readership, I thought I would share some of my ideas and methods for
calculating price targets. If you're new to this topic, it would be
helpful to review my prior posts on hidden volatility assumptions
anddefining effective price targets with the previous day's data.
What we saw in that latter post was that using the previous day's
high, low, and average prices provides us with relatively high
probability targets for the current trading day.
In my own work, I do not use the average price as defined in the post
(H+L/2). Rather, I use (H+L+2C/4). This is the "pivot" level that I
post each morning for SPY via Twitter. This overweights the closing
price relative to the prior day's high and low, so that--on
average--the pivot price will be closer to the current day's open.
Going back to late 2002 (N=1894 trading days), my Excel calculations
show that we have touched the previous day's pivot on 70% of all
trading days.
For this reason, the previous day's high, low, and pivot prices are
key near-term price targets for my trading. As I mentioned previously,
even closer price targets are the overnight high and low prices from
the ES futures.
If I anticipate a slow trading day with a narrow price range and we
open in the middle of the overnight and prior day's ranges, I will
look for trades to take out the overnight high or low price and then
the previous day's high or low. If I anticipate a slow trading day and
we open nicely above or below the overnight and prior day's pivot
levels (for overnight "pivot" I use the day's VWAP), I look for a move
back to VWAP and then the previous day's pivot if buying or selling
can't be sustained.
If I anticipate an average or busier trading day, I look toward more
distant profit targets. Below is one way of calculating those that
builds on the previous post.
FORMULAS FOR CALCULATING PRICE TARGETS
* Let us call the difference between yesterday's high and low prices
R, for range. That means that the difference between yesterday's
average price and yesterday's high is 1/2 R and the difference between
yesterday's average price and yesterday's low is 1/2 R. (We're using
average price, not the pivot level, for this calculation. More on
pivot-based calculations in the next post in the series).
* If we calculate (yesterday's average price + 3/4 R), we will get a
price level above yesterday's high that we'll call R1. If we calculate
(yesterday's average price - 3/4 R), we will get a price level below
yesterday's low that we'll call S1.
* Going back to late 2002, the odds of hitting R1 or S1 during today's
trade are 67%. Two-thirds of the time, we'll hit R1 or S1. It's a high
probability target if volume is average or better.
* If we calculate (yesterday's average price + R), we will get a price
level above R1 that we'll call R2. If we calculate (yesterday's
average price - R), we will get a price level below S1 that we'll call
S2.
* Going back to late 2002, the odds of hitting R2 or S2 during today's
trade are 41%. We want to see above average relative volume (and
today's volume > yesterday's volume) to assume that we'll touch R2 or
S2.
* If we calculate (yesterday's average price + 5/4R), we will get a
price level above R2 that we'll call R3. If we calculate (yesterday's
average price - 5/4R), we will get a price level below S2 that we'll
call S3.
* Going back to late 2002, the odds of hitting R3 or S3 during today's
trade are 26%. We would need to see significantly above average
relative volume (and today's volume significantly > yesterday's
volume) to assume that we'll touch R3 or S3.
VARIATIONS OF THE ABOVE WORTH RESEARCHING:
* Instead of using yesterday's average price as a base for
calculation, you can use the traditional pivot formula of (H+L+C)/3.
* Instead of using yesterday's average price as a base for
calculation, you can use today's open. That is especially helpful when
the overnight session leads to an opening price far from yesterday's
average price.
* Instead of using R values based on yesterday's trading range, use
the average trading range from the prior N days. My research shows
some benefit to going out several days, but returns are diminishing
out to a five-day lookback.
Regardless of your calculation method, you will find that R increases
as the market's volatility increases and decreases as the market's
volatility wanes. This automatically adjusts your price targets for
the market's most recent volatility.
Going back to late 2002, yesterday's volatility correlates with
today's volatility by a whopping .75. That means that we can predict
more than half of the variance in today's volatility simply by knowing
the prior day's trading range. If we go out to a five-day period, the
correlation between the prior five-day's average range and today's
range has been .80.
Once you become good at tracking today's volume relative to
yesterday's (or the prior five days'), you can make very reasoned
estimates as to which levels we're likely to hit during the day. That
considerably strengthens our exits and helps us maximize our
risk/reward.
This post and the next one (tomorrow) will remain on the blog for a
limited time. If the research is of interest, you might want to print
out the post or copy the relevant data.
Thanks again for all the interest and support--
Brett
.
