Sunday, August 27, 2006

Where We Can Find Directional Edges in the Market - Part Two

The last post found that sharp one-day changes in the number of stocks that rise above the envelope surrounding their 20-day moving averages have bullish implications in the near term. Similarly, sharp reductions in the number of stocks trading above their envelopes yield bullish price change expectations. It's when momentum is low that we see no directional edge 1-5 days out.

How about when stocks trade beyond their *lower* envelopes? Do sharp one-day movements at the bottom envelope also bring a directional edge to short-term trading?

When we've had an increase of 300 or more stocks trading below their lower envelopes (N = 84), the next three days in SPY have averaged a gain of .27% (53 up, 31 down). That is stronger than the average three-day gain of .12% (521 up, 394 down) for the entire sample. Interestingly, that edge is not present the next day, but emerges over the following days.

On the other hand, when we've had a large increase of 300 or more stocks *return* to their envelopes after having traded below the lower envelope (N = 86), the next three days in SPY average a gain of .29% (50 up, 36 down). Again, this is stronger than the average market performance.

Once again we can see that a movement of many stocks either well above their moving averages or back toward those averages has bullish outcomes several days later. When the change in number of stocks trading below their 20-day MA envelope is between +100 and -100 (N = 350), the next three days in SPY average a gain of .10% (193 up, 157 down)--no edge whatsoever.

The conclusion is that much of the market's edge--particularly to the upside--is the result of either strong positive momentum or strong negative momentum. When stocks are hugging their moving averages and showing little momentum, that's when we see mean reversion and little directional edge to trading over a several day period.

Once again, I will track these momentum measures on the Trading Psychology Weblog. As I write, we're seeing little short-term momentum over the past week.