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I’m a big believer in efficiency, in finding that balance that allows us to get the best possible results in the least time. To that end, I thought I would write a post that basically lays out my philosophy and understanding of markets. This will let you, the reader, see if my approach resonates with you; it is entirely possible that you may work from a different philosophical background or perspective and you might find my work less relevant. I think many of the misconceptions the public has about markets come first from faulty information, and then from trying to assimilate correct information out of context. This post, then, should be taken as context for everything else I will write.

After many years of trading across a wide range of instruments, styles and timeframes, supported by deep quantitative research on both technical and fundamental factors, I have arrived at a set of core beliefs about markets. As my understanding is ever-evolving and I don’t have any kind of monopoly on absolute truth, I reserve the right to modify these in the future. But, today, these things I believe:

  • Markets are very close to efficient, in the academic sense.
    • From a practical perspective, this means that all available information is usually very quickly assimilated into the price of any asset.
    • Therefore, there is little value in doing the type of “armchair economist” analysis that many retail traders rely on. You are exceedingly unlikely to understand the forces at work in any market in any way that will give you a significant edge.
  • Markets evolve.
    • Many classical formulations of market efficiency postulate “steady state” efficiency: markets are efficient, and they always have been.
    • I believe a more accurate reflection of reality is to be found in the work of thinkers like Andrew Lo, who are proposing frameworks that allow markets to evolve with technology and the advances of market participants.
    • One need only think of the large groups of traders who have been able to profit at one time, but whose edge seems to have eroded with time to realize that this may apply very well to real markets.
  • The movement of market prices is usually well-described by random walks.
    • In plain English, this means that 99%+ (not an exaggeration) of what you see in price movements or patterns is random and meaningless.
    • If you are focusing on chart review and study without this understanding, your are likely wasting your time because…
    • There are no profits possible in random markets. A lot of my writing, work and teaching is aimed at helping to build intuition around that vital concept.
    • It is necessary to identify the fleeting moments (dependent on timeframe) where markets are somewhat less than random. If this cannot be done, then there is no hope of achieving significant and consistent trading profits.
  • Buying and selling pressure moves markets. Only that, and nothing more.
    • People (individually or aggregated in institutions) make decisions based on three factors:
      • Rational analysis of the payoff associated with various scenarios. (This is where traditional Efficient Markets Hypothesis stops.)
      • Emotional decisions driven by pain, hope, fear and greed. (The basis for Behavioral Finance)
      • Constraints, which are another expression of the first two. For instance, a fund may be forced to sell due to redemptions.
    • Buying and selling pressure from large market interests leave patterns in prices.
  • There are patterns in prices.
    • They are relatively rare, and offer small edges at best. Most of these edges do not exceed transactions costs (i.e. are not economically significant.)
    • It is difficult for traders to capture these edges.
    • Most patterns I have found are relatively simple.  Simple mathematical tools work for defining and understanding these patterns.
    • Patterns can have implications for the future path of:
      • Simple, directional biases. (Most retail traders stop here.)
      • Relative value
      • Volatility
  • It is possible to trade profitably based on these patterns
    • Trading need not be complex. High-level trading may appear to be very simple.
    • There are no reliable, naive “chart patterns” that work out of context.
    • Patterns are only meaningful insomuch as they are an expression of an underlying buying / selling imbalance.
    • There are many possible approaches to profitable trading. They may appear to be very different, but they all have these elements in common:
      • A good risk-management scheme. (It may vary between approaches, but it must be there.)
      • Consistency
      • Discipline

 

Within this framework, the core tasks of technical (tactical) trading are relatively simple:

  1. Identify patterns which may offer statistically and economically significant edges. Understand the context in which those patterns appear and identify them in real time.
  2. Take an appropriate position.
  3. Manage the risk generated by the position. This implies managing downside risk, and also taking profits as they become available.