Current Monthly Trading Article
(appeared in October '04 issue of CANSLIM.net News)
Buying Quality Stocks in Today's Market:
Pullbacks Versus 21-Day New Highs and 21-Day New Lows
Buying Quality Stocks in Today's Market: Pullbacks Versus 21-Day New Highs and 21-Day New Lows
Larry Connors and Conor Sen wrote an important book detailing the importance of chart patterns, “How Markets Really Work: A Quantitative Guide to Stock Market Behavior”. I received my copy just before hurricane Ivan arrived and was so fascinated by the subject that I finished it that evening, storm and all. It presents 15 years of historical data (1/1/89 through 12/31/03) refuting much of what passes for "common market truisms." These authors looked at several market criteria (new 5 and 10-day highs and lows, the impact of being above or below the 200-day moving average, multiple day pullbacks, and others) to evaluate how each impacted one day through one week returns for the S&P 500 and Nasdaq 100 cash markets. Most of what they found went against our dearly held market beliefs.
For example, during this period there were 947 10-day highs in the S&P. Buying the close of a new 10-day high then selling one week later returned 0.0% on average with 53.43% of the trades being profitable. Not too impressive, since the average 5-day return (irrespective of whether a new 10-day high had been made or not) was +0.21%. Contrast this behavior with buying a 10-day low then selling one week later. This strategy returned 0.56% on average with 333 (of 557) profitable trades (almost three times the unrestricted average 5-day return). The message: Buying strength hasn't worked as well as buying weakness! If one buys the 10-day low but requires the S&P 500 cash index to be above its 200-day moving average, the average return increases to +0.66% with a 66.43% win rate (190 winners of 286 occurrences). The authors put it this way: "...the greater opportunity and edge lies in being a buyer as the market makes a new short-term low versus buying when it makes a new high."
Following this theme, I tested three common patterns used for entering long positions in individual stocks: three or more day pullbacks, new 21-day highs (breakouts), and new 21-day lows (bottom fishing). Chart 1 shows examples of each for ARO as they occurred over a two-month period in 2003. To validate this study, I studied these three patterns for a group of fundamentally sound stocks (9/24/04) with earnings and analysts’ rankings revision fuel (Zacks rankings of 1 or 2) and value left in price (two year PEG ratios less than 1.25): 36 stocks shown in Table I were evaluated over the 294-day period between 7/30/03 and 9/28/04 (10,584 test days).
For the pullback, three or more lower highs were followed by a reversal candle. To limit purchases to stocks in up trends, the 50-day moving average was required to be rising over the last six days, and the 20-day moving average to be greater than its 50-day. When these conditions were met, a long position was entered then exited at the close five days later.
Similarly, for the 21-day high, a position was entered when today’s price exceeded the high of the last 20 days, again, when the 50-day moving average was rising over the last six days, and the 20-day moving average had to be greater than its 50. When these conditions were met, a long position was entered then exited at the close five days later.
Finally, for the 21-day low, a new position was taken today when price exceeded the high of yesterday’s new 21-day low, this time with no additional conditions. And again, the position was exited at the close five days later.
Table I provides results for each of the 36 stocks over the 294-day period. AMED, for example, had 16 pullbacks meeting the required conditions and an average resultant five-day gain of +3.0% (10 with positive gains and 6 with losses); AMED had 33 instances of making new 21-day highs and an average five-day gain of +3.89%. AMED also had 6 instances of new 21-day lows and an average gain of +5.58%. Contrast these returns with the average 5-day gain (+2.29%) earned from the control condition, i.e., from buying each occurrence where today’s price exceeded yesterday’s high and holding for five days.
For these stocks, the average 5-day gain for the control condition was +1.27%, as these were quality stocks performing in both bullish and bearish phases of the market. Limiting buys to pullbacks increased returns to +1.84% (1.45x the control), to new 21-day highs increased returns to +1.38% (1.09x the control), to new 21-day lows increased returns to +2.59% (2.04x the control). Clearly, in this market, buying the new 21-day lows for a week-long trade was a superior strategy to either buying pullbacks or buying breakouts. These results are consistent with Connor’s findings for 15 years of S&P data. While significantly longer holding periods lessens the importance of an entry strategy, the strategy of buying 21-day lows reduces short-term risk and provides better risk/reward limits.