Tuesday, October 02, 2007

Fading the Directional Herd: One Source of Market Edge

It’s common in sentiment polls of traders and investors to find that the majority report being either bullish or bearish. Relatively few are neutral, and even then it’s difficult to know what “neutral” means. Does it mean that they expect little market movement, or simply that they lack conviction about the market’s future altogether?

I find it interesting that 70-80% of market participants are bullish on directionality. They are either bulls or bears. But do markets truly move in a directional fashion 70-80% of the time? Hardly. A look at charts over any time frame will reveal lengthy rangebound periods punctuated by directional market movements.

What does it mean when a market is rangebound? Quite simply, there is relative unanimity regarding the proper pricing of the asset in question. The narrower the range relative to past price variability, the greater the degree of relative unanimity. Indeed, one could construct an indicator of the market’s recent range divided by the market’s past range to quantify the degree of consensus regarding the market’s proper value.

In the Market Profile graphic, such consensus appears as a relatively narrow value area, in which the majority of volume is trading within a narrow band of prices.

If markets move within ranges a majority of the time, but the majority of market participants are bullish on directionality, there is always the potential for breakout trades, in which the traders who are correct on direction can press their advantage and the traders who are incorrect on direction must exit their positions and add to the emerging move.

This dynamic also creates the potential for false breakouts, in which random price movement to new highs or lows triggers orders from breakout traders (including stops), without any fundamental basis for the repricing of the market. When those trades return to their prior range, the breakout traders are forced to exit their position, accelerating the market’s return to its value area.

In teaching a new trader to trade, I start with notions of value and volume—supply, demand, and asset pricing—and then move to a recognition of ranges (bracketing markets) and trends (directional markets). Specifically, we explore how volume behaves as markets stray from and return to value. From there, we begin to look at correlated markets (fixed income, currencies, energy, various sectors) to understand why volume might be behaving in a particular way.

The goal is to think like the large, institutional traders who ultimately move markets.

If we’re near the edge of a range, there is generally a good trade at hand. We will either break out of the range or we will return toward prior levels of value.

That is where I start with the new trader: identifying the ranges, reading supply and demand within the range and as we move away from value, and understanding the impacts of correlated markets.

From there, we refine and work on execution: getting good prices, knowing when to scale in and out of trades, where to set targets, etc.

It helps to have a bread-and-butter trade: a pattern you become so familiar with that it anchors your other trading. For me that bread and butter involves fading the herd who think directionally and looking for those returns to value that sustain trading ranges.


Detecting Participation in Breakout Moves

Identifying and Trading Breakout Moves