Thursday, December 25, 2014

How to View Markets Through Fresh Lenses

I generally find that traditional ways of viewing traditional market indicators and charts are not the most informative.  Years ago, a developer of trading software lamented in a conversation that he wanted to educate customers in the use of his product, but he found that the vast majority of users never even tried to vary the software's preset levels.  Traders wanted answers from the software, not new information that could lead to new questions and answers.  

In the spirit of looking at old things in new ways and extracting information that others miss, here are a few variations I've found helpful during 2014:

*  Change the Charts - Who says that arraying price on the y-axis and time on the x-axis is the best or most informative way of gleaning information about markets?  When we create bars based on volume rather than time and generate indicators from the volume bars, intraday and multi-day changes in volatility are greatly attenuated and patterns become more stable.  Market Delta charts include, within the bar, important information about the distribution of volume at the bid vs. offer, revealing short-term shifts in demand and supply.  WindoTrader charts display bars within bars so that you can visualize price action across time frames in a single view.  Charts from e-Signal display the percentage of stocks trading at new highs vs. new lows for the day session, capturing short-term shifts in breadth.

*  Change the Indicators - Tracking net upticks vs. downticks in the market (NYSE TICK) is useful, but my greatest advance in 2014 came from separating upticks (buying pressure) from downticks (selling pressure) and treating those as separate variables, tracking the behavior of separate market participants.  (See above).  Strong or weak buying can occur within the context of strong or weak selling--it's a difference that makes a difference.  We commonly look at market indicators for the stock or index we're trading.  StockCharts displays the number of stocks giving buy vs. sell signals for a variety of indicators, turning traditional indicators such as Wilder's Parabolic SAR into sensitive breadth measures.  Everyone asks about the trend, but sometimes the world is not linear.  StockSpotter has built an impressive track record by basing buy and sell signals on the cycle-based behavior of stocks.

*  Change the Interpretation - I've been tracking the number of stocks giving buy and sell signals via Bollinger Bands and found something interesting.  The best predictor of market strength in the short run has been the number of sell signals.  Since May, when the number of sell signals has been high (top half of distribution), the next five days in SPY have averaged a loss of -.06%.  When the number of sell signals has been low, the next five days in SPY have averaged a gain of +.70%.  This has led me to identify the absence of weakness--not just the presence of strength--as a predictor of upside momentum.  The Pure Volatility measure that I recently shared takes volume out of volatility and displays informative dynamics at market turns.  David Aronson has published a worthwhile paper on the purification of the VIX measure.  It turns out a number of indicators can be improved through purification:  eliminating their overlap with other measures.  Aronson and Masters offer a book and software for traders interested in looking at purer versions of market measures.   

Show me what a trader looks at during the day and I'll show you how successful he or she is.  If we process old information in traditional ways, we're not likely to achieve unique, standout returns.  The best traders I know display a passion for understanding markets, not simply trading them.

Further Reading:  Turning Innovation Into a Habit