Underlying behavioral trends
- Posted by DynamicHedge
- on February 22nd, 2016
It seems the market is in a downtrend, but trends can be notoriously difficult to identify in their early stages. Trend fakeouts are just one of the many factors that make trend following so difficult in practice. So, how can we qualify price action to gain a more detailed view of what’s going on under the hood — and how and when do we know our reasoning is wrong?
Without overthinking too much, what is one measurable factor that marginal buyers/sellers are focusing their immediate attention? It might be the sudden rally off the bottom (up 2.7% in a week) which introduces the potential for a “V-bottom” reverse of the overall downtrend. Let’s look at that.
To understand the overall risk appetite of the market, let’s calculate how the market has reacted to >2.5% weekly rallies in the past. The purpose of this is to see whether momentum had followed thru or not in the days after the >2.5% rally. Significant price appreciation leading to even higher prices is evidence of a risk seeking market. Conversely, if big gains are used as an opportunity to sell, it is evidence of a risk-averse market. Observing successive years of data helps illustrate how patterns have shifted over time. To show this, I’ve batched instances into one-year segments. Graphs show the dominant market patterns over the next two weeks after a >2.5% weekly move.
It’s clear that markets transitioned to risk seeking in 2012 and continued until 2014 at which time they switched to neutral and now, slightly negative.
Right now, the highest probability pattern is for continued weakness in the long run. Rallies will continue to be sold, until they are not. Specifically, in the last year it has been best to wait several days after the big weekly move and then sell the market (highly probable patterns occur when the two dominant patterns are aligned in the same direction). If the market ignores the precedent (as it did in the trend change of 2012), it may be the beginning of a change in tone and we can start thinking that this is something different than a bear market rally. If it plays out as expected, we can assume that the market is continuing a trend of weakness and that more weakness should follow.
Understanding the overall tone of the market doesn’t mean that I’m calling the top of this range. No one can predict exactly where and when the market will ultimately top out and fall. We can just use the hints the market is providing and try and stay on the right side of the tape. At the moment, the tape looks to be weak regardless of the near-term bullish price action. Also, keep in mind that long-term trends take time to develop and there are lots of tradable ranges and patterns in the interm.
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DynamicHedge is an equities, futures and derivatives trader based on the West Coast. He runs a long/short opportunistic relative-value strategy within a proprietary trading group. More
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