Thursday, February 21, 2008

Will The Reversal That Reversed The Reversal Reverse?

Tuesday night’s study suggested upside was likely over the next 1-5 days following Tuesday’s gap up and reverse lower. In my Subscriber Letter Tuesday night I suggested a gap down Wednesday morning to $134.50 or lower should offer compelling risk/reward for the long side. As luck would have it, the market actually gapped down and reversed up. I was glad to hear some traders were able to take advantage of this. So now the market has gapped and reversed two days in a row – leaving some participants scratching their heads and suggesting this market is acting crazy. In reality, it’s played out according to historical norms.

So is there any historical edge after the market gaps and reverses 2 days in a row as it now has? Assuming Day 1 is a gap up and reversal lower and Day 2 is a gap down that reverses higher I ran some tests. I tried running the tests with a number of different parameters, including adjusting the size of the gap and the size of the reversal. Generally this two-day pattern has led to short-term weakness – in effect reversing the reversal that reversed the original reversal. (Huh?)

As an example let’s look at the NDX. If you require a gap of at least 0.25% each day and a reversal of at least 1% from the opening price, the NDX has closed lower between 57.5% - 61% of the time over the next 1-3 days. Losses generally outsized gains as well. The pattern has occurred 41 times since 1986. The next day the market lost 0.8% on average. It lost 0.9% on average over the next 2 days.

The downside edge here isn’t huge but it appears overly optimistic to think today’s rally is going to send the market off to the races. In fact, the market seems more likely to lose a little over the next day or so and find itself stuck in the same range it has been.


Anonymous said...


Do you think it is bearish that the vix is almost 8% below the 10 day ma and the market has gone nowhere. Even if we do break above the recent range the vix seems like it will be very over bought . Every time I have seen this happen in a downtrend it has usually not ended well

Anonymous said...

I must say it once again, I really really appreciate you blog.

Thanks Rob!

Johan from Sweden

Rob Hanna said...


The VIX is one of my favorite indicators. I have not found the action in recent weeks extraordinary in any way and have failed to identify significant market edges with it recently. As you suggest, I think the relatively low level compared to its short-term moving averages has the potential to act as a damper on an upside market breakout. We'll need a market breakout first, though, before we can really utilize the position of the VIX.