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Trading Primer

The illustrated elements of trading


Basics | Digging | Deeper | Ocean | Universe

The Investing and Trading Universe

What it is

The idea of a “Trading Primer” is to provide a practical framework and foundation for trading.

If successful, anyone, starting from scratch, should be able to read this, and understand how markets work, and how to trade them.

The bigger goal is to give an overview of the entire financial universe.  Ideally, this is practical information, that can be used to trade profitably.

But in my opinion, understanding the features and inter-relationships within economies is important to understanding the human world.  People who don’t understand how banking and business work, how financial products and currencies interact, are subject to media manipulation.

In light of a deeper understanding of “money,” many stories about so-called politics can appear like theater, more or less true, that mask economic realities, and mechanics.

For me, the economic underbelly is interesting.  It’s a hobby.  It can be big and scary.  But grappling with it can engage us in the world.  Make us players instead of pieces or pawns.  But it may involve dissolving attitudes about “us and them.”

Why it is

One of my main motivations in trading, and creating this site, this product, is to build a “social hedge fund.”

In short, the idea is to help train people with financial need or ambition to trade.  And then connect those traders with ordinary investors.

This is not inventing the wheel.  Training traders is something that happens at prop shops and in investment banks.  Connecting traders to investors happens in hedge funds and Vanguard, and lots of places.

However, at Vanguard you cannot find a “market wizards” type hedge fund.  And most “market wizards” are only accessible to high net worth individuals.

Also, I’m not aware of a prop shop that systematically reaches out through schools and the developing world, and markets the prospect of opportunity to anyone with the ambition to work at it.

But who knows what’s out there.  There’s a lot I don’t know.  This is just my working idea.

My idea is to self-fund this as a charitable organization through my own trading profits.

But in the meantime, a friend of mine, Michael Strong, who runs an “entrepreneurial school” in Austin TX (among many other endeavors designed to promote entrepreneurial-ism all over the world) suggested we make a prototype of this program, and run it in his school.

With that in mind, I set out to create a sort of trading primer and resource list.  I made an index of topics off the top of my head.  Since then I’ve been filling in the topics one by one, and making a website around it.

This is sort of like the blind leading the blind a little bit, if anyone were to follow me.  I’m not an expert trader.  I’m a trader in training myself, sharing things as I learn about them, and develop, rather than after mastery.  (To be fair, not overly self-deprecatory, I’m not “blind.”  But I’m still clumsy, with big, thick horn-rimmed glasses.)

I hope in the future to attract actual experts for guest instruction.  In my fantasy, someday our “social hedge fund” will have villas in exotic locations where this instruction will take place.  But more likely, or sooner, it will be webinars.  And even sooner than that, I will provide links in a resources section, to already existing instruction from experts, that has been invaluable to me.

How it is

My idea at this stage is to separate the course in to a few sections.

  1. Introductory and general

In this area, I will introduce myself, and tell my trading story.  Then talk about some generalities about markets, such as why people want to trade, what typically happens to them when they do, what markets are and how they work.

  1. Technical basics

The goal here is to lay out a framework that presents the most important features of trading, as I see them.  Most of this is already posted, since this is the part I started on.

  1. Technical fine tuning

This area would dig deeper in to technical and fundamental phenomena in trading, like market profile, tools, how to trade news, and so on.

  1. The economic universe

This area would survey many of the products and components of the financial world, and the history of markets.  For me, personally, this is academically interesting.  But I also don’t feel comfortable making financial decisions if I don’t think I have at least a general understanding about what all the parts are, how they work, how that got that way, and so on.  And in some cases these more macro studies do play direct parts in making actual trade decisions.

  1. Psychology and stuff about “self”

Almost every successful trader says that at most half of trading is understanding markets and how to trade.  It’s not ultimately so difficult to understand all that.  But still, many people fail, or find it hard to profit, as traders.  This can have to do with the observer effect.  We cannot observe markets objectively.  The moment we try to engage, we become a part of the process.  So we may need to address issues about ourselves, in order to succeed.

Me and Trading

How I got started

This is a relatively long post, which is designed as part of the introductory section for my Trading Primer idea.  This may end up getting broken in to bits.

My history and year 1

When my dad died it changed my life.  That’s when I started to trade.  I had no idea at the time how profound the change would be.

He left me part of his Vanguard account.  It was fully invested.  70 % mutual funds.  And 30% in stocks my dad had picked.  His choices were top companies from the SP500.  Dividend stocks.

I got control of the account in August of 2014.  That’s when I started my new life as a trader.

I decided I would learn to manage this account myself.  The goal I set for myself was to be totally objective, and learn about all types of investing.  I thought of it as the investing universe.

Trading wasn’t even yet a glimmer in my eye.

My former life as a trader

I thought I knew a little something about investing.  I had tried it about 10 years earlier.  About 2004.  But I knew in my former attempt, I had not been objective.

I had come to the market with a bias.  I approached the market like a gold bug.  I thought the whole economy, companies, currencies and so on, were a house of cards, which would come crashing down, any minute.

Accordingly, I invested at first in junior gold mining companies.  They were supposedly a leveraged way of trading gold.  So that if gold went up, they would go up even faster.

I was following a news-letter by Doug Casey, because his way of thinking appealed to me.  He made recommendations, and talked about the companies.

It was a sort of fundamental trading.  Doug Casey would talk about the economy as a whole, then about the prospects of gold mining companies.  I would read about them, and pick some from the list to buy.

I had no idea about reading charts.  There was a vague idea that people did read try to read charts.  But I didn’t even know the term for this was “technical trading.”  And I figured that people who tried to make choices about what to buy, based on charts, were probably stupid.

For a while, I did pretty well.  I think I doubled my account in about a year.  Then I dreamed about how rich I would be, when I doubled the account every year.

It turns out Doug, and I, were totally right about the price of gold.  I even convinced Janel to buy some physical gold and silver.

Through Doug Casey, and the associated Bill Bonner Agora catalogue, we found a famous libertarian in Burlingame.  We went up there to buy our actual gold and silver, and talk about how rich we were going to be, when the US dollar was recognized as an “IOU” nothing.

From the time I began, gold went up nearly 8x.  Silver 12x, by it’s height in 2011.

I would have done better if I’d just used my stock account to buy plain vanilla gold and silver, along with the investment with Janel, and not stocks.

Year 2 of my former trader life, about 2005

After big success in my first year, I decided to try something new, to build on my success.

Doug Casey launched a new service.  Now he was going to follow junior oil mining companies.  He not only talked about the fundamentals of these companies.  He flew around the world and visited him.  It was an entertaining news-letter.

This was the time of the idea of “peak oil.”  Not only did Doug, and other media, lead me to believe gold was going to the moon.  But so was oil.  These calls turned out to be dead on.  I was right.  So right!  Oil soon spiked 5x.

In retrospect, I would say I was right, but for the wrong reasons.  And worse, I not only failed to earn money on my right predictions, I lost money.  My junior oil companies tanked.  I had no plan for stop losses.  So some of my positions literally lost 100%.  The companies went out of business.  My doubled account halved.

But I had some other companies that went up 10x.  That rescued the account to some degree.  I think it stabilized about break even.

Another thing that happened during all this time, which I vaguely noticed, was that Google went public.  The stock did very well.  Apple began its historic run up.  It out-performed anything I bought.  So did other stocks of plain old companies that made things, and were part of the normal economy.

The economic sky didn’t fall.  Gold went up, and so did real estate prices.

Somewhere around this time, I got drastically ill.  It was a prolonged illness, and seemed like it might be the end for me.  I forgot all about investing in stocks.  I forgot the password to my brokerage account, and left the positions in it untouched for years.

Fast Forward

I went through a couple of more life phases, different lives, after the first attempt at investing in stocks.

Meanwhile, learning about how money and banking works continued to be a hobby of mine.  I was interested in it for purely academic reasons.

I learned a lot from writings like Michael Lewis books.  And the gold bug facet of me continued with books like The Creature from Jekyll Island.

The 2008 housing crash happened, which seemed like a vindication of my gold bug thinking.  But I observed that the economic world still did not crumble.  Then the Fed proceeded to print money on an unprecedented scale.  I was mind boggled.  Still, the world did not end.

I felt like I could read Doug Casey telepathically by this point.  I figured he would say they are just kicking the can down the road.  This still wasn’t the “big one.”  Generations of gold bugs have lived and died saying that.

Someday, some of them may live to see it, and hoot at their success.  Who knows when.

Objective study

So with this history behind me, I knew I had not looked at stock investing (I still thought of trading as “stock investing” at that point) objectively.  I’d come to the markets with my bias, and gotten stuck in a little niche.  And it hadn’t worked out well for me.

I also knew that you could be right about something, like the direction of oil, and yet chose the wrong vehicle to make money on the prediction.  And in fact, even be right about direction, make an investment choice on that basis, and end up losing money.

In summary, by the time I came to my new trading endeavor, in 2014, I had failed at my first attempt at trading, quit when I got deathly-chronically ill, realized at a deeper level the ultimate value-less-ness of making money for it’s own sake, revived myself in my next phase of life by trying to “save the world” by making a busienss, Selfport, which was another failure, and then tried real estate.

By 2014 I had succeeded, with Janel, in real estate (the second of my two life phases sandwiched between my two “stock” phases.)  After I called Selfport a failure, Janel convinced me we should invest in real estate, in 2010.

This turned out to be a great idea.  And it was very therapeutic for me.  Because the first property we bought was considered a “tear down.”  I was able to go in and really get to work, get my hands dirty, and rehab the property.

This was a game changer for us.  Once we had rented our real estate finds, we finally had a new stream of income.

Up to this point, all our income had been contingent on Evans Data.  And while there are great freedoms and potential rewards to building a business, rather than working for someone else, over the years, entrepreneurs become “unemployable.”  So that if the business fails, it’s a different version of the worry of losing your job.

I had a new vocation, managing real estate, and in the early days maintaining our rentals myself.  And I liked looking for new prospects.  Even though buying and fixing rentals, and “trading” real estate wasn’t going to “change the world,” like I hoped to do with Selfport, it was very satisfying to simply work on something that succeeded, feel like I was adding something of value to our family.

This helped add to our family support system, without taking so much of my time that I couldn’t focus the bulk of it on the next dream project, when it came along.

So by the time I came back to trading, I was doing well financially.  And I was older, and hopefully wiser.

My dad, on the other hand, had done quite well with his investment portfolio.  He had taken the Warren Buffet approach, of buy and hold, pretty much forever, quality companies.  Vanguard also advocates this approach.

My dad had lived his life with very modest income.  And yet, unbeknownst to me, he’d quietly been investing in stocks for most of his life.  By the time he died, his account was pretty impressive for someone who had lived on an income where most Americans wouldn’t even have a savings.

He would have had a huge draw down during the 2008 crash.  But by the time I inherited his account, it had grown dramatically, from the 2009 low, for 5 straight years.

This was the entrance point for my new phase in life.  Now I would begin my attempt to objectively study the “investing universe.”

Learning and training

One of the first things I knew I had to tackle was charting.  I knew I’d ignored that, scoffed at it.  I hadn’t been objective about that at all.

Also, as a lot of people do, I think, when they decide to learn to invest (or trade) stocks, I immediately began to try buying and selling things.

One of the first books I read was William O’Neil’s How to Make Money in Stocks.  I wanted to be older and wiser, and this just seemed so mainstream.  Contrary to my former contrarian self.

ONeil made sense to me, and I joined IBD, “Investors Business Daily.”

But I was also poking around the web, and reading other books.  I wasn’t going to just stop and settle on one thing.  I had a plan.  Learn about every type of investing, and style.  And by now, the idea of trading had dawned on me.

I observed that some of my first stock picks went up and down.  The first one I bought, when I dipped my toe back in, was BBRY.  It was in a range.  It vacillated by 10-20%.  So while my account went sideways, I realized if I could figure out how to repeatedly buy it on the low end, and sell it on the high end, I could double my investment, or more, in a year, instead of end up flat.

But I found out this was easier said than done.

My study felt kind of random.  I’d spend a few hours here or there, look at new sites, Finviz, Stock Charts, Investimonials, read a book here and there, look at charts now and then, look at various fundamental aspects of companies, try buying or selling this or that.

I’d figured out there was such a thing as “momentum stocks.”  And you could find those on Finviz and in various ways.  On any given day or week, a handful of stocks would be on the move, very volatile.  And some traders specialize in these.

At the time I started this, it was the Ebola scare, and related stocks were on the move.  At an earlier time it had been pot stocks.  There was always something.

I decided I should join a service.  I needed some kind of guidance.  And some way to stay more routinely engaged with trading.  I needed to become more systematic.  To become successful, I needed some kind of training, and regularity.

I wanted to succeed, and actually make money.  At the same time, I was keeping in mind my broader mission statement, to be objective, and learn about all kinds of investing and trading.

I was also no babe in the woods.  It seemed clear to me that there would be many services that were scams, or at least more or less valuable.  So now I had a new sub-mission.  To explore services, but not just academically.  I had to actually try one at some point.

I almost joined one, early on, started by the writer of one of the books I read, called “Superstocks.”  Not to say that was a scam, but his fee was $10k per year.

Combing through sites like Stocktwits and Seeking Alpha, I found more candidates.  Some mentors used pseudonyms, like Superman, which seemed suspicious to me.

Day and Swing trading

Eventually, I settled on Investors Underground.  By this point, I’d decided I probably wanted to be a swing trader.  I wanted to buy great stocks, and hold them for a few months, while they went up.  I got this idea from the “Superstocks” book.

Super-stocks is actually a term William ONeil uses.  In fact Superstocks was the first book I read, which led me to ONeil.  A “super-stock” is like Apple when they first launched the IPod. A great company, fundamentally, that is about to explode, and run up for months or years, to many multiples.

I now know, or believe (I haven’t done a survey…would like to!) that this is what the vast majority of new traders want to find.  This is one of the reasons why a lot of new traders buy cheap flat-lined stocks.  They want to get in on the ground floor.

A lot of new traders also play very cheap “penny stocks,” because they seem cheap.  And there are a host of hazards specific to those waters, that I’d detail somewhere else.

Anyway, my idea was to be a swing trader.  And I found out (can’t recall how) that Investors Underground had a swing trader named Michele Koenig, who seemed legitimate to me.

But when I contacted them, it turned out she was only just about to launch her specific swing trading service.  The main service of Investors Underground was for day-trading momentum stocks.  It was led by Nate Michaud.

Michele recommended I join Nate’s group, and when her service launched, it would be included in my membership.  She said there was a lot you could learn from day-trading, that was applicable to swing trading.  So I wouldn’t be wasting my time.

I had never considered day trading up until that moment.  Jesse Stine, the author of Superstocks, said “Swing trade, never Day Trade!”  His metaphor was that day trading was like “picking up pennies in front of a steam roller.”

Besides, my goal was to learn all about every type of investing and trading.  But I had never intended to literally do it all day every day.  The only reason I was spending more and more time on it, was because I was finding that, by just poking around at random, I wasn’t developing any actual, practical trading skills.

Besides, day trading is one feature of the investing and trading landscape.  Why not learn about it?

And once I did consider it, I noticed that, just as BBRY bounced 10-20% every few weeks, or months, every day there were stocks that moved 10-20% in one day!

I realized that if you could capture even a few tiny % profit every day, it would add up quick.

I don’t live entirely in a cave.  And I’m not young and, hopefully, not naïve.  I knew that day-trading (and most any type of trading) is widely regarded as anathema by most of the public.  Almost all of my friends and family found the idea of trading violently distasteful.  Abhorrent, verging on criminal.

But this was the next step on the path I was pursuing.  And what if it was possible?

The Dream, and history

As I studied trading and the investing universe, a new dream was kindled, a parallel process.  The “social hedge fund” idea.

In these early months of trying to learn to trade, it began to dawn on me that I might go beyond just investing in dividend stocks.  Beyond just managing my dad’s Vanguard account.  If I could succeed, I could theoretically make A LOT of money!

By nature, my head is in the clouds.  But over time, I’ve increasingly tried to stretch myself to get my feet on the ground.  When I was a kid, my dad coached me to “never forget your dreams.”

I don’t want to get my head out of the clouds!  But I do want to actually accomplish things, in “real life.”

I’ve had a lot of dreams in my life.  Never was one of them to be vastly wealthy for its own sake (consciously.)  But I have wanted to do great good, make great art, make products that change the world for the better, on a giant scale!  And I’ve tried.

After my drastic illness that ended my first round of stock investing, in about 2006, I emerged back in to health through attempting to make a world-changing business.

I thought that, maybe the reason I got so ill, was because I wasn’t following my life purpose.  Life isn’t about making money.  It’s about doing something worthwhile, benefitting others, changing the world for the better.

Maybe I got so sick because I’d gone down the rabbit hole of focusing too much on money, with the 2 year long investing endeavor.

My real roots were in spiritual endeavors, writing and art.  My college degrees were in Religious studies, psychology and literature, in that order.

My first mentor and role model in life (other than my dad), was my college professor, Noel Q King.  I regarded him as a true holy man, much more than an academic guide.  When I first walked in to his classroom, I cried with joy.

He was, in a very real sense for me, a guru.  Although he was an anti-guru.  Which was the only fit for me anyway.  He never acknowledged the role.  And he became a dear lifelong friend.

Another seminal part of my history from early days, was that I made my own idiosyncratic version of the bodhisattva vow.  It was absolutely sincere, and I expected it to be the guiding force of my life.

My version of the vow was, “I vow to do the greatest good.  Guide me through whatever needs to happen to me to make me able to do that.”  I made this vow to God.  And since the “bodhisattva vow” is a Buddhist concept, obviously my idea of “God” is….very flexible.

I understood that everyone and everything is interconnected.  From a “God’s”-eye perspective, we are all part of the same body.  This life, and the seeming self, is impermanent.  Everything flows in to everything else.  It’s impossible to be absolutely happy, or lastingly rich, in a context where others suffer, or are poor.

So, when I got deathly ill, I thought of my Bodhisattva vow.  I thought it was a mid-life crisis, and I thought it might literally be the end of my life, if I didn’t get on with my mission.  But not right away.  First I got very interested in the condition itself.

When it comes to studies, I tend to get very immersed, focused, obsessive.  I studied and tried all kinds of medical and health treatments and modalities.  Nothing seemed to work.  I learned about syndromes, illnesses that are hard to define, in a mechanistic medical model.

Around this time, my dad developed a syndrome called Relfex Sympathy Dystrophy (RSD).  An incredibly painful, “incurable disease.”  My dad had many nearly saintly qualities.  He helped many people, and touched many lives, personally.  He was widely loved and admired.

(Not like me.  I have always been anti-social.  I really do want to help others, do good, and improve the world.  But I always wanted to do it in bulk, not one person at a time, like my dad.)

My dad REALLY CARED about others.  And I thought it was ironic that his condition was called what it was…because it was like he cared SO MUCH about the suffering of others, that his sympathy reflex caused a dystrophy.

The actual name RSD refers to the sympathetic nervous system.  But again, from a yoga perspective, the nervous system is a quasi-physical part of our bodies.  It is an electric system, and could be seen as an interface between mind and body.

His condition was impossible for modern medicine to exactly define, like all “syndromes.” There was no particular “cure.”  And it occurred to me that my condition might be like that too.

I thought maybe the treatment I needed was not a physical medicine, but to change my life.  But not in the sense of a new diet, and exercise.  But to actually do my life mission, and do something significant to change the world, or at least try…really hard!

Selfport

The idea that grew out of this was Selfport.  I was so immersed in health modalities at the time, that at first I thought it would be like a website where people could rate and review health treatments, for particular conditions.  And that might have worked.

But one of my dystrophies, or attributes (all of our qualities can be either) which might start to be clear from this personal history of my trading career, is that I have a tendency to see how one thing is connected to another.  It’s hard for me draw boundaries.

I see all the steps that led to this place, and I see many of the ways things might unfold from current conditions.  Which, btw, could be useful, in predicting future market moves.  If it can be harnessed, and directed.  We’ll see.  Early signs are positive!

So with the Selfport idea, particularly in light of syndromes, I quickly expanded beyond health conditions and treatments, per se.

If I was treating my condition by making Selfport (and it was working!), health is clearly more complex than just biological disorders and treatments.

Why do placebos work?  As Andrew Weil said, why are placebos the control?  They are the most intriguing medicine of all.  They should be one of the primary medicines we study.

What Selfport grew in to was an “entrepreneurial platform.”

The theory that I developed was that health involved everything about life.  Diet, exercise, medicines, yes, but also lifestyle, which involves how we think, interact with others, and make money.  And ultimately how we CAN make money.  What options do people have?

My thought was that for many people in the world, the socio-economic model, in which most people saw their only option for sustenance as getting a job, working for someone else (at best!) was not conducive to health, for many.

So what I built, working full time over 3 years, was a website with a menu of entrepreneurial options.  It also included a mechanism for people to invest through the site in each other’s micro businesses.

The idea was to make a platform that allowed anyone, anywhere in the world, to develop themselves to the scale of their ambition, with no earning ceiling, no limits of any kind!

There was no way that most people could have even considered this endeavor.  But since my bread and butter income came from Evans Data, which my wife Janel ran, while I was completely incapacitated, I was able to devote all my time, and money, to this project.

Without Janel, I don’t know how I would have even lived through this phase.  I re-started from a point where I could barely crawl up and down the hall, and built out the idea through 3 years of full time effort.  Everything I’ve learned about business and investing would have been impossible without a wife supporting me in unique ways.

I learned a lot from this endeavor, but ultimately called it a failure, in about 2009. For 3 years I had spent all my extra money, and all my time, building a complex website, visiting VCs, meeting some interesting people that have remained friends.

And many of my entrepreneurial “menu items,” or versions of them, did become part of the modern business landscape: Homeway, Airbnb, Uber, Gofundme, Facebook, Kiva, and others.  And other parts of my idea still have not emerged.

One thing I concluded was that my idea was too complex.  Most of the businesses that ended up being valued at $billions were only one piece of my idea.

But even back then, I did have the idea of simplicity, and phases.  And I still believe the endeavor might have gotten off the ground, if I’d gotten a first round of funding.

But funding in the VC world is a chicken and egg thing.  It’s usually predicated on prior success.

So, end of story.

The Social Hedge Fund dream

Fast forward, back to my early trading days.

The idea started to germinate, that if I succeeded, I might make A LOT of money.

Thinking back to the Selfport idea, I thought, if I could have self-funded it, I wouldn’t have had to abandon it.  I’d basically completed a working version of the website.  It was launch ready.  But I was out of money.

The site was complex, and required at minimum one skilled programmer to maintain it, and continue to develop it.  And funds would have been needed to implement the marketing idea, even though it was very pared down, to start on a local level.

Now, it wasn’t just that I wanted to reincarnate Selfport.  The world had moved on, and so had I.  Some aspects of what I’d done might still be relevant, others not.

And I’d learned things from Selfport, and also become more jaded.  Even as I was developing Selfport, I was asked, how many people do I really think have what it takes to be entrepreneurs?  And I said, everyone, of course!  Mumbling, assuming they wake up to their potential…maybe you could give them some kind of drug…trailing off.

Truth is, most people are lazy.  It would have been an uphill battle to get a majority (or even a large minority) of people to actually self-start.  Of course, there was the investment-in-others part of Selfport.  Which was intriguing.  (There is still nothing out there like the model I built for that.)

Think about Facebook.  It has billions of supposed users.  A large part of the world.  But it’s mostly passive.

Parts of the entrepreneurial economy has happened.  But it hasn’t massively changed conditions in poor countries, nor even statistically raised standards of living in the US and Europe.  In fact, we have had stagflation for 15 years.

If Selfport had succeeded as I’d built it, would that have made a huge difference in this equation?  Probably not.  Even if it had succeed, IPO’d and I’d become a $billionire, it might have changed some lives, maybe even a lot.  But as it stood, it would not have fundamentally changed our global socio-economic modality.

But to give my old self credit, I did have the idea that Selfport was a first iteration.  Like the Google guys, and Elon Musk, my dream was to use a big success on the first iteration to fund future components.  So, a sort of incubator, and framework for the future parts…most of which still have not happened.

(I have no idea why all $billionaires aren’t like these guys, or Bill Gates, either trying to make all the obvious, cool, sci fi like products you can dream up, and or trying to fix all the problems in the world. What else is the point of money on that scale?)

Meanwhile, time has marched on.  We are on a further future lookout than we had 10 years ago.  And we can see clearly that a significant new, and bigger socio-economic challenge faces us.  Robotics and Machine Learning are poised to fundamentally change the way economics have worked throughout history.

But we’re getting ahead of ourselves again.

Baby Steps

So what is the step right in front of me?  And where am I trying to go first?  And then after that?  And so on.

The frustrating thing for me with Selfport was that I had to stop.  I had to admit failure.  Because I ran out of money, and couldn’t attract a large investment.  The work part I liked.  I like working really hard.  I like making big dreams, and working towards them.

So I thought, I am now financially comfortable.  I can work to learn to trade, and nothing can stop me.  I can work as hard and as long as I want at it.  As long as I don’t do something stupid, and lose all my money, I can keep trying until I succeed.

And I had no doubt I could succeed.  And I still have no doubt.  But I didn’t know how long it would take.

And then, if and when I do succeed, I can try my future idea, the “social hedge fund.”

Taking what I’d learned from Selfport, I said, the new idea has to be dead simple.  You should be able to describe it in a text message.  In a tweet.  So, here it is:

“Connecting ordinary investors with extra-ordinary traders for out-sized returns.”

Phase 1

My idea was, and is, simple.  First I learn to trade.  That’s really phase 1, but let’s call it phase 0, and assume that already happened.

If I made money, the idea is to use that money to train, and fund other traders.  Change some lives one at a time.  Give people access to a new lifestyle, with no earning ceiling, that they could probably not have achieved otherwise.

At the time, I’d never heard of a prop shop.  I later learned about those.  Pretty similar to my phase 1 idea.  Proprietary funds, where traders can come to learn, trade, and earn.

The only extra dimension to my idea is to intentionally reach out to people with financial need.  But many versions of this idea have indeed happened.  It’s not inventing the wheel.

Phase 2

Make a web platform that allows ordinary people to invest in super traders.  Ordinary people are defined as:

  1. don’t want to trade themselves (the norm.)
  2. not super rich, but with some savings.

The pitch for this phase is “Vanguard on steroids.”

The main modality of Vanguard is mutual funds.  But when I first joined, and surveyed the available funds, I quickly realized that none of them had achieved spectacular returns.

The best Vanguard mutual funds had achieved what I considered modest or ok returns.  On the order of 10% per year, not compounded, when looked at over a large span of time, and allowing for large draw downs…since the Vanguard ethos is like the Buffet prescription, buy and hold, come hell or high water.

Meanwhile, if you read the (highly entertaining) Jack Schwagger books series, Market Wizards, you hear all these stories about traders who made hedge funds that returned extra-ordinary returns.  40%, 50%, sometimes more, yearly, compounded!

Such traders exist.  And some of them made life changing fortunes for their clients.  But their funds were almost exclusively available to high net worth individuals.

So the idea of phase 2 is to make Market Wizard type traders available to ordinary investors.

Phase 3 and beyond

If this all happened, things could get interesting.  Vanguard has $3trillion under management.  My enterprise could become a large concern.

That would lead back to the incubator idea.  Multifarious businesses and products.  The nutshell pitch of this phase would be “social VC.”  And again, versions of this are happening now, with sites like Gofundme.  And even now, the SEC is reworking rules around social investment sites.

I hope I’m beyond wanting to get rich for its own sake.  One thing I noticed with Selfport was that, even though I said I never wanted that, the idea snuck up on me.  It’s inveigling.  I caught it flirting around the edges of my sub-conscious.

And if it really did happen, super wealth is notoriously treacherous territory for the soul.  Although I’m too old and cynical to swallow anything I read or hear without question.  So I don’t necessarily believe the eye of the needle thing.  But I also try not to dismiss anything out of hand.

Anyway, the ultimate goal is still the ultimate goal.  To do the greatest good.  To produce the “wish fulfilling gem.”  To fulfill all desires, or make their fulfillment accessible to anyone, through their own efforts.  To make all types of suffering only optional.

So I have gone down this road of dreams, and much further down this road than I’ve described here.  But I don’t do it every day, or even often.  I don’t wander around and around in dream territory.  I am not hung up on it.

My day to day routine is still learning to trade, trading, practicing, working, trading, reviewing, learning, working, and so on.  Nose to the grindstone stuff.

But I work in context of the dream.  I have not forgotten the road, and even some of the interesting features and questions that lie further down that road.

Further down the road

If robots did all the work in the world, would a true “investor economy” be possible?  I have ideas and thoughts about that.

As “artificial” intelligence evolves, how will algos and humans co-exist in markets?  How will markets change?  It certainly will happen.  An interesting question to explore.

Will most humans become cyborgs?  Probably.  It will certainly be an option.  How will that change things?

What other products and services will change the socio-economic landscape over the next 10, 20, 50 years?

This certainly will be more wild and crazy in reality that most commentators seem capable of imagining.  It’s interesting to think about.  Could I and my endeavors be significantly involved in some of these developments?

Back to trading

That concludes the aside, about the parallel thought process, inspired by my nascent trading efforts.

But when, in reality, profits seem so tantalizingly close, while the account slowly dwindles, the luster of dreams fades.

I spent a couple of months in “Nate’s room,” trying to get the hang of day-trading momo stocks.  I paid for and took Nate’s video courses.  I floundered.

Then Michele’s swing room opened up.  I slowly spent more and more time in there.  Michele developed a video course.  I paid for that and took that too.

As 2015 wore on, I certainly was learning a lot.  I certainly wasn’t profiting.  But I wasn’t losing interest.  I was fascinated, and daunted.

There was a ton of stuff to learn, and I wasn’t sure how to organize it all.  Charting techniques, market sectors, indicators, tools, market “internals.”  Disciplines that every trader “should” be doing, journaling, making a “plan,” a watch list, and so on.

I started to become aware of many new trading vehicles I’d never heard about before.  There were so many ways to trade, and things you could trade.  Indices, volatility, etfs and 3 times leveraged etf (that degraded with time), options, futures….I wasn’t sure when I would have a sense of comprehensive understanding.

It was not easy for me to merge the academic pursuit to generally understand the trading and investing universe, and also the process to practically focus on something, one or two things, or a small group of things, to practice on, and actually learn how to profitably trade.

I did try putting on trades here and there, and lost in various ways.  But not a lot, relative to my account size.  I touched the Vanguard account less and less, and used the remnants of my 10 year old account to practice on.  It was at Ameritrade, and I got to know and like the software offered there for free, Think or Swim.

Webinars and Tim

Every week Michele and Nate would have webinars.  I consumed a lot of webinars.

Each room had its protocols.  Nate’s room was very crowded and popular. 100s of participants.  There were strict rules, and people would often get chastised for disobedience.  No idle chatter, for one thing.  Not with 100s of people.  It should be strictly trades.

In Michele’s room, the protocol was to share charts.  In Nate’s room, people would call their entries and exits.  In Michele’s room it was considered crude to specify your moment of entry.  The chart was supposed to convey your idea.

I got intrigued by one particular character in Michele’s room.  Tim Parker.  His charts looked like nothing anyone else shared.  They had horizontal waves of color going up one side or the other.  I had no idea what he was trying to convey.

He would also spout out loquacious streams of big words.  People called him “the professor.”  He took big trades.  Sometimes he said his size, and it was big, and he was confident.

He would respond to private messages, and I chatted with him, and asked him questions.  I learned that the horizontal waves on his charts were volume profile.  Volume at price, rather than the more common volume at time.

He said “All futures traders use volume profile.”  He said a lot of things like that, which I suspected, and later learned, were not always true.  Probably a good rule of thumb is “all people are right some of the time, and some people are right most of the time, but no person is right all of the time.”

And if you find someone that is right, and has good ideas, most of the time, it’s probably worth listening.  Tim set me on the path of learning about volume profile, and market profile.

Tim also started to give guest webinars in Michele’s room.  He was my biggest mentor to date.  He seemed like something special to me.  I would say mentors in trading are pretty important.

Tim was pretty young compared to me.  He had come from a literature background, hence the eloquence.  Out of college he had gone to work for a hedge fund, and the rest was history.

He talked about designing $billion bets, and talks with the $billionaire who ran the fund.  He did webinars on “macro” views of markets, which fascinated me.  He did others on market profile, options, and ways he looked at charts, which were not the way I’d heard others talk about charts.

He talked about “empty trades,” trading against initiative, Fibonacci levels, topics that I continue to learn about, and use in trading, today.  To me, he seemed on a different level than anyone else in the room.  And one day, he disappeared, and that was it.  Although, by then, he was on my Tweet deck.

Market Profile

After hearing about market profile from Tim, I set off to learn about that.  One of the first things I found was the Shadow Trader.  The original Shadow Trader was Peter Resnicek.  There is a Shadow Trader website, and also daily radio show, which broadcasts inside Think or Swim, TOS.

Shadow Trader had lots of free information, very well presented and informative, about trading, including tutorials on market profile.

Peter was also a disciple of James Dalton, who invented the concept of Market Profile.  I read (I admit, part) of Dalton’s classic on the subject, Markets in Profile.

(One of these days I’ll finish it.  But even at that time, even with my deep interest, it was hard to stay engaged.  It seemed very dry.  For me, learning this stuff really had to be a combination of theory and practice.  Theory couldn’t strictly precede practice, or it was just too damn boring!)

Market profile works on anything, any product.  But the quintessential product is the /ES.  E Mini futures on the SP500.  Dalton had been trading the ES for decades, using market profile.

As another aside (sorry, this one won’t be so far aside as dream businesses), another early service I considered was called Day Trader Academy.  They traded exclusively the ES.

It did occur to me at the time that the quickest way from point A to point B, (with point B being profitable trading) might be to focus on a single product.  But this defied my idea to learn all about the trading and investing universe.  And also, I was by no means sure I wanted to trade only one product.

Michele and Nate traded all kinds of stocks, whatever was moving.  Tim traded all kinds of stuff, futures on commodities, options on stocks, he was a wild man!

Plus, the Day Trader Academy said they made students throw out everything they had learned about trading, and start fresh.  On one hand, it seemed like it might be efficient to start with them, since I had hardly learned anything.  On the other hand, part of my mission was to learn all the ways people traded, not just to succeed as soon as possible.

But one thing the Day Trader Academy did do, is gave me part of the idea for the “social hedge fund.”  They said they had investors.  And people who could prove their trading on a simulated account, could get funded to trade.

Anyway, the Shadow Trader put out great material.  Brad Augunas ran the daily trading radio show.  And I began to listen to that throughout the day.  I kept trying to find ways to get more and more engaged in trading.  Even 6 month in, I would find my mind wandering.

Peter and Brad were not only informative, but funny.  The idea of “shadow” trader was that they would specify their trades, and their rationale, so that you could “shadow” their trades.  Try to copy, or at least follow, the trade.

There was no membership fee.  I guess Ameritrade pays them for the show.  But if you follow their trades, you can see they are pretty darn good at it.  But the point of shadowing their trades is not to make money by copying them, but to learn how to think about trading, how to make your own plan.

Almost everyone says, including me, that it is almost impossible to consistently extract profits from the market by shadowing someone else’s trade.  This goes way back to my early days of trying to copy Doug Casey’s ideas.

No matter how much someone explains a trade to you, they are almost sure to have ideas that you don’t have, about how to initiate an entry, set stops and targets, determine of the trade is working, if they should add, reduce, scale, etc.

Even if you get ideas that are seeded by someone else, trading partners, chat rooms, whatever, you have to MAKE IT YOUR OWN.  If you want to succeed over time, you have to own your ideas for trades.

FT71

Another person I found in the process of learning about market profile, and volume profile, was FT71.  Futures Trader 71.  Again with the pseudonym.

But FT, as he’s affectionately known, also puts out a free thing.  Every day, on Youtube, he posts a 15 minute video, pre-market, detailing his trading process.

All of these people, when I first saw them in videos, Brad and Peter, FT, and others, I first regarded dubiously, with suspicion.  It was an actual membrane of resistance I had to push myself through, to pay attention in the first place.  A sense of, hm, what’s the scam here?

I started to watch FT’s trader bite off and on.  And over the months, more on and on.  He also had some videos on his website, which were pretty cheap, compared to everything I had purchased up to this point (like the Investor’s underground videos and services…and those were cheap compared to the first thing I almost joined, Jessi Stine’s Superstocks group.)

FT’s videos were a 5 part series that were supposed to explain volume profile.  And the proceeds supposedly went to charity.  So I watched those.

This takes us in to the summer, approaching a year after I started, in some sense.  It was hard to set an exact date or definition for “starting.”  Since each layer I proceeded through felt exponentially more engaged, and more work, than the one before it.  Each time I went deeper, it felt like I was just starting…like everything before that had just been warm up.

Pay services

Another aside, sorry.  Regarding pay services.  There are A LOT of pay services in the trading world.  Some trading cynics say, the only people that make money in trading, are the ones that sell services to traders.

The reason pay services flourish is obvious.  When people decide they want to trade, they want to make a living, or more, get rich.  They want to make money, real money, big money.  They have some money, which they are prepared to risk, even if they haven’t admitted to themselves that they are risking it.

But as soon as they lose once or twice, if not before, they realize they are risking their money.  And even if they only want to make a living from trading, what is a living?  $50k per year?  $100k per years.  So $1000 for a service seems trivial.  Even $5000 for a service seems relatively modest, if it truly results in profitable trading, and pays off with $50k or $100k per year profit.  Or more!

So in a way, selling services to would be traders is a relatively easy sell.  At least for the first time or two times.

And they are not all scams.  But even services that are not scams will not necessarily make you a profitable trader.

Ameritrade itself offers a variety of services in the $5000 and up range.  They have an enormous array of services, ranging from free, to quite expensive.

I just wanted to comment on the landscape of services and costs.  I don’t believe all paid services are scams.  And some expensive ones may be good or valuable.  I have not tried a wide variety myself.  But I strongly suspect it is not a “get what you pay for” type of situation.

I think becoming a successful trader is primarily dependent on the work and discipline any individual is willing to commit to the process.

Year 2

Next to come, I’ll outline how my trading evolved over the second year.

overview

Trading vehicles
Stocks/equities
  1. Common stock
  2. Options
derivatives
  1. futures
  2. Commodities
  3. Forex
  4. Indices
    Trading modalities
  1. Long term investing (Warren Buffet style)
  2. Dividend investing
  3. Investor’s Business Daily style/trend investing
  4. Swing trading
  5. Day trading
    1. Penny stocks
    2. Large caps
    3. Options scalping
    4. Futures
Trading styles
  1. Directional trading
    1. Breakout/trend
    2. Impulse/continuation
  2. Non-directional trading
    1. Options spreads
    2. Selling premium
  3. Pump and dump
  4. Dumpster diving

topics Index

Introduction

Thinking probabilistically

Technical and fundamental trading

Psychology in trading

Charting, horizontal and trend support, flags

Price and volume

Market profile, volume profile

Reading the participants of the auction

Various time frame participants

Little fish (us) and whales (big funds)

Lagging indicators, RSI, Mac d etc

Fibonacci and fractals

Algorithmic trading

Morality of trading

Potential rewards

Failure rate

Lifestyle, meditation, health

Habits in trading, thought

Prop shops

The dream of the social brokerage and micro hedge funds

Investing/trading economy

Mutual funds and traditional brokerages

Investment banks

Services scams and hype

Twitter and chat

The bond market, 3x the size of the stock market

News and economic indicators vis a vis trading and markets

The ocean of world capital and it’s currents

Total size of markets

How money and banking works

History and purpose of stocks, bonds, options, futures

The Ocean of the World’s Capital

Viewed from the moon


Ocean-of-Money_art (1)Market products and their purposes

The vast majority of the world’s total capital is held in these three products.

  1. Stocks
  2. Bonds
  3. Derivatives

(Real estate, for instance, by comparison, represents only around 3 % of the world’s capital.)

Purpose of the products.

The goal in this section is to define the purpose, to the end user, of each type of financial product.  Of course, all these products are traded.  And to traders, their purpose is just to make money.

But here we want to define the actual intended purpose of each product.

(Similarly, the purpose of houses is to live in, and of course as a store of value too…an investment.  But there are people who “flip,” houses.  They are house traders. )

Stocks

When most people think of “the market,” they think of stocks.  But stocks are the smallest of the three main pools of capital.

The purpose of publicly traded stocks is to allow the public to take an ownership stake in corporations.  That way, when the corporations grow in value, their investment appreciates.  And some companies also offer dividends.

From the point of view of the corporation, the initial public offering is used to raise money, by selling a portion of the company to the public.  Companies typically use the money they raise to consolidate their market position, through acquisitions, and ramping up production, marketing, etc.

Bonds

The total amount of the world’s capital held in bonds is 2-3 times the amount held in stocks.

Bonds come in two main flavors, corporate, and government.  The government type are further broken down by federal, state and municipal.

The function of bonds is to allow the public to act as a bank, to governments and corporations.  When you “buy” a bond, you are actually loaning money to the corporation, country, state or city.  In a normal world, traditionally, you are rewarded by some interest paid on the debt.

Although, in the increasingly bizarre modern world, sometimes people and others buy bonds with zero interest, or very low interest, with the idea that their money will shrink less in that form, than by holding cash, or some other asset.

The purpose of bonds for the issuer, of course, is another way to raise money.

Derivatives

This is a more complex topic.  The size of the derivatives market is not normally included in the total world net worth, or all the money in the world.

The notional value of the derivatives market is hard to estimate precisely, but it’s somewhere around 4-5 times bigger than all the actual assets in the world.

Derivatives is an interesting topic, worth more exploration.  But for now, let’s just outline the main types of derivatives, and their supposed purpose.

Tradable derivatives

There are two main types of derivatives that the public can trade on open exchanges, through their broker.

  1. Options
  2. Futures

Options

The purpose of options is usually seen as a form of insurance policy, for other assets in a portfolio, like stocks, commodities, etc.

For instance, a fund that owns a lot of Apple stock, might buy puts, that will pay off, if the stock goes down.  This is known as a “hedge.”  They pay a small premium, which is just an expense, if they stock does not go down.  So it is very much like an insurance policy.

Of course, others trade options, as if they were a commodity themselves.  And that is true of all asset classes.  But the point of this section is to define the actual purpose of the product.

Futures

A futures contract represents some quantity of an underlying product, barrels of oil, quantities of soy beans or corn, quantities of bonds, etc.  They are “derived” from various underlying commodities or asset classes.

Futures, like options, have expiration dates.  Futures are sort of like options on commodities, and other things.  They are an option to buy a specified quantity of the product, at a certain price.

The purpose of futures to the end user is to lock in a quantity of a product, at a certain price, in order to stabilize their costs.

For instance, if an airline or refinery wants a specified amount of oil, at a certain price, they can use futures to buy it.  Or if Nestle wants a certain amount of corn, each month, they can lock in prices for future months, to help stabilize their cost structure.

Forex

Is similar to futures, except used for trading the relative flow of currencies against one and other.

Over the counter derivatives

This is a class of product that is even harder to estimate and talk about.  And it’s largely irrelevant, to ordinary investors and traders.

These are derivatives like the mortgaged backed securities and credit default swaps, which became famous due to the 2008 housing crash.

But unless you are a fund with $100 million or more, or an investment bank, or other large type entity, interest in these is mainly academic.  You can’t trade them through your broker, or on the open market.

To learn more about this type of derivate, Michael Lewis’s Big Short is a great book, which is also a move.

This is an incredibly murky pool, the size of which has been roughly estimated at 2-3 times the value of the total world’s capital.

This is a relatively new class of “product,” only developed an grown over recent decades.

The purpose of this type of derivative, is to commoditize (make a product out of) things like loans a bank issues.

Loans, debt, to a bank, is an “asset,” a product.  Before this type of derivative, the bank was the end user of that product.

But this type of derivative added a new tier of end user.  It allowed banks, and large entities, to “trade” or invest in debt, like a commodity.


Market players

  1. End Users. This is the part discussed above, the actual users of the products.
  2. Traders are like merchants, or stores.  They buy and sell products, and try to make money on the transactions.

Traders

Traders provide “liquidity to the market.”  So that if the end user comes to the market, wanting to buy stocks, bonds, options, or whatever, there is some of that product available for sale.

Traders come in various sizes, and time frames.  Smaller traders try to make money from smaller price movements in products.  They try to buy low and sell high, and they might be buying and selling from and to bigger sized traders than them.

Traders can also be seen analogously to stores, and their suppliers.  A big trader is like Safeway or Wallmart.  A smaller trader might buy  products from local people, and sell them for a profit to a bigger trader, like Safeway.


2013-08-07_Geldwelle_Dollar_1500pxTotal size of the ocean of capital

World net worth

These #s are hard to gauge precisely, and are a moving target.  But it’s good to get an Applo type view of the size of the world’s capital, how it is distributed, and how it tends to flow.

Some links to estimates:
$241 trillion in one estimate, which is arguable, as of 2015

Total world of stocks $69 trillion

The total world of bonds  is about 3x the size of stocks, so approximately $180 trillion.

To give an idea of the fuzziness of money on this scale:

This article recites 2011 figures and has the ratio of stocks to bond at 1 to 2 instead of 1 to 3.

The main takeaway is that the bond market is much bigger than the stock market, and almost all of the world’s money is tied up between the two, stocks and bonds.

What is left over is a small pool of hard assets, owned without debt, such as precious metals, real estate, actual physical currency, and knick knacks (art, cars, jewels, etc.)

All the money in the world

So how much money is there in the world?  Those pesky diapers.  Depends. Somewhere between $80 trillion and $quadrillions.

http://www.marketwatch.com/story/this-is-how-much-money-exists-in-the-entire-world-in-one-chart-2015-12-18

A useful figure for stock and bond traders is: the total value of all stocks, bonds, is probably about $250-300 trillion as of mid 2016.

Derivatives as “dark matter”

As a derivatives trader myself (futures) and financial hobbyist, the nature of the derivatives market is interesting to me, both academically and practically.

Derivatives are sort of like “dark matter,” in the financial universe.  In some sense derivatives may represent $1 quadrillion, 4 times the size of all the stocks and bonds in the world.

But derivatives are not something one actually buys, or owns.  They are positions taken relative to one and other.

So as the underlying goes up or down, the leveraged derivative position gets more or less valuable, very quickly.

You need a certain amount of money in your account to hold a position in a derivative contract.  But you don’t really “own” anything.  (Unless of course you hold the product until it expires.  Then, in the case of 1 contract of oil, you take delivery of 1000 barrels of oil.  Or one options contract of Apple delivers 100 shares of Apple.)

So like dark matter, it’s bigger than all the regular matter (actual money, or stocks and bonds.)  And in some theoretical sense, it’s known to be there.  But in another way, it’s quite hard to measure, or put a finger on it.

Currents in the ocean

The main point of getting an overview of the ocean of the world’s capital, as a trader, or investor, is

  1. To get a general sense of the scale of the ocean (traders and investors are like financial mariners setting out on journeys on this sea)
  2. To get a feel for the weather and currents of the ocean, by knowing the general purpose and behavior of the main financial products.

For instance, bonds are seen as less risky than stocks (equities.)  Roughly speaking, traditionally, bonds and stocks are thought to move inversely to each other.  This is a current in the ocean of the world’s capital.

When the financial world is worried, it becomes risk averse, and theoretically, capital flows in to bonds, out of stocks, and therefore stock markets “should” go down, while bonds go up.

This is only the broadest way to talk about the currents in the ocean of the world’s capital.

Active traders and investors can learn about many, many smaller currents.  For instance, a strengthening dollar tends to correlate to weakening commodities.  Small cap companies tend to lead bigger companies in an uptrend, when appetite for risk is growing.

There are probably unlimited combinations and permutations among the world’s financial products, which create weather and currents in the ocean of world capital.

Learning to read these relationships and the currents they create is a useful, important, part of trading and investing.

But like the actual weather, the components are so complex and dynamic, that true “mastery” of the subject is probably like Zeno’s arrow.  We can get closer and closer to the target, but never quite reach it.

But from a functional perspective, with practice, we can probably get close enough, to help us make decisions, which, while not always right, over time, should be right often enough to become profitable.

How to trade directionally

Initiative and response, balance and imbalance

There are two conditions in any market: balance and imbalance.  Initiative and response.  Like binary code, the entire language, or music, of markets is built out of this duality.

All possible directional trades can be planned in the context of these two conditions.  You could say there are only 2 types of trades, although there may be a lot of nuance, perhaps infinite variation.

Markets and trading tend to lend themselves well to metaphors.  They reflect nature and life.  And duality is a common theme in reality.

In one quasi mythical origin story I recall, the I Ching , arguably the prototypical book, was written when the progenitor scratched one solid line and another broken line.  That’s all he wrote.  The rest of the I Ching was implicit.  Man and woman.  Yin and yang.  Self and other.  Everything that will or can happen.

Reality can be seen to be fabricated on a foundation of duality.

It may seem like hyperbole, an overstatement, to attribute to markets and trading such profound characteristics.  But in my opinion, it is accurate and fair to suggest that markets mirror the fundamental characteristics found in nature.  We’ll see.

Imbalance and Balance

In trading, it is commonly said, that balance leads to imbalance, and vice versa.

Balance on a bar chart is seen as a sideways consolidation, or a range.  Imbalance is seen as an initiative thrust.  Movement back and forth within balance is “responsive.”  Movement out of balance is “initiative.”

balance and imballance

The yellow circles are imbalance.  The grey boxes are balance.  This is taken from current action in the SP500.

How to trade balance

Trading balance is a responsive trade.  It is traded from the outside in.  The 80% rule says that whenever price goes outside of a range, and comes quickly back in, 80% of the time, it retraces to the other side of the range.

In this chart of the US dollar index, the light green circle was a buy, because price fell out of the range, then entered back in.

DX 80% rule buy

There was the additional confirmation of the bounce off the channel line.  It’s always nice to have some additional back up, or support of some kind, to add confidence to an idea for taking a position.  The primary targets on this type of trade would be the middle of the range, and the other side of the range.

How to trade imbalance

Trading imbalance is a go with the flow sort of thing.  Buy pullbacks, or short pops, depending if the initiative is up or down.  The expectation is that as long as price sticks in the top 50% of an initiative up thrust, it is likely to continue and test further.

Sometimes price may pull back 50% of the initiative impulse, providing an entry.

gold 50% pullback

Other times, if the impulse is particularly big, price may not pull as far back.  In that case, the consolidation for continuation creates the phenomena known as a flag.

TSLA flags

These flag consolidations on the TSLA run up did not pull back to 50% of the impulses that drove them there.

And by the way, while these are cherry picked examples, they are by no means rare.  I did not have to look hard to find them.  These phenomena happen all the time.  And in fact, all market (auction) action can be seen as composed of these principles, and variations on them.

On the topic of variations, in the TSLA chart, notice the first flag actually looks like its flying off a flag pole.  The second version looks different, but it’s the same thing: impulse, consolidation, continuation.

There are various conditions which support each type of entry.  I’ll try to outline the conditions.  But getting to know them is like learning any skill, it’s partly a study of examples, and partly experience.

One rule of thumb is, measure 1 standard deviation, on the time frame you are looking at.  Anything bigger than that can be considered an initiative move.  A standard deviation is the average wave length for that time frame.  It is also how volatility is measured in options.

You can eyeball this, or measure it mathematically.  If you trade the same instrument routinely, you will get to know the standard wave lengths on your time frame.

If the initiative movement is slightly more than 1 standard deviation, the 50% pullback may happen.  If the move is considerably more than 1 standard wave length, the flagging phenomena may be more likely.

As we dig deeper, we’ll explore ways to fine tune entries, targets and stops.

Time frames and fractals

I have provided examples of these phenomena on large time frames, many days, weeks or years.  But it’s often said that auctions are fractals.  (And markets are btw auctions.)  These same phenomena happen over the course of minutes in a day, days, weeks, and years.

Here was TSLA today, with 5 minute candles:

TSLA intraday flag

After the initial drop, we can see that the up move became a new initiative, because it took back more than 50%, and then more than 61.8% of the early morning down move.  So the down initiative was canceled, the up initiative flagged, and then made the expected continuation move.

Zooming in even further on this chart, using 1 minute candles, we can see that the down move was composed of two tiny bear flags (balance areas), which led to continuation.

TSLA 1 minute waterfall

This is a chart I chose at random.  TSLA is not an instrument I trade.  And in fact, I have seldom even been trading stocks.  I’ve been training on and trading futures.  But these phenomena happen in all instruments.

It’s often recommended that new traders pick one or two instruments, and trade them regularly, to get to know their behavior.  I trade mainly oil futures (/CL) and SP500 futures (/ES).

Once you understand that these principles of behavior, initiative and response, balance and imbalance, constantly occur on all time frames, there is a reasonable argument that day trading offers the best training environment.  Because you get several trades a day, where you can learn to observe, and play these actions.

The skills gained can later be applied on various time frames, and to various instruments.

Innovation vs Responsiveness

How to guess, when price is breaking out of a range, if it’s an impulse or a flush

And self psychoanalysis, my bad trade

When price breaks out of a range, there are two things that can happen next, which set up opposite trades.  Either price re-enters the range, and triggers the 80% rule, or the auction takes price away from the range, in a new initiative.

How do you tell which is which?  I have paid for this lesson.  I’ve learned this by being on the wrong side of this trade.

The traders that begin an initiative are called “innovators.”  It’s tricky to get in on the ground floor of innovation.  Usually, we wait to see the initiative impulse, and look for a pullback to get on.

Likewise, it’s hard to catch the absolute bottom, or top, when range exits a range, and then goes back in to it, to trigger the 80% rule.  It’s hard to precisely catch that responsive move.

We can try to catch the exact entry.  And we can keep a tight stop if we are wrong, perhaps not even losing anything, by observing that the auction is not behaving as it “should.”

Should is a word that always needs quotes in trading.  Like Nabokov said of the word “reality.”  Should is sort of a dirty word.  But if used properly, it can give us valuable clues.

When price leaves a range, there is no “should.”  It can go either way.  We can take a position right there, based on some additional rationale from our homework.  It would be foolish to take a position otherwise.

If price behaves as it “should” according to our position, we are right.  And we are precisely positioned.   If it behaves the opposite, we “should” not stick to our guns.  We “should” either stop out or reverse.

If price is going to re-enter a range, it should do it quickly.  Not much volume or time should be traded outside of the range.  If this is the beginning of an impulse away from the range, price should do exactly the opposite, hang outside of the range, and build volume there.

The edge of a range is likely a critical level. A lot of traders are looking at this exact location.  When price breaks through, it’s called a breakout.  Newbie breakout traders try to get on board right at this moment, to ride with the innovators from the ground floor.  They are trying to catch the beginning of a trend.

The rule is, a breakout usually re-tests the breakout level.  This could take seconds, or days, or years, depending on your time frame.  The sharpest entry is on the re-test.  If you got on board any sooner, you should scale out of some of your position, expecting the re-test.

If price suddenly goes back in range, all the innovators, and all the early bird breakout traders are wrong.  If this happens at the bottom of a range, it’s a flush.  If it happens at the top, it’s a blow off.

How do you know which is which?

Here’s a trade I recently got wrong, and lost money, and mental capital.  Now I’m trying to turn the trade to profit, by writing this.

(When we are wrong in trading, a good attitude is that we are buying information.  We should profit from the experience, even if we lose money in the short term.  We can look at trading losses, in this context, like a business expense.  As long as we actually learn something from mistakes, this is fair and honest to ourselves.)

Anyway, here’s my bad trade.

Oil broke down below a critical level on a large time frame.  It was 50% of a 6 month long up move.  There was all kinds of stuff going on at this level.  I chronicled the details in the Oil Bellwether entry.  But I didn’t dig in to how I should have known I was wrong, and saved myself some money, or even profited.

Here we are approaching that critical level of $41.77 several days before.  I’m already planning my long trade.

CL 7-23-16

There was all sorts of stuff going on there.  Not just 50% of the up move.  It was the bottom of a channel.  There was support from several months earlier, where days had opened and closed (the bodies of candles on a daily bar chart.)  Lots of stuff.

This was a natural bounce point, and oil flushed through it.  I guessed it was a shake out of weak hands.  I have watched oil long enough to know that a bounce “should” wash through the critical level, if it’s going to bounce there.  Oil is messy.

Then on the day time frame, it “should” surge back through that level, and end the day by making a hammer candle, with a tail poking beyond the key level.  In that tail, we see all the wrong innovators, and early bird breakout traders, trapped.

A friend of mine, Tim Parker, calls this “emptying the trade.”  After a year and more of practice, I’m still learning what this means.  He says his favorite trade is the “empty trade.”  It’s catching a knife.  The adrenaline rush, big swinging dick, bingo, perfect-entry trade!

“Emptying” means, in that flush, it washes out all the weak hands.  All the longs throw in the towel and stop out.  A bunch of early bird breakout traders get short.  Then there is no one left to get short.  The trade is empty.  And price reverses.

For this to be right, it SHOULD happen quickly.  It did not.  I held my position.  I was determined not to be a weak hand getting shaken out (also a wrong trade I’ve made many a time…some of us are slow learners.)

I spent the day with a negative P&L, and worked on a story to justify my idea.  I was thinking, “all these guys are getting short down here, then late in the day, buyers will take it back up through that level.  The shorts will all be wrong, and their short covering will fuel the surge up.”  That did not happen.

It’s a famously known psychological mistake to keep coming up with arguments and explanations to justify your idea, even while you are being presented with data that contradicts it.  This is the definition of cognitive dissonance (an often incorrectly used term.)

If it sounds like I’m psychoanalyzing myself, that’s because I am.  It’s widely agreed that learning “how to trade” is at most half the equation. Understanding our own individual psychology, why we do what we do, decide what we decide, is a significant component to successful trading, for most people.

Here’s how the day ended

oil 7-28-16

Looking into that red candle, with no tail, and the close at the low, here is how the day looked on a 15 minute bar chart.

CL macro mid breakdown day

Price broke down through the critical level and never looked back.  The first hour of trade is often considered especially important.  Various types of players are involved in various time slices throughout a day.

You can see that price opened above the important level, (after the greyed out section on the left, which is the over-night session) then after about 30 minutes, plunged through, and could not regain it by the end of the first hour.  That could have, should have, been enough to abandon the long idea.

Aside: Bar Charts vs Volume profile

I keep saying “bar” chart, because there are other ways to look at the auction.  One of the best is a volume profile chart.  I’ll later make a complete entry devoted to volume profiling.

But in brief, we can see not only where the price was at what time, but how much volume traded at each price level.

This way of looking at auctions was developed by Jim Dalton, and his book, Markets in Profile, is a classic.  He looked at both volume and time spent at each price.  Morad Askar (Futures Trader 71), has offered an enormous amount of free training on this sophisticated way of charting, which he has further developed and simplified, to just show volume at price.

There are various tools that can be used to view this.  In Think Or Swim (TOS) which I’m using to show the bar charts, you can view this data in two ways.

Here is a regular bar chart, showing the amount of volume that traded at each price as horizontal blue bars.

CL macro mid breakdown day in TOS bar + vol profile

TOS also has a feature called “Monkey Bars,” which represents all the data that Jim Dalton uses in market profile.  But TOS had to rename it, because market profile is trade-marked.  This is how that day looked viewed in Monkey bars.

CL macro mid breakdown day in Monkey Bars

In Dalton’s idea of market profile, we have both volume at price and time at price.  On the left side is the volume that traded at each price, and on the right side, the time slices that traded at each price are represented by letters.

But don’t get bogged down in all this.  You can trade without any of this.  This is all fine tuning.  These are all just different ways to look at the same market data.

In all cases, obviously there is a big blob of volume at the lows.  For my idea to work, there should have been a thin little tail of volume below the critical level of $41.77.  The longer and skinnier the tail the better.  And then a big blob of volume on top of the level, with a close up above it.

You can pretty much divine that a bunch of volume traded below that critical level, since it fell through there, never came back, and traded the rest of the day near the lows.  You can help confirm that volume traded down there by looking at the more common volume-at-time read-out, which I highlighted with a grey oval.

Or you can just use any breakdown of the day.  15 minute candles.  Hours.  Whatever.  Any way you slice it, all the trading happened down there.

Breakdown/retest

What happened next?

Not only did price not rebound above the breakdown level that day, and start moving up from $41.77, but that price became resistance on a retest.  A revisit of the level was a short, which I mentioned to Brendan.  And he made the most money of his career playing the level short.  But it happened at midnight.  I was profiting from sleep!

CL macro mid breakdown retest

Things don’t always work out exactly like this, or exactly like anything.  This is another way in which markets are fractal.  Patterns and phenomena repeat, but not in exactly the same way.  And sometimes an idea doesn’t work at all.  And then later, it becomes clear that the smaller idea was wrong because it was subsumed in a bigger fractal.

One way this situation could have worked differently, and still been correct, is that the retest might not have worked perfectly.  Price might have started to grind up through the $41.77 level.  But once all that volume had traded below it, it would become like a magnet, dragging price down again.  So price might have wandered up higher, and found a different resistance level, then fallen back through $41.77 and continued down.

That may be happening in the ES right now.

Market anatomy

Guts of a flag, bowels of a megaphone

pace and size, tempo and wave length

As discussed in Balance and Imbalance, Initiative and Response, the entire market is made out of these phenomena.  There is nothing else.  This discussion of flags and megaphones builds on the same ideas. 

The point is, we don’t have to look hard, or cherry pick to find situations where these things happen.  Everything that happens is some version or variation of balance and imbalance.

Cherry picking involves finding the prettiest versions of the phenomena.  Your prettiness may vary.  Or rather, it will definitely vary.  But it is all still the same phenomena.

Sometimes it’s easier to find these things on a very large time frame.  Price ultimately tends to form fairly pretty large fractals of common patterns. 

Zooming in, price tends to look noisier at first, and it takes practice to pick out the smaller fractals as they are forming, since they often start to look like one thing, then become their opposite. 

A flag is a balanced consolidation pattern.  It compresses and coils price.  And we expect price to squirt out of it.  Usually a continuation of the direction that came in to the flag.

old golf flag, weekly chart

A megaphone is the opposite, a widening balance, or consolidation pattern, where price gets looser and looser, and eventually reverses.  Usually counter to the direction price came in to the pattern.

oil megaphone

Questions we want to think about:

Why do these phenomena happen?  What are market participants doing behind the chart pattern? 

How do we estimate how long the phenomena will last, and how far the move out of them will go?  How do we trade them?

Variations:

We can expand someday on the topic of variations.  But note that variations exist.  And most of their action can be understood in light of the analysis of the primary phenomena, below.

flags: consolidations with no “flag pole,” descending vs ascending wedges.

INTC 20 year consolidation

We can use this 20 year Intel chart to illustrate a couple of variations.  As a whole, it’s a bullish consolidation over many years. Within it, there is contained a descending wedge type consolidation, a bullish formation….but the type that often does what this one did, breaks up, and then later fails.

Overall though, from 2002-2008, you may have said to yourself (in super slow motion), but wait, isn’t this a giant bear flag, that “should” complete down.  You might have thought, WFT, is Intel gonna go out of business.  Is it gonna be 2 buck chuck?  Surely the completion of that giant down wave will take this thing to pennies.

Well, look at the little highlighted oval.  The market dutifully did its technical job of “completing” the bear flag to the downside, when it took at the 2002 low.  It made a super crappy low for 4 months, that looked like it was headed in to the gutter.  Then, in your face bears! 

Megaphones: at the top of a trend vs at the bottom of a correction, square ranges or slight widening.

SPX pattern mash up

Look what the SPX has been doing lately.  It’s a smorgasbord of patterns, all contained within a megaphone.  First there was a square type range.  Then it tried to fall out of bed, formed a megaphone at the bottom, then faded back up.  It completed the 80% rule, retracing the square range, while channeling upwards.  What’s next, SPX?

Ranges: ranges within ranges, or distributions. 

EUR-USD 18 mo bear flag ranges 7-30-16

This is a chart snapsnot of the Euro/Dollar that I made a while back for a blog post. You can see, contained within the giant bear flag, many little fractals. 

WHY!?!

Why do these phenomena happen?  What are market participants doing behind the chart pattern?

All of these phenomena are caused by actual buyers and sellers, taking positions, hitting targets and taking profit, or being wrong and getting stopped out.

As a beginner, we look at patterns, and how they tend to play out, and try to formulate a plan on that basis.

But from the very beginning, I was asking why?  Like an infant.  I wanted to know WHY these things were happening.

For me, it’s important to have an idea of the mechanism behind the action, in order to feel confident in my plan.  It’s not enough for me to observe THAT it happens.

When we just look at charts historically, we see the finished patterns, they always all make sense.  But if we don’t live through the action, or replay the action, we don’t see how we can get fooled, what appears to be one pattern becomes it’s opposite, and is subsumed in a larger fractal.

An apparent bear flag can become a giant W shape, double bottom, and instead of completing lower as a bear flag would, there is a big reversal to the upside.

There has to be more to my thinking than simply the belief that a pattern is forming, or some pattern that is there will follow through in some expected way.

Looking at charts historically, it seems like it would be easy to figure these things out, and make a fortune.  But in the heat of the moment, with your account bleeding, it’s a knack to keep your wits about you.

Serial

In a Bull Run (a bear break is the same, only opposite)

These things happen in serial fashion.  Consolidation leads to explosion, creating the flag pole phenomena.

Part way up the pole, price consolidates again, forming the bull flag.  It then erupts in the same direction, and goes equally far, or less far.

Then, again, consolidation, and pop.

gold run up

Eventually, the pop goes less far than the last.  Then a seller wave in the opposite direction takes more than half of the last pop.  Then another wave of buyers negates them in the direction of the pop, but just gets a little past the earlier high.

The wave lengths get longer than standard deviations.  Seller and buyer repeatedly negate each other.  This creates the megaphone phenomena, indicative of a reversal.

The guts of a flag

Sorry I’ve chosen the infantile anal stage for my metaphor.  You could probably equally liken the consolidation phase to the gathering excitement of a lover, athlete, concert fan, and the explosion of adrenaline and endorphins as price erupts ups.  But no, I’ve chosen guts and bowels. 

What is happening during consolidation? 

As price narrows, compresses, what is happening is, over time, more and more people are taking positions, long and short.  They have their stops above and below.  They have opposite ideas.  As price narrows, more and more participants place their bets.  Fewer and fewer get stopped out.

So what you end up with is a series of layers of buy stops (of the shorts) above the layers in the flag, and sell stops (of the longs) below the layers of the flag.  Like strata in erosion.

TSLA flag anatomy

(BTW, this specific example did not happen to be a bull flag, even though it completed up.  It was a consolidation.  Just a pretty example.)

So as the trade gets crowded with positions, to repeat, all the shorts have placed buy stops above, and the longs have placed sell stops below.

At all those levels, you also have new sellers above, and buyers below.  But those become fewer and fewer, because during the consolidation, most people have already taken their position.  And everyone knows each of those levels are not the places to place a new order in that direction, but to abandon the idea, and stop out.  So there are only a few stupid new people at each of those levels that actually want to initiate a new position…or big swinging dicks, who want to fool everyone, and mess up the pattern with their big size.

So that, when one side takes firm control, when you get an “innovator,” who is willing to buy up (in an upward break, for instance, like in the example above), there are only a few actual sellers up there.  So when he makes a large order, he plows through several price levels, buying all the inventory for sale through several price levels.

This triggers a series of short stops, which are buys, adding fuel to the fire lit by the innovator.  One innovator can buy through all the layers in the flag and a bunch more layers above, but quick chasers also often start buying too, trying to catch the wave early.  “Breakout traders.”

This causes the big impulse seen as a flag pole, or the trend up out of the flag, as above.  It goes until the innovator and all the breakout-traders/wave-catchers have spent their wad.  Then it tops and fails.

New buyers start setting orders that back fill in the wave, wherever they think the product is “cheap.”  As the wave grows above 1 standard wave length, these orders will trail it up at approximately half its size.  If the wave is anything up to 2 standard deviations, it is likely to fall halfway back, and then resume the rise for a higher crest.

If the wave keeps growing without pulling back (the Innovator is a bigger player, or more chasers believe in the opportunity, and the buying keeps plowing through more sellers above), and the wave grows larger than 2 times 1 standard wave size, the orders will tend to trail up at a slowing pace, but will usually trail the top by at most 1 standard wave size, one standard deviation, for that time frame.

This is why larger waves create the pole and flag look, on a bar chart.  Why the pennant hangs up high, and doesn’t fall back to half mast, if the “pole,” or up wave, is tall.

So maybe the guts metaphor in this instance is more appropriate to the bear flag, and for the bull situation I should have used the lover’s eruption, or the enthusiastic hoot of adrenaline and endorphins.  Whatever.

Anyway, does this happens because people consciously calculate these levels, or because they instinctually sense them, or because the market is traded algorithmically?  Yes.

So this happens again and again, until it doesn’t.

The Bowels of the Megaphone

Ok, since we went with the bull phenomena, the alimentary metaphor now starts to work better, when the phenomena tops.  Price is about to poop out. 

At the tops and bottoms, price action tends to widen, instead of consolidate.  Why?

If price had been going up, we still have committed buyers, on various time frames.  We don’t know the depth of the innovator’s commitment.  Maybe he’s a giant hedge fund, and he thinks this instrument is the next Apple with a new iPod thingy.

He is going to buy up every pull back for months or years.  This is every long-term, William O’Niel style trend-follower’s wet dream.

To add another example, since I’m a futures trader, maybe this is Exxon loading up on oil futures, because they want to lock in oil at a series of prices.  They are actually buying millions of barrels of oil, and they will just buy more on every dip.  Not because they want to support or cause a trend, but because they actually want the product.

Then beneath these bigger picture market driving innovators, there are a series of traders with different sizes and time horizons.  Some of them are happy to catch one continuation after a bull flag completes with a higher wave, and they will start selling.

Some of them may have a bigger idea.  They are not Exxon or the giant hedge fund.  But they think or believe they detect the action of that bigger entity.  And there are a series of layers of these sizes and time frames.

So the smaller time frame guys start selling at the top.  It’s not just that the up initiative has petered out.  It’s not just a lack of more buyers.  Now actual sellers are appearing.

However, the next time frame higher than them perceives this as a buying opportunity.  So first you get a sub-standard wave length down, then a standard wave length or more up.  But there is no one big left behind it, so it doesn’t go very much higher.

Then you get a standard wave length or more down, as the next bigger set of players senses a temporary top.

If falls until a bigger time frame sees price as cheap again, and may cause a new mini-initiative up, a slightly higher high.  And then the next size up sells.  And so on.  The wave sizes grow.  And you get a megaphone widening pattern.

megaphone anatomy

At some point all the medium time frame players are exhausted.  The longs have given up.  They realize this is not going higher for now.  They start to sell their positions.  And they are fueled by active short sellers, who want to catch the top.

Price keeps falling, seeking the next time frame bigger, seeking buyers.  When it falls halfway back to wherever the whole phenomena started, then new buyers step in, expecting the original buyer to start adding, and often price makes a bigger fractal wave.

Oil off the bottom

If it falls through 50% on a shorter time frame, players start to throw in the towel, and figure the big guy left the room.  They start to sell more, and the down move continues.

On a larger time frame, another significant, strong line in the sand is 61.8% (the fibronnanci #) of the initial impulse wave.  Is this because people literally calculate this, or because they sense price as cheap instinctively, because it is built in to nature that fractals are formed like this, or because algos are coded to react to this level?  Yes.

As an aside, there are a whole series of Fibonacci levels, where price often does react.  However, 50% and 61.8% are the big kahunas.  And think about it.  Half of anything.  You don’t need Fibonacci to tell you that’s a thing.

After that, the final last stand is the place where the innovators initiated the impulse in the first place.  Will they show up again?  Often the answer is yes.  Or at least enough people believe it is yes, that buying reappears at the exact spot where there were buyers before.

If this spot was the breakout from a bull flag, it’s a “breakout-retest.”  Often the phenomena will happen all over again, bigger than the first time.

Double bottoms

If it’s a place buyers appeared before, and took price up, but it was not a consolidation, that is a double bottom.  That is a different phenomenon than what we are discussing.

But in short, double bottoms usually will support on the first test, at least for a bounce.  It deserves a fuller discussion elsewhere.

But in short a double bottom is considered a “poor low,” and needs to be “repaired.”  Which means price “should” explore beyond that level at some point.

But there are variations where a double bottom can be a significant bigger picture bottom.  Depending on context.  Again, more later.

If price comes back to the level a third time, it looks increasingly like it wants to explore further.

But this is also the location where you might start to see a megaphone phenomenon forming.  It could be the formation of the edge of a range.  And trading that situation has been discussed elsewhere.

And that brings us full circle.

A flag is a tightening range.  A wedge is a widening range.  And then then there are plan vanilla square ranges.

As discussed in “Balance and Imbalance,” and “initiative and Response” the whole market is made up of these two conditions.

And it can be said that all initiative is response on a higher time frame, and all responsiveness (consolidation) is part of a bigger picture initiative.

How do we estimate how long the phenomena will last, and how far the move out of them will go?

This is the real meat of the matter.  Now we know what is happening.  But how do we play it?  How do we make money?  How to we not go terribly wrong and lose a lot of money?

The short, general, mostly useless answer is, the parts of the phenomena are relative to the wave sizes of which they are a part.  And the waves sizes tend to be a function of time frame, or tempo.

Although, sometimes a larger than normal wave happens unusually quickly. And that is meaningful.  Noteworthy.  Tradable information.

But the real answer is that we use historical context.  We look for where buyers and sellers were before.  So we are looking at the same phenomena, just a larger fractal of it.

oil historical breakdown

That’s how an initiative trade can also be a responsive trade, and vice versa.

And why the idea of “catching a falling knife” is ultimately meaningless.  Every level everyone chooses to enter a market is a “falling knife,” if they are a buyer. (And what’s the converse?  Never, I admonish thee, NEVER try to pop a rising balloon, Timmy Trader!)

Unless your product has been lying there dead for a long time.  In that case you’re not catching a falling knife, you’re just sticking your money in a dead thing and hoping it will come to life.  Hey, sometimes they do!  (Not very often.)  I only mention this, since it’s the most common newbie strategy.

Accumulation

One important point, as an afterthought (last, but not least.)  A reason why large trends can go in bursts, in fits and starts, is because if a buyer is very large, like a large hedge fund buying a stock, or our example of Exxon buying oil futures, there is only so much of the product on the market.

They buy as much as they can, without artificially inflating the price with their own buying pressure.  The want more.  But as price goes up, there are less and less sellers, because more and more people feel they can get a higher price.

So if the large entity just kept buying all at once, they would pay an astronomically high price for their later shares or contracts, which would cause a parabolic price spike, followed by a giant crash.  So they have to buy a load, then wait for the market to settle down.  Then start buying again.

This is known as “accumulation.”  The converse is “distribution,” and works the same way, in reverse.

Candlesticks

Ranges and day trading

Candlesticks give us five basic bits of information.  Where price opened, where it closed, the high and low of the range, and if the close was higher or lower than the open.

If the candle is green, price closed the time frame higher than it opened, if it’s red it closed below the open.

hammer candle

This example candle also shows us the expected relationship to the candles around it.  The hour before this was a big green candle that closed way above it’s open, and didn’t explore much higher.  Our example candle therefore did explore higher, as expected.

However, before it did that, it took back the entire range of the hour before it, then rapidly rejected back up.  If you looked at this as a mini range trade, you would say, when it left the range of the hour before, then quickly re-entered, you could go long, expecting the 80% rule, to retrace the entire range of the previous hour, which it did.

The quick rejection of the low left a long “tail.”  The tail, combined with a close higher than it opened, makes a very nice hammer candle, which is a bullish sign.  Sure enough, in the next hour, it did explore higher than the high of this hour.

And actually, we can see that it even gave almost exactly a 50% pullback on the next hour, before it proceeded to complete the impulse wave, which a hammer represents.  So once again, we happen to have a micro fractal of the phenomenon discussed “Initiative and Response.”

50% of hammer candle

In fact, in this two hour period, we had both types of trade, both a response, and an initiative trade.

First, when our example candle came back in to the range of the hour before it, it completed the 80% rule, by retracing the range of the hour before it, that was a responsive type trade.

Second, our example candle was an initiative move, by completely engulfing the range of the hour before it, and ending up well on top.  So in the next hour, the pullback to 50% of our hammer candle, provided an entry for a completion of the initiative wave.

Time frames

Candles can be used on any time frame: minutes, hours, days, weeks, months, even years.

Basically reading candle sticks is super simple.  They give us an indication of the sentiment of that time frame, and where the next candle stick is likely to explore, on the same time frame.

There are plenty of books or info sites about the meaning of candles, and a series of candles.  It’s very simple at its most basic, but can become very nuanced to a skilled reader.

Candlesticks were supposedly invented by a Japanese rice trader in the 1500s.  So lots of them have Japanese names.  It doesn’t matter what they are called.

Candlesticks are just part of the puzzle. “Man” does not trade by candlesticks alone.  But as a starting point, I’ll explain candles in a nutshell.

Here is a basic reading from a single string of hourly candles.

series of hour candles

  1. Starting with the first big red candle I highlighted with the grey oval. We can see price was still coming down hard, continuing from the hour before that.  Price did not explore much higher above where this hour opened, and then moved far down, and did not explore much below where it closed.  Therefore we expect it to continue lower.
  2. In the next hour, that I did not highlight, we can see the pace slowed. The range got smaller, and price did go lower.  But it was a red hammer candle, the reverse of the green one in the example above.  So again, we expect lower levels.
  3. Sure enough, in the next candle, price got a little lower. The second highlighted candle is slightly a hammer candle.  So it’s slightly bullish.
    (But the tails are almost the same length.  When they are exactly the same length, and price opens and closes at exactly the same level, it’s a perfect doji.  That is often said to indicate indecision.  It’s an equal power of buyers and seller, or equal lack of power, or interest.  If often occurs at the end of a big impulse, before price corrects in the other direction. )

In this case, both the hammer candle aspect of it, and the indecision played as expected, and price began to wander up in the next two hours.

  1. The next candle I highlighted is a lot like a doji. The tails on either side are give it a bigger range than the four hours before it.  That shows us interest is picking up in both buyers and sellers.  And sure enough, the recent uptrend starts to reverse.  The sellers start to gain control.
  2. The next candle I highlighted is a doji in the sense that open and close are at exactly the same level. But the tail on top is bigger than the one on the bottom.  And sure enough, from there price rolls over to the down side, over the next few hours.
  3. The second to last candle I highlighted is like a bull candle, in the sense that price tried lower, and rejected, leaving a tail. So that shows the buyers are starting to assert themselves.  But they couldn’t get it higher than the open of the hour.  So it ends up needing to explore lower.
  4. The next candle leaves and long tail, and closes exactly at it’s open, so again, it acts like a hammer candle, and so on.

Btw, at the end of the sequence, I just happened to capture a candle with a very long tail.  That was a dramatic moment.  I was there, and traded it.  So I happen to know the guts of that candle intimately.

Can you guess what happened in that candle, and what happened next?  It’s detailed in my post, Crude, In the Zone.

Would you have had the concept and confidence to take and hold a position based on that big tail, while your account value wildly fluctuated?

In my case, it’s taken a long time.  It’s one thing to look at charts historically.  It’s another thing to trade them on the “hard right edge,” as the candle is forming, burning.

I have needed to live though it many times, before I could begin to believe that I can make predictions that come out right more often than not, as well as how to put my money on the line, and set targets and stops based on those predictions.

Daily candles

A candle stick is a range of a time frame.  A day is by definition a range.  A daily candle graphically represents that range.  But not all ranges are created equal.

Some of the most important information in day trading are the five elements of a day, defined in a candlestick.

The opening and closing of a day, and the high and the low, and if the day closed above or below it’s open.

Everyone knows, or can learn in a minute, that this is the information a candle stick conveys.  But, for me at least, the significance of this data, and how to use it profitably, has been a slowly unfurling realization that continues to flower over years.

The candle stick, in fact, conveys more than 5 pieces of information.   It tells us how far above the closing and opening range (body of the candle) price explored.  How far above or below the opening it closed.  And it tells us how this time frame reacted to the same time frame before it.

I randomly selected the day 8-1-16, in oil futures, as an example.

CL 8-1-16 daily candle

Days are also broken in to a day session, and an overnight session.  The chart above is a candle that represents just the day session.

If you include the overnight session in your chart, the day will appear to open at the beginning of the overnight session the day before, and may give different highs or lows.

Leaving the same lines on the chart, but including the overnight session, the candle looks different.

CL 8-1-16 daily candle with overnight session

All of this information can seem confusing, but is valuable and useful, once you get to know your product.

How price behaves in response to previous levels, highs, lows, closes, opens, and ranges within the day or night, gives us clues about what it will do next.  Who is in control.

Different participants in different time slices of the day and night have different characteristics.  As we train, we get to know them, and the anatomy of our product.  The various participants are like organs, and we get to know how they each tend to behave.

Later, we see signs of how the organs are functioning, at a glance, in the simple daily candle.

But as we learn, we need to look deeper.  And in fact, we will always look deeper.  The candle is only short hand.  It is like the finger pointing at the moon.  We don’t want to focus on the finger, but on the object it’s indicating.  Then we get out our telescope, or microscope, stethoscope, metronom…whatever we find useful.

Looking at this this candle, including the overnight session, this is what the information is actually telling us.

CL 8-1-16 daily candle with overnight session levels marked

If we then zoom in to an hourly chart, dissect the day candle, and see how the overnight action took place, this is how it played out.

CL 8-1-16 hourly candles with overnight session

The main thing I want to convey, is that price reacts to the day before it, the range before it.

The earlier simplistic explanation of the hour long candle sticks gives us a rudimentary idea of how one time frame might behave relative to the one before it.

In this daily Crude example, we had a big red daily candle, and price closed near the low of the day.  So from our hourly candle study, we know it is likely to explore lower the next day, which indeed it did.

So if we had this idea, this was our hypothesis, that it would somehow take out Monday’s low on Tuesday, how could we have tried to find an entry?

Let’s look at the Tuesday open, in relationship to the Monday action.  Also, we should consider any history before Monday, where it was recently in this range.

The easiest thing for me to do is measure half of the entire Monday move, from high to low, including the overnight session.  As we can see, price topped out 4 cents above that level.  (I used Think-or-Swim’s handy dandy fib tool to get this measurement.  Probably my single most used tool.)

cl Tuesday in relation to Monday

So clearly, $40.86 was a great short entry.

We can also see that there was some back up above this level.  Places where price goes sideways and forms a range,  volume consolidates, and acts like a wall.  Price tends to move quick where it moved quick before, and slow where it moved slow before.

There is a reason for this.  Price is a reflection of market participants.  Where price went back and forth, it indicates that there were a lot of buyers and seller in that area.  When price comes back to that area, the same two-way interest tends to reappear, and slow price down.

Relationships to the day before

Where price opens in relation to the previous range gives us clues about how it might act next.

Price can open inside of the previous range or outside of it.  If it’s inside, it can be right in the middle, or near the top or the bottom.  If it’s outside of the previous range, it can be far outside, or very close.

If it is outside of the previous range, that is called a gap in day trading.  It only exists due to the overnight session.  There are no gaps in a series of 1 hour candles.  However, price moving very quickly is similar to a gap.  It moves quickly through an area where there are few buyers or sellers, auctioning higher or lower, to find a range the market values.

There are rules of thumb for how price is likely to behave, depending on it’s relationship to the former range.

  1. If it gaps far away from a range, or moves quickly away, it’s likely to go father in that direction. That is like an initiative move.  In a gap situation, Peter the Shadow trader calls this “gap and go.”  The rule for how to play this is similar to how to play an initiative move.  It might come back to 50% of the overnight range, but not back to the former day’s range, then continue away from it.
  1. If it moves slightly outside of a former range, it’s more likely to come back in to the former range. Then there are two choices, it either completely retraces the former day’s range, or it comes back to somewhere in the middle, then continues back out of it, in the direction it started outside.
    These two situations are subdivided like so:

    a. If price spends more time outside of the former day range before re-entering, it’s more likely to only move back to the middle of the former range, then reject away.
    b. If price is only slightly outside of the former range, and quickly re-enters, it’s more likely to either retrace the former day range, or get stuck inside it all day.

    3. If price opens inside the former day range, it’s likely to be choppy. That means it’s still tangled up with the same set of buyers and sellers who batted it around in this area before.  In this case, we have to either try to scalp tiny moves, or wait to see if one side takes control, and pushes it with conviction.  This is called an “inside day.”  The choppy action is also called an open auction.

As we can see from the oil example above, price did indeed, in this case, open inside the former day range.  But it did not act very choppy.  It only moved up 18 cents from the open, then sellers firmly took hold, and it trended down all day, right through the former day range, and through the bottom.  Why?

In this case, the former day range was not back and forth.  It was not an open auction.  It was one continuous down impulse.  So this is an example of how “not all ranges are created equal.”  Even though Monday was by definition a range, it was the range of an impulse.

If Monday had been a sloppy, two way day, that went back and forth, covered the same ground over and over….then Tuesday had opened inside of that noise, Tuesday would have been more likely to be similar.  Instead, Tuesday was simply a continuation of Monday.

In a nutshell, the next day is most likely to complete whatever action the day before it appeared to telegraph.

Time slices, and the messiness of actual trading

Lastly, we’ll take a brief look at time slices within a 24 hour period.  This is an area of nuance that, for me at least, required a not only theory, but some life experience, before I started to get the hang of it.

Additionally, various products have slightly different time slices.  Oil opens a half hour before the US stock market, and closes an hour and a half before stocks close.

In oil, like many products, the opening and closing hour trades are often seen as important.  Bigger players trade during those times, and the smaller players that follow tend to follow through with the directions the bigger players initiated.

The first hour tells us a lot about how the rest of the day will play out.  And the last hour gives us clues what the over-night session will do, and what will happen the next day.

The high and low of the first hour are called the Initial Balance.  It’s the first hour candle of the day.

So on our Tuesday chart, which we’re trying to trade, based on the Monday candle, range and action, I’ll mark the initial balance with IBH and IBL.

Tuesday IBH and IBL

In this case, we don’t get an easy read.  It looks like a bull candle, right?  If I had cherry picked this day, to show how the first hour can give you a lot of confidence, this would not have been the day.

The only way you could have held a short, from that exact top, was by keeping a much bigger picture in mind (the mid of Monday, including the overnight session.)  That is, you would have entered short at the 50% level, and said to yourself, “I will hold this hell or high water, unless it gets x cents above that level, in which case I’ll stop out.”

If we zoom in further, we see, on this day, the sellers did not appear until 7:10am PST.  10 minutes after the first hour ended.  So the only way you got this trade was, shorting the big picture idea, or on a break down below initial balance mid, 1.5 hours in to trade.  That gave a perfect 50% pullback of the down move off the high of day, which then of course continued down the rest of the day.

Tues 710am selloff

$40.60 was the open.  The first move was down, to $40.30.  Over the next 45 minutes, price moved up to $40.94.  That was an impulsive move.  It is defined as impulsive if it is more than one standard wave length (standard deviation) in that product for the time frame.  We are looking at the smallest time frame, and the smallest standard wave size in oil is 30 cents.  Anything smaller than that is noise.

So the up move was impulsive, and the mid of that move was right at the open, $40.60.

And if we look closely at the impulsive up move, it paused briefly at $40.83, pulled back, then continued.  That little pullback, and continuation, technically “finished” the move.

The next expected move was corrective.  The corrective wave should have two parts.  We see it pulled back from $40.94, then bounced.  Then the second part of the correction came.

If that second part had stopped at $40.60, it would have been expected to continue up.  In fact, $40.60 was a reasonable long entry.  If taken, it was obviously a loser.

But $40.60 broke, the down move had become the new impulse.  So a quick witted trader would have stopped out, and begun looking for a short, to continue the down move.  The perfect entry came at 7:30 am, when price touched 50% of the down move, continued down, and never looked back.

All this could easily confuse a trader.  And mis-interpreting this kind of action leads to “getting chopped up.”  Thinking, “It’s a long.  No.  It’s a short.  No.   Etc.”  Repeatedly stopping out and losing.  That’s why it’s said, “trading is simple, but it’s not easy.”

One of the things that is not easy is to process all this in real time.  There is information on various time frames.  Why did this confusing action make sense, and not?

Price opened inside of yesterday’s range, so chop is common.  We often go back through the open, and back through mids of impulses, while in range.  However, there was the bigger impulse of Monday to lean against.

On the other hand, the actual trade of the day contradicted the first hour traders, who are usually relatively big, compared to the rest of the day.  But on this day, they were smaller, compared to the scale of Monday.  Plus, since price went through the mid of the first hour up impulse, what reason could we have to think it would hold the mid of the down impulse?

We couldn’t know for sure, and might have lost twice, if we’d gone long on the first mid, then short on the second mid, and the second mid didn’t work.  But it did, so if we didn’t take the second trade, because we were sulking about the first miss, we’d have lost money on the day, rather than vice versa.

Which is one reason that some people discipline themselves to take every trade that fits their plan, on principle.

And one thing the second mid trade had going for it was, that the down impulse had been one wave, it hadn’t completed yet.

This discussion took us in an unexpected direction from the time slice idea.  A cherry picked chart would have showed how the first hour traders set the tone of the day, rather than end up getting run over.

So, let me briefly outline the time slices.  The first hour and last hour, bigger traders tend to come in.  The middle of the day tends to get slow.  After close, the Asian session starts, in oil or Indices.  The Asians often complete the action the day suggested.  At midnight Pacific Time the European session starts.  Sometimes news in Europe will reverse the Asian action….or accelerate it.  Often there is an abrupt move at midnight.

And of course, news days trump all these phenomena, and often spur trends.  In oil, inventories almost always do.

The main point of the time slice discussion is that time slices exist, and it’s helpful to get to know them for products you trade.

And it’s also the conclusion of looking in to the guts of a candles.  Like human bodies, candles on charts have internal organs.  Sometimes they fart, or their hearts race, or a mood moves them.  Sometimes bigger candles eat smaller candles.

Auction Theory

And volume profile


In conversationsauction with friends, I have been discussing “auction theory.”  The initial purpose to help non-traders understand how markets work, and see THROUGH charts.

Price charts represent the action of people, making choices to buy and sell things.

The deeper purpose is to develop a discussion of “auction theory,” that can serve as an introductory part of a Trading Primer. Here the goal is help me and other traders to think through, rethink, and clarify what is actually happening in markets, behind charts, in order to improve our trading skills.

trading floorAuction theory is simply how auctions work.  Most people have been to an auction, or seen one on tv.  An auction for livestock, or cars, art work or antiques.  It’s a familiar process.

And yet, when people look at a chart, be it the price action of a stock, like Apple, or the price of Gold or corn, it sometimes looks random and disorderly.  They don’t automatically think of it as an auction.  But that’s what it is.

And even if we know what an auction is, we may not have considered the mechanisms by which market participants value products in an auction.

How do auctions work?

In a nutshell, how and why does an auction create a “flag.”

A flag is probably the most basic chart pattern.
Basically, price moves quickly in one direction, pauses, goes sideways
for a while…often it looks like a pennant flying off a flag pole.
The expectation is that it will continue in the same direction.

flag

There are lots of places people can find basic chart pattern ideas like
this.

What I have been endeavoring to do, is explain WHY markets do that.
In particular in my “market anatomy” chapter, I do that.  But it is peppered
throughout my blogs, and parts of the “Trading Primer.”

But I still need to discuss it more in terms of “auction theory,” and “volume
profile.”  It’s not a theory, really, but the way auctions work.

Think of an auction.  You are selling anything.  A car, a cow, a painting.
Let’s say it’s a brand new thing, a thingamajig.  You have 1000 thingamajigs
to sell, and you have no idea how much they are worth.

You open the auction at $15.  No takers.  You offer it for $14.  No takers.
Price slides all the way down to $9 with no buyers.  Suddenly someone bites.
You sell one at $9.  You and the rest of the audience perceive this as the base
price.  There is only one print (sale) there.  You quickly rise the price to $10, and
someone quickly buys a second thingamajig.

Some excitement starts to build in the audience, and everyone starts to realize
there is interest in thingamajigs.    You raise the price to $11, and 2 people buy
one before you can raise it further.

You start raising the price as quick as you can, and buyers are buying as quick
as they can.  there are 2 sold at $12, 2 sold at $13, 3 sold at $14, 12 sold at $15,
24 sold at $16, 120 sold at $17…then, suddenly, there are no takers at $18.

So it auctions back down a bit, and 70 sell at $15, then another 100 at $16…then
price stalls again.  But each time it goes lower by a buck or two, buyers perceive a
deal, and buy it back up.  The biggest amounts sell at the highest prices, around
$15-17.  Very few sold below $15.  There were just a few sales as price rose
rapidly from $9-15.

$9-15 is the “flag pole,” and $15-17″ is the flag.

If you look at the volume of thingamajigs sold, on a vertical chart, you see there
is a big blob at $15-17, and a little tail below.

This is like half of a bell curve, standing horizontally.  Or like the letter P.
This is also known as a “poor high.”

A “completed auction” should look like a vertical bell curve of volume of thingamajigs
sold.

Just as the market rejected prices below $15 as “too cheap,” normally, it will want
to explore above the value range that the market has established, to find out what
is “too expensive.”  If all these people will buy thingamajigs for $15-17, maybe you
can get more.

Everyone else starts thinking that too, and some of these buyers start thinking they
might resell theirs for a profit.

As soon as someone buys the first one for $18, it’s game on, and there is another
buying frenzy, that drives the price higher.  People buy as fast as they can.

A perfect bell curve of volume would be formed if price went up $6 more, the exact
length of the low volume tail from $9-15.  So the perfect top would be $24.

If price rose to $24, while less and less buyers were found, so there was, say,
250 thingamajigs sold at $18, 120 at $19, 25 at $20, 12 at $21, 8 at $22,
4 at $23, 1 at $24….then price stalled, and rapidly fell back down to the commonly
accepted value of $15-17….that would be called “a complete auction.”

If the price of thingamajigs, on the other hand, rose rapidly, and started selling more
and more at $22-26….then you have another flag, another incomplete auction, and it
again looks like it wants to explore higher.  This is the anatomy of a trend.

This is how Apple would have looked, day after day, for weeks, months, and so on,
as it climbed.

Volume profile

Looking at price action in auctions according to the volume traded at each price is known as Volume Profile. 


Here is a textbook picture of a Bull Flag, in ES, futures of the SP500

bull flag in IRT

The volume that traded at each price, during this overnight session, is represented by bars on the right.  And on the right of those, by the exact # of contracts traded at each price.

The idea with a bull flag is that it “should” go higher, to complete the auction.  A completed auction looks like a bell curve.  There should be a taper one either side, with the biggest amount of volume traded in the middle.

Here’s a textbook type example of a completed auction

bell curve

This is a statistical phenomenon.  It is a bell curve, also known as a Gaussian distribution.

We can flip this chart on its side, so that the price axis is horizontal, and time is falling vertically down, and we’ll see the more familiar bell curve on its side.

Gausian profile

More statistics terms:
When the shape of the bell curve is perfect (as in a completed auction), it is “leptokurtic.”  It has greater kurtosis than usual.

The point of the statistics terms is to point out that price action in auctions is literally a mathematical, statistical phenomena.

When you look at price charts of stocks, bonds, futures, etc. what you are seeing is an auction.  The purpose of the auction is to explore value.

The market explores value when people actually buy and sell products.  Price charts represent surveys of the market, about the values of products.

People cast their votes about the value by actually buying and selling them.  So you can believe they are honest about their responses!

Price discovery and Price acceptance

In a when price moves sharply in one direction, leaving a tail, as in a bull flag, it is called “price discovery.”  The market is saying the value of that product has changed, and it’s seeking the new value.

When price goes back and forth and makes a bell curve, or volume blob, it is called “price acceptance.”  The market is saying that for now, it finds this a fair range of value.

Notice that the flag part of the bull flag is a little bell curve.  It’s only when you look at it in context, and you see the tail, that you realize the product recently repriced from a different value area.

Moving targets

Why does the market move around?

Because the values of products are moving targets.  Companies change value.  Commodities change value.  Everything that has value is constantly being re-evaluated.  Value is never a static thing.

When we look at volume within a day time frame, price action seldom forms a perfect bell curve, or a bull flag (although it often forms little bell curves or bull flags throughout the day…tiny fractal auctions.)

What the auction strives to do is always to create the perfect bell curve.  This can take minutes, days, or weeks, or years.  And smaller auctions are little parts of larger ones.

A bull flag on one day may complete up the next day, and then fall back down in to the main volume area.  That way, the two days, taken together, form a bell curve.

And other times, this happens over a much bigger time frame.  We can then draw a volume profile around the larger time frame action.

So, for instance, looking at the SP 500, in its move up, during the summer of 2016, starting 6-27, we can see that, the first part of the move created a bull flag.  And then from there, we got another sharp move up, which created a second bull flag.

8-17-16 ES composite

We can see this, more or less, in the bar chart, even without the data about how the volume traded.

History and composite volume profiles

Since most products have a history, they are in territory they have covered before.

(The SP500 is not, currently, in the chart pasted above. This is new territory, all-time highs.  This auction very probably wants to explore higher prices at some time.)

But when price is zig zagging back and forth through places it has already historically traded, it can be helpful to have a composite of all the volume that has ever traded at any price.

In that case, what we get, is peaks and valleys of value.  Each of the peaks is the peak of a bell curve, and the hill around it is a Gaussian profile.  We call that a “high volume node.”  (HVN).

And each of the valleys is an area where price historically moved quickly through, as in the stem of a bull flag.  The areas where price traded the least volume, we call a “low volume node.”  (LVN.)

Here is a composite histogram of all the volume traded in the SP500, between 1700 and 2193.

8-17-16 ES composite histrogram

Price moves in characteristic ways around these hills and valleys of volume.  And all this movement is based on the principles outlined above, when looking at a bull flag, or a bell curve, on a specific day.

More recent price action is prioritized over older price action, naturally, since it represents more recent values of products.

But all prices at which a product ever traded are relevant.

Areas of high volume are areas where value was accepted.  Areas of low volume are where value was rejected.

Price tends to move quickly through areas of low volume, where it moved quickly before.  And price tends to slow down, and trade more, where value was accepted before.

If you look at the big jagged histogram on the right, which represents all the trades over the past few years in the SP500, and realize, what the market is trying to do, is form a bell curve, it helps to clarify the action.

In the never ending process of trying to “complete,”

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