Flat Stock Market: Which Way Will We Break Out?

Technical analysis wisdom tells us that the longer a market remains rangebound, the more significant the eventual breakout move. The problem for the trader is that is difficult to handicap the odds of which way the market will make its breakout move.

I decided to draw upon two of my recent posts to address this question, given that we are trading in a five-day range in which the S&P 500 closing price (SPY) has barely budged. Recall that I found reversal effects in the S&P 500 market following periods of uptrending and also following periods of downtrending. Suppose we look at what other, correlated ETFs are doing during the flat period to see if we get a reversal effect from their action.

Going back to 2004, I found 84 occasions in which the five-day change in SPY has been less than +.20% but greater than -.20%. We'll call those relatively flat markets. I then divided this sample in half based on what was happening in the NASDAQ 100 Index (QQQQ).

When SPY was flat over five days, but QQQQ was relatively strong, the next day in SPY averaged a loss of -.01% (21 up, 21 down). When SPY was flat but QQQQ was relatively weak, the next day in SPY averaged a gain of .11% (26 up, 16 down). Indeed, when SPY was flat and QQQQ was down by more than -.50% (as is the case at present), the next day in SPY averaged a healthy gain of .22% (21 up, 10 down).

If we look a bit further out, when SPY was flat over five days, but QQQQ was relatively strong, the next three days in SPY averaged a loss of -.08% (19 up, 23 down). When SPY was flat, but QQQQ was relatively weak, the next three days in SPY averaged a very respectable average gain of .33% (28 up, 14 down).

And when QQQQ has been down more than -.50% during the flat period in SPY? The next three days in SPY have averaged a solid gain of .54% (22 up, 9 down).

Very interestingly, I have not found this reversal effect for the Russell 2000 ETF: IWM. This suggests to me that the smaller-cap Russell may have different characteristics of continuation and reversal than the large cap S&P and NASDAQ stocks. That's a pattern worthy of investigation.

By looking strong and weak sectors during a market's flat period--and by assessing those sectors' tendencies toward reversal or continuation--we might be able to handicap the odds of breaking out in a particular direction in the S&P 500 Index. It appears that, when QQQQ is weak during a flat period in SPY, the eventual reversal in the Qs also tends to lift the Spooz. Let's see if that pattern plays out in the current market.

Here's Dr. Brett's Blog Links and Game Plan for Thursday

Coming Changes in TraderFeed

I recently mentioned changes to the Trading Psychology Weblog that will integrate the indicators, research, and links into a day-to-day trading outlook for short-term traders. I've already received excellent feedback on the changes--and on further suggested changes. Thanks much.

Not one to stand still, I'm also in the process of making changes in TraderFeed that will broaden its content (and hopefully its usefulness):

1) We'll see more Morning With the Doc sessions in 2007 to illustrate how research and the reading of short-term volume and intermarket patterns can aid short-term trading. Indeed, I'm shooting for another Morning session this coming Tuesday, December 19th; stay tuned!

2) I will be broadening out the research to include longer time frames and multiple trading instruments. I am especially interested in identifying historical patterns among the universe of ETFs. This will potentially provide many more trading ideas of merit, as we look to benefit from both the right trading vehicles and the right timing of trades;

3) I hope to broaden the content of TraderFeed. You'll notice that selected TraderFeed posts are now picked up on the excellent Seeking Alpha site and may be available through Yahoo! Finance as well. I will also provide Seeking Alpha with some original market psychology research on sentiment and historical patterns among the various ETFs and alternative trading vehicles. These articles will also be linked on the Weblog, of course.

4) As part of broadening out the content, I will be addressing more of the intermarket, global/macro themes that affect the market's big trends. One of the reasons I'm particularly looking forward to working with Seeking Alpha is the site's commitment to international perspectives/markets and its interest in democratizing editorial content by enabling readers to interview industry leaders. If they do this right (and I think they will), this will lead to many worthwhile global conversations about markets, trends, and research.

As with the Weblog, I welcome ideas and suggestions and greatly appreciate the interest and support of readers. With the increasing globalization of markets and the rapidly expanding universe of trading and investment options, it only makes sense to take the blog research and content beyond the short-term patterns in the S&P index.

Thanks,

Brett

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Stock Market Psychology: What You See Is Not What You Get

In my recent post, I showed how unaided perception of the market can be misleading. A market that looks as though it is rising over three different time periods ends up having worse near-term returns than an average market. Because of this, the naive trader--one who makes decisions solely based upon the appearance of a chart--is at an objective disadvantage relative to the trader who digs beneath appearance with careful analysis.

How about declining markets? Does a visual appearance of a downtrend alert us to future weakness, or is it a similar perceptual distortion when we extrapolate a negatively sloped line into the future?

Since 2004 (N = 734 trading days), we've had 134 occasions in which the S&P 500 Index (SPY) has been down on a one, four, and nine day basis. We could reasonably call this a short-term "downtrend". Four days later, SPY is up by an average .37% (84 up, 50 down), which is stronger than the average four-day gain of .08% for the remainder of the sample (330 up, 270 down). In other words, a market that is likely to be perceived as weak--down simultaneously across three time frames--has shown better returns than the average market.

Once again, however, let's extend our experiment. We'll pull out those occasions in which the market is down more on a nine-day basis than on a four-day basis and down more on a four-day basis than on a one-day basis. That creates our visual downtrend (N = 47). When the market looks as though it's in a steady downtrend, the next four days in SPY average a gain of .65% (33 up, 14 down), much stronger than the average market. Conversely, when the market is down over the three time periods but not in a visual configuration of a downtrend (N = 87), the next four days in SPY average a gain of only .21% (51 up, 36 down). In other words, the worse the market has looked, the better its near-term returns have been.

So let's summarize the results from the two experiments. Average returns over the next four days are as follows:

SPY up over three time periods and in a visual uptrend: -.11%
SPY up over three time periods and not in a visual uptrend: -.02%
SPY down over three time periods and in visual downtrend: +.65%
SPY down over three time periods and not in visual downtrend: +.21%

The naive visual trader who bought when the chart looked strong and sold when it looked weak would have lost consistent money. Conversely, the psychologically sophisticated trader who understood the limitations of human perception could have profited quite nicely. It is not paranoia to believe that the market systematically reallocates capital from naive hands to sophisticated ones: a process of natural selection every bit as ruthless as that found in the jungle.

Check Out New Changes To The Weblog: Links And Trading Plan For Wednesday

Changes To The Trading Psychology Weblog

For a few years now, the Trading Psychology Weblog has been the place where I track a number of market indicators and the short-term movements of the stock indices. Starting today, I've made a subtle but important change to the Weblog.

The first portion of each Weblog entry consists of Market Ideas from various blogs and sites across the Web. I try to cull out unique perspectives that are of practical relevance to the economy and markets. The links are a great way to discover interesting work being done by bloggers across the world.

The second segment of the Weblog, Market Expectations, looks at some unique facet of the market that otherwise might go unnoticed. Sometimes this will be an indicator; other times it will be a historical pattern. Generally, however, it is designed to provide a big picture for what is happening in the current market.

The third and final Weblog section is the one that has changed. I'm calling it "Market Synthesis", and it now puts together a narrative that integrates the various Weblog measures. Basically, the synthesis is a kind of mental game plan that starts my market day. It is not a mechanical set of ideas to be traded: only my way of orienting myself to recent market action.

The key indicators in the Synthesis are:

1) Average trading price for the day - This enables you to see if we're trading above or below value early in the next trading session;

2) Adjusted TICK - This is a daily reading of the transactions in NYSE stocks that have occurred at the offer minus those that have occurred at the bid. It is normalized with respect to the past 20 trading days, so that a positive Adjusted TICK tells you we had more buying pressure than average over the past 20 sessions. A negative Adjusted TICK informs us that we had relative selling pressure for the day.

3) Institutional Composite - This is exactly the same as the Adjusted TICK, only it is constructed with the large cap Dow issues, not the entire list of NYSE stocks. It tells us whether or not we've had relative buying/selling pressure for the day relative to the past 20 sessions.

4) Demand/Supply - Demand is a proprietary index of the number of stocks across the NYSE, NASDAQ, and American Exchanges that have closed above their volatility envelopes surrounding their short-term and intermediate-term moving averages. Supply is a proprietary index of the number of stocks closing below their envelopes. These are very effective momentum measures.

5) New 20 Day Highs and Lows - This is the number of NYSE, NASDAQ, and American Exchange stocks making fresh highs or lows over the past 20-day period. An excellent measure of market strength.

6) Institutional Momentum - This is a bit like the Demand/Supply data, only it is a single, proprietary index that measures whether a basket of large cap stocks is trading above or below their moving averages and volatility envelopes. Excellent large cap measure of intermediate-term momentum.

All of these measures have been tested for historical patterns that predict the S&P 500 Index over a 1-5 day horizon. They are included in the Weblog because they've been found to be relevant to the market's near-term picture. I'll occasionally post research to illustrate this.

As I write this, there are 840 emails in my inbox--and that's after the spam's filtered out. Every single day I am getting requests to do talks for traders, write articles for traders, meet with traders, etc. While I can't possibly meet all these requests (and appreciate them greatly), my hope is that the Weblog, in its new form, will help you--as it helps me--organize your thoughts for the day. From the blog links to the indicator/research perspectives to the indicator readings, the Weblog is meant as a one-stop read at the start of the market day to help you frame your trading ideas.

I welcome your feedback and hope to make continued changes and improvements during 2007. Thanks for your kind support and interest.

Brett

Perceptual Distortions In The Stock Market

One of the signs that a field of study has become a science is the recognition of the need for controlled observation with tools that transcend the limits of the human senses. From the electron microscope to the Hubble telescope, advances in science have followed the acceptance that the unaided human eye cannot perceive all of nature's patterns.

Behavioral finance researchers teach us that unaided human senses are particularly ill-equipped to accurately assess the market's patterns. Our tendencies to overweight recent events and highly salient events; our overreliance on simple heuristics; our emotional weightings of losses vs. gains: these create perceptual biases that skew our responses to risk and reward under conditions of uncertainty.

Still, surprisingly, we find traders evaluating markets based upon nothing more than the unaided eye. Inevitably we look at a chart, notice a slope, and declare a "trend" in place. Can such visually-based analysis succeed?

I decided to try a little experiment. I went back to 2004 (N = 734 trading days) in the S&P 500 Index (SPY) and identified all occasions in which the market was up on a one-day basis, a four-day basis, and a nine-day basis (N = 234). We might call that an "uptrending" market. Four days later, SPY was down by an average -.07% (115 up, 119 down). That is weaker than the average four-day gain for the remainder of the sample of .22% (299 up, 201 down). In other words, the market that--to the unaided observer--has been consistantly up over the last two weeks has had no bullish edge whatsoever. Indeed, it has tended to underperform its recent norms. This fits with my recent research showing underperformance when we trade above a moving-average benchmark.

But let's take the experiment a step further. Suppose we isolate those occasions in which the market is up more on a nine-day basis than on a four-day basis and up more on a four-day basis than on a one-day basis. This would represent, to the unaided eye, a nice steady uptrend. We have 115 such occurrences in our sample. Four days later, SPY is down by an average -.11% (53 up, 62 down). When the market has been down on a one, four, and nine-day basis, but not in a visual uptrend, the next four days in SPY have averaged a loss of -.02% (62 up, 57 down). In other words, we've seen the worst short-term market outcomes when markets have looked their best. The more consistent the visual uptrend, the worse the near-term returns.

In my next post, I will investigate our perception of markets moving downward.

The perceptual distortion in the market is that the unaided human eye tends to extrapolate straight lines into the future. Like a ball tossed into the air, we expect markets to continue moving in their most recent direction. Statistical analysis is a tool for transcending the unaided eye. It, among other things, is what separates astrologers from astronomers, alchemists from chemists. Market psychology begins with the recognition of the limits--and limitations--of human perception.

How Do Federal Reserve Announcements Affect The Markets?

Life is full of unpleasant surprises. Few events are as eagerly anticipated among traders as Federal Reserve announcements of monetary policy. I decided to go back to 2005 and examine what surprises, if any, have been in store for the markets following the last 15 announcements.

One surprise from my findings was that the equity index market (S&P 500 Index; SPY) has not been as volatile on Fed days as might have been expected. The high-low price range for the S&P 500 Index on Fed days exceeded the 20-day average price range on only 8 of the last 15 occasions. Overall, the range on Fed days has been 15% greater than its 20-day average, or about 2 futures points. Three of the last five Fed announcements have led to daily ranges less than the 20-day average.

We do see enhanced volume on Fed days. I looked at volume in the SPY ETF and found that 11 of the 15 Fed days showed volume above the 20-day average. In all, volume on Fed days was about 19% greater than the 20-day average. So what we've seen is elevated volume, but not necessarily elevated ranges. That's a potential formula for whipsaw price action in markets.

I also looked at the high-low ranges for 10-year interest rates on Fed days. One would expect quite a bit of interest rate movement on those occasions. Surprisingly, however, only 7 of the 15 days had a wider range than their 20-day average. Overall for the sample, the interest rate range on Fed days has been about 7% wider than normal, but this is skewed by one particularly large reading.

Now here's the really interesting part: Over the 15 Fed days, the correlation between the day's price range in stocks and the day's range in interest rates is a very strong .56. In other words, when rates move, stocks move. When Fed policy is affecting bond and bill yields, stocks tend to be repriced. That is something to watch carefully today.

Here's another interesting note: Five days after the Fed meeting, the S&P 500 Index (SPY) has averaged a loss of -.18% (7 up, 7 down, 1 unchanged). That is weaker than the average five-day gain of .19%. Five days after Fed day, 10-year interest rates ($TNX) have declined by an average of -.62% (7 up, 8 down). That is a much weaker performance than the average five-day change in interest rates of .07%.

So there you have it. Fed days aren't quite as volatile as they are made out to be, largely because Fed policy has not changed greatly from meeting to meeting over that time and has been effectively signaled in advance. When Fed statements do move rates, stocks also tend to move. After the Fed meetings, we've seen some bond strength (interest rate declines) and stock weakness, although this is based on an admittedly small sample.

I will be watching the response of rates and the dollar to the announcement to seek real time guidance for the likelihood of sustained repricings of equities. If there are any unpleasant surprises, they will be priced into bonds and currencies quickly.

Here are Dr. Brett's Tuesday Blog Links and Market Stats

Controlling Emotions Is NOT The Goal Of Trading Psychology

Pick up a book or magazine article about trading psychology and you're likely to find prescriptions for success based on controlling emotions and increasing discipline.

Yes, emotional arousal can interfere with performance, but does that mean that elite performance is a function of dampened emotions?

When you look at some of the greatest performers in sports--and in trading--you'll find highly competitive individuals. They are quite emotional and don't take well to losing. Lance Armstrong? Michael Jordan? Tiger Woods? Muhammad Ali? All were quite intense, emotional individuals who managed to channel their emotional drive into victory.

Conversely, I've encountered many well-balanced individuals who have sought success in trading. They don't blow up, they follow rules faithfully, and they have no intense, competitive emotional flame burning within. I've never yet seen one go on to become successful.

Can anyone watch the really successful college basketball coaches--Coach K., Jim Boeheim, Bob Knight, Tom Izzo--and attribute their success to emotional restraint? Yes, there have been emotionally reserved winners--think John Wooden and Dean Smith--but one suspects their emotionality was that of a warm mentor, not that of a cold fish.

The important ingredient in success is not emotional dampening per se, but the enhancement of concentration and focus. That is what enables people to act with sustained purpose and stay rooted in their goals.

When we review the lives of great individuals across a variety of fields--the research of Dean Keith Simonton and K. Anders Ericsson stands out in this respect--what we find is that the greats have prodigious capacities for work. They are hugely productive. They sustain effort hours at a time, day after day, week after week, year after year.

Only the ability to regularly access "the zone"--that flow state of consciousness that comes from being wholly absorbed in an activity that captures our interests, skills, and talents--can account for the amazing dedication of the Olympic athlete, the great career scientist, or the chess grand master.

Indeed, such exemplary performers can use emotion to access the zone. Michael Jordan used to provoke players on opposing teams so that they would argue and fight back. That would arouse Jordan's competitive instincts and elevate his game.

When we operate outside that "zone" and lose our focus, we are no longer activating that executive center of our brains--the frontal lobes--that control planning, judgment, and reasoning. Left with a weak executive center, we become like the person with Attention Deficit Disorder: prone to wandering attention, reduced self-control, and impulsive behavior.

That makes it look as though "emotion" and "lack of discipline" cause our trading problems.

In reality, however, these are the results of the problem; not the causes.

The goal of trading psychology is to build consciousness, not reduce emotion. The goal is to create regular access to the flow state of heightened learning and focus. Talking to a trading coach, in itself, won't accomplish that; nor will well-intentioned efforts to calm oneself or take breaks from trading.

We can only build consciousness by working on consciousness. That is why I find meditation, heart rate and galvanic skin response biofeedback, self-hypnosis, and newer methods such as hemoencephalography to be valuable tools for traders and emphasized their use in my book on the psychology of trading.

These methods don't eliminate emotion; they build minds. If we can exercise for 30 min./day and build our cardiac fitness and our physiques, maybe--just maybe--a similar commitment could strengthen our abilities to operate within life's "zone". I'll be posting more re: my personal experiments with mind training in the near future.

Blog Links for Monday From Dr. Brett

Finding the Zone With Hemoencephalography

Slowly, a subfield of biofeedback, known as hemoencephalography, is gaining recognition as a method for developing the cognitive skills of focus and concentration. Hemoencephalography is the measurement of voluntarily-controlled regional blood flow in the brain. Research suggests that, with practice, people can learn to increase the relative blood flow to their prefrontal cortex, which is the brain's executive center. This is one way of creating the kind of brain fitness activity advocated by cognitive neuroscientist Elkonon Goldberg. It is also a way of enabling people to develop the capacity to access "the zone": that region of consciousness associated with peak performance. The zone, as it turns out, is actually a state of sustained concentration and frontal activation.

Unlike some other forms of biofeedback, which measure the body's level of arousal and hence assess whether someone is stressed or relaxed, hemoencephalography measures skin forehead temperature. The idea is that, with infrared detection, it is possible to identify when blood flow to the frontal areas is relatively high or low. A skin forehead temperature index is displayed continuously for the user, providing the feedback. The goal is to enhance concentration, not induce relaxation. The technique originally was utilized by Dr. Jeffrey Carmen to control migraine headaches and by Dr. Hershel Toomim to enhance cognitive functioning.

Above you can see my forehead temperature index readings while I was casually surfing the Web in a relaxed manner. The readings dipped over time, then stabilized (blue line). I immediately shifted to a cognitive imagery exercise that requires a high degree of concentration (red line). Note the steady rise in forehead skin temperature.

Now here's the fascinating part: After 12 minutes doing the imagery exercise, I immediately returned to casually surfing the Web. Now, however, I was doing so in a very alert, attentive state. Instead of my temperature dropping, it continued to rise. I was engaging the Web while in the zone; I was highly focused on what I was reading.

Subjectively, my surfing experience was quite different as well. Initially the material I was reading seemed routine and not especially interesting. After the imagery exercise, however, I found my reading material more engaging. My recall is better for the latter material as well.

This, of course, is far from a controlled laboratory experiment, but I believe it makes an important point: Our experience of the world is mediated by our states of consciousness. In one state, I have low concentration and process little of what I experience. In another state, the same material becomes more interesting, and I learn more of it.

Colin Wilson, following the Russian philosopher Gurdjieff, has pointed out that human beings habitually operate at a subnormal level of consciousness. In essence, we operate much of the time along the blue line, not the red one. With intentional exercise, however, we can more frequently engage the world with mental energy and alertness.

How might such capacity for sustained operation in the zone affect performance in trading and in all fields? Might we be less likely to make impulsive trading errors under conditions of heightened awareness? Could we accelerate our learning of trading patterns while maintaining elevated frontal blood flows?

Surely this is a worthy frontier for neuroeconomics. It won't be long before hemoencephalography units and similar devices become widely available to the public--as commonly used for self-development as fitness equipment. With such methods, we will increasingly become the executives of our own minds.

Sunday Blog Links From Dr. Brett

Musical Interlude

Wild Is The Wind - David Bowie: This was the song that opened my wedding reception. More than twenty years later, it's still the song I'd choose for Margie if we held another ceremony.

Winterborn - The Cruxshadows: Thoughts of a dying soldier on the battlefield. Violin, vocals, dance, classical images: beautiful.

Stripped - Rammstein: The Depeche Mode classic, reinterpreted to the images of Leni Riefenstahl's Olympia. Riefenstahl's association with the Nazis has been the source of controversy, but does not diminish the power of her celebration of the human body.

Trading's Mid-Life Crisis: Getting Bigger Vs. Getting Broader

Well, my trading mid-life crisis is nowhere near as dire as Santa's (thanks to the usually off-color Moohead for the cartoon link), but it's surprisingly common--and yet rarely discussed by trading coach/psych types.

The crisis arrives when you've hit a level of relatively consistent success in your trading. You're at an equity curve high; you're not taking large drawdowns; you're following your game plan; and you're comfortable.

Now what do you do? Do you get bigger (do more of what's working in larger size), or do you get broader (find non-correlated markets and time frames to exercise your edge)?

The reason we don't hear too much from the trading coaches and psychologists on this topic is that they tend to address that portion of the trading public that *isn't* successful: those who are not following their discipline and those who, perhaps, have not yet found their edge.

The successful trader has an edge and has the discipline to utilize it. The question becomes how to take maximum advantage.

It truly is a mid-life crisis for traders. In the mid-life crisis we normally think about, we get to the point where we're established in a career field and in a marriage/family. We realize that either we're going to coast to the finish line or tackle something new and challenging while we still have enough time and youthful energy to see it through. That 's really the same issue facing the successful trader.

And, in life as in trading, we facing the issue of getting bigger vs. getting broader. Do I build on success by growing my company and doing more of what is working, or do I begin to develop other aspects of my life and use this success as an opportunity to widen my horizons?

The problem with getting bigger is that you're bound to be at your maximum size when markets change and your edge erodes. I have seen this occur with many very successful traders at prop firms. In a sense, they were one-trick ponies and all their eggs were in the basket of that one trick. In my latest book, I refer to this as "first-order competence": the ability to master a particular market. "Second-order competence" is the ability to master markets as they change. Second-order competence requires going broader, not just bigger.

Systems developer and successful trader Henry Carstens weighs in on this issue with his most recent post. His point is that there is a limit to which you can keep doing more of the same thing. Eventually, you run into problems of collinearity: the overlap among trades. You're not just increasing your size, but your risk. Going broad by trading other time frames or other instruments diversifies risk. That strategy, we might say, is getting broader before you get bigger.

And, you know, that's what the great artists do. They don't just paint, write, or sing in the same style the same way throughout their careers. They remake themselves and keep their work fresh. Read the early biography of rocker John Mellencamp and then his latest bio. He has never stayed still. He was already successful when he announced to his band that everyone, for the next album, would have to learn a new instrument--himself included. Out of that emerged the folk/Appalachian style that made "Lonesome Jubilee" a hit. More recently, he has spent time atop the blues charts.

The time to get broader, I suspect, is when you're on top of your game, not when a shifting market forces you to adapt. It's time for me to learn a couple of new instruments. Too much of my profit has come from short-term countertrend (mean reversion) trades. In that sense, I'm no different from the momentum traders of the late 1990s. Feeling good and feeling flush, doing the same thing over and over. That, too, shall pass.

The explosion of ETFs has made it easier than ever for individual traders to get broader. Different time frames, different markets: when one strategy is drawing down, others are making money. Getting bigger without expanding risk: that's the goal of getting broader.

Blog Links for Saturday

Assessing Market Psychology With Relative Options Indicators

In my last post, I proposed a different way to construct put and call options ratios. Specifically, the equity put ratio looks at equity put option volume as a fraction of its own 100-day moving average. Conversely, the equity call ratio measures equity call option volume as a proportion of its own 100-day moving average. The relative put/call ratio is the equity put ratio divided by the equity call ratio.

Going back to 2004 (N = 720 trading days), we have had 54 occasions in which the five-day equity put ratio has been above 1.2 *and* the five-day relative put/call ratio has been above 1.2. What this means is that we've had a five-day period of higher than average put activity relative to call activity that can be attributed specifically to speculator interest in puts.

Ten days following this spike in put activity, the S&P 500 Index (SPY) was up by an average of 1.11% (42 up, 12 down)--quite a bullish edge. The remaining days in the 2004-2006 sample were up by an average of only .25% (391 up, 275 down). It thus appears that, when put activity is high relative to call activity and relative to its own recent level of activity, returns are above average.

Now let's look at occasions in which the five-day equity call ratio has been above 1.2 (20+% more call options traded relative to the 100-day average) *and* the five-day relative put/call ratio has been below .90 (N = 69). What this means is that we've had a five-day period of higher than average call activity relative to put activity that can be attributed specifically to speculator interest in calls.

Ten days following this spike in call activity, SPY was up by an average of .69% (46 up, 23 down). That is considerably stronger than the average ten-day gain for the rest of the sample (.28%; 387 up, 264 down). It thus appears that, when call activity is high relative to put activity and relative to its own recent level of activity, we see superior returns over a two-week period.

What I'm seeing in the data so far is evidence of reversal effects (for puts) and momentum effects (for calls). When we get a significant expansion of put activity, it's usually in a falling market and that falling market tends to reverse itself. When we get a significant expansion of call activity, it's usually in a rising market and that bullishness enables the market to sustain its rise. In the current market, we see neither strongly elevated put or call activity on a five-day basis.

Clearly, there is much more to be studied in the options data, particularly at an intraday level. So far, at least, it does appear that the sentiment of options participants does have an impact on the distribution of future price changes in the stock indices. The way to superior returns, I suspect, is to look at new market data or to explore old data in new ways. Trading success, in that context, requires an unusual combination of tight discipline and open-minded creativity.

Friday's Blog Links and Market Stats Are Here

A Different Way To Measure Market Sentiment With Options Data

I recently mentioned that I had begun a large research project to investigate historical patterns connecting options data to future movements in stocks. Some of my initial efforts have focused on the equity put/call ratio and its relationship to future equity index movements.

Suppose, however, we treat the put option data and the call option data as completely different time series. Might there be information in each that is obscured when we solely focus on the put/call ratio?

As a result, I calculated the ratio of each day's equity put volume relative to the average equity put volume over the past 100 trading sessions. This we will call the put ratio. I then calculated the equity call volume relative to the average equity call volume over the past 100 sessions. This we'll refer to as the call ratio.

Armed with a separate put ratio and call ratio, we can address the question of whether relative peaks and valleys in equity call and put volume reflect sentiment shifts that impact future stock prices.

Additionally, we can form a new relative put/call ratio that is the put ratio divided by the call ratio. In other words, the relative put/call ratio identifies whether we're getting more put or call activity in the market as a function of the past 100 days' volume.

It turns out that elevations in puts and calls have different impacts upon the S&P 500 Index (SPY). And the relative put/call ratio does a pretty good job as a sentiment measure and as a predictor of S&P 500 prices 1-20 days out. Tomorrow I will begin detailing some of these findings.

For now, suffice it to say that the relative put/call ratio got very low in mid November prior to the short, steep market drop. We have since moved to neutral levels in the put ratio, call ratio, and the relative put/call ratio.

When we have had such neutral levels on a one-day basis (N = 126), there has been no overall edge--bullish or bearish--over the next 1-2 days. When the neutral day occurs during a bearish five-day relative put/call period, however, the next two days in SPY average a gain of .24% (40 up, 23 down). When the neutral day occurs during a bullish five-day relative put/call period--which is what we have at present--the next two days in SPY average a loss of -.11% (27 up, 36 down).

The new options measures clearly point out that returns are superior following five-day periods of bearish sentiment and subnormal following five-day periods of bullish sentiment. By measuring bearishness (put ratio) separately from bullishness (call ratio), we can tease apart periods in which the traditional put/call ratio is high because of high put activity vs. low call activity. More soon to come...

Gurdjieff, Turtles, and Trading

"The highest that a man can attain is to be able to do."

G. I. Gurdjieff

Most posts about trading, mine included, are about doing: what to do, what not to do. This is a post about how to do. This is an important post.

In Vonnegut's book Cat's Cradle, there is a religion called Bokononism. It is a collection of lies ("foma") that make life on the dreary island of San Lorenzo more palatable. Among other things, Cat's Cradle is a book about the role of lies in human life.

Philosopher and mystic G. I. Gurdjieff also emphasized the role of lies in human psychology. The greatest of lies that we tell ourselves, Gurdjieff asserted, was that we have free will. In reality, most of our actions are mechanical, tossed here and there by moods, whims, needs, and the impact of external events.

Of course, it is painful to face the fact that we lack control over our own lives. So we create our own personal Bokononisms. We take solace in New Year's resolutions and earnest plans for self-improvement that, like last year's exercise equipment, eventually become part of our forgotten mental furniture.

Psychologists would never exist if people had free will. Those with problems would read self-improvement books, take good advice, and end their problems straightaway. But, no; that's not how human psychology works. We can know what to do and we still don't do it. We know we're supposed to eat healthy foods; we know we should always be appreciative of our spouses; we should exercise, not overspend our savings accounts; and we should cut our losing trades.

Quite simply, people lack intentionality: the ability to sustain directed activity. They cannot do.

Gurdjieff's insight was that we lack intentionality because we fail to remember ourselves. In a state of self-awareness, we vow to do the right things. Once we exit that self-awareness, the right things vanish with it.

Zen masters spend years cultivating the capacity to remember themselves: to remain self-aware. They realize that free will begins with the ability to sustain a single thought--and only that thought. Sit quietly in a dark, silent room and make the effort to focus all your attention on a mental image of an empty vessel. See how long you can sustain the image without your attention drifting to random thoughts and images. Before long, you forget the vessel altogether...

So what does this have to do with trading?

In 1983, Richard Dennis and Bill Eckhardt sought to resolve their dispute over whether trading success could be taught or whether it is inborn. They tested a trading system, to be known as the Turtle Trading System, and taught it to their group of novice traders.

Legend has it that the Turtles went on to become wildly successful traders. But, of course, like much of history, that is a pack of foma.

The Turtles varied significantly in their trading performance. Some followed the rules Faithfully and made significant money. Others did not and could not follow the rules and were dropouts from the experiment. Intentionality, not the system rules (which were the same for all traders), predicted trading success.

And now I will give away the secret of the Turtle Trading System and why it so effectively illustrates Gurdjieff's insights:

The Turtle Trading System is a system for losing money.

It makes losing money scientific and details precisely how it should be done.

Most traders want lies: how to make money easily, without the constraint of rules or the demands of research. They do not want an education in how to lose money, because they do not want to lose money.

And that is why they never make money.

The precise rules for the System are readily available and there is even software that will tweak the rules and identify the most promising markets to trade. According to Alexa, less than 4 people in a million will visit those pages. And, let's be generous and say that 10% of those visitors make the effort of downloading the rules and 10% of them can actually follow the rules to learn how to lose money.

That leaves us with very few people.

Gurdjieff taught, "If we do what we like doing, we are immediately rewarded by the pleasure of doing it. If we do what we don’t like doing the reward must come later. It is a mathematical law and all life is mathematics."

Not many people like learning how to lose.

Losing money with intentionality: that's a useful secret of the Turtle Trading System, even for those who aren't Turtle System traders.

Thursday's Blog Links and Market Stats From Dr. Brett

Early December Morning With The Doc

10:10 AM CT - OK, I would have loved to have seen a more exciting day for our morning session, but as always we take what the market gives us. My research suggested subnormal returns going forward and my read of the volume and TICK suggested a range bound day. That had me shorting early in the session when we traded above the prior day's average price. That was a very nice trade idea, but it paid out only moderately, which again clued me into a slow, rangebound day. When I saw institutions jump into the market and the TICK distribution go positive, I decided to enter in the direction of the market trend from the last two days as long as TICK stayed healthy. I knew that such a trade was flying in the face of the rangebound thesis, but my risk-reward was pretty good. As it happened, the market did slow down and I had to bail out with a small loss when the TICK no longer looked healthy to me. The main thing for today was using research and market data to figure out what kind of day it was likely to be and then to frame trades patiently rather than chase moves that reverse. Tomorrow's a fresh day...and we may see more slow trade ahead of Friday's numbers. Hope this morning's session has given you some ideas for how to track markets. Let's do it again later this month. Have a great day!

10:00 AM CT - Well, our AM range has been about 4-3/4 points on ES, so the range bound notion has held up so far. I decided to let that last trade breathe, but buyers just didn't come in on the heels of the program trades. We know that from the diminished volume and weak price action on bounces in the TICK. My trading is finished for the day. I'm just not seeing enough opportunity to continue, given the likelihood of trade slowing down further as we head into the midday hours. Back with a wrap up in a few.

9:55 AM CT - OK, lost half a point on that one. Back in a few.

9:50 AM CT - Sticking with the long position, but have my stop in place. As long as the TICK stays skewed to buyers, I'll stick with the position. We've been treading water with lower volume since those buy programs hit. I'm seeing if we can test those overnight highs in ES.

9:26 AM CT - Long some ES

9:21 AM CT - Buy programs hit the market in force; that was institutional and with solid volume lifting offers. One idea to toy with is that we've made our low for the day. As long as the buyers remain in the market lifting offers, we should see a test of the preopen highs.

9:15 AM CT - It's trading more and more like a local-dominated market. No real trend. Note that we made new AM lows in ES and Russell, but not in NAZ, and then we reversed the selling. Those types of thrusts up and down with frequent reversals of the moves are typical of markets dominated by locals. It's dangerous to chase such moves, which is one reason I wasn't selling the ES on that recent move down. Note also how the TICK is starting to turn upward. Let's see how things look on the next TICK pullback.

9:06 AM - Dollar weakening, rates dropping; take a look and let's see how stocks react.

9:04 AM CT - There's a seller's skew to the NYSE TICK and the TIKI and we continue to see sellers hitting bids in the ES. That has to turn around for me to take the long side this AM. Put/call activity remains bullish, though not quite as much as at the open. TRIN is still a touch below 1.0, but drifting higher. Declining stocks lead advancers by 765. My leaning is to sell bounces that occur on successively lower price lows.

8:55 AM CT - When we look at what the large ES traders are doing, we're seeing that there isn't a huge amount of large trader activity so far this AM, but what there is remains skewed to hitting bids. Note that semiconductors and NAZ did not make fresh AM lows on the very recent selling. I'm not seeing a big selling push among institutions so far, and yet there's no substantial buying either. That keeps me on the sidelines. If I have to content myself with one trade for the day, so be it. I don't trade unless a solid idea in line with my research presents itself. That's the discipline part of trading. Waiting like the sniper for the one good shot.

8:46 AM CT - Took profits; not much, point and a half. All this so far is consistent with range bound, pretty slow action; nothing fundamentally driving the market. We're not seeing decisive selling in the TICK and that had me taking what the market gave me.

8:37 AM CT - Note the bullish put/call ratio, but we're not seeing decisive lifting of offers either in the ES (Market Delta) or among the broad list of stocks (NYSE TICK). Declining stocks lead advancers by -525 as I write and volume is not outstanding. This is consistent with a range bound day so far. We already hit the avg price from yesterday on my trade. That was first target.

8:32 AM CT - Small short position in ES here.

8:20 AM CT - Here's the link to the Mortgage Bankers Association weekly survey of mortgage applications. Note that we're seeing an uptick in mortgage loan application and an uptick in refinancing. The dollar initially strengthened vs. the Euro on the news, but has since fallen back. Stocks initially rallied, but also fell back and since have stabilized. Interest rates are up and are hovering at those higher levels. The important thing is that we're not seeing a move outside yesterday's trading range in the equities. So the market is not treating the housing news as being of fundamental importance to stocks. I will be looking closely to see if the ES can move above the 1417.5 level that was rejected after the news came out. If so, with meaningful volume, that would be fresh buying and worth following. Conversely, an inability to surmount that pre-opening level would target yesterday's average price and yesterday's trading lows. These are the kind of what-if scenarios I play with prior to the open. The goal is to anticipate various situations and to be ready to act decisively if and when they occur.

8:05 AM CT - SOX to be you...notice how the semiconductors have lagged during the recent runup in stocks. I'll be watching the semis this AM. As I noted in today's Weblog, we're also seeing lagging action in the European bourses. If you missed my post on what I look for in the initial minutes of trading, do check that out. My main focus initially is simply volume: how much we're getting and how it's distributed. That will tell us who's in the market and which way, if any, they're leaning. So far, we're retracing some of the recent action: dollar up, interest rates up, gold down, oil down. Let's see how stocks respond. Back before the open.

7:40 AM CT - Good morning! We'll be talking a bit about the equity put/call ratio this AM, so check out the chart on the Trading Psychology Weblog and the recent blog post on the topic. As the Weblog noted, my research finds subnormal returns in the near term following periods of bullish intraday sentiment. This also fits with the put/call research mentioned in the blog post. We've got some strength in the dollar and a rise in interest rates prior to the open--both retracing movements from the last few days. That's weighing a bit on stocks in the pre-opening market, which are trading back toward the average price from Tuesday (1414.5). We see overnight resistance at 1417.5 and some support from Tuesday AM at 1412.25. There are no major numbers out today, although we will see crude inventories reported at 9:30 AM CT. The big unemployment numbers are due Friday, so we could see trade slow down as we approach that time. I'll be watching volume early in the session to see who is in the market and how much participation there is. My initial leaning is to expect a relatively slow, rangebound day, as we digest good gains from the last two trading sessions. We've had good participation on that rise, so it will take some distinct bearish intraday sentiment--traders aggressively hitting bids--to get me short for anything other than a short-term trade. I am going to be especially alert for market rises that either fail to breach the overnight resistance or that test the highs with poor participation (i.e., many sectors failing to make new highs). Those will be candidates for fading. Back before the open.

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What We Can Learn From The Equity Put/Call Ratio

If you take a look at today's Weblog entry, you'll notice a chart of the equity put/call ratio for yesterday, December 5th, on a five-minute basis. That chart, which I was unfortunately unable to post here due to some technical difficulties, is worth a bit of study.

We opened with the put/call ratio at about .59, well below the 100-day average ratio of .78. That tells us right away that call buyers are being more aggressive than put buyers in relative terms. When we also see, from the NYSE TICK, that traders are lifting offers in more stocks than they're hitting bids, it clearly tells us that the market's initial sentiment is bullish.

By tracking the TICK and the equity put/call ratio through the day, we can determine whether or not bullish sentiment is increasing or reversing during the session. The Weblog chart shows us clearly that, as the afternoon wore on, call buyers continued to be more aggressive than put buyers. Indeed, we saw a downward move in the put/call ratio leading the market's afternoon rise toward its highs.

When bullish sentiment is sustained--and especially when it's expanding--during the day, fading market moves can be costly.

The 1-5 day market forecast when we have put/call sentiment extremes, however, suggests that we should fade those extremes. Since 2004 (N = 733), when we have a relative put/call ratio (i.e., the ratio of the current put/call reading to the 100-day average) that is below .70 (N = 26), the next five days in SPY average a loss of -.18% (11 up, 15 down). When the relative put/call ratio has been above 1.4 (N = 31), the next five days in SPY have averaged a gain of .21% (18 up, 13 down).

Indeed, when the relative put/call ratio is above 1.0, the next day in SPY averages a gain of .07%. When the relative ratio is below 1.0, the next day in SPY averages a loss of -.01%. All other things being equal, bullish sentiment tends not to carry over to the next day's trading.

As my research with options and stock market trading patterns continues, I will be reporting on further results.

Blog Links and Market Stats for Wednesday

What You Can Learn From The Opening Minutes Of Trading

Is today likely to be a trending day or a range bound day? Are we likely to see volatile price action or slow meandering? Are we likely to test recent highs or lows? All of these are important questions for short-term traders as they begin their days. Because most stocks show a significant, positive correlation with the movement of the stock indices, handicapping the odds of the index moving in a particular way can provide a useful edge. Here are a few items on my radar during the opening minutes of trading. Hopefully I'll be able to illustrate some of them during tomorrow's Morning With the Doc session:

1) Trading volume in the first few five-minute segments of the session - Volume correlates very highly with volatility, and volume tells us if large, institutional participants are in the market. Low volume compared with recent norms tells us that we have a market dominated primarily by locals and we can expect lower volatility and range bound trade. The volatile, trending moves tend to occur when we sustain above average volume.

2) The distribution of the NYSE TICK ($TICK) and the Dow TICK ($TIKI) - Recall that the TICK measures are constant updates on the number of stocks trading at their offer price minus those trading at their bids. These provide us with the shortest-term sentiment information possible. As with volume, I am looking at how the TICK measures are distributed relative to recent norms. If we see both TICK measures skewed in a positive direction relative to recent sessions, the odds of sustained upward movement are greatly increased. Similarly, a sustained negative skew to the TICK measures tends to occur during downward trending days. It's where we see little skew and/or a mixed skew between the two measures that we tend to get range bound action.

3) The behavior of global markets - I keep my eye not only on European stocks, but also on gold, oil, bonds, and the dollar. If these markets are moving significantly and breaking out to new levels, we're more likely to see a repricing of equities. Quiet global macro markets provide little incentive for large traders to reprice equities, and that's when we see range bound drifting markets.

4) Recent trading ranges and support/resistance - Think in Market Profile terms. We want to identify the market's value range, and we want to identify how the market trades as we test the upper and lower boundaries of that range. The first range that is important to me is the pre-opening Globex range. I also want to look at the range from 7:30 AM CT to the open if we've had an economic report prior to the open. Ditto the 7:30 AM - 9:00 AM CT range if we get numbers early in the trading session. We also want to be aware of the previous day's range and how the market trades as we test prior days' highs and lows. If we cannot generate increased volume and participation as the market tests range extremes, we're much more likely to fall back into that range.

5) Distribution of volume, especially of trades by large traders - This is the data I gather from the Market Delta program. I'm looking at the proportion of volume in my instrument (usually the ES futures) that is occurring at the bid price vs. the offer. I also place volume filters on the data so that I only observe the distribution of large trades at the bid vs. offer. This tells me if large locals and large institutions are primarily buyers or sellers. I always want to be trading in the direction of the whales. Always.

So there you have it. Every single trade I place is an idea derived from some combination of the above information. No, I don't look at chart patterns, oscillator readings, Fib levels, or wave patterns. If you utilize such methods and have found success, perhaps some of the above pieces of information will help your batting average. If those methods are not making you money, perhaps you'll want to weight the above factors more highly. The idea is to see *how* the market is trading and *who* is participating in the market. Within the opening minutes of trading, you can hold your finger to the market air and figure out which way the wind is blowing. That, in itself, can confer a meaningful edge.

Here Are Blog Links and Market Stats For Tuesday

Tuesday Blog Links and Market Stats

Note: The Trading Psychology Weblog will resume daily posting Tuesday night. Wednesday AM will be another Morning With the Doc session, in which we'll track the market in real time.


Market Ideas:

Trader Feed's three steps toward self-improvement in trading.

Divergent thinking, a key to the pros' success, from Trading Markets.

I like how Seeking Alpha parcels blog content into long ideas, short ideas, sector themes, etc. Here's an interesting perspective on lower dollar, higher stocks.

Excellent economic overview and perspective on Turkey from Yaser Anwar.

Kirk takes a look at the CNBC stock screener.

Trader Mike tracks new highs in the indices.

Trading the Charts, with a variety of market perspectives in its December newsletter.

Resilience and more from Adam Warner.

Sentiment and more from Abnormal Returns.

Very thoughtful post on buying bonds from Random Roger.


Market Expectations:

My measure of upside momentum (Demand) to downside momentum (Supply) rose on Monday to 149:27. Recall that this measure tracks the number of stocks closing above their volatility envelopes vs. those closing below. We're seeing the number of stocks with strong upside momentum outnumber those with weak momentum by more than 5:1. In general, we tend to be more likely to see upside follow through 1-5 days out following new highs with broad participation vs. new highs with weak participation.

The number of S&P 500 stocks making fresh 52-week highs rose nicely to 65 on Monday, although that remains below the 80 level recorded about two weeks ago. Among the S&P 600 small caps, new highs were 56, down from a little over 80 two weeks ago. As long as we make day over day highs and expand the number of stocks making new highs, the short-term trend has to be considered bullish.

Note that this rally has actually broadened. The Russell 2000 made a new high on Monday, but the Dow did not. In general, weakening markets don't broaden to the upside.

Three Relentless Steps You Can Take Now Toward Becoming A Better Trader

One of the goals of my book Enhancing Trader Performance was to figure out what makes successful performers tick--in any field of endeavor. What I learned in researching the field was that talent--inborn abilities--are necessary for success, but not sufficient. It's how people channel their talents by structuring their learning processes (i.e., their building of skills) that ultimately determines whether or not they become elite performers. Here are three straightforward ways you can structure your learning to make the most of your talents:

1) Keep score. Relentlessly. When Lance Armstrong's performance team works with him, no aspect of performance is ignored. They measure his stance in the bike to minimize wind resistance; they measure his pedaling frequency to maximize his speed and minimize his effort; and they tweak the design of the bike to achieve every possible edge. His cycling performance may be art, but behind it is plenty of science. So it is in other performance domains, from NASCAR to chess to ballet: the greats study what they do to constantly improve. Take a look at the performance metrics that professional traders collect to figure out their strengths and weaknesses. They figure out how they perform in rising, falling, and flat markets; they evaluate their performance as a function of being long or short and as a function of time of day. Keeping score builds the motivation to continuously improve, but it also tells you which improvements to make. Track every trade you make: How much did it go against you while you were in the trade? How much did it go your way after you exited? How could you have recognized that it was a winner (so that you could have scaled in with more size) or a loser (so that you could have exited with minimal loss)? The really great performers make themselves a subject of study.

2) Study the market. Relentlessly. There's a reason why the great basketball and football coaches review game tapes obsessively with their teams. There's also a reason why chess grandmasters play and replay games from past tournaments. So much of performance--especially in trading--boils down to pattern recognition, and so much of pattern recognition boils down to multiple, high-quality exposures to the marketplace. A program that I use called Market Delta breaks down trades by their size and by whether they were transacted at the market bid or offer. That way, we can see if large traders are leaning to the buy or sell side. A replay feature in the program enables us to review each market day and see how the buying or selling unfolded. This provides us with many more of those high-quality market exposures than we could ever hope to get from simple live trading. In my book, I mention a learning technique used by many of the most successful traders I've known: they videotape their trading and then review the tapes after the close. It's a great way to review what the markets did--and how you responded. After a while, the patterns jump out at you.

3) Read. Relentlessly. Particularly for the independent trader, trading can be an extremely isolating activity. It's easy to get locked in your own head, your own ideas. If you look at the life histories of expert performers in various fields, you find that most of them have not been isolated. They have had mentors at various points in their careers to help them learn and grow. How can you pick the brains of the world's greatest traders and investors? Books and blogs offer one important avenue. True, there are many fluff books and self-absorbed blogs, but there are a few written by the pros that are worth their weight in gold. Right now, I'm reading Inside the House of Money by Steven Drobny. It's a wonderful collection of interviews that gets inside the heads of global macro traders. I'm also reading Ken Fisher's new text, The Only Three Questions That Count. He explodes a number of market myths and models a way of thinking about markets that has led him to consistent success as a money manager. Take a look at blogs written by Barry Ritholtz and Bill Cara; read the extensive Q&A sessions posted by Charles Kirk in his Members section. You may not agree with all their conclusions, but you'll learn how they think about markets. That is mentorship-by-observation.

It takes a relentless pursuit of excellence to become excellent: that is what I learned from my performance research. You can only sustain such a pursuit if you truly love what you're doing; if it captivates your very being. If you're not relentless in your pursuit of trading success, perhaps it's not that you need discipline or motivation. Perhaps trading is not the domain in which you were meant to excel. What my daughter Devon taught me is that somehow, somewhere there is a kind of productive activity you were meant to do. And when you find it, you will be relentless, because you want to be doing nothing else.

Blog Links and Market Stats for Monday AM

Market Ideas:

Trader Mike tracks the recent volatility in the indices.

Declan Fallond finds weakness among internals.

A Dash of Insight questions the negative spin on economic data.

How Trader X screens for gap trades.

Altucher's links, including playing the baby boomers in China.

Trader Eyal on process improvement in trading.

Weekend linkfest from Barry Ritholtz.

Bill Cara explains his market stance with a broad perspective.

Adam Warner passes along some very interesting observations on correlations.

Energy has been the strongest sector of late, finds Ticker Sense.

24/7 Wall St. finds e-commerce and Amazon looking healthy.

Carl Futia revises his forecast and offers a perspective on flexibility in forecasting.

Millionaire Now! on profiting from the office condo boom.

Interesting market stampede notion is among the links at Abnormal Returns.


Market Perspective:

I took a look at the intraday volatility of market days in the ES futures, given the sharp moves during Friday's trading session. I did not find a directional bias following such volatile days, but did find evidence of serial correlation. In other words, these volatile days tend to cluster. That will have me looking for further volatility early in the week, particularly if we continue to see sharp moves in the dollar and interest rates.

Despite recent downmoves on Monday and Friday of this past week, we're still seeing over 73% of S&P 500 stocks trading above their 50-day moving averages. That figure is almost 66% for the S&P 600 small caps. At 34 new 52-week highs among S&P 500 stocks, we're well off the momentum peaks from a couple of weeks ago, not to mention the March-May peaks. But how many S&P 500 stocks made new annual lows on Friday? Zero.

In other words, we've been seeing volatility, but not sustained weakness. Each time we've had strong selling, buyers have jumped in. Funds are judged by their annual performance and perhaps no one wants to be on record at year's end as out of the equity market. Whatever the cause, if the buyers continue to absorb this selling we could see further tests of the market highs in the not too distant future. The options players are bearish and the economic weakness and weak dollar are on everyone's radar. The contrarian in me wonders about the upside.

How Trading on the Screen Differs From the Floor

Let's say that you wanted to sell your car at an auction. It's a several year old sedan with average miles in very good condition. How would you price your vehicle?

Well, you could look at a guide, such as the one published by NADA, and that would provide a good starting point.

The reality is, however, that how much money your car will fetch will depend upon how many other, similar cars are available for sale at the auction. You need to know if it's a buyer's auction, with lots of recent model sedans available, or a seller's auction, with few such cars on the market.

Moreover, you would look to see who else is participating in the auction. If you saw a representative from Hertz pull into the auction with a fleet of sedans to sell off, you'd want to sell your car as quickly as possible (before the fleet) and take the best price you get. Conversely, if you saw a group of used car dealers wanting to buy cars for their lots, you might price your vehicle more aggressively.

Chances are, with Hertz in the auction, you would accept the highest bid for your car. When the dealers are in the market, they might have to compete with each other and grab your car at the price you're offering. The transaction at the buyer's bid price or at the seller's offer would tell you whether it's a buyer's or seller's market.

On the floor, in the commodities pits, you can see who is buying and who is selling--a bit like the auto auction. You know who the locals are, and you can see brokers come into the pit with orders from "paper"--the institutions. You actually see and hear the volume being transacted and can see prices move or stall as locals make markets. Most important of all, you can see from the activity of the participants whether it was a buyer's market, a seller's market, or a dull market with locals trading back and forth with each other.

The market's auction process is far less visible on the screen, which is why successful pit traders are not always successful when they move to electronic trading. They no longer have the visual and auditory cues when volume picks up and, most important of all, they no longer have that feel for who is in the marketplace. Imagine selling your car at auction and finding out that Hertz has just placed 100 similar cars alongside yours. That happens on the screen to new traders all the time.

This is why I consider volume analysis to be important to short-term trading. By decomposing volume into component trades, seeing what is happening with large vs small trades, and seeing which trades are occurring at the market bid or offer, the screen trader can regain some of the edge of the pit trader.

Here is a worthwhile exercise for former pit traders adapting to the screen (and for new electronic traders): Watch volume on a 1-minute basis and see where volume expands significantly and remains elevated for several minutes at a time. This elevation is created by large traders entering the market. Look at what was going on in the market to trigger these large trades. Maybe it will be a technical event, such as breaking a support level. Perhaps it will be a news item or economic report. Other times, it will be triggered by a move in a related market, such as bonds, the dollar, or oil.

By watching, watching, watching those volume elevations each day and what causes them, you begin to think like the large traders. You gain familiarity with the rules of the game that they are playing by.

And *that* is an edge.