Tuesday, February 12, 2008

Can Contracting Range Hint At Direction?

After the negative inside day on Friday, the S&P refused to sell off hard and even posted a decent gain today – breaking its recent streak. Perhaps this may signal a change in character from the downtrend since the October highs. Traders may not be looking to leave the party every time there’s a pause in the conversation.

Speaking of pauses, have you noticed how the price range has been tightening? The range over the last 3 days has been the tightest of any three days since December. Even more interesting to me is that over the last 13 days, the high-low range the S&P 500 has traveled has barely exceeded the range it traveled in the one day prior to that. The SPY on January 23rd had a range of $7.35. Since then the total range has been $7.88.

Looking at the S&P 500 cash index I went back to see other times the market traded in a range nearly as tight relative to one bar over a 13-day span. The parameter I used was that the range of the last 13 days had to be within 115% of the range of the 14th day back. I found 31 other occurrences going back 30 years. Twenty-five of those occurrences saw the market higher a month later. Only three times that I found was the range contraction followed by a break to the downside which led to significantly more selling. Those occurrences were August 1985, September 1990 and August 1998.

This study seems to be another example of what I’ve been seeing lately. Over the next several weeks risk/reward appears to favor the upside. Even this contracted range has some serious volatility, though, so risk should not be underestimated. Good timing and proper (reduced) position sizing appear key.

On another note, I was pleased to have my recent post on leadership breadth appear in this week’s Festival of Stocks along with many interesting columns from other bloggers.

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