The DeMark Sequential is a popular indicator among market professionals. It is designed to pinpoint potential tops and bottoms in any market. It is available by subscription to large investors using expensive Bloomberg terminals and other professional trading tools.

According to a recent article in Bloomberg magazine, Steve Cohen uses the indicator to help run his $14 billion hedge fund empire. Cohen has delivered average returns of about 30% a year over the past 20 years, and has invested in the company that developed this unique indicator.

Tom DeMark described the rules in a book titled, The New Science of Technical Analysis. The rules have been expanded since they were first published in 1994, but the old rules can be amazingly accurate at times.

The chart below shows recent trading signals on PowerShares QQQ (Nasdaq: QQQ).

Traders tend to get carried away and take trends too far in the short term. The Sequential is a way to define when this happens. The exact rules will sound confusing at first, but for a sell signal, like the one shown in September on QQQ, the DeMark Sequential is trying to identify an extremely overbought market.#-ad_banner-#

The DeMark Sequential begins with a setup. For sell signals on a daily chart, the setup involves identifying nine consecutive daily closes that are higher than the close was four days earlier. Once the setup is complete (shown with boxes in the chart above), the sequential countdown begins.

The first time the price closes higher than it did two days ago, the bar is assigned a value of 1. The next close that is higher than the one that occurred two days earlier is assigned a value of 2 and so on. When the countdown reaches 13, it is time to look for a sell signal. That signal (a red arrow on the chart) is given when the price closes lower than the close from four days ago. 

Buys are the exact opposite with the setup requiring nine consecutive days where the close is lower than it was four days ago. The countdown moves toward 13 when the close is lower than it was two days ago. Buy signals (blue arrows on the chart) come after the price closes higher than it was four days ago once the countdown reaches 13.

Testing on QQQ using only the Sequential to enter and exit the market shows that there have been eight buy signals and each has been a winner. For SPDR S&P 500 (NYSE: SPY) and SPDR Dow Jones Industrial Average (NYSE: DIA), 75% of the buy signals have been winners.

Sell signals have been accurate only about 50% of the time for those ETFs if the position is held until a Sequential buy signal is recorded. Profitability of short signals can be improved to 100% for QQQ by only taking the signal if the market continues lower for another two days, confirming that the uptrend has reversed.

Currently, Sequential is signaling a sell on SPDR S&P Homebuilders (NYSE: XHB). Homebuilders have been a market leader, and a reversal in this sector could be a warning that the bull market is near an end.

Short trades are always high risk and some traders may prefer to use put options to benefit from market declines. January $25 puts on XHB are attractively priced at about $1.15. They would break even if XHB falls below $23.85. There is support near $23, and if XHB declines to support, the options would be worth at least $2. The risk is limited to the price paid for the options.

Trading professionals are responsible for buying or selling thousands or millions of shares at a time. Because they require deeper markets than individual investors, it is not surprising that they rely on different market tools. DeMark Sequential is an institutional favorite and thousands of market pros are seeing a sell signal in homebuilder ETFs. Now could be a good time for individual traders to open a short position in XHB.

Action to Take –> Buy XHB Jan 25 Puts at $1.25 or less. Set stop-loss at $0.65. Set initial price target at $2 for a potential 60% gain in two months.

This article originally appeared on TradingAuthority.com:
This $14 Billion Hedge Fund Indicator is Flashing ‘Sell’