Stock Market Breadth Cycles
Simple Market Regime Filters
A breadth cycle is a unique way of measuring the health of the market environment based exclusively on market internal data.
We calculate two cycles, one for active traders, and another for longer term position traders.
Cycles are broken into three zones: green, yellow and red, corresponding to the underlying health of the market.
The following chart shows our long-term breadth cycle overlaid on the S&P500 in 2015:
Why should we care about breadth and these cycles?
Market breadth is important to monitor because it helps us measure the quality of the market environment using the total number of individual stocks participating in a move.
It can offer crucial insights of divergence and confirmation at key market inflection points as well as issue warning signs of dangerous price action before volatility arrives (like our 2016 example above).
This is information that cannot be obtained from simply looking at a price chart of the major indices.
If you're someone who monitors market breadth already, then the benefit of our cycles is that they aggregate a handful of different data sources into a, single, actionable, and easy to understand color coded cycle.
It does all this, accurately, and completely systematically.
The following chart shows our short-term breadth cycle overlaid on the S&P500 in 2016:
What do the colors represent?
They represent different market types:
- Green: a healthy bullish environment, good for long exposure and upside momentum.
- Yellow: some warning signs present, but mostly chop and mean reversion to be expected.
- Red: a weak market environment, vulnerable to lower prices and downside momentum.
The scale of these conditions depends on what cycle length you're looking at. The short cycle, on average, is reflective of the next 3 to 10 days, while the long cycle represents a month or longer.
The following chart shows our long-term breadth cycle overlaid on the S&P500 in 2008:
How are breadth cycles calculated?
Calculations are currently based on the following market breadth data:
- Advance decline line.
- Number of stocks making new highs and lows.
- Percentage of stocks above moving averages.
Price action is not an input into either cycle, I simply overlay them over a SPY daily chart for illustration purposes.
The following chart shows our long-term breadth cycle overlaid on the S&P500 in 2014:
How can breadth cycles help me trade?
Cycles help you quickly make sense of current market conditions.
They'll give you a higher degree of confidence when there is bullish, bearish, or no momentum, so you can better align/prepare yourself to take advantage of the environment type.
They also have a good track record of spotting divergences at key inflection points which can lead to great risk/reward trade opportunities.
Other common use cases I've found are:
- Setting market/trade expectations.
- Guiding your overall market exposure.
- General market direction.
Cycles should not be used as an independent trading system or relied upon as stand-alone timing signals to enter and exit the market. They should be used as a filter to classify a constantly changing market.
How Evan uses breadth cycles
Very simply, these cycles help set my expectations about the current market environment.
My setups and strategies have their own independent buy and sell decisions, and the cycles help me:
- Determine overall market exposure.
- Influence what kind of trade setups to look for.
- Confirm periods of momentum.
- Shape individual trade expectations.
Here's a short video showing how they can assist in spotting trade opportunity:
How I use the long-term cycle
When it's green, I want to increase my 'baseline' long exposure because I'm more confident we're in a structurally bullish environment. I view pullbacks in the market as an opportunity to position long not short weakness.
When the long term cycle moves into yellow or red territory, it generally means we're in a more uncertain environment, and I prefer to focus on short term tactical swing trading.
How I use the short-term cycle
When it's green, it suggests upside momentum is building and I'll more confidently trade breakout setups, hold for bigger targets, and in general, have more long exposure.
When the short cycle moves into red territory, I will not put on any new long trades for the first couple of days and my expectation is that sellers are in control with some downside momentum building.
Get Access to Market Breadth Cycles and our Market Health Dashboard
Cycles are included free in all premium memberships at The Trade Risk.
If you're not interested in a full swing trading service, then we also offer a stand-alone option below.
Questions? Contact Me.