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Still trapped in a triangle pattern

December 29, 2011 By Leave a Comment

Bulls have been beaten down at every attempt of a breaching the SPY resistance area (former support in June) near 126.50. The market is resilient enough to crawl back, and a significant break above this barrier would permit a convinced long entry. Should the market resume today’s sell-off, a break of an uptrend seen in the daily time frame could be an opportunity to short.

Filed Under: Market Commentary

Managing and understanding the nature of trends

December 28, 2011 By 2 Comments

A trend represents the evolution of public sentiment, specifically, the psychology between optimistic market participants (bulls) and its pessimistic counterparts (bears). Moreover, the angle of a trend can determine whether the market’s mood is extremely optimistic or extremely pessimistic.

One thing that is very common of traders is that they consistently take a pounding from the market because they do not understand the underlying forces of trends. If the market is visibly moving down, sellers possess greater authority while buyers are countering against the seller’s strong influence. In the bigger perspective, such upswings are mere counter-moves on the way down. Buying is thus a much more challenging proposition than going with the dominant force. The opposite applies to rising markets in which buyers are in control.

If a market is in a decline and a trader is short, there is no point in covering, buying, and shorting again lower and lower because he will not be accomplishing anything of greater significance. What is the advantage in being exposed to new risk if a market is in an obvious decline already? You should stay short in a downtrend and not be overly concerned about reversals against you. On the contrary, there is no point in buying into every dip in hope for a massive recovery rally. New spikes on the way down are a necessity and a chance for bears to adjust their stops lower, thus reducing their risks or even secure increasingly more profits.

If you think about why markets move up and down: It is because there is an ongoing war between bulls and bears. These two opposing groups behave like armies on a battlefield. The aim of the bulls is to push markets up because they make money if they are successful, but they forfeit money if they are not. Then you have an opposing crowd that is just as intense as bulls in moving markets to the opposite direction. We basically have two enemies with two very different goals.

The bottom line is that all up and down movements are actually the result of a dynamic battle being fought out between these two forces. Significant battle lines are drawn days to weeks before, and have an immense impact on how the market moves the following day. A fight for control is taking place at these lines and are what we call a support or resistance area. As the bulls advance, the bears retreat and regroup at the next resistance. There, more bears enter the market in hope to overwhelm the bulls in a larger number to push the bulls back down toward support. Bulls regroup at support with the goal to push the bears back up towards resistance again. It is a cycle that appears in all markets.

What is being exploited for profit is the dominant trend of the market. We do not make money by predicting support and resistance areas, but by catching turnarounds there. Once a trend is initiated after such a turnaround, it is not going to stop right away, but it will continue for an extended period. The ignition will trigger a chain reaction of orders that will predominantly serve the winning army’s interest. In an uptrend, bullish traders are making more and more money while bearish investors need to cover their shorts and reverse their position which, in turn, gives further boost to the ongoing uptrend.

Obviously, those market participants holding long positions will not easily give up their money-printing machine and stick to this position for as long as possible. Same for the former bearish participants who are finally starting to profit, expect the trend to continue. A trader’s fear that the market would turn against him any moment is usually unjustified. The challenging part is to stick with a position through thick and thin until the position is stopped out for good. Prior to this, a trend follower’s job is easier than you might imagine: wait and sit on your hands.

Filed Under: Trader Education Tagged With: , ,

Traders’ delusion with random patterns

December 23, 2011 By 2 Comments

In his book How We Decide, Jonah Lehrer wrote about a simple experiment conducted among students at Yale University. It reminded me a lot of the senseless undertakings that traders do to seek logic in random price action:

Look, for example, at this elegant little experiment. A rat was put in a T-shaped maze with a few morsels of food placed on either the far right or the far left side of the enclosure. The placement of the food was random, but the dice were rigged: over the long run, the food was placed on the left side 60 percent of the time. How did the rat respond? It quickly realized that the left side was more rewarding. As a result, it always went to the left of the maze, which resulted in a 60 percent success rate. The rat didn’t strive for perfection. It didn’t search for a unified theory of the T-shaped maze. It just accepted the inherent uncertainty of the reward and learned to settle for the option that usually gave the best outcome.

The experiment was repeated with Yale undergraduates. Unlike the rat, the students, with their elaborate networks of dopamine neurons, stubbornly searched for the elusive pattern that determined the placement of the reward. They made predictions and then tried to learn from their prediction errors. The problem was that there was nothing to predict; the apparent randomness was real. Because the students refused to settle for a 60 percent success rate, they ended up with a 52 percent success rate. Although most of the students were convinced that they were making progress toward identifying the underlying algorithm, they were, in actuality, outsmarted by a rat.

Update on December 29: Please find insightful discussions on LinkedIn.

Filed Under: Psychology Tagged With:

The hostile opponent never ceases

December 22, 2011 By Leave a Comment

Have you experienced repeated hostility from someone, without a chance to change the situation? This is probably what every trader is confronted with every day. I am not referring to a distinct enemy figure per se, rather a metaphor for everyone whose opinions and actions oppose your interests. Trading is challenging (at the very least, it is emotionally exhausting). I don’t attempt to sweet-talk it.

If you are long, you condemn the bears for selling off. Once you switch sides, you condemn the bulls for recovering. There is little you can do about it. As a trend follower, I’m in a position basically throughout the year, which is why I have to deal with adverse movements frequently. The only solution I have found is to look at the big picture and trade trends that sustain itself over multiple days while managing my stops rigorously.

Although it demands a lot of attention, trend following can be done in any market condition. It is only a matter of time frame and frequency of adjustments whether you prosper from trends or not. If I’m wrong, I will be stopped out. If I am right, I still have to manage risk because no trend lasts eternally.

Yesterday was the perfect example of adversity. A new rally was gaining traction the previous day, after the price broke a multi-day downtrend (see 4H chart below). I was in a long position since then and pleased that the market closed near the highs of the session. On the following day I first witnessed some stability, until a news item must have disrupted the harmony. We dropped nearly 30 points off the pre-market highs. I condemned this.

Why is the market never sticking to its direction? Why must it be so challenging to trade? At the same time, I was aware that the trend had already shifted so drastically that going short was out of any sensible options. So I hang on. I waited. Maybe the market simply got ahead of itself in the first place.

The S&P 500 started to recover eventually and we are now back to the old highs as if nothing had happened. A lot happened emotionally, though. It was a battle within myself. We may scold imaginary bullish or bearish participants, but we are actually our worst enemies. The equity curve is the direct result of our own trading decisions. When entering a trade, one is too consumed with the very moment, so that the emotional impacts of subsequent adversities are neglected. A trend follower may not expect markets to explode higher every minute, but neither does he like a vicious sell-off.

At least we formed a higher low which means that the uptrend remains intact, and I can adjust my stop to that area now. In the broader context, the bear’s attempt at pushing prices lower resulted in just a minor dip.

Filed Under: Psychology Tagged With: ,

Wonderful last-minute Christmas gift for traders

December 20, 2011 By Leave a Comment

If you know anyone in your family or circle of friends who is very devoted to trading or investing, here is the perfect Christmas gift idea for him or her. At $209.95 it may appear pricey, but of all sculptures I have seen so far, this is the most appealing one. You can add one line of text, such as the person’s name, for free. Ideal to decorate an office desk with. Find it at Memorable Gifts.

Filed Under: Uncategorized

The philosophy of trend following

December 19, 2011 By 1 Comment

What causes a movement in financial markets? Two market participants can come to different valuations for a security, based on the same information at the same time. This arises out of the Subjective Theory of Value. Carl Menger said that “the measure of value is entirely subjective in nature, and for this reason a good can have great value to one economizing individual, little value to another.” For one trader it makes perfect sense to sell a security whereas another trader wants to buy it for entirely different reasons and circumstances.

If two individuals come to two different conclusions, they obviously cancel each other out. Once an opinion outnumbers all others, however, things start to move. It is therefore the sum of the identically enforced decisions that leads to a move.

Imagine a freight train which advances according to the laws of inertia: Once this heavy locomotive with all its fully loaded wagons has started moving, it is very hard to reverse its direction. An extreme amount of force needs to be put up to halt the train first.

Money has resembling motion in financial markets because there are countless of market participants involved who need to react and adjust their individual position appropriately – a process which obviously takes a lot of time.

Similar applies to the inertia of crowds. If you are a small trader, use this to your advantage as you can switch your position easily and ride a trend from a very early stage on. The following excerpt from The Book of Five Rings by Miyamoto Musashi transcribes it best:

The way to do battle is the same whether it is a battle between one individual and another or a battle between one army and another. You should observe reflectively, with overall awareness of the large picture as well as precise attention to small details.

The large scale is easy to see; the small scale is hard to see. To be specific, it is impossible to reverse the direction of a large group of people all at once, while the small scale is hard to know because in the case of an individual there is just one will involved and changes can be made quickly. This should be given careful consideration.

In his 1954 work New Blueprints for Gains in Stocks and Grains, William Dunnigan articulated his insights on the philosophy behind trend following:

We think that “forecasting” should be thought of in the light of measuring the direction of today’s trend and then turning to the Law of Inertia (momentum) for assurance that probabilities favor the continuation of that trend for an unknown period of time into the future. This is trend following, and it does not require us to don the garment of the mystic and look into the crystal balls of the future.

Let us believe that it is possible to profit through economic changes by following today’s trend, as it is revealed statistically day-by-day, week-by-week, or month-by-month. In doing this we should entertain no preconceived notions as to whether business is going to boom or bust, or whether the Dow-Jones Industrial Average is going to 500 or 50. We will merely chart our course and steer our ship in the direction of the prevailing wind. When the economic weather changes, we will change our course with it and will not try to forecast the future time or place at which the wind will change.

The main message here is to stop predicting. Every economist tries to predict the future with apparent certainty. Their actual ambition is to strike the big coup for instant vanity. Since their ubiquitous urge cannot be put aside, the individual trader is better advised by ignoring pundits.

You must understand that the market will never ever trade according to your liking but always according to its liking. Trend followers ride those trends as they are offered by the market and hence listen to what the market is telling them. Sitting on a winning position is like riding a fire-breathing dragon that burns its path free and every trader who dares to stand in its way. No single trader who attempts to impress his princess by outsmarting the dragon stands a chance to beat it, ever. It is actually quite an entertaining ride to watch inexperienced traders in chat rooms buying and shorting the market without any sensible reasoning, and have them take one pounding after another.

Being passive by merely maintaining your active position with a properly set stop-loss order can be truly magical.

Filed Under: Trader Education Tagged With: ,

Getting ahead in trading

December 14, 2011 By Leave a Comment

I recently received an email from an individual who already gained extensive hands-on experience in trading, but seems unable to get ahead. Whenever a large gain was made, it is slowly drained away by little losses here and there. At the end of the day, he is muddling around break even:

After all this, I feel I should be further in the game. Instead of being a consistent breakeven trader, I want to be a consistent profit maker. Perhaps you can open my eyes to trading.

Upon analyzing his transactions, I believe to have figured out the root of his problem. The most striking misbehavior is that he scalps the market up and down and takes way too many opportunities. Taking that many opportunities will result in many errors because a trader is not proficient enough to maneuver every move. He took 13 trades on a single day, very typical for beginners.

Trading off the 2 minute chart as he does is a false belief of having control over the market. You do not get more details from shorter time frames, but more confusion.

To design and execute a winning system, you must design yourself to becoming a winner, too. It implies that you refrain from trading out of gut feel, but according to rules of your strategy. I believe it’s a fallacy to assume that being break-even is a significant step toward consistent profitibality. You will think that one final touch to the strategy will make you profitable. Actually, it just proves that you cannot hold onto gains and will lose a lot of money very soon. A winner is someone who can hold onto gains and continue to build up the equity curve. So take less trades out of gut feel, and more based on objective observation of trends.

In case you do not have a firm trend following strategy yet, I advice you to take a step back and look at what is really happening in the market. Try to interpret the battle of bulls and bears behind. It’s all common sense. Concentrate on pure price action, not on candlestick formations, head and shoulders, topping patterns, you name it. They are all a consequence of this dynamic battle anyway. Close the small time frames and look at nothing below the 1H chart.

I know that you are seeking an indicator that will give you the answer each time, but a reliable indicator or a combination thereof does not exist. Do not fall into this trap that so many traders before you have, and still do. The only indicator which I find helpful is the exponential moving average (EMA) for general orientation. But beyond that I use none, not even volume. Only price pays.

Trading is about using common sense and objective analysis. I can tell you that the successful trend trader always looks at the big picture, not the small one. And it is quite obvious why. His experience has taught him that being active is not beneficial.

It is infinitely easier to understand the underlying forces and flow with them instead of taking a beating up and down. What was the reason he took those 13 trades? Was the market changing direction that often? In fact, it was exploding higher and never changed direction on that particular day. It was not hard to figure out that buying and staying long was the only sensible thing to do.

Filed Under: Mentoring Tagged With: , , ,

Concept of a new trend following strategy

December 8, 2011 By 2 Comments

There is a trend following tactic which I believe has great potential for the average market participant. It involves a moving average and signals an entry as price bounces off it. I want to take the time to explain the concept to you here and experiment with it live in the coming months. The performance will be published regularly so that we will see if it’s a viable approach.

The strategy is simple to set up and you will only need a basic charting package to get started. By using an influential moving average in several time frames, we get a good read of the market. The way I have my charts configured for this experiment is as follows:

  • A monthly, weekly, daily chart with an 200 exponential moving average (EMA) in each. These three time frames will serve as orientation and show at which zones our attention is needed.
  • In addition, we need an intraday chart such as the 1H or 4H time frame which gives the necessary precision in trade entries.

Note how the price basically bounces from the EMA in one time frame to another. Without this, we would float in a sphere of tremendous lack of orientation. Some understanding of price action is required to take the actual trades, but is otherwise very straightforward.

Take the AUD/USD currency pair for example. See how price has approached and penetrated the 200 EMA from below in the daily chart (bottom left), and is now on the verge of a turnaround. We take this bounce as a potential short entry and switch to the intraday chart (bottom right) to find a confirmation therein. A break of this visible support level at 1.014 would confirm the bounce and we go short. A stop-loss order to limit our risk would be set to a visible high created in the daily or intraday time frame.

With the moving average bounce strategy, you are looking for the price to fall toward the EMA and then make a rapid move upward away from it for a long entry. For a short entry, you want price to move downward away from the EMA. It is common to see the price briefly penetrate the EMA, since there are many market participants involved. But what follows is often a noticeable bounce.

 

Filed Under: Experimental Tagged With: , ,
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