TraderNovice.com
Have you ever gone long at the day's high, or short at the low and wondered what happened? Unfortunately, that is part of the price you often pay to get a trading education. Learning to trade can sometimes be a nauseating process.
When I first started trading I always seemed to go the wrong direction with my trades. It would move higher and uncertain, I would simply watch, then watch more, until finally it would break above a resistance level. Up until the time that the market broke through that level, I would be afraid to trade. I would be so uncertain of the market's intent, that I would simply watch, thinking that I needed more information before risking my money. It was only after the market broke through the prior day's high, or some other level of previous resistance that I would feel confident enough to place my money on the line. I would react to the market. Unfortunately, it seemed as if every time I made a trade like this, the market would reverse at precisely that moment, leaving me long at the high for the day or short at the low. Try as I might, I could not understand why this happened. I read books, listened to other traders, went online to trading rooms”, but it was only when I learned about Market Profile and met Jim Dalton that I really began to understand what was happening with my trades. (see Jim's books in our book reviews).
Mind over Markets is Jim Dalton's first book on the market profile approach to trading. It is an excellent primer on the subject and I highly recommend it. An easy read, the book introduces traders to Steidlmayer's theories on use of market profile for market assessment, and early in the book Jim uses the analogy of a cattle auction as an analogy with the trading auction. Reading this simple description, and then listening to Jim on multiple occasions, helped me enormously in understanding why I made those mistakes in my trading.
Consider if you will an auction of any sort. Picture the auctioneer surrounded by a circle of bidders interested in the item up for sale. The bids start at a given number with an initial bidder offering $100, and soon others are bidding the price slowly higher 104...106.....108....112. The price continues to rise because as several of the bidders assess the situation, they view the object in question as more valuable than the spot price (price at any given moment). Because of this, there is always someone who is willing to bid higher and the price rises. This continues........until a point. At some point the last bid has reached the consensus fair market value How do we know what that fair market value is? We know it only because at that point the auction ends. There is no else willing to bid the price higher. Each of those left to consider such a higher bid, views that price as too much to pay. The item sells.
Now instead of that scenario, consider another option. We still have an auction, but it is a rather unusual one. In this auction the seller states his offer price and if there is a buyer at that price, then the object is his. That buyer is then free to continue the auction process, so he states his ( hopefully higher) selling price, and looks for other buyers. The bidders are free to offer, and to withdraw, their bids at any instant. In addition, instead of one seller we have many, each competing with the other but with identical products. In this example we will again consider a cattle auction, but assume no variation in cattle quality. The auction process starts and an initial bidder commits to buy at the $100 offer. That lot is now his. This time others bid higher for the remaining cattle being auctioned, and our $100 buyer then resells his cattle too, for a small profit. The price still rises to 106,108 and on. Let's further assume that the buyer for a major meat distributor is known to arrive late to these auctions. He has not yet shown his face. The price of the cattle in question rises, at least partially, because those bidders are thinking they can then resell their purchased cattle to the late arriving major distributor, at a profit. But then lets say that the distributor arrives, and it is clear that he views the current bid as too high and makes no bid. Each of those in the room recognizes the issue and that immediately affects their view of “fair market value”. In that instant, every bidder then withdraws his bids at the current ($108) level, and some of those resubmit bids much lower ($98), assuming that this will allow for some profit on resale, were they to purchase at this price. The buyers who earlier bought at 108 are then left with cattle for which they paid more than the current fair market value. These holders see the bids falling and are left with a choice. They can hold on, in hopes of the price rising again later, or can sell at a lower price right now to mitigate any further loss. Many choose to sell, pushing the price lower still. The price falls to 98, and those buyers who earlier thought this was a fair price, are now finding that the distributor still is not bidding, nor are others. The price falls further.
The market, through this process, is attempting to find the real value of the product in question. The instantaneous value is known. It is the current bid. But instantaneous values may not reflect the actual true value for a given day. Perhaps bidders are late arriving. Perhaps bidders are waiting for news on cattle market saturation or meat consumption, which will be released later in the day. The market does not wait for this information, it continues to trade...searching for buyers and sellers, trading higher and lower, in an effort to find stability. In this scenario the market will trade lower looking for buyers, until the buyers equal the sellers and then the price will hold. If the number of buyers subsequently begins to outnumber sellers, the price will again rise. This back and forth, up and down movement of the market is the trading auction process.
Let us compare this to my description of how I used to always be the buyer at the high price, or the seller at the low price.
I trade bonds quite often and that was usually the product in question. Lets assume I was trading the thirty year bond, and further that the day prior it had traded in a range from 129 22 to 130 09 closing at 129 28. The market opens on this day at 129 28 and trades higher. I watch, not knowing what trade to make. The market continues slowly rising to 130 and up, and then a fed governor releases his speech. At first there is no impact, but soon the bond price rises a little more quickly to 130 04, then 130 07, then quicker still to 130 10 and with a rush trades 130 12,14, and finally 13016.
Now I am convinced. I have no idea what the fed governor said, nor do I care. I see the price rising, and rising quickly and so I am done watching. The bond price has surpassed yesterday's high and so now I am convinced it is going to rise further. I get in the market. I BUY.
The market pauses ever so slightly …..and …....then......begins …....to fall.
I am perplexed. I do not understand. What happened?
In this example the explanation may be quite simple. Suppose the bond market had been in a downtrend from 140 to its current level of 129 28. Many traders were short the long bond expecting the trend to continue lower. The day prior the market had traded in balance, with a narrow range, because it was balancing after a sharp fall, and traders were unsure of where it would go next. On the morning in question the market trades only slightly higher and then when the fed governor releases his speech it moves little at first as traders digest the information and what it means for their position. New traders see little in the speech to guide them so they do not initiate new trades. The current shorts, however, note that there is a slight change in wording from a previous speech. The governor said he expects rates to increase in the future, as opposed to near future. Little by little those who are short recognize this change, interpret it as meaning that rates will rise less quickly than they had expected, and then several of those traders becomes less comfortable with their short position. One of those shorts commits to getting out of the market and he buys. The price goes up slightly. The small price rise pushes another short to buy, and another......the price rises more and more quickly. Finally all the shorts who were equivocating on closing their position,see the market rising quickly and they immediately buy at the market, rapidly pushing prices well through yesterday's high. I see this and I think the fed governor must have said something bullish for bond prices, so I too buy. But in reality the federal reserve governor had not said much at all, certainly nothing bullish. It was only the shorts in the market , already well profitable, who had gotten scared and decided to buy back their shares. (You can see more on this in Tradernovice Short Covering section). They, as it turns out, were the only ones who wanted to buy and do so quickly, ......then, after the short rush up in price, the market trades back lower. It may simply trade back to yesterday's balancing level, or it may resume the bearish trend even lower. I am left as a buyer at the high of the day.
Why would the shorts buy back?
The assumption would be that those left short at the time of the fed governor's speech, would have already made money, likely a lot of money after a sharp fall. They had assumed his speech would confirm their thoughts that the market should go lower. But when the market did not go lower immediately after the speech was released, each short assessed his position and some found it to be too risky, so they bought back their short positions. Once that happened, and the market began to rise, other shorts fell in line. Each of these was buying at the market, knowing that a market order would get them out quickly, with little effect on their profit. In the end there was a small frenzy to get filled as more and more shorts piled on.
I saw the buying. That was all I saw. I did not see the big picture. I never thought about shorts. I didn't read the speech release. I did not look at the trend coming into the day. I saw buying in a frenzy above yesterday's high and thought it represented new buyers. It did not. It represented old sellers getting out. Once they were out, there were no more buyers, no more bids. The only thing left was the new sellers who..... after a pause in the buying......saw an opportunity to sell above market value, and took it. The market fell and it continued to fall because once all the shorts were out it had to drop significantly to find a pool of new buyers that would balance out the selling.
The initial rise of the bond market to 130 16, then quick fall thereafter, is simply the auction process in which the market continually looks for buyers and sellers. Even though at any moment we know the spot price, and bid, and can assume fair market value at that instant, the market is constantly bombarded with new information. As that information is digested by the market participants, the number of buyers and sellers will increase and decrease throughout the day. As this happens, the bid/ask will go up and down, moving higher as buyers come in and outnumber sellers, and lower as sellers outnumber buyers. The market will follow these imbalances of buyers/sellers as it looks for fair value.
The auction process will carry the market to higher or lower prices, but it won't give us information as to the motive behind the price rise or fall. We must determine that on our own. Had I thought of the possibilities in this bond scenario, I might have realized that the heavy, quick burst of buying might be short sellers buying back contracts, and I might have refrained from buying. Even better, I might have sold.
One of my favorite examples of the trading auction process comes from the book Reminiscenes of a stock operator. In this book Edwin Lefevre is thought to recount the escapades of Jesse livermore, a great early twentieth century trader.
Lefevre details the story of a great trader who is approached by a tipster, and told of heavy buying in a particular equity. Upon hearing this news, the trader puts in a large sell order "at the market". The price holds and the trader again does the same thing selling a large market order.
The tipster, now livid at the great trader's refusal to heed his advice, is surprised to see the trader follow his earlier orders with market "buys", and he listens as his host explains that he had to find out for himself if he thought the tip was accurate or not.
What happened in this story? The trader was watching a market at a given level. He then had news which caused him to question if in fact there were heavy buyers. He is well aware of the market's auction process. He sells a large market order, which would normally cause the market to explore lower prices, but it does not go lower and instead price holds. The trader sells again, once more trying to force prices lower suspecting that his sell order, large as it is, will outnumber buyers and cause the auction process, the market itself, to go lower. But once again he finds that the outcome is stable price. He is convinced now. He knows that there is only one way that prices could stay stable in spite of his heavy selling. There are buyers below the market current price. He buys. Again, this is the auction process.
My explanation above with regard to the short sellers was one scenario, which might leave me as the buyer at the high price of the day. But there is one other important point to consider in this scenario, and that is that not just news but price as well, may bring in more market participants. In the above example once there a was a pause in buying at the highest prices, new sellers came in. It was the new higher price brought on by the shorts buying back their shares, which brought in those new sellers. That caused the price to again fall. But there could have been another outcome. It could be that the 130 level represented a previous significant level of support, and that once this level was breached on the upside, new buyers viewed this as a bullish opportunity for a rebound, and thus entered the market. As one and then another entered, the price would rise, thus causing more new buyers to see the opportunity and enter as well. The market is continually looking for these participants and if they enter long, price will rise. If they fail to enter, or enter short, the price will fall. Every market will constantly search for fair value at any instant. This is the market's trading auction process.