Saturday, March 31, 2007

Trading Principles: Efficiency and Inefficiency

Here's a principle that has served me well over the course of my nearly 30 years of trading: Every day in the market teaches a lesson. There is always at least one pattern illustrated in a market day. It might be an intermarket pattern, a statistical one, or a relationship among indicators. My job at the end of the day is to ferret out what were or would have been the best trades of the day and identify clearly and explicitly the patterns that accompanied those trades. That means that, in a year of trading, you'll have at least 250 lessons: about as much "classroom" exposure as a college student would accumulate in two courses over the span of an academic year. Over time, those lessons outside of trading hours add up and amount to a graduate education in trading.

Indeed, thinking in principles is one feature that distinguishes experts from novices. Principles enable us to integrate many perceptual concretes into a single frame of reference, widening our cognitive grasp. Where the beginning trader sees bars on a chart, the expert perceives patterns. The expert, over the course of seeing many, many instances of a phenomenon, develops a concept--a principle--covering those instances. From that point forward, the expert's perception is guided by his or her conceptual lens.

With this post, I will begin a series of articles in which I share some of my "patterns of the day" with readers and identify the trading principle(s) behind the patterns. My hope is that this will help traders not just see markets, but *understand* them.

The pattern from Friday morning's trade in the ES futures is one of inefficiency. Efficiency is the term I use to denote the relationship between sentiment (a market input) and price change (a market output). When looking at efficiency, we're asking: How much input is it taking to generate a given amount of output?

When positive sentiment can no longer drive prices higher or negative sentiment cannot yield fresh price lows, we have evidence of inefficiency. Sentiment is no longer able to move price. Such inefficiency frequently precedes tradable price reversals.

In the chart above, we see sentiment represented by the gray bars (NYSE TICK) and price represented by the red candles (ES futures). Notice how we have net buying sentiment (positive TICK) early in the morning, but--after the initial upthrust--the bullish sentiment is no longer able to move price higher. Wave after wave of buying left us still below the price highs from around 9:45 AM ET.

Eventually all those buyers are going to have to give up and sell out of their positions. For that reason, the duration of the period of inefficiency generally correlates well with the extent of the subsequent price reversal.

We can see that reversal occur when declines in the NYSE TICK starting around 11:15 AM ET take us to new price lows. That tells us that we are *gaining* efficiency to the downside. We can also see that volume expands on the declines. That tells us that the longs are capitulating.

When you study enough efficiency/inefficiency patterns over varying time frames, you eventually gain the ability to see the patterns in real time as they unfold. But you need the principle to guide your perception, and you need to perceive before you trade.

Find at least one lesson from every day's trade, and you'll be amazed at the transformation of your perception.

Review of Curtis Faith's Way Of The Turtle

Curtis Faith's Way of the Turtle is a significant contribution to the trading literature. It works on several levels: It is an engagingly written first-person narrative of one of the most interesting experiments in trading, but it is also a thoughtful presentation of the various ingredients of trading success.

Faith spells out the Turtle trading method in detail, providing a template for a more general approach known as trend following. Most helpful is the way he breaks down the method into components: entry criteria, criteria for adding to positions, position sizing, stops, and exits. A particularly interesting chapter draws upon his Trading Blox software to update trend following research and illustrate the results of several systems in recent markets. One of the impressive--and sobering--conclusions from this exercise is that one must weather large drawdowns on the way to large profits. The research results hammer this home, and the book weaves the psychological implications.

If I had to identify a single theme for the book, it might be this: Relatively simple trading systems can provide a tradable edge, but it is psychologically difficult for traders to follow these systems and exploit that edge. Faith illustrates this with the variability in the results among the Turtle trainees (despite the fact that all of them were given the same system rules). He also provides a detailed accounting of the psychological biases that make it difficult to follow systems that ride relatively few big winning trades for an overall positive expectancy. Among the gems provided by Way of the Turtle is a discussion of stop loss criteria and surprising research about what works and doesn't; a concluding chapter that lays out the Turtle rules in manual form, along with execution tactics; and an insightful presentation of the reasons most traders do not succeed in trading.

Faith questions both discretionary trading--trading without systematically testing one's trading ideas--and the notion that trading systems eliminate emotions from trading. He makes it very clear that traders need an objective edge in the marketplace *and* the psychological fortitude to ride out inevitable drawdowns on route to exploiting that edge. Rigor in defining rules and consistency in following them emerge as keys to success. I particularly liked Faith's presentation of optimization (finding the best rules) vs. curve fitting, and his clear differentiation of the two.

I don't think it's necessary that one be a dedicated trend follower to greatly benefit from this book. Besides being a fun and interesting read, it is an excellent introduction to the various components of trading methods and how they impact outcomes. It is also a first-rate integration of the psychology and techniques of trading. Perhaps most important of all, Way of the Turtle is an illuminating presentation of risk management, a major contributor to market success. Readers will greatly benefit from Faith's clear examples of the ways of measuring risk and performance, as well as the Turtle rules for managing risk.

There are no glaring weaknesses to the book that I can detect. Personally, I would have enjoyed a discussion of the pros and cons of trend following at shorter time frames. I also would have liked a discussion of the capital required to properly implement the Turtle approach, given that success derives from holding a diversified portfolio. Those, however, are small quibbles when compared to the book's strengths. The author's chapter elaborating the Turtle method as a life philosophy is, by itself, worth the price of the text.

In short, Curtis Faith has written the definitive book on the Turtle experience and way of trading. It's hard to imagine anyone reading this book and not coming away from the experience impressed with the blend of research and psychological strength that goes into trading success. Readers interested in Faith's work might also check out his blog. See also my take on the psychology of Turtle trading, which dovetails nicely with Faith's.

Friday, March 30, 2007

Fading The Herd: Five-Day Reversal Effects In The Stock Market

As noted in today's Trading Psychology Weblog entry, we made an intraday low in the major indices yesterday, but fewer stocks participated in the decline. We saw this drying up of participation in the reduced number of issues making fresh 20-day lows. We can also see that net closing five-day lows yesterday (red line in the above chart) were much reduced from the previous day's level. Indeed, we can see from the chart that, among the 40 S&P stocks that I follow that are evenly divided among eight sectors, we had 29 more five-day closing lows than five-day highs on Wednesday--considerable weakness.

So what happens after we have a session in which we have many net new five-day lows in the 40-stock basket? Going back to 2004 (N = 805 trading days), we've had 38 occasions in which those new lows have outnumbered new highs by 25 or more. Over the next five days in the S&P 500 Index (SPY), the market has gained an average of .74% (30 up, 8 down). For the remainder of the sample, the average five-day gain is only .12% (428 up, 339 down). What that tells us is that, when traders have been bailing out of stocks across a variety of sectors, that has been an excellent time to be a swing trade buyer.

And when we've had 25 or more net new five-day highs among stocks? The next five days in SPY (N = 32) have averaged a feeble gain of only .06% (16 up, 16 down). When traders have been buying up stocks across the sectors, returns have been subnormal.

It's a great example of how markets confound human nature. So much of trading success boils down to fading human sentiment.

Three Principles For Blogs And Businesses

A reader, noting the growth in traffic at this blog, recently asked the question of how one increases blog readership. My immediate reaction to the question was a thought that I hadn't explicitly entertained before: that running a blog is like running a business. True, no money changes hands with blogs. Nonetheless, the dynamics of blogs and businesses are remarkably similar. There are readers/customers who have needs, and there are providers of blogs/goods and services who attempt to meet those needs. The readers/customers typically have many choices available to them, so it is incumbent upon the providers of blogs/products to offer real value. The question of how blogs can increase readership is not at all unlike the question of how businesses can attract customers. With that in mind, here are three principles that have guided me in this blog that also make a lot of sense for businesses:

1) Always, always assume that the reader (customer) knows more than you - It's especially tempting for trading educators, coaches, and psychologists to assume the "guru" role. I work hard to avoid that. Readers know their needs better than anyone, so it is absolutely essential to listen to what readers tell you. I do look at my blog traffic numbers daily, not because I'm concerned about becoming the most widely read site, but because the data tell me what traders are truly interested in. Similarly, I read every comment to every post and try my best to respond meaningfully. Those comments are *my* education: they tell me what is on the mind of traders. A good blog doesn't just provide information; it also listens to readers to ensure that it provides information of value. Similarly, the successful business stays close to the customer. It doesn't assume that it knows customer needs better than the customer does.

2) Give more than readers (customers) expect - I smile at blogs that provide teaser content, hopeful that readers will click links and purchase products or services. I've never seen such blogs attract meaningful traffic. Look at the *really* successful financial blogs and you'll find more information and insight there than anyone realistically can expect from a free service: the voluminous links of Charles Kirk and Barry Ritholtz; the daily links, market updates, and articles from Trader Mike; and the in-depth economic analyses of Mish are just a few cases in point. Now look at the Alexa traffic ratings for those blogs: quite, quite impressive. Why? Because those excellent bloggers, like really good businesses, provide so much value that they build enduring loyalty. Many of the excellent comments I receive from readers express appreciation for the amount of good material I provide. Indeed, many of those same readers share with me their own research, trading methods, and outlooks. When you provide more than people expect, you receive far more than you anticipate.

3) Focus on addressing the reader's (customer's) needs; all else will follow - There is *so* much that is shoddy in the world of trader education. Vendors, brokers, exchanges: all have a vested interest in getting you to trade and trade more. Self-anointed gurus offer lavish promises and thin content; trading coaches lure traders with the hope that self-help methods will bring a trading edge. In the middle of all of this is the beginning trader, with little guidance, little capital, and a heart full of motivation and hope. When I started in the trading world as a grad student at the University of Kansas, my beginning portfolio was $2500--just large enough to enable me to buy 100 shares of stock with margin. But it was a great learning experience, and I eventually found an interested and helpful mentor named Joseph Granville. Granville was a showman, but he also studied and developed indicators and taught market interpretation with his newsletters. He addressed the needs of customers like me, and he built a reputation and a business as a result. If you view the reader/customer as someone you serve out of genuine interest--not as someone to exploit--success is bound to follow. Want to know a common feature of successful bloggers? They actively link to other blogs. That's because they're more concerned with serving the educational needs of their readers than with cornering their own audience. In so doing, they build a much larger audience over time.

Listen. Give. Serve: Three principles for blogs and businesses.

Now let's perform a little experiment. Go back to the three numbered paragraphs above and substitute the word "spouse" for "reader".

You'll then have my ideas, developed over 23 happy years, for how to make a marriage work. Whether you're a business owner, a blogger, a psychologist, or a spouse, it's all about building relationships that last and leading by being an exquisitely close follower.

Thursday, March 29, 2007

How To Trade: A Call To Trader/Bloggers

I want to thank readers--and especially my colleagues in the financial blogging arena--who have helped to grow the readership of TraderFeed. The first four months of my blogging, the traffic was between 6000 and 8500 visits per month. Frankly, that was fine by me. I knew that the blog, with its short-term equity index trading focus and its emphasis of historical trading patterns and trading psychology, was a niche offering. Since that time, the niche has grown substantially, as the chart of monthly visits (and my swollen email inbox!) indicates.

I'd like to show my appreciation by calling attention to other fine blogs that are out there. Specifically, I'd like to link to posts that describe, in some depth, how you trade. The posts could illustrate specific trades, summarize trading methods, or both. I find there is a real need among beginning traders to see models of how other people are doing it. From those models, traders might then be able to discover the trading styles and time frames that best fit their interests and talents.

So what I propose is an upcoming linkfest of posts on "How To Trade". If you have a post that fits the bill, either in your archives or that you newly create, please email me with the URL in the next few days. I'll be more than happy to highlight your work and introduce new readers to your blog by adding a few of my own words re: your methods and your site. My email address is at the bottom of the "About Me" section of the TraderFeed home page.

Thanks for your interest, support, and willingness to provide guidance to new traders.


Why Traders Plan Trades But Don't Trade Their Plans

Consider the following advice:

* Trade what you see;

* Trade the plan, and plan the trade;

* Don't let emotions interfere with trading;

* Don't overthink trades; go with your feel for the market.

All of these are reasonable in themselves, but they also contradict one another. Should you shut off your emotions or go with your feel for the market? Should you stick with your trading plans or get in/out of the market when you see an unexpected development?

If you read my last post, you can see that the reason for the contradictions is that the advice pertains to different time frames. The very short term trader--the scalper or market maker--can't afford to overthink trades. He or she also can't afford the luxury of a well laid-out trading plan. Rather, that trader needs to become so familiar with short-term trading patterns that he/she embeds them in perception itself. Instead of seeing 2400 contracts at the bid and 800 at the offer, for instance, the trader sees a pattern of growing contracts at the bid as the market repeatedly--but unsuccessfully--attempts to penetrate that bid price. That pattern in the order book, occurring in the context of a market that has already declined by 1-2 ES points, might well signify to the scalper that a short-term bottom is forming and lead to a quick trade for a few ticks once short covering occurs.

Conversely, the longer-term trader might develop an idea that the market is weakening over the past several days and that we're likely, in today's market, to take out yesterday's low price. The trader waits for early trade to confirm that buying is unable to take the market above its overnight high and then sells the market. A couple of ticks above the overnight high is the stop loss point, a couple of ticks below the previous day's low is the profit target for the first half of the position, and then the trader sits back and lets the trade work out. That's planning the trade and trading the plan, taking the emotion of moment-to-moment trade--for the most part--out of the equation.

What is good trading in the first mode--getting out, say, if large trades occur at the bid--would be getting scared out of a trade plan in the second mode. What is signal to the short-term trader is noise to the longer timeframe participant. That is why traders feel as though they sabotage themselves when they put the trade on in one mode (by feel or by explicit plan), but then manage the trade in the different mode.

So here's a good question: If you do truly trade a plan, what percentage of your exits have you out: a) at your price target; b) at your stop loss; c) somewhere between the two. If a large proportion of exits qualify for option c), then there is a good likelihood that you're managing the trade by feel and not by your plan. While there are occasions in which that can minimize losses and lock in gains, over time--if your plan is a solid one--you will tend to take yourself out of trades with small losses that ultimately could have been winners, and you will tend to cut winners short of their potential.

Notice what I'm saying: If you are managing your planned trade more often by feel than by plan, you are expressing--through your behavior--a lack of confidence in that plan. If the plan is solid, it should be worth following more often than not. If you're frequently not managing the trade the way you put it on, you're using short-term criteria to bail out of the plan (i.e., weighting short-term criteria more highly than plan criteria).

Now there could be all sorts of reasons for this. It could be a plain vanilla anxiety problem that could benefit from behavioral techniques, such as relaxation training and biofeedback. It could be faulty planning: perhaps position sizing is too large or stop loss points are too far away for your personal level of risk or account size. It could also be that you're trying to trade a longer time frame, when your cognitive skills and style better suit you to a shorter one. Too, traders often bail out of plans when they have not had sufficient first-hand experience with those plans and thus naturally lack confidence. This often occurs when you try to trade someone else's plan/setup without having researched or practiced it extensively yourself.

My general advice is to practice the behavioral methods, cut your size considerably (perhaps even going into simulation trading mode), and then religiously follow your plan trade after trade after trade. That will tell you if the plan truly suits you, and it will also give you the first hand realization that the plan is worth following. You can't expect yourself to tune out noise on the short timeframe unless you have a high degree of conviction in what you see and plan in the larger picture.

But here's a second exercise--one that I've adapted from Linda Raschke--that can be very helpful in dealing with information processing challenges in trading. Select a time frame to practice. You can do this by trading in simulation mode and setting your charts to 1 minute, 5 minute, 15 minute, 30 minute, or 60 minute bars. You have to stick with the setting you choose throughout the trading session. No toggling to shorter or longer time frames. Then set your alarm clock for a random time in the next few minutes. When the alarm rings, you have to enter the market within the next bar period (i.e., if you're trading 5 min bars, you must enter in the next five minutes). You can either sell or buy the market, but you have to enter, and you have to manage the trade at your chosen time frame. Moreover, you have to hold your trade for at least one entire bar period (i.e., if you're looking at 5 minute bars, you hold for at least 5 minutes, etc.), but no more than two. That means being prepared, in advance, with support/resistance levels or indicator levels that can serve as stops and as profit targets.

Reset your alarm for another random time in the near future once you exit a trade until the day's trade is complete. This will have you trading much more actively if you're trading 1 min or 5 min bars than if you're trading 30 min or hourly bars.

Make sure you trade each time setting (the 1 min, 5 min, etc bars) many times over many days. Force yourself to perceive/plan, enter, manage, and exit trades like a short-term trader and like a longer-term one. Feel free to look at whatever news, indicators, or other data you ordinarily consider during trading, as long as the data are not derived from shorter-term bars than the ones you're trading. Over time, what you'll find out is the kind of trading--and hence the kind of information processing--that you're best at and that is most comfortable for you. Are you best and most at ease when making fewer trades and planning these in detail? Are you in your element when you're reading short-term patterns from minute to minute? Which feels most natural for you? Which keeps you in your "zone"?

Traders rarely have subconscious desire to sabotage themselves. We do ourselves in when we don't truly know who we are, what we're best at, and thus what would provide us with the greatest degree of conviction and confidence.

Wednesday, March 28, 2007

Trading And Information Processing: Why Traders "Sabotage" Themselves

We sometimes hear traders say that they are sabotaging their own pursuit of success. They don't act on what they know, and sometimes they act even though they know better. Usually, traders attribute these problems to personality difficulties. In this post, however, I'm going to suggest that such "sabotage" has a very different source: one that is rarely acknowledged among trading psychologists and coaches.

In my recent post on the epistemology of trading, I suggested that conceptual integration is essential to the acquisition of expertise in any field. This integration is not merely an intellectual awareness. Rather, it becomes a lens through which the expert sees the world. The expert physician, for example, sees patient complaints in terms of clusters. These clusters are organized by his or her understanding of organ systems, pathology, and diagnoses. A patient who presents with a swollen jawline may have (among other things) mumps, a tumor of the parotid gland, salivary stones, or a bacterial infection. Think of the large amounts of information needed to sort through these possibilities to achieve a proper differential diagnosis--and then to prescribe the right treatments. Within minutes, the expert physician can narrow the possibilities, order the proper tests and imaging, and begin treatment.

The expertise of the diagnosing physician is akin to that of the long-term investor: It requires a conscious integration of information acquired over a considerable period. A large fund of knowledge is brought to bear on a particular situation to make a proper decision. Such reasoning-based expertise can be found in many other fields, from jurisprudence (the Supreme Court judge who must integrate the particulars of a case with a long history of case law to render a decision) to engineering.

Other forms of expertise, such as those of the short-term trader, do not allow for the luxury of extended decision making. The fighter pilot, hockey goalie, or SWAT team member must integrate information on the fly, making critical decisions by "instinct" alone. Such instinct, however, is actually highly automatized skill. The expert scalper integrates a huge amount of information from price, volume, time of day, and shifts in the depth of market. This integration, however, is not a deliberative process. It is built into the scalper's perception. Just as a batter must quickly integrate information about the pitcher's delivery, the rotation of the ball, the location of the pitch, and the pitch count in order to decide whether or not to swing, the scalper cannot afford the luxury of deliberation. An entire trade may last but a few seconds.

Perceptually-based expertise is an evolutionary necessity. There are many life situations--from avoiding an oncoming car to responding to a complex social interaction--that require us to react more quickly than we can explicitly process. As I describe in my book, it is the function of training to immerse performers in the real-time patterns of a performance field to hone this perceptually-based expertise. This is one way in which the training of short-term traders is more similar to that of expert athletes than to Supreme Court justices. Investors can learn to weigh evidence and render reasonable decisions like judges. Very short-term traders, however, need their expertise built into their perceptual systems. They are more like race car drivers navigating a speedway than vacationers consulting maps for destinations.

A while back, I questioned several myths of trading psychology and indicated that there is a common process that underlies the acquisition of expertise. What we can see from the above discussion, in addition, is that trading itself requires very different forms of expertise, based partly on the market participant's time frame. The longer the timeframe, the more important the role of explicit deliberation and reasoning. The shorter the timeframe, the greater the need for rapid perceptual processing based upon pattern recognition.

When, however, a trader operates at a time frame that is intraday, but not at the level of scalping ticks, we have a unique cognitive challenge: the need to integrate perceptually-based expertise with an explicit knowledge base. Or, more simply, the need to integrate one's instincts with one's reason. The emergency room surgeon is a good example of an expert who must achieve such an integration: making rapid, on-the-fly judgements with a dying patient, but also bringing to bear a wealth of factual information regarding proper treatment. A trader who manages positions lasting minutes to hours must respond quickly to real-time market developments, but also must constantly process explicit information about where value is located, who is participating in the market, whether buying or selling sentiment is prevailing, etc. Many, many traders stumble because they lack the training to coordinate what they know and what they see. They are trading a time frame that requires, not one, but two forms of expertise.

Many challenges of trading performance--those seeming sabotages--are not a function of personality problems. Rather, they are the result of faulty integration of these two forms of expertise. That is why we may know the right trade to make, but not see it in time to put the trade on. Similarly, we might see a great trade and then talk ourselves out of it. It's as if we have two brains: one trained to respond instantly to our perceptions, the other trained to weigh relevant evidence. In some ways, it's easier to be a pure scalper or a pure long-term investor. The scalper can operate pretty much on auto-pilot, responding to shifts in the order book and from trade to trade. The long-term investor can accumulate research and review markets weekly.

But what happens when we follow the markets short-term, tick-by-tick (like a scalper) but make decisions based upon planned setups (like an investor)? We run the risk of having one set of mental inputs and outputs interfere with the other. How to deal with this challenge? That will be the topic of my next post. For now, however, let me suggest a basic principle: Trades must be managed on the same basis on which they were put on. That means that, if planned, reasoned criteria put us into the trade, we need a set of planned, reasoned criteria to manage the trade, and we need to limit our tracking of the market to those criteria. Conversely, if our gut put us into the trade, we need to manage the trade by what we perceive, not by all the possibilities of what we *think* might happen.

Trading problems begin when we enter trades by one information-processing system, but manage them by another.

Tuesday, March 27, 2007

Toby Crabel And The Epistemology Of Trading Expertise

I recently posted about opening range breakout (ORB) trades and illustrated an intraday example. An early presentation of ORB trading was Toby Crabel's book Day Trading With Short Term Price Patterns. It has become a classic text and, indeed, now fetches a handsome price, given that it is out of print. (Rumor has it that the author, a successful hedge fund manager who worked at one time with Victor Niederhoffer, has not pursued additional printings of the text, believing that it gave away too many of his valuable trading ideas).

I've read the book several times myself and do find it valuable. One of its great strengths is that it is an attempt to statistically test the efficacy of price patterns. Instead of merely asserting that a chart formation is bullish or bearish, Crabel actively searches for evidence. In this empirical approach, Crabel's work shows the influence of Niederhoffer.

(As an aside, allow me to mention that the works of many fine authors owe a debt to Niederhoffer, including his recent work with Laurel Kenner, which includes years' worth of financial columns and insights via the Spec List. The quantitative tradition is now very well established in the trading world; it's difficult--especially for younger traders--to recall that there was a time when that was not the case and when the idea of testing one's trading ideas was quite novel. Sadly, that empirical influence remains something of a novelty even to this day in the popular trading literature).

Less well appreciated is that Crabel's book is explicitly founded on the base of Ayn Rand's epistemology. Ayn Rand was a novelist and philosopher who developed a philosophy (Objectivism) that emphasized reason, political and economic freedom, and a heroic view of human potential. Her book Introduction to Objectivist Epistemology is an attempt to explain how the human mind is able to grasp reality. (Epistemology is the philosophy of knowledge). Central to Rand's account is the role of concept formation. "The ability to regard entities as units is man's distinctive method of cognition," Rand wrote (p. 7). This ability opens the door to both mathematical and conceptual reasoning.

Rand defines a concept as "a mental integration of two or more units which are isolated according to a specific characteristic(s) and united by a specific definition" (p. 11). The formation of concepts requires abstraction--isolating certain attributes from others--but also integration: combining concretes into a larger category. When we form the concept of a "trend", we are isolating certain aspects of price and volume and integrating these on the basis of a definition. Through ever-widening efforts at abstraction and integration, we expand our conceptual universe and extend our grasp of the world.

Crabel understood this, beginning with very simple notions of range and then investigating increasingly complex patterns over individual and multiple days. His abstraction of a "Principle of Contraction/Expansion" enabled him to widen his investigations to a variety of narrow and wide range price formations. He systematically investigated patterns of 2 bars, 3 bars, etc., using the chart to aid in the formulation of market concepts.

Crabel's book is best known for its treatment of ORB and narrow range (NR4, NR7) patterns, but I would argue that his greatest insight was his understanding of the role of epistemology in trading success. The successful trader may indeed trade patterns that appear to be simple. Behind these seemingly simple ideas, however, is a high degree of conceptual integration. Chess grandmasters do not see an assortment of isolated pieces on the board; they see formations that have strategic value. Similarly, skilled physicians don't perceive an array of disconnected complaints; they see interconnected symptoms that lead them to diagnoses of diseases.

Similarly, the successful trader is not mired in perceptual concretes. A good stock pick, such as the one mentioned in my recent post, integrates a wide range of information, from price action to the behavior of institutions, to actual earnings performance and industry trends. A good trade, such as the breakout example from my recent post, also integrates a large amount of data regarding the prior price range, recent and current volume patterns, and behavior during pullbacks. This integration is achieved perceptually, and it is the role of training to effect such perceptual transformation. The expert performer learns to see his or her domain in terms of patterns, whether they're the patterns of a chess opening, a defensive alignment in football, a military strategy, or a breakout from a trading range.

This is the great weakness of most efforts at "trader education". Such education consists of isolated Website posts, magazine articles, and conference presentations. Even books in the field fail to build a conceptual foundation for traders to help them understand *what* to trade and *why*. And, of course, few educational efforts help traders train their "eye" to see the patterns from their conceptual integrations. That, in trading as in chess and medicine, is a process that takes years of devoted effort.

Ayn Rand understood that philosophy is the most practical of disciplines. Without a solid epistemological foundation, what assurance do we have that we're trading anything other than randomness? Proper training for a trader is, at root, an epistemological undertaking. It transforms the knower by expanding the realm of the known. When you become expert, you forever see the world differently. You also think differently, guided by principles, not just percepts. Crabel understood that as few do. That, in itself, is justification for his book's reputation.

Monday, March 26, 2007

Tracking Shifts In The Distribution Of Stock Market Sentiment

Today's market has been such a textbook example of a sentiment-based trading pattern that I had to post it. We had a narrow trading range early in the morning. Then, with the housing news, we had a downside breakout in the NYSE TICK (Point A) and a price breakout from the two-day range mentioned in the Weblog. The fact that the break in equities was accompanied by a strong move down in the dollar and a rally in bonds told us that the news was truly new and that markets were being repriced.

We then proceeded to see follow through selling on the breakout, as volume was hitting bids aggressively (Point B). The downward shift in the NYSE TICK, with sentiment well below the 20-day average TICK level, told us that large traders were leaning to the sell side.

After an attempted rally, we saw program selling hit the Russell stocks, sending the TICK to a new low for the day (Point C). At this point, however, many indices (ES, NQ) and sectors (financials, energy, semiconductors) were *not* making lows for the day. This was our classic pattern of inefficiency: negative sentiment could no longer drag the entire market lower.

This emboldened the bulls, leading to an upside breakout in the TICK (Point D). From that point forward, we saw higher lows in the TICK, telling us that selling sentiment was drying up. We also saw a nice expansion in very positive TICK values. With that shift in the distribution of sentiment (TICK), we saw the markets recapture their morning losses.

Once again, notice how an understanding of the day's action requires an integration of multiple pieces of information, including the prior range, the breakout levels, the divergences at the TICK lows, the TICK breakout, and the changes in TICK highs/lows. Observe how such an integration requires far more cognitive complexity than the usual simplistic advice to buy or sell particular oscillator readings or chart patterns. I will have more to say about this cognitive complexity in my next post.

Price-Volume Correlations: Assessing Stock Market Trends

My recent post looked at a promising stock (Manor Care; HCR) and found, among its virtues, a very positive dollar volume flow. What I noticed going back to 2004 was that, whenever there was significantly elevated volume in HCR, the stock also rose significantly. That told me that institutions--the ones who could account for such large volume--were accumulating the stock.

How can we measure such accumulation? I decided to create a version of my Power Measure, as described in my latest entry on the Trader Performance page, which consists of a 50-day moving correlation between daily price change and daily stock volume. If a stock is under accumulation, we should see positive values for this correlation; if it is under distribution, we should observe net negative values. A stock that is neither under net accumulation nor distribution (and hence probably in a trading range) should oscillate around the zero correlation level.

In the chart above, which goes back to the start of 2004 (N = 781 trading days), we can see stock price for HCR (dark blue line), the 50-day moving correlation between price and volume (pink line), and the horizontal red line at the zero correlation level. Notice that we spend far more time above the red line than below it. That tells us that HCR is a stock under accumulation. Elevations of volume are more apt to be associated with price rises than declines.

Interestingly, this price-volume correlation ends up also being a useful timing tool. Pullbacks in the correlation have corresponded to excellent times to purchase the stock. Specifically, when the correlation has been below -.10 (N = 118), the next 30 trading sessions in HCR have averaged a whopping gain of 5.65% (83 up, 35 down). When the correlation has exceeded .40 (N = 107), the next 30 trading sessions in HCR have averaged a loss of -1.86% (44 up, 63 down).

What this tells us is that it has been best for active traders to buy HCR when price-volume correlations have been negative and are now turning higher. This puts volume (and hence volatility) on the side of our trade. Similarly, once volume has already powered prices higher, it has been a good time to take profits.

In future posts, I will explore the price-volume correlations for other stocks and ETFs, including looks at different time frames. This could be a useful metric for comparing the "trendiness" of stocks: the degree to which volume/volatility is associated with directional movement.

Sunday, March 25, 2007

Resources For Trading And Market Psychology

Over the course of the last several years, I suspect I've written close to 1000 articles and posts related to the psychology of traders and markets. At some point, I'll organize all this material into a single, indexed database. For now, however, there are several ways of tapping into the knowledge base:

1) Archived Articles - The articles page on my personal site groups articles by topic (Trading Psychology and Trading Techniques) and also lists the articles in chronological order. I recently updated the Articles page. There are now nearly 200 articles available; all can be downloaded free, without registration. I ask only that they, like the other articles, not be reproduced on other sites.

2) Trader Performance Page - Here is where I sketch out new research and trading ideas, particularly those related to performance improvement. Over 30 favorite and recent entries are linked.

3) TraderFeed Archives - Over 700 posts to TraderFeed are archived on the site. These include posts on the market, on trader psychology, and on trading performance. A great way to search through the archives is to perform an advanced search on Technorati. Just go to the Technorati home page, click on "advanced search" at top right, and then enter "ALL of the words" in your Keyword Search and enter the TraderFeed URL where it designates to "Search In". For instance, you can enter "NYSE TICK" where it prompts you to "Show Posts That Contain" and the TraderFeed URL on the last line of the "Search In" options and up will pop all TraderFeed posts that discuss the NYSE TICK.

4) Seeking Alpha Archives - I'm gradually accumulating market-related posts in the Seeking Alpha archives, with over 25 entries at present. These focus more on stocks, ETFs, and markets than on trader psychology.

If I've written about it, you'll find it in one of those four places. As far as I can tell, it's the largest archive of trading psychology-related articles in the world. My hope is that it can serve as a resource base for traders interested in learning more about themselves and their markets. Thanks for the interest--


Three Steps Toward Successful Stock Picking

After my recent participation in the CNBC show concerning the Million Dollar Challenge, I received several emails asking a good question: How do you choose stocks to invest in if you're not just trying to go "all in" for a big score? In other words, if you're a real-life stock investor putting his/her capital to work, what do you look for in a good stock?

Let's break it down into three steps to find good stocks for your money:

1) Find The Sizzle - Psychologists have found that narratives are more likely to stick in people's minds than straight information. Perhaps that's why, since the days of the Greeks and Romans, the world's great lessons have been conveyed in myth, fable, and parable. A stock with a story is more apt to attract--and retain--investor interest than a stock that merely has a nice chart or earnings. As restaurant owners know, what brings people in the door is the sizzle as well as the steak. For my illustration of sizzle, I chose Manor Care (HCR). The story is compelling: With the aging of the American population, there will be a burgeoning need for assisted living. This is particularly the case with respect to care for the dementias, including Alzheimer's disease. The StockPickr site is particularly good at finding sizzle, citing the 24/7 Wall St. site regarding the appeal of the nursing home stocks.

2) Find the Steak - Sizzle is great, but there has to be some meat on the bones. I went to the InstantBull site and found that, according to Yahoo! Finance, analysts are expecting earnings of $2.77 for HCR in the current year ending December, 2007 and $3.14 for the following year. Indeed, over the past five years, earnings have grown 26.8% per year on average for HCR. The current (first) quarter is expected to see increased earnings of 27.5%, compared with a 5.5% gain for the industry overall. The fourth quarter of 2006 logged an earnings gain of over 50%. As we can see from the chart above, the stock price (dark blue line) is in an uptrend, with pullbacks at successively higher price lows. Analysts I tracked through InstantBull note that, because nursing home beds are regulated by strict Certificate of Need criteria, there are barriers to entry into the field. Rising demand and regulated supply makes for profitable steak, not just sizzle.

3) Find the Customers - OK, so we have sizzle and we have steak; we just need customers ready to dine! In stock terms, that means that we want to find evidence that investors are *buying* the story and are attracted to what's behind it. Once again we turn to the StockPickr site and its coverage of nursing home stocks. We find that three professional money managers have recently added HCR to their portfolios and one firm, Matrix Research, has upgraded its profit estimate. The above chart shows 20-day Dollar Volume Flow for HCR (pink line). Note that the flow of funds into the stock has been increasing over time. In fact, spikes in trading volume have also corresponding to spikes of buying (red arrows). This tells us that large market participants are putting funds to work in HCR. Pullbacks in Dollar Volume Flow (blue arrows) have provided good buying opportunities on average. Note that such pullbacks have been at levels above zero. Thus far, there has been no net outflow of dollars from HCR--a sign of strong underlying demand.

Finally, note that HCR has shown great relative price strength during the recent market scare. We've seen a pullback of dollar volume flow into the stock, but very little price retracement. That suggests to me that the desire to unload HCR is not there among institutions, a happy development that should bring new highs before too long. When you have a stock with sizzle, meat on the bones, and hungry institutional customers, good things can happen for your portfolio!

Saturday, March 24, 2007

Psychological Risk Management

Not too long ago, a trader indicated to me that he was having difficulty controlling his emotions when trading. At times he would become paralyzed by fear, missing opportunities. Other times, determined to not be caught in the headlights, he would lurch into markets and refuse to cut his losses. It became a cyclical process: he would lose money, reduce his size and trading frequency, become frustrated with missing out on opportunity, jump into positions out of that frustration, and then lose money again. Interestingly, this happened even if he was trading so small that the losses could not hurt him financially. Indeed, he found that he was trading emotionally even when he was placing "paper" trades in simulation mode.

The problem was that, even though he was trading small size and controlling his risks financially, when it came to his emotions, he was "all in". As he described it to me, he *needed* trading to work out for him. He saw no alternate future in another career and, indeed, dreaded the possibility that he might have to seek a "regular job". He also had experienced disappointment in love and had few friendships to fall back upon when things got tough.

In short, he was counting on trading for most of his self-esteem. It didn't matter what his financial risk was: his psychological risk was always sky high. His cyclical attempts to make profits and pull back from markets were not real trading strategies: they were coping strategies to manage his feelings about himself.

What we *need* controls us, and when the eggs of our needs are placed within a single basket called "trading", the performance pressures are simply too great to bear. Diversification of our positions in the market will matter little if we lack diversification in our sources of gratification and self esteem. The want for success is very different from a need for success, and the desire for success is different from the need to not be a failure. A rich and full life outside of trading is the best form of psychological risk management. The inevitable periods of drawdown in trading are far easier to bear when we are collecting dividends from the rest of life.

Tracking Swing Highs And Lows In The Stock Market

My recent post showed how I use a basket of 40 S&P stocks evenly divided among eight sectors to track new highs and lows on an intraday basis. What we found is that intraday divergences between S&P 500 Index price (SPY) and the closing 30-minute new highs minus lows helps us identify short-term turning points. If the underlying principle is valid, however, it should be evident at other time frames. So let's take a look at five-day highs and lows and see if they similarly help us assess swing reversals in the market.

The above chart shows the data from the start of 2007 to the present. The pink line represents the number of stocks in my basket making closing five-day highs minus those making five-day lows. The dark blue line is the daily closing S&P 500 Index (SPY) price. Notice how the five-day new highs minus lows reliably peaks prior to seeing price peaks. We also see at the recent important market bottom that five day new lows were drying up. Those major divergences are marked by the light blue arrows. If you look closely at other price lows, you'll see other divergences. When new highs/lows aren't expanding with market rises/declines, reversal is much more likely. Before stocks start going up, they stop going down and vice versa.

As you can see from the recent market action, new highs minus lows have been steadily rising over the past several days. Even with the range bound action of the last two sessions, we're still seeing many more stocks making new highs than lows on a five-day basis. Until we see meaningful divergences similar to those observed at prior highs, I expect price to be able to grind higher.

In my database, I track everything from 30-minute to 65-day new highs/lows. I post 20-day new highs/lows daily to the Trading Psychology Weblog, and will begin posting the shorter-term data as well. This enables me to see emerging strength and weakness at multiple time frames, which is helpful in framing trades that entail trend-following vs. reversal. Putting the different time frames together into a coherent trading picture is particularly helpful and a topic I hope to tackle shortly.

Friday, March 23, 2007

Anatomy Of A Stock Breakout

Here's a great example of a breakout trade for a very short-term stock trader. This is the kind of pattern that can work well in trading competitions, such as the one sponsored by CNBC. First, we look for the opening trading range of the first 15-30 minutes. The opening range tells us how market makers are establishing value for the stock (National Semiconductor, NSM; 5 minute bar chart). Note that the opening range (Point A) is above the prior day's close. That tells us that we are seeing increased value being placed in the stock.

At Point B we see a breakout from the opening range on increased volume. That tells us that large market participants are viewing the stock positively, jumping in to buy at new AM highs.

Point C represents the first pullback from the breakout, as some short-term participants take profits. When we see a shallow pullback on reduced volume, as we do here, it tells us that the higher prices are not attracting significant selling. This sets us up for further upside (Point D).

At each pullback in the stock (the horizontal blue lines), we see how far sellers could knock the issue down. Once we get a new move to daily highs, those blue lines can serve as trailing stops to lock in profits.

The nice thing about such setups is that it only takes a few winners to pay for a number of ideas that chop around and don't do much. A majority of profits will come from a handful of nicely trending trades.

Using Intraday New Highs And Lows To Anticipate Stock Market Turns

In my post on five principles of short-term trading, I mentioned that strong markets tend to follow through on their moves in the short run, while weaker rises and declines are vulnerable to reversal. I've especially found this principle to be helpful with respect to new highs and new lows among stocks. This is why I track the number of stocks that make fresh 20-day highs and 20-day lows each day in the Trading Psychology Weblog. All other things being equal, a market with expanding new highs will continue to rise; a market with expanding new lows will be vulnerable to further decline.

This makes divergences in the new high/low data particularly informative. For example, when the S&P 500 Index hit its recent low on March 14th, we had 1894 stocks making 20-day lows in the NYSE, ASE, and NASDAQ. On March 5th, however, the number of 20-day lows was 3274. The expansion of new lows on the 5th told me we probably had more downside to go. The shrinking of new lows on the 14th indicated that many stocks were no longer participating on the downside--a pattern that often leads to reversal.

So how about tracking new highs and new lows on an intraday basis?

The chart above for yesterday's market tracks 30-minute new highs minus new lows for the 40 stocks in the 8 S&P sectors that I follow for Dollar Volume Flow. We use closing five-minute prices for the new high/low data (charted in pink) and plot the difference between new highs and lows vs. the S&P 500 Index (SPY; in dark blue). The light blue arrows identify intraday areas where SPY moved higher/lower, but we didn't get a commensurate expansion/contraction in the new highs minus lows. As a whole, these divergences do a nice job of identifying potential meaningful intraday reversal points.

The value of using these 40 stocks is that they are evenly spread across the S&P 500 sectors, which enables us to track situations in which one or more sectors are no longer participating in moves. The stocks are very highly weighted within their sectors, as those are represented by the sector Spyders. Here are the sectors, the Spyder ETFs, and the stocks used for the high/low calculations:

Materials (XLB) - DD, DOW, AA, IP, WY
Industrials (XLI) - GE, UPS, BA, UTX, MMM
Consumer Discretionary (XLY) - CMCSK, TWX, HD, DIS, MCD
Consumer Staples (XLP) - PG, MO, WMT, KO, WAG
Energy (XLE) - XOM, CVX, COP, SLB, OXY
Health Care (XLV) - PFE, JNJ, MRK, LLY, AMGN
Financial (XLF) - C, AIG, BAC, WFC, JPM
Technology (XLK) - MSFT, INTC, IBM, CSCO, VZ

These stocks can be used in a watch list for a screening program (such as Trade Ideas), which can calculate the new highs and lows for you on the fly. My own calculations came from dumping the data from my real-time datafeed to Excel.

Note one other interesting characteristic of the intraday new high/low data: On a range bound day such as yesterday, we'll spend a relatively even amount of time above and below the zero line. When we see consistent more new highs than lows or vice versa, that's when we're likely to have a trend. Similarly, on good breakout moves, we'll see many stocks simultaneously register new highs or lows. That's what happened Wednesday following the Fed announcement: all 40 stocks immediately made fresh 30-min highs and then sustained those. In yesterday's market, we don't see such extreme levels of new highs/lows. Rather, at range extremes, we tend to see a drying up of new highs or lows.

Of course, we could create other groupings of stocks to monitor for those who trade small caps or NASDAQ stocks. We could also create larger, sector-based baskets of stocks for those trading the sector ETFs and track new highs and lows specific to the sectors. For that reason, the intraday new highs and lows are a particularly flexible analytical tool for the short-term trader.

Thursday, March 22, 2007

Thursday, March 22nd Morning With The Doc

9:48 AM - OK, my hope is that the research at the start of this AM, combined with a read of preopening markets and the moves in sentiment in the AM helped you see that this AM has been a consolidation of yesterday's gains. We've seen net hitting of bids in ES, a negative distribution in Adjusted TICK, and a break below the overnight lows in the major indices. Still, with all that, declining stocks only lead advancers by about 250 issues. That, so far, is consistent with a pullback in a bull move, not an outright bear leg. In my own trading, because I view the main edge to be a move over the next few days (follow through of upside momentum) my main focus is waiting for selling to dry up to find a good place to go long. That will require more than the TICK bounces we've seen to this point. Have a great rest of your day!

9:40 AM - After the failure of the TICK to sustain its breakout and upward distribution, we're now seeing a resumption of selling. Note how staying with the distribution of TICK helps keep you on the right side of the market. TICK broke its early AM lows prior to the downside move in the futures. Wrap up in a few.

9:32 AM - Until we see a TICK distribution maintain an upward shift--note how we're well below that average TICK of 250--it's premature to jump in aggressively on the buy side.

9:27 AM - Need to see selling dry up above the early AM lows to hit the buy side hard. Otherwise, it will be back to selling TICK bounces.

9:15 AM - I continue to view this as range bound action in ES, with today's highs and lows framing the range. Note how buying that first pullback after a TICK breakout provides a nice continuation trade.

9:11 AM - Note upside breakout in NYSE TICK; looking at those overnight lows as important support now and leaning toward buying pullbacks in TICK that keep us above the AM lows.

9:08 AM CT - Watching to see if the market holds here, as ES has come down toward its overnight lows.

8:59 AM CT - We've been getting consistently more volume at the bid than the offer in ES, as shown in Market Delta. Under those conditions, you can wait for the lifting of offers and then fade those bounces if you're a very short-term trader. Note how ER2 and NQ have been leading ES...important tell.

8:49 AM CT - Remember LEI at 9:00 AM CT.

8:46 AM CT - Note that we've broken preopening lows in ER2 and NQ. Watching for spillover into ES.

8:44 AM CT - TICK and advancers/declines remain positive, so even though we had an early pullback, I'm not selling into those. Remember that TICK reflects sentiment and is highly influenced by institutional trade. As long as that TICK distribution is positive--and especially as long as it's above its 20-day average (which is about 250), I'm not likely to sell the market. So far, especially in NQ and ER2, the response to buying sentiment has been poor--a classic sign of inefficiency, which is not characteristic of markets that are uptrending.

8:35 AM CT - Advancers lead declines and TICK has stayed above zero in early trade. What we're seeing is inability of buyers to lift market so far; not a surplus of sellers. I'm keeping an eye on ER2 weakness. If that is leading the downside, I'm more likely to lean short on ES. Volume moderately high in first 5 min. No big institutional push.

8:33 AM CT - Note that we've already retraced the preopening gain in NQ. Market very much following the scenario mentioned earlier of testing high, failing the test, and perhaps establishing range bound trade.

8:18 AM CT - So far, so good. We've gotten our test of the previous day's high and now we've pulled back into yesterday's range. My main idea for the early morning is to watch for early buying in the NYSE TICK and see if we get a situation where the buying can't push us to new price highs. If that occurs, I'll be willing to sell the market and take a short-term position for a move back into the thick of the preopening range. My larger idea and main trading priority for the day is to see if we can get some weakness and then get to a point where the market holds up well on subsequent selling. At that point, I'd be a buyer to ride a possible move higher over the next few days, in keeping with the research posted today. Note that interest rates have already bumped up over the level from the post-Fed announcement reaction. Dollar/Yen has also retraced its post-Fed move. I don't think the Fed announcement really changed things in a macro sense--another factor leading me to believe we could see a digesting of yesterday's gains today. Back after the open.

7:57 AM CT - So here are three steps I take to prepare for the day's trade: 1) I conduct my studies to see where there might be a directional edge. The better the studies look, the more aggressive I'm likely to be in trading. My studies take a look at what is unique and distinctive about the recent market. I then examine occasions when these distinctive features have occurred in the past and what the market has done in response. So, for instance, the broad and strong upside momentum is most distinctive about the current market. My research, posted recently, found no edge the following day, but a solid upside edge over the next few days. That helps me frame my strategy for the upcoming trade. 2) I look at the larger market context. I want to put the current market into a framework that helps me understand what's happening at a longer time frame. We had a sharp decline on housing mortgage woes and concern over the Yen carry trade; that led to unusual bearishness in options sentiment. That, along with the improving market internals, told me that market history was not on the side of the bears. With the recent rally, we're now in a position to be testing the bull market highs. As noted in the entry for today's Weblog, we're already seeing new highs among 43 S&P 500 stocks and a couple of market sectors. That suggests to me that, while we may very well see near-term consolidation of market strength, the general direction is likely to be to the upside. 3) I examine the most recent market ranges. This helps me gauge where we have support and resistance and where we're most likely to have breakout moves. My last post a few minutes ago outlined some of those ranges. More broadly, I look at the previous day's trade as a range, since 85+% of all days are *not* inside days. That means that we'll either take out the previous day's high or low. In a strong market, we should be able to take out the prior highs. Indeed, as I've been writing, that's exactly what's happened. The best trades will occur when your view of the short-term ranges coincides with your research and your view of the longer-range context. My preference is to be selective with trades and wait for all three of these factors to line up, rather than to trade actively with a dubious edge. Back before the open.

7:41 AM CT - OK, we had some buying come into the market and take us to a new high for the premarket session. All of that fits well with the notion of testing yesterday's highs at 1449.75 in ES. Note that we have near-term support at 1442.75 - 1443. If we can hold above that support on any AM session selling, that would have me looking to test those highs. A lot of what I do in the early AM is play out "what-if" scenarios in my head to prepare myself for the morning trade. One of those scenarios is early AM selling holding above the overnight lows, leading us to break out of the overnight highs and test yesterday's lows. Another scenario is a failed test of yesterday's highs, leading us to return to the middle of the overnight range. Still another scenario is unexpected selling taking us below the overnight lows on negative NYSE TICK readings. That would normally have me waiting for the first bounce, gauging the market's ability to rebound, and then entering the downside if that ability to rebound is deficient. The scenario that's worked well the last few days--breakout to the upside on solid volume and TICK, followed by a pullback that you buy--is a lesser probability in my view, but I like to consider all angles, play them out in my head, and then be prepared when market action tells me what's happening. Back in a few with some context.

7:20 AM CT - Good morning! We have Initial Claims at 7:30 AM CT and Leading Economic Indicators at 9:00 AM CT. Let's see if those reports can nudge us out of a preopening range that has been pretty narrow so far. We saw strength in Asia and Europe on the heels of the post-Fed announcement rally, but the follow-through so far in the U.S. has been muted. This is consistent with the idea from the previous post, that high momentum rises tend to pause before resuming their upward course. Accordingly, I'm not planning a great deal of trading for my personal account today. My main goal is to buy on weakness for a holding period of up to four days, in accord with the posted research. Note that volatility in the premarket tends to correlate well with volatility in the morning session, so I'll be watching to gauge response to the Claims number. At this point, I'm looking at the pullback low following the surge yesterday afternoon as the bottom of a range and yesterday's high as the range high. Normally, in a market with solid upside momentum, we should be able to test that high. My research didn't find any upside edge on the day, however, which leads me to believe that any such tests of the high might be part of a consolidation, not another sustained upswing. Once again, I'll be tracking volume and buying/selling sentiment (Market Delta, NYSE TICK) to assess the likelihood of such a directional swing. Back shortly with some background for the day.

Strong Upside Momentum In The Stock Market: What To Expect Next

Readers of the Trading Psychology Weblog are no doubt familiar with one of my favorite measures, which I call Demand and Supply. For this proprietary measure, I construct two sets of moving averages--one short-term, the other intermediate-term--and volatility envelopes around each of these. Demand is an index of the number of stocks that close above *both* envelopes; Supply is an index of the number of stocks that close below both envelopes. Accordingly, Demand and Supply capture both market breadth and market momentum. When Demand or Supply are very high, we know that we have a broad, high momentum move in the market.

My Demand and Supply data go back to mid-September, 2002 and cover all issues within the NYSE, ASE, and NASDAQ exchanges. Wednesday's rise on strong upside momentum provided us with a Demand reading of 226. That is the fourth strongest reading since that time. What this tells us is that buying interest in stocks has been extremely broad and strong over the past several days, a conclusion also supported by my dollar volume flow data.

A little while back, I mentioned a trading principle that has served me well: When we have expanding Demand or Supply, I expect a market move to continue in the short run. This is because momentum tends to peak or trough ahead of price. A while back, I applied this idea to a downside market. Let's see if this principle applies to the current strong reading in Demand.

Going back to September, 2002 (N = 1127 trading days), I found 11 occasions in which Demand exceeded a reading of 180. To provide a point of reference, this is a level at which stocks with significant upside momentum are outnumbering those with significant downside momentum by 8:1 or greater. When that has happened, the next day in the S&P 500 Index (SPY) has been up 6 times, down 5 times for an average loss of -.22%. By comparison, the average one-day gain for the market overall during the study period was +.04%. Certainly no bullish edge there.

When we look four days out, however, we see that the average gain following a very strong Demand reading is +.49% (9 up, 2 down). That is much stronger than the average four-day gain of .18% (632 up, 495 down).

If we broaden the Demand criteria and look at all occasions in which Demand has exceeded 150 (N = 32), we find quite a bullish edge four days out. Specifically, SPY has averaged a gain of .82% (27 up, 5 down). There is no bullish edge for the next day's trade, however.

What this suggests is that, in the very near term, strong upside momentum markets often take a bit of a breather before resuming their rise over the next several days. Accordingly, after strong and broad upside momentum, buying near-term weakness for a rise several days out has been a successful strategy.

Wednesday, March 21, 2007

CNBC Appearance And Morning With The Doc

Looks like we'll do it all over again with a CNBC appearance on Friday at 7 PM Eastern/6 PM Central. I'll post details as soon as I have them. Apparently my telling the audience that my trading advice came from a celebrity guest's prostitute didn't prevent a future appearance... :-)

Also, just a quick reminder that tomorrow (Thursday) AM before the open, I'll start my posts for a morning session tracking the market in real time. I suggested some readings as preparation for the session in an earlier post; here are other relevant readings:

* NYSE TICK and momentum effects;

* Anatomy of market breakouts;

* Using the opening minutes to gauge the day's trade;

* Gauging shifts in the NYSE TICK as a sign of directional movement;

* The structure of market reversals.

Let's see if we can apply some of these ideas as markets are trading! Thanks for the interest and support--


A Mechanical Strategy That Has Produced Consistent Stock Market Profits

In this post, I'd like to introduce a mechanical strategy that has yielded profits in 81 of the 82 historical periods studied. I'd then like to divulge the specific mechanical rules and explore what it takes, psychologically, to be able to pursue this strategy.

First, a few notes about the strategy's performance:

1) The 82 historical periods studied cover decades, not just a selected grouping of years. That period has included many bull, bear, and sideways markets and many economic conditions. While past performance is no guarantee of the future, the lengthy period over which this strategy has been successful suggests that it is highly robust;

2) The strategy has not been optimized or curve-fit in any manner. The system rules are very simple. Indeed, as we'll see below, the average annual returns as noted on the chart above very much understate the achievable returns of market participants;

3) The strategy does not require access to unusual market data or resources. The strategy utilizes data from the public domain. Indeed, anyone can benefit from this strategy without being tied to the screen during the day. The amount of time and effort needed to make decisions and trades does not interfere with holding a full-time job or any other life responsibility or activity.

OK, now for the performance run down:

The average annual return for the strategy is 14.17%. This is without any leverage whatsoever. Out of the 82 historical periods studied, 39 produced returns greater than 10% per year and 20 yielded returns greater than 20%. Six periods provided returns greater than 40%. The one losing period out of the 82 lost an average of -.25% per year. As a result, the risk-reward profile of the strategy is very favorable.

I'm quite convinced that these results are more impressive than those achieved by most mechanical systems marketed to the trading public. It's difficult to think of a strategy that has been so consistently profitable over a period of decades.

Here are the specific system rules:

1) Buy the Dow Jones Industrial Average at the end of the last trading day of the year;

2) Hold the position for 25 years;

3) Sell the position on the last day of the 25th year.

That's it.

Buy it. Hold it. Sell it.

The reason the above results greatly understate actual returns is that I haven't factored dividends (and their reinvestment) into the mix. My data on S&P 500 Index dividends finds that, going back to 1928, these have averaged 3.92% annually. Even if you assume no reinvestment whatsoever, you can see that adding this return to the mix means that every single period studied has been profitable. Buy and hold over the course of a 25 year investment career has never lost money going back to the start of my historical data in 1901.

The returns from the chart above were obtained by taking every sequential 25 year investment period from 1901 to 2006 to simulate what any investor might have obtained based on each beginning year. For a more in-depth treatment of these long-term return, their amazing consistency, and how they handily outpace inflation, I recommend the book Triumph of the Optimists: 101 Years of Global Investment Returns by Dimson, Marsh, and Staunton.

How many in-and-out traders, over the course of a 25-year career, can achieve such consistency and returns? How many actively managed funds can boast of such a record?

But think of the psychological fortitude it takes to participate in this strategy. An investor needs to ride out bear market drawdowns, periods of economic recession, oil shocks, inflation, and myriad geopolitical crises.

Just as important, an investor needs to tune out the many, many "sky is falling" jeremiads that were issued over those years, as market commentators became convinced that market meltdowns were in the offing. Consider the fact that, for the career investor, those cries of doom have never been vindicated. Never.

Indeed, to hang in there for a quarter century, an investor has needed the optimism described by Dimson, Marsh, and Staunton. The pessimist sees emerging nations that will eclipse the U.S.; the optimist sees free markets on the rise worldwide, providing expanding markets and improving standards of living globally. The pessimist sees peak oil. The optimist envisions the spirit of human innovation, which will provide cheaper and more abundant forms of energy, reducing the tensions now present over limited oil supplies. The pessimist sees bear markets. The optimist perceives fresh opportunities to pick up bargains.

So that's what it takes to benefit from the mechanical strategy of buy and hold for a lifetime: optimism and the courage to tune out intervening events and voices.

Don't get me wrong; I love trading. It is challenging, stimulating, and potentially quite rewarding.

But let's not kid ourselves. If we were to trade in and out of careers every time we became fearful of our current career progress or every time another career looked better, we'd wind up with a lifetime of unfulfilled promise. If we similarly traded in and out of relationships, we wouldn't achieve a fraction of the emotional depth and fulfillment of a fine lifetime marriage. The great rewards go to those who invest themselves in life--and who have the tenacity and optimism to stick with those investments and build upon them.

Tuesday, March 20, 2007

Euphoria, Panic, And The Stock Market: The Lesson Of The Recent Market Decline

There are few hard and fast rules in the stock market, but this one is a candidate: The market doesn't reward euphoria or panic.

I recently mentioned that bearish sentiment, as assessed by the equity option volume data, was at a higher level than at any time during the 2000-2003 bear market. Carry trade fears, combined with concerns over mortgage lending defaults, raised the 20-day equity put/call ratio above 1.0, something we hadn't seen in many years.

By the time we hit an intraday low in the S&P 500 Index on March 14th, fears were high--the VIX spiked above 21; put volume hit its highest level since the 27th, exceeding call volume by about 20%--but a number of things had changed beneath the surface:

* We were unable to make new lows in the Russell 2000 Index;

* The number of stocks making fresh 20 day lows dropped to 1894 from 3274 on March 5th;

* The number of stocks trading below their 20-day moving average envelopes dropped to 875 from 2021 on February 27th;

* Dollar volume flows in S&P stocks had reached normal levels.

In other words, stocks had stopped responding to the panicky sentiment.

I just took a look at the 40 S&P stocks that I use to track eight market sectors. Only six are trading below their February 27th lows. Thirty four out of forty are trading above that level. Those who sold in panic on the 27th--and especially thereafter--are most likely underwater.

When extreme market sentiment lags the actual behavior of stocks, you can fade that sentiment profitably. That's the lesson of the recent market decline.

Trading Opening Range Breakouts

Few intraday trading ideas are as popular as the opening range breakout (ORB) trade. The first extensive presentation of this idea came in Toby Crabel's book "Day Trading With Short Term Price Patterns And Opening Range Breakout". That book, no longer in print and reportedly fetching hundreds of dollars per copy, is an interesting one in many ways. I will be posting on Crabel's work shortly.

Since that time, ORB has come in a variety of flavors, including Mark Fisher's version in his book The Logical Trader and the eMESA mechanical trading system. It has been the subject of extensive discussion on trader boards and is available as alerts in the Trade Ideas screening program.

With the low volatility trading environment following the market decline of 2000-2003, we saw a tendency for short-term price movements to reverse. This wreaked havoc with much of the ORB trading. Indeed, if you run the Odds Maker module of Trade Ideas with breakouts of the 60 minute range, you'll often find that the odds are in your favor by *fading* such breakouts in the broad stock indices.

Monday's market was a nice illustration of proper ORB trading in that we had a false breakout and then the real one. Let's review the above chart, which tracks the ES futures vs. the NYSE TICK.

The trader only focusing on the opening prices from the stock market open would have viewed the decline after 10 AM ET as an opening range breakout. Three things, however, led me to not take that trade:

1) The opening range has to be viewed as the entire pre-opening market in ES futures. That is what tells us how U.S. stocks have responded to news and market developments from Asia and Europe to that point, as well as pre-opening economic reports. If we break out of *that* range, it's truly telling us that new buying or selling is impacting traders' assessments of value. The Monday dip was toward the lower end of the overnight range, but did not break out of that range.

2) Although we broke below the very early AM prices in the ES futures after 10 AM ET, we did not make a similar low in the Russell (ER2) futures. A valid breakout move should carry all the major market averages and sectors.

3) Volume was conspicuously low on the downside move. A valid breakout should give us increased participation as we see higher or lower prices. That tells us that large traders are participating in the move, which enables us to ride their coattails. The large traders were not jumping all over the early market decline.

In short, the early morning downside move--which looked like an ORB to an inexperienced trader--was really a failed test of the overnight lows! It was a buying opportunity, from that vantage point, especially given the overall advance-decline strength at that point.

Ah, but now look at the market at the points labeled A, B, and C in the above chart. We see at Point A that sentiment breaks to the upside before we get the big pop in price. It is not unusual that the NYSE TICK breaks out to new highs or lows prior to a general market breakout, as improving sentiment precedes further buying or selling. For that reason, I look at ORB in the NYSE TICK, not just in price.

Point B shows us the price breakout to the upside. Note that it is accompanied by very strong TICK (sentiment) and very strong volume. Clearly, large traders are jumping all over this move.

Very often, after such a surge, we'll get a pullback in the TICK toward the zero area as very short-term participants take profits. Note that, at Point C, the pullback only retraces a small proportion of the prior surge and the pullback occurs on vastly reduced volume. In other words, the large traders are not treating the highs as an opportunity to bail out of the market. This makes the first pullback after the breakout move a nice high-probability entry once you start to see resumed buying.

You'll hear that ORB trading "no longer works". That's not true. What we see is that market patterns evolve; they become more complex over time as the simple variants are exploited. It takes more conceptual integration of market data to separate valid ORB trades from false breakouts now than when Crabel wrote his book. If you understand the last few sentences (which are the most important ones of this post), you'll see why it is so challenging to *sustain* success in trading and why trading--like medicine and other evolving fields--requires continuing education. As traders, we are always chasing a moving, evolving target.