Thursday, December 08, 2016

Momentum in the Market: Trade It or Fade It?

A trend day is basically a day with momentum on the day time frame.  The buyers or sellers so dominate the market activity that the other side backs off for the remainder of the session.  That is what we saw in yesterday's trade:  once we broke to new highs with significant uptick readings, the buyers remained in control for the session.  I find it useful to track the distribution of NYSE TICK readings during the trading day to identify when we have made significant shifts in buying/selling and when we are extended within a relatively static range.  That shift of distribution often makes the difference between trading strength or weakness versus fading it.

The momentum principle is true on longer time frames as well.  Yesterday's post took a look at the absence of market weakness as an indication of potential future market strength.  Now let's look at the presence of market strength, such as we saw in yesterday's session.  Does that tend to lead to future weakness as an overbought signal, or does it tend to yield further gains as part of momentum?

If we track the number of NYSE stocks closing above their individual Bollinger Bands and those closing below, we find that 412 closed above their bands.  That is a huge number; one of the highest since I began aggregating these data in 2014.  For comparison, since 2014, the median number of stocks closing above their bands each day has been 62 with a standard deviation of 69.  We've had 48 occasions over that period in which more than 200 stocks have closed above their upper bands in a trading session.  Five sessions later, the average price change in SPY has been a loss of -.13%, compared with an average gain of +.15% for the remainder of the sample.  When we look 20 days out, however, the average gain in SPY after the strong session has been +.96% versus an average gain of +.49% for the remainder of the sample.  While it's been normal to have some near-term pullback after extreme strength, it's also been common for the strength to resume.

The market spends much of its time trading in a range.  During that range trade, by definition the moves higher and lower lack the momentum to be sustained.  The best trading strategy is to recognize the loss of momentum and fade the strength or weakness.  Once we expand buying or selling, however, we can get the breakouts from ranges in which strength or weakness leads to further strength or weakness.  We lose flexibility when we identify ourselves as range (mean reversion) traders or trend (momentum) traders.  One of the great challenges of trading markets lies in recognizing shifts in buying and selling regimes.

Further Reading:  Tracking Institutional Participation in the Market