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Learning to Trade - 1: Building Understanding

This series of short posts will describe the process by which I am teaching myself a new form of trading.  The idea is to illustrate a learning process and concepts that I have found important in trading.  Eventually I'll post actual trades and how these become part of the ongoing learning process.  Given the unusual interest in the recent post on what is missing in much of the trading education world, my hope is that this blog can provide a realistic, hype-free alternative.

OK, so step one in my learning process is building my understanding of markets.  At this point, I am not trading or even observing trading.  I want to understand what I'm dealing with before I enter the performance arena.  An example would be a mechanic studying engines before practicing on model engines and apprenticing with an experienced person.  Another example would be studying basic sciences, such as anatomy, physiology, and pathology, before shadowing a practicing physician and helping with patient care.

Understanding precedes doing .  And, typically, understanding takes a while to internalize.

The building blocks of my understanding are threefold:  price, volume, and time. This post, the most popular in the 13 years of writing TraderFeed, describes how understanding lies at the intersection of these three variables.  We want to see who is in the market, what they are doing, and where they are doing it.  The edge that I am seeking comes from a simple reality that I observe across traders and trading firms:  In seeking meaningful gains, most participants are leveraged.  This prevents them from taking normal heat (normal adverse movement) in their trades.  If a market or stock does not go their way, they need to quickly exit.  This creates a situation in which buyers and sellers who come late to moves are potentially trapped in their positions and eventually need to bail out.  The trader who can recognize signs of exhaustion in moves and able to assess the volume that is potentially trapped can take advantage of these reversals.

This ultimate sentence is essential.

The form that these periods of market movement, exhaustion, and trapping/retracement take is one of cycles.  At the next level of abstraction, our ideas of price, volume, and time lead to ideas of trending and cyclical movements in assets.  It is the persistent need of traders to make money and not lose money that creates the mixture of trends and cycles that we see in each market.  It is the fact that different market participants operate on different time frames--some as investors, some as market makers, some as traders--that creates trends and cycles on different time frames.  Very, very often, what is a trend on a shorter time frame is a directional part of a cycle on a larger time frame. The presence of short, medium, and longer time-frame participants ensures that trends and cycles will be nested in one another, so that understanding the context of any particular market movement is essential to trading.

OK, so far?  Note that I've said nothing about setups, chart patterns, technical indicators, etc.  It is not clear to me that those possess explanatory power.  If something is not explanatory, it cannot fuel our understanding.  We want to understand what we're trading.

Note also that I've made no reference to fundamental variables, such as earnings, economic strength/weakness, monetary policy, etc.  These are very relevant to longer-horizon investing, but only very weakly connected to the shorter time frames of the trader.  Over an average holding time of minutes to hours, the fundamentals simply don't change in a meaningful way.  They may become relevant as catalysts during Fed announcements, data releases, earnings reports, etc.  Even there, however, what is crucial is who is acting on the information, how they're acting, and the prices at which they are transacting. We're interested in supply and demand and their shifts in real time.

Reading is essential to building your understanding.  The two frameworks that I have found most helpful are:  1) Market Profile and 2) Market Delta.  Market Profile helps us understand where price/volume relationships, so that we can see levels from which many participants are long or short.  With profile displays, we can see where markets establish value and where we depart from value.  More on that later.  My favorite source of information regarding Market Profile is Jim Dalton.  His books Markets in Profile and Mind Over Markets are essential reading for understanding market behavior as an auction process that regulates supply and demand.  Jim also has a website and offers courses and webinars related to Market Profile.  When I taught an internship program in Chicago, Market Profile was the framework we started with and the Mind Over  Markets book was the core reading.

The second framework for understanding is the distribution of volume at market bid versus offer prices.  This measure was pioneered byMarket Delta.  The idea is to assess each transaction in an instrument and its location at that moment's bid price or offer price.  As a result, over time, you're seeing how much volume is going through the market and whether that volume is more aggressive on the buying side (lifting offers) or selling side (hitting bids).  The original Market Delta website and product are no longer available, but similar functionality can be found via charting platforms that divide volume at bid vs. offer.  I currently use Sierra Chart for this functionality.  Conceptually related to bid/offer volume are measures of upticks versus downticks across the entire stock market or sectors of the market.  For example, the NYSE TICK measure captures the balance of all stocks trading on upticks versus those trading on downticks at each moment of the trading day.  Both the bid/offer volume and TICK measures tell us in real time if buying or selling pressure is high/low/average and whether they are expanding or drying up.

The integration of Market Profile and the volume/TICK measures helps us track cycles and trends over their lifetimes, identifying opportunities to benefit from real-time shifts in buying and selling.  In our next post, we'll explore how to achieve this integration and internalize truly meaningful patterns in markets.

Further Reading:

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