After Friday’s gain, SPDR S&P 500 (NYSE: SPY) has closed above its 5-day moving average (MA) for 26 consecutive days. The chart below, from the PowerRatings web site, shows SPY with its 5-day MA. For most of the past five weeks, SPY has been overbought with a PowerRatings of 3.
PowerRatings are based on the relationship between price and the 5-day MA of price. The further prices move away from the 5-day MA, the stronger the tendency to snap back becomes. PowerRatings uses the 5-day MA and several other components to identify high probability trade entry points. This strategy was thoroughly back tested and the history of over 4 million trades was analyzed.
We know from back testing that PowerRatings can be used as the basis of a trading strategy. Detailed back testing has confirmed that the higher the rating, the greater the one week historical gain has been for stocks and ETFs with that rating. For best results, enter trades on stocks with a PowerRatings of 8 or higher with a limit order 3-7% below the previous day’s closing price. Higher % limit entries have historically shown a greater percentage of winning trades but higher % limit orders also reduce the chance of trade execution.
As an example of a trading strategy that can be used, in the past, buying stocks with a rating of 10 on a 3% pullback the next day and selling after the stock closes above its 5-day simple moving average has been profitable 75% of the time with an average gain of 5.9%. Other entries and exits also show high winning percentages and large average gains.
A similar strategy can be applied to short trades. Again based on detailed back testing, we have confirmed that the lower the rating, the lower the one week historical returns have been for stocks and ETFs with that rating. For best results, enter short trades on stocks with a PowerRatings of 3 or higher with a limit order 3-7% above the previous day’s closing price. Higher % limit entries have historically shown a greater percentage of winning trades but higher % limit orders also reduce the chance of trade execution.
As you can see in the chart above, SPY has not moved more than 3% above its closing price the day after a PowerRatings of 3 has been recorded. This indicates that although the ETF is overbought, it is not a strong short candidate.
Short trading strategies can be useful in bull and bear markets. We present other high probability short trading strategies in Connors Research Trading Strategy Series: Short Selling Stocks with ConnorsRSI. Back testing shows these strategies have, in fact, worked in both bull and bear markets. Over 20 variations of the basic strategy have winning trade rates over 75%.
Despite the stock market’s strong up trend since mid-October, there are some high probability short trade candidates. DR Horton (NYSE: DHI) and Tessera Technologies (NASDAQ: TSRA) could be considered potential short candidates if they move higher.
As detailed in the guidebook, trades are entered by “submitting a limit order to short the stock at a price Y % above yesterday’s close, where Y is 2, 4, 6, 8, or 10.”
You can also enter with Variable Limit Entries, using a limit percentage that is 1.5 times the standard limit when the stock is above its 200-day MA, or MA(200). For example, if we’re using a variation with a stated limit percentage (Y) of 4%, then a stock that closed above the MA(200) on the Setup day will actually use a 6% limit order to enter the trade, while a stock trading below the MA(200) will use the 4% limit. Both DHI and TSRA are above their MA(200).
Now let’s look at the most overbought and oversold stocks (according to ConnorsRSI) heading into trading for November 24, 2014. ConnorsRSI is a proprietary and quantified momentum oscillator developed by Connors Research that indicates the level to which a security is overbought (high values) or oversold (low values).
JMEI (Jumei International Holding Ltd) is the most oversold stock with a ConnorsRSI reading of 2.95.
FXE (CurrencyShares Euro ETF) is the most oversold non-leveraged ETF with a ConnorsRSI reading of 13.31.
DUG (ProShares UltraShort Oil & Gas) is the most oversold leveraged ETF with a ConnorsRSI reading of 8.91.
ENI (Enersis S A) is the most overbought stock with a ConnorsRSI reading of 97.96.
ILF (Ishares S&P Latin America 40 Index) is the most overbought ETF with a ConnorsRSI reading of 96.68.
TradingMarkets Lists provide users pre-populated lists of stocks and ETFs identifying symbols with overbought and oversold ConnorsRSI and Bollinger Bands® readings. The Screener Lists are powered by The TradingMarkets Screener.
All data is as of the end of day on 11/21/2014.