Tuesday, March 21, 2006

The Power Measure: What Happens Once a Trend Emerges?

Yesterday's entry on the Trading Psychology Weblog dusted off a proprietary indicator I developed a while ago, which I dubbed the Power Measure. It was my very first effort to measure a variable I call "trendiness": the market's tendency to persist in directional movement. After writing the recent articles that tracked the decreasing trendiness of the stock indices, I decided to modify the Power Measure and utilize it as an operational measure of trending that could be applied to a variety of markets and time frames. The nice thing about the measure is that it creates a normalized measurement, in which perfect upward trending earns a score of +100 and perfect downward trending earns a score of -100. Scores near zero suggest absence of trending: a tendency for price movement in period one to reverse in period two. Note that the Power Measure is a pure measure of price persistence; it does not confuse momentum/price strength with trending.

I went back to March, 2003 (N = 759) and looked at future price movement in SPY as a function of the Power Measure reading. When the measure was 90 or greater (consistent upside trending; N = 85), the next three days in SPY averaged a loss of -.02% (43 up, 42 down)--much weaker than the average three-day gain of .18% for the sample overall (443 up, 316 down).

When the Power Measure was -80 or lower (consistent downside trending; N = 55), the next three days in SPY averaged a gain of .53% (39 up, 16 down)--much stronger than average.

This is the clearest cut evidence I've yet seen of a countertrend bias to the market. Waiting for a distinct trend to emerge and then fading it has proven far more successful as a trading strategy than trying to ride trends. It will be interesting to see if this holds for shorter time frames as well. If my future investigations prove equally promising, I'll bring the Power Measure back to the Weblog.