Retest approaching

Just time for a quick note tonight…

The study I posted last night showed a good possibility of a one-day rally in the S&P. The one day rally lasted only half a day. After that the market fell apart again.

I’ve gone over a few things tonight, but I’m seeing pretty much what I expected. Price is becoming stretched, but the price drop alone isn’t providing any huge edge. An example would be the current Nasdaq price action. The Nasdaq has dropped over 1.25% three days in a row. Looking back to 1985 this has happened 48 other times. Over the next 1-2 days the Nasdaq has rebounded about 2/3 of the time. Not a bad ratio, but the average losing trade dropped about 4%. That’s more downside risk than I’d like to take on.

Many of the oscillators and other market gauges I follow are simply not stretched the way they were two weeks ago. My Capitulative Breadth Indicator (CBI) -click CBI label for details- for instance still remains at 0. Once we get closer to retest area a case could be made for an entry on some kind of reversal since a reasonable stop should be nearby. We aren’t there yet and I’m not comfortable looking for even a swing trade at this point.

One thing that may interest me is a gap down tomorrow morning. Cisco (CSCO) is trying to help create that. I showed recently that large gaps down in downtrending markets offer significantly more reward than large gaps down in uptrending markets. A gap lower therefore could be playable. I would only consider keeping part of the position beyond a day if it was strongly in my favor.

These Are Some Big Arms!

There was some serious selling pressure today. Selling swamped buying on both the NYSE and the NASDAQ. The Dow, S&P 500 and Nasdaq all finished down close to 3%. Volume rose across the board.

The Arms Index for both the NYSE and the NASDAQ was very big. (Although as you can plainly see from the picture on the right, my arms are bigger.) The NASDAQ Arms Index closed over 3 and the NYSE Arms Index closed at about 2.7. Many people view large spikes in the Arms Index as a contrary indicator. It reflects panic selling on the part of market participants. This panic is viewed as a short-term oversold condition that leads to a reflexive bounce.

I ran some tests to measure today’s action against history. All tests were run back to 1/1/92. I found that a 1-day spike in the Arms Index of either the NYSE or Nasdaq without confirmation from the other showed very little edge.

A Nasdaq Arms Index greater than 3 has occurred 79 times since 1992. The next day the Nasdaq finished higher 57% of the time. The average winning trade was 1.7% but the average losing trade was 1.9%. The total expected value was a scant 0.2% rise the next day in the Nasdaq.

The NYSE Arms Index has posted readings over 2.5 fifty-seven times. The next day the S&P 500 rose 63% of the time. The average winning trade was 1.2% and the average loser 0.8%. On average the S&P gained just over 0.4% the following day.

Neither of these stats really gets me juiced about jumping in front of this train. (Did you see the photo of me looking juiced?) When I look at the events on a combined basis, though, results improve dramatically. Since 1992, there have been 13 days where the Nasdaq Arms finished over 3 and the NYSE Arms finished over 2.5. The S&P 500 rose 11 of the 13 times the following day. The average gain in the S&P 500 was 1.6% and the average loss was 0.15%. The average trade the next day was good for 1.3% and the mean was 1.2%.

After one or two days the results fell more in line with random. Any edge here appears to be very short-term.

Looking out a bit longer, the recent bottom is now looking very much in question. The positive feelings the bounce brought about were nearly all washed away yesterday and today. As I’ve been pointing out, the action immediately after a Follow Through Day is normally telling. So far it doesn’t look good.

Lastly – some house cleaning. Tradestation apparently did a data update on their advance/decline data last night. The Appel Daily Breadth signal I’d mentioned a few nights ago is now no longer appearing. As you might imagine, this aggravates me to no end. I doubled checked using other databases and found a signal should not have been generated. (It came very close.) I’ve imported advance/decline and volume data from one of my other data sources and will be using that from now on. Tonight’s tests were run using QP3 data imported to Tradestation (and confirmed with a 3rd database). I apologize for the false information generated by bad data and have already taken steps to minimize the chance of it happening again.

I.B. Ranting

After persistently running higher for almost two weeks, the market finally began its pullback today. I am not a participant in the pullback, but rather an observer. While the overbought readings indicated there would likely be one soon, my studies indicated risk/reward was unfavorable in trying to short it.

As far as I’m concerned the action during this pullback becomes very important. I demonstrated last week that the first several days following a Follow Through Day are a pretty good predictor of success or failure. After 2 days we are still holding up. I’ll continue to monitor the action carefully.

Warning…rant coming…

One issue that has been raised is whether last Thursday was in fact a Follow Through Day. IBD apparently failed to label it one. In Friday’s Big Picture column they wrote:

“Given the market’s volatility since late December, you’d need to see bigger gains than Thursday’s to signal a fundamental shift in the market’s trend.
As noted in Thursday’s Big Picture, it’s almost a moot point even if the market did manage to assemble a follow-through session of powerful gains in heavier volume. The reason? There are virtually no stocks close to proper buying positions right now.”

From my perspective, Thursday satisfied the requirements IBD previously laid out for Follow Through Days. Due to their perception of volatility and breadth they remain negative on the market’s prospects. As they should, they are deriving their outlook from multiple readings of market health. Unfortunately it seems they would like to advertise the Follow Through Day as a magic indicator that never fails. Therefore, either they make excuses or change the definition of it so that it appears not to fail. Should this rally take hold I have no doubt they will refer to last Thursday as a Follow Through Day in a future publication. It is a tool that uses volume and price action. Breadth, while important, is a separate matter.

Whether Follow Through Days always work is not important to traders. What is important is whether they can be utilized as an effective tool for helping to identify market bottoms. So far we’ve seen that they have been about 55% accurate and risk outweighs reward. (part 1 and part 3) I’d say they have some utility. Constant refinement of the definition to retrofit recent market conditions destroys much of that utility in my eyes.

The McClellan Oscillator is a terrific tool for measuring the market’s health. Should the McClellans decide to constantly adjust the way it should be calculated, it would fail to be as useful.

The Follow Through Day study I laid out and have been discussing the last few weeks has identified Thursday as a Follow Through Day based on the original definition offered by William O’Neil. For purposes of my study and my trading it shall remain one whether it works or not.

…end of rant.

Breadth Follow Up & CBI and Bounce Candidates Closure

Lowry’s Breadth

First, a quick follow up to my post on breadth yesterday. It was pointed out to me that Thursday and Friday may have qualified as back to back 80% Days. In Lowry’s report, back to back 80% days can substitute for one 90% day at some bottoms. I said “may” qualify, because according to my data (which could be wrong)**, Thursday was a 79.61% upside volume day. This could qualify as 80% by human standards, but perhaps not by computer standards. Anyway, certainly seems close enough to quell some of the concerns I’d previously expressed about the lack of a 90% day…

Bounce Candidates Closure

Back on the night of the 21st as the futures were down about 5% I wrote a post showing that market bounces from extremely oversold and capitulative conditions typically see the most beat up stocks bounce the best – and by a substantial amount. I looked at Dow stocks to illustrate this. I also listed the 5 worst performing and best performing Dow stocks from December 26th through January 18th. The time frame I looked at for the intial move off the lows in that study was 6-8 days. It has now been 8 trading days since the market bottomed, so I thought it might be interesting to see how things played out this time. Below are the stocks I listed in the previous column along with the results:

Once again the Lowest RS stocks trounced the Highest RS stocks by more than the Dow itself bounced. In fact 4 of the top 6 performing Dow stocks during the bounce were among the 5 “Lowest RS” stocks I listed.

Capitulative Breadth Indicator (CBI) Returns to Zero
For those that haven’t been paying close attention, the CBI closed at 2 on Thursday and 0 on Friday. While I suggested taking at least partial profits earlier, Thursday’s move below 4 would have signaled the exit to the standard CBI trade I’ve discussed in the past. Below is a graph showing the action in the CBI going back to October. Buying the close on the 22nd and holding until Thursday’s close would have been worth about 5% in the S&P 500. Of course with some stock selection such as described in the Dow example above, traders may have done significantly better.

Incidentally, a zero CBI is not a signal to short. The CBI only measures “oversold” – not “overbought”.
**9:55 am – Edit – I’ve now been told my data is in conflict with others who show 1/31 to be about 82% upside volume.

Whose Breadth Stinks?

Breadth indicators seem to be at odds here. Is it bad, good, or so good it’s bad? Here are some notes to help confuse you:

Leadership Breadth
Investors Business Daily in their Big Picture column on Friday noted that “There are virtually no stocks close to proper buying positions right now.” This is a measure of breadth and potential leadership. The basic idea is that the market will struggle to rally strongly without leadership.

90% Days and Herding
A few weeks ago it was pointed out to me that from July 2007 until now there has been a higher concentration of 90% volume days on the NYSE than at any time since the 1940’s. (A “90% volume day” is a day where either up volume or down volume swamps the other by at least 9 to 1.) Lowry’s created the 90% day concept and has used them to identify market bottoms in the past. Detailed information can be found in their recently updated 2001 study. So far while this market rally has produced some strong up days with both price and volume it has yet to produce a 90% upside volume day. This would seem especially concerning to me given the fact that they have become more frequent recently.

Brett Steenbarger has also done some great work with the concept of breadth volume. He refers to it as “herding”. Here is an introductory discussion of it from his blog. For more discussion you could simply search on “herding” in his search box on the top left hand corner of his page. I’m curious to see if Dr. Steenbarger has anything to say about this in the near future.

A Rare Breadth Thrust Signal
In Gerald Appel’s book “Technical Analysis – Power Tools for Active Investors” he publishes a system called the “Daily Breadth Impulse Signal” (chapter 6, page 142). Essentially it looks to enter the market when the 10-day exponential average of advancers/decliners hits an extreme. The trade closes when the same measure eventually declines to a certain number. The published results were fairly impressive. Since 1970, there were 26 trades with 22 winners and four losers. Avg winner: 5.24%. Avg loser: 2.37%.I recreated his indicator some time ago. Using my data, results were slightly different, but similar.The last signal given before publication was 05/2004.

According to my data, in November of 2004 another signal triggered. This one lasted for close to a month and was good for about a 1.3% gain.

March 21, 2007 was the next trigger I could find. Unfortunately, the signal was cancelled 5 days later on a shakeout, causing a whipsaw loss for the system as it was unable to benefit from the uptrend that followed.

According to my data, Friday 2/1/2008 gave the first buy signal since 3/21/07.

The McClellan Oscillator
A few people have pointed out to me the overbought nature of the McClellan Oscillator. I’ve yet to complete my study of the current situation in regards to the oscillator, but I did find the following quote from a 2004 paper by Tom McClellan very interesting:

“First of all, deeply negative readings tend to indicate conclusion of a down move, whereas extremely high readings tend to show initiation of a new up move…The postings above +200 in September 1998 were a sign that the bulls were going to be coming rushing back in, and they had a lot of money in their pockets to push prices higher for a sustained period of time…So when one sees a very high reading, it may be a sign that a brief pullback is needed, but it is also a sign that higher prices should be expected following that pullback.”

The entire paper may be found here. The quote was taken from pages 24 and 25.

Summary thoughts
Breadth has been extremely strong, but we’ve yet to see a real rush that would look like a “herding” day. The strongest areas in the last week and a half have been those that were beaten down the hardest. Contrary to what some would have you believe, this is NOT unusual at market bottoms. (I’ll review results from my previous post on this later.) I’m continuing to take it day by day. Since exiting my long positions based off my bottom indicators I’ve yet to reallocate heavily either long or short and am waiting for a better edge.

Short-term Implications of Follow Through Days

Time for CANSLIM traders to go back to work. An IBD Follow Through Day triggered today. At Quantifiable Edges I’ve discussed the intermediate-term implications of Follow Through Days in great detail. Catch the entire series so far below:

While intermediate-term traders are rejoicing with today’s Follow Through Day, swing traders are noting how overbought the market has become on a short-term basis. Most of what I’ve read by short-term traders this afternoon and evening has been short-oriented. The prevailing theme is that we are now short-term overbought in a longer-term downtrend (or bear for some). Most people believe these are ideal conditions for shorting.

What swing traders looking to short need to understand is that nearly every Follow Through Day produces short-term overbought conditions in a downtrending market. They frequently arrive within 4-7 days of a bottom. Today was day 7 of the rally. As it was last week, most of the time the reversal off that bottom is violent. This can cause oscillators to become overbought. When the formula calls for a typically violent reversal, a week of gains, and a strong rally on high volume to cap it off – you’re bound to be overbought short-term. Does that mean it’s a good time to try a swing trade short?

To test it I looked at the 1-5 day returns of all 64 Follow Through Days listed in my study. $100,000 per trade. Go long on the close of the Follow Through Day. Exit X days later. Results below:

More often than not the market trades higher over the next 1-5 days. The average win is larger than the average loss. Profits continue to be made on the long-side. Shorting is a losing game in this scenario. Perhaps this disbelief by short-term traders is what helps to continue to fuel the rally as they are constantly forced to cover their losing positions.

Is short-term success or failure indicative of long-term success or failure?
One interesting claim that IBD sometimes makes about Follow Through Days is that those that fail normally do so shortly after the Follow Through Day. I decided to also look at this concept tonight.

I broke the 64 Follow Through Days in my study up into two groups – the successful ones and the unsuccessful ones – to see if their early performance hinted at their chance of longer-term success. Below are the breakdowns – same as above – $100,000/trade, long at the close of the Follow Through Day, and exit X days later.

Early action after Follow Through Days that eventually “succeeded”:

Right off the bat most of these posted nice gains. The short-term winners among the group averaged another 2-3% upside in the first week. The short-term losers suffered 1-1.5% drops on average. Net profits were substantial.

Early action after Follow Through Days that eventually “failed”:

Those that eventually failed tended to show signs of failure right away. Notable here is the average loss was appreciably higher than the average gain.

A basic rule of thumb is that the success or failure was determined with about 67% reliability within the first week after a Follow Through Day. For instance, note there were 41 total trades that were in the black after 5 days. About 2/3 of them went on to “successful” rallies. The same ratio applies for the losers. There were 23 losers after 5 days. 15 of them ended up with “failed” rallies and the other 8 were “successful”. The 2/3 rule holds fairly accurate whether you are looking at winners or losers over any period from 1-5 days after the Follow Through Day. The Unemployment Report tomorrow morning has a chance to set the tone early on in this one.

To summarize the two main points tonight:
1) Don’t be too eager to short. It’s doesn’t have positive expected value just after a Follow Through Day.
2) Watch market action closely over the next week. It should give you a pretty good indication of the intermediate-term.

Large Gaps Lower in Uptrends vs. Downtrends

After nosediving into the close today, the futures are markedly lower in the overnight session. As I type this around 10:30pm Eastern the S&P futures are down nearly 1% and the Nasdaq futures are down over 1%. Last week we saw two large gaps down that reversed. But do buying gaps down provide you an edge? Is it any different in bear markets than in bull markets?

I looked at the SPY from November 1993 to the present. Over that time it has gapped lower by 0.75% or more 190 times. It has happened 105 times when the SPY was trading below its 200-day moving average and 85 times when it was trading above its 200-day moving average.

Since most people know “the trend is your friend”, prevailing wisdom indicates that buying gaps down in uptrends is a sounder strategy than buying gaps down during downtrends. Prevailing wisdom is wrong.

When the SPY has traded above its 200-day moving average and gapped down 0.75% or more, buying the open and selling the close would have resulted in 42 out of 85 (49.4%) trades to be profitable. There would have been a net loss of about 1.7% over the course of those 85 trades.

Buying the open and selling the close when the SPY is trading below its 200-day moving average and gaps down by 0.75% or more showed much different results. In this case, 55 of 105 (52.4%) were profitable – only a slight improvement. But the net gain on the 105 trades was over 34.8% – a huge difference compare to the small loss in an uptrending market.

Emotion drives markets. Large gaps down in an already fearful environment can provide nice buying opportunities. While the win rate is only slightly better than a coin flip, the potential reward far outweighs the risk and provides a quantifiable edge. Agile traders could also improve their risk/reward by fine tuning their entries and exits intraday. Bear markets are driven by fear. Gaps are frequently fearful overreactions. Don’t ride along with the bear.

Follow Through Days pt. 3 – Do They Miss Too Much of the Move?

With the Fed meeting tomorrow, another volatile day (after 2:15pm) seems a near certainty. CANSLIM traders will be watchful to see if the Fed can help to produce a Follow Through Day. The S&P 500 is already up over 7% off the lows hit last week. I therefore thought tonight would be a good time to post the 3rd part in my series on IBD Follow Through Days: Do Follow Through Days Frequently Miss Too Much of the Move or do They Signal Early Enough to Capture a Sizable Portion of the Rally?

Should you have missed the first few parts in the study on follow through days you may find them below:

Part 1 – Are They Predictive?
Part 2 – Does Every Rally Have One?

To determine whether they do a good job of catching a large portion of the rally, I first split all the 1% Follow Through Days into two groups – winners and losers. The test I used was the exact test described in part 1 using 1% Follow Through Days after an 8% market decline. I then measured how far from the bottom the market closed at on the follow through day. I am using the 1% Follow Through Day in this test rather than the 1.7% that IBD currently recommends due to the fact that the 1.7% requirement has had about a 20% chance of missing nearly the entire rally.

Interestingly, when I measured the distance from the low that the Follow Through Day closed, it seemed to have no affect on success or failure. For both winners and losers the average Follow Through Day closed about 5.2% higher than the recent low.

I then decided to examine just the Follow Through Days that worked to see how much the market typically gained on a bull move between December 1971 and now. The average bull move over the period was about 28.8%. This includes some fantastic moves such as the 64% market rise from 10/1990 to 2/1994. Of the 35 “successful” Follow Through Days, 25 (71%) of them saw the market gain at least another 10% before correcting again.

Of course there is no chance of actually selling at the top and capturing the entire remaining portion of the move. If you assume the Follow Through Day gets you into a move 5.2% from the bottom and you will end up or missing out on the top third of the move, then on average each successful Follow Through Day would lead to a gain of nearly 14%.

Using the exit criteria described in Part 1, the average loss on failed Follow Through Day would be about 5.6%

Since 55% of Follow Through Days are “successful”, the expected value of buying the S&P 500 at the close of a follow through day with the above assumptions is ((0.55) * 14%) – ((0.45) * 5.6%) = 5.18%. The nicely positive expected value indicates the Follow Through Day is capable of catching enough of the move to make it worthwhile.

An important point that I neglected in calculating these numbers is that most traders that use Follow Through Days don’t simply trade indices. Stock selection and timing are important components of CANSLIM. Should their stock selection and timing be better than the market on average, then they could see gains many times greater than the expected 5.2%.

So in summary – here’s the good news. If this is a real bull rally there should be plenty of room left to make money even if a big Follow Through Day occurs soon. The bad news is this really isn’t an endorsement of Follow Through Days. It’s more an exercise in risk/reward analysis. And while the 5.2% that’s being given up on average around the market bottom pales in comparison to the potential gains, 5.2% is still more than S&P returned in total in two of the last three years. It’s not a trivial amount. Fortunately, as I’ve demonstrated in the last few weeks, alternate methods can help capture a good portion of that 5.2%. Still, for traders without better methods of identifying market bottoms, the IBD Follow Through Day seems to give a decent chance of capturing a good portion of a rally.

I’ll continue my series on Follow Through Days shortly with my next installment: Do They Work Better After Small or Large Declines?

The Edges Are Dulling

There’s a fair amount of studies outstanding and the market has been putting in a decent bounce, so let’s see where we are at:

First off I found it interesting that the Nasdaq 100 /Russell 2000 Relationship remains disjointed. We are now at 8 days of at least a 1% differential in returns.

Time Stretch Study
This was the first study of the currently active bunch to be posted. The exit on this study was based on a close above the 10-day moving average. The S&P 500 accomplished that today, closing the study. The entry was officially at the close on Friday the 18th. Since I didn’t post it until Sunday the 20th, anyone who may have taken a trade based on this should have gotten a significantly better entry price due to the massive gap down on the 22nd. Even assuming the lousy Friday the 18th entry this study would have been good for about a 2.2% gain.

Capitulative Breadth Indicator
On January 22nd the CBI jumped from 5 to 13. I discussed in detail how moves as high as ten or more have led to strong market bounces in the past. (Click on the “CBI” label at the bottom of this post to see all posts related to this topic.) The standard exit I discussed was exiting when the CBI fell back to 3 or lower. On Thursday I discussed the “profitable 8” exit strategy. This entailed selling on drop in the CBI to 3 or lower or the first profitable close of 8 or lower. This strategy, while consistently profitable, would have shaved about 0.6% per trade off affected trades.

With the drop in the CBI to 5 today I decided to look at a similar exit – selling the first profitable close of 5 or lower or selling when the CBI hit 3. A “profitable 5” exit would have affected only 4 instances. Two of them it hurt the return. The other two it helped the return. The net effect using a “profitable 5” strategy was slightly positive. An exit at today’s close would have netted about 3.3% from the 1/22 entry trigger. If the alternate entry on 1/23 was taken it would be a 1.1% gain. I will continue to update the CBI until it triggers the standard exit reading of 3 or less.

Reversal Bars Studies
The Large Reversal Bar Study which was originally published on the 9th, triggered again on the 23rd. After pulling back below the close of the reversal bar (1/23/08) it has now closed back above it. On the 15th I posted a trade management follow up to the January 9th study. Based on the trade management outlined then, a stop should now be placed below today’s low (1/28).

The Large Bars Down and Up Study is on track so far. That study showed a pullback was likely within the first 5 days following the reversal up (1/23). After that the market was likely to rally – probably after retesting the lows. It’s too soon to draw any real conclusions here, yet.

Summary Thoughts
Oversold conditions are being worked off in most of the outstanding studies. Even with less than ideal entries, profits should be available. Profit taking seems prudent. While certain studies like Reversal Bars and Nasdaq/Russell indicate more upside is likely to come, they also indicate extremely high volatility is likely. Wednesday will almost certainly see volatility with the Fed decision due. There is nothing wrong with letting some profits ride, but I’d suggest traders consider taking at least a portion of their holdings off the table now to protect gains. Preserve capital and wait for a better edge.

Rob Hanna

Does A Disjointed Nasdaq / Russell Relationship Mean Anything?

Below are the returns for the Nasdaq 100 and Russell 2000 for the last 7 days:

The correlation between the Nasdaq 100 and the Russell 2000 in 2007 was about 0.65. Over the last seven days the correlation is -0.14. While it’s a mildly unusual for the correlation of the two to become negative over seven day time spans, it’s not terribly notable. What is notable is something my father-in-law, a very smart and observant trader who is always full of ideas, pointed out to me yesterday. The percent change spread between the two indices has been greater than 1% each of the last seven days. Even days when they are going in the same direction, the disparity between the returns has been large. It’s not because one is clearly outperforming the other. They’ve taken turns having the best/worst performance.

I decided to run some tests to see if I could glean anything from this.

My Russell 2000 data went back to the fall of 1987, so that is how far back I ran the tests. Over the last 20 years I found 10 other instances of 1% or greater divergences of seven days or longer. The most recent occurred in 2001. I then looked to see how the Nasdaq performed over the 20 trading days following an event. The 10 trades are listed in the table below.

With the exception of the 1996 trade, the remaining instances all occurred between 1999 and 2001. The first thing I noticed was that while half the trades occurred during the recent bear market, 9 of the 10 instances led to positive returns over the next 20 days. This would indicate a decent chance of a bullish bias. This is not what really caught my eye though.

What most stood out to me was the size of the returns and the range ((high of 20 days-low of 20 days)/close of day 1) the Nasdaq 100 traded in over the subsequent 20 days. The average winning trade gained 12.8% in the next 20 days. The lone loser lost 18.1%. The average range for the 10 instances was 24.25%, with the smallest range being 14.9% and the largest a whopping 36.5%. Truly eye-catching numbers.

While it’s difficult to draw any concrete conclusions from this study, it appears to me that when major indices diverge this much, something is possibly disjointed in the market. This disjointedness has often corrected itself and led to a multi-week rally. In all cases though, it seems to indicate the market is volatile and is likely to remain that way for a while. This agrees with several of the other studies I have discussed recently. Recall my summary in CBI, Reversal Studies and Bear Market Rallies…


P.S. Per request, I’ve posted a CBI reading on the top right hand corner of the page. I will update there each day until the reading drops back to 3 or below. I will also update intraday should a significant move be apparent.

CBI Update and Profit Taking Food for Thought

It’s 3pm as I write this. The Capitulative Breadth Indicator CBI will almost certainly drop from 13 to 8 today at the close. In November, which was the last time the CBI had reached 10, I had someone ask me to look at the implications of taking profits a bit quicker. Rather than waiting for the CBI to return to 3, the alternate exit we explored entailed selling on the first profitable close when it dropped to 8 or lower. If the trade remained unprofitable then continue to hold until the CBI returned to 3 before selling. Changing the exit criteria in that way meant early exits on 11 of the 16 trades. In the other 5 trades the CBI dropped from 9 or higher to 3 or lower in one day never allowing the “profitable 8 rule” to take effect.

The net effect of this early exit technique was that profits were reduced on the 11 early exits by about 0.6% per trade. Traders that are nervously sitting on winning positions may want to factor this information into their thinking when deciding whether to take partial or full profits at this point.

The Large Bars Down and Up Study from last night indicated that a pullback was likely within a few days. Whether the pullback comes before or after the CBI hits 3, I don’t know. If you’re sitting on healthy profits and not willing to wait through a pullback of potentially 2%+, then you may want to consider taking at least partial profits. It is not the mathematically optimal exit, but I find sometimes taking partial profits can help alleviate trade anxiety – allowing you to think more clearly and manage the rest of the trade more objectively. If the pullback happens to arrive before the CBI hits 3, then there is also the possibility of adding back to your position at a lower price.

Just some food for thought…


The CBI, Reversals, and Bear Market Rallies

Quite a day today. For those of you who “missed” the reversal – don’t sweat it. My studies indicate there’s plenty of upside left. Let’s first review and update things we’ve already looked at. Then I’ll show some new stats.

Capitulative Breadth Indicator (CBI)
The CBI remained at 13 today. It normally takes more than one day of buying to significantly reduce the number. The exit signal for this model will come when the CBI closes at 3 or lower. I’ve discussed it in great detail in the last several days. If you missed those posts and want to read up on it, just click the CBI label at the bottom of this post.

Time Stretch Study
Although I didn’t post this study until Sunday night, the study used Friday’s closing price as the presumed entry point. Amazingly, even with an entry as bad a Friday’s close, this study is currently 1% in the black.

Large Reversal Bar Study
The criteria for the reversal bar study on January 9th was the S&P 500 makes a 20-day low and closes greater than 1% higher on increased volume over the previous day. We met those criteria again today. While the Jan. 9th reversal bar ultimately failed, it wasn’t before opportunities for profit, or at least a scratch, made themselves available. Traders may want to go back and review that study and the subsequent trade management follow-up post as they both apply again today.

Large Bars Down and Up
What stood out over the last few days was the volatility and extremely wide range that the market traded in. I did a study looking at these two-bar reversals rather than just looking at the single bar reversal like above. Below are the results: (click table to enlarge)

All of the key stats here look pretty good. An average return of over 3% on a short-term index trade is always eye-catching. I also like the Win/Loss Ratios and Profit Factors (Profit Factor = Gross Profit / Gross Loss). There are fewer trades listed when the trades lasted more than 1 week because the setup occurred again a short time later and I didn’t want to double-count the stats for those instances. I’ve listed all the trades with a 5-day exit below.

A few notable things here:

1) All but one of these trades saw a pullback within the first five days. The lone holdout (9/11/98) pulled back below its entry price intraday on Day 6. Most of the pullbacks were 2% or more. As in the previous reversal bar study, this indicates it is likely unnecessary to chase an entry.

2) All of the instances led to a decent rally at some point beyond the five days shown. Five of the seven groups saw retests before their rallies. These were 10/87, 10/89, 9/98, 4/00, and 7-8/2002. The other two – 10/97 and 9/01 marked the bottom.

3) While the setup has occurred only ten times in the last 30 years, 3 of those times it happened within two weeks of a previous instance. The volatility experienced over the two-day reversal period did not dissipate quickly. This indicates the ride will likely remain a wild one.

Today was a good start. I believe in the days and perhaps weeks to come there is going to be more volatility and ultimately more upside. While I normally like to stick to the numbers in this blog, logically it makes sense to me that we get some upside here. Here’s my thought process. It seems the whole world is convinced we’re in a bear market. Most of what I see and hear is saying “sell into any rallies”. It is this disbelief which should help fuel to the rise. This may or may not be “the” bottom. If it is, then we will certainly see a nice rally. If it isn’t “the” bottom the rally should still be nice enough to suck in a good number of people before the next serious leg down begins. That’s what bear-market rallies do. They make believers out of suckers then take their money. In either case my studies indicate the rally should be strong enough to grab some profits. Just peek at the trades listed above – several of them were of the Bear Market Rally variety. So have we hit “the” bottom? I have no idea, but I’ll be re-evaluating all along the way.

CBI Closes At 13 – Some Alternate Entry Techniques

The Capitulative Breadth Indicator (CBI) officially closed at 13 this afternoon. The number is now significant.

Some people asked me to look at a few different entry techniques to see how they may have fared over the years. I used SPY instead of the index for these tests so that gaps would be accounted for using stop orders.

The entry techniques tested all looked for confirmation that the market was bouncing rather than simply looking to enter on a spike in the CBI. The exit remained selling on the close when the CBI closed at 3 or lower as I’ve previously described.

The first and second tests looked to buy following a CBI reading of 10 or greater at 1) A move above the prior day’s high or 2) A move above the prior day’s close.

Of these two options, a move above the prior day’s high worked better at avoiding drawdown. Both options saw two of the trades move from winners to losers – though the losses were quite small (0.05% and 0.64%).

The third entry tested looked at buying at the first close that was higher than the previous day’s close (after the CBI hit at least 10). This seemed to work the best (good suggestion Tim). All 16 trades remained positive. The average gain was 2.2%. The maximum drawdown was 4.3% and the average drawdown was only 1.9%. For those who prefer to wait for confirmation rather than scaling in on the way down, a close higher than the previous day’s close seems to have worked quite well in the past.

Today’s action put the market squarely into capitulation territory. The CBI broke 10 as expected. Price is now more stretched and some of the measures I use there (RSI, Bollinger Bands, etc.) are now giving extreme readings. Time was already stretched. I’m expecting a significant multi-day bounce to materialize within the next few days. If it materializes, I expect the most beaten down areas to bounce the most.

Stay tuned…

CBI Spiking – How Bad Can It Get?

The Capitulative Breadth Indicator is on track to spike up from 5 on Friday to between 12 and 15 today. It has only spiked as high as 15 high 5 other times since 1995. As I’ve stated in the past, spikes above 10 typically lead to a strong bounce. This does NOT preclude more downside before the bounce occurs, though.

Below are graphical displays of the two biggest spikes (and scariest declines) the indicator has seen. (It was backtested to 1995 and has been measured live since 2005.)

July 2002

In this case there were three more days of selling before the bottom and the bounce came. Going long at the close when it spiked above 10 would have led to a 12% intra-trade decline before posting a 2.4% gain.

September 2001

Here as well there were 3 more days of selling before the bottom was hit. This time the continued drop was about 8.5% from the entry to the low. The gain on the trade in this case was 3.8%.

The CBI is now signaling a sharp short-term reversal is near. As demonstrated above, there still could be a significant amount of short-term pain yet to endure. Spikes of 10 or higher have happened 16 times. Buying that close and selling on a return to 3 or lower has been profitable all 16 times. The average gain on the 16 occurrences from open to close was about 1.8%. The average intra-trade drawdown was about 3.1%. Starting relatively small and continuing to scale in as the market sinks is my preferred way to play it.

I will continue to update CBI readings in the days ahead.

What stocks will benefit the most when the market bounces?

When the market bounces, what do you want to be buying? Contrary to popular belief, the stocks that held up the best during the selloff, do NOT perform the best on the bounce. In fact, it’s quite the opposite. Below are snapshots of the best (Highest RS) and worst (Lowest RS) performing Dow stocks on a few recent waterfall declines. I show the amount they declined prior to the bottom and then how much they bounced during the course of the initial move off the lows (6-8 days). I also show what the Dow did over the same time period.

In every case, the Lowest RS stocks outperformed the Highest RS by an amount close to or greater than the bounce in the Dow! In other words, a spread trade could have achieved returns close to or better than simply going long the index. Careful, though. A spread trade between the best 5 and worst 5 does NOT eliminate the need for market timing. Typically the least favorable stocks will remain so until the market actually turns. When it does turn, though – look to the most beat up stocks to give the best bounces.

Below are the top 5 and bottom 5 Dow stocks since the swing high of December 26, 2007: