In my last article, I made the case for relative measurement of market indicators. Rather than use the raw values for indicators to gauge the market, it makes more sense to compare the current values to a recent norm. On the TradingMarkets site, for instance, the VIX (VIX | Quote | Chart | News | PowerRating) is compared to its recent moving average and provides useful trading signals when it is elevated above that norm. Similarly, in my article, I found that relative price change--comparing daily price change to the median absolute value of daily price changes--provided a potential trading edge.

The reason for this is that people respond to events within their context. "Bear right" means something very different to a driver and a hunter. When we look at an indicator in its recent context, we examine the extremity of that indicator relative to its recent context--which is what traders are likely to respond to.

On my research blog, I have been tracking an indicator called Relative Range. Quite simply, this takes the range of a price period and compares it to the median range over the past 20-periods. This Relative Range measure tells us if volatility has expanded greatly relative to recent norms. It also signifies that the marketplace is shifting its definition of value, as market participants accept a wide range of prices during the day or week. A low Relative Range suggests that traders are accepting value within a relatively narrow band of prices; a high Relative Range reveals a lack of consensus regarding value.

It is during such low consensus periods, I believe, that markets are most likely to miss the value mark with overreactions, creating potential trading edges. For instance, as of the close on Wednesday, we had a five-day drop in the S&P 500 Index (SPY | Quote | Chart | News | PowerRating) of 4.3%. The Relative Range was a whopping 2.39, which means that the price range over that five-day period was more than double its median over the past 20 days. Since March, 1996 (N = 2551 trading days), we've only seen 36 occasions in which SPY has been down by 4% or more on a Relative Range of greater than 2.0. The market was up five days later on 25 of those occasions, by an average 2.31%. When SPY has been down by 4% or more but the Relative Range is less than 2.0, the next five days average a bounce of only .48% (50 up, 34 down). Note that the average five-day gain for the entire sample is .17%.

Large drops on large relative ranges are rare, but seem to be associated with favorable odds of a bounce going forward. Since March, 1996, when we have a single day decline of more than 1.5% and the Relative Range is greater than 2.0 (N = 49), the next day in SPY has averaged a gain of .55% (30 up, 19 down). When SPY has declined by more than 1.5%, but the Relative Range is less than 2.0 (N = 180), the next day in SPY has averaged a gain of only .15% (99 up, 81 down). Again, note that the average one-day gain for the entire sample is .03%.

In short, I believe that large drops on large relative ranges represent market overreactions, which tend to correct themselves in the near term. This creates short-term trading opportunities for the intrepid trader. It would be interesting to see if the pattern of bounces following large declines on large relative ranges also applies to intraday time frames. The fact that it has produced a solid edge for over ten years of market history--embracing bull, bear, and low volatility conditions--is impressive.

Brett N. Steenbarger, Ph.D. is Associate Clinical Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical University in Syracuse, NY and author of The Psychology of Trading (Wiley, 2003). As Director of Trader Development for Kingstree Trading, LLC in Chicago, he has mentored numerous professional traders and coordinated a training program for traders. An active trader of the stock indexes, Brett utilizes statistically-based pattern recognition for intraday trading. Brett does not offer commercial services to traders, but maintains an archive of articles and a trading blog at www.brettsteenbarger.com and a blog of market analytics at www.traderfeed.blogspot.com. His book, Enhancing Trader Development, is due for publication this fall (Wiley).