Perhaps one of the most stressful and difficult challenge for momentum trader is to identify whether counter trend move against us represent a change of trend or just a pullback move which stop all newbies out of the market before the trend continues its march.
Fortunately, we have market breadth statistics to help us do just that in the stock market. The premise is that market trend requires participation of all common stocks. Market trend cannot be sustained by trending move in just a handful of highly capitalized stocks.
In a bull market, money flows to the stock market as risk appetite grows and ultimately reach lower quality stocks. When risk appetite is not that great, only the best quality of them will continue to rise.
Near the end of a bear market, less and less stock participate in its march down. Higher quality stocks which were sold during the panic will be accumulated by those in the know. As a result, participation to the downside diminish. Before the market return to bull market, though, participation from lower quality stocks is needed before a bull market can be sustained. Often, this start with bang! There will be repeated days with high number of stocks being accumulated without high number of stocks being distributed in between.
Now assume there is a tendency for the market to move in a manner necessary to frustrate the majority of players. Short lived counter trend move is one such way for the market to frustrate the majority of us because it will turn our profitable position quickly into a loss and leave us behind before the market move in our favor again — but without us. Nothing is more frustrating than this. Money will flow from the accounts of these frustrated newbies to those few with more experiences.
Now, what is the most cost effective way for a counter trend rally in the market indexes to happen? Yes, move the few stocks with the most influence in the indexes. These are usually highly capitalized and liquid stocks. Being liquid, the transaction cost of moving them is minimal. Being highly capitalized, its move significantly affect the index. This operation cannot be done in less liquid small cap stocks. This is the key to the success of market breadth statistics in separating real trend change versus counter trend move in market indexes.
Thus, trend change requires wide participation among common stocks to significantly move in the same direction while counter trend move is associated with sharp move in market indexes without wide range participation from common stocks.
This concept applies to both intermediate (weeks to months) as well as intraday horizon.
Let’s have a look at intermediate horizon which is suitable for Swing trader and Position trader. Below is my latest reading of raw breadth statistics up to 22 Sept 2011. Look at the 7th row where I put three circles there. This row count the number of range-bound stocks which are being accumulated or distributed with high volume. Notice that the green up bars (accumulation) during reflect bounce is dwarfed by the magenta down bars (distribution) during down leg. Perhaps you noticed this yourself when you hardly found many swing trading setups. What I saw here convinced me that the bounce where just counter trend rally. Indeed, my mechanized timing system haven’t issued a single bullish signal since 27 July 2011.
Pay closer attention to 27 July. You notice very huge spike in Magenta down bar (range bound stocks being distributed), more than double what you have seen prior to that day in 2011. This is a very bearish sign as it occurs after a series of smaller sized Magenta bars in the preceding two weeks. Once such day happen, usually two sequence of events take place: (1) selling tapper off as there is enough bottom fishers, or (2) a chain of selling events compounded as stops were hit until exhaustion takes place — not much different from atomic chain reaction where the explosion gets larger until the mass are all converted into energy. Following 27 July, the second scenario unfold. When this happen, you should look for the end of it… Where the stops are all hit. Where the mass in the chain reaction are all used up. In this case, you look at the 6th row. This shows the number of down trending stocks which were distributed on high volume (dark red bar) or the number of up trending stocks which were accumulated on high volume (dark green bar). Soon after 27 July, the dark red bars just explode day by day. Until it stops on 9 August. This is where you should have identified the end of panic selling. From here, another down leg or consolidation might occur. Same process can be observed in 2002 and 2008.
We should not preempt the end of panic selling by looking at some statistics dropping into certain pre-defined level as oversold. Whatever that statistic, it can go much lower and much longer. Instead, we wait until the selling has really ended.
The following graph show market reaction just after Fed announcement on 21 Sept. Notice the bounce in Emini S&P futures is not accompanied by significant bid-ask volume on NYSE stocks.
Same thing happened yesterday, Emini futures rose sharply around 2:20PM but bid-ask volume barely budge. On the last hour, the buying was barely supported by breadth. Thus I should be skeptical on whether it will be followed through.
You can be creative and create your own market breadth statistics. But each should provide a different angle. The bid-ask volume is publicly available. In addition, I created my own intraday breadth statistics to detect program trading and exhaustion among influential stocks. All in the purpose of separating real trend change and counter trend move. But it should be noted that if you can detect it early enough, participating in counter trend move can be hugely rewarding. I believe this requires understanding of how program trading is executed and how counter trend move is initiated with minimal cost.