Wednesday, May 10, 2006

Strategy Session: Exhausted Rallies

UPDATE: Make sure to read the first comment on this post containing perfect examples of what this strategy finds from the next day's (5/11)market activity.

An insightful new article by Dr. Brett Steenbarger inspired this latest edition of Strategy Session. He asks the question, "What happens after we get a rest day after market strength?" Brett applies his valuable expertise in culling the history of the SPY to come up with valid, statistically proven patterns to use a trading guidelines. Read the article in detail if you are interested (see Footnotes). Here is his conclusion:

It thus appears that a narrow day after a market rise is not a pause that refreshes, but rather may indicate an exhaustion of the rally. Incredibly, 10 of the last 11 times this pattern has occurred (since 2/05), the market (SPY) has been down ... the next day ... [and] three days later.
The Strategy: Exhaustion of the Rally
We will test Brett's finding against other stocks - specifically stocks with a lot of liquidity (i.e., highly traded) and higher in price (than not) as a proxy for the SPY. This is a strategy for shorting stocks. We are looking for stocks with a narrow range after a market rise. To mitigate some risk we'll look for stocks opening downward and consider as triggers stocks that show a small pullback from the lows as good entry points - in this case, the pause that does not refresh.

How It's Modeled:
The set-up includes these filtering conditions:
  • Minimum Price is set at $20
  • The spread between bid and ask cannot be larger than 10 cents
  • The candidate stocks must trade on average at least 5,000,000 shares/day
  • The candidate stocks must be in a previous uptrend: a minimum of 2 up days prior to today but must be down from yesterday's close by at least $0.10
  • The candidate stocks must be trading more than their normal, current volume - at least 10% above average at the time the alert is triggered
Subject to these filters above, the alerts will trigger whenever the stock: pulls back 25% from daily lows, crosses below daily resistance, OR exhibits a NR7 pattern.

Who Could Benefit:
Note: This strategy does not produce many alerts (~5 to 15 on the days we tried). Traders with patience will appreciate this strategy as a good contrarian spotter (i.e., an opportunity to short). Swing traders and intraday traders will also see opportunities in line with their holding preferences.

This strategy is not recommended during a strong bull market session. It works best when the market is sideways or weak.

Note: If these stocks take a real dive as a result of showing up on this strategy, you could consider using a previous strategy called, "Oversold, Phoenix" to catch any bargains as they roar back.


  • Link to Brett Steenbarger's article, "Rest Day After Strength: What Comes Next?"
  • Configure this strategy for your own use here.
  • Link to other Strategy Sessions here.
  • Remember that these set-ups are sketches meant to give you an idea how to model your own trading plan. Use this 'as is' or modify it to your own liking as many others do. Know, however, that and all individuals affiliated with this site assume no responsibilities for your trading and investment results. The indicators, alerts and all other features are for research purposes only and should not be construed as investment advice.
  • June Seminar Footnote - To gain a full understanding of how this strategy and others can help you in your trading plan, we suggest you attend our training seminar in June. There we will focus on all the advanced aspects of our software needed to give you an edge against larger, more capitalized participants. We just opened the sign up page so that you can officially pay for and reserve your spot (conference limited to 100 existing subscribers).

1 comment:

D TradeIdeas said...

UPDATE: Today's market presented a perfect environment for this strategy.

Take a look at what the alert window looked like at the beginning of the market session for Thursday, May 11, 2006:

Examine the first alert published on EBAY at 9:46 AM (EST) describing a 25% pullback from lows.

Click on the link to see the daily chart for EBAY and what it did right after our alert.

Let's take another example from the same alert window strategy.

Examine the first alert published on PD at 9:50 AM (EST) describing a 25% pullback from lows.

Click on the link to see the daily chart for PD and what it did right after our alert.

As we mentioned in our original post, the "Strategy Session: Exhausted Rallies" works best in down or weak markets. Not all of the alerts produced today were as good (but there were many). The point is that this strategy's filters stacked multiple probabilities in its favor for downward movement as its alerts were triggered. These results today are very encouraging for the next time.