Wednesday, March 14, 2007

How To Utilize The Trading Psychology Weblog

A reader recently asked me for guidance regarding the indicators and ideas tracked in the Trading Psychology Weblog. This post will summarize the content of the Weblog and how it can best be utilized.

I generally post to the Trading Psychology Weblog daily. Exceptions are when I'm on the road, working with traders, or on vacation.

It's best to think of the entries as preparation for the trading day ahead. The posts are generally divided into three sections:

* Blog Links: These track blogs and websites for interesting perspectives. The links are grouped according to theme. Some are "Ideas" regarding markets and the economy; others are collections of "Links" gathered by bloggers; and some are specifically related to "Trading". I try to focus on the blogs that provide fresh, high-quality educational content, and I also try to highlight the work of new bloggers. A read through the entries will provide an idea of what's on the minds of experienced analysts and traders.

* Market Perspective: This is a section in which I take an indicator and update it for the current market. I try to focus on indicators that are out of the ordinary, and that offer a compelling message. The goal is to look at the market from a fresh angle.

* Market Synthesis: This is the section that will require the greatest explanation. It is my attempt to synthesize a number of indicators, some of them proprietary, into a trading outlook for the coming day. The synthesis generally assesses the short-term trend of the market, whether the recent market is strengthening or weakening, and how I plan to approach the coming day's trade.

Here is an explanation of each of the measures referenced in the Market Synthesis and how they are used:

1) Pivot Points - I've posted to TraderFeed on the topic of pivot points; an advanced search in Technorati will provide a full list of relevant posts. These pivots, derived from the previous day's prices in the ES (S&P futures) market, were first used by floor traders and since have gained wide currency. The daily pivot level is simply the average of the previous day's high, low, and closing prices (day session data only). It is closely related to another Weblog measure, the Volume Weighted Average Price (VWAP). Whereas the daily pivot is a simple price average, VWAP weights each minute's average price by the volume traded that minute to show where most trade has occurred. In a range bound market, if you fail to break out of the upper or lower edges of the range, the daily pivot and the VWAP will be your high-probability price targets. In my own trading, I generally take some profits at these levels. If trade is slow, I'll probably take my entire position off at that profit target. Recall that volume is correlated with volatility: in a slow market, a move back to the average price may be all the directional movement you get on a short-term trade.

Along with the daily pivot, I provide the S1, S2, and R1 and R2 price targets. These are calculated as a function of the daily pivot and the price movement from the previous day away from the pivot. The specific formulas are in my article. When volume is normal and you have a trending day or a breakout from a price range, your high-probability price target will be R1 in a rising market and S1 in a falling market. Generally, I will take profits at or near these levels. In a high volume trending market, where we can expect greater volatility, I will leave at least a piece of my position to hit the R2 (in a rising market) or S2 (in a falling market) targets. The other price targets to keep in mind are the high and low from the previous trading session (Since 85% of all trading days are not inside days, we're likely to hit one or another of those extremes) and the high and low from the overnight futures market (a good first target for an early morning trade). Monitoring where we are trading in the day relative to these levels provides a good set of reference points for the market's overall action.

2) Short-Term Trend - I refer to a bullish short-term trend as one in which we see higher/lower prices day-over-day and at least one of the two following: a rising number of stocks making fresh 20-day new highs/new lows and/or a rising/falling balance between Demand and Supply (see below). In other words, price alone won't define a trend. We have to see rising participation in the market move. When we don't have these criteria met, I refer to a neutral trending mode, which generally signifies a range bound environment. In a short-term uptrend, think about the previous day's high and R1 as initial price targets; in a short-term downtrend, think about the previous day's low and S1 and initial targets. In a neutral trending mode, think about fading range extremes toward the daily pivot and VWAP levels.

3) Adjusted NYSE TICK - This has also been the subject of a number of TraderFeed posts. The NYSE TICK measures the number of stocks trading at their offer price minus those trading at their bids. The Adjusted TICK is an index that subtracts the 20-day average TICK reading from each one-minute reading and then cumulates the one-minute readings into a single daily total. When the Adjusted TICK is greater than zero, it means that there is an above average tendency of traders to lift offers among the broad list of stocks. Readings below zero indicate an above average tendency of traders to hit bids among stocks. In range bound markets, we typically find Adjusted TICK readings relatively close to the zero level--generally between -200 and +200. Extreme positive or negative readings--generally greater than +500 or less than -500--are typical of trending markets. Monitoring TICK during the day is a major way of establishing the kind of day you're in--especially if you compare the current day's readings with those of the previous day. This will tell you if buying or selling interest are increasing over time. In general, if I see that the previous day's Adjusted TICK was quite positive/negative, I'll look for some upside/downside follow through the next day and establish pivot targets accordingly. I'm more likely to look for range bound markets and returns to the day's pivot and VWAP following relatively neutral Adjusted TICK readings.

4) Institutional Composite - Pretty much the same thing as the Adjusted TICK, except the TICK data are derived from the Dow 30 stocks and not from the broad NYSE universe. That makes the Institutional Composite sensitive to buying and selling among large caps, but it also makes it sensitive to program trading activity. The best trending days will have distinctly positive or negative readings in *both* Adjusted TICK and Institutional Composite. Following those days, I tend to look for follow through the next trading day. When Adjusted TICK is strong and Institutional Composite weak or vice versa, I use this as an indication of which sector is gaining the most interest: small/midcaps or large caps.

5) Demand and Supply - This is my main measure of stock momentum. It, too, has been the subject of several TraderFeed posts. Both are proprietary indexes that track the number of stocks across all major exchanges that close above (Demand) or below (Supply) the volatility envelopes surrounding their short- and medium-term moving averages. A high level of Demand thus indicates many stocks have very strong upside momentum; a high level of Supply suggests very strong downside momentum. Low levels of both and relatively balanced readings between Demand and Supply are typical of range bound markets. Once again, this is very useful information in setting pivot-based price targets for trades. Very strong Demand and Supply markets tend to follow through to the upside and downside in the near term. Rises and declines on weak Demand and Supply are more likely to reverse. The combination of Adjusted TICK and Demand/Supply will tell you quite a bit about the trending strength of the recent market.

6) New 20 Day Highs and Lows - This measure also tracks all stocks trading on the major exchanges (NYSE, NASDAQ, ASE). It is an index of the number of issues making fresh 20-day highs on the day vs. the number of issues making fresh 20-day lows. If we get a market rise, but do not meaningfully expand the number of stocks making fresh 20-day highs (and vice versa for declines), I tend to look for reversals of that move the next day. Conversely, expanding new highs or lows suggests a trending tendency. At the end of a trading day, I'll ask myself: What did the market try to do today (price action) and how successful was it (expansion of NYSE TICK/Institutional Composite, Demand/Supply, New Highs/Lows)? Seeing how the most recent values for the indicators compare with the prior days' levels will give you an idea of whether the market is gaining or losing trendiness.

7) Institutional Momentum - This also is a proprietary measure that tracks the momentum of a group of 17 large cap stocks over medium to longer time frames. Accordingly, it functions as a kind of overbought-oversold measure for a longer time frame. Very positive numbers--greater than +500--suggest solid upside momentum. Very negative numbers--less than -500--indicate solid downside momentum. We especially want to see how today's readings compare to those of recent days, to see if the market is gaining or losing momentum. Along with Institutional Momentum, I track the number of stocks in the basket that are trading in intermediate-term uptrends vs. downtrends. This, too, acts as a kind of intermediate-term overbought-oversold measure.

All in all, these are measures that tell you what's happening beneath price action. I find they are useful in helping me frame ideas of whether markets are gaining vs. losing strength and whether I want to plan trades that ride a trend vs. look for reversal. Of course, it is crucial to observe how the market is trading in real time before setting up a trade; none of the Weblog indicators are designed as mechanical tools. Still, I find them valuable in understanding what's happening in the market and in providing context for intraday trading ideas.