Trader Dynnamics Toolkit: Riding the wave

These are times  of big changes. Volatility is at an all time low in many global markets. Trader apathy is at an all time high and the no economy cocktail of low growth and low inflation has created an economic cycle where Central Banks have cut their hands off.

They have deliberately or foolishly left themselves with very little power to manage the economy. Interests  rates are so low that ECB had to bring in negative interest rates to force banks to lend their money. In the US, on Wednesday, Jannet Yellen acted more like a CNBC commentator telling everyone proudly that stocks were not overvalued. The market blindly jumped on the bandwagon.

For many traders it has been a  quiet year and, if it wasn't for the special situations that have arisen from political turmoil in the Ukraine or in Iraq many funds would be well under break-eve.  Every day more and more forex traders disappear as the Euro/USD regularly trades in tight ranges.

All this is not earth shattering news to  any seasoned trader. In fact it is these moments that  test the market knowledge of most traders. As robots, computers and automatic algorithms take over much of the trading the possibility of arbitrage, whereby taking advantage of the slight variations in different markets evaporates.

In the past this has led banks and trading houses to come up with novel and exotic ways of making money. We had junk bonds, we had a biotech bubble and a Dot Com  bubble. We had a sub-prime bubble. As traders and market followers this is like sitting and waiting for the encore or the next wave in the ocean. The market continues and traders are dusting off strategies for low volatility none existent economic conditions until the next wave appears.

In 2007 Paulson became a billionaire by short-selling subprime mortgages and made $3.7 billion that year. It is hard to believe that in 2011, he made losing trades in Bank of America, Citigroup and, Sino-Forest Corporation.

His flagship fund, Paulson Advantage Fund, was down over 40% as of September 2011. So, how is it possible that with all the resources and a deep understanding of the market the same person can get things fundamentally wrong.

Trading is a combination of 2 activities, one mechanical and one emotional or psychological. The mechanical side of trading is very much like chess. You know all your moves and you can pretty much foresee the other sides moves and counter them. It eventually becomes a war of attrition. Whoever has the most knowledge, patience and willpower will gain the advantage. When things go as planned the mechanical side of trading is beautiful.

Then there is backgammon. The players know all the moves, yet the dice is the king. The game can change quite rapidly if you throw some bad numbers. The reality about trading is that despite all the theory you can not predict what can happen one tick from now.

But the best explanation for me, a mathematician, is Schrödinger’s cat. In the Copenhagen interpretation, a system stops being a superposition of states and becomes either one or the other when an observation takes place. The market can be dead or alive at any particular moment and it is only its observation at any particular moment that makes it relevant.

Financial markets have the same mathematical basis as natural laws. Why else would a Fibonacci number that measures spirals on shells, and spiral galaxies be relevant. There are financial models based on fluid dynamics, wave patterns, crowd dynamics and mass mood psychology. In fact there are very few purely economic models to trade, apart from following fundamental news. However, that can be extremely distorted at times too.

So what is it that makes the trader successful in this dynamic ? It is the persistent and powerful motion of the financial market. Any surfer who sits in the ocean will get a massive wave eventually and maybe it will be a Tsunami. The second he observes the wave he is doomed to act. He will either ride it to the shore or die.

The observation is part of the equation and being observed as an actor is the other. Your system observes the market waiting for the next best move but is all the decisions made by you that ensures the trade is successful.

Many traders sit through wave after wave waiting for the big one and nothing happens. Look in the right places and really observe the market and you will see trading opportunities in every candle. Sometimes you will get it wildly wrong and be on the wrong side of a Tsunami. But that is trading. Sensible money management ensures that you will not get blown out and you keep on trading.

Volatility conundrum

The key ingredient that moves prices is volatility. Demand and supply, creates a market but price volatility moves it. In the past few weeks volatility has been scarce in the commodities and index markets. Volatility in forex has fallen significantly in the past few years. This development does not bode well for hedge funds which thrive on volatility. However, they are partly responsible for pulling the plug on volatility.

Many of the complex algorithms used by hedge funds depend on a number of interlocking variables that provide regular winning trades again and again. The success of the algorithm is the consistency and the fractal  nature of markets. Whether they bet for 5 minutes or 5 months they will ensure a steady return.

The drawback of algorithmic trading is the inevitability that markets change over time. In the past hedge funds have been burned in moments of market change. This time they have learnt from the failed lessons of the past and have pulled the plug on the algos. Most traders are sitting on their hands. Maybe they are waiting for the World Cup to finish. Maybe there is some significant news around the corner that we are not aware of. The only real movement seems to be in treasuries. Who does that benefit ?