Short-Term Diffusion Enhances Trade Signals
Following on from my previous post, in which I discussed a similar short-term diffusion approach, I’m going to share the performance of another simple breadth indicator this week. This study serves to confirm that breadth is a valuable addition to any trader’s toolkit. QuantTrade – our new product set to launch any day now – will provide traders with free access to a broad spectrum of quantified breadth indicators that they can use to enhance the quality of their trade signals. All the breadth indicators discussed in my blog will be included in our free offering so be sure to lookout for that. I know of vendors in South Africa that charge a fare penny for this data, so we’re excited to be in a position to give back to the trading community.
Percentage of Equities that have Closed Lower Today
This week’s indicator is simply the percentage of liquid stocks trading on the JSE that have closed lower than their closing price the day before. Because we know that equities exhibit a strong propensity to revert to the mean after moving strongly in one direction, we expect to see the JSE Top 40 Index move in the opposite direction following high readings in our breadth indicator. For instance, if more than 80% of equites close lower today, then the theory of mean reversion states that the market should favour a rise in price during the next trading session. Let’s see if our theory holds up?
Testing our Breadth Indicator
To test this theory I applied our breadth indicator to the Satrix 40, which is a tradeable ETF (Exchange Traded Fund) listed on the JSE, since its inception in 2000. The Satrix 40 tracks the JSE Top 40 Index and can be readily traded just like any other stock listed on the exchange.
Here are the rules that I used:
Entry: Today more than 80% of liquid listed JSE equities closed lower than their close yesterday
Exit: Exit the following day after an entry at the closing price
Since 2000 this simple breadth indicator predicted a rise in price with 60% accuracy following our trade signal. That’s an impressive track record given the simplicity of our indicator. Traders definitely want to pay attention to these readings, at least in the short-term.
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Enhance Your Trade Signals
You probably will not want to trade this indicator on its own, however, by overlaying this as a trade filter in one of your strategies you will likely see a boost in win rates and average trade returns.This is exactly what I aim to do in our new product, and the quantified results are impressive. In fact, market breadth will form an integral part of my daily analysis in my Daily Battle Plan. I’ll use breadth daily to set risk management, directional bias and strategy selection. If you aren’t already using breadth as an input into your trading then I suggest you begin exploring the concept further.
And if these results don’t impress you, remember that Las Vegas was built on 52% favourable odds. Trading is all about tilting the table ever so slightly in your favour and then managing risk. This little indicator does a superb job of placing the odds on our side.
As always, I welcome your comments. Until next week, happy trading.