On Tuesday March 11th, the
flagship S&P 500 (SPX) stock index rocketed 3.7% higher in a single
trading day! This big rally proved a welcome respite for embattled
stock traders. Not only did it nicely boost most sectors, but it
temporarily dispelled the oppressive fog of fear billowing out of the
mortgage markets.
While it was certainly a
profitable day for me as a speculator, I found it far more interesting as a
student of the markets. The catalyst for this particular surge as well
as the extensive commentary on CNBC about how long it had been since
we’d last seen a similar rally led me to ponder big SPX daily moves in
general.
Understandably, the Fed is
getting all the credit for this rally. But before we get into its role,
some background is in order. On the morning of January 23rd during that
wicked global stock-market panic, the SPX plunged as low as 1270
intraday. Yet such an extreme fear-drenched low was totally irrational
and couldn’t be sustained. So the index rallied 5.4% off this low
into its close that day!
Despite this stunning
intraday recovery, since then the majority of traders have expected a retest
of those deep January lows. They believed the SPX once again needed to
revisit 1270 and then bounce successfully off of it to confirm a major
interim bottom. Naturally this universal expectation made traders
hesitant to buy big US
stocks so it soon became a self-fulfilling prophecy.
Fast forward to this
week. On Monday the SPX closed near its lows at 1273. It was a
retest, on a closing basis no less, of the deep intraday lows of late
January. Traders were ready to buy early the next morning to game this
retest, as SPX futures were up 0.5% or so even before the Fed’s latest
machination went live.
On March 11th, one hour
before the stock markets opened, the Fed announced it was offering $200b in
loans to the struggling Wall Street banks. In addition to the enormous
amount, the Fed was offering this capital for 28-day terms instead of the
usual overnight duration. Even more amazing, the Fed said it would
accept universally unwanted GSE mortgage-backed securities as collateral for
loans of US Treasuries!
On this news the SPX
futures, due for a technical rally anyway thanks to the retest, accelerated
dramatically. They were up about 2.0% before the markets opened.
As the Fed was effectively saying that Fannie and Freddie paper was as good
as US Treasuries, perhaps the mortgage debt crisis was really turning a
corner. The SPX powered higher into the close and racked up an
impressive 3.7% daily gain.
Since such big daily
rallies are so profitable, I wanted to know more about them. How rare
are they? When do they tend to rear up within stock-market
cycles? Is Fed action necessary to drive such extraordinary daily
moves? Can we deploy call options in advance to game such big moves?
To learn more I analyzed
big daily SPX rallies going back a decade or so, to 1998. Not only is
this modern period most relevant to today’s markets, but it encompasses
massive bull and brutal bear markets alike. It is a good sample of
wildly different stock-market environments. And since I was studying
big daily rallies, I figured I may as well look at big daily plunges
too. They could also be gameable via put
options.
Interestingly, this
week’s big SPX surge was only the 17th largest daily rally in this
index since 1998! But it was still the best day we’ve seen since
October 15th, 2002’s massive 4.7% daily surge (the 6th largest). Any
headline market event rare enough to only be seen one time in over 5 years is
certainly worthy of further study.
I was curious about the
size, relative rank, and temporal distribution of big SPX daily moves. So
I plotted them on the next two charts. The top 12 biggest SPX daily
surges and plunges are marked below. I wanted to include more, but this
chart was getting too busy. Each big move’s relative rank
(white), gain or loss (green or red), and any Fed rate cut on that particular
day (yellow) are noted. The results are interesting.
Due to the stark asymmetry
marring this chart, you’d think I failed to finish it. But the
crowded left and deserted right is no oversight. The biggest daily SPX
moves, both rallies and plunges, tend to happen almost exclusively in bear
markets. Only the terminal downleg-ending
plunges in full-on bears are able to consistently generate extreme-enough
volatility to drive such huge daily moves.
Of the top 12 daily rallies
in the SPX over the last decade or so, 9 happened during the brutal SPX bear
of 2000 to 2002. And 2 of the remaining 3 happened during the 1998
Russian debt crisis, a short period of extreme bearishness within a bullish
trend. I don’t think most casual traders realize that bear
markets and crises are where the biggest daily rallies
erupt. Bull markets are seldom volatile enough to spawn them.
Of the top 12 daily plunges
in the SPX since 1998, 6 erupted within the SPX bear. The Russian debt
crisis spawned 3 more in 1998. Understandably such big daily declines
are exceedingly rare in bull markets. The last one witnessed was the
3.5% plunge in late February 2007 driven by a vicious 8.8% slide in the
Chinese stock market the day before. Sometimes exogenous events spark
randomly-timed big moves.
So if you want to game big
SPX daily rallies or plunges, don’t even bother unless we are in a bear
market. The extreme volatility late in bear-market downlegs
is the only force powerful enough to consistently generate outsized
daily swings. A crisis in a bull can sometimes pull it off, but
crises are almost always very unpredictable in their arrivals and short-lived
to boot. This makes it tough to game them with options relentlessly
ticking away towards expiration.
Another striking attribute
of big daily moves is their symmetry. Big daily rallies tend to arrive
soon after big daily plunges, and vice versa to some extent. It is
relatively rare to have a big daily move in one direction without a big daily
move in the other direction close by. While not so apparent with the
limited dataset I could fit in these charts, this trait becomes really clear
once you make your way through the top 50 big daily moves in both directions.
This is logical too.
In order to stand out historically, the SPX has to push 4% in either
direction. Out of the 2563 trading days since 1998, there have only
been 10 days with gains exceeding 4% and 5 days with losses exceeding
4%. 4%+ daily swings in either direction are exceedingly rare
events. They are utterly unsustainable and only extremely unbalanced
sentiment can generate them.
To many traders,
especially the gunslingers playing wildly volatile sectors like commodities
stocks, 4% might not seem like a big deal. 4% days in gold stocks are
more norm than exception! But remember we are talking about the S&P
500 here. It is the 500 biggest and best companies in America with
a massive collective market capitalization up near $12,373b. Essentially
whenever this index moves 4% in either direction in a single day, American
stock investors have gained or lost 4% of their total stock wealth in
less than 7 hours!
It is true theoretically that
an index could gain (or lose) 4% a day forever. But imagine if the
initial 4% swing was converted into raw dollars of market cap and then this
number was extended forward. If the capital equivalent of the initial
4% gain persisted daily for 25 trading days, the SPX would double. If
the capital equivalent of the initial 4% loss persisted daily for just as
long, the SPX would hit zero in five weeks! 4%+ moves in such a
giant index are gargantuan wealth-affecting events.
To drive such anomalous
moves, sentiment has to be really unbalanced. You need an awful
lot of greed to spill into 500 stocks with enough fury so this entire group
rises 4%. On the other side of the coin, only extreme fear can
force such a broad group of elite stocks to fall 4% in a single day. But
the markets abhor sentiment extremes, they are never sustainable. Excessive
greed or fear never last too long.
Since these emotions that
drive such massive moves simply can’t remain so intense, strings of
consecutive big up or down days just don’t exist. Big up days are
only probable right after big down days driven by unsustainable fear. And
as we saw this week, fear can evaporate in a nanosecond. As a herd,
stock traders are incredibly fickle and capricious in their sentimental biases.
They are as emotional as schoolgirls.
Thus the very best odds for
a massive daily rally occur right after a massive daily plunge. Any
afternoon where the SPX is pushing 4% to the downside and fear is extreme is
a high-probability-for-success time to buy call options. I’d add
them in two sectors. The irrationally beaten-down sector driving the
fear is probably way oversold by this time. In addition, whatever hot
sector the bulls were chasing before the fear is also a great place to
buy. Traders can buy calls on the leading stocks in both sectors.
And despite the Fed’s
apparent role in our big rally this week, the Fed is really irrelevant across
the biggest SPX moves of the past decade. Rate cuts only happened on
the days of 3 of the 24 biggest moves rendered above. In each case,
even for surprise rate cuts, the markets continued on following their primary
trends soon after the rate cut. Even though the Fed tries to meddle in
stock-market sentiment, it is virtually always unsuccessful. Greed or
fear will work themselves through in their own good time.
This next chart zooms in to
just the 2000-to-early-2003 bear period since 18 of the 24 biggest daily
moves of the past decade happened in this time frame. This
higher-resolution view shows where in bear markets the biggest daily rallies
and plunges are likely to occur. Traders can game these times and
deploy options trades in anticipation.
Bear markets have a
fearsome reputation, but most of the time they are just plain boring.
While the SPX ultimately lost 49.1% of its value from March 2000 to October
2002, this loss happened over 637 trading days. This yields an average
loss per day of bear of less than 0.1%. This slow burn is the
primary reason why bear markets are so effective and devastating at
destroying capital. It is brilliant psychological warfare.
When markets are falling
fast, traders get scared fast. They want to sell out immediately to end
their bleeding. Thus a bear can’t fall too fast too often or it
will generate too much fear and drive out too many traders too soon. So
truly fast plunges are rare even within bears, as the bear needs to allow
enough rallying between the plunges to breed general complacency and keep
fear from getting out of line.
Bears do most of their
revaluing work in short periods of time, their downlegs.
Three massive downlegs bloomed in the SPX bear
rendered above, in Q1 2001, Q3 2001, and straddling Q2 2002. It is near
the bottoms of these downlegs, and their resulting
sharp V-bounces, where most of the biggest SPX daily moves occur. The
SPX falls off a cliff leading into their terminal descents, but then it
bounces sharply.
Late in bear-market downlegs is when fear is most likely to temporarily spin
out of control, driving the brutal and unsustainable 4% daily declines.
Interestingly the biggest SPX daily plunge we’ve seen in 2008 was February
5th’s 3.2%. It ranks as the 17th biggest daily plunge of the past
decade. It occurred after a sharp 16.3% decline in the SPX between
early October and late January. Interestingly this looks an awful lot
like a bear-market downleg!
Right after these downlegs bounce, when their fear gets too extreme, is
when the biggest daily rallies tend to erupt. Following such aggressive
selloffs, prices are so low and so much capital is
driven to the sidelines that it isn’t too difficult to drive big daily
rallies. Note in the chart above that all of these biggest SPX daily
rallies occurred just after a sharp decline. So did our latest big
rally of March 11th, 2008.
So if you want to game
these big moves, your best odds for hitting them are late in bear-market downlegs for the massive daily plunges and just after
that in the resulting V-bounces for the massive daily rallies. The
biggest moves ever witnessed in the stock markets are clustered around these
bear downleg bottoms. Although calling a
major interim bottom on any particular day is risky, options traders who
succeed can earn giant profits very rapidly.
Provocatively, the fact
that we witnessed the 17th largest SPX daily plunge of the last decade a
month ago and the 17th largest rally in the SPX this week increases the odds
we are in a new bear market today. Big daily moves are almost
entirely a uniquely bear-downleg and V-bounce
phenomenon. This piece of evidence joins other threads of research illuminating
the growing probabilities that a new bear is upon us.
An occupational hazard of
speculation is an almost preternatural focus on probabilities. Since no
mere mortal can see the future in advance, the best we can do is clumsily
attempt to understand the odds governing it. Studying the past helps us
better game how likely future events are. So as I did this research, I
felt compelled to build a probability distribution of the all the daily SPX
moves.
The total dataset modeled in this chart is the 2563 trading days from
January 2nd, 1998 to March 12th, 2008. Each column below is mutually
exclusive for its integer range. The +1% column, for example, shows the
odds of the SPX gaining between 1.00% and 1.99% on any given trading
day. Not surprisingly this particular probabilities distribution forms
a nice bell-curve approximation.
Over the past decade
through incredibly volatile markets encompassing major bull and bear alike,
our odds of seeing a big move were still exceedingly low. We are
talking about a 1.2% cumulative chance of seeing a daily gain greater than 3%
and a 1.0% chance of seeing a daily loss greater than 3%. Truly huge
moves are even rarer, at just a 0.4% chance of seeing a 4%+ up day and a 0.2%
chance of seeing a 4%+ down day.
So gaming big daily moves
in the SPX can’t be a bread-and-butter strategy for traders. They
just don’t happen often enough to build a comprehensive trading
strategy around. Most of the time, the SPX doesn’t do much at
all. Fully 67.5% of the days, 2/3rds of all days, run between +1% to
-1% on the SPX.
For many years now, I have
considered all stock-market days of sub-1% moves in either direction to be
essentially “unchanged”. Considered in isolation without
their cumulative trend, they are meaningless statistical noise.
But for astute traders
carefully watching market technicals and monitoring
prevailing sentiment, the rare big SPX daily moves offer fantastic
opportunities for large very-short-term profits. The
highest-probability-for-success scenario to game is the big up day following
a big down day. If the SPX is down 4%ish just before close, buy
short-dated at-the-money call options in anticipation of a likely big
bounce. This is risky of course, as the bottom you are gaming could be
a week or two out yet. Nevertheless, the potential payout is really
big.
Applied to today, the
recent clustering of big SPX daily moves significantly increases the odds
that we are in a new bear market. This may seem troubling, but
there are sectors that thrive in such environments. I believe the
highest-potential one today is gold stocks. They follow gold on balance
regardless of what is happening in the stock markets, as they proved by soaring
during the 2000-to-2002 stock bear.
For a broad array of
reasons totally unrelated to this research, we have been aggressively buying
elite gold and silver stocks at Zeal. Today’s stellar gold and
silver prices are likely to drive an incredible couple months in
precious-metals stocks. Subscribe today to our
acclaimed monthly newsletter to mirror our
trades to ride this trend! You’ll learn how to integrate all
kinds of valuable research, like today’s SPX explorations, to launch high-potential-for-success trades of your
own.
The bottom line is big SPX
daily moves are pretty rare. Over the last decade, an incredibly
volatile span of time, only about 1 out of every 50 trading days witnessed a
3%+ gain or loss. Both big gains and losses tended to cluster near
terminal-stage downlegs and their resulting
V-bounces in bear markets. Only bears can consistently generate the
extreme volatility necessary to spawn these rare outsized days.
But their very
rarity is what makes the big SPX daily moves so darned exciting. They
spice up the often dull day-to-day grind in the general stock markets. Not
only are they quite fun to experience, in either direction, but they offer great
short-term trading opportunities for shrewd speculators.
Adam
Hamilton, CPA
Zealllc.com
March
14, 2008
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