The Nasdaq and the Four Day Corollary

06/05/03 09:47:33 AM

by David Penn

The only thing more amazing about the Nasdaq's rally since March is that it hasn't featured more than four consecutive up days.

Security: $COMPX, NQM03
Position: N/A

Not having more than four consecutive up days in a market advance spanning a few months or more is not necessarily a rarity. Actually, those who thought there was no reason for stocks to be rallying as powerfully and thoroughly (i.e., in volume and breadth) should know that the absence of too many consecutive up days is actually a sign of strength in an advancing market. A down day every few sessions in the course of market advance tends to reflect broader participation in the rally (more good opportunities for entries and exits), as well as tamping down the sort of groupthink optimism that bull markets inherently (if eventually) engender.

The March 2003 rally in the Nasdaq, which saw the average climb more than 29% from mid-March to early June, may be a poor example of any "tamping down" of optimism. But it may be an excellent example of what can happen when a market that has been in an uptrend for an extended period of time, experiences a similarly extended series of consecutive up days--and then has a down day.

Does the reversal day following a series of consecutive up days late in the advance anticipate an actual reversal in trend?

Graphic provided by: TradeStation.

What I'm thinking about is a pattern recognition tool presented by Victor Sperandeo in his excellent book, Trader Vic--Principles of Professional Speculation. Sperandeo refers to it as the "Four Day Corollary" and this corollary suggests that whenever a market in a mature trend (he admits that this much of the corollary is relatively subjective) has four or more consecutive days in the direction of the trend, the first day that is against the trend tend to anticipate a loss of momentum and a possible reversal of trend. Like many of Sperandeo's pattern-based set-ups, the Four Day Corollary is oriented around spotting and seizing advantage of reversals and, thus, strict money and trade management are required. But also like many of Sperandeo's set-ups, the possibility of catching a market at its peak or bottom makes the Four Day Corollary--at a minimum--another effective analytic tool that technicians can add to their arsenal.

In the case of the Nasdaq in early June, there is the first (and only) instance of more than four consecutive pro-trend days. In fact, there are seven consecutive up days leading to the reversal day on June 2nd. The Four Day Corollary here would suggest selling on the reversal day (or, alternately, beneath the low of the reversal day), with a buy stop just above the high of the rally--which, in this case, is the high of the reversal day.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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