Market Weather Basics

In the past few years I have spent quite a bit of effort categorizing distinct market phases as they clearly can affect both discretionary as well as automated system trading. I often also refer to it as ‘market weather’ and my first treatise on the subject was two years ago in a pertinent post. It mostly focuses on the psychological aspects of how market gyrations affect trading behavior and distorts perceptions among market participants. In combination with a trader’s respective cognitive biases various market conditions will affect one’s daily activities. Whereas a swing trader may be perfectly happy and successful playing the swings in a volatile sideways market a trend or system trader may run into draw down periods, thus affecting discipline due to recency bias.

Of course there are various technical approaches of how to categorize market periods and among my favorites are Van Tharp’s SQN based approach or the StretchStat and VolStat indicators developed by Ken Long. Scott recently covered those in his posts, so if you want more meat on your sandwich then I suggest you point your browser here.

In today’s post however I want to go back to the basics as you don’t really need any fancy indicators in order to develop a pretty good ‘feel’ (if I may use that word) for categorizing various market periods on a chart. The human mind is actually pretty damn good at pattern matching – and with a bit of practice it’ll quickly become second nature. So let’s cover a few core markets of recent past, starting with the bonds.

This is actually a wonderful example as the difference in the two prevalent phases couldn’t be more salient. Starting in early January until the end of the month bonds pushed up significantly in what I would call a low to mid volatility trending phase. If you recall Scott’s treatise on the subject – that is a very common period and one I would categorize as easy to slightly challenging for the average trader. Of course your mileage will vary greatly – again for a trend trader this can be fun, for a swing trader this is more challenging as reversals/corrections are shallow.

The inverse speaks true to what followed – a high volatile sideways market which I consider the most difficult for most retail traders. The reasons for that are plenty and have been rather prolific on this subject and prefer to not repeat myself in this post. Suffice to say that anyone with a directional opinion or expecting resolution will be taken the woodshed all the way through Sunday.

Here is another example – the spoos on which I highlighted three distinct phases. The sell off in January was rather directional but with some volatility in the middle. What followed was a low volatility trending phase. Of course any indicators won’t tell you that until you’re halfway in but the human mind can easily pick up the fact that we have very few overlapping candles and most importantly 10 consecutive higher highs in a row.

Since about mid February things however got a bit more dicey and I would categorize the recent month as a volatile sideways period – once more the most difficult to trade for most participants. Psychologically also rather taxing and it has been taking its toll right here in the comment section (which has been rather quiet in the past two weeks). I always try to warn you guys when I see storm clouds on the horizon but often get the impression that very few are listening. Perhaps educational posts like these will serve to instill a bit more sensitivity as to when trading can be easy and when it can feel like helping Sisyphus push a rock up a steep hill.

Another example gold – I think one of the reasons why we have been rather successful in trading the shiny metal is that gold has the habit of switching between volatile sideways and trending phase with a mix of volatility, usually medium to heavy. You probably remember our gold entry in early February at which point I was expecting gold to continue trending higher. What I did not anticipate is that it would make a sudden u-turn but what’s interesting is that the market phase has barely changed – we are still trending and volatility is probably identical to what it was on the way up. So clearly we must differentiate between direction and market phase. For the seasoned trader direction may be insignificant but retail traders often get married to a particular direction, with the expected results.

And then there are charts which are almost impossible to categorize – I usually stay away from those unless I see then knocking on very pronounced inflection points (a subject for a different day). But when you look at a chart just like this – what do you see? What I see is acceleration followed by slower periods. In terms of volatility that creates a strange mix – the tape looks pretty directional but it’s rather volatile. But clearly this is NOT any easy chart to trade, would you agree?

Here is another example that may be even more pronounced – the fabled natgas contract Just look at how different these market phases are and I haven’t even bothered trying to categorize them. An accumulation of slow/sideways tape followed by quick spikes, long wicks, and sudden reversals. I also see a lot of gapping action and for a futures contract that is very rough to trade. Once again, stay away unless you really know what you are doing.

In summary – market phases are much neglected but integral part of trading and one you should come intimately familiar with. System developers often thrive to write systems that offer a lot of opportunity by being in the market all the time. That’s understandable but it is largely based on an unrealistic assumption that the same entry and campaign rules will work in all market conditions. Instead you will find that some systems promising only a very small or no edge may suddenly work extremely well if used only in the context of certain market conditions. To that end it is important that you sit down and document the characteristics and beliefs of your trading activities and then correlate them with the various market conditions you will encounter. Again, that in itself deserves its own post and I think Scott has definitely pointed the way.

My own work is strongly influenced by market categorization and without padding my own shoulder many here would agree that it has kept us out of various traps in the past. This morning’s spike higher for instance could not have been predicted but it had pretty good odds given what we saw on the Zero as well as in the context of the tape we experienced in recent weeks. Which is why I happily exited my TF trade yesterday according to the rules.

In essence what you always want to ask yourself is this: Does the current market phase impair or support my trading activities? In either case you can either change your current approach or just sit on the sidelines until you see better weather on the horizon. Unlike fund managers or professional traders you are only responsible for yourself and your personal assets, thus you are afforded the luxury of flexibility and the ability to be nimble. Once you are pushing a few hundreds of millions of Dollars around the dynamics of trading become quite different. It’s like the difference between driving a speedboat and an oil tanker. Say what you will – the speedboat is a lot more fun and if you’re lucky you’ll enjoy attractive company in sexy bathing suits.

Well it’s been a rough week and now it’s time to kick up our feet and crack open a cold one. I see you all next Monday morning.

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Seven More Reasons Not To Be Long

Let me precede this post with a warning: I am not saying that it’s impossible for equities to push any higher. Quite on the contrary – there are signs that indicate that we soon may run into a little short squeeze. If that outlook sounds contradictory to you then you may want to go back and read Volar’s excellent excerpt on platykurtotic vs. leptokurtotic markets which he posted almost a year ago. Simply put – it all depends – August is a good month for trend traders and if you are betting on mean reversion you may get burned.

Now as stainless steel rats we are sworn to trade by our rules (whatever they are) and to only take setups which strongly suggest that the odds are in our favor. And it’s that last little detail that is the problem right now – momo and sentiment is all over the place.  Meaning if you look hard enough you will find plenty of reasons to be short and plenty of reasons to be long. Unfortunately as human beings we all have a tendency to discard information that contradicts our current point of view and at the same time embrace information that supports it. Which easily translates into trading losses.

The purpose of today’s post is to show you the upside risk that is present right now. If you are a trend trader then you don’t care as you have been long for a while and your rules tell you to stay in until your stops take you out. Your system thrives on leptokurtotic markets and the few times you get away with it you win big. For the rest of you guys I have collected seven charts that demonstrate why holding long here represents significant risk. Over the next few days these charts may be meaningless but medium to long term I believe that their combined message advocates caution.

Exhibit 1 – the Dow vs. the TRAN: According to Dow theory those two should on average be moving in the same direction. When the performance of the average diverges it is a warning that change is in the air. Again, bear in mind that this is a long term chart – nevertheless it started to detach in July and the present divergence resembles a mirror image.

Exhibit 2: Similar situation on the Russell 2000 which obviously represents quite a bit more risk than the trannies. That little trend line I painted has been breached but I’m still labeling this as divergent.

A lot more where this came from – I will also show you two charts that suggest that we may head into a short squeeze before gravity sets in. As the old saying goes – the bus moves fastest once everyone got off. Please step into my lair:

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Scalping With The Mole

And now for something completely different – but I have a hunch you’re going to like it. If you’re a Zero sub then you are probably familiar with the Mole indicator which is located right above the Zero Lite on the 5-min panel. The basic tutorial refers to it as a different way of visualizing the Zero – as a matter of fact it represents an early version of the Zero indicator. As it shows a bit more context the Mole indicator often offers valuable clues as to impending swings in momentum or a shift in participation. For example: Be on alert when you see the Mole’s bubble expand or contract – the former indicating strengthening and the latter a weakening of the current move.

Some of you may recall that I introduced both the Mole and the Zero indicator in late 2008 and it has served us very well since. Which is why I have barely made any changes to it since about early 2010. It’s not that I’m lazy, rather I happen to be a believer in the old aphorism ‘it it ain’t broken – don’t fix it!’.

However recent events suggest that I might want to go and have my eyes checked. Let me explain: It all started earlier this week when an intrepid sub sent me an email asking why the Mole’s green line was dipping below the Zero mark. Now, I had seen this happen for years now and to me it was simply an expression of downside acceleration as it is almost always associated with red candles. And of course the inverse applies to whenever the red signal line crosses above. I was about to just bounce him back a quick note when suddenly my Spidey sense got triggered and urged me be useful for a change and take another look. I don’t know why but I had a sneaking suspicion that I may have overlooked something important.

The second I took a look the scales fell off my eyes – and Jim Morrison explains it best! When in doubt always consult a dead rock’n roller for important clues. Maybe I have to change my listening habits during trading hours.

Frankly it’s something I should have seen years ago – as you may imagine I am really kicking myself. It seems that zero mark breaches are almost always followed by snapbacks – usually within one or two candles. Also, the scope of the reversal appears to be directly correlated with the depth of the zero mark intrusion. Shown above are examples over the past three sessions – I did not change any of the settings. As you can see the reversals are not always big but they seem pretty reliable. The only exception being the last few candles of the NYSE session – obviously a lot happens in the spoos overnight and a scalper obviously would not get positioned the next day.

I poked around a bit more and the past month of Zero signals seem to strongly point towards a solid edge. As I’m not completely useless the first thing I did of course was to create a new version of the Mole – this new one changes the green or red lines to blue whenever they cross over to the other side. Since I took these snapshots I also have added handy blue arrows to the spoos panel – if you log into the Zero now then you can already see them in action.

Here I’m simply scrolling back a bit more. Another event which would have worked out nicely. This was not a very strong signal and perhaps the vehemence of the reversal was coincidence. More observation is needed I think.

And further back we go – as you can red line breaches to the upside seem to follow the same pattern. Not always are the ensuing reversals significant but that does not render them useless. Perhaps you are already long/short and you encounter an opposing signal which of course tells you that it’s time to take profits.

At least for the next few months we should stay away from any signals that occur at the open or the close. The example above would have worked and maybe the open signals are a possibility.

You can see that this was near this year’s highs but we are already in the process of rolling over. I see three valid signals and one I would declare a failure, however even that one turned back to b/e rather quickly.

And this shows you that the inverse signals seem to be equally good – we just haven’t seen many of those in the past few weeks. Which in itself is perhaps an important clue. Unfortunately I do not have more than 20 days worth of data right now but perhaps the presence of majority of downside reversal signals (i.e. buying exhaustion) may indicate that the current trend is down. A majority of upside reversal signals (i.e. selling exhaustion), as we have experienced in the past few weeks, may indicate that the current trend is up.

As we all have access to months worth of EOD wrap up videos this is of course something we can easily pursue further. If anyone is interested in spending some time on this I am sure it would be very much appreciated by everyone here. Feel free to discuss any results in the comment section – I only ask you to refrain from posting snaphots of the live chart (unless it’s from the previous day).

The good news here is that we may all have been sitting on a very handy scalping tool for the spoos and just didn’t know about it. And the really good news is that if you’re a Zero sub then you’re getting it for free :-)


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