Friday, April 25, 2008

Anticipating Reversals by Tracking Participation in Stock Index Moves

I want to thank everyone who attended the Webinar after the close yesterday. We had over 200 traders in the room; I hope they found the review of short-term sentiment measures and trading setups helpful. When the link for the archived Webinar is posted, I will point readers to it. Thanks to Bill of IOAMT and Trevor of Market Delta for hosting the program and making the archive available.

The Webinar focused on short-term sentiment measures: NYSE TICK and Market Delta. Another element that I find important in trading is participation. Participation refers to the proportion of stocks within a sector or index that are participating in a move when we reach new price highs or lows in that sector or index.

Many times an index will make new highs or lows simply because a relative handful of highly weighted issues are dominating the move. When a significant portion of issues are not participating in a rise or fall, that move is more likely to reverse. This is a principle that I find helpful across multiple time frames. That is why I monitor 20-day new highs and lows in my Twitter comments and in my weekly indicator reviews; it's also why I like to keep tabs on individual stocks and sectors intraday.

Very often, market reversals of direction are preceded by waning participation in moves.

Above we can see that principle illustrated in yesterday's market action in the Dow Jones Industrial Average (DIA) and the 30 Dow stocks. The chart tracks the number of Dow issues making fresh two-hour price highs minus those making two-hour lows; that number is updated every five minutes. Only closing five-minute prices are used for the calculation.

Early in the morning, the Dow moved lower, bounced a bit, and then moved to a new price low for the day. That price low did not show an expansion in the number of component stocks registering fresh new lows. That was a warning that the decline was running out of steam.

As the market reversed, new highs steadily expanded, which kept traders in the trending move. Note, however, that the fresh price highs around 2 PM ET were not confirmed by the new highs. This deterioration was a nice tell for the selloff late in the day: the rise was running out of steam. Waning participation preceded reversal.

It is not necessary to monitor all stocks within an index to track participation. Tracking individual sector ETFs can be a useful strategy as well. In general, if I see multiple S&P 500 sectors not participating in a move to new highs or lows in the ES contract, I will be likely to take profits if I'm riding that move, and I'll be likely to look for spots to fade the move. Combining assessments of participation (new highs/lows) with readings of shifts in sentiment (TICK, Market Delta) can be very effective in identifying directional changes in the indexes.


Detecting Participation in Breakout Moves

Participation: A Key Market Variable