Wednesday, September 30, 2009

Evening Briefing for September 30th

* MARKET THEMES FROM WEDNESDAY: Stocks traded stronger overnight, but were buffeted by early economic reports before a weak Chicago PMI report led to very strong selling and a retracement of much of Monday's rally. Stocks rallied strongly off their lows, only to sell back down, and try another bounce late in the day. The net result was that stocks are finding important resistance in the low 1060 range and support at the Friday lows--particularly in the NASDAQ and Russell 2000 Indexes. Gold and oil were strong today; the U.S. dollar was weak relative to the Aussie dollar; and 10-year Treasury yields were firmer. I found the selling today to be significant; a break in any of the indexes below the Friday lows would suggest a more extended, intermediate-term market correction. The aggressive position from my system was stopped out on the break below 1050; no positions at this time.

* OVERSEAS/OVERNIGHT NUMBERS: 1:00 AM CT - Germany, retail sales; 4:00 AM CT - EU, unemployment; 6:30 PM CT - Japan, household spending, unemployment. Earnings reports scheduled for Thursday can be found here.


-- Sugar as the new oil and other worthwhile reads;

-- Thanks to an alert reader for this heads up on the Google Domestic Trends page; here's a look at queries re: real estate;

-- PIMCO perspective on investing in a low yield environment;

-- The danger of reasoning by metaphors when dealing with the economy;

-- StockTwits has its own Dr. Phil offering a shrink's view of markets;

-- Interesting post on the "party effect" in trading.

Overcoming Frustration in Trading

If I had to name one emotion that causes the greatest losses among active traders, it would be frustration. Overconfidence is certainly high on the list, but the market has a way of smacking sense into the heads of people who start feeling invulnerable. Frustration, on the other hand, leads traders to compound their errors by sticking to wrong opinions and overtrading markets that offer little opportunity. Overconfident traders will generally stop trading once they're humbled; frustrated traders generate more frustration and trade larger, with more risk.

In upcoming posts, I'll be addressing ways of minimizing the impact of frustration on trading. It's inevitable that traders will be frustrated at times. Indeed, the same competitive spirit that leads people into trading can be a part of their frustration. Intense competitors don't like to lose. Sadly, in the frantic effort to recoup losses, frustrated traders can lose everything.

With frustration, as with so many trading problems, prevention is the best cure. Traders are less likely to become frustrated if they prepare well for the market day; frame their trades with clear stop loss points that they can accept; and size their positions so that any series of losing trades won't wipe out weeks' worth of profits.

Good trading practices are also good psychological practices: controlling risk and losses goes a long way toward taming emotional reactivity. If you actively *plan* your losses and think through your plan, you've already gone a long way toward accepting those losses. People aren't likely to be frustrated by events they anticipate.

In my next post in the series, we'll look at cognitive strategies for overcoming frustration.


Afternoon Update: Two-Sided Trade

Unable to take out its overnight highs, the ES contract has moved back through its volume-weighted average price (red line). This is the first two-sided trade we've seen in a while, with aggressive buying being met with equally aggressive selling. This is setting up that low 1060 area as important resistance.

Midday Briefing for September 30th: Shift in Sentiment

Note how the distribution of the NYSE TICK has shifted over the course of the day, with reduced downticking and increased upticking. The moving average of TICK has been moving steadily higher, from below zero to above, indicating growing buying interest off the market's lows.

Identifying Short-Term Momentum and Breakouts With Intraday New Highs/Lows

At 10:55 AM CT, 23 of my 40 stocks registered fresh five-minute highs as we broke to multi-minute highs. Note how that momentum carried us forward for the next several minutes.

Quick Look at Oil

Note how oil is breaking out to multiday highs after basing over the last several days. That is buoying energy and raw materials shares, several of which have registered 60-minute highs and/or moves back above their VWAP recently.

A Few Notes on Intraday Stock Screening

I've been watching my basket of 40 stocks and how many have been making fresh five-minute new highs and lows. Here are a few observations:

* When we get a several minute market bounce or drop and far fewer than half of stocks register fresh five-minute new highs or lows, it's worth looking for a retracement of that move;

* A cumulative line of the number of stocks making new highs vs. lows gives a general sense of trending;

* If you stop seeing new highs or lows from stocks in a sector that has been leading the market higher or lower, that often precedes a market turn;

* When the market is making a valid breakout move, the vast majority of stocks will register new highs or lows;

* In a slow, range trade, you'll see a mixture of stocks making new highs and lows;

* If you define an X-minute opening range, seeing a great majority of stocks break higher or lower than that range is a useful alert to an early trending move;

* If you track new highs/lows and breakout moves at different time frames (for example, five minutes vs. one hour), you can catch short-term moves within larger-term moves.

I'm finding the Trade-Ideas platform to be useful as a way of creating custom baskets of stocks and tracking their strength and weakness over time.

When Economic Reports Are Game Changers

The Market Delta chart shows the dramatic selling on the weak Chicago PMI data, with greatly expanded volume hitting bids. We know when an economic report is a game changer when we greatly expand volatility and volume is one-sided, hitting bids or lifting offers. Recognizing the shift in volatility and intraday sentiment is key to capitalizing on these moves--or avoiding getting run over by them!

Intraday Screening for Trend Status

Yesterday I posted one of my intraday stock screens to show how I was tracking short-term strength and weakness with my basket of 40 stocks. The screening program I am using for this purpose is Trade Ideas.

Today I'll be tracking a different, but related set of screens, including the number of stocks in my basket moving above and below their volume-weighted average prices; the number of stocks making fresh hourly new highs and new lows; and the number of stocks breaking above and below their first hour's opening price range.

The idea is to gauge market strength and weakness by setting benchmarks that will help us identify trending vs. range markets. Stay tuned; I'll update the screening results during the day via the blog.

Morning Briefing for September 30th: Mixed Market

We can see that stocks moved higher in premarket trading before shooting lower on weaker than expected employment numbers. We pulled back into the premarket range and then shot higher on better than expected GDP numbers--only to once again pull back into that range. As a result, we're trading at levels not far from where we were trading before those numbers. The lows from the employment numbers and the highs from the GDP release have set us up in a clear range, with the day's average price around 1058.75.

The U.S. dollar has strengthened vs. euro since the releases; oil is trading off its early highs; gold is higher. Yields on the 10-year Treasury note remain higher. I will be following intraday sentiment closely to see if we can sustain prices above the low 1060s resistance area in ES. If we cannot sustain that level, I'd expect a test of the premarket lows. I'll be updating market action via Twitter and intraday posts.

Gauging Trend Status With Intraday Advance-Decline Data

One indicator regularly on my screen is the intraday advance-decline number: the number of NYSE stocks advancing minus those declining for the day. When that number is below +1000 and above -1000 in midday trade, it's a good tell that we're in a range bound environment.

Non-confirmations of stock index moves by the intraday advances/declines can also be informative. Although the indexes closed near their lows for the day yesterday, the number of advances minus declines was well off its lows. That told me that the market was closing stronger than it appeared.

Also useful in this regard is monitoring the number of stocks advancing versus declining from their opening prices (see this post for details and this post for explanation). That number stayed negative for most of yesterday, alerting us to late day weakness.

I regularly include intraday advance-decline data in tweets during the trading day (follow here), as a way of gauging trend vs. non-trend status for the day. Once I establish trend status, I then use the price targets published each morning via Twitter as a guide for where moves to and away from value might take us. Range markets will tend to revert toward value (pivot price); trend ones will move toward the R1/S1, R2/S2, and R3/S3 targets.

Tuesday, September 29, 2009

Evening Briefing for September 29th

* MARKET THEMES FROM TUESDAY: We moved above the Monday highs in early trade, only to be smacked down by weak consumer confidence data. Although we retraced much of the breakout move from Monday, we remained above the former resistance in the upper 1040s in the ES contract. Weakness late in the session was not confirmed by the intraday advance-decline line, which was balanced between gainers and losers for most of the afternoon. As long as we stay above that key support area, I'm viewing today's action as a range bound consolidation of yesterday's gains. The U.S. dollar closed off its recent highs, especially versus the Aussie dollar; gold and oil remained in tight ranges; while 10-year Treasury yields continued to drop.

* OVERSEAS/OVERNIGHT NUMBERS: Lots of data overseas. 1:45 AM CT - France, PPI; 2:50 AM CT - Germany, unemployment; 3:00 AM CT - Italy, PPI; 4:00 AM CT - Italy, CPI; EU, consumer prices; 7:30 AM CT - Canada, PPI, GDP; 6:50 PM CT - Japan, retail sales, Tankan surveys. Earnings reports scheduled for Wednesday can be found here.


-- Looking for SPX at 1200 and more good reading;

-- Betting on Brazil and commodities;

-- Excellent look at ETFs and the dollar/stock relationship;

-- Cyclicals anticipating a V-shaped recovery?

-- Pain for holders of CIT;

-- Excellent review of economic reports from last week and expectations for this week.

Overcoming Stubbornness as a Trader

A reader notices that he has been fading strong moves, much to the detriment of his account. What can he do to stop himself from being stubborn?

Many times stubbornness comes from trying to be right: investing one's ego in catching market highs or lows. Sometimes that stubbornness comes from missing a market move and then fading that move just to be proven "right".

The opposite of stubbornness is accepting losses and the inevitability of losses. If you mentally prepare yourself for losing, you will be maximally flexible in exiting losing positions and getting into good ones.

You emotionally prepare yourself for losing by not just viewing stop loss points as price or time levels, but as concrete action plans. You want to mentally rehearse those plans--actually visualize yourself taking those losses if the stops are hit. If you make yourself familiar with a scenario and make yourself cope with it and accept it, it will lose much of its threat value.

It helps to view every trade idea as a hypothesis, not a fixed opinion or conclusion. If you frame a trade idea as a hypothesis, you immediately open yourself to the possibility of the hypothesis being wrong. That helps you plan "what-if" scenarios for how you would respond if the hypothesis is not supported. Similarly, the what-if scenarios can help you become more aggressive in trades that do find market support.

Developing traders should trade small enough that inevitable losses won't hurt the account too badly. If you make losing painful, you'll try to avoid losing...and that will keep you in bad trades well beyond any rational stop level.


Midday Briefing for September 29th: Building Volume Lower

12:12 PM CT - I added the above chart to show how we were unable to hold prices below the overnight lows, leading to volume coming in at the offer in ES and a positive shift in the NYSE TICK. That has taken us back above VWAP, creating range dynamics for the day, with advancers leading declines by about 200 issues.

Note how we broke below the volume-weighted average price (red line) on the weak 9 AM CT confidence numbers, with volume at bid exceeding that at offer in ES since then. We moved below the preopening lows and have retraced much of the Monday rally, especially in NQ. We are back to yesterday's breakout level in NQ and only a few points above that in ES, as we're building volume below VWAP. Gold and oil are in multiday ranges; the dollar has strengthened vs. Aussie dollar, but is well off its highs from yesterday. NYSE TICK has been moderately negative on the day, reflecting the selling pressure. Should we hold above that Monday breakout level with improved TICK distribution, I would expect a rotation back above VWAP. A move below that breakout level would represent fresh selling and place us in a range trade between Friday's lows and today's overnight highs.


Screening for Intraday Strength and Weakness

If you click on the Trade Ideas display above, you'll see how I'm tracking five-minute new highs and lows; moves above and below VWAP; and opening range breakouts for my basket of 40 stocks. Over time, you can see the flow of green (buying interest) and red (selling interest) and gain a feel for how the market is trading overall. By knowing which stocks belong to particular sectors, you can also track strength and weakness among the sectors and differentiate range/rotation markets from trending ones.


Morning Briefing for September 29th: Digesting Gains

We've seen some selling come into the preopening market, with ES holding above its late Monday afternoon highs around 1056, but NQ trading lower. Should we be able to hold that 1056 level, I'd expect us to take out Monday's high and continue the rally. I noted a little while back that the alpha version of the trading system I'm developing has been long. The conservative version of the system closed that trade at yesterday's close; the aggressive version stays long above 1050 for a move to at least 1070. The system is still in development, so take with grains of salt.

We're seeing strength in USD vs. euro; weakness in gold and oil. Rates in the 10-year Treasury note have moved below 3.3%. So, all in all, intermarket themes are not so supportive of stocks here. That being said, we've held Monday's gains well. I'll be updating intraday sentiment and intermarket themes via Twitter; I'm also testing out a couple of new tools and might mention those.

Tracking the U.S. Dollar and Intermarket Themes

A trader wrote to me about the change in the relationship between the U.S. dollar and the U.S. stock market yesterday, as we saw dollar strength (vs. the euro; bottom chart), but very strong stocks. A quick look at the Aussie dollar, however, shows that the U.S. dollar traded weaker on the day (top chart). Indeed, what we were seeing was more euro weakness than strength in USD.

Until recently, the USD has been trending lower against the major currencies; lately, though, we've seen more differentiated performance. I'll be watching to see if this represents the start of firming in USD. Meanwhile, it pays to watch a variety of crosses and not judge dollar strength or weakness on any one.


Monday, September 28, 2009

Evening Briefing for September 28th

* MARKET THEMES FROM MONDAY: Early strength took stocks past resistance just below ES 1050, setting off an upside trend day. The NYSE TICK was strong through the day; volume at the offer in ES greatly exceeded that at the bid; and advancing stocks led decliners by over 1800 issues. We saw Demand at 173, Supply at 18, suggesting broad upside momentum. The U.S. dollar strengthened in the afternoon and gold closed well off its highs; I'll be following these intermarket themes closely tomorrow and posting via Twitter.

* OVERSEAS/OVERNIGHT NUMBERS: 3:30 AM CT - Great Britain, GDP; 4:00 AM CT - EU, economic sentiment; 6:50 PM CT - Japan, industrial production; 8:30 PM CT - Australia, retail sales. Earnings reports due out Tuesday can be found here.


-- Currency crashes in weak economic conditions have positive effects;

-- Credit market indicators, a look at earnings revisions, and much more;

-- Indexes bouncing off oversold readings;

-- Review of economic indicators;

-- Questioning the argument about sideline cash.

Evaluating Proprietary Trading Firms

I hear from many traders who wish to affiliate with proprietary trading firms. It is difficult to know how to evaluate such firms if you've never worked for one. Here are a few of the criteria that I would look for:

1) How long has the firm been in existence? How long have the top traders been working with the firm? Has the firm grown large, successful traders? If you see highly successful traders sticking with a firm, you know that the firm is generating loyalty and offering value;

2) Is there sound management and risk management? What is the management philosophy about growing traders? How do the traders view the management?

3) How does the firm make their money? Do they require high fees? High commissions? How do they split profits? Are traders required to put up money before trading?

4) Does the firm offer structured training and mentorship? Is the firm invested in its developing traders?

5) What is the atmosphere within the firm? Do traders collaborate and share ideas? Are they happy with the firm? Is it a fun place to work?

6) What are the firm's resources? Do they have superior trading platforms, IT support, and decision-support tools for traders? Does the firm offer a good working environment?

7) Does the firm trade a variety of products and strategies? Are there different things you can learn at the firm?

No single firm will offer all you want across all of these criteria, but if you keep score, you'll quickly separate the best from the rest. Find a firm that makes the bulk of its money from your success and that invests in good support for traders. Beware firms that charge high fees and then offer very small amounts of capital to trade.

Most of all, find a firm that trades the way you want to be trading. Ultimately, there has to be a fit between the firm's strategy and the skills and interests of traders.


A Different View of a Trending Market

Here the Market Delta chart shows how volume is distributed within each bar as well as from one bar to the next. Note how we continuously build volume higher during a trend move, with volume dominantly lifting offers.

Midday Briefing for September 28th: Breakout and Trend

I've updated the chart from the morning briefing to illustrate the break above the identified resistance area just below ES 1050. Note how solid volume, very strong NYSE TICK, strong plurality of advances over declines, strong volume at offer vs. bid, and corroborating intermarket themes (pullback in dollar vs. Aussie dollar; bounce in commodities) all supported the move.

As long as TICK remains strong and we stay above that breakout level around 1050, we have a candidate trend day in the making. That makes intraday pullbacks in TICK areas to consider buying.

Morning Briefing for September 28th: Weekly Profit Targets

We can see in premarket trading that, so far, the S&P 500 e-mini (ES) contract is finding support in the 1036/1037 area. If we can hold Friday's lows with modest selling pressure in the morning session, I would expect a test and possible breakout of resistance in the 1048 region. Failure to break that resistance would set us up for range trading and potential retests of the recent lows. So far this morning, we're seeing the dollar off its highs vs. the Aussie dollar and gold trading higher.

I published the daily price targets for today via Twitter, along with Friday's indicator readings. Here are the proprietary weekly price targets for SPY:

Pivot=105.26; R1=107.77; R2=108.28; R3=108.95; S1=102.74; S2=102.23; S3=102.56.

Recall that these targets are volatility adjusted and represent estimates of how far the market is likely to move in the given time period. Since 2000, about 75% of all weeks have touched their prior week's pivot level; 70% of weeks have hit either the prior week's R1 or S1 level; 50% of weeks have hit R2 or S2; and 33% of weeks have extended to R3 or S3.

When you see that a market move is particularly strong or weak, it makes sense to hold at least a portion of your positions for the more distant profit targets. Range markets will fail to hit R1 or S1 or will fall back below those levels after touching them. Those situations can set up worthwhile reversion trades back to the market's pivot level.

For more on the use of profit targets in swing trading, check out this post and its links.

Indicator Update for September 28th

Last week's indicator review suggested that we had put in a momentum top for the recent bull swing and that it would not be surprising to see a pullback prior to any further price highs. We did indeed pull back last week, taking most of the sectors out of their uptrends. This moved our momentum-based Cumulative Demand/Supply Index (top chart) into modestly oversold territory. Pullbacks in this measure have occurred at higher price lows and have represented excellent intermediate-term entry points thus far.

We've also pulled back in the number of stocks registering 20-day highs minus lows (middle chart); these pullbacks have similarly occurred at higher price lows since the March bottom and have represented excellent entry points. I expect this pullback to be no different, but would revise that assessment should we take out the early September lows in this measure.

The bottom chart, from the excellent Decision Point site, shows that we've pulled back in the advance-decline line specific to S&P 500 stocks. Note how the early September lows in the A/D line represents important support. As long as we hold above that level, I view the longer-term uptrend as intact; a move below that level would suggest more significant distribution characteristic of intermediate-term topping.

I will be updating indicators each morning before the market open via Twitter (follow here). At this point, nothing has occurred to change my view that we're seeing a normal pullback following a momentum peak and should see further price strength before an outright bear swing takes hold.

Sunday, September 27, 2009

Evening Briefing for September 27th

* MARKET THEMES FROM FRIDAY: Stocks traded lower once again on Friday, taking many of the market sectors out of their uptrends. We're seeing significant resistance in the ES contract just below 1050. Although we made day over day lows in the major averages, only 276 more stocks declined on the day than advanced. The U.S. dollar closed off its highs; gold and oil closed off their lows. Ten-year Treasury rates continued lower; they show significant resistance around the 3.5% area. Several sectors have sustained solid declines this past week, including the commodity-sensitive energy and materials shares. I will be watching closely early this week to see if we can stay above the 9/14 lows; I'll be updating my views via Twitter during the week.

* OVERSEAS/OVERNIGHT NUMBERS: Germany, CPI; 6:30 PM CT - Japan, CPI. Earnings reports scheduled for Monday can be found here; its a light calendar.


-- Excellent wrap of the market week;

-- Thanks to a wise reader for passing along these insights about banks and lending;

-- Stark view of the unemployment situation, despite the economic recovery;

-- Which ETFs are strong and weak and a great look at the implications;

-- Fascinating research on how our minds rewrite memories; thanks to a sharp reader for the catch.

Sector Update for September 27th

Last week's sector update noted that all the sectors were trading in uptrends, with particular strength among sectors representing risk appetite among investors. With the pullback of the past week, we're now seeing a much more mixed picture of Technical Strength among the sectors, with most of them in a short-term non-trending mode. (Note: Technical Strength is a proprietary measure of short-term trend behavior that varies across the sectors from +500--strong uptrend--to -500, strong downtrend. Scores between -100 and +100 suggest no significant directional tendency).

Pullbacks in strength were particularly evident among raw materials (XLB) and energy (XLE) shares, reflecting commodity weakness and U.S. dollar strength. The week's weakness affected all sectors, however, as the chart above indicates: all show lower Strength scores than the week previous.

Here's how the sectors sorted out as of Friday's close:

ENERGY: -140

We can see that only the Industrial group qualifies as being in an uptrend and that just barely. The picture is consistent with what I mentioned in last week's indicator review: we have made a momentum high in the market and now find ourselves consolidating those gains. If this is the case, the current pullback should not be the start of a bear swing, but should be sufficient to inflict technical damage on what has been a very strong market since July. It is after that pullback that we should see tests of the bull highs.

I will be tracking the trend status of the sectors and reporting each morning before the market open via Twitter. The early morning tweets also summarize measures of market strength (new highs/lows) and momentum (Demand/Supply). You can follow the most recent Twitter postings on the blog page under Twitter Trader or you can follow the entire stream of tweets by going to my Twitter page.

The Limitations of Mechanical Trading Systems

The first two posts in this series described some lessons I was learning while developing a trading system and broader reflections on theory-building in market investigation. In this last post, I'll tell you where an intensive weekend of research has left me and where I plan to go from here.

Please note that my observations are for only the markets and market data that I am observing; I cannot make with confidence judgments about other markets and data. Please also take my observations with many grains of salt, as system development is hardly my area of expertise.

What I can tell you with respect to the market variables I am investigating, which include price change, momentum, and market breadth/strength, is that a proper model for the markets would have to be one that incorporates the notion of state dependence. Over the course of years of daily data, it appears to me that the stock market exists in a finite number of states and that the predictive value of any traditional market indicator is contingent upon the market state at that time.

I suspect this is why market indicators as a whole are not good predictors of future price action, as Aronson's research suggests. What is an accurate predictive indicator in one market state--say, a narrow trading range--is not predictive in another, such as a vigorous trend. When we average performance of trading systems/indicators across a lookback period, we inevitably are averaging days from different market conditions/states. The result is that performance may look smashingly good for a period of time and then inexplicably degrade.

To make this more concrete, suppose I have a patient who has a bipolar (manic-depressive) mood disorder with episodes of psychosis (loss of contact with reality due to delusions or hallucinations). My patient has at least five different states: manic/non-psychotic; manic/psychotic; depressed/non-psychotic; depressed/psychotic; and relatively normal mood/cognition. If I try to predict how my patient will respond to something I say, I have to take into account the state that he is in. A backpat of encouragement would be read one way in a depressed state; another way in a manic one. It would have one meaning in a psychotic state; another meaning in a normal cognitive mode. Any global prediction across all states is apt to be weak. Indeed, a clinician that treated the patient the same across all conditions--a mechanical counseling system--would be hamhanded at best.

And that's the problem with mechanical trading systems with respect to the variables I'm studying. They are hamhanded. They work well when markets behave "normally" and can work surprisingly poorly when market states shift.

That isn't to say that successful systems can't be developed; I just think that such systems would have to factor in state-dependence and market context. In a sense, such a system would really embrace a set of subsystems, at least one for each distinctive market state. Their logic and validation would be non-linear: to test each subsystem, you'd have to go back to only those periods from the past that fit the state definition.

Procedurally, that means not just testing systems on the last X number of years of data. It is probably more akin to conducting nearest-neighbor modeling, where the neighbors are selected from the last X years of data based upon an objective definition of state. A set of tools for conducting such investigations can be found here; a set of common mistakes in these investigations is here.

Before using those tools, it would be helpful to develop an explanatory model that incorporates the notion of states and state dependence, per my recent post on theories and science. Such a model, if useful, would suggest candidate variables/predictors for those modeling tools. That's where I hope to be taking all of this.


Learning Self-Regulation: Building Our Brains

An interesting story in the New York Times reports that, "The ability of young children to control their emotional and cognitive impulses, it turns out, is a remarkably strong indicator of both short-term and long-term success, academic and otherwise. In some studies, self-regulation skills have been shown to predict academic achievement more reliably than I.Q. tests."

Teaching the executive skills of self-control is not easy, the article notes. The key may be extended dramatic play, in which children immerse themselves in realistic scenarios and work at controlling their impulses. Children are taught "private speech"--focused self-talk--to help them focus on tasks and avoid distractions and impulses.

The goal is to create internal behavioral controls, not ones guided by external reinforcement.

When traders engage in real-time trading simulations, they are engaged in a kind of realistic play. It is an opportunity to not only build and test trading skills, but also to hone those executive, self-regulatory skills. This may be one of the most effective ways of teaching new traders the psychological skills necessary for profitable trading. By making successful performance in simulation a requirement for going live, the simulation can take on some of the performance pressure characteristics of having real money on the line.

We build our muscles by using them in challenging situations; perhaps it's not so different when it comes to building our brains.


Saturday, September 26, 2009

Reflections on Qualitative Research, Science, and Trading System Development

I recently mentioned lessons that I was learning in developing a trading system. Since 3 AM this morning, I've been taking apart every signal from the past several years and investigating the factors differentiating the successful signals from the unsuccessful ones.

My sense, for what it's worth, is that far too little attention is paid to the value of qualitative research in markets. Qualitative research refers to systematic observation that is designed to *generate* hypotheses, not test or validate them. Qualitative research does not replace quantitative work; its purpose is different.

We can think of qualitative research as theory building research. It is the observation that we perform to develop an understanding of phenomena.

When Darwin collected his notebooks of observations from nature, he organized the information in a way that enabled him to generate an explanatory framework: evolution. That framework not only explained existing observations; it suggested new ones. It is the testing of those fresh observations that forms the backbone of quantitative research.

"There is nothing more practical than a good theory," psychologist Kurt Lewin once observed. His point was that science aims at more than prediction: it seeks explanation. Indeed, it is through understanding that we are able to generate predictions.

A technical presentation of the structure of scientific theories can be found here. One theme that has emerged over the course of philosophy of science is the role of models and analogies in generating theories and explanations. We explain something we don't know well by casting it in terms of what is better known. This process of analogy helps us think about complex, partially understood phenomena in novel ways: the good theory is practical to the extent that it leads us to observations we otherwise would have never made.

As I pour through data, I increasingly realize that equating a "scientific" approach to markets with a predictive one is a limited and limiting perspective. There are many predictive statements generated regarding markets daily; few of them are backed by formal efforts at explanation and understanding. Before we enter the laboratory--like Darwin--we need to fill in our notebooks and view our investigations as ways of generating hypotheses, not conclusions.

Two Very Useful Resources for Traders

* MARKET DASHBOARD - Suppose you could have gauges on a dashboard that could give you important market readings, just like in your vehicle? Well, it looks as though Jeff Pietsch of Market Rewind has developed just such a set of tools, which he calls Mrkt Metrics. There is a gauge of daily sentiment based upon trading patterns among major sectors; a short-term overbought/oversold gauge; gauges for short-term, intermediate, and long-term trends; and a measure of market normalcy that tracks how far prices are from their mean levels. It's a great idea for a quick, visual view of how the market is trading.

* TRADING WITH MARKET PROFILE - Matt Fahmie has been posting very useful Market Profile perspectives on his Trade Order Flow blog, including video views of failed auctions; guidelines for trading with the Profile; and commentary on recent markets. There are good insights on the blog, particularly for those trading on a swing time frame.

A Few Lessons Learned From My First Trading System Development

I'm in the process of developing a mechanical trading system for a money manager; the basic logic is similar to that of the transition patterns I've described in numerous posts. I've learned a few useful lessons thus far.

What I can tell you so far in the development process is that tweaking the entry parameters has less impact on profitability than defining when to exit trades.

At least for the patterns that I'm testing, the advice to hold your winners and cut your losers does not fully hold water.

There is an optimal holding period that has remained stable over years of backtesting; that holding period is based on the conditional probability of trades being profitable at a defined exit criterion. If you hold winning trades too long, they revert to losers more often than they add to gains.

Conversely, if you exit a trade that goes against you too quickly, you risk missing your move more often than you avoid further losses.

The optimal holding periods are different for long and short trades.

The most effective way to cap losses that I've found is to cap holding period, not define a dollar or percentage stop loss. A good deal of performance improvement comes from capping holding periods and thereby avoiding large losing trades.

To benefit from a "let your winners run" philosophy, you need holding times greater than 20 days. Within a 20-day window, defining optimal points for exit and not extending holding times on winning trades works better.

If you define exits as signals in the opposite direction, so that the system is always in the market, you increase total profitability, but at the expense of increased heat taken on trades and increased variability in returns. That could make the system difficult to trade psychologically.

The quicker a signal goes your way, the more profitable it is to wait for a signal in the opposite direction to trigger an exit. Promising money management rules appear to follow from this observation.

The trading patterns and parameters do not work equally well across different stocks and asset classes. Trading the same idea in the same way across all instruments is inefficient in my backtesting.

It may well be that other system ideas would generate different conclusions. With the system ideas I'm testing, however, I'm finding that common trading wisdom, while commonsensical, is not necessarily accurate.

FWIW: The alpha version of the system--take with a grain of salt--is long the S&P 500 Index.

Friday, September 25, 2009

Readings for a New Weekend

* Here's a post on mental preparation for the trading day based upon a talk I recently gave at a Chicago prop firm;

* Excellent service that tracks the entire universe of ETFs, relative strength, pairs trades, and much, much more;

* Thanks to a reader for this interesting research on how mindfulness can reduce burnout;

* Recognizing key price levels in trading;

* Even after the stock market rally, investors are pursuing yield, not stocks;

* Worthwhile trading resources from EOTPRO;

* Excellent post from Down Under re: importance of relative volume;

* What the good Dr. listens to while posting links.

Quick Week End Note to Readers

Just a quick heads up for readers: In the next couple of weeks, I'll be scaling back the frequency of my posting to Twitter and the blog. I've taken on new coaching work that will require my hands on involvement with traders during market hours. That work will include help with both trading psychology and with the development and application of decision support tools for traders.

I'm looking forward to sharing insights from the new work and am hopeful that the quality of the resulting posts will compensate for the cutback in quantity.

Thanks as always for your understanding and support--


Midday Briefing for September 25th: Downside Break

Note the expanded selling volume (and overall volume) as large traders sold the ES futures as we neared the morning lows. The inability to sustain buying above vwap (and greater volume at bid vs offer) were important downside tells, as were the intermarket themes of strong dollar and weak commodities as the morning wore on. This sets up the earlier morning lows (and high volume regions highlighted by the arrows) as potential resistance for bounces.

Example of a Short-Term Transition Reversal Pattern

Many of the transition, reversal patterns that I've posted cover longer time frames, where we look at 30 or 60-minute bars. Here is an example using 5-minute bars, in which the move back toward overnight highs stalls out, with less volume transacted at ES 1048 and above as we stall out. We can also see from the bottom histogram less net volume transacted at offer vs. bid as we trade near those highs. Recognizing that we weren't breaking away from the volume bulge identified in yesterday's trade led to the range idea that we would revert back below VWAP.

Again, these patterns work because you're catching short-term traders leaning the wrong way. They're playing for an upside breakout and have to cover their positions once it becomes clear that, for the time being, we've put in a high.

Morning Briefing for September 25th: Probing the Lows

After a bounce overnight, we saw selling re-enter the market on the durable goods report, taking the dollar higher and gold, oil, and 10-year yields lower. Right now, as we can see in the ES chart above, we're trying to stabilize in the area of yesterday's lows. I am watching the intermarket picture closely, as well as buying/selling sentiment early in the day to assess the odds of sustaining weakness below yesterday's lows vs. moving back into the thick of the volume range identified in yesterday's post.

It is not at all clear to me that the bull has ended with the recent market pullback. Rather, per my weekend indicator comments, I suspect that we've seen a momentum high and now have entered a topping process. If so, we should be able to stabilize at lower levels before making a test of the bull highs. I'm watching for indications of such stabilization/bottoming and will be updating observations via Twitter (follow here).

What is the Trend for the Day?

Is the day trending or is it trading in a range? Is it breaking out of a range, or will it stay within? Those are some of the key questions I ask during each session.

Henry Carstens has been tweaking a couple of tools to address this question. He tracks a large basket of high volume stocks and investigates whether each one is moving directionally higher, lower, or non-directionally during the trading day. On that same page, he's also tracking directionality sector by sector, so that traders can see if we're in a general trending environment or a mixed one of sector rotation.

While I can't disclose Henry's methodology, I will say that it is directly derived from the strategies he utilizes in managing money with his trading systems. The idea of the tools, however, is to use the system-related research as decision support for discretionary traders.

In my own research, I'm pursuing a similar purpose, but with a different method. I'm tracking a different basket of stocks and investigating how they are trading with respect to their volume-weighted average prices (VWAP). The idea is not just to track the absolute numbers, but to identify significant shifts in those numbers. Trade Ideas offers the ability to screen stocks for how they're trading relative to VWAP; the key is filtering moves above and below VWAP, so that you're not just catching random noise around a particular price.

When we see large shifts in these indicators, we have validation of a breakout move. Breakouts without large shifts offer a look at possible reversal moves.

These are indicators with considerable potential.

Thursday, September 24, 2009

Evening Briefing for September 24th

* MARKET THEMES FROM THURSDAY: We opened the day in a multiday trading range, but broke to the downside on significant volume following a weak housing report. There was significant strengthening in the U.S. dollar, which helped push commodities and Treasury yields significantly lower. New 20-day lows expanded to 365, with only 584 20-day highs; my Demand/Supply measure was heavily skewed toward Supply, meaning that a large number of stocks closed below the volatility envelopes surrounding their short-term moving averages. That often leads to follow through weakness on a short-term basis, followed by reversal. As usual, I will be tracking the indicators each morning before the market open via Twitter (follow here) to gauge whether we are seeing expanded weakness or a drying up of selling.

* OVERSEAS/OVERNIGHT NUMBERS: 1:45 AM CT - France, GDP; 3 AM CT - EU, money supply; Italy, retail sales. Earnings reports due out on Friday can be found here.


-- As households save, government goes deeper into debt;

-- Luxury hotels face potential default;

-- The dangers of being rewarded for doing the wrong things;

-- Reflections on whether this is a sucker's rally in stocks;

-- A look at the stock/dollar correlated trade.

Identifying and Trading Off of Key Price Levels

When volume builds in a price range, that represents the market's setting of value in that time frame. That estimate of value can be regarded as a kind of magnet, as weak rises and declines above and below the range tend to return to value. We saw that in much of this afternoon's trade, as volume built in the 1045-1048 price level. Strong moves away from that level can be conceptualized as breakout moves; failed breakouts can be traded for reversion trades back to value. An important facet of market preparation is knowing those price levels from the current and recent trading sessions.

When Breakouts Turn False

The recent lows in ES were achieved on lower volume at the bid (bottom blue arrow). As noted in the intraday tweet, we also saw non-confirmations of daily lows among the NQ index and the XLB, XLV, XLY, XLP, and XLK sectors. Those non-confirmed breakouts often become false ones, as sellers are forced to cover positions on failure to sustain the lows.

Looking at Breakouts in NYSE TICK

Note how the NYSE TICK and its moving average (blue line) have stayed below the zero level (purple horizontal line) for most of the session. The breakout to new morning lows in TICK after the weak 9 AM CT housing number showed a shift in selling pressure. We generally think of breakout trades and opening range breakouts as a function of price movement. Breakouts in TICK, however, can indicate an important shift in intraday market sentiment.

Midday Briefing for September 24th: Oil Weakness and More

After multiple failed attempts to make new highs during the summer, oil is under considerable pressure recently on dollar strength. That is weighing on raw materials and energy stocks, both of which are quite weak from their opening prices. The relative outperformance today of consumer staples shares, health care stocks, and utility names suggests that equity traders are taking a risk-averse stance. That also shows as relative weakness among Russell small caps and NASDAQ shares.

Morning Briefing for September 24th: Broad Range

Here we see the ES futures, which moved lower overnight on weak numbers out of Germany, only to hold support at the 1052/1053 area and bounce higher. That sets us up in a broad trading range. Oil continues weak on the day, which could continue to weigh on stocks via energy and materials shares. Rates are down to 3.411% on the 10-year Treasury note; the U.S. dollar is well off highs from late yesterday. I'm not inclined to be aggressive in the middle of the multiday range; let's see how stocks trade as we test one of the range extremes. I'll be updating market action via Twitter (follow here) during the day.

The Dollar-Adjusted Stock Market: The Effect of Weak Currency Headwinds

The U.S. stock market has rallied sharply off its March lows. Sometimes, however, we forget that stocks--like other assets--are denominated in currency units. Those currencies change value, as do other asset classes.

When we look at the S&P 500 Index (chart above) denominated in the U.S. dollar index--a basket of international currencies--we see that the recent bull run has only retraced a modest portion of the massive decline from 2007.

An international investor who has owned U.S. stocks has seen gains in equities eroded by losses in the U.S. dollar. Similarly, holders of U.S. debt find themselves being repaid in cheaper dollars. It is difficult to imagine U.S. assets finding relative strength on a global basis when those assets are facing weak dollar headwinds.

Passing The Plate: Shift From Oversold to Overbought

If you recall, my "passing the plate" post requested perspectives from readers regarding trading patterns that they were utilizing.

Here, Babak of the Traders Narrative blog responds by offering his historical perspective on what has happened when the stock market has gone from being far below its moving average to being far above in a short period of time. As the chart above and Babak's post indicate, we have gone from being a record amount below the 200-day moving average to near a record amount above.

Momentum peaks often precede price peaks and similar vertical rises from oversold to overbought, such as after the sharp drops in December, 1974; October, 1987; and March, 2003, led to rises that lasted well over a year in duration before a new bear market ensued. As the Traders Narrative piece indicates, however, not all shifts from oversold to overbought have led to sustained gains.

This research is very much related to a pattern reported by Rennie Yang of Market Tells, pertaining to the S&P Oscillator. That indicator tracks changes in overbought/oversold conditions via daily advance/decline figures. It has given very positive readings lately, reflecting the sharp move from very oversold to overbought conditions. As Rennie notes, such positive readings have generally led to further price strength in the intermediate term.

Thanks to Babak for highlighting this pattern. I will be posting additional patterns and setups from readers in coming days.

Wednesday, September 23, 2009

Evening Briefing for September 23rd

* MARKET THEMES FROM WEDNESDAY - Stocks showed good resilience in early trading, holding above support around ES 1062, even after a bearish oil number knocked commodity-related stocks for losses. A rebound ahead of the Fed announcement took stocks back near their day's highs, and strong buying after the announcement brought fresh bull highs in ES. Those highs were not confirmed by a number of sectors, as noted in the intraday Twitter posts. They were also not confirmed by the new high/low indicator (1675 new 20-day highs, 192 lows) and were accompanied by tepid advance/decline numbers. As we retreated back into the day's range, selling pressure mounted significantly, accompanied by strength in the U.S. dollar, buying in U.S. Treasuries (drop in yields), and selling in gold and oil. We dropped below the day's lows (and that 1062 support region), creating a outside, reversal day. The action is consistent with the topping scenario mentioned in the recent indicator review, setting the 1070 region as continued significant resistance. Market wrap here.

* OVERSEAS/OVERNIGHT NUMBERS: 11:30 PM CT - Japan, industry output index; 3:00 AM CT - Ifo business sentiment index; Italy, merchandise trade balances. Earnings reports due Thursday can be found here.


-- Worthwhile readings with a macro focus;

-- Good look at stock indexes, oil, and GOOG;

-- Questioning the market rally and other excellent links;

-- A look at P/E ratios and what they mean for stocks and much more;

-- Lessons from sports betting and trading;

-- Housing less affordable despite price drop.

Listening to Yourself as a Trader

When you've been following markets for a while and something you're seeing just doesn't feel right, the chances are good that your implicit pattern recognition is kicking in and something *isn't* right. When I posted the following tweet, I felt strongly that something in the rally off the Fed announcement was not right:

steenbab1:52 PM CT - Unusual breakout; only 772 more adv than dec; still not confirmed by a number of SPX sectors. TICK weaker, still pos tho

A host of market sectors didn't confirm the new highs and a large number of stocks in my basket were not even up on the day from their opening price! That recognition led to one of the best trading days in recent months, as prices retraced all of their gains off the premarket lows and then some.

So often we hear that traders need to overcome emotion when trading. But sometimes emotions contain valuable information: we often feel danger before we explicitly identify it. The value of experience is that it hones our antennae; we become more finely calibrated in our feel for markets. To sustain contact with that feel, however, means that we have to stay market-focused, not focused on P/L, yesterday's trade, or our particular opinions about the Fed, the Administration, or the economy.

Once we sustain that contact with market feel, it becomes clear that we often know much more than we know we know.


Midday Briefing for September 23rd: Awaiting the Fed

Going into the Fed announcement, we can see that the S&P 500 (ES) futures moved below their overnight lows, but held support above yesterday's lows, despite a sharp selloff in oil and commodity-related stocks. We've since bounced above VWAP, creating a range day ahead of the announcement. The U.S. dollar is stronger against the euro and the Aussie dollar (though off its highs); oil remains significantly lower on the day; gold is down, but off its lows. Ten-year Treasury yields are down on the day. With the extended range going into the announcement, traders will be looking for breakout moves. If selling holds above the morning lows, I would expect new highs in ES; failure to make new day highs in ES would target the day's lows as an initial target. I'll be updating via Twitter following the announcement to gauge buying and selling interest.

Morning Briefing for September 23rd: Ahead of the Fed

We can see that the S&P e-mini (ES) futures have ground higher in overnight trade, having held above the 1062 support area identified yesterday. We're also trading above the day's volume-weighted average price (VWAP; red line) thus far this morning. Ability to hold above that level will target the bull market highs and set up a potential breakout trade with respect to the recent multiday range. A move below VWAP would continue us in the multiday range. We're seeing some USD strength vs. Aussie dollar, and gold and oil are trading off a bit. I'll be watching those intermarket themes closely, as--thus far--they are not particularly supportive of higher stock prices.

We've generally seen positive market performance going into FOMC announcements, as noted by the excellent Quantifiable Edges blog. I'll be watching the cumulative NYSE TICK over the course of the morning and posting via Twitter to see if that bullish bias follows through today.

Notes and Observations

* Thanks to readers who sent in trade setup ideas in response to the recent post. I will be featuring those setups in posts beginning later today;

* Increasingly, I find myself entering trades late in the afternoon and holding into the next trading day. I can adjust for overnight price risk by sizing positions properly; I can't adjust for missing opportunities that are occurring prior to the U.S. open;

* The best psychological strategy I have found for not getting caught up in choppy markets is simply to not watch those markets. If I have my profit target set, my stop loss point identified, and my strategy for adding to/scaling out of the position fixed, then I find that watching the market tick by tick adds little value;

* I start my trading day by asking: where is the market likely to move today? The volatility-adjusted price targets that I publish each morning before the open via Twitter give me a road map for that. (Follow the tweets here). Everything else is gauging market strength/weakness and volatility to handicap the odds of touching one of those targets and finding good entry spots to optimize risk/reward.

* At one firm, I'm working in a "pod" with a large trader and an analyst. The pod is supported by a programmer who creates proprietary tools for market timing. There are three sets of eyes on the markets; three sets of eyes on the trader. A lot more bandwidth for processing what's happening; a lot more checks and balances to aid discipline. I suspect we'll be seeing more of that at large proprietary trading firms.

* A number of recent posts have featured tools that capture market data in a unique way for quick processing. As with carpentry or vehicle repair, I find that having good tools makes a big difference in performance. Traders need to minimize their overhead, but I'm hard pressed to think of successful traders I've worked with who haven't invested in good tools to support decision-making.

Tuesday, September 22, 2009

Evening Briefing for September 22nd

* MARKET THEMES FROM TUESDAY: Stocks traded with their multiday range on Tuesday, ahead of Wednesday afternoon's scheduled Fed announcement. Intermarket themes were largely bullish, with a weak U.S. dollar and strong gold and oil prices. The ES futures held support in the morning at the 1062 area and stayed above that level in the afternoon, with net buying sentiment in NYSE TICK. Should we hold above the afternoon lows overnight, I would expect a run to test the bull highs. New 20-day highs on Tuesday were 1681; lows were 166, so no meaningful deterioration there. Advancing stocks led decliners handily on the day, returning the advance/decline line specific to S&P 500 stocks within a short distance of its bull high. Market wrap here.

* OVERSEAS/OVERNIGHT NUMBERS: 1:45 AM CT - France, consumer consumption of mfg. goods; 6:50 PM CT - Japan, merchandise trade balances. Earnings scheduled for Wednesday can be found here.


-- Very interesting contrary view on the vigor of the economic rebound;

-- Nice source for market summary and comment;

-- Fed dilemma: tight credit impeding economic growth;

-- Interesting site covering the options market in real time;

-- Issues in rebalancing China's economy;

-- Economic indicators continue to rebound.