Tharp's Thoughts Weekly Newsletter (View On-Line)

• Article Reading Psychological Footprints by Gabriel Grammatidis
• Trading Education Three Forex Trading Systems Revealed in October
• Trading Tip Understanding Market Volatility in 3 Charts by D. R. Barton, Jr.

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Article

Reading Psychological Footprints for Low-Risk Ideas

A Follow Up to May's Yen Crossing Opportunities

by Gabriel Grammatidis

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For traders and investors, finding low risk ideas is one of the most important tasks no matter what asset class you trade — stocks, bonds, forex, commodities or real estate. Looking back a couple of hundred years ago, this task has not changed much: Native Americans read footprints in order to provide for their families. Being able to read these tracks well (pattern recognition) represented a major edge for their survival. Back then and today, the key was/is to find a large reward for a minimum amount of risk.

In the context of modern capital markets, we try to identify opportunities having a large reward-to-risk ratio or simply being a low-risk idea. Today, finding distinct, repeating, and profitable footprints or patterns in the charts is still an edge.  Has so much really changed over the centuries? 

Being able to read the footprints in the charts requires a calm mind, a large amount of experience, and a good portion of intuition can be helpful. Based on past experience, one can draw valuable conclusions (e.g. a set of useful beliefs) and deduct probabilities that form the basis for trading systems with an edge that produce a sufficient stream of low-risk ideas. 

“Psychological Footprints” — Left By Market Actors

A “footprint” is a specific constellation (or pattern) at a certain moment in time that can be described by selected indicators, specific price patterns, certain multi-timeframe constellations, and other factors. At specific points in charts, strong emotions of both buyers and sellers converge and the interaction leaves a distinct trace in the chart. The more emotional pain involved, the clearer the trace (Native Americans would sometimes detect traces of blood). These same points yield good predictive powers as to how market participants will behave once they approach these emotionally-loaded levels again. 

A Practical Example — Yen Busted Breakout

In my last article on 21st of May titled “Yen Crossing Opportunities”, the charts made a good case for a short trade in the Yen.  Based on the psychological footprints at that point, the Busted Breakout (System 1 from the Forex Workshop) triggered short for the EURJPY (15min chart, 14th May).  What were the first footprints in the chart that generated attention at the higher timeframes?  Let’s have a quick look —

• Overextension of price from the MAs (Monthly chart)
• Bar close breaking below the 21MA (Weekly chart)
• Trend change down with the MAs stacked correctly on top of each other (Daily chart)
• Triple price top (240min chart)

Now, zooming into lower timeframes is needed (like with a microscope) to identify the psychological dynamics of buyers & sellers of that currency pair. The real “big footprints” were found with the Busted Breakout pattern that initiated the EURJPY short in the 15min chart.  In the chart below, see the entry indicated by the red arrow and the initial stop indicated by the purple line:

(To see a larger version of this chart, click here.)

Two requirements (of several) for a Busted Breakout pattern are a good price consolidation with a horizontal level on the top (thick red line) and a breakout above the line that fails and re-breaks the line (two green breakout bars just prior to red arrow). The re-break of the line is the point of entry and the stop is positioned at the breakout failure high.

Red Lines in The Sand

Active buyers and sellers make a market. In the above example we have a situation in which buyers and sellers have been stalking each other for quite some time (see horizontal thick red line).  Let’s take a look at the psychology in the footprints found in the pattern above.  This description of what happens in the pattern is based on a set of my beliefs.

The longer a price consolidation goes on, the more convinced buyers become that a long breakout of this horizontal level will be successful.  (Please keep in mind that in general the majority of breakouts fail.) After a quick 2 bar breakout, prices re-break the line to the negative side resuming the overall downtrend. In this situation buyers are “trapped” in a breakout that fails to go up – their stops are hit and this generates emotional pain.

On the other hand, sellers had been shorting the EURJPY already and moved their stops to some level above the horizontal red line where they thought their short was “well-protected” (based on their beliefs). When the long breakout was attempted, those short stops got triggered, and the sellers were “trapped” too. As prices start to go lower finally after the failed breakout, sellers feel emotional pain as they are now out of their short positions. They see the lost opportunity and want (need?) to get short again.

This situation “double traps” buyers and sellers and is associated with a lot of pain (or blood, to continue the metaphor) in the markets. As a result, observant traders can identify a major resistance level that remains valid in the future and draw a “red line in the sand” (the dashed red line in the chart above).

Actually, the price pattern in the 15min chart above was the first of three consecutive Busted Breakouts (and very good trades) for the EURJPY pair.  The daily chart below shows the levels at the exact positions where the three Busted Breakout patterns occurred— see thick red lines labeled S1.  The associated dashed red lines (lines in the sand) represent three major resistance levels.

(To see a larger version of this chart, click here.)

One can observe how these three levels — three double traps — established themselves as major levels of resistance. The first strong pullback upwards went right through the first two lines, but stopped at the 3rd line of resistance on June 9 (see the first black circle). This was the point in the chart where a major lower high was generated, and from which prices went for a new low. 

In mid-June, I made a short video about framing a good reward to risk trade based on that second Busted Breakout pattern.   The second pullback from the downtrend did not go very high at all and was rejected at the 1st line of resistance (second black circle) in early July which provided another sign of further EURJPY weakness to come.

For any additional pullbacks to happen, please be aware that these levels still remain important. Psychological footprints remain “reality” until the emotional pain that generated them has dissolved. Very similarly, footprints in nature can only be detected for a certain amount of time after an animal left them. 

With a slightly different twist, I hope you found this article interesting & helpful.

All the best, Gabriel  

Image credit: blackhawkproductions.com

About the Author: Gabriel Grammatidis is a successful full-time trader and graduate of the Super Trader program. He has extensive experience trading Forex and will share his knowledge at a three-day Forex Workshop being held October 11-13, followed by two days of Live Trading, October 14-15. Gabriel can be reached at gabriel "at" vantharp.com.

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Understanding Market Volatility in Three Charts

Plus an Institutional Trading Desk Insight

by D. R. Barton, Jr.

The persistently low market volatility has been an unending source of discussion for analysts, pundits and traders. And rightfully so — the low volatility environment that is a major characteristic of grinding bull markets (mid-1990s, 2003–2007, and late 2011–present; see chart below) has not only changed the trading strategies for options writers but has also given equities traders a seeming carte blanche to pile into the markets.

The sometimes wacky, sometimes useful Business Insiders website has just put out its “Most Important Charts” roundup, where serious analysts and a few traders send in their contributions.  Not surprisingly, low volatility visuals often show up along with Chinese debt & housing, Fed QE explanations and several on the U.S. housing market and employment picture.  I’ve included a couple of my favorites below (yes I did slog through all 91 charts for you loyal readers…!). 

2014 Market Performance VS. Implied Volatility Forecast

First up is a chart that I found interesting because it shows, in a very useable format, a visual interpretation of implied volatility.  Implied volatility is a mathematical forecast of price’s future variability. In this chart, Jared Woodard, Equity Derivatives Strategist at BGC Partners took the beginning-of-the-year price projections from a group of analysts for each of the past four years and projected them out as pink parabolic cones.  These cones represent the implied range based on options prices at the beginning of the year:

(To see a larger version of this chart, click here.)

A few observations:

• This year’s market movement so far has been well within the implied range.
• There is some upside still available along with some significant downside possible.
• We’ve already exceeded the 14 analysts’ median target for the year.
• Last year, the market showed true outperformance.
• Even the huge drop in 2011 when U.S. debt was downgraded amid the early stages of the European debt crisis was contained within this definition of implied annual range.

Small Caps & Large Caps Volatility Ratio

In our last chart (below) you can see the ratio of the Russell 2000 Volatility Index divided by the S&P 500 Volatility Index. The chart shows the 30-day implied volatility between small cap and large cap stocks. David Marquart, Portfolio Manager at Quad Capital contributed this chart and note that it ends right on July 17th.  The Malaysian airliner was tragically shot down earlier that day over eastern Ukraine which sent equity prices down across the board. The ratio is significantly lower now at 1.475, though still in the upper end of the range:

 Observations:

• Marquart interprets this divergence as a shift in risk sentiment from higher-beta assets.
• His second insight is that this chart highlights the correlation opportunities that volatility traders look to exploit until implied volatilities begin to realize historical levels again.
• Both of these are very astute interpretations; remember that implied volatility goes up as price goes down. This means the Russell has retreated significantly from its record highs while the S&P has not…

Insights from an Institutional Trading Desk

Here are a few closing thoughts on a lesser known aspect of volatility.  An institutional trading desk that we work with told us that the implied volatility skew is at the highest levels seen since the real estate / credit bubble burst. 

Volatility skew is the difference between the price for out-of-the-money (OTM) puts vs. OTM calls.  Since the 1987 Black Monday crash, this skew has been persistent and significant but the trading desk reports that the skew on the S&P 500 is currently at an extreme. That is, puts are very expensive and calls are relatively cheap. A primary impact on institutional investors is that the buy-write strategy (where a firm sells or “writes” a call option to produce income and hedge the position) has dwindled to almost nothing. 

The trading desk manager cautioned us that volatility really is creeping into the market but not showing up in traditional VIX calculations.  All investors and traders should heed this warning. 

As always, your thoughts and comments are always welcome — please send them to drbarton “at” vantharp.com.

Great Trading,
D. R.

About the Author: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena. He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at "drbarton" at "vantharp.com".

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