Sunday, August 31, 2008

Making the Trend Your Friend: A Remarkably Consistent Trading System

I want to thank Delbert Dunmore of Aurora, IL for this very promising foundation for a trading system. Del, as you might recall, was the subject of behavioral finance research into the "Reverse Midas Effect" before he was hired by a major investment bank to head up their Contrary Opinion Desk.

The key to Del's system is constructing a price channel consisting of a 10-day moving average of daily high prices and an 8-day moving average of daily low prices. When the current day's closing price closes above this channel, buy at close. When the current day's closing price closes below the channel, sell short at close. The trades are closed when SPY closes within its price channel.

Going back three years in the S&P 500 Index (SPY), we find that this short-term trend following system has been remarkably consistent in its profitability. A total of 104 trades were generated, averaging 5 days per trade. The system generated 27 profitable trades and 77 losers, impressively losing about three-quarters of the time. But how about average win/loss per trade? Here is where the system shines: the average loss is 1.40 points (14 S&P futures points), but the average gain is 1.47 points (14.7 S&P futures points).

That's right: the system loses three times as often as it wins, but keeps winners about even in size with losers. Over the three years, the system has lost 67.9 SPY points or a whopping 679 S&P futures points. Hats off to Del and all other short-term trend followers for another trading system that is so bad that it's promising.

P.S. - The system went long on 8/29.

Money Flow Update for August 31st

Stocks tried to mount a rally this past week, only to fall back on Friday. We saw a bounce in four-day money flow (pink line above), but note that we once again remained below the zero line, as more dollars were flowing out of Dow stocks than into them. This fits with the recent sector review, which found evidence of sector rotation during the past week--not sustained strength across market sectors. Until we see greater evidence of sector strength and money flows, I will be viewing the recent market bounce as a countertrend rally in a broader bear market.

Saturday, August 30, 2008

Sector Update for August 30th

After rallying from the mid-July lows and then pulling back, stocks made a bid for new highs, with the S&P 500 emini futures turned back from the 1300 area on Friday. Here is how the eight S&P sectors that I track are faring in their Technical Strength (a quantitative measure of trending) and in the percentage of their shares trading above their 50-day moving averages (in parentheses):

MATERIALS: +240 (45%)
INDUSTRIAL: +140 (53%)
ENERGY: -60 (10%)
HEALTH CARE: -140 (69%)
FINANCIAL: +320 (58%)
TECHNOLOGY: -80 (54%)

If we compare these numbers with those from the last sector update, we can see that Financial issues have strengthened, while some of the sectors that had been stronger early in the bounce--Technology, Health Care, and Consumer Staples--have weakened. Once again, this appears to be a picture of sector rotation, rather than a concerted flow of funds into or out of large cap U.S. equities.

Friday, August 29, 2008

The Fundamental Error of Trading Coaches

My last post suggested that we learn trading problems in much the same way that we learn market patterns: through implicit learning, accelerated by novelty and emotional impact. One implication of this view is that the problems that affect trading--from performance anxiety to frustration and impulsivity--are not verbally mediated. Because they are the result of repeated negative experiences in markets, they are conditioned responses that occur without prior thought.

The fundamental error that trading coaches make is to assume that, because such problems interfere with trading discipline, they can be solved by imposing stricter discipline. If the anxieties and frustrations that disrupt decision-making are implicitly encoded, however, they cannot be modified by creating more and different trading rules, by talking oneself into discipline, by discussing discipline with coaches, or by establishing trading plans. All of these are conscious, verbal, explicit attempts to deal with phenomena that are not encoded in conscious, verbal, explicit ways.

This is why, for example, talk therapies tend to be relatively ineffective in dealing with post-traumatic stresses. Suppose a soldier has been traumatized in wartime and now finds his work in civilian life disrupted by memories and images from his time on the battlefield. Would he be helped by reviewing and writing down rules for the workplace? Would he be helped by talking to someone who encouraged him to stay disciplined in his work? Would creating plans for greater productivity even begin to touch the problem? Of course not.

Psychological problems created by repeated negative emotional experience can only be solved through experiential means. That is why conditioning therapies work so well with traumatic stresses; it's also why anxiety can be dealt with more effectively through relaxation and imagery than through talking about one's fears. About 60 years ago, two psychoanalysts, Alexander and French, challenged Freudian orthodoxy by insisting that change occurs through "corrective emotional experiences", not from intellectual insight. That perspective has greatly shaped the approaches to helping known as brief therapies. Sadly, it has yet to permeate coaching practice with traders.


Brief Therapy for Traders

Therapy for the Mentally Well

Thursday, August 28, 2008

Implicit Learning, Single-Trial Learning, and Trading Performance

In my last post, I suggested that much of trading performance hinges on implicit learning and that psychological factors impair performance to the degree that they interfere with access to what we know (but don't necessarily know that we know). A wealth of research has demonstrated that people can learn artificial grammars without being able to verbalize the rules underlying those grammars. Interestingly, patients with total amnesia still retain the ability to perform routine tasks, such as tying shoes. In such cases, people exhibit learning that is not explicit. The hallmark of such learning is that it has not be acquired through the usual means of study, but rather by frequent repetition.

Another line of learning research pertains to single-trial learning. In some cases, repetition does not seem to be needed for learning. Rather, a single exposure can generate lasting learning. This goes against the notion that significant study is required for explicit learning and that significant repetition of patterns is needed for implicit learning. It is significant that typical examples of single-trial learning involve novelty: the more something stands out in our experience, the more likely we are to process it in a lasting way. A good example of this is taste-aversion. I'm in Singapore now, where the durian is a renowned fruit. It has an extremely powerful odor, which some find appealing and others find offensive. A single exposure to the durian for those who find it overpowering will result in a permanent impression: it is unlikely to be forgotten!

Conditioned fears can be similar examples of single-trial learning. We see this most powerfully in post-traumatic stress disorder: a single, highly stressful event can produce lifelong patterns of avoidance, anxiety, and withdrawal. After the trauma of rape, for example, a woman learns completely different associations to men, altering her behavior.

Novelty and the emotional conditioning power of experiences are not all-or-none variables. Some events are more novel or more emotionally impactful than others. These are the ones most likely to stick in memory. Research into the process of psychotherapy finds that the items recalled from sessions--and that affect clients most--are those that are novel and emotionally laden. This is not necessarily single-trial learning, but it *is* accelerated learning.

One factor that seems to separate successful therapists from less successful ones, for example, is their ability to generate novel, emotionally-impactful experiences for their clients. One client is afraid of change and talks about it with others in group therapy; another client has the same fear and is suddenly asked to change by leading the group. Navigating this experience successful shows the person that change need not be threatening. This is much more likely to be internalized than a simple verbal message that says, "Change need not be threatening."

Where traders often fail in their development is that their most novel and emotionally powerful events tend to be negative ones, particularly ones of losing money. This may not generate single-trial learning, but repeated with even modest frequency may generate a kind of implicit learning in which certain kinds of market participation are linked to particular negative outcomes. Like all implicit learning, this is unlikely to be consciously verbalized. Rather, it is evident in the moods and behaviors that suddenly change under particular market conditions.

It makes sense to many people that pattern recognition can be the result of implicit learning, particularly among high-frequency traders. What may not be so clear is that the problems that beset traders may also be the result of an implicit process in which what is learned is accelerated and cemented by high degrees of novelty and emotional impact. If that is the case, explicit discussion with coaches or therapists may not be the most effective way to deal with these problems. Rather, purposeful positive learning under heightened conditions of novelty and emotionality may be most effective. That could help to explain why classical conditioning therapies, such as the exposure methods that I wrote about in Enhancing Trader Performance and that will be a part of my new book, are particularly effective for such problems as traumatic stress and performance anxieties.

If we can learn to structure and accelerate our learning to maximize the depth and speed of knowledge and skill acquisition, this has powerful implications for improving trading performance and dealing with the psychological forces that impede performance.

Wednesday, August 27, 2008

Implicit Learning and the Unattached Mind

In my books, I've described pattern recognition as fundamental to trading, with patterns learned through a process of implicit learning. Implicit learning occurs when we are exposed to multiple examples of patterns and thus become sensitive to the rules or regularities behind those patterns. This process is implicit in that it occurs without conscious calculation. For example, young children can speak in grammatical constructions--having heard so many sentence patterns over time--but they cannot verbalize the rules of proper grammar. Similarly, we know how to act and react in social situations, having experienced them so often, but could never formulate enough rules to capture our sensitivities to other people.

When traders see enough examples of supply and demand, they develop a "feel" for markets that is the result of implicit learning. Invariably, the very short-term traders (scalpers) I have worked with cannot verbalize their rules for entries and exits. They react to what they see, having seen those patterns play out thousands of times in the past.

This is why many experienced daytraders will encourage beginners to not think too much about markets. It's not just anti-intellectualism; they realize that explicit thought can interfere with access to implicitly encoded patterns.

When traders personalize their trading--when they attach their self-esteem to their results--they lose this access to implicit awareness. At those times, it's no longer about market patterns; it's about the trader. Bad trading is not necessarily emotional trading; after all, it's a kind of feeling that alerts traders to what they know. Rather, bad trading begins with attachments: to one's ideas, to trading results, to reputation, or to just being right. Once we are attached to what markets can bring us, we're no longer receptive to what we know implicitly. At that point, we are not mindful of patterns; we're mindlessly reacting to our own needs and desires.

This is where much self-help, coaching advice about trading has it all wrong. It's not about thinking more positively about yourself; it's about removing the self from pure performance skill. We cannot access what we know implicitly when we are locked into mindless patterns of explicit thought. To stay unattached to the outcomes of our actions when we are surrounded by vast risk and reward: this is why trading is such a vexing--and noble--challenge.

Tuesday, August 26, 2008

Catching Up From Asia

* Wonderful City, Wonderful Hosts - Many thanks to Ana Wang and Ray Barros for their gracious welcome to Singapore. You can tell a lot about a country and city by how it maintains and develops its infrastructure, and Singapore is stellar in that regard.

* Nice to See Him Back - Happy to see that Charles Kirk has landed on his feet in Utah and is back to finding excellent market themes in his links.

* More Themes - Trader Mike updates with views on short-selling bounces, guidelines for novices, and more. See the latest from Abnormal Returns, including a look at two-year reversion patterns in markets, performance of small banks, and more.

* Wall St. and Washington - A thoughtful perspective on GSEs from A Dash of Insight.

* Dollar Strength - Chris Perruna notes a buy signal on USD.

* NASDAQ Weakness - Alpha Trends notes support becoming resistance.

* Expecting Bad Things? - Credit spreads are at all-time highs, Bespoke notes.

Reading the Communications and Metacommunications of the Markets

Think about reading a market like reading a person: you'll listen for the communications of the market--what it's doing--but also for the metacommunications: how it's expressing itself. Let's take yesterday's market as an example.

* How did markets in Asia and then Europe open? How might a trader have picked up on overnight underperformance by U.S. stock index futures and weak performance by individual stocks in their pre-opening trade to anticipate weakness during the regular trading day?

* What news came out early in the morning trade? How did stocks respond to the housing news? How could the failure of stocks to rally on the news have helped a trader anticipate a retest of the prior day's low price?

* How did sentiment unfold during the morning trade? How could traders note that institutional participants in the market were dominantly hitting bids across the universe of stocks (negative NYSE TICK) and hitting bids in the S&P 500 futures (negative Market Delta) to identify a weak trading day?

* How was volume behaving during the day? How could traders have noted the increase in volume on downward moves early in the day relative to bounces? What does that tell a trader about the participation of large traders and institutions?

* What were support and resistance areas from the overnight session? The previous day? How did the market behave as it approached these? How can traders anticipate that the failure to break one end of a trading range will lead to efforts to test the other end? How can traders distinguish valid breakouts from such a range from unsuccessful retests by noting sentiment and volume at those price levels?

* What were interest rates doing during the day? How were leading stock sectors, such as financial stocks and consumer cyclicals, behaving? How might that have been linked to the housing news earlier in the day? How could a trader have noted risk-aversion evolving over the day's session from such themes?

* What were market indicators, such as the new highs/lows noted in my indicator review and the money flows noted in my recent post, noting about longer-term market strength? How might a look at such measures help a trader anticipate weakness from day to day?

It's not about imposing your views of what markets *should* be doing; it's about reading what they *are* doing by placing price action into a broader context and reading how that price action is evolving. These are performance skills that are developed over time; they're like the expertise of a physician who learns to piece together signs to arrive at diagnoses. The skill is in the ability to connect new, unfolding information with the information you've already gathered to constantly update your views of market activity. That skill serves you well over any time frame.

Note: The topic of market communications and metacommunications is a major theme of my first book, The Psychology of Trading. I personally find it interesting that traders who lack social skills--who don't read people well--also seem to struggle with markets. I listen carefully to the market views of defensive, abrasive, or socially inept people; they're uncommonly wrong, which makes their opinions useful in unintended ways.

Monday, August 25, 2008

Indicator Update for August 25th

We saw weakness early in the week and a bounce at the end, but stocks overall have fallen from their moderately overbought levels (top chart) and have stalled out in terms of new 65-day highs versus lows (middle chart). Even after Friday's bounce, we only had about 400 stocks making fresh 20-day highs against a similar number of new 20-day lows. By contrast, we had over 2000 new 20-day highs on August 11th. We see how the broad NYSE market has been range bound since the bounce from the mid-July lows (bottom chart; credit to Decision Point), with only tepid strength in the advance-decline line specific to NYSE common stocks.

This fits with the money flow and sector data that I recently posted, indicating that fresh funds have not been flowing into stocks. Nothing has changed from my last update, suggesting that what we've been seeing has been a bounce in a bear market, not the start of a fresh bull leg. I will be watching the indicators closely for possible divergences on any tests of the recent market highs.

Sunday, August 24, 2008

A Look at a Few Market Themes

With increasing globalization, every asset class is related to every other one. This makes it useful for understanding how these relationships shift over time. Many times, movements in one asset class will anticipate movements in others. With an understanding of how these different groups are moving--stocks, bonds, interest rates, and commodities--we can appreciate the themes that are driving markets that day.

Since 2007, on days when the euro (FXE) has risen versus the U.S. dollar, the average price change in the S&P 500 Index (SPY) has been -.15% (107 occasions up, 112 down). When the U.S. dollar has risen versus the euro, the average price change in the S&P 500 Index has been .14% (112 up, 83 down).

On days in which the euro has risen versus the U.S. dollar, the average price change for commodities (DBC) has been .42% (137 occasions up, 82 down). When the dollar has risen versus the euro, the average price change in commodities has been -.22% (91 up, 104 down).

When the euro has risen versus the dollar, the average price change for oil (USO) has been .59% (130 occasions up, 89 down). When the dollar has risen versus the euro, the average price change in oil has been -.32% (88 up, 107 down).

When short-term Treasury notes (SHY) have risen in price (yields falling), the average change in SPY has been -.42% (83 up, 136 down). When Treasury notes have fallen in price (yields rising), the average price change in SPY has been .44% (136 up, 59 down). When short-term notes have risen in price, USO has averaged a gain of .24% (123 up, 96 down). When short-term notes have fallen, USO has averaged a gain of .07% (105 up, 90 down).

These are not permanent relationships that serve as the basis for mechanical trading. Rather, they are correlations that reflect broad themes such as recession concerns, inflation worries, and the like. By understanding how asset classes are moving--and moving relative to each other--we can gain insight into the mindsets of institutional money managers.

Sector Update: A Look Across Two Timeframes

The week ended with a bounce in stocks and a drop in crude oil prices. Here's how the eight S&P 500 sectors that I follow are faring in Technical Strength (trending; a positive figure denotes uptrend and a negative figure downtrend) and in the percentage of component stocks trading above their 50-day moving averages (in parentheses).

MATERIALS: +100 (52%)
INDUSTRIAL: +160 (56%)
ENERGY: +220 (10%)
HEALTH CARE: +200 (88%)
FINANCIAL: -80 (45%)
TECHNOLOGY: +160 (64%)

Note that, for the Technical Strength ratings, I track five highly weighted stocks per sector. The Technical Strength rating for each stock varies from a maximum of +100 (perfect uptrending) to -100 (perfect downtrending), with scores around zero suggesting a non-trending environment. We can see that financial issues are bringing up the rear, while energy shares have gained some traction since last week's summary. Overall, on the short time frame, we're seeing strength among the sectors, but relatively few vigorous uptrends.

On the longer time frame, as reflected in the percentage of stocks trading above their 50-day moving averages, we can see that energy shares remain weak, with the defensive health care and consumer staples issues displaying relative strength. This is the recessionary theme that, so far, seems to be dominating the inflation theme.

Saturday, August 23, 2008

Weekend Reading: Strategies and Perspectives

* Options Strategy - Condor Options shares their strategy for making money from iron condors. See the iron condor links on that page, including trading rules.

* The Learner's Focus - Henry Carstens on what learners should focus on--and it's not winning.

* What the VIX Tells Us - Daily Options Report looks at the message from VIX options. More perspectives on those options from VIX and More.

* A Market Leader - Market Sci examines how semis lead the broad stock market.

* The Value of Being a Maverick - CXO Advisory summarizes research on unique hedge fund strategies.

* Sector Views - A Dash of Insight offers weekly perspectives on sectors and ETFs.

* Trading Rules - Globetrader offers an interesting set, covering just about every facet of trading.

Money Flowing Out of Stocks

Recall that dollar volume flow (aka money flow) represents the dollars flowing into or out of a particular stock or market. We look at each transaction in each stock and multiply the transacted price times the volume of that transaction. If the transaction occurred on an uptick, we add it to a cumulative total; if the transaction occurred on a downtick, we subtract it from the cumulative total. That cumulative total at the end of the day is the money that has been flowing into (if the sum is positive) or out of (if the sum is negative) the stock.

For the money flow for the Dow Jones Industrial Average (chart above), I add the money flow figures for each of the 30 components of the Dow to get an overall sense of dollars flowing into or out of the market. (A four-day moving average of money flow is depicted above). This money flow figure on a daily basis significantly correlates with price change in the Dow since 2008 (.57), but obviously does not completely overlap. I have found divergences between money flow and price to be very helpful in tracking market strength, such as the higher bottoms in March and July preceding rallies and the lower highs in May preceding the market decline.

Note how money flows have been quite weak since the market's pullback from its highs earlier this month. Observe also how flows have remained mostly negative throughout 2008; forays into positive territory have been brief. There is little indication from money flow that investors are aggressively putting fresh funds to work in the stock market. Much of what we're seeing in the market's choppiness appears to be sector rotation and a covering of existing positions.

Friday, August 22, 2008

Forex Trading Expo and Other Upcoming Events

* Forex Trading Expo in Las Vegas - Just a quick reminder that I'll be delivering a keynote address at the conference on Saturday, September 13th at 8:45 AM. My topic will cover some of the themes from my new book and will illustrate how traders can use principles of psychology and coaching to further their performance. I'll be arriving at Las Vegas Friday morning and will be around all that day on the 12th. Do let me know if you'll be at the event; I'd enjoy getting acquainted.

* Change of Schedule - I appreciate the continued interest in the Twitter posts; over 700 traders have subscribed to the Twitter feed and many others read the posts on the blog site (where the last five "tweets" are posted). The posts will be irregular over the next week, as I'll be traveling to Asia to work with traders. I will continue to track market themes and indicators during that time, however, and will be posting to the blog daily.

* Returning Home - I'll be back in Syracuse October 8-10th to teach at my med school department and deliver a grand rounds presentation. If there are any Upstate New York traders who'd like to meet over coffee, by all means get in touch. For anyone interested in my academic writing, many of my recent publications are listed here.

Ideas to Finish Off the Market Week

* Tough Trading - Quantifiable Edges looks at the challenges of trading a choppy market environment; see the commentary also from Afraid to Trade.

* No Decoupling in an Information Age - Excellent perspective from Paul McCulley, contributing to The Big Picture.

* Good Reading - The difficulties of running a hedge fund, sobering views on real estate, and other good updates from Trader Mike. Check out excellent readings from Abnormal Returns, including what $SOX performance means for the market and views on hedge fund performance.

* Questioning the Doubters - John Forman challenges the idea that those who can't trade teach.

* For Those Starting Out - Ana Wang and the Market Success blog offer perspectives for new traders.

* Preparation - Before the N.Y. stock market open, Kirk posts his overview of the day and premarket movers; Mike posts his watchlist.

* Two Excellent Readings - A sobering view from David Rosenberg via John Mauldin. See also Stratfor's take on the current geopolitical equation following Russia's action in Georgia.

* Fun List - Top 100 undiscovered websites, from PC Mag.

* Getting Smaller - The eminis were supposed to address small traders; now we have microlot trading.

Thursday, August 21, 2008

Tracking Fed Sentiment With Short-Term Treasury Yields

One gauge of Fed sentiment are the yields on short-term Treasury bills and notes. These are sensitive to anticipated Fed easing and tightening, providing a way of assessing whether the Fed is more sensitive to recession (and thus needs to ease rates) or whether the Fed is more sensitive to inflation (and thus needs to hike rates).

Above we see a chart of 2-year Treasury Note yields vs. the Dow Jones Industrial Average for 2008. We saw aggressive Fed easing early in the year as stocks moved to lows on the heels of banking problems. Indeed, the Fed Funds rate moved from about 4.25% in January to under 3% in March.

The Fed Funds rate has remained at 2% since May, but 2-year Treasury yields have crept up to over 2.5% since that time--even as the Dow has moved to new lows and the GSEs (FNM and FRE) have been in a tailspin. As bad as the economy looks, in the face of inflation, markets are not expecting any quantitative easing from the Fed.

Short-Term Reversal Patterns Among Global Equity Indexes

A number of traders have commented to me on how choppy the market conditions have become. A strong movement seems under way, and then it just as strongly reverses.

As a way of looking simply at recent trading conditions, I went back to the start of 2007 and investigated three-day returns as a function of the prior three-day returns. Specifically, I looked at what happens when the market is up jointly on a one- and three-day basis (uptrending) and when it is down jointly on a one- and three-day basis (downtrending).

When the S&P 500 Index (SPY) has been up for the past one and three days, the next three days average a loss of -.30% (80 occasions up, 83 down). When SPY has been down for the past one and three days, the next three days average a gain of .22% (82 up, 51 down). If traders wait several days for a trend to assert itself and then jump on board, they are likely to start in the hole.

When we look internationally at the Europe, Australasia, and Far East (EAFE) stocks (EFA), when those are up on a one- and three-day basis, the next three days average a loss of -.27% (76 occasions up, 80 down). When EFA has been down over the last one and three days, the next three days have averaged a gain of .09% (74 up, 65 down).

Finally, when we examine emerging market stocks (EEM), we find that when they are up on a one- and three-day basis, the next three sessions average a loss of -.31% (86 up, 81 down). When EEM has been down over the last one and three days, the next three days have averaged a gain of .69% (79 up, 45 down).

Across the globe, short-term trend following has been hazardous for traders' wealth. Even longer-term traders need to take these reversal patterns into account, if only to size positions and set stops for expected heat.


Fading the Herd

Momentum and Reversal Effects

Wednesday, August 20, 2008

Looking at Relative Strength as a Sentiment Gauge

My last post explained how the sentiment of investors and traders regarding the economy is reflected in the relative performance of various classes of bonds. Here we're looking at the relative performance of stock market sectors as a barometer of sentiment. The relative strength of consumer discretionary shares (XLY) reflects investor confidence in economic strength. Conversely, when there is worry that housing-related concerns and rising prices weigh on consumer spending patterns, investors and traders express this outlook by selling consumer discretionary stocks.

We can see from the chart above that, after a year of steady underperformance relative to the S&P 500 Index (SPY), the consumer discretionary stocks have gone into a relative strength range for 2008. After having recently visited the top of that range, we're now seeing a pullback. This pullback in relative strength for XLY corresponds to a period of economic concern, as also seen in rising Treasury prices (flight to quality) and continued negative news regarding housing.

I will be watching this relationship closely for indications of shifting economic sentiment among traders/investors.

Treasury Bonds, Tax-Exempt Bonds, and Corporate Bonds: Year-to-Date Returns

One way that investors signal their sentiment toward the economy is through their differential interest in various classes of bonds. If there is a flight to safety, we expect Treasury bonds to outperform other bond classes. If investors are risk-seeking, they will gravitate to high-yield bonds. If the outlook is questionable for companies, we will see corporate bonds underperforming Treasuries and tax-exempt bonds.

For this look at year-to-date performance among bond classes, I examined bond funds within the Vanguard family. Here are some of the observations:

1) Treasuries have outperformed - Intermediate-term Treasuries (VFITX) and long-term Treasuries (VUSTX) are the only groups with positive price returns for the year.

2) Intermediate-term has outperformed long-term - Price performance has been better for intermediate-term tax exempt bonds (VWITX) than for long-term tax exempts (VILPX); for intermediate-term investment grade corporate bonds (VFICX) than for long-term investment grade corporate bonds (VWESX).

3) Investment grade has outperformed high yield - Price performance has been better for long-term investment grade corporate bonds (VWESX) than for high-yield corporate bonds (VWEHX); slightly better for insured long-term tax-exempt bonds (VILPX) than for high-yield tax-exempt bonds (VWAHX).

We we see is that, in relative terms, bond investors have been gravitating toward safety (Treasury yields) and away from corporate and high yields. With concerns regarding inflation and perceptions of a maintenance of Fed ease, intermediate-term bonds have outperformed long-term ones.

It is when we see underperformance at the shorter-end of maturities and among Treasuries relative to corporates that we'll know that themes have changed (tighter Fed, more confidence in the economy). I'm also watching the relative performance of tax-exempts to see if they are hurt by continued housing weakness (and questions about municipal defaults) or if they become bond darlings in the face of likely tax hikes from the next administration.

Tuesday, August 19, 2008

Market Strength and Weakness: Tracking New Highs and Lows

Each morning via the Twitter app, I update readers with the number of stocks making fresh 20-day highs and lows across the NYSE, NASDAQ, and ASE. It's a great way of tracking emerging strength and weakness across the broad range of issues.

Note how, after rallying and expanding the new highs minus new lows (chart above), we are now seeing a weak Cumulative NYSE TICK and now new 20-day lows significantly exceed new highs. Weakness across the financial stocks, noted in the last sector update, has been spreading to the broad market, a resumption of a relationship seen during the last bout of market weakness.

Greatness in Life and Trading

A while back I wrote several perspectives on achieving greatness as a trader. There are many traders who want to do well, and many who want to make money. Few of us, however, think of ourselves greatly. That, we're told, is boasting. Pride goeth before the fall. We shouldn't think that we're better than others. No one likes an egotist.

Abraham Maslow, the humanistic psychologist, recounted how he would ask the students in his classes to raise their hands if they expected to achieve greatness in their professions. Inevitably, no hands raised. "If not you, then who?" he asked.

When people perform their work greatly--when they pour themselves into what they love and work at it because that's their enjoyment and they couldn't possibly settle for less--they develop a level of mastery that is uncommon. They begin to experience themselves uncommonly: at a deep level, they feel that they *deserve* success. They know they're special.

When people perform their work routinely--when they do what's expected of them, but never are wholly absorbed in what they're doing--no mastery develops. The common level of effort leads people to experience themselves commonly. They want success, but at that deep level, they don't feel that they've *earned* it. They've done nothing special.

How can people experience themselves greatly if there's no single thing during the day that they undertake in an exemplary way? Good enough *is* good enough, but it's not good enough for greatness. In life as in bodybuilding, if you don't go beyond yourself and set the bar just beyond your comfort level, you never grow and develop. You never become more than who you are.

We internalize greatness by doing things greatly; by making those extra, exemplary efforts that take us to a new place, where we *see* that we are more than we thought we could ever be.

Monday, August 18, 2008

No Bulls In This China Shop and Other Market Ideas

* No Gold Medal For This Market - China's Shanghai A index continues to make new lows, having been cut by more than half in the past year. Whereas we've seen a bounce in U.S. stocks since mid-July, no such strength has been evident among China's shares. Note falling commodities as well; this is not a market that's pricing in growth.

* Austrian Economics Perspective - Ray Barros examines the implications of free-market economics.

* A Grand Slam System - bzbtrader offers a tested system idea that looks like its name.

* Poker and Trading - Eerie similarity among patterns of mistakes chronicled by Don Miller.

* Oil and Equities - Are they really correlated? Market Rewind takes a look. See also his take on gold and the U.S. dollar.

* Changing Market Patterns - Excellent analysis from MarketSci shows how patterns have shifted among Treasuries.

* Options for Rookies - Mark Wolfinger offers his take on the perils of overconfidence.

* Locating Longer-Term Value - Nice Market Profile perspective from Traders Tee Time.

* Tracking Markets - A few tools and perspectives for assessing market direction from My SMP.

Indicator Update for August 18th

Last week's indicator review noted signs of strength in the new high/new low data and particularly in the cumulative NYSE TICK measure. That strength carried over through Monday's session, as we saw an expansion in the number of stocks registering fresh 20- and 65-day highs (second chart down) to the highest levels since the July lows. We continue to register moderately overbought readings in the Cumulative Demand/Supply Index (top chart); this measure tends to top out ahead of price, suggesting that we could see further price gains ahead.

That having been said, we saw some weakness in the Cumulative TICK following Monday's session, indicating a pickup of selling pressure. While NYSE common issues have been trading in a range, with modest advance-decline strength (second chart from bottom), there has been significantly greater strength among small caps (bottom chart). I will be watching the large cap/small cap relationship closely, as weakness in the latter--combined with weakening TICK--would suggest a stalling out of the recent rally. Of particular concern for bears would be an expansion in the number of stocks registering fresh 20-day lows, a figure I track each morning via the Twitter posts.

As mentioned last week, I continue to view this as a rally in a bear market. Money flows suggest that we are not seeing significant commitments of capital to stocks and I remain concerned about the financial stocks, which have been looking stagnant when compared with other sectors. The relative weakness in the cumulative TICK is a new development; I'll be tracking that closely this week.

Sunday, August 17, 2008

A Little Toppiness in the Stock Market?

After peaking on Monday, when we saw 2096 20-day highs and 699 lows, the cumulative NYSE TICK remained under pressure for most of the week. Though the market rose on Friday and new 20-day highs rose from 953 to 1285, we also saw an expansion of 20-day lows (from 499 to 547). I will be closely watching the cumulative TICK and 20-day highs/lows (which I post each AM via Twitter) to see if this represents a shift in market strength.

Stock Market Sectors: A Look at Relative Strength and Weakness

A look at the 40 stocks across eight S&P 500 sectors that I track in a basket shows a continued picture of Technical Strength: 27 are in uptrends, 5 are neutral, and 8 are in downtrends. Of those in downtrends, half are energy issues and another two are financial stocks. Here's how Technical Strength shapes up, sector by sector, followed (in parentheses) by the percentage of stocks within the sector that are trading above their 50-day moving averages:

MATERIALS: +220 (52%)
INDUSTRIAL: +240 (65%)
ENERGY: -280 (3%)
HEALTH CARE: +360 (94%)
FINANCIAL: -140 (55%)
TECHNOLOGY: +220 (76%)

What we can see is that consumer-related issues--particularly the consumer discretionary stocks--have rebounded nicely from their July lows and quite a few sectors are behaving well. The notable laggard is the sector that held up the best during the decline: energy. Lower commodity prices can only be a positive for the consumer; that's a relationship worth tracking going forward.

Meanwhile, the other notable laggard in short-term Technical Strength are the financial shares. Their lagging strength suggests that traders and investors are not yet seeing that the coast is clear with respect to credit-related problems, and that offers a cautionary element to the recent market strength.

Saturday, August 16, 2008

Financial Markets: Harder, Faster, Not Necessarily Better or Stronger

It's been a tricky environment for sector relationships since the July bottom. The U.S. dollar has turned sharply higher, particularly against European currencies; commodities have fallen significantly; U.S. stocks have bounced; and the shares of emerging markets have lagged. You couldn't ask for a more thorough unwinding of themes from earlier in the year. Just in the last few days, we've seen housing stocks break out to multiweek highs (bottom chart), while energy shares languish near their lows (top chart).

Once these themes unwind, they go further than one would expect from a normal correction, shaking out large numbers of participants. Conversely, those who catch the turn in themes can make significant money in a relatively short period. While in London, I read an interesting piece in a financial publication that noted that the sharp down move in gold was initiated and sustained almost entirely in the futures markets by large participants who were trading an algorithmic relationship vis a vis the U.S. dollar. Gold may be classified as a commodity, but it trades as a currency when these algorithms dominate.

All of this makes it difficult to be a classic trend follower or a fundamental, longer-term participant waiting for relatively undervalued assets to return to (or overshoot) their fair value. The normal way of trading those approaches is to wait for markets to confirm your views and then gradually add to positions as the markets move your way. When themes unwind, however, such a money management scheme almost ensures that a trader will be running the greatest risk just as markets reverse.

I'm not sure there's an easy answer to this dilemma. Either you stick to long-term views and prepare yourself for considerable noise and retracement, perhaps by hedging markets that have moved sharply in your favor, or you supplement your longer-term core positions with more active trading to lighten up risk as markets have moved your way and add risk on the large pullbacks. Either way, the investor is prodded to become more of a trader if for no other reason than money management. You can't afford to be scaling into positions just as markets are ready to make violent turns.

For the more active, shorter-term market participant, it's a different challenge. The idea that you are trading just one instrument or asset class is seemingly increasingly outdated in a global financial environment. You may choose to express your market views through a single instrument--an potentially inefficient way of deploying capital in a literal world of alternatives--but to not know how your instrument is affected by others is to run the race for returns with at least one leg tied. Many stock market moves, for instance, are intimately tied to what we're seeing in the U.S. dollar, commodities, and interest rates. Trading without awareness of those relationships leaves traders in the dust when those markets turn, taking stocks with them.

Does this mean you have to become a macro-economic fundamental trader? I don't think so. It does mean, however, that the playing field has become wider and faster as increasing capital chases a finite number of markets and market relationships. The speed with which you manage positions and the breadth of markets you track change as a result. Many failures that I'm seeing and reading about among traders are the result of experienced traders trading new markets in old ways. The traders that are thriving are broad of vision, fleet afoot; they've adapted to changed realities.

It all reminds me of changes in communication technology. Back in the day, the letter sent by parcel post was a primary means of communication. With the advent of the telephone, communication became more immediate. Now, some people continue to rely on telephones. Others ground their communication in email. Still others are instant messaging and text messaging. Yet others are joining multiple communities and aggregating instant communications across them. Harder, faster, better, stronger? I'm not sure of all those Darwinian consequences of shifting markets, but recent markets *are* different: not only in their extent of change, but also in their rate. And they leave few countries for old men.

Friday, August 15, 2008

Resources and Readings for Friday

* Market Profile Webinar - I've always liked Jim Dalton's work on Market Profile; it offers a very useful framework for thinking about markets. Nice to see that he is doing a webinar on Saturday to introduce traders to the Profile and the trader education that he and Terry Liberman offer.

* Great Reading - Trader Mike updates with a look at building better trading plans, the value of taking the long view, and more. Abnormal Returns offers perspectives on BRIC performance, recession vs. inflation, and more. Kirk keeps up his morning updates during the long move to Utah; impressive!

* Know Your Strengths - Michael Osacky takes a look at a day in the life of a prop trader.

* Integrating Market Perspectives - Great opening post from Traders Tee Time that synthesizes perspectives on the market. We tend to spend a lot of time on technical *analysis*; less on synthesis.

* Great Educational Resource - I like the Wikinvest site and its overview of various topics related to the market and the economy. Here's the view on the housing market.

* Morning Preparation - SMB recounts setting up for a trade in the AM.

* Herd Behavior - Thanks to an alert reader for this link to a post on how bubbles form in the market.

* New Sites - If you offer or know of an unheralded blog site that offers quality, free educational material to traders, please bring to my attention with a comment to this post or an email to me and I'll be happy to link. I enjoy uncovering and bringing attention to good work.

Thursday, August 14, 2008

More Thoughts on Mindful and Mindless Trading

I was pleased to see that my recent post offering thoughts on trading stress and emotions generated a bit of controversy. I appreciate comments to the posts, including those that push back and stimulate a little more consideration of the issues involved.

The point that generated some discussion was my example of the currency trader who blindly entered a position in euro/U.S. dollar without any awareness that a key piece of economic data was coming out in Europe. It was a known market mover, and the trader was blown out of his position with a significant loss. My comment was that "this represents trading at its worst."

Here's why:

It's a question of awareness. Had the trader *known* about the report, known the expected volatility around the news, and placed his trade accordingly--sizing it to reflect the increased volatility and placing stops around the expected noise around the news--this could have been a fine trade. If you think, for instance, that the fundmentals support a weaker euro relative to the dollar because of bearish economic fundamentals in Europe and if you see technical reasons to be long U.S. dollar, then placing a core trade ahead of the news in anticipation that the news may be a catalyst for your trade could be *excellent* trading.

The key is that the trade is planned, with full awareness of what's happening in Europe and the U.S. and with conscious reasons for being in the market. The stop-loss point would reflect that point at which you decide that: a) the news is not a catalyst; b) the news is so dollar-bearish that the fundamentals have changed; or c) the move is sufficiently adverse that the technical picture has changed.

But, no, that's not what the trader in my example did.

He had no more reason for being in the trade in the first place than a simple, superficial chart pattern. The pattern involved short-term market strength, but was neither confirmed by any longer-term, contextual technical analysis or by any fundamental view. Was there overall bullish demand for the dollar or overall bearish supply overhanging the euro? The trader had no clue, never looked at other currency crosses. It was simply a shape on a chart, and it was never tested for any kind of edge. That was the first shortcoming.

The second shortcoming of the trade was that the stop was placed in ignorance of the news report and the increased volume/volatility of that market around the news. The same was true of position-sizing: the trader had large size on the position, in ignorance of the report. This greatly increased the odds that: a) the trade would get stopped out on normal, expectable noise around the trade; and b) the trader would lose a meaningful sum because of the trade sizing.

In short, it wasn't the fact that the trader was in the market before a news event that constituted bad trading. It was the fact that the trade was placed mindlessly, without thought and awareness, without any demonstrable edge, and without any realistic planning. "Here's a good shape on the chart, let's go for it," was the sum and substance of the trade idea. That's why it was "trading at its worst."

Too often, such mindless trading is justified by having a "feel" for the markets. Intuition is important in trading and can reflect a sophisticated pattern recognition that comes from years of experience. But even an intuitive currency trader (and I know several good ones) understands his/her markets and doesn't place large-size trades with relatively close stops ahead of market-moving news. Very often, intuition will prompt an idea; analysis will confirm it; and planning will guide the execution. There's no conflict between being discretionary/intuitive and being planned/thoughtful once you distinguish the genesis of an idea from its validation and execution.

Thanks for the opportunity to clarify an important issue. For another interesting debate on an important topic, check out the Daily Speculations site's recent back-and-forth about stop-losses and whether or not they add value. My short take on the question: they do add value, especially when they are conceptually based (i.e., based on considerations that the reasons underlying the trade have changed, not just based on a particular price/loss getting triggered) and when they are placed in the context of expected market volatility and proper position sizing.

Wednesday, August 13, 2008

A Dozen Thoughts on Trading Stress and Emotion

* Everyone has a stop-loss level: For some, it's a price; for others, it's a pain threshold.

* It's not stress and emotion that get in the way of trading; it's the stress and emotion that results when trading becomes personal: about you, rather than about supply and demand.

* The measure of a trader is how hard he or she works when markets are closed.

* Much bad trading is hormonal: too much testosterone, too little.

* When traders don't track their results, it's because they don't want to know them.

* The best traders have a passion for markets; the worst have a passion for trading.

* When it comes to market history, there are only two choices: trading with awareness of it, trading in ignorance of it.

* I recently encountered a daytrader of currencies who was trading EUR/USD with high leverage. News came out in Europe and the market blew through the trader's mental stop-loss. The trader had no idea that an economic report was due at that time; he was only looking at chart patterns. That represents trading at its worst.

* Losing a job or not wanting a 9-to-5 one is not the right reason to pursue trading.

* Markets tend to move in the direction of the greatest number of stops.

* The best traders are not relaxed *and* they are not anxious. They are alert.

* Deep down, traders who don't prepare don't feel they deserve to win. We always gravitate toward our just desserts.

Tuesday, August 12, 2008

Catching the Market's Themes

I once again want to thank those who have recently emailed regarding the Twitter posts. These are my way of trying to alert readers to important market themes and developments, so that you can make sense of the coming day's action.

Recently we've seen a number of interwoven themes: strong U.S. stocks and U.S. dollar; weaker stocks and currencies overseas; and falling commodity prices. All of these are reflections of the relative concerns investors and traders are placing on global recession relative to global inflation.

With ETFs, it's easier than ever to track movements in the U.S. dollar (UUP), commodities (DBC), oil (USO), gold (GLD), overseas stocks (EFA, EEM), and Treasury instruments (SHY, TLT). A review of those charts, along with the charts for stock sector ETFs, provides an excellent view of the rise and fall of various themes.

When psychologists listen to clients, they listen for themes: broad issues that connect the dots of various life events. A client may talk about relationship problems and then suddenly switch gears and discuss trading challenges. On the surface, it looks like a total change of topic. But the psychologist is aware of themes and knows that the real issue is dealing with potential loss.

Similarly, these may look like different markets, but in a world of globalization and instant information flows, they respond to the same themes: inflation worries, recession concerns, risk-seeking, risk-aversion, central bank shifts in outlook (and eventually rates), etc. Once you know those themes, you can see one market move and anticipate movements in other, related ones. That is helpful whether you're a daytrader, swing trader, or longer-term investor.


Trading by Intermarket Themes

Monday, August 11, 2008

Preparing for Trading Disasters

I thought this New York Times story on the topic of how people are unprepared for crises and emergencies has particular relevance to trading.

How many of us have "disaster plans" that we've actually walked ourselves through for the following situations:

1) Outlier moves in the market against our positions;

2) Series of losing days/weeks/months leading to unexpected outlier drawdowns;

3) Failure of equipment (online connection, computer) or inability to reach a broker when a position is moving against us;

4) Incapacitation when we have positions in markets;

5) Financial failures of our banks or brokers, tying up our money unexpectedly.

The interesting message from the Times article is that people are most likely to act upon their plans if they've actively rehearsed them. I suspect this is as true for minor disasters--such as a market blowing through your mental stop-loss point--as for large ones.

Indicator Review for August 11th

Last week's indicator review emphasized the range bound nature of the stock market, with more evidence of sector rotation than a fresh influx of funds being put to work. We broke higher late in the week on the heels of a strong U.S. dollar; now we need to see if this is a legitimate upside breakout. We remain moderately overbought in the Cumulative Demand/Supply Index (top chart), but have been making higher price highs with each bounce in the DSI--a pattern common after a strong upthrust from a very oversold market.

New highs/lows have stalled out for a while now (middle chart), but I did notice a pickup in fresh 20-day highs on Friday to 1385. An expansion above the level of 1742 recorded on 7/23 would be bullish for the market. Note that the Cumulative NYSE TICK has been making fresh highs during the past week, also a development in favor of the bulls.

The fly in the ointment is the continued lag in money flows. As long as we fail to see new funds coming into equities, the current rally looks more like a bear market bounce than the start of a fresh bull market leg. The financial shares have been a good bellwether for risk-aversion and risk-seeking in the broader stock market; I'll be tracking them closely.

Meanwhile, among the 40 stocks in my basket that are equally divided among eight S&P 500 sectors, we now see 24 in uptrends, 7 neutral, and 9 in downtrends--a decidedly bullish development, suggesting that many stocks broke to the upside with the late week rally. Interestingly, five of the nine stocks in downtrends are energy issues; the rest of the market sectors are looking bullish-to-neutral.

In sum, I retain my doubts that a bull market has begun, but the market's late week resilience, expansion of 20-day highs, and rising NYSE TICK line all suggest that we could see further movement to the upside. Global weakness has pressured commodities and aided the U.S. dollar: these dynamics are worth following as we move forward, as they may be catalysts for further share gains.

Sunday, August 10, 2008

How Do I Avoid Overtrading?

A trader recently posed this question in a comment to a blog post: How can I avoid overtrading?

First, let's get definitions straight:

Overtrading typically has two connotations: trading size that is too large for one's portfolio (i.e., taking too much risk per trade) and trading too often (i.e., when an objective edge for the trade is not present).

Keeping metrics on your trading will tell you if your size is too large (you will have large P/L swings and drawdowns and large outlier gains and losses) and/or if you're trading too much (you will have more losing trades than winners and will tend to lose more on days in which you're trading more).

The antidote to overtrading--in both its forms--is rule-governance. Trading rules are what guide our position sizing and risk-taking, and they are what put us into markets and keep us out.

Many times, traders do not formulate their rules explicitly: they do not have clear and concrete formulas for position sizing, and they do not have hard-and-fast rules for when to enter and exit. It is a curious, but surprisingly common error to assume that discretionary trading means trading without rules. Discretion means that we employ real-time judgment in entering, exiting, and managing positions. Rules can guide that discretion, just as rules and plans may guide a quarterback who calls plays in a huddle and changes those calls at the line of scrimmage.

We avoid overtrading in position-sizing by limiting the losses on any single trade to a small, fixed fraction of portfolio value. We avoid overtrading in the number of positions we enter by limiting trades to those setups (entry criteria) that have demonstrated their profitability. For example, I will not take a short position in a market in which the cumulative NYSE TICK is making new highs; I won't trade at all if volume falls below threshold levels. These rules and guidelines keep us out of unprofitable situations, and they help us concentrate our capital in areas of greatest opportunity.

It is through repetition that rules turn into habits. This is a topic I'll be taking up in the new book. To avoid overtrading, you lay out your trading rules and then you rehearse and follow those rules so consistently that they become automatic. You can't expect to follow a discipline that you haven't clearly defined in the first place.


Understanding Lapses in Trader Discipline

Why Traders Lose Discipline

Saturday, August 09, 2008

Some Good Weekend Reading

* All About Trading: Check out this page of links from the Informed Trades site; both trading techniques and trading psychology material--a nice collection of readings.

* Going Retro: Here's the best of Charles Kirk's posts from 2007; here's an oldie-but-goodie of mine with links on the topic of how to coach yourself for success.

* Politics and the Markets: Excellent collection of posts from CXO Advisory, including a look at market phases during the Presidential cycle. See also their summaries of research regarding momentum trading/investing.

Valuable Trading Lessons From a Prop Firm

Hats off to Larry Fisher and Reid Valfer, co-founders of TradingRM, a proprietary trading firm in Chicago who have just launched their own blog.

What makes this blog unique is that the posts consist of the same messages they send out to their developing traders during the day as part of their mentorship. The blog thus enables readers to benefit from the same real-world lessons that they might be getting inside a trading firm. For instance, check out their insights into yesterday's upward trend, his take on what traders need to do to prepare for the open; and his way of adjusting trading for the quality of each market day.

I invited Larry to contribute to my upcoming book because TradingRM has an unusual philosophy of mentorship. Everyone calls out their trades to everyone else. This promotes accountability, but it also stimulates learning, because the young traders are seeing how the experienced people are taking positions, stepping back from markets, etc.

There's a saying in medical education: see one, do one, teach one. You learn, first from observation; then from doing; then from teaching others. Larry and Reid have carried that philosophy forward to their mentorship of young traders, and I applaud that.

Oh yes, by the way, what is the cost for their trading education? Zero. You put in your time and effort, you trade very small until you earn size, and the firm earns a percentage of your returns. *That* is how prop firms operate when their interests are fully aligned with those of traders.

Friday, August 08, 2008

Tracking Themes Among Asset Classes With Rolling Correlations

One way I like to track themes in financial markets is by tracking rolling correlations. These can be correlations among stock sectors/indexes or between equities and other asset classes.

Here are a few correlations of daily returns since June that caught my eye:

S&P 500 Index (SPY) and rising U.S. Dollar (UUP): .58
Rising U.S. Dollar (UUP) and Commodities (DBC): -.53
S&P 500 Index (SPY) and long-term Treasury bond prices (TLT): -.56

When we've seen a rising dollar and weak commodities, that's been associated with rising stock market prices (which we clearly saw today). When we've seen money pour into Treasury instruments (a common flight to safety trade), that's been associated with falling stock market prices.

As traders and portfolio managers place their bets on global inflation and recession, we can track their views in the movements of these and other instruments and asset classes. These movements can be tracked in the waxing and waning of rolling correlations. More on this theme to come.

A Look at the Advance-Decline Line and Other Market Perspectives

Going Nowhere - One feature I like in the Decision Point site is their tracking of common stocks only among the NYSE issues, eliminating preferred shares, closed-end funds, ETFs, and other issues that might not truly reflect what equities are doing. As the above chart shows, after a healthy bounce off the July lows, the market has remained range bound and the advance-decline line for NYSE common shares has gone nowhere. Given the weak new high/new low figures, which I just updated in my Twitter post, and the weak money flows, it's tough to be a bull here.

More on Pairs Trading - I recently posted on this topic; see an excellent post from Market Rewind on pairs trading within the energy complex.

Tracking the Markets - Trader Mike is following the U.S. dollar strength and oil weakness; The Big Picture notes that the media has been wrong on the issue of housing.

Thanks - To those who wrote regarding the midday Twitter updates that caught some market themes and divergences. This month I'm in NY, UK, and Asia to work with traders, so my screen time will be limited, but I hope to include more of these kinds of real-time market observations in the future. The last five updates are on the blog under "Twitter Trader".

Tracking Global Markets - The ProRealTime web-based charting service looks interesting, with free end-of-day coverage.

Tracking the News - StreetRead looks like an interesting aggregation of news specific to individual stocks and media sources.

Thursday, August 07, 2008

Seeing the Whole Field: More on Divergences and Breakout Trades

We recently took a look at the significance of divergences among sectors; an earlier post chronicled a longer-term divergence in the new high/low data. Early today, we saw a similar sector divergence play out: as the ES futures made new highs for the regular trading day (top chart), we remained in a solid downtrend among banking issues (middle chart) and could not make new highs in the housing sector (bottom chart). The highs around 12:00 Noon CT also were not matched by the energy and consumer staples sectors. Sure enough, we retraced the day's range in ES and then broke through the lower end of the range, as financial and housing shares led the way down.

The good trader, like the good quarterback, has vision for the entire playing field.

Divergences and Pairs Trading

Here we see three charts from yesterday's trade: the Standard and Poor's 500 Index (SPY; top chart); the Financial sector ETF (XLF; middle chart); and the Housing sector index ($HGX; bottom chart). Note that, as the S&P 500 Index moved to new highs in the afternoon, the financial and housing stocks failed to follow. This is what's known as a divergence--a discrepancy in path between an index and its component(s)--and it was something I noted in the day's Twitter comments. When you see multiple sectors fail to follow an index higher or lower, it means that a relatively small proportion of high cap stocks are accounting for a good amount of the move in the index. Very often, those narrow moves are not sustainable and are prone to reversal.

But let's dig a little deeper and ask what it *means* when we have divergences such as the above. Traders--particularly those outside institutional settings--tend to think directionally: they trade SPY, XLF, etc. outright for a move either up or down. That's great when the market is moving directionally; not so profitable when the market chops around.

An alternate trade is a relational one, known as a pairs trade, in which we buy one stock, sector, or index and sell another one against it. Instead of trading the market directionally, we're trading the relationship between two assets directionally: we're trading the relative strength of one stock/sector versus another.

The pairs trade, properly constructed, can be a powerful tool precisely because it is not dependent on market trending. In other words, the S&P 500 Index could move higher or lower, but if Financial stocks underperform the index, I'll still make money if I'm short XLF and long SPY. When markets trade in ranges, they are doing so precisely because large traders and investors are reallocating capital among sectors. This environment of sector rotation is perfect for pairs trading, if you can catch the reallocation shifts early.

So now back to divergences. When we see a new high in SPY and Financial and Housing stocks failing to confirm, what we're really seeing is a decline in the pairs relationship of XLF/SPY and $HGX/SPY. Think of that relationship as a single stock that moves each minute: as SPY is moving to high ground and XLF is not following, we are trending lower in XLF/SPY.

The divergence can be an important sign of directional shift in the broad index (which is why I Twittered the observation yesterday), but it can also signal an emerging pairs trend. If you can catch those pairs trends early, you can run a more diversified book--and you can expose yourself to greater opportunity in non-trending market conditions.

Wednesday, August 06, 2008

Higher Prices, But So Far Not More New Highs

If you click on the daily chart of the S&P 500 Index (SPY) above, you'll see in blue the number of stocks across the NYSE, NASDAQ, and ASE that registered fresh 20-day highs at the current and previous market peaks. Mad props to the Barchart site for the new high data.

Although we touched a new rebound price high in SPY and in the NASDAQ 100 Index--as noted in this afternoon's Twitter post--we have not seen an expansion in the number of stocks making fresh 20-day highs.

I'll need to see an expansion of new highs in order to consider the current move a solid breakout candidate. And, while we're at it, I'd also be encouraged if we could see the financial and housing stocks participate in the new highs.