General Market Indicators

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General Market Indicators

You can use technical indicators reviewed in previous chapters to analyze any trading vehicle: a stock, a future, an index, etc. Such tools as moving averages, MACD, Force index, and others, can provide signals for any ticker in any timeframe. Now we turn to a different group of tools: general market indicators, which analyze the entire market rather than any specific stock. They are worth following because general market trends are responsible for as much as half the movement in individual stocks.

While there are dozens of general market indicators, this is not an encyclopedic review—I’ll simply share the tools that help me trade. You may use the same or different tools—select those that appeal to you and test them on your market data. We can trust only those indicators that we have tested.

■ 34. The New High–New Low Index

Stocks that reach their highest level in a year on any given day are the leaders in strength. Stocks that fall to their lowest point for that year on the same day are the leaders in weakness. The New High–New Low Index (NH-NL) tracks the behavior of market leaders by subtracting the number of New Lows from the New Highs. In my experience, NH-NL is the best leading indicator of the stock market.1

¹ In 2012, I wrote an e-book with Kerry Lovvorn on the New High–New Low Index. We publish nightly updates on its signals on SpikeTrade.com.

How to Construct NH-NL

The New High–New Low Index is easy to calculate, using information that appears in many online sources and in major newspapers.

NH-NL = New Highs − New Lows

Most data services in the United States report the daily numbers of New Highs and New Lows, but it is shocking how loosely they define their data. Some are too narrow and track only the NYSE stocks, ignoring other exchanges. Others are too broad and track everything, including interest rate ETFs. My favorite source of reliable data is www.barchart.com. I take their data, subtract New Lows from New Highs, and plot the result underneath the daily chart of the S&P 500.

The task of constructing NH-NL is harder for traders outside the United States, in countries where such data isn’t reported. There you’ll need to do a bit of programming. First, run a daily scan of the database of all stocks in your country to find those that have reached the highest high and the lowest low for the year during the day. Once you have those two lists, take the above formula and apply it to the numbers you found.

On the days when there are more new highs than new lows, NH-NL is positive and plotted above the centerline. On the days when there are more new lows than new highs, NH-NL is negative and plotted below the centerline. If the numbers of new highs and new lows are equal, NH-NL is zero. We normally plot the New High– New Low Index as a line, with a horizontal reference line at a zero level.

While I plot NH-NL underneath the S&P 500, keep in mind that it has a much broader reach than the S&P—NH-NL includes data from the NYSE, AMEX, and NASDAQ, excluding only ETFs, unit investment trusts, closed-end funds, warrant stocks, and preferred securities. The chart of the S&P 500 is there simply for a comparison.

Crowd Psychology

A stock appears on the list of new highs when it’s the strongest it’s been in a year. It means that a herd of eager bulls is chasing its shares. A stock appears on the list of new lows when it’s the weakest it’s been in a year, showing that a crowd of aggressive bears is selling its shares.

The New High–New Low Index compares the numbers of the strongest and the weakest stocks on the exchange. It reveals the balance of power between the leaders in strength and the leaders in weakness.

You can visualize all stocks on the New York Stock Exchange, the NASDAQ, or any other exchange as soldiers in a regiment. The new highs and new lows are their officers. The new highs are the officers who lead an attack uphill. The new lows are the officers who are deserting and running downhill.

The quality of leadership is a key factor in any conflict. When I was in officer training, they kept telling us that there are no bad soldiers, only bad officers. The New High–New Low Index shows whether more officers are leading an attack uphill or deserting downhill. Where the officers lead, soldiers follow. The broad indexes, such as the S&P 500, tend to follow the trend of NH-NL (Figure 34.1).

When NH-NL rises above its centerline, it shows that the bullish leadership is dominant. When NH-NL falls below its centerline, it shows that bearish leadership is in charge. If the market rallies to a new high and NH-NL climbs to a new peak, it shows that bullish leadership is growing and the uptrend is likely to continue. If the market rallies but NH-NL shrinks, it shows that the leadership is becoming weak and the uptrend is in danger. A regiment whose officers are starting to desert is likely to retreat.

A new low in NH-NL shows that the downtrend is well led and likely to persist. If officers are running faster than the men, the regiment is likely to be routed. If stocks fall but NH-NL turns up, it shows that officers are no longer running. When officers regain their morale, the whole regiment is likely to rally.

Trading Rules for NH-NL

Traders need to pay attention to three aspects of NH-NL: the level of NH-NL above or below its centerline, the trend of NH-NL, and divergences between the patterns of NH-NL and prices.

FIGURE 34.1 S&P 500 daily, 26- and 13-day EMAs, Autoenvelope, NH-NL daily. (Chart by TradeStation)

NH-NL—Daily Chart, Yearly Look-Back

This chart tracks daily NH-NL during a mostly bullish year in the stock market. Still, every bullish trend gets interrupted by pullbacks. Bearish deterioration patterns of NH-NL, marked here by diagonal red arrows, warn you of coming declines. These signals emerge because officers start shifting towards the rear before the soldiers retreat.

Declines end and rallies begin when NH-NL rallies from negative into positive territory, marked here by purple circles. Those signals work especially well when the S&P is oversold, i.e., near its lower channel line. As always, trading messages are especially strong when independent signals confirm each other.

NH-NL Zero Line

The position of NH-NL in relation to its centerline shows whether bulls or bears are in control. When NH-NL is above its centerline, it shows that more market leaders are bullish than bearish and it is better to trade from the long side. When NH-NL is below its centerline, it shows that bearish leadership is stronger, and it’s better to trade from the short side. NH-NL can stay above its centerline for months at a time in bull markets and below its centerline for months in bear markets.

If NH-NL stays negative for several months but then rallies above its centerline, it signals that a bull move is likely to begin. It is time to look for buying opportunities, using oscillators for precise timing. If NH-NL stays positive for several months but then falls below its centerline, it shows that a bear move is likely to begin. It is time to look for shorting opportunities using oscillators for precise timing.

NH-NL Trends

When the market rallies and NH-NL rises, it confirms uptrends. When NH-NL declines together with the market, it confirms downtrends.

• 1. A rise in NH-NL shows that it’s safe to hold long positions and add to them. If NH-NL declines while the broad market stays flat or rallies, it is time to take profits on long trades. When NH-NL falls below zero, it shows that bearish leadership is strong and it’s safe to hold short positions and even add to them. If the market continues to fall but NH-NL rises, it shows that the downtrend is not well led—it’s time to cover shorts.
• 2. If NH-NL rises on a flat day, it flashes a bullish message and gives a buy signal. It shows that officers are going over the top while the soldiers are still crouching in their foxholes. When NH-NL falls on a flat day, it gives a signal to sell short. It shows that officers are deserting while the troops are still holding their positions. Soldiers aren’t stupid—if their officers start running away, they will not stay and fight.

NH-NL Divergences

If the latest market peak is confirmed by a new high of NH-NL, that rally is likely to continue, even if punctuated by a decline. When a new market low is accompanied by a new low in NH-NL, it shows that bears are well led and the downtrend is likely to persist. On the other hand, divergences between the patterns of NH-NL and broad market indexes show that leaders are deserting and the trends are likely to reverse.

1. If NH-NL traces a lower peak while the market rallies to a new high, it creates a bearish divergence. It shows that bullish leadership is weakening even though the broad market is higher. Bearish divergences often mark the ends of uptrends, but pay attention to the height of the second peak. If it is only slightly above zero, in the low hundreds, then a big reversal is probably at hand and it’s time to go short. If, on other hand, the latest peak is in the high hundreds, it shows that the upside leadership is strong enough to prevent the market from collapsing.

2. If the market declines to a new low, but NH-NL traces a shallower bottom than its previous decline, it creates a bullish divergence. It shows that bearish leadership is shrinking. If the latest low of NH-NL is shallow, in the low hundreds, it shows that the bearish leadership is exhausted and a major upside reversal is near. If the latest low sinks deep, then bears still have some strength, and the downtrend may pause but not reverse. Keep in mind that bullish divergences at stock market bottoms tend to develop faster than bearish divergences at market tops: buy fast and sell slowly.

NH-NL in Multiple Timeframes and Look-Back Periods

Markets move simultaneously in different timeframes. My original work on the NH-NL focused on the daily charts with a one-year look-back period—counting stocks that have reached a new high or a new low for their latest 52-week range. I have since added several dimensions for a deeper understanding of this key indicator.

Weekly NH-NL

The weekly NH-NL helps confirm major stock market trends and identify major reversals. I build it from the daily data of barchart.com, mentioned above, by running a five-day moving total. I plot the result underneath a weekly chart of the S&P 500.

The weekly NH-NL gives its most important signals when it reaches extreme levels and also by divergences. To understand its logic, keep in mind how the weekly NH-NL is constructed. For example, if the weekly NH-NL rises to a +1,500 level, it means that in each of the past five trading days there were on average 300 more New Highs than New Lows. It takes a period of sustainable bullishness or bearishness to push the weekly NH-NL to an extreme.

These are the most important signals of weekly NH-NL:

• When it drops below minus 4,000 and then rallies above that level, it delivers major buy signals.
• When the weekly NH-NL rises above plus 2,500, it confirms bull markets.
• When the tops or bottoms of weekly NH-NL diverge from price patterns, they signal important reversals.

A drop below −4,000 reflects an unsustainable market panic. To fall that low, the market has to deliver an average of 800 more daily New Lows than New Highs for five days in a row. Such massive panic is not going to last. When the weekly NH-NL rises above −4,000, it flashes a buy signal I call a Spike. It’s so powerful and effective in both bull and bear markets that I named our SpikeTrade group after it. This signal misfired only once in several decades, as you’ll see on the chart in Figure 34.2.

FIGURE 34.2 S&P 500 weekly, 26-week EMA, NH-NL weekly. Green line at +2,500, purple line at −4,000. (Chart by TradeStation)

NH-NL—Weekly Chart

When the weekly NH-NL falls below −4,000 and then rises above that level, it nails important bottoms, marked here with vertical green arrows. This chart covers 11 years—the signal works in bull and bear markets. There was only one exception—in October and November 2008, during the worst bear market of a century (marked by a purple oval). Let this serve as a reminder that no market signal works 100% of the time, making risk management essential for survival and success.

Red diagonal arrows mark major bearish divergences. Weekly NH-NL touching the +2,500 level confirms bull markets and calls for higher prices ahead, even if interrupted by a correction.

When the weekly NH-NL rises to the +2,500 level, it confirms bull markets. This indicator never rises this high during bear market rallies. When you see it above that level, you know you’re in a bull market, with higher prices likely ahead.

The 65-day and 20-day NH-NL

One of the great innovations in the New High–New Low analysis in recent years was the addition of two new look-back windows: a 20-day and a 65-day. While the regular daily NH-NL compares each day’s high and low to the high-low range for the preceding year, a 20-day NH-NL compares it only to the preceding month and a 65-day NH-NL to the preceding quarter. These shorter-term views of the NH-NL are useful for short-term timing.

These two new time windows deliver more sensitive signals than the standard year-long NH-NL. The logic is simple: before a stock reaches a new high for the year, it must first make a new high for the month and then for the quarter. If a stock has been in a downtrend, it may take a long time to recover and reach a new yearly high, but it can reach monthly and quarterly highs much sooner.

In addition to the usual signals, such as trends and divergences, a very sharp shortterm buy signal occurs when the 20-day NH-NL drops below minus 500 and then rallies above that level. It shows that the market has touched and rejected a shortterm bearish extreme, and afterwards it usually launches a short-term rally. We call this a “Spike bounce” signal (see Chapter 54).

Tracking market leaders with the help of NH-NL helps improve timing. There are two ways to utilize the New High–New Low signals. First, since individual stocks largely depend on broad market trends, we can use NH-NL signals to decide when to buy or sell our stocks. Furthermore, we can use NH-NL signals to trade vehicles that track the broad market, such as the S&P e-mini futures.

■ 35. Stocks above 50-Day MA

This broad stock market indicator is based on the key concepts regarding prices and moving averages (Figure 35.1). Each price represents a momentary consensus of value among market participants, while a moving average represents an average consensus of value during its time window. This means that when a stock trades above its MA, the current consensus of value is above average—bullish. When a stock trades below its MA, the current consensus of value is below average—bearish.

When the market is trending higher, the percentage of stocks above their moving averages keeps growing. In a broad downtrend, the number of stocks above their MAs keeps shrinking.

FIGURE 35.1 S&P 500 weekly and 26-week MA; Stocks above 50 MA with reference lines at 75% and 25%. (Chart by TradeStation)

Stocks above 50-Day MA

When the “stocks above their 50-day MA” indicator reaches an extreme—above 75% or below 25% and then moves away from that level, it shows that the intermediate-term trend has reached a likely turning point. A reversal of this indicator flashes a signal for the entire market: buy when it turns up and sell when it turns down. In the latter part of 2013, as the market started going up with almost no pullbacks, buy signals from upside reversals began to occur at levels higher than 25%. These signals don’t mark every reversal—no indicator does—but when it flashes its signal, we had better pay attention.

This indicator tracks all stocks traded on the New York Stock Exchange, American Exchange, and NASDAQ and calculates how many of them trade above their moving averages. It plots that percentage as a line that fluctuates between 0% and 100%. We can use the pattern of this line to confirm market trends and anticipate reversals.

The indicator for tracking the number of stocks above their 50-day MAs is included in many software packages. I like to view it on a weekly chart, where it helps catch intermediate reversals—market turns that augur in trends that last anywhere from several weeks to several months. You don’t need to look at this indicator daily, but it can be an important part of weekend homework.

In theory, the highest possible reading of this indicator would be 100%, if all stocks rallied above their MAs. Its lowest possible reading of 0% would occur if all stocks were to fall below their MAs. In practice, only exceptional market moves swing it near the 90% or 10% extremes. Normally, this indicator tends to top out near 75% and bottom out near 25%. I draw two reference lines on its chart at 75% and 25% and start looking for the market turn as this indicator approaches those levels.

The percentage of stocks above their 50-day MA gives its trading signals not by reaching any certain levels but rather by reversing near those levels. It signals the completion of a top by rising to or above the upper reference line and then sinking below that line. It signals that a bottom has been formed when it falls below or even near the lower reference line and then turns up.

Notice that the tops of this indicator tend to be broad, while its bottoms are sharper. Tops are formed by greed, which is a happier, longer-lasting emotion. Bottoms are formed by fear—a more intense and shorter-lived emotion.

While some of this indicator’s signals are right on time in catching reversals, others mark only temporary pauses in major trends. Let this serve as a reminder never to rely on a single indicator for trading decisions. Use multiple tools: when they confirm each other’s signals, they reinforce one another.

■ 36. Other Stock Market Indicators

Only a handful of general market indicators have stood the harsh test of time. Many that used to be popular in previous decades have been swept away by the flood of new trading vehicles. The New High–New Low Index and Stocks Above 50-day MA, reviewed above, continue to work because of their clear logic. Several other indicators are listed below. Whatever tools you choose, be sure to understand how they work and what exactly they measure. Select a few and track them on a regular basis, until you come to trust their signals.

Advance/Decline

The Advance/Decline line (the A/D line) tracks the degree of mass participation in rallies and declines. Each day it adds up the number of stocks that closed higher and subtracts the number of stocks that closed lower.

While the Dow Jones Industrials track the behavior of the generals and the New High–New Low Index focuses on the officers, the A/D line shows whether soldiers are following their leaders. A rally is more likely to persist when the A/D line rises to a new high, while a decline is likely to deepen if A/D falls to a new low in step with the Dow.

The A/D line is based on the day’s closing prices for each stock at any exchange: take the number of advancing stocks, subtract the number of declining stocks, and ignore unchanged stocks. The result will be positive or negative, depending on whether more stocks advanced or declined during the day. For example, if 4,000 stocks were traded, 2,600 advanced, 900 declined, and 500 were unchanged, then Advance/Decline equals +1,700 (2,600−900). Add each day’s Advance/Decline figures to the previous day’s total to create a cumulative A/D line (Figure 36.1).

Advance/Decline Line

The turns of this indicator usually coincide with price turns, but occasionally precede them. This ability to give early warnings makes A/D line worth following. In area A, prices are scratching the bottom and make a new low, while the uptrend of the A/D line calls for a rally. In area B, the opposite occurs—prices press higher, while a downturn of the A/D line calls for a decline. In area C, prices continue to decline, while the A/D line turns up and calls for a rally. Those warnings don’t occur at every turning point.

Traders should watch for new peaks and valleys in the A/D line rather than its absolute levels, which depend on its starting date. If a new high in the stock market is accompanied by a new high of the A/D line, it shows that the rally has broad support and is likely to continue. Broadly based rallies and declines have greater staying power. If the stock market reaches a new peak, but the A/D line reaches a lower peak than during the previous rally, it shows that fewer stocks are participating, and the rally may be near its end. When the market falls to a new low but the A/D line traces a shallower bottom than during the previous decline, it shows that the decline is narrowing down and the bear move is nearing an end. These signals tend to precede reversals by weeks if not months.

The Most Active Stocks indicator (MAS) is an Advance/Decline line of the 15 most active stocks on the New York Stock Exchange. It used to be listed daily in many newspapers. Stocks appeared on this list when they caught the public’s eye. MAS was a big money indicator—it showed whether big money was bullish or bearish. When the trend of MAS diverged from the price trends, the market was especially likely to reverse.

Hardly anyone today uses an indicator called TRIN, which was important enough to have its own chapter in the original Trading for a Living. Very few people track another formerly popular indicator called TICK. Old stock market books are full of fascinating indicators, but you have to be very careful using them today. Changes in the market over the years have killed many indicators.

Indicators based on the volume of low-priced stocks lost their usefulness when the average volume of the U.S. stock market soared and the Dow rose tenfold. The Member Short Sale Ratio and the Specialist Short Sale Ratio stopped working after options became popular. Member and specialist short sales are now tied up in the intermarket arbitrage. Odd-lot statistics lost value when conservative odd-lotters bought mutual funds. The Odd-lot Short Sale Ratio stopped working when gamblers discovered puts.

■ 37. Consensus and Commitment Indicators

Most private traders keep their opinions to themselves, but financial journalists, letter writers, and bloggers spew them forth like open hydrants. Some writers may be very bright, but the financial press as a whole has a poor record of market timing. Financial journalists and letter writers tend to overstay trends and miss turning points. When these groups become intensely bullish or bearish, it pays to trade against them.

It’s “monkey see, monkey do” in the publishing business, where a journalist’s or an advisor’s job may be endangered by expressing an opinion that differs too sharply from his group. Standing alone feels scary, and most of us like to huddle. When financial journalists and letter writers reach a high degree of bullish or bearish consensus, it’s a sign that the trend has been going on for so long that a reversal is near.

Consensus indicators, also called contrary opinion indicators, are not suitable for precision timing, but they draw attention to the fact that a trend is near its exhaustion level. When you see that message, switch to technical indicators for more precise timing of a trend reversal.

A trend can continue as long as bulls and bears remain in conflict. A high degree of consensus precedes reversals. When the crowd becomes highly bullish, get ready to sell, and when it becomes strongly bearish, get ready to buy. This is the contrary opinion theory, whose foundations were laid by Charles Mackay, a Scottish barrister. His classic book, Extraordinary Popular Delusions and the Madness of Crowds (1841) describes the infamous Dutch Tulip Mania and the South Seas Bubble in England. Humphrey B. Neill in the United States applied the theory of contrary opinion to stocks and other financial markets. In his book, The Art of Contrary Thinking, he made it clear why the majority must be wrong at the market’s turning points: prices are established by crowds, and by the time the majority turns bullish, there aren’t enough new buyers to support a bull market.

Abraham W. Cohen, an old New York lawyer whom I met in the early 1980s, came up with the idea of polling market advisors and using their responses as a proxy for the entire body of traders. Cohen was a skeptic who spent many years on Wall Street and saw that advisors as a group performed no better than the market crowd. In 1963, he established a service called Investors Intelligence for tracking letter writers. When the majority of them became bearish, Cohen identified a buying opportunity. Selling opportunities were marked by strong bullishness among letter writers. Another writer, James H. Sibbet, applied this theory to commodities, setting up an advisory service called Market Vane.

Tracking Advisory Opinion

Letter writers follow trends out of fear of losing subscribers by missing major moves. In addition, bullishness helps sell subscriptions, while bearish comments turn off subscribers. Even in a bear market, we rarely see more bears than bulls among advisors for more than a few weeks at a time.

The longer a trend continues, the louder the letter writers proclaim it. They are most bullish at market tops and most bearish at market bottoms. When the mass of letter writers turns strongly bullish or bearish, it’s a good idea to look for trades in the opposite direction.

Some advisors are very skilled at doubletalk. The man who speaks from both sides of his mouth can claim that he was right regardless of what the market did, but editors of tracking services have plenty of experience pinning down such lizards.

When the original Trading for a Living came out, only two services tracked advisory opinions: Investors Intelligence and Market Vane. In recent years, there has been an explosion of interest in behavioral economics, and today many services track advisors. My favorite resource is SentimenTrader.com, whose slogan is “Make emotion work for you instead of against you.” Jason Goepfert, its publisher, does a solid job of tracking mass market sentiment.

Signals from the Press

To understand any group of people, you must know what its members crave and what they fear. Financial journalists want to appear serious, intelligent, and informed; they are afraid of appearing ignorant or flaky. That’s why it’s normal for them to straddle the fence and present several sides of every issue. A journalist is safe as long as he writes something like “monetary policy is about to push the market up, unless unforeseen factors push it down.”

Internal contradiction is the normal state of affairs in financial journalism2 . Most financial editors are even more cowardly than their writers. They print contradictory articles and call this “presenting a balanced picture.”

For example, an issue of a major business magazine had an article headlined “The Winds of Inflation Are Blowing a Little Harder” on page 19. Another article on page 32 of the same issue was headlined “Why the Inflation Scare Is Just That.” It takes a powerful and lasting trend to lure journalists and editors down from their fences. This happens only when a tide of optimism or pessimism sweeps up the market near the end of a major trend. When journalists start expressing strongly bullish or bearish views, the trend is ripe for a reversal.

This is why the front covers of major business magazines serve as contrarian indicators. When a leading business magazine puts a bull on its cover, it’s usually a good time to take profits on long positions, and when a bear graces the front cover, a bottom cannot be too far away.

Signals from Advertisers

A group of three or more ads touting the same “opportunity” in a major newspaper or magazine warns of an imminent top. This is because only a well-established uptrend can break through the inertia of several brokerage firms. By the time all of them recognize a trend, come up with trading recommendations, produce ads, and place them in a newspaper, that trend is very old indeed.

The ads on the commodities page of The Wall Street Journal appeal to the bullish appetites of the least-informed traders. Those ads almost never recommend selling; it is hard to get amateurs excited about going short. You’ll never see an ad for an investment when its price is low. When three or more ads on the same day tout gold or silver, it is time to look at technical indicators for shorting signals.

² And not only journalism: in 2013 three academicians shared a Nobel Prize in economics. The work of one of them showed that the market was efficient and couldn’t be timed; the work of another showed that the market was irrational and could be timed. Take your pick and wait for next year’s prize.

FIGURE 37.1 Monthly total dollar value of OTC stocks. (Courtesy SentimenTrader.com)

Money pours into penny stocks when the market is up, dries up when it is down. This is reflected in the monthly reports of penny stock volume at the NASDAQ. After markets have hit new highs and the news is good, volume often spikes up for these “lottery ticket” stocks. When the stock market hits the skids, their volume dries up.

A more malignant breed of promoters appeared on the scene in the past decade: thanks to the Internet, “pump and dump” operators have migrated online. The scammers touting penny stocks know that they need to wait for an uptrend to hook their victims. Whenever a higher than usual number of promo pitches starts showing up in my spam filter, the top can’t be too far away (Figure 37.1).

Commitments of Futures Traders

Government agencies and exchanges collect data on buying and selling by various groups of traders and publish summary reports of their positions. It pays to trade with the groups that have a track record of success and against those with track records of persistent failure.

For example, the Commodity Futures Trading Commission (CFTC) reports long and short positions of hedgers and big speculators. Hedgers—the commercial producers and consumers of commodities—are the most successful market participants. The Securities and Exchange Commission (SEC) reports purchases and sales by corporate insiders. Officers of publicly traded companies know when to buy or sell their shares.

Positions of large futures traders, including hedge funds, are reported to the CFTC when their sizes reach the so-called reporting levels. At the time of this writing, if you are long or short 250 contracts of corn or 200 contracts of gold, the CFTC classifies you as a big speculator. Brokers report those positions to the CFTC, which compiles the data and releases summaries on Fridays.

The CFTC also sets up the maximum number of contracts a speculator is allowed to hold in any given market— these are called position limits. Those limits are set to prevent very large speculators from accumulating positions that are big enough to bully the markets.

The CFTC divides all market participants into three groups: commercials, large speculators, and small speculators. Commercials, also known as hedgers, are firms or individuals who deal in actual commodities in the normal course of their business. In theory, they trade futures to hedge business risks. For example, a bank trades interest rate futures to hedge its loan portfolio, while a food processing company trades wheat futures to offset the risks of buying grain. Hedgers post smaller margins and are exempt from speculative position limits.

Large speculators are those whose positions have reached reporting levels. The CFTC reports buying and selling by commercials and large speculators. To find the positions of small traders, you need to take the open interest and subtract from it the holdings of the first two groups.

The divisions between hedgers, big speculators, and small speculators are somewhat artificial. Smart small traders grow into big traders, dumb big traders become small traders, and many hedgers speculate. Some market participants play games that distort the CFTC reports. For example, an acquaintance who owns a brokerage firm sometimes registers his wealthy speculator clients as hedgers, claiming they trade stock index and bond futures to hedge their stock and bond portfolios.

The commercials can legally speculate in the futures markets using inside information. Some of them are big enough to play futures markets against cash markets. For example, an oil firm may buy crude oil futures, divert several tankers, and hold them offshore in order to tighten supplies and push up futures prices. They can take profits on long positions, go short, and then deliver several tankers at once to refiners in order to push crude futures down a bit and cover shorts. Such manipulation is illegal, and most firms hotly deny that it takes place.

As a group, commercials have the best track record in the futures markets. They have inside information and are well-capitalized. It pays to follow them because they are successful in the long run. Big speculators used to be successful wealthy individuals who took careful risks with their own money. That has changed, and today most big traders are commodity funds. These trend-following behemoths do poorly as a group. The masses of small traders are the proverbial “wrong-way Corrigans” of the markets.

It is not enough to know whether a certain group is short or long. Commercials often short futures because many of them own physical commodities. Small traders are usually long, reflecting their perennial optimism. To draw valid conclusions from the CFTC reports, you need to compare current positions to their historical norms.

Legal Insider Trading

Officers and investors who hold more than 5 percent of the shares in a publicly traded company must report their buying and selling to the Securities and Exchange Commission. The SEC tabulates insider purchases and sales, and releases this data to the public.

Corporate insiders have a long record of buying stocks when they’re cheap and selling them high. Insider buying emerges after severe market drops, and insider selling accelerates when the market rallies and becomes overpriced.

Buying or selling by a single insider matters little: an executive may sell shares to meet major personal expenses or he may buy them to exercise stock options. Analysts who researched legal insider trading found that insider buying or selling was meaningful only if more than three executives or large stockholders bought or sold within a month. These actions reveal that something very positive or negative is about to happen. A stock is likely to rise if three insiders buy in one month and to fall if three insiders sell within a month.

Clusters of insider buying tend to have a better predictive value than clusters of selling. That’s because insiders are willing to sell a stock for many reasons (diversification, buying a second home, sending a kid to college) but they are willing to buy for one main reason—they expect their company’s stock to go up.

Short Interest

While the numbers of futures and options contracts held long and short is equal by definition, in the stock market there is always a huge disparity between the two camps. Most people, including professional fund managers, buy stocks, but very few sell them short.

Among the data reported by exchanges is the number of shares being held short for any stock. Since the absolute numbers vary a great deal, it pays to put them into a perspective by comparing the number of shares held short to that stock’s float (the total number of publicly owned shares available for trading). This number, “Short Percent of Float,” tends to run about one or two percent. Another useful way to look at short interest is by comparing it to the average daily volume. By doing this, we ask a hypothetical question: if all shorts decided to cover, while all other buyers stood aside and daily volume remained unchanged, how many days would it take for them to cover and bring short interest down to zero? This “Days to Cover” number normally oscillates between one and two days.

When planning to buy or short a stock, it pays to check its Short Percent of Float and Days to Cover. If those are high, they show that the bearish side is overcrowded.

Apple Incorporated	$534.97	Green Mountain Coffee Roasters	$119.74
AAPL	$-1.00$	GMCR	0.34
Daily Short Sale Volume	view	Daily Short Sale Volume	view
Short Interest (Shares Short)	16.538.900	Short Interest (Shares Short)	32.931.300
Days To Cover (Short Interest Ratio)	0.9	Days To Cover (Short Interest Ratio)	15.1
Short Percent of Float	1.86 %	Short Percent of Float	25.76 %

FIGURE 37.2 AAPL and GMCR shorting data. (Source: Shortsqueeze.com)

Short Interest and Days to Cover

Compare short interest data for two popular stocks on the day I’m editing this chapter. “Short Percent of Float” is 1.86% for Apple, Inc. (AAPL), but nearly 26% for Green Mountain Coffee Roasters, Inc. (GMCR). “Days to Cover” are 0.9 for AAPL but over 15 for GMCR. These numbers reflect much more aggressive shorting of GMCR. Not to forget, each and every one of those shorts at some point will need to buy in order to cover his short position.

Perhaps savvy shorts know something very bad about GMCR, but what if its stock rallies even a little? Many bears will run for cover, and as they scramble to cover shorts, the stock may soar. Whatever its long-term prospects, it could be sent flying in the near term.

A rally may scare those bears into panicky covering, and send the stock sharply higher. That would be good for bulls but bad for bears.

Fear is a stronger emotion than greed. Bulls may look for bargains but try not to overpay, while squeezed bears, facing unlimited losses, will pay any price to cover. That’s why short-covering rallies tend to be especially sharp.

Whenever you look for a stock to buy, check its Short Percent of Float and Days to Cover. The usual, normal readings don’t provide any great information, but the deviations from the norm often deliver useful insights (Figure 37.2).

High shorting numbers mark any stock as a dangerous short. By extension, if your indicators suggest buying a stock, its high short interest becomes an additional positive factor—there is more fuel for a rally. It makes sense for swing traders to include the data on shorting when selecting which of several stocks to buy or sell short. I always review these numbers when working up a potential trade.