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.