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.
.

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.

Brett
.

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.

RELEVANT POSTS:

Becoming Your Own Coach

How to Change Yourself
.

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.

RELEVANT POSTS:

Becoming the Play-Actor of Your Ideals

The Relationship Between Happiness and Success
.

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.

RELATED POSTS:

Tracking Sentiment Shifts

NYSE TICK and Sentiment

Trading With Sentiment Bars

Sentiment and Mean Reversion

An Options Sentiment Measure
.

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.

RELATED POST:

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.
.

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.
.

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.

RELATED POSTS:

* Building Self Efficacy

* Questions to Ask When You're in a Slump

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.

RELATED POSTS:

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
.

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.

RELEVANT POST:

Weakness in Financial Sector
.

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:

MATERIALS: +120
INDUSTRIALS: -380
CONSUMER DISCRETIONARY: -60
CONSUMER STAPLES: -240
ENERGY: +380
HEALTH CARE: -280
FINANCIAL: -400
TECHNOLOGY: -160

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.
.

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.

RELATED POSTS:

What Makes Expertise

A Look at a World-Class Trader
.

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.

RELATED POSTS:

Participation and Reversal Moves

Participation as a Key Market Variable

Participation and Breakout Moves
.

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.
.

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.

RELATED POSTS:

Market Strength and Short-Term Price Cycles

Momentum and NYSE TICK

The Importance of Participation
.

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.

RELATED POSTS:

Anticipating Volatility

A Psychological View of Volatility

Relative and Absolute Volatility

An Indicator for the Coming Day's Volatility

When VIX Becomes Volatile
.

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.

RELATED POST:

It's All One Market
.

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.

RELATED POSTS:

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.

RELATED POSTS:

Tracking the Style Box

Tracking the Style Cube
.

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.

RELEVANT POSTS:

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.
.

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 other...is an essential to the speculator."

* Courage - "...confidence to act on the decisions of the mind...be 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.

RELATED POSTS:

Four Overlooked Qualities of Successful Traders

Resilience and the Courage of Your Convictions
.

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.

RELEVANT POST:

Last Week's Indicator Review
.

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.

RELATED POST:

The Importance of Stock Picking
.

The Importance of Stock Picking

If a commodity is hot, stocks of companies that deal in that commodity should be hot as well, right? Well, not necessarily so. To be sure, energy shares have outperformed the stock market indexes during the recent period of oil price strength. Take a look at relative performance of two energy shares (XOM, top chart; VLO, third chart down) vs. oil itself (DBO). From these charts (kudos to the MSN Money site), it's clear that the stocks have greatly underperformed the commodity.

In the two money flow charts (XOM, second chart down; VLO, bottom chart), you can see the reason for this: as a whole, funds have been flowing out of these issues over the past six months. Forays above the neutral, blue line (the point separating five-day inflows from outflows) have been relatively brief and contained.

With oil making fresh price highs over the past two weeks, one would expect these stocks to be making new peaks as well. XOM, however, has moved from 92.45 to 88.82 in that time, with only one day out of the last ten displaying positive money flows. VLO has seen a particular sharp outflow over this period (as the money flow chart above displays), and the stock has moved from 52.93 to 44.56. Only three in the last ten sessions have shown positive money flows for VLO.

The moral of the story is twofold:

1) Assuming a stock will be strong just because a related commodity is strong is surface reasoning that can get you in trouble. Oil prices might be strong, but it doesn't mean that particular oil companies are drilling or refining more of it.

2) Money flows matter. Regardless of the attractiveness of the story, if investors are taking money out of a stock over time, it is going to be difficult for that issue to perform strongly.

I notice that HAL and XTO have seen net inflows to their shares for five of the past ten trading sessions; both of those energy issues are higher over the last ten days, unlike XOM and VLO. Stock picking matters, and the flows of funds in and out of shares and sectors is one important factor in determining relative stock performance.

RELATED POSTS:

This Post Explains Dollar Volume (Money) Flows

Money Flows and Sector Rotation
.

What the Cumulative NYSE TICK is Telling Us About Market Psychology

Recall that the NYSE TICK is a measure of very short term sentiment across the broad universe of NYSE issues. When a stock trades at its offer price, that contributes +1 to the NYSE TICK. When a stock trades at its bid price, -1 is added to the TICK. These readings are summed for all NYSE stocks every five seconds. As a result, a TICK reading of +500 means that, at that moment, 500 more stocks are trading at their offer price than at their bid. This means that traders are sufficiently bullish on stocks that they're more willing, on balance, to be paying the offer price than the bid. When sellers are more aggressive, we'll see negative TICK readings, suggesting that traders are sufficiently motivated to get out of stocks that they'll settle for the bid price.

The adjusted TICK takes the raw one-minute TICK values and subtracts from each of them the average TICK one-minute TICK reading over the past 20 trading sessions. As a result, the adjusted TICK tells us whether we're seeing more or less buying sentiment *on a relative basis*: relative to the past four weeks of trading.

If we cumulate these adjusted TICK readings over time, the resulting line (see chart above) provides an excellent picture of how sentiment is unfolding from day to day. Note that sentiment turned sharply positive from mid-March through early April, with the cumulative adjusted TICK trending steadily higher.

Since that time, the S&P 500 Index has moved to new highs, but the cumulative adjusted TICK line has not. Interestingly, we are also seeing weaker money flow readings and fewer stocks making fresh 52-week highs over this same period. Not surprisingly, the index has had difficulty sustaining its move above the 1400 resistance region.

We've had a nice move from the March lows. It will take an influx of buying sentiment to keep that move going, however.

RELATED POSTS:

The Cumulative NYSE TICK

Capturing Trends With NYSE TICK
.

Shady Proprietary (Prop) Trading Firms

I just received a call asking about a nearby proprietary trading firm that trains their traders. The catch is that they charge tens of thousands of dollars for the training.

We got a taste of this particular scam when Devon was doing some modeling in the Chicago area before heading off to college. After getting on some mailing lists, she received mail and phone solicitations from "agencies" that promised fantastic modeling assignments. To qualify, models had to enroll in their training programs (costing thousands of dollars). There were plenty of anecdotal success stories, but no hard indications that concrete jobs ever came of these "agencies".

Hey, if a modeling agency thinks you're talented, they'll sign you to an exclusive contract, get you lots of work, and make money from each job that you take.

Similarly, proprietary trading firms make money by splitting profits with their traders. If a prop firm is skilled at training traders, they'll make plenty of money by sharing in the traders' success. Yes, there will be "desk fees" to cover overhead and a pass-through of commission expenses, but the lion's share of a prop firm's profits should come from trader profits. That's what aligns the interests of the firm and the trader.

I assure you, any prop firm that is confident of their ability to grow and support talent won't need to make their money from charging sky-high commissions to their traders or by saddling them with huge fees for training and overhead. Their interests are *not* aligned with those of traders. Like the pseudo modeling agencies, they try to get as many people in and out of their doors, paying the big fees.

In short, the shady firms are selling a dream and a fantasy, not a career.

Please exercise due diligence before committing yourself to an expensive and disappointing venture. If you can display promise, prop firms will want you; you won't need to pay them to get in the door.

RELATED POSTS:

Steps Toward Joining a Prop Firm

Things to Consider When Joining a Trading Firm
.

Worthwhile Readings to Kick Off the Weekend

Self-Efficacy - It's difficult to achieve something if you don't experience yourself as capable of achieving. Thanks to trading coach Doug Hirschhorn for pointing out this excellent Wall St. Journal article on self-efficacy. Here's one of my posts on self-efficacy and why it's important, and here's my favorite framework for building self-efficacy.

Range Markets - I recently wrote about how to identify slow, range markets. Today, Trader Mike's favorite indicator of range markets was quite helpful as the day wore on.

Learning How to Trade - This is just a great post, with quite a bit of wisdom and experience from Globetrader. There's a lot to be said for learning how to trade by learning how others have learned.

Good Reading - Kirk links the best investments of the decade, the case for the end of the housing crisis, and more. See also his review of a website resource that tracks sector rotation and more.

Building Expertise - While we're on the topic of learning to trade, thanks to an alert reader for pointing out this blog entry on deliberate practice. Here are some implications for trading.

Credit Crunch Goes to School - Research Recap notes the crunch in student loan issuance.

Chop, Chop - Quantifiable Edges notes the chopfest, but finds a pattern in the noise.

Links Galore - Looking for more links? Abnormal Returns links the linkfests.

Beating the Market House - Suppose there was a market indicator that had a stationary distribution and that was significantly associated with price behavior. The distribution need not be normal; it would only need to be stable over time. In that event, the search for trading edges would be very similar to card counting in blackjack. Just a thought... ;-)
.

Six Signs of a Range Bound Market

Several traders emailed me yesterday, tripped up by the narrow, range market. After a period of volatility such as we had during the first quarter of 2008, it is understandable that traders expect moves to extend. In a range market, however, reversals of market moves are the order of the day. If traders don't recognize the character of the day early, it's easy to get chopped up in those reversals.

Here are several cues I rely upon in gauging a possible range day. Not all of these are present on all of the days, and not all of these pertain to yesterday. As a whole, however, I've found these to be relatively accurate guides that help me pull back my trading, enter trades only near range extremes, and take profits more quickly than I would in a trending market.

1) Other, related markets are range bound - If the interest rate markets are in a narrow range, there may be little reason for investors to reprice equities;

2) Little news - Either there is no news and no economic reports, or the news and reports that come out fail to move interest rates, currencies, etc. Per number one above, that means that the news has not significantly impacted investor expectations, and there's little reason to move value;

3) Decreased volume - Often this is a first signal: Volume either starts the day well below recent norms, or quickly tails off to below average as the day goes on. This means that the large institutional participants that move markets (and ultimately set value) are not active and trade will be dominated, in relative terms, by market makers;

4) Narrow breadth - When we get an initial market move for the morning, it occurs on narrow breadth, with advancing and declining issues relatively balanced. That tells us that the move is not a broad trend;

5) Sector rotation - When we get that initial market move in the morning, some sectors may be up quite a bit (energy, for instance) and some might be down quite a bit (financials). When sectors are taking their separate paths, there is no general trend to the market;

6) Initial trades don't work - A scratched trade often provides market information. If you catch an early market move and then it reverses on you before it hits an expectable price target, you have an early indication of the character of the day. It's worth paying attention to good trade ideas that don't pay you out.

The main thing is to not overtrade these narrow days. If a market is trading in a range, the best trades are to fade moves around the range extremes. Since moves tend not to extend, it's necessary to take profits more aggressively than you ordinarily would.

As the VIX grinds to new lows and we get closer to possible summer doldrums, we may see an increasing number of these narrow days. If you can recognize them early, you can preserve your capital and maybe even make a little money.

RELATED POST:

Volume and Opportunity in the Market
.

A Quarterly Performance Review for Traders

Any given trade and any given day may or may not go a trader’s way, depending upon personal and market circumstances. A three-month period, however, is ample opportunity for frequent traders to demonstrate progress in their development. Here’s a quarterly report card that you might find helpful in tracking your own performance improvement:

1) Have I been profitable after expenses over the last quarter? If so, which markets and trading ideas have contributed most to my profitability? How can I maximize those markets and ideas going forward? If I haven’t been profitable, which markets and trading ideas have contributed most to my losses? How can I minimize or modify those markets and ideas going forward?

2) Have I improved my P/L over the prior quarter? Over the average of the prior three quarters? If so, what changes did I make in the last quarter that contributed to my improved performance? What changes in the markets have aided my recent performance? If I have not improved my P/L over the last quarter and/or over the average of the prior three quarters, what have I been doing differently that has been holding me back? What has changed about the markets that’s hampered my performance?

3) Have I managed risk well compared with other quarters? Have I made more in my largest winning days than I’ve lost in my largest losing ones? If so, what has worked for me in capping my losses that I can carry forward to the next quarter? If not, what do I need to do to limit my losses better in the next quarter?

4) Have I adapted well to market changes? How have my markets changed over the last quarter, and what did I do to adapt? Which of those adaptations do I need to emphasize in the next quarter? Which further adaptations can I make next quarter to deal with market changes?

5) How have I improved myself as a trader over the last quarter? What improvements have I made in my trading? In my finding opportunities? In my discipline and self-management? Which improvements do I most want to emphasize and carry forward to the next three months? What improvements haven’t I made in the last quarter that I need to focus on during the coming months?

Notice that the follow up questions are as important as the lead questions. It is those follow ups that turn the quarterly assessment into next quarter's goals. It is not enough to plan trades. Career success also means planning your development.

RELATED POSTS:

The Development of Talent

A Trading Curriculum

Blueprint for an Uncompromised Life
.

Ten Core Ideas of Trading Psychology

1) We are most likely to behave in inhibited or impulsive ways, violating trading rules and plans, when we perceive events to be threatening;

2) What we perceive to be threatening is a joint function of events themselves and how we think about those events;

3) A key to gaining control over trading and maintaining consistency is to be able to reduce the threat associated with market events and process adverse outcomes in normal, routine ways;

4) We can reduce the threat associated with adverse market events through proper money management (position sizing) and through proper risk management (limits on losses per position);

5) We can reduce the threat associated with adverse market events by training ourselves to respond calmly to adverse outcomes (exposure methods) and by restructuring how we think about those outcomes (cognitive methods);

6) Optimal skill development in trading will occur in non-threatening environments in which learners can sustain concentration, optimism, and motivation;

7) A proper mindset is therefore necessary to the development of trading skills, but does not substitute for such development;

8) The cultivation of trading expertise is a function of the amount of time and effort devoted to learning and the proper structuring of that time and effort;

9) Proper structuring of learning involves the setting of specific, doable, cumulative goals and the provision of rapid feedback and correction regarding the achievement of those goals;

10) Practice does not make perfect in trading or anything else; perfect practice makes perfect. Training must gradually build competencies and correct deficiencies in a manner that sustains a positive mindset and optimal concentration and motivation.

RELATED POSTS:

Series of Posts on Becoming Your Own Trading Coach

Programming Our Own Experience
.

Fannie Mae...or May Not

So let's say that I take a large position in the market and wind up with a harrowing loss that forces me to cut back my lifestyle. What would you think of my decision to borrow additional funds to add to that losing position?

Few rookie traders would engage in such dismal risk management. That, however, describes the situation of Fannie Mae (FNM), which today reported large losses and a dividend cut, but rose nicely on news that their regulator is giving them greater rein to expand their mortgage portfolios.

If the housing market stabilizes, the decision to go "all in" will be hailed as a ballsy vote of confidence in the U.S. economy. (It also might set an interesting moral hazard precedent, when the next crises hit).

If, however, the housing market experiences a deeper drop than is currently projected, the liabilities incurred by FNM are truly mind-boggling. This is because billions of dollars of equity are supporting trillions of dollars of debt, as recently reported by the New York Times in an excellent article.

I'll be tracking price performance for FNM and money flows into the stock as a way of staying on top of this theme. I'm not a bear by temperament, but it makes me nervous to see our government engaging in actions that are characteristic of losing traders.
.

Perspectives on Achieving Greatness as a Trader

I want to thank Abnormal Returns for passing along this excellent New York Times article on the role of habits in learning and creativity.

The article highlighted a few ideas that I think are very relevant to the development of trading expertise:

1) Much of performance learning is the cultivation of positive habit patterns - If you have to make efforts to follow trading rules, that is effort not devoted to tracking markets. The key to success is turning rules into habits, so that they can be followed without effort, preserving mental capital for analysis and decision-making.

2) The development of new habits opens the door to fresh ways of thinking and behaving - I've long noticed that successful traders periodically remake themselves and their trading, adapting to changing market conditions. They cultivate new habits, which aids them in developing new skills and ways of making money.

3) We will learn and perform best by making maximum use of our learning strengths - This is an extension of the notion of operating within a trading niche. If we're engaged in a concerted program of learning and development, it makes sense to ground our efforts in learning competencies.

4) Performance improvement often occurs in small, continuous steps forward - This is an idea central to quality and performance improvement among manufacturing firms. The successful trader may set a single goal each trading session and track progress faithfully. Over the course of a year, that is hundreds of opportunities missed by the trader who lacks such goals. Take a look at this excellent New Yorker article on Toyota and the notion of kaizen. The path of kaizen is difficult to follow, but it's a sure path to excellence.

RELEVANT POST:

Trading Psychology Observations
.

Ideas, Inspirations, and Resources for a Monday

* Implications of Sector Rotation - A reader emailed me with the idea that the market was weak because the recent rise was accompanied by greater than normal sector rotation. That's intuitively appealing, but may not match historical precedent. I went back to 1990 and examined all five day periods in which the S&P 500 Index (SPY) was up more than 1% but not more than 2% (N = 792). This matches the five-day period that ended on Friday. I then split the sample in half based upon the five-day proportion of advancing stocks to declining stocks on the NYSE. The rationale was that a high degree of sector rotation should suggest greater balance among rising and declining stocks. If the rise is occurring across all sectors (i.e., without rotation), advancing stocks should dominate decliners. When we've risen in SPY and advancing stocks have strongly led declining issues, the next five days in SPY have averaged a loss of -.11% (192 up, 204 down). When we've had a similar rise in SPY and advancing stocks have been more in balance with declining issues, the next five days in SPY have averaged a gain of .13% (205 up, 191 down). This, of course, is not an exhaustive study of the topic, but it suggests that rotation may not be bearish for a rising market in the short run.

* Primary Bull Market? - David Korn, in his excellent newsletter, notes the implications of the view that we made a bear market low in August, 2006 and still remain in a primary bull market: "The implication that we are in a secular bull market is important because if you follow that belief then you should be expecting record all time new highs in the major indices BEFORE ANY BEAR MARKET ARRIVES. That would mean significant gains, even from these levels." I think there's merit to this view and will be tracking money flows carefully to look for support or disconfirmation of the idea.

* Trading Insights - Gap trading, the psychology of consecutive losses, and more link updates from Trader Mike.

* Stocks With Energy - Kirk, with an excellent observation on the value of stock screening.

* A Look at Management Integrity - A very interesting post from Research Recap identifies five stocks with particular risks related to accounting and governance.

* Themes - Thanks to readers for emails and comments on my recent post concerning theme-based trading. I see that over 400 traders are now subscribed to the Twitter posts that track themes each day. My hope is that those links help keep you posted on what traders and investors are looking at each day.

* Inflation Matters - Eddy Elfenbein posts a couple of excellent charts that show how we remain below the 2000 peak in the S&P 500 Index, when adjusted for inflation. While on the Eddy topic, here's his interview conducted by Tim Sykes.
.

Indicator Review for May 5th

Last week's indicator review found strength in the stock market, but also selectivity within that strength. That view was most recently supported in my look at sector rotation within the market rise. While we've continued to see rising prices--and firming of many of the indicators--the gains in some sectors (technology, financial) have been at the expense of others (materials, energy).

We can see from the top chart that the number of stocks registering fresh 20-day highs minus lows has remained firm as the market has moved higher. The selectivity, however, is evident in the new 52-week high/low numbers. Among NYSE common stocks only, Friday's move to new price highs saw only 59 issues making fresh annual highs and 11 making new lows. We had over 100 new highs three weeks ago. Many of the issues that were making fresh highs at that time (commodity-related stocks) have since retreated.

We've also seen firming in the Cumulative NYSE TICK (bottom chart), but that, too, has lagged as buying sentiment has been selective. Demand/Supply numbers, while positive on Friday, were relatively modest as well, suggesting that upside momentum is waning. It would not surprise me to see a modest correction this week prior to any important resumption of a bull move.

That having been said, it's important to stress that, on the heels of the drying up of selling noted in prior indicator reviews, we are seeing positive money flows into stocks and an increase of strength in the market this past week. 52% of S&P 500 issues are now trading above their 200-day moving averages, and 77% are above their 50-day benchmarks. Those are both the strongest readings of 2008. The percentage of issues above their moving averages typically tops out ahead of price in any intermediate-term bull move, which suggests that we are likely to see further gains after any pause/correction in the recent rally.

As I recently explained, I do not see this as a vigorous bull move and, for that reason, am not expecting a fresh bull market to take us to all time highs. Still, an important bottom was put into place during the January-March period, and I need to see distinct weakening of the indicators before assuming that the recent market strength will reverse in any meaningful way.
.

Finding Success in Trading

I just received an email from a developing trader who now has been learning trading at an excellent proprietary trading firm in Chicago for the last six months or so. He reported to me two positive events:

* He has made money nine of the last eleven trading sessions;

* He lost money early on Friday, saw that the market wasn't moving his way, reversed his positions, and made money on the day.

Now let me tell you two other things about this trader:

* He keeps a journal daily with specific trading goals and emails his entries to me every day without fail;

* He works at a firm that actually teaches traders how to trade and works hands on with traders to promote their development. (Please, I am required by confidentiality to not disclose the name of the trader or the firm).

What that tells me is that, when you're in the right trading environment and when you have the right work ethic, you will experience a steady, rising learning curve. As my book outlines, this will accelerate your development of competence, and that will put you on a path toward expertise.

Success is possible in trading, but it requires learning and development. Role-modeling from experienced traders and continuous work on one's craft are vital elements in that success. It takes some searching, but there *are* role models on the Web, whether in blogs, online trading rooms, or via coaching/mentoring. The rest is dedication and the willingness to work as hard outside of trading hours as during them.

RELEVANT POST:

How Can I Learn Trading?
.

Underneath the Stock Market's Sector Rotation

The top chart updates an earlier look at money flows into S&P 500 stocks. I've taken the ten most highly weighted issues within eight sectors (technology, energy, consumer discretionary, financial, consumer staples, materials, industrials, and health care) and summed a five-day moving average of dollar volume flows into those 80 stocks.

What we see is that, like my recent assessment of money flows into the Dow Industrials, selling pressure has been abating since January and we've been seeing modest inflows of dollars to the market since early April. These inflows have been particular modest over the past week, even as we've made fresh price highs.

I have speculated that the reason we're seeing only modest inflows of dollars to the market is that much of the rise has featured sector rotation: allocation of funds from certain sectors (that had been market winners during the decline) to others (that had been beaten down during the decline).

To examine that rotation idea, I took a look at dollars flowing into and out of sectors over the last ten trading sessions (bottom chart). Dollar volume flow is expressed in millions of dollars for each of the eight sectors mentioned above. What we see most notably is net outflows from materials, energy, and consumer staples issues and net inflows to technology and financial sectors. Indeed, essentially all of the market's net inflows can be accounted for by the rotation out of the commodity-related themes (materials, energy) and into technology.

On the surface, it looks as though there is little money flowing into or out of the S&P 500 universe. Underneath the surface, however, we're seeing potentially important signs of asset reallocation among investors.
.

Trading Like a Sniper: Blending Aggression and Self-Control

In my recent post, I outlined how a trader's very achievement motivation can lead to "pressing": trying so hard to make trades happen that trading plans and rules are abandoned. This often happens when traders become frustrated with losses or slow markets and try to make up for the lack of results by sizing positions too aggressively or by taking too many positions. Traders press when they feel pressure, whether for profits, for action, or to achieve competitive advantage over other traders.

The result is a loss of self-control, as aggressiveness takes over and judgment takes a back seat. Successful trading may be discretionary or system-based, but it should always be rule-governed: controlled by basic considerations of risk management and opportunity. Indeed, this might be an apt definition of poor trading: when the need to trade overwhelms the need to preserve and add to capital.

One of my favorite posters in my office is of a military sniper in the field, peering out from ground cover. The caption beneath the picture reads, "The sniper's greatest weapon is a sharply honed intellect. He combines a mastery of stealth, situational awareness, ballistics and precision shooting skills into one of the most lethal weapon systems to ever strike fear into the enemy."

If the sniper became too aggressive and excessively bored with sitting in the field waiting for the right shot, he might leap from his cover and begin spraying the enemy with fire. Most of the shots would probably go wild, and the out-of-control sniper would quickly be located and mowed down.

No, the sniper waits for the ideal shot: "stealth" and "situational awareness" are essential tools of the trade. Being a sniper means combining aggression with exquisite self-control and judgment. It is controlled aggression.

Over the years, I've learned to trade like a sniper by not placing one trade after another in rapid succession. When a trade is concluded, I go flat and wait for a fresh setup. During the waiting time, I refresh my "situational awareness" (assessment of market conditions, my own condition), and return to my basic trading rules.

The idea is to trade only when I have an unobstructed view of the target. Everything else is waiting and preparing, staying low in a defensive posture. It's the time between those shots at the target that provide the self-control. It is difficult to press if you take the time to reassess, reload, and return to cover after an errant shot. With repetition, that reassessment and reloading become automatic: your default mode becomes one of self-control.

Plan. Trade. Reassess plan. Trade: It's a rhythm that combines the best of achievement motivation and aggression with the best of judgment and forethought. It's a beautiful feeling to plan one good trade, execute it to perfection, and then sit back and wait for the next opportunity. Any performance skill, honed and executed with precision, is a kind of work of art. I think the best snipers understand that.

RELATED POSTS:

Bridging Hot and Cold Emotional States in Trading

Three Steps for Breaking Out of Frustration
.

Four Observations About the Current Stock Market

1) Selling Pressure Has Abated - If you look at five-day money flows in the 30 Dow Industrials stocks (top chart), you can see that, since January, we've had reduced outflows from stocks. Indeed, during the month of April, we saw more inflows than outflows--particularly in the S&P 500 stock universe. As long as flows into stocks are improving, I find it difficult to sustain a bearish stance on the market.

2) Buying Pressure Is Modest - This is clear from the low level of recent positive readings in money flows (top chart), but also from overall advance-decline figures; cumulative NYSE TICK; and 52-week new high/low readings. This is because much of the recent market rise has featured sector rotations--flows of funds out of certain sectors and into others. While it seems clear that selling has abated, I find it difficult to anticipate a fresh bull market as long as much of the upside action is robbing one sector to pay another.

3) The Market Is Getting Stronger In Recent Days - Yes, the buying pressure is modest, but if you look at the percentage of S&P 500 stocks trading above their 200-day moving average, it has been steadily rising. An additional look at the excellent chart from Decision Point shows that we are coming off highly oversold levels in the percentage of issues trading above their 200-day average and are not yet near overbought levels. I noticed that we expanded to over 1900 new 20-day highs among NYSE, NASDAQ, and ASE issues on Friday. That's not how weak markets behave.

4) The Market Is Showing Underlying Long-Term Strength - We've had credit crises, a plunging dollar, a housing meltdown, concerns over investment bank failures, and an economic slowdown, but look closely at the long-term chart of the S&P 500 Index (bottom chart). The recent market decline has been small potatoes compared to the 2000-2003 rout. Could the economic situation get worse? Could the market turn tail and move lower? Of course. But, for now, in the face of major bearishness and quite a wall of worries, the market has held its own quite well. We are only about 10% from all time bull highs.

Bottom line: I think we'll need to see increased buying pressure to reach and sustain new bull highs in the broad market indexes, but I also think we'll need to see a resumption of increased selling pressure to take the market to fresh bear territory. With considerable sector rotation, it's a selective rally, with funds coming into beaten down consumer discretionary, technology, and financial shares. Investors may not have concluded that happy days are here again, but increasingly they're acting as if the financial world as we know it just may not come to an end.
.

Options and Stock Market Sentiment for a Friday

* Improving Sentiment - Notice how the 10-day equity put/call average (pink line in chart above) spiked to a high with the March bottom and since has been trending lower as stocks have moved steadily to new highs. Indeed, we're getting close to sentiment levels that have been associated with recent short-term market tops.

* VIX Excursion - I recently noticed that we had moved well below the 50-day moving average in the VIX, indicating low option volatility on a relative basis. I went back to 1991 (N = 4314 trading days) and found that, when the VIX has been above its 50-day moving average, the next 50 days in the S&P 500 Index (SPY) have averaged a gain of 2.35% (1346 up, 604 down). When the VIX has been below its 50-day average, the next 50 days in SPY have averaged a gain of only 1.26% (1499 up, 865 down). When the VIX has been more than 10% above its 50-day moving average, the next 20 days in SPY have averaged a gain of 1.49% (574 up, 305 down). When the VIX has been more than 10% below its 50-day moving average (as has been the case recently), the next 20 days in SPY have averaged a gain of only .27% (566 up, 401 down).

* For Option Rookies - Mark Wolfinger has a new book out for beginners in the options markets, as well as other resources on his web site. Nice way to learn the ropes from a CBOE floor guy.

* What You Should Know About the VIX - Bill Luby outlines VIX essentials, including a rundown of different option volatility measures.

* Summer Doldrums Coming Early? - Daily Option Report takes a look at the implications of a declining VIX.

* Looking at Options Measures in Tandem - An earlier post on how VIX and Put/Call Ratio are related; note that both are in decline of late.
.

Thinking in Themes and Seeing in Color: A Key to Trading Success

Themes give the stock market color; they capture the movement of capital from certain sectors of the economy to others. Many traders are color-blind. They fail to detect the themes underlying market moves and, as a result, fail to understand *why* those moves are occurring.

A great example of color blindness came in 2000-2001 when the technology stocks, which had been furious leaders of the rally from the late 1990s to March, 2000, began underperforming large cap Dow stocks. Traders who understood this as a movement toward safety--away from growth and risk and toward stable blue chips--weathered the subsequent bear market far better than those who color-blindly stuck with the NASDAQ all the way down.

Permabears are another great example of color blindness. They see one kind of market, heedless of the themes underneath the movements of the averages.

Note from the chart above that, as the broad market (SPY) has been in decline since mid-2007, the relative strength of consumer discretionary stocks (XLY) to consumer staples stocks (XLP) was also on the decline. This makes sense: in the face of recessionary fears, investors move away from companies dependent upon consumer spending and toward defensive names that will sustain revenues even in a bad economy.

Note, however, that, as SPY made new price lows in March relative to January, the relative strength of XLY to XLP did not follow suit. Now SPY is breaking to multimonth price highs (and is less than 10% off its bull market highs) and the XLY:XLP relationship is moving higher as well. Similarly, we're seeing some recent relative strength of financial stocks (XLF) to materials stocks (XLB), as investors shift money out of commodity-related areas and into beaten-down bank shares.

Make note: It's not just that the stock market is holding its own that is significant; it's that the themes that underpinned the market decline are being unwound. In other words, it's not just the market move that's important; it's also the reasons why the market is moving.

Gradually, but unmistakably, money has been flowing back into high yield bonds. Money has been flowing back into financials. Money has been flowing back into consumer discretionary shares. Money has been flowing into the U.S. dollar. We have been seeing a drying up of risk aversion and a pick up in risk-seeking trades. Slowly, we are seeing a willingness to own financial assets over hard commodities.

That's the color of the current market.
.

RELATED POSTS:

A Shift of Themes Among Sectors

Two Sector Ratios I Watch

Sector Correlations
.

The Importance of Keeping Score

How much do you know about your trading?

* Take the absolute value of your daily gains and losses and divide them by your total portfolio value. How much of your portfolio are you putting at risk each day on average? 1%? 3%? 50 basis points? How has this changed over time? How does this change when you're making money? Losing money?

* Take a look at the 10% of your largest trades (i.e., when you've taken the largest positions). Have those tended to be winning trades or losers? Do you have a greater edge when you're more aggressive or less?

* Take a look at your trading results as a function of day of week and as a function of time of day. Do you trade better at certain times than others? Take a look at how you start a day, week, or month: does this affect how you trade subsequently, and does that affect your overall profitability?

* Take a look at how long you hold winning trades vs. losing trades. Do you get out of winners quicker than losers? Do you have a small number of large losing trades that you hold well beyond your average holding time per position?

* Take a look at your trading results after a down day or a down week. Does being down affect your trading? Do you trade better or worse when you've lost money the day or week before? How about trading results after an up day or week? Do you trade better or worse when you've been making money?

As I emphasized in my performance book, all of these are metrics that you can keep in a trading journal to track what you're doing right in your trading and what needs improvement. Most traders don't have an objective picture of how well or poorly they're doing, because they don't track the drivers of their success or failure.

In my recent post, I mentioned two very nice resources for tracking your performance. Another tool you might want to consider to track your performance is the Trade Performance program developed by Steve Geringer. In addition to helping traders track their performance as a function of date ranges, security types, symbols, etc., Trade Performance doubles as a tool for journaling, trade planning, risk management, and business planning.

Steve is making a "lite" version of Trade Performance available to traders free of charge. This version contains much of the functionality of the standard version, with the exception of tax reporting and automatic importing of trade data. Screenshots of the program might help you figure out if the program would be helpful for you.

I work with quite a few professional traders. One thing that distinguishes them as professionals is that they keep score religiously. They know how much risk they're taking, how well they're performing, and whether their trading is better or worse than usual. That helps them make rapid course corrections, pull back their risk, and keep overall losses modest. If you don't work for a firm that keeps score for you, dedicated tools are worth looking into.

Some tools for tracking metrics, in addition to Trade Performance, include:

* StockTickr

* TraderDNA

* Ninja Trader

If you know of others and can recommend them, please add to this list with comments to this post. Thanks!

RELEVANT POST:

Trader Psychometrics
.

Thursday Thoughts

* Parallel Paths - Stocks (SPY) and 10-year Treasury rates ($TNX) have taken a very similar path during this period of market weakness. On the heels of the Fed announcement, stocks attempted to move to new highs, only to fall back into their long-term trading range. Meanwhile, 10-year rates couldn't make it to new highs and also fell back, revealing a bit of return to the safety trade. In response to the Fed announcement, it appears that concerns over economic weakness have taken priority over concerns regarding inflation.

* New Highs Continue to Stall - Despite the jump in stocks immediately following the Fed announcement, which took the major averages to multi-month highs, the number of stocks registering fresh 20-day highs continued to lag. We had 1346 new highs across the NYSE, NASDAQ, and ASE, against 587 new lows. If we just limit the count to common stocks traded on the NYSE, we had only 40 new highs against 18 lows. That is well below the 100+ new highs registered two weeks ago.

* Lots of Good Reads - Kirk takes a look at sovereign wealth fund dominance, the next bubble, frontier investment, and more. Trader Mike recaps an anticlimactic Fed day and Abnormal Returns tracks weak housing, the Fed model, the VIX, and quite a few other themes. The Big Picture displays one big picture when it comes to food inflation.

* Tomorrow's Post - Will highlight strategies that traders can take to enhance their self-control. As I write the new book, I increasingly realize that traders need concrete methods to coach themselves for success. I'll be emphasizing those "how-to's" in the blog as well.

* Quotables - Sharp Brains offers favorite quotes from neuroscience interviews, many of which pertain to the role of the brain in performance.

* Nice Resources - TickerLog offers a structured way to keep trading journals online. StockTickr turns journaling into a social process. Check out the Stock Market Beat on the NewsFlashr site, filtering top news stories for traders.
.