Wednesday, March 01, 2006

Up Open After Down Day: Sequence Analysis in Action

This is an important blog entry; you may want to review the posting from 2/26 (Sequence Analysis) before reading what I have here. The following is an example of sequence analysis at work.

Let's set the stage. After an up day on Monday which made a five-day high, we sold off on Tuesday and made a five-day low. Several of my analyses suggested a high likelihood of a down day today.

In sequence analysis, you always update forecasts with the most recently available data. This morning, the market opened up by more than a quarter of a percent. The updated forecast thus asked the question: What has happened historically when a down day has been followed by an up open? Specifically, I looked at occasions in which the market was down more than .75% on the day (N = 118) since March, 2003 (N = 755) and then divided the sample in half based on the following day's open.

When the next day's open is strong (as was the case today; N = 59), the average move from the open to the close has been .19% (38 up, 21 down). When the next day's open is weak (N = 59), the average move from the open to the close has been -.01% (33 up, 26 down).

Looking a bit further out, when the market opens strong after the down day, the move to the *following day's* close has been .41% (36 up, 23 down). When the market opens weak after the down day, the move to the *following day's* close has been -.06% (29 up, 30 down).

In short, a strong open following a weak day affects the market's short-term trajectory. This is an example of how updating forecasts with real time data can greatly aid trading. Traders need not wait for real time events to occur, however, to conduct these analyses. They can prepare for real time possibilities by conducting "what-if" scenarios with the historical data. Such sequence analysis would look at all historical occasions of market declines such as Tuesday's and then investigate what happened when the following day opened strong.

This captures the difference between mechanical system traders and historical pattern traders. Mechanical traders trade a model. Historical pattern traders conduct ongoing modeling as a dynamic process. Very, very few traders understand this and appreciate its potential.

No comments: