I tend to write from a more theoretical perspective in these blogs, but today’s market action provides a few interesting lessons.  By way of background, I have not been happy with my trading performance over the past few months.  I am just not achieving the level of consistency in my intraday trading that I know is possible.   In response to the frustration I have been feeling, I have scaled back both the size and scope of mytrading and am now focusing on the broad market by only trading a few hundred shares of SPY at a time.  (This is also a return to my days when I traded S&P futures exclusively.  In this post I will speak in S&P futures points, where each ES point = .10 in SPY.)  My focus over the past several weeks has been working to refine my practical application of the interaction of smaller and larger timeframe patterns, but always using the patterns to get to an understanding of the relative balance of power of the buyers vs the sellers.

(I started writing this to illustrate one simple pattern, but as I’m writing, this post spiraled a bit out of control.  I find myself mentioning quite a few other patterns that are also important, and I think this post actually became pretty good illustration of a pure technical version of Bella’s “What’s in your circle?”.  Technical trading is never as simple as “see this pattern then buy”, but it’s more about seeing evolving market structure to try to understand how the relative balance of buyers and sellers is playing out.  I ended up numbering all of the smaller patterns with numbers in parenthesis, just to highlight what I think are the important, relevant, and repeatable patterns.)

-The big gap up on the open is a welcome sight in late summer, because it sets up a high probability for a directional day(1).  Finally.  I know most true gaps (today’s open outside of yesterday’s range) tend to fail(2) and at least to fill a significant percentage of the range, if not all.  However, I also know that bigger picture the (cash S&P) market has tested support at 1,040 three times over the past two weeks, with good price rejection at the level, we put in what looks like a significant higher low on the hourlies, and there was some strange buying after the close.  In addition, I know what happened overnight with economic released from Asia, but more importantly I saw the price action in those broad equity indexes overseas.  My bias is strongly up for the day, but there’s too much potential for a 5-8 point flush on the open to ignore that possibility, so I have to trade what I see as the price action evolves.

-I actually shorted the new lows about 10 minutes into the day, but was very aware that a standard pattern is to drop the lows, trap some bears, and then go screaming to new highs(3) early in the day.  You have to take the short because there is too much good downside potential, but you have to realize it is probably a trap so it puts you in an interesting state of mind.  I also know potentially significant (in retrospect, that turns out to be a humorous understatement) reports at 10AM today so I will not be holding my full size into those reports, regardless.

-The short was short-lived.  Flipped long a point and a half above my entry a few minutes later as the market held the lows and took out some swing points to the upside(4).  Nice little ding to start the day, and of course the potential for being round-tripped now, but you have to do the right thing regardless of how you feel about it.  Sold enough of my longs into the rally to be very small in front of the number.

-Now we get the real fun:  A huge rally off the number… 10+ S&P points in a single 5 minute bar.  I know two things:  this is unsustainable behavior so it is probably some kind of buying climax(5), but anyone thinking short after what has just happened, is a complete idiot.  I will hold my small remaining long until I see clear reason to get out, and then will reestablish lower.  I also know that a giant climax after a gap up like this can easily leave us rangebound in a tight range for most of the rest of the day(6), but I know there’s a very good statistical edge for that range to resolve the upside(7), if not today then tomorrow morning.  I also know that, even though people like to think about measured moves, the probability of having a clean measured move off of a climax bar like this is rather small(8), so I will have to be happy with a smaller upside target.  I make a mental note to only short today if I see clear and sharp downside momentum (which never happened).

-Now we get the reason I originally started writing this blog.  A very common trend-ending pattern occurs when a market makes three symmetrical pushes (on any timeframe).  Depending on how extended the trend is, you may start thinking countertrend, but at least you must be very, very careful about holding with-trend positions through this pattern.  The pattern grows out of the standard ABC wave, which itself is a continuation off of a strong impulse move.  When you see the three pushes, it just means that the normal trend leg has reached its expected target.  This is a good warning to not press with-trend positions.  Schematically, the pattern looks like:

3 Pushes: A common trend-ending pattern

As I was holding my long position, I saw the S&P market make 3 symmetrical pushes to new highs(9), the last of which came at noon, which, as we know, is a common inflection point(10).  I was quick to get flat after the inside bar following the third push resolved to the downside(11).

3 Pushes ended the first trend swing up in the S&P today

3 Pushes to End a Trend is a form of buying climax.  I know that there is a chance that this is an actual end of trend which may be followed by a reversal(12), but I also know that I will have to see real weakness before even thinking short(12a?).  For now, the highest probability play is a substantial pullback to work off the overbought condition, and at least a retest of the highs later in the day(13).  I re-establish my long position at the 20 period EMA which simply provides a reference for a point of relative balance in an overextended market(14).  After a very sharp move, the first pullback to the moving average is always worth a shot. In addition, we see a “ragged bottom” which is a sign of classic Wyckoff-type accumulation(15).  Intuition tells you you would rather buy a clean test of support, but intuition is wrong in this case.  Every little test below support was immediately met by buying pressure.  We rallied a bit off that support, so the first pullback is another good spot to add to your position(16).

So now I’m feeling pretty good about myself, and am positioned fully long (ok… fully long and then some) as the market is pressing against new highs at 2PM.  Considering the structure of the day has been a very sharp up move, a long sideways consolidation with good accumulation, I know there is a very high probability of another leg up in the afternoon, and probably closing on the highs(17).  In addition, I see the market pressing against new highs at 2PM, which we know is the ideal time for a breakout(18).  I use this as justification to be overloaded on my long position (mistake #1).

I realize that the Russell is rallying harder than the S&P, which you can see on the chart below by noticing that the Russell is lifting farther off the EMA than the S&P on rallies(19).  If  there was any doubt about which was stronger, the Russell makes 3 attempts to take out the high of the day while the S&P is holding well under.  This is a form of divergence.  We want to see all indexes taking out the highs at the same time for the highest probability of a good rally.  If we see divergence, it significantly reduces our confidence in the rally(20).  In addition, I can see clearly on my 1 minute chart of the Russell that the Russell just made 3 pushes to new highs (you might call it some variation of a triple top), and failed fairly dramatically.  This is bad, bad, bad for long positions(21), but I decide to hold my larger-than-full-size position a bit, just to give it a little more room.  (This is mistake #2, and you don’t need three to do damage.)

The blue line in the chart below is high of the day for both indexes.  Notice how clear this pattern is, but I ignored what I knew was a very high probability pattern.  This is fighting the market, and it is pretty stupid… and the way to really do it right is to do it on larger-than-full-size!  Ugh.  I took a nasty ding out of what had been a pretty good day up to that point.  The market is pretty efficient in punishing mistakes and stupidity.  Of course, the right thing to do was to have sold at least the extra size at the first sign of weakness, to have gotten very small on the 3rd push failure, and to have at least taken the rest off at breakeven.

3 Pushes and divergence at the highs: Mid-day breakout attempt DENIED

The day eventually did break to new highs, which is an important reminder that these trend-ending patterns do not mean the trend is going to reverse.  I did not repeat my mistake and ended the day with a decent profit for the size I’m trading, but easily gave half my day away with one stupid mistake — trading against a high probability pattern.

This AM I tweeted that VMW was a long if it was holding above 80.  VMW got on my radar last night when I saw an article on the WSJ site that it was investing in the “cloud”.  For those of you who aren’t aware of the “cloud” it is the buzz word du jour with respect to technology firms.  Even if you aren’t a primary provider of cloud technology services it probably would serve you well to throw out a press release or two about how you are helping customers move there as it will cause a nice bump in your stock price.

Buzz words have always been important with respect to short term movements in stocks.  Back in the 90s “B2B” was all the rage.  Then there was “nanotechnology” and in more recent years “alternative energy” firms were just killing it for awhile.  Once you know the key words that are attracting the momentum players attention you should be on alert for trading setups that might occur in a stock that becomes associated with such buzz.

Back to the VMW trade.  The second tweet about VMW observed that we needed to see some real volume come in to confirm the up move above 80, which would be the precursor for a much larger move in the stock.  The reason why volume is important in this particular example is it would be an indication that some major momentum players were moving into the stock and most likely intended to push it higher in the days ahead.  But the volume never materialized and I was stopped out for a small gain when it broke its intraday uptrend.

Syposis

1. pay special attention to stocks on a day a story is released that contains key “buzz words”
2. indentify important support/resistance levels in the stock for potential entry points
3. only lay into the stock if their is significant volume driving it through key inflection points

I think too many traders focus on “setups” or “trading patterns” when they should be focusing on trying to really understand what is driving market action at any point.  Focusing on oscillators or other indicators usually only serves to exacerbate the problem.  Real mastery of market patterns follows naturally once a trader has an intuitive sense of buying and selling pressure, but intuition only grows out of constantly thinking about market structure and exposure to tens of thousands of pattern variations.  Having said that, today I do want to share a pattern that I have found extremely useful in short-term trading.

This pattern is simply a failure test of support / resistance.  (The examples I am giving all show shorts, but the pattern applies exactly reversed to buys.)  The pattern is probably best applied after multiple trend legs up, but, in general, most breakouts fail (ask yourself, did you know that?) so disciplined application of this pattern has a positive expectation under most conditions.  Perhaps a picture can best illustrate the concept:

From a mechanical standpoint, entering these can be a little bit difficult.  I traded them for about a year on a very large basket of stocks, entering the orders as close to the market close as possible.  This was extremely difficult because a large number of stocks would trigger on some days (due to correlation to the market), but it is possible.  Another alternative, especially in forex and futures, is to do your homework after the market close and then try to enter unch in the electronic overnight market.  This can be done well over 90% of the time, but there will be a certain percentage of the trades that you have to enter at the market on the next regular session open, at a much worse price.  These are often big winners so I don’t think it makes sense to skip on this set of trades.  Intraday, patterns are not as clean, but it is still possible to trade this concept on anything from 1 minute to 120 minute bars.

Trade management is a bit of a potential issue because a certain number of these will give you a chance to short and then the market just explodes higher.  Actually, it happens a lot so you must be prepared and execute your stop with iron discipline.  Giving these ” a little more room” or doubling up when it moves past your stop will guarantee you have a short, but very interesting, trading career.  (It also should go without saying that this is not a great overnight plan for certain kinds of stocks like biotechs, or for anything in front of an earnings announcement or significant report.)  Surprises happen, so you must have a plan that encompasses every eventuality.  You also need a plan for possible re-entry if stopped out, and clear rules for profit taking, but those are beyond the scope of this post.

It is also useful when people show actual trades when discussing patterns.  Here are two trades that I called several days before the entry in my daily market report (www.themacroreport.com).  I was able to alert readers to the possibility of a good trade setup because these markets were overextended and were showing momentum divergence.  Note that I have added a momentum oscillator to these charts to illustrate the divergence, but I do not actually use an oscillator in analysis or trading.  The choice of oscillator is not important, but the concept that the market is making another leg higher on weakening momentum is key.  Here are two example trades on daily charts, in real time.

First, a short in 10 Year Treasury Note Futures:

Short in TY Futures

And another in the S&P 500.  Note that this bar, so far, was the exact high of the year.  This raises a real issue as you consider your exit strategy on this pattern, because most of these should be treated as scalps.  The majority of these patterns will give you a nice profit (1-2 times your risk), and then the market continues higher, but a few of them come at major turning points.  Here was a sell on the close of the high of the year in the S&P 500.  Again, this is not wishful thinking… this was a trade actually done in real time.

Sell signal in the S&P 500 Futures

Speaking of major turning points, consider this sell in Crude Oil futures.  Major turning points in commodities have this pattern more often than not, but there is also a fairly high false positive rate.  (Disclaimer:  this is a hindsight trade not taken in real time as I was not trading this market at the time.)

Sell signal at the high of Crude Oil Futures in July '08.

If you are interested in more information on this pattern, Victor Sperandeo has written about it at considerable length with a number of good examples in his first two books.  Again, if you choose to use this pattern in your trading it is extremely important that you are disciplined and consistent with it.  Start by examining a few hundred examples on charts in your chosen markets and timeframes, then apply it on the smallest size possible for a few months, then scale up.  That is pretty much the plan for learning any trading technique, but risk management and having a gameplan for disaster management is especially important in a potentially risky countertrend pattern like this one.

It is important for all stock traders to be aware of broad market tendencies, since they can have  a dramatic impact on individual stocks.  In fact, most of us who hold a large number of stocks intraday soon discover that you don’t actually have 8 different positions… it’s more like 1 big one, tightly correlated to the S&P.  As goes the market, so will go your basket of stocks more days than not, so it pays to understand the behavior of the broad market as well as you possibly can.

Today, I want to get you started thinking about some times of the trading day that tend to be inflection points.  A few of them are very obviously event-driven, but there are a couple others that don’t have a clear cause.  I would encourage you to use this as a departure point for your own research, with one (serious) caution.  If you are going to do research to try to understand how the market works, you need to look at A LOT of data.  In fact, one of the newer traders probably still remembers the time I couple weeks ago when I bit his head off for his idle speculation that today “kind of reminded” him of a previous trading day.  I was too harsh on him at the time, but my point was that any casual observation or anecdotal connection you draw is likely to do you more harm than good.  The right way to do this is to sit down and go through at least a year of ES days, bar by 5 minute bar, taking notes on each day.  Yes, that is roughly 260 trading days, but the really bad news is that this is only a start!  Really you need to look at several years, and if we’re honest about it, no one really develops market feel without living through at least a complete bull – bear cycle, which takes exposure to over a decade of price data.  You can dramatically shorten the learning curve by focused study, but above all, please avoid casual observations until you’ve really examined a lot of data (or lived through it firsthand.)

There is a high degree of random noise in the market, which makes any kind of analysis more difficult, but there also are some significant patterns that occur with regularity.  I’m not sure how to put this into blog form (and I’ve certainly been guilty of trying to write 1,500+ word blogs which has turned out to be too much for me to handle with regularity), but let me just start today with some high-level thoughts about the times of the trading day.  I will probably expand on some of these ideas in a future post:

3AM (New York time):  Yes, that’s right, 3AM.  One reason we need to use futures and not SPY is that Europe actually trades our futures fairly actively when their markets open.  Most major European markets open around 3AM so the first thing I look at in the morning is the price action around 3AM.  This often sets a key inflection point for the day, as our futures will tend to lock into European market direction and follow them in our overnight session.

I will also look at the rest of the overnight for significant levels, but the key word is significant.  If you have to really look and think about it, it’s not significant.  If you see a level that is hit 6 times and holds with only a 1 tick drop in the futures, that level just might be important later today, no?

8:30 AM – sometimes an inflection point but purely driven by economic numbers.  If no report, then this is probably not a significant time.  There are releases at other times, but they have enough of an impact to make those typical inflection points.  At any rate, this is a minor inflection point.  (Note that pit sessions for US Bond futures open at 8:20AM.  This used to be more of an inflection point, but I don’t see it so much in recent years.)

9:30AM – obvious inflection point and the study of patterns around the opening is a whole book in itself.

10:00AM – same as 8:30.  This has been an inflection point, but primarily because of the number of significant economic reports released around this time.

11:30AM – European markets close.  If our markets have staged a major reversal to the European session (eg. Europe was up overnight, we trade up on the open and then collapse into downtrend), this time of day can be very interesting as European traders scramble to cover a lot of their positions on their close.  This is more of an influence than it was 5 years ago, but do not expect it to be significant if our markets are relatively quiet on the day.  Also, this inflection can be a bit of a climax, temporarily capping the morning drive at exactly the point where naive traders are expecting the start of a major move.

12:00 – 1:30PM – Lunchtime.  This is traditionally a dead time for the markets, and it continues to be true.  Much less followthrough in broad indexes, and you really have to pick your spots.  Depending on the kind of trading day (more on that later), we are on breakout watch near the end of this period.

2:00 – 2:45PM – Ideal breakout time.  If the market has been rangebound, we are looking for a breakout to carry into close.  If that breakout comes much before 2:00, your thought should be “this is early, maybe too early to carry into the close.”  After 2:45, it’s getting a little late, but still possible.  A breakout of a rangebound market that occurs in this timeframe deserves your respect — best to go with it or if you must fade, so so with the utmost care.

3:00 – 3:10 – Countertrend inflection.  This used to be related to the bond pits closing (and maybe it still is), but if we are in a good trend there will often be a pretty dramatic countertrend inflection right around 3:00 PM.  This move will be big enough to shake out weak trend followers, so you need a plan.

3:00 – close.  Simple rule:  Do not fade a last hour trend, especially if confirmed by NYSE ticks and multiple broad indexes.  There is a lot of latitude for different trading styles, but I believe anyone looking to fade a strong last hour trend is making a critical mistake because some of the best market tendencies are for last hour followthrough.  If you have been trading for a while and weren’t aware of that you probably need to re-think your market study process.  At any rate, one of my very few hard and fast trading rules is “do not fade a last hour trend.”

4:00 – 4:15.  This is a very interesting time when indexes are open, futures are open, but the cash market is closed.  Sometimes you can see a real resolution of moves as pressure comes off the market and you get good trends in this time.  Be careful because many ETF products are not as liquid as you might think in this time.

That’s pretty much it… we do not (yet) see the kind of inflection points around the Asian opens that we do around Europe.

I hope this helps some of you begin a process for your own study of these time of day inflections.  They are messy (not nearly as neat as this blog post leads you to believe), but they are very real, recurring influences that you MUST be aware of if you trade stocks or index products.

(If you do nothing else, pull up today’s SPY chart (8/23/10) and look at the turning points on that chart against this list of times of day.  Interesting, huh?)

There is a lot of money to be made in a stock that has been beaten down.  Generally, after a stock has been destroyed for some fundamental reason it will have some type of longer term bounce where traders can gather information from its price action over the course of several weeks.  In the case of RIG it bottomed back on June 9th around 42. There was very heavy volume on both June 8th and 9th leading to what appeared at the time to be a longer term bottom.

During the next seven trading days RIG bounced to the mid 50s.  It then traded down to 45.75 prior to bouncing up to the mid 50s again.  In the world of technical analysis this is called a “higher low”.  This higher low was violated two weeks ago on July 23rd when RIG closed at 45.23.  Things were not looking so good.  But the following Monday after trading below Friday’s low it reversed course and closed above 46 on good volume.  This caught my attention.

It made higher highs for two more days but failed at 47.96 on Wednesday.  I set an alert for 47.90 in anticipation of a possible move through 48.  When the alert was triggered this morning sellers rejected RIG at the 48 level the first time it traded there.  But each time RIG struggled close to 48 the pullbacks became shallower and shallower.  Buyer were gaining confidence.

Once above 48 RIG became a Trade2Hold.  The next major resistance was around 52 but based on RIG’s level of volatility I wasn’t really expecting a move much higher than 50 for today.  I took sales at 49.20 and 49.60 and got flat at 50.80.   I  will look to buy my shares back on a pullback tomorrow to around 49.70.

The market had a broad rally on Tuesday.  When we came into the office on Wednesday we cautioned our traders against chasing moves in stocks that could be a bit overextended when the market opened.  Our thought process was to look for safer long entries based on the prior day’s support levels.  I think you probably know how the rest of this story goes.  Most of our traders stepped in and bought stocks too aggressively prior to Tuesday’s proven support levels (this trader included), and were in a position of weakness when the “good” prices were reached.

Why would a trader step in at prices where the risk/reward is not great?  A large part of it is the psychological need not to miss the eventual expected up move.  The problem with this type of thinking is that it removes one of the most valuable trading edges a professional tends to possess.  The amateur retail investor/trader’s behavior can be gamed fairly well BUT if your behavior as a professional begins to mimic that of amateurs then your edge disappears.

By 10:00AM almost every market leader we were prepared to buy on pullbacks had hit their preferred entry prices but many on our desk were unable to participate because they had hit their daily loss limits or were close enough to their loss limits that they were hesitant to buy stocks that momentarily appeared to be weak.  Each of these stocks had multi-point bounces that would have provided very nice chops.

Most well trained traders have great ideas.  They can identify trades that offer great risk/reward.  Almost always under performance will come down to execution.

Basic Principle: If a stock moves quickly in either direction accompanied by a huge surge in volume then all trades placed in that stock should be made on the side of the initial move.

Examples:

MON (11/9/09)

TIVO (3/4/10) (5/14/10)

V (6/21/10)

GS (4/16/10) (7/15/10)

BP (6/9/10)

I foolishly decided that buying NTRS on a pullback to 48.50 this morning was a great risk/reward trade.  NTRS had broken its recent downtrend yesterday and closed at the high of the day on good relative volume.  In my many years of trading this has proven to be a high percentage play.  BUT during the past three weeks I have noticed that strong finishers, whether they trended up or down for the day, were tending to reverse the following trading day.  On several occasions I have even made a counter-trend Second Day Play to take advantage of this pattern.

Nevertheless while reviewing NTRS’ chart last night the 48.50 level looked so good to me that I decided if it pulled back to that level this morning I would get long.  I even had one of our interns include it as the “Best AM Idea”.  Of course the trade didn’t work.  In fact, it was a great short below that level and trended down all the way to the 47.30s prior to some late day buying.

I’m not going to guess as to what underlying factors are causing so many second day reversals but instead will focus on simply making the “reversal” trade as often as possible.  I have started a spreadsheet to track various attributes of the stocks that are trending very strongly on a particular day so I can closely track other recent trading characteristics of these stocks to develop a more detailed trading edge.

I have included a chart below of POT that is a prime candidate for this reversal trade tomorrow.  It would be preferable if it gapped above today’s high and I could short it on a drop below 91 and look for a move down to89.  My only slight concern with this trade not possibly working is that POT was accumulated as part of a general buying wave today in all the Ag name such as MOS, MON, and CF.

I will tweet further details of my trading plan in POT in the pre-market and after the open on my twitter account. @spencermagic

I was trading FCX this morning.  I noticed a clear buyer at 60.90 during the Open.  In the late morning the buyer dropped and I got short.  FCX traded down about 30 cents over the next ten minutes.  It then did a bit of a short squeeze up to 61 before trading down to its opening price of 60.20

From my perspective by far the best trading opportunity that occurred in FCX was one hour later when it clawed its way all the way back to 60.90.  What an amazing opportunity to get short and risk only 10 cents with 2+ points of upside.

Here is why I think this was the best opportunity presented in the stock today.

1. The 60.90 level is not at price such as a whole number where HFTs would be focused on pushing the stock above and below the level, in order to take money from the silly day traders who would be focused on such a level for no other reason than it is at the “fig”.
2. The stock has already proven it can have a significant move off of this price based on the earlier 70 cent down move
3. The risk was clearly defined by the earlier squeeze that couldn’t get FCX to trade above 61
4. The entry price was far enough away from the opening low that even if FCX didn’t break down today the risk/reward was better than 1:5 on the trade
5. There was a clearly defined downside target of almost two points based on Friday’s afternoon resistance of 59

US equity markets are completed dominated by HFTs.  I believe in peaceful co-existence and therefore will focus on trades where I know they are least interested.  They are faster than me so I find trades where speed is not determinative.

Ok… so I think I’m finally ready to do this. One of the things I wanted to do with these blog posts from the beginning was to lay out a lot of the foundation work for technical analysis—basically to spend a lot of time thinking about what actually works and why it should work. I had done something a little like this when I started writing my daily advisory letter, but it was much more focused and had a specific goal. In The Macro Report, I was explaining my methodology and thought process so that clients could understand my work. I think this generated a pretty interesting set of articles, but in these blog posts I really wanted to do something with a much larger scope.  (If you’re interested in reading the other posts they are archived here).

Over the past several weeks, I have filled an entire legal pad with notes, building out a complete theoretical framework for technical analysis starting with theory and progressing to psychology and tradable patterns in the market. This is something I have tried to do for over a decade, and I finally think I have something that makes sense, is internally consistent, and explains the price patterns we see. I’m looking forward to sharing much of this work here on this blog, and will also do my best to respond to comments. In addition, there is also a practical, applied component to this series of blog posts. I boiled the theoretical framework down to a small set of actual trading concepts and patterns. For the next month, a group of traders who sit near me are focusing on trading these patterns intraday, and our results, after a few weeks, will say a lot to either support or question the validity of this approach.

One of the things that has always fascinated me about markets and trading is epistemology—what do we know about the way markets move, how do we acquire that knowledge, and how do we know we know it? Too many times people think about trading issues in very sloppy ways. It’s too easy to look at a chart after the fact and say “you could have bought there and could have sold there”. It’s too easy to think about one specific trade that was a big winner when the real question is, what would happen if I do this trade a thousand times? It’s too easy to think about a pattern that looks like a winner but couldn’t possibly be pulled out of the market in real time.  Real market knowledge must be robust and more or less universal in scope.

On the other extreme, there is a large body of very in-depth, very scientific research from the academic community that leads to very little practical application. Traders tend to completely discount academic work, which I think is a mistake. Many of the quantitative strategies being traded successfully had their roots in academic work, and academics have done a fantastic job of framing the questions that traders need to ask. We will also touch on some of the current academic work in these discussions, especially looking at some of the results that challenge our assumptions as traders.

So, let’s start today by thinking about how price is determined. If you ask someone this question they will usually think for a minute and come up with something like “buyers and sellers agree on a price”. This is one of the fundamental concepts of markets and trading, but I think it may be slightly flawed. If buyers and sellers agree that a price is THE price, shouldn’t they be willing to take either side of the trade? If we agree that a share of RIMM is worth 52.23, what difference does it make if I buy or sell? In fact, shouldn’t I be willing to buy, and (in the absence of transaction costs) immediately flip to a short position?

In reality, this is not the way it works. I am buying RIMM because I think it will be worth more than I paid for it at some point in the lifetime of my trade, which could be seconds to years. I would assume the person on the other side of my trade believes the opposite, but even that assumption may be flawed. Many times, we see someone selling a lot of stock at a specific price when he could obviously sell it at least a little higher, and we assume that person is an idiot. Actually, we don’t know. Perhaps that trade is part of a pair trade. If the guy selling RIMM is doing a relative value play and buying AAPL at the same time, he literally doesn’t care if RIMM goes up or down because he is only trading that spread. Maybe I am buying the stock, intending to hold it five minutes, and the guy on the other side of my trade is selling a long position he has held for 2 years. The point is that we just don’t know who is on the other side of our trade or what their motivations are, and, assuming both parties have a simple directional outlook, each trade is actually more representative of disagreement over future value than of a momentary agreement over current value. This is a small, but important distinction.

Next post we will look at what happens when we assemble records of individual trades, first in the form of the tape and then into charts.