QE2 CURVE BALL

Whether we like it or not, the $600 billion QE2 has begun with the Fed conducting almost daily POMOs and as will be the case the Monday after Thanksgiving, two POMOs conducted in one day. Unlike September and October when traders front-ran the Fed and their 2-3 times weekly excursions into the open market, traders appear to be taking profits from their earlier front-running purchases in treasuries and equities, by selling into the Fed's outright treasury coupon purchases.


Bernanke has steadfastly maintained throughout the QE2 debate that his intentions were to prevent a Japan style deflation, and to force investor's out of treasuries into riskier assets, i.e., the equity market. He hoped this would in turn, create a wealth effect resulting in more consumer spending, which would in turn, reflate the economy. In addition, continued low interest rates would help ameliorate the interest payments on the debt service of the federal deficit. Interest now eats up nearly half the government’s income tax receipts.


As a result of Fed policy, a continuously falling dollar and near 0% interest rates, created a dollar carry trade that produced various unwanted results; surging commodity and currency prices abroad, a widening trade gap, and the expatriation of “hot money”. While the anticipated effects from QE2, was a continued decline in the U.S. dollar, Bernanke felt that the "benefits" of renewed inflationary expectations, continued low interest rates, and rising equity prices would be worth the risks incurred.


The actual effects of the second round of quantitative easing has been rising interest rates, a flight to the dollar, falling commodity and energy prices, and a narrowing of the yield curve. Are these effects the result of profit taking/short covering, or are we at a turning point in the markets, where new paradigms are emerging and existing trends are reversing?


While the answer to this question should become more apparent in the following days and weeks ahead, it’s mere postulation suggests that the market is at a major inflection point. Contrary to what was anticipated by Bernanke and the Fed, interest rates are rising, the yield curve is narrowing, the dollar is getting stronger, commodity prices are falling, and the strength of the bounce and seasonality in equities is in serious doubt. The current market’s action as a result of QE2 does not point to inflation, but rather to what it was intended to prevent...deflation.


One of the trading opportunities that has presented itself as a result of these macroeconomic changes is the narrowing of the yield curve or the NOB ( 10 Year Notes over 30 Year Bonds). In a normal yield curve, short-term rates are lower than long term rates. It is assumed that the Fed attempts to keep the short end down to spur economic activity, and that bond investors demand higher rates further out the curve to compensate for inflation. It is also assumed that the Fed and short end of the curve is the determinant of the slope of the curve. In general, bond traders link the dynamics of the yield curve to their expectations of the future economy. When the yield curve flattens it is usually accompanied by deflation or steady and low inflation and a slowing of the economy, and a steeping of the yield curve is usually the result of an accelerating economy and inflationary expectations.


As a result of QE1 we witnessed a prodigious equity rally and a yield curve on steroids as the 10/30 steepened to historic levels. From a trading perspective this meant you wanted to be long the short end (falling rates) and short the long end (rising rates). In the case of the NOB, you would be long the 10 Year (ZN), and short the 30Year (ZB) or long the NOB.


From a mean reversion standpoint alone traders should have been looking for the curve to narrow, but the Fed had stated that one of the goals of QE2 was to lower yields(keep rates down) and increase inflation expectations, so a continued steeping of the curve was not only highly possible, it was expected.


But, the market has thrown a (yield) curve ball! Post QE2 the yield curve has been coming in, instead of going further out, and selling the NOB is the trade that has been working. The fact that rates are rising despite the Fed’s campaign to buy $600bln in Treasuries is amazing. Yet once again, it is a testament to the pricing power of the markets. Central bank intervention can only work for so long; eventually the underlying trend will prevail, and if the laws of supply demand call for higher rates, then higher rates will prevail.

LAW OF LARGE NUMBERS

Besides loving to trade and possessing an extremely compulsive personality, I am ardent subscriber to the theorem, the law of large numbers, and on an occasion when I have too much too drink, a literal believer in the infinite monkey theorem.

In probability theory, the law of large numbers (LLN) is a theorem that describes the result of performing the same experiment a large number of times. According to the law, the average of the results obtained from a large number of trials should be close to the expected value, and will tend to become closer as more trials are performed.

A great deal of traders interpret this law in a negative way, reasoning that the more they trade, the greater the chance they will have losing trades, which would result in exacerbating current losses, or giving back current profits. What they don’t take into consideration is that the law is postulated on the premise of random events, i.e., a coin flip or the spin of a roulette wheel. Obviously, if you flip a coin 6 times, you may see 6 consecutive heads or 6 consecutive tails, but if you flip that same coin 100 times, you will probably realize app. 50 heads and 50 tails.

However, while trades are statistically independent events, and one trade has no bearing on another trade, they are not simple random events. Trading decisions may appear to be binary; either buy or sell or up or down, but they are not. There are a critical variables which must be accounted for, such as how much higher or lower is the market is going to move, or in other words, what is the risk/reward of the trade and how do I manage the trade. So, there is something other than chance that comes into play when trading, and that is skill and technique.

It stands to reason then, that the better your skills and technique, the more you should trade. While LLN is important because it "guarantees" stable long-term results for random events, it follows that it is also important that your sample of trades is large enough to maximize the number of successful outcomes from your skillful trades and therefore maximize your earning potential.

You can't find yourself subscribing to the theory that " you're only as good as your last trade. " If you are going to trade for a living, there is no last trade, only the next trade. Whether, your last trade was a winner or a loser, it has absolutely no bearing on the outcome of your next trade. Look forward to taking your next trade, because it's going to be the best trade you have ever made. At least, that's how you should be approaching it.

Unlike gambling, a winning streak by a trader will NOT eventually be overcome by the parameters of the game, unless he somehow convinces himself that this is his inevitable outcome. Trading is not gambling where the house has the edge; trading is a performance based activity that requires skill, technique, experience, and practice. Most important though, the trader must have the right attitude, focus, patience, and self-confidence, and then the trader will be the one who possesses the edge.

THE ETERNAL DICHOTOMY

If Dickens were writing a book on trading it would probably begin; it is the best of times, it is the worst of times, the market can go up, the market can go down, we make money, we lose money, it is easy to do, it is impossible to do, we are full of hope, we are full of despair.

Such is the dichotomy that is trading. You must be confident, but ego-less. You must be objective, but subjective, mechanical but analytical, focused but relaxed, and disciplined but flexible. Your decisions may appear to be binary, buy or sell; but they are infinitely more complex.

Acquiring the knowledge of trading mechanics, tactics, strategies, and risk management is a relatively easy and finite process. Developing the mental skills of focus, discipline, objectivity, and self- confidence are much more demanding. In fact, it’s the one area of trading performance that is a continuous learning experience, and for some a continuous struggle.

The problems and challenges we face trading are not due to a lack of knowledge, but are due to a lack of patience and self-confidence. Improvement begins with changes in how we choose to think, act and be. Positive changes that will only be realized when we make a decision: a choice to learn to let go of the selfish and self-defeating side of our emotions which blocks our minds and clouds our decisions.

The journey to becoming a successful trader is a winding and bumpy road, filled with great triumph, and frustrating sorrow, but everyone has the talent to succeed and the power to create value in their lives. We have all made money, and we have all lost money, but somehow we have all survived and continued along the path to greater knowledge and practice.

APPROACH TO TRADING

This article is intended for the edification of all who are interested, but is especially intended for those who are just starting out. There is not any information in this text that experienced traders haven’t seen before. In fact, everything that is mentioned here is in the public domain, and has probably been discussed at one time or another in this forum and/or practiced by it’s participants. However, this is the routine that I follow, the charts and indicators that I look at, and the thought process and philosophy I employ, so in that sense it is proprietary.

While I look at and consider a multitude of factors, my overriding determinant for initiating and exiting a trade is what I have always referred to as my “feel”. Feel is an intuitive sense a trader develops about the direction of the market, after continuously having watched and studied price action and market behavior. It is not an end state but a dynamic goal, always adapting to changing and evolving market conditions and drivers of price.

For the most part, my trading is not mechanical in nature, although there are certain rule based trades that I take because of their high probability of success. I would like to think that the majority of my trades are still predicated on thoughtful analysis and feel, even though I pay serious attention to the signals generated by my charts and indicators. At times visceral input may generate a trade while the technicals confirm, and at times the converse may be true.

In the most general way, I classify market action as either trending or range bound and my trades as either proactive or reactive, and as either breakout, continuation, or reversal trades.

Algorithmic and high frequency trading has forced traders to transform from “momentum chasers” to “mean reversion” traders. Buying new highs, and selling new lows, rarely works now as passive algorithms are programmed to buy the new low and sell the new high. Even before AT and HFT, the markets traded in ranges about 80% of the time while trending only 20% of the time.

Due to these factors I find myself making a lot of reactive, reversal trades. When I traded at the CBOT, I always felt more comfortable taking the other side of retail stops and fading the rest of the pit, rather than trading with the market, and being the same way as the rest of the locals.

This contrarian strategy is perfectly suited for today’s algo driven and range bound markets, and is luckily already in my trading DNA. The 4 days or so a month that the markets have a trend day, I will adjust my hold times and position sizing upward, but I will still initiate my trades by buying weakness and selling strength, although they will be in the direction of the prevailing trend.

I do make proactive trades based on leading indicators, such as pivots, trendlines, support/resistance, pattern set-ups, etc. which may be also be continuation or breakout trades, but it is far more natural for me to fade extreme moves.

My trade/risk management and position sizing is not mechanical, but is predicated on my on-the-fly assessment of price action and volatility. The broad risk reward parameters and trade plan is outlined, but the final draft has not been finished. Price action is dynamic, and so is my decision process. However, I hope to know within a relatively short amount of time, if the market has me by the balls, or I have the market by the balls, or if it’s just a ring-the-register kind of trade.

What I am very adamant about, and what I feel is a very overlooked topic, is position sizing. Especially on trend days, I am looking to add to good trades. It is critical that you press on these days, because there are so few of them. Adding to, and milking your winners is one of the most, if not the most, important techniques you can employ for making money.

While the opening has progressively become less of a factor and it’s importance continues to become increasingly diminished, I will use it as a general reference point for this article.

FIRST THING IN THE MORNING

I break out the journal and begin to make entries. They begin with cognitive or psychological remarks that continue to the trading session where commentaries about the markets are added. Educational entries are usually made after trading hours as they are made evident.

The idea is to use the cognitive journal to keep a real time record of what I’m thinking and feeling while I’m trading, so that I can become a better self-observer. This helps me to identify problems as they occur, so that I can keep them from affecting my trading. The sooner in the day I begin to assess my emotional status, the better. Therefore, my best practice calls for writing in my journal, first thing in the morning. This initiates the process of clearing my mind for the remainder of the day, and better prepares me for the trading session.

MORNING CALL

This where I bring myself up to speed on overnight developments in Europe, Asia, and the U.S., check the financial calendar for upcoming reports, and try to get a feel for what the market will be focusing on today. As a rule I always have charts up for the Bonds and Dollar, but if something else is in play or is being emphasized that correlates to the e-minis, it will need to be added. Barchart.com has a very good morning call newsletter which summarizes all of the above.

I then begin to make my:

INITIAL APPRAISAL OF TRADING DAY PRIOR TO OPENING

Where is the market trading relative to:

• VWAP
• Overnight Range
• Previous Day’s Range
• Value
• Developing Value
• 200 MA
• Pivots

As it gets closer to the opening, I start to formulate an opinion about what kind of opening it’s going to be:

OPENING STRUCTURE

• Opening Range relative to price benchmarks above
• First Bar and Second Bar - Range (doji) or Trend ( big body)
• Opening’s Structure

a) Open Drive

b) Open Test Drive

c) Open Rejection Drive

d) Open auction

INDICATORS

I am checking the following indicators for reference:

● VIX

● SPX Cash

● Cumulative Adjusted Tick

● Cumulative Delta

● Advances/Declines

● Relative Volume

● Delta Volume

I am now starting to formulate an idea of the potential structure of the day and after the first hour(initial balance) I am getting a better idea of the probabilities for the size of the day’s range, and what kind of day it will be.

● Range Day - The market will oscillate around an average price value with relatively low volatility through the day, likely ending the day not far from its opening price level and/or its volume-weighted average price (VWAP);

● Upside Trend Day - The market will open near its low price for the day session and build its way higher through the day, closing near its high price. The market will tend to stay above its VWAP for most of the day;

● Downside Trend Day - The market will open near its high price for the day session and work its way lower through the day, closing near its low price. The market will tend to stay below its VWAP for most of the day;

● Upside Breakout Day - The market will open within a range, but will build volume and attract participation at the upper end of that range, leading to a price break above the range, and further acceptance of price above the range with solid volume. An upside breakout represents a transition from range to upside trending conditions.

● Downside Breakout Day - The market will open within a range, but will build volume and attract participation at the lower end of that range, leading to a price break below the range, and further acceptance of price below the range with solid volume. A downside breakout represents a transition from range to downside trending conditions.

● False Upside Breakout Day - The market opens within a range and moves above the range, usually with limited participation and volume that wanes with higher prices, only to fall back into the range and return toward VWAP. A false upside breakout represents an extension of range trading conditions.

● False Downside Breakout Day - The market opens within a range and moves below the range, usually with limited participation and volume that wanes with lower prices, only to bounce back into the range and return toward VWAP. A false downside breakout represents an extension of range trading conditions.

TYPES OF TRADING DAYS - MARKET PROFILE STYLE

CONSOLIDATION 80%

● Normal

● Non Trend

● Normal Variation

● Neutral

TREND 20%

● Trend

a) Trend from Open - open, trend

b) Spike and Channel - spike, channel, reverse to prior range

c) Trending Trading Ranges - trend, range, trend, range, trend

d) Trend Resumption - trend, range, fbo, trend-symmetrical

● Double Distribution

Concurrently, I am checking various charts that give me a macro-economic perspective of the markets:

INDICES

● SPX

● COMP

● DJIA

● RUT

MACRO ETF INDICATORS

● VIX - Volitility Index

● UUP - Dollar

● TLT- 30yr bond

● GLD - Gold

● DBA - Commodities

● USO - Crude Oil

GLOBAL MARKETS

● VGK - Europe

● FXI - China

● EWZ - Brazil

● EPI- India

● RSX - Russia

● EWJ - Japan

BONDS

● TLT - 30YR

● IEF - 10YR

● SHY - 2YR

● LQD - IN. GR.

● AGG - AGGR.

● TIP- INFL.ADJ.

STOCKS

● NFLX

● GE

● BIDU

● GOOG

● AMZN

● RIMM

● AAPL

● CME

This is how I break down the trading day, and intra day tendencies I’m looking for

9:30 AM -10:30AM Opening - Initial balance 10:00-12:00 Contra- trend

reversal- Fed open market operations

10:30 AM -12:00PM Morning - The !0am move may continue till Noon

12:00PM - 2:00PM New York Lunch Hour 12: 00 - (1:00 - 2:00)

Consolidation or slight contra- trend move

2:00PM - 3:30PM Afternoon 1:00 - 2:00 - 3:00 ABC Move

3:30PM - 4:00PM Close 3:30 Linear Move

REAL F.E.A.R. - FED ENGINEERED ASSET RAMPING

Short-term traders and the 2-and-20 crowd may be able to take advantage of the current asset ramping perpetrated by the Fed, but long-term investors will continue to lose money in real terms. On a constant-dollar basis, or inflation-adjusted basis, investors will lose value on their investments in terms of the purchasing power of their assets.

 12 Month Performance

• SPX - UP 8.5%
• DJIA - UP 11%
• COMP - UP 12%
• GOLD - UP 30%

12 Month Performance Relative to Gold

• SPX - DOWN 22%
• DJIA - DOWN 19%
• COMP - DOWN 18%

 Future economic conditions/inflation expectations are being priced into the 30 year while the current state of the real economy is being priced into the short end. The long end of treasury curve is selling off while traders/investors are still chasing the short end.

Chasing returns by buying U.S. stocks , (especially at current levels), because the Fed is destroying the dollar may be one of the most irrational exuberances we have ever seen.

ARE WE NEARING A CYCLICAL TOP IN THE S&P?

ARE WE NEARING A CYCLICAL TOP IN THE S&P 500?

---

Are we nearing the top of the March 2009 cyclical rally, which is part of the secular bear market that began in 2000?

Monthly chart of the SPX, it is approaching major resistance at the 50MA at about the 1200 level.

Daily chart of the SPX , both the rate of change and money flow index, started to fall about mid September, as the market continued to rally. This suggests that the "smart money" was selling into the rally.

Daily chart of the VIX w/ 5period RSI, the VIX is approaching 6 months lows and very oversold readings.

LESS IS MORE...MORE OR LESS

Technology was supposed to make life simpler, but as Alvin Toffler warned in 1970, in his prophetic novel "Future Shock", rapid technological change has made life even more complicated and increasingly stressful. After having stared at my 10 chart workspace, replete with a varied sampling of custom indicators, I remembered a quote from Mark Twain. “Civilization is the limitless multiplication of unnecessary necessities.” I realized that in my quest for the perfect workspace, I had inadvertently overwhelmed myself with too much information. The immediate corollary of my actions had left me feeling disoriented and disconnected from the markets.

 
There is an abundance of information in the public domain, and a multitude of brilliant people whom never cease to amaze me with their knowledge and experience. Collectively utilizing their ideas, I devised an integrated system comprised of traditional candle charts, Market Profile, Market Delta, DeMark indicators, Fibonacci confluence zones, VWAP/SD, and various indicators and chart formats, in search of the “perfect” workspace. After having weeded out, the charts and indicators I felt were ineffective, I was left with what I believed was necessary to keep me on a level playing field with other traders.

 
While I do utilize every chart in my workspace, they do detract from what should be a visceral experience, so in this case-more may be less. There has been much debate as to the importance and potential benefits of “keeping it simple”, and the competence to objectively analyze price action, and it is my belief that this arcane ability is perhaps the “key to the kingdom”, and the quintessential prerequisite for trading success.

Too much emphasis and reliance has been placed on what is perceived as being technically necessary, rather than concentrating on the art of observation and perception and objective analysis of market behavior and price action. Sometimes less, really is more. 

However, while simplicity may be easy to attain, it is much harder to maintain, because the temptation is always there to try to do more. Therefore, simplicity is not an end state, but a dynamic goal. That being said, the time may have come, for simplicity to come full circle from near obsolescence to absolute necessity.

---

GAME THEORY

In the 1987 film “House Of Games”, written and directed by David Mamet, Lindsey Crouse 1/2questions-1/2 states to Joe Mantegna “a sucker is born every minute”, to which Mantegna replies, “and two to take him.” This exchange sets the stage for what is arguably one of the best films ever made about con men and deception, and also one of the most compelling movies about the unpredictability of human nature.

Drawn into Mantegna’s game, Crouse and the movie's viewers, become unwitting victims of Mantegna's deceit and deception, all the while thinking they are in on the game, only to find that inside every con is another one. What the viewer soon realizes, is there is an eternal gulf between the shark and the mark, between the con man and his victim. And there is a code to protect the secrets.

Not unlike the characters and viewers of Mamet’s movie, the American people have been victims of a very complex shell game perpetrated and perpetuated by the the banking system for many years. The chief ruse of this confidence game was convincing us to mis-allocate and over- leverage the majority of our personal wealth into homes we could not afford. They convinced us home prices never went down and always went up. And that the equity we "built up" in our homes would always provide us with a ready source of capital, and a long term retirement asset.

Unfortunately house prices like other assets in their giant Ponzi scheme, were artificially inflated as a result of the Fed keeping interest rates artificially low. The Fed continues to keeps interest rates artificially low by rigging the credit market. Continuing to rig the credit market without destroying stock prices means the Fed now has to artificially inflate stock prices by funding the primary dealers with money created "ex nihilo" to buy government and mortgage backed debt, so the primary dealers can buy large cap-high beta tech stocks and stock index ETFs. This unfortunately devalues our currency and raises the fear of inflation, so they manipulate the currency and precious metals markets in the Fed's own version of three-card Monte.

The barely perceptible uptick in the economy created by the economic stimulus, quantitative easing, and inventory restocking has all but disappeared. However, the Obama administration continues to try to con the American people  with rhetoric about job creation and business activity. In reality unemployment remains stubbornly high and the problem is becoming structural in nature. Consumer credit continues to contract while small companies find it difficult to access new bank lines of credit. Housing activity is falling, and home values are poised for further declines as foreclosures increase. The trade balance has taken an ominous turn, with exports stagnating and imports surging.
 

The Fed and the Obama administration continue to apply Keynesian solutions to problems caused by Keynesian policies, failing to acknowledge that government controlled interest rates are the real cause of the boom bust cycles that have plagued our economy. Continuing to "bait and switch" the public by rigging the price of money is a solution that has failed miserably, but has made transparent  Obama's real motive of replacing the free market system in favor of one controlled by the government.

  

Central to Mamet's theme but ignored by Obama and Bernanke, is that human nature is complex and human beings are not passive non-adaptive subjects.  When money is too cheap or too available, you cannot count on individuals to invest wisely or frugally. And when confronted with the extreme trauma of the near total destruction of one’s wealth, you cannot count on individuals to re-inflate the economy with continued deficit spending.

Admittedly, Obama and Bernanke did not cause the problem that is before us today. However, they continue to "do the same thing over and over again expecting different results." As Albert Einstein said, this is the definition of insanity and the primary reason why the market is headed lower and the economy is going to continue to deteriorate for the unforeseeable future. 


TEN MORE REASONS THE MARKET AND ECONOMY WILL CONTINUE TO DETERIORATE...

 
10) Continued  Credit Squeeze-  2 years after the 2008 bailout, the economy continues to struggle with a lack of credit. Credit (or debt) is issued by banks and is the source of virtually all money today. When credit is not available, there is insufficient money to buy goods or pay salaries, so workers get laid off and businesses shut down, in a vicious spiral of debt and depression. 

Even though liquidity was added to the banking system with QE1, banks did not provide loans, choosing instead to take advantage of a steep yield curve and play the carry trade. They continue to avoid risk and perpetuate this practice to date.

The central banks’ “central bank”, the BIS, recently raised Tier 1 capital requirements for commercial banks. The banks most affected by this decision are the banks that lend to small businesses thereby stifling bank lending  and credit creation even more. 

A majority of banks have been essentially marked to solvency through  creative accounting. If they are ever "marked-to-market", they have the potential to be a catalyst for another crisis. 

9)  Lack of Consumer Spending/ Housing Market / Destruction of Wealth - 66% of Americans own their own home. But for +90% of them, their house is also their largest financial asset. House prices therefore drive a lot of  the majority of Americans’ “wealth effect’ – the portion of their spending that is driven by how well-off they feel rather than how much they make.  

It is estimated that there is 2 year inventory build up of homes indicating that home prices have further to fall. 

401ks  and pension plans have been decimated contributing to the additional destruction of personal wealth.

8)Slowdown in Industrial Activity- Key indicators (differences between indexes of new orders and inventories in various surveys, including the ISM’s) point to a significant deceleration in the near term.

7)Structural Unemployment/Labor Weakness- In past recessions employment bounced back rather quickly, signaling a recovery. This recession is glaringly different due to a structural change in the kind of  worker. There is a shortage of skilled workers and a glut of unskilled workers, which will seriously inhibit recovery.

6) Inflation-Deflation Hybrid or Disinflation/Deflation- Not a threat? How come the Fed keeps printing money and the money supply isn’t growing and the velocity of money isn’t picking up? One possible reason is the gradual disintegration of the shadow banking system which was at one time larger than than traditional bank liabilities. It is collapsing at a rate of $4 trillion a year annualized rate. 

The amount of leverage used and the opacity of the various transactions involved in this unregulated industry, surely contributed to the financial crisis, but also provided a source of liquidity that is obviously missing today.

5) Secular Bear Cycle - The markets and the economy are still in a secular bear market that began in 2000.  Secular bear markets can last up to 15 years and we have neither seen a sufficient capitulation statistically nor in sentiment that would indicate a secular bottom.

4) Polarized Government- We are experiencing a period in history where the two major political parties have never been more polarized, preventing the passage of effective economic legislation.

The President's top economic advisers have been leaving the White House one by one as they fail to find a consensus solution to the nation's economic woes, nevertheless one that works.

3) Regulatory/Taxation Overhang-   Business owners don’t know how much Obamacare will cost them, and along with financial services regulatory reform, CEOs don’t know what the future holds for their ability to access capital and what their labor cost structures will be like.

Higher  income taxes for the wealth impaired, debt riddled consumer, would further restrict consumer spending.

2) Global Problem: Industrialized and Emerging Economies Offer No Help China’s private sector debt is as bad as ours. Housing in China has become unaffordable which may be leading to a bubble of their own. 

While Beijing is implementing additional structural changes to reorient its economy toward domestic consumption, the pace remains measured; and will do little to help sustainably rebalance the global economy.

A protectionist administration may legislate a trade war with China.

Debt solvency in some eurozone countries (Greece, Ireland, Portugal and Spain) remain high.

1) Debt /Deficit Spending - The balance sheets of  Americans, states, municipalities, federal government,  much of the euro zone, corporate defined- benefit pension plans, et.al. are in various stages of near insolvency. 
 
Total U.S debt is now $13.6 trillion with publicly traded debt running at $8.5 trillion, but estimated to grow to $14 trillion by 2015. Interest on this debt would be app. $1 trillion. Revenues in 2009 were app. $2.1 trillion. If they were to grow by 50% to $3 trillion by 2015 then, the interest payment on the  2015 debt would be 30% of 2015 revenues.

CUMULATIVE ADJUSTED TICK DIVERGENCE

Dec E-mini S&Ps rallied the last hour of the trading day, making new highs for the day and closed up 3.75 or +0.34%.  However, cumulative adjusted tick failed to make new highs for the day, once again suggesting that institutional investors did not participate or sold into the rally.

POTENTIAL NEAR TERM TOP

There is a perfected TD sequential 9 count forming on the S&P 500 Pit Daily chart which would indicate the possibility of price exhaustion and a near term top. In addition, the Cumulative TICKscore hit a new 30-day low. The S&P has been posting negative TICKscores on a daily basis this month while the market has rallied 2.7% since the Labor Day selloff. This demonstrates a total lack of institutional support on the rally and adds credence to the assumption of a possible formation of a near term top

ANATOMY OF A HIGH PROBABILITY TRADE

C

Every now and then you get a confluence of signals that indicates a very high probability trade. It is those times when your position sizing should be at its largest.

Chart 1:  DeMark TD Combo - Sell Signal  TD DeMarker 1 - OB Sell Signal
Chart 2:  Confluence Area of Resistance -  Sell Signal with additional indicator confirmation
Chart 3: Market Delta -  Divergence Sell Signal with additional indicator confirmation
Chart 4: VWAP w/3 Standard Deviations - Sell Signal & d9 Particle Oscillator - OB Sell Signal
Chart 5: Cumulative Adjusted Tick -  Early Sell Signal and Sell Confirmation

Weekend at Bernanke’s 2

A pair of losers try to pretend that their murdered employer is really alive, but the murderer is out to "finish him off”. No, the losers are not Andrew McCarthy and Jonathon Silverman; they are Ben Bernanke and Barak Obama. And it’s not a corpse they are propping up, but a lifeless and morbid economy that is about to finish off the markets and what’s left of America’s wealth.

The original “Bernie “ film, although premised on a  ludicrous story line, was actually funny and a box office success. As with Bernie 1,  QE1 was "successful". It created artificially low interest rates and along with the fiscal stimulus, it enabled and forced capital to flow toward riskier assets. With risk mitigated by an acknowledged Fed put and a low yield environment that offered minimal returns on safer assets, the market responded with a 83% rally in the SPX off the March 2009 lows.

However, QE2 the sequel, appears destined for box office failure. While the original “solution” may have propped up the market the first time around, investors don’t seem to be buying into the story this time around. In spite of record low yields in the bond market, investors are staying away from risky assets, and are hunkered down in the perceived safety of treasuries, commodities, and gold. 

Investors realize the current “recovery” is unsustainable. While the U.S. and the rest of the world markets have experienced a bounce, industrial countries remain below pre-crisis levels of GDP, wealth, and employment. The bounce has not translated into the type of job creation and corporate investment, we would normally see during an economic recovery.

The U.S. economy is still experiencing low to medium growth, and deteriorated public finances, and is now going to be facing greater government regulation and higher taxes. Consumer confidence is abysmal along with the the housing market, and the money supply continues to shrink, leaving both the domestic and global economies  vulnerable to more  financial instability.

It is under this context that the market rallied Friday, following Dr. Bernanke’s speech in Jackson Hole. However, there are a confluence of technical indicators that suggest this rally may be as short lived as all the other rally attempts of late.

There is a downside gap overhead in the SPX that is filled at 1067.08, along with the 9MA at that same level, which provides the closest level of resistance, and a multitude of other factors that  lead to a high probability  of  the market trading lower, which Rennie Yang discusses on his “ Market Tells” site. I am planning on coverings my longs from Friday afternoon at 1073.25 against the R1 pivot on Sunday evening, and waiting to reassess the market tomorrow morning.

MIDDAY MARKET MEAT - THURSDAY - 08/26/2010

Market is setting up for it's 2:00 PM move , after a FBO of the H&S neckline. E-minis never broke above the 500MA which was needed for confirmation and subsequently sold off, but held the high of value and the pivot, and is  now trading below the opening range, 200 MA, 100 MA  and. VWAP.

Support is the pivot at 1050 .75 and primary resistance is  at 1055.25. Cumulative tick and cumulative adjusted tick just made new lows which indicates willing sellers and a break down to 1044.

HEAD & SHOULDERS BOTTOM

There is a potential break-out above the neckline of an inverted head and shoulders, with a minimum measuring implication of app. 20 points. However, the market needs to clear the 500MA at 1064.00 for confirmation.* CLICK ON CHART TO ENLARGE

The Path To Success

Along with filling my tires with air and my tank with gas, I always wash my car before embarking on a road trip. Not only is a clean machine more pleasing to the eyes, but a clean windshield is more transparent to the eyes. This pristine condition however, is about as ephemeral as the freshly filled tank of gas. Between the smoke and dirt, to pollution and oil, it is amazing how quickly, dirt and gunk can collect on a clear windshield and morph it into an opaque sheet of glass. Even after, I generously apply my spritzers, I cannot attain the level of transparency I had achieved at the car wash.

Just like car windows, we go through life, and as we progress, we all collect some level of gunk on our souls and subconscious minds. This gunk consists of misinformation, prejudices, conflict, trauma, and myriad other experiences, that form negative layers on our psyches. These layers form an opaque film, that prevents us from seeing the world in the way it truly exists. And being unable to see reality clearly,  will severely limit  one from fulfilling their true potential. 

Enveloping us, this obscuration and its destructive effects, are often exposed and magnified when trading. Negative habits and emotions cause more trading losses, than misreading a chart or misinterpreting market fundamentals. It is often said that the eyes are the window to the soul, but anyone who has ever traded,  knows that trading can expose one's weaknesses, and open up a Pandora's box of vulnerabilities, that are there for all to see and quantify.

The only way traders are able to shed this fabric of filth is through self-discovery. You can read as many books on trading  as you desire, and create new indicators and ways of looking at, and analyzing the market, but if you don’t look at, and analyze yourself first, it will be difficult to find success.

The road to self-discovery inevitably leads to the path to success, but you must first be able to chip away at the layer that obscures your vision and clouds your view of the road. By determining and eliminating your weaknesses, negative habits, and negative emotions, you will then be able to trade with a clear head and clear vision.

One of the reasons I enjoy writing, is that allows me to express my feelings and emotions, and vent my frustrations in a positive way. It not only also forces me to think about what is happening around me, but also what’s happening within me. It is my path to self-improvement, and it helps provide me with guidance and direction throughout my life, and my trading.

In his book The Daily Trading Coach, Dr. Brett Steenbarger writes about the importance of keeping a cognitive or psychological journal, along with an educational and trading journal. He place equal importance on all three categories, but recommends beginning with the educational, following with the trading, and progressing to the psychological.

The idea is to use the cognitive journal to keep a real time record of what you're thinking and feeling while you are trading, so that you can become a better self-observer. This helps you to identify problems as the occur, so that you can keep them from affecting your trading.

His suggested progression is logical because perfecting the psychological skill is the most difficult one to achieve. Traders not only have to learn what do correctly, but have to unlearn bad habits, and deeply embedded negative emotions. 

My best practice calls for writing in your journal first thing in the morning, describing exactly what’s on your mind, and what is troubling you. This initiates the process of purging your negative emotions and clearing your mind,  allowing you to be focused  for the remainder of the day and the trading session.

Acquiring the knowledge of trading mechanics, tactics, strategies, and risk management is relatively easy and a finite process. Developing the mental skills of focus, discipline, objectivity, and self- confidence is much more demanding. In fact, it’s the one area of trading performance that is a continuous learning experience, and for some a continuous struggle.
 

For the most part,  electronic traders are all participating on a level playing field. They all have access to powerful computers, large band-with, the same front ends and pipes, and resources. The traders that rise to the top, however, are the ones that have achieved mental mastery along with trading expertise. They have found a way to clean that gunk off the window, and obtain a clear view of life, the markets, and themselves.

BEFORE THE BELL- MARKET MEANING 08/20/10

ES 09 10 is currently trading pre-market below yesterday's low of 1068.50, below the VWAP, well below the 200MA, and below value, developing value, and below the S1 pivot. Bonds traded higher last, and the euro sold off (dollar rallied). Resistance is at 1068.50 and 1071.00, and the S2 target is 1063.58. There are no major economic reports today, and the path of least resistance is still to the downside.

MARKET MATTERS - MIDDAY MARKET MEAT - THURSDAY 08/19/2010

E-minis sold off from their overnight highs at 1095.00 on the Initial Claims report, and then pulled back to the 100MA - 200 MA cross just after the opening, and out the bottom of the opening range for a 20+ handle free fall down to 1068.50.
Today's range is already 1.75X today's Initial Balance. If the market were to extend it's range 4 pts.to the downside, the range would be 2X the IB. On any given day there is a 37% chance of that occurring. But considering today is shaping up to be a trend day down, it is highly likely we extend the range lower, and close near the lows.

MEMOIRS OF A FLOOR TRADER

Growing up in Chicago and getting a job as a teenager at the one of the futures or options exchanges, was like growing up in L.A. and getting a job at one of the movie studios in Hollywood, or perhaps like a kid coming of age in Brooklyn and finding work on Wall Street. When I started my trading career in 1971 at the Chicago Mercantile Exchange, working at the exchanges wasn’t quite as in vogue, as it would be a decade later. Of course now, the floors of the CME and CBOT are one in the same, and ironically, trading is primarily done electronically.


One would think that having spent my entire adult life either working at the world’s largest futures exchanges, or being an independent trader in the world’s largest futures pit, that I would have been adequately prepared for screen based electronic trading when I retired from the floor. In part, my previous experience was beneficial, and in part it, my years at the exchanges inhibited my transition to screen based trading and prohibited my potential future success.


A popular misconception is that floor traders, were exactly that...traders. In fact, the majority of us were not. Some of the guys in the bond pit didn’t even know what treasuries were, or didn’t know a head-and-shoulders, from a double bottom. Most of the locals on the floor, were market makers. Our job was to make a two sided market for the brokers, taking the other side of both retail and institutional orders. Without the local independent trader, there would not be sufficient liquidity to facilitate the customer order flow.


For taking the risk of providing liquidity, and aiding in the process of price discovery and risk transference, the local was afforded privileges, that non members of the exchanges were not so lucky to enjoy. Of course, this created an extreme advantage for the local trader and created a very unlevel playing field for outside customers..


There were certain perks that were shared universally by all members, such as a very favorable commission structure, with a yearly cap that was usually reached within the first few months of the year. For those who “demanded the edge” and didn’t step out on trades, they got to buy on the bid, and sell on the offer, and to varying degrees everyone had a “look” at the order flow. In essence we were making the market and the market information flowed out from the exchange; not the other way around.


Where you stood, whom you stood next to, and which pit you traded in, in most instances had more to do, with how much much money you made, than how good of trader or market maker you were. I stood next to a couple large “order fillers” with retail decks, but I also knew who the brokers were that were filling Goldman’s, PIMCO’s, and other institutional orders.


Obviously, you didn’t want to be on the other side of one of those big institutional orders, you wanted to be in front of them. Conversely, you did want to be on the other side of the retail orders, as they were more likely to be wrong, and more likely to place their stops at bad levels. The advantages and edges that were intrinsic to being a member of the exchange and a floor trader did lead to some questionable practices, at times. Ironically, most of the toxic algorithmic techniques you see today, were first manually practiced by local traders in the pits.



Standing next to a broker meant you had “something to lean on”. If the broker was bidding for size at a certain price, and you could buy it elsewhere in the pit, you could then lean on his bid. If the market started to trade heavily on the bid, you could hit the broker’s bid and scratch your trade, and if the market turned you could easily flip.


Irrespective of all these advantages and various other edges, if you were not disciplined and practiced good money and trade management, you would still get your ass handed to you, just like anyone else. It still boiled down to limiting your losses, and milking and adding to your winners. If you traded a large enough sample, let’s say a 100 a side and you scratched half of them, lost a tic on 15 of them and made 1-3 tics on the remaining 35, you could easily make $1500.00 after commissions and exchange fees. If you were disciplined you could do this 5 days a week 50 weeks a year, and if you wanted to take more risk, you could increase your size to scale, and make multiples of this amount.



So naturally, one would think that after having been a pretty successful trader for all those years, the transition to electronic trading would be easy and natural. Well it was and it wasn’t. Luckily, I had always been a student of the markets and technical analysis, and not only made a market in the bond pit, but position traded, and traded options. I understood the markets, I knew how to interpret charts, and I was even one of the first locals to try Pete’s funny looking Market Profile. Nevertheless, the transition was very difficult, and when I first left the floor I spent the first year trading Steve Schonfeld’s money and not mine.



Discipline, trade management, and money management were not the issues affecting my progression to a successful screen based trader. However, over trading and interpreting the price action, sans all the feedback I had taken for granted over the years, were 2 of the biggest problems.



While trading on the floor, commissions and execution slippage were not issues, so you could trade as much as you liked. In addition, you could “feel” and see what was happening. I could easily tell if the pit was long or short, and I could clearly determine what the commission houses were doing, and if there was any institutional buying or selling. It was all there for me to see. With electronic trading, it was all gone.



After quite a period of “ deliberate practice” I am starting to feel that I have reached the level of expertise I enjoyed on the floor, albeit not the consistency. I had so many edges on the floor that I think it is virtually impossible to achieve that kind of consistency trading electronically. That’s not to say that I don’t make as much or more money, than I used to make while trading on the floor. But, I am taking more risk and experiencing much bigger swings now.


In the final analysis, electronic trading has made me a smarter and better trader. No longer playing with the "house edge", it has forced me to relearn my craft, adapt, and re-invent myself. And, it is in the ways, in which we adapt to change, that ultimately defines our success.