The Active Boundaries

The Active Boundaries indicator has three objectives:
  1. To determine value
  2. To capture a trend
  3. To set pricing targets

1. Determine Value

For an investor with a long-term view, the value is best measured in terms of growth, earnings, market strength, and so on. However, a trader can benefit by following the technical price signals that were discussed earlier. The striking difference between the two approaches is that long-term investors look at the future earnings growth, while traders look at past price levels.

Who is right? Our gut feeling is that future earnings growth expresses real value. However, past price levels express the market's interpretation at that time of what the future earnings growth will be. Past price levels only represent a speculation of future earnings growth. Therefore, for traders to look at past prices levels in order to predict future prices is highly speculative. What a trader is saying is that "the stock was more expensive yesterday. Therefore, it is now comparatively cheap". This measure, however, does not give him a clue whether tomorrow's price will still be cheaper.

However, what most people tend to forget is that buying and selling a stock mainly means dealing with other people. When you buy a stock, it means that you find it "cheap". It also means that someone else finds it "expensive". This means that the concepts of "cheap" and "expensive" had better be measured against the group of traders who are active in the stock instead of against some other measure. Why is this? The simple answer is that on the stock market, we are not trading "reality", but rather the perception of that reality. Therefore, instead of talking about "cheap" or "expensive", we'd better talk about "expectation".

Indeed, nobody really buys a stock because it is cheap, or because it is a good stock. These reasons (and others) are rationalizations of the buying act. If it is not to cover an existing position, the only reason for a trader to buy a stock is because he expects the share price to increase. This trader expects to sell his position later at a profit.

In the stock market, you buy a stock because you want to resell it at a higher price. Your feeling about the expensiveness (the value) of the stock is intimately linked to your expectation to sell the stock higher or not. That expectation itself certainly depends on the stock price, but it also depends on other traders' expectations (you'll need to find a buyer).

We could say that a trader's expectation at time t of a further price increase is inversely proportional to the Return on InvesTMent (ROI) this trader is running at time t. This means that if you already have a 50% profit, for example, your expectation for a further profit increase is lower now than at the time you bought the stock when you had 0% profit.

I found out that the average ROI of the pool of active traders gives a good representation of the value of a stock as perceived by said traders. The upper panel of figure 4 represents the minute-by-minute stock price of the company OpenWave, while the lower panel represents the average ROI for a volume of 30 million shares.

The upper boundary (Dotted Red Line) says that "At this high level of collective ROI, the average expectation for a further price increase is very low, and we may expect more profit taking to occur"

The lower boundary (Dotted Green Line) says that "At this low level of collective ROI, the average expectation for a further price decrease is very low, and we may expect more bargain seekers"
2. Capture a Trend

The Active Boundaries indicator is very useful to indicate changes within a trend. Typically, in an uptrend, the Active Boundaries indicator moves between two positive limits: both upper and lower boundaries will be above 0%. This means that the average ROI of the active traders is always positive, even during retracements. This indicates that traders are bullish on the stock. You can see on the lower panel of figure 5 that for XTO Energy, the lower boundary is close to 5%. This is typical of a long uptrend.

If you look at the upper panel, you can see that the share price of XTO Energy is moving in a positive trend. If we want to profit from retracements to buy, by looking at the upper panel, it is difficult to see where we need to buy and sell. However, the Active Boundaries indicator nicely captures the trend, and shows you where the cheap entry points and expensive exit points are.

You can indeed see that buying at the lower boundary and selling at the upper boundary would have produced a 15% return on each trade (1-2 and 3-4). Two trades would have gotten you about 32% of profit, or about the same return as what a buy-and-hold strategy would have brought. However, you would have missed the X-4' or X-4'' runs. Indeed, the Active Boundaries indicator does not tell us if, at point X, the stock price will move up or down. The Effective Volume indicator or the Divergence Analysis, however, would have nicely indicated the probable direction (not shown here).

You may also notice something strange about this indicator:
Indeed, at point 2, the expectation of the active pool of traders is low. On average, people do not expect the share price to increase much. Therefore, it is expensive for the majority of traders. At that point, the probability that the share price will decrease is higher than the probability that the share price will increase.

However, at point 5, the expectation of the active pool of traders is high. On average, people expect the share price to increase. Therefore, it is cheap for the majority of traders. At that point, the probability that the share price will decrease is lower than the probability that the share price will increase.

3. Set Pricing Targets

Since the stock is moving between its upper and lower boundaries, it is important when entering a trade to know how far you are from both limits in terms of price change. Indeed, since you know the average ROI of the actual active float, it is a straightforward step to calculate the stock price that needs to be realized for the indicator to reach the upper or lower limits. Let's take the example of OpenWave. Table 1 shows the price targets set at point A, while Table 2 represents the price targets set at point B (Please refer to Figure 4).

Table 1: Point A price targets

Table 2: Point A price targets

It pays
  1. to select entry points on stocks that have a large appreciation potential
  2. to put your selling price limit below the price that corresponds to the upper boundary

At point A, we could have bought, placing a target price corresponding to the upper boundary. At point A, the price was 17.4 US$, and Table 2 shows that we had a 24% potential gain, with a target price of US$ 21.57

The target was reached at point B, on January 27, 2006, with a downside potential of 20.7%, down to $ 17.22.

The 20.7% downside potential as of January 27, 2006 does not say that we will go down to that point. It simply says that if we go down to the lower boundary, we will lose 20.7% and at that point, there is a great probability for a rebound. In other words, shorting at point B does not guarantee profit. It would make sense to short at point B if the other indicators (Effective Volume and Divergence Analysis) were showing a selling signal.