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.