he was totally fatigued tosimulate game scenarios.To become a truly skilled investor or trader, you must immerse yourself deeply in the market’s auction process, experiencing a variety of similar situations until you begin to understand how that process works ina real-time, present-tense perspective. If you observe only long-term markets, it will take years before you will have seen and recorded enough patterns to competently recognize transitioning activity, let alone be able toact on that information while balancing intellect and emotion. However,recall that everything we’ve discussed thus far is applicable to all timeframes; to accelerate the learning process, we suggest that you also studyshort-term markets, analyzing the shorter-timeframe balances that occurwithin intermediate-term brackets. This will give you increased confidenceabout the entire auction process, as well as further insight into the actionsand motivations of the various timeframes.
PRELUDE TO A SEA CHANGEHaving examined how trends begin and end, let’s now look at the securities markets as they converged with our writing Markets in Profile in May2006, when the U.S. equity market was entering its fourth year of an extended longer-term up trend. After the markets closed on Friday, May 5,I commented to a long-time friend and Chicago-based trader, WilliamKennedy, that everything we look at to analyze auction strength and confidence was leading me to assess the risk—from the long side of themarket—as being very high. The upward auction, despite accomplishinghigher price movement, was accompanied by continually decreasing volume, and the volume was not well distributed throughout the market profile. As a result I had refused to trade from the long side for the previoustwo weeks. Additionally, I commented to Bill that trading from the short
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side was also risky, as there had been no sign of sellers—only marginalbuying activity. The greatest point of market opportunity is when you feelalone. Given the high risk of being outright long, and the fact that longertimeframe sellers had yet to surface, I purchased out-of-the-money putswith extended time, feeling that the market would at least have to auctionlower to determine if buyers remained present under the current price levels.Remember the subtlety in what we do: we don’t forecast, we assessthe risk of our positions. We seek to exit positions that have above-averagerisk, and to establish positions that provide favorable risk/reward characteristics. Once a position has been established, we then monitor the auction process for continuation. There was no expectation that the May 2006decline would develop as it did; an auction continues until it is completed.Let’s further this discussion by reviewing a strong upward trendingmarket, so that we’ll have something against which to compare the Mayauction.Figure 6.5 exhibits the pattern of a strong, upward trending market.Notice how the market trends upward, balances, then resumes its upwardtrend again and again. The stronger the trend, the greater the distancebetween successive balance areas. As the auction ages, this distance decreases. In the late stages of the trend, price may continue to rise but thenext balance area will often be resting on top of or within the prior, lowerbalance area.Long-term trends often resemble stairs, with each balancing area representing a step. Downward auctions appear as if they are descending astaircase, as you can see in the daily bar chart of Figure 6.6 . Figure 6.5, arising trend, reveals an ascending staircase pattern. Note that the same security, displayed via a different time interval, looks entirely different. That’swhy we suggest that you review each security you trade using monthly,weekly, and daily bars—it broadens your perspective and assist, you inidentifying your own timeframe.As the downward auction becomes exhausted in Figure 6.6, note thatthe lower balance area overlaps the previous, higher balance area. Thisdoesn’t mean that the downward auction is over; rather, that it is latein the process, and so the corresponding risk of holding short positionshas increased. If you’re a long-term portfolio manager, at this late point ina downward auction the risk of holding defensive securities or cash hasrisen, and you would want to begin to commit to new positions or add tofavorable positions. Long-term returns are greatly enhanced by committingcash at lower levels, as long as the auction is ending.Trends that are growing “tired” will begin to exhibit increased volatilitywithout producing much further directional progress. Additionally, volumewill begin to decrease and, in some cases, auctions that are in the direction
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$110Each vertical barrepresents one monthUpside breakout
Balance
Balance
Upside breakout
Intermediate-termauction or balance$45
FIGURE 6.5 Common pattern of an upward-trending market: UBS weekly barchart, January 2004 through May 2006.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
of the trend will be accompanied by less volume than on days the marketauctions against the trend.Having reviewed these two auction patterns, let’s look at the monthlybar chart for the S&P 500 prior to the May 2006, nonlinear break.We have labeled the trend in Figure 6.7 a “long-term” trend. However, one could easily argue that the market is continuing to consolidate
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Balance
Daily chartU.S. 30-year Treasurybond
BalanceDownsidebreakout
Downside breakout
BalanceBalance is lower andwithin upper balance.
FIGURE 6.6 Common pattern of a downward-trending market: U.S. 30-year Treasury bonds daily bar chart.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
(balance) between the high established in March 2000 and the low createdin October 2002. While the market has, in fact, stayed within an extremelybroad bracket between the March 2000 high and the October 2002 low, ithas steadily risen since an upside breakout in March 2003, a period exceeding three years. Few have the patience or perspective to say that a threeyear rally is not a bull market; even though it remains contained within thelonger-term bracket. (The practical thing for a money manager to do is totreat it like a bull trend, because if he doesn’t, he won’t retain any clients.)John Mauldin, in Bull’s Eye Investing: Targeting Real Returns in a Smokeand Mirrors Market (New York: John Wiley & Sons, 2004), tells us that itis not uncommon for markets to consolidate for years. In fact, he writesthat the shortest period of consolidation following a bear market is eightyears. We are now in year six, and when we finally break out of the March
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March 2000 high
Long-termupward trendline
Upside breakout May2003
October 2002 low
FIGURE 6.7 Longer-term upward trend developing in the S&P: S&P 500 weeklybar chart.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
2000 through October 2002 bracket, we would expect an extremely activemarket.The strategies you employ for a trend and a bracket are quite different,but there are times when the market is tricky, exhibiting elements of both.The “final answer,” as it were, is to remain flexible and open-minded, andif you want to excel as a money manager, don’t be a trend trader, sticking only to long positions—there is a big difference between buying andholding and staying fully invested. The last report I saw on money managers’ holdings revealed that the average position was held for less thana year. For the most part, it seems, money managers aren’t really “buying and holding” as much as they are staying fully invested. While I wasat UBS Financial Services, the team that researched money managers reported to me, and I have monitored the rate of money manager turnover foryears, and while there have been a few managers that did exclusively buyand hold securities for extended periods, I have observed that this practice is certainly not the norm. In other words, being more market sensitivethan dogmatic is not unheard of—which is the core of what we’re trying
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to impart. Even while money managers are selling customers on the ideaof buying and holding, there is more nuance to it than that: there is marketawareness.If you measure the price distance from the top to the bottom of thetrend line for the S&P 500 shown in Figure 6.7, you will notice that thedifference is approximately 5 percent. This distance is commonly referredto as a channel. When volatility increases, which expands the channel, itis not uncommon to see a difference of 8 to 10 percent. Common theorywould suggest that you buy a pullback to the bottom of the channel inan upward trend, and sell a rally to the top of the channel. The challengeis that if you don’t hedge, and instead ride out the decline to the bottomof the channel, and it turns out that there is a downside breakout fromthere, you’ve already given back a gain (if you even had one going into thecorrection). Worse, if you weren’t on the plus side as the decline began, itwould take a strong rally just to get you to back to the break-even point.This is where money managers can get into big trouble—their emotionssay, “I can’t sell now; the market’s got to turn around.” But once you enterthat head space, you’ll be lucky if you can keep your relative standing, andyour absolute performance will be shot.Now let’s view the S&P 500 through a shorter-term lens, a daily barchart shown in Figure 6.8.The S&P 500 futures contract broke out to the upside on November18, 2005 on reported volume in the Wall Street Journal of more than2 billion shares. To provide some reference, typical daily volume duringthis period ranged from 1.6 to 2 billion shares (although there were certainly a few days above and below these levels). A breakout on high volume, with the close near the daily high, indicated that higher prices wereattracting more activity, which means the auction would be expected tocontinue higher—which it did for three more days.The world spends a lot of time searching for easy answers, and nearthe end of 2005 most financial talk show guests were predicting a yearendrally, which then became the “Christmas rally.” This talk wasn’t enough toactually empower the rally, so hints of a Fed pause were thrown into themix. Media-generated situations often set up excellent opportunities fordiligent investors who can observe the proceedings objectively, withoutgetting emotionally caught up in the media-generated hype.A review of Figure 6.8 shows that the market first balanced above theNovember breakout low for approximately six weeks before staging another upside breakout. Following this new upward auction, the market’ssecond balance was established slightly above, but still well within, the firstbalance—an indication that the trend was aging, but not necessarily over.The second balance occurred over the first two-and-a-half months of 2006.
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Third balance
First balancefollowing Nov. 18upside breakout
Second balance
Nov. 18, 2005upside breakout
Compositebalance
FIGURE 6.8 Balancing marking the aging of a longer-term trend: S&P 500 dailybar chart, November 2005 through May 2006 (focus area).Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
On March 15, a third upside breakout took place with resulting balancingaction similar to the second balancing period. As new highs were continuing to provide comfort to investors, encouraging complacency, marketgenerated information (time, price, volume) was revealing that the risk ofholding long positions was increasing. For those that focus primarily onearnings, additional comfort arrived in the form of strong reports of individual company and S&P Composite earnings. At the time, a prominentspeaker from a money management firm told a daily business show that ifinvestors “keep focusing on earnings, we will be all right.” Based on how headdressed the commentator, he probably knew that hype had outstrippedreality, but he also understood that if he said anything clearly negative itcould hurt his business. I think he was trying to be honest in a diplomaticway, because the will of the herd is a force to be reckoned with, even whenit’s facing the wrong way.Opportunities, just like markets, are regulated by time. If you squanderthat time waiting for confirmation, the consequences can be harsh. Oncethe investing world recognizes that change is underway, it is usually toolate for large money managers to take advantage of it, as liquidity dries upand the “change” becomes the “norm.”
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HEAR THE BELLS A-RINGINGOn May 8, 2006, the Wall Street Journal’s “Evening Wrap” quoted MerrillLynch economist David Rosenberg: “There is no question that the quarterearnings season has been superb.” The article stated that quarterly resultsfor more than 400 companies in the Standard & Poor’s 500 Index are in,and on average their per-share earnings were 14 percent higher than a yearago, according to Thomson Financial. It also referenced Thomson reporting that the quarter was the 11th straight period of double-digit earningsgrowth for the S&P 500. Mr. Rosenberg, according to the Journal, “notedthat analysts are already marking up their earnings forecasts for quarters tocome.” Just three days later, on Thursday, May 11, the stock market beganits significant move down. The point is that while earnings are important,so is market structure when assessing risk. Unfortunately, articles aboutweak market structure aren’t very sexy, and are easily dismissed as “technical analysis.”When we started writing this chapter in early May, we talked about themarket converging. By the time we were in the editing phase it was midJune and the decline had continued. From the high on May 5 to the closeon Tuesday, June 13, the S&P futures contracts were off 8.18 percent andthe Dow futures were off 8.58 percent. Still, the “experts” clung to their former beliefs. A typical Wall Street Journal quote from a company presidentsaid he believed the Dow’s pullback was only “temporary,” and that theindex would close at over 12,000 by the end of the year. Isn’t that comforting? Another Wall Street Journal headline read: “Fed Derails Dow RecordReach.” There always has to be a scapegoat, so everyone can externalizetheir angst and anger. After all, it would be too esoteric to blame the market’s decline on “weak structure.” It can’t be said often enough: you mustdevelop a holistic understanding based on the market’s real-time structurein order to separate yourself from the pack and become a truly competitivemoney manager.
COUNTERTREND AUCTIONSAnother sign that the upward trend had aged was provided by observingthe countertrend auctions—auctions that, in many cases, were strongerthan those that occurred with the trend. Figure 6.9 shows the final daysprior to the nonlinear move that began on May 11, 2006.On Friday, May 5, S&P futures broke out to the upside, establishinga new life-of-contract high. Volume on this day, as reported in the Wall
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S&P 500 futurescontractTop of bracket and contracthigh
Friday, May 5, 2006
Key downsidereference
FIGURE 6.9 Strong counter auctions to the upward trend, followed by nonlinearbreak to the downside. S&P 500 daily bar chart, November 2005 through May 2006(focus area).
Street Journal following the close, was 1.6 billion shares—at the low endof the range we discussed earlier. If the market was attracting new buyersand had any real underlying strength, an upside breakout to new life-ofcontract highs should have exceeded the upper end of the volume range.Investors often lament that “No one rings a bell at the top of the market.”But in a sense, the low volume that accompanied the upside breakout wasthat bell.During the first three days of the following week, the S&P high wasnot exceeded, although the Dow did manage to barely establish a newpeak. In terms of assessing the risk of holding a long position, once amarket attempts and fails to auction above a bracket high, the odds aregood that sellers will emerge and auction price downward and explorethe opposite end of the bracket. In other words, the odds were stackedagainst those holding long positions. If you recall, at the beginning ofthe chapter we made the statement that a new bracket had been formedonce excess was created and the market began a nonlinear move to the
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downside. When an auction attempt fails to establish value in one direction, and price re-enters a previously accepted value range, the odds aregood that the market will auction down and explore the opposite endof the accepted range. Looking back at Figure 6.9, we would define acomposite bracket made up of the three previous, interwoven balanceranges.On May 11, the S&P began its nonlinear descent, and as of the close onJune 13 the market had already declined more than 8 percent. Was some ofthis capital destruction avoidable? We think so. While the world was talking about the Dow being only 80 points from historic highs and analystswere marking up their forecasts, there where many anomalies that shouldhave been raising questions and ringing bells; yet it was not until after thefact that the experts appeared with the answers. Some of the experts saidthat the drop was because the market didn’t like what the new Fed chairman, Ben Bernanke, brought to the party. But obvious clues to the market’s eroding structure had been creeping in since early December, longbefore the world had a look at the new chairman. In our interpretation ofmarket-generated information, we saw continuously overlapping balanceranges, low volume, poor volume distribution among the daily profiles, andcounter auctions that were at least equal to auctions with the trend—justto mention a few of the factors that led to our conclusion that the upwardtrend could not continue. Our question is this: While the talk shows wereclearly providing us with a surplus of information and hype, where was theintellect?
THE QUEST TO DO BETTER THAN “NORMAL”In The Structure of Scientific Revolutions, Thomas S. Kuhn describesmajor shifts in scientific theory as occurring when some new set ofcircumstances—an anomaly—violates “normal” expectations. This changeis initially (and fiercely) resisted by all those invested in what was previously considered scientific “fact.” Malcolm Gladwell would argue that thisdynamic occurs in every type of human endeavor, with the “innovators”first to recognize that a major shift is occurring. These innovators, in boththe scientific and financial realms, are generally rebuffed by the majoritythat have a (literally) vested interest in the status quo. But eventually thechange that has taken place is recognized by everyone—even the “late majority” and the “laggards,” who get on board long after there is any significant opportunity to take advantage of the change.The major shift in market sentiment that occurred in May 2006 is aprime example of such a change. The financial media, the columnists, the
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arm-chair analysts, nearly all of them were in agreement about the fact thatthe market was going to rip through those historic highs. Unfortunately forthem, and anyone else who got long on their advice, the market had otherideas—a new set of circumstances had developed, which were visible forthose who knew where, how and when to look. The buyers were finally “allin” (the aforementioned “capitulation”). And while human nature dictatesthat no one ever wants to be first into the breach, sellers did emerge, andthe market did a major about face.Relative return managers are often caught by moves such as the onejust described. (Relative return refers to how an asset class performs relative to a benchmark.) That is because their clients—which include pensionfunds, endowments, foundations, and individuals—are quick to penalizemanagers who miss significant upward market moves. As a result, mostmanagers attempt to stay fully invested during significant rallies (such asthe three-year rally preceding the break). Portfolio managers and investment firms don’t just risk a little “under performance” at these moments,but rather a significant decline in their business, which sometimes provesto be fatal.When money managers get too bearish, stay out of the market, andmiss the next leg up, their reputation (not to mention their self-confidence)gets damaged. For those that develop an understanding of market structure, which provides a strong foundation upon which to build rational decisions, some of the inherent risks in investing can be diminished—whichcould be the difference between being successful and being a footnote inthe history books.
OH, THE DIFFERENCE A FEW POINTS MAKESWe have spent a lot of time demonstrating the difference between trending and bracketing markets, and as you recall, we referred to major trendsas long-term, and bracketing markets as intermediate-term—two distincttimeframes. We have also discussed the distinction between risk and forecasting. We never know how high or low a market will go (that job ishandled expediently by the auction process), but we can assess the resulting risk to existing positions. It is paramount to seek confirmation inthe market’s unfolding present-tense structure; by observing market movement and volume in relation to the mean, it is possible to monitor auctionsfor continuation. Days in the direction of the auction timeframe you aretrading should result in better volume, progressive value-area migration,and more elongated Market Profile shapes.To recap, if a market is trending upward and higher prices are attracting new buyers and additional volume, then the mean is continually rising.
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If the opposite is true, and higher prices are attracting less volume, thenit becomes apparent that the mean has remained well below the currentprice, which means the odds are high that price will return to those levels.If you can identify when the odds are changing and then act on thatknowledge, then you have a meaningful advantage over the majority ofinvestors who wait until proof is incontrovertible before making a move.In the highly competitive investment business, the reward—even if only afew percentage points—can be very significant.
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Short-TermTrading
If you can keep your head when all about youAre losing theirs and blaming it on you;If you can trust yourself when all men doubt youBut make allowance for their doubting too;If you can wait and not be tired by waiting . . .—Rudyard Kipling
B
efore we plunge into short-term trading, let’s take a few steps backand look at a continuum we call the trader development spectrum.Understanding the way the different timeframes process and interpret information helps you begin to identify your own unique timeframe:Ĺ Long-term strategyĹ Intermediate-term strategyĹ Short-term tradingĹ Day tradingĹ ScalpingLong-term trades or investment ideas are made from a slower, morelogical analytical approach, with little attention paid to short-term details.At the other end of the spectrum, scalpers rely mostly on the unconscious mind, with rote memorization and keen reflexes being paramountskills—long-term information is far too slow and cumbersome to be considered in the frenzy of the daily grind.Intermediate- and short-term trading requires the most attention andagility because successfully trading in these timeframes requires retaining,99
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recalling, and managing large quantities of information, some of which arepart of a long and complex series of events and indicators. Real-time data,culled from present tense market structure, often reveal additional significance in data that we’ve already seen and processed. When old informationis bombarded with a constant flow of new data, it takes an agile mind tocontinually assess and reassess both the big picture and the minutia of thedaily auctions.Longer-term trading is often enhanced by not looking too closely atthe smaller pieces of information, while day trading requires that you immerse yourself in short-term market conditions so you can react quicklyand intuitively to the day’s evolving data. We’re in no way suggesting thatday trading is “easier,” rather, that it requires parsing data that may notbe as complex and interrelated as the information germane to longer-terminvesting.Take a moment to think about your own thought processes as they relate to the different phases of the Trader Development Spectrum describedabove. Are you beginning to understand where your individual strengths(and weaknesses) would ideally place you on the timeframe continuum?The “analyst” will likely be frustrated attempting to day trade, while the intuitive trader, with strong reflex skills, will probably be equally frustratedwith the prospect of trading the longer timeframes. It’s simple in theory,but difficult in practice: in addition to knowing the market, you’ve got toknow yourself.No matter what timeframe you ultimately trade, the market profile provides you with a visual manifestation of market activity—the unfolding patterns that capture complex information in a manner consistent with thebrain’s mechanism for understanding complex information. Having accessto a tool that so cohesively sums the actions of all market participants issimply indispensable for keeping your head about you, especially duringtimes of crisis when your blood pressure soars and opportunity is fleeting.One last thought before we begin to explicate short-term market activity: Perhaps the most important skill you must master to become asuccessful trader is the ability to distinguish “price” from “value.” Thisis something expert traders do intuitively, and Market Profile does by itsvery nature, organizing information from the entire timeframe spectrum ina way that enables you to visualize how value is building and migrating.While separating price from value is the hardest concept to internalize, itis absolutely essential to understanding and effectively employing marketgenerated information.Remember, the auction’s fundamental purpose is to advertise opportunity (price), fairly and efficiently allocating bids and offers among themarket’s participants. As you gain experience reading market-generatedinformation via a market profile in the “present tense”—as it unfolds—you
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will learn to interpret price in context, which is the key to successfullytrading in any timeframe.
ANALYZING SHORT-TERM MARKETSShort-term trading has no formal definition; a short-term trade can last aday or several days, even weeks. But no matter what timeframe you’re operating in, you are a day trader on the day you enter or exit a trade. Andgood day-timeframe trade location, enhanced by a sound understanding ofthe auction process, contributes to good performance for all timeframes.Now let’s dig in.We’ll begin by analyzing the preceding days’ activity in order to determine good trade location for the current day—the day you intend to trade.Like top professionals in any sport, you must analyze past action in orderto be truly competitive; tennis star Andre Agassi analyzed endless matchfilms before he ever faced an opponent. The same holds true in the investing realm: securing good trade location has as much to do with understanding the market’s prior behavior as it does with effectively analyzing activityon the day you trade.On Day 3 in Figure 7.1, notice where the market opened—well abovethe previous day’s close and accepted value. This will serve as an early important reference point, along with the previous day’s high and the fact thatthat the previous day’s market profile shape is broad, or “fat.” Remember,for the market to find acceptance away from a well-established mean itneeds power, manifest in volume. The more pronounced the mean—suchas the wide center point of Day 2 in Figure 7.1—the more significance youshould attach to it; a wide mean essentially acts as an anchor, becausea large number of market participants have agreed that price was fair toboth sides at that level. When a day exhibits a broad market profile, unlessthe following day’s auctions occur on high volume, the odds are good thatprice will revisit the gravitational center of that mean.On Day 3—the day we’re going to “trade”—the market opens just below the high of day two. After exploring above this reference point, responsive sellers quickly return price to the center of the previous day’s valuearea, where the pronounced mean from Day 2 exerts its pull. In order tosecure good execution for trades to be entered or exited on this day, youshould have started by reviewing the previous day’s activity, followed bya review of overnight activity, in order to get an idea of where the opening was expected to occur. As we have stated in previous chapters, youshould have also determined if the market was balancing or trending. Ifbalancing, you should have carefully noted balance area highs and lows, aswell as longer-term reference points. If trending, you should have noted the
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Day 2OpenMMMNMNMNMNMNMNMNMNMNMNMNLMNLMKLMKLMKLKLKLKLKLKKKKKKKKKJKJKJKJKJKJJCDJCDJCDEJCDEJCDEGJCDEFGHJCEFGHJCEFGHIJBCEFGHIJBCEFHIBCEFHIBCHIBCH
Fat
MMMLMLMJLMJLMJLMNBJLMNBJKLMNABCFJKLMNABCDFIJKMNABCDFI