Monday, December 29, 2014

Using Pure Price Momentum to Track Market Cycles

I'm not a big fan of terms like "overbought" and "oversold".  Too often, those terms embed a bias--that the stretched market is likely to snap back.  Similarly, one person looks at a chart and notices "consolidation"; another perceived "topping".  There is a lot of room for subjectivity in how we label what we see.  That's a good reason to look at many things with a fresh set of eyes.  We're less likely to fall victim to confirmation biases if we view the world through multiple lenses and invite information that doesn't neatly fit into our views of the moment.

Above is a chart of the ES futures.  Each point on the chart represents 50,000 contracts traded.  On busy days, we print more points on the chart; slow days print fewer.  Similarly, the busy times of day print more points than the slow, midday hours.  This normalizes, to some degree, volatility within and across days.  I further take volatility out of the picture by simply recording whether the average price of each volume bar is up or down relative to the prior bar.  The chart is an 80-bar moving average of this up/down count.  It can be viewed as a relatively pure measure of price momentum.

When the 80-period average has been in the top half of its distribution, the next 40 bars have averaged a gain of +.15%.  When the average has been in the bottom half of its distribution, the next 40 bars have averaged a loss of -.01%.  If you look at the chart closely, you'll see the reason for this momentum effect:  early in a market cycle, we see a surge in upside momentum, which stays positive but wanes as the cycle matures.  Eventually we get negative momentum, leading to a crescendo of downside price change shortly before we hit a price low.

Seeing where we're at in this process gives a good read for where we stand in the present market cycle.  Much of the upside movement in the market can be attributed to momentum following strong positive readings and value/reversal following strong negative readings.  Tracking these helps us adapt to the phases of a market cycle.

Further Reading:  Finding Opportunity in Market Cycles