Thursday, January 04, 2007

Periods of High Flux in Markets: Historical Patterns as a Heads Up in Trading

When I meet with a person as a psychologist, I try to get to know them as a human being. What are they like? How do they usually behave?

In doing that, I become extra sensitive to situations in which the individual no longer behaves in his or her normal manner. There is something unique about those situations that leads the person to respond differently than they usually do. Many times, understanding what's happening at those unique occasions is crucial to understanding what's bringing the person for help in the first place.

Markets are not much different. Sometimes they behave in usual ways, but occasionally they stop responding in their normal manner. I find that those occasions are the most valuable to investigate.

Let's take Wednesday's market, the first trading day of 2007. We had over 600 stocks across the NYSE, NASDAQ, and Amex close above the volatility envelopes surrounding their two-week moving averages. We also had over 600 stocks closing below those envelopes. That means that many stocks are showing positive upside momentum, but many are also displaying negative, downside momentum. Given that the number of stocks closing above their envelopes on a daily basis correlates with the number of stocks closing below their envelopes by -.55 going back to late 2002, we can see that it is unusual for both to be elevated on the same day. Indeed, I could only find one other occasion during that period that matched Wednesday's elevation.

When many stocks are simultaneously strong and weak in their recent price movement, the market is in flux. This is the opposite of a low momentum, low flux market, where almost all stocks are closing within their envelopes, near their moving averages. Going back to 2005, I found 41 occasions in which we've had more than 300 stocks closing above *and* below their envelopes on the same day. Five days later, the S&P 500 Index was up by an average of .35% (27 up, 14 down). That is stronger than the average weekly gain of about .19% over that same period (288 up, 206 down). Indeed, the very next day in SPY tended to be up following a high flux day by almost a 2:1 margin.

As when I'm working in psychology, seeing such patterns does not lead me to act automatically in a session. These historical patterns are not mechanical signals to trade. Rather, they are a heads-up that tells me: Here's how the market has behaved under similar situations. Times of flux have tended to be bullish in the short run. That leads me to be particularly sensitive to situations in which selling might dry up and lead to a short-covering rally. At the very least, the numbers tell me to not get too caught up in Wednesday's selling: there's no historical edge to the downside during high flux periods.

With markets, as with people, understanding is sometimes as important as predicting. There is often a risk premium built into markets for those willing to step in during periods of flux and uncertainty. Understanding when markets are uncertain can provide many useful trading opportunities.