Count To Three

In Larry Connors’ book “How Markets Really Work” he devotes a chapter to “Up Days In A Row vs. Down Days In A Row”. He looks at how the market has performed after it has moved in one direction for 1, 2, or 3 days in a row. Because of the long-term upward drift of the stock market, very few of the studies published in the book show much of a negative tendency. One situation that showed a negative tendency over the following 1, 2, and 5 day periods was when the market was trading below its 200-day moving average and had posted three higher closes. (This happened today.)

The book looked at data from 1989-2003. Over that period the following results were shown:

Since the end of 2003 it has only happened 4 times until today. Those dates were 7/29/04, 8/17/04, 8/26/04, and 11/29/07. So Larry’s data for this study remains pretty current.

I tested back 35 years and found the results to be similar. About a coin flip on direction, but downside risks were higher than upside rewards giving the next 1-5 days a negative expectancy.

This study on its own is not a reason to sell short. It should serve as a caution though for those holding long positions. Rallies during longer-term downtrends are not normally very persistent. Long-side traders will many times shorten their time frames while short-sellers use the bounces as an opportunity to add more short exposure – all causing a lot of backing and filling. Also note that two of the highest volume days of the last two and a half weeks were on January 31st and February 1st. A lot of people bought a lot of stock on those two days. They’ve been underwater ever since. After three up days in a row, the market has moved back into the middle of the range of those two days. We may see a lot of folks here that are relieved to be able to get out near breakeven on their purchases. This should create some additional selling pressure.

Seems to me like a good time to tighten things up on the long side. Aggressive traders could consider taking a shot short here soon if they’re able to find a favorable entrypoint.

Rob Hanna


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The Double Support Trailing Stop

Today saw some big swings but did little to change my moderately bullish bias. Rather than post a study tonight, I thought I’d change things up a bit.

In some comments on January 23rd, “Tim” mentioned he remembered an article I’d written a long time ago in which I discussed “double support stops”. (It was actually the first column I ever published). Since then I’ve seen a large number of readers have done searches on “Double Support Stop Rob Hanna” or something along those lines. Anyway, the column can’t be found anywhere anymore. But you want it – you got it. From way back in 2002 (along with a 2002 chart and ticker symbol – the ticker has since changed to HW if you want to pull it on your own software), I give you “The Double Support Trailing Stop”.

The Double Support Trailing Stop

The Concept
Like most traders, I have a whole checklist of criteria that must be met before I will consider purchasing a stock. I spend a substantial amount of time researching potential candidates so that I may find a few stocks that meet my criteria. One of the most frustrating and difficult things for me is finding a great stock, buying it at the right time, and then being stopped out of it just before it reverses and goes on to huge gains. Having traded in multiple time frames over the years I have experienced this frustration with day, swing, and intermediate term trades. To keep myself in winning trades longer and avoid being shaken out early, I developed my “Double Support Trailing Stop Technique”. I will show an example of this technique on an intermediate term trade, but have successfully employed it in many different time frames, and originally created it for my day trades.

The idea is simple. If I require a large numbers of reasons to enter a trade, I should require more than just one reason to exit it if I want to catch as much of the move as possible. I will therefore require two levels of support to be broken before I will PERMANENTLY & COMPLETELY exit a trade. How you define support does not really matter. You can use pullbacks, consolidation lows (or highs), fibonacci’s, moving averages, trend lines, or whatever fits your trading style.

An Example
Being that the below example is an intermediate term trade, I simply used consolidations & pullbacks, along with the 50 day moving average (shown as the rising blue line) for my support levels. I define a pullback to be any bar (or series of bars) with a lower low AND lower high after a stock has made new highs. The stock shown is Headwaters Inc (ticker: HDWR). I purchased this stock as it burst out of a flat base in the middle of March. My initial stop on the breakout would have been 8% from my purchase price, or the low of the base. After breaking out, it moved up sharply for 5 days before starting to pull back. It pulled back for seven days before reversing and moving higher. The low of this pullback is near the 1st green arrow labeled “Support”. It became support in my eyes after the stock move higher from there by making a higher high and higher low on the next bar. When that happened I was able to move my initial stop up to the breakout point. (I consider the high of a flat base or high tight flag to be a level of support also.)

Next, the stock moved up again for several days before making a second pullback down to the green arrow labeled “Broken Support”. The “Broken Support” bar was initially just the next area of support after the stock had pulled back and moved higher. When that happened, I was able to move my stop up under the 1st green support arrow. It became “broken” 5 days later when the next bar labeled “Support” moved below the low of “Broken Support”. If I had exited at the “broken support” level here, I would have been shaken out of the stock and missed the rest of the move. Instead, the stock continued to move up and create higher and higher support levels.

The time came for me to sell this stock at the area marked “Double Support (Sold When Broken)”. It was at this time that the stock moved below two levels of support. The first was the 50 Day Moving Average, and the second was the pullback low just above the “Double Support” green arrow. As you can see, this turned out to be a good time to take profits and exit this trade. Three days later it was trading nearly 30% lower.

Additional Considerations
Earlier I used the term “permanently & completely exit”. Due to the fact that the 1st and 2nd levels of support may be very far away from each other in some instances, I may consider exiting the position partially, or exiting and then looking for an opportunity to re-enter the position, when it breaks the 1st level of support. The main reason I would do this is not to give back too much of my profits. Once two levels of support are broken, I want to be completely out of the position and will not consider re-entering without a whole new base setting up.

Since the “Double Support Trailing Stop” will keep you in positions longer, it is most effective when you are trading with the overall trend of the market. In other words, long positions in an uptrending market, and short positions in a downtrending market.

Can Contracting Range Hint At Direction?

After the negative inside day on Friday, the S&P refused to sell off hard and even posted a decent gain today – breaking its recent streak. Perhaps this may signal a change in character from the downtrend since the October highs. Traders may not be looking to leave the party every time there’s a pause in the conversation.

Speaking of pauses, have you noticed how the price range has been tightening? The range over the last 3 days has been the tightest of any three days since December. Even more interesting to me is that over the last 13 days, the high-low range the S&P 500 has traveled has barely exceeded the range it traveled in the one day prior to that. The SPY on January 23rd had a range of $7.35. Since then the total range has been $7.88.

Looking at the S&P 500 cash index I went back to see other times the market traded in a range nearly as tight relative to one bar over a 13-day span. The parameter I used was that the range of the last 13 days had to be within 115% of the range of the 14th day back. I found 31 other occurrences going back 30 years. Twenty-five of those occurrences saw the market higher a month later. Only three times that I found was the range contraction followed by a break to the downside which led to significantly more selling. Those occurrences were August 1985, September 1990 and August 1998.

This study seems to be another example of what I’ve been seeing lately. Over the next several weeks risk/reward appears to favor the upside. Even this contracted range has some serious volatility, though, so risk should not be underestimated. Good timing and proper (reduced) position sizing appear key.

On another note, I was pleased to have my recent post on leadership breadth appear in this week’s Festival of Stocks along with many interesting columns from other bloggers.

Why Inside Days Get Me Down

Friday was an inside day. For me that meant laying in bed most of the day trying not to vomit. For the market that meant a lower high and a higher low than Thursday causing Friday’s range to be completely “inside” Thursday’s range. The indices also closed lower on the day. Below is a chart of the SPY going back to October 8th, which was the day it closed at its highest level. Every inside day with a down close is marked with a blue dot.

The return following each of the inside days with a down close is as follows: -0.48%, -2.62%, -1.27%, -2.45%, -2.64%. That is an average loss of 1.9% the following day. Five for five losers. The pattern isn’t pretty.

Even before the recent market top, this pattern has had bearish tendencies. Looking back to the beginning of 2004, there have been 53 inside days with down closes for the SPY. Sixty-four percent of them were followed by a selloff the following day. The average loss was about 0.7% and the average gain 0.5%. Total losses outsized total gains by 2.3 to 1.

Looking back even further, since the 2000 market top, the SPY has closed down 58% of the time following an inside day with a down close. There were 104 occurrences. The average loss the next day was 0.9% while the average gain was 0.6%. In all total losses outsized total gains by about 2.1 to 1.

Friday’s pattern may have been an ideal one for me while trying to deal with the flu. For the market, the pattern has historically signaled short-term trouble.

Two other quick notes:

After conducting the study I did a search on “stock market inside day”. Dr. Steenbarger had an interesting study regarding them a couple of years ago.

In the comments section after my study of leadership breadth at market bottoms on Thursday night there was some discussion of the importance of looking at new low figures near market bottoms. Dr. Steenbarger also saved me some time this weekend and wrote a nice post on new lows near market bottoms. Thank you Dr.! (Now how about a little something for the nausea?)

Is Leadership Breadth Important For A Successful Bottom?

One reason cited by IBD recently for their lack of confidence in the current bottom attempt is the lack of stocks with sound basing formations. While doing a historical study of the number of basing formations seems near impossible to me, one reader suggested looking at new highs. I thought this was a good idea since it should give a reasonable estimate of leadership breadth.

I looked at every Follow Through Day (FTD) identified in Part 1 of the IBD Follow Through Day Study and calculated the percent of New York Stock Exchange stocks that hit new 52 week highs on the day of the FTD. I broke the results down into “Successful” and “Unsuccessful” FTD’s.

This is what I found:

The average percentage of NYSE stocks making new highs on “successful” FTD’s – 2.1%
The average percentage of NYSE stocks making new highs on “unsuccessful” FTD’s – 2.0%

The median percentage of NYSE stocks making new highs on “successful” FTD’s – 1.2%
The median percentage of NYSE stocks making new highs on “unsuccessful” FTD’s – 1.4%

The minimum percentage of NYSE stocks making new highs on “successful” FTD’s – 0.1%
The minimum percentage of NYSE stocks making new highs on “unsuccessful” FTD’s – 0.1%

It appears that leadership breadth has no predictive value when assessing the likelihood that a FTD will succeed or fail.

On January 31st there were 18 new highs out of 3272 issues traded on the NYSE according to my database. This equates to 0.55% and has hereby been deemed a useless fact.

I found the results somewhat surprising as I thought leadership breadth would provide at least some advantage.

I still feel leadership is important to sustain a rally. It appears many times the real bull leaders may not emerge immediately. While the FTD typically comes 4-10 days after the bottom, leadership may take 3 weeks or more to establish itself.

So will this rally attempt succeed? I don’t know. I do know if it fails it won’t be because leadership breadth was too weak.

After all this recent testing of “conventional market wisdom” I’m starting to feel like Adam and Jamie from the Discovery Channel. Myth: Leadership Breadth Is Important At Market Bottoms – BUSTED! Think I could land my own tv show?

Good For A Day – But Back To No-Man’s Land

The market gapped lower as I was hoping and then after much back and forth it finished on an up note. As I indicated last night, I was interested in buying a large gap down and have held on to some of the position for a swing trade. This one has worked out so far, but I’m not terribly excited with today’s action.

Over the last few days there have been some fairly extreme readings. Two examples were the Arms Index mentioned two nights ago and the sharp three day selloff followed by a sizable gap down this morning. The reversals generated from these conditions the last two days have not been inspiring. Today’s action was wildly up and down. Bulls have not been able to take control for more than a couple of hours at a time.

It has now been 5 days since the January 31st follow through day. Last Friday I did a study on the short-term implications of follow through days. It showed that success or failure of the new bully rally attempt is about 67% predictable based on the action of the first 5 days after the follow through day. That study therefore now predicts a continuation of the bear.

The good news is the market has managed to hold support so far. Readings around the January lows were severe enough that it remains plausible a significant bottom could have been made. I’ve obviously not yet given up on that idea. The market is in no-man’s land right now. Tests run tonight based on current action are showing no significant edge. Technically, a move above 1400 would signal the bulls are taking charge while a move below 1270 would signify the bears are still in control. That range is very wide but with the recent and expected volatility, I’d be surprised if it wasn’t broken fairly soon. I’m holding a small long position leftover from today but not looking to aggressively add to it.

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