Stalling Action

Today is what I classify as a day of stasis when the difference between buying and selling was negligible. This in and of itself is enough for me to take notice as it suggests that there is an impasse between buyers and sellers as neither is showing much interest in altering the flow of supply and demand. As I wish to be on the side of the buyers, the lackadaisical atmosphere of today coupled with yesterday's minimal buying leads me to believe that the market is going to have some issues moving much higher here.

Besides the lack of buying, there were three additional flags that are reddish in hue alerting me to caution. The current leg up commenced 10 sessions ago on 03/07. At the time the 10 day breadth was .66 and the 5 day breadth .33 indicating that selling was dominant over the referring periods. This selling can be seen on 03/06 with 384 stocks down 4% on that session which was also brought most of the indexes down over 1%. The following day some buying came in and continued over the next 5 sessions with a 390 4% up day on 03/13 which led to a thrust on the 5 day.

Breadth Ratio

At that point, the preponderance of evidence indicated that going long was the path of least resistance.

This was confirmed as buying continued with mostly positive days of 3-1 buying to selling. However the first red flag was raised as the persistent issue of the last thrust pestered with follow through days lacking. So while break outs were looking promising, holding for more than a day was likely to give up gains. The second red flag is that this move commenced 10 days ago, so having a 10 day breadth thrust now, especially when it's the result of a large day falling off rather than large buying days is to be viewed suspiciously. Lastly, coupling a 10 day thrust with a falling 5 day thrust warrants concern.

Broken down, the breadth is currently informing me that market risk is increasing here and the likelihood of consolidation or a pullback is an increasingly probable scenario. Currently each dip has been quickly bought so my expectation is that over the remainder of this week we'll begin to see this scenario play out and should it proceed as anticipated, situation specific reevaluation will be the next step.    

Weekend Review 03/02/12

Sometimes trading is like idling under a red light at an intersection on a scarcely traveled road without another car in sight. A glance out the window shows a number of flower laden white picket crosses so the danger is obvious and the signs are there, but do you keep discipline and maintain law sight unseen or gas the engine? Nothing bad can happen right? Except in trading you're liable to get side swiped by the ghost train and skid of the road.

There's always risk in trading. As a trader a primary focus of mine is risk mitigation and one of the biggest risk in trading is the risk of myself. Every so often I remind myself of the maxim “strong opinions, weakly held.” I also remind myself I reserve the right to change my views at any moment even if it results in being contradictory. Characteristics I would not approve of myself in general practice sometimes become a vital necessity in reducing market related risk.

Overall my general viewpoint is that there are indications suggesting that we are in the initial stages of a bull market that has the potential to become secular. I find conviction in this belief from the number of stocks that are making all time highs and breaking multi-year ranges, the number of IPOs that have shown strength over the past 6 months, and emerging technology in the tablet and mobile sector that can be leaders of the next wave.

However, it is also important to temper myself and be realistic about what the current market is informing me. Presently the implications are quite clear, the market is diverging and the drum beat I keep rhythm to is syncopated. This week could get a little messy and the market is telling me it's in my best interest to stand aside and avoid taking long positions. The evidence supporting this continues to mount. Much of the information is simply a continuation of the past few weeks cemented with further information and some recent observations.

First up, a look at the NASDAQ and RUSSELL using GMMA gives a clean visualization of the underlying divergence occurring. While the NASDAQ has continued to make tortoise like progress to the upside, the RUSSELL is starting to make lemming like progress towards the cliff.

NASDAQ 03/02/12

RUSSELL 03/02/12

Second, looking at the $USHL5, there is divergence and the SP continues upside on waning new highs.

$USHL5 03/02/12

Third, this divergence can also be seen in the percentage of stocks above their 20 period MA. This has continued to wane.

% of Stocks Above 20MA

What started off as a stealth correction through time hidden by the indexes is now becoming “obvious” with the RUSSELL beginning to crack the month long range to the downside. As this index is a gauge of the overall tolerance of risk in the market, it's indicating that small caps are not taking the lead. Since small caps are my main source of trading vehicles, and 52-Week highs are not increasing as break outs continue to fade and breadth deteriorates, there is increasing market risk added to the mix resulting in a quicksand like environment where long trades may just dig a deeper pit.

Markets can do anything at anytime.  What looks ominous today may bring in strong buyers tomorrow.  What looks like potentially increased selling moving through this week may simple become another month long range.  Ultimately it comes down whether or not a market it tradeable for a given style and today my style is out of fashion.  Perhaps tomorrow it will become the next in-thing.  There will always be signs and being disciplined to adhere to them when they flash and taking advantage of the opportunities when they arrive for whatever length of time they exists is what it basically comes down to.  Confusing this opens the door for the ultimate risk factor in trading --one's self.

Some Selling Hits the Tape

As I pointed to yesterday, there had yet to be any significant selling hitting the tape. That changed slightly today as the selling into the close sticks out like a sore thumb.

Selling Pressure

While obvious, the significance remains to be seen. An under the surface correction has been the theme over the past month but the waters have been mostly placid. Seeing some selling ripple the surface and a pullback on the indexes would be neither unexpected nor out of the ordinary. Should a series of larger selling days begin to follow in the near term and further distribution hits the tape then reassessment will clearly be in order.

Buying/Selling Pressure

As February comes to a close tomorrow I thought it worth looking over the past month from the perspective of the number of stocks up/down 4% daily. The early part of the month showed two large volume buying days with well over 300 stocks up, but since then the 200 plateau has only been broken once and most days were quite subdued. Additionally during this month there were 5 days where the selling was higher than the buying but not by much as most sell days were less than 100.

Stocks Advancing/Declining 4%

Daily dips and gaps down on the market have been bought and days that look like they may muster a significant break have waned by the close. This has been evident in the Small Caps in particular that are either reversing intraday or failing to follow through the next. Big Cap Tech on the other hand has continued to show strength. Markets need buying to support moves higher but can fall on gravity and their own weight. The current equilibrium of the market is heightening the anticipation of direction and leaves one with the impression a move may be on the horizon.

Weekend Review 02/24/12

Risk awareness is one of my main approaches to trading. It is with purposeful intent that I approach the beginning of each trading week with an assessment of what the market is doing and whether or not the probabilities over the next 5 days will be a conducive market environment for me to trade in or not. Through daily analysis and weekly reviews if there is one aspect where I've experienced the greatest discernible growth it has been in identifying these periods and placing myself in step with the markets direction.

Given that the current correlation of stocks to index is between 75%-80%, being on the correct side of the market is a key component to reducing risk exposure. Rising indexes indicate robust markets and robust markets are simply more forgiving and easier to trade. From December to February this has been the case and then the market simple halted, stopping dead in its tracks. For the past three weeks the Russell hasn't budged and sits half a percent from where it was on 02/03.

Russell 02/24/12

For the past week and a half this became apparent to me and as such I took it upon myself to modify assessment of risk due to the belief that the underlying market breadth had become quite frothy and was beginning to stall out. As such I took ½ risk positions and tightened my profit targets. This was the prudent speculation from my perspective, however it didn't turn out completely as anticipated and in some ways may have increased my exposure to risk.

While I believe I still have the underlying market direction on my side, the relative flatness that has occurred over the month of February introduced a risk I hadn't taken clearly into account –higher propensity of break out failures. The underlying thrust that has propelled this market was waning indicating that the set-ups I trade were now becoming riskier to take due to an increased probability of failure. Avoiding market whiplash means avoiding the market entirely so using this information I can now reassess my plan coming into this week and make a decision to not trade, or further refine my set ups and look for more stringent requirements.

This becomes more apparent when looking at the buying to selling differential and the buying over selling ratio.  The current downward slope is not from an increase in selling as these days have been few and limited in scope, but primarily due to the lack of buying.  A number of days over the past two weeks have shown near equal days of buying to selling resulting in a stagnant range with little upside or downside movement.  Basically we're undergoing a state of stasis.

Buying-Selling Pressure

Breadth Thrust Ratio 

What I'll be looking for first and foremost this week is some indication of increased buying. While there has been a consistent bid to this market, the facts as indicated by the ratios downtrend correlating with the lack of market movement over February indicate a lack of participation driving up prices. When I'm interested in buying it does me little good if there aren't others more interested and it remains to be seen if they'll show up this week.  The signs I'll be looking for are a large buying day with an increase of the ratio above 1.5 to become an interested participant again.

Weekend Review 02/17/12

By nearly every breadth measure the market is currently at extremes. What's noteworthy is that this was the same situation last week, and the week before that, and the week before that and... This clearly embodies the concept of markets being and remaining overbought regardless of which breadth metric is used to slice and dice the current environment. This is also the environment where the temptation of caution be damned begins to manifest because the allure of “It's different this time” kicks in.

Stepping back, and by back I mean a decade three things have stood out this week.

Both the NASDAQ-100 and NASDAQ closed at 11 year highs this week. In terms of nearer history the NASDAQ has now cleared the 2007 highs indicating that a change of character is under way as the market shakes off the effects of housing and the Euro-Zone crises.

NASDAQ Monthly

   The second point to stand out this week is the $BPNYA during this same period. Looking back it is very rare to reach the current level. Other than a period in 2006, the only other times this level has been surpassed was in 2011 which was the peak of the move that came off of the 2009 extreme lows. This is something to keep in mind in the near future.

$BPNYA

Third, the primary ratio I keep track of is a very high reading as well and beginning to waver which I associate with instability at this stage.

Primary Ratio as of 02/17/12

Another point to keep in mind is that the NASDAQ has moved nearly 17% during this up let without an “obvious” pullback.

NASDAQ- Current

While much of this suggest an overheated market, it is also noteworthy to observer that the index has moved a mere 1.56% over the past two weeks so under the surface there has been a correction occurring.

NASDAQ Move Since 02/03

Further, this under the surface correction shows up in a number of other scans.  The Secondary Ratio I observe has followed suit and peaked approximately two weeks ago and nearly halved in this time.

Secondary Ratio

The buying pressure over this period has also waned over this time.

Buying Pressure

The $USHL5 further solidifies February 3^rd as a pivotal date since this indicator pulled back on that date and ended the current week on the upside.

$USHL5 02/17/12

Overheated market? Yes.  However, it's my general belief that the market is acting and behaving in accordance to my personal cadence and what I believe to be a healthy market for me to trade in. Metrics aside, sometimes it simply comes down to how stocks are behaving. Recently a number of set ups have broken out as others continue to form solid bases;  also with extended stocks pulling back and a number of stocks breaking out or down based upon earnings, the underlying tone is that it is a stock pickers market right now and focus on vehicle selection is key.  

Reality Based Trading- Balancing What You Want with Who You Are

Breaking down some numbers today it's become abundantly clear that the metrics I'd like to achieve and what I've accomplished are night and day. This is a principled example of cognitive dissonance and the resolution to this is not 100% clear, so I thought it in my best interest to externalize the conundrum in an attempt of ascertaining coherence.

Ideally my benchmark to achieve is a risk/reward ratio of 3-1. This number is not something I've simply pulled out of my ass --it is completely rationale and here is why; Cognitively it has been shown that the human brain reacts approximately 2.5x more to losses than gains which means that for each loss the gains to balance the internal state should be 2.5 or more. Given this, my thoughts were that if I could maintain this ratio the internal balance of my mental state would be more harmonious and would lessen the discomforts I have at times being in a trade.

The problem is that I've latched onto this anchor and continue to hold to this metric as a goal to achieve while in turn completely neglecting the information my trades are telling me. Here in lies the crux of the problem; what I'd like to achieve I have thus far been unable to do with consistency.  In turn I  have ignored the profits achieved consistently resulting in sub-par performance. The result is that this has done anything but appease my internal state and in fact it has simply increased frustration and exasperation.

Currently what I have shown myself capable of is a 58% success rate with an average of 1.17 R/R. I have not shown I am capable under the current market conditions to extract 3-1, let alone 2-1 with consistency so it is to my detriment to hold onto this view any longer. In fact, given that my time frame is 5 days I can simply take the max high over this time compared to entry and note that the average has only been 4.8% to begin with. Couple this with my current average profit extraction of 3.93% and I'm really not missing much profit and in fact causing detriment to my productivity in attempting to extract more.

Given this I can only come to the conclusion that it is time to stop fighting the reality of the situation and to accept fully what my personal performance is indicating to me. Which in turn means I will have to modify my plan for the time being. This isn't to say that I'll completely give up on reaching for 2.5+ R/R, it simply means I'll also have to let my metrics show me when I am capable of that. Once my stats begin to show me I am costing myself by not holding on a little bit longer and maximizing potential profit I'll adapt.  

Breaking it all down trading in it's essence is simply a game of numbers and probabilities. Each trade increases our sample size and inches us closer to truths about who we are as traders at any given time. One of my priorities written in my trading plan this year was to become more aware of how my numbers speak to me; and given the number of trades I've taken thus far the outline is starting to become a story and it's time for me to start listening.

In keeping with the theme, here are some key formulas to be aware of for trading:

Risk of Ruin is a gambling concept and an important calculation to understand.  This is the ultimate calculation a trading strategy is measured against for if ruin is reached that's it --no mas.  While a near 0 risk of ruin is not a guarantee that one will not blow up their account, it is important to be aware of as an indication of how well one is trading. If this number begins to increase somewhat significantly it is a good clue that one is not in cadence with the market or that ones strategy is not currently working or worse, one is not trading well at all regardless of the market or the method.

There are two caveats to consider in this calculation.  The first being that it requires gains to be larger than losses.  Obviously a 50% success rate where losses are twice as large as gains will lead to ruin but it is also important to acknowledge that trading is not a zero sum game.  While it is true for every winner there is a loser, it is also true the house wins.  A series of ten flat trades can still burn 1% of an account.

Risk of Ruin

Expected Value is another important concept to understand. If you don't know the expected value of each trade you are doing yourself a disservice.  In conjunction with a near zero risk of ruin this is the second factor that must be taken into consideration: a +EV system.  Knowing these correlations will greatly assist in understanding the risk that is being taken.  If the system is not positive and there is an 8% risk or ruin why is the system being traded at all?  If it is marginally positive, where can things be tweaked to improve performance or reduce risk? 

Expected Value

If the first two are positive, then the tweaking comes in the form of personal performance statistics. Figure out what stats are important. I trade with a 5 day time stop so I keep track of how the trades I take perform on this time frame whether I get stopped out or exit before then. Additionally what has been critical information for me to know is if the days close is higher than entry and if the second day has a follow through. A secondary piece of information I watch is the max high over the 5 day period which further heightens the discrepancy between what the stocks over my time frame were capable of moving from my personal desires. You're numbers won't lie to you so deducing this information is absolute imperative.