Reading Market Internal Trading Strategy

By: Chris Vermeulen

In this article I am going to teach you how to read the market internals so you can – are
able to day and swing trade consistently earning 4-8% per month trading futures &
ETF’s.

To give readers a little information about my trading history, I fondly remember when I
first learned and experimented with technical analysis and chart patterns. I was
immediately blown away and I firmly believed that I had found the holy grail of trading.
It was after six months passed that I realized my trading account was essentially the same
size and my trades were only showing profitability around 50% of the time. That is when
it finally hit me; I eventually realized that reading just chart patterns and volume was not
enough to give my trading a significant edge.

The primary culprit behind my problem was that many of the breakouts which I bought
into quickly reversed and I watched as price action reversed and went against my
position. After months of chatting with fellow traders and consistent reading which I
hoped would hone my trading craft, I set out to find the missing link. It was then that my
interest surrounding market internals began to blossom.

We always hear the professional traders articulating that if we want to consistently pull
money out of the market, we need to trade against the herd mentality (masses). This
sounds quite simple, but just how do traders go about doing that?

In theory, if everyone is buying stocks then it is only be a matter of time before everyone
runs out of trading capital and the buying will evaporate. When the last buyers purchase
stock, it leaves only the sellers in control of the broad market. If you spend time thinking
about this, it makes perfect sense as to why 50% of the breakouts I traded eventually
failed and went against me.

A simple, clean pattern that large numbers of traders see unfolding means only one thing:
everyone is taking a position before the breakout in anticipation of the coming move.
With the general public moving into this chart pattern, it would naturally make sense that
the underlying investment vehicle would move higher and lead to a breakout with the last
of traders (breakout traders/ME) jumping on the train.

The primary issue to my strategy was that just as the last traders enter the trade, the smart
money (big guys) would start selling into the buying surge getting top dollar on their
trades. Once the breakout failed, everyone who was long hopes for another rally which
inevitably never comes. As time drags on, this leads to traders getting impatient exiting
their positions which causes price to erode and slowly creates more fear in the market. As
this process comes full circle, significant numbers of traders get out of their losing
positions causing a waterfall sell-off with me holding the bag and a few other unlucky
souls holding the proverbial bag.
After watching this process unfold time after time, I started looking at the market
completely backwards from my previous analysis. I focused on buying into heavy
volume sell-offs and selling into heavy volume breakouts. This was a very tough
transition to make, and it is best to paper trade until you are comfortable with buying into
fear and selling into greed. It will feel completely wrong at the beginning, but the profits
speak for themselves!

My Trading Strategy for ES-Mini Futures:

I am going to show you the 4 main tools that are required to create profits by trading
against the herd. While I utilize more than one strategy, this is my absolute favorite. I
trade the ES futures contract and occasionally the SDS and SSO 2x leveraged exchange
traded funds. The indicators I focus on are the NYSE Down/Up volume ratio, the
Put/Call ratio, and the NYSE Advance/Decline line. While these may seem quite
elementary at first glance, when you combine their information you end up with a simple,
yet highly effective trading strategy.

ES Mini Futures Contract – 5 Minute Chart

The E-Mini S&P futures contract is my investment vehicle of choice. It’s a highly
versatile, efficient, and economical way of capitalizing on S&P 500 market swings. At
the same time, traders can capitalize on both rising and falling markets. Additionally,
there is no longer a need to have a $25K minimum in your trading account to meet the
pattern day trading rule (PDT) which is required if you want to day trade stocks or
exchange traded funds.

So what is the E-mini?

The E-mini S&P 500 futures contract is one-fifth the size of the standard S&P 500
futures contract. While a full S&P contract provides $250 potential for each point it
moves, the e-mini contract (ES) gives you $50 per point. E-mini trading represents a
whole new world of opportunities! Once you learn more about the many advantages of
the e-mini, you may not want to trade individual stocks or exchange traded funds ever
again!
Here is a 5 minute chart of the ES futures showing signals where I went short. It is
important to know that over the past 2 years, the S&P 500 has provided a 1.25% profit on
average each time one of these extreme sentiment readings occurred on the charts. These
trades were in late August and averaged a 1.75% return and each trade lasted only 24
hours. Obviously this means that my money was not at risk for very long periods of time.

I firmly believe that this strategy helps reduce risk, particularly in today’s volatility laced
marketplace.

Now let me show you how to find these low risk trades using market internals as your
guide…
NYSE Advance Decline Indicator – Stocks overbought/oversold short term

The advance/decline line is by far my favorite indicator and measures market breadth. It
is a simple measure of how many stocks are taking part in a rally or a sell-off. This is the
very meaning of market breadth, which answers the question, "how broad is the rally?"
The formula for the advance/decline line is as follows:

A/D Line = # of Advancing Stocks - # of Declining Stocks

This is the most easy to follow and understand of the three indicators I focus on. I utilize
this indicator when there are 1000 or more individual stocks trading up on the day. In that
scenario, the market is nearing an overbought condition, meaning too many stocks have
moved up too quickly and traders should start to take profits or exit their positions. I also
look at the intraday and daily chart for topping patterns or resistance levels. Then I wait
patiently for the other two indicators to confirm my sentiment before going short the
market.
Put/Call Ratio – Sentiment

The Put/Call Ratio is based on CBOE statistics, the ratio equals the total number of puts
divided by the total number of call options traded. When more puts are traded than calls,
the ratio will exceed 1. As an indicator, the Put/Call Ratio is used to measure market
sentiment. When the ratio gets too low, it indicates that call volume is high relative to put
volume and the market may be overly bullish. When the ratio gets too high, it indicates
that put volume is high relative to call volume and the market may be overly bearish.

Put/Call Ratio = # of Put Options / # of Call Options

This indicator can be a little tougher to use at times because when the market is trending
down, the ratio tends to fluctuate in the upper end of the scale between 0.75 – 1.20. In an
up-trending market, the indicator will trade between 0.35 – 0.75. As long as you monitor
the upper and lower range for the current market trend, your analysis should be right on
track. In addition, if you zoom out slightly on the chart you will see the average range it
has been trading in and then you are able to set you the upper and low bands accordingly.

Back in late August, the S&P 500 was trending down and I only looked to short bounces
in the market. When the broad market bounces and we see the put/call ratio drop into the
lower band it is telling me that the majority of traders have gotten bullish. This tends to
happen once a previous high is broken as it triggers short covering and breakout traders
start buying. While there are other times on this chart where the indicator traded into the
lower range, there was not a signal to short the market because the other two indicators
did not confirm the extreme sentiment level. For this strategy to be the most effective,
they all must have an extreme reading for the trade to have the best odds and greatest
profit potential.
NYSE Buying/Selling Volume – Measuring Fear & Greed

This is a simple volume based indicator which measures fear and greed in the market.
NYSE Buying/Selling Volume indicator is routinely a powerful tool for timing market
tops and bottoms. It is calculated by taking the NYSE buying volume and dividing it by
the selling volume. It measures panic buying and acts as a contrarian indicator. It is not
an indicator that many other traders follow, but in my opinion this indicator is critical in
order to get a feel for the rhythm of the market.

NYSE Buying Strength = Up Volume / Down Volume

When you see this indicator start to rise over 3 it means there are 3 buy orders for every 1
sell order on the NYSE. This tells us that the majority of traders (the herd) are buying.
Obviously the higher this indicator moves, or the longer it stays above 3, the more
potential there is for a sharp sell-off.
Trading Strategy - Putting It All Together:
Follow these trading rules and you should start to make consistent money month after
month in both up and down markets. All you need to do is setup these indicators, focus
on the 15 minute charts, trade only with the trend, and take profits at 1%, 2%, etc. For
larger gains be sure to keep a smaller position open with a defined risk level where you
utilize a protective stop order.

It is critical that you take partial profits at a 1% gain because you must start moving your
protective stop into the money to lock in a profit for the balance of the position. It is also
mandatory to wait for all three indicators to reach the extreme levels at the same time for
a trade to be triggered. I have witnessed firsthand when the market trend has stayed in the
extreme levels on the charts for 1-2 weeks. Anticipating an overbought/oversold
condition before all three indicators confirm your suspicions is a great way to potentially
lose money. Be patient, and wait for the indicators to confirm your suspicion, there will
be plenty of time to acquire a quality entry.

Following the trading rules and using protective stops is crucial for success. Remember
that each time there is a trend change this setup will fail. So be sure to stick to your
protective stops to avoid holding onto a losing position.

This strategy works just as well in a bull market, but there are some minor changes
required on each of the indicators. I also use inter-market analysis following the US
Dollar, Gold, Bonds and the Volatility Index for other trading strategies that I incorporate
with my portfolio. I hope in the future you can utilize these indicators in your own
trading strategy and enhance your gains.

Over the next 6 month you will be receiving education material like this to help you
get a good read on the market for both short and long term trends. There are times
which we should trade defensive and times to be more aggressive depending on the
overall market condition. From May – Oct 2010 the market was unstable with wild
price swings in a sideways pattern. Its times like these when trading becomes more
difficult and cash is my preferred position with the small trade here and there. Once
the market breaks out of this sideways pattern and starts to trend, there will be
many more low risk opportunities available.

Email: Chris@TheGoldAndOilGuy.com