Sunday, October 29, 2006

The Four Legs of Market Psychology

We can think of the short-term psychology of equity index markets as standing on four legs: price, volume, sentiment, and participation. I will be discussing these in real time during Tuesday's Halloween Morning With the Doc.

The distribution of volume at various prices, captured by the Market Profile, tells us whether demand or supply are expanding as we move further away from value. This helps us handicap the odds of breakout vs. retracement as we near the edges of ranges.

Sentiment, on the short-term basis, is captured two ways: by tracking the volume at the bid vs. offer, especially among large traders; and by following the number of stocks trading at the bid vs. offer, reflected by the NYSE TICK.

Participation is a measurement of the number of stocks participating in a general market move. As I recently posted, gauging the number of stocks making new highs vs. new lows on a market move provides useful information about whether that move is likely to continue or reverse.

These four variables are worth tracking across multiple time frames. Together, they provide a reading of the market's psychology.

Above, I've taken the new highs/new lows from my basket of stocks, but now am applying the data to 5 minute closing values rather than daily data. We're looking at the number of stocks making two-hour highs minus those making two-hour lows over a two day period.

Observe the divergences marked by the arrows. It is very common that, when the S&P 500 Index (SPY) makes new highs and we get an expansion in the number of issues making new highs, that upmove will continue. Conversely, when we see divergences such as those marked, we commonly encounter retracement of those upmoves.

A more complete analysis, drawing on all four legs of market psychology, would show you that, as you were above value in the market near 139 in SPY, volume was decreasing, the proportion of volume at the market offer was decreasing, the average NYSE TICK was waning, and fewer stocks were participating in the average's new highs.

Much of what constitutes skill in the markets is recognizing in real time when these four variables are acting in concert and making decisions accordingly. Ultimately, what all successful traders are doing is tracking shifts in supply and demand. The four legs of market psychology are simply tools to help traders conceptualize such shifts.