It All Starts with an Understanding of Probabilities
It is often said that bull markets live above the 200 DMA, and bear markets below them. But how true is that statement exactly? It turns out, even more true than I first suspected. As a professional trader, I have built my trading system, or better said philosophy, around the discovery and fusion of probabilistic edges in the three metrics I follow: technical, fundamental, and psychological (sentiment). In this offering, I will discuss the cornerstone of my trading strategy, buying weakness in strong markets.
Using a database of daily closing S&P prices back to 1962, I discovered the following:
Being in the market during periods in which the close is higher than the 200 DMA, the 5-day forward annualized return is 10.5%, in periods in which the market closes below the 200 DMA, the return drop to 3.2%. Impressive, but just the beginning. The next step was to combine an up-trending market (as measured by the 200 DMA) with the principle of buying weakness. How did it turn out? The following table summarizes the results:
200 Moving Avergage: >200 DMA <200 DMA
Prior 5-Day Change:>1% 8.8% -4.2%
Prior 5-Day Change:<1% 19.9% 7.7%
So what helpful conclusions does this previous table provide?
- Buying the market below the 200 DMA at which time the close was 1% higher than the 5 day prior close yields an annualized return of negative 4.2%.
- Buying the market above the 200 DMA at which time the close was 1% lower than the 5 day prior closes yields an annualized return of positive 19.9%.
-If the prior 5-day change threshold is raised from 1% to 2%, the return from the buy weakness in a strong market strategy goes from 19.9% to 27.2%.
While this is not a trading system in and of itself, it validates the strategy so persuasively argued by Craig on this site, and that which has been the foundation of my successful trading career: buying weakness puts the probability of success strongly in your favor.