Identifying Short Covering: Day Traders Perspective

[Soultrader 12]

A question popped up in the forums on "how to identify short covering?" so I thought I'de start a thread on it. Please feel free to share your insights.

 

We all have our interpretations but this is how I define market participants. I have excluded participants who enter to hedge... as I do now know what category they fit in.

 

Category 1

 

Long term buyers and sellers - these participants are looking to profit on a longer time frame basis using daily, weekly, and monthly charts. Usually known as commercials.

 

Category 2

 

Medium term buyers and sellers - Although some may prefer to include traders who hold positions for weeks... I prefer to place swing traders in this category. Traders who hold positions anywhere from 1 - 10 days.

 

Category 3

 

Short term buyers and sellers - Day traders and scalpers who trade electronically.

 

Category 4

 

Floor traders

 

Okay.. so out of these 4 category, as a day trader I am mainly looking for short covering by participants in category 3 and 4. Why? First Category 1 and 2 do not care about these intraday swings. They are looking on a bigger time frame. However, it would be wrong to completely exclude these groups as they are also day traders when placing a trade. The time I watch for short covering from participants in Category 1 and 2 is when we have a down trend day or we have had several lower value placements during the previous trading sessions.

 

For example, if the YM hits a daily pivot and declines 30-40pts... I am not watching for short covering by Category 1 and 2 market participants. Their attitude is "who cares?". As a day trader we tend to go "Wow" when the dow rallies or declines 40+ pts. So who are the shorts that will drive the short covering rally? Category 3 and 4 participants. I am mainly concerned about short covering from day traders and floor traders. In other words, those who sold earlier... when will they start covering?

 

For a short covering to happen the market must be in a decline. Ask yourself who are the traders that shorted at the top and when will they be looking to cover? This can be 30 secs ago, 3 min ago, 30min ago, whatever. The point is understand the psychology of the traders that need to exit in order to profit from this move.

 

So how do I spot short covering? First, I am a hardcore tape reader. I will remember the 10-lots that appeared on tape on the sell side at the top of the move and look for the same lots appear on the buy side after a decline. You can spot these guys covering on the tape as the tape will start to become green and price decline will slowly come to an end.

 

So what areas should you watch for? Let's say the markets rallied at the open, formed a double top, and then reversed. Now the shorts from the top or double top.. where will they cover? Perhaps at the 61.8% fibonacci retracement, perhaps at the open, or previous day low, etc... Knowing the reference point is important in my opinion. What I tend to do is to picture myself on the short side and looking for an exit. I ask myself "Where is a good place to exit?" I am sure the majority of the shorts are thinking the same thing. Pick a reference point and stare at tape... you will see all the shorts jumping on the ask to cover, cover, cover!! Short covering fueled rallies are ones I hate the most. It is such an amateur move since everyone is chasing.

 

Another method I use by looking at volume delta. Basically throughout the decline, I am looking for volume bars that show more contracts being bought at the ask versus sold at the bid. Basically, you will have the early shorts who fear of losing profit covering first. Most of the time price will decline a little further and then you still start seeing the better traders starting to cover. Volume delta shows this clearly as you will start to find more volume bars that show more contracts bought at the ask as price declines. Eventually, most of the shorts will cover and the greedy ones will cover the same time the amateurs start chasing the market.

 

Its just something that I look for... hopefully traders here can add their input as well. Happy trading.

[Nick1984 10]

G'day mate nice write up. After the events of last week I have been watching our local markets here closely to see what would happen as our major stocks took a tumble. I tried to anticipate when the short coverings would come. I have to use end of day data at the moment and basic market depth data which is not only confusing to me but also misleading. Once I have enough money and knowledge to open up a futures trading account I'll be able to use more up to date data!

 

Soul, do you think you could explain the working of the Volume Delta a little more? So far the only indicators I've tried to get to know are the P/C ratio, Tick, Trin, Volume, Price, and im trying to read about tape reading. Fib's are also a little alien to me atm but one step at a time i guess!

 

Cheers and good luck with your trading.

[Soultrader 12]

Hello nsitt,

 

The most interesting part about the following days after the major decline is the continuous lower value placement. In my opinion we are still headed south.

 

Okay.. volume delta is a tool that plots the number of contracts at the bid vs the number of contracts at the ask. Let's say you were long... now you want to exit for a profit. Would you use a market order or a limit order? In most cases you would use a market order and hit the bid. This gets you out guaranteed.

 

Now if you were short and had to exit would you use a market or limit? Market would be the better decision here and you would hit the ask. Therefore, more contracts at the bid means selling. More contracts at the ask means buying. (shorts need to buy to cover)

 

The volume delta takes these two set of numbers and plots whatever the greater on top. So a volume bar with more selling would plot red on top of the green and vice versa. I have attached a snapshot.

[keymoo 10]

I have a question for you on the tape. Let us assume that the guy selling the top of the rally goes in with a market order. This will show up as a red 10 on tape. Got me so far? If he placed his order as an ask then who knows how his sale would appear on tape?

 

I am wondering whether the guy that shorted at the top with his 10 lot at the market would use a market order to cover? I would say that he would most likely scale out with bids at say 5 and 5 or some other combination. It would, in my opinion be highly unlikely you would see a 10 lot as a market order to buy. Therefore it would be very difficult to see the actions of one trader.

 

You see this on ES a lot. You will see an order to buy 1500 ES contracts, but you never see the same lot on the same day to liquidate that purchase because the liquidation would have been done using limit orders at different prices by scaling out.

 

I personally believe a lot of the orders you see on tape are by people that are eager to get out of a position (stop hits). So if you see lots of sell market orders on a decline they are people getting stopped out from buying the high. People taking profit are more likely, in my opinion, to use limit orders.

 

I know this depends on the style of trading and a lot of traders will take profit on a market order, but I am proposing to you that most don't.

 

What are your thoughts on this and how does it affect your thinking (if at all)?

 

Another thing to bear in mind is that people that want to take a large position will often scale in to their position with limit orders and you will find this hard to see on the tape as we all know the tape only shows market orders. You can see this in the pit very often that a bank that wants to take a large position will do so at its leisure by sitting on the bid (or ask) and not going in at the market.

[Soultrader 12]

Not necessarily keymoo. If you watch the tape closely you can see the footprints of these bigger traders. First, a 10lot trader is not going to do any harm. He will simply appear as a small guy if he is scaling out at 5 and 5. What I am interested in is those bigger traders who scale out at 10+ lots each. Not only that... you will be surprised to see the 50+ lot traders who exit all at once. There are plenty of them out there to see their footprints. Also you find traders have weird lot sizes at times. Sometimes you see a 88 lot trader... now when you see 44 lot at the market what does this tell you? The 88 lot trader is scaling out.

 

Now I do not know exact figures but I do think more traders use market orders than limit. Even if this is not the case you can see clear footprints of those that use market orders. Even if big traders started using limit order, you can see that price is being sold as there is no price advancement with high volume.

 

The tape tells it all. Whether market or limit, doesnt make a difference if you are able to read the tape. You can also tell if the orders you see on tape are simply stops or sellers. If 10+ lots sell orders started to appear on tape what does this tell you? Well... first of all did 10+ lot buy orders appear near the top of the rally? If yes, this would indicate stops. If no, this would indicate shorts.

 

Also, I am not interested in insitutional orders on these intraday swings. (not referring to 500pt decline days) They do not care about these swings and they may have traders working their orders their entire day. If they want to accumulate, volume shows all their footprints. If they distribute, volume will show this as well. Try to think of it in a more micro basis. Short covering by big money can be detected with market profile and volume. Short covering by day traders and floor traders can be detected by tape.

[keymoo 10]

I guess what I need is a lot more experience reading the tape. I am still confused though as to how you know whether traders are using limit or market orders? Of course there has to be one of each for every trade. How do you know that guys that get in with a market order of 88 cars will exit with a market order? a 44 lot may not necessarily be the same guy. He may scale out 44,22,22 with limit orders.

 

I want to learn how you observe and interpret these orders in the market as you seem confident in your observations. This may be a good topic for a video - identifying footprints on tape. ;-)

[maharaj07 10]

Hello Soultrader, nice write up on tape reading. May I ask what trading platform you are using to display 10+lot trades on the right column and the small lots on the left?

And what software are you using to plot the volume delta? Thanks.

[Soultrader 12]

Hello Soultrader, nice write up on tape reading. May I ask what trading platform you are using to display 10+lot trades on the right column and the small lots on the left?

And what software are you using to plot the volume delta? Thanks.

 

I use Tradestation for all my charting needs maharaj07. The volume delta is an indicator written by one of the members on the forum and is available under our indicators section.

[notouch 10]

The tape can be misleading at times. There may be big institional offers sitting at a resistance level but on the tape all you would see is the offers being hit which would look bullish. Also a lot of traders take profit using a limit order. The most common order is probably a bracket order with a stop on one side and limit on the other to take profit. It's difficult to tell from the tape what is covering/liquidation and what is new orders. The way I see it, when the offers are being hit it just means the buyers are more aggressive - more desperate to get the order in because they're scared the price will run away from them. When the bids are being hit the sellers are more aggressive. What you're looking for is aggressive sellers at a resistance level or aggressive buyers at a support level.

[Soultrader 12]

Good point notouch. I must say discussing tape through text is probably the hardest way to understand. We are definitely looking for which side is more aggressive. You can see when momo pick up on tape.. or when after a nice run the tape slows down. All of these are good visual clues to warn and confirm your trade.

[GCB 10]

I'm curious about something keymoo said, that the tape only shows market orders. Is this true? If so, why? (Or is the other side of the market order which is shown on tape a limit order?)

 

Do market orders always have to be matched with limit orders? Or can two market orders or two limit orders be matched? If so, do these appear on the tape and how? It would seem from what's been said and how the tape appears that market orders are always matched with limit orders. Otherwise at what price would they be matched and how would they be presented on the tape, as buys or sells? But then, this begs the question, if there is only one buyer and one seller in the market, and they both place market orders, are we saying their orders cannot be matched until somebody comes along with a limit order? Or suppose they both place limit orders for the same amount of shares at the same price, on to buy and one to sell. How would these be presented on the tape? And what does it mean when an order executes "between the bid and the ask?" Is that two market orders being put together?

[keymoo 10]

It's easier to get this straight in your head if you look at the pit. At any time in the pit there will always be a bid and an offer. The bid is a buy-limit order and the offer is a sell-limit. These prices will be the best bid price and the best offer price and the difference between them is called the spread.

 

So, let's take the SP as an example. If the best bid in the pit (the highest someone is willing to pay) is 1410.00, the best offer price would likely be 1410.50. Because there is a difference in the prices, people on the bid and on the offer never trade with each other. So, limit orders never get matched because an agreement on price has not been reached - there's 0.50 difference in price.

 

OK. Now a trade is executed only when someone who needs to buy or sell NOW comes to the market and wants to place his order. So let's say we have a keen buyer who needs to buy urgently. He won't place a bid (limit-order) to buy because he may not get filled - it's just a bid. He was to wait for someone to sell to him to get filled. Instead, as a keen buyer he will buy at the best offer price in the market at the time which is 1410.50. The 1410.50 appears on the DOM as an ask. When the transaction takes place and our buyer hits the offer and agrees to buy at the price the other guy is offering, the transaction shows up on the tape as a BUY, because he bought it at the market.

 

The tape can show bids and offers if you switch that option on in tradestation, however these are not trades, they are just bids and offers. Trades that take place are market orders - people hitting the bid, or hitting the ask - because they are a keener buyer or seller. This, I feel is important to understand when you hit levels of resistance.

 

For instance yesterday on YM we had a lot of resistance at VAH and the pivot. There simply were a lot of people on the offer (people with sell-limit orders) around VAH and the pivot - people that either want to take profit there from their longs, and people wanting to fade the pivot/VAH. To get through this thick layer of offers, buyers have to come in strong and persistent to exhaust all the offers which may take some time as we saw yesterday with price hugging the pivot. There were lots of people buying at the market, and there were lots of offers to absorb all the buying - hence price didn't move up. However, once all the offers have been filled and buyers still come in, price then starts to move up to the next best offer price.

 

I hope that clears things up.

 

I'm not clear on prices that take place between the bid and the ask - if someone knows this I'd love to understand it. In the pit this usually only happens between locals where they trade with themselves, but I'm not sure how this would happen on YM.

[ItalianSharp 10]

Excellent posts guys.

 

As far as I understand about prints on the tape coming out WHITE - execution occurred between the bid and the ask - it's gotta be something to do with the pit and market makers. Since the market maker's job is to make the market, when the bid and the ask are off by more than one tick - as in the ES example mentioned in this thread - he steps in and satisfies both demand and supply.

 

I personally ignore those prints.

[dalby 10]

this is spot on. every trade that occurs on the bid or the ask (which is 95%+ of YM trades) is a market order for one person and a limit order for the other.

 

so, which side is making the market orders tells you a lot. that's the whole concept behind market delta, tick delta, etc.

 

and a big part of tape reading.

[novicetrader99 10]

Hello nsitt,

 

The most interesting part about the following days after the major decline is the continuous lower value placement. In my opinion we are still headed south.

 

Okay.. volume delta is a tool that plots the number of contracts at the bid vs the number of contracts at the ask. Let's say you were long... now you want to exit for a profit. Would you use a market order or a limit order? In most cases you would use a market order and hit the bid. This gets you out guaranteed.

 

Now if you were short and had to exit would you use a market or limit? Market would be the better decision here and you would hit the ask. Therefore, more contracts at the bid means selling. More contracts at the ask means buying. (shorts need to buy to cover)

 

The volume delta takes these two set of numbers and plots whatever the greater on top. So a volume bar with more selling would plot red on top of the green and vice versa. I have attached a snapshot.

 

Hello I'm from India. Can you tell me how to get this volume delta indicator (attached image) customized for indian markets? is it directly from tradestation or modified via easy language.