Thursday, May 31, 2007

When Yields Are High, Should We Buy?

We had an interesting situation on Thursday in which both the price of the S&P 500 Index (SPY) and the ten-year Treasury yield hit 40 day highs during the session. Rising rates have been the bane of many a bull market, but how have they affected prices recently?

I went back to 2004 (N = 819 trading days) and examined what happened in the S&P 500 Index following rising vs. falling 40-day periods in the 10-year yield. When the yield has been up over the past 40 days (N = 398), the next 40 days in SPY have averaged a gain of only .12% (206 up, 192 down).

When 40-day yields have fallen (N = 421), the next 40 days in SPY have averaged a healthy gain of 2.54% (326 up, 95 down).

What that tells us is that much of the rise of the recent bull market is associated with periods of falling yields. This, in addition to the tepid participation in the recent rise, is a reason I'm not chasing current highs in U.S. equities.

Market Notes and Observations for a Thursday

The headlines are noting the closing record highs in the Dow and S&P 500 Indices. Here are a few observations from my data:

* Short-Term New Highs/Lows Are Tepid - On Wednesday's record close, we had 851 fresh 20-day highs across the NYSE, NASDAQ, and ASE and 751 new 20-day lows. Hardly broad participation. I'm looking at the current action as a topping process unless we can see a broadening of the rally.

* Demand/Supply Is Also Mediocre - Demand (an index of the number of stocks across the three exchanges closing above the volatility envelopes surrounding their moving averages) was 85; Supply (index of issues closing below their volatility envelopes) was 64. This is actually a loss of momentum relative to the prior trading session.

* Even S&P New Highs Are Weak - Wednesday was a record close, but only 48 S&P 500 stocks made new 52-week highs. That's down from over 70 two weeks ago and almost 90 last month.

* The Dow is Getting Popular - I took a look at the top 25 dollar volume issues on Wednesday. DIA was number seven. Before the recent market rise, DIA only very occasionally hit 10,000,000 shares--and those occasions occurred during selloffs. We've now had five consecutive weeks above 10,000,000 shares in DIA, four of which have occurred during rising weeks.

* Energy is the Hot Sector - Of the top 25 dollar volume issues, six are energy related: XOM (#6); OIH (#10); XLE (#14); VLO (#20); COP (#23); and CVX (#24).

* Emerging Markets Have Already Emerged - I notice that EEM was #11 in dollar volume traded on Wednesday. On signs of waning money flows, I will happily short energy and emerging markets. The key is being patient and letting those dollar volume flows lead the way.

* New Readings - I've updated the Articles page on my personal site, with articles divided into trading techniques and trading psychology and also organized chronologically.

Wednesday, May 30, 2007

Trading Patterns: Identifying Transitional Structures

With this post I'll begin a series on trading patterns for short-term traders. I refer to today's pattern as a transitional structure; it is a common sequence that marks the shift from one trend to another.

Above (top chart) we see the five-minute ES futures for Tuesday, 5/29 and below (bottom chart) we have the corresponding chart of the NYSE TICK. This particular transitional structure is one from a declining market to a rising one. In future posts, I'll display transitions from rising markets to falling ones.

The pattern begins with a very high volume decline on very negative NYSE TICK. If you're also tracking intraday new highs/lows among a basket of stocks or ETFs, this is frequently the point at which a maximum number of issues make concurrent new short-term lows. We can see that this high volume decline occurred a little after 12:00 Noon CT. This is the momentum low for the market. Whenever you see a major elevation of volume and a selloff across a broad range of stocks, you want to consider the possibility that a momentum low is being put into place.

After the momentum low, we typically get a decent bounce on strong NYSE TICK readings. This occurred around 13:00 CT. The solid TICK readings tell us that there is widespread buying interest across a broad range of stocks. That means that traders are finding some bargains at the lower prices and are accumulating shares. If the bounce occurs on weaker TICK readings (below +500, for example), it is much more likely that the rally is mere short covering. That often suggests that the market needs to go still lower to find that bargain-hunting among traders and investors.

After this bounce, we typically get a test of the momentum lows; frequently we get new price lows as a result of this test. This test often occurs on very weak TICK readings. Note that, after 13:00, we saw a very weak NYSE TICK, but price could not make new lows. This is the inefficiency pattern I've described in previous posts. If broad selling sentiment can't push the ES lower, you want to consider the possibility that the decline is becoming exhausted.

Another characteristic of these tests of momentum lows is that they invariably occur on lower volume. Note how volume steadily dropped from the point of the momentum low to the NYSE TICK lows after 13:00. This is yet another indication of selling drying up: the big traders are no longer participating to the downside.

Once the market successfully completes its test, we typically get solid buying on strong NYSE TICK readings. Volume will typically expand on this buying--an excellent indication that buyers are taking control. By making this identification early, you can benefit from the short covering that typically follows a market turn.

These transitional structures occur over varying time frames; no two are identical. The basic dynamics of the momentum peak, the subsequent test, the inefficiency, the drying up of volume, and the subsequent increase of volume on the countertrend move are common to these structures. With practice you can see these patterns emerge and use them for excellent short-term directional trades.


The Structure of Market Reversals

Tracking the Large Trader

When Do I Get Out of a Trade?

Five Principles of Short-Term Trading

Tuesday, May 29, 2007

Update on the Trader Coaching Project

I recently announced a Trader Coaching project on my Trader Performance page and on this blog. The idea was to select a single trader to coach--free of charge--for a month and then post the ongoing process and results to the blog, so that readers could learn from the experience.

The response to the project has been overwhelming, and I thank everyone who has volunteered. At this juncture I must stop accepting volunteers and spend my time responding to the many fine traders who have expressed interest. It's a highly diverse group, from beginners to pros, with many applicants coming from outside the U.S.

If I have not yet gotten back to you, please don't take this as an indication of a lack of interest. I did not plan for so many responses, and--given that I'm leaving town for two days to work with traders--I won't be making any selection until the weekend. I will personally respond to each trader who has expressed interest, however.

If the project proves valuable for all concerned, I'll certainly be willing to take on another trader as an educational project on the blog. Thanks again for your interest and support; I'm hopeful that this will be a unique and worthwhile experience.


The Most Important Step in Becoming Your Own Trading Coach

Before you read this post, I'm going to ask that you review my previous post on "The Devon Principle". It is very, very relevant to a question recently asked of me by a trader: "I know I can't afford to hire a private trading coach. What do I need to do to coach myself for success?"

The Devon Principle states that we are what we eat and that, psychologically, we are always digesting our experience. Internalizing our experience makes us who we are.

If we have negative experiences, we internalize that and develop a loss of confidence and motivation. If we have positive experiences, these become part of our outlook on ourselves and our world.

To mentor yourself, your most important step is to create positive learning experiences that will sustain your motivation, interest, and sense of efficacy.

Every trading session should involve working on a specific, doable goal and making progress toward that goal.

We can't control how markets move, so we can't control whether any single trade we make will be profitable or not. But we can control how we make trades: how we enter, how we size positions, how we exit, and how we contain losses. Having rules about all of those helps us set specific goals about the process of trading, rather than about the outcome.

The goal of your learning is to trade well, just as the goal of a pitcher is to make a good pitch. If you do that often enough, you'll win your share of outings.

But the equally important reason for setting attainable, concrete goals is that--as your own coach--you are creating the experiences that you'll be digesting. By setting yourself up for success, you build a positive identity as a trader, day by day.

Without goals, there can be no sense of attainment. Without the sense of attainment, there can't be an internalization of competence and confidence. You generate your own sense of control by--trading session by trading session--controlling your own pursuit of trading goals.


Becoming Your Own Trading Coach

Letting Profits Run: Becoming Your Own Coach

Building Self-Efficacy With a Solution Focus

My last post identified self-efficacy as an important link between a person's goals and their ability to sustain action toward those goals. If we experience ourselves as efficacious--if we feel that we are in control of our destinies--we will be more likely to muster the motivation to do what we know is best for us.

In my co-authored book The Art and Science of Brief Psychotherapies, I wrote a chapter specific to solution-focused brief therapy (SFBT). The idea behind SFBT is that, instead of focusing on a person's problems, it is often helpful to identify strengths and build upon these. The psychologist using SFBT identifies what you're doing when you're not having problems; when you're acting in a manner more consistent with your goals. From those exceptions to problem patterns, it is possible to find solution patterns: positive modes of thought and behavior that can be duplicated in new situations.

Thus, if I'm working with a trader with discipline problems in a SFBT framework, I will review his recent trading with him and work with him to identify occasions when he *did* follow his plans and trade in control. We'll then figure out how he was able to do that and create a solution pattern from his own recent behavior. Perhaps, for instance, we'll learn that he was able to trade in a disciplined way when he traded a position reasonable for his portfolio size, took a break after losing trades, and clearly identified a market direction in his pre-opening preparations. We might then use a self-hypnosis technique to mentally rehearse these solution patterns again and again--until they become a more natural part of the trader's repertoire.

Research on SFBT suggests that the approach works because it directly improves the individual's self-efficacy. Here's what I had to say in my book chapter:

"Beyebach et al (1996) examined SFBT outcomes and found that the sole significant predictor of success was client internal locus of control, which reflects the degree to which individuals perceive that they are in control of their lives. The internal locus was positively correlated with favorable pretreatment reports of change and subsequent goal formation in counseling" (p. 96).

Pretreatment reports of change refer to partially successful efforts that the person made prior to getting professional help. By focusing individuals on what they are already doing to change and by helping them form clear, doable, positive goals, the solution-focused approach enables them to feel more efficacious, more in control of their own lives.

This, I have found, is the most effective means for helping people bridge the gap between their actions and their goals. If coaching or counseling focuses on problems and what people are doing wrong, it unwittingly reinforces the lack of efficacy. By identifying what you're already doing--even in a small way--to bring you closer to your goals and then gradually building on that, you increase your sense of control and eventually pave the way for larger goals and greater progress.

Positive focus, measurable and achievable goals: these are key to a trader's self-coaching and improved control over one's own actions.


A Solution-Focused Linkfest

The Most Important Question to Ask When You're in a Slump

Solution-Focused Trading

Monday, May 28, 2007

Self-Efficacy and the Psychology of Consumer Debt

Popular personal finance expert Jean Chatzky calls it an epidemic and organizes self-help groups to deal with its impact. U.S. News and World Report, Newsweek, the Center for American Progress, and Fox News all use the same word to describe the situation: drowning.

Increasingly, they note, middle class Americans are drowning in debt.

Statistics from the Federal Reserve show that, from 1980 to the present, homeowners are paying an increasing percentage of their disposable income toward debt repayment. Indeed, the financial obligations ratio for the average American is at a record 19.4%. In an excellent review, Mike Shedlock notes that personal bankruptcy rates are rising among baby boomers and particularly among those above the age of 55. He refers to the situation of housing woes and rising fuel prices as a "perfect storm" of debt, with household expenses increasing and home equity not keeping pace.

To be sure, many causes of debt are unavoidable. Those without health insurance, for example, can be wiped out by expenses associated with treatment of major diseases, such as cancer. Many times, however, debt is simply a function of lifestyles that fail to balance income with expenditures. Chatzky's recent book on making money rather than excuses, for instance, covers a number of practical steps--simple reductions of regular purchases--that can meaningfully reduce a family's debt burden.

So what keeps individuals and families from taking such steps?

Consider these situations that appear quite different, but are psychologically similar:

* A man knows he needs to lose weight given his heart problems, but he continues to overeat.

* A woman vows to exercise to get in better shape, but fails to use the expensive equipment she's purchased.

* An investor knows that he should hold onto winning positions and not let losers get out of hand, yet he finds himself doing exactly the opposite.

* Arguments are killing their marriage; both members of the couple realize it and don't want a divorce, but they continue to wound one another in bitter verbal battles.

Each of these situations is one in which a person knows what to do, but cannot match their actions to their awareness. We usually associate such a lack of will with addictions, but as the above suggests--and as we see with many families in debt--the problem is much more widespread than that.

Why do we lack the will to do what is best for us?

The answer, one group of psychological researchers suggests, can be found in self-efficacy. Self-efficacy refers to the belief system of the individual: the degree to which people hold the conviction that they are *capable* of attaining their goals. A person may wish to lose weight, for example, but may not perceive that she is in control of her weight. Her belief is that "I just have a slow metabolism". Without the underlying conviction that she's in control, she won't be motivated to take the actions needed to change her situation.

Self-efficacy has been found to be associated with positive outcomes in educational and health settings, as well as athletic performance. When people believe that they *can* achieve a goal, they're more likely to initiate action toward that goal. A great example of how a lack of self-efficacy can dampen motivation can be found among abused children and spouses. Even when they have opportunities to leave their environments, they often do not act on these. They have learned--through painful experience--that they cannot control their own life outcomes.

So it is with many families facing potential bankruptcy. Their self-talk is that they're "in debt", just like they might be *in* an accident or *in* a hurricane. Such self-talk reinforces the notion that debt happens to them--not that they can influence their own financial outcomes. Similarly, the investor who hangs onto losing positions and risks going bust talks about being *in* the red, *in* losing trades, and *in* a drawdown.

Changing such self-talk requires fresh emotional experience, not just intellectual awareness. Intellectually everyone pretty much knows what they need to do to follow a budget, exit losing positions, stay in good physical condition, etc. If, however, you don't experience yourself as being in control, you can't internalize an enduring sense of self-efficacy. Building that experience of control requires at least two steps:

1) Developing a new kind of self-talk, which makes nouns like "debt" and "drawdown" into active verbs, stressing decision-making and choice. Debt is something you do, not something you passively find yourself in;

2) Cultivating a hierarchy of doable goals to create the emotional experience of being in control and seeing in one's own experience that it *is* possible to make good things happen.

In short, self-efficacy can only result from first-hand experiences of being efficacious. Unless we truly, consistently feel ourselves to be in control, we're unlikely to sustain the actions needed to achieve our goals. In my next post, I'll take a look at one immediate step people can take to generate those first-hand experiences of efficacy.


The Devon Principle

Reading for the Long Weekend

* A Look Beneath the Market Surface - The updated Trading Psychology Weblog reviews markets, indicators, and money flows and takes a glance at the week ahead.

* Trader Coaching Project - I'll take on one trader for a month free of charge and we'll document the process on this blog. Details are on the Trader Performance page.

* Andrew Lo on Trading Psychology - Great post from the Daily Speculations site on Dr. Lo's Adaptive Market Hypothesis.

* Interesting New Charting Application - Stock Spy integrates RSS feeds directly into the charts, so you see the news and the buzz along with price, volume, and indicators.

* Margin Debt Exploding - David Korn, in his excellent newsletter, notes that, since August, margin debt has increased at a 67% annual clip. He also notes that money continues to flow into domestic and international equity funds.

* Breaking Bad Habits - Practical advice from Dr. Bruce Hong, who stresses the importance of self observation.

* Is Directional Trading the Way to Go? - Matt at C++ trader provides a thoughtful perspective on directional and non-directional trading for retail traders.

* Oil Stocks Worth a Look - I recently noted the huge money flows into energy issues. This Seeking Alpha post reports on seven issues to consider for ownership.

* Alternative Energy - InvesLogic aggregates feeds from a variety of blogs in the alternative energy space. Excellent way to generate ideas, track trends.

* Memorial Day Linkfest - The Big Picture reviews the economy and markets, including a look at the fastest growing tech firms.

Sunday, May 27, 2007

The Trader Coaching Project

TraderFeed will be going behind the doors of a trading psychologist. I've just announced on my Trader Performance page that I will be taking on one trader for coaching completely free of charge for the period of one month. The "catch" is that the trader must agree to sharing summaries of the coaching as part of posts to TraderFeed. That will enable all readers to potentially benefit from the coaching. During the month, we'll learn about a trader and his/her challenges; how we're tackling those challenges; and the progress we make.

If you're interested in being considered as the trader for this project, check out my post to the Trader Performance page and send me an email as outlined in the instructions. Please note that I can only accept one trader at this time, but if the project goes well, I'll be happy to open it up to other traders.

My hope is that this creates a unique learning experience for all involved; thanks for your interest!



Coaching the Professional Trader

When Coaching Works, and When It Doesn't

Trading Coaches: What Works?

The Heroic Dimensions of Trading

For me, there's no better time than a long holiday weekend to step back and ask the big questions: those that deal with the meaning and significance of being a trader. These segments from my two books capture much of my sentiment on the topic.

"It is better to struggle in the service of one's dreams than to find instant success at meaningless work. The greatest joy in life, George Bernard Shaw once wrote, is being used for a purpose you recognize to be mighty. The greatest fields--those that are a calling and not a mere job--give one room to expand and develop oneself. There is only one valid reason for trading the markets, just as there is only one valid reason for being a psychologist, a dancer, or an architect: because it is your calling, the arena that best draws upon one's talents and passion for self-development." - The Psychology of Trading, p. 317.

"There are few arenas left in life where the independent individual can enact the heroic struggle...This, I believe is the eternal allure of the markets. With a reasonable stake and an online account, each person can undertake his or her own gold rush and enact the highest entrepreneurial quest. Like salmon that swim upstream to spawn, sperm that pursue the egg, and prospectors that dig for precious metal, many will be called and few chosen. It matters not. What matters is the dignity and the dimension of soul conferred by one's noblest impulses. It is not desirable to rule in hell or to serve in heaven; far preferable, to paraphrase Ayn Rand, is to fight for tomorrow's Valhalla in order to walk its halls today." - The Psychology of Trading, p. 318.

"Let us not forget what it means to be a trader. It means that I am free to own property: shares of a private company or contracts in a commodity. I can take delivery of my property and dispose of it as I wish, or I can trade it to others. My decisions are mine to make; I need not follow the dictates of those who would put other interests--those of gods, governments, or guns--above my own. If I lose, it is my loss. If I profit, the gain is mine...Without freedom, there is no trading. Trading is a celebration of economic and political freedom. Slaves are traded; they do not trade." - Enhancing Trader Performance, p. 253-4.

"What are we really developing when we train for expert performance in any domain? We develop skill and knowledge, to be sure, but we also develop more than that. We cultivate will: the ability to formulate goals and direct our actions toward reaching those goals. Every training session is a battle of will: a struggle to overcome our limitations and reach a particular performance goal...When you enhance your performance as a trader, you replace a small piece of randomness with intention. To that degree, your outcomes are self-determined. If you train yourself properly, you will become not only a successful trader, but a more self-determining human being." - Enhancing Trader Performance, p. 254-255.


Ayn Rand and Objectivism

Colin Wilson

"Dr. Miller says we are pessimistic because life seems like a very bad, very screwed-up film. If you ask "What the hell is wrong with the projector?" and go up to the control room, you find it's empty. You are the projectionist, and you should have been up there all the time." - Colin Wilson

"Every man builds his world in his own image. He has the power to choose, but no power to escape the necessity of choice." - Ayn Rand

Saturday, May 26, 2007

Energy Stocks Powering Ahead: The Geopolitics of a Market Rally

Energy stocks are attracting huge investor interest. Chevron Texaco (CVX) has risen from the mid $60 range to over $80/share just since March. Over that time, we have had exactly one day--one day!--of negative money flow in the stock. Every other day, funds have been flowing into CVX.

Exxon (XOM) has risen from the low 70s to over $80/share in that same time. We've seen only four days of money outflows from the stock since the mid-March lows.

Schlumberger (SLB) has risen from the mid $60's to about $80/share since mid March. How many days of negative money flow have we seen during that time?


I'd say that's a pretty strong performance for a sector. The S&P Energy Sector ETF (XLE) has risen over 20% since mid-March, helping to underpin the strength in the large cap stocks.

A recent Congressional vote on funding the Iraq war set benchmarks for the Iraqi government needed for continued funding of the war. While most discussion of the benchmarks has focused on the achievement of democratic reforms, quelling of sectarian hostilities, and the like, a less-remarked benchmark concerns the disposition of Iraqi oil.

The Iraq Hydrocarbon Law requires a privatization of Iraqi oil to develop Iraq's untapped resources. Understandably, oil companies are reluctant to commit funds to such an effort without the protection of such a law. It has been difficult for the various factions to agree on revenue sharing, creating limbo for the proposed law--and opposition to the notion of foreign control. Each of the sectarian groups has reasons for opposing the law. There is expectation that oil and gas assets will be auctioned off within the next couple of months, however.

In the U.S., serious political opposition to the privatization of Iraqi energy assets appears minimal, given that the recent bill passed by Congress represented a Democratic compromise with the White House. When Dennis Kucinich took an hour of House time to blast the "exploitation" of Iraqi oil, his remarks went without further comment or debate.

Christopher Hitchens, on the other hand, makes a case for the Iraq Hydrocarbon Law, suggesting that the proper development and distribution of oil revenues will benefit the entire country and abolish the economic rationale for dictatorship.

The American public, seeing higher gasoline prices at the pump thanks to refining bottlenecks, is unlikely to oppose any efforts to expand energy reserves, as oil companies blame the push for biofuels for reduced refining capacity.

I don't think the U.S. would be building the world's largest embassy complex in Baghdad unless there was a solid economic rationale, whether you agree with the rationale or not. The stock market seems to agree, and investors--seeing higher energy prices and availability of what appears to be the world's second largest oil reserves--are steadily pouring money into international oil/energy companies as a result.

Money Flow Review: Stocks on the Radar

* Stock Looking Sharper? - Sharper Image (SHRP) has been quite a disappointment as an investment, as it's trading around $11/share, down from $38 in 2004. It's an interesting short-squeeze candidate, however, as Friday's Wall St. Journal reports a mammoth short position in SHRP: equivalent to 37 days worth of average trading volume. The last two trading days this week saw sharp gains in Sharper Image on much above average money flow.

* Taking Profits From the Oil Patch? - In the current environment, which stocks should be doing better than the oil refiners? Valero (VLO) is up from about $58 to $74 since the late February/early March weakness. Money flow for VLO, however, has been outright negative--dollars have been flowing out of the stock--for each of the past six trading sessions and 13 of the last 20. Large traders/investors taking profits into recent strength?

* Soft Flows at MSFT - Microsoft is another stock showing net dollar outflows of late. We've had negative money flow readings seven of the past eight trading sessions, as price has stalled in the 30s.

* NTRI Gets Expansive - NutriSystem (NTRI), featured here recently as another short-squeeze candidate, hit its highest price since January on Friday.

* Power Behind the Stock - Toshiba was another stock I featured last month; it trades on NASDAQ as TOSBF. After hitting a bull market high on 5/8, it has settled back but remains in a firm uptrend. This is an interesting play on nuclear power as an oil alternative.

* Honda Ready to Zoom Ahead? - I just purchased a Honda Fit and have to say the company got it right, with a bit of performance (for a subcompact), good gas mileage, low emissions, and a surprisingly roomy interior for the small footprint. Honda stock (HMC) is down for 2007 and has gone nowhere over the past year. Money flows have been doggedly positive, however, and the stock remains in a long-term uptrend.

* Chips Are Down for INTC? I noted a surge in Intel (INTC) money flows last month, and the stock closed at its highest price of 2007 this past Tuesday. But now money flows have been outright negative--dollars exiting the stock--for seven of the past ten trading sessions.

* Wal-Mart is Being Discounted - The stock (WMT) closed at its lowest levels since March this past week and money flows have been outright negative for 8 of the past 10 trading sessions.

* Gains Still Flowing in TTEK - I featured this stock earlier this month as a worthy play on the water-as-resource theme. The stock made a new high on Tuesday and continues to enjoy net dollar inflows. Tuesday's gain met with stiff selling and net money outflows on Wednesday, which may herald some consolidation.

Friday, May 25, 2007

Musings for a Friday

* When downside momentum is strong - My Demand/Supply Index hit a lopsided extreme on Thursday, with Demand at 23 and Supply at 210. As noted in my recent post, that means that we have about 9 times as many stocks that closed with significant downside momentum as ended with significant upside momentum. Going back to 2005 (N = 582 trading days), we've only had 7 occasions in which Supply has exceeded 200. The S&P 500 Index (SPY) was lower three days after this extreme on six of those seven occasions, with an average loss of -.57%. In other words, very strong downside momentum tends to persist in the short run before reversing. On average, it's when we see price lows on improving momentum that we look for bullish reversals.

* Excellent update on links - Trader Mike does an excellent job of updating his site with practically relevant links for traders. There are some particularly good posts in his recent updates, including thoughts re: Web 2.0 and China bubbles. And if you're looking to get a jump on long weekend reading, check out Abnormal Returns' links--particularly the interesting post on an indicator off the beaten path.

* Wickedly funny post - CXO Advisory lists the top ten guru excuses for getting the market wrong. Check out their analysis of guru calls on the market.

* Spotlight on China - Ticker Sense does a fine job tracing the "A" and "B" shares in Shanghai vs. the Yuan.

* The Personal Bankruptcy Storm - Mish has provided a detailed and eye-opening analysis; great work.

Protracted Selling Pressure in the NYSE TICK

We've now seen net selling pressure over the past 20 trading sessions. In my last post, we saw a tendency for the S&P 500 Index to bounce following days of extreme selling pressure in the Cumulative Adjusted TICK measure. Above we can see the S&P 500 Index (SPY; blue line) vs. the 20-day moving average for the daily cumulative Adjusted TICK values. Note that, although we're not far off price highs--despite Thursday's decline--the 20-day Adjusted TICK is at rather oversold levels. This suggests that we've seen protracted selling pressure: something that's far more noticeable in the small cap market than in the Dow or the S&P 500 Index.

Interestingly, going back to 2005 (N = 834 trading days), when the 20-day cumulative Adjusted TICK has been below -150 (N = 71), the next ten days in SPY have averaged a subnormal gain of .07% (37 up, 34 down). That is notably weaker than the average 10-day gain of .39% (481 up, 282 down) for the remainder of the sample.

This result also fits with findings regarding my Demand/Supply Index, which hit lopsided selling extremes on Thursday. Demand closed at 23; Supply ended the day at 210. For readers unfamiliar with this measure, it means that--across the three exchanges--roughly 9 times as many issues closed below the volatility envelopes surrounding their moving averages as closed above them.

When we get such extremes in selling sentiment (TICK) and momentum (Demand/Supply), the tendency is for the decline to continue in the short run, even as downside momentum wanes. It is rare to make a low on extreme negative momentum and then turn on a dime and sustain a bullish trend. More often, we see bottoming action with further price lows and moderating Supply, TICK, and new 20-day lows among stocks. For this reason, I will look for the possibility that any bounce after the selling (per the previous post) will provide an additional opportunity for selling the market and testing recent lows.


Trading with the NYSE TICK - Part One

Trading with the NYSE TICK - Part Two

Identifying Sentiment Trends with NYSE TICK

When Selling Becomes Indiscriminate: What Happens Next?

On Thursday my cumulative Adjusted TICK measure gave a daily reading below -1000. This has only occurred 16 times since 2004. To achieve such a reading, we have to have persistently negative NYSE TICK readings: far below the 20 day average. That means that traders have been hitting bids across a wide range of NYSE stocks--an indiscriminate selling that affects good stocks and bad. Indeed, we saw declining stocks exceed advancers by over 2000 issues on Thursday.

When we've had cumulative Adjusted TICK readings below -1000 in a single day (N = 16), the next three days in SPY have averaged a solid gain of .58% (13 up, 3 down). That is much stronger than the average three-day gain of .10% (468 up, 376 down) for the remainder of the sample.

I will want to see evidence of waning selling pressure--and an inability of negative TICK readings to drive price to new lows--before acting on this pattern. Nevertheless, when selling has become extreme, it's generally been a good idea to look for a bounce. In my next post, I will take a somewhat longer-range perspective on the performance of the Cumulative Adjusted TICK and provide a note of caution.

Thursday, May 24, 2007

Capturing the Intraday Trend with the Cumulative Adjusted TICK

Here we see the ES futures for 5/24/07 (blue line), a one-day cumulative total of the Adjusted NYSE TICK. Recall that the Adjusted TICK is the one minute NYSE TICK minus the average TICK level over the past 20 trading sessions. When the cumulative total slopes downward, we know that we're getting above average selling interest (hitting of bids) across the NYSE stock universe.

Note at point (1) that, despite the early rise in ES, we never saw above average TICK readings. That was our first clue that buyers were not aggressive in the market. We then saw above average hitting of bids and a reversal of ES, with price declining below the open.

Observe at points (2) that bounces in price were not accompanied by significant bounces in the Adjusted TICK: buying remained below average. The general rule during such occasions is to sell these bounces, as they represent short covering and not an influx of fresh buying. This principle would have kept a trader short through much of the decline.

We did get a bit of a bounce in the Adjusted TICK in midafternoon, but note at point (3) that the pattern of lower cumulative readings at price bounces reasserted itself. This led to fresh selling late in the day.

Very, very often I find that following the slope of the cumulative Adjusted TICK line keeps me on the right side of the market. My worst trades have occurred when I've bucked the trend of buying and selling interest.


Identifying the Trend of Sentiment With NYSE TICK

What You Can Learn From the Opening Minutes of Trading

Market Psychology and Trader Psychology: Thoughts for a Thursday

* More on Extreme Negative Sentiment - Here's a post I sent to a distribution list of traders after we hit an extreme negative level in the NYSE TICK on Wednesday:

I show that, since 2004 (N = 848 trading days), we've had 61 occasions in which there has been at least one daily NYSE TICK reading of -1100 or lower. Five days later, we've averaged a gain in SPY of .65% (43 up, 18 down). That is stronger than the average five-day gain of .19% (493 up, 355 down) for the entire sample.

It turns out that we hit another such negative extreme today. Going back to 2004, we've only had 48 occasions in which we've had back to back daily readings of less than -1000 in the NYSE TICK. Five days later, SPY has averaged an impressive gain of .83% (36 up, 12 down)--again much stronger than the average five-day gain for the sample.

* Great Research on the NYSE TICK - In his latest newsletter, Rainsford Yang has replicated my research on the Cumulative Adjusted TICK and charted it long-term to show how this indicator has consistently led market rises and declines. Rennie has graciously offered readers of TraderFeed a renewable 25% discount on a subscription to the newsletter. I'm not financially affiliated with MarketTells, and I don't benefit from subscriptions, but I can tell you that I am a paid subscriber and greatly respect Mr. Yang's work. If you're interested in the discount, just enter "traderfeed" where the subscription form asks you for a promotional code.

* Trade Ideas on the Web--Backed by Research! - Every day James Altucher is putting out value by tracking "system trades of the day" on the StockPickr site. You not only see the ideas, but how well they performed over recent market history. I continue to believe this is one of the Web's best information sources for traders and investors.

* More on the Turtles - I recently addressed some of the psychological challenges associated with investment (as opposed to short-term trading). It turns out that Michael Covel has addressed this topic on his site and will also be tackling it in a forthcoming book. I look forward to reading and reviewing that book.

* Brain Fitness - Here's an excellent collection of resources concerning brain fitness and cognitive neuroscience from SharpBrains. Once again, I have no commercial relationship with this firm, but I applaud their commitment to trader education.

* Rising Interest Rates Taking a Toll? - I find it difficult to believe it's a coincidence that the number of stocks making new 65-day highs topped out in mid-April, which is also when 10-year interest rates bottomed. Since then, rates have risen to over 4.9% intraday today--one factor that may be playing into the stock market weakness today. I am very curious to see how the market would tolerate a move above 5%.

The Psychology of Investing: How Investors Differ From Traders

Investment is different from short-term trading, psychologically as well as strategically. The shorter the time frame, the less time traders typically have to plan and research their trades. The intuitive, implicit recognition of patterns is a core skill for the high frequency trader. Many of the traders I have worked with in proprietary firms don't trade with a directional bias. They observe the flow of orders in the depth-of-market (DOM) display, the distribution of large transactions (buying vs. selling), and the waxing and waning of volume to frame trading ideas on the fly. As I've noted before, this rapid pattern recognition requires intensive exposure to multiple market scenarios, so that the high frequency trader literally develops a feel for market action.

The investor, on the other hand, seeks capital appreciation over a lengthy time period. There is plenty of time to research various markets and strategies, and this research is often key to the investor's success. Any investor will only see a limited number of bull and bear markets during their lifetime--not nearly enough to develop that intuitive, implicit grasp of patterns. As a result, the long-term investor must find an edge in his or her ability to identify strategies with an edge and then sustain the patience to stick with those strategies. Where the scalper is relying on implicit feel, the investor must follow conscious reason.

To understand the psychology of investing, it's helpful to look toward other areas of life in which we invest ourselves, such as relationships and careers. Can you imagine what would happen if we were to take a "trading" perspective on relationships or careers? We would set a close "stop loss" and exit the relationship or career whenever that was hit. No doubt, we'd wind up with an impoverished love and work life as a result. To sustain a romantic relationship or a successful career, we have to be able to ride the ups and the downs and remain rooted in our commitment despite difficult times.

This is equally true for the financial investor. Consider the long-term investor in stocks who was frightened out of the market during the scary drop late in February and early in March. Had the investor behaved like a trader, cut losses, and abandoned his or her strategy at that time, a great deal of opportunity would have been lost.

The experience of the Turtles suggests that it is not so easy to follow longer-term market strategies. The Turtles, recall, were given a purely mechanical system to trade, with rules governing when to enter and exit positions, how to size those positions, and how many different positions to take. Even with strategy mapped out for them neatly, the Turtles varied greatly in their returns, as recently noted in Curtis Faith's book. They could not ride out the inevitable drawdowns of the trading method.

To stick with a career, you have to believe in the value of your work; to stay with a marriage, you must remain grounded in the love that brought you to that other person. In no small measure, the successful professional or spouse relies on emotional bonds to ride out short-term adversity. The investor, unlike the trader, must bond with his or her strategies--must really believe in them and their intrinsic value. Look at the trend followers featured on Michael Covel's site: they are passionate about their method. Consider Warren Buffett or Jimmy Rogers: they truly value their (quite different) value approach to investments.

I've often heard advice from short-term traders: "Don't get married to a position." Investors, however, do enter into a kind of marriage: a marriage with their basic approach to markets. Frequency of exposure drives the rapid pattern recognition of the scalper, but it is depth of conviction that enables investors to stay their course. The key, in investing as in marriage and careers, is finding the right partner for that bonding and commitment--not just something you think can work, but something that captures your deepest beliefs; that you're willing to subordinate yourself to.


Guiding Principles of Trading Psychology

The Objective Basis for Subjective Knowledge

Reflections on Life and Markets

Wednesday, May 23, 2007

Squeezing Shorts With Money Flow: A Stock Picking Strategy

When pessimism is overdone, you can benefit from short squeezes. The idea here is that, when everyone seems to be bearish on a stock, there are few sellers left. Once buying comes into the stock, the effect is amplified by short sellers fleeing their positions.

Several services help traders find promising short squeeze plays. The Squeeze Shorts blog has gotten off to a nice start. The Short Squeeze site is devoted to scanning for stocks with high short positions that are trading near important pivot levels; that are long and short candidates; etc. A recent post to the excellent StockPickr site identified a number of stocks with high short interest that also display high insider buying: a potentially powerful combination.

I decided to add to StockPickr's criteria by tracking my money flow measure (adjusted relative dollar volume flow) for one of the high short interest stocks that also display solid insider buying. NutriSystem (NTRI) has a short interest ratio of 10 and insider buying of $2.6M, according to StockPickr. It has also been added as a holding by three professional money managers.

As we can see, NTRI stock (blue line) has been trading in a range since early 2006. Its 20-day adjusted relative dollar volume flow (pink line), however, has been above its 200 day moving average (above zero on the chart) since the February/March decline. Indeed, over the past 30 trading sessions, NTRI has displayed net dollar inflows on 21 occasions--18 of which were above the 200 day moving average.

By adding money flow to the criteria of insider buying and high short interest, we can refine the short squeeze stock selection process. The fact that pros are buying NTRI, that the stock is displaying above average dollar inflows, and that there is still a very heavy short position overhanging the stock leads me to surmise that the resolution of the extended trading range will be to the upside. A portfolio of such candidates would make for a worthy strategy.


Overview of Relative Dollar Volume Flow Indicator

Tracking the Dollar Volume Flows Among Stocks

Midweek Stock Market Observations

* Money Flow Chugs Along - My weekend review of money flow across the S&P sectors found that dollars were still flowing into the large caps. Nothing so far this week has altered that scenario. Indeed, we've had six consecutive sessions in which dollar volume flow into the Dow 30 stocks has been above the 200-day average. Hard to sustain the downside with that kind of buying interest.

* What's Hot, What's Not - Keep an eye on PFE; dollar volume flows are up noticeably over the past three trading sessions. The money flow laggards among the Dow stocks are INTC and WMT. WMT shows net outflows for eight of the last nine sessions; INTC has shown net outflows for seven of the last eight sessions.

* Know Your Limits - Victor Niederhoffer makes a case for periodic, difficult self assessments.

* Energy Stock Recommendations and Much More - Charles Kirk opens up his Q&A for members for general viewing, with plenty of insights regarding his new stock screening.

* Support for the Russell 2000 Index - Trader Mike tracks index strength and notes the 50-day moving average support for $RUT.

* Technicals Look Healthy for this Market - Brian Shannon reviews the NASDAQ 100 and S&P 500 Index and likes what he sees.

* The Private Equity Boom is Affecting the Options Market - Adam Warner offers a nice insight into the underlying bid. See also the analysis from A Dash of Insight: how private equity is creating an underlying bid for equities.

* The Market's a BRIC House - The Big Picture notes optimistic sentiment in a recent WSJ piece and shows how the emerging markets of Brazil, Russia, India, and China have trounced the European averages and especially the U.S. equity market.

* Inverted Nifty Fifty? - Abnormal Returns notes how undervalued large caps have been making their return. Check out StockPickr for data on 10 large cap stocks rising on increasing volume.

* Saving Dessert for Last - Many thanks to Rennie Yang for his recent shout out. His Market Tells service has pointed out a number of historical trading patterns that enabled traders to benefit from the recent strength. But now that we've had eight consecutive higher highs on the weekly chart for the S&P 500 Index and nine higher weekly lows, can we expect a correction? Rennie looks at the historical evidence and finds that such consistent strength leads to further price gains going forward.

Tuesday, May 22, 2007

NYSE TICK and the Small Cap/Large Cap Relationship

The NYSE TICK tells us something about sector strength. Long time readers of this blog are familiar with my cumulative Adjusted TICK statistic. This takes the NYSE TICK (the number of stocks trading at offer minus those trading at their bid prices) and subtracts from each one minute value the average one-minute NYSE TICK reading from the prior 20 days. These values are cumulated to give a single end-of-day reading. If the cumulative Adjusted TICK is above zero, it means that we're seeing a tilt toward buying interest (lifting of offers) among the broad list of stocks. If the cumulative Adjusted TICK is below zero, it means that we have net selling sentiment (hitting of bids).

Since 2005 (N = 596 trading days), the cumulated Adjusted TICK has correlated very highly with concurrent daily price change in the S&P 500 Index (SPY; .76) and price change in the Russell 2000 Index (IWM; .80). This is why one of my most effective intraday strategies is to assess shifts in the distribution of the TICK for emerging directional moves in the indices. Shifts in the TICK, including breakouts from ranges, frequently precede or initiate short-term directional moves in the indexes.

But suppose we are interested in answering the question: should I be trading the large cap index (S&P 500 issues) or the small cap index (Russell 2000)? Or suppose we decide to craft a pairs trade in which we'll be long one of those indexes and short the other one. In both cases it turns out that the cumulative Adjusted TICK provides useful guidance.

I went back to 2005 (N = 596) and found that the cumulative Adjusted TICK correlates .60 with the difference in performance between IWM and SPY. Specifically, when the Adjusted TICK is strong, IWM is significantly more likely to outperform SPY than the reverse. When the Adjusted TICK is weak, we see underperformance of IWM relative to SPY.

In fact, when the cumulative Adjusted TICK was above zero (N = 301), IWM outperformed SPY on 212 of those occasions. When the cumulative Adjusted TICK reading was above +300 (N = 144), IWM outperformed SPY on 114 occasions, or about 80% of the time.

When, however, the cumulative Adjusted TICK was below zero (N = 295), SPY outperformed IWM on 196 of those occasions. When the cumulative Adjusted TICK reading was below -300 (N = 139), SPY outperformed IWM on 117 occasions--over 80% of the time.

A strong NYSE TICK not only tells us that there is buying interest in the market, but it's also telling us that the buying interest is extending to the broad list of stocks, including small caps. Similarly, very weak TICK readings tell us that investors are selling off the smallest of stocks along with the larger ones. In strong or weak TICK environments, traders can consider trading long or short positions in IWM or perhaps constructing pairs trades in which they are long IWM/short SPY (or the reverse in a weak TICK setting).

Note that this strategy also suggests that it could be fruitful to monitor custom TICK measures for specific market sectors. (The NeoTicker platform enables the construction of such TICK-specific measures). A range of ETF trading strategies (or pairs trades among ETFs) could follow such an effort--a worthy area to research.


Trading With the NYSE TICK

NYSE TICK and Short-Term Breakout Moves

Buying Panic Among SPY Traders?

SPY Traders Are Jumping Into This Market. Monday's rise took the S&P 500 Index to a new all-time high. As we can see from the chart above, the recent market rise has been accompanied by quite a spike in the ratio of volume of the S&P 500 Index ETF (SPY) to NYSE Volume.

In the recent past, spikes in SPY volume relative to general market volume have occurred at market lows as a function of panicky selling. To that degree, SPY traders as a whole have not looked like smart money; spikes in their participation have been a contrary indicator. This was particularly evident during the market weakness of late February/early March.

This is the first time I can recall during the bull market when we've had an elevated ratio of SPY:NYSE Volume on a market rise. It invites the perception that, just as SPY traders panicked on the downside during the Feb./Mar. weakness, they are now panicking to the upside, eager to get into a market making fresh all-time highs.

I'm watching closely to see if this, too, proves a contrary indication of sentiment.


NASDAQ Volume as a Sentiment Measure

Equity Option Volume and Sentiment

Mutual Fund Sentiment

Monday, May 21, 2007

Decision Making and Risk: Fascinating Research From Dr. Itiel Dror

As part of my recent post on trader psychometrics, I reviewed a number of research studies dealing with risk taking and personality. One of the happy outcomes of my search was coming across the research of Dr. Itiel Dror, who teaches at the School of Psychology at the University of Southampton in England. His work on decision making is particularly relevant to trading.

Among the interesting findings from his research:

* Time Pressure Affects Risk Taking - Under time pressure, individuals are more conservative when they face less risk, but more risk-taking at higher levels of risk.

* Emotions Affect Pattern Recognition - Increased negative emotionality led raters to identify more patterns in ambiguous situations.

* Contextual Information Affects the Judgments of Experts - When you provide leading information to experts, their subsequent judgments change to fit the prior information.

* Perception is Far From Perfection - What we perceive is greatly influenced by our mental states, the information we've already stored and organized, and the meanings we impose upon ambiguous situations.

* Primacy Effects - What we see first biases our perception and affects our subsequent performance.

The important take-away from this research is that many of the factors that influence performance--even among expert performers--are situational and not part of fixed personality traits. What we perceive and how we respond are greatly influenced by the environment. A full understanding of a trader's performance requires an appreciation of the specific situation in which the performance was embedded.


Inside the Trader's Brain

Finding an Objective Basis for Subjective Knowledge

Four Insightful Studies From Dr. Andrew Lo

Assessing Trader Personality: The Role of Trader Psychometrics

Are there personality patterns common to successful traders? This is a question that interests aspiring traders and trading firms alike. The usual way of addressing the issue is to offer traders a set of pencil-and-paper questionnaires that evaluate personality traits and then see if the results correlate with trading outcomes.

There is much to be said for the questionnaire method of assessing personality and performance. Questionnaires are easy to administer and score. There are also highly reliable, valid, and standardized measures of personality traits in the psychological literature, such as the NEO PI-R based upon the work of Costa and McCrae. Research coming out of the London Business School has found that personality traits--including overconfidence and sensation-seeking--are significantly associated with trading results. This corresponds to my own, more informal, findings that high degrees of neuroticism, coupled with sensation-seeking and low conscientiousness, are associated with poor trading outcomes.

There are several potential weaknesses to the questionnaire approach, however. First, and most fundamentally, it is not at all clear how much of the variance in real world trading outcomes is accounted for by self-reported traits. My investigation with Andrew Lo's research team at MIT did not find any strong association in a sample of traders. Nor is it clear that the universe of traders is homogeneous, with a single set of optimal personality traits. Just as different personality styles are associated with specialties within medicine--psychiatry vs. surgery vs. radiology--it may well be the case that different personality patterns typify successful market makers vs. portfolio managers vs. mechanical system traders.

Equally problematic, questionnaires tend to be face valid; it is obvious to respondents what is being asked of them. This makes it easy to manipulate the results, particularly in employment settings where test-takers will provide the most socially desirable responses.

For these reasons, it can be worthwhile to supplement the use of questionnaires with measures of trader psychometrics. As David Norman of the Illinois Institute of Technology indicates, we can learn about traders from an assessment of their trading, just as we can learn about trading by asking questions of traders. Dr. Norman's Trader DNA program is an effort to collect metrics on one's trades, so that traders can identify their own patterns of successful and unsuccessful trading.

Having utilized this approach in my own work with traders, I would like to propose that trader psychometrics can reveal several important dimensions of trader personality that are useful supplements to the information gleaned from questionnaires:

1) Frequency of Trading - I propose that this is a manifestation of a trader's need for stimulation and tendency toward sensation-seeking. The trader who needs/desires to be active in the marketplace (e.g., the day-trader) displays different needs for stimulation than the long-term investor;

2) Size of Positions Relative to Portfolio Size - This is a direct measure of risk-taking vs. risk assumption;

3) Average Size of Losing Trades vs. Winning Trades - This assesses the prudence or conscientiousness of the trader in managing risk. Traders with large outliers among losing trades display a lack of control over risk.

4) Number of Different Positions and Strategies Employed - This is a measure of behavioral complexity, which in turn has been found to be associated with superior performance in a variety of work settings. Such complexity may also prove to offer a degree of insulation from changing market conditions.

The trader psychometrics address many of the shortcomings of pencil-and-paper self-report personality questionnaires. They are easily gathered by computer and need no psychological interpretation and administration. They represent objective, observable data that are not subject to subjective interpretive bias. The metrics also cannot be faked by traders.

Most important of all, however, the trader psychometrics create a process-based assessment. We can see how patterns of trading change over varying market conditions and across different markets and strategies. The research of MacCrimmon and colleagues, for example, found that risk-assumption has a very strong situational component: people who are risk-takers in one situation (personal life, for example) may be risk averse in other situations (finances). The trader psychometrics view personality as it is manifested in the specific trading context. We can detect personality at work as trading proceeds. This makes trading metrics a fine supplement to more global personality measures.

Finally, an advantage of trader psychometrics is that they can be collected by traders themselves and used to identify patterns of success and failure. For instance, traders can track their trading and learn whether they become more or less risk averse as markets become more volatile; whether they become more prudent over time; etc. In this sense, trader psychometrics are both assessment tool and learning tool.

Your personality affects your trading, but your trading also reflects your personality. A well-rounded approach to assessment looks at the trader from both angles, identifying elements of performance associated with the person and with the trading situation.


How Personality Affects Trading Performance

Steps Toward Becoming a Better Trader

A Personality Questionnaire for Traders

Interpreting the Personality Questionnaire

Sunday, May 20, 2007

Weekend Reading and Market Insights

* Large Cap Strength: The updated Trading Psychology Weblog reviews the recent strength among large cap stocks and looks at where money is flowing among the S&P 500 sectors.

* Developing Creative Trade Ideas: The Trader Performance Page and my recent post on market vision represent directions I'm taking in my own research and trading. The idea is to trade themes, not just broad market movements.

* Great Weekly Review: Every weekend from Barry Ritholtz and the Big Picture's linkfests. This week's links include some insight into what happens when markets display bad breadth. See also the top ten water stocks.

* An Alternate View of Web Search: Trader Mike notes the recent interview with Jimmy Wales and wiki implications for search.

* Membership Hath Its Privileges: Charles Kirk offers a wide ranging Q&A session for members touching on such issues as what could derail the bull market, recommended software for learning technical patterns, setting trading goals, perspectives on market timing, and much more.

* Blogging the Frenzy: The Wall St. Journal MarketBeat feature does a nice job of tracking trading ideas, market developments, and posts through the day.

* More Fine Links: Abnormal Returns hits a number of fine posts, including a view on how financial stocks are turning in disparate performances.

* The Value of Moving Averages: Michael Covel shares a great perspective from Ed Seykota.

* Wrapping Up the Market Week: Larry Nusbaum offers a great collection of posts, including ETF performance.

* Chronic Stress: Dr. Hong outlines the biology of chronic stress and the implications for traders. Great new site.

* Perspectives Galore: From Misstrade, including a bicoastal view of trading.

Have a great start to your week!


Understanding Market Themes

One of the findings that stand out in dramatic relief in my research is the relative strength of the Materials, Industrials, and Energy stocks relative to Consumer Discretionary, Consumer Staples, Financial, and Technology stocks. Above we see the relationship between the Materials sector ETF and the Technology sector ETF within the S&P 500 Index. This, I believe, represents an important thematic dimension for markets: the degree to which capital is rewarding physical vs. intellectual assets. In the late 1990s, we saw a premium according to the intellectual assets of technology. Since 2004, however, we've seen an upward trend in the relationship between hard assets and technology.

One of the promising areas of money flow research is its ability to detect these themes among sectors. The usual question traders ask is whether the market is likely to rise or fall. An equally fruitful question, however, is: Which themes are likely to benefit from capital inflows? When the dollar (and returns from dollar denominated assets) are relatively weak, hard assets become attractive storehouses of value.

Market Review: The Large Caps are Living Large

Market observations for a Sunday morning (hats off to Decision Point for the Advance-Decline stats and to Barchart for the new high/low data):

* The NYSE Advance-Decline Line has been flat since mid-April and is below peaks achieved earlier in April and May, despite the rise to new price highs on Friday.

* The Advance-Decline line specific to the Dow Industrials has steadily moved to new highs through the rise; the AD Line for the S&P 500 large caps also touched a marginal new high on Friday.

* From mid-April to early May to this past Friday, the AD Line specific to the S&P 600 small cap stocks has traced out lower highs and lower lows. This pattern of lower AD highs and lower AD lows is especially noticeable in the advance-decline stats specific to the NASDAQ Composite stocks.

* The AD Line specific to the NASDAQ 100 stocks is also not confirming the Friday highs in the large caps, but is notably stronger than the AD Line for the full range of NASDAQ Composite stocks. Clearly the large cap stocks are the beneficiaries of the recent market strength.

* Among the S&P 500 sectors, the AD Lines are strongest among the Materials, Utilities, Industrials, Health Care, and especially the Energy stocks. This fits my money flow data very well. The AD Lines for Technology, Financials, Consumer Discretionary, and Consumer Staples stocks are lagging.

* Despite Friday's highs in the large cap indexes, we had 856 new 20-day highs across the NYSE, NASDAQ, and ASE on Friday against 984 new 20-day lows. Clearly the rally is quite selective at this juncture.

* We see more new high/low strength in the NYSE than in the NASDAQ Composite. On Friday, we had 432 new 20-day highs among NYSE stocks against 409 new lows. But we had 205 NASDAQ new 20-day highs against 369 new lows.

* Among stocks that trade more than 100,000 shares daily, we had 509 new 20-day highs against 467 new lows. Among those trading less than 100,000 shares daily, we had 347 new highs and 517 new 20-day lows. No matter how you slice it, the larger caps come out on top.

* Will those large caps be the ones to benefit as China diversifies the investment of its reserves in search of superior returns? Will the diversion of this capital away from fixed income lead to a rise in U.S. interest rates?

* Will China's participation in the private equity-led takeover boom accelerate the shrinkage of supply in equities, further fueling the market rise? And will China's diversification continue to lead to allocation of capital to Anything But U.S. Equities?

Lots of dynamics favoring large caps here. I'll review money flow numbers in those large caps late Sunday in the Trading Psychology Weblog.

Saturday, May 19, 2007

Goldman Sachs (GS): Does Money Flow Matter?

I'm building out models of individual stock performance based on historical patterns of money flow. Let's take GS, which made a new high on Friday. On a five-day basis, money flow in GS has been outright negative: investors have pulled dollars out of the stock. It turns out that the correlation between five-day price change in GS and five-day money flow is only .08. This suggests that flow represents a different variable (sentiment) from simple price change.

But does money flow matter?

Going back to 2004 (N = 845), when GS has been up more than 1% over a five-day period and money flow during that time has been negative (N = 158), the next five days in GS have averaged a gain of .73% (87 up, 71 down). When GS has been up more than 1% and money flow has been positive over the five day period, the average gain in GS over the next five sessions has been only .06% (113 up, 105 down). It thus appears that five-day returns have been subnormal when GS has been up strongly over a five-day period on positive money flow. When GS has been up strongly on negative flow, returns have not been subnormal; indeed, they're slightly stronger than the average (.54%) from 2004 to the present.

How about when GS is down over a five-day period? When GS loses ground over five sessions and money flow is negative during that time (N = 164), the next five days have returned an average of a whopping 1.60% (115 up, 49 down). That is much stronger than the average gain when GS is down over five days on positive money flow (.13%; 106 up, 85 down).

What this suggests is that sentiment, as measured by money flows, makes a difference for short-term returns in GS. When five-day money flow has been positive, the next five days in GS have returned an average of only .08% (264 up, 224 down). When five-day flows in GS have been negative, the next five days have returned an average of 1.17% (226 up, 131 down).

If you envision separate models for different stocks--some of which will show positive sentiment and some negative--you can see how a worthwhile long/short strategy might evolve. By being long the stocks with the most bullish flow patterns and short the stocks with the most bearish patterns, you can trade off sentiment and eliminate a large measure of general market (directional) risk.


Overview of Relative Dollar Volume Flow

Going With the Money Flow

Money Flow and Returns in the Dow Jones Industrials

On the Value of Broad Market Vision

I had a great time on Friday talking with traders at a well-regarded financial institution. A particular treat was sharing the stage with a very successful trader who has been highlighted in financial publications. He addressed his comments to the new traders in the audience and, among other things, offered the following piece of wisdom:

"Whatever asset class you're trading, someone is trading something else against it. The more you know about that something else, the more prepared you'll be for market moves."

It was a great example of the broad market vision that I encounter among many fine traders. Like great quarterbacks, they see the entire field. Many fine trading ideas result when related markets change their relationships to one another.

If you think of it, every trade is a pairs trade. It's just that we often take the denominator--dollars--for granted. What I see in many very successful traders is that they think in denominator terms, not just numerators. They're very aware that they're trading one thing vs. another, and they frame their ideas and trades accordingly. The number of viable trade ideas rises exponentially when you think across asset classes and become free to change denominators as well as numerators.

I'll post more, with specifics, in an upcoming post.


What Makes a Professional Trader

The Myths of Trading Psychology

Friday, May 18, 2007

Hybrid Trading: How Discretionary Traders Can Become More Systematic in Their Decisions

I recently finished an article for SFO Magazine with Henry Carstens, the system developer who contributed a worthy best practice for the series a while back. I continue to feel that Henry's introduction to testing trading ideas is the best article on the topic I've ever read.

For that reason, I was only too happy to write the current article with Henry. This article deals with something we call hybrid trading: the blending of discretionary and system trading styles.

If you recall, Henry worked with a blog reader and successful trader to help him extend his edge. Since that time, he has extended his ideas regarding helping discretionary traders become more systematic and consistent in their trading.

The creative idea that underlies the article is that successful traders can articulate their trading ideas and approaches to a system developer (with assurances of confidentiality, of course), who also studies the actual trades placed by the trader. From the account statements and the trader's own descriptions, the system developer identifies the rules behind the discretionary trader's trading.

Once the developer has this initial set of rules, he can then test the rules and improve upon them as part of system development. The result, for the trader, is a trading system that trades the trader's way. Many trading systems don't work for traders because they involve larger risks and drawdowns and different activity levels than are right for the trader. When a system is developed around *your* trading style, however, you're most likely to be able to use it out of the box.

The beauty of this hybrid is that you can accept or override its signals as you see fit. This enables you to see exactly how much your discretionary judgment adds to the performance of your basic rules. Moreover, you can automate your system so that you will be trading, even when you're not in front of the screen. This frees you up for other tasks and priorities, including (perhaps) developing new trading methods for other markets. Eventually, you could have a dozen computers trading just like you across different markets and time frames.

My sense is that this idea will be a particular boon to proprietary trading firms, enabling them to leverage the skill sets of their traders. A profit sharing arrangement between the trader and the firm to let a computer trade the hybrid method would prove a win-win--and it would help firms make the most of their talented traders. Too, a system developed to reflect a trader's own style could serve as a mentoring tool for beginning traders who might study under the expert trader.

I come across new ideas every week, but I have to say this strikes me as one of the most promising ones in quite a while. I'll post the link when the SFO article comes out.


Blending System and Discretionary Trading

Every Trader is a Trading System