Ten Principles of Short-Term Trading

The recent action in the market, coming on the heels of the weak rise noted in the Trading Psychology Weblog, calls to mind several principles of short-term trading that have served me well over the years. I hope to elaborate on these in coming posts, with market examples and trading implications. The useful thing about these principles is that they apply to many time frames:

1) Strength Begets Strength - A market rise that expands the number of stocks making new highs and that finds more stocks trading with strong upside momentum tends to persist in the short run.

2) Weak Rises Tend to Reverse - When markets move higher with fewer stocks making new highs and with fewer stocks showing strong momentum, the rise tends to reverse in the short run, often entering a trading range prior to making an extended decline.

3) Broadly Weak Markets Tend to Reverse - When the market is very weak (many stocks making new lows and many stocks displaying strong downside momentum), it is common to see the market make marginal new lows in the short run, but reverse after that. Wednesday's action in the S&P 500 Index was a good example of that, coming on the heels of Tuesday's weakness.

4) Weak Tests of Prior Market Highs or Lows Tend to Reverse - When we get a market trading above or below its value area on low volume, few stocks making fresh new highs/lows, and weak momentum, we tend to get a "mean reversion"--a trade back into the value area. That's basically what this week's action has been about.

5) Strong Tests of Prior Market Highs or Lows Tend to Persist - When we see expanding volume and expanding new highs or lows on a move above or below the value area, such a breakout move tends to becoming a short-term trend. The longer the prior consolidation period (the heavier the volume within the value area), the more extended the subsequent trend tends to be.

6) Weak Pullbacks Following a Strong Move Will Reverse - When we have a strong market move that expands new highs/lows and momentum, a pullback on weak volume and with relatively few stocks participating will lead to at least a test of the impulse highs or lows and often to a resumption of the strong move.

7) Markets Are Dominated by the Sentiment of the Largest Participants - Look for how volume behaves during market rises or falls to see if higher/lower prices attract the interest of large traders. Examine the distribution of the NYSE TICK and the volume transacted at bid vs. offer to see if large traders are predominantly hitting bids (selling weakness) or lifting offers (buying strength).

8) Important Market Moves are Often Set Up on Larger Time Frames - Always track what the market is doing one and two time frames above your own trading time frame. Short-term trends are set up by strengthening and weakening dynamics at those larger time frames.

9) Important Market Moves are Often Triggered by Intermarket Events - Economic news and intermarket dynamics affect bonds (interest rates), oil, and currencies. Big trends in the stock market tend to be accompanied by important shifts in these other markets, as investors reprice equities in light of new developments.

10) Watch for Reversals When Sectors Fail to Travel Together - The rising tide should lift all boats and the falling tide should bring the boats lower. When you see sectors failing to make new highs or lows when the broad, weighted averages are hitting new peaks or valleys, watch for reversal. Inefficiency--the inability for significant buying/selling pressure (such as NYSE TICK) --to move sectors to new highs or lows frequently precedes reversal.

There is much more to markets than your market, and there is much more to markets than price alone. Observing the dynamics of market behavior opens the door to strategies that exploit intraday and swing shifts in market direction.

RELEVANT POSTS:

Guiding Principles of Short-Term Trading

Trading Psychology and Techniques Links
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