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How to Trade - 3: Using Breadth, Strength,and Momentum to Track Market Cycles

The first post in this series focused on market understanding, building upon the foundation of price, volume, and time.  This led us to the core idea that edges in trading come from buyers and sellers coming late to market moves and becoming trapped when demand/supply cannot move the market higher/lower.  It is their need to exit their positions combined with the new activity of value sellers/buyers (participants at higher time frames) that creates the market moves that active traders can exploit.

The second post in the series elaborated two important ideas:  context and cycles.  The rise and fall of supply and demand creates cyclical and trending movement in stocks and markets.  The complexity of market behavior is, in part, a function of longer-term trends and cycles nested within one another.  Understanding market behavior requires placing shorter-term movements into the context of larger trends and cycles.  A directional trading edge can occur when we can utilize our understanding of shorter-term cycles to find good risk/reward spots to participate in trending movement.

There are unique measures that enable us to track the waxing and waning of buying and selling pressure, such as the uptick/downtick and bid/ask volume stats described in the first post and the idea of event time as captured in the second post.  In this post, we will take a look at measures of breadth, strength, and momentum as important metrics for capturing the phases of market cycles and trends.  The next post will begin integrating all this information by applying to recent markets.

Before we get into the breadth, strength, and momentum measures, however, I'll offer a perspective grounded in trading psychology. Any form of greatness and exemplary achievement requires the capacity for sustained, directed effort.  Whether it's starting a business, pursuing a scientific discovery, or writing a book, it's our ability to see a larger picture and sustain the pursuit of that vision that makes achievement possible. The majority of traders do not succeed because they simply do not--and perhaps cannot--sustain the effort required to properly understand markets .  This inability to sustain effort results in the adoption of simplistic trading techniques that inevitably fail.  False trading gurus, operating under the guise of trading educators, are all too happy to exploit this need/desire for simplicity.

Markets contain many moving parts, with participants operating on different time frames and responding differently to new price and fundamental information.  Correlations among market components shift over time; the factors (momentum, value, carry, etc.) driving markets rise and fall over time; volatility shifts over time; and we move from trending/directional periods to range bound/consolidating ones across all time frames. There is nothing simple about markets, but it is our need to (over)simplify them that creates a great deal of our losses and emotional reactions to those .  Only the capacity to sustain the effort to achieve an understanding of market behavior allows us to adapt to continual shifts in price action.

Breadth refers to the balance between rising and falling stocks within the market universe.  The classic measure of breadth is the advance/decline line, but we can think of uptick/downtick measures, such as the NYSE TICK, as indicators of instantaneous breadth.  The key idea to keep in mind is that strong trending markets reflect a broad demand or supply for stocks as an asset class. When we see extreme breadth, we want to be thinking in trend terms.  Other times, markets may move higher or lower on modest breadth.  Often, these are markets dominated by sector rotation.  There isn't a broad increase or decrease in the demand for equities, but rather a shift from one type of stock (growth, small caps, or industrial) to another (value, large caps, or consumer discretionary).  As we will see in upcoming examples, recognition of the breadth environment can help us determine what to trade and how to trade it.  We would trade a potential trend day in the market differently from a rotational, range day, for instance.

Related to breadth is the notion of market strength, which captures the number of stocks displaying unusual upside and downside characteristics.  The classic measure is the number of stocks registering fresh 52-week new highs versus new lows.  Very often we will see skewed positive or negative new high/low balances during trending markets. It's when markets advance or decline with fewer new highs/lows that we begin to entertain the idea of a maturing market move.  To complement the standard 52-week measure, I also track the number of NYSE stocks making fresh one- and three-month new highs and lows (data from Barchart.com) and the number of SPX stocks making fresh 5, 20, and 100-day new highs versus lows (data from Indexindicators.com).  I also follow the major market indexes and sectors in real time to see if SPX moves to new highs/lows are accompanied by similar moves in the various components of the market. Together, breadth and strength tell us a great deal about the sustainability of market moves.

A recent addition to my arsenal of tools has been measures of market momentum.  We can think about momentum as a second derivative of price movement; it captures rate of change.  The key idea here is that momentum tends to wane before we see actual reversals of price moves.  Some of the momentum measures I follow have been doing a nice job of anticipate reversals of directional moves.  These measures include the percentage of SPX stocks trading above their short, medium, and longer-term moving averages (data from Indexindicators.com); the number of stocks crossing above/below their 20-day moving averages (data from Barchart.com); and the number of stocks registering buy versus sell signals on various technical trading indicator/systems such as RSI and Bollinger Bands (data from StockCharts.com). A nice way to think about all this is that we're constantly updating our views of momentum, strength, and breadth to revise the odds of a market move continuing or reversing.

Expertise in trading requires experience and skill in integrating this information in real time.  This requires a capacity to sustain focus, the ability to process many pieces of information at one time, and the ability to detect meaningful patterns among these pieces of information.  This makes short-term trading very different from longer-term investing, which looks at different information and processes that information at less frequent intervals, but often across multiple markets/asset classes.  Success in markets requires a lining up of our cognitive strengths with the demands of the kinds of trading/investing we're performing.

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