Sunday, February 28, 2010

Trading Journals: What Format is Right for Me?

Periodically, I get questions about the "right way" to keep a trading journal. There's really no one right answer, as the journal will meet different needs for different traders.

Broadly speaking, there are three kinds of journals that traders keep:

1) Learning Journals - This is how I started out as a trader. I kept daily records of market action, along with charts of indicators and indexes, and reviewed each day to identify the patterns that accompanied important directional moves. From such review, I learned which indicators and patterns were most promising (that's how I discovered the value of NYSE TICK, volume, sector confirmation/non-confirmation, new highs/lows, etc.). I also learned which patterns did not help me (chart formations, most canned indicators).

The purpose of the learning journal was to provide daily and weekly reviews to aid pattern identification. It was only after reviewing those journals for a considerable period of time that I attempted to identify the patterns in real time. And it was only after that that I paper traded and then traded live. If I had to identify one technique that most aided my development as a trader, it was keeping and reviewing those learning journals.

2) Psychological Journals - These are journals that track the traders themselves. These can be particularly valuable when traders are having problems with lapses of concentration, disruptions of decision-making, discipline problems, and the like. The idea is to use the journal to keep a real time record of what you're thinking and feeling, so that you can become a better self-observer. Keeping the journal helps a trader identify problem patterns as they are occurring, so that the trader can interrupt those patterns and not allow them to sway trading decisions.

The cognitive journals described in the Trading Coach book are a good example of psychological journals. They are used to monitor our self-talk and restructure the ways in which process personal and market events. Other psychological journals could be simple mood checklists that help a trader recognize when he or she is in or out of the performance zone.

3) Trading Journals - Classic trading journals are ways in which traders can track what they're trading and how well they're trading. Journal entries can be both qualitative (written summaries of the day's trading strengths and weaknesses) and quantitative (summaries of performance metrics, including P/L, number of winning/losing trades, etc.) . The idea of the trading journal is to help traders recognize when they're trading well (so that they can take maximum advantage of their performance) and when they're trading poorly (so that they can avoid deep drawdowns).

Trading journals can also be effective as review tools. For instance, the journal can review specific trades and evaluate performance, identifying areas for future improvement. The journals can also serve as a useful way for traders to log their ideas about markets, stocks, emerging patterns, etc. Many times, the journal can capture insights from the trading day that can be useful for review during future trading sessions.

As a rule, I'd encourage beginning traders to start with learning journals, then progress to trading journals, and then shift to psychological journals as needed. In my next post, I'll toss out a few suggestions that apply to all three journal types. For more on keeping trading journals, check out the posts below:


Sunday Potpourri: Weekend Perspectives

* What to look for and what to do when trading demons get out of control;

* How to change yourself: seek out discrepancy;

* Is there an evolutionary purpose behind depression?

* Wise words about making sacrifices for success;

* The Prediction Wizard site offers its forecasts and a trading blog;

* A contrarian view on market response to consumer confidence numbers;

* Thanks to a sharp reader for this article on the value of checklists;

* A look at stock valuations and more good links;

* U.S. stock market closing stronger after European markets close;

* What's strong and weak among ETFs;

* Dual divergences and reversals in the stock market;

* Reflections on Fannie Mae and short selling restrictions;

* Buffett betting on housing recovery;

* Lessons not learned from the market decline;

* Lots of noise in recent government economic data.

Saturday, February 27, 2010

Stock Market Momentum and Price Cycles

The most sensitive indicator of stock market momentum that I've been able to develop is the measure of Demand and Supply that I post each morning prior to the market open via Twitter (follow here). Demand is an index that tracks the number of stocks that close above the volatility envelopes surrounding their short-term moving averages. Supply tracks the number of stocks closing below their volatility envelopes.

As a rule, Demand tends to peak ahead of price during market rises; Supply tends to bottom ahead of price during market declines. When Demand is rising and Supply is staying relatively low, we generally have uptrend conditions; when Demand is relatively low and Supply is rising, we usually have downtrend conditions. Range bound markets that are ready for breakout tend to occur when both Demand and Supply are well below average. (Click on above chart to illustrate some of these patterns).

I collect the data myself and archive each day in Excel. I've been doing that since late 2002. This gives me a large database that I can review; it also serves a practice function, as I walk through the data day by day and understand how upside and downside momentum shift during a market cycle. Doing that for years provides a feel that is difficult to achieve simply by watching canned indicators on the screen.

So what is the indicator saying? If this is a normal bullish bounce from the early February lows, we should see a move to two-week price highs on a rise in Demand that falls short of the high levels recorded on 2/16. That would be consistent with the pattern of Demand peaking ahead of price. Failure of Demand to stay above Supply this early in a cycle would be unusual and unusually bearish and would be expected to lead to a move below last week's lows.

By building scenarios with the indicator, I prepare myself for the coming week's market action. The best indicators serve logical and psychological functions.


The Risk Oscillator: An Intermarket Gauge of Sentiment

Here I've created an oscillator from the Risk Asset Index presented in the previous post. This measure captures whether risk assets are overbought (significantly above zero) or oversold (significantly below zero) over a two-week horizon. (See the above linked post for the specific assets that comprise the measure)

We can think of this as a kind of short-term sentiment gauge: when risk assets are overbought, confidence in global economic growth is strong. When risk assets are oversold, fears about global recession are relatively strong.

You can see from the chart above that this, like most sentiment gauges, serves as a contrary measure: it's when traders are most fearful of risk assets that we are most likely to see bullish moves emerge and vice versa.

Interestingly, my initial studies suggest that expectations for the S&P 500 Index (SPY) over the following five days tend to be positive when the Risk Oscillator is above 15 or below -15. Above 15, we see some positive momentum effects: bullish sentiment carries over to the next few days before expectations turn negative. Below 15, we see mean reversion and short covering over the following five days.

With some tweaking, this may make a worthwhile timing indicator.


The TraderFeed Risk Asset Index: A Measure of Risk Asset Performance

Above I'm introducing what I'm calling the Risk Asset Index. It is an initial version of a proprietary measure that assesses the daily performance of risk assets.

The components of the index are emerging market stocks (EEM), U.S. stocks (SPY), oil (USO), Treasury rates ($TNX), and an inverse calculation for U.S. dollar (UUP).

Investors and traders are considered risk-seeking if we have rising EEM, SPY, USO, $TNX and falling UUP. They are considered risk-averse if we have falling EEM, SPY, USO, $TNX and rising UUP.

The index is calculated by adding the daily price changes in the five asset groups. One unique element of the index is that daily price changes are expressed as a function of recent volatility, so that the price changes are directly comparable. This also means that the index is sensitive to shifts in volatility patterns among risk assets.

We can see that the recent bounce in risk assets has only recovered a fraction of the decline since mid-January. On a long-term basis, we're within the broad range between the mid-2008 highs and the early 2009 low; failure to take out resistance in the 100 area would target a move back toward the midpoint of that range--a move which would likely see falling stocks, commodities, and Treasury rates and a rising U.S. dollar.

More on the Risk Asset Index and its applications soon to come.


Friday, February 26, 2010

Five Lessons From Recent Trading

Just a few reflections on my own trading that might be of relevance to readers:

1) So much of my edge is not needing to trade. I had a long bias going into this morning's trade, saw the early weakness on the numbers, and also saw the likelihood of a range day. Still, things weren't lining up the way I wanted. I was trading from home and said to myself that I just wouldn't be placing any trades. I was satisfied with my week's performance and didn't need to put trades on if I didn't see anything. I went into the kitchen, petted Gina (who was patiently waiting for me), and took one last look at the screen. That's when things lined up at 9:14 AM CT, I bought the S&P, and took three points to the good with no heat whatsoever. No way I make that trade if I hadn't been willing to not trade.

2) Just make the good trade. The folks at SMB talk about making "one good trade". There's a lot of wisdom in that. I *know* the feeling of when everything lines up for a good trade. If I'm patient and wait for that feeling, the results take care of themselves. When I'm thinking about the profit potential of trade (or how much it could lose), I'm lost. I'm no longer *in* the market, even though I may be in a trade.

3) Everyone's overleveraged. It sounds like an overstatement, but the more I interact with traders, the more I see it's true. Leveraged traders can't take much heat, and so everyone scrambles in and out of positions when levels are broken. If you can see where the overleveraged traders are overcommitted, you can make good money from their scrambles for the exits.

4) Learn from winning trades. If the good trades--those that line up for me, are made with conviction, and bring little heat--are on the long side or short side, that says something about the market. The really good trades usually are in the direction the market wants to move. If I'm thinking bearish but making money on the long side, that tells me something important.

5) Execution matters. I really don't like most technical indicators. Recently, however, I've been overlaying a simple, short-term oscillator on my charts. If the oscillator is near a low, I'm not allowed to sell; if it's near a high, I'm not allowed to buy. It's moronically simple, but it's saved me considerable money. Buying dips in rising markets and selling bounces in falling ones beats chasing highs and lows over time.


Midday Briefing for February 26th: Catching Day Structure

If I had to identify one key skill that intraday traders most need to learn, high up on my list would be the ability to recognize day structure as early in the day as possible. This is because the trading strategies that work well in trending markets (going with strength or weakness) are quite different from what works in range markets.

The ability of the NASDAQ 100 Index to hold its lows around 9 AM CT was a good initial clue that we were in a range environment, not a trending one. Another piece of evidence is that, despite early weakness, we could never get declining stocks to outnumber advancers by more than 1000 issues on the NYSE.

Further confirmation of range trade came with the sharply waning volume as the day progressed (above) and the mixed performance of stock sectors, with financial shares showing relative strength and consumer issues lagging from the open.

A great exercise is to call out the day structure as early as possible and keep a record of the accuracy of the calls. Much of knowing how to trade is knowing the kind of market you're in.


Wisdom and More to Close Out the Week

* My checklist for preparing for the trading day;

* Five of my guiding principles;

* Thanks to Ms. Tavakoli for link to this article on the role of banks in the crisis in Greece;

* Great success advice; thanks to a reader for the pick up;

* Trading wisdom from Dr. Seuss;

* Credit to an alert reader for this article on humor and pattern recognition;

* Thoughts on durable goods numbers;

* Increasing focus on sovereign debt risk;

* Very interesting perspective: how government might deal with debt without inflating.

Thursday, February 25, 2010

Brainstorming Notes

Technical indicator constructed with the last X hours of data.

A lookback period of Y days.

Buy signals at level A in the indicator; sell signals at level B.

X and Y chosen to maximize profitability of the signals across a set of ETFs and A/B levels.

Trade the indicator for day Y+1 for the ETFs with the clearest signals, thus making the assumption that the next period will not differ significantly from the past Y periods.

Each day, reconstruct the indicator parameters over the moving lookback period and select a new set of ETFs to trade based on performance over the lookback period.

Repeat this process using daily periods for the indicator and weekly lookback periods. Using 5 minute periods for the indicator and hourly lookback periods. Etc.

If you do that, you find that Y is a small number, a smaller number than would allow for traditional statistical significance testing.

Which is what makes developing trading systems so difficult: before the market behaves in a pattern that can be detected conventionally, the pattern tends to change.

Which means that patterns have to be detected non-conventionally:

Predictability is a market variable that fades in and out over time.

The key is finding the time frame(s) where markets are displaying predictability/regularity.

Which would make a trader operate sometimes like a scalper, sometimes like a position trader, and sometimes like an investor.

Trading failure is a result of trying to make markets fit into a style of trading, rather than fitting the trading style to current market conditions.

Using the Intraday Equity Put/Call Ratio to Gauge Sentiment

The stock market opened sharply lower this morning and broke below important support in early trade. Although this looked quite bearish, the mixed sector performance and firmness among other asset classes suggested that we might be in more of a range environment. A number of traders apparently did not make this shift; by the end of the day, I heard from more than a few frustrated bears.

The intraday CBOE equity put/call ratio (above) helps us understand what was going on. Average put/call levels since the start of 2010 have been around .63. Notice how bearish sentiment grew through the morning, even as stocks were basing. Once the market broke out of its morning range on solid buying interest (NYSE TICK) and volume, put/call levels never dipped below average and indeed stayed elevated during the afternoon. This bearishness helped buoy the market through the afternoon trade.

Once we broke obvious support, it was obviously time to be short. Unfortunately, markets rarely reward what is readily apparent. A look below the surface at the put/call sentiment showed that the short side was crowded--and that set up a significant reversal.

Reflections on an Intuitive Trade

I'm not sure it's difficult to teach good trading to motivated, capable students. So much of good trading is pattern recognition and repetitive training to act promptly and decisively upon patterns.

It's the great trades that are so tough to teach. Because many of the great trades are like the audibles that a quarterback will call or the surprise moves of a chess grandmaster. It's the pattern hidden behind the pattern that often leads to the great trade...and so often that hidden pattern will only manifest itself as a strong hunch or gut feeling.

We opened today super weak and many patterns looked bearish. Within a relatively short time, however, things didn't feel right to me. I investigated further based on that feeling and saw that several sectors were trading up from their opening prices. There was also firmness in the euro and gold. That led to a nice short-term trade to buy the market, rather than buy into the panic.

(We can see from the screenshot above that just about as many stocks in my basket were recently trading up from their opening prices--green color--as down. That is more characteristic of range trade than trend days).

It's intriguing that many of the worst trades and many of the best start out as emotional experiences. It's when the patterns we're not focusing on kick off a sense of unease that we can often call the good audible. When our unease comes from P/L and performance concerns, it's rare that we'll sustain a feel for markets.


Finding Your Niche in Life and Trading

An important premise of this series of posts is that elite levels of performance and success can be modeled. Greatness is a manner of approaching life, not simply a trait that is present from birth. I recently flew to London to work with traders. Across the aisle from me was a mother traveling with her 2-year old son. Throughout the flight she read to him, played with him, and kept him stimulated and engaged. And you could tell that she genuinely enjoyed and relished the interactions.

Other single mothers would have been burdened by the task of traveling with a young one for 8 hours. This mother was absolutely in her element. There was no doubt in my mind that she was a great mom. It wasn't just that she was skilled at the tasks of parenting. It was the manner in which she approached parenting. She loved it and put her all into it.

A key idea from my research into performance is
the concept of niches. A niche is a domain of endeavor that not only captures our talents and skills, but also our deepest values and interests. When we are in a niche, we identify wholeheartedly with our work: it becomes central to our identity. Genuine artists may work at other jobs for financial support, but they experience themselves as artists: they view life through aesthetic eyes. Psychologists operating within a niche doesn't just turn on and off an interest in people when the work day begins and ends: it's how they approach the world.

This sense of identification is crucial to performance niches: at some point the performer goes from being successful at art to
being an artist. The distinction between work time and play time breaks down: that mom is a mom 24 hours a day. The psychologist is interacting sensitively with people at the grocery store when looking for an item.

Such an absorption can only occur when native abilities (talents) fuel interest; interest fuels skill-building; and skill-building fuels further interest. The result of this intersection of talent, skill, and passionate interest is a quantum leap forward in the development of expertise and performance. The great individual is on a much faster learning curve than peers, because they are immersed in the doing--and they are continuously doing.

I have long maintained that traders experience a high failure rate, not just because of the difficulty of the work, but because they place their capital at risk before they find a true niche within the trading world. I meet with portfolio managers, flow traders at banks, prop traders making markets, developers of trading systems, and traders of complex options positions. They are as different in their skill sets and temperaments as surgeons, psychiatrists, and radiologists. In the medical world, students sample various specialties and choose the one that best fits their interests and skills. Rarely does this occur in the trading world.

This is where the solution-focused approach can be so valuable. By focusing on what we love doing and what we are doing well, we can discover who we are at our best. And who we are at our best is central to defining our niches in life. If you consult your experience and think of when you felt most happy, most fulfilled, most alive, and most productive, the odds are good that you've identified your path toward excellence.

The solution focus is evolution in real time. We are selecting the strongest of our behavior patterns and allowing the weakest to become extinct. Over time, our own guided natural selection enables us to become learning machines, capable of superior adaptation.

Think about how a solution focus could guide your trading development, your career development, and your relationships. Think of yourself as an engine of continuous evolution. How far we could go if we provided every facet of life with an emotional P/L statement and just focused on doing more of what makes us happy, fulfilled, and successful!

Wednesday, February 24, 2010

Relative Volume Update: Gauging Market Participation

Volume is important in that it gives us some idea of the degree of institutional participation in market moves. Volume also correlates very highly with volatility and thus gives us an idea of how far markets are likely to move directionally.

One way to determine whether volume is high or low during the day is to compare the volume at a given time period with the average volume for that same period. I call this relative volume. If relative volume is high, we can expect markets to move more than average. Low relative volumes provide alerts for markets that are likely to be slow and rangebound.

Here are the relative volume numbers for the ES contract that I use for trading this week. These are median volumes over the past 12 full trading sessions from 2/4 through 2/22. All times are Central Time in the U.S. and each 15-minute period begins with the time shown:

8:30 - 136,909
8:45 - 90,226
9:00 - 99, 162
9:15 - 79,342
9:30 - 81,984
9:45 - 64,960
10:00 - 71,259
10:15 - 54,271
10:30 - 63,874
10:45 - 41,411
11:00 - 51,194
11:15 - 48,285
11:30 - 28,964
11:45 - 23,345
12:00 - 38,385
12:15 - 43,116
12:30 - 45,863
12:45 - 42,296
13:00 - 38,460
13:15 - 45,881
13:30 - 55,808
13:45 - 46,632
14:00 - 57,238
14:15 - 49,700
14:30 - 76,879
14:45 - 105,354
15:00 - 107,443

For more on relative volume and its use, please see the posts below:


Midday Briefing for February 24th: Watching Patterns Across Time Frames

We can see from the last several days of market action that we have been forming important support in the 1090-1092 area of the ES futures (bottom chart). Today's trade has been in line with the bullish bias for the day, and a positive Cumulative NYSE TICK has confirmed that, but we also face resistance in the 1110-1112 area and thus a key trading range.

The resolution of this range will be important; failure to sustain recent market strength would position us with a lower high across most averages and the possibility of a test of recent lows from early this month. That would have technicians making hay out of a possible head and shoulders pattern on the daily chart (top chart).

While I'm less than enthusiastic about chart patterns, the possibility that we're seeing a lower high in a broad topping pattern has me concerned about the market upside and ready to position aggressively for a decline if short-term action is supportive.

Using the Day's Pivot Level to Identify Trending Days in the Stock Market

One of the most important price levels for my own trading is the pivot level for the day. The way I calculate pivot level is as an approximation of the average trading price from the prior day. I post the day's pivot level each morning before the open via Twitter (follow the tweets here).

Over time, watching markets long enough and tracking indicators of intraday sentiment, intermarket themes, and patterns of sector strength/weakness, you can gain a sense for when we're likely to trade back to the day's pivot level and when we won't.

There's a historical tendency for strong markets to open above the pivot and never look back during the trading day.

There's a historical tendency for weak markets to open below the pivot and never look back during the day.

Going back to 2000 (N=2550 trading days), when we've opened above the pivot and never returned to the pivot (N=427), we've averaged an open to close gain of .64% (346 days up, 81 down). Not too bad.

Over that same period, when we've opened below the pivot and never returned to the pivot (N=335), we've averaged an open to close loss of -.80% (58 up, 277 down). Also impressive.

The whole trick is identifying early strength after we open above the pivot and identifying early weakness after we've opened below, so that you can ride that directional tendency. And that's a function of sustained market observation and pattern recognition.


Decline in a Firm Stock Market: What Comes Next?

Hats off to Rennie Yang of Market Tells, who identified a worthwhile historical pattern relevant to today's trade. I find the patterns he identifies to be very helpful in framing trading hypotheses. When I see current market action supporting the hypothesis, it tells me that the market is following its historical script--and those are trades that merit conviction.

What Rennie found is that when the S&P 500 Index makes a five-day low but 20-day lows decline from the prior day, the odds of a short-term bounce are quite good.

I decided to frame the pattern a bit differently: I went back to late 2002, when I began collecting these data, and looked for all occasions in which the S&P 500 Index (SPY) made a five-day closing low, but new 20-day lows across all exchanges were fewer than 500. That means that we've seen a short-term decline in a relatively firm market.

That situation has occurred 63 times during that period. The next day, SPY was up 40 times, down 23, for an average gain of .38%. By contrast, on days when we had a five-day closing low with more new 20-day lows, the average next day gain was .18% (212 up, 155 down). All other occasions have averaged a loss of -.03% (758 up, 675 down).

Interestingly, the pattern only held for the next day's trade. Going five days out, there was no further upside edge.


Tuesday, February 23, 2010

Key Reads for a Tuesday Eve

* What's your coping style?

* Steps for improving how you cope with stress;

* Anticipating sovereign debt defaults;

* Sobering look at Japan and its prospects;

* Thanks to a sharp reader for the link to this story on touch and emotion;

* Volatility contractions lead to big moves and more good readings;

* Props to an alert reader for this story on team success: choosing winners, not necessarily the best players;

* Deflationary pressures still present;

* Greece not alone among countries with debt problems;

* "Current employment levels are incongruous with servicing existing levels of household debt.";

* Why the upcoming jobs number could look bad.

Price Rarely Tells the Whole Story

The early afternoon tweet a little after 1 PM CT noted that the ES lows at that time (left blue arrow above) were not accompanied by lows in either the Russell 2000 or NASDAQ 100 Indexes. Most of the ES weakness was a function of weak prices among financial shares; other sectors did not confirm the ES lows.

In such situations, the downside is losing participation even as we reach price lows. When that happens, the seeming downside break often becomes a false breakout, trapping shorts. Note how that occurred this afternoon, with the two volume bulges (at right) as natural price targets to the upside.

It's a nice example of how it's important to monitor the context of price moves: price rarely tells the whole story.


Midday Briefing for February 23rd: Thoughts on Game Changers

We can see from the updated Market Delta chart that we rejected the volume bulge that had built up in pre-opening trade around 1104-1106 in the ES futures, with high volume selling following the weak consumer confidence numbers. As noted in the morning briefing, this was not only a break from the volume bulge, but also a breakout from a multiday range.

As a rule, multi-day range breakouts tend to show follow through, as those trapped on the wrong side of the market need to scramble out of positions. We can see that follow-through in the very weak Cumulative Market Delta and Cumulative TICK numbers. We also can see that we've remained consistently below the day's Volume-Weighted Average Price (VWAP; red line).

If you review this morning's briefing, you'll see that we were on breakout watch because of the very low levels of Demand and Supply from Monday's trade. My research finds that we tend to get outsized moves out of such equilibrium. All it took was the consumer confidence numbers to tip the scales. It was a game changer, in that it was unexpected and dashed cold water on the market strength we had been seeing.

You don't need to predict the direction of a breakout move in order to anticipate one and trade it successfully once the markets show their hands. Many traders hold back from trading breaks once they've occurred, not wanting to chase a move in progress. What they fail to appreciate is that the market has shifted from a range mode to a trending one, allowing profitable entries on bounces.


The Psychology of Those Who Win

Last year I gave a talk at a conference of traders and concluded the session by giving out my email address and phone number and inviting the attendees to contact me for any help they might need. I made it clear that I would not be soliciting them as commercial clients for coaching and that I would not charge them for time spent with them.

One of the participants approached me at the end of the session and expressed surprise that I would make myself so widely available at no charge. He noted that there were over 100 traders in the session and that I could easily be swamped with calls.

I smiled and simply said, "We'll see."

Within a two week period, I counted all the contacts that resulted and tracked who initiated them. It was a very easy task, because there was only one contact. It was from a very successful independent trader. No one else followed up.

And that's the way it usually is: Of the people with professed trading passions, only a fraction will sustain keeping any kind of journal or performance record; of those, only a fraction will use the journal and performance data to set and pursue concrete goals; of those, only a fraction will reach out for assistance in achieving those goals.

On the whole, people fail to reach high levels of success because they are not doing the things that successful people do: they are not on a path that can possibly lead to success. Traders can repeat positive affirmations and invoke positive images, but nothing replaces the hard work associated with preparation, practice, and focused work on oneself and one's craft.

The motivation to trade? Everyone has that. The motivation to be more than who you are: that's what makes winners.

And by the way, that one guy who did follow up and call me? He made well over $1,000,000 last year.

And he still calls.


Morning Briefing for February 23rd: A Few Stock Market Views

8:22 AM CT - I've added the top, Market Delta chart to show how we are building volume (and thus accepting value) below the day's VWAP. When we build volume in a relatively narrow area (1103/4 in ES futures), we want to look for moves away from that area as a kind of breakout move. The volume and participation associated with such moves will help determine whether we sustain a rejection of the price level or will fall back to that consensus area. Note that the current volume bulge is occurring at the lower area of a multi-day range: a break below that level would also be a candidate break of that wider range. Conversely, rejection of the bulge area to the upside would target the opposite end of the range.

We can see that CBOE equity put/call ratios have been running about average in the wake of the recent market rise. While we're well off the bearish sentiment levels seen at the recent lows, we're also not near bullish levels that have been associated with recent market tops.

My proprietary index of short-term market momentum has also moved smartly higher in recent days. It tends to top out ahead of price, particularly during market upturns, suggesting that we could see further upside to the rally.

My Demand/Supply Index, which is a measure of the number of stocks closing above and below the volatility envelopes surrounding their moving averages, is showing low levels of both Demand and Supply--a characteristic of range markets. That places us in watch mode for a breakout move today.

I'll be updating this post later this morning and tracking the market via Twitter (follow tweets here).

Monday, February 22, 2010

Stock Market Sector Correlations as a Sentiment Measure

My recent post took a look at intermarket correlations and how those wax and wane with periods of relative fear and complacency in markets.

Above is a similar perspective, but now looking at intercorrelations among daily changes for four S&P 500 sectors: energy (XLE); financial (XLF); technology (XLK); and consumer discretionary (XLY). As before, I calculated the 10-day correlations among all of these; took the absolute values; and calculated an overall average correlation.

What we see is that the sectors tend to be highly correlated during periods of market decline and subsequent bounce. At relative market peaks, we tend to see divergences and patterns of differential sector allocation, which leads to lower correlations.

Once again, this is but a rough look, but a promising avenue for investigation. When traders and investors become fearful, there is a tendency to treat all stocks similarly, raising correlations. This is a useful sentiment gauge, as it tracks the actual portfolio-related behavior of money managers, not their stated beliefs about markets.

Midday Briefing for February 22nd: More Range Action

The morning update identified the range bound market conditions, and those have continued through the afternoon. Note how we've set clear bounds to the range by rejecting the false breakout highs in preopening trade (top blue arrow) and the early morning lows (bottom arrow). Thus far we've been correcting recent strength in a relatively flat manner, and we've seen a positive shift in NYSE TICK during the afternoon. Commodities are off their morning lows, as are the euro and Aussie dollar. As long as we can hold above those morning lows, my leaning is to look for higher prices in keeping with the short-term uptrend noted in the indicator review.

Morning Briefing for February 22nd: Consolidating

We've been trading in a range for the most part in the overnight and morning sessions, not holding the Friday highs, but staying above the Friday morning lows. Such consolidation at higher average trading prices is consistent with the bullish short-term trend mentioned in the weekend indicator review. Advancing and declining stocks on the NYSE are running about even; banking issues have been strong this morning, currencies are mixed, commodities are off their overnight highs, and commodity related stocks (energy, materials) have been weak. All in all, thus far, a mixed, rangy picture, which is supported by the balanced action thus far in the NYSE TICK. That has me leaning toward buying weakness and selling strength today--and not necessarily expecting large moves, given most relative volume thus far today.

Assessing Sentiment With Intermarket Correlations

When markets go through periods of fear, there is a tendency to jump out of riskier assets and into ones that are perceived to be safer. If that's the case, during periods of fearful sentiment, we should see higher intercorrelations among asset classes than during periods of relative complacency.

Above I looked at the absolute values of moving 10-day correlations for stocks (SPY), oil (USO), 10-year Treasury rates ($TNX), and the U.S. dollar (UUP). I computed how each of the above was correlated with every other one over moving 10-day windows, took the absolute values of those correlations, and then averaged all of those correlations into a single average correlation across the asset classes.

As you can see from the chart above, we tend to get high correlations during and immediately after periods of market correction, as traders and investors bail out of risk assets and then back into them. At relative price peaks in markets, especially when volatility has been lower, the average intermarket correlations have been lower.

This is a rough look at an important phenomenon, as it captures portfolio-related decision making across a broad range of assets. Only large institutions can affect these correlations, which makes the average correlation a useful tool in gauging the sentiment of active money managers.


Sunday, February 21, 2010

Reads For a New Week

* What works when it comes to changing our behavior?

* One key to life success;

* Possible bear trap and many more excellent reads;

* Many thanks to an alert reader for this research post on mindfulness and cognitive functioning;

* Shortcomings with 60-minute charts;

* Euro to face further challenges;

* Asia higher in early trade;

* Perspective on the Fed's discount rate hike;

* Nice look at the week just passed and the week ahead;

* U.S. cities highest on the misery index;

* More people rate themselves as conservative vs. liberal, but more prefer Democrats to Republicans in U.S.

Indicator Update for February 21st

Last week's indicator review observed that we had a bounce off momentum lows, but no resumption of bullish market action. That changed significantly this past week, as we failed to take out the prior week's lows and rallied higher through the week.

Sector Technical Strength (a proprietary, short-term measure of trending) turned bullish across most of the sectors (top chart), with notable week-over-week strength among Industrial, Materials, Consumer Discretionary, and Financial shares. Follow-through will be important to sustaining the upside trend; even relatively modest weakness would turn four of the eight sectors to neutral trending status.

We can also see the sharp advance in the Cumulative Demand/Supply Index (second chart from the top), which has rallied steadily from its lows. Such sharp rallies have historically led to further price strength 20-days out, as upside momentum in the Index typically precedes price peaks.

Our second chart from the bottom shows that 20-day new highs are once again handily outnumbering new lows; this in part reflects very solid strength among small cap issues. Despite early weakness on Friday owing to the Fed news, we registered a fresh weekly high in the number of shares making 20-day peaks. That indicator has not been losing steam.

Finally, the helpful chart from Decision Point at bottom shows that we've seen unusual recent advance/decline strength among the small cap issues comprising the S&P 600 Index. Indeed, the advance-decline line specific to the small caps is back near its bull highs. I would view a clear break of this indicator to new highs to be a bullish development.

In all, I am watching the indicators closely to see if we stall out and make a lower top around current levels vs. continue strength and test the bull highs across the major indexes. I emphasized in last week's review that we were seeing an intermediate-term correction in an ongoing bull market. This past week's action is consistent with that perspective.

Vitality, Greatness, and Success in Life and Trading

The first post in this series dealt with factors that underlie creative genius and how those relate to performance in the trading world. My own observations regarding very successful, productive, and creative individuals, however, suggest that more may be at work in generating elite levels of performance and success.

The first common element in my observations is something that, for lack of a better word, might be called "vitality". Vitality has several components:

1) A high energy level; people with a high level of vitality spend a relatively high proportion of their time actively doing things in a purposeful manner, even when those things are relaxing and recreational.

2) An active mind; people with a high level of vitality spend a good deal of their time encountering new ideas, new people, new places, and new experiences.

3) High psychological well-being; people with a high level of vitality experience positive moods more frequently than negative ones.

4) Productivity; people with a high level of vitality accomplish a great deal. They are not just active, but active toward directed ends.

The vast majority of the very successful traders I've encountered have unusually high levels of vitality. Not only do they spend more time reading about markets, researching markets, and thinking about markets than their less accomplished peers; they also are more active and productive in their personal lives. They participate in community activities, travel, spend time with their kids--it is if they are plugged into a different, higher voltage circuit than others.

"How do you have time for it all?" is a common question these high-vitality traders encounter. And yet it's not an issue of time: it's a function of how time is utilized. Low vitality people spend a great deal of vegetative time that is neither productive nor rejuvenating; it's as if they're running on spent batteries. High vitality people often have very good work/life balance because they are actively doing things that enhance life and work.

We are all familiar with the distinction between active and passive learners. An active learner is one who reads the chapter in the textbook before going to the lecture. She comes to the lecture with questions and ideas already percolating. A passive learner simply copies notes on the board from the lecturer and then reviews the chapter before the test--perhaps never generating meaningful questions or ideas.

Or how about the difference between truly religious people who attend a service and those that are not religious? The religious person meditates on the meanings of the prayers and uses the time to actively connect to a higher spiritual power. The non-religious person simply repeats the prayers and never seeks or makes a connection. Who feels vitalized and who feels bored during the service?

High vitality people attack life the way that the active student attacks learning; the way that a devout monk approaches prayer: with interest and intent. The secret to their vitality is that they engage in effortful activities in a manner which gives energy, rather than drains it. This enables them to persist where others drain their batteries.

Think of how you review your trading performance (and how often you review). Think of how you review markets and factors that influence markets. Are you digging into yourself and digging into markets, like the active learner? Or are you going through the motions like the bored person at church?


Saturday, February 20, 2010

A Quick Look at Euro Weakness Fallout

In the wake of the collapsing euro (top chart), we see a potential upside breakout in the price of oil denominated in euros (bottom chart; USO/FXE).

Rising oil prices for euroland would contribute an additional headwind to economic growth. I notice that European stocks (VGK) have bounced only modestly this past week after hitting multimonth lows. Year-to-date, the S&P 500 Index (SPY) is down less than 1%, but VGK is down nearly 6%.

Greatness, Creativity, and Trading Success

Perhaps my greatest interest in psychology is understanding what differentiates highly productive, successful, and creative individuals from their more ordinary peers. Trading happens to be a worthwhile area to assess factors that lead to success, because success is so quantifiable.

In the next series of posts, I will be exploring factors associated with greatness: superlative achievement across various disciplines. An excellent overview of this area is Dean Keith Simonton's book Greatness: Who Makes History and Why. Summarizing Simonton's research, Dutton outlines several characteristics of creative geniuses:

* They have an unusually broad range of interests;

* They are open to novel and complex ways of viewing things;

* They are capable of defocused attention: thinking about one thing while focusing on others;

* They display flexibility in their work habits;

* They tend to be introverted and prosper during periods of relative isolation;

* They generally are independent and unconventional.

In combination, these qualities enable creative geniuses to draw upon a broad range of experience to understand things in new, enlightening ways.

I work with traders and portfolio managers who have achieved consistent success across a number of years. To a person, they view markets in unique ways: not one of them looks at markets in a conventional, textbook manner. They come up with out-of-the-box trade ideas, because they truly are operating out of the box--and are not afraid to buck convention.

Of the factors contributing to trading success, creativity is one of the least appreciated. Show me a true "market wizard", and I'll show you someone who has developed his or her own philosophy and approach to generating, executing, and managing trade ideas.


Weekend Vantage Points

* Good questions to evaluate yourself as a trader;

* Managing your energy as a trader;

* Trading from a position of power;

* Free Sat. AM seminar on tape reading;

* Twenty bank failures this year in U.S.;

* Rising short sales of homes and other fine links;

* Concerns over municipal bond defaults;

* Currency revaluation in China?

* Continued challenges for the euro;

* Deflation not off the radar;

* Fannie and Freddie to return as GSEs?

* Paulson's views on the financial crisis and lessons learned.

Friday, February 19, 2010

Happiness, Health, and Quality of Life

An interesting prospective study found that people who reported high levels of positive emotional experience were significantly less likely to develop heart disease than those with lower levels of well-being. This fits with findings that happiness is associated with lower levels of illness and longer lifespans. It also fits with research that finds depression as a significant predictor of heart disease.

Michael Frisch, Ph.D., a graduate school colleague of mine when I was at the University of Kansas, has written a book on Quality of Life Therapy: techniques for expanding happiness and life satisfaction. Three "pillars" of this work, he explains are:

1) Inner Abundance - This relates to self-care and maximizing one's energy and internal resources;

2) Quality Time - Time spent by oneself, for oneself;

3) Finding Meaning - Having goals that give purpose and significance to life.

The key idea here is that happiness is not just something that happens to people. It is the result of one's relationship to oneself.

I encounter many traders who lack a sense of abundance--they are forever fearing that they will miss market moves and opportunity. I find many traders that lack quality time: they are slaves to the screen and experience more frustration than joy in their efforts. I also see many traders who derive little sense of meaning and purpose in their work. If they're not making money, they are not happy.

Conversely, I encounter very successful traders who find no lack of opportunities in markets, who achieve a high quality of life with activities inside and outside of markets, and who derive great meaning and significance from the self-mastery, growth, and insight required by their work.

Happiness is a lifestyle, not just a set of moods. It is also life-enhancing, and it is a crucial element in performance. We cannot master a field if we do not love and embrace it.

Midday Briefing for February 19th: Assessing Stock Market Participation

As regular readers are aware, I like to follow a basket of highly rated stocks across S&P 500 sectors to give me a sense for the relative participation in market moves. When the S&P makes a new high or low, it's helpful to see how many stocks are contributing to that strength or weakness. Very often, the seeming breakouts to new highs that are not accompanied by broad participation are the moves most likely to fail and return to trading ranges.

For traders not constructing and tracking their own baskets, FinViz offers an excellent spectrum view of sectors and stock performance within those sectors (above). When the stocks are showing meaningful rises, we see them in the green end of the spectrum; those showing meaningful declines are in the red end. When we see many stocks in the black region between green and red, it suggests that a large number of issues are not moving significantly.

In a single glance, such a perspective can lead us to be cautious about chasing the upside when we've made day-over-day highs in the market index.

Morning Briefing for February 19th: Watching an Evolving Trading Range

So far, at least for stocks (ES futures, above), the Fed's decision to hike the discount rate has not been a game changer in the short run. We saw selling on the news and some follow-through weakness overnight, but as I was tracking markets here in London prior to the U.S. open, it was clear that a rout was not in the cards and that markets are not expecting that a discount rate hike will necessarily bring a near-term hike in the Fed Funds rate (i.e., a more general tightening of monetary conditions).

That leaves us in a trading range over the last several sessions defined by today's overnight lows and yesterday's highs, with the low 1100 area important resistance from a longer time frame vantage point. Equity put/call ratios are showing neither unusual bearishness nor bullishness thus far today, volume is not elevated relative to recent norms, and intraday sentiment has been mixed. It may take a catalyst greater than the Fed news to resolve this trading range.

Physical Health, Cognitive Functioning, Emotional Well-Being, and Trading Performance: Frontiers for Trading Psychology

There are close relationships between physical and mental health: emotional stress can affect the immune system, physical exercise can impact mood, and emotional well-being is associated with favorable health effects. We also know that emotional stress can impair decision-making.

What is less clear is how our physical level of well-being affects the decisions we make.

The recent posts have focused on factors that interfere with the cues that comprise our intutive feel for markets, including anxiety. Might it be the case that stress impairs decision-making by switching our attentional focus to our bodies (and ourselves) and away from the pattern recognition that could lead to good decisions?

Might it further be the case that, at a higher level of cognitive and physical conditioning, we could become especially sensitive to subtle pattern recognition cues and make decisions that, on the surface, would make us look lucky because of enhanced access to our gut feel for markets?

Finally, would such conditioning entail a training of attention and concentration, so that we process more from our environments?

If we think of trading as akin to athletic competition, what conditioning exercises would place us in the best competitive positions?

I think these questions address some of the most interesting, challenging, and least understood areas within trading psychology.


Thursday, February 18, 2010

Fed on the Radar and More Thursday Evening Notes

* Topic I'll be taking up further: Surprising reason why physical exercise enhances mood and self-esteeem;

* Dollar up, stocks down, Treasury yields higher, commodities lower on surprise Fed tightening of discount rate

* Rise in Fed discount rate does not mean we'll see rise in Fed Funds rate;

* Concerns over rising debt levels, future inflation from a Fed member;

* Dangers of a slow Fed exit from mortgage debt;

* Dollar strength could affect company profits;

* Rising interest rates, debt levels in Columbia.

Midday Briefing for February 18th: Themes and Sentiment in Gear

Here's a recent futures heatmap from the excellent FinViz site. In one glance, we can see strength and weakness across stock sectors and also across asset classes. With oil, metals and AUD firmer, intermarket themes have once again supported higher stock prices.

Notice also how the pattern mentioned yesterday--moving average of NYSE TICK consistently above the zero area--has again played itself out today.

When short-term sentiment and intermarket themes are in gear, it is tough to fade the market's dominant direction.

Looking for Information, Not Trades

An important implication of the recent post on building intuition is that coming to markets looking for setups to trade is probably the wrong approach if you're trying to maximize your gut feel for trading patterns. By explicitly looking for setups, we lose sight of what might already be setting up. We have no feel for the real time patterns, because we are attending to our expectations and needs--not what the markets are actually communicating.

I've found that running through a checklist of observations--much like a physician runs through a standard list of questions during a history and physical--is helpful in arriving at a "market diagnosis." Those questions pertain to intermarket themes, short-term sentiment, how sectors are moving relative to one another, how we are trading relative to established ranges and VWAP, etc.

Out of the observations will often emerge an insight regarding the likely structure of the market day: trending, range, breakout. That, in turn, leads to fresh observations that suport a gut feel for how the market is likely to trade going forward and whether it will make sense to trade or fade market moves.

When we look for trades, we're putting the epistemological cart before the horse. If we look for the right kinds of information, the trades can come to us.


Building Market Intuition: How Chance Favors Prepared Minds

The recent post focused on how anxiety and frustration can interfere with the subtle cues that provide an intuitive, gut feel for markets. That has led some trading gurus to insist that emotions are the enemy of good trading. Once we understand the nature of intuition, however, we can see that this is not the case. Our feel for markets *is* a kind of feeling; if we were brain damaged and unable to feel, we would not only lose anxiety; we would lose an intuitive sense for markets and the very helpful feelings that keep us out of dangerous situations.

The problem with accessing intuition is not unique to emotion: any strong set of inputs that cloud our attention to our gut will result in a loss of market feel.

Here are several situations that I have found lead to poor trading because they create a focus on explicit thought rather than a natural feel for markets:

1) Strong Opinions - Once we become anchored to a strong opinion about market direction, we attend to factors that support our view--or we become concerned about factors that aren't lining up with our view. The result is that we're no longer attending to our own feel for markets. Instead we've imposed a view over our gut, trading what we think *should* be happening, instead of what is actually happening.

2) Focus on P/L - When we become unduly concerned over profitability, our attention is directed away from markets and we can no longer register the patterns that evoke our intuitive feel. This can occur both when we're overconfident and trying to juice profitability and when we're worried about losses. Intuition is a function of implicit pattern recognition--and that requires an immersion in markets.

3) Tunnel Vision - Many times, the patterns that evoke our feel for markets are only apparent when we view those markets in unique ways. If we become trapped in a particular market or a particular time frame, we cannot see the patterns that may be occurring across markets or time frames. This often happens to traders who are following the market tick-by-tick: they lose sight of the big picture and never intuit the larger market moves (that eventually run them over).

It is easy to fall into the opposite trap and conclude that *any* explicit thought process is a danger. That, of course, is silly. We cannot achieve an intuitive synthesis of market data unless we're first absorbing and processing the market data. It's the analysis after analysis--observing what is happening across indicators, sectors, markets, and time frames--that leads to the eventual intuitive synthesis and the great trade.

"In the field of observation," Pasteur noted, "chance favors only the prepared mind."

Now we know why.


Wednesday, February 17, 2010

Viewpoints at Midweek

* Crucial topic: What to do when you lose confidence as a trader: Part One, Part Two, Part Three

* Nice video on using simulation to become a better trader;

* Worthwhile post on re-entering trades you've been stopped out of;

* Eye-opening article on bypassing Congress and bailing out Fannie Mae, Freddie Mac;

* Will foreign investors step in when Fed stops buying mortgage-backed securities?

* Soros buying gold; so are pension funds;

* Debt plan for Dubai;

* What a European bailout would require;

* Breadth trumps volume--excellent site.