Testing the S&P 500

Every trader knows a pullback when they see one—after the fact, that is—but it’s a horse of a different color to gauge in real-time whether a down move is just a pullback or the beginning of a downtrend.

Consider what’s happened the past several days in the S&P 500 (SPX): The index rebounded yesterday after stringing together three days of lower lows and lower closes, the last of which bottomed almost exactly at the level of the June 4 breakout above the May highs:

S&P 500 (SPX), 2/13/18 – 6/20/18. S&P 500 (SPX) daily price chart. Current pullback

Source: OptionsHouse

It may surprise some traders to find out the advantage of buying the stock market after the simplest of pullback patterns: three consecutive days with lower lows and lower closes—exactly what happened on Tuesday. Sure (skeptics will say), the market bounced back yesterday, but that’s just one day and one pullback. But the numbers don’t lie. Since July 1982, the SPX has made 407 other pullbacks consisting of (at least) three days of lower lows and closes. Here’s how things shook out five days later:

  1. SPX median return after the three-day pullbacks: 0.55%. (SPX median return after all five-day periods: 0.32%.)
  2. Percentage of times SPX was higher after the three-day pullbacks (“win rate”): 61%. (SPX win rate for all five-day periods: 57%.)

In other words, five days after the pullbacks, the SPX was up more, and more often, than it typically is. There’s no magic at work here. Because of the stock market’s long-term upside bias, over time, buying market indexes on dips means you’re getting in at a better price than if you buy every time the market rallies.

But if you look at March 1, March 15, and March 23—the last three times the SPX put together three-day strings of lower lows and closes—you can see how your mileage can vary from case to case. Going long on the March 1 close would have been great, but traders would have gotten killed by the March 15 trade, and buying on March 23 would have been so-so, at least for a couple of weeks. In other words, we’re talking about a market tendency here, not a finely-tuned trading strategy.

What can this tendency tell us about the current S&P 500 situation? To keep things as general as possible and focus on the most important price dynamics, let’s look at past patterns that match the following description of the SPX as of yesterday:

  1. The index must make three consecutive days with lower lows and lower closes.
  2. The highest high of the three days immediately preceding the pullback must be at least a new 10-day high.
  3. The day after the third pullback day must have a higher low and a higher close.
SPX pullback pattern analysis: July 1982–June 2018. Pullback edge

Source: OptionsHouse

The chart above compares the SPX’s returns for the first 10 days after 76 instances of the pattern to the SPX’s median returns for all one- to 10-day periods since July 1982. The blue line in the top half of the chart shows the SPX gained more than usual (except at days 8 and 9), while the bottom half of the chart shows the pattern’s win rate (dark green bars) was also higher than the SPX’s overall win rate (light green bars) at each day.

Past results, as we all know, don’t guarantee future performance, but historical pattern analysis can provide useful reference points and help round out a market picture that incorporates other inputs—for example, the fact that Tuesday’s low could be considered a test of the previous breakout level—a market tendency noted many times in this space.

When independent signals align, it can be worthwhile to pay attention.


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