Tag Archives: trading strategy

Fear & Greed vs. Panic

Several years ago I designed a day trading system for the stock indexes based on the following assumptions:1) Bulls favor an orderly, steady march higher.          This can be seen in               a. Smaller daily ranges as the market climbs.               b. Declining volatility. (less daily variance).               c. Declining put/call ratio. (less desire to purchase downside insurance)

As this story builds, complacency shifts to greed. Bulls are less likely to buy put options for fear of giving up top end growth. The television’s pundits tell us why “This bull is different.” John Doe investor feels secure enough to enter individual positions directly. The rising tide of the market begins to float all issues.

2) Bears are waiting for Achilles to bare his heal. Wide ranges and exceptional volatility create mass confusion.          This can be seen in               a) Large daily ranges as the swings from positive to severely negative.               b) Expanding volatility. (large daily variance) Think, back to back 300 point Dow ranges ending roughly                              unchanged.               c) Rising put/call ratio. (strong willingness to protect what equity is left)

As this story deteriorates, open interest in put options begins to rise. Investors try to protect their equity through the purchase of put options as the market declines. These purchases are made in an increasingly volatile market and are marked up with heavy premiums (Louisiana hurricane insurance). Ultimately, panic sets in and we get some kind of flush where equities are dumped, investors head to the sidelines and put options are purchased in a rush.  This creates the common “spike” bottom. A single day’s events can create the reversal necessary to set the bull/bear cycle in motion again.

For more on the development of this program see here.http://www.commodityandderivativeadv.com/andyftp/dcb%20dt%20article%20for%20web.doc

The interest in today’s article comes from the wide range of data now available to us. I’ve spent some time analyzing the option data governed by the Options Price Reporting Authority (OPRA). Finally, I can track open interest on index options as well as volume. I was interested to find out which component was more important; volume or, open interest. Is daily activity a better predictor of market direction or, am I better off tracking the number of participants?

Volume simply tells me how many contracts were traded that day. I’ve used short term exponential averages to track the general flow of activity for years. I’ve never been able to quantify the number of players involved in creating the volume. Tracking open interest would allow me to determine the degree of greed or fear in the market. The higher the option open interest, the greater the anticipation of big event.

Would this data be a better predictor than volume? As it turned out, the volume generated by panic, combined with the direction of the market’s volatility was still the single one, two indicator of future short-term stock market direction. The correlation between open interest and market direction was random, at best.

Frequently, very frequently, the process of analysis bears very little tangible proof. Seemingly logical and fundamental truths of market behavior produce no better than random results when subjected to the rigors of quantifiable testing methodologies. Thus, a robust system in place for several years has withstood another attempt at, “improvement.”

Volume & Open Interest 101

The following is reprinted from the Chicago Board of Trade

Volume and Open Interest

Next to price, volume is the most frequentlycited statistic in reference to a futurescontract’s trading activity. Each unit of volumerepresents a contract traded. When a traderbuys a contract and another trader sells thatsame contract, that transaction is recordedas one contract being traded. Therefore,the volume is the total number of long orshort positions.Open interest, on the other hand, refers to thenumber of futures positions that have not beenclosed out either through offset or delivery. Inother words, the futures contracts that remainopen, or unliquidated, at the close of eachtrading session.To illustrate, assume that a trader buys 15contracts and then sells 10 of them back tothe market before the end of the trading day.His trades add 25 contracts to the day’s totalvolume. Since 5 of the contracts were notoffset, open interest would increase by 5contracts as a result of his activity.Volume and open interest are reported dailyand are used by traders to determine theparticipation in a market and the validity ofprice movement. For instance, if a marketmoves higher on low volume some tradersmay not consider this an important pricemovement. However, the same pricemovement on high volume would indicatethat an important trend may be emerging.Combining volume and open interest alsoyields an interesting perspective on themarket. If a contract experiences relativelylow volume levels but high open interest,it is generally assumed that commercialparticipation, via the commitment of traders report is high. This is becausecommercial hedgers tend to use the marketsfor longer-term hedging purposes, puttingtheir trades in and keeping them until they’reno longer needed to manage a given pricerisk. Conversely, high volume with low openinterest may indicate more speculative marketactivity. This is because the majority ofspeculators prefer to get in and out of themarket on a daily basis.

Mass Commodity Liquidation

The past week’s action has seen a large decline in many of
the commodity markets. We’ve seen declines in oil, platinum, copper, corn,
wheat, sugar, OJ and others. Therefore, one has to ask, “What is the
justification for such a broad based selloff?” The answer, in short form, can
be found in the Commitment of Traders report. I track the commercials and large
and small speculators every week. However, Steve Briese, author of Commodity
Trading Bible
, also tracks the Commodity Index Traders. This group makes up
the long only index funds that have been at the center of the Capitol Hill
rhetoric as it relates to high commodity prices. Over the last two months, we’ve
seen this group begin to liquidate their positions. Over the last two weeks,
they’ve begun to liquidate in earnest.

Certainly, some of the commodity markets have been trading
at prices far above any fundamental justification for quite some time. I’ve
written at length that there is little justification for crude above $100 per barrel.
Power outages in South Africa were a major contributor to the rise in platinum
and cocoa, as usual, is subject to the usual political and social turmoil. However,
the grain markets, have a substantial fundamental foundation to build from.
Just as there has been little justification for $140 oil, there is considerable
justification for “beans in the teens,” and corn at $6.50+ per bushel. In
general, this appears to be a case of, “throwing the baby out with the bath
water.”

Given the broad nature of the selloff and its corresponding
volatility, the most effective way to take advantage of a rebound in commodity
prices may be through the purchase of a commodity based currency like the
Australian Dollar futures. This currency is highly correlated to the commodity markets
and is also coming under technical pressure. The successive highs from June 6th
and July 18th were not confirmed by increasing open interest (black
vertical lines and lower magenta graph). Also, we have seen tightening
consolidation as the trend developed in ’08. Currently, we are sitting on the
weekly trend line at .9430. I would not be surprised to see the market violate
this trend. If the market trades down to its deeper support between .9221 –
.9321 and open interest does not increase on the violation of the weekly trend,
I think we have a golden opportunity purchase the Australian Dollar as a proxy
for a continued commodity based rally and further appreciation of the
Australian Dollar.

Multiple Confirmations

Chart traders often find themselves with conflicting commodity trading signals. On the same chart, one man’s failing rally is another man’s bull flag. While looking at multiple time frames of the same chart can yield drastically different projections. How often has a daily chart given a strong indication one way, only to have the weekly chart totally counteract it in the context of the bigger picture?

One analysis technique I like to use when individual charts are yielding conflicting signals, is correlated chart analysis. For example, while the Dollar Index may yield mixed signals, I can use the Euro, Yen, Pound and Canadian which make up 57, 14, 12, and 10% of the index, respectively, to develop a consensus of the markets traded against the Dollar.

Another example would be to use interest rate futures to determine a bottom in the stock index futures. In times of duress, money flows out of the stock market and into the safer government backed securities. This is the, “flight to quality,” so frequently discussed in print and on t.v. Currently, there is much debate as to whether the bottom is in for the stock market or, not. As a trader, I’m not concerned about the rest of the year, only finding quality trading opportunities. Recent statistical analysis is suggesting the stock market rally may continue (see, “Counter Trend Moves…What’s Next?) However, conflicting evidence manifested itself during yesterday’s stock market decline. The flight to quality generated a significant rally (higher price/lower yield) in interest rate futures. However, it’s important to keep in mind that interest rates were rallying off their lowest levels in a month. Yesterday’s action suggests a further rally in in interest futures and declining yields over the coming weeks.

So, we now have statistical analysis that suggests a two week rally in both 5yr. Notes and the S&P 500. Has using multiple market analysis created more confusion than clarity?

Fortunately, macro economic theory holds that, in a healthy normal market relationship, we will see a positive correlation between interest rates and stocks. Therefore, if the pressure is off of the stock market and we are turning the economic corner, it is very possible that we see rallies in both of these markets. It is reasonable to suggest that yesterday’s correction in the stock market was a necessary correction in a market that bounced off of its lows too far and too quickly. Furthermore, given that the interest rate quadrant did not fall through the June lows as the stock market bounced does suggest that we may be seeing a return to “normal” market behavior. Lastly, given the election season, the Federal Reserve Board is far more likely to cut rates at the next meeting than to raise them.

Counter Trend Moves…What’s Next?

This week’s commodity trading featured many strong counter trend moves. Many of the markets saw swift turnarounds in trends that have been established for weeks and months. The 64 million dollar question is; “What’s Next?”Here is what I’ve defined as established trend and counter trend moves.The following markets are share the following traits:

1) They are all near their respective 13 week highs or, lows. The market began within spitting distance of its  recent extreme.

2) Their weekly sentiment readings are > 70 or < 30, respectively. Each market has a large, one sided public following.

3) They’ve experienced a large 5 day counter trend move. All week the market has moved conter to the public’s expectations.

4) Thursday’s ranges were larger than average. The market has moved far enough to force traders into action.

These criterea do a reasonable job of establishing a market direction and bias. Now, what can we learn from this. Is the counter trend move done? Does the longer term trend hold? Are the market’s topping or, bottoming out? Based on the following statistice, we can see that not all of the markets react in the same way.

Here is what to look for in a general sampling for the coming week. We can expect, in order of predicted strength, the following markets to bounce from the week’s declines.PlatinumNatural GasCrude OilSoybeans

Sugar looks like it will continue to decline, reaching a projected low of 1111 approximately 7-8 weeks from now.

The S&P 500 shows the strongest statistical bias. According this week’s events, we can expect the S&P to continue its rally over the coming month, peaking around 1312.

Rare Occurrence in Crude

The fundamentals in crude oil have continued to erode since February of this year. The highs, over the last $40, can be viewed as a “bubble.” This bubble has been fueled neither by Commodity Index Traders and large speculators, nor Hedge funds and carry trades. I think a strong case can be made that the last leg of this rally should be attributed to large producers unwinding their forward hedges. Producers and forward short hedgers are subject to human error just as individual traders are. Hedge transactions manifest themselves in the Commitment of Traders data as commercial purchases when the market makes new lows and as commercial sales when the market rallies. Just as most economic decisions are made, “at the margin,” so too are the hedger’s trading decisions. Their traders use their understanding of the fundamentals in their market to create oversold and overbought zones within the market’s natural movement and attempt to trade accordingly.

This strategy works for them the vast majority of the time.  However, when a market unhinges from fundamental factors and begins trading on sentiment, the commercials find themselves at the mercy of the public at large. Using the chart below, the white line represents the commercial index of positions on a scale of 0 to 100. Zero equals totally short and can be seen at the following points, (5/06, 7/07, 8/07). One hundred equals totally long and can be seen at, 6/05 and 10/05. Currently, the index is at 78, the highest since a 79 reading in February of ’07.

The yellow line represents total open interest. Technically, speaking, in a healthy trend, open interest should increase as the market moves out to new territory, either higher or, lower. This has not been the case with crude oil. Open interest peaked in July of ’07 and has continued to decline ever since. Open interest now stands at 1.3 million contracts, the lowest since March of ’07.

Furthermore, I have discussed, at length, the negative spread we’ve seen between the front month prices and the later expirations. In real terms, this backwardation in prices is evidence that producers don’t believe that we will be near these prices as the deferred contracts come due for delivery. Producers continued to sell the deferred contracts in order to lock in profits at levels they don’t believe will hold into the future.

Lastly, over the last previous weeks, we have seen the total commercial position shift from net short, to net long, with the market at all time highs. Therefore, I would suggest that the rally from the January highs, under $100 per barrel through the current highs, over $145 has been driven by commercial capitulation and a speculative blow off, rather than fundamental supply and demand issues. Ultimately, it proves the old adage true for everyone, even the big guys, “The market can remain irrational longer than one can remain solvent.”

Historically, there have only been three times when commercial positions have shifted from net short, to net long while the market was at all time highs.  The market declined, twice, by an average of 22.5% and once, the market rallied by 5.8%. Clearly, we are on the cusp of a top. Given the magnitude of a possible decline, one may be advised to purchase put options. Those wishing to sell futures may wish to wait for a close under $140 to initiate a short position.

The “Market Book” as a Trading Tool

RJO Vantage has a tool called the “Market Book.” The Market Book provides live access to the resting bids and offers in the electronic market. The effectiveness of the Market Book becomes more and more apparent now that 90+ percent of total commodity volume is executed via electronic trading platforms. As a former pit trader in the S&P 500, I find myself used to looking at the depth of the market’s bids and offers to establish any strength or weakness biases the market may have at a given price level. I now use the market book as much as I do the Commitment of Traders Reports.     This morning’s action in August live cattle was an excellent example of how the Market Book can increase the effectiveness of one’s trading strategies. Cattle have run up considerably for the month of June without any type of pullback. Over the last week, the market has consolidated just above the 103 level. Knowing that cattle prices tend to peak around Independence day and given the month’s run up, I felt like we could see extended selling on a penetration of the support at 103. I was watching the market as we neared the support this morning looking for the tell tale signs of a stop run to begin the decline. I expected to see standard volume on the available bids….maybe 2-6 contracts on every bid price under the lows, with an occasional 10 lot. Had I seen this, I would have been anxiously looking for a bid to hit to get my contracts sold. However, as the market declined to the support / breakout level, it was greeted with 10 – 85 contracts at each bid. This is an exceptionally large and supportive bid in the cattle market!    Therefore, rather than rushing to get my contracts sold, I decided to wait. As I waited, the market climbed and climbed.     The point is, had I placed an entry stop at the breakout level, I would have found myself stopped into a short position in a fully supported market. The beauty of the market book is that I was able to get a “read” on the market’s bias and avoid putting my accounts in harms way. If you haven’t spent any time with it, I highly recommend that you do. The market book can be a valuable tool in a trader’s arsenal.Any questions, please call.866-990-0777.Andy.