbone of VantagePoint is moving and predicted moving averages derived from a Neural Network. For those of you who don’t know, a Neural Network as applied to VantagePoint is a complicated beast involving pattern recognition and intermarket analysis. One of the ways the Neural Network shines is when it is expressed as the simple 1.00 and 0.00 that make up the Predicted Neural Index.

The Predicted Neural Index predicts whether or not a 3 day simple moving average of the typical price will be either higher or lower 2 days in the future. The typical price is the average of the day’s high, low and close. The Predicted Neural Index and the 3 day simple moving average are derived from the machinations of the proprietary VantagePoint Neural Network. On the face of it, this seems quite complicated. In a sense it is. Why? Because we need to determine how and when we can profit from the data provided by the Neural Index. 

VantagePoint boasts an 80% accuracy rate in predicting where the price will be at a point in the future. VP bases this claim on the accuracy of the Neural Index. Thus, 8 out of 10 times the Neural Index will be correct in predicting where the price will be 2 days in the future. Let’s take a look at the Neural Index in action.

As you can see from the chart below, the Predicted Neural Index went to 1.00 on January 25, 2007, and in fact the close was higher on the 27th. What I like about this snapshot is that the Predicted Neural Index stays at 1.00 for a number of bars. That is an indicator that the market is decidedly trending in the direction of 1.00 or up.

The obvious question to ask is how can we use the Predicted Neural Index in our trading practice? I use the Predicted Neural Index as the secondary confirmation that I want to enter a trade. I use the Predicted Long and Short Term Differences as my first level of trade indicator, and the Medium Term Crossover as the decisive entry signal for entering a trade. Once I am in a trade, the Predicted Neural Index becomes a very important part of how I feel about a trade, whether I want to tighten my stops, and whether I decide to leave the trade outright. Take a look at the next soybean meal May 2008 contract.

The first thing to look at is the general pattern of the Predicted Neural Index as it appears in this chart. Most of the last 3 months, the Predicted Neural Index has been a mess. It looks more like an oversize stitch pattern more than meaningful financial data. Why, because the markets have been a mess of uncertain volatility! When I see the spaghetti pattern highlighted with the red circle, I say “Danger Will Robinson, Danger, Danger”! I steer clear of markets like this. I like to see a nice pattern of several days of either 1.00 or 0.00 in a market for me to trade it. The green rectangle shows you a good example of a nice and stable pattern of 0.00 and 1.00 lasting two or more days.

Now, take a look at the light blue circle and arrow. On January 29, after observing a more stable run of the Predicted Neural Index, I went long soybean meal on January 29. For the next 4 trading days, the Neural Index and the trade went in my direction, quite nicely. But, then at the end of the day on February 5, the Predicted Neural Index went to 0.00. Coupled with the cross of the Predicted Short Term Difference below the Predicted Long Term Difference, I knew I had to tighten down my stops. There was a very high probability that there would be a down day on February 6. I tightened my stop to a couple a points below the Predicted Next Day Low to 358. As luck would have it, I was not stopped out. The bar closed at 358.4. But, I kept my stop pretty tight from then on. If you look at the next few bars and the Predicted Neural Index, you will see that it stayed down for a day, and then went back up for 2 more days, and then went down again. Ultimately, I was stopped out on February 11. But, I made a profit. 

The Predicted Neural Index is a VERY valuable tool once you have entered a trade. It provides you with a very clear and direct indication of when to tighten stops. In my opinion it is an invaluable way to preserve profit and ultimately make better and more profitable trades. 

With the volatile action in many markets since mid-2007, it has become a challenge to apply logical thinking to whether prices are “too high” or “too low.” For example, soybeans have been a speculative trader favorite for many years, but when the boom in commodity prices in general took soybean futures along for the ride above record highs from the mid-1970s, there comes a point when you might assume prices have to drop back to “normal.”

Of course, markets don’t “have” to do anything so how should you approach trading when soybeans are making up or down moves of $2,000 or $3,000 per contract daily? Here is how I use VantagePoint in conjunction with candlestick charts to look at these markets, keeping in mind that I am pretty timid about taking positions during such erratic conditions and am always looking at different ways to apply the software.

I need to step back a few months to put the recent soybean market activity into context and to explain on the chart of May soybean futures below how I use VantagePoint in my analysis and why I agonized over making trading decisions in this scenario, even with the clues that VantagePoint provided. 

After reaching a record high above $13 a bushel and then making a low at $12.07 Jan. 23 with a big bearish candle, the question was whether the bull market in soybeans was over. It certainly appeared to be, but who wanted to bet against the big bullish commodity train coming at them? But the tide changed with a typical VantagePoint 1-2-3 signal:

1. The predicted short-term difference (red line) crossed above the predicted long-term difference (green line). 
    

2. The predicted short-term difference moved above the zero line, and the predicted Neural Index reading changed to 1.00.
    

3. The predicted 4-day exponential moving average (EMA) moved above the actual 10-day simple moving average (SMA) of the close. But where to get long? On a close above the EMA? On a close above the SMA? Or was this just a reaction trap that might cause you to wait until prices exceeded the previous high (dashed line)? But who thought it might be a wise move to buy soybeans above $13.30 a bushel?
    

4. On the breakout to a new high, the predicted long-term difference accelerated higher. But is this a case of the green line crossing above the red line, suggesting buying or adding to a long position, or is the red line crossing below the green line, an early alert for a possible price decline?
    

5. The predicted Neural Index drops to 0.00 combines with an ominous doji candle top after a daily range of about 60 cents ($3,000), indicating traders had rejected higher prices and suggesting the bearish interpretation. But the EMA still pointed up and there was no VantagePoint moving average crossover so the uptrend remained intact.

Assuming you had a long position (I didn’t) and you stayed with it, you had several dicey situations to deal with:

1. The closes drop to or just below the EMA and near the SMA and threaten the previous low (lower dashed line). The predicted Neural Index is at 0.00 and both the predicted short-term difference, which falls below the zero line, and long-term difference are on a downward angle. The sideways range is about 70 cents ($3,500). Buy or sell a breakout?
    

2. The predicted short-term and long-term differences angle higher together, the predicted Neural Index is at 1.00 and the predicted EMA is still above the actual SMA, all favoring a long position or, if already long, a spot to add a long contract on the breakout above the previous high (upper dashed line). But who buys soybeans at $14 a bushel?
    

3. After reaching a new high of $15.86½ a bushel, everything appears to be changing: The big black bearish engulfing candle with a daily range of about 75 cents, the turn down in the predicted EMA (but no crossover indication yet), the predicted Neural Index at 0.00 and the predicted short-term and long-term difference lines both on steep downward angles. But after watching one of the biggest bull markets in history make some unprecedented gains, not just in soybeans but in corn and wheat (particularly spring wheat), who could sell any of these markets?

Bubbles and busts are difficult to forecast and usually even more difficult to trade. But, in general, it’s probably safe to say that while markets use the stairs to climb to new heights, they often fall down an elevator shaft after the peak. Farmers and traders have never had a chance to sell soybean futures above $15 or above $14 or above $13. But how and when do you sell a landslide?

1. The predicted short-term and long-term differences both point down with the predicted short-term difference sagging below the zero line, the predicted Neural Index is at 0.00, and the price closes below the predicted EMA and actual SMA followed by a bearish EMA crossover below the SMA. But a big up day indicated by a long white candle might have you thinking about a resumption of bull fever.
    

2. 2. The predicted short-term difference red line is moving up and crosses above the predicted long-term difference green line, one bullish indication. Or is the green line accelerating below the red line, suggesting even more weakness. The predicted Neural Index is at 0.00 and the market seems to be in another wide range (dashed lines near 1). Buy or sell a breakout?
    

3. 3. The downtrend resumes but with another big up day that might add to your confusion. Then, going into the Easter weekend, May soybean futures close right at their January low at $12.07. With an extra day to ponder the market and with major planting intentions and stocks report coming up next week – I know, those are fundamentals but that’s a part of my synergistic analytical approach – will traders produce a bounce and an interim high from which a more tradable bear market begins or will they start another runup to new highs? That’s the current dilemma.

There is an expression in trading that there are old traders and there are bold traders but there are no old, bold traders. I fit more nicely into the older trader category. But here are a couple of conclusions that might be helpful:

• No one said trading would be easy, even with a tool like VantagePoint.
   

• Although VantagePoint is not a magic silver bullet that can guarantee trading success, take the moves that VantagePoint indicates if your account – and personality – can tolerate the risk of wider stops.
   

• Options may be one way to reduce risk. Stops can be dangerous due to opening gaps, and option premiums can be outlandish in volatile conditions, so be careful out there.
   

• Shifts in the predicted difference or predicted Neural Index can provide good early alerts about underlying market direction changes before they are noticeable on a chart. Not all changes may materialize so you need to wait for confirmation, but the early clues prepare you to take action.
   

• VantagePoint indicators lend themselves to lots of alternatives and require more study. For example, are closes above or below the predicted EMA a viable indicator of direction or a good place for stops? Or are closes above or below the actual SMA a better indicator? Or should you wait for confirmation provided by the moving average crossovers or traditional chart analysis, such as breakout signals? When the predicted long-term difference green line crosses above or below the predicted short-term difference red line, is that a good clue for an accelerated move and a place to increase the size of a position? Or is it really the red line crossing over the green line that offers the best indications? All of those concepts are on my VantagePoint study list.

As I wrote in my book, Trading with VantagePoint, One User’s Perspective, the software is not a magic bullet. For it to work for you, you have to do the work of learning how to use it. To further this thought, not only do you have to learn how to use it, you have to learn what the indicators are telling you in a variety of market conditions.

One of those conditions is extreme volatility. When I started trading equities in the fall of 2004, the markets were just beginning to steadily climb out of the hole created by the dot.com crash and the recession that came in its wake. From that point until July 2007, I understood market volatility to mean the rate at which an individual equity rose and fell on any given day. Some simply move faster and with greater unpredictability than others. Although this definition is one to understand for trading, it is a different animal than “overall market volatility,” which is the rapid rise and fall of all the equity markets on any given day.

This is the current state of the equity markets today, and it is extreme. It has not been uncommon to see a 400-600 point, two-day swing in the Dow, for example.

Some would argue, and I tend to agree, that extreme market volatility is like surfing the really big waves. If you don’t know how to surf the big waves, stay out of the water. Stick to the steady, six-foot swells that roll in throughout the summer. Your rate of success, and enjoyment, will be so much higher.

And so it is with VantagePoint. In the steady flow of summertime six-footers, VantagePoint provides an easy ride. When the market is steadily moving up over time, as it did from the autumn of 2004 until the summer of 2007, VantagePoint produces winner after winner. But what value is VantagePoint in the volatile markets we saw in the late summer of 2007 and in the extremely volatile markets we are now experiencing in the winter and spring of 2008? Plenty of value, I would say, and here is an excerpt from my book to explain one benefit of trading with VantagePoint in volatile markets:

Even though volatility is technically not a VantagePoint indicator, I still consider it a confirming tool, and here is why. In the first half of July 2007, I was having fun trading, and then, seemingly without warning, the overall markets began to bounce radically up and down, and they would continue to do so for several weeks. In this period, VantagePoint served me well. Every evening, I performed my VantagePoint ritual, and every evening I would get mixed signals on virtually every potential trade I considered. I interpreted that as instability in the markets. So, for the rest of July and through most of August, VantagePoint pretty much kept me on the sideline. I took only three trades in August (one loss, two wins). Two of the trades I entered were marginal at best (one win, one loss). I took them because I was impatient. The other successful trade I entered because all the VantagePoint indicators suggested I should. When the indicators pointed to a solid trade, I trusted them, and it paid off. 

Although I only traded three times during August, I nevertheless continued my daily VantagePoint work. This was time well spent. Day in and day out, I watched the indicators compared to the markets. I watched as the Dow, NASDAQ, and S&P 500 jumped this way and that. I began to understand more about how the VantagePoint indicators and markets behaved in such volatility. In that timeframe, the functionality of the VantagePoint tools sharpened and clarified in my mind. I clearly could see their value, not just in stable markets but in any market. With this new understanding, I realized that VantagePoint clearly reflects instability in the overall markets, and that reflection acts as a confirmation tool unto itself. 

The above clearly suggests staying out of the water when the waves are really big. It worked for me then, and I encourage any trader to sit it out when market movements are so extreme -- unless, of course, you have the spirit and tenacity of the “big wave” surfer… Well, I do have the spirit and in February, I jumped in. The waves were big, and I crashed on the rocks 11 times, but I did catch four nice waves. The end result? My bruises were small because I was barely testing the water, but my knowledge level increased dramatically. I learned four important things: 1) Reduce the amount you usually “bet.” 2) Of the two timing elements (entry and exit), entry is far more important. Where and when you enter the water gives you far more control over where you get out. 
3) You have to “bend” or suspend some of your normal trading rules. 4) Patience and restraint are the two most important skills to possess. 

So if you decide to jump in, bet small. Look to the VantagePoint predicted high and predicted low for entry and exit indications. I enter as far below the predicted low as I can and then exit as soon as I achieve my profit targets, which I have reduced by 50% to reflect a quick exit. In addition, of my potential trades, I select only those that have shown the least movement in the previous five days. Remember, in these turbulent waters you have to be alert, vigilant and quick to catch that one wave that will give you a profit. If the wave is not just right, let it pass. If you catch a wave and it begins to fold over you, cut out. Otherwise, when you catch a wave, watch its movement, go with its flow and ride it until the whitewater begins to foam. 

Many recently overheated commodity futures markets have taken a steep tumble recently, with gold and crude oil leading the slide. Crude oil futures at the New York Mercantile Exchange have dipped back below $100.00 a barrel in recent days, while gold dropped by over $100.00 an ounce from its recent highs.

There are two catalysts that ignited the sharp downturn in commodity futures prices the past couple weeks: The short-term credit market crisis that prompted the U.S. Federal Reserve add liquidity to the financial system and reduce U.S. interest rates, and the rebound in the value of the U.S. dollar versus the other major currencies, which can be tracked at www.TradingEducation .

Commodity market speculators, including the large commodity "funds" have been seriously rattled and many are now moving to become de-leveraged in the highly leveraged commodity futures markets. Much of the recent selling pressure this week was profit-taking from previously established long positions in the commodity markets and also long liquidation from the weak-handed futures traders.

There is also the old trading adage that says, "When in doubt, get out." There is, at present, certainly enough doubt among financial, currency, stock and commodity traders after the sudden demise of the investment banking firm Bear Stearns.

An examination of the daily chart for the Continuous Commodity Index (CCI) shows just how severe the decline in commodity futures market prices has been this week. In the past few weeks, markets like gold, crude oil, corn, soybeans and wheat had set all-time record highs. Many other commodity futures markets hit multi-year highs, like those predicted by VantagePoint Trading Software ( www.TraderTech.com ).

A major fear for all commodity market bulls in the present economic environment is deflationary pressure. Weakening world economies and shaky world financial markets argue for lessening demand for raw commodities. If deflation does grip world economies, that would be a sure bet that major market price tops are near, or already in place, in those recently high-flying commodity futures markets.

There is also a camp of analysts and traders that argue the present setback in the commodity markets is just a needed downside price "correction" after big price advances that were scored in recent weeks. They are proclaiming the present declines in commodity futures prices are, or will be soon, bargain-hunting buying opportunities in markets that are destined for still-higher prices in the coming months.

Where to in the markets from here?

I've said before that bold, specific predictions of market tops (or bottoms) before they actually occur are foolish endeavors that most respected analysts and veteran traders avoid. What is apparent, at present, is that the strong price up trends in the grains, precious metals, liquid energies and other markets are in jeopardy. What we have in many commodity futures markets are mature bull runs--and arguably very mature. These mature bull markets are fraught with high volatility and the risk at any time of steep
downside price corrections in the major up trends. When near-term price up trends on the daily charts are soundly negated, near-term chart damage starts to be inflicted. Even stronger technical clues that market tops would be in place would be downtrends developing on the weekly charts.

Importantly, it has become apparent to me that one key market in trying to determine where most of the other markets are heading is the Euro currency. As the Euro hit a new all-time high against the U.S. dollar recently, the bullish commodity markets followed with strong price surges, themselves. As long as the Euro currency continues to trend higher (and the U.S. dollar careens lower) the bullish commodity markets are likely to do the same. Keep in mind that the Euro currency is in a mature bull market move.

Note that traders could also argue the U.S. dollar is most important currency watch, via the U.S. dollar index futures. However, the reason I choose the Euro is that it's more liquid in currency futures trading than is the U.S. dollar index futures. And in the cash FOREX trading market, the Euro currency-U.S. dollar is a major currency pair traded by FOREX traders.

When markets are making parabolic price moves, like so many are doing at present, it's also prudent to examine longer-term historical charts to seek out classical technical patterns, major highs and lows, and to seek out any correlations that might occur with a technical study overlaid on the longer-term charts.

Watch for Government "Jawboning" as a Precursor to Central Bank Intervention

I want to also touch on a matter that could seriously impact the Euro currency and the value of the U.S. dollar.  It's coordinated central bank foreign exchange market intervention. This phenomenon has not occurred in any significant fashion since the mid-1990s. Central bank intervention in currency markets occurs when central bankers from the major industrial countries act in unison to try to influence the value of one currency against other currencies--usually the U.S. dollar.

It has been and still is the official policy of the government of the United States of America to have a "strong dollar." U.S. Treasury Secretary Henry Paulson reiterated such just Thursday. Most economists and analysts would agree that at present the value of the U.S. dollar versus the other major currencies could not be considered "strong."

If the U.S. dollar continues to slump (and the Euro to rise), then what is likely to occur sooner rather than later is more U.S. government officials "jawboning" and trying to talk up the value of the greenback. That tactic is not likely to work. What comes next would likely be coordinated central bank intervention in the world currency markets--done by buying or selling huge sums of currencies on the world market. In this case the central banks would likely dump other major currencies on the world market and buy up U.S. dollars.

The results of central bank intervention in the currency markets are debatable. What has occurred in the past is that shortly after the intervention is announced, the currency markets do react in the fashion the central bankers hoped they would--usually a rise in the value of the U.S. dollar versus the other major currencies. However, then what has happened is the currency speculators become emboldened by the central bank intervention, as they sense the move by the governments is a "last ditch" effort to support a weakened U.S. currency. That has caused the greenback to make one last stab to the downside, but then it does begin a sustained recovery. Importantly, the history of coordinated central bank intervention that occurred in the early-to-mid-1990s does suggest it's a last major step that occurs just before the U.S. dollar does put in a major low and embark upon an uptrend in value.

Bottom line: In the coming days or weeks, if you see more pronounced jawboning by U.S. government officials trying to talk up the U.S. dollar's value--with little results, then you can look for the next step to be coordinated central bank intervention. To likely follow that would be a last and quick jab down in the dollar's value (up in the Euro), and then the beginning of a major and longer-term recovery process in the dollar's value. To extrapolate further, at such time when the U.S. dollar does start to trend solidly higher (Euro lower) on the daily chart, then it would likely mean the end of the major bull market runs seen in many commodity futures markets. My job will continue to be to point out to you, my valued reader, any early clues that price trend changes are occurring.

I have been following the rise and fall of technology markets ever since 1974 when, as a student, I purchased 1,000 shares of National Semiconductor for $2 and watched it rise dramatically well past $20 over the next year as the markets climbed out of a deep recession. It was then I realized just how dramatically technology shares can rise and fall. A more recent example was the technology bubble that burst after 2000. 

One current technology opportunity I am watching is the Semiconductor Holders exchange-traded fund (SMH), a basket of equities that includes National Semiconductor as well as Applied Materials, Texas Instruments, Intel and other semiconductor stocks. SMH traded as high as $41 recently and is now off its lows of $26. What I find interesting is the current two-month view of SMH using VantagePoint 7.1 (see chart). 

SMH has not been a good equity to trade during the last two months but rather a good one to watch as it waits like a coiling spring getting ready to break out either up or down. I have found that semiconductor equities tend to move quickly and dramatically in relation to, or even in advance of, overall stock market sentiment. 

SMH – Semiconductor HOLDR

The VP chart properties I prefer for SMH are the VP Triple Crossover forecast combined with Predicted Stochastic and Volume. As you can see, over the last two months there have been lower highs and higher lows as the tightening coil is preparing to spring. The predicted exponential moving average forecast lines are tightening toward the center line around $29. Interestingly, while the Predicted Stochastic is currently below the trigger, both lines are trending up. Additionally, volume on recent down days is high while up volume has been low. If I were to guess which way it will break, it would be down to resume its prior trend. Fortunately, however, I do not have to guess. 

At the present time I am watching SMH very, very closely. One way or the other, SMH will soon be an opportunity to play when the Triple Crossover forecast gives the buy or sell signal. SMH is even more interesting because both put and call options are available on this ETF, which can greatly magnify a position while limiting risk.