If you are dedicated and disciplined, you can read the market internals to day- and swing-trade, making consistent profits trading futures and exchange-traded funds (ETF).
Most of us remember when we first learned and experimented with technical analysis and chart patterns. Likely, you were blown away by discovering what you may have imagined to be the Holy Grail of trading strategies. However, after the first six months of real trading, your trading account was the same size and your trades were winning around 50% of the time.
The culprit usually is that many of the breakouts you buy into quickly reverse, and you watch as price action goes against the original position. That’s when the obvious reveals itself: Reading chart patterns and volume is not enough to give you a significant trading edge.
We hear professional traders articulate that to consistently pull money out of the market, you need to trade against the masses and avoid herd mentality. This sounds quite simple, but just how do traders go about doing it?
Market internals are the answer. The concept is relatively simple. In theory, if everyone is buying a commodity or stock, then it is only a matter of time before everyone runs out of trading capital and the buying will evaporate. When the last buyers buy, it leaves only the sellers in control of the broad market.
A simple, clean pattern that large numbers of traders see unfolding means only one thing: Everyone is taking a position before the breakout in anticipation of the coming move. With the general public moving into this chart pattern, it would make sense that the underlying investment vehicle would move higher and lead to a breakout with the last traders (breakout traders) jumping on the train.
Just as these last traders enter the position, the smart money (large traders) would start selling into the buying surge, getting top dollar. Once the breakout fails, everyone who was long hopes for another rally, which inevitably never comes. As time drags on, this leads to traders getting impatient, exiting their positions and causing price to erode and create more fear in the market. As this process comes full circle, significant numbers of traders get out of their losing positions, causing a waterfall sell-off with an unlucky few holding the proverbial bag.
The key is to look at the market backwards from the straightforward analysis. Focus on buying into heavy volume sell-offs and selling into heavy volume breakouts. This is a tough transition for most breakout traders to make, and it is best to paper trade until you are comfortable with buying into fear and selling into greed. It feels completely wrong at the beginning, but the profits speak for themselves.
E-mini trading strategy
Four main tools are required to trade against the herd. This will be described for the S&P 500 E-mini futures contract, although it also works with other markets.
The futures market structure makes it easy to capitalize on both rising and falling markets. Additionally, there is no requirement to have a $25,000 minimum in your trading account to meet the pattern-day-trading rule, which is required to day trade stocks or ETFs.
The internal market indicators to focus on are the New York Stock Exchange (NYSE) down/up volume ratio, the put/call ratio and the NYSE advance/decline line. While these may seem elementary at first glance, when you combine their information you end up with a simple, highly effective trading strategy.
Over the last two years, the S&P 500 has provided a 1.25% profit, on average, each time one of these extreme sentiment readings occurred (see "Extreme reactions," below). These trades were in late August and averaged a 1.75% return, and each trade lasted only 24 hours. Another benefit is that money is not at risk for long periods of time.
Now, let’s look more deeply at how to find these low-risk trades using market internals.
The advance/decline line is a favorite indicator that measures market breadth. It is a simple measure of how many stocks are taking part in a rally or a sell-off. This is the meaning of market breadth, which answers the question, "how broad is the rally?" The formula for the advance/decline line is as follows:
A/D line = number of advancing stocks - number of declining stocks
This is the most easy to follow and understand of the three indicators. This tool is most effective when there are 1,000 or more individual stocks trading up on the day. In that scenario, the market is nearing an overbought condition, meaning too many stocks have moved up too quickly, and traders should start to take profits or exit their positions (see "Market advancement," below). It’s also helpful to look at the intraday and daily chart for topping patterns or resistance levels. Then, wait patiently for the other two indicators to confirm this sentiment before going short the market.
The put/call ratio is based on Chicago Board Options Exchange (CBOE) statistics. The ratio equals the total number of puts divided by the total number of calls traded. When more puts are traded than calls, the ratio will exceed 1.00. As an indicator, the put/call ratio is used to measure market sentiment. When the ratio gets too low, it indicates that call volume is high relative to put volume and the market may be overly bullish (see "Selling down," below). When the ratio gets too high, it indicates that put volume is high relative to call volume and the market may be overly bearish.
Put/call ratio = number of put options / number of call options
This indicator can be a little tougher to use because when the market is trending down, the ratio tends to fluctuate in the upper end of the scale between 0.75 and 1.20. In an uptrending market, the indicator will trade between 0.35 and 0.75. As long as you monitor the upper and lower range for the current market trend, your analysis should be right on track. In addition, if you zoom out slightly on the chart, you will see the average range it has been trading in, and then you can set the upper and low bands accordingly.
Back in late August, the S&P 500 was trending down, and a good strategy was to sell bounces in the market. When the broad market bounces and we see the put/call ratio drop into the lower band, it says that the majority of traders have gotten bullish. This tends to happen once a previous high is broken, as it triggers short covering and breakout traders start buying.
While there are other times on this chart where the indicator traded into the lower range, there was not a signal to short the market because the other two indicators did not confirm the extreme sentiment level. For this strategy to be the most effective, they all must have an extreme reading for the trade to have the best odds and greatest profit potential.
Nyse buying/selling volume
The NYSE buying/selling volume indicator is a simple volume-based indicator that measures fear and greed in the market. It routinely is a powerful tool for timing market tops and bottoms. Calculated by taking the NYSE buying volume and dividing that by the selling volume, it measures panic buying and acts as a contrarian indicator. It is not an indicator that many other traders follow, but is critical for getting a feel for the rhythm of the market.
NYSE buying strength = Up volume / Down volume
When you see this indicator rise to about 3.00, it means there are three buy orders for every one sell order on the NYSE. The majority of traders (the herd) are buying. Obviously, the higher this indicator moves, or the longer it stays above 3.00, the more potential there is for a sharp sell-off (see "Tracking the herd," below). Obviously this is only a confirming indicator; both the indicator and the market can continue to rise after touching 3.00.
Putting it all together
With these indicators, you can stay ahead of the herd and capture quick sharp moves while the masses are still wondering what happened. As always, logistics are important. Focus on 15-minute charts. Trade only with the trend. For instance, even though the market bottomed in July the downtrend exploited in "Extreme reactions" was still in place until the trendline was broken in September.
Do not get greedy. This strategy is designed to capture short-term market swings; take profits at defined levels – 1%, 2%, etc. If you wish to hold on for larger gains, it’s critical to take partial profits at a 1% gain and move your protective stop to a level that locks in a profit for the balance of the position.
Wait for all three indicators to reach extreme levels concurrently before you initiate a trade. The market trend can keep individual measures at extremes for one to two weeks. Trading on the anticipation of an overbought/oversold condition before all three indicators confirm your suspicions is a great way to lose money. Be patient, and wait for the indicators to confirm. There will be plenty of time to acquire a quality entry.
The strategy as presented works best in a downward trending market. While it also works well in a bull market, there are some minor changes required on each of the indicators that affect their user-friendliness.
Chris Vermeulen can be reached at Chris@TheGoldAndOilGuy.com or from his website www.TheGoldAndOilGuy.com.