Saturday, March 14, 2009

The NYSE Advance-Decline Line: Identifying Trending and Range Environments

I've emphasized in recent posts that the single most important market call an active trader makes during the early portion of the day is whether we are in a range bound or trending environment. This one call sets trading tactics going forward. If we're range bound, we will want to identify the "fulcrum"--the midpoint--of that range and fade moves away from that estimate of value. Friday was a good example of that kind of trade. As readers are aware, I utilize volume-weighted average price (VWAP) as an evolving estimate of fulcrum/value.

Conversely, in a trending environment, we've typically broken out of an established range and are moving directionally. We want to identify the first counter-trend movement in such a directional move (pullbacks in NYSE TICK are useful for this purpose) and then enter in the direction of the trend.

So, in a range environment, you tend to fade strength and weakness; in a trend environment, you tend to go with market direction. Because traders lack the tools and skills to identify the environment as it unfolds--or because they get into mindframe that denies them access to the information from their tools and skills--they fade trends and chase direction during ranges. If you just identify the market environment properly, your execution can be less than stellar and the market will be somewhat forgiving. If you misidentify the environment, there is swift retribution.

(That is one reason that losing trades can also be good learning experiences. A losing trade may provide you with information that you are wrong in your expectations of the day's unfolding structure. That is a great topic for review when you're losing money during the day).

In my intraday Twitter comments, you'll sometimes see me suggest very early in the trading day that we might be in a range environment. For example, here was an early comment on Friday morning:

8:45 AM CT - Mixed performance among sectors continues; AD line stalling out; if that continues, entertaining reversion move to pivot.

In a trending environment, sectors should be moving in unison. When we see some sectors quite strong and others struggling to break even or even down, that tells us that we're either not trending as a market or that the trend is not robust.

A very effective tool for identifying trend environments vs. range ones is the intraday NYSE advance-decline line. I track the difference between advancing and declining stocks on an intraday basis; this goes under the symbol $ADD on the e-Signal platform.

Interestingly, the opening value for $ADD correlates with the value at the end of the first half hour of trade by .56, going back to October, 2008. The median opening value for $ADD has been -1, with a standard deviation of 81. So when we see $ADD open at +150 or greater or at -150 or less, that's a bit of a heads up that we might be in a trending environment.

By the end of the first half hour of trade, again going back to October, 2008, we find that the median value for $ADD has been -346, with a whopping standard deviation of 1378. That tells us that, within the first 30 minutes of trading, much of the issue of whether or not we're in a trending environment has been sorted out. (My next post will explore this issue more specifically). If we're seeing $ADD between -1000 and +1000 by the end of the first half hour of trade, we're much less likely to be in a trending environment than if we have readings of +1500 or more or -1500 or less.

Will a break above or below a range lead to a directional, trending move? It's likely that the participation of the NYSE advance-decline line will provide some clues. If, for instance, a break above a market's opening range (say, its range for the first 15 minutes of trade) occurs with $ADD well below +1000 and with mixed sector strength, we might be much less likely to go with that move than if the breakout vaults $ADD above +1500 with strong sector participation and leadership.

When I'm not tied up working with the firms I work with, I'll make early AM Twitter comments about $ADD for traders' decision support. Over 2800 traders are signed up for the Twitter feed (subscription is free, no registration required), and an equal number appear to be pulling the "tweets" off the blog page, where the most recent five always appear. The goal is to help you think about markets in a more structured and disciplined fashion. This is where trading skill and psychology come together: when we're grounded in skill, we're most likely to sustain a proper performance mindset.