Saturday, March 31, 2007

Trading Principles: Efficiency and Inefficiency

Here's a principle that has served me well over the course of my nearly 30 years of trading: Every day in the market teaches a lesson. There is always at least one pattern illustrated in a market day. It might be an intermarket pattern, a statistical one, or a relationship among indicators. My job at the end of the day is to ferret out what were or would have been the best trades of the day and identify clearly and explicitly the patterns that accompanied those trades. That means that, in a year of trading, you'll have at least 250 lessons: about as much "classroom" exposure as a college student would accumulate in two courses over the span of an academic year. Over time, those lessons outside of trading hours add up and amount to a graduate education in trading.

Indeed, thinking in principles is one feature that distinguishes experts from novices. Principles enable us to integrate many perceptual concretes into a single frame of reference, widening our cognitive grasp. Where the beginning trader sees bars on a chart, the expert perceives patterns. The expert, over the course of seeing many, many instances of a phenomenon, develops a concept--a principle--covering those instances. From that point forward, the expert's perception is guided by his or her conceptual lens.

With this post, I will begin a series of articles in which I share some of my "patterns of the day" with readers and identify the trading principle(s) behind the patterns. My hope is that this will help traders not just see markets, but *understand* them.

The pattern from Friday morning's trade in the ES futures is one of inefficiency. Efficiency is the term I use to denote the relationship between sentiment (a market input) and price change (a market output). When looking at efficiency, we're asking: How much input is it taking to generate a given amount of output?

When positive sentiment can no longer drive prices higher or negative sentiment cannot yield fresh price lows, we have evidence of inefficiency. Sentiment is no longer able to move price. Such inefficiency frequently precedes tradable price reversals.

In the chart above, we see sentiment represented by the gray bars (NYSE TICK) and price represented by the red candles (ES futures). Notice how we have net buying sentiment (positive TICK) early in the morning, but--after the initial upthrust--the bullish sentiment is no longer able to move price higher. Wave after wave of buying left us still below the price highs from around 9:45 AM ET.

Eventually all those buyers are going to have to give up and sell out of their positions. For that reason, the duration of the period of inefficiency generally correlates well with the extent of the subsequent price reversal.

We can see that reversal occur when declines in the NYSE TICK starting around 11:15 AM ET take us to new price lows. That tells us that we are *gaining* efficiency to the downside. We can also see that volume expands on the declines. That tells us that the longs are capitulating.

When you study enough efficiency/inefficiency patterns over varying time frames, you eventually gain the ability to see the patterns in real time as they unfold. But you need the principle to guide your perception, and you need to perceive before you trade.

Find at least one lesson from every day's trade, and you'll be amazed at the transformation of your perception.