Unfilled Downside Gaps Coming From Overbought Conditions

The last time the market was moving off a similar overbought condition was January 7th and that day’s bar was very similar to similar to Thursday’s. It included an unfilled gap down from an overbought condition and a selloff of close to 3%. Below is a study that appeared in the January 8th Subscriber Letter that looked at similar situations. Note the study does not include the January 7th instance which led to further selling.

I also found when doing this study that the stronger selloffs led to stronger further declines on average.

When The Market Gaps Up & Continues Higher

Days that gap higher, don’t fill their gap and close above their open have a tendency to pull back over the next several days.

In order to get a decent sample size I decided to use the 1% gap level as my criteria in testing. Below I look at the daily performance numbers over the following week:

While the “% Wins” isn’t much worse than a coin toss on average, the poor W/L Ratio creates a negative expectancy. The bearish implications peak at 4 days across the sample. Not seen in the above table is that about 70% of all instances closed below their trigger price at some point in the following 3 days. This number increases to 89% when looking out 6 days.

2% Gaps Up Revisted

A few months ago I showed a table that looked at every instance of SPY gapping up 2% or more. What I saw was a strong tendency for such large gaps tp pull back and close below their gap level at some point in the next week. There have been 10 instances since and we may get another one this morning. Therefore I've updated the table below:

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The pullback doesn't seem quite like the slam dunk it once did, but it still appears probable. Combined with the fact that the market has already traded higher for 3 days in a row, I'd say the chances of seeing a pullback in the next few days is pretty high.

Strong SOX Action Could Be Good For Nasdaq

I’ve discussed in the past the fact that strong SOX action can often be a good harbinger for the the market. While both the S&P 500 and the Nasdaq failed to gain even 1% on Friday, the SOX rose more than 4%. It’s especially unusual for the SOX to post such strong gains without bringing the Nasdaq composite along with it. It has provided a nicely bullish expectation for the Nasdaq going forward.

Stops Part 1 - When Not To Use Them

One topic I’ve received a good number of questions about lately is Stops. Using a stop on a position is a very popular risk management technique used by traders. My research and experience has led me to believe they are appropriate for some – but not all – types of trades. Today I will discuss when I believe they aren’t appropriate.

In Larry Connors new book, “Short-term Trading Strategies That Work” he dedicates a chapter to stops. It’s entitled, “Stops Hurt”. The chapter discusses how Larry’s research team ran hundreds of tests to try and find optimal stop levels. In doing so they came to the conclusion that for the trades they were looking at, the optimal stop was consistently none at all. In every case they found that instituting stops hurt system performance.

You should keep in mind that Larry Connors trades mean reversion strategies. Much of what I do is mean reversion based also. For instance, the Catapult system which makes up the CBI looks to buy stocks that are undergoing capitulative selling. It enters long positions in stocks or ETFs that are extremely oversold. When I first designed the system in 2005 I went through a massive series of tests to find a way to successfully incorporate stops into the methodology. Like Larry I failed to find a stop technique that would enhance the performance of the system.

I’ve gone through numerous other exercises and found the same thing time and again. When looking to trade overbought/oversold techniques, stops generally don’t work well. If the system suggests the security should bounce when it drops to $20 and it continues to $18 then it is REALLY overdue for a bounce. Any level of stop ensures you are selling an extremely oversold security that is making a low. Those are buying conditions for oversold systems – not selling conditions.

One stop technique for oversold systems that I will sometimes use that in testing hurt performance less than the other techniques I evaluated is this:

Wait until the security bounces for a bar or two. Look for a higher high, higher low, and higher close – or at least 2 of those 3. Then place a stop under the swing low that was just made. In cases like this even if the security doesn’t hit your target exit price, it still ensures that you won’t have to suffer through the entire next leg down. While it seems logical and can sometimes help avoid catastrophic trades in the long run you’re normally better off just waiting for the mean reversion to occur and exiting at your target level.

Not using stops does not equal not controlling risk. Position sizing becomes very important. Traders could also consider using options to trade their short-term positions. Options provide a natural stop (zero). I wrote a series back in the Spring (when the VIX was a lot lower) on how I sometimes use options for my short-term trading. You can find links to that series below:

Options – part 1
Options – part 2

This is getting a bit lengthy so in a future post I’ll discuss situations when I believe stops are absolutely appropriate.

20% VIX Stretch Provides Upside Edge

One index that saw a big spike Tuesday was the VIX, which rose almost 23% on the day. It closed more than 20% above its’ 10-day moving average – the first time that has happened since November 20th. Stretches this extreme in the VIX have provided a bullish historical edge over the next few days in the S&P. Below is a study exemplifying this:



Peak stats here are at 4 days. Beyond the 1st week there is no significant edge. 89% of instances saw the market close higher than the trigger price within the next 4 days. The one recent failure was early October 2008. Prior to that you’d need to go all the way back to 1998 to find another failure.

Quantifiable Edges Gold Subscriber Letter 2008 Index Trade Idea Results

While 2008 was an incredibly difficult year for buy and hold, it was an especially good year for the Quantifiable Edges Subscriber Letter. The trade ideas listed in the Letter are generally short-term in nature. They come from either mechanical systems that are published by Quantifiable Edges, our proprietary Catapult system (which is used to measure the CBI), or as index trades through our detailed market analysis and studies. Only large-cap stocks (primarily S&P 100) and highly liquid ETF’s are used for the trade ideas. This helps to assure subscribers wishing to trade some of the ideas that liquidity won’t be a problem.

The trades ideas that are most popular among subscribers are the studies-based index trades. Frequently I will use the Aggregator tool to help time entries and exits.

After several inquiries I have decided to simply show a listing of all the index trades closed in 2008. A few notes:

I typically scale in to index trades. Most often ¼ at a time. Therefore in the listing below you will notice there were times where more than 1 entry was open at once. The max is 4.

These are just trade ideas. I never suggest allocation percentages. A ¼ index position could mean a 5% allocation to one person or a 75% allocation to another (who may eventually get 300% or more leveraged).

The index trade ideas are tracked using either SPY or QQQQ. Some subscribers may use options, futures, inverse or ultra ETF’s or some combination of the above to better suit their trading. I never suggest ultra etf’s in the Subscriber Letter. While I believe they are a worthy trading vehicle and utilize them myself on occasion, I prefer not to use them in the trade ideas section as it could appear I’m simply trying to inflate my results.

Trade ideas are all published in the Subscriber Letter each night. In many cases the exits are also established in the nightly Letter. In response to subscriber feedback, in May I began sending out intraday updates on open positions when appropriate. The intraday updates are sometimes used to set stops or targets or suggest an exit at the close of the day. Intraday updates are NEVER used to suggest new positions.

So while personal results would vary greatly depending on the traders approach to the ideas, below is the complete listing of closed index trade ideas from last February’s inception through the end of 2008 (Summary results shown further down. Commissions not included.):

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Past results are not necessarily indicative of future returns. But if you’d like to improve your market timing and think Quantifiable Edges could help then click here for a free 1-week trial. For complete subscription information to the Gold package click here.