A Study on Market Reversals

August 17, 2016

The neural network logarithms that generate the forecasts of indicators in the buying and selling of securities are somewhat unreliable. They don’t explain why certain securities languish in time with small up and down sequences. Even the fuzzy logic systems that seem to control non-linear systems where ambiguity and vagueness is common are prohibited by mathematics achieving hazy boundaries in human logic.


About 15 stocks from different sectors of the economy provided us with returns in excess of 100%. From a macroeconomic perspective, if there is an overall upward trend in the market, ETFs such as the S&P500 will rise and propel the movement of the securities that the ETF is composed of. The stocks we looked at all established a sequence with relative strength of over 80%.


Higher analyst revisions effectively run the stock to its higher desired price and allow market makers to anticipate positive and negative liquidity of a stock. Market makers are compensated for inventory risk by returns from the reversal of a stock. They are able to persevere with reversals because it is complementary to inventories and past returns. Market makers have responsibility for a group of stocks called a ‘panel’. A very large sell order will limit a market maker in purchasing other stocks and may affect imbalances that could lead to liquidity risks. Even though the market maker is the first level of liquidity, hedging companies and investment banks are willing to take on liquidity risk providing that they are sufficiently compensated in the future price movement. 


When you have a security that is above the 80% RSI and when you have the S&P500 ETF above 70% RSI, there is almost 100% accuracy that the stock itself will reverse in zero to 91 days. All the puts we bought in the three-month period expired over 100% in the money.


Price shocks in a stock increase inventory which enables the market makers to go long until stabilization occurs. These occurrences are not profitable for them because demand has dried up and they are not compensated for their risk. Large institutional sell-offs determine the prices in terms of what market makers are willing to risk with respect to liquidity. Market makers make money by buying and selling shares, going long or short. If there is a seller then they must pick up the risk and provide liquidity. If there are buyers they have to provide the stock at a higher price and if they need the stock for inventory then the price will go up. 


The Dow Theory entered a transformative world, one which uses prosperity as a tool to drive men to excess. Repentance for the consequences of the excess produces a corresponding depression. The Dow Theory only needs to be tweaked by replacing man with global economies. It is the propensity to have global economies that will drive them to prosperity while repentance will still be governed by human nature.


The transformative nature is the steam of the stock that seems to be dispersing in the way that human nature has to profit from. It is no different than the rising temperature of an engine that plays a significant role in profit-taking. There’s no doubt that repentance comes with a unison human endeavor that primarily allows institutions to profit from. Sometimes even the rising expectations of earnings become a lure to the individual investors to get into the action and reap the rewards from their investments alongside institutions. Seldom is that the case.


Most of the small individual investors lose even with indicators and logarithms at their disposal. The key in making a fortune is finding stocks that are easily liquid and reach Fibonacci levels of over 80%. At this point, the S&P has a high probability of reversing along with the stock itself. The money flow index is a good indicator of measuring the power of these underlying trends in the market. Money flow is unable to sustain rising trends for a long period of time and acts as a good signal in identifying probable areas of reversals.


Technical analysts are unable to sort out the significance of inventory variables. They simply focus on past charting methods and past returns. Market makers prefer to be long or short because they face short-sale constraints. It is their quest to find inventory and move the market higher. If inventories are short because of inventory constraints and higher price movements then they need to forecast the time and size of the reversal. When market makers are short they need to be buyers to return inventories to their desired level requiring other traders to be sellers. Short traders face constraints that the market makers are able to anticipate and react to by increasing inventories and selling them at higher prices in the future.


Market volatility poses inventory risks, that is why they position themselves long or short knowing that longer positions in a stock are easier to liquidate. It is a mechanism that allows them to short the security. Institutions demand stock orders to be executed, if there’s a shortage of inventory then the market maker has to short the stock to deliver those shares or simply find an institution willing to sell. If a stock has large inventories and good prospects then market makers will be eager in taking a large position until the demand weans.


Our studies conclude that if stocks rise above 80%-85% RSI then the probability of a reversal is at least 99%. It’s no different than the survival of the fittest: It is the instinct of something that rises through exuberance and comes to terms with taking profit now rather than later.



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