Saturday, May 02, 2009

Building A Measure of Market Strength


My earlier post took a look at market strength and momentum as a simple function of where the stock market closed on the day: nearer to its daily high or low price. As mentioned in the post, that was but a first approximation of a workable measure.

Now let's try something a little more nuanced. We will evaluate whether the S&P 500 Index (SPY) closes above or below various pivot-derived benchmarks: the pivot price (an approximation of the previous day's average trading price) and R1/R2/R3 and S1/S2/S3 price targets above and below the pivot respectively.

As I have defined these price target levels, the market since 2000 has a 70% chance of hitting either R1 or S1; a 50% chance of touching R2 or S2; and a 33% chance of reaching R3 or S3. Because these targets are defined as a function of recent volatility, the odds of hitting the targets remain relatively constant across periods of high and low market movement.

If the market closes above or below the prior day's pivot, that merits a score of +1 or -1. If the market closes above R1 or below S1, we give the market a score of +2 or -2. If the market closes above R2 or below S2, it receives a score of +3 or -3. Finally, if we close above R3 or below S3, the market is scored +4 or -4. We will call those scores the "Strength" of the market day. Charted above is the 20-day moving average of Strength vs. SPY going back to 2007.

We can see that Strength acts as a kind of overbought/oversold measure; note how across bull and bear markets, we see lower peaks as markets top and higher bottoms as they bottom. We're now seeing more Strength than at any point since August, 2008.

The reason I like Strength over the earlier measure is that it gives a market additional points if volatility is high in the direction of the market move. Note that, to get points, a market must *close* above the targets, not merely hit the targets. That means that the strong day must finish relatively strong, and the weak day must finish relatively weak.

It may well be that a 20-day moving average is not the best use for this indicator. Looking at a fresh variation will be the next post in this series.
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6 comments:

tryittry said...

Hi Brett,

DO you think the strength is way too strong as we ar still in bear market, market top sign?
Thanks!

tryittry said...

Hi Brett,

I just found your post, great! Should read earlier. But ther is no such thing is market called should or would.
One thing bother me is the strength, it is way too strong. we never get a coorections, meaningful. I am still wait in the sideline and waiting to join. This rally burned my shorts.
BTW, do you expect pull back or taget 940 SPX?
Thanks again!
Liang

kris said...

Brett,

It's a nice idea, however I see it works more like a contrarian indicator, as we see that since July 2008 we see higher lows in the indicator and lower lows in SP500...

rgds,

Kris

Brett Steenbarger, Ph.D. said...

Hi Liang,

Thanks for the note. I do not forecast specific price levels, but do not anticipate a sustained correction until we see some weakness and divergences among the indicators I track weekly. Those indicators have done a nice job of keeping traders from fading strength the last month or so.

Brett

Brett Steenbarger, Ph.D. said...

Thanks, Kris; you're a bit ahead of me with these postings: how the indicator functions is partly reflective of the time frame over which the data are aggregated. I'll be posting more on this--

Brett

Jason said...

Hi Dr. Steenbarger,

As learned from your writings, many indicators correlates with price. In general, what would be the kind of tests one needs to do before deciding an indicator is valuable.

Can you suggest any book or paper that touch upon this area? I am decently familiar with the maths being used in some of the analysis. However, I am finding it difficult to apply them when it comes to analyze the market. Is there any "statistical analysis for trader" book out there which would help a trader to analyze indicators and market conditions.

Thank you,

Jason