Trading Education Articles Table of Contents Trading Education Article #1 Protecting Yourself Trading Education Article #2 Structure Trading Education Article #3 Timeframe Tactics Guide: What a difference a Timeframe Makes Trading Education Article #4 Day Timeframe Market Confidence Trading Education Article #5 Knowing What to Look for Trading Education Article #6 Buying and Selling Tails and Trader Development Trading Education Article #7 Initial Balance Trading Education Article #8 Understanding Timeframes Through Example Trading Education Article #9 Understanding the Importance of Two-sided Versus One- sided Trade Trading Education Article #10 Traders and Costco Shoppers Trading Education Article #11 The Auction Process—Incorporating Multiple Observations—All in One Example Trading Education Article #12 Separation and Divorce are Always Difficult Trading Education Article #13 What I Internalized on My Own I Still Use Trading Education Article #14 The Horses are at the Gate and There They Go! Trading Education Article #15 How we View the Market Often Delivers Far Different Perspectives Trading Education Article #16 Does Your Brain Need Defragmenting Trading Education Article #17 A Week of Trading with Jim Part 1 Trading Education Article #18 A Week of Trading with Jim Part 2 Trading Education Article #19 A Week of Trading with Jim Part 3 Trading Education Article #20 References Trading Education Article #21 Keeping the Market Profile in Perspective Trading Education Article #22 Destination trades Trading Education Article #23 Contrasting Symmetry Trading Education Article #24 Day Timeframe Inventory Imbalances Trading Education Article #25 The Learning Process Trading Education Article #26 Stops Trading Education Article #27 A Week of Trading with Jim April 2011 Trading Education Article #28 Reading Structure for Day Timeframe Trading Trading Education Article #29 I Remember When Trading Education Article #30 Resting Orders Trading Education Article #31 A Bad Day in the Life of a Guru Trading Education Article #32 Timeframes: Out of the Abstract Trading Education Article #33 Defense Trading Education Article #34 We Have Met the Enemy and He is Us Trading Education Article #35 The Transition from Bracket to Trend Trading Education Article #36 Trend Days Trading Education Article #37 Where to Get In: A Real-Time Trading Example Trading Education Article #38 Looking Past the Hood Trading Education Article #39 Price Versus Value Trading Education Article #40 Fading Trend Days Trading Education Article #41 Spikes—How to Employ Them in Your Own Trading Trading Education Article #42 If Trading Education Article #43 A Market on the Move Trading Education Article #44 Does the Market Profile Work 45 Trading Landscape – A Recent Example 46 Recap of Dec 2, 2011 Real-time Markets Webinar 47 Understanding How We Really Make Decisions 48 So What Do I Do with This… 49 So What Do I Do with This..Continued 50 Confidence 51 Responsive Trading 52 Odds and Context are Inseparable 53 It’s Too Late I Missed the Trade 54 Circuit Breakers 55 Actionable Nuances from the Pre-Market Updates 56 Shakeout 57 How to Trade a Trend 58 The Fairest Price or POC Migration 59 TPO versus Volume Profiles 60 The Successful Trader’s Mindset 61 At Odds with Market Price 62 & 63 Disappointing Friday; Long Weekend 64 S&P Recap August 24, 2012 65 Poor Highs and Poor Lows and Excessive Buying and Selling Tails 66 Hierarchy of Information 67 Hierarchy of Information Continued 68 Acceptance 69 Taking the Ambiguity Out of Confidence 70 Monitoring for Continuation 1 PROTECTING YOURSELF FROM ME AND ALL OTHERS Successful trading requires that you protect yourself from your own opinions, my opinions, if you are reading our blog, the news services, and anyone else that you may be following. The answer rests in employing market‐generated information (MGI): listening to the market versus those referred to above. Quite often we get an opinion riveted into our mind only to see the market doing something entirely different; if you have advanced to the stage of understanding and endorsing MGI yet are unable to act when you clearly see a different opinion expressed by the MGI, you are experiencing cognitive dissonance, the psychological conflict resulting from holding two simultaneous, conflicting thoughts. I never knew a trader who hasn’t constantly had to deal with this issue; the emphasis is ongoing. S&P 500 Dec 2010 as of Thursday, September 23, 2010 for Pre‐Market Friday: Let’s make this real and very personal: on Thursday afternoon, Sept 23, 2010, when the S&Ps couldn’t trade and stay above “unchanged”, 1129.60, which is always a day timeframe reference, the market called for a day timeframe short. The market broke and settled below the reference I had previously published (1122.00). But because the POC or fairest price to conduct 2 business remained just slightly below unchanged and did not migrate lower with the price break, the market also called for the day timeframe short to be covered. Our Pre‐market blog post on Friday, September 24th stated that the NASDAQ rally didn’t look complete to the upside while the S&P auction didn’t look completed on the downside; we thought that the better odds for Friday’s S&Ps were for a balancing day. S&P 500 Dec 2010 after Close on Friday, September 24, 2010: As you can see, the market gapped 13 handles higher on the opening; the news stories attributed Friday’s rally to the Durable Goods report. The rally was well under way prior to the news report. The failure of the POC or fairest price to conduct business to migrate lower with price on Thursday alerted us to the possibility of heavy short inventory positions, inventory that was “short in‐the‐hole”, trader talk for short at bad prices. This is often a setup for a short covering rally. The fairest price to conduct business (POC) on Thursday was substantially higher than Thursday’s close; these late day shorts had very poor trade location—many traders were caught short at poor prices. 3 On the other hand, since the settle was below my reference level at 1122.00, I thought the best case to be made for Friday’s trade was to see the market balance; this was my final opinion to be posted on our blog. Our post also said, “The upper focus is on the market’s ability to trade above and maintain price and value above Thursday’s high; failure to accomplish this keeps the pressure on the downside.” However, I didn’t pay this possible scenario enough respect. On Friday morning, as you watched the overnight trade continue to creep higher with the opening approaching, you should have been on high alert and prepared for, at least, a short covering rally given the traders that got caught ‘short in the hole’ on Thursday’s late downside break. Thursday illustrates one of the more subtle pieces of market‐generated information you will deal with. Yet its subtlety also hides it from the majority of traders—an identifiable edge to those traders who do pick up on it. I often say, nuances are important. Let’s discuss some of these to understand the subtle market‐generated information generated by Thursday’s auction. Below is a split out Profile of the S&P on Thursday, September 23, 2010: We observed eight auctions that stayed around unchanged. The auction did not find acceptance above this day timeframe reference. An important part of trading is 4 recognizing who is dominating in the session: if longer‐term money was buying on the move up, the day timeframe reference of unchanged would have been taken out in a shot. The auction rotating around the unchanged level indicated that day timeframe traders were dominating. Wednesday’s ‘b’ shaped Profile indicated liquidation—old business versus new money selling. The laggard longs that had not liquidated on Wednesday were likely getting nervous late Thursday afternoon, as price was unable to probe higher. Day timeframe longs that bought the upside move on Thursday morning were not getting much for staying in their long positions either. As the day wore on and the closing bell approached, these laggard longs and day timeframe longs began to liquidate contributing to the late afternoon break that ended with a close near the lows. This emotional, rapid liquidation break also brought in emotional sellers (weak hands) that got short at poor trade location, as we discussed above. This set up the possibility for a short covering rally. The pieces to the puzzle from Thursday’s auction required independent thinking and a focus on market‐generated information. Focusing on price late Thursday afternoon was very misleading. Market Logic: Too often traders make decisions in a vacuum and fail to look at other markets or potential influences. On Friday morning the Dollar Index was at new recent lows and opened about 4 handles lower; this was likely seen as bullish by stock market traders. Whether there is long term data to support this stock market reaction to lower Dollar Index prices is questionable; nonetheless this is what we often see. We are not economists, we are traders. The S&P’s (big contract) gapped higher and failed to back up and fill that gap; the markets said we were out of balance to the upside; MGI quickly told us that prices would auction higher on Friday. This certainly wasn’t what I expected; however, applying MGI allowed traders to get on the trade. 5 S&P December 2010 Big Contract Open September 24, 2010: Market‐generated information telegraphed the rally once the market opened and couldn’t fill the gap. Simple right? Yet this market situation on Friday illustrates (once again) the concept of cognitive dissonance. The big downside break on Thursday afternoon followed by an upside gap opening of 13 handles required a huge mental shift in market perspective; a difficult task for most. Yet the market‐generated information was there to convey what was happening in the auction. 1 STRUCTURE: THE MARKET PROFILE® VERSUS A BAR CHART STRUCTURE Bar chart Profile Components: Components: Open Open High High Low Low Close Close Volume at each price Time at each price 2 We start this discussion with a bar chart and the Market Profile graphic side by side to compare a one dimensional versus a two dimensional graphic. In one dimension, the bar chart is not able to show the character of the market; where the majority of business took place, at what prices levels, and for how long. The Profile graphic releases a substantial amount of information to inform the observer of the complexity, as well as the nuances, of the auction process. Market‐Generated Information and Structure The Market Profile® graphic is a time sensitive, evolving database that updates in real‐time to reflect the structure of the market’s natural two‐way auction process. Market‐generated information (MGI) is the byproduct of the natural two‐way auction process and it is conveyed through the Profile graphic. Structure is revealed through the market‐generated information and provides us a composite view. It is much more than individual data points; it graphically conveys complex information that allows us to see timeframe participation, inventory, completion (or lack thereof), emotional trading, as well as the nuances reflected over various timeframe perspectives. The Profile graphic equally conveys day timeframe structure to enable a trader to formulate a tactical plan inside the day. Similar to the broader perspective, it allows a composite view, and in this light, may prove even more helpful to protect a day timeframe trader from being mesmerized by price. Day timeframe information is relevant to all traders when you consider that everyone is day timeframe trader the day they enter or exit the market. Our objective in this article is to discuss structure through various examples so that those interested to learn more can get a feel for what structure conveys. It is not linear with several reference points listed on a sheet. Because it is a composite, we can draw on the power of the human mind to see several data points in context and get a sense for what is transpiring. After all, the market is where buyers and sellers come together to engage in two‐sided trade; people, not numbers, transacting as the auction unfolds over the day, multiple days, weeks, months, and years. Structure enables us to view confidence, emotion, strength, and weakness, along with the more mechanical components, to understand the various participants and the virtually infinite motivations that move the markets. INTERNALIZING THE IMPORTANCE OF STRUCTURE—The best way to begin to appreciate the importance of structure and how you can employ it is through example; let’s begin with day timeframe structure. In a future educational article we will show how you can carry day timeframe structure forward and apply it to longer‐ term perspective and longer‐term trades. 3 AN ALMOST PERFECT DAY Collapsed Extended TREASURY BONDS SEPT 13, 2010 Chart 1: Treasury bonds September 13, 2010 The Profile on the left represents a relatively strong, healthy day timeframe auction; on the right is the same Profile with each 30 minute time period split out, which allows you a clearer perspective of how the day developed. You see from the expanded Profile that the market auctioned higher, balanced for five periods then departed the balanced range to auction higher again, and then balance again into the close. 4 There are no perfect standards; however, this Profile will represent our standard for reviewing further examples. Next, let’s go to the opposite extreme and show a very weak two‐way auction with no conviction or completion in either direction in an attempt to identify the range of observations. S&P 500 (Large contract) December 2010 SEPT 24, 2010 Chart 2: S&P September 24, 2010 REFERENCE—Our example is actually going to be the following day; however, nothing happens in a vacuum; there is a serial relationship between days just as there in a string of Christmas trees lights. It this example we are just using the last two lights; however, the entire series is important. 5 1. Our Profile on the left and the “Almost Perfect Day” Profile we showed to begin with have one thing in common: they both record a market attempting to auction higher. We are always trying to assess what a market is trying to accomplish followed by asking, “What grade would we assign to the effort?” If we assigned a B+ to our 1st Treasury bond example, the last example might receive a gentleman’s C. The odds of upside continuation are much lower in our 2nd S&P Profile example. The fatness, reading from left to right, allows us to see how much time was spent at each price level; the widest area represents the fairest price at which business was being conducted, or the point of control (POC). The more prominent the point of control (POC) or fairest price at which business was being conducted, the more volume it will likely require for the point of control to migrate to another sustainable level. 6 2. The daily auction doesn’t look to be complete; when an auction is over, price should drop away quickly. It spent three ½ hour periods here. 3. Review this profile; you should notice that it lacks any symmetry. This statement becomes clearer as your experience with viewing Profiles expands. The lower portion has no symmetry with the upper portion. Over time, the continual two‐way auction process, very often, completes the symmetry. 4. Just as we commented about the top of the S&P Sept 24th profile not appearing to be completed, the same comment is now is applied to the S&P Sept 27th profile next to it. 5. The market has attempted to auction lower and selling has dried up; it is likely that the market has gotten too short, in the day timeframe, to go any lower. The uncompleted previous high also indicated that the market had gotten too long in the day timeframe to go any higher (these are other concepts that you will explore as you continue your education). Often, markets have to “break before they can rally” or “rally before they can break”; this is how inventory is adjusted. 6. The rally that begins in J period and terminates in L period completes the auction from the previous day, much like a baseball game that was suspended because of rain. You will hear us refer to this as “repair”. Now that there is a completion of the upward auction, our focus should return to the uncompleted lower auction. Remember, markets are continually developing through a natural two‐ way auction process. 7. The downward auction is completed. Again, this would be considered “repair”. Understanding the complex information visible through the market’s structure allows traders to begin to migrate away from price‐based thinking and trading, to move to a more complete appreciation of the continual two‐way auction process and the continually unfolding opportunities. Remember, price is simply an advertising opportunity, structure allows us to put price in perspective. 7 On the morning of September 29th 2010 our blog post identified the trend line in the chart above as our short‐ term, downside reference; let’s review the Profile from the early morning ‘pit’ session of September 29th to determine the information delivered by the market structure as recorded via the Market Profile®. 8 1. The same trend line shown on the bar chart and the reference we identified in our blog. 2. An uncompleted auction; caution, this is just one data point. Notice the substantial difference between this uncompleted auction and those in our last example, adding another time period to the low would have delivered exponential information. Exponential information, as it used here, simply refers to a rapid increase in importance, a two wide low is not twice as likely to fail as a single print low but multiple times more likely, a three print low is, again, many multiples more likely than a two wide low to fail. 3. The third auction period saw the market auction down and through the trend line; a simple price‐ based view witnessed the trend line being broken. A structural auction view saw quite different information; the probe below the trend line was quickly rejected and the auction accelerated more than $5 dollars higher over the next three days. 4. We likely would have never projected the magnitude of the auction; however, by identifying the beginning of the auction you are now in a position to monitor for upside continuation with excellent trade location. Structure—not price—contained the most important information. 9 RECAP: The study of structure and timeframes is a lifelong process; however, as a sign says as I enter my health club reads, “A year from now you will be glad you started today”. We provided two extremes to give you a base to illustrate the concept of structure. However, it should be noted that structure is internalized over time, through various observations, as you watch the markets every day and accumulate experience. Do not be hard on yourself as you assimilate these concepts into your market understanding; it is one thing to be introduced to something but quite another to learn it and make it a part of your thinking and your developing market perspective. There is a common thread among the comments from our clients from both the very experienced to those just starting to trade: you cannot hear or see this information enough. This was a driving factor in our decision to create a video. Not only do I feel like the visual medium is the most powerful way to learn the markets, but it also avails a trader the opportunity to review the material as many times as it takes to internalize the various concepts that I employ in my trading. Structure is not linear; it requires context and an understanding of the bigger picture. Yet the rewards of leveraging it in your trading, I believe, far outweigh the effort. Recognize and identify structure, think about what it conveys in the broader perspective. As Benjamin Hoff states in The Tao of Pooh, “much learning does not create understanding”. Structure will help you understand the composite puzzle of the market‐generated information pieces and graphically conveys the broader dynamics of the two‐way auction process. 1 WHAT A DIFFERENCE A TIMEFRAME MAKES Timeframes Tactics Guide When trading begins to operate beyond the parameters examined in these examples you will begin to sense longer timeframe involvement. Successful traders continually readjust their strategy and tactics depending upon timeframe involvement. Timeframe Trading Behavior: Determining who is dominating in the market on any given day and understanding how their participation will affect the auction process is crucial in determining one’s trading strategy and tactical implementation. For this article we have combined scalpers, day traders, and short-term traders into a single group and classified intermediate and long-term traders into the second group. The three most important aspects to trading are: 1. Understanding the markets natural two-way auction process and organizing that information so that you can interpret it to trade effectively 2. Understanding the auction’s different timeframe participants and each of their traits and behaviors 3. Controlling and employing your emotions in a productive manner. [to trade successfully] The dilemma of learning complex information: The whole is too complex to learn without understanding each of the pieces, and each of the pieces can’t be fully learned and understood without understanding their context within the whole. This is the same issue that scientists continually wrestle with. The global warming analysis is a prime example albeit on a much broader timeline. Scientists must understand recent and current temperature excursions since they started recording this data; yet they must put these observations in context with long term climate changes that have occurred prior to science even recording such information. A note about conflicting information: What is not directly conveyed in the above point but is equally important to traders is that there will always be an element of uncertainty when our analysis is completed. This is probably one reason why many traders continually dissect information, attempting to ‘figure it all out’ before completing their analysis or, executing a trade. As humans we have a propensity to seek certainty; however as traders, accepting uncertainty is a fundamental necessity. To quote Karl Popper as he is cited in The Black Swan by Nassim Nicholas Taleb,”… uncertainty is our discipline, and..understanding how to act under conditions of incomplete information is the highest and most urgent human pursuit.” We highly suggest reading this book listed on our Suggested Reading list. The basic timeframe descriptions are recapped below. Chapter Three of Markets in Profile deals more in depth with the broader topic and the Field of Vision video takes timeframe analysis even deeper as several differing live market examples illustrate this concept. Timeframes: Market activity is influenced by a wide variety of participants operating under a wide 2 variety of timeframes and motivations. The way each of these participants combines and employs information is different. For learning purposes we have segregated the markets into 5 timeframes: 1. Scalpers are very short-term oriented, trades being completed possibly in seconds; they rely primarily on intuition and order flow. Today most scalping is done via computer. 2. Day traders come to market each day flat (no position) and leave the day flat. Their behavior is very short-term and often emotional. They depend almost exclusively on market-generated information because fundamental information is too slow and cumbersome; fundamental information can actually be counterintuitive for the day trading process. 3. Short-term traders’ timeframe is usually 3-5 days or slightly longer under the right contextual conditions. They supplement market-generated information with an awareness of recent fundamental information and the effects this can cause on market movement. They love to trade from the top to the bottom (or bottom to the top) of multiple-day trading ranges—5 to 10 days is ideal. 4. Intermediate-term traders’ timeframe covers weeks or months of market activity; they rely on a blanched mix of fundamental and market-generated information. This timeframe prefers to trade from the top to the bottom or vice versa of large trading ranges or balance. When the intermediate-term traders begin to dominate a market, their behavior is aggressive. While they tend to dominate markets far less frequently than the short-term timeframe discussed above, when they are dominant they are usually very aggressive and move the market substantially. Shorter-timeframe traders who are unaware of their entry into the market often suffer substantial losses. 5. Long-term investors/traders may hold positions for months or even years; they are far more attached to the securities and investments they own. They tend to follow fundamental information first, followed by market valuation, and finally market-generated information to supplement their understanding of market activity. When they become dominant, markets can move out of the more traditional contained ranges of the other timeframes. They move markets; and when they do, the other timeframes “pile on”. LEARNING BY EXAMPLE We have chosen Friday October 8, 2010 for our example. The monthly Jobs report, which is often the most important economic report, was released and showed very poor labor conditions. This would normally be expected to create volatility and interest among all of the timeframes. Let’s review the S&P’s on October 8th in segments: 3 1. Opening—The opening immediately begins to prepare us for tactical trading; is the market in or out of balance. On this day it is in balance; opportunities are likely small unless the market immediately auctions out of balance. Openings are important references for day and short-term traders. 2. The initial auction is up leaving a “local top”. Local top is a carryover term form the old days when floor locals played a more important part in the market. Local tops provided evidence that the floor traders were dominating the market; longer timeframes were absent. The locals could have their way with the market. Now we refer to this non excess high or low (meaning no buying or selling tail) as a poor or unsecured high or low, which communicates that day or short-term traders are in control. These traders are unlikely to 4 want to or to be able to move the markets very far out of containment areas; that is not their style or interest. They prefer to trade within well established boundaries. 3. The two-way auction process at work—Once the initial auction ends it immediately begins in the opposite direction; it continues until an opposite auction begins. 4. Half back—Half back is a simple linear observation that short-term traders use to judge the day’s progression and serves as a day timeframe reference. It is simply the center of the range. If the market, for example, has built up short-term buying interest, a pullback from the early high would likely find short-term buying interest at halfback; if there is little buying interest, the halfback reference will not act as support and the selling is likely to continue. 5. Prominent point of control (POC)-The width of the POC, or fairest price at which business was being conducted, varies depending on the amount of volume that occurred or time that was spent at this price level; the greater the time and volume spent at the POC, the more prominent it becomes and the higher the odds that prices will revisit this level. We pointed out in our October 8th Pre-market update that the previous session (October 7th) POC was very prominent and, as a result, presented high odds that prices would revisit it on October 8th. (Some of you will have questions regarding many of the terms; unfortunately, to explain them all here would cause us to lose the overall focus of this trading education article. The books, video, blog, and these trading education articles are designed to become part of your accumulated experience.) The odds were correct; the market opened higher but came back down to revisit this numerous times over the first hour and a half of trading. 6. The downward auction terminates with a local low; the market remains within balance, i.e. within the previous day’s range. There is no indication of longer timeframe interest; our combined group of scalpers, day traders, and short-term traders continue to have their way with the market. The two-way auction process continues to function as it begins to explore higher: 5 Current and previous day’s high for intermediate- term rally 1. The two-way auction continues-Having stopped auctioning lower the two-way auction continues in the opposite direction. The two-way auction process is the market’s way of searching for information and what is uncovered is referred to as market-generated information (MGI). The Market Profile® is a time sensitive, evolving data base that records this process. 2. Half back finds buyers rather than sellers; the next likely destination is the “local high”; markets are very visual and, very often, trade to the next nearby visual reference. Any trader can look at a bar chart quickly sees the morning high as a visual reference. 6 3. Developing value is unchanged from the previous day—If you will think in terms of value versus price you will maintain a healthier perspective. 4. The “local high” is reached—The auction probes to the visual reference; our focus is now on the continuing two-way auction process; does it reverse or continue. 5. Current longer-term and previous daily high—If the two-way auction continues higher, the next references are the current longer-term rally high, which is also the high of the previous day. (You mean here the balance area high of past 3 days=115860 area) 6. Destination-The next visual upside destination trade is to the top of these visual references, this being the high of Thursday, Oct 7th at 116050. 7 1. The original “local high”—I’m going back to referring to my newer description as a poor or unsecured high; that simply means that the odds of holding or remaining in place are low. The auction took out the high and continued upward. 2. The auction continues; during the auctioning process the auction’s goal is to discover a level where two-sided trade can take place; this is the goal of any business-to involve as many participants as possible. We monitor price acceptance or failure to determine if this will be the level. 3. Destination trade—Once again the visual, upside reference of Thursday’s high was reached. I suggest that traders continually divide the market into segments delineated by as many visual references that are clearly defined and take the market one step at a time. If we are in a long in this upward move, we monitor for continuation as each reference comes into play. A logical question—A logical question would be: how about the poor or unsecured low on October 8th, isn’t this important? The answer is yes; in fact, it is important on the afternoon of October 8th. The poor low was an indication that the longer timeframes weren’t intently or aggressively involved in the market on this day, which greatly reduces the odds that the auction will carry very far beyond the morning high. As the auction continued higher, trade expectations and profit targets should have been relatively small. Looking for the ‘big trade’ on this day would have lead to disappointment. This poor low is also important to carry forward after the Friday, Oct 8th session. This data point is part of market structure that you can read about in our Trading Education article on 10-3-10. Summary: Like an operating room, we have chosen a sterilized environment to examine our short- term trader combined group. I chose to say it this way: We have chosen to examine short-term timeframe dominance by isolating this discussion to their behavior; how to recognize these participants and subsequently the most effective trading tactics in any particular session. However it would be incomplete not to mention other factors to consider as your understanding develops and you incorporate more context into your observations. Additional information to consider: Volume: on this day developing volume was very low, which also reduced the odds of further upside continuation. Market confidence: tends to be low on those days that are controlled by scalpers, day traders, and short-term traders with confidence being considerably higher on days that are dominated by longer timeframes. When the longer timeframes are dominant the shorter timeframes tend to pile on and drive the auction even further. Observation: from observation you will see that quite often a daily high or low is established during the first 90 minutes; once a directional auction begins to dominate it tends to go that way for the remainder of the day. On October 8th, although the shorter-term traders 8 dominated, the market reverted to the longer-term trend, still relatively contained, and continued through to the close. Before we present the final three graphs I thought that the market would slightly extend the range in the afternoon, which would be consistent with the capabilities of the combined scalpers, day trader, and short-term traders; however, any measurable or lasting upward extension would be inconsistent with this group; remember, they would prefer to trade within confined level only pushing beyond those levels to trigger stops. Destination had been reached and exceeded; stops triggered. 9 Once the highs were within reach the game became to go trigger the stops; stops are triggered by bidding prices up until the stops are triggered. The profit occurs when the short-term traders that bid prices up to trigger the stops immediately sell into the additional rally created by the election of those stops. Once the game is over two-side trade can begin. 10 The final outcome-On this low confidence day dominated by scalpers, day, and short-term traders the market settled at the previous day’s high and had discovered the level where two-side trade could occur. This is the market’s ultimate objective. Our goal was to show you a low confidence day so that you would be better able to assess when a higher confidence atmosphere was developing; On a high confidence day the auction will generally begin moving directionally much earlier and see much less rotation. On a low confidence day your expectations should be greatly reduce, which allows you to adjust your tactics and attitude toward risk. 1 DAY TIMEFRAME MARKET CONFIDENCE Market confidence versus personal confidence—We very often get into trouble when our personal market confidence level differs from that of the market; these are also the days that our emotional decision making is more likely to become impaired. Keep in mind that the direction that price is moving does not necessarily coincide with the market’s level of confidence. Patience—You often hear the advice that patience is required to become a successful trader; to that I answer a definite maybe. On those days that the market is exhibiting a high level of confidence you want to execute immediately. When market confidence is low, patience is required to let the market develop and identify an inventory imbalance. Inventory imbalances—High confidence days may lead to inventory imbalances; however, they are seldom corrected within the same day. Low confidence days may offer several opportunities as short-term inventories constantly swing from too long to too short. Judging Confidence Opportunities that involve longer timeframes versus the shorter timeframes: Is the market opening in or out of yesterday’s range: Opening outside of yesterday’s range will certainly garner more attention and excitement than opening within yesterday’s range. This is far more likely to galvanize a directional opinion than opening within yesterday’s range. a. If the market opens outside of yesterday’s range and doesn’t trade back into the range, conviction is likely to be high in the direction of the breakout. This is being written on the afternoon of October 14, 2010; the morning opening offers us the perfect example. b. If the market is driven back within the previous day’s range the day timeframe confidence is more likely to be high that prices are too high. Let’s contrast these two scenarios with two examples: 2 1. Market opens outside range, fails in its attempt to fill gap, and moves higher: S&P 500 December 2010 Morning of October 14, 2010 1. Market opens out of balance to the upside. 2. Responsive sellers attempt to sell into higher prices. 3. Initiating buyers are strong, they are willing to buy above yesterday’s high; gap is not filled. Day timeframe conviction is high if buyers are willing to pay 10, for example, for something they could have bought for 7 yesterday. The issue is not if they will be proven right or wrong over time, or that you agree or disagree with their decision, but rather that their conviction is high today. 4. For several periods the market one timeframes higher; one-timeframing is another sign of, at least, short timeframe confidence. 3 2. Market opens outside of balance and finds price accepted back within the previous day’s range: S&P 500 December 2010 Morning of October 7, 2010 1. Market opens outside of balance. 2. Responsive sellers take advantage of advertised opportunity to sell price above value; initiating buyers are absent on this occasion. 3. Near the previous day’s low, responsive buyers step in. It is importance to be able to contrast the level of confidence in this example versus our prior example. In our prior example initiating buyers were one-timeframing higher; in this example the responsive buyers were only able to rally the market for the second and third periods. 4. Sellers reentered on the rally and drove prices out of balance to the downside. What I want you to feel, at this point, is the difference in confidence between the first and second examples. The lower confidence in the second example led to an afternoon rally, unchanged value for the day, and higher price. Had you been able to reflect on the lower confidence in our second 4 example your own emotions might have been tempered, which would have reduced your downside expectations, allowing you to have exited a short and possibly opened your mind to a long trade. Opportunities that revolve more around day timeframe traders: Markets that open within balance (within the previous day’s range) are far less likely to initially involve the longer timeframes. At the lowest extreme the market would be dominated by the day timeframe traders; it is rare that this timeframe can dominate for the entire day making it important for us to learn to recognize when subtle or maybe not so subtle shifts in control begin to appear. Note: For educational purpose we have made this black and white; however, that is rarely the case. Once you grasp the references and concepts they will be transportable. a. The Opening: Day timeframe traders focus on the opening to determine direction or lack of direction. See Mind over Markets as an introduction and the Field of Vision video for more in depth discussion of openings. Back and forth through the opening multiple times signifies low confidence; it is not the time to initiate a trade. A direct march away from the opening signifies a higher level of short-term confidence. If a market has advanced, for example, and then pulls back to the opening without going back through it the chances are good that the market will perform another short-term rally. If price is allowed back through the opening confidence is weak. b. The previous day’s extremes: Markets in Profile discusses the behavior of the various timeframes as does the Field of Vision video; the expected behavior of the day timeframe is to trade within a predefined range exceeding the previous day’s extreme mainly to trigger stops. If there is price acceptance beyond the previous day’s range it is usually an indication of the entry of, at least, the next longer timeframe—change is occurring. c. Unchanged: Day and short-term traders focus intently on unchanged price from the previous day; if the market is falling, for example, and price can’t get below unchanged the odds of a rally are high. d. Halfway back: I lost my best trading friend last year, he was a short-term hedge fund trader known as the king of “half back”; the first 30 minute period has a center of that range, which is referred to as “half back” or half way back. If he wanted to buy and the market rallied prior to him getting his position on he was an automatic buyer at half way back. As the range for the day extends there will always be a center of the daily range; that center or half back continues to be a short-term reference throughout the trading day. e. Overnight high and low: These are, like the previous day’s high and lows, very visual and visual day and short-term references. As this is being written the following example serves to help our appreciation of a previous day’s low as a day timeframe reference. 5 S&P 500 December 2010 Morning of October 14, 2010 1. The market’s opening; our initial reference. 2. The first auction was up 3. The next auction came back through the opening—a sign that we were not at the highest confidence level. At the highest confidence level the opening would have been the low of the day. 4. The auction stopped at one tick above the previous session low; mechanical trading off this reference indicates that day timeframe traders are dominating the market. Longer timeframes could care less about a single tick; again, review Markets in Profile, and for more in depth analysis the Field of Vision video, for a clearer understanding of this discussion. It is important to understand the thought process of the different timeframes. 5. The day timeframe traders immediately rallied the market once the low held; you will not have much time to make up your mind at these lows. 6. The rally off the lows began to stall at the original opening price. Without understanding the process described above you are much more likely to get entrapped by price, emotionally selling into the early break. This process only works if you truly understand it and remain fluid; if the prior session low isn’t taken out very 6 quickly you must exit immediately; the counter auction can be very sudden as day timeframe shorts cover and day timeframe traders buy; this is their game, not yours. Early morning highs and lows: Early morning highs and lows are also natural references when the day timeframe is dominating the market. Observations We have tried to give you an idea of what to look for; it will only be yours after a period of observation and trade execution. Trading experience is accumulated slowly and over time. Without knowing what to look for it is difficult to begin the path toward expert trading. We hope these concepts provide you with fundamental observations that will help you move toward this goal. 1 KNOWING WHAT TO LOOK FOR The first riddle I ever remember hearing was asked by my mother; “When you are looking for something why is it always in the last place you look?” Of course I was puzzled until she said, “because then you stop looking because you found it.” Sometimes in trading we look right at something we were looking for but don’t realize we actually found it, and so we continue looking. We are constantly writing that markets are very visual, which means that, very often, they will auction to a level that is very visual on our charts and graphs. Along with this we often attempt to identify potential “destination” trades; the destination is also a very visual market level. We are not saying that the market will necessarily arrive at the destination; however, if the market begins to auction in the direction of the destination it is certainly a targeted level. Let’s look at an example from Friday Oct 15, 2010 that meets both of the above qualifications: it is visual and a likely destination. Opens in lower range of two day balance CRUDE OIL DAILY and auctions out of range 2 We always talk about levels rather than specific prices; attempting to try and be too exact will, very often, freeze you in place as you try to squeeze out every penny from the existing trade or cause you to miss initiating a new trade. Let’s examine the same trade via the Market Profile. CRUDE OIL Market opens and is trading out of balance Practical application: 1. Consistent and return readers know that one of our favorite trades is a breakout from balance; breakouts represent change and change spells opportunity. Consider if you came into the morning with a plan recognizing the two day balance in context with the longer term conditions. We refer to a trading plan as a Narrative, which is your overall view of the market. Following the narrative are a series of scenarios. Scenarios are possible directional trading events for the day; one of the scenarios in the above situation would be for a downside breakout. See our balance rules in our glossary for further explanation of how we trade balance areas. 2. Value immediately begins to build lower; we trade value not price. 3. During G period, the seventh 30 minute trading period, the auction begins to auction aggressively lower. A visual market audience, these are likely to be skilled and experienced traders, has already locked in on the visual gap as a likely target. Who do think has the edge? 3 Visual perspective: Anyone with experience knows that the previous day’s high and low are relevant to today’s trading. This high or low may only be relevant in slow markets because shorter-term traders want to run the stops and fade price moves back into the range. However let’s extend this to longer time periods. On those days that the longer timeframes have an interest, whether it is to “go with” a breakout or fade the high or low, a longer-term high or low is very visible as well. For example, if a trader did not look at the monthly or the weekly bar for the 30 Yr Treasury bond below, he probably would not have recognized the price level(s) that may interest the longer timeframes; it is unlikely he will have a longer-term perspective. The Field of Vision video discusses this in depth; understanding timeframes and how to interpret their participation takes experience gained over months and years. We suggest labeling references in terms of timeframes (day, short, intermediate, long-term) so that you have a better appreciation of references. This monthly Treasury bond chart was captured on Saturday, Oct 16, 2010. As I edit this article on Monday, Oct 18, 2010, bonds closed at 132.06, more than a handle off the two month balance low of 130.25; do you think this rotation back up into range is the result of the day timeframe trader? Probably not. Oct low 4 The monthly bar allows for a visual review of the previous month’s highs or lows exactly as a daily bar or weekly bar would do for shorter timeframes. In the above example you see that the October low failed to take out the September low by three ticks. The majority of struggling traders I talk with have no idea about these important visible references. If you have not looked at the charts and you are not aware of the references, you will be at a disadvantage for day trading or longer-term trading when the level is reached. We refer to this as a “Top down-Bottom up” approach: first gain a bigger market perspective by looking at the longer-term charts. Then use short-term and day timeframe market-generated information to formulate strategy and a tactical plan from the ‘bottom up’. Visual perspective continued: 5 We often get so focused on the short-term, economic reports, and the talking heads that we fail to keep a perspective of what the market is actually doing; a visual look at the monthly bar quickly allows you to see that; 1. We see an excess low near the 1000 level back in July—excess is one of the most important concepts we work with. 2. One-timeframed higher for three months in a row. One of the best ways to ward off cognitive dissonance is by maintaining a solid overall perspective of the market. We could certainly add multiple examples; however, the objective was simply to expand your awareness of how visual the markets are. When you reflect back on this idea you quickly realize how logical it is. We are drawn to what we can see and become comfortable using it to our advantage. Depth and market perspective will increase when you start to view longer-term charts in conjunction with the short-term. Many traders do not review the longer term charts or they just have a cursory look. Or, they are looking at indicators or other derivatives of price rather than observing the visual levels on the charts. Often times the relevant information is right before our eyes; but if we don’t know what to look for, it’s difficult to find it. Going beyond the Majority of Those You Compete Against What we have shown so far is available to all that have access to traditional bar charts; we can take visibility up another level by viewing Market Profiles®. The Market Profile® is actually a real-time, time sensitive, evolving data base that displays its data in structural form via the Profile graphic. The bar charts that we reviewed earlier are one dimensional; a Market Profile® is two dimensional which allows us to see the market in greater depth. We can see patterns via the structure that allows us to differentiate between price and value, which is at the heart of all rational decision making. We can also observe patterns that suggest that inventory in different timeframes is either too long or too short. Additionally, we can see anomalies in the structure that need to be repaired. Repair can only take place when price returns to the scene of the anomaly. Let’s view a couple of examples. 6 S&P 500 DEC 2010 An anomaly is a single price or level that lacks symmetry, an unusual structural arrangement in the Market Profile®; the above is described as an anomaly because price traded at the POC or fairest price to conduct business in all but one of the daily time periods, a very rare occurrence. The odds are very high that this anomaly will be revisited; it normally requires substantial volume away from the anomaly to open and not revisit such an anomaly. Those who had visual access to the Market Profile had a clear advantage. Note: I understand that the above paragraph lacks a full description and explanation; however, the point of this article is to highlight the importance of visual market references. Our final example is more complex and subtle; however, we have several clients that have effectively traded with this visual picture in mind. 7 1. Our starting point; a fairly balanced day; notice the anomaly at 82.08 and how visual it is. 2. Market opens and rallies to 83.07 in 2nd period (B) before retracing to trade at anomaly from day one. We are overusing the word anomaly here; we would normally refer to the anomaly level 82.08 as the POC or fairest price at which business is being conducted. 3. Shifting gears; I want you to notice how almost perfectly the daily lows are beginning to fit a short-term trend line—this is a very visually displayed. 4. The market continues to conform to the visual trend line. 5. The mechanical trend line that has been the buying reference for the short- term momentum traders. 6. Once the mechanical trend line that has been buy point for the momentum traders is penetrated, one set of stops sets off another, sets off another, etc.