The Lawrence Chan Blog

Market breadth analysis is a lesser known analysis tool comparing to price patterns or technical indicators. As there are not many technical papers and books written on the subject, most people would have no choice but to refer to the older information on how to utilize the market breadth statistics. The problem with the classic interpretation of the breadth data, however, is that the observations were done many years ago while the breadth data themselves are changing rapidly as the stock markets worldwide have been undergoing major structural change over the past 10 years.

I am going to show you the changes happened to the advance / decline issues breadth data over the past 14 years and how these changes can affect classic breadth studies.

A 30-Minute Chart Covering Past 14 Years

Following is a 30-minute chart of Emini S&P 500, NYSE Advance Issues, NYSE Decline Issues, NYSE Total Issues Traded and NYSE Percent Advance Issues. Data appear in the chart from top to bottom in the order listed.

This chart may appear as a highly compressed chart of some very noisy data with the exception of the S&P Emini contract. This overall impression of the data series is correct. The advance issues and decline issues data are very noisy data. There are no rules bounding what will be traded everyday. Hence, we never know exactly which issues are traded on any particular day.

But do we really have no idea what will be traded at all?

The truth is that it is pretty safe to assume that the most actively traded issues today will likely be at least traded quite actively tomorrow even though they are not necessarily turning up as the most actively traded issues again. There is the exception that if an issue is halted for whatever reason, we will not be able to trade it until it re-opens again. But that is exceptional situation and is rare. In general, over long period of time, certain stocks will fade away from being the trading community’s favourite while a new batch of stocks will replace them gradually.

Common Sense Expectations

What are we suppose to see from the breadth data based on the common sense thinking stated above?

First, the number of issues traded should be unstable. From the time the stock market open until the end of a trading day, many stocks should have been traded lightly only while just a small set of stocks would have the focus of the active traders. We should see that every day the total number of issues traded should start from a small number and increase to the usual expected norm.

This is indeed what happened back in year 2000 and many years before that. Every trading day back then the NYSE would start from low 2000 issues trading in the first 30 minutes and then climb up to the average at the time around 3000 issues. Some trading day you have a lot more total issues traded while some days you have significantly fewer ones traded. The data did not stay in a static range all the time.

Sudden Change In Characteristics

After year 2000, something interesting happened. Notice the obvious tightening of the daily range of the issues traded. This process continues even though the S&P was going through its first prolonged major decline. This development did not stop after the major bottom back in year 2003. The daily range of the traded issues continue to contract all the way until end of year 2007 right before the start of the financial crisis.

Since end of 2007, the stock market has declined in the overall number of issues traded by abut 10% and settled in a very unusual stable horizontal range. A range that is not possible unless some form of control is applied to the stock market as a whole. I am not implying conspiracy theory here as many would jump to that conclusion immediately. What I am thinking of is way more interesting.

My guess is that majority (if not all) of the stocks in the stock market are now handled by market making bots. These bots are all similar in design and they are all designed to take advantage of potential intraday change in market direction by observing what all other stocks are doing. All kinds of metric are used to position these bots on the right side of the market. Thus many of these bots simply make the same decision during the day at the same time, almost all the time. Do not underestimate the power of these market making bots. When they are all doing the same thing across almost all the traded issues, it could easily force the market moving with extreme intraday swings in majority of the stocks going from one direction to the other.

Overall Stability From Totally Broken Internal Structure

My conjecture above is supported by the evidence in increased range in the percentage advance issues intraday. The first phase of the increase happened back in year 2000 but it was masked out by the huge bear market. At that point in time, it was difficult to determine if the increase in percentage advance issues was a function outside of the volatile bear market. With the benefit of several years of rising market condition, we can now see clearly how messed up the overall stock market is right now.

The higher intraday volatility in percentage advance issues tells us that this synchronization of stocks moving together is a very dangerous game. Should the bots all bet wrong on the same side just once, there is no telling how fast the market will move as every bots will try to exit at market at the same time. We have already seen this happening several times. We have also seen how authorities using this market behaviour to adjust the price level of the indices at will.

Classic Breadth Analysis Methods Seriously Challenged

This change in characteristics of the advance / decline issues has caused serious setback in the classic breadth indicators depending on them.

Due to the way the advance issues are bounded in such a tight range, the original intention of detecting extreme buying or selling with these breadth indicators cannot work properly anymore. Without the natural swings in the advance issues observable up to year 1999 to year 2000, many classic breadth indicators were producing indicator patterns that do not resemble anything before year 2000. That caught many casual technical traders off guard as they are not really familiar with the behaviour of these breadth indicators.

Since end of year 2007, the advance / decline issues data has become even more controlled. This in turn messed up the classic breadth indicators further. Many of these breadth indicators are perfect market timing tools in the last century. Now, they can no longer produce the highly accurate timing signals they were famous for.

One of the main weaknesses with many of these classic breadth indicators is the use of moving averages to smooth out the raw data. When the raw data no longer has the cyclical characteristics, the smoothing of the raw data would either delay the signal for too long, or, dampen the information from showing up at all. Potential solution to this problem is to adjust the smoothing method that may in turn leading to new ways to interpret these classic indicators in the current environment.

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Anyone interested in trading the stock market indices have to choose among many alternatives available nowadays. Finding out the specific financial instrument that is best to trade with can be difficult. After all, who would have imagine that index trading has become such a big hit among the trading instruments. Currently, there are three most common choices to choose from – CFD (contract for difference), ETF and index future. They all have their strength and weaknesses. I will explain in this article what they are good for in different situations.

Index Future Is Best Overall For Its Liquidity

One of the most important characteristics that a market need for better trading experience is good liquidity at the bid and ask level. This is known as having a tight spread. With tight spread, you can enter a trade at market price and exit right after with just one tick loss, the smallest increment of the price.

The most common index future contract in North America is the emini S&P. During normal trading hours, you can consistently find several hundred contracts at both the bid and the ask price where they are just one tick apart. This makes it easy for small traders to enter and exit the market without serious slippage issues most of the time.

Slippage is the daunting issue of not being able to get fill at a reasonable price with a market order. The moment you try to enter an order at market, your order could be one of many other orders trying to do the same. In a market with liquidity issue, there will not be enough pending orders in the price book to absorb all the orders. Hence you may get a price worse than what you think you are suppose to get.

Many index future markets are very liquid, making it possible to enter and exit the market with predictable precision (i.e. limited slippage). Due to the limitation with day trading, a trader may not have enough time to wait for a fill for the orders. Thus it is important to be able to get in and out of the market quickly whenever it is needed.

Good liquidity makes index futures best among the three classes of index markets for day trading and trading in general.

Index CFD Is Best For Small Traders Learning To Swing Trade

CFD is short form of Contract For Difference. It is a special kind of market. CFD is not a standardized instrument listed on exchanges. It is essentially a betting instrument provided by a firm for you speculate in the particular market you are interested in. There are stock CFDs, commodity CFDs and other types of CFDs. CFD is very popular in UK because it is considered as a kind of betting as oppose to trading in regulated trading instruments like stocks. So technically it is tax free to speculate in CFDs in some parts of the world.

Lately, CFD is introduced to North America by several big CFD / Forex firms. Regulators in North America have been very picky about the way CFDs can be offered thus the availability is very limited and not everyone can open an account with these firms to trade CFDs. One of the original selling point of trading CFDs is the ability to use  very high leverage. Due to the restrictive regulations, the CFDs offered in Canada and United States require higher margin, making them not as attractive as the offerings by the same firms in Europe.

The advantage of CFDs is the ability to trade in micro lot size. Hence you can be a speculator without risking the kind of money that index futures would require. Most of the bigger CFD firms offer their own order placement software with real-time quotes tracking the actual underlying index or index future pretty closely, so trading the CFDs is not that much different from trading the real thing.

The disadvantage with CFDs is that these firms offering the CFDs have to make money off the spread of the price. Spread is the difference between the best bid and ask price at any moment. From my experience, there are firms whose spread is about 0.5 point of the S&P and there are firms offering spread at as low as 0.15 point. The difference is huge and would add up quickly if you are going to move size with them.

Another issue with trading CFDs is the firm you are going to trade with can be the source of problem. Remember that CFD is offered by the firm for you to bet on. The firm offering you the service is essentially betting against you, unless it is big enough with many clients so that the risk is properly distributed among the clients. The firm can also offset its risk by proper hedging against the bets placed by the clients automatically. A CFD firm that hardly making any money may choose to scam money from its clients through rigged bid/ask pricing. Hence the size and reputation of a CFD firm is very important when you are considering to open an account with one.

As a whole, the weaknesses in CFDs making it not the best choice for day traders. On the other hand, if you are trading very small size to learn to swing trade the indices, it is a very reasonable vehicle to work with. For example, the regular margin requirement for trading 1 emini S&P contract would allow a trader to trade 50 units of S&P CFD. That will allow very efficient scaling in and out of a position similar to a sizable hedge fund.

CFD is a great choice for anyone whose interest is swing trading the indices and that the position size is not going beyond the equivalent of say 10 contracts in emini S&P.

Index ETF Is Needed For Special Account Requirements

For those whose investment / trading capital being locked in special accounts like the Canadian’s RRSP and United States’ IRA, they may not be able to trade index futures nor the index CFDs. That pretty much leaving just the ETFs as the only choices to trade the indices.

There is no special advantage to trade the ETFs (e.g. SPY). A standard lot is 100 shares. Going below the regular lot size your trade may have to be routed to odd-lot dealers as oppose to directly handled through the regular channels. If you have very small size trading account, trading ETFs is not as flexible as trading CFDs.

Day trading ETFs subjects the trader to the pattern day trader rule (PDT) which enforces a minimum account size for those involve in entering and exiting their holdings within a day or two. That raised the barrier to entrance for the small investors to proper investing. As they cannot learn to trade properly before raising enough money to cover the PDT minimum account size, it would in turn making sure that they would more likely losing money instead of making it in the stock market due to lack of trading experience.

If a trader has enough trading capital and experience, trading ETFs is not necessarily a bad thing. The advantage includes capital gain tax rate, special dividend treatment and reasonable liquidity. For certain parts of the world including Canada and United States, stock brokerage accounts are insured up to certain limit so it has the advantage of extra protection from brokerage firms.

The main advantage with ETFs like SPY is the potential of cheap commission. Some brokerages offer very low commission rate to ETFs traders that is comparable to, and often better than, the index futures commission rate. The catch is that trading ETFs requires more margin in general so those traders who are not trading with special brokerage accounts would be under utilizing their trading capital significantly.

In short, ETF works very well for those who are not looking for high leverage, have capital well beyond the PDT rules (or if that does not apply to your country) and the trading experience to utilize them.

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"How much money will I make trading Forex?" is the question I am going to answer in this article.

I have posted another article, Position Sizing For Forex Traders and CFD Traders, that serves as the basis on the position sizing that will be used in this article. If you find that the assumptions in the sections below are too conservative to your taste, you can check out that article for the reasons behind.

This article is long so get yourself a cup of coffee (or tea, or energy drink, or whatever) and take your time to read it.

The Importance Of Patience

Many forex traders and CFD traders think that they need exceptional luck to make big bucks trading forex. That is not true. To make good money trading forex consistently, all you need is a half decent trading strategy with matching trading capital. You may not start out with enough capital to make a lot of money in the beginning, but that is not important. What is important is that you have to be consistent in executing your trading strategy so that you can accumulate enough trading capital.

In a sense trading forex and CFDs with very small starting capital is like the professional poker scene. Majority of the professional poker players learn their skills from trading tiny bet size tables. They do not play just a few times or even a few hundred times at those tables to gather their initial stakes for buy-ins to the major poker tournaments. They played thousands of hands to accumulate both experience and bankroll.

These professional poker players can make a decent living by continue playing poker games at tables (both real ones and online ones) offering bigger bet size. But some of them would choose to enter major tournaments to see if they can get a big break. Those who enter the major tournaments using all the money they gathered for the buy-in may not be able to take home any prize money, hence losing all the gains and have to start all over again.

In this case, those poker players are doing the same thing like the forex and CFD traders who raise their position size significantly disregarding the risk of losing everything in the trading accounts. If things work out, of course, the trader would be looking at a significant boost in the available capital to trade with. Well, if things do not work out in the trader’s favour, this trader has to start all over again.

There is no absolute right or wrong in a situation where raising the position size so much that the risk of losing all the money in the trading account becomes a real possibility. Every market scenario unfolding in real-time are different. That is the probabilistic nature of the markets. Just make sure 1. you understand the possibility of losing the account is real and possible, 2. you have considered the consequence, and most important of all, 3. prepared mentally to handle the negative outcome.

Before you get to the point of facing this decision, however, you have to have the patience to grind through the bankroll accumulation process.

Power of Scalability

Forex and CFD trading offer the most flexible position sizing options available to small traders. Hence it is possible to increase position size steadily to improve overall performance. Following is the projected performance of a trader trading euro dollar multiple times a day with average profit of 20 pips per trade expectancy and that the trader would adjust his position size every 100 trades.

Notice that in the beginning the profit per trade is expected at $6. It is a small amount. And many people who do not have experience trading would have the urge to increase their position size quickly so that they can make more money faster. The problem is that increasing position size too quickly will easily ruin the account if it is not done properly. Hence, focus on the the potential and stick to a plan that is reasonable and doable is always better than rushing towards the finish line.

Given the example above, which is not that remote for many day traders who pay attention to the price movement closely, a day trader who do 3 to 5 trades a day will likely reach 100 trades within a month or two. A very consistent trader having a stable strategy and following this plan with no accidents and no deviation from the execution of the plan, would be able to accumulate an ending balance by the end of the year (or by the end of the 600 trades) would be $48,500.

I leave out the calculation on next few levels of position size from the table. If you are paying attention, you will be able to figure that out easily. You will also be able to figure out the profit potential the same way.

This is the power of scalability. The very same trading strategy that generates only $6 per trade on average in the beginning can also generate $264 per trade on average when it is executed with position size of $132,000 instead of the original $3,000. A position size of $132,000 is not a big one in the forex markets at all. Moving positions of size $300,000 to $500,000 is also not a problem during busy market hours. Beyond that, you will have to think about your impact on the market with your orders in illiquid conditions.

Liquidity And Slippage

I just show you a very simple growth plan trading forex. It exists and it is possible to do it. It may take you 6 months. It can take you 3 years. The time needed to get to the point where you have a decent size trading account varies depending on the person. It is not something you can rush.

Just remember that by the time you get to the point of $200,000 position size, you need to stop increasing your position size at the prescribed rate. You have to start working on strategy that enables you to trade even bigger position size, or, diversify into trading other forex pairs.

Why diversify from a winning strategy when it is working so well?

The problem lies in the fact that the approach which works with small account size are mainly scalping strategies. Some people call that trading the flow. It enables you to get a piece of the action in the market and works very well up to certain extend. Such strategies will have execution problem if you try to do it in large scale. Slippage becomes a very real problem when your average profit is just 20 pips and that slippage eats into that by 5 pips or more.

Depending on the brokerage you use and also the exact strategy you are using, you may be able to push the position size larger but eventually at $500,000 range you will have to deal with the liquidity issue still. It is better to resolve the problem by keeping your current strategy to work on a reasonable size so that you have capital allocated for diversification into trading other forex pairs and/or strategies.

The Bottleneck

Consider the transition from the small account size (less than $50,000) to reasonable account size or trading capital (up to about $200,000) as the bottleneck period, it is the the most likely time when a good trader who can turn, say, a $5,000 account, into $30,000 in months, going busted in just a few weeks. A trader who can run the account up 6 times the initial capital is not stupid. The trader obviously has done something right. The problem, however, is that along the way in accumulating the capital, unlike playing pokers, the trader can easily deviate from his original working strategy to optimize for the current market environment.

Even a slight change of a good strategy will drastically modify the risk profile and performance of the strategy. In this situation, however, the trader most likely does not even know he is drifting away from his working method because relaxed money management can often get away in certain market conditions that are more forgiving. Hence it is important for the trader to make sure the trading plan is followed properly.

If the trading plan is followed rigorously but the performance is still slipping, it is important to give yourself time by reducing the position size and observe objectively if the strategy is no longer working, or, it is just one of those periods where the method has a tough time making money.

Diversification

By keeping your original strategy to trade at a reduced position size, you get to give yourself some room to test out new strategies. For example, if you successfully traded your account from $1,000 to $25,000, you may consider lowering your position size to base on just $15,000. Then use the other $10,000 as your capital for testing new strategies.

It is best to keep the position size as small as possible for the new strategies. This time, however, you are not cash strapped to just the $1,000 you start with. You can try out multiple strategies with say $2,000 behind each experiment. As long as you are doing this carefully like how you first started, this will speed up your process in finding new ways to trade your account more efficiently.

Swing To Win

Many professional day traders trading forex make only 50 to 60 pips a day net on average. It is not that much at all. They do not scalp that often as it is easier to maintain multiple positions trading the swings. The take home profit per unit traded stays approximately the same as trading the flow, although with few trades. The reason for the similarity in performance is that capturing swing profits require relatively larger risk per trade which is not feasible with very small trading accounts.

These traders are making decent amount of money because they are doing it with size. Yet, we seldom hear or read anyone telling this simple truth to the beginners. It is their hard earned wisdom. I guess not that many people like to share this.

Those home runs we hear people keep talking about are the glory trades. They are also talking points in social gathering but they are not the norm. Beginners often confuse that these glory traders are the reasons why some traders can make it big. The glory trades are just frosting on top of a sustainable trading career. They are done on the side with limited risk and usually do not affect the daily trading routines of these traders.

Summary

The secret to trading forex successfully for most retail traders is to start small and learn to trade the flow. After accumulating enough capital, the trader will have to learn the next set of skills to master swing trading, even if the timeframe is just day trading. By then, the trader will be able to carry decent position size, making it possible to make a good living off the trading profits.

The income potential of trading forex and CFDs is not that different from trading the emini S&P (see Day Trading Income Potential For Index Trader) with similar trading capital. The difference, however, lies in the transition issue mentioned above.

Traders trading the emini S&P index futures do not suffer from this problem in general because of its better liquidity at each smallest price increment (probably one of the best markets in this aspect) and non-directional volatility (allowing efficient scalping).

Traders trading forex can start out with smaller account size and have the advantage of being able to trade smaller position size and easier to scale up the positions with very small incremental size but have to deal with the slippage issue later if their trading style depends heavily on very small profit targets.

No one can speed up the process of evolving from trading the flow to trading the swings for you. You need the experience yourself so that you can handle changes to the trading environment in the future without going into a panic. As I mentioned many times in my other writings, it takes personal growth to make you a consistently profitable trader.

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I have a huge collection of scripts, data, indicators, example systems, etc. on hand.

The difficult part is to figure out an organized way to upload these things to the forum.

Or do I really need a plan at all?

Something I have to decide quickly.

Let me know what you think. You can comment here, post your suggestion in the forum (I have started a thread there already) or email me. I will gather the ideas and get someone to organize the stuff.

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My monthly update on market internals.

The current snapshot of S&P 500 3-Day Advance Issues, Tick16 Short Term + Long Term as of 2013 March 19 close.

Reading

1. Long Term Tick16 (yellow line) below neutral zone but not dropping

2. Short Term Tick16 (red line) moved above the neutral zone

3. 3 Days Advance Issues (green line) diverging from new high printed by S&P

Inference

a. #1 is bearish pointing to overbough and oversold on 30-min chart and higher timeframe can easily result in reversal.

b. #2 points to buying in underlying components near the all time high pretty much continuously.

c. #3 points to a pullback in advance issues back down to oversold zone may be necessary to correct the prolonged period of divergence we experienced over the past month. As long as price can hold a higher low when the advance issue reading is oversold again like end of February, we will get a tradable swing long coming.

Last update predicted we would experience a significant pullback and we got that in late February.

A selloff is now in progress and how it develops from here will determine if the long term price up trend is over or that another leg up is in store for us. Monitor the way how 3 days advance issues is moving will give us the clues.

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