There are any number of commonly accepted truths in the markets, some of which—“let your winners run and cut your losers short,” comes to mind—can be quite useful. Others, less so.
Consider the inside day, which is a day whose range is contained entirely within the range of the previous day—that is, it has a lower high and higher low. Conventional wisdom regarding inside days usually revolves around the idea that they essentially represent the price hitting the “pause” button, since the market was unable or unwilling to push beyond the boundaries of yesterday’s range.
From this perspective, it shouldn’t matter much how an inside day unfolds—for example, whether it closes up or down. As just one example, let’s consider the inside day that occurred on Monday in the S&P 500 index (SPX). The market closed down on the day (the previous day’s close was a record high) but also below the open. To better wrap our arms around what these patterns could mean, let’s summarize this pattern as an inside day that closes below the open and the previous day’s close, when that day is at least a 10-day high. There have been 193 such days in the SPX since 1958, after which:
●The next day closed above the close of the inside day less than 48% of the time.
●The day after that closed above the close of the inside day nearly 54% of the time.
Now let’s tweak the pattern and see what happened after the 110 instances when the inside day closed above the open and above the previous day’s close (suggesting more bullish intraday momentum):
●The next day above the close of the inside day a little more than 48% of the time—about the same as the original pattern.
●The day after that closed above the close of the inside day only 46% of the time, and was still below the inside day’s close more than 50% of the time one day later.
These results aren’t mind blowing either way, but they suggest a difference in the market’s immediate follow-through depending on how the inside day closes—and that difference runs contrary to the direction of the close. (Note: In keeping with the pattern, the SPX opened lower on Tuesday and looked poised to close down on the day.)
Bottom line: Inside days can hint at direction—but not necessarily the way you'd think. So it’s a good reminder not to take any conventional wisdom at face value. In the markets, it pays to check your assumptions at the door.