Saturday, April 11, 2009

Trading by Themes

One of the most important calls an active trader can make is the dominant theme of the day's trade. Sometimes a news or earnings report will set the theme of the day, as in the case of Friday's market, when bullish earnings from WFC sparked a major rally in the financial sector. Other times, we will see themes carry over from trade in Asia and/or Europe. Seeing which asset classes, stocks, and sectors are strong and weak in pre-opening trading, for example, can provide useful clues regarding themes. For instance, we may see strength in oil and other commodities overseas, and that will carry over to bullish trading among materials and energy shares. ETF price performance and volume can provide especially useful clues as to market themes.

During the past year, an especially important theme has been whether markets are bullish or bearish on risky assets. For example, a market that is buying Treasuries, selling speculative grade debt, and selling stocks is exhibiting relative risk aversion: a preference for assets perceived as safer. In such markets, we'll tend to see emerging market equities underperforming U.S. stocks, and we'll tend to see defensive sectors (consumer staples, health care) outperform more growth-oriented sectors (small caps, technology, consumer discretionary).

When institutional traders and investors are bullish on risky assets, they will tend to buy more speculative currencies and stock sectors and commodities tied to economic growth. They'll also be likely to sell safe Treasuries and buy more speculative debt.

Traders who become caught up in the tick by tick action of their particular stocks or indexes often miss these themes--and shifts in themes during the day. Much of the financial world is trading globally, following intermarket relationships and macro themes. Knowing those themes can help you anticipate ways that your particular stocks, ETFs, and indexes are likely to trade during the day.