Persistent Day Selling and Other Topics for a Monday

Selling in the Day - I noticed that only 13 of the past 30 day sessions in SPY have been up in price. Going back to 2004 (N = 878 trading days), we've seen 121 occasions in which 13 or fewer days out of 30 have been higher. Thirty days later, SPY has been up by an average of 2.27% (100 up, 21 down), much stronger than the average 30-day gain of .79% (476 up, 281 down) for the remainder of the sample. When we go back to 1996 (N = 2836 trading days), we find 685 instances of persistent day selling. SPY has been up by an average of 2.03% 30 days later (463 up, 222 down), again stronger than the average 30-day gain of .73% for the remainder of the sample. Interestingly, in the larger sample (unlike 2004-present), there was no positive edge five days out and plenty of instances of drawdown.

Tracking the Markets - Trader Mike finds us in "no man's land", trapped between moving averages, but observes continued strength in on-balance volume. Adam lends some perspective on fair value and what it means. Phil checks out double bottom patterns in the major indexes and strength in some sectors. Brian reviews the averages and is looking for further mini-panics.

Links Worth Checking Out - Abnormal Returns on what insiders are doing here and the quant bloodbath; Chris, with views on creativity and the fear/volatility mix; Big Picture with a linkfest featuring views on volatility and housing contagion; Larry Nusbaum with weekend reading, including many ways of going short.

Forecasting Unlikely Events - Interesting perspective from A Dash of Insight, relevant to the many emails I'm getting about crash concerns.

Do Some Individual Investors Find Consistent Success? - CXO examines the evidence and finds some interesting conclusions.

A Few Observations to Start the Week

* Fewer New Lows - With each downthrust in the market, fewer stocks have been making new lows, as the chart from my latest Weblog entry indicates. For the week, the Adjusted Cumulative TICK was solidly positive. I also notice that Friday's momentum numbers (Demand/Supply) were stronger than Thursday's. I will be watching for signs of buying interest on Monday to see if diminished selling pressure can bring out the bulls.

* Where Value Lies - Since 7/27, nearly 70% of all ES volume and nearly 70% of all one-minute closing prices occurred between 1487 and 1453.50. That's the broad value area for this market. Given the market weakness at week's end, a good Market Profile trader will now look to see this week how we trade relative to this range, especially if we accept or reject value below the lower band.

* Where Strength Lies - It's been a weak month for stocks, but 9 of the 40 S&P stocks I follow in my basket (evenly divided among eight sectors) are actually up over the past 20 trading sessions. These include UPS, PG, KO, WAG, SLB, MRK, LLY, IBM, and CSCO. Recession resistant issues--Consumer Staples stocks--have been particularly strong. Defense stocks ($DFX) have also held up relatively well.

* Strength in the Mortgage Patch - FNM and FRE--Fanny and Freddy--don't seem to mind the mortgage weakness; their securities are backed by fixed-rate mortgages, not the riskier adjustables that are experiencing foreclosures. They were unusually strong, though volatile, this past week.

Do You Trade Strength or Fade It?

In my recent post, I illustrated that waiting for confirmed strength and weakness and then going with those trends in the S&P 500 Index was a great way to lose money. If you examine the relevant links at the end of that post, you'll see that this logic holds true over multiple time frames.

Still, a writer makes an excellent point. Dr. Humphrey Lloyd, whose work I happened to feature in my latest Trader Performance post, emailed to make the point that he has been very successful catching early strength in markets and going with it.

That makes sense to me, particularly coming off an oversold condition. In essence, you're counting on a reversal of weakness, but using incipient strength as your entry. The reverse logic also makes sense with respect to fading overbought markets.

What Dr. Lloyd does in his book is track an indicator that places the current market relative to two moving averages. You can then identify which stage or zone a market is in by seeing whether it is above both averages, below both, or trading between the two. Buying early strength or selling early weakness would have you trading something akin to a moving average crossover, filtered with overbought/oversold indications.

My own work addresses this issue differently. I separate the measurement of strength (as assessed by the number of stocks making fresh new highs or lows over a lookback period) and momentum (as assessed by the number of stocks trading above or below their volatility envelopes surrounding moving averages) from price change. When we have rising or falling markets with strength/momentum that is increasing/falling, I look for short-term continuation. When we have rising or falling markets with strength/momentum not confirming price weakness, I look for reversal.

Still, I think the basic point raised by Dr. Lloyd is valuable: one might go with a strengthening market, even as one fades markets that have already been strong.

The problem, however, is that traders tend to look at past price change alone and become more confident in markets as prices rise. We can see this in the positive correlation between put/call ratios and past price change and in the positive correlations between sentiment surveys and past price changes.

In my next post, I'll look at market strength and weakness in the current market and report on a study that addresses the trade vs. fade issue.

RELEVANT POST:

The Most Common Trading Problem
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Help Dr. Brett Write His Next Book!

Dear Readers,

It's about that time when I devote time to writing another book. This one will be my fifth--I have two psychology texts and two trading ones--and it will be my most unique.

My first two trading books were trader-centric, focusing on the psychology and performance of the trader, respectively. This one will emphasize the psychology of the markets themselves, highlighting trading strategies that are grounded in trader/investor sentiment and behavior patterns.

I say the book will be unique, because it will be an electronic product as well as a print text. That means that it will incorporate annotated color graphics, links to online resources, audio presentations, and trading videos in a single package.

Most e-books are simply electronic versions of print texts with a few HTML links tossed in. In the future, books will be multimedia publications that integrate text, graphics, audio, and video in a single package. The text will explain a concept, the graphics will illustrate it, and the audio/video will explain and show how to utilize it.

That means that readers will learn more effectively, seeing, hearing, and reading information, processing the material through multiple sensory/learning modalities.

Static text is great for conveying factual information, not so good for illustrating and demonstrating skills. The books of the future will be anything but static.

My next book will also be unique in that I will make an effort to incorporate the ideas of many different writers from the trading literature. One of the surest signs that trading is a non-scientific field is that it lacks a literature that is cumulative. Books rarely make a conscious effort to survey existing knowledge in the field and add to the corpus. Instead, writers tread old ground and fail to advance the solid understandings from the past.

So, to the best of my ability, I will review a range of trading literature. My aim is to give credit to those who have lent their shoulders and provided me with a broader view than I could ever have achieved on my own.

Finally, I'm hoping that the book will be unique in that its content will be influenced by its future readers. I'm asking interested traders to either comment on this blog or email me (at the address at the bottom of the "About Me" section of the blog home page) and suggest topics they would like to see covered in a book that addresses trading strategies that draw upon the psychology of markets themselves.

What would most help you in *your* trading? Pass along your questions and topics of interest, and I'll do my best to incorporate them in the new book.

Or maybe you have strategies you'd like to share with others: ones that have worked for you and draw upon an understanding of trader psychology. I'm also open to incorporating those in the book and citing you as the source.

As an electronic text, some of the book will reside on the Web. That means the book can always be updated, always be elaborated. No need for second and third editions: as markets change, ideas will be added to the book and chapters will be revised. The book, if done right, will evolve with our own understandings. And it will never go out of print.

For those who engage in the commerce of ideas, these are exciting times indeed. The technology is there to create books like those in the Harry Potter movies: you open the cover and the material literally comes to life.

I invite you to be my co-author and suggest topics for the book to address and ideas to share.

As always, I greatly appreciate your interest and support. The many fine people I've met through the blog have been one of the true joys and rewards of my life.

Brett

How to Lose at Trading the Stock Market

"I need to see the market making new highs to confirm an uptrend," a trader recently told me with a knowing air. "I'm not going to sell until we get confirmation of a downtrend."

I haven't heard from that trader since the market began its high volatility decline. I shudder to think what would have happened had he consistently bought highs and sold lows.

The reality, however, is that the stock market has never rewarded the obvious. A belt-and-suspenders approach to trading has never produced superior returns. Give me a short-to-intermediate term moving average and I'll show you the returns that will refute our trader's strategy.

Today's little exercise draws upon data from Barchart.com, which has a nice "performance" feature that tracks the P/L of various stocks using various technical indicators for entries and exits. Here we'll be looking at the S&P 500 Index (SPY) and the Commodity Channel Index (CCI), an oscillator that captures market strength and weakness.

We'll follow our trader's strategy by buying SPY when the 40-day CCI hits +100 (shows strength) and exiting the position when it crosses below +100. Similarly, we'll sell SPY when the CCI hits -100 and exit the position when it crosses back above -100.

This strategy may produce a fair number of whipsaws, but should capture the big trends.

Over the past two years of trading, this strategy has produced 49 trades, with an average holding time of 8 days. We've had 11 winning trades (including one that is presently open) and 38 losers, about a 22% win rate. The total number of SPY points lost over the two years was a bit over 23 (or 230 S&P futures points), which roughly translates to a 16% loss of capital if we assume no leverage and equal position sizing for each trade.

In other words, during a distinct market uptrend, trading a strategy that buys strength and sells weakness has lost significant money.

But let's look further under the hood to understand *why* such a strategy fails.

If we break out the trades, we find 35 long trades and only 14 shorts. This reflects the upside bias in the market: we haven't often dipped below -100 on an intermediate-term oscillator.

Of the 35 long trades, we would have had 9 winners and 26 losers. Cumulatively, those would have lost us 6.45 SPY points. The winning trades would have brought in 14.40 points, or 1.60 SPY points per trade. The losing trades would have cost us 20.85 points, or .80 point per trade.

When we examine the short trades, we would have had only 2 winners and 12 losers. The winning trades would have made us 1.37 SPY points or about .69 point per trade. The losers would have cost us 18.22 points, or about 1.52 SPY points per trade.

In a limited way, the strategy worked; it did catch some large moves on the long side. As a result, the average size of the winning long trade was twice as large as the average size of the loser. Even so, however, the long trades would have cost us money. Why? Because losing trades outnumbered winners by about 3:1. Stated otherwise, even in a bull market, strong moves only followed through with further strength 25% of the time.

It's when we look at the short side that we see the trading system completely break down. The win rate on trades was about 15%. On top of that, the average size of losing trades was more than double the average size of the winners! Selling weakness over the last two years has been a complete and utter disaster.

Now for some disclaimers: Yes, there are other ways to trade the CCI; my purpose is not to dis this particular indicator. And, yes, results would be different if you added a variety of stops and money management elements to the mix. And, of course, results would have been different had we examined the strategy at other points in market history or if we had pre-selected a wonderfully trending market over these past two years.

My point is this: If we use SPY as a proxy for the stock market (as the most actively traded index ETF) and adopt a strategy of "buy confirmed strength, sell confirmed weakness", we would have lost money at an alarming pace. Even if we had employed it as a long-only strategy, it would have lost us money in a solid bull market! Trading the short side in this environment led to severe losses.

In fact, I would go so far as to say that the "buy strength, sell weakness" strategy is so bad that it's promising. Simply reversing (fading) the strategy in SPY and adding a time stop (to avoid the few long uptrends) would have made a trader a chunk of change.

Of course, nothing is 100%. The "sell weakness" part of the strategy had us going short SPY on 8/9/07 and, as of Friday's close, the trade was profitable. The system sold at 145.39; it remains an open trade. The previous short trade was on 7/26/07 and covered on 8/8/07 for a loss of 1.81 SPY points (about 18 ES futures points). That was a bearish period, but still the strategy managed to lose a decent sum. You have to marvel at the consistency of the market's ability to punish the obvious.

RELATED POSTS:

Why Short-Term Traders Lose Money

How to Lose Money Buying in an Uptrend

Reversal Effects and Fading the Herd

The Market is Rigged Against Human Nature
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Short-Term Waterfall Declines in the Stock Market: What Happens Next?

Well, I was all excited and went to show Mali the post about her, but she'd hear none of it. "The market was down big overnight yesterday," she exclaimed. "Then it was down big during the day session. Now it's down big going into today's open. Tell the people what happens in the market when this has occurred in the past!"

Mali's a very practical cat.

Anyway, I went back to 1996 (N = 2891 trading days) and found only four occasions in which we had a prior overnight session down by 1% or more followed by a day session down by 1% or more and a current overnight session down by 1% or more. Interestingly, these short-term waterfall declines tended to occur at key junctures near intermediate lows in bear markets: 9/21/01 (after the 9/11 incident); 10/28/97; 4/17/2000; and 10/1/98. Three of the four occasions rose very sharply during the subsequent day session (over 3%) after dipping very little after the open. The one occasion that was down during the day session (by a little over 1%), recovered to a gain the following day.

I relaxed the criteria to look for occasions in which the prior overnight session, prior day session, and most recent overnight session were each down .50% or more (N = 16). When we look two days out (to the close of the *following* day's trade), the market was up 12 times, down 4 for an average gain of 2.20%--much stronger than the average gain of .01% for the market overall during the remainder of the sample.

Once again, it was when the downside was contained during the day session following the short-term waterfall that near-term returns were particularly outstanding. It appears that these waterfalls have the potential for triggering considerable short covering when they dry up.

Life Lessons From My Cat

Our loved ones provide some of life's best lessons. I've written about wife Margie and what makes a trader's marriage work. I've also written about daughter Devon and what she taught me about finding one's niche in life. Then there's son Macrae, who showed me the communications that are possible across cultures.

So now it's Mali's turn.

Mali is our calico cat.

Mali was neglected at birth by a Syracuse, NY shop owner and kept in a cage in a storefront. She received little attention or care. When she developed feline herpes, it went untreated and spread to her eyes. She was blinded as a result.

I heard about Mali from an angel of a woman in Syracuse who went out of her way to rescue animals in need. She saw Mali in the store and insisted that the owner surrender the cat. The little calico was taken to a vet and there she stayed in a larger cage, awaiting adoption.

But there were no takers for a blind cat. Truth to tell, Mali was not a great candidate for adoption. Her fur was not kept especially clean and her eyes had frequent discharges. There was concern that, because of these discharges, she could infect other cats with the herpes virus.

So when we were called about Mali--we had already rescued two cats from this woman--our leaning was to take a pass. We didn't want Gina and Ginger to possibly contract the virus.

But, I decided on my own--without telling anyone in the family--to visit Mali.

She was very small, and she had kitty litter in her fur. Her eyes were visibly damaged, and she sniffed loudly to check out her environment. When I held her, she purred louder than any cat I'd ever heard.

Here was a cat that wanted love.

We adopted Mali and she's done very well. The other cats have stayed healthy, and we added quite a friend to the household. Every night Mali tucks herself under the covers between Margie and me and sleeps with us. Her purring at night reminds me of that day I first visited her.

Mali's taught us several important lessons:

1) Make the Most of What You Have - Mali had very little stimulation early in her life. She was an active, curious kitten locked in a small cage. A big part of the reason she didn't keep herself clean was that she learned to use her kitty litter as a toy. She would scoop it in her paws and toss it around. Not exactly the most sanitary activity, but it was the only game available to her. She kept herself stimulated until a family came around for her. How many of us would have the presence of mind to avoid self-pity and create stimulation out of an otherwise barren environment? Mali demonstrated that it *is* possible to make the most of even the most limited situations.

2) Love Comes From Love - What convinced me to adopt Mali was not only her loud purr, but her sudden cleaning of herself when I held her. In her cage, she rarely washed herself. Once I held her, however, she began her ritual cleaning, furiously licking her paws and washing her face and sides. To this day, she grooms herself very well, but she most vigorously cleans herself when she's in bed with us. It is difficult to value yourself when you're neglected. But exposed to love, we feel loved, and that makes us love ourselves. Mali took care of herself once someone wanted to take care of her. How similar people are: We feel most special when we're special to others.

3) It's How You Compensate for Weaknesses That Counts - Mali is almost totally blind; she can only distinguish bright light from dark. Nevertheless, she has compensated with an excellent sense of smell and an uncanny sense of direction. When we brought Mali home, it only took her a few days to learn her way around our house. When we moved to a larger home, it similarly took her just a few days to figure out the layout. She navigates around furniture, sniffing, feeling with her whiskers and paws, and listening for sounds. Given little stimulation at an early age, she now craves stimulation and loves to have new people come to the home. As a result, she's an unusually friendly cat and receives loads of attention. By compensating for her weaknesses and limitations of upbringing, Mali has cultivated strengths.

Mali has been a true inspiration. She's a survivor--and a reminder that happy endings are always possible.

But every so often, she still tosses her kitty litter!

RELATED POSTS:

What Trading Teaches Us About Life

Life Lessons From a Personal Crisis
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Ideas and Links for a Volatile Thursday

* A Market of Reversals - We had downside range breakouts on 8/3 and 8/6 that were sharply reversed, then an upside breakout on 8/8 that we reversed hard today. Meanwhile, recount all the (volatile) market movement during the last ten trading session and consider that every one of those trading days but one traded between 1467 and 1470 in the ES futures at some point during the regular trading session. The trend has simply not been the trader's friend during this period. Meanwhile, Adam nicely illustrates the explosion of volatility in the market indices themselves.

* Interesting Observation - Trader Mike finds bullish on-balance volume (OBV) patterns for the major stock indices.

* Global Credit Squeeze - Excellent graphic from WSJ passed along by Todd Chalem shows how the credit crunch has taken on global dimensions. Abnormal Returns documents some of the resulting damage.

* Historical Perspective on Market Declines - Roger Nusbaum and Seeking Alpha take out the almanac and find plenty of precedent for normal, large market declines.

* World Wide Economic Calendar - Here's a nice resource from Daily FX: A listing of economic reports due out each day around the world.

* Is It Trading, Or Is It Gambling? - A thoughtful essay from InvestorGuide looks at the differences--and similarities--between the two. My take? Self-control is an important differentiating element.

* Playing Defense in a Weak Market - The defense stock sector ($DFX) has held up well overall during this decline, despite today's drop. James Altucher and StockPickr offer some bull plays that won't be affected by mortgage concerns.
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Why Trading Ranges Are Important

Markets establish value; that is their purpose. When we trade within a defined trading range, there is relative consensus about value. A break out of that range represents a potential repricing of an asset, and thus the beginning of a possible trend. When that break out returns to the prior range, it tells us that market auction participants are not perceiving the repricing as justified. This typically takes us back to at least the midpoint of the prior range and often has us probing value at the opposite end.

Key to trading is seeing these range/value dynamics at multiple time frames. Here is an hourly chart of the ES futures (including overnight trade) that shows how we broke above a multi-day range on Wednesday, only to return to that range in preopening trade today. (Click on chart for greater detail). We have sliced through important support around 1483; that becomes the important range level above us, with the 8/7 lows (also roughly the range midpoint) as next major support.

Some of the best trades we're seeing in the current market involve handicapping the movement of the market out of--and back into--these ranges, as traders are both entering and exiting the market in panicky ways. Tracking the ebb and flow of volume around these movements--including the distribution of this volume around the market bid and offer--has been one important source of this handicapping. I'll be illustrating in upcoming posts.

Using the Intraday Twitter Comments

I've received a number of positive responses regarding the intraday Twitter comments on the blog. These have been my attempt to add observations to the market as trade is occurring. The last five comments appear on the blog home page and can be updated simply by refreshing the page. The complete list of comments appear on my Twitter page; interested traders can subscribe to my Twitter feed and receive updates automatically.

Gradually I've been formalizing the comments, and this will continue this coming week as my coaching work with traders (and writing commitments) expand and keep me from the screen. What this will mean in practice is that there will be Twitter comments after the trade that summarize major indicators and what they mean, and there will be Twitter comments before the trade that summarize overnight developments and implications. The goal of these post-market and pre-market comments will be to help traders prepare for the coming trading session. Look for a blog post on the topic of "preparing for the day's trading" to come shortly. That will explain in detail how to utilize the Twitter content.

I will then update Twitter on an intraday basis (preferably midday) as best I can given my increasing work (and phone work) with traders, travel/writing schedule, etc. The goal will be to provide decision support for traders--an intraday blog within a blog. I welcome comments on the comments, as I attempt to make this feature as useful as possible. Thanks for your interest.

Brett

It So Rarely Pays to Act on Panic

During the recent market volatility, we've had a number of sudden, sharp runs both to the upside and downside. One of the things I've marveled at is how infrequently those who jumped aboard those sharp runs actually made money--whether they were bulls *or* bears. On a larger scale, we can see that those selling into the persistent bearishness noted earlier have also not fared well, as we've now retraced more than half the market's declines.

And to think it was just yesterday that we were wondering if Ben would be taking a helicopter over Wall St.! Meanwhile, the 10-year yield is up to 4.879 as I write, the Yen has broken to multiday lows, and the NYSE TICK distribution has been in monster positive territory. Indeed, traders seem positively giddy about owning stocks. And look at those "A" shares in China: they barely caught their breath during the market weakness before launching to new highs--even as inflation rumbles.

All's well with the financial world indeed. Which may be cause for concern.

Chess, Tai Chi, and Trading: Inner Views of Learning and Performance

My recent post on "Becoming Your Own Trading Coach" referenced Josh Waitzkin's excellent book The Art of Learning. In his book, Waitzkin describes principles of learning and performance that helped him excel in two disciplines: chess and Tai Chi Chuan. These principles are highly relevant to the cultivation of expertise in trading, though they're rarely acknowledged.

To illustrate three of these principles and their application to trading, let's take a simple day trade from Tuesday's market in the ER2 (Russell 2000) futures. We can see that the Russells moved to a new high on expanded volume around 11:30 AM. It was at that point that a nice short-term trade set up--but only for those who had achieved a degree of inner mastery.

Let's break it down, principle by principle:

1) Investment in Loss: Waitzkin describes putting "your ego on hold" and growing through challenges that leave you beaten up. He also captures the essence of Push Hands Tai Chi, in which elite performers "dissolve away from attacks", absorbing and dispelling their energy rather than resisting it. When the market jumps on high volume and makes a new high, our emotions are engaged: we become fearful of missing a good move; we become overeager to jump aboard the move; we become mired in regret for having missed the move. But the expert trader absorbs the event and widens his perception. The market may have thrown him for a loop, but his is the stance of the observer, not the frustrated or defeated participant. He looks for the information in the event: that's the investment. Standing apart from his own market, he can see that the other stock index futures--the ES and NQ--have not made new highs on this move. What looks like a breakout--and the start of a new trend--looks, from a wider perspective, more like a fakeout. Physiological arousal speeds us up; it narrows our perception. The expert performer, looking for the investment, widens his view. Like a good quarterback under the pressure of a blitz, he focuses, sees the whole field, and completes the play.

2) Slowing Down Time - Time moves extra quickly when we're in the physiological arousal of flight or fight. The market seems to be racing when it's moving to new highs without us on board (or against our position). But the expert performer knows how to slow down time. Waitzkin describes observing minute tells in his adversaries--shifts in their eyeblinks or breathing--that enable him to time his movements. Such fine observation is only possible when the mind operates in slow motion--and when we've trained the mind to slow itself under duress. When the experienced trader sees buyers chase the new highs, he becomes very slow and focused for the next minute or two. He watches each trade coming into the market: are large traders jumping aboard the move or standing aside? Are they entering as buyers (lifting offers), or as sellers (hitting bids)? The slowed-down trader can *feel* that the market has stalled after its upward thrust. It's just like a martial arts opponent who has lunged at you, and now is off-balance. That's the cue to enter the market in the opposite direction, knowing that all those buyers who chased the highs will have to unload their positions at lower prices.

3) Numbers to Leave Numbers - Waitzkin explains that the beginning chess player learns by explicitly studying the value of each of the pieces and using this information to help guide play. Eventually, with repeated experience and the internalization of study, the developing chess master no longer thinks in terms of numbers. The value of the pieces in relation to one another is something that is felt, not calculated. But you can only leave numbers by first immersing yourself in numbers. The beginning trader diligently calculates all the relevant information: volume, price movements in various markets, etc. But the expert trader *feels* that the market is stalling and losing steam. His knowing is visceral, like the Push Hands player who senses an opponent that has lost his center of gravity. At that point, you are the market; it is within you. But you never get to that point of implicit knowing without those arduous investments in loss: what Waitzkin calls "using adversity" to further development.

A move in the market. The movement of our emotions. Consciousness widens or narrows. Time slows down or speeds up. We either lose our investment or invest in our losses. These are the invisible, but vital, facets of performance for the short-term trader. I think you'll find that Waitzkin's book is a fine introduction to learning and expertise, a rich road map of the performer's inner world.

RELEVANT RESOURCES:

Trading and Information Processing
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Yen and Stocks: Mirror Images

Above you can see charts from today's action in the Yen and ES futures (click on charts for greater detail). When the Yen could not catch a bid at the 13:35 PM bar (marked with check mark), we started firming in ES. Failure of Yen to make a new high when ES made its marginal new low was a great tell and an instructive illustration of why it helps to keep an eye on correlated markets.

Microanatomy of a Market Bounce

If you click on the chart, you'll see a nine minute period of the market under the microscope. The chart shows where the ES futures were trading at various levels of NYSE TICK. You can see the zero TICK line in red, showing us that the most recent distribution has been positive.

Note the pullback in TICK from 10:49 through 10:52 AM cannot take us meaningfully below the zero line and also retraces only a small portion of the prior market move.

This sets us up for the next surge in TICK and a nice short-term move.

In a bull swing, this pattern sets up many times.

Chart created in e-Signal with prices overlaid with a graphics app.
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Stocks Making New Highs: Early Signs of Market Strength?

I find it helpful to look underneath the market averages to see what individual stocks and sectors are doing.

The top chart (click for greater detail) shows the recent market decline in the S&P 500 emini (ES) futures, with a series of lower price highs and lower price lows interspersed with sharp rallies.

The bottom chart tracks the 40 stocks in my basket that are drawn equally from eight S&P 500 sectors: Materials, Industrials, Consumer Discretionary, Consumer Staples, Energy, Healthcare, Financial, and Technology. I track the five most highly weighted stocks within these eight sectors to provide a balanced picture of large cap stock action across sectors.

The blue line in the bottom chart is the S&P 500 stock index (SPY); the pink line is the number of stocks in the basket making new 10-day highs minus those making new ten day lows.

Interestingly, Monday--the day of hitting a new price low for the S&P index--we had more stocks closing at 10 day highs than at 10 day lows.

Stocks closing at 10-day lows were: AA, IP, TWX, SLB, and OXY.

Stocks closing at 10-day highs were: UPS, PG, MO, KO, JNJ, BAC, WFC, and VZ.

When you see stocks from different sectors closing at fresh highs and fewer closing at new lows on a day where you've made new lows in the overall index, it makes you wonder about how much steam the decline has left.

Let's look at some of those new ten-day closing highs:

PG, MO, KO, JNJ: Defensive names. It makes sense that these might be attractive if there are concerns about economic weakness.

BAC, WFC: Banks. Perhaps we're seeing bargain hunting within this beaten up sector.

You can learn quite a bit beneath the surface of an index.

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Complete Intraday Twitter Comments
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What I'm Reading on a Monday Eve

* Growth Stocks Have Become the New Value - Interesting perspective from this Bloomberg article, with some worthwhile stockpicking implications, as growth and value are now priced similarly. May be one reason NASDAQ stocks have held up relatively well during the recent market weakness.

* Best and Worst Performing Stocks of the Year - This article from Seeking Alpha and Bespoke highlights winners and losers. One surprise is the number of energy stocks on the list...as losers. I first began to notice money flows leaving energy stocks (XLE) as we were making market highs. They have seen net outflows since then.

* Fine Updates From Mike - I routinely check Mike's site for link updates; he seems to catch the interesting ones. Note the link to Google's Canada finance portal. Eventually, we can expect similar portals around the world, providing international perspectives that, in the past, were relegated to the pros.

* Fear in the Marketplace - Abnormal Returns tracks themes in the decline, including yield curve re-inversion, the tendency of assets to correlate strongly during times of risk aversion, and more.

* Trading Coach Interview - StockTickr interviews Toni Hansen; she touches on how to keep trading journals. StockTickr has added quite a few reporting features to their service, including the ability to track performance vis a vis risk and expectancy. Good stuff.

* Making Sense of the Credit Mess - The Big Picture passes along graphics that illustrate the credit process--and where it can break down.

* Perspectives on the Fed Meeting - The Daily Options Report looks at views on the Fed, the decline, and more.
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From Traders To Portfolio Managers: Becoming Your Own Hedge Fund

I had the pleasure on Friday of watching a demonstration of the beta version of Trade Ideas' automated trading capability. At present, that functionality is being offered through accounts with OptionsXpress via a pilot program. The way it works is that you determine in advance the universe of stocks you want to track and the specific setups you want to trade during the day. These will be determined by your use of the Trade Ideas Odds Maker, which tests out a variety of user-defined patterns over a three-week lookback period, including stops and profit targets. Once you identify the successful strategies in Odds Maker, you enter them (along with the stocks that you'll be trading) into a "bot" that sits on your desktop. The program will then wait for your entry criteria to be met in each stock, send the orders to buy or sell, and monitor the trades (including P/L for each position and overall) for you. During the day, you can turn strategies on and off based on your read of market conditions.

This frees traders from the task of execution and makes it automatic, reducing the role of emotion in failing to take good trades and chasing bad ones. It enables the trader, instead, to focus on strategy selection and monitoring strategies over time. That is exactly how it works in many institutional settings: the portfolio manager is free to research strategies and manage the portfolio and an execution desk actually handles the details of transactions.

More important, however, is that automated trading enables traders to track and trade multiple strategies across different stock groups--including strategies that are non-correlated. Thus you can trade strategies that are short the market for weak stocks/patterns and strategies that are long the market for strong stocks/patterns. The net effect is to reduce your volatility and the impact of general market swings. This, too, is how the pros do it.

I am not connected financially in any way with OptionsXpress or Trade Ideas. My interest is in helping individual traders find some of the benefits of professional portfolio management. Are there limitations to automated trading for the individual trader/investor? Absolutely. Investment in redundancy is crucial; you don't want to run a book of positions and have orders ready to fire if your computer or online connection fail. (Automation of stops helps this problem somewhat). You also want to make sure that you adequately assess the impact of commissions and slippage on your trading results, particularly with standard retail commission fees and the kinds of slippage possible in volatile market conditions. And, yes, you need an account size large enough to exploit the trading of multiple stocks and strategies.

With ETFs now enabling traders to trade multiple asset classes from a single stock market account and the ability to automate a variety of strategies across different time frames, we're coming ever closer to that point where each trader can manage his or her own hedge fund. Spreading risk across markets and sectors, long and short; trading big idea themes that cut across international markets and asset classes: we're witnessing the continued professionalization of the independent trader.

RELEVANT POSTS:

How Professional Traders Differ From Amateurs

Three Myths of Trading Psychology
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Ideas to Start Another Volatile Stock Market Week

* When Investors Seek Safety - Over the past three weeks, we've seen the S&P 500 Index (SPY) shed more than 7% of its value. At the same time, we've seen 10-year Treasury yields drop more than 7% in a flight to quality. I went back to 1997 (N = 509 trading weeks) and found 15 occasions in which both SPY and 10-year yields had dropped more than 5% in a three-week period. These periods included late August/early September, 1998; December, 2000; March, 2001; June-July, 2002; September, 2002; and December, 2002. Interestingly, when we look 20 weeks forward, SPY was up on 11 of the 15 occasions, by an average of 5.95%. That compares quite favorably to the average 20-week gain of 2.18% for the remainder of the sample. The June, 2002 occasions were the most dangerous, showing a further double-digit drop during the next twenty trading weeks. Eight of the 15 occasions were up more than 5% twenty weeks later. Clearly there has been opportunity as well as crisis when investors flee risk.

* Tracking the Indicators - Tonight I'll update the Trading Psychology Weblog with indicators and a few of the recent market weakness. We continue to see waning downside strength and momentum, but also continued bearish trading patterns among large market participants. The basic indicators--TICK and Money Flow--have done a fine job of staying on the right side of this market.

* Here's a Neglected Topic - The Trader Performance post for the week takes up the topic of execution. Not sexy, but surprisingly responsible for differences between making money and losing it among short-term traders.

* What's Your Stock *Really* Worth? - Money manager Todd Chalem, whose work is featured on the excellent VesTopia site, passed along this link to his fair value calculator. The calculator takes earnings, projected earnings growth, and volatility and arrives at a fair value estimate. It would be interesting to use this for a basket of stocks (like the S&P 500!) to gauge when markets are overvalued and undervalued. Registration is still free during VesTopia's beta period; you can register and see Todd's latest portfolio moves and blog entries. Great way to see portfolio managers in action.

* Another Resource Worth Registering For - Jim Dalton is offering weekly market commentary via a free newsletter that features Market Profile perspectives. His latest piece explains why traders should be skeptical of the late Friday market drop. Ask for the "Index Insights" article. Jim is the author of the recent and very practical book Markets in Profile; his Mind Over Markets is one of my favorite market texts of all time.

* Where Are We Most Likely to Find Stocks That Will Snap Back From Losses? - Check out James Altucher's weekend links for the surprising answer. See also his link re: an Asian market often forgotten: Malaysia. And, in line with my recent blog post, check out StockPickr's list of big-yielding bank stocks.
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Safety Becoming Sexy: An Unappreciated Link Between Housing and Stocks

Yes, the housing market is weak and looking to extend weakness into 2008. Yes, the mortgage credit market is a mess and risk aversion is spreading to other sectors of the market, helping to drag down the shares of financial companies.

Eventually we'll see a floor on the stock market's pessimism. Why? Take a look at PEY, the PowerShares high-yield ETF that seeks out stocks with high yields and consistent dividend payments. With the recent decline, the yield on PEY has risen to over 4.3%. Why? About two-thirds of its holdings--which come from the Dividend Achievers 50 Index--are financial stocks. The decline is creating a situation in which, eventually, some of these issues will become interesting as yield plays.

But that's not the big picture. What we're seeing is the longer-term seeding of doubt regarding the idea of housing as a safe investment/retirement vehicle. Baby-boomers and young professionals who have been resting assured that their home equity *is* their retirement nest egg will increasingly rethink that wisdom. And I don't think stocks will, by themselves, fill the void. Memories of tech market crashes and these sudden market swoons will be too fresh.

So what could provide safe haven? Savings. Dividends. Safety. The generation that blazed their way through the Sixties questioning The Man may yet exit the stage as a group of coupon clippers. Holding onto what you've got will be the grim imperative. Housing was the great bastion of growth *and* safety. For the first time in recent memory, that basic perception is undergoing scrutiny.

Yes, there will still be opportunities in real estate, in sectors and specific markets. But it is the fundamental premise of housing as a source of retirement safety that will be irreparably eroded in many markets. Years from now we'll look back on those TV shows featuring home-flippers and wonder how we missed the signs of a bubble.

Above we see a chart of the dividend yield on the S&P 500 Index from 1970 to the present. We're currently yielding a little over 1.8%, having bottomed closer to 1% at the market top in 2000. I propose that we're seeing a nascent uptrend: rising lows in dividend yields at market tops. That, eventually, will lead to rising peaks in yields, when investors demand more safety for the perceived risk of stock ownership.

We can only get rising yields in one of two ways or a combination thereof: companies raising their payouts or stock prices falling to create attractive returns on existing payouts. With housing gone as a psychological prop to retirees and those saving for retirement, sub 2% yields on blue chip stocks ain't gonna cut it.

I happen to agree with my colleague Roger Nusbaum that there is much more to a well-diversified portfolio than yield. But what's makes logical sense is not always what makes psychological sense. When much seems at risk, safety becomes sexy.
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Walking Through a Trade Setup

When I first learned trading, I made it a habit to print out daily charts of the "trade of the day". This was a look, in retrospect, of the best trading move of the day and how it set up. After looking at hundreds of trades of the day, I became more sensitive to these patterns in real time. No pattern is exactly like any previous instance, and no setup has every element line up perfectly. But when you see many examples, you can filter out the irrelevant differences and focus on the common elements of the good setups--much like a radiologist can ignore idiosyncratic differences from one person's X-ray to another and focus on what's important in the images.

If you click the Market Delta chart above, you'll see an example of one of my walk-throughs in Friday's ES futures. Let's take it step by step:

1) We make a momentum low in selling at the 13:30 bar, with expanded volume and very heavy volume hitting bids.

2) The market rallies sharply in the next bar, but volume does not expand and the net volume of contracts traded at offer vs. bid is modest relative to the prior selling extremes.

3) At this point, two things are going through my head: 1) V-bottoms are the exception and we should see retests of momentum lows; 2) This market is in a downtrend, with net volume skewed toward sellers (hitting bid) and with a negative TICK distribution.

4) In the next two three minute bars, we make successive price highs. I'm doing nothing, because I don't sell markets that make new highs and I don't chase highs on dwindling volume. The reduced volume and volume at offer suggests to me that the rally is running out of steam (buyers).

5) We get a stiff drop in the 13:42 bar taking us below the lows of the prior two bars. Sellers have re-entered the market. I don't chase sellers, so now I'm waiting for the next rally to see if we get a good entry in the direction of the general market trend.

6) The market bounces higher, but does not expand its TICK distribution and does not expand volume or volume traded at the offer. This is short-covering and I see we're having trouble making new highs relative to the 13:39 bar. I declare to myself that the highs of the 13:39 bar are my "candidate highs" for this bounce and I now view the market as in a trading range defined by the 13:30 lows and the 13:39 highs.

7) I sell when we make positive TICK readings and green Market Delta readings (more volume at offer than bid) that cannot make fresh price highs. We're seeing waning buying interest within the short-term trading range, and my trade idea is that we'll retest the lows of the range and resume movement in the market's longer-term (day session) direction. My stop is above the 13:39 highs--a move to new highs invalidates my idea. My profit target is the lows of the trading range.

8) I sit for quite a few minutes as the market churns, but continues to fail to make new highs as we get bounces in the TICK. Eventually we get to the bottom of the trading range in the 13:48 and 13:51 bars. As one-minute ES volume picks up and we get very negative (-1000) TICK readings, I cover my position. I generally like buyers who can't push the market higher to get me into my short positions and sellers who are panicking out of the market to help me cover my positions.

9) My goal is to enter the position *after* I identify a short-term candidate high, but as close to that high price as possible to keep losses small if I'm stopped out. This creates a favorable risk:reward profile to the trade. My goal is also to simply play for the highest probability move. In this case, it's simply a return to the bottom of the range. I'm not playing for a home run breakout trade. If the market moves into breakout mode, I'll consider that a separate trade and setup.

10) Note that I'm spending a lot of time sitting and doing nothing other than observing market dynamics and planning out the trade. There are times I'll sit for a very long time, just waiting for one great setup. The goal is not to put on trades; it's to wait for things to line up in your favor, giving you an edge.

The type of pattern I'm illustrating above occurs on multiple time frames. A key to trading this way is being able to follow one market across many time frames (which is different from following multiple markets in a single time frame) and focusing on: 1) the market's general direction; 2) the presence of a trading range; 3) a candidate price high or low; 4) an entry that leans on this candidate high or low to follow the market's broader direction; and 5) a high probability price target.

Ultimately, a good trade represents an integration of significant amounts of information. This happens to be one way to achieve that integration. There are many others, and I welcome others to share these in comments to this post.

RELEVANT POSTS:

Identifying Transitional Structures

When Do I Get Out of a Trade?

Catching Short-Term Market Transitions
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Painful Truths About Trading

The markets have been exceedingly volatile, and that has created pain as well as opportunity for traders. Here is a portion of an unusually perceptive email to me from a reader:

I have to trade conservatively since I am still in the beginning stages of the trading process…I trade a miniscule amount of shares. (I used to trade a large number in the beginning, which was not a smart thing to do, needless to say). But for now…I am trying to be as careful as possible...

When I enter a trade (upon breakout)…, I know exactly where to put my stop, so I know the exact amount I am willing to lose (less slippage). It usually…rallies a little bit, then pulls back, many times even below my entry point.

So far lately, I have taken the very tiny profit as it rallies a little after the breakout and then I quickly get out with a market order (...just because I have been burnt so much in the past - so I am being neurotically cautious to my detriment perhaps, since I could have so much more by staying in the trade). But then often the stock will rally back up and up and up ...without me on board....

So, then I get in again at the next breakout point and I am nickel and diming myself to wealth (to achieve wealth this way could take the next thousand years)....

Would it be actually smarter for me to just set my stop loss...but IF it does not retreat that far back, then, after it definitely cleared my entry point, just move my STOP LOSS to break-even (or arrange trailing stops) and go to find another trading opportunity?

There is so much pain involved in trading....

The reader is well aware that these trading patterns will not bring success. The question is how to address them. Here are a few considerations from both a trading psychology perspective and a pure trading one:

1) End the Pain - If you were experiencing significant spinal pain every time you walked, I would tell you to stop walking and call for help. Pain is a warning signal, and that includes emotional pain. A key to our trader's post is that he used to trade larger, but no longer because, "I have been burnt so much in the past." It is the retriggering of those losses that is contributing to his sense that "there is so much pain involved in trading." This is the dynamic of traumatic stress: events in the present flash us back to the painful events of the past, and we relive many of those emotions. While we may not be able to resolve traumatic stresses immediately, we certainly can stop restimulating them. Above all else, do no harm. Stop trading. Totally. Learn some behavioral methods of controlling anxiety and frustration and practice these daily (meditation is a great skill in this regard; combining biofeedback with deep breathing and guided imagery can also be effective). Once you master these methods, make yourself relive your prior trading losses *while you perform the meditation or relaxation exercises*. Keep repeating that until you get to the point where you can vividly visualize and reexperience your past trading losses without getting physiologically worked up. This is far and away the most effective approach to reprogramming traumatic memories. A therapist trained in behavioral methods (exposure work) can assist you with this work; it's not necessary that the person be a "trading coach" or know anything about trading.

2) Re-create Safety - Once you've made significant strides in reprogramming your emotional experience, go into simulation mode and rehearse proper trading strategies (see below) while keeping yourself calm. Only when you can implement your strategies *consistently* and with a calm focus should you consider going live with small positions. Then make yourself achieve consistency and calm with small positions before you gradually raise your size. The only way to overcome trauma is to experience repeated safety. The worst thing you can do is get frustrated and try to make your money back all at once, risking further emotional injury.

3) Research, Research, Research - If you're trading breakout patterns, study every breakout and false breakout you can find to become sensitive to the differences between the two. Look at volume on breakout moves; study normal retracements of valid breakouts vs. the more significant and rapid retracements of false breakouts. Examine behavior of indicators such as NYSE TICK on breakout moves. Your trading approach should reflect your research. Study the "tells" that occur prior to the big volume moves: selling (negative TICK) that cannot move the market to relative lows or buying (positive TICK) that fails to push the market meaningfully higher. Work on entering the long side on those TICK pullbacks; the short side on the TICK bounces. That little execution edge adds up over time. It also provides a natural stop point for short-term traders if the market initially goes your way and then reverses.

4) Practice Hitting Targets - What's missing from our trader's email? Profit targets! We hear a lot about stop loss and pain, not much about profit targets. In the absence of such targets, it's easy to get caught up in tick-by-tick action and take a quick, small profit, reducing reward as well as risk. It is important to have explicit profit targets. These may be pivot points, support/resistance levels, etc. Moreover, these targets should enable you to enjoy as much reward from trades as risk. Some of my own targets are indicator based: if I'm short, for example, I will cover at least some of my position if we get very negative TICK readings on enhanced volume, regardless where that price level may be. Once you establish your targets, practice in simulation mode letting trades run until they either hit the target or are stopped out. While the trade is running, you practice keeping yourself chilled with those relaxation exercises. You can't develop confidence in a trade if you never let the trade run. Simulation is a safe way to build experience and confidence.

I am often asked why I don't accept advertising on my blog, and why I don't participate any more in the popular trading conference events. One important reason is that I want the freedom to speak my mind, with as much honesty and integrity as I can muster. Our reader's email is not unusual in my experience. Writers blithely quote statistics that 80% or more of traders lose money, but rarely do we stop to consider that trading is creating pain for 80% or more of its participants.

Trading can be an incredibly destructive activity. You can pour money and dreams into trading without a demonstrable edge, go against professionals who have the best in research and execution, and you can lose everything.

Lose a house? Lose all your money? Lose your marriage? I've seen it all with traders. For every fortune made, I've seen many, many dreams dashed.

No one in the trading magazines, books, or seminars talks about that. One time I did mention it in a seminar and was told by the conference organizer to not talk on that topic further. I have not appeared at that conference since, by their wishes as well as mine.

The trading industry exists to get people to trade. Brokerages offer products that will get people to trade more. Software firms build in features that make it easier to place orders. Coaches and vendors offer promises of trading for a living and winning in markets.

But no one talks of the pain. No one wants to read the dozens and dozens of emails I receive every week from traders who are hurting.

So I choose to speak my mind without fear of commercial repercussions: If you're going to trade, do it the right way. Don't traumatize yourself. Observe and research before you trade; practice trading small and in simulation mode before you put your capital at risk. Don't abandon your day job until you have a track record of consistent profits across various market conditions. Trade less, not more: emphasize the high probability trades and keep your capital safe in the interim. Forget about riches and don't put yourself in a position where you need to trade large and often to make a living; work on covering costs consistently and managing risk. If you don't see objective evidence of an improving learning curve after a year or two of consistent effort, consider the possibility that your talents lie elsewhere.

Trading may or may not produce gain, but it should not be a continual source of pain. No one has ever traumatized themselves to success.

RELEVANT POSTS:

When Trading Gets Out of Control

Addictive Trading
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Is This a Bull Market or Bear?

As the three sector charts indicate (Industrials, Financials, Technology), whether you view this as a bull market correction or as a fresh bear market depends largely where you're invested. If you look at a long-term chart of the Russell 2000 stock ETF (IWM), you'll see that we've retraced the entire move up since early March. The S&P 500 Index (SPY) is well above its March levels. Not all market segments are behaving the same.

If you look at five of the most highly weighted stocks within the XLK (technology) universe--MSFT, INTC, IBM, CSCO, and VZ--you'll see only the mildest of corrections.

A look at the five most highly weighted XLF (financial) stocks--C, AIG, BAC, WFC, and JPM--shows harrowing declines.

A number of consumer staples (XLP) stocks--PG, KO, and WAG come to mind--are proving relatively resistant to decline of late. Many consumer discretionary (XLY) issues--TWX and HD--are weaker.

There is a great deal of fear-based trading in the recent markets. We see huge flights to quality in the drop in 10-year Treasury yields, massive unwinding of carry trade (Yen strength, flight from risky assets), and sharp moves late in the day from participants unwinding positions. As noted earlier, we're also seeing considerable bearishness in the put/call ratios and extreme weakness in advance-decline readings.

That tells me that good stocks (and sectors) are being sold off with the bad, and that has me patiently looking for values. One of the places I'm looking is sectors (and stocks) that--even with massive selling--are holding their valuations, staying off my list of fresh 65 day lows.

This is not a monolithic bear market.

It just feels like it.

When Bearishness Has Been Persistent--And More

* Lots of Bearishness Out There - We've had six consecutive days in which equity put volume has exceeded equity call volume. I went back to the start of 2004 (N = 868 trading days) and examined occasions in which five-day equity put volume exceeded equity call volume. This occurred in mid-May, 2006; early-mid June, 2006; mid July, 2006; and a broad stretch of time from 2/27/07 through very early April, 2007. Out of the 28 trading days covered during these periods, 27 were up thirty days later in SPY by an average of 4.73%--much better than the average 30-day gain of .89% for the remainder of the sample. Interestingly, we're only down slightly during this most recent five-day period of bearishness, suggesting that the bears are having difficulty keeping the market down.

* Blogs that Kirk Reads - Here's a potpourri of readings from some of the blogs Charles Kirk checks out, including speculation as to what sparked that late rally on Wednesday.

* Trading EuroStoxx and DAX Futures - On August 7th there will be a live trading event sponsored by Eurex and hosted by Market Delta's Trevor Harnett describing trading techniques utilized by proprietary traders.

* Trading Events Through the Day - This is a useful post on when the world's exchanges open and close. Those of you who read my Twitter comments will note that I've begun posting the times of important U.S. economic releases. (Last five comments appear on the blog home page).

* The Brain and Performance - Here's a linkfest from the Sharp Brains site, with a number of articles dealing with practical aspects of cognitive neuroscience. Check out the link re: beating forgetfulness and boosting the brain; relevant to many performance disciplines.

* Market A Buying Opportunity? - Trader's Narrative outlines 12 reasons to be buying this market. Worthwhile contrary thinking.

* How Will the Election Affect Stocks? - A Dash of Insight has begun an "election project" to highlight stocks that will benefit from election developments. Excellent idea.
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Five Steps Toward Becoming Your Own Trading Coach

Let's face it: the average beginning trader can't afford a dedicated trading coach, and what passes for trading education lacks the structure and continuity of effective coaching. This creates a special challenge for the developing trader: the need to simultaneously be both student and coach, guiding one's own learning process.

This may seem impossible, but in fact--as I point out in my book--there are many such precedents for self-training. These include the training of many jazz musicians, chess players, and--yes--successful short-term traders at proprietary trading firms. The common element behind all of these is that performance events are frequent, with rapid feedback. This combination accelerates the learning curve, as the performer squeezes years of experience into months of concentrated effort.

So what does it mean to coach oneself in trading? Five elements come readily to mind:

1) Developing a Framework for Thinking About Markets - The successful traders I've known and worked with have developed their own ways of thinking about markets, supply and demand, intermarket relationships, and the like. This framework helps them understand why markets do what they do; they are conceptual lenses through which traders interpret market action. My own framework has developed from an appreciation of Market Profile theory and concrete experience working with various groups of market participants: retail, market makers, investors, etc. That framework sensitizes me to the market behavior of the largest participants, seeking clues from their behavior as to likely near-term price movement.

2) Developing a Way of Translating One's Framework Into Concrete Market Terms - A framework for thinking about markets is useless unless it organizes actual market data in actionable ways that provide a potential trading edge. My own framework leads me to organize recent market action into value areas and relevant trading ranges, looking for auction behavior (buying at offer, selling at bid) as we approach those ranges to handicap the odds of breakouts or returns to value. I find an understanding of those auction dynamics helpful to entries (entering positions near range extremes after buying/selling have shown evidence of waning or expanding); stops (basing stops on market dynamics, not just price action); and exits (setting profit targets at high probability pivot points, range midpoints, support/resistance, etc.)

3) Establishing a Routine for Practicing Market Understanding and Translating That Understanding Into Action - A trader recently gave me the excellent book "The Art of Learning" by Josh Waitzkin, the childhood chess prodigy who went on to become a master of Tai Chi. The book is not about trading, but it is extremely relevant to developing expertise in any field--including trading. Waitzkin emphasizes the role of immersion in the learning process and the training of intuition. Just as chessmasters learn the game through intensive review and observation, as well as play, traders can apply their market understanding by immersing themselves in the trading process. For me this means knowing where value is located at different time frames, where we find the edges of trading ranges, and how correlated markets are behaving as we attempt to shift value areas. (See my Twitter comments for examples). In practice, I require myself to make trades at the edges of any identified trading ranges to process market data and anticipate whether we're going to break out or return to the range midpoint (or beyond). Practicing such exercises day after day builds one's ability to "feel" market action and recognize trading patterns.

4) Gathering Feedback and Setting Goals - It's not enough to practice; coaches also provide feedback to students about their performance, praising progress and identifying areas where further development is needed. Breaking down trades into components (execution/entry, money management/stops, exits) makes it easier to identify strengths and weaknesses and to set goals for improvement. Much of the talent of a coach is making the learning process fun as well as challenging, keeping goals difficult, but reachable. Keeping score with performance metrics (P/L, average size of wins/losses, drawdowns, etc.) is a great way to engage the competitive drive in the service of learning and development. Journals are excellent tools for documenting one's learning, reviewing lessons, and cementing goals.

5) Developing Self Control - Research suggests that it is the state of mind that we're in during rehearsal--focused or distracted, open-minded or anxious--that dictates the quality of our learning. Because so much of the expertise of the performer resides at an implicit, intuitive level, any interference from negative self-talk, physical discomfort, or efforts to consciously control what should come naturally will necessarily interfere with performance. A coach does not only provide drills and teaching, but teaches the skills needed to achieve the concentration required for effective learning. Many "trading coaches" focus almost exclusively on this element, failing to appreciate that development always occurs in the context of performance.

In sum, becoming your own trading coach means structuring your learning experience, so that you become capable of deep levels of knowing and doing. In future posts, I plan to illustrate this self-coaching process in greater detail.

RELEVANT POSTS:

Josh Waitzkin video on The Art of Learning

Becoming Your Own Trading Coach

How Can I Learn Trading?

What Brett Listened to While Writing This Post
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The Trading Coach Project: Cementing Gains

The most recent post in this series found Trader C engaging in two steps to alter trading patterns that were holding him back. First, he began grading himself each day on three criteria: 1) his position sizing; 2) his use of stops; and 3) his use of profit targets. Second, he began daily use of a meditative exercise prior to trading in which he became calm and focused and vividly visualized the specific behaviors he'd need to engage in to receive an "A" grade on these criteria. Thus, for instance, he would visualize trades in which he'd size the position appropriate and exit when his stop was hit. Then he might visualize an entry at proper size and visualize the market going his way, taking profits when the target is hit.

The key to these two steps is repetition: developing new patterns of thought and behavior. By making visualizations highly vivid and by mentally rehearsing desired trading patterns, the trader creates a kind of practice outside of actual trading hours. Moreover, by combining the focused relaxation with the positive trading patterns, the trader becomes more able to access these patterns simply by taking some deep breaths and getting focused during the trading session.

Our timing couldn't have been better, as we began work on this just as the market volatility began to pick up significantly. For the most part, Trader C has been able to grade himself well on the three criteria, and this has corresponded to an upward move in his equity curve to fresh yearly highs. The exceptions occurred when he was particularly fatigued with an illness or distracted by family health concerns. I encouraged him to gauge his readiness to trade at the start of each session and size positions smaller if he was not feeling 100%. I have found this "taking your emotional temperature" to be a simple, but helpful step in avoiding unnecessary bad trading due to poor concentration. Just as an athlete should not start a game if he is injured, a trader should not be putting capital at risk if his focus isn't there.

Recall that Trader C trades both intraday and a longer-term set of themes in which he is long stocks from particular market segments. With the market's recent decline, his longer-term portfolio has taken a hit. Nonetheless, he resized those positions per his grading criteria and he also instituted a hedge with SPY to reduce exposure to overall market weakness. The combination of these two steps prevented him from undergoing a crippling drawdown.

Moreover, Trader C has used the enhanced volatility to trade well intraday and play the short side of the market. Indeed, as of our last conversation, his combined equity curve--intraday and longer-term portfolio--was actually up modestly during the market meltdown.

The takeaway is two-fold:

1) Consistent following of rules produces consistency of trading and that yields emotional consistency. Despite the enhanced market volatility, Trader C was able to trade well intraday and stay grounded in what he does best;

2) Having a combination of uncorrelated strategies is among the best of all risk management tools. By holding his longs, hedging them, and trading around them intraday, he has managed to stay profitable during market turbulence and has positioned his portfolio for the next rebound.

I was pleased to learn that Trader C was granted an interview at a major trading firm. He'll certainly have a number of positives to present; it's rare to see someone with both short-term trading skills and a knack for portfolio management. The formal part of our coaching project is over, but we will stay in touch and work on things as they arise. The goal is not for me to be Trader C's coach, but for him to get to the point of coaching himself well.

RELEVANT POSTS FROM THE TRADING COACH SERIES:

Changing Behavior Patterns

Beginning the Change Process

Creating a Focus for Change

Conducting an Assessment

When Performance Coaching Works
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Where Money is Flowing in the Dow Stocks

Here we can see an update of the five-day composite money flows into the Dow 30 Industrial stocks. We're seeing for the first time since 2006 net outflows from those stocks.

(Note: Due to the repeal of the NYSE uptick rule, it is likely that money flow--like the NYSE TICK--has shifted downward in recent weeks. This may also be contributing to the weakness of the data).

Not all stocks are showing outflows over the past ten trading sessions, however.

The stocks with net money inflows over the past two weeks are: AA, AXP, C, CAT, GE, HPQ, INTC, JNJ, KO, MMM, MO, MRK, and VZ.

Stocks with net outflows are: AIG, BA, DD, DIS, GM, HD, HON, IBM, JPM, MCD, MSFT, PFE, PG, T, UTX, WMT, XOM.

Outflows from XOM have been especially consistent, despite recent high prices in crude oil futures. The greatest outflows have been from JPM, no doubt a reflection of credit worries. PFE, WMT, MCD, and BA have also seen solid outflows.

The strongest inflows have been into C, interestingly enough. AA, INTC, and MRK have also seen strong inflows.

If we are indeed putting in a bottom here, we should see a distinct improvement in money flows coming shortly. I will be watching closely for that and reporting here.

RELEVANT POST:

Behind the Market's Weak Money Flows
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Is This Morning's Drop a False Breakout or Fresh Bear Leg?

If you click on the chart, you'll see what I'm looking at this AM to set up the big picture for today's trade.

Will we return to the trading range defined by the upper end of the range (top blue line) and Monday support? If so, that false breakout should lead to nice short covering and a retracement of much of that range.

Will we see fresh selling and a new bear leg? If so, we should see volume hitting bids and taking us below the overnight lows without us sustaining a move into the prior trading range.

My job, as a trader, is not so much to crystal ball what will happen as to define the possible scenarios and then *identify* what's happening early in the unfolding move so that I can take advantage.

Monday's support is today's resistance; let's see how we trade as we approach that level.
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Sharp Drops After Multi-Year Highs: What Comes Next?

We made all-time highs in the Dow Jones Industrial Average and multi-year highs in most major indexes, only to see a sharp decline over the following eight trading sessions. I decided to take a very long-term look at market history and see what has happened when the Dow has made a 1000 trading-session high, followed by an eight-day decline of 4% or more.

I went all the way back to 1909 (!) and found 53 such occurrences in 27,782 days of market data.

Sixty days following a sharp market drop from multi-year highs, the Dow was up by an average of 4.16% (39 up, 14 down). That is considerably stronger than the average 60-day gain of 1.59% for the remainder of the sample.

The occasions in recent market history include:

* Late Feb./Early March, 2007 - Up over 10% 60 days later.
* May, 2006 - Up modestly 60 days later after drawing down several further percent.
* January, 2000 - Down less than 2% 60 days later after drawing down over 10% further.
* September, 1999 - Up about 1% 60 days later after drawing down over 7% further.
* May, 1999 - Up over 4% 60 days later.
* July, 1998 - Down over 4% 60 days later after drawing down over 14%.
* August, 1997 - Down 3% 60 days later after being up over 3%.
* Feb., 1993 - Up over 4% 60 days later.
* April, 1991 - Up 3% 60 days later.
* Jan., 1990 - Up 1% 60 days later after drawing down over 4%.

Since 1990, when we've made multi-year highs and then dropped sharply, the market was higher 10 times and lower 5 times after 60 days for an average gain of 2.27%. Drawdowns, however, have been the norm: eleven of the fifteen occasions were down after 10 trading sessions.

Now here's an interesting finding: There were three periods in which the drop from multi-year highs turned into full-fledged bear moves (declines of more than 10%): Jan., 2000; July, 1998; and September, 1987. All three of those times, the market had moved sharply lower in the next ten trading sessions (over 1.5%) and continued lower thereafter.

Conversely, when the market was up 10 days following the sharp drop from multi-year highs (N = 27), it remained higher over the 60 day period 23 of those times. In fact, on 22 of those occasions, it added to its 10-day gains.

What that suggests is that a short, sharp drop from multi-year highs that stabilizes over the next two weeks tends to have a better trajectory than one that moves lower over the next two weeks. The short, sharp declines tend to be corrections in bull markets. It's when the short, sharp corrections don't find buyers swooping in to pick up values that the correction is most apt to become a bear.
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