Blog - Quantifiable Edges

5 Weeks Lower – Another Example Of Persistence

Posted by Rob Hanna in Quantitative Study July 6, 2008

Last week I showed how the recent downtrend has shown persistence to a degree rarely seen since the 70’s. Below is another example of the downtrend’s persistence from tonight’s Weekly Research Letter.

This test was run from 1960-present. Only 8 occurrences makes it difficult to draw any solid conclusions. Still, these numbers are terrible. The maximum gain 20 weeks later is only 1.7%! The average loss is over 7% and the average trade lost over 4%. There were only three occurrences since 1988, but none of them were positive. They were 8/24/90, 10/13/00 and 3/2/01. Downside persistence like we’re seeing has historically been bearish.

For more information on the Quantifiable Edges Weekly Research Letter, click here. For a free sample, simply email weekly@quantifiableedges.com with your name and email address.

The Quantifiable Edges Aggregator

Posted by Rob Hanna in Uncategorized July 4, 2008

In both the nightly Subscriber Letter and the Weekly Research Letter, I feature a chart in the short-term outlook section of the Quantifiable Edges Aggregator. Below is a write-up on the construction and use of the Aggregator.

In an effort to better illustrate what my studies are suggesting vs. what the market is doing, I developed the Quantifiable Edges Aggregator. To construct the QE Aggregator I first tally what the Quantifiable Edges studies are projecting. To do this I take each active study listed in the Quantifiable Edges Subscriber Letter and plug the gains and losses it projects over the next several days, weeks, or months into a spreadsheet. For each day I add up the projection of all studies and average them. This provides the projection for that day. Since the individual day can be highly variable, I use a 3-day average to determine the projections.

I then compare this with the behavior of the market vs. the studies over the past three days to see whether the market has been outperforming or underperforming expectations. Below is a chart with the indicator included for easier reference:

What’s being shown:

Candlesticks in the top section of the chart are daily bars of the S&P 500.

The bottom section contains the QE Aggregator. There are several lines here to look at:

1) The brown horizontal line is at “0”.

2) The dotted grey line is simply the 3-day moving average return of the S&P 500 in percent terms. If it was up over the last 3 days this will be above the brown line, if it was down it will be below the brown line.

3) The green line is the projected return of the studies for the NEXT 3 days. (The Aggregator.)

4) The thick black line is the difference between the QE Aggregator’s value from 3 days ago and the S&P’s return over the last 3 days (Green line value from 3 days ago – today’s grey line value = black line.) Its value represents whether the market has outperformed or underperformed the Aggregator’s expectations over the last three days. If the black line is above 0 that means the S&P has been underperforming expectations. If the black line is below 0 then the S&P has outperformed expectations over the last three days.

What should we look for to help identify opportunities?
The Aggregator on its own is of some value, but the real opportunities arise under two scenarios:

1) The S&P has underperformed expectations over the last few days and the Aggregator is showing a positive expectation for the next few days. Instances where this occurs are marked with a purple dashed vertical line. You are basically looking for times when both the green line (Aggregator) and the black line are stretched above the “0” line. The higher the stretch the better. These represent long opportunities.

2) The S&P has outperformed expectations over the last few days and the Aggregator is showing a negative expectation for the next few days. Instances where this occurs are marked with a red-dashed vertical line. You are basically looking for times when both the green line and the black line are stretched below the “0” line. The lower the stretch the better. These represent short opportunities.

Several of these “signals” line up with actual long and short trade ideas I put into the Subscriber Letter. These would include the 2/26 short, 3/7 and 3/10 longs, the 3/25 short (which went unfilled in the Letter), and the 3/28 long. By quantifying and visualizing the studies in this way it may make it easier to identify opportunities.

The orange circled areas are the last ones to discuss. The first one near the end of Feb shows a point when then S&P had largely underperformed the Aggregator but the Aggregator was still suggesting lower prices over the next few days. The two circled areas in April represent times when the market had largely outperformed over the past few days but the Aggregator was suggesting a positive bias. In all such cases this generally led to a few days of choppy trading.

Related Quantifiable Edges Studies

Quantifiable Edges Weekly Research Letter

Posted by Rob Hanna in Uncategorized July 4, 2008

Quantifiable Edges will be releasing a new Weekly Research Letter. It will include additional research and detailed analysis, along with weekly snapshots of some of the tools and indicators featured in the nightly Subscriber Letter. The 1st official issue will be released this Sunday night.

If you would like to receive the 1st week’s issue at no charge, just send an email with your name and email address to weekly@quantifiableedges.com

Subscriptions will be $19/mo or $195/yr. For more details, click here.

A Selloff Reminiscent of the 60’s and 70’s

Posted by Rob Hanna in Quantitative Study, Time Stretch July 3, 2008

Anyone who traded through the bear market of the 2000-2003 knows that it was marked with sharp selloffs and sharper reversals. Moves lower were short and violent and moves back up were much the same. Since early May the market has sold off in a way that has rarely been seen since Reagan entered the White House.

The S&P 500 and Dow have both closed below their 10-day moving averages for 19 days in a row. Unless the S&P rises over 2.7% tomorrow and closes above 1295.57, then it will mark 20 days for that one. I looked back to 1960 to see all other times the S&P closed below its 10-day moving average for at least 20 days in a row. Below is the list.

1/29/62
4/17/62
5/22/62
6/14/65
3/15/66
11/8/67
2/13/68
1/10/69
6/16/69
12/11/69
2/6/70
5/1/70
5/27/71
8/9/71
2/9/73
11/27/73
4/15/74
1/31/77
3/14/80
2/9/84
2/12/03

What we seem to be experiencing is a selloff similar to those that occurred in the 60’s and 70’s, but not since.

The selloff in financials has been more than twice as long. KBE and RKH, two bank ETF’s, have now closed below their 10-day moving averages for 40 days in a row. The last day they closed above it was May 6th. Since that time RKH has lost 29.9% and KBE 33.5%. I am unable to find any other ETF that has ever traded below its 10-day moving average for 40 days. EWW (Mexico) came close when it went 39 days in 1998. While the history for many ETF’s is limited, the persistency of this selloff is quite incredible.

CBI Hits 10 – Some Hypothetical Results

Posted by Rob Hanna in CBI July 2, 2008

The Capitulative Breadth Indicator (CBI) closed at “10” on Tuesday (July 1st). Historically, this has been a reliable indication that the market is nearing a bounce. Using backtested data from 1995-2005 and live data from 2005 forward, there have been 18 instances when the CBI reached at least 10. Buying the S&P when it hit 10 and selling on a return to 3 or lower would have been profitable all 18 times. Below are some summary statistics ($100,000 per trade):

The max drawdown is important to keep in mind. A CBI of 10 is not magic. It doesn’t guarantee anything. It’s indicating that downside breadth is overdone. This shouldn’t be a revelation. Last week I showed another breadth indicator that was also overdone. It still is. Hopefully the market does what breadth says it’s supposed to do soon.

Gap Reversed

Posted by Rob Hanna in reversal bar July 1, 2008

When the market gaps lower, trades at a new recent low and then closes up on the day, most people tend to perceive the action as bullish. A rally could form off such a bar, but I have not found it reliable under such a description.

I thought a visual might be more interesting than a statistics table tonight. Below is a chart of the 2002 summer selloff. All bars with a gap lower, a 20-day low, and a close higher have arrows pointing at them. The 2 large pink arrows represent the 2 times the gap down was greater than 1% as happened today.

Simple Gap Reversals as seen above are not necessarily bullish. On the other hand, simple Gap Reversibles as seen below are quite fetching.

When The CBI Spikes But The VXO Doesn’t

Posted by Rob Hanna in CBI, Quantitative Study, VIX July 1, 2008

The CBI hit 9 today and is reaching elite territory. The VXO is not near an extreme. The VXO (and/or VIX) are getting a lot of discussion lately as traders fret that a market bounce won’t happen until after a VIX spike does. It remains my contention that extreme sentiment measures like the VIX and Put/Call Ratios are “nice to haves”, not “need to haves”.

Tonight I decided to look at CBI readings of 8 or higher broken out by those times the VIX was stretched vs. those times it wasn’t. Rules for entry for the first test are as follows: 1) CBI closes greater than or equal to 8. 2) CBI closes higher than yesterday and 3) The VXO is greater than 10% above its 10-day moving average. If all three are met $100,000 worth of SPX is bought at the close. It is sold when the CBI returns to 3 or less. Results below:

Keeping the first two criteria the same and changing #3 to “VXO is LESS than 10% above its 10-day moving average” would provide the following results:

See the big difference? Neither do I. The results are almost identical.

But today the VXO wasn’t near 10% above its 10ma. In fact it was less than 5% above its 10-day MA. Below are the results when changing requirement #3 to “VXO is less than 5% above its 10-day moving average”.

It appears to me the odds favor a bouce soon with or without a higher VIX.

Nasdaq Still Leads Despite Sharp Drop

Posted by Rob Hanna in Quantitative Study June 30, 2008

While the Nasdaq has fallen rather sharply lately, its still stronger than the NYSE composite based on 10-week relative strength. As I’ve discussed in the past, Nasdaq relative strength over the NYSE has generally been a positive for the market. I figured I’d look at this in the context of the recent selloff as well.

Glaring about this study is the low number of trades. This speaks to the relatively unusual market environment. While the 5 instances were somewhat mixed over the short-term, performance once you got out 13 weeks was strongly positive. For those interested, the trigger dates were 12/6/74, 8/8/75, 8/14/98, 8/6/99, and 7/19/02. ’74 and ’02 basically marked the bottoms. The other instances did some wiggling around before moving smartly higher.

To try and include some more instances, I loosened the “% drop” requirement for the Nasdaq. Lowering it to 5% produced the following results:

Not nearly as positive at the steeper 9% decline, but still very good on a risk/reward basis when looking out 10-20 weeks.

Nothing here that appears to be immediately actionable on its own, but as long as the Nasdaq can hold on to its leadership spot, the market stands a pretty good chance of putting in some intermediate-term gains.

Does A Lackadaisical Put/Call Keep The Market From Bouncing?

Posted by Rob Hanna in Quantitative Study June 27, 2008

One measure of sentiment that is notably underwhelming is the CBOE Put/Call ratio. This is a concern for some traders. As of today the 10-day put/call was 101.3. This is actually lower than the 200-day moving average of 101.7. Below are two studies that show what has happened when negative price action has been accompanied by a lackadaisical put/call:

This first one I looked at both above and below the 200-day moving average, and it made little difference. The implication of the Put/Call tests seems to be that a relatively low Put/Call doesn’t hurt the chance of a nice bounce. This was a bit surprising. Also a bit encouraging.

Using Options For Short-Term Trading – Part 2

Posted by Rob Hanna in options June 26, 2008

Last week I discussed why and how I sometimes use options for short-term trades. Today I will expand on that with some rules I follow and other thoughts. If you didn’t catch last week’s post, you may want to check that out first.

As a very quick review, when trading in stocks or ETF’s that I anticipate being in for a number of days, rather than weeks or months, I frequently trade deep in the money options rather than the stock or ETF. The reasons and a general methodology were outlined last week. Below are some more specifics for you to consider along with answers to a few questions I received:

How do I decide whether an option is preferable to the stock?
Some general rules as to when I use options:
1) The stock should trade for at least $25 or more. The higher the better. I especially like stocks in the $40-$80 range. – The spread on many deep options is $0.10. Sometimes you’ll find something appropriate with a $0.05 spread, but not always. In many cases you can assume you will lose at least most of the spread on the trade. If I’m looking for a 2-3% move I don’t want to give away $0.10-$0.15 on a $15 stock. Doing that may destroy my edge. With low priced stocks I normally just buy the stock.
2) The option should have almost no premium – Even with higher priced stocks, I don’t want to pay much premium on the option. More than $0.15 or $0.20 and I begin to lose some interest. In low-volatility environments this is easily accomplished. During panic situations when the VIX spikes you’ll be hard pressed to find anything trading without a decent amount of premium.
3) I want enough time for the trade to work, but not too much time left on the option – The contracts are generally monthly. My trades average about 1 week. Two weeks to expiration is the sweet spot. Less than one week and I’m normally looking out to the next month (which means additional premium). Three weeks or longer and your going to have to pay for some time value. If the trade works quickly then you may be able to sell the option with time value left in it. There will be some erosion, though.
4) The delta should be 90 or higher – This is normally the case if you’re not paying much premium for a deep option. Basically, I want the price to move up very close to the same amount as the stock price.

What if the exit trigger doesn’t arrive before the option expires?
In this case some decisions need to be made. If I’m trading a stock then I’m normally not trading a size larger than I would trade if I owned the stock anyway. Therefore, taking delivery of the stock is an option. If it is index shares that I’m leveraged with, then I need to roll them out to the next month.

Rolling out to the next month adds some cost. First, you have basic transaction costs since you are selling your options and buying others. Frequently more significant is the premium cost. You are selling an option with 0 premium and buying one with some premium. To help reduce the amount of premium the roll will cost you, a spread trade normally helps. Rather than entering a sell for X contracts and then a buy for X contracts, put it in as a spread trade. Even though the option may trade with a $0.10 spread, you can enter spread trades to the penny.

When else might it be appropriate to switch option contracts?
If the trade goes sharply against you and you still feel positive about the position you could consider moving to a lower strike price (assuming long call). Two things will happen when your stock price rapidly approaches your strike price. 1) Premium may get built into the option since you are now near or at the money rather than deep into it. 2) The increase in premium will also mean a decrease in delta. So when the stock does bounce your option initially may go up $0.75 for every dollar rather than the $0.95 for every dollar that it would have when you bought it.

Therefore, one strategy to consider would be to sell the now “near the money” option you hold and buy a deep one. This accomplishes two things: 1) You are able to make money on the premium that was just built up and 2) You own an option with a higher delta that will rise faster than your original option.

Of course there is a big disadvantage to doing this, and that is that you are now laying out more capital. Part of the reason for using options is to control risk. Swapping out for deeper ones when the trade goes against you increases your initial risk, so it’s something that needs to be carefully thought through before doing it.

For index trades, why use options instead of futures?
There are advantages and disadvantages to both. Some advantages for options include: 1) They can be traded in the same account as stocks. No need to segregate to a futures account. 2) In low volatility environments, you can actually get more leveraged than with futures.

A big disadvantage rears its head in high volatility environments. When the market sells off hard and volatility spikes, even fairly deep index options carry a decent amount of premium. With futures this is not as much of an issue.

To sum up below are a list of advantages and disadvantages to using deep options for short-term trading vehicles:

Advantages:
Lower capital outlay
Lower risk (option goes to $0 before stock does)
Leverage without paying margin costs
Can be traded in same account as equities rather than separate futures account

Disadvantages:
Lower reward due to delta Higher slippage due to option spreads
Some premium costs
Premiums increase in volatile environments

A Breadth Indicator That’s Suggesting A Bounce

Posted by Rob Hanna in Breadth, Quantitative Study June 25, 2008

In Gerald Appel’s book, “Technical Analysis – Power Tools For Active Investors” he discussed a breadth measure he uses to anticipate market rallies. Bascially, he takes a 10-day Exponential Moving Average of the NYSE advancing issues divided by the advancers + the decliners. In the book he discusses a system where a strong thrust upwards in this indicator frequently leads to rallies. I have found that strong downward moves also tend to lead to rallies.

According to my data provider, the 10-day Advancer EMA came in at 0.3714 on Tuesday. Below I looked at results for the S&P 500 following any time it dropped below 0.375:

These results are quite good, especially considering the averages had to absorb the max loss that occurred thanks to the Crash of ’87. You’ll notice I ran the test back to 1982. The reason being that prior to 1982 the system would have been a disaster. Look at the returns in the 70’s-1981:

While the indicator has not always worked, it has done a nice job over the last 25 years or so. It could also be used as a system parameter for a trade exit. Below I show the results of entering an index position when the indicator drops below 0.375 and then selling when it moves back above a certain number. Results here are from the 1982 – present period and are quite robust.

Selling Quiets During Narrow Range Day

Posted by Rob Hanna in Quantitative Study June 24, 2008

I’ve discussed the pattern of a WR7 down followed by an NR7 in the past. Generally it’s had bullish implications over the short-term. When applied to a chart of the S&P 500 rather than SPY or the Nasdaq, the formations look a little different. This is because the S&P 500 has a staggered opening. Therefore the chart is basically gapless. These bars therefore more often look at true range rather than a bar with a large gap. Applying the WR7down – NR7 study to the S&P 500 chart yields the following results:

As in the Nasdaq study, WR7 down – NR7 implications appear bullish.

Another way to look at the last two days would be to ignore the size of the bar on Friday, and rather focus on the high level of volume. This next study does that:

Both studies seem to suggest the same thing. When a substantial selloff (measured in either price or volume) rapidly loses steam, the result is typically a bounce back up.

Also notable is the fact that the CBI hit “8” today. To see recently reported results following moves to 7 or higher, see the June 11th blog.

On the negative side, the VIX didn’t budge, the Put/Call ratio dropped precipitously, and it looks like another possible case of Draggin’ Breadth today.

Lastly, while the studies help to construct a market bias, the biggest mover in the next few days may be the Fed. Right now, that seems to be a wild card that could spark a move in either direction.

Selloff Doesn’t Scare VIX

Posted by Rob Hanna in Quantitative Study, VIX June 23, 2008

One gauge sometimes used to measure fear is the VIX. While the S&P 500 dropped sharply on Friday and closed below its lower Bollinger Band, the VIX barely nudged higher, closing less than 5% above its 10-day moving average. Below I examine other times this has happened:

Negative results on a fairly low number of trades. Interesting was the fact that most of the winners occurred in the early ‘90’s. The table below shows the results of the above test from 1993 – present.

The number of trades here is quite low, so it’s dangerous to read too much into it, but the implication appears to be negative. While the market is oversold, the Capitulative Breadth Indicator is back to 5, and a sharp bounce could ensue at any time, we may need to see a little more fear before it happens.

A Lame Reversal

Posted by Rob Hanna in Quantitative Study, reversal bar June 19, 2008

In one of my first blog entries I looked at S&P 500 reversal bars that made new 20-day lows and then rallied strongly to finish the day up 1% or more on higher volume. A key ingredient in that study was the 1% price rise. While the market put in a reversal Thursday on increased volume the price rise was not that impressive. The first table below is the one from January’s study:

This next table shows what happens to reversal bars with unimpressive price advances like Thursday (again 1978-present):

The January study showed a clear edge to the upside from an average trade standpoint. That edge disappears when the reversal is weak. Doesn’t look like Thursday’s action is anything to get to hyped about.

Selloff In Financials Incredibly Persistent

Posted by Rob Hanna in Uncategorized June 19, 2008

One statistic I look at and use in my trading is the amount of time a security trades above or below certain moving averages. One moving average I look at is the 10-day moving average. Right now there are 4 stocks in the S&P 100 that have closed below their 10-day moving average for at least 30 days in a row. They are BAC, RF, GM and WB. Using the current S&P 100, I ran some scans back over the last 10 years to find out how unusual this is.

In the last 10 years there have been only 65 occurrences of an S&P 100 stock closing below its 10-day moving average for 30 days in a row. Twice there have been 4 or more on at once. The first time was in late August of 1998 when there was up to 5 and the 2nd time was early March of 2000 with 4.

From a historical perspective, some of the recent selling, especially in banks and financials, has been persistent to a degree that has rarely been seen.