Thursday, January 08, 2015

Short-Term Market Moves: Should We Trade Them or Fade Them?

You think the market will be going up and, sure enough, it rises sharply and you only have a small position on.  Should you buy the strength and play for momentum, or should you count on mean reversion and wait for a pullback to buy?  It is not at all clear that chart patterns are informative in answering this key question of entry execution, which has led me to research some technical alternatives.  This is a work in progress with a relatively small data sample, so please take with appropriate caveats and grains of salt.

What we have above is SPY plotted against a composite measure of daily buy vs. sell signals for several different technical trading systems:  RSI, MACD, Bollinger Bands, CCI, and Parabolic SAR.  (Raw data from Stock Charts).  Every stock on the NYSE is tracked for each of these systems and we sum the buy signals and subtract the sell signals.  The composite tends to peak ahead of price during market cycles and bottoms shortly prior to price even at seeming v-bottoms.

The technical systems overlap one another to a fair degree, so I took just the ones that showed low correlation and volatility-adjusted them to equalize their signals.  When we've had the greatest number of buy signals (top quartile of distribution since July), the next five days in SPY have averaged a gain of +.33%.  When we've had the fewest buy signals (bottom quartile), the next five days in SPY have averaged a gain of +.42%.  All other days (middle quartiles) have averaged a loss of -.12%.  In other words, we have seen upside momentum when buy signals have been plentiful and we've seen mean reversion when very few stocks have been demonstrating strength.

When we look at sell signals as a distinct distribution, we find that when there are many sell signals (top half of distribution), the next five days in SPY average a loss of -.21%.  When there are relatively few sell signals (bottom half of distribution), the next five days in SPY average a gain of +.47%.  We thus see some downside momentum following broad weakness and some upside momentum when there has been an absence of weakness.

There is much more work to be done and considerably longer time frames to analyze.  The work thus far suggests that the breadth of market strength and weakness is relevant to the question of whether one should be trading short-term market moves or fading them.

Further Reading:  Tracking Market Cycles With Pure Price Momentum