All futures today. This video talks about my stock watchlist, and how I didn’t see any trades to take at the open. I also spend some time talking about why you should buy into big offers, and sell into big bids. Long-time readers will have already heard me say it, but it’s a common misconception in stock trading, so I think I should repeat it every once in awhile.

On top of what I said in the video, in stocks another dimension to the issue are so-called “iceberg” orders. The theory goes like this: A seller wants to sell 2 million shares. Are they going to put out an offer with a size of 2 million? No way… they’re going to issue shares a little at a time, only showing 1000 or less on the Level-II screens at any one time. Then, maybe when they have 10k shares left to sell, they might pick a price and show the whole thing… because they want to be done with it, and a large bid is a big invitation to sellers. So, in stocks anyway, you usually only see a big bid when it’s the last portion of a big buy order. Do you want to buy in front of a big buyer, just as they are about to stop buying? NO, you DON’T! You want to be a seller when the big buyer is about to walk away… So, that’s another reason to buy into offers and sell into bids. Of course, good timing helps a great deal…

This post was contributed by a guest author, and does not necessarily reflect the views of Richard or MovetheMarkets.com

I made a trade today in the S&P500 eMini Futures (ES) based purely on watching the tape.
The setup for this trade took well over half an hour to develop. The time window of opportunity existed for only a few seconds, and the trade was over in just under 1 minute. Making a video of what happened would be the only way to do justice to what I saw, but I will try to describe it here in print as best as I can.

I was watching the volume chart in agony after having painfully missed out on the 16pt drop in the early afternoon. Price stopped dropping at 1456 after breaking previous support and setting a new LoD, and proceeded to bounce up a little from there. For the next half hour, I watched it chop around. But even as it proceeded to do that in almost random fashion, it was already leaving signs of another potential move:
a. Each bounce was weaker than the previous one, ie, it was making lower highs.
b. The moving averages were trending down.
c. The Keltner Channel was trending down (sort of).

So I proceeded to watch the charts and the tape, all the time wondering whether 1456 would hold up as support or not. Just before noon (PST), I observed that price action was getting weaker and weaker. It just didn’t seem to want to reclaim previous congestion areas. As a test, I put in a limit sell @1460. It never got hit. I proceeded to drop it down, tick by tick, and it still never got hit. I realized quickly that this thing was “gonna blow.” I immediately changed my limit to a market order and was filled @1456. Immediately I placed a 1pt stop. It never got hit, and I could see that the tape started running away from my stop. So I decided to “chase” the tape with my stop. Tick by tick, the tape would drop and drop, with barely a retrace. My palms became sweaty from dropping the stop tick by tick. I had blinders on the tape and nothing else - no volume chart, no PnF, no TICK chart, no technical indicators, nothing except the pure, unplugged, unadulterated, raw price action. Finally when price dropped down to 1452.25, it started to change behaviour - it actually started retracing! I knew the end of the run was imminent, but I kept dropping my stop down tick by tick until I got stopped out @1453. Price would later on retrace beyond my initial stop @1457. Only after I closed out the trade did I look at the volume chart, and this is what I saw:

Note that 32000 contracts were traded for the minute that I was in the trade. This kind of price action, where there is literally barely any retrace, just does not happen too often. It is fast becoming my favourite type of trade. Although this seems to be yet another example of a breakout pattern, I think this particular tape reaction pattern is applicable to reversals as well, since I’ve seen this kind of price action during a reversal (although there is admittedly a bit more retrace on reversals).

Why did I take profits so soon, instead of staying in the trade longer?
1. The whole day was choppy, with price swinging up and down for at least 4-5pts each way. In this kind of environment, it becomes even more difficult to distinguish between a benign pullback and a bona fide reversal, so I did not want to overstay my welcome.

2. There was no indication at the time that the market had another 16 point drop in store. And given that the markets had rallied in the last half hour the prior two days, I had no clue what it was going to do in today’s last half hour.

3. There was actually signs that this was a “sweep the legs” flush out and once that happens, price usually reverses back to the congestion area.

4. I did not anticipate nor did I plan for any more downside for the rest of the day.

I don’t know if this sort of reaction pattern occurs more often in a high volatility environment such as the one we are currently in, but I will certainly be looking for more of these in the coming weeks.

This post was contributed by a guest author, and does not necessarily reflect the views of Richard or MovetheMarkets.com

This post was contributed by a guest author, and does not necessarily reflect the views of Richard or MovetheMarkets.com

As a part of my never-ending quest to improve my competency as a trader, I recently turned my attention to the craft of tape reading. Unlike a search on chart patterns or technical analysis, a search on Tape Reading in Amazon will yield only a scarce few relevant results. The topic of tape reading has very little coverage in the trading community, and if I had to guess at the reason for that, it could be because Tape Reading is even more so an art than chart reading. With chart analysis, you could theoretically write down a method and use it to develop an automated trading system, but no one has been able to automate tape reading techniques.

But just because tape reading is more discretionary does not invalidate its merits as a tool.

In my search (aka googling) to learn more about tape reading, I came across an article on this mysterious lost art, written by one of the (new) Market Wizards, Linda Bradford Raschke (LBR). In her article, LBR espouses tape reading as a means of anticipating trade entries and exits, and also to filter out “false” trade signals. This is appealing to me because no matter what technical indicator I use (PMA crossovers, stochastics, ADX, MACD, etc.), all signals based on such indicators will be delayed.

There are three main points to this article:

1. Use a meaningful reference point (such as previous day Hi/Lo, Pivot Points, S/R levels from the daily chart, etc.) to measure magnitude and direction of price action.

2. Monitor the market’s response to a particular condition in order to gauge the strength or weakness of the market.

3. Think in terms of levels. For the eMini S&P 500 futures, a level would be a round number like 1560.

Cool.
As I read through this article, one of the points that I had trouble understanding was the concept of a “whoosh.” I mean, as a student of the scientific method, I just didn’t find “Whoosh” to be a very precise description. LBR describes a “whoosh” as any impulsive price action when the market is near an important reference point. That was a very technical definition which I wasn’t able to internalize until today. In this WallStreak post, I wrote about what I thought might happen as the e-Mini S&P Futures (ES) approached a seemingly meaningless reference point. Then here, I called what I thought would be a double bottom and which would imply support for a move back up to prior resistance levels. Up to that point, the tape was moving slow, and not too many big players (ie. +100 contract size trades) were participating in the 2pt drift upwards from 1564 to 1566. Because the tape was sluggish at 1565, and we had just bounced up from 1563.50, I thought we would be entering a trading range (from 1563.50 to 1565). What happened next really caught me by surprise. The volume tracker started beeping and beeping, as sellers started appearing in droves. In exactly 62 seconds, the price dropped 4 ticks, which is significant, because it had been doing very little prior to that move. The volume tracker also showed that buyers were retreating as the sellers started coming in, since at 10.07:37, there were 500 shares traded at the ask, but the bid/ask still dropped. So, you actually have two components of a “Whoosh”: buyers are retreating (ie. number of bids at a given price level are decreasing), and sellers are increasing (ie. expansion of ask at a given price level). This phenomenon can be seen more easily when watching instruments that are more thinly traded (like Silver futures, or GROW pre-split).

The following characteristics can be inferred from the above picture:

1) Range expansion of the NYSE A/D

2) TICK extreme in the direction of the impulse price action.

3) buyers disappearing

4) Sellers increasing

6) Volume expansion thru the reference point

I don’t know if these characteristics are typical of a “Whoosh.” If I had to guess, I would say that the one about buyers disappearing and sellers increasing might be a common characteristic. But it is certainly worthwhile (for me) to continue studying it.

As it turns out, the whoosh pattern, as I see it, is just another variation of the classical breakout pattern. Nonetheless, it is still a powerful pattern. That’s because once you have correctly identified the “Whoosh” pattern, you have pretty much identified what the herd is doing, so entering in the direction of the whoosh is almost certainly a low risk, high probability trade (within a reasonable time window of opportunity). And that is what I always want, uncovering those low risk AND high probability trades.

The only problem is that this “Whoosh” pattern doesn’t occur consistently, nor does it follow any chart pattern that I know of. There are no technical indicators, nor rules that I know of which tells of an impending “Whoosh” that is likely to happen. A “Whoosh” may or may not happen at an important reference point, there’s just no way of knowing beforehand. I guess what I’m trying to say is that the “Whoosh” pattern can only be identified in real-time by watching the tape.

Ok, so that’s what I got out of this article. As I come across more interesting “stuff” on tape reading, I will share them with everyone.

This post was contributed by a guest author, and does not necessarily reflect the views of Richard or MovetheMarkets.com

I haven’t been backtesting much lately. One problem I have noticed with backtesting trading systems, is that there’s no way to account for the effect that your trades have on the instruments you are trading. I have been noticing that effect more than ever, recently. If you look for it, I bet you can spot it, as well.

It should be obvious, if you think about it, that interacting with the markets can change their future direction. When you buy shares of a stock, no one else can get those shares anymore. So, if there are 2000 offered at a price, and you buy 1900 of them as other market orders come in, chances are good that the ask is about to go up. With all the backtesting systems I am aware of, though, you get your 1900 shares and the system keeps on playing back its canned market data. Unfortunately, in that data, someone else may have gotten the same 1900 shares as you did. In real life, that could not have happened.

But, it’s no big deal, right?

At this point, you might think, “so what? the ask moves up a cent, momentarily…” First off, on some stocks your buy order could eat through 5 or 10 cents of ask levels. Even on a small order, I’ve been victimized a number of times by pesky specialists who find a way to raise the ask, fill my order, and then drop it back down (probably laughing at me the whole time). But, that’s still a small effect, that you could just call slippage in a backtester, right?

I say, wrong. Sometimes even a single cent makes a big difference. It’s like how they say a butterfly flaps its wings in Kansas, and causes a typhoon in Asia (as if foreign countries needed more reasons to hate the US!). What if that one cent ripple is a new high that triggers a wave of computerized institutional buying? After a couple more cents, shorts get nervous about the volume and start to cover. Then, any idiot can see the stock is moving, and more money pours in. etc. etc. None of which would have happened if you hadn’t eaten up a few shares a couple minutes before.

To take it even further, what if all that buying in your stock pushes your sector’s index through an important technical level? Perhaps that causes a huge number of participants to pile on to several stocks, adding more fuel to the fire. Or perhaps not, but it grabs a lot of attention, regardless.

It’s Not Always A Rosy Experience

The previous example is the case we want, where our buying helps cause a wave of additional buying. Score! I’m far from the first to notice that this can happen. I was reading an old elite trader thread about tape reading the other day. In it, someone pointed out that when they are long a stock, they’ll buy 100 more shares at stalled new highs, to keep the ball rolling. (I don’t normally read the elite trader site, but this post from Tyro Trader pointed it out to me.)

However, it’s easy to imagine cases where your effect on the price action can work against you, as well. Take the case where you sell a stock short, and the specialist manages to pull that trick where the bid drops 5 cents just long enough to fill your order. Then, the bid pops right back up. That sucks, but it’s just part of the game, you think. Then, a couple buyers pick up some shares and the stock moves up a couple more cents. Hmmm… What does this look like on a 1-minute candlestick chart? If you sold enough shares short, it can look like a relatively high-volume hammer candle! That’s a bullish signal that could cause trigger-happy speculators to start buying more. The more they buy, the more interest is generated. Had you not shorted those shares, it would just be a flat 2 cent green candle that no one would care about. It might have even gone on to drop hard, just like you imagined when you shorted the shares in the first place!

Continuing the example, let’s say the stock keeps moving up, and you decide you must have been wrong, so you cover your shares. This eats through some ask levels (at which point you swear to yourself you will never trade this stock again!), and causes another wave of buying. The irony is, had you not covered, maybe the stock would have fallen back down.

Then again, maybe not. You’ll never know, and your backtester won’t tell you, either.

Another Example

Your order doesn’t even have to be filled to make a difference in the price action. How many times have you put in a limit order that splits the bid/ask, only to see other buyers step in one cent in front of you? You chase the bid, but they keep one-upping you before you can get filled. Who’s to say that would have happened if you hadn’t put in your greedy limit price?

Just backtest very liquid stocks?

Of course, your influence on a market is minimized if you trade instruments that are highly liquid. Even so, you do have an undeniable effect on the supply/demand when you trade. Further, only the most liquid stocks are truly liquid all the time. To minimize your effect, you should really only enter your trades at times when $/sec churning through the stock is pretty high. I mean, it doesn’t matter that 2 million shares traded in the opening hour, if only a few thousand shares are trading right now.

I’ll add that backtesting fewer shares might help preserve the integrity of the simulation, but it would also make the results useless. You can’t take those results, trade larger in the real markets, and expect proportional results.

Summary

Because of the deficiency I’ve described here, I’ve lost some of my interest in backtesting. Or, at least, I’m now more interested in scanning for potentially good setups, than I am in going through an entire trading simulation. The simulation simply cannot account for my effect on the price action, which is very real. Look for it in your own trades, and you may be able to discern the difference you are making. All too often, I can look at a chart and spot my trade on it. The effect may be pronounced for me, because I am primarily a breakout trader, and often my trades help fuel the breakout (and sadly, sometimes my trade represents the upper wick on the highest candle of the day).