Two of the questions most important to understanding market behavior are: 1) Who is in the market? and 2) What are they doing? We need the broad participation of buyers and sellers to move markets, and we want to see if there is a skew in the participation of buyers and sellers. So, in a sense, we can characterize any given market as being quiet, average, or busy with respect to volume and selling, neutral, or buying with respect to the relative dominance of buyers vs. sellers. Above we can see the tracking of buyers vs. sellers over the past several months. The top chart tracks buying pressure and is a measure of total upticking among all NYSE stocks. The zero line means that we have average buying interest; positive values suggest strong buying and negative values indicate weak buying. The general pattern during market cycles is that we come out of a market low by attracting longer timeframe participants, who respond to the lower prices as value. This creates a surge of buying pressure out of market lows, as we saw early in October and as we have been seeing recently. It is this sharp turn from diminished buying (levels below zero) to strong buying (highly positive values) that tells us that the skew of market participation has shifted. The bottom chart tracks selling pressure and is a measure of total downticking across all NYSE shares. The zero line represents average selling pressure; positive values represent below average selling and negative values indicate above average selling pressure. As we move to market lows, selling pressure expands to a crescendo and typically hits its most extreme level shortly before we get a price bottom. When those low prices attract longer timeframe participants, we see selling pressure reduce significantly, as the balance between buyers and sellers quickly inverts. During the early phase of a market's topping process, we typically see above average buying pressure and below average selling pressure. As the market cycle matures, we characteristically see buying interest wane and actually go below average, while selling pressure also remains low. In the later stages of a market upturn, selling pressure picks up, while buying remains restrained, eventually pulling prices lower. By tracking buying and selling pressure separately, we can more clearly identify where we're at in an intermediate-term market cycle and gauge the odds of reversals vs. continuation of recent moves. In my next post, I will take a look at how overall levels of market participation vary across phases of intermediate-term cycles. Further Reading: Who Has the Upper Hand in the Market?
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Well, here we go again: another V bottom! Stocks rallied sharply yesterday and are up substantially in overnight hours to add to gains. But perhaps V bottoms are only V bottoms if we focus on price. Might there be changes in momentum patterns that precede the price reversal? Above are a few things I've been focusing upon. The top chart is what I call the momentum curve: it depicts the percentages of stocks in the SPX universe that are above their 3, 5, 10, 20, 50, 100, and 200-day moving averages over the past several days. (Data from the Index Indicators site). What we can see is that the percentage of stocks trading below their shortest moving averages (3 and 5-day) actually bottomed ahead of price. (They actually hit their lows on 12/10). There was no V in short-term momentum. In the middle chart, we track the number of NYSE stocks closing above their upper Bollinger Bands vs. those closing below their lower bands. (Data from the Stock Charts site). The number of stocks closing below their bands peaked on 12/12 and did not confirm the actual price lows. In the bottom chart, we track the number of buy vs. sell signals across all NYSE stocks for the Commodity Channel Index (CCI). (Data from the Stock Charts site). It, too, hit its lowest downside point on 12/12, prior to the price lows. What I'm seeing is that, recently, tops have been distinguished by price divergences; bottoms have been characterized by momentum divergences. It's an observation and hypothesis only at this point, but one that warrants further investigation and testing. Further Reading: Bollinger Balance
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Suppose we could ask all participants in the U.S. stock market whether they are bullish, bearish, or neutral on the market's direction and get a fresh reading every minute? That might be useful information, as it would show when bullish or bearish sentiment is turning; when it is becoming extreme; when it is staying bullish or bearish over time, etc. When market participants pay up to buy a stock by accepting the best offer price ("lifting the offer"), they display urgency getting into their positions. Similarly, when they sell a stock at the best bid price ("hitting the bid"), they show their urgency getting out of positions. If a participant has no particular urgency, they will leave orders in the market to achieve better execution by buying at bid prices and selling at offers. Urgency reveals sentiment on a moment-to-moment basis.
Above we see a chart for yesterday's price action in SPY (blue line) and a measure of bid/offer sentiment. (Raw data from e-Signal). This measure looks at where each trade in each stock occurs relative to the best bid/best offer at that moment and tells us how many stocks in the NYSE universe are executing at offer prices minus those executing at bids. Savvy readers will recognize that this is similar to the logic behind the Market Delta measure and is similar (but not identical) to the NYSE TICK measure I've covered in the past.
Notice the dramatic shift in sentiment near the day's high price and how later periods of bullish sentiment occurred at successively lower price levels. In short, the bulls were lifting offers, but their sentiment was not able to lift price higher. That's a nice tell for a weak market.
Central to sound trading is taking trades that offer favorable reward relative to the risk taken. This assumes, however, that we can accurately estimate both risk and reward--and the likelihood of achieving those. That may sound easier than it proves to be in practice. We know that volatility in the stock market is intimately connected with the volume of shares traded. As the VIX has recently climbed from low double digits to over 20, volume in SPY has moved from less than 100 million shares per day in late November to close to 200 million shares in recent sessions. Average daily true range has gone from about .50% in late November to over 1.5% in recent sessions. Complicating the picture is that the relationship between volume and volatility itself changes over time. The measure of pure volatility charted above shows the average amount of movement that we get for a given unit of market volume. As markets peak, volume contracts, but a given unit of volume gives us less movement. As markets fall, volume expands, and a given unit of volume gives us increasing volatility. The bottom line is that markets move much less near market tops and much more near market bottoms than we typically expect. Both volume and the relationship of volume to volatility change frequently, so that traders who anchor expectations to the recent past are going to become poor estimators of movement going forward. That will result in poor placement of stops and targets and poor decisions regarding when moves are likely to reverse vs. extend. When traders leave too much on the table or overstay their welcome in trades, it's not necessarily emotions and poor discipline doing them in. Rather, they are shooting at targets that are proving to be more fast moving than stationary. Further Reading: Pure Volatility and Market Efficiency
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The recent post outlined a way of setting goals for the new year based upon a breakdown of key elements of trading process. Two mistakes that traders can make in such a review are 1) the comfortable inaction of casually reviewing without taking the next steps of setting concrete goals and steps toward reaching those and 2) the tackling of too many goals at one time, diluting efforts to fully work on any of them. My experience is that selecting a very limited set of highest yield goals--no more than three--and working on those intensively produces the best outcomes over time.
So if you are limited to a couple of trading goals for the new year, what might they be? Here are some areas where I find traders need the most work:
* Generating better ideas - Looking at 2014, most traders can find plenty of missed opportunities. Many times the opportunities are missed simply because we were not focusing on the right markets or the right stocks in the right time frames. Improving our data set--looking at more things in different ways--is an important step in feeding our pattern recognition. Reading fresh perspectives from knowledgeable writers and speaking with insightful traders similarly can fuel our creative thinking. One of my goals for 2015? I've chosen the Abnormal Returns site as a source of readings and podcasts and will hold myself to keeping a daily Evernote journal of market-relevant ideas. Indexing those ideas over time should produce a valuable database for future reference.
* Better risk management--and opportunity management - It helps to look at the tails of your P/L distribution. Do fat tails on the left side--outsized losses--hold your overall returns down? That is a challenge for risk management: sizing positions appropriately, utilizing reasonable stops, ensuring that multiple positions are sufficiently uncorrelated, using options rather than cash where prudent, etc. On the other hand, are you missing fat returns on the right side of that P/L distribution? Cutting opportunity short can significantly weigh upon overall returns. Plotting your P/L for each trade and looking at the shape of the distribution will tell you a great deal about your management of risk and opportunity.
* Better entry and exit execution - It doesn't show up in the P/L stats directly, but looking at how your trades performed after you entered and after you exited will give you some idea as to whether your execution is adding value. Too often traders will chase market moves and enter at bad levels and/or puke out of trades on noise and exit prematurely. A review of market paths following recent entries and exits can identify those problems. No one should hold themselves to buying the low tick and selling the high one. Overall, however, you should be aware of the heat you take on trades once you enter and the amount you leave on the table when you exit. My goal for 2015 is to be quicker at entering good ideas with at least a small position. Too often I've become perfectionistic about entry levels, missing good portions of good trades.
Everyone likes to identify the next big trade, the can't fail setup. It's like throwing the long pass for a touchdown. In reality, however, the game is more often won by the unsexy blocking and tackling: gathering information to generate better ideas, managing positions better, and having clear and useful entry and exit criteria. Work on trading process is the best way to achieve better trading outcomes. Further Reading: What Works in Goal Setting
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Ah, yes: more wisdom from those purveyors of Despair! A positive attitude may be necessary if we're to learn from experience, but it's not sufficient. Change only happens when we turn observations into goals and goals into corrective actions. As we get to year's end, I find a look back on the year's trading to be very helpful in identifying goals for the coming year. One way of accomplishing that is to break trading down into component processes and map out what you've done well in each area and what you need to improve. Goals can be all about extending strengths and becoming more consistent with what you do well as well as shoring up weaknesses and correcting mistakes. So here's a starting point for a report card for your year's trading. Give yourself an A, B, C, D, or F grade in each category, followed by a strength or weakness-related goal for each:
INFORMATION COLLECTION - Consistently gathering useful information that is relevant to your trading
IDEA GENERATION - Engaging in creative thought to turn information into unique and promising ideas
TRADE STRUCTURING - Expressing ideas as trades that possess promising risk/reward
EXECUTION - Entering trades at levels that provide promising risk/reward; exiting trades at planned targets
POSITION/RISK MANAGEMENT - Sizing positions appropriately for risk control and targeted reward; using hedging and scaling in and out of positions to dynamically manage risk/reward
PORTFOLIO MANAGEMENT - Assembling ideas and trades into a coherent whole where each trade provides potential unique returns; monitoring correlations and managing risk and reward effectively across the portfolio
SELF-MANAGEMENT - Keeping yourself in optimal mental, physical, emotional, and spiritual condition to make sound decisions and sustain a high energy level
Your own trading may include fewer or more categories; these are ones I find particularly relevant across traders. The idea is to approach your trading the way a physician approaches diagnosis: assessing the health of every facet of your functioning. By turning your performance review into a process review, you are more likely to pinpoint areas of work that can make a meaningful difference to the bottom line in 2015.
I propose that there are two primary ways in which traders engage markets: via the intellectual functions of the brain and via the social functions of the brain. This distinction underlies the differences we see between traders who are primarily quantitative and systematic versus those who are more qualitative and discretionary. When a trader engages markets intellectually, decisions about buying and selling are made empirically based upon observed relationships. Growing revenues and promising new product development at a company may lead to higher expectations for earnings and a higher price multiple, leading an equity manager to place the company on the buy list. The decision is governed by a model that links inputs (revenues, profit margins, expenses, contributions of new product areas) to outputs (price-earnings multiples, target prices). When operating in the intellectual mode, the trader is looking at current pricing relative to historical norms, finding a discrepancy, and placing trades that exploit this discrepancy (mispricing). The intellectual mode thus involves considerable analysis and research. When a trader engages markets socially, decisions about buying and selling are made qualitatively, based upon the perceived intentions and anticipated behaviors of other market participants. For example, if I see--going into year end--that positioning is stretched in a number of markets and I know that traders will be reluctant to lose too much money in December because of year-end bonus conventions, I might anticipate greater than normal volatility in the stretched markets. That could lead to a profitable options trade. The trade is predicated on a situational theory of the behavior of market participants, not a historically generalizable theory about market volatility. The social mode thus involves considerable synthesis of information about markets and market participants. The social brain hypothesis suggests that the brain has evolved in size and function as our social networks have expanded. From this perspective, the brain is as much a social organ as an intellectual one, with distinct brain centers coordinating knowledge of our own minds and knowledge of those of others. In his excellent book A User's Guide to the Brain, John Ratey explains, "...traditional psychologists and neurologists have been slow to acknowledge that social behavior is, at least in part, a brain function just like memory or language...Neurologists and neuroscientists have shown that damage to the cortex can affect one's ability to be empathetic, that problems in the cerebellum can cause autism and its social ineptness, and that deficits in the right hemisphere can make it difficult to understand life's overall picture. Together, these parts and others make up the social brain" (p. 296). Having worked with many traders and portfolio managers, my observation is that the very skilled ones have either: a) very developed intellectual capacities; b) very developed social capacities; or c) a very developed integration of the two. The first we see among world-class systems traders and those with keen analytical frameworks; the second we see among short-term traders who can read order flow and sentiment and anticipate the behavior of "the herd"; and the third we see among skilled portfolio managers who factor logical and psychological factors into their idea generation. A great example of the latter recently showed up in a meeting I had with a manager who explained the anticipated action of the Fed in coming months based upon an analysis of incoming data. He then referenced the internal dynamics of the Fed and the relationships among the members and explained how the group was likely to process the incoming data. It was apparent that he displayed a level of expertise regarding the central bank in terms of the logical and psychological factors at work in its decisions. This perspective suggests that brain function--and cognitive strengths--may be more important than personality in determining trading success. It also suggests that understanding and playing to our cognitive strengths may be particularly important in guiding our own trading success. I suspect many traders fail at the kind of trading they're doing, not because they lack emotional control or discipline, but because they are not wired for the cognitive demands of that particular approach to markets.
If we look at the same things in the same way, the odds are good that we'll keep doing the same things. That's great if we have a formula for success; not so good if we're repeating mistakes. Different perspectives can bring fresh perception, and that can spark insights and new action patterns. One way I've found useful to gain flexibility of viewpoint is to track measures across different time frames. Above is a chart of my intermediate-term market strength measure, which is a moving average of the number of stocks in the SPX universe making fresh 5, 20, and 100-day highs vs. lows. It is much less noisy than shorter-term measures and has done a good job of cresting ahead of price during market cycles. It is also helpful to see where we stand on the intermediate-term measure when we're short-term oversold. As you can see, we're not yet at levels that have corresponded to recent market lows.
Still another aid to flexibility of perception is to look, not only at the stock or index you're trading, but an array of related shares and sectors. It is not unusual to find weakness or strength seeping into leading stocks or sectors that can serve as heads up for more general weakness or strength. The expansion of stocks making new short-term lows--even when SPX was trading at or near its recent highs--was a great tell for weakness that spread to the general market.
A third way to gain flexibility in perception is to examine markets across asset classes, not just within the asset class you're trading. A key to understanding recent market weakness has been seeing the rising correlations among a number of macro assets, including oil, high yield bonds, currencies, and stocks. Those macro correlations are an excellent indication that the drivers of market prices are becoming larger than the dynamics within your particular stock or index. Earnings for a company may look good, for example, but if global deflationary fears are driving stocks lower, it could be a big mistake to assume that nice earnings will translate into strong upward price performance.
In general, we can generate new views by either looking deeper into what we're trading or by looking broader. By switching our levels of breadth and depth, we can develop a more complete view of the big picture and spark those "aha!" experiences that lead to great trade ideas.
The weakness that has been showing up in stocks picked up yesterday, with SPY (top chart) breaking to multi-day lows. The middle chart shows breadth specific to stocks in the SPX universe: it is a composite of the percentages of stocks trading above their 3, 5, 10, and 20-day moving averages (data via Index Indicators). Note how it tends to top ahead of price and often troughs ahead of market bottoms as well. For the first time in a while, we've hit an oversold level similar to levels that preceded market lows in early August and mid-October. Once we expand our look beyond the SPX universe, the picture becomes interesting. My data show 891 stocks across all exchanges posting fresh monthly lows yesterday. That compares with 1180 lows the day before and 1007 lows the day before that. As the bottom chart (IWM) shows, smaller cap shares have not posted multiday lows in the same way that the large caps have. That is noteworthy, because the smaller caps have been performance laggards since early in the year.
A nice intraday tell for yesterday's weakness was the high correlation across multiple asset classes. Stocks, the U.S. dollar, oil, and high yield bonds all moved lower in relative concert. I will be watching closely to see whether those rising macro correlations swamp the divergences that are showing up among stock indexes. Good trading means sustaining flexibility when evidence is mixed and conviction when evidence lines up. Further Reading: Keeping an Open Mind in Roiling Markets
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Many observers of markets note the tendency toward "group think": good ideas (and some not so good ones) catch on, eventually become consensus, and then become oversubscribed. Here's an illuminating exercise regarding stock market sentiment: I went back to 2006 and looked at the daily equity put/call ratio: the ratio of puts to calls traded for every stock with listed options. (Index options were excluded). I then divided the observation into halves, based on high vs. low put/call readings. When the ratio was in the upper half (more puts traded relative to calls), the next 10 days in SPY averaged a gain of +.50%. When the ratio was in the lower half (more calls traded relative to puts), the next 10 days in SPY averaged a gain of only +.03%. It's been when traders and investors have been relatively bearish that we've seen the lion's share of broad market gains. But suppose we look at how sentiment is related to recent, past price action. When the put/call ratio has been in its highest quartile (most bearish), only 45% of stocks have traded above their five-day moving averages. When the put/call ratio has been in its lowest quartile (most bullish), a little over 59% of stocks have traded above their most recent five-day moving averages. In other words, sentiment is sensitive to recent price action. Traders and investors are susceptible to recency biases: how markets have behaved over the last few days has impacted how bullish or bearish they are going forward. (BTW, the correlation between equity put/call ratio and the proportion of stocks above their five-day moving averages is a statistically significant -.38). The human tendency is to project the recent past into the immediate future--and that leads to substantially poorer near term returns.
How can we extract ourselves from short-term information processing biases? One way is to make sure our thought processes are operating at a time frame greater than the one we are observing on screens. Yesterday was a classic example for short-term traders: we started the day with significant weakness, but small cap stocks notably could not trade to fresh multiday lows. Indeed, my measure of monthly new lows showed that we had fewer new lows yesterday than during the prior decline early in the month. As yesterday's post noted, when we see large groups of shares not participate in a market move, we have to question whether the move truly represents a sustainable trend. It often reflects rotation within a range market. But we can't know that if we can't stand back from the time frame we're trading and see the larger picture. Feeding the brain with big picture thinking is a great way of freeing ourselves from becoming slaves to the short term. This is why I like reading well-assembled collections of links from astute market observers: * Charles Kirk posts "quotes for the day" in his service that are uniquely insightful. I don't agree with all the perspectives offered, but almost all of those views are plausible and well reasoned--which helps me question my own thinking and not become locked in a single mindset. * Every day, Abnormal Returns is curating best content from the financial web. A good example are his links from yesterday: several reads ended up providing me with fresh perspectives.
* Barry Ritholtz shares his daily reads, with a useful slant toward economics and markets. Great to get inside the head of an experienced market observer. * Reformed Broker Josh Brown shares what he's reading in the morning as his "hot links" of the day. He finds great articles and research pieces as well, such as this one regarding income inequality during economic recovery periods. If we're not operating at least one time frame above the one we're observing, our trading is likely to be more reactive than proactive. Feeding the brain is a great way to avoid starving our trading accounts. Further Reading: Trading and Cognitive Bias
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The recent post highlighted weakness that had shown up in the broad stock market. Above we see three perspectives on that weakness. The top chart tracks a cumulative total of the proportion of NYSE stocks trading above vs. below their daily volume-weighted average prices. The idea behind this measure is that, in a strong/weak market, we should see the great preponderance of shares trading above/below their daily moving averages. When stocks made their recent highs, we saw fewer shares participating in strength vis a vis their VWAPs.
The middle chart follows buying pressure vs. selling pressure, where zero represents a balance between the two. Buying pressure is a function of moment-to-moment upticks among NYSE stocks; selling pressure reflects downticks. In a strong/weak market, we should see the majority of stocks upticking/downticking. Note how the balance between buying and selling pressure has been steadily waning in recent days. The bottom chart tracks the proportion of NYSE stocks closing above/below their upper/lower Bollinger Bands. Note here also how recent sessions have provided us with a negative Bollinger balance.
What I look for are common themes among multiple indicators. The big question I'm addressing is whether the stock market is: a) rising and getting stronger; b) rising and getting weaker; c) in a balanced range; d) falling and getting weaker; or e) falling and getting stronger. As market cycles evolve, we shift from a) to b) to c) to d) to e). It is the preponderance of evidence, not any single market measure or chart pattern, that provides a meaningful answer to where we're at in a market cycle. Right now I'm gauging market strength vs. weakness for the current market versus where we stood at the end of December 1st. So far, we're seeing more new highs and fewer new lows than at the start of the month, but also more stocks closing below their lower bands. Raw materials and energy shares are down over 3% on the week; healthcare and financial shares are up over 1%. It is not clear to me that what we're seeing so far is a broad based decline, as opposed to a correction in a broader topping process. Trending markets generally cut across sectors. When sectors are doing very different things, that smacks more of rotation than outright trend--and that keeps me nimble.
A shoutout to Adam Grimes for a thought-provoking post on the development of the trader as an example of the hero's journey. Adam's point is that, as we move from lesser to greater competence and expertise, we are inevitably tested. It is our ability to weather these tests and learn from them that determines whether we truly become--as Joseph Campbell describes--heroes of our own stories. Campbell's quote above adds one key observation to Adam's post: we only become heroes by finding and pursuing causes larger than ourselves. We all know boasters and self promoters who puff themselves up as gurus. The hero does just the opposite, subordinating self in the service of a greater ideal. The entrepreneur is driven by a vision; the soldier soldiers on when inspired by a righteous cause. We survive the challenges of heroism, not because we've mastered one or another psychological techniques, but because we tap into energy sources that call upon the best within us.
I've found it to be a warning sign when traders are predominantly focused on aims smaller than themselves. They're trying to get through the next trade, the next day. They're trying to earn that next paycheck. At some point, it becomes all about coping and getting by. Rarely, very rarely, do I hear traders speak of accomplishing great things, tackling worthy challenges, and expanding in exciting directions. More often, I hear, not the hero's quest, but the worries of the worn-down warrior.
To be sure, trading brings its worries and the best of us become worn down at times. What elevates us is tapping into our strengths, while pursuing noble goals: our competitive drive, our intellectual curiosity, our vision of building a trading or investment business, our mentorship of others, our contributions to the world based upon our success.
Psychologically, profits are necessary in trading, but not sufficient. It is what we achieve to earn profits and how we make use of those profits that define our hero's course. We hear of fear and greed, lack of discipline, cognitive biases, and the perils of poor emotional self-control. All can undermine us. But perhaps, like the tree rotting away from the inside, we only fall prey to those once our vision decays. A tree with a strong core survives the strongest winds.
One of my favorite Ayn Rand quotes is, "Anyone who fights for the future, lives in it today." A good self-evaluation is this: Are you living in today? Are you caught up in yesterday? Or are you fighting for tomorrow and living in it today?
* Here's an indicator I've devoted a good amount of time to this weekend. The idea is to track a basket of stocks, where each of the names is actively traded by large institutions. I look at the behavior of the stocks multiple times per minute throughout the trading day and identify occasions in which most or all of the components trade higher or lower at precisely the same moment. These occasions represent the impact of program buying and selling in the market. The chart above compiles the data on a one-minute basis and examines the ongoing proportion of buy programs to sell programs. I believe this provides a unique window on institutional sentiment and participation. You can see how sell programs dominated as we went into the October lows, followed by a significant preponderance of buy programs. Most recently, we've seen a tailing off of buy programs and some expansion of selling. This is consistent with the recent weakness I noted from my other measures. * Thanks to a savvy trader at SMB for a heads up on this article concerning the value of repetition and resilience. By the way, that savvy trader recently put out a video on trading secondary offerings. I love learning new stuff!
* Kudos to Abnormal Returns for linking to the Morgan Housel post on rules for investors to live by--especially the observation that short-term thinking is a major source of investing problems. Investors cannot expect stratospheric Sharpe ratios, which means that drawdowns will be proportional to sought returns. Strategies to cut off losses by restricting holding periods also cut off positive returns, a factor that has contributed to recent modest fund performance.
I find it helpful to step back every so often and reflect on the lessons that life and markets teach us. Here are a few that have stood out recently: 1) Nothing is quite so unfulfilling as engaging in battles of wits with the half prepared - There will always be those who don't like you, who are threatened by you, who don't share your values, etc. Some of them don't offer constructive feedback, but do spew ad hominem insults and accusations. You know that menu choice in Twitter labeled "block"? It helps to have one of those in your head. Engaging naysayers only amplifies negativity. Never let anyone distract you from the beauty of the world and what is possible in life.
2) If you're not routinely alienating and attracting people, you're not sufficiently visible - Speak your mind, voice your beliefs, act on your convictions. Life will present you with a bell-shaped curve of many who are indifferent and a relatively few who can't stand you and those few who are deeply attracted to you. The tails of the negative distribution make for funny stories to tell at the next craft beer outing; the positive tail consists of those who will become your closest friends and colleagues. Life is all about being visible enough to generate a large positive tail of soul mates. 3) We repeat the same mistakes until we learn the right life lessons - Freud called it the "repetition compulsion". We repeat patterns until we figure out a way to write a new ending to our life's script. But the only way to change our patterns is to first become aware of them. Few people have dozens of problems. Most have one or two issues that repeat themselves in dozens of contexts. To the extent we unwittingly enact patterns, we live life unconsciously, without free will. We can't trade the patterns of markets if we're busy acting out our own. 4) The greatest changes make us more of who we already are - We are who we are. We are born with certain talents and capacities. These lead us to seek certain experiences and those help build our skills. When we align ourselves with our interests, strengths, and values, we operate in a zone and good things happen. When we try to become someone we are not, we swim against our own psychological current. If you're not in the zone on a reasonably regular basis, you are probably not in a setting, not in activities, and not with the people that bring out the best in you. 5) Put the "I" in "Love" and then we "Live" - Love transforms. It is very difficult to be filled with doubt, fear, frustration, anger, or resentment when we connect with those we love. There are all sorts of psychological exercises to reduce negative emotions. Next time you're feeling down or upset, don't try to quell the bad feelings. Try to amplify the loving ones. Recently when I was feeling pressured by a growing workload and a confusing market, I started to take a power nap and was quickly joined by Mali, who curled up by my side and placed her face against mine. I got a lot of work done--and really enjoyed it--after the shared nap.
When trading the day time frame in the stock indexes, two questions are important: 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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The world would be a far less beautiful place without the artistry of creativity. If there's one relationship I've seen over the years as a psychologist, it's that fresh viewing leads to fresh doing: When we see life's challenges through new lenses, it opens the doors to new actions, novel solutions. Sticking with one mode of thought is a great way to stay stuck in any action pattern. This morning I was up at my usual 4 AM time, aided by the hungry cats that serve as my daily alarm bell. Seemingly out of nowhere I posed a question to myself: Suppose we were to measure, every few minutes during the day, how many stocks in the broad market were trading above and below their day's volume-weighted average price. And suppose we were to keep a running, cumulative total of that number. Would that create an effective diffusion index assessing market strength and weakness? So, after feeding the cats, I went back in time, pulled the data, and assembled the spreadsheets. What I saw looked promising as a first approximation. I now have my homework for the day to refine this measure and put it to some challenging tests. If history prevails, the new measure will either overlap old ones--or merely overlap contemporaneous price movement--so that it adds little fresh information to the analytical arsenal. As I've mentioned earlier, however, my strategy is to generate at least one such fresh idea per week. If ten percent of those prove unique and useful, I will have added meaningfully to my understanding of markets over the course of the year. The compounding effect over several years is particularly significant.
But there is another, deeper benefit to this work: When you are generating new ideas and stimulating yourself with fresh perspectives, there is no need to seek stimulation in (over)trading. If your mind craves activity, you will keep yourself active--even if that activity is not constructive. The answer to overtrading is not to discipline yourself to be less active, but rather to channel activity in creative and constructive directions. Nietzsche observed, "Under peaceful conditions, a warlike man sets upon himself." When markets are quiet, that is when we can work on ourselves. That is when we can generate and test ideas. Much of long-term success comes, not just from trading, but from what we're doing when there are no sound trades to place. Further Reading: Cultivating Emotional Creativity Conflict and Creativity in Trading Performance
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It's been a great run in stocks from the mid-October lows, fueled by significant buying pressure coming out of those lows. By mid-November, my measures were showing diminished upside momentum, but not the kind of weakness that would normally lead to meaningful intermediate-term corrections. By the end of November, pockets of outright weakness became evident in the market, with smaller cap issues and commodities-related stocks showing particular weakness. This led to a recent situation in which stocks making fresh three-month lows actually outnumbered those making new highs, despite SPX hovering near its all-time highs. Not only have we been seeing signs of weakness within the U.S. stock market; globally stocks have not kept up with SPX. Recall that I track the number of upticks and downticks across all stocks in the NYSE universe. That buying and selling pressure measure has been quite useful in tracking strength and weakness during the evolution of intermediate-term cycles. What we see in the top chart is that the buying-selling balance has been below zero for a number of recent sessions, a pattern we have seen during the topping phases of market cycles. In itself, that simply indicates a waning of broad buying interest and some pick up of selling, though not to the degree we saw prior to the early October drop. Truly outstanding has been the plunge in my measure of correlation among stocks, which looks across both capitalization levels and sectors. Indeed, this is the lowest correlation level I have seen since tracking the measure since 2004. Correlation tends to rise during market declines and then remains relatively high during bounces from market lows. As cycles crest, we see weak sectors peel off while stronger ones continue to fresh highs. As those divergences evolve, correlations dip. Right now we're seeing massive divergences, thanks to relative weakness among raw materials shares (XLB), energy stocks (XLE), regional banks (KRE), and small (IJR) and midcap (MDY) stocks. Why is this important? Going back to 2004, a simple median split of 20-day correlations finds that, after low correlation periods, the average next 20-day change in SPX has been -.33%. After high correlation periods, the average next 20-day change in SPX has been +1.43%. A very interesting sentiment measure that I track is the amount of capital flowing into and out of various ETFs. The number of shares outstanding in an actively traded ETF changes daily, reflecting underlying buyer and seller interest. Trim Tabs follows these ETF flows and notes that we are at extremes that were seen prior to the 2008 market meltdown. My own figures for SPY find that shares outstanding recently have hit double digit increases over the past 20-day period. That reflects bullish sentiment in the top 90% of all values I have tracked since 2006. Going back to 2006, when sentiment has been in the top bullish quartile, next 20-day returns have averaged a loss of -.57%. When sentiment has been in the bottom, most bearish quartile, next 20-day returns have averaged a gain of +1.57%. I put all that together and find it difficult to see good upside risk/reward from this point. When I saw lack of strength turn into outright weakness in mid-September, my bullish chips came off the table. Now I find myself in a similar mode. Could ECB or the Fed come to the market's rescue and inject fresh catalytic strength into stocks? Absolutely. Could investors pour money into stocks and chase late December seasonal strength? Of course. I am confident those developments will show up quickly in my buying/selling strength measures and I will report them duly. Right here, right now, however, I see global signs of disinflation and economic weakness; a Fed that has been talking about exiting QE; low equity put/call ratios; and persistent relative weakness in high yield bonds (HYG). It will take a fresh catalyst--and fresh evidence of buying interest--to get my chips back on the bull's table.
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We don't have to be exposed to the financial media for long before we're inundated with market predictions. How valuable are those prognostications? Do market prophets truly bring profits? An excellent 2014 review of market prophecies from The Mathematical Investor answers this question: as a group, the prophets have not been profitable at all. The performance of funds has largely fallen short of benchmarks; the doomsayers have brought doom to their followers; and even those forecasters who beat the market over a prior ten year period are likely to underperform the following year. Markets by their very nature possess a high degree of uncertainty as well as risk. It is understandable that traders and investors would seek an illusion of control by either listening to the predictions of others or by investigating so many relationships that finding significant ones becomes inevitable. This is particularly the case when market participants become wedded to particular bearish or bullish views. Their predictions are particularly susceptible to confirmation bias. There is, however, a deeper problem at work. It is an epistemological problem: a problem with understanding how science truly operates in generating knowledge. Before scientists render predictions, they observe phenomena and try to make sense of them. Understanding and explanation precede prediction: that is the role of theory. Predictions follow from good theories, not from endless data manipulations. If you want to judge a prediction, you don't have to wait to see if it plays out: you can evaluate the explanatory framework from which it is derived. I recently visited a very successful trader. When asked what he thought the market would do the next day or week, he candidly acknowledged that he had no idea. In fact, he said that, when he becomes wedded to predictions, he is most likely to lose flexibility in markets--and also lose his shirt. What made this trader successful was that he had a sophisticated understanding of different market participants, the markets in which they typically participate, and the times of day in which they typically execute their trades. When he saw these participants do certain things in one market at a certain time of day, he knew that there was a high likelihood of follow-up events in other markets during the next time interval. He was less interested in market prediction than in understanding what other traders were doing and responding to that. To be sure, his underlying theory of market participation did lead to an anticipation of future events--his trades, in that sense, represented the predictions following from his understanding--but, for him, prediction was the end point of an intellectual process, not the starting point. It certainly was not the main point. Prophets typically put predictions front and center because they place themselves front and center. More show horses than work horses, they rarely put in the effort to generate insightful theories as to why markets should move in a particular way. They might cloak their prognostications in pseudo-mathematics or in convoluted wave counts, numerological sequences, and chart patterns, but what is missing is understanding: a coherent explanation of why markets should behave in the anticipated way. All too often, prophets fit world events into their preconceived views. Profits come from identifying what is happening, explaining it rigorously, and acting accordingly. Further Reading: Market Cycles
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Here are three simple practices that can improve alertness, concentration, and overall cognitive performance: 1) Hydration - Thanks to Henry Carstens for pointing this one out. A lack of proper hydration has been found to negatively impact mood among women and decrease alertness and concentration among men. A wide range of studies link dehydration to declines in short-term memory, concentration, alertness, visuomotor tracking, motor skills, and computational performance. Water is essential for feeding the brain.
2) Power Naps - Sleep is a restorative. Although sleeping on the job has a negative connotation, research finds that power naps improve creativity, memory, energy level, and general cognitive functioning. Naps also improve decision-making and problem-solving, with naps of different lengths offering different benefits. A 20-30 minute nap is ideal for improving alertness. 3) Moving Around - Prolonged sitting carries a number of health risks. Standing at the desk for a portion of the day can also increase energy and improve mood. Exercise during the day improves sleep quality, energy level, and mood. So what does that tell us? The traditional way of working as a trader--sitting at the desk all day, hunched over and focused on screens, guzzling coffee and soda--is bad for our cognitive performance and bad for our health. If you're a world-class athlete, you will do everything possible to maintain your body in peak condition. If you're a world-class trader, keeping your brain in peak condition is equally important. It makes little sense to spend time looking for more and better trade setups when our minds are poorly maintained to act upon those. Further Reading: Improving Concentration and Productivity
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Here we see charts since July of U.S. large cap stocks (top; SPY); emerging market stocks (second from top; EEM); European stocks (second from bottom; VGK); and Asian stocks (bottom; VPL). What we can see clearly is only the U.S. index has achieved new highs in recent weeks. Emerging market stocks are very well off their highs and not so far from their October lows. Stocks in developed European and Asian markets have only retraced a fraction of their losses during September and October. This is consistent with global deflationary concerns and overseas economic weakness. It is also part of what has been weighing on U.S. stocks recently. With a strong U.S. dollar and weak trading partners, there are headwinds for U.S. companies as well as tail winds from lower energy prices.
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* The recent post noted growing weakness among small cap stocks as well as commodity-related shares. Above we can see that the number of NYSE stocks closing below their lower Bollinger Bands has decisively exceeded the number closing above their upper bands for the first time since the recent rally began.
Author of The Psychology of Trading (Wiley, 2003), Enhancing Trader Performance (Wiley, 2006), The Daily Trading Coach (Wiley, 2009), Trading Psychology 2.0 (Wiley, 2015), and Radical Renewal (2019) with an interest in using historical patterns in markets to find a trading edge. As a performance coach for portfolio managers and traders at financial organizations, I am also interested in performance enhancement among traders, drawing upon research from expert performers in various fields. I took a leave from blogging starting May, 2010 due to my role at a global macro hedge fund. Blogging resumed in February, 2014, along with regular posting to Twitter and StockTwits (@steenbab). I teach brief therapy as Teaching Professor at SUNY Upstate in Syracuse, with a particular emphasis of solution-focused "therapies for the mentally well". Co-editor of The Art and Science of Brief Psychotherapies (American Psychiatric Press, 2018). I don't offer coaching for individual traders, but welcome questions and comments at steenbab at aol dot com.
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