Is July going to be the top for several months?

An edited piece from Al Brooks. For those with mid-term market investments and wondering what might happen in the markets over the next few months.

There is a tendency for the market to have selloffs in August through October time frame. The 1929 and 1987 crash both were in October. Both crashes had more than a 10% selloff in August.

We are entering that window. Also, the Emini is overbought, and it might try to become more neutral ahead of the (US) election.

These factors favour a reversal down to the middle of the 3-year trading range within a few months.

Larry Williams, who is a well-known trader, uses his reasoning to come to a similar conclusion. He recently said that he expects the market to rally to around the old high into around July 27 and then turn down.

But why is the market still going up? Liquidity. The single most important factor over the past four months is Fed Governor Neel Kashkari’s statement on 60 Minutes in March that the Fed has “an infinite amount of cash” to protect the economy.

But as powerful as the Fed is, it will not bother to stop a 15% correction. Therefore, a pullback to 2700 can take place, despite the Fed’s proclamation.

Emotions, no thanks

To trade is odd, romantic, exciting, challenging and mundane all rolled into one. Anyone wishing to partake in such a pastime will experience many different emotions.

But that is the point, emotions, as any successful trader will attest, are the thing to avoid. So how do we do that?

Firstly, let me clarify what I mean by financial trading. To me, trading is working to a structured and practised strategy and timeline. It also comes with a clear understanding of the probability of one’s method based on (losses and wins) exit rules.

A vehicle for financial trades is via derivative speculation—an account that provides leverage controlled by a tradable margin by percentage.

For example, this might be via a spot, futures, options or contracts for difference (CFD). Or, if resident in the UK it could also be via a much miss understood spread bet account. Each has their place depending on a trader’s geographical location (and therefore access), strategy, timeline, size of consideration and understanding.

But, has nothing to do with emotion. The above are groupings in which we conduct our bets. Within which we stamp our authority. If we approach these groupings with any uncertainty, lack of clarity or perspective, they will rule us. That includes not taking a blunderbuss approach.

It will seem that a derivatives trader is always on a knife-edge of emotions. For example, patient on entries but not hesitant—and precise in the loss but variable in wins.

It occurs to me that how we take away speculation and reduce emotion is to make the decisions, as far as is humanly possible, mathematically. What we are attempting to do is anticipate the loading of a market, either long or short, by a few dominant institutions.

I say a few because with major currency pairings it takes more than one institution to move the price. Moreover, trading is a zero-sum outcome, which means that there is always someone (an institution) taking the opposite side of the trade. Our job is to align our entries with the dominant few.

Computers do a more significant part of a price move. Machines construct most trades following algorithmically (unemotional) programmes of entry and exit. It behoves us, as far as is structurally possible, to (manually) do the same.

What aspects of our approach can be mathematically structured? The entry conditions, trade amount regardless of stop-loss position, method of entry, stop loss positioning, requirements for an early (manual) exit, desired outcome or automatic exit point and (more advanced) exit flexibility.

The latter is advanced as it often disrupts a trader’s results by encouraging us to inappropriately hold a bet hoping for an inordinately more significant than usual gain. Therefore, for my strategy, I’m not talking here about particularly massive changes in exit criteria.

We have to be clear in our outcome desire. (1) You only lose when you sell, so don’t have a strict exit criterion. (2) Take lots of small losses holding for a ‘black swan’ event. Or, (3) take lots of small wins with a strict exit criterion. (Number three is my method of choice).

As any ‘long term’ successful trader will attest, the first point above is a dud strategy. And the next two approaches do not, in my experience, coexist emotionally.

What is most important to the short-term trader?

What is the thing that I work on the most in my trading?

I get asked this question, or similar, a lot. It’s a bit like the question I got when a very junior pilot (actually, I was between flight training courses) when I had a week standing next to a plastic mock-up of a Hawk trainer on the south coast. That particular question, with little variation, was “how fast does it go (Mister)”. Closely followed by “what does the point on the front do—is it a gun?”

The answer to the trading point, like the pilot question, has a reply that can be simple or in-depth. For the Hawk response (to the beach holiday crowd, bless them) I realised the top speed in a relatable format irrespective of flight conditions—namely altitude—was everything.

I have to admit now, some 40 years after the event, and pre-Top Gun movie, that for the “point on the front” the answer being a pitot-static sensor understandably got blank looks far better that I did not disagree with the gun theory!

For the trading answer, it is context, entry identification, risk (including spread) and, last but not least, exit criteria. Okay, slightly more depth but you’re not the south coast beach holiday crowd.

Let’s consider spread again. I’ve talked about it previously (maybe a few times), but it always deserves a fresh look. I bring it back up now as recently my stop-loss positions have tightened. A stop-loss order ejects a trade automatically. Traditionally, it is a level at which a trader has ‘got it wrong’ and needs to get out.

The amount risked, from entry to stop, needs to be consistent with each trade.

As an aside, the risk is significantly more detailed. Nassim Taleb describes this best in his thought-provoking book ‘fooled by randomness’. Best read on an electronic device as, if like me, you’ll need to make good use of the thesaurus facility.

My ‘stop positions’ nestle well inside the ‘you’ve got it wrong’ level. Why I do this is for another discussion. But what it does reemphasise (because of the tightness) is the importance of working with the spread.

Note: If a trader is thinking of following suit with particularly tight stops without first solving the contextual, and other issues, as mentioned above, you will be throwing your money away rather rapidly.

Spread is similar to holiday money exchange. For example, today, we get 1.26 US dollars for a pound. But, of course, we don’t. Because of the exchange fee, we get nearer one for one. If we exchange £100 the cost is annoying but no big deal. If, however, we’re exchanging £100 dozens of times a week every week, then we can see why this would need careful consideration.

The spread in trading is the brokers’ fee. Investor deals entered with wide-stops, and over immense periods have little concern in this regard. A trader’s success, however—with tight stops and sharp targets—is defined in large part by the spread. (For the short-term trader, I notice that planned profit is adjusted down by a third due to this fee.)

The three things of concern to a trader are risk per trade defined as a percentage of the account, R (meaning reward/risk, or the amount of reward achieved on average over and above the average loss) and the win rate defined as a percentage.

Therefore, a trader’s R may signal a winning formula. But when we factor spread into the equation, the consequential reduction in R reverts the (probable) good results into a losing strategy.

A final point on the matter is that successful retail and professional traders have a method that one way or another follows on the coattails of winning institutions—institutions are not burdened unduly by the spread.
Trading is not a level playing field.

Short term traders that don’t consider all the implications of spread very, very carefully are the same as those who were happy to hear that it is a ‘gun’. Rather than acknowledge the more complicated and crucial truth that it is an essential (if not rather comparatively dull) ‘pitot-static system’.

The bigger picture

I lost a few points on the fund this fortnight but started a real pullback by Friday’s close.

Market cycle

A transition in the market cycle is always a good excuse when traders drop a few percentage points. So, I will try not to use it here.

It is a weak excuse as markets are transitioning, relative to one’s timeframe, routinely.

In the lower timeframe of day and even intra-day bars, some news events can change the cycle. For example, this week, Apple announced the closing (again) of some of its USA stores which had an unpredictable effect on the stock market and probably various currency pairings short term pricing.

Therefore, this market transition thing has got to be realised and managed better. We do this through such choices as being careful of overall exposure in any one market—because the Apple thing was unforeseeable.

What is a market cycle, you ask? Students of Wychcroft and the like will be able to go into great detail. However, for our purposes, a market is either trending or ranging.

And a market tends to spend significantly more time ranging than it does trending.

In this regard, a pattern is identifiable after the event. The anticipation of which is the tricky bit for a trader.

Upper timeframe

A few clues help. Observation of a higher timeframe structure can be instrumental. Either via an appropriate indicator or, as is my preference, viewing a representation of a more upper timeframe chart.

Indeed, not to do so is like a professional footballer only watching the ball and not taking into account the full picture of other players on the field.

To only chase the ball is what defines an amateur footballer!

I trade the hourly charts. That is my anchor timeframe and the one in which James will analyse to the nth degree—including micro, anchor, contextual and macro information.

However, as with our intrepid footballer, a regular glace up at the ‘bigger picture’ really helps.

How to choose what FX pairings to trade

The last couple of weeks have been steady for the fund.

The currency pairings that we trade were increased again from several to a couple of dozen.

I wouldn’t view so many if I weren’t working with a full-time analyst—someone to take the analytical strain.

Indeed, when James was on paternity recently, we felt it prudent to reduce our traded pairings significantly.

How do we choose what to trade?

Many traders would reduce to the obvious, which are those pairings with the lowest spread.

As a reminder, the spread is the broker’s charge. If for example, we traded NZD/CAD (that’s the New Zealand dollar and how it fares against the Canadian dollar) that particular pairing would most probably have a high spread in comparison to others we trade.

If we entered an NZD/CAD trade and exited immediately, we would have a high cost relative to, say, trading the EUR/USD.

However, it is not only spread size that counts.

The experienced trader is looking for trades that provide an edge: (1) The market cycle of the pairing; (2) consistency or recent predictability measured against our recent success in that pairing; and, (3) the size of tails on bars on our time frame and over a relevant timespan. These would be a few things that we’d consider.

With the last point, some currencies are commodity-based. Hence short-term volatility at times. Moreover, some money markets and associated pairings are more active over our night-time.

We have to consider all this. Particularly recently as the market has been significantly broader in its price movement relevant to our timeframe.

Therefore, going back to a full suite of currency pairings, is that necessarily a good idea?

It comes down to discipline.

If we weren’t stubborn about our trading strategy and objective, it wouldn’t work. James will analyse each of the pairings, but day to day and maybe week to week, the majority of pairings will not present us with a trade opportunity because of some of the reasons already mentioned.

However, we’re never sure at what point that will change. Sure, if trading an hourly timeframe, the change isn’t minutes but probably days.

Nevertheless, we stay on top of the analysis so that everything is in place when the trade entry presents itself—which it always does.

Pesky swans

How a loss this month has led to a credible improvement.

In the first part of this month, I dropped the fund several percentage points before I picked up my game. We currently stand slightly below where we started at the months beginning— now moving forward again diligently. Why did this happen?

One poor aspect of my management, I came to realise, was my protective stop flexibility.

A stop, as I’m sure you’re all aware by now, is a get out of dodge level. It is a level that says, if the price goes beyond this point, then I’ve got it wrong. It is an automatic cancellation of the trade.

There is a little more in it than that as a stop can be a regular variety or guaranteed. But let’s leave that discussion for another day.

The 1% rule

By flexible, I mean that I had the habit of altering my stop to prevent small but accumulative losses. That rather defeats the point of a well-placed stop.

Why would I have done that? It’s an incorrect mindset thing. As I’ve said several times, I tend to risk 1% of the fund with each trade. My strategy is that we may lose that single per cent but with the proviso that our wins are, on average, bigger.

The 4% rule

That’s super, but unfortunately, I had another rule which was not to be committed overall by more than 4% of the fund at any one time. Meaning I could trade four single percentage loaded trades on the same or different currency pairings.

Where this comes unstuck is when we are trading overall at less than four percentage points.

Bad habit and ‘black swans’

My bad habit was that instead of taking a small loss, I could move a stop as long as I didn’t have an overall loss of more than four percentage points—a critical flaw.

A loophole to my thinking. It was also a loophole that paid very well towards the fund, as I had few small losses. But it left me vulnerable to ‘black swan’ occasions where the unexpected happened, and 4% could occasionally become many times greater.

Those rare events could occupy most of our trading margin for extended periods—not a satisfactory situation.

I rewrote my trading rules to close the subconscious loophole. And the reason for losing several trades early this month was, I think, a consequence of this much-needed change.

Somethings had to improve

Without the flexibility of moving a stop from its single percentage loss level, I had to get appreciably better at trade selection and the placement of that (unmoveable) stop.

In turn, I think that has led to our improved real-time coordination between analyst and trader—[As you know, James has been on paternity but is now back almost fulltime]. We have developed our Skype screen share of James’ charts and with real-time trade audio.

The responsibilities of the analyst and the trader are clear. Still, the ability to define individual trades in real-time and in terms of probability and improved definition of an entry, stop and objective have gone stratospheric.

In other words, as you can probably tell, I’m pleased with the change and where it can lead us. And without those pesky swans!

So why is the stock market rallying if 20% of the country is unemployed?

Our thing is day trading—holding as necessary out to a couple of days. We trade currency pairings both long and short. We read the markets price action—the value, setup and signal. We do this technically, which means we read a chart and without the undue concern about fundamentals.

However, you also have money in medium-term funds. Al Brooks is an exceptional short term trader and teacher. Those abilities have technical relevance in all timeframes. Here is what Al says about the medium term. It relates to the S&P 500, but as we have noted before, all markets in some way or other will follow the S&P—often much slower if it’s good news, but much quicker if it’s terrible.

With interest rates at or approaching zero, you may be thinking that the medium-term share/stock market is the only option. Maybe, but I’m content taking the short term technical view. Below explains why.

How far will the stock market fall?

The pandemic will lead to unemployment comparable to the Great Depression that started in 1929. The stock market fell almost 90% from its peak in the 1930s. Why is the market rallying so strongly when the unemployment and GDP now are the worst since the Great Depression?

One reason is that we now have a Fed; brilliant, bold people who have learned from the past. The Fed Governors have said that they will effectively create infinite dollars to prevent the destruction of the economy. Investors see that as the Fed placing a floor under the market. 

I think investors and traders are getting this wrong. The market is down only 10 – 20%. The Fed’s floor would be around 50-60% down from the high. There have been many selloffs in that range since the Depression, and we completely recovered each time. I, therefore, think that the Fed’s real floor will be about 50 – 60% down from the high. The market is up in part, simply because investors believe there is a floor somewhere. 

We live in a country (US) with a relatively free market. The Fed wants it to stay that way. They, therefore, will not intervene as quickly as many investors hope.

Investors and traders who are buying at the current price think they are buying just above the Fed’s floor. They are not. The base is far below, and these traders will discover that the support that they expected is not where they assumed it would be.

The rally is technical.

So why is the market rallying so strongly? The pandemic (we assume) is not going to be as bad as the bubonic plague in Europe in the 1300s. Also, institutions love what the Fed is doing. 

These are both necessary for the rally, but the sine qua non is the technical or chart pattern.

The market is merely repeating a behaviour that it has done thousands of times on all time-frames. It is no more complicated than that. Experienced chart readers know that, and they are trading with that expectation. 

The stock market probably would not be able to do it as strongly as it has without the (good) news about the pandemic and the Fed. However, that technical pattern merely is unfolding as it usually does. 

Traders and investors should soon expect a test back down, and then a trading range. That range will be a continuation of the last 30-month trading range, and it will probably last all year.

The stock market and the pandemic

Al Brooks is a trader and previously a physician with some virology expertise. These are his (re-written) thoughts on the pandemic and its effect on the stock market.

Impact of the pandemic

When the pandemic struck in February, traders were confident of one thing. They knew it would drastically change the behaviour of consumers. 

Since consumer spending is responsible for 70% of the GDP, companies would make less money or even lose money. Earnings determine the value of companies. If the total revenues of America’s companies were going to be less, the price of stocks had to fall. 

No one knew how bad the unemployment and the reduced spending would be. But everyone knew the economy would be wrong. It took a while for America to conclude that life will not get back to normal until there is a vaccine next year.

The stock market leads the economy

The stock market is a futures market. People buy a stock based on what they think the price will be in the future. Therefore, the market typically goes down before there is a recession and up before a recession ends. 

The market has rallied sharply over the past four weeks. Traders concluded that a 34% reduction in the stock market’s price was more than what was needed. 

The market is now in search of a price that is appropriate. Traders concluded that the February high is too high and the March low is too low. Somewhere in the middle is just about right. 

It will take many months to find the theoretically fair price. As traders become more confident of what the reasonable price is, the legs up and down will get smaller. 

After many months of equilibrium, traders will become confident that there is no more significant risk of a 2nd or 3rd wave of infections and economic damage. Traders will begin to ignore the pandemic and then life will start to get back to normal, or at least a new normal. Once that happens, the bulls would try to create a rally to a new high.

The vaccine will probably work

Traders want to know that a vaccine will work. Vaccines work for most viruses, but not all. HIV is an obvious example. It took decades to create a reasonably good treatment for people infected with HIV. A satisfactory treatment is one that helps the patient and dramatically reduces the chance of spreading the virus to others. 

For COVID-19, it would probably also take many years to develop a comparably effective treatment. Treatment without a vaccine would have the world living with the virus indefinitely and possibly forever. That dismal prospect would be a chronic weight on the economy. 

Remdesivir might help

There was a report this week from the University of Chicago, concerning Gilead’s Remdesivir. They used it to treat 113 patients with severe disease—most discharged within a week. 

While it is good that the drug appears to reduce the death rate, it is not enough to make American life healthy again. Being on one’s death bed and then surviving is better than not surviving. But whoever wants to be so sick that he is on a deathbed? That is not our regular life.

It is important to note that there are politics in everything, including medical research. Also, there are statistical abnormalities that result in what appears to be a good result but is just a coincidence. Doctors know this and therefore want to see similar results from several medical centres before being confident that a drug is beneficial.

What traders want from a vaccine

Traders want a vaccine that will prevent infection in a large percentage of the population. For example, the flu vaccine only works in about 70% of people who get vaccinated. People want a more reliable vaccine than that because COVID-19 is a more severe illness. Traders also want the protection to be permanent or last at least several years. 

Viruses mutate. If they mutate enough, the old vaccine is ineffective.

Finally, traders want to be sure that a vaccine will not have horrible side effects. If it does, many will refuse to get vaccinated. The result will be lots of people choosing to risk getting sick and passing the infection to others. That would prolong the damage to the economy. 

These uncertainties will be here for another year. That will probably keep the market sideways into 2021.

But what if the pandemic is not the main problem?

The stock market was the most overbought in its 100-year history. It will probably take a decade for the fundamentals to catch up to the high price. 

That is what happened after the buy climaxes in the 1960s and the 1990s. Each led to about a decade of sideways trading. There were 50% selloffs and 100% rallies, but the market was in a trading range. The market sometimes made new highs, but they led to a reversal back down instead of a bull trend.

The stock market has been in a trading range for over two years and will probably continue so for the rest of the decade. However, there will be at least one more new high. It might even come next year. But the market will likely have a difficult time getting far above this year’s top for a long time. 

Don’t lose money

Don’t lose money, is a Warren Buffett motto.

The sentiment applies to all investments, but as a financial trader, I need to be clear in my mind what this message means.

My goals are: (1) protect the account, (2) make some money, (3) make a lot of money.

As with any business, and unlike investing, to trade necessitates taking losses. It’s part and parcel of doing business.

Protect the account

Protect the account (or don’t lose money) means to follow the rules. Such rules have to be agreed, understood and written down. Determining trade guidance at the point of or during a trade’s activation is unacceptable.

If you glance at my trading plan, you will notice that the rules are not complicated or excessive—however, they are necessary.

For instance, before taking a trade and as part of my strategy I need to be sure that a potential reward is at least equal to my initial risk; and I need to trade at a size that if lost will not break my 5% weekly rule. The list goes on.

As an intraday trader (which means I mostly day trade but now and again trades will be held overnight) trading is relaxed, but at the moment of a trades activation, it can all happen in moments.

If I break a rule, it is classified as a mistake and needs to be brought out in debrief and corrected—irrespective of whether the outcome was positive.

Protect the account does not mean to be tentative with a trade or take profits too early. It means don’t make mistakes—don’t break the rules.

Make some money

If my rules work, and I don’t break them, and my methodology is sound, after one hundred trades (about 30 days) I am sure that I will make some money.

And that is the bedrock of it all—doing the same thing well over and over without mistakes. If I do that (we) will profit.

Make a lot of money

Albert Einstein famously said that compound interest is the most (potent) force in the universe.

How to make a lot of money is compound the trade amount. I do this at the start of each week. I adjust my risk/reward percentage to reflect the account size. (Note: if not an expert then a monthly adjustment is more appropriate).

If I follow my first and second goal, then the third (the real purpose of it all) will happen.