The large drop in the market on Thursday was interesting, but the question is always what does it mean, and what is likely to happen next. In order to get some insight into this question I ran a test that looked back over the last three years to see how many times the market was down at least 80 points, and what would happen if I had bought at the opening the next day. The table to the left shows that during the last three years the market was down at least 80 points 16 times. If you bought the market the next day, and sold the following day, you would have been profitable eight times and shown eight losses. Essentially being down more than 80 points has not been predictive of whether or not the market will be up or down in the short run. When the market shows strong down days, like we saw on Thursday, the news media is full of stories about major corrections and the like. The news media’s job is to sell commercials, advertising space, and not necessarily to provide actionable information for traders. The market’s behavior over the last three years indicates that in the short-term it is just as likely to bounce after an 80 point drop as it is to continue going down. Based on this data we need to look elsewhere to determine an effective trading plan.
Extensions below the lower Bollinger band are unusual, as you can quickly verify by just scanning a NASDAQ chart for the last couple of years. The Bollinger bands contain the vast majority of the price action, and movements outside the band rarely last more than two or three days. The market typically moves back inside the lower Bollinger band by either moving sideways for a few days, or bouncing. I ran another test that bought the market every time the NASDAQ closed at least 10 points below the lower Bollinger band. I ran this test over the last 36 months using a one-day holding period to determine whether or not closing below the lower band was predictive of short-term behavior. The results, as shown in the chart to above indicate that during the last three years the market closed at lease 10 points below the lower band 21 times, and buying the open the next day and holding for one day was profitable 12 times and showed losses nine times. 57% of the time the market bounced. This data, along with other extensive testing, is why I take profits on short positions when the market becomes extended below the lower Bollinger band. It’s not a guarantee, but if the market bounces in the short-term 57% of the time then in the long run I am better off to have taken profits on shorts when the market moves below the lower band.
Trading is a statistical business, there are no magic indicators that tell you what is going to happen in a given situation every time. Trading is about knowing how the market, and different stock patterns, usually behave in a given situation; and then being positioned to profit if the market, or the stock set up, do the normal thing. Since by definition they do the normal thing most of the time, over the long run I have a good chance to see profits. On any given trade I do not know what is going to happen, it may be a winner or a loser, but over the long run being positioned to profit when the market or stock position does the normal thing is the way to bet.
Sometimes traders will start trading more aggressively when they are down in an attempt to get back to even. Draw downs are a fact of life in trading. Trading is not like drawing a paycheck. You do not get paid because it is Friday. I research the systems and then use that information when trading. If I have a losing streak I know that is to be expected and just stay focused on using the knowledge and skills that come from fully testing and analyzing trading systems.
Steve Palmquist a full time trader who invests his own money in the market every day. He has shared trading techniques and systems at seminars across the country; presented at the Traders Expo, and published articles in Stocks & Commodities, Traders-Journal, The Opening Bell, and Working Money.
Steve is the author of, “Money-Making Candlestick Patterns, Backtested for Proven Results’, in which he shares backtesting research on popular candlestick patterns and shows what actually works, and what does not. Steve is the publisher of the, ‘Timely Trades Letter’ in which he shares his market analysis and specific trading setups for stocks and ETFs.
To receive a sample of the ‘Timely Trades Letter’ send an email to sample@daisydogger.com. Steve’s website:www.daisydogger.com provides additional trading information and market adaptive trading techniques.