How To Trade (Basics)

How to trade, NOT invest.

There are 3 primary market styles: Fast, Normal and Slow.

Fast Markets

Fast markets are when big news releases occur (NFP Political Strife, Central Bank data). Often big news, especially unexpected news, makes for a fast market. When a tweet happened that said there was an attack on the Whitehouse (from the cracked Whitehouse account saying that Obama was fine, but staffers were killed), High Frequency Trading algorithms (HFTs) slammed price before it was revealed the tweet was fake making a very fast move. When the Brexit vote occurred, it was a fast market that was directional but it also reverted, unexpectedly. When Trump won the Presidency, it was a fast market that also reverted quickly. When Mario Draghi or the ECB testify, it is a fast market for volumes and price swings. These are best to trade with Momentum, in the short term.

Most traders listen to a Squawk - data service - to avoid getting slammed by fast markets. Squawk is faster to publish information than the news stations and without 1 or 2 minute delays. They get the market data in real time, especially if it is accidentally released early. They also have contacts in markets and can make sense of unusual price moves. I remember when ZN - US 10 year note futures - made a decent move (big single order) and Squawk found out it was a Saudi value buyer not a fat finger order that would need to be closed (directional vs. mean reversion).

Normal Markets

Normal markets are when average trade occurs. They are more difficult to define, but usually price makes a small move from the mean level and works itself back to that level, then slightly beyond and back again. There is an orderly feel to these markets (and they are very rare in current conditions compared to where they once were). These are good to trade with Mean Reversion under a longer time frames.

Slow Markets

Slow markets are like watching paint dry. Volumes are often very low. Price wiggles between a couple of ticks and can make for a good Mean Reversion chop (1 or 2 ticks at best) if you can get a fill. If price decides to go directional, there is usually little volume on the opposite side to escape a position, so it can wipe away any gains from chopping single ticks. These markets occur most frequently during July and August, when Northern Hemisphere traders go on holiday.

Trading Styles

There are really only two short term trading styles: Mean Reversion or Momentum

Mean Reversion (Stochastic Oscillator)

Mean Reversion means that prices will return to the value that markets think is the fair price. Mean Reversion believes that markets return to a norm or average price (VALUE level) so that when it swings wide of price then it will return to it.

The Stochastic Oscillator is a good indication of price reversals towards VALUE, if the Stochastic is set to a wide enough setting versus time frame of the trade. This is because when the Stochastic is blown out (high or low), then when volumes drop off, price is about to revert (reverse direction). Stochastic will often stall at the 50% value and reverse in slower markets, so it should not be the only indicator used (RSI is also a good one, see below).

When a news release occurs, like Trade War news, markets believe the new VALUE level has changed. Price then moves (momentum) to near that new price (often past VALUE), but reverts to the new (perceived) VALUE level.

If markets were actually orderly and intelligent, then price would always find the VALUE level and stabilize. Support and Resistance levels are based upon the idea that the price is outside of the VALUE level and will move back to that level. However, these Support and Resistance levels are often breached, so by definition, markets are NOT orderly and intelligent.

In reality, markets are stupid and inefficient. That is why Arbitrage (Arbitrage is the price difference in 2 markets for the same thing) still exist. In crypto markets this can be seen with Bitcoin (XBT or BTC) against 2 major currencies, USD and EUR. There can be a spread up to 3% price variation on currency (USDEUR cross) when using Bitcoin as the middle of the spread. NB: Crypto trade costs are still lower than most exchanges, so they provide better value for simple currency exchange, too.

That spread is:

Buy XBTEUR / Sell XBTUSD

- OR -

Sell XBTEUR / Buy XBTUSD

EXIT at current exchange rate for USDEUR because Mean Reversion will be the FX currency value at the exchange rate.

For Comparison:

https://dwq4do82y8xi7.cloudfront.net/widgetembed/?symbol=KRAKEN%3AXBTUSD&interval=D&symboledit=1&toolbarbg=f1f3f6&hideideas=1&studies=&theme=White&style=1&timezone=exchange

https://dwq4do82y8xi7.cloudfront.net/widgetembed/?symbol=KRAKEN%3AXBTUSD&interval=D&symboledit=1&toolbarbg=f1f3f6&hideideas=1&studies=&theme=White&style=1&timezone=exchange

https://dwq4do82y8xi7.cloudfront.net/widgetembed/?symbol=KRAKEN%3AXBTUSD&interval=D&symboledit=1&toolbarbg=f1f3f6&hideideas=1&studies=&theme=White&style=1&timezone=exchange

Momentum

Momentum is when price, direction and volumes are moving bid/ask in a consistent direction, short term. Momentum, if you are positioned in the right direction is very lucrative. Prop traders use it to "skim the cream" off the market. If you are positioned wrong, most professional software has a "cut and reverse" button to sell a position at market and re-enter in the opposite direction.

However, mean reversion traders know that long term markets revert, so momentum trades should be limited by time frame.

A good indicator of momentum is RSI, Relative Strength Index. RSI is a good indication of a momentum move, but look for an exit when Overbought (70+) or Oversold (30-) indicators exist. This is often the indicator that most software uses to highlight price moves (red/green) without taking into account potential directional changes (for that, you should use the Stochastic).

Momentum (price and volume that are directional) works better for news and markets that are fast (higher volumes and faster price changes). The idea is when a move starts, traders pile onto the move and ride it until volumes drop off and price stalls. This can be seen with Non-Farm Payrolls trades or when the Fed would release QE news (not so much in current markets). Many trading platforms have momentum indicators (red and green lights, usually) to help traders make chop trades in short-term trades.

A good example is to trade Non-Farm Payrolls (USA jobs data):

A good Momentum trade is in the direction of market move after NFP through the Fri trading session. On the Monday / Tuesday price moves back to pre NFP levels (Mean Reversion). So the Mon trade could be considered a Momentum trade with the direction defined by Mean Reversion (so it is easier to know in advance what direction markets will move), while the price action is slow enough to mean that a position will not violate risk models.

Challenges

The challenge for Momentum in the last 5+ years is that the High Frequency Trading algorithms (algos or HFTs) are slamming price so fast that humans cannot get a fill. This has increased the speed that prices move and rebounds after a move. So price spikes will come into market that look like they will have legs (keep going), but those spike are quickly reverted (like a fat-finger order reversal).

For Mean Reversion, markets don`t make sense. In a logical market, news should only change the VALUE level so that price moves to the new level of perceived value. For many years, bad news was good because it implied the Fed would print more money which drove price counter to where VALUE should exist. Many traders and algos are still trading in this fashion, which is illogical and must end at some point (if markets are logical). Manipulation in market - Plunge Protection Team - and lack of counter traders (S&P shorts have all been pushed out of the markets by the long term directional moves over the last 10 years) means that the trade is crowded (one-sided) which must fail when traders exit or even reverse position.

Markets have become illogical or at best they are a bunch of people trading together and patting themselves on the back when they are right (even counter to underlying fundamentals). Those that would trade against them are a minority, but that will change when underlying fundamentals take hold. In the real world, FUNDAMENTALS must exist if only to define VALUE.

Markets can only be propped artificially in a direction for a limited time or those markets cease to function. Forced markets, and excessive money printing, lead to blowouts like hyperinflation or currency collapse. This forced manipulation of markets has historically destroyed the instrument used to prop up the markets (usually currency printing). This is because markets fail to find any buyer willing to trade (at any price) the instrument (bonds, currency) used to prop up the markets.

Current Markets

These markets are propped artificially. So then the argument is Soft Landing or Hard Landing?

In my opinion, markets have been pushed well past where a VALUE level which reflects the underlying fundamentals. So when traders and big money investors figure that out, it will be an awesome momentum trade (collapse). However, it will also be counter intuitive to most of the traders currently in markets (BTFD traders), so these traders will likely loose big.


DISCLAIMER:

YOU ARE AN ADULT and must make your own decisions. ONLY YOU know what level of experience you possess. ONLY YOU know what level of risk you are willing to take. ONLY YOU know what your financial goals are, and to what lengths you are prepared to go to meet those goals. You will be the one to wear your losses, so trade with caution and do your own research.

Henry Ledyard is an independent trader. He has NO affiliations with banks, brokerages, funds, trading houses or markets. He trades for himself and posts trading ideas merely to share information. He does NOT want your money, advice or opinions. He does NOT want your unsolicited emails. If you require further financial advice, seek it elsewhere. Henry`s opinions should be considered as addled as his blog site:

www.addlepated.com.au