Sunday, February 04, 2018

Lessons in Trading and Psychology - 1: Regime Changes

In this series of posts, we'll look at ways of integrating trading psychology and the process of trading.  It is my hope that the series will illustrate the richness of the relationship between trading and psychology--a depth rarely captured in traditional writings on the topic.

Here we see a chart of SPY (blue line; 5 minute values) from December 15th through this past Friday, February 2nd.  In red, we see a 2-hour moving average of NYSE TICK values over that same period.  Recall that this measure captures the number of stocks trading on upticks minus the number trading on downticks at each moment of the trading day.  The symbol is $TICK on the e-Signal platform and most others

Note that for a good part of the first half of the chart, the NYSE TICK values stayed above the zero line.  As SPY moved higher, we saw evidence of buying strength:  more stocks trading on upticks than downticks.  Look, however, what happened in the second half of the chart.  The distribution of TICK values shifted and we now saw more selling pressure than buying pressure--even as SPY moved to all time highs.

In other words, the psychology of the market changed--we shifted from a buying regime to a selling one--well before SPY made its recent correction.  The change in the distribution of TICK values alerted us to market vulnerability.

Here is an analogy:  suppose the economy of the U.S. is quite strong in large urban areas of the east and west coasts, but weak everywhere else.  A company's sales continue to rise, but when management looks at the distribution of sales, they see that fewer and fewer regions are holding up the rest.  An alert management would not be high-fiving over record earnings.  They would be reducing production and shifting the product mix to prepare for potential economic downturn.

The psychological takeaway is that we need to drill down and look beneath the market surface and approach each fresh set of data with an open mind.  On the day we made a peak in SPY, we had 599 stocks make fresh three month highs and 199 register new monthly lows.  Two weeks before that, we had almost 900 new three month highs against 135 lows (data from  The open mind respects price action and market strength, but also is alert to cracks beneath the surface.  Then, when price can no longer sustain new highs, volatility increases, and TICK readings become very negative, that alertness allows for a quick transition to the new regime.

You have to have the right information, and you have to have the right mindset of openness.  That is an important way that trading and psychology come together to create success.

Further Reading: