. Let’s beginwith the homework debate.The only group that can consistently profit without doing homework isthe pure scalpers—those that execute many trades, often totaling in thehundreds and involving thousands of shares or contracts, that are heldfor very short periods of time, sometimes only seconds. These scalpersare traders who have become extremely adept at reading market swings;they’ve developed a purely reflective response to significant changes in order flow. But the truly successful scalpers are few; most have a checkered
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history in that they’ve done well in certain types of markets, only to giveit all back when conditions change. For example, scalping a low-volatilitymarket is quite different than scalping a high-volatility market. And scalping has become much more competitive due to computer programs thatexecute via electronic trading and can instantaneously respond to bidsand offers.In a trending market—whether it is a long- or intermediate-termtrend—I do a lot of homework (as discussed in Chapter 7) so I can begin the trading day with two or three possible scenarios worked out.This homework consists of analyzing the previous day’s volume andidentifying past areas of excess (including gaps), beginning with the latestday and working backward. Next, I identify past balance ranges, beginningwith shortest time period—the shortest would be an inside day or symmetrical balancing day—and working toward the longest timeframe. (Note thatthis process is the inverse of what I do for longer term trade identification.)As already discussed, too much detail can blur your focus on longer-termtrading, causing you to overreact to short-term information—which is fuelfor day traders. I also place a high priority on identifying prominent pointsof control (POC) from previous trading sessions. To reiterate, the POC isthe longest horizontal line in a day’s profile. A “prominent” POC is unusually wide, and tends to create a gravitational center that prevents the dayfrom becoming elongated. Prominent POCs are often revisited, and mayprovide guidance for placing or exiting the following day’s trade. Why? Because they represent a recent area of a widely accepted fair price.In nontrending markets or markets that are exhibiting a great deal ofvolatility, I begin with the same analysis described above and then diveinto more granular detail by adding short-term references points, such asthe previous daily highs and lows, weekly highs and lows, trend lines (notthat I necessarily believe in them; however, if markets are trading withoutdirection, traditional technical reference points provide some guidance),and a look at other markets that may affect short-term trading. When markets lack direction or conviction—are nontrending—peripheral influencesare far more important. For example, if stocks are in a strong trend, interest rate changes may not have any meaningful short-term effect, whilein a nontrending environment interest rate changes may greatly influencemarket activity.While I prefer to trade early, there is nothing wrong with waiting forthe day to develop. Having said that, I believe you should act as if you weretrading the entire day—otherwise you may miss some of the important details that provide harbingers of the structure you’re waiting for. In general,I believe that beginning traders would benefit from witnessing the day’sstructure become more manifest before trading, while experienced tradersshould be able to gain an advantage from trading early in the day.
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I have always maintained that it is unwise for day traders to tradein front of early economic releases; there are simply too many opportunities for chaos that result in unreadable market conditions. If the release has been correctly anticipated, for example, the market may have already incorporated the information beforehand, which can actually resultin the market moving in the opposite direction than was expected. Or thismonth’s information may be right on the money, but corrections from pastmonths may end up having a greater impact than was expected. Seasonaladjustments can result in traders reacting to a different spin than you expected, or the market may have been too long or too short coming into thenews release, which can trigger a more significant auction to adjust inventory imbalances. If you get in before the release, and the market trades inthe opposite direction from your trade, you will find yourself in a losing position that is unfortunate in and of itself, but more importantly, could keepyou out of the winning trade that sets up after the market has digested therelease. Therefore, it’s necessary to maintain maximum flexibility so youcan trade after the market settles down and direction becomes somewhatclearer.It’s also a good idea to do your homework and identify significant reference points above or below the current market level, so that you can fadea release-caused spike that auctions sharply in one direction, with salientreference points helping you determine if there will be continuation or rejection following the spike. Using predetermined levels requires the marketto come to you, rather than you chasing the market.
WHAT YOU DON’T DO MAY BE MOREIMPORTANT THAN WHAT YOU DOWe stated in the preface to this book that you must understand the wayyou process and respond to information. That way your ability to act is notblocked or distorted by peripheral influences. In The Mature Mind (Basic Books, 2005), Gene Cohen discusses two types of intelligence: crystallized intelligence, which is the intelligence we accumulate in school andfrom everyday life; and fluid intelligence, which he describes as “on-thespot reasoning ability—a kind of raw mental agility that doesn’t dependcompletely on prior learning. It includes the speed with which informationcan be analyzed as well as attention and memory capacity.” Many tradersconstantly listen to business news, visit blogs, talk markets with peers, andread numerous newsletters—all of which provide conflicting opinions fordiffering timeframes. For those information hounds, by the time the market opens their memory is most likely crammed full, and their attention is
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accordingly distracted, pulled in multiple directions. In such instances,what do suppose happens to their “fluid intelligence”?The shorter the timeframe you trade, the more important your fluidintelligence. Intuitively, traders often recognize that they can’t effectivelyprocess this deluge of information, and so fall back on mechanical approaches or trading systems to decide which trades to execute. But askyourself this: What price would you pay for a mechanical system that actually worked over an extended period of time? There isn’t enough moneyin the world to buy such a system, as it would be priceless. What we’re presenting is a more linear thought process that will help you prepare for eachday, as well as monitor the day’s progress once trading begins. Before wedo that, however, let’s review the 30-year bond futures for July 5, 2006.
THE REAL WORLD IN ACTIONWe have made it clear that the day-timeframe trader must sort throughextensive information prior to making a decision. Just like other timeframetraders, volume analysis becomes incredibly important in attempting tounderstand the inventory positions of other day-timeframe traders as wellas the actions of the longer timeframes. This is mandatory if you expect tobe a viable opponent. Before we delve into the details of volume analysis,let’s first understand the context.In 2006, inflation (or possibly stagflation) once again became the buzzin the financial markets, with the experts constantly missing the mark. Inthe Wall Street Journal on July 5, 2006, a headline read: “Sinai Tops Economy Forecasters With Aggressive Inflation View.” The article went on tosay that in the Wall Street Journal‘s December 2005 survey, Decision Economics’ Chief Global Economist Allen Sinai topped the list with the mostaggressive forecast—up 3.5 percent for the 12 months ending May 2006.The article went on to report that the actual number was 4.2 percent. Thesurvey included 56 economists.Most market participants closely watch the monthly employment report for signs of growth and indications of inflation that can influence Federal Reserve policy decisions. In this case, the next report was due to bemade public two days later, on Friday, July 7. Two of the key componentsof this report, along with hours worked and wage rates, is the number ofnew jobs lost or created as well as the overall rate of employment. Cominginto Wednesday, July 5, the expected number of jobs for the Friday reportwas approximately 175,000.Early Wednesday morning, ADP, a firm specializing in payrolls andmacroeconomic advisers, predicted that new private sector jobs wouldequal 386,000—almost double what was anticipated by the market. With
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Long-term trenddown
Marketgappedlower onJuly 5BalancingJuly 5 low10514
Low,10507
10514
FIGURE 8.1 Intermediate term bracket (focus area) in U.S. Treasury bonds: Dailybar chart ending July 7, 2006.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
this background, we can now examine the trading in the Treasury bond forthat fateful Wednesday.Figure 8.1 revels that the long-term trend is down (at least that ishow we view it—longer-term continuation charts might dispute this assessment), with the market in a balancing phase that has developed for roughlythree months. This three-month range, as you recall, is an intermediateterm bracket, which calls into play a strategy that suggests buying thelower end of the bracket and selling the upper end, as long as volumeanalysis supports that decision. (Volume isn’t increasing as the marketauctions toward the extremes, indicating change is underway.) Now let’sexpand our analysis to include the individual profile and volume analysisfor Wednesday, July 5.
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MNMNKLMNKLMNJKLMJKLMJKLJKHIJKHIJHIJHIGHIGHGHGHGFGFFFFDFDEFDEFACDEFACDEACDABCABCABCABABAAAA
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Pre-holidayJuly 3rdshortened dayJKADIJKLADEFIJKLADEFHIJADEFGHIACDEFGHABCDFGHABCFGBCB
Electronic 30-yearTreasury Bound futurescontract
July 5The letterb
Lower opening gap
Numbers insidethe vertical boxshow the contractvolume at each price.
205972708374875460546239179921319024407458737923996666906012182234392226122236257263572219777129223488662
AAAAAABCABCBCBCCCCCDCDMNCDKMNDIKLMNDHIKLMDFHIJKLNDEFGHIJDEFGHIJDEFGIJDEFGDED
106-23106-22106-21106-20106-19106-18106-17106-16106-15106-14106-13106-12106-11106-10106-09106-08106-07106-06106-05106-04106-03106-02106-01106-00105-31105-30105-29105-28105-27105-26105-25105-24105-23105-22105-21105-20105-19105-18105-17105-16105-15105-14105-13
FIGURE 8.2 U.S. Treasury bonds, July 5, 2006.R . All rights reserved worldwide.Source: Copyright ľ 2006 WINdoTRADErwww.windotrader.com.
Viewing Figure 8.2, we see that July 3 was a shortened, preholiday trading session that demonstrated two forms of balance: (1) It was an insideday, as it was totally contained within the previous day’s range; and (2) itwas also a narrow, balanced day on its own. As you read in Chapter 7, thetrading strategy is to go with any directional move following a balancingday.July 5 gapped lower following the ADP report discussed above andsold off sharply for the first four periods (A through D). Once again, we seethe b formation that indicates short-term inventory liquidation. The buyerstaking the other side of this selling activity are apparently not buying for instant gratification, but rather intend to hold for at least a day, if not longer.It’s not uncommon to see an up-trend day following this kind of formation.Now review Figure 8.1 and note that the bracket low is at 105’07, with thelow on the 5th at 105’14—only 7 tics from the bracket low. Trade locationfor shorts, of any timeframe, was very poor on this day. Trading opportunities are created when investors/traders act impulsively and don’t considerthe risk/reward of their trade. From the profile shape we see here, we have
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Contract Volume89,608 (32%)
Contract Volume194,141 (68%)
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205972708374875460546239179921319024407458737923996666906012182234392226122236257263572219777129223488662
AAAAAABCABCBCBCCCCCDCDMNCDKMNDIKLMNDHIKLMDFHIJKLMDEFGHIJDEFGHIJDEFGIJDEFGDED
106 – 07106 – 06106 – 05106 – 04106 – 03106 – 02106 – 01106 – 00105 – 31105 – 30105 – 29105 – 28105 – 27105 – 26105 – 25105 – 24105 – 23105 – 22105 – 21105 – 20105 – 19105 – 18105 – 17105 – 16105 – 15105 – 14105 – 13105 – 12
FIGURE 8.3 U.S. Treasury bonds with volume, July 5, 2006.R . All rights reserved worldwide.Source: Copyright ľ 2006 WINdoTRADErwww.windotrader.com.
evidence that the bonds were not giving up ground easily. Now let’s reviewthe actual electronic volume to assess confirmation of these findings.The settlement, or closing price on the trading day before the oneshown in Figure 8.3, was 106’18, with the POC on the 5th at 105’20. Afteropening approximately 1/2 point lower on the 5th, the market continuedto sell off to 105’14, which is approximately $1,100 lower for just one fullsize contract. The most important thing to reflect on here is that 68 percentof the daily volume occurred in the lower portion of the range, which isfrom 105’25 down to 105’14. The circled price at 105’23 indicates the closingprice on the 5th. That means almost 68 percent of the short traders from the5th are going home with a loss. How do you think they feel, with such poortrade location and already upside down? How might this affect overnightand early trading on the 6th? How would your thinking have changed if theprofile from the 5th was elongated, volume was more evenly dispersed, andthe close or settle was near the daily low?Figure 8.4 shows the first four periods for the following day, July 6.The market was clearly higher, forcing short covering, or an “unwinding”of the overenthusiastic trades of the 5th. An opportunity for a great long
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First 2 hoursof trading onJuly 6July 5
Boxed arearepresents thevalue area
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205972708374875460546239179921319024407458737923996666906012182234392226122236257263572219777129223488662
AAABoxed areaArepresents theAvalue areaABCABCBCBCCCCCDCDMNCDKMNDIKLMNDHIKLMDFHIJKLMDEFGHIJDEFGHIJDEFGIJDEFGDED
292128198824512672773673604293091423789106481480416209142344144166
DDDDDDDCDCDBCDABCABCABCABABA
106-09106-08106-07106-06106-05106-04106-03106-02106-01106-00105-31105-30105-29105-28105-27105-26105-25105-24105-23105-22105-21105-20105-19105-18105-17105-16105-15105-14105-13105-12
FIGURE 8.4 U.S. Treasury bonds with volume, July 6, 2006.R . All rights reserved worldwide.Source: Copyright ľ 2006 WINdoTRADErwww.windotrader.com.
day trade occurred when price could not find acceptance back within theheavy volume range from the 5th. This could also have been an excellententry position for short-term traders, which is of course a longer timeframethan a day trade.As we discussed at the end of Chapter 7, there can be a moat betweenyour intellectual analysis and your emotions. You have seen price declineconsistently all day, with the market losing over $1,100 in just two days, andyou are expected to feel comfortable buying it now? Earlier, we said thebrain usually accepts new information at face value, and only gives up thisbelief after substantial analysis. Truly great opportunities, by definition,only present themselves for a brief period of time. In day trading, thereis rarely sufficient time for substantial on-the-spot analysis; the best tradesare often those that make you feel the most uncomfortable.Recall that the original estimate for the employment report due out onthe 7th was for approximately 175,000 new jobs. Following the ADP report, several analyses increased their estimate to 200,000. On Friday, whenthe actual report was released, U.S. employers added just 121,000 nonfarm
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jobs. The number excluding government jobs was 90,000, versus ADP’sprediction of 386,000. The market rallied. All 56 economists missed theinflation numbers by a wide margin, and most of the estimates for the employment report were far too high. Next to these types of pell-mell predictions, market generated-information is an oasis of sanity and objectiveclarity.To nurture and maintain that objective clarity, it’s vital to keep track ofthe Big Picture; the following list is meant to get you thinking about yourown system for holistic analysis, accounting for all the subtleties that cancloud clear thinking. We’ll discuss the ramifications of each in the followingsections.Ĺ Top down—preparation analysis. What is currently driving the market?Ĺ FundamentalsĹ EconomicsĹ Stock-specificĹ Lack of convictionĹ Flight-to-safetyĹ Market conditionĹ Trending—early/lateĹ Too longĹ Too shortĹ Bracketing—where within the bracketĹ Inventory imbalancesĹ Bottom up—preparation analysisĹ Intermediate-term bracketĹ Define high and lowĹ Price location within the bracketĹ Upper quadrantĹ Upper middleĹ Lower middleĹ Lower quadrantĹ Volume analysis, inventory balanced, imbalancedĹ Short-term trading ranges within intermediate-term bracketĹ Identify highs and lowsĹ ExcessĹ Inventory positionĹ Volume analysisĹ Yesterday’s tradeĹ Value area placementĹ Volume analysisĹ ShapeĹ Current day
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Ĺ OpeningĹ Developing value areaĹ Volume analysisĹ Overall confidenceĹ News announcementsĹ Projected profile shapeĹ Possible destinations
TOP DOWNIn the financial business, the term top down is generally thought of as theBig Picture, a snapshot of broad economic conditions. To us, however, topdown refers to an understanding of the key driving forces that are influencing a market—they may be economic factors, but they can be otherfactors as well. The goal of our top-down approach is to identify these factors because understanding their nature and influence can help us moreaccurately place all other information into its appropriate context. (Thereit is again: context, context, context.)Once you’ve correctly identified the top down, it’s paramount to remain flexible, as conditions constantly change. For example, you may recognize that there is a long-term reassessment of PE ratios underway that iseither contracting or expanding PE’s on a long-term basis. And while thatmight be extremely important for positioning long-term portfolios, immediate market activity might be influenced more directly by stock-specificearnings. Identifying the reality of what is most influencing the marketright now is essential if you want to effectively trade the market in anytimeframe, especially if you’re trading the day timeframe.
LACK OF CONVICTIONThere will be times when the market is directionless. This phase is commonly accompanied by widely gyrating daily price swings, as illustrated byFigure 8.5.Although directionless markets offer few opportunities for trend andintermediate-term traders, they are often fertile ground for day traders because of their volatility. When markets lack conviction, participants oftenattach themselves to short-term themes such as yearend rallies or what isoccurring as we are writing this book—speculating on whether the Fedpauses in its practice of periodic rate hikes.Conversely, when markets have intermediate- to longer-term conviction, participants (and therefore the market) will roll right over theseshort-term themes if they are counter to the directional auction, and will
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DirectionlessmarketConstant Wide SwingsHigh Volatilty
FIGURE 8.5 Directionless market: Daily bar chart.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
accelerate if they are facing the same direction. That’s why making an accurate assessment of the market’s directional conviction is essential tobeing able to weight the significance—to the market and therefore yourwallet—of shorter-term themes and events.
FLIGHT TO SAFETYFlights to safety can occur when there are natural disasters, terrorist attacks, wars, political imbroglios, large-scale bankruptcies, or meltdowns
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such as occurred with Long-Term Capital Management and the Asian crisissome years back. Once a flight-to-quality rally is underway, the process foranalyzing markets that we have been describing may, in fact, work againstyou for short-term trading. When markets are being driven by fear and emotion, price and volume simply don’t matter. For example, as we are writingthis section, the short-term yield in the Treasury market (six-month billsyielding 20 more basis points than three-month bills) only makes sense ifyou understand that these securities aren’t being purchased for yield, butrather for safety because of concerns regarding the international politicalclimate—instability in Iraq, Iran, Israel, Lebanon, and so on. It is imperativeto perform this kind of analysis, for when the flight-to-safety trades are ultimately unwound, asymmetric opportunities abound because the markethas usually rallied far above value. Once this unwinding begins, the market is likely to return quickly to, and potentially pass through those areaswhere price movements weren’t supported by healthy volume.During a flight-to-safety rally, previous balance areas and brackets aregood visual reference points. Market participants are continually drawn torecent areas of acceptance (value), and once these areas are taken out, themarket moves to test the next balance area.
INVENTORY IMBALANCESFrom time to time, markets get too short in all timeframes. Hedge fundshave contributed to a more realistic employment of investment or tradingideas in that they simultaneously hold both long and short positions, butthis doesn’t mean that they always get it right. And when hedge fund managers get too short, they too may have to buy to cover, which could addto market volatility and create opportunities for those who are correctlyreading the market in the present tense.On the surface, you might wonder why a chapter on day trading wouldspend so much time discussing information that is beyond the scope ofthe day timeframe. The reason is that if markets become extremely activeduring the day, longer-timeframe information may trump day-timeframe information and take control of the market. On a day that exhibits a narrow price range, for example, it is unlikely that there will be much interestfrom the longer timeframes. The market may trade in a fairly orderly manner, auctioning back and forth, continually searching for new short-terminformation. However, on a day in which the trading range continually increases, longer timeframes may be drawn in, and their participation canquickly dominate the activity of shorter-term traders. During situations likethis, day traders who have not familiarized themselves with longer-termcontext are in a precarious position; unaware that the longer timeframe has
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entered the market, their natural reaction may be to fade what the marketis doing, because it conflicts with their day-timeframe analysis. As a result, they can get run over. This often occurs when the market auctions farenough to trigger longer-term short covering.Staying abreast of the top-down drivers isn’t as difficult as it mightseem, because once you’ve completed your long-term analysis, it doesn’tchange that often. Unfortunately, a nice and neat list of the current topdown drivers will never be found in the newspaper or on the newsshows. This understanding must come from being immersed in the markets and paying attention to all relevant information. And as always,the challenge is making sure that you remain objective in your analysis,keeping outside opinions at bay and focusing on what market-generatedinformation—always objective—is telling you.
CORRECTION OF INVENTORY IMBALANCESLet’s focus in on longer-term short covering, as it’s one of the more difficulttop-down drivers to anticipate and detect.In Figure 8.6, notice that the two lows marked “Excess.” These are considered to be “good lows,” in that the market auctioned lower, forced outthe final laggards (for this timeframe, at least), and immediately found aggressive buyers that led to a reversal of the downward auction. Remember,excess marks the end of one auction and the beginning of another in theopposite direction.Now examine the third area noted in Figure 8.6. Here, there are multiple lows at approximately the same price. When a market has repeatedly attempted to auction lower without being able to establish excess,this is usually a sign of inventory imbalance; the market may be too shortto go any lower, and so needs a short-covering rally that will allow longterm inventory to come into balance. It’s not unusual to hear professionaltraders say that a market needs to rally before it can continue to break.They’re simply expressing the view that there are too many weak sellersin the market—sellers who continue to cover on each small break, whichhas the effect of stopping any further decline until the covering is over.Shorts are always potential buying power.Skeptics might point out the ambiguity in this concept, but after yearsspent observing this phenomenon in all timeframes, I have come to recognize the fact that longer term short covering is a recurring pattern. Longterm investors that take large positions in the market don’t wait until themarket gets to within a few tics of a prior low to make their purchases. Infact, a lot of them aren’t even aware of those levels. Hedge funds and otherintermediate-term traders are very much aware of the prior lows, however,and once they start feeling insecure in their positions, they begin to look
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Lows, 10515105131051410514Excess low06106211071410619
Too shortExcess low
FIGURE 8.6 Longer-term inventory imbalance developing in U.S. Treasury bonds:Daily