trading realities

back in the day, markets were inefficient and dominated by heavy retail participation. pricing was a value oriented phenomena that actually reflected the laws of supply and demand. technical analysis was more effective back then, because markets were more auto-correlated, and retail participation in the markets contributed to the self-fulfilling prophecy that drives ta. historical price patterns were more reliable, and price reacted in predictable ways after this conditionality was presented. if one could identify these repetitive patterns, then determining path dependency was easy. the markets are now dominated by commercials, commodity funds, indexers, etfs and hfts. the financialization of traded instruments has resulted in more cross asset correlations which have stripped individual assets of their uniqueness, and price discovery and risk transference functions.

over the past decade, institutional management of equity portfolios has increased from 54% to 81% and over the same period, “real institutional trading” has declined from 47% of trading volume to 29%. there are far fewer market participants today than just ten years ago, managing much larger portfolios across more asset classes, and using much less trading. the retail trader has all but disappeared, and traditional traders are predominantly competing against professionals and machines in a relatively illiquid market. this perspective is important to realize, because it underscores how markets have changed. given the near extinction of retail participation, and the almost total dominance of professional and algorithmic trading, it is unlikely that the biases and readily "available" cognitive reference points that are the hallmark of the retail trader, still exert their influence on pricing today.

more than ever, the market is predisposed to preying on unsophisticated traders; and there is no shortage of material for the flexions to practice on to refine their skills. the internet is full of trading forums, venting the opinions of naive wannabe traders who don’t know the difference between a stock and a bond, yet live in the delusional world in which they believe they can better the traders who are rigging the game. at the core of their beliefs is the illusion that they can grind out a living i.e., they can overcome trading friction and be consistent enough to collect a steady paycheck from the market, while taking very little risk and very small profits. they continue to believe in the existence of the exploitable edge that is reproducible on a daily or intra-day basis. and, herein lies the biggest and most stultifying misconception about trading -the belief in the existence of alpha and the denial that the grind is gone.

one of the many advantages of being a local trader on the floor of an exchange was that a trader could earn the bid/offer spread as an incentive for providing liquidity. when a local made a trade he could buy-the-bid and sell-the-offer, which meant he was buying below fair value and selling above fair value. in addition to this edge, traders were able to transact business at a cheaper rate than the public, and had first-hand knowledge of market structure and order flow. this enabled them to trade ahead of large orders and "race" the retail stop orders. a member trader did not have to go far in his quest for alpha.

following decimalization and regulatory initiatives aimed at creating competition between trading venues, the equities market fragmented, and liquidity was dispersed across many lit venues and dark pools. this complexity, combined with exchanges becoming electronic and for-profit, created profit opportunities for technologically sophisticated players. high frequency traders (HFTs) now use ultra-high speed connections with trading venues and sophisticated trading algorithms to exploit inefficiencies created by the new market structure, and to identify patterns in 3rd parties’ trading, so that they can use it to their own advantage in much the same way as the floor trader used his proximal and informational edge to generate alpha.

however, as a short-term, point-and-click, discretionary directional trader, one does not have access to the same process required to generate alpha. for traditional traders, the new market conditions insure that the playing field is tilted against them. retail traders continually find themselves falling behind these new competitors, in large part because the game has changed and because they lack the tools required to compete effectively. nevertheless, as the complexity of trading increases, it is still possible for a trader to separate from the pack and profit. the trader who has the better (more complete) and more timely (current) analysis will enjoy the greatest edge and have the greatest success, because they will have increased the gap between the traders who have adapted to the new environment, and the less informed, less diligent, and less talented ones.

it’s not that alpha doesn’t exist- it just doesn’t exist for the retail trader. what traders earn beyond the risk-free rate is not a true profit but simply factor compensation—the market rate for the risks they take. any positive expectation is the result of accepting that risk: the payment for taking such a position is compensation for risk, not an excess return. so, a trader must assess his approach to trading and decide what steps must be taken to find a proxy for alpha; and it begins with adopting an attitude, that is both realistic and relevant. the best any trader can hope to achieve, under any circumstance, is an incomplete, but probabilistic knowledge of the trading environment. so a trader must realize and accept that the markets are dominated by the rules of chance and randomness, both skill and luck come into play. how traders cope with probabilistic uncertainty and their imperfect view of the market is critical to their success. the essential job of traders then is to reduce uncertainty, not risk.

as a leveraged trader, one makes short-term decisions/trades, but understands what is happening at time frames greater than the one he's currently trading. the decision to trade and its management, flows from an analysis of price action. he is aware traders operate at different time-frames, markets are interconnected, themes abound in markets and that probabilities and departures from value govern trading opportunities. he understands and incorporates relevant informational signals from a wide range of deterministic processes to arrive at a summed probability that acts as deeper context.

he manages the risk through diversification, keeps draw-downs to manageable levels and strikes a balance between profit maximization and loss mitigation by adjusting trade size and stop-loss levels, so that only an extreme event will trigger the stop. he keeps losses in a predetermined range, and prevents getting stopped-out of a potential winner by managing expected value along with p&l, while allowing for a margin of error, so that he may stay-in-the-trade.

he is not concerned about how often he is right about the market, and frequently adds to his winners and turns short-term winning positions into longer ones. yet, never loses sight of the fact there is a downside scenario with an associated probability. the way decisions are evaluated affects the way decisions are made, so one does not allow stress, cognitive load, emotions, and bias, to non-linearly affect the decision process.

smart traders have the capacity to aggregate and synthesize large volumes of information, analyze it, and then derive an edge from it. the primary step in this process is to develop the capability to gather timely information from all the various sources and attach relevance to the information as accurately as possible. then merge both data sets, public information and proprietary tools, to derive insights that are applied in making trading decisions. good traders figure out what game is working and play that game. if they can understand the interactions of the individual factors and their effects on the market as a whole, then they will be able to identify higher order patterns that are the result of these interactions. going beyond the standard correlation/causation question, the trader must ask, does this source of edge make sense? is there a behavioral or structural reason why this source of edge should persist? and he must expect to be surprised and have to make adjustments, and build that into his expectancy.

good traders are always working on themselves, always refining what they do. in an important sense, they don't just use introspection to improve their performance. they work on their performance as a means of extending their personal mastery. the best traders spend significant time generating trade ideas, researching markets, and staying on top of developments worldwide. the ratio of time spent in preparation to time spent actually in trading, is a measure of a trader's professionalism

every trade a trader makes provides an opportunity to learn. gathering information from every trade, as opposed to a select few, helps give the trader a better understanding of how those trades may perform in the future. the more frequent the analysis, the more relevant the findings will be. however, the findings serve a purpose only if they are acted upon. the key is to use information to guide actions whose outcomes are then analyzed and the findings reapplied. this creates a continuous iterative loop that drives towards ever greater efficiency.

if you look at alpha as various types of beta doing different things at different times, then a trader's returns are going to be lumpy and cyclical in nature and performance will revert to the mean. the central message for traders then, is to trade efficiently, and make the most money with the least cost. it's not how often you're right, but how much you're right. if you want to make money, then maximizing geometric returns should be front and center in your thinking.

the market and its past is identical for all observers. yet, the market and the future are understood uniquely by each trader. no matter how crude or refined a method one follows in ascertaining the likelihood of change, it still boils down to surviving against one's own incomplete intellect, a misfired bout of randomness, in controlling the risk, and in executing a set of consistent ideas day in and day out, so that chance can prevail. the opportunity is there for the traditional trader to capture his personal alpha. all he has to do is see the market for what it is, and not what it was, or what it appears to be. 

my solemn pledge

i must confess, i’d rather just guess

than be duped and fooled, by randomness

i rather think twice, than just roll the dice

since lines on a chart, do not drive price

rather think like a fox, not be put in a box

as the markets are, a recursive paradox

if not arc sine laws, then ever-changing-cycles

if you are in denial, it can be almost suicidal

these damning effects, must be circumvented

but not with the invented, nor the misrepresented

not with tools that are myopic, or simply synoptic,

lest the retail hypnotic, not benefit the agnostic

a causal understanding, is certainly demanding

but in-or-out of sample, it sets the best example

there’s so much more, than just trade and win

like adding to profits, when others are cashing in

immune to the tout, trading without any doubt

entering trades, where others are stopped-out

not stepping out-on-the ledge, with an illusory edge

there’s no need to hedge, this is my solemn pledge

it ain't over till it's over...

last friday’s end-of-the-week bullish festivities failed to endure past the european markets’ close, and couldn’t even reach a level lofty enough to allow thursday morning’s longs the opportunity to escape at break-even, before the es began it’s daily swoon. after all was said and done, the spx was still trapped in the ~40pt trading range that had defined the market for the past +1 month. emerging markets re-emerged and displayed very good relative strength as money rotated out of past over-performers (bio-techs-naz and momentum stocks-rut) into past under-performers (EEM). the yield curve continued to flatten and credit spreads widened as the market discounted yellen’s and others, hawkish comments. once again, internals were mixed, with bearish p/c ratios and breadth, juxtaposed against a benign and bullish $vix. after settling the week midway between the weekly S1 and the weekly pivot, the market appeared to be waiting for long-term traders at-the-margin to finish weighing their options before stepping in full force. relatively low vix and skew readings indicated an unreasonably complacent mood in the market, although a $2.8BB put position was executed last week - so someone was concerned about downside tail risk. the market had taken on the visage of an aging fighter who had absorbed an inordinate amount of blows to the head and body, yet still remained standing; willing, but not as eager as he once was, to continue fighting. of course, the market couldn't stay in the current trading range indefinitely; some endogenous or exogenous event had to cause the threshold to be breached, so that the market could make it' move away from current value. perhaps the fix was in, but somebody was betting a lot money, that an overextended and beaten down mr. market, would finally utter no mas on his way to a hard landing on the canvas. but like it has , so often, the past 5 years, the market summoned up it's courage and strength and rallied once again, forging new historical highs. it was a comeback that many had thought to be unattainable; and in it's aftermath, there were the usual accusations that the fight was "rigged". mainstream media denied the rumors and in another classic example of hyperbolic hypocrisy, the game's biggest promoter denounced the practice and announced it was getting out of the game. or as the boys at goldman would say, timing's everything.

Zappa said it best...

 The market may not appear to be portrayed against a bullish backdrop, but irrespective of fundamentals, geopolitical perturbances, inter-market context, and lofty location, it is the willing beneficiary of the matriarch's munificence and investor inflationary expectation.

you are what you is
you is what you am
you ain't what you're not
so see what you got
a cow don't make make hams
and a bear don't make clams
five years since its birth
the bulls still inherit the earth

p/c ratios, breadth and volatility are all sanguine — but not overly so, it is what it is — and that's all it is

are we in store for another structural change to the market?

a long career in the markets has afforded me the perspective to see how the markets have changed over the years. when i first started trading more than 40 years ago, markets were undeniably less efficient; information was extremely asymmetric, spreads were large, audit trails were virtually nonexistent, and there weren't any computers, nor the internet. however, the law of ever-changing cycles has had some help along the way; not the least of which are:

• government regulations
• changes in order handling rules/reg ats
• market fragmentation (dark pools)
• financialization/indexed instruments & etfs
• electronic trading
• decimalization
• for-profit exchanges
• systemic market shocks (flash crash)
• global economic shocks (credit crunch)
• advances in information processing and the internet
• algo/hft driven trading and market-making
• central bank policy/qe-zirp

so, if we were to see hft banned or regulated, and a return to normal levels of human market activity, would the markets morph, once again?

never trade retail...

uncertainty is a fundamental reality in trading. the best we can hope to achieve, under any circumstance, is an incomplete, but probabilistic knowledge of that environment. most new traders neither understand the markets are dominated by chance and randomness, nor possess the ability to cope with the day-to-day gyrations of the market. the natural inclination is to find a comfortable resolution and a shortcut to order amongst all the chaos, while never understanding the structure of its source. ironically, they tend to herd with other naive neophytes into a socialistic like trap, incorporating cliched and anachronistic methods, strategies, and approaches to the market. like churchill remarked, it is a philosophy of failure, and a creed of ignorance, whose inherent virtue is the equal sharing of misery. paradoxically, the less they really know and understand about the market, the more they think they know, and the more likely they are, to have a predictive bias to the market.

as previously mentioned, strategies with the greatest commitment to predicting the future, maximizes the probability of failure. trading today's markets requires a new approach that must be built on an analytical framework that is relevant to current drivers of price. what dramatically distinguishes today's markets from yesterday's trade, is market structure and fed policy. to a very large extent, price action is no longer controlled by humans, and to an even larger extent, price action has been contaminated by qe/zirp. unless we see a return to normal levels of human market activity, and an absence of artificially controlled markets by the fed, we will never see markets that even bear a resemblance to markets of the past, nor will yesterday's approaches to market analysis ever be applicable again.

how traders cope with probabilistic uncertainty and their imperfect view of the market is critical to their success. incorporating relevant informational signals from a wide range of deterministic processes is the foundation for a trader’s success. this means resisting the sirens' call to assign causality to traditional ta patterns, trend-lines, fibs, and other hackneyed tools that were created for highly auto-correlated markets, driven by human decisions and real risk/reward considerations. the new-normal approach begins with recognizing the current dynamics of liquidity provision and developing an informational framework with signals that reflect the machine driven reality of hft, along with an understanding of the the impact of qe/zirp and risk-on/risk-off on relative value and carry strategies. there is a right way and a wrong way to deal with the inherent fuzziness and noise in today's markets, and without the right tools and the proper perspective it's easy for human decision makers to be misled by the machines and policy makers. or, you could just wait for a head-and-shoulders top, trend-line resistance, or a moving average crossover to get short, and then hope and pray.

don't blame the player, blame the game OR if i could, i always would

i must (somewhat) sheepishly admit, that i don't see that much difference between yesterday's human-driven liquidity providers (floor traders) and the machine-driven liquidity providers of today (hfts). the only difference is that as a local in the pit, we often possessed exogenous information, that was yet to be incorporated in the market. predatory algorithms must rely on their endogenous actions to trigger the desired outcome. of course, in my own version of strategic sequential trading, i would often hit bids and lift offers in search of stops, just not as efficiently and unemotionally as hfts. of course, our rather dubious actions were as summarily and similarly rationalized back then as they are today; as our privilège intitulé and due compensation for the risk we incurred for providing liquidity. after all-was-said-and-done however, we did it for the same reason that a dog licks his balls... because we could. perhaps, if goldman wasn't obama's largest campaign contributor, sec employees didn't have quid pro quo agreements with private sector bd's and wall st. law firms (for post govt.-service employment) and the exchanges hadn't gone for-profit, mr. lewis would have had to write a book on a different topic.