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As markets languish in the summer doldrums, Glenn comes back with a good philosophical question:

The edge in technical analysis is to find an imbalance of buying and selling pressure.. However, most retail traders fail( so I am told )… Most retail traders follow the crowd and or are the crowd…. The crowd causes buying and selling imbalance!! See the disconnect in my mind?

Example: Every retail trader in my community is long oil.. The sentiment is overwhelming and no one is short… However all these traders where long oil for the past couple months and obviously they have all lost since oil has been tanking the whole time… So if the retail community represents a imbalance clearly why is that not an edge like a price pulse in the market? Institutions are not the only people who trade , I would assume retail traders can move the market due to their sheer numbers? Maybe not.

However , the old saying is the market will hurt the greatest number of traders but that doesn’t really make sense to me since that would represent an imbalance of buying or selling. 

This concept has really baffled me since I have learned to trade and your input would be appreciated.

Well, as I said this is almost a philosophical question. Barring deep analysis of exchange-level data over a long period of time, we won’t know the true answer. Even if we had that data, we’d probably find it difficult to untangle the mass of offsetting orders, hedges, agency orders, etc… so I think, with any question about “who is doing what” in the market, we have to accept that we will not and cannot know the true answer–any answer we come up with will only be an assumption.

However, that doesn’t mean our answer is useless. A model is a simplification of reality, and models can be useful tools to shape our thinking about a complex situation. In this case, we can use a model to think about who might be trading and who might be moving markets.

One time-honored model (which, again, does not mean that it’s right!) is the insider/public model (or, to put it less kindly, the smart money/dumb money model). In this model, we assume that there are a handful of very large traders who have some insight into future market direction. Perhaps they are actual insiders (as they might be in futures markets), perhaps they have a deep understanding of value, or perhaps they simply have very deep pockets. These big players may work together, but they also may work in “pools” or otherwise collaborate. For whatever reason, the “smart money” tends to be right and to be right early.

We also assume that there are a large number of ill-informed public traders who, individually, have fairly limited capital and resources.These ill-informed traders will herd together, and have a remarkable tendency to be wrong at important times.

This is the model that drives the Wyckoff method and all modern methods that flow from Wyckoff. (Truthfully, much of modern thinking about markets goes back to Wyckoff.) The short answer to your question is that “everyone in your community”, all together, probably represents a tiny fraction of one big, smart trader. Even if everyone you talk to is passionate about oil (“the worst are full of passionate intensity…”) how much capital do they represent? Some of these guys probably have no positions, or a few hundred dollars in CFDs, or some small amount of option delta (for which they are paying rent they do not fully understand while gamma melts against them.) And, as you notice, they’ve been wrong for months, often magically without incurring losses. How do you think that happens?

Let’s bullet point a few things:

• “Imbalance” can either express itself in the market (big move, insufficient liquidity on one side of the book, etc.) or can be hidden. A lot of work goes into trying to understand what the insiders are doing before it’s obvious through sentiment analysis, CoT reports, or technical tools that try to tease out accumulation/distribution. In my experience, these attempts are mostly futile–I’ve never found an edge there, but, again, this is my personal experience. The imbalance that I wish to target is the imbalance of liquidity that causes a sharp move in the market, but just be aware that my perspective may be short-sighted.
• Be careful of market sayings. “More buyers than sellers” is a stupid mental shortcut, just as is “there must be a buyer for every seller.” Neither one of these statements is true–it’s buying and selling power that move the market. One large trader might easily absorb hundreds of little guys on the other side, so just be careful when you hear people say things like this. It’s not that there are more buyers than sellers, it’s that the buyers want to buy a lot more.
• Be aware that it is basically people “switching sides” that moves market. If someone moves from neutral to bullish, they’ll express that opinion by buying, right? (More or less.) Bearish to bullish? They buy. But what if someone is already fully bullish? All this person can do is become less bullish, selling, and possibly challenging the rally. It is not agreement that moves markets; it is dissension and disagreement. One-sided markets (a figure of speech, if we are being precise) are dangerous.
• One important take away from this model is that markets are manipulated! Always! Don’t cry about it and don’t expect someone to regulate it away to make it safe for you. If you understand the reality of the game, which is that you are playing against large interests who may know things you don’t and certainly have resources you don’t, you can then decide if and how you want to play that game. Never assume that markets are fair.
• However, the market is not “out to get you.” They did not get your stop. (Read this.) Markets do what they do out of the competitive behavior of individuals processing information and events in both rational and emotional contexts–the market simply is what it is. To think otherwise is to abdicate personal responsibility–if you’re going to trade successfully you must reconcile the truth of this bullet and the previous bullet point. The answer to flowing with the market, and to pulling some money out of the market, lies in the resolution of this dissonance.

I didn’t answer your questions directly, but I think the answers are there. For instance, the most traders get hurt when they agree on something and the market does something else. Think through these bullets and tweak your own thinking on market action, and I think some of the answers will fall into place.