Sperandeo Analysis

Sperandeo Chart Analysis

Based on the books 

Trader Vic:  Methods of a Wall Street Master and 

Trader Vic II:  Principles of Professional Speculation by Victor Sperandeo
[Note:  I will refer to the second book in citations as "II"]

I have long been an admirer of Vic Sperandeo, after reading about his methodology and astonishing track record in Jack Schwager's excellent book Market Wizards. 
After reading the two books by Sperandeo cited above and applying a number of his ideas over the years, I must admit that the simple 123 Trend analysis is hard to beat for understanding and responding to markets.

123 Trend Analysis

Vic Sperandeo's definition of a trend change is a 1-2-3 process (I will present here a change in trend from up to down, but the same process (reversed) applies to market bottoms):

    1.  A properly-drawn trend line is violated.   A properly-drawn trend line connects all the lows for an uptrend or all the highs for a downtrend) Since this may occur many times without a trend change, in and of itself this is not significant unless:
        - the market gaps across the trendline;
        - the volume of the gap across the trendline is very high; or
        - both. 
    2.  The market rallies but fails to make a new high.   (A variation allows the market to make a new high but then quickly reverse.)  That situation is found at point 2 (also B).  (This is not a necessary part of a trend change, however.)
    3.   The market closes below the lowest low made AFTER breaking the trend line but BEFORE the market attempted (and failed) to form a new high.   Step 3 confirms the change in trend.

 
    [I find the easiest way to envision this is as an upside down W:

Sperandeo adds an extra twist, advocating that a trader NOT wait until step 3.  Instead, assume a direction change on what he calls a "2b" meaning as soon as it appears the market has failed to make a new high, or better yet, has exceeded it by a point or two, then reversed below it.   This is difficult emotionally to do, since many true breakouts may look like 2b tops but the risk-reward profile is excellent.  You could go short and get stopped out (placing you stop just a few ticks above the high) several times and be right only once to make a lot of money.  Plus, if you are trading options, volatility for puts is often lower when the market is surging to new highs, or seems to be. 

So if you have a long position, you should be very aware of the last high the market made.  If the trend line is violated, watch to see if the market stalls at or just above or below that high.  Consider exiting or going short if the market fails to exceed that high, with a stop just above the high. 

Some useful corollaries:  

   - gap across trendline means a probable change of trend has occurred; 

The gap rule is simple; when you have a gap above or below a trend it indicates an important change (news and/or fundamental) and probable change of trend. Under this rule, you no longer need a test or a 2B.  The gap must break the trend line, however, to make this rule valid.  - II p. 168

   - reversal above 3 day high or below 3 day low - take position

The high-low 3-day rule uses the intraday high and low of the preceding three days.   When a reversal occurs, to the extent that it goes above or below a 3-day high or low, you go long or short.  You use the high or low of the third day as your stop, and if that stop is hit, you then reverse your position...  Please note that these two rules [the gap rule and 3-day rule] can but used only in conjunction with another confirming principle.  [168]

Fundamentals

Sperandeo emphasizes that he is far from a pure technical analyst.  In fact, in general, he expresses skepticism for chart analysis that deviates far from simple trend line analysis and is not combined with some fundamental awareness.  

Remember fundamentals!

200 day Moving AverageSperandeo advocates following the 200-day moving average as an indicator of long-term market trend.  Buy if prices are above the 200-day, sell if below.  

4 day rule 

If the market reverses 4 days down or up, the odds of trend change are high.  In other words, if the market is in an uptrend and declines for 4 or more days in a row, the trend has probably changed to a downtrend.  

Four-Day Corollary
After a long move of intermediate proportions, when you have a 4-day (or longer) sequence in the direction of the trend, the first day in the opposite direction often signifies the top or bottom and a change in that trend. [160, II]

  -25% of intermediate highs or lows were immediately followed by a 4-day sequence in the direction of the new trend,
  -41% were followed by a 4-day sequence within 6 days;
  -75% had a 4-day sequence in the first 24 days. 
  - only 10% of the intermediate moves didn't contain a 4-day sequence in the direction of the trend. 
       - page160, II, emphasis added

5 day rule

If market climbs 5 days in row at end of an extended move, the odds of market reversing are high.

Sperandeo Checklist

Fundamentals - don't use tech alone!

Determine odds of bull market continuing (Sperandeo created extensive bull market "life expectancy tables" which he presents on page 135, Table 9.2 of II).  Of all bull markets he has studied:

• median advance = 78%
• 25th %ile: 50%,
• 75^th %ile: 110%

Example:  let's say we are in a bull market that has advanced 50% and is showing signs of stalling.  Sperandeo's work (published in 1994, so obviously not reflecting and market behavior since then) would indicate that the odds are 3:1 that the bull market should continue based on its extent alone which he never uses in isolation.  Why?  because the 25th percentile of all bull market advances is 50% (where we are in this hypothetical situation) which means that 25% of all past bull markets only advanced this far, whereas 75% advanced farther.   Other interesting findings:  if a market has doubled, advancing 100%, this does not mean that one should automatically take profits and lighten up, since one-fourth of all bull markets advanced farther than 110%, so although the odds are growing longer (3:1) against the market rallying beyond this point, it is far from rare for this to occur.

[Editor's note:  Sperandeo uses these tables in a somewhat idiosyncratic way.  What an investor or trader is really interested in is not the percentage of all markets but the probability of a market that has advanced x% already advancing another y%.   This is a different proposition (technically, it is called Bayesian probability, the probability of one thing occurring given that we know another thing occurred) and gives some counterintuitive results.    Since markets spend most of their time in trading ranges, moving back and forth with little net movement, and most advances or declines are concentrated in spurts that usually catch most people by surprise, looking at averages or even percentile distributions could be misleading.  Put another way, although most markets do not advance beyond 110%, I would wager that those that do have a higher probability of gaining another 20% than markets that have NOT gained this much.]

The odds of a correction continuing were also worked out based on his studies presented on page 133, table 9.1 of II).  Of all corrections:

• median % retracement = 50%
• 25th percentile: 36%, 
• 75th percentile: 72%