MARKET INDICATORS AND DAY TRADING STRATEGIES
Day traders put their research to work through a range of different strategies. All strategies have two things in common: They are designed to make money, and they are designed to work in a single day. And the best ones help traders cut through the psychology of the market.
Although some trading is handled through automatic algorithms and other programs that place orders whenever certain conditions take place, the vast majority of trading takes place between human beings, who want to make money, in markets where short-term profit potentials can be very small. As much as they want to be dispassionate, traders are going to get sucked into hope, fear, and greed: the three emotions that ruin people every day.
To complicate matters, many markets, such as options and futures, are zero-sum markets, meaning that there is a loser for every winner. Some markets, such as the stock market, have a positive bias, meaning that there are more winners than losers in the long run — but that doesn’t mean that will be the case today.
With thin profit potential and so much emotional upheaval, it can be tough to make money in the long run. In it, I cover some common day trading strategies, and I discuss some of the cold analysis that goes into figuring out the psychology of the markets.
The Psychology of the Markets
For every buyer, there is a seller. There has to be, or no transaction will take place. The price changes to reach the point where the buyer is willing to buy the security and the seller is willing to part with it. This is basic supply and demand. The financial markets are more efficient at matching supply and demand than almost any other market there is. There are no racks of unsold sweaters at the end of the season, no hot model cars that can’t be purchased at any price, no long lines to get a table. The prices change to match the demand, and those who want to pay the price — or receive the price — are going to make a trade.
Despite this ruthless capitalistic efficiency underlying trading, the markets are also dominated by human emotion and psychology. All the buyers and all the sellers are looking at the same information, but they are reaching different conclusions. There’s a seller out there for every buyer, so the trader looking to buy needs to know why the seller is willing to make a deal.
And why would someone be on the other side of your trade?
- The other person may have a different time horizon- For example, long-term investors might sell on bad news that changes a security’s outlook. A short-term trader might not care about the longterm outlet, if the selling in the morning is overdone, creating an opportunity to buy now and sell at a higher price in the afternoon.
- The other person may have a different risk profile- A conservative investor might not want to own shares in a company that’s being acquired by a high-flying technology company. That investor will sell, and someone with more interest in growth will be buying.
- The other person may be engaging in wishful thinking, or acting out of fear, or trading from sheer greed.
- You may be engaging in wishful thinking, acting out of fear, or trading from sheer greed.
It’s highly unlikely that you are smarter than everyone else trading, but you might be more rational and disciplined. In the long run, controlling your emotions and sticking to your limits will make you more money than if you are smart but can’t control your trading. And if you happen to be both disciplined and smart, you might do very well.
Betting on the buy side
Every market participant has his or her own set of reasons and rationales for placing an order today. In general, though, it’s safe to say that although there are many reasons to sell — to pay taxes, generate cash for college tuition, or meet a pension obligation, among many others — there’s only one reason to buy: You think the security is going up in price.
For that reason alone, traders often pay more attention to what is happening to buy orders than to sell orders. They look at the number of buy orders coming in, how large they are, and at what price to get a sense of who out there is projecting a profit. I cover volume and price indicators.
Because there are so many good reasons to sell but only one good reason to buy, it can take a long time for the market to recognize bearish (pessimistic) sentiment indicators. Even if you see that prices should start to go down in the near future, you have to consider that the market today can be very different from what you see coming up. And day traders only have today.
The projection trap
If you took a peek at some of the technical analysis charts, you may have noticed that it’s possible to see what you want to see in some price charts. And if you thought a little about fundamental analysis, you might have seen that it’s just as easy to interpret information the way you want to, too. Instead of looking objectively at what the market is telling them, some traders see what they want to see. That’s one reason it’s so important to know your system and use your limits.
The best traders are able to figure out the psychology of the market almost by instinct. They can’t necessarily explain what they do — which makes it hard for someone trying to learn from them. But they can tell you this much: If you can rationally determine why the person on the other side of the trade is trading, you can be in a better position to make money and avoid the big mistakes brought on by hope, fear, and greed.
Measuring the Mood of the Market
For decades, most traders were rooted on the floors of the exchanges. They had a good sense of the mood of the market because they could pick up the mood of the people in the pits with them. They often knew their fellow traders well enough to know how good they were or the needs of the people they were working for. It made for a clubby atmosphere, despite all the shouting and arm waving. It wasn’t the most efficient way to trade big volume, but it allowed traders to read the minds of those around them.
And now, almost all trading is electronic, and not all those old floor traders have been able to make the transition. Some find that unless they can watch the behavior of other traders and hear the emotions in their voices, they can’t gauge what’s happening in the markets.
Other professional traders, who work for brokerage firms or fund companies, trade electronically, but along long tables (known as trading desks) where they sit next to colleagues trading similar securities. Even though everyone is trading off a screen, they share a mood and thus a sense of what’s happening out there. Some day traders can replicate this by setting up shop at a trading arcade, a business that operates trading desks for day traders, but most traders are working alone at home, with nothing but the information on their screens to tell them what’s happening in the market.
There are ways to figure out what’s happening, even just looking at the screen, and some of these may work for you. These include price, volume, and volatility indicators, and you’re in the right place to learn more about them.
Some traders rely on Internet chat rooms to help them measure market sentiment. This can be risky. Some chat rooms have smart people who are willing to share their perspectives on the market, but many are dominated by novice traders who have no good information to share, or by people who are trying to manipulate the market in their favor. Check them out carefully before lurking or participating.
Pinpointing with price indicators
In an efficient market, all information about a security is included in its price. If the price is high and going up, then the fundamentals are doing well. If the price is low and going lower, then something’s not good. And everything in between means something else.
The change in a security’s price gives you a first cut of information. Price changes can be analyzed in other ways to help you know when to buy or when to sell.
Momentum is the rate at which a security’s price is increasing (or decreasing). If momentum is strong and positive, then the security will show both higher highs and higher lows. People want to buy it for whatever reason, and the price reflects that. Likewise, momentum can be strong and negative, and negative momentum is marked with lower highs and lower lows. No one seems interested in buying, and that keeps dragging the price down.
The exact amount of momentum that a security has can be measured with indicators known as momentum oscillators. A classic momentum oscillator starts with the moving average, which is the average of the closing prices for a past time period, say the last ten trading days. Then the change in each day’s moving average is plotted below the price line. When the oscillator is positive, traders say that the security is overbought; when it is negative, they say that the security is oversold. Figure shows a momentum oscillator plotted below a price line.
If a momentum oscillator shows that a security is overbought (when it’s above the center line), that means that too many people own it relative to the remaining demand in the market, and some of them will start selling. Remember, some of these people have perfectly good reasons for selling that may have nothing to do with the underlying fundamentals of the security, but they are going to sell anyway, and that will bring the price down. Traders who see that a security is overbought will want to sell in advance of those people.
If a momentum oscillator shows that a security is oversold (when the line is below the center line), that means that the security is probably too cheap. Everyone who wanted to get out has gotten out, and now it may be a bargain. When the buyers who see the profit opportunity jump in, the price will go up.
The trend is your friend . . . until the end. Although there are great reasons to follow price trends, remember that they all end, so you still need to pay attention to your money management and your stops, no matter how strong a trend seems to be.
Given that most trends end, or at least zig and zag along the way, some traders look for securities that fit what they call the 1-2-3-4 criterion. If a security goes up in price for three consecutive days, then it’s likely to go down on the fourth day. Likewise, if a security has fallen in price for three days in a row, it’s likely to be up on day four. Be sure to run some simulations to see if this works for a market that interests you.
Trading on the tick
A tick is an upward or downward price change. For some securities, such as futures contracts, the tick size is defined as part of the contract. For others, such as stocks, a tick can be anywhere from a penny to infinity (at least in theory).
You can also calculate the tick indicator for the market as a whole. (In fact, most quotation systems calculate the market tick for you.) This is the total number of securities in that market that traded up on the last trade, minus the number that traded down on the last trade. If the tick is a positive number, that’s good — that means that the market as a whole has a lot of buying interest. Although any given security might not do as well, a positive tick shows that most people in the market have a positive perspective right now.
By contrast, a negative tick shows that most people in the market are watching prices fall. Sure, some prices are going up, but there are more unhappy people than happy ones (assuming that most people are trading on the long side, meaning that they make money when prices go up, not down). This shows that there’s negative sentiment in the market right now.
Tracking the trin
Trin is short for trading indicator, and it’s another measure of market sentiment based on how many prices have gone up relative to how many have gone down. Most quotation systems will pull up the trin for a given market, but you can also calculate it on your own. The math looks like figure.
The numerator is based on the tick: the number of securities that went up divided by (not less) the number that went down. The denominator includes the volume: the number of shares or contracts that traded for those securities that went up, divided by the number of securities traded for those that went down in price. This tells you just how strongly buyers supported the securities that were going up and just how much selling pressure faced those securities that went down.
If the trin is less than 1.00, that usually means that there are a lot of buyers taking securities up in price, and that’s positive. If the trin is above 1.00, then the sellers are acting more strongly, and that indicates that there’s a lot of negative sentiment in the market.
The trin indicator looks at price in conjunction with volume. That makes this a good time to introduce volume indicators.
Volume tells you how much trading is taking place in the market. How excited are people about the current price? Do they see this as great opportunity to buy or to sell? Are they selling fast, to get out now, or are they taking a more leisurely approach to the market these days? This information is carried in the volume of the trading, and it’s an important adjunct to the information you see in the prices. Volume tells you whether there’s enough support to maintain price trends, or if price trends are likely to change soon.
The force index gives you a sense of the strength of a trend. It starts with information from prices, namely that if the closing price today is higher than the closing price yesterday, that’s positive for the security. And that means that if today’s closing price is lower than yesterday’s, then the force is generally negative. Then that price information is combined with volume information. The more volume that goes with that price change, the stronger that positive or negative force.
Although many quotation systems will calculate force for you, you can do it yourself, too. For each trading day,
Force index = volume × (today’s moving average – yesterday’s moving average)
In other words, the force index simply scales the moving average momentum oscillator for the amount of volume that accompanies that price change. That way, the trader has a sense of just how overbought or oversold the security is any particular day.
The on-balance volume is a running total of the amount of trading in a security. To calculate it, first look at today’s closing price relative to yesterday’s.
If today’s close is higher than yesterday’s, then add today’s volume to yesterday’s on-balance volume. If today’s closing price is less than yesterday’s, then subtract today’s volume from yesterday’s total. And if today’s close is the same as yesterday’s, don’t do anything: Today’s balance is the same as yesterday’s.
Many traders track on-balance volume over time, and here’s why: A change in volume signals a change in demand. That might not show up in price right away if there are enough buyers to absorb volume from sellers. But if there are still more buyers out there, then the price is going to go up. Hence, the volume from even small day-to-day increases in price need to be added up over time. If the volume keeps going up, then at some point, prices are going to have to go up to meet the demand.
On the downside, the volume from small price declines will add up over time, too. Over time, it may show that there is very little pent-up interest, indicating that prices could languish for some time.
Many traders look to on-balance volume to gauge the behavior of so-called smart money, such as pension funds, hedge funds, and mutual fund companies. Unlike individual investors, these big institutional accounts tend to trade on fundamentals rather than emotion. They tend to start buying a security at the point where the dumb money is tired of owning it, so their early buying may show big volume with little price change. But as the institutions keep buying, the price will have to go up to get the smarter individuals and the early institutions to part with their shares.
Open interest has a different meaning in the stock market than in the options and futures markets, but in both cases, it gives traders useful information about demand.
In the stock market, open interest is the number of buy orders submitted before the market opens. If the open interest is high, that means that people are ready to add shares to their positions or initiate new positions, and that in turn means that the stock is likely to go up in price on the demand.
In the options and futures markets, open interest is the number of contracts at the end of every day that have not been exercised, closed out, or allowed to expire. Day traders won’t have open interest, because by definition, day traders close out at the end of every day. But some traders will keep open interest, either because they think that their position has the ability to increase in profitability or because they are hedging another transaction and need to keep that options or futures position in place.
If open interest in a contract is increasing, then new money is coming into the market and prices are likely to continue to go up. This is especially true if volume is increasing at about the same rate as open interest. On the other hand, if open interest is falling, then people are closing out their positions because they no longer see a profit potential, and prices are likely to fall.
If open interest in a contract is increasing, then new money is coming into the market and prices are likely to continue to go up. This is especially true if volume is increasing at about the same rate as open interest. On the other hand, if open interest is falling, then people are closing out their positions because they no longer see a profit potential, and prices are likely to fall.
The volatility of a security is a measure of how much it tends to go up or down in a given time period. The more volatile the security, the more the price will fluctuate. Most day traders prefer volatile securities, because that creates more opportunities to make a profit in a short amount of time. But volatility can make it tougher to gauge market sentiment. If a security is volatile, the mood can change quickly. What looked like a profit opportunity at the market open might be gone by lunchtime — and back again before the close.
Average true range
The average true range is a measure of volatility that’s commonly used in commodity markets, but some stock traders use it, too. Many quotation systems calculate it automatically, but if you want to do it yourself, start with finding each day’s true range. This is the greatest of
- The current high less the current low.
- The absolute value of the current high less the previous close.
- The absolute value of the current low less the previous close.
Calculate those three numbers, then take the highest of them and average it with the true range for the past 14 days.
Each day’s true range number shows you just how much the security swung between the high and the low, or how much the high or the low that day varied from the previous day’s close. It’s a measure of how much volatility occurred each day. When averaged over time, it shows how much volatility takes place over time. The higher the average true range, the more volatile a security is.
Beta is the covariance (that is, the statistical measure of how much two variables move together) of a stock relative to the rest of the market. The number comes from the Capital Assets Pricing Model, which is an equation used in academic circles to model the performance of securities. Traders don’t use the Capital Assets Pricing Model, but they often talk about beta to evaluate the volatility of stocks and options.
What does beta mean?
- A beta of one means that the security moves at a faster rate than the market. You would buy high betas if you think the market is going up, but not if the market is going down.
- A beta of less than one means that the security moves more slowly than the market. This is good if you want less risk than the market.
- A beta of exactly one means that the security moves at the same rate as the market.
- A negative beta means that the security moves in the opposite direction of the market. The easiest way to get a negative beta security is to short (borrow and then sell) a positive beta security.
VIX is short for the Chicago Board Options Exchange Volatility Index. The calculation of it is complex enough to border on being proprietary, but it is available on many quotation systems and on the exchange’s.
The VIX is based on the implied volatility of options on stocks included in the S&P 500 Index. The greater the volatility, the more uncertainty investors have, and the more options that show great volatility, the more widespread the concern is within the market. Hence, some consider the VIX to be a gauge of market fear. The greater the VIX, the more bearish the outlook for the market in general.
Traders can use the VIX to help them value options and futures on the market indexes. (For that matter, traders who want to take a position on market volatility can use option contracts on the VIX offered by the Chicago Board Options Exchange.) The VIX can also be used to help confirm bullish or bearish sentiment that shows up in other market signals, such as the tick or the on-balance volume measures described earlier.
In addition to the VIX, the exchange also tracks the VXN (volatility on the NASDAQ 100 Index) and the VXD (volatility on the Dow Jones Industrial Average.)
The volatility ratio tells traders what the implied volatility of a security is relative to the recent historical volatility. It shows if the security is expected to be more or less volatile right now than it has been in the past, and it’s widely used in option markets. The first calculation required is the implied volatility, which is backed out using the Black-Scholes model, an academic model for valuing options. When you plug in time until expiration, interest rates, dividends, stock price, and strike price to the model, the implied volatility is the volatility number that then generates the current option price.
Once you have the implied volatility, you can compare it to the historical volatility of the option, which tells you just how much the price changed over the last 20 or 90 days. If the implied volatility is greater than the statistical volatility, the market may be overestimating the uncertainty in the prices, and the options may be overvalued. And, if the implied volatility is much less than the statistical volatility, the market may be underestimating uncertainty, so the options may be undervalued.
Measuring Money Flows
Money flows tell you how much money is going into or out of a market. They are another set of indicators that tell you where the market sentiment is right now and where it might be going soon. They combine features of price and volume indicators to help traders gauge the market. Although amounts spent to buy and sell have to match — otherwise, there would be no market — the enthusiasm of the buyers and the anxiousness of the sellers shows up in the volume traded and the direction of the price change. Just how hard was it for the buyers to get the sellers to part with their positions? And, how hard will it be to get them to part with their positions tomorrow? That’s the information contained in money flow indicators.
The most basic money flow indicator is closing price multiplied by the number of shares traded. If the closing price was higher than the closing price yesterday, then the number is positive; if the closing price today was lower than the price yesterday, then the number is negative.
In trading terms, accumulation is controlled buying, and distribution is controlled selling. This is the kind of buying and selling that doesn’t lead to big changes in securities prices, and it’s usually because the action was planned. No one accumulates or distributes a security in a state of panic.
But even if the buying and selling activity isn’t driven by madcap rushes in and out of positions, it’s still important to know whether, on balance, the buyers or the sellers have the slight predominance in the market, because that may affect the direction of in the near future. For example, if a security has been in an upward trend, but there are more and more down days with increasing volume, that means that the sellers are starting to dominate the trading and that the price trend is likely to go down.
Here’s the equation:
Accumulation/distribution = ((Close – Low) – (High – Close)) / (High – Low) × Period’s volume
Some traders look at accumulation/distribution from day to day, whereas others prefer to look at it for a week or even a month’s worth of trading.
Money flow ratio and money flow index
Money flow is closing price multiplied by the number of shares traded. That basic statistic can be manipulated in strange and wonderful ways to generate new statistics carrying even more information about whether the markets are likely to have more buying pressure or more selling pressure in the future.
The first is the money flow ratio. This is simply the total money flow for those days where prices were up from the prior day (days with positive money flow), divided by the total money flow for those days where prices were down from the prior day (which are the days with negative money flow). Day traders tend to calculate money flow ratios for short time periods, such as a week or ten days, while swing traders and investors tend to care about longer time periods, like a month or even four months of trading.
The money flow ratio is sometimes converted into the money flow index, which can be used as a single indicator or tracked relative to prices for a given period of time. This equation looks like Figure.
If the money flow index is more than 80, the security is usually considered to be overbought — meaning that the buyers are done buying, and the sellers will put downward pressure on prices. If the money flow index is less than 20, then the security is usually considered to be oversold, and the buyers will soon take over and drive prices up. In between, the money flow index can help clarify information from other market indicators.
Short interest ratios
Short selling is a way to make money if a security falls in price. In the options and futures markets, one simply agrees to sell a contract to someone else. In the stock and bond markets, it’s a little more complicated. The short seller borrows stock or bonds through the brokerage firm, and then sells them.
Ideally, the price will fall, and then the trader can buy back the stock or bonds at the lower price to repay the loan. The trader keeps the difference between the price where the security was sold and the price where the security was repurchased.
People take the short side of a position for only one reason: They think that prices are going to go down. They may want to hedge against this, or they may want to make a big profit if it happens. In the stock market in particular, monitoring the rate of short selling can give clues to investor expectations and future market direction.
The New York Stock Exchange and NASDAQ report the short interest in stocks listed with them. The data are updated monthly, as it can take a while for brokerage firms to sort out exactly how many shares have been shorted and then report that data to the exchanges. The resulting number, the short interest ratio, tells the number of shares that have been shorted, the percentage change from the month before, the average daily trading volume in the same month, and the number of days of trading at the average volume that it would take to cover the short positions.
The loans that enable short selling have to be repaid. If the lender asks for them back, or if prices go up so that the position starts to lose money, the trader is going to have to buy shares in order to make repayment. The harder it is to get the right number of shares in the market, the more desperate the trader will become, and the higher prices will go.
An increase in short interest shows that investors are becoming nervous about a stock. However, given that short interest is not calculated frequently, the number would probably not give a trader a lot of information about the prospects for the company itself. This doesn’t mean short interest doesn’t carry a lot of useful information for traders. It does. If the short interest is high, then the security price is likely to go up when all the people who are short need to buy back stock. Likewise, if short interest is low, there will be little buying pressure in the near future.
High short interest, along with other bullish indicators, is a sign that prices are more likely to go up than down in the near future.
Information Cropping up During the Trading Day
Technical analysis and all the indicators offer useful information about what’s happening in the markets, but there’s one problem: Because so many of those indicators are based on closing prices and closing volume, they aren’t much use during the trading day. And in fact, many traders read through the information in the morning before the open to sort out what is likely to happen and what the mood of the market is likely to be, but then they have to recalibrate their gauge of the market as information comes to them during the trading day. That information doesn’t show up on charts or in neat numerical indicators until the day ends. But there are several sources of information that are updated while the market is open to give a trader a sense of what’s happening at any given time.
Price, time, and sales
The most important information for a trader is the current price of the security, how often and in what volume it has been trading, and how much the price has moved from the last trade. This is the most basic real-time information out there, and it’s readily available through a brokerage firm’s quotation screens.
A discussion of the different quotation services that traders can obtain from their brokerage firms. Although your broker may charge you more to get more detailed quotes, it’s worth it for most trading strategies. Knowing how the price is moving can give you a sense of whether the general mood of the market is being confirmed or contradicted. That can help you place more profitable trades.
High-level price quote data, such as that available through NASDAQ Level II or NASDAQ TotalView, include information on who is placing orders and just how large those orders are. The book gives you key data, because it gives you a sense of how smart the other buyers and sellers are. Are they day traders just trying not to be killed? Or are they institutions that have done a lot of research and are under a lot of performance pressure? Sure, day traders are often very right and institutions are often very wrong, but the information you see in the order book can help you sense whether people are trading on information or on emotion.
An additional piece of information from the order book can help you figure out what’s happening in the market now — namely, the presence of an order imbalance. An order imbalance means that the number of buyers and sellers don’t match. This often happens during the open, because some traders prefer to place orders before the market opens, whereas others prefer to wait until after the open. These imbalances tend to be small and clear up quickly.
However, if a major news event takes place, or there’s a great deal of fear in the market, large imbalances can occur during the trading day. These can be disruptive, and in some cases the exchange stops trading until news is disseminated and enough new orders are placed to balance out the orders.
Although the information contained in price, volume, and other trade data, the actual information that comes from news releases is at least as important.
Much of the news is regularly scheduled and much predicted: corporate earnings, Federal Reserve discount rates, unemployment rates, housing starts, and the like. When this information comes in, traders want to know how the nactual results compare with what was expected, and how this fits with the overall bullish or bearish sentiment of the market.
The second type of news is the unscheduled breaking event, such as corporate takeovers, horrible storms, political assassinations, or other happenings that were not expected and that take more time for the market to digest. That’s in part because these events have the ability to change trends rather than play out against them. In some cases, the markets will halt trading to allow this information to disseminate; in others, traders have to react quickly based on what they know now and what they suspect will happen in the near future.
What’s the difference between risk and uncertainty? Risk is something that happens often enough that people can quantify the damage. Uncertainty is something that might happen, but no one can figure out the likelihood. A fire that knocks out power to Midtown Manhattan sometime in the next ten years is a risk; the invasion of the planet by aliens from outer space is uncertainty.
News can happen at any time. It can change a trend and throw all your careful analysis into disarray. That’s why careful analysis is no substitute for risk management. Watch your position sizes and have stops in place so that you exit when you need to.
Anomalies and Traps
Traders can be superstitious, and that shows up in different anomalies and traps that affect the mood of the market even if there is no logical reason for their existence. You want to be aware of them, because they can affect trading, even if there doesn’t seem to be a justification for them.
An anomaly is a market condition that occurs regularly, but for no good reason. It can be related to the month of the year, the day of the week, or the size of the company involved.
A trap is a situation where the market doesn’t perform the way you expect it to given the indicators that you are looking at. You have a choice: Go with what the market is telling you, or go with what your indicators are telling you.
To a long-term investor, perception is perception. When it’s different from reality, there’s an opportunity to make money. To a short-term trader, perception is reality, because that affects what happens before everyone figures out what’s real.
Bear traps and bull traps
Traders talk about getting caught in traps, which neatly fits the language of bulls and bears. When this happens, they are stuck moving against the market, and that causes them big trouble. After all, day trading is about identifying trends and moving with them, because you only have a few hours to work before it’s time to close out.
In this section, I list a few common traps to help you identify them and, I hope, avoid them. The best antidote for a trap is to take your loss and move on to the next trade.
If you go back and look at some of the sample charts, and if you look at actual price charts created in the market every day, you might notice that sometimes, it’s really hard to tell whether a breakout is false or real, whether a trend is changing or just playing out with a smaller subtrend. A ton of subjectivity goes into reading charts, and some days you’ll read them wrong. You’ll be thinking that you are ahead of the market when you’ve actually just traded against it. Ouch!
Some traders try to work around this by automating their trading. Several different software packages will scan the market and identify potential trading opportunities. But even the best software will misread the market on some occasions. That’s why you need to monitor your positions and make sure you stick to your loss limits.
Way back, I noted that about 80 percent of day traders lose money. So maybe you’re thinking that the way to make money is to just do the opposite of what everyone else is doing. But the reason that they lose money isn’t so much that they are wrong about the trend, it’s that they are sloppy in their trading and don’t limit their losses. (That’s why so much of this book is about the business of trading, rather than the actual mechanics of placing buy and sell orders.)
In a contrarian trap, the trader has made the decision to trade against the market, and that’s exactly what happens: He or she loses money because the market is moving in the opposite direction. Taking a contrary position doesn’t work too well in day trading. In most cases, you have to go with the flow, not against it, to make money in a single day’s session. The market is always right in the short term.
Many trading anomalies follow time periods. That’s not completely unexpected, as many economic and business trends follow the calendar. Companies report their results quarterly. Most close their books for tax purposes at the end of the year. Investors are also evaluated quarterly. Retail sales follow holiday seasons, demand for commodities follows the growing season, and fuel demand varies with the weather. Whatever you decided to trade, you need to do enough fundamental research so that you know how your chosen securities move over time.
But some of the calendar effects make little logical sense, yet they influence trading. Hence, this explanation of the January effect, the Monday effect, and the October effect.
The January effect
Many years, the stock market goes up in the early part of January. Why? No one is entirely sure, but the guess is that people tend to sell at the end of December for tax reasons, and then buy back those securities in January. It may also be that in the new year, everyone is flush with excitement and ready to see the market go up, so they put money to work and start buying.
If stocks go up in January, then you can get a jump on the market by buying in December, right? And that would make prices go up in December. To get a jump on the December rally, you could buy in November. And that’s exactly what people started to do, and the once-pronounced January effect is now weak to non-existent. In an efficient market, people will eventually figure out these unexplained phenomena, then trade on them until they disappear. Use these anomalies as a way to gauge psychology, not as hard and fast trading rules.
The Monday effect
The market seems to do more poorly on Monday than on the other days of the week. And no matter what the evidence shows (and the research is ambiguous and the findings vary greatly based on the time period and the markets examined), many traders believe this, so it has an effect. Why? There are two thoughts. The first is that everyone is in a bad mood on Monday because they have to go back to work after the weekend. The second is that people spend all weekend analyzing any bad news from the end of the prior week, then sell as soon as they get back to the office.
The October effect
The stock market has had two grand crashes and one smaller but profound one, all in October. On October 29, 1929, a day known as Black Tuesday, the Dow Jones Industrial Average declined 12 percent in one day as market speculators caught up with the less rosy reality of the economy. This crash kicked off a general decline that contributed to the Great Depression of the 1930s. On October 19, 1987, known as Black Monday, the Dow Jones Industrial Average declined 23 percent. No one is really sure why it happened, but it did. Then, on October 13, 1989, the Dow Jones declined 7 percent in the last hour of trading when a leveraged buyout for United Airlines fell through.
Because of these crashes, many traders believe that bad things happen in October, and they act accordingly. Of course, bad things happen in other months. The crash in the NASDAQ market that marked the end of the 1990s tech bubble took place in March of 2000, but no one talks about a March effect.