The question came up yesterday about the technical formation known as an "outside day."
An outside day occurs when one day’s high is higher than the previous day’s high, and its low is lower than the previous day’s low. This is often taken as a signal that the market is about to make a move in the direction of the close.
However, negative outside days are less than a conclusive formation, according to the Encyclopedia of Chart Formations (Bulkowski). The expected response to an outside day with a downside breakout (like yesterday’s) — more selling — has a 42% failure rate.
That’s rather inconclusive.
Bulkowski did a study of 510 outside day formations in 51 stocks over 5 years. He found the pattern, at least for individual names, was fairly common. The stocks failed to move in the predicted pattern 4 out of 10 instances. A pattern is considered a poor predictor if it fails 2 out of 10 times. So the outside day with a downside breakout turns out to be little better than a 50/50 predictor — a toss of a coin.
Some surprising tidbits: The best performing (negative) outside days turn out to be those with lower volume; Yesterday’s volume (even backing out Sirius Radio) was high.
Also, the smaller the formation, the more powerful. Tight outside days with an upside breakout are like coiled springs; The data was inconclusive regarding downside breakouts.
Nasdaq’s recent action (before the outside day) does show heavy churn, suggesting a tiring market. That is consistent with yesterday’s conclusion that additional consolidation and backfilling is required before the next significant leg up.
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