The Finance Book Club

Quite right. As long as you've already accounted for trading costs, and the ratios don't fluctuate too much during the lifetime of the account.

Just curious if this is your own take on it or are you correcting something I posted earlier?

I was just trying to relate the two (Win-Rate & RRR) because they were mentioned in the previous post (post #518).

To get a consistent RRR, use a fixed number based on the account percentage to calculate the lot-size of each planned trade. For example, let’s say we want to risk a maximum of 5% on each trade out of a 10000-pip account (= 500pips) and consistently play a 1:3-RRR trade. Then a signal came along, prompting us to plan a trade with risk = 60pips. The lot-size of the planned trade will be 8 lots, so we’ll be consistently risking about 5% on each trade while expecting about 15% gain if winning.

If the system is profitable as described above, don’t worry too much about commission, overnight and rollover fees because the system’s profitability will be able to cover those costs …

That's usually true, unless you're trading very frequently, intraday.

Part 3 - Understand Risk Management
This is the section we just finished going in reverse.

Chapter 10 - Trading the News

1. BD doesn’t say it this way but there’s a reason and a real reason for every move. The reason stocks went up 2010-2012 on bad economic news (and continue to do so for now) is that the markets expected Quantitative Easing to continue. The real reason is T.I.N.A. There is no other place for the huge pool of capital to go. Either way traders who don’t know the backstory will be confused by price going up on bad news.
2. An event is ‘priced in’ if the price already reflects the widespread market acceptance of an event, even before it happens. So if it’s widely speculated that a business is going to release bad news, and then it does, you wouldn’t expect price to go down much and it might even go up because the news wasn’t as bad as feared or just because traders will take profits as there’s not much left to do with the trade.
3. Conversely if something is surprising to the markets, the event is not priced in and price will move wildly to compensate.
4. Buy the rumour, sell the fact
   1. “Buy the rumor/sell the fact is only applicable when an event is highly anticipated, the result comes in as expected, and the market has been moving in the direction of pricing that specific outcome for some time.”

BD uses this as an example chart but notice price was rising before the ‘surprise’ cut so how much of a surprise was it, really?

 

1. Trading algos have taken all the slack out of the system
   1. It’s like trying to compete against a heavily armed cyborg with a slingshot in a darkened gym
   2. By the time news is released the price is already finding equilibrium
   3. Humans are shut out of this contest that is over in milliseconds
   4. Before 2005 you could make your year trading news
   5. Now there is far less money after data releases
   6. Adapt or die

Trade the Extreme Data

1. One solution is to trade extreme data undershoots/overshoots as the algos can only buy so much - they have risk limits
2. The actual data is not as important as what the expectation was for the data (recall Shannon and information theory - the more surprising the info the more value it has)
3. The whisper number is the number traders have in mind as opposed to economists

1. Suppose the number comes in worse than expected. Traders should jump short at #2 knowing that the market has not yet found equilibrium.
2. Not every economic release is suitable to ‘go with’ but this one was a real surprise.
3. The level where a currency was trading before the news was released is the ‘newsPivot’. It’s crucial to see how price behaves around the newsPivot
4. In this case 120.03, 10 pips above the newspivot of 119.92 is a good SL because if price rises above the newsPivot it means the market completely rejects the bearish news
5. BD covers at point 3 as it’s 11AM NY when London liquidity dries up.
6. A miss or beat by more than 2 standard deviations on any major economic release is important. However BD admits that in this case the release was off by much less than 2 sigma and the move was driven ‘more by positioning’. (which can be established how?)

Not necessary, it also works on swing trading.
One of my strategies only had 41% win-rate doing 24 trades from 2017 to 2020. But since it maintained a consistent 1:3-RRR on each of its trades, it could produce a 75% return in 4 years or 18% annually, enough to cover the overall trading costs ...

Yes, I'm talking about strategies where you trade possibly hundreds of times a day. I have actually lost money in real time using a 'winning' strategy because I didn't take into consideration all the effects of commissions, spread variability, and the like. Of course now I have abandoned trying to make money this way - as a retail trader there is only so much efficiency the system will let you squeeze out of it.

Beat the Algos - going the other way after economic data

1. Fade the initial kneejerk move
2. Scary because you’re going against momentum
3. Algos and humans pile in on the initial reading but often the headline is not as strong as thought or the details actually contradict the headline
4. Then you see a rapid turnaround
5. As usual it pays to know which way the market is already leaning
6. Look for asymmetries
7. Listen to reactions from economists and strategies (really?)
8. This is easiest if you work at a bank or hedge fund
9. Watching the newsPivots
10. Good news bad price
    1. “very good news comes out and the currency goes back through the level it was trading before the news,
    2. That's bearish price action”

11. Bad news / good price
    1. Bullish

12. There are many reasons for counterintuitive moves in FX after news
    1. The main ones are:

Reversal for a good reason (headline and details don’t match)

1. BD gives the example of the Australian jobs release of Sept 10, 2014
2. The market was expecting a big fall in AUD for months
3. The market expected 15k new jobs
4. Economists expected -5k to 35k
5. Headline number is 122k jobs!
6. The strongest number in history
7. AUDUSD spikes 60 pips
8. Algos go ‘limit long’ as their calculations show 1% rise
9. Shorts are ‘obliterated’
10. The price bounces wildly trying to find equilibrium
11. A new headline comes in saying the jobs data number is distorted by a new methodology!
12. Now long positions get hammered.

This familiar story looks like this


Reversal for No Reason

1. Market goes the logical way at first
2. Reverses for no macro reason
3. Don’t worry too much about trying to figure out why
4. The fact that’s rallying is all the info you need (so why even waste time watching macro data?)
5. “The media’s job is to tell a story around every market move, and even the best journalists cannot always come up with a coherent narrative. It doesn’t always have to make sense.” (so it doesn’t ever have to make sense. Making sense of things must not be important)
6. The example used is the Canadian CPI release of Sept. 19, 2014. I’ll spare you the details.

Understand Central Banks

1. There is a skill to understanding central banks
2. You need to read the speeches and do the work of interpreting official statements if you want to be a serious FX trader (hmmmmmmm)
3. They are boring but you need to read all of them
4. Don’t be lazy
5. The longer you follow a central bank the more of a feel you get for their bias, tactics and communication strategy

Central Bank Meetings

1. Can have a dramatic impact
2. You need to know all the subtleties and BD cannot emphasize this enough (!)
3. Some traders focus on a particular bank
4. You need an expert-level understanding of what’s going on to have an edge
5. Central bank’s main levers are interest rates, balance sheet management, forward guidance
   1. Target interest rate / overnight rate / cash rate
      1. Influences T-bills, prime lending rates, mortgage rates
      2. Central banks raise rates to fight inflation and cut rates to battle unemployment, weak growth, disinflation/deflation

   2. Balance sheet
      1. Increases via asset purchases called quantitative easing or ‘QE’
      2. Purchases are mostly bonds, domestic stocks or even foreign assets
      3. Central banks can reduce their balance sheets but slowly (can they though?)
      4. QE is still ‘somewhat experimental’ says BD (! in a book published in 2019??)

   3. interest rate cuts and QE should:
      1. Push a country’s currency lower
      2. Drive bond yields lower
      3. Drive its stock market higher
      4. Increase inflation

   4. In practice results have been mixed
      1. Loose monetary policy creates dependence, (like a crack whore needs crack as Norm Macdonald used to say)
      2. Side effects include wealth inequality, stability risk

   5. Forward guidance
      1. By telling the market what it plans to do the bank guides behaviour, in theory
      2. For example the Fed promised to keep rates low trough 2012-2013 and the market moved higher, as participants bought riskier assets with higher yields (and every year since then)
      3. The Fed hoped a higher stock market would create a wealth effect (it did, for the wealthy, and they bought into it too)

   6. What is priced in?
      1. If everyone expects the fed to hike rates and they do, the market will not move much
      2. If no one expects them to hike and they do, it will move a lot

Positioning into a central bank meeting

1. You need to have a view that differs from the market
2. BD then does an expected value calculation

1. He makes educated guesses about the odds of success and another educated guess about the amount the currency could move and he guesses about where the break-even point could be (with so many assumptions it really doesn’t seem like the grid is doing much apart from possibly making his thinking less fuzzy? And covers his ass if the bet doesn’t win. Look, boss I did an EV calculation!)
2. BD offers an example of a EURNOK trade that wins because he guesses the Norges bank will cut rates, based on having read all their speeches over the year.

Trading the outcome of a central bank meeting

1. If don’t see any edge in taking a position beforehand you can make money trading the outcome
2. This similar to trading a data release but central bank meetings are ‘unambiguously important’
3. Never fade unexpected central bank moves - jump on them (don’t fight the fed)
4. Central bank speeches - more of the same
   1. Speeches give humans an advantage over algos as they cannot easily be translated into action
   2. Almost all speeches are announced in advance - do your homework
   3. The audience of the speech matters - for ex. Governors talk down their currency more when addressing exporters
   4. Know the speaker’s bias
   5. The impact is usually smaller than meetings but be alert for a game changer

Other headlines and news

1. Unscheduled bank actions - big impact as they are completely unexpected
   1. Jump on and do not get out unless the price moves back through the newsPivot

2. Correlated news (OPEC/CAD example)
3. Sympathy plays
   1. If one central bank moves the others will follow suit

4. Geopolitical events - wars, etc
   1. Stay informed; don’t rely on other people

5. Natural disasters
   1. Exceedingly rare says BD, (but maybe not in the future)

Steps to becoming an expert in your currency

1. Read everything on the central bank’s website
2. Read all the central bank speeches
3. Chart the market profile manually on graph paper to get a feel for it (!!!)
4. Stay on top of strategist and analyst comments on Reuters, Bloomberg, etc
5. Have a ‘list’ of all major support and resistance levels
6. Make a list of what drives the currency, especially commodities
   1. What is the major narrative for those commodities
   2. What is the supply/demand dynamic

7. Read the press of the country you’re trading
   1. Canada: Globe and Mail, and Financial Post
   2. Australia: AFR
   3. UK: Telegraph and Guardian

8. List the central bankers and outline their recent comments; you should know:
   1. Their interest rate view (dove or hawk)
   2. Currency view
   3. Most recent comments

9. Make a list of strong and weak parts of the economy
   1. Jobs
   2. Manufacturing
   3. Trade Import/export
   4. Housing
   5. Inflation
      1. How it relates to official target
      2. What is central bank’s target
      3. Are they targeting core or headline

10. Understand what is priced in to interest rate markets
11. Trading news can be a huge edge

But it is also clearly a lot of work for something that you could straddle.

Chapter 9 - Understand Behavioral Finance

1. Looks at the psychology of people involved in the markets
2. The academic view of market used to be that they were populated by purely rational actors
3. That’s bonkers of course

Positioning and sentiment
“‘You can’t escape the madness of crowds by dogmatically rejecting them . . . The most contrarian thing of all is not to oppose the crowd but to think for yourself.’’ – Peter Thiel, Zero to One

1. Tends to be overrated in FX
2. It does not pay to be a reflexive contrarian all the time (as I’ve learned the hard way)
3. Sentiment: how people view the market
4. Positioning: how people are actually trading
5. You can have a market that is very bearish but not heavily positioned which is very different from one that is bearish and heavily short
6. A market that is bearish but not yet positioned is primed to go short
7. A market that is already heavily short is ripe for a short squeeze
8. Why would a market have extreme sentiment but not extreme positioning?
   1. The theme is new; sentiment moves faster than positioning
   2. Sentiment leads positioning (does it though?)
   3. Major upcoming event risk
      1. For example if NFP is coming up nobody wants to get very short before the data release because of gap risk or even risk if the number sucks
      2. The moment the number is out the market will move big
      3. This explains why you get some moves contrary to the data - the actual number was less important to traders than simply getting the event risk out of the way so they could trade the way they were going to trade anyway

   4. Time of year
      1. Risk appetite varies depending on time of year and success so far

   5. Positioning clear-outs
      1. Crowded positions will get rinsed by counter-moves from time to time

   6. When positioning and sentiment don’t match there is opportunity

Positioning

1. Proprietary indicators - COT
   1. Shows only about 10% of the market but still a good snapshot
   2. Over-represents carry, trend-following and momentum traders
   3. Positions and price tend to trend together
   4. Positioning often leads price at turning points (not my experience)
   5. Positioning can trend for a long time
   6. Absolute levels mean less than rate of change (interesting)
   7. Trends can last months or years so extreme positioning can persist and is not a contrarian indicator necessarily
   8. “Most research shows that it is generally more profitable to go with COT positioning, not go against it.” (go with which group?)

2. Twitter
   1. Watching how people respond can give you the same data
   2. If people are confused or angry about a move you can be assured they are on the wrong side

3. “Similarly, if you are at a hedge fund and you get 11 different ‘‘BUY USDCAD!’’ recommendations in your inbox; you should probably hit a bid.” (sell)

“You will rarely see, for example, a situation with falling prices and
bullish sentiment because sentiment almost always follows price.” (Right, so how can BD say that sentiment leads positioning? Have I been confused by semantics?)

“Another way to pick a top or bottom in price is to identify situations where sentiment readings are extreme and then wait for a reversal formation such as a shooting star or bear hammer. This is a great way to trade sentiment because you remain very patient, recognizing that high sentiment readings are a standard part of a bull market; then when you see a bearish technical setup, you pounce.”

Look for:

1. Extreme positioning AND
2. Turning fundamentals AND
3. Technical Reversal
4. Then you have a five-star setup

Cognitive Bias

1. Confirmation
   1. Most important to understand
   2. We internalize evidence that confirms our beliefs and ignore the rest
   3. If you are bullish you will ignore bearish signs
   4. The antidote is to get flat. Flat is a position. (right, so why work so hard to develop a bias through fundamental mining?)

   
   

2. Overconfidence
   1. 90% of drivers think they’re above average

   
   

3. Extrapolation
   1. People think whatever is happening now will continue to happen (this is 90% of forecasting)
   2. Read many, respect few
   3. The inverse of this is the Gambler’s Fallacy
      1. The belief that the next bet will win if a sequence of prior bets were losers
      2. Extrapolation is more common in FX says BD but I’m not so sure

      
      

   
   

4. Asymmetric loss aversion
   1. We feel more pain from losses than joy from wins
   2. This can lead to burnout
   3. Traders find it hard to exit losing positions
   4. “Most successful traders take many, many small losses and achieve fewer but larger gains.”

   
   

5. Greed and fear
   1. When markets are in the grip of fear or greed they become more volatile
   2. Use smaller positions

   
   

6. Anchoring
   1. People tend to anchor estimates or expectations around suggested or recent figures
   2. Kahneman and Tversky found that re-arranging a sequence of numbers whose product needs to be estimated, so that small numbers are at the start of the sequence would persuade subjects to guess smaller. When the sequence was arranged with the larger numbers at the start, they guessed larger.
   3. The common example I know is when auctions start the bidding at a high figure - the bids tend to be higher from that point than if they use a lower figure.

   
   

7. Round number
   1. BD admits this is less important
   2. Humans prefer round numbers over non-round numbers
   3. I have seen no evidence for this bias in the market but BD provides a bunch of studies about it. I may have to check my confirmation bias!

   
   

8. Favorite/longshot
   1. Humans tend to overweight small probabilities
   2. They overvalue long shots and undervalue favorites
   3. The larger payout for the long shot makes it look good even though it’s unlikely
   4. This is basically what allows lotteries to exist
   5. Don’t feel the need to go for home runs
   6. But if you do go for one, evaluate the payoff correctly

   
   

9. Herding
   1. It feels safer to be part of the crowd
   2. At least as far as trading goes the crowd is usually wrong
   3. If we see some ‘expert’ with an opinion we’re more likely to follow them then to think for ourselves
   4. On the sell side, some experts may prefer to give ‘safer’ estimates even if they know they’re not what they truly think, because it’s not career-ending to be wildly wrong when everyone else is, but the reverse is not true

   
   

Anecdotal evidence

1. Stories are not evidence
2. Ironically BD demonstrates this with anecdotes
3. BD and his colleague found that the economist cover story was a reverse indicator 68% of the time

Skyscraper Indicator

1. “Countries build world-record-setting skyscrapers only during bull markets when credit is plentiful, and thus historically there have been many instances where the country building the world’s tallest skyscraper subsequently fell upon hard times.”

Cheer Hedge

1. Irrational exuberance is a likely indicator of extreme top or bottom
2. BD notices whenever his colleagues yelled in jubilation about a trade that was usually the top
3. The reason is these only happen at emotional extremes; if someone is feeling this others are also feeling this
4. If you feel yourself wanting to cheer or sing - you are probably due for a reversion

The WTF indicator

1. If people are confused about a move then it has further to run

IPO Indicator

1. Companies want to be sold at the top of their game and it often shows the top of an industry or market cycle
2. IPOs are plentiful in the latter stages of a bull market
3. BD cites the example of Glencore which foretold a top in commodities

Books recommended:
Woody Dorsey - Behavioural Trading
Daniel Kahneman - Thinking Fast and Slow
James Montier - Behavioural Finance
Robert J Shiller - Irrational Exuberance
Nate Silver - Signal and the Noise

Note that I have a Montier book in the stack already. I don't know if 'Behavioural Finance should replace 'Behavioural Investing'. I would assume that the latter is more practical and less academic? I've read Thinking Fast and Slow and while it's vital reading, it's not really a trading book. We've already covered Shiller's thinking, I feel, and I just don't trust Nate Silver. 'Beware of Geeks Bearing Formulas'. That leaves Dorsey - I think I'll check it out.

Chapter 8 - Understand Correlation and Intermarket relationships
“I believe that my understanding and application of intermarket correlations is one of the primary keys to my success over the past 20 years.”
“The world has evolved significantly since I started trading and there is much less edge in correlation trading than there used to be.”

Intermarket, lead/lag, cross-market or cross-analysis all refer to watching price moves in one market to determine what will happen in a different market

Ask:

1. Does the correlation make any sense?
2. Is it likely to continue?
3. Are there periods of up and down in the sample?
   1. A correlation is more likely to be spurious if it is simply two trends moving in the same direction

4. Is there a third variable influencing correlation?
5. Canadian rates follow US interest rates not because one causes the other but because the two economies work in sync; so correlations don’t need to be direct, determinable or even real, but they must persist

BD mentions the common AUD and Gold connection

The market is a super complicated organism. A Rube Goldberg machine.

The most reliable correlations in FX are (in order of reliability):
1. FX vs. other currencies (one currency vs. another)

1. USD pairs move in sympathy
2. “Some traders believe so strongly in the power of USDCAD to predict the rest of the dollar pairs that it has earned the nickname ‘‘The Truth.’’

2. FX vs. interest rates

1. “the most consistent driver of currencies has been changes in relative interest rates.”
2. “a move higher in rates is often a good predictor of an upcoming move higher in the currency.”

3. FX vs. commodities (especially gold, oil, and copper)

1. “Because commodities are mostly priced in US dollars, there tends to be a strong and persistent correlation between commodity prices and the US dollar.”
   1. Weaker dollar = higher commodity prices
   2. Stronger dollar = lower commodity prices

2. Example of USDCAD and oil
   1. Oil and gas mining contribute to CAD GDP
   2. Every barrel of oil sold by a Canadian oil company receives USD but these must be converted to pay for operations
   3. If crude prices rise on geopolitical fears, people will buy CAD as a safe haven.
   4. CAD and NOK are petrocurrencies

3. Higher gold prices benefit AUD and Chile
4. Higher milk prices benefit NZD

4. FX vs. equity indices

1. USDJPY and Nikkei
2. Japanese citizens hold a large supply of JPY savings
3. In good times they buy foreign assets seeking yields
4. In bad times they bring back their dollars (lower USDJPY)
5. “Another way to look at currency versus equity correlation is to use the relative performance of two equity indices to determine possible direction for those two currencies.”
6. BD likes doing this with AUDCAD versus the ratio of Australian to Canadian equities.

5. FX vs. single name equities and ETFs

1. BD uses the example of crude oil producers like Suncor, Encana and Cenovus in Canada
2. For Australia, BHP or Freeport (mining stocks)
3. The equities will be correlated to the commodity but provide a ‘different lens’ to look through
4. Look for divergence or confirmation. If AUD and copper are diverging, check how BHP and Freeport are doing. If the mining stocks confirm the copper move that boosts the AUD signal.

Trading the Correlations

1. Create a group of ‘overlay charts’ using Reuters Eikon or Bloomberg or some other high quality charting software (tradingview? Yup https://www.tradingview.com/support/solutions/43000543042-how-do-i-use-the-add-function/)
2. When you have 15-20 overlay charts of FX versus correlated assets, scan for divergences
3. BD has every currency pair overlaid with its key drivers on separate charts

1. BD runs 50-60 overlays at a time, dropping and adding 5-10 each year
2. Go through the charts and look for ‘major dislocations’

Equilibrium


Dislocated!

 

1. It’s often necessary to invert the chart so that the overlay is logical as in the chart above where oil is inverted
   1. Crude is weak
   2. USDCAD hasn’t really responded to this weakness
   3. USDCAD looks low (cheap) so buy USDCAD in anticipation of catching up with the weak oil price
   4. USDCAD is 150 points off the lows though so if you want to go long you need a wide stop
   5. BD looks at his other CAD correlation overlays to compare more variables
      1. Canadian interest rates
      2. Canadian equities
      3. Gold

      
      

   6. If they support, great, if not, excitement is diminished, if they contradict the long thesis then BD will not enter
   7. Stay away from trades where different variables point different directions (don’t they mostly?)
      1. Avoid crosswinds; favor winds at your back

      
      

   8. If these variables are supportive BD digs deeper
      1. What are Canadian fundamentals like
      2. Upcoming catalysts?
      3. How is the market positioned?

      
      

   9. If he still likes the idea, it’s time to put on the trade

   
   

If this kind of thing works it could be a game changer, but I have never had much luck with correlation trading. Maybe I just didn’t go deep enough. However, let's take a quick look at oil and CAD.

Oil is up

CAD is also up (remember it’s inverse to USD in USDCAD). However it looks like there is some divergence happening lately. I guess this isn’t dislocated enough? Maybe that was my problem?? I dunno. I guess if oil keeps going up I should expect USDCAD to stop rising and resume its downward trend. How can I know that WTI won’t begin to drop instead? I guess this is where pairs trading comes in. (update: BD answers my question further on)

 

1. BD uses technicals to figure where to put his stop loss
2. He puts his SL below the lows
3. He puts his TP below the major high
4. If the BOC meeting is coming up BD might expect the market to sell CAD into it on rate cut expectations
5. “the goal is to fill in as many blanks as possible to find trades where everything points the same way.”
6. This is a lead/lag setup where you expect one variable to lead and the other to lag but catch up

Update: since I captured those charts oil is up even more aggressively, but no change in CAD to match. This would drive me nuts. I like to react to market reactions. If something is clearly happening and there's no reaction, there's no correlation as far as I'm concerned.

BD goes on to give another example involving the Euro and DAX where he takes advantage of a bank holiday in the US that is not a holiday in Europe. Because US traders weren’t trading, the market was less efficient.

1. “Correlations can flip without notice or just fade to irrelevance”
2. Often perception == reality
3. Always use stop losses
4. How do we know if the variable or the currency will move to close the gap?
   1. If you have multiple variables pointing one way then it is more likely that FX is ‘wrong’ and you have a stronger trade
   2. The variable with the most momentum usually wins
   3. “what you are looking for are divergences where FX is doing nothing and correlated variables are moving with momentum in a specified direction”
   4. If both the FX pair and the variable are moving in opposite directions - do not touch this confusing situation
   5. You are looking for situations where the FX market is asleep or out of line

5. BD calls pairs trading ‘relative value’ trading (RV) and he doesn’t do that
   1. RV is a different skill and thought process
   2. Most RV traders trade baskets of smaller trades
   3. Directional FX traders (like BD) put on a few concentrated leveraged trades looking for directional profits

6. Be careful of chart scaling - the magnitude of the move can look very different depending on scaling
   1. BD uses hourly charts
   2. Scaled between 21-42 days (1-2 months or 500-1000 hours)
   3. Be consistent
   4. Scaling should fit your time horizon
   5. 10, 30, hourly charts scaled 1-3 months. Less is too noisy, more is too zoomed out to see dislocations
   6. If a dislocation happens because of a recent ongoing event it makes more sense to scale your chart to match the time when the event started rather than going back 3 months to see data before the correlation started

7. This is all a combination of art and science, not pure math says BD
   1. Systematizing this hasn’t worked well because “lead/lag relationships are unstable, imperfect, and hard to measure and because I use many other types of analysis to make my trading decisions, not just lead/lag” (suspicious to me)

8. Use leaders in the stock market to forecast the index
   1. Apple / NASDAQ
   2. Use sub-indices like the transport index to predict the main index.

BD then goes into a case study of Feb. 2016, recalling when the transports index ‘showed the way’ throughout 2015. He expects that with transports rising the US equity indices should do the same.

In 2015 Transports began to diverge and the market followed shortly after.


Except what a wild ride. If you stayed short based on the this advice you’d be back where you started until the very end.


Transports are ‘ripping’ in 2016 and indeed foretold the continuation of the greatest bull market in history. If you look carefully though there is hardly any divergence.

BD advises being creative with correlations but keeping a logical connection and remember they are only ‘one piece of the puzzle’.

“Wheat versus milk prices? Brent crude versus NYMEX crude? USDCAD against natural gas futures? Keep an open mind and logical correlations and relationships will come to you as you gain trading experience.”

Here’s my issue though. For example, look at the transportation index now.

Attached Image (click to enlarge)

It has been flat or dropping since May 2021!

What have equities been doing?

Attached Image (click to enlarge)

I’m sure you know as well as I do they only went up until about September of this year with some occasional dips. So that would mean I’d be waiting nearly four months for the DJT to foretell a drop! That’s a long time to wait.

Attached Image (click to enlarge)

Maybe if you look at the DJIA it does look a little flatter during May/June but it went up eventually too.
Could you stay short US equities for 4 months based on a DJT signal? I guess we have to recall that BD advises using technicals before entering. Hopefully that would have helped but I doubt it - those May or June dips would have suckered you in and fed you a hubris sandwich. You probably would have gone bust or given up in September just as things started to move your way and will you get the amplitude of drop you saw in June? I dunno. We’ll see I guess.

Bigcharts.com has a convenient way to overlay DJT/DJIA. Here’s a view of the last six months. I guess it really depends on whether the DJT leads the DJIA or vice versa or if they aren’t reliably correlated.

Attached Image (click to enlarge)

Ok, so DJT says stay short during this time of uncertainty. What does a leading stock like Apple tell us?

Attached Image (click to enlarge)

Is it saying stay short or is it pulling up? Does it matter that the AAPL line is above the index? Not much help it seems at least on this horizon. Maybe I need to wait a few weeks.

It still seems to me the only thing that really matters is price and what it ends up doing. If it crosses your line in the sand, that’s an entry, if not, leave it. Simpler, reliable. Maybe I’m not being open-minded enough and maybe I’m just ignorant. I should probably spend some time on this.

Chapter 6 - Understand Technical Analysis 1
What do we think so far? It’s a thorough treatment and most of it has far exceeded my expectations from a book that is not well known. I did not expect this much quality thinking in a trading book in general, much less one based in non-quantitative or non-algorithmic methods.

However now I think I see the benefit of moving through this book in reverse as my interest in the material begins to decline somewhat. We have been introduced to the interesting, but possibly spurious world of correlations and now we dip our toes once more into the breach of technical analysis, almost assuredly spurious.

However it seems BD has his own unique take on things and I have to give him the benefit of the doubt as an experienced pro.

The next two chapters won’t be in reverse as they wouldn’t make sense otherwise. So I’m starting with chapter 6, moving to chapter 7 and then we’ll go back to chapter 5. Confusing, I know.

 

1. BD asks right off the bat if TA works. He comes up with the answer that it is inconclusive despite evidence of trends and patterns.
2. Trend-following models in FX have performed poorly since the 1990s
3. Profitable technical patterns are arbitraged away over time
4. Studies cited by BD are mixed; data snooping bias (which we might remember from the Aronson book) is a common culprit
5. BD is centered between those who think TA is a joke and those who think it’s all you need
6. BD believes “technical analysis should be used as a tactical and risk-management tool and not as a trade selection tool.”
7. BD has never worked with a purely technical trader who made ‘meaningful P&L’.
8. “Every successful trader I have worked with over the years either trades macro or uses a multifactor approach.”
9. “Think of the most successful traders of all time: Soros, Tudor-Jones, Bacon, Druckenmiller. They are macro or hybrid guys, not pure technicians. They supplement their analysis with charts but their ideas come from all over the place.”
10. Technicians always think their model is just one tweak away from perfection but can’t produce the profits they think their system should deliver
11. ‘Healthy skepticism’ is warranted
12. “Do you really think it passes the common-sense sniff test that you can just look at a chart, see a simple pattern, trade it, and consistently make money? Given the thousands of traders and billions of lines of code you are competing with, probably not.”
13. Systematic funds that used TA profited in the 80s/90s but those days are long gone
14. Humans are built to see patterns where none exist
15. BD uses the example of the ‘face’ in an electric socket (pareidolia-although BD’s footnote references apophenia which is seeing logical connections that don’t exist)
16. If you look at a chart long enough you will find some pattern to confirm your pre-existing bias
17. Research shows popular patterns like head & shoulders don’t work
18. BD uses technicals to determine entry level, stop loss, take profit and position size
19. Research shows that portfolio managers who use technical analysis outperform those who don’t
20. TA is a risk management and tactical tool, not to be used for forecasting or trade selection

Next: the 'need to know' of TA according to BD

The Need to Know of TA
There are 3 main branches of TA:

1. Traditional - trends, breakouts, cycles, retracements, momentum, support, resistance, moving averages, overbought, oversold
2. Candlestick charting - the only difference between candles and and a ‘regular’ OHLC chart says BD is that candlesticks have coloured bodies so you can see which is up and which is down
3. Elliot Wave and cycle analysis - specialized, highly complex, used by a limited group
   1. Criticized as pseudoscientific
   2. Different practitioners can come up with different interpretations even with the same methodology and chart
   3. Highly subject to confirmation bias
   4. BD says the method is too complicated and subjective to have any practical use and doesn’t know any successful traders who use it but he’s sure there are some ‘out there’.
   5. When BD subscribed to the ‘most famous’ subscription services for Elliott wave he found their analyses to be convincing, intelligent and ‘totally useless’ (same)

1. Basic indicators
   1. Support and resistance (it must be me. I guess I’m the only trader in the world who doesn’t use this)
   2. The simplest and most useful concept says BD
   3. There are 4 explanations for its existence

2. Large limit orders create pockets of liquidity that can stop the market
   1. While the large order is being filled, any selling gets ‘absorbed’ by demand from the large buy order in this example. Once the order is filled the market drops.

1. Self-fulfilling prophecy - it works because people think it will work
2. BD himself admits this is circular logic
3. Traders tend to put bids ahead of obvious levels and the more often price bounces off those levels the more attention they get
4. Option-related - option strikes and barriers create hedging needs around certain levels
5. Round number bias - revealed in many studies says BD (bah humbug)

Using S&R in Your Trading

1. Imagine you are bullish EURUSD based on assessment of fundamentals, positioning, and recent news
2. You did not pick this trade with TA!
3. ‘Zoom in’ via technicals
   1. Look for major bottoms and tops
   2. The more times a level holds the more likely the market is focused on it
   3. You have to avoid leaving your orders where the herd leaves theirs

The market is currently at 1.3177. The 1.3150/60 level has been tested and retested.
The lows are above 1.3150 which suggests that could be a barrier. Someone is protecting the level by bidding for a chunk of euros so that 1.3150 doesn’t trade, or maybe a buyer is patiently waiting there.

1. BD goes long
2. He puts his stop below 1.3150 by starting with 1.3149 (away from that round number!) and adding 20 pips of padding
3. That puts his stop at 1.3129
4. Finding a stop loss is a balance that was covered in chapter 12

Simple and exponential moving averages (plus crossovers)

1. SMA is average price of a security over over the past X periods
   1. The shorter the period of the average the more volatile it will be and the more accurately it will track the price of the security itself
   2. Length of SMA depends on your trading horizon

2. EMA puts more weight on recent data versus older data so it turns faster
3. BD ‘generally finds’ the 200 hour SMA to be the best moving average in most currency pairs

How to use the MA:

1. Use it as support and resistance
   1. You generally want to be long when price is above the MA and short when below
   2. Enter as price nears a faster moving average and put your stop below a slower one
   3. Ideally for a long price should be above the MA and the slope should be upward
   4. BD uses 20, 55, 100, 200 period averages on 10min and H1 charts.
   5. He prefers 55 and 100 for fast/slow but whatever you use the results will be similar
   6. Trying to find the optimal length of an MA for a currency is wasted effort as anything that worked well in the past is unlikely to match performance in the future (data mining)
   7. Better to fit a MA to your trading horizon

2. Us a crossover of two MAs to trigger buys/sells and define a trend
   1. When the 100-hour crosses up through the 200 hour that shows an uptrend
   2. Bullish golden cross - when the 50 day crosses up through the 200 day
   3. Bearish death cross - when the 50 day crosses down through the 200 day
   4. Focus on longs when 20d is above 55d and short when 20d is below 50d
   5. The main point is to keep you on the correct side of the trend

3. Use slope to enter new trends
   1. Wait for an MA to turn up or down and then enter a trade when price returns to the average (last kiss!)
   2. Use faster MAs like 20d

4. Use closing prices
   1. When the close is above the MA go long, if below go short

5. Don’t use MAs in isolation. You need to like a trade for other reasons.
6. MAs prevent you from ‘fighting the market’ and blowing up
7. MAs give good signals in trending markets but are ‘worse than useless’ in ranging markets
8. So ignore them if you plan to trade a ranging market
9. Keep it simple; TA is just a fine-tuning device

Measuring Momentum, overbought and oversold

1. BD finds MACD, RSI, Parabolic SAR and ‘the Deviation’ to be most useful
2. If price moves too far it acts like a rubber band and snaps back
3. It’s redundant to use multiple momentum indicators as they all use the same math foundation
4. Use MACD or RSI to find divergence between price and the indicator
5. BD uses PSAR ‘mostly as a visual reminder of the current trend’ (come on - that’s what the MA was for. I doubt very much that BD bothers with a PSAR on his charts at all. For one thing, we haven’t seen one yet in any chart he’s posted)
6. Gives you a tight and clear stop-loss (all the better to whipsaw you with my dear)
7. In fact later BD admits “any trend-following indicator (moving average, Parabolic SAR, MA crossover) will give you approximately the same message, so don’t clutter up your chart with too many similar indicators.”

Next: candlestick charts