AT THE CLOSE
Understanding The Trading Environment
Spending time to assess the market environment you are trading is a good habit to develop.
I have a lot of trading experience from trading — some good, some bad, but great lessons all. One of the lessons I’ve learned has been about the use of the chart. Understanding the chart is important. Understanding what drives the chart is invaluable.
I use the Market Development and Market Structure methodology. What drives the method is Auction Market Theory, where a willing buyer and a willing seller agree on price. When you have many buyers and sellers coming together and agreeing on price, they determine where value is for whatever commodity they are trading. It is the determination of value and depicting value on the profile chart that gives us the information that is the basis of a trade or investing strategy.
Making an agreement
Behind the buyer and seller agreeing on price (value) is a greater force that makes the determination of value possible, and that is the psychology of the players in that market or instrument. When the trading psychology involved in a market or equity changes its outlook on that market or equity, it will move price (value) to a different level. Understanding the mindset of the players in a market can give an advantage in trading and investing.
For example, the stock indexes have been trading in wide ranges recently. They are markets in search of value. The trading psychology is such that the traders are not sure where value is. Therefore, they keep driving prices up and down in search of that value. So if psychology drives perception of value for traders, what drives psychology? One of the largest influences on the psychology of a trader or on a market as a whole is the environment of that market.
Here’s another example. A market is made up of people. If you put all those people in a room and asked them to trade a product, they would bid and ask until they came to an agreed-upon value. Most likely, each would feel he or she had made a good deal, so the trade would be facilitated. If you were to introduce into that room new information that changed one or the other’s perception of value, then the psychology of the room — the market — would change. This would then change the determination of a fair price, and price will be driven up or down until they again agree on the value.
Thus, if the trading psychology determines value, and the environment in which the trader trades determines psychology, then it must be important to understand that environment. More important, we must anticipate changes to the environment that will have an impact on the psychology because that will have an impact on price.
By understanding this, we can go back to the example. We are currently experiencing wide swings in market ranges. With Auction Market Theory, these are markets in search of value because the trading psychology has changed due to the shift in the marketplace’s environmental conditions. This causes large vertical swings in different directions every other day as the psychology changes in the interpretation of new environmental information or the perception of information coming into the market.
Environmental factors
Currently, we are experiencing a great example of environmental factors affecting trading psychology and therefore value. The US economy is facing two distinct environmental issues: financial distress and an economic slowdown. Traders have focused on the financial distress in their determination of value. As the credit and housing crisis gets worse, price is driven down. As news of possible solutions is revealed, price is driven up by euphoria over averting an increasing crisis. The market psychology changes every other day as information switches from fear to euphoria.
If you understand the trading environment, you can gain an edge in the business by comprehending the competitive environment you are in and what you must do to be successful. It is important to understand the environment of the market you trade.
As we begin the trading day, we must ask what the market environment is going to be that day. What information could come into the market that may change the trading psychology and therefore price? Once these questions have been answered, we can develop a good trade strategy using whatever methodology we have developed. Developing a good trade strategy is critical to success. Many traders think they can develop a few tactics without fully understanding the market environment. Once you understand the environment, you can develop a strategy to approach it. When you have the strategy in place, you know what information the market will have to give you, or what it will do before you look for a tactical setup.
Coming back to our current environment, if the financial crisis finds a solution, the trading psychology will be such that traders will feel more at ease about buying, and a relief rally will ensue. However, from an environmental aspect it is important to remember there is another influence that must be dealt with, and that is an economy in a recession, where credit is tight.
Changes
It is not my purpose here to discuss the fundamental or economic reasons behind environmental changes, but to provide a good understanding of recognizing the environment you are trading in and how it may influence the psychology of traders in that market.
As an example, about a year ago, I had a longer-term position in a gold stock. The company had as one of its greatest assets a gold mine in Bolivia. After holding the position for several weeks, I heard that the president of Bolivia was considering nationalizing the natural resources of his country not unlike what Venezuela had done. That was an environmental factor that would affect the psychology of traders in that stock. It certainly affected my psychology. I liquidated the position and, a few days later, I was pleased that I had.
It is a similar situation in trading futures. You can take a position in a market based on a strategic analysis and tactical execution. However, if you are unaware of changing environmental information, you may have set yourself up to be run over.
As a trader or an investor, you are a money manager. As a money manager, your job is twofold: capital preservation and to gain a fair return on capital. Taking into consideration, the environment is a tool and a necessity in your trading that will help preserve your capital and assist you in gaining a fair return on that capital.
Assessing the environment
The trading psychology and the environment that may affect that psychology are important, no matter what methodology you use. Before each trading day, always make an environmental assessment of the markets you are trading, as it will help you to be long, short, or stand aside.
Joseph J. Mertes is the author of The Markets in Development newsletter and advises individuals and institutions in the use of Auction Market Theory, the application, and principles involved with developing, implementing and controlling a professional business approach to trading and investing. His focus is on building technical skills to recognize full trading potential with an emphasis on reward to risk strategies, money management techniques, and the use of diverse instruments to enhance profitability. He may be reached via www.josephjames.com.