By Scott Tafel
Learn how my professional trader friends and I can effectively trade the stock market for relatively short term gains. The trades last from a day or two to as long as several weeks (but not several months). In this article we will look at three of the pillars of stock trading: Section 1: Market Sentiment, Section 2: Technical Analysis, and Section 3: Hedging. But first let's look at some background:

This type of trading is a technique used to forecast the direction of prices by studying historical outcomes of similar patterns. In the scholarly world it falls under Behavioral Economics and Quantitative Analysis ("quant"/"quants"). Quantitative analysis is used by High Frequency Traders with computers. Technical Analysis ("T/A" or "TA") has been used by successful traders since the 17th century in Europe and the 18th century in Japan. The first serious book on trading using TA that includes techniques that we use today was printed in 1755 by Munehisa Homma who was a rice merchant in Japan. He is the considered the father of the candlestick chart and he was the first to write on how to use market sentiment in trading. He observed that one should position oneself against the market when all are bearish, because that alone is enough of a cause for prices to rise (and vice versa). The next great advance came with the work of Charles Dow (inventor of the Dow Jones Industrial Average). In 1948 Robert D. Edwards and John Magee published Technical Analysis of Stock Trends, which is the Bible of Technical Analysis to this day. Other pioneers of TA are: Ralph Nelson Elliott, William Delbert Gann and Richard Wyckoff. Some topics in this article are discussed in my other articles but I always cover plenty of new material so it is worth your time.

Section 1: Market Sentiment Market sentiment is monitored with a variety of technical and statistical methods such as the number of advancing versus declining stocks, new highs versus new lows comparisons, put/call ratio, Volatility Index (VIX), bull/bear surveys, Short Interest, and several others. The fundamental principle is that if everyone is long, then no one is left to buy so a prolonged period of bullishness is bearish. Also, if the market has been declining and everyone thinks that it is going to decline much further, then anyone who can't handle a further decline has already sold out and there are no sellers left. A large share of overall movement of an individual stock has been attributed to market sentiment. Major tops and bottoms in the market are always formed by sentiment extremes. Several surveys of investor sentiment are available to the trader. Some of the more popular are the AAII Sentiment Survey, the Consensus Index from Consensus, Inc., Investors Intelligence, Hulbert Financial Digest’s Newsletter Sentiment, and Market Vane. All except for the Hulbert market gauge are carried weekly in Barron’s under Investor Sentiment Readings in the Market Week section or at various locations on the Internet. These surveys will not tell you exactly when the market's direction will change, only that it is getting close. With it you can adjust your hedging (Section 3) to be ready for the change. The Short Interest Ratio is one of the popular measures of market sentiment. Short interest is the number of shares that have been sold short and not yet repurchased. The short interest ratio takes the mid-month New York Stock Exchange short interest and divides it by the average daily trading value over the preceding four weeks. A short interest ratio of one means that the total outstanding short positions are equivalent to roughly one day’s trading volume. A rising market typically follows high short interest ratios, while low ratios are generally followed by a declining market. When too many people are on the same side of the trade then the market direction is likely to reverse.

The Put/Call Ratio indicates the relationship between the number of Puts (bought by bearish option traders) to Calls (bought by bullish option traders) which were traded on the Chicago Board Options Exchange CBOE. Historically, options investors have done a poor job of timing market reversals, as the market tends to move in the opposite direction to what their sentiment would seem to indicate. For this reason, the put/call ratio is another contrarian indicator. The higher the level of the put/call ratio, the more bearish these investors are on the market. Conversely, lower readings indicate high Call option volume and thus bullish expectations. When it reaches “excessive” levels, the market usually corrects by moving in the opposite direction.

The VIX measures positive and negative sentiment such that a rising VIX indicates that negative sentiment is growing while rising optimism is marked by a falling VIX. Historically, the majority of Put/Call buyers are wrong—making the VIX another contrarian indicator. Therefore, a rising VIX is an indication that the market is becoming oversold, meaning a short-term bottom may be approaching. Likewise, when the VIX reaches low levels—the market is overbought—we can expect a possible short-term top to the market.

The Advance/Decline ("A/D") Ratio compares new 52 week highs vs. new 52 week lows such that you can easily see extremes. A "90% down day" is when 90% of stocks decline and only 10% rise. Conversely, a 90% up day is when 90% rise and only 10% decline. The end of a long decline in the market often includes a 90% up day as the many short sellers start covering their positions. A 90% up day in the context of a bull market is usually a good day to take profits as the market will probably rest a bit before going up any more and may even pull back soon. A 90% down day usually bounces up a bit the next day.

The Advance/Decline ("A/D") Ratio and new 52 week highs vs. new 52 week lows you can quickly see extremes. A "90% down day" is when 90% of stocks decline and only 10% rise. Conversely, a 90% up day is when 90% rise and only 10% decline. The end of a long decline in the market often includes a 90% up day as the many short sellers start covering their positions. A 90% up day in the context of a bull market is usually a good day to take profits as the market will probably rest a bit before going up further and may even pull back soon. A 90% down day usually bounces up a bit the next day.

A healthy rally will have an expanding number of 52 week highs and a declining number of 52 week lows. If a rally begins to narrow then the number of 52 week highs will decline even though the market continues to rise. Conversely, a declining market may be showing signs of bottoming when there are fewer 52 week lows when the market declines. The Advance/Decline numbers as well as new 52 week high/low values can be found on most trading platforms or at stockcharts.com.

Next page: Stock Trading How to: Technical Analasys » Scott Tafel is the founder and principle partner in Falcon Trading Systems: computers for traders. He has been a trader since 1999. Mr. Tafel spent 27 years working in the Nuclear power industry, principally as a Nuclear Reactor Operator.