At the Edge of Chaos: Buyers, Sellers and Short Sellers – Who’s in Charge and What Does it Mean for the Price Trend?

The ultimate truth in any market is the price of an asset. And, at present, money is cautiously moving back into the market, although it’s doing so in an unpredictable and seemingly haphazard fashion. It’s important to understand that this is perfectly normal behavior, but also that the short-term remains uncertain due to the Federal Reserve’s intentions of continuing their interest rate increases.

Last week in this space, I noted: “the fate of this rally depends on how many investors actually believe that the central bank is close to ending its rate increases.” What I meant is that, even though the stock market is influenced by external factors – primarily the actions of the Federal Reserve and the general trend of corporate earnings – stock prices ultimately move up or down based on whether the majority of investors are buying or selling stocks at any one time – regardless of the presence of outside influences. Therefore, even though external influences are important, it’s more important to gauge what investors are not just thinking or talking about, but what they are actually doing with their money.

This week, I review how the markets work and break down the actions of the three major players and what it could mean for the future of prices.

How Markets Work

During volatile markets, it’s important to understand the mechanics that drive price trends. Let’s review:

  • All markets, including the stock market, are complex systems composed of agents – traders, market makers, investors – who interact with the environment – the Fed, consumers, global governments.
  • In complex systems, when enough agents find success via a certain method, the others follow, creating a herd effect and taking the system through a point of emergence to a new level of operation.
  • In the language of the discipline of Complexity, a move toward a new level is called emergence.
  • In the stock market, emergence is exemplified on a price chart when it displays a price reversal, which leads to a breakout or a breakdown.
  • When a upside price trend is established, the market is in the realm of Complexity.
  • When prices break down and volatility reigns, the market is in the Chaos zone.
  • When prices are moving sideways price, trends are at the edge of Chaos, where Chaos and Complexity are vying for control of the trend.
  • It is from the edge of Chaos that points of emergence appear and new trends form.

You can see these moments on the price chart for the U.S. Ten Year Note Yield (TNX):

  • Point of emergence (breakout) to new yield highs (January 2022), and
  • Possible trend reversal to downside (April 2022)

Remember that, when bond sellers prevail, the yield rises, and when bond buyers are in control, the yield falls. At the moment, it seems that we are seeing a power struggle between buyers and sellers in bonds, which, as I detail below, you can also see in stocks.

So, the takeaway is that, when it’s all said and done, price trends result from one primary relationship – whether there are more buyers than sellers in the system at any one moment in order to create a price trend that can last.

Buyers, Sellers, and Short Sellers Who’s in Charge?

That said, it’s important to note that short sellers – those who borrow shares and sell them in hopes of buying them back at a lower price in the future – are just as important as buyers and outright sellers, for two reasons:

  • When short sellers sell stocks short, market makers buy put options and sell stock index futures to hedge their bets. This drives stock prices down.
  • When short sellers buy stocks to cover their short positions, stock prices rise, often igniting market rallies.

Still, in order for short covering to lead to a sustainable rally, it has to be followed by actual buyers coming into the market. It’s that actual buying – on top of the short covering – that actually creates lasting rallies. Thus, even though the Fed and the environment are an important part of the equation, the price trend is all about whether there are enough believers (agents) in the system who are buying or selling in order to create that particular trend.

What that means is that if we’ve achieved critical mass in believers (buyers), then the odds of the stock market being near a significant reversal and a tradable rally have increased. See the section below on the New York Stock Exchange Advance Decline line and the major indexes for full details of where we are at the moment.

Welcome to the Edge of Chaos:

The edge of chaos is a transition space between order and disorder that is hypothesized to exist within a wide variety of systems. This transition zone is a region of bounded instability that engenders a constant dynamic interplay between order and disorder.” – Complexity Labs

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Short Sellers Pause but Buyers are Hard to Find

I’ve been watching the relationship between the CBOE Volatility Index (VIX) and the New York Stock Exchange Advance Decline line (NYAD) for months now. Usually, when VIX rises, NYAD falls and vice versa. That’s because a rise in VIX means rising put option volume, a bearish development for stocks.

And here’s where we ended on 6/3/22:

  • NYAD failed on its bid to move above its 50-day moving average.
  • VIX still looks as if it could be headed for its recent lows below 20.

So it looks as if the rally is struggling because, even though (as I describe below) we’ve seen plenty of short covering, the buyers – whose actions would move stocks even higher after the short covering rally – have yet to materialize.

The S&P 500 (SPX) remained above the 4000 level and remains in the midst of a significant resistance zone at 4100-4200. Moreover, there is even more major resistance in SPX all the way back to 4300-4450.

Accumulation Distribution (ADI) shot up in a big way during the recent rally, which means the short sellers are bailing out. On the other hand, On Balance Volume (OBV) bottomed out but did not move up in a similar fashion.

That confirms that we have a dearth of buyers. So, when OBV starts to move aggressively higher, the rally could well move higher.

The Nasdaq 100 index (NDX) rallied as well, but remains well below what was key support at 13,000, which now becomes a key overhead resistance level. Moreover, we see a similar picture to that of SPX when it comes to ADI and OBV.

So, what’s the absolute bottom line? We are not likely to get a new sustainable uptrend in stocks until we get real buyers to pour into the market after short sellers cover their bets.

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Joe Duarte

In The Money Options

Joe Duarte is a former money manager, an active trader and a widely recognized independent stock market analyst since 1987. He is author of eight investment books, including the best selling Trading Options for Dummies, rated a TOP Options Book for 2018 by and now in its third edition, plus The Everything Investing in Your 20s and 30s Book and six other trading books.

The Everything Investing in Your 20s and 30s Book is available at Amazon and Barnes and Noble. It has also been recommended as a Washington Post Color of Money Book of the Month.

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