Wednesday, October 31, 2007

Finding Your Voice as a Trader

Occasionally I'll meet a trader for the first time who wonders aloud why he hasn't made greater progress. He keeps a journal, he reviews his performance, he identifies what he does wrong and tries to correct his mistakes: why isn't he succeeding?

Here's a sample of dialogue from such a trader at the start of a coaching session:

"I feel like I should be so much further along than I am. There's been great opportunity in the market, and I just haven't taken advantage of it the way I should have. I'll have a good day or two and then I just go back to making the same mistakes. I'll get too aggressive and lose money. Then I get stopped out for the day and miss out on great trades. Sometimes I even wonder if I should keep doing this. I know what I need to do, but I can't seem to do it."

Now how does that sound to you? Sounds like a trader who is frustrated; a trader in some distress.

Now let's alter the dialogue by substituting "you" for "I" and pretending that the dialogue is coming from someone talking to the trader:

"I feel like you should be so much further along than you are. There's been great opportunity in the market, and you just haven't taken advantage of it the way you should have. You'll have a good day or two and then you just go back to making the same mistakes. You'll get too aggressive and lose money. Then you get stopped out for the day and miss out on great trades. Sometimes I even wonder if you should keep doing this. You know what you need to do, but you can't seem to do it."

Now how does that sound?

What sounded frustrated in the first person voice now comes across as hostile and blaming in the second person.

How would you feel if, during one of your slumps, someone spoke to you in this way? Probably not very good. One of the reasons why is that there is nothing in these statements that is a concrete idea or suggestion for constructive change.

Many traders have not found their own constructive voice; they are not consistently good at mentoring themselves. They recognize that they are frustrated, but they don't recognize that, by immersing themselves in negative, angry talk, they undercut their own confidence and motivation.

After all, how much motivation would you sustain as a rookie trader if your supervisor at a firm spoke to you that way after a few losses?

A theme I emphasize in The Psychology of Trading book is that each of us has a relationship to ourselves. That relationship is defined, in large part, by our self-talk: how we communicate to ourselves during good times and bad.

You can't advance yourself and browbeat yourself at the same time. You can't pursue success wholeheartedly if you're also telling yourself how bad you are and how badly you're doing.

Often, traders seek help simply to find their voice: the ways of talking to themselves that encourage, support, and challenge rather than blame, attack, and catastrophize. The frustrated voice, so often, is the abusive voice. Just turn those "I" statements into "You" statements and you'll see how they sound.

The way we develop a new voice starts with identifying and building upon strengths and successes, not becoming mired in weaknesses and losses. You'll succeed by more consistently enacting the best within you, not by making fewer mistakes.

And you'll succeed when you talk to yourself like a winner, not a loser. Because that's the voice you'll internalize. Once you internalize that voice, nothing short of growth, progress, and self-development will feel natural.


Changing Your Self Talk

Building Self-Efficacy

Solution-Focused Trading

Tracking Stock Market Trending and the Market's Technical Strength

I've received a few emails with questions about my measure of Technical Strength. It is simply a quantification of trending behavior over a given lookback period. The measure takes into account, not just the slope of a stock or index, but also the variability around that slope. Thus, a stock that is continuously and smoothly moving higher will have a higher score than one that chops around and ends higher.

I apply this Technical Strength measure to 40 stocks in the S&P 500 Index that are among the most highly weighted issues within the Materials, Industrials, Financials, Energy, Technology, Health Care, Consumer Staples, and Consumer Discretionary sectors. By summing the scores for the individual stocks, I arrive at a single Technical Strength Index for $SPX.

Where I find this helpful is in tracking growing strength and weakness within sectors and from day to day across the broad market.

For example, Monday we had 21 stocks qualify as technically strong, 13 as neutral, and 6 as weak, giving us a Technical Strength Index score of +820. On Tuesday, that changed to 13 issues strong, 16 neutral, and 11 weak (total score of +200). What happened is that some of the strong stocks fell into the neutral category and some of the neutral stocks fell into the weak category.

That tells me that we're in a fluid market situation--many stocks are hovering around neutral. That means they're not trending. Just as I would look to price for breakout of a trading range, I look for large shifts in the Technical Strength picture to gauge longer-term breakouts that might represent nascent market trends.

As far as sector perspectives go, here are Tuesday's scores by sector:

* Materials: +240
* Industrials: -80
* Consumer Discretionary: -140
* Consumer Staples: +220
* Energy: -140
* Health Care: +20
* Financial: -180
* Technology: +260

It looks as though three sectors are holding up the S&P 500 Index. I continue to be surprised by the weak scores among energy stocks despite oil moves to new highs. All in all, this looks to me like less than a robust market: the strength is very mixed and selective.

Note: I've been using the Twitter application to update my various market measures from day to day and to link articles in the financial media that seem informative; watch for the Technical Strength data in those Twitter "tweets".


Measuring Technical Strength (with a link to the 40 stocks I track)

My Last Technical Strength Update

Tuesday, October 30, 2007

Seven Themes I'm Tracking in the Stock Market

1. Outperformance of Asia, especially the impact of China's investors on Hong Kong;

2. Scarcity of water resources world wide and need for infrastructure development;

3. Within the U.S., outperformance of large cap issues relative to small cap;

4. Housing and banks as weak sectors in the U.S., with spillover to consumer discretionary areas, including some retail;

5. Weak dollar themes, including strong oil/energy, gold, and raw materials;

6. Growth among emerging economies, leading to increased demand for foodstuffs and inflation among agricultural commodities and related products;

7. A structural shift toward increased volatility among financial markets following historic low volatility, with heightened correlation of returns among asset classes during alternating periods of (liquidity/illiquidity-driven) risk seeking and risk aversion.

The Value of a Trading Setup

I've received a few emails that lead me to believe I wasn't sufficiently clear in my recent posts investigating the odds of hitting such price targets as the prior day's high and low, the average trading price, and pivot-derived support/resistance levels.

Those probabilities that I reported in SPY from 2004 - present were just that: baseline probabilities. I did not mean to suggest that, in and of themselves, these probabilities offer a trading edge.

Rather, by establishing baseline probabilities, we now have an objective basis for determining the value of a trading setup. The setup could be a chart pattern, an indicator reading, or an intermarket event. The question is: does this setup significantly alter the probabilities of hitting these target prices during the trading day? If the answer is no, either you have to alter or toss the setup or you have to redefine your price targets.

In my subsequent posts, I'll begin looking at the value of adding variables to price by seeing how odds change as a function of those variables. In general, my experience is that many indicators that seem to be valuable end up not adding predictive value to odds simply because they are so correlated with price itself.

But if we *can* find variables that affect the odds of hitting these targets, *then* we have the beginnings of a trading edge and idea. It is from those beginnings that we can add money/risk management rules and generate more rule-governed approaches to trading.


Odds of Hitting Support/Resistance Levels

Odds of Closing Opening Gaps

Odds of Hitting Previous Day's Levels

Trading With the Odds

Pivot Level Support and Resistance: How Often Do We Hit Those Price Targets?

In recent posts, I have examined the odds of hitting high and low prices from the previous trading day and the odds of closing opening price gaps and hitting average trading prices from the prior day. This post will conclude a survey of intraday price behavior by examining how often we hit pivot-derived support and resistance points.

For the purposes of calculation, the pivot price is defined as the average of the previous day's High, Low, and Closing price. As with the earlier posts I am using the S&P 500 Index (SPY) going back to 2004 (N = 963 trading days) for my calculations.

The R1 resistance level is defined as (Pivot Price *2) minus the prior day's low price. The S1 support level is defined as (Pivot Price *2) minus the previous day's high price.

Thus, let's say that SPY closes at 150. Its high price is 151 and its low price is 149. The Pivot Level would be (151+149 +150)/3 = 150. The S1 level for the next day would be (150 * 2) - 151 = 149. The R1 level for the following day would be (150 *2) - 149 = 151.

Going back to 2004 (N = 963 trading days), we find that SPY hits either the S1 or R1 levels on 779 occasions, or a little over 80% of the time. We hit R1 on 490 occasions (a little over half the time), we hit S1 on 425 occasions (about 45% of the time), and we hit both levels on 135 occasions (about 15% of the time).

Thus, we tend to hit one of the pivot-derived levels during a given trading day, but which one we hit--on the basis of price alone--is pretty much a crap shoot. We'll want to look for indicators that help us effectively handicap the odds of hitting these levels.

Finally, let's look at the frequency with which we *close* above or below R1 and S1. Of the 490 occasions in which we hit R1, we close above R1 on 244 occasions, or about half the time. Of the 425 instances in which we hit S1, we close below S1 on 212 occasions, again about half the time.

Clearly, then, it is more common to trade above the R1 resistance and S1 support levels than to close above them. If we think of R1 and S1 forming a trading range, it will be helpful to have indicators that help us handicap the odds of closing outside that range vs. returning to that range.

In all, going back to 2004 (N = 963 trading days), a total of 455 days closed outside R1 or S1, a bit less than 50%. So about half of the time, we will close within the range defined by R1 and S1.

In my upcoming posts in this series, we'll begin the search for indicators that help us handicap the odds of hitting and closing above these benchmark prices:

* Previous Day's High
* Previous Day's Low
* Previous Day's Pivot Level
* Opening Gap (Previous Day's Close)
* R1 Resistance Level
* S1 Support Level

If we can find measures that assist us in handicapping those odds, we'll be able to trade more like a card counter, placing bets when probabilities are favorable and standing aside when they're not.


Handicapping Odds in Trading

Monday, October 29, 2007

Views From the Trading Penalty Box

At 10:50 AM CT, I placed myself in the penalty box. What that means is that I'm done trading for the day.

Actually the day started out just fine. I hit a new equity curve high last week and felt I was seeing the market well. My first trade Monday morning was a classic false-breakout, fade-the-strength trade and resulted in a several pt winner in ER2. My second trade pressed the downside in NQ and escaped with a half-point winner as the downside follow through never materialized.

That last trade should have told me that the downside was limited and warned me about continuing to sell the market. Moreover, what the hell was I doing fading NQ when the semiconductors were catching a bid and the Russells were still leading the downside? Worst of all, I didn't ask those questions before launching into my third trade: selling ES a little after 10 AM CT.

The market moved smartly against me, but I was seeing volume slow down and no outstanding sector strength, so I hung in there. One point against me. Two points. Then three. To say I was disgusted with myself would be an understatement. Not only had I failed to ask the right questions before entering my trade; I also left my stop fuzzy--not something that got me making the money in the first place.

I had a strong sense that, if I covered, I'd be buying the highs, so I established a firm catastrophic stop and waited the market out. Fortunately I got a retracement and managed to get out with a one-point loss about 50 minutes later. Much longer than I should have held a trade like that.

All the while, as the market moved back my way, I told myself that my trading day was done. It was in the penalty box for me. That was just an ugly trade.

I bring up this episode because it illustrates several lessons:

1) You never stop working on your discipline - I don't care how many letters you have after your name or how much you're up on the year. You stop executing the fundamentals and doing what got you where you are and you'll pay a price.

2) Overconfidence kills - It's when things are going well and I'm feeling good about trading that I tend to be sloppiest. The key, for me, is to always trade as if I'm down money. That keeps me sizing positions reasonably, waiting for good entries, defining my stops clearly, and being selective in my trades. Fear and greed may get top billing, but overconfidence is one of the greatest trading challenges.

3) The penalty box works - There was a time when I only entered the penalty box when I went through decent-sized drawdowns. Now just one bad trade can take me out of the trading day. That may seem harsh, but I can't tell you how much money and anguish it has saved me. I spend the rest of the day identifying what I did wrong and making sure it doesn't carry over to tomorrow. In August, I entered the penalty box after a couple of good trades that lost me money. The market wasn't doing its usual thing; my ideas weren't working well. By shutting down my trading for a little while, I came back when I had a feel for the market and was able to add to a profitable year.

I've been trading since 1978. I have a doctoral degree in psychology and work with traders professionally. I average well over 100 trades a year and have read most the major trading and trading psychology books.

Still I make the mistakes. Still I learn from experience. Still I visit the penalty box.

Sometimes it seems as though the only progress I've made in decades of trading is that I enter the penalty box a helluva lot quicker than I used to.

But that has made all the difference.


Understanding Overconfidence and Underconfidence in Trading

The Most Common Trading Problem

Update of Technical Strength and Other Thoughts to Start the Week

* Market in Balance - Of the 40 SPX stocks that I track across eight sectors, 13 qualify as technically strong, 15 as neutral, and 12 as weak. This Technical Strength measure is a quantification of short-to-intermediate term trending. The Technical Strength Index, a summary of trending across the 40 stocks, is a neutral +240--an improvement over figures from earlier in the week. The figures show a market with mixed strength. Very technically strong stocks include AA, MCD, PG, MO, KO, MRK, and MSFT. Relatively weak issues include CMCSK, BA, HD, LLY, and C.

* Technical Strength by Sector: Here are the eight SPX sector groups that I track and their Technical Strength Index scores. (Here's how the sectors looked last month). Perhaps anticipating economic slowdown, it appears that investors are favoring consumer staples. I'm surprised that energy stocks aren't stronger:

Materials: +180
Industrials: -180
Consumer Discretionary: -100
Consumer Staples: +320
Energy: +60
Health Care: +60
Financial: -80
Technology: +100

* Market Updates - Here are some good readings from across the blogosphere. I also have posted readings via Twitter:

** Overcoming market fears and other links from Trader Mike

** New tools for evaluating ETF risk and reward and other links from Abnormal Returns

** Excellent review by Kirk of a little book designed to make you rich

** The challenge of making markets in options with penny quotes: Daily Options Report

** Abandoning dollars for yuan and other links from Millionaire Now!

** Speculation of half-point Fed cut and other themes for the week: The Big Picture

Have a great start to your week!

Sunday, October 28, 2007

Stock Margin Debt: Are We Past the Bull Peak?

This is an update to a prior post, which looked at margin debt as a sentiment indicator. That post found that annual rates of change in margin debt closely tracked cyclical highs and lows in stocks, and my subsequent post found a tendency for changes in rates of margin debt to lead market tops. That latter post also found that annual returns in stocks tended to be best when margin debt was neither growing nor contracting at rapid rates.

As we made our market top in July, the annual rate of change in margin debt soared to over 67%. Since 1970, we have registered only two higher readings: over 70% in early 1984, prior to a drop of about 15% by July of that year; and over 90% in April of 2000, prior to the multiyear bear market. Interestingly, since the July peak, not only has the annual rate of increase in margin debt declined (to about 40%), but the absolute level of debt has declined by over 15%.

What that tells me is that we've passed a peak in bull market sentiment. If investors are pulling back from stock margin debt the way they're pulling back from other kinds of debt in credit markets, this places a limit on buying power. And, at least in the past, that has also placed limits on prospective market gains.

Turtle Trading Lessons From Michael Covel

Few legends in trading have been as enduring as that of the Turtles. The Turtles were traders in the 1980s trained in a trend-following methodology by Richard Dennis and William Eckhardt. The traders came from a variety of backgrounds; most had no background whatsoever in financial markets. Dennis championed the cause of nurture: he believed that great traders could be made. Eckhardt took the other side of the bet, and the Turtle experiment was on.

The Complete Turtle Trader, Michael Covel's engaging and well-written account of the Turtles, covers not only the experiment, but a second generation of Turtles who were inspired by the Dennis/Eckhardt vision. One of the most interesting segments of the book covers Salem Abraham, who by chance met one of the original Turtles, took a 180 degree life turn, and began his own highly successful fund. It's a powerful illustration that, though markets have changed since the 1980s, the dynamics of success have not.

Covel's book reads more like a piece of financial journalism than I expected, and I mean that as a compliment. It is this well-rounded perspective that makes "The Complete Turtle Trader" complete and a definitive contribution to the trading literature. He has clearly researched his topic and sources his quotes. He also casts a critical eye on his subjects, investigating why some Turtles found long-term success and why others didn't. A very enlightening portion of the book concerns Richard Dennis himself, the ending of the Turtle experiment, and the master's departure from his own trading rules and principles.

For those wanting access to the Turtle philosophy and rules, they're laid out clearly and unflinchingly. This is not a methodology for the faint-hearted, which is one reason so many Turtles and would-be Turtles have not stuck with it. Large drawdowns inevitably accompany the quest for large gains, and it's those large gains that ultimately provide trend following with its edge. Investors who place their money in funds simply don't want to see 20% of their money evaporate in a quarter. This inevitably leads money managers to refine (and ultimately eviscerate) the Turtle methodology.

Many of Covel's themes will ring true to readers of this blog, including the role of deliberative practice in the acquisition of trading expertise and the importance of emotional resilience and entrepreneurial spirit in sustaining a trading career. My impression, reading the book, is that Covel is under no illusions: the methodology, which provides the statistical edge in trading, is necessary but not sufficient for success. After all, the Turtles started with the same methods; some made it, others didn't. Covel's segment discussing what separated a successful Turtle, Jerry Parker, from his less successful peers is perhaps the most insightful portion of the book.

Because Covel so clearly lays out these ingredients of success, his book is relevant not just to trend traders, but to anyone who aspires to greatness in the markets. The message is clear: to win, the odds must be in your favor, and you must have the fortitude to keep playing, remain consistent, and compound your edge. That's a formula for success in any field of endeavor, which may be why the Turtle story finds universal appeal.

And, by the way, for readers who want to dig a little more into Turtle trading before purchasing Michael's book, I recommend his website. There are quite a few resources there, including articles on money management and trend following.


Review of "Way of the Turtle"

Saturday, October 27, 2007

Trade Like a Card Counter

In two recent posts, I have outlined baseline odds of prices hitting various benchmarks, including the prior day's highs and lows and the previous day's average trading price.

What makes trading interesting is that these odds shift dynamically: as markets move, so do the odds of hitting those benchmarks. It is the inability of market participants to adequately update their outlooks in the face of recent events that creates one important source of short-term trading edge.

When trading is compared to gambling, the implication is generally negative: that traders are little more than people who roll dice in hopes of a big payout. There is another side to gambling, however, typified by the card counter. The card counter, dealt a hand, is aware of the odds of winning with those particular cards. The counter also follows which cards have been dealt already, dynamically updating the odds that new, favorable cards will be forthcoming. It is this knowledge of odds--and the ability to update them in real time--that makes card counters so formidable that they are banned in many casinos.

Yesterday's market is like a set of cards dealt to us. Then we get a new card with the overnight market. The market open provides yet another card. All the while, the new cards either improve or fail to improve the odds that we'll hit target prices as the day moves forward.

As this analogy makes clear, a major source of trading edge becomes the decision to not trade. Just as a professional poker player will muck many hands when the odds are unfavorable, giving up a small amount to preserve the opportunity to bet large when circumstances are more favorable, the professional trader does not need to trade. Rather, the trader bets when the odds of winning are enhanced.

Such a trading approach emphasizes the exit--the target price--as well the entry. Yes, it's important to get as good an entry price as possible, but it's knowing the odds of hitting those benchmark prices that ultimately define the good trade idea if you're trading like a card counter. By controlling the bet size--not going "all in" on any one idea and risking ruin--and by exiting as soon as market events take the odds out of your favor, you let probabilities work in your favor.

Notice that this is a major reframing of stop-losses. A stop loss level is not defined by how much you're willing to lose. Rather, it's defined as that point at which the odds cease to be in your favor. The poker player will draw a new card that adds nothing to the hand and folds shortly thereafter: the updating of probabilities tells him to stop. But if you don't know the probabilities to begin with, it's hard to hold positions until the benchmarks are hit, and it's difficult to know when and where to stop playing.

Every day in the market offers us a few hands to play. To win the tournament of trading, we play many, many hands. Consistency--knowing and following the odds--distinguishes the professional gambler from the guy feverishly feeding a slot machine. Perhaps it's not so different in markets.


Handicapping Odds in Trading

Opening Price Gaps and Reversions to Average Trading Prices: More Intraday Stock Market Patterns

In my recent post, we looked at intraday price patterns in the S&P 500 Index (SPY) and found a few patterns of interest, including the frequency with which markets trade out of the range defined by the previous day's high and low price but then fall back into that range by the close. We also saw that markets that close strong are more likely to trade above their previous day's highs and markets that finish weak are more likely to pierce their prior day's lows.

In this post, we will examine reversion tendencies at an intraday level. Specifically, we'll look at how often the S&P 500 Index (SPY) closes its opening gap and how often it trades back to the average price of the previous trading day.

Going back to 2004 (N = 962 trading days), we find that SPY has closed its opening gap each day on 696 of those occasions, or about 70% of the time. We can thus see why traders commonly believe that "gaps tend to be filled". Interestingly, however, the median gap size (to the upside or downside) for the days in which gaps were ultimately filled was .14%. The median gap size for days in which gaps were not filled was .31%.

Let's look at this another way: When the opening gap up or down was greater than .35% (N = 211), the gap was filled on 97 of those occasions, or less than half the time. When the opening gap up or down was less than .35% (N = 751), the gap was filled on 599 of those occasions, or about 80% of the time.

This certainly makes sense: A large opening gap will tend to occur when a news event, economic report, or overseas market development has a significant impact upon the outlooks of traders and investors. When the market opens far from its prior day's close, there is a greater likelihood that market participants are repricing stocks in a way that will persist through the day. We should thus amend the slogan "opening gaps tend to fill" to "relatively small opening gaps tend to fill". When opening gaps are modest, fundamental events are not repricing U.S. equities and thus price will tend to drift back toward the prior day's close.

Now let's look at another price benchmark: the pivot price defined by the average of the prior day's high, low, and closing price. How often does SPY trade back to this pivot, which is one measure of the previous day's average trading price?

Note that this question is not entirely independent of the issue of opening gaps. Perhaps markets with small opening gaps (those not being repriced) are more likely to be range bound and hence trade back to the prior day's average price.

When the opening gap has been greater than .35% (N = 211), we've hit the prior day's pivot (average price) on 107 of those occasions or about half the time. When the opening gap has been less than .35% (N = 751), SPY has traded back to its pivot on 550 of those occasions, or about 70% of the time. It thus appears that markets that open with small opening gaps are more likely to trade well within the prior day's range, hitting the previous day's average trading price.

This is particularly obvious when opening gaps are very small. When SPY has opened within .10% of its prior day's close (N = 269), the gap has filled on 251 of those occasions, well over 90% of the time. On those occasions, SPY has also hit its pivot level 203 times, or about 80% of the time. A very small opening gap, particularly on days where there are no major economic reports due out and no major news stories, suggests that equities have little reason to be repriced.

Overall, going back to 2004 (N = 962 trading days), SPY has traded back to its pivot level (prior day's average price) on 657 occasions, or about 2/3 of the time. For those occasions in which SPY has returned to its pivot, it had closed the prior day a median of .31% from that pivot level. For occasions in which SPY did not return to its pivot, it closed a median of .73% from the pivot. In other words, late day strength or weakness that took the market far from its average trading price for that day--most likely an intraday breakout move--does not tend to be retraced the following day.

Another way of looking at this is that, when we close more than .40% from the prior day's pivot level (N = 508), we retouch that pivot the following day on 262 occasions, or a little more than half the time. When we close less than .40% from the prior day's average price (N = 454), we return to that pivot the next day on 395 occasions--almost 90% of the time.

If you combine the prior post with this one, you can see that we've established several price benchmarks for a daily trading session. We can calculate the odds of hitting the prior day's high price, low price, and average trading price. We can also calculate the odds of filling the opening gap. That just leaves us with one remaining set of price benchmarks: the odds of hitting prices outside the prior day's range. That will be the topic of the next post in this series. Then we will look at variables that improve the odds of hitting these price benchmarks.


Do Opening Gaps Tend to Fill?

Opening Gaps in the S&P 500 Index - Part One

Opening Gaps in the S&P 500 Index - Part Two

Friday, October 26, 2007

Making Use of the Twitter Trader Feature

As most readers are aware, I'm posting comments throughout the day with the Twitter application. Indeed, in the few months since beginning the Twitter posts (called "Tweets" among Twitter devotees) I've already logged in over 1100 comments.

I try to group my comments in sets of five, so that the most recent Tweets will always appear on the blog home page. The full set of comments are available on my Twitter page and also can be delivered automatically via RSS subscription.

Most of the Twitter entries fall into one of three categories:

1) Early morning observations to prepare for the trading day, such as economic reports due out, how international markets are behaving, breakout levels, etc.

2) Tweets during the day regarding interesting articles and blogposts that I come across, as well as comments about the markets as they're trading.

3) Summary notes after the market close that summarize my major market indicators and whether we're seeing greater or reduced strength and momentum day over day.

Increasingly, I'll be using Twitter to outline trading plans for the day based on market themes and the various indicators. Over time, I'd like the "blog within a blog" to be a way to help traders think about markets both before and after trading hours.

Thanks, as always, for the interest and support.



Twitter Update

Intraday Movement in the S&P 500 Index

This will kick off a series of posts regarding the intraday movement in the S&P 500 Index and factors associated with patterns that may hold a trading edge. We'll start with very simple observations and then add variables as the posts progress.

Going back to 2004 in the S&P 500 Index (SPY), we have 961 trading days. Of these 961 days, 528 closed higher than the day previous, and 427 closed lower.

Of the 961 trading days since 2004, 516 traded above the previous day's high price and 433 traded below the prior day's low. Interestingly, however, only 274 of the 516 occasions actually closed above the prior days high and only 211 of the 433 occasions closed below the prior day's low.

What that illustrates is that, if we consider the previous day's trade to represent a trading range, the next trading day often trades outside the range but ultimately falls back into that range.

Along that line, only 129 out of the 961 days--less than 15%--are inside days (i.e., trade with both a lower high and a higher low than the prior day). Thus, 832 out of the 961 days break out of the prior day's range at some point during the day, but only 485 of those occasions (about 60%) actually close outside the previous day's range.

Out of the 961 trading days, 117 (or about 12%) were outside days (i.e., trade with both a higher high and a lower low relative to the prior day). Of these outside days, only 24 closed higher than the prior day's high and 40 closed lower than the previous day's low. This means that, once again, about 40% of all moves outside the prior day's range returned back to that range.

As we look at variables beyond current and recent price, we will want to identify those that help us determine which days will sustain their moves outside the prior day's range and which will revert to that range.

Now for just one added variable:

When the current market closes in the top half of its daily trading range, the next day takes out the previous high price 378 out of 554 times, or about 2/3 of the time. When the current market closes in the top half of its daily trading range, the next day takes out the previous low price on 189 occasions--about 1/3 of the time.

When the current market closes in the bottom half of its daily trading range, the next day takes out the prior low price 244 out of 407 occasions, or about 60% of the time. When the current market closes in the bottom half of its daily trading range, the next day takes out the prior high price 138 times--about 35% of the time.

As we might expect, then, strong closes (those that finish in the top half of their trading range) are more likely to be associated with days in which we trade above the prior day's high; weak closes are more likely to be associated with days in which we trade below the prior day's low. Only about 1/3 of the time will a strong (weak) close be followed by a break of the prior day's low (high).

When we close strong, the next day closes above the prior day's high 210 out of the 378 occasions in which it trades above that high. When we close strong, the next day closes below the prior day's low only 91 of the 189 occasions in which it trades below that low. Once again, we see that many days that trade outside the prior day's range fall back into that range.

Similarly, when we close weak, the next day closes above the prior day's high 64 of the 138 occasions in which it trades above that high. When we close weak, the next day closes below the prior day's low 120 of the 244 occasions in which we trade below that low. In other words, half of all occasions in which we trade below the prior day's low don't ultimately close below that low.

These are basic observations; nothing in them by themselves is a trading pattern. But there are some interesting findings. 85% of all days will trade outside the prior day's range. Only 50-60% of all trading days, however, will close outside that range. About 2/3 of strong days will be followed by days that trade above the prior day's high; 2/3 will stay above the previous day's low. Similarly, about 60% of weak days will be followed by days that trade below the previous day's low; about 2/3 will stay below the prior day's high.

Let's see in upcoming posts if any indicators help us shift those odds further.


How Dr. Brett Trades

A Favorite Trading Pattern

Thursday, October 25, 2007

The Psychology of Behavioral Premises

I'm going to try to explain an important psychological concept and why it's of paramount importance to trading. The concept is something I call "behavioral premises". A behavioral premise is a rationale for our actions; it's the set of assumptions that drive our choices and responses in various situations. The network of our behavioral premises represents our belief system about ourselves, others, and the world around us. These beliefs may not be enunciated, but they are the filters through which we perceive the world, thus coloring how we respond.

An important principle is that our behavioral premises tend to evoke responses from other people that, in turn, reinforce those premises. That is, people's responses toward us will be shaped, in part, by how we approach them--and the beliefs that underlie our approach. Here are a few examples:

* A person has been hurt in past relationships and doesn't want to face rejection again. Her behavioral premises are that relationships are dangerous and that others don't really care about her after all. As a result, she maintains a guarded stance with people who might otherwise want to get to know her. Seeing that she is not approachable, others keep their distance from her and make no effort to open up themselves. This reinforces her premise that people are uncaring and unavailable, convincing her that she must stay all the more guarded.

* A job applicant believes that he has no chance to land a desirable position. His behavioral premise is that he lacks the charm and personality to come across well in an interview. As a result, he is nervous throughout his visit to the firm and comes across as unsure of himself. Sensing this, the interviewer concludes that he won't be an effective representative of the company and turns him down. This confirms the man's belief that he is not cut out to be hired for a good job, and he approaches the next interview with even less confidence.

* A businessman is convinced that others are out to cheat him. His behavioral premise is that he needs to be on guard at all times, because his employees can't be trusted. He establishes strict rules and maintains stifling oversight of his employees, even after their training phase has been completed. The employees, feeling untrusted and not valued, leave the business one by one to find a more suitable work environment. This convinces the businessman that he's right; that employees will just take his training, use him, and move on. As a result, he trusts the new group of employees even less.

Notice that each of these scenarios is one in which there is a vicious cycle. The behavioral premise leads to actions that bring outcomes that reinforce the premise. This is one major reason people stay stuck in self-defeating patterns.

The same dynamics occur in trading. Imagine that, feeling like a defeated trader (per the recent post), you act on the behavioral premise, "I just can't make money in the market." You follow your rules, enter a trade, and it moves a few ticks against you. This only reinforces your negative belief and you quickly exit the position before the loss becomes too great. Meanwhile, the market chops around a bit before eventually moving in the direction you had anticipated. All you can do is shake your head: your premise has proven true once again.

So how do people escape from these vicious cycles? Most people can't talk themselves out of their premises; they need direct, powerful emotional experiences to show them that their beliefs are wrong. This is one reason I emphasize solution patterns with the traders I work with. We spend extra time examining trades that have worked out and isolating what the trader did right on those trades. By creating a model for good trading out of these successful trades, we increase success and disconfirm negative behavioral premises.

One of my favorite exercises is to look at what happened in the market after exiting a trade. Very often the basic trade idea was right all along; it was the timing that was off. This also disconfirms negative premises. The message is that it's not that you can't read the market; it's just that you need to refine your execution: when you enter, how large you enter, and where you stop yourself out. I've often seen big results from such seemingly small refinements. Why? Because the process of making those refinements challenges the behavioral premises that led to the "stuck" patterns to begin with.

We will always live up to our most deeply held behavioral premises--for better or for worse.


Solution Focused Trading

The Question to Ask When You're in a Slump

Advance-Decline Line Dynamics and Other Items On the Thursday Radar

* Lagging Advance-Decline Line
- Above we see a great chart from Decision Point. It tracks only the common stocks within the NYSE universe. Throughout the recent bull market we can see that the Advance-Decline line for the NYSE common stocks has confirmed price rises--until very recently. Note how the most recent high in the NYSE Index was not accompanied by a fresh peak in the AD line. A look at advance-decline lines that are sector specific finds that the line for the S&P 600 small caps is actually making new lows, as are the lines for financial and consumer discretionary stocks within the S&P 500 universe. The lines specific to the Dow Industrials and S&P 500 have made new highs recently. This continues to be a large cap led market, with notable weak sectors related to housing, banking, and certain consumer areas.

* What's Holding Up Well? - Four stocks in my forty-stock basket (five most highly weighted stocks within eight S&P 500 sectors) show particular relative strength: MO, KO, MSFT, and MRK. That having been said, looking at my Technical Strength measure (which quantifies trending behavior), we have 8 stocks qualifying as technically strong, 11 as neutral, and 21 as weak. What that tells me is that, even among the relatively strong large caps, strength is selective at present. Here's a post on the Technical Strength measure; note that I track Technical Strength (along with other measures of momentum and strength) each day in my Twitter comments. The most recent five Twitter comments appear on the home page of this blog (under "Twitter Trader"); the entire set of comments can be found on my Twitter page.

* Strongest and Weakest Sectors - The excellent Barchart site ranks industry groups by their intermediate-term relative strength. The strongest, from top down, are agricultural chemicals, shipping, copper, personal computers, technical services, and internet service providers. The weakest, from bottom up, are residential construction, surety title insurance, home furnishing stores, toy and hobby stores, home improvement stores, and department stores. Housing and the consumer seem to be the problem areas. Sectors benefiting from the weak dollar are among the leaders.

* Thoughtful Subprime Comments and More - A worthwhile perspective linked by Trader Mike analyzes what got us into the mess. See also his link to the article on blogs as takeover targets. It's difficult to appreciate the inroads blogs have made in a short time. I was recently approached about speaking to a major investor conference that would attract well over 1000 participants. Many of the financial blogs, this one and Mike's included, address much larger audiences every day. But the average blog visitor only spends a few minutes on each site. Clearly, there's been a shift in how people access information and engage the media.

* Seasonal Trends - Kirk examines seasonal trading patterns and stocks broken down by monthly performance. Markman has also done some nice work in this area in his Online Investing book.

* Macro Views of Markets - The rise of emerging markets and diversification isn't what it used to be: more worthwhile links from Abnormal Returns.

* Worthless Indicators - Great video clip from Fox Business and Jon Hoenig.

Wednesday, October 24, 2007

Four Problem Traders; Four Trading Strengths

A while back I posted on the topic of trader strengths, and readers offered worthwhile perspectives on some of the factors that distinguish successful from unsuccessful traders. After much consideration, I decided to approach the topic a bit differently: by outlining four kinds of problem traders I frequently encounter and by identifying the strengths that help people deal with these problems.

Problem Trader #1: The Frustrated Trader - The frustrated trader deals with frequent angry reactions during trading. Sometimes the anger may be vented outward; other times it is turned inward. For example, many rigidly perfectionistic traders are also frustrated traders, because they cannot live up to their impossible standards and thus artificially create failure experiences for themselves. Frustrated traders are often impulsive traders and will make trades to either compensate for prior losing trades or to make up for missed opportunities. Frustrated traders will often ignore position-sizing rules and undergo occasional blowup losses as a result. It's easy to identify the frustrated trader by their physical cues: yelling, cursing, complaining, and gesturing when they should be focused on the screen. The key strength that combats frustration: self-acceptance and being supportive of oneself. Key techniques for combating frustration: setting reasonable goals; using biofeedback for building self-control and calm focus; and mentally rehearsing trading plans/rules to make them more automatic during the trading day.

Problem Trader #2: The Anxious Trader - The anxious trader is consumed with fears of loss, missing out on objective opportunity either by not taking signals or by sizing positions too conservatively. In a sense, the anxious trader is more concerned about not losing than about winning. This risk aversion can lead to analysis paralysis, as the trader waits for the perfect setup that never quite materializes. Sometimes the anxious trader is one who has been traumatized by prior losses. It's too painful to relive memories of those losses, and so the anxious trader exits positions too quickly and is too reluctant to get into positions. A very common feature is cutting profits rapidly out of fear of losing those. Signs of the anxious trader include muscle tension, worry, relief over getting out of positions (or away from the screen), and inability to trade reasonable size. The key strength that combats anxiety is confidence and an ability to accept loss as a natural part of trading. The techniques most helpful in combating anxiety include cognitive methods for replacing worry talk with constructive problem solving; behavioral techniques to calm oneself and reprogram stress responses; setting process rather than outcome goals; and regaining confidence by trading successfully in simulation mode and gradually building one's size.

Problem Trader #3: The Overconfident Trader - Overconfident traders approach trading like a casino--and they're not the house! The overconfident trader typically overtrades, which means trading size too large for their account and trading more often than opportunity dictates. Very often the overconfident trader is attracted to action in markets, rather than consistent profits and sound discipline. As a result, the overconfident trader can be identified by winning periods punctuated by unusually large and damaging losses. Sometimes the overconfident trader is also a desperate trader, hoping to strike it rich. A common feature of overconfident traders is their lack of preparation: they think that anyone can make it with simple methods and a gut feel. The problem is that they never spend enough time reviewing markets and intensively watching screens to develop that feel. The key strength that combats overconfidence is humility, a respect for markets and risk, and conscientiousness in crafting and following trading rules. Techniques that combat overconfidence include mental rehearsal and self-hypnosis to instill trading rules and support rule-governance; mechanical position sizing to avoid risk of ruin; and cognitive techniques to intercept and challenge grandiose thoughts following winning periods.

Problem Trader #4: The Defeated Trader - Defeated traders are ones who, in trader parlance, have "lost their mojo". Their thought patterns are negative and this blinds them to opportunity. Very often they will be filled with shame, remorse, and guilt over past losses and very often they enter new trades expecting the worst. As a result, they don't often enter new trades and will miss out on opportunities that are genuinely present. They often stop working at their trading, as anything trading-related is associated with emotional pain. Defeatism thus becomes a self-fulfilling prophecy. It's easy to recognize defeated traders, not only by their depressed mood, low energy, and lack of enthusiasm, but also by their "yes, but" rejection at helping efforts. Very often the defeated trader will focus on losses and mistakes and gloss over progress that's been made: they see the trading cup as half empty, rather than half full. The key strength that combats defeatism is emotional resilience and the ability to use losses as learning experiences. Techniques that combat defeatism include cognitive methods for reprocessing negative thought patterns; structuring of the learning process to emphasize strengths and solutions rather than mistakes; and a focus on attainable goals and the creation of success experiences.

Most of us can identify elements of these four traders in ourselves. If I had to choose, I'd say that I am most like the Anxious Trader. I am quick to step away from markets when my setups aren't there--sometimes too quick! Many of the traders I work with fit into the Frustrated Trader category: they're aggressive, achievement-oriented, and hard on themselves.

Knowing your patterns does not, in itself, enable you to change them, but it's a necessary step. Indeed, I find that, regardless of the patterns, the first step of progress a trader makes is interrupting old patterns that aren't working and trying something different. The ability to stand outside oneself as an observer of patterns is a core self-coaching skill.


Becoming Your Own Trading Coach

A Framework for Rapid Behavior Change

An Important Step in Self-Coaching

Preparing for the Coming Day's Trade

At the top, we have a Market Delta chart of the overnight session in the ES futures up to about 5:30 AM CT. Note on the left axis how we are now accumulating volume at lower price levels over the course of the morning, which tells us that value is being accepted below 1520. Very often I will use the overnight range as an initial reference point for the morning trade. If you think of the overnight range as the consensus re: value, given all overnight events (including how overseas markets have traded), a move out of the range in early morning trade represents a potential breakout trade. We can then use volume at the bid vs. volume at the offer (the numbers inside the Market Delta bars) to see if prices away from the overnight range are attracting significant participation.

If we do get a break out of the morning range, what would be potential price targets? Here is where it's valuable to observe markets at a larger time frame. The second chart shows how we've been trading from the premarket on Tuesday (yesterday) through the present. We can see that the ES market made an attempt at a downside break (that failed) and an attempt at an upside break (that also failed). This has kept us in a trading range over the entire period. It makes sense that we would test the top or bottom of this range on any break from the current overnight session that attracts solid participation.

Very often we can get clues as to which way the ES market will break by tracking specific sectors and how they're behaving relative to their ranges. Sectors such as the semiconductors (SMH), energy issues (XLE), and banking stocks ($BKX) have been theme leaders of late. We can also use the new day's distribution of NYSE TICK values to see if buying or selling interest is dominating, leading us to potential breakout moves. And, of course, we can track the emerging day's volume relative to average volume for that time of day to see if we have enough interest from large traders to sustain volatility and potential breakout moves.

All of these things go into my homework before a day's trade. From my observations I frame hypotheses--"what-if"scenarios--about the market and how I would like to trade those. The more clearly I frame my actions in advance, the more automatic those decisions will be when the time comes to execute.

Preparation, I find, is a key to consistency.


Using Market Delta in Trading

Tuesday, October 23, 2007

Reflections on Opportunity and Trading Success

I just received word from my publisher, Wiley, that The Psychology of Trading and Enhancing Trader Performance have been picked up for translation in the Czech Republic. That adds to foreign language translations in China, Germany, Japan, Poland, and Spain. Much of the international interest in the books has come through this blog; many thanks to international readers for their support.

A valuable point about trading psychology and performance was made by Jeff in his comment to my recent links post. Jeff quoted an excellent article from Teresa Lo, in which she cited William Eckhardt's observation that "what really matters is the long-run distributions of outcomes from your trading techniques, systems, and procedures". Further, Eckhardt observes that, if you make a bad trade and maintain good money management, you won't get hurt too badly. But if you miss a good trade, that opportunity is lost forever. Moreover, it may be that those missed good trades that makes the difference to those "long-run distributions of outcomes."

I'm glad that Teresa posted that perspective and that Jeff picked up on it. So much of success, whether it's writing books, trading, or advancing in a career, boils down to consistently pursuing opportunities when they present themselves. The majority go nowhere, but it's the few that work out that can make all the difference.

So it is in trading. I'm in the process of reading Michael Covel's new book The Complete Turtle Trader, which highlights the opportunity theme in a different context. (By the way, I like the book quite a bit and will write a review shortly). The Turtles had no magic formula for crystal-balling which markets would trend and which wouldn't. Instead, they diversified their capital and went with relative strength. Many of the the strong markets reversed and whipsawed them. But it was the few, good trending markets that provided the lion's share of the profits and more than compensated for the losses due to chop.

We often focus on bad trades and trying to eliminate those. What doesn't show as readily in our P/L summaries are the missed opportunities: the occasions in which we failed to take trades either because of fear, risk aversion, discouragement, or because we hit our loss limits for the day or week. That's Eckhardt's point: if you manage your losses, the odds are pretty good they won't put you in the poorhouse. But if you fail to seize opportunity, you'll never make the big leagues.

If you are truly serious about a trading career, seize every opportunity you can. If you have the chance to trade with really good traders, go for it. If you have the opportunity to talk with a successful trader, jump at it. A new idea? A new market? Keep looking for where opportunity may lie: the difference between success and failure may just be the one or two promising paths you take the time to investigate.


Dynamic Thinking and Trading Success

Core Self-Evaluations and Trading Success

A fascinating study tracked 7000 young people over a 25 year period to examine their success during the middle of their careers. The researchers found that young people who exhibited positive core self-evaluations earned significantly more than their lower self esteem counterparts. Family socioeconomic status and academic achievement were also positively correlated with career success decades later.

Perhaps the most striking finding was that self-evaluations facilitated success by enabling young people to take advantage of their socioeconomic and educational advantages. When those advantages were present among lower self-esteem individuals, higher incomes were not achieved.

In this study, self-esteem was one element of core self-evaluations. Also included were self-efficacy (belief that one can achieve one's goals); emotional stability; and locus of control (the degree to which one perceives an ability to control life outcomes).

The authors stress that we need certain advantages to achieve success (socioeconomic advantages, educational attainment), but that we also need to view ourselves in ways that enable us to make use of these advantages.

Interestingly, the authors suggest that those with low core self-evaluations may avoid opportunities, simply because these could be threatening to their self-views.

The implication for trading is that two traders could begin with the same "edge" in the markets--the same ideas, the same trading system--and achieve very different results based upon their core self-evaluations. It is difficult to imagine a trader taking advantage of an edge if he or she did not truly experience themselves as worthy and efficacious.

Perhaps this is why research finds that the four dimensions of core self-evaluations are highly correlated with job satisfaction and job performance. When we think we can make a difference, we are most likely to pour ourselves into our work and find it fulfilling. Perhaps, too, this is why so few traders succeed in making trading a career: their learning process undercuts, rather than boosts, their core self-evaluations by failing to structure the learning in a way that promotes experiences of mastery.


Building Self-Efficacy

Goal-Setting For Traders

Monday, October 22, 2007

Extreme Bearish Sentiment and Other Ideas to Start the Week

* Extreme Bearish Sentiment - The NYSE TICK captures intraday sentiment, assessing at each minute the number of stocks trading at their offer price minus those trading at their bids. My Adjusted Cumulative TICK compares the current 1 minute TICK readings with the average 1 minute reading over the last 20 trading sessions and then adds these readings to arrive at a single daily total. When the total is below zero, we have more selling sentiment than the 20-day average; when the total is above zero, we have more buying sentiment than the 20-day average. On Friday, we had a five-day average Adjusted TICK of less than -400. That's only happened on 53 other occasions since 2004 (N = 952 trading days). Five days after the extreme selling sentiment, the S&P 500 Index was down by an average of -.17% (26 up, 27 down). That's notably weaker than the average five-day gain of .19% for the remainder of the sample. Our earlier post noted a bullish edge after five down days, but when the bearish sentiment is extreme, we don't see this bullish edge.

* Time Frame Selection - Trader Mike updates his links with interesting posts on selecting a time frame for trading and recession talk from CAT.

* Trading Education - Chris Perruna with some excellent links re: managing your money and stock market education.

* Market Summaries - The Shark Report tracks market internals and big winners/losers on the day.

* Market Fear - VIX and More tracks the fearfulness of Friday's market.

* Where Are The Earnings? - Bespoke Investment Group tracks earnings by market sector--interesting patterns.

* Frontier Market - Random Roger takes a look at Kazakhstan and sees something interesting.

Big Gap Down After a Big Down Day: What Comes Next?

My historical studies typically take the most distinctive aspects of the present market and then ask, "When this has occurred in the recent past, what has typically followed in the markets?" As it looks right now, the S&P 500 Index (SPY) looks set to gap open much lower following a very weak day on Friday. What has typically occurred when a large gap to the downside has followed a big down day?

I went back to 1996 (N = 2934 trading days) and found 26 occasions in which SPY was down by more than 2% the prior day and then gapped open to the downside by -.5% or more. From the downside gap open to the close of that same day, the market was up 15 times, down 11, for an average gain of .86%. The following day (from the close of the gap down day to the close of the next day), the market was up 18 times, down 8, for an average gain of 1.18%. All in all, from the downside gap open to the close of the following day, the market was up 20 times, down 6.

In short, there has been no bearish edge to selling into a sizable gap down when the prior day has been down sharply. Indeed, on average, the trader would have made money by buying the open and holding through the following day.

While that's not a pattern I'll be trading mechanically, it is one that primes me to look for buying setups during the day--especially price lows that are accompanied by fewer stocks making new lows and less extreme negative TICK readings. Should we not get those setups, that too would be an important indication, as it would suggest that the market is so weak that it cannot live up to historical precedent.


Short-Term Waterfall Declines in the Market

Sunday, October 21, 2007

Short Rate Drops and Other Ideas for a New Market Week

* Safe Haven - When markets drop, it's not uncommon to see capital flow to short-term Treasury bills. That reduces their yield. We also see short-term yields fall in anticipation of (or in response to) Fed rate cuts. I went back to 1992 (N = 3891 trading days and found 282 occasions in which the yields on the 6 month Treasury bills fell by 5% or more over a ten day period. Twenty days later, the S&P 500 cash index ($SPX) was up by an average of 2.29% (194 up, 88 down). That is much stronger than the average 20-day gain of .64% (2237 up, 1372 down).

When $SPX is down over a 10-day period and yields on the 6 month Treasury bills fall by 3% or more during that same time (N = 259), the next 20 days in $SPX average a gain of 1.34% (155 up, 104 down). When $SPX is down over a 10-day period and yields on the 6 month Treasury bills fall by less than 3% or rise (N = 1339), the next 20 days in $SPX average a gain of .77%. Aggressive reductions of short-term rates have generally been bullish for stocks. Worth keeping an eye on in the wake of Fed speculations.

* Turnaround in the Market Indicators - My Trading Psychology Weblog noted divergences two weeks ago as we made new highs; now we're seeing weakness across a number of indicators, including the NYSE TICK and 20-day new lows. Meanwhile, Adam Warner passes along some insights about the Hindenburg Omen pattern.

* Do You Trade Historical Patterns? - Brian at Alpha Trends makes the important point that he would never mechanically trade a historical pattern, such as the one I noted regarding action following very weak market days. I completely agree. What's key about that post is that a very weak market does not have a bullish edge in the near term, unlike other reversal patterns I've written about. When we get an expansion of new lows and weakening of downside momentum, it's not at all uncommon to find follow-up weakness 1-5 days out. Note, in Brian's wrap up of Friday's weak market, he tracks the 5 day MA to gauge intermediate-term market trend. That's something I'll take a further look at.

* New Resources - Fox Business Network has begun operations and offers ETF-based model portfolios. TraderNews tracks news headlines relevant to traders (including Asia and Europe) and updates index quotes and market news.

* Excellent Reviews of the Market - Bill Cara reviews the past week's performance in ETFs and various sectors. Abnormal Returns looks at market themes, including gold, stocks, and inflation. The Big Picture examines prospects for a Fed rate cut and an oil price shock. James Altucher finds some stock picking nuggets, including 10 stocks with significant insider buying.

* Odds of a Bounce - The Short-Term Trading blog looks at the odds of bounces of various sizes when we're oversold. Many of my trades are based on the odds of hitting previous day's high or low price and the odds of hitting first and second pivot point levels. That's another topic I'll be revisiting.

A Site Devoted to Finding a Trading Edge

I'd like to call attention to the excellent site, which conducts research on historical market patterns.

Here is a page with links to their various research articles. Among the topics you'll find are moving average crossover patterns, VIX patterns, and sentiment patterns with put/call ratios. The article on predicting the VIX itself is particularly interesting.'s most recent post develops an idea that I recently advanced: looking at the relationship between gold and technology as a sentiment measure. Technology, as a growth sector, benefits from risk-seeking sentiment in the market; gold, as a safe haven, benefits from risk aversion. That suggests that the relative performance of gold to technology might provide a nice window into the risk appetites of traders and investors.

What they found was that, when the 3-day exponential moving average of the gold:technology ratio was below the 3-day simple moving average, returns for gold were above average. Indeed, cumulative returns from such a strategy look compelling (although further refinement to reduce drawdowns would be needed).

The reason such a strategy works, they suggest, is that profits from risk-seeking assets tend to flow toward risk-averse ones. An alternative interpretation is that dips in the gold:technology ratio represent trader/investor overreactions that tend to correct over time. If that is the case, then we should expect short-term outperformance by any safe haven to have bullish implications prospectively.

My next post will examine just such a possibility.


Finding Gain Where There's Been Pain

Saturday, October 20, 2007

Dow Industrials vs. Russell 2000: A Long-Short Illustration

Here's a chart of the Dow Jones Industrial Average (DIA) denominated in shares of the Russell 2000 Index (IWM). The charts we're accustomed to denominate shares in dollars. When we use a second market as the denominator, we create a new instrument that reflects the relative strength of the numerator with respect to the denominator.

In other words, what we're looking at is the price performance of a holder of a long-short position (long DIA, short IWM). Note that this looks like a pretty nice bottom pattern on a chart; DIA has been in an uptrend vs. IWM for over a year now.

When you trade a long-short portfolio, the relationships between markets become your trading instrument. When those markets are highly correlated, your portfolio is thus hedged against general market risk. A long-short portfolio is an excellent way to exploit market themes without having to time or crystal ball general market direction.

Moreover, your new instrument--the relationship between markets--has its own historical price patterns that you can identify and exploit, no less than an individual stock or index. More on this to come shortly.


2007 Performance By Style

2007 Performance By Style and Region

Weekly New Highs and Lows: The Stock Market's Recent Dynamics

If you click on the above image, you'll see a weekly chart of the Russell 2000 ETF (IWM), with a set of numbers overlaid in blue type. The first number of the set is the number of NYSE stocks making 52-week highs during the week. The second number is the number of NYSE stocks making 52-week lows during the week.

I specifically chose the peak new high and new low periods during the recent market swings to emphasize the market's recent dynamics. Note that IWM has been in a trading range since late December, 2006. While the large cap indexes, such as the Dow and S&P 500 Index, made new highs during the recent upswing, IWM failed to surmount its prior highs. We've now pulled back into the middle of the longer-term trading range.

The weekly NYSE new high/low figures show that progressively fewer issues are participating in the market's upswings. Moreover, we've seen an expansion of new lows during the declines of 2007. That is what I'm focusing my attention upon at present. If we see fewer new lows as IWM tests the lower end of its trading range, I'll expect that range to hold. An expansion of new lows from the August extremes would be troublesome for the bulls indeed and would put a large proportion of shares in bear market mode.

Bear market? We're not there yet, in my estimation. A look at the charts for banking stocks ($BKX) and homebuilders ($HGX) shows clear bear markets in those sectors. Quite simply, we're making lower lows during 2007's declines. On the other hand, we have other sectors, such as energy (XLE) and technology (XLK), that are in clear uptrends, making fresh highs during 2007's rallies. One sector I'm watching particularly to see if we hold or break recent lows is the consumer discretionary issues (XLY). They may provide one of the best indications of whether housing-related weakness creates bear market conditions across the economy.

My gut tells me that large cap growth is too attractive to pass up with the dollar's decline and the current level of liquidity; that's helped sustain the NASDAQ 100 rise. For that reason, I expect the trading range to hold. But my gut's been wrong before. That's why I track the sectors and the new highs/lows every week and review major indicators in my Weblog. It helps to have objective data to support subjective perception.


Recent Market Themes

Friday, October 19, 2007

Big Down Day in the Stock Market: What Comes Next?

Well, it started with divergences in our indicators last week and then picked up with a repeat of the risk aversion trade from August, as noted in the Twitter comments. Friday's market truly accelerated the weakness: we saw 456 new 20-day highs across the major exchanges and 1805 new lows. The downside momentum was evident in the Demand/Supply data, with Demand (an index of the number of stocks closing above the volatility envelopes surrounding their short- and intermediate-term moving averages) at 21 and Supply (those closing below the envelopes) at 204.

I went back to the start of 2003 (N = 1185 trading days) and found 22 occasions in which we had more than 1000 new 20-day lows and Supply greater than 150. These, like Friday, are days in which we have seen high downside momentum, with a number of stocks extended to the downside.

Interestingly, of the 22 occasions, 16 registered a lower daily close in the S&P 500 Index (SPY) during the next week of trading. Indeed, five days after the strong momentum down day, SPY was up 11 times and down 11 times, for an average loss of -.14%. That compares poorly with the average five-day gain of .23% for the remainder of the sample.

In sum, broad weakness and downside momentum are often followed by further price weakness in the short run. It's when index lows occur with fewer stocks making fresh price lows on less extreme downside momentum readings that reversals are most likely to occur.


Stock Market Momentum and Short-Term Price Cycles

Five-Day Price Relationships in the Stock Market

In a recent post, we took a look at simple 20-day price relationships and what they told us about future price changes. In this post, we'll move to a five-day basis and see if we can learn anything from similar price relationships.

As before, I went back to 1990 (N = 4482) and investigated five-day new highs and new lows in the S&P 500 cash index ($SPX).

When we have made a five-day high in the S&P 500 Index (N = 1381), the next five days in $SPX have averaged a gain of .04% (740 up, 641 down). When we've made neither a five-day new high nor a five-day new low (N = 2081), the next five days in $SPX have averaged a gain of .14% (1166 up, 915 down). When we've made a five-day low in $SPX (N = 1020), the next five days have averaged a gain of .48% (611 up, 409 down).

Once again, as with the 20-day data, we see subnormal returns following five-day highs and above average returns following five-day lows.

Interestingly, when the S&P 500 Index makes a five-day high *and* it closes above its 50-day moving average (N = 1145), the next five days in $SPX average a gain of .02% (610 up, 535 down). When the S&P 500 Index makes a five-day high and closes below its 50-day average (N = 236), the next five days in $SPX average a gain of .12% (130 up, 106 down).

It thus appears that returns are lowest when we make a five-day closing high in a market that is already extended to the upside.

When the S&P 500 Index makes a five-day low *and* it closes above its 50-day moving average (N = 466), the next five days in $SPX average a gain of .37% (284 up, 182 down). When the S&P 500 Index makes a five-day low and closes below its 50-day moving average (N = 554), the next five days in $SPX average a gain of .58% (327 up, 227 down).

As with the 20-day data, we see superior returns whenever a five-day low is made, with the best returns coming following five-day lows in markets that have been extended to the downside--a clear reversal effect.

These five-day findings largely confirm observations made by Larry Connors and Connor Sen in their book "How Markets Really Work". The test of any market indicator that is not purely price-based is whether or not it adds value to an analysis of price relationships alone. That will be the topic of follow-up posts on this theme.


The Trend You See Is Not What You Get

Thursday, October 18, 2007

Trading Gold and Other Topics on the Thursday Radar

* A Short-Term Model for Trading Gold - Brilliant post from MarketSci builds on a TraderFeed observation and turns it into quite a trading model. I'll comment further in a separate post. Fantastic work.

* Market Themes
- Accelerating dollar weakness, a flight to safety among Treasuries, and record oil prices.

* Terrible Idea for a Terrible Reason - Markman on the bank bailout. I'm currently reviewing his new book manuscript; looks very good.

* Top Five Yielding Stocks From a Prince - A view from StockPickr; perhaps what a number of sovereign funds are looking at, as they watch U.S. assets become cheaper thanks to the dollar.

* Charles Kirk Interview - Here's the link to the transcript of the Stocks & Commodities interview; check out his ideas on screening stocks.

* "The Crowd Has Yet To Panic" - Ritholtz on housing: no end in sight.

* Consumer May Not Be Down and Out - Gallup survey on holiday spending prospects.

* Disaster as an Investment Strategy - Thanks to a reader for the heads up on this New Yorker piece on Nassim Taleb.

What Can We Learn From Simple Price Relationships?

In recent posts, I've emphasized the importance of seeing relationships among sectors and markets. But how about price alone? Does past price tell us anything about future price?

First I went back to 1990 (N = 4467 trading days) in the S&P 500 cash index ($SPX) and examined next 20-day returns after the market had closed at a 20 day high or a 20 day low.

When the S&P 500 Index has closed at a 20-day price high (N = 763), the next 20 days in $SPX have averaged a gain of .48% (475 up, 288 down). When the Index has closed neither at a 20-day high nor at a 20-day low (N = 3319), the next 20 days in $SPX have averaged a gain of .75% (2028 up, 1291 down). When the S&P 500 Index has closed at a 20-day low, the next 20 days in $SPX have averaged a gain of 1.38% (261 up, 124 down).

We thus see subnormal returns after 20-day highs and superior returns following 20-day lows.

But let's look a bit deeper. Suppose we have a 20-day high in which price is also above its 200-day moving average. In that situation (N = 691), the next 20-days in $SPX have averaged a pretty normal .62% (439 up, 252 down). When, however, we've had a 20-day high in which price was below its 200 day moving average (N = 73), the next 20 days in $SPX have averaged a *loss* of -.98% (36 up, 37 down).

What that suggests is that a 20-day high in a market that has been in a longer-term uptrend is not necessarily a bearish event or even one with significantly subpar returns. Rather, it's when we have a 20-day high in the context of a market that has been in a longer-term downtrend that we want to consider the possibility of a (bearish) return to that larger trend.

And how about when we have 20-day lows? When we've had a 20-day low in the S&P 500 Index and we're above the 200-day moving average (N = 166), the next 20 days in $SPX have averaged a gain of 1.01% (118 up, 48 down). When we've had a 20-day low and we're below the 200-day moving average (N = 219), the next 20 days in $SPX have averaged a healthy gain of 1.66% (143 up, 76 down).

In short, we've seen the greatest upside returns when the market has made a 20-day low in a market that has been down over a longer time frame--a clear reversal effect. Even when we have a 20-day low in a market that has been up over a longer period, however, returns are still favorable.

Price may not tell us everything, but it does offer a few indications that can be of use to an intermediate-term time frame.


Momentum and Reversal Effects

Fading the Herd