It All Starts with an Understanding of Probabilities

by Brent
(Curitiba, Brasil)

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.

Boa sorte!

Comments for It All Starts with an Understanding of Probabilities

Click here to add your own comments

Sep 27, 2014
interesting, please explain
by: Anonymous

Could you please be more specific?

Apr 07, 2008
by: Anonymous

First Congratulations to Craig - in my last 10 years of involvement in Stock Trading I have yet to come across a person who has taken to giving sound basic and sensible advice to all of us in the market. To me its more like a 'selfless service to the investor community'. Three cheers to the owner and author of this website.
I have tried many methods and the only one that has succeeded for me is to enter the market when there is 'doom and gloom' all around and all the market pundits are negative on the market sentiment. Then pick the best companies in the business in a basket of sectors that were up before the crash occurred - have faith in the system and yourself and be prepared for some fall or sideways movement in the near term. Buy in small or medium lots that make sense to you and most importantly have FAITH. So in other words if you can mimic the 'Institutional Investors' even though one has a smaller amount of resources its likely that one will make money in the medium term. So like Craig says there are many ways to the money god - one way is to become a good 'Positional Trader'.

Nov 18, 2007
Excellent data on Strength and Weakness
by: Craig

Great post! If I could only use one moving average on my charts, it would be the 200 MA.

Excellent data on buying and selling above and below the 200 period moving average.


Click here to add your own comments

Join in and write your own page! It's easy to do. How? Simply click here to return to Tips and Tricks.

Beginners: Learn the Basics

Intermediate: Trading Strategy

Advanced: Swing Trading Tactics