Expectations: A Market Time Machine

In H. G. Wells’ novel, The Time Machine, a traveler’s desire to find out what will happen to the human race ultimately leads him on a tremendous expedi- tion into a terrifying and perilous future. Metaphorically, the expectations of market participants also function like a time machine, as they allow partici- pants a glimpse into the market’s future. Foreign exchange traders stress that expectations play one, if not the, leading role in the dynamics of the market. ‘‘It is the expectation of the market which is most important,’’ says one trader regarding exchange rates. ‘‘Everything is expectation,’’ another trader concurs. Also market observers (i.e., financial journalists) underscore the vital role of expectations in the foreign exchange market. ‘‘Markets deal on expectations and the future. If you didn’t have news of expectations and expectations of the market then what would traders deal on?’’ one financial journalist asks. ‘‘When a market goes from being golden to being rotten, like Mexico [i.e., the Mexican peso] goes from one day to another, not because anything fundamental has changed, it’s because all of a sudden expectation went one way or the other,’’ another journalist adds in support of this view.

Similar to travel in a time machine, market expectations change not only the views but also the behavior of participants, both among individuals and on the level of the collective market. Indeed, the foreign exchange market may be the most rapid of all financial markets to translate and integrate expectations of the future into the present market behavior. One trader observes lucidly that, ‘‘Especially the currency markets tend to run ahead. We have seen that over the last few years, especially the currency markets tend to focus very much on the future. We often had discussions with our economist in which he said, ‘All the figures currently would point to such and such trend.’ And then all that was already priced in!’’ Thus, in their present evaluations of currencies and trading decisions, market participants include their expectations of future events and discount the probable effects of yet-to-come developments. Conse- quently, on the aggregate level of the market, collective expectations about future events are integrated into the current level of exchange rates. ‘‘The market is always expecting some events ... and the thing is before this event happens, the market moves in that way ... Everyone said, ‘OK, the dollar is coming up because there are interventions, there is some especially good big figure . . . and the market is expecting that and buying dollars, and of course dollar–mark is going higher’,’’ according to one trader. Thus the foreign exchange market creates an anticipatory reality that turns the expected future into the present in advance. ‘‘The market positions itself beforehand,’’ another trader declares. As expectations about future events are built into the market, a trader’s shrewd observation that, ‘‘If the news has come out, it is old for us: it is the past, it is already built into the prices,’’ is hardly surprising.

Like a time machine, market expectations allow individual participants to turn the wheel of time ahead, and the collective market to preempt the likely future of the market. This journey in time, however, transforms the meaning and impact of market news and information. Effective news is the difference between the market’s expectation and the actual published figure. Pointing to his massive, wooden trading desk, one trader explains that, ‘‘Information that comes out that is expected is not really information. It just confirms something you already know. You know, this table is made of wood. I don’t need to know that [news] comes out that this table is made of wood. Because we know that— fantastic. [However, news that] this table is made out of gold, that’s something different. If people don’t know it, it is going to move [the market]!’’ Expecta- tions thus determine the market’s reactions to news by turning news into a check of already acted-on expectations. ‘‘What makes the market move is the delta between the expectations and the news. It’s not the news itself,’’ one trader explains. Thus, news that merely confirms expectations does not change the already created status quo of the market, independent of how positive ornegative the intrinsic content of the news may be. Only unanticipated news, such as economic indicators deviating from what was expected, will move the market. Accordingly, as one trader observes, ‘‘Some figures are coming. If the figures are good or bad does not make any difference. [However], it makes a big difference if you expect a bad number and a good one comes.’’ Another trader echoes this sentiment, saying, ‘‘The final event gives just the conclusion and tells the people if their expectations were right or their positions were right. The expectations move the market, not the event.’’

According to traders, because expectations are already integrated into the market before the corresponding information confirms them, the arrival of anticipated news may even trigger a paradoxical move—in the opposite direction of what identical news would have triggered normally. ‘‘If the market has positioned itself beforehand, then you could get a totally adverse reaction to a certain event. You might get a positive number for the American economy, nevertheless the market reacts to the contrary because people were already long, and they are just going out of it,’’ one trader observes. Another trader explains this shift with a pertinent market example: ‘‘Five percent inflation is a bad figure, and that would under normal circumstances hurt any bond market. But if the market’s perception was the figure should be 5.5%, although 5% is still a bad figure the market could actually react the other way because what is expected is different from what the actual figure is.’’ Thus, traveling in the time machine of expectations, participants not only catch a glimpse of the foreign exchange market’s future; doing so actually changes the future they finally encounter. 

From the book "The Psychology Of The Foreign Exchange Market" by Thomas Oberlechner

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Happy New Year And Best Wishes For 2014!

Here finally comes the first post of the year 2014. The past year has seen the simutlaneous public launch of the Retailpropshop blog along its FX portfolio. 

Since inception in May 2013, the Retailpropshop FX portfolio have returned a ROI of 40,6% with a daily closing basis drawdown of only 7,6%.

With 262 trades, a win rate of 54%, an average winning trade return of 0,6% and an average losing trade return of 0,4%, the profit factor was equal to 1.58.

I take these 2013 results as some good achievements, though this year trading highlighted some weaknesses in my game that I want to address in this coming 2014. I also had the chance to identify my strengths more clearly and this will help me achieve my goals next year.

I am currently on a two weeks holidays and this time away from the market is a great place to think about my trading. I realize that this vacation time arrived just in time as I was starting to make mistakes without even noticing them and that translated in my portfolio performance in the last few weeks trading. 

I already feel much more energized to attack this new year and my holidays reading gave me some ideas to improve my game. I came across the book "The Playbook" by Mike Bellafiore that resonated inside me and I plan to add this new process to my existing daily routine as I feel the power in its application. Mike is the founder and trainer of the proprietary trading firm SMB Capital and I think his expertise should be listen to, even more by retail traders, so I have setup Evernote along Clarify on my macbook and I am now ready to go.

Regarding the blog, I will keep updating it with articles from my news browsing routine, as I feel it is a great way of keeping oneself immerse in macro developments around the world and therefor keeping in touch with investor sentiment.

I wish every traders a great 2014!

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Why Markets Trend

I really liked this way of thinking about trending markets courtesy of the Michael Platt chapter in Jack Schwager's excellent Hedge Fund Market Wizards.  Platt founded the $25 billion hedge fund BlueCrest thirteen years ago. It is one of the ten largest hedge funds in the world and has become well known for its dedication to risk management.

Here's Platt (emphasis mine):

One of the only things I could say with certainty was that markets trend because I can observe trends in any financial market, in any time era. You could go back 150 years in cotton futures, and there are trends everywhere. The same is true for equities, bonds, short-term rates, everything.

It seems illogical that markets trend. Markets should discount all information and then be static waiting for the next piece of information before changing price level. But that is not what they do. And the reason they trend is because our minds just don't work properly. We make an estimation of the future based on all of the knowledge we have of the past at the current moment...

If the market is going up today, your forecast is going to be that it will continue going up because it is how you feel at the moment that is the most important thing. Today becomes how you felt in the past because you misremember, So everything is about today. If it is going up today, it will go up tomorrow. In this sense, financial markets become self-referential.

Michael nails it here. I see this kind of thing everyday, writ large, in real-life. People (including myself) think about the next day or week in terms of what is happening right now.

Watch an hour of financial television on a green day for the markets, you'll hear confidence in the voices of almost all of the guests. Then watch for an hour on a day in which an economic report misses forecasts or the Fed says the wrong thing, you will pick up on the caution that has crept into everyone's demeanor - even the names and themes of the segments are skewed negatively to "match" the prevailing feeling of the day.

You're only human, you should not expect to be able to overcome this cognitive bias all the time. But I find that just being aware of it - within yourself and among the people around you - might be good enough.

Markets trend because we overemphasize the relevance of what's happening today and act accordingly the next day by repeating the same actions - buying on the way up, selling on the way down. The "reasons" we assign to explain our actions and the embellished narratives we create around them are only there for decoration.

This post originally appeared at The Reformed Broker. Copyright 2013.

Read more: http://www.thereformedbroker.com/2013/10/06/why-markets-trend/#ixzz2hXIch3HS

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Transformational Tools Intro

The late astronomer Carl Sagan was known for his gentle-spirited wit. One of his more amusing statements is as follows:

"If you wish to make an apple pie from scratch, you must first invent the universe."

It's funny because of the juxtaposition.

You begin with a common, comforting mental picture -- who hasn't had apple pie? -- and then sweep out to the impossibly abstract.

When one thinks about making a pie "from scratch," the natural tendency is to envision a kitchen counter with ingredients on it: The apples, the flour, the eggs and milk and sugar, and so on.

Technically, though, Sagan is correct. He has simply expanded the frame to maximum degree. To truly start from "scratch," i.e. nothing, you must manifest the atoms that make up the molecules of the pie ingredients... determine the physical laws that bind the atoms together... age the universe appropriately for billions of years, through all the various phase changes and evolutionary cycles to bring forth apples, sugar, homo sapiens, and so on.

It's a tongue in cheek meta-statement with useful purpose. It reminds you how the narrow view (which we often take for granted) can only exist in the context of the very (very) broad... and also how, for those who can see it, the magnificent secretly envelops the mundane.

So what does this have to do with trading, and more specifically with "Transformational Tools"?

The purpose of this installment, Transformational Tools, is to help "transform" you into a successful trader by offering a suite of mental tools, technologies and perspectives you can use to change and grow.

Let us zoom out a bit. How does one become a successful trader?

What must one "do," in the broadest sense of the word?

This takes us back to Sagan's apple pie. To wit:

If you wish to make a successful trader from scratch, you must first invent a successful trading life.

Ah-ha! See what we did there?

Before you can bake a pie, you must address the external layers of reality surrounding the possibility of baking.

And before you can focus on success in trading efforts, you must expand your consciousness to focus on the life that surrounds those efforts.

You must, in a quite literal sense, invent (and implement) a successful trading life.

Your destiny shall not be thrust upon you; you must boldly go forth and create it, by creating the life that enables it!

An apple pie is baked in an oven, which in turn resides in a kitchen... and not just any kitchen, but a particular and specific one.

Every apple pie ever baked has a single point of origin. No one has ever baked an apple pie in a generic void.

Similarly, a successful trading methodology is executed by a specific trader, in a specific intersection of time and space, in the context of that trader's "kitchen" i.e. his or her life. No one has ever traded purely in the abstract.

This matters because, just as one cannot bake a good pie in a bad kitchen, one cannot trade consistently well in an inconsistent life. And this is all very personal as far as the actual doing is concerned -- as personal as it gets.

So for you to become a successful trader, you have to work in your kitchen. There is no removing "you" from the equation... and this simple observation explains a lot.

So many failed traders were obsessively focused on the ingredients of the pie -- the parameters of the trading methodology deployed -- that they completely failed to address the state of the kitchen they were baking in (i.e. the state of their actual lives).

Many kitchens have problems. If your oven is under-powered and cannot get hot enough... or your cutting board is permanently onion and garlic stained... or you keep switching recipes mid-stream, or lack the self-discipline to follow a recipe all the way through and wait for results... then the ingredients you have literally do not matter.

You will never have the pie you want - until your kitchen problems are dealt with.

"If I could just find the perfect combination of oscillators and moving average crossovers... or the best fundamental screen for picking small cap winners... or the ideal juxtaposition of Elliott waves and Gann Wheels when the moon is in the seventh house..."

Nope. Nuh-uh. Not gonna work. All of that stuff is ingredient focused. Just like the ads you see on Stockcharts.com or in the back of Stocks and Commodities magazine. This system has a 92% win rate! Winning trades in five minutes a day! No kitchen clearance, no success. That which is zealously ingredient focused, is virtually guaranteed to be incomplete. (And much of the time pure bullshit.)

To bake well, even world class ingredients are not enough. You must have a clean kitchen, a powerful oven, and the right tools (mixing bowl, cutting board, knife, whisk etc) for the job.

Trading well, and consistently -- an accomplishment significantly more challenging, sorry pie enthusiasts -- similarly requires a successful trading life. One in which not just the state of the "kitchen" matters, but all the rooms of the house!

Again, most people do NOT take this approach.

Vetting the "state of their lives," if you will - which in turn cascades down into all sorts of things - never occurs to them as vital success / failure input.

The insight is not obvious. It is certainly not talked about much, especially in the trading world. The vast majority of market gurus, book peddlers, system hawkers et al will never address this stuff. It is too fuzzy, or too squishy, or too far afield from tapping into greed and making a quick sale.

But we address it here -- and address it first, in the context of the Field Guide -- because the cultivation of a healthy trading life is so important.

Those who ignore contextual life considerations, even if they succeed at trading for a time, are like young athletes living off junk food and cigarettes. Energy and enthusiasm can cover over sins... for a while. But the bad habits always catch up, and typically sooner rather than later.

You Must Become Extraordinary

Now let us face another unpopular truth. Of those who attempt trading, the majority will fail. There is no shame in this by the way -- the majority of small businesses fail too.

(As we have said before, if you have what it takes to run a small business, you probably have what it takes to be a trader. In addition to comparable success / failure rates, both favor traits such as determination, resourcefulness, work ethic, functional capacity with numbers, and so on.)

But here is the thing:

If failure is the "ordinary," or common, result...

And success is the extraordinary, or uncommon, result...

It follows you must become extraordinary yourself to best ensure success.

According to motivational business author John C. Maxwell, the successful entrepreneur fails an average of 3.8 times before they succeed.

We are generally skeptical of broad stats like that -- there are so many ways to misread or manipulate data -- but conceptually the gist feels right.

The entrepreneur who has shown willingness to fall down and get back up three-plus times, without throwing in the towel, has already demonstrated an exceptional level of determination and resilience relative to the general human population.

And if he has "failed forward" each time -- learning from his mistakes, remembering what not to do -- he (or she) has demonstrated an extraordinary level of adult learning capacity.

So, again: To best ensure the odds of extraordinary results, you must become extraordinary yourself.

But what does that mean? How can we better define "extraordinary" in this context?

Let us propose a definition:

The extraordinary individual embraces outlier standards of human excellence in multiple areas of life.

The ancient Greeks had a wonderful word, "arête," which, roughly translated, represents the qualities of all around excellence. Via Wikipedia:

Arête (/ˈærətiː/; Ancient Greek: ἀρετή), in its basic sense, means excellence of any kind.[1] In its earliest appearance in Greek, this notion of excellence was ultimately bound up with the notion of the fulfillment of purpose or function: the act of living up to one's full potential.

Sometimes translated as "virtue", the word actually means something closer to "being the best you can be", or "reaching your highest human potential".

Yep. It is no accident that top traders -- those with stellar track records spanning decades -- have a very strong arête quotient, not to mention spic-and-span kitchens (well-ordered and well-integrated trading lives).

There is Much You Must Do...

Switching tracks for a moment: To be successful as a trader, you must attain and manage capital. You must have cash flows, and be comfortable handling those cash flows.

To be blunt, it takes money to make money. The reason, say, a Warren Buffett or a Carl Icahn can make $300 million in profit on a single equity position is because they routinely put billions to work in the first place.

Fortunately you don't need billions or anything close to that. Heck, you don't even need thousands when just starting out. (As we will clarify in the next report, "How to Build a Trading Stake," you could start with ten bucks if need be).

But you will need to think about cash flow management, whether your account balance has seven zeroes or one zero in it, and the possible question of how to increase your cash flows, while managing your obligations, via money-making activities that exist alongside trading for a period of time.

And this, in turn, goes back to a successful trading life, and becoming extraordinary by embracing outliers of human excellence.

You cannot be average. You must become extraordinary to succeed. For instance:

The average individual is not disciplined enough to save money; as an extraordinary trader, saving money will be key in building your cash flows for trading.

The average individual is not on top of their finances; as an extraordinary trader, you will need to know your finances inside out, so as to know your resources and constraints.

The average individual is prone to rationalization and susceptible to fantasy; as an extraordinary trader, you will need to cultivate a hard-nosed objectivity, and maintain touch with reality at all times.

The average individual is bad at time and energy (T&E) management; as an extraordinary trader, you will need to become excellent at T&E management, so as to free up personal resources to do all that needs to be done.

Do you see, now, how so much of trading success comes back to a clean kitchen... a powerful enough oven... and the embrace of human excellence in the context of a well-integrated trading life?

All of this stuff is VITAL to true trading success... and we still haven't touched the ingredients yet!

The deep-dive methodology aspects - entry and exits, position sizing, pattern filters, portfolio management - WILL come soon enough, and over time will represent the main body of DM materials.

But first things first... who cares about ingredients if the kitchen ain't right!

For those of you to whom this thinking is new, there are two ways to respond to all this - the mad way and the glad way.

Door #1 (Mad Way): Are you kidding me! I just want to be told where to buy and sell so I can start trading and make some dough! You mean I have to go back and worry about figuring out my whole damn life and psycho analyzing myself and blah blah blah? This SUCKS!!!

Door #2 (Glad Way): Wow! I never thought of it like this... getting my "kitchen" in order, and approaching this whole thing from the perspective of inventing and implementing a successful trading life... this could be the puzzle piece I've been missing, which both 1) helps explain previous failures and 2) brings me a big step closer to success! That is AWESOME!!!

Those who choose Door #1, don't let it hit you...

Remember, hard problems are your friend in highly competitive environments.

When you identify a hard problem, you are closer to smashing the barrier that previously held you back.

And when you confirm your competitors have not solved this problem, you confirm the logic as to why an edge exists, and why that edge can persist.

And finally, when you solve that hard problem yourself - a feat your competition has not achieved -- a sustainable advantage is created, quite possibly a permanent one...

Inventing and implementing a successful trading life (the meta-context of "life" enveloping and sustaining the methodology you execute) is just such a hard problem.

Figuring out how to upgrade your personal arête quotient (embrace outlier standards of human excellence) is another hard problem. (One that takes knowledge and technique and study, not just willpower and determination, to solve.)

And the Transformational Tools - conceptual technologies, ways of framing and thinking - are designed to be your rocket fuel in that regard...

Now that you understand the magnitude of your goal - commensurate with the magnitude of rewards for success! - let's dive right in...

(to be continued...)

Feedback: jack@mercenarytrader.com

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