Thursday, April 12, 2007

Stock Market Momentum And Short-Term Price Cycles

In my most recent Trading Psychology Weblog entry, I describe the structure of short-term market cycles. This understanding is very important in framing hypotheses for the next day's trade, which is why the Weblog tracks market momentum and strength daily. While I appreciate the kind comments readers have given this blog, the most important day-to-day trading information I have to provide is actually on the Weblog.

To illustrate the relationship between stock market momentum and short-term cyclical behavior, I've summarized the S&P 500 futures market (ES) from March 13th to the present. Each daily price bar is accompanied by two numbers: that day's Demand reading (on top) and Supply reading (on bottom). Take a moment to study those numbers. You'll see an important pattern: Demand tends to top out ahead of price during rising markets; Supply tends to bottom out ahead of price during market declines. This provides us with a useful heads-up for swing changes in the market.

(Note: The H in the chart represents futures action during the market holiday when stocks were not open. The last bar in the chart represents pre-opening futures action for 4/12 before stocks began trading).

Demand and Supply, as I've noted in past posts, are indices that I construct to summarize the number of NYSE, NASDAQ, and ASE stocks that close above (Demand) and below (Supply) the volatility envelopes surrounding their short- and medium-term moving averages. To contribute to Demand, a stock must have strong upside momentum; to contribute to Supply, a stock must have strong downside momentum. Days in which Demand or Supply is strong tend to be trending days. Days in which Demand *and* Supply are low tend to be range bound days. When Demand or Supply is expanding, I look for the trend in place to continue. When Demand *and* Supply are waning, I look for consolidation. When Demand *and* Supply are very low, I look for a breakout move.

Bull swings lose momentum before they become bear swings.

Bear swings lose momentum before they become bull swings.

Broad momentum market moves tend to consolidate in momentum.

Low momentum markets yield breakout moves in the short run.

Because momentum generally peaks ahead of price, it pays to hold overnight following momentum breakouts, particularly to the upside.

If you watch diligently, you'll see these patterns replay themselves in different variations. You'll also see how these shorter-term cycles become nested within longer-term market trends.

Tomorrow, we'll take a similar look using new high/new low data in place of Demand and Supply and explore some of those longer-term trends.