Reversals in choppy markets

By David Bukey
In the first seven months of 2010, the stock market basically went nowhere, leaving nearly everyone — including professional traders — scratching their heads.

Barton Biggs, co-founder of Traxis Partners, a hedge fund that gained 38 percent in 2009, changed his mind twice about U.S. stocks in less than three months.

On May 11, Biggs was bullish, telling Bloomberg news that stocks could rally 15 to 20 percent as the economy recovers. But less than two months later, on July 2, Biggs claimed he turned bearish and cut his equity holdings in half, citing the risk of a double-dip recession. Biggs then changed his tune again on July 26 after economic data brightened somewhat. As Biggs turned full-circle, the Dow Jones Industrial Average (DJIA) lost only about 2 percent overall.

One way to approach a volatile, yet directionless, market is to trade short-term patterns. In May we spotted an intriguing pattern in a daily chart of the S&P 500 tracking stock (SPY); price dropped at least 2 percent during the day, but managed to rally and close above yesterday’s close (see Figure 1).



This one-day reversal pattern isn’t overtly bullish or bearish; closing on a strong note is encouraging, but such a large intraday loss is hard to ignore. However, both patterns in Figure 1 formed after a fairly strong downtrend as the market dropped roughly 11 percent from late April to late May. Figure 1 shows SPY dropped at least 0.6 percent on the day after patterns formed on May 21 and 25.

Has price really tended to slide following this pattern, or is this just a coincidence? The following study examines how SPY behaved around the reversal pattern and its opposite (i.e., intraday gains of at least 2 percent plus lower close). The trends we uncovered are stronger than one might think.

For the complete article, see the October 2010 issue of Active Trader magazine. Click here to subscribe.



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