Monday, October 12, 2015

Trading Notes: Week of October 12th

Friday, October 16th

*  Yesterday's sharp rally and new high close for this move fits with the "buy weakness, sell strength" idea from yesterday's posting and is consistent with the idea of a market that may have topped in upside momentum, but not price.  It was interesting to see that we had 609 stocks make fresh monthly highs yesterday, down from the 1274 new highs last Friday.  Such breadth divergences can be expected to continue if we indeed have made a momentum peak for this cycle.  It's when we see significant expansion of stocks/sectors making fresh short-term lows that we need to seriously consider the market's downside.

*  Meanwhile, volatility continues to be crushed with VIX closing around 16, down from around 27 late in September.  My pure volatility measure also hit new lows and is getting close to levels that are associated with subnormal upside returns.  It has been challenging for traders to adapt to the reduced volatility, which punishes trading on momentum and rewards patient, counter-trend entry execution and quick, tactical profit-taking.

*  A project I will begin this weekend is gauging the expectable size and duration of moves based upon volatility regimes.  My sense is that such an approach could help making trading far more flexible and adaptive than it currently is for many traders.

Thursday, October 15th

*  So here's my question of the day:  Why do so many bastions of capitalism pursue change via centralized planning?  From large corporations to finance firms, capitalist enterprises increasingly rely on central planning as they grow.  Indeed, if countries ran their economies the way many companies run their businesses, we'd view them as communist/socialist bureaucracies hopelessly out of date.  We extol "leadership" in corporations and large organizations; perhaps that's how dictators think of themselves in centrally planned economies.

*  A good buy trade early in the day reversed on the WalMart news and stocks traded off through much of the session yesterday, though they've recovered in overnight trading.  This back and forth is what we'd expect if we recently hit a momentum peak for the current cycle and now are engaged in a topping process.  In that scenario, buying weakness and selling strength makes sense.  Yesterday closed with further weakness, as we had 348 stocks make new monthly highs and 261 register fresh monthly lows.  That new lows figure is the highest we've seen since October 2nd.

*  The weak retail sales number and WalMart news highlights what seems to be a changed story:  instead of economic growth justifying a Fed hike, there's increasing talk of economic weakness and no hike this year.  If the topping out scenario holds, then we're seeing a cycle peak cresting below the prior peak, volatility bottom at higher levels, and increasing concerns of recession--all bearish on a longer time frame.  I will continue to monitor breadth measures to see if this scenario is playing out.

*  I've heard from multiple sources that this has been a difficult trading environment, with poor P/L, for many traders.  Per yesterday's entry, we're seeing reduced volatility in stocks and reduced volatility of volatility.  In such an environment, movement fails to extend--and becomes more consistent in failing to extend.  That kind of reversal mode is difficult for traders wanting to trade momentum or trend.  I'm not sure many traders explicitly work on adapting to changes in volatility regimes.  In such cases, sticking to a process is actually a failure to adapt.

Wednesday, October 14th

*  Per yesterday's post we indeed saw price consolidation in Tuesday's session and we've now worked off the short-term overbought conditions.  According to the Index Indicators stats, at Tuesday's close we had under 19% of SPX stocks close above their three-day moving averages and under 32% close above their five-day averages.  In general, particularly as uptrends mature, I like to be a buyer when the majority of shares fall below their short-term moving averages and lighten up when the majority are short-term stretched and rolling over.  My leaning is toward the buy side if we see selling dry up above the overnight price lows.

*  Below is an interesting chart that looks at the volatility of the pure volatility measure that I track, with the chart going back to August 17th.  Notice how the volatility of volatility spiked during the August decline and has since returned near levels seen prior to the market's drop.  Vol of vol tells us something about the stability of price action, which in turn tells us something about the participation of market makers.  If a market is dominated by market makers, we oscillate between bid and offer and volume cannot move price a great deal.  If market makers pull back and the order book becomes more sparse, a given unit of volume can impact price much more greatly.  Interestingly, when vol of vol is in its highest quartile since late 2013, the next four days in the ES futures average a gain of +.34%.  When vol of vol is in its lowest quartile, the next four days average a loss of -.05%.  As market cycles mature, we tend to see a crushing of vol but also of vol of vol.  I believe we're seeing a maturation of the present market cycle; if that's the case, we should begin to see breadth divergences on further strength.  Yesterday's weakness among small caps might be the start of that pattern.

Tuesday, October 13th

Last week's punchy post on why we trade emotionally seems to have struck a chord.  The hits on the post have been about 4x average and it's already become one of the top ten TraderFeed posts in terms of hits.  One reader took offense to the language and style of the post, and I sympathize with that view.  One of the things I've learned as both psychologist and parent is that how you deliver a message has as much impact as the message itself.  But part of that impact is saving the punchy style for the most important messages.

*  We had a slow holiday trade yesterday, with rangebound action.  One measure that helped my trading yesterday was looking at the extremes in the NYSE TICK.  (I typically look at one- and five-minute readings during the day).  If we don't have many positive or negative extremes, it means that institutions simply are not active in the market.  It takes large, basket executions to get TICK above +800 or below -800.  If you don't get those extremes early in the morning, you can anticipate a slow day and often a rangy one.

*  As my intermediate term strength chart below shows, we continue to be stretched to the upside.  This measure is a five-day moving average of 5, 20, and 100-day highs vs. lows among SPX stocks.  (Raw data from Index Indicators).  In a strong cycle, this will top out ahead of price.  I noted yesterday that I wasn't thrilled with risk/reward and indeed we've pulled back in overnight trade.  I would not be surprised to see further consolidation near-term, but am not expecting an outright bear move.


Monday, October 12th

The weekend article on "flourishing" is, in my view, one of the most important topics in psychology broadly and trading psychology specifically.  By and large, traders do a decent job of keeping themselves out of damaging, negative states of mind and body.  They don't necessarily make special efforts to keep themselves in optimal states.  As a result, we never truly experience how well we could perform across many areas of life, including trading.

*  This past week's entries have focused on strong market breadth and the favorable implications of high buying strength.  That has led to buy-the-dips trading and has done well to this point.  Breadth continued strong on Friday with 1274 new monthly highs, the highest figure in a week.  (Raw data from the Barchart site).  We generally see significant corrections after a period of waning breadth.  That just hasn't been occurring to this point.

*  That being said, I'm not enamored of the risk/reward right here.  As the chart below depicts, we have come down quite a bit on the Pure Volatility measure (volatility per unit of volume in the ES futures), and that has historically led to subnormal returns.  We're also stretched to the upside on many of my indicators, which in the past has occurred near momentum peaks (not necessarily price peaks).  The put/call ratios have come down; all that leads me to believe we could get some consolidation early in the week.  

*  Should we get some pullback this week, my leaning would be to resume the buying strategy.  Good short-term pullbacks would be ones in which a majority of shares close below their three and five-day moving averages and where we see more stocks give sell signals vs. buy signals on the technical measures I follow, such as Bollinger Bands, Parabolic/SAR, and CCI.  The past few days we've seen many more buy signals than sells on those measures, but the number of buy signals tailed off on Friday.