It's been a great year, and I want to wish all readers a very happy and prosperous 2007. Below are links to TraderFeed posts from the first half of 2006 that capture a few of my New Year's thoughts--and resolutions! Tomorrow I'll post links to favorite psychology posts from the second half of the year.
* How I use volume flow information in trading to capture the market's psychology;
* Why I find historical analyses of the markets to be useful;
* Reflections on life and the markets;
* Why having odds in your favor doesn't assure success;
* How the S&P 500 Index behaves on a very short time frame;
* Some defining features of market pros I've worked with;
* VIX as a measure of daytrading opportunity;
* A psychology checklist for traders;
* Lessons that traders have taught me;
* Why scalping the stock indices has become so difficult;
* The opening range and market opportunity;
* A solution-focused framework for working on one's trading;
* How the markets confound human nature.
* The most common trading problem of all.
* Why traders lose their discipline.
* Diagnosing trading problems.
* Playing it safe avoids reward as well as risk. Even for investors.
* Living the heroic life: Part one, two, three, four, five
* What a bodybuilder teaches us about life success.
Sunday, December 31, 2006
Saturday, December 30, 2006
Interest Rates and the Stock Market: Have Rising Rates Mattered to Traders?
We finished the 2006 trading year making 20-day highs in the interest rate on the 10-year Notes ($TNX). Have rising rates been affecting stock returns for traders? I decided to take a look by going back to 2004 (N = 729 trading days).
Since that time, we've had 103 occasions in which the rate on the 10-year Note has made 20-day highs. (Observe that this means the Note itself made 20-day price lows). When that has occurred, the S&P 500 Index (SPY) has averaged a gain over the next three weeks of only .07% (56 up, 47 down). Conversely, when the 10-year rates have not made new 20-day highs (N = 626), the next three weeks in SPY have averaged a gain of .54% (389 up, 237 down). It would appear that returns have been subnormal after rates have been rising.
The rate on the 10-year Note has only been above 5% for 67 trading days, and these were clustered during the period of April-July, 2006. Three weeks after these occasions, SPY averaged a decline of -.47% (25 up, 42 down). When rates have been below 4.1% (N = 118), however, the next three weeks in SPY have averaged a gain of .97% (76 up, 42 down). Could it be that the market interprets rates above 5% as potentially damaging to the economy and hence to stocks?
Finally, when 10-year rates have risen by more than 5% in a 20-day period (N = 126), the next three weeks in SPY have averaged a loss of -.20% (53 up, 73 down). When 10-year rates have dropped by more than 5% over the past 20 days (N = 79), the next three weeks in SPY have averaged a gain of .78% (50 up, 29 down). Large rises (declines) in rates appear to have been associated with subnormal (superior) returns in the near term.
Clearly, the recent equity index market has preferred low rates to high ones. The recent rise in rates is one factor that may subdue near-term returns.
Since that time, we've had 103 occasions in which the rate on the 10-year Note has made 20-day highs. (Observe that this means the Note itself made 20-day price lows). When that has occurred, the S&P 500 Index (SPY) has averaged a gain over the next three weeks of only .07% (56 up, 47 down). Conversely, when the 10-year rates have not made new 20-day highs (N = 626), the next three weeks in SPY have averaged a gain of .54% (389 up, 237 down). It would appear that returns have been subnormal after rates have been rising.
The rate on the 10-year Note has only been above 5% for 67 trading days, and these were clustered during the period of April-July, 2006. Three weeks after these occasions, SPY averaged a decline of -.47% (25 up, 42 down). When rates have been below 4.1% (N = 118), however, the next three weeks in SPY have averaged a gain of .97% (76 up, 42 down). Could it be that the market interprets rates above 5% as potentially damaging to the economy and hence to stocks?
Finally, when 10-year rates have risen by more than 5% in a 20-day period (N = 126), the next three weeks in SPY have averaged a loss of -.20% (53 up, 73 down). When 10-year rates have dropped by more than 5% over the past 20 days (N = 79), the next three weeks in SPY have averaged a gain of .78% (50 up, 29 down). Large rises (declines) in rates appear to have been associated with subnormal (superior) returns in the near term.
Clearly, the recent equity index market has preferred low rates to high ones. The recent rise in rates is one factor that may subdue near-term returns.
Friday, December 29, 2006
What Is Options Sentiment Saying About The Start of 2007?
One of the joys of conducting analyses of historical market patterns is the discovery of relationships you hadn't anticipated. Sometimes those are mere anomalies; other times, they represent discoveries.
In my recent posts, I've been analyzing the put/call data for individual equities and for the equity indexes. As I was looking at relative put/call ratios for the equities (how the current ratio compares to the average ratio for a given lookback period), I noticed that we have had quite an elevated relative put/call ratio over the past four trading sessions. In other words, the put/call ratios for the past four sessions have been high (skewed toward puts) relative to the 20-day average ratios.
I decided to take a closer look at four-day elevations in the relative equity put/call ratio going back to 2004 (N = 734). When the put/call ratio for the past four trading sessions is more than 20% greater than its 20-day moving average (N = 62), the next 15 days in the S&P 500 Index (SPY) have averaged a gain of 1.31% (46 up, 16 down), quite a bullish bias. To state it otherwise, when the options traders shift heavily toward put volume over a twenty-day period, the next three weeks in the S&P 500 Index have dramatically outperformed their average. That would bolster the bull case for the start of 2007.
Now for the unexpected finding:
When the relative equity put/call ratio has been 10% or more beneath its 20-day moving average (N = 85), the next 15 days in SPY have averaged a *gain* of .95% (60 up, 25 down), again quite a bullish edge. We are accustomed to thinking of a low put/call ratio as extreme optimism and hence a bearish market indication. It appears, however, that when bullish sentiment shifts strongly over a 20-day period, the shift has bullish implications over the following three weeks.
I will be refining the methods I use to assess relative options movement, so consider this a work in progress. What I hope to determine is whether *changes* in sentiment are more important to market outcomes than absolute levels of sentiment themselves.
In my recent posts, I've been analyzing the put/call data for individual equities and for the equity indexes. As I was looking at relative put/call ratios for the equities (how the current ratio compares to the average ratio for a given lookback period), I noticed that we have had quite an elevated relative put/call ratio over the past four trading sessions. In other words, the put/call ratios for the past four sessions have been high (skewed toward puts) relative to the 20-day average ratios.
I decided to take a closer look at four-day elevations in the relative equity put/call ratio going back to 2004 (N = 734). When the put/call ratio for the past four trading sessions is more than 20% greater than its 20-day moving average (N = 62), the next 15 days in the S&P 500 Index (SPY) have averaged a gain of 1.31% (46 up, 16 down), quite a bullish bias. To state it otherwise, when the options traders shift heavily toward put volume over a twenty-day period, the next three weeks in the S&P 500 Index have dramatically outperformed their average. That would bolster the bull case for the start of 2007.
Now for the unexpected finding:
When the relative equity put/call ratio has been 10% or more beneath its 20-day moving average (N = 85), the next 15 days in SPY have averaged a *gain* of .95% (60 up, 25 down), again quite a bullish edge. We are accustomed to thinking of a low put/call ratio as extreme optimism and hence a bearish market indication. It appears, however, that when bullish sentiment shifts strongly over a 20-day period, the shift has bullish implications over the following three weeks.
I will be refining the methods I use to assess relative options movement, so consider this a work in progress. What I hope to determine is whether *changes* in sentiment are more important to market outcomes than absolute levels of sentiment themselves.
Thursday, December 28, 2006
Stock Market Psychology: Equity and Index Put/Call Ratios
In my most recent post, I showed that there is a near-zero correlation between the daily equity put/call ratio and the daily index ratio over the past several years. Whereas the equity ratio has shown more call than put activity over that period, the index ratio has been skewed toward puts. These factors lead me to believe that different groups of market participants are active in the equity and index options markets. Are they both accurate measures of market psychology, despite their differences? I decided to take an initial look.
Going back to 2004 (N = 748 trading days), I divided the sample in half based upon whether the five-day put/call ratios were relatively low (more bullish) or high (more bearish). I then looked to see how the S&P 500 Index (SPY) behaved over the following five days.
When the five-day equity put/call ratio was relatively low (N = 374), the next four days in SPY averaged a loss of -.03% (190 up, 187 down). When the five-day equity put/call ratio was relatively high (N = 374), the next four days in SPY averaged a gain of .29% (232 up, 142 down). This is quite a difference. It suggests that the common wisdom has held true: market returns are superior when equity options participants are relatively bearish and are subnormal when equity options participants are relatively bullish.
Now let's look at the index put/call ratio. When the five-day index put/call ratio was relatively low (N = 374), the next four days in SPY averaged a gain of .08% (197 up, 177 down). When the five-day index put/call ratio was relatively high (N = 374), the next four days in SPY averaged a gain of .19% (225 up, 149 down). Although the difference is not as dramatic, we see a similar pattern among the index option ratios: when relatively bullish, market returns have underperformed; when relatively bearish, market returns have been superior.
Interestingly, five-day index put/call ratios have correlated with five-day equity ratios by only .05--meaning that they are essentially independent of one another. My best interpretation of the data is that both are measuring sentiment, but among different market participants. The equity put/call ratio is assessing the psychology of speculative traders; the index ratio is tapping the psychology of those using index vehicles for hedging purposes. While there are obviously other uses of the options to be considered, it does appear that the sentiment of these groups is worth tracking for the short-term trader. In my next post, I will examine these ratios on a relative basis (i.e., when they are elevated or depressed relative to their moving averages).
Going back to 2004 (N = 748 trading days), I divided the sample in half based upon whether the five-day put/call ratios were relatively low (more bullish) or high (more bearish). I then looked to see how the S&P 500 Index (SPY) behaved over the following five days.
When the five-day equity put/call ratio was relatively low (N = 374), the next four days in SPY averaged a loss of -.03% (190 up, 187 down). When the five-day equity put/call ratio was relatively high (N = 374), the next four days in SPY averaged a gain of .29% (232 up, 142 down). This is quite a difference. It suggests that the common wisdom has held true: market returns are superior when equity options participants are relatively bearish and are subnormal when equity options participants are relatively bullish.
Now let's look at the index put/call ratio. When the five-day index put/call ratio was relatively low (N = 374), the next four days in SPY averaged a gain of .08% (197 up, 177 down). When the five-day index put/call ratio was relatively high (N = 374), the next four days in SPY averaged a gain of .19% (225 up, 149 down). Although the difference is not as dramatic, we see a similar pattern among the index option ratios: when relatively bullish, market returns have underperformed; when relatively bearish, market returns have been superior.
Interestingly, five-day index put/call ratios have correlated with five-day equity ratios by only .05--meaning that they are essentially independent of one another. My best interpretation of the data is that both are measuring sentiment, but among different market participants. The equity put/call ratio is assessing the psychology of speculative traders; the index ratio is tapping the psychology of those using index vehicles for hedging purposes. While there are obviously other uses of the options to be considered, it does appear that the sentiment of these groups is worth tracking for the short-term trader. In my next post, I will examine these ratios on a relative basis (i.e., when they are elevated or depressed relative to their moving averages).
Assessing Stock Market Sentiment: A First Look At Equity and Index Option Indicators
It's natural to look toward the option markets to assess sentiment toward stocks: by separating put activity and call activity, we can see who is more active at any given period of time. If we think of puts as bets that traders are placing on the market's decline and calls as the bets traders are placing on the market's rise, the relative movements of put and call volume reveal the shifts in speculative sentiment among those traders.
Of course, options are also used for hedging purposes, which could greatly diminish their value as sentiment indicators. A large trader could be selling both puts and calls in anticipation of a flat market, for example.
Despite the hedging caveat, it does appear that equity put/call indicators have value as sentiment measures. Indeed, we may even derive benefit from considering puts and calls as different pieces of information, rather than joining them in a single ratio. My initial look at such relative put ratios and relative call ratios showed some promise as measures of stock market psychology.
To this point, I have focused on the put and call activity of individual stocks (equity puts and calls). With this post, I'll add another data series: the put and call volume for the stock indices. As it turns out, index put/call activity differs greatly from equity put/call data.
One outstanding difference is that the index put/call ratio is skewed toward put volume, whereas the equity ratio is slanted toward calls. Specifically, since 2004 (N = 753 trading days), the average equity put/call ratio has been .73. The average index put/call ratio has been 1.49.
Interestingly, the total volume of equity puts and calls each day since 2004 correlates with the total volume of index puts and calls by a sizable .80. That means that when equity options traders are active in the market, so are index options traders. The daily correlation between the equity and index put/call ratios, however, over that same period has been only .12. In other words, equity and index options traders appear to be responding to the same market events, but they are responding differently.
What this suggests is that the equity put/call ratio may be tapping more into the universe of options speculators and the index put/call ratio may be tapping more into the universe of options hedgers. This might help to account for why the equity ratio is skewed toward calls in a bull market, but the index ratio is skewed toward puts. If this is the case, both might reflect market sentiment, but in different ways--and in ways that might be synergistic. My upcoming posts will explore the value of these indicators.
Of course, options are also used for hedging purposes, which could greatly diminish their value as sentiment indicators. A large trader could be selling both puts and calls in anticipation of a flat market, for example.
Despite the hedging caveat, it does appear that equity put/call indicators have value as sentiment measures. Indeed, we may even derive benefit from considering puts and calls as different pieces of information, rather than joining them in a single ratio. My initial look at such relative put ratios and relative call ratios showed some promise as measures of stock market psychology.
To this point, I have focused on the put and call activity of individual stocks (equity puts and calls). With this post, I'll add another data series: the put and call volume for the stock indices. As it turns out, index put/call activity differs greatly from equity put/call data.
One outstanding difference is that the index put/call ratio is skewed toward put volume, whereas the equity ratio is slanted toward calls. Specifically, since 2004 (N = 753 trading days), the average equity put/call ratio has been .73. The average index put/call ratio has been 1.49.
Interestingly, the total volume of equity puts and calls each day since 2004 correlates with the total volume of index puts and calls by a sizable .80. That means that when equity options traders are active in the market, so are index options traders. The daily correlation between the equity and index put/call ratios, however, over that same period has been only .12. In other words, equity and index options traders appear to be responding to the same market events, but they are responding differently.
What this suggests is that the equity put/call ratio may be tapping more into the universe of options speculators and the index put/call ratio may be tapping more into the universe of options hedgers. This might help to account for why the equity ratio is skewed toward calls in a bull market, but the index ratio is skewed toward puts. If this is the case, both might reflect market sentiment, but in different ways--and in ways that might be synergistic. My upcoming posts will explore the value of these indicators.
Blog Links and Market Update for Thursday
Wednesday, December 27, 2006
Matching What You Trade With How You Trade
In several recent posts, I have mentioned that the growing number of ETFs across the "style cube" are providing active market participants with an increasing number of vehicles for trading. A look at recent returns, for example, shows us that value stocks have been outperforming growth and that smaller cap stocks have been outperforming larger cap ones. Just as important, we see patterns of volatility in smaller cap ETFs that may well make them better trading vehicles than their larger, more popular counterparts.
I decided to use a very simple benchmark trading system to evaluate the trading performance of some of the most popular ETFs. On Tuesday, for example, I found 10 ETFs that traded over 3 million shares on the day: QQQQ, SPY, IWM, XLE, OIH, EWJ, XLF, DIA, SMH, and EFA. Notice the growing popularity of small cap trading (IWM) and international trading (EWJ, EFA). Let's see how some of these popular ETFs perform if we simply buy the ETF when it crosses its 20-day moving average to the upside and we sell it when it crosses it to the downside. Such a very simple system should give us a fair number of whipsaw trades, but should also capture nice trending moves.
In the U.S. large caps, of course, we have seen more evidence of mean reversion than trending during the last several years. For example, going back to 2004 (N = 732 trading days), we find that, when the S&P 500 Index (SPY) is above its 5-day moving average *and* above its 20-day moving average (N = 336), the next 10 days in SPY average a loss of -.04% (188 up, 148 down). That is quite an underperformance: The remainder of the occasions in SPY average a 10-day gain of .63% (256 up, 140 down).
Conversely, when SPY has been below its 5-day moving average *and* below its 20-day moving average (N = 194), the next 10 days in SPY average a gain of .77% (124 up, 70 down). A trend following approach in SPY, which would have a trader buying when the index is above its short-term moving averages and selling when the index is below, would have lost considerable money during this bull market.
But with the help of the "performance" feature from the excellent Barchart site, let's actually see how some of the ETFs would have performed since 2005 if we had implemented the simple system described above:
For SPY, we would have had 16 winning trades and 47 losing trades. This would have lost us about 12 SPY points or the equivalent of 120 S&P futures points--during a bull market! The system did catch two large winning trades--it bought in October, 2005 and in July, 2006--but this wasn't enough to make up for a system that had three times as many losing trades as winners.
If we move over to the iShares Emerging Markets ETF (EEM), we find that we had 13 winners since 2005 and 33 losers. Interestingly, however, the system actually made about 25 points over that period. (It started 2005 trading in the 60s). Why? Because the system was able to catch winners that were much larger than the losers. EEM displayed more runs following breaks above and below its moving average than did SPY.
Now let's look at EFA, the iShares MSCI EAFE international ETF. We had 16 winners with our system and 44 losers. That's not at all a favorable ratio, but still the system eked out a little over 5 points of profit. Once again, we saw good sized runs in EFA that simply were not present in SPY--but not ones as pronounced as EEM.
The point of this, of course, is not to trade such a simple system. Indeed, the approach never made more than simple buy-and-hold during the period studied. Rather, we can see that different ETFs display different trending properties that can make the difference between profitability and significant losing. The takeaway message is that *what* you trade should be compatible with *how* you trade.
I decided to use a very simple benchmark trading system to evaluate the trading performance of some of the most popular ETFs. On Tuesday, for example, I found 10 ETFs that traded over 3 million shares on the day: QQQQ, SPY, IWM, XLE, OIH, EWJ, XLF, DIA, SMH, and EFA. Notice the growing popularity of small cap trading (IWM) and international trading (EWJ, EFA). Let's see how some of these popular ETFs perform if we simply buy the ETF when it crosses its 20-day moving average to the upside and we sell it when it crosses it to the downside. Such a very simple system should give us a fair number of whipsaw trades, but should also capture nice trending moves.
In the U.S. large caps, of course, we have seen more evidence of mean reversion than trending during the last several years. For example, going back to 2004 (N = 732 trading days), we find that, when the S&P 500 Index (SPY) is above its 5-day moving average *and* above its 20-day moving average (N = 336), the next 10 days in SPY average a loss of -.04% (188 up, 148 down). That is quite an underperformance: The remainder of the occasions in SPY average a 10-day gain of .63% (256 up, 140 down).
Conversely, when SPY has been below its 5-day moving average *and* below its 20-day moving average (N = 194), the next 10 days in SPY average a gain of .77% (124 up, 70 down). A trend following approach in SPY, which would have a trader buying when the index is above its short-term moving averages and selling when the index is below, would have lost considerable money during this bull market.
But with the help of the "performance" feature from the excellent Barchart site, let's actually see how some of the ETFs would have performed since 2005 if we had implemented the simple system described above:
For SPY, we would have had 16 winning trades and 47 losing trades. This would have lost us about 12 SPY points or the equivalent of 120 S&P futures points--during a bull market! The system did catch two large winning trades--it bought in October, 2005 and in July, 2006--but this wasn't enough to make up for a system that had three times as many losing trades as winners.
If we move over to the iShares Emerging Markets ETF (EEM), we find that we had 13 winners since 2005 and 33 losers. Interestingly, however, the system actually made about 25 points over that period. (It started 2005 trading in the 60s). Why? Because the system was able to catch winners that were much larger than the losers. EEM displayed more runs following breaks above and below its moving average than did SPY.
Now let's look at EFA, the iShares MSCI EAFE international ETF. We had 16 winners with our system and 44 losers. That's not at all a favorable ratio, but still the system eked out a little over 5 points of profit. Once again, we saw good sized runs in EFA that simply were not present in SPY--but not ones as pronounced as EEM.
The point of this, of course, is not to trade such a simple system. Indeed, the approach never made more than simple buy-and-hold during the period studied. Rather, we can see that different ETFs display different trending properties that can make the difference between profitability and significant losing. The takeaway message is that *what* you trade should be compatible with *how* you trade.
Tuesday, December 26, 2006
Three Pervasive Myths of Trading Psychology
My work as a trading psychologist has provided me with a fascinating window on the factors that separate successful from unsuccessful traders across a variety of settings, from proprietary firms to investment banks to hedge funds. Having met and worked personally with well over 100 professional traders in the past few years, the main conclusion I’ve come to is that most of the generalizations about trading success are simply not true. In this article, I thought I’d summarize three of the more pervasive myths about trading success out there and offer my own, different perspectives.
Myth #1: Emotions are at the root of trading problems. Yes, emotions can interfere with concentration and performance, but that doesn’t mean that they are a primary cause. Indeed, emotional distress is as often the result of poor trading as the cause. When traders fail to manage risk properly, trading size that is too large for their accounts, they invite outsized emotional responses to their swings in P/L. Similarly, when traders trade untested patterns that possess no objective edge in the marketplace, they are going to lose money over time and experience an understandable degree of emotional frustration. I know many successful traders who are fiercely competitive and highly emotional. I also know many successful traders who are highly analytical and not at all emotional. Trading is a performance field, no less than athletics or the performing arts. Success is a function of talents (inborn abilities) and skills (acquired competencies). No amount of emotional self-control can turn a person into a successful musician, football player, or trader. Once individuals possess the requisite talents and skills for success, however, then psychological factors become important. Psychology dictates how consistent you are with the skills and talents you have; it cannot replace those skills and talents.
Myth #2: Anyone, with dedicated effort, can get to the point of trading for a living. That is nonsense. How many people make their living from acting or musical performance? What proportion of people playing sports can actually make their livelihood from athletics? Many people play chess or poker, but how many can sustain a living from it? Quite simply, to make a living from any performance activity means that you are consistently good at what you do. Not everyone has the talent, skill, or drive to be that successful—in any field. Across the many traders I’ve met in various settings, from home-based, independent traders to professional ones in firms, the best predictors of trading success have been the size of the trader’s account and the resources available to the trader. If a person were to make 30% per year on their accounts year after year, they would be among the world’s most successful money managers. Most money managers of mutual funds, hedge funds, and pension funds cannot sustain such performance. If, however, a trader begins with $60,000 of capital, he or she may not be content with $18,000 of profit. This leads the trader to accept huge leverage and court a risk of ruin when an inevitable string of losing trades occurs. Indeed, such excess leverage is a main cause of emotional distress in trading. Take a look at how the Turtles made their money: they learned a trading method, learned to be consistent with that method, and were given enough money by Richard Dennis that they could trade multiple markets with enough size to scale into positions in each. Even with those resources, not all of the Turtle students could succeed. Talent, skill, and opportunity are the ingredients of success, and these are relatively normally distributed in the trading population, just as they are relatively normally distributed in the population at large.
Myth #3: The main cause of trading failure is a loss of discipline. This is a myth perpetuated by “trading coach” and “guru” types that: a) don’t trade themselves and b) have a vested interest in your belief that their services are all that stand between you and success. The main cause of trading failure is a lack of an objective edge in the marketplace, trading random patterns that have never been tested out for success. We would never consider buying a car simply by looking at it. We’d want to research it, test-drive it, and peer under the hood. Amazingly, however, many traders will risk far more money trading patterns that they never research or test-drive. Many times, the reason they stray from those methods is that, intuitively, they realize that those methods are not working. In any performance field, we find a hard-and-fast truth: the great performers spend more time practicing their performances than actually performing. That is just as true for the Broadway actress as for the Olympic athlete. Many traders, however, think that on-the-job training will be enough. Unfortunately, their accounts often don’t survive their learning curves. A well-placed executive within a trading firm confided to me last year that the average time it takes the average trader to blow through their entire account is seven months. That is why brokerage firms are always on the hunt for new customers. It’s not that these traders are all deficient in discipline: they simply haven’t engaged in sufficient practice to figure out the right markets and trading styles for them and to hone their skills. In every other performance field, you can find relatively easy levels of competition: you can join a community theater, play rounds of golf at the par-3 course, or set the challenge level on your chess computer. There is no easy level of competition in trading, however. When you place a trade on a major exchange, you are up against the pros from day one. No wonder it is so difficult to succeed! Discipline is necessary for trading success, but there is much more to success than discipline. It takes concerted practice and the cultivation of skills at reading and acting upon market patterns.
In an ideal world, I wouldn’t have to challenge these myths. You’d be able to obtain very realistic messages about trading success from brokerage firms, vendors, trading gurus, books, and magazines. The reality, however, is that most of these commercial entities have a vested interest in perpetuating a dream that is, in reality, a cruel fantasy: that, without real, sustained effort, anyone can make it big as a trader.
Does that make me a Scrooge during this holiday season, saying “Bah, humbug!” to the aspirations of thousands of traders? I think not. The reason I wrote my most recent book, Enhancing Trader Performance, was to show that there is a common process beneath the development of elite performance in any field. That process involves several components:
Finding a Niche – Identifying a performance field that takes maximum advantage of your skills, talents, and interests;
Deliberative Practice – Rehearsing skills in increasingly realistic settings to prepare for the challenges of actual performance;
Constant Feedback – Intensive review of performance to identify strengths and weaknesses, so that you can capitalize on the former and address the latter.
The successful traders I’ve known have found a market (or set of markets) and a trading style that capitalizes on their abilities. They have been relentless in working on their skills, using videotaping to review markets and performance and using simulators to rehearse under different market conditions. To sustain such effort requires a love of the markets themselves, something not all traders have. Some traders love the action, some love the dream of making money, some love the opportunity to work for themselves—but many don’t love the work itself: the effort of mastering patterns in demand and supply.
Success is possible in trading as it is in any performance field. If anyone tells you, however, that the path to trading success is different than it is for the surgeon or Olympian, you know that you’re hearing a myth. If you choose the path of the elite performer, trading can be wonderfully challenging and rewarding. If trading is not your ideal path for self-development, however, you are far better off finding your passion elsewhere and managing your money prudently. The goal is to develop the best within you, whether that is as a trader or as something else. Your life deserves nothing less.
Monday, December 25, 2006
A Cross-Section of ETF Returns for 2006
Here we see market performance for four ETFs during 2006: the S&P 500 Index (SPY; dark blue line); the MSCI EAFE Index (EFA; red line); the Russell 2000 small cap index (IWM; yellow line); and the MSCI Emerging Markets Index (EEM; turquoise line). The ETFs have been adjusted for an equal market price at the start of 2006 to illustrate their relative performance.Notice that two themes jump out:
1) International ETFs (EFA and EEM) have outperformed the U.S. market ETFs (SPY and IWM);
2) Smaller cap ETFs (EEM and IWM) have outperformed the larger cap ETFs.
What this means is that the large cap U.S. stocks have been the style cube laggards. We tend to think of those U.S. large caps as "the market", but in reality they are but one sector in a much larger global marketplace.
The chart also illustrates an obvious, but oft-neglected truth: Returns are a function of both what markets you're in and when you're in them. Superior returns have gone to those who invested in international markets and smaller cap shares. Note also, however, that had someone bought the emerging markets stocks or U.S. small caps near the May peak, their returns going forward would not have been impressive.
Indeed, one shift along the style cube that may have begun with that May decline is a shift away from the smaller-cap, more speculative world equity sectors toward large cap value stocks, both international and domestic. With the aging of the European and American baby boom cohorts, it would not be surprising to see a growing emphasis on "blue chip" reliability and dividend payment. The current shift away from growth and toward value may not be a short-term phenomenon, especially given the greater volatility of returns from small cap stocks and emerging markets.
From Style Box to Style Cube: The iShares EAFE Indices
In my recent post to the Trader Performance page of my personal site, I suggested that I viewed ETF trading through the lens of a "style cube", rather than the traditional "style box". We have already seen two dimensions of the style cube: large cap-small cap and value-growth. The important third dimension to the cube we might call "domestic-international": investing in the U.S. vs. investing internationally.
To illustrate two of the cube dimensions, I've created the chart above, which tracks the iShares EAFE Value Index ETF (EFV), the iShares EAFE Growth Index ETF (EFG), and the S&P 500 Index ETF (SPY). Prices have been adjusted for equal value at the start of 2005.
Before we examine the chart, however, allow me to comment on the MSCI EAFE Index. EAFE refers to Europe, Australia, Far East. The index consists of companies in the developed world outside the U.S., with liberal weighting of Japan, U.K., and continental Europe. The ETF covering the MSCI EAFE Index itself is EFA, and it has become an increasingly popular investment and trading vehicle. EFV and EFG break down the Index into value and growth components, so that we can see how those market segments perform relative to one another.
At this point in time, we don't really have ETFs developed for the small cap/large cap portions of the EAFE Index. What we do have, however, is the iShares MSCI Emerging Markets ETF (EEM), which represents international markets in the developing world. To the extent that we view the emerging markets as "small cap", we could think of EEM as representing the international-small cap space on the cube and EFA as representing the international-large cap space. Eventually, as Russell Wild points out in his excellent "Dummies" book on Exchange-Traded Funds, we will likely see actual small-cap and large-cap versions of the EAFE Index itself.
So now to the chart. Notice that value has been outperforming growth among the EAFE stocks, similar to what we've seen in the U.S. market. There is, however, quite a gap in performance between both EAFE subindices and the U.S. large cap market. Traders have done better by being in value than growth, but they have especially profited when they've been in international markets vs. the U.S.
The style cube is simply a way of organizing our thinking about equity performance. Which segments of the market represent the greatest opportunity? Which have the greatest flows of funds? Should we weight our portfolios toward international or U.S.? Toward large cap or small? Toward value or toward growth? With ETFs, any individual investor can become a relatively sophisticated money manager.
I would argue, however, that the style cube ETF options will also become increasingly relevant for shorter-term traders, who will provide much of the growing liquidity in ETFs. Traders will be attracted to ETFs that are trending, those that are showing relative strength, and those that have good volatility for intraday moves.
The day of limiting trading to the major indices (SPY or QQQQ) in the U.S. or even to individual U.S. stocks is rapidly coming to an end. Markets are global, and ETFs permit increasingly global participation by the individual trader. That not only includes the equities that make up the style cube, but also the trading and investment options among the growing number of commodity, currency, and fixed income ETFs. I will be covering those in future posts.
Sunday, December 24, 2006
Significant Buying and Selling Days: The Trajectories of Bull and Bear Swings
Well, this isn't the neatest chart I've ever created, but hopefully it will be informative. What we're looking at here is the S&P 500 Index ($SPX) since 2005 plotted against two 20-day moving averages. The first, in green, is the number of significant buying days that occurred within that 20-day period. The second, in red, is the number of significant selling days within the past 20 sessions.
I defined a significant buying day as one in which advancing stocks outnumbered declinining ones on the NYSE by more than 2:1. Similarly, significant selling days represent occasions in which declining stocks have outnumbered advances by more than 2:1. That 2:1 criterion represents more than one standard deviation of strength/weakness in the advance-decline indicator. Fewer than 10% of market days qualify as being significant in their buying or selling. (The total of all significant days--buying and selling--represents roughly 15% of all market occasions).
What the chart illustrates is that there is a common trajectory to bull and bear swings. Let's walk through the phases of bull and bear swings.
As a bull swing matures, the rally becomes more selective and we see fewer significant buying occasions over time (i.e., the green line is dropping, even as the $SPX continues to rise). That is occurring in the present market. The number of significant selling days has not meaningfully expanded over this phase: we're merely seeing less broad-based buying.
The next phase of the market occurs when we see significant selling days interspersed with the muted number of significant buy days. During the early phases of a bull advance, it is common to see the number of significant selling days at zero for a number of days. As the bull swing matures, we see a creep up in the number of significant selling days. By the time the market makes its price peak, we've already had a lift of the significant selling days off of the zero trough.
Once a bear swing takes over the market, the number of significant selling days expands steadily, reaching a peak at or near the market bottom and exceeding the number of significant buying days. Each bear swing we've had in the past several years has had six or more significant selling days out of 20. Note that, overall, significant down days normally occur only about 7% of the time, which translates to 1-2 occasions out of 20. The bear swing represents a cluster of significant selling occasions.
What happens after this cluster is most interesting. We tend to get a flurry of significant buying days, as value-oriented market participants pick up bargains off the recent lows. That leads to a situation in which, temporarily, over a 20-day period, there are *both* a large number of significant buying and selling days. This clustering of significant selling and buying occasions appears to represent the appearance of longer timeframe participants in the market.
From that point, we go back to the initial phase, as the bull swing continues, but with a gradually decreasing number of significant buying days. That is where we're at in the current market. We have not yet seen a meaningful increase in significant selling days.
I've looked over these data going back several decades. The conclusion I am coming to is that it may be worthwhile to separate significant market days from normal, routine ones when analyzing the market. Normal selling days may well scare off traders, but they do not derail a bull swing. Similarly, normal buying days might lead to short-covering, but they do not reverse a bear swing. A "trend" stays in place until longer timeframe participants detect that stocks are trading too far above or below what they deem to be value. Until those participants engage in broad-based buying or selling, a market will tend to continue in its most recent directional movement.
Many trading strategies, over many timeframes, might be developed out of traders' overreactions to normal buying and selling occasions during directional swings. One longer timeframe implication: if we see a market correction that is no more significant in its selling than the last several have been, we can expect the market to resume its upward course. Every correction we've had during 2004-2006 has represented normal selling vis a vis that longer timeframe--not significant selling. An analysis of significant buying and selling weeks and months confirms that perspective.
Dr. Brett's Blog Links and Research Note
Saturday, December 23, 2006
Policies For The TraderFeed Blog And My Personal Site
I've never had to write out the policies for the TraderFeed blog (which also apply to my personal site), but the time has come to make them explicit so that there are no misunderstandings in the future. I'm receiving an increasing number of requests from commercial vendors and purveyors of trading services to use my blog to promote their sites and products. Here are my policies about such matters:
1) I don't do link exchanges. Ever. If you think my sites are worth linking to, that's very nice. I'm not interested in increasing my "exposure" or in selling any services. I'll be more than happy to look over your site and, if I find unique, educational material, I'll be only too happy to link to it from my personal site. I don't expect links in return.
2) I don't accept payments or promotional considerations for mention on my sites. Ever. If you have something worth linking to, I'll gladly link for nothing simply to inform readers. I do link to commercial sites and services that provide unique information to the trading public, but this is not on a compensated basis. I don't link to sites that are largely self-congratulatory and self-aggrandizing.
3) I post essentially all comments to my blog. The only exceptions would be spam and obscene, name-calling, or vulgar posts that do not offer constructive content. The role of comments is to establish dialogue among colleagues. I prefer that personal messages to me be sent by email to me directly rather than posted as blog comments. I welcome constructive criticism and, indeed, learn much from it. If you send a comment that isn't posted the same day, please email me with a heads up. I average well over 100 emails and comments a day and occasionally overlook some.
4) I do not authorize my articles to be republished on other sites without my expressed permission. Respect for copyright is the operative principle here. At present, only one site has permission to republish selected articles from TraderFeed: Seeking Alpha. Once again, anyone wishing to link to my articles is welcome to do so. The appearance of my articles on a site could be construed as an endorsement, and I choose to avoid that perception.
5) I don't provide coaching or commercial services to the trading public. I appreciate requests for my services and am flattered that someone would think of me, but my responsibilities to the trading firms I work for, my own trading, my writing, and my family preclude such involvements. If I can, I'm happy to provide free referrals for professional services.
So there it is. The blog site and my personal site are designed as educational tools only. They are not designed to recommend specific trades or investments; nor are they designed to provide counseling or psychotherapy assistance. My goal is to help traders become their own coaches and mentors. I've appreciated the tremendous support over the past year and wish all readers a wonderful 2007!
1) I don't do link exchanges. Ever. If you think my sites are worth linking to, that's very nice. I'm not interested in increasing my "exposure" or in selling any services. I'll be more than happy to look over your site and, if I find unique, educational material, I'll be only too happy to link to it from my personal site. I don't expect links in return.
2) I don't accept payments or promotional considerations for mention on my sites. Ever. If you have something worth linking to, I'll gladly link for nothing simply to inform readers. I do link to commercial sites and services that provide unique information to the trading public, but this is not on a compensated basis. I don't link to sites that are largely self-congratulatory and self-aggrandizing.
3) I post essentially all comments to my blog. The only exceptions would be spam and obscene, name-calling, or vulgar posts that do not offer constructive content. The role of comments is to establish dialogue among colleagues. I prefer that personal messages to me be sent by email to me directly rather than posted as blog comments. I welcome constructive criticism and, indeed, learn much from it. If you send a comment that isn't posted the same day, please email me with a heads up. I average well over 100 emails and comments a day and occasionally overlook some.
4) I do not authorize my articles to be republished on other sites without my expressed permission. Respect for copyright is the operative principle here. At present, only one site has permission to republish selected articles from TraderFeed: Seeking Alpha. Once again, anyone wishing to link to my articles is welcome to do so. The appearance of my articles on a site could be construed as an endorsement, and I choose to avoid that perception.
5) I don't provide coaching or commercial services to the trading public. I appreciate requests for my services and am flattered that someone would think of me, but my responsibilities to the trading firms I work for, my own trading, my writing, and my family preclude such involvements. If I can, I'm happy to provide free referrals for professional services.
So there it is. The blog site and my personal site are designed as educational tools only. They are not designed to recommend specific trades or investments; nor are they designed to provide counseling or psychotherapy assistance. My goal is to help traders become their own coaches and mentors. I've appreciated the tremendous support over the past year and wish all readers a wonderful 2007!
iShares S&P 500 Growth (IWV) and Value (IVE) ETFs: Value is the New Growth
The stock market is like a finely crafted symphony: It develops its themes over time, offering endless variations before transitioning to fresh movements. For the investor, as for the concert goer, excess returns result from an appreciation of themes and their shifts.
The theme of the bull market of the late 1990s up to 2000 was one of growth, highlighted by optimism concerning technology and the Internet. A stormy second movement from 2000-2003 brought this theme to a crashing close, ushering in a new theme that has seen new all-time highs in the small-cap and mid-cap indices, but not in the once high-flying NASDAQ market.
Ah, but the current market's theme is a complex one: Even as we've seen the smallest cap stocks stumble since May, the value component of the market has emerged triumphant relative to growth stocks. Above we see the iShares S&P 500 Growth ETF (IVW) charted against the iShares S&P 500 Value ETF (IVE). Somewhat perversely--and in a complete reversal of the growth bias of the late 1990s--value has become the new growth.
The market is a fine composer: It does not introduce and then toss away its themes. Shifts along the "style box" represent reallocations of capital that don't fade away within days or weeks. Increasingly, with an expanding universe of ETFs, individual investors can track and participate in these shifts.
So what do we call a current theme that sees all-time new highs in the Dow Jones Industrials, outperformance of value over growth, and underperformance of technology? The word "defensive" comes to mind: this bull market is the anti-Nineties.
Friday, December 22, 2006
Why This Editorial and Why Now?
I normally avoid political posts on this blog. But the psychologist in me jumps to attention when things aren't adding up, and this just isn't adding up.
Why is the CIA redacting a routine op-ed piece for the New York Times? From what the Times is saying, even the CIA is acknowledging that state secrets were not the issue in the censoring of the material. The gist of the censored editorial is that the U.S. has not been sincere in pursuing dialogue with Iran. What is unusual is that the authors have written on this topic over the past several years, with no interference from government censors. See, for example, the references linked by the Truthout site, including this one from the Washington Post and this lengthy analysis by the lead author.
Given that no New York Times editorials have been subjected to similar censorship, the question becomes: Why this editorial and why now?
Could it be a misguided effort to not scuttle a tenuous UN agreement regarding sanctions against Iran?
Could it be a PR effort to keep Tehran on the hot seat in the face of a Democratic electoral victory in the U.S. and widespread disenchantment with our involvement in Iraq?
Or could this be a way to minimize dissent ahead of a military build up in the Middle East?
Whatever the motivation, it was deemed important enough by the White House to impose what appears to be a kind of censorship normally associated with strong-arm dictatorships. Let's see if there's another side to this story.
But if this is, indeed, part of an effort to keep public sentiment in favor of a military effort to put Iran on a hot seat, traders in the oil and equity markets might feel some repercussions in 2007.
Why is the CIA redacting a routine op-ed piece for the New York Times? From what the Times is saying, even the CIA is acknowledging that state secrets were not the issue in the censoring of the material. The gist of the censored editorial is that the U.S. has not been sincere in pursuing dialogue with Iran. What is unusual is that the authors have written on this topic over the past several years, with no interference from government censors. See, for example, the references linked by the Truthout site, including this one from the Washington Post and this lengthy analysis by the lead author.
Given that no New York Times editorials have been subjected to similar censorship, the question becomes: Why this editorial and why now?
Could it be a misguided effort to not scuttle a tenuous UN agreement regarding sanctions against Iran?
Could it be a PR effort to keep Tehran on the hot seat in the face of a Democratic electoral victory in the U.S. and widespread disenchantment with our involvement in Iraq?
Or could this be a way to minimize dissent ahead of a military build up in the Middle East?
Whatever the motivation, it was deemed important enough by the White House to impose what appears to be a kind of censorship normally associated with strong-arm dictatorships. Let's see if there's another side to this story.
But if this is, indeed, part of an effort to keep public sentiment in favor of a military effort to put Iran on a hot seat, traders in the oil and equity markets might feel some repercussions in 2007.
iShares IWC and IWB ETFs: Tracking the Smallest and Largest Caps
Small capitalization stocks, such as those included in the Russell 2000 Index, have received increasing attention from investors. The iShares IWM ETF, which tracks the Russell 2000 Index, has gone from an average daily volume of a little over 12.6 million shares in 2004 to almost 46.9 million shares during 2006.
Interestingly, however, the corresponding smallest of the small cap funds, the iShares IWC ETF, which tracks the Russell Microcap Index, has averaged only about 76,500 shares per day since its inception in August of 2005. This index captures the smallest 1000 of the Russell 2000 stocks, plus the next smallest 1000 companies. As noted in an earlier article, IWC is a passive index that represents the price behavior of these smallest cap stocks, unlike the PZI ETF, which actively rebalances its microcap holdings. This makes IWC a superior vehicle for studying the market performance of microcaps.
So how does the price behavior of the microcaps differ from that of the largest cap stocks. For the chart above, I chose the corresponding iShares Russell 1000 Index ETF, IWB, for comparison. That index, as its name implies, captures the performance of the 1000 largest companies by market capitalization. This provides a nice basis for comparison since there is no overlap between the stocks in the IWB and IWC products.
Notice that the microcaps (red) have swung more dramatically than the large caps (blue). Indeed, the average daily range of the IWC ETF since its August, 2005 inception has been about 1.2%, considerably larger than the .87% average daily range of IWB over that same period.
The two ETFs tracked one another pretty closely during most of 2005. During early 2006, however, we saw the microcaps dramatically outperform the large caps up to the May high. At that point, with the unwinding of the carry trade and weakness in emerging markets, the microcaps dropped precipitously. Since the July lows, the two ETFs have again tracked each other relatively closely. As a result, however, the large cap IWB has been making multi-year highs, whereas the microcap IWC has yet to exceed its May peak. In fact, though their paths have been different, the net performance of the large caps and microcaps since August, 2005 has been equivalent.
In line with my earlier article on the EEM emerging markets ETF, we might view the relative performance of IWC and IWB as a kind of sentiment measure. When the microcaps are outperforming the large caps, there is positive speculative sentiment in the market, as we saw during the runup to May. Conversely, when investors are bailing out of the microcaps relative to large caps, as occurred this past summer, relative defensive sentiment prevails.
When IWC and IWB are down concurrently, we have a pretty good indication that traders are fleeing equities. Conversely, when we see a concurrent rise in IWC and IWB, we know that traders are more favorably inclined toward stocks. Since the introduction of IWC in August, 2005 (N = 332 trading days), that has been a contrary indicator for the microcaps.
Specifically, when both IWC and IWB have been up over a five-day period (N = 153), the next five days in IWC have averaged a loss of -.31% (67 up, 86 down). When both IWC and IWB have been down over a five-day period (N = 109), the next five days in IWC have averaged a gain of .72% (70 up, 39 down). That's quite a discrepancy, suggesting that the best time to buy the microcaps has been when traders have not been loving stocks.
Thursday, December 21, 2006
Setting Up Trading On An Economic Report Day
Here's what my Market Delta screen looks like this morning prior to the 7:30 AM CT release of GDP and Initial Claims numbers. Then, at 9:00 AM CT, we have Leading Economic Indicators and at 10:00 AM CT, we have the Philly Fed report on manufacturing, which could turn out to be the most important of all if it shows dramatic weakness.
You can see that Wednesday's market established value (the area where most volume is traded) above Tuesday value region. We bounced higher overnight and have pulled back, so I'm now seeing if we can hold the Wednesday lows for a test of the Tuesday/Wednesday highs.
I like to look at the market's trading range(s) prior to economic releases and then after to see if the data have truly brought fresh buying or selling to the market and especially if the market is repricing its assessment of value. I also look at interest rates and the dollar to see if those markets are undergoing significant repricings in the face of the economic data. We are most likely to see trending moves in stocks (i.e., repricings of value) if the global/macro traders are also repricing rates and currencies.
It sounds simplistic, but it's easy to lose sight of: In a rising market, you'll see bouts of selling terminate at successively higher levels. In a falling market, you'll see buying spurts terminate at successively lower levels. When we have buying or selling bursts that end near the termination points of prior bouts of buying/selling, we have a relatively rangebound market. In a market that shows short-term mean reversion, buying when selling peters out at a higher level or selling when buying dries up at a lower level is often a good trading strategy.
On an economic report day, I like the market to show me its response to news and actually *see* where the buying and selling are terminating. That speaks volumes about the market's pricing and repricing of value over time.
Two Applications of Historical Market Patterns
The historical patterns I identify on this blog are only the starting point in configuring a worthy investment or trading strategy. If you're investing, it's important to select promising stocks and sectors through solid fundamental research. If you're trading, the historical patterns must be accompanied by proper money management and exit strategies. Those can then be objectively tested as trading strategies.
Here are two very recent examples of extensions of historical patterns:
1) Yaser Anwar's recent blog post summarizes the fundamentals for AIG and sees a favorable outlook. By adding a "technical" component to the fundamental analysis--an identification of recent trading patterns in AIG stock--the investor can address the question of whether to wait to get better prices after a three-week runup in the stock.
2) The Dogwood Report drew upon the two-day trading pattern recently mentioned on this site and conducted a test of a related trading strategy. The long-only strategy handily outperformed buy-and-hold, especially in QQQQ over the timeframe tested, which included a major bear market.
I strongly suspect that integrating historical patterns with sound technical trading strategies would yield fruitful results. If there is a technical trader out there who is also writing a blog and would like to collaborate on a post, drop me a line. I welcome the opportunity to explore synergies among different trading approaches.
Here are two very recent examples of extensions of historical patterns:
1) Yaser Anwar's recent blog post summarizes the fundamentals for AIG and sees a favorable outlook. By adding a "technical" component to the fundamental analysis--an identification of recent trading patterns in AIG stock--the investor can address the question of whether to wait to get better prices after a three-week runup in the stock.
2) The Dogwood Report drew upon the two-day trading pattern recently mentioned on this site and conducted a test of a related trading strategy. The long-only strategy handily outperformed buy-and-hold, especially in QQQQ over the timeframe tested, which included a major bear market.
I strongly suspect that integrating historical patterns with sound technical trading strategies would yield fruitful results. If there is a technical trader out there who is also writing a blog and would like to collaborate on a post, drop me a line. I welcome the opportunity to explore synergies among different trading approaches.
Wednesday, December 20, 2006
A Context For The Market Open
Good morning, all. Thought I'd post a screen shot of what I watch to prepare for the market open. Notice that my Market Delta screen is set for 10-tick bars, which means that we form a new bar every time there's a ten tick move in ES. This enables me to see how the pre-opening morning trade compares to how we were trading in the afternoon. You can see clearly that we're trading above yesterday's value region (area with the most volume on the left hand Y-axis) and point of control (1434.75). Notice also how buying dried up as we tried to take out yesterday's afternoon highs, pulling us back into the preopening trading range.
My basic strategy for a first trade of the day is to see how we trade in the opening minutes and especially how the NYSE TICK distribution looks and whether or not we're seeing net buying or selling among large traders on the Market Delta chart. Once I get a handle on that, I'll get into the market for a move to break the preopening range. My research from the Weblog tells me to be alert for a consolidation of yesterday's reversal move, so I'm not assuming we're going higher just because we had good afternoon buying yesterday. Indeed, if we get buying that can't push us above yesterday's highs (and the overnight highs), I'd be a seller in the AM.
Have a great trading day--
Brett
SPY and QQQQ: Once It's A Trend, Will It End?
If you're looking at daily data, the shortest "trend" you can identify is a series of two up days or a sequence of two down days. So I decided to look at what happens in the S&P 500 Index (SPY) after two up days and after two down ones.
Since 2004 (N = 745 trading days), we've had 233 occasions in which SPY has been up for two consecutive days. Three days later, SPY has averaged a loss of -.02% (119 up, 114 down)--no bullish edge at all. Conversely, across the remaining occasions in the sample, the average three-day gain in SPY has been .16% (301 up, 211 down). It thus appears that, once we have a two-day bullish "trend", market returns have been subnormal.
When we've had two consecutive down days in SPY (N = 146), SPY has averaged a three-day gain of .25% (89 up, 57 down). Over the remaining occasions in the sample, SPY has been up by .07% over a three-day period (331 up, 268 down). Here we see that, once we have a two-day bearish "trend", near-term returns have been superior.
If we look at the NASDAQ 100 Index (QQQQ), a similar pattern appears. When we've had two consecutive up days (N = 219), QQQQ has been down by an average of -.01% over the next three days (118 up, 101 down). Once again, no evident bullish edge. Over the remainder of the occasions in the sample, QQQQ has been up by an average of .12% over the next three days (284 up, 202 down).
But wait! When QQQQ has been down for two consecutive days (N = 159), the next three days in QQQQ have averaged a gain of .07% (83 up, 76 down). Over the remainder of occasions in the sample, the next three days have averaged a gain of .09% (319 up, 267 down).
Interestingly, we see no evidence of a reversal effect for QQQQ after two down days and a relatively modest effect after two down days. In the S&P 500 Index (SPY), there's a more pronounced tendency toward reversal once a two-day "trend" appears.
Might we be able to classify ETFs and individual stocks based on their simple trending or countertrend patterns? Would such patterns provide useful trading guidance? An interesting post from James Altucher's StockPickr site suggests that similar patterns may indeed guide active trading in the NASDAQ 100 stocks. I'll add a twist to the pattern in my next post.
Since 2004 (N = 745 trading days), we've had 233 occasions in which SPY has been up for two consecutive days. Three days later, SPY has averaged a loss of -.02% (119 up, 114 down)--no bullish edge at all. Conversely, across the remaining occasions in the sample, the average three-day gain in SPY has been .16% (301 up, 211 down). It thus appears that, once we have a two-day bullish "trend", market returns have been subnormal.
When we've had two consecutive down days in SPY (N = 146), SPY has averaged a three-day gain of .25% (89 up, 57 down). Over the remaining occasions in the sample, SPY has been up by .07% over a three-day period (331 up, 268 down). Here we see that, once we have a two-day bearish "trend", near-term returns have been superior.
If we look at the NASDAQ 100 Index (QQQQ), a similar pattern appears. When we've had two consecutive up days (N = 219), QQQQ has been down by an average of -.01% over the next three days (118 up, 101 down). Once again, no evident bullish edge. Over the remainder of the occasions in the sample, QQQQ has been up by an average of .12% over the next three days (284 up, 202 down).
But wait! When QQQQ has been down for two consecutive days (N = 159), the next three days in QQQQ have averaged a gain of .07% (83 up, 76 down). Over the remainder of occasions in the sample, the next three days have averaged a gain of .09% (319 up, 267 down).
Interestingly, we see no evidence of a reversal effect for QQQQ after two down days and a relatively modest effect after two down days. In the S&P 500 Index (SPY), there's a more pronounced tendency toward reversal once a two-day "trend" appears.
Might we be able to classify ETFs and individual stocks based on their simple trending or countertrend patterns? Would such patterns provide useful trading guidance? An interesting post from James Altucher's StockPickr site suggests that similar patterns may indeed guide active trading in the NASDAQ 100 stocks. I'll add a twist to the pattern in my next post.
Tuesday, December 19, 2006
Several Lessons From The Day's Trading
Going over the transcript from this morning's session, several valuable lessons jump out at me:
1) There's a difference between a good losing trade and a bad losing trade - A good losing trade provides you with information about the market. My initial short position was a good trade, riding the market's weakness in a short-term downtrend. When the trade reversed and took me out with a small loss, that was concrete evidence that buyers were attracted to value below 1430 in the ES. By waiting for the next round of selling in the TICK, I was able to ride this strength for a decent winner when the ES returned to the top of its preopening range. A bad losing trade results from a failure to take all the facts into account. The only information it provides is a heads-up to stay grounded in the market's volume flow before entering a trade. My last trade ignored solid buying in ES, even as the Russell was pulling back. That's not the kind of market weakness that should justify a short position. The large traders were not hitting bids in the most liquid of the indices. By jumping on a trade that had worked for the past two days before checking all the facts, I made a bad losing trade.
2) When You're Wrong, Get Out - When the market reversed against my initial position, I didn't get stubborn. Similarly, after that last trade (the bad losing one) hit my stop, I was out. Had I fought the market tides at those times, I could have been down significant money on the day. In both cases, I knew where I needed to get out and what would make me wrong. It's back to that lesson I mentioned earlier: It's OK to be wrong, but don't dig a hole for yourself that you can't get out of.
3) Stay Flexible - I went into the day session leaning to the short side, but approached the early morning as a range bound situation to keep myself alert to buying possibilities. When the initial trade reversed on me, I was able to reverse to the long side. Research and market information can give you an opinion about the market, but you always want your opinion to be a hypothesis, not a fixed conclusion. "Don't marry your opinions" is another piece of market wisdom that serves us well.
Perhaps the most important lesson of all, however, is to never stop learning and never stop working on your game. I've been trading since the late 1970s in some shape, manner, or form and I still make some boneheaded mistakes. I am just as happy to post the errors as the good trades. There's something to be learned in both.
Thanks to all who have kindly commented online and off re: the session.
Brett
1) There's a difference between a good losing trade and a bad losing trade - A good losing trade provides you with information about the market. My initial short position was a good trade, riding the market's weakness in a short-term downtrend. When the trade reversed and took me out with a small loss, that was concrete evidence that buyers were attracted to value below 1430 in the ES. By waiting for the next round of selling in the TICK, I was able to ride this strength for a decent winner when the ES returned to the top of its preopening range. A bad losing trade results from a failure to take all the facts into account. The only information it provides is a heads-up to stay grounded in the market's volume flow before entering a trade. My last trade ignored solid buying in ES, even as the Russell was pulling back. That's not the kind of market weakness that should justify a short position. The large traders were not hitting bids in the most liquid of the indices. By jumping on a trade that had worked for the past two days before checking all the facts, I made a bad losing trade.
2) When You're Wrong, Get Out - When the market reversed against my initial position, I didn't get stubborn. Similarly, after that last trade (the bad losing one) hit my stop, I was out. Had I fought the market tides at those times, I could have been down significant money on the day. In both cases, I knew where I needed to get out and what would make me wrong. It's back to that lesson I mentioned earlier: It's OK to be wrong, but don't dig a hole for yourself that you can't get out of.
3) Stay Flexible - I went into the day session leaning to the short side, but approached the early morning as a range bound situation to keep myself alert to buying possibilities. When the initial trade reversed on me, I was able to reverse to the long side. Research and market information can give you an opinion about the market, but you always want your opinion to be a hypothesis, not a fixed conclusion. "Don't marry your opinions" is another piece of market wisdom that serves us well.
Perhaps the most important lesson of all, however, is to never stop learning and never stop working on your game. I've been trading since the late 1970s in some shape, manner, or form and I still make some boneheaded mistakes. I am just as happy to post the errors as the good trades. There's something to be learned in both.
Thanks to all who have kindly commented online and off re: the session.
Brett
Another December Morning With the Doc
10:15 AM - Let's wrap up. As I mentioned earlier, I'll write a separate post on the early AM trade. Today pretty much showed the gamut. I had a plan to trade the premarket range and indeed sold the Russells when we broke down. For a time the trade went with me, but then reversed strongly and I got out with my point loser. I saw a real shift in the buying dynamics and, after we pulled back, went long the ES targeting the premarket range high. I let the market take me out on a high TICK move for a 3 point winner. My strategy at that point was to wait for a pullback, see how the ES traded, and then go long again for a breakout of that range. That turned out to be not such a bad idea, but the Russells and NASDAQ pulled back more than I wanted to see, leading me to scratch the trade. I decided to use a bit of patience and, when I saw the TICK jump and the Russells not respond, I went back to the shorting mode. Of the four trades for the day, only that one was really not a good trade. There was no selling in size hitting the ES throughout the pullback, and I would have been much smarter to keep my nose in the volume flow and stick with the initial idea of ES breaking out of its range. So I took a point loser to teach me a good lesson.
The challenge I find (which doesn't get easier when you're trying to blog and trade at the same time!) is to keep my eyes on everything. For the last two days, I've looked to the Russell to lead and that's made me money. On that last trade today, the Russell certainly did not lead. The support and buying were in the large caps. I was focused too much on what had worked before and did not stay grounded in my bread and butter, making the market's volume--and its distribution--tell the story.
So there you have it. All in all it was a nice opportunity to demonstrate a few things: 1) getting out of trades quickly if the basic idea isn't panning out; 2) taking what the market gives you when you're right; 3) staying flexible and changing positions in the market as the participation in the market shifts; and 4) always using each day's trade to figure out what you've done right and wrong and learn from both. Have a great day; market wrap up tonight on the Weblog and another blog post to follow today.
9:59 AM - OK, that last trade was an admitted longer shot. I was looking for growing weakness in the TICK and didn't get it. I'm not about to let a winning day turn into a loser, so that's it for me unless something really hits me in the eyes. A wrap up will follow.
9:55 AM - Out of that one with a point loser as well.
9:50 AM - Short Russell
9:43 AM - Scratch; don't like how ND and Russell are trading.
9:36 AM - Bought some ES here; tight stop.
9:25 AM - I'm flat, looking for a place to get long if sellers can't do damage to the recent runup. I'll do a blog post later today explaining more about that long trade. Many important market principles touched upon by both my losing trade and the winning one. I'm in a patient mode here. We just got a burst of buying in the TICK, but not a great price response in ES. Not what I wanted to see.
9:17 AM - Took my 3 pts more in a bit I might enter again on breakout above range
9:10 AM - As long as we see a positive shift in the TICK and lifting of offers by big traders above the 29.50 price, my leaning is to test the upper end of the premarket trading range mentioned earlier (1433 area). The initial buying struck me as short covering, but the second burst had some real size to it and was buying Russells and NAZ.
9:05 AM - Long some ES here.
8:57 AM - Buying solidified, taking me out of my short position with a point loss. The TICK has strengthened noticeably, and the ES returned back into their premarket trading range. The last trade in a trend following mode is always going to be a loser; the key is to keep the losses reasonable. Let's see if we can put in a bottom in ES after the rejection of the move down to the 1426 region.
8:47AM - I added some Russells on the recent bounce; my leaning in this situation is to "dance with the one who brung you" and Russell has made me money the last few days on my short trades. Obviously, I want to see this market stay below that trading range mentioned earlier to stick with the short idea. There was definite short-covering going on during the recent bounce, with large traders lifting offers and getting out. So far, however, I'm not seeing broad based buying in the NYSE TICK. If that TICK distribution goes solidly positive, I'll be out of the Russells. They're sensitive to the TICK for obvious reasons.
8:38 AM - We've opened with weakness; over 1000 more declining stocks than advancing; NYSE TICK negative, but not dramatically so; lots of whippy action. NASDAQ and Russell leading the downside, continuing the recent pattern. We've broken the lows in ES, triggering my selling a small Russell position. Volume above average for this time of day, suggesting institutional participation along with the locals and verifying that we're likely to see some volatile trade.
8:22 AM - The dollar and rates have pretty much stabilized following their moves after the PPI news; no big trending action has continued. DAX also remains above its sessions lows. Basically, I'm viewing this market as in a premarket trading range between the 1433.50 and 1428.75 levels. A move above 33.50 could easily trigger some stops and some short covering. I think we'd see some frantic selling if the DAX makes new lows and the stocks fail to hold the 28.75 level. So my job as a short-term trader is to see if I can handicap the odds of a move outside this range and get in at a good enough price to profit. If buying dries up without us breaking the upper range, I'll lean toward selling. If selling dries up without decisively taking out the lower end of the range, I might buy a little for a countertrend move. My leaning is to be patient and let the distribution of volume tell me what the large traders are doing. No need to get whipsawed early in a trading day. Based on the premarket activity, there should be decent movement in the AM and perhaps through the day. Back after the open.
8:00 AM: Ok, we have producer prices up sharply and home sales up as well, with housing permits a tad weaker than expected. Interest rates jumped on the PPI news , with the 10-year rate moving over 4.6% (though off initial highs). The dollar gyrated on the news and is weaker vs. the Euro, though also off its lows. Stocks fell on the news, with the ES getting as low as 1428.75, nearly ten full ES points off its average trading price from yesterday. The short-term trend is definitely down, but I am hesitant to chase lows after we've come so far below the average trading price. My leaning is to let bulls have their turn and see how much genuine buying vs. short covering we get. I'm watching the DAX, which did not make session lows on the economic news. It has led some nice moves in ES the last couple of trading sessions. Back in a few.
7:25 AM: Good morning. Looks like lots is happening on the heels of yesterday's decline. Here is a report from the excellent Barchart service:
Thailand's SET stock index plunged 14.8% today after the Thai government imposed currency controls in order to clamp down on short-term foreign investment and prevent undue strength in its currency. The Thai government announced that foreign investors will only be able to invest 70% of the funds they transfer into Thailand and will only be able to withdraw their cash if the cash is kept in the country for longer than 1 year. Withdrawals of cash that has been in Thailand for less than a year will be subject to a 10% penalty. The move by the Thai government caused concern that other emerging countries might follow suit. Emerging market stocks in general took a hit today and Asian stocks today generally fell 1-2%. However, the Chinese yuan was little changed today and the Chinese stock indexes today closed higher, illustrating that concerns didn't extend into China which already has very restrictive currency controls.
Notice the hit to emerging nation markets, an interesting development in light of my most recent post. We've got housing starts and PPI on the docket in a couple of minutes; back after the numbers to digest everything. Remember: a volatile premarket tends to bring volatile trade in the morning hours. Let's see...
The challenge I find (which doesn't get easier when you're trying to blog and trade at the same time!) is to keep my eyes on everything. For the last two days, I've looked to the Russell to lead and that's made me money. On that last trade today, the Russell certainly did not lead. The support and buying were in the large caps. I was focused too much on what had worked before and did not stay grounded in my bread and butter, making the market's volume--and its distribution--tell the story.
So there you have it. All in all it was a nice opportunity to demonstrate a few things: 1) getting out of trades quickly if the basic idea isn't panning out; 2) taking what the market gives you when you're right; 3) staying flexible and changing positions in the market as the participation in the market shifts; and 4) always using each day's trade to figure out what you've done right and wrong and learn from both. Have a great day; market wrap up tonight on the Weblog and another blog post to follow today.
9:59 AM - OK, that last trade was an admitted longer shot. I was looking for growing weakness in the TICK and didn't get it. I'm not about to let a winning day turn into a loser, so that's it for me unless something really hits me in the eyes. A wrap up will follow.
9:55 AM - Out of that one with a point loser as well.
9:50 AM - Short Russell
9:43 AM - Scratch; don't like how ND and Russell are trading.
9:36 AM - Bought some ES here; tight stop.
9:25 AM - I'm flat, looking for a place to get long if sellers can't do damage to the recent runup. I'll do a blog post later today explaining more about that long trade. Many important market principles touched upon by both my losing trade and the winning one. I'm in a patient mode here. We just got a burst of buying in the TICK, but not a great price response in ES. Not what I wanted to see.
9:17 AM - Took my 3 pts more in a bit I might enter again on breakout above range
9:10 AM - As long as we see a positive shift in the TICK and lifting of offers by big traders above the 29.50 price, my leaning is to test the upper end of the premarket trading range mentioned earlier (1433 area). The initial buying struck me as short covering, but the second burst had some real size to it and was buying Russells and NAZ.
9:05 AM - Long some ES here.
8:57 AM - Buying solidified, taking me out of my short position with a point loss. The TICK has strengthened noticeably, and the ES returned back into their premarket trading range. The last trade in a trend following mode is always going to be a loser; the key is to keep the losses reasonable. Let's see if we can put in a bottom in ES after the rejection of the move down to the 1426 region.
8:47AM - I added some Russells on the recent bounce; my leaning in this situation is to "dance with the one who brung you" and Russell has made me money the last few days on my short trades. Obviously, I want to see this market stay below that trading range mentioned earlier to stick with the short idea. There was definite short-covering going on during the recent bounce, with large traders lifting offers and getting out. So far, however, I'm not seeing broad based buying in the NYSE TICK. If that TICK distribution goes solidly positive, I'll be out of the Russells. They're sensitive to the TICK for obvious reasons.
8:38 AM - We've opened with weakness; over 1000 more declining stocks than advancing; NYSE TICK negative, but not dramatically so; lots of whippy action. NASDAQ and Russell leading the downside, continuing the recent pattern. We've broken the lows in ES, triggering my selling a small Russell position. Volume above average for this time of day, suggesting institutional participation along with the locals and verifying that we're likely to see some volatile trade.
8:22 AM - The dollar and rates have pretty much stabilized following their moves after the PPI news; no big trending action has continued. DAX also remains above its sessions lows. Basically, I'm viewing this market as in a premarket trading range between the 1433.50 and 1428.75 levels. A move above 33.50 could easily trigger some stops and some short covering. I think we'd see some frantic selling if the DAX makes new lows and the stocks fail to hold the 28.75 level. So my job as a short-term trader is to see if I can handicap the odds of a move outside this range and get in at a good enough price to profit. If buying dries up without us breaking the upper range, I'll lean toward selling. If selling dries up without decisively taking out the lower end of the range, I might buy a little for a countertrend move. My leaning is to be patient and let the distribution of volume tell me what the large traders are doing. No need to get whipsawed early in a trading day. Based on the premarket activity, there should be decent movement in the AM and perhaps through the day. Back after the open.
8:00 AM: Ok, we have producer prices up sharply and home sales up as well, with housing permits a tad weaker than expected. Interest rates jumped on the PPI news , with the 10-year rate moving over 4.6% (though off initial highs). The dollar gyrated on the news and is weaker vs. the Euro, though also off its lows. Stocks fell on the news, with the ES getting as low as 1428.75, nearly ten full ES points off its average trading price from yesterday. The short-term trend is definitely down, but I am hesitant to chase lows after we've come so far below the average trading price. My leaning is to let bulls have their turn and see how much genuine buying vs. short covering we get. I'm watching the DAX, which did not make session lows on the economic news. It has led some nice moves in ES the last couple of trading sessions. Back in a few.
7:25 AM: Good morning. Looks like lots is happening on the heels of yesterday's decline. Here is a report from the excellent Barchart service:
Thailand's SET stock index plunged 14.8% today after the Thai government imposed currency controls in order to clamp down on short-term foreign investment and prevent undue strength in its currency. The Thai government announced that foreign investors will only be able to invest 70% of the funds they transfer into Thailand and will only be able to withdraw their cash if the cash is kept in the country for longer than 1 year. Withdrawals of cash that has been in Thailand for less than a year will be subject to a 10% penalty. The move by the Thai government caused concern that other emerging countries might follow suit. Emerging market stocks in general took a hit today and Asian stocks today generally fell 1-2%. However, the Chinese yuan was little changed today and the Chinese stock indexes today closed higher, illustrating that concerns didn't extend into China which already has very restrictive currency controls.
Notice the hit to emerging nation markets, an interesting development in light of my most recent post. We've got housing starts and PPI on the docket in a couple of minutes; back after the numbers to digest everything. Remember: a volatile premarket tends to bring volatile trade in the morning hours. Let's see...
Does The iShares Emerging Market ETF EEM Capture Speculative Sentiment?
The emerging markets have been stellar performers during the 2003-2006 bull market. A harrowing drop in May and June of 2006 notwithstanding, the iShares Emerging Markets Index ETF (EEM) has tripled in value since its debut in May, 2003. By contrast, the S&P 500 Index of large cap U.S. stocks has risen by about 49% during that same time.
What constitutes emerging markets? As the ETF Connect site summarizes, EEM has a relatively even distribution of exposure to various industry groups, with about 17% of the fund in energy; 15% in banks; 13% in materials; 12% in semiconductors; and 12% in telecommunications. South Korea accounts for about 16% of assets; Taiwan for 11%; Brazil, Russia, and China for 10% each; South Africa for 9%; Mexico for 8%; and India for 5%.
The above chart shows that EEM has traded like a very volatile version of the American market. Since 2004, the day to day correlation between EEM and SPY has been .74, but the average daily percentage size move in EEM has been twice that of SPY (1.08% vs. .52%). Even the pattern of changes in EEM has mirrored that in SPY. Since 2004, SPY has gained about 31 index points. 30-1/2 of these points have come during the period between the previous day's close and the next day's open (overnight gap). During the day trading session, SPY has gained only half a point since 2004.
EEM has displayed an even more exaggerated version of this disparity. EEM has gained about 58 index points since 2004. Of those, 104 have come between the previous day's close and the next day's open. During the U.S. daytrading session, EEM has actually lost 46 index points!
All of this has led me to wonder if EEM might be a speculative version of SPY from a trading standpoint. When EEM is outperforming SPY, traders and investors are bullish on this most speculative segment of the world markets. Conversely, when EEM underperforms, traders and investors are avoiding such speculation.
Going back to 2004 (N = 727 trading days), I split the data in half based upon the 20 day relative performance of EEM to SPY. When EEM strongly outperformed SPY (N = 364), the next ten days in SPY averaged a gain of .12% (199 up, 165 down). But when EEM was in the bottom half of its performance relative to SPY (N = 363), the next ten days in SPY averaged a gain of .52% (240 up, 123 down).
What this suggests is that the relative performance of EEM and SPY might be capturing the degree of speculative sentiment in the market. When traders are at their most speculative, the U.S. market tends to underperform compared to those occasions when traders are less risk-taking. Notice that, as during the March-May period, the relative performance of EEM to SPY has been ramping up since October--perhaps a bit of caution for this market.
Monday, December 18, 2006
Three Pieces of Trading Wisdom
Over the years, I've been the fortunate recipient of much good trading advice and wisdom from those far more experienced in the markets than me. Here are three gems that have stood me in good stead in up markets, down ones, and everything in between:
1) Focus on being profitable for the week - Individual trades may go against you and individual trading days can offer little opportunity. As a senior trader once explained to me, for the active trader, however, there are enough fresh opportunities in a week to make it reasonable to set a goal of being profitable for the week. You won't reach your goal every single week, but the mere act of setting the goal keeps you focused. For example, you don't want to lose so much money in a single day that you can't make it back during the other days of the week. You also don't want to lose so much money on a single trade that you can't come back during the remainder of the day. When you really push yourself to be profitable every week, you don't let individual days get away from you. And when you don't let individual days get away from you, you start managing each trade carefully to ensure that your largest loss won't exceed your largest gain. Time and again I've seen a consistent sign of progress among developing traders: they stop digging themselves into holes.
2) Take what the market gives you - Today I peeled out of several short positions after a spate of very negative TICK readings in the afternoon. I've learned that such concentrated selling often precedes nasty short-covering rallies. My S&P position hadn't made as much profit as my NASDAQ and Russell positions, but the market doesn't care about that. I took what the market gave me and started the week green. Did the market go down even further after I exited? Absolutely. As one experienced trader explained to me, when the market rewards your position right off the bat, you want to take something off the table. You might let a piece of your position ride if you have a longer-term opinion, but never give green a chance to become red. A winner that turns into a loser is a double loss.
3) Always have something to "lean on" - Scalpers will notice heavy and persistent selling at a certain tick, accompanied by large offers in the order book. They'll lean on that information to find a good entry to sell the market. If the offers disappear from the book or if new buyers start lifting those offers in size, they can get out quickly. Knowing you have something to lean on, however, allows you to ride out the noise between entry and exit. As long as what you're leaning on doesn't vanish, you stay with your idea. Today I leaned on the inability of the Russell to make new highs on Friday. When we got some morning buying, but could not break above the early AM highs (and also above Friday's highs), I added to my shorts and vowed to stay short unless we broke the highs with expanded buying. Leaning on the pattern of Russell weakness enabled me to stick with a good trade idea during a choppy morning.
So let's restate the pieces of wisdom in reverse order:
1) Before you put your capital at risk, have a well-formed trade idea;
2) When your idea pays you out quickly, take some profits;
3) Don't get caught up in individual trades; focus on profitability over a series of trades and days.
I know, I know. These things sound ridiculously simple. But it's only been in the last couple of years that I can look myself in the mirror and say that I'm doing all three consistently. The spinning reverse dunks get the attention in basketball; the long touchdown pass makes the evening replays; and the big winning trades are the ones we like to talk about. The greater part of success, however, boils down to Xs and Os on the basketball court; blocking and tackling on the football field; and following basic fundamentals about framing and managing trades. It may not be sexy to execute on the fundamentals, but it gets the job done day after day and builds a career.
1) Focus on being profitable for the week - Individual trades may go against you and individual trading days can offer little opportunity. As a senior trader once explained to me, for the active trader, however, there are enough fresh opportunities in a week to make it reasonable to set a goal of being profitable for the week. You won't reach your goal every single week, but the mere act of setting the goal keeps you focused. For example, you don't want to lose so much money in a single day that you can't make it back during the other days of the week. You also don't want to lose so much money on a single trade that you can't come back during the remainder of the day. When you really push yourself to be profitable every week, you don't let individual days get away from you. And when you don't let individual days get away from you, you start managing each trade carefully to ensure that your largest loss won't exceed your largest gain. Time and again I've seen a consistent sign of progress among developing traders: they stop digging themselves into holes.
2) Take what the market gives you - Today I peeled out of several short positions after a spate of very negative TICK readings in the afternoon. I've learned that such concentrated selling often precedes nasty short-covering rallies. My S&P position hadn't made as much profit as my NASDAQ and Russell positions, but the market doesn't care about that. I took what the market gave me and started the week green. Did the market go down even further after I exited? Absolutely. As one experienced trader explained to me, when the market rewards your position right off the bat, you want to take something off the table. You might let a piece of your position ride if you have a longer-term opinion, but never give green a chance to become red. A winner that turns into a loser is a double loss.
3) Always have something to "lean on" - Scalpers will notice heavy and persistent selling at a certain tick, accompanied by large offers in the order book. They'll lean on that information to find a good entry to sell the market. If the offers disappear from the book or if new buyers start lifting those offers in size, they can get out quickly. Knowing you have something to lean on, however, allows you to ride out the noise between entry and exit. As long as what you're leaning on doesn't vanish, you stay with your idea. Today I leaned on the inability of the Russell to make new highs on Friday. When we got some morning buying, but could not break above the early AM highs (and also above Friday's highs), I added to my shorts and vowed to stay short unless we broke the highs with expanded buying. Leaning on the pattern of Russell weakness enabled me to stick with a good trade idea during a choppy morning.
So let's restate the pieces of wisdom in reverse order:
1) Before you put your capital at risk, have a well-formed trade idea;
2) When your idea pays you out quickly, take some profits;
3) Don't get caught up in individual trades; focus on profitability over a series of trades and days.
I know, I know. These things sound ridiculously simple. But it's only been in the last couple of years that I can look myself in the mirror and say that I'm doing all three consistently. The spinning reverse dunks get the attention in basketball; the long touchdown pass makes the evening replays; and the big winning trades are the ones we like to talk about. The greater part of success, however, boils down to Xs and Os on the basketball court; blocking and tackling on the football field; and following basic fundamentals about framing and managing trades. It may not be sexy to execute on the fundamentals, but it gets the job done day after day and builds a career.
Is A Trending Bull Market Due For A Fall?
Over the past five months, the major stock market indices have been in a steady uptrend. How have similar uptrending periods resolved themselves? Do we get further strength, or do we see evidence of reversal?
I went back to June, 1989 (N = 4326 trading days) and found 337 periods in which the S&P 500 Index was similar to today's market: up by more than 10% over a 100-day period; up by over 5% over the last 50 days; and up by more than 2.5% in the past 25 days, with the gains over 100 days exceeding those of 50 days and those of 50 days exceeding those of 25 days. These have been steady uptrend occasions.
Twenty five days later, the S&P 500 Index was up by an average of only .16% (200 up, 137 down). That is weaker than the average 25-day gain of .90% (2609 up, 1717 down) for the entire sample. When we look 100 days out, however, the average gain following the uptrending period has been an impressive 6.00% (276 up, 61 down). That is stronger than the average 100-day gain of 3.60% (3030 up, 1296 down) for the entire sample.
What we're seeing, of course, is that the market has been highly bullish since 1989--some decent bear moves notwithstanding. After we've already had a trending up move for 100 days, returns have been subnormal over the next 25 days, but have actually been quite healthy over the next 100 days. The reversal effects that we've seen in short-term market movements have not occurred when we look as far out as 100 days.
This has implications for investment--as opposed to active trading--strategies and for traders interested in diversifying their returns by holding over a variety of time frames. About 80% of all uptrending 100-day periods since 1989 have been higher 100 days later. Interestingly, however, seven of the last ten occasions--those since December, 2003--have lost money. Even at the longer time frame, the most recent market regime has not rewarded trend followers.
I went back to June, 1989 (N = 4326 trading days) and found 337 periods in which the S&P 500 Index was similar to today's market: up by more than 10% over a 100-day period; up by over 5% over the last 50 days; and up by more than 2.5% in the past 25 days, with the gains over 100 days exceeding those of 50 days and those of 50 days exceeding those of 25 days. These have been steady uptrend occasions.
Twenty five days later, the S&P 500 Index was up by an average of only .16% (200 up, 137 down). That is weaker than the average 25-day gain of .90% (2609 up, 1717 down) for the entire sample. When we look 100 days out, however, the average gain following the uptrending period has been an impressive 6.00% (276 up, 61 down). That is stronger than the average 100-day gain of 3.60% (3030 up, 1296 down) for the entire sample.
What we're seeing, of course, is that the market has been highly bullish since 1989--some decent bear moves notwithstanding. After we've already had a trending up move for 100 days, returns have been subnormal over the next 25 days, but have actually been quite healthy over the next 100 days. The reversal effects that we've seen in short-term market movements have not occurred when we look as far out as 100 days.
This has implications for investment--as opposed to active trading--strategies and for traders interested in diversifying their returns by holding over a variety of time frames. About 80% of all uptrending 100-day periods since 1989 have been higher 100 days later. Interestingly, however, seven of the last ten occasions--those since December, 2003--have lost money. Even at the longer time frame, the most recent market regime has not rewarded trend followers.
Sunday, December 17, 2006
Are Money Managers Hedging Their Bets With The ProShares Ultra ETFs?
The ProShares Ultra ETFs enable traders and investors to leverage the movements of the major equity indices. For each 1% that an index moves, these ETFs will move 2%. This provides ETF traders with a degree of leverage normally associated with the trading of futures. Note that a pattern daytrader who qualifies for 4x leverage can reach 8x with the Ultra ETFs.
A unique feature of the Ultra ETFs is that they include separate trading instruments for long and short market exposure. By buying an inverse (short) ETF, a trader makes 2% when the underlying index falls by 1%. The non-inverse (long) Ultra ETF, of course, would rise 2% if the market rises by 1%.
Here are the symbols for the three most liquid Ultra ETFs:
NASDAQ 100: QLD (2x long); QID (2x short)
S&P 500: SSO (2x long); SDS (2x short)
Dow 30: DDM (2x long); DXD (2x short)
My initial idea was to compare volumes for the long vs. short Ultra ETFs to see if they functioned like call volume and put volume among options. In other words, by tracking participation in the Ultra ETFs, we might have a new sentiment indicator.
I'll save that idea for a later date, however. My first look suggested that something else is up with the Ultra ETFs: total volume. But not just all volume: volume in the inverse (short) ETFs. Check it out:
I went back to 7/13/06, which is when I show trading histories for the three Ultra ETFs above (N = 110 trading days). I then compared the average volumes for the ETFs for the first half of the sample and for the second half. Here's what I found:
NASDAQ long (QLD) volume: up 51%
NASDAQ short (QID) volume: up 217%
S&P 500 long (SSO) volume: up 15%
S&P 500 short (SDS) volume: up 69%
Dow 30 long (DDM) volume: down 29%
Dow 30 short (DXD) volume: up 88%
Clearly, we're seeing much more interest in the short product than the long one, an interesting finding in a rising market.
What's more is that this interest is correlated across the Ultra ETFs. I went back to November 1st, which is roughly when we first saw a burst of new volume in the short products, and correlated the daily volumes in the inverse Ultras. The correlation between the NASDAQ inverse volume (QID) and the S&P 500 inverse volume (SDS) was .60. The correlation between the NASDAQ inverse volume (QID) and the Dow inverse volume (DXD) was .87. The correlation between the S&P 500 inverse volume (SDS) and the Dow inverse volume (DXD) was .43. All are healthy, positive correlations. This suggests that when there is buying interest in one inverse ETF, there tends to be buying interest in the others.
Correlations in the daily volume of the long ETFs is also positive and significant: around .50-.60.
What are we to make of the growing interest in the inverse ETFs and the correlated volumes of all six of these Ultra ETFs?
My take is that they are being used as hedging devices by money managers. Many managers who have been buying stocks like banshees this fall have been hedging their bets with these Ultra inverse products. They are getting the best of both worlds: they can say that they participated in the rally and they can extend their stock ownership over longer (capital gains) periods, while at the same time hedging their general market risk.
Over the last five days of relative market strength, volume in the inverse NASDAQ product has exceeded volume in the long product by 5:1. Volume in the inverse S&P ETF has exceeded volume in the long product by over 3:1. There have been no dips in the ratios of short:long volumes in the Ultra ETFs as there have been among equity put/call options.
Bottom line: At least among some money managers, their bullishness may be a mile wide and an inch deep. At the same time they're buying stocks for year end gains, they're making sure their tails are covered. Other managers may be more selective in their bullishness, preferring specific issues, but protecting themselves from overall market risk. In any event, in the Ultra ETFs, we have an interesting tool for examining the behavior of these managers. As the market has broken to new highs, they've stepped up their participation in the inverse ETF market.
A unique feature of the Ultra ETFs is that they include separate trading instruments for long and short market exposure. By buying an inverse (short) ETF, a trader makes 2% when the underlying index falls by 1%. The non-inverse (long) Ultra ETF, of course, would rise 2% if the market rises by 1%.
Here are the symbols for the three most liquid Ultra ETFs:
NASDAQ 100: QLD (2x long); QID (2x short)
S&P 500: SSO (2x long); SDS (2x short)
Dow 30: DDM (2x long); DXD (2x short)
My initial idea was to compare volumes for the long vs. short Ultra ETFs to see if they functioned like call volume and put volume among options. In other words, by tracking participation in the Ultra ETFs, we might have a new sentiment indicator.
I'll save that idea for a later date, however. My first look suggested that something else is up with the Ultra ETFs: total volume. But not just all volume: volume in the inverse (short) ETFs. Check it out:
I went back to 7/13/06, which is when I show trading histories for the three Ultra ETFs above (N = 110 trading days). I then compared the average volumes for the ETFs for the first half of the sample and for the second half. Here's what I found:
NASDAQ long (QLD) volume: up 51%
NASDAQ short (QID) volume: up 217%
S&P 500 long (SSO) volume: up 15%
S&P 500 short (SDS) volume: up 69%
Dow 30 long (DDM) volume: down 29%
Dow 30 short (DXD) volume: up 88%
Clearly, we're seeing much more interest in the short product than the long one, an interesting finding in a rising market.
What's more is that this interest is correlated across the Ultra ETFs. I went back to November 1st, which is roughly when we first saw a burst of new volume in the short products, and correlated the daily volumes in the inverse Ultras. The correlation between the NASDAQ inverse volume (QID) and the S&P 500 inverse volume (SDS) was .60. The correlation between the NASDAQ inverse volume (QID) and the Dow inverse volume (DXD) was .87. The correlation between the S&P 500 inverse volume (SDS) and the Dow inverse volume (DXD) was .43. All are healthy, positive correlations. This suggests that when there is buying interest in one inverse ETF, there tends to be buying interest in the others.
Correlations in the daily volume of the long ETFs is also positive and significant: around .50-.60.
What are we to make of the growing interest in the inverse ETFs and the correlated volumes of all six of these Ultra ETFs?
My take is that they are being used as hedging devices by money managers. Many managers who have been buying stocks like banshees this fall have been hedging their bets with these Ultra inverse products. They are getting the best of both worlds: they can say that they participated in the rally and they can extend their stock ownership over longer (capital gains) periods, while at the same time hedging their general market risk.
Over the last five days of relative market strength, volume in the inverse NASDAQ product has exceeded volume in the long product by 5:1. Volume in the inverse S&P ETF has exceeded volume in the long product by over 3:1. There have been no dips in the ratios of short:long volumes in the Ultra ETFs as there have been among equity put/call options.
Bottom line: At least among some money managers, their bullishness may be a mile wide and an inch deep. At the same time they're buying stocks for year end gains, they're making sure their tails are covered. Other managers may be more selective in their bullishness, preferring specific issues, but protecting themselves from overall market risk. In any event, in the Ultra ETFs, we have an interesting tool for examining the behavior of these managers. As the market has broken to new highs, they've stepped up their participation in the inverse ETF market.
Saturday, December 16, 2006
Three Lessons From The Daytraders' Index
Above is a chart of the S&P 500 Index (SPY) since 2004 (red) and an index that I call the Daytraders' Index (blue). The Daytraders' Index consists of the cumulative changes of the market's move from open to close. So, in essence, the Daytraders' Index is a chart of SPY with the effect of the overnight (close to open) action eliminated.
What we can see clearly is that the Daytraders' Index looks very much like a detrended SPY. We are almost exactly at the point in 2006 that we were at the start of 2004, even though SPY is more than 30 points (300 S&P futures points) higher.
There are several important lessons we can gather from the Daytraders' Index:
1) A directional bias in the S&P 500 Index has not helped the daytrader. The daytrader's market has not had a systematic, trending bias, even though we've been in a bull market. The daytraders should not necessarily become more bullish when the S&P 500 Index breaks to new highs, because--in an important sense--that is not the market they are trading.
2) Daytraders need to trade the patterns relevant to their market. Useful historical price patterns may be present in the Daytraders' Index that are obscured by the market's overnight action. Conversely, price patterns over multiple days in the S&P 500 Index may not benefit the daytrader if a large part of the price gains from those patterns occur in the overnight market. Developing an idea from a daily barchart, for example, won't necessarily benefit a daytrader because, even if it is correct, the anticipated movement may not happen at the trader's time frame.
3) The market has been paying a handsome risk premium to traders willing to assume overnight risk. By avoiding overnight exposure, daytraders also insulate themselves from the opportunity of participating in the bull market. Rather than simply grow larger in response to profitability, it could make sense for the daytrader to diversify by time frame and capture some of the market's risk premium. By properly sizing overnight vs. intraday positions, the trader can easily manage the risk of overnight exposure and cultivate a new source of alpha.
In a very real sense, the S&P 500 Index is an amalgam of two different trading markets. One is a relatively trendless day session and the other is a trendy overnight market that responds to international market movements and premarket economic news. In my upcoming posts, I will explore some of the historical patterns in the Daytraders' Index and how they might be relevant to both intraday and swing traders.
Friday, December 15, 2006
Sector Rotation or Breakout Rally: Perspective From The ETFs
Here we see how the different "Spyder" sector ETFs have performed since August. Those that have outperformed the S&P 500 Index (SPY) are coded green; those that have underperformed are in red.
Now here's the interesting thing: Of the seven sectors that have outperformed the S&P500 Index, only one made a new closing high on Thursday. That was XLY, the Consumer Discretionary ETF. The other six sectors that have been strong since August did not make new highs on Thursday.
Conversely, five of the ten sector ETFs that have underperformed the S&P 500 Index closed at new highs on Thursday. My take? The rally Thursday and this AM represent sector rotation and not "the rising tide that lifts all boats". I'm watching carefully to see if this rally broadens out or stalls out. One way of doing that is tracking the ETFs and seeing how many can remain above their Thursday highs. So far, a majority are struggling to ride the tide.
Divergences At The Market Highs: What's Hot, What's Not Among ETFs
When I was putting together today's Weblog entry, I noticed that--even after Thursday's impressive rise--only 1345 stocks across the NYSE, NASDAQ, and American Exchanges had made fresh 20-day highs against 550 new lows. By comparison, on December 5th, we had 1920 new 20-day highs and only 276 new lows.
Above, I take a larger picture from August of this year to the present. The red line is the daily closing price of the S&P 500 Index (SPY). The blue line is the difference between the number of stocks across the three exchanges that are making fresh 65-day highs minus those making 65-day lows. Notice that, recently, as we've moved to new highs in SPY, the net number of stocks making new intermediate-term highs has lagged. (Props to the excellent Barchart site for the new high/low data).
So what's hot and what's not?
Most noticeably, we see that the S&P 500 large cap ETF (SPY) has made a new multi-year high. We see no such new high in the Russell 2000 small cap ETF (IWM) or the NASDAQ 100 Index fund (QQQQ). The midcap ETF (MDY) is knocking at door of new highs, but so far is lagging. In other words, we're seeing divergence based upon capitalization and market.
How about sectors?
I took a look at the 17 State Street "Spyder" ETFs to see which have made new highs since August on this recent rise. Six closed at new highs:
XES - Oil and Gas Equipment and Service
XLE - Energy
XLF - Financial
XLP - Consumer Staples
XLU - Utilities
XLY - Consumer Discretionary
Eleven sector State Street "Spyder" ETFs, however, did not make new highs on Thursday:
XBI - Biotech
XHB - Homebuilders
XLB - Materials
XLI - Industrial
XLK - Technology
XLV - Health Care
XME - Metals and Mining
XOP - Oil and Gas Exploration and Production
XPH - Pharmaceuticals
XRT - Retail
XSD - Semiconductors
While this is a mixed bag, it's clear that, overall, growth sectors are lagging value ones.
They say a rising tide lifts all boats. My research suggests that rising boats are indicative of significant rising tides. On Thursday, there were fewer rising boats than meets the eye.
Thursday, December 14, 2006
Institutional Behavior At The Close: Does It Affect The Next Open?
When institutions enter large numbers of buy or sell orders on an MOC (market on close) basis, does this affect the next open?
I went back to 2004 (N = 744 trading days) and divided the sample in half based upon the net buying vs. selling in institutional MOC orders. When there was relatively strong buying at the close (N = 372), the next open in the S&P 500 Index (SPY) was up by an average of .01% (168 up, 204 down). Conversely, when there was relatively weak buying at the close, the next morning's open in SPY was up by an average of .06% (225 up, 147 down). Interestingly, when there was outright net selling at the close (N = 87), the next morning's open was up by an average of .11% (55 up, 32 down).
If you've ever had the feeling that you bail out of positions at the wrong time, at least you now know that you're in good company. Even at the market close, at a very short time frame, we see evidence of reversal effects.
So here's the puzzle: How do we know what institutions are doing at the market close? I'll verify the answer if anyone figures it out and posts it as a blog comment. It's actually pretty simple.
I went back to 2004 (N = 744 trading days) and divided the sample in half based upon the net buying vs. selling in institutional MOC orders. When there was relatively strong buying at the close (N = 372), the next open in the S&P 500 Index (SPY) was up by an average of .01% (168 up, 204 down). Conversely, when there was relatively weak buying at the close, the next morning's open in SPY was up by an average of .06% (225 up, 147 down). Interestingly, when there was outright net selling at the close (N = 87), the next morning's open was up by an average of .11% (55 up, 32 down).
If you've ever had the feeling that you bail out of positions at the wrong time, at least you now know that you're in good company. Even at the market close, at a very short time frame, we see evidence of reversal effects.
So here's the puzzle: How do we know what institutions are doing at the market close? I'll verify the answer if anyone figures it out and posts it as a blog comment. It's actually pretty simple.
Flat Stock Market: Which Way Will We Break Out?
Technical analysis wisdom tells us that the longer a market remains rangebound, the more significant the eventual breakout move. The problem for the trader is that is difficult to handicap the odds of which way the market will make its breakout move.
I decided to draw upon two of my recent posts to address this question, given that we are trading in a five-day range in which the S&P 500 closing price (SPY) has barely budged. Recall that I found reversal effects in the S&P 500 market following periods of uptrending and also following periods of downtrending. Suppose we look at what other, correlated ETFs are doing during the flat period to see if we get a reversal effect from their action.
Going back to 2004, I found 84 occasions in which the five-day change in SPY has been less than +.20% but greater than -.20%. We'll call those relatively flat markets. I then divided this sample in half based on what was happening in the NASDAQ 100 Index (QQQQ).
When SPY was flat over five days, but QQQQ was relatively strong, the next day in SPY averaged a loss of -.01% (21 up, 21 down). When SPY was flat but QQQQ was relatively weak, the next day in SPY averaged a gain of .11% (26 up, 16 down). Indeed, when SPY was flat and QQQQ was down by more than -.50% (as is the case at present), the next day in SPY averaged a healthy gain of .22% (21 up, 10 down).
If we look a bit further out, when SPY was flat over five days, but QQQQ was relatively strong, the next three days in SPY averaged a loss of -.08% (19 up, 23 down). When SPY was flat, but QQQQ was relatively weak, the next three days in SPY averaged a very respectable average gain of .33% (28 up, 14 down).
And when QQQQ has been down more than -.50% during the flat period in SPY? The next three days in SPY have averaged a solid gain of .54% (22 up, 9 down).
Very interestingly, I have not found this reversal effect for the Russell 2000 ETF: IWM. This suggests to me that the smaller-cap Russell may have different characteristics of continuation and reversal than the large cap S&P and NASDAQ stocks. That's a pattern worthy of investigation.
By looking strong and weak sectors during a market's flat period--and by assessing those sectors' tendencies toward reversal or continuation--we might be able to handicap the odds of breaking out in a particular direction in the S&P 500 Index. It appears that, when QQQQ is weak during a flat period in SPY, the eventual reversal in the Qs also tends to lift the Spooz. Let's see if that pattern plays out in the current market.
I decided to draw upon two of my recent posts to address this question, given that we are trading in a five-day range in which the S&P 500 closing price (SPY) has barely budged. Recall that I found reversal effects in the S&P 500 market following periods of uptrending and also following periods of downtrending. Suppose we look at what other, correlated ETFs are doing during the flat period to see if we get a reversal effect from their action.
Going back to 2004, I found 84 occasions in which the five-day change in SPY has been less than +.20% but greater than -.20%. We'll call those relatively flat markets. I then divided this sample in half based on what was happening in the NASDAQ 100 Index (QQQQ).
When SPY was flat over five days, but QQQQ was relatively strong, the next day in SPY averaged a loss of -.01% (21 up, 21 down). When SPY was flat but QQQQ was relatively weak, the next day in SPY averaged a gain of .11% (26 up, 16 down). Indeed, when SPY was flat and QQQQ was down by more than -.50% (as is the case at present), the next day in SPY averaged a healthy gain of .22% (21 up, 10 down).
If we look a bit further out, when SPY was flat over five days, but QQQQ was relatively strong, the next three days in SPY averaged a loss of -.08% (19 up, 23 down). When SPY was flat, but QQQQ was relatively weak, the next three days in SPY averaged a very respectable average gain of .33% (28 up, 14 down).
And when QQQQ has been down more than -.50% during the flat period in SPY? The next three days in SPY have averaged a solid gain of .54% (22 up, 9 down).
Very interestingly, I have not found this reversal effect for the Russell 2000 ETF: IWM. This suggests to me that the smaller-cap Russell may have different characteristics of continuation and reversal than the large cap S&P and NASDAQ stocks. That's a pattern worthy of investigation.
By looking strong and weak sectors during a market's flat period--and by assessing those sectors' tendencies toward reversal or continuation--we might be able to handicap the odds of breaking out in a particular direction in the S&P 500 Index. It appears that, when QQQQ is weak during a flat period in SPY, the eventual reversal in the Qs also tends to lift the Spooz. Let's see if that pattern plays out in the current market.
Wednesday, December 13, 2006
Coming Changes in TraderFeed
I recently mentioned changes to the Trading Psychology Weblog that will integrate the indicators, research, and links into a day-to-day trading outlook for short-term traders. I've already received excellent feedback on the changes--and on further suggested changes. Thanks much.
Not one to stand still, I'm also in the process of making changes in TraderFeed that will broaden its content (and hopefully its usefulness):
1) We'll see more Morning With the Doc sessions in 2007 to illustrate how research and the reading of short-term volume and intermarket patterns can aid short-term trading. Indeed, I'm shooting for another Morning session this coming Tuesday, December 19th; stay tuned!
2) I will be broadening out the research to include longer time frames and multiple trading instruments. I am especially interested in identifying historical patterns among the universe of ETFs. This will potentially provide many more trading ideas of merit, as we look to benefit from both the right trading vehicles and the right timing of trades;
3) I hope to broaden the content of TraderFeed. You'll notice that selected TraderFeed posts are now picked up on the excellent Seeking Alpha site and may be available through Yahoo! Finance as well. I will also provide Seeking Alpha with some original market psychology research on sentiment and historical patterns among the various ETFs and alternative trading vehicles. These articles will also be linked on the Weblog, of course.
4) As part of broadening out the content, I will be addressing more of the intermarket, global/macro themes that affect the market's big trends. One of the reasons I'm particularly looking forward to working with Seeking Alpha is the site's commitment to international perspectives/markets and its interest in democratizing editorial content by enabling readers to interview industry leaders. If they do this right (and I think they will), this will lead to many worthwhile global conversations about markets, trends, and research.
As with the Weblog, I welcome ideas and suggestions and greatly appreciate the interest and support of readers. With the increasing globalization of markets and the rapidly expanding universe of trading and investment options, it only makes sense to take the blog research and content beyond the short-term patterns in the S&P index.
Thanks,
Brett
Not one to stand still, I'm also in the process of making changes in TraderFeed that will broaden its content (and hopefully its usefulness):
1) We'll see more Morning With the Doc sessions in 2007 to illustrate how research and the reading of short-term volume and intermarket patterns can aid short-term trading. Indeed, I'm shooting for another Morning session this coming Tuesday, December 19th; stay tuned!
2) I will be broadening out the research to include longer time frames and multiple trading instruments. I am especially interested in identifying historical patterns among the universe of ETFs. This will potentially provide many more trading ideas of merit, as we look to benefit from both the right trading vehicles and the right timing of trades;
3) I hope to broaden the content of TraderFeed. You'll notice that selected TraderFeed posts are now picked up on the excellent Seeking Alpha site and may be available through Yahoo! Finance as well. I will also provide Seeking Alpha with some original market psychology research on sentiment and historical patterns among the various ETFs and alternative trading vehicles. These articles will also be linked on the Weblog, of course.
4) As part of broadening out the content, I will be addressing more of the intermarket, global/macro themes that affect the market's big trends. One of the reasons I'm particularly looking forward to working with Seeking Alpha is the site's commitment to international perspectives/markets and its interest in democratizing editorial content by enabling readers to interview industry leaders. If they do this right (and I think they will), this will lead to many worthwhile global conversations about markets, trends, and research.
As with the Weblog, I welcome ideas and suggestions and greatly appreciate the interest and support of readers. With the increasing globalization of markets and the rapidly expanding universe of trading and investment options, it only makes sense to take the blog research and content beyond the short-term patterns in the S&P index.
Thanks,
Brett
Stock Market Psychology: What You See Is Not What You Get
In my recent post, I showed how unaided perception of the market can be misleading. A market that looks as though it is rising over three different time periods ends up having worse near-term returns than an average market. Because of this, the naive trader--one who makes decisions solely based upon the appearance of a chart--is at an objective disadvantage relative to the trader who digs beneath appearance with careful analysis.
How about declining markets? Does a visual appearance of a downtrend alert us to future weakness, or is it a similar perceptual distortion when we extrapolate a negatively sloped line into the future?
Since 2004 (N = 734 trading days), we've had 134 occasions in which the S&P 500 Index (SPY) has been down on a one, four, and nine day basis. We could reasonably call this a short-term "downtrend". Four days later, SPY is up by an average .37% (84 up, 50 down), which is stronger than the average four-day gain of .08% for the remainder of the sample (330 up, 270 down). In other words, a market that is likely to be perceived as weak--down simultaneously across three time frames--has shown better returns than the average market.
Once again, however, let's extend our experiment. We'll pull out those occasions in which the market is down more on a nine-day basis than on a four-day basis and down more on a four-day basis than on a one-day basis. That creates our visual downtrend (N = 47). When the market looks as though it's in a steady downtrend, the next four days in SPY average a gain of .65% (33 up, 14 down), much stronger than the average market. Conversely, when the market is down over the three time periods but not in a visual configuration of a downtrend (N = 87), the next four days in SPY average a gain of only .21% (51 up, 36 down). In other words, the worse the market has looked, the better its near-term returns have been.
So let's summarize the results from the two experiments. Average returns over the next four days are as follows:
SPY up over three time periods and in a visual uptrend: -.11%
SPY up over three time periods and not in a visual uptrend: -.02%
SPY down over three time periods and in visual downtrend: +.65%
SPY down over three time periods and not in visual downtrend: +.21%
The naive visual trader who bought when the chart looked strong and sold when it looked weak would have lost consistent money. Conversely, the psychologically sophisticated trader who understood the limitations of human perception could have profited quite nicely. It is not paranoia to believe that the market systematically reallocates capital from naive hands to sophisticated ones: a process of natural selection every bit as ruthless as that found in the jungle.
How about declining markets? Does a visual appearance of a downtrend alert us to future weakness, or is it a similar perceptual distortion when we extrapolate a negatively sloped line into the future?
Since 2004 (N = 734 trading days), we've had 134 occasions in which the S&P 500 Index (SPY) has been down on a one, four, and nine day basis. We could reasonably call this a short-term "downtrend". Four days later, SPY is up by an average .37% (84 up, 50 down), which is stronger than the average four-day gain of .08% for the remainder of the sample (330 up, 270 down). In other words, a market that is likely to be perceived as weak--down simultaneously across three time frames--has shown better returns than the average market.
Once again, however, let's extend our experiment. We'll pull out those occasions in which the market is down more on a nine-day basis than on a four-day basis and down more on a four-day basis than on a one-day basis. That creates our visual downtrend (N = 47). When the market looks as though it's in a steady downtrend, the next four days in SPY average a gain of .65% (33 up, 14 down), much stronger than the average market. Conversely, when the market is down over the three time periods but not in a visual configuration of a downtrend (N = 87), the next four days in SPY average a gain of only .21% (51 up, 36 down). In other words, the worse the market has looked, the better its near-term returns have been.
So let's summarize the results from the two experiments. Average returns over the next four days are as follows:
SPY up over three time periods and in a visual uptrend: -.11%
SPY up over three time periods and not in a visual uptrend: -.02%
SPY down over three time periods and in visual downtrend: +.65%
SPY down over three time periods and not in visual downtrend: +.21%
The naive visual trader who bought when the chart looked strong and sold when it looked weak would have lost consistent money. Conversely, the psychologically sophisticated trader who understood the limitations of human perception could have profited quite nicely. It is not paranoia to believe that the market systematically reallocates capital from naive hands to sophisticated ones: a process of natural selection every bit as ruthless as that found in the jungle.
Tuesday, December 12, 2006
Changes To The Trading Psychology Weblog
For a few years now, the Trading Psychology Weblog has been the place where I track a number of market indicators and the short-term movements of the stock indices. Starting today, I've made a subtle but important change to the Weblog.
The first portion of each Weblog entry consists of Market Ideas from various blogs and sites across the Web. I try to cull out unique perspectives that are of practical relevance to the economy and markets. The links are a great way to discover interesting work being done by bloggers across the world.
The second segment of the Weblog, Market Expectations, looks at some unique facet of the market that otherwise might go unnoticed. Sometimes this will be an indicator; other times it will be a historical pattern. Generally, however, it is designed to provide a big picture for what is happening in the current market.
The third and final Weblog section is the one that has changed. I'm calling it "Market Synthesis", and it now puts together a narrative that integrates the various Weblog measures. Basically, the synthesis is a kind of mental game plan that starts my market day. It is not a mechanical set of ideas to be traded: only my way of orienting myself to recent market action.
The key indicators in the Synthesis are:
1) Average trading price for the day - This enables you to see if we're trading above or below value early in the next trading session;
2) Adjusted TICK - This is a daily reading of the transactions in NYSE stocks that have occurred at the offer minus those that have occurred at the bid. It is normalized with respect to the past 20 trading days, so that a positive Adjusted TICK tells you we had more buying pressure than average over the past 20 sessions. A negative Adjusted TICK informs us that we had relative selling pressure for the day.
3) Institutional Composite - This is exactly the same as the Adjusted TICK, only it is constructed with the large cap Dow issues, not the entire list of NYSE stocks. It tells us whether or not we've had relative buying/selling pressure for the day relative to the past 20 sessions.
4) Demand/Supply - Demand is a proprietary index of the number of stocks across the NYSE, NASDAQ, and American Exchanges that have closed above their volatility envelopes surrounding their short-term and intermediate-term moving averages. Supply is a proprietary index of the number of stocks closing below their envelopes. These are very effective momentum measures.
5) New 20 Day Highs and Lows - This is the number of NYSE, NASDAQ, and American Exchange stocks making fresh highs or lows over the past 20-day period. An excellent measure of market strength.
6) Institutional Momentum - This is a bit like the Demand/Supply data, only it is a single, proprietary index that measures whether a basket of large cap stocks is trading above or below their moving averages and volatility envelopes. Excellent large cap measure of intermediate-term momentum.
All of these measures have been tested for historical patterns that predict the S&P 500 Index over a 1-5 day horizon. They are included in the Weblog because they've been found to be relevant to the market's near-term picture. I'll occasionally post research to illustrate this.
As I write this, there are 840 emails in my inbox--and that's after the spam's filtered out. Every single day I am getting requests to do talks for traders, write articles for traders, meet with traders, etc. While I can't possibly meet all these requests (and appreciate them greatly), my hope is that the Weblog, in its new form, will help you--as it helps me--organize your thoughts for the day. From the blog links to the indicator/research perspectives to the indicator readings, the Weblog is meant as a one-stop read at the start of the market day to help you frame your trading ideas.
I welcome your feedback and hope to make continued changes and improvements during 2007. Thanks for your kind support and interest.
The first portion of each Weblog entry consists of Market Ideas from various blogs and sites across the Web. I try to cull out unique perspectives that are of practical relevance to the economy and markets. The links are a great way to discover interesting work being done by bloggers across the world.
The second segment of the Weblog, Market Expectations, looks at some unique facet of the market that otherwise might go unnoticed. Sometimes this will be an indicator; other times it will be a historical pattern. Generally, however, it is designed to provide a big picture for what is happening in the current market.
The third and final Weblog section is the one that has changed. I'm calling it "Market Synthesis", and it now puts together a narrative that integrates the various Weblog measures. Basically, the synthesis is a kind of mental game plan that starts my market day. It is not a mechanical set of ideas to be traded: only my way of orienting myself to recent market action.
The key indicators in the Synthesis are:
1) Average trading price for the day - This enables you to see if we're trading above or below value early in the next trading session;
2) Adjusted TICK - This is a daily reading of the transactions in NYSE stocks that have occurred at the offer minus those that have occurred at the bid. It is normalized with respect to the past 20 trading days, so that a positive Adjusted TICK tells you we had more buying pressure than average over the past 20 sessions. A negative Adjusted TICK informs us that we had relative selling pressure for the day.
3) Institutional Composite - This is exactly the same as the Adjusted TICK, only it is constructed with the large cap Dow issues, not the entire list of NYSE stocks. It tells us whether or not we've had relative buying/selling pressure for the day relative to the past 20 sessions.
4) Demand/Supply - Demand is a proprietary index of the number of stocks across the NYSE, NASDAQ, and American Exchanges that have closed above their volatility envelopes surrounding their short-term and intermediate-term moving averages. Supply is a proprietary index of the number of stocks closing below their envelopes. These are very effective momentum measures.
5) New 20 Day Highs and Lows - This is the number of NYSE, NASDAQ, and American Exchange stocks making fresh highs or lows over the past 20-day period. An excellent measure of market strength.
6) Institutional Momentum - This is a bit like the Demand/Supply data, only it is a single, proprietary index that measures whether a basket of large cap stocks is trading above or below their moving averages and volatility envelopes. Excellent large cap measure of intermediate-term momentum.
All of these measures have been tested for historical patterns that predict the S&P 500 Index over a 1-5 day horizon. They are included in the Weblog because they've been found to be relevant to the market's near-term picture. I'll occasionally post research to illustrate this.
As I write this, there are 840 emails in my inbox--and that's after the spam's filtered out. Every single day I am getting requests to do talks for traders, write articles for traders, meet with traders, etc. While I can't possibly meet all these requests (and appreciate them greatly), my hope is that the Weblog, in its new form, will help you--as it helps me--organize your thoughts for the day. From the blog links to the indicator/research perspectives to the indicator readings, the Weblog is meant as a one-stop read at the start of the market day to help you frame your trading ideas.
I welcome your feedback and hope to make continued changes and improvements during 2007. Thanks for your kind support and interest.
Brett
Perceptual Distortions In The Stock Market
One of the signs that a field of study has become a science is the recognition of the need for controlled observation with tools that transcend the limits of the human senses. From the electron microscope to the Hubble telescope, advances in science have followed the acceptance that the unaided human eye cannot perceive all of nature's patterns.
Behavioral finance researchers teach us that unaided human senses are particularly ill-equipped to accurately assess the market's patterns. Our tendencies to overweight recent events and highly salient events; our overreliance on simple heuristics; our emotional weightings of losses vs. gains: these create perceptual biases that skew our responses to risk and reward under conditions of uncertainty.
Still, surprisingly, we find traders evaluating markets based upon nothing more than the unaided eye. Inevitably we look at a chart, notice a slope, and declare a "trend" in place. Can such visually-based analysis succeed?
I decided to try a little experiment. I went back to 2004 (N = 734 trading days) in the S&P 500 Index (SPY) and identified all occasions in which the market was up on a one-day basis, a four-day basis, and a nine-day basis (N = 234). We might call that an "uptrending" market. Four days later, SPY was down by an average -.07% (115 up, 119 down). That is weaker than the average four-day gain for the remainder of the sample of .22% (299 up, 201 down). In other words, the market that--to the unaided observer--has been consistantly up over the last two weeks has had no bullish edge whatsoever. Indeed, it has tended to underperform its recent norms. This fits with my recent research showing underperformance when we trade above a moving-average benchmark.
But let's take the experiment a step further. Suppose we isolate those occasions in which the market is up more on a nine-day basis than on a four-day basis and up more on a four-day basis than on a one-day basis. This would represent, to the unaided eye, a nice steady uptrend. We have 115 such occurrences in our sample. Four days later, SPY is down by an average -.11% (53 up, 62 down). When the market has been down on a one, four, and nine-day basis, but not in a visual uptrend, the next four days in SPY have averaged a loss of -.02% (62 up, 57 down). In other words, we've seen the worst short-term market outcomes when markets have looked their best. The more consistent the visual uptrend, the worse the near-term returns.
In my next post, I will investigate our perception of markets moving downward.
The perceptual distortion in the market is that the unaided human eye tends to extrapolate straight lines into the future. Like a ball tossed into the air, we expect markets to continue moving in their most recent direction. Statistical analysis is a tool for transcending the unaided eye. It, among other things, is what separates astrologers from astronomers, alchemists from chemists. Market psychology begins with the recognition of the limits--and limitations--of human perception.
Behavioral finance researchers teach us that unaided human senses are particularly ill-equipped to accurately assess the market's patterns. Our tendencies to overweight recent events and highly salient events; our overreliance on simple heuristics; our emotional weightings of losses vs. gains: these create perceptual biases that skew our responses to risk and reward under conditions of uncertainty.
Still, surprisingly, we find traders evaluating markets based upon nothing more than the unaided eye. Inevitably we look at a chart, notice a slope, and declare a "trend" in place. Can such visually-based analysis succeed?
I decided to try a little experiment. I went back to 2004 (N = 734 trading days) in the S&P 500 Index (SPY) and identified all occasions in which the market was up on a one-day basis, a four-day basis, and a nine-day basis (N = 234). We might call that an "uptrending" market. Four days later, SPY was down by an average -.07% (115 up, 119 down). That is weaker than the average four-day gain for the remainder of the sample of .22% (299 up, 201 down). In other words, the market that--to the unaided observer--has been consistantly up over the last two weeks has had no bullish edge whatsoever. Indeed, it has tended to underperform its recent norms. This fits with my recent research showing underperformance when we trade above a moving-average benchmark.
But let's take the experiment a step further. Suppose we isolate those occasions in which the market is up more on a nine-day basis than on a four-day basis and up more on a four-day basis than on a one-day basis. This would represent, to the unaided eye, a nice steady uptrend. We have 115 such occurrences in our sample. Four days later, SPY is down by an average -.11% (53 up, 62 down). When the market has been down on a one, four, and nine-day basis, but not in a visual uptrend, the next four days in SPY have averaged a loss of -.02% (62 up, 57 down). In other words, we've seen the worst short-term market outcomes when markets have looked their best. The more consistent the visual uptrend, the worse the near-term returns.
In my next post, I will investigate our perception of markets moving downward.
The perceptual distortion in the market is that the unaided human eye tends to extrapolate straight lines into the future. Like a ball tossed into the air, we expect markets to continue moving in their most recent direction. Statistical analysis is a tool for transcending the unaided eye. It, among other things, is what separates astrologers from astronomers, alchemists from chemists. Market psychology begins with the recognition of the limits--and limitations--of human perception.
How Do Federal Reserve Announcements Affect The Markets?
Life is full of unpleasant surprises. Few events are as eagerly anticipated among traders as Federal Reserve announcements of monetary policy. I decided to go back to 2005 and examine what surprises, if any, have been in store for the markets following the last 15 announcements.
One surprise from my findings was that the equity index market (S&P 500 Index; SPY) has not been as volatile on Fed days as might have been expected. The high-low price range for the S&P 500 Index on Fed days exceeded the 20-day average price range on only 8 of the last 15 occasions. Overall, the range on Fed days has been 15% greater than its 20-day average, or about 2 futures points. Three of the last five Fed announcements have led to daily ranges less than the 20-day average.
We do see enhanced volume on Fed days. I looked at volume in the SPY ETF and found that 11 of the 15 Fed days showed volume above the 20-day average. In all, volume on Fed days was about 19% greater than the 20-day average. So what we've seen is elevated volume, but not necessarily elevated ranges. That's a potential formula for whipsaw price action in markets.
I also looked at the high-low ranges for 10-year interest rates on Fed days. One would expect quite a bit of interest rate movement on those occasions. Surprisingly, however, only 7 of the 15 days had a wider range than their 20-day average. Overall for the sample, the interest rate range on Fed days has been about 7% wider than normal, but this is skewed by one particularly large reading.
Now here's the really interesting part: Over the 15 Fed days, the correlation between the day's price range in stocks and the day's range in interest rates is a very strong .56. In other words, when rates move, stocks move. When Fed policy is affecting bond and bill yields, stocks tend to be repriced. That is something to watch carefully today.
Here's another interesting note: Five days after the Fed meeting, the S&P 500 Index (SPY) has averaged a loss of -.18% (7 up, 7 down, 1 unchanged). That is weaker than the average five-day gain of .19%. Five days after Fed day, 10-year interest rates ($TNX) have declined by an average of -.62% (7 up, 8 down). That is a much weaker performance than the average five-day change in interest rates of .07%.
So there you have it. Fed days aren't quite as volatile as they are made out to be, largely because Fed policy has not changed greatly from meeting to meeting over that time and has been effectively signaled in advance. When Fed statements do move rates, stocks also tend to move. After the Fed meetings, we've seen some bond strength (interest rate declines) and stock weakness, although this is based on an admittedly small sample.
I will be watching the response of rates and the dollar to the announcement to seek real time guidance for the likelihood of sustained repricings of equities. If there are any unpleasant surprises, they will be priced into bonds and currencies quickly.
Monday, December 11, 2006
Controlling Emotions Is NOT The Goal Of Trading Psychology
Pick up a book or magazine article about trading psychology and you're likely to find prescriptions for success based on controlling emotions and increasing discipline.
Yes, emotional arousal can interfere with performance, but does that mean that elite performance is a function of dampened emotions?
When you look at some of the greatest performers in sports--and in trading--you'll find highly competitive individuals. They are quite emotional and don't take well to losing. Lance Armstrong? Michael Jordan? Tiger Woods? Muhammad Ali? All were quite intense, emotional individuals who managed to channel their emotional drive into victory.
Conversely, I've encountered many well-balanced individuals who have sought success in trading. They don't blow up, they follow rules faithfully, and they have no intense, competitive emotional flame burning within. I've never yet seen one go on to become successful.
Can anyone watch the really successful college basketball coaches--Coach K., Jim Boeheim, Bob Knight, Tom Izzo--and attribute their success to emotional restraint? Yes, there have been emotionally reserved winners--think John Wooden and Dean Smith--but one suspects their emotionality was that of a warm mentor, not that of a cold fish.
The important ingredient in success is not emotional dampening per se, but the enhancement of concentration and focus. That is what enables people to act with sustained purpose and stay rooted in their goals.
When we review the lives of great individuals across a variety of fields--the research of Dean Keith Simonton and K. Anders Ericsson stands out in this respect--what we find is that the greats have prodigious capacities for work. They are hugely productive. They sustain effort hours at a time, day after day, week after week, year after year.
Only the ability to regularly access "the zone"--that flow state of consciousness that comes from being wholly absorbed in an activity that captures our interests, skills, and talents--can account for the amazing dedication of the Olympic athlete, the great career scientist, or the chess grand master.
Indeed, such exemplary performers can use emotion to access the zone. Michael Jordan used to provoke players on opposing teams so that they would argue and fight back. That would arouse Jordan's competitive instincts and elevate his game.
When we operate outside that "zone" and lose our focus, we are no longer activating that executive center of our brains--the frontal lobes--that control planning, judgment, and reasoning. Left with a weak executive center, we become like the person with Attention Deficit Disorder: prone to wandering attention, reduced self-control, and impulsive behavior.
That makes it look as though "emotion" and "lack of discipline" cause our trading problems.
In reality, however, these are the results of the problem; not the causes.
The goal of trading psychology is to build consciousness, not reduce emotion. The goal is to create regular access to the flow state of heightened learning and focus. Talking to a trading coach, in itself, won't accomplish that; nor will well-intentioned efforts to calm oneself or take breaks from trading.
We can only build consciousness by working on consciousness. That is why I find meditation, heart rate and galvanic skin response biofeedback, self-hypnosis, and newer methods such as hemoencephalography to be valuable tools for traders and emphasized their use in my book on the psychology of trading.
These methods don't eliminate emotion; they build minds. If we can exercise for 30 min./day and build our cardiac fitness and our physiques, maybe--just maybe--a similar commitment could strengthen our abilities to operate within life's "zone". I'll be posting more re: my personal experiments with mind training in the near future.
Yes, emotional arousal can interfere with performance, but does that mean that elite performance is a function of dampened emotions?
When you look at some of the greatest performers in sports--and in trading--you'll find highly competitive individuals. They are quite emotional and don't take well to losing. Lance Armstrong? Michael Jordan? Tiger Woods? Muhammad Ali? All were quite intense, emotional individuals who managed to channel their emotional drive into victory.
Conversely, I've encountered many well-balanced individuals who have sought success in trading. They don't blow up, they follow rules faithfully, and they have no intense, competitive emotional flame burning within. I've never yet seen one go on to become successful.
Can anyone watch the really successful college basketball coaches--Coach K., Jim Boeheim, Bob Knight, Tom Izzo--and attribute their success to emotional restraint? Yes, there have been emotionally reserved winners--think John Wooden and Dean Smith--but one suspects their emotionality was that of a warm mentor, not that of a cold fish.
The important ingredient in success is not emotional dampening per se, but the enhancement of concentration and focus. That is what enables people to act with sustained purpose and stay rooted in their goals.
When we review the lives of great individuals across a variety of fields--the research of Dean Keith Simonton and K. Anders Ericsson stands out in this respect--what we find is that the greats have prodigious capacities for work. They are hugely productive. They sustain effort hours at a time, day after day, week after week, year after year.
Only the ability to regularly access "the zone"--that flow state of consciousness that comes from being wholly absorbed in an activity that captures our interests, skills, and talents--can account for the amazing dedication of the Olympic athlete, the great career scientist, or the chess grand master.
Indeed, such exemplary performers can use emotion to access the zone. Michael Jordan used to provoke players on opposing teams so that they would argue and fight back. That would arouse Jordan's competitive instincts and elevate his game.
When we operate outside that "zone" and lose our focus, we are no longer activating that executive center of our brains--the frontal lobes--that control planning, judgment, and reasoning. Left with a weak executive center, we become like the person with Attention Deficit Disorder: prone to wandering attention, reduced self-control, and impulsive behavior.
That makes it look as though "emotion" and "lack of discipline" cause our trading problems.
In reality, however, these are the results of the problem; not the causes.
The goal of trading psychology is to build consciousness, not reduce emotion. The goal is to create regular access to the flow state of heightened learning and focus. Talking to a trading coach, in itself, won't accomplish that; nor will well-intentioned efforts to calm oneself or take breaks from trading.
We can only build consciousness by working on consciousness. That is why I find meditation, heart rate and galvanic skin response biofeedback, self-hypnosis, and newer methods such as hemoencephalography to be valuable tools for traders and emphasized their use in my book on the psychology of trading.
These methods don't eliminate emotion; they build minds. If we can exercise for 30 min./day and build our cardiac fitness and our physiques, maybe--just maybe--a similar commitment could strengthen our abilities to operate within life's "zone". I'll be posting more re: my personal experiments with mind training in the near future.
Sunday, December 10, 2006
Finding the Zone With Hemoencephalography
Slowly, a subfield of biofeedback, known as hemoencephalography, is gaining recognition as a method for developing the cognitive skills of focus and concentration. Hemoencephalography is the measurement of voluntarily-controlled regional blood flow in the brain. Research suggests that, with practice, people can learn to increase the relative blood flow to their prefrontal cortex, which is the brain's executive center. This is one way of creating the kind of brain fitness activity advocated by cognitive neuroscientist Elkonon Goldberg. It is also a way of enabling people to develop the capacity to access "the zone": that region of consciousness associated with peak performance. The zone, as it turns out, is actually a state of sustained concentration and frontal activation.
Unlike some other forms of biofeedback, which measure the body's level of arousal and hence assess whether someone is stressed or relaxed, hemoencephalography measures skin forehead temperature. The idea is that, with infrared detection, it is possible to identify when blood flow to the frontal areas is relatively high or low. A skin forehead temperature index is displayed continuously for the user, providing the feedback. The goal is to enhance concentration, not induce relaxation. The technique originally was utilized by Dr. Jeffrey Carmen to control migraine headaches and by Dr. Hershel Toomim to enhance cognitive functioning.
Above you can see my forehead temperature index readings while I was casually surfing the Web in a relaxed manner. The readings dipped over time, then stabilized (blue line). I immediately shifted to a cognitive imagery exercise that requires a high degree of concentration (red line). Note the steady rise in forehead skin temperature.
Now here's the fascinating part: After 12 minutes doing the imagery exercise, I immediately returned to casually surfing the Web. Now, however, I was doing so in a very alert, attentive state. Instead of my temperature dropping, it continued to rise. I was engaging the Web while in the zone; I was highly focused on what I was reading.
Subjectively, my surfing experience was quite different as well. Initially the material I was reading seemed routine and not especially interesting. After the imagery exercise, however, I found my reading material more engaging. My recall is better for the latter material as well.
This, of course, is far from a controlled laboratory experiment, but I believe it makes an important point: Our experience of the world is mediated by our states of consciousness. In one state, I have low concentration and process little of what I experience. In another state, the same material becomes more interesting, and I learn more of it.
Colin Wilson, following the Russian philosopher Gurdjieff, has pointed out that human beings habitually operate at a subnormal level of consciousness. In essence, we operate much of the time along the blue line, not the red one. With intentional exercise, however, we can more frequently engage the world with mental energy and alertness.
How might such capacity for sustained operation in the zone affect performance in trading and in all fields? Might we be less likely to make impulsive trading errors under conditions of heightened awareness? Could we accelerate our learning of trading patterns while maintaining elevated frontal blood flows?
Surely this is a worthy frontier for neuroeconomics. It won't be long before hemoencephalography units and similar devices become widely available to the public--as commonly used for self-development as fitness equipment. With such methods, we will increasingly become the executives of our own minds.
Saturday, December 09, 2006
Musical Interlude
Wild Is The Wind - David Bowie: This was the song that opened my wedding reception. More than twenty years later, it's still the song I'd choose for Margie if we held another ceremony.
Winterborn - The Cruxshadows: Thoughts of a dying soldier on the battlefield. Violin, vocals, dance, classical images: beautiful.
Stripped - Rammstein: The Depeche Mode classic, reinterpreted to the images of Leni Riefenstahl's Olympia. Riefenstahl's association with the Nazis has been the source of controversy, but does not diminish the power of her celebration of the human body.
Trading's Mid-Life Crisis: Getting Bigger Vs. Getting Broader
Well, my trading mid-life crisis is nowhere near as dire as Santa's (thanks to the usually off-color Moohead for the cartoon link), but it's surprisingly common--and yet rarely discussed by trading coach/psych types.
The crisis arrives when you've hit a level of relatively consistent success in your trading. You're at an equity curve high; you're not taking large drawdowns; you're following your game plan; and you're comfortable.
Now what do you do? Do you get bigger (do more of what's working in larger size), or do you get broader (find non-correlated markets and time frames to exercise your edge)?
The reason we don't hear too much from the trading coaches and psychologists on this topic is that they tend to address that portion of the trading public that *isn't* successful: those who are not following their discipline and those who, perhaps, have not yet found their edge.
The successful trader has an edge and has the discipline to utilize it. The question becomes how to take maximum advantage.
It truly is a mid-life crisis for traders. In the mid-life crisis we normally think about, we get to the point where we're established in a career field and in a marriage/family. We realize that either we're going to coast to the finish line or tackle something new and challenging while we still have enough time and youthful energy to see it through. That 's really the same issue facing the successful trader.
And, in life as in trading, we facing the issue of getting bigger vs. getting broader. Do I build on success by growing my company and doing more of what is working, or do I begin to develop other aspects of my life and use this success as an opportunity to widen my horizons?
The problem with getting bigger is that you're bound to be at your maximum size when markets change and your edge erodes. I have seen this occur with many very successful traders at prop firms. In a sense, they were one-trick ponies and all their eggs were in the basket of that one trick. In my latest book, I refer to this as "first-order competence": the ability to master a particular market. "Second-order competence" is the ability to master markets as they change. Second-order competence requires going broader, not just bigger.
Systems developer and successful trader Henry Carstens weighs in on this issue with his most recent post. His point is that there is a limit to which you can keep doing more of the same thing. Eventually, you run into problems of collinearity: the overlap among trades. You're not just increasing your size, but your risk. Going broad by trading other time frames or other instruments diversifies risk. That strategy, we might say, is getting broader before you get bigger.
And, you know, that's what the great artists do. They don't just paint, write, or sing in the same style the same way throughout their careers. They remake themselves and keep their work fresh. Read the early biography of rocker John Mellencamp and then his latest bio. He has never stayed still. He was already successful when he announced to his band that everyone, for the next album, would have to learn a new instrument--himself included. Out of that emerged the folk/Appalachian style that made "Lonesome Jubilee" a hit. More recently, he has spent time atop the blues charts.
The time to get broader, I suspect, is when you're on top of your game, not when a shifting market forces you to adapt. It's time for me to learn a couple of new instruments. Too much of my profit has come from short-term countertrend (mean reversion) trades. In that sense, I'm no different from the momentum traders of the late 1990s. Feeling good and feeling flush, doing the same thing over and over. That, too, shall pass.
The explosion of ETFs has made it easier than ever for individual traders to get broader. Different time frames, different markets: when one strategy is drawing down, others are making money. Getting bigger without expanding risk: that's the goal of getting broader.
Friday, December 08, 2006
Assessing Market Psychology With Relative Options Indicators
In my last post, I proposed a different way to construct put and call options ratios. Specifically, the equity put ratio looks at equity put option volume as a fraction of its own 100-day moving average. Conversely, the equity call ratio measures equity call option volume as a proportion of its own 100-day moving average. The relative put/call ratio is the equity put ratio divided by the equity call ratio.
Going back to 2004 (N = 720 trading days), we have had 54 occasions in which the five-day equity put ratio has been above 1.2 *and* the five-day relative put/call ratio has been above 1.2. What this means is that we've had a five-day period of higher than average put activity relative to call activity that can be attributed specifically to speculator interest in puts.
Ten days following this spike in put activity, the S&P 500 Index (SPY) was up by an average of 1.11% (42 up, 12 down)--quite a bullish edge. The remaining days in the 2004-2006 sample were up by an average of only .25% (391 up, 275 down). It thus appears that, when put activity is high relative to call activity and relative to its own recent level of activity, returns are above average.
Now let's look at occasions in which the five-day equity call ratio has been above 1.2 (20+% more call options traded relative to the 100-day average) *and* the five-day relative put/call ratio has been below .90 (N = 69). What this means is that we've had a five-day period of higher than average call activity relative to put activity that can be attributed specifically to speculator interest in calls.
Ten days following this spike in call activity, SPY was up by an average of .69% (46 up, 23 down). That is considerably stronger than the average ten-day gain for the rest of the sample (.28%; 387 up, 264 down). It thus appears that, when call activity is high relative to put activity and relative to its own recent level of activity, we see superior returns over a two-week period.
What I'm seeing in the data so far is evidence of reversal effects (for puts) and momentum effects (for calls). When we get a significant expansion of put activity, it's usually in a falling market and that falling market tends to reverse itself. When we get a significant expansion of call activity, it's usually in a rising market and that bullishness enables the market to sustain its rise. In the current market, we see neither strongly elevated put or call activity on a five-day basis.
Clearly, there is much more to be studied in the options data, particularly at an intraday level. So far, at least, it does appear that the sentiment of options participants does have an impact on the distribution of future price changes in the stock indices. The way to superior returns, I suspect, is to look at new market data or to explore old data in new ways. Trading success, in that context, requires an unusual combination of tight discipline and open-minded creativity.
Going back to 2004 (N = 720 trading days), we have had 54 occasions in which the five-day equity put ratio has been above 1.2 *and* the five-day relative put/call ratio has been above 1.2. What this means is that we've had a five-day period of higher than average put activity relative to call activity that can be attributed specifically to speculator interest in puts.
Ten days following this spike in put activity, the S&P 500 Index (SPY) was up by an average of 1.11% (42 up, 12 down)--quite a bullish edge. The remaining days in the 2004-2006 sample were up by an average of only .25% (391 up, 275 down). It thus appears that, when put activity is high relative to call activity and relative to its own recent level of activity, returns are above average.
Now let's look at occasions in which the five-day equity call ratio has been above 1.2 (20+% more call options traded relative to the 100-day average) *and* the five-day relative put/call ratio has been below .90 (N = 69). What this means is that we've had a five-day period of higher than average call activity relative to put activity that can be attributed specifically to speculator interest in calls.
Ten days following this spike in call activity, SPY was up by an average of .69% (46 up, 23 down). That is considerably stronger than the average ten-day gain for the rest of the sample (.28%; 387 up, 264 down). It thus appears that, when call activity is high relative to put activity and relative to its own recent level of activity, we see superior returns over a two-week period.
What I'm seeing in the data so far is evidence of reversal effects (for puts) and momentum effects (for calls). When we get a significant expansion of put activity, it's usually in a falling market and that falling market tends to reverse itself. When we get a significant expansion of call activity, it's usually in a rising market and that bullishness enables the market to sustain its rise. In the current market, we see neither strongly elevated put or call activity on a five-day basis.
Clearly, there is much more to be studied in the options data, particularly at an intraday level. So far, at least, it does appear that the sentiment of options participants does have an impact on the distribution of future price changes in the stock indices. The way to superior returns, I suspect, is to look at new market data or to explore old data in new ways. Trading success, in that context, requires an unusual combination of tight discipline and open-minded creativity.
Thursday, December 07, 2006
A Different Way To Measure Market Sentiment With Options Data
I recently mentioned that I had begun a large research project to investigate historical patterns connecting options data to future movements in stocks. Some of my initial efforts have focused on the equity put/call ratio and its relationship to future equity index movements.
Suppose, however, we treat the put option data and the call option data as completely different time series. Might there be information in each that is obscured when we solely focus on the put/call ratio?
As a result, I calculated the ratio of each day's equity put volume relative to the average equity put volume over the past 100 trading sessions. This we will call the put ratio. I then calculated the equity call volume relative to the average equity call volume over the past 100 sessions. This we'll refer to as the call ratio.
Armed with a separate put ratio and call ratio, we can address the question of whether relative peaks and valleys in equity call and put volume reflect sentiment shifts that impact future stock prices.
Additionally, we can form a new relative put/call ratio that is the put ratio divided by the call ratio. In other words, the relative put/call ratio identifies whether we're getting more put or call activity in the market as a function of the past 100 days' volume.
It turns out that elevations in puts and calls have different impacts upon the S&P 500 Index (SPY). And the relative put/call ratio does a pretty good job as a sentiment measure and as a predictor of S&P 500 prices 1-20 days out. Tomorrow I will begin detailing some of these findings.
For now, suffice it to say that the relative put/call ratio got very low in mid November prior to the short, steep market drop. We have since moved to neutral levels in the put ratio, call ratio, and the relative put/call ratio.
When we have had such neutral levels on a one-day basis (N = 126), there has been no overall edge--bullish or bearish--over the next 1-2 days. When the neutral day occurs during a bearish five-day relative put/call period, however, the next two days in SPY average a gain of .24% (40 up, 23 down). When the neutral day occurs during a bullish five-day relative put/call period--which is what we have at present--the next two days in SPY average a loss of -.11% (27 up, 36 down).
The new options measures clearly point out that returns are superior following five-day periods of bearish sentiment and subnormal following five-day periods of bullish sentiment. By measuring bearishness (put ratio) separately from bullishness (call ratio), we can tease apart periods in which the traditional put/call ratio is high because of high put activity vs. low call activity. More soon to come...
Suppose, however, we treat the put option data and the call option data as completely different time series. Might there be information in each that is obscured when we solely focus on the put/call ratio?
As a result, I calculated the ratio of each day's equity put volume relative to the average equity put volume over the past 100 trading sessions. This we will call the put ratio. I then calculated the equity call volume relative to the average equity call volume over the past 100 sessions. This we'll refer to as the call ratio.
Armed with a separate put ratio and call ratio, we can address the question of whether relative peaks and valleys in equity call and put volume reflect sentiment shifts that impact future stock prices.
Additionally, we can form a new relative put/call ratio that is the put ratio divided by the call ratio. In other words, the relative put/call ratio identifies whether we're getting more put or call activity in the market as a function of the past 100 days' volume.
It turns out that elevations in puts and calls have different impacts upon the S&P 500 Index (SPY). And the relative put/call ratio does a pretty good job as a sentiment measure and as a predictor of S&P 500 prices 1-20 days out. Tomorrow I will begin detailing some of these findings.
For now, suffice it to say that the relative put/call ratio got very low in mid November prior to the short, steep market drop. We have since moved to neutral levels in the put ratio, call ratio, and the relative put/call ratio.
When we have had such neutral levels on a one-day basis (N = 126), there has been no overall edge--bullish or bearish--over the next 1-2 days. When the neutral day occurs during a bearish five-day relative put/call period, however, the next two days in SPY average a gain of .24% (40 up, 23 down). When the neutral day occurs during a bullish five-day relative put/call period--which is what we have at present--the next two days in SPY average a loss of -.11% (27 up, 36 down).
The new options measures clearly point out that returns are superior following five-day periods of bearish sentiment and subnormal following five-day periods of bullish sentiment. By measuring bearishness (put ratio) separately from bullishness (call ratio), we can tease apart periods in which the traditional put/call ratio is high because of high put activity vs. low call activity. More soon to come...
Gurdjieff, Turtles, and Trading
"The highest that a man can attain is to be able to do."
G. I. Gurdjieff
Most posts about trading, mine included, are about doing: what to do, what not to do. This is a post about how to do. This is an important post.
In Vonnegut's book Cat's Cradle, there is a religion called Bokononism. It is a collection of lies ("foma") that make life on the dreary island of San Lorenzo more palatable. Among other things, Cat's Cradle is a book about the role of lies in human life.
Philosopher and mystic G. I. Gurdjieff also emphasized the role of lies in human psychology. The greatest of lies that we tell ourselves, Gurdjieff asserted, was that we have free will. In reality, most of our actions are mechanical, tossed here and there by moods, whims, needs, and the impact of external events.
Of course, it is painful to face the fact that we lack control over our own lives. So we create our own personal Bokononisms. We take solace in New Year's resolutions and earnest plans for self-improvement that, like last year's exercise equipment, eventually become part of our forgotten mental furniture.
Psychologists would never exist if people had free will. Those with problems would read self-improvement books, take good advice, and end their problems straightaway. But, no; that's not how human psychology works. We can know what to do and we still don't do it. We know we're supposed to eat healthy foods; we know we should always be appreciative of our spouses; we should exercise, not overspend our savings accounts; and we should cut our losing trades.
Quite simply, people lack intentionality: the ability to sustain directed activity. They cannot do.
Gurdjieff's insight was that we lack intentionality because we fail to remember ourselves. In a state of self-awareness, we vow to do the right things. Once we exit that self-awareness, the right things vanish with it.
Zen masters spend years cultivating the capacity to remember themselves: to remain self-aware. They realize that free will begins with the ability to sustain a single thought--and only that thought. Sit quietly in a dark, silent room and make the effort to focus all your attention on a mental image of an empty vessel. See how long you can sustain the image without your attention drifting to random thoughts and images. Before long, you forget the vessel altogether...
So what does this have to do with trading?
In 1983, Richard Dennis and Bill Eckhardt sought to resolve their dispute over whether trading success could be taught or whether it is inborn. They tested a trading system, to be known as the Turtle Trading System, and taught it to their group of novice traders.
Legend has it that the Turtles went on to become wildly successful traders. But, of course, like much of history, that is a pack of foma.
The Turtles varied significantly in their trading performance. Some followed the rules Faithfully and made significant money. Others did not and could not follow the rules and were dropouts from the experiment. Intentionality, not the system rules (which were the same for all traders), predicted trading success.
And now I will give away the secret of the Turtle Trading System and why it so effectively illustrates Gurdjieff's insights:
The Turtle Trading System is a system for losing money.
It makes losing money scientific and details precisely how it should be done.
Most traders want lies: how to make money easily, without the constraint of rules or the demands of research. They do not want an education in how to lose money, because they do not want to lose money.
And that is why they never make money.
The precise rules for the System are readily available and there is even software that will tweak the rules and identify the most promising markets to trade. According to Alexa, less than 4 people in a million will visit those pages. And, let's be generous and say that 10% of those visitors make the effort of downloading the rules and 10% of them can actually follow the rules to learn how to lose money.
That leaves us with very few people.
Gurdjieff taught, "If we do what we like doing, we are immediately rewarded by the pleasure of doing it. If we do what we don’t like doing the reward must come later. It is a mathematical law and all life is mathematics."
Not many people like learning how to lose.
Losing money with intentionality: that's a useful secret of the Turtle Trading System, even for those who aren't Turtle System traders.
Wednesday, December 06, 2006
Early December Morning With The Doc
10:10 AM CT - OK, I would have loved to have seen a more exciting day for our morning session, but as always we take what the market gives us. My research suggested subnormal returns going forward and my read of the volume and TICK suggested a range bound day. That had me shorting early in the session when we traded above the prior day's average price. That was a very nice trade idea, but it paid out only moderately, which again clued me into a slow, rangebound day. When I saw institutions jump into the market and the TICK distribution go positive, I decided to enter in the direction of the market trend from the last two days as long as TICK stayed healthy. I knew that such a trade was flying in the face of the rangebound thesis, but my risk-reward was pretty good. As it happened, the market did slow down and I had to bail out with a small loss when the TICK no longer looked healthy to me. The main thing for today was using research and market data to figure out what kind of day it was likely to be and then to frame trades patiently rather than chase moves that reverse. Tomorrow's a fresh day...and we may see more slow trade ahead of Friday's numbers. Hope this morning's session has given you some ideas for how to track markets. Let's do it again later this month. Have a great day!
10:00 AM CT - Well, our AM range has been about 4-3/4 points on ES, so the range bound notion has held up so far. I decided to let that last trade breathe, but buyers just didn't come in on the heels of the program trades. We know that from the diminished volume and weak price action on bounces in the TICK. My trading is finished for the day. I'm just not seeing enough opportunity to continue, given the likelihood of trade slowing down further as we head into the midday hours. Back with a wrap up in a few.
9:55 AM CT - OK, lost half a point on that one. Back in a few.
9:50 AM CT - Sticking with the long position, but have my stop in place. As long as the TICK stays skewed to buyers, I'll stick with the position. We've been treading water with lower volume since those buy programs hit. I'm seeing if we can test those overnight highs in ES.
9:26 AM CT - Long some ES
9:21 AM CT - Buy programs hit the market in force; that was institutional and with solid volume lifting offers. One idea to toy with is that we've made our low for the day. As long as the buyers remain in the market lifting offers, we should see a test of the preopen highs.
9:15 AM CT - It's trading more and more like a local-dominated market. No real trend. Note that we made new AM lows in ES and Russell, but not in NAZ, and then we reversed the selling. Those types of thrusts up and down with frequent reversals of the moves are typical of markets dominated by locals. It's dangerous to chase such moves, which is one reason I wasn't selling the ES on that recent move down. Note also how the TICK is starting to turn upward. Let's see how things look on the next TICK pullback.
9:06 AM - Dollar weakening, rates dropping; take a look and let's see how stocks react.
9:04 AM CT - There's a seller's skew to the NYSE TICK and the TIKI and we continue to see sellers hitting bids in the ES. That has to turn around for me to take the long side this AM. Put/call activity remains bullish, though not quite as much as at the open. TRIN is still a touch below 1.0, but drifting higher. Declining stocks lead advancers by 765. My leaning is to sell bounces that occur on successively lower price lows.
8:55 AM CT - When we look at what the large ES traders are doing, we're seeing that there isn't a huge amount of large trader activity so far this AM, but what there is remains skewed to hitting bids. Note that semiconductors and NAZ did not make fresh AM lows on the very recent selling. I'm not seeing a big selling push among institutions so far, and yet there's no substantial buying either. That keeps me on the sidelines. If I have to content myself with one trade for the day, so be it. I don't trade unless a solid idea in line with my research presents itself. That's the discipline part of trading. Waiting like the sniper for the one good shot.
8:46 AM CT - Took profits; not much, point and a half. All this so far is consistent with range bound, pretty slow action; nothing fundamentally driving the market. We're not seeing decisive selling in the TICK and that had me taking what the market gave me.
8:37 AM CT - Note the bullish put/call ratio, but we're not seeing decisive lifting of offers either in the ES (Market Delta) or among the broad list of stocks (NYSE TICK). Declining stocks lead advancers by -525 as I write and volume is not outstanding. This is consistent with a range bound day so far. We already hit the avg price from yesterday on my trade. That was first target.
8:32 AM CT - Small short position in ES here.
8:20 AM CT - Here's the link to the Mortgage Bankers Association weekly survey of mortgage applications. Note that we're seeing an uptick in mortgage loan application and an uptick in refinancing. The dollar initially strengthened vs. the Euro on the news, but has since fallen back. Stocks initially rallied, but also fell back and since have stabilized. Interest rates are up and are hovering at those higher levels. The important thing is that we're not seeing a move outside yesterday's trading range in the equities. So the market is not treating the housing news as being of fundamental importance to stocks. I will be looking closely to see if the ES can move above the 1417.5 level that was rejected after the news came out. If so, with meaningful volume, that would be fresh buying and worth following. Conversely, an inability to surmount that pre-opening level would target yesterday's average price and yesterday's trading lows. These are the kind of what-if scenarios I play with prior to the open. The goal is to anticipate various situations and to be ready to act decisively if and when they occur.
8:05 AM CT - SOX to be you...notice how the semiconductors have lagged during the recent runup in stocks. I'll be watching the semis this AM. As I noted in today's Weblog, we're also seeing lagging action in the European bourses. If you missed my post on what I look for in the initial minutes of trading, do check that out. My main focus initially is simply volume: how much we're getting and how it's distributed. That will tell us who's in the market and which way, if any, they're leaning. So far, we're retracing some of the recent action: dollar up, interest rates up, gold down, oil down. Let's see how stocks respond. Back before the open.
7:40 AM CT - Good morning! We'll be talking a bit about the equity put/call ratio this AM, so check out the chart on the Trading Psychology Weblog and the recent blog post on the topic. As the Weblog noted, my research finds subnormal returns in the near term following periods of bullish intraday sentiment. This also fits with the put/call research mentioned in the blog post. We've got some strength in the dollar and a rise in interest rates prior to the open--both retracing movements from the last few days. That's weighing a bit on stocks in the pre-opening market, which are trading back toward the average price from Tuesday (1414.5). We see overnight resistance at 1417.5 and some support from Tuesday AM at 1412.25. There are no major numbers out today, although we will see crude inventories reported at 9:30 AM CT. The big unemployment numbers are due Friday, so we could see trade slow down as we approach that time. I'll be watching volume early in the session to see who is in the market and how much participation there is. My initial leaning is to expect a relatively slow, rangebound day, as we digest good gains from the last two trading sessions. We've had good participation on that rise, so it will take some distinct bearish intraday sentiment--traders aggressively hitting bids--to get me short for anything other than a short-term trade. I am going to be especially alert for market rises that either fail to breach the overnight resistance or that test the highs with poor participation (i.e., many sectors failing to make new highs). Those will be candidates for fading. Back before the open.
10:00 AM CT - Well, our AM range has been about 4-3/4 points on ES, so the range bound notion has held up so far. I decided to let that last trade breathe, but buyers just didn't come in on the heels of the program trades. We know that from the diminished volume and weak price action on bounces in the TICK. My trading is finished for the day. I'm just not seeing enough opportunity to continue, given the likelihood of trade slowing down further as we head into the midday hours. Back with a wrap up in a few.
9:55 AM CT - OK, lost half a point on that one. Back in a few.
9:50 AM CT - Sticking with the long position, but have my stop in place. As long as the TICK stays skewed to buyers, I'll stick with the position. We've been treading water with lower volume since those buy programs hit. I'm seeing if we can test those overnight highs in ES.
9:26 AM CT - Long some ES
9:21 AM CT - Buy programs hit the market in force; that was institutional and with solid volume lifting offers. One idea to toy with is that we've made our low for the day. As long as the buyers remain in the market lifting offers, we should see a test of the preopen highs.
9:15 AM CT - It's trading more and more like a local-dominated market. No real trend. Note that we made new AM lows in ES and Russell, but not in NAZ, and then we reversed the selling. Those types of thrusts up and down with frequent reversals of the moves are typical of markets dominated by locals. It's dangerous to chase such moves, which is one reason I wasn't selling the ES on that recent move down. Note also how the TICK is starting to turn upward. Let's see how things look on the next TICK pullback.
9:06 AM - Dollar weakening, rates dropping; take a look and let's see how stocks react.
9:04 AM CT - There's a seller's skew to the NYSE TICK and the TIKI and we continue to see sellers hitting bids in the ES. That has to turn around for me to take the long side this AM. Put/call activity remains bullish, though not quite as much as at the open. TRIN is still a touch below 1.0, but drifting higher. Declining stocks lead advancers by 765. My leaning is to sell bounces that occur on successively lower price lows.
8:55 AM CT - When we look at what the large ES traders are doing, we're seeing that there isn't a huge amount of large trader activity so far this AM, but what there is remains skewed to hitting bids. Note that semiconductors and NAZ did not make fresh AM lows on the very recent selling. I'm not seeing a big selling push among institutions so far, and yet there's no substantial buying either. That keeps me on the sidelines. If I have to content myself with one trade for the day, so be it. I don't trade unless a solid idea in line with my research presents itself. That's the discipline part of trading. Waiting like the sniper for the one good shot.
8:46 AM CT - Took profits; not much, point and a half. All this so far is consistent with range bound, pretty slow action; nothing fundamentally driving the market. We're not seeing decisive selling in the TICK and that had me taking what the market gave me.
8:37 AM CT - Note the bullish put/call ratio, but we're not seeing decisive lifting of offers either in the ES (Market Delta) or among the broad list of stocks (NYSE TICK). Declining stocks lead advancers by -525 as I write and volume is not outstanding. This is consistent with a range bound day so far. We already hit the avg price from yesterday on my trade. That was first target.
8:32 AM CT - Small short position in ES here.
8:20 AM CT - Here's the link to the Mortgage Bankers Association weekly survey of mortgage applications. Note that we're seeing an uptick in mortgage loan application and an uptick in refinancing. The dollar initially strengthened vs. the Euro on the news, but has since fallen back. Stocks initially rallied, but also fell back and since have stabilized. Interest rates are up and are hovering at those higher levels. The important thing is that we're not seeing a move outside yesterday's trading range in the equities. So the market is not treating the housing news as being of fundamental importance to stocks. I will be looking closely to see if the ES can move above the 1417.5 level that was rejected after the news came out. If so, with meaningful volume, that would be fresh buying and worth following. Conversely, an inability to surmount that pre-opening level would target yesterday's average price and yesterday's trading lows. These are the kind of what-if scenarios I play with prior to the open. The goal is to anticipate various situations and to be ready to act decisively if and when they occur.
8:05 AM CT - SOX to be you...notice how the semiconductors have lagged during the recent runup in stocks. I'll be watching the semis this AM. As I noted in today's Weblog, we're also seeing lagging action in the European bourses. If you missed my post on what I look for in the initial minutes of trading, do check that out. My main focus initially is simply volume: how much we're getting and how it's distributed. That will tell us who's in the market and which way, if any, they're leaning. So far, we're retracing some of the recent action: dollar up, interest rates up, gold down, oil down. Let's see how stocks respond. Back before the open.
7:40 AM CT - Good morning! We'll be talking a bit about the equity put/call ratio this AM, so check out the chart on the Trading Psychology Weblog and the recent blog post on the topic. As the Weblog noted, my research finds subnormal returns in the near term following periods of bullish intraday sentiment. This also fits with the put/call research mentioned in the blog post. We've got some strength in the dollar and a rise in interest rates prior to the open--both retracing movements from the last few days. That's weighing a bit on stocks in the pre-opening market, which are trading back toward the average price from Tuesday (1414.5). We see overnight resistance at 1417.5 and some support from Tuesday AM at 1412.25. There are no major numbers out today, although we will see crude inventories reported at 9:30 AM CT. The big unemployment numbers are due Friday, so we could see trade slow down as we approach that time. I'll be watching volume early in the session to see who is in the market and how much participation there is. My initial leaning is to expect a relatively slow, rangebound day, as we digest good gains from the last two trading sessions. We've had good participation on that rise, so it will take some distinct bearish intraday sentiment--traders aggressively hitting bids--to get me short for anything other than a short-term trade. I am going to be especially alert for market rises that either fail to breach the overnight resistance or that test the highs with poor participation (i.e., many sectors failing to make new highs). Those will be candidates for fading. Back before the open.
What We Can Learn From The Equity Put/Call Ratio
If you take a look at today's Weblog entry, you'll notice a chart of the equity put/call ratio for yesterday, December 5th, on a five-minute basis. That chart, which I was unfortunately unable to post here due to some technical difficulties, is worth a bit of study.
We opened with the put/call ratio at about .59, well below the 100-day average ratio of .78. That tells us right away that call buyers are being more aggressive than put buyers in relative terms. When we also see, from the NYSE TICK, that traders are lifting offers in more stocks than they're hitting bids, it clearly tells us that the market's initial sentiment is bullish.
By tracking the TICK and the equity put/call ratio through the day, we can determine whether or not bullish sentiment is increasing or reversing during the session. The Weblog chart shows us clearly that, as the afternoon wore on, call buyers continued to be more aggressive than put buyers. Indeed, we saw a downward move in the put/call ratio leading the market's afternoon rise toward its highs.
When bullish sentiment is sustained--and especially when it's expanding--during the day, fading market moves can be costly.
The 1-5 day market forecast when we have put/call sentiment extremes, however, suggests that we should fade those extremes. Since 2004 (N = 733), when we have a relative put/call ratio (i.e., the ratio of the current put/call reading to the 100-day average) that is below .70 (N = 26), the next five days in SPY average a loss of -.18% (11 up, 15 down). When the relative put/call ratio has been above 1.4 (N = 31), the next five days in SPY have averaged a gain of .21% (18 up, 13 down).
Indeed, when the relative put/call ratio is above 1.0, the next day in SPY averages a gain of .07%. When the relative ratio is below 1.0, the next day in SPY averages a loss of -.01%. All other things being equal, bullish sentiment tends not to carry over to the next day's trading.
As my research with options and stock market trading patterns continues, I will be reporting on further results.
We opened with the put/call ratio at about .59, well below the 100-day average ratio of .78. That tells us right away that call buyers are being more aggressive than put buyers in relative terms. When we also see, from the NYSE TICK, that traders are lifting offers in more stocks than they're hitting bids, it clearly tells us that the market's initial sentiment is bullish.
By tracking the TICK and the equity put/call ratio through the day, we can determine whether or not bullish sentiment is increasing or reversing during the session. The Weblog chart shows us clearly that, as the afternoon wore on, call buyers continued to be more aggressive than put buyers. Indeed, we saw a downward move in the put/call ratio leading the market's afternoon rise toward its highs.
When bullish sentiment is sustained--and especially when it's expanding--during the day, fading market moves can be costly.
The 1-5 day market forecast when we have put/call sentiment extremes, however, suggests that we should fade those extremes. Since 2004 (N = 733), when we have a relative put/call ratio (i.e., the ratio of the current put/call reading to the 100-day average) that is below .70 (N = 26), the next five days in SPY average a loss of -.18% (11 up, 15 down). When the relative put/call ratio has been above 1.4 (N = 31), the next five days in SPY have averaged a gain of .21% (18 up, 13 down).
Indeed, when the relative put/call ratio is above 1.0, the next day in SPY averages a gain of .07%. When the relative ratio is below 1.0, the next day in SPY averages a loss of -.01%. All other things being equal, bullish sentiment tends not to carry over to the next day's trading.
As my research with options and stock market trading patterns continues, I will be reporting on further results.
Tuesday, December 05, 2006
What You Can Learn From The Opening Minutes Of Trading
Is today likely to be a trending day or a range bound day? Are we likely to see volatile price action or slow meandering? Are we likely to test recent highs or lows? All of these are important questions for short-term traders as they begin their days. Because most stocks show a significant, positive correlation with the movement of the stock indices, handicapping the odds of the index moving in a particular way can provide a useful edge. Here are a few items on my radar during the opening minutes of trading. Hopefully I'll be able to illustrate some of them during tomorrow's Morning With the Doc session:
1) Trading volume in the first few five-minute segments of the session - Volume correlates very highly with volatility, and volume tells us if large, institutional participants are in the market. Low volume compared with recent norms tells us that we have a market dominated primarily by locals and we can expect lower volatility and range bound trade. The volatile, trending moves tend to occur when we sustain above average volume.
2) The distribution of the NYSE TICK ($TICK) and the Dow TICK ($TIKI) - Recall that the TICK measures are constant updates on the number of stocks trading at their offer price minus those trading at their bids. These provide us with the shortest-term sentiment information possible. As with volume, I am looking at how the TICK measures are distributed relative to recent norms. If we see both TICK measures skewed in a positive direction relative to recent sessions, the odds of sustained upward movement are greatly increased. Similarly, a sustained negative skew to the TICK measures tends to occur during downward trending days. It's where we see little skew and/or a mixed skew between the two measures that we tend to get range bound action.
3) The behavior of global markets - I keep my eye not only on European stocks, but also on gold, oil, bonds, and the dollar. If these markets are moving significantly and breaking out to new levels, we're more likely to see a repricing of equities. Quiet global macro markets provide little incentive for large traders to reprice equities, and that's when we see range bound drifting markets.
4) Recent trading ranges and support/resistance - Think in Market Profile terms. We want to identify the market's value range, and we want to identify how the market trades as we test the upper and lower boundaries of that range. The first range that is important to me is the pre-opening Globex range. I also want to look at the range from 7:30 AM CT to the open if we've had an economic report prior to the open. Ditto the 7:30 AM - 9:00 AM CT range if we get numbers early in the trading session. We also want to be aware of the previous day's range and how the market trades as we test prior days' highs and lows. If we cannot generate increased volume and participation as the market tests range extremes, we're much more likely to fall back into that range.
5) Distribution of volume, especially of trades by large traders - This is the data I gather from the Market Delta program. I'm looking at the proportion of volume in my instrument (usually the ES futures) that is occurring at the bid price vs. the offer. I also place volume filters on the data so that I only observe the distribution of large trades at the bid vs. offer. This tells me if large locals and large institutions are primarily buyers or sellers. I always want to be trading in the direction of the whales. Always.
So there you have it. Every single trade I place is an idea derived from some combination of the above information. No, I don't look at chart patterns, oscillator readings, Fib levels, or wave patterns. If you utilize such methods and have found success, perhaps some of the above pieces of information will help your batting average. If those methods are not making you money, perhaps you'll want to weight the above factors more highly. The idea is to see *how* the market is trading and *who* is participating in the market. Within the opening minutes of trading, you can hold your finger to the market air and figure out which way the wind is blowing. That, in itself, can confer a meaningful edge.
1) Trading volume in the first few five-minute segments of the session - Volume correlates very highly with volatility, and volume tells us if large, institutional participants are in the market. Low volume compared with recent norms tells us that we have a market dominated primarily by locals and we can expect lower volatility and range bound trade. The volatile, trending moves tend to occur when we sustain above average volume.
2) The distribution of the NYSE TICK ($TICK) and the Dow TICK ($TIKI) - Recall that the TICK measures are constant updates on the number of stocks trading at their offer price minus those trading at their bids. These provide us with the shortest-term sentiment information possible. As with volume, I am looking at how the TICK measures are distributed relative to recent norms. If we see both TICK measures skewed in a positive direction relative to recent sessions, the odds of sustained upward movement are greatly increased. Similarly, a sustained negative skew to the TICK measures tends to occur during downward trending days. It's where we see little skew and/or a mixed skew between the two measures that we tend to get range bound action.
3) The behavior of global markets - I keep my eye not only on European stocks, but also on gold, oil, bonds, and the dollar. If these markets are moving significantly and breaking out to new levels, we're more likely to see a repricing of equities. Quiet global macro markets provide little incentive for large traders to reprice equities, and that's when we see range bound drifting markets.
4) Recent trading ranges and support/resistance - Think in Market Profile terms. We want to identify the market's value range, and we want to identify how the market trades as we test the upper and lower boundaries of that range. The first range that is important to me is the pre-opening Globex range. I also want to look at the range from 7:30 AM CT to the open if we've had an economic report prior to the open. Ditto the 7:30 AM - 9:00 AM CT range if we get numbers early in the trading session. We also want to be aware of the previous day's range and how the market trades as we test prior days' highs and lows. If we cannot generate increased volume and participation as the market tests range extremes, we're much more likely to fall back into that range.
5) Distribution of volume, especially of trades by large traders - This is the data I gather from the Market Delta program. I'm looking at the proportion of volume in my instrument (usually the ES futures) that is occurring at the bid price vs. the offer. I also place volume filters on the data so that I only observe the distribution of large trades at the bid vs. offer. This tells me if large locals and large institutions are primarily buyers or sellers. I always want to be trading in the direction of the whales. Always.
So there you have it. Every single trade I place is an idea derived from some combination of the above information. No, I don't look at chart patterns, oscillator readings, Fib levels, or wave patterns. If you utilize such methods and have found success, perhaps some of the above pieces of information will help your batting average. If those methods are not making you money, perhaps you'll want to weight the above factors more highly. The idea is to see *how* the market is trading and *who* is participating in the market. Within the opening minutes of trading, you can hold your finger to the market air and figure out which way the wind is blowing. That, in itself, can confer a meaningful edge.
Monday, December 04, 2006
Tuesday Blog Links and Market Stats
Note: The Trading Psychology Weblog will resume daily posting Tuesday night. Wednesday AM will be another Morning With the Doc session, in which we'll track the market in real time.
Market Ideas:
Trader Feed's three steps toward self-improvement in trading.
Divergent thinking, a key to the pros' success, from Trading Markets.
I like how Seeking Alpha parcels blog content into long ideas, short ideas, sector themes, etc. Here's an interesting perspective on lower dollar, higher stocks.
Excellent economic overview and perspective on Turkey from Yaser Anwar.
Kirk takes a look at the CNBC stock screener.
Trader Mike tracks new highs in the indices.
Trading the Charts, with a variety of market perspectives in its December newsletter.
Resilience and more from Adam Warner.
Sentiment and more from Abnormal Returns.
Very thoughtful post on buying bonds from Random Roger.
Market Expectations:
My measure of upside momentum (Demand) to downside momentum (Supply) rose on Monday to 149:27. Recall that this measure tracks the number of stocks closing above their volatility envelopes vs. those closing below. We're seeing the number of stocks with strong upside momentum outnumber those with weak momentum by more than 5:1. In general, we tend to be more likely to see upside follow through 1-5 days out following new highs with broad participation vs. new highs with weak participation.
The number of S&P 500 stocks making fresh 52-week highs rose nicely to 65 on Monday, although that remains below the 80 level recorded about two weeks ago. Among the S&P 600 small caps, new highs were 56, down from a little over 80 two weeks ago. As long as we make day over day highs and expand the number of stocks making new highs, the short-term trend has to be considered bullish.
Note that this rally has actually broadened. The Russell 2000 made a new high on Monday, but the Dow did not. In general, weakening markets don't broaden to the upside.
Market Ideas:
Trader Feed's three steps toward self-improvement in trading.
Divergent thinking, a key to the pros' success, from Trading Markets.
I like how Seeking Alpha parcels blog content into long ideas, short ideas, sector themes, etc. Here's an interesting perspective on lower dollar, higher stocks.
Excellent economic overview and perspective on Turkey from Yaser Anwar.
Kirk takes a look at the CNBC stock screener.
Trader Mike tracks new highs in the indices.
Trading the Charts, with a variety of market perspectives in its December newsletter.
Resilience and more from Adam Warner.
Sentiment and more from Abnormal Returns.
Very thoughtful post on buying bonds from Random Roger.
Market Expectations:
My measure of upside momentum (Demand) to downside momentum (Supply) rose on Monday to 149:27. Recall that this measure tracks the number of stocks closing above their volatility envelopes vs. those closing below. We're seeing the number of stocks with strong upside momentum outnumber those with weak momentum by more than 5:1. In general, we tend to be more likely to see upside follow through 1-5 days out following new highs with broad participation vs. new highs with weak participation.
The number of S&P 500 stocks making fresh 52-week highs rose nicely to 65 on Monday, although that remains below the 80 level recorded about two weeks ago. Among the S&P 600 small caps, new highs were 56, down from a little over 80 two weeks ago. As long as we make day over day highs and expand the number of stocks making new highs, the short-term trend has to be considered bullish.
Note that this rally has actually broadened. The Russell 2000 made a new high on Monday, but the Dow did not. In general, weakening markets don't broaden to the upside.
Three Relentless Steps You Can Take Now Toward Becoming A Better Trader
One of the goals of my book Enhancing Trader Performance was to figure out what makes successful performers tick--in any field of endeavor. What I learned in researching the field was that talent--inborn abilities--are necessary for success, but not sufficient. It's how people channel their talents by structuring their learning processes (i.e., their building of skills) that ultimately determines whether or not they become elite performers. Here are three straightforward ways you can structure your learning to make the most of your talents:
1) Keep score. Relentlessly. When Lance Armstrong's performance team works with him, no aspect of performance is ignored. They measure his stance in the bike to minimize wind resistance; they measure his pedaling frequency to maximize his speed and minimize his effort; and they tweak the design of the bike to achieve every possible edge. His cycling performance may be art, but behind it is plenty of science. So it is in other performance domains, from NASCAR to chess to ballet: the greats study what they do to constantly improve. Take a look at the performance metrics that professional traders collect to figure out their strengths and weaknesses. They figure out how they perform in rising, falling, and flat markets; they evaluate their performance as a function of being long or short and as a function of time of day. Keeping score builds the motivation to continuously improve, but it also tells you which improvements to make. Track every trade you make: How much did it go against you while you were in the trade? How much did it go your way after you exited? How could you have recognized that it was a winner (so that you could have scaled in with more size) or a loser (so that you could have exited with minimal loss)? The really great performers make themselves a subject of study.
2) Study the market. Relentlessly. There's a reason why the great basketball and football coaches review game tapes obsessively with their teams. There's also a reason why chess grandmasters play and replay games from past tournaments. So much of performance--especially in trading--boils down to pattern recognition, and so much of pattern recognition boils down to multiple, high-quality exposures to the marketplace. A program that I use called Market Delta breaks down trades by their size and by whether they were transacted at the market bid or offer. That way, we can see if large traders are leaning to the buy or sell side. A replay feature in the program enables us to review each market day and see how the buying or selling unfolded. This provides us with many more of those high-quality market exposures than we could ever hope to get from simple live trading. In my book, I mention a learning technique used by many of the most successful traders I've known: they videotape their trading and then review the tapes after the close. It's a great way to review what the markets did--and how you responded. After a while, the patterns jump out at you.
3) Read. Relentlessly. Particularly for the independent trader, trading can be an extremely isolating activity. It's easy to get locked in your own head, your own ideas. If you look at the life histories of expert performers in various fields, you find that most of them have not been isolated. They have had mentors at various points in their careers to help them learn and grow. How can you pick the brains of the world's greatest traders and investors? Books and blogs offer one important avenue. True, there are many fluff books and self-absorbed blogs, but there are a few written by the pros that are worth their weight in gold. Right now, I'm reading Inside the House of Money by Steven Drobny. It's a wonderful collection of interviews that gets inside the heads of global macro traders. I'm also reading Ken Fisher's new text, The Only Three Questions That Count. He explodes a number of market myths and models a way of thinking about markets that has led him to consistent success as a money manager. Take a look at blogs written by Barry Ritholtz and Bill Cara; read the extensive Q&A sessions posted by Charles Kirk in his Members section. You may not agree with all their conclusions, but you'll learn how they think about markets. That is mentorship-by-observation.
It takes a relentless pursuit of excellence to become excellent: that is what I learned from my performance research. You can only sustain such a pursuit if you truly love what you're doing; if it captivates your very being. If you're not relentless in your pursuit of trading success, perhaps it's not that you need discipline or motivation. Perhaps trading is not the domain in which you were meant to excel. What my daughter Devon taught me is that somehow, somewhere there is a kind of productive activity you were meant to do. And when you find it, you will be relentless, because you want to be doing nothing else.
1) Keep score. Relentlessly. When Lance Armstrong's performance team works with him, no aspect of performance is ignored. They measure his stance in the bike to minimize wind resistance; they measure his pedaling frequency to maximize his speed and minimize his effort; and they tweak the design of the bike to achieve every possible edge. His cycling performance may be art, but behind it is plenty of science. So it is in other performance domains, from NASCAR to chess to ballet: the greats study what they do to constantly improve. Take a look at the performance metrics that professional traders collect to figure out their strengths and weaknesses. They figure out how they perform in rising, falling, and flat markets; they evaluate their performance as a function of being long or short and as a function of time of day. Keeping score builds the motivation to continuously improve, but it also tells you which improvements to make. Track every trade you make: How much did it go against you while you were in the trade? How much did it go your way after you exited? How could you have recognized that it was a winner (so that you could have scaled in with more size) or a loser (so that you could have exited with minimal loss)? The really great performers make themselves a subject of study.
2) Study the market. Relentlessly. There's a reason why the great basketball and football coaches review game tapes obsessively with their teams. There's also a reason why chess grandmasters play and replay games from past tournaments. So much of performance--especially in trading--boils down to pattern recognition, and so much of pattern recognition boils down to multiple, high-quality exposures to the marketplace. A program that I use called Market Delta breaks down trades by their size and by whether they were transacted at the market bid or offer. That way, we can see if large traders are leaning to the buy or sell side. A replay feature in the program enables us to review each market day and see how the buying or selling unfolded. This provides us with many more of those high-quality market exposures than we could ever hope to get from simple live trading. In my book, I mention a learning technique used by many of the most successful traders I've known: they videotape their trading and then review the tapes after the close. It's a great way to review what the markets did--and how you responded. After a while, the patterns jump out at you.
3) Read. Relentlessly. Particularly for the independent trader, trading can be an extremely isolating activity. It's easy to get locked in your own head, your own ideas. If you look at the life histories of expert performers in various fields, you find that most of them have not been isolated. They have had mentors at various points in their careers to help them learn and grow. How can you pick the brains of the world's greatest traders and investors? Books and blogs offer one important avenue. True, there are many fluff books and self-absorbed blogs, but there are a few written by the pros that are worth their weight in gold. Right now, I'm reading Inside the House of Money by Steven Drobny. It's a wonderful collection of interviews that gets inside the heads of global macro traders. I'm also reading Ken Fisher's new text, The Only Three Questions That Count. He explodes a number of market myths and models a way of thinking about markets that has led him to consistent success as a money manager. Take a look at blogs written by Barry Ritholtz and Bill Cara; read the extensive Q&A sessions posted by Charles Kirk in his Members section. You may not agree with all their conclusions, but you'll learn how they think about markets. That is mentorship-by-observation.
It takes a relentless pursuit of excellence to become excellent: that is what I learned from my performance research. You can only sustain such a pursuit if you truly love what you're doing; if it captivates your very being. If you're not relentless in your pursuit of trading success, perhaps it's not that you need discipline or motivation. Perhaps trading is not the domain in which you were meant to excel. What my daughter Devon taught me is that somehow, somewhere there is a kind of productive activity you were meant to do. And when you find it, you will be relentless, because you want to be doing nothing else.
Sunday, December 03, 2006
Blog Links and Market Stats for Monday AM
Market Ideas:
Trader Mike tracks the recent volatility in the indices.
Declan Fallond finds weakness among internals.
A Dash of Insight questions the negative spin on economic data.
How Trader X screens for gap trades.
Altucher's links, including playing the baby boomers in China.
Trader Eyal on process improvement in trading.
Weekend linkfest from Barry Ritholtz.
Bill Cara explains his market stance with a broad perspective.
Adam Warner passes along some very interesting observations on correlations.
Energy has been the strongest sector of late, finds Ticker Sense.
24/7 Wall St. finds e-commerce and Amazon looking healthy.
Carl Futia revises his forecast and offers a perspective on flexibility in forecasting.
Millionaire Now! on profiting from the office condo boom.
Interesting market stampede notion is among the links at Abnormal Returns.
Market Perspective:
I took a look at the intraday volatility of market days in the ES futures, given the sharp moves during Friday's trading session. I did not find a directional bias following such volatile days, but did find evidence of serial correlation. In other words, these volatile days tend to cluster. That will have me looking for further volatility early in the week, particularly if we continue to see sharp moves in the dollar and interest rates.
Despite recent downmoves on Monday and Friday of this past week, we're still seeing over 73% of S&P 500 stocks trading above their 50-day moving averages. That figure is almost 66% for the S&P 600 small caps. At 34 new 52-week highs among S&P 500 stocks, we're well off the momentum peaks from a couple of weeks ago, not to mention the March-May peaks. But how many S&P 500 stocks made new annual lows on Friday? Zero.
In other words, we've been seeing volatility, but not sustained weakness. Each time we've had strong selling, buyers have jumped in. Funds are judged by their annual performance and perhaps no one wants to be on record at year's end as out of the equity market. Whatever the cause, if the buyers continue to absorb this selling we could see further tests of the market highs in the not too distant future. The options players are bearish and the economic weakness and weak dollar are on everyone's radar. The contrarian in me wonders about the upside.
Trader Mike tracks the recent volatility in the indices.
Declan Fallond finds weakness among internals.
A Dash of Insight questions the negative spin on economic data.
How Trader X screens for gap trades.
Altucher's links, including playing the baby boomers in China.
Trader Eyal on process improvement in trading.
Weekend linkfest from Barry Ritholtz.
Bill Cara explains his market stance with a broad perspective.
Adam Warner passes along some very interesting observations on correlations.
Energy has been the strongest sector of late, finds Ticker Sense.
24/7 Wall St. finds e-commerce and Amazon looking healthy.
Carl Futia revises his forecast and offers a perspective on flexibility in forecasting.
Millionaire Now! on profiting from the office condo boom.
Interesting market stampede notion is among the links at Abnormal Returns.
Market Perspective:
I took a look at the intraday volatility of market days in the ES futures, given the sharp moves during Friday's trading session. I did not find a directional bias following such volatile days, but did find evidence of serial correlation. In other words, these volatile days tend to cluster. That will have me looking for further volatility early in the week, particularly if we continue to see sharp moves in the dollar and interest rates.
Despite recent downmoves on Monday and Friday of this past week, we're still seeing over 73% of S&P 500 stocks trading above their 50-day moving averages. That figure is almost 66% for the S&P 600 small caps. At 34 new 52-week highs among S&P 500 stocks, we're well off the momentum peaks from a couple of weeks ago, not to mention the March-May peaks. But how many S&P 500 stocks made new annual lows on Friday? Zero.
In other words, we've been seeing volatility, but not sustained weakness. Each time we've had strong selling, buyers have jumped in. Funds are judged by their annual performance and perhaps no one wants to be on record at year's end as out of the equity market. Whatever the cause, if the buyers continue to absorb this selling we could see further tests of the market highs in the not too distant future. The options players are bearish and the economic weakness and weak dollar are on everyone's radar. The contrarian in me wonders about the upside.
How Trading on the Screen Differs From the Floor
Let's say that you wanted to sell your car at an auction. It's a several year old sedan with average miles in very good condition. How would you price your vehicle?
Well, you could look at a guide, such as the one published by NADA, and that would provide a good starting point.
The reality is, however, that how much money your car will fetch will depend upon how many other, similar cars are available for sale at the auction. You need to know if it's a buyer's auction, with lots of recent model sedans available, or a seller's auction, with few such cars on the market.
Moreover, you would look to see who else is participating in the auction. If you saw a representative from Hertz pull into the auction with a fleet of sedans to sell off, you'd want to sell your car as quickly as possible (before the fleet) and take the best price you get. Conversely, if you saw a group of used car dealers wanting to buy cars for their lots, you might price your vehicle more aggressively.
Chances are, with Hertz in the auction, you would accept the highest bid for your car. When the dealers are in the market, they might have to compete with each other and grab your car at the price you're offering. The transaction at the buyer's bid price or at the seller's offer would tell you whether it's a buyer's or seller's market.
On the floor, in the commodities pits, you can see who is buying and who is selling--a bit like the auto auction. You know who the locals are, and you can see brokers come into the pit with orders from "paper"--the institutions. You actually see and hear the volume being transacted and can see prices move or stall as locals make markets. Most important of all, you can see from the activity of the participants whether it was a buyer's market, a seller's market, or a dull market with locals trading back and forth with each other.
The market's auction process is far less visible on the screen, which is why successful pit traders are not always successful when they move to electronic trading. They no longer have the visual and auditory cues when volume picks up and, most important of all, they no longer have that feel for who is in the marketplace. Imagine selling your car at auction and finding out that Hertz has just placed 100 similar cars alongside yours. That happens on the screen to new traders all the time.
This is why I consider volume analysis to be important to short-term trading. By decomposing volume into component trades, seeing what is happening with large vs small trades, and seeing which trades are occurring at the market bid or offer, the screen trader can regain some of the edge of the pit trader.
Here is a worthwhile exercise for former pit traders adapting to the screen (and for new electronic traders): Watch volume on a 1-minute basis and see where volume expands significantly and remains elevated for several minutes at a time. This elevation is created by large traders entering the market. Look at what was going on in the market to trigger these large trades. Maybe it will be a technical event, such as breaking a support level. Perhaps it will be a news item or economic report. Other times, it will be triggered by a move in a related market, such as bonds, the dollar, or oil.
By watching, watching, watching those volume elevations each day and what causes them, you begin to think like the large traders. You gain familiarity with the rules of the game that they are playing by.
And *that* is an edge.
Well, you could look at a guide, such as the one published by NADA, and that would provide a good starting point.
The reality is, however, that how much money your car will fetch will depend upon how many other, similar cars are available for sale at the auction. You need to know if it's a buyer's auction, with lots of recent model sedans available, or a seller's auction, with few such cars on the market.
Moreover, you would look to see who else is participating in the auction. If you saw a representative from Hertz pull into the auction with a fleet of sedans to sell off, you'd want to sell your car as quickly as possible (before the fleet) and take the best price you get. Conversely, if you saw a group of used car dealers wanting to buy cars for their lots, you might price your vehicle more aggressively.
Chances are, with Hertz in the auction, you would accept the highest bid for your car. When the dealers are in the market, they might have to compete with each other and grab your car at the price you're offering. The transaction at the buyer's bid price or at the seller's offer would tell you whether it's a buyer's or seller's market.
On the floor, in the commodities pits, you can see who is buying and who is selling--a bit like the auto auction. You know who the locals are, and you can see brokers come into the pit with orders from "paper"--the institutions. You actually see and hear the volume being transacted and can see prices move or stall as locals make markets. Most important of all, you can see from the activity of the participants whether it was a buyer's market, a seller's market, or a dull market with locals trading back and forth with each other.
The market's auction process is far less visible on the screen, which is why successful pit traders are not always successful when they move to electronic trading. They no longer have the visual and auditory cues when volume picks up and, most important of all, they no longer have that feel for who is in the marketplace. Imagine selling your car at auction and finding out that Hertz has just placed 100 similar cars alongside yours. That happens on the screen to new traders all the time.
This is why I consider volume analysis to be important to short-term trading. By decomposing volume into component trades, seeing what is happening with large vs small trades, and seeing which trades are occurring at the market bid or offer, the screen trader can regain some of the edge of the pit trader.
Here is a worthwhile exercise for former pit traders adapting to the screen (and for new electronic traders): Watch volume on a 1-minute basis and see where volume expands significantly and remains elevated for several minutes at a time. This elevation is created by large traders entering the market. Look at what was going on in the market to trigger these large trades. Maybe it will be a technical event, such as breaking a support level. Perhaps it will be a news item or economic report. Other times, it will be triggered by a move in a related market, such as bonds, the dollar, or oil.
By watching, watching, watching those volume elevations each day and what causes them, you begin to think like the large traders. You gain familiarity with the rules of the game that they are playing by.
And *that* is an edge.
Saturday, December 02, 2006
A Promising Research Direction
I've begun a research project that appears at this stage to be most promising. I'll outline the basics, and you can judge the ideas for yourself.
As you know from my morning sessions and blog posts, I like to look at *how* volume trades during the day. It is very helpful to see if buyers are being more aggressive in the market place (by lifting offers) or if sellers are dominating (by transacting at the market bid). By isolating the large trades and where they occur in the bid-ask matrix, we have a good sense for whether markets are likely to be pushed higher or lower by large locals and institutions.
Suppose, however, we take this same framework and apply it to options transactions. We can separate out large options trades from small ones and see how pros vs. amateurs are trading. We can see if call option transactions are occurring in size and if they're occurring predominantly at the bid vs. offer, and we can do the same with put options.
The beauty of such an analysis is that it allows us to tease out the behavior of market bulls (call option buyers) from the behavior of bears (put option buyers), and it allows us to see when activity is skewed toward calls vs. puts or whether there is high activity in both (suggesting, perhaps, spreading rather than directional trade).
I broke down the data from Friday--which was a great trading day with several sizable intraday swings--and found patterns in the option data similar to those I have observed with Market Delta in the futures. Some of these patterns are quite like the "transitional structures" I have written about in the past: points at which buying or selling volume hits an extreme, dries up, and then leads to price reversal.
My sense is that very few short-term equity and equity index trader are using intraday options data and patterns among options traders to help them time the market. Eventually, with enough data, I plan to run historical analyses to see if, indeed, the sentiment in the options arena predicts outcomes in the stock indices. From my limited investigations to this point, it appears that the sentiment of traders who trade sentiment--puts and calls--is valuable information to the intraday trader.
As you know from my morning sessions and blog posts, I like to look at *how* volume trades during the day. It is very helpful to see if buyers are being more aggressive in the market place (by lifting offers) or if sellers are dominating (by transacting at the market bid). By isolating the large trades and where they occur in the bid-ask matrix, we have a good sense for whether markets are likely to be pushed higher or lower by large locals and institutions.
Suppose, however, we take this same framework and apply it to options transactions. We can separate out large options trades from small ones and see how pros vs. amateurs are trading. We can see if call option transactions are occurring in size and if they're occurring predominantly at the bid vs. offer, and we can do the same with put options.
The beauty of such an analysis is that it allows us to tease out the behavior of market bulls (call option buyers) from the behavior of bears (put option buyers), and it allows us to see when activity is skewed toward calls vs. puts or whether there is high activity in both (suggesting, perhaps, spreading rather than directional trade).
I broke down the data from Friday--which was a great trading day with several sizable intraday swings--and found patterns in the option data similar to those I have observed with Market Delta in the futures. Some of these patterns are quite like the "transitional structures" I have written about in the past: points at which buying or selling volume hits an extreme, dries up, and then leads to price reversal.
My sense is that very few short-term equity and equity index trader are using intraday options data and patterns among options traders to help them time the market. Eventually, with enough data, I plan to run historical analyses to see if, indeed, the sentiment in the options arena predicts outcomes in the stock indices. From my limited investigations to this point, it appears that the sentiment of traders who trade sentiment--puts and calls--is valuable information to the intraday trader.
The Devon Principle
You've probably gathered by now that our children serve as the inspiration for several of my posts. Daughter Devon attuned me to the Ewwww! Factor, and son Macrae was our companion on the Cross-Cultural Journey. Yesterday's lesson from Devon, however, might have provided the best insight of all.
A couple of nights ago, Devon walked into my study in tears. She felt she was falling behind in her schoolwork and not doing as well as she should. Worst of all, she found herself procrastinating over the work, even though she knew it needed to be done. At one point, she referred to herself as "lazy". I reassured her that I'd help her get things done, but the degree of her self-doubt left an impression on me.
Yesterday, out of the blue, Devon received a notice inviting her to a casting call for a movie to be filmed in Chicago. She's done some modeling (see above), but this was the first acting invitation she had gotten. She practically pranced into my study and exclaimed, "Let's do it!" Within minutes, she had chosen the photo to submit and had written a cover letter to go with it.
When I read the cover letter, I was stunned. It was perfect. Far and away the best thing she had ever written. I could not have prepared a better letter myself--and I have a fair amount of writing experience!
Later, I talked with Devon about what had happened. She somewhat shyly admitted that she was *very* proud of her letter. What I pointed out, however, was that she was no longer a "lazy" person who procrastinated and did mediocre work when she pursued something that was meaningful to her. As a student in a math class, she struggles to get work done; the work doesn't speak to her. But acting and modeling? She's never missed a class or assignment.
Reflecting on our talk, I came up with what I'm calling the Devon Principle. Here it is:
Everything we do in life--our work, recreation, relationships--is a mirror. It reflects an image of ourselves back to us. If we're doing the wrong things in life, the mirror reflects a distorted image. Over time, we begin to mistake that image for reality. We really do think of ourselves as lazy or incompetent.
When we do the work we're meant to do, however, the mirror reflects the best of who we are. Over time, we internalize that image and the pride and confidence that go with it.
People who are successful--in life and in markets--find positive mirrors. They have found markets and ways of trading that reflect back to them unique skills and talents. They enjoy relationships that reflect love, caring, and respect and, as a result, they feel those things for themselves. "You are what you eat," is an old saying. The Devon Principle says that we're always eating life experience. We're always internalizing what our activities reflect to us. And we will always live up to the image of that reflection.
So I say to you what I said to Devon: There is some sphere of life in which you already are the person you want to be. The key is to find those activities and relationships and organize your time around them. Find the trading where you're at your best and make that your specialty. Or maybe trading isn't where you're at your best; perhaps a far better mirror awaits you.
The Devon Principle points out that how you feel about yourself is not simply the result of something inside you. It is a function of the relationship you have with your activities: what you actually are doing in your life.
Do the right things, and you will be the hero of your own life story.
Thanks, Dev, for teaching Dad that lesson.
Friday, December 01, 2006
A Few Housekeeping Details
I hope the recent posts on trading macro relationships helped you with this morning's trade. When you finish trading, notice how we traded going into the 9 AM CT reports and right afterward, focusing on bonds, currencies, and size hitting bids in the stock indices. This has been a very profitable pattern recently.
I'm pleased to report that my personal site is up and running, so all the Trading Psychology Weblogs are now up to date. Also check out my new article on identifying your best practices; it highlights one of the most common shortcomings of trading journals.
Finally, I'm shooting for this coming Wednesday, December 6th, for another "Morning With the Doc" session. We'll follow the market in real time and track patterns in the macro markets, as well as the various stock sectors. A few people have asked me questions about "tape reading", which I'll try to touch upon in the morning session.
Have a great day--
Brett
I'm pleased to report that my personal site is up and running, so all the Trading Psychology Weblogs are now up to date. Also check out my new article on identifying your best practices; it highlights one of the most common shortcomings of trading journals.
Finally, I'm shooting for this coming Wednesday, December 6th, for another "Morning With the Doc" session. We'll follow the market in real time and track patterns in the macro markets, as well as the various stock sectors. A few people have asked me questions about "tape reading", which I'll try to touch upon in the morning session.
Have a great day--
Brett
Corporate Bonds and Stocks: Important Relationships
My recent post emphasized how important it is to follow the global markets and track their impacts upon stocks. Here we'll look at corporate bonds--the Dow Jones 20 Bond Index--and their relationship to stock prices (S&P 500 Index).
The chart above shows an interesting relationship. Since 2000, the 20-day volatility--as measured by high-low percentage range--of corporate bonds and stocks correlate by about .25. Note how volatility has come out of both markets since the 2002 volatility peak. Corporate bond volatility bottomed out in May of this year and has been on the rise since then; that is not true of SPX volatility. One hypothesis I'm entertaining is that increasing volatility in interest rates and the dollar will be leading increasing equity volatility.
Since 2004 (N = 715 trading days), when the Dow Jones 20 Bonds have been up over the last 20 days, the next 20 days in SPX have been up by an average of .88% (311 up, 135 down). When the Dow Bonds have been down over a 20 day period, the next 20 days in SPX have been up by an average of only .15% (151 up, 118 down). Strong corporate bonds have thus tended to lead strong stocks and weak bonds (i.e. rising rates) have led to subnormal performance. Indeed, when the bonds have been down more than 2% over a 20-day period (N = 44), the next 20 days in SPX are down by an average of -.35% (16 up, 28 down).
Whatever you trade--individual stocks or equity indices--does not exist in isolation. Interest rates affect business profitability, and fixed rate instruments compete with stocks for capital. Short-term traders focusing solely on short-term patterns in their own instrument run the risk of picking up nickels in front of a global macro steamroller.
Friday's Trading Psychology Weblog Links and Stats
It looks as though the server problems with my personal site will take a while to fix. Until that gets sorted out, I'll post daily Trading Psychology Weblog entries on the TraderFeed blog. So, here we go:
Market Ideas:
TraderFeed celebrates its first birthday with a market pattern based on tracking global macro market players.
Following the market's U-turn.
Charles Kirk summarizes aspects of a trading journal, as laid out by Doug Hirschhorn.
Justin Lenarcic summarizes the technical evidence on the market.
Ticker Sense on how the market has behaved on December firsts.
The Big Picture on big discounting by the retailers.
Dollar, yields, oil, housing; excellent links from Abnormal Returns.
Controlled Greed, on why value investing works.
Nice opportunity to preview Brian Shannon's work.
Jon Markman finds opportunity in plastics.
Bonds scream recession. The dollar just screams.
Market Expectations:
Pricing In Recession? Since November 6th, the ten-year yield has moved from 4.71% to 4.46%. The Euro has moved from 1.275 to the dollar to 1.326. The gold ETF has moved from 61.89 to 64.39. U.S. stocks (S&P 500) are up over that time, but the German DAX, British FTSE, and French CAC 40 are down from their highs. A strong set of currencies isn't likely to help their export business.
Market Summary:
The market lower on Thursday before rallying and then selling off late in the session. We finished above the day's average price of ES 1401.5, continuing the short-term uptrend. The Power Measure closed positive, though off its high. Once again, buying dominated the broad market, with the Adjusted TICK at +442. Action was more neutral in the large caps, however, with the Institutional Composite at -29. Demand dropped to 86; Supply rose to 47. New 20 day highs rose to 1500; new 20 day lows fell to 375. Institutional Momentum rose to a still tepid -40, with 8 stocks in intermediate-term uptrends, 8 in downtrends, and 1 neutral. I am viewing this as a broad trading range and am carefully watching the tape as we approach the range highs. As long as we get day over day price highs and an expansion of new 20-day highs, the uptrend will remain intact.
Market Ideas:
TraderFeed celebrates its first birthday with a market pattern based on tracking global macro market players.
Following the market's U-turn.
Charles Kirk summarizes aspects of a trading journal, as laid out by Doug Hirschhorn.
Justin Lenarcic summarizes the technical evidence on the market.
Ticker Sense on how the market has behaved on December firsts.
The Big Picture on big discounting by the retailers.
Dollar, yields, oil, housing; excellent links from Abnormal Returns.
Controlled Greed, on why value investing works.
Nice opportunity to preview Brian Shannon's work.
Jon Markman finds opportunity in plastics.
Bonds scream recession. The dollar just screams.
Market Expectations:
Pricing In Recession? Since November 6th, the ten-year yield has moved from 4.71% to 4.46%. The Euro has moved from 1.275 to the dollar to 1.326. The gold ETF has moved from 61.89 to 64.39. U.S. stocks (S&P 500) are up over that time, but the German DAX, British FTSE, and French CAC 40 are down from their highs. A strong set of currencies isn't likely to help their export business.
Market Summary:
The market lower on Thursday before rallying and then selling off late in the session. We finished above the day's average price of ES 1401.5, continuing the short-term uptrend. The Power Measure closed positive, though off its high. Once again, buying dominated the broad market, with the Adjusted TICK at +442. Action was more neutral in the large caps, however, with the Institutional Composite at -29. Demand dropped to 86; Supply rose to 47. New 20 day highs rose to 1500; new 20 day lows fell to 375. Institutional Momentum rose to a still tepid -40, with 8 stocks in intermediate-term uptrends, 8 in downtrends, and 1 neutral. I am viewing this as a broad trading range and am carefully watching the tape as we approach the range highs. As long as we get day over day price highs and an expansion of new 20-day highs, the uptrend will remain intact.
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