This is the third of a series of four articles titled “Key Concepts to Correct Trading Behavior – A guide to relevant concepts for trading success in a market governed by High Frequency Trading (HFT) and Program Trading”, focusing on the most important concepts any trader should internalize in order to show a correct trading behavior, in a world where the majority of trading volume is generated by computer programs.
I have written an introduction to the eBook and the first and second part of it, titled respectively “The Bandwagon Theory” and “The Dangers of Asking “Why?”“. This week I present the third part titled: “Facts and “Truth” Do Not Make Money”. I will keep working on the other sections of the eBook. Notice that I am also working on the most important section that illustrates a practical application of the Bandwagon Theory, using the daily chart of the EUR/USD forex cross (the section ‘The Psychology of Trading: the Bandwagon Theory illustrated’ will only be included in my free eBook that I will make available on the home page of this Blog). This series of articles is introduced here.
Traders who spend their time delving into the facts that governments, central banks, companies and news services ceaselessly put out will not be successful like those who learn to focus and capitalize on how the crowd and Program Trading react to those facts, i.e. learning to observe price behavior. Actually only the crowd of emotionally driven traders will react to news. In fact, Program Trading will just keep executing the rules encoded into the computerized algorithms and will not be affected by news at all. Of course the crowd’s perception and/or reaction to the facts can and will be out of sync with the reality of those facts. This is why Program Trading does not trade news (although some High Frequency Trading programs may still do that), in fact, usually programs operating on the smaller timeframes are turned off when important events – capable of generating high volatility – are expected. There are times when the reaction can even be diametrically opposed to those facts, which really throw most novice market players onto a state of even bigger confusion.
The huge focus on news and the fact that some market services or ‘professionals’ base their ‘systems’ on news interpretation generates a widespread but wrong idea that learning to interpret the news is important and even fundamental to forecast (but it would be better to say guess) market direction. The money-making potential is in the recognition of the reaction to facts and news which requires an objective analysis with regards to what price is already doing.
Who has not witnessed a stock or futures market dropping in the face of positive news, while other markets rise on the heels of what appears to be damaging news? In essence the successful trader has to come to terms with the knowledge that it is the understanding of people and what moves them that makes for truly profitable trading. So instead of investigating the actual news the right question is “how are people likely to respond or are responding to this news?” In reality it is even better to not go that far in trying to interpret people’s response, as I will show to you later in this section.
Why do markets, at times, totally defy the facts and/or logic? The important truth is that reality does not matter in the trading and investment worlds. It is the perception of reality that is important and actually it is the crowd’s and smart money perception and not the trader’s own perception. Moreover the crowd’s perception is often different with regards to similar news in different time and states of the economy, fundamentals, sentiment and technical patterns the market is in. This is often hard to accept because it requires acknowledgment that a trader has no control over the markets. But, on the other hand, this is also liberating because it releases time and resources to focus on the most important aspect: price dynamics.
There will be times in which the truth (facts) and crowd’s perception will be identical, perfectly in sync. Other times the truth and the perception of it will be completely opposed. In the shorter timeframes the truth does not always win out. It can certainly be argued that the crowd’s perception and the actual reality cannot stay out of sync forever, and what is real will ultimately prevail. Besides the fact that behavioral finance shows that biases can affect the evaluation of what is real, i.e. the fair value of a market or stock, traders do not have the luxury of a great deal of time. Traders’ success only depends on the correct evaluation of price dynamics in the “here and now”. In such a context the truth does not always count.
Believing that the market responds to what is real and true is an erroneous assumption that generates million of losses among less inexperienced traders every year. The truth is that futures, stocks, ETFs, commodities and other markets rise and fall based on beliefs, not facts. The reality does not matter but perception of reality does. Therefore when a trader buys a futures or a stock what he is really buying is people and the beliefs they have about the traded instruments.
Van Tharp says that “we do not play the markets, but our beliefs about the markets”. Indeed when a trader puts money on the line he is betting on the knowledge of how people, investors, professional traders and the crowd will perceive price action in that market over the short-term. These days we can also add that the trader is betting on its knowledge about how Program Trading tackles and runs some high volume stock and futures markets. This is because it is people psychology and, more and more Program Trading, that move the markets one way or the other, not facts. A fact has never moved a market and never will.
Another important point is that markets are anticipatory in nature, i.e. they try to play on what will happen and not what has happened. Facts and news are remnants of the past and they tell very little about what will happen tomorrow. This is why professionals tend to “buy the rumors (perceptions) and sell the news (facts)”.
How traders and investors as a whole interpret the facts in the context of current conditions is the reality, the true driving force behind a market’s movement. This is the reason why markets can and do depart from logic – the recurring phenomenon that makes trading difficult. Traders should bet on how others feel about such markets. Because it is people and their feelings and emotions that ultimately move markets. People are far more unpredictable than any other entity in existence due to free will.
Nowadays things are even more complicated, but when things are put in perspective they are indeed easier. Let me explain: facts are ‘known’ in advance, way before they are announced, and are already reflected in price. Program Trading sets up technical patterns that reflect and push price in a direction that discounts the facts with days and weeks in advance. When news come out they typically contribute to complete the technical pattern already in place on bigger timeframes, i.e. weekly and daily. News however can affect price on the smaller timeframes (e.g. 4-hour and 15 min charts). In conclusion, the trader is invited to assume and build a belief that news, facts and truths are not important for successful trading. It is better to understand how specialized computerized programs tackle the markets and the trader should derive the rules such programs use from the behavior of price, because news will always move price in the direction that completes the pattern in place.
For similar reasons, news fading (i.e. trading in the direction opposite to the one suggested by the news) is dangerous too. Forex related news, for instance, whether apparent and/or real, immediately precede an upward spike or a downward spiral. This is because news is the most accessible means of information gathering for traders in general, and is provided and reported by reputable news institutions that are generally considered ‘reliable’. Spikes and spirals usually last for 15 to 30 minutes or longer during FOMC or ECB days. After that traders will see a slow return to previously traded levels and price structure re-enter into the areas and thresholds identified studying Program Trading rules.
It is quite cheerful for example to hear that, historically speaking most traders determine the value of the US Dollar (USD) based on the Non Farm Payroll (NFP) which is released at the 1st Friday of every month. In practice, all a trader should do is to pay special attention to when the news is released and not what are the actual numbers. News is relevant only when it contributes to break sequences of measured moves induced by Program Trading on the larger timeframes, i.e. daily and weekly. But very rarely news is capable of doing that: what can really change market direction is huge and coordinated participation from smart money and/or central banks. For instance, the S&P500 was turned higher twice in the last 3 years: the first time in March 2009 and the second time in May-July 2011 by the intervention of the FED with Quantitative Easing initiatives.
So when dealing with news the indications are to: 1) understand the technical pattern Program Trading has created and that is being completed; 2) take partial profits before news; 3) know well when news is released and never attempt to play it, but stop trading; 4) resume trading the next day in the direction of the current technical pattern, if not yet completed (i.e. targets where not reached), or just wait for targets to be hit.
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