Inside the Mind of the Worlds Smartest Trader: Part 1

THE WORLDS SMARTEST trader does not think about markets like normal people think about markets. Normal thinking is not going to put you on a level playing eld with Wall Streets rocket scientists and a legion of hungry hedge funds scanning markets for opportunities. Now, I may not know the worlds single smartest trader, or maybe I do. In 28 years, Ive modeled the thinking processes of those, who were at one time or another, considered to be the best and the brightest. And, Ive traded continuously myself during that same period. In the last 20 years of running a trading system research & development business, Ive also had the privilege of working closely & openly with a loosely-knit group of world-class traders, most of whom are obscure, quietly running their private trading funds and raking in outlying returns year-after-year that would be the envy of any hedge fund. Remember, this composite mind, which I call the worlds smartest trader does not, by nature, think about markets like normal people think about markets. Normal minds trade systems & price patterns; or use a linear thinking process trying to beat the Street at fundamental analysis. First of all the smartest trader in the world is formless. This means that his (or her) behavior is essentially adaptive by nature, moving between strategic and tactical behavior according to the type of market environment. Second, the smartest trader in the world uses principle-based trading methods. This means his trading methods are an extension of core trading principles which reect primal market behavior and optimal decision-making practices extracted from vast stretches of market time. This is the only way to insure consistent prots that his trading remains stable and robust over time. Now, if I gather up that entire constellation of observations & experiences and condense it into the simplest possible trading model, I would really end up with two models: one tactical (shorter term) and the other strategic (longer term) model. I can describe the tactical model like this... A. Degrees of Surprise George Soros, Co-founder of the Quantum fund, is a legendary trader, famously known for breaking the Bank of England in 1992. With an estimated current net worth of around $8.5 billion, hes ranked by Forbes as the 27th richest person in America. Soross trading was greatly inuenced by philosopher Karl Popper and an oddball concept called reexivity. Popper, considered one of the more inuential philosophers of science of the 20th century, claimed that unexpectedness, or degree of surprise, is the correct measure of the information content of a scientic hypothesis. In other words, he proposed that when analyzing a body of data, the unexpected data point or the observed oddity provides a richer source of information for drawing conclusions. Lets call this the Popper Principle . Restated from a trading perspective: Unexpected price action foreshadows directional bias (trend).

I believe this was (is) a seminal idea for Soros and it really deserves to be a seminal idea for anyone using technicals, because one of the primary goals of technical-analysis is to determine whether a trend is continuing or reversing. The most effective technical-based trading tools which weve developed for clients are based on this same idea of measuring the degree of surprise in price events, which we call out of character price action. We also think its critical to monitor the variance in perception among traders who pull information from different points of view. Simply put, a day trader whose world-view of a market is comprised of tick or intraday bars has a vastly different perception of current price action than another trader operating in that same market in a monthly or quarterly timeframe. Surprise Comes in Two Flavors The most important type of surprise in the technical world are counter-trend retracements which are out-of-character (different from recent retracements). A second form are sustained directional moves (trend runs) which are out-of-character because they move beyond normal objectives in terms of price or duration. The essential point is simply that abnormal price action reveals important changes in order ow and momentum and provides the context that the smartest trader in the world keys off for tactical trade ideas. Lets call the movement into and out of a given market at opportune times, smart money order ow. Part B: Pre-conditions for a Tactical Entry An effective model for tracking smart money order ow into tactical trade entries has two core elements. Well describe those elements in terms of a buy. First, an unexpected (as described above) retracement occurs which reveals a change in the supply-demand dynamics and serves as a green light alerting smart money traders to begin stalking a possible buy long. Joseph Hart of Trend Dynamics called this the surprise swing. And recall that the Popper Principle says that unexpected price events foreshadow directional bias (trend). Recently (in 2006) we alerted subscribers of the potential for important lows in PPH and Natural Gas futures. Here are two examples that illustrate how we isolated those lows and then initiated long entries in them before they exploded. We cant reveal
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the exact algorithms we use in-house to identify when surprise swings occurs, and the actual process is more complicated than recited here, but the general idea is presented. In late Spring and Summer of 2006, PPH was mired in a downtrend (see Chart 1, page 2). There were a couple of key countertrend reactions (A-to-B and C-to-D). Suddenly a surprise swing occurred in late June (E-F). This particular surprise swing was out-of-character as it exceeded the previous rallies in amplitude. Since price has already moved signicantly away from the low, the trade location for going long is not attractive, but this type of rally attracts the attention of smart money traders who will begin stalking PPH to watch for low risk buy entries or to accumulate longs on a retracement under the assumption that the buy-side order ow may be emerging as a new dominant factor. The second example (Chart 2, right) set up our recent buy in Natural Gas futures. In August and September of 2006, Nat Gas was in a severe liquidation burdened by news of major hedge funds taking severe losses in Nat Gas positions. From the top in early August, there were two distinct countertrend reactions (A-to-B and C-to-D). After touching the $6 handle there was a subtle surprise swing up in October which is out-of-character. W.D. Gann, in How To Make Prots in Commodities, called this process overbalancing as the E-to-F move exceeded the previous corrections in both duration and amplitude. Again, this is the type of rally that draws the attention of smart money traders who consider this sort of price action indicative of a possible trend reversal and a reallocation by commodity traders back into the long side of Natural Gas. So the rst element, a surprise swing, hints that the order ow in a particular market may be reversing which, attracts large speculators and hedge funds. Part C: Technical-based Variant Perception In Part B, we described the rst condition for a tactical long entry as a surprise swing. The second element is essentially a condition called variant perception. It comes in many colors, but was rst coined by another wildly successful investor/trader,
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Michael Steinhardt who, like Soros, extracted multi-millions of dollars in prots from markets using this principle. In Steinhardts case he considers a perception hes developed about a market which is at variance from consensus to be a variant perception. Technicals can be used for tracking variant perception among traders because traders using different types of data (intraday vs. weekly for example) draw varying conclusions about the import of adverse reactions. After a rally, offers begin to come in and price begins to drop which forces action. Sellers, whether bears going short or bulls liquidating longs, sell because they anticipate that price is going signicantly lower in the near future. If sellers think price is only going to move marginally lower, they would not feel any urgency to sell. Volatility fuels that urgency to sell and creates an exaggerated perception in the minds of sellers of price moving down to some projected price which longs believe is intolerable, and shorts believe is ample enough to offset their risk, hence they liquidate or sell short. This mental projection is essentially a form of negative sentiment and it directly correlates with short-term price action and volatility. In other words, a violent move down tends to equate with a more bearish (lower) projection than an incremental move down. Weve developed an indicator, called STS for shortterm sentiment, which plots a minimum downside projection where bearish short-term traders expect price to go based on the intensity of selling. In the PPH (Chart 3, right), the blue line, at A, is the STS or short-term sentiment plot of projected downside based on the onset of the sharp decline (from C). But, large specs and hedge funds are usually operating in a higher timeframe. If they believe a trend is in the process of reversing, they will often stalk a retest of the low for two reasons. One, many of them are moving so much capital that they have to buy weakness (absorb offers) in order to initiate large size positions. Two, many hedge funds trade with leverage so they must look for low risk entries which accommodates a leveraged strategy and offsets the probability of being wrong. Therefore, after a surprise swing up, smart money bids will stack up at specic levels
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underneath a market anticipating a retest of the low which facilitates smart money accumulation. We use technical tools that accurately determine where smart money bids will begin to defend (buy into) the retest, we call this the bid (or offer) line. The light and dark green dots (near D, Chart 3) represent our calculation where smart money bids are stacked. Now keep in mind, the smart money has superior odds because theyre trading WITH the Popper Principle: that unexpected market events foreshadow directional bias. In PPH, you can see the shortterm sentiment (STS) is below the smart money bid line (D), which means sellers believe price is likely to drop to a price level which is more pessimistic than smart money buyers, who are willing to accumulate at and below the bid line. This is an example of a technical-based variant perception (or divergence) between short-term sellers and higher timeframe smart money buyers willing to absorb offers at the bid line. We call this a TT (tribal tactical) buy. When this condition is realized, when smart money detects optimal trade location and the offers are absorbed, new bids come in and price often rises suddenly (see Chart 4, upper right). Lets review the Natural Gas example using the same tracking model. In Part B, we isolated a surprise swing up in Natural Gas (shown here at A, Chart 5, right). This subtle price action
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attracts the attention of smart money buyers who look to buy a retest which creates stacked bids under the market at D. Meanwhile, at C, the STS or short-term sentiment plot of projected downside drops below the smart money bid line (at D). In Chart 6, (right) we see that smart money buyers successfully defended the bid line (at D) as they accumulated tactical longs for a sharp move up. These are two classic examples of variant perception based on technicals and we alerted traders to both of these trades BEFORE the rallies took place. We issue these timely alerts via e-mail in a PDF format, titled Tribal Trading Tactics (if you arent getting them, sign-up HERE). Keep in mind, in markets were always dealing with uncertainty and probability; sometimes the short-term bearish sellers increase in number and intensity and overwhelm buyers and price moves on down and a tactical buy (or sell) fails so risk management is always important. RISK MANAGEMENT: For sellers to breech the bid line and negate the trade we need to see the high of a daily bar form completely below the bid line (lower light green dots) and for the low of that signal bar to be breached to the downside. We also provide a xed price level as an alternate fail-safe stop (not shown here). You can review that risk management process in more detail HERE. At the beginning of this tour inside the mind of the worlds smartest trader, I said the smartest trader in the world is formlessessentially adaptive by nature, moving between strategic and tactical behavior according to the type of market environment. Weve already described a model for tracking smart money behavior at a tactical level. To explore how the smartest trader in the world thinks strategically... Go Here

Tribal Trading Tactics and Ultimate Market Timing, Trend Dynamics are produced by Axis Analytics/Trend Dynamics, Inc. Web sites: www.Axis-Analytics.com and www.Trend-Dynamics.com PHONE: 805-481-4358 Fax: 805-714-3419 Mail: 122 Deer Trail Cir. Arroyo Grande, CA USA 93420. INQUIRIES can be directed to: Subscription Inquiries: Kristie Kophamer: subscriptions@axis-analytics.com Information Technology: Taher Mashour: subscriptions@axis-analytics.com