Rob Hanna from Quantifiable Edges performed an excellent research on the short-term effects following downside acceleration. He tested a system than buys SPX at the close after 4 straight down days and the decline during the last (fourth) day is twice bigger than the preceding three. The system sells after x days, where x varies from 1 to 8. The positive expectancy of the system is excellent. Not only the reliability of the trade (% of time being right) is above 70% for all tested cases, but the average profit is more than twice bigger than the average loss. The nature of the trade is strictly short-term.
How come big acceleration in downside momentum often leads such reflex bounces? When the price of an equity reaches certain level of depreciation, it:
1. Attracts value investors.
2. The traders, who shorted it are afraid to give up their nice sized profit and are covering part of their positions.
3. Short-term traders are trying to trigger short-squeeze.