The 50% Rule

Fundamentals of Market Investing by Adam J. McKee

The fifty percent principle predicts that an observed trend will undergo a price correction of one-half to two-thirds of the change in price.  This means that if a stock has been on an upward trend and gained 20%, it will fall back 10% before continuing its rise.  This is an extreme example, as most times this rule is applied to the short-term trends that technical analysts and traders buy and sell on.  The idea is that if you can “call the bottom” of a big decline, you can buy the stock and sell it after it goes back up about half of the amount that it dropped.

Adherents to this strategy believe that this correction is a natural part of the trend.  It is thought to be caused by apprehensive investors taking profits in order to avert being caught in a true reversal of the trend.  If the correction exceeds 50% of the change in price, it is considered a sign that the trend has failed and a real reversal has come.  As you can see, this strategy is appropriate for short-term trading if you can make it work at all.  Because you have to closely watch the charts in order to detect the buy and sell signals you are looking for, you would have to be a professional day trader to make the strategy work.

This strategy depends on what statisticians call autoregression.  If the EMH is correct, this strategy will not work over the long haul, and the coin toss probabilities will eat away any gains you may garner via luck.  Professor Shiller has demonstrated (to my satisfaction at least) that a random walk fits the historical data better than the autoregressive model which would allow us to profit from a dependable regression to the mean.  I firmly believe that market prices will refer to the regression line, but you could wind up waiting for decades.  If there were an edge to be had from this strategy, it would apply only to day traders using stop-loss orders to control the size of “wins.”

[ Back | Contents | Next ]


Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.