Tuesday, February 24, 2009

Following the Stock Market Like a Psychologist: Catching Shifts in Market Behavior

When a psychologist listens to a client in therapy, he or she focuses on the flow of conversation. Attention is paid to both what is said and how it is said. For example, let's say I am talking in a friendly, informal way with someone to start a counseling session and then ask about the person's marriage. Immediately the person shifts position and posture in the chair and adopts a halting tone of voice that is very different from the tone of the previous conversation. Without even attending to *what* the person is saying, I can detect from that radical shift of posture and tone that this is not a comfortable topic and that there are issues to be explored.

These shifts occur in subtle ways and not so subtle ones in all conversations. Rate of speech, volume, inflection, gestures, the richness of language used--all of these are indicators of a person's inner world. When a person is angry (without even acknowledging it), those shifts manifest themselves as changes in muscle tension and vocal intensity. When a topic changes in a conversation and we see such shifts, we know that the topic is emotionally loaded for that individual.

Markets produce their own streams of "conversation" in the form of price and volume movements that evolve through the day. Volatility, directionality, choppiness: these are some of the market's "body language". Just as a person's tone or posture can shift over the course of a conversation in response to meanings and what they stimulate, the market will alter its patterns of movement through the day, particularly in response to news events, economic reports, rumors, and the sentiment of traders.

Much of success in short-term trading is a function of being able to read the market's body language and respond promptly and appropriately. A good conversationalist is one who picks up on nuances of meaning and responds to those in his or her own speech and mannerisms. Similarly, a good trader is attuned to market communications and responds to these flexibly.

Consider the ES futures during the early part of the trading session today (top chart). Moving in a range, they drifted away from their opening price, only to be pulled back toward it. A bit after noon, however (second chart from top), the market moved violently higher on expanded volume and significant volatility. You can see from the size of the bar and its break to new highs that this was a shift in trading pattern.

In the third chart from the top, we see the result of this shift: the market never looked back and trended higher into the afternoon: a range market had morphed into an uptrending one.

Notice how the NYSE TICK distribution (the distribution of five-minute bars around the blue zero line, bottom chart) changed from balanced to distinctly bullish prior to the breakout bar. If you look at the energy (XLE) and especially the financial (XLF) stocks, you'll also see that they broke to new daily highs ahead of the breakout. These subtle pieces of body language--the sentiment of traders, the behavior of leading sectors--are important clues to those who follow markets like a psychologist. For the trader as for the shrink, it isn't necessary to predict shifts; rather the challenge is to identify them in real time and know how to respond.


Emotional Intelligence and Trading