9:53 AM - OK, let's wrap up for the AM session. It was good that I blogged more actively this AM, despite my aching fingers, because it shows how *the same market principles apply* regardless of a market's trend or volatility. I started the day with a dual schema: some research suggested we tend to bounce after big days down, other research suggested follow through weakness after big downside momentum days. My leaning was to go with the trend and the idea of downside weakness to test Tuesday's lows. Well, we got the weakness and ER2 did break the lows, but not ES. Note my post on buying of large caps in the downward market. More of that seemed to be going on, as the TICK lows on the weakness were not extreme. When we broke below the overnight lows in ES and then moved back up into that range, it was a good sign that sellers just couldn't get it done. The TICK distribution gradually shifted upward and it was clear we'd see a test of those overnight highs. We broke the highs, but now note we're heading back into the range. Just as a move back into the range suggested the sellers couldn't get it done, a move back into the range now would indicate that buyers don't have the follow through. That would lead us to expect a move back to the day's average price. Just keep the principles in mind and size your positions so that any move against you in this heightened volatility won't blow you out. Hope this has been helpful. I'll update the market tonight on the Weblog; now I need to rest those fingers!! Have a great day.
9:45 AM - Sweet. Now we have to stay above that range.
9:40 AM - If we can stay in positive TICK on pullbacks, we should get a big breakout move.
9:36 AM - Note we touched the upper end of the overnight range and have pulled back a bit. We actually broke above this range in NQ and ER2 is now close. I would expect a significant move up if we can take out that range; that TICK distribution should tell the story. So far, it and ER2 remain strong.
9:29 AM - I'm getting a ton of emails from confused traders. Sorry I can't answer all in a timely fashion. I'm getting carpal tunnel syndrome as it is... :-) Note the upward shift in the TICK following the drying up of selling mentioned below. That has triggered the recent move.
9:19 AM - Wonderful illustration of the principle I mentioned a few minutes ago. Drying up of selling often precedes an influx of buying. Then, if we get subsequent selling that holds above prior lows on higher TICK lows, that becomes a secondary buying opportunity.
9:13 AM - Overall, we're seeing more volume at the bid than at the offer in ES, but not by much. I have to say that this market is behaving in a resilient way thus far. But drying up selling *often* leads to an influx of buyers--keep an eye on ER2 and TICK if that is to be the case--but we do need to see those buyers to be confident in any market rebound.
9:03 AM - Continued ER2 weakness. Still need to surmount the overnight range highs. That would turn me bullish.
8:54 AM - And we're pretty much back to where we opened! Note the breakout high in the TICK and the fact that, so far, we have not seen a TICK reading below -500. Quite a contrast to yesterday. Looks like this mkt is searching for a bottom--esp. if we get higher TICK lows on successive declines. Remember we have housing at 9:00 CT.
8:52 AM - Hope you can see that: the low of the overnight range is now overhead resistance.
8:50 AM - Note that we broke Tuesday's lows in ER2. Note also how that overnight range high couldn't be breached and led to the breakout below the overnight low. Let's now see if we stay beneath that range and how much volume buyers can sustain.
8:42 AM - The ER2 weakness was a good tell that we weren't going to break above that range this time around. I'll be watching ER2 for continued signs of strength or weakness.
8:40 AM - Note the trading range from 1402 to the 1413 area in the overnight mkt. That's the range to keep an eye on.
8:38 AM - Very high volume; ER2 showing some relative weakness. Keep an eye to see if it leads us down.
8:12 AM CT - Once again, I'll blog on this market only when I see something of real note. I've been getting record traffic on the blog--as have other bloggers--which attests to the heightened interest and uncertainty surrounding this market. My recent posts have tried to put the market decline into some kind of perspective. Bottom line is that we had an afternoon bounce to 1413.25 in ES and then a rise in overnight trading to 1412.50. We need to see the buyers take out those levels with fresh, solid buying volume to take the bull position. Note that we *did* take out the Tuesday afternoon highs in NQ and ER2 during overnight Globex trade, thanks to the bounce in the Shanghai market. So, in those markets, we need to see buyers sustain a move above those overnight highs. That would target the Tuesday average trading price (pivots posted to the Weblog). Failure to hold those highs would target a test of the overnight lows; then the Tuesday lows. We have Chicago PMI at 8:45 AM and new home sales at 9:00 AM. There are concerns regarding economic weakness that could affect this market. Also keep an eye on the Yen. We're getting a bit of a bounce from the recent drop, and it's Yen strength that has helped to hurt this market. Remember: volatility and movement in the overnight session tends to correlate well with volatility in the morning session. Position sizing and stops need to account for that shift. Back after the open.
Wednesday, February 28, 2007
How Did Money Flow During the Market Decline?
I mentioned recently that, throughout this bull market, it was rare to see a day in which net funds had flowed out of the Dow 30 stocks. As I was going through my market stats at the end of Tuesday's sharp decline, I noticed that the TIKI (the net number of stocks trading on upticks minus downticks for the Dow stocks) was actually positive on the day. This was in marked contrast to the NYSE TICK (which tracks the net upticks minus downticks among all NYSE-listed issues), which was quite negative on the day. Could it be, I wondered, that investors were putting money to work in safer, blue cap issues during the market decline and shunning more volatile, smaller stocks? That would certainly fit with the risk-aversion theme associated with the drop in China and the rise of the Yen.
I examined the Dollar Volume Flows into and out of each of the Dow stocks and indeed found that the Dow attracted net dollars on the trading session. Far and away the net money flow winner was XOM, followed by T, GE, and IBM. Stocks with net outflows on the day were paced by a stock that has seen outflows for a while: MSFT. Other stocks with outflows on the day were PFE, WMT, KO, JNJ, INTC, DIS, HON, GM, DD, CAT, C, and AIG. Of these, the first six have also had net outflows over the past several weeks.
What it looks like from this angle was that traders were putting their money into some old-line safe names--most notably an oil stock--and taking further money out of stocks that were already out of favor. Overall, however, there may have been less of an institutional exodus from large cap stocks than is apparent from the Dow chart.
I examined the Dollar Volume Flows into and out of each of the Dow stocks and indeed found that the Dow attracted net dollars on the trading session. Far and away the net money flow winner was XOM, followed by T, GE, and IBM. Stocks with net outflows on the day were paced by a stock that has seen outflows for a while: MSFT. Other stocks with outflows on the day were PFE, WMT, KO, JNJ, INTC, DIS, HON, GM, DD, CAT, C, and AIG. Of these, the first six have also had net outflows over the past several weeks.
What it looks like from this angle was that traders were putting their money into some old-line safe names--most notably an oil stock--and taking further money out of stocks that were already out of favor. Overall, however, there may have been less of an institutional exodus from large cap stocks than is apparent from the Dow chart.
High Momentum Stock Market Declines: What Comes Next
My recent post took a look at what typically follows a single day of large price declines. Here is a very different take on near-term prospects following a high momentum decline. Recall that one of my core trading principles is that a trending move with strong momentum tends to persist in the short run. Let's see if that might apply to the current market.
My best measure of stock momentum is the proprietary Demand/Supply index that I track daily on the Trading Psychology Weblog. Demand, you might recall, is an index of the number of stocks closing above the volatility envelopes surrounding their short- and intermediate-term moving averages. Supply is a similar index, tracking the number of issues closing below the volatility envelopes surrounding both their moving averages.
Demand and Supply follow every operating company trading on the NYSE, NASDAQ, and ASE. They tell you the relative number of issues closing either very strong or very weak in the equity markets. I have collected the Supply and Demand data since September, 2002. Tuesday's market hit the highest level of Supply recorded over that period: 420. We have only had seven other days with Supply levels above 200. The next day in SPY, five of the seven days finished lower in price, by an average of -.38%. Five days later, six of the seven occasions finished lower, by an average of -1.06%. These are much weaker results than the average market performance over that period.
Of the seven sessions in which we had very strong downside momentum, six traded below their day's lows during the following session. Indeed, four of the seven broke those lows by more than ten full ES points. Weakness, then, tends to carry over to the next day following a high momentum decline.
Interestingly, when we had days in which downside momentum was strong but not extreme (Supply greater than 1500, but less than 2000; N = 24), the next five days in SPY averaged a healthy gain of .67% (15 up, 9 down). By contrast, the average five-day gain over the entire period was .24%.
In sum, when we have large declines on downside momentum that is extremely broad--as we had Tuesday--we tend to see followthrough to the downside over the short term. When large declines are not so extreme in the breadth of their negative momentum, we tend to see reversals over the short term. It is for this reason, in spite of the small sample size from my data, that I will be open to selling strength early on Wednesday in anticipation of breaking Tuesday's lows. Note, however, that as I'm writing, we have bounced significantly higher in the overnight stock index futures. A recent comment on my previous post from Trading Nerd took the data back to 1930 (!) and found evidence of positive returns after a 3% decline, but that most of those occurred the next trading day. Such a pattern--sharp bounce, then some follow through decline--would help to connect the results from my previous post and this one.
My best measure of stock momentum is the proprietary Demand/Supply index that I track daily on the Trading Psychology Weblog. Demand, you might recall, is an index of the number of stocks closing above the volatility envelopes surrounding their short- and intermediate-term moving averages. Supply is a similar index, tracking the number of issues closing below the volatility envelopes surrounding both their moving averages.
Demand and Supply follow every operating company trading on the NYSE, NASDAQ, and ASE. They tell you the relative number of issues closing either very strong or very weak in the equity markets. I have collected the Supply and Demand data since September, 2002. Tuesday's market hit the highest level of Supply recorded over that period: 420. We have only had seven other days with Supply levels above 200. The next day in SPY, five of the seven days finished lower in price, by an average of -.38%. Five days later, six of the seven occasions finished lower, by an average of -1.06%. These are much weaker results than the average market performance over that period.
Of the seven sessions in which we had very strong downside momentum, six traded below their day's lows during the following session. Indeed, four of the seven broke those lows by more than ten full ES points. Weakness, then, tends to carry over to the next day following a high momentum decline.
Interestingly, when we had days in which downside momentum was strong but not extreme (Supply greater than 1500, but less than 2000; N = 24), the next five days in SPY averaged a healthy gain of .67% (15 up, 9 down). By contrast, the average five-day gain over the entire period was .24%.
In sum, when we have large declines on downside momentum that is extremely broad--as we had Tuesday--we tend to see followthrough to the downside over the short term. When large declines are not so extreme in the breadth of their negative momentum, we tend to see reversals over the short term. It is for this reason, in spite of the small sample size from my data, that I will be open to selling strength early on Wednesday in anticipation of breaking Tuesday's lows. Note, however, that as I'm writing, we have bounced significantly higher in the overnight stock index futures. A recent comment on my previous post from Trading Nerd took the data back to 1930 (!) and found evidence of positive returns after a 3% decline, but that most of those occurred the next trading day. Such a pattern--sharp bounce, then some follow through decline--would help to connect the results from my previous post and this one.
Tuesday, February 27, 2007
Big Down Days: What Happens Next?
That seems to be the question everyone is asking following the meltdown on Tuesday. What we observed is a scenario in which everyone simultaneously runs for the exits. China's market was down over 9% in Shanghai prior to our open. The Yen soared to multiweek highs, a risk factor to the carry trade, as mentioned here a while back. As selling in the U.S. markets begat selling, we saw weeks' worth of profits eroded in a single session. Among money managers, who fight tooth and claw for each quarter's performance, such a drop was a major threat. Volume picked up dramatically, reflecting the exit of the institutional traders, and--with that--the decline accelerated, now wiping out months' worth of performance.
Such an occurrence is rare. I went back to 1990 (N = 4304 trading days) and could only find 25 occasions of a single day drop of 3% or more in the cash S&P 500 Index. What's even more rare is to have such a decline in the context of a bull market. How many times in the last 17+ years have we seen a 3+% decline in a market that had been up over the prior 20 and 60 days? It's only occurred three times out of all those trading days.
But shifts happen. And that, my friends, is why money management and risk control are all important. If you double your money, double it again, and then double it again, only to lose 90% in the next debacle, you wind up down 20% on your initial capital, needing a 25% gain just to return to where you were at the start.
So what happens after big down days? Let's start with the 25 occasions in which we've dropped 3% or more in a single day. At just about every time frame from one to twenty days out, returns following such a large single-day drop are quite bullish. One day later, the S&P averaged a gain of .47% (17 up, 8 down), much stronger than the average single day gain for the rest of the sample of .03% (2256 up, 2023 down). Twenty days later, the S&P was up by an average of a whopping 4.47% (20 up, 5 down), again much stronger than the average 20-day gain of .73% for the remainder of the sample (2641 up, 1638 down). In all, large down days have tended to represent buying opportunities since 1990.
Those findings may be a bit deceptive, however, because--of those 25 large down days--15 occurred in the context of a market that had *already fallen* 3% or more over the past 20 sessions. In other words, large down days have tended to occur toward the end of market downmoves--as a kind of washout. We don't typically see large down days following intermediate term strength, as noted above.
I relaxed my criteria a bit and found six occasions in which the market had not been down more than 2% on a 20 and 60 day basis prior to the large down day. All six occasions were up the next day, and all were up over the following 20 sessions. Indeed, the average gain over the next 20 trading days was an impressive 3.89%.
In short, big down days have tended to represent panic and, even when they've occurred in relatively strong markets, they have tended to occur nearer to market bottoms than tops. On average, traders have made money by buying into such panicky markets. While the current volatility may be more than many traders wish to tolerate, at the very least the pattern of superior returns following panicky declines should offer caution to those tempted to arrive late to the bear's party.
Tuesday, February 27th Morning Market Comments
9:36 AM - So far, note that the selling has come on higher TICK lows and the major indices have held their AM lows. If the TICK continues its positive shift, I'd expect us to take out the opening prices in ES. Note the upward shift of the TICK distribution thus far. As long as we get TICK pullbacks at higher lows and price stays above prior lows, I'll look to buy. Breakdown of those prior lows or breakdown in TICK would alter that, however. Hope that's helpful. Have a great remainder of your trading day.
9:14 AM - Note that we're hovering around the opening prices in ER2 and NQ. If you look at the TICK, really the selling is not as dramatic as the numbers would lead you to believe. A lot of the market's weakness was baked into the open. I'm focusing on how strong or weak the market is *since the open*. Not versus yesterday's close. That will tell us if we have underlying followthrough of supply or buyers laying in wait.
9:00 AM - Short covering rallies in declining markets can be quite sharp. Note we've seen some bargain hunting in NQ and ER2, which had been leading the downside. Seeing if we can put in a bottom this AM and get a real mother of all short coverings!
8:50 AM - I'm showing an equity put/call ratio of 1.5. That's as high as I can recall in a long time. Trin is close to 3.0. Declines lead advancers by well over 2000 issues. Lots and lots of bearishness.
8:43 AM - Keep an eye on EEM as a proxy for those emerging markets. Especially watch for strength.
8:27 AM - It's really funny and perhaps a sentiment indicator: there are a record number of visitors on the TraderFeed site right now. I'd like to think it's part of that flight to quality... :-)
More likely, people seek information when there is uncertainty...
8:24 AM - Thanks also to a reader and fine trader who points out that we're seeing multi-week highs in the Yen which, if you recall my earlier post, is associated with subnormal returns due to the dampening of the carry trade. Well, I don't think too many traders want to be carrying BRICs right now; we see a huge rally in the rates markets with the flight to quality. Look for a TraderFeed post coming up: what happens after we have large market declines and a flight to quality in bills/bonds.
8:13 AM CT - Well, I wasn't planning on continuing the comments so immediately, but it looks like a wild and wooly start to the morning, so I thought I'd add a little perspective. Bottom line is that we had a drop of over 9% in the Shanghai market overnight. That has spilled over to world markets, so look for a continued flight to safety (buying fixed income) and a retreat from emerging markets (big drop in EEM in premarket). As the Barchart newsletter reported earlier this AM, "The vice chairman of China's parliament said on Feb 6 that the government said that China's stock market was showing signs of a "bubble" and said that only 30% of the companies on the Shanghai Stock Exchange are "good to invest in by Western standards." I guess when you say those kinds of things about your own market, eventually people will listen! Does this mean the start of a bear market, or is this a correction that shakes out weak bulls? I try to address this in my latest post. We are trading some 15 ES points below yesterday's volume weighted average price. For two days, as noted in the Weblog, we've been in a short-term downtrend. This simply accelerates the momentum of the downtrend. In general, such momentum tends to persist in the short run. So I would caution against attempts to bottom pick this AM. The most important consideration, however, is that overnight range is correlated with volatility the next AM. We should see considerable market volume and movement this morning--much different from the slow, range bound, low VIX trade of recent weeks. Be very careful re: your placement of stops and your position sizing. The market is likely to move more than you are accustomed. If I notice anything major, I'll post observations. Have a good start to your morning trade!
9:14 AM - Note that we're hovering around the opening prices in ER2 and NQ. If you look at the TICK, really the selling is not as dramatic as the numbers would lead you to believe. A lot of the market's weakness was baked into the open. I'm focusing on how strong or weak the market is *since the open*. Not versus yesterday's close. That will tell us if we have underlying followthrough of supply or buyers laying in wait.
9:00 AM - Short covering rallies in declining markets can be quite sharp. Note we've seen some bargain hunting in NQ and ER2, which had been leading the downside. Seeing if we can put in a bottom this AM and get a real mother of all short coverings!
8:50 AM - I'm showing an equity put/call ratio of 1.5. That's as high as I can recall in a long time. Trin is close to 3.0. Declines lead advancers by well over 2000 issues. Lots and lots of bearishness.
8:43 AM - Keep an eye on EEM as a proxy for those emerging markets. Especially watch for strength.
8:27 AM - It's really funny and perhaps a sentiment indicator: there are a record number of visitors on the TraderFeed site right now. I'd like to think it's part of that flight to quality... :-)
More likely, people seek information when there is uncertainty...
8:24 AM - Thanks also to a reader and fine trader who points out that we're seeing multi-week highs in the Yen which, if you recall my earlier post, is associated with subnormal returns due to the dampening of the carry trade. Well, I don't think too many traders want to be carrying BRICs right now; we see a huge rally in the rates markets with the flight to quality. Look for a TraderFeed post coming up: what happens after we have large market declines and a flight to quality in bills/bonds.
8:13 AM CT - Well, I wasn't planning on continuing the comments so immediately, but it looks like a wild and wooly start to the morning, so I thought I'd add a little perspective. Bottom line is that we had a drop of over 9% in the Shanghai market overnight. That has spilled over to world markets, so look for a continued flight to safety (buying fixed income) and a retreat from emerging markets (big drop in EEM in premarket). As the Barchart newsletter reported earlier this AM, "The vice chairman of China's parliament said on Feb 6 that the government said that China's stock market was showing signs of a "bubble" and said that only 30% of the companies on the Shanghai Stock Exchange are "good to invest in by Western standards." I guess when you say those kinds of things about your own market, eventually people will listen! Does this mean the start of a bear market, or is this a correction that shakes out weak bulls? I try to address this in my latest post. We are trading some 15 ES points below yesterday's volume weighted average price. For two days, as noted in the Weblog, we've been in a short-term downtrend. This simply accelerates the momentum of the downtrend. In general, such momentum tends to persist in the short run. So I would caution against attempts to bottom pick this AM. The most important consideration, however, is that overnight range is correlated with volatility the next AM. We should see considerable market volume and movement this morning--much different from the slow, range bound, low VIX trade of recent weeks. Be very careful re: your placement of stops and your position sizing. The market is likely to move more than you are accustomed. If I notice anything major, I'll post observations. Have a good start to your morning trade!
Which Dow Stocks Are Hot, Which Are Not, and What It Might Mean
In my recent post and on my Trader Performance page, I introduced a measure that I called Relative Dollar Volume Flow. This indicator is designed to assess the sentiment of large traders in individual stocks by multiplying the price of each trade by its volume and either adding that amount to a cumulative total (if the trade occurs on an uptick) or subtracting it (if it occurs on a downtick). The daily total is then divided by the volume for that day to obtain a relative sense of the proportion of volume that was occurring at the market bid (on downticks) vs. the market offer (on upticks). If the Relative Dollar Volume Flow is positive, we have net dollars flowing into the stock for the day. If the Relative Dollar Volume Flow is negative, we have net dollars flowing out of the stock for that day.
As a whole, dollars have been flowing into the Dow. Since 2004 (N = 787 trading days), we have only had 57 occasions in which net money flowed out of the Dow 30 stocks as a whole. In other words, when we compute the Relative Dollar Volume Flow for each of the Dow 30 issues and sum these to obtain a total Flow for the Dow, rarely have we seen net selling of the Dow. More on that later.
This strength of money flow, however, belies large differences among the individual Dow components. Over the past 25 trading sessions, the Dow as a whole has been modestly higher. Let's look, though, at how many of those trading sessions saw net dollar inflows for each of the Dow issues:
AA - 22
AIG - 19
AXP - 17
BA - 24
C - 20
CAT - 24
DD - 25
DIS - 13
GE - 18
GM - 25
HD - 17
HON - 22
HPQ - 21
IBM - 24
INTC - 16
JNJ - 13
JPM - 18
KO - 11
MCD - 21
MMM - 19
MO - 23
MRK - 22
MSFT - 7
PFE - 8
PG - 23
T - 22
UTX - 22
VZ - 22
WMT - 14
XOM - 21
What we can see is consistent inflows into such issues as BA, CAT, DD, GM, and IBM and more consistent outflows from MSFT, PFE, KO, DIS, JNJ, and WMT. Overall, 17 of the Dow 30 have seen net inflows for 20 or more days in the last 25 trading sessions. That is not exactly a picture of broad weakness. Rather, it suggests that institutions have been moving money away from selected issues (many of which might be characterized as blue chip growth rather than value). I find it informative to go to a site such as Instant Bull and examine the news and the message board buzz about these stocks, as a way of seeing what the market is concerned about. In the case of the stocks with the most consistent outflows, MSFT and PFE, there are clear concerns surrounding Vista and health care costs, respectively. The Dollar Volume Flow figures suggest that money managers are truly acting upon those concerns.
Overall, since 2004, we have had corrections in the market, generally in the vicinity of 5-7%. On those occasions, we've seen a reduction of net inflows into the Dow 30 stocks, but no systematic liquidation. I went back to the 57 trading days in which we had net outflows from the Dow 30 as a whole. Three days later, the Dow (DIA) was up by an average of .35% (35 up, 22 down). That compares to the average three-day gain in DIA for the remainder of the sample of .06% (396 up, 334 down). In other words, investors have tended to use outflows from the Dow as short-term buying opportunities.
At some point we will have a bear market. Indeed, as I write, the preopening stock index futures are trading much lower. What will tell us whether such a move is a normal correction vs. a full-fledged start to a bear market? One thing we might look for is a broadening of dollar outflows from the Dow issues. As long as outflows are selective and money is moving into the Dow stocks as a whole, market declines are likely to be contained. That's been the pattern since 2004. To this point, I've seen no change to the pattern in the recent market data. The Dow has been down for three consecutive sessions, but only 9 of the Dow 30 have seen net outflows over this period.
As a whole, dollars have been flowing into the Dow. Since 2004 (N = 787 trading days), we have only had 57 occasions in which net money flowed out of the Dow 30 stocks as a whole. In other words, when we compute the Relative Dollar Volume Flow for each of the Dow 30 issues and sum these to obtain a total Flow for the Dow, rarely have we seen net selling of the Dow. More on that later.
This strength of money flow, however, belies large differences among the individual Dow components. Over the past 25 trading sessions, the Dow as a whole has been modestly higher. Let's look, though, at how many of those trading sessions saw net dollar inflows for each of the Dow issues:
AA - 22
AIG - 19
AXP - 17
BA - 24
C - 20
CAT - 24
DD - 25
DIS - 13
GE - 18
GM - 25
HD - 17
HON - 22
HPQ - 21
IBM - 24
INTC - 16
JNJ - 13
JPM - 18
KO - 11
MCD - 21
MMM - 19
MO - 23
MRK - 22
MSFT - 7
PFE - 8
PG - 23
T - 22
UTX - 22
VZ - 22
WMT - 14
XOM - 21
What we can see is consistent inflows into such issues as BA, CAT, DD, GM, and IBM and more consistent outflows from MSFT, PFE, KO, DIS, JNJ, and WMT. Overall, 17 of the Dow 30 have seen net inflows for 20 or more days in the last 25 trading sessions. That is not exactly a picture of broad weakness. Rather, it suggests that institutions have been moving money away from selected issues (many of which might be characterized as blue chip growth rather than value). I find it informative to go to a site such as Instant Bull and examine the news and the message board buzz about these stocks, as a way of seeing what the market is concerned about. In the case of the stocks with the most consistent outflows, MSFT and PFE, there are clear concerns surrounding Vista and health care costs, respectively. The Dollar Volume Flow figures suggest that money managers are truly acting upon those concerns.
Overall, since 2004, we have had corrections in the market, generally in the vicinity of 5-7%. On those occasions, we've seen a reduction of net inflows into the Dow 30 stocks, but no systematic liquidation. I went back to the 57 trading days in which we had net outflows from the Dow 30 as a whole. Three days later, the Dow (DIA) was up by an average of .35% (35 up, 22 down). That compares to the average three-day gain in DIA for the remainder of the sample of .06% (396 up, 334 down). In other words, investors have tended to use outflows from the Dow as short-term buying opportunities.
At some point we will have a bear market. Indeed, as I write, the preopening stock index futures are trading much lower. What will tell us whether such a move is a normal correction vs. a full-fledged start to a bear market? One thing we might look for is a broadening of dollar outflows from the Dow issues. As long as outflows are selective and money is moving into the Dow stocks as a whole, market declines are likely to be contained. That's been the pattern since 2004. To this point, I've seen no change to the pattern in the recent market data. The Dow has been down for three consecutive sessions, but only 9 of the Dow 30 have seen net outflows over this period.
Monday, February 26, 2007
Monday, February 26th Morning Market Comments
9:41 AM - Seeing a little relative strength in the semis; let's see if that continues. As long as we get more volume in ES hitting bids than offers, it's tough to pull off any turnaround in that index. Notice how the short-term trader breaks down the market into swings up and down and continuously compares the strength of the swings relative to one another to gauge underlying demand and supply. That's where the tools such as TICK and volume at bid and offer come in handy. We saw strength in the overnight market, but then buying soon after the open could not move us above the premarket highs and we saw selling in NQ and ER2, as well as semis. That set us up for a move back into the value area of Friday's trade.
Hope these morning sessions have sensitized you to some short-term patterns in the market. I will hold occasional morning sessions during March as the schedule allows. Thanks for your interest, and have a great day!
9:34 AM - Well, no sooner did I post that than we saw a bounce in TICK on low volume and then strong renewed selling. From the standpoint of execution, it makes sense to wait for those bounces to enter in the direction of the trend, not to get excited and sell weakness. I find it helpful to watch not only the net buying vs selling in the Market Delta bars, but also the high and low Delta values for the bar to see if we're getting stronger or weaker *within the bar period*. This very much helps for execution, as it keeps you out of buying a market in which price may be bouncing, but buying volume is tepid. Back in a bit.
9:28 AM - When you see selling in the TICK and volume hitting bids in ES but the indices can't make new price lows, it's telling you that the selling sentiment is still there, but that sentiment is having a harder time moving price. In other words, the market is becoming less efficient to the downside. Such shifts in efficiency are common around market turns, so I usually don't chase weakness if price is having a hard time budging.
9:12 AM - When you have downthrusts like that, what you want to do is wait for the buyers to take their turn. You'll see that by bounces in the NYSE TICK and by buying in the Market Delta (green). The important thing is to compare the volume on the bounces to the volume on the prior decline and to compare the level of the TICK on the bounces to the prior TICK levels. If the bounces are occurring at lower volume levels, with less buying at the offer, and at lower TICK levels, those become opportunities to ride the market for another move down. Conversely, if you get solid volume on the bounces and new TICK highs, that's when you look for a short-term reversal in the market. More on that in a bit.
8:55 AM - You can see how the ER2 and NQ weakness were great tells for the short-term breakdown in ES, which has now attracted increased selling volume. Nice example of how looking at the more volatile sectors/indices can alert you to what is likely to happen in the broader market.
8:49 AM - Seeing some profit taking in ER2 and NQ, as well as semis, despite positive TICK. We're getting more ES volume at offer than bid, but again not impressively so. I'd need to see greater TICK weakness before being aggressive on the downside, but neither is the buying follow through impressive so far.
8:40 AM CT - Watching some early relative weakness in semiconductors and NQ. Worth keeping an eye on. Volume in ES is decent, not extreme; with more volume transacted at offer than bid, but not by as much as you might have thought given the overnite strength.
8:17 AM CT - And a very good morning to you! I'm wrapping up my morning session blogging today, and today will be a very light day of blogging at that. Lots of new projects going on here, and those will be taking my time and attention. One of those projects is described in my latest post; some promising research for swing traders. See also my latest entry in the Trader Performance section of my personal site. Another project is learning online video production. Eventually I'll start posting some instructional videos that I think will be more informative in a how-to way than the morning session posts. I also talked with my editor at Wiley and we're investigating the possibility of putting together a combination book/video that focuses on some of the trading ideas from the blog and the morning sessions. And, finally, as we move into March and weather improves, I'll be back on the road and working with traders at different firms. It's all good...just a lot of balls to juggle at once! I know things are hectic when my email inbox reads over 900!
We have some good overnight buying in both Europe and in the U.S. futures. Interest rates are down, and we're back into the prior trading range in the equity indices. Note that Friday we broke the prior day's lows in ES, but not in ER2 and only barely in NQ. I'm looking at the possibility of this representing an intermediate-term bottom that will take us to new price highs. So my leaning is to be buying on selling that dries up. I had the right general idea on Friday, but jumped the gun on the buying. We need to see evidence of sellers being unable to push the market lower before committing to the long side. I'll be watching the semiconductors (which have been strong lately) and ER2 for signs of strength vs. reversal. NQ and ER2 are pretty close to their previous week's highs; keep an eye on those levels and whether or not they attract volume. Pivot targets are posted to the Weblog. Note that we are trading pretty much at the average level of the prior trading range at present. No economic releases today, but quite a few coming up this week. Let's see if trading slows ahead of those numbers. Back after the open; I will be posting only when I see something of significance.
Hope these morning sessions have sensitized you to some short-term patterns in the market. I will hold occasional morning sessions during March as the schedule allows. Thanks for your interest, and have a great day!
9:34 AM - Well, no sooner did I post that than we saw a bounce in TICK on low volume and then strong renewed selling. From the standpoint of execution, it makes sense to wait for those bounces to enter in the direction of the trend, not to get excited and sell weakness. I find it helpful to watch not only the net buying vs selling in the Market Delta bars, but also the high and low Delta values for the bar to see if we're getting stronger or weaker *within the bar period*. This very much helps for execution, as it keeps you out of buying a market in which price may be bouncing, but buying volume is tepid. Back in a bit.
9:28 AM - When you see selling in the TICK and volume hitting bids in ES but the indices can't make new price lows, it's telling you that the selling sentiment is still there, but that sentiment is having a harder time moving price. In other words, the market is becoming less efficient to the downside. Such shifts in efficiency are common around market turns, so I usually don't chase weakness if price is having a hard time budging.
9:12 AM - When you have downthrusts like that, what you want to do is wait for the buyers to take their turn. You'll see that by bounces in the NYSE TICK and by buying in the Market Delta (green). The important thing is to compare the volume on the bounces to the volume on the prior decline and to compare the level of the TICK on the bounces to the prior TICK levels. If the bounces are occurring at lower volume levels, with less buying at the offer, and at lower TICK levels, those become opportunities to ride the market for another move down. Conversely, if you get solid volume on the bounces and new TICK highs, that's when you look for a short-term reversal in the market. More on that in a bit.
8:55 AM - You can see how the ER2 and NQ weakness were great tells for the short-term breakdown in ES, which has now attracted increased selling volume. Nice example of how looking at the more volatile sectors/indices can alert you to what is likely to happen in the broader market.
8:49 AM - Seeing some profit taking in ER2 and NQ, as well as semis, despite positive TICK. We're getting more ES volume at offer than bid, but again not impressively so. I'd need to see greater TICK weakness before being aggressive on the downside, but neither is the buying follow through impressive so far.
8:40 AM CT - Watching some early relative weakness in semiconductors and NQ. Worth keeping an eye on. Volume in ES is decent, not extreme; with more volume transacted at offer than bid, but not by as much as you might have thought given the overnite strength.
8:17 AM CT - And a very good morning to you! I'm wrapping up my morning session blogging today, and today will be a very light day of blogging at that. Lots of new projects going on here, and those will be taking my time and attention. One of those projects is described in my latest post; some promising research for swing traders. See also my latest entry in the Trader Performance section of my personal site. Another project is learning online video production. Eventually I'll start posting some instructional videos that I think will be more informative in a how-to way than the morning session posts. I also talked with my editor at Wiley and we're investigating the possibility of putting together a combination book/video that focuses on some of the trading ideas from the blog and the morning sessions. And, finally, as we move into March and weather improves, I'll be back on the road and working with traders at different firms. It's all good...just a lot of balls to juggle at once! I know things are hectic when my email inbox reads over 900!
We have some good overnight buying in both Europe and in the U.S. futures. Interest rates are down, and we're back into the prior trading range in the equity indices. Note that Friday we broke the prior day's lows in ES, but not in ER2 and only barely in NQ. I'm looking at the possibility of this representing an intermediate-term bottom that will take us to new price highs. So my leaning is to be buying on selling that dries up. I had the right general idea on Friday, but jumped the gun on the buying. We need to see evidence of sellers being unable to push the market lower before committing to the long side. I'll be watching the semiconductors (which have been strong lately) and ER2 for signs of strength vs. reversal. NQ and ER2 are pretty close to their previous week's highs; keep an eye on those levels and whether or not they attract volume. Pivot targets are posted to the Weblog. Note that we are trading pretty much at the average level of the prior trading range at present. No economic releases today, but quite a few coming up this week. Let's see if trading slows ahead of those numbers. Back after the open; I will be posting only when I see something of significance.
Tracking the Dollar Volume Flows of Stocks
Over the weekend, I've been working on some fascinating research to answer a group of questions: How much money is actually flowing into or out of a particular stock on a given session? Are these dollar volume flows increasing or decreasing over time? Is the stock attracting more dollars than other stocks in the same sector? Than stocks in other sectors? And--most important of all--how is the amount of dollars flowing into a stock related to how that stock behaves going forward?
As I indicate in my latest Trader Performance entry, Relative Dollar Volume Flow appears to be a promising measure of underlying demand or supply for a stock. The idea is simple: take every trade that occurs in a stock during the day and multiply the price at which the trade was transacted by the volume of that trade. If the trade occurred on an uptick (or if the last price change was an uptick), you add this value to a running cumulative total for the day. If the trade occurred on a downtick (or if the last price change was a downtick), you subtract this value from the running cumulative total for the day. At the end of the day, the final cumulative total reflects the buying or selling of large market participants (institutions that transact large blocks, large portfolio managers), because their transactions account for most of total (given the large volume of their purchases or sales).
If you have institutions eager to get into a stock, they will buy large positions on upticks. If those institutions are eager to bail out of a stock, they will sell large positions on downticks. The logic is similar to Market Delta, only this is a measure intended for longer-term analysis. (It would be interesting to study it on an intraday basis for signals, but so far I have not done so).
I refer to this as *Relative* Dollar Volume Flow because I divide the cumulative total at the end of the day by that day's trading volume. This provides a better comparison of the money flowing into one stock vs. another: One million dollars flowing into a large cap stock that is an institutional favorite will reflect lower Relative Dollar Volume Flow than one million dollars flowing into a lightly traded small cap issue.
One application of Relative Dollar Volume Flow is to ETFs. Does the amount of money flowing into or out of an ETF tell us anything about the Fund's performance going forward?
I conducted a small investigation of the Dow Jones Industrial Average ETF (DIA) by tracking its daily Relative Dollar Volume Flow from the beginning of 2004 to the present (N = 771 trading days). When the 20 day Flow for DIA was positive (net money flowing into DIA; N = 442), the next 20 days in DIA averaged a gain of only .05% (245 up, 197 down). When the 20 day Flow was negative (net money flowing out of DIA; N = 329), the next 20 days in DIA averaged a very solid gain of 1.11% (227 up, 102 down). This is a pronounced reversal effect: when we see money flowing out of DIA over a 20-day period, returns have been superior. When DIA has attracted dollars over a 20-day period, returns have been subnormal.
Very interestingly, if we calculate the Dollar Volume Flow for the Dow by individually summing up the Flows for the 30 component stocks, this value correlates with the Flow for DIA by only .14. In other words, money flowing into and out of DIA is not especially reflective of money flowing in and out of the individual Dow stocks. Rather, DIA's flows (like those of other index ETFs) may be more skewed by the activity of hedgers and program traders who might not be making long-term portfolio adjustments.
Indeed, the Dollar Volume Flows for the summed 30 Dow stocks shows that money has been continuously flowing into those issues through the bull market and really accelerated after we made a bottom in July of 2006. Although there are individual issues with net dollar outflows (MSFT is notable in that regard), there is little evidence at present that money is systematically flowing out of the Dow. (Inflows have slowed over the last two weeks, but remain positive).
An especially promising strategy is to identify stocks with favorable expectations based on their Relative Dollar Volume Flows and those with subnormal expectations and create a long/short strategy of buying the former and selling the latter. This would create a diversified portfolio that would be relatively market neutral. I'm also beginning to take a look at falling stocks with rising Dollar Volume Flows and rising stocks with weakening flows to see if we can anticipate turns in those issues. Clearly, there's a lot of room for interesting research here. I hope to report results in the near future.
As I indicate in my latest Trader Performance entry, Relative Dollar Volume Flow appears to be a promising measure of underlying demand or supply for a stock. The idea is simple: take every trade that occurs in a stock during the day and multiply the price at which the trade was transacted by the volume of that trade. If the trade occurred on an uptick (or if the last price change was an uptick), you add this value to a running cumulative total for the day. If the trade occurred on a downtick (or if the last price change was a downtick), you subtract this value from the running cumulative total for the day. At the end of the day, the final cumulative total reflects the buying or selling of large market participants (institutions that transact large blocks, large portfolio managers), because their transactions account for most of total (given the large volume of their purchases or sales).
If you have institutions eager to get into a stock, they will buy large positions on upticks. If those institutions are eager to bail out of a stock, they will sell large positions on downticks. The logic is similar to Market Delta, only this is a measure intended for longer-term analysis. (It would be interesting to study it on an intraday basis for signals, but so far I have not done so).
I refer to this as *Relative* Dollar Volume Flow because I divide the cumulative total at the end of the day by that day's trading volume. This provides a better comparison of the money flowing into one stock vs. another: One million dollars flowing into a large cap stock that is an institutional favorite will reflect lower Relative Dollar Volume Flow than one million dollars flowing into a lightly traded small cap issue.
One application of Relative Dollar Volume Flow is to ETFs. Does the amount of money flowing into or out of an ETF tell us anything about the Fund's performance going forward?
I conducted a small investigation of the Dow Jones Industrial Average ETF (DIA) by tracking its daily Relative Dollar Volume Flow from the beginning of 2004 to the present (N = 771 trading days). When the 20 day Flow for DIA was positive (net money flowing into DIA; N = 442), the next 20 days in DIA averaged a gain of only .05% (245 up, 197 down). When the 20 day Flow was negative (net money flowing out of DIA; N = 329), the next 20 days in DIA averaged a very solid gain of 1.11% (227 up, 102 down). This is a pronounced reversal effect: when we see money flowing out of DIA over a 20-day period, returns have been superior. When DIA has attracted dollars over a 20-day period, returns have been subnormal.
Very interestingly, if we calculate the Dollar Volume Flow for the Dow by individually summing up the Flows for the 30 component stocks, this value correlates with the Flow for DIA by only .14. In other words, money flowing into and out of DIA is not especially reflective of money flowing in and out of the individual Dow stocks. Rather, DIA's flows (like those of other index ETFs) may be more skewed by the activity of hedgers and program traders who might not be making long-term portfolio adjustments.
Indeed, the Dollar Volume Flows for the summed 30 Dow stocks shows that money has been continuously flowing into those issues through the bull market and really accelerated after we made a bottom in July of 2006. Although there are individual issues with net dollar outflows (MSFT is notable in that regard), there is little evidence at present that money is systematically flowing out of the Dow. (Inflows have slowed over the last two weeks, but remain positive).
An especially promising strategy is to identify stocks with favorable expectations based on their Relative Dollar Volume Flows and those with subnormal expectations and create a long/short strategy of buying the former and selling the latter. This would create a diversified portfolio that would be relatively market neutral. I'm also beginning to take a look at falling stocks with rising Dollar Volume Flows and rising stocks with weakening flows to see if we can anticipate turns in those issues. Clearly, there's a lot of room for interesting research here. I hope to report results in the near future.
Sunday, February 25, 2007
Five Guiding Principles of Short-Term Trading
I recently posted five guiding principles of trading psychology. Those are big concepts that help me understand traders. Here are five guiding principles that I draw upon in understanding the psychology of the marketplace:
1) Markets are moved by their largest participants - I believe this is the single most important principle in short-term trading. Accordingly, I track the presence of large traders by determining how much volume is in the market and how that compares to average. Because volume correlates very highly with volatility, the market's relative volume helps you determine the amount of movement likely at any given time frame--and it helps you handicap the odds of trending vs. remaining slow and range bound.
2) Trends are created by shifts in supply/demand generated by global/macro relationships - The forces that ultimately move stocks are related to intermarket changes in supply and demand that result from interest rate shifts, movements among currencies, inflation and commodity prices, and profitability among companies in various international markets. This means that the short-term trader must keep one eye on the intraday shifts in buying and selling of large traders, but the other eye on the day to day and week to week changes that impact the demand for stocks. Knowing the big picture is crucial to trading in the right direction, even when the trading is short-term and your focus is on the initial minutes of trading.
3) Market moves on strong momentum tend to persist in the short run; moves on weak momentum tend to reverse - When the vast majority of stocks are participating in a market move, those moves tend to continue as short-term trends. When markets make new highs or lows and a large proportion of stocks and sectors do not follow, those moves are more likely to be reversed. This is one reason that it is important to watch the entire market, not just the stock or instrument that you happen to be trading. Because the major market indices tend to be capitalization weighted, they can make new highs or lows simply because a few stocks happen to be strong or weak. Tracking the breadth of moves tells you if there is an overall demand or supply for stocks.
4) There are only three kinds of trades: breakout trades, trend-following trades, and reversal trades. Breakouts and reversal typically occur in the context of bracketing markets. As we establish value in a relatively narrow range, the market probes the upper and lower bounds of the value range to test demand and supply. The breakout trades result when prices away from value (i.e., away from the average trading price within a range) attract fresh buying or selling interest. The reversal trades occur when prices away from value fail to attract buyers or sellers, leading to movement back toward value (the average trading price). The trend-following trade occurs after a breakout and consists of buying pullbacks in an uptrend or selling bounces in a decline. These trades last as long as markets continue to make new highs or lows on successive moves in the trend direction--and especially as the majority of stocks participate in those new highs or lows. Knowing the status of the market--bracketing or trending--tells you the type of trade likely to set up. Following Market Profile over multiple time frames is very helpful in determining market status.
5) Tracking market activity at the bid and offer is useful in detecting shifts in short-term demand and supply - Such tracking includes contract volume at the bid vs. offer, as charted in Market Delta, but also includes the number of stocks trading at their offer vs. bid price, as in the NYSE TICK. Over time, we commonly see transitional structures in which extremes of buying or selling interest bring the market to new highs or lows, resulting in reduced buying/selling, and eventual reversal. These transitions clue us into shifts in the psychology of the marketplace and are very helpful in framing trade ideas.
I stress the above five principles because they capture how I've found successful professional traders approach the markets. I'm sure there are highly profitable pros somewhere who trade wave patterns, moving averages, chart formations, and the like. In several years of working hands on with such traders, however, I have yet to meet one who uses these methods. The pros do, on the other hand, care very much about who is in the markets and why markets are moving. The principles provide a framework for making sense of market behavior, which then can be used to filter the setups provided by charts, cycles, and the like. The really good traders understand markets; they don't just predict them.
1) Markets are moved by their largest participants - I believe this is the single most important principle in short-term trading. Accordingly, I track the presence of large traders by determining how much volume is in the market and how that compares to average. Because volume correlates very highly with volatility, the market's relative volume helps you determine the amount of movement likely at any given time frame--and it helps you handicap the odds of trending vs. remaining slow and range bound.
2) Trends are created by shifts in supply/demand generated by global/macro relationships - The forces that ultimately move stocks are related to intermarket changes in supply and demand that result from interest rate shifts, movements among currencies, inflation and commodity prices, and profitability among companies in various international markets. This means that the short-term trader must keep one eye on the intraday shifts in buying and selling of large traders, but the other eye on the day to day and week to week changes that impact the demand for stocks. Knowing the big picture is crucial to trading in the right direction, even when the trading is short-term and your focus is on the initial minutes of trading.
3) Market moves on strong momentum tend to persist in the short run; moves on weak momentum tend to reverse - When the vast majority of stocks are participating in a market move, those moves tend to continue as short-term trends. When markets make new highs or lows and a large proportion of stocks and sectors do not follow, those moves are more likely to be reversed. This is one reason that it is important to watch the entire market, not just the stock or instrument that you happen to be trading. Because the major market indices tend to be capitalization weighted, they can make new highs or lows simply because a few stocks happen to be strong or weak. Tracking the breadth of moves tells you if there is an overall demand or supply for stocks.
4) There are only three kinds of trades: breakout trades, trend-following trades, and reversal trades. Breakouts and reversal typically occur in the context of bracketing markets. As we establish value in a relatively narrow range, the market probes the upper and lower bounds of the value range to test demand and supply. The breakout trades result when prices away from value (i.e., away from the average trading price within a range) attract fresh buying or selling interest. The reversal trades occur when prices away from value fail to attract buyers or sellers, leading to movement back toward value (the average trading price). The trend-following trade occurs after a breakout and consists of buying pullbacks in an uptrend or selling bounces in a decline. These trades last as long as markets continue to make new highs or lows on successive moves in the trend direction--and especially as the majority of stocks participate in those new highs or lows. Knowing the status of the market--bracketing or trending--tells you the type of trade likely to set up. Following Market Profile over multiple time frames is very helpful in determining market status.
5) Tracking market activity at the bid and offer is useful in detecting shifts in short-term demand and supply - Such tracking includes contract volume at the bid vs. offer, as charted in Market Delta, but also includes the number of stocks trading at their offer vs. bid price, as in the NYSE TICK. Over time, we commonly see transitional structures in which extremes of buying or selling interest bring the market to new highs or lows, resulting in reduced buying/selling, and eventual reversal. These transitions clue us into shifts in the psychology of the marketplace and are very helpful in framing trade ideas.
I stress the above five principles because they capture how I've found successful professional traders approach the markets. I'm sure there are highly profitable pros somewhere who trade wave patterns, moving averages, chart formations, and the like. In several years of working hands on with such traders, however, I have yet to meet one who uses these methods. The pros do, on the other hand, care very much about who is in the markets and why markets are moving. The principles provide a framework for making sense of market behavior, which then can be used to filter the setups provided by charts, cycles, and the like. The really good traders understand markets; they don't just predict them.
P&L Management: A Best Practice in Trading
From Brett: Our next best practice in trading comes from David Aferiat of Trade Ideas, who passes along a practice from some of the firms he works with. The idea is that we can become emotionally connected (or disconnected) to the specific stocks or instruments that are most recently contributing to our profit and loss (P & L). Such reactions take our attention away from sound money management. My comments follow David's submission.
From David: We work with many trading firms across the country that use Trade-Ideas to assist in their idea generation and risk management decisions. Dan Mirkin mentioned this in his recent appearance at the NY Traders Expo. Several firms teach their newer traders to remove a common heuristic that emphasizes previous winning trades over losing trades.
Traders tend to review their P&L and focus more on what symbols were winners for them in the current session. To reduce the tendency to get tangled up in winners and losers, these traders, who manage an average of 10 – 12 positions at any given time; minimize the ‘Symbol’ field in their open portfolio view. Only ‘Number of shares’, ‘Last Bid/Ask’, and ‘P&L’ fields are viewed.
When a trader does not see the symbol or name of the instrument, all the focus shifts to the P&L and the money lost or won in the position and making decisions based solely on money is a lot easier and quicker to process than a mini-internal debate about what the symbol is doing to your P&L.
From Brett: A similar practice that some traders found helpful at the proprietary trading firm where I worked was that they would cover up their day's P/L display so that they would not become overly focused on the money in making decisions. They knew that they had a risk manager at the firm who would call them if they hit a "warning level" of losses for the day. They didn't want to become too aggressive when they were winning, and they didn't want to become too risk averse if they were down money. The idea here is to separate out as much as possible your trading decisions from the ups and downs of what has happened most recently (much of which is random). Once you have your position sizing, price targets, and stops in place, you let the profits and losses take care of themselves based upon the edge you've cultivated. You want to be trading opportunity, not your mood of the moment. Tuning out data that would bias your trading--whether it's the TV, the "hot" or "cold" stock symbols, or a green/red P/L number--is helpful to emotional P&L management and a best practice. Thanks to David for passing this along.
From David: We work with many trading firms across the country that use Trade-Ideas to assist in their idea generation and risk management decisions. Dan Mirkin mentioned this in his recent appearance at the NY Traders Expo. Several firms teach their newer traders to remove a common heuristic that emphasizes previous winning trades over losing trades.
Traders tend to review their P&L and focus more on what symbols were winners for them in the current session. To reduce the tendency to get tangled up in winners and losers, these traders, who manage an average of 10 – 12 positions at any given time; minimize the ‘Symbol’ field in their open portfolio view. Only ‘Number of shares’, ‘Last Bid/Ask’, and ‘P&L’ fields are viewed.
When a trader does not see the symbol or name of the instrument, all the focus shifts to the P&L and the money lost or won in the position and making decisions based solely on money is a lot easier and quicker to process than a mini-internal debate about what the symbol is doing to your P&L.
From Brett: A similar practice that some traders found helpful at the proprietary trading firm where I worked was that they would cover up their day's P/L display so that they would not become overly focused on the money in making decisions. They knew that they had a risk manager at the firm who would call them if they hit a "warning level" of losses for the day. They didn't want to become too aggressive when they were winning, and they didn't want to become too risk averse if they were down money. The idea here is to separate out as much as possible your trading decisions from the ups and downs of what has happened most recently (much of which is random). Once you have your position sizing, price targets, and stops in place, you let the profits and losses take care of themselves based upon the edge you've cultivated. You want to be trading opportunity, not your mood of the moment. Tuning out data that would bias your trading--whether it's the TV, the "hot" or "cold" stock symbols, or a green/red P/L number--is helpful to emotional P&L management and a best practice. Thanks to David for passing this along.
Saturday, February 24, 2007
Book Review: Markets in Profile
From Brett: I recently mentioned the use of Market Profile as a trading best practice. Here is my full review of Markets in Profile: Profiting from the Auction Process by James Dalton, Robert Dalton, and Eric Jones (Wiley, 2007). I believe the underlying concept behind the book--understanding what is happening in the auction process at timeframes longer than your normal trading horizon--is an important one. "Which timeframe is in control of the market?" is a question that short-term traders rarely address, leaving them open to unexpected market shifts. The Markets in Profile book does a nice job of showing traders how to answer this question--and what to do about it. The following review was posted to the Amazon site earlier today.
When I initiated an internship program for new traders at a proprietary trading firm, I began by providing students with a conceptual overview of markets and the factors that make markets move. That overview drew heavily upon the book "Mind Over Markets" by James Dalton, Eric Jones, and Robert Dalton. Quite simply, that book is the most readable, lucid, and insightful work on the auction process underlying trading markets that I have yet encountered.
You can imagine, then, my delight when I had the opportunity to read an advance copy of the authors' new work, "Markets in Profile" and provide a review statement for the book's cover. I turn down these endorsement requests rather often. Frankly, many of them are simply favors being done by buddies and don't reflect an actual reading of the text. The least authors can do for their readers is keep it real.
There was no problem in my keeping it real when I wrote that "Good books teach, but the best books enlighten". Markets in Profile is one of those enlightening books, because it takes the conceptual framework from the first book and applies it to concrete trading time frames and trading scenarios. In that sense, I would say it is a worthy bridge between theory/understanding and practice.
A core theme of Markets in the Dalton, Dalton, and Jones text is the following nugget: "If you can correctly identify which timeframe is in control of market activity, and you have a good understanding of how the individual timeframes generally behave, then you are in a stronger position to trade, invest, and effectively control risk." The practical aspect of the book is that it illustrates how to read the Market Profile to grasp the long-, intermediate-, and short-term auctions and place current market activity into a proper context.
Time and again I have observed that a trading edge comes from understanding what is happening at the timeframes greater than the one you're trading. If you're in a trading range, you might want to be prepared for a breakout. Which way is it likely to break? Using price, time, and volume to see how value is being established at those larger timeframes provides invaluable clues.
As the authors also explain, observing volume patterns as the market moves away from value at one timeframe is very important to understanding whether or not we will return to value or reprice value (perhaps in line with the longer-term auctions). Seeing these dynamics evolve over time helps traders understand what is likely to occur, but also *why*.
I find the authors' use of examples, charts, and Market Profile diagrams to be quite helpful. This is not an encyclopedic work; it's a very readable 200 pages. By the end, however, readers will have a solid understanding of how to apply auction-based principles across timeframes and frame their trade ideas with that broader understanding. A particularly practical chapter is the one on day-trading, which shows how these principles are relevant to the active trader.
The authors make clear that Market Profile is not a trading system, but a framework from which trading ideas can be derived. My analogy isn't perfect, but perhaps it will make sense: Just as the periodic table helps chemists organize their understanding of elements and predict how elements are likely to interact with one another, the Market Profile organizes data on price, time, and volume to help traders anticipate market behavior. We have types of elements (metals, non-metals) and combinations of elements, and we have types of markets and combinations of markets: knowing type provides invaluable clues as to likely behavior in various situations.
It's rare that I don't have some reservations about a book. This one is clearly written, straightforward, and doesn't get away from its topic. There's no fluff, and (mercifully) there's no chest-beating self-congratulations from authors who try to make themselves out to be gurus. Markets in Profile is simply a guide for putting theory into practice at different time frames. That, in itself, is unique in the trading literature.
When I initiated an internship program for new traders at a proprietary trading firm, I began by providing students with a conceptual overview of markets and the factors that make markets move. That overview drew heavily upon the book "Mind Over Markets" by James Dalton, Eric Jones, and Robert Dalton. Quite simply, that book is the most readable, lucid, and insightful work on the auction process underlying trading markets that I have yet encountered.
You can imagine, then, my delight when I had the opportunity to read an advance copy of the authors' new work, "Markets in Profile" and provide a review statement for the book's cover. I turn down these endorsement requests rather often. Frankly, many of them are simply favors being done by buddies and don't reflect an actual reading of the text. The least authors can do for their readers is keep it real.
There was no problem in my keeping it real when I wrote that "Good books teach, but the best books enlighten". Markets in Profile is one of those enlightening books, because it takes the conceptual framework from the first book and applies it to concrete trading time frames and trading scenarios. In that sense, I would say it is a worthy bridge between theory/understanding and practice.
A core theme of Markets in the Dalton, Dalton, and Jones text is the following nugget: "If you can correctly identify which timeframe is in control of market activity, and you have a good understanding of how the individual timeframes generally behave, then you are in a stronger position to trade, invest, and effectively control risk." The practical aspect of the book is that it illustrates how to read the Market Profile to grasp the long-, intermediate-, and short-term auctions and place current market activity into a proper context.
Time and again I have observed that a trading edge comes from understanding what is happening at the timeframes greater than the one you're trading. If you're in a trading range, you might want to be prepared for a breakout. Which way is it likely to break? Using price, time, and volume to see how value is being established at those larger timeframes provides invaluable clues.
As the authors also explain, observing volume patterns as the market moves away from value at one timeframe is very important to understanding whether or not we will return to value or reprice value (perhaps in line with the longer-term auctions). Seeing these dynamics evolve over time helps traders understand what is likely to occur, but also *why*.
I find the authors' use of examples, charts, and Market Profile diagrams to be quite helpful. This is not an encyclopedic work; it's a very readable 200 pages. By the end, however, readers will have a solid understanding of how to apply auction-based principles across timeframes and frame their trade ideas with that broader understanding. A particularly practical chapter is the one on day-trading, which shows how these principles are relevant to the active trader.
The authors make clear that Market Profile is not a trading system, but a framework from which trading ideas can be derived. My analogy isn't perfect, but perhaps it will make sense: Just as the periodic table helps chemists organize their understanding of elements and predict how elements are likely to interact with one another, the Market Profile organizes data on price, time, and volume to help traders anticipate market behavior. We have types of elements (metals, non-metals) and combinations of elements, and we have types of markets and combinations of markets: knowing type provides invaluable clues as to likely behavior in various situations.
It's rare that I don't have some reservations about a book. This one is clearly written, straightforward, and doesn't get away from its topic. There's no fluff, and (mercifully) there's no chest-beating self-congratulations from authors who try to make themselves out to be gurus. Markets in Profile is simply a guide for putting theory into practice at different time frames. That, in itself, is unique in the trading literature.
Detecting Participation in Breakout Moves: A Best Practice in Trading
From Brett: Our next Best Practice post comes to us from Aiva_Trader, who examined the last five months of data in the NASDAQ 100 Index (QQQQ) to establish the odds of continued upward movement once QQQQ breaks above its current day's high. Specifically, the study broke down occasions in which fewer than 30% of NDX stocks were participating in the move (i.e., not surpassing their current day's highs) vs. those occasions in which more than 70% of NDX were also participating in the breakout. Here are the findings:
From Aiva_Trader:
When QQQQ breaks its current day high (all occasions):
The close 1 minute later is up by an average of .026% and closed up 68% of the time.
The close 5 minutes later is up by an average of .030% and closed up 59% of the time.
The close 15 minutes later is up by an average of .043% and closed up 56% of the time.
When QQQQ breaks its current day high and fewer than 30% of index stocks participate:
The close 1 minute later is up by an average of .002% and closed up 68% of the time.
The close 5 minutes later is down by an average of -.028% and closed up 44% of the time.
The close 15 minutes later is down by an average of -.05% and closed up 39% of the time.
When QQQQ breaks its current day high and more than 70% of index stocks participate:
The close 1 minute later is up by an average of .05% and closed up 71% of the time.
The close 5 minutes later is up by an average of .05% and closed up 62.5% of the time.
The close 15 minutes later is up by an average of .07% and closed up 58% of the time.
From Brett: These results fit well with my own research. Breakout moves are more likely to reverse when a large proportion of sectors and individual stocks are not participating in the breakout. This helps to differentiate a market that is topping out (becoming more selective as it approaches highs) from a market that is breaking out (ready to establish fresh new highs). I suspect Aiva_Trader's observations could form a core concept for a trading system, particularly if the signals were filtered by such criteria as whether or not the market was overbought at the time of new highs, time of day of the breakout move, etc. It would also be fruitful to examine holding periods from 30-90 minutes out. My own recent research found that fading new 60 minute lows in SPY and IWM has been profitable at those holding periods. Many thanks to Aiva_Trader for the valuable observation in the NASDAQ market. Knowing the odds that a market has gone your way in the recent past is, for me, a best practice--and a helpful aid in avoiding bad trades.
From Aiva_Trader:
When QQQQ breaks its current day high (all occasions):
The close 1 minute later is up by an average of .026% and closed up 68% of the time.
The close 5 minutes later is up by an average of .030% and closed up 59% of the time.
The close 15 minutes later is up by an average of .043% and closed up 56% of the time.
When QQQQ breaks its current day high and fewer than 30% of index stocks participate:
The close 1 minute later is up by an average of .002% and closed up 68% of the time.
The close 5 minutes later is down by an average of -.028% and closed up 44% of the time.
The close 15 minutes later is down by an average of -.05% and closed up 39% of the time.
When QQQQ breaks its current day high and more than 70% of index stocks participate:
The close 1 minute later is up by an average of .05% and closed up 71% of the time.
The close 5 minutes later is up by an average of .05% and closed up 62.5% of the time.
The close 15 minutes later is up by an average of .07% and closed up 58% of the time.
From Brett: These results fit well with my own research. Breakout moves are more likely to reverse when a large proportion of sectors and individual stocks are not participating in the breakout. This helps to differentiate a market that is topping out (becoming more selective as it approaches highs) from a market that is breaking out (ready to establish fresh new highs). I suspect Aiva_Trader's observations could form a core concept for a trading system, particularly if the signals were filtered by such criteria as whether or not the market was overbought at the time of new highs, time of day of the breakout move, etc. It would also be fruitful to examine holding periods from 30-90 minutes out. My own recent research found that fading new 60 minute lows in SPY and IWM has been profitable at those holding periods. Many thanks to Aiva_Trader for the valuable observation in the NASDAQ market. Knowing the odds that a market has gone your way in the recent past is, for me, a best practice--and a helpful aid in avoiding bad trades.
Friday, February 23, 2007
Friday, February 23rd Morning Market Comments
9:27 AM - Clearly we didn't get the buying interest; once again stopped out. That TICK distribution is all important, and in retrospect I was bucking it and holding too long onto a strength scenario. Food for review and learning this weekend! Have a great weekend; wrap up on the Weblog tonite.
9:19 AM - Well, we'll either hit my target or my stop. I'd be stopped out on new lows for the day and the initial target would be that average price range for ES.
9:17 AM - Once again, I tried a little buying as we failed to make lows on the recent selling, but stops are tight and I'll need to see solid buying coming in. My basic idea is to buy as long as we stay above yesterday's lows; I'm not impressed with the breadth of selling today relative to yesterday, so have been leaning toward buying weakness. We'll see if that works out. The key is to keep position sizing and stops reasonable to survive being wrong!
9:10 AM - Note semi and NQ strength here.
9:05 AM - Need to see more strength in ER2 and TICK and ability to hold lows before retaking long side. Looking at bounces as potential selling areas, particularly if TICK and volume are weak on the bounces.
9:02 AM - Stopped out as ER2 and TICK weakened. Watching those bounces carefully now.
8:55 AM - I'm going to have to wrap up shortly, but my basic strategy will be to buy pullbacks in the TICK as long as those occur at higher TICK lows and price stays above its lows. Otherwise I'm out.
8:52 AM - The nice thing about entering positions small and then adding to them if conditions are right is that you can more easily ride initial shakeouts. We need to see a positive shift in the TICK and we need to see ER2 strength, or I'll be out of that initial position quickly.
8:48 AM - Bought a little ES on that last drop, but will have tight stops; seeing if support from yesterday PM will hold.
8:42 AM - Note some relative strength in the semis early on; keep an eye open.
8:38 AM - I'm looking to see if we can put in a bottom and get selling to dry up above the Thurs afternoon lows. That would make me a buyer for a move back to that average price we've been oscillating around. If we break those lows, esp on strong volume, I'm in the mode of selling TICK bounces. During early trade, I try to frame these what-if scenarios to guide my strategy in advance. That helps me pounce more quickly if opportunity arises.
8:35 AM - Volume pretty tepid so far in ES; nothing to write home about, and nothing to suggest thus far an active institutional presence for a trending trade. Volume skewed toward the hitting of bids; weakness in ER2 has led ES in opening minutes.
8:32 AM - Note that we've already broken overnight lows in NQ and ER2. Need to see them acting stronger before I'd take the long side.
8:19 AM - So far we're looking at 1459.25 as near-term resistance in the pre-opening market and 1456.50 as near-term support. I was impressed, given the intensity of selling, that the market held its AM lows during the afternoon. I'm looking for those afternoon lows to hold in today's trade. If they don't, that clearly represents fresh selling interest and would be a bearish indication. If they do hold, I'd expect us to take out the pre-opening highs and the afternoon high of 1459.75 as initial targets. Morning weakness and afternoon strength has been a common pattern in the past several weeks. This suggests that selling is finding buyers: there's been an underlying bid to this market. Note that semis were strong yesterday; let's see if this is something more than a one-day wonder. This is often a leading sector. Note also that we held above Wednesday's lows in ER2 and NQ, even as we made a day-over-day low in ES. That also suggests some underlying strength to the broad market. Back after the open.
8:09 AM CT - Good Friday morning to you. This will be an abbreviated morning session for my blogging, as I have a 9:30 AM appt. No economic releases scheduled for today; that, on top of a Friday trade, may keep us in the recent multi-day trading range, as prices have pretty much oscillated around the 1458-1459 level in the ES futures for over a week. In addition to the day's pivots, the Weblog also summarizes an intraday trading pattern that has worked well over the last few weeks; do check out. Many thanks to those who participated in my online chat session hosted by John Forman; the audio archive is now up. My most recent blog post summarizes a few of the points from that session. More in a few.
9:19 AM - Well, we'll either hit my target or my stop. I'd be stopped out on new lows for the day and the initial target would be that average price range for ES.
9:17 AM - Once again, I tried a little buying as we failed to make lows on the recent selling, but stops are tight and I'll need to see solid buying coming in. My basic idea is to buy as long as we stay above yesterday's lows; I'm not impressed with the breadth of selling today relative to yesterday, so have been leaning toward buying weakness. We'll see if that works out. The key is to keep position sizing and stops reasonable to survive being wrong!
9:10 AM - Note semi and NQ strength here.
9:05 AM - Need to see more strength in ER2 and TICK and ability to hold lows before retaking long side. Looking at bounces as potential selling areas, particularly if TICK and volume are weak on the bounces.
9:02 AM - Stopped out as ER2 and TICK weakened. Watching those bounces carefully now.
8:55 AM - I'm going to have to wrap up shortly, but my basic strategy will be to buy pullbacks in the TICK as long as those occur at higher TICK lows and price stays above its lows. Otherwise I'm out.
8:52 AM - The nice thing about entering positions small and then adding to them if conditions are right is that you can more easily ride initial shakeouts. We need to see a positive shift in the TICK and we need to see ER2 strength, or I'll be out of that initial position quickly.
8:48 AM - Bought a little ES on that last drop, but will have tight stops; seeing if support from yesterday PM will hold.
8:42 AM - Note some relative strength in the semis early on; keep an eye open.
8:38 AM - I'm looking to see if we can put in a bottom and get selling to dry up above the Thurs afternoon lows. That would make me a buyer for a move back to that average price we've been oscillating around. If we break those lows, esp on strong volume, I'm in the mode of selling TICK bounces. During early trade, I try to frame these what-if scenarios to guide my strategy in advance. That helps me pounce more quickly if opportunity arises.
8:35 AM - Volume pretty tepid so far in ES; nothing to write home about, and nothing to suggest thus far an active institutional presence for a trending trade. Volume skewed toward the hitting of bids; weakness in ER2 has led ES in opening minutes.
8:32 AM - Note that we've already broken overnight lows in NQ and ER2. Need to see them acting stronger before I'd take the long side.
8:19 AM - So far we're looking at 1459.25 as near-term resistance in the pre-opening market and 1456.50 as near-term support. I was impressed, given the intensity of selling, that the market held its AM lows during the afternoon. I'm looking for those afternoon lows to hold in today's trade. If they don't, that clearly represents fresh selling interest and would be a bearish indication. If they do hold, I'd expect us to take out the pre-opening highs and the afternoon high of 1459.75 as initial targets. Morning weakness and afternoon strength has been a common pattern in the past several weeks. This suggests that selling is finding buyers: there's been an underlying bid to this market. Note that semis were strong yesterday; let's see if this is something more than a one-day wonder. This is often a leading sector. Note also that we held above Wednesday's lows in ER2 and NQ, even as we made a day-over-day low in ES. That also suggests some underlying strength to the broad market. Back after the open.
8:09 AM CT - Good Friday morning to you. This will be an abbreviated morning session for my blogging, as I have a 9:30 AM appt. No economic releases scheduled for today; that, on top of a Friday trade, may keep us in the recent multi-day trading range, as prices have pretty much oscillated around the 1458-1459 level in the ES futures for over a week. In addition to the day's pivots, the Weblog also summarizes an intraday trading pattern that has worked well over the last few weeks; do check out. Many thanks to those who participated in my online chat session hosted by John Forman; the audio archive is now up. My most recent blog post summarizes a few of the points from that session. More in a few.
Five Guiding Principles of Trading Psychology
When I recently participated in an online chat presentation for John Forman, I assembled my ideas into ten basic principles that have guided my thinking about the psychology of traders and the psychology of markets. In the very near future, if my testing continues to be promising, I hope to present a market indicator for swing traders that rests firmly upon these principles. Stay tuned! In the interim, here are the five principles that pertain specifically to trading psychology. Next up will be five principles for trading the markets.
Principle #1: Trading is a performance activity - This is the core idea behind my most recent book. Like the playing of a concert instrument or the playing of a sport, trading entails the application of knowledge and skills to real time performances. Success at trading, as with other performances, depends upon a developmental process in which intensive, structured practice and experience over an extended time yield competence and expertise. Many trading problems are attributable to attempts to succeed at trading prior to undergoing this learning process. My research suggests that professional traders account for well over three-quarters of all share and futures contract volume. It is impossible to sustain success against these professionals without honing one's performance--and by making sure that you don't lose your capital in the learning process. Confidence in one's trading comes from the mastery conferred by one's learning and development, not from psychological exercises or insights.
Principle #2: Success in trading is a function of talents and skills - Trading, in this sense, is no different from chess, Olympic events, or acting. Inborn abilities (talents) and developed competencies (skills) determine one's level of success. From rock bands to ballet dancers and golfers, only a small percentage of participants in any performance activity are good enough to sustain a living from their performances. The key to success is finding a seamless fit between one's talents/skills and the specific opportunities available in a performance field. For traders, this means finding a superior fit between your abilities and the specific markets and strategies you will be trading. Many performance problems are the result of a suboptimal fit between what the trader is good at and how the trader is trading.
Principle #3: The core skill of trading is pattern recognition - Whether the trader is visually inspecting charts or analyzing signals statistically, pattern recognition lies at the heart of trading. The trader is trying to identify shifts in demand and supply in real time and is responding to patterns that are indicative of such shifts. Most of the different approaches to trading--technical and fundamental analysis, cycles, econometrics, quantitative historical analysis, Market Profile--are simply methods for conceptualizing patterns at different time frames. Traders will benefit most from those methods that fit well with their cognitive styles and strengths. A person adept at visual processing, with superior visual memory, might benefit from the use of charts in framing patterns. Someone who is highly analytical might benefit from statistical studies and mechanical signals.
Principle #4: Much pattern recognition is based on implicit learning - Implicit learning occurs when people are repeatedly exposed to complex patterns and eventually internalize those, even though they cannot verbalize the rules underlying those patterns. This is how children learn language and grammar, and it is how we learn to navigate our way through complex social interactions. Implicit learning manifests itself as a "feel" for a performance activity and facilitates a rapidity of pattern recognition that would not be possible through ordinary analysis. Even system developers, who rely upon explicit signals for trading, report that their frequent exposure to data gives them a feel for which variables will be promising and which will not during their testing. Research tells us that implicit learning only occurs after we have undergone thousands of learning trials. This is why trading competence--like competence at other performance activities such as piloting a fighter jet and chess--requires considerable practice and exposure to realistic scenarios. Without such immersive exposure, traders never truly internalize the patterns in their markets and time frames.
Principle #5: Emotional, cognitive, and physical factors disrupt access to patterns we have acquired implicitly - Once a performer has developed skills and moved along the path toward competence and expertise, psychology becomes important in sustaining consistency of performance. Many performance disruptions are caused when shifts in our cognitive, emotional, and/or physical states obscure the felt tendencies and intuitions that lie at the heart of implicit learning. This most commonly occurs as a result of performance anxiety--our fears about the outcome of our performance interfere with the access to the knowledge and skills needed to facilitate that performance. Such performance disruptions also commonly occur when traders trade positions that are too large for their accounts and/or do not maintain sound risk management with their positions. The large P/L swings cause shifts in emotional states that interfere with the (implicit) processing of market data. Cognitive, behavioral, and biofeedback methods can be very useful in teaching traders skills for maintaining the "Yoda state" of calm concentration needed to access implicit knowledge.
The most important question I can ask an aspiring trader is: Are you engaged in a structured training process? Education--simply reading articles in magazines, websites, blogs, and books--is important, but it is not training. Training is the systematic work on oneself to build skills and hone performance. It requires constant feedback about your performance--what is working and what isn't--and it requires a steady process of drilling skills until they become automatic. No amount of talking with a coach or counselor will substitute for the training process: not in trading, not in athletics, and not in the dramatic arts. Training yourself to proficiency is the path to a positive psychology.
Principle #1: Trading is a performance activity - This is the core idea behind my most recent book. Like the playing of a concert instrument or the playing of a sport, trading entails the application of knowledge and skills to real time performances. Success at trading, as with other performances, depends upon a developmental process in which intensive, structured practice and experience over an extended time yield competence and expertise. Many trading problems are attributable to attempts to succeed at trading prior to undergoing this learning process. My research suggests that professional traders account for well over three-quarters of all share and futures contract volume. It is impossible to sustain success against these professionals without honing one's performance--and by making sure that you don't lose your capital in the learning process. Confidence in one's trading comes from the mastery conferred by one's learning and development, not from psychological exercises or insights.
Principle #2: Success in trading is a function of talents and skills - Trading, in this sense, is no different from chess, Olympic events, or acting. Inborn abilities (talents) and developed competencies (skills) determine one's level of success. From rock bands to ballet dancers and golfers, only a small percentage of participants in any performance activity are good enough to sustain a living from their performances. The key to success is finding a seamless fit between one's talents/skills and the specific opportunities available in a performance field. For traders, this means finding a superior fit between your abilities and the specific markets and strategies you will be trading. Many performance problems are the result of a suboptimal fit between what the trader is good at and how the trader is trading.
Principle #3: The core skill of trading is pattern recognition - Whether the trader is visually inspecting charts or analyzing signals statistically, pattern recognition lies at the heart of trading. The trader is trying to identify shifts in demand and supply in real time and is responding to patterns that are indicative of such shifts. Most of the different approaches to trading--technical and fundamental analysis, cycles, econometrics, quantitative historical analysis, Market Profile--are simply methods for conceptualizing patterns at different time frames. Traders will benefit most from those methods that fit well with their cognitive styles and strengths. A person adept at visual processing, with superior visual memory, might benefit from the use of charts in framing patterns. Someone who is highly analytical might benefit from statistical studies and mechanical signals.
Principle #4: Much pattern recognition is based on implicit learning - Implicit learning occurs when people are repeatedly exposed to complex patterns and eventually internalize those, even though they cannot verbalize the rules underlying those patterns. This is how children learn language and grammar, and it is how we learn to navigate our way through complex social interactions. Implicit learning manifests itself as a "feel" for a performance activity and facilitates a rapidity of pattern recognition that would not be possible through ordinary analysis. Even system developers, who rely upon explicit signals for trading, report that their frequent exposure to data gives them a feel for which variables will be promising and which will not during their testing. Research tells us that implicit learning only occurs after we have undergone thousands of learning trials. This is why trading competence--like competence at other performance activities such as piloting a fighter jet and chess--requires considerable practice and exposure to realistic scenarios. Without such immersive exposure, traders never truly internalize the patterns in their markets and time frames.
Principle #5: Emotional, cognitive, and physical factors disrupt access to patterns we have acquired implicitly - Once a performer has developed skills and moved along the path toward competence and expertise, psychology becomes important in sustaining consistency of performance. Many performance disruptions are caused when shifts in our cognitive, emotional, and/or physical states obscure the felt tendencies and intuitions that lie at the heart of implicit learning. This most commonly occurs as a result of performance anxiety--our fears about the outcome of our performance interfere with the access to the knowledge and skills needed to facilitate that performance. Such performance disruptions also commonly occur when traders trade positions that are too large for their accounts and/or do not maintain sound risk management with their positions. The large P/L swings cause shifts in emotional states that interfere with the (implicit) processing of market data. Cognitive, behavioral, and biofeedback methods can be very useful in teaching traders skills for maintaining the "Yoda state" of calm concentration needed to access implicit knowledge.
The most important question I can ask an aspiring trader is: Are you engaged in a structured training process? Education--simply reading articles in magazines, websites, blogs, and books--is important, but it is not training. Training is the systematic work on oneself to build skills and hone performance. It requires constant feedback about your performance--what is working and what isn't--and it requires a steady process of drilling skills until they become automatic. No amount of talking with a coach or counselor will substitute for the training process: not in trading, not in athletics, and not in the dramatic arts. Training yourself to proficiency is the path to a positive psychology.
Thursday, February 22, 2007
Profiting From Short-Term Momentum: A Best Practice in Trading
From Brett: Today's best practice comes from reader Steve, who generously shares one of his setups in the Russell index market. His methodology is based on trading in the direction of short-term momentum, as long as this is aligned within a greater trend. Recall that Lord Tedders and Henry Carstens recently offered their perspectives on testing trading ideas. This would be an excellent core idea to test out and tweak with filters, stops, etc. Many thanks to Steve for passing this along. My reaction comments follow at the end of his post.
From Steve:
I call this best practice "Trading Short Term Momentum"...
I suggest that for futures trading, a setup geared to trading short term momentum can be profitable.
My chart setup for the Mini-Russell (ER contract) would include two (2) simple moving averages
1. Three (3) period sma with two (2) period offset (+2 offset)
2. Eighty (80) period sma
System rules
No trades within the first half hour.
On a close above the three (3) period sma, enter long on a stop at the next open
On a close below the three (3) period sma, enter short on a stop at the next open
Long only above the eighty (80) period sma (Enter long positions only on a close above the 80 sma)
Short only below the eighty (80) period sma (Enter short positions only on a close below the 80 sma)
Stop loss of one (1) Russell point
Min profit target of two (2) Russell points
(Once price "touches" two (2) points profit, trader must close at least 1 contract)
Maximum three (3) losing trades/session
Maximum three (3) consecutive losing days/week...stop trading for 7 trading days.
Minimum position size two (2) contracts
Chart time frames 3-7 minute candles/bars
From Brett: There are several things I like about Steve's idea. First, he is selective. He will only take trades after the first half-hour, and he will only take trades when the 3 SMA and 80 SMA are aligned. Note that he is using 3-7 minute bars. That means that the 80 period SMA will put him in trades in which the market has been strong or weak for a day or so. My best hunch is that this would work best in an environment of above average volume/volatility. I also like the money management--taking quick profits with half the position--and I like the discipline of limiting the number of losing trades per day and week to avoid catastrophic drawdowns during periods in which there is poor follow through on short-term trends. All in all, it's a great example of what I've called "rule-governed trading". By formulating rules for good trading practice, Steve is able to capitalize on short moves that go with the trend. By avoiding the first half hour of trading (during which we sometimes get economic releases), he lets the trend show itself before he commits capital. Very nice window on some best trading practices; thanks, Steve.
From Steve:
I call this best practice "Trading Short Term Momentum"...
I suggest that for futures trading, a setup geared to trading short term momentum can be profitable.
My chart setup for the Mini-Russell (ER contract) would include two (2) simple moving averages
1. Three (3) period sma with two (2) period offset (+2 offset)
2. Eighty (80) period sma
System rules
No trades within the first half hour.
On a close above the three (3) period sma, enter long on a stop at the next open
On a close below the three (3) period sma, enter short on a stop at the next open
Long only above the eighty (80) period sma (Enter long positions only on a close above the 80 sma)
Short only below the eighty (80) period sma (Enter short positions only on a close below the 80 sma)
Stop loss of one (1) Russell point
Min profit target of two (2) Russell points
(Once price "touches" two (2) points profit, trader must close at least 1 contract)
Maximum three (3) losing trades/session
Maximum three (3) consecutive losing days/week...stop trading for 7 trading days.
Minimum position size two (2) contracts
Chart time frames 3-7 minute candles/bars
From Brett: There are several things I like about Steve's idea. First, he is selective. He will only take trades after the first half-hour, and he will only take trades when the 3 SMA and 80 SMA are aligned. Note that he is using 3-7 minute bars. That means that the 80 period SMA will put him in trades in which the market has been strong or weak for a day or so. My best hunch is that this would work best in an environment of above average volume/volatility. I also like the money management--taking quick profits with half the position--and I like the discipline of limiting the number of losing trades per day and week to avoid catastrophic drawdowns during periods in which there is poor follow through on short-term trends. All in all, it's a great example of what I've called "rule-governed trading". By formulating rules for good trading practice, Steve is able to capitalize on short moves that go with the trend. By avoiding the first half hour of trading (during which we sometimes get economic releases), he lets the trend show itself before he commits capital. Very nice window on some best trading practices; thanks, Steve.
Thursday, February 22nd Morning Market Comments
9:44 AM - Some days you see the market well, other days forget about it! Today was one of the better days. I hope these sessions help you frame hypotheses about how the market is trading by focusing on the balance of buying and selling within defined ranges and in the context of concrete price targets. These ways of thinking can be of help regardless of the concrete entry signals you might happen to use. Once you see how to identify ranges, read buying/selling pressure, and identify how large traders are leaning, the rest is practice and skill development. I'll be doing my phone interview tonite (link below); wrap up tonite on the Weblog.
9:37 AM - I exited a bit early; we did touch that 1458.75 target, but I wasn't seeing big sellers hit the market the way they had done earlier. I'd be on the lookout for putting in a bottom, which would establish a new range bound market. Wrap up in a bit.
9:35 AM - Clear downward shift of TICK over the course of the AM. Those TICK bounces are providing excellent entries.
9:33 AM - Took a little profit here. Watching to see if selling dries up, but ready to get back in if TICK expands to downside.
9:23 AM - We barely took out the overnight low; 1458.75 pivot is next downside target.
9:19 AM - Note how volume really picked up on the decline as the longs liquidated. Excellent market sequence. Textbook. Those TICK bounces are great short entries once sellers start to dominate.
9:15 AM - Great example of a false breakout and reversal. Worth reviewing at the end of trading.
9:12 AM - My leaning is to sell TICK bounces that come at successively lower price levels, esp in ER2. Note how we're back into the trading ranges for the 3 indices.
9:09 AM - In general, I try to follow the large traders. Over 30% of all stock market volume (and futures) is due to program trading. So when I saw a buy program hit the broad market--and especially ER2--with an upside breakout in TICK, I knew that the large traders had shown their hand, at least in the short run. I waited for the first pullback following the buy program to make sure no huge sellers slammed us down, and that was my entry. R1 was my target and when we didn't move promptly toward R2, I took what the market gave me. Very typical trade for me, combining awareness of large traders, TICK, price ranges, and execution on pullbacks from the anticipated move.
9:04 AM - Sure enough: ER2 back into its overnite range.
9:01 AM - Keep an eye on ER2. It led the upside, but may also lead the downside if buying is not sustained.
8:58 AM - Note that we've broken above our trading range. We want to see buyers sustain the rally, however, and *keep* the market above that range. Otherwise, I'll be looking to fade the breakout.
8:55 AM - Took some profits here after we surpassed R1; I'll be explaining the trade in a bit.
8:48 AM - I went long on the pullback following the program buy; will explain later.
8:45 AM - Program buy
8:41 AM - Reminiscent of yesterday's trade, with lots of little runs and reversals; very choppy. Makes it dangerous to buy strength or sell weakness. I become very patient in these kinds of markets. Until I see a clear trend of buying or selling interest, I stay on the sidelines.
8:36 AM - 1459.75 represents the overnight lows; I'd want to see that level hold on selling before I buy. We're very near overnight lows in ER2. I need to see some selling dry up in ER2 before I'd take the long side for a breakout trade.
8:35 AM - Moderately high volume; decent participation in ES, with slant toward early buying. Strong semis; watching ER2 closely for selling. If we're going to take out the upside, I want to see the indices and sectors in gear.
8:27 AM - I've been contacted by a couple of professional trading organizations to work with their traders starting in March, so I will be wrapping up these daily morning market updates at the end of February. It's been great being able to do these; February has been a nice free time for me, and it's given me a lot of time to work on my own trading. If you have questions about any of the topics touched upon in the morning sessions, feel free to leave a comment on the blog or email me directly. During March I'll conduct occasional morning sessions as my travel and work schedule permit and will announce those in advance. Also in March, I'll begin work on a video training project for traders that will tie together many of the themes from these morning sessions. Many thanks for your interest and support.
8:22 AM - After the close today at 3:30 CT (4:30 Eastern time), I'll be doing a free Web talk with John Forman, author of The Essentials of Trading. Here's the link for registration. I'll be taking calls/questions and talking about the psychology of traders and trading. Some of my talk will touch upon the theme of the most recent blog post on somatic markers. It's a fascinating topic and area of research. Also, later today I'll put out the group email to help programmers and traders get connected. Do email me if you are interested and haven't already gotten in touch. Thanks!
8:18 AM CT - Good Thursday morning! We're knocking on the door of bull market highs in the equity indices; a bit of a pop in interest rates. Initial claims came in a tad higher than estimates; no major move in the dollar vs. Euro. We're hovering near lows in the Yen. As noted in the Weblog, we're operating in a five-day trading range, so the big issue is whether these current price highs attract sufficient buying interest to launch us to new levels of valuation. If we see a drying up of buying in early trade, a logical price target would be the Wednesday pivot level and volume-weighted average price, as posted to the Weblog. If we see firmness in the NYSE TICK, I will expect a move to new price highs. Back in a few.
9:37 AM - I exited a bit early; we did touch that 1458.75 target, but I wasn't seeing big sellers hit the market the way they had done earlier. I'd be on the lookout for putting in a bottom, which would establish a new range bound market. Wrap up in a bit.
9:35 AM - Clear downward shift of TICK over the course of the AM. Those TICK bounces are providing excellent entries.
9:33 AM - Took a little profit here. Watching to see if selling dries up, but ready to get back in if TICK expands to downside.
9:23 AM - We barely took out the overnight low; 1458.75 pivot is next downside target.
9:19 AM - Note how volume really picked up on the decline as the longs liquidated. Excellent market sequence. Textbook. Those TICK bounces are great short entries once sellers start to dominate.
9:15 AM - Great example of a false breakout and reversal. Worth reviewing at the end of trading.
9:12 AM - My leaning is to sell TICK bounces that come at successively lower price levels, esp in ER2. Note how we're back into the trading ranges for the 3 indices.
9:09 AM - In general, I try to follow the large traders. Over 30% of all stock market volume (and futures) is due to program trading. So when I saw a buy program hit the broad market--and especially ER2--with an upside breakout in TICK, I knew that the large traders had shown their hand, at least in the short run. I waited for the first pullback following the buy program to make sure no huge sellers slammed us down, and that was my entry. R1 was my target and when we didn't move promptly toward R2, I took what the market gave me. Very typical trade for me, combining awareness of large traders, TICK, price ranges, and execution on pullbacks from the anticipated move.
9:04 AM - Sure enough: ER2 back into its overnite range.
9:01 AM - Keep an eye on ER2. It led the upside, but may also lead the downside if buying is not sustained.
8:58 AM - Note that we've broken above our trading range. We want to see buyers sustain the rally, however, and *keep* the market above that range. Otherwise, I'll be looking to fade the breakout.
8:55 AM - Took some profits here after we surpassed R1; I'll be explaining the trade in a bit.
8:48 AM - I went long on the pullback following the program buy; will explain later.
8:45 AM - Program buy
8:41 AM - Reminiscent of yesterday's trade, with lots of little runs and reversals; very choppy. Makes it dangerous to buy strength or sell weakness. I become very patient in these kinds of markets. Until I see a clear trend of buying or selling interest, I stay on the sidelines.
8:36 AM - 1459.75 represents the overnight lows; I'd want to see that level hold on selling before I buy. We're very near overnight lows in ER2. I need to see some selling dry up in ER2 before I'd take the long side for a breakout trade.
8:35 AM - Moderately high volume; decent participation in ES, with slant toward early buying. Strong semis; watching ER2 closely for selling. If we're going to take out the upside, I want to see the indices and sectors in gear.
8:27 AM - I've been contacted by a couple of professional trading organizations to work with their traders starting in March, so I will be wrapping up these daily morning market updates at the end of February. It's been great being able to do these; February has been a nice free time for me, and it's given me a lot of time to work on my own trading. If you have questions about any of the topics touched upon in the morning sessions, feel free to leave a comment on the blog or email me directly. During March I'll conduct occasional morning sessions as my travel and work schedule permit and will announce those in advance. Also in March, I'll begin work on a video training project for traders that will tie together many of the themes from these morning sessions. Many thanks for your interest and support.
8:22 AM - After the close today at 3:30 CT (4:30 Eastern time), I'll be doing a free Web talk with John Forman, author of The Essentials of Trading. Here's the link for registration. I'll be taking calls/questions and talking about the psychology of traders and trading. Some of my talk will touch upon the theme of the most recent blog post on somatic markers. It's a fascinating topic and area of research. Also, later today I'll put out the group email to help programmers and traders get connected. Do email me if you are interested and haven't already gotten in touch. Thanks!
8:18 AM CT - Good Thursday morning! We're knocking on the door of bull market highs in the equity indices; a bit of a pop in interest rates. Initial claims came in a tad higher than estimates; no major move in the dollar vs. Euro. We're hovering near lows in the Yen. As noted in the Weblog, we're operating in a five-day trading range, so the big issue is whether these current price highs attract sufficient buying interest to launch us to new levels of valuation. If we see a drying up of buying in early trade, a logical price target would be the Wednesday pivot level and volume-weighted average price, as posted to the Weblog. If we see firmness in the NYSE TICK, I will expect a move to new price highs. Back in a few.
The Role of Somatic Markers in Trading Decisions
I think this is one of my more important articles: a perspective on trading psychology from the field of cognitive neuroscience.
In past posts, I have emphasized the importance of controlling the body's level of arousal as a fundamental trading skill, because so many psychological disruptions of trading are state-dependent. There are cognitive and behavioral methods for achieving such control; these include simple exercises that traders can perform on their own.
There is far more to trading psychology, however, than simply taming emotions. The idea that emotions are the root of trading problems--and that successful traders eliminate their emotions--is one of the great myths in the field. Indeed, research in cognitive neuroscience--particularly the work pioneered by Antonio Damasio--suggests that emotion is absolutely crucial in decision making.
Damasio's seminal contribution in this area of research is his somatic marker hypothesis. An overview of this hypothesis and relevant research is available in this review article. According to that article, the gist of the somatic marker hypothesis is that:
"Structures in ventromedial prefrontal cortex provide the substrate for learning an association between certain classes of complex situation, on the one hand, and the type of bioregulatory state (including emotional state) usually associated with that class of situation in past individual experience. The ventromedial sector holds linkages between the facts that compose a given situation, and the emotion previously paired with it in an individual's contingent experience. The linkages are ‘dispositional’ in the sense that they do not hold the representation of the facts or of the emotional state explicitly, but hold rather the potential to reactivate an emotion by acting on the appropriate cortical or subcortical structures..."
Let's paraphrase that in plain English! A section of the brain's frontal cortex is responsible for storing and processing associations between situations and the emotions that had been activated by those situations. When we store these associations, we are not storing conscious memories. Instead, we create links between situations and how those situations make us feel. Those linkages are "dispositional", which means that they lead us to act in one way or another.
Here's a simple example: I have many fond memories of spending time in cafes in the U.S. and Europe. If I pass a cafe on the streets of Seattle and smell the aroma of coffee, that perception activates the feeling-states associated with my prior experience. Thanks to those feeling states, I am disposed to enter the cafe and spend some time there. My decision to enter the establishment is not a simple, rational process of toting up pros and cons. Rather, the feeling state mixed with the perception of the cafe--a link embedded in the ventromedial prefrontal cortex--leads to the decision.
So it is with all decisions, Damasio argues. Feelings--from explicit emotions to felt body states--are joined with perceptions to guide our behavior.
The research cited in the review article suggests that, when people experience damage to their ventromedial prefrontal cortex, they are no longer able to make sound decisions. One especially fascinating lines of research involves a risk-taking game that requires decision-making similar to that involved in trading. This "gambling task" involves choosing cards from four decks. Two of the decks have higher payoffs on wins, but also larger penalties for losses, so that the overall returns are negative. Two of the decks have smaller payoffs for wins, but smaller penalties, and an overall positive expectation of gain.
At the start of the gambling task, subjects don't know the odds for the piles. Over time, however, normal subjects learn to prefer the piles with the positive odds for winning. When they are hooked up to biofeedback equipment, they display clear skin conductance responses ahead of making their choices. These stress-related feeling states appear to help guide the choices of piles. Conversely, subjects with damage to their ventromedial prefrontal cortices do not display such anticipatory responses. They lack the feelings that guide good decision-making. As a result, they display a sustained preference for the high-return, high-penalty, negative expectation decks. Without access to their encoded feeling states, they cannot make good decisions under conditions of risk and uncertainty.
Now here's the really interesting part. Normal adults who describe themselves as risk-takers do not have damage to their ventromedial prefrontal cortex regions, but they do display a similar tendency to persistently choose cards from the risky, low-return piles. When connected to biofeedback equipment, the risk-takers *do* display emotional signals prior to making their choices, not unlike the normal subjects. They tend, however, to override those signals with their explicit thought processes. The brain-damaged subjects, on the other hand, never receive the emotional signals from the ventromedial prefrontal cortex in the first place.
The implications for trading are significant. The idea that successful traders overcome or eliminate their emotions is completely off-base. If that were to truly happen, the trader would behave like a brain-damaged patient. Rather, it is the overriding of emotional signals and signals from felt bodily experience that facilitates poor decision-making. This overriding can occur because of anxiety, greed, or myriad cognitive rationalizations. The implication, however, is that--at some level--experienced traders receive valuable physical and emotional signals to guide their decision-making. It is the temporary lack of access to these signals that leads traders to behave like the risk-takers in Damasio's experiments.
In a recent post, I emphasized the value of biofeedback in achieving self control. It may well be, however, that the greatest value of such disciplines as meditation, relaxation training, and biofeedback is to help people maintain a clear mind so that they do not override and obscure the somatic markers that are necessary for sound decision making. I strongly suspect that traders would be better served by disciplines that enable them to be accurate observers of their feelings than prescriptions for squelching those feelings. Choice lies at the heart of trading, and if Damasio is correct, our felt experience is a necessary substrate of choice. The somatic markers are there; it's simply a matter of keeping our access open to them, even as we're surrounded by risk, reward, and uncertainty.
In past posts, I have emphasized the importance of controlling the body's level of arousal as a fundamental trading skill, because so many psychological disruptions of trading are state-dependent. There are cognitive and behavioral methods for achieving such control; these include simple exercises that traders can perform on their own.
There is far more to trading psychology, however, than simply taming emotions. The idea that emotions are the root of trading problems--and that successful traders eliminate their emotions--is one of the great myths in the field. Indeed, research in cognitive neuroscience--particularly the work pioneered by Antonio Damasio--suggests that emotion is absolutely crucial in decision making.
Damasio's seminal contribution in this area of research is his somatic marker hypothesis. An overview of this hypothesis and relevant research is available in this review article. According to that article, the gist of the somatic marker hypothesis is that:
"Structures in ventromedial prefrontal cortex provide the substrate for learning an association between certain classes of complex situation, on the one hand, and the type of bioregulatory state (including emotional state) usually associated with that class of situation in past individual experience. The ventromedial sector holds linkages between the facts that compose a given situation, and the emotion previously paired with it in an individual's contingent experience. The linkages are ‘dispositional’ in the sense that they do not hold the representation of the facts or of the emotional state explicitly, but hold rather the potential to reactivate an emotion by acting on the appropriate cortical or subcortical structures..."
Let's paraphrase that in plain English! A section of the brain's frontal cortex is responsible for storing and processing associations between situations and the emotions that had been activated by those situations. When we store these associations, we are not storing conscious memories. Instead, we create links between situations and how those situations make us feel. Those linkages are "dispositional", which means that they lead us to act in one way or another.
Here's a simple example: I have many fond memories of spending time in cafes in the U.S. and Europe. If I pass a cafe on the streets of Seattle and smell the aroma of coffee, that perception activates the feeling-states associated with my prior experience. Thanks to those feeling states, I am disposed to enter the cafe and spend some time there. My decision to enter the establishment is not a simple, rational process of toting up pros and cons. Rather, the feeling state mixed with the perception of the cafe--a link embedded in the ventromedial prefrontal cortex--leads to the decision.
So it is with all decisions, Damasio argues. Feelings--from explicit emotions to felt body states--are joined with perceptions to guide our behavior.
The research cited in the review article suggests that, when people experience damage to their ventromedial prefrontal cortex, they are no longer able to make sound decisions. One especially fascinating lines of research involves a risk-taking game that requires decision-making similar to that involved in trading. This "gambling task" involves choosing cards from four decks. Two of the decks have higher payoffs on wins, but also larger penalties for losses, so that the overall returns are negative. Two of the decks have smaller payoffs for wins, but smaller penalties, and an overall positive expectation of gain.
At the start of the gambling task, subjects don't know the odds for the piles. Over time, however, normal subjects learn to prefer the piles with the positive odds for winning. When they are hooked up to biofeedback equipment, they display clear skin conductance responses ahead of making their choices. These stress-related feeling states appear to help guide the choices of piles. Conversely, subjects with damage to their ventromedial prefrontal cortices do not display such anticipatory responses. They lack the feelings that guide good decision-making. As a result, they display a sustained preference for the high-return, high-penalty, negative expectation decks. Without access to their encoded feeling states, they cannot make good decisions under conditions of risk and uncertainty.
Now here's the really interesting part. Normal adults who describe themselves as risk-takers do not have damage to their ventromedial prefrontal cortex regions, but they do display a similar tendency to persistently choose cards from the risky, low-return piles. When connected to biofeedback equipment, the risk-takers *do* display emotional signals prior to making their choices, not unlike the normal subjects. They tend, however, to override those signals with their explicit thought processes. The brain-damaged subjects, on the other hand, never receive the emotional signals from the ventromedial prefrontal cortex in the first place.
The implications for trading are significant. The idea that successful traders overcome or eliminate their emotions is completely off-base. If that were to truly happen, the trader would behave like a brain-damaged patient. Rather, it is the overriding of emotional signals and signals from felt bodily experience that facilitates poor decision-making. This overriding can occur because of anxiety, greed, or myriad cognitive rationalizations. The implication, however, is that--at some level--experienced traders receive valuable physical and emotional signals to guide their decision-making. It is the temporary lack of access to these signals that leads traders to behave like the risk-takers in Damasio's experiments.
In a recent post, I emphasized the value of biofeedback in achieving self control. It may well be, however, that the greatest value of such disciplines as meditation, relaxation training, and biofeedback is to help people maintain a clear mind so that they do not override and obscure the somatic markers that are necessary for sound decision making. I strongly suspect that traders would be better served by disciplines that enable them to be accurate observers of their feelings than prescriptions for squelching those feelings. Choice lies at the heart of trading, and if Damasio is correct, our felt experience is a necessary substrate of choice. The somatic markers are there; it's simply a matter of keeping our access open to them, even as we're surrounded by risk, reward, and uncertainty.
Wednesday, February 21, 2007
Designing a Robust Mechanical Trading Strategy: A Best Practice in Trading
From Brett: This best practice post comes to us from Edward Heming, who is the author of the Lord Tedders trading blog. He discusses a few aspects of developing a reliable mechanical trading strategy and also covers the pros and cons of mechanical trading. Note that Henry Carstens has also made available a series of articles on the topic of developing trading systems. What I most like about Lord Tedders' article is the insight that researching system ideas is a great way to gain a feel for the market. For that reason, it can even benefit the discretionary trader. Those wanting to gain some of the benefits of system testing without the challenges of programming can look to the Odds Maker program developed by Trade Ideas or can follow the advice of Bonnie Lee Hill and utilize the drop-down menu testing platform available through Ensign Software. With such tools, it is easier than ever to truly determine if your ideas are providing you with a performance edge. Thanks to Edward for the insightful post.
One of the questions that I often get asked about strategy design is, “how do you design a robust mechanical trading strategy?”
To understand how to build a robust mechanical strategy it is important to understand what a robust mechanical strategy is. A mechanical strategy is simply a quantified decision stream that leads either a “trading robot” or the trader himself to determine position size, entries, exits and stops all in a completely hands off fashion – in other words if you have a working mechanical system your input is not needed (or if so to a very limited degree). Additionally, for a mechanical strategy to be robust, it must capitalize on a “trading edge”. This can be anything from a statistical edge (trending) to an execution edge (arbitrage). Furthermore, this strategy must hold up over an extensive period of trades historically (at least several hundred) and must hold up in future trading (which can be simulated).
A mechanical system has several advantages that discretionary traders do not, such as the ability to perform quantitative and data mining analysis quickly and over extended historical periods. Additionally, mechanical systems can alleviate some of the emotional distress that accompanies discretionary trading – particularly among new traders.
However, it is important to recognize that mechanical trading has several disadvantages as well. The first being that you must be able to quantify each and every trading decision that the system will make, secondly the mechanical system will have to be periodically adjusted (just like a discretionary trader adjusts their methods) either through inherent adaptivity, optimization, or diversification. Lastly, mechanical systems only work if one puts in the tremendous amount of time and effort required to program, test, debug, and continually adjust it.
To design any mechanical strategy it is important to consider three things before anything else: 1) your objective for that system, 2) your market, 3) your timeframe. Once you have determined this, it is easy to find your essential methodology because there are only 4 ways to trade any market: 1) trend trading, 2) momentum trading, 3) reversion to the mean trading, 4) and fundamental trading. Once you have determined your objective, market, timeframe and method you are ready to attempt to put together your first strategy. Many of you are probably thinking at this point, “what if I don’t know any of that stuff?”
If you are already an experienced discretionary trader this should not prove to be overly difficult. However, if you do not have extensive experience you will have to find a method that works. This method can be as simple as a moving average cross long/short to as complicated as a continually adjusting collaborative neural network that is genetically re-optimized daily. The very best way for the inexperienced trader to build a new system is to test ideas. This can be done in two ways – visually or programmatically. For someone without extensive programming experience, the best would be to start with what I call “candle by candle” back testing. This is performed by taking an idea (such as a moving average crossover) and testing it with historical data on the given market and time frame by moving your charts forward from the past into the future and trading the way the system would – without future knowledge of the markets.
This method is how I tested my first ten “strategies”, four of which I still continue to trade today (including two that were designed by Phil McGrew which I tested using this method and still trade today). However, I had to test nearly fifty or sixty ideas to get down to those ten strategies that work, and finally refine the process until I had found four of those ten systems that I found tradable. To give you an example of how time consuming this process is, I tested these ten strategies extensively often looking at over 2 years of 15 minute bars and “executing” hundreds of trades. I spent nearly 700 real hours doing this testing (and I’m pretty quick with a chart and excel). It sounds like a lot of work right? Well it was, but it also gave me a feel for those markets that is nearly as good as having traded those markets in real time.
After doing this for some time, I felt that there had to be a more effective way to test ideas. And there is – programmatic testing. Programmatic testing again can be very easy – a simple moving average cross is a simple thing to program in nearly any programming language. However, the difficulties that can destroy the beginning programmatic trader are nearly endless. Many popular trading packages do not trace your equity position tick by tick, rather it is tracked bar by bar (and if you’re trading daily bars you can imagine the problems). Also, ideas that I had tested extensively by hand sometimes were difficult to program. I have had so many experiences where I miscoded a critical concept (even by a slight degree) and this ended up giving drastically different results than my hand testing. Without the knowledge that it was the code that was incorrect, I might have falsely dismissed many trading ideas that were in fact valid.
Additionally, at this level of programmatic trading it is very important to consider factors of minimizing inputs (degrees of freedom) and utilizing flexible inputs. An example of this would be to utilize a 3 ATR stop instead of a 60 pip stop so that as the prices and volatility of the market fluctuate your stop is not being taken out because of random noise. Other ways that you can improve the robustness of your strategy include utilizing realistic fills and commissions and ensuring that your limit orders would have actually been filled (this is not as easy to test in some software as it should be).
Optimization is another useful tool to consider at this point in your strategy testing career. This is a powerful but two edged sword. Utilization of genetic algorithms and similar “hill climbing” techniques are a common way to ensure that your optimization does not give you a single point anomaly, but rather that there are similar input values surrounding your inputs that give similar equity graphs. Walk forward testing is another useful tool that can help you achieve realistic results and see for yourself whether a strategy would have been successful on data that was not optimized (similar to the future).
Going further into programmatic trading, after having experienced many pitfalls, I feel that I ought to be able to test more than one idea at a time. In fact, ideally I would like to test many ideas, over multiple time frames and multiple markets. Right now this is the work that I am involved in designing and I feel that this will help me analyze the markets with the speed and precision that will take my trading to the next level. This is the arena of the best strategy designers, where statistical data mining, market analysis, timeframe analysis, technical analysis, fundamental analysis, and money management are combined with realistic evolutionary testing into a single package.
As you can see, advanced programmatic testing and trading is a complex arena. I myself am still learning and by no means consider myself an expert. The good news is that successful robust mechanical strategy creation and implementation can be done in as simple or as complex a manner as you choose. After all, the very simple strategies tested and/or designed with candle by candle backtesting are still a cornerstone of my trading methodology.
From Brett: Notice Edward's advice: start small, keep it doable, and then build your skills. Your best ideas will come from intensive observation, but some of the best ideas are the simplest and most straightforward. I've recently posted a call for traders and programmers who would like to collaborate; this could be one promising way of getting started!
One of the questions that I often get asked about strategy design is, “how do you design a robust mechanical trading strategy?”
To understand how to build a robust mechanical strategy it is important to understand what a robust mechanical strategy is. A mechanical strategy is simply a quantified decision stream that leads either a “trading robot” or the trader himself to determine position size, entries, exits and stops all in a completely hands off fashion – in other words if you have a working mechanical system your input is not needed (or if so to a very limited degree). Additionally, for a mechanical strategy to be robust, it must capitalize on a “trading edge”. This can be anything from a statistical edge (trending) to an execution edge (arbitrage). Furthermore, this strategy must hold up over an extensive period of trades historically (at least several hundred) and must hold up in future trading (which can be simulated).
A mechanical system has several advantages that discretionary traders do not, such as the ability to perform quantitative and data mining analysis quickly and over extended historical periods. Additionally, mechanical systems can alleviate some of the emotional distress that accompanies discretionary trading – particularly among new traders.
However, it is important to recognize that mechanical trading has several disadvantages as well. The first being that you must be able to quantify each and every trading decision that the system will make, secondly the mechanical system will have to be periodically adjusted (just like a discretionary trader adjusts their methods) either through inherent adaptivity, optimization, or diversification. Lastly, mechanical systems only work if one puts in the tremendous amount of time and effort required to program, test, debug, and continually adjust it.
To design any mechanical strategy it is important to consider three things before anything else: 1) your objective for that system, 2) your market, 3) your timeframe. Once you have determined this, it is easy to find your essential methodology because there are only 4 ways to trade any market: 1) trend trading, 2) momentum trading, 3) reversion to the mean trading, 4) and fundamental trading. Once you have determined your objective, market, timeframe and method you are ready to attempt to put together your first strategy. Many of you are probably thinking at this point, “what if I don’t know any of that stuff?”
If you are already an experienced discretionary trader this should not prove to be overly difficult. However, if you do not have extensive experience you will have to find a method that works. This method can be as simple as a moving average cross long/short to as complicated as a continually adjusting collaborative neural network that is genetically re-optimized daily. The very best way for the inexperienced trader to build a new system is to test ideas. This can be done in two ways – visually or programmatically. For someone without extensive programming experience, the best would be to start with what I call “candle by candle” back testing. This is performed by taking an idea (such as a moving average crossover) and testing it with historical data on the given market and time frame by moving your charts forward from the past into the future and trading the way the system would – without future knowledge of the markets.
This method is how I tested my first ten “strategies”, four of which I still continue to trade today (including two that were designed by Phil McGrew which I tested using this method and still trade today). However, I had to test nearly fifty or sixty ideas to get down to those ten strategies that work, and finally refine the process until I had found four of those ten systems that I found tradable. To give you an example of how time consuming this process is, I tested these ten strategies extensively often looking at over 2 years of 15 minute bars and “executing” hundreds of trades. I spent nearly 700 real hours doing this testing (and I’m pretty quick with a chart and excel). It sounds like a lot of work right? Well it was, but it also gave me a feel for those markets that is nearly as good as having traded those markets in real time.
After doing this for some time, I felt that there had to be a more effective way to test ideas. And there is – programmatic testing. Programmatic testing again can be very easy – a simple moving average cross is a simple thing to program in nearly any programming language. However, the difficulties that can destroy the beginning programmatic trader are nearly endless. Many popular trading packages do not trace your equity position tick by tick, rather it is tracked bar by bar (and if you’re trading daily bars you can imagine the problems). Also, ideas that I had tested extensively by hand sometimes were difficult to program. I have had so many experiences where I miscoded a critical concept (even by a slight degree) and this ended up giving drastically different results than my hand testing. Without the knowledge that it was the code that was incorrect, I might have falsely dismissed many trading ideas that were in fact valid.
Additionally, at this level of programmatic trading it is very important to consider factors of minimizing inputs (degrees of freedom) and utilizing flexible inputs. An example of this would be to utilize a 3 ATR stop instead of a 60 pip stop so that as the prices and volatility of the market fluctuate your stop is not being taken out because of random noise. Other ways that you can improve the robustness of your strategy include utilizing realistic fills and commissions and ensuring that your limit orders would have actually been filled (this is not as easy to test in some software as it should be).
Optimization is another useful tool to consider at this point in your strategy testing career. This is a powerful but two edged sword. Utilization of genetic algorithms and similar “hill climbing” techniques are a common way to ensure that your optimization does not give you a single point anomaly, but rather that there are similar input values surrounding your inputs that give similar equity graphs. Walk forward testing is another useful tool that can help you achieve realistic results and see for yourself whether a strategy would have been successful on data that was not optimized (similar to the future).
Going further into programmatic trading, after having experienced many pitfalls, I feel that I ought to be able to test more than one idea at a time. In fact, ideally I would like to test many ideas, over multiple time frames and multiple markets. Right now this is the work that I am involved in designing and I feel that this will help me analyze the markets with the speed and precision that will take my trading to the next level. This is the arena of the best strategy designers, where statistical data mining, market analysis, timeframe analysis, technical analysis, fundamental analysis, and money management are combined with realistic evolutionary testing into a single package.
As you can see, advanced programmatic testing and trading is a complex arena. I myself am still learning and by no means consider myself an expert. The good news is that successful robust mechanical strategy creation and implementation can be done in as simple or as complex a manner as you choose. After all, the very simple strategies tested and/or designed with candle by candle backtesting are still a cornerstone of my trading methodology.
From Brett: Notice Edward's advice: start small, keep it doable, and then build your skills. Your best ideas will come from intensive observation, but some of the best ideas are the simplest and most straightforward. I've recently posted a call for traders and programmers who would like to collaborate; this could be one promising way of getting started!
Wednesday, February 21st Morning Market Comments
9:52 AM - Back to the mode of looking at bounces for possible selling. I will be on the phone conferencing with traders so need to wrap up. Two important items for today: patience--let the market show its hand. We were getting a drying up of selling and only then did it make sense to go long. I nibbled long, the buying began to wane, and then we retraced. Second important item: don't let the winners turn into losers. I thought we had more upside potential, it didn't emerge, and I got out. That avoided significant losses. It's been a whippy trading session--we're not so far from where we opened. The important thing is to watch for those shifts in buying/selling to gauge likelihood of followthrough on moves. Have a great rest of the day; wrap up tonite on the Weblog.
9:41 AM - You can see how the shift from absence of buyers to the emergence of sellers occurred. That's why it's so important to scratch positions; not hold and turn gains into losses. Clearly market momentum has shifted back to sellers.
9:33 AM - Waited, waited, and buying never came. Scratched out.
9:12 AM - I continue to buy those pullbacks, but need to see stronger TICK to stay long.
9:05 AM - I'm nibbling long on TICK pullbacks that stay above the prior TICK and price lows.
8:59 AM - I'm considering the market's ability to hold above its Tuesday lows a positive for bulls here. Need to see expansion of buying (TICK), however, to return to the Tuesday highs.
8:55 AM - A lot of oscillation ahead of LEI, TICK distribution weak, but not extreme in either direction. Volume moderately high. My leaning is to be patient and let the market show its hand by either breaking out of its AM range or failing to sustain such a breakout.
8:49 AM - Need to stay above overnight lows in ER2 to get me buying.
8:45 AM - I'm actually now leaning toward buying if we get pullbacks that stay above the overnight lows. Basically letting the market show its hand.
8:38 AM - Volume is moderately high, got some bounce early. Need to see that dry up before I would go short.
8:26 AM - Oh yes. We have Leading Economic Indicators reported at 9:00 AM CT and FOMC minutes released at 13:00 CT. Clearly the equity index markets haven't liked the higher than expected core CPI; a strong LEI might also stoke inflation fears.
8:22 AM CT - Well, we moved above the 3-day trading range on Tuesday after overcoming early weakness, but now we're right back into that range on the response to the CPI data. Interest rates are up, dollar stronger vs. Euro, and--surprise--the dollar is stronger vs. the Yen despite an interest rate hike by BOJ. Not much in that response that would threaten the carry trade in the near term! Longer term, the BOJ may be forced into additional action if selling in the Yen persists, especially vs. the Euro. Check out this morning's post regarding persistent market strength; there's a very interesting trading pattern that's worked out 10 of the last 10 occasions over the past 3 weeks. Pivot-based price targets and some evidence of continued selectivity in the recent market runup are posted to the Weblog. My leaning will be to sell bounces that stay below yesterday's pivot, with an eye toward S1 and Tuesday's lows as downside targets. I am, however, also keeping an eye on the pattern mentioned in the blog post, in which early selling has been an opportunity to buy. We saw that in spades yesterday. Back after the open. I have some phone conferences with traders this AM, so my posts will be less frequent and focused more on general market conditions and ideas than specific trades that I'm placing.
9:41 AM - You can see how the shift from absence of buyers to the emergence of sellers occurred. That's why it's so important to scratch positions; not hold and turn gains into losses. Clearly market momentum has shifted back to sellers.
9:33 AM - Waited, waited, and buying never came. Scratched out.
9:12 AM - I continue to buy those pullbacks, but need to see stronger TICK to stay long.
9:05 AM - I'm nibbling long on TICK pullbacks that stay above the prior TICK and price lows.
8:59 AM - I'm considering the market's ability to hold above its Tuesday lows a positive for bulls here. Need to see expansion of buying (TICK), however, to return to the Tuesday highs.
8:55 AM - A lot of oscillation ahead of LEI, TICK distribution weak, but not extreme in either direction. Volume moderately high. My leaning is to be patient and let the market show its hand by either breaking out of its AM range or failing to sustain such a breakout.
8:49 AM - Need to stay above overnight lows in ER2 to get me buying.
8:45 AM - I'm actually now leaning toward buying if we get pullbacks that stay above the overnight lows. Basically letting the market show its hand.
8:38 AM - Volume is moderately high, got some bounce early. Need to see that dry up before I would go short.
8:26 AM - Oh yes. We have Leading Economic Indicators reported at 9:00 AM CT and FOMC minutes released at 13:00 CT. Clearly the equity index markets haven't liked the higher than expected core CPI; a strong LEI might also stoke inflation fears.
8:22 AM CT - Well, we moved above the 3-day trading range on Tuesday after overcoming early weakness, but now we're right back into that range on the response to the CPI data. Interest rates are up, dollar stronger vs. Euro, and--surprise--the dollar is stronger vs. the Yen despite an interest rate hike by BOJ. Not much in that response that would threaten the carry trade in the near term! Longer term, the BOJ may be forced into additional action if selling in the Yen persists, especially vs. the Euro. Check out this morning's post regarding persistent market strength; there's a very interesting trading pattern that's worked out 10 of the last 10 occasions over the past 3 weeks. Pivot-based price targets and some evidence of continued selectivity in the recent market runup are posted to the Weblog. My leaning will be to sell bounces that stay below yesterday's pivot, with an eye toward S1 and Tuesday's lows as downside targets. I am, however, also keeping an eye on the pattern mentioned in the blog post, in which early selling has been an opportunity to buy. We saw that in spades yesterday. Back after the open. I have some phone conferences with traders this AM, so my posts will be less frequent and focused more on general market conditions and ideas than specific trades that I'm placing.
Persistent Strong Closes: The Personality of This Stock Market
Here's a little piece of trivia to chew on: Out of the last 15 trading sessions, we've traded below the prior day's closing price 10 times. On 13 of those 15 occasions, however, we've closed closer to the high of the day than to the low. In other words, we've typically had some degree of weakness during the market day, but--as on Tuesday--buyers have tended to step in and use such weakness as an opportunity to accumulate stocks.
How rare is this? Going back to 1990 (N = 4305 trading days), I could only find 34 occasions in which 13 or more days out of 15 finished closer to their highs than to their lows. Such persistent strong closes are rare.
One stretch of persistent daily strength occurred between October 20 and October 31, 2006. We had one occasion on June 6, 2005, two on February 15 and 16, 2005, and one on September 4, 2003. We don't see another such string until September, 1996. Sixteen of the occasions occurred between 1991 and 1993; none before that. If you recall your market history, you'll see that, over this period, strings of 13 or more days out of 15 closing nearer to their highs than lows have occurred only during bull markets. They have not occurred during 2000-2002, 1998, 1994, or 1990, for example. Indeed, we might even conjecture that part of what makes a bull market is not an absence of daily weakness, but the tendency for investors to pounce upon such weakness as value and an opportunity to buy.
This pattern of pouncing on weakness as an opportunity to buy has been occurring at even very short time frames. I took a look at the Odds Maker program from Trade Ideas and asked the question: What has happened over the past three weeks when you have bought a breakdown from the opening 15-minute range in the S&P 500 Index (SPY)? Such a break below the range of the first 15 minutes of trade has occurred on 10 of those days; buying those occasions and holding for the next 30 minutes resulted in 10 winners. The average win size was the equivalent of a little over 1 full S&P point, so that the trade would have netted about 11 ES points over that period.
So what has happened after periods of persistent strength when we've had 13 or more days out of 15 in which we've closed closer to the day's high than to the low? Ten days later in the S&P 500 Index, we've averaged a gain of 1.17% (23 up, 11 down). That is much stronger than the average ten-day gain of .37% (2508 up, 1797 down) for the entire sample. It would appear in this case that strength begets strength. One of the reasons for this is that the occasions of persistent strong closes have tended to cluster. We had a string of eight occasions in October, 2006; four in August/September, 1993; four in January, 1992; and six in January/February, 1991. Because such strings are common, we cannot assume that, because the market has been persistently strong on a daily basis, it is now due for weakness.
Every market, like every person, has a personality: a set of traits that define behavioral tendencies. This has been one facet of the current market's personality: persistence of strength. This investigation suggests that such persistence is rare, but--at least in the short run--it, too, tends to persist.
How rare is this? Going back to 1990 (N = 4305 trading days), I could only find 34 occasions in which 13 or more days out of 15 finished closer to their highs than to their lows. Such persistent strong closes are rare.
One stretch of persistent daily strength occurred between October 20 and October 31, 2006. We had one occasion on June 6, 2005, two on February 15 and 16, 2005, and one on September 4, 2003. We don't see another such string until September, 1996. Sixteen of the occasions occurred between 1991 and 1993; none before that. If you recall your market history, you'll see that, over this period, strings of 13 or more days out of 15 closing nearer to their highs than lows have occurred only during bull markets. They have not occurred during 2000-2002, 1998, 1994, or 1990, for example. Indeed, we might even conjecture that part of what makes a bull market is not an absence of daily weakness, but the tendency for investors to pounce upon such weakness as value and an opportunity to buy.
This pattern of pouncing on weakness as an opportunity to buy has been occurring at even very short time frames. I took a look at the Odds Maker program from Trade Ideas and asked the question: What has happened over the past three weeks when you have bought a breakdown from the opening 15-minute range in the S&P 500 Index (SPY)? Such a break below the range of the first 15 minutes of trade has occurred on 10 of those days; buying those occasions and holding for the next 30 minutes resulted in 10 winners. The average win size was the equivalent of a little over 1 full S&P point, so that the trade would have netted about 11 ES points over that period.
So what has happened after periods of persistent strength when we've had 13 or more days out of 15 in which we've closed closer to the day's high than to the low? Ten days later in the S&P 500 Index, we've averaged a gain of 1.17% (23 up, 11 down). That is much stronger than the average ten-day gain of .37% (2508 up, 1797 down) for the entire sample. It would appear in this case that strength begets strength. One of the reasons for this is that the occasions of persistent strong closes have tended to cluster. We had a string of eight occasions in October, 2006; four in August/September, 1993; four in January, 1992; and six in January/February, 1991. Because such strings are common, we cannot assume that, because the market has been persistently strong on a daily basis, it is now due for weakness.
Every market, like every person, has a personality: a set of traits that define behavioral tendencies. This has been one facet of the current market's personality: persistence of strength. This investigation suggests that such persistence is rare, but--at least in the short run--it, too, tends to persist.
Tuesday, February 20, 2007
Connecting Traders and Programmers
Hi! I've sent out an email today to the traders and programmers who expressed an interest in collaboration. This is for experienced traders who have ideas they'd like to test out and experienced programmers who are interested in testing and honing ideas.
What I'm proposing is that interested individuals email me with a brief description of their background and experience that I could share with the entire group of participants in a group email. (The group email would only go out to the screened list of interested participants). That would enable traders and programmers to freely network on their own, rather than have me play matchmaker.
If you haven't gotten an email from me today and you'd like to participate, by all means get in touch. Once again, my email address is at the bottom of the "About Me" section to the right on the TraderFeed home page.
Thanks for your interest. I hope this bit of networking is helpful to all parties involved.
Brett
What I'm proposing is that interested individuals email me with a brief description of their background and experience that I could share with the entire group of participants in a group email. (The group email would only go out to the screened list of interested participants). That would enable traders and programmers to freely network on their own, rather than have me play matchmaker.
If you haven't gotten an email from me today and you'd like to participate, by all means get in touch. Once again, my email address is at the bottom of the "About Me" section to the right on the TraderFeed home page.
Thanks for your interest. I hope this bit of networking is helpful to all parties involved.
Brett
Tuesday, February 20th Morning Market Comments
9:58 AM - Well, the takeaway for the day is to know recent history and how the buying and selling you're seeing *now* compare to that history. It's when we see shifts from recent trading that markets make meaningful intraday tops and bottoms. We saw a nice example of that today. Hope this has been helpful; have a great rest of your day. Wrap up tonite on the Weblog.
9:50 AM - We returned to the thick of the recent trading range and volume picked up nicely on the buying. Those pullbacks in TICK will continue as buying opportunities as long as we sustain the positive TICK distribution and stay above the recent lows at 1454 in ES.
9:46 AM - Sure enough, we got a pullback toward -400 TICK, but now we couldn't make new price lows and buyers came right back in. You can see how the market transitioned from sellers to buyers with the shift in the TICK. Great tell. Back to wrap up shortly.
9:40 AM - Notice how the distribution of the NYSE TICK up to 9:09 AM CT was quite different from how it has been since then. Once we broke to new lows, we found buyers and not an avalanche of sellers (the TICK never hit extreme negative levels). Recognizing those shifts is key to short-term trading. We had shifted down relative to Friday to start the day, and that's what led me to be short. I still leaned short after the shift upward in TICK, but I've had to pull in my horns with respect to selling bounces, because those bounces have been sustained. If we can put in a bottom here, I'd expect buyers to return us to the midpoint of the Friday range as a target.
9:29 AM - Note that we, indeed, have sustained buying in TICK and it is showing up in ER2 strength. Note also that ER2 did not take out Friday's low--an interesting divergence. Watching to see if TICK pullbacks now start coming on higher price lows, which would signal us for buying and a return to the prior price range.
9:21 AM - Nice bounce in the TICK; the question, however, is whether we can sustain that buying. I continue to have doubts, but need to see bounces on weaker TICK strength to confirm.
9:11 AM - Seeing a touch of relative strength in the semis; held above their prior low on the recent selling. Also seeing a little more strength in the TICK and ER2. I'm still leaning toward selling bounces until we see a recent high from a previous TICK bounce taken out.
9:07 AM - Note also how volume has really picked up on the declines. Need to see volume pick up on a bounce to show us that large traders are finding value at these lower prices. Otherwise, you just keep shorting those bounces in TICK.
9:04 AM - Clear breakouts from Friday lows in ES and NQ. TICK distribution very weak if you follow the reasoning from my recent article. It took an average TICK reading of about +400 to sustain the neutral trending mode (trading range) over the past 3 days. When we couldn't sustain readings above that level, it was clear that there was not enough buying in this market. That, with the semi and ER2 weakness, kept me leaning short early on.
9:01 AM - Took some more profits, but again ready to reenter
8:51 AM - I'm using these TICK bounces to short ER2 and ES until we see signs of sustained high TICK that can make relative price highs.
8:46 AM - Took some profits, but very ready to reenter on short side if selling accelerates.
8:40 AM - These are actually weak TICK readings; more on that in a bit. Nice tell from ER2 and semis. Need to see if volume picks up on weakness, or if we'll dry up and return to the thick of the recent trading range.
8:35 AM - Volume modest in ES; no substantial institutional involvement to this point relative to usual. Consistent so far with range bound market; I'm short a bit of ES here and looking to add on TICK bounces that fail to take price higher.
8:33 AM - Keeping an eye on early weakness in ER2 and SMH. Will be short this market if that persists.
8:28 AM - This Market Delta chart goes back to Friday, with 10 price ticks per bar. You can see the narrow value area (left Y axis) and the narrow trading range. We're handicapping the odds of a break out of this range today by tracking NYSE TICK, volume, and volume distribution.
8:20 AM CT - And a good morning following a long weekend. The three averages have all established very clear resistance levels over the past three trading sessions and most recently failed to breach those levels in Globex trading on the holiday morning. As a result, we're pulling back well into the trading range over those several days. It would not at all surprise me to test the lows of those ranges, and I will most likely be selling bounces that fail to take us above the recent pre-opening high of 1460.50 in the ES contract. Some good reading over the weekend, with several best practices posts. Pivots are posted on the Weblog, along with a link to a PDF of collected "classic" articles. The Weblog also notes some deterioration of internals during the market's recent consolidation that also has me looking to the downside. No major economic releases scheduled for today; tomorrow we have CPI. Oil lower so far today; 10 year rates back above 4.7%. Back after the open.
Identifying the Trend of Market Sentiment With the NYSE TICK: A Best Practice in Trading
Here is a best practice that will help you identify the trend of the market's sentiment in a single glance. It is a simple way of calculating the Adjusted NYSE TICK, as reported daily in the Trading Psychology Weblog.
In past posts, I have described the use of the NYSE TICK as a real-time measure of market sentiment. Because it captures the number of stocks trading at their offer price minus those trading at their bid at each point in time, it illustrates whether buyers are more aggressive in the broad market (they are accepting the offer price to get into stocks) or whether sellers are more urgent (accepting the bid price to get out of stocks). The NYSE TICK, when cumulated over time, is helpful in anticipating momentum effects in the market and in determining whether or not we're likely to hit pivot-based price targets. For this reason, a number of very nice setups can be identified using TICK, price, and volume.
The chart above, taken from e-Signal, is of the NYSE TICK on a 1-minute basis. Notice that the TICK values, displayed in candlestick bars, are accompanied by three horizontal lines. The first line, in red at the center, is the regression line over the past day of trading (i.e., the past 405 bars). This line is the best fit connecting the high-low-closes for each bar over that period. The blue lines above and below the TICK bars represent values that are two standard deviations above and below the regression line. When the TICK exceeds these levels, we know that an unusually large amount of buying or selling is occurring simultaneously among the NYSE stocks. Very often this is because program trading is hitting the market.
Note that, by looking a 3-minute or 5-minute bars, we can adjust the lookback period for the regression line and the standard deviation calculations, since the lines will always be based on the past 405 bars. I generally use a lookback period that corresponds to a relatively flat market condition (e.g., if the market has been flat over the past three trading sessions I'll look at a 3-minute bar of TICK), because that tells me the net buying vs. selling sentiment needed to sustain zero price change. If new TICK values consistently exceed the value represented by the regression line, that signals a shift toward bullish sentiment, and I would be leaning toward buying pullbacks in the TICK (i.e., pullbacks toward the lower blue line). If TICK values consistently fall short of the regression line value, that would indicate a shift toward bearish sentiment, and I would lean toward selling bounces in the TICK (i.e., upthrusts toward the upper blue line). When TICK oscillates evenly around the regression line, we often will have range bound conditions.
The key visual identification is the slope of the regression line for the NYSE TICK. If the slope is positive (the line is rising), we have increasing buying sentiment over time and vice versa. The slope of the regression line--and particularly a change in the slope--informs us of the trend of market sentiment. This is very useful in identifying shifts in the market's trend. In the above example, the slope is steadily rising and that--all other things being equal--would lead me to buy dips in the TICK that do not make fresh price lows. That would be one way to buy pullbacks in an upward trend.
Viewing the NYSE TICK-based sentiment in this fashion, you can filter your own entry signals. For instance, you might identify a bullish configuration in a chart pattern or in a CCI pattern, but only take that trade if the slope of the TICK (the sentiment trend) is positive. Many, many times the TICK distribution--the direction of the line--has kept me out of a bad trade by forcing me to go with the dominant market sentiment (which is set by the large traders). This is why identifying the trend of sentiment is, for me, a best practice.
Monday, February 19, 2007
Do the FX Futures Help Us Track Large Traders in the Currency Markets?
You're probably aware that the Chicago Mercantile Exchange trades Euro FX contracts that trackscurrency trading involving the Euro and the dollar. (The CME also has contracts covering many other currency pairs). The price of the contract reflects the value of a Euro in dollar terms, so that when the contract rises in price, it reflects Euro strength and dollar weakness. The symbol for the Euro FX contract is 6E, and the current contract is 6EH7.
What you may not be aware of is that the Euro FX contract has gained respectable volume over time. It is not at all unusual to see 20-40 thousand contracts trade per hour during the busier hours. While this is not as much volume as we're accustomed to seeing in the emini S&P 500 Index (ES), it is sufficient liquidity for most independent traders. During those busier hours, a one-pip spread is the norm (a pip is the equivalent of a tick in the equity index futures and is equal to .0001 dollar.) Further background on the FX markets and the Euro product is available through the CME.
The question, however, is whether volume in the Euro product reflects true underlying demand and supply in the much larger cash market for currencies. After all, the cash market for FX, according to the CME, amounts to 1.9 trillion dollars daily. The FX futures, with their tens of thousands of contracts traded, are but a tiny fraction of this much larger market.
Readers are aware that I use futures volume in the S&P 500 Index to help me understand how large traders are trading. This is valuable in identifying breakout trading opportunities, and it also helps me identify when markets are likely to be range bound. To gauge how much movement we're likely to get during the day, I track how much volume in the ES futures we're getting relative to how much we normally have for that time of day. This is a helpful measure of market opportunity, because it tracks the presence of large traders in the futures, which is well-correlated with the presence of institutional traders.
But can we obtain similar benefits by tracking FX futures volume? One problem in the FX markets that we don't have in equities is that there is no central marketplace for the cash trade. For U.S. stocks, for instance, we can compare the cash trading volume in the NYSE Stock Exchange with the day's futures trading volume in the CME emini S&P contract and observe a positive correlation. Cash currencies, however, trade on multiple platforms and lack a single, central marketplace that reports volume. There is no equivalent of a New York Stock Exchange for cash currency trading.
If, however, we can establish that futures volume in the FX market is connected to price movement, then we can infer participation of large traders in the currency market when futures volume is high relative to its norm. We know that small futures traders don't move the world currency markets. When those markets are moving significantly, large institutional traders--from banks to hedge funds to monetary authorities--are responsible. A high, positive correlation between FX futures volume and movement in the Euro/Dollar relationship would suggest that we might be able to use FX futures volume data similarly to the ways in which I use futures volume in the ES product.
I went back to 1/3/2007 in the 6EH7 contract and examined hourly futures volume from 8:00 AM ET to 15:00 ET. What we see is a great deal of variability in hourly volume within the day--even more than is typical in the equity index futures markets. Volume is highest in the morning hours and noticeably tails off from noon forward. The correlation between hourly volume in the Euro FX emini contract and the high-low price range for that hour is a very high .89. Equally interesting, volume for the hour correlates with the price range for the next hour by about .30. What this means is that, for FX futures as for equity index futures, volume is telling us something about volatility. When there is more volume, there's more movement--and thus more potential opportunity for the trader. Since only large, institutional participants can move the currency markets, this suggests that Euro FX volume is telling us something about the involvement of the "big boys" in that market.
When I limited my look to the period between 8:00 AM ET and noon, a similar, high correlation between volume and price range was evident: .86. Interestingly, however, there was a smaller correlation between volume in the current hour and price range for the next hour: .11. That tells me that volume may be variable within the hour for the FX futures, limiting serial correlations.
I decided to drill down and examine Euro FX futures volume on a 15-minute basis between 8:00 AM ET and noon. Once again, the correlation between volume and price range was very strong: .85. Moreover, we see a substantial correlation between volume in the prior 15-minute period and price movement (range) in the next 15-minute segment: .31. Even on this short time frame, volume informs us not only about current volatility, but also contains information about upcoming opportunity.
My very strong suspicion is that it is not absolute volume that is important, but current volume relative to the average volume for that particular time of day. If we're trading 20,000 contracts at 9:00 AM, that might be average volume or even a bit below. That same volume at noon would be quite high. Knowing typical volume at each time period and how much volume we're currently getting helps us infer likely movement, which is really a function of institutional participation.
Can a currency trader infer the likelihood of a range bound or trending day based on unfolding volume? Can we use futures volume in the Euro FX eminis to validate genuine vs. false breakout moves? Can we combine an analysis of volume with movements toward and away from value areas for an enlightened application of Market Profile (tm) to FX trading? Many fine avenues of analysis are opened by the relationship between volume and price movement.
One conclusion, however, strikes me as inescapable. If I'm an active trader in the Euro currency and need to ascertain likely opportunity in my market, I would be wise to track the Euro futures contract. The volume information from the futures--data not available in the cash market--offers an informational edge that, at least in my equity index trading, has proven invaluable.
What you may not be aware of is that the Euro FX contract has gained respectable volume over time. It is not at all unusual to see 20-40 thousand contracts trade per hour during the busier hours. While this is not as much volume as we're accustomed to seeing in the emini S&P 500 Index (ES), it is sufficient liquidity for most independent traders. During those busier hours, a one-pip spread is the norm (a pip is the equivalent of a tick in the equity index futures and is equal to .0001 dollar.) Further background on the FX markets and the Euro product is available through the CME.
The question, however, is whether volume in the Euro product reflects true underlying demand and supply in the much larger cash market for currencies. After all, the cash market for FX, according to the CME, amounts to 1.9 trillion dollars daily. The FX futures, with their tens of thousands of contracts traded, are but a tiny fraction of this much larger market.
Readers are aware that I use futures volume in the S&P 500 Index to help me understand how large traders are trading. This is valuable in identifying breakout trading opportunities, and it also helps me identify when markets are likely to be range bound. To gauge how much movement we're likely to get during the day, I track how much volume in the ES futures we're getting relative to how much we normally have for that time of day. This is a helpful measure of market opportunity, because it tracks the presence of large traders in the futures, which is well-correlated with the presence of institutional traders.
But can we obtain similar benefits by tracking FX futures volume? One problem in the FX markets that we don't have in equities is that there is no central marketplace for the cash trade. For U.S. stocks, for instance, we can compare the cash trading volume in the NYSE Stock Exchange with the day's futures trading volume in the CME emini S&P contract and observe a positive correlation. Cash currencies, however, trade on multiple platforms and lack a single, central marketplace that reports volume. There is no equivalent of a New York Stock Exchange for cash currency trading.
If, however, we can establish that futures volume in the FX market is connected to price movement, then we can infer participation of large traders in the currency market when futures volume is high relative to its norm. We know that small futures traders don't move the world currency markets. When those markets are moving significantly, large institutional traders--from banks to hedge funds to monetary authorities--are responsible. A high, positive correlation between FX futures volume and movement in the Euro/Dollar relationship would suggest that we might be able to use FX futures volume data similarly to the ways in which I use futures volume in the ES product.
I went back to 1/3/2007 in the 6EH7 contract and examined hourly futures volume from 8:00 AM ET to 15:00 ET. What we see is a great deal of variability in hourly volume within the day--even more than is typical in the equity index futures markets. Volume is highest in the morning hours and noticeably tails off from noon forward. The correlation between hourly volume in the Euro FX emini contract and the high-low price range for that hour is a very high .89. Equally interesting, volume for the hour correlates with the price range for the next hour by about .30. What this means is that, for FX futures as for equity index futures, volume is telling us something about volatility. When there is more volume, there's more movement--and thus more potential opportunity for the trader. Since only large, institutional participants can move the currency markets, this suggests that Euro FX volume is telling us something about the involvement of the "big boys" in that market.
When I limited my look to the period between 8:00 AM ET and noon, a similar, high correlation between volume and price range was evident: .86. Interestingly, however, there was a smaller correlation between volume in the current hour and price range for the next hour: .11. That tells me that volume may be variable within the hour for the FX futures, limiting serial correlations.
I decided to drill down and examine Euro FX futures volume on a 15-minute basis between 8:00 AM ET and noon. Once again, the correlation between volume and price range was very strong: .85. Moreover, we see a substantial correlation between volume in the prior 15-minute period and price movement (range) in the next 15-minute segment: .31. Even on this short time frame, volume informs us not only about current volatility, but also contains information about upcoming opportunity.
My very strong suspicion is that it is not absolute volume that is important, but current volume relative to the average volume for that particular time of day. If we're trading 20,000 contracts at 9:00 AM, that might be average volume or even a bit below. That same volume at noon would be quite high. Knowing typical volume at each time period and how much volume we're currently getting helps us infer likely movement, which is really a function of institutional participation.
Can a currency trader infer the likelihood of a range bound or trending day based on unfolding volume? Can we use futures volume in the Euro FX eminis to validate genuine vs. false breakout moves? Can we combine an analysis of volume with movements toward and away from value areas for an enlightened application of Market Profile (tm) to FX trading? Many fine avenues of analysis are opened by the relationship between volume and price movement.
One conclusion, however, strikes me as inescapable. If I'm an active trader in the Euro currency and need to ascertain likely opportunity in my market, I would be wise to track the Euro futures contract. The volume information from the futures--data not available in the cash market--offers an informational edge that, at least in my equity index trading, has proven invaluable.
Sunday, February 18, 2007
Entering Markets on Pullbacks From a Trend: A Best Practice in Trading
Note From Brett: This best practice post comes from professional trader, fund manager, author, and educator Ray Barros. Since he started trading 20 years ago, his track record reflects a whopping 39 percent per annum return on a compounded basis. He is also the author of two books--The Nature of Trends and The Ray Wave. Ray has been regularly featured in regional newspapers and publications, including the Sydney Morning Herald, Your Trading Edge Magazine, Business Times, and Smart Investor. I've been in touch with Ray for a while now and can vouch for his experience, insight, and dedication to teaching. In this post, he generously shares one of his favorite trading setups. His basic method is to enter trends on pullbacks, relying on the structure of the setup to provide both entry and stop. This creates a nice risk:reward ratio and, in my book, merits acknowledgment as a best practice.
From Ray:
I am writing to introduce an idea that has been around since at least the days of Richard Wyckoff (1920). I have seen it in many different guises from Bruce Babcock’s ‘Slinky System’ (http://www.rb-trading.com/bbbio.html) to Bradford Radsche’s ‘Turtle Soup’
(http://www.lbrgroup.com/index.asp) to Joseph Hart's ‘Repo’ (http://www.trend-dynamics.com/). Nowadays, I use the word ‘RePo’ to identify the pattern.
I’ll describe the buy pattern; reverse the rules for a sell. The conditions for a buy are:
q Identify an uptrend in the timeframe you are trading.
q Identify a correction to that trend.
q Within that correction, identify a swing low (A). Following ‘A’, there will be a rally to a swing high (B). That rally is followed by a new low (C).
My research shows that it is best if ‘C’ is within 20% of the ‘AB’ range. For example if the AB range is 20 points, and ‘A’ is 1404, then it is best if ‘C’ is no lower than 1400.
The calculations are: 1404 (which is A’s low) – 4 ( which is 20% of the AB range of 20) = 1400. [corrected- BNS]
While it is best that ‘C’ be within 20% of AB, it need not be. But, it is essential there be no close below the 20%.
q After ‘C’, the market reverses the down move and closes above ‘A”. This bar (D) must show buying conviction. In my own trading, a bar that shows buying conviction takes one of two forms:
· a bar that opens no higher than in the bottom third of its daily range and closes no lower than the top third of its daily range. I call this a bull bar will stop
· a bar that opens no higher than in the bottom 25% of its daily range and closes no lower than in the top 25% of its daily range. I call this a directional bar up.
The keys to this setup are
- the identification of the trader's Timeframe trend and
- the ability to define a corrective move.
The best tools I know to do this are Swing Charts. I like swing charts because they give a clear visual picture of the trend and they give earlier warnings of a change in the trend.
There are at least two types of swing charts:
- Arthur Merrill’s ‘Filtered Waves’. These are the most popular. (If you are an E -signal user, Jan Arps offers a free utility, Universal Swing Analysis Tool (UST), at:
(select free download).
The utility probably draws percentage charts. I say seem because the logic is not disclosed.
- The other type of charts by timing price based: Hart Swing Charts and Barros Swing Charts (http://www.tradingsuccess.com/ . These differ from percentage swing charts because they use both time and price inputs to draw the charts.
The question I am usually asked is: does it matter what type of swing construction you use? Not really, provided about the same magnitude swings are compared.
Dealing With Price Spikes: A Best Practice in Trading
Note: This best practice post comes from AnaTrader, a relatively new trader with a background in the arts. Over the time I've corresponded with her, I've found her to be not only a Renaissance woman, but a dedicated student of the markets. AnaTrader relates an incident regarding market spikes due to either faulty ticks or manipulated trades. When you're working orders in the book, such spikes can create unwanted fills. AnaTrader passes along a message from her mentor, Ray Barros, who reassures Forex traders about spikes they might see in their charts.
Over the weekend, some market makers' trading platforms Down Under showed a big spike in GBP/USD, a one time high of 300 pips from normal spread of bid and ask prices as per chart which I extracted this Monday morning.
Over the weekend, some market makers' trading platforms Down Under showed a big spike in GBP/USD, a one time high of 300 pips from normal spread of bid and ask prices as per chart which I extracted this Monday morning.
Many have shorted this instrument, including me, with stops in place for the weekend pending the G7 weekend meeting announcements.
I have to say that when I checked my trading platform, I was not hit or stopped out.
I was perplexed and this is what I learned from my mentor:
Quote
A spike can be a false price that did not actually
take place in trading, It usually occurs on weekends
when M-East traders play with the prices. Most
good brokers don't carry the data.
Even if they did, it would not be considered
a trade - in trading parlance the prices would be 'outed' .
take place in trading, It usually occurs on weekends
when M-East traders play with the prices. Most
good brokers don't carry the data.
Even if they did, it would not be considered
a trade - in trading parlance the prices would be 'outed' .
Am I relieved that there is a trading practice that such a big spike would be outed or disregarded and not carried on trading platforms of renowned brokers.
We could be slaughtered like pigs, all right.
From Brett: The best practice takeaway from AnaTrader's post is that, in the Forex market, it is important to not overreact to false price spikes that may appear. It sounds as though this is just what the traders are trying to cause in the first place.
A different kind of spike is caused by "fat finger" episodes in which a trader might mistakenly buy 10,000 contracts at the market rather than 1000. The resulting purchase takes out quite a few price levels and can lead to further short covering before anyone figures out that this was simply a mistake. A trader who might be working an order to sell above the market would find themselves short and immediately down a couple of points or so on their position. This is not common, but it is an occupational hazard of working orders in the book. Another occupational hazard is working orders in the book prior to the release of an economic report. If the report does not fall within expectations, a spike of price movement created by automated trades can fill you at very bad prices. Unlike the situations mentioned by AnaTrader, these trades will not be "outed". Rather, you'll be out some capital! My own practice is not to work orders far from the market. If I want in at a good price, I'll try to buy at the current bid or sell at the current offer. But I'm not a scalper and, if I'm telling myself I have to be first in the order queue to get filled and make my trade work out, that suggests my trade idea is not so robust.
Bottom line: You have to know *your* market. The meaning of a rogue price spike in one market could be very different from that in another.
AnaTrader Adds:
From Brett: This is indeed an advanced trading method. To place orders in the book ahead of an economic release, you need to have a keen sense for how far a market is likely to move under various scenarios. This means studying past releases and reactions to those. It is not at all uncommon for the market's first, knee-jerk price spike after, say, the release of Fed minutes to not be the direction the market ultimately takes for its subsequent price direction. If you can enter at a good price, it's possible to benefit from the rapid reversal. Prudent position sizing is needed, however, to guard against catastrophic losses should the spike become an outright trend in itself. Thanks to AnaTrader and Ray Barros for the excellent perspectives on price spikes.
From Brett: The best practice takeaway from AnaTrader's post is that, in the Forex market, it is important to not overreact to false price spikes that may appear. It sounds as though this is just what the traders are trying to cause in the first place.
A different kind of spike is caused by "fat finger" episodes in which a trader might mistakenly buy 10,000 contracts at the market rather than 1000. The resulting purchase takes out quite a few price levels and can lead to further short covering before anyone figures out that this was simply a mistake. A trader who might be working an order to sell above the market would find themselves short and immediately down a couple of points or so on their position. This is not common, but it is an occupational hazard of working orders in the book. Another occupational hazard is working orders in the book prior to the release of an economic report. If the report does not fall within expectations, a spike of price movement created by automated trades can fill you at very bad prices. Unlike the situations mentioned by AnaTrader, these trades will not be "outed". Rather, you'll be out some capital! My own practice is not to work orders far from the market. If I want in at a good price, I'll try to buy at the current bid or sell at the current offer. But I'm not a scalper and, if I'm telling myself I have to be first in the order queue to get filled and make my trade work out, that suggests my trade idea is not so robust.
Bottom line: You have to know *your* market. The meaning of a rogue price spike in one market could be very different from that in another.
AnaTrader Adds:
For your added information and illustration, just before any major economic news release like last Friday's PPI, one could put in a buy stop and sell stop order for say, GBP/USD, to catch the entry if it spikes up or down. If the figures were to be outside expectations, it would spike either up or down so fast that you cannot get filled at your price level unless you place a straddle order of buy stop and sell stop. Once either order gets hit, one can delete the other not filled or leave it as a protective stop. One has to determine in advance which way an instrument will go if the news were to be outside expectations.
For last Friday, I expected the GBPUSD to spike up should the expectations were outside, and only placed a buy stop order just a few minutes before the economic release at 8.30ET.
Quote of economic releases:
The latest read on inflation at the wholesale level also hit the wires at 8:30 ET. Total PPI and core PPI matched economists' forecasts; but since the data won't alter inflation expectations, the report failed to provide investors with overwhelming evidence that pricing pressures are abating. The focus now turns to next week's more closely-watched CPI report.
Since the reports were within expectations, there was no spike in the GBPUSD immediately after release and I just deleted my buy stop order.
For a novice, it is generally not advisable to trade before any major economic release, but in my case, I am a mentor student and therefore, have an added advantage of being coached and guided in this complex trading method, which has given me some experience in such volatile trade entries.
From Brett: This is indeed an advanced trading method. To place orders in the book ahead of an economic release, you need to have a keen sense for how far a market is likely to move under various scenarios. This means studying past releases and reactions to those. It is not at all uncommon for the market's first, knee-jerk price spike after, say, the release of Fed minutes to not be the direction the market ultimately takes for its subsequent price direction. If you can enter at a good price, it's possible to benefit from the rapid reversal. Prudent position sizing is needed, however, to guard against catastrophic losses should the spike become an outright trend in itself. Thanks to AnaTrader and Ray Barros for the excellent perspectives on price spikes.
Saturday, February 17, 2007
Stock Screening for Index Traders: A Best Practice in Trading
We normally think of stock screeners as tools for stock pickers. The stock picker screens for stocks that possess certain fundamental and/or technical characteristics that presumably affect supply and demand and then trades those stocks. So it's quite possible the stock picker will be trading energy stocks one day, tech stocks the next--or both simultaneously. The index trader, on the other hand, has a more limited array of options. Many only trade one thing, such as the ES futures. In my experience, active traders of the indices do relatively little stock screening. They are more likely to look at aggregate market indicators, such as the number of stocks advancing vs. declining or the total market volume for the day.
To see how stock screening might aid the index trader, let's take a hard look at that aggregate indicator: advancing vs. declining stocks. When a NYSE issue is counted as an advancing or declining stock, it means that the shares are trading above or below their previous day's close. While that is useful information, it also has its limitations--particularly for the daytrader. First, what is going on in the broad NYSE universe may not be reflective of what is happening within the stocks in the trader's index. If, say, the trader is trading a sector index of energy issues (XLE), what is happening across all stocks is only partly relevant. Second, calibrating stock strength from the prior day's close doesn't tell the intraday trader much about strength during the day session. If stocks as a whole open higher but then trade in a narrow range for the entire morning, a strong advance/decline reading hardly tells the whole story.
Suppose we redefine criteria for advancing and declining stocks. When a stock opens for trading, its opening price reflects the balance of supply and demand coming from a number of factors, including overseas interest, pre-opening economic news, overnight movement of the index futures, etc. During the first minutes of trade, the stock establishes a range of prices that we can consider to be its opening range. This is the market's initial attempt to set value for the shares.
If a stock moves above this opening range and sustains that move, we can truly say--on a day timeframe--that the stock is advancing. If the stock moves below the initial range of prices and stays below, we can say that it is declining on the day. The stock may or may not be up or down relative to the previous day's close. What we want to know is whether that stock is strong or weak relative to that day's initial estimate of value.
Taking this logic one step further, it makes sense that if we track a universe of stocks in this way, we can obtain a sense for whether the stocks that make up a particular index are--as a whole--advancing or declining relative to their opening range. If a significant number of stocks are moving below their initial estimates of value, we want to think long and hard about buying that index, and vice versa.
So where can we get statistics, customized for the stocks that are in the indices that we are trading, that will show day timeframe advances vs. declines? The answer lies in stock screening.
Above you'll notice my Trade Ideas screen from 2/9/07, tracking the 17 stocks that make up my large cap basket. (Please note that I have no commercial relationship with Trade Ideas; nor have they solicited this post or been involved in its writing). These stocks, followed daily on my Trading Psychology Weblog, represent a mix of tech, consumer, cyclical, and financial stocks. I've found over time that they do an admirable job of tracking the S&P 500 Index. I've set Trade Ideas to spit out upside and downside breakouts of the stocks' opening 10 minute trading range. This shows me in real time which stocks are turning into advancers and which into decliners. A nice feature of this particular screen is that the breakout move has to be sustained for 1 minute before it registers as an alert. This provides a modicum of assurance that the stock isn't simply peeking above or below its range and creating a whipsaw with a move in the other direction.
February 9th was interesting in that the market opened higher, with strong NYSE TICK readings in the opening minutes of trade. Four stocks in my basket quickly established upside breakouts from their opening 10-minute range, but then four just as rapidly registered downside breakouts. That is not what you'd expect in a trending market and was a great initial signal to the index trader that strength was selective. As we approached 9:00 AM CT, the ES futures were still trading above their open and above their previous day's close, but stocks advancing vs. declining relative to their opening range were dead even.
As you can see from the alerts, from 9:00 AM CT forward, one stock after another pierced its opening range to the downside. The index weakness lasted much of the next hour, providing plenty of opportunity for the short-term trader to join the move back into the prior day's trading range.
The stock screen showed us that what looked like strength (relative to the previous day's close) really wasn't strength at all. Indeed, the strong buying sentiment, as registered by the NYSE TICK, was unable to move a majority of stocks in my basket above their opening range. As a rule when buyers lifting offers can't move price higher, it's only a matter of time before sellers become emboldened and existing longs liquidate their positions.
The nice thing about the Trade-Ideas screen is that it is highly customizable. I could have set the screen to register 5, 15, or 30 minute breakouts, depending on my trading style. I also could have entered any universe of stocks into my watchlist, including all energy stocks or all stocks in the NASDAQ 100 Index. That ensures that the screens are providing information about the stocks that are most relevant to what we're trading: from stock index futures to ETFs.
Indices are deceptive because many are capitalization weighted. A relatively small number of stocks can make the index look strong or weak. By tracking a universe of stocks in real time and screening for their strength or weakness, we can see if a breakout move in the index is genuine or artificial. We can also determine if leading sectors are breaking out to directional moves prior to the index.
Index traders may not be stock pickers, but they can benefit by taking a look under the hood and seeing how the stocks in their index are really trading. That, for me, makes it a trading best practice.
Friday, February 16, 2007
Friday, February 16th Morning Market Comments
9:47 AM - Volume has really tailed off here. You know, one thing I've always hated is when traders blame their losses on the market. They blame the big traders who "manipulate" the market; they blame news events or lack of news events; they blame low volatility. Energy spent externalizing blame is energy used up without working on yourself. I came into the day with a leaning--that we'd opened lower but would trade back well into the previous day's range--and I was slow to revise that leaning, even as selling picked up in NQ and ER2. That flexible thinking that I've emphasized in the past (and occasionally demonstrated myself!) just wasn't there. Sizing initial positions reasonably and having good stops in place ensured that I didn't get burned by my mistake, but it *was* a mistake nonetheless and is something I will bring to next week's trade as a learning lesson. Sometimes, like yesterday, I develop an early opinion based on a read of the market and really capitalize. But sometimes I can get married to that opinion and don't focus sufficiently on what would tell me I'm wrong (and should make me flip my perspective). That happened for me today. And, yes, I can blame expiration trade and phone calls that interrupted, but if I'm honest with myself, that's not it. The research helps, and knowing market tendencies helps, but you need to also be sensitive to what's happening in the moment. Maintaining that Janus face: one side looking to historical tendencies and the other looking to what's happening *now* is a real psychological challenge. And it's a skill I'll probably always be working on. That, my friends, is the takeaway for today. Have a great long weekend. Wrap up tonite on the Weblog and Best Practices posts this weekend. Thanks for all the recent emails and expressions of support.
9:34 AM - Well, you can see why many traders sit out these expiration days. Let me show you something. Notice what happened to the TICK at 9:15 - 9:22 AM CT. We had several pushes down and selling dried up. A big trader tried to knock ES down around 9:21 AM, but no follow through. That should have been a fine time to enter long. And, yes, we did get a bounce. But then there was no follow through whatsoever. That's why I said I would just scalp trade. I could see the next couple of ticks, but not the next couple of points. But let's not blame all that on the market and expiration; it's time for the Doc to cure himself. Back on that topic in a min.
9:23 AM - Another phone call; just a bit too much distraction, I'm afraid. As a result, I'm done trading for the day. Some very whippy buy and sell programs hitting ER2; very tough to short-term trade. Note slow down in volume recently. Back in a few.
9:14 AM - Volume has remained quite healthy, so we're getting movement. I need to see price hold at higher lows on TICK pullbacks to think about the long side again. I don't have much downside conviction despite the break. My expectations may get the better of me, but I don't see this as a trend day in the making.
9:10 AM - Back after a phone call. My nibbling led to a couple of ticks, but as you can see, there wasn't anything more in the market than that as we broke below the preopen lows and sustained the negative TICK with ER2 leading the way down. No question I was leaning the wrong way in the market and should have been selling those bounces. Now watching to see if we re-enter that AM range vs. trend downward with expansion of volume.
8:54 AM - I am nibbling long on TICK pullbacks that hold above recent lows, but these will be scalp trades for me, so I won't post. Too quick to type them in a timely way. Just wanted to let you know my intentions.
8:50 AM - We may yet get the range trade and I may yet reenter that position, but the weakness in ER2 and NQ turned my risk reward upside down. Better a small loss than a possible significant one.
8:48 AM - Stopped out.
8:44 AM - Bought some ES tight stop.
8:35 AM - Solid volume to open, some related to expiration. Let's see how it goes from here. Leaning to long side if we don't fall out of bed in TICK and ER2.
8:27 AM - I'm showing 1458.75 in ES as the "point of contol" at which we've done the most volume lately, so will use that as my initial estimate of average trading price for this market and then will evaluate the strength and volume participation of moves away from this level for odds of continuation vs. reversal. This, BTW, will be an abbreviated trading (and blogging) session for me, as I have a writing project for my academic department in Syracuse that needs to be completed.
8:21 AM - OK, housing starts came in a bit weak; PPI was in line; and we have Michigan sentiment numbers coming out at 9:00 AM CT, but remember that subscribers to their service do get the data a bit early. We dipped as low as 1456 in ES overnight and now trade just a tad below yesterday's VWAP (pivots and VWAP published daily on the Weblog). With a 3 day weekend coming up and options expiration today, general expectations are for a slow, range bound day. A reader asked me to look into what happens after the Dow has been outperforming the Russell stocks. We've been up a bit more than 1% over the past five days in the Dow (DIA), but actually down over the same period in the Russell 2000 Index (IWM). That has happened 18 times since the start of 2004. The Dow, over the next week, has averaged a gain of .56% (9 up, 9 down), but the Russell has been especially impressive, averaging a gain of 1.11% (13 up, 5 down). In other words, when the Dow has been strong and Russell weak over a five-day period, the next five days in Russell have tended to play catchup. Note also the interesting stats on the Yen vs. the S&P in my latest post on the carry trade. That's definitely a relationship worth watching going forward, IMO. My leaning is to be a buyer if we can see selling dry up above the overnight lows; I also would not want to be chasing highs if we don't get a nice influx of volume. My usual strategy when I anticipate range bound trade is to identify (and keep updating) my estimate of the market's average trading price and fade moves away from that. Back after the open.
8:12 AM CT - And a very good morning to all. I'm getting a very nice response from experienced programmers who are interested in working with experienced traders in testing out trading ideas. As I've mentioned recently, this process can greatly help both parties. If you're a trader with some good ideas and would like to have those tweaked and expanded in a confidential fashion, do send me an email (address is on the TraderFeed home page under the heading "About Me") and I'll use the upcoming long weekend to help connect interested parties. Of course there's no charge or obligation; this is simply an effort to help traders expand skill sets and learn from each other. Ditto the "Open Mic" idea posted recently. If you'd like to co-lead a morning session and blog your ideas, setups, etc., do get in touch! Great way to build some visibility and share with others.
9:34 AM - Well, you can see why many traders sit out these expiration days. Let me show you something. Notice what happened to the TICK at 9:15 - 9:22 AM CT. We had several pushes down and selling dried up. A big trader tried to knock ES down around 9:21 AM, but no follow through. That should have been a fine time to enter long. And, yes, we did get a bounce. But then there was no follow through whatsoever. That's why I said I would just scalp trade. I could see the next couple of ticks, but not the next couple of points. But let's not blame all that on the market and expiration; it's time for the Doc to cure himself. Back on that topic in a min.
9:23 AM - Another phone call; just a bit too much distraction, I'm afraid. As a result, I'm done trading for the day. Some very whippy buy and sell programs hitting ER2; very tough to short-term trade. Note slow down in volume recently. Back in a few.
9:14 AM - Volume has remained quite healthy, so we're getting movement. I need to see price hold at higher lows on TICK pullbacks to think about the long side again. I don't have much downside conviction despite the break. My expectations may get the better of me, but I don't see this as a trend day in the making.
9:10 AM - Back after a phone call. My nibbling led to a couple of ticks, but as you can see, there wasn't anything more in the market than that as we broke below the preopen lows and sustained the negative TICK with ER2 leading the way down. No question I was leaning the wrong way in the market and should have been selling those bounces. Now watching to see if we re-enter that AM range vs. trend downward with expansion of volume.
8:54 AM - I am nibbling long on TICK pullbacks that hold above recent lows, but these will be scalp trades for me, so I won't post. Too quick to type them in a timely way. Just wanted to let you know my intentions.
8:50 AM - We may yet get the range trade and I may yet reenter that position, but the weakness in ER2 and NQ turned my risk reward upside down. Better a small loss than a possible significant one.
8:48 AM - Stopped out.
8:44 AM - Bought some ES tight stop.
8:35 AM - Solid volume to open, some related to expiration. Let's see how it goes from here. Leaning to long side if we don't fall out of bed in TICK and ER2.
8:27 AM - I'm showing 1458.75 in ES as the "point of contol" at which we've done the most volume lately, so will use that as my initial estimate of average trading price for this market and then will evaluate the strength and volume participation of moves away from this level for odds of continuation vs. reversal. This, BTW, will be an abbreviated trading (and blogging) session for me, as I have a writing project for my academic department in Syracuse that needs to be completed.
8:21 AM - OK, housing starts came in a bit weak; PPI was in line; and we have Michigan sentiment numbers coming out at 9:00 AM CT, but remember that subscribers to their service do get the data a bit early. We dipped as low as 1456 in ES overnight and now trade just a tad below yesterday's VWAP (pivots and VWAP published daily on the Weblog). With a 3 day weekend coming up and options expiration today, general expectations are for a slow, range bound day. A reader asked me to look into what happens after the Dow has been outperforming the Russell stocks. We've been up a bit more than 1% over the past five days in the Dow (DIA), but actually down over the same period in the Russell 2000 Index (IWM). That has happened 18 times since the start of 2004. The Dow, over the next week, has averaged a gain of .56% (9 up, 9 down), but the Russell has been especially impressive, averaging a gain of 1.11% (13 up, 5 down). In other words, when the Dow has been strong and Russell weak over a five-day period, the next five days in Russell have tended to play catchup. Note also the interesting stats on the Yen vs. the S&P in my latest post on the carry trade. That's definitely a relationship worth watching going forward, IMO. My leaning is to be a buyer if we can see selling dry up above the overnight lows; I also would not want to be chasing highs if we don't get a nice influx of volume. My usual strategy when I anticipate range bound trade is to identify (and keep updating) my estimate of the market's average trading price and fade moves away from that. Back after the open.
8:12 AM CT - And a very good morning to all. I'm getting a very nice response from experienced programmers who are interested in working with experienced traders in testing out trading ideas. As I've mentioned recently, this process can greatly help both parties. If you're a trader with some good ideas and would like to have those tweaked and expanded in a confidential fashion, do send me an email (address is on the TraderFeed home page under the heading "About Me") and I'll use the upcoming long weekend to help connect interested parties. Of course there's no charge or obligation; this is simply an effort to help traders expand skill sets and learn from each other. Ditto the "Open Mic" idea posted recently. If you'd like to co-lead a morning session and blog your ideas, setups, etc., do get in touch! Great way to build some visibility and share with others.
Is the Carry Trade Carrying the Stock Market?
When my wife and I bought our new house in Fayetteville, NY, we originally planned to make the purchase outright. We heard, however, of an adjustable rate mortgage with a very low initial teaser rate, no points, and no prepayment penalty. So we took out the mortgage, paid a couple points of interest, and kept our money in high yielding CDs for that year. Altogether we netted about 5% on our money with no downside risk.
Little did we know it back then, but we were engaging in a version of the "carry trade" now popular among institutional investors. Japan is acting as the generous world bank, offering money at very low interest rates. This enables investors to borrow Yen and invest money in the higher yielding debt markets, such as those of New Zealand. Those investors net several percent return essentially risk free.
An excellent summary of the carry trade is provided by Michael Shedlock, aka Mish. He reports, "The yen has thus been tantamount to the ATM of the global credit world – spewing out (almost) free cash."
This free cash has also encouraged riskier trading. After all, if I can go to my local bank and get very low interest loans, I can participate in the stock and commodity markets and pay very little for this new source of margin debt. This dynamic has helped lift multiple markets simultaneously, as we've had bull markets in equities, commodities, and fixed income markets.
An interesting view of the impact of the carry trade can be obtained by examining the relationship between the Yen/Dollar and the S&P 500 Index (both cash markets). Let's see what happens in stocks when the Yen is weak vs. strong.
Going back to 2003 (N = 1017 trading days), we have 380 occasions in which the Yen has been above its 10, 20, and 40 day moving averages. Twenty days following such Yen strength, the S&P 500 Index has been down by an average of -.40% (153 up, 227 down). A strong Yen has not been kind to stocks, perhaps because--reflecting interest rate firmness in Japan--it is associated with a more expensive carry trade.
Conversely, since 2003, we've had 394 occasions in which the Yen has been below its 10, 20, and 40 day moving averages. Twenty days later, the S&P 500 Index has been up by an average of .44% (222 up, 172 down). Returns have been more favorable following periods of weak vs. strong Yen, as we'd expect from the carry trade.
Since 2005, a strong Yen has been especially toxic for stocks. When the Yen has been above its three moving averages (N = 125), the next 20 days in the S&P 500 cash index have averaged a decline of -1.30% (34 up, 91 down). That is an amazingly negative performance during a bullish market period. Interestingly, however, weak Yen periods since 2005 have not been associated with the bullish edge that they possessed in 2003 and 2004. Indeed, 20 days following periods of Yen weakness, stocks have averaged a loss of -.15% (119 up, 146 down).
What this might suggest is that the U.S. equity market is obtaining diminishing returns from the carry trade. Stated otherwise, stocks might be growing more sensitive to an unwinding of the carry trade (via stronger Yen and higher rates in Japan) than to further Yen weakness. If that is the case, the carry trade may have more potential to carry us lower than higher.
Little did we know it back then, but we were engaging in a version of the "carry trade" now popular among institutional investors. Japan is acting as the generous world bank, offering money at very low interest rates. This enables investors to borrow Yen and invest money in the higher yielding debt markets, such as those of New Zealand. Those investors net several percent return essentially risk free.
An excellent summary of the carry trade is provided by Michael Shedlock, aka Mish. He reports, "The yen has thus been tantamount to the ATM of the global credit world – spewing out (almost) free cash."
This free cash has also encouraged riskier trading. After all, if I can go to my local bank and get very low interest loans, I can participate in the stock and commodity markets and pay very little for this new source of margin debt. This dynamic has helped lift multiple markets simultaneously, as we've had bull markets in equities, commodities, and fixed income markets.
An interesting view of the impact of the carry trade can be obtained by examining the relationship between the Yen/Dollar and the S&P 500 Index (both cash markets). Let's see what happens in stocks when the Yen is weak vs. strong.
Going back to 2003 (N = 1017 trading days), we have 380 occasions in which the Yen has been above its 10, 20, and 40 day moving averages. Twenty days following such Yen strength, the S&P 500 Index has been down by an average of -.40% (153 up, 227 down). A strong Yen has not been kind to stocks, perhaps because--reflecting interest rate firmness in Japan--it is associated with a more expensive carry trade.
Conversely, since 2003, we've had 394 occasions in which the Yen has been below its 10, 20, and 40 day moving averages. Twenty days later, the S&P 500 Index has been up by an average of .44% (222 up, 172 down). Returns have been more favorable following periods of weak vs. strong Yen, as we'd expect from the carry trade.
Since 2005, a strong Yen has been especially toxic for stocks. When the Yen has been above its three moving averages (N = 125), the next 20 days in the S&P 500 cash index have averaged a decline of -1.30% (34 up, 91 down). That is an amazingly negative performance during a bullish market period. Interestingly, however, weak Yen periods since 2005 have not been associated with the bullish edge that they possessed in 2003 and 2004. Indeed, 20 days following periods of Yen weakness, stocks have averaged a loss of -.15% (119 up, 146 down).
What this might suggest is that the U.S. equity market is obtaining diminishing returns from the carry trade. Stated otherwise, stocks might be growing more sensitive to an unwinding of the carry trade (via stronger Yen and higher rates in Japan) than to further Yen weakness. If that is the case, the carry trade may have more potential to carry us lower than higher.
Thursday, February 15, 2007
Open Mic: A TraderFeed Invitation
Well, it struck me that I talk a lot about being consistent in trading, but--as the fine folks at Despair.com note--that only matters if you're not consistently bad.Fortunately, there are many traders who read this blog who are not screwups, so I'd like to extend an invitation:
If you would like to be a morning host and post your ideas about how the market is trading, what trades you're making, etc., I will be very happy to turn the "mic" over to you for a session. What this means is that we'd have the possibility of learning from more people and seeing a variety of ways of approaching markets.
I'm open to traders who trade different instruments and time frames. Nor do you need to be a "Market Wizard" in order to post your ideas and trades. It just takes a willingness to share ideas, even when those come from losing trades. But all of us learn from how to take losers (and how to use losing trades as information), just as we can learn from winners.
So if you'd like to be a morning host or co-host for the market comments, I'll give you authorship access for the blog for that day. I might also comment on your comments (but will let you lead the way). And I look forward to being a student, too. If you're a blogger/trader, author, or trading coach, I'll be only too happy to use this site to highlight the good work that you do.
Don't be shy; let's learn from each other! My email address is at the right on the TraderFeed home page under the heading "About Me". Thanks for your interest and support--
Brett
Thursday, February 15th Morning Market Comments
10:34 AM - One quick note: I see that the Teach Me Futures site is hosting a presentation on business planning in trading from Joseph Mertes of Alexander Trading. That is after the market close today; registration required. John Conolly of Teach Me Futures does a fine job of attracting good Webinar presenters.
9:48 AM - OK, volume tailing off and my sense is that we'll oscillate around a mean trading price for the day. The only way I know to trade that kind of market is to wait for moves away from that mean and then wait for buying or selling to dry up and then enter in the direction back toward that mean for a short-term trade. I continue to be unimpressed with the price action in ER2. Takeaway lesson for the day is to try to figure out the type of day you're in as early as possible and adjust your trading accordingly. When I saw low volume early on, I went with the assumption of a range day and was willing to fade short term market moves for quick trades. By not allowing the trading of the last two days to color my view of what's happening today, I didn't try playing for big breakout moves, and that--so far--has paid off. If we get a downward shift in the distribution of the TICK, I'd be looking for TICK bounces to fade ER2, with the idea that we've put in a top for the day in that index. Hope that's been helpful; wrap up tonite on the Weblog. Have a great rest of your day!
9:39 AM - What happened there was that a buy program hit the ER2 stocks and you could see TICK jump as a result. I waited for that to pass, got the usual pullback that results when the buy programs aren't across the board and persistent, and then did my best to scratch the trade. I may reenter that short ER2 position on bounces that fail to take out the recent high.
9:36 AM - Out for small loss.
9:29 AM - Volume has slowed down, and I expect movement to do the same going forward.
9:23 AM - I'm short some Russells
9:18 AM - For these morning posts, folks, the specific trades I make are less important than the reasoning behind them. I'm trying to illustrate how to think about trading on a short-term basis by knowing price levels, volume patterns, and how correlated markets behave. It's not the only way to trade and, since Jack Schwager isn't banging my door down for another edition of Market Wizards, we can conclude it's not the *best* way to trade. But it has brought me consistent profitability ever since leaving my full-time position with the prop firm and just might supplement what you're already doing. But the idea is to take away what makes sense to you from these posts and then integrate into what you do best. The idea is not to try to imitate me, trade like me, etc. At some point, I'll use these sessions to try to illustrate longer-term trade setups and strategies (swing trades).
9:14 AM - Volume did turn up on the rise, but not anywhere near like yesterday. My leaning is to fade highs, esp if we see heaviness in ER2. In fact, my leaning is to short ER2 if continued bounces in TICK can't take that index higher. If volume tails off, I'd be just taking small profits on those positions. No major selling pressure in the TICK, but advances only slightly ahead of declines for the day and ES volume at offer vs. bid relatively even. Not how a trend day sets up.
9:04 AM - What happened with that trade is that I saw large traders stop selling ES as we hit that average trading price from Wed. Rates were down and we're still in a bull mode, so my idea was to go with that direction. Had we seen NQ and ER2 fall out of bed, I surely wouldn't have been long ES. In retrospect I could have held that position longer for a test of the Wed. highs, but was not impressed with volume and decided to take the quick profit. NQ and SMH looking strong here.
9:00 AM - Took profits again.
8:52 AM - Bought some ES; very tight stop.
8:46 AM - Volume continues quite modest; that also leads me to take smaller profits, anticipating smaller price moves and ranges.
8:44 AM - That was simply my old standby: if you get buying early and can't promptly test the overnight highs, look for a reversion back to the previous day's VWAP/pivot. We hit VWAP, I waited a bit to see if it would go further, decided to take what I got.
8:42 AM - Took profits.
8:37 AM - Short some ES here
8:35 AM - Pretty flat open, with subnormal volume. I'm on alert for a range day.
8:28 AM - Note that rates continue to tumble, and the dollar continues to weaken. That was supportive of stocks yesterday.
8:22 AM - And, oh yes, we have continued testimony from our Fed chief starting at 9:00 AM CT. That lit things up yesterday; no change in testimony expected, but some nuances might emerge from the different questions posed.
8:20 AM - OK, initial claims came in a bit high, but no major market impact. Yen is up across the board; I'll be posting on this topic tomorrow. With yesterday a strong day (up in price, expansion of 20-day new highs), I'd be looking to test yesterday's high in ES and the R1 level. I'm also aware, however, that we saw some selling in the broad market (esp. ER2) during the afternoon, which may well create some divergences at new price highs. I'll be watching for that, and especially watching to see if that selling spills over to the large caps to help us transition to a range bound trading mode. Remember: as VIX declines, we tend to see narrower trading ranges. I need ES to stay above 1456.25 (and preferably above the overnight lows) to sustain a bullish posture. Pivot targets once again are posted to the Weblog. Failure of buyers to take out the Wednesday high would target the day's pivot/VWAP as initial targets. Philly Fed is out at 11:00 AM. Here's a great article on that economic indicator from Briefing.com. Back after the open.
8:13 AM CT - And another good morning to you. Markets have held up reasonably well overnight after yesterday's jump on Fed testimony, lower rates, and a weaker dollar. We also dipped in option volatility; see my post this AM on that topic. If you've emailed me lately re: best practices, connecting with programmers/experienced traders, etc., I may not have yet gotten back to you. The inbox has been bulging lately, and I'm doing my best to keep up! I hope to get caught up by the end of the day today. Don't let that stop you from emailing me, however, if you're an experienced, successful trader who would like to expand your edge by connecting with an experienced programmer, or if you're an experienced programmer who would like to collaborate (and learn from) an experienced, successful trader. My email address is on the TraderFeed home page under the "About Me" heading. If you haven't read the best practice post on testing trade ideas, I encourage you to check it out; it's a source of edge that is easier to pursue than many people believe. Back with market overview shortly.
9:48 AM - OK, volume tailing off and my sense is that we'll oscillate around a mean trading price for the day. The only way I know to trade that kind of market is to wait for moves away from that mean and then wait for buying or selling to dry up and then enter in the direction back toward that mean for a short-term trade. I continue to be unimpressed with the price action in ER2. Takeaway lesson for the day is to try to figure out the type of day you're in as early as possible and adjust your trading accordingly. When I saw low volume early on, I went with the assumption of a range day and was willing to fade short term market moves for quick trades. By not allowing the trading of the last two days to color my view of what's happening today, I didn't try playing for big breakout moves, and that--so far--has paid off. If we get a downward shift in the distribution of the TICK, I'd be looking for TICK bounces to fade ER2, with the idea that we've put in a top for the day in that index. Hope that's been helpful; wrap up tonite on the Weblog. Have a great rest of your day!
9:39 AM - What happened there was that a buy program hit the ER2 stocks and you could see TICK jump as a result. I waited for that to pass, got the usual pullback that results when the buy programs aren't across the board and persistent, and then did my best to scratch the trade. I may reenter that short ER2 position on bounces that fail to take out the recent high.
9:36 AM - Out for small loss.
9:29 AM - Volume has slowed down, and I expect movement to do the same going forward.
9:23 AM - I'm short some Russells
9:18 AM - For these morning posts, folks, the specific trades I make are less important than the reasoning behind them. I'm trying to illustrate how to think about trading on a short-term basis by knowing price levels, volume patterns, and how correlated markets behave. It's not the only way to trade and, since Jack Schwager isn't banging my door down for another edition of Market Wizards, we can conclude it's not the *best* way to trade. But it has brought me consistent profitability ever since leaving my full-time position with the prop firm and just might supplement what you're already doing. But the idea is to take away what makes sense to you from these posts and then integrate into what you do best. The idea is not to try to imitate me, trade like me, etc. At some point, I'll use these sessions to try to illustrate longer-term trade setups and strategies (swing trades).
9:14 AM - Volume did turn up on the rise, but not anywhere near like yesterday. My leaning is to fade highs, esp if we see heaviness in ER2. In fact, my leaning is to short ER2 if continued bounces in TICK can't take that index higher. If volume tails off, I'd be just taking small profits on those positions. No major selling pressure in the TICK, but advances only slightly ahead of declines for the day and ES volume at offer vs. bid relatively even. Not how a trend day sets up.
9:04 AM - What happened with that trade is that I saw large traders stop selling ES as we hit that average trading price from Wed. Rates were down and we're still in a bull mode, so my idea was to go with that direction. Had we seen NQ and ER2 fall out of bed, I surely wouldn't have been long ES. In retrospect I could have held that position longer for a test of the Wed. highs, but was not impressed with volume and decided to take the quick profit. NQ and SMH looking strong here.
9:00 AM - Took profits again.
8:52 AM - Bought some ES; very tight stop.
8:46 AM - Volume continues quite modest; that also leads me to take smaller profits, anticipating smaller price moves and ranges.
8:44 AM - That was simply my old standby: if you get buying early and can't promptly test the overnight highs, look for a reversion back to the previous day's VWAP/pivot. We hit VWAP, I waited a bit to see if it would go further, decided to take what I got.
8:42 AM - Took profits.
8:37 AM - Short some ES here
8:35 AM - Pretty flat open, with subnormal volume. I'm on alert for a range day.
8:28 AM - Note that rates continue to tumble, and the dollar continues to weaken. That was supportive of stocks yesterday.
8:22 AM - And, oh yes, we have continued testimony from our Fed chief starting at 9:00 AM CT. That lit things up yesterday; no change in testimony expected, but some nuances might emerge from the different questions posed.
8:20 AM - OK, initial claims came in a bit high, but no major market impact. Yen is up across the board; I'll be posting on this topic tomorrow. With yesterday a strong day (up in price, expansion of 20-day new highs), I'd be looking to test yesterday's high in ES and the R1 level. I'm also aware, however, that we saw some selling in the broad market (esp. ER2) during the afternoon, which may well create some divergences at new price highs. I'll be watching for that, and especially watching to see if that selling spills over to the large caps to help us transition to a range bound trading mode. Remember: as VIX declines, we tend to see narrower trading ranges. I need ES to stay above 1456.25 (and preferably above the overnight lows) to sustain a bullish posture. Pivot targets once again are posted to the Weblog. Failure of buyers to take out the Wednesday high would target the day's pivot/VWAP as initial targets. Philly Fed is out at 11:00 AM. Here's a great article on that economic indicator from Briefing.com. Back after the open.
8:13 AM CT - And another good morning to you. Markets have held up reasonably well overnight after yesterday's jump on Fed testimony, lower rates, and a weaker dollar. We also dipped in option volatility; see my post this AM on that topic. If you've emailed me lately re: best practices, connecting with programmers/experienced traders, etc., I may not have yet gotten back to you. The inbox has been bulging lately, and I'm doing my best to keep up! I hope to get caught up by the end of the day today. Don't let that stop you from emailing me, however, if you're an experienced, successful trader who would like to expand your edge by connecting with an experienced programmer, or if you're an experienced programmer who would like to collaborate (and learn from) an experienced, successful trader. My email address is on the TraderFeed home page under the "About Me" heading. If you haven't read the best practice post on testing trade ideas, I encourage you to check it out; it's a source of edge that is easier to pursue than many people believe. Back with market overview shortly.
When Option Volatility is Low on a Relative and Absolute Basis
We recently made 20-day lows in the option volatility indicators for the NASDAQ 100 Index (VXN) and for the S&P 500 Index (VIX). In past posts, I've reported that option volatility captures how much opportunity is likely to be present for daytraders going forward, as low volatility is associated with more narrow trading ranges. It also defines the average size of gaps we're likely to see between the market close and open. When option volatility itself becomes volatile, we tend to see further volatility and bullish implications in the short run. Low option volatility readings tend to be associated with subnormal near-term market returns in the Dow , in the NASDAQ 100 Index, and also in the S&P 500 Index.
I went back to 2005 (N = 513 trading days) and found that the option volatility for the NASDAQ 100 Index (VXN) has varied on a closing basis between 25.73 and 12.61. We closed a bit above 15 on Wednesday, which places us on the low side of option volatility for this period.
When we've made a 20-day low in VXN (N = 60), the next five days in the NASDAQ 100 Index (QQQQ) have averaged a loss of -.28% (26 up, 34 down). That compares to an average five-day gain of .20% (249 up, 204 down) for the remainder of the sample. Once again we see that low option volatility is associated with subnormal returns in the near term.
If we break down those 20-day VXN lows by their absolute VXN values based on a median split, the pattern is even more stark. When we make a 20-day VXN low and VXN is in the lower half of its range of values for those occasions, the next five days in QQQQ average a loss of -.55% (10 up, 20 down). When we make a 20-day VXN low and VXN is in the upper half of its range of values for those occasions, the next five days in QQQQ average a loss of only -.01% (16 up, 14 down). In other words, it's when VXN is low on a relative and on an absolute basis that we see the weakest short-term market returns.
Now let's see how that pattern shapes up in the S&P 500 Index. I note that, since 2005, we have varied between a VIX level of 23.81 and 9.9. That puts our most recent reading of 10.23 on the very low end of the continuum.
Since 2005, we've had 63 occasions in which S&P 500 Index option volatility (VIX) has made a closing 20-day low. (On Wednesday we hit a 20-day low intraday, but did not close at such a low). Five days later, the S&P 500 Index (SPY) has averaged a loss of -.01% (34 up, 29 down). Across all other occasions, SPY has averaged a five-day gain of .22% (266 up, 184 down). Once again, we see inferior near-term returns following 20-day lows in option volatility.
When we again split the 20-day low occasions in half based on absolute VIX level, we once again see the pattern highlighted. When we've had a 20-day low in VIX and VIX has been in the lower half of its range of values for those occasions (N = 31), the next five days in SPY have averaged a loss of -.28% (14 up, 17 down). When we've had a 20-day low in VIX and VIX has been in the upper half of its range of values for those occasions (N = 32), the next five days in SPY have averaged a gain of .10% (20 up, 12 down).
It thus appears that when option volatility is low on a relative basis but also in absolute terms that we have the weakest returns in the short run. Further declines in option volatility would put us at those levels in both the NASDAQ 100 and S&P 500 markets and would have me looking for consolidation and/or a short-term pullback.
I went back to 2005 (N = 513 trading days) and found that the option volatility for the NASDAQ 100 Index (VXN) has varied on a closing basis between 25.73 and 12.61. We closed a bit above 15 on Wednesday, which places us on the low side of option volatility for this period.
When we've made a 20-day low in VXN (N = 60), the next five days in the NASDAQ 100 Index (QQQQ) have averaged a loss of -.28% (26 up, 34 down). That compares to an average five-day gain of .20% (249 up, 204 down) for the remainder of the sample. Once again we see that low option volatility is associated with subnormal returns in the near term.
If we break down those 20-day VXN lows by their absolute VXN values based on a median split, the pattern is even more stark. When we make a 20-day VXN low and VXN is in the lower half of its range of values for those occasions, the next five days in QQQQ average a loss of -.55% (10 up, 20 down). When we make a 20-day VXN low and VXN is in the upper half of its range of values for those occasions, the next five days in QQQQ average a loss of only -.01% (16 up, 14 down). In other words, it's when VXN is low on a relative and on an absolute basis that we see the weakest short-term market returns.
Now let's see how that pattern shapes up in the S&P 500 Index. I note that, since 2005, we have varied between a VIX level of 23.81 and 9.9. That puts our most recent reading of 10.23 on the very low end of the continuum.
Since 2005, we've had 63 occasions in which S&P 500 Index option volatility (VIX) has made a closing 20-day low. (On Wednesday we hit a 20-day low intraday, but did not close at such a low). Five days later, the S&P 500 Index (SPY) has averaged a loss of -.01% (34 up, 29 down). Across all other occasions, SPY has averaged a five-day gain of .22% (266 up, 184 down). Once again, we see inferior near-term returns following 20-day lows in option volatility.
When we again split the 20-day low occasions in half based on absolute VIX level, we once again see the pattern highlighted. When we've had a 20-day low in VIX and VIX has been in the lower half of its range of values for those occasions (N = 31), the next five days in SPY have averaged a loss of -.28% (14 up, 17 down). When we've had a 20-day low in VIX and VIX has been in the upper half of its range of values for those occasions (N = 32), the next five days in SPY have averaged a gain of .10% (20 up, 12 down).
It thus appears that when option volatility is low on a relative basis but also in absolute terms that we have the weakest returns in the short run. Further declines in option volatility would put us at those levels in both the NASDAQ 100 and S&P 500 markets and would have me looking for consolidation and/or a short-term pullback.
Wednesday, February 14, 2007
Wednesday, February 14th Morning Market Comments
10:27 AM - Until we can attract sellers, you have to lean long on pullbacks. That's what happened with that last trade. Once ER2 started holding its pullback lows and TICK couldn't get much below zero, I concluded that sellers were drying up and expected another run at the highs. The distribution of the TICK is quite positive, and it doesn't make sense to fight that. A psychology takeaway for today is to not make regret part of your trading repertoire. I missed the big upmove on the economic news because I was busy managing to get out of a small ER2 short position. I wasn't aligned with the trend and missed the move. I didn't get angry or frustrated and didn't chase highs. I waited for the pullback and stabilization and found an entry. I'm not as profitable as I would have been had I been long from the open, but neither did I succumb to revenge trading/frustration/regret. There will always be another day and another trade. Keep losses reasonable and your opportunity will come. Just a couple of good opportunities per trading day can make a career; the important thing is to capitalize on those, not to regret the moves not traded. Have a great rest of the day; wrap up tonite on the Weblog.
10:15 AM - Wasn't seeing big influx of volume as before and ER2 still isn't looking great, so I decided to take the sure thing. Back for wrap up shortly.
10:14 AM - Took profits here.
10:04 AM - Still consolidating after the big rise. As long as we don't see an influx of sellers in TICK and ER2, my inclination is to hang with a long bias for a test of highs.
9:52 AM - We continue to sell down toward that zero TICK area on reduced volume; so far more a pullback of buyers than an influx of sellers, which is why I'm willing to stick with the initial long position.
9:40 AM - Long some ES here, but again, tight stop on an initial position.
9:33 AM - It would not at all surprise me to see new highs in ES as we move forward; I'd lean toward using such upmoves to unload longs rather than chase highs if we continue to see relative weakness in ER2.
9:29 AM - Watching ER2 carefully for non-confirmations of any move toward highs in the other indices.
9:23 AM - TICK remains positive, so I am not selling, but I want to see what buyers have left before we're off to new highs across the board. Note some selling in semiconductors. We're either going to break big to the upside here or fall back into the longer-term trading range. I'm sitting back handicapping that.
9:15 AM - With us knocking at the door of highs in ES and ER2, I'm looking to see if the higher prices *sustain* this buying interest. If we started getting TICK upmoves that fail to make new price highs, I'd be cautious chasing the upside and might even try a scalp trade short. I'm not going to post anything I do in that scalping vein; just can't post it quickly enough.
9:09 AM - Extremely high volume and high TICK; those TICK pullbacks are the buying areas as long as this persists.
9:06 AM - As long as we see the positive TICK distribution and relative strength in ER2 and NQ, I would not be short this market.
9:05 AM - Big drop in rates, drop in dollar vs. Euro, rally in stocks. Don't think the market is expecting Fed tightening!
9:04 AM - Note we are knocking on the door of new highs in ES. Let's see how we react to that level.
9:02 AM - Clear upside breakout in TICK and averages vs. their AM ranges; need to stay above those ranges to be buying on TICK pullbacks.
9:01 AM - Had to scramble to get out when ER2 sold but other indices stayed firm. One problem posting my trades is that I can't execute and blog quick enough to stay very timely.
8:59 AM - Took quick profit
8:55 AM - Narrow range ahead of the testimony, cross currents, but no real direction. Not adding to my position at this time. Need more evidence of selling in TICK.
8:46 AM - Short some ER2 on TICK bounce; tight stop.
8:40 AM - Note we are well back inside Tuesday range in ER2.
8:36 AM - Seeing a bit of early buying and relative strength in NQ; not much in ER2. Mixed bag thus far, with the tilt toward buyers in the TICK. Volume is healthy so far.
8:26 AM - 1449 is the low end of the overnight range; 1451.50 is the upper end. I like to track how we trade early in the day relative to that range to see how much fresh buying or selling is entering the market early. In that sense, I treat the overnight/preopen range just like any range and look for breakout vs. "mean reversion" moves based on volume and its distribution.
8:18 AM CT - And a very good Valentine's morning to you! The snow has moved eastward and soon we'll all be digging ourselves out of winter's fury--even my former stomping grounds in Upstate New York, which (in some areas) got 12 *feet* of snow recently. Homeowners were frantically shoveling off their *rooftops* to avoid the pressure of the gathering snow. No such snowing under yesterday, as stocks started strong and, despite lagging NQ and ER2 through much of the day, still registered healthy gains. We closed near the day's highs and now are trading yet higher, awaiting the 9:00 AM CT Congressional testimony of Fed Chair Bernanke. It would not surprise me to see some slow, rangebound trade ahead of that testimony. It would also surprise me to see testimony that differs significantly from recent Fed minutes and statements. We're getting a bit of dollar weakness vs. Euro, and interest rates dipped on the retail sales news, which was weaker than expected at unchanged. 9:00 AM CT we have business inventories and 9:30 we have crude oil inventory data. Normal expectations for a strong day are to at least test the R1 pivot level (pivots are posted daily to the Weblog) in follow through trade. Failure to do so would target the Tuesday pivot/VWAP. Do check out the Best Practice post this AM: there's a link to an article by Henry Carstens that is a phenomenal introduction to developing and testing trading ideas. I immediately talked with Henry by phone after reading his article and told him he had outdone himself. Thanks to everyone so far who has submitted a Best Practice! Back after the open.
10:15 AM - Wasn't seeing big influx of volume as before and ER2 still isn't looking great, so I decided to take the sure thing. Back for wrap up shortly.
10:14 AM - Took profits here.
10:04 AM - Still consolidating after the big rise. As long as we don't see an influx of sellers in TICK and ER2, my inclination is to hang with a long bias for a test of highs.
9:52 AM - We continue to sell down toward that zero TICK area on reduced volume; so far more a pullback of buyers than an influx of sellers, which is why I'm willing to stick with the initial long position.
9:40 AM - Long some ES here, but again, tight stop on an initial position.
9:33 AM - It would not at all surprise me to see new highs in ES as we move forward; I'd lean toward using such upmoves to unload longs rather than chase highs if we continue to see relative weakness in ER2.
9:29 AM - Watching ER2 carefully for non-confirmations of any move toward highs in the other indices.
9:23 AM - TICK remains positive, so I am not selling, but I want to see what buyers have left before we're off to new highs across the board. Note some selling in semiconductors. We're either going to break big to the upside here or fall back into the longer-term trading range. I'm sitting back handicapping that.
9:15 AM - With us knocking at the door of highs in ES and ER2, I'm looking to see if the higher prices *sustain* this buying interest. If we started getting TICK upmoves that fail to make new price highs, I'd be cautious chasing the upside and might even try a scalp trade short. I'm not going to post anything I do in that scalping vein; just can't post it quickly enough.
9:09 AM - Extremely high volume and high TICK; those TICK pullbacks are the buying areas as long as this persists.
9:06 AM - As long as we see the positive TICK distribution and relative strength in ER2 and NQ, I would not be short this market.
9:05 AM - Big drop in rates, drop in dollar vs. Euro, rally in stocks. Don't think the market is expecting Fed tightening!
9:04 AM - Note we are knocking on the door of new highs in ES. Let's see how we react to that level.
9:02 AM - Clear upside breakout in TICK and averages vs. their AM ranges; need to stay above those ranges to be buying on TICK pullbacks.
9:01 AM - Had to scramble to get out when ER2 sold but other indices stayed firm. One problem posting my trades is that I can't execute and blog quick enough to stay very timely.
8:59 AM - Took quick profit
8:55 AM - Narrow range ahead of the testimony, cross currents, but no real direction. Not adding to my position at this time. Need more evidence of selling in TICK.
8:46 AM - Short some ER2 on TICK bounce; tight stop.
8:40 AM - Note we are well back inside Tuesday range in ER2.
8:36 AM - Seeing a bit of early buying and relative strength in NQ; not much in ER2. Mixed bag thus far, with the tilt toward buyers in the TICK. Volume is healthy so far.
8:26 AM - 1449 is the low end of the overnight range; 1451.50 is the upper end. I like to track how we trade early in the day relative to that range to see how much fresh buying or selling is entering the market early. In that sense, I treat the overnight/preopen range just like any range and look for breakout vs. "mean reversion" moves based on volume and its distribution.
8:18 AM CT - And a very good Valentine's morning to you! The snow has moved eastward and soon we'll all be digging ourselves out of winter's fury--even my former stomping grounds in Upstate New York, which (in some areas) got 12 *feet* of snow recently. Homeowners were frantically shoveling off their *rooftops* to avoid the pressure of the gathering snow. No such snowing under yesterday, as stocks started strong and, despite lagging NQ and ER2 through much of the day, still registered healthy gains. We closed near the day's highs and now are trading yet higher, awaiting the 9:00 AM CT Congressional testimony of Fed Chair Bernanke. It would not surprise me to see some slow, rangebound trade ahead of that testimony. It would also surprise me to see testimony that differs significantly from recent Fed minutes and statements. We're getting a bit of dollar weakness vs. Euro, and interest rates dipped on the retail sales news, which was weaker than expected at unchanged. 9:00 AM CT we have business inventories and 9:30 we have crude oil inventory data. Normal expectations for a strong day are to at least test the R1 pivot level (pivots are posted daily to the Weblog) in follow through trade. Failure to do so would target the Tuesday pivot/VWAP. Do check out the Best Practice post this AM: there's a link to an article by Henry Carstens that is a phenomenal introduction to developing and testing trading ideas. I immediately talked with Henry by phone after reading his article and told him he had outdone himself. Thanks to everyone so far who has submitted a Best Practice! Back after the open.
Testing Your Trading Ideas: A Best Practice in Trading
Note: I'm doing the writeup, but credit this idea to professional trader and system developer Henry Carstens. His article linked below is one of the best trading articles I have ever read. If you recall, Henry is the developer who worked with one of the blog readers to develop his trading edge. From that interaction, we learned quite a bit about what it takes to succeed at trading. Most important, we saw that the partnership of programmers and traders is of benefit to both: traders learn which of their ideas work best (and how they can be improved), and developers gain new market insights from experienced traders. For that reason, today's Best Practice is to test your trading ideas, either by learning one of the testing platforms yourself or by partnering with a programmer already familiar with the testing process. At the end of this post, you'll see how Henry's article can help you take steps in these directions.
Brett
Traders often think of trades in terms of "setups". These are conditions that have to be met in order to enter the market. A setup typically defines a situation in which demand and supply become sufficiently imbalanced that they lead to directional market movement. A setup can be defined as a configuration in an oscillator, a chart pattern, or an indicator reading.
Of course, much more goes into a trade idea than the initial setup. There is also the issue of money management: how much capital to allocate to the trade, and there is the issue of exiting the setup once entered. Traders also typically address the issue of stop loss points--where to get out when a trade turns out poorly--and they also make assumptions about which trading instruments to utilize in pursuing the setup.
As you can see, there are many different components to a trade. When we review our P/L, we tend to attribute our results to our setups. But that isn't necessarily accurate. Our results are also a function of our money management, our stops, and our exit criteria. Results also vary as a function of *what* we trade, not just how we trade it.
This is a major challenge for the discretionary trader. We might be making money--or just approaching profitability--but we don't really know which parts of our trading are working for us and which aren't. Because we don't know if our setups, exits, stops, etc. are holding us back or contributing to our success, it is difficult to maximize our performance.
That's where testing our trading ideas comes into play. When we test ideas, we go back into recent history and see, first hand, how each component of our trading contributes to P/L. Very often, as was the case with the recent trader, we find that our ideas work for us, but still can be improved. Sometimes we find that what we thought was working really isn't adding to our success. A while back, for instance, I tested my morning setups and found they were working better in the Russell futures than in the S&P 500. As a result, I commonly place trades in both markets, which has improved my profitability.
The prospect of testing trading ideas is daunting for many traders, who might be intimidated by the programming. Current platforms, however, make such testing easier than ever. This article by Henry Carstens is the clearest summary of how to test ideas that I've yet encountered. I strongly recommend it as reading for any trader who wants to better understand what goes into good trading ideas. There are also sections on how to test the significance of trading ideas and how to optimally allocate capital to those ideas. An additional, fantastic feature of the article is the template at the end, written in TradeStation code, than enables you to drop in your ideas and test them out for yourself!
If you've been successful with your ideas but don't want to tackle the programming yourself, consider teaming up with an experienced programmer. To help traders with this challenge, I will collect names and contact information from all experienced traders and experienced programmers who might want to collaborate. Simply email me at the address given at the right side of the TraderFeed homepage (under the section "About Me") and I will do my best to get you connected.
My goal is not just to help traders learn, but to help traders learn from their own experience and from each other. Henry's idea of using testing to sharpen our trading is a great way to move ourselves to the next level of performance. That's why I consider it a "best practice".
Brett
Traders often think of trades in terms of "setups". These are conditions that have to be met in order to enter the market. A setup typically defines a situation in which demand and supply become sufficiently imbalanced that they lead to directional market movement. A setup can be defined as a configuration in an oscillator, a chart pattern, or an indicator reading.
Of course, much more goes into a trade idea than the initial setup. There is also the issue of money management: how much capital to allocate to the trade, and there is the issue of exiting the setup once entered. Traders also typically address the issue of stop loss points--where to get out when a trade turns out poorly--and they also make assumptions about which trading instruments to utilize in pursuing the setup.
As you can see, there are many different components to a trade. When we review our P/L, we tend to attribute our results to our setups. But that isn't necessarily accurate. Our results are also a function of our money management, our stops, and our exit criteria. Results also vary as a function of *what* we trade, not just how we trade it.
This is a major challenge for the discretionary trader. We might be making money--or just approaching profitability--but we don't really know which parts of our trading are working for us and which aren't. Because we don't know if our setups, exits, stops, etc. are holding us back or contributing to our success, it is difficult to maximize our performance.
That's where testing our trading ideas comes into play. When we test ideas, we go back into recent history and see, first hand, how each component of our trading contributes to P/L. Very often, as was the case with the recent trader, we find that our ideas work for us, but still can be improved. Sometimes we find that what we thought was working really isn't adding to our success. A while back, for instance, I tested my morning setups and found they were working better in the Russell futures than in the S&P 500. As a result, I commonly place trades in both markets, which has improved my profitability.
The prospect of testing trading ideas is daunting for many traders, who might be intimidated by the programming. Current platforms, however, make such testing easier than ever. This article by Henry Carstens is the clearest summary of how to test ideas that I've yet encountered. I strongly recommend it as reading for any trader who wants to better understand what goes into good trading ideas. There are also sections on how to test the significance of trading ideas and how to optimally allocate capital to those ideas. An additional, fantastic feature of the article is the template at the end, written in TradeStation code, than enables you to drop in your ideas and test them out for yourself!
If you've been successful with your ideas but don't want to tackle the programming yourself, consider teaming up with an experienced programmer. To help traders with this challenge, I will collect names and contact information from all experienced traders and experienced programmers who might want to collaborate. Simply email me at the address given at the right side of the TraderFeed homepage (under the section "About Me") and I will do my best to get you connected.
My goal is not just to help traders learn, but to help traders learn from their own experience and from each other. Henry's idea of using testing to sharpen our trading is a great way to move ourselves to the next level of performance. That's why I consider it a "best practice".
Tuesday, February 13, 2007
Replaying the Trading Day: A Best Practice in Trading
Note: Today's Best Practice post is from reader Bonnie Lee Hill, who has shared with me a number of insights and perspectives into what makes a trader successful. Below is Bonnie's post; I follow it with a few observations of my own. Her premise is that you can improve your learning of markets by increasing your exposure to trading patterns.
Since trading is a performance art, a trader must practice his craft. A trader needs time to trade, research, test his ideas, update his trading journal, etc. There are not enough hours in the day (unless you are a FOREX trader who never sleeps :-) I daytrade the QQQQ, and require a lot of screen time. I have found a way to become more efficient. I can replay any day's trading action. The replay can occur at any desired speed -- normal, 2X, 10X, etc. This allows me to increase my amount of "screen time".
I can use my replay time in many different ways. I can test a new idea on randomly selected days. In this situation, yesterday's market action can not be used to help me trade "today". I can study a particular situation in the market. For instance, I can replay all the FOMC days in one study session. This helps me to see the "pattern" in that volatile day. I can replay all the Options Expiration Fridays as a group. I also have a group of Congestion Days. These are the days in which a trader may try to force a trade. These days are a very good test of a new idea or indicator.I have a group of Runaway Days. These are the days in which the market can leave the trader behind. Again, these days are great for testing a new idea or indicator.
I also practice the same trading day at multiple speeds. There are times at which the market may seem too fast for me to handle. I can replay trading days at faster speeds. Let's assume I replayed several trading days at the 10X speed. The next actual trading day seems to move very slowly. The market didn't "slow down", I "speeded up" :-)
A playback (or simulation) feature should be included in a good charting package. I am using the Playback feature of Ensign Software. The website maintains a collection of Playback files which can be downloaded by the user. The user can also generate a Playback file for anything he wishes to study.
If you are interested in studying this technique, here are a few links:
Playback Instructions
Video which describes how to use the Playback files
An article on Playback
How to open the Demo chart
Bonnie Lee Hill
From Brett: This is truly an excellent feature and aid to learning. What makes this a best practice in my view is the archiving of particular market days, such as FOMC days or breakout days. This enables traders to concentrate their practice and achieve months' worth of experience is a single learning session. The ability to speed up the market's action is also a very useful tool for sharpening rapid perception and judgment. It reminds me of basketball drills in which we used to take 25-30 foot jump shots, one after another. That made the standard 20 foot 3-point shot look like a layup! For the active trader, speed of mental processing is a core skill. By practicing at different speeds, a trader can actively work on cultivating that speed. Thanks, Bonnie, for the excellent ideas! I welcome comments to this post if traders have ideas of their own to add.
Since trading is a performance art, a trader must practice his craft. A trader needs time to trade, research, test his ideas, update his trading journal, etc. There are not enough hours in the day (unless you are a FOREX trader who never sleeps :-) I daytrade the QQQQ, and require a lot of screen time. I have found a way to become more efficient. I can replay any day's trading action. The replay can occur at any desired speed -- normal, 2X, 10X, etc. This allows me to increase my amount of "screen time".
I can use my replay time in many different ways. I can test a new idea on randomly selected days. In this situation, yesterday's market action can not be used to help me trade "today". I can study a particular situation in the market. For instance, I can replay all the FOMC days in one study session. This helps me to see the "pattern" in that volatile day. I can replay all the Options Expiration Fridays as a group. I also have a group of Congestion Days. These are the days in which a trader may try to force a trade. These days are a very good test of a new idea or indicator.I have a group of Runaway Days. These are the days in which the market can leave the trader behind. Again, these days are great for testing a new idea or indicator.
I also practice the same trading day at multiple speeds. There are times at which the market may seem too fast for me to handle. I can replay trading days at faster speeds. Let's assume I replayed several trading days at the 10X speed. The next actual trading day seems to move very slowly. The market didn't "slow down", I "speeded up" :-)
A playback (or simulation) feature should be included in a good charting package. I am using the Playback feature of Ensign Software. The website maintains a collection of Playback files which can be downloaded by the user. The user can also generate a Playback file for anything he wishes to study.
If you are interested in studying this technique, here are a few links:
Playback Instructions
Video which describes how to use the Playback files
An article on Playback
How to open the Demo chart
Bonnie Lee Hill
From Brett: This is truly an excellent feature and aid to learning. What makes this a best practice in my view is the archiving of particular market days, such as FOMC days or breakout days. This enables traders to concentrate their practice and achieve months' worth of experience is a single learning session. The ability to speed up the market's action is also a very useful tool for sharpening rapid perception and judgment. It reminds me of basketball drills in which we used to take 25-30 foot jump shots, one after another. That made the standard 20 foot 3-point shot look like a layup! For the active trader, speed of mental processing is a core skill. By practicing at different speeds, a trader can actively work on cultivating that speed. Thanks, Bonnie, for the excellent ideas! I welcome comments to this post if traders have ideas of their own to add.
Tuesday, February 13th Morning Market Comments
9:59 AM - We continue to see weakness in ER2 and NQ, and that keeps me out of the long side in the large caps. Note the transition we made from solid buying to mixed performance on new highs (small caps, semis, NQ underperforming) to reduced volume on buying to outright selling. Those transitions are what you want to be sensitive to in handicapping the odds that market moves will continue vs. reverse. Note how, with the inability to sustain the price highs relative to Monday, we fell back into the Monday range and back toward average trading prices from Monday in the 3 indices. The key to identifying that, as you review charts tonite, is the reduced volume on TICK upthrusts and especially the reduced lifting of offers in the Market Delta chart. That has led to increased downside volume and outright selling. We'll need to see a similar transition, with selling drying up, before we can again take the long side. Hope this has been helpful; have a great remainder of the day. Update tonite on the Weblog.
9:53 AM - Just not a lot of buying volume here so far. I need to see that *before* committing to a position. I'll wrap up in a few.
9:46 AM - Watching 5 min Market Delta to see if we can put in a short-term bottom here. If so, I'd expect to take out the day's highs. What I need to see on buying, however, is expanded volume. So far, volume has turned anemic on buying.
9:40 AM - A reader just passed along this tool for assessing market trend in ES. Much thanks. Note that we really haven't had extensive selling in TICK, just a lack of follow through in buying. Energy issues continue strong; semis weak.
9:36 AM - Note weakness in semis.
9:35 AM - Very nice volume lesson right there. If a move cannot attract fresh volume, the odds of reversal are quite high. Looking to see if we put in a short-term top in ER2 and NQ.
9:30 AM - Volume has tailed off substantially here. One of the reasons I've stayed profitable is that I'm willing to sit and not trade. I wasn't seeing consistent buying across the indices once ES broke the Monday highs, so I took what the market gave and just sat back. The buying right now is on reduced volume; let's see if new buyers commit and sustain the move.
9:23 AM - Seeing weakness in NQ and semis. I'm out and need to see these rises in TICK produce better price action before I'd get long again.
9:12 AM - Got a high in the Dow and ES, but not ER2 or NQ so far. I use the TICK pullbacks as buying opportunities as long as they come at higher price levels. If we get a TICK surge and we see non-confirmations, I take quick profits.
9:06 AM - If we break that 811.40 low in ER2, I'd be more cautious about the long side. NQ looking a bit heavy. Need to stay above 1793.5.
9:05 AM - My trade idea was to take out the prior day's high and that also got me out for a very short-term trade. I'm still viewing pullbacks as buying opportunities as long as we stay above the AM lows.
9:00 AM - Took profits, ready to re-enter if we get better ER2 action.
8:55 AM - ER2 having some trouble catching a bid, now getting selling; watching closely.
8:47 AM - I'm using weakness to gradually add ES. Tight stops.
8:40 AM - Targeting the Monday highs in ES; already there in ER2 and NQ.
8:38 AM - Energy stocks strong; semiconductors falling back into Monday range. Advancers lead declines by well over 1000 issues. Solid open.
8:35 AM - Solid buying out of the gate across the three indices. Note that we're very close to taking out Monday's high in ER2. Volume is above average for this time of day, which shows institutional involvement in picking up bargains. I'm looking at that 1438 low as the potential low for the extended trading session, which would have me buying dips.
8:23 AM - I'm looking to see if we can hold that 1438 overnight low; 1440.75 is the overnight high thus far. We're trading pretty much in the thick of the market's value area, so my leaning is to wait for tests of the edges of the overnight range before entering. Thanks to a reader (and excellent trader) for passing along this link for following world markets. If there are other tools you find helpful in tracking markets, do email me and I'll be happy to pass along. I find the Economic Calendar at Briefing.com to be a useful resource. It summarizes the economic reports due out and the expectations for those. See ya in a bit.
8:12 AM CT - Good morning! Chicago is pretty well shut down because of the snow, and I'm still fighting off this flu, but maybe we'll get some warmth and cheer from the markets. I just posted some expectations following weak market days, so that will help guide my thinking in early trading. We're currently trading above the pivot level and VWAP from Monday (posted on the Weblog, along with other pivot-based targets), so basically, we want to see if buying can keep us above that benchmark. If so, we'll target Monday's high; if not, we'll look for a test of those average prices and then a test of Monday's low. My general leaning is to be a buyer if we see selling dry up above Monday's lows and to be a seller if buying cannot sustain a move above Monday's average trading price. No big movement from the Trade Deficit number; no other big numbers scheduled for today. Thanks to all those who have submitted "best practice" ideas: I'll be posting those, one a day, for the next several days. Great stuff; I really appreciate the willingness to share ideas and collaborate. Back after the open.
9:53 AM - Just not a lot of buying volume here so far. I need to see that *before* committing to a position. I'll wrap up in a few.
9:46 AM - Watching 5 min Market Delta to see if we can put in a short-term bottom here. If so, I'd expect to take out the day's highs. What I need to see on buying, however, is expanded volume. So far, volume has turned anemic on buying.
9:40 AM - A reader just passed along this tool for assessing market trend in ES. Much thanks. Note that we really haven't had extensive selling in TICK, just a lack of follow through in buying. Energy issues continue strong; semis weak.
9:36 AM - Note weakness in semis.
9:35 AM - Very nice volume lesson right there. If a move cannot attract fresh volume, the odds of reversal are quite high. Looking to see if we put in a short-term top in ER2 and NQ.
9:30 AM - Volume has tailed off substantially here. One of the reasons I've stayed profitable is that I'm willing to sit and not trade. I wasn't seeing consistent buying across the indices once ES broke the Monday highs, so I took what the market gave and just sat back. The buying right now is on reduced volume; let's see if new buyers commit and sustain the move.
9:23 AM - Seeing weakness in NQ and semis. I'm out and need to see these rises in TICK produce better price action before I'd get long again.
9:12 AM - Got a high in the Dow and ES, but not ER2 or NQ so far. I use the TICK pullbacks as buying opportunities as long as they come at higher price levels. If we get a TICK surge and we see non-confirmations, I take quick profits.
9:06 AM - If we break that 811.40 low in ER2, I'd be more cautious about the long side. NQ looking a bit heavy. Need to stay above 1793.5.
9:05 AM - My trade idea was to take out the prior day's high and that also got me out for a very short-term trade. I'm still viewing pullbacks as buying opportunities as long as we stay above the AM lows.
9:00 AM - Took profits, ready to re-enter if we get better ER2 action.
8:55 AM - ER2 having some trouble catching a bid, now getting selling; watching closely.
8:47 AM - I'm using weakness to gradually add ES. Tight stops.
8:40 AM - Targeting the Monday highs in ES; already there in ER2 and NQ.
8:38 AM - Energy stocks strong; semiconductors falling back into Monday range. Advancers lead declines by well over 1000 issues. Solid open.
8:35 AM - Solid buying out of the gate across the three indices. Note that we're very close to taking out Monday's high in ER2. Volume is above average for this time of day, which shows institutional involvement in picking up bargains. I'm looking at that 1438 low as the potential low for the extended trading session, which would have me buying dips.
8:23 AM - I'm looking to see if we can hold that 1438 overnight low; 1440.75 is the overnight high thus far. We're trading pretty much in the thick of the market's value area, so my leaning is to wait for tests of the edges of the overnight range before entering. Thanks to a reader (and excellent trader) for passing along this link for following world markets. If there are other tools you find helpful in tracking markets, do email me and I'll be happy to pass along. I find the Economic Calendar at Briefing.com to be a useful resource. It summarizes the economic reports due out and the expectations for those. See ya in a bit.
8:12 AM CT - Good morning! Chicago is pretty well shut down because of the snow, and I'm still fighting off this flu, but maybe we'll get some warmth and cheer from the markets. I just posted some expectations following weak market days, so that will help guide my thinking in early trading. We're currently trading above the pivot level and VWAP from Monday (posted on the Weblog, along with other pivot-based targets), so basically, we want to see if buying can keep us above that benchmark. If so, we'll target Monday's high; if not, we'll look for a test of those average prices and then a test of Monday's low. My general leaning is to be a buyer if we see selling dry up above Monday's lows and to be a seller if buying cannot sustain a move above Monday's average trading price. No big movement from the Trade Deficit number; no other big numbers scheduled for today. Thanks to all those who have submitted "best practice" ideas: I'll be posting those, one a day, for the next several days. Great stuff; I really appreciate the willingness to share ideas and collaborate. Back after the open.
Weak Day in the Stock Market: What Comes Next?
In a recent post, I found that, in the trading session following a day of broad downside momentum, markets tend to take out that day's lows. That led me to short the market in early trade on Monday, which followed the historical scenario quite nicely. As it turns out, Monday also finished as a weak day in the stock market. By that, I mean that Monday: a) was a down day in the S&P 500 Index (SPY); b) closed in the bottom half of its daily range; and c) had a level of stocks making new 20-day highs minus new 20-day lows lower than the day previous.
Going back to 2004 (N = 776 trading days), I found 206 occasions meeting the above criteria of weakness. Out of those, we broke the prior day's lows on 131 occasions during the follow day of trade in SPY or nearly 2/3 of the time. Conversely, during the remainder of occasions in the sample (N = 570), we broke the prior day's lows 220 times, or about 40% of the time. This fits with the earlier research: weakness tends to follow through in the short run during the next trading session.
Once again, however, by the end of the next day's trading, that downside edge is lost: the market closes up 112 times and down on 94 occasions for an average gain of .05%--no bearish edge at all. Indeed, if we look three days out from a weak day, SPY averages a gain of .20% (123 up, 83 down), stronger than the average three-day gain of .07% (315 up, 255 down) for the remainder of the sample. What that means is that downside follow through after weakness has been very short term on average. Several days out, SPY has tended to rebound following such weakness.
These ideas will again inform my trading on Tuesday. By handicapping the odds of hitting key price levels--and determining the likelihood that moves will continue vs. reverse--we can develop a basic road map for the coming day's activity.
Going back to 2004 (N = 776 trading days), I found 206 occasions meeting the above criteria of weakness. Out of those, we broke the prior day's lows on 131 occasions during the follow day of trade in SPY or nearly 2/3 of the time. Conversely, during the remainder of occasions in the sample (N = 570), we broke the prior day's lows 220 times, or about 40% of the time. This fits with the earlier research: weakness tends to follow through in the short run during the next trading session.
Once again, however, by the end of the next day's trading, that downside edge is lost: the market closes up 112 times and down on 94 occasions for an average gain of .05%--no bearish edge at all. Indeed, if we look three days out from a weak day, SPY averages a gain of .20% (123 up, 83 down), stronger than the average three-day gain of .07% (315 up, 255 down) for the remainder of the sample. What that means is that downside follow through after weakness has been very short term on average. Several days out, SPY has tended to rebound following such weakness.
These ideas will again inform my trading on Tuesday. By handicapping the odds of hitting key price levels--and determining the likelihood that moves will continue vs. reverse--we can develop a basic road map for the coming day's activity.
Monday, February 12, 2007
Monday, February 12th Morning Market Comments
9:38 AM - OK, it's been a good AM of trading, my being under the weather notwithstanding. Our research told us we had good odds of taking out the Friday low. When we saw early selling in ER2 and no taking out of the overnight high in ES, that was a nice time to get short for a good trade. When I saw program trades enter on the buy side, esp. in ER2 (which had been leading the downside), I flipped my bias and took a quick long trade for a modest winner. I needed more confirmation that the market was bottoming, and now, as I write, we'll see if that thesis holds up, as we're getting some fresh selling. The takeaway for this AM is that research into historical trading patterns once in a while will turn up a nice edge and form the basis for a worthwhile trade idea. Still, you have to closely monitor trading conditions in real time. Those institutions doing the program trading are among the participants you want to be following. I'm watching for an opportunity to get long, but need to see selling dry up. Have a great rest of your day; wrap up tonite on the Weblog.
9:30 AM - An upside breakout in TICK and continued relative strength in ER2 would cement my idea of having put in a bottom this AM and would have me leaning long the remainder of the day. If we test the AM lows, watch closely for non-confirmations and for volume (expanding or drying up at the bid) in ES to determine if that is part of a bottoming process or the start of a new leg down. Unfortunately, I'm as sick as can be with the flu and will need to wrap up shortly. More in a bit.
9:21 AM - Notice how my entire market perspective shifted when I saw program buying at the 9:10 time area. More on that later.
9:18 AM - Took a quick profit, but ready to reenter long if TICK declines hold at higher price levels. Recall the research: strong market if we don't take out prior day's low. I'm looking to see if we put in a bottom for the day this AM, but I need the market to show that to me.
9:13 AM - Bought a little ES here, but tight stop.
9:10 AM - Program buy in ER2; note shift upward in TICK. That will have me watching TICK declines carefully to see if we are getting a transition from selling to buying.
9:08 AM - Observe that we really haven't seen extreme low TICK readings this AM and declining stocks only lead advancers by about 600 issues. It's a down morning to be sure, but this is lighter selling than we saw on Friday, and the volumes, while elevated to the downside, are more modest than Friday as well. Selling the TICK bounces continues to work as long as those occur at lower price levels with less volume than we see on the declines.
9:02 AM - Note semis holding up relatively well recently.
9:01 AM - Note we've taken out the Friday lows in NQ; very close in ER2. Still gotta lean short.
8:58 AM - Took some profits here; might reenter quickly.
8:46 AM - I'd need to see buying in ER2 and semis and upside TICK breakouts to think about being a buyer; until that happens, I see the TICK bounces as opportunities for shorting as long as we stay below the overnight highs.
8:39 AM - Also note weakness in semiconductors; Dow is relatively strong.
8:37 AM - Note that ER2 has broken below its overnite range. I'm looking for that to lead.
8:35 AM - Real mixed bag early on; greater strength in ES than NQ or ER2. If that continues, I'd expect to see all the averages test those Friday lows. I have an initial short position in ES with a tight stop.
8:19 AM CT - Good morning! Alas, the good Doctor is ailing this AM--a wicked case of flu going around our household--so my comments may be abbreviated this morning. My recent post noted high odds of taking out the previous day's low following a strong momentum decline, but also observed strong market behavior if we cannot take out that low. So let's see if we can track volume at bid/offer and various sectors to handicap the odds of continuing Friday's decline. No major economic reports on tap this AM; interest rates are a bit higher this AM, as is the dollar vs. the Euro. Oil is lower; the DAX is down, but off its lows from earlier in the session. The 1445 area in ES represents short-term overnight resistance; 1441 represents near-term overnight support. A breakout from that range--and whether such a breakout can be sustained--will provide us with information about who is in control: buyers or sellers. Pivot levels for the day have been updated on the Weblog; note also the first Best Practices post on Market Profile. Back after the open.
9:30 AM - An upside breakout in TICK and continued relative strength in ER2 would cement my idea of having put in a bottom this AM and would have me leaning long the remainder of the day. If we test the AM lows, watch closely for non-confirmations and for volume (expanding or drying up at the bid) in ES to determine if that is part of a bottoming process or the start of a new leg down. Unfortunately, I'm as sick as can be with the flu and will need to wrap up shortly. More in a bit.
9:21 AM - Notice how my entire market perspective shifted when I saw program buying at the 9:10 time area. More on that later.
9:18 AM - Took a quick profit, but ready to reenter long if TICK declines hold at higher price levels. Recall the research: strong market if we don't take out prior day's low. I'm looking to see if we put in a bottom for the day this AM, but I need the market to show that to me.
9:13 AM - Bought a little ES here, but tight stop.
9:10 AM - Program buy in ER2; note shift upward in TICK. That will have me watching TICK declines carefully to see if we are getting a transition from selling to buying.
9:08 AM - Observe that we really haven't seen extreme low TICK readings this AM and declining stocks only lead advancers by about 600 issues. It's a down morning to be sure, but this is lighter selling than we saw on Friday, and the volumes, while elevated to the downside, are more modest than Friday as well. Selling the TICK bounces continues to work as long as those occur at lower price levels with less volume than we see on the declines.
9:02 AM - Note semis holding up relatively well recently.
9:01 AM - Note we've taken out the Friday lows in NQ; very close in ER2. Still gotta lean short.
8:58 AM - Took some profits here; might reenter quickly.
8:46 AM - I'd need to see buying in ER2 and semis and upside TICK breakouts to think about being a buyer; until that happens, I see the TICK bounces as opportunities for shorting as long as we stay below the overnight highs.
8:39 AM - Also note weakness in semiconductors; Dow is relatively strong.
8:37 AM - Note that ER2 has broken below its overnite range. I'm looking for that to lead.
8:35 AM - Real mixed bag early on; greater strength in ES than NQ or ER2. If that continues, I'd expect to see all the averages test those Friday lows. I have an initial short position in ES with a tight stop.
8:19 AM CT - Good morning! Alas, the good Doctor is ailing this AM--a wicked case of flu going around our household--so my comments may be abbreviated this morning. My recent post noted high odds of taking out the previous day's low following a strong momentum decline, but also observed strong market behavior if we cannot take out that low. So let's see if we can track volume at bid/offer and various sectors to handicap the odds of continuing Friday's decline. No major economic reports on tap this AM; interest rates are a bit higher this AM, as is the dollar vs. the Euro. Oil is lower; the DAX is down, but off its lows from earlier in the session. The 1445 area in ES represents short-term overnight resistance; 1441 represents near-term overnight support. A breakout from that range--and whether such a breakout can be sustained--will provide us with information about who is in control: buyers or sellers. Pivot levels for the day have been updated on the Weblog; note also the first Best Practices post on Market Profile. Back after the open.
Market Profile: A Best Practice in Trading
My recent posts have emphasized the importance of tracking the large traders in the market you're trading. Such tracking will help you identify when we are making breakout moves and when we are trading within bracketed ranges.
Market Profile is a tool for organizing time and price data, graphically representing how volume builds at various prices over time. When we see most trades occurring within a relatively narrow range of prices, we know that the market is in balance. Price will probe the edges of this balance area--called the value area--as markets constantly update their estimates of value. If prices higher or lower than value cannot facilitate trade (i.e., if higher prices don't attract buyers or lower prices don't attract sellers), we will tend to trade back into the value area. If these probes to the edges of the value region do facilitate expanded trade, we will break free of the value area in a trending move. That trend will continue until sufficient sellers or buyers perceive value in the new prices and take the other side of the trade, beginning the process of forming a new region of balance.
My specific best practice is to be aware of value areas at one level larger than the timeframe you are trading. Very often, a breakout at a shorter time frame occurs within the context of a longer-term market bracket. Knowing where value is located on the longer timeframe helps you identify price targets for the shorter-term move.
An excellent resource for understanding the dynamics of Market Profile at multiple timeframes is the new book Markets in Profile: Profiting from the Auction Process by James Dalton, Robert Dalton, and Eric Jones. It is not a lengthy book, but it is packed with trading principles and clear examples of how the Market Profile is relevant at various timeframes: from the daytrader to the longer-term investor. Dalton and colleagues explain how markets transition from brackets to trends and, more importantly, they help traders understand why. One of my favorite features is the graphics that help you see balance areas on bar charts. It enables you to see the market in profile even if you're not looking at a Market Profile.
If you are just getting started in the area of Market Profile, the authors' earlier book, Mind Over Markets, is a classic and a great introduction to understanding market auctions. You can also find excellent reading resources on Market Profile on the WINdoTRADEr website. WINdoTRADEr is a charting application that enables traders to see Market Profiles at different time frames simultaneously; the firm also offers hands-on training in the use of Market Profile and the software. It's a brilliantly designed piece of software (which, by the way, has benefited from input from Jim Dalton).
What makes Market Profile a best practice in my book is that it provides new and experienced traders with a way of thinking about market action and framing their trade ideas. If I were running a training program for traders, Market Profile would be a mandatory part of the curriculum. It's important to know, not just *what* to do, but *why* to do it.
Market Profile is a tool for organizing time and price data, graphically representing how volume builds at various prices over time. When we see most trades occurring within a relatively narrow range of prices, we know that the market is in balance. Price will probe the edges of this balance area--called the value area--as markets constantly update their estimates of value. If prices higher or lower than value cannot facilitate trade (i.e., if higher prices don't attract buyers or lower prices don't attract sellers), we will tend to trade back into the value area. If these probes to the edges of the value region do facilitate expanded trade, we will break free of the value area in a trending move. That trend will continue until sufficient sellers or buyers perceive value in the new prices and take the other side of the trade, beginning the process of forming a new region of balance.
My specific best practice is to be aware of value areas at one level larger than the timeframe you are trading. Very often, a breakout at a shorter time frame occurs within the context of a longer-term market bracket. Knowing where value is located on the longer timeframe helps you identify price targets for the shorter-term move.
An excellent resource for understanding the dynamics of Market Profile at multiple timeframes is the new book Markets in Profile: Profiting from the Auction Process by James Dalton, Robert Dalton, and Eric Jones. It is not a lengthy book, but it is packed with trading principles and clear examples of how the Market Profile is relevant at various timeframes: from the daytrader to the longer-term investor. Dalton and colleagues explain how markets transition from brackets to trends and, more importantly, they help traders understand why. One of my favorite features is the graphics that help you see balance areas on bar charts. It enables you to see the market in profile even if you're not looking at a Market Profile.
If you are just getting started in the area of Market Profile, the authors' earlier book, Mind Over Markets, is a classic and a great introduction to understanding market auctions. You can also find excellent reading resources on Market Profile on the WINdoTRADEr website. WINdoTRADEr is a charting application that enables traders to see Market Profiles at different time frames simultaneously; the firm also offers hands-on training in the use of Market Profile and the software. It's a brilliantly designed piece of software (which, by the way, has benefited from input from Jim Dalton).
What makes Market Profile a best practice in my book is that it provides new and experienced traders with a way of thinking about market action and framing their trade ideas. If I were running a training program for traders, Market Profile would be a mandatory part of the curriculum. It's important to know, not just *what* to do, but *why* to do it.
Sunday, February 11, 2007
Best Practices in Trading: Response to the TraderFeed Poll
I recently polled TraderFeed readers for their interest in using the blog to integrate discretionary and quantitative/systems aspects of trading. Having seen how the collaboration of traders with good ideas and developers with the programming ability to improve those ideas has been helpful to both, I thought I might make such collaboration more widely available to interested traders. My experience has been that identifying trading patterns is useful in capturing the personality of the market, yielding worthwhile trading ideas. Experienced, successful traders know (sometimes intuitively) what those patterns are; successful system developers can cull and test that knowledge and expand upon it by adding from their own bags of tricks. If such collaboration produces even a small, consistent edge, that can be enough to generate meaningful profitability.
Readers provided many thoughful responses to this idea, posted to the blog and directly emailed to me. The gist of the feedback was:
1) There is a considerable demand for quality education from experienced traders - Almost all the responses were complimentary regarding this blog and its emphasis on trader development. Respondents expressed what I would call a desire for training--teaching of hands-on skills--as opposed to a simple dissemination of information. Most responses were very positive on the idea of trader collaboration, though there was considerable difference of opinion over what should be shared and how.
2) There is considerable skepticism regarding the majority of trader education efforts currently available - If I had to summarize the feedback in a single sentence, I'd say that a very high proportion of traders don't perceive value in the majority of conferences, books, and mentoring services that are out there. These are perceived as overpriced and/or lacking in practical, useful how-to skills. I have heard a number of accounts of questionable services costing thousands of dollars, well beyond what is prudent for beginning traders to spend as overhead.
3) There is widespread skepticism over my idea regarding using signals from backtested trading systems as tools for decision support - The most common concern mentioned was that these signals could become a crutch, rather than an encouragement to original thinking. The signals were perceived--understandably--as not being of true educational value if they are not accompanied by the underlying system logic. Among system developers, of course, there is a great reluctance to share such system logic and potentially diminish its value. Many traders are also concerned that signals from systems could become invalid over time as markets change.
I have taken a few days to think carefully about this feedback, and I've benefited from consultation with a number of colleagues whose opinions I value. Here is my proposal to move forward with collaborative trader education:
I propose that we begin a special blog feature called Best Practices in Trading. Best Practices posts would be so identified in their title and would describe how-to skills and methods that have been helpful for traders. The novel feature in this proposal is that any TraderFeed reader is free to submit a Best Practice for inclusion on the blog. (Procedure for submission appears below). Experienced traders who would like to be contacted by a programmer for collaboration (or vice versa) could share an idea and connect for their own mutual learning (just as I recently placed the experienced trader in touch with Henry Carstens to improve his trading rules). Beginning traders could share learning strategies, setups, exits, and psychological techniques that are working for them and then receive feedback from many experienced readers who could offer further suggestions.
The Best Practices feature would accomplish several goals:
1) It would capture the knowledge and experience that each of us possess and stimulate interactions to further those;
2) Archived over time, it would provide a meaningful trading knowledge base;
3) It would provide traders, bloggers, and vendors with a sizable audience of several thousand readers for rich feedback (much as I benefited from the poll feedback);
4) It would expand the coverage of this blog to a variety of markets and trading strategies, enriching all of us.
Here's how it would work:
To submit a "best practice", you would simply email me (my address is at the end of the "About Me" section at the right hand side of the TraderFeed home page), placing "Best Practice" in the subject header. Your best practice would be briefly described in the body of the email, providing enough information to enable readers to try out the idea for themselves. I would copy the material into the blog, add my own, separate commentary and ideas, and post for everyone to see and respond to. If you want the "best practice" to appear under your authorship, you would include your name and a brief bio blurb. If you wanted readers to contact you directly (optional), you could include your contact information in the bio. I would format it in the post so that bots don't pick it up and deluge you with spam. Alternatively, if you'd rather remain anonymous or just have readers respond to your idea through the comment section of the blog, that would be fine too.
Groundrules for submission:
1) I will review all "best practice" submissions. I welcome submissions from other bloggers and from vendors of trading products and services as long as the submissions have clear educational content and are not primarily for self-promotion and advertising. I will happily include links to the blogs/sites of those who contribute entries. Submitted items should describe practices in how-to terms as much as possible, while staying within a reasonable reading length. If I need to edit a submission substantially (not just for wording), I would ask your permission in advance. I will exercise quality control over submissions and I will not permit flaming of other people's comments or ideas.
2) You are free to post your own submissions simultaneously to your own blog or site; if you do, I'll link to your URL. I do request that others not publish the best practice material on their own sites without the author's expressed permission. I will not use submitted material for any publication purpose other than the TraderFeed blog. I'm not looking to profit from others' work. Everything on TraderFeed will remain free of charge.
3) If you provide me with your contact info, I will not share it with any other groups. I do not maintain a subscriber list, and would never sell email information to advertisers or other groups.
4) Over time, I will create a separate archive of Best Practice posts so that readers will find your work in the future.
TraderFeed currently averages about 1700 unique reader visits per day. A similar number of readers access my personal site. If only 10% of readers contribute one good idea, we would have quite an online encyclopedia of trading methods--at no cost, other than the time it takes to write an email. I ask that readers challenge the premise that expertise is something possessed by others. You have gained experience, and you have learned. If you can share the expertise you've already acquired--modest though that may seem--you will help to advance others, and you will attract the comments and suggestions of others who might be of help to you.
I will get the ball rolling on Monday with an initial best practice post, so you can see what one might look like. Then, if you decide to contribute, you can email me with your basic idea before writing it up and I can make suggestions for your entry. In most cases, I will provide personal feedback to traders who submit "best practices" as well as commentary on the post.
Of course, I welcome comments and suggestions regarding this blog feature and am happy to make modifications to meet readers' interests and needs. My goal is to make trader education a social process, rather than a one-way stream of information from a self-anointed guru to a relatively passive group of receipients. My hope is that, among ourselves, we can generate more solid ideas and superior learning and training than could be accomplished through any number of expensive and ephemeral seminar/workshop/coaching events.
Thank you so much for your interest. I look forward to this collaboration.
Brett
Readers provided many thoughful responses to this idea, posted to the blog and directly emailed to me. The gist of the feedback was:
1) There is a considerable demand for quality education from experienced traders - Almost all the responses were complimentary regarding this blog and its emphasis on trader development. Respondents expressed what I would call a desire for training--teaching of hands-on skills--as opposed to a simple dissemination of information. Most responses were very positive on the idea of trader collaboration, though there was considerable difference of opinion over what should be shared and how.
2) There is considerable skepticism regarding the majority of trader education efforts currently available - If I had to summarize the feedback in a single sentence, I'd say that a very high proportion of traders don't perceive value in the majority of conferences, books, and mentoring services that are out there. These are perceived as overpriced and/or lacking in practical, useful how-to skills. I have heard a number of accounts of questionable services costing thousands of dollars, well beyond what is prudent for beginning traders to spend as overhead.
3) There is widespread skepticism over my idea regarding using signals from backtested trading systems as tools for decision support - The most common concern mentioned was that these signals could become a crutch, rather than an encouragement to original thinking. The signals were perceived--understandably--as not being of true educational value if they are not accompanied by the underlying system logic. Among system developers, of course, there is a great reluctance to share such system logic and potentially diminish its value. Many traders are also concerned that signals from systems could become invalid over time as markets change.
I have taken a few days to think carefully about this feedback, and I've benefited from consultation with a number of colleagues whose opinions I value. Here is my proposal to move forward with collaborative trader education:
I propose that we begin a special blog feature called Best Practices in Trading. Best Practices posts would be so identified in their title and would describe how-to skills and methods that have been helpful for traders. The novel feature in this proposal is that any TraderFeed reader is free to submit a Best Practice for inclusion on the blog. (Procedure for submission appears below). Experienced traders who would like to be contacted by a programmer for collaboration (or vice versa) could share an idea and connect for their own mutual learning (just as I recently placed the experienced trader in touch with Henry Carstens to improve his trading rules). Beginning traders could share learning strategies, setups, exits, and psychological techniques that are working for them and then receive feedback from many experienced readers who could offer further suggestions.
The Best Practices feature would accomplish several goals:
1) It would capture the knowledge and experience that each of us possess and stimulate interactions to further those;
2) Archived over time, it would provide a meaningful trading knowledge base;
3) It would provide traders, bloggers, and vendors with a sizable audience of several thousand readers for rich feedback (much as I benefited from the poll feedback);
4) It would expand the coverage of this blog to a variety of markets and trading strategies, enriching all of us.
Here's how it would work:
To submit a "best practice", you would simply email me (my address is at the end of the "About Me" section at the right hand side of the TraderFeed home page), placing "Best Practice" in the subject header. Your best practice would be briefly described in the body of the email, providing enough information to enable readers to try out the idea for themselves. I would copy the material into the blog, add my own, separate commentary and ideas, and post for everyone to see and respond to. If you want the "best practice" to appear under your authorship, you would include your name and a brief bio blurb. If you wanted readers to contact you directly (optional), you could include your contact information in the bio. I would format it in the post so that bots don't pick it up and deluge you with spam. Alternatively, if you'd rather remain anonymous or just have readers respond to your idea through the comment section of the blog, that would be fine too.
Groundrules for submission:
1) I will review all "best practice" submissions. I welcome submissions from other bloggers and from vendors of trading products and services as long as the submissions have clear educational content and are not primarily for self-promotion and advertising. I will happily include links to the blogs/sites of those who contribute entries. Submitted items should describe practices in how-to terms as much as possible, while staying within a reasonable reading length. If I need to edit a submission substantially (not just for wording), I would ask your permission in advance. I will exercise quality control over submissions and I will not permit flaming of other people's comments or ideas.
2) You are free to post your own submissions simultaneously to your own blog or site; if you do, I'll link to your URL. I do request that others not publish the best practice material on their own sites without the author's expressed permission. I will not use submitted material for any publication purpose other than the TraderFeed blog. I'm not looking to profit from others' work. Everything on TraderFeed will remain free of charge.
3) If you provide me with your contact info, I will not share it with any other groups. I do not maintain a subscriber list, and would never sell email information to advertisers or other groups.
4) Over time, I will create a separate archive of Best Practice posts so that readers will find your work in the future.
TraderFeed currently averages about 1700 unique reader visits per day. A similar number of readers access my personal site. If only 10% of readers contribute one good idea, we would have quite an online encyclopedia of trading methods--at no cost, other than the time it takes to write an email. I ask that readers challenge the premise that expertise is something possessed by others. You have gained experience, and you have learned. If you can share the expertise you've already acquired--modest though that may seem--you will help to advance others, and you will attract the comments and suggestions of others who might be of help to you.
I will get the ball rolling on Monday with an initial best practice post, so you can see what one might look like. Then, if you decide to contribute, you can email me with your basic idea before writing it up and I can make suggestions for your entry. In most cases, I will provide personal feedback to traders who submit "best practices" as well as commentary on the post.
Of course, I welcome comments and suggestions regarding this blog feature and am happy to make modifications to meet readers' interests and needs. My goal is to make trader education a social process, rather than a one-way stream of information from a self-anointed guru to a relatively passive group of receipients. My hope is that, among ourselves, we can generate more solid ideas and superior learning and training than could be accomplished through any number of expensive and ephemeral seminar/workshop/coaching events.
Thank you so much for your interest. I look forward to this collaboration.
Brett
What Happens After a Day of Strong Downside Momentum?
Recently, the Trading Psychology Weblog mentioned that there is a high probability of taking out the low of a day that closes with strong downside momentum. On Friday, with the market breakout, we had just such a day. What tends to happen following a day in which a plurality of issues closes very weak?
To address this question, I went back to 2004 (N = 771 trading days) and identified all occasions (N = 42) in which: a) my measure of Demand (an index of the number of stocks closing abvove the volatility bands surrounding their short- and intermediate-term moving averages) was less than 400; b) Supply (stocks closing below their volatility bands) was greater than 1200; and c) Supply was the highest figure recorded over the past ten trading sessions.
The following trading session, the S&P 500 Index (SPY) traded below the low of the strong downside momentum day on 31 of the 42 occasions, or about 75% of the time. On about half of those occasions, SPY traded by more than .30% below its previous day's low, or about 4 full ES points. Conversely, on the remainder of the occasions in the sample, the market took out its previous day's low on only 320 out of 729 days: less than half the time. This suggests that there is near-term weakness after a day of strong downside momentum.
Interestingly, however, if we look out further, that pattern changes. By the *close* of the next trading session following the downside momentum day, the market has been up on exactly half the occasions. When we look four days out, SPY has been up by an average of .21% (25 up, 17 down), actually a bit stronger than the remainder of the sample (.12%; 403 up, 326 down). As a whole, then, we tend to see near-term weakness reverse following a strong downside momentum day.
Finally, when trading the next day *doesn't* take out the low of the downside momentum day (N = 11), the next four days in SPY average a very healthy gain of .89% (9 up, 2 down). In other words, failure to continue the downside thrust in the short run turns out to be an indication of further strength to come later in the week. I will be watching for these patterns on Monday.
To address this question, I went back to 2004 (N = 771 trading days) and identified all occasions (N = 42) in which: a) my measure of Demand (an index of the number of stocks closing abvove the volatility bands surrounding their short- and intermediate-term moving averages) was less than 400; b) Supply (stocks closing below their volatility bands) was greater than 1200; and c) Supply was the highest figure recorded over the past ten trading sessions.
The following trading session, the S&P 500 Index (SPY) traded below the low of the strong downside momentum day on 31 of the 42 occasions, or about 75% of the time. On about half of those occasions, SPY traded by more than .30% below its previous day's low, or about 4 full ES points. Conversely, on the remainder of the occasions in the sample, the market took out its previous day's low on only 320 out of 729 days: less than half the time. This suggests that there is near-term weakness after a day of strong downside momentum.
Interestingly, however, if we look out further, that pattern changes. By the *close* of the next trading session following the downside momentum day, the market has been up on exactly half the occasions. When we look four days out, SPY has been up by an average of .21% (25 up, 17 down), actually a bit stronger than the remainder of the sample (.12%; 403 up, 326 down). As a whole, then, we tend to see near-term weakness reverse following a strong downside momentum day.
Finally, when trading the next day *doesn't* take out the low of the downside momentum day (N = 11), the next four days in SPY average a very healthy gain of .89% (9 up, 2 down). In other words, failure to continue the downside thrust in the short run turns out to be an indication of further strength to come later in the week. I will be watching for these patterns on Monday.
Saturday, February 10, 2007
How to Identify and Trade Breakout Moves in the Stock Market
In my recent post, I emphasized the importance of following the actions of the largest traders. I also provided a simple tool that enables traders to track volume relative to its monthly average, showing periods of greater or lesser institutional participation. We've also seen how to use charts to track the behavior of large traders, particularly when identifying transitions in market direction. In this post, I'll draw upon Friday's market to illustrate these ideas with respect to a different market pattern: the breakout from a trading range.Above we have a Market Delta chart for morning and midday Friday. (Please note that I am not affiliated with Market Delta in any commercial fashion; I simply use the product as a trading tool). We are looking at half-hour bars. Within each bar, at each price, are two numbers. They are displayed as A x B. The first number is the volume of contracts traded at that price when that price was the market bid. The second number is the volume of contracts traded at that price when that price was the market offer. By comparing the two, we can determine whether more volume is occurring at each price at the bid (meaning that sellers are more aggressive and settling for the lower price to bail out) or at the offer (meaning that buyers are more aggressive and paying up at the higher price to enter the market). As I've emphasized in the past, this information is the shortest-term sentiment data available to a trader. It represents shifts in actual trader behavior as a function of the ongoing market auction.
You'll observe that the bars on the chart turn red when more volume is being transacted at the bid (indicating greater bearish sentiment and behavior) and green when more volume is transacted at the offer (greater bullish sentiment and behavior). The darker the bar, the greater the skew toward either bid or offer. This color coding enables traders, at a glance, to see who is dominating the current market trade: bulls, bears, or neither.
At the bottom X-axis, you'll notice two sets of numbers. The first is the total volume transacted during that 30-minute period. For instance, from 11:00 - 11:30 AM CT, only 6912 contracts were traded. The number below the total volume is the net number of contracts during that 30 minute period that are executed at the market bid vs. the market offer. Thus, the -3082 number tells us that volume at the bid exceeded that at the offer during that half hour by over 3000 contracts. Note that this net volume at bid vs. offer (also called Delta) is color coded green and red for quick reference.
On the left, Y-axis, you can see the total volume that has traded at this price. I've set that to reflect the past three days of trading. That volume is also broken down by volume at bid (red horizontal bar) and volume at offer (green horizontal bar) and by Delta values to provide a sense for where there has been previous supply and demand. You can see on the chart that a bulge of volume was trading in the 1453 price area. In Market Profile terms, this represents the market's best estimate of value. In a range bound market, prices will tend to oscillate around this estimate of value.
Finally, one important note: I have filtered the data to only show trades of 200 contracts or more. In other words, we are *only* looking at the trade data for the market's largest participants. By using this filter in Market Delta, we can see--in real time--if large participants are in the market and which way they're leaning (at the bid or offer).
With that background, we can now understand the dynamics of Friday's breakout trade. We opened the day trading higher, above value. When the buying was not sustained, the market reverted to its average trading price, moving back into its prior range. This "mean reversion" trade is a high probability setup in itself. It occurs when we move away from value but cannot attract new buyers or sellers. The initial move up in the early morning was met with equally aggressive selling among the large traders.
After that, you can see that volume slowed down considerably and we moved in a narrow range within that value region. Once we broke below this range during the 12:00 bar, note how volume dramatically expanded (remember, this is the volume of large traders only) and note how the volume is totally skewed to the bid side. In other words, large traders entered the market in force and they entered entirely on the sell side. Moreover, the lower prices attracted continued volume: the volume during that half-hour bar was much above average for that time of day.
This is a great illustration of the concept that volume = volatility. In a breakout trade, volume skewed at the bid or offer = directional volatility. The short-term market trend is created by large traders entering with a strong directional bias. This particular market breakout eventually took us well below the lows of the 12:00 - 12:30 bar--another 10 ES points or so! As a rule, the longer the period of market consolidation (this one lasted most of the recent trading week), the more extended the subsequent breakout move. This latter principle, combined with knowledge of the volume/volatility relationship, is helpful in determining price targets for breakout moves. A very rough guideline is that, on a downside breakout, the price move from high to low during the period of consolidation will form a downside target if subtracted from the low price of the recent trading range. Thus, if the market has been moving in a 9 point range over the past several sessions, I'd look for an initial price target on a downside breakout 9 points below the range low.
So, in summary, here's what you look for in a breakout trade:
1) A prolonged trading range, usually with reduced trading volume;
2) An initial break out of that range on increased volume from large traders;
3) Subsequent prices on the breakout attracting increased volume from the large traders;
4) A directional move well outside the prior range that establishes new levels of market value.
What makes breakout trading so difficult for traders is that they look at price only--not at the ability of price to attract large trading volume. As a result, they assume that any move out of a range is a breakout. That leaves them vulnerable to reversals on those mean reversion trades. Friday's example was particularly dramatic in its snowballing of volume from large traders. It isn't just price moving below or above value that makes a breakout trade; it's the ability of those breakout prices to get the snowball rolling. When you see a true breakout move, you can comfortably jump into the market during the initial thrust. That market is repricing value and won't return to its prior trading range.
Friday, February 09, 2007
Friday, February 9th Morning Market Comments
9:38 AM - OK, I'll be getting ready for the traders in Chicago; gotta wrap up. Note that we opened near the high of the recent range. Volume started robust and we saw buying in the semis. When ER2 showed weakness and subsequent buying came on much reduced volume, I saw that buyers weren't going to take us above the preopening highs. That led me to sell, with a natural target at the overnight lows. Notice how helpful the tracking of volume can be. It told us that buyers were abandoning the early market, and then recently it told us that sellers were in the wings. That leads us to be sellers on TICK bounces, targeting the next set of lows--until we see evidence of large traders coming into the market as buyers. More important than my specific trades is taking away from how I'm looking at markets something that can be useful to your own trading. You may have very different setups from me, and that's great. By understanding who is in the market, however, and how much we're likely to move, you can take maximum advantage of those setups and stay out of unfavorable situations. Have a great rest of the day; update tonite on the Weblog; will be on the radio show this afternoon (see first entry this AM).
9:30 AM - No sooner had I mentioned the reduced volume and taking quick profits than we saw a program hit the market in ER2, drive the TICK to a new morning low, and then volume at the bid followed on the heels of that. You had to be pretty nimble to take advantage of that, but it did take us to that initial AM target. From here, you pretty much have to be selling bounces if the pickup in volume continues, with the midpoints an obvious next target. Keep an eye on volume during the bounces; if it's particularly light, the bounce is more likely to be reversed.
9:26 AM - Some program selling hit ER2. Keep an eye.
9:23 AM - If I *had* been in that short position in ES, I'd have been out by now. Volume really tailing off and TICK not getting it done so far for sellers. It would be another take what the market gives you trade.
9:20 AM - Keep an eye on ER2, esp if it's not making new AM session lows.
9:16 AM - Notice how we've basically gone nowhere since volume tailed off. That volume/volatility relationship is *so* important. I'm actually pretty comfortable being out of the market; no real evidence of important selling in TICK, but also struggling to get to the overnight highs. Not my kind of trading market in general, although well timed trades for a scalp, small profit can work.
9:12 AM - Ideally if you're going to be short, you want to see evidence of sellers *before* you commit. Failure to make highs (or failure of buying to produce highs) often precedes sellers coming in (and sometimes I'll front run that process with an initial position), but the highest odds trades come when you're getting lower lows in the TICK, lower highs in the TICK, more selling at bid in Market Delta, etc. I would never go in with maximum size prior to seeing direct evidence of selling.
9:10 AM - On a normal day, I'd be selling bounces in the TICK that can't bring us to new highs, looking for a test of those overnight lows; then a test of pivot/VWAP from Thursday.
9:07 AM - I'm probably done trading for the AM, as I'll need to get prepared for my meetings with traders. Just about every trade I've made this week has given me a point of profit; the problem is that the profit has quickly evaporated when markets didn't follow through. So when I got my point this time and I saw volume really tail off, I decided to take the modest gain and call it a trade. In retrospect, that was the right move. More in a bit.
9:03 AM - A logical downside target is the 1453 overnight low in ES if you're holding a normal position. I'm quick in and out this AM due to having to leave for Chicago shortly.
8:59 AM - Took quick profit.
8:54 AM - Volume has tailed off, but semis remain strong. Need to see them turn over; otherwise I'm out.
8:48 AM - Initial short in ES; tight stop.
8:45 AM - Volume is average in ES. Waiting to see if it tails off or picks up steam with buying interest.
8:42 AM - Selling in ER2 has kept me from taking the long side. If we get subsequent buying that can't make new highs, I'm back in the mean reversion mode, selling with a target of the Thurs. pivot.
8:39 AM - I may test bullish waters with an initial position, but we need to stay above 1453.25 for that idea to hold.
8:37 AM - NQ strong on heels of semis; ES takes out previous day's high; very solid buying (lifting of offers in ES) so far.
8:35 AM - Volume a bit above average if you're following your volume sheet from the recent post. More volume at offer than bid in ES. When I saw SMH pop higher in preopening trade, that had me looking at semis as a source of early strength.
8:28 AM - Keep an eye on semiconductors this AM; let's see if they lead.
8:18 AM - OK, we have what could be the makings of a slow day, with a Friday coming at the end of a series of narrow, rangebound days and no major economic developments on the horizon. We dipped below the prior day's lows in ES yesterday, but as I pointed out in the morning comments, that was not confirmed in the other averages. As a result, we rebounded back into the trading range of the past several days. I'm watching to see if that relative strength in NQ and ER2 continues, and I'll be watching AM volume to handicap the odds of today being slow and rangebound as well. If so, and if early buying cannot surmount the overnight highs, we have logical initial targets at the Thursday pivot and VWAP (listed in the Weblog). That's my primary trading scenario. I would only be a buyer of ES if we see upside strength in those other averages and an expansion of volume (and volume lifting offers) in ES. I'll be finishing early today to get to Chicago and meet with traders. Back after the open.
8:10 AM CT - Good Friday morning! Thanks to readers once again for the many excellent comments and insights in response to the recent poll. Indeed, there were so many good--and unexpected--observations that I'm taking extra time to synthesize them and produce a summary this weekend. That will also give me a chance to catch up on emails and blog comments! As noted on the Weblog, I'll be doing an online radio program for Jack Bouroudjian this afternoon at 3:00 PM Central Time (link on left side of that page). I'll also be visiting traders in Chicago before that, so today's morning comments will be abbreviated. Check out today's post on how to track volume patterns during the day; it provides a tool that I have found very helpful. This weekend I'll also be following up on my earlier post on promising biofeedback methods for "in the zone" performance. Comments on the opening market to follow shortly.
9:30 AM - No sooner had I mentioned the reduced volume and taking quick profits than we saw a program hit the market in ER2, drive the TICK to a new morning low, and then volume at the bid followed on the heels of that. You had to be pretty nimble to take advantage of that, but it did take us to that initial AM target. From here, you pretty much have to be selling bounces if the pickup in volume continues, with the midpoints an obvious next target. Keep an eye on volume during the bounces; if it's particularly light, the bounce is more likely to be reversed.
9:26 AM - Some program selling hit ER2. Keep an eye.
9:23 AM - If I *had* been in that short position in ES, I'd have been out by now. Volume really tailing off and TICK not getting it done so far for sellers. It would be another take what the market gives you trade.
9:20 AM - Keep an eye on ER2, esp if it's not making new AM session lows.
9:16 AM - Notice how we've basically gone nowhere since volume tailed off. That volume/volatility relationship is *so* important. I'm actually pretty comfortable being out of the market; no real evidence of important selling in TICK, but also struggling to get to the overnight highs. Not my kind of trading market in general, although well timed trades for a scalp, small profit can work.
9:12 AM - Ideally if you're going to be short, you want to see evidence of sellers *before* you commit. Failure to make highs (or failure of buying to produce highs) often precedes sellers coming in (and sometimes I'll front run that process with an initial position), but the highest odds trades come when you're getting lower lows in the TICK, lower highs in the TICK, more selling at bid in Market Delta, etc. I would never go in with maximum size prior to seeing direct evidence of selling.
9:10 AM - On a normal day, I'd be selling bounces in the TICK that can't bring us to new highs, looking for a test of those overnight lows; then a test of pivot/VWAP from Thursday.
9:07 AM - I'm probably done trading for the AM, as I'll need to get prepared for my meetings with traders. Just about every trade I've made this week has given me a point of profit; the problem is that the profit has quickly evaporated when markets didn't follow through. So when I got my point this time and I saw volume really tail off, I decided to take the modest gain and call it a trade. In retrospect, that was the right move. More in a bit.
9:03 AM - A logical downside target is the 1453 overnight low in ES if you're holding a normal position. I'm quick in and out this AM due to having to leave for Chicago shortly.
8:59 AM - Took quick profit.
8:54 AM - Volume has tailed off, but semis remain strong. Need to see them turn over; otherwise I'm out.
8:48 AM - Initial short in ES; tight stop.
8:45 AM - Volume is average in ES. Waiting to see if it tails off or picks up steam with buying interest.
8:42 AM - Selling in ER2 has kept me from taking the long side. If we get subsequent buying that can't make new highs, I'm back in the mean reversion mode, selling with a target of the Thurs. pivot.
8:39 AM - I may test bullish waters with an initial position, but we need to stay above 1453.25 for that idea to hold.
8:37 AM - NQ strong on heels of semis; ES takes out previous day's high; very solid buying (lifting of offers in ES) so far.
8:35 AM - Volume a bit above average if you're following your volume sheet from the recent post. More volume at offer than bid in ES. When I saw SMH pop higher in preopening trade, that had me looking at semis as a source of early strength.
8:28 AM - Keep an eye on semiconductors this AM; let's see if they lead.
8:18 AM - OK, we have what could be the makings of a slow day, with a Friday coming at the end of a series of narrow, rangebound days and no major economic developments on the horizon. We dipped below the prior day's lows in ES yesterday, but as I pointed out in the morning comments, that was not confirmed in the other averages. As a result, we rebounded back into the trading range of the past several days. I'm watching to see if that relative strength in NQ and ER2 continues, and I'll be watching AM volume to handicap the odds of today being slow and rangebound as well. If so, and if early buying cannot surmount the overnight highs, we have logical initial targets at the Thursday pivot and VWAP (listed in the Weblog). That's my primary trading scenario. I would only be a buyer of ES if we see upside strength in those other averages and an expansion of volume (and volume lifting offers) in ES. I'll be finishing early today to get to Chicago and meet with traders. Back after the open.
8:10 AM CT - Good Friday morning! Thanks to readers once again for the many excellent comments and insights in response to the recent poll. Indeed, there were so many good--and unexpected--observations that I'm taking extra time to synthesize them and produce a summary this weekend. That will also give me a chance to catch up on emails and blog comments! As noted on the Weblog, I'll be doing an online radio program for Jack Bouroudjian this afternoon at 3:00 PM Central Time (link on left side of that page). I'll also be visiting traders in Chicago before that, so today's morning comments will be abbreviated. Check out today's post on how to track volume patterns during the day; it provides a tool that I have found very helpful. This weekend I'll also be following up on my earlier post on promising biofeedback methods for "in the zone" performance. Comments on the opening market to follow shortly.
Finding Opportunity in the Stock Market: A Tool For Tracking Large Trader Participation
In a recent post, I suggested that we can track the presence of large institutional traders by knowing how current volume compares to average volume. Because the majority of volume is attributable to large trades (and large traders), below average volume or above average volume gives us an indication of the relative absence or presence of these large market participants. Since many of these participants are trading directionally, their presence is associated with enhanced volatility and greater likelihood of short-term trending behavior.But how do we track high and low volume during the day, given that average volume varies greatly through the day? Here is a simple tool I've made available to the prop traders I work with. It's also sits on my desk as I trade for quick reference. It's a synopsis of median trading volume in the ES futures for every 15 minute period in the morning over the past month (N = 22 trading days). The chart above shows the median trading volumes plotted as a cumulative curve, so that you can see what average total volume looks like at each point in the trading day. If today's trading volume in ES, as reported on your datafeed, exceeds the curve, you know we have above average volume. If we're falling below the curve, we have a relative absence of large traders--and a greater likelihood of a narrow, rangebound market, as has been the case most of this week.
You can click on the chart, print it out, and use it for reference during the trading day. I like to update mine weekly.
Here are the median trading volumes--and trading ranges--for each 15 minute period (Eastern Time).
9:30 - 9:45 AM - Median volume is 66,022; median range is 2.75 ES points
9:45 - 10:00 AM - Median volume is 58,107; median range is 2.875 points
10:00 - 10:15 AM - Median volume is 59,408; median range is 3 points
10:15 - 10:30 AM - Median volume is 46,598; median range is 2.25 points
10:30 - 10:45 AM - Median volume is 53,226; median range is 2.75 points
10:45 - 11:00 AM - Median volume is 36,549; median range is 2.125 points
11:00 - 11:15 AM - Median volume is 36,203; median range is 2.375 points
11:15 - 11:30 AM - Median volume is 27,419; median range is 1.75 points
11:30 - 11:45 AM - Median volume is 27,273; median range is 1.75 points
11:45 - 12:00 N - Median volume is 23,638; median range is 1.75 points
Note that both volume and volatility fall considerably during the course of the morning, with a notable dropoff around 10:45 - 11:00 AM Eastern Time. This is why I commonly stop trading (and blogging) around that time. Volume tends to dry up, and opportunity for short-term trading tends to dry up with it.
Also observe that a trading volume of 50,000 contracts at 11:00 AM ET might not attract a trader's notice, because it is not higher than the volume seen earlier in the day. For that time of day, however, 50,000 contracts would represent seriously elevated market participation. You would want to identify what is going on at that time (breakout from a range; news item; etc.) and see if it represents an opportunity for you to join the trend of the large traders. Similarly, if you see below average volume for the first 15 minutes of trading (as has happened most of this week), you'd want to mentally prepare yourself for a slow, narrow-range day.
Finally, knowing these numbers helps you figure out when an economic report at 10:00 AM ET is truly having a significant market impact. If the volume shoots significantly higher than the average volume for that time of day--and is higher than the volume earlier in the day--you know that the economic release is attracting large traders. These are the participants likely to reprice the market. On the other hand, if a release comes out and you don't see an elevation of volume, you have an excellent indication that this will have no meaningful impact on subsequent trading.
(Note that the median 15-minute ranges give you a sense for expectable movement in any 15-minute period, which can be useful information in determining when a move has gone about as far as it's going to in the short run.)
My sense is that these curves can be created for any futures contract and any stock. They provide you with a sense for who is usually in the market--and who is participating now. The periods of enhanced participation will provide you with the periods of greatest market movement, and the largest traders will point the way to which way the market is likely to move.
I will update the data periodically if there is interest. Because most large cap U.S. stocks and equity indices are highly correlated with the S&P 500 Index, a reading on ES volume will provide useful clues as to likely activity in your trading instrument.
Thursday, February 08, 2007
Thursday, February 8th Morning Market Comments
10:44 AM - Well, it was one of those days. Tried a basic idea a couple of times, got initial movement my way, but no follow through. Actually, for the purpose of these morning sessions I think it's good to illustrate the difficult days (such as today) with the easier ones (such as yesterday). How to handle being wrong is every bit as important as managing to be right. What I try to do with position sizing is start with a small initial position, wait to see if it goes for me, and add if conditions are right. If the position goes against me initially, I don't get hurt in a big P/L way. I generally find that, if positions don't go my way pretty quickly, they're much more likely to not go for me at all. The other important piece of risk control is scratching trades when you have a reasonable paper profit that evaporates. In retrospect, the one thing I could have done better is take some profit off the table when we got to the initial target of the AM high in ER2. In a range bound market, that probably makes sense. That "taking what the market gives you" is important when the market doesn't give you much! Summary tonite on the Weblog; have a great rest of the day!
10:37 AM - Small profit and I'm out. Back in a bit.
10:18 AM - The trade that I've been pursuing is based on the fact that ES made a low relative to yesterday, but the other averages have held above their lows despite selling in the TICK and the dominant hitting of bids in ES. I'm looking for the averages to put in a low for the day, which then would lead to tests of the AM high and the previous day's high as targets. We got right to the AM high in ER2, but buying wasn't sustained and we traversed back through the range. Now I've reinitiated the trade, once again nibbling and adding as we hold lows on selling, and I'm trying it all over again. More in a bit to wrap up.
10:10 AM - Well, we'll see how the nibbling works out this time. I'd be buying more ER2 on TICK pullbacks that hold above AM lows. The entire trade is predicated on holding above yesterday's highs as part of longer-term strength. Need to see net buying in ES, however, and a positive shift in TICK to be aggressive on the long side.
9:55 AM - Once again we see a low in ES not confirmed by the other indices thus far. I will be nibbling at ER2 as long as we don't get new lows for the AM.
9:47 AM - When I put on an initial position and add to it, I keep in mind my average purchase price. If I have a profit and then the whole position goes to scratch, I'm out. Part of the discipline. We just couldn't take out those AM highs, so the breakout trade I was looking for didn't come. I will likely try the idea again if selling dries up above the AM lows. Nice example of a decent trade idea that just didn't go.
9:43 AM - Scratched out.
9:33 AM - Initial ER2 target is the AM high, then yesterday's high. Targets for ES are the AM high and pivot and VWAP from yesterday.
9:29 AM - I'm adding to ER2 positions on TICK pullbacks at higher price lows. Bail out if TICK drops take us below those lows. Need to see TICK breakout highs.
9:19 AM - The upside TICK couldn't amount to much; need buyers to come in and sustain. Note ES low not yet confirmed in other averages. Holding small initial ER2; no adding to longs until we see evidence of buyers.
9:04 AM - I'm playing with the idea that we made a low for the AM; long some ER2.
9:00 AM - Note difficulty of sellers getting market below the ES range and difficulty sustaining selling in ER2 and negative TICK.
8:49 AM - Selling TICK bounces in ER2 working fine so far, targeting yesterday low.
8:45 AM - Nice tell with ER2 leading ES down on the TICK breakout to the downside. Volume above average and targeting those lows mentioned earlier.
8:38 AM - Volume is pretty healthy; I'm watching to see how buyers come in as we break the previous day's lows in ES (but not the other indices so far). I need to see NQ and ER2 lead the weakness for me to sell lows in ES.
8:15 AM CT - And another good morning to you! Thanks to the many people who have responded so far to the poll. My email inbox reads 935 (not all are poll responses!), so I'm pretty much buried in electronic communications. If I haven't gotten back to you about your comments, that's why. I greatly appreciate the interest. I think this morning's post is one of the more important ones in a while. It certainly is a key to how I read markets. My next post will offer concrete numbers that you can use during the day to gauge market participation. So now let's talk about this AM. We had some weak reports from retailers just a bit ago and we're seeing selling in Europe and in the preopening equities futures markets as a result. Indeed, we're quite close to yesterday's lows in ES as I write. That puts us back into the thick of the trading range of the past four trading sessions. Our first challenge, then, will be to see if pressure from sellers continues during early trading, which would have us testing the lows of this multi-day range (around 1448 on ES). Pivots for the day are on the Weblog; note that S2 is quite close to the low of the multi-day range in ES. The dollar has weakened somewhat vs. the Euro; not much rate movement so far. I'm not sure there's a major fundamental shift at work to justify a repricing of stocks. So the market will have to show me that a breakout is in the works before I assume that we'll jump outside the recent trading range. Back after the open.
10:37 AM - Small profit and I'm out. Back in a bit.
10:18 AM - The trade that I've been pursuing is based on the fact that ES made a low relative to yesterday, but the other averages have held above their lows despite selling in the TICK and the dominant hitting of bids in ES. I'm looking for the averages to put in a low for the day, which then would lead to tests of the AM high and the previous day's high as targets. We got right to the AM high in ER2, but buying wasn't sustained and we traversed back through the range. Now I've reinitiated the trade, once again nibbling and adding as we hold lows on selling, and I'm trying it all over again. More in a bit to wrap up.
10:10 AM - Well, we'll see how the nibbling works out this time. I'd be buying more ER2 on TICK pullbacks that hold above AM lows. The entire trade is predicated on holding above yesterday's highs as part of longer-term strength. Need to see net buying in ES, however, and a positive shift in TICK to be aggressive on the long side.
9:55 AM - Once again we see a low in ES not confirmed by the other indices thus far. I will be nibbling at ER2 as long as we don't get new lows for the AM.
9:47 AM - When I put on an initial position and add to it, I keep in mind my average purchase price. If I have a profit and then the whole position goes to scratch, I'm out. Part of the discipline. We just couldn't take out those AM highs, so the breakout trade I was looking for didn't come. I will likely try the idea again if selling dries up above the AM lows. Nice example of a decent trade idea that just didn't go.
9:43 AM - Scratched out.
9:33 AM - Initial ER2 target is the AM high, then yesterday's high. Targets for ES are the AM high and pivot and VWAP from yesterday.
9:29 AM - I'm adding to ER2 positions on TICK pullbacks at higher price lows. Bail out if TICK drops take us below those lows. Need to see TICK breakout highs.
9:19 AM - The upside TICK couldn't amount to much; need buyers to come in and sustain. Note ES low not yet confirmed in other averages. Holding small initial ER2; no adding to longs until we see evidence of buyers.
9:04 AM - I'm playing with the idea that we made a low for the AM; long some ER2.
9:00 AM - Note difficulty of sellers getting market below the ES range and difficulty sustaining selling in ER2 and negative TICK.
8:49 AM - Selling TICK bounces in ER2 working fine so far, targeting yesterday low.
8:45 AM - Nice tell with ER2 leading ES down on the TICK breakout to the downside. Volume above average and targeting those lows mentioned earlier.
8:38 AM - Volume is pretty healthy; I'm watching to see how buyers come in as we break the previous day's lows in ES (but not the other indices so far). I need to see NQ and ER2 lead the weakness for me to sell lows in ES.
8:15 AM CT - And another good morning to you! Thanks to the many people who have responded so far to the poll. My email inbox reads 935 (not all are poll responses!), so I'm pretty much buried in electronic communications. If I haven't gotten back to you about your comments, that's why. I greatly appreciate the interest. I think this morning's post is one of the more important ones in a while. It certainly is a key to how I read markets. My next post will offer concrete numbers that you can use during the day to gauge market participation. So now let's talk about this AM. We had some weak reports from retailers just a bit ago and we're seeing selling in Europe and in the preopening equities futures markets as a result. Indeed, we're quite close to yesterday's lows in ES as I write. That puts us back into the thick of the trading range of the past four trading sessions. Our first challenge, then, will be to see if pressure from sellers continues during early trading, which would have us testing the lows of this multi-day range (around 1448 on ES). Pivots for the day are on the Weblog; note that S2 is quite close to the low of the multi-day range in ES. The dollar has weakened somewhat vs. the Euro; not much rate movement so far. I'm not sure there's a major fundamental shift at work to justify a repricing of stocks. So the market will have to show me that a breakout is in the works before I assume that we'll jump outside the recent trading range. Back after the open.
How You Can Track The Stock Market's Large Traders
I have a backlog of emails and comments from the recent poll concerning integrating system and discretionary trading. Many thanks to readers for their interest. I'll look for further comments today and then will summarize them--and my reactions--in a post tomorrow.
As a gesture of appreciation, allow me to share a piece of my research in this and the next post. In the past, I have only shared this with specific prop traders I have worked with in a coaching vein. The idea of the research is to identify two (related) things that every short-term trader should know:
1) When are institutional participants active in the market?
2) When are we likely to have large price moves during morning trade?
Let's start with the basics. As a gross distinction, imagine that we have two kinds of traders in the marketplace. The first are market makers (locals) who provide liquidity. They are in the markets throughout the day, and they are in the markets every day. Having worked with prop traders who function as liquidity providers in the electronic futures markets, I can tell you that their participation in the market is relatively consistent from day to day. For simplicity's sake, I treat their involvement (volume) in the market as a constant.
The second group of traders are directional traders who enter the market when they perceive that we are trading away from what they deem as value. They may fade highs and lows, identifying value as somewhere between, or they may trade breakouts, placing value away from recent trading ranges. They generally enter the market on longer-term bases than the locals (scalpers). While directional traders include small individual traders, their volume is dominated by CTAs, hedge funds, mutual funds, and other large, institutional traders.
If we make the assumption that the participation of locals is relatively constant from day to day, then we can attribute surges or plunges in volume relative to average to the increased or decreased participation of large, institutional traders. When markets are trading with below average volume, they are dominated by liquidity providers. Because those traders generally work orders above and below the current market price, they are selling offers and buying bids. That tends to make them short when markets rise and long when markets fall. They profit, on average, when moves do not follow through and trend. This is why local-dominated markets (i.e., low volume markets) tend to trade in narrow, choppy ranges. There just aren't enough large, directional traders participating to move the market far from current levels of value.
Conversely, when volume is significantly above average, we have active participation of the large institutional traders. They are perceiving that value is away from where the market is currently trading, and they exert a directional pressure on the market as they lift offers or hit bids. When markets get very active, you'll often notice that the average quantity of ES contracts at each level in the order book (your depth of market display) often drops. This is because locals are pulling in their horns. They don't want to get run over by the large institutions, and they--on average--lack the firepower to hold the market to ranges where they would benefit from selling offers and buying bids. With locals pulling back, directionally biased institutions create short-term trends.
This, then, is why volume is so closely correlated with volatility. The presence of large institutional traders is what makes for trends. Knowing how volume compares to average tells you a great deal about *who* is in the market and *how* the market is likely to move. When volume is very low, there is little market movement. At those times, there may not be enough opportunity to justify the slippage and commissions of trading. In short, volume = volatility = opportunity. Knowing volume is knowing how much markets are likely to move, because you're tracking who is in the market.
Now for the details. You may want to print this out and keep it by your side when trading. That's what I do.
Going back to the past 105 trading sessions, the median morning trading volume (8:30 AM CT - 11:00 AM CT) in the ES contract is 442,369 contracts. The median trading range (high - low range) for morning trade is .47%. That is a little less than 7 ES points.
The correlation between morning volume and size of the morning trading range has been .73. That's quite high. If we divide our sample into quartiles based upon volume, the highest volume group of days (with a median 569,000 contracts) average a trading range of .71% (about 10 ES points). The next highest volume group of days (median of 485,000 contracts) averages a trading range of .51% (about 7 ES points). The third, next-to-lowest volume group (median of 407,000 contracts) averages a trading range of .38% (about 5.5 ES points). The lowest volume group (median of 280,000 contracts) averages a trading range of .35% (about 5 ES points). In other words, you get twice as much movement (range) in morning trading when you compare the highest volume days to the lowest volume ones.
Think: Can you see how this information helps you set profit targets for morning trading? Can you see why, yesterday, I took profits once the morning market had moved about 6 points from low to high?
Tracking volume *is* tracking the stock market's largest traders. When you see volume expand significantly and when you see that the volume is asymetrically distributed at the bid or offer, you know that large market participants with a directional bias are taking over the show. That is why, yesterday, I alerted readers to a pending breakout move. I'm not clairvoyant; far from it. But I could see that large traders were leaning one way and locals would not be able to fade that in the short run.
When there is low volume, there is relative consensus about market value; when there is high volume, there is uncertainty. Uncertainty is what moves markets and facilitates future trade. As we will see in my next post, the current period's volume and volatility is positively correlated with those in the next period. Knowing participation *now* informs us about the near-term future.
But how can we track volume within the morning to determine if volume is waning or picking up? I'll provide some numbers in my next post that you might want to print out.
As a gesture of appreciation, allow me to share a piece of my research in this and the next post. In the past, I have only shared this with specific prop traders I have worked with in a coaching vein. The idea of the research is to identify two (related) things that every short-term trader should know:
1) When are institutional participants active in the market?
2) When are we likely to have large price moves during morning trade?
Let's start with the basics. As a gross distinction, imagine that we have two kinds of traders in the marketplace. The first are market makers (locals) who provide liquidity. They are in the markets throughout the day, and they are in the markets every day. Having worked with prop traders who function as liquidity providers in the electronic futures markets, I can tell you that their participation in the market is relatively consistent from day to day. For simplicity's sake, I treat their involvement (volume) in the market as a constant.
The second group of traders are directional traders who enter the market when they perceive that we are trading away from what they deem as value. They may fade highs and lows, identifying value as somewhere between, or they may trade breakouts, placing value away from recent trading ranges. They generally enter the market on longer-term bases than the locals (scalpers). While directional traders include small individual traders, their volume is dominated by CTAs, hedge funds, mutual funds, and other large, institutional traders.
If we make the assumption that the participation of locals is relatively constant from day to day, then we can attribute surges or plunges in volume relative to average to the increased or decreased participation of large, institutional traders. When markets are trading with below average volume, they are dominated by liquidity providers. Because those traders generally work orders above and below the current market price, they are selling offers and buying bids. That tends to make them short when markets rise and long when markets fall. They profit, on average, when moves do not follow through and trend. This is why local-dominated markets (i.e., low volume markets) tend to trade in narrow, choppy ranges. There just aren't enough large, directional traders participating to move the market far from current levels of value.
Conversely, when volume is significantly above average, we have active participation of the large institutional traders. They are perceiving that value is away from where the market is currently trading, and they exert a directional pressure on the market as they lift offers or hit bids. When markets get very active, you'll often notice that the average quantity of ES contracts at each level in the order book (your depth of market display) often drops. This is because locals are pulling in their horns. They don't want to get run over by the large institutions, and they--on average--lack the firepower to hold the market to ranges where they would benefit from selling offers and buying bids. With locals pulling back, directionally biased institutions create short-term trends.
This, then, is why volume is so closely correlated with volatility. The presence of large institutional traders is what makes for trends. Knowing how volume compares to average tells you a great deal about *who* is in the market and *how* the market is likely to move. When volume is very low, there is little market movement. At those times, there may not be enough opportunity to justify the slippage and commissions of trading. In short, volume = volatility = opportunity. Knowing volume is knowing how much markets are likely to move, because you're tracking who is in the market.
Now for the details. You may want to print this out and keep it by your side when trading. That's what I do.
Going back to the past 105 trading sessions, the median morning trading volume (8:30 AM CT - 11:00 AM CT) in the ES contract is 442,369 contracts. The median trading range (high - low range) for morning trade is .47%. That is a little less than 7 ES points.
The correlation between morning volume and size of the morning trading range has been .73. That's quite high. If we divide our sample into quartiles based upon volume, the highest volume group of days (with a median 569,000 contracts) average a trading range of .71% (about 10 ES points). The next highest volume group of days (median of 485,000 contracts) averages a trading range of .51% (about 7 ES points). The third, next-to-lowest volume group (median of 407,000 contracts) averages a trading range of .38% (about 5.5 ES points). The lowest volume group (median of 280,000 contracts) averages a trading range of .35% (about 5 ES points). In other words, you get twice as much movement (range) in morning trading when you compare the highest volume days to the lowest volume ones.
Think: Can you see how this information helps you set profit targets for morning trading? Can you see why, yesterday, I took profits once the morning market had moved about 6 points from low to high?
Tracking volume *is* tracking the stock market's largest traders. When you see volume expand significantly and when you see that the volume is asymetrically distributed at the bid or offer, you know that large market participants with a directional bias are taking over the show. That is why, yesterday, I alerted readers to a pending breakout move. I'm not clairvoyant; far from it. But I could see that large traders were leaning one way and locals would not be able to fade that in the short run.
When there is low volume, there is relative consensus about market value; when there is high volume, there is uncertainty. Uncertainty is what moves markets and facilitates future trade. As we will see in my next post, the current period's volume and volatility is positively correlated with those in the next period. Knowing participation *now* informs us about the near-term future.
But how can we track volume within the morning to determine if volume is waning or picking up? I'll provide some numbers in my next post that you might want to print out.
Wednesday, February 07, 2007
Adding to Your Edge: A TraderFeed Poll
In this post, I'd like to ask a favor of blog readers. I'm taking a poll regarding an idea, and I'd like your sincere opinion. I'm not looking for folks to agree with the idea and I won't be discouraged if there's a lack of interest in the concept. Your honest opinion and comments are all I'm looking for. You can post your reactions as comments to the blog, or you can feel free to email them to me at the address at the end of the "About Me" paragraph on the TraderFeed home page. Your comments can be anonymous if you like, and no email addresses or identities will be shared with anyone else.
Three groups of participants are particularly sought for the poll:
1) Developing traders who have not yet established consistent profitability and are open to adding to their edge;
2) Successful traders who have worthwhile trading methods, but have never attempted to actually backtest and improve upon those ideas;
3) Successful traders who develop mechanical trading systems by appropriately backtesting entries, exits, stops, money management strategies, etc.
The poll question is this: Suppose it were possible to create a cooperative structure uniting these three groups of traders in which three things would happen:
1) Developing traders could subscribe to real time signals from a variety of backtested trading systems. They could use these signals for decision support, with the tested ideas providing ideas regarding market direction, guidance for position sizing, price targets, and stops. Over time, the trader would become familiar with these signals as a new set of market indicators and would develop a feel for how to integrate those into his or her existing setups and skills. For a single, reasonable subscription price, the trader would have access to signals that, otherwise, would require many months of system development or many thousands of dollars to purchase.
2) Successful discretionary traders could collaborate with system developers to backtest and improve their trading ideas and adapt them to new markets and time frames. The successful discretionary traders who lack programming skills and/or the time to backtest their ideas could form a partnership with successful system developers, creating a win-win. The discretionary traders learn about what is working in their methods and how to improve returns. The system developers gain access to new market approaches and inspirations for trading new markets and time frames. I recently wrote about a successful trader who shared ideas with Henry Carstens. I have since talked with both, and both have greatly benefited from the collaboration, creating methods more robust than either could have accomplished individually. This could greatly add to the edge of a successful discretionary trader.
3) The successful discretionary traders and system developers could make the signals from their collaborative efforts available to developing traders, creating a constantly updated portfolio of trading methods that provide edge. When new systems are developed jointly between traders and programmers/statisticians, the revenues from subscriptions would be shared fairly between them. This would create a diversified income stream for both groups. Moreover, as the developing traders become more experienced and generate their own ideas, they, too, could collaborate with programmers and make their work available by subscription. The result would be an ongoing flow of new trading methods that would benefit all participants.
Now for a few important additional considerations:
* All intellectual property would be kept confidential. Signals from systems and overall system logic would be shared, but traders would be able to keep their specific methods proprietary if they so choose.
* Subscription prices would be kept low to developing traders, given that they often have limited capital. This is meant to empower traders, not exploit them.
* The signals would be transmitted electronically (email, IM), keeping overhead down and ensuring timely broadcast. This would permit global participation among traders and, over time, would encourage traders from various parts of the world to collaborate on ideas covering the entire range of global markets.
* Every new system would be accompanied by hands-on education regarding how to use the signals. That would be included in the subscription.
* The vision would be to create a Web 2.0 approach to the trading process, in which system development and education would occur in a social network. The "customers" who would utilize the signals could also be the "business owners" who develop (and benefit from) new methods and signals.
In short, what I'm proposing is a kind of trading co-operative, linking system developers, experienced traders, and developing traders. My vision is for a collaborative structure that benefits all parties, instead of the all-too-common "charge a big fee and make big promises" approach to trader education and development prevalent at conferences and the media.
My poll question is simple: Which of the above three groups of traders best describes yourself, and would you have an interest in pursuing something like this?
I realize many operational details and legalities need to be worked out. At this point, however, I'm just interested in determining traders' interest in becoming part of a network that would blend research and trading skills and seek mutual growth and success. I look forward to hearing your honest feedback and will summarize the responses (anonymously, of course) in a future post.
Thanks so much for your interest and support.
Brett
Three groups of participants are particularly sought for the poll:
1) Developing traders who have not yet established consistent profitability and are open to adding to their edge;
2) Successful traders who have worthwhile trading methods, but have never attempted to actually backtest and improve upon those ideas;
3) Successful traders who develop mechanical trading systems by appropriately backtesting entries, exits, stops, money management strategies, etc.
The poll question is this: Suppose it were possible to create a cooperative structure uniting these three groups of traders in which three things would happen:
1) Developing traders could subscribe to real time signals from a variety of backtested trading systems. They could use these signals for decision support, with the tested ideas providing ideas regarding market direction, guidance for position sizing, price targets, and stops. Over time, the trader would become familiar with these signals as a new set of market indicators and would develop a feel for how to integrate those into his or her existing setups and skills. For a single, reasonable subscription price, the trader would have access to signals that, otherwise, would require many months of system development or many thousands of dollars to purchase.
2) Successful discretionary traders could collaborate with system developers to backtest and improve their trading ideas and adapt them to new markets and time frames. The successful discretionary traders who lack programming skills and/or the time to backtest their ideas could form a partnership with successful system developers, creating a win-win. The discretionary traders learn about what is working in their methods and how to improve returns. The system developers gain access to new market approaches and inspirations for trading new markets and time frames. I recently wrote about a successful trader who shared ideas with Henry Carstens. I have since talked with both, and both have greatly benefited from the collaboration, creating methods more robust than either could have accomplished individually. This could greatly add to the edge of a successful discretionary trader.
3) The successful discretionary traders and system developers could make the signals from their collaborative efforts available to developing traders, creating a constantly updated portfolio of trading methods that provide edge. When new systems are developed jointly between traders and programmers/statisticians, the revenues from subscriptions would be shared fairly between them. This would create a diversified income stream for both groups. Moreover, as the developing traders become more experienced and generate their own ideas, they, too, could collaborate with programmers and make their work available by subscription. The result would be an ongoing flow of new trading methods that would benefit all participants.
Now for a few important additional considerations:
* All intellectual property would be kept confidential. Signals from systems and overall system logic would be shared, but traders would be able to keep their specific methods proprietary if they so choose.
* Subscription prices would be kept low to developing traders, given that they often have limited capital. This is meant to empower traders, not exploit them.
* The signals would be transmitted electronically (email, IM), keeping overhead down and ensuring timely broadcast. This would permit global participation among traders and, over time, would encourage traders from various parts of the world to collaborate on ideas covering the entire range of global markets.
* Every new system would be accompanied by hands-on education regarding how to use the signals. That would be included in the subscription.
* The vision would be to create a Web 2.0 approach to the trading process, in which system development and education would occur in a social network. The "customers" who would utilize the signals could also be the "business owners" who develop (and benefit from) new methods and signals.
In short, what I'm proposing is a kind of trading co-operative, linking system developers, experienced traders, and developing traders. My vision is for a collaborative structure that benefits all parties, instead of the all-too-common "charge a big fee and make big promises" approach to trader education and development prevalent at conferences and the media.
My poll question is simple: Which of the above three groups of traders best describes yourself, and would you have an interest in pursuing something like this?
I realize many operational details and legalities need to be worked out. At this point, however, I'm just interested in determining traders' interest in becoming part of a network that would blend research and trading skills and seek mutual growth and success. I look forward to hearing your honest feedback and will summarize the responses (anonymously, of course) in a future post.
Thanks so much for your interest and support.
Brett
Wednesday, February 7th Morning Market Comments
9:59 AM - OK, done for now. It's been two good AM trading sessions in a row, but none of it would have mattered had I not kept myself from losing money on Monday when trade was narrow and my computer was freezing more than the weather. Can't emphasize enough that issue of keeping losses down. Then you truly benefit when opportunity arises. The other lesson for today pertains to levels. We had a level at the Tuesday midpoint and, when sellers couldn't break below that, it was logical to assume we'd be revisiting the highs. Knowing levels and tendencies makes a big difference, and hopefully this AM provided a small illustration. The latest TICK bounce was pretty anemic, so I'm content to regroup. Have a great rest of the day; update tonite via the Weblog.
9:49 AM - As long as pullbacks in TICK occur at higher price lows, you have to assume the uptrend is intact. It's when you get TICK surges that fail to produce new price highs that you think about taking some off the table. That works well for me.
9:42 AM - Hope you were able to catch that; I saw big traders lifting offers again and sure enough it took us to the R1 level for a nice pop. Back in a while. I'm basically buying TICK pullbacks until the market tells me not to.
9:37 AM - Watch for breakout move
9:31 AM - Took profits here and will reassess for breakout and reentry.
9:15 AM - Targeting a breakout above the AM highs in ER2 and ES. What we were seeing was a drying up of the TICK and some shift toward relative strength and lifting of offers in ER2. I used that as my indication that we might hold at the Tuesday midpoint and at least attempt a retest of highs.
9:12 AM - Tight stops; long and will get longer on TICK pullbacks that stay above the AM lows.
9:04 AM - Watching for possible upward shift in TICK distribution, which would have me buying.
8:51 AM - Volume pretty healthy in ES, with contracts skewed toward hitting of bids. Again, I'd need to see drying up of negative TICK and selling in ER2 before I'd take the long side.
8:48 AM - Inability of buyers to keep market above Tuesday highs and the weakness in NQ excellent tells for the ES move back toward the average trading range.
8:39 AM - Need to see selling dry up in ER2 before I'd be aggressive long; otherwise looking for return to avg price in ES.
8:24 AM CT - I've got several things going on this AM, including phone contacts with traders and trading firms, so that's going to make it tough to post in a very frequent way. Basically I'm going long this AM if selling dries up above 1453.25 in ES and above 813.90 in ER2. Otherwise, I'll be watching for the possibility of a pullback to the midpoint as we had early yesterday. Back after I get some calls made!
8:19 AM CT - Good morning! We're knocking on the door of recent price highs in the preopening market for the three major indices after the productivity news, firmness in Europe, and the rally following yesterday morning's decline. No other major economic releases scheduled. We could have a very solid upside breakout if sellers cannot push the indices back into their Tuesday ranges; I'll be watching those large traders carefully for some clues. Interest rates have come off a bit here; we're also seeing a rise in oil and in energy shares. We've had three consecutive trading sessions in which we've oscillated around an average trading price of 1451-1452 in the ES. This region should be a magnet for prices if we are to stay rangebound; failure of sellers to bring us back to that point would be important for the bulls. Failure to sustain the preopening move above Tuesday's highs would target that average price as an initial, high probability target. Note the article posted a little bit ago on a new form of biofeedback that might aid traders. I'll have more to say on that topic coming up. Back after the open.
9:49 AM - As long as pullbacks in TICK occur at higher price lows, you have to assume the uptrend is intact. It's when you get TICK surges that fail to produce new price highs that you think about taking some off the table. That works well for me.
9:42 AM - Hope you were able to catch that; I saw big traders lifting offers again and sure enough it took us to the R1 level for a nice pop. Back in a while. I'm basically buying TICK pullbacks until the market tells me not to.
9:37 AM - Watch for breakout move
9:31 AM - Took profits here and will reassess for breakout and reentry.
9:15 AM - Targeting a breakout above the AM highs in ER2 and ES. What we were seeing was a drying up of the TICK and some shift toward relative strength and lifting of offers in ER2. I used that as my indication that we might hold at the Tuesday midpoint and at least attempt a retest of highs.
9:12 AM - Tight stops; long and will get longer on TICK pullbacks that stay above the AM lows.
9:04 AM - Watching for possible upward shift in TICK distribution, which would have me buying.
8:51 AM - Volume pretty healthy in ES, with contracts skewed toward hitting of bids. Again, I'd need to see drying up of negative TICK and selling in ER2 before I'd take the long side.
8:48 AM - Inability of buyers to keep market above Tuesday highs and the weakness in NQ excellent tells for the ES move back toward the average trading range.
8:39 AM - Need to see selling dry up in ER2 before I'd be aggressive long; otherwise looking for return to avg price in ES.
8:24 AM CT - I've got several things going on this AM, including phone contacts with traders and trading firms, so that's going to make it tough to post in a very frequent way. Basically I'm going long this AM if selling dries up above 1453.25 in ES and above 813.90 in ER2. Otherwise, I'll be watching for the possibility of a pullback to the midpoint as we had early yesterday. Back after I get some calls made!
8:19 AM CT - Good morning! We're knocking on the door of recent price highs in the preopening market for the three major indices after the productivity news, firmness in Europe, and the rally following yesterday morning's decline. No other major economic releases scheduled. We could have a very solid upside breakout if sellers cannot push the indices back into their Tuesday ranges; I'll be watching those large traders carefully for some clues. Interest rates have come off a bit here; we're also seeing a rise in oil and in energy shares. We've had three consecutive trading sessions in which we've oscillated around an average trading price of 1451-1452 in the ES. This region should be a magnet for prices if we are to stay rangebound; failure of sellers to bring us back to that point would be important for the bulls. Failure to sustain the preopening move above Tuesday's highs would target that average price as an initial, high probability target. Note the article posted a little bit ago on a new form of biofeedback that might aid traders. I'll have more to say on that topic coming up. Back after the open.
Heart Rate Variability (HRV): Enhancing the Trader's Self-Control
In a recent post, I suggested that the enhancement of focus and concentration--not the elimination of emotions--was a central goal of trading psychology. Because expertise comes from a relentless learning process, and because we process new information more deeply when we are in a state of enhanced concentration, anything we can do to minimize distractions is likely to help us internalize market patterns and retain access to them once they're acquired. Unlike many authors who have written on the topic of trading psychology, I do not subscribe to the notion that emotions are the root of all trading problems and that anyone can succeed at trading if they develop themselves psychologically. Trading success requires skill and a true edge in the marketplace. When the loss of discipline is an issue for traders, many possible causes may be present. Often, it is the result of trying to trade a style or time frame that does not fit one's basic talents, skills, and interests. It is very difficult to find your performance edge if your basic approach does not match your basic skill sets.Where the issues of focus/concentration and behavioral discipline come together is under a wider umbrella that we can call executive self-control. In a recent post, I explained how I use a form of biofeedback called hemoencephalography to enhance activation of the brain's executive center: the frontal cortex. When we sustain such activation, we not only possess superior concentration; we also have greater behavioral control. As mentioned in that article, the frontal cortex is the CEO of the brain: it focuses our efforts and effects our reasoning, planning, and judgment. The ability to sustain frontal activation should thus help traders on two related fronts: 1) in the deep learning (internalization) of market patterns; and 2) in the ability to act upon these patterns in planful ways. In short, the highly developed trader is the highly regulated trader: able to retain an emotional feel for markets after seeing many patterns repeated, but also able to not become overly swayed by situational pressures and the shifts of emotional state they create.
A recent journal article in psychology highlights heart rate variability as a promising index of self-regulation. As the article explains, heart rate variability is a measure of flexibility of autonomic responding. In the authors' words, "...heart rate variability (HRV) is a measure of the continuous interplay between sympathetic and parasympathetic influences on heart rate that yields information about autonomic flexibility and thereby represents the capacity for regulated emotional responding" (p. 230). High levels of HRV, suggesting superior ability to regulate emotional responses, have been found to be linked to superior coping under stress and enhanced attention. Low HRV has been linked to such psychological disorders as anxiety and depression. A list of studies related to HRV can be found on the SharpBrains site.
Now here's the interesting part. When I sat at my trade station and used the Freeze Framer program to measure and chart my own HRV, I found that I had a smooth set of sine-wave curves (see above). That smooth pattern, which the developer of Freeze Framer calls "coherence", represents a high degree of HRV: enhanced flexibility and regulation of emotional response. I then introduced an annoying distraction into the situation and notice how the shape of the sine wave curves was destroyed. I entered a period of low HRV. After a few other experiments, I found that even the simple distraction of a conversation lowered my HRV readings.
Might it be possible to track our degree of executive self-control during trading by following our HRV through the day? Might it be possible to train traders to achieve higher levels of self-regulation? Might enhanced HRV be related to trading performance? These will be the topics of the second post in this series.
Tuesday, February 06, 2007
Tuesday, February 6th Morning Market Comments
10:33 AM - One more quick observation. Note on this most recent low in ES that we did not make new lows in the semiconductors and NQ (as well as ER2), which had been leading the downside. That has me looking to see if the market laggards are running out of sellers. If so, I'd be looking for a short-covering rally at the least.
10:06 AM - OK, hope the research and tracking the market's inability to make highs helped you take advantage of the move back into the Monday range. Three takeaway lessons here: 1) On average, markets will not give you inside days. If you can't make new highs, consider the possibility that you'll be testing new lows; 2) Rangebound markets tend to revert to their average trading prices. At the edge of a range, you generally have a good trade either for a breakout or for a mean reversion; 3) Keep an eye on the most volatile market sectors, such as semiconductors, NQ, and ER2. Very often they will lead the way on short-term trending moves. Have a great rest of your day. Update tonite on the Weblog.
9:58 AM - Note that we broke Monday lows in NQ and are approaching them in ER2. The failure of those two averages to take out their prior day's high was an important early AM tell as well that figured into my being short. Again, if markets are going to be really strong or really weak, all the sectors will travel together. Continued weakness in semiconductors has led to broadening selling, with much more volume at bid than offer in ES. Back for a wrap shortly.
9:49 AM - My strategy is to sell TICK bounces, not chase declines that have already occurred. Note we have a downside breakout of the 1st hour's range. Odds Maker tells us that selling that downside move has been a losing strategy over the last 3 weeks. I prefer to be quick and take profits or, at the very least, not chase lows.
9:47 AM - The semiconductors have been a great tell for this market; they've led the weakness. You can see, however, that the bears are gaining ground only grudgingly, only now hitting the VWAP target.
9:37 AM - Next downside targets would be 1451.25 (VWAP), 1449.75 (S1), and 1448 (Monday low).
9:35 AM - Note weakness in semiconductors and energy issues. I don't have enough reasons to be long, given those dynamics and the research.
9:28 AM - I'm flat and may stay that way unless I see we're at the edge of an important range where I can handicap the odds of either a breakout or another reversion to a mean trading price. This really is not my best trading environment; many times I'll get a point out of a trade, and then it will reverse. So I've learned to take what the market gives me. The other reason I took profits a little while back is the Odds Maker finding that downside breakouts of opening ranges were tending to reverse. So when we broke to a new AM low, I was not thinking of adding to shorts; I was concerned about reversal. Which, as it turned out, is what happened in the short run. Once again, a nice piece of decision support from research. Back in a few.
9:21 AM - Well, the idea was for a trade back into the value area toward the Monday pivot/VWAP. There was solid buying sentiment early in the AM with solid TICK numbers, but I noticed that wave after wave of buying could not push the market to new highs relative to Monday. That led me to take an initial short position in anticipation of sellers taking over (which fit with this AM's research idea). The sellers did come in and then bounces in the TICK provided an opportunity to add to shorts and catch the move back to the mean price from Monday. It wasn't a huge move by any stretch, but it was a nice illustration of how research and a reading of the market can go together and produce a solid trade. In a higher volatility environment, that same trade would have paid me out much more. Back in a short while.
9:16 AM - Took profits on the shorts.
9:06 AM - Got the move back into the value area; now watching to see if we get lower price highs on TICK bounces. That would set up further selling opportunities, although I'm not aggressive in this rangebound environment with modest volume.
8:56 AM - Lots of choppy cross currents, but with net buying in TICK and in ES, with volume at offer exceeding that at bid. Because of those dynamics, I am not aggressively short, but I'm willing to hold a small short position to see if the inability of buyers to make new highs relative to Monday will bring in sellers.
8:45 AM - Carrying an initial short in ES. But need to see selling in TICK and no break of AM highs or I'll be out quickly.
8:36 AM - Got some solid buying off the AM pivot. Now watching to see if we can hold above the AM lows on pullbacks in TICK. Advancers well ahead of decliners thus far and no negative TICK. Note that ER2 and NQ did not surpass their Monday highs in overnite trade.
8:26 AM - Here's my Market Delta chart this AM. Note we're trading above value and handicapping the odds of reverting to the value area vs. breaking out to the upside in a new bull leg.
8:17 AM CT - Good morning. It's another cold one in Chicago. Let's just see if I can keep my screen from freezing today! Note my post earlier this AM on what happens after narrow market periods. Pretty modest expectations, so even though we're seeing some pre-opening strength in the ES on the heels of gains in Europe--and we're trading above the Monday highs--I'll need to see evidence of buying volume in ES and across the broad range of stocks to target the R1 and R2 levels outlined in the Weblog. A return back to the Monday range would target that day's pivot and VWAP levels as initial targets. No major economic news today; just testimony from Sec Treas and others through the day. My other post this AM takes a look at combining information from trading research with information we glean from real-time following of the markets. I think it's a topic very important to developing and sustaining a market edge. While on that topic, BTW, here's an interesting pattern from Odds Maker: When we've had a breakout above the opening 15 minute range in SPY over the past three weeks, 7 out of 10 occasions you would have made money by fading the upside breakout. By selling strength and holding the trade for 30 minutes, you would have averaged 2.2 ES points per trade, with a net gain of slightly over 10 ES points. Knowing patterns and odds like this--and then tracking in real time whether the patterns are setting up *now*--can make for an effective trading methodology. Back after the open!
Deepening Our Understanding of the Stock Market's Personality
When we refer to the "personality" of an individual, we're creating a shorthand that describes that person's tendencies: How they think, feel, behave, and relate to others. Our categories of personality--such as calling someone "Type A" or "narcissistic"--help us understand that person, predict their behaviors, and communicate our understanding to others. To be sure, personality traits don't capture all of the variance in human behavior; much is determined situationally. Still, human behavior is sufficiently patterned that we benefit from our various categories.
When we perform studies of historical market behavior--or when we create a mechanical trading system--we are attempting to capture some aspects of the stock market's personality. Each study or system is looking for a recurring pattern. We might say that the sum of patterns across multiple time frames defines the personality of a given market. Some markets have "trending" personalities; others are "volatile". With markets, as with people, such personalities don't capture all the variance in the behavior of a stock or index. Situational factors, from interest rate movements to geopolitical developments, play important roles. Still, we see sufficient patterning of markets that it is meaningful to say that, for example, we've been in a low volatility bull market.
When we deal with a person, we do not expect that his or her personality will radically shift from day to day. The tendencies that have stood out in the recent past are assumed to hold for the immediate future unless we have some reason to believe that the person has changed or that the situational influences are unique. Similarly, traders assume that past patterns will carry forward to the immediate future. This is just as true for discretionary traders as mechanical systems ones: whether we trade off of chart patterns or quantitative relationships, we are assuming that patterns we've noticed in the past will, in the absence of situational influences to the contrary, carry forward to the near-term future. Without that assumption--the assumption of some patterned nature to markets--trading makes no sense whatsoever.
We tend to think of discretionary trading--trading based on the real-time judgment of the trader--and mechanical trading--trading based on a defined system of entries, exits, and money management--as opposite sides of the trading spectrum. In reality, however, both are undertaking the same thing: capturing market patterns. It is for this reason that the development of trading systems greatly benefits from the expertise of traders who employ their judgment and discretionary traders benefit from the decision support of knowing quantitative market patterns. As I suggested in a post a while back, the ideal is a trader with both head and gut: someone who has a feel for market patterns and a head for market odds.
During my morning trading sessions, I have sometimes referred to the Odds Maker module of the Trade Ideas screening program as one bridge between discretionary and system trading. Indeed, today's Weblog entry mentions an Odds Maker pattern regarding downside breakouts of opening trading ranges. I am a discretionary trader, but I find it helpful to know that, during the past three weeks of trading, the great majority of downside breaks of the opening trading range have been reversed. Indeed, on balance, one would have made nice money buying such breaks rather than joining the sellers. Knowledge, indeed, is power.
What Odds Maker is doing is capturing a piece of recent market personality. A broader piece of market personality is captured by a trading system that has been tested over many years, such as the one recently mentioned in my post. Such patterns and systems won't account for all market behavior--their absolute edge might be relatively small--but followed consistently over time, they can yield major profits. The bullish trader who has bought market weakness has consistently outperformed the bullish trader who has bought strength: knowing the market's short-term personality has been crucial to the success of the active trader.
The bottom line? Two important implications:
1) Quantitative assessment can aid subjective judgment. The psychologist relies on psychological tests; the fighter pilot relies on radar readings; the poker champion knows the odds of each hand. Knowing patterns--whether of clients in therapy, opposing football teams, or markets--helps professionals make better decisions.
2) The expertise of subjective decision makers can aid the development of quantitative tools. I have seen many programmers at trading firms who have programming expertise and no feel whatsoever for *what* to program. It's when the expert trader shares patterns with the programmer that a superior trading system can be developed--the kind of system that, then, can offer the aforementioned decision support.
Can discretionary traders form partnerships with quantitative system developers for their mutual benefit? My next post will propose a vision for just such an arrangement.
When we perform studies of historical market behavior--or when we create a mechanical trading system--we are attempting to capture some aspects of the stock market's personality. Each study or system is looking for a recurring pattern. We might say that the sum of patterns across multiple time frames defines the personality of a given market. Some markets have "trending" personalities; others are "volatile". With markets, as with people, such personalities don't capture all the variance in the behavior of a stock or index. Situational factors, from interest rate movements to geopolitical developments, play important roles. Still, we see sufficient patterning of markets that it is meaningful to say that, for example, we've been in a low volatility bull market.
When we deal with a person, we do not expect that his or her personality will radically shift from day to day. The tendencies that have stood out in the recent past are assumed to hold for the immediate future unless we have some reason to believe that the person has changed or that the situational influences are unique. Similarly, traders assume that past patterns will carry forward to the immediate future. This is just as true for discretionary traders as mechanical systems ones: whether we trade off of chart patterns or quantitative relationships, we are assuming that patterns we've noticed in the past will, in the absence of situational influences to the contrary, carry forward to the near-term future. Without that assumption--the assumption of some patterned nature to markets--trading makes no sense whatsoever.
We tend to think of discretionary trading--trading based on the real-time judgment of the trader--and mechanical trading--trading based on a defined system of entries, exits, and money management--as opposite sides of the trading spectrum. In reality, however, both are undertaking the same thing: capturing market patterns. It is for this reason that the development of trading systems greatly benefits from the expertise of traders who employ their judgment and discretionary traders benefit from the decision support of knowing quantitative market patterns. As I suggested in a post a while back, the ideal is a trader with both head and gut: someone who has a feel for market patterns and a head for market odds.
During my morning trading sessions, I have sometimes referred to the Odds Maker module of the Trade Ideas screening program as one bridge between discretionary and system trading. Indeed, today's Weblog entry mentions an Odds Maker pattern regarding downside breakouts of opening trading ranges. I am a discretionary trader, but I find it helpful to know that, during the past three weeks of trading, the great majority of downside breaks of the opening trading range have been reversed. Indeed, on balance, one would have made nice money buying such breaks rather than joining the sellers. Knowledge, indeed, is power.
What Odds Maker is doing is capturing a piece of recent market personality. A broader piece of market personality is captured by a trading system that has been tested over many years, such as the one recently mentioned in my post. Such patterns and systems won't account for all market behavior--their absolute edge might be relatively small--but followed consistently over time, they can yield major profits. The bullish trader who has bought market weakness has consistently outperformed the bullish trader who has bought strength: knowing the market's short-term personality has been crucial to the success of the active trader.
The bottom line? Two important implications:
1) Quantitative assessment can aid subjective judgment. The psychologist relies on psychological tests; the fighter pilot relies on radar readings; the poker champion knows the odds of each hand. Knowing patterns--whether of clients in therapy, opposing football teams, or markets--helps professionals make better decisions.
2) The expertise of subjective decision makers can aid the development of quantitative tools. I have seen many programmers at trading firms who have programming expertise and no feel whatsoever for *what* to program. It's when the expert trader shares patterns with the programmer that a superior trading system can be developed--the kind of system that, then, can offer the aforementioned decision support.
Can discretionary traders form partnerships with quantitative system developers for their mutual benefit? My next post will propose a vision for just such an arrangement.
Consecutive Narrow Days: What Comes Next
We've had three consecutive days in which the high-low range in the S&P 500 Index (SPY) has been well under the average range for the prior 20 trading sessions. In all, the average range of the three days has been less than 60% of the 20-day average range. Clearly this represents a kind of consolidation. What tends to follow when we get such a protracted period of narrow trading?
Going back to 2004 (N = 773 trading days), I found 81 periods in which the average three-day range was less than 70% of the average 20-day range. Four days later, SPY averaged a loss of -.01% (41 up, 40 down). That is weaker than the average four-day gain of .15% (395 up, 297 down) for the remainder of the sample.
When, however, we break down the sample of narrow periods by their prior 20-day price performance, a pattern emerges. When the narrow period follows 20 days of an up market (N = 67), the next four days in SPY average a loss of -.17% (30 up, 37 down). Conversely, when the prior 20 days have been down in price (N = 14), the narrow period was followed by an average four-day gain of .82% (11 up, 3 down). In other words, when a narrow period has followed 20 days of strength, it has tended to be part of a corrective process that has lasted several more days. When the narrow period has followed 20 days of weakness, it has tended to be followed by a price reversal. We might say, then, that these narrow periods have tended, on average, to be periods of short-term market transition.
I note that we had 26 narrow periods in the S&P 500 Index during 2006; 19 of these were lower four days later. While this by no means indicates a likely bear market, it does suggest modest expectations for the remainder of this week.
Going back to 2004 (N = 773 trading days), I found 81 periods in which the average three-day range was less than 70% of the average 20-day range. Four days later, SPY averaged a loss of -.01% (41 up, 40 down). That is weaker than the average four-day gain of .15% (395 up, 297 down) for the remainder of the sample.
When, however, we break down the sample of narrow periods by their prior 20-day price performance, a pattern emerges. When the narrow period follows 20 days of an up market (N = 67), the next four days in SPY average a loss of -.17% (30 up, 37 down). Conversely, when the prior 20 days have been down in price (N = 14), the narrow period was followed by an average four-day gain of .82% (11 up, 3 down). In other words, when a narrow period has followed 20 days of strength, it has tended to be part of a corrective process that has lasted several more days. When the narrow period has followed 20 days of weakness, it has tended to be followed by a price reversal. We might say, then, that these narrow periods have tended, on average, to be periods of short-term market transition.
I note that we had 26 narrow periods in the S&P 500 Index during 2006; 19 of these were lower four days later. While this by no means indicates a likely bear market, it does suggest modest expectations for the remainder of this week.
Monday, February 05, 2007
Monday, February 5th, 2007 Morning Comments
10:25 AM - We're pretty much in the middle of a 4-3/4 pt range in ES; note how volume has tailed off substantially. The distribution of TICK has been on the negative side; we're also seeing more ES volume at bid than offer. Both of those things have me cautious re: the idea of chasing the upside. I'd want to see an upward shift in that TICK distribution and better performance from the Russell in order to take the long side. All in all, however, the scenario is consistent with a high upside momentum market taking a pause before it attempts new highs. Update tonight on the Weblog; I may also try to update that market pattern described below. Have a great day!
10:15 AM - I'm working on a new setup that seems to materialize fairly often for a good short-term gain. I actually did get an initial move my way on both the trades placed today, but no follow through and hence the scratches. The logic underlying the setup is this: I'm looking for evidence of program selling among the large caps, as indicated by $E-PREM and $TIKI, that does *not* spill over into selling in the broad market. Think of it as a virus that hits a population, but turns out to not be highly contagious. When that program selling abates, there is generally a pop upward in ES as sellers temporarily back off, unable to push price meaningfully lower. (E-PREM is the S&P emini futures premium to cash; $TIKI is the number of Dow Industrials stocks trading at offer vs bid quoted every six seconds). The key is to distinguish program selling (simultaneous trading of Dow stocks at the bid as revealed by $TIKI and preceded by downward moves in E-PREM) that is accompanied by broader selling (which is what happened earlier this AM) from program selling that is unable to push markets lower and will eventually lead to buyers coming in. I will need to figure out parameters for the setup and more carefully define an entry criterion, but so far I think this may be a worthwhile pattern to investigate. My second scratched trade attempted to take advantage of this. Back to wrap up in a few.
10:02 AM - Well, you know, I went into the day expecting a transition from an uptrending market to a rangebound one per the research on the Weblog and so far that's what's materialized. We tried to take them up early in the session, program trades hit the market hard and took us below Friday's lows, but selling dried up at those levels and buying brought us right back into the Friday range. There's a saying in medicine, "Above all else, do no harm." That was my goal for today as very odd freeze ups in my platform occurred several times. The only good thing that came of it is that I got to see how my work on my emotional discipline has paid off. No cursing, no frustration. It's just one of those days. The one thing I *can* control is not letting the situation push me into bad trades. I'll be back in a few to explain that last scratched trade.
9:52 AM - And yet another scratch.
9:48 AM - Long some ES here. I'll talk a bit about this trade in a few min.
9:37 AM - I'm definitely a day late--fortunately not a dollar short!--due to major problems with my datafeed. It's keeping me out of the market, which may be for the best. What we saw is a taking out of the Friday high, but a waning of selling in ER that showed up nicely in a 5 min Market Delta chart. Seeing that, and a bid underneath ER2 is what had me scratching the trade. I was loaded up to go long ES and everything froze. Just like the weather and the Bears. Be that as it may, it's put us in a range in ES and I'm watching from here for clues as to a break from that range or at least pullbacks into the range on failed breakout attempts.
9:25 AM - Scratched that one.
9:15 AM - I'm short ER2 here...let's see if the selling continues based on the thesis below.
9:10 AM - Note how volume has picked up on the selling and how ER2 has gone from leader to laggard with the broadening of the selling. That has me leaning toward the idea that we've seen a high for the AM (and possibly the day) and thus I'm looking to sell bounces.
8:58 AM - The very negative shift in the TICK for the Dow stocks (TIKI) had me concerned, and notice how that selling has now broadened out to the small caps, as reflected in the TICK.
8:55 AM - What's keeping me from going long are persistent sell programs in the large caps. I'll explain in a bit.
8:47 AM - Russell and NQ continuing to lead ES with underlying strength as reflected in positive shift in TICK. That leads me to be a buyer on pullbacks that stay above the AM lows. Note we've taken out Friday highs in NQ. Those highs are a target for ES.
8:42 AM - Good buying off the overnight support. I won't be selling as long as ER2 is making highs above its overnite range.
8:35 AM - Some strength in oil and energy issues here. Very narrow TICK with declines leading advances by about 360 issues. Volume quite moderate in ES, with more volume hitting bids.
8:32 AM - I've edited the comments below given problems with my data feed re: DAX.
8:15 AM CT - Good morning! It's wicked cold in Chicagoland--recently 35F below zero with the chill factor--and the sentiment of Bears fans is even chillier following the Super Bowl. Let's see if we can warm things up to start a week of trading. We have ISM non-manufacturing (services) numbers coming out at 9 AM; that's it for economic releases today. Expectations are for a strong reading, in line with recent estimates of GDP growth. Meanwhile, we have some firming of the dollar vs. the Euro. We've seen overnight support in the ES contract at 1449.75; note that Friday's low was a point lower. (Pivots for Monday's trade are on the Weblog). If we get early selling drying up above the overnight lows, I'd be looking to buy to test the Friday highs; inability to sustain any test of those highs (buying drying up) would target the Friday pivot level/VWAP. Back after the open; when you have time, check out recent trading lessons from these morning sessions.
10:15 AM - I'm working on a new setup that seems to materialize fairly often for a good short-term gain. I actually did get an initial move my way on both the trades placed today, but no follow through and hence the scratches. The logic underlying the setup is this: I'm looking for evidence of program selling among the large caps, as indicated by $E-PREM and $TIKI, that does *not* spill over into selling in the broad market. Think of it as a virus that hits a population, but turns out to not be highly contagious. When that program selling abates, there is generally a pop upward in ES as sellers temporarily back off, unable to push price meaningfully lower. (E-PREM is the S&P emini futures premium to cash; $TIKI is the number of Dow Industrials stocks trading at offer vs bid quoted every six seconds). The key is to distinguish program selling (simultaneous trading of Dow stocks at the bid as revealed by $TIKI and preceded by downward moves in E-PREM) that is accompanied by broader selling (which is what happened earlier this AM) from program selling that is unable to push markets lower and will eventually lead to buyers coming in. I will need to figure out parameters for the setup and more carefully define an entry criterion, but so far I think this may be a worthwhile pattern to investigate. My second scratched trade attempted to take advantage of this. Back to wrap up in a few.
10:02 AM - Well, you know, I went into the day expecting a transition from an uptrending market to a rangebound one per the research on the Weblog and so far that's what's materialized. We tried to take them up early in the session, program trades hit the market hard and took us below Friday's lows, but selling dried up at those levels and buying brought us right back into the Friday range. There's a saying in medicine, "Above all else, do no harm." That was my goal for today as very odd freeze ups in my platform occurred several times. The only good thing that came of it is that I got to see how my work on my emotional discipline has paid off. No cursing, no frustration. It's just one of those days. The one thing I *can* control is not letting the situation push me into bad trades. I'll be back in a few to explain that last scratched trade.
9:52 AM - And yet another scratch.
9:48 AM - Long some ES here. I'll talk a bit about this trade in a few min.
9:37 AM - I'm definitely a day late--fortunately not a dollar short!--due to major problems with my datafeed. It's keeping me out of the market, which may be for the best. What we saw is a taking out of the Friday high, but a waning of selling in ER that showed up nicely in a 5 min Market Delta chart. Seeing that, and a bid underneath ER2 is what had me scratching the trade. I was loaded up to go long ES and everything froze. Just like the weather and the Bears. Be that as it may, it's put us in a range in ES and I'm watching from here for clues as to a break from that range or at least pullbacks into the range on failed breakout attempts.
9:25 AM - Scratched that one.
9:15 AM - I'm short ER2 here...let's see if the selling continues based on the thesis below.
9:10 AM - Note how volume has picked up on the selling and how ER2 has gone from leader to laggard with the broadening of the selling. That has me leaning toward the idea that we've seen a high for the AM (and possibly the day) and thus I'm looking to sell bounces.
8:58 AM - The very negative shift in the TICK for the Dow stocks (TIKI) had me concerned, and notice how that selling has now broadened out to the small caps, as reflected in the TICK.
8:55 AM - What's keeping me from going long are persistent sell programs in the large caps. I'll explain in a bit.
8:47 AM - Russell and NQ continuing to lead ES with underlying strength as reflected in positive shift in TICK. That leads me to be a buyer on pullbacks that stay above the AM lows. Note we've taken out Friday highs in NQ. Those highs are a target for ES.
8:42 AM - Good buying off the overnight support. I won't be selling as long as ER2 is making highs above its overnite range.
8:35 AM - Some strength in oil and energy issues here. Very narrow TICK with declines leading advances by about 360 issues. Volume quite moderate in ES, with more volume hitting bids.
8:32 AM - I've edited the comments below given problems with my data feed re: DAX.
8:15 AM CT - Good morning! It's wicked cold in Chicagoland--recently 35F below zero with the chill factor--and the sentiment of Bears fans is even chillier following the Super Bowl. Let's see if we can warm things up to start a week of trading. We have ISM non-manufacturing (services) numbers coming out at 9 AM; that's it for economic releases today. Expectations are for a strong reading, in line with recent estimates of GDP growth. Meanwhile, we have some firming of the dollar vs. the Euro. We've seen overnight support in the ES contract at 1449.75; note that Friday's low was a point lower. (Pivots for Monday's trade are on the Weblog). If we get early selling drying up above the overnight lows, I'd be looking to buy to test the Friday highs; inability to sustain any test of those highs (buying drying up) would target the Friday pivot level/VWAP. Back after the open; when you have time, check out recent trading lessons from these morning sessions.
Making Each Day a Learning Experience: Trading Lessons From the Morning Sessions
I've now been conducting the morning sessions, tracking the equity index markets in real time, for a while. My goal is to make every trading session a lesson that will move me forward in my craft. I decided to go back and pull out a few of the more important lessons from those morning sessions. These cement important trading ideas for me and, hopefully, for you as well as we start a new trading week:
Sunday, January 7th, 2007: In my personal site, I try to summarize the market data I'm looking at each day and how I'm putting the data together into an initial framework to start the day. This site summarizes some of the research I conduct to identify possible trading edges, mostly from 1-5 days out. The reality of trading, however, is that such preparation only gives you initial hypotheses and plans. The real skill of trading comes in when markets open and you have to analyze shifting patterns of supply and demand as they emerge. In my own trading, I follow several variables very closely (one-minute data):
* Whether volume is higher, lower, or equal to average volume for that time of day;
* How the most volatile market sectors (small caps, NASDAQ, semiconductors) are trading relative to the large cap indices;
* How interest rates, currencies, gold, and oil are trading during equity trading hours;
* NYSE TICK (number of stocks trading at offer vs. bid) and shifts in the distribution of the TICK;
* Volume of contracts executed at the market bid vs. ask for the ES futures;
* Whether a majority of sectors are participating in moves in the ES futures (I look at Spyder sector ETFs for much of this info);
* Value area (Market Profile) from the previous day's trade and how volume expands or contracts as we trade outside that area;
* Levels of support and resistance from the previous day as well as the current day, to identify potential trading ranges and levels we're likely to test.
If you were to watch me trade, you'd see me continuously shifting from one window/screen to another, monitoring these variables. At some point a pattern becomes clear and I get an idea of shifting demand/supply that will lead us to test a particular market level. That becomes the basis for a trade idea, particularly if it is in line with my prior research. I average 2 trades per day, mostly in the AM, and averaging 20 minutes in holding time.
Monday, January 8th, 2007: The main thing to take away from the AM trading session is the importance of flexible thinking. We started off with some research that suggested we were likely to take out the Friday lows. As the selling progressed early in the morning, however, it was apparent that many sectors were not participating. That suggested that it would be a mistake to chase those lows and, indeed, made sense to watch for reversals. Perhaps the most important mental shift was from "downtrend" thinking to "rangebound" thinking, with the AM lows and the 1420 resistance area forming the range. Having that range in mind enabled me to get on board to the long side when heavy selling could not bring us to new daily lows, but the range also alerted me to be aggressive in taking profits when the buying ran into a wall of sellers.
Tuesday, January 9th, 2007: That's a good lesson for the day: when you see the TICK hitting negative values, but the index can't make new price lows, it's generally an early sign that sellers can't move the market any further: that buyers are finding value at those levels. That doesn't necessarily mean that buyers will enter the market in force, but it's usually a good bet that you'll get enough buying to move the index back toward a prior high for a short term trade.
Monday, January 15th, 2007: It's not unusual to see a breakout move begin in one of the more volatile indices before strong buying shows up in the Dow or the S&P 500. I've found that helpful on occasions for timing. I also like to follow the DAX as a potential leader of the S&P 500 early in the AM. Most helpful of all is filtering the Market Delta charts so that they only post trades of a certain size or greater. You then can see how many large traders are in the market and whether they're predominantly buying or selling. That is *very* useful in handicapping the odds of reaching a pivot support or resistance level.
Tuesday, January 16th, 2007: Notice that measures such as TICK and volume at bid/offer tell us about supply and demand, but volume levels relative to average for the time of day tell us about volatility: how much movement we can expect from given supply or demand. Because we don't have strong buying or selling in the TICK (the Adjusted TICK is negative on the day, but not at extreme levels) and we don't have above average volume, I don't expect a large move on the day and, indeed, anticipate more of a rangebound market. The key is monitoring these variables in real time to identify as early as possible what type of market we're likely to be in and which price levels we're likely to hit.
Thursday, January 18th, 2007: I like to cement a lesson from each trading day. Perhaps the takeaway for today is that 85% of all days in ES are *not* inside days. That ratio is well over 90% when we have above avg volume. Once you know that, it's a matter of handicapping the odds of taking out either the prior day's high or low. Once we saw selling in those leading sectors and breaks to new lows, and once the TICK turned down and we got sellers hitting bids in size, we had a nice trade in ES toward Wednesday's lows and S2.
Friday, January 19th, 2007: The AM illustrated a few important things. First is the importance of flexibility. The odds of taking out yesterday's lows in ES were quite high, and that was my initial leaning. When selling dried up early in the AM with only a modestly negative TICK and not many stocks declining relative to advancers, I entertained the reverse hypothesis: that we were not getting selling and that leaning to the long side was the way to go. The second principle illustrated is the importance of patience. It was a choppy morning session, and it was easy to get scared out of a good position. But as long as the overall dynamics of supply and demand were not shifting, patience was indicated. Finally, you can see how a drying up of selling (today relative to yesterday) often precedes an influx of buying. That's a pattern that sets up intraday as well as on a swing basis.
Thursday, January 25th, 2007: Takeaway for today is this: transacting at the bid vs offer, which is what I'm tracking with the NYSE TICK, Dow TICK, Market Delta, etc, is a very short-term measure of trader sentiment. When we don't see buying sentiment following a nice up day, it makes sense to think about a transition to range bound trade and a reversion to the prior day's average prices. An absence of buyers (sellers) often precedes an influx of sellers (buyers), but it pays to wait for the latter, pick price levels, and take the high percentage trades.
Friday, January 26th, 2007: The lesson I want to stress for today's session is position sizing. We had huge odds of taking out yesterday's lows, creating a very favorable edge. Once selling started appearing in the market, you have to participate with all the size you can muster. You can lose money on 2 or 3 small trades, make money on one high odds trade with size, and wind up the day/week a solid winner. Your position size should reflect your confidence in the trade. Yesterday I mentioned putting small size on when you're feeling out a market. Today it was time to press the advantage. Those odds don't come along every day.
Tuesday, January 30th, 2007: In general, once you identify a candidate morning low, it makes sense to put in an initial position and use pullbacks in the TICK as opportunities to add to the position, as long as the TICK bursts take you to successive price highs. If you can't hit your price target and the buying sentiment (TICK, volume at offer) isn't moving you higher, then you have to entertain the hypothesis that you're in a trading range environment and take what you can from the market.
Wednesday, January 31st, 2007: As long as we can trade 15,000 contracts or so every five min in ES, there should be some movement for the short-term trader. It's when we get below 10K per five min period that things get deadly slow and I stop trading. I've found keeping those volume levels by my side to be helpful. Let's me know when it's worth playing, when it's not. The main thing is whether or not volume is above avg or not for that particular time of day. When well below avg, not worth trading.
Wednesday, December 6th, 2006: 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.
Wednesday, November 22nd, 2006: After each day of trading, I like to evaluate what I did right and wrong and use those to frame goals for the next session(s). What's clear to me from today is that I need to stick with my basic method of exiting positions: entering with enough size that I can take quick profits on one piece but let the other piece breathe and take advantage of a possibly longer move. I was too much in the mindset of "This is pre-holiday; just take what the market gives you". As a result, I didn't benefit as much from the patient, good entries as I should have. The point is to always be learning. Figure out what you do well and extend it. Adjust what you're not doing well. Today I did entries much better than exits.
Tuesday, December 19th, 2006: 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.
Sunday, January 7th, 2007: In my personal site, I try to summarize the market data I'm looking at each day and how I'm putting the data together into an initial framework to start the day. This site summarizes some of the research I conduct to identify possible trading edges, mostly from 1-5 days out. The reality of trading, however, is that such preparation only gives you initial hypotheses and plans. The real skill of trading comes in when markets open and you have to analyze shifting patterns of supply and demand as they emerge. In my own trading, I follow several variables very closely (one-minute data):
* Whether volume is higher, lower, or equal to average volume for that time of day;
* How the most volatile market sectors (small caps, NASDAQ, semiconductors) are trading relative to the large cap indices;
* How interest rates, currencies, gold, and oil are trading during equity trading hours;
* NYSE TICK (number of stocks trading at offer vs. bid) and shifts in the distribution of the TICK;
* Volume of contracts executed at the market bid vs. ask for the ES futures;
* Whether a majority of sectors are participating in moves in the ES futures (I look at Spyder sector ETFs for much of this info);
* Value area (Market Profile) from the previous day's trade and how volume expands or contracts as we trade outside that area;
* Levels of support and resistance from the previous day as well as the current day, to identify potential trading ranges and levels we're likely to test.
If you were to watch me trade, you'd see me continuously shifting from one window/screen to another, monitoring these variables. At some point a pattern becomes clear and I get an idea of shifting demand/supply that will lead us to test a particular market level. That becomes the basis for a trade idea, particularly if it is in line with my prior research. I average 2 trades per day, mostly in the AM, and averaging 20 minutes in holding time.
Monday, January 8th, 2007: The main thing to take away from the AM trading session is the importance of flexible thinking. We started off with some research that suggested we were likely to take out the Friday lows. As the selling progressed early in the morning, however, it was apparent that many sectors were not participating. That suggested that it would be a mistake to chase those lows and, indeed, made sense to watch for reversals. Perhaps the most important mental shift was from "downtrend" thinking to "rangebound" thinking, with the AM lows and the 1420 resistance area forming the range. Having that range in mind enabled me to get on board to the long side when heavy selling could not bring us to new daily lows, but the range also alerted me to be aggressive in taking profits when the buying ran into a wall of sellers.
Tuesday, January 9th, 2007: That's a good lesson for the day: when you see the TICK hitting negative values, but the index can't make new price lows, it's generally an early sign that sellers can't move the market any further: that buyers are finding value at those levels. That doesn't necessarily mean that buyers will enter the market in force, but it's usually a good bet that you'll get enough buying to move the index back toward a prior high for a short term trade.
Monday, January 15th, 2007: It's not unusual to see a breakout move begin in one of the more volatile indices before strong buying shows up in the Dow or the S&P 500. I've found that helpful on occasions for timing. I also like to follow the DAX as a potential leader of the S&P 500 early in the AM. Most helpful of all is filtering the Market Delta charts so that they only post trades of a certain size or greater. You then can see how many large traders are in the market and whether they're predominantly buying or selling. That is *very* useful in handicapping the odds of reaching a pivot support or resistance level.
Tuesday, January 16th, 2007: Notice that measures such as TICK and volume at bid/offer tell us about supply and demand, but volume levels relative to average for the time of day tell us about volatility: how much movement we can expect from given supply or demand. Because we don't have strong buying or selling in the TICK (the Adjusted TICK is negative on the day, but not at extreme levels) and we don't have above average volume, I don't expect a large move on the day and, indeed, anticipate more of a rangebound market. The key is monitoring these variables in real time to identify as early as possible what type of market we're likely to be in and which price levels we're likely to hit.
Thursday, January 18th, 2007: I like to cement a lesson from each trading day. Perhaps the takeaway for today is that 85% of all days in ES are *not* inside days. That ratio is well over 90% when we have above avg volume. Once you know that, it's a matter of handicapping the odds of taking out either the prior day's high or low. Once we saw selling in those leading sectors and breaks to new lows, and once the TICK turned down and we got sellers hitting bids in size, we had a nice trade in ES toward Wednesday's lows and S2.
Friday, January 19th, 2007: The AM illustrated a few important things. First is the importance of flexibility. The odds of taking out yesterday's lows in ES were quite high, and that was my initial leaning. When selling dried up early in the AM with only a modestly negative TICK and not many stocks declining relative to advancers, I entertained the reverse hypothesis: that we were not getting selling and that leaning to the long side was the way to go. The second principle illustrated is the importance of patience. It was a choppy morning session, and it was easy to get scared out of a good position. But as long as the overall dynamics of supply and demand were not shifting, patience was indicated. Finally, you can see how a drying up of selling (today relative to yesterday) often precedes an influx of buying. That's a pattern that sets up intraday as well as on a swing basis.
Thursday, January 25th, 2007: Takeaway for today is this: transacting at the bid vs offer, which is what I'm tracking with the NYSE TICK, Dow TICK, Market Delta, etc, is a very short-term measure of trader sentiment. When we don't see buying sentiment following a nice up day, it makes sense to think about a transition to range bound trade and a reversion to the prior day's average prices. An absence of buyers (sellers) often precedes an influx of sellers (buyers), but it pays to wait for the latter, pick price levels, and take the high percentage trades.
Friday, January 26th, 2007: The lesson I want to stress for today's session is position sizing. We had huge odds of taking out yesterday's lows, creating a very favorable edge. Once selling started appearing in the market, you have to participate with all the size you can muster. You can lose money on 2 or 3 small trades, make money on one high odds trade with size, and wind up the day/week a solid winner. Your position size should reflect your confidence in the trade. Yesterday I mentioned putting small size on when you're feeling out a market. Today it was time to press the advantage. Those odds don't come along every day.
Tuesday, January 30th, 2007: In general, once you identify a candidate morning low, it makes sense to put in an initial position and use pullbacks in the TICK as opportunities to add to the position, as long as the TICK bursts take you to successive price highs. If you can't hit your price target and the buying sentiment (TICK, volume at offer) isn't moving you higher, then you have to entertain the hypothesis that you're in a trading range environment and take what you can from the market.
Wednesday, January 31st, 2007: As long as we can trade 15,000 contracts or so every five min in ES, there should be some movement for the short-term trader. It's when we get below 10K per five min period that things get deadly slow and I stop trading. I've found keeping those volume levels by my side to be helpful. Let's me know when it's worth playing, when it's not. The main thing is whether or not volume is above avg or not for that particular time of day. When well below avg, not worth trading.
Wednesday, December 6th, 2006: 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.
Wednesday, November 22nd, 2006: After each day of trading, I like to evaluate what I did right and wrong and use those to frame goals for the next session(s). What's clear to me from today is that I need to stick with my basic method of exiting positions: entering with enough size that I can take quick profits on one piece but let the other piece breathe and take advantage of a possibly longer move. I was too much in the mindset of "This is pre-holiday; just take what the market gives you". As a result, I didn't benefit as much from the patient, good entries as I should have. The point is to always be learning. Figure out what you do well and extend it. Adjust what you're not doing well. Today I did entries much better than exits.
Tuesday, December 19th, 2006: 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.
Sunday, February 04, 2007
Six Keys to Trading Success: Lessons From a Successful Trader
In my last post, I mentioned that a generous blog reader shared his intraday trading approach with me last week. His ideas seemed sound, so I suggested that he contact Henry Carstens, an experienced systems developer. Henry, I told him, could test his trading ideas and perhaps suggest improvements, while avoiding the problem of curve-fitting. The reader, trusting that Henry and I would not divulge the particulars of his method, patiently explained his setups with numerous examples. Within a matter of hours, Henry had backtested the ideas over the past five years of trading. What Henry's report revealed tells us quite a bit about what it takes to be successful as an intraday trader. My subsequent conversations with the trader revealed yet more. Here are six lessons from our experience with a successful short-term trader:
1) The successful trader is selective. The trader's approach took about 1300 trades in a five-year period, or about one a day. It spent more time out of the market than in the market. As a result, it did not rack up huge commission overhead. Instead, it only took very high percentage trades. Without any optimization whatsoever on Henry's part, the system had almost 80% of trades as winners. This selectivity makes for very high risk-adjusted returns. Most of the time, the trader's capital was not at risk. He only entered the market when he could make money consistently. He had clear ideas regarding execution that enabled him to get into the market at favorable prices, minimizing losses when the trade didn't work out and maximizing gains when he got the moves to his target.
2) The successful trader has made the approach his or her own. When I talked with the trader by phone, I sometimes had trouble following his thinking. He spoke quickly about hitting the red line or the brown line on his charts and casually mentioned important trading ranges and levels. It was clear that this way of trading had become part of him. The way he set up his charts is the way he thinks. No doubt this internalization helps him see when the market is acting normally and when it is not, enabling him to quickly act upon opportunity or threat. Only considerable experience, watching markets day after day and studying charts upon charts, makes it possible to internalize a method to that degree.
3) The successful trader has found a niche. The trader did not just send me one or two charts illustrating his method; he sent dozens. On the phone, when he talked about his approach, there was real enthusiasm in his voice. It was clear that this kind of trading had captured his interests, skills, and talents. That creates a virtuous cycle in which success leads to more excitement which leads to more learning, which creates further success. He didn't try to trade instruments or time frames for which his approach--and his skills--were not suited. He focused on his strengths.
4) The successful trader is creative. I think it's fair to say that his approach is a short-term trend-following method. His way of evaluating the market trend, however, is unique. He is definitely not just looking at the same old 14-period oscillator that comes pre-programmed in most charting applications. Similarly, he has clear stop points and price targets, but these are defined in a unique way, based upon the market conditions he's observing. This "out-of-the-box" thinking style is common to successful traders, I've found. They look at markets in unique ways that help them capture shifts in supply and demand.
5) The successful trader is always seeking improvement. If our trader is already successful, why does he need to talk with Henry? He knew that, by sharing his ideas, he would learn a great deal about the strengths and weaknesses of his trading. Sure enough, Henry found that the average size of the trader's losers was larger than it needed to be. A simple modification of stop-loss rules improved the system's performance meaningfully. Similarly, by putting a filter on the system--only taking trades if certain conditions were met--the average profit per trade went up significantly. That could aid position sizing. The trader knew he had something good, but good wasn't good enough. He wanted better.
6) The successful trader is persistent. One thing I want to stress: the trader's methods were very sound--and Henry found ways to make them better--but they were not perfect. Out of about sixty months analyzed, fourteen were losers. The drawdowns were not hellacious, but there were periods of flat performance and drawdown. What that means is that a successful trader needs to have the confidence to ride out these periods of poorer performance to get to the periods of success. That is one reason why it's so important to find a way of trading that you can make your own. You're more likely to stick with a method that fits with how you think (and that fits with your skills) than if it's something you've blindly copied from others. Our trader believes in his method, and that gives him the brass ones to hang in there during relatively lean periods.
Note that our trader is not a mechanical systems trader. What Henry did was test out his major ideas and identify their strengths and weaknesses if they were traded consistently, with discipline, as if they were a system. If you are a successful trader, this is a valuable exercise. It will break your trading into components and show you how each component is contributing to profitability. It very often shows how the components can be slightly modified to produce even better results. By looking under the hood, so to speak, and making a couple of adjustments, we can meaningfully improve upon our success. There are very few trading strategies that cannot be programmed and tested, including complex chart and indicator patterns. The results can be most enlightening.
1) The successful trader is selective. The trader's approach took about 1300 trades in a five-year period, or about one a day. It spent more time out of the market than in the market. As a result, it did not rack up huge commission overhead. Instead, it only took very high percentage trades. Without any optimization whatsoever on Henry's part, the system had almost 80% of trades as winners. This selectivity makes for very high risk-adjusted returns. Most of the time, the trader's capital was not at risk. He only entered the market when he could make money consistently. He had clear ideas regarding execution that enabled him to get into the market at favorable prices, minimizing losses when the trade didn't work out and maximizing gains when he got the moves to his target.
2) The successful trader has made the approach his or her own. When I talked with the trader by phone, I sometimes had trouble following his thinking. He spoke quickly about hitting the red line or the brown line on his charts and casually mentioned important trading ranges and levels. It was clear that this way of trading had become part of him. The way he set up his charts is the way he thinks. No doubt this internalization helps him see when the market is acting normally and when it is not, enabling him to quickly act upon opportunity or threat. Only considerable experience, watching markets day after day and studying charts upon charts, makes it possible to internalize a method to that degree.
3) The successful trader has found a niche. The trader did not just send me one or two charts illustrating his method; he sent dozens. On the phone, when he talked about his approach, there was real enthusiasm in his voice. It was clear that this kind of trading had captured his interests, skills, and talents. That creates a virtuous cycle in which success leads to more excitement which leads to more learning, which creates further success. He didn't try to trade instruments or time frames for which his approach--and his skills--were not suited. He focused on his strengths.
4) The successful trader is creative. I think it's fair to say that his approach is a short-term trend-following method. His way of evaluating the market trend, however, is unique. He is definitely not just looking at the same old 14-period oscillator that comes pre-programmed in most charting applications. Similarly, he has clear stop points and price targets, but these are defined in a unique way, based upon the market conditions he's observing. This "out-of-the-box" thinking style is common to successful traders, I've found. They look at markets in unique ways that help them capture shifts in supply and demand.
5) The successful trader is always seeking improvement. If our trader is already successful, why does he need to talk with Henry? He knew that, by sharing his ideas, he would learn a great deal about the strengths and weaknesses of his trading. Sure enough, Henry found that the average size of the trader's losers was larger than it needed to be. A simple modification of stop-loss rules improved the system's performance meaningfully. Similarly, by putting a filter on the system--only taking trades if certain conditions were met--the average profit per trade went up significantly. That could aid position sizing. The trader knew he had something good, but good wasn't good enough. He wanted better.
6) The successful trader is persistent. One thing I want to stress: the trader's methods were very sound--and Henry found ways to make them better--but they were not perfect. Out of about sixty months analyzed, fourteen were losers. The drawdowns were not hellacious, but there were periods of flat performance and drawdown. What that means is that a successful trader needs to have the confidence to ride out these periods of poorer performance to get to the periods of success. That is one reason why it's so important to find a way of trading that you can make your own. You're more likely to stick with a method that fits with how you think (and that fits with your skills) than if it's something you've blindly copied from others. Our trader believes in his method, and that gives him the brass ones to hang in there during relatively lean periods.
Note that our trader is not a mechanical systems trader. What Henry did was test out his major ideas and identify their strengths and weaknesses if they were traded consistently, with discipline, as if they were a system. If you are a successful trader, this is a valuable exercise. It will break your trading into components and show you how each component is contributing to profitability. It very often shows how the components can be slightly modified to produce even better results. By looking under the hood, so to speak, and making a couple of adjustments, we can meaningfully improve upon our success. There are very few trading strategies that cannot be programmed and tested, including complex chart and indicator patterns. The results can be most enlightening.
Saturday, February 03, 2007
How Large An Edge Do You Need to Succeed at Daytrading?
In past posts, I have tried to capture what separates market pros from the less successful traders. I've also stressed the importance of tracking the market pros in short-term trading. There are many factors that contribute to trading success. Some of those are psychological; others relate to skills and talents and how those match up with the markets we trade. This means that, to become a trading professional ourselves, we inevitably wind up working on both ourselves and on the markets we trade.
But how much of an edge does a professional trader need for success? Allow me to relate an incident from this past week that nicely illustrates an answer to this question.
Not infrequently, traders will write to me and share their trading ideas and methods. Over the years, I've learned quite a bit from these interactions; they've been personally rewarding and often helpful to my trading. This past week, a gentleman who had been following my morning market comments on the blog shared his trading methods with me, indicating that he thought they would aid my timing. My initial impression of his methods were that they were sound. While I cannot share the specifics of his approach, suffice it to say that it can be described as a short-term trend following methodology with unique ways of defining both entries and price targets.
He shared with me specific examples of his setups and I could see that his trading was highly structured. I mentioned to him that he might want to actually backtest his ideas and integrate them into a formal trading system. Toward that end, I referred him to someone I consider to be a wizard at developing and testing trading ideas: Henry Carstens. Mr. Carstens is a successful trader in his own right and has many years of experience testing out systems in different time frames and markets. He is also a professional of consummate integrity and would never rip off people's ideas or develop a curve-fit system and pawn it off as a viable trading strategy.
Literally within hours, Henry coded the trading ideas and tested them over the past five years of market data. The system was profitable every single year. Incredibly, close to 80% of the trades were profitable--and that was with no optimization whatsoever. But what was the edge? Henry reported that, after slippage and commission were properly factored in, the system had an edge of one tick.
That's it.
The trader who corresponded with me was a bit disappointed. That doesn't sound like much of an edge, he said. Henry and I begged to differ. Here's why.
An intraday trading strategy generates a fair amount of overhead in commissions and slippage. If you wind up buying the market's offer price and selling the bid, you lose a tick right there. At a retail commission of, say, five dollars per contract per round turn, you generate annual commissions of roughly $1250 per contract just trading once per day.
Let's say, for argument sake, that you have a $100,000 portfolio and that you'll trade 10 lots once per day in the ES futures. If you lose a tick per trade on execution/slippage, you'll be down ($12.50 * 10 contracts * 5 days per week * 50 weeks per year) = $31,250 per year. At the aforementioned commission rate, you'll be down $12,500 per year. So right off the bat, you're in the hole by over 40% of your initial portfolio value. And that is *before* we consider other trading overhead, such as expenses for computers, software, online connections, redundant systems, etc.
Given this reality, you can see why my definition of a competent trader is one who is consistently able to cover his or her costs. To cover one's trading overhead actually requires a high degree of profitability, and most traders can't do that.
[Please note how rarely the trading industry acknowledges this basic economic reality and ask yourself why.]
So when Henry said to our trader that his system averaged a tick of profit after slippage and commissions, he was saying that--without any tweaking whatsoever--your ideas are more than competent. Indeed, if we use the example of the $100,000 portfolio that trades 10 lots in the ES market, that system would return $31,250 per year, or about 30% annually. On a year in and year out basis, the world's best hedge fund managers would be proud of such a return on capital.
But now suppose that our trader decides to ramp up his trading and access the greater size and lower commissions afforded by a proprietary trading firm. With round-turn commissions per contract of well under half a dollar, it suddenly becomes feasible to trade hundreds of contracts per position. Even with the fees and 50/50 profit split that is common at many prop firms, our trader with a one tick edge trading 200 contracts per position will have a very respectable six-figure annual income.
And if you consider a manager at a hedge fund handling a portfolio worth $500 million, you can just imagine the returns that a single tick of net profit per transaction would bring. It's not the size of the edge, but the frequency with which the edge can be exploited--and the size with which it can be exploited--that makes the trader a living. Most of the pros that I've personally known and worked with *don't* have a huge edge in absolute terms. But they have an edge that they can exploit frequently and with size.
I hope this helps to explain why undercapitalization is probably the greatest barrier to success in trading. If, say, our trader begins with a portfolio of $20,000 and trades two lots rather than tens, that same sound trading methodology would yield profits of a little over $6000 a year. That's actually a very respectable performance in percentile terms, but it will hardly make anyone a living.
To hope to make a living from a $20,000 portfolio, the trader in our example either has to have a huge edge after all costs or has to trade with maximum leverage and frequency to exploit a smaller edge. That is simply asking too much of any trader. No one sustains that kind of edge with regularity year after year--not even the top portfolio managers--and no one ultimately can survive the lack of risk management that results from trading maximum size with maximum frequency.
When traders are undercapitalized, they have to swing for the fences, and that's generally what kills them. As with most businesses, you need a certain amount of capital to invest in your trading to make a living from it. Even our trader with a $100,000 portfolio is not going to sustain a family on the income from a very sound trading methodology.
So what kind of an edge do you need to succeed at daytrading? Like a gambling casino, you don't need a large edge. You just need to replicate that edge with enough money and enough frequency to add up. That requires sound trading ideas and a sound capacity for executing them. In my next post, I will outline several features of the trader's successful system that should be part of every trading pro's playbook, whether they trade mechanical systems or discretionary ideas.
My thanks to the trader who corresponded with me and to Henry Carstens for contributing to the ideas in these posts.
But how much of an edge does a professional trader need for success? Allow me to relate an incident from this past week that nicely illustrates an answer to this question.
Not infrequently, traders will write to me and share their trading ideas and methods. Over the years, I've learned quite a bit from these interactions; they've been personally rewarding and often helpful to my trading. This past week, a gentleman who had been following my morning market comments on the blog shared his trading methods with me, indicating that he thought they would aid my timing. My initial impression of his methods were that they were sound. While I cannot share the specifics of his approach, suffice it to say that it can be described as a short-term trend following methodology with unique ways of defining both entries and price targets.
He shared with me specific examples of his setups and I could see that his trading was highly structured. I mentioned to him that he might want to actually backtest his ideas and integrate them into a formal trading system. Toward that end, I referred him to someone I consider to be a wizard at developing and testing trading ideas: Henry Carstens. Mr. Carstens is a successful trader in his own right and has many years of experience testing out systems in different time frames and markets. He is also a professional of consummate integrity and would never rip off people's ideas or develop a curve-fit system and pawn it off as a viable trading strategy.
Literally within hours, Henry coded the trading ideas and tested them over the past five years of market data. The system was profitable every single year. Incredibly, close to 80% of the trades were profitable--and that was with no optimization whatsoever. But what was the edge? Henry reported that, after slippage and commission were properly factored in, the system had an edge of one tick.
That's it.
The trader who corresponded with me was a bit disappointed. That doesn't sound like much of an edge, he said. Henry and I begged to differ. Here's why.
An intraday trading strategy generates a fair amount of overhead in commissions and slippage. If you wind up buying the market's offer price and selling the bid, you lose a tick right there. At a retail commission of, say, five dollars per contract per round turn, you generate annual commissions of roughly $1250 per contract just trading once per day.
Let's say, for argument sake, that you have a $100,000 portfolio and that you'll trade 10 lots once per day in the ES futures. If you lose a tick per trade on execution/slippage, you'll be down ($12.50 * 10 contracts * 5 days per week * 50 weeks per year) = $31,250 per year. At the aforementioned commission rate, you'll be down $12,500 per year. So right off the bat, you're in the hole by over 40% of your initial portfolio value. And that is *before* we consider other trading overhead, such as expenses for computers, software, online connections, redundant systems, etc.
Given this reality, you can see why my definition of a competent trader is one who is consistently able to cover his or her costs. To cover one's trading overhead actually requires a high degree of profitability, and most traders can't do that.
[Please note how rarely the trading industry acknowledges this basic economic reality and ask yourself why.]
So when Henry said to our trader that his system averaged a tick of profit after slippage and commissions, he was saying that--without any tweaking whatsoever--your ideas are more than competent. Indeed, if we use the example of the $100,000 portfolio that trades 10 lots in the ES market, that system would return $31,250 per year, or about 30% annually. On a year in and year out basis, the world's best hedge fund managers would be proud of such a return on capital.
But now suppose that our trader decides to ramp up his trading and access the greater size and lower commissions afforded by a proprietary trading firm. With round-turn commissions per contract of well under half a dollar, it suddenly becomes feasible to trade hundreds of contracts per position. Even with the fees and 50/50 profit split that is common at many prop firms, our trader with a one tick edge trading 200 contracts per position will have a very respectable six-figure annual income.
And if you consider a manager at a hedge fund handling a portfolio worth $500 million, you can just imagine the returns that a single tick of net profit per transaction would bring. It's not the size of the edge, but the frequency with which the edge can be exploited--and the size with which it can be exploited--that makes the trader a living. Most of the pros that I've personally known and worked with *don't* have a huge edge in absolute terms. But they have an edge that they can exploit frequently and with size.
I hope this helps to explain why undercapitalization is probably the greatest barrier to success in trading. If, say, our trader begins with a portfolio of $20,000 and trades two lots rather than tens, that same sound trading methodology would yield profits of a little over $6000 a year. That's actually a very respectable performance in percentile terms, but it will hardly make anyone a living.
To hope to make a living from a $20,000 portfolio, the trader in our example either has to have a huge edge after all costs or has to trade with maximum leverage and frequency to exploit a smaller edge. That is simply asking too much of any trader. No one sustains that kind of edge with regularity year after year--not even the top portfolio managers--and no one ultimately can survive the lack of risk management that results from trading maximum size with maximum frequency.
When traders are undercapitalized, they have to swing for the fences, and that's generally what kills them. As with most businesses, you need a certain amount of capital to invest in your trading to make a living from it. Even our trader with a $100,000 portfolio is not going to sustain a family on the income from a very sound trading methodology.
So what kind of an edge do you need to succeed at daytrading? Like a gambling casino, you don't need a large edge. You just need to replicate that edge with enough money and enough frequency to add up. That requires sound trading ideas and a sound capacity for executing them. In my next post, I will outline several features of the trader's successful system that should be part of every trading pro's playbook, whether they trade mechanical systems or discretionary ideas.
My thanks to the trader who corresponded with me and to Henry Carstens for contributing to the ideas in these posts.
Friday, February 02, 2007
Friday, February 2nd, 2007 Morning Comments
9:59 AM - OK, we continue to appear in range bound mode, with trade slowing down a bit from the earlier, busier pace. One last point I want to emphasize is position sizing. I had a full size initial position on the first trade; half size on the second. I knew, shorting the market the second time, that we had just had a good runup on solid volume. While my overall idea of being in a range and moving to the AM midpoint worked out in ER2, the ES contract just wasn't feelin' it. When buying volume at a key price level turned higher than it had been several minutes earlier, I got out. Never fun to take a loss, but a limited loss on a small position doesn't put you in a hole. I've known a fair number of successful traders and one common feature is their ability to press the market when they're confident of their edge in a trade. But the flip side is their ability to *not* press it when they're just feeling a market out. Had the second trade gone my way, I would have had time to add to it and make it a nice winner. By entering with smaller size and not pressing it, I preserved my day's profitability. It's all about execution and sound fundamentals. That may be less sexy than finding that perfect setup, but day in and day out it's what making money is about. Have a great rest of your day; update tonite on the Weblog.
9:44 AM - Note the TICK and ER2 weakness. I continue to believe we're seeing a short term topping/trading range formation in the making.
9:42 AM - Basically on a short-term trade, I'll take my loss on a short trade if I see volume lifting offers above the point where previous buying had terminated, esp if it's buying from large traders. That tells me it's fresh market interest and I get out. The idea is to have ticks of losses and points of profits.
9:37 AM - Out of the market; small loss on that one. ER2 looking a bit heavy.
9:30 AM - Looking to see if we get a downward shift in the TICK distribution. Small short on the TICK bounce.
9:16 AM - Solid buying once again, with the TICK showing a distinct positive bias once again. It's back to that theme from yesterday: strong upside markets typically lead to trading ranges, not to sharp bear markets. We're getting good back and forth right now that may be part of such a building of a range. If so, the profitable strategy is to identify the midpoint of the prospective range and fade moves away from that. That's just a hypothesis at this point, but I'm flirting will a small short here for a return to the middle of the AM range.
9:06 AM - I try to trade with an "anti-confirmatory bias". What that means is that I keep myself alert to everything that *doesn't* fit with my trade idea. And the strength in semiconductors and DAX didn't fit. That was another reason I was quick to take profits. Now we see that those indices continue strong and the market overall has bounced decently. If you're going to get a washout or a big upside rally, all sectors will be in gear. If they're not in gear, it pays to take profits at the first target. Another one of those execution lessons.
9:01 AM - I usually will take something off the table when I hit the first price target. Nice to have cash in the bank. In this case, I may reenter quickly if buyers can't get this thing going.
8:59 AM - Hit pivot target. Out for now.
8:54 AM - Semiconductors strong, also DAX.
8:50 AM - My position is predicated on the hypothesis that we've put in a high for the day with that preopening runup. So I add to shorts on TICK bounces as long as TICK declines take us to price lows.
8:42 AM - Short some ES here; tight stop.
8:38 AM - Volume is high, lots of institutional participation. Great sell right out of the gate with ER2 weaker than ES and consistent volume hitting bid.
8:24 AM CT - Good morning! Two articles to start out the day; the first looks at what happens after consistent market strength; the second teaches a little lesson about trade execution. Pivots are posted on the Weblog. We got the pop on the jobs numbers, but note that the dollar has regained strength vs. the Euro and interest rates have moved off their lows. Net, net: I'm not sure the new data is truly leading to a repricing of currencies and fixed income, and that leads me to doubt if it will power a trend in stocks. Indeed, the indices have come off their lows. Trading below the preopening lows would suggest fresh selling and would take me out of any long bias. Back after the open!
9:44 AM - Note the TICK and ER2 weakness. I continue to believe we're seeing a short term topping/trading range formation in the making.
9:42 AM - Basically on a short-term trade, I'll take my loss on a short trade if I see volume lifting offers above the point where previous buying had terminated, esp if it's buying from large traders. That tells me it's fresh market interest and I get out. The idea is to have ticks of losses and points of profits.
9:37 AM - Out of the market; small loss on that one. ER2 looking a bit heavy.
9:30 AM - Looking to see if we get a downward shift in the TICK distribution. Small short on the TICK bounce.
9:16 AM - Solid buying once again, with the TICK showing a distinct positive bias once again. It's back to that theme from yesterday: strong upside markets typically lead to trading ranges, not to sharp bear markets. We're getting good back and forth right now that may be part of such a building of a range. If so, the profitable strategy is to identify the midpoint of the prospective range and fade moves away from that. That's just a hypothesis at this point, but I'm flirting will a small short here for a return to the middle of the AM range.
9:06 AM - I try to trade with an "anti-confirmatory bias". What that means is that I keep myself alert to everything that *doesn't* fit with my trade idea. And the strength in semiconductors and DAX didn't fit. That was another reason I was quick to take profits. Now we see that those indices continue strong and the market overall has bounced decently. If you're going to get a washout or a big upside rally, all sectors will be in gear. If they're not in gear, it pays to take profits at the first target. Another one of those execution lessons.
9:01 AM - I usually will take something off the table when I hit the first price target. Nice to have cash in the bank. In this case, I may reenter quickly if buyers can't get this thing going.
8:59 AM - Hit pivot target. Out for now.
8:54 AM - Semiconductors strong, also DAX.
8:50 AM - My position is predicated on the hypothesis that we've put in a high for the day with that preopening runup. So I add to shorts on TICK bounces as long as TICK declines take us to price lows.
8:42 AM - Short some ES here; tight stop.
8:38 AM - Volume is high, lots of institutional participation. Great sell right out of the gate with ER2 weaker than ES and consistent volume hitting bid.
8:24 AM CT - Good morning! Two articles to start out the day; the first looks at what happens after consistent market strength; the second teaches a little lesson about trade execution. Pivots are posted on the Weblog. We got the pop on the jobs numbers, but note that the dollar has regained strength vs. the Euro and interest rates have moved off their lows. Net, net: I'm not sure the new data is truly leading to a repricing of currencies and fixed income, and that leads me to doubt if it will power a trend in stocks. Indeed, the indices have come off their lows. Trading below the preopening lows would suggest fresh selling and would take me out of any long bias. Back after the open!
Three Qualities of Good Trade Execution
Here's a look back to my Market Delta chart for the short trade that I placed on Thursday morning. The market had moved steadily higher in the early morning and then steadied ahead of the release of the ISM report. When the report was released, we saw sellers come into the market with size. This shows up in the Market Delta chart as a red color within the bars. Red occurs whenever the first number within the bar (the number of contracts transacted when that price is the market bid) is greater than the second number (the number of contracts transacted when that price is the market offer). After a bounce in which buying did not attract significant volume relative to the volume during the decline, this offered a fine opportunity to go with the flow of the sellers. Shortly after, fresh sellers hit the market again with size. A more meaningful bounce then occurred, followed by two more bouts of selling that could not push price lower and that occurred on lower volume. This was my signal to cover the short position.The trade illustrates three qualities of good trade execution:
1) It exploits immediate market conditions - Buyers had been bidding the market higher. Any good news from ISM was priced into the market. Once sellers hit the market, the short-term momentum shifted to the sellers. This led to a situation in which many participants who were long the market would exit their positions. The trade, catching the shift early, was able to exploit this disgorging of positions. Many of the best intraday trades are ones in which you catch a shift in buying or selling interest and can front run longs or shorts getting out of their positions.
2) It limits risk by having a clear stop loss point - The ideal stop point is that point that tells you your idea was wrong. If we had suddenly gotten a spurt of volume lifting offers (green color on the Market Delta chart) shortly after the sellers hit the market--or certainly if we made a new price high after the ISM release--my idea would have been invalidated. Once you see selling dominate, the bars should stay red. Otherwise, the volume flow is not in your direction and you do your best to limit losses. You want your entry to be as close to the point that would prove you wrong as possible, so that your risk:reward ratio is always far better than 1:1.
3) It holds onto profits by having a clear set of exit conditions - My initial price target was the low of the overnight range at 1442.5. I also, however, exit trades if, over a period of 10-15 minutes, I do not see volume continuing to expand in the direction of the trade. (I often think of this as a "three strikes and you're out" rule in Market Delta. If three consecutive bars can't push the volume flow and price my way, I get out). I knew that the overall market trend was not down, so I did not hold out for my price target. I let the market tell me where buying and selling were expanding and drying up and took what the market gave me on that trade.
Of course, much more goes into a good trade than execution. I'll tackle that in another post. The important takeaway here is that good execution can minimize losses on wrong ideas and maximize the potential of good trade ideas. Much of a trader's profitability comes, not from the setup ideas, but from their proper execution.
Four Consecutive Days of Strength: What Comes Next?
Each day on the Trading Psychology Weblog, I track the number of stocks making fresh 20-day highs and lows. This provides a general sense of whether market moves are gaining or losing participation from the broad list of stocks. Recently, we have had four consecutive days of rising new highs, culminating in 1966 new 20-day highs on Thursday. What has happened in the market after we've seen four such days of strength? Do we see a pullback, or does upside momentum carry forward?
Going back to 2004 (N = 772 days), I found 48 occasions in which 20-day new highs rose for four consecutive trading sessions. The next day, the S&P 500 Index (SPY) was up by an average of .21% (32 up, 16 down). That is considerably stronger than the average one-day gain for the entire sample of .03% (417 up, 355 down). It thus appears that, in the short run, strength begets strength.
I then examined a subset of the strong four-day periods in which new highs on the fourth day numbered 1500 or greater (N = 17). The next day in SPY averaged a gain of .09% (12 up, 5 down). Again, there tends to be some upside follow through after a surge in new highs.
When we look over a five-day horizon, however, a different picture emerges. Following four consecutive days of rising new highs (N = 48), SPY averages a subsequent five-day gain of only .11% (24 up, 24 down). That is certainly no better than the average five-day performance for the entire sample of .17% (440 up, 332 down). Indeed, when the four-day surge has resulted in more than 1500 new highs (N = 17), the next five days in SPY have averaged a loss of -.40% (4 up, 13 down).
What this suggests is that market surges tend to carry over into the next day of strength, but do not on average lead to outperformance over the subsequent week. Indeed, there seems to be a tendency for very strong markets to take a breather and digest their gains over the subsequent five days of trading. This pattern will provide some overall context for my day-to-day trading ideas.
Going back to 2004 (N = 772 days), I found 48 occasions in which 20-day new highs rose for four consecutive trading sessions. The next day, the S&P 500 Index (SPY) was up by an average of .21% (32 up, 16 down). That is considerably stronger than the average one-day gain for the entire sample of .03% (417 up, 355 down). It thus appears that, in the short run, strength begets strength.
I then examined a subset of the strong four-day periods in which new highs on the fourth day numbered 1500 or greater (N = 17). The next day in SPY averaged a gain of .09% (12 up, 5 down). Again, there tends to be some upside follow through after a surge in new highs.
When we look over a five-day horizon, however, a different picture emerges. Following four consecutive days of rising new highs (N = 48), SPY averages a subsequent five-day gain of only .11% (24 up, 24 down). That is certainly no better than the average five-day performance for the entire sample of .17% (440 up, 332 down). Indeed, when the four-day surge has resulted in more than 1500 new highs (N = 17), the next five days in SPY have averaged a loss of -.40% (4 up, 13 down).
What this suggests is that market surges tend to carry over into the next day of strength, but do not on average lead to outperformance over the subsequent week. Indeed, there seems to be a tendency for very strong markets to take a breather and digest their gains over the subsequent five days of trading. This pattern will provide some overall context for my day-to-day trading ideas.
Thursday, February 01, 2007
Thursday, February 1st Morning Comments
10:03 AM - OK, no more calls, no more emails. I'm starting to feel like that guy in the Timekiller video. Anyway, what we're looking for in short term trading are shifts from demand to supply, from buyers to sellers, and vice versa. When ISM came out, I noticed very large traders hitting bids, which I interpreted as getting out of their positions, given that large traders earlier had been lifting offers aggressively. I then waited for the first bounce in buying (NYSE TICK, attempts to lift offers) to show me that the buyers couldn't get price back above the highs and I aggressively shorted the market. At that point, one of the things that keeps me in the trade is if I see a continued dominance of volume at the bid vs. offer, especially among the large traders. That is easy to track in Market Delta (which I have to credit for this AM's trade), because as long as the bars stay red, you stay short. When you get hitting of bids and negative TICK that can't push the market to new lows, that becomes a short-term opportunity to take some profits. In that sense, in a short time frame, you become a trend follower, where large traders create the trend.
I continue to think we're putting in a range, esp. given relative weakness in NQ and ER2 recently. Short-term the bounces in TICK have given us some selling opportunities, but we've yet to see extreme selling in TICK. Have a great morning! Update tonite on the Weblog.
9:49 AM - As I noted in the Weblog, this is a common pattern, in which we get a momentum peak, then sell off, and begin the process of finding a trading range. I believe that's what's going on now. More in a bit to explain my trade. I've been handling phone calls and emails galore this AM, trading, and doing the blog. Talk about multitasking!
9:33 AM - Took some profits here. I'll explain a few things in a min.
9:20 AM - I continue to watch to see if we start getting lower price highs on TICK bounces and lower price lows on TICK declines, as well as a downward shift in the TICK distribution. Selling in ER2 and volume at bid in ES keep me short.
9:08 am - The selling in ES on the release showed some heavy volume; some large participants were taking profits. I'm watching to see if that dynamic continues and if we start to roll over to a more negative TICK distribution. I continue to lean short as long as we see more volume at bid than offer in ES.
9:05 am - Another drop in the dollar on ISM release, but stocks fell, rebounded, now looking somewhat tired. I'll lean short in ES if we cannot stay above prev. day's highs.
8:53 AM - Notice DAX continues to new highs.
8:50 AM - We continue to see solid buying in the TICK and solid volume at the offer vs. bid in ES, with ER2 especially strong. It's in these kind of situations that you don't want to buck the trend. Let's see how we respond to ISM shortly.
8:40 AM - Nice follow through strength in ER2 has taken us above the Wed. highs, and we see advancing stocks well ahead of decliners with very positive TICK. Upside target is R1; NQ a bit heavy here; watching carefully to see if we stay above overnite high in ES.
8:05 AM CT - Good morning. I'll be fielding some calls from traders this AM and working on some research, so my comments (and my trading) may be lighter than usual. We had economic numbers come pretty much in line this AM, with initial unemployment claims a little below consensus. Bottom line is that bonds continue to rally, and the interest rate on the 10-year note is now down to under 4.8%. (Early yesterday we were briefly above 4.9%). See my most recent post re: short-term moves in rates and stocks. The dollar, so far however, is not falling meaningfully further relative to the Euro. Note that we have the important ISM number at 9:00 AM CT, with expectations for continued firmness. We've already taken out Wednesday's highs in pre-opening trade in ES and NQ. Note how we are at very long-term resistance in ER2, but also at highs in ES that go back to mid-December. I would expect that taking out these highs, at least in the short run, would produce a spate of buying from breakout traders. So while my research suggests modest returns in the near term following a rate drop, I am watching those levels closely. Price levels for the day are on the Weblog; I'd expect a failure to hold the Wednesday highs to lead to a test of the Wednesday pivot. Back after the open.
I continue to think we're putting in a range, esp. given relative weakness in NQ and ER2 recently. Short-term the bounces in TICK have given us some selling opportunities, but we've yet to see extreme selling in TICK. Have a great morning! Update tonite on the Weblog.
9:49 AM - As I noted in the Weblog, this is a common pattern, in which we get a momentum peak, then sell off, and begin the process of finding a trading range. I believe that's what's going on now. More in a bit to explain my trade. I've been handling phone calls and emails galore this AM, trading, and doing the blog. Talk about multitasking!
9:33 AM - Took some profits here. I'll explain a few things in a min.
9:20 AM - I continue to watch to see if we start getting lower price highs on TICK bounces and lower price lows on TICK declines, as well as a downward shift in the TICK distribution. Selling in ER2 and volume at bid in ES keep me short.
9:08 am - The selling in ES on the release showed some heavy volume; some large participants were taking profits. I'm watching to see if that dynamic continues and if we start to roll over to a more negative TICK distribution. I continue to lean short as long as we see more volume at bid than offer in ES.
9:05 am - Another drop in the dollar on ISM release, but stocks fell, rebounded, now looking somewhat tired. I'll lean short in ES if we cannot stay above prev. day's highs.
8:53 AM - Notice DAX continues to new highs.
8:50 AM - We continue to see solid buying in the TICK and solid volume at the offer vs. bid in ES, with ER2 especially strong. It's in these kind of situations that you don't want to buck the trend. Let's see how we respond to ISM shortly.
8:40 AM - Nice follow through strength in ER2 has taken us above the Wed. highs, and we see advancing stocks well ahead of decliners with very positive TICK. Upside target is R1; NQ a bit heavy here; watching carefully to see if we stay above overnite high in ES.
8:05 AM CT - Good morning. I'll be fielding some calls from traders this AM and working on some research, so my comments (and my trading) may be lighter than usual. We had economic numbers come pretty much in line this AM, with initial unemployment claims a little below consensus. Bottom line is that bonds continue to rally, and the interest rate on the 10-year note is now down to under 4.8%. (Early yesterday we were briefly above 4.9%). See my most recent post re: short-term moves in rates and stocks. The dollar, so far however, is not falling meaningfully further relative to the Euro. Note that we have the important ISM number at 9:00 AM CT, with expectations for continued firmness. We've already taken out Wednesday's highs in pre-opening trade in ES and NQ. Note how we are at very long-term resistance in ER2, but also at highs in ES that go back to mid-December. I would expect that taking out these highs, at least in the short run, would produce a spate of buying from breakout traders. So while my research suggests modest returns in the near term following a rate drop, I am watching those levels closely. Price levels for the day are on the Weblog; I'd expect a failure to hold the Wednesday highs to lead to a test of the Wednesday pivot. Back after the open.
When Interest Rates Drop, Do Traders Become Interested In Stocks?
On the heels of the Fed announcement, we had a sharp rally in fixed income, sending interest rates on the 10-year note to a five-day closing low. Stocks also rallied on the announcement, suggesting that traders were greeting the moderate inflation scenario. But what happens going forward after sharp one-day drops in rates? Does that stoke further interest in stocks over the near term?
Going back to 2004 (N = 770 trading days), I found 124 occasions in which yields on the 10-year note declined by 1% or more in a single trading session (as was the case on Wednesday). Interestingly, two days later, the S&P 500 Index (SPY) was down by an average of -.02% (58 up, 66 down). That is certainly no bullish edge. By contrast, the remainder of the sample averages a two-day gain of .09% (352 up, 295 down). A one-day drop in rates does not appear to be bullish for stocks in the short run.
I then decided to divide the big interest rate drop days based upon the S&P 500 Index performance that day. Specifically, I wanted to see if returns were better following occasions in which stocks rallied on the interest rate drop vs. occasions when stocks dropped during the rate decline.
When rates dropped more than 1% in a day and stocks gained on the day (as was the case Wednesday; N = 63), the next two days in SPY averaged a loss of -.17% (25 up, 38 down). Conversely, when stocks fell on the rate drop (N = 61), the next two days in SPY averaged a gain of .13% (33 up, 28 down). In short, it appears that stocks might overreact to large interest rate moves in the short run. When stocks like falling rates (perhaps suggesting moderate inflation and possible Fed easing), they perform subnormally over the next two days. When stocks don't like falling rates (perhaps out of a concern re: economic weakness), they perform more normally.
My last look at the data compared days in which we made a five-day closing low in interest rates with all other days. When the rate on the ten-year note was at a five-day low (N = 214), the next two days in SPY averaged a loss of -.07% (102 up, 112 down). By comparison, the remainder of the sample averaged a two-day gain of .12% (307 up, 249 down). Once again, the falling rates, on a short term basis, are not associated with a bullish edge in the equities and, in fact, have led to a slight underperformance.
Note that over longer time frames--several weeks--I found that, across the rate spectrum, falling rates have been positive for stocks and rising rates in the 10 year note have led to subnormal returns. See also my analysis of stock returns and yields following Fed days for relevant data concerning near-term returns. Earlier in April, I noted that short-term market returns were not superior following short-term declines in rates. Since that time, the pattern has not changed. Of the 17 occasions since then in which we've had a large rate drop and a five-day low in 10-year yields, 8 have led to gains two days later and 9 have been followed by losses for an average loss in SPY of -.04%.
Perhaps the most important conclusion is that you can't generalize longer-term intermarket relationships to the market's short-term performance. While long-term falling rates are positive for stocks over the long run, the same relationship does not exist over short time horizons.
Going back to 2004 (N = 770 trading days), I found 124 occasions in which yields on the 10-year note declined by 1% or more in a single trading session (as was the case on Wednesday). Interestingly, two days later, the S&P 500 Index (SPY) was down by an average of -.02% (58 up, 66 down). That is certainly no bullish edge. By contrast, the remainder of the sample averages a two-day gain of .09% (352 up, 295 down). A one-day drop in rates does not appear to be bullish for stocks in the short run.
I then decided to divide the big interest rate drop days based upon the S&P 500 Index performance that day. Specifically, I wanted to see if returns were better following occasions in which stocks rallied on the interest rate drop vs. occasions when stocks dropped during the rate decline.
When rates dropped more than 1% in a day and stocks gained on the day (as was the case Wednesday; N = 63), the next two days in SPY averaged a loss of -.17% (25 up, 38 down). Conversely, when stocks fell on the rate drop (N = 61), the next two days in SPY averaged a gain of .13% (33 up, 28 down). In short, it appears that stocks might overreact to large interest rate moves in the short run. When stocks like falling rates (perhaps suggesting moderate inflation and possible Fed easing), they perform subnormally over the next two days. When stocks don't like falling rates (perhaps out of a concern re: economic weakness), they perform more normally.
My last look at the data compared days in which we made a five-day closing low in interest rates with all other days. When the rate on the ten-year note was at a five-day low (N = 214), the next two days in SPY averaged a loss of -.07% (102 up, 112 down). By comparison, the remainder of the sample averaged a two-day gain of .12% (307 up, 249 down). Once again, the falling rates, on a short term basis, are not associated with a bullish edge in the equities and, in fact, have led to a slight underperformance.
Note that over longer time frames--several weeks--I found that, across the rate spectrum, falling rates have been positive for stocks and rising rates in the 10 year note have led to subnormal returns. See also my analysis of stock returns and yields following Fed days for relevant data concerning near-term returns. Earlier in April, I noted that short-term market returns were not superior following short-term declines in rates. Since that time, the pattern has not changed. Of the 17 occasions since then in which we've had a large rate drop and a five-day low in 10-year yields, 8 have led to gains two days later and 9 have been followed by losses for an average loss in SPY of -.04%.
Perhaps the most important conclusion is that you can't generalize longer-term intermarket relationships to the market's short-term performance. While long-term falling rates are positive for stocks over the long run, the same relationship does not exist over short time horizons.
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