Trader Dynamics Toolkit: Evolving on the Edge of Chaos

Markets are inherently chaotic. To an external observer and newbie trader the counter intuitive movements of markets creates a vacuum that makes rational decisions difficult. This is the sole reason why many traders fail and blow out their accounts. They believe all the false moves as changes in the direction of trend and get caught out in a counter move.

Furthermore at lot of the market gurus advocate an over dependence on lagging indicators and short-term trading. Anyone that has followed short-term movements in prices knows how chaotic that is. Throw in the behaviour of banks and market makers in taking out stops and creating false breakouts and we have a very volatile cocktail.

So how does one manage expectations in this turmoil. Firstly even chaos theory recognises that at some level, even micro, there is inherent order in a system. An airport might look like a manic place to most observers but it is a highly organised complex place with every person following a definite route and timeline.  One has to acknowledge that within chaos there is a point where perfection exists.

In markets this point is difficult to find as so much of market movements are based on psychology and sentiment. If you break down the movements you see a tug of war between the traders going up and the traders going down. In a micro and short-term time-frame it seems like it goes both ways all the time but on a longer and medium time-frame the charts look quite ordered.

The challenge for most traders is to follow the long-term sentiment yet trade regularly in the short-term. The rapid and chaotic movements in the short-term stops out many people if the entry points are not chosen correctly. If we revisit the airport analogy the people who arrive early have a long wait and the people who arrive late often rush and miss their plane but there is a point right before it gets too busy about 1 and half hours before departure when the momentum gains and most people arrive at the check in counters.

This is when the lines can be longest, but the system is working at maximum efficiency to get the people on that plane. The deadline starts to loom and the authorities want to ensure that everything runs smoothly. This is the moment any accomplished trader should be getting into the market.

Early signs of a buildup of momentum. Most traders get there too early, get nervous and sell out or get there too late and miss the plane. There is a case for getting there early but this is wasted time as the plane may be delayed and the move may not happen for hours, days, or weeks.

The problem with most systems is that they bring you to the extremes. They are either lagging or get there too early. How many times have people made a trade based on the RSI only to realise it has floated up in the extremes for weeks. And how many times have people made a decision based on a moving average, just to see it swing back.

 So the only indicator you really need are the key points and blockages. These are normally the pivot points where congestion starts to happen and markets get choppy and some indication that prices are moving and momentum is happening in a particular direction. If you use candlesticks this is when the small candles become long and solid in a particular direction. If you look at numbers you will see numbers start moving fast but predominantly in the same direction 4 forward 2 back 6 forward 3 back, that kind of thing. This is the moment to trade.

Be mindful of the longer term trend and realise you are on the edge of chaos. Things will start moving rapidly but the momentum has started the lines are building up and the people are moving. Just like in the airport. Go with the flow, don’t fight it. You will get there in the end.

Trader Dynamics Toolkit: Noise trading

The massive moves in oil in the past days made me wonder why loads of people sit and stare at the multitude of indicators on their screen all day. If you look a bit further back you will see oil  has been moving for a couple of weeks, quite significantly. If you search in Google you will notice that there were stories about ISIS and Iraq and the impeding crisis around the same time.  Suddenly, you have a neural trading system, which would normally cost, you an arm and a leg. But this kind of trading based on noise is age old.  Even  Edwin Leferve read the ticker and made quick trading decisions based on it in the 1920's

There are all sorts of labels for Traders based on what time-frame and system they use to trade. Everyone has heard of the swing trader and day trader or position trader. In my many searches on the web I discovered a label for a trader I had never seen before. Noise Trader.  Actually, it was coined in a report written by Andrei Shleifer and the famous Lawrence H Summer  titled “The Noise Trader Approach to Finance” . Link at the bottom of the page for your information.

Many of you think I am mad to think that a 21-year-old document has any relevance to modern-day trading. I agree its all pretty boring until you get to page 28 and positive feedback trading. “The key to success, says Soros, was not to counter the irrational wave of enthusiasm, about conglomerates, but rather to ride this wave for a while and sell out much later.” It goes on to say that this could lead to a bubble but can make you very rich in the short-term. Even back then they were scared of the noise traders as they suggest taxing them to the hilt. Well 20 years later and after a series of bubbles nothing much has really changed.

I guess that means all great traders are noise traders. Now to me that makes perfect sense. The false prophets and market Gurus that peddle indicators and mechanical systems inherently dismiss the one real mover of markets, Sentiment. Yes, some people say much of this is built into the market and I totally agree, if you are a high frequency trader, but most of us are not. For them lagging means a millisecond for us it could be hours or days. It is not bad if you want to make a few great trades, but to be a real trader you need consistency. That means trading well, most days for  years. The only way to do that is to follow the successfull crowd, and follow it as perfectly, as you can.

So the question comes down to how one measures noise and sentiment in the markets. Most of trading these days is done by machines and even in dark pools where there is no transparency. The few indicators for momentum are based on the price anyway and are pretty much useless. A friend was following sentiment based on his Twitter posts. That is not a bad idea but its a bit like standing outside a football stadium and predicting the results based on the crowd cheering. You will get it right sometimes but you would be blind, literally.

The answer to all this is very much in built in the strategy. There are a host of analogies traders use, riding the wave, jumping on the bandwagon,and buy low, sell high. The implication for these statements is a fundamental shift in a market, towards a certain direction. Too many traders, these days want to know the whys and the how's. None of that is relevant.

The real questions are  ”is the market moving ?” and “why aren’t you in it ?”

The Noise Trader Approach to Finance
http://scholar.harvard.edu/shleifer/files/noise_trader_approach_finance.pdf