Trading the Market By Knowing *Who* Is Participating

At the close of the day, TraderFeed will have finished a year of publication. I want to thank all readers who have made this a most rewarding experience. As a note of thanks, I'm going to suggest a trading pattern that is quite powerful and that just happened to make me a few pennies this morning.

The pattern occurs when one or more of the big global markets--the dollar, gold, oil, or treasuries--breaks out to new highs or lows. The more significant the breakout--and the more markets participate in the breakout--the better. Today, we saw the Euro break out to yet further highs vs. the dollar and the 10-year Note break to new highs (i.e., yields broke to new lows).

From the point of the breakout move (just as it's begun), trace the volume in the stock indices to see if: a) volume picks up; b) the distribution of volume (at bid vs. offer) becomes skewed; and c) the NYSE and Dow TICK become skewed. Specifically, you want to see if large traders enter the market around those points and whether they're dominantly entering on the buy or sell side.

What you're tracking are the global macro participants in the marketplace. Many of these are hedge fund and investment bank traders, and they have the size to run the locals over. When you track the global markets *and* the trade flow, you start thinking like the macro traders yourself and you can ride their coattails.

IMO, this may be the most valuable and practical blog post I've come up with this past year. Markets are global and markets are interrelated. If you focus only on *your* market, it's easy to get run over when the big money managers act on a theme you don't even see. If you start thinking like the pros, you may just start trading like one.

U-Turns In The Market: What Comes Next?

We've had an unusual situation in the stock market, in which we had a high momentum decline on Monday followed by a two-day recovery that erased that decline on strong positive momentum. The natural question to ask is: What has happened historically following such market U-turns?

Before I address this question, however, allow me to step back and reflect upon how to utilize these historical findings. For me, they are background: they tell you if there has been any directional edge to the market under current conditions and how large that edge has been. If I see a decent skew to the data, that forms a hypothesis in my mind that will help shape my thinking about the market 1-5 days out.

A hypothesis, however, is not a conclusion. A hypothesis is an idea that needs to be tested out. In trading, what tests the hypothesis is the actual supply and demand that occur in the market under real time conditions: how much volume is being done, at which prices, at the market bid or offer, and by whom. If my hypothesis shows a bullish bias for the next day of trading *and* I see large traders lifting offers early in the AM, I will wait for a pullback and enter in the direction of market sentiment--and the direction of my hypothesis.

So a historical pattern is really a heads up, telling you: "Be on the lookout for this". After we had the large market drop on Monday, my research said: "Be on the lookout for a rise". Heeding that heads up when you saw buyers become aggressive paid off. But that is different from treating the hypothesis as a conclusion and using the pattern as a mechanical trading signal.

OK, so we had our decline and then our recovery: what happens next? Since 2004 (N = 729), we've had 24 days in which the market recorded strong downside momentum (Supply > 1000) two days ago and strong upside momentum today (Demand > 1000), using the indicators from the Trading Psychology Weblog.

Five days later in the S&P 500 Index (SPY), the market was up 11 times, down 13, for an average loss of -.17%. That is weaker than the average five-day gain of .16% (415 up, 314 down). It appears that, overall, U-turns tend to turn all over again within a five day period.

Interestingly, however, when the U-turn has occurred during a two-day period of positive sentiment in the broad market (NYSE TICK) and in the large caps (Institutional Composite), all five of those occasions were up the next day and four of five were up an average of .98% three days later.

While five days is a very small sample, the hypothesis I'm left with is that the willingness of traders to lift offers as we approach the bull market highs will be an important factor in whether or not we sustain an upside breakout. If we see sector divergences and waning lifting of offers as we test new highs, I'll be much more likely to look for yet another U-turn than if participation in the rise is broad, with sustained volume at the offer.

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Wednesday's Blog Links and Market Wrap Up

Due to server problems, I was not able to post my update to the Trading Psychology Weblog. Here's the material for Thursday AM:

Market Ideas:

TraderFeed finds an investment strategy based on disgust.

Euro:USD, plus other technical analysis from Especulacion.org. Many thanks to Jesus Perez for translating TraderFeed posts to that excellent site. (Babel Fish translation).

Massively cool: brain fitness for basketball players. I'll put the biofeedback topic on my list for upcoming posts.

David Gaffen on frantic efforts to ignore the yield curve.

The Big Picture offers bloggers' takes on retail sales.

Wide ranging reading list from Victor Niederhoffer and Laurel Kenner.

Great post on the persuasive personality and his corrosive effects from Trader Gordo.

Lowell Christie shows how he trades what he sees.

Lots of links from Charles Kirk, including a great quote on buying dreck from Altucher.

Yaser Anwar analyzes Alcoa and aluminum.

Boogster on using flexible moving averages.

Interesting to see people's methods. Estocastica tracks a couple of day trades. Here are related trades from Trader X.

Humble Money, with some good questions about fair value.

Trader Mike notes a large number of high NYSE TICK readings during the day, rightly attributing it to program trading. It would be interesting to take a historical look at what markets tend to do the day following a high program trading day...

Mr. Paul's blog list.

Great way to keep up with the news.


Market Expectations:

Divergences? With Wednesday's rise, the S&P 500 retraced its Monday drop and is within 10 points of a closing bull market high. Just the same, only 29 S&P 500 stocks made 52 week highs on Wednesday and only 26 S&P 600 small cap issues made annual highs. That's about a third of the level of new highs seen during the past couple of weeks. My best estimate is that near term strength will bring multiple divergences, which will have me questioning the market's upside potential. Across the entire market thus far, 20-day highs peaked at 2052 on 10/26 and then again at 1951 on 11/15. Current 20-day highs are 1168.


Market Summary:

The market moved steadily higher Wednesday morning, dipped midday, and then finished strong. We closed above the day's average price of ES 1398.25, initiating a short-term uptrend. The Power Measure closed strong on the heels of late buying. Buying was once again evident in the broad market, with the Adjusted TICK at +465, and in the large caps, with the Institutional Composite ending at +246. Demand soared to 180--quite a turnaround from Monday's weakness--and supply fell to 22. New 20 day highs rose to 1168 (see above); new 20 day lows fell to 390. Institutional Momentum rose to a tepid -140, with 5 stocks trading in intermediate-term uptrends, 9 in downtrends, and 3 unchanged. It appears that we are attempting to test the recent highs, setting up a potential wide trading range. I will be careful about buying strength near those highs if the rally does not remain broadly based.

The Ewwww! Factor

Let me toss a list your way and see if you can figure out the connection among these items:

* Michael Jackson
* Michael Richards
* The proposed O.J. Simpson book
* The Republican Party
* Pee Wee Herman

Quite simply, if you asked my teen-aged children or their friends about any of the above, one of the first words you'd be likely to hear is "Ewwww!"

"Ewwww!" is a very special term. It doesn't connote dislike. It expresses disgust. Complete and utter disgust.

Someone vomited on the school floor? Ewwww!

That kid who never used deodorant in junior high school? Ewwww!

The creepy teacher who looks at girls the wrong way? Double Ewwww!

The thing about "Ewwww!" is that, for all practical purposes, it is a final verdict. Once something is "Ewwww!", it never turns around and becomes "Cool" or "Cute".

In other words, once you've hit the "Ewwww!" point, you're toast.

Just ask the Republican Party in the wake of Congressional Page scandals or Michael Richards after his very un-Kramereque racial diatribe.

People can bounce back from dislike or even distrust. But not Ewwww!

Having spent years in Upstate New York, my wife and I were spoiled by shopping at the wonderful Wegman's grocery chain. Now, we live outside Chicago and dislike our area groceries. But we shop there. One day, however, we visited a store that had dirty floors and unkempt displays.

Ewwww!

We left and never returned. And never will. That's the way it is with Ewwww!

You're probably wondering what this has to do with investing. My hunch is that it might be quite relevant.

You see, we are hard-wired to experience disgust. The facial expressions that express disgust in one culture are universally recognized in other cultures. And many of the things that disgust us also disgust people around the world: from feces to spoiled food.

It makes evolutionary sense. Memories of disgusting experiences keep us away from what is bad for us. Some of the earliest studies of single-trial learning in animals (i.e., learning that does not require repeated practice) tested memory for disgusting food. It appears that dogs and mice have their own versions of Ewwww!

What makes humans different is that they can attach disgust to social experiences, not just physical stimuli. That means that companies and their products can evoke the Ewwww! response. And that means that we have an interesting pairs trading strategy: short the Ewwww! stock and go long the correlated, acceptable company.

If I had listened to my kids and their friends, for example, I'd be short Wal-Mart ("Ewwww!") and long Target (see above). No one, but no one, among their peer group would be caught dead in Wal-Mart. But Target? Those Choxie candies are cute...and how about those flip-flops on sale?

Come to think of it, the Ewwww! factor would have long ago had me short the American autos ("Ewwww!") and long Toyota/Lexus.

And I'd have been short Dell ("Fire in my laptop??? Ewwww!") and long H-P.

The great thing about "Ewwww!" is that, because it's hard-wired, it doesn't turn around in a day, week, month, or even year. Sometimes it doesn't turn around ever.

I guess you could say the "Ewwww!" factor is the opposite of Warren Buffet's investment strategy. He would have you buy the companies you directly experience, understand, and really like. Trading by "Ewwww!" has you shorting what people absolutely can't stand and buying its favored alternative.

Just the other day, we stopped off at a local eatery known for its fresh fast food.

Earlier, we had passed a McDonald's, and I offered to stop. Daughter's verdict: "Ewwww!"

No longer cool to be part of the "fast food nation".

Another family trip, another investment idea percolating.

Today's Blog Links and Market Stats From Dr. Brett

Tuesday Observations

We got the bounce that the recent research suggested, which made for a nice trading opportunity following the data release at 9:00 AM CT. If you click the above chart, you'll be able to see the steep volume on that rise into the 9:50 AM bar. We got a selling squall after that and then one more push toward highs. Note that this push came on lower volume, with far fewer contracts lifting offers. (Remember, within each bar, the first number is the volume transacted at the bid price; the second number is the volume transacted at the offer. When we get more volume at the offer, the bar turns green). Quite simply, the buyers ran out of steam and we have since retraced some of the gains, with the TICK hitting a very oversold -915.

At this point, we're looking to form a trading range between today's highs and lows, and I'd be looking for evidence of selling drying up (prices holding near their lows where the TICK hit its negative extreme, and higher TICK lows on subsequent selling) prior to getting back in on the long side. Specifically, I'd be looking to buy pullbacks that stay above the 1384.25 lows on evidence of reduced selling pressure.

What you're looking for is the ebb and flow of volume from the market and the distribution of this volume among buyers and sellers. Reading those shifts is essential to short-term trading.

More on today's market on the Weblog tonight.

Big Bear Days: What Comes Next?

Monday's market was unusual in a couple of respects. First, there was tremendous short-term bearish sentiment, as measured by the NYSE TICK. Recall that the TICK is measuring the number of stocks in the NYSE Composite Index that are trading at their offer price minus the number trading at their bid. My Adjusted TICK measure simply transforms this data series to obtain a zero mean. Monday's Cumulative Adjusted TICK reading was -1418, the third lowest reading since July, 2003 (N = 839 trading days). What that means is that, across the broad universe of NYSE stocks, traders were hitting bids. Sellers were bailing out at the bidders' prices, taking whatever the market would give them.

Monday's market was also unusual in that the ratio of stocks displaying significant downside momentum outnumbered those with significant upside momentum by a ratio of over 10:1. Indeed, since July, 2003, we've only had five other occasions in which this ratio was so lopsided. My measure of upside and downside momentum, which I call "Demand" and "Supply" and track every day in the Weblog, simply tracks the number of stocks closing 2 standard deviations above and below their short- and intermediate-term moving averages.

So what we had on Monday was a big bear day: lots of traders hitting bids across a broad range of stocks, sending the vast majority of issues well below their moving averages.

Since July, 2003, we've had 15 trading days in which we've had the ratio of stocks with downside momentum exceed those with upside momentum by over 5:1 *and* an Adjusted TICK daily reading below -1000. The next day, the market (SPY) was up 11 times, down 2, and unchanged 2 for an average gain of .30%. That is much stronger than the average single-day gain of .04% over the total sample.

Four days after a big bear day, SPY was up by an average .50% (11 up, 4 down), again stronger than the average four-day gain of .16% for the entire sample.

Ten days after the big bear day, SPY was up by an average 1.07% (12 up, 3 down), once again much stronger than the average ten-day gain of .40% over the entire sample.

So what we've seen is a tendency to bounce following big bear days, probably as a function of bargain hunting. Note, however, that this analysis covers most of the recent bull market. What we're really finding out with the analysis is that, in bull markets, selling squalls tend to right themselves. If the bull is healthy, we should see some evidence of those bargain hunters. Conversely, it's when no bargain hunters emerge that big bear days turn into big bear weeks and months.

Lots of Blog Links and Market Stats for Today

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Observations for a Down Monday

I hope that some of the themes from the recent morning sessions have been helpful to you in trading today's market. Notice that we have seen consistent hitting of bids across the broad universe of stocks, as seen in the weak NYSE TICK readings. We have also seen consistent hitting of bids within the S&P futures contract (ES), as measured by the Market Delta program. Note how, during periods of extreme weakness such as this, bounces in the TICK/Market Delta provide selling opportunities. You want to think of those indicators themselves as being in a downtrend. Once you make that identification, the move is much easier to trade.

My preliminary measurements show that we have a lot of stocks across the board that are trading below their lower volatility envelopes (my measure of Supply on the Weblog). If we close that way, there is a tendency to get a small bounce higher before further weakness sets in. Of the 18 similar negative momentum days since 2004, 8 have been higher and 10 have been lower five days later in SPY, for an average loss of -.01%.

It's tempting to go bottom fishing when we see such weakness, but as long as large traders continue to hit bids rather than lift offers, this is (and has been so far today) a losing proposition. It's when declines lose downside momentum that they offer superior returns--not when there is broad participation to the downside.

Hope that's helpful. I'll do another AM session early in Dec. and hopefully can illustrate these ideas further. Have a great day.

Three Market Idiots

There are three varieties of idiots in the market you're likely to encounter during your trading career. Contemplating the above truth from the great site of Despair, I thought I'd give you a heads up, so you can avoid these laggards in the great Darwinian race. You see, social success is not so different from trading success: you ride your winners and dump your losers. And, trust me, these three are not ones you want to ride:

1) Idiot #1: The True Believer - You've probably encountered at least one of these dolts during your market sojourns. They are the ones who have figured out the answer to the market. Not an answer, mind you. *The* answer. It usually is some kind of numerological or astrological scheme, and it is always a hidden secret. Unfortunately, True Believers don't seem content with keeping their knowledge hidden. They're always after you to "unlock the mysteries" of the market by sharing in their discoveries. A surprising number of True Believers are also True Bears, which means that they're forever predicting the end of the financial universe as we know it. They predicted it in 1980, 1990, 2000, and they're still predicting it. And when the market rallies and proves them wrong? Well, that just means the bubble is getting even bigger and the implosion of the universe will be even more profound. My take on True Believers? This is not investing or trading; it's cultism. And true believers are at the point where they *have* to believe, or they'd come face to face with the awful realization of the utter waste of time and money their beliefs have brought, as the Dow has risen from 775 to over 12,000 within a 25-year period.

2) Idiot #2: The Gambler - This is the "I'm-giving-up-my-job-to-become-a-trader-because-I-don't-like-working-9-to-5" idiot. Observe that this bottom-dwelling resident of the phylogenetic scale is not giving up his job because he's had success at trading. He's also not giving up his career because he so loves trading that he researches it day or night and has found a winning edge. No, The Gambler doesn't do anything beyond 9-to-5, because what he's after are easy riches, not effort and earned success. He hears that others have been successful (usually from Idiot #3), and he figures, "That means I can do it too". Invariably, the Gambler is attracted to daytrading. Why? It gives him a sense of action, and it justifies his decision to abandon all efforts at productive work. Besides, you can't really explain to your wife and kids why you're not out there with working humanity supporting your household when you're sitting around doing nothing, holding positions for weeks at a time. So the Gambler actively trades in and out of markets, pretends like he’s got a job, and every so often berates his spouse when she wonders when the family will be able to pay its bills. My take on Gamblers? They're not interested in trading; they're interested in their fantasy. So interested that they'll take their bank accounts and families down with them.

3) Idiot #3: The Self Promoter - It's easy to find the Self-Promoters. By their very nature, they're in your face hawking their wares, lauding their recent market calls, and promising easy trading success. Open any trading magazine and you'll see their well-coiffed, grinning idiot faces leering at you, usually as part of a trading "event" that just happens to be selling all their products. The key to recognizing Self-Promoters is that they promote themselves, not ideas or methods. Indeed, a substantial number of them don't trade. Those include the "Trading Coaches" who promise to improve your confidence, but offer no concrete trading guidance that you could ever feel confident in. They also include the "Gurus" who tout simple chart patterns and indicators, carefully avoiding any possible objective testing of their wonderful setups. Self-Promoters never talk about how hard it is to achieve trading success; that would not sell well, especially among The Gamblers. Instead, they borrow their pitches from the "no money down" real estate guys and tell you how easy it will be to succeed with no capital. My take on Self Promoters? I don't mind people who deceive others; they're merely dishonest. It's the ones that deceive themselves that frighten me. That's when dishonesty becomes delusion.

So there you have it: a rogue's gallery of trading idiots. Once you tune your mind to this threefold taxonomy, you'll have no problems at all recognizing them within moments of their opening their mouths. And, if you want to be happy, you'll follow the advice of literary critic Dorothy Parker and not toss these idiots aside lightly. Rather, you'll hurl them with great force.

Blog Links and Market Stats for Today

The (Trading) World At Your Fingertips

Some of the best trading opportunities are in the least popular investments. Take the world stock markets. Above we have a chart of the S&P 500 Index (SPY; blue); the Vanguard Pacific ETF (VPL; yellow); the Vanguard Europe ETF (VGX; red); and the Vanguard Emerging Markets ETF (VWO; light blue). Going back to March, 2005, we can see that the most popular of the indices has also been the most punk performer. In terms of directional movement and volatility, we've had better trading opportunities from almost any other major portion of the world.

The best investment talent in the world--including many hedge fund and investment bank traders I've been privileged to know--shares one thing in common: they are not restricted to particular trading instruments or asset classes. They also do not limit their trades to vehicles within a particular set of national boundaries. They go where the opportunity is, whatever and wherever that might be.

With ETFs, it is increasingly possible for individual traders to pursue a world full of opportunities. Value vs. growth? National vs. international? Equities vs. fixed income? Currencies, commodities, equity sectors? All can be traded from a single stock market account.

Old habits die hard. We gravitate to the known trading instruments. But there's a trading world at your fingertips--and it's expanding every month.

Mutual Fund Sentiment: It's What Traders Do, Not Say, That Matters

My Weblog entry for today found something surprising: the correlation between the surveyed bullishness of investors (Investors Intelligence survey) and their actual ratio of mutual fund purchases to redemptions has been slightly negative. In other words, what investors say about the market has had no positive relationship to what they're actually doing--at least with respect to mutual funds.

Above, we can see the ratio of fund purchases to redemptions from 2000 to the present, charted against the Dow Jones Industrial Average (N = 334 weeks). Note how the ratio was consistently elevated above 1.0 during the 2000 market top and dropped below 1.0 during the subsequent decline. Notice also that we rose well above 1.0 in May of this year at the market top and dipped close to 1.0 at the market bottom in July prior to the recent rally. So far, we haven't seen a meaningful bounce in the ratio as the market has ridden its wall of worry higher.

Since 2000, dips in the ratio of mutual fund purchases to redemptions have provided solid buying opportunities. When the ratio has exceeded 1.20 (N = 198), the next 20 weeks in the Dow have averaged a loss of 1.29% (92 up, 106 down). When the ratio has been below 1.20 (N = 136), the following 20 weeks in the Dow have averaged a gain of 3.36% (93 up, 42 down). It appears that investors attempt to time their mutual fund purchases and redemptions and have been quite poor in their timing.

While we see very bullish sentiment in the recent surveys, the ratio of mutual fund purchases to redemptions has only recently popped up to 1.25. Should we see higher ratios ahead--approaching the 1.4 level from May and from early 2004--I'll take that as a yellow sentiment light for this market. As noted in the Weblog, throughout the recent bull market we have seen nothing like the 2-plus to 1 ratios from the 1990s; since the 2000-2003 decline, investors, as a whole, have been modest in their mutual fund purchase patterns.

In other words, today's investors may talk a good bullish game, but they really haven't put their money where their surveys have been.

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Is the Dow in a Bull or Bear Market?

Magicians are quite clever: they pull the audience's attention to their right hand and then do the "magic" with the hidden left.

Markets aren't so different. While our attention is drawn to the numerator--the price change of an equity index such as the Dow--the real magic is occurring in the hidden denominator.

That hidden denominator, in the case of the Dow, is the dollar. U.S. stocks and indices are measured in dollars. But the dollar itself is a moving target.

And it's been moving down.

Denominated in dollars, we have the magic of Dow 12,000.

Denominated in British pounds, the Dow has only recovered a tad more than half of its 2000-2003 decline.

Denominated in gold, the original hard currency, the Dow has been in freefall and only recently recovered from multi-year lows.

So how much of the bull market has been Dow strength (vigor in the numerator), and how much has been dollar weakness (a plunge in the denominator)?

At the very least, judging from the red line, at least half of the Dow's strength can be attributed to weakness relative to other currencies. The Dollar Index chart I posted recently makes that point far better than I ever could.

But bullishness in the Investor's Intelligence survey is at an annual high. Watching the right hand, we celebrate Dow 12,000. Meanwhile, no one mourns what's happening in the left hand.

Magic, indeed.

Dr. Brett's Blog Links for the Day

Connecting the Currency Dots

With the vigorous economic expansion we've had over the last few years--earnings for the S&P 500 stocks have tripled since 2002--one would think that the U.S. dollar would be robust vs. other currencies. As the chart from the excellent DecisionPoint service makes clear, however, the dollar is weaker now than during the start of the equity bull market. It's a little hard to see in the chart above--my Weblog entry has a larger chart--but we've broken trendline support in the Dollar Index. Now, this AM, we see the dollar in freefall against the Euro and Sterling and stocks are down in pre-opening trade by about a half-percent.

Let's connect the dots. A large portion of the Democratic victory in Congress is attributable to the party's strength in the labor states of Ohio, Michigan, and Pennsylvania. Those candidates ran against globalization and won. The Democratic leadership has already worried Asian leaders, by going on record as favoring punitive tariffs against China if that country doesn't allow its currency to rise against the dollar. Which, of course, is another way of saying that Democrats want to reduce the value of the dollar vs. the yuan.

The Secretary of the Treasury and the Fed chief have formed a delegation to China to head off a confrontation between the upcoming Congress and that country. Meanwhile, we now hear that China is considering reducing its dollar reserves due to--surprise!!--dollar weakness. That has tanked, not only the dollar in this morning's trade, but equities as well.

The reality is that China has amassed foreign currency reserves to the tune of one trillion dollars. The message from China is that, if we push them too hard on their economic policies, they will push back by diversifying those reserves out of dollars and into Euros, Sterling, Yen, etc. That places Mssrs. Paulson and Bernanke between a Democratic rock and a Chinese hard place.

It also generates considerable dollar uncertainty, which has gold rising this morning and stocks falling. Figuring out the investment themes that will be winners and losers in a weak dollar scenario may prove crucial for traders going forward. At the moment, with weak housing precluding meaningful interest rate hikes and the perils posed by the potential clash between Congress and China, it is difficult to imagine a scenario that does not involve, at the very least, a managed drift of the dollar lower. Particularly when you consider the expansion of M3 money supply in the face of an inverted yield curve, as noted by Barry Ritholtz.

And at some point, global traders will question pouring their money into dollar-denominated assets that sport such currency uncertainty. Which is what we're seeing this morning.

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Will This Water ETF Keep Investor Profits Flowing?

The New Yorker recently published an eye-opening article on the water shortage in the developing world and the possibility of global catastrophe. News reports of pollution in China's Yellow River and competition for water resources in India lend credence to the concern. Could water be the next oil, a commodity with huge price appreciation potential? The PowerShares Water Resources ETF (PHO) is one way to take advantage of this theme through a diversified group of stocks.

The PowerShares site explains that PHO is based on the Palisades Water Index, which tracks companies that focus on the provision of potable water, water treatment, and technology devoted to water consumption. Over 52% of the portfolio consists of small-cap issues, while large cap accounts for about 11% and mid-cap about 37%. Industrials and utilities represent the largest sectors at nearly 60% and over 25% respectively. Over 36% of the portfolio is concentrated in the top ten holdings.

So how does the ETF behave? As the chart above indicates, PHO has been strongly correlated with the small cap stocks since its inception. It remains below its May peak, thus behaving more like a small cap growth stock than a value issue. The correlation between daily price changes in PHO and IWM is .81, meaning that over 64% of the variance in PHO price from day to day is accounted for by movement within the broad small-cap universe. The average price change from day to day in PHO is only slightly greater than for IWM: .96% vs. .87%. Interestingly, average volume for PHO has not grown over its relatively short lifetime. It peaked during its market peak in April, 2006 and is down to early 2006 levels at present.

My earlier report on a promising sector ETF, the PowerShares WilderHill Clean Energy Fund (PBW), found that this fund has been growing its volume and is considerably more volatile than the Russell index. This points to a difference between the two funds: clean energy may be more on the radar of U.S. investors than water resources and hence generating greater speculative interest. Unfortunately, it is far easier to see Congress and the President aggressively moving on domestic alternative energy funding than water initiatives in developing countries.

Nonetheless, there appears to be growing interest in ETFs with a conscience since the Democratic victory in Congress, so I'm keeping my eye on PHO. It has underperformed the recent market rally and its component stocks sport a generous 22 multiple to current earnings. Given the strong correlation with the small cap indices, my leaning is to wait for the next market pullback and assess the action in PHO from there. Although initial volume has been impressive for a relatively new ETF, I will want to see growing investor participation in the fund as a sign that the water-as-natural-resource theme is taking hold.

Here Are Blog Links For Today

Are Moving Averages A Useful Trading Guide?

Is the market trend up, down, or neutral? One of the most common ways to assess a trend is the moving average. But is the moving average a useful guide for trading decisions? I decided to take a look.

Since 2004 (N = 710 trading days), we've had 328 days in which the S&P 500 Index (SPY) has closed above both its five-day and twenty-day moving averages. Over the next ten days, SPY has averaged a loss of -.03% (182 up, 146 down).

Conversely, when SPY has closed below both its five-day and twenty-day moving averages (N = 200), the next ten days have averaged a gain of .72% (126 up, 74 down).

Indeed, just knowing where the S&P 500 Index has been trading relative to its 20-day moving average has been informative.

When we've closed above that moving average (N = 441), the next 20 days in SPY have averaged a gain of only .20% (261 up, 180 down). That's about a third of the average 20-day gain from 2004 to the present.

On the other hand, when we've closed below the 20 day MA (N = 269), the next 20 days in SPY have averaged an impressive gain of 1.24% (188 up, 81 down).

In short, knowing where we're trading relative to moving averages *has* provided us with useful trading information, but not in the way many technicians expect. Because of mean reversion, returns when we're trading above moving averages have been subnormal. Returns when we've been trading below moving averages have been superior.

The trend has indeed been your friend in the last few years in the large cap stock indices, but only if you've faded it.

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A Cross-Cultural Journey

Note: The following was submitted to a local contest asking residents of the Naperville area to write their stories of a "journey" related to Thanksgiving. This captured my favorite journey, with our son (above), Macrae.

A Cross-Cultural Journey

He was diagnosed as having brain damage. That explained why he was kept in a separate hospital wing in the Moscow orphanage.

The video taken by own oldest son, however, told a different story. The little 13-month old guy who weighed only 15 pounds—in the early nineties, food and medicine were in short supply in Russia—seemed alert and engaging. He interacted with his caregivers, and he played with the few toys in his area. His movement, his emotion—all appeared to be normal.

And so it was that we made a three-week trip to Moscow and wound our way through the social service system to finalize our adoption of little Pavel, soon to be known as Macrae. It was not only a journey across an ocean, but across cultures. In Moscow, we were the foreigners in a strange land, but we and our hosts were also bound by a common desire: to secure a loving home for that eager boy in the video.

Little did we know that the most meaningful part of the journey would occur during the ride home.

And some ride it was: Thirteen hours with an excited toddler squirming on our laps. After seeing only his hospital unit for his short lifetime, Macrae was far too excited to be in the real world to ever fall asleep.

I held him close, and he looked up at me.

Our eyes met.

He pulled his head back just a bit.

Bump! In a flash, he tapped his forehead against mine.

I was a bit startled, but stroked his head and continued holding him.

Back went his head.

Bump! This time his head hit mine harder. Ouch!

I shifted him back on my lap and the sequence began anew.

Our eyes met.

He pulled his head back.

CLUNK! This time it was a big knock against my head.

What was going on? A dim voice within me entertained an awful thought: Maybe he really *is* brain damaged!

It made for an interesting trip: holding Macrae close, pulling away to avoid getting head-butted, and him starting the action all over again.

When we returned, I called the social worker in Moscow. As casually as I could, I mentioned the head butting. She laughed and explained:

In the orphanage, the care givers played a game with the male children. The game was called “ram”. They would count to three and touch heads, just like rams.

Only I wasn’t playing the game! I wasn’t counting, and I wasn’t touching heads. So, with ever greater insistence, little Macrae tried to get me to play. Quite literally, he was attempting to knock some sense into my head.

It was the greatest journey of all: the journey of understanding. Our new son didn’t have a problem. He was trying to bond with us in the only way he knew. I was the “brain damaged” one, unable to pick up on his communications!

How many other misunderstandings in life—between people and between cultures—could be resolved if we just took that journey to understand what is communicated, not just what is heard?

Happy Thanksgiving to All: Here Are Today's Blog Links and Market Stats

Thanksgiving Morning With the Doc

10:20 AM CT - I'm not trading any more today, but if I were, I'd think about the AM highs and lows forming a range and fading moves toward the edges of that range. I don't see enough selling pressure at present to sustain a downtrend, but I'm also not seeing good volume participation on rises. Hope this has been informative. We'll do it again early in December. In the interim, have a great Thanksgiving, and please give thanks to the family and friends who contribute daily to your happiness and success. Trading is important, but it isn't life. Thanksgiving calls on us to take the big picture and remember the blessings we have, regardless of P/L. I'll update the Weblog tonight and both sites through the long holiday period.

10:15 AM CT - Carbon copy of the first trade! I saw selling dry up after the initial retreat from highs and went long ES to take advantage of a return to the day's average price. The problem was that the move took a while to materialize, leading me to take a small profit before the market eventually went further my way. After each day of trading, I like to evaluate what I did right and wrong and use those to frame goals for the next session(s). What's clear to me from today is that I need to stick with my basic method of exiting positions: entering with enough size that I can take quick profits on one piece but let the other piece breathe and take advantage of a possibly longer move. I was too much in the mindset of "This is pre-holiday; just take what the market gives you". As a result, I didn't benefit as much from the patient, good entries as I should have. The point is to always be learning. Figure out what you do well and extend it. Adjust what you're not doing well. Today I did entries much better than exits. One last post before breaking for the day.

10:05 AM CT - OK, I'm done for this AM with the trading. I had gone back to breakeven and didn't execute the stop, seeing that the other indices (Russell, NAZ) were holding up, as was the TICK. The next bounce had little volume to it, so I took the little bit that I could. Volume has really slowed here, and we could get a pretty slow day from here on out as traders leave for the holiday. Back with a wrapup in a few minutes.

9:58 AM CT - Took half pt profit. flat

9:52 AM CT - Volume has been unimpressive on the buying. My stop is up to breakeven and we'll see if any buyers come in. As long as that TICK distribution looks shifted positive and we're not seeing big traders hitting bids in ES, I'm sticking with the long position. Once again, had I been trading larger size, I would have taken a profit on the first move up with one piece and let the other one ride. What I'd like to see is a buying spurt over 1000 TICK to take me out.

9:40 AM CT - When we got an ES low at 9:31 AM, nothing else was making a low and we weren't getting an expansion of selling from large traders in the ES. Indeed, only 308 more contracts traded at the bid than offer during that five min bar. The TICK also wasn't expanding in a negative direction. Volume, however, has been tailing off and we're not seeing buyers jump into the market. So I may scratch here if nothing develops soon.

9:32AM CT - Long small ES position.

9:25 AM CT - I'm looking to go long a small ES position if we pull back and can't get expanded selling when the bears take their turn. Still watching that TICK distribution closely. I'm also noticing that, so far, we're establishing value at a higher price than yesterday, which has me questioning the downside.

9:18 AM CT - Notice that we got the move back to the 1405 value area in ES. The general rule is that market rises that fail to lift many of the most volatile stock sectors are more likely to reverse than rises with broad participation. It's one reason that it's *so* important to watch the whole market, not just your particular trading instrument. That's probably the best learning lesson of this AM's session. Our next price target in Russell and ES would be yesterday's lows. I'd wait for buyers to take their turn, push the TICK higher, and see how prices respond. If we don't get good upside price movement, that could provide an opportunity to reinstate the shorts. Note the downward distribution of TICK since the early market high. Still, we haven't had very negative TICK readings, which says that buyers are covering and going away; it's not broad selling. I'd expect a range bound market out of that dynamic, not a broad trending decline.

9:12 AM CT - OK, I'm going to stop trading for now, just to focus on explaining what I did and why. The market moved higher on very strong NYSE TICK. Volume in the ES expanded on the move. So far so good for the bulls. The problem was that neither the midcaps nor the small caps made new highs on that move. Neither did the semiconductors. So my reasoning is that, if we're not getting economic/fundamental reasons for an upmove, if we're in a pre-holiday session, and if major sectors of the market aren't participating in the move, then I want to fade that move. And I chose the weakest index at the time: the Russell. As it happens, I could have held that position longer and taken more out of it, but the TICK distribution just didn't look negative enough to me, so I got out with what I had at the time. Generally, if it's not a preholiday and I can watch every tick carefully, I'll bail out of part of the position and hold the rest for a move back toward the day's average price. That's been a sound idea even in this preholiday trade.

9:02AM CT - Took a 1.5 pt profit, now just watching the mkt. Back in a couple min.

8:52 AM CT - Of course, what I'm looking for with the short Russell position is a failure to move to new highs, followed by selling that would make the longs puke their positions and move us back toward that value area. Risk reward ratio is good on the trade, though if the TICK stays persistently high, I'll need to bail out. Ideally I'd let a selling burst to negative TICK take me out of the trade. Note that the NQ is heavy here.

8:45 AM CT - FWIW, I'm short a small Russell position here.

8:42 AM CT - Notice how staying on top of the distribution of NYSE TICK kept you out of any premature short ideas. We're seeing steady buying, and I wouldn't short this market until we see a shift away from that. Notice also how volume expanded greatly on the rise to new highs. If this breakout is for real, we should stay above the overnight highs. Note, however, that we *didn't* make new highs yet in the Russell.

8:35 AM CT - Remember, volume correlates with volatility and ultimately determines how much we can take out of a trade for a given holding period. So I look at the volume every five minutes to see if we're doing more or less business than average. This being a pre-holiday session, I'm not expecting big volume. That means that the locals and black box traders could dominate price action. I also look at the distribution of the NYSE TICK in early trade to see if buying or selling sentiment dominates, and I look at the Market Delta distribution of volume at the bid vs offer in ES. So far, TICK is positive and advancing stocks lead decliners by about 500 issues. Volume is predictably modest.

8:20 AM CT - Just heard from Wiley that there will be a Japanese translation of my new book, Enhancing Trader Performance. On this Thanksgiving, one of the things I'm thankful for are the many traders/readers who have supported this blog and the book. I appreciate your comments and ideas and hope that these morning sessions help model one way of looking at markets. Your task is to take away from what I write what's helpful to you and leave the rest. Integrating other people's perspectives and methods into what you've already learned is how you ultimately develop your own trading style--much as artists or writers develop theirs. Back after the open. If I don't see good strength early in trade, I'll be short for a move back toward the 1405 value area.

8:10 AM CT - Just a quick note; we retreated a bit further from the overnight highs before bouncing a bit; clearly there was nothing bullish for stocks in the economic reports thus far. Note that the dollar made multi-week lows against the Euro on the weak housing data. When you get a chance, do read this important post from Barry Ritholtz. I think it goes a long way toward explaining why we've been seeing strong stocks of late, as well as firm commodities. The growth of money has meant that liquidity has had to find a home. The loser in such a scenario over time is the dollar. If I had to guess--and it's only a guess--I'd say that we're trying to pre-empt a housing-led recession by easing monetary conditions aggressively. Hence the inverted yield curve, but the sharp recent rise in large cap value stocks. As long as that persists, that should put a bid under commodities and a lid on the dollar. The risk is that we could stoke inflation (drop in the dollar; boom in commodities) at the same time that economic weakness kicks in, creating that old stagflation scenario that is bad for stocks. That's why watching the dollar, interest rates, and commodities is so important--even for the short-term trader. The big trends are created by those who trade global macro developments.

7:45 AM CT - Good morning. I'm writing this on the heels of the unemployment numbers coming out at 7:30 AM. We had mortgage applications drop during the latest reporting period despite lower interest rates; refinancing also dropped. That report, suggesting continued housing weakness, took the stock indices off their overnight highs. We still have University of Michigan consumer confidence numbers coming out at 9:00 AM CT. Note that subscribers to that number get the data ahead of the general public and thus get a jump on trading any significant change from expectations. Initial claims for unemployment came in pretty much in line with estimates; no great movement in stocks from that. Bottom line is that we're up relative to yesterday's close, though a bit off overnight highs. The average price we've been oscillating around has been 1404.50 in the S&P futures; my only trading yesterday faded moves above this value. Remember, in a range bound market, you want to fade moves to the range extremes if you see that volume (and especially the hitting of bids or lifting of offers by large traders) is drying up as we move away from value. So our big job this AM, should we continue to the upside relative to yesterday's close, is to figure out whether we're going to break out of this five-day trading range or settle back toward the recent average price. It's pre-holiday trading, so I don't expect a lot of volume or volatility. If you check the Weblog, you'll notice a directional bias to the next five days based on recent low volatility. Also check out this morning's TraderFeed entry that finds better movement in the Russell 2000 Index than in the S&P 500. I'm noticing that, while the S&P 500 hit contract highs this AM, the Russell has not so far. Let's see how much strength we get at the open and how broad it turns out to be. More before the open.

What You Trade Matters As Much As How You Trade

With the VIX plunging below 10, I thought it might be worthwhile to take a broad look at stock index volatility. Here I'm focusing on the size of the daily percentage price change by taking the 20 day moving average of the absolute value of open-to-close change. In the chart above covering 2003 to the present, we can see how the average size of the day's movement in the S&P 500 (SPY; blue) has hit bull market lows. The NASDAQ 100 (QQQQ; red) and the Russell 2000 (IWM; yellow) have remained above their volatility low points.

The trend that is apparent is that the average size of the daily price change in SPY has been reduced by about 2/3 since 2003. The average open-to-close change in QQQQ has been cut in half over that same period. Notice, however, how IWM has retained far more of its daily price change volatility since 2003. Note also that the current average percentage price change in IWM is twice as large as in SPY. In relative terms, far more volatility has come out of the S&P 500 Index as out of the Russell 2000.

The volatility patterns of the three indices are highly correlated, as are their daily price changes. What this suggests is that, for short-term traders, the S&P 500 has been offering far less opportunity as a trading vehicle than either the NASDAQ 100 or the Russell 2000. For a given pattern that is valid across those markets, there has been more profit potential among the smaller caps and growth stocks than among the large caps.

Moral of the story? It's not just how you trade, but also *what* you trade that determines your P/L.

The Latest Blog Links and Market Stats From Dr. Brett

Double Heads Up

I want to thank Charles Kirk for including my books The Psychology of Trading and Enhancing Trader Performance among his top 100 list recently. Charles was gracious enough to host me on his site for a Q&A session, which was just posted. He was *very* prepared for the interview and asked some great questions. In fact, I'd say it was the best interview (and interview questions) I've ever encountered. If you read the financial blogs with any regularity, you're probably aware of The Kirk Report's extensive set of links and informative stock screens. Do check out the rest of Charles' site, especially within the member's area. That's where you learn how he trades, what he's thinking, etc. He's one of the good guys when it comes to educating and training traders. The donation required to become a member will provide you with one of your best returns on investment in any market.

The other heads up is for the Morning With the Doc session I'll be conducting tomorrow AM, starting before the open. It should be a slow day prior to the Thanksgiving holiday, but that will give me time to illustrate a few methods for tracking the market and coming up with trade ideas that have an edge. My hope is that the morning sessions will help interested traders apply ideas from the blog to actual market conditions. We'll also apply the ideas to a busier market in early December. See you tomorrow!

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Do Opening Gaps Tend to Fill?

The difference between the market's opening price and its previous day's close forms a gap on a bar chart. Does this gap tend to fill in during the next day's price action? That is, when we open with a gap lower or higher, do prices subsequently move back to the prior day's close?

For this investigation, I measured gaps as a function of the previous day's high-low range. This measures the gap relative to the prior day's volatility. Thus, an opening gap of two points that follows a day with a range of six points is measured as a 33% gap. The same opening gap of two points that follows a day with a range of ten points is measured as a 20% gap.

Assessed in this manner, we find that the average opening gap is 27% of the previous day's range going back to May, 2003 (N = 897 trading days) in the S&P 500 Index (SPY). That provides us with a benchmark for defining relatively large and relatively small gaps.

When upside gaps exceed 40% of the prior day's range (N = 99), 46 of them fail to close during the day session. When downside gaps exceed 40% of the previous day's range (N = 81), 40 of them go unfilled. Bottom line: approximately half of all large opening gaps don't fill during that coming day's action.

Conversely, when the upside or downside gaps are less than 40% of the last day's range (N = 717), only 144 of them go unfilled. When the gaps are less than 20% of the last day's range (N = 431), only 51 of these fill in. Stated otherwise, 80-90% of relatively small gaps will fill in during the coming day's action.

Interestingly, when we have a large opening gap to the upside, the *following* day's price change averages .18% (68 up, 31 down). When we have a large opening gap to the downside, the next day's price change averages .09% (48 up, 33 down). But when the opening gap is small, the subsequent day's price change averages only .03% (381 up, 336 down). In sum, large gaps in either direction tend to be bullish for the next day's price change.

When we measure gaps in this fashion, it takes relative changes in volatility out of the equation. The average size of the opening gap, defined as a function of the prior day's range, has been the same in 2006 as previously, despite our dramatic drop in volatility since 2003. Standardizing how we measure gaps provides us with a better sense for when gaps are large--and are less likely to fill--and when they're small--and more likely to fill.

Here's Dr. Brett's Blog Links and Market Stats For the Day

Pursuing the Green in Clean Energy

My recent post looked at how to use ETFs for diversification. Here's an example of using a fund to pursue a sector theme.

Several forces have come together recently to support the pursuit of alternative, clean energy:

1) On the heels of the Iraq experience, the U.S. will look to energy independence as a response to national security that will supplant the recent paradigm of unilateral interventionism.

2) Clean energy is a natural response to concerns over global warming that will help us re-establish ties with ecologically concerned allies abroad.

3) Clean energy is no longer a pipe dream, as the average consumer is now familiar with ethanol and hybrid engines--not to mention higher fuel prices.

4) Energy independence is increasingly seen as a way of taking us out of thorny competitions for resources with Russia, China, India, and developing nations.

5) Most important of all, clean energy has become as American as apple pie. Republicans are looking to launch a large initiative and Democrats are ready to make global warming a national priority.

Bottom line? We're going to see an increasing share of resources devoted to clean energy, which could bring some green to investors in that sector.

The problem, however, is that the sector is highly fragmented. Where do you place your bets: Renewable energy, such as solar? Power conservation? Clean fuels? Power storage? Fuel cell technology?

The best play I can find in the field is the diversified one: the PowerShares WilderHill Clean Energy Fund (symbol PBW). The fund holds 42 stocks across the green spectrum and allots no more than 4% of the portfolio to any single stock. (Click here for details on the construction of the index on which the Fund is based). Most of the issues are small cap, pure plays in clean energy.

Participation in the Fund has been growing. When it was first introduced in March, 2005, the average volume was under 100,000 shares per day. By June, 2006, the 50-day moving average of volume peaked at over 700,000 shares per day and, at present, is over 300,000. As investors seek a way to participate in the green theme without having to crystal ball individual stock winners, the volume should continue to expand.

As the chart above indicates, PBW nearly doubled in value between May, 2005 and May, 2006. Volume exploded by over a factor of 10 during that time. Since then PBW has pulled back from May highs on reduced volume and failed to participate meaningfully in the recent large-cap/value stock led rally. Note also that the Fund is quite volatile relative to the S&P 500 Index. In 2006 thus far, the average daily change has been 1.42% and the average daily high-low range has been 2.25%.

The correlation between PBW and the S&P 500 Index (SPY) during 2006 has been .62. That means that general market movement accounts for over 36% of the variance in PBW price. The correlation between PBW and the Russell 2000 Index (IWM) in 2006 has been .71, accounting for nearly half the variance in PBW price change.

What to do? I'm waiting for a general market pullback and will assess PBW at that time. It may be a while before these stocks generate meaningful profits, and it will take Congress and the President a while to hammer out any clean energy initiatives. It is difficult to imagine, however, that the two parties, struggling for a popular response to problems with terrorism and global warming, won't try to outdo each other by wrapping themselves in the mantle of clean.

And that could mean green for investors with a longer-term horizon.

Dr. Brett's Blog Links and Market Stats

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Broadening Your Trading Horizons

One of the questions I most frequently hear is a version of, "I'm doing well with trading. How can I grow my size?"

To me, that's like saying, "I'm doing well with two dozen eggs in my basket; how can I load it with three?"

Yes, it can make sense to take full advantage of an edge by trading at the largest size that allows you to survive any possible risk of ruin created when markets change and you get an inevitable series of losing trades.

But it can also make sense to smooth out your equity curve by using your trading prowess to diversify into other trading vehicles. The key is to find instruments to trade that are not correlated with your original market.

Fortunately, the world of ETFs offers a number of trading instruments with modest correlations to the major stock indices. The recent book Exchange Traded Funds for Dummies is, as its name suggests, a primer on the topic, but it is quite thorough and informative, pointing out ETF options I didn't know existed. The author understands the need for non-correlated instruments and also the need to focus on ETFs with low expense fees. All that is laid out in the text.

So let's take an example. The Deutsche Bank Commodity Index Tracking Fund (DBC) came out in February, 2006 and tracks six groups of commodities: crude oil, home heating oil, aluminum, corn, wheat, and gold. The day-to-day correlation in price movement between DBC and the S&P 500 Index since inception (N = 191 trading days) has been .086--essentially zero. When you trade DBC, you are trading something relatively independent of stocks.

How can we use this to broaden our trading horizons? Trading instruments such as DBC have their historical market patterns, just like the stock indices. SPY, for example, displays mean reversion tendencies following five-day moves: returns are subnormal following five-day rises and superior after five-day declines.

In DBC, the reverse seems to be the case. When DBC is up over a five-day period (N = 102), the next five days in DBC average a gain of .38% (53 up, 49 down). That is stronger than the average five-day change of .24% (102 up, 89 down). Conversely, when DBC is down over a five-day period (N = 89), the next five days average a subnormal gain of .07% (49 up, 40 down). My research further suggests that volume and money flow, when added to the analysis, improves the batting average of this pattern.

Imagine a basket of ETFs, each traded by a tested pattern and each producing returns independent of the others. When one pattern/instrument shifts and goes into slump, others are performing normally. The result is that you can avoid high leverage, produce consistent returns, and minimize drawdowns.

For the stock trader, ETFs have opened the world to currencies, commodities, fixed income, and international equities. This is surely one of the great trading opportunities out there.

Dr. Brett's Blog Links and Market Stats

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Performance Resources for a Saturday

Not captivated by Michigan-Ohio State? Here are some resources to check out on a Saturday afternoon:

* I've bookmarked my recent, favorite entries on the Trader Performance page, including the most recent post that finds common ground across different trading theories.

* This is the first biofeedback application that I'm aware of that is uniquely marketed to traders. I've used biofeedback to monitor my body's level of arousal during trading and have found it to be quite useful.

* Downloadable Market Profile resources from WINdoTRADEr.

* At the Futures Trading Summit, I had a chance to preview the new version of TraderDNA and the many performance metrics it offers. I don't know of anything more complete; it spits out reports on your trading, allowing you to frame goals for self-improvement.

* Ninja Trader offers a free version of their order execution software for simulation purposes and conducts training sessions for users. This is a great way to learn markets and test out strategies before risking your capital. I especially like how performance reports are built into the simulation.

* I get questions about Market Delta as a performance tool because I utilize it in both my own trading and in working with traders. Here are video resources that show traders how to use the program to read volume patterns in the market. Trevor, BTW, can get you free admission to the excellent FIA Expo later this month.

There are some good tools for traders out there, if you look hard enough!

Greatness Is Summoning The Strength Of Those We Yearn To Be

Legion

Enveloped in a sentiment, a sound that rushes over me.

Engage an impulse to pretend

I have a faith as pure.

Not forgetting what it means to dream.

Indulging everything.

Entertaining thoughts that I've the strength of those I yearn to be.

Cheers and tribute greet the saviours.

Reckless thoughts survive.

Anachronistic and impulsive.

And what will happen?

Will I dream?

I am too scared to close my eyes.

For a second please hold me.

None can change in me these things that I believe.

But I don't know what happens now.

I am too scared to close my eyes.

© VNV Nation

Heads Up: Morning With the Doc Session This Week

The next Morning With the Doc session will be held this coming Wednesday, starting before the open with market prep and original research to help us trade that day.

One of the comments that came from attendees at the Futures Trading Summit was a desire for more live trading educational sessions. That makes a great deal of sense. Teaching a person what to look for in a market is quite different from illustrating its recognition in real time. Many chart patterns, for instance, are far more recognizable in retrospect than during their formation. Live training is key to every performance field, from athletics to the elite military. Why should trading be any different?

During the Morning With the Doc sessions, I track the market on this blog in real time and tell you what I'm seeing and thinking. I also point out any trades that I make. Here's the transcript of the last session and the one before that. My hope is that my mistakes as well as my good observations will be real time learning experiences and a model of one way to look at markets. The idea is not to mimic me, but to take away pieces of what I do that can supplement your own talents and skills.

This Wednesday, I'll focus on two themes:

1) Integrating research concerning the day ahead into the minute-to-minute reading of the market;

2) Picking up as quickly as possible whether or not we're in a trending or bracketing market for the day.

I'll also talk a bit about finding your niche as a trader and maximizing opportunity from market patterns.

If there are other themes you'd like me to touch upon, feel free to mention these as comments to this post. My goal is to make these sessions as useful as possible. Thanks for your interest and support.

How You Can Lose Money Buying In An Uptrend

It's not enough to get market direction right, if your timing is all wrong.

Many markets (like the current stock indices) can form an uptrend by having occasional strong up days punctuated with periods of consolidation. If you buy after the strong days, you can get chopped up in the consolidation. If you sell the consolidation, you get run over by the bullish days. Markets can exhibit non-trending, reversing qualities on a short time frame and yet form a trend (i.e., conform to a trend line) over a longer period.

Here's an eye-opening finding. Since 2004 (N = 718 trading days), we've had 385 days in which we have been profitable from open to close. Following such a positive day, the next two days in the S&P 500 Index (SPY) have averaged a loss of -.06% (185 up, 200 down). That is weaker than the average two-day gain of .03% (387 up, 331 down) for the entire sample.

Conversely, when we've been down from open to close (N = 333), the next two days in SPY have averaged a gain of .21% (196 up, 137 down)--considerably stronger than average.

In other words, if you just look for selling after an up day session and buying after a down day session, you would have had an edge--despite the fact that the market has been in an overall uptrend since 2004.

The trend is not necessarily your friend if you're buying highs in a rising market. For the day timeframe trader, there's been no trending effect from day to day. Indeed, there has been a tendency toward reversal. This has also occurred at intraday time frames. The average open to close change in the S&P 500 Index since 2004 has been essentially zero.

For daytraders and short swing traders, we've basically had no bull market in the last 2+ years. Whether we're in a bull or bear market in the big picture matters not at all if that trend doesn't filter down to the time frame you're trading. Failing to understand that has cost daytraders a lot of money.

A Few More Insights From The Futures Trading Summit

The second day of the Futures Trading Summit featured some well-known speakers, who shared their trading strategies. One of the best aspects of the Summit was the opportunity to interact with the speakers and attendees. Because none of the sessions were concurrent, everyone attended the same meetings and had plenty of opportunity to see each other. It was also refreshing to have a conference in which attendees were not bombarded with sales pitches. Here are just a few notes I jotted down:

* Andy Bushak. professional trader: When you have an oscillator make a strong high, pull back, and then make another, weaker high, that divergence represents waves 3 and 5 in a five-wave Elliott pattern. Look for correction.

* Jim Dalton, author of Mind Over Markets and the forthcoming Markets in Profile: Volume is crucial: How you get from point A to point B is all-important. The important question for the trader is whether price is attracting activity. If not, you'll have reversal back to value; if so, you'll have a trend.

* Sheldon Natenberg, options expert and author: When volatility is low, buy protective puts for insurance. When volatility is high, sell covered calls. A good options trader is willing to take a lot of small losses in order to hit an occasional home run.

* John Carter, trader and principal of Trade The Markets: Market internals (TICK, TRIN, Put/Call Ratio) will tell you as early as possible during the day whether it is likely to be an uptrending day, downtrending day, or choppy day. Ignore short trade setups in a strong market and vice versa. Watch for extremes in sentiment measures such as TICK and put/call ratio: the market will turn around and trap people at those extremes.

Some of the presenters have written excellent books. Jim Dalton, Sheldon Natenberg, and John Carter come to mind immediately. Yra Harris was featured in the book House of Money by Drobny, which is an interesting profile of hedge fund traders. For traders interested in tracking their performance, a new version of Trader DNA is being rolled out and looks very user friendly. I'll be testing it out and reporting on it here.

Some Worthy Reads For A Thursday Night

It's so nice to have finally found a good online connection here at the convention facility. If you've emailed me or sent blog comments, I'll get to the backlog ASAP. (I had 812 emails in my inbox when I opened it a few minutes ago!) I'll also be updating the Weblog by late Friday.

Meanwhile, here's some great reads from across the financial blogosphere:

Michelle B. via Trader Mike discusses finding your trading niche. See also Mike's post on moving averages--a nice concept you can apply to tracking your trading results.

Lots of good links from Charles Kirk, including fear and greed and a worthy simulation platform.

What to make of the low VIX? Views from Adam Warner.

Has there *really* been Fed tightening? Great blog spotlight from The Big Picture.

Inflation, money supply, and more among the links at Abnormal Returns.

Zoom-mobile stock picks from Jon Markman.

Do-it-yourself hedge funds from CXO Advisory.

Maximizing your returns, a quant view from Dr. Chan. Here's a psych perspective on returns from Random Roger.

Doesn't This Market Have to Go Down?

Several attendees at the Las Vegas conference have asked me if we're ripe for a decline, given the "overbought" situation. My response has been that all market rises are not created equal. When a large proportion of stocks participate in a rise, the odds of continuation are much better than if the rise is dominated by just a few issues or sectors.

Let's take a current example. I track the number of stocks making fresh 65-day highs and lows and compare this number to the 100-day moving average of new highs and lows. When fresh 65-day highs greatly exceed the average number of new highs that we've seen over 100 days, that tells us that participation in a rise is solid.

Since 2004 (N = 703 trading days), when the relative new highs have exceeded 400--as at present--there has been no significant trading edge five days out. Twenty days later, however, the S&P 500 Index (SPY) has been up by an average of .94% (68 up, 23 down)--considerably stronger than the average 20-day gain of .58% (443 up, 260 down) for the entire sample.

Stated otherwise, 70% of the time after a strong participation rise, we've had higher prices 20 days later, with superior average returns.

Yes, geopolitical events, large interest rate movements overseas, and other situational factors could change the equation quickly. So far, however, during this upmove, when we've had rises with strong participation, pullbacks have been relatively minor consolidations. Selling strong upmoves for an intermediate-term hold has not been a winning strategy for the better part of three years.

A Few Insights From the Futures Trading Summit

It's been a great Futures Trading Summit so far. I'm writing from Las Vegas after day one of the two-day event. Here are a few tidbits of interest:

* From Yra Harris, currency trader and analyst: We didn't see an antiwar election; we saw an anti-globalization election. This dynamic greatly affected races in Ohio, Michigan, and Pennsylvania--areas in which the electorate perceives a loss of jobs due to globalization. This could easily lead to a greater push for protectionism, which would be fatal to global markets.

* Also from Yra: Europe is suffering from the Yen carry trade, which exploits low Japanese rates and high European rates by borrowing Yen and buying the Euro. Watch for a shift in reserves, whereby Europe decides to add Yen in greater proportion to its mix. That would boost the Yen and wipe out the carry trade, carrying many markets with it.

* Dominic Chirichella, energy trader/analyst: China now accounts for 12% of energy consumption, second only to the U.S. If per capita energy consumption in China reached U.S. levels, China would require all the world's oil production for its needs. This will keep a bid under energy for as long as China is expanding.

* Braden Janowski, automated systems developer and trader: The goal of most automated trading systems is to place a "tax" on all your trades. When you enter positions at the market, you get a price that is out of line vis a vis correlated markets, providing a spreading opportunity for the black boxes. Over many trades, this tax adds up.

* Philip Klapwijk, metals analyst: Silver has followed gold, supported by the great success of the silver ETF. But the fundamentals for silver are worse than for gold, due to lower industrial demand. Fundamentally, silver is a $6-7 metal.

Of course, there have been many trading ideas/patterns provided as well, and more will come today. Good people, good show. I'll post some highlights from today late in the day tomorrow.

Where We Close Affects Where The Market Goes

When does it make sense to hold a position overnight? There may be a simple guide.

Since 2004 (N = 722 trading days), when we close in the top half of the day's range (N = 411), the average subsequent overnight change in the S&P 500 Index (close to open; SPY) is -.02% (181 up, 230 down). When we close in the bottom half of the day's range (N = 311), the overnight change has averaged a gain of .11% (205 up, 106 down).

What this suggests is that the overnight action tends to reverse the late movement during the previous day. Essentially all of the day-to-day upward drift in the S&P 500 Index since 2004 has consisted of this overnight reversal effect.

Here's another interesting, related pattern: When we close in the top half of the day's range, the next day takes out the previous day's high 280 times and fails to breach the high only 131 times. We take out the previous day's low only 142 times, and fail to take out the low 269 times.

When we close in the bottom half of the day's range, the next day takes out the previous day's high only 105 times and fails to break the high 206 times. But we break the prior day's low 185 times and fail to make a low 126 times.

Bottom line? Where we close in the previous day's range seems to affect the next day's overnight and intraday trajectory. Combining this tendency with intraday setups can lead to very fruitful trade ideas.

Trader Short-Term Sentiment Matters

Some of my favorite trading patterns look at the relationship between price change and sentiment to find a short-term trading edge. My preferred sentiment measure for intraday trading is the NYSE TICK. I use an adjusted version of the TICK, which simply subtracts the 100-day average reading from the raw figure, creating a zero mean.

Let's see what that short-term sentiment tells us:

Since 2004 in the S&P 500 Index (SPY), there has been a bullish drift. SPY has averaged a gain of .06% on a two-day basis, with 381 periods up and 337 down.

Now let's divide those occasions into periods when the day's average TICK reading was positive (bullish sentiment) vs. negative (bearish sentiment).

When the two-day Adjusted TICK was positive, the next two days in SPY average a loss of -.02% (187 up, 186 down). There's no bullish drift at all.

When the two-day Adjusted TICK has been negative, the next two days in SPY average a gain of .16% (194 up, 151 down).

What that tells us is that the bullish drift in SPY has been a reversal effect, in which markets move opposite to short-term trader sentiment. Returns are subnormal following bullishness and outperform following bearishness.

Combine that principle with your favorite intraday setups and you can derive a nice little edge, as those who sold cover their shorts and those who bought puke out their longs. Understanding the dynamics of mean reversion is key to trading the current equity index market.

Is Money The Rationale Or The Motivation For Trading?

Here's an interesting thought experiment: Suppose you find a trading system that made money consistently in all market conditions. It was backtested objectively during independent time periods and handily beat your own trading performance. It also took less risk to obtain these results, with minimal drawdowns. The system's price is quite reasonable. The catch? The system trades four times a year.

Would you obtain the system? Would you trade it? Would you buy it and then try to tweak it in various ways? Would you be able to follow its rules faithfully, or would you convince yourself in the middle of trades to take sure gains or limit losses?

Such a system would not meet the needs of many traders: needs for action, needs to figure out the market on your own, needs to feel like *you* were beating the market. Money is the rationale for trading, but it is not the only motivation. Traders also trade to make themselves feel good, to validate themselves, to avoid a 9-5 job, and so much more.

This is truly the source of most problems with "trading discipline": what we need to do to make money conflicts with the other needs that we impose upon trading.

If we bring a host of unmet emotional needs to the perfect trading method, we will inevitably sabotage that method. A rich and fulfilling life outside of trading might just be the best trading strategy of all.

Buying When The Yield Curve Is Inverted: Good Bet or Regret?

Those masters of the anti-motivational posters at Despair.com have it right: the worst mistakes are often the swiftest. So, it's with that in mind that I decided to take a look at the inverted yield curve in hopes of avoiding future regrets. After all, we always hear that inverted yield curves are bad for stocks, but here we are now--the curve having been inverted for a while--and we still stand at the summit above Dow 12,000.

I went back to January, 1970 (N = 1872 weekly periods) and identified all occasions in which the yield on the 3 month t-bill exceeded the rate on the long bond. This is the case at present. It turns out that we've only had 277 such inverted periods over the past 36 years.

When we look at the Dow Jones Industrial Average 40 weeks later, we see that the average price change following an inverted yield curve is a loss of -1.06% (105 up, 172 down). This is very much weaker than the average 40-week gain of 5.12% (1273 up, 599 down) for the entire sample. In short, buying the market during an inverted yield curve has indeed been a losing strategy.

Consider some of the historical periods with inverted curves: January-May, 1970; March 1973 - December 1974; September 1978 - April 1980; October 1980 - October 1981; February 1982 - April 1982; August, 1989; July - December 2000. All in all, pretty bad times to have been in stocks if your holding times were within a two-year horizon.

Note also that inverted periods can persist for quite a while before resolving in a decline and eventual Fed easing.

This time, of course, *could* be different. No doubt that's what our friend in the poster thought as he passed the summit.

Dr. Brett's Blog Links and Market Stats for Tuesday

Monday Morning Links and Notes

Here's an intraday trading pattern that has performed quite well over the last three weeks, with a nod to the Trade Ideas Odds Maker.

There are many new Web 2.0 tools to help you research your trading ideas.

I'll be attending the Futures Trading Summit in Las Vegas this week and giving a presentation on Wednesday. Some of my upcoming blog posts will summarize what I've learned from this multi-day event. Both days of the Summit will be streamed over the Web for online registrants.

The next Morning With the Doc will be Wednesday, November 22nd. We'll follow the market in real time and see if we can track patterns with a historical edge.

Carl Futia lays out his scenario for this market, drawing upon the work of George Lindsay.

Here are Charles Kirk's premarket trading ideas.

Here's what Trader Mike is looking at in early trade.

Here's trading ideas from Alpha Trends.

Have a great start to your week!

More Links

Anticipating Next Day Returns in the Russell 2000

The Russell 2000 has proven to be an increasingly popular trading vehicle. Indeed, average 50-day volume in the IWM ETF has risen by a factor of over 13 since July, 2003. The greater volatility of the small caps--and their outperformance through much of the recent bull market--have made the Russell an important trading market.

Looking over the data from 2004 - present (N = 719 trading days), we see that the Russell does not tend to reverse the move of the previous day. The average daily change in IWM has been .05% (378 up, 341 down). After an up day in IWM (N = 378), the next day's average change is .056% (195 up, 183 down)--no different from average.

Momentum effects do seem to occur in the Russell. When IWM is up and the number of stocks closing above their 20-day moving averages increases (N = 260), the next day in IWM averages a gain of .10% (142 up, 118 down). When IWM is up, but the number of stocks closing above their 20-day moving averages declines (N = 118), the next day in IWM averages a loss of -.04% (53 up, 65 down). Broad participation in market rallies thus tends to carry forward into strength the next day for the Russell; weak participation does not.

The Russell does show signs of reversal effects as well. When the prior five days in the Russell have been up (N = 214), the next day in IWM has averaged a loss of -.03% (98 up, 116 down). When the previous week in the Russell has been down (N = 164), the next day in IWM has averaged a gain of .17% (97 up, 67 down). Buying after a week of weakness has paid off well in the Russell; buying after a week of strength has not.

Finally, when we've had more than 1000 issues making fresh 20-day highs (N = 192), the next day in IWM has averaged a loss of -.01% (93 up, 99 down). When we've had fewer than 1000 issues making new 20-day highs (N = 186), the next day in IWM has averaged a gain of .12% (102 up, 84 down). Once again, we see that buying multi-day strength has not worked in the Russell.

It is when we combine these factors that we can sometimes discover meaningful edges. When we see strong upside participation following multiday weakness, holding for next day strength exploits a nice edge. A rise with poor participation at a multiday high offers a cautionary signal. Knowing how your stock or index has been trading--its patterns of next-day returns--tells you a great deal about whether you should trade or fade moves to the upside.

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Dr. Brett's Blog Links and Market Stats

Why It's So Difficult To Be A Trend Follower

The excellent Barchart site contains a great deal of performance information about stocks, sectors, ETFs, etc. Here is my little mashup of some of their findings:

Take a 40-day version of the Commodity Channel Index. When the oscillator moves above 100 (showing good upward price momentum), buy. When it moves back below 100, sell. Similarly, when the Index moves below -100 (showing strong selling momentum), go short. When it moves back above -100, cover shorts.

Let's see how this little system performed for the S&P 500 Index (SPY) over the past two years:

* The system made 48 trades, averaging 7 days per trade. We had 11 winning trades and 37 losers.

* Overall, the system lost a little more than 18 SPY points (the equivalent of 180 points in the futures). This, of course, occurred during a bullish period of market prices.

* The average size of the winning trades was considerably higher than the average size of the losers, but the better than 3:1 ratio of losers:winners kept the system in the red.

Ironically, this might be a great nucleus for a trading system. It's telling us that the market is trading in a countertrend mode. If you had a method to limit your losses and faded the system signals, you'd have a fighting chance to make some good money. After all, a consistently losing system *does* have a potential edge.

Now consider the following:

If we traded that exact same system in GOOG, we'd have had 33 trades averaging 11 days per trade. We'd have had 14 profitable trades and 19 losers, but the system would have made over 134 GOOG points over the last two years by catching trending moves. Almost half of that profit came from a single big trending move.

The examples show how hard it is to be a trend follower. The indices are reversing directional moves, making trend following a losing proposition. Even with good trending stocks, you have to be able to tolerate frequent losing trades. Most of all, you have to be consistent enough to stick with the system for the occasional huge winner. There *are* traders able to succeed with trend following, but shrewd stock/asset class selection and steely discipline are necessary.

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Dr. Brett's Blog Links and Market Stats

Brief Therapy Techniques: How Traders Can Become Their Own Trading Coaches - Part Three

In the second post of this series, I laid out three principles to guide traders in working on patterns of thinking, feeling, and behaving that might be interfering with sound trading decisions. The first article in the series introduced the notion of brief therapy techniques as relatively rapid and effective tools for self-change. In this final installment, I will outline a process for utilizing these tools.

Let's say we have a trader named Chris who is struggling with a problem of impulsive trading. Although Chris has a general idea of a trading plan, she finds that she takes many trades that don't meet her criteria. This is costing her money, both in added commissions and in trading losses. How could she begin to help herself with the problem?

Recall that brief methods for changing problem patterns are effective when those patterns are situational. The first question Chris should ask is whether she is impulsive and undisciplined in other areas of her life, outside of trading, and whether she is experiencing negative consequences from this broader impulsivity. If the answer is yes, that's evidence that this is not just a situational problem. Rather than try to tackle the problem on her own, she should seek a professional to help her figure it out. Perhaps it's an addictive problem; maybe it's a problem related to attention deficits and/or hyperactivity. Perhaps it's the result of a mood disorder. An objective evaluation is in order.

If, however, this is a recent problem limited to trading, the odds for success with self-help are much greater.

What Chris needs to answer is the following: "What is the problem that she is trying to solve with her impulsive trades?"

My earlier post noted that what we label as problems are actually attempted solutions to situations that bring unwanted consequences.

In Chris' case, she may be trying to manage a specific fear: one that trading coach Doug Hirschhorn refers to as the "fear of missing out". She is afraid that the market will move without her being on board.

Her real problem is in her definition of opportunity. She equates opportunity with movement in her market. Movement, however, in itself is not opportunity. Opportunity comes from anticipated movement. Behind her impulsive trades is a kind of thinking that says, "I should be able to anticipate movement. I don't want to be wrong."

In a very real sense, Chris is trading to avoid self-blame. It's her self-blaming and her faulty definition of opportunity that are the real problems. Impulsive trading is simply her way of trying to cope with these problems.

Once we frame the problem in this manner, it is not difficult to find solutions. I review Chris' trading performance with her and identify times in which she was *not* impulsive and traded well. I ask her what she did at those times that seemed to work for her. She tells me that she made a conscious effort to stick with one or two setups, wrote those down, and taped them to her monitor.

I tell Chris that self-blaming is a good thing if we're focusing on the right behavior. A person without self-blame would be a sociopath. Chris should blame herself if she doesn't trade her setups; those are her real opportunity. If a market moves without her setup, she can always research the move after the fact and see if there's opportunity in a different setup. For now, however, her opportunity is what she knows how to do best.

We perform mental rehearsals before the start of the trading day in which Chris visualizes herself trading her setups and focusing on her opportunity. I also have her visualize the "old Chris" and imagine herself correcting her errant ways. This talk of "new Chris" and "old Chris" helps cement the changes in her mind. Then, at the end of each trading day, we give her a report card based, not on P/L, but on her ability to pursue true opportunity.

In one sense the change has occurred quickly. But in another sense, no change at all has occurred. Chris is simply more consistent in doing something she already knew how to do. By focusing on solutions rather than problems, we turned self-blame and the obsession with opportunity into virtues. While, to an outsider, it appears that she's become more "disciplined", in fact she has simply redefined what it means to pursue opportunity.

Brief change occurs in four steps:

1) View the problem as a solution and ask yourself what this pattern is accomplishing. What real problem am I trying to solve by thinking, acting, and feeling the way I do?

2) Find exceptions to your problem pattern. Once you understand what your underlying fear or concern is, go back in your trading performance and identify occasions when you've successfully dealt with that fear.

3) Create a pattern out of those successful occasions that you can become part of a market routine. Do more of what you've been doing when you've been trading well.

4) Keep repeating your solution pattern until it becomes automatic. It's not enough to initiate change; you want the change to become part of you.

Additional resources are available on the Articles page of my personal site. My Psychology of Trading book goes into greater detail about solution-focused techniques for change; my latest book on Enhancing Trader Performance details cognitive and behavioral methods you can use to shift problem patterns. My hope is that these tools help you become your own trading coach. If so, you'll have developed skills to last a trading lifetime.

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Weekend Reading - 11/10/06

Best of Dr. Brett's Trading Markets articles via Yahoo! Finance.

Weekend charts from Charles Kirk.

Weekend linkfest from Barry Ritholtz.

Trader Mike tracks distribution.

Big Picture on the yield curve and recession.

Weekend blog watch from James Altucher.

Hedge fund pressure to perform from Abnormal Returns.

Bill Cara's week in review, with insight on WMT.

My next Weblog post will be Sunday. Have a great weekend!

Brief Therapy Techniques: How Traders Can Become Their Own Trading Coaches - Part Two

In my first post, I introduced the idea of rapid change of patterns of thought, emotion, and behavior. This post will focus on three principles to guide traders in becoming their own coaches.

Consider a trader we'll call John. He has been successful in the markets over different market conditions and demonstrated a profitable edge in his trading. He is now at the point at which he wants to grow his size and take fuller advantage of his edge, but he is concerned about the risk and pressure of growing larger. How can he overcome his emotional reluctance?

This is a classic pattern that can be addressed with short-term behavior change techniques. It is not the result of a chronic emotional disorder, and it is not the result of poor trading practices. The best patterns to work on using brief therapy techniques are ones that are situational: ones in which you want to change how you deal with specific scenarios.

Which brings us to our first principle:

1) When you are working on yourself, carefully target the changes you wish to make. Don't try to alter your entire personality or your behavior overall. Rather, focus on a single situation that you would like to approach differently and concretely identify a goal for that situation. If you don't know what you're seeking, you almost certainly won't find it. Many times, it's helpful to conduct a review and examine occasions in which you have dealt effectively with your chosen situation. One of the first questions I'd ask John is whether there have been any times in which he has successfully raised his size, even just a little. If so, we might use that success as a foundation to build upon. Many times, we're so focused on our problems that we fail to recognize the solutions that we've stumbled upon. Start your work on yourself by trying to do just one or two things differently. Set yourself up for success and build upon that.

Our second principle is very important to setting proper goals for change:

2) Problems are something you do, not something you have. We sometimes talk about emotional or behavioral problem patterns as if they are viruses: something we've picked up and have to get rid of. The reality is that problem patterns are usually efforts at solving a problem that simply aren't working--but are the best we know to do at the time. John's reluctance to grow his size is his way of managing risk and the emotions associated with perceived risk. The "problem" serves a function and meets a need ; he won't change that pattern unless he has another way to satisfy the need. If I were working with John, I would help him measure risk in percentage terms rather than absolute dollars. I'd encourage him to grow his size very slowly, but steadily, to manage the psychological aspects of risk. I'd also help him define methods of risk management that he might not have thought of, such as using his edge to diversify across non-correlated positions. You can grow your trading size without growing the size of your individual positions: just trade more than one thing and make sure the trades are independent of each other and preserve your edge!

Our third principle is perhaps most important of all:

3) You cannot rapidly change a pattern unless you face that pattern in real time. Talking about a problem does not, in itself, resolve that problem. People learn from new experience. John will feel comfortable getting larger by actually getting larger, not by discussing his insecurities. Accordingly, I might start John on a simulator and have make some practice trades with larger size. I would teach him some basic cognitive and behavioral skills for staying calm and focused and encourage him to use those skills while placing his simulated trades. Once that goes well, we would raise his size just a small notch and have him trade live--again using the skills he's learned. Only when that's gone well do we ratchet up the size another small notch, and another, and another. John will internalize the repeated experience of success; over time, he'll think of himself as a larger trader.

These principles hold true whether you're working on trading discipline, marital arguments, or a fear of heights. Your work on yourself will be successful when you find a safe context to be the change you want to make. Changing by enacting solutions rather than discussing problems is a powerful way to develop yourself as a trader--and as a person. How to do that will be the topic of the third and final post in this series.

Dr. Brett's Blog Links and Market Stats

Free Articles on Trading Psychology

Brief Therapy Techniques: How Traders Can Become Their Own Trading Coaches - Part One

Beginning with a review article that I published in 1992, I focused my career on brief therapy: techniques for accelerating emotional, cognitive, and behavioral change. My co-edited textbook on the topic has become a standard training text for residents in psychiatry, and I've written articles for traders to teach them some brief change techniques. Most recently, my book on Enhancing Trader Performance contains two chapters with self-help manuals to help traders become their own short-term cognitive and behavioral therapists.

Many trading problems related to emotional disruptions can benefit from short-term work, but not all of them. How you trade affects your emotions just as much as emotions affect trading. This is why it is important to distinguish when frustrations are the cause of trading problems and when they are the result.

When I tried to summarize my reasons for writing my first book for traders, The Psychology of Trading, I emphasized the neurophysiology of risk and reward. Quite simply, when we encounter conditions of uncertainty and risk, the blood flow patterns in our brain facilitate our "flight or fight" response patterns. Blood flows away from the frontal cortex, our executive center, and toward motor areas and lower brain structures. That means that we are least likely to activate our judgment, planning, reasoning, and analysis when we most need it.

Brief therapy techniques help people remain grounded in their executive cognitive functions under conditions of high emotional arousal. Stated otherwise, these short-term methods help you stay calm and focused during situations that normally evoke anxiety, impulsivity, negative thinking, or greed.

This series of posts will introduce some of the basics of brief therapy in hopes that you can become your own trading coach. I often stress to traders I work with: my goal is to get fired. I want you to be your own counselor, not to become reliant on me. With practice, any trader can learn techniques for short-term change that have been validated by scores of outcome research studies. My hope is that this series of posts can begin the process for interested market participants.

Market Update for 11/10/06

We came into the day on Thursday with a bit of a bearish bias, as noted in the recent posts, and, indeed, the sellers came out in the afternoon. Altogether, we saw 1159 stocks make fresh 20-day highs across the major exchanges and 618 register new lows. This continues to be a source of concern; it is a much higher level of new lows than we typically see near market peaks and suggests possible distribution among shares. My Demand measure, reflecting the number of stocks trading above their moving average volatility envelopes, was 44; Supply (index of stocks trading below the envelopes) was 89. This suggests continued weak momentum among stocks. If you check out the Weblog and the link to the Adjusted TICK, you'll see that the recent rise has been very unimpressive in terms of buying pressure. We're in a trading range between, roughly, 1380 and yesterday's highs. Unless we can establish greater buying interest, momentum, and strength, I will continue to view this action as part of a topping process. My next full Weblog update will be Sunday.

Testing Out The Beach Ball Pattern In The Stock Market

We have head-and-shoulders patterns, double tops and bottoms, and flags and pennants. Why not beach ball patterns? You know how beach balls are in the water: You push them down, and they bounce right up.

Wednesday we had a beach ball day, as investors sold stocks on the election news but rallied them higher in the afternoon. What happens after such bouncy occasions?

It turns out that, since 2004 (N = 717 trading days), we've had 16 beach ball days in the S&P 500 Index (SPY), in which the market opened down by more than -.30%, but rallied to close higher than the previous day's close. The next day, the market has been down by an average -.16% (6 up, 10 down). That is notably weaker than the average one-day gain of .03% (390 up, 327 down) for the sample overall.

There's an interesting pattern within the pattern, however. When the market has a beach ball bounce following a five-day period of rising prices (N = 7), as at present, the market has been down an average of -.64% (1 up, 6 down) the next day. That is quite a weak performance.

Conversely, when the beach ball day has follwed a five-day decline (N = 9), SPY has been up by an average of .22% the next day (5 up, 4 down)--stronger than normal.

These are small samples, so must be taken with a grain of salt. Two lessons, however, follow from this little exercise:

1) Subjective impressions in the market aren't always accurate - Before doing any testing, I would have predicted that the beach ball pattern would have been bullish for next-day performance. That seems logical: the market was rejecting lower prices. In fact, if anything, the pattern has been bearish--especially when it follows a period of strength.

2) Context matters - Many chart patterns test out differently depending upon what has happened leading up to the patterns. This is restating something veteran technicians have always known: what's happening on the longer time frame really is important. The beach ball pattern tested out quite differently when it followed strength vs. weakness.

Just about any market pattern you can identify can be tested out. All of my testing is done in Excel with simple open-high-low-close data. Such tests won't always show you a significant edge, but they can be helpful in alerting you to occasions where none exists. In this case, I'm alert to the possibility that the beach ball's bounce may be more of a last gasp for air than a sign of continued buoyancy.

Stock Market Sentiment Is Not Necessarily A Contrary Indicator

Sometimes the crowd gets it right.

Let's take the current market. We've been up over a three-day period in the S&P 500 Index (SPY) by over 1.5%. During those three days, the ratio of put volume to call volume among equity options has been .72. That's pretty much the average put/call ratio that we've seen since 2004 (N = 717 trading days) and slightly bearish for periods of solid three-day gain.

Since 2004, we've had 67 occasions in which SPY has been up by more than 1.5% on a three-day basis. The next day, SPY has averaged a loss of -.04% (32 up, 35 down), which is weaker than the average one-day gain of .03% (390 up, 327 down) for the sample overall.

But let's break it down by put/call ratio. When the ratio is greater than .70 over those three days (N = 33), it suggests that put buyers are more aggressive relative to call buyers. The next day, SPY averages a loss of -.22% (12 up, 21 down)--much weaker than average. When the ratio is less than .70 (N = 34) and call buyers are relatively more aggressive, SPY averages a next-day gain of .14% (20 up, 14 down).

In other words, relatively bearish sentiment from options traders during a large three-day rise has led to a correction the next day. Relative optimism among options traders during a three-day advance has carried over to greater strength the next day.

Sometimes, I guess, a true contrarian has to fade even a contrary indicator.

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What's Up, Doc?

I'll tell you what's up this morning in the wake of Democratic celebration and a down S&P 500 Index: some of those favorite names in alternative energy.

Ballard Power Systems (BLDP) is up over 4% as I write. Plug Power (PLUG) is up over 3%.

The alternative energy sector has long been a darling of speculators, but nothing was going to happen in a sustained way while an administration dominated by oil executives and supported by Congress was dictating policy.

With this election, that scenario is changing.

Energy independence will be the mantra of the next party in power. It will frame a response to terrorism, human rights, and the Middle East--and it will capture patriotic appeal. It will address growing concerns with global warming and the environment and will promise economic security. It will bring us closer to our allies abroad and ease some of the tensions with countries that compete with us for oil.

A few traders in that alternative energy space seem to have figured that out.

What Drives Investor Sentiment?

After my recent post on bullish market sentiment, a reader expressed surprise that we were seeing such protracted optimism. After all, weren't housing prices falling? Isn't the war going poorly? Aren't we reacting to geopolitical problems in North Korea, Iran, and the Middle East more widely?

My response was that, perhaps, sentiment is simply a function of price. We haven't seen a 10% correction in the Dow since the 2003 start of the bull market. Perhaps that's why sentiment has remained elevated. It's not just that bullish sentiment leads people to put their money on stocks; rising stocks also might generate bullish sentiment.

Such a conclusion would fit with the interesting research noted on the excellent CXO Advisory blog, which found that margin debt actually slightly lags stock index price: people borrow money for investment when they see rising prices.

Above we see a chart of weekly data from 2003-present. The red line is a detrended composite measure of sentiment taken from the three surveys from my prior research. The blue line represents weekly 52-week new highs minus new lows in the NYSE, adjusted as a percentage for the number of issues traded. Note that there is a strong correlation between new highs/lows and sentiment. Indeed, from July, 1987 to 2006 (N = 980 weekly periods), the correlation between new highs/lows and sentiment has been .54. When we have many stocks making new highs, sentiment tends to be more bullish; when we have many stocks making annual new lows, sentiment tends to be less bullish.

Viewed another way, we can say that the new highs/lows account for almost 30% of the variance in investor sentiment. That still leaves a chunk of variance unexplained--and room for sentiment to diverge from the new highs/lows.

Might there be trading patterns in such divergence?

When bullish sentiment across the three surveys runs 10% or more above average (N = 124), the next 20 weeks in the Dow Jones Industrials average a gain of 1.46% (70 up, 54 down). That is weaker than the average 20-week gain of 3.67% (682 up, 298 down) for the entire sample. Very bullish sentiment leads to inferior returns in the intermediate term.

But wait! Let's divide the bullish sentiment periods in half based upon the new highs/lows. When new highs are strong *and* we have high bullish sentiment, the next 20 weeks in the Dow average a gain of .28% (28 up, 36 down). When new highs are not strong and there is bullish sentiment, the next 20 weeks in the Dow average a gain of 2.63% (42 up, 22 down).

What that says is that markets yield subnormal returns when lots of stocks are making new highs and investors are very bullish. When investors are bullish in the absence of great strength in new highs, that bullishness is associated with much more normal returns going forward.

How about when sentiment is bearish? When bullish sentiment has been 10% or more below average (N = 114), the next 20 weeks in the Dow average a gain of 7.30% (94 up, 20 down), much stronger than the average 20-week Dow gain. That tells us that very bearish sentiment leads to superior returns in the intermediate term.

When we have weak bullish sentiment *and* a high level of stocks making new lows (N = 57), the next 20 weeks in the Dow average a gain of 9.1% (50 up, 7 down). That's stronger than the performance when we have weak bullish sentiment and a low level of stocks making new lows (5.49%; 44 up, 10 down).

In short, sentiment is highly but not perfectly correlated with price and market strength. It's when sentiment is highly bearish and lots of stocks are making new lows that returns are most favorable for investors.

Dr. Brett's Blog Links and Market Stats

This Market Is Full Of Bull!

In my recent post, I averaged the bullish stock market sentiment from three well-regarded and longstanding surveys and found unprecedented bullishness during the past two years. My latest article for Trading Markets found that the peaks and valleys of sentiment across the three surveys have tracked intermediate-term market swings quite nicely. A chart of those data can be found on the 11/7 Trading Psychology Weblog.

Going back to mid-1987 (N = 1006 weekly periods), I created a composite measure of investor sentiment by averaging the bullish percentages from the American Association of Individual Investors survey, the Investors Intelligence poll, and the survey from Market Vane. Over that period, these measures of sentiment are positively correlated with each other, but do not have huge areas of overlap. The AAII and Investors Intelligence polls are most closely related, with a correlation of .52. Those two polls correlate with the Market Vane measure by only about .26. Altogether, the polls share less than 30% of the total variance in reported sentiment. That suggests to me that the surveys may be tapping different kinds of traders: some shorter-term, some longer-term, some index traders, some traders on individual equities.

By averaging the three surveys and focusing on when they are all bullish or bearish, we can obtain a good sense for when a variety of traders are leaning the same way in the market.

What we find in doing so is that, since 1987, the 2004-2006 is unprecedented in its persistent bullishness. Specifically, the average bullish percentage from 2004-2006 has been 53%. The average bullishness from 1987-2003 has been 43%. To put that into perspective, 71% of all weekly periods since 2004 have seen bullish readings over 50%. Prior to 2004, only 20% of readings exceeded 50%.

But now the big question: Does investor sentiment have an impact upon future price changes?

When composite bullishess has exceeded 55% (N = 108), the next 10 weeks in the Dow Jones Industrial Average have averaged gains of only .57% (60 up, 48 down). That is considerably weaker than the average ten-week gain of 1.70% (640 up, 366 down) for the entire sample. Indeed, when bullishness has exceeded 60% (N = 22), the next ten weeks in the Dow average a loss of -2.51% (7 up, 15 down)--a remarkable finding, given the long-term bullish bias in the Dow over that period.

How about when bullishness has been below 40% (N = 308)? The next ten weeks in the Dow average a robust gain of 3.0% (217 up, 91 down)--much stronger than average.

It does, indeed, appear that investor sentiment possesses some contrary value. Consider the outcomes when we look 20 weeks out: When sentiment is bullish (over 55%), the average gain over the next year is a subnormal 1.44%; when there are relatively few bulls (under 40%), the average gain is a robust 5.34%.

The present market, hovering near that 60% level, has some uncomfortable company in market history, including January, 2000; April, 1998; and August,1987. Not every period of very high bullishness has led to a market crash, but only 6 of the 22 highly bullish periods were higher 20 weeks later. And that's no bull.

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The Most Promising Application of Psychology to Trading

If trading firms managed money as scientifically as they conduct their hiring, most would be out of business quickly.

The problem is prevalent in the business world. We have sophisticated tools for accounting, process control, and marketing, but hiring practices remain mired in the subjectivity of personal interviews and reviews of resumes.

Hiring new traders poses special challenges. Without an established track record of success, how can firms determine if candidates have the skills and talents needed to succeed?

Few people are aware that research in psychology has led to the creation of highly realistic simulations that allow firms to directly measure the competencies needed for success. The studies of Drs. Siegfried Streufert and Usha Satish are particularly noteworthy in this regard. Their Strategic Management Simulations put candidates through a series of scenarios that require decision making. The decisions made and rationales for these are used to create a web-like diagram of the candidate's cognitive functioning. What the diagram actually measures, the researchers note, are aspects of frontal activity in the brain.

The brain's frontal cortex is called by cognitive neuroscientist Elkhonon Goldberg our executive center. It is responsible for much of our reasoning, planning, judgment, analysis, and problem-solving. By creating standardized tasks for a variety of professions--from CEOs to physicians--Streufert and Satish in essence have designed a methodology to match people's brains to the work they will be doing.

The implications for trading are immense.

It is not difficult to create highly realistic trading simulations utilizing actual historical market data. By asking traders to trade a standardized set of markets and track news and market events as they occur, we can analyze their reasons for decisions. This analysis will generate cognitive maps that display how candidate traders think and behave under varying conditions of challenge, complexity, and stress. We can directly observe how people handle risk, how their emotions aid or hinder their objectivity, and how they manage change and new information.

If simulations on a computer can accurately predict the performance of surgeons, perhaps they can unlock some of the factors that account for trading success. Perhaps, too, they can help identify future superstar performers.

The most promising application of psychology to trading--and many other fields--comes, not from the therapy couch, but from cognitive neuroscience. Quietly, in a variety of fields, matching brains to tasks is revolutionizing hiring practice.

Dr. Brett's Blog Links and Market Stats

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Are The Bulls Stampeding?

I know that sounds like a crazy question, but I like to listen to the data.

Let's take three measures of investor sentiment: the polls of the American Association of Individual Investors, Investors Intelligence, and Market Vane. What we find across all three is that more than 50% of survey participants are bullish on the stock market.

Going back to 1987 in all of those polls (N = 1006 weeks; the extent of my data set), we only find 86 weekly periods in which this has been the case.

Three clusters of those occasions fell during August, 1987; April, 1998; and January, 2000. Not exactly great times to be owning stocks.

But here's the really unusual thing: 64 of the 86 weekly periods of unanimous bullishness since 1987 have occurred during this bull market: since June, 2003.

We have never had such a protracted period of bullishness in the surveys in recent history.

Tonight I'll break it down and post my analyses tomorrow AM. Odd that this isn't on the radar for more traders and investors.

Testing The Market's Winds

Much of my morning routine consists of looking at a few core measures of market sentiment, participation, momentum, and strength and seeing what stands out in the recent market. Once I find something that stands out, I go back in time and see what happened following similar episodes. This gives me an initial idea of whether this historical pattern might be associated with a directional trading edge.

The historical pattern is just that. Such patterns do not last forever, and--at best--they can put probability on your side, not certainty.

I treat these patterns like a scientist treats a hypothesis: an idea that will have to be supported by further investigation before it is accepted. Each day in the market, in that sense, is a kind of laboratory experiment, either supporting or failing to support history's hypothesis.

This morning, one pattern that I'm looking at is four consecutive days of negative daily readings in the Adjusted NYSE TICK. The Adjusted TICK is quoted daily in the Weblog and reflects whether more stocks were trading at their offer prices or at their bids. This is an excellent short-term measure of sentiment, because it captures the willingness of buyers to pay up to acquire stocks and the willingness of sellers to bail out at market prices.

The first thing we see in the data is that four consecutive days of negative TICK (bearish sentiment) is relatively unusual. We've only seen 45 such occasions since the beginning of 2004 (N = 709). The next day in the S&P 500 Index (SPY), the market was up by an average of .29% (31 up, 14 down), much stronger than the average one-day gain of .03% (382 up, 327 down). Stated otherwise, the odds of an up day following a four-day period of persistent bearish sentiment have been better than 2:1.

Sometimes we'll see more than one historical pattern point toward the same general conclusion. That provides us with a bit more confidence in our hypothesis. Still, it is just a hypothesis. If today is going to be an up day from open to close, we need to see a net positive TICK. That means an abundance of high readings (above +500) and very few weak ones (below -500). If we see selling in the ES futures--traders hitting bids--but TICK staying relatively strong, I'll conclude that the selling is not spilling over into the broad market, and I'll be willing to go with my hypothesis on the long side.

Should selling in ES spill over to the broad market, I will entertain the notion that this market is not living up to its historical norms. That, too, is valuable information.

The good scientist is open minded. Carl Swenlin of the Decision Point service makes a fine point when he says that indicators are windsocks, not crystal balls. They tell you which way the market wind is blowing. All history can do is prepare you just a bit for those winds.

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Tracking Market Psychology With NYSE Margin Debt

In my recent post, I tracked margin debt on the NYSE back to 1970 and found a consistent pattern across bull and bear markets. During cyclical declines, we tend to see year-over-year declines in margin debt. During bull market peaks, we tend to see substantial annual gains in margin debt. It is this tendency to borrow money to buy stocks when markets are already high and refrain from borrowing when markets are weak that makes margin debt a worthy contrary indicator.

From the vantage point of market psychology, margin debt is one of the purest measures of fear and greed. When investors are greedy, they will go beyond their cash balances to buy stocks. When they are fearful, they will refrain from leveraged positions. The big question, however, is whether future market returns are impacted by the fear and greed of margined investors.

Going back to 1970 (1818 weekly periods) in the Dow Jones Industrial Average, we find that, when annual changes in margin debt exceed 30% (N = 445), the next 52 weeks in the Dow average a gain of only 1.39% (209 up, 236 down). That is much weaker than the average 52-week gain of 9.05% (1285 up, 533 down) for the entire sample. In short, periods of greed lead to subnormal market performance.

How about fear? When the annual rate of change in margin debt has been -25% or less (N = 128), the next 52 weeks in the Dow average a gain of only 1.14% (57 up, 71 down). Again, that is much weaker than the average yearly gain for the Dow since 1970.

Indeed, when we have neither fear nor greed--when the annual rate of change in margin debt is less than +10% but greater than -10% (N = 427), the next year in the Dow brings an average gain of 13.91% (357 up, 7o down)--considerably stronger than average. Given that we are neither seeing extreme fear or greed at present in margin debt, we'd have to say that there are no immediate bearish indications.

In short, extremes of investor fear or greed have led to subnormal returns in stock prices. It is when sentiment has been moderate that returns have been best.

Let's however, consider the trajectory of margin debt at recent market peaks. The annual rate of margin debt peaked in March/April, 2000, near the peak in the NASDAQ but prior to the Dow peaks later that year and in May of 2001. The annual increase in margin debt peaked in May/June, 1998, a month or two ahead of the sharp decline. The peak in August, 1989 preceded the price peak of 1990 by nearly 11 months. The margin debt rate peak of December, 1986 preceded the price peak of 1987 by about 9 months. The annual peak in November, 1983 preceded the price peak of 1984 by about 2 months. The late April peak in 1981 was only about 2 months ahead of the price peak.

What is clear from this little excursion is that annual rates of change in margin debt are not precise market timing tools, but there is a tendency for these rates of change to top out ahead of the Dow stocks. In other words, investors reduce the growth in their margin accounts as markets are topping. This is relevant because we saw our maximum annual rate of change in margin debt all the way back in April, 2004. The most recently reported rate is well below that recorded in May of 2006. The slowing of growth in margin debt following a multi-year rise is a yellow--not a red--light for stocks going forward.

Dr. Brett's Links and Market Stats

Solution Focused Trading

What is the one thing we see among successful traders, artists, athletes, executives, researchers, and companies?

They build upon their strengths and don't become bogged down trying to invent new ones or attempting to improve their weaknesses. In so doing, they become learning machines.

Consider a simple example. When I first began this blog not quite a year ago, I averaged about 7500 visits per month. This continued for the first few months.

I then began to study the daily statistics of how many people were accessing the site, which pages they went to, and where they were referred from. What I found was that certain topics interested readers and other bloggers quite a bit. Other topics fell flat and generated little interest.

Did I spend time trying to make the unpopular topics more palatable or trying to convince other bloggers to link to my less desired work? No, I took what brief therapists call a solution focus instead. The readership was telling me what their needs and interests were. I needed to do more of what was already working, not fiddle with topics that weren't relevant for readers.

With a shift in emphasis toward highly practical research findings and psychology themes, I found that readership had tripled by May. Feedback from reader comments and emails led me to build further on strengths, adding the morning market updates to help readers apply information from the blog in real time. With that, readership has undergone a doubling from May levels.

By gathering information every day on how the blog was performing and using the data to identify and build upon strengths, I've been able to make the site more useful for readers. Every post, popular and unpopular, became a learning experience. The trajectory of growth in readership, which had been flat prior to my studying the statistics, took a significant upward turn.

This is the process by which all elite levels of success are achieved: identify core competencies and build upon them, constantly assessing what is working and what is not. Figure out what you're doing right--and then become very intentional in doing it more often, more consistently. Don't invest your limited time and effort in areas that don't represent what you do best.

This is why it is vital to study your best trades, not just write in a journal about your worst ones. Find the trades where you had an excellent plan or read of the market and where you were able to execute the idea well. What patterns did you pick up on? How did you act upon the pattern? Were the patterns more apt to appear in certain stocks or at particular times of day? Such questions will lead you to what works best for you.

You may find that just one or two patterns in one or two markets at one or two time frames account for a large part of your success. Don't try to tweak what isn't working: figure out ways to capitalize on your core success in related markets, with steadily increased size. Build upon what you do well; don't try to remake yourself based on preconceived notions.

The solution focus is evolution in real time. We are selecting the strongest of our behavior patterns and allowing the weakest to become extinct. Over time, our own guided natural selection enables us to become learning machines, capable of superior adaptation.

Think about how a solution focus could guide your trading development, your career development, and your relationships. Think of yourself as an engine of continuous evolution. How far we could go if we provided every facet of life with an emotional P/L statement and just focused on doing more of what makes us happy, fulfilled, and successful!

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Stock Market Margin Debt: An Indicator That Hasn't Lost Its Value for Investors

One of the best indicators of speculative sentiment among investors is margin debt. This doesn't measure what participants think will happen in the market; it assesses their actual commitments to the market. A sharp rise in margin debt means that investors are eager to get into stocks. A sharp contraction in debt suggests that investors are loathe to commit funds. When all the speculative money has piled into stocks--or has pulled out--what will sustain future rises or declines? It's for this reason that margin debt is a consummate contrary indicator.

Let's check the historical track record:

* During the large market drop in 1970, margin debt plunged year over year by over 35%

* With the market recovery in 1972, debt had risen by over 50%.

* During the large market drop in 1974, margin debt fell by 30%.

* By the market's recovery early in 1977, margin debt rose by over 50%.

* During the 1982 market decline, debt fell by over 22%.

* By the market peak in 1987, market debt had risen over 30%.

* With the 1987 crash, debt dropped by over 25% in 1988.

* Margin debt was slow to recover after that crash and rose only 8% by 1989.

* With the 1990 drop, debt dropped by nearly 20%.

* By early 1994, speculators were back and margin debt was up by 40%.

* Speculators were reluctant to leave the market and, by late 1994, margin debt was down only about 4%.

* With the market's speculative binge in 2000, margin debt had risen by 90%.

* The ensuing crash in tech stocks took margin debt down over 40% by 2001 and cut total margin debt in half from 2000 peaks by 2002.

* Since that drop, we saw a year-over-year peak in margin debt change of over 30% in early 2004 and over 20% in 2006, although we are not yet at the 2000 level of margin debt.

In my next post, I'll see if some guidance for long-term investment can be gained from the margin debt figures.

In the interim, several conclusions stand out:

1) Spikes in annual changes in margin debt have been associated with market tops.

2) Large declines in annual changes of margin debt have been associated with most major market bottoms.

3) Speculators have been relatively slow to jump on board the stock market following the drop of 2000-2002. In that sense, the response to the decline has been similar to the response following the drop of 1987 and, to a lesser degree, 1970 and 1974. Large bear markets appear to affect the behavior of speculators over the next business cycle.

Interestingly, margin debt is below the levels recorded in May, despite the market's recent rise. Year over year, we're up about 9% in margin debt, down from the 2006 peak of over 24%. It is hard to believe this bull swing will have legs if it continues to fail to attract speculative interest. If history is a guide, it will take a significant year-over-year drop in margin debt to usher in a cyclical market bottom.

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How Can I Join A Trading Firm?

There are many disadvantages to trading independently. Many independent traders cannot command the same low commissions received by exchange members and member firms. Trading on your own may also be isolating. At a firm, you have dedicated support teams handling equipment, software and hardware upgrades, and developing/acquiring new trading tools. That is beyond the budget of many independent traders.

It is natural, therefore, that many independent traders consider joining a trading firm. Having coordinated a training/hiring program for a Chicago-based proprietary trading firm, I have some familiarity with the challenges and issues involved in making such a move. Here are a few items for your consideration:

1) Many of the best career opportunities for traders are at large institutions, such as investment banks and hedge funds. These are often very well capitalized and able to invest in training and development of traders. The catch? These organizations like to hire graduates of finance and financial engineering programs. Quantitative and programming skills are in demand. If you're looking to build a long-term career in the financial world, I'd strongly encourage you to consider an MBA program with a finance concentration or a Master's program in financial engineering to provide yourself with the competencies and skill sets that are increasingly in demand. In such firms, you'll be an employee with benefits and a salary.

2) Can you afford to start out by trading your own capital? If so, this opens several doors. There are trading "arcades" that provide you with office space, tech support, equipment, and trading platforms and pass along economies of scale to you. These shops generally can command low commission rates and may or may not pass along some of their own commissions to you on top of monthly fees for the service, rent, and equipment. Note that in this structure, you are a customer of the firm, not an employee. That means no salary and, in all likelihood, no draw against future earnings. The upside is that you keep the lion's share of your trading profits. One nice variation on the arcade is the trader's co-op, in which a few experienced traders go in together to share equipment, office space, and other overhead, but trade their own accounts.

3) Do you need capital to get yourself started? Then you might be looking at a proprietary trading firm, in which you trade the firm's capital. The firm provides you with all equipment, space, tech support, software, and platforms. At some of these firms, you may be charged a commission on top of monthly fees. The firm, because it takes 100% of risk, will also take a good chunk of profits. You may qualify as an employee of the prop firm, which means that you would be eligible for normal employee benefits. A monthly draw against future profits may provide you with some stable income; straight salaries are not the norm.

You'll be more competitive to join a bank or hedge fund if you have the education and internship placement experience. You'll be more competitive to join a prop firm if you already have an independent track record of trading success. The education departments at the major exchanges, such as the Chicago Mercantile Exchange and the Chicago Board of Trade, publish lists of member firms and often are aware of training programs and hiring among these. Googling "Master's of Science in Financial Engineering" and looking into MBA programs with strong finance components (see who is publishing in the Journal of Finance!) will give you leads for training for institutional positions.

The bottom line is that few organizations will take you off the street and put capital into your hands to trade. If you're not an experienced trader with your own capital, my advice is to find a graduate program or a training program within a proprietary firm and learn the business from the ground up. Think about building a career, not just getting a job.

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Sell Stocks After A Week of Weakness?

Two measures of buying and selling activity tracked on the Trading Psychology Weblog each day are the Adjusted NYSE TICK (a daily summed measure of number of stocks on NYSE trading at offer minus those traded at bid, adjusted for a zero mean) and the Institutional Composite (the same measure, but with the Dow Jones Industrial Average stocks). During the past five trading sessions, we've had four net selling days in the TICK and all five showing net selling in the Composite. I decided to investigate what happens after we get similar periods of significant weakness in both measures (average daily Adjusted TICK < -300; average daily Composite < -200).

It turns out that we've had 20 such occasions since 2004 (N = 708). Three days later in the S&P 500 Index (SPY), we've seen an average gain of .44% (15 up, 5 down). That is a meaningful bullish edge compared to the average three-day gain of .10% (397 up, 311 down) for the sample overall.

The market, of course, is on edge this AM awaiting the big jobs numbers. Keep an eye on the interest rate and currency markets to see if the news pushes us to new levels of valuation in those markets. If so, the news really is economic news and the adjustments of macro traders could lead to a sustained downward revaluation of equities as well. If the news doesn't really change the outlook for rates or the dollar, I'm going to question whether we'll sustain a major revaluation of stocks. In that scenario, the odds tell us that, as a whole, selling into a week of weakness is not a good bet.

Addictive Trading: Getting Your Life Back

My recent post on out-of-control trading brought many email inquiries and insightful comments on the blog. One of the common questions voiced was: How can you tell when a trader is passionate about trading vs. addicted to it?

The first step in dealing with any addictive pattern is identifying it--and identifying it as a problem. Here are a few questions that you might ask yourself:

* Have there been times when I told myself to stop trading, but still found myself placing trades any way?

* Do I find myself overtrading by putting on positions with too large size or by trading during periods when nothing is happening?

* Have my trading losses created problems for me in my relationship(s), or have they caused financial problems for me?

* Have people close to me told me that I need to stop trading?

* Is the pain from losing more extreme than the satisfaction from winning?

* Do I find my moods fluctuating with my P/L?

* Do I trade simply out of boredom sometimes?

* Do I find myself preoccupied with trading outside of market hours at the cost of other work and relationships?

Notice that, for many of these questions, you could substitute the word "drinking" or "gambling" for "trading". The dynamics of addictions are the same across the board. If you answered yes to three or more of these questions, I would suggest that trading has become a problem for you.

How does one deal with addictive trading? The first step is to identify it, but the second--and harder--step is to acknowledge that you need help for it. It's pride that tells us we can handle it on our own through will power, but addictions wouldn't occur in the first place if will power were sufficient to prevent consequences.

Telling yourself you can manage your own addiction is itself a form of denial.

That is why a key step in Alcoholics Anonymous is acknowledging that you are powerless against alcohol.

That is why AA substitutes mutual support for drinking and advocates abstinence as a goal.

Through books, self-help groups, and counseling, you learn to identify the thought and behavior patterns that drive your addictive behaviors. You also learn to identify cravings in advance and channel these in productive directions.

Most of all, you regain a measure of control over your life and end the negative consequences of the addiction.

If you find yourself unable to control your trading and you find the emotional, financial, and social consequences mounting, that's not a passion for trading. It's an addiction.

Do the right things:

1) Close your account.

2) Get help.

I do not provide private counseling myself, but will be happy to assist with a referral in your region. If these posts help just one person turn his or her life around, that will be one of the best returns on investment I've ever achieved.

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What Happens After A Bearish Engulfing Pattern?

I notice that Brian Shannon, in his fine video review of the market, observed that Wednesday's action constituted a bearish engulfing pattern. Now I'm not exactly an expert on candlestick patterns, but the basic notion of a bearish engulfing pattern makes sense to me. We rise above the previous day's high, decline below the prior day's close, and close near the bottom of the day's range. On the face of it, that should be bearish, as we rejected higher prices. Brian notes that he doesn't put much stock in the pattern, preferring to focus on the longer time frame. In the end, as Victor Niederhoffer emphasizes, we must always do our counting and verify any conclusions with hard data.

I went back to 1996 in the S&P 500 Index (SPY; N = 2694 trading days) and found 45 occasions (like Wednesday) that met the following criteria: 1) today rose above yesterday's high; 2) today declined below yesterday's low; 3) today was the largest range of the past five trading sessions; and 4) today closed in the bottom 10% of its day's trading range.

Interestingly, the next trading day in SPY sports an average gain of .10% (31 up, 14 down), notably stronger than the average daily change of .04% (1405 up, 1289 down). Since 2004, we've only had 12 such bearish engulfing days, but--incredibly--11 of them have closed higher the following day for an average gain of .32%.

Clearly there is no next-day bearish edge to outside days that finish near their daily lows. Indeed, there has been a nice bullish tendency following such one-day declines. Once again, we find that anecdotal reasoning has its limits when it comes to market intelligence.

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Dr. Brett's Heartfelt Plea: When Trading Gets Out of Control

What I love most about trading is that it exercises the brain and the will. It involves ongoing analysis and problem solving, and it requires the steady development of performance-based skills. I'm sure serious players of chess and poker enjoy similar benefits. Talk to any successful athlete and you'll find someone who has cultivated themselves, not just their bodies.

There are times, however, when trading becomes a vehicle for destroying mind and soul. You won't hear brokerage firms, trading publications, or seminar producers talking much about this problem, because their common aim is to keep the public trading and buying trading-related products. But, as someone who has worked with many independent traders and traders at firms, I've seen this problem far too often: trading becomes an addictive activity.

Oh yes, trading coaches and psychologists will talk about losing "discipline", but rarely will they use the "A" word. Discipline you work on, addictions you get rid of. If you get rid of a trading addiction, there goes the trading coach.

Many times, however, losses of discipline in the markets are related to addictive patterns of behavior.

An addiction occurs when an activity provides a strong source of stimulation that, over time, a person becomes psychologically and sometimes physically dependent upon. We generally label a behavior as an addiction when people seek out the activity even in the face of demonstrable negative consequences. It is the inability to stop the activity when those consequences interfere with life that marks any addiction.

Let's look at the facts:

* According to research cited by the National Council on Problem Gambling, 2 million adults (1% of the population) meet the diagnostic criteria for pathological gambling. Another 4-8 million adults (2-4% of the population) can be considered problem gamblers who are experiencing direct problems as a consequence of gambling.

* Research in psychology and psychiatry reported in the Oxford Textbook of Psychopathology finds that between 14 and 16 million Americans meet diagnostic criteria for alcohol abuse or dependence. Between 4-6 million Americans are dependent upon illegal drugs.

* Rates of substance abuse among men ages 18-44 are double those of the general population.

* A family history of addictive problems is one of the best predictors of risk for addiction. Peer influence is another significant risk factor.

* According to a research review in the Oxford Textbook, rates of depression are significantly higher among people with addictions than in the general population, with indications that people are using the addictive activities to medicate themselves for the pain of depression.

* Addictions are also most common among individuals with attention deficits and hyperactivity problems and appear to be related to sensation-seeking among those needing stimulation.

Even if we assume that traders do not have more frequent addictive behaviors than the general population, the statistics tell us that, in all likelihood, nearly one trader in every ten has a diagnosable addictive problem.

For the trader with attention deficits who cannot tolerate boredom or lack of stimulation, trading provides action.

For the trader who is depressed, trading can provide an escape from the self and a sense of immediate gratification.

Such traders need to trade and keep trading when they have no edge whatsoever.

They lose their money, generate failure experiences for themselves, and create hardships for their families.

For them, it's not about "discipline" and following trading rules. It's about getting their lives back. And getting the right kind of help. If you see any aspect of yourself in this portrait, do the right thing. For you, and also for those who love you. Trading should expand your control and self-mastery, not become an instrument for its destruction.

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