Tech Note
A Non-Trending Stock Strategy
1/6/2009

Since October, the market has fallen into a non-trending pattern of seemingly random up and down moves.  A trend is broadly defined as a consistent series of either higher highs and lows (an "uptrend"), or lower highs and lows ("downtrend").  Over the past 3 months, we have seen highly volatile up and down moves, without a real direction.  How do we buy and sell in this environment?

The Friendly "Mean-Reversion"
One simple strategy is to look at a mean-reversion indicator.  To review, "mean-reversion" simply means that a data series tends to move back to the average value after being too stretched out.  Think of this as a rubber band that's been pulled out under tension, but will immediately move back to it's original shape upon release.  Stock markets tend to be mean-reverting to some degree, and sometimes more than others.  In contrast, commodities markets tend to be more trending.  Part of this difference has to do with limits on trading in the commodities markets, which aren't as restrictive in the stock market.

I've written a simple indicator which I call PctFromMA, or Percent from Moving Average.  I didn't invent it, but it is not included in most charting packages, so I coded it myself.  In the chart below, you can see this indicator at work. 


S&P Dep Receipts (SPY). Daily, 7/08 to 1/09


The black line shows how much the SPY is trading above or below its 10-day simple moving average, in percentage terms.  For example, if the SPY is at 99.00, and the Moving Average for that day was at 100.00, the indicator would register a -1.0%.  The pink line is just a 3 day average of the PctFromMA.  The red and green dashed lines are 1.5 standard deviation (SD) bands, to show volatility and "over-stretchedness".

Notice the tight bands prior to October, 2008.  This shows a market with shallow moves above and below its rather fast 10 day average.  Starting in October, though, the SD bands widened out considerably, showing how much the market swung around the average.  With such wide swings, and no general direction up or down, I would classify the post-September market as non-trending.

The strategy in such a market would be to buy stocks when the PctFromMA touches or moves below the bottom SD line (green), and to sell when it touches or goes above the red SD line.  This is the standard approach for all oscillator-type indicators.

As an example, in early October, you would have bought the market around SPY 90-95.  This chopped around for a few days, for probably no profit.  However, in mid-October you got a sell signal at SPY 98.  The down move was sharp, to SPY 85, for a 13% short gain.  The buy at 85 was another sharp move, this time up, to SPY 100, or an almost 18% gain.  On election day, early November, the PctFromMA again crossed above the red SD line, for a sell signal at SPY 100, the down move to Thanksgiving, 3 weeks later, took the Spy down to 76, for a 24% down move, when the PctFromMA crossed below the green buy line. 

That's a total of over 50 percentage points (13% + 18% + 24%) in a month and a half.  The ironic thing is that the market ended that period at nearly the same level as it started.

CONCLUSION
As you build your arsenal of market knowledge, always understand whether you are in a trending or non-trending market.  This is a simple, binary distinction that should be your first decision upon reading charts, before you trade.
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