TradeStation Interview with David Stendahl

Value Charts the Dynamic Trading Indicator:

David Stendahl, a trading principal with Talon Eight, was interviewed by TradeStation Technologies Inc. The discussion focused on the Value Chart indicator featured in the book Dynamic Trading Indicator: Winning with Value Charts and Price Action Profile co-written by David Stendahl.

TradeStation: Thank you for joining us today. You've had a long history of portfolio construction and strategy design. What we'd like to focus on today are Value Charts. Can you begin with an overview?

Stendahl: Traditional bar charts may not provide the information traders need to make appropriate trading decisions. Value Charts represent a market analysis tool that allow traders to trade stocks, bonds and futures with additional poise and confidence. It's a different view of the markets because they were developed to display the valuation of the market.

TradeStation: David, before we go into the mechanics of value charts, can you share with us some of the potential benefits of using value charts?

Stendahl: Several come to mind.

• Buy into markets at undervalued, or oversold, price levels.
• Avoid buying into markets at overvalued, or overbought, price levels.
• Allow traders to identify fair value price levels and confidently transact business at these price levels.

TradeStation: Can you expand on "confidently transact business"?

Stendahl: Sure. Value Charts, and what I'll later explain as Price Action Profile, help keep the two emotions in check that have the potential to destroy the efforts of any trader -- greed and fear. These market analysis techniques allow traders to enforce discipline and avoid being taken by markets at short-term peaks or being scared out of the markets at short-term bottoms.

TradeStation: Is there an example you'd like to share with us?

Stendahl: What comes to mind is a pilot. Pilots will be the first to testify that the artificial horizon is much more reliable than their physical sense of up and down. Without a sense of direction, they ultimately risk crashing into the earth when they exercise poor judgment. In the trading arena, Value Charts and Price Action Profile are the instruments that will help to keep greed and fear in check for any trader. The artificial horizon represents the current condition (orientation) of the airplane, and the Value Charts and Price Action Profile represent the current condition (valuation) of the markets.

TradeStation: You mentioned removing emotions as a benefit. Since it's well-known that strategy traders can also benefit from removing emotions from their trading, is there an added benefit of using Value Charts with a strategy?

Stendahl: By utilizing Value Charts, traders can now create trading systems that have the ability to enter or exit markets at relative price levels intraday. The ability to define relative price levels, and hence relative value levels, during a trading period represents an exciting breakthrough.

Quantifiable information is useful information. Many market analysis strategies rely too heavily on the eye of the beholder when determining if certain rules or conditions are met. Market analysis strategies that rely on the judgment of a trader often contain too much gray area and have little long-term usefulness. Value Charts and Price Action Profile, on the other hand, generate quantifiable information that can be interpreted only one way. This allows traders to know when a certain condition is being met during the trading day, which allows them to act confidently.

TradeStation: Please explain the "valuation of the market."

Stendahl: The valuation of the market has to do with whether the current price level is trading at fair value, is trading above fair value (overvalued), or is trading below fair value (undervalued). It is determined by analyzing the percentage of buyers and sellers who consider current price levels acceptable, or fair.

TradeStation: What are some of the major differences between a bar chart and a value chart?

Stendahl: Value Charts were developed to pick up where traditional price charts leave off. More specifically, bar charts display the absolute current and historical price activity for a market. This is important if we are interested in learning about the magnitude of historical price moves. Value charts display price activity in relative terms.

In addition, it is important to note that value is a function of time whereas price is not a function of time. Price is absolute and is unaffected by the passing of time. However, the valuation of a market is a function of both price and time.

The market is made up of many individual participants who are in a constant search of fair value across every time frame. Regardless of the trader's time horizon, every trader should concern themselves with short-term price activity in order to identify the optimal entry or exit point. Most of the trading activity for any market will occur around the fair value price level.

TradeStation: What are the major requirements needed to determine valuation?

Stendahl: The two requirements that are needed to accurately determine the valuation of any market are liquidity and standardized contracts. The valuation of a market can be established by referencing historical price activity, or past price levels where buyers and sellers have willingly met and transacted business. The current valuation of a market is very important when we are seeking to enter or exit market positions.

TradeStation: Can you put this into perspective?

Stendahl: The experience of buying a used car serves as an excellent example of how historical price data are used to understand the current market valuation. Unlike the new car market where price fixing by the manufacturers impacts the market price, the used care market is solely influence by supply and demand forces. We normally use the Blue Book, which ideally should list the price level that the mass market considers to be acceptable by both buyers and sellers, or the fair value price level.

We need the Blue Book fair value so that we can have a reference price level to compare the asking prices quoted to us by the sellers of the vehicles under consideration. In this example, Value Charts were developed to be the Blue Book for the stock, bond, currency, and futures markets.

TradeStation: Are the removal of fear and greed also applicable in this example?

Stendahl: Yes, absolutely. If we had allowed ourselves to become overwhelmed with excitement at the prospect of purchasing an automobile, we most likely would have allowed emotions to negatively impact our decision-making process. By allowing this to happen, we most likely would have bough the first used car that we happened upon and quite possibly could have paid too much. Instead of attempting to understand which sales prices represent a good deal and which sales prices represent a bad deal to a potential buyer, we would be taking a chance and potentially overpay for the automobile we want to purchase.

TradeStation: Now that we have an overview of the benefits, let's delve into the mechanics. Can you describe a Value Chart?

Stendahl: At first glance, a Value Chart looks very much like a price chart. However, a quick inspection of the Value Chart reveals that it is divided into five valuation ranges. Starting from the top, the Value Chart is labeled as significantly overbought, moderately overbought, fair value, moderately oversold, and significantly oversold. Price activity that takes place within each of these individual ranges can be understood to fit under the corresponding valuation description. For example, all trading activity that takes place within the -4 to +4 Value Chart price range would be considered fair value. Each of the five valuation ranges can be distinguished by their different shades.

TradeStation: David, when describing the differences between a price and value chart, you mentioned that the Value Chart displays price activity in relative terms. Can you expand on that?

Stendahl: Sure. The terms overvalued and undervalued are defined on a relative basis. When we are seeking to identify undervalued or overvalued price levels, it is necessary to reference the fair value price level. Therefore, instead of plotting price with respect to zero, it is necessary to plot price (open, high, low, and close) with respect to a moving (floating) axis, which is designed to represent fair value. Because fair value represents the price level where the majority of buyers and sellers will transact business, a carefully selected moving average of price activity should be representative of fair value in any market. This moving average is referred to as the floating axis.

TradeStation: Is displaying price activity relative to a zero axis or a floating axis another major difference between a price and Value Chart?

Stendahl: Exactly. Traditional bar charts state price activity relative to the zero axis. The first step in creating a Value Chart is to state price activity relative to the floating axis, which represents fair value.

TTradeStation: What is the difference between a relative price chart and a Value Chart?

Stendahl: This is a great question. Value Charts are a significantly improved version of relative price charts. Allow me to explain -- in order for a relative chart to be useful in identifying overbought or oversold price levels, it would have to have the ability to adapt to changing market volatility. The need for a relative chart to be defined in terms of volatility was the driving force in developing a dynamic volatility unit instead of using a static price unit. This resulted in the creation of Value Charts.

TradeStation: Since it plays such an important role in Value Charts, can you define market volatility?

Stendahl: Market volatility can be defined as "a measure or expectation of how much a market can move over time." Higher volatility equates to more price movement, whereas lower volatility equates to less price movement. For example, if the weekly trading range of Microsoft was $4 per share last week and the weekly trading range is $8 this week, we would conclude that the volatility of Microsoft stock has increased. Typically, the market volatility is correlated to the absolute price level of a market. A stock that is trading near the $10 price level might be expected to have weekly price fluctuations of $1, whereas a stock trading near the $100 price level might be expected to have weekly price fluctuations of $10.

As the price of a market climbs to higher price levels, the volatility almost always increases. There tends to be a high correlation between the magnitude of price fluctuations around fair value and the absolute price level in the market. Value Charts use dynamic volatility units to effectively adjust to changing market volatility.

TradeStation: David, you mentioned the five valuation ranges. Would you explain how to read the ranges?

Stendahl: Value Charts are effective in normalizing deviations from fair value in different volatility environments. This means that a deviation of +4 Value Chart units, which represents a specific degree of overbought prices, should very nearly equal a deviation of +4 Value Chart units in a totally different volatility environment. It's important to understand that the closer prices are to zero, the more closely prices represent fair value. On the other hand, the further away prices trade from zero, the more overbought or the more oversold it becomes. The ability to identify the portion of the price bars that extend into the extreme overbought and oversold zones is one of the most powerful features of Value Charts.

TradeStation: Besides optimal entry and exit points, how else can Value Charts be used?

Stendahl: Value Charts can be used in a variety of ways to improve trading performance. One of the easiest ways to put Value Charts into action is by scaling into additional positions based on market dips. There is an ebb and flow to trading, even strong bullish trends run into small market dips. Value Charts can help pinpoint these dips and offer traders an opportunity to increase the number of shares or contracts traded. Typically adding to positions at high probability entry points translates into larger profits with limited risk potential.

TradeStation: Can you help us visualize how Value Charts can enhance trading strategies?

Stendahl: Certainly. The example I'm going to share with you also appears in my latest book "Dynamic Trading Indicators". It's a Crude oil trading strategy that follow these rules:

• Buy Signal - Buy highest (high,10) + 1 point stop (applied to a 30-minute crude oil bar chart).
• ExitLong Signal - Exitlong at +8 Value Chart price level or higher (applied to a daily crude oil value chart).
• Money Management Stop - Place money-management stop 1 tick below lowest low in 30-minute bar chart for the 10 bars preceding the short-term breakout buy signal.

These trading rules simply state that we will buy crude oil when (1) an uptrend has been established, (2) crude oil trades below the -8 Value Chart price level, and (3) a buy signal is generated by a 10-bar breakout system applied to 30-minute bar charts. We will exit our long position when the crude oil Value Chart trades above the +8 Value Chart price level or gets stopped out below our 30-minute bar chart entry point.

The first step would be to confirm that crude oil is in a bull market as defined by the Filter:

• Filter One: Uptrend will be established by a trend-following strategy -- only following trading signals in the direction of the trend. When a 25-day simple moving average of the closing prices crosses above (and remains above) a 75-day simple moving average of the closing prices, than an uptrend will be indicated.
  

And we have yet a second requirement:

• Filter Two (Buy signal): Once an uptrend is indicated by the moving average trend-following system, look to buy into the daily crude oil market when it trades below the -8 Value Chart price level.

The purpose of reviewing this example trading strategy is simply to demonstrate how many different trading tools can be used to enhance Value Charts. You can use these simple rules to identify trading opportunities in other markets.

TradeStation: You also mentioned the Price Action Profile Indicator. Can you briefly share with us how it can be of value to a trader?

Stendahl: Price Action Profile is used to both complement and validate Value Charts. A Price Action Profile is simply "a profile that describes, or plots, the historical price behavior of a Value Chart." Price Action Profiles can define how frequently a Value Chart has traded above, below, or within any given Value Chart sector. Chapters 3 and 4 of the book go into full details on how to best use this indicator.

TradeStation: Any final thoughts you'd like to share with the TradeStationWorld community?

Stendahl: Yes, as with any trading indicator test your methodologies before you begin trading it real time. At my firm we have spent a great deal of time evaluating our systems in detail. The way in which we have incorporated Value Charts into our investment programs allows us to trade with a high degree of confidence.