Sunday, January 22, 2006

One More Perspective on Steep Declines

Note: I recently submitted an article to Trading Markets regarding the recent downward volatile trade. That should appear Monday AM. Also see the last couple of entries on this site for a perspective on the week to come. Finally, Sunday evening's Trader Performance blog on my personal site will offer some psychological insight as to how to utilize the historical analyses offered herein.

For my last analysis of Friday's sizable decline, I took a different approach. Going back to January, 2000 (N = 1518), I calculated the 200 day standard deviation of price changes and investigated what happens after the market moves more than 2 standard deviations lower in a single day. The beauty of this analysis is that it adjusts the investigation for changes in volatility over time, so that what is steep in a non-volatile market and in a volatile one is different.

I found 34 such occasions and looked at what happens in SPY afterward. Two days after the steep drop, the market was up 23 times, down 11 for an average gain of .77%. This is much stronger than the average two-day gain of .00% for the sample overall (759 up, 759 down). Steep drops tend to be followed by rebounds in the near term. Buying weakness the day after the steep drop and holding for strength the following day was a profitable strategy overall.

That having been said, the strategy was much less successful for much of 2001 and 2002 than for the rest of the sample. As we saw before, weakness in a bull market provides opportunity; in a bear market it often leads to a cascade of selling and a clustering of weak days. This clustering, such as we saw in July, 2002, is the reason why such weak market occasions must be followed by careful reading of subsequent real-time action. Although the odds are bullish following weak market days overall, when weakness does follow weakness, the downside can be substantial--especially given the enhanced volatility that such big down days engender.

Since the bull market started in 2003, we have had 7 instances of weak market days that have fallen more than two standard deviations. The market has been up 5 times, down twice, for an average two-day gain of .85%. Once again, the response of the market to the latest weakness will provide a piece of information regarding whether we continue in the bull mode.

2 comments:

veterantrader said...

I have recently stumbled across some of your writings in which it is comforting to see someone have the same approach to trading the markets as I do. The article

Will The Market Be Volatile Today?
Friday January 20, 9:36 am ET
By TradingMarkets Research

is what I have been thinking of lately. For the past few years I have been a fader of the markets and it is worked extremely well. The markets have not been volatile, the fed has been tightening, and breakout traders have suffered. Coming into January 2006, it was announced that the Fed may be non-tightening soon, sending our markets for a 2 weeks bull run.

Still stuck in the fading mentality, I was wondering why many strategies that should be working aren't and realized the market is now more for breakout traders, becuase as you clarified the volatility has increased and thus the trading range. It took me a good week to notice market patterns have now changed and haven't for the past 2 years, and therefore I remembered how I should be trading.

Everyday I begin my day trying to gauge what mode the market is in today.

As an example: I find Fridays moves to be different than that of the rest of the week. There may be more exaggerated profit taking on a Friday, simply because fewer want to commit into a weekend. Stocks also move more exaggerated in the end of a quarter or the end of the year. These are things with my experience of 10 years as a trader of the markets have learned can alter the direction and moves of the markets, and are worth paying attention to.

I find your approach of looking at the markets for an edge are very similar to my thinking. I will certainly be paying attention to your writings and research, and will drop you comments time to time.

If you are looking for an opinion to your research, I welcome any inquiries to discuss.

My email is schang@cemcapital.com

Sincerely,
Stephen Chang

Brett Steenbarger, Ph.D. said...

Stephen, I could write volumes about the situation you're describing. It is the single most common trading challenge facing experienced, talented traders. The reason for this is that one's instincts become calibrated to a particular kind of market and then are completely off when the market changes trend and/or volatility. This is why so many successful late 1990s daytraders are no longer with us. I added the Trader Performance section to my personal site for precisely that reason (www.brettsteenbarger.com). It is also a major topic in the new book that I'm writing. The bottom line is that good traders learn markets; great traders relearn them. You have exactly the right mindset for the relearning. Thanks for your note.

Brett