Monday, August 20, 2007

Walking Through a Short-Term Stock Index Trade

In this post, I will walk through a trade I placed this AM, explaining the rationale for the trade and how it unfolded. This particular trade was one that worked out well; it illustrates many of the ideas I've written about in the blog and in the Twitter comments. In a future post, I will write about a losing trade and what can be learned from that.

If you click on the chart above, you'll see what I was following in a one-minute chart of the ES futures. In this case, I was watching the futures and basing my trade on their action, but the actual execution was in the corresponding ETF (SPY). The trade was to sell the S&P 500 Index at 9:19 AM CT. I bought it back at 9:30 AM CT.

Now the walkthrough:

* Start of the Session - I was anticipating early strength today, given that we saw solid buying interest on Friday. Generally, if we see day-over-day improvements in strength (new highs/lows) and momentum (Demand/Supply), I'll look for spillover strength the next day, such that we'll test the prior day's highs.

* 8:33 AM CT - We opened with positive NYSE TICK and a nice move up, particularly in the ER2 (Russell 2000) futures. My anticipation was a test of the prior day's highs in the Russell. As a result, I was looking for a pullback for a possible entry on the long side.

* 8:36 AM CT - The Yen moves sharply higher and yields on the 10 yr. Treasury move lower. This is more of the risk averse trade that has been associated with falling stock prices--and it's certainly not what the bulls would hope for following a Fed intervention. The Russell futures come off their highs with significant selling; I now entertain the possibility that we will not be able to sustain a move to Friday's highs.

* 8:39 AM CT - When I see that we can't bounce meaningfully from the sharp drop--and especially when I see the Yen move yet higher--I enter my first position of the day, selling SPY. I cover six minutes later for a $.33 profit (about 3 ES points) when the market moves lower, but TICK makes a higher low. This is as close as I come to a "scalp" trade: I'll sell a weak bounce in the TICK and then buy back when the TICK makes its next move into negative territory.

* 8:55 AM CT - My leaning is to the downside, but I'm noticing that TICK is not moving to fresh lows. The market has moved lower after my exit, but I decide not to chase anything. We soon afterward get a bounce back toward the opening highs, with NQ actually touching highs for the session. My idea is to wait for the bounce to run out of steam and re-enter on the sell side.

* 9:08 AM CT - We get a solid upmove in the TICK above +1000, and this pushes us toward those AM highs. I'm watching the financial stocks, such as C, however, and not seeing much strength whatsoever. I'm also seeing that yields remain weak, indicating that there is still risk aversion out there. Despite the seeming strength in TICK, my thought at the time is that market conditions are not right to sustain this strength. Still, I'm not going to sell a market that's making fresh short-term highs until I see evidence that the buying is petering out.

* 9:18 AM CT - We get another upthrust in TICK above +900. NQ is flirting with its recent AM highs; ER2 is unable to make new highs; ES makes a marginal high above its 9:08 AM level but remains below its overnight highs. This looks like a false breakout in NQ. Yields remain weak and those financial stocks just can't catch a bid. As soon as I see some selling from the 9:18 peak, I sell the S&P 500 Index. I'm willing to take 2-3 ES points of heat on the position, but will stop out if we get another surge in TICK above +1000. My price target, labeled in the chart above, is a retest of the AM lows.

* 9:22 AM CT - I see some solid selling in C, and know my position is OK. The ES futures sell off and my stop moves to breakeven. That's a standard risk management tool I use once a position initially goes my way.

* 9:25 AM CT - We get a move down to a new AM low in the NYSE TICK, which generally keeps me in a position until I see some evidence of short-term divergences or hit my price target. But the market bounces sharply from that level, not something I expect. What concerns me is that there's some decent bounce in those financial stocks. At this point, I start hunting for an exit. Any sustained strength in the financials will take me out of the trade; the trade is predicated on risk aversion. I'm no longer feeling comfortable in the position.

* 9:30 AM CT - We get another nice downmove in the NYSE TICK, but I exit the position when I don't see the TICK make a fresh AM low. It's a bit above my price target, but I'm also not seeing new AM lows in C, so I decide to take what I've got: $.46 profit in SPY (about 4-1/2 ES points). Just one minute later, the market (and TICK) move lower without me on board. That's pretty typical: I'll catch a piece of a move, not the whole thing. I have a Chicago commitment and have to leave at 10 AM; that's my trading for the day.

Why did the trade work? I read the AM risk aversion theme correctly and had an open mind to switch my mindset from a long bias to short. My read of the yield and financial stocks as a tell was especially helpful. It was also helpful to see that, while NQ had made AM highs, the other indices had not followed. My execution was also good: I sold when TICK was strong; bought it back when TICK showed weakness.

This, as best as I can recreate, is my flow of thinking during the 11-minute trade. It illustrates the large amount of information that is integrated even for a relatively simple, short-term trade. I am following multiple indices and tracking a market theme (risk aversion) across several different markets. I'm also employing a variety of risk management strategies, from a modest position size (I've cut my size ever since the volatility rose significantly) to short-term holding periods and stops that provide a favorable risk/reward profile for the trade.

While there are rules underlying what I'm doing, the decisions are discretionary. I cannot say that the trade was easy or emotionless. I was very uncomfortable in the last few minutes of the trade when I sensed reduced selling interest in the financial stocks. This no doubt played a role in my exiting the position before actually hitting my price target. Just because the trader is a psychologist doesn't mean he's not affected by psychology!


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