Wednesday, May 05, 2010

Core Ideas in Trading Psychology: Reading Market Psychology With Volume and Price

An important theme throughout the TraderFeed blog is that reading the psychology of markets is a core trading skill. Markets, like people, behave in patterns. Those patterns shift over time, with shifts accompanied by markers that accompany changes in state: changes in direction and changes in volatility.

The first important state marker to be able to read is volume. Volume tells us *who* is in the marketplace. Volume also correlates highly with volatility. When volume jumps, it tells us that institutional participants have become more active. When volume dries up, it tells us that the market is dominated by market makers: the liquidity providers. Is a news item or price movement to a new level significant? Volume will typically provide us with an answer: events are significant if they can attract the participation of large traders. It is their revaluation of assets that creates market trends.

What is most important about volume is relative volume: the degree to which current volume diverges from recent volume. If we want to know if the volume from 11 AM to 12 Noon is high or low, we should compare it to the median volume posted during that hour. If we want to know if today's volume is high or low, we should compare it to the most recent median volume. Because relative volume is so closely connected to volatility, reading volume and its shifts provides important clues as to how far markets can go for or against us. That is useful information in setting stop loss points and profit targets.

Equally important, the astute trader wants to see the total volume that transacts at each price over the course of a trading day or week. The range at which the lion's share of volume has transacted defines a market's value area. Many trade ideas--at short and longer time frames--can be formulated by handicapping the odds that a market will return to a value area (if higher or lower prices cannot attract volume) or that a market will accept prices higher or lower than value (if those prices attract volume). The former situation defines a range market in equilibrium; the latter defines a trending market. In the former market, traders make money by fading strength and weakness; in the latter, they make money by going with market direction.

It is the oscillation of price between range and trending modes across a variety of time frames that defines the market's complexity, as market participants reveal their sentiment: either accepting value or redefining it.

The astute trader can also read the psychology of markets by seeing whether volume is dominantly transacted at the market's bid price (suggesting that sellers are willing to take lower prices to get out of their trades) or at the market's offer (suggesting that buyers are willing to pay up for higher prices to get into trades). This measure of sentiment, which is effectively gauged by the Market Delta tools, can be tracked over time to see if buyers or sellers are becoming more or less aggressive.

We can also track market sentiment to see if more transactions across the broad stock market universe are occurring on upticks vs. downticks. When buyers are more aggressive, we will see more transactions occurring on upticks; when sellers are more aggressive, we will see more transactions occurring on downticks. This measure of sentiment, captured in the NYSE TICK, can be tracked over time to reveal whether sentiment in the market is waxing or waning.

When we read these shifts in sentiment over time and combine them with a reading of shifts in relative volume, we can determine whether the largest market participants are becoming more or less bullish. That will tell us if volatility (volume) is expanding with direction (sentiment) and whether moves to new price levels are likely to result in market trends.

Much of the skill of reading these shifts is placing market dynamics at a shorter time frame within the context of the longer time frame. What is a trending market at the short time frame may be a movement within a range at the longer time frame. A breakout at the short time frame may be trend continuation at the longer time frame. Context rules. A great deal of developing a feel for markets is a recognition of the patterns that occur as market participation (volume) and market sentiment (direction) shift, with longer time frames exercising impact over shorter ones.



Soberba Insônia said...

Hi, Doc. Extremely useful post. I don´t wanna push your good will, but would you have a word or two related with the necessity of taking fast decisions when someone decides to choose daytrading as a way to operate and (linked to this post) just its volume relation?

I´m gonna leave a passage of an article that I kept for years and really opened my mind in the begining:

´Trading outbreaks is a fine art, where some successful traders have been very successful in removing all emotions that prevent them from taking immediate action.

Some of them have "perfected" their trading systems to recognize trends and patterns using just price bars and time- without any other technical indicators - so that they can trade their proven systems without being paralyzed by too much analysis. ´


Brett Steenbarger, Ph.D. said...

Hi Soberba,

Yes, true scalpers have to work off price, volume, and order flow. The longer the intraday time frame, the more relevant the intermarket themes, volume/value data, etc.


Geoff Woods said...

Thanks Brett. Lot to be said for the age old skills of those tape reading Masters I think.

Simple concept really - price goes up due to more buying than selling, and vice versa.

I forget who said it, but if this were complicated, then everyone would know how to do it. Somehow simple things are just too confusing for most of us.

Jason Beinstein said...

Dr. Steenbarger,

Absolutely love the blog all of your posts are extremely informational and I find them very useful...I'd consider myself to be a novice investor and of all the posts I've come across recently I found this to be one of the most valuable to date... Keep up the awesome work!


jolo said...

I'm a newcomer (few months) to your blog and wish to thank you. I know you're winding down your involvement "here" and pursuing other "interesting" interests. I wish you joy and prosperity in your endeavor.

I wanted to post a comment about my experience and or amazement with Market Profile or price & volume histograms. I had been trading for several years and as most traders spent hours trying to build a better "mouse trap". I looked at M/P a few times over the years and maybe it was the data I was looking at, or the settings, or the clutter on the chart, or the size of the chart. What ever it was I turned away...

Sometime later I saw a M/P chart that had color filled in the areas of LVA to Point of Control and HVA to POC. Still had the vertical histogram on the left.

I was hooked... With a little tweeking and removal of my other indicators I had a M/P chart to be proud of. It's funny, when I turned that floodlight on my market data I wondered how I ever got along without it.

Mini vans don't "turn me on" but old Packard's do!! If I hadn't "seen" that chart, that way, in those colors. I'd still be trying figure out why my first entry either "took heat" or got stopped out.