Monday, January 21, 2008

Time & CBI Indicate A Bounce Could Be Near

In Friday’s blog I mentioned it looked like the market was beginning to capitulate, but I didn’t feel it was quite there yet. The study I showed indicated that strong, high-volume, extremely weak breadth declines like we’re seeing are difficult to time. Frequently there was more downside when looking at those conditions. Friday in fact brought about some more downside. While price and volume are still not telling me to dip my toe in, breadth and time are.

My favorite breadth indicator when the market is experiencing strong sellofs is my Capitualtive Breadth Indicator (CBI). On Friday morning I noted the CBI had only hit 3 so far and I would feel better about being aggressive if it was 7 or higher. It poked up to “5” at the close. This is normally the first level where I begin to consider it somewhat significant. Based on the position of stocks in the qualifying list it could easily spike up to 7 or higher on Tuesday and possibly even reach the “10” level by Wednesday. The CBI is not a perfect timing device, as it can be early, but the higher it gets, the stronger the subsequent bounce is likely to be. In an upcoming post I’ll show some worst-case scenarios using the CBI.

Time is beginning to favor the “bounce” argument as well. The move down has been extremely persistent and the major indices have all failed to put in a decent bounce. The closest thing we got was the minor rebound following the large reversal day. While that ultimately failed, it did put in an effort just barely good enough to allow traders to exit with a small win or small loss. Still, the major averages all failed to even poke above their 10day moving average on that bounce.

I took a look at a fairly simple mean-reversion strategy based on the current setup and the results were quite positive. I ran the test back 30 years. Below is the setup:

Condition1 – S&P 500 has failed to post a HIGH above its 10-day simple moving average for at least 12 straight days.

Condition2 – S&P 500 posts its lowest close in at least 12 days.

Buy the S&P 500 on the close. Exit the trade when it closes above its 10-day moving average.

There have been 12 such setups over the last 30 years. Every one of them has been a winner. The average gain was 1.9%. The worst drawdown was about 4% on a closing basis. The average trade lasted a week. The trades are listed below:

I also ran the same trades with a time exit. Rather than selling on a cross of the 10ma, I simply sold “X” days later. This will help to illustrate the typical type of action:

As you can see, most of the bounces lost steam after about a week. In fact, once you get 3-4 weeks out, losers outnumbered winners and losses were larger than gains. So while this kind of “time stretch” trade has been good for a bounce – that’s normally about it. Outstaying you’re welcome could be hazardous.

Mean reversion trades can be especially difficult in markets like this where price is in a freefall and there is no support nearby and no reasonable place to set a stop. Limiting exposure to control risk is therefore extremely important. And since exact timing is difficult and the market may still have a good amount left to fall, it is imperative that traders have additional capital they can put to work should the setup improve.

To sum up, the time stretch is indicating a bounce is likely coming soon and the rising CBI is indicating the bounce could be sharp. These two factors are providing a quantifiable edge. Aggressive traders could consider adding a small amount of long exposure in anticipation of this bounce.
P.S. Traders interested in seeing another similar example of a "time stretch" may see the October 11th post from my old blog.


bzbtrader said...

Great blog with good context and empircial analysis. Since you mention mean reversion you might check out my Saturday posts at regarding the possibilities for the Qs and the Vix. I'm reluctant to see a near term bottom yet as many of recent technical expectations of Carl Futia, Market Tells and others have proven elusive. I hope I'm wrong, but have chosen to be prepared for the worse.

John Cook said...

What platform do you use to test your trading models?


John Cook

Anonymous said...


He answered me before, TradeStation.

Johan Lindén said...

This model is now on again!

Johan Lindén said...
This comment has been removed by the author.
Johan Lindén said...

Wow! Despite a 5% draw down the signal "worked". It ended pretty much break even yesterday.