Four Ways to Read the Psychology of the Markets

In the recent webinar (here is a link to the recording of the event), I touched upon two themes that will be part of my program at the upcoming Chicago workshop.  The first theme is using our emotional responses to markets as market-relevant information.  Very often, we first notice changes in market regimes--shifts in volatility, in trend, in patterns of correlation--experientially.  When we reasonably expect a market to do one thing and it begins to do something else, we experience confusion, frustration, and concern.  The emotionally intelligent trader uses emotion to take a second, objective look at that market and reevaluate ideas and positions.  The less emotionally intelligent trader becomes caught up in that emotion and responds reactively, often with impulsive and ill-considered actions.

The second theme is that we can read the psychology of other market participants and thereby gain a sense for when their buying and selling intentions are waxing and waning.  The ways in which markets transact provide us with important clues as to the leaning of large participants, giving us early identification signals on breakouts, failures of moves, and momentum.

There are four ways that I've used to gauge the psychology of the markets:

1)  Market Profile - The profile is a tool for identifying where markets are setting value and how volume is behaving relative to value areas.  Are we breaking out of a value area and accepting value higher or lower?  Are we oscillating within a value range?  Viewing profiles on multiple time frames can help us understand market behavior in a multidimensional way.

2)  Upticks/Downticks - The NYSE TICK (and related measures) is a tool I have used for years to assess real time sentiment in the stock market.  It measures the number of stocks trading on upticks minus the number trading on downticks every 10 seconds or so.  When large market participants are actively buying or selling, we see TICK values jump to extreme positive or negative levels.  Shifts in the distribution of TICK readings over time commonly accompany market turning points.  

3)  Market Delta Footprint - Whereas the NYSE TICK assesses upticks and downticks across all stocks in the NYSE Index, the Market Delta footprint tracks each transaction in a particular instrument, such as the ES futures.  It identifies when a transaction is occurring at the current bid price or offer price and cumulates that information over a variety of time periods.  As a result, we can see when volume is dominantly lifting offers (buyers are aggressive), hitting bids (sellers are aggressive), or relatively balanced.  Shifts in the footprint very often accompany changes in market direction.

4)  Event Flow - As described in the recent post, event flow divides the volume in any instrument into many thin slices and examines price behavior within each slice to infer the relative dominance of buyers or sellers.  That information is cumulated across slices to depict changes in buying and selling dominance.  Unlike upticks/downticks and the footprint, event flow does not rely upon aggressive behavior of buyers and sellers to infer the intentions of participants.  This is particularly helpful in markets where sophisticated market making can disguise those intentions.

These are multiple lenses through which traders can read the psychology of other participants, much as a skilled poker player in Las Vegas can read the tells of players around the table.  The ability to see markets through multiple lenses enables traders to develop ideas and--most importantly--revise those ideas based upon real data.  I look forward to elaborating on the reading of market psychology at the Chicago event. 
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