What short-term traders need to know

I've recently taken time off my research to emphasize how important it is for short-term traders to understand the role of size in the market and the importance of tracking the real-time ebb and flow of supply and demand in the marketplace.

Here's a favorite technique of mine that helps me track the short-term trending (or non-trending) of the ES market.

I'll look for a short-term period (an extended number of seconds, not minutes) in which price is stable and bouncing between the bid price and the offer. So, for example, it will trade a number of contracts at 1275, then a bunch at 1275.25, then more at 1275, and then some at 1275.25. This oscillation, in a very short time frame, creates a trading range.

I then wait for a large trader (defined as someone who transacts an order with 100 or more contracts at a time) to either buy the market at the offer price or sell the market's bid.

Now, think about it. If a large trader is willing to lift an offer or hit a bid during a stable market, that trader is betting on a breakout move in the very short run.

If the market is really going to break out, we should see other large traders come in on the coattails of the large order. Conversely, if no large orders follow the trader's big trade, it is unlikely that the market will break out, and our trader will probably have to cover his or her position.

On this shortest time frame, we can define a trending market as one that pays out a large trader who hits the bid or lifts the offer during a stable period of market oscillation. If the market absorbs a large order and does not break out of its bid-offer range, the market is refusing to trend.

So here's the favorite technique: I simply wait for size to hit the market (i.e., large orders hit the bid or lift the offer) and note the price(s) at which the large order was transacted. I then wait a little while to see if that big trader is getting paid out. I particularly like this technique when we see a flurry of large orders hit the market in a short time. If the market absorbs those orders and does not shift its bid-offer range, I note that we're in equilibrium and will not take a position in the direction of those large traders. Indeed, if I see that a number of large trades have failed to move the market's range, I might take a trade in the opposite direction to benefit from those traders needing to unwind those positions.

A very simple example of this technique occurred recently when I was short the S&P and the market moved nicely in my favor. A large trader then hit the bid with a 1500 lot and the market just sat there, oscillating. Several more large trades hit the bid in the next fifteen seconds, also failing to move the market. I quickly took my profits and avoided a sharp rise when buyers, sensing the loss of downside momentum, began to lift offers (and force the prior sellers to puke their positions at higher prices).

It's the electronic equivalent of tape reading, and it can be invaluable in helping short-term traders stay in good trades, but not overstay them.

Brett N. Steenbarger, Ph.D. is Associate Clinical Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical University in Syracuse, NY and author of The Psychology of Trading (Wiley, 2003). As Director of Trader Development for Kingstree Trading, LLC in Chicago, he has mentored numerous professional traders and coordinated a training program for traders. An active trader of the stock indexes, Brett utilizes statistically-based pattern recognition for intraday trading. Brett does not offer commercial services to traders, but maintains an archive of articles and a trading blog at www.brettsteenbarger.com and a blog of market analytics at www.traderfeed.blogspot.com. His book, Enhancing Trader Performance, is due for publication this fall (Wiley).