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.