Thursday, March 02, 2017

Reading the Market's Psychology

One of the first things I look at in a market chart is whether the large candlestick bars are dominantly green or red.  That is, when we have range extension, does that tend to be to the upside or downside?

Let's think about that.  Range extension denotes volatility over the time period and volatility is highly correlated with volume.  When we see large bars, those are periods of higher volatility and volume.  If large participants are moving the market higher, we should see more large green bars than red ones and vice versa.  It's a quick way of gauging the psychology of the market--which way large, active players are leaning.

Of course, we can formalize that idea by creating a rolling correlation between volume and price change.  Above we see SPY (blue line) and the rolling two-hour correlation between five minute price change for SPY and five minute volume (red line).  This behaves as a kind of "overbought/oversold" measure, telling us when volume has been pushing stocks higher or lower.  Notice, for instance, how volume was decidedly on the sell side on February 28th and then decidedly on the buy side with yesterday's sharp rally.  Seeing that shift was an important tell for detecting the market's psychology.

Notice also how Tuesday's volume to the downside could not push SPY prices to new lows.  We had selling activity, but the selling could not move price significantly (i.e., it could not break the market's trend).  That is an example of the idea of inefficiency, as noted in the earlier blog post.  We want to know, not only if the active and large traders are leaning one way or another, but how much their leaning can ultimately impact price.  We're getting plenty of selling periods in the recent market, per the chart above.  What creates the uptrend is the relative inability of sellers to move markets meaningfully.  The selling, in other words, is inefficient relative to the buying.

Our job as traders is to read and follow the market's psychology, not impose our own psychology (our bullishness or bearishness) onto the market.  That means that the skilled trader displays emotional intelligence: intelligence in reading the psychology of the market and being sensitive to that psychology.  Much bad trading is not simply the result of the trader's emotional state, but of the trader's preoccupation with what they think *should* happen as opposed to what is actually happening.

Emotional tone deafness doesn't work any better in markets than in relationships--and for much the same reason.

Further Reading:  Calculating the Power Measure in Excel