Monday, March 8, 2010

Another Example Of Why I Prefer The 1% FTD Rule

On February 11th the market put in a Follow Through Day according to the original IBD definition requiring at least a 1% rise in one of the major indices on rising volume. I mentioned the Follow Through Day and dedicated a few posts to it in mid-February. The S&P is now less than 1% from new highs and very close to hitting a level that that would qualify the current rally as “successful” based on the rules I set up in the original Follow Through Day test a couple of years ago. This would mean the lesser of 1) a new high or 2) a rally twice as large as the distance from the close of the Follow Through Day to the bottom of the downmove. Meanwhile the Russell 2000 is already hitting new highs.

In the last few years IBD has changed their rules and stated that a 1.7% rally on higher volume should be required instead of a 1% rally. Ironically the first major index to actually put in a 1.7% rally on higher volume since the February bottom is the Russell 2000, which did it on Friday - as it was hitting new highs. Not a great bottom call when you’re already at new highs. Over the last few years I’ve suggested ignoring the new rule. In a study I did a little over 2 years ago I showed how waiting for a 1.7% FTD would have missed several rallies. The current instance now serves as yet another example. Not that I a see a huge value in the 1% FTD rule, but it has been at least marginally effective and can be used to set up a positive risk/reward scenario. Additionally, requiring a 1.7% FTD not only puts you at risk of missing the rally but it also hasn’t proven to be any more predictive than the original 1% requirement.


The Stock Speculator said...

in fairness aren't you applying the FTD rule to buying an index and not a leading stock? Also, you are exiting on 'x' days and not taking the long pull to see how far a leader can run? It's good work, but it seems to me that its applied out of context

Rob Hanna said...

Stock speculator,

1) Yes. The FTD studies don't look at leading stocks, but rather at the S&P 500. So it is not a critique of the method of buying momentum stocks that IBD employs. It is a critique of using the FTD as a tool to time market bottoms.

2) No. You'll need to go back to the 1st or 2nd post on FTDs to see the "success" and "failure" criteria exactly, but I don't use an X day count. I did need to make up my own definitions for success and failure, because while IBD claims certain "success" rates on FTDs, they never define success.