Traders don’t make anything. Trading do not create any value. Well actually they do. Traders make markets.
When a manufacturing company that makes something wants to raise cash to fund their operations they can borrow money or sell stock. What if the company needs more money than is available from private sources, friends and family, angels, VCs? They go to the capital markets. The financial markets are really just a giant pricing mechanism. Traders make these markets. It is their job to assess the value of companies or of commodities like corn, gold or oil. Traders grease the wheels of the economy.
People are wrong when they say traders create no value. Traders “make” prices. Sometimes they make prices we don’t like. Why is the price of oil so high? The traders are stealing all our money. Nope. Oil is running out. If supply is 85 million barrels / day and demand is 86 or 87 and rising, prices go up. It’s like blaming the weather wo(man) for bad weather.
Some traders carried away and do stupid things. Business that make real things never do that, do they?
Somebody once told me he could draw all kinds of patterns on a stock chart–cars, people, unicorns, you name it. I’m sure he would find these and many more weird and wonderful patterns. Personally, I would not put money on some vision of a unicorn. Then there are the so called “armchair technical analysts” who devote vast amounts of personal energy using all manner of exotic indicators to create impressive looking but completely meaningless charts. Nine times in ten they have no idea what any of the indicators mean or even how they are calculated. The patterns themselves are not important–it is the price action they represent that counts. I stick with simple technical patterns I can justify with reasonable arguments. I make use of simple indicators to maintain a sense of perspective–the topic of another post.
The diagram depicts a typical bullish ascending triangle pattern. This is one of the most reliable trading chart patterns around. The reason is quite simple. The time to trade this pattern is during a strong upward bullish move. The pattern represents a strong pullback after a strong move up. It would be extremely unwise to bet against the trend on the back of such momentum.
How do you go about making sense of chart patterns?
I take a bottom up approach. I don’t actually use a fixed methodology but here are some useful guidelines.
- Fundamental economic principles–supply and demand 101
- Fundamental human behavior
- Contextual human behavior
- Characteristics of the financial instrument
- Contextual characteristics of financial instruments
- Macroeconomic context
- Other crowd: Political context, major events
Supply and demand is the most useful tool to help formulate a general theory of price action. The basic idea behind technical analysis is human behavior, especially crowds, does not change. People are creatures of habit and our responses to fear and greed are to some extent hardwired. People tend to do the same things over and over, and technical analysis gives us the tools to observe that behavior in graphical form.
The red line in the diagram marks a level of significant resistance to further upward price movement–buyers outnumbered sellers by enough margin to push prices sharply higher. As the price reached that resistance level bears stepped in and (temporarily) tipped the scales in favor of sellers. The bears soon exhausted themselves and bulls once again stepped in at the rising blue line to push prices higher. This pattern (of behavior) repeated until the sellers exhausted themselves to the point where on balance buyers outnumber sellers. At this point the last of the sellers gave up and covered their short positions. Some closed out their positions, others reversed and bought in the opposite direction–either way, they are all bids (orders to buy) in the opposite direction that help push prices to the next value area.
Note the pattern of higher lows along the rising blue line. This is a sign of strength that makes this a particularly strong pullback. Prices can’t go up forever. At some point they must take a break–pull back. The pattern of higher lows shows little interest in selling. Traders were waiting for this pullback–either to enter with a new position or add to existing positions.
What makes prices pause at the support and resistance levels?
There are many factors at work behind the scenes. It is often argued that it is not necessary to know anything about the fundamental factors at play. We believe rather than mindlessly drawing lines on their charts people should at least try to understand price action. Some of price action can be attributed to psychology. Prices often bounce off psychologically significant whole numbers–for example gold $1000/ounce. Trader tactics can account for some price action–there are a number of common trade setups professional traders watch for. A big part price action is supply and demand. Part of it is supply and demand for financial securities or derivatives; commodity financial and security futures, options, warrants, bonds–and of course supply and demand of the actual underlying instruments–gold, stocks, credit, currency etc.
Tags: Price Action, Technical Patterns
We commonly get people asking about the use of neural nets with financial prices.
Standard back-propagation neural nets are generally good when the solution space is finite/discrete. Such neural nets are good at recognizing what they have seen in the training set–common uses are in credit scoring and facial recognition.
It’s very easy to over-train a neural net and often difficult to tell if it is over-trained. Neural nets on their own tend not to work well with financial prices because the solution space is continuous and stochastic vs. discrete and finite.
Think of a neural net like a camera, especially when over-trained. Such a neural net could learn to recognize thousands of faces–but fail when upon encountering a face it did not see in its training set.
Statistical/kernel methods are far more effective for financial prices.
There are many other interesting machine learning methods, including decision tress and even some hybrid neural nets. Still, the real problem is always your choice of data representation. Depending on what you want to achieve and with a suitable representation you might even get good results from a basic neural net.
Tags: Machine Learning
A common criticism of trading is that it is nothing more than gambling. That’s not entirely incorrect. Professional trading can be thought of as professional gambling.
Let’s illustrate with a simple game of coin tosses.
How much can a person expect to win consistently betting on one side of a coin in a series of several thousand of coin tosses? The answer is nothing. A fair coin in the long run has an expected return (mean) of zero. That’s not to say the player will be completely even after X thousand coin flips. It’s unlikely the player will be completely even at any given point in time. They can typically expect be up or down by some amount. The longer they play, the larger the potential deviation of the mean. Over many trials this player’s winnings should balance their losses.
If the coin were altered slightly to make it more likely to land heads up the player consistently betting on heads should accumulate winnings in the long run. Effective (profitable) trading is exactly like designing a game of chance that puts the odds of winning in the player’s favor. This is the direction we wish take our software platform. Solving hard problems with software, making hard things easy, is our passion.
Professional traders are essentially professional gamblers regardless of whether or not they consider what they do a “game of chance” or whether they explicitly calculate the odds. They execute the same simple strategies over and over.
The mechanics of trading and gambling are similar. Mathematically they are equivalent. The different is you are not setting any prices in a casino–you know you are going to lose in the long run. The price is set and favor the house. Casinos create the illusion that you can win something. The key here is “winning”. Traders generally don’t try to “win” anything. Traders and investors look to profit from value. “This company is selling for less than it is worth–I’m going to buy it and then sell it for a profit.” You bid help bid up the price of this stock (helping the company) and assume the risk that you I might be wrong about its value.
What do gamblers bid for in a casino? Nothing. It is entertainment (for some people). Trading is a serious business.
We exist to solve hard problems with innovate state-of-the-art software. That is our passion. We aim to deliver state-of-the-art software tools to people like you who want them but may not be so interested in the idiosyncrasies of the complex underlying technologies. You want it wrapped up in a nice easy interface and we want to give it to you.
Our product is called the Ticktopia Platform. It arrives with all with the standard tools and features one would expect from such software, but we are not interested in reinventing the wheel. What makes Ticktopia unique is the power and flexibility afforded by the innovative state-of-the-art technology we are building into the platform. It cannot be seen on the surface. You may interact with it indirectly through our user-friendly user interface or directly through our powerful simple programming language interface if you are into strategy trading.
We have our own vision of The Ultimate Trading Platform. We set out to build it because we don’t believe it exists. Ultimately our vision will differ somewhat from your vision and from that of every other traders visions. You can help us realize part of your vision through feedback and participation in our community.
It’s fun trying to time the market. It is, however, better to avoid trying to predict the future and just watch to see what the market IS doing now.
The chart is of the ES continuous contract. It’s a good proxy for the S&P and also what I prefer to trade most of the time. On the chart are a large blue trend line and two more intersecting blue lines marking a bull flag. In that bull flag we’ve had two tests of the horizontal support and two of the upper declining trend line. Two tests is usually sufficient before more decisive price action develops. The vertical dotted lines mark higher volume tests of the upper declining trend line. Volume dropped on tests of the lower horizontal support line.
The black arrow marks a potential breakout point. We could see that breakout any day now, maybe even today.
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- 05/29/09 - ES Continuous Contract - Daily
What looked like a potential double top a few weeks is now a Bull flag. The question now is whether it succeeds or fails. It looks like it’s going to succeed, and given the momentum of the rally so far it would be extremely unwise to consider any countertrend shorting.
The market has rallied an awe inspiring 35% without a significant correction. So how high can we go? Has the current leg of this rally to come to the end? These questions really don’t make much sense because nobody knows how high the market will go. Anybody can guess a number. Inevitably, some of those guesses will come to fruition, but nobody has a crystal ball. However, a look at previous market bottoms can provide some clues. The past will not repeat itself, we will not see a replay of a previous bottom. History can, however, provide useful insight into what is possible.
Thus far the stock market has appeared to form a very unusual V shaped bottom. Few expected it work workout this way. It is far more common to see a test of lows at least once before the market takes off.
The first chart shows where we are now.
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- How high? Is this the end?
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- A similarly impressive move occurred in 2006
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- V shaped bottoms not typical. This is much more typical.
The second chart is from 2006. That rally was similar in that nobody expected it to go on as long or strong as it did. We see in that chart that the S&P did retest lows–such a bottom is often referred to as a W bottom and is marked on the chart in blue. We may see such a retest this time, in fact it would not be unreasonable to expect it.
The third chart shows the bottom of the 2002 bear. The blue arrow in that chart shows approximately where we are today in the context of that chart. That was also a W bottom with a deep higher low retest.
W bottoms often retest all the way to the top of the W as can be seen in the W bottoms in both the second and third charts. If the current pattern completes the W formation, it will also have retested all the way to the top of the pattern.
The 2006 rally occurred about 9 months after the Fed stopped its round of back to back 1/4 point rate cuts. It should be noted that we are about 9 months from the time the Fed first started aggressively cutting rates at the height of the financial crisis last year–Warren Buffets Financial Pearl Harbor.
Markets are moved by waves of liquidity. Liquidity is essentially cash. How much cash exists in the world system? How much is available for investing in each of the asset classes–stocks, bonds, financial futures, and hard assets such as commodities and real estate. Often cited measures of liquidity are M1, M2 and M3–in economics this is called Money Supply.
Few if any institutions can move the markets like the US Federal reserve. But Asian, especially the Bank of Japan and the Chinese Central bank, and European central banks can also have a large impact. When central banks cut rates the idea is to pump liquidity into the system.
Over the coming weeks we will explore some of the charateristics of previous bear markets to attempt to gain some historical context, and in the light of that context try to figure out where we are today.