I am not getting overly excited about the 3.55% move in the DOW, the 3.98% move for the NASDAQ and the 3.71% jump for the S&P 500. Today’s action does raise some interest but trend reversals and new bull rallies can’t be confirmed after one day of action. All major bull markets started with a reversal and then a follow-through within the next four to ten trading days.
This idea was first revealed by William O’Neil, the founder of Investor’s Business Daily, and became a cornerstone in his CANSLIM investing method. I believe this theory to be accurate but it is not an exact science. Before I describe this method, I would like to be clear that my indicators are still pointing down and my screens are still focusing on shorts. It’s a good time to write about reversals and follow-through days even though I don’t think this rally has legs but my opinions must be checked at the door.
The key to understanding this follow-through philosophy is that reversal signals usually occur after a significant market correction, not a minor market correction. The reversal and follow-through in 2003 was classic and one I like to refer back to when looking at the present market. Both the reversal and follow-through days must move at least 2% to the upside on above average volume.
If today acts as day 1 of a possible reversal, then the next two days are not very important except for one fact: the market must not undercut today’s low as that would kill the start of a new rally. As long as prices stay above today’s low, the rally attempt is safe.
The follow-through day should come within four and ten days of today’s reversal although O’Neil’s original rules stated that the follow-through should come between day 4 and day 7. One of the major indexes must move higher by 2% or more on larger volume than the previous day to qualify for a follow-through. Multiple indexes participating with a follow-though shows conviction that the market has sustainability to move in the new direction.
As IBD states, the method is simple but has been tested through time to be reliable. It’s not perfect but the odds state that a follow-though day signals a new trend for the market.
Take a look at the reversal and follow-though from March 2003 (keep in mind that this market action happened after a significant market correction; we aren’t in the midst of a significant market correction).
The market gained more than 70% from its follow-though confirmation.
I don’t believe we are in the same situation as 2003 but we must remain neutral and allow the market to tell us what will happen. All things considered, I will add put contracts to current positions that rise on weaker volume and fail to recover moving average lines. I will hedge my contracts if they do mange to recover the moving averages. All in all, I will be ignoring the major news networks and mainstream newspapers this week.
Excellent work once again, Chris..
It will be interesting to see how O’Neil’s thinking plays out going forward.
Cheers,
-Bill
I’m with you Chris. I’m still following a bearish thesis until we get follow through. However, I am also taking a few nibbles to the long side in strong stocks with recent earnings breakouts, like GTLS.
Be short at your own risk here, from a sentiment point of view you’re on very thin ice. Go see Jason Goepfort’s work at sentimentrader.com and you won’t be so inclined to be bearish.
Here is the link to learn how WON is thinking currently!!
http://www.tfnn.com/ibd.php
Ram
Over the past 20 years, such a blast has been seen five times: Oct. 20, 1987, April 5, 2001, Sept. 24, 2001, July 24, 2002 and Oct. 10, 2002. That’s some pretty distinguished company — each and every one of them marked the end of intermediate-term declines. The average two-week return was 6.7%, with none of them showing a return less than 3.9%.
Thanks Bill!
Paul,
I agree that GTLS is one of the few decent looking charts to the long side.
Hi Chris..Why do you say we have not had a significant correction?? The markets have been pounded relentlessly for months now. Personally, I think it is time to do some buying.
Brad,
Thanks for the link but I only trade my data, not opinions from others. This is not to attack another trading style but I only trust my own research and developed systems. They have worked for worked for many years (long and short).
Janet,
The DOW corrected more than 35% prior to the 2003 reversal and follow-through. The current DOW is down 14%, less than half the significant correction in 2001 and 2002.
The NASDAQ dropped 76% prior to the 2003 reversal and follow-through. The current NASDAQ is down 20%.
That is where I get significant from versus today’s market. Besides, the market has only trended down for 4 months. Downtrending markets head lower for years. Maybe the market will go higher but the current trend on a longer term scale is down. It may be up short term but what do I care about the small moves.
Yea, I can see the difference there but that correction was due largely to the tech bubble. I don’t think we are in any type of bubble like that. That kind of correction comes (IMO) around every 10 years or more. (IMO) the norm is more quick corrections and the resumption of up-trend. We shall see, anyway, for what it’s worth that is what I think. Thanks
Janet,
Time will tell. I will trade the charts; that’s all I can do. I don’t have an opinion on where the market is going (up or down) nor do I care – I just want a trend. I will follow it, not guess.
That’s what makes you a good trader, the trend is definitely saying down. I don’t short stocks so I’m always looking for a bottom.
Chris,
I am curious to see how you use option PUT to trade any down trend stocks.
Can you post an article on how you handle your short candidates using PUT strategy?
Thanks