Using Results to Determine Robust Markets

Suffice to say there are many analogies between poker and trading.  Knowing when to shift gears, probe for information and feedback, and press edges or sit out are common themes between the two.  As a swing trader using timing techniques to gauge market health, improving my awareness on a daily basis is a priority.  Avoiding periods when errors are induced and compound instead of capital is frequently in my thoughts.  Being alert to whether a market is robust or not on our horizon has a direct impact upon our returns and bottom line.

All the data we need to quantify this is available in our own records: our average gain, our average stop level, and our average holding period.  Knowing this we can scan our stock universe and determine how robust the current period is.  For example, assuming our average gain is 2R and our holding period is 10 days we can scan our universe for stocks that have had moves to this extent (whether dollar amount, percentage or a combination of the two) over 10 days.  In doing such a scan over a 5 and 10 day period I have a return of 58 and 126 stocks respectively.  As I trade 3 month momentum, stocks that meet this requirement over 5 days is 25, and 85 over 10.

Robusto or Busto Market?

The significant of using this approach is that I am merging my personal trading data with corresponding stocks in my universe that meet the same criteria.  In a robust market I should expect to see a much larger result set than I am currently.  So, clearly if my average expectation is being meet by such a small number of stocks, I in turn should not expect to achieve typical results.  if anything I should be concerned of the other spectrum of consequences by trading in this environment.   

Pullbacks Welcomed

Market pullbacks and corrections are excellent times to prune and rebuild watch list and add to our model book.  During these periods a search for stocks that meet our set up criteria can assist our edge when the dust settles and we're in sync when the next leg up occurs.  I tend to focus upon tight price patterns that are flat and have resisted the greater market undulations.  Ideally I'd like to see this occur after there has already been a leg up in the particular stock before flat lining with contracting price volatility.   To assist visually I use a 10 period moving average.  If it's static it informs me that the stock has undergone a period of price agreement and should this balance shift to the upside with range expansion and volume I want to be involved and ride the tide of the path of least resistance.

KANG

LQ

TEDU

ZEN

Weekend Review August 01, 2014

The market on my time frame had been running on fumes and sputtering.  This past week the divergences finally caught up as the major indexes cracked 2% on Thursday.  In the larger picture this is just 2%, but 2% can quickly turn into 4, especially if the underbelly of stocks is soft and the general health of the market is sickly.  The ills of the market are evident across multiple time frames as shown by the number of stocks making new highs vs. new lows across multiple time frames.

New High New Low

It is also clearly evident that market breadth has stretched to extreme levels with a bearish bias very quickly.  Looking at $MTMW, T2106, and T2108 the market is currently at zones infrequently reached that suggest near term extension from which bounces occur.  The confluence of these lead me to believe that a snap back rally is a higher probability event.  However, what also must be taken into consideration is the context.  These extended readings are occurring while multiple indexes are still in close proximity to their recent highs.  Had these occurred after a significant correction I would tend to side with the belief that a significant bottom is in place and operations on the long side should be pursued with vigor.  As this is not the cause I continue to be leery of the current market structure and until there are signs of strong buying coupled with bread and butter set ups I will pursue a strategy of looking to short 3x long biased ETFs such as TQQQ or SPXL on bounces.

$MTMW

T2018

T2106

I also consider it important to review the events over the past few weeks in order to solidify a model moving forward.  Clearly one of the first and most important clues was that the set ups I took lacked follow through and were not moving in my favor in accordance with my stats.  I can not stress enough how important this piece of information is above all else because regardless of what breadth is showing, the immediate feedback is negative.  Breadth can wane and diverge for some time before there is a downside break, and given that this is merely a tool to gauge general market health on my time frame, if there is discordance in my results I must accept that this trumps everything else.

As traders we're not always going to have the fortune of stars aligning perfectly for our quadrant to guide us.  However we can model certain guidelines for safer passage through rough seas.  When it is full speed ahead there should be alignment in breadth.  When it's patchy we should take note of the discrepancies and act accordingly.  When there are divergences the focus should be upon those that most effect our vehicle selection.  As I trade mostly Russell and Nasdaq stocks these should be my divining rod regardless of the what DOW or SP are doing.  When breadth begins to wane across multiple time frames and there is a confluence upon stocks that make up my vehicle selection I should heed the omens.

There has been a conditioning to buy the dip, and a look at the index reactions Friday suggest this is still the mentality subscribed to.  But what we also know is that at inflection points there is very slow transition and acceptance of new information.  If this was not the case there wouldn't be as many participants stuck on the wrong side of a trade.  As a swing trader with a horizon of 5 to 10 days holding period time stop, the market should be cashing me out fairly quickly when these transitional periods occur.  At this point it is up to me to recognize the market in incongruent and be disciplined and patiently wait for the window of opportunity to open again.  These are the periods not to fight and induce drawdowns.  These are the periods to honestly listen to what the market is telling me and plan accordingly.  These are the periods to avoid overtrading and fighting the tide.  These are the periods to be vigilant about squelching the noise of the Sirens.  

Weekend Review July 25th, 2014

Market Wizard Wisdom

I often write about being in cadence with the market and attempting as best as possible to trade when my time frame is in sync with the market.  Unfortunately my discipline often wanes even when all the data I follow indicates it's time to: slow down, be more selective, increase patience, or even get out of the market all together because I'm not in tune or the market is in a difficult period from my trading style.  I've become increasingly aware that these are the times to isolate myself, turn down the noise and influence, and perhaps just out right step away for a day or two.

I've also written about being a fact based trader and insisting that my trading record be the ultimate determinant of whether this (in sync or not) is true or not because it is the only factual information I have.  Much else is merely my belief about the market as I perceive it and the tools I use to hone in on periods where I can exploit my edge to maximum effectiveness.  However, even when all indications suggest it's go time, there's no unwritten rule that I have to be successful during this time and make money, just as when my indicators say lay off the gas there's no fast rule that the market should reverse.

I consider my vehicle selection to have vastly improved, but the window of opportunity I was expecting this week and attempted to take advantage of shut exceptionally quickly.  The trades I took lacked follow through and traction.  I intentionally undersized my positions to deal with a potentially chop and slop environment, but perhaps it would have been better to have stepped aside as the bigger picture seems to be having a larger influence on my time frame than I anticipated.

So, when trades are now working and I consider my selection fairly solid, and my trades are not making money, I must defer to the market itself as being unhealthy.  In commentary this week, Zortrades post In Case You Are Struggling This Month is well worth a read as he breaks down multiple data sources that inform what stocks are actually doing and not merely what we think we see they are doing.  There are times when the maxim "Trade what you see," is useful and there are times to realize that what we see has often put an innocent man in a line up behind bars for life.  We must be aware of the deception of our senses.  Merely because we see most indexes churning up to new highs doesn't mean the body of stocks underneath are behaving in a healthy manner.

Going into next week I continue to see signs of caution on my time frame and will stick to a primary cash strategy and avoid long positions until things clear up.  If anything I'm actively looking for an opportunity to go short index ETFs because there are increasing signs that the market is vacillating in a manner that suggest it is waning here and losing steam.  One sign I am looking at is the number of stocks in my universe that are breaking down has been increasing in July suggesting slow distribution.

Break Out/Break Down

There is also some vacillation on higher time frame breadth readings I follow.

MM

Primarily what I take from this is that there are fewer stocks breaking out and their potential for gains on my time frame is limited at best.  As an overall 50/50 trader in the best of times, down shifting into a 40/60 or worse during these periods is a recipe for draw downs.  I've experienced periods of explosive markets where I've struggled to make dimes, so in unhealthy markets even expecting nickels could be asking for pennies.  There are larger dynamics at work in the market currently that are not conducive to my trading and sometimes we just have to admit this to ourselves as a reminder, especially when noise around us suggest that there's gold to be vacuumed up at will.

Chart of the Moment

The following is a tale of two time periods.  In one there is a confluence of waning breadth and a declining market and in the other there is disharmony.  The definitive answer as to what is going to happen to a rising market on weakening breadth is yet to be resolved, however from a probabilistic stand point what is the more like scenario and how should we as traders prepare ourselves?  

Market Disharmony

Modest Bounce

One of the things I was looking for this week was indication that the bounce I anticipated was more than just a reflex due to extended breadth.  I was looking for signs that buyers were returning to small cap stocks.  While there has been a modest bounce on the Russell, the evidence suggest this might be short lived.  When buyers are stepping in aggressively from extended zones there's a strong tendency for the number of stocks below their respective 20 day moving average to increase from approximately 20% to 70%+ in short order.  As the following chart shows, this characteristic is lacking.

$MTMW

Additionally the breadth indicators I follow will begin to increase sharply on the lower time frame from red to green across the board and often in short order.  Instead, there is still a lack of breakouts on my time frame and higher time frames are vacillating.

MM

Weekend Review 07/18/2014

Is that all there is?  This is a familiar refrain I've continued to ask myself over the past year and a half.  Each time the market reaches a level of exuberance and extended breadth across multiple time frames there's a shake out.  With each one I position myself on the defensive because it can never be known at the time which one is the Redd Foxx.  Looking at nearly two years of data from the primary breadth indicator I use it's clearly evident that this has never really been an issue, but one never knows, and by looking at the damage done to individual stocks in April of this year, it's often best not to find out.

Primary

One of my core instructions is to align my time frame when the market affirms that there is a window of opportunity to exploit on my horizon.  One of the means in which I do this is to track the number of stocks that are breaking out and down over a 5 and 10 day period.  When the balance tips in my favor I increase my aggressiveness and when the balance tips against me I begin to lay off the gas.  My risk tolerance is dynamic to market conditions.  The number of positions held, the position size,  and risk of 1% or perhaps .05% per trade will increase or decrease in accordance to the current market conditions.

Market Monitor

Currently the market according to my metrics is red across multiple time frames, however as shown in the first image posted, there have only been two periods where there was significant enough damage to stocks suggesting a much larger correction may be looming.  In both of these situations the length was short in duration.  Granted there are some macro conditions hanging over the market and there are some indications that money is rotating into defensive sectors, but this is still a bullish leaning market until a guilty verdict is handed down.  Until then, pockets of opportunity should be exploited and waning breadth must be respected.

There are two indications that there may be a pocket of opportunity in the near term.  This may be very short in duration and tactics adjusted accordingly, but there is evidence that the market may experience a bounce here.  First, the percentage of NYSE stocks above their 20 period moving average has reached a level where bottoms have formed.  This may just be a technical relief bounce of a few days, hence my general caution about the longer term relevance.

$MTMW

In conjunction the number above their 40 period average have bounced from 43% to 51%.  As we can observe from the following chart, whenever there has been a decline followed by a significant increase over a one to two day period, the market had a rally.  There was a bit more complex bottoming in the August of 2013 which merely affirms that while there is a "tendency", anything can happen.

T2108

If a door opens this week, a few patterns on my watch list are:

GBX

$PAH

$VEEV

$VHI

Lastly, earnings season offers opportunities for catalyst based trades with their own merits regardless of market and macro conditions.  For the next couple of weeks there will be a plethora of releases offering opportunities to find the beginning stage of the next major winner.