Saturday, February 17, 2007

Stock Screening for Index Traders: A Best Practice in Trading

We normally think of stock screeners as tools for stock pickers. The stock picker screens for stocks that possess certain fundamental and/or technical characteristics that presumably affect supply and demand and then trades those stocks. So it's quite possible the stock picker will be trading energy stocks one day, tech stocks the next--or both simultaneously. The index trader, on the other hand, has a more limited array of options. Many only trade one thing, such as the ES futures. In my experience, active traders of the indices do relatively little stock screening. They are more likely to look at aggregate market indicators, such as the number of stocks advancing vs. declining or the total market volume for the day.

To see how stock screening might aid the index trader, let's take a hard look at that aggregate indicator: advancing vs. declining stocks. When a NYSE issue is counted as an advancing or declining stock, it means that the shares are trading above or below their previous day's close. While that is useful information, it also has its limitations--particularly for the daytrader. First, what is going on in the broad NYSE universe may not be reflective of what is happening within the stocks in the trader's index. If, say, the trader is trading a sector index of energy issues (XLE), what is happening across all stocks is only partly relevant. Second, calibrating stock strength from the prior day's close doesn't tell the intraday trader much about strength during the day session. If stocks as a whole open higher but then trade in a narrow range for the entire morning, a strong advance/decline reading hardly tells the whole story.

Suppose we redefine criteria for advancing and declining stocks. When a stock opens for trading, its opening price reflects the balance of supply and demand coming from a number of factors, including overseas interest, pre-opening economic news, overnight movement of the index futures, etc. During the first minutes of trade, the stock establishes a range of prices that we can consider to be its opening range. This is the market's initial attempt to set value for the shares.

If a stock moves above this opening range and sustains that move, we can truly say--on a day timeframe--that the stock is advancing. If the stock moves below the initial range of prices and stays below, we can say that it is declining on the day. The stock may or may not be up or down relative to the previous day's close. What we want to know is whether that stock is strong or weak relative to that day's initial estimate of value.

Taking this logic one step further, it makes sense that if we track a universe of stocks in this way, we can obtain a sense for whether the stocks that make up a particular index are--as a whole--advancing or declining relative to their opening range. If a significant number of stocks are moving below their initial estimates of value, we want to think long and hard about buying that index, and vice versa.

So where can we get statistics, customized for the stocks that are in the indices that we are trading, that will show day timeframe advances vs. declines? The answer lies in stock screening.

Above you'll notice my Trade Ideas screen from 2/9/07, tracking the 17 stocks that make up my large cap basket. (Please note that I have no commercial relationship with Trade Ideas; nor have they solicited this post or been involved in its writing). These stocks, followed daily on my Trading Psychology Weblog, represent a mix of tech, consumer, cyclical, and financial stocks. I've found over time that they do an admirable job of tracking the S&P 500 Index. I've set Trade Ideas to spit out upside and downside breakouts of the stocks' opening 10 minute trading range. This shows me in real time which stocks are turning into advancers and which into decliners. A nice feature of this particular screen is that the breakout move has to be sustained for 1 minute before it registers as an alert. This provides a modicum of assurance that the stock isn't simply peeking above or below its range and creating a whipsaw with a move in the other direction.

February 9th was interesting in that the market opened higher, with strong NYSE TICK readings in the opening minutes of trade. Four stocks in my basket quickly established upside breakouts from their opening 10-minute range, but then four just as rapidly registered downside breakouts. That is not what you'd expect in a trending market and was a great initial signal to the index trader that strength was selective. As we approached 9:00 AM CT, the ES futures were still trading above their open and above their previous day's close, but stocks advancing vs. declining relative to their opening range were dead even.

As you can see from the alerts, from 9:00 AM CT forward, one stock after another pierced its opening range to the downside. The index weakness lasted much of the next hour, providing plenty of opportunity for the short-term trader to join the move back into the prior day's trading range.

The stock screen showed us that what looked like strength (relative to the previous day's close) really wasn't strength at all. Indeed, the strong buying sentiment, as registered by the NYSE TICK, was unable to move a majority of stocks in my basket above their opening range. As a rule when buyers lifting offers can't move price higher, it's only a matter of time before sellers become emboldened and existing longs liquidate their positions.

The nice thing about the Trade-Ideas screen is that it is highly customizable. I could have set the screen to register 5, 15, or 30 minute breakouts, depending on my trading style. I also could have entered any universe of stocks into my watchlist, including all energy stocks or all stocks in the NASDAQ 100 Index. That ensures that the screens are providing information about the stocks that are most relevant to what we're trading: from stock index futures to ETFs.

Indices are deceptive because many are capitalization weighted. A relatively small number of stocks can make the index look strong or weak. By tracking a universe of stocks in real time and screening for their strength or weakness, we can see if a breakout move in the index is genuine or artificial. We can also determine if leading sectors are breaking out to directional moves prior to the index.

Index traders may not be stock pickers, but they can benefit by taking a look under the hood and seeing how the stocks in their index are really trading. That, for me, makes it a trading best practice.