My latest research on reversal days

Monday’s action was not
. After gapping up and hitting new multi-year highs, the Nasdaq sold off hard all afternoon and finished in the red. The S&P also ran up in the morning. It attempted to break out to new highs, but for the 5th time in the last 2 ½ weeks, 1311 refused to be penetrated. It is now closer to the bottom of its recent range (1291) than the top (1310). Volume was strong, which also is a discouraging sign on a reversal day like this. But just how discouraged should people be? The common belief about reversal days like today is that they lead to more down side in the short term. I ran some tests to see if this is true.

Since the market has been range-bound and reversal-oriented since the beginning of 2004, I decided the time frame I would use to explore this would just be Jan 2004 to the present. I looked for the following conditions:

1) The market makes a 10-day high.

2) The market closes below its open.

3) The market closes below yesterday’s close.

Over the test period, the following conditions have been met 21 times for the Nasdaq (not including today).

Of those 21 times, the market has continued lower the next day 9 times and moved higher 12 times. Interestingly, the 9 moves lower saw the market fall an average of 1.12%, while the 12 moves higher only saw a bounce of 0.65% on average. So while the pattern isn’t terribly reliable, the old adage “false moves lead to fast moves” rings true. The false move in this case being the reversal day that set up the entry.

I also looked at what happened over the next week following one of these reversal days. In this case, we saw 11 instances where the market was lower and 10 where it was higher. Once again, the percent drop was significantly more than the percent increase as they came in at -1.87% to +1.34%.

When looking out over longer periods of time, the results were comparable. The market bounced more often than not, but those times where it sold off, it did so harder than those times it bounced.

Based on these findings, it would seem that there may be some playable shorts over the next few days should the market decide to head lower. The down move could be sharp and that is where the easy short-term profits may be. Make sure you use proper entry techniques and stops, though, as the chance of a further move down is less than 50%.

Good trading,


P.S. If anyone wants the Tradestation code for the study, just drop me a note and I’ll send it.