Sunday, August 16, 2015

Tracking the Footprints of Supply and Demand in the Stock Market

In some ideal, dispassionate world all participants in financial markets would behave like my friend NRK and only buy at bid prices and sell at offers.  It's a great way to do well in auction markets, and there are optimal execution platforms that will accomplish that for large market participants.  The problem with optimal execution is that you often have to wait to get good prices, and price can get away from you while you're waiting.  That can happen if you're looking for a bargain in a hot real estate market or if you try entering on limit orders in a fast market.  

The truth of the matter is that the world is neither ideal nor dispassionate.  People chase price bubbles and puke out of positions when everyone else is doing the same.  Real world traders--and even those execution systems--recognize this and allow for execution with urgency.  When markets are moving with signs of momentum, it's acceptable to lift offers and hit bids to participate in the movement.  Of course, in this less than ideal world, there's also that small inconvenience called cognitive bias.  We all too often extrapolate straight lines and think that every move higher or lower is a budding trend.  That gets us executing with urgency more often than truly objective signs of momentum would dictate.

The long and short of this foray into the vicissitudes of decision making is that even the largest market participants leave footprints as to their intentions.  Yes, they can chop orders up into pieces and execute in baskets and trade on different exchanges.  At the end of the day, however, their transactions occur within a bid/offer matrix, and they are either executing with urgency or they are not:  they are either willing to pay the seller's price or they're willing to let markets sell down to their desired buying level.

When you analyze markets transaction by transaction, you can actually see the flow of trades and volume hitting bids and lifting offers--and you can track the evolving sentiment/urgency of market participants.  That is highly useful information that is obscured by looking at traditional intraday or daily charts.  A daily chart is a telescope, revealing a big picture.  Viewing markets transaction by transaction to detect the flows of trader behavior requires a microscope.  A major error that traders make is attempting to engage in microscopic analyses by changing the magnifying power of their telescopes.

Above is a chart that tracks a measure of "volume flow" that I've spent the better part of this weekend constructing.  It looks at every trade for every stock in the NYSE universe and identifies where the transacted price occurred within the bid/offer matrix existing at that time.  If the volume of that transaction occurred nearer to the bid price, it is considered "selling volume".  If the volume occurred nearer to the offer price, it is considered "buying volume".  The volume flow measure is a running total of buying vs. selling volume.  If you think of it as a volume-weighted NYSE TICK measure or as a cumulative Market Delta for all stocks, you wouldn't be far off the mark.

Much as I love the TICK measure, it is democratic to the point of promiscuity.  All upticks and downticks are equal, whether they stem from the smallest microcaps or the bluest of blue chips.  That is not so helpful when trading a capitalization-weighted index.  You can have relative strength or weakness among small caps as part of a sector rotation that will skew the TICK measure--sometimes considerably.  A volume-weighted TICK measure, on the other hand, naturally weights larger, more actively traded issues more highly, providing a potentially better supply/demand view for the stocks that matter in the index being traded.

Note above how selling flows were quite moderate in early trade and then accelerated even as price was topping out for SPY.  This is potentially useful information for the intraday trader.  

As I work with the new measure, I hope to share further findings and details.  The important takeaway is not about the specific measure--it may or may not add value over time.  Rather, what is important is looking at markets in fresh ways and sustaining a process that periodically renews and extends your perspectives.  Looking at the same charts and indicators as everyone else is a great way of replicating the returns of everyone else.  If you want distinctive returns, you need to view markets through distinctive lenses that reveal fresh opportunities.  It used to be that discipline meant following a particular set of rules or processes.  In crowded, ever-changing markets, however, creativity is the new discipline.

Further Reading:  Why to Keep a Journal