1) Who is in the market?
2) How are they positioning themselves in the market?
At the most basic level, I want to generate an estimate--as early in the day as possible--whether the day is shaping up as a potential trend day or range day.
Who is in the market is addressed by volume. As I've stressed in the past, volume is important because it correlates quite highly with volatility. Knowing whether we're trading above average, average, or below average volume gives us important clues as to whether we're likely to have a daily range greater than, equal to, or lesser than the average range. That, in turn, impacts whether moves are likely to extend or reverse on a given time frame.
So let's take Friday's trade as an example. We had a very strong payrolls number, so traders were justified in thinking that we could have a catalyst for a strong market day. I was less convinced of that, given weakness that had been showing up in the market. During the first five minutes of trading in SPY, we transacted just a bit over 2 million shares. The average first five minute volume in SPY over the past three months has been a little over 3 million shares. During the next five minutes, we transact about 1.8 million shares. The average for that five minute period is almost 2.5 million shares.
You get the idea.
Right out of the box, we have modest participation in the market. When volume is below average, it's not that market makers have taken the day off. Rather, it's the shorter and longer-term directional participants who are not active. It is much more difficult to get a vigorous trend day when those directional players aren't playing. So you could tell yourself every pretty story in the world about how the payrolls number was a game changer, but market participation in stocks--at least for the day session--was giving a resounding yawn.
OK, so once we see who is participating, we can then take a look at how they are participating. Notice the top chart of the NYSE TICK, which is the net number of upticks vs. downticks among all stocks in the NYSE universe. (Chart is for the day session, where each bar = five minutes). What do we see early in the session? First, there is no significant selling. The average low figure for each five minute period is a little less than -300, with a standard deviation of a little over 300. Early in trading we're not getting even a standard deviation's worth of selling. Once again, we can tell ourselves all we want about how weak the market has been coming into the day session. There just aren't any sellers in significant proportion to be found early in the day.
We also don't see a tremendous surge of buying early in the day, as we get only one upside reading in the first half hour exceeding +600. But if we look at the yellow zero line in the top chart, we can see that we're spending more time above that line than below. Net activity is skewed modestly toward the buy side--more because of the absence of selling interest than the presence of statistically significant buying.
That view is confirmed by the bottom chart, which tracks the percentage of NYSE stocks trading above their day's volume-weighted average price. In a strong or weak trending market, the great majority of stocks will trade above or below their VWAPs. When we have more balance between buying and selling pressure, that percentage will look pretty mixed and not deviate far from 50%. For the most part, early in the day, we hovered between 50 and 60%. Again, a modest skew to the buy side.
Within the first minutes of the trading day, we can generate a reasonable estimate of whether the day is shaping up to be a busy or quiet one; a trending or balanced one. Note that this has nothing to do with chart patterns, wave structures, or economic fundamentals. It's based upon how participants are actually behaving in the marketplace. We then can track that participation over time to identify whether the market is getting stronger, weaker, or more balanced and whether it's getting busier or quieter.
Many problems in day trading occur when we impose our own views on markets and do not focus on how markets are actually behaving. Problems also occur when we do not stay sufficiently flexible to continually update our views of how markets are behaving. With a strong payrolls number, we could have imposed a view of a big market day. We could have conducted studies of how the market has behaved with past big payrolls numbers and used those to guide our expectations. It's fine to enter the day with a hypothesis, but as Ayn Rand liked to point out, the ultimate arbiter is objective reality. And that reality told us that, both in level of participation and the skew of participation, this was not shaping up to be a big day.
A reader recently asked about trading with a positive mindset. When I am trading well, I don't have a positive mindset. I also don't have a negative mindset. I have a very open mindset. As a trader and as a psychologist, I'm best off listening before acting.
Further Reading:
Keys to an Upside Trend Day
Identifying Downside Trend Days
Identifying Trend Days With Intraday New Highs and Lows
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