System Discussion From Other Blogs

I’ve noticed some good posts on systems lately. Below are a few for your review:

Using RSI(2) to time ETF entries – Woodshedder shows some results and discusses a current trade.

IBD Index seems to out-do himself every weekend with a new post on system design. This week he discusses profit targets. One of the few authors I’ve seen to thoroughly test breakout systems. This is a regular part of my weekend reading.

Afraid to Trade with some thoughts on backtesting.

Skill Analytics – A brand new blog dedicated to discussing system based trading strategies. I’ll be keeping an eye on this one as it looks to have potential.

Failure To Launch

About 2 ½ weeks ago the Nasdaq 100 blasted through it 200-day moving average. Tests I ran at that time suggested an edge over the 1-4 weeks following such activity. So far so good for the NDX. Today the S&P 500 tried to smash through the 200-day moving average. After a strong morning it turned tail and dropped fairly hard in the afternoon. In doing so it failed to close above the 200. Tonight I looked at possible implications of intraday spikes above the 200ma that fail.

This first test looks quite negative for the 1st week and then positive over the following three weeks. Note the Max Loss column, though. This one triggered the night before the Crash of ’87. This is the biggest possible outlier you could have over the time period tested. To see results more representative of typical, I excluded that trade.

It is always important to look at outliers. A massive outlier like the crash of ’87 could dramatically change the results. Now the results don’t look so bad initially. There is still some downward chop in the first week, though, followed by a nice rise in prices.

To better asses the possible influence of the criteria on performance I then looked at how the Dow and Nasdaq performed under similar circumstances.

The Nasdaq never got it together following the “Failure to Launch” through the 200. The Dow results were choppy and uneven. Four weeks out they were positive but less so than a random sample over the test period.

The way I see it, a failure of the 200 like we saw today appears to lead to weakness in the short-term. The one consistent of the tests is that they all showed a negative expectancy shortly after the event. Longer-term whether the market gets it together like the S&P results suggest or continues to struggle as the Nasdaq results suggest is unclear. Keep in mind that beyond the short-term there are much bigger forces at work than today’s action. I therefore wouldn’t try and extrapolate out too far with this test.

The short-term negative does jive with some of my other work and I continue to believe a pullback is likely in the next few days.

High Five

Friday the market made its 5th higher high in a row. Below is a table showing how the market reacts to at least 5 higher highs and a 50-day high:
This study suggests limited upside and a good chance of sideways chop over the next 1-20 days.

The VIX system oulined in Thursday’s blog would have triggered a short index entry Friday at the close.

I’m having a hard time finding anything suggesting prices are likely to continue higher.

A Few Sentiment Observations

A few quick notes today on Thursday’s market action:

I sliced Thursday’s price and volume action a number of different ways last night. Factors I looked at included new intermediate-term highs being hit, a 1% move up, and relatively low volume. The results of all my tests indicated choppy action over the next week.

The VIX spike down more than 10% below its 10-day moving average. Check out my post from yesterday which discusses in detail the implications of this. Basically, this on its own is not a signal to short, but when the oversold condition of the VIX begins to work off, it may be.

The VIX:VXV ratio that Bill Luby tracks hit it’s lowest level to date on Thursday. Breaking the previous low set on 12/21/07. Also The CBOE total put/call ratio hit its lowest level since 12/21. December 21st was not a good time to be going long.

Dr. Brett Steenbarger tracks the 10-day moving average over the 200-day moving average of the CBOE total put/call ratio. That reading dropped below 0.85 for the first time since early October – also not a good time to be long.

Is A Low VIX A Short Trigger?

The declining VIX has been a hot topic lately. Adam at the Daily Options Report had an interesting and (as you’ll see below) accurate comment the other day about overbought/oversold VIX readings: “Also, oversold VIX does not provide as good an indicator as overbought. Outright fear tends to lead to big turns, outright disinterest can just linger.”

The most common technique I see discussed for trading based on the VIX is viewing it in relation to its 10-day moving average. This was originally made popular by Larry Connors. Many traders will throw moving average envelopes around the VIX, wait for a stretch and then trade the S&P 500 based on a mean reversion. A relatively high VIX means market participants are fearful and the market should be bought while a relatively low VIX is a sign of complacency and a short signal. With the VIX continually dropping, traders have been on alert for a VIX stretched below its 10-ma to try and short. But is that really a good time to be short?

Over the last 10 years, owning the S&P 500 when the VIX was more than 10% below its 10-day moving average was significantly more profitable on average than owning it when it wasn’t. Let me repeat that. Owning the S&P 500 when the VIX was more than 10% below its 10-day moving average was significantly more profitable on average than owning it when it wasn’t. To illustrate I ran a study:

Short the VIX on a cross of the lower 10% envelope of the 10-day moving average. Cover when it moved back above this envelope. From 5/98 until now there were 87 such trades. The average lasted just over 3 days. The S&P actually GAINED 91.09 points in the 272 days that this was in effect. That is an average of about 0.33 points per day. In the other 2,379 days the market only managed to gain 184.22 points – about 0.08 points per day. In other words, the market actually performed over 4 times BETTER when the VIX was stretched more than 10% below its 10-day moving average. Also, when this VIX-stretch was active the S&P made nearly 1/3 of its total gains in only 9% of the time.

So is the whole low VIX = complacency thing a fallacy? Not completely. Many times it will lead to a selloff. Here’s a system which demonstrates that. Again, last 10-years is the time period. 1) Short the S&P 500 when the VIX crosses from below to above the lower 10% envelope but remains below its 10-day moving average on a closing basis. 2) Exit the trade when the VIX closes above its 10-day moving average. Here you would have had 58 trades. The average trade would have made you about 7 S&P points and the total system gain, or S&P points lost, over the time period is 403.17 – a very substantial number.

To sum up – just because the VIX is “low” doesn’t mean the market is about to fall. In fact a good portion (about 1/3) of the S&P gains over the last 10 years have come under these conditions. When the VIX moves out of complacent territory and back towards its mean, then the market is susceptible to a decline.

I’ll look at high VIX readings an upcoming post.

For more VIX discussion, check out what VIX and MORE had to say earlier this week.

What The Extremely Low Volume On Monday May Mean

I’m seeing more and more bearish signs. In the Quantifiable Edges Subscriber Letter on Sunday the intermediate-term outlook moved from slightly bullish to slightly bearish. The move was based on recent research, some of which appeared on the blog while some was for subscribers only. Today’s action did nothing to make me feel more bullish.

Let’s take a look at the S&P 500. It rose 1.1% today on the lightest volume since the week between Christmas and New Years. I looked back in history to see how the market performed any time the S&P 500 rose 1% or more on the lightest volume in at least 20 days. Results looking back 30 years below:

As you can see the implications are quite bearish over the next 12 days. One issue when looking at low volume studies, though is holidays. Six of the instances happened on a shortened session near either 4th of July or Thanksgiving. Those were 7/3/1997, 7/3/2000, 11/24/2000, 11/23/2001, 7/5/2002, and 11/23/2007. Two things are notable about these dates: 1) 7/5/2002 was followed by a massive 19% selloff over the next 12 days which skewed the above results negatively. 2) Most of the other holiday instances were followed by rallies which skewed results positively. I re-ran the study excluding these instances. Those results over the last 30 years are listed below:

From a winning percentage standpoint this is quite a bit worse for the bulls. Even eliminating the massive 7/2002 outlier the remaining results have a strong bearish tilt.

For those who would like to read more about the bearish case, check out Bill Luby’s latest chart and some of Dr. Steenbarger’s findings here and here.

A Subscriber Letter Time Stretch System – And Some New Features

Nearly every trade idea tracked in the Quantifiable Edges Subscriber Letter is backed by a fully disclosed historically designed system. The systems all have specific entry and exit criteria and historical risk reward statistics are provided so subscribers can decide whether the trade idea may be appropriate for them. Here is an example from the 5/2/08 letter of a “time stretch” system that was used for gold (GLD):

GLD – buy @ $84.00. GLD has dropped sharply over the last several days. I am looking to buy based on the following criteria: 1)It has closed below its 10-day moving average for at least 10 days. 2) It is above its 200-day moving average. 3) It made its lowest low of the recent selloff today. 4) It closed stretched further below its 10-day moving average than it has on any day of the recent selloff.

Buying the next day at the setup day’s closing price and selling when it closed above the 5-period moving average would have produced the following results over the last 10 years in the list of 109 heavily traded ETF’s I track (most of which have not been around for 10 years):

The setup has only occurred once before in GLD – on June 14th, 2006. It was sold 2 days later for a 3.15% gain.

The trade idea was entered at the open on 5/2/08 @ $83.96. It was closed at the next session’s close (5/5/08) for $86.27 – a 2.75% gain.

Due to feedback from subscribers, I have now begun providing the code for any such system trades to the subscriber base. Tradestation users may import it right into their software for further testing and design.

The 2nd recently added subscriber desired feature is intraday updates. When notable action is occurring in open trades, I may send out Intraday Updates to subscribers alerting them.

If you haven’t trialed the Quantifiable Edges Subscriber Letter yet, just drop a note to and receive three free days. Simply include your name and email address.

Time Stretches

Chris over at Smallcap Slingshot made an observation Wednesday night that the QQQQ hadn’t closed below its 9-day moving average for 15 days. He was curious to see if spending so long on one side of a short-term moving average provided any edge. First I’ll show a test based on his observation then I’ll give my thoughts on this kind of action.

The table below shows the results of shorting anytime the QQQQ closes above it’s 9-day moving average for 15 days in a row, and then holding for “X” number of days. The data goes back to 1999.

As you can see, the results are somewhat choppy.

If instead of holding for a specified number of days, you sell when the QQQQ closes below its 9-day moving average, then your results will improve slightly. Here are the results for QQQQ with this exit strategy:

Trades – 11
Winners – 7
Avg win – 1.8%
Avg Loss – 1.5%
Avg Trade – 0.6%
Profit Factor – 2.1

Not bad, but the low number of trades makes it questionable. Running the same test on the S&P 500 for the last 25 years produces the following results:

Trades – 52
Winners – 31
%Profitable – 59.6%
Avg Win – 0.9%
Avg Loss – 1.0%
Avg Trade – 0.13%
Profit Factor – 1.3

Throw in some commissions and slippage and the positive expectancy of 0.13% is likely close to or at a negative number. On its own, just being above or below a moving average for an extended period provides only a small edge.

Does that mean the ideas should be scrapped? No. In fact, Chris is on to something and his observation is a keen one. Combine a few small edges and you may end up with a substantial one. Some kind of action to trigger an entry when the market is in this extended condition could work quite well.

I’ve referred to these extended periods above or below moving averages in the past as “time stretches”. In January I showed a time stretch technique which worked well in timing the bottom. In that case it was a simple time stretch below a moving average while posting a new closing low. In an upcoming post I may show an example of a time stretch technique from the Quantifiable Edges Subscriber Letter.

Lower Lows

The S&P and Dow have both seen some choppy action over the last week. Each of the last 4 days has been a reversal of the previous day’s direction. Up, down, up, down, up. What’s unusual about the chop is that is has been accompanied by 4 lower lows in the indices (Dow and S&P). In Larry Connors “How Markets Really Work”, he demonstrates that an edge typically exists when the market makes a series of lower lows or higher highs. The edge is in the opposite direction. In the book he also breaks it down by whether the market is trading above or below the 200-day moving average. In my own work I have found the concept of looking at consecutive lows or highs helpful as well.

Let’s look at some statistics based on how the market has performed in the past after a series of at least 4 lower lows. I’ll then offer some opinion on how it translates to our current situation.

A few things to note in the above tables:

The chance of seeing a bounce is greater when you are above the 200ma than when you are below. Over the period tested it’s in the range of 57%-67% above and 44%-60% below. In either case the market is generally more likely to rise over the next 1-10 days.

The average loss is slightly larger when under the 200ma. The difference would be skewed quite a bit more in the favor of the “greater than 200ma” bucket if not for the “max loss” outlier. The unusually large loss above the 200ma came courtesy of the Crash of ’87. (Which incidentally was not included in Connors book since those tests only ran to 1989.)

The average win below the 200ma is nearly twice the size of the average win above the 200ma for most time periods looked at. For those wondering why this is, think “short-covering rally” and increased volatility. Both trademarks of long-term downtrends.

Even with the increased chance of a bounce above the 200ma, the expected value (avg trade) is greater below the line. This would remain true even if you were to eliminate the “worst trade” from the upper bucket.

This study suggests an upside edge over the next few days. Before getting too excited though it may be worth considering what we just learned in the context of the current market situation. Yes, we’ve pulled back 4 days in a row, but although the market is below its 200 day moving average, volatility remains relatively low. The chance of short-covering helping to fuel a bounce seems muted as well since the market has been rallying already for a month and a half. Based on these facts, I would reduce the expected potential reward from the “under 200 ma” level to the “over 200ma level”. The chance of a bounce actually materializing I might put somewhere in between the two buckets. There has been a series of higher lows and the market is in an uptrend, but it isn’t quite a healthy sustained rally just yet.

Overall, I believe the study suggests a positive expectation over the next few days – just not one that is as large as it first might appear when glancing at the tables.

More on Gap Bands

A few nights ago I looked at upside gaps outside of Bollinger Bands for SPY. Tonight I will show them along with downside gaps below Bollinger Bands. I am using the standard 20ma and 2 standard deviations bands for the study. As was pointed out, the band levels are fixed until the close, so the gap criteria is simply a gap beyond yesterday’s closing band. I tested using SPY going back to 7/1/98. I’ll let the table speak for itself tonight.

Equity Put/Call Ratio Spikes Down

Dr. Brett Steenbarger over at Traderfeed has done some excellent work with put/call ratios over the last few years. One way he measures it is by comparing a short-term moving average of put/call volume to a long-term put/call moving average. He has demonstrated numerous times how spikes in the short-term averages over the long-term averages tend occur near market bottoms.

The options market is now experiencing a spike down, rather than a spike up, in the put/call ratio. An example of this could be seen by considering the 5 and 65 day moving averages of the CBOE Equity put/call ratio (two averages that Dr. Steenbarger sometimes uses). As of tonight’s close the 5-day stood at 0.62 and the 65-day at 0.80. This is over a 20% gap from the 65 to the 5.

If spikes up in the put/call can predict a bottom, could a spike down predict a top?

Not based on the limited data available. The equity put/call data has only been tracked back to 2003. Below are the results:

The dates for the 4 instances were 11/10/04, 12/16/04, 5/24/05, and 7/14/05. Basically it happened at times where the market rallied strongly following a pullback or correction. I suspect the sharp drop in the average put/call ratio represents a shift in attitude of market participants. Coming out of a corrective period it appears this buying enthusiasm is a good thing and not representative of complacency.

I also ran the same test using the Total Volume Put/Call Ratio back to 1996. Results there leaned to the bullish side as well with between 57% and 67% of cases showing continued gains over the next 2-3 weeks.

The low put/call ratios may become an issue if they remain low for an extended period. I’d be careful of trying to call a top based on any spikes lower in the ratio, though. Spikes may represent enthusiasm rather than complacency. Now if we could just get some volume we could really make a case for enthusiasm.

Quantifiable Edges Subscriber Letter April Results

I’ve presented below the summary results of the Quantifiable Edges Subscriber Letter trade ideas for April and since inception. April was a decent month. Although there were fewer trade ideas and rewards were a bit smaller than March, it was still strongly positive.

In addition to the trade ideas, the Subscriber Letter provides additional research beyond the blog and shows CBI analysis down to the sector level. More features will be announced soon. Should anyone wish to receive a free three-day trial to the Quantifiable Edges Subscriber Letter, just send an email to and include your name and email address.

A Look At Light Volume

The market pulled back today on light volume. Often heralded as a good thing, readers of this blog understand over the short-term it isn’t.

So I spent some time looking at volume tonight. I’ve been noticing how it has just fallen off a cliff since Easter. I decided to compare the volume the last 30 days to the volume of the previous 50. The last 30 days have posted average daily volume less than 75% of the average of the previous 50. I thought this unusual and did a study to find other times this may have occurred.

Looking back to 1960 I found 10 other instances. Over the next 2-6 months prices rose 7 of ten times. There was also a general decrease in historical volatility 8 of the 10 times. Gains were generally in line with random and 7 for 10 isn’t mathematically significant, so I’m not sure there’s a lot to be learned here. I did find it interesting that all prior instances happened between 1960 and 1980. Dates are listed below:

6/26/61, 8/10/62, 7/26/63, 6/29/66, 2/25/74, 8/25/75, 4/19/76, 7/27/78, 12/13/78, 4/21/80.

If someone sees something I don’t I’d love to hear about it. I did find it interesting that many of the occurrences happened in a generally difficult period for the market but returns were pretty good. For instance, the 70’s had 5 instances – 4 of which led to higher prices over the next two months.

The Gap Band

I received an interesting note from Dr. Steven F. over the weekend who observed the SPY gap open put it above it’s upper Bollinger Band on the gap. For an index to gap open outside of its Bollinger Band, price will almost always need to be somewhat stretched already. It would seem logical that a gap up into an already short-term overbought condition would be a likely candidate for a reversal. I decided to test.

The criteria was simple. A gap up over the upper Bollinger Band would signal a short entry. The trade would be exited near the close of the day. Looking back to 1998 in the SPY I was able to identify 79 such instances. There were 43 (54%) winners and 36 losers. The average winner made 0.56% and the average loser lost 0.50%. The profit factor was a modest 1.34.

I then broke it down by instances above and below the 200-day moving average. Above the 200-day moving average there have been 62 instances of a gap up above the Bollinger Band. Shorting these and covering on the close resulted in 53% winners. Winners outsized losers by 0.57% to 0.38%. The profit factor was a decent 1.7.

The trouble occurred with this less than “Outstanding” Gap Band strategy when it was attempted below the 200-day moving average. There were 17 instances. Ten winners, but the average loss was 1.0% vs. an average gain of 0.5%. Overall a losing strategy below the 200ma.

As with previous gap studies, it appears gaps up in long-term downtrends are dangerous to try and short. While it would’ve worked out on Friday, you always need to be wary of a short-covering rally or trend day up.

Initial results of buying a gap down below the lower Bollinger Band appear better. I will look at them in more detail at a later time.