TRADING: Market Analysis and Education

First off, let me apologize for the delay in making this thread to those who were interested. It has been a hectic few weeks, but now we are ready to roll.

In this first post I would just like to outline the goals and purposes of this thread. It was an idea that Mango and I got while participating in the monstrous 4,000 page Stock Market thread. There is a clear dichotomy between Investing/Stock Picking and Trading. And since we found plenty who were interested in learning purely the art of Trading, we felt it was appropriate to branch out to minimize the clutter.

In this thread I would like to focus on two things, Trading Education and Market Analysis.

Trading Education:

This was the primary purpose of making this thread. To teach those who were interested how to trade. We will cover a series of topics ranging from the philosophical- "Trade vs. Invest", "What exactly is Technical Analysis?" to the technical- Indicators, Patterns, and other tools, to the technique- Money Management, applying the technicals etc. I will do this in the form of updates whenever I have time, eventually everything I know about trading will be out there and archived for whomever is interested.

Market Analysis:

I wanted to use this to supplement the topics we discuss in the educational process. What better way to learn than to examine and apply it to real time market conditions. Also as noble as our intentions may be, more than a few would probably be more interested in market "calls" than education. Although that is not the intentions of this thread, it is probably what the more experienced traders are looking for. I will not hold back on any of the analysis, even if we haven't gotten to the topics in the education. This means a lot of stuff will go over your head in this section at first if you are learning. That's fine because we will eventually cover all the topics. The reason to do it this way is 1. to accommodate the experienced traders 2. so that all the analysis is in real time. Sure I can go back in history and find examples of when our technicals/technique worked, and that is what most trading educational folks would do. But hindsight is always 20/20, there's nothing like applying it in real time, or even ahead of time. Then afterwards when we get to the subject in our educational updates, you can go back and look at how we used it.

So that is the gist of what we hope to accomplish. If you know nothing about trading, then maybe this can peak your interest. If you are already a seasoned veteran, then join the discussion and we welcome your feedback/contribution.

 

[Education]

What is trading?

Seems simple enough. Buy low, sell high.

The first image that comes to mind is a computer room full of rabid screeching monkeys banging furiously on their keyboards. Okay, maybe that's just me. But it isn't so far from reality. Wall St., trading desks at the major firms, on the floor and pits of the exchanges, all a bunch of rapid monkeys flinging poo. There's no talk of "earnings", "under/overvalued", or "future prospects". Just unadulterated, primal emotion.

Okay, maybe that's taking it a little overboard, and oversimplifying things. But the point is, most day-to-day, or even week-to-week, market fluctuations are driven not by the fundamentals of economies/companies, but rather by the people/monkeys behind the keyboard. This is not at all to invalidate fundamentals, just that they apply on a different time frame.

So if it is the People that drive prices in the short/medium term, then it is the fundamentals of People that we should study. After all, people move in herds(mentality), and people are predictable. They call it "Human Nature" because we humans have a pattern of behavior that we unknowingly or knowingly repeat, over and over. This is also why "history repeats itself", in all fields and aspects of life. This couldn't be more true in a field where real money is on the line.

Someone once told me that one of the training that some special forces sent in the Vietnam war had to go through was trading commodities on the floor of the Chicago Mercantile Exchange. The idea was that it was the closest thing to replicating real live combat, where there is a "fear of loss, with decision made in real time under pressure". Now I am not sure if the anecdote was actually true or not, but it makes sense. Under those conditions is when you see Man's true nature.

This is the essence and key to trading, riding the waves and profiting from predictable human behavior. This is not to say we can predict the market's every move. In fact most of the time it is the opposite, when it is just plain noise. But the point is, when factors line up, odds can be in your favor if you can identify the patterns of the market.

So that is where we will begin, identifying the factors and patterns we look at to analyze People, and in turn the Market that they trade.

 

[Education]

Why do we trade?

Trading is much different from investing. It is closer to a game or a professional sport. Like poker, or chess. Except instead of balls, we play with cash. So why do we trade? Well, to win. That's obvious, so why exactly do we trade, what are the advantages?

Since we defined what trading is, we know that to trade we analyze people. The swings in the moods of people are manifested in Price Action. Since price action is in real time, our analysis has to be as well. The advantage of this is that we will know whether we are right or wrong in real time.

In comparison, an investor analyzes the fundamentals of a company, or an economy. While there is nothing wrong with that, know that price action usually leads fundamentals. This is because price action is driven by people, and people speculate. This is why they say the economy usually turns 6 months after the stock market already bottomed/topped. Not that the market is some great crystal ball, just that it is driven by speculation. What we don't hear about is the 5 other times the market tried to turn before, only to fail because the economy did not confirm. We just call those "corrections" or "bear market rallies".

Meanwhile, the bottom line of an investor is still directly tied to price. What this means is that while their actions are determined by fundamentals that are lagging, their results are determined by price action in real time. Those two thing operate on completely different time frames. Which means if you are wrong in your fundamental analysis, by the time it is confirmed, God knows where the price is.

And that is not even considering a bigger issue: the irrationality of People. While fundamentals are rational, people are not. And since it is people who drive price action in the short/medium term, price can be irrational as well. So not only do fundamentals and price operate on separate time frames, due to irrationality, their relationship can get so disjointed that any analysis would be pointless. Sure, in the long run prices inevitably return to sanity, but God knows were it can go before then.

Case in point:

All the "textbook stuff" relate to fundamentals. And all your problems come from evaluating the market solely on that. There is a saying that goes, "The market can remain irrational much longer than an investor can remain solvent."

Another example is Peter Schiff who is famous for correctly predicting the collapse of the financials and the rise of Gold. Now those are two great fundamental calls that he made way before the fact. And that's the problem. What we don't hear about is how much more those financials stocks went up after he was calling for their demise. How much some gold stocks went down after he was screaming "buy buy buy"(-90% on some). They are great calls because he was correct. And if he turned out wrong then anyone who listened would be broke. In fact you can be broke even now if you listened too early or used leverage.

Which gets us to the point of all this. The reason we trade is because by analyzing people and in turn price action, we can determine whether we are right, and more importantly WRONG, in real time. With the ability to determine when we are wrong in real time, we can quantify our risk. Only with quantifiable risk can we incorporate money management techniques, risk/reward ratios etc. And even more importantly, apply leverage.

Now that is something I don't want new traders to even think about yet. But leverage is a key topic that we will discuss down the line. When you don't know how much you are risking, leverage can be suicide. But when risk is quantified, it can be your best friend. But that is for another day.

Next up, how do we trade?

 

[Education]

How to trade?

There is obviously not one answer to that. There are many methods of trading, with each individual applying it differently to suit their personalities/tendencies. With that said, I will lay out my own trading method, and you guys can apply it however you see fit. By the way, when I say "my" trading method, none of it is original. It is all taken from various traders who have experienced success, I just try to put it all together. Here is the general idea, and we will go into detail in later updates.

There are 2 models thats I use: Breakout and Overbought/Oversold.

Overbought/Oversold

In this model I look at a list of technical indicators that work well together. One or two indicators in isolation may not be very useful, but when there is a confluence of several, it sets up a good trade. In general, this trading method is looking to fade extremes, buying oversold and selling overbought, however that does not mean we can't buy/sell pullbacks to get in on the trend. Here are the indicator:

1. Condition

Bollinger bands: measures 2 standard deviations up/down from a moving average. Basically tells us when we are far away from the mean. Above bands is overbought, below bands oversold. Does NOT mean long/short based on this condition alone. To use this effectively, must determine if market is trending or oscillating.

Stochastics: Measures momentum. Above 80 is overbought, below 20
oversold.

Use Bollinger bands and Stochastics in conjunction with eachother. When Stochastics are above 80 and price is above BB then it is overbought. When Stochastics are below 20 and price is below BB then it is oversold.

2. Levels/Price

Pivot: Simply previous highs/lows. Market as memory, because the people who trade it has memory.

Gap: Unfilled gaps act as resistance/support.

Moving average: I use the 50SMA(quarterly), 100SMA(biannual), and 200SMA(yearly).

Fibonacci retracement/extension: The market at times move in waves proportionate to eachother. It will either retrace or extend proportionately to prior legs. The proportions have something to do with the Fibonacci sequence, which has something to do with the mathematics behind our emotions. We will go into detail on this later, as it is a key part to our trading. For now just know that the 38.2% retracement is an aggressive trade, 50% is a standard trade, 61.8% is an optimal trade. For extensions I mainly look at the 100% extension, but 61.8% may also be relevant.

Pivots and moving averages are less useful in isolation. Gaps and Fib levels are important on their own. The effectiveness of all levels are amplified when used in conjunction with condition.

3. Divergence

Intermarket: We look at different markets and asset classes and evaluate their relationship with each other. When the relationship changes, it may signal a turning point in price. We look at Bonds, Gold, Dollar, VIX, Commodities, and equity sectors.

Momentum: We look at divergences in momentum through the Stochastics, MACD, McCellan Oscillator etc. The idea is the pivots in these indicators should follow price. But when they diverge- price makes a higher high, Stochastics makes a lower high etc.- the momentum is waning, signaling a potential turning point.

It is difficult to trade on divergences alone, since rarely will you get a good price(entry) from it. Which is why we use this to confirm some of the other indicators we use.

4. Spectral Analysis

So far all the indicators we look at are derived from Price. In Spectral analysis we look at Time.

Seasonality: The market has historically strong/weak periods. This is useful info at times, but I've never traded on it alone.

Fibonacci Counts: The time unit in a leg can also determine turning points, just like the retracements. For the counts we look at 3, 5, 8, 13, 21 units. With 3 being a very aggressive trade, and 8, 13 being optimal.

Spectral: At times, the market simply moves in identical waves. For example 9 days up, 9 days down, 9 days up, 9 days down. Spotting this will help you picking a turning point.

The Fibonacci counts is by far the most useful tool in our spectral analysis. But it is IMPERATIVE that you use it with other indicators: price/levels and condition. EXAMPLE: Condition is oversold, we are at a Fib retracement price, AND it has been 8 or 13 days/weeks down on the counts.

5. Astrofinance

Okay, this is a bit out there, but can be useful when used with everything else. It isn't a necessity by any means though.

Breakout

This model is based on pattern breakouts. It is basically the opposite of trading overbought and oversold, where we try to fade moves. This is not an accident, as I want different strategies to cover the whole spectrum of market conditions. The patterns to look for:

Channel, pennant, flag, head and shoulder, cup and handle etc.

There are plenty of patterns out there, however the key to this trading style has nothing to do with the patterns themselves. The key is money management. The reason for this is so many traders nowadays use chart patterns that it creates noise and false breakouts all over the place. This means identifying the patterns isn't enough, as your win% may be in the 40s or even 30s. Without proper money management there is no way to make money this way. The only way to make it work is for your winners to run and to successfully manage your losses. With a proper risk:reward ratio, this is a valid strategy even if you are right 3/10 times.

For examples of breakout setups, it is all I used in this previous trading thread. http://bbs.clutchfans.net/showthread.php?t=171850

__________________

So that is a summary of the trading system I use. Up next I will do a current Market analysis, using all the factors in this post. It's okay if you don't get everything yet, since I will go into detail with each individual factor in future updates. In the meanwhile do NOT trade on any one factor, since the key to the system is how to use them all together.