Spark Global Limited reports:
How to Classify selling
When it comes to market sell-offs, the first step is to categorize what we mean by sell-offs.
Your definition should vary depending on your holding period and time frame, but we need to be consistent.
Here are some ideas on how to classify the severity of market moves:
Multiple of a decline in ATR over a period of time (i.e., “a three-fold decline in ATR in three days constitutes a sell-off”)
Price moves to lower bands (Bollinger band, Keltner Channel, and VWAP band can all provide this feature).
The standard deviation
The easiest way for me is to measure it in terms of standard deviation or ATR.
There are many tools that can help you do this, whether it’s technical metrics, but a straightforward way is to plot +/- 2 or 3 standard deviations around the linear regression line.
This method is popular among mean reversion traders.
Here’s an example:
One disadvantage of using this indicator is that it does not take into account volatility as bollinger’s band does. As always, it’s a trade-off.
Using the VIX can be risky because it and other VIX indices may not be accurate representatives.
For example, in the latter stages of the most recent post-coronavirus rally, the VIX and stock indexes rose simultaneously.
So while historically there has been a strong negative correlation between the two, when option premiums start to rise, they get misaligned regardless of what the market is doing.
The percentage decline does not take into account the overall level of volatility in the market.
In addition to tools that give specific readings, simple analysis of price movements is enough to read between selling, random market noise and pullbacks.