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5% Rules! How Can We Be So Right? (Members Only)

While I love a good Ouija board as much as the next guy, I'm not big on TA.

What I am a fan of is the law of large numbers, fundamental analysis, freakonomicschaos theorypsychohistory and crowd psychology – all in the elusive search for the objective truth, which I have on good faith is 42

Surprisingly enough, based on this outlook, I get a lot of consulting work and sometimes that consulting work led me to consult on trading systems and that led me to figuring out a very useful system for predicting the move of the markets without charts (though I'll use them to illustrate points) and without all the silly fuss that TA guys make about their "craft" (sorry Dave). 

The 5% Rule does NOT tell you which way the market is going.  It does tell you where the resistance points will be.  Of course, knowing that and knowing what kind of bounces to expect and knowing where a proper breakdown or break-out occurs is kind of useful and, when it coincides with the tea leaves that are read by the "real" TA guys – you can really have something good to go by! 

Unfortunately, the 5% Rule is not really a RULE because it requires a cynical background in statistics, especially regarding aberrant values or "outliers" and a general understanding of market history as well as current market events because all need to be taken into account in order to give you accurate "consolidation levels" from which we base out chart movement. 

For example, not to get too into it now but a while ago I pointed out that our V-shaped recovery on the S&P, etc. wasn't all so impressive if you consider that the drop from 800 to 666 was simply a panic spike and was not statistically relevant.  That means that the S&P is not up 80% at 1,200 but is, in fact, up 50% off what we call the "non-spike" floor at 800 after topping out at 1,576.09 in October of 2007:

There are a lot of things going on here but I wanted to impress on you that they are, to a large extent, the same thing!  The Fibonacci series, which is a study of regressive sequencing that incorporates elements of chaos theory, statistics and the law of large numbers and tends to work very well when studying market movements.  Without getting too off topic, the key point is you can expect to hit resistance points between two significant points (like a high and low) at 23.6%, 38.2%, 50% and 61.8% due to a tendency of larger and larger sequences to converge towards a mean.  Suffice to say it works well enough that most charting programs include the tool…

Our 5% rule is fairly simple.  We expect major market moves to trigger in 5% blocks.  Why is this?  Because all the clever programmers and all the captains of industry and all their little consultants all get together to design the ultimate trading system but they all end up rounding off here and rounding off there and, ultimately, the decision to push the button comes down to a person (or, even worse, a group) who then end up being affected by psychological resistance points as well as the usual mob psychology that dominates the markets.  The reason Goldman's trade-bot is able to convert winning days 93% of the time is they are NOT trying to do any of these things – they are simply inserting themselves in the middle of a transaction to swipe pennies – that's not trading but it sure is profitable! 

MOST market participants actually buy stocks and they try to buy low and sell high and they have profit targets and stop losses, etc.  Over 1/2 the funds playing the market rely on various TA methods for entry and exit points and many funds use Fibonacci series in their calculations so it all becomes a self-fulfilling prophesy.  We take advantage of that by effectively averaging out the results which gives us a general rule that stocks tend to move in 5% incriments before a 20% retrace (keeping in mind that Fibonacci looks for 23.6% so it's an "about" number). 

The more liquid something is, the smaller the 5% Rule breaks down so when I say "the 2.5% Rule" or the "1.25% Rule" or the "20% Rule," it's all the same rule.  What becomes critical is the bounce zone.  If we're watching a movement, like the S&P drop above, we see a floor forming at 1,240, which we expect at 20% below the consolidated top at 1,550.  We also expect a 20% bounce at least as a weak bounce while a strong bounce is a 50% retrace but neither one violates the trend.  As the S&P is a large index, we got first a strong bounce, retracing 1/2 the 310-point drop from 1,550 to 1,240 and back to 1,395 and you can see that we consolidated there, then fell back to 1,240, consolidated (not bounced) there, then bounced 20% back to 1,302, then broke 1,240 and plunged to our doom. 

How far did we plunge?  Just about 25% to 930 (another 310 by the way) before weak bouncing to our expected test of 992.  20% bounces are a sign of weakness, not strength!  In the 5% Rule, 10%, 20%, 25%, 40% and 50% tend to be the strongest turn indicators – 10% because a lot of pshychology kicks in, 20% and 25% because they straddle the first Fibonacci level at 23.6% and then 40% and 50% are also close to Fib levels at 38.2% and 50%.  Never mistake the 5% Rule for an exact science, we are looking for consolidations around those points and we are very happy to throw out our targets in favor of exact numbers, like 800 on the S&P rather than 813.75, which is the 12.5% decelerating leg we expect if things are going to turn around.

So the gravity of a big number like 800, especially when it's nearly 50% off the top, trumps our expected 813.75 line but I tend to use both and look for strong intersections that line up from two points.  It's also important to note that a 20% move off the bottom will NOT get you halfway back from a 40% drop from the top so, again, we need to look for intersecting points and defer to Fibonacci as well as psychological levels in those areas.  Still, we got out 12.5% drop, which was 1/2 of the 25% drop and then we're looking for 3 bounces:  A bounce of 20% is always expected and anything less than that (non spike) means we're weak and probably legging down.  A bounce of 50% is strong but no consolidation and falling back below 50% means at least a re-test of the 20% bounce

For the S&P at 800, we're looking for a 20% bounce off 775 (real support from 1,550) back to 930.  Since 930 was already a magic number on the way down, we are very excited to see it coming into play on the way back up as that makes it "significant."  And, of course it's significant, it's a 20% long-term bounce off a 50% drop of a major index!  Also, our last drop from consolidation was from a 1,300 top to 800 (38.5% Fib series) and that's an expectation of a 100-point bounce back to 900 and then we expect a bounce off our fall from 930 to 800 and that's 26 points back to 826.

As you can see, we bounced back hard to 930, consolidated there but failed, then found some support at 826, made another run that failed at the halfway mark between the two and then fell about 25% more but came back exactly as fast as we fell so we can ignore the whole thing (although that's hard to do while you are in the middle of it, isn't it?). 

You can see on the way back up how nicely everything lines back up and we have multiple lines of convergence in this zone as the 50% move up from 800 is 1,200, the 20% drop from the 1,550, non-spike top is 1,240 and the 38.2% Fib level is 1,228 so you are in for a slog around that zone and we need consolidation there in order to break back up.  That's why I was not at all impressed with anything that didn't end up with the S&P over 1,200 – that's still 40 points shy of showing proper strength and, of course, fundamentally, I don't see that the market is "worth" 80% of what we were at the top at the moment. 

So, 5% Rule is VERY useful for long-term planning.  What about short-term?  Hopefully we've establised that 1,200 is our consolidation point for the S&P and, if that's true, then we can expect that a 2.5% move up or down from there would be significant and even a 1.25% move should hold some weight.  Those levels around 1,200 are 1,230, 1215, 1,200, 1,185 and 1,170 so, if 1,200 is our mid-point, we'll be looking to see where we're getting resistance and which side of our series the index is trending to:

See – this isn't hard (other than the fact that I accidentally used 1,218)!  Also note that our last consolidation point at 1,100 would have had a 5% series of 1,155, 1,114, 1,100, 1,073 and 1,045 and you can see how that range worked out on the chart.  The funny thing about 5% Rule numbers is that we could have written these numbers down in 2008 (I did!) if someone wanted to know how far the markets would fall and where we were likely to recover to. 

So what lies ahead?  Most likely a retrace back to 1,100 (25% of our run) but if that holds and we consolidate a bit, I will be downright bullish.  I will also be impressed if we hold 1,145, which was our last breakout line but, for now, we have a 3.75% drop from 1,218 but a poor bounce yesterday indicates we are likely to get down to a 5% pullback from 1,218 to 1,157 and not holding that is going to be nasty.  For now, we have the rising 50 dma and the 2.5% line at 1,170 so VERY BAD if we can't pull a bounce together here.  We'll call it a 50-point drop from 1,220 and figure a 10-point bounce to 1,180 would be lame (a very important 5% rule term) and 25 points, 1,195, has got to be retaken before we get all impressed with a "rally."

Consider this a work in progress.  Let's keep all 5% Rule quesitons on this post and, over time, hopefully I can refine my explanation as this is pretty much the first time I've tried to lay it out.  Like all "systems," it's important to pick one that fits the way you think.  This one is perfect for the way my brain is wired as I can do these numbers in my head as soon as I look at a chart so it let's me know if a stock or an index is "behaving" itself or not.  That last bit is an important point – no matter what system you have, there are going to be some things it works on and some things it doesn't.  DON'T force your system on a stock – find stocks that work with your system and you'll both be happier! 


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  1. Stranglers/TOS:
    I talked to two guys on the margin desk last night about the margin changes. I’m just happy that there are now clear rules that apply to everybody and that the rules are implemented in the TOS software. I suspect there’s still good money to be made on SPX strangles with these stricter margin requirements.

  2. FAS is showing a drop to $31. this am. Some kind of mistake?

  3. Great stuff, Phil. Thanks for your insights.

  4. lol! I’ve been wondering where you’ve been coming up with the numbers you’ve been talking about for the past couple of weeks – now I know, even if I don’t understand. As an epidemiologist, and therefore a second-rate statistician, I’m amused by the need for "a cynical background in statistics" – I’ve got that! And I’m shocked that you didn’t include the famous Sydney Harris cartoon "This must be Fibonacci’s". Look it up.

  5. sorry about the mess above

  6. thanx Phil, great stuff,
    just to clear up: if bounce only 20% – very high probability of another leg (2.5 or 5%).  If 50% bounce – high chance to test low but high probability that price will stuck in this range or even change direction
    did I get it correctly?
    Now how do you play it??? could you pls explain how you use stops ( hard, mental, trailing) when you play this bounce,  and if it possible with examples explain your rule 3 of 5 and how you use volume for this

  7. judahbenhur 
    Phil/5% rule.  Just got around to reading your morning’s 5% rule post.  As the recent top of SPX was 1219 and 5% down from 1219 is 1158, where did the ball bounce off this morning?  1158, of course.  Scary accurate.  It sure makes a believer out of me that the bots are programmed to buy at 5% down from a recent top.   Wish I had read the post before the day’s trading instead of after.  To me, the chart is looking a lot like the chart from late Jan-early Feb, a 5% drop, a pause, another 5% drop and a rapid rebound.  So, we’ve got the first 5% drop, maybe now a pause and down to 1097, perhaps by the end of next week.  Great stuff.

    5%/Judah – Here’s where we’ll have to refine my rules over time as I figure out how to explain it.  There are big and small 5% moves.  The big one we’re tracking, is off the consolidation at 1,200 and we expect a 2.5% drop to 1,170 and from there (as with any 2.5% move) we expect a 20% retrace back to 1,176.  Anything less than that is a very weak bounce and anything less than a 50% recovery (1,185) will leave us very skeptical of any move up. 

    Yesterday was very telling as we topped out right at 1,176, so our "weak bounce" was a strong top.  We also got that indication on Monday as we bounced along the zone between 1,170 and 1,176 and finishing in the bottom 20% of the 2.5% Rule is a strong indication of follow-through the next day. 

    Now let’s look at follow-through.  I look for accelerating or decelerating (where does that other "c" go?) behavior in our follow-through days.  If there is a 5% move – that’s tragic and often means there is much more to come.  Less than 5%, especially less than 2.5% indicates that there are plenty of dippy programs coming in at that spot and we expect less of a follow-through than we do at 5%.  In either case we’re looking for a drop to fall off 50% per day until the next test bounce is passed. 

    Normal deceleration from a 2.5% drop is 1.25% the next day, that would have been another 15 points, down to 1,155, which we didn’t quite make in the morning. 

    Now, here’s where you can get a headach as we have to consider more converging lines…  In addition to the 2.5% line at 1,170 and the bounce line at 1,176, we now have the 3.75% line at 1,155 AND the mini bounce line off that day’s move (-15) at 1,158 (which we did bounce off) AND the 20% bounce off the 3.75% move from 1,200 to 1,155 (45 points) to 1,164. 

    Since the weak bounce of the 1.25% follow-through held as a bottom and we broke the weak bounce off the anticipated 3.75% drop then we now have 2 reasons to think that the 3.75% line is not going to be in play.  Of course, I don’t go crazy with predictions at the end of each day on those things because a single day’s move never means anything but it’s the pattern we want to watch today. 

    So this morning, when I say that we need to clear 1,176 as a key move up on the S&P and we will get more bearish if we blow 1,158, watching 1,155 to confirm a breakdown - you’ll know how I pulled those numbers out of my ass!  If those lower numbers hold and I toss in a bullish play – you’ll also know why.  Of course, keep in mind I don’t fixate on these numbers, in fact, I don’t even write them down or do the calculations usually but I know what I expect to see – as I said in the 5% rule post, the system works for me because it fits the way my brain thinks and I have an easy time "seeing" the fractional relationships so this "system" is not a distraction from what I really like to do, which is research the fundamentals.  If I had to sit here with a calculator or worrying over a spreadsheet all the time, I probably wouldn’t bother because I still firmly believe fundamentals triumph over all (eventually) but, in the short run, it’s good to know what the TA guys are doing and this is a big help for that!

    As you know, I tend to personify market actions as it helps me clarify my thinking (and writing).  To a large extent I think of the whole thing as a huge chess match with all the various players in whatever positions and this particular item, to me, is like a little tug of war between the bullbots and the bearbots and WHEN we see our resistance points being obeyed on decent volume, THEN we have a pretty good idea we have reached a critical point of contention and then it becomes more interesting to look for signs of a winner or a loser in that competition and that’s where our levels do the most good.  That’s why the 5% rule is most effective after a period of consolidation – when the bullbots and bearbots have both played their hands and we have a clear indication of where the battle lines have been drawn. 

  8. Phil,
    New Buy List Ideas (?) : US water co.s w/  growth prospects, decent div. yeilds, low beta but tradable, & outperform ratings : NLC,  WTR,  CWT,  AWR          see Seeking Alpha /  David White  4/4/10

  9. finally read this – been an open tab for a while.
    just wish i had read it earlier.  still, better late than never.