Getting Off the Performance Roller Coaster

A surprising number of traders I hear from and work with experience what might be called a performance roller-coaster. They make money for a while, then become sloppy and overly aggressive in their trading. This leads to harrowing and frustrating losses, which in turn force them to focus their efforts and resume trading well. Not infrequently, these traders experience several boom-and-bust cycles before they reach out to seek help.

The culprit in this scenario is overconfidence. Trading gains lead to heightened expectations, which in turn facilitate overtrading. These changed expectations, ironically, lead traders to change how they're trading right at the time they're trading at their best! Instead of being satisfied with their gains, they press to achieve more. This leads to crippling drawdowns, because they're trading most aggressively even as they've strayed from their best trading.

My recent post focused on the importance of self-management in trading. A very perceptive reader who had experienced some of these trading ups and downs wrote to me recently and described a scoring system that he implemented for his trading. The system gave him points each day based upon his preparation for the day, the quality of his trading ideas; his execution of those ideas; and his management of the trades. Instead of focusing on his P/L each day, he has been emphasizing keeping his trading score high. This has aided his consistency, and that has paid off in profitability.

Another savvy trader wrote to me and described how he used visualization techniques each day to convince himself that he was coming back from a drawdown--regardless where his actual equity curve stood. By mentally rehearsing this "coming back from drawdown" mode, he also kept the focus on the *process* of trading, resulting in his best and most consistent profitability to date.

That is the paradox at the heart of trading and many other performance activities. The goal is profitability, but the best practice is to not focus on the goal. By staying connected to the processes that lead to the goal, we maintain consistency in our expectations, mood, and outlook--and that pays off in consistent performance.

RELATED POSTS:

Overconfidence in Trading

Top Reasons Traders Lose Their Discipline
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A Quick Review of Stock Market Sectors

With Thursday's powerful rise, we had 809 stocks across the NYSE, NASDAQ, and ASE register fresh 65-day highs and 1257 record new 20-day highs. By contrast, we had 227 and 604 new lows, respectively. While these numbers are below peaks recorded a few weeks ago, they're a meaningful turnaround from recent weakness. Demand, a measure of strong upside momentum, closed at 163; Supply at 24. That indicates that the rise was broad, affecting the majority of issues. This is also reflected in the relative strength of the small caps, with the Russell 2000 futures hitting a post-March price high.

My technical strength measure is a method of quantifying price trending behavior over a short-to-intermediate term time frame. Here's how the S&P 500 sectors look at present in terms of technical strength:

MATERIALS: -160
INDUSTRIALS: -40
CONSUMER DISCRETIONARY: +220
CONSUMER STAPLES: +220
ENERGY: +180
HEALTH CARE: +280
FINANCIAL: -320
TECHNOLOGY: +340

What we can see is that, as a group, there's been a nice turnaround from recent lows, but we continue to see very mixed sector performance. The weakness in the materials sector and the restrained strength of the energy shares are particularly noteworthy, as commodities have been performance leaders of late.

Technology remains a performance leader, which is consistent with my recent findings on money flows. The big story, perhaps, remains financial shares, which continue to lag badly. We've seen many steps taken to stabilize vulnerable banks, and these have yet to translate into meaningful, sustained confidence in the sector. This remains a potential Achilles heel for the market's attempted recovery.

RELATED POST:

Money Flow Analysis

The Trader as Manager: Implications of Quality and Trading

The last post took an initial look at quality control in trading. This stemmed from my realization that even relatively disciplined traders (including myself) pursue markets with a level of standardization that would be unthinkably low in the business world. One of the factors that has made a Toyota, Starbucks, or McDonald's so successful is that quality is controlled, across people and settings, day after day and year after year. That requires an unusually high level of managerial planning and oversight.

Trading is often described as a business, and traders are encouraged to treat their trading as a business. Many writers talk about the importance of business planning in trading. But if traders are to truly treat their work in a businesslike fashion, they need more than planning. They need to serve as the managers of their businesses. The maintenance of quality is one important facet of that management.

If we think about trading in quality terms, we want to identify the inputs into trading decisions, the processes by which decisions are made, and the outputs from those decisions. Inputs can be defined by the information that we need to process to make our best decisions. Processes involve information processing itself, including our ability to maintain a mindset conducive to optimal decision making. The outputs from trading decisions include the orders that we place, our management of those positions, and the profits that accrue.

The first sign of quality control problems in trading is lack of consistency. Inconsistency of inputs reflects variability in our preparation: sometimes we're more prepared for trading--we've done more and better homework--than other times. Inconsistency can also be present in our trading processes: variability in our state of mind while trading and our following of rules. Inconsistency often first shows up in trading outputs: variability in profitability, but also variation in how we size trades and take profits and losses.

If a trader truly operated as a business, he or she would identify "best practices" and turn these into standard operating procedures, with careful managerial oversight to ensure that these procedures are followed. Few of us truly know our best practices, however. It is impossible to implement quality if we have not made ourselves objects of our own study.

It is important to be one's own trading coach, but successful sports teams need managers as well as coaches. Writing out a business plan is the easy part. Managing that plan over time and becoming as consistent as a Toyota: that's a challenge. More on this aspect of working on oneself to come shortly.

RELATED POST:

Blueprint for an Uncompromised Life
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Changing Minds and Markets: Quality Control in Trading

Suppose a person has demonstrated trading skills: an ability to read markets based upon lengthy exposure to live markets and internalization of trading patterns. What would cause such a trader to go into a prolonged slump?

One possibility is changing markets. If the patterns familiar to the trader change, then there is a need for a fresh learning curve. I see this very often when markets change their volatility, as has happened from the first quarter of the year to the second quarter (and as has been happening from day to day at times). Inability to adjust to changes in the market's tendency to follow through on moves creates losses (or missed opportunities), which then creates frustration, which then leads to further trading problems.

A second possibility is that changes in the trader's mind state result in variability in the sensitivity to market patterns. Though those patterns may be stable, the trader's frame of mind may vary from alert to bored to fatigued; mood may vary from positive to neutral to negative. Variation in concentration would lead to variation in ability to pick up patterns. Divided attention would create interference in one's feel for markets.

The challenge for traders in slumps is to differentiate between these two sources of trading problems. My sense is that too little thought goes into both alternatives: traders don't systematically look at markets over time and their changes, and they don't take time each day to standardize their mental and physical states. If traders were manufacturers, they would have poor quality control.

Of course, all this only makes sense for traders who have developed core skills and the ability to read patterns in markets. The majority of trading problems, I believe, come neither from changing markets nor changing minds, but the lack of time and effort devoted to systematic market learning. It's when those skills *have* developed that quality control becomes as important for traders as for car makers and restaurants. I'm not sure most traders know their quality or know how to improve it. That's something I'm thinking a lot about as I trek the Pacific Northwest this week.

RELATED POSTS:

Somatic Markers and Trading

Stilling Negative Thoughts

Themes and Thoughts to Start a Tuesday

* Sentiment Shift - We saw considerable bearish sentiment at the March lows, as the above chart of the five-day equity put/call ratio indicates. More recent readings have been closer to levels seen at recent relative tops in markets. Interestingly, I see a meaningful correlation between these sentiment data and traffic to this blog: a tell that is becoming quite useful.

* Detecting More Market Themes - A warning about banks from FDIC, performance anxiety among hedge fund managers, dividends in jeopardy, ETF updates, and more from The Kirk Report.

* Hitting Resistance - Trader Mike notes a couple of moving averages that are acting as resistance areas for the major averages. Double top in the Russell?

* Themes and Themes - Abnormal Returns finds still more, including emerging market risk, actively managed ETFs, and a Fed on hold.

* Interpreting the Data - A Dash of Insight is doing a great job cutting through the fog of coverage of economic data. I find the nuclear theme quite interesting right here.

* Weakness Among States and Cities - The Big Picture tracks an important theme, as economic weakness affects states and cities and passes through to the economy.

* Keeping Up With the Blogs - Newsflashr updates headlines from the financial blogs.

* Stocks Making the Screen - Chris Perruna offers his recent choices.

* Recognition - Nice to see Brian is getting good reviews of his recent book on technical analysis.

* After a Big Down Day - Quantifiable Edges finds...an edge!

* Training the Brain - Thought-provoking interviews with neuroscience experts from Sharp Brains.
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Weakness in Financial Stocks and Other Market Themes

* Banks Lead the Way - Well, with the heroic music cranked up, I proceeded to watch the themes play themselves out this AM, following the pattern noted in the earlier post. Falling yields/rising treasuries (flight to quality); weak NYSE TICK; rising Yen/US Dollar: it was a nice illustration of how intraday themes can combine with longer-term research to provide an edge. Among the more important themes, however, was the weakness in the banking sector. As the top chart indicates, the banking sector ($BKX) is testing bear market lows, and the six-month advance-decline line for S&P financial stocks (XLF; bottom chart) is doing the same. This continues the very mixed performance of sectors noted in my prior post.

* More on Mixed Sector Performance - Monday's performance left us with 648 stocks across the NYSE, ASE, and NASDAQ making fresh 20-day highs against 950 making 20-day lows. Clearly we're seeing some areas of relative strength in the market and other areas of distinctive weakness. Although we're near bull swing highs in the NASDAQ 100 Index ($NDX) and Russell 2000 Index ($RUT), the S&P 500 ($SPX) universe is much shakier. Among my basket of 40 stocks taken evenly from eight different sectors, we have 9 stocks qualifying as being in short-term uptrends; 10 neutral; and 21 in downtrends. Only 55% of $SPX stocks are trading above their 50-day moving averages, down from 80% at the market peak.

* Housing Rebound? Among the sectors hitting two-month lows on Monday were the housing stocks ($HGX). The index has been in a wide range since December, 2007; the resolution of that range will tell us quite a bit about not only housing, but the broader economy.

* Election Anticipation? Among two sectors likely to be impacted by the U.S. Presidential election, pharmaceutical stocks ($DRG) have been in the toilet, but defense issues ($DFX) have bounced nicely from their bear lows. Even if we were to withdraw from Iraq, there's a fair amount of military rebuilding that might need to get done, but drugs have to be a major focus of cost-cutting in health care.
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Indicator Review for June 2nd

Last week's indicator review noted weakness across many of the measures in the wake of a several-day pullback. We've since bounced from those price lows, but remain well off the highs across most of the indicators. Money flows to the S&P 500 stocks continue to be weak, with divergences common since April.

Interestingly, the money flow divergences match what we're seeing in the cumulative NYSE TICK (bottom chart), which has shown tepid strength since its peak on April 7th and which is currently well off its highs. Unlike money flow, TICK is not volume based, suggesting that we're not just seeing waning summer volume. Rather, buyer interest itself seems to be waning since that early April period.

Still, that did not prevent us from making fresh peaks in the number of stocks making new 65-day highs (top chart) during May. Since the pullback two weeks ago, the market's bounce has left us well shy of those peaks so far. On Thursday and Friday, for example, we registered 48 and 57 new 52-week highs respectively across the NYSE common stocks against 16 and 18 new lows. By comparison, we had over 150 new highs two weeks ago.

In past indicator reviews, I've noted considerable sector rotation and divergence, even within the S&P 500 large-cap universe. This continues at present and appears to be a major reason we're not seeing more broad-based strength since the January/March market bottom. For example, we're only seeing 30% of financial stocks trading above their 20-day moving averages, but 78% of technology stocks. Materials issues have shown recent weakness in the wake of pullbacks among commodities--only 54% are above their 20-day averages--but previously weak health care issues have bounced, with 73% above their benchmarks.

All in all, the weakness in TICK and money flows and the relative performance of sectors suggests two things: 1) that more money is shifting from sector to sector than actually entering the stock market; and 2) that when money is entering the market, it is doing so selectively (commodity-based themes, technology). This is not necessarily a prescription for a fresh bear market, but it also is not a solid foundation for a sustained market rally. For this reason, as my recent post indicated, I am being more tactical than long-term strategic in my own trading.
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Finding a Historical Edge in the Stock Market

I mentioned in my new blog that my forthcoming book will include skills-building lessons for identifying potential historical edges in the market by analyzing historical data in Excel. Unlike some traders, I do not rely on these historical studies for mechanical trading signals. Rather, I use them as indications of how markets tend to behave under a particular set of conditions. If I see the market open and begin to follow the historical scenario, I will then trade the pattern. If the market opens and does not follow the historical pattern, that, too, is useful information. Often, something special is going on if a market isn't following its usual script--and that something special can lead to useful trade ideas.

If I'm a physician and I know that a patient's normal pulse is 80, blood pressure is 110/75, cholesterol level is 160, and average blood sugar level is 104, that's useful information. I can take current readings and see if the patient is deviating from historical norms. Those deviations help lead to diagnoses; when there's no deviations, I can rule out certain problems.

Similarly, if I know the measurements of an average manufactured ball bearing and the variation around that average, I have useful information to tell me whether the current batch is up to standard or not. That, in turn, tells me if my equipment is faulty or operating normally. The same logic that applies to quality control applies to markets: when their outputs deviate from historical norms, something is afoot.

That is not the usual way people use historical information in markets. They would like the historical analyses to provide predictions. I use them for diagnoses.

Most markets at any point in time have some unique, distinctive feature. Maybe they've been up on strong volume; maybe they're moving lower on reduced volatility. Maybe they're moving one way, while other markets are moving differently. Each of these features can be investigated for past occurrences to see if there is a directional tendency associated.

It's when we see multiple distinctive features and a directional tendency common to all of them that we most want to take note of historical patterns. Those are strong tendencies that serve as solid bases for diagnosis.

One advantage of archiving unique market data (20-day new highs; money flows; adjusted TICK) is that you can then investigate historical patterns that few other people are looking at.

So let's say that we investigate the number of stocks closing above the volatility envelopes surrounding short- and medium-term moving averages (Demand) and the number of stocks closing below those envelopes (Supply). I think it's safe to say not too many people look at that.

What we find is that we've had more Demand than Supply for four consecutive trading sessions. That seems distinctive. So I go back in my database to 2004 (my first full year of those data; N = 1105 trading days) and examine all occasions in which we've had four consecutive sessions of Demand exceeding Supply. Five days later, the S&P 500 index (SPY) averages a loss of -.42% (34 up, 62 down), much weaker than the average gain of .16% (588 up, 421 down).

You might wonder what happens when we have four consecutive trading sessions in which Supply exceeds Demand, a situation that occurred last week. Five days later, SPY averages a healthy gain of .52% (41 up, 21 down).

When I saw the findings for this and related patterns, I took a small short position in the market to hold over the weekend. If we break the highs of the past week, I'll be stopped out with minimal risk. If I see weakness early in the week, I'll add to my short position as long as I see the historical pattern playing itself out.

I mention this, not at all necessarily to suggest that you trade similarly or that you take a similar market position. Rather, it's an illustration of one way of planning trades, managing risk, pursuing opportunity, and making sense of market uncertainty. The best trades have a proactive quality: they're the result of seeing patterns and acting upon them in a manner that maximizes the reward taken per unit of risk. The worst trades are reactive: the result of chasing markets out of the emotion of the moment.

One value of historical analyses is that they help keep me out of reactive trades.

RELEVANT POST:

Historical Patterns and Understanding Markets
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Divergences in Money Flows

One of the factors that led me to question the bear market's viability back in March was the divergence in money flows for the Dow and S&P stocks relative to January. Although we saw fresh price lows in March, higher lows in money flows suggested that selling was drying up. These divergences were confirmed by the fewer stocks making 52-week lows in March relative to January and by a host of sectors that failed to make fresh price lows in March. Money flows are thus part of a larger picture of market participation that can tell us when supply or demand is growing or waning.

In my recent post, I noted a money flow divergence within the S&P 500 energy sector (XLE). As price has moved higher, we're seeing lower peaks in money flow, suggesting that demand for the energy stocks may be drying up.

Interestingly, we're seeing a similar pattern among the materials stocks from the S&P 500 universe (XLB; top chart) and among the consumer staples issues (XLP; bottom chart). Price has been moving higher for those sectors during May, but money flows have been weakening. This tells us that, overall, upticks have been occurring on lower volume than downticks--a sign that large investors and traders are leaning to the sell side.

Taken alone, these divergences are simply yellow caution lights for the sectors. When they are occurring across a large number of stocks and sectors, they are caution lights for the broader market. It's when we see waning flows accompanied by fewer stocks making fresh price highs; divergences in the cumulative NYSE TICK; and divergences in the number of stocks closing above their long-term moving averages that it makes sense to become concerned about significant price reversals. I will be examining those latter indicators tomorrow in my indicator update post.
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Stock Picking With Money Flow Data

The previous post took a look at money flows across the ten most highly weighted stocks within the technology (XLK) and energy (XLE) sectors. I also showed that, by aggregating the most highly weighted stocks across the sectors, we can also arrive at estimates for money flowing in and out of the S&P 500 Index as a whole.

Instead of aggregating the money flow data for each stock to derive estimates of flows across sectors and indexes, we can compare the flows for stocks within sectors to see which issues are attracting buying and selling interest.

For example, within the technology sector, we see net inflows over the past 20 trading sessions for CSCO, AAPL, INTC, GOOG, and ORCL. There are net outflows over the same period for T, MSFT, IBM, HPQ, and VZ. Interestingly, as a whole, the NASDAQ-related technology issues tend to be sporting more sizable inflows; the NYSE-based issues are displaying outflows.

Within the energy sector, we're seeing notable inflows to RIG, XTO, and HAL. Considerable outflows are evident within XOM, CVX, and COP. Here we see the largest cap energy issues--and those most highly weighted within the index--displaying the greatest selling interest.

By comparing flows for stocks within sectors, we can identify potential sub-sector themes and aid the process of stock picking.
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Money Flows: A Look At Energy and Technology

Money flows can be thought of as a kind of NYSE TICK measure applied to individual stocks. When a stock trades on an uptick, the price of that trade times the volume (dollar volume) of that trade is added to a daily cumulative total. When a stock trades on a downtick, the dollar volume is subtracted from the daily total. Positive values at the end of the day reflect money flowing into the stock; negative values mean that investors and traders are withdrawing their capital from those shares.

The top chart takes the ten most highly weighted stocks in each of eight S&P 500 sectors and tracks their combined money flows over a four-day moving average to capture the flow of funds in and out of the S&P 500 index. (See my earlier post covering the Dow issues; this post links to the sectors that I cover and the ten stocks within each sector).

What we see from the overall money flow picture is that flows have turned modestly positive over the last few days across the S&P 500 issues, but that overall we're still spending more time below the blue zero line than above. The money flows at the March lows held well above their January lows and turned outright positive in April, but since have lagged.

Interestingly, the strongest of the S&P 500 sectors, energy, has been showing a pattern of dwindling inflows even as the sector ETF (XLE) has moved higher. Over the last week, flows have actually been negative, despite an overall market rally. I will be watching this divergence carefully; it may well be that institutions are taking some chips off the table when it comes to energy related stocks.

Technology shares, on the other hand, have had the most consistent set of inflows of any of the sectors. Flows have turned positive once again in the last week, though so far are not as robust as we've seen in April.

In all, we're seeing more money fleeing stocks when the market sells off than entering stocks when the market rises. As we've moved from April through May, markets have moved higher, but money flows have been drying up. That poses a yellow caution flag for June.
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A Blog for the New Book

I'm pleased to announce that my new book is entitled Becoming Your Own Trading Coach, and it will have its very own supporting blog.

My goal is to teach traders the same techniques and approaches that I utilize in my work with traders at hedge funds, banks, and proprietary trading firms.

The idea is not for me to promote my own coaching--I'm busy enough, thank you!--but rather to get you to the point where you won't need to hire a trading coach.

Check out my opening post to the new blog and you'll see one of the more exciting topics I'll be covering in the new book.

As always, I greatly appreciate your interest and support. I very much hope to make this my best and most practical book yet.

Brett
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Psychological Change and the Power of Discrepancy

In my post on constructivism, I described change as a revision of the mental maps we construct to make sense of the world. We provide coherence to our experience by shaping it into narratives; when we tell the story of our lives, we literally tell a story. We include and emphasize certain events, exclude others. The story line is our personal drama, one in which we play leading roles. (See my earlier post on the roles we play and the importance of shifting roles).

Discrepancy--encountering new experiences that don't fit our mental maps--is the source of all change. We change by thinking new things, behaving in new ways, and feeling differently. If we stay in the same roles, engaging in the same activities, thinking the same things, nothing in our mental maps will require revision. We do not change.

When we enter new roles, we are forced to think and behave in new ways. This is how we adapt to new careers, new relationships, and new responsibilities such as parenthood. As we play the new role, it increasingly becomes a part of us, integrated into our mental maps.

But that is not easy. When we encounter discrepant events and situations, we will naturally feel uncomfortable. We are outside the familiar realm of our maps. A certain anxiety and discomfort precedes all change; without it, we are too stuck in existing roles and maps to shift the ways we think and act. It is only human nature to avoid such discomfort, so we tend to stay with the known, the existing set of maps. We resist change.

My earlier post emphasized that we bring our life dramas--the scripts from our accumulated roles--to our trading. If you find yourself making the same mistakes in trading repeatedly, the odds are good that you are reprising a role in the markets. Maybe you're caught in a success fantasy or a story line of high expectations that are never met. Perhaps your drama is one of fighting larger forces or encountering risky thrills.

It is impossible to adapt to changing markets when we are rigidly bound to scripts from the past.

There are so many ways of changing how you trade and thereby revising your mental maps. You can trade in a more structured, rule-based way. You can trade larger; you can trade different markets or time frames. Each change shifts our experience of markets and our experience of ourselves in markets, and that alters the viewing, making it easier to continue altering the doing.

At one time a trader I work with thought of himself as a promising beginner. With success under his belt and a network of successful peers, he now experiences himself as an established professional. Another trader I've seen for a while used to view himself as undisciplined. He took on roles in his physical fitness and development, carried those over to his trading, and now sees himself as a trader with excellent risk-adjusted returns. When I first met him, I'm not even sure he had thoughts about risk-adjusted returns. Now it's how he keeps score.

You can't talk yourself into change. Only encountering new situations and placing yourself in new roles will provide the discrepancies that prod you to revise those maps and change your ways of viewing and doing.

If you get that, then you can see that the changes you most want to make as a trader are those that will enable you to experience yourself as the trader you want to become. The links below might just help you get started on that adventure.

RELEVANT POSTS:

Becoming Your Own Coach

How to Change Yourself
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Stock Market Trends and Reversals and Other Perspectives

More About Participation - Note how the S&P emini futures made a fresh price high around 13:20 (top chart), but the difference between advancing and declining stocks (bottom chart) did not confirm. Quite a few S&P 500 sectors also didn't make new highs at that time, including financial stocks (XLF); energy issues (XLE); materials shares (XLB); and consumer discretionaries (XLY). It's a nice illustration of how declining participation often leads short-term market reversals.

Intraday New Highs/Lows - If you didn't catch my Twitter comments for today, note how the expansion of new 20-day highs relative to new lows was an early tell for the morning market rally. Major props to Barchart for tracking those data.

What We Can Learn From Sports - My Naperville neighbor A Dash of Insight shares insights on wisdom from sports and trading. See also this contrarian insight into housing inventory.

More Great Links - Trader Mike has quite a few, including views on ETFs of ETFs; Twitter finance; housing inventory; and more.

Fresh Perspectives? - Quite a few, thanks to the Trader Interview archives; great resource.

Thinking Without Thought - Thanks to an alert reader for picking up on this fascinating interview from Sharp Brains, outlining how conscious and subconscious thought processes are involved in simple and complex decision-making.

Types of Trades - Corey of the Afraid to Trade blog outlines four different kinds of trades for the INO blog, which does a nice job of bringing in guest bloggers.

Trading Signals - I like how Trade By Trend publishes the trade ideas from their computerized system in real time and then tracks the results.
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Constructivism: Changing Viewing and Doing

All of us are like scientists, in that we are driven to make sense of the world around us. Just as scientists construct theories to explain their observations, we generate our own mental models that provide coherence to our experience. When a trader speaks of his or her trading, the depiction is not a photographic representation, realistic in each and every detail. Inevitably, some facets are left out and others are emphasized, as the trader creates a narrative. This narrative is constructed to fit with the trader's existing mental models. What we're hearing is not reality, but the trader's reality: how the trader is construing his or her experience in the markets.

Our mental maps are necessary--without them experience would seem chaotic--but they are also prisons of a sort. Fixed modes of viewing lead to fixed modes of doing: we can become trapped by the lenses through which we view the world. One trader, affected by his childhood, sees the market as a battleground of "us versus them". Another trader, equally influenced by his experience, regards trading as a way of overcoming past failure and finally proving himself worthy to others. Still another views trading as an arena for displaying his intellectual prowess and tinkers, tinkers, tinkers in search of grails.

Constructivism in psychology emphasizes that the goal of change is the ability to revise our mental models just as scientists revise their theories. By encountering experiences that don't fit our models, we have the opportunity to change those models to account for new experience. That is why all psychological change requires novelty and discrepancy: the good psychologist afflicts our comfort as well as comforts our afflictions. New experience forces us to alter our viewing, and that leads us to alter our doing.

The challenge for traders seeking to change is to generate their own novel, discrepant experiences. Talking to a counselor or coach, in itself, or writing in a journal does not create change. Change requires fresh experience that we can internalize--i.e., that can revise our mental maps. Just as new viewing leads to new doing, new doing can generate fresh views. More on this aspect of coaching oneself shortly to come.

RELEVANT POSTS:

Becoming the Play-Actor of Your Ideals

The Relationship Between Happiness and Success
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Stock Market Sentiment and Reversals: The Temporal Anchoring of Expectations

For this investigation, I'm working with two assumptions:

1) That market participants overall are naive trend followers: they ground their expectations in the latest price action. Thus they become most bullish when recent price action has been rising and most bearish when recent price action has been falling. As a result, sentiment shows a marked recency effect.

2) That market participants anchor their perceptions temporally, punctuating market action by the most convenient units of time: the day and the week. As a result, their perceptions of the recent past are especially influenced by what happened over the last day (particularly among daytraders) and what happened over the last week (particularly among swing traders).

When we put these assumptions together, we can infer that traders will tend to have the most bullish expectations when the last day and the last week have been rising in price. Traders will tend to have the most bearish expectations when the most recent day and week have been falling in price.

Because the bullish traders have largely followed their views and expended their capital, we'd expect market returns to be subnormal following a rising day and week. Because bearish traders have followed their sentiment and either exited the market or sold it, we'd expect market returns to be above average following a falling day and week.

Going back to 1990 (N = 2107 trading days), the average five-day price change in the S&P 500 Index (SPY) has been .025% (1109 up 998 down).

When the most recent day and week have been rising (N = 722), the next five days in SPY have averaged a subnormal return of -.27% (351 up, 371 down).

When the most recent day and week have been falling (N = 616), the next five days in SPY have averaged an above average return of .35% (346 up, 270 down).

This temporal anchoring of sentiment has been particularly pronounced since 2007, with the rising days/weeks leading to an average five-day loss of -.56% (55 up, 70 down) and the falling days/weeks leading to an average five-day gain of .48% (61 up, 35 down).

It is precisely because average traders are trend-followers in the near term, anchoring their market expectations to the most recent time periods and price action, that the stock market displays intriguing patterns of reversal. These patterns were noted in part by Connors and Sen in their research and appear to be operative to this day.

RELATED POSTS:

Tracking Sentiment Shifts

NYSE TICK and Sentiment

Trading With Sentiment Bars

Sentiment and Mean Reversion

An Options Sentiment Measure
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Why Volume Matters: Reading the Market's Real-Time Auction Process

If you click on the chart, you'll see today's afternoon trade in the ES futures with price displayed in one-minute candlesticks and volume below. You can see that we traded in a range for over a half-hour and then broke higher at 13:36 PM CT. As the pink arrow indicates, that breakout occurred on increased volume. We then contracted in volume on a brief consolidation of that burst upward before resuming the upward course on even greater volume.

After a solid rally, prices consolidated for about 40 minutes, but notice how volume dried up during the consolidation. We then traded higher and, again, volume expanded on the rise.

Recall that volume is significantly correlated with volatility. When volume expands in the direction of the trade, it means that you have a correlation of volatility and direction: those are the sweet spots that will give you your best short-term moves. When volume contracts as the trade moves against you, it suggests that volatility is not moving against you, and it can make good sense to stay in that trade.

Volume expands because of the presence of large traders; it is not a sudden influx of small, retail traders creating a doubling or more of volume during a time period. Rather, institutional traders are attracted to the new price highs--and help keep the move continuing in the short run. When volume expands in the direction of the market, it means that the new prices are attracting market participation. There is acceptance of value at these new prices. It is out of such dynamics that trending moves are born.

Good breakout moves will feature an expansion of volume on the move out of the prior trading range, a pullback in volume during any subsequent consolidation, followed by further trending price action on expanded volume. The pullbacks on reduced volume represent opportunities to enter the trade in the direction of the trend.

Just knowing whether you're making new highs or lows isn't enough: you want to see how the market's auction process is accepting and facilitating trade at those fresh price levels. Volume is one important key to reading the market's real time auction. The link below (and the links within that post) will provide further background on this important facet of trading.

RELATED POST:

Tracking the Market's Large Traders
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Indicator Review for May 27th

In the last indicator review, I noted strength in a number of the indicators, despite concurrent weakness in money flows. Over the past week, the market's pullback has also brought weakness to the indicators.

New highs/lows (top chart), after reaching a post-March peak, have pulled back significantly. Indeed, we're now seeing more 20-day lows than highs, with 431 new highs and 1079 lows on Friday. This suggests that the recent pullback has been broader as well as deeper than normal during a market rise. Indeed, when we look only at NYSE common stocks on a 52-week basis, we find only 14 new highs on Friday, against 44 lows.

This idea of broad weakness is also expressed in the advance-decline line for NYSE common issues (bottom chart), as nicely displayed by Decision Point. While the broad averages are well above their February highs, the advance-decline line never reached that level and now is not far off March lows. In fact, the advance-decline line specific to financial stocks has been making bear market lows, and the lines specific to consumer staples issues, consumer discretionary stocks, and health care shares are all very close to March lows.

My Technical Strength measure is also showing weakness across the eight S&P sectors that I track--further weakness compared to my recent review. As of Friday, we had 6 stocks in my basket showing uptrends, 5 neutral, and 29 in downtrends. The energy sector is the only sector showing net uptrending, and even that has deteriorated in the last week despite firmness in the price of crude.

I maintain a cumulative line of my Demand/Supply indicator (which is updated each AM via my Twitter posts) and then compare the current reading to a long-term moving average (middle chart). The pullback of this adjusted Demand/Supply Index to below the zero line following a healthy rally is something that often occurs during the early phase of a topping process. As a result, I will watch the indicators carefully during any market bounce during this post-holiday, end-of-month week to see if we're losing steam to the upside, which would be consistent with a topping process.

In sum, the picture is neither as bad as bears would like to have it, nor as good as bulls would like. The January-March period represented a significant bottoming of the major indexes, but the subsequent rise has been restrained, with considerable sector rotation and unevenness and weak money flows. It is difficult to imagine sustaining a vigorous bull market on such a foundation.
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A Look at the Dollar and Other Ideas Worth Cashing In On

* Dollar Weakness - As the chart of the U.S. Dollar Index (cash) vs. S&P 500 Index (cash) indicates, we've seen more of a bounce in stocks since March than in the dollar. Whereas stocks are meaningfully above their lows even after last week's selloff, the U.S. dollar is approaching its all-time lows. Though expectations of continued Federal Reserve easing have themselves eased, any anticipations of rate firmness have not been sufficient to support the dollar.

* Framework for Day Trading - The EminiDayTrading site offers a free webinar that offers their interesting approach to understanding and trading markets on the day timeframe.

* Missed It By a Tick - An erudite and experienced trader and author writes to me of a trade that he missed, hoping to get filled at just the right tick. When that tick went unfilled, his trade idea went unfulfilled. Inspired by Swinburne's stanza in The Garden of Proserpine, he writes:

Tricked for a Tick

The trading gods are fickle
They live I have no doubt.
They love to cause a pickle
Hoping to sound us out.
The answer is decision
One made with quiet precision
With fear and greed unrisen
That's what it's all about.

"Decision made with quiet precision": I don't think I could summarize trading psychology any better--certainly not more poetically!

* The Advantages of the Pros - One way that professional traders seize an advantage in the marketplace is by testing trading strategies across a range of market conditions and then automating the execution of the successful strategies. This can be extended across a range of strategies so that, under any market conditions, there will be some strategies making money--without untoward psychology affecting the execution. I see where Stock Tickr has teamed up with Trade Ideas to test and automate strategies for active traders. This strikes me as particularly promising.

* What's Going On With Oil? - Trader's Narrative offers an interesting view and John Mauldin passes along his perspective on the speculative boom.

* Just Keeps Getting Worse - Research Recap recaps the delinquency rates among residential mortgage-backed securities as a function of issuance year.
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Readings Worth Reading for a Holiday Monday

* Dark Side of an Economic Miracle - China's exploding growth has brought explosive problems with pollution at a great human cost. I highly recommend Nicholas Kristof's blog for a variety of international perspectives from a ground's eye view.

* What You See May Not Be What You Get - Trader Mike makes the case for looking under the hood at your ETFs.

* Most Promising ETFs - A Dash of Insight takes a look at top performing sectors and themes.

* Themes and Links - Why cash flow is king, top performing brokers, and more ETF views are among Kirk's most recent links.

* More Good Views - Why understanding value in a price-oriented trading universe is helpful and more perspectives from Abnormal Returns.

* Size Matters - CXO Advisory summarizes fascinating research information that relates the size of companies to their stock returns.
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