Market internals beat the herd
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.