Friday, January 23, 2009

When Is There Significant Buying and Selling in the Stock Market?

You just sold the S&P emini futures, the market starts to go your way, and then it spikes upward and returns to your entry level. Is this fresh, significant buying that should lead you to scratch your position, or is it mere short covering that has little import for the general market trend?

One way of addressing this important question is with the NYSE TICK. Recall that the TICK is the number of NYSE issues trading on upticks minus the number trading on downticks. Another way of viewing this is that the TICK assesses the number of stocks trading at their offer price minus the number trading at their bid. When buyers are more aggressive, they will "pay up" to get into the market and the trade will transact when the instrument is trading at its offer price. Conversely, when sellers are desperate to bail out of stocks, they'll "hit the bid" and the instrument will transact at the lower, bid price.

NYSE TICK is helpful, because it is a real time gauge of very short-term sentiment across the broad list of stocks. When we create a cumulative line for the one-minute TICK values during the day, we find that uptrending markets tend to occur during uptrending cumulative TICK lines and vice versa. Gauging the direction of the cumulative TICK as the day unfolds is very helpful in identifying market trends.

Now suppose we have a TICK value that exceeds +1000 or plunges below -1000. That not only means that 1000 more stocks are trading at offer or bid; it means that they are doing so at the same time. This can only occur when institutions execute basket trades to buy or sell large segments of the stock market. An individual trader--or even a large trader at a prop house--cannot make 1000 stocks trade simultaneously at their bid or offer prices. It takes real buying or selling power to do that.

One way of defining significant levels of buying or selling is to look at the distribution of one minute high and low values for TICK and examine the standard deviation of these. Going back to the beginning of October, we find that the average one-minute high value for TICK is around +250 and the average one-minute low value is around -250. The standard deviation is approximately 450. That tells us that, roughly, two-thirds of all TICK values will fall between +700 and -700. About 95% of all TICK values will fall between +1040 and -1040, making values greater than +1000 or less than -1000 rare indeed.

If I've sold the market and, after going my way a bit, it bounces higher on +500 TICK, that by itself will not take me out of the trade. In a purely statistical sense, that is not significant buying. The same is true if I am long the market and we retrace on -500 TICK. It's when we get above +700 or below -700 that I look much more closely at the trade. It's when you start to get a cluster of such readings that you realize that the Cumulative TICK is shifting and that you need to think about an exit. And, of course, if the TICK moves toward or above +1000 or toward or below -1000 when you're short or long, that is very significant sentiment against your position and warrants genuine caution.

Less important than individual TICK readings is the distribution of TICK values over time. In the chart above, we see the first hour of trade for Thursday's market. The center blue horizontal line is placed at zero, and we have horizontal lines at the one- and two standard deviation points to the upside and downside. Click on the chart for a good view and take a look at whether the bars, over time, are distributed more above the zero line or below. Further look at whether more bars exceed the +1 and +2 standard deviation levels or the -1 and -2 levels. Clearly, the net distribution of TICK is skewed negatively, and we're seeing more bouts of significant selling than buying. That keeps me on the seller's side until I see clear evidence of a shift in the distribution of TICK values.

Knowing what is significant and what is not can be the difference between staying in a good trade and getting whipped out of it. Reference lines such as the ones plotted above can help you keep your eye on the true sentiment of the market. For more background on trading with NYSE TICK, the links below should get you up to speed.