Thursday, February 12, 2009

Upside Reversal Days in the Stock Market: What Comes Next?

On the heels of the recent post regarding historical trading patterns, several readers emailed me with questions. One obvious question was how one knows which patterns to test out.

The general rule is that you want to investigate whatever makes the current market distinctive. If the market has been unusually weak, you want to see what has happened in the past following such weakness. If the volume is particularly low, it makes sense to see what has happened following those slow markets. The best edges follow markets that are extreme in some fashion. Average markets yield average outcomes; it's the unusual markets that tend to be associated with unusual edges.

I joked in this afternoon's Twitter comment that there would be some talk of plunge protection teams in the wake of a ferocious late session rally. It was fortuitous indeed that we got an announcement of a (not fully detailed) housing program just as the S&P was challenging important support. Conspiratorial thinking aside, it was a ferocious rally indeed taking the market from its lows to well above its opening price.

That's an unusual upside reversal, so it makes sense to ask the question, "What has tended to happen going forward when the market has reversed from a sizable loss to a sizable gain?" I went back to the start of 2000 in the S&P 500 Index (SPY) and examined past occasions in which the index (like today) moved more than 1% below its open before closing more than 1% above its open.

Out of 2287 trading days, only 38 have shown such strong upside reversals. Four days later, SPY was down by an average of -.61% (17 up, 21 down). Across all other occasions, SPY averaged a loss of -.05% (1159 up, 1090 down). While a trader might be tempted to conclude that strong upside reversals represent trend changes and lead to further strength over the next week, that hasn't proven to be the case since 2000.

Many times, historical observations act as a check on our assumptions. That is valuable psychologically, as well as in formulating trading strategy.