Editors note: Van and Chuck recently had a lively conversation about market structure. This article is a transcript of sections of this conversation.
Chuck: Every market we trade has a legitimate business purpose and commercial firms legitimately use that market to manage their business. Without that, the market does not work.
I believe that traders benefit by understanding this concept – that markets play an important business purpose.
When you ask a lot of people about trading, they’ll say trading is a form of gambling. Look at the definition of gambling: to play any game of chance for money or other stakes. Chance is key with gambling and the outcome produces a winner and a loser.
I want to make this point – trading is not gambling. The definition of a trade is to give one thing in exchange for another. You place a bet based on a particular outcome and there’s no exchange of value. When we trade, there’s an exchange of value. If you buy a gold futures contract you gain the right to get physical gold, if you want to receive it. In exchange for that right, you supply Dollars for gold. It’s far different than gambling where you supply Dollars in anticipation of an outcome. You have no rights to anything.
I think it’s important to step back and realize that trading is not gambling. The purposeful exchange of value in markets leads most of them to have four major types of participants generally:
- Commercial Firms
- Large Speculators
- Small Speculators
- Market Makers.
Understanding the role of each participant type is very helpful for any trader in any market. Understanding those roles helps us understand how the market functions. Why does this matter? We want to know who is on the other side of our trade.
I work with new traders and I see a lot of them trading some sort of breakout system. Something simple like a channel breakout or breakout above a swing high. When you step out and buy on a breakout you want to think about who is on the other side of your trade. You’re not the only one who knows it’s a breakout. Trust me. Why would someone sell that to you? These are the questions you want to ask yourself.
The reality is that the most knowledgeable participants in the market are usually the commercials. They know everything about the market. Let’s look at corn. They know the cost of production, freight, financing, the stress in the delivery points, how much it costs to put it on a railcar or a truck. They are getting real time information. They are getting all of this simultaneously. When you buy corn on a breakout, they know you are paying too much and they are excited to sell it to you.
You need to think about that. That might not be very good for your idea.
Secondly, I think when we examine how commercials trade, most traders are totally unaware of their world and how they think. When they know that world exists, they aren’t aware of the types of strategies used. Some of these strategies are appropriate for you.
For example, if you look at the majority of successful traders, they are an expert on just a handful of products. They trade those same products day after day. Not only do they know a lot about that product, they know about strategies on that product. They’ve become an expert. They are able to trade that expertise over and over to be consistently profitable. The majority of them are experts in niches. Riches are in the niches.
Their income may vary with volatility. If a market is volatile they will make more money. They will be consistently profitable within their niche. For example, read Thanh Nygen’s chapter in Trading Beyond the Matrix. One of the reasons she was so good at what she did is that she day trade only a few stocks and he know the behavior of those stocks inside out.
Most people never think about that possibility. If you’re aware of all the different strategies and what your edges and expertise are, you can create strategies that maximize what you already know to make you an expert. That can lead to a road of consistent profitability. We want to model those who are successful. I know how the majority of successful traders trade and that’s one of the ways. The majority of them are experts in niches. Riches are in the niches.
Also, there’s another school of thought. Some pros use a similar strategy but they use it across many products. These people are experts in a method, not in a market. I think there are more pros who are experts in a market, however, being an expert in a method is a way to always trade the best type of products for your strategy.
We need to know why we trade what we trade. When I talk to traders they all trade the E-minis, gold or Amazon or Tesla, etc. They are all trading the same thing and they don’t know why. We all know competition can be very fierce.
There are commodities you can trade that are small. It’s easier to compete because the number of competitors here is smaller. I’ll give you an example. We started trading Milling Wheat out of Paris. We were incredibly successful. We were one of only four or five market makers that were trading it. We quickly found the best market maker and took a chunk of their market share. It was easy. We were able to manifest edges we brought to it. There are strategies like this that will make it an easier path for you.
I’ll give you another example. I had a student working with me who was trading the euro. I was talking to him about why. A lot of traders have no idea why they trade what they trade. Their friends trade it or they read about it in the Wall St. Journal.
He traded the euro because it was big and everyone traded it. However, he was a petroleum engineer and spent several years working on offshore oil rigs. He migrated into upper corporate management working for an energy firm. We’d have conversations and he would tell me that they aren’t letting ships out of Venezuela so oil will be disrupted until they let tankers come out of Venezuela. I asked him why he doesn’t trade crude and he said it was because that was his work. I told him millions of traders were trading euros. Why would you trade euros when you’re an expert in crude? Very few people know about the distribution problems in crude. We reconstructed his trading plans to make him an expert in crude. I see this come up a lot.
In this workshop Van and I are putting together, we hope that by understanding how large participants trade that it will open up a new world for you and how you trade. What strategies can you trade with edges that will be low competition where you could become an expert?
Van talks about psychology being the most important aspect followed by position sizing. The third aspect is market or strategy selection. If you’re trading one market you need the right strategy for the market environment. That’s far more important than exits or entries. We hope that when you leave this workshop, this will give you insights on how to set up your strategy selection in a way that fits you. This will greatly impact your trading.
Van: Let’s go into the example you started with, which was trading channel breakouts. The Turtles made that system famous with a 40/20 channel breakout. Almost all of them became successful money managers using these strategies. What you’re saying is that they’re playing the opposite side of the commercials.
Chuck: I was saying, people can fall on either side of that. I think it was 1986 or 1987 when Richard Dennis, the founder of the Turtles, was trading his strategy in the soybean market one particular year, he kept getting 40-day breakouts. He would put a stop behind a 20-day low.
That particular year soybeans kept breaking out up or down on 40-day breakouts. Paul Tudor Jones, another famous trader, was on the other side of most of his trades. That year the market broke up and Richard Dennis bought the highs while Paul Tudor Jones was waiting for him to do that and he smashed them. Then Richard Dennis sold 40-day lows. Over the course of the summer, Richard lost $100 million in soybeans mostly to Paul.
If we step back and go to a higher level, we can see market environments. The system wasn’t accounting for market environments. Paul was good at fading new highs or new lows and taking the market back into the range. Richard and Paul are both in the same category (Large Speculators), but their strategies were very different. One ended up taking advantage of the other.
Van: Sometimes the person who is fading the channel breakouts gets hurt.
Chuck: Correct. The fader is usually correct, but when they are wrong they can lose big.
Van: Can you talk about a few more of your objectives for this workshop? Then we’ll open it up to questions.
Chuck: In the workshop on How Big Money Trades, I’m going to explain to you how each participant trades through different asset classes. These asset classes are not the same. We’ll talk about commodities, fixed income, equities, and cash. We won’t get into specific commodities but we’ll talk about it at a high level. Each asset has its own market structure and regulatory regimes and market participants. For example, commercial in commodities will trade far different than commercials in equities. We’ll get into that. I’m also big on positive versus negative reversion.
Van: And by the way, you haven’t mentioned that you are planning to bring in experts in several different asset classes to talk about them.
Chuck: Yes, that’s one of our big secrets about this workshop.
A big aspect of my trading is understanding what is fair value in the market and trading around what fair value is. Most people trading don’t think about what fair value is.
The same people, if they step out of the market, they know a lot about fair value. If they’re buying a car or a house or going to Costco or Walmart, they aim to buy under that value and sell over. But in the market the same people have no concept of what fair value is.
There are lots of different definitions of value, but I’ll give you specific ways of thinking about value that’s helpful to trading.
It’s really important to understand the market’s job. The market’s job is to facilitate trades by finding short term equilibriums where buyers and sellers agree on the price. The market wants to go find bids and offers. Understanding where this facilitation of trade occurs is very important for finding fair value. I’ll teach you how to interpret that. I’ll also dive into technical indicators and how there’s a hierarchy to how they work.
You can see what kind of adjustments you might make to improve on how you trade.
Live Q&A From Our Webinar Audience
Question: Is it a bad idea to trade breakouts? Cup and handle.
As it relates to that question, I want to be clear that it’s not that breakouts are bad. There are traders who make a living on breakouts. It’s important to understand the context. A typical breakout strategy has a typical profile. Long term trend following is a time tested strategy. If you look at basic trend following models they work and will always work. Do you know why? Because people don’t have the psychological makeup to follow them.
I have friends who own a firm that’s one of the great long-term trend followers of this generation. Over the last 25 years, they have made billions. However, they went through 2015, 2016, and 2017 without making money – just like Richard Dennis lost $100 million to Paul Tudor Jones.
Their Assets under management went from $1.2 Billion to $280 million which was mostly their own money. Few investors would stay with them through three years of drawdowns. Was their strategy broken? No. It has a lot of volatility and a low win rate. It’s made up of big winners. The average trader would not stick with a strategy that loses money three months in a row, let alone three years in a row. That’s why it works – because most people won’t follow it.
You can go a level deeper and understand the context where breakouts occur. There’s typically volume patterns and little environment tricks where you can start to determine if a breakout has a higher probability of working.
To be clear, I do take breakouts. More than take them, I use them as a tool for knowing when to take other trades. Breakouts are great signals. I can reduce the risk and make better trades from the breakout signal.
A cup and handle is a range retraction near a high. They can be really effective because they are an extension of a breakout or a major run. They are really a pause. That’s a chance to get back in. Cup and handles can be very effective. You want to understand the context in which the cup and handle is occurring. Hopefully, that makes sense.
Question: Are there any specific prerequisites for attending the workshop?
No. What I really like about this workshop is that if you’re relatively new – you will learn about market structure and see the market landscape you are stepping into. There will be a lot to take in and market structure isn’t trivial. However, this will help you see what is possible and potentially what is the best fit for you.
Question: After getting into a position how do you determine if the pullbacks are normal? If you widen the stop loss that reduces the position size rather than stretching it out to get target R.
This gets into what I talk about in the workshop. A lot of strategies say don’t fade a move. Let the market turn and confirm your idea. Then place your trade and put the stop above the recent high or low. For example, the market is rallying, then rolls over, so you go short and put your stop above the swing high. Selling the turn off the high is another person’s pullback. What they don’t realize is that they are selling it to the pullback buyer who has been waiting to buy the pullback because they think the market is going higher.
One will be right and one will be wrong. The key for me, is that you really need to understand when you’re wrong. That’s where your stop needs to go.
Traders get into a lot of trouble when they ignore this concept. The trader does the analysis and the trader doesn’t like the point where the market tells them they’re wrong. They will know they’re wrong after a $2 pullback, but they only want to risk $1 so they set the stop at $1. The trade then pulls back $1 and they won’t want to take the loss. Do they double their loss or cut their position size? This introduces a lot of psychological stress.
People will set the stop in a place to save money, not where they will be wrong. My advice is to understand where you will be wrong on the trade and set your stop there. Look at your reward to risk ratio and see if the Reward/Risk Ratio is still good. Every trader should have a minimum acceptable Reward/Risk Ratio. If the trade doesn’t meet the minimum threshold, skip the trade and move on. There will be plenty of other great opportunities. The worst thing you can do is force trades. People try to go with a smaller stop or a smaller R, but the market does not care what you want. When people try to impose their will on the market it usually goes poorly.
Question: How do we find out which side of the Market the Commercial participants are trading in?
We can see commercial participation through reports such as Commitment of Traders Report for futures (COT). We will be discussing reports and services that can be used to determine their positions. Also, when you learn how they trade, you can begin to anticipate their behavior and use that as an edge for how to structure trade ideas and trade management.
Question: Has the market changed in the last 20 years with the elimination of the trading floor, and if so how have you adjusted to this change to a purely electronic trading environment?
Yes, market structure has changed substantially since the advent of electronic trading and the closing of exchange floors. The execution of large orders now has to be hidden and broken up because electronic algos are always searching for large orders to front run which makes executions difficult. As a result, liquidity has, in general, been taken from the market and is much more opaque than it was prior to electronic trading.
Question: Is the fair value concept in trading the same as the fair value arrived at while calculating it for long-term investing? If the answer is yes, then how does it justify short selling while trading when fair value suggests it for buying.
The fair value that is generated from a value investor will be a different concept than how we discuss fair value in our webinar. Different participants will have different fair values. Different fair values make trades. It is important to understand what timeframe we are focused on when we discuss fair value because each timeframe will have different fair values. The fair value that a value investor calculates could be a fair value for the company over a given time-frame but other market participants have different timeframes and thus different fair values. This is why a value investor might calculate a company to be cheap to value but the market doesn’t care and the stock price remains depressed for months or even years.
Question: Will you be discussing the options market for indices and equities?
We will discuss option markets briefly but the primary focus will be on underlying instruments
To watch the replay of this webinar, click HERE.