Saturday, March 28, 2015

1 Month Low Signal In Stocks - Probably Just a Short Term Pause Before More Downside

Thursday's price action registered a "1 month low" signal in my bottom spotting algorithm.  These signals can be traded on the signal alone, but as an estimation, about 50% of failed signals will be removed if you wait for a close above the high of the signal day.  The downside of that method is that your reward to risk ratio will be smaller.

In any case, I track this signal primarily to be alerted to as many potential inflection points in the market as I can.  But I don't consider it to be a consistently outstanding signal for going long a market.  I like to have other factors also clearly pointing to an upside skew to trade on this signal.  I have other signals that I prefer to trade on for going long the US stock indexes.

Click on Chart to Enlarge - Bull Market Signals

This chart shows all the "1 month low" signals generated going back to the 2009 bear market low.  The averages at the bottom show the future 2 month max gains and losses in both the SPY etf as well as a proprietary at the money call and put option max gain calculation if buying exactly 2 months until expiration at each signal.  The results show a modest upside skew during the bull market.  So if the bull market remains intact, we may expect SPY to rise to roughly 213.00 during the next 2 months.  And an AVERAGE May expiration call option may be expected to gain 100% or so within the next 2 months.  In order to expect to capture nearly that on average on these signals, quality option exit points will need to be objectively flagged.  I also have an algorithm which nicely identifies such key points as a market rises.

Click on Chart to Enlarge - 2007-2009 Bear Market Signals

This chart shows all the "1 month low" signals which occurred during the last bear market.  The averages shows a distinctly negative skew here.  So the signal often flagged a very short term pause in the market decline, but not the type of signal you want to trade on in a downtrend.  It could be used to help you identify short term covering points on short positions or put options, but I would not use it as a buy signal in a downtrend.  So the point here is that if the bull market has topped, we realistically don't have any quality upside expectation, and price is not too far off the highs.  

Click on Chart to Enlarge - 2000-2002 Bear Market Signals

This chart shows the "1 month low" signals generated during the 2000-2002 bear market.  Again the averages show a negative skew to future price movement.  So nothing to add here.

If you are short stocks currently, I would view this signal as a partial exit position to help create an objective scale out process.  My suggestion would be to exit 1/3 to 1/2 of the short position, and hold the rest of the position short and await another signal to be generated at a lower low.  

OF NOTE here.....while a signal was generated on Thursday, a qualitative examination of the price reversal on Thursday reveals a very weak reversal bar.  The close was near the midpoint rather than the top of the range.  And the high-low range of the bar was modest, indicating the day was not likely a major flush out of positions on either side.  I feel that this signal is more likely a temporary blip in a market with at least a little more downside likely to unfold.  That is my opinion anyway from observing many signals and understanding how they are derived.

Click on Chart to Enlarge

To further quantify the signal, the right edge of the chart shows the current level of fear/panic in the market as evidenced by several real money measures of market sentiment.  The point here is that this week's decline did not cause much of a spike in the fear, and there is no statistical extreme even given the recent range trade in the market.  A signal without a corresponding extreme is much less significant in my opinion.

Hopefully this information is helpful in determining how to manage your trading positions.  In short my take given the data here and the price logic confirmation to the downside, I think prices will fall at least modestly lower before a better buying signal or short covering signal occurs.


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