Monday, October 12, 2009

Profit When Market Patterns Shift

All trading systems work. All trading systems fail. It is difficult to find a trading system that DOESN’T work in some market at some time. It is also difficult to find a system that DOES make consistent returns in all market conditions.

Here is the really good news.

Independent traders have the luxury of picking and choosing their trades. They don’t have to trade all of the time. This is their edge. They can wait until the market patterns are working for them.

It is in the evolution and transition of trading patterns that a lot of money can be made and lost. Because trading patterns are driven by humans who trade repeatedly with the same behavioral responses the destruction and emergence of new patterns create profit opportunities.

The problem we have as traders is that if we have a system that is making money in one market pattern, we get attached to that system. We build our ego on the fact that 15 of our last 18 trades were winners. This rewards our dream that we have found the secret to trading.

It’s like one of those Zen puzzles…any belief you are attached to, the market will destroy. As a trader, it is your ability to see new trading patterns emerge that create the most profit potential. To do this, the mind needs to see the markets as they are without the prejudicial filters we all carry around. If our ego is attached to a trading system and its success, the ability to see new patterns emerging is difficult.

When I was an option floor trader, I would get a “sense” that a market pattern was about to change. This “sense” was built on years of experience. Even though I might not be able to articulate what was happening, I could feel it.

At these times I would go to the market to reduce my risk. It was expensive because I would have to trade with other market makers to change my positions quickly. More often than not, nothing had changed. I would have paid $10,000 or more for the insurance. However, a few times a new pattern would emerge and I could see it because I didn’t have positions based on the previous pattern. Other market makers, with large complex positions based on the previous pattern would need to believe that the current change was an aberration and that the markets would come back to their previous patterns. As the market continued the shift, it would get more and more expensive to realize the losses, and the more stubborn these market makers would get.

Here is the cool thing. Since I no longer had a risk position, a few times I was able to visualize the new patterns very early in the shift, reset my option volatility tables and start building a new position. I would often be trading with other market makers whose values were based on the previous patterns. Slowly, one by one, the other market makers would see what was happening and the options would come in line with the new pattern. With the new option values, I made a lot of money.

As a market maker, I had to be trading and make markets for incoming orders at all times and it was expensive to shift positions. But as an independent trader, you can pick and choose the times to trade. This is a powerful advantage. You can get out of a position with a click of the mouse when you sense a market pattern is changing.

Here are some potential indicators of changing market patterns:


-Unusual Emotions in yourself such as exuberance, fear or cockiness
-Emotions in other traders you talk to such as exuberance, fear or cockiness
-Overwhelming consensus of where the market is going
-Physiological changes in yourself such as stomach pain, tenseness, funny taste in your mouth, back ache etc.
-Emotions in the news and headlines

Market Indicators:

-Daily Range
-Volatility and implied volatility in options
-Size of trades or unusual large orders
-New chart patterns
-Unexpected price moves
-Time of day pattern shfits
-Opening market patterns changes
-Closing market pattern changes
-Changes in your ability to execute trades
-Changes in your P&L patterns
-Unusual price gaps
-Sudden quiet
-Shifts in how the market reacts to news
-Changing margin requirements

Remember, all trading systems work during certain market periods. All trading systems eventually fail. It’s the law. If you can free yourself from the belief in your system as the holy grail, you can see new patterns as they emerge and profit.

Easy to say, but how do you see new patterns? In my coaching practice we create a series of Mind Muscles™. These are neurological circuits that help us create new responses to market conditions. Creating concrete visualizations is one way of building new Mind Muscles™ and behavioral responses. If you want to create a Mind Muscle™ for new pattern recognition try this exercise.

First, get comfortable in a place that you won’t be interrupted. Take a moment do some deep breathing exercises. One exercise that works well is to slow count to three on your inhale through your nose. Hold the inhale for another count of three. Exhale through your mouth to a slow count of three and rest at full exhalation for another count of three. Repeat 10 times or until you feel your body settling in.

Then close your eyes and imagine a dog, a well trained bloodhound. He is sniffing the air, the ground and various objects. Imagine this hound dog in detail, his colors, movements and sounds. He is looking for some scent that is out of the ordinary. Spend some time with him as he sniffs his world. Now give him a name. Sniffer works great if nothing else comes to mind. Call the dog to your side. Pet him and give him some love. Then tell him to go and sniff out new patterns and to bay at the top of his voice when he finds one. Call him back, reward him with love, and send him out again.

Now, when you are trading and have a moment, visualize your new bloodhound. He represents a new behavior you have created in your brain. Call him by name. Give him some love. Tell him to go sniff out pattern changes. Watch him as he sniffs both psychological indicators and market metrics. And wait for the baying to begin.

For more on the how and why of creating Mind Muscles™ please call.

Richard Friesen


S Benard said...

Thanks for this great article! There are some important principles taught in it that I have learned over the years. I also picked up a few new insights as well!
I've learned that biases are dangerous for my profits. I can't completely eliminate them, but if I acknowledge them, then I can nullify their damaging effects on my trading effectiveness.
I've also found that forecasts are for prophets, not profits. Does ANYONE really know where the S&P 500 or the price of wheat will be six months from now? There are simply too many variables to know where the future will lead. We can only respond to the circumstances that the market presents to us. The winds and tides of the financial world can change very quickly, and I try to avoid trying to forecast those movements. My job is to bring myself into harmony with the market, NOT trade based upon my biases and forecasts.
Because all trading systems work only some of the time, I have developed a series of trading systems that I call "Dynamic" Technical Analysis, as opposed to "static" systems that are used by most traders. It is based upon the idea that the market must tell me what system is working, and the market will dictate what system to use, and at what times. I use different systems for different market circumstances. The essence of it it that I will use different trading methods for different circumstances, depending upon what the market is telling me at the time. Hence, these trading methods are "dynamic".

Thanks for the interesting insights. I'll continue to read and learn from your blog.

Richard Friesen said...

There is so much I agree with.

Predicting the future is dangerous. As mentioned, you can't do it. But just as important, when we predict the future, we have attached our ego to the prediction which clouds our present view of the market.

I would love to hear more about "bring myself into harmony with the markets."

S Benard said...

Ran across this quote today and thought I'd share it with you:

"I learned long ago never to let an opinion get in the way of making money." - Todd Harrison