This new indicator suggests a bounce
In my
last article, I made the case for relative measurement of market
indicators. Rather than use the raw values for indicators to gauge the
market, it makes more sense to compare the current values to a recent
norm. On the TradingMarkets site, for instance, the VIX
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its recent
moving average and provides useful trading signals when it is
elevated above that norm. Similarly, in my article, I found that relative
price change–comparing daily price change to the median absolute value of daily
price changes–provided a potential trading edge.
The reason for this is that people respond to events within their
context. "Bear right" means something very different to a driver
and a hunter. When we look at an indicator in its recent context, we
examine the extremity of that indicator relative to its recent context–which is
what traders are likely to respond to.
On my research blog, I have been tracking an indicator called Relative
Range. Quite simply, this takes the range of a price period and compares
it to the median range over the past 20-periods. This Relative Range
measure tells us if volatility has expanded greatly relative to recent
norms. It also signifies that the marketplace is shifting its definition
of value, as market participants accept a wide range of prices during the day or
week. A low Relative Range suggests that traders are accepting value
within a relatively narrow band of prices; a high Relative Range reveals a lack
of consensus regarding value.
It is during such low consensus periods, I believe, that markets are most
likely to miss the value mark with overreactions, creating potential trading
edges. For instance, as of the close on Wednesday, we had a five-day drop
in the S&P 500 Index
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PowerRating) of 4.3%. The Relative Range was a whopping
2.39, which means that the price range over that five-day period was more than
double its median over the past 20 days. Since March, 1996 (N = 2551
trading days), we’ve only seen 36 occasions in which SPY has been down by 4% or
more on a Relative Range of greater than 2.0. The market was up five days
later on 25 of those occasions, by an average 2.31%. When SPY has been
down by 4% or more but the Relative Range is less than 2.0, the next five days
average a bounce of only .48% (50 up, 34 down). Note that the average
five-day gain for the entire sample is .17%.
Large drops on large relative ranges are rare, but seem to be associated with
favorable odds of a bounce going forward. Since March, 1996, when we have
a single day decline of more than 1.5% and the Relative Range is greater than
2.0 (N = 49), the next day in SPY has averaged a gain of .55% (30 up, 19
down). When SPY has declined by more than 1.5%, but the Relative Range is
less than 2.0 (N = 180), the next day in SPY has averaged a gain of only .15%
(99 up, 81 down). Again, note that the average one-day gain for the entire
sample is .03%.
In short, I believe that large drops on large relative ranges represent
market overreactions, which tend to correct themselves in the near term.
This creates short-term trading opportunities for the intrepid trader. It
would be interesting to see if the pattern of bounces following large
declines on large relative ranges also applies to intraday time frames.
The fact that it has produced a solid edge for over ten years of market
history–embracing bull, bear, and low volatility conditions–is impressive.
Brett N. Steenbarger, Ph.D. is Associate Clinical
Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical
University in Syracuse, NY and author of The
Psychology of Trading (Wiley, 2003). As Director of Trader Development
for Kingstree Trading, LLC in Chicago, he has mentored numerous professional
traders and coordinated a training program for traders. An active trader of the
stock indexes, Brett utilizes statistically-based pattern recognition for
intraday trading. Brett does not offer commercial services to traders, but
maintains an archive of articles and a trading blog at www.brettsteenbarger.com
and a blog of market analytics at www.traderfeed.blogspot.com.
His book, Enhancing Trader Development, is due for publication this fall
(Wiley).