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Home Commentary

Essay: Are you smarter than the market?

AlgoFast by AlgoFast
January 9, 2015
in Commentary, Trading Psychology
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Essay: Are you smarter than the market?
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by Justin Bouchard, AlgoFast

The answer is yes.  You are smarter than the market, but don’t let that go to your head.  The market is an inanimate object.  It’s not capable of intelligent thought.  A less arbitrary question might be: “Are you smarter than the wind?”  It’s got ebbs and flows and there are some smart people behind market moves, but there are also a lot of stupid people driving market moves.  The concept that the market is some all-knowing omnipotent god like entity is ridiculous.

As a veteran trader, I see this view as one of the most widespread and annoying misconceptions about our financial system.  It’s a romantic and overly dramatized ideal that economists love to talk about and average investors tend to soak up with a mystical awe.  The thing that you have to know about economists is that they’re not traders.  They don’t have their money where their mouth is.

I don’t mean this in an insulting way, more of a hard truth about the markets, you learn much more about the market when you’re making or losing money.   The market is not a collective conscience, like the crowdsourcing or open source movements dominating Silicon Valley rhetoric where the group, precisely because you don’t know what the other guy is thinking.  It’s more of a huge game of chicken.

The market is controlled by two things: Greed and Fear.

These are not logical emotions, exactly the opposite.  Greed and fear are the most powerful and erratic of emotions.  They say love can make us do crazy things, but greed and fear, especially fear are the most unpredictable emotions any human will go through.   Self-preservation is the most and primal of emotions.  You could say that when a mother protects her children while risking her own well-being that love is the stronger emotion, but in that situation I’d argue that she’s acting out of fear for her children.

It’s fear that triggers adrenaline filled fight or flight response.  We can forget about that example because physical danger doesn’t really apply to trading although it sometimes feels that way.I’ll ask the question again.  Are you smarter than the markets?  IF YOU PLAN ON TRADING FOR A LIVING, YOU MUST BELIEVE THIS ONE CONCEPT!  This is not an optional trait to have for a trader.

The market is wrong.  It’s almost always wrong.

There are an infinite number of variables simultaneously pushing and pulling at prices that a perfectly priced market is just not possible.  You have a better chance of calculating the location of a specific drop of water in the ocean than you do for calculating the perfect price of the S&P.   It’s a ridiculous metaphor, I know, but I can’t emphasize strongly enough that there is no perfect answer to market pricing.  I use the ocean metaphor because it gets you thinking about currents and direction.  You can catch a wave for a short ride, or you can catch a trade wind and ride it across the ocean.  You can be both right and wrong on a trade depending on when you get out, and when you get out is largely dependent on your ability to control your emotions.  Think about this: at any given point in time, the market can be overpriced in the short term and underpriced in the long term or vice versa.

Now that we’ve established that you’re smarter than the market, does that mean you have what it takes to make it in the pits?  Well…most people don’t.  If you have any chance of being a successful trader, your response must be “I’m not most people.”

How can you ever expect to make money if you think the market is never wrong?  Not only is that a defeatist attitude and sure fire recipe for disaster for any trader, but logically it makes no sense.  It assumes that the market is never overbought or oversold.  Any idiot can see that fear often takes over the markets.

The markets are so dominated by fear and greed that you should think about them as just that.  When you think about the markets, try replacing the word markets with the words fear and greed.  You will have a much better understanding of what it takes to be a trader.

The best traders are the ones who think clearly under pressure without letting emotion control their decisions.  Now, instead of managing your emotions, put yourself in a totally different frame of mind.  Prey on the emotions of others.  It’s easier said than done when everyone around you is screaming that the world is coming to an end, but it can be done.  The markets are no place for the faint of heart and that’s why not everyone is cut out for it.  Ultimately a predator doesn’t have any emotion when stalking its prey.

To reach the next level as a trader, take the focus off of yourself and observe your prey in a patient methodical way.  You don’t have to actually see your prey or competition.  You can be trading electronically from anywhere in world and observer their actions by watching bids and offers or the patterns in their price movements.  Just like an online poker player would read the strength or weakness of bet or the time it takes an opponent to even place a bet, you don’t have to see a person’s face to know what emotions they’re going through.

Yesterday, on CNBC, Steve Leasman asked Rick Santelli if he was smarter than the market.  Rick said something about interest rates being too low and Steve couldn’t wrap his head around the idea that the market can be wrong.  Steve had the classic condescending attitude of an economist with no money on the line, while Rick has the background of an unapologetically loud mouthed, opinionated, and sometimes overconfident trader from pits of the CBOT.  Rick was put on the spot on live tv and was taken aback by the question.  I can only imagine how I’d answer the question if put on the spot.  I’ve got the benefit of hindsight and time to formulate my thoughts, but Rick did a good job.  He flew off the handle like he usually does, and rightfully so.  It was that exchange that prompted this response, so I should thank Rick and Steve for helping to focus my thoughts on the subject.

Today, right now as I write this it’s January 8, 2015 at 12:02PM and the S&P is up 34.25 points.  Yesterday it was up 27 points.  I’ve probably never been as right about the market as I am now, or as I was on Tuesday afternoon.  To put things in perspective, I put on the biggest position I’ve ever had on in my entire career on Tuesday as everyone ran around with their hair on fire.  The market was selling off at a break neck pace.  Oil was leading the way down, and every single market was falling with it.  It was the worst start for the stock market in any fiscal year in something like 85 years, or ever, I don’t care.  Oil had pushed through to a new low of about $47 and “experts” were saying that was an indication of a global slowdown.  It was complete panic.

The claim that oil selling off indicates a global slowdown bears some weight.  In 2008, oil was doing the exact same thing.  For me, it was de-ja-vu.  Oil had sold off from $140 to about $40 in a period of about 6 months, and what came next was the great recession with Lehman Brothers and Bear Stearns going down.  Media used terms like “the financial crisis,” “the real estate crisis,” “the credit crisis.”  It was bad.  When oil first started selling off in 2008 everyone was happy and economists said the falling oil prices were like a big tax break for American consumers.  When oil had fallen far enough, people started to panic and stocks started selling off hard.  There was an unbelievably high correlation between oil and stocks, which just doesn’t make sense, but it was there.  It was real.  Every trader was watching oil.

Stock traders, bond traders, grain traders…everyone became an energy trader.  All eyes were on oil, and that was eerily similar to what happened in the first few days of 2015.  By the way, I held on to a small oil position in 2008 and took it for over 100% return.  You’ve got the same opportunity now, but it may take longer than a year.  My guess is about 2 or 3 years.  At some point there’ll be a run to the upside and to think oil won’t hit $100 at any time in the next 10 years is crazy.  Oil is in the trough.  It may go lower, but buy it and hold on.

The difference between 2008 and now is that Lehman and Bear can’t go bankrupt twice.  They’re already gone.  We went through Dodd Frank and a million other overbearing regulations to make sure 2008 doesn’t happen again soon.  While oil companies will have to lay off people if oil prices stay this low, we’re talking about a few thousand people at most.  Energy comprises less than 2% of US GDP, so for the S&P to drop 5% in 3 days just doesn’t add up.  In 2008 we had months were we lost 500,000 jobs.

That is obviously not happening now although the Unemployment Situation comes out tomorrow, knock on wood.  When that number rolls around at 7:30AM, do you think any stock traders will care if oil is at $45 or $50. No way.  By tomorrow morning, there will be ZERO correlation between oil and stocks.  All eyes will be on the number.  That’s why you can be confident that oil has reach its lows or at least a trough when the stock market tracks it so closely.   It makes no sense and you know that fear has completely taken over.  Energy is more volatile than the larger stock market.  It’s a fundamental truth that will always hold true in the long run.

The other difference from 2008 is that we’ve had major technological improvements in the way we extract oil from the ground in the form of hydraulic fracking and horizontal fracking.  It’s been an economic boon for states like North Dakota with new towns popping up out of nowhere just to support all the new jobs.   It’s been the biggest technological improvement in energy extraction since we started drilling for oil.  This didn’t happen until well after the 2008 collapse.  Lower oil prices were inevitable with the massive new supply that came to the market.

There was another excuse for the start of year stock selloff that had nothing to do with oil, the pending Greek election.  The theory is that a new regime would potentially default on their debt and get kicked out of the EU on purpose.  Greece has been a major thorn in the Europe’s side for a long time.  For any politician in Greece, it’s easy to talk tough about negotiations over their bailout debt.  The voting pool has been described as notoriously cheap when it comes to paying taxes, lazy when it comes to hourly work week, and overly eager to retire early.  They have unsustainable cultural habits.  This is nothing new.  Remember the “Flash Crash”?  It was triggered by rioting in Greece for lower austerity measures, and that was 5 years ago the May.

Greece is far too insignificant to bring down the European Union.  Greece should be considered a stick in the bundle and not the weak link in a chain.  More importantly, we need to show more faith in European leadership.  Draghi knows what he’s doing.  Angela Merkel is a rock-star.  The Euro currency is not going anywhere, and if any country brings it down, it’s not going to be Greece.

So those are the two fears that were reportedly pushing the market.  They were logical arguments supported by charts of oil and the EUR/USD.  What was the real reason for the selloff?  Two Words…

Amateur Hour

The craziest days that I’ve ever traded are all times when most traders, or the best traders anyway, aren’t trading.  Christmas night, Thanks Giving night, and “No Number Fridays” are the craziest times to trade.  Why?  Because the market just drifts in the strangest ways and you can’t read the emotion causing the move.  It has no rhyme or reason.  There is a lack of liquidity, so the mildest of summer breeze can send the market moving like a hurricane.  Economic numbers bring in the big players to pay attention, and if there is no economic number on a Friday, guess who’s out golfing or out on the yacht.  It’s not the scrubs.

Jon “DrJ” Nagarian said it best, “Every day has an amateur hour at the open.  The first week of the year is like amateur week.”  First of all, the good traders are gone.  Second, it’s a big milestone that causes people to stop and rethink their strategy.  They get out of the way because they’re not sure what to do and the market just drifts.  All the conviction of a week ago is gone and there is a shocking lack of liquidity in the market.

The next reason is that prices don’t move in a straight line.  2014 was a great year for stocks and if there was ever a time for a turnaround, it’s when no one is watching.  This isn’t much of a reason.  Just because it went up doesn’t mean it has to come down.  That’s probably the worst reason you’ll ever hear.   I don’t place much faith in technical trading, but as a trader, you have to be aware of a lack of liquidity and plan ahead to know when those times might be.

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