How Market Internals Can Help You Read the Market
By Joanna White, CapitalDiscussions.com
Market Internals can be used to give you an overall feel of the market direction. The market internals are similar to a compass or the instrument panel on your car. The internals can give you a sense of the speed and direction of the market. The internals can give you the overall strength or weakness in the market.
This can help you determine if you are neutral, bullish or bearish. Then you can plan your trades according to your market bias. The internals are used for the most part for the equities markets. There are several market internals which can be tracked and this article is based on the NYSS.
Up Volume vs. Down Volume Chart or Breadth Chart
The first chart to set up in your grid is the $UVOL-$DVOL 15 minute chart. This chart allows you to see the breadth of the market. $UVOL-$DVOL measures the amount of volume moving into stocks which are increasing in value to the amount of volume moving into stocks which are decreasing in value.
You can get a sense of the market by looking at the ratio of the $UVOL-$DVOL. If the ratio is plus 2 to 1 or greater, the market could be considered to be bullish. If the ratio is negative 2 to 1 or greater, the market could be considered to be bearish.
Advance Decline Line or AD Line
The $ADVN-$DECN or advance-decline(AD) line is the next chart to set up in your grid. It tracks the NYSE. Use the 15 minute time frame for this chart. The advance-decline line chart looks at the difference between the number of stocks which are advancing minus the number of stocks which are declining.
When the price action is hovering around the zero line on the AD chart it usually shows a market with very little confidence.
A strong reading on the AD line chart is usually above the 800 or 900 level. Extreme readings are around the 2000 area. Reversion to the mean days will be around the plus or minus 500 area and the price action will be oscillating above and below the zero line.
If the chart level reaches the plus 1500 area, the market can be considered to be bullish. If the chart level reaches plus 2000, the market can be considered to be very bullish.
If the chart level reaches the negative 1500 area the market can be considered to be bearish. If the chart level reaches negative 2000, the market is considered to be very bearish.
The TICK Chart
This chart tells you how many stocks are trading on an uptick verses the number of stocks trading on a downtick at the exchange level. This tick chart is looking at the NYSE. Many traders use either the 5 or 15-minute chart. Some important levels on the chart to consider are the plus 800, the plus 1000, the negative 800 and the negative 1000.
The tick chart many times is used to gauge very short term market extremes. The tick chart readings usually range between the plus 700 to plus 800 to minus 700 to minus 800. When you see plus or minus 1000 on the tick chart, this can be considered to be a large extreme. Usually, these large extremes signal a short term reversal may be coming. Many times day traders will use these extremes to see when a short-term market reversal may occur. Some say the tick chart is one of the most important tools for day traders.
Tips to Read the Tick Chart
The tick chart for some day traders is very important. The tick chart can affirm or deny how a trade progresses before or after you enter a trade. You can use the tick chart to monitor your trade.
On strong trending days the tick chart will read plus or minus 1000 multiple times. The tick chart is the fastest of the three market internals.
To get a feel for the tick readings look at the body of the candle to see if most or all the candle is above the zero line or below. This will give you a sense of the market. If the candle bodies are mostly above the zero line it can signal a bullish bias. The opposite can signal a bearish bias.
The 5 or 15 Minute Price Chart
When you set up the price chart of the underlying market many use ES; some use SPY, SPX, etc… Many traders use a 5-minute chart or a 15-minute chart. I like to use the 21 EMA. Some use pivot points on their price charts. Set up the indicators, moving averages, etc to whatever parameters allow you to read the price action on a chart. What makes you comfortable is best.
The Internals Can Help You Confirm Your Trading Decisions
By evaluating the internals using convergence and divergence, you can create a market opinion. When you see changes happening in the price of the underlying that are not evident on one or more of the market internals, such as the advance-decline line or the tick chart, this could be a signal of divergence.
If you are evaluating a directional bullish position, you most probably want the market internals to be bullish. If you are bearish on the market and want to make a directional play, you most probably would want the market internals to be bearish. The internals can help you to confirm your decision.
If you are the type of trader who does not like watching charts throughout the day, you can get a sense of the general market by looking at the internals. The internals can give you a quick overall synopsis of the market, which can be a large time saver.
Market Context and the Internals
When you use the internals it is important to reference the price action on the price chart of the underlying(s) you are trading. By looking at the longer term highs and lows, previous day highs and lows, pivot points, channels, congestion, swing highs and swing lows etc., you can then relate the internals to your overall market outlook.
A choppy market can be reflected in the breadth which is the $UVOL-$DVOL chart. If the ratio reading on the breadth chart starts with a 1, the market is choppy and not trending. Price action will be ranging close to the zero line on a choppy day.
When you have a trending market the breadth ratio will generally get above the 2 to 1 ratio.
Reading the Internals is an Art and not a Science…
Learning to read the internals takes a lot of practice. Understanding the internals is an art and not a science. It will most probably take you some time to learn, but it could well be worth the time invested. You can use the internals to look at the overall market to gain a general bias of the markets. Or you as a day trader can learn the signals provided by reading the internals to guide you in your trading. Use your edge and use the internals to be a consistently profitable trader.
Backtesting – Is it Worth Your Time?
I think we can agree that understanding market internals can be a significant aid in helping you decide when and how you may want to enter and exit a trade. But, it takes practice and “feel” to gain a real appreciation for how market internals can be best put to use. For this reason, I cannot emphasize enough how important it is to backtest any new trading idea or recommendation before you risk real capital.
Some traders are of the mindset of “what good is backtesting if it doesn’t always replicate real-life trading?”
It’s true that backtesting isn’t the same as live trading. It doesn’t recreate all the emotions and the market conditions such as low-volume days when you just can’t get a decent fill, news events that can cause erratic market behavior intra-day, etc. However, what backtesting does do is to allow you to keep trading a workable trade during a period of draw-downs and be confident that overall, the trade is profitable. backtesting gives you a track record that instills confidence in your trade plan.
What else does backtesting do for you?
- Backtesting could keep you from abandoning your trade plan.
- Backtesting could help you from over-adjusting because your testing results confirm your adjustments as planned have a higher probability to work as intended.
- Backtesting could prevent you from jumping around from one trade to another.
- Backtesting could give you confidence in a new trade strategy, or in an existing strategy when considering increasing the size of the position.
- Backtesting could minimize the paralyzing insecurity that sometimes accompanies the switch from paper trades to live trading.
What if you don’t have backtesting capabilities?
If you don’t have backtesting capabilities, almost all brokerage platforms allow you to reset certain parameters in your trade or a simulated trade setup looking. This allows you as a trader to look at possible future results you may encounter as the trade matures. This may include rolling implied volatilities up or down, changing the date, or changing the price. If you are a trader without backtesting capabilities, you could test your trades in this manner if your platform has the capability to determine how it might act theoretically in certain market conditions looking into the future. You could follow a trade through each expiration cycle on a simulated basis. You as a trader could also simulate several expiration cycles, always pre-testing how certain adjustments might work. Then these simulated adjustments can be monitored with your live position to determine if they worked as predicted in your simulation.
So, how does your backtesting and simulating trades relate to live trading?
Don’t underestimate the importance of your trading style and confidence level when evaluating a back-tested trade. A good result of your back-test can make your trade plan mechanical, as much as possible. By becoming more mechanical due to your backtesting, your experience will allow you to act as your trade plan dictates, making the necessary adjustments to your trade at the proper moments.
You can’t replicate all the hurdles of live trading with either backtesting or forward-testing, but it all helps. It’s about building confidence in your trade. Your confidence can help you follow your trade plan and guidelines. This confidence can allow you to enter, make appropriate adjustments if needed and exit your trade as planned in your live position.
The quote below can be related to the benefits of backtesting:
“Your primary goal has to be to learn how to think like a consistently successful trader. Remember, the best traders think in a number of unique ways. They have acquired a mental structure that allows them to trade without fear and, at the same time, keeps them from becoming reckless and committing fear-based errors.”Mark Douglas
In summary, whether you have a backtesting program or use your broker’s simulated trade capabilities, test, test, test. Test a lot. Testing can help identify potential pitfalls and potholes. However, it’s important to be aware that when you’re ready to make the switch to live trading, that testing can act somewhat like sunlight on rain-slicked roads. All that shiny sunlight can bounce off the water, covering a pothole that can cause you to veer off course. Don’t speed into live trades too quickly; drive carefully until you’re feeling certain of the surface beneath you.
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