The Close, lesson 1: The idea and the research behind it
The idea behind the rule, the public research it comes from, and what our own tests found, including where the edge is thin.
The idea is simple. In an uptrend, an index that falls sharply has tended to bounce soon after. The rule turns that into one decision a day: it buys the dip, and gets out on the first strong close.
Rules
- Trade with the trend. The rule only buys when the close is above a long-term average.
- Turn “sharp” into a number. A short-term momentum reading measures how fast and how far price has just fallen, so the rule can test it.
- Say how the trade ends before it begins. The rule exits at the first close back above a short-term average.
- Decide once a day. The rule is long only and holds one position at a time. It has no stop, which is why lesson 6 is about size.
What the evidence says
The rule is not ours. It comes from published research on short-term pullbacks, from 2008, and we took it as published, with no tuning. We tested five documented timing rules for owning an index, on the four big index ETFs (SPY, QQQ, DIA and IWM) from their launch, after costs, and we registered the test before the data was fetched. Only this rule passed.
| Test | Average a trade | t |
|---|---|---|
| Four index ETFs, 897 trades | +0.455% | 5.60 |
| NQ futures, 203 trades | +38.8 pts | 3.30 |
| ES futures, 196 trades | +13.6 pts | 4.32 |
ETF figures are after costs and T-bills. The ES history is chained, so its result is provisional. The t figure is the average divided by its own noise: the higher it is, the less luck explains the result.
Two cautions. On the ETFs, the edge since 2010 is about a third of what it was before, and no single index clears t 3 over that stretch alone. On NQ the profit factor, total won divided by total lost, held up: 2.34 since 2010 against 2.27 over the whole history. But 2010 to 2019 was a thin decade, and lesson 7 shows it.
The three data sets cover many of the same days, so they are not three independent tests. The rule is long only and has no stop in the tested form, so a crash that starts during a trade is taken in full.
Hypothetical results1, not actual trading. The full statement is at the end of this page.
Exercise
Open a daily chart of an index ETF and add a long-term average and a short-term average. Find five dips inside an uptrend: price above the long average, then a sharp fall. For each, note how many days passed before the close was back above the short average, and whether price kept falling first. Write down what you expect before you look.
The pointIn an uptrend, a sharp fall has tended to bounce soon after; the rule buys that dip and gets out on the first strong close.
Check yourself
The index has been falling for weeks and now closes below its long-term average. Then it drops sharply. What does the rule do?
- Buys, because the fall was sharp
- Nothing: it only buys when the close is above the long-term average
- Sells short, because the trend is down
Answer
B. The rule trades with the trend: it only buys when the close is above a long-term average. It is long only, so it never sells short.
The rule passed on four index ETFs, on NQ futures and on ES futures. Why is that not three independent confirmations?
- The three data sets cover many of the same days
- The futures tests were tuned after the ETF test
- The ETF tests left out costs
Answer
A. The three data sets cover many of the same days, so they are not three independent tests. The rule was taken as published, with no tuning, and the ETF figures are after costs.
A trade goes against you right after the buy and keeps falling. What limits the loss?
- A stop just below the entry
- Selling as soon as the trade shows a loss
- Only the size you chose, because the rule has no stop
Answer
C. The rule has no stop in the tested form, so a crash that starts during a trade is taken in full. That is why lesson 6 is about size.
Next: Why the money is made overnight
Education only. Nothing here is advice about your account.