Trading system to trade S&P 500

Volume Tutorial:
Building a Mid-Term Trading System based on PVO Analysis

We define a mid-term trend as a broad market trend that commonly persists for several weeks up to several months. No matter what timeframe you trade, it is our position that you should always know about the market's prevailing mid-term direction. It is a common misconception that short-term traders need not be concerned with the mid-term trend - this mistaken belief can lead to large losses. Many short-term players prefer not to play against a well-defined mid-term trend. Knowledge of the market's prevailing direction over this timeframe allows these traders to adopt an appropriate stop-loss strategy.

In the example below, we applied the Percentage Volume Oscillator (PVO), an indicator that can help you anticipate mid-term reversal points. While the following research was carried out using a 5-day VMA as the "fast VMA" (VMA1 on IV chart) and a 25-day VMA as the "slow VMA" (VMA2 on IV chart), you may wish to experiment with various other VMA settings instead - it all depends on your trading style and on the index to which you wish to apply the indicator. We recommend that you do your own personal research to find your ideal VMA settings.

In our analysis, we used a (5/25) PVO and applied it to the S&P 500 index. The goal was to determine at which index levels trend reversals where most likely to occur. We analyzed several different VMA settings and finally came to the conclusion that a PVO setting of 5/25 (i.e., a (5/25) PVO) best fit our goals (Click HERE to see different VMA settings). After testing several PVO settings, we decided to use a cut-off level of 14%. Table 1 below shows a list of the days where the S&P 500's 5-day (fast) VMA reached or exceeded its 25-day VMA (slow) by 14% or more. The chosen time period was January 2004 to June 2005 (i.e., 18 months).

Table 1: Days where the 5/25 PVO reached or exceeded the 14% level. S&P 500 index. January 2004 to June 2005.

Date	PVO

April 21, 2005	17%
April 20, 2005	18%
April 19, 2005	15%
April 18, 2005	15%
February 1, 2005	15%
January 31, 2005	16%
January 28, 2005	17%
January 27, 2005	15%
January 26, 2005	16%
January 25, 2005	15%
December 21, 2004	16%
December 20, 2004	19%
December 17, 2004	21%
October 6, 2004	14%
October 5, 2004	14%
October 4, 2004	16%

Date	PVO

September 23, 2004	14%
September 15, 2004	15%
January 30, 2004	14%
January 29, 2004	17%
January 28, 2004	16%
January 27, 2004	17%
January 26, 2004	20%
January 23, 2004	29%
January 22, 2004	31%
January 21, 2004	28%
January 20, 2004	28%
January 16, 2004	24%
January 15, 2004	22%
January 14, 2004	26%
January 13, 2004	30%
January 12, 2004	29%

High PVO values define volume surges. The longer a surge's duration (i.e., PVO levels remain elevated for several consecutive days), the stronger an index reversal may be. If you take a look at the two charts below, you can see that each time the S&P 500 index's 5/25 PVO moved above its critical level of 14%, the index reversed its trend soon thereafter.

Chart 1:	Example of a mid-term trend reversal. S&P 500 index. January - August 2004.1-year chart.

Chart 1 shows a volume surge during the price advance at point A. By referring to Table 1, you discover that for the January 12 to January 30 period, the corresponding PVO value exceeded 14%. The PVO reached a peak value of 34% on January 22. Since both the magnitude of this volume surge and its duration (of about 2 weeks) were extensive, the index showed a large reaction to this surge over the next 7 months. In fact, by August 2004, a decline of more than 7% had occurred. Please note that we ignore the high PVO reading before January 12, 2004 since it was mainly caused by the gap during the Christmas / New Year's Holiday.

On the same chart, note the volume surges at B, C, and D. At these points, the fast VMA traded above the slow VMA. Because the corresponding PVO levels remained below 14%, these surges are not included in Table 1; however, lowering the critical level from 14% to 12% would have put these surges in the list as well.

Chart 2:	Example of a mid-term trend reversals. S&P 500 index. October 2004 - June 2005. 1-year chart.

Chart 2 shows four surges that are included in Table 1. Note how each time the PVO hit a critical level of 14% and remained there for several days, an index reversal followed soon thereafter. If you compare Chart 1 and Chart 2, you will see that the critical PVO level of 14% works differently on different timeframes. It would be logical to use the 12% critical PVO level for the period from January to August 2004; however, the 14% level works perfectly well for the later period until June 2005.

Because market conditions and reactions change constantly, you cannot necessarily apply the same critical PVO level at all times. As long-term conditions evolve, the market's mid-term reactions to volume surges will also change. We therefore recommend that you revisit our historical PVO database at least once a month in order to adjust your critical PVO levels. (Click HERE to analyze historical PVO levels - PVO Quotes).

Using the PVO as an indicator:

The PVO can serve as an indicator and may be applied in a simple trading system. The indicator may also be used to simply alert users that other indicators should be consulted, to study the possibility of a coming trend reversal.

A volume surge during the price decline would generate a buy signal whereas a volume surge during the price advance would produce a sell signal. For high PVO levels, the critical PVO level and the minimum number of days when PVO is above it's critical level could be used to define the critical magnitude and duration of volume surges.

For instance, based on the PVO level of 14% discussed above, we could trade this system as follows:

Assume the index is moving higher and building up a volume surge. Then, once the PVO has reached a level equal to or greater than 14% for at least 2 consecutive days, get ready to short (however, please note that we ignore the first PVO high associated with a surge - see details below). Sell short once the PVO starts to decline from this high level;
Assume the index has reversed from its previous up-move and is now starting to push lower. If you see a volume surge to the price (Moving Average) downside, and the PVO reaches a level above 13%, then cover your short position;
Assume the index is now starting to push lower and is building up a volume surge. Once the PVO has reached a level equal to or greater than 14% for at least 2 days, get ready to go long. Initiate your long position once the PVO starts to decline from this high level;
Close out your long position once the PVO has reached a level above 13% in conjunction with a volume surge to the price up-side.

If the PVO starts to rise again, you may wish to add to either the long or to the short position. Assume you opened a long position based on a volume surge to the price downside, but you do not see the market reverse its direction at this time (because of a delayed volume reaction). Under these circumstances, you may wish to wait for another volume surge during the price decline and use the opportunity to add to your long position.

Very important: Ignore VMA surges (i.e., PVO highs) if they occur immediately after an index reversal has just occurred. Volume surges at this point simply confirm that a reversal has taken place. Do not trade based on these surges.

Table 2: Simulated Signals generated with a simple trading system using critical 5/25 PVO levels. S&P 500 index. July 2004 to July 2005.

Date	PVO	Trend*	PVO Analysis	Action

04/21/05	17%	down	PVO decreasing	Go Long
04/20/05	18%	down	PVO High
04/19/05	15%	down	PVO High
04/18/05	15%	down	First PVO High

01/27/05	15%	down	PVO decreasing	Go Long
01/26/05	16%	down	PVO High
01/25/05	15%	down	First PVO High

01/25/05	15%	down		Cover Short

12/21/04	16%	up	PVO decreasing	Sell Short
12/20/04	19%	up	PVO High
12/17/04	21%	up	First PVO High

10/21/04	13%	down		Cover Short

10/07/04	11%	up	PVO decreasing	Sell Short
10/06/04	14%	up	PVO High
10/05/04	14%	up	First PVO High

* The trend was defined using a 6-month chart with a 5-day index moving average.
Click HERE to read more about these trade calculations.

The trading system we described above is both very simple and highly conservative - it generates only a few signals per year. The settings for the critical PVO levels and for volume surge durations are the same for buying and for selling volume surges. The timeframe for trading the system is 18 months. The system does not incorporate a stop-loss strategy and there are no predetermined profit taking levels.

The following is a summary of the steps required to build a trading system based on the PVO:

Strategy 1

Define the current long-term trend;
Carry out a historical PVO analysis (PVO Quotes);
Determine the critical PVO levels to open a trade for both buying and selling volume surges;
Determine the critical PVO levels to close a trade for both buying and selling volume surges;
Find the minimum duration for both buying and selling volume surges;
Set an alert to let you know when the PVO has reached a critical level.

Strategy 2

Set a critical PVO level for the S&P 500 index, for instance a PVO of 15% (given a 1-day VMA and a 10-day VMA);
When the PVO exceeds this critical level, look at buying or selling VMA surges and define a magnitude for this surge (assume the PVO is 20%);
Find historical occurrences of high PVO values (for instance, a PVO of 20%). Cross-reference them with our volume charts and compare the results with the current VMA surges;
Make a determination as to how the present VMA surge might impact the current trend.

The simple trading strategies outlined above requires data adjustments on a regular basis.

As you can see, these steps are simple. The trading system we outlined can be used as a stand-alone method, or it can be applied in conjunction with other systems (see an example of a mid-term system based on AD analysis).

We hope this approach will help you increase profitability and reduce your trading risk.

Note: The principles described in the above research report may be applied to different securities, as well as to various timeframes (from short- to long-term).

Disclaimer: The above research results are provided for educational purposes only. Should you wish to apply any of the numbers, systems, or the trading strategy discussed above, you should understand that you are doing so at your risk and that you - and only you - are responsible for any trading decisions you make.

A. v. S.
V. K.

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