Tracking an Upside Breakout in the Stock Market

The recent post looked at how we were trading in a compressed range; above we see how the upside breakout materialized early in the day. (Here's a post on identifying upside breakout moves that was relevant to today's trade).

One thing to look at in breakout moves is the time of day in which they occur. Institutional participants tend to be most active early and late in the trading day; that's when we see volume and volatility highest. If institutions are going to establish value significantly higher or lower, they'll tend to do that when trade is best facilitated.

Today's buying represented significant new demand from institutional participants, as relative volume expanded, and we registered a new peak in the number of stocks making fresh 20- and 65-day highs. This supports the earlier noted new highs that we've been seeing in the advance-decline lines for the major averages.
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Trading Addiction: The Side of Trading That Few People Discuss

Thanks to an alert reader for passing along this article on the addictive aspect of trading.

I continue to believe that this is one of the most neglected topics in the trading literature. While it is common to talk of traders who "lack discipline", rarely is there acknowledgment that such out of control behavior is often indicative of addictive behavior.

Take the trader who loses money in a downward spiral through the day, without ever taking a break or exercising restraint. How is that different from someone who drinks themselves into a coma or who gambles away the family paycheck? The circular dynamics are identical: out of control behavior, unwanted and negative consequences, remorse and guilt, efforts at control, eventual relapse and loss of control.

The tell-tale sign of trading addiction is a trader who cannot refrain from trading--even when markets are objectively offering no opportunity. Even when losses are mounting.

Who benefits from helping traders identify and overcome addictive trading? Not the brokerage firms that harvest commissions; not the exchanges that take the fees; not the vendors who sell the trading tools and service; not the "coaches" who keep the addicted traders' hopes up. All are witting or unwitting enablers.

And the families of addicted traders? Their security is lost. Too often, if they raise concerns, they are chastised for not believing in the trader's "dream", for not being supportive of a gambling problem that masquerades as a professional undertaking.

My only hope is that traders who trade addictively can marshal the courage to look in the mirror and see what they're doing to their lives, their finances, and their loved ones.

Trading can be a wonderful, noble profession and a life-affirming challenge. It can also be pursued in a way that is highly destructive. Here are some articles that might help with self-assessment and that look in the mirror:

A Self-Assessment for Trading Addiction

When Trading Gets Out of Control

Warning Signs of Trading Addiction

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Thoughts on Low Volatility Markets and Trading Slumps

The chart above shows how average five-day trading range (volatility; red line) has been steadily falling since the March lows. The average daily range is now about a third of what we were seeing earlier in the year. This is the main reason why the profit targets that I work with are adjusted for recent volatility. (Note: SPY targets are posted each morning prior to the open via Twitter; subscription is free).

Without such adjustment, it is very easy to assume that markets will move further than they actually will. This leads traders to be slow in harvesting profits.

I hear traders say that there is no opportunity in the current markets. That is not completely true. I find that recent moves set up much the same as they do in more volatile, busy markets. It's just that the moves don't travel as far. A move above the prior day's high that cannot sustain buying and moves back to the volume-weighted moving average (such as yesterday) is the same basic setup whether the market is swinging or slow.

The key is adjusting one's expectations of those setups--and having the patience to wait for them to set up. What setups and times of day are contributing to your profitability in the recent market? Grounding yourself in what is working is the first step toward exiting a trading slump.

More about breaking trading slumps can be found here.
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More on Time as a Market Indicator

A while back I noted that time itself can be viewed as a variable for evaluating historical trading patterns. On a short-term basis, time as an indicator can exploit those occasions in which it seems as though markets are rigged against human nature by giving reversal moves when we expect continuation.

Here's a starting point to consider and a pattern that may set up in coming days. Since 2000, when we have had only 1 or no five-day closing lows in SPY during the past 10 trading sessions, the next five days in SPY have averaged a loss of -.17% (363 occasions up, 363 down). When we have had five or more five-day closing lows in the past ten trading sessions, the next five days in SPY have averaged a gain of .33% (161 up, 145 down).

By the time we've made several closing five-day lows, the market is ready to bounce; by the time we've sustained strength for two weeks, we often see a correction.

Nice, but not a huge edge. If you go back to the post from Wednesday, you'll see how momentum is an important indicator in anticipating whether strength or weakness will continue or reverse. When we filter those time-based occasions by momentum, we have the start for a nice screen for likely market reversals.
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Evening Briefing for July 22nd

* MARKET THEMES FROM WEDNESDAY - We continue to accept value at higher prices in stocks, with particular strength among economically sensitive issues. Traders are using dips as reasons to buy, with the strong overall earnings picture contributing to risk appetite. That is also showing up as firm oil and gold prices; a weakening dollar; and firmness in Treasury rates. We have set up a two-day trading range, with continued weakening of strength and momentum to the upside. I will be watching those intermarket themes closely to gauge short-term sentiment and the prospects for sustaining the recent rally. Given the weakening momentum and drying up of volatility, I am not inclined to chase strength unless it is clear that we have expanded participation to the upside. That did not occur on Wednesday.

* OVERSEAS/OVERNIGHT NUMBERS - 3:00 AM CT - Italy, retail sales; 3:30 AM CT - UK retail sales; 4 AM CT - EU trade balances.

* EARNINGS FOR THURSDAY - AMZN, AXP, BIDU, BMY, COF, CIT, CS, FITB, F, MCD, MMM, MSFT, NEM, NOC, OXY, RMBS, UPS

* WORTH READING:

-- Tracking a war against the producers;

-- The future of neuroscience and neuroeconomics;

-- Poll numbers mixed re: health care reform;

-- Excellent article outlining concerns re: a second stimulus;

-- Bearish outcomes when banking stocks lag;

-- Spain's eye-raising housing glut.
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Midday Briefing for July 22nd: Compressing the Trading Range

Here is a look at how we stand at the end of today's trade. Notice the compressed trading range, as we've experienced significant resistance at the 955-956 level in the S&P 500 e-mini (ES) futures, but have also made higher lows day over day. Today's trade peeked above yesterday's highs, only to fall back toward the middle of the day's range. We registered only about 1665 20-day highs on the day across the NYSE, NASDAQ, and ASE, down from almost 2300 highs on Tuesday. I'll need to see expanded upside participation on any tests of the range highs to play for an upside breakout; today's and Tuesday's low prices give us clear short-term targets to the downside should we fail to take out the range highs in early trade tomorrow.
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Keeping Your Time Frames Consistent

With volatility at lows for the year (VIX is below 24) and S&P 500 (SPY) volume also at annual lows, we're seeing quite a few choppy directional moves. This morning, we took out the lower end of the overnight range after the weak earnings reports, but firmed at the open and moved promptly back into the range. We then took out the highs prior to the earnings news before again reversing and moving back into the late pre-opening range.

Such trade either requires great patience--waiting for prices to ultimately hit a target that takes volatility into account--or great nimbleness, taking the moves that markets give you rather than assuming that breaks out of ranges will necessarily continue. Where traders often fall short is by conceptualizing trades (and targets) on a longer-term basis (requiring the patience), but then managing the trades short term. This gets them exiting good ideas at the worst possible times, as markets reverse against them on the way to ultimately hitting their targets.

Contrast that scenario to the patient trader who uses such reversals to scale into positions that are working longer-term.

I'm seeing some profitable traders simply trade hit and run style and take profits when we take out a near term level. That can work well also. But if you are going to hit and run in taking profits, it's important to do the same with losses. Setting targets on one time frame and managing them on another is a recipe for disaster. (See this post for more on the topic).
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Morning Briefing for July 22nd: Back in Yesterday's Range

Following weak bank earnings reports, we have moved back into yesterday morning's range in the ES futures. That gives us yesterday's low and the overnight high as important reference points with respect to range trading and possible breakouts. If you didn't see the earlier post, note the expectations for consolidation, as the rally has been losing momentum on falling volatility. If, indeed, that consolidation is to take hold starting today, we should remain below the low 950 level from which the market made its recent drop on the earnings news.

Staying below that 950 area would frame yesterday's lows as an initial target in such a consolidation move. Note that such a move would roughly correspond to a move to the S1 level, as posted via Twitter this AM. I see we're set for a meaningful drop in XLF at the open, given the bank news. That sector will be worth following to see if it continues to lead to the downside. Note also the weakening of oil and gold prices, as the dollar has strengthened off recent lows. Those themes are also on the radar.

Watch for intraday blog updates and tweets as the day unfolds; good trading!
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Strong Stocks, Declining Volatility and Momentum: What Next?

I noticed that we made a 20-day high in the S&P 500 Index (SPY), while 20-day median daily volatility in SPY (median daily range over the past 20 days) made a 20-day low.

Going back to 2000, we have had 130 such instances of 20-day highs in stocks and 20-day lows in volatility. Five days later, SPY averaged a loss of -.32% (52 up, 78 down). By comparison, for the remainder of the sample, SPY averaged a loss of -.03% (1158 up, 1065 down).

I also saw that, as we made the 20-day high in SPY, my Demand measure of upside momentum (an index of the number of NYSE, NASDAQ, and ASE issues closing above the volatility envelopes surrounding their moving averages) was lower than my Supply measure (stocks closing below their volatility envelopes). Since September, 2002, when I began assembling those data, that has occurred 61 times. Five days later, SPY was down by an average -.45% (24 up, 37 down). By comparison, for the rest of the sample, SPY was up by an average .07% (904 up, 760 down).

In all, the declining volatility and momentum during a move to new highs has been associated more with short-term correction than a bullish edge. As I mentioned in the evening briefing, the rally is looking a bit tired.
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Evening Briefing for July 21st

* MARKET THEMES FROM TUESDAY: Continued strength among major averages, with 2250 20-day highs among NYSE, NASDAQ, and ASE shares and 235 lows. We saw stocks retreat from early strength, with the dollar coming off its lows and oil pulling back. The afternoon saw some retracement of that retreat, with particular strength among NASDAQ shares and weakness among the banks. Ten-year Treasury yields pulled back to under 3.50% and gold retreated from its early highs. My Demand/Supply numbers are getting tired; the rally appears to be running out of upside momentum. (Demand/Supply and other indicators will be posted via Twitter prior to Wednesday's open; follow here).

* OVERSEAS/OVERNIGHT NUMBERS: 7:30 AM CT - Canada, retail sales.

* EARNINGS REPORTS FOR WEDNESDAY: BA, DAL, EBAY, LLY, GSK, MO, NTRS, PEP, PFE, USB, WFC.

* WORTH READING:

-- Improvement in leading economic indicators;

-- Prospects for muted growth in developed economies, relative strength in developing nations;

-- Possibility of 17 year bear market, economic perspectives, and much more good reading;

-- Perspectives on the internet as an investment and other worthwhile updates;

-- Will China export its economic model as a creditor nation?

-- Not all boom and bust can be attributed to the economy;

-- A look at four bad bear markets and how this one stacks up.
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PowerPoint Slides From the Chicago Seminar Now Posted!

Thanks to Trevor Harnett of Market Delta for posting the PowerPoint slides from the recent Chicago seminar. He did a great job of organizing the event, and we both had a great time meeting traders and offering some perspectives and tools for active traders.

Trevor and I are looking at the possibility of conducting a webinar event this fall; details will be posted on the blog well in advance. That will make the content available to traders worldwide, as we will archive the session for download as well as conduct the session live.

As always, thanks for the continued interest and support. TraderFeed recently posted its 2500th blog post, and tweets are rapidly approaching 8000. In coming months, I hope to push the envelope further, making the transition from providing information to integrating that information via training. (See this post for more on that topic). Stay tuned!
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China: Boom, Bust, Boom,????

I stepped back to take a look at a weekly chart of China's stocks market (FXI) and you can appreciate the tremendous volatility in this market. From 2006 to the third quarter of 2007, FXI more than tripled in value--only to lose it all by late 2008. Now we've doubled from those 2008 lows on the heels of favorable economic reports regarding the Chinese economy. Amid doubts about the accuracy of economic data in China and the impact of aggressive economic stimulus, one is entitled to wonder if boom, bust, boom might continue its sequence down the road. At the very least, the strong rise in China's shares leaves little room for disappointment should very favorable expectations not materialize.
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Morning Briefing for July 21st: A Bout of Risk Aversion

After opening higher, the S&P 500 e-mini futures (ES) have pulled back into yesterday's trading range, accompanied by strengthening of the U.S. dollar, weakening of oil prices, and a dip in 10-year Treasury yields. It's when we see the asset classes move in tandem that we can recognize the impact of thematic trades in the market, as pro-risk sentiment gives way to a measure of risk aversion. The selling was significant--only 27 stocks separate advancing issues from decliners--and, in my basket, only 10 stocks are up from the open and 30 are down. Selling is particularly strong among small caps and among such economically sensitive sectors as consumer discretionary shares. With the rejection of the early morning highs (and the test of the bull highs), we may be setting ourselves up for a range bound consolidation.
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A Look at What is Lagging in a Strong Market

At the same time that we see stocks (S&P 500 Index; SPY, top chart) challenging their bull highs, several sectors are lagging. Those include banking stocks (second chart), homebuilding shares (third chart), energy issues (fourth chart), and industrial stocks (bottom chart).

Despite these potential divergences, several indicators are giving strong readings. We have made bull market highs in the advance-decline lines for many of the indexes, including the S&P 500 Index. We also have seen bull market highs for the percentage of stocks trading above their 200-day moving averages: over 64%, according to Decision Point. We've also seen strength in emerging market, small cap, and technology shares, suggesting a healthy risk appetite.

With 995 65-day new highs across the NYSE, NASDAQ, and ASE, we are well off the June peaks. I will be respecting the bull's strength for now, but will become defensive should we be unable to expand these new highs meaningfully (and should sector non-confirmations persist).
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Evening Briefing for July 20th

* MARKET THEMES FROM MONDAY'S SESSION: Continued strength on afternoon break above morning range. Firm oil prices, weak U.S. dollar, though we've reversed some of that after hours. Consumer discretionary stocks strong, outpacing consumer staples issues. 10-year Treasury yields firm early, but well off their highs as day progressed. Indicators stronger: 2344 20-day highs, 210 lows. Short-term bullish trend continues as long as we expand number of stocks making fresh 20-day highs.

* OVERSEAS/OVERNIGHT NUMBERS: 12:00 M - Japan, steel production; 12:30 AM CT - Japan, department store sales; 8 AM CT - Canada, Bank of Canada interest rate decision.

* EARNINGS: AMD, AAPL, CAT, DD, FCX, KO, MRK, SGP, LUV, SBUX, UAUA, UTX, UNH, YHOO

* WORTH READING:

-- Looking at the possibility of fiscal ruin; the case for stimulus;

-- Unusually good short-term market information, not for beginners, on Matt Fahmie's site;

-- Thanks to an alert reader for this article on why we keep repeating mistakes;

-- Hats off to a reader for finding this piece on overly optimistic assumptions in Asia;

-- Learning the lessons of the Great Depression;

-- Looking for further economic strength in China;
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Trading Order Flow: Lost Skill, Important Art

I want to call attention to Damien Hoffman's excellent interview with Mike Bellafiore of SMB Capital. Damien has assembled a number of high quality interviews at the Wall St. Cheat Sheet site that are worth reading. Mike offers his perspectives from the front lines of a New York City proprietary trading group. One thing I like is that he emphasizes the role of reading order flow in short-term trading.

My experience is that an understanding of (and ability to read) order flow is one important factor that separates the older, successful generation of daytraders from the newbies who only know simple chart patterns and indicator readings. Reading order flow consists of two facets: 1) seeing and understanding where large orders (bids and offers) reside in the book; and 2) seeing and understanding where large orders are actually transacted.

Think:

If large offers consistently appear at a particular price, but we end up transacting relatively little volume when we hit that price, what does that tell you about the sentiment of sellers?

If large bids appear at a cluster of adjacent prices and we transact relatively large volume eating through those bids, what does that tell you about buying sentiment?

What does it tell you when large offers or bids consistently appear above or below VWAP? At the edges of trading ranges?

If you don't see the order book, all of that information is lost to you.

Mike trades and trains traders; here's his take on order flow:

"The thing I see with new and developing traders is their lack of ability to read the tape. When we make trading decisions, we read the tape, look at our charts, and have an understanding of fundamental analysis intraday. But I see too many people who just rely on the charts or their own brand of fundamental intraday analysis. They don’t understand how to read the order flow. And order flow gives us a huge advantage. We can truly see the most important levels of a particular stock. So when I tweet a particular level and you see the trade works out, it’s not a coincidence. If you see that level isn’t on your charts, that’s also not a coincidence. Again, we’re seeing the most important levels intraday because we’re watching where the orders are being exchanged. Having this skill enables you to take much bigger positions at very important levels and decrease the risk you would have in a position. It makes your win rate a lot more consistent. Finally, tape reading gives you an edge over a lot of the market players who you’re competing against. We see too many people who don’t know how to read the order flow, and we’d like to see more traders learn that skill."

Very, very few authors who write trading books and articles will cover this topic. Very many traders don't know what they don't know. The shorter the holding period of your trades, the more important it is to see where bids and offers reside, where they are pulled, and where they transact.
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The Psychology of Trading Slow Range Days

If you click on the chart above for the S&P 500 e-mini (ES) futures, you'll see that the market has probed both extremes of its overnight range, reverting back into the range each time. Note how the market's volume has been steadily declining during the range trade, as large participants have elected to sit out the chop.

Trade location is central to trading such slow ranges well: you want to wait for the market to show you that it is failing at or near a range extreme before entering to fade the recent move. If you examine the NYSE TICK during the 9:00 AM CT hour, for example, you'll see how selling dried up at the morning low. Those tells are useful in executing trades in ranges with good risk/reward, as the distance to your stop (below AM lows) is meaningfully less than the distance to the targets at VWAP and the upper range extreme.

To make such trades, however, requires selectivity and patience. Many traders overtrade slow, range markets trying to catch each squiggle within the range. That puts them short when near the bottom of the range and long when they're near the top. Unless there's distinct evidence of weakening or strengthening that could generate a breakout move, those poor location trades are likely to cost money over time.

For more, here are specific ways of identifying range bound market conditions as they're unfolding.
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A Worthwhile Indicator of Investor Sentiment

One quick and dirty way to evaluate investor sentiment and risk appetite is to compare the performance of investment grade corporate bonds (LQD; top chart) with that of high yield corporates bonds (JNK; bottom chart). When investors are bullish on the economy and perceive relative safety in the economic/financial environment, they will reach for yield and buy high yield debt over investment grade alternatives. Conversely, in times of perceived economic danger, investors will tend to favor the relative safety of investment grade debt over more speculative alternatives.

We can see that high-yield bonds dramatically underperformed investment grade debt through March of this year. Note how we saw new lows in JNK in March, not confirmed by LQD. Since that time, JNK has outperformed LQD on a relative basis, reflecting a re-emergence of risk appetite. That having been said, note that LQD has retraced most of its post-Lehman losses, whereas JNK remains well below the fall 2008 highs.

Note also that, in recent weeks, JNK has underperformed LQD. I will be watching this relationship closely. New highs in stocks not accompanied by fresh risk appetite among corporate debt investors would offer a caution light for the present rally.
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Sector Update for July 20th

Last week's sector review noted the possibility that selling could dry up in stocks, frustrating the bears and leading to an intermediate-term move back into the May/June trading range. With stocks unable to take out the prior week's low on Monday weakness, it was off to the races for the bulls, who rejected those price lows and moved shares all the way through that May/June range. As we can see from the top chart, the turnaround was evident across all sectors, as all are now trading in short-term uptrends, as measured by the proprietary Technical Strength indicator. The bottom chart, averaging the Technical Strength across sectors, shows that we have risen on substantial momentum, with Technical Strength near multi-month highs.

Here is how the individual sector readings looked as of Friday's close:

MATERIALS: 280
INDUSTRIAL: 240
CONSUMER DISCRETIONARY: 320
CONSUMER STAPLES: 280
ENERGY: 200
HEALTH CARE: 260
FINANCIAL: 160
TECHNOLOGY: 340

Note the particularly large jump in the technology and consumer discretionary sectors, both groups that draw upon themes of risk-seeking and economic expansion. After notable commodity weakness in the prior weeks, we can see that the materials and energy shares also bounced back strongly last week.

While it would not be unusual to get short-term weakness following five consecutive rising trading sessions, the bullish themes are in relative unison and there is impressive breadth to the turnaround. New highs in the average Technical Strength reading (bottom chart) would support a scenario of sustaining new bull highs for the move since March. I will be tracking the indicators via Twitter and posting observations prior to market opens (follow here).
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Evening Briefing for July 19th

* MARKET THEMES FROM FRIDAY'S SESSION: Range bound trade on Friday consolidated the gains during the week, with averages either near or above their May/June highs. The number of stocks making new highs remains below the levels seen in May/June, but several advance/decline lines for indexes, including the NYSE common stocks and the S&P 500 Index, have made fresh bull highs. Themes of dollar weakness, commodity strength, and rising Treasury yields continue to accompany share buying. Here is an excellent summary of the week in the economy and markets.

* OVERSEAS/OVERNIGHT NUMBERS: 1:00 AM CT - Germany, PPI; 7:30 AM CT - Canada, wholesale trade. Earnings: HAL, TXN.

* WORTH READING:

-- Second-guessing oneself in trading; thanks to Jorge for the Spanish language translation and link to the original article;

-- The swine flu story doesn't seem to be going away; Argentina hit hard;

-- Earnings reports are supporting the rise in share prices;

-- Eye-opening look at leverage at banks globally and implications for Europe;

-- The relationship between changes in home prices and share prices; excellent site;

-- Where jobs have been gained and lost in the economy;

-- Reflections on trading options expiration days;

-- Looks as though we may need to extend unemployment benefits further.
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