Sunday, February 11, 2007

What Happens After a Day of Strong Downside Momentum?

Recently, the Trading Psychology Weblog mentioned that there is a high probability of taking out the low of a day that closes with strong downside momentum. On Friday, with the market breakout, we had just such a day. What tends to happen following a day in which a plurality of issues closes very weak?

To address this question, I went back to 2004 (N = 771 trading days) and identified all occasions (N = 42) in which: a) my measure of Demand (an index of the number of stocks closing abvove the volatility bands surrounding their short- and intermediate-term moving averages) was less than 400; b) Supply (stocks closing below their volatility bands) was greater than 1200; and c) Supply was the highest figure recorded over the past ten trading sessions.

The following trading session, the S&P 500 Index (SPY) traded below the low of the strong downside momentum day on 31 of the 42 occasions, or about 75% of the time. On about half of those occasions, SPY traded by more than .30% below its previous day's low, or about 4 full ES points. Conversely, on the remainder of the occasions in the sample, the market took out its previous day's low on only 320 out of 729 days: less than half the time. This suggests that there is near-term weakness after a day of strong downside momentum.

Interestingly, however, if we look out further, that pattern changes. By the *close* of the next trading session following the downside momentum day, the market has been up on exactly half the occasions. When we look four days out, SPY has been up by an average of .21% (25 up, 17 down), actually a bit stronger than the remainder of the sample (.12%; 403 up, 326 down). As a whole, then, we tend to see near-term weakness reverse following a strong downside momentum day.

Finally, when trading the next day *doesn't* take out the low of the downside momentum day (N = 11), the next four days in SPY average a very healthy gain of .89% (9 up, 2 down). In other words, failure to continue the downside thrust in the short run turns out to be an indication of further strength to come later in the week. I will be watching for these patterns on Monday.