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Indicator Review for July 7th

2008-07-07T06:31:00.001-05:00

Last week's indicator review noted that we were oversold, but that indicators were weakening and it was dangerous to try to catch the falling knives. That turned out to be pretty good advice, as we became even more oversold (top chart)--reaching levels seen at recent intermediate-term market bottoms--but continued to see an expansion of stocks making new lows (middle chart). Buying sentiment, as measured by the cumulative TICK (bottom chart) remains nowhere to be seen, as bounces have led to reversals. In short, the weak market has become weaker. Traders looking for signs of capitulation in the usual indicators have been frustrated; it's been a grinding decline rather than a sharp panic.

The advance-decline lines specific to NYSE common stocks and S&P 500 issues have both moved to bear market lows this past week. We've also seen an expansion in the number of stocks making fresh 52-week lows. The over-300 new lows among NYSE common stocks eclipsed the March level, though the 90+ new lows among S&P 500 stocks remain beneath the peaks from January and March (though still expanding). Only 14% of NYSE stocks are trading above their 50-day moving averages, also quite an oversold level commensurate with recent intermediate-term market bottoms.

When markets make a bottom, we like to see divergences and a narrowing of participation to the downside. Recently, however, the opposite has been the case. Sectors that had been strong, such as materials, have joined the downside and the small caps, which had been showing relative strength, have been quite weak of late. Indeed, only 14% of S&P 600 small cap issues are trading above their 50-day moving averages, down from 70% in May; a level similar to the market overall, as noted above.

With the widening number of issues making new lows, the falling advance-decline lines, and the weak sentiment/TICK, I once again am not inclined to try to pick the bottom. We're overdue for a bounce, and we're at oversold levels that have been associated with market rallies. Until we see some stabilization among the housing and banking issues, however, I suspect it will be difficult to sustain any such rallies. As always, I will be updating many of these indicators in my daily Twitter posts, along with links to posts and articles on market moving themes.
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Weakness Begetting Weakness

2008-07-06T17:26:00.000-05:00

As I was putting together my indicator review for the week (which I'll post tomorrow AM), I noticed how consistent the recent stock market weakness has been:

* For six consecutive sessions, we have had over 2500 stocks across the NYSE, ASE, and NASDAQ making fresh 20-day lows. The highest number of 20-day highs over that period was 410.

* We have had more stocks making 20-day lows than 20-day highs for 20 consecutive sessions.

I think it's fair to say that a strong stock market is one in which, over time, we see more stocks making fresh 20-day highs than lows. A weak market is one in which the number of stocks making fresh lows outnumbers the number making highs.

Above we see the S&P 500 Index (SPY; blue line) plotted against a cumulative line of new 20-day highs minus lows from 2004 to the present. We can see that the current market strength topped out in July, ahead of the October price peak. We can also see that the market has been weakening since that time: the cumulative line of highs minus lows continues to fall.

One definition of a bear market is one in which lower prices fail to attract buyers, leading to still lower prices. If you peruse the indicator reviews from the past several weeks, that is what we have been seeing.
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Message From the Materials Sector?

2008-07-06T01:09:00.000-05:00

It was difficult to not notice the swoon in the coal sector (KOL; pink line above) this past week, even as materials stocks have been in steady retreat (XLB; blue line).

Wasn't it just in May that the materials sector was making bull market highs, rising more than 50% from its 2006 lows? Back in May, we saw over 85% of materials stocks trading above their 50-day moving averages. At present, that is down to 7%. Over 70% of the sector's issues were trading above their 200-day moving averages since May; now only 21% are above that benchmark. That's quite a retreat.

Notably, the advance-decline line specific to the XLB stocks has moved from a bull market highs in May to 15+ month lows at present.

Back in May, voracious growth in the emerging economies was the story behind the commodities-linked materials stocks. Now, with stock markets in India and China in hasty retreat, markets may be pricing in the effects of a global recession.

This shift from an emerging markets growth story to a truly global recession theme has important implications for commodities markets as well as rates and equities. Inflation has been making the headlines, fanning concerns over central bank rate hikes, but falling materials shares may be foretelling a very different economic future.
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Fear, No Panic, at the Market Disco

2008-07-05T07:08:00.002-05:00

The Dow has been moving to bear market lows and the number of NYSE common stocks making fresh 52-week lows has taken out its March peak, but so far investors seem to be seeing this as more credit-related sin than tragedy. I've mentioned in the past that there have been spikes in traffic on this blog at recent intermediate-term lows (August, November, January, March). No such spike has yet occurred during the market drop.

OK, maybe it's just summer doldrums in blog traffic. Maybe my readership has deserted me at the altar of the blogosphere. Still, let's face the data with a sense of poise and rationality. As the chart above notes, the American Association of Individual Investors poll has also shown spikes at those prior market bottoms. We're now seeing an elevation of bears in the poll above the 50% level, but the bearishness is more muted than in January or March.

We're also not seeing the January or March levels of bearishness in the equity put/call ratio, and surely no panic has hit the disco in the VIX, which remains below the 30+ level seen at those prior market lows.

Perhaps we'll yet successfully test the March lows in the S&P 500 Index and, technically we can be saved and pour the champagne. For now, however, I note the continued decline in the advance-decline line of NYSE common stocks to new bear lows and the continued decline in the cumulative NYSE TICK and I'll stick with poise and rationality: my door remains closed.
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Proprietary Trading Firms, Arcades, and Scams

2008-07-04T14:49:00.002-05:00

I've received several emails lately in which traders asked me about joining proprietary firms that offer training for very high fees (many thousands of dollars/euros). The traders want to know, "Are these firms legitimate?"

I have very sincere doubts.

A proprietary trading firm is one in which you trade the capital of the firm in exchange for a split of profits. An arcade is a firm in which you trade your own capital, but the company provides the trading infrastructure, including member commissions/fees. At an arcade, you pay for the overhead/commissions but keep your profits. Prop firms can be good options for traders who lack sufficient capital for a meaningful account; arcades can be good options for successful traders who benefit from the lower overhead associated with economies of scale. Both options offer access to other traders, which can be a benefit.

A firm that charges for training with the promise of trading proprietary capital sounds like a scam. It reminds me of modeling "agencies" that charge for classes with the promise of contracts that never materialize. They make their money from the training fees, not from splitting fees with successful professionals.

At the very least, if you're considering such an arrangement, exercise due diligence and make sure that the firm can put you in touch with traders who have completed the training and are now trading prop capital for a living. If they can't do that, you surely know you have a scam. But let's face it: if a firm was successful in training traders and was confident of their success, they'd make plenty of money from the profit splits. They wouldn't need to talk traders into huge training fees with pretty promises.

And, really, is a several week course going to turn a beginner into a successful trader? Caveat emptor.

RELATED POST:

Joining a Prop Firm
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Cross-Talk: The Role of Emotion in Trading

2008-07-04T07:19:00.002-05:00

SFO Magazine has another trading psychology issue available, and there are several articles worthy of a look. Here is the link to my article in that issue.

The theme of the issue, as titled on the magazine cover, is "Contain Your Emotions". Here is a sampling of quotes from articles included in the feature:

"It is a generally agreed upon industry fact that traders spend a disproportionate amount of time focusing on external market analysis and significantly less time on understanding themselves as traders."

"...while it's difficult to contain emotion 100 percent of the time, the more you can keep it at bay, the better off you will be."

"...it is imperative...to be able to sustain calm without having to mask roiling emotion. One key to success is to be calm and methodical in general and at every point in the trading journey..."

"Markets are full of endless opportunities, and the only obstacles preventing us from consistently capitalizing on them are our own mental models..."

Well, you get the idea. Emotion is bad and if you control emotion you'll succeed.

Contrast that view with this quote from my article:

"Just ask yourself: Would you want to be operated on by a physician who put as much time into keeping on top of his profession as you put into your preparation for trading? Would you want to be represented in court by an attorney who put as much preparation time into your case as you put into your trading days?"

If you don't understand markets, if you don't systematically prepare for trading, and if you haven't sufficiently rehearsed trading-related skills, you'll perform miserably and you'll become emotional. Plenty of emotional traders contact me seeking help; the vast majority trade simple patterns that have no demonstrable edge whatsoever, do not understand intermarket relationships, and do not know how to read intraday market sentiment. They're emotional because they haven't a clue.

Because emotionality enters into much bad trading does not mean that controlling emotion will, in and of itself, lead to successful trading. That's like saying that infidelity is common in bad marriages, so if you contain your urges for people other than your spouse, you'll enjoy a blissful union.

The question that should be addressed is *why* emotion is playing a destructive role for some traders and what, specifically, can be done about that (just as the question for any competent marriage counselor would be *why* the desires for infidelity are there to begin with). The idea that emotion is bad and should be minimized in decision-making is flat out wrong; cognitive neuroscience research is clear on the role of emotion in normal, sound thought and decision-making. When people's capacities to feel are genuinely minimized--through brain damage--*that* is when they behave in irrational, maladaptive ways.

Of course, emotions of fear, greed, overconfidence, and anger can skew our decisions and actions. But there are two major reasons these emotions can intrude into trading:

1) The trader is biologically predisposed to a high degree of negative emotional experience (i.e., the trait of neuroticism) and probably shouldn't be operating in a field with high degrees of risk and uncertainty;

2) The trader has not sufficiently studied and learned markets, is not succeeding at his/her decision-making, and is becoming frustrated and emotional as the result--not the cause--of trading problems.

It's unlikely that trading coaches offering commercial services will emphasize either of those perspectives. Many traders, as well, want to hear the message that if you just "contain your emotions", you can participate in "endless opportunities"; that traders don't need to spend as much time on "external market analysis" as long as they work at "understanding themselves as traders."

The truth of the matter, in trading as in other performance fields, proper training is the best source of discipline and the most effective safeguard against intrusive anxiety and impulsivity. Learn how to trade well and you'll master most emotional difficulties associated with performance. Learning to "contain emotions" without proper cultivation of trading skills will only help you more comfortably part with your capital.

RELATED POSTS:

Somatic Markers and Trading

Trading and Intuition

Trading Psychology Myths
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Views on Markets and Traders

2008-07-03T01:40:00.002-05:00

* A Philosophy of Coaching - Brief therapy perspectives on changing the patterns that affect our trading.

* When History Doesn't Repeat - The recent blog post was quite applicable to Wednesday's trading: bullish expectations, bearish market behavior. Seeing when markets deviate from their historical scripts itself becomes a useful indicator.

* Twittering Away - Suppose someone was to alert you when credible articles on market-moving themes appear online, notify you of economic reports due out for the trading day, and summarize indicators that capture the strength and weakness of the market--and suppose it was free for anyone who signs up? That's what I'm trying to accomplish with the Twitter app, and already the list of posts is approaching 3000. Once I finish the book and return to more regular trading, I'll include trading signals in the Twitter "tweets". That should be fun.

* Good Question - The Big Picture asks if the pundits are too optimistic, or if the public is too gloomy.

* Triple Bottom? - Trader Mike finds this and other worthy topics among his link updates.

* Missed Opportunity - GlobeTrader offers unusual insight into the dynamics of missing trades.

* Being Prepared - Ray Barros, with an excellent post on the value of contingency plans.

* Trading Multiple Timeframes - Great trading lesson from Brian Shannon.

* Market Wisdom - Chris Perruna offers choice quotes from Bernard Baruch.

* Messy Market - WSJ MarketBeat notes the beating in the coal sector and cross-currents on a down day.
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When Trending Trends and When It Ends

2008-07-02T01:33:00.000-05:00

If I had to describe my trading approach in a nutshell, it would be to identify what markets have done historically under a set of conditions and then observe whether or not this scenario is playing itself out in real time. We've had an oversold market that, based on historical precedent, should have led to a sharp reversal. Tracking such indicators as the Cumulative NYSE TICK, however, it's been clear that buyers have been absent and that the market has not been following its historical script. Some might call that a failure of historical indicators; I call it useful, practical information.

Above we see how the indicators have been weakening (kudos to Decision Point for the charts). New lows among NYSE common stocks have expanded beyond their March levels (top chart; click for greater detail); the advance-decline line for NYSE common stocks (bottom chart) has also been making new bear market lows.

Notice in the bottom pane of the second chart that the volume-weighted advance-decline line for NYSE common stocks has been much weaker than its traditional counterpart. This suggests that stocks are falling on higher volume than they're rising: just another sign of institutional bearishness.

When indicators and sectors are in gear, we have a trending market. Distinguishing trending markets from ones that are likely to reverse is one of the great challenges of trading at any time frame. Knowing what markets "should" do based on precedent--and observing what they *are* doing--is helpful in making the distinction.

RELATED POSTS:

Indicator Review

Sector Strength
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Coaching Hedge Fund Portfolio Managers: Bursting the Myths of Trading Psychology

2008-07-01T01:44:00.001-05:00

In my recent post, I passed along four things that I have learned from serving as a trading coach for hedge fund portfolio managers. This post takes a different perspective, identifying several trading psychology "truths" that I have had to unlearn as a result of working with experienced professionals. Here are a few myths I've had to dump along the way:

1) Success is Largely a Function of Psychology - Simply not true. The portfolio manager generally has a core strategy that is implemented in different markets and/or across different instruments. This means juggling large amounts of information over time and viewing markets multidimensionally for opportunity, extracting themes from the relative movements of national markets and asset classes. Success is a function of information, creative thinking with that information, a deep understanding of what moves markets, and experience with different market conditions. Only when those are present does psychology matter.

2) A Good Trader Is One Who Makes Large Returns - Those who make large returns with large risks are tomorrow's casualties. In the hedge fund world, you lose investors if you cannot rein in risk. It's the ability to generate consistent, significant risk-adjusted returns--not just large absolute returns--that matters in the long run. Successful portfolio managers don't just look at daily profitability. They actively evaluate the correlations among their positions, their levels of risk, and their shifting horizons of risk/reward.

3) Execution Is a Huge Part of Success - When you have hundreds of millions of dollars or more to invest, you don't just click a mouse and enter a full-sized position. You scale into positions over time so as to not disrupt markets and so as to obtain good prices. Similarly, you can't just exit many positions all at once when you have large portfolios, particularly when some of your positions are in markets that have limited liquidity. This is where the management part of portfolio management becomes crucial.

4) Opportunity is Limited - There are plenty of markets to invest in if you have 15 million dollars. It is more challenging to find opportunities for 15 billion dollars. Firms are in a constant race to find new markets, new spheres of opportunity. This lies behind the development of the latest quantitative trading models and the development of frontier investment opportunities. For a daytrader, markets are always moving and there's always a trade around the corner. Not so in the larger world of money management. Much of the long-term success of large hedge funds hinges on their ability to push the opportunity envelope and cultivate new sources of edge.

I sometimes receive mail from traders asking me how they can break into the hedge fund world. Success at portfolio management is not simply a larger version of success at trading individual markets directionally. It's a different game, with a different thought process. Not many traders get that and, sadly, neither do many would-be coaches.

RELATED POSTS:

Three Myths of Trading Psychology

Resilience and Success
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Indicator Review for June 30th

2008-06-30T06:28:00.000-05:00

The most recent indicator review found continuing market weakness and, once again, we've seen more of the same this past week. The adjusted Demand/Supply Index (top chart) finally hit the -30 level that has been typical of intermediate-term market lows over the past few years, which suggests a very oversold market. On the way to that level, however, we've seen an expansion in the number of NYSE, ASE, and NASDAQ stocks making fresh 65-day lows (middle chart) and a breakdown in the advance-decline line specific to NYSE common stocks (bottom chart; credit to Decision Point). The cumulative NYSE TICK, as well, has been making fresh lows, indicating that--thus far--lower prices have not been attracting the interest of institutional buyers.

My recent look at the market's technical strength found that the weakness has affected most of the major sectors. Only 17% of S&P 500 Index ($SPX) stocks are trading above their 50-day moving averages; that number is only 13% for NASDAQ 100 Index ($NDX) issues and 3% for Dow Industrials ($DJI) shares. Small caps have been stronger, with 22% of S&P 600 Index ($SML) stocks above their 50-day benchmarks.

Among NYSE common stocks, we had 24 stocks making 52-week new highs on Friday against 289 lows. That compares to over 300 new lows at the March bottom and over 700 at the January bottom. Large cap issues--particularly in the Dow--are much weaker now than at those two prior junctures, but we've seen some residual strength among small cap and midcap shares. For example, we had only 52 new annual lows among S&P 400 midcap stocks ($MID) and 65 among S&P 600 small caps. Both those numbers are well below their January and March peaks.

The bottom line is that we are at oversold levels that historically have led to intermediate-term bottoms, but we're not yet seeing signs of buyer interest in stocks. To the contrary, we've seen a steady weakening of the market indicators. As long as that's the case, it's been dangerous to try to catch the market's falling knives.
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On the Radar for the Coming Week

2008-06-29T13:48:00.003-05:00

* Crosscurrents in Iran policy - An interesting inside look from Seymour Hersh.

* Trading Sectors - Henry Carstens outlines a "relative value" approach to trading sector ETFs and follows up with a strategy tested on indexes.

* Beating the Market With Stock Screening - Charles Kirk follows up his stock screening recommendations with a performance evaluation.

* Perspective on the Bear - Barry Ritholtz asks, "What makes a bear market?"

* No Panic? - There have been a number of comments about the lack of upside in the VIX; my blog hits have also not shown their customary elevation during market bottoms. Quantifiable Edges examines the relatively low put/call ratio and implications.

* Good Reads - Exploiting industry momentum and other worthy market views from Abnormal Returns; see also the recent reads that include a look at neglected stocks and more.

* False Beliefs - How our brains lie to us.
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Technical Strength of a Weak Market

2008-06-29T05:38:00.002-05:00

My measure of technical strength quantifies the trending behavior of five highly weighted stocks for each of eight S&P 500 Index ($SPX) sectors. The technical strength measure varies from +500 (very strong uptrend) to -500 (very strong downtrend), with readings near zero indicating a lack of trend.

Here are how the sector readings are looking for the eight sectors:

MATERIALS: -460
INDUSTRIALS: -500
CONSUMER DISCRETIONARY: -440
CONSUMER STAPLES: -420
ENERGY: -80
HEALTH CARE: -160
FINANCIAL: -460
TECHNOLOGY: -400

This is one of the weakest set of technical strength readings I've encountered; it's typical of markets in which all stocks and sectors--the good with the bad--are being punished. I will be publishing a review of market indicators here on the blog tomorrow; I'm also starting to keep track of stocks and themes *not* making new lows here with the broad market.
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Four Lessons I've Learned From Coaching Hedge Fund Portfolio Managers

2008-06-28T05:59:00.000-05:00

As someone who works as a coach/psychologist with portfolio managers at hedge funds on a regular basis, I have the opportunity to see the business from several unique angles. I find that, for the most part, writings from trading coaches and psychologists don't capture much of my experience. Just as there is a large gap between what is written about successful trading techniques and the actual techniques employed by professional traders, there is a significant gap between what is written about the success of traders and how success actually manifests itself in settings such as hedge funds. Here are five lessons I've learned from coaching hedge fund traders/portfolio managers that differ from the common wisdom in the magazines, seminars, and books.

1) Success is Individualized - Many writers and coaches, understandably, promote particular models of success, emphasizing common features of successful traders. While I do think there is a common *process* to developing expertise, the notion that successful portfolio managers have a common set of personality features or trading approaches simply does not hold water in the real world. It's much more important that portfolio managers understand and operationalize what works for them than fit a preconceived model of success. What works in one set of strategies and markets may not in others; what works for one trader is not helpful for others;

2) The Game is Different - This should go without saying, but it is rarely acknowledged: portfolio management in the hedge fund context is a different process from trading in the prop firm or retail context. As the name suggests, much of the success of portfolio management comes from managing ideas and positions over time, with multiple ways of expressing and hedging each idea. Too, many of these ideas are relational (relative strength based), not directional, and cut across markets and asset classes. This requires different knowledge and skill sets than trading in and out of individual markets with a directional bias. In particular, I find that writers give short shrift to the knowledge component of portfolio management expertise.

3) The Environment Matters - Many writings on traders attribute success to individual trader characteristics (personality, mindset, etc) and give very little mention to the role of the environment in the success of portfolio managers. The research, platform, risk management, and managerial support of traders matter quite a bit--so much so that portfolio managers who are successful in one setting may fail at another despite employing similar strategies. How a portfolio manager is managed matters quite a bit, and this is poorly understood.

4) Success Starts at the Beginning - Even very large hedge funds and investment banks are surprisingly unscientific when it comes to the hiring process. Much of portfolio manager/trader success or failure simply comes from putting the wrong people into positions. Because a portfolio manager has made money over the last X years, does not necessarily mean that they'll make money in a different setting, in different market conditions, or in a different regime of money management. There is much to be said for the fit between portfolio manager and the hedge fund as a firm, yet the fit is often not well understood--even by the firms themselves.

It would be great if helping hedge fund managers succeed was as simple as keeping them unemotional, as many writings suggest. The reality of the work I do week in and week out is that success is far more a function of applying specific skill sets to specific market conditions and cultivating/maintaining unique ways of viewing market relationships that capture opportunity. One size fits all approaches to coaching are of very limited utility in the real world of money management. It's all about helping professionals utilize the experience, skills, and resources at their fingertips in ways that work for them.

RELATED POST:

Coaching Professional Traders
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Another Look at a Trend Day

2008-06-27T12:36:00.000-05:00

My previous post took a look at the NYSE TICK during Wednesday's trend day to the downside. We saw consistent selling sentiment through the day, as the broad list of stocks traded on downticks--at their bid, rather than offer, prices.

If we take a look at the TICK measure specific to the Dow 30 Industrials ($TICKI in e-Signal), we see a similar pattern. As the day wore on, the Dow stocks increasingly traded on downticks.

Because the Dow stocks are among the most liquid blue chip stocks, they are common constituents of the baskets traded by program traders. For that reason, the Dow TICK offers a good reflection of program trading sentiment.

By integrating Market Delta (volume traded at bid vs. offer) with NYSE TICK (stocks traded at bid vs. offer) and Dow TICK (large caps traded at bid vs. offer), we obtain a multidimensional picture of sentiment minute by minute.

RELATED POSTS:

Dow TICK and Program Trading

Tracking the Opening Minutes
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A Look at a Trend Day

2008-06-27T01:34:00.001-05:00

Good trend days will show consistent buying or selling sentiment across the session. The NYSE TICK captures short-term sentiment by providing frequent readings of whether the broad list of stocks are trading on upticks or downticks.

Yesterday's market, as shown in the chart above, showed consistent downticking among NYSE issues. By cumulating the NYSE TICK, much as an advance-decline line is calculated, we can catch intraday shifts in sentiment. There were no such shifts yesterday.

As long as you see a trending cumulative NYSE TICK, it pays to fade countertrend moves in the index.

RELEVANT POSTS:

Cumulative TICK and Sentiment

Trading With TICK
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The Fear of Missing is the Fear of Dissing

2008-06-26T06:11:00.001-05:00

A reader recently asked me about a problem he was having with "the fear of missing". It appears that he front-runs his setups, getting into trades before he gets proper signals. This fear of missing opportunity has hurt his performance, as it has placed his capital at risk during periods of low opportunity.

At the very least, the fear of missing signals can result in poor execution. Instead of buying on pullbacks or selling on bounces, you chase the market higher or lower. The several ticks of retracement typically incurred add up to quite an opportunity cost over time.

I'll be addressing the fear of missing trading opportunities in detail in my new book. (One chapter will be devoted to the "ten most common problems" of trading psychology and how to deal with them using psychodynamic, cognitive, behavioral, and solution-focused coaching methods). For now, however, let me focus on one aspect of this fear: the fear of oneself.

Let's say you *do* miss a golden trading opportunity. What will happen? Fear is a response to perceived danger. Where's the danger? What's the threat?

Very, very often the consequence of a perceived missed opportunity is a bout of angry thinking turned inward. After missing the good trade, the trader launches into self-blaming and a beating up process that mixes guilt with self-directed hostility. "How could you be so stupid?" and "Look how much money you could have made!" are among the common self-recriminations.

It is in this context that the fear of missing is really a fear of one's own negative thinking process.

Let's face it: we *always* miss potential opportunity. If you don't hold trades overnight, you miss possible opportunity. If you don't trade your maximum size, you miss potential opportunity. The reasonable trader knows that it's not about taking every conceivable opportunity: that would be impossible. Rather, it's about limiting your risk, while taking advantage of the best opportunities.

But if the result of missing trades is going to be an avalanche of self-criticism, the danger is not financial risk, but the risk of feeling worse about yourself.

If you don't have a negative, self-critical thought process, there's nothing to fear in missing. We always miss the very top and bottom ticks; we always are away from the screen when something is happening. No, it's not about the markets. Most often, the fear of missing is the fear of dissing oneself. The links below, as well as the chapter on cognitive techniques from my Enhancing Trader Performance book, should be helpful in dealing with this problem.

RELATED POSTS:

Stilling Negative Thoughts

Breaking Patterns of Frustration in Trading

Trading With Emotional Intelligence
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The Daily Trading Coach

2008-06-25T18:48:00.003-05:00

My new book has a tentative cover, and the writing is now past the halfway mark. I'll be updating readers about the new material covered in the text through a dedicated website. That site will have quite a bit of material to supplement the book. Thanks for your continued interest!

Brett

Market Views Ahead of the Fed

2008-06-25T06:30:00.000-05:00

* Weakness Across Sectors - Looking at the 40 stocks in my basket, chosen evenly from eight S&P 500 sectors, my technical strength measure (a quantitative measure of trending) finds 4 in uptrends, 3 neutral, and 33 in downtrends. In a different show of weakness, we had over 3000 stocks across the NYSE, NASDAQ, and ASE making new 20-day lows on Tuesday. This has only occurred 12 times since September, 2002; one week later, the S&P 500 Index was up 7 times, down 5, for an average gain of 1.02%, much higher than the .16% average five-day gain for the remainder of the sample.

* Seeking Quiet - I was interested to see Charles Kirk's posting on noise-canceling headphones. I use a Bose variety during some of my guided imagery sessions to tune out distractions and help cancel some of the internal noise. Reducing physical activity and tension while eliminating outside stimulation is part of the meditative discipline, and I find it useful for getting back to calm, focused states during the market day.

* Useful Wisdom - The value of admitting errors, the perils of taking big chances, and other nuggets of wisdom are part of the review at Abnormal Returns.

* ETF Update - A Dash of Insight into the ETFs that Jeff Miller is rating.

* Bounce? - Quantifiable Edges examines a breadth indicator and what it suggests.

* Technically Speaking - Barry Ritholtz offers some perspective on technical analysis.

* VIX Views - Daily Options Report on the different implications of high and low VIX.

* Sentiment Indicator - VIX and More tracks the put/call ratio for SPY options.

* Commodity Patterns - CXO reviews a study of how commodity markets respond to surprise news events.
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The Psychology of Risk and Return

2008-06-24T06:18:00.000-05:00

Here is an absolutely phenomenal resource from Henry Carstens that takes your average win size per trade and the standard deviation of your daily returns and generates, Monte Carlo style, plots of your forecasted P/L curves. If you play with the two parameters, you'll see how changes in your risk (variability of your returns) and reward (size of your average profits) affect your overall results over time.

Imagine a $100,000 portfolio that averages, over the course of two years (100 weeks) a return of 50 basis points (1/2% or $500) profit per week with 100 basis points (1%) average variability per week. That would be a high Sharpe ratio trader. In the top chart, we see what that gets you: a pretty smooth equity curve and a return of about 50% over those two years.

Now let's imagine the same scenario but with double the variability of returns (middle chart). Notice that the end result is slightly better, but our P/L curve is much less smooth. There is a meaningful drawdown, peak to trough, along the way that lasts for over half a year.

Finally, let's imagine that markets change and our edge is cut in half as the volatility of our returns is increased (bottom chart). Not only do we make much less money--about 22% over the two years--but the pattern of returns is quite lumpy.

All of this has real psychological implications. When markets become more volatile and when market patterns change, we can go from scenario 1 to 2 to 3 rather easily, with exactly the same skills sets we've always had. The reduced returns and choppier path of returns can prove frustrating, leading traders to change their trading and further complicate the problems. Imagine, for instance, if our excellent trader in scenario 2 became discouraged during the drawdown period and stopped trading. Much potential profit would be lost.

Try Henry's forecaster by generating multiple possible forecasts for exactly the same parameters. You'll see that chance alone will affect the paths of returns. A trader who understands that it's not just about returns, but risk-adjusted returns, can best adapt to these trading realities.

RELATED POSTS:

Decision Making and Risk

Risk and the Biology of Trading

The Psychology of Risk Management
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Banks and Housing

2008-06-23T16:59:00.002-05:00

While the large cap indexes are testing their March lows, the banking (middle chart) and housing (bottom chart) sectors have blown through those levels to make bear market lows. It's difficult to imagine the Fed aggressively raising rates with these sectors on their heels; that outcome might just rival the fate of the dog who decided to chase something other than his tail (top).
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Indicator Review for June 23rd

2008-06-23T01:30:00.000-05:00

In the most recent indicator review, we looked at a number of signs of weakness, including an expanding number of stocks making fresh 65-day lows and weak money flows. This past week saw more of the same, as new lows once again expanded (top chart) and selling sentiment (NYSE cumulative TICK; bottom chart) continued its bearish trend. We're now testing March lows in the Dow Jones Industrial Average and nearing those lows in the S&P 500 Index. Interestingly, the S&P 600 small caps and S&P 400 midcaps are well off their March lows, as is the NASDAQ 100 index.

These divergences help to explain why we're not seeing as many stocks making fresh 52-week lows as we did in January or March. On Friday, for example, we had 27 NYSE common stocks register fresh 52-week highs, against 161 new lows. By comparison, we had over 300 new lows in March and over 700 in January. Homebuilders, financials, auto manufacturers, airlines: there are a number of very weak sectors making annual lows. When we look at such sectors as technology, consumer staples, consumer discretionaries, materials, and energy, however, we see no new lows.

To be sure, the market is weak. The advance-decline lines specific to NYSE common stocks and S&P 500 stocks are right at their March lows. We're seeing fresh bear lows in the A-D line specific to the Dow 30 Industrials. But the S&P 400 midcaps and S&P 600 small caps? The lines specific to those remain modestly above their 2008 lows. So while the market is weak, it is not clear to me that it is weakening relative to the first quarter of the year. As long as selling sentiment (cumulative NYSE TICK) remains negative, riding the trend continues to be the best course of action. I'm not aggressively chasing the downside here, however, and may indeed nibble at the long side should sentiment improve.
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Year to Date Returns By Sector

2008-06-22T12:58:00.002-05:00

How you've been faring this year so far in the stock market is very much a function of the sectors you've been invested in. While the S&P 500 Index (SPY) has been down about 10% thus far in 2008, the commodities-related materials (XLB) and energy (XLE) sectors are up on the year. Financial stocks (XLF), on the other hand, have more than doubled the losses in the overall index and health care (XLV), facing calls for reform from both parties in a presidential election year, is also trailing the pack. Meanwhile, consumer staples shares (XLP) have shown a more modest decline than more growth-oriented sectors, reflecting investors' overall defensive stance in a slowing economy.
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A Look at Bearish Stock Market Sentiment

2008-06-22T01:51:00.000-05:00

The trading of options on equities rather than the equities themselves has become increasingly popular among retail and prop traders. This makes the equity option volumes particularly relevant as market sentiment measures.

We can see from the chart above that spikes in equity put volume have accompanied recent intermediate-term market lows. With the latest pullback in prices in the S&P 500 Index (SPY; blue line), we can see that the four-day moving average of put volume (pink line) is once again spiking. While this doesn't mean we can't trade lower, it has recently been associated with price reversals over the intermediate term.

RELEVANT POSTS:

Sentiment and Relative Options Indicators

Sentiment and the Relative Put/Call Ratio
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Cross-Talk: A Different Picture of Global Equity Returns

2008-06-21T13:42:00.000-05:00

In my last post, I illustrated the global bear market across the U.S., Asia, and Europe via country-specific ETFs. A number of readers pointed out that some countries are up on the year, and that is correct.

In the graph above, I plotted year-to-date returns for the U.S. (SPY); Australia (EWA); Canada (EWC); Russia (RSX); South Africa (EZA); and Brazil (EWZ). I included these countries alongside the U.S. to illustrate the more favorable performance among resource-rich economies. The exception is South Africa which has seen a weak currency, power shortages, and social unrest over the past year.

As oil producers, Canada, Russia, and Brazil have performed positively, even as large oil consumers, such as China, have been relatively weak. Since mid-May, however, with some toppiness in oil prices and intimations of greater supply from the Saudis, even the stock markets of the oil producers have undergone a correction.
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A Worldwide Bear Market

2008-06-21T01:41:00.000-05:00

While a great deal of attention has focused on U.S. stock market weakness (SPY), we're seeing just as much weakness among European equities, including the U.K. (EWU) and Germany (EWG). China (FXI) is leading the downside with Hong Kong, as inflation forces significant monetary tightening and a soft landing doesn't seem in the cards. Australia (EWA), a resource producer, has been relatively stronger, but the surprise in the bunch is Japan (EWJ), which has held up surprisingly well through the spike in energy and agricultural commodities and the weakness across Asia.

Clearly the picture is one of a worldwide bear market.
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