Sunday, August 12, 2007

Do You Trade Strength or Fade It?

In my recent post, I illustrated that waiting for confirmed strength and weakness and then going with those trends in the S&P 500 Index was a great way to lose money. If you examine the relevant links at the end of that post, you'll see that this logic holds true over multiple time frames.

Still, a writer makes an excellent point. Dr. Humphrey Lloyd, whose work I happened to feature in my latest Trader Performance post, emailed to make the point that he has been very successful catching early strength in markets and going with it.

That makes sense to me, particularly coming off an oversold condition. In essence, you're counting on a reversal of weakness, but using incipient strength as your entry. The reverse logic also makes sense with respect to fading overbought markets.

What Dr. Lloyd does in his book is track an indicator that places the current market relative to two moving averages. You can then identify which stage or zone a market is in by seeing whether it is above both averages, below both, or trading between the two. Buying early strength or selling early weakness would have you trading something akin to a moving average crossover, filtered with overbought/oversold indications.

My own work addresses this issue differently. I separate the measurement of strength (as assessed by the number of stocks making fresh new highs or lows over a lookback period) and momentum (as assessed by the number of stocks trading above or below their volatility envelopes surrounding moving averages) from price change. When we have rising or falling markets with strength/momentum that is increasing/falling, I look for short-term continuation. When we have rising or falling markets with strength/momentum not confirming price weakness, I look for reversal.

Still, I think the basic point raised by Dr. Lloyd is valuable: one might go with a strengthening market, even as one fades markets that have already been strong.

The problem, however, is that traders tend to look at past price change alone and become more confident in markets as prices rise. We can see this in the positive correlation between put/call ratios and past price change and in the positive correlations between sentiment surveys and past price changes.

In my next post, I'll look at market strength and weakness in the current market and report on a study that addresses the trade vs. fade issue.


The Most Common Trading Problem