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


TTmarun said...

Hi Brett, just wanted to let yu know how helpful this concept of viewing price action as a personality. I have a wyckoff back ground in viewing price action and he uses the same concept, constantly "comparing buying and selling waves" for "Ease of Movement" or direction. Yu expand that concept in yur first book. the idea of communication and meta communication ... just great insights on yur part on how to apply it. your a crafty man Dr. Brett to explain it in this manner.. here is one of yur post that help put yur ideas into practical application:
I can't thankyu enough for all yu do for the new & up & coming traders...... JT

Ziad said...

Once again as I read this and compare it to how I currently trade, I can't help but notice just how much your blog has influenced my trading. I've modeled how I look at the market after you, while using my own style for entries and exits that best fits me.

But also, I now see why it was a natural fit for me to learn to read the markets in the same manner that you do. Ever since I can remember, one of my strongest skills has been reading people, and picking up on very subtle social cues. My family tells me that I've always been very empathetic and tactful, which I think is a direct result of picking up on what people are thinking and feeling and responding to it appropriately. Little did I know that this would be a core strength I would eventually end up drawing on in my trading, and that it would in fact dictate the style in which I read markets. I'm glad there was someone else out there with the same natural strengths that translated it into a way of reading markets and then so graciously shared this with us. Thank you Dr. Brett, without your blog it may have taken me years and years to connect my natural strengths with my reading of the market.

OKL said...


Your blog has been tremendously useful to me... especially in today's breakout, which met the following criteria:

1) Re-valuation in other markets
a) Treasuries starting breaking down
b) Euro moved higher (the euro actually preceded this breakout)
c) BKX spiked (also preceded the breakout)
d) VIX broke down (preceded the breakout); on a sidenote, im not using the yen as a proxy for "fear" for now, as it has gone wacky the past 2 weeks
e) Crude started to move higher, but it was rather lagging today

2) TICK spiked and stayed staunchly above the zero line

but i unfortunately did not buy into this breakout...

Here's what bugged me mainly- volume and the lack of a sharp upwards move in vwap.

I know the breakout occurred on higher than average volume for that period of the day, and it was also higher than average.

However, it wasn't high enough, for me at least. I'm used to seeing breakouts on volume up to 30k contracts per minute, which would indicate the strong panic buying/selling by institutions.

On hindsight, when I was reviewing the move, perhaps I was a little to presumptuous to expect big volume breakouts based on:

1) There was a slow bleed to test the Nov lows on the ES yesterday, and thus it is reasonable to expect a bounce of sorts today... thus, the bounce wouldnt be participated by larger institutions (if they still exist in their large numbers before the meltdown) since this is somewhat anticipated.

2) Expecting a big breakout straight to R1, but it didnt happen and instead chopped around friday's close, which was a reversal day; i neither shorted or went long... i was just observing, but couldnt pick a trade, again based on volume.

3) I forgot that at these sub-800 levels, there were no clear lines of support/resistance (like 820 or 870) where players can refer to time and time again. The lack of a price reference would also account for a weaker volume on breakouts/downs. (Having said that, I'm using 777-780 as a price ref; where the reversal on friday paused)

I did try a short later at 769 with a tight stop, but didnt work out and i ended my day.

Perhaps there is a different category of breakouts? Or am I making too much of volume?

Your comments are always welcome!

By the way, this way of looking at the markets is quite an interesting perspective...

Adam said...

Though I use strictly quantitative and mechanical methods in performing my work, I must say that this is a beautiful analogy, beautifully explicated.

Quoting Ziad, I must add, "I can't help but notice just how much your blog has influenced my trading," my overall view of markets, and sometimes life itself.

Thank you for your important and insightful contributions to our field.


JDMoodie said...

I have always used the analogy that learning to trade a market or a particular stock is like getting to know someone. It's not something that you can learn by rote, you have to get in there and get to know it in your own way.


adan said...

this looks too good to glance through

will have to either print or read later more thoroughly

looking fwd to it - thank you much!

dgoverde said...

Great post, Brett.

Trader M said...

Very nice description on how to see and catch changes in mood.

I had a bullish outlook today (after 6 down sessions) and after 1:00 PM saw the market was near the session highs. I waited for a slight pullback and put on a small position, because I find that in this scenario (heavily oversold, market up significantly after 1:00 PM) the shorts tend to panic and you get a huge melt up that can be very very profitable.

As soon as I saw the price action you flagged above, I started adding to my position in size, eventually backing up the entire truck by mid-afternoon in hopes of getting lucky with a 300-400 point dow day. We didn't get that but I did make my best profit of February, so far.

I was very aggressive today since this is a very high percentage move that tends to run pretty much straight up until after 3PM in this kind of oversold environment. I used stop management to bring worst-case losses to breakeven or even better after just a few minutes in the trade, while cranking on the leverage as the market went my way. As always I only added to positions on pullbacks.

Hope you all had a very profitable short squeeze today.

adan said...

finally got to read this yesterday

well worth the wait, plus allowing myself a time frame where i could pause, absorb, and enjoy the lines of thought

really worthwhile stuff

thank you much!