Monday, August 21, 2006

A Framework for Thinking About Short-Term Market Behavior

In this post, I would like to focus on the importance on having a framework for assessing short-term market action. The mid-morning market updates on TraderFeed, which will begin this AM, will draw upon this framework. The goal is to provide a useful model for thinking about market action as it is occurring.

Having a way to think about real-time supply and demand is crucial, because that tells us if the historical edge that we may have found in the marketplace is indeed playing itself out. The really good trades occur when we see a solid edge on a historical basis (here and as posted on the Trading Psychology Weblog's new modeling section) and then when we see supply and demand in real time lining up in favor of that edge.

Of the many posts to TraderFeed, the one on what short-term traders need to know has generated the most reader interest. Not only did it bring significant hits; it also led to many reader comments on and off the blog. It became clear to me that there is a tremendous latent interest in the trading world to learn more about how professional traders assess supply and demand in real time. Intuitively, I believe, traders recognize that chart patterns, indicator readings, and various calculated market levels are but dim reflections of actual auction activity occurring on the screen and in the pits. A more direct reading of trader sentiment and behavior can be found in the actual moment-to-moment buying and selling activity of traders and the location of trades within the bid-offer matrix. What we need as traders is a way of conceptualizing this activity: a coherent framework for thinking about markets.

Above is a chart of actual buying and selling activity for 8/10/06, as it appeared in a recent Trading Markets article. (Click chart for better view). Props to Market Delta for making these data available in real time.

First off, a bit of orientation. You'll notice price on the Y-axis of the chart and time at the top X-axis. Each bar represents a five-minute period in the ES futures. The bottom X-axis provides the total volume for the five-minute bar. Thus we can see volume expand and contract from bar to bar as markets move up and down. This provides a rough idea of supply and demand. Note, for instance, that volume expanded on the move to new lows during the 9:10 CT bar, but then contracted over the next ten minutes. As the market then rose in the 9:25 CT bar, expanded volume told us that buyers were taking control, helping us jump aboard that move.

Notice that within the bars, at each time and price, there are two numbers that are written as "first number X second number". For example, in the 9:10 AM CT bar, we can see at 1264.75 the entry "316 X 0". That tells us that 316 contracts traded at 1264.75 when that price was the market bid and 0 contracts traded at that price when it represented the market offer. When the number of contracts traded at bid exceeds those at the offer, the line in the bar is coded red. When contracts traded at the offer exceed those at the bid, the line is blue. The relative amount of blue and red within each bar provides us with a general sense for whether buyers or sellers are being more aggressive. Note, for instance, that sellers were quite aggressive during the 8:35 AM CT bar, but much less so during the next ten minutes. Buyers recognized this and bid up the market during the 8:50 and 8:55 AM ET bars. Was this an impressive rally? No, we can see that total volume (bottom X-axis) did not expand on the rise. Sellers no doubt saw that and helped push the market lower over the next 15 minutes.

Markets begin to make sense when you view them this way.

If we look at the numbers within the bars vertically (top to bottom/bottom to top), we can see if volume (and proportion of volume at the bid vs offer) is expanding as the market is falling or rising. Look, for example, at that market drop during the 9:10 AM bar. Was volume expanding as we made new lows? Absolutely not. Were we seeing expanded trade on the bid? No way. Sure enough, that turned out to be a false breakout to the downside. No big traders came in to hit the bids, a major, major clue that we were not going lower.

Now let's look at vertical volume during the rise at the 9:25 AM CT bar. Notice what happened at the 1268 price: Volume suddenly jumped. A closer market analysis on a one-minute Market Delta bar chart revealed that this jump occurred because large traders (ones trading over 100 contracts at a clip) were lifting offers at that price, responding to the market's jump above the prior bar's high. With volume expanding--and more volume occurring at the market offer--price moved steadily higher. No false breakout there!

I like to look at the bars horizontally, as well. Notice how selling dried up at the 9:15 and 9:20 AM CT bars. Not only do we see a drop in total volume; as we move from left to right, we see less volume occurring at the market bid. Sellers are becoming less aggressive over time. The volume action at 1265.75 going from left to right is a beautiful example of that. Conversely, note the shift of volume at 1267.75 and 1268 from the 9:15 to the 9:25 AM CT bars. More total volume and more volume at the offer told us that buyers were becoming more aggressive over time.

My purpose is not to sell you on this particular way of viewing markets or on Market Delta as a program. I have no commercial ties to Market Delta, but I do utilize it in my own trading and find it useful. What's most useful, however, is having a framework for conceptualizing the auction process in the marketplace: the dynamic shifting of interest among buyers and sellers. That framework helps me understand what is happening from moment-to-moment in the market and make decisions accordingly. It keeps me out of bad trades and alerts me to occasions when the market is following expectations from my market research.

It is not important that you share my framework, but it is important to have a framework. If you are looking at simple barcharts and reading oscillator patterns, you are looking at shadows on the market wall, not the raw data of what is actually occurring in the market itself. Your framework for those raw data may be Market Profile, depth of market displays, Market Delta, or something else. The important thing is to have a way to think about supply and demand that aids you with decision support in real time. That's what professional traders have, and they're only too happy to take the other sides of our trades when we focus on price alone and they detect shifting supply/demand.