Using information outside the charts

PS: The following article was something I wrote for a website in 2014. It can’t be found anymore so I’m republishing it here as I thought it might be useful to someone out there.

A key to being a good trader is the ability to deduce future price movements. It is about finding situations where people will move the market in your favour after you enter a trade. There are many ways to skin a cat. All methods are valid as long as they have an edge and work for the individual trader.

The most popular approaches to trading in recent years revolve around information in the charts, namely technical analysis, tape reading and price action trading. It is no surprise that they are popular given the ease of learning and somewhat mechanical applications

But, given that we are living in an information age, it seems pretty wasteful if traders are not making use of information available outside of the charts (I shall refer this as outside information from this point on) to improve on their own performance.

There are many ways to use outside information to get what you need. One of them is to figure out the themes and events that are on the minds of market participants. Below are three essential concepts needed to do that and avoid information overload:

First:
It is impossible for most humans to properly process all the information that is available out there. Thus, it is part of human nature to make use of heuristics in decision making (“rule of thumb”).

Second:
The idea of Schelling points in game theory (simply put, something that can act as a focal point for market participants).

Third:
The market is forward looking. That is, it will seek to price in expectations of events before they happen by using existing information.

The application of the first point is that no matter how complex an analysis a market participant makes to determine how they are going to trade, it will eventually be simplified into some sort of theme or story e.g., risk on/risk off.

The application of the second point is that the majority of market participants will, almost as if coordinating together, focus their trading into one or a few market themes or stories at any given time which will dictate price movement.

Putting the concepts together

First, find the major market themes and stories. That is quite easily done by reading the various market reports or major news sources out there.

Unfortunately, after figuring out the major market themes and stories, a common mistake most people make is to go on and form their own opinions on the dominant themes/stories and thus how prices should move (in their own opinion). Then after a few occasions when prices do not go the way they think it should move, they will go on to conclude that outside information is not useful. Never forget you’re playing the other market participants’ perceptions, not the events themselves.

With that out of the way, figure out how the prices across various assets should behave given certain outcomes of a theme/story. This done by understanding basic economics inasmuch as how major players think of basic economics (e.g., how inflation influences central bank interest rate policy) — again, major newswires, banks/funds analysts, and the central banks themselves will mention the things that are important.

Finally, watch the price in those various assets react (or not) to certain events and data releases. Relate the price reactions to the likely emotions of other players. Did you get shocked that price didn’t move higher on a really strong Manufacturing PMI (what should have been an obvious, no-brainer move)? Others are probably shocked as well. Is it probable that others were confused as to why price shot lower even though the central bank didn’t say anything new? These are the questions you need to ask yourself. When you find that things line up just right: a surprisingly dovish stance from an important central bank member moved price lower, you can rest assured that this is a major part of the current market theme.

All that is left for the trader is just execution using the information that you have gained together with the information available in the charts. Here are two ways to approach it:

Event based trading:

  • Find future data releases/events that the market is focused on
  • Determine the expectation
  • Be ready to take the trade when the result is distinctly unexpected. A straightforward example is a cut in interest rate when the expectation is to hold.

Pattern based trading:

  • Find out the direction of the market given the current dominant theme/story
  • Trade the formation of certain technical patterns in line with the dominant theme/story
  • Example: price direction is down, trade the top of the second shoulder of a Head and Shoulder as it is forming, aiming for an extension past the neckline.

So this is how I approach assimilating outside information into my trading. Hopefully what I’ve shared here would be useful to you as well.

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