Monday, February 24, 2020

How Can We Determine When The Market Is Topping Out?

Recently we took a look at framing hypotheses for trading that suggested we could be seeing a correction following a solid run-up in prices for the major stock indexes.  This morning, as I write, we certainly seem to be correcting.  Above, I drew a chart of the ES futures, covering roughly the past month and a half, with each bar representing 350,000 contracts traded.  (Data from Sierra Chart).  As in the earlier post, the middle graphic shows the net amount of volume transacted at the market's offer price (green) minus the amount transacted at the market bid price (red).  This is a great way of tracking the psychology of the marketplace itself, a sorely neglected topic in trading psychology.    

The previous post examined this market from a cycle perspective.  Here we're asking a different question:  How can we identify when a market might be topping out?

To answer this question, we need to look at, not only the amount of volume at bid and offer, but also two other things:

  • How much is volume moving price?
  • How much breadth strength are we seeing with the volume?
Note where I drew the pink arrows that we have a good amount of volume lifting offers, suggesting that buyers are aggressive.  Despite that, price has stopped moving meaningfully higher.  Moreover, when we look at the breadth statistics for that period, we see something interesting.  The number of stocks across all indexes making fresh one month new highs and fresh one month new lows were as follows:

Feb. 12th:  634 highs; 313 lows
Feb. 13th:  562 highs; 389 lows
Feb. 14th:  595 highs; 408 lows
Feb. 18th:  602 highs; 580 lows
Feb. 19th:  682 highs; 402 lows
Feb. 20th:  646 highs; 476 lows

We can see that, as buyers were lifting offers, the number of stocks making new highs could not meaningfully improve.  Moreover, even though we were hovering at all time highs, the number of stocks making fresh lows was not all that different from the number registering new highs.

This pattern occurs at the tops of many market cycles.  Buyers are aggressive, sentiment is bullish, but the buying cannot move price or breadth significantly higher.  This occurs because there are many resting sell orders above the market absorbing the buying.  Large market players no longer perceive value at the elevated prices (or might be perceiving risk associated with the virus outbreak, political events, etc.) and are using the market strength to exit their positions at good prices.  This leaves a lot of bulls trapped and needing to puke positions on a market decline.

Many short-term market edges can be attributed to bulls and bears getting trapped in their positions once their activity can no longer move the market higher or lower.  This is why the psychology of the marketplace is just as important as the psychology of the trader.

Further Reading: