Indicator Update for January 31st

Last week's indicator review found a market in oversold condition, but cautioned against catching falling knives given the steady weakness. That proved to be worthwhile counsel, as the weak market became weaker during this past week.

We can see from the Technical Strength (a proprietary short-term measure of trending) of the eight S&P 500 sectors that I track weekly (top chart) that the sectors remain in bearish mode, with the exception of Industrial stocks, which are in neutral territory. Other than the Industrial shares, the sectors that are relatively stronger are the more defensive Consumer Staples and Health Care names. Energy and raw Materials stocks remain weak, given commodity weakness, and Technology shares were notably weak. Financial stocks showed the greatest gain over the week, albeit from a very bearish trend position the week prior.

My Cumulative Demand/Supply Index (second chart from top), which tracks the momentum of stocks across the NYSE, NASDAQ, and ASE, is in oversold territory that, in the past, has led to significant market bounces. Such bounces tend to last more than one day, so at the first indication of Demand/Supply strength, I would be tempted to play the long side. In 2008, this indicator stayed oversold for an extended period, even as the market drove lower; that is reason once again to not catch falling knives and wait for Demand strength to signal sustainable buying interest.

We can also see that 20-day new highs minus lows (second chart from bottom) have remained skewed to the negative side for the past week. Interestingly, 65-day lows expanded throughout the week. Normally, an elevated number of new lows will bring in buying interest, if only because of short covering. That has not happened to this point, again warranting caution about those falling knives.

Finally, the Decision Point chart of the advance/decline line for NYSE common stocks (bottom chart) shows continued weakness throughout the past week. I am watching to see if the October lows can hold in the A/D line, as well as in the NYSE Composite Index. Thus far, we're not seeing any bottoming process in the advance/decline numbers.

All in all, this is clearly more than a short-term correction, as we've taken out lows from November and December and see short-term weakness followed by continued weakness. Intermarket themes among currencies and commodities have tracked the bearish stock market action; I need to see a shift in those themes before taking the long side for anything more than an intraday bounce.
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Preparation, Performance, and the Look of Success

Thanks to Bella of SMB Trading for this link that illustrates what lies behind greatness. We see a young basketball player like JaShaun and we think of inborn talent. What we don't see is the many hours, days, weeks, months, and years of preparation needed to hone that talent into skill.

Each weekend I spend several hours scouring my indicators, reading the best blog posts and articles I can find, and reviewing my trading performance from the past week.

Out of that comes a tentative game plan: an idea of where I think markets are headed, an idea of alternate scenarios, specific plans for trading those scenarios, and concrete goals for improving my trading over the past week.

Week after week, that preparation adds up. It builds a sense of mastery and fuels confidence. There is nothing that beats the feeling of stepping into the arena and knowing that you *deserve* to win because you are prepared.

I used to have that feeling in college. I'd spend all-nighters studying for tests, while others slept or partied. I'd be exhausted sitting for the test, but it didn't matter. Sheer adrenaline--and the knowledge that I knew the material cold--pushed me through the exam. I knew that if I didn't have a 3.5 cumulative average, I wasn't going to clinical psychology grad school. That pushed me, and I pushed harder as my college career progressed. My GPA in my last two years was just shy of 3.9.

When I walked into the exam room, I *knew* I had a good shot to ace the test. It was a great feeling. Later, I would have that feeling as a psychologist. As a new professional, I would ask for the toughest emergency cases--the suicidal clients, the difficult to treat problems--because I knew I had a preparation edge. I wanted the ball in my hands when the clock was ticking down.

It's not overconfidence, and it's not cockiness. It's being prepared and knowing that deep in your being. It's the greatest feeling in the world, and it's the one that I see in the eyes of so many great, great traders.

More:

Greatness in Life and Trading

Achieving Trading Greatness

Self-Efficacy and Trading

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Weekend News and Market Views

* When traders lose confidence: Part One and Part Two;

* Profiting from inertia in markets;

* Making good trading decisions when under stress;

* Paul Volker on reforming the financial system;

* Thanks to a sharp reader for this article on how more wins leads to more losing;

* The case for taking a trading sabbatical;

* Interesting take on traders and entrepreneurs;

* Views on market weakness and other good reading;

* Recovery may be long in coming and challenges faced by Greece;

* China in the lead for clean energy;

* Concern over China ETFs;

* The foreclosure market and fake home ownership;

* What could drive foreclosures higher and weigh on housing market.

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A Technique for Defusing Trading Stress and Anxiety

My recent post on moving beyond fear and anxiety emphasized the difference between experiencing threat and allowing that threat to color decision-making.

A very simple technique that I use in my own trading for containing stress consists of several steps:

1) Observing the Stress - Openly acknowledge to yourself that you're feeling fear and threat. The idea is to become the observer of your emotions, not the person who is lost in those feelings;

2) Reducing the Stress - Take a few deep breaths and focus your attention. It is difficult to lose control and perspective if you're under control physically and cognitively;

3) Identifying Why You're Stressed - Locate the source of your threat. In my case recently, for example, a trade had gone my way and then stalled. I was afraid that we'd see a sharp reversal that would eliminate my profits in the trade;

4) Questioning the Source of Stress - I double down on my market observations. Is anything happening in the market right here and now to lead me to abandon my position? I look at correlated indexes, sectors, and asset classes; I look at buying and selling sentiment. If the picture has not substantively changed, I tell myself that the rationale for the trade has not changed;

5) Facing the Threat - I actively tell myself that I can live with the scenario of losing my paper profits. It will be annoying, but not catastrophic. I also remind myself that I will feel much worse abandoning a good idea for no reason other than fear than incurring a stop at breakeven due to a rogue market move.

In other words, my technique involves distancing from my feelings, establishing control, and reworking my self-talk to regain perspective. This kind of self-talk is really the coach in me talking to the trader in me. When the technique works particularly well, I can even use my anxiety to remind myself that others must be feeling the same way--and add to my position at exactly the time I'm tempted to bail out. That transforms fear into opportunity.

More:

Changing Your Self-Talk by Talking to Yourself

Self-Talk is Destiny

More on Handling Trading Stress

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Moving Beyond Fear and Anxiety

I had the pleasure of running into Dr. Doug Hirschhorn this past week, and he was kind enough to pass along a copy of his new book "8 Ways to Great".

The book is subtitled "Peak Performance on the Job and in Your Life" and offers worthwhile insights that go beyond trading.

From the book's section on keeping your cool:

"Everyone gets scared, even the best of the best. In fact, sometimes being scared is the most rational reaction to a given situation. There's no shame in that. It's when people give in to those feelings that they get into trouble. As I frequently say to my clients, 'Feeling fear is okay so long as you don't act afraid or make a decision because you are afraid.'" (p. 80).

The distinction is important. It is not a problem to feel fear; the problem occurs when we allow fear to drive decision-making. Success is not banishing anxiety, but learning to tolerate and contain it. Indeed, one can even learn from one's discomfort, as I recently highlighted in a post. It is that resilience that enables traders to overcome loss and find opportunity from the losing.

Ironically, it is in embracing one's fears that we learn from them--and prevent them from reactively driving our decisions.

More:

Understanding Anxiety

The Challenge of Performance Anxiety

Techniques for Overcoming Anxiety

Secondary Anxiety and Trading

Trading Anxiety and Risk Management

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Should Proprietary Trading Firms Charge for Their Education?

I notice that several readers have commented upon my recent post that quoted SMB Trading's Bella. The comments concerned the fees that SMB (and other firms) charge for their training programs. This, to some, smacks of a scam.

So allow me to wade into a contentious area, one that has been hotly debated on some online forums:

I think the model in which prop firms charge a training fee before a trader can join the firm is fraught with potential problems. How it is implemented makes all the difference in the world.

As I note in this post and in this one, very high education fees may be a sign that this is actually the way that the "prop firm" is making its money. When this is the case, the firm will have five-figure fees as a rule and will allocate very, very small trading size to traders. The firm will also charge traders high commission rates. If the trader hits a certain loss limit (and the vast majority will because of the small size and high commissions), the trader will either lose their "job" or will be asked to advance more capital.

This, in my opinion, is an outright scam. There *is* no prop firm, only the illusion of one to lure newbie traders into educational programs. Very often, these efforts at education are quite thin, consisting of nothing more than the kind of garden-variety technical analysis you could pick up in any trading text. There are no skills building efforts through simulators, no substantive mentorship. Often, these watered down programs are offered to traders who trade remotely (i.e., from their home locations). That's actually a warning sign: true prop firms value teamwork, hands-on mentorship, and trading technology; it's tough to sustain those when traders are remote.

Another warning sign, ironically, is that the less-than-legitimate firms will feature unusually high payout ratios, allowing traders to keep almost all of their profits. That means that the firm is not counting on trader profitability for their own profits, and it usually means that the firm is not firmly committed to trader profits. Rather, fees and commissions are what the firm is after. The trader is a customer of such a firm, not an employee.

If you want to join a prop firm, you should be able to see the trading floor, interact with the traders, and see first hand who is making their living from their trading. If the kimono isn't open to that degree, beware.

OK, that having been said, let me take the other side of the argument:

I have no problem with firms charging a fair fee for their educational efforts. This is particularly the case when the firm is offering the education as a stand-alone offering. There are very few prop firms that make their training available to outside traders. For instance, it's very difficult to find credible educational programs on reading order flow (tape reading). The program at SMB is available at a fee for those who aren't affiliated with the firm. Traders can assess the fee and the content of the program and decide if it's a fair deal.

As a rule, if the educational offerings have a structured curriculum, opportunities for skills building (and not just information), and last for weeks or months (not just days), they have the potential to move traders' learning curves forward. I am not a fan of brief training programs, as they simply lack the time to develop skills.

When a trader is required to go through the educational program (at a fee) to join the firm as a prop trader, it's important to view the firm as two separate companies. The first company is the education provider; the second is the trading firm. It is possible that you could like the company for its education, but not for its actual trading--or vice versa. By separating out the education from the prop opportunity, you can evaluate each on its own merits.

Personally, I would view the opportunity to trade for the firm as an out-of-the- money call option. In other words, if they like me and I like them and I do well in the program, I may get a large payoff by joining the firm. But I'm going to go into the education with the idea that the option may expire worthless. I might not like the firm, they might not like me, and my trading style ultimately may not fit theirs.

Once I have that mindset, I can ask myself: would I pay the fee for the education, even if it doesn't lead to an offer to join the firm? If the answer is no, I say move on. If the answer is yes and you also like the frosting on the cake of the call option, then it makes sense to pursue the training. But no trader, in my opinion, should "pay to play". The training has to stand on its own as a career and economic value.

All of this means that joining a prop firm requires considerable due diligence. There are real scams out there, and there are honorable firms that offer a teamwork, learning-based culture and solid training. Just make sure that the firm is selling you real training, not just hopes, dreams, and fantasies. The posts below should be helpful in making the distinction.

More:

What Should a Training Curriculum Look Like?

Considerations in Selecting a Training Program

What Makes for Expertise?

Success as a Developmental Process

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How Prop Firms Can Attract the Right Talent

My recent post took a look at how traders can make themselves attractive to proprietary trading firms. Now let's take a look at how prop firms can attract promising trading candidates.

The best way that prop firms can recruit top people is by being ethical and honest. Please take a look at the extraordinary post from Bella at SMB Capital on "The Failure Rate of a Proprietary Trader". How many prop firms would dare talk about failure and the sobering reality that the majority of prop traders don't sustain a living from trading? How many would play down the promises of riches and, instead, emphasize the importance of hard work and skills building?

Kudos to SMB for telling it like it is. It's one reason I'm honored to work with the firm. (And, no, they didn't solicit this post).

As Bella emphasizes:

"The market requires that you become an elite performer. Most people can 'punch the clock' at their jobs, do average work, and be appreciated by their employers. Heck you might even get promoted. Try this as a trader and the market will swallow you like a shark does squid. The best trader on our desk grinds it out daily like a steam pipe fitter."

Ultimately, all any prop firm can do is what a college basketball or football team can do: give you the best shot at big league success possible. The coaches can provide the training, teach the plays, and offer the encouragement--and then it's up to each player to make the most of practice and playing time.

So if you interview at a prop firm, listen for pie-in-the-sky promises and listen for tough love about the challenges of trading. If one firm lures you with the promises and the other encourages you to think long and hard before taking the challenge, you'll know the firm to choose: the one with the integrity to acknowledge and assist the steep learning curve ahead.

More:

Prop Firms and Scams

Steps Toward Joining a Prop Firm

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How Traders Can Attract the Attention of a Prop Firm

Well, I guess one way to try to attract the attention of a proprietary trading firm is to promote yourself as a psychic. At least that's what's recently crossed the desk of the good folks at Trading RM in Chicago.

(But wait, if he's really psychic, wouldn't he already *know* who is going to hire him??)

Anyway, for those interested in joining a proprietary trading firm, other strategies might be more useful:

* Show that you know and follow markets;

* Show that you've gained some trading experience in a personal account, even if you're trading very small;

* Show that you've gained some experience trading in a simulated mode;

* Show what you've learned and how you've learned it;

* Show the life experiences that make you who you are and will help make you successful as a trader;

* Show that you understand the firm you're applying for and how you see a good fit between you and them.

Joining a prop firm makes the most sense if you need access to capital and specialized trading technology/tools, want to learn from others (and share your learning with them), and if you are interested in trading strategies (automated trading, day trading options, trading order flow) not easily accessible to individual, independent traders.

For more on prop firms and whether they're right for you, check out the following posts:

* Evaluating Prop Firms

* Pitfalls to Avoid With Prop Firms

* Steps Toward Joining a Prop Firm

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Concerns Over Greece and the Euro Trade

The crisis over debt in Greece is not going away. The euro currency (vs. USD above) has become a nice sentiment indicator for that concern.

As long as we see broad selling of the euro and a flight to the relative safety of USD, I'm wary of the market's long side.

My concern is that stocks just aren't pricing in enough volatility given what the currency markets are telling us.
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Tracking the Market With Individual Stocks

If you click on this screenshot from my trading station, you'll see the 40 stocks in my basket: five from the eight S&P 500 sectors that I track regularly.

If the price change is green, that tells me that the stock is up on the day *from its opening price*.

I also compare the current stock price to its volume weighted average price (VWAP) and see how many stocks are trading above and below VWAP.

Both perspectives are useful in gauging whether trading days are shaping up as trend days or range ones.

Early in the day, when I saw that an increasing number of the stocks were trading up from their open and above their VWAP, I was able to scramble out of a short position without damage. Many times, individual stock action can illuminate what's going on in the broader indexes.
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Morning Briefing for January 29th: No Panic in This Market

Doesn't look as though options traders are pricing in a stock market implosion: as we've made fresh lows in the major stock indexes, we've seen declining highs in VIX.

Meanwhile, at .69 and .67, the CBOE put/call ratios for the past two sessions have been above average, but not at highly bearish extremes.

New 20-day lows continue to hover in the 2000 area, which says that bounces are not lifting many boats.

If we cannot punish the shorts soon with a rally that bursts the important resistance in the low 1100 area of ES, I'd look for a washout below today's overnight lows. I generally like the bull side and find it historically profitable to fade weakness. My memories of 2008 have not altogether faded, however, and I recall when bullish setups based on market weakness failed, one after another.

Hence the caution amidst signs that we're not seeing panic.
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On the Virtue of Integrity

Well, the recent rant ended up being the most commented post in the history of this blog. I think that says a lot.

I once shared with readers that one of my first exposures to the questionable integrity of many ventures within the trading industry came when I learned that a "guru" who touted making millions of dollars in the market was only toting up his gains. He had also lost millions. Technically what he claimed was true: he *had* made millions. He simply hadn't made profits. But that didn't deter him from holding himself out to needy traders at a fee that would provide the income he could not make from markets.

There are many excellent vendors of trading goods and services out there. I try to link to those I find useful and informative, because I like seeing value and integrity recognized and rewarded in the marketplace. The exemplary services offer tangible decision support for traders; the less than honorable services exploit hope.

As long as there are traders seeking easy livings in markets, looking for magic bullets, there will be those that offer the snake oil.

But there's an easy way to identify those who offer goods and services with integrity and those who don't: Go to their websites or blogs and measure the ratio of self-promotional posts/articles to the number of substantive, informational posts/articles.

If you have substance, showing it is your best marketing strategy. If you don't have substance, all you can bank on is hand waving.

We all put our best foot forward when we first meet someone we want to know. What vendors of goods and services put on their home pages represents their best feet forward. If there's no substance there, caveat emptor.

Integrity means staying true to one's values, and sometimes that means feeling outrage when those values are trampled. If you really love the trading profession, it's difficult to feel indifferent toward those that drag it through the mud.

Thanks for the supportive comments; they mean a lot to me.

More:

The Market Idiots

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The Reason I Don't Partner With Your Firm is Because You Are Cheap Whores

* You are a forex brokerage that lures small accounts with enticing promises of huge leverage;

* You are a "prop firm" that requires traders to pay big bucks to join, drastically limit the size that can be traded, charge ridiculous commissions to traders, and toss traders (or ask for more money) when you've milked them dry;

* You are a trading guru that touts your trading prowess (with no evidence of success), but offer nothing more than off-the-shelf technical "setups" that are readily available in the public domain;

* You are a trading coach that promises success without offering substantive trading guidance (and without showing evidence of substantive trading knowledge);

* You are a brokerage house that executes a fixed income trade for me and then busts the trade and offers the same trade now at a much worse price (yes, this happened to me this past week);

* You sell inferior trading software with breathless promises and faulty logic;

* You offer seminars that offer nothing but infomercial sales pitches to attendees;

All of you have solicited my partnership and support in the past month.

Go f*** yourselves.
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Finding Opportunity in Loss: A Hallmark of Great Trading

Let's say I think stocks will break to the upside and I take a long position. The market goes my way initially, but then reverses. What looks like a valid breakout now shows itself to be a false breakout. I stop out of the position and take a modest loss.

That is good trading.

One trader I recently talked with took exactly those actions--and one more. He saw that the breakout was false, stopped out of his position, and took a modest loss. But he had mentally rehearsed what he would do under just such a scenario. He had told himself that if this long trade didn't work out, the market could retrace the entire prior day's range.

So he stopped out, took his loss, and flipped his position to be short.

He made money on the day.

That is great trading.

The losing trade set him up for a winning day, and all because he was prepared to act on opportunity, not just prepared to limit risk.

More:

Learning From Good, Losing Trades

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Keeping an Eye on Three Trading Ranges

Are we in the midst of an ongoing bull market? Are we getting ready for a double dip into economic (and market) weakness?

I'm watching three instruments in trading ranges for possible clues to an answer: oil (USO; bottom chart); homebuilders (XHB; middle chart); and financial stocks (XLF; top chart).

We should see strength in these three if economic strength takes hold and if we see continued recovery among two of the hardest hit sectors: banks and real estate.

Conversely, if the global economy is threatened, we'd expect to see weakness in oil demand and possible continued pressure on those vulnerable sectors of the economy.
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When Risks Exceed Rewards: The Costs of Overtrading

In my recent post, I took a look at some of the dynamics of one's trading edge. That post assumed a relatively modest degree of risk taking to achieve a 10% annual return over the course of 100 trades.

In this post, we'll once again turn to Henry Carstens' P&L Forecaster and see what happens when we increase the amount of risk needed to achieve the same level of return. Instead of a standard deviation of daily returns of 1%, we'll now assume a standard deviation of 3% to earn that 10% annual return.

That means that our $100,000 account holder is swinging plus or minus $3000 on returns for approximately 2/3 of all trading days. While that might not seem like a lot of money, it's a large swing for the sought return of $10,000 over the course of the trading year. Personally, I don't know of any reputable hedge funds that seek such levels of volatility among their portfolio managers.

I ran Henry's Forecaster 20 times and here were the projected P/L results after 100 trades:

$6676, $15,226, $18,378, $8932, $6633, $15,503, $14,586, $15,733, $12,259, $6174, $19,608, $11,057, $5794, $18,365, $9778, $12,992, $13,378, $7473, $10,976, 7850.

Now compare this with the annual returns when risk was at a 1% standard deviation:

$9379, $12,097, $12,861, $9210, $10,934, $11,529, $9779, $7992, $10,694, $11,827, $10,839, $11,535, $10,300, $11,738, $9324, $9052, $13,197, $11,712, $10,736, $9683.

What you can see is that, even with the higher volatility, the presence of the trading edge is apparent. The "Rule of 100" still holds: After 100 trades, with any reasonable degree of risk-taking, you know if a trading edge is present.

Notice, however, how the size of the edge relative to the random swings in P/L is diminished when risk is increased while returns remain the same. Whether the trader makes more than 15% on the year or less than 8% is completely due to chance. Risk levels magnify the chance component of returns. This happens most often when traders "overtrade": they take more risk (by putting on more trades, trading larger size, or both) without achieving a positive edge for the added risk exposure.

I ran the simulation one more time (see P/L chart above) to show what that means in practice. Note how a trader with a positive edge but high level of risk (i.e., someone who is overtrading their edge) goes through massive P/L swings during the trading year. In the above scenario, the trader is losing money for half the year, with double digit negative percentage returns, only to sharply swing higher later in the year, steeply drop, and then rebound.

Realistically, could a trader stick to his or her edge while drawing down in this fashion?

More than likely, such a trader would abandon a winning strategy during an extended, deep drawdown and/or double down on the strategy during a big winning period. Both would create fresh problems.

The moral of the story is that, as Henry says, the path of one's P/L contains as much information as the endpoint. It is not absolute returns alone, but also the risk taken to achieve those returns, that matter in the long run. If your daily swings in P/L are much larger than your average daily profits, it will be difficult to stick with your strategy and edge.

The wise trader seeks positive risk-adjusted returns, not just large returns on capital.

More:

Risk Management and Emotional Self-Control

Drama, Trauma, and Position Sizing

Overcoming Overtrading

Avoiding Risk of Ruin

Making the Most of Opportunity

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What Is Your Edge in the Markets?

For this post, I made extensive use of Henry Carstens' P&L Forecaster, a nifty tool that estimates returns for a given trading edge (average profit per trade) and risk level (standard deviation of returns).

In this exercise, I used an example of a trader with a $100,000 personal account. The trader averages 100 trades per year and averages $100 profit per trade. Moreover, we'll assume a daily standard deviation of returns of 1% or $1000. That means that about 2/3 of all trading days fall within 1%. (For the exercise, we'll ignore commissions and other fees). That means that, on average, our trader achieves an annual return of 10% on capital and doesn't take large risk.

Using the Forecaster, I ran 20 P/L simulations. The returns were as follows:

$9379, $12,097, $12,861, $9210, $10,934, $11,529, $9779, $7992, $10,694, $11,827, $10,839, $11,535, $10,300, $11,738, $9324, $9052, $13,197, $11,712, $10,736, $9683.

Two things immediately stand out:

1) There is a decent variability of returns simply due to chance (i.e., where the drawdowns hit during the 100-trade period). Whether the trader made $9000 or $11,000--a 2% difference in annual returns--was purely random. It would be a mistake to call one year a bad year and one year a good one;

2) In spite of that variability, returns are bounded. There are no $20,000 years, and there are no years of zero or negative returns. After 100 trades, your edge--or lack of it--is apparent as long as risk is reasonable. As I'll show in a future post, the risk level (standard deviation) very much affects the path of returns (including depth of drawdowns), but the average endpoint for a given level of edge remains pretty similar after 100 trades;

What that tells us is that chance plays a meaningful role in returns, even when there is an objective edge and a reasonable level of risk-taking. That being said, after 100 trades, you should know whether or not an edge is present. That is important to those training via simulator. There is no sense putting capital at risk if you can't generate a decent return from 100 simulated trades.

If you're placing 100 trades and not making money, you don't have an edge. That could reflect problems with your trading methods, your execution of those methods, or both. And if you are generating a decent return after 100 trades, you have something promising. Keep your overhead down and your risk management reasonable and you may just make a go of trading.

More:

The Psychology of Paths of Return

The Psychology of Risk and Return

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One of the Best Life Lessons I've Learned

Back in the day, I was a graduate student in psychology at the University of Kansas, and I got it into my head that I wanted to experience the other side of the business. So I looked around for a therapist who would be willing to see me for the modest fees I could afford to pay.

Liz was a Jungian analyst, which meant that dream interpretation formed a large part of our work together.

In one notable dream, I was riding in a huge roller-coaster. To my right, there was a lever, which had 10 settings for one's "coefficient of experience".

I couldn't decide on the setting for the lever; the roller-coaster was pretty steep and intimidating. I wound up choosing an 8, but was none too comfortable with the setting.

Liz's comment on the dream stood out for me:

Sometimes anxiety points to our growth.

We're all most comfortable with what lies within our comfort zones, of course. Once we leave the comfort zone, we experience anxiety and uncertainty. But we cannot grow if we forever stay in comfort. We need a high enough coefficient of experience to ensure that we'll be anxious...always stretching ourselves a bit farther than comes easily or naturally.

So often traders look to me to reduce their anxiety.

But sometimes the best strategy is to follow your anxiety and take that ride beyond the comfort zone.

More:

* Mali's Life Lessons

* Life Lessons From Writing This Blog

* What Trading Teaches Us About Life

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Strong Readings for the Week

* The most common problem I help traders with; my fave techniques for dealing with it;

* What it takes to sustain market focus as an active trader;

* Avoiding the UK and more good readings from a fave source;

* Now here's a collection! Lots of themes for 2010;

* Interesting perspectives on the recent market uncertainty and weakness;

* Leaning on the 50 day MA and top of November/December range;

* Will tightening recreate the Great Depression? See also this skeptical view of a spending freeze during fragile economic times;

* Real estate disaster on the way?

* Here's a bullish view on commercial real estate;

* AAPL: A Daytrader's Dream.

* Great view of where countries stand re: bailouts and stimulus.

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Relative Volume: How Busy Can You Expect the Market to Be?

Relative volume is an important indicator that tells you whether markets are more or less busy at a given time of day compared with normal volume at that time of day.

Relative volume gives us a clue as to the participation of large, institutional traders in the current market. It also correlates highly with intraday volatility, thus providing clues as to whether or not we'll be able to hit particular profit targets.

Here are median five-day ES volume numbers for each 15-minute period during the day that I use in my trading. All times are Central Time:

8:30 AM - 151,383
8:45 AM - 132,213
9:00 AM - 149,659
9:15 AM - 114,851
9:30 AM - 98,618
9:45 AM - 90,566
10:00 AM - 142,282
10:15 AM - 72,932
10:30 AM - 58,067
10:45 AM - 53,210
11:00 AM - 52,965
11:15 AM - 57,078
11:30 AM - 33,053
11:45 AM - 47,135
12 N - 40,629
12:15 PM - 47,346
12:30 PM - 41,972
12:45 PM - 31,933
1:00 PM - 47,043
1:15 PM - 38,975
1:30 PM - 50,185
1:45 PM - 55,170
2:00 PM - 48,564
2:15 PM - 73,848
2:30 PM - 79,974
2:45 PM - 135,342
3:00 PM - 150,838

Note how volume shifts during the day (the well-known "smile" pattern), with institutions most active early and late in the day. The 10 AM bulge represents activity due to economic releases at that time. Expectable volume would be more like 80,000 for days without releases.

With these numbers, you can make a reasonable estimate of whether markets are likely to be volatile or quiet during the trading day; you can also observe where volume picks up and tails off: nice clues as to the market's auction activity.

More:

Volume and Intraday Opportunity

Relative Volume and Volatility

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Why Intraday Trading is So Difficult

Imagine the market affected by two relatively independent vectors. One vector describes directionality: the "trendiness" of the market. The other vector describes volatility: the degree to which markets vary around a central price.

The first vector describes the degree to which market participants are reassessing value in the auction marketplace.

The second vector is closely connected to volume and reflects who is currently active in the marketplace.

Both vectors are distributed in a non-stationary way through the trading day. That is, measures of trendiness and volatility exhibit different means and standard deviations through the day.

Early identification of when the vectors shift their means and standard deviations is important in recognizing the beginning and ending of trading ranges and market trends.

Many trading problems occur because traders trade the vectors as if they are stationary: they automatically assume that past levels of direction and volatility will be accurate estimates of future direction and volatility.

In other words, markets change their behavior faster than people can change their minds.

And that is why intraday trading is so difficult.

More:

Overconfidence as the Most Common Trading Problem

How Markets are Rigged

Why Traders Lose

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Morning Briefing for January 26th: Pickup in Bearish Sentiment

Note the recent spike in the CBOE put/call ratio. Spikes in the ratio have been a nice tell recently for market lows, as excess pessimism has indicated that weak longs have been shaken from their positions.

What makes this spike different from recent ones is that it is not occurring at a higher price low. In a bull market, you want to see stocks hitting oversold levels and bearish sentiment levels at successively higher prices. The retracement of the late 2009/early 2010 strength suggests that a longer-term topping process may be occurring, fueled by monetary tightening in China and the relative weakness of many non-U.S. equity markets.

We traded below the Friday lows overnight; I will be watching closely to see if that break holds. Note also that we established value in the mid-1090s in the ES contract during yesterday's trading session and have rejected that during the overnight trade. Acceptance of value in the 1080s (or lower) during today's day session would continue the market's downtrend.

Meanwhile, we're on Fed watch, with tomorrow's announcement likely affecting the willingness of traders to make commitments today. The weekend indicator review reviews the signs of strengthening I'll need to see before committing longer-term positions to the long side.
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Daily Profit Targets: Handicapping Likely Directional Movement

This is a follow-up on my post outlining the recalculated daily profit targets. Going back to January, 2000, we find:

About 70% of all trading days touch their pivot level;

About 84% of all trading days touch either R1 or S1 levels;

About 66% of all trading days touch either R2 or S2 levels;

About 50% of all trading days touch either R3 or S3 levels.

The keys to using this information are twofold: 1) identify relative volume in real time to gauge likely market volatility and 2) track intraday sentiment in real time to gauge likely directionality. Those two factors help traders handicap in real time the levels we're likely to hit.

Range days will almost always trade back to the pivot level calculated from the prior day.

Trend days will almost always reach the R3 or S3 levels.

About 85% of trading days will take out their prior day's high or low. For that reason, R1/S1 and the prior day's high/low are often good initial targets for directional trades.

On a strong market day, VWAP should be greater than the pivot level from the prior day. On a weak market day, VWAP should be less than the pivot level from the prior day. When VWAP is close to the pivot level, you're in a short-term range market.

The targets you hit or don't hit the prior day affect the odds of hitting targets the next day. Promising historical patterns come from such analyses.

You don't need to trade often. If you can catch one or two moves to the targets during the day with good size, you can make a good living and keep trading costs down.

I will be posting the new targets each morning via Twitter (follow the tweets here).

More:

Questions to Prepare for the Trading Day

Trading With Key Price Levels and Targets

Relative Volume and Volatility

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Midday Briefing for January 25th: Forming New Value Area

Note how we are forming a fresh value area between 1093 and 1097 in the ES contract, as failure to take out Friday's lows thus far led to a bounce back to VWAP (red line above). That being said, we're seeing erosion in the Cumulative Delta over time and the Cumulative NYSE TICK has been negative. If we cannot take out the upper end of the value area above, I'd look for a rotation back down to test the low part of value. Financial shares led the bounce from morning lows; I'm watching them for signs of leadership this afternoon.
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Accepting vs. Rejecting Price Magnet Levels

Recall the recent post re: price magnets in the market. We've seen a rejection of such a price level (blue arrow above) in early ES trade; if this is a legit continuation of the downside, we should not return to that magnet level; it should serve as resistance. Those breaks from a magnet level can be powerful short-term trades, fueled by those on the wrong side fleeing their trades.
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Recalculating Daily Profit Targets

As regular readers are aware, a cornerstone of my preparation for the day is calculating price targets for the trading session, so that I can handicap the odds of hitting those objectives. Having concrete, backtested targets in advance is helpful in holding winning trades.

What makes the targets I calculate different from normal "pivot levels" is that I adjust the targets for recent market volatility, so that the odds of hitting a distant target in a high volatility environment are similar to the odds of hitting a more modest target when volatility is low.

In the last couple of years, I've made several adjustments to my calculations so that the targets work as well as possible in providing guidance in terms of how far we're likely to move up or down. Over the last few days, I've made yet another adjustment. I'll be keeping the methodology proprietary for now, but will continue to post target levels in my morning Twitter posts (subscribe to the Twitter stream free of charge here).

Here are the pivot, resistance, and support numbers with the revised methodology for this morning for SPY:

Pivot = 109.81
R1/R2/R3 = 110.93/111.31/111.68
S1/S2/S3 = 108.69/108.32/107.95

To calculate rough equivalent values for the ES contract, multiply the above numbers by 9.96. In the tweets, I refer to this conversion factor as ESf.

For more on the targets, see the links below:

Handicapping the Odds of Hitting Profit Targets

Planning Trades Around Profit Targets

Pivot Targets and Historical Trading Patterns

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When Markets Are Weak, Should You Tweak?

I've commented recently on the topic of how what seems visually obvious--the continuation of short-term market trends--is not usually the obvious, winning trading strategy.

We registered over 2000 20-day lows on Friday across the NYSE, NASDAQ, and ASE, indicating broad market weakness.

Note, however, that we only registered a little over 300 fresh 65-day lows.

What that tells us is that, so far, we have a sharp decline in a rising market.

Going back to late 2002, when I first began compiling these data, we find only 23 days in which 20-day lows exceed 2000, but 65-day lows are below 1000. Over the following five trading sessions, the S&P 500 Index (SPY) has averaged a gain of .65% (15 up, 8 down). That compares with an average five-day gain of .10%.

These historical studies can provide a useful part of context for the trading day. More on that later.
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Indicator Update for January 24th

Last week's indicator review found that we had fallen into a range after starting the year on a bullish note. With the stock market decline late this past week, we've now come full circle and retraced the new year's strength, falling back into a multi-month trading range.

A major issue going forward will be whether stocks can hold above their November/December lows. Thus far, we have not seen an explosion of new 65-day lows, even though 20-day lows rose to over 2000 across the NYSE, NASDAQ, and ASE (top chart). Should we see a meaningful expansion of 65-day lows, that would tell me that we're in an intermediate-term corrective mode and could revisit the October lows.

We have dropped to the point in my Cumulative Demand/Supply Index (second chart from top) and momentum measure (second chart from bottom) where we normally expect to see a market bounce. I will be watching closely for the vigor of that bounce; if it is not strong, I'd expect at the very least a test of momentum lows.

Meanwhile, the sectors (bottom chart) are trading in short-term downtrends according to my proprietary measure of Technical Strength. The one exception is Health Care, which is still in a neutral mode. We saw particularly bearish swings in the last week in Industrial and Technology shares; the commodity-related Materials and Energy stocks were also weak.

All in all, we're extended to the downside, but with all indicators weakening, I'm not looking to catch falling knives. Should we stabilize around the November/December lows and begin to see some firming of the indicators, I would be treating this as a longer-term trading range and looking for areas to be buying. Until we see fewer stocks making 20-day lows, however, and improvement in the Demand/Supply numbers, it is premature to act on that idea.
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Thinking Without Words

Here is an eye-opening video of what can be accomplished with an abacus.

Notice that what's really accomplished here is rapid thinking that does not take place in words.

This is very relevant to recognizing patterns in order flow and very short-term price patterns.

The key is to develop a "language" that is not verbal. The soroban provides a non-verbal language.

More:

Single Trial Learning

Implicit Learning and Trading

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Mid-Weekend Wrap: Markets and More

* By controlling trading risk, you control your brain;

* Trading lessons from neuroeconomics;

* Growing perceptions of sovereign debt risk in Europe;

* Nice sentiment overview and more good reading;

* Using the selling as an opportunity to buy;

* Are we facing a significant correction?

* We've taken out that 50 day moving average;

* VIX has jumped; watching for a bounce;

* Are easy gains over for the market?

* Why are underwater homeowners still paying on mortgages?

* Low interest rates boosting leading economic indicators;

* Lessons history teaches us about excessive debt;

* China's monetary predicament;

* The challenges of addressing "too big to fail"; the six largest financial institutions hold the equivalent of 62% of U.S. economy.

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Trading Psychology: The Best of TraderFeed 2009 - Volume Four

With this posting, we wrap up the catalog of best trading psychology posts from this blog during 2009. Here is where you can find the best of the 1st quarter, 2nd quarter, and 3rd quarter. You can also find the best posts from 2006, 2007, and 2008, as well as a collection of posts on trading indicators and methods.

* A Cognitive Strategy for Overcoming Frustration; see also a Solution-Focused Strategy for Dealing with Frustration;

* Finding Freedom in Commitment

* Being Right vs. Being Profitable

* Life Problems that Become Trading Problems

* Living for Trading vs. Trading for a Living

* The Power of Market Metaphors

* Ten Qualities of Successful Traders

* Avoiding Confirmation Bias in Trading

* How to Avoid Going on Tilt

* The Psychology of Position Sizing

* The Best Projective Test of All; see also Life as a Projective Test

* Why Traders Don't Make More Money

* Trading From a Position of Power

* Reducing Bias in Trading

* Preparing to Win

* The Value of Previewing and Reviewing Markets

* Discovering Your Trading Patterns

* Managing Your Psychological Energy

* Preparation and the Perception of Time

* Setting Trading Goals

* A Theory of Romantic Relationships

* Learning to Shift Emotional Gears

* Well-Being and Frustration; see also Goal Setting and Frustration

* Novelty and Psychological Change

* The Value of Trading as a Performance Activity

* Why Traders Keep Losing Money

* What Moves Markets; see also More Perspectives on What Moves Markets

* Biofeedback Applications for Traders

* Visualization Practices for Traders

* The Psychology of Return Paths

* Hard Lessons for Traders

* Why Quiet Markets Reveal Good Traders

* Turning Human Performance Into a Lifestyle

* Market Awareness and Self Awareness

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The Psychology of Trade Execution

The recent post on trade execution emphasized a perspective in which one trades with the market trend, but executes trades in a countertrend fashion.

Thus, for instance, a trader would be selling the market today given multiple signs of weakness following yesterday's breakout move, but would enter those trades on market bounces. Even on a short-term basis, a trader can wait for moves to positive NYSE TICK before entering the trade on the short side.

While this is easy in theory, it can be more challenging in practice. Having the discipline to wait for buyers to come into the market before you sell (or vice versa) means that you cannot chase trades. Nor can you give in to the fear of missing market moves.

Could the market extend in the direction of the trend with you not aboard? Absolutely. If, however, you are operating from a vantage point of plenty rather than scarcity, that is not a threat. The odds are with you if you're not selling short-term oversold markets or buying short-term overbought ones. If you miss a leg of the move, you can always position for the next one.

The one thing we can control when we trade is whether we take on risk and how we assume that risk. The ultimate edge that a trader possesses is the ability to play the game only when the odds of success are favorable.

More:

Trading With Abundance, Rather Than Scarcity

Trading With Patience

Behind The Fear of Missing Market Moves

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Viewing Markets Through the Telescope

If I were running a training program at a trading firm, a nice quiz question I would pose to developing traders would be the following:

We see that the euro (top chart; FXE) and stock market in China (bottom chart; FXI) are making multimonth lows. Why are the charts so similar?

And I might pose some follow-up questions:

What are the implications of those similar charts for interest rates and credit markets?

What are the implications for U.S. stocks? For U.S. stocks vs. European and Asian markets? For the yen?

What would you be tracking going forward to handicap the odds that the bull market in stocks will continue vs. the odds that we've made a longer-term top?

It's important to view markets through both microscopes--the short-term action, including volume, sentiment, and order flow--and through telescopes, the big themes that shape trends and reversals.

The above are telescope questions; later I'll pose a few through the microscope. Meanwhile, the posts below will provide some clues as to answers to my quiz.

More:

Understanding Market Context

Identifying Intermarket Themes

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Understanding and Trading Stock Market Breakout Moves

Yesterday's market gave us a textbook example of a breakout move. It began with the identification of a multiday trading range, as noted in the recent post. Why a multiday range? Because over the course of multiple trading sessions, both bulls and bears are positioning themselves for the next move. When that move does occur, those on the wrong side of the trade have to scramble out of their positions, fueling the breakout move. As a rough rule, the longer the trading range, the more extended the breakout move.

Note that a trader didn't have to predict the breakout to still profit from it. The genuine breakouts will not return to their prior trading ranges for the reasons outlined above. The first retracement after the breakout can make a fine short-term entry point.

So what do we look for in a valid breakout move, as opposed to one that will ultimately fail and reverse? Here are a few keys:

1) Expanded volume on the break (see blue arrow above). That tells us that there is broad acceptance of lower prices and that institutional traders are participating in the move;

2) Volume heavily weighted toward buyers or sellers. We should see very positive or negative NYSE TICK on the break, and the proportion of volume transacted at market offer or bid should be quite high;

3) We should see broad participation on the break. Most if not all stock market sectors should be moving with the general averages, and we should see a commensurate break in the intraday advance/decline figures;

4) Intermarket themes should be confirming the break. In yesterday's case, that meant a rising dollar, falling commodities, rising Treasury prices, and risk aversion in credit markets.

The breakout move indicates that the fundamental supply/demand situation of the stock market has shifted, moving from the equilibrium of a trading range to a more one-sided trade. That one-sided action will continue until can reach a new equilibrium. That occurs when longer-timeframe participants become tempted by the new price levels and become convinced that the market has moved too far from value.

Until that time, the breakout move becomes a short-term trend. Traders who stand aside and fret that they "missed the break" can end up missing a more extended move by not recognizing the market's fundamental demand/supply shift.

More:

Tracking Large Traders During Breakout Moves

Identifying Market Breakouts

Catching False Breakout Moves

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