Saturday, January 16, 2010

Tracking the Stock Market's Short-Term Momentum

I've refined a proprietary measure of short-term momentum that I am incorporating into a short-term trading system. Readings from the indicator appear above (pink line), plotted against the S&P 500 Index (SPY; dark blue line). We can think of readings above the light blue zero line as "overbought"; readings below as "oversold".

A unique aspect of the indicator is that momentum is measured relative to recent volatility, so that similar readings are generated across a variety of market conditions.

Going back to 2005, when readings have been above 150 (red line), the next five trading days have averaged a loss of -.48% (114 up, 144 down). When readings have been below -150 (green line), the next five trading days have averaged a gain of .97% (69 up, 38 down).

When I combine this indicator with a second criterion that measures where the current price falls within the distribution of recent prices, a promising countertrend (reversion) system emerges. I hope to post more on the system shortly.

With Friday's decline, we have dropped below the zero line, but remain above levels that have corresponded to reliable buying signals. The most recent signal came on Thursday and was a sell.