Saturday, May 31, 2008

Stock Picking With Money Flow Data

The previous post took a look at money flows across the ten most highly weighted stocks within the technology (XLK) and energy (XLE) sectors. I also showed that, by aggregating the most highly weighted stocks across the sectors, we can also arrive at estimates for money flowing in and out of the S&P 500 Index as a whole.

Instead of aggregating the money flow data for each stock to derive estimates of flows across sectors and indexes, we can compare the flows for stocks within sectors to see which issues are attracting buying and selling interest.

For example, within the technology sector, we see net inflows over the past 20 trading sessions for CSCO, AAPL, INTC, GOOG, and ORCL. There are net outflows over the same period for T, MSFT, IBM, HPQ, and VZ. Interestingly, as a whole, the NASDAQ-related technology issues tend to be sporting more sizable inflows; the NYSE-based issues are displaying outflows.

Within the energy sector, we're seeing notable inflows to RIG, XTO, and HAL. Considerable outflows are evident within XOM, CVX, and COP. Here we see the largest cap energy issues--and those most highly weighted within the index--displaying the greatest selling interest.

By comparing flows for stocks within sectors, we can identify potential sub-sector themes and aid the process of stock picking.

Money Flows: A Look At Energy and Technology

Money flows can be thought of as a kind of NYSE TICK measure applied to individual stocks. When a stock trades on an uptick, the price of that trade times the volume (dollar volume) of that trade is added to a daily cumulative total. When a stock trades on a downtick, the dollar volume is subtracted from the daily total. Positive values at the end of the day reflect money flowing into the stock; negative values mean that investors and traders are withdrawing their capital from those shares.

The top chart takes the ten most highly weighted stocks in each of eight S&P 500 sectors and tracks their combined money flows over a four-day moving average to capture the flow of funds in and out of the S&P 500 index. (See my earlier post covering the Dow issues; this post links to the sectors that I cover and the ten stocks within each sector).

What we see from the overall money flow picture is that flows have turned modestly positive over the last few days across the S&P 500 issues, but that overall we're still spending more time below the blue zero line than above. The money flows at the March lows held well above their January lows and turned outright positive in April, but since have lagged.

Interestingly, the strongest of the S&P 500 sectors, energy, has been showing a pattern of dwindling inflows even as the sector ETF (XLE) has moved higher. Over the last week, flows have actually been negative, despite an overall market rally. I will be watching this divergence carefully; it may well be that institutions are taking some chips off the table when it comes to energy related stocks.

Technology shares, on the other hand, have had the most consistent set of inflows of any of the sectors. Flows have turned positive once again in the last week, though so far are not as robust as we've seen in April.

In all, we're seeing more money fleeing stocks when the market sells off than entering stocks when the market rises. As we've moved from April through May, markets have moved higher, but money flows have been drying up. That poses a yellow caution flag for June.

Friday, May 30, 2008

A Blog for the New Book

I'm pleased to announce that my new book is entitled Becoming Your Own Trading Coach, and it will have its very own supporting blog.

My goal is to teach traders the same techniques and approaches that I utilize in my work with traders at hedge funds, banks, and proprietary trading firms.

The idea is not for me to promote my own coaching--I'm busy enough, thank you!--but rather to get you to the point where you won't need to hire a trading coach.

Check out my opening post to the new blog and you'll see one of the more exciting topics I'll be covering in the new book.

As always, I greatly appreciate your interest and support. I very much hope to make this my best and most practical book yet.


Psychological Change and the Power of Discrepancy

In my post on constructivism, I described change as a revision of the mental maps we construct to make sense of the world. We provide coherence to our experience by shaping it into narratives; when we tell the story of our lives, we literally tell a story. We include and emphasize certain events, exclude others. The story line is our personal drama, one in which we play leading roles. (See my earlier post on the roles we play and the importance of shifting roles).

Discrepancy--encountering new experiences that don't fit our mental maps--is the source of all change. We change by thinking new things, behaving in new ways, and feeling differently. If we stay in the same roles, engaging in the same activities, thinking the same things, nothing in our mental maps will require revision. We do not change.

When we enter new roles, we are forced to think and behave in new ways. This is how we adapt to new careers, new relationships, and new responsibilities such as parenthood. As we play the new role, it increasingly becomes a part of us, integrated into our mental maps.

But that is not easy. When we encounter discrepant events and situations, we will naturally feel uncomfortable. We are outside the familiar realm of our maps. A certain anxiety and discomfort precedes all change; without it, we are too stuck in existing roles and maps to shift the ways we think and act. It is only human nature to avoid such discomfort, so we tend to stay with the known, the existing set of maps. We resist change.

My earlier post emphasized that we bring our life dramas--the scripts from our accumulated roles--to our trading. If you find yourself making the same mistakes in trading repeatedly, the odds are good that you are reprising a role in the markets. Maybe you're caught in a success fantasy or a story line of high expectations that are never met. Perhaps your drama is one of fighting larger forces or encountering risky thrills.

It is impossible to adapt to changing markets when we are rigidly bound to scripts from the past.

There are so many ways of changing how you trade and thereby revising your mental maps. You can trade in a more structured, rule-based way. You can trade larger; you can trade different markets or time frames. Each change shifts our experience of markets and our experience of ourselves in markets, and that alters the viewing, making it easier to continue altering the doing.

At one time a trader I work with thought of himself as a promising beginner. With success under his belt and a network of successful peers, he now experiences himself as an established professional. Another trader I've seen for a while used to view himself as undisciplined. He took on roles in his physical fitness and development, carried those over to his trading, and now sees himself as a trader with excellent risk-adjusted returns. When I first met him, I'm not even sure he had thoughts about risk-adjusted returns. Now it's how he keeps score.

You can't talk yourself into change. Only encountering new situations and placing yourself in new roles will provide the discrepancies that prod you to revise those maps and change your ways of viewing and doing.

If you get that, then you can see that the changes you most want to make as a trader are those that will enable you to experience yourself as the trader you want to become. The links below might just help you get started on that adventure.


Becoming Your Own Coach

How to Change Yourself

Thursday, May 29, 2008

Stock Market Trends and Reversals and Other Perspectives

More About Participation - Note how the S&P emini futures made a fresh price high around 13:20 (top chart), but the difference between advancing and declining stocks (bottom chart) did not confirm. Quite a few S&P 500 sectors also didn't make new highs at that time, including financial stocks (XLF); energy issues (XLE); materials shares (XLB); and consumer discretionaries (XLY). It's a nice illustration of how declining participation often leads short-term market reversals.

Intraday New Highs/Lows - If you didn't catch my Twitter comments for today, note how the expansion of new 20-day highs relative to new lows was an early tell for the morning market rally. Major props to Barchart for tracking those data.

What We Can Learn From Sports - My Naperville neighbor A Dash of Insight shares insights on wisdom from sports and trading. See also this contrarian insight into housing inventory.

More Great Links - Trader Mike has quite a few, including views on ETFs of ETFs; Twitter finance; housing inventory; and more.

Fresh Perspectives? - Quite a few, thanks to the Trader Interview archives; great resource.

Thinking Without Thought - Thanks to an alert reader for picking up on this fascinating interview from Sharp Brains, outlining how conscious and subconscious thought processes are involved in simple and complex decision-making.

Types of Trades - Corey of the Afraid to Trade blog outlines four different kinds of trades for the INO blog, which does a nice job of bringing in guest bloggers.

Trading Signals - I like how Trade By Trend publishes the trade ideas from their computerized system in real time and then tracks the results.

Constructivism: Changing Viewing and Doing

All of us are like scientists, in that we are driven to make sense of the world around us. Just as scientists construct theories to explain their observations, we generate our own mental models that provide coherence to our experience. When a trader speaks of his or her trading, the depiction is not a photographic representation, realistic in each and every detail. Inevitably, some facets are left out and others are emphasized, as the trader creates a narrative. This narrative is constructed to fit with the trader's existing mental models. What we're hearing is not reality, but the trader's reality: how the trader is construing his or her experience in the markets.

Our mental maps are necessary--without them experience would seem chaotic--but they are also prisons of a sort. Fixed modes of viewing lead to fixed modes of doing: we can become trapped by the lenses through which we view the world. One trader, affected by his childhood, sees the market as a battleground of "us versus them". Another trader, equally influenced by his experience, regards trading as a way of overcoming past failure and finally proving himself worthy to others. Still another views trading as an arena for displaying his intellectual prowess and tinkers, tinkers, tinkers in search of grails.

Constructivism in psychology emphasizes that the goal of change is the ability to revise our mental models just as scientists revise their theories. By encountering experiences that don't fit our models, we have the opportunity to change those models to account for new experience. That is why all psychological change requires novelty and discrepancy: the good psychologist afflicts our comfort as well as comforts our afflictions. New experience forces us to alter our viewing, and that leads us to alter our doing.

The challenge for traders seeking to change is to generate their own novel, discrepant experiences. Talking to a counselor or coach, in itself, or writing in a journal does not create change. Change requires fresh experience that we can internalize--i.e., that can revise our mental maps. Just as new viewing leads to new doing, new doing can generate fresh views. More on this aspect of coaching oneself shortly to come.


Becoming the Play-Actor of Your Ideals

The Relationship Between Happiness and Success

Wednesday, May 28, 2008

Stock Market Sentiment and Reversals: The Temporal Anchoring of Expectations

For this investigation, I'm working with two assumptions:

1) That market participants overall are naive trend followers: they ground their expectations in the latest price action. Thus they become most bullish when recent price action has been rising and most bearish when recent price action has been falling. As a result, sentiment shows a marked recency effect.

2) That market participants anchor their perceptions temporally, punctuating market action by the most convenient units of time: the day and the week. As a result, their perceptions of the recent past are especially influenced by what happened over the last day (particularly among daytraders) and what happened over the last week (particularly among swing traders).

When we put these assumptions together, we can infer that traders will tend to have the most bullish expectations when the last day and the last week have been rising in price. Traders will tend to have the most bearish expectations when the most recent day and week have been falling in price.

Because the bullish traders have largely followed their views and expended their capital, we'd expect market returns to be subnormal following a rising day and week. Because bearish traders have followed their sentiment and either exited the market or sold it, we'd expect market returns to be above average following a falling day and week.

Going back to 1990 (N = 2107 trading days), the average five-day price change in the S&P 500 Index (SPY) has been .025% (1109 up 998 down).

When the most recent day and week have been rising (N = 722), the next five days in SPY have averaged a subnormal return of -.27% (351 up, 371 down).

When the most recent day and week have been falling (N = 616), the next five days in SPY have averaged an above average return of .35% (346 up, 270 down).

This temporal anchoring of sentiment has been particularly pronounced since 2007, with the rising days/weeks leading to an average five-day loss of -.56% (55 up, 70 down) and the falling days/weeks leading to an average five-day gain of .48% (61 up, 35 down).

It is precisely because average traders are trend-followers in the near term, anchoring their market expectations to the most recent time periods and price action, that the stock market displays intriguing patterns of reversal. These patterns were noted in part by Connors and Sen in their research and appear to be operative to this day.


Tracking Sentiment Shifts

NYSE TICK and Sentiment

Trading With Sentiment Bars

Sentiment and Mean Reversion

An Options Sentiment Measure

Tuesday, May 27, 2008

Why Volume Matters: Reading the Market's Real-Time Auction Process

If you click on the chart, you'll see today's afternoon trade in the ES futures with price displayed in one-minute candlesticks and volume below. You can see that we traded in a range for over a half-hour and then broke higher at 13:36 PM CT. As the pink arrow indicates, that breakout occurred on increased volume. We then contracted in volume on a brief consolidation of that burst upward before resuming the upward course on even greater volume.

After a solid rally, prices consolidated for about 40 minutes, but notice how volume dried up during the consolidation. We then traded higher and, again, volume expanded on the rise.

Recall that volume is significantly correlated with volatility. When volume expands in the direction of the trade, it means that you have a correlation of volatility and direction: those are the sweet spots that will give you your best short-term moves. When volume contracts as the trade moves against you, it suggests that volatility is not moving against you, and it can make good sense to stay in that trade.

Volume expands because of the presence of large traders; it is not a sudden influx of small, retail traders creating a doubling or more of volume during a time period. Rather, institutional traders are attracted to the new price highs--and help keep the move continuing in the short run. When volume expands in the direction of the market, it means that the new prices are attracting market participation. There is acceptance of value at these new prices. It is out of such dynamics that trending moves are born.

Good breakout moves will feature an expansion of volume on the move out of the prior trading range, a pullback in volume during any subsequent consolidation, followed by further trending price action on expanded volume. The pullbacks on reduced volume represent opportunities to enter the trade in the direction of the trend.

Just knowing whether you're making new highs or lows isn't enough: you want to see how the market's auction process is accepting and facilitating trade at those fresh price levels. Volume is one important key to reading the market's real time auction. The link below (and the links within that post) will provide further background on this important facet of trading.


Tracking the Market's Large Traders

Indicator Review for May 27th

In the last indicator review, I noted strength in a number of the indicators, despite concurrent weakness in money flows. Over the past week, the market's pullback has also brought weakness to the indicators.

New highs/lows (top chart), after reaching a post-March peak, have pulled back significantly. Indeed, we're now seeing more 20-day lows than highs, with 431 new highs and 1079 lows on Friday. This suggests that the recent pullback has been broader as well as deeper than normal during a market rise. Indeed, when we look only at NYSE common stocks on a 52-week basis, we find only 14 new highs on Friday, against 44 lows.

This idea of broad weakness is also expressed in the advance-decline line for NYSE common issues (bottom chart), as nicely displayed by Decision Point. While the broad averages are well above their February highs, the advance-decline line never reached that level and now is not far off March lows. In fact, the advance-decline line specific to financial stocks has been making bear market lows, and the lines specific to consumer staples issues, consumer discretionary stocks, and health care shares are all very close to March lows.

My Technical Strength measure is also showing weakness across the eight S&P sectors that I track--further weakness compared to my recent review. As of Friday, we had 6 stocks in my basket showing uptrends, 5 neutral, and 29 in downtrends. The energy sector is the only sector showing net uptrending, and even that has deteriorated in the last week despite firmness in the price of crude.

I maintain a cumulative line of my Demand/Supply indicator (which is updated each AM via my Twitter posts) and then compare the current reading to a long-term moving average (middle chart). The pullback of this adjusted Demand/Supply Index to below the zero line following a healthy rally is something that often occurs during the early phase of a topping process. As a result, I will watch the indicators carefully during any market bounce during this post-holiday, end-of-month week to see if we're losing steam to the upside, which would be consistent with a topping process.

In sum, the picture is neither as bad as bears would like to have it, nor as good as bulls would like. The January-March period represented a significant bottoming of the major indexes, but the subsequent rise has been restrained, with considerable sector rotation and unevenness and weak money flows. It is difficult to imagine sustaining a vigorous bull market on such a foundation.

Monday, May 26, 2008

A Look at the Dollar and Other Ideas Worth Cashing In On

* Dollar Weakness - As the chart of the U.S. Dollar Index (cash) vs. S&P 500 Index (cash) indicates, we've seen more of a bounce in stocks since March than in the dollar. Whereas stocks are meaningfully above their lows even after last week's selloff, the U.S. dollar is approaching its all-time lows. Though expectations of continued Federal Reserve easing have themselves eased, any anticipations of rate firmness have not been sufficient to support the dollar.

* Framework for Day Trading - The EminiDayTrading site offers a free webinar that offers their interesting approach to understanding and trading markets on the day timeframe.

* Missed It By a Tick - An erudite and experienced trader and author writes to me of a trade that he missed, hoping to get filled at just the right tick. When that tick went unfilled, his trade idea went unfulfilled. Inspired by Swinburne's stanza in The Garden of Proserpine, he writes:

Tricked for a Tick

The trading gods are fickle
They live I have no doubt.
They love to cause a pickle
Hoping to sound us out.
The answer is decision
One made with quiet precision
With fear and greed unrisen
That's what it's all about.

"Decision made with quiet precision": I don't think I could summarize trading psychology any better--certainly not more poetically!

* The Advantages of the Pros - One way that professional traders seize an advantage in the marketplace is by testing trading strategies across a range of market conditions and then automating the execution of the successful strategies. This can be extended across a range of strategies so that, under any market conditions, there will be some strategies making money--without untoward psychology affecting the execution. I see where Stock Tickr has teamed up with Trade Ideas to test and automate strategies for active traders. This strikes me as particularly promising.

* What's Going On With Oil? - Trader's Narrative offers an interesting view and John Mauldin passes along his perspective on the speculative boom.

* Just Keeps Getting Worse - Research Recap recaps the delinquency rates among residential mortgage-backed securities as a function of issuance year.

Readings Worth Reading for a Holiday Monday

* Dark Side of an Economic Miracle - China's exploding growth has brought explosive problems with pollution at a great human cost. I highly recommend Nicholas Kristof's blog for a variety of international perspectives from a ground's eye view.

* What You See May Not Be What You Get - Trader Mike makes the case for looking under the hood at your ETFs.

* Most Promising ETFs - A Dash of Insight takes a look at top performing sectors and themes.

* Themes and Links - Why cash flow is king, top performing brokers, and more ETF views are among Kirk's most recent links.

* More Good Views - Why understanding value in a price-oriented trading universe is helpful and more perspectives from Abnormal Returns.

* Size Matters - CXO Advisory summarizes fascinating research information that relates the size of companies to their stock returns.

Sunday, May 25, 2008

A Simple Step That Turns Things Around

I recently received an email from a reader who reported his first solid, profitable week in a while. He was particularly happy that, during the week, he had tamed some of those trading demons that led him to overtrade and make bad decisions.

Interestingly, the trader didn't do anything radical to turn his trading around, and he certainly didn't change his fundamental approach to markets. I'll let the trader's own words explain the simple step he took to turn things around:

"I started to do brief meditation after each losing trade and it really helps to tame the demon. By keeping emotion in check helps me to avoid any trading disasters I had so many times in the near past."

In other words, the trader taught himself some meditative techniques to slow down his mind and body, and he stuck with these techniques until he could calm himself down in a very short period of time.

He then took the meditation a step further and used it to center himself proactively after each losing trade. Instead of waiting for himself to become frustrated and risk making bad decisions, he didn't allow frustration to build in the first place. By repeating this through the week, he began the process of creating a routine that, eventually, can become a positive habit pattern.

This is one of the simplest, but most effective psychological techniques I know. It is very difficult to become controlled by emotions when you're keeping mind and body in a controlled state. What is really happening is that you're building your sense of control and self-efficacy. Over time, using a technique such as this, you internalize the confidence of knowing that you are in control of your trading: one loss doesn't have to spill over to affect subsequent decisions.

For specifics about behavioral exercises to interrupt negative trading patterns, check out this post; this follow up blog article; and my two trading books. The trader's unique application is to utilize these methods before he can become frustrated and make poor decisions. This proactive use of psychology can be applied to any situation that triggers trading problems, from performance anxiety scenarios to periods of overconfidence.


* Building Self Efficacy

* Questions to Ask When You're in a Slump

Saturday, May 24, 2008

Changing Yourself As A Trader

A reader recently wrote to me of a dilemma: He is trying to change the way he trades, because he is no longer seeing an advantage in his old approach. His new way of trading involves taking moves on longer time frames, rather than very actively trading in and out of markets. He has created plans to guide his new trading mode, but finds that he is not following those plans and now is puzzled as to how to proceed.

The problem with changing yourself as a trader is not just the learning of new patterns; it's the unlearning of old ones. A trader calibrated to a particular market (say, S&P 500 eminis) will have difficulty reacting to the speed and extent of moves in other markets (say, crude oil). A trader calibrated to one time frame will have trouble putting that "feel" on hold while trying to trade another time frame.

Often traders have difficulty changing their approaches, because the old ones get in the way.

For that reason, I have almost always found that an extended period of observation and simulated trading/extremely small trading must precede any major transition of trading markets or styles. This period permits an immersion in new patterns, and it also facilitates the unlearning of old trading habits. It additionally enables traders to try out new approaches without losing significant money.

Much of trading boils down to pattern recognition and the ability to act promptly on patterns as they unfold. When traders change markets or time frames, they inevitably move to different patterns or similar patterns that unfold differently. I've seen traders make successful transitions in their careers, but the key has been their willingness to undergo a fresh learning curve. Impatience is the enemy of change.


Learning How to React to Changing Markets

How to Keep a Trading Journal

Three Steps to Take If You're a New Trader Losing Money

Friday, May 23, 2008

Stocks Having Difficulty Going With the Flow

Recall that money flow is a measure of the dollar volume either entering a stock (buying interest) or leaving a stock (selling interest). If a trade occurs on an uptick, the volume of that trade times the transacted price is added to a cumulative total. If a trade occurs on a downtick, the volume of the trade times the transacted price is deducted from the total. The cumulative total for the day is that stock's money flow. In the chart above, I've calculated the daily money flow for all 30 Dow Jones Industrial stocks, added the daily totals to obtain money flows for the index as a whole, and plotted the four-day moving average (pink line) versus the Dow ETF (DIA; blue line).

When the pink line is above zero, we're seeing net dollar inflows into Dow stocks. When we're below zero, there are net dollar outflows.

What we can see is that we have seen less outflow of money since the January bottom--a divergence I noted at the March lows--but that since March we have not sustained dollar volume inflows. After money flows turned modestly positive in April, we've seen a resumption of dollar outflows in May. Indeed, we've seen net dollar outflows from the Dow stocks on 13 of the last 15 trading sessions.

Interestingly, 19 of the 30 Dow issues are showing net outflows for the last ten trading sessions; 11 are showing inflows despite recent market weakness. As my earlier post indicated, we're seeing outflows from financial stocks and industrials; materials and energy companies are holding up better.

This suggests to me that, once again, even when the market has been rising, we're seeing more of a shifting of funds from sector to sector, rather than influxes of new funds into stocks. If this continues, it may well keep a lid on market gains.


Weakness in Financial Sector

Thursday, May 22, 2008

Technical Strength by Sector and Other Market Themes

* Technical Strength - Earlier posts have noted considerable sector rotation within the market's bounce since March. With the recent market weakness, here's how the technical strength of the S&P 500 sectors are now looking:

ENERGY: +380

The only strength we're seeing is among the commodity-related sectors. The sectors that have weakened most notably are the industrials and technology, which suggest that energy and commodity related strength is showing its effect on anticipated economic growth. Wednesday's new high/low figures underscores how the current market is one of haves and have nots: we had 1019 fresh 20-day highs across the NYSE, NASDAQ, and ASE and 868 20-day lows.

* Why Commodity Markets Are Exploding - Thanks to a very astute reader for passing along this summary of testimony before the Committee on Homeland Security and Governmental Affairs. Eye-opening reading.

* Why Oil Prices Are Exploding - As oil producers become increasing consumers, exports decline over time; another thought-provoking piece passed along by John Mauldin.

* Decisive Break - Trader Mike sees the recent market action as a decisive break through a level and makes particular note of action in the Transports. See also this worthwhile and relevant post on how mini-bubbles develop in the market, as momentum trading makes its comeback.

* Themes for the Current Market - The Kirk Report once again picks out important themes, including myths of energy independence, warnings of a commodities bubble, and where the action is in MSN Money's Stock Scouter.

* Time Zones in the Stock Market - An outline of what goes on at different times of day, something day traders keep track of.

Wednesday, May 21, 2008

How Trading Dreams Come True

There is no lack of market charlatans who promote the idea that trading is easy and that riches are around the corner. These, like all get rich quick idiots, prey upon the fantasy that anyone can have it all, without really working for it.

When I wrote Enhancing Trader Performance, my goal was to describe actual successful traders I had personally observed and worked with and to capture how they became successful. I noticed a difference between the learning curves of those who succeed and those who don't, and it was my conviction that most traders fail to reach their potential because they don't go about learning markets in the right ways.

Yesterday I received two emails from traders who were doing it the right way.

The first trader had gone through a frustrating period of reduced performance, particularly as markets had become less volatile. He made conscious efforts to adjust his trading by taking profits more aggressively and reducing his trading during periods of low opportunity. He took time to visit other traders and attend a seminar, where he learned a few trading techniques that seemed promising. The input from others convinced him that he needed to narrow his stock picking and focus on areas of greatest opportunity, eliminating lower volatility names. He did that and reported in his email that it was like "a light bulb went off in my head". He had his best day in months and regained much of his enthusiasm and optimism.

Instead of simply becoming frustrated and trading more when he was trading poorly, that trader managed his risk well and sought new learning. He adjusted to markets and tweaked his trading to find enhanced opportunity. That is what winners do, and I'm very optimistic that he will find long-term success as a result.

The second trader, an insightful contributor of comments to this blog, wrote to me of hitting a trading milestone. He went through two months of unprofitable trading about a year ago and then pulled back, studied markets, and traded actively in simulation mode. He found areas of opportunity in that way and returned to live trading in December. Since that time, he has doubled his trading account, while keeping risk moderate.

This trader was unusually good at pulling good ideas from various sources and integrating them into his own trading style and niche. He didn't try to imitate anyone else, and he didn't put making money first in priority. Instead, he focused on learning and discovering his own opportunity in markets. Because he put learning ahead of trading, he is now trading very successfully.

I do see dreams dashed among traders, but I also observe trading dreams that come true. It isn't easy; it requires ongoing learning and effort. My two correspondents are a shining reminder to me--and hopefully to all readers--that success in any life endeavor is possible if you find what you love, what you're good at, and devote yourself to building skills through structured practice.


What Makes Expertise

A Look at a World-Class Trader

Tuesday, May 20, 2008

Tough to Bank on the Financial Stocks

As we can see from the top chart, financial stocks within the S&P 500 large cap universe (XLF; red line) have diverged noticeably from the broader market as a whole (SPY; blue line). Indeed, even as we've seen multi-month highs in SPY, financial shares have been making multi-week lows.

The advance-decline line specific to financial stocks (bottom chart), as tracked by Decision Point, is nearing its bear market lows. Only 33% of all stocks within XLF are trading above their 20-day moving average. By contrast, 62% of all NYSE stocks are above that benchmark.

The dramatic underperformance of financial shares suggests that, even as there are signs of easing with respect to the credit crisis, the profit outlook for banks is not favorable in the wake of deleveraging. Amidst indications that bank deleveraging around the world has only just begun and that, in the words of Fed Vice President William Dudley:
"It will take time for market function to return to normal.
The reintermediation and deleveraging process has, in my view,
a considerable ways to go,"
it may be a while before investors can bank on a bull market in financial shares.

Participation and Intraday Market Reversals

Above we see a five-minute chart of the S&P 500 Index (SPY; blue line) plotted against the number of three-hour new highs minus lows among the stocks in the basket I follow. These are the same stocks that I use to track Technical Strength: five highly weighted issues taken from eight different S&P 500 sectors. As a result, the basket assesses a nice cross-section of stocks within SPY.

The new highs and lows are taken from five-minute closing values over a rolling three-hour lookback period. They give us a keen measure of the degree to which a range of stocks from different sectors are participating in rallies and declines.

Note that new highs minus lows never hit a high level of participation during the morning market rise. At the market peak, for instance, only half of the stocks in the basket were making fresh three-hour highs. Moreover, notice how--as the rally progressed through the morning--new highs minus lows actually peaked ahead of price. This is a common pattern: bullish moves tend to continue when participation is expanding and are more likely to reverse as participation wanes.

An even more subtle pattern was an excellent tell for the afternoon selloff: prior to making the peak price in SPY, five of the basket stocks were actually registering fresh three-hour lows, sending the new highs minus lows into negative territory. These five issues were not limited to a single sector: they were spread across four different sectors. This told us that there was selling underlying the market strength, and it pointed the way to the specific stocks that were leading the weakness. In other words, for some issues, the selloff had already begun.

Finally, note how participation to the downside was much broader than the upside rally had been. All but a handful of shares made three-hour lows in the afternoon. With expanding participation, the decline did not readily reverse, but continued through much of the afternoon.

Traders who watched price only for the broad index or for their particular stock were apt to be surprised by the market reversal. By looking under the hood at the participation in the market rally and subsequent decline, traders could prepare themselves for potential reversal and the subsequent extension of the downside move.


Participation and Reversal Moves

Participation as a Key Market Variable

Participation and Breakout Moves

Monday, May 19, 2008

Trading Insights to Start the Market Week

* Breakout in Sentiment - Here is a five-minute chart from today's market. The candlesticks represent the S&P 500 Index (SPY; left axis), and the blue bars represent the NYSE TICK (right axis). At the 12:55 CT bar, you can see that the TICK broke out of its range to make a dramatic new low for the trading day. I've generally found that such TICK breakouts represent an intensification of buying (if the breakout is to the upside) or selling (breakout to the downside) sentiment that can lead to short-term trending moves. Note that even after the TICK breakdown, SPY headed significantly lower before rebounding late in the day.

* Solid Trading Insights - Earlier today I had the pleasure of talking by phone with Evan Lazarus, who heads up the T3 Live blog and the T3 Live multimedia site for trader education. The material for both resources is contributed by successful active traders at an established proprietary trading firm. Both are excellent ways of seeing what some of those traders look at when they trade.

* Useful Research - Bespoke Investment Group does a great job of tracking market themes and patterns. Here's their work on the relative performance of value and growth stocks over two time periods. See also their breakdown of the transport stocks, which recently hit a bull high.

* More Fine Research - CXO Advisory examines guru stock picks and what happens to them after they're issued. See also their summary of research on inflation shocks and stock performance.

* Links - Welcome back to Abnormal Returns, who start the week off with some sound advice.

* High Five - The market makes a fifth consecutive high, but Quantifiable Edges finds it tough to locate an edge here.

Indicator Review for May 19th

Last week's indicator review highlighted the uneven sector performance during the market's recent rebound from March lows. By Wednesday, I noted that the number of stocks making fresh annual highs had expanded, a sign of growing breadth to the rally. This strength owed much to the midcap stocks (top chart above from Decision Point), which have recovered much of their bear market losses. We can also see the strength reflected in the move of the Cumulative NYSE TICK to new highs (middle chart above) and in the expansion in the number of stocks registering fresh 65-day highs (bottom chart).

I also note that a growing percentage of stocks are closing above their 200-day moving averages; among SPX issues, that percentage is now 58%, up from 15% at the March lows. On a shorter-term basis, 77% of S&P 500 large cap; 76% of S&P 400 mid cap; and 64% of S&P 600 small cap stocks are trading above their 50-day moving averages, also indicating good participation in the rally.

To be sure, sector variation is still present, and I will review this in an upcoming post. Financial, airline, and homebuilding stocks remain weak; energy and technology issues remain strong. Because of this uneven sector performance, I would not call the advance-decline line for NYSE common stocks strong, but it did reach a post-March high this past week.

In general, these measures of strength tend to peak ahead of price, which suggests to me that--though we may be due for some correction--we have not seen the last of the rally following the double-bottom in January/March. I continue to harbor doubts that this rally will bring us significant new price highs for the major averages. Rather, I see it as a late, selective continuation of the bull cycle that began in August, 2006. Some sectors (financials) have likely seen their bull peaks; others (energy) are still making them. If that conjecture is correct, the good news is that we should see further price strength in the major averages into the summer. The bad news is that a more significant bear may lie beyond.

Sunday, May 18, 2008

End of Week Review: Blogosphere and More

* Easing Crisis - Gold is sometimes a safe haven during periods of perceived crisis. Note the spike in gold price as stocks made their March lows and the selloff in gold as stocks have steadily moved higher. So far in 2008, stocks and gold seem to be traversing opposite paths.

* Fewer Planes in the Sky? - The excellent 24/7 Wall St. site, which tracks company news and developments, notes the start of a possible trend: airlines grounding their planes to save fuel.

* Following a Trader's Thoughts - The itrade4real site offers some trading wisdom, but also tracks trades and ideas about markets in real time.

* Dr. Brett in an Upcoming Documentary - I'll be interviewed this week for a film documentary on the psychological aspects of trading, to be aired on the France24 television network. I hope to pass along a link once it airs.

* Free Webinars - Here is a session sponsored by Market Delta, describing how tracking the volume at bid vs. offer on any time frame can assist short-term trading decisions. If you missed it, here is my webinar session on trading the psychology of the market.

* Stocks to Watch For - Brian Shannon posts his long and short candidates, along with their respective charts. It's a nice application of the principles in his new book.

Market Strength: When Do Strong Markets Trend Higher?

I have to credit Henry Carstens, a master system developer, for this line of research. If you're not familiar with Henry's work, check out his creative system for providing an "all clear" signal following a spike in VIX. He also has a free e-book that is an introduction to testing trading ideas and a larger volume for sale at a modest price that goes into greater detail. Excellent resources.

Henry emailed me yesterday with an idea for a system that would predict trending behavior in a bullish market environment. In other words, it would capture when a rising market is likely to continue rising.

I took Henry's line of reasoning and adapted it to the historical indicators that I collect. Specifically, I went back to 2004 (N = 1101 trading days) and took a look at an indicator that I will call Market Strength. Market Strength is one way to assess the relative proportion of stocks that meet an upside momentum criterion.

When the S&P 500 Index (SPY) is up on the day (N = 577), the odds of the next day closing higher in price has been 51%. Pretty much tossing a coin.

When the S&P 500 Index is up on the day and Market Strength is above average (a simple median split of the data; N = 288), the odds of the next day closing higher in price is 57%. When the S&P 500 Index is up on the day and Market Strength is below average (N = 289), the odds of the next day closing higher in price is 45%.

Perhaps even more interesting, the odds of getting an up day following an up day appears to be directly related to Market Strength. When we have a very strong Market Strength reading (N = 52), the odds of the next day closing higher rise to 66%.

While Market Strength will remain a proprietary measure for now, I will be refining this line of inquiry and eventually incorporating into my blog posts and Twitter comments so that traders might benefit from the historical research. Hats off to Henry and to all those who express their passion for markets through original research and who fertilize their efforts by sharing with other researchers.


Market Strength and Short-Term Price Cycles

Momentum and NYSE TICK

The Importance of Participation

Saturday, May 17, 2008

The Psychology of Market Volatility

The chart above displays the relentless decline in option-related volatility ($VIX) from the March stock market lows to the present. But how does this decline in volatility affect traders and their psychology?

I ask the question because three observations have struck me in the past week:

1) An increasing number of traders have contacted me, indicating frustration with their (day) trading, including greater losses during the afternoon trade;

2) An increasing number of traders have contacted me, indicating that they have been "too aggressive" in trading the current market;

3) My own trading performance, which had been quite consistent through 2007, turned flat for several months before resuming consistency in April and now becoming quite positive in May.

I don't think these observations are unrelated. The day traders I talk with benefit greatly from volatility. When markets become less volatile, they find themselves going after large moves that never materialize. This leads to frustration and over-aggressive trading.

I, on the other hand, tend to be quite risk averse in my trading: a peak-to-trough P/L decline of 3% would be a major deal for me. When I detect large volatility in markets, I immediately cut my size to standardize my returns and I trade less. Where the traders I talk with experience volatility as opportunity (and indeed take advantage of it), I experience it as risk (and benefit far less from it).

Conversely, as volatility drops in the market, I am comfortable with the market conditions, take small profits frequently, and build my account. Where the traders I talk with see the low volatility environment as low opportunity, I experience it as low risk. As soon as the VIX moved back into the low 20s, I was in my glory. The traders, on the other hand, were finding it more difficult to participate in large moves, frustrating their ambitions.

The point here is that volatility affects the psychological environment of trading. Depending on our risk appetites, we will respond differently to volatility regimes--and that will likely affect our trading performance.

A few statistics will highlight the psychological importance of volatility. I went back to January, 2008 (a higher volatility environment) and found that the median 30-minute high-low range for the ES futures was .60%. I then looked at May, 2008 to date (a lower volatility environment) and found that the median 30-minute high-low range for the ES futures was .29%. In other words, at a 30-minute time frame, markets are moving half as much now as they were in January. Is it any wonder that traders looking for big moves are becoming frustrated?

Traders don't realize that volatility scales at every time period. If we have lower daily volatility (as the chart above depicts), we will have lower volatility for every intraday time period. Whatever our average holding period might be, the market will move less in a low VIX environment than a high VIX one. That greatly affects trading behavior:

* It means that any standard method of placing stops and targets will perform poorly as volatility changes dramatically. When volatility rises, we will tend to have our stops too close and get whipsawed frequently. When volatility falls, our targets will tend to be too far away, leaving us in a situation in which we make money on trades, only to see the trades reverse before we are ready to exit.

* It means that any standard method of sizing trades will lead us to go through periods of high performance volatility as markets become more volatile. These large P/L swings can create considerable distress for risk-averse traders (like myself). On the other hand, the standard method of sizing trades will lead to lower performance volatility as markets become less volatile, leading more aggressive traders to become frustrated with the truncated range of their returns.

Markets change how they trade periodically. What we've been seeing since March, 2008 is a noteworthy change in market direction, themes, and volatility. The ideal is to recognize these shifts as they are occurring and make mid-course corrections as promptly as possible. This is especially difficult for newer traders, who lack the database of personal experience to know how to adjust to radically different trading environments.

I'm not going to name names, but if a "Market Wizards" book were to be written now, surprisingly few of the people featured in those earlier volumes would qualify for chapters today. It's difficult to succeed at trading, but--given rapidly changing market conditions--even more difficult to sustain success. It's not good enough to find winning trading techniques; one has to continually adapt these techniques to an ever-changing environment.


Anticipating Volatility

A Psychological View of Volatility

Relative and Absolute Volatility

An Indicator for the Coming Day's Volatility

When VIX Becomes Volatile

Friday, May 16, 2008

Free Trading Resources You Might Not Be Aware Of

* Market Data - A wealth of data can be found on the Online Wall St. Journal site. Also check out news and data from Reuters.

* Researching ETFs - ETF Connect offers broad coverage and excellent summaries of the various ETF alternatives.

* World News - Here's global news organized by feeds, an excellent feature assembled by NewsFlashr.

* Stock Picking Resource - StockScouter from MSN Money is an excellent research tool.

* Creative Charts - The StockCharts site features market carpets that summarize performance across markets and drill down to individual sectors.

* Tracking Markets - The Barchart site enables you to follow currencies, energies, financials, and more.

* Global Financial TV - You can watch Bloomberg TV from around the world by going to their site and launching their video player from the left hand tool bar.

Treasury Yields: A Real-Time Market Sentiment Gauge

Suppose we could conduct a poll each day of traders and investors, asking them for their outlook on the strength vs. weakness of the U.S. economy? That might provide some useful sentiment data.

Well, we have something better than a self-report poll, which may or may not reflect the actual market behavior of these participants. The rise and fall of Treasury yields provides the market's real-time assessment of whether the economy is weakening or strengthening.

If the economy is weakening and requires stimulus, anticipations of Federal Reserve easing will lead to falling short-term yields. If the economy is encountering inflationary pressures and may require monetary tightening, short-term yields will tend to rise.

Like any sentiment gauge, yields can overdo things on the upside and downside. Take a look at the chart above, which tracks two-year Treasury yields versus the cash S&P 500 Index from mid-year 2007 to the present. The correlation between the two is striking. As stocks were falling and housing and credit issues dominated the headlines, yields fell all the way to 1.41%--a negative return vis a vis inflation.

Since March, those concerns have abated to a degree. Stocks have retraced essentially all of their year-to-date losses and yields have moved steadily higher to 2.47%. If traders and investors expect the Fed to put inflation fighting ahead of liquidity provision, we should continue to see rate firmness. That is bullish for stocks, because it means that the Fed is not so worried about bank failures and economic collapse that they need to engage in Japanese-style quantitative easing.

Should we see rates move back toward their March lows, however, it would signify a resumption of worries regarding the financial system and a pricing in of expectations regarding Federal Reserve ease. When new economic data are released, it's worth keeping an eye on short-term yields for a quick poll of market reaction.

If you understand how yields serve as sentiment gauges, then it's not too far a leap to see how the relative movement of yields from country to country reflects real-time pollings of economic strength and weakness on a global basis. This has important implications for currencies, as well as the flows of funds from one global market to others.


It's All One Market

Thursday, May 15, 2008

When the Trading Demons Get Out of Control

The following is a direct quote (with the trader's permission) from an email I received just a little while ago. It illustrates a dilemma that many traders face at some point in their career:

"I was doing ok for a few days, then I went back to my old trading ways and just suffered a big loss of my account today. I committed all the the trading sins, etc double my position size, go against the trend, being stubborn and hold onto a losing position. I think I know the correct way (maybe I am fooling myself), but I don't seem to be able to control the demon inside of me and just can't break the old bad habits."

So let's imagine this is happening at one of the trading firms where I serve as psychologist/coach? How would we tackle the situation?

First off, we would tackle it quickly. Times of crisis are also times of opportunity, when it comes to psychological change. That's when people are most motivated--and most open--to making changes. "Strike while the iron hot" is an apt principle when situations feel desperate.

Second, I would immediately institute a three-way meeting with the trader, myself, and the firm's risk manager. We would greatly cut back the trader's risk (i.e., trading size), so that no further harm could be done to the account. "Above all else, do no harm," is a principle that works for physicians and traders alike. The idea is that, with profit/loss (P/L) pressures removed from the equation temporarily, it is easier to focus on problem patterns, their causes, and possible solutions.

Third, I would interview the trader extensively (and observe him trading, if possible) in order to identify the specific situations that are associated with the loss of discipline. In other words, I would ask in detail about what is happening in markets when the trader's discipline is good and what is happening when "the demon inside of me" comes out. What we're looking for are *patterns* that we could then address with specific change techniques.

Here are the patterns that I find to be most common:

1) The trading problem is the result of a broader emotional disorder - This is more common than is commonly recognized. About 5-7% of the population suffers from a diagnosable emotional disorder during any given year, with a similar incidence of substance use disorders. As a result, at least one in ten traders can be expected to experience emotional disruptions that interfere with trading, but are not specific to trading. These disruptions include anxiety disorders (such as panic disorder and generalized anxiety), mood disorders (depression), and disorders related to attention deficits and hyperactivity. Many of these problems can be addressed effectively--and without debilitating side effects or addictive potential--through the use of medications. Many of them also benefit from counseling/therapy assistance from a qualified professional. If the problem affecting trading is also occurring in other spheres of life (relationships, work) or has predated trading experience, the odds are high that it could benefit from professional assistance. The proper course of action is to get a high-quality referral to a licensed professional, not a self-proclaimed trading coach.

2) The trading problem is the result of trading-specific performance pressures - Many times traders experience performance anxiety regarding the uncertainty and risk of markets and the pressures to make money. This anxiety leads them to trade in fearful ways, and it sometimes leads them to overtrade in the desire to make things work out. Many times the disruptions of trading occur during periods of drawdown and slump, when performance pressures become most acute. Common to these performance problems are difficulties with negative self-talk, including self-imposed, perfectionistic pressures. The key to this set of problems is that they are trading-specific. Other areas of life don't exhibit the same patterns of pressure and disruption. Many of these concerns can benefit from self-help methods, including the cognitive and behavioral methods that I outline in my book on trader performance.

3) The trading problem is literally a trading problem - This is most common when traders put their money at risk before they've gone through a proper learning curve. They have read a little, observed a little, and now try their hand at trading. Because they don't understand how markets move--and what makes them move--they rely on simple patterns for entry and exit that provide them with no statistical edge whatsoever. The result is increasing frustration and loss of capital. Although the problem may look psychological, the emotional distress is really the result of the more fundamental absence of skills and experience. I would guess that easily half of all people who seek my advice and assistance fall into that category. When I ask trading and market-related questions, it's clear that they don't understand even basic fundamentals. The proper solution for this situation is to go through the learning curve the right way, starting with observation and practice (simulated) trading, and then gradually moving toward real-time risk as skills build.

A major shortcoming of seeking help from trading coaches is that they are usually only experienced and knowledgeable in area #2 above. They are not trained as professional psychologists to help with #1, and they lack the trading experience to be of assistance in identifying #3. Additionally, it is in their financial self-interest to lump as many traders into category #2 as possible, since the first and third categories are unlikely to build their book of business.

Because I don't work with individual, independent traders myself--either as a coach, psychologist, or trading mentor--I don't feel wedded to any of the scenarios above. The key is for traders to accurately diagnose the problem, so that they can follow a promising, structured plan of action. There are many reasons why the trading demons can get out of control: understanding the why of the demons is half the battle of figuring out what to do about them.


Coaching the Professional Trader

When Coaching Doesn't Work, Part One

When Coaching Doesn't Work, Part Two

Performance Coaching

A Referral List of Mentors and Coaches

Year to Date Global Equity Returns by Style

By clicking on the above chart, you'll be able to see comparative year-to-date returns for EAFE (Europe, Australasia, Far East) value stocks (EFV); EAFE growth stocks (EFG); S&P 500 value stocks (IVE); and S&P 500 growth stocks (IVW).

Here are a few noteworthy observations:

1) Across the world, equities have retraced most of their year-to-date losses (though they remain below their 2007 peaks);

2) Growth has been outperforming Value among the EAFE stocks since the January market lows, and now in the last month has outperformed Value among U.S. stocks;

3) U.S. Value stocks were relative performance leaders during the market decline, but have been laggards since the March lows;

4) EAFE stocks were relative performance laggards during the market decline, but have been leaders since the March lows.

I believe these results suggest an improvement in overall market sentiment, which has led investors away from safety (large cap U.S. value) and back toward growth themes. That is not to say that the key bear market themes (weak housing, credit concerns) have gone away; only that global markets are according these themes less weight in their asset allocations.


Tracking the Style Box

Tracking the Style Cube

Wednesday, May 14, 2008

Gauging Market Strength After a Move to New Highs

Whenever a market makes new price highs or lows over a period of time, I like to examine whether the number of individual stocks making fresh new highs or lows has expanded. This tells me whether the move has been broad-based or simply dominated by a limited number of sectors. Interestingly in the recent market, we've seen considerable sector rotation, with new highs lagging as the stock indexes moved higher. Most recently, however, as noted in my Twitter comment, we've seen leadership from the small caps as well as NASDAQ stocks, suggesting a broadening of the rally.

Today we hit fresh price highs in the NASDAQ and Russell 2000 indexes, as those markets have moved nicely off their March lows. As the above chart of the NYSE Composite Index indicates, we came close to price highs in the broad market before backing off in the afternoon. The helpful chart from Decision Point shows, however, that new 52-week highs among NYSE common stocks expanded, reaching a fresh post-March high.

I then examined new highs specific to the S&P 500 large cap stocks and the S&P 600 small caps. These also expanded to post bear-move highs: we had 38 annual highs among the large caps and 2 new lows; 25 new highs and 7 new lows among the small caps.

On a shorter-term basis, we also saw strength in the market, with 968 NYSE, NASDAQ, and ASE issues making fresh 65-day highs and 195 registering new lows.

Yet another way that I assess market strength during a move to new highs is to gauge the number of stocks closing above their moving averages. On Wednesday, we saw 54% of S&P 500 stocks close above their 200-day moving averages, the highest reading of 2008. Similarly, we had 46% of S&P 600 small cap stocks closing above their 200-day averages, also the highest reading of the year.

Because the proportion of stocks closing above their moving averages tends to crest ahead of price peaks during bull moves, an expanding reading suggests that we should see higher prices ahead, even if there is some corrective action in the near term.

By looking at new highs/lows and percentage of issues above moving averages for multiple indexes, we can gain a multifaceted perspective on whether markets are gaining or losing strength. This is quite helpful in identifying trends that are more likely to continue, and those that are more likely to reverse.


When New Highs Get Higher

What Happens When New Lows Expand

Intraday New Highs and Lows

A Few Resources to Prepare You for the Market Day

* Morning Twitter - Thanks to readers who have emailed re: their use of the Twitter posts as a help in preparation for the trading day. The last five posts appear on the blog under the heading "Twitter Trader"; the full set of posts can be found on my Twitter page (which is also where you can subscribe for automatic updating). Each AM I post market indicators, including new 20-day highs and lows across the major exchanges and figures for Demand (index of number of stocks with strong upside momentum) and Supply (index of number of stocks with strong downside momentum), as well as the percentage of SPX stocks trading above their 50-day moving average. By tracking these numbers from day to day, you can gain a feel for whether the market is strengthening or weakening in the short-term. I also link important news stories via Twitter to identify themes impacting markets and send out a heads up notice for upcoming important economic reports. These items are part of my daily market preparation, and I hope they can be helpful for you as well.

* Looking for Stocks in Play? - That may be another part of your morning preparation. Trader Mike's watch lists each morning summarize market-moving events and stocks on the radar. He also offers swing trade candidates.

* Ideas for Shorts - Charles Kirk posts a simple screening idea for stocks that may be overextended. See also his morning posts that are helpful in preparing for the trading day, including a list of stocks rising and falling pre-market.

Tuesday, May 13, 2008

Eternal Truths About Trading Success

A portfolio manager lent me an interesting small book from the late 1800s written by Dickson G. Watts and reprinted by Traders Press. Entitled "Speculation as a Fine Art and Thoughts on Life", the book begins with a description of the "qualities essential to the equipment of a speculator" (p. 8). Here is the author's perspective, written well over a century ago:

* Self-Reliance - "A man must think for himself, must follow his own convictions...Self-trust is the foundation of successful effort."

* Judgment - "...equipoise, that nice adjustment of the faculties one to the an essential to the speculator."

* Courage - "...confidence to act on the decisions of the bold, still be bold; always be bold."

* Prudence - "The power of measuring the danger, together with a certain alertness and watchfulness, is very important."

* Pliability - "The ability to change an opinion, the power of revision."

I especially like Watts' formulation: "There should be a balance of the two, Prudence and Courage; Prudence in contemplation, Courage in execution."

This very much fits patterns of success I detect among the most profitable traders. They are prudent in contemplating their ideas--they wait for the odds to be in their favor and conserve their capital when the edge is not there--but they are courageous in executing those ideas.

Equally important, they can be courageous without getting their egos tied to their ideas. If markets are not confirming their views, Pliability ensures that they can revise those views and not hang on to losing trades.

"The qualifications named are necessary to the makeup of the speculator," Watts explains, "but they must be in well-balanced combination. A deficiency or an overplus of one quality will destroy the effectiveness of all" (p. 9).

Too much courageousness and too little prudence leads to impulsive risk-taking. Too much pliability and too little self-reliance leads traders to get chopped up, reacting frantically to the last market movements.

Some trading truths never go out of date.


Four Overlooked Qualities of Successful Traders

Resilience and the Courage of Your Convictions

Monday, May 12, 2008

Indicator Review for May 12th

My Technical Strength measure is a quantification of trending behavior over an intermediate-term time frame
. The measure tracks five highly weighted stocks within eight different S&P 500 sectors. Scores range from -500 (near perfect downtrending) to +500 (near perfect uptrending), with scores near zero suggesting the absence of trending.

Here are the sector scores as of Friday:

Materials: +20
Industrials: -180
Consumer Discretionary: +200
Consumer Staples: -220
Energy: +300
Health Care: -280
Financial: -260
Technology: +220

What stands out is that we have sectors moving in very different directions. Beneath the action of the broad index is considerable sector rotation, as noted in a recent post. Although we've recently moved to price highs following the March lows, a limited number of sectors have accounted for essentially all the strength. That is not a healthy market situation and helps to explain why broad buying sentiment has been lagging.

It is this very mixed sector performance that also helps explain why the advance-decline line specific to NYSE common stocks, as nicely illustrated by Decision Point in the above chart, has been lagging. While the S&P 500 Index has vaulted above its February highs, the broad advance-decline line remains significantly lower. Moreover, as stocks moved to new price highs early this past week, the AD Line failed to follow.

Indeed, when we look at advance-decline lines specific to each of the above S&P 500 sectors, we can see a similar pattern of mixed performance. The line specific to energy stocks is hovering at its April highs, which are also all-time highs. The line for consumer staples stocks, however, hit a new bear low this past week. We are very close to bear lows for financial and health care stocks, but technology shares remain well above their bear lows (though nowhere near their bull highs).

Finally, the broad stock market indexes are nicely higher over the past month, but Friday's market showed 797 new 20-day highs and 747 fresh 20-day lows--more mixed performance. I cannot imagine the market sustaining a significant bull move on such a selective basis.


Last Week's Indicator Review

Sunday, May 11, 2008

Stock Picking and the Value of Sub-Sector Perspectives

The excellent Barchart site divides the stock market into 232 sub-sectors and tracks their performance relative to the broad market. The charts above represent the relative strength of the sub-sectors, not price. A zero value means that the sub-sector matches the strength of the broad market. Negative readings signify underperformance; positive readings indicate relative strength.

From these sub-sector perspectives, we can gain unique stock picking insights. Note, for instance, how the independent oil and gas companies are significantly outperforming the majors. Similarly, regional banks in the Northeastern part of the U.S. (which has been less hit by the housing crisis) are significantly outperforming regional banks in the Pacific region (which have been affected by housing weakness in California).

Themes dominate markets, not only at the sector level, but also among sub-sectors. This has important implications for traders and investors alike.


The Importance of Stock Picking