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Part 2 from Brett on Price Targets

This will be my second and final bonus post on the topic. As with the
earlier one, I will be keeping it on the site for a limited time as a
thanks to current readers. If the ideas interest you, you might want
to print the post out or jot down the relevant ideas.

In this post, I will explain how I calculate the daily price targets
that I post each morning via Twitter. I'm in the process of tweaking
my weekly target calculations and will wait for a future occasion to
share those.

CALCULATIONS

The calculations begin with the day's pivot level, as I define it:

Pivot = (H + L +2C)/4

Today's pivot price is defined as the average of yesterday's high
price plus yesterday's low price plus two times yesterday's closing
price. That gives us an approximation of yesterday's average trading
price.

Going back to late 2002, we touch the pivot level during today's trade
on 70% of all trading days. This is a useful "reversion" target if we
open above the pivot, but cannot sustain buying or if we open below
pivot and cannot sustain selling. (The current day's VWAP for the
index futures contracts is generally my first reversion target).

As mentioned in the earlier post, the overnight high and low price and
the prior day's high and low are generally my first price targets.
Along with the pivot level and VWAP, those are generally targets for
the first trades I will place during the day. Once I know those
targets, it's a matter of: 1) discerning the balance between buying
and selling sentiment, as well as sector and intermarket dynamics, to
gauge direction; 2) assessing today's volume relative to yesterday's
(and the prior five days' average volume) to gauge evolving
volatility; 3) executing the trade in the identified direction at a
price that provides a favorable level of reward relative to risk; and
4) holding the trade to the price target most likely to be hit given
the market's current strength and volatility.

(The above paragraph is a concise description of how I trade on the
day time frame).

The price targets above the prior day's high are identified as R1, R2,
and R3. The price targets below the prior day's low are identified as
S1, S2, and S3.

To calculate this levels, we need an estimate of recent volatility.
That estimate in my calculations is the median daily price range for
the past five trading sessions in SPY. Thus, each day we calculate the
Daily Range: DR=((H-L)/O)*100. That is the difference between the
day's high and low prices divided by the opening price multiplied
times 100 (to give us a percentage). The Volatility estimate (V) for
our calculations is the median of the prior five days' DR values.

As I mentioned earlier, going back to 2002, the median volatility for
the prior five days correlates with today's volatility by .80. Knowing
V gives us a good idea for today's DR.

So now we can define our R and S price targets:

R1 = Pivot + (.60*V)
S1 = Pivot - (.60*V)

Going back to 2002, we touch R1 or S1 about 84% of the time. If the
volume today is anything like yesterday's volume, R1 or S1 should be
hit during the day.

R2 = Pivot + (.80*V)
S2 = Pivot - (.80*V)

Going back to 2002, we touch R2 or S2 about 66% of the time. If
today's volume is above average, we should hit R2 or S2 during the
day.

R3 = Pivot + V
S3 = Pivot - V

Going back to 2002, we touch R3 or S3 about 50% of the time. If
today's volume is meaningfully above average, we should hit R3 or S3
during the day.

R4 = Pivot + 1.2 V
S4 = Pivot - 1.2 V

Going back to 2002, we touch R4 or S4 about 36% of the time. We need
to see volume today much greater than the recent average volume to
have confidence in hitting R4 or S4.

Obviously, you could define R5 and S5 levels (and beyond) accordingly
for relatively rare occasions of high volume trending and range
breakouts.

NOTES ON THE CALCULATIONS

These price levels were calculated and tested empirically in Excel
using historical data. They are not based on any Fib or any other
numerical scheme.

A worthwhile tweak on the above methodology would be to use today's
Open price in lieu of the Pivot for the calculations.

Another tweak substitutes weekly data for daily data to use for swing trading.

Another tweak is to adapt the formulas to different trading markets.

Knowing how far a market is likely to move in a direction is
invaluable in guiding the placement of stop and exit levels and
calculating the risk/reward parameters of a trade. By adjusting price
targets for recent volatility, traders can adapt quickly to faster and
slower market conditions. The price targets are not necessarily hard
exit levels; rather, they provide anticipation of where those proper
exits are likely to occur.