Let’s look at the how the market set up as of Tuesday’s close as an example. SPY closed higher 3 days in a row. Tuesday was the narrowest range in the last 5 days. When trading under the 200-day moving average, this combination can signal the market is likely to pull back. See the test below:
The propensity to pull back is most pronounced over the first 4 days.
Now let’s break down the above results a little differently. First let’s look at times the SPY set up as above but was NOT coming off a 50-day low:
Results here are decidedly more negative than in the original study. Two days out for example there are only 18% winners.
Now let’s look at the first setup again, but this time we only want to see those trades that were coming of a 50-day low:
There is no longer a bearish edge to the setup. In fact, there appears to be a bit of a bullish one. Now 2 days out there are 82% winners. (Although instances are low and that’s not really the point.) The point is that it is much more dangerous to short a market coming off of fresh lows. This is especially true when the lows occurred on extremely oversold conditions.
While previous attempted rallies did quickly roll over the last 2 months, that’s not always the case. Examples of oversold bounces off lows that would have been especially dangerous to short include August 2007, October 2002 and September 2001.