Market Timing The Stock Market Trends With The Follow Through Day

Oh, that evil market timing!  A few years ago, there was a big push to blame market timers for everything wrong with the stock market. Thankfully, high frequency trading has taken the center stage as the things that the evil computers do. Those that participate in this “rigging” of the system are being held responsible for everything from the increase in volatility, to the lack of a sustainable trend.  Market timing will still be mentioned in passing, but it’s no longer considered the death of the tradable stock market trends.

The truth is, market timing is essential to success on the short, intermediate and long term horizons.  After all, that’s what technical analysis is about.  You can find the stocks you want to trade using fundamental or technical analysis, but only technical analysis will tell you when to get in and out.

 The Discovery Of The Follow Through Day And How It Relates To Stock Market Trends

William O’Neil, founder of Investor’s Business Daily (IBD), and writer of one of the most highly regarded books on investing/trading- How to Make Money In Stocks, blends both fundamental and technical analysis in order to select stocks worthy of allocating investment capital. O’Neil discovered what he termed the “Follow Through Day”, and it is one of the most talked about trading patterns for timing the end of a market decline a.k.a. correction, and the start of a bull market.

When Do We See A Follow Through Day?

A Follow Through Day occurs after a significant decline has occurred in the market. A bounce starts the watch for a Follow Through Day, and the first day of the bounce counts as day 1.  Days 2 and 3 are irrelevant except for counting purposes, as long as they do not undercut the day 1 low. From day 4 forward, a Follow Through Day can occur on any session that one or more of the three major indexes, the S&P 500, the Dow Jones Industrial Average, and/or the NASDAQ see an increase of at least 1.7% with volume higher than the previous session’s turnover.  Ideally, the Follow Through Day should come between days 4 and 7, and when it happens after day 10, the success rate allegedly diminishes, or so it used to be said to.  Lately, IBD is saying that it can come any time after day 4 to be legitimate, but it can even occur on day 3 and still be valid.  Oy!

Not all Follow Through Days start a new Bull market, but according to Investor’s Business Daily, no Bull market going back to the 1880s (where they have data up to) has started without a Follow Through Day. About 25% of Follow Through Days fail, according to their statistics, and it is said that usually a failed Follow Through Day will fizzle quickly. Failure is defined by the day 1 low being taken out.  I’ve previously said that I haven’t done enough research on the Follow Through Day, and while this is still true there is no reason that I will not take Investor’s Business Daily’s research at it’s word, as they have done extensive research on the Follow Through Day.

Different Variations On The Follow Through Day

There have been variations of the Follow Through Day I’ve read from people that have worked with O’Neil, as well as those have their own take on the pattern based on the back-testing and optimization they have done. These include defining what a significant decline is; how much of percentage gain the index should actually have; what indexes count more than others; and how much volume need be present, besides just an increase over the previous day’s reading, among some other factor. I do my best to follow the “traditional” rules, but I can’t help throwing my own twist into the mix.

My Twists On The Follow Through Day

First, my definition of a significant decline is at least 20%. Some will argue that is too much to put as the threshold, while a rare few may say it’s not deep enough.  I think 20% is enough to get the media and most traders that actually follow the market enough to call it a down trend. It’s not an absolute number, and I’m not going to split hairs if the market only declines 19%, or has an obvious, good looking correction.

Second, I want to see price at the time of day 1 under the 200 day moving average, which with the type of decline for my first rule to be valid is usually the case.  A Follow Through Day is the ONLY time I have a bias to the long side when we are under the 200 day moving average. I don’t mess with stock market trends, and research has shown that taking long side trades below the 200 day moving average is a disadvantage to taking them above the 200 day. That being said, the Follow Through Day is an exception for my trading plan. I like to have day 1 under the 200 day moving average, because of the extra squeeze factor, if the Follow Through Day starts a big rally.

Third, I am skeptical of lows that aren’t a test, but lead to a Follow Through Day.  For example, on August 23^rd 2011, there was a Follow Through Day on the three major indexes. This was after the low and start of the bounce on August 9^th.  While we did come down and test the August 9^th low before the Follow Through Day printed, I like to see a Follow Through Day that is based on the lows after the test.  The chart below should explain this better. By skeptical, it doesn’t mean that I don’t count them as being valid, but I will be more cautious in my buying on probes back down, and will use other tactics for entries.  While this may not amount to much difference, the level of commitment is what matters.

Fourth, the Dow Jones Industrial Average cannot be the only index that is signaling the Follow Through Day.  I don’t use the Dow as a leading index, period. While it’s good for confirmation of the other indexes, if the Follow Through Day only shows on the Dow, I will wait. I must see it on the S&P 500 and/or the NASDAQ

I follow along with IBD in case there are any changes to what is the normal “recipe”, such as a bigger percentage gain or is the decline has been deep enough for their standards.  After all, since they did all the research and put the time in, why not use them as the authority on the subject.

In another article, I’ll discuss some ways to trade after a Follow Through Day signal, and how to build a watch list to use for stock selection.  In the meantime, in this book that I highly recommend, there is a good amount of talk about the Follow Through Day and how the rules can and do vary.

Trade Well,

Michael tiny Saul

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