Wednesday, December 24, 2014

A Powerful Way to Deal With Trading Discomfort

Successful traders get more rational when they get more uncomfortable.  That feeling of discomfort is not a call to act; it's a call to plan a course of action.

In the past five trading sessions, we've moved from a situation in which fewer than 20% of SPX have been trading above their 20-day moving averages to one in which over 80% have exceeded that benchmark.  That is quite a shift in breadth in a short period of time.  I found myself feeling uncomfortable with my long position; it seemed as though anything that's moved that far, that fast is due for a pullback.

So I decided to become more rational.  I went back to 2006, when I first began collecting breadth data, and looked all occasions in which the above criteria were met in a sub-20 VIX market and what happened in SPX going forward.  There was only one problem:  it had never occurred over that time span.  This was a greater five-day breadth thrust than we had ever seen in a sub-20 VIX market.

I then decided to take a second tack.  I looked at five-day breadth thrusts exceeding the level of 50 under sub-20 VIX conditions.  That is, the percentage of stocks trading above their 20-day moving averages had to move over 50% in a five day period.  Still, I only found 9 non-overlapping occasions.  Over the next three trading sessions, 8 occasions were up, 1 down for an average gain of .65%.  It's too small a sample to make for a statistically significant analysis, but it certainly did not support the source of my discomfort.  It did encourage me to look further into breadth thrusts and the price paths of the market when breadth moves higher, sharply.  

My observations?  Not all strong markets are "overbought".  How we reach strong breadth readings is as important as the absolute level of those readings themselves.

Further Reading:  Perspectives on Breadth