Thursday, August 24, 2006

Dynamic Thinking and Trading Success

A while back, I wrote about the defining features of market pros. There are many factors that contribute to trader performance, of course, and many ways to succeed in the markets. One factor, however, particularly stands out in my experience: successful traders think dynamically. They are not locked into static trading ideas.

Yesterday morning's market action is a case in point. The above chart shows the ES market (red candles) on a 3-minute basis, with the bottom yellow bars representing volume. The overlaid blue lines are the NYSE TICK. As the morning update noted, the ES market changed character after the 10 AM ET housing data were released. Up to that point, we barely had a negative reading in the TICK: more stocks were trading at their offer price than their bid. Volume was quite moderate, with considerably fewer than 20,000 contracts trading on a rolling five-minute basis.

With the release of the data, volume expanded, and the vast majority of that volume was hitting the bid price in the ES futures. The NYSE TICK went solidly negative and then continued to register negative readings each 3-minute period. Even on a very short-term basis, volume tended to expand on declines and contract on rises, as large traders lined up on the side of the sellers.

The trader who went into the day with a fixed, bullish view got hurt. Other days, a fixed bearish perspective will put a trader under water. The successful trader doesn't so much predict the market as identify what it is doing. That means keeping an open mind to market action and being ready to switch from the long side to the short side (or to exit altogether) as conditions dictate.

Static thinking can be appealing. It is alluring to think that there is a single, unchanging order to the marketplace and that we--aided by our gurus--can achieve a privileged view of that order. It doesn't matter whether than fixed order is expressed as chart patterns, market waves, cycles, or some other contrivance. Static traders want rules they can count upon to make money, now and forever.

But there's a wonderful quote from George Soros in the book "Inside the House of Money" by Steven Drobny. Soros said, "I don't play the game by a particular set of rules; I look for changes in the rules of the game."

This is the essence of dynamic thinking in trading. Markets change their rules with regularity, based upon shifts in interest rates, currencies, economic conditions, commodity prices, sentiment, and institutional participation. Catching moves in markets, as with yesterday morning, requires that we see--in real time--the rules shift as they are turning. Which, by definition, means that we cannot be locked into any single set of rules.