Optionetics Interview with Tom McClellan
The following interview of Tom McClellan was featured on the optionetics.com web site in 2005. It is no longer available there, but we are happy to share it here. -TM
Optionetics: How did you first become interested in trading the markets?
I grew up in a house where tracking the stock market with charts was a daily occurrence. My parents developed the McClellan Oscillator and Summation Index back in 1969, when I was just 9 years old, and they had done a lot of other types of chart work. My mother had been a math major in college, back when that was not quite so fashionable for women to do, and her math skills were essential for the development work they did. Remember that this was in the age before computers or even hand held calculators were available. My Dad had first become interested in using technical analysis to track prices because of a family interest in an Illinois corn farm. The farm was rented out to a family that worked the farm in exchange for half the crop, and my Dad was charged with managing the whole situation. That included deciding when to sell our family's portion of the crop. They did not want to sell right at harvest time, because that's when everybody else was coming to market and that depressed prices. So he read Farm Journal magazine, subscribed to commodity charting services, and tracked corn prices on paper charts in order to find the best points in time to make the phone call and have the crop taken to the mill so they could get the best return
He also watched a local business TV station in Los Angeles called KWHY, which was the first TV station to offer live stock market coverage. It had originated the concept of running a live ticker on the bottom of the screen, and they showed periodic updates of index and commodities prices on big scoreboards with rotating number wheels like a car's odometer to display the updated prices. So when you hear them say on CNBC "Let's go to the boards," you'll know where that phrase originated. There was an end of the day chart analysis program called Charting The Market, with Gene Morgan, who taught a whole generation of people that there was value to be gained from looking at a chart of prices. That is a bigger concept than it sounds like today; chartists who worked in the banking business in the 1960s had to keep their chart books hidden for fear of being fired. Gene Morgan was the guy who named the McClellan Oscillator and made it famous by inviting my Dad on the air to present it to his viewers.
My Dad taught me basic high-low bar charting when I was around 8 years old, and I used graph paper to track the prices of the one share of Disney stock I owned, bought at around $41. I can still remember my Dad handing me the 15 cent dividend checks that I had to endorse, and then taking 15 cents out of his pocket to pay me my dividend. Luckily for me, Disney did well in the late 1960s. My one share split 3 times and I sold the 8 shares for just over $400 (on the way down from the top), money which went toward buying my first motorcycle. So I guess that using charts for tracking stock prices was something that I always knew inherently was what someone could and should do as a profitable exercise. My Dad even took a copy of my little Disney chart with him during one appearance with Gene Morgan, so you might say that my technical work has been before the public for over 30 years. Ha!
Instead of pursuing a career in finance after high school, my interests lay elsewhere, so I went off to the U.S. Military Academy at West Point, graduating in 1982. I studied aerospace engineering, and chose to be a helicopter pilot after graduation. Just before the stock market crash of 1987, I started getting interested again in investing (finally had some money to have to worry about), and got more interested after seeing what the crash could do to the markets. By 1991, while still in the Army, I started getting interested in the work my parents had done and began doing my own charting (on an 8086 IBM-compatible computer with dual floppy disk drives!). In 1993, the Army decided it had too many people now that the Cold War was over and the "mother of all battles" had been won, so Uncle Sam started waving money around and asking who wanted to get out early. I raised my hand, and decided to leave after 11 years to pursue a new career doing stock market analysis with my Dad.
We started our newsletter in 1995, and added a Daily Edition in 1998. The calls we make in our Daily Edition are used to advise the trading in a pair of managed accounts programs at an affiliated firm called Global Investment Solutions which trades mutual funds and ETFs for client accounts.
Optionetics: What kind of decison making do you go through before taking on a new position in the markets?
We do a lot of predictive work based on analysis of the current pattern versus prior patterns, and also based on a proprietary technique I developed for predicting dates of future turning points. I discovered this purely mathematical technique while I was still in the Army, and the quality of the signals was good enough to convince me that it was worth getting out of the Army to pursue this new venture.
I want the market's movements to make sense in terms of an overall framework for what I expect prices to do, and I want to have confirmation from price and/or breadth indicators that things are unfolding according to plan. Lastly, I want some degree of assurance from all of the above that the potential return on the move I foresee is sufficient to be worth the risk of taking on a position.
Optionetics: What are the things you like best about being a trader?
I have an engineer's brain. I tend to reduce everything down to black and white, yes or no, go or no-go. That was a useful mindset as a pilot when it came to decisions like "Do we have enough fuel to reach our destination?" or "Is the cloud ceiling high enough to make a flight?" My wife will attest, however, that it is a lousy mental framework when it comes to picking out paint colors or wallpaper from an infinite set of choices. It is not that I am color blind, but more like I am color tone-deaf. Luckily she can pick out ties that match my suits.
For trading, once the trading vehicle is chosen, then it comes down to establishing a set of criteria that lead to a yes/no answer. Choosing from among the vast universe of trading vehicles can be a bit daunting, so I have to reduce it down to simpler yes/no situations, such as whether the overall market is going up or down, is growth or value leading, etc. Anyone who trades an individual stock is taking at least two types of risk: market risk and individual story risk. I'd rather have only one type of risk to deal with, so we tend to focus on just the overall market's situation. That cuts the risk picture in half as far as the analysis task goes. Luckily in this era, there are vehicles that are easily traded which allow one to focus on the overall market picture. No-load mutual funds and ETFs abound, and so it is a much better situation than the 1960s and 1970s, when one had only individual stocks and one got locked into positions by the high brokerage commissions.
Optionetics: How do you treat losses and how do you go about establishing your risk tolerance before the trade is entered?
Losses are a part of the game, just like falling down is part of football. So before one suits up, he had better accept that there are going to be times when he falls down. But we don't play the game in order to fall down, and we need to find ways to make sure that we don't get irrepairably injured when we do fall.
There are times when risking a full position just cannot be justified, even though we have a strong indication that the trend is going to move a certain way. Often we will scale into and out of full positions, adding on as confirmations are apparent, and lightening up as either the move matures or confirmation begin disappearing. There are sometimes, very occasionally, when the situation is just so juicy that we know that even if we are a day early that when the ensuing turn comes it will bail us out. Unfortunately, those don't come around as often as we would like them to, and so we must prepare emotionally to guard against seeing them when they are not there.
Optionetics: What are some of the key rules that you feel are most important for a trader to keep in mind when evaluating any potential trading opportunity?
1. Am I the only one seeing this, or am I doing this because everyone seems to think it is the right thing to do?
2. What event will get me into this position, and what are the set of events any one of which will get me out?
3. Can I accept failure of this signal, and can I recognize it?
4. What has to work in order for this trade to succeed? What is the driving force or market mechanism that will make this trade work?
Optionetics: What are your favorite markets that you like to trade?
Our main focus is on the overall stock market, as typified by the SP500 or DJIA or Nasdaq Comp. Interestingly, the DJIA seems to "work" best lately as an index for technical analysis of price movements. It exhibits better support/resistance behavior, it hits Fibonacci targets better, and it interrelates with its moving averages better.
This is somewhat difficult to accept, because the DJIA is such a poorly designed index with only 30 stocks and with a price weighting rather than a capitalization weighting. It shouldn't be true that such a poorly constructed index would work better than a more properly constructed index like the SP500 or Wilshire Total Market Index, but it does. Perhaps this is because the DJIA is what everybody watches. If someone says that "The market is up 85 points", most people immediately assume that he is talking about the Dow. The NYSE passed out Dow 10,000 hats, but nobody passed out Nasdaq 3000 hats. I believe that it is the human awareness of the level of the DJIA that helps bring about its better technical behavior. Public reaction in the marketplace is the heart of why most technical analysis tools work, and so the more people who know the level of an index the better it is likely to work from a technical standpoint. Many sector indices that no one watches (or knows the index level of) turn out to be very poor in their technical behavior, especially concerning static levels of support or resistance. The Nasdaq Comp and Nasdaq 100 Index tend to overshoot both upward and downward, blowing just far enough past likely support or resistance to make people conclude that this support/resistance has been broken, only to reverse once you have reached that conclusion.
We also have a big interest in following the Russell subindices. Most people have heard of the Russell 2000 and 1000, but the Frank Russell Co. also subdivides those indices into growth and value components. We do some relative strength work to analyze which of these market segments is leading, and report that each day in our Daily Edition. The initial work in this area was done by my colleage Roger Kliminski, of Global Investment Solutions, and I have added some additional interpretive insight. He and I have a great working relationship. One of the biggest things that we have found is that the overall market tends to perform best when the Russell 2000 Growth Index is leading in our relative strength model. Nelson Freeburg of Formula Research did a detailed study of our findings on this subject, which you can read about on our web site. Go to http://www.mcoscillator.com/SpecialReports.html and scroll down to the 3 items related to Formula Research.
Optionetics: What is your most memorable trade?
There are 4 that come to mind. The first was many years ago, and it is memorable because I did such a lousy job with it. I purchased stock in a medical services company that I read about in a financial newspaper. I did not know what I was doing as an early trader while I was still in the Army, and fell into the the standard trap of buying what seemed like a hot thing. I bought near its top, and held the whole way down, finally giving up and selling right near its bottom. That one trade taught me a lot as a new trader.
The second memorable trade was buying Marion Labs, a pharmaceutical company, which I also bought as a relatively new trader. But that one I bought based on my own research of its chart plus its earnings growth prospects as opposed to reading somebody else's hype. It was memorable because the company got bought out in a tender offer, and I learned of it by reading about the deal in The Stars and Stripes newspaper while I was on a gunnery exercise at the Grafenwoehr Training Area near Amberg, Germany. I made $1000 in one day on my small position while dressed in BDUs tromping around in the woods. You can imagine the emotional impact of that for a young Captain earning about $2500 a month at the time.
The last two were memorable because they were the fulfillment of predictions we had made weeks in advance. We called the Oct. 8, 1998 bottom well ahead of time, and put our managed accounts clients into long positions that exact day. John Bollinger (creator of Bollinger Bands) says you only get to buy the low tick and sell the high tick once in your life, and so we have likely used up half our allotment.
Finally, in August 2001 our predictive tools were telling us to look for an important bottom due Sep. 17-21, 2001. We had no idea that the 9/11 attacks were coming, but the attacks caught the market in the middle of a down move into the bottom that was already on the schedule. The attacks served to push prices down further than they would have otherwise gone, but did not change the timing of the bottom. Putting it into engineering terms, the excitation force of the attacks was exerted at the appropriate point in the natural vibrational frequency of the market so as to increase the amplitude of the movement without changing the time point when the pendulum was due to reverse. The market ended up bottoming on Sep. 21, at the end of our time window for that bottom.
Optionetics: With all the different technical as well as fundamental analysis tools out there, how does a new trader avoid information overload or "analysis paralysis"?
There is a natural tendency to want to focus on just a small number of indicators (like maybe one) to avoid this exact problem, and so many traders pursue the "holy grail" indicator. The reality is that there are so many great indicators out there that are worth following at certain times, but which will all fail you at other times. To follow just one would mean having to ignore the great things that others might be saying. The trick is learning which ones to listen to at various times, and that is not an easy trick. Every day since we have been in business, there have been conflicting indications among which we have to choose to make a decision. Sometimes we listen to the right ones, and are successful. Other times, we whack ourselves in the head and ask ourselves why we listened to A when B was screaming at us with an obvious indication.
One key point to remember is that certain indicators work during trending markets, and other tools work during choppy sideways markets. So you have to first understand what type of market you are in so that you can know which set of tools to use. That sounds easy, but real life is harder. One good way to know which type of market you are in is to see which type of tools are working right now. If your overbought/oversold detection tools are letting you down, you are in a trending market.
Optionetics: Do you pay attention to sentiment readings before getting into a position?
We try to pay attention to everything. Sentiment is a big part of what we do in terms of trying to get inside of what is happening in the market's structure. We like the more obscure sentiment indications, if only because we want to watch what no one else is watching. We were among the first to do detailed work with the Rydex asset ratios, following the discovery of their use as a sentiment indicator by fellow newsletter writer Steve Todd (The Todd Market Forecast). Unfortunately, Rydex asset ratios do not work as well now that Rydex allows money to come in from the fund supermarkets.
There are some good indications to be gleaned from various Put/Call ratios, although a lot of the options series produce junk indications when looking at their Put/Call volume ratios. One of our favorites for years has been examining OEX option Put/Call open interest ratios, although it has started not to work so well lately. One of the indicators we like a lot looks at a comparison of the total volume (puts plus calls) on equity options versus the volume on index options. Nervous traders tend to trade more index options, and so seeing comparatively higher index option volume is a sign that there is a lot of nervousness, which of course is a sign of a bottom. But that indicator gets all screwy at the quarterly options expiration dates, and so it must be ignored then.
We also like to examine the Commitment of Traders numbers. One of our recent findings is that commercial traders' positions in the big SP500 contract are not working as well as they used to as a sentiment indicator, having been largely net short since 2000. We thought that it might be due to the advent of eMinis as an alternative, plus all of the other stock index futures, competing with the big SP500 contract for traders' attention. So we constructed a composite indicator that combines the dollar value of all stock index futures contracts contained in the COT Report to see what the commercials are doing across the board.
Optionetics: What are your favorite market analysis techniques that you like to employ?
This is a bit like asking which of your children do you love the most. Not fair!
Having said that, I want to have the answers ahead of time. So we look at various predictive techniques, including the one mentioned above that I discovered while still in the Army. Someday I'll get the book written to reveal that to the world, but for now only 2 people other than me know about how it works. We do reveal the signals it produces in each issue of our twice monthly newsletter.
I also like cycle analysis of various types. We constructed a Presidential Cycle Pattern to see exactly what the 4-year cycle looks like at each point in the presidential term. The 9-month cycle is very important for the stock market, as are its half and quarter cycle harmonics at 20-weeks and 10-weeks. They are hard to use in the cookie cutter fashion that a lot of people would like to employ them for, however, so it is best to use their indications to get a notion of what is likely to happen but to then zoom in with confirming indicators to tell you that a bottom or top has been reached (or passed).
Optionetics: Do you ever trade the markets with a weekly or monthly cash flow objective and if so what strategies do you typically use?
We don't. We have to swing at the pitches that the market throws at us. You cannot step up to the plate planning on hitting a home run or planning to hit a single to right field. You have to do the best you can with the pitches that are thrown, and you cannot take from the market more than it is going to offer. The key is getting that which you can while losing as little as possible.
Optionetics: How would you characterize your approach to the markets?
I am an unapologetic market timer, and predictor of the future (cue horror movie dramatic music). People say you cannot predict the future, but that is not true. The future can indeed be predicted, and sometimes even successfully. If you think about it, anyone who takes an investment position is making a prediction, so people should get over the notion that it cannot be done and set about finding ways that do work. Weather forecasts can now be made with some startling degrees of accuracy, and the earth's atmosphere is more complicated that the financial markets.
If there were more good market timers out there, the world would be a better place. There would have been more sellers as the Nasdaq was hitting 5000, and more buyers in 2002 as it was hitting its lows. Getting more sellers at tops and more buyers at bottoms would dampen out the swings, making the pain much smaller for the economy. A buy and hold person is not fulfilling his responsibilities as a market player by inefficiently applying capital to the markets. The markets need people to feed in money when money is scarce, and take money off the table when it is plentiful, and the market is willing to reward those who serve its needs well.
Optionetics: What do you think are the greatest misconceptions beginning traders have about trading the markets?
That the aforementioned holy grail indicator is indeed out there.
That if I just tune my trading system a little bit more by tweaking my entry and exit thresholds, then everything will turn out great.
That I can trade successfully without having to deal with learning to control my emotions.
That once I get this market figured out then it is going to be a lot easier and I won't have to do as much work all the time.