What Does A Follow Through Day Mean In Trading?
As a stock trader, you may likely have asked this question several times: “How do you identify a stock rally?” That might have been the question that led William J. O’Neil to develop the concept of a follow-through day for identifying the onset of a rally after a downtrend or market correction. But what does a follow-through day mean in trading?
A follow-through day is a key concept in the market-timing system designed to help you identify a change in general market direction from a downtrend or market correction to a new rally. A follow-through day occurs during a market correction when a major index closes significantly higher than the previous day, and in greater volume. It happens on Day 4 or later of an attempted rally.We backtest follow-through days on the S&P 500 index.
What is a follow-through day?
Developed by MarketSmith founder, William J. O’Neil, who developed the CANSLIM method, the follow-through-day concept is a key concept in the market-timing system. It was designed to help investors and traders identify a change in general market direction from a downtrend or market correction to the next uptrend. A follow-through day occurs during a market correction when a major index closes significantly higher than the previous day while also having a greater volume.
A follow-through day only happens after the market hits bottom, and it confirms that a new market uptrend has begun. Leading up to the follow-through day during a downtrend, the market often makes several attempts to rally, with a major index closing with a gain. The rally attempt remains intact as long as the index doesn’t make a new low, and most times, the follow-through day happens on Day 4, or later, of an attempted rally.
To identify a follow-through day, here is what you do: When a market correction, or even a bear market, is in play, you should look out for any day on which one of the major equity indexes, such as the Dow Jones Industrial Average, the Nasdaq (QQQ), or the S&P 500, gains in price compared to the day before. That day with price gain counts as Day 1 of an attempted rally.
Over the next two days, that index must not fall below the low on Day 1 — as long as it stays above that level, the rally attempt is still alive. By Day 4, or later, of that rally attempt, a follow-through day will occur, and it is characterized by one or more of the major market indexes making a big gain in price and volume, which is higher than it was on the previous day. The occurrence of a follow-through day confirms a new market uptrend.
Ironically, when a follow-through day occurs in the stock market, indicating that a new uptrend is underway, many individual investors who should be aiming to make money from growth stocks tend to remain skeptical. The negative reaction is not surprising anyway, since a bullish follow-through signal comes after a period of bearish sentiment in the market.
Follow-through day – backtest, example, and analysis
Based on the text further down in the article, we backtest a follow-through day / strategy like this:
- The first day must close higher than the close yesterday.
- Day 2 and 3 must not have a low lower than day 1.
- On the fourth day, the gain is at least 0.75 of the 25-day average of the H-L.
- If 1-3 are correct, then buy at the close.
The first column shows the number of days until you exit. For example, the row number “5” is the result and strategy performance metrics by holding the position for five days and then exiting.
The result is not good. The reason is simple: the stock market has over the last three decades been very mean revertive, and thus it’s much better to buy on weakness (a follow-through day buys strength). However, this is for the short term. In the long term, the stock market trends up. Moreover, O’Neil, the inventor of the follow-through day, is not a market timer nor an index trader. O’Neil focuses on stocks and the results might be somewhat different if we backtest on individual stocks.
The results improve slightly if we include a filter, for example, the 25-day RSI should be lower than 55 (to limit buying strength).
Understanding follow-through day
Before we go ahead to break down the follow-through day, let’s consider a question that may be bugging you: What is a trading day in stock? Well, a trading day is a day that a particular stock exchange is open for trading. So, it excludes weekends and market holidays when the market is not open. A follow-through day is a full trading day, not some 4-hourly trading session.
Back to our explanation of the follow-through day, the equity market often moves in a cycle: an uptrend is followed by a downtrend, which is then followed by another uptrend. In an uptrend, there will be many market corrections, which are usually about a 10% decline in market value that occurs over a few weeks or months. Since the equity market is mostly in an uptrend, most downtimes you will encounter in the market are corrections.
As an investor or trader, you want to know when a market correction or downtrend has bottomed. That is what a follow-through day can show you, and interestingly, you don’t need a bunch of complicated indicators — you use just the price and volume data to identify it. A follow-through tells you that the selling has likely ended and the market has started a new uptrend, so it’s a green light to start buying leading stocks once again.
Here is how it works: after a long, hard sell-off in a market correction or an outright bear market, start monitoring the market index (Nasdaq or S&P 500) for a day with a higher close. The volume on that day could be higher or lower than the preceding day. This first up day tells you that the tsunami may be losing steam, at least, for the moment. You can mark it as Day 1 of a rally attempt — it is not the follow-through signal itself but a key first step.
The following two trading days, dubbed Day 2 and Day 3, don’t have to show any remarkable pattern. Whichever way the market closes on those two days, the rally attempt is still valid, long as the index doesn’t go below its recent low. Should the market make a new low, the rally attempt is considered failed, and you watch for a new rally attempt.
The follow-through day comes on Day 4, or later, of a valid rally attempt. It is characterized by the market index closing significantly higher and with a greater volume. Usually, the best follow-through signal happens any day from Day 4 to Day 7 of a valid rally attempt. However, there have been occasions when a follow-through day occurred later than Day 7 and still worked well.
As with every other thing about trading, the follow-through signal isn’t perfect. So, you should study the behavior of leading stocks and other forms of sentiment analysis. You should not immediately get fully invested once a follow-through happens, as it will not always indicate the absolute low in the market.
The key factors in the follow-through-day signal
Some key requirements must be met for a follow-through day to be valid, and they are as follows:
1. Rally attempt before the follow-through day
The follow-through day simply indicates that there is enough momentum to get back into the market. But it all begins with a rally attempt, which usually happens over four or more days. A rally attempt must occur before a follow-through day is declared, and it consists of Rally Day 1 and Rally Days 2 & 3.
Rally Day 1
This is established upon the occurrence of one of the two following events:
- A major index closes up from the previous session.
- A major index closes down slightly from the previous session but in the top 50% of its day’s range.
Whatever the scenario, the day’s volume or the amount of the gain is not important. However, the second scenario refers to a pink rally day. But what is a pink rally day? Well, it is a rally Day 1 in which the index closes slightly down but in the top half of the day’s range. MarketSmith shows the day as a down day but marks it in pink.
Rally Days 2 & 3
The intraday low of these two days must not go below the low of Rally Day1. However, these rally days do not need to close higher than the previous rally day. Furthermore, if intraday, any rally day goes below a previous rally day low (not necessarily Day 1), the rally fails. In that case, the process has to start over, so you wait for another Rally Day 1.
2. Follow-through day
From the fourth day onwards, a follow-through day can occur, and here are the features:
- One of the market indexes closes significantly higher.
- The price gain is at least 1.25%.
- The move up is on a higher volume than the previous day. The volume doesn’t necessarily have to be above the 50-day average volume.
Follow-through day early signs and failure
The early signs that a follow-through day may fail include:
- An intraday decline below the low of the follow-through day, but this is not much of a big deal
- Closing below the low of the follow-through day
The second one is definitely an early sign that the signal may fail, so you may choose to sell your position, if you have bought, at that time. But if there is an additional follow-through day where the close is above the low of the previous follow-through day, you may consider keeping your position.
How to know that a follow-through day has completely failed
If the market index makes an entirely new low — that is, falling below the low where you started looking for Rally Day 1, the follow-through day has completely failed. This situation is considered a sell signal.
Why is a follow-through day important for investors?
Although not all follow-through days led to a bull market, the signal has been pretty consistent — since the early 1900s, no bull market has ever started without a follow-through day. As you know, the equity market cycle is often ahead of the economic cycle, so trying to spot the end of a bear market based solely on news events and economic data is an exercise in futility.
By the time you see a strong GDP report, big corporate earnings, or other headlines to confirm that the economy has started recovering after a recession, the equity market will have already been well into the next bull market. The equity market usually makes huge gains before analysts, reporters, and the general public starts figuring out what’s going on.
Using the follow-through day analysis to time the end of a bear market or a correction enables investors to get into the new bull market in time ahead of everyone else, affording them the opportunity to make bigger profits.
Using the follow-through day analysis in your trading
As regards using the follow-through day analysis in trading, you need to follow your own style and risk tolerance. However, here is a basic guide:
- Confirm the follow-through day signal by checking the behavior of leading stocks. There should be an increase in the number of stocks that are breaking out of traditional pivots.
- You may start taking positions in the market, starting with leading stocks. Alternatively, you can buy an ETF that tracks the performance of the market index you used for your follow-through day analysis. So, you may buy SPY or IVV if you used the S&P 500 Index, but if you used the Nasdaq 100 Index, you can buy QQQ. This approach allows you to get market exposure without relying on an individual stock’s performance. If the market continues to improve, you may go ahead to buy individual stocks.
- You may increase your exposure as the market closes above the moving averages, such as the 21-day or 50-day moving average.
This guideline can help you minimize risk and, at the same time, allow you to capture some new growth stocks that usually break out at this time.
Follow-through days – ending remarks
Our backtest shows that follow-through days are not good in the short term for stock market indices due to the market’s nature of mean reversion. Thus, we would say a follow-through day is not particularly useful for a trader.
– How do you identify a follow-through day in trading?
To identify a follow-through day, look for a day during a market correction when a major index, such as the S&P 500, closes significantly higher than the previous day with increased volume. This is typically Day 4 or later of an attempted rally.
– When does a follow-through day occur in the market cycle?
A follow-through day occurs after the market hits bottom and confirms the beginning of a new market uptrend. It follows a series of attempts to rally, with the actual follow-through day often happening on Day 4 or later of an attempted rally.
– What are the trading rules for backtesting a follow-through day strategy?
The backtesting strategy includes rules such as the first day closing higher than the previous day, Day 2 and 3 not having a low lower than Day 1, and on the fourth day, a gain of at least 0.75 of the 25-day average of the high-low range. Buying occurs at the close if these conditions are met.