Traders write to me and talk with me about a lot of things. Sometimes it's about problems they're having in their trading; sometimes it's trying to make sense of markets. Few traders talk about new discoveries they've made; fresh challenges they've undertaken; or new and promising approaches they're taking to markets. If I had to describe the stance of most traders I encounter through the blog, it would be "coping". They're weathering the vicissitudes of markets, hoping to not blow up, hoping to get paid at the end of their efforts. There's a lot to be said for coping, especially relative to the alternative. But there's nothing magical in coping; nothing energizing, ennobling, exciting, or stimulating. It's no way to approach a marriage or a career. You might make it through and arrive safely as a well-preserved body, but have you lived? My recent post outlined an experiment I'm conducting with my trading. It might turn out well; it might go bust. Part of the fun is finding out how the story ends. Either way, I intend to arrive in a cloud of smoke, thoroughly worn out, happy for the ride.
I'm starting a trading experiment and will be recording the results on the blog periodically. The experiment has involved going back to my research and identifying robust, replicable patterns in the ES futures contract and SPY ETF. I specifically selected patterns that play out over a multiday period, with average holding times of several days. The patterns demonstrated a distinct edge in 2012 and 2013 trading and then were tested independently on 2014 data as an out-of-sample test and then were further tested independently on 2015 data to date. Now it's time for live trading. There are three general patterns: 1) Failure Pattern - A market advance loses breadth and momentum and reverses. 2) Reversal Pattern - A market decline leads to broad weakness and expanded volatility, resulting in a reversal bounce higher. 3) Momentum Pattern - A market rise occurs with solid breadth and momentum and continues higher in the short run. In the experiment, I will only trade those patterns. That means plenty of days of not trading and sizing up days when patterns occur. Each pattern is defined by a scorecard of criteria; if all criteria are not met, no trade is taken. A first unit of risk is entered when the signal fires; further units are added on evidence that the signal is playing out as expected. Entries and exits for those further units are discretionary, based on intraday trading patterns. A journal will track all signals and trades and how I traded them, with observations translated into goals for continuous improvement. The experiment is thus also an experiment in self-coaching. I hope to share lessons learned via the blog. At the craft beer networking event a week from Thursday (May 21st), I will discuss the project further with interested traders. A notice about that event will go out this coming week.
Imagine if a group of likeminded, dedicated traders conducted their own experiments and shared results. That would generate quite an accelerated learning curve. There's a big difference between years of market experience and a single year's experience repeated many times over. That difference is deliberate practice and a structured learning from experience.
An interesting meta-analysis (a study that statistically combines many different research studies) found that mentorship is associated with a number of favorable outcomes, including positive attitudes and career success. That study found academic mentoring to be particularly effective, enhancing the motivation, performance, and goal-setting of proteges. In the recently published Forbes interview, Charles Kirk points out that tenacity--the ability to hang in there during challenging times--is an essential component of trading success. He makes a very important point about mentoring. The mentor teaches and supports, but also provides that push in the right direction--particularly when things aren't going so well. In modeling persistence, mentors help their students sustain tenacity. Many times a student won't give up because their mentor refuses. I was recently speaking with Mike Bellafiore of SMB Capital about an interesting development on their trading desk. Senior traders have been taking on junior traders for mentoring, creating their own groups within a group. The senior traders are provided additional financial incentives based on the success of their proteges, and the proteges learn trading at the side of an experienced professional. It's a powerful model, one that lies at the heart of medical education and any career field that draws upon apprenticeships. Mike mentioned that several students have made significant progress under their mentors. In one case, the mentor threatened to shut down a junior trader if he made a mistake a second time. Instead of coming across as punitive, that threat came across as a supportive kick in the pants, much like a basketball coach might give to a player who lapses on the court and fails to properly run the called play. The fatal shortcoming of most efforts in trader education is that they provide teaching but not mentoring. We learn by example, not just by the textbook. Good firms recruit good talent; great firms grow talent. A close look at the Tiger Cubs who have learned under Julian Robertson finds that his involvement in vetting their trades has been essential to their success. There is no better path to winning than studying under a winner.
One of my more reliable measures of market strength and weakness comes from a disaggregation of the NYSE TICK, the cumulative measure of upticks vs. downticks among all NYSE stocks. I treat the upticks and downticks as separate distributions, reflecting buying and selling pressure respectively. In the chart above, we're looking at a 10-day moving average of downticks (raw data from e-Signal; all computations in Excel). Generally, we see a relative absence of selling (high levels of the red line on the chart) preceding market tops and an intensity of selling pressure (low levels of the red line) at relative market lows. Note the increase in selling pressure in recent sessions, taking the measure below -400.
Going back to 2012, when we've had readings of -400 and less (N = 132), the next five days in SPY have averaged a gain of +.71% versus an average gain of +.21% for the remainder of the sample, with 88 occasions closing higher and 44 closing lower.
This and the excess number of sell signals we've been seeing from the technical systems I follow leave me open to the possibility that the market's current choppy range will ultimately find resolution to the upside. I find these kinds of market queries more helpful in formulating hypotheses than hard and fast conclusions. It's when markets look strongest and weakest that it's helpful to look at what has happened historically under those conditions. Very often that tempers any recency bias and tendency to extrapolate the recent past to the near-term future. Further Reading: NYSE TICK
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If you have problems with your old Ford, repairing the car is a worthwhile undertaking. Repairing your Ford, however, will not build you a Tesla. The fundamental insight of positive psychology is that ameliorating life's negatives--resolving conflicts, coping with stresses--is necessary to an optimal life, but not sufficient. Healing physical aches and pains won't make us physically fit. For that, we need workouts in a gym. Positive psychology is a set of cognitive, emotional, spiritual, and social workouts in life's gymnasium.
For years, traders have turned to psychology to help them deal with the emotional challenges and stresses of making financial decisions in uncertain and changing markets. They have an old Ford and they look for repairs. If you ask those traders about their goals, however, they want a Tesla. They want distinctive success, not just fewer problems and setbacks. For that, traders need to actively exercise their strengths, not just correct their mistakes. But how many traders truly treat each trading day as time in the gym, identifying and developing what makes them successful?
One of the greatest costs of a negative mindset are the lost opportunities to develop life's positives. Couples think that working on their communication skills will restore their marriages when the problem is that they no longer engage in the activities and interactions that inspired their initial love. You know a relationship and a career are over when all that's left is working on problems. It's only a matter of time before that old car can't be fixed. A great starting point for finding that new car is to recognize that we have a wide range of capacities and competencies and all of them are subject to the principle of "use it or lose it." The diamond we become depends upon the facets we carve and polish. What do you want to use and develop? What are you willing to lose and set aside? The best gems don't have the most cuts, but the most flawless ones. Here are some resources to kickstart your sojourn in life's gymnasium: 1) Dr. Nico Rose highlights 10 contributors to positive psychology across a variety of domains; 2) Helpful database of researchers working in the field of positive psychology; 3) A wealth of articles on positive psychology topics from The Greater Good Science Center; 4) Comprehensive list of readings in positive psychology; 5) My Forbes blog specifically addresses trading, investment, and positive psychology, with a focus on peak performance. Happy workouts!
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Now that's some good cowboy wisdom. No cowboy ever said, "Ride the horse that fits your personality." Hell, no. If you want to win at the rodeo and rope that steer, you ride your best horse. But every rodeo needs its clowns to distract the bulls; it's only markets that have the clowns that distract the bulls and the bears. Once in a while the clowns say something that gets on my nerves, kind of like that guy in the square dance who doesn't know allemande left from allemande right and messes things up. But then I realize that if I'm distracted by the clowns, then I'm the bull, not the bull roper.
The single thing I've done this year that has helped my trading performance is ride my best horse and forget everything else. I examined my winning trades, backtested the most robust patterns over multiple time frames, and now I'm only trading those. If there's no robust pattern, I don't trade. And that's most the time.
It turns out that those patterns occur when the bulls and bears are most distracted by clowns. Very strong markets continue their strength, but people want to fade them. Very weak markets continue their weakness and people stop out in panic. Underreaction and overreaction--those are solid behavioral foundations of market edges.
When I traded patterns that fit my personality, it was like running a clothing store and stocking it only with merchandise that fit my tastes. A successful store figures out the tastes of customers and even anticipates shifts in those tastes. Success is about figuring out the market's personality, not indulging your own. And that personality has a distinct set of behavioral biases if you can just focus on the cowboys and not the clowns.
In the recent article outlining three principles of performance grounded in positive psychology, one of those principles involved the importance of managing your experience first and foremost. Drawing on the Einstein quote, that means prioritizing and engaging in the activities that are associated with the physical, emotional, and cognitive states you most want to sustain. What we do from hour to hour each day shapes our experience, and that determines the resources we're able to devote to the work, play, and relationships most important to us.
The challenge is to staying burning without burning out. We want to live positive, energized, exciting, meaningful lives and yet somehow we find ourselves engaged in activities that take more energy than they give. If daily experience does not incorporate activities that are renewing, we eventually deplete our resources. How do we stay productive, loving, and creative when we're burned out? Tom Rath, in his recent work, outlines three important elements in staying fully charged: 1) meaning; 2) interactions; and 3) energy. We renew ourselves when we:
* Engage in activities we find meaningful; that directly express our deepest values and beliefs; * Engage in interactions that are interesting, rewarding, caring, and loving; * Engage in energizing activities that stimulate and challenge us, from physical exercise to pursuing goals. Rath notes research suggesting that only 11% of people surveyed report having a great deal of energy. Ironically, we would never drive a car that operated as inefficiently as we do in our own daily lives. The greatest mistake we make is that we prioritize the things we need to get done rather than the states in which we best achieve our desired ends. If we match the frequency of the reality we wish to achieve, we're far more likely to live that reality. Further Reading: Why We Fall Short Of Our Potential
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* Above we see a composite measure of breadth specific to SPX stocks (raw data from the excellent Index Indicators site). Specifically, we're looking at a composite of the percentages of SPX stocks trading above their 3, 5, 10, and 20-day moving averages. Note the pattern of declining highs and rising lows in the recent data, as the average has traded largely within a range. A disproportionate share of the market's gains since 2006 have occurred when the breadth measure has fallen in its weakest quartile, with an average five-day gain of +.48%. Conversely, when the breadth measure has been in its strongest quartile, the next five days have averaged a loss of -.09%. Yet another example of how a short-term trend does not necessarily yield short-term momentum. * If you live in the greater NYC area and are interested in participating in a craft beer networking, pencil in the date of Thursday, May 21st. The specific after-hours time and location will be forthcoming. I'll be there to discuss my latest market research and fresh topics in trading psychology and my good friends from SMB will offer trading insights as well. Should be a fun way to meet other traders and enjoy a few good brews! * My Forbes blog is slowly turning into the single largest source of posts on trading that draws upon the relatively new field of positive psychology. The new book, slated to come out in September, will be the first book I know of to specifically go into detail re: how positive psychology can fuel trading performance. It's an exciting area that continues to expand.
We often hear that traders should be process driven and strictly follow their process as a way of avoiding psychologically-driven biases and poor trading practices. This draws upon an analogy between trading and the running of a manufacturing or service business. In the business setting, you are looking for consistent, high quality. Variability of output = low quality. For example, if you're manufacturing a drug, you want the production process to turn out the same pill all the time. If you're a delivery service, you want consistent on-time delivery--and you standardize each step of the process to make sure that happens. Essential to process-driven quality control are two ingredients: 1) measurement of outcomes and 2) identification of the activities that consistently generate those outcomes. In the world of medicine, that has led to a focus on outcome research and the creation of evidence-based treatment protocols that standardize best practices. If you receive surgery from an evidence-based treatment center, many of the decisions that are made, from the amount and type of anesthesia to the sterility of the operating room and the method of incision, will be laid out as protocols and derived from rigorous, controlled outcome studies. When traders say that they are "following their process", what they should mean by that is that they have intensively studied what makes them money and what does not; identified their best trading practices; codified these best practices as protocols to follow; and then tracked their fidelity to these evidence-based practices. In other words, a trader who is truly process-driven should demonstrate: 1) Reliability - They do the same thing in the same situation each time; 2) Validity - What they do is known to result in greater positive outcomes than following other procedures. Most traders who speak of being process-driven do not truly track reliability and validity. When they talk about being process-driven, what they mean is that they follow a routine. Routines are necessary for quality control, but hardly sufficient. Rowing a boat in a consistent manner doesn't help if you're headed in the wrong direction. If traders don't track outcomes, identify the practices that generate favorable outcomes, and *then* ground routines in those practices, they are not trading with quality. Trading with quality means putting as much time and effort into studying trading performance as studying markets. The process-driven trader doesn't simply define a routine and follow it blindly. Rather, process-driven trading means that you identify and understand what works and then systematically become more consistent in executing that. Would you fly an airline that operated with the same quality control as you demonstrate in your trading? It's all about doing things right and doing the right things. Further Reading: Quality, Minds, and Markets
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In his recent research report, Peter Brandt offered a keen observation: "Profitability comes from a trade finding you, not in you finding a trade. The best trades are the ones you wait for, not the ones you find." I have found this to be the case in most areas of life: the best opportunities find you. When I first returned to blogging, I didn't write about markets; I wrote about our new cat. That was one of the key lessons I wanted to convey: she found us. What was important to that discovery was that we visited many cat shelters and spent quite a bit of time with the three cats at home before Mia clung to my shoulder. A lot of preparation took place before opportunity could find us. So it is with discretionary trading: we look at markets; we look at economic developments; we look at monetary trends; we study various indicators of market behavior--and all of that is preparation. As Peter points out, at any juncture we can take a chart or piece of data and find a trade in it. If we are in a mindset where we want to trade--and need to trade--we can find trades to do. And we don't make money. When we are patient and prepare and prepare and prepare, eventually a pattern presents itself to us. All the analysis falls into place with a keen synthesis. We might conceptualize the pattern in statistical terms, chart-based terms, macroeconomic terms, or some other terms. There are many languages we can speak to capture the patterns in complex phenomena.
The reason patience is important to trading is that it allows us the time and space to synthesize. We can never get to the point of trusting our gut if our heads are cluttered with what we want to do next. It is when we stop doing that the things worth doing come to us. Further Reading: The Greatest Mistake Traders Make
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* On Thursday across the NYSE universe, we saw quite a few more stocks close below their lower Bollinger Bands than above their upper bands. As you can see from the chart above, important intermediate-term lows have occurred in market cycles when we've seen a plethora of stocks trading below their lower bands. I went back to the start of my data set (May, 2014; raw data from Stock Charts) and looked at all occasions in which we registered more than 200 stocks below their lower bands versus above their upper bands, where this was the first occasion in at least two weeks. Interestingly, three days later, SPY was up twice and down five times for an average loss of -.54%. Too small a sample to hang one's hat on, but the point is that markets can display short-term momentum to the downside as well as upside when there is a strong breadth move. * We often hear that your trading style should fit your personality, but what is your trading style and what aspects of personality are important to performance? Too often traders lose money because they drift from one trading style to another, not mastering any and not truly leveraging their strengths. I can think of few more important topics in trading psychology. * Banks are not providing the liquidity they once did. This can lead to mini flash crash situations and is very relevant for risk management. * Two valuable professional activities are networking and not working. Networking exposes us to new ways of thinking and new ideas; as James Clear suggests, not working allows us to renew and rejuvenate, so that we can generate our own fresh perspectives. I'll be announcing a NYC networking event for active traders shortly.
Three questions that are key to understanding the day behavior of stocks are: 1) Who is in the market? 2) Are they becoming more active in the market over time? 3) Are they able to move the market directionally? Above we see a chart of yesterday's price action in SPY (blue line), plotted against five-minute readings of relative volume (red line). (Raw data from e-Signal; all calculations in Excel). The relative volume is expressed in standard deviation terms. Each five minute period's volume is expressed relative to the median five-minute volume and standard deviation for that same time period over the past two months. So, for example, a reading of zero at 10:05 AM (all Eastern time) would mean that we traded exactly at the median volume for the 10:05 - 10:10 period. A reading of 1.0 would mean that we traded at one full standard deviation above the median volume for that period.
What we're looking for relative to the three questions above are:
1) Do we see significantly above average participation in the market? If so, we have a good indication that speculative players in the market are active. If not, we could have a slow market dominated by market makers.
2) Do we see participation increasing over time? We want to know if those speculative players are being drawn to the price action or whether the market's auction is shutting down as prices move from value.
3) Do we see evidence of trending behavior corresponding to the participation in the market? Are we getting two-sided action--action where both buyers and sellers are aggressive and keeping the market in a range--or do we see a dominance of buyers or sellers over their counterparts facilitating a market move away from value? Yesterday was a Fed day and we also had an important GDP number early in the morning. As a result, we saw above average participation in the market early in the trading session. Relative volume picked up with morning market weakness and dried up ahead of the Fed announcement at 14:00. At that point relative volume spiked with the appearance of buyers. Nothing in the Fed's announcement--and certainly nothing in the weak GDP report--led participants to think that monetary conditions would be altered in a way that would be harmful to stocks. Yet what do we see for the remainder of the afternoon? Apropos to points 2) and 3) above, relative volume tailed off steadily and price could not break above its early morning levels. In other words, on a relative basis buying interest was drying up and there was no reason to move price above where value had been established on the day time frame. What does that suggest? Nothing in the Fed action was perceived as a meaningful game changer for stocks. The interplay of volume, price, and time help us understand the demand and supply behind the market's action. That provides us with meaningful reference points for the following day, as it will take fresh volume flows to move us out of yesterday's range. Further Reading: Relative Volume and Market Opportunity
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Bella at SMB offers some excellent perspectives regarding trading on tilt. Tilt is a term that originated in poker and describes a state in which sheer frustration with the game takes over and distorts one's betting. As I noted in an earlier post, trading on tilt is a function of our outcome expectations. If we are not emotionally prepared for the possibility of losing, we are more likely to be thrown by losses. We set ourselves up for the tilt state by needing and expecting to win, rather than letting probabilities play themselves out and accept that there will be winning and losing periods.
I recall becoming an avid pinball machine junkie in college and watching players become frustrated to the point where their own tilt led them to throw their machines into tilt. My first book describes how I never really succeeded consistently at pinball until I discovered a quirk in the machine I was playing. If I let the ball hit my left flipper and did absolutely nothing, the ball would bounce to my right flipper. From the right flipper, I could swing the ball through an area of the table and it would ring up points and send the ball to my left flipper. Once again I would do nothing, the ball would bounce to my right flipper, and I would swing the ball through the scoring alley. One time I repeated this so many times that I won 32 free games in a row.
I never went on tilt and I never put my table into tilt. The game became pretty emotionless, because I was repeating a technical maneuver over and over again. I got to the point where I almost always won free games. I never really mastered pinball machines; I just became good at finding and exploiting quirks in machines. The best quirks came from doing something that no player would normally do, like not use your flipper when the ball came your way.
There's an important lesson there for trading. Further Reading: Regaining Self Control
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Lately I've seen a variety of observations about stock market sentiment, ranging from bullish to bearish to neutral. My favorite measure of sentiment is the put/call ratio for all individual stocks with listed options. This excludes index option volume. Above we see a five-day moving average of the equity put/call ratio (red) plotted against the SPX. (Raw data from e-Signal). In general, we've tended to see elevations of the ratio at relative market lows. Over the last few weeks, the ratio has dramatically declined as we've percolated to new highs. We are currently in a zone where traders are bullish in their options-related behavior. Since the start of 2014, sentiment has been an important tell for forward market returns. If we simply conduct a median split of the daily data, we find that when traders have been relative bullish (N = 160), the next 10 days in SPX have averaged a loss of -.28%. When traders have been relatively bearish (N = 160), the next 10 days in SPX have averaged a gain of 1.18%. In other words, if you followed the sentiment herd and bought the market when traders were bullish and sold when they were bearish, you lost significant money. Essentially all the market's returns have come from time periods when traders did not believe we were going to get good returns. There's an important lesson there. Further Reading: The Index Put/Call Ratio
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* Above we see a cumulative running total of the number of NYSE stocks giving buy versus sell signals with respect to their Bollinger Bands. This is one way of looking at the breadth of strength versus weakness over time. After notable weakness going into the October, 2014 drop, we have been working our way higher in this measure. More stocks have been showing strength than weakness, as much because of the relative absence of sell signals as the high presence of buys. * This is a very important concept for developing traders: How we are wired socially, emotionally, and cognitively defines where we will find our edge in markets. We are best positioned to know markets if we first know ourselves. * I've been making increasing use of the Investing.com site. I like the feature that tracks advancing and declining stocks across international as well as U.S. averages. I also like the coverage of international markets, FX, and the international commentary.
* Great series of posts on mindfulness in trading by SMB Training and Bruce Bower. The clearest problems with mindfulness occur when we are caught up in emotional reactions to market action. Less appreciated is that we can lose self-awareness as a function of good trading. If we're absorbed in markets, we're not focused on our best trading of those. It's that transition from market awareness to trading awareness that is key. Many great traders use post-it notes for reminders on their screen precisely because it's when they're most focused on markets that they're least focused on best trading practices.
* Are we trending on a day time frame? Stats provided by Vic Scherer are quite relevant. I've also been looking at volume as a relevant measure. It's tough for short-term moves to extend if volume is drying up. Note that trend on an X time frame is dependent upon momentum at the Y time frame, where Y > X. If you have a measure that has a momentum edge, you can generally define a winning trend strategy at a lower time frame.
One of the joys of social media is the opportunity to discover people who are doing good work. True, you have to wade through quite a few emo and self-promotional posts and tweets to find the nuggets of insight and talent, but all you need is to find one per month and over time you build quite a stimulating and meaningful network. Are you doing good work? Are you looking at markets in fresh and rigorous ways to generate better trading ideas? Are you looking at yourself in fresh and rigorous ways to better improve yourself? If so, I encourage you to make use of two symbols to facilitate your networking with other creative, productive market pros: $STUDY and #tradingpsychology. $STUDY is the symbol for educational tweets posted to the excellent StockTwits site. These may consist of insights in themselves or may link to original posts that contain insight into markets and trading. A great way to see who is doing good work is to punch up $STUDY and find the people who are talking more about ideas than about themselves.
#tradingpsychology is an underutilized hashtag. I've been making greater use of it in my tweets in hopes of making it a better archive for original insights posts that deal with the psychology of trading. Again, there's a bit of wading through the self-promotional stuff, but by and large people who are posting good things on trading psychology topics are not making use of the #tradingpsychology hashtag.
So here's the deal: I will be making conscious and consistent use of $STUDY and #tradingpsychology when I have ideas and posts to share about markets and the trading of those. If you're doing good original work, I encourage you to do the same. I will go out of my way to then favorite, retweet, and link to the best of your work. Over time, this will be a great way to facilitate networking among likeminded professionals and allow the workhorses to stand out from the show horses. I look forward to organizing a greater NYC craft beer event this spring for those of us sharing via $STUDY and #tradingpsychology. After all, there's a reason it's called social media! Further Reading: A Different Kind of Trading Group
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One of the best ways to generate fresh ideas is to question accepted wisdom. What is often assumed among traders and market writers is just not the case. Technical indicators are generally regarded as measures of market strength and weakness. When price action has been strong over a lookback period, the technical indicator is viewed as bullish and vice versa. At extreme values, the indicator may be regarded as an "overbought" or "oversold" measure. Since the middle of last year, I have been tracking the buy and sell signals for all NYSE stocks for several technical indicators. (Raw data compiled via the Stock Charts site). Three indicators I've looked at in particular detail are Bollinger Bands, MACD, and Parabolic SAR. Since June, 2014, the correlations of buy signals across the indicators have been positive, ranging from +.23 (Bollinger:MACD) to +.56 (MACD:Parabolic SAR). Similarly, the correlations of sell signals have been high, ranging from +.22 (Bollinger:MACD) to +.75 (MACD:Parabolic SAR). Clearly, different indicators are not measuring completely different things. Indeed, an argument can be made that indicators are simply implementations of different moving average rules. When we look at which indicator is best, we're really fitting past market behavior to a particular moving average, which may or may not be predictive on a prospective basis.
On Friday, we had buy signals outnumber sell signals for all three of the above indicators, reflecting the recent market strength. Going back to June, 2014, when this has occurred (N=62), the next five days in SPY have averaged a gain of only +.01%, compared with an average five-day gain of +.26% for the remainder of the sample. Clearly, strong readings have not brought near-term strength--though neither have "overbought" readings reliably led to market declines. The failure of strength to be followed by strength is yet one more reflection of the distinction between trend and momentum outlined in the recent post.
Conversely, when we've had all three indicators yielding more sell signals than buys (N=49), the next three days in SPY have averaged a gain of +.33% versus +.04% for the rest of the sample. Market weakness has tended to reverse in the near term, though much of that relative performance boost tends to fade over subsequent trading sessions.
It is human nature to extrapolate from the recent past to the immediate future when we are trying to anticipate events. In the case of the stock market, failing to question "strength" and "weakness" has been hazardous to our wealth.
Here is something I watch closely while trading. The blue line is the SPY ETF; the red line takes the SPY volume for each five-minute period and expresses that relative to the average SPY volume at that same five-minute period (30-day lookback). The ratio is expressed in standard deviation units. When the ratio is above 1.0, we're seeing above average flows come into the market for that five-minute segment. When the ratio is below 1.0, we're seeing below average volume participating in that period. Because volume correlates highly with volatility, this ratio gives a nice real-time updating of how much movement we can expect in the stock index. Note that the couple of times we bounced above zero during the morning, relative volume tailed right back off. It's when we see persistence of high ratio readings that we generally see range extension and short-term momentum. In the low volume environment, we're more likely to see moves reverse before possibly continuing in their initial direction. In the case of this morning's market, the tailing off of volume represented a pulling back of buyers; there was no influx of sellers. While low volume is not good for momentum trades, it is not necessarily a bad thing for trend trades. Further Reading: Momentum and Trend Trades
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As I speak with traders, I notice a common mistake that is responsible for quite a few losses: the confusion between trend trading and momentum trading. They are not the same thing. Traders who fear missing out on a trending move and chase strength or weakness frequently get whipsawed and stopped out. Let's define our terms: An asset that is trending is making higher highs (lower lows) and higher lows (lower highs) during a given lookback period. If you imagine a regression line for price as a function of time, the line would be the trendline and there would be a noticeable positive or negative slope over that lookback period. An asset that is trading with momentum tends to continue in the direction in which it has been trading. Strength tends to be followed by strength; weakness by weakness. Think of that regression line that is the best fit for a given trend. If price oscillates widely around that line (i.e., the fit is not great), this is because the trending asset is not trading with momentum. When price is strong, it tends to fade and vice versa. A line that is a very good fit suggests momentum in the direction of the trend. When traders assert that there is a trend and then buy strength (or sells weakness) to ride the trend, they are assuming that the trend also displays momentum. That ain't necessarily so. Buying strength in an uptrend and selling weakness in a downtrend is a great way to underperform in a trend market that is not a momentum one. Let's go to the excellent Paststat site for a couple of illustrations. A technical indicator is a useful and familiar measure of price strength and weakness. If an asset shows momentum effects, it should demonstrate significant strength following high indicator readings and significant weakness following low readings. Different indicators incorporate different lookback periods, so a look at several is useful if we want to gauge momentum over differing time periods.
To start, let's say we buy SPY when it closes above its upper Bollinger Band and hold for five trading days. Over the past three years, this has resulted in 40 trades. Of those, 24 have been winners and 16 losers for an average gain of +.04% and a profit factor of 1.13. Meh. No distinctive upside edge to buying strength, but also no significant weakness. This fits with my research: when price strength occurs with positive breadth thrust and elevated momentum, there is a greater probability of upside follow through than when the strength occurs with little oomph. Averaged together, we see no meaningful tendencies.
Now let's buy SPY when it closes below its lower Bollinger Band and hold for five trading days. Now we have 43 trades: 28 winners and 15 losers for an average gain of +.98% and a profit factor of 3.14. That's a meaningful bullish tendency. It suggests anti-momentum following weakness. When price has dropped significantly, we've tended to bounce.
The trader who bought strength and sold weakness during the last three years lost money on average. It has been a trending market, but not a momentum one. Executing based on momentum has turned a normally winning trend strategy into a losing one. Think about traders who trade with a "fear of missing out", and you can appreciate why that emotional pattern is so costly!
OK, so let's buy SPY when its RSI is above 70 and hold for 5 days. Now we have 122 trades over a three year period: 60 wins, 62 losses, for an average gain of +.02% and a profit factor of 1.08. Meh. If we buy SPY when its RSI has been below 30, we have 24 trades: 18 up, 6 down for an average gain of +1.79% and a profit factor of 7.08%.
It's interesting that traders often emphasize trading with the trend but not chasing trades. That's an implicit realization that a directional bias doesn't have to be a momentum bias. Many trends are traded best when they look as though they're ending.
Last year I wrote about Market Profile as a practical theory that helps traders achieve a fresh perspective on markets and trading. Market Profile stems from the early work of Peter Steidlmayer, which was grounded in an innovative approach to charting. (See this early manual for an overview). This approach tracks the market's auction process by identifying where markets set value and gauging whether current trading is accepting or rejecting a given value area. Markets rotate in and out of balance as they oscillate within value areas and create new ones.
Since this early work, a variety of new tools for understanding the market's auction process have become available. Market Delta is a unique charting format that helps identify when buyers and sellers are dominant in markets based upon whether transactions are occurring dominantly at the current bid or offer price. This can be an effective way of visualizing how volume is behaving as we depart from a value area--a nice tell for whether we are likely to rotate back into a value range or trend and establish fresh value.
WindoTrader is an unusually flexible charting and analytics package that helps traders visualize value relationships at different time frames within a single graphic, as well as value relationships among different instruments. (See their list of reading resources and trading blog.) It is not at all uncommon to see a market move out of a shorter-term value range to the value area of a longer timeframe auction. Visualizing this activity in real time is quite valuable.
I don't know of anyone who has done more to popularize Market Profile and educate traders in its application and interpretation than Jim Dalton. He has archived a great number of articles and videos for his students and has developed training programs both by DVD and live. I notice that he is conducting a summer intensive, in which he presents fresh developments in Market Profile application, including "signature trades" that result from an understanding of the auction process. His current work builds on the excellent foundation of his Mind Over Markets book.
Jim makes an important point: when you look through the lens of the profile, you begin to think in terms of market structure and value, not price. When we focus on price alone, we lose the context of that price movement. Markets make sense as auction processes, providing us with a unique perspective on how markets move. Many trading problems occur when we spend so much time and effort trying to predict the next market move, when it would be far more helpful to truly understand the market's movement to that point.
Author of The Psychology of Trading (Wiley, 2003), Enhancing Trader Performance (Wiley, 2006), The Daily Trading Coach (Wiley, 2009), Trading Psychology 2.0 (Wiley, 2015), The Art and Science of Brief Psychotherapies (APPI, 2018) and Radical Renewal (2019) with an interest in using historical patterns in markets to find a trading edge. Currently writing a book on performance psychology and spirituality. As a performance coach for portfolio managers and traders at financial organizations, I am also interested in performance enhancement among traders, drawing upon research from expert performers in various fields. I took a leave from blogging starting May, 2010 due to my role at a global macro hedge fund. Blogging resumed in February, 2014.
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