THE MEAN TRADE

Of course, we would all like to be able to buy the low and sell the high of every move, but this is a reality that can only be realized when practiced in hindsight. In real-time there are very few traders that can pull this feat off with any kind of real consistency. To catch the beginning of a trend implies that we must either anticipate price exhaustion and the subsequent reversal of the previous trend, or anticipate and catch the breakout from a trading range. What makes this task so complicated and frustrating is that there are so many false reversals and false breakouts.

In practice then, catching the beginning of a trend may not really be the optimal entry. If you are going dance with the market, you want the market to lead. So it is often best to wait for buyers/sellers to make their move and show their hand before you enter the market. That doesn't mean you chase highs and lows; rather you buy/sell the first pullback from an initial push as your entry. Of course, you always buy weakness in a strong market, and sell strength in a weak market. If you're patient and wait for after the initial thrust that kicks off a trending move, you have a natural stop loss point: if market participants are truly rejecting price at the start of that move, you shouldn't see that price again.The key to making this execution approach work, is being patient enough when you're a buyer to let sellers "take their turn", and when you're a seller to have the patience to wait out the buyers' next bounce. You want to see those sellers and buyers get trapped on the next leg of the trend so their exits will help your position.

Unfortunately though, markets are in a trading range 80% of the time, which means that markets are trending only 20% of the time or approximately 4 days a month. Markets like the ES and ZB which are heavily arbed and dominated by HFTs and algorithmic trading, are often lacking volatility, and are choppy and directionless. This has proven to be a major challenge for short term traders, who often find themselves faked out on seeming moves that reverse. It would make sense then, that following a momentum based strategy as the mainstay of your methodology would not be optimal. It would seem that not only including, but concentrating on a strategy that offered you the opportunity to capitalize on current market conditions would be economically prudent.

The general idea is to find points in the market in which bulls or bears are trapped. They have committed to positions, but can no longer move the market their way, and the market has become over-extended. They then have to exit out of their positions and the market reverses which provides a trading opportunity. Because traders often presume that breakouts will continue in their direction without actively planning for the possibility of retracement, we should take advantage of this dynamic and actively build a scenario for a possible reversion trade.

As a rule traders are drawn to movement and momentum. They like to trade breakouts from ranges, and they like to see clear signs of strength or weakness before they buy or sell. A lot of the passive algorithms are programmed to take advantage of these tendencies by selling the new highs and buying the new lows. Now consider that there are thousands of these programs on thousands of computers, and each one is programmed to work offers at X period highs and work bids at X period lows--and if you imagine X as scalable across all time frames, then you can get a sense for what drives markets over the short time frame when directional, institutional traders are not active. Small wonder why the markets rarely trend, and are often range bound instead!

The predominant benchmark for AT is the VWAP or volume weighted average price. The VWAP is simply the average price of a security traded over a period of time. It is essentially a tool for investors that want to be passive in their execution, and are seeking the average price based on volume, i.e., a guaranteed VWAP execution. The implementation of the VWAP was in response to the decimalization of the market and the proliferation of algorithmic trading that resulted from this change, and became popular as a way to reduce transaction costs and the impact of large institutional orders on the market.

Knowing where we are trading during the day relative to that day's VWAP is very helpful in identifying the kind of day that we're in. The VWAP can be thought of as the market's evolving estimate of value. In a weak trending or non-trending market, we will tend to move away from VWAP to probe trader/investor interest. If that interest is lacking, we will tend to gravitate back toward that VWAP value level. In weak trending markets, you want to be fading moves away from VWAP. In a good range trade, we'll tend to see a narrow value area (volume will be transacted within a narrow price band) and moves away from value will tend to return back to (and usually through) VWAP. In a true range trade, we'll also see little slope to VWAP, as we transact volume relatively evenly above and below that average price. We can take advantage of this tendency for the market to move 1, 2, or 3 standard deviations away from the VWAP and then revert back to the mean, by fading the moves away from the VWAP and covering the trades when they return back to the VWAP.