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Thursday, December 8, 2011

Dec 8 - Daily Cycles, Looking for an Edge

Okay, enough things have happened that I can now start thinking about this scenario more concretely.

1. The overbought condition on the 60-min Trend System has been relieved. And the fact that it is done so in a relatively sideways manner is pretty bullish
2. A couple of days ago a Daily Cycle Long Signal occurred on my Daily Trend System.

I talked about a potential setup last month here (Daily Cycles - Looking for an Edge), that did not end up materializing. The triangle did not break up, it broke down pretty hard and the Daily signal cross never happened. But the rally this past 2 weeks reversed that trend and we now have a positive signal. I will rehash much of what I said last month (because the stats are still valid) and what I will be looking for in the current environment.

There has been a big (and good/useful) discussion of cycles in my blog comments recently. What I want to do in this post is to take a step back and offer a statistical look at the cycle signals from my Daily Trend System

Note: I am referring to my Daily System, not my 60-minute System. I have backtested my Daily System to 1982. And like with my 60-minute system, I trade the signals based on the sub-cycles. The last Daily System trading signal was a Cover Short/Establish Long signal at 1181 on 10/10/11 on the SPX (see here and see here)

There are multiple sub-cycles within a cycle in my system. And while I don't show the cycle signals (because I don't trade off of them, I use them to 'reset the boundaries' of my system, and they are used as confirming indicators), they do have some analytical usefulness and might give some insight here.

The reason being that we did get a Long Daily Cycle Signal earlier this week and now have a short term pullback to relieve overbought conditions, which I tend to view as a buying opportunity.

My cycles are not defined on some strict time relationship, in fact there is no time requirement at all. It is based completely on indicator moves (mostly MA based). Since 1982 there have been 24 cycles (with a long/up half and a down/short half). Minimum Duration: 154 days, Maximum Duration: 951 days, Median Duration: 390 days, Average Duration: 444 days.

So let me pose this hypothetical: We close above the 200 day MA sometime in the next week.

Like I said above, we got a long cycle signal earlier this week. I measure a cycle from long cycle signal to the next long cycle signal. This made the last cycle 440 days, which is right around the average and median cycle durations. That is good and makes sense.

So what would be the odds that a close above the 200 day MA would be a 'fakeout' (i.e. that it close slightly above the 200 day MA in mid/late Dec and then crash, in a Wave 3 down or something similar)?

Even though I don't trade the cycle signals, I ran a study that was formulated like this: From the price the long cycle signal was issued, what is the highest sub-cycle signal price before the next cycle short signal was issued? This gives a way to quantify how many cycles did not 'fail'. The stats are pretty compelling:

Study Results
24 Long cycle signals
21 cycles made higher high sub-cycle signals before next cycle sell (88%)
Max Gain: 68.0% (Max sub-cycle peak, not necessarily the next sub-cycle peak)
Avg Gain: 19.7% (Avg sub-cycle peak, not necessarily the next sub-cycle peak)
Avg Loss: -2.2% (Max value of failure)
Max Loss: -2.8% (Max value of failure)

Here is what I see, and here is the edge that I think the stats are giving me:

If we close above the 200 day MA (in essence making a higher high), there is an 88% chance that we made a legitimate bottom in October, that the last higher low confirmed that bottom, and that we should be looking for more upside (and on average a large amount of upside, 20% gains).

Again, these are statistics, not prognostications.

But given the way this bottom has developed on my Daily System, and the bullish seasonality, the fact that we made a higher low above the October low which confirmed the divergence seen at the October bottom, the fact that the overbought conditions have been relieved on my 60-min trend system, etc. etc. I think if there is any edge to be gained from this analysis, it is to go long after this current pullback ends [aggressive] or to go long after a higher high / close above the 200 day MA [conservative] and not to expect a fakeout and crash (end of Minor 2 and looking for a Minor 3 down, or something equivalent).
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