Here's A Way To Better Time The Market
Friday December 19, 5:56 pm ET
By Larry Connors
TradingMarkets.com
Email, Deluge!
I received hundreds upon hundreds of emails over the past few weeks about my column "Do You Buy Breakouts? Think Again, Parts 1 and 2." If you have not heard back from me yet, you will. Obviously, the research struck a chord with many of you and I want to make sure all of your questions are ,answered. If you missed either of the columns, you can find them here:
Part 1: biz.yahoo.com
Part 2: biz.yahoo.com
Successful Traders/Active Investors Don't Guess!
Ove,r the years, we have quantified a number of ways that have shown the likelihood of prices rising or declining over the next 1-5 days. The past two weeks' columns were a small example of how you can help get a better edge on the market over the majority of people who like to use their "gut" and "guess" where prices are going.
Hell, anyone can guess and lose money. Look at all the smart people (especially the professionals) who bought at th,e open on Monday (and nailed the day's high!) because of the capture of Saddam Hussein. They "logically" assumed (they guessed) that his capture would lead to profits. And they were partially right! It did lead to profits. It led to profits for the specialists and market makers who marked prices up on the opening and gladly sold stock to these people at levels that were unsustainable for the day. These people used their gut and they guessed wrong. It happens all the time. Day after day, month after month, year after y,ear.
So, let's continue with the knowledge we gained over the past few weeks and now let's look at another way of buying pullbacks. Last week, we saw that buying pullbacks has been a superior strategy to buying breakouts over the past decade. This week, let's look at how buying pullbacks is superior to "guessing" which direction the market is going for the upcoming day.
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The Test
Let's assume the trend for the market is up, as defined by price of the S&P 500 closing above its 200-day moving average. What percentage of the time since 1989 did the market rise the next day when this occurred?
A) 52%
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B) 52%
C) 52%
D) 52%
Very good! Yes, in spite of the fact that prices have risen significantly since 1989 (with a much higher bias), there was ,little edge in "guessing" either up or down for the upcoming day.
Now, let's get smart and be a bit selective here. Let's say we waited for the market to drop, three days in a row. What percentage of the time did prices rise the next day?
A) 0%
B) ,52%
C) The combined IQ of Major League Baseball's Players Union
D) 62.3%
Well, this is partially a trick question because answers A and C are the same. The correct answer is D) 62.3% of the time (and, if you held the position five days, it jumped up to, over 66% of the time). That's right, if one were to have simply waited until the market went down three days in a row while in an uptrend, and bought the market -- you can use the (AMEX:SPY - News)s -- on the close of the third down day, one would have made money 62% of the time the next day, and nearly two-thirds of the time a week later. This is versus using simply "guessing" as the entry, which has been shown to have little to no edge at all, in spite of the fact that the Dow has moved up from well under 3000 t,o over 10,000 during this period of time.
Here's a recent example of what this looks like:
Trade With Edges!
What does this tell us?
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1. It confirms even further that buying on pullbacks is a strong place to start when making your investment decisions.
2. That on a day-to-day basis, unless the market has pulled back, these guys on TV and in print are usually just guessing what the market will do for the day. And worse, many of them were buying at the highs Monday morning with your retirement and investment money!
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3. Not only has there been an edge in buying three-day pullbacks for the upcoming day, but the edge was even greater when looking at prices a week later.
4.. At least over the past 15 years, waiting for the market to drop three days in a row while prices are above the 200-day ma, has been an opportune time to be entering the market. As I stated last week, there are no guarantees this will, continue in the future and this should not be traded as a system. Stops must strongly be considered in order to protect yourself from potential drawdowns. But, at least looking back, it's been shown to have a significant edge as opposed to just randomly entering market any given day.
Conclusion
Guessing does not work...there is no edge. Blindly buying bre,akouts does not work either (even though we have never been able to quantify it, I do feel that applying the proper filters and screening techniques as taught and used by some of the better momentum managers does have an edge). Waiting for uptrending markets to touch 10-day lows (as shown over the past few weeks) or waiting for the market to sell-off three days in a row, has shown a strong historical edge. It still fits into the simplest investment theme in the world that has stood the test of time...buy low (no ma,tter what the time frame!) and sell high. FYI, you can find an abundance of information on pullbacks at the University section of www.tradingmarkets.com.
Have a great week trading, feel free to email me any questions you may have (and Happy Holidays)!
Larry Connors
l,connors@tradingmarkets.com
PS-Dave Landry just published a new book on Swing Trading and Pullback Trading ("Dave Landry's 10 Best Swing Trading Strategies") which discusses many of the themes we've looked at over the past three weeks. If you'd like more details on it, you can find it at www.TradersGalleria.com
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