Low SPY Volume & Low VIX on Options Expiration

I was on vacation last week with limited access to the internet. While subscribers still got the nightly Subscriber Letter, I was unable to produce blogs. I’m back now and will have some edges to share this week. This is one study I found interesting from Sunday night’s Subscriber Letter.

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Pretty much everything I’m looking at short-term is suggesting a pullback. Longer-term that is not the case.

What Happens After A Sharp Contraction In Volatility

I did a study looking at situations where historical volatility has contracted rapidly like it has in the last 3 days. For the study I looked at the 3-day historical volatility and compared it to the 10-day historical volatility 3 days ago. In other words I divided Friday’s 3-day historical volatility by Tuesday’s 10-day historical volatility. A result below 1 would indicate the last 3 days have been less volatile than the previous 10. A number above 1 would indicate a recent uptick in volatility. For the SPX, Friday’s 3-day over Tuesday’s 10-day came in at a very low 0.23.

I then looked to see what the 3-day historical volatility has typically been 3 days later. What does a sharp contraction over the last 3 days indicate you might expect over the next 3 days? What I found is that when the 3-day over the offset 10-day dropped to 0.25 or lower the next 3 days were 5.5 times as volatile as the recent 3 days. This is based on 1,111 trading days since 1960 – or about 9% of all trading days. Going back to just 1999 gave similar results, as the 3-day historical volatility increased by 5.4 times.

This suggests we may see some increased movement over the next few days. A breakout of the recent 3-day range could be very sharp.

Another Example of a Weak Bounce

My studies indicated a bounce was likely yesterday. It arrived, but unfortunately it was another example of a weak bounce. Below is a study that looks at SPY bounces from lows that lack volume.

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The only instance that did NOT post a lower close within 3 days was just 2 weeks ago – on 6/23/09.

A Couple Of Links Courtesy of the Quantifinder

I'll try and get a new post up later. In the meantime, below are 2 studies the Quantfinder picked out yesterday from former blog posts:

1) 4 Lower Lows

2) Mild Selloff After Sharp Drop

Monday's Disspoitning Bounce & What That May Suggest

Some technical problems this morning delayed my routine and didn’t allow me to post a fresh study before the market opened. I thought I would discuss a point I made in last night’s Subscriber Letter about the strongly bullish short-term study from Sunday night.

The indication was that following a day like Thursday, the SPY had closed up strongly over every 1 and 3 day period. Monday closed marginally higher in the S&P 500, although the SPY closed down 1 cent. Compared to the other 7 instances that were identified in the study, Monday’s action was the weakest. This can serve as a warning sign. When the market doesn’t rally as it is supposed to it may be suggesting a move in the other direction.

It may help some traders to think of such scenarios as they might failed patterns. Take a breakout for instance. When breakout from a triangle or other consolidation pattern fails, it can often lead to a sharp reversal in the opposite direction. The same concept applies to historical studies. When the market doesn’t do what it is supposed to, you need to reassess. Like any other type of analysis, historical analysis requires constant reassessment. The market isn’t static and your analysis shouldn’t be either.

A Rare Setup That Has Triggered Powerful Bounces

Thursday’s action was extreme in that the gap down was large and the SPY opened at its high and closed at its low. Often reactions this strong and persistent are overreactions. Overwhelming negativity such as this has led to quick, sharp, bounces in the past. Below is a study that exemplifies this:

An average rise of over 2.3% the next day and nearly 4% over the next 3 days is substantial. It can be dangerous to draw concrete conclusions from results that only consist of 7 instances. On the other hand, when results are this overwhelmingly lopsided, it can also be dangerous to ignore them.

1st Day Of Month Tendencies

The Stock Traders Almanac noted that the Dow Has been up 16 of the last 19 years on the 1st trading day in July. It's been a while since I last looked at 1st day of the month tendencies.

From 1960 until the late 80's there was no decided edge on the 1st trading day of the month. In the late 80's this changed and the 1st day of the month became an outperformer. The most often cited theory as to why is that defined contribution retirement plans like 401k's became more popular. This meant there was a lot of money going into funds right at the beginning of the month, and funds managers were putting it to work.

Below is a performance report showing all the 1st trading days of the month from 1/1/1987 through June, 2009.

The average performance on the 1st day of the month is over 0.2%, which is substantially stronger than the remaining days.

The 1st day of month strength has not been immune to bear markets, though. Below is an equity curve. As you can see, there were sizable dips in the strategy in 2002 and 2008/09.

Lastly I broke out the performance by month. You'll note July has been the most reliable month over the last 22 years. It also ranks 3rd based on average profits. August has had the worst performance.