One thing traders need to keep in mind in the current environment is that when the market is bouncing off of intermediate-term lows it is more likely to get overbought and STAY overbought than when it’s simply consolidating in a downtrend. Shorting bounces off lows typically carries an extra level of risk because of this.

Let’s look at the how the market set up as of Tuesday’s close as an example. SPY closed higher 3 days in a row. Tuesday was the narrowest range in the last 5 days. When trading under the 200-day moving average, this combination can signal the market is likely to pull back. See the test below:

The propensity to pull back is most pronounced over the first 4 days.

Now let’s break down the above results a little differently. First let’s look at times the SPY set up as above but was NOT coming off a 50-day low:

Results here are decidedly more negative than in the original study. Two days out for example there are only 18% winners.

Now let’s look at the first setup again, but this time we only want to see those trades that were coming of a 50-day low:

There is no longer a bearish edge to the setup. In fact, there appears to be a bit of a bullish one. Now 2 days out there are 82% winners. (Although instances are low and that’s not really the point.) The point is that it is much more dangerous to short a market coming off of fresh lows. This is especially true when the lows occurred on extremely oversold conditions.

While previous attempted rallies did quickly roll over the last 2 months, that’s not always the case. Examples of oversold bounces off lows that would have been especially dangerous to short include August 2007, October 2002 and September 2001.

I’ve often heard about the positive tendencies of the market to rally Thanksgiving week. So I ran a quick test:

The above results actually go through the Monday following Thanksgiving. Positive tendencies may have existed in the distant past, but over the 21-year period I looked at there doesn’t appear to be any edge – bullish or bearish.

The market rallied hard on Friday after hitting historically extreme conditions. There are reasons to be optimistic about some follow-through this week. Thanksgiving doesn’t appear to be one of those reasons, though.

In my last post I looked at the increased volatility based on the size of the average overnight gap in SPY. Today I’ll examine the current market’s volatility based on its Average True Range Percent.

In the chart below I show the Dow Jones Industrial Average from 1986 – present. The yellow line represents the 30-day average true range on a percentage basis. The average true range over the last 30 days closed at an astonishing 6.02% on Wednesday.

It appears the only time since 1986 where it has come close the current 6% level was during the Crash of ’87 period when it poked just above 6. In actuality, though, the comparison isn’t quite fair due to the way the range was calculated previous to 1992. From Investopedia:

Theoretical Dow Jones Index
A method of calculating a Dow Jones index (most often the DJIA) that assumes all index components hit their high or low at the same time during the day.

In other words, the “theoretical Dow” uses the daily highs for all 30 Dow components to calculate the index high, and the lows to calculate the index low. In January of 1992, Dow Jones started using the “actual” method, which calculates the index at 10-second intervals throughout the day. Before this point, the theoretical calculation was the only way to compute the high and low of the index. This method assumes that all stocks hit their high or low at the same time. Because this rarely happens, the theoretical high will almost always be higher than the actual, and the theoretical low will almost always be lower than the actual.

Taking the pre – ’92 exaggerated range into account, it appears almost certain that the recent market has displayed a higher Average True Range % than 1987. Going back further in history, the only other period where ranges approached these levels were…the 1930’s.

Even during this period the only time where the average true range percent got much above 6% was following the Crash of ’29 when it hit nearly 7%. Since the ranges were exaggerated due to use of the Theoretical Dow calculation, it’s possible that the current environment may actually be the most volatile.

You may notice from the charts that the spikes in volatility tend to occur near market bottoms. An ATR spike can alert you that a bottom may be coming. Like many indicators that use moving averages, though, the 30-day ATR% is a lagging indicator. It typically peaks after the bottom has been made. Look for this measure to turn down again once a bottom (at least a temporary bottom) is in place.

I looked back at all prior 5% drops in the S&P 500 since 1960. From 1960 until 1987 there weren’t any. Since 1987 there have now been 14 of them. The November 5, 2008 drop was the 6th 5% drop since early September. Generally these large drops have been followed by a bounce at some point over the next few days. I show all instances since 1960 in the table below:

Of the 13 instances, 10 closed higher the following day. If you give the trade 4 days to work then 12 of 13 closed higher than the entry at some point. The lone loser was October 16, 1987. That date is notable because it was the Friday prior to Black Monday.