Momentum and Reversal Effects for the Swing Trader

If you get a week in which more stocks advance than decline, is that a buying opportunity? I went back to the start of 2004 (N = 158 trading weeks) and examined how many NYSE issues advanced on the week and how many declined. When we had more advancers than decliners (N = 98), the following week in the S&P 500 Index (SPY) averaged a loss of -.01% (52 up, 46 down). When we had more declining stocks than advancers, however (N = 60), the next week in SPY averaged a gain of .44% (38 up, 22 down). For a short-term swing trader, therefore, returns have been superior when buying strength and subnormal when buying weakness.

Interestingly, when advancing stocks were 2500 or greater--a level at which they exceeded declines by well over 2:1 (N = 24), the next week in SPY averaged a gain of .20% (15 up, 9 down). When advancing stocks were less than 2500 (N = 74), the next week in SPY averaged a loss of -.07% (37 up, 37 down). This suggests that when advancing stocks swamp declines, there tends to be short-term momentum follow-through. It is when advancers lead declines by non-extreme amounts that we see subnormal returns over the next week.

Although we've only had a relative handful of occasions since 2004 in which weekly declining stocks have been 2500 or greater (N = 12), we see a similar pattern. When declines swamp advances, the next week in SPY averages a loss of -.23% (5 up, 7 down). When declines lead advances by a more narrow margin (N = 48), SPY averages a very healthy gain of .60% (33 up, 15 down). Once again, when declines lead advances by an extreme margin, there tends to be short-term momentum follow-through. It is when declines lead advances by non-extreme levels that we see superior returns over the next week.

These findings have relevance for short-term swing traders. Extreme market strength or weakness can be traded for momentum follow-through. More moderate moves can be traded for possible reversal--particularly when those moves are to the downside. I will be investigating this dynamic with daily measures of strength and weakness as well.

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