Friday, July 14, 2006

After Strong Downside Momentum Days: Does the Trend Tend to End?

Readers of the Trading Psychology Weblog are familiar with the Demand and Supply measures, which reflect the number of operating company stocks that are displaying significant bullish momentum (Demand) and bearish momentum (Supply). I measure this by seeing how many stocks close above and below two volatility envelopes: one surrounding a short-term moving average, the other surrounding an intermediate-term moving average. To qualify, the stock must close above both envelopes.

On Thursday, we had Supply exceed Demand by more than 10:1. I went back to September, 2002 (when I first began collecting these data) and looked at all occasions in which Supply was greater than 175 and exceeded Demand by at least 7:1 (N = 15). Instead of looking at what happens by the close of the following days (my usual analysis), I looked at the subsequent days' high and low prices in the S&P 500 Index (SPY).

What I found was that, during the next day of trade, 14 of the 15 occasions traded above their close at some point during the day. But 13 of the 15 occasions also traded below their close during the day. In all, 12 of the 15 days traded *both* above and below their prior day's close.

During the second day of trade after the extreme Supply reading, 13 of the 15 occasions traded above the close from the extreme day, and 13 also traded below the close. In all, 11 of the 15 days traded *both* above and below the close from two days prior.

In other words, in the short run, once there has been an extreme momentum day to the downside, it has been common to get volatility--but not necessarily directional volatility. Rather, prices have tended to whip above and below the close of the extreme downside momentum day. This might provide a note of caution to traders trying to ride short-term trends.