A Look at Some Stock Market Indicators and What They're Saying

There are a few indicators I follow daily that reflect momentum and strength in the stock market. I look to these indicators to give me an idea of whether stocks overall are strengthening or weakening. If strengthening, I tend to look for continuation of uptrends or short-term reversals of downtrends. If weakening, I look for downtrends to continue or uptrends to reverse. I use these measures more as a heads-up than as precise timing devices. They've been very helpful in keeping me in trending moves and avoiding chasing moves that are about to reverse.

So what are the indicators and what are they saying now?

My first measure is the number of stocks in the S&P 500 Index that are trading above their 50-day moving averages. At present, that percentage is 23%, which has--over the last few years--been a level at which we've tended to see intermediate-term market bottoming. What that tells me is that, if we're in a corrective mode, we should start to see some signs of market bounce shortly. If we fail to see buying after a dip such as we've had, that would be more consistent with a bear market scenario. Among S&P 600 small cap issues, we similarly see 23% above their 50 day MA. This, too, is consistent with levels we've seen at recent intermediate-term lows.

A second measure I like to look at is the number of NYSE common stocks (not all NYSE issues) that are making fresh 52-week lows. This is my favorite measure of the health of the broad market. Here we see that, on Monday, we registered 7 new annual highs against 94 lows. Interestingly, this is the second consecutive day in which the market has closed lower, but with fewer stocks making new lows. This is very much worth watching. It says to me that the downside might be drying up here; in the past, it has paid to look for signs of near-term reversal.

A third measure I track is the advance-decline line specific to those NYSE common issues. This is a second useful way of tracking the health of the broad market. Here we see that the AD line is pretty much where we were at the August lows. I am watching carefully to see if we break those lows. Meanwhile, the AD line specific to the S&P 500 Index stocks remains above its August lows, as is the case for the NASDAQ 100 Index. The AD line specific to the Dow 30 Industrials is unusually strong, suggesting that money may be flowing to these large caps during the market weakness as a kind of flight to quality. The AD line specific to the S&P 600 small caps has been making new lows during this downturn, though it has also stabilized over the last two trading sessions--something I'm again watching.

A particularly sensitive indicator of market strength and weakness is the number of stocks across all the major exchanges that are making fresh 20-day new highs vs. new lows. Here we see on Monday that we had 131 new 20-day highs against 1137 new lows. Once again, we're seeing new lows dry up, even as the market has moved lower of late.

Finally, my favorite momentum measure reflects the number of stocks that are closing above and below the volatility envelopes surrounding their short-term moving averages. I translate these figures into an index that I call Demand and Supply, respectively. On Monday, Demand was 58 and Supply was 67. That is a narrower gap that one would normally expect after market weakness, with Supply running below levels from the past week. That tells me that fewer stocks are maintaining downside momentum.

So what does all this mean? It tells me that, for now, the market is weak, but it is not weakening. Indeed, most measures of strength and momentum are making higher lows even as we close lower. That puts me on watch for possible short-covering rallies and serves as a heads-up for possible intermediate-term bottoming. I don't discount the possibility of further bear action, but need to see it reflected in my indicators before I sell market lows.

RELATED POST:

Principles of Short-Term Trading
.

Six Positive Trading Behaviors

There is much more to good trading than merely eliminating bad habits. Here are six trading behaviors I find among many of the best traders I've had the pleasure to work with:

1) Fresh Ideas - I've yet to see a very successful trader utilize the common chart patterns and indicator functions on software (oscillators, trendline tools, etc.) as primary sources for trade ideas. Rather, they look at markets in fresh ways, interpreting shifts in supply and demand from the order book or from transacted volume; finding unique relationships among sectors and markets; uncovering historical trading patterns; etc. Looking at markets in creative ways helps provide them with a competitive edge.

2) Solid Execution - If they're buying, they're generally waiting for a pullback and taking advantage of weakness; if they're selling, they patiently wait for a bounce to get a good price. On average, they don't chase markets up or down, and they pick their price levels for entries and exits. They won't lift a market offer if they feel there's a reasonable opportunity to get filled on a bid.

3) Thoughtful Position Sizing - The successful traders aren't trying to hit home runs, and they don't double up after a losing period to try to make their money back. They trade smaller when they're not seeing things well, and they become more aggressive when they see odds in their favor. They take reasonable levels of risk in each position to guard against scenarios in which one large loss can wipe out days worth of profits.

4) Maximizing Profits - The good traders don't just come up with promising trade ideas; they have the conviction and fortitude to stick with those ideas. Many times, it's leaving good trades early--not accumulating bad trades--that leads to mediocre trading results. Because successful traders understand their market edge and have demonstrated it through real trading, they have the confidence to let trades ride to their objectives.

5) Controlling Risk - The really fine traders are quick to acknowledge when they're wrong, so that they can rapidly exit marginal trades and keep their powder dry for future opportunities. They have set amounts of money that they're willing to risk and lose per day, week, or month and they stick with those limits. This slows them down during periods of poor performance so that they don't accumulate losses unnecessarily and have time to review markets and figure things out afresh.

6) Self-Improvement - I'm continually impressed at how good traders sustain efforts to work on themselves--even when they're making money. They realize that they can always get better, and they readily set goals for themselves to guide their development. In a very real sense, each trading day becomes an opportunity for honing skills and developing oneself.

These six criteria, I believe, can form the basis for effective report cards. Traders can grade themselves in these six areas and, over time, establish where they're strongest and weakest. I find such self-appraisals very helpful for coaching; ultimately they provide goals for self-development and criteria for measuring progress over time. In no small measure, good trading boils down to three factors:

1) Having a demonstrated edge;

2) Having the skills needed to exploit that edge; and

3) Having the resilience to bounce back when the edge is no longer present.

It's the traders who have all three qualities that are most likely to make a long-term career out of the markets.

RELATED POST:

A Potpourri of Articles on Trading and Trading Performance
.

On My Mind: Ideas to Start the Market Week

* Tracking Weakness and Opportunity - As I mention in my weekly market summary, I'm looking at the market's ability to hold the August lows as a key test. We can see a range in the Russell 2000 Index going all the way back to early 2007; also for the S&P 500 Index (SPY). We're either at or approaching key levels in those indexes, which may tell us a great deal as to whether this is another correction a la March and August or the start of a true bear market. Note the wise words of caution from Charles Kirk.

We're hearing concerns about the dividends for the financial stocks; that is hurting high yield ETFs such as PEY. That also can't be good for fundamental market valuations. Note also that we've breached August lows in the Semiconductor Index ($SOX) and the S&P Consumer Discretionary stocks (XLY). The weakness is not just limited to financials and homebuilders, and indeed recently has spread to those outperforming sectors: large cap technology and China. One possible tell: will institutions step up to the plate and start buying those bank stocks, perceiving value--more opportunity than risk--in the beaten up area? We saw a little such interest late in the week. Let's see if that was the start of a theme or mere short covering among the long/short participants.

* Hot Blogs - Excellent listings of sites worth visiting from Chris Perruna. See also Chris' perspectives on corrections, bear markets, and the market's big picture.

* Lessons From Market Wizards - Keen insights; The Big Picture outlines what we can learn from the Wizards in Schwager's series. See also the week in preview, including a link to why our brains are wired for optimism.

* Options for the Fed - Very interesting perspectives on how the Fed could respond to the current credit challenges, further unwinding of quant trades, and other market/economy links from Abnormal Returns.

* Historical Patterns and Trading System Ideas - Check out Jeff Pietsch's blog and his recent posts. He finds favorable returns after big NASDAQ drops and outlines a sentiment trading system.

Thoughts on Trading and Creativity

Researcher Mihalyi Csikszentmihalyi describes creativity as an integration of ten seemingly opposing qualities. For example, the creative person exhibits great seriousness and intensity of work, but also the capacity to play with ideas and draw upon fantasy. Well-known researcher Robert Sternberg has compared the creative individual to an investor who buys low (entertains ideas when they are unpopular) and sells high. A key facet of creativity, from this vantage point, is novelty. The creative person thinks and performs in novel and productive ways.

We commonly hear that it is impossible to make money in the markets by following the herd. But the flip side of that assertion is that the successful trader and portfolio manager needs a degree of creativity: an ability to see markets in new ways, perceiving fresh relationships. A creative mode I've noticed among successful traders is a deep look at assumptions that the majority accepts and that might not be true or might already be fully priced into the market. The ability to question fundamental assumptions requires independence of thought, a willingness to be out of step with the status quo.

In 2002-2003, we saw the highest levels of bearish sentiment among investors polled by AAII in a decade, as half or more of those polled were bearish. Since August, 2006, we've been seeing an increasing number of 50+% bearish readings, including this past week. Those negative readings have marked good buying opportunities. That doesn't mean we can't go lower in the markets--the majority isn't always wrong--but it does call for creative pause. There are *so* many reasons to be bearish here; they fill the weekend financial media. So many reasons, indeed, that it makes me keep an eye open for opportunity, even as I protect capital.

RELEVANT POST:

Assessing Your Personal Strengths
.

Reflections on the Trader as Warrior

In his book Shambhala, The Sacred Path of the Warrior, Chogyam Trungpa lays out a vision of living life as a warrior. His definition of warrior surprised me. He said, "The key to warriorship...is not being afraid of who you are. Ultimately, that is the definition of bravery: not being afraid of yourself" (p. 28).

Later, Trungpa explains, "The warrior, fundamentally, is someone who is not afraid of space. The coward lives in constant terror of space. When the coward is alone in the forest and doesn't hear a sound, he thinks there is a ghost lurking somewhere. In the silence he begins to bring up all kinds of monsters and demons in his mind. The coward is afraid of darkness because he can't see anything. He is afraid of silence because he can't hear anything" (p. 155).

I suspect that Trungpa would see many of the things of our lives--from TV to iPods to cell phones to food and drink--as the space-fillers that maintain our cowardice. In space--silence, darkness--we are left with nothing but ourselves. If we are afraid of who we are, we will frantically seek to fill the space, running ever further from ourselves. But warriors derive strength from space...in tuning out the space-fillers they get closer to who they really are.

In the Japanese tradition of Morita therapy, people stay in their bed and refrain from any activity, day after day. For a while, they catch up on sleep and daydream, but eventually they become bored. After a while, the boredom passes, and they begin to reflect on themselves and their lives. They come to terms with issues that had long been put aside. The whole of therapy consists of doing nothing. It's about contacting space, finding the warrior within.

Ironically, the self we flee from often is not the bad self, but the very best within us. We are afraid to face our potentials, how far we could truly come. This is what makes the warrior: the willingness to face that chasm between the real and the ideal and forge a bridge from one to the other. It takes a certain bravery to sustain the look into the chasm, even as one builds bridges.

We enact our warriorship or cowardice each trading day. Markets move, and it is only in space--the silence of our minds--that we can be open to what they are doing. The cowardly trader, in constant terror of that space, fills it with fantasies of what the markets might do. Thus it is that the cowardly trader fails to take trading signals, gets out of trades prematurely, or lurches into trades where no signals are present. The warrior trader, in Morita mode, engages in the doing that is not doing: silently observing each piece of information until the time is right for action, then letting positions go and do their thing.

So much of bad trading amounts to cowardice. So much of success amounts to sitting and doing nothing and feeling grounded in that space.

RELATED POST:

Devotion to Development
.

Making Decisions From Current Stock Market Data

In recent posts, I have taken a look at the relationship between volume and stock market movement. I've also examined market direction and its relationship to the NYSE TICK. It's been a bit confusing for some readers, because I reported on contemporaneous relationships among these variables: how the current volume or TICK is associated with current price movement. This is quite different from taking a predictive look: examining past values and their association with future ones.

And yet I find that the contemporaneous look is truer to my own decision-making process in trading than the predictive one, particularly with respect to short-term (intraday) trading. In this final post in my series, I'd like to explain that decision-making process.

We often think of decision making as an event: something that happens at a single point in time. We observe X and predict Y. We see a pattern, and we decide to buy or sell. There are certainly decisions that arise in such a manner, but I think there's generally much more to making up our minds.

Consider members of a jury. If they approach their task properly, they enter the courtroom with an open mind. They hear testimony from both sides, listen to cross-examinations, and weigh evidence. As each new witness or piece of evidence is introduced, the jury members revise their estimates of the guilt or innocence of the defendant. Their reasoning occurs over time, reflecting a weighting process that considers new data in the light of past information. A statistician would say that the jury members are engaged in an informal Bayesian process.

Much of our decision making in life follows the informal Bayesian model. Consider:

* We're in our car trying to get home by a new route. As we pass by streets and buildings, we revise our judgments as to whether we're going the right way or not. At some point, landmarks might be so unfamiliar that we decide we're getting lost and we turn around. Alternatively, we may see familiar streets and decide we're headed in the right direction.

* A physician listens to the complaints of a patient and then makes a physical examination. Along the way, the doctor revises his or her judgments about the patient's illness, discarding hypotheses and narrowing down to an eventual diagnosis.

* We gather economic reports to gauge the health of the economy. With each major piece of data, we revise our estimates of whether or not we're headed for recession, inflation, Fed easing, etc.

In other words, we behave like informal scientists. We accumulate tentative hypotheses about the world and then test those against our ongoing observations. Those hypotheses are either strengthened or revised based upon the fresh information gathered.

All of which brings us to stock market volume and the NYSE TICK. My job, as I'm trading, is to use current readings of volume or buying/selling sentiment to estimate the eventual distribution for the day. If volume in the first X minutes of the day is running significantly above average, I make an initial inference that institutions are active in the market and that the day will see above-average volatility. With each new five-minute reading of volume (compared to the average five-minute volume for that time of day), I revise my ideas about institutional participation and volatility to come.

Similarly, I view the NYSE TICK, not as a set of discrete readings, but as a distribution of values over time. If, in the opening minutes of trade, I note a negative distribution of the Adjusted TICK values, I infer that selling sentiment is outweighing buying sentiment. I then look to each bounce and drop in TICK to see if that distribution is changing, adding to negative or positive sentiment. On Thursday, the TICK distribution was negative but not falling. Then, with an upward shift (which is often heralded by an upside breakout in the TICK values), I quickly revised my estimate that the market would close near its lows. Indeed, my revision suggested we could see significant short-covering. With each subsequent positive TICK reading, my own estimate of the market's bounce potential gained confidence.

I believe this informal Bayesian process gets at the heart of what it means to be a discretionary trader. It's the impulsive or inexperienced trader who makes decisions at a single point in time based on a single observation. The skilled discretionary trader--even at very short time frames--weighs evidence as it comes in and revises expectations accordingly. For the scalper, that evidence might come from a depth of market ladder; for a short-term trader it might come from volume transacted at market bid vs. offer; for a longer-term trader, it might come from accumulation of money flows. Like the wandering driver in a new city, we look for landmarks and decide over time if we're headed in the right direction.

Getting lost in new places is inevitable. The good trader, like the good driver, is one who keeps an open mind to new information and can quickly change direction if needed. Such openness requires a non-defensive stance vis a vis one's ideas--a readiness to acknowledge being wrong--and an ability to be in the present and (like the jury member) impartially process fresh information.

RELEVANT POST:

How I Trade
.

Test Before You Invest in a Trading Career

Contemplating this nugget of wisdom from the wonderful Despair.com site, I reflected upon all those traders who have described their competitive edge in the marketplace as "a passion for trading". Can you imagine asking your surgeon for his or her qualifications and receiving a similar reply? Not that there's anything wrong with passion, but one would like to see it backed up by a bit of training and skill!

So what is one's competitive edge in trading? If you're a systems trader, your edge comes from your trading rules: entries, exits, stops, and position sizing. That edge is documented through historical backtesting across a range of market conditions. Conducted properly, such testing shows precisely how much money you would have lost and won during various historical periods--the risk adjusted returns you can reasonably hope for going forward.

When you're a discretionary trader, your edge comes from your skill. Your ability to recognize market patterns, act on them with consistency, and effectively balance risk and reward provides your advantage in the marketplace. Your edge is documented through paper trading (or live trading of small positions) across a range of market conditions. Such a track record enables you to see how much money you won and lost during various historical periods--the risk adjusted returns you can anticipate in the future.

What is not a valid means for testing one's trading advantage is taking on faith that the methods have worked for others (including would-be gurus). "Other people use the X method," traders have told me. "It must be valid." But do you know that these methods are working for others? Do you know that you would have the same skills, risk tolerance, and consistency to exploit these methods?

Ultimately, a real time track record--for systems as well as discretionary traders--is the gold standard for estimating one's trading edge.

But if you haven't backtested your rules or diligently tracked your performance in real time, can you know you have an edge?

Moreover, if you don't know you have an edge, can you have full confidence in your trading?

When traders don't stick with their ideas, they call it lack of discipline. But perhaps lack of testing is the better term. Maybe traders don't stick to their ideas because they've never truly put those ideas to the test. Down deep, they lack the conviction that can only come from hard-won experience.

Would you invest in a car without giving it a road test? Would you buy a house without testing the mechanicals and inspecting the structure? A trading career is no less valuable: testing before investing in your trading is a great means for cultivating confidence--and, as we recently saw, confidence is a great step toward clarity in decision-making.

RELEVANT POSTS:

Understanding Lapses in Market Discipline

Top 10 Reasons Traders Lose Discipline
.

We're All Trading the Same Markets

The first market development that we've seen the last few months is that we're all trading the same market. Above we see charts for the Ten-Year Treasury Note Yield, the Russell 2000 Index futures, the Yen/Dollar futures, and the VIX. Note how the Russell and Yen are near mirror images, and how the VIX is similar to the Yen. In early August, drops in the Russell began to correspond to declines in yield. As a result, we see falling yields when stocks are weak, Yen is strong, and VIX is rising. There's reduced diversification: currencies, stocks, fixed income; they're pretty much all the same.

The second market development is that we're all daytraders now. Of course that's an overstatement, but the dramatic rise in volatility over the last year, combined with losses at banks and hedge funds, has meant that traders have to manage their risk intraday. That is helping to create significant volume and significant intraday market swings. I can't remember a period in which so many longer-term traders have stayed so glued to their screens, making decisions in a potentially reactive manner.

All of this is relevant to what you watch when you trade, how you size positions, and how you view your risk when positions are correlated. In the end, there's just two settings on traders' current thermostats: risk seeking and risk aversion. And the two are playing themselves out daily.

RELEVANT POST:

What's Carrying the Stock Market
.

Option Volume Burst and More Ideas for a Volatile Market

* Equity Options on the Rise - We see above (click chart for greater detail) the S&P 500 Index (SPY; blue line) from 2004 to the present alongside 20 day average total equity put and call volume (red line). Equity option volume has expanded about 50% over this time period; note how total option volume has tended of late to spike during market declines. According to my stats, Thursday's total equity option volume was a record. We've also had two consecutive days in which total equity put volume has exceeded call volume. Here's a worthwhile post on put/call spikes among the equity options.

* Links Worth Reading - Charles Kirk has an extensive link selection, including a view on how long the housing slump could last and a look at where the dollar's fair value may lie. See also Trader Mike's updates, including outlooks on the economy and housing, and more enlightening views from Abnormal Returns, including the bear market in financial issues and picking a bottom. The Big Picture also weighs in with a sobering look at how financial companies may be even worse off than they seem.

* Trading With the Rat Brain - The Trading Success blog looks at how we need to get our multiple brains in sync to trade well.

* Options as an Option - Daily Options Report: "Options should always be viewed as an alternative to stock. And if *actual* volatility is higher than the implied volatility you paid for the options, you are better off owning an option."

* Abandoning the Dollar? - Here's a list of countries considering diversifying reserves and what it might mean from the Currency Trading blog.

When Good Traders Lose

Good traders lose money. They also go through slumps. I've seen it with people who have made millions for multiple years running. What makes them good traders is, in part, how they lose. Here are three qualities I've seen in good traders who go through rocky periods:

1) They're quick to identify when their ideas aren't working - They don't fight the market, and they don't become threatened or defensive. Rather, they quickly enter a mode where they look at what's working, what isn't, and what they can do about it. They accept that there will be periods when they see things well and periods when they don't.

2) They're quick to de-lever - They get smaller when they realize their trading isn't working. They avoid digging large holes for themselves, but they also don't stop trading. By trading smallest when they're having the most trouble and largest when they're seeing things clearly, they leverage their strengths.

3) They're patient in regaining their feel - They keep trading small until they have a good understanding and feel for what's going on. They don't press to catch up and make money; they ride out the storm and take minimum damage. Because they've been through this before, they know that their time will come--and that helps them sustain patience.

The traders who are most at risk are those that fight markets, trade larger or more often to recapture lost money, and can't stay out of the water when conditions are unfavorable. All traders lose money; it's how you trade when you're down that makes all the difference.

RELEVANT POSTS:

Ten Lessons I've Learned From Traders

Blueprint for an Uncompromised Life
.

Weakening Stocks: A Sector by Sector Look

Here's a quick update of some of my indicators. The Wednesday drop affected the Technical Strength numbers for the 40 S&P stocks that I track across eight sectors. We have 5 issues qualifying as strong, 4 and neutral, and 31 as weak. This gives us a weak Technical Strength Index of -1820. Looking sector by sector, we have these Technical Strength scores:

Materials: -260

Industrials: -300

Consumer Discretionary: -240

Consumer Staples: -100

Energy: -220

Health Care: -280

Financials: -460

Technology: +40

Among NYSE common stocks, we had 83 new 52-week highs and 228 new lows. That's the most new lows since the August bottom. Among S&P 600 small caps, we had 6 new highs and 104 new lows. That's the most new lows since the weakest day in August. Among the S&P 400 midcaps, we had 12 new 52-week highs and 53 new lows. That's also the highest level of new lows since August--and very close to the August nadir.

All in all, we have 33% of NYSE issues and SPX issues trading above their 50-day moving averages; we've tended to see intermediate bottoming begin when that number has been below 30%. The numbers are weak and have been weakening. It's when we see markets make fewer new lows on increasing technical strength that buying weakness makes sense. We're not there yet.

RELATED POSTS:

My Previous Look at Technical Strength

Last Week's Indicator Readings

Self-Confidence and Performance

An enlightening analysis of the research literature by Woodman and Hardy found that cognitive anxiety and self-confidence are significantly related to performance. Interestingly, cognitive anxiety appears to affect performance among men more than women and interferes with performance much more for high standard tasks than for tasks with low standards. It is not difficult to see how, given these findings, perfectionism can be so deadly to trading results. By raising the psychological bar to success, we create performance pressures for ourselves that ironically inhibit performance.

Their research, however, found that self-confidence bears a stronger relationship to performance than anxiety. Once again, this effect was stronger for men and for high standard performance tasks. It thus appears that one need not have a huge level of self-confidence to achieve a task with a low standard of success, but when the challenge is raised, self-confidence becomes important to performance.

Importantly, these were measures of *state* anxiety and self-confidence, not trait measures. In other words, one could have modest levels of anxiety and generous levels of self-confidence in daily life, but if one's current state is anxious and self-doubting, performance will be at risk.

Why might these findings be more significant for men than women? Perhaps it is because men are more likely to judge themselves and attach their self-worth to their performances. If that is true, strategies to put performances into perspective--to divorce the ego from short-term results--should be helpful even when anxiety and self-doubt are present.

One interesting study asked students to toss nerf balls into a garbage can. Half the students received negative feedback prior to the task; the other half received positive feedback. The negative feedback group performed significantly worse than the positive feedback group. Think about how markets always give us feedback about our positions and how this might affect our state levels of self-confidence, anxiety--and ultimately performance.

Research suggests that self-confidence is crucial to performance even among elite athletes. Those athletes do experience symptoms of anxiety, but the self-confident ones are more likely to label these in a positive way and use them in a manner that aids performance ("I'm getting pumped up") than the non self-confident ones. It thus appears that it's not so much anxiety that matters than how we interpret the signals of the body and mind. Self-confidence channels stress into performance.

RELEVANT POST:

Building Self Efficacy
.

Thoughts on Psychological Scarcity and Abundance

Some people live in a universe of scarcity. Their underlying view is that resources and opportunities are limited. To the person who lives in scarcity, what one has must be hoarded. The worst thing one can do is miss an opportunity, because--the reasoning goes--these only come around rarely.

Jealous people live in a universe of scarcity; they dare not allow their loved ones to share affection. Anxiety is the hallmark of the scarcity mindset; fear of loss is a driving motive: fear of losing what one has, fear of losing out on possibilities to get more.

Other people live in a universe of abundance. Their underlying view is that resources and opportunities are unlimited. To the person who lives in abundance, what one has must be shared, because in mutual sharing, everyone is enriched. The worst thing one can do is become attached to something that doesn't work, because--the reasoning goes--there are so many other possibilities around.

Daring people live in a universe of abundance; they can afford to dare, because new challenges and opportunities will always present themselves. Quiet confidence is the hallmark of the abundant mindset; pursuit of values is a driving motive: maximizing positives, not minimizing threat.

Two men lose their jobs. One views himself as eminently skilled and employable; another views a tight job market. Who will be stressed? Who will jump at the first job offered? Who will wait for--and achieve--the right opportunity?

Two traders watch the market. One sees volatility and plenty of market moves; she waits for the market to come to her. Another sees opportunity as limited and is focused on making up for losses. Who will be stressed? Who will jump at the first market move? Who will wait for--and achieve--the right setup?

A permabear is one who raises psychological scarcity to a life philosophy.

There are many permabears, even outside finance.

Open Source is a celebration of abundance. As is Web 2.0.

Scarcity leads us to hang onto jobs, for better or for worse. The entrepreneur thrives on abundance: One startup fails, another soon follows.

The fear of missing out, the fear of losing money, the press to overtrade: could any of these things exist in a universe of abundance?
What good does it do to teach new trading and self-help methods to one who remains mired in scarcity?

The wise trader told me that there are only two types of trades: winning trades and trades where you pay for information.

You sell the market, it won't go lower. You quickly take the small loss, and flip the position to ride the upside. A small price to pay for information, for a wise trader. Wisdom means that even one's losers provide opportunity.

Opportunity in abundance.

RELEVANT POSTS:

Reflections on Life and Markets

Weathering Storms
.

Psychological Stress, Cognitive Regression, and Training

High levels of stress can interfere with performance, whether in athletics, trading, or the bedroom. Psychological research suggests that moderate levels of stress can actually enhance performance, increasing vigilance and a sense of challenge. Beyond this moderate threshold, however, stress impairs memory, perception, and decision-making. This inverted U function between arousal and performance is known as the Yerkes-Dodson law. One reason training is so important in fields such as the military is that it helps performers adapt to stressful situations and retain normal functioning and performance. In a sense, training moves our inverted U curves further to the right, so that we can perform better under conditions of enhanced duress.

Interestingly, we can better tolerate high levels of arousal during simple tasks than complex ones. This is because the cognitive and physiological effects of stress interfere with concentration, impairing performance on the complex tasks. A very interesting line of research finds that experts differ from novices in their use of contextual information. The expert in any field of performance possesses knowledge structures that rapidly integrate present information into a broad context. This is true of the chess grandmaster, who sees an entire board, and the expert physician, who processes patient data in the context of historical data, diagnostic impressions, and test results.

When we become highly stressed, we move down the inverted U curve and, in a sense, regress cognitively from greater to lesser expertise. This is because the narrowed focus and attention created by the stress response (the worried trader hanging on to every tick in the market) takes our attention away from the context of our knowledge. The availability heuristic is, in that sense, a cognitive regression--an undue focus upon immediate data at the expense of context. Shorn of context, we reason more like novices, less like experts.

A cardinal principle of training in athletics, the military, and performing arts is to rehearse performance in situations that mimic real-life demands and pressures. Rarely, however, is this principle fulfilled in the development of the trader. Reviewing research, charts, or market data after the close or before the open hardly prepares us for the emotional challenges of a volatile trading market. Too, markets can provide us with scenarios that have not occurred in recent history, making emotional preparation difficult.

Rehearsing decision-making in market simulations using actual historical data is not perfect--like a practice athletic contest, it doesn't mimic all the emotional realities of game time--but it does bring us closer to dealing with the heat of action and maintaining focus and contextual awareness. I recently organized my market data by VIX regimes and began a process of replaying market days similar to the most recent days in volatility. This has sensitized me to patterns that occur in fast markets; as a result, those markets don't seem to move as quickly.

The key to such training is to force yourself to make decisions and follow sound decision-making during the market simulations. In a sense, you're training yourself to sustain focus in the face of uncertainty, so that you can perform as well in more complex situations as in simpler ones and shift your inverted U curve rightward. Biofeedback is an especially promising tool for keeping score of one's self-control during exposure to stressful market scenarios.

It is difficult to get stressed out by a familiar situation. Training makes unusual challenges familiar. In so doing, it helps us retain access to our cognitive capacities, so that we can draw upon such expertise as we possess. How do we know when a situation is familiar? Quite simply, familiar situations do not leave us cognitively and physiologically aroused; like a joke we've heard many times, familiar situations no longer evoke emotion. If we trade when we're aroused physiologically and emotionally, we leave ourselves open to cognitive regression: quite literally we begin to see markets and respond to them as rookies!

RELEVANT POSTS:

Biofeedback for Performance

Heart Rate Variability and Performance
.

NYSE TICK and Intraday Market Movement

Recently we looked at stock market volume and its relationship to intraday market movement, including the likelihood of hitting particular price targets. In this post, we'll examine the NYSE TICK and its relationship to intraday price behavior.

Recall that the TICK is a moment-to-moment measure of buying and selling sentiment. It measures the number of NYSE stocks that are trading at their offer price minus those trading at their bid. When buyers are eager to own stocks, they're willing to "lift the offer" and the stocks will transact at that offer price. When sellers are eager to bail out on stocks, they're willing to "hit the bid" and the stocks will transact at the bid price. A very positive or negative NYSE TICK number reflects broad buying or selling interest in stocks overall.

My Adjusted TICK measure updates the 20-day average NYSE TICK reading each minute of each trading day and subtracts that average from each new minute's reading. The Adjusted TICK thus tells us if the current TICK readings are above or below their 20-day average. When we add all the Adjusted TICK readings during a market day, we get a single number--the Cumulative Adjusted TICK--that tells us how much buying or selling interest (relative to the 20-day average) we've sustained.

Going back to July, 2003 (which is when I began collecting my Adjusted TICK data; N = 1094 trading days), we've had 299 days in which the Cumulative Adjusted TICK has been above +300; 255 days in which it's been between zero and +299; 251 days in which it's been between -300 and -1; and 289 days in which it's been less than -300. For labeling purposes, I will call these Groups I, II, III, and IV.

Here are the odds of hitting the R1 pivot-derived resistance level for SPY as a function of Group. The second group of numbers (in bold) show the odds of *closing* above R1:

Group I: 238/299 - about 70%; 186/299
Group II: 150/255 - about 60%; 66/255
Group III: 90/251 - about 35%; 20/251
Group IV: 73/289 - about 25%; 4/289

Here are the odds of hitting the S1 pivot-derived support level as a function of Group. The second group of numbers (in bold) show the odds of *closing* below S1:

Group I: 40/299 - about 13%; 4/299
Group II: 80/255 - about 30%; 10/255
Group III: 132/251 - about 55%; 57/251
Group IV: 225/289 - about 80%; 166/289

I also have data on the frequency with which we hit and close above/below the previous day's high and low prices as a function of Group. The data for those look very similar to the above data.

Clearly, the tendency of market participants to hit bids or lift offers during the day is well correlated with directional price movement. We are most likely to close above or below the target R1/S1 levels on very strong or weak Cumulative Adjusted TICK days.

Once again, these are correlational data only; we're looking at how Adjusted TICK is associated with price movement; how today's Cumulative Adjusted TICK correlates with today's price behavior. What we're finding is that volume tells us about how much movement we're likely to have; TICK tells us how much price directionality there's likely to be. The two together, as they unfold during the day, help us understand the type of day we're likely to get. More on that in my next and last post in this series.

RELEVANT POSTS:

Cumulative TICK as a Measure of Sentiment

Identifying Sentiment Trends With TICK
.

Advance-Decline Line Weakness and Other Themes to Start the Week

* AD Line Lags - I've sung the praises of Decision Point numerous times on this blog, and this post will be no exception. Carl tracks only the common stocks from the NYSE, providing a purer view of how stocks are behaving (eliminating preferred issues, funds, etc.). Note how the advance-decline line for the NYSE issues has lagged significantly of late. I would not be surprised to see us test the August lows. We can see similar weakness in the Cumulative NYSE TICK, which is charted in the weekly post for the Trading Psychology Weblog.

* Building a Trading Plan - Ray Barros has started a new blog, and he begins on a positive note, with a description of the components of a trading plan.

* How You Know You're a Quant - That, a view of what is responsible for the performance of high quality bonds, and more from the Sunday links at Abnormal Returns.

* Trading and Investing - A Dash of Insight provides some insight into common principles of success. See also the post on trading feel and ETF rankings.

* Options Perspective - Adam Warner explores when we should own a call rather than the stock.

* Forecasting Favorable Markets - Henry Carstens' models show favorable expectations at a 20-day time horizon.

* The Week Ahead - Barry Ritholtz looks at 16.7% inflation and other scary economic themes looming this week.

Stock Market Volume and Intraday Price Behavior

In a recent post, we saw how stock market volume correlates quite highly with next day volatility. This, along with our understanding of options volatility, helps us anticipate the magnitude of movement likely in the day ahead. In this post, we'll take a look at how volume affects the odds of hitting particular price targets.

Once again, we'll use relative volume--how today's volume compares with the median 20-day volume--as our basis for analysis. We'll go back to 1996 in the S&P 500 Index (N = 2935 trading days) and examine what happens when we have above average relative volume (N = 1519) and below average relative volume (N = 1416).

When today's volume exceeds the 20-day median, we had an inside day (today's high lower than yesterday's high; today's low above yesterday's low) only 127 times in 1519 days, or about 8% of the time. When today's volume is below the 20-day median, we had an inside day 246 times in 1416 days, or about 17% of the time. We're thus twice as likely to have an inside day on slow days as busy ones. Stated otherwise, when volume is above average, we've hit yesterday's high or low price 92% of the time.

Conversely, when today's volume has exceeded the 20-day median, we've had an outside day (today's high greater than yesterday's high; today's low below yesterday's low) 212 times in 1519 days, or about 14% of the time. When, however, volume has been below the 20-day median, we've had an outside day only 107 times in 1416 occasions, or a little over 7% of the time. Thus we're twice as likely to have an outside day when the market is busy than when the market is slow and 93% of all slow markets won't be outside days.

Interestingly, whether the market is busy or slow does not significantly affect the odds of hitting yesterday's pivot level, which is defined as the average of the high, low, and closing prices. When relative volume is in the top quartile of its distribution, we see a slightly lower set of odds of hitting the prior day's pivot level, but this is not meaningful. Overall, we average hitting the prior day's pivot about 2/3 of the time.

Now let's look at the odds of hitting the R1 and S1 resistance and support levels, derived from the prior day's pivot price. (See my previous post for details on the calculation of R1 and S1). When volume has been above the 20-day median, we've hit either the R1 or S1 level 1328 out of 1519 times or close to 90% of the time. In a busy market, then, it makes sense to not just use the prior day's high or low as a price target, but R1 or S1. When volume has been below the 20-day median, we've hit the R1 or S1 level 1170 out of 1416 times, or about 80% of the time--still a hefty percentage.

When relative volume has been 30% or more ahead of the 20-day median (N = 722), we've hit either R1 or S1 642 times, again about 90% of the time. When relative volume has been 30% or more below the 20-day median (N = 425), we've hit R1 or S1 288 times, about 70% of the time. Thus, there are overwhelming odds of hitting R1 or S1 when markets are relatively busy and somewhat reduced, but still favorable, odds when markets are slow. Overall, it makes sense to look to R1 and S1 as initial price targets, particularly in busy markets.

Now for one last look: Let's examine what happens when today's raw volume in SPY exceeds yesterday's volume (N = 1457). When today is busier than yesterday, we hit either the R1 or S1 levels on 1350 occasions or over 90% of the time. When today is slower than yesterday (N = 1478), we hit these levels on 1036 occasions, or about 70% of the time. When today's volume exceeds yesterday's volume by 30% or more (N = 745), we hit R1 or S1 a whopping 713 times--about 95% of the time. When today's volume falls short of yesterday's volume by 30% or more (N = 496), we only hit R1 or S1 on 279 occasions, about 55% of the time.

Again, we see that, the busier the market, the more likely we are to hit price targets derived from the prior day's pivot data. This makes sense, since the R1 and S1 targets are derived from the prior day's range. If today's volume exceeds yesterday's, on average we'll have a larger range and thus will trade through those targets.

Of course, none of this is predicting directionality. We're simply using volume to investigate the likelihood that moves to certain targets will occur. Given that volume correlates with volatility, it makes sense that markets would be somewhat more likely to hit targets (prior day high or low; R1 or S1) when they're busiest.

In my next posts in this series, we'll start to look at handicapping market direction.

RELEVANT POST:

What Every Short-Term Trader Should Know About Volume
.

What Stresses Traders Out?

There are stresses inherent to trading, as with any high risk/high reward activity, as fighter pilots, brain surgeons, and poker champions can attest. But not all trader stresses are trading related; understanding *why* you're stressed is an important first step in ensuring that work demands don't interfere with performance.

Here are some of the most common sources of trader stress:

1) Excessive risk-taking: Traders who overtrade (trade more frequently than opportunity dictates and trade larger size than is prudent for their accounts) create volatility of returns, which enhances emotional volatility. By creating large drawdowns during slump periods and by ignoring stop loss rules (per trade, per day), traders generate stress through their poor trading practices. A great stress buster for these situations is to make good trading practices as rule-like as possible. By writing out rules and mentally rehearsing them (with imagery, self suggestions), traders can turn good trading behaviors into positive habit patterns.

2) Changing markets: When markets shift their behavior, becoming more or less volatile and changing their direction, traders' ideas can stop working. This creates potential frustration, as well as losses. It can also lead to temporary feelings of loss of control and confusion. Psychological research suggests that perceptions of control are important mediators of stress levels. Here is where it's very helpful to stay on top of your performance statistics and quickly recognize when your trading is deviating from its norm in a negative way. That can serve as a cue to cut your size, focus your attention on what *is* working for you, and build upon your strengths.

3) Unrealistic expectations: Another way traders can generate their own stress is by holding themselves to perfectionistic standards that they can't possibly reach. No one consistently buys the lows and sells the highs; that means it's always possible to focus on the money left on the table. Such rigid perfectionism turns winning traders into psychological failure experiences, generating frustration, negative self-talk, and stress. Cognitive techniques, such as those outlined in my book on trader performance, can be very helpful in learning how to turn negative thought patterns into constructive ones.

4) Personality patterns: Sometimes the trader's stress is part of a larger constellation of personality patterns that yield stress in other areas of life as well. For example, a trader may have a biological tendency toward depression, expressing itself through negative thinking and problems in concentrating. Similarly, anxiety disorders can manifest themselves in trading--excessive worry, catastrophizing--but also in such other areas as relationships and work. When stress patterns occur across life spheres, getting an evaluation from a professional is important. Not all problems that affect trading are trading problems.

5) Real life challenges: Stress can be a perfectly appropriate response to objective life challenges. When a trader is facing family or personal illness, relationship problems, or budget crises, these can easily intrude into decision making. The worst thing traders can do in these situations is try to put the problems out of their head. Rather, setting time aside to face the challenges directly, developing ways of dealing with them, and finding effective supports is the best way to ensure that realistic stress does not become overwhelming distress.

In short, it's helpful to diagnose when stress problems are coming from trading and markets and when they're coming from our own personality patterns.

A forthcoming book that is helpful in describing and illustrating (with multiple, helpful case studies) the varieties of stress that affect traders is the volume Mastering Trading Stress by Ari Kiev. Dr. Kiev covers such topics as the effects of fear on performance; risk management; and personality patterns that contribute to stress. It's a clearly written, well-organized, and concise volume--one of the very few practical resources on the topic.

As I've emphasized in past posts, however, stress--while vitally important--is only half of a larger emotional equation. The other side of that equation is emotional well-being. One of the greatest protections against stress and distress are life activities that bring joy, contentment, energy, and affection. The absence of positive emotional experience can be as corrosive to performance as an excess of stress.

RELEVANT POSTS:

Why Well-Being is Important for Traders

Transforming Stress Into Well-Being

A Personality Questionnaire for Traders
.

Using Stock Market Volume to Predict Stock Market Volatility

I recently posted on the topic of VIX as a predictor of daily volatility in the S&P 500 market and the role of volatility in money management. This next post in my series dealing with intraday market movement will explore volume as a predictor of daily volatility in SPY.

Relative volume is a cornerstone concept in my trading. Relative volume simply refers to whether today's volume is ahead or behind the average volume for a given lookback period at a given time of day. Thus, if we are trading with X volume at 10:30 AM, I want to know how X volume compares to the average volume at 10:30 AM for the past 20 trading sessions.

There are two reasons for wanting to know relative volume through the day:

1) As we'll see below, volume correlates with volatility. Knowing if volume is ahead or behind the 20-day average helps me estimate the likely size of the daily range. It also helps me estimate how much I can expect to take out of a given trade, the size I should trade, and where I should place my stops (see the prior post).

2) The lion's share of volume in the S&P market is attributable to large (professional) traders. When we see volume ahead of the 20-day average, it suggests that there is good institutional participation in the move we are seeing. If volume is below the 20-day average, it suggests that locals (market makers) are dominating the price action. Since my trading is predicated on following the footsteps of the large traders, I stop trading when relative volume drops significantly. There just isn't enough volatility and institutional participation to sustain meaningful moves, and the choppy action of the locals does not lend itself to short-term position trading.

So let's look at relative volume (how the current day's volume compares to the median volume for the prior 20 trading sessions) and relative range (how the current day's range compares to the median high-low range for the previous 20 sessions). Going back to 1996 (N = 2934 trading days), we find that the correlation between daily relative volume and daily relative range is a very high .66. About 40% of all variance in the day's relative range can be explained by the day's relative volume.

In practice, that means that I'm regularly updating volume during the day and comparing it to what the median volume has been for that same time of day over the past 20 trading sessions. This updating of relative volume through the day enables me to see if we are building participation or losing it; if we're likely to have above average volatility or below average for the day. Very often I will identify relative volume for the first 15 minutes of trading and come up with a reasonable estimate of what that day's volatility (size of range) is likely to look like.

There are also important serial correlations in relative volume. Yesterday's relative volume correlates with today's relative volume by an impressive .42. That means that we can estimate today's participation of institutional traders simply on the basis of yesterday's participation. Moreover, yesterday's relative range correlates with today's range by .26--not huge, but significant. Busy, volatile days tend to be followed by busy, volatile days.

Interestingly, overnight volatility is correlated with the volatility of the next trading session in the S&P 500 market (SPY). The absolute size of the market's opening gap (difference between the open and the prior day's close) correlates with the size of the range for the next trading session by .35. Thus, when we see above average volume for the previous day and an above average size opening gap for the current day, we are justified in expecting a busier, more volatile trading session ahead.

Let's say that an intraday trader is seeking moves of X points. Volatility defines how many of those trading moves will be likely to occur in a given trading session. In that sense, volatility helps define raw, gross opportunity. Volatility also helps define risk, the market's likely speed of movement (time it takes to make a move of X), and the likely amplitude of random movement around one's position (which affects stop placements).

It's important to a trader to know which direction a market is likely to move in, but it's also important to know how much a market is going to move. As we will see in upcoming posts, knowing how much a market is likely to move is a valuable aid in handicapping the odds of that market hitting various target price levels.

RELATED POSTS:

Five Guiding Principles of Short-Term Trading

Finding Opportunity in the Market
.

So You Want To Trade For A Living

I receive quite a few emails from aspiring full-time traders. Some hope to land positions with trading firms; others are looking to make a living by trading independently. Here are a few considerations for those thinking of making the leap:

1) Make sure you're adequately capitalized - This is, in my experience, the achilles heel of most traders who aspire to make a career of their market participation. If you start with a capital base under $100,000, you have to make a huge annual return on your money year after year to sustain a decent living. That leads traders with small accounts to take outsized risks, and those risks are what eventually blow them up. As a relatively new trader, you'd do *very* well to make 20% on your money per year after costs. If you can't make an adequate living from 20% returns, you know you're undercapitalized.

2) If you're not adequately capitalized, focus on building a track record - It doesn't matter if you're trading small. If you can show consistent returns from your trading and sound money management, you'll have something to take to a proprietary trading firm to land a position. They will front you capital, and you can get your start in the business. If you don't have the track record, however, you'll find many doors closed. Motivation and a passion for trading don't substitute for experience and demonstrated skill.

3) Make sure you have a durable edge - Before you quit your day job and pursue trading, make sure you've traded in a variety of market conditions over a variety of market cycles. Look at it this way: if a person with a track record of a few months asked you to give him money to trade for your account, would you pony up? Probably not. For the same reasons, you should establish a sound track record with solid profitability and good risk management before you make the full-time leap. Make as many of your mistakes as possible *before* you go full time.

4) Make sure you have reserves - Just as many new businesses tread water their first year, many traders struggle to cover costs when they go "live". After all, to cover commission, equipment, and software costs alone requires a fair return on capital. You should have more than a year's worth of living expenses available as liquid capital before you go full time. A second income (your own or from a spouse) also helps tremendously. This will take pressure off your early performance and help you focus on making good trades, rather than making the rent money.

The bottom line is that starting a trading career truly is starting an entrepreneurial business. The same dynamics that lead to success in startup firms--from knowing your markets to having a solid plan to being well capitalized to executing on details--apply to aspiring traders. If you can approach trading with the mindset, work ethic, and creativity of a successful entrepreneur, you have a real shot. And that's what entrepreneurs live for.

RELATED POSTS:

The Trader as Entrepreneur

Joining a Proprietary Trading Firm
.