Wednesday, April 23, 2008

Reading Stock Market Psychology

If you click the chart above, you'll see my annotations of the pre-opening Market Delta chart for the June ES contract. The point I want to emphasize is that reading the psychology of the market *before* the open is excellent preparation for the trading day.

First, a little orientation about the chart. We see price on the left and right vertical (Y) axes. At the left is the "Delta" at that price: the number of contracts that have been transacted at the market offer minus those transacted at the bid. When the color is green and the number beside price is more positive, it means that we have greater buying interest at that price. When the color is red and the number next to price at the left is more negative, it means that we have greater selling interest at that price.

So, along that left-hand Y-axis, we're seeing demand and supply at each market price. As the annotation at left indicates, we're seeing supply swamp demand as prices move lower: the numbers become *more* negative. Selling is not drying up as we move lower. Lower prices are attracting more sellers. This is what drives short-term market trends.

Along the X-axis, we have two sets of numbers. The top is total volume for the bar period (in this case 30 minutes). The bottom number is the Delta at that *time*. This shows us the net number of contracts transacted at the market offer minus bid over each half-hour period.

If we want to see how demand and supply are distributed *within* the bar period, we look to the numbers within the bar. The first is the volume transacted at that time and price at the market bid. The second is the volume transacted at that time and price at the market offer. When volume at bid exceeds volume at offer, that portion of the bar becomes red. When volume at offer exceeds that at bid, that portion of the bar becomes green. The mix of red and green within the bar--and from bar to bar--shows how market psychology, the shift of sentiment among buyers and sellers, evolves over time.

This view of changing market psychology within time periods and from one period to the next is especially powerful when correlated with total market volume. We can see this from the way the market topped out early in the morning. Note that during the period from 2:30 to 4:30 AM CT, the market was moving higher, but then stalled out in total volume (X axis, top number) and stalled out in the proportion of volume within each period dominated by buyers vs. sellers (less green than red). This stalling out of a market rise brought out the sellers, who then piled into the market during the 6:00 AM bar.

Once volume picked up dramatically during the selling, the bounce in the next bar was feeble, both in terms of price (amount of retracement of the recent decline) and in terms of volume transacted at offer vs. bid (very little green). This set us up for continuation of the downside move and a resumption of control by the bears.

During my Thursday Webinar, I'll have much more to say about reading market psychology. Every day in the market is an auction, and the price and volume figures reveal to us the relative interest of buyers and sellers in this auction. By understanding the dynamics of the auction prior to the market open, we can formulate hypotheses about the coming morning trade and become alert to any shifts that might occur in market sentiment.


Stock Market Reversals

Tracking Market Transitions

Breakout Trades