Friday, August 21, 2009

To those who do not believe the rally...

... I don't believe it either. But it sure didn't make sense not to get aboard and ride what has been a fantastic trend. My beliefs are that the country is on an unsustainable public debt binge that will end badly. But I don't trade on beliefs. I trade on price and it has been profitable to be long over the last 4 months that I have been long, with a short term shakeout last month. After reading a few articles on market makers, the markets make sense. There are a few investment banks that control where prices are going to move because they see order flow. They also know how to create order flow through price movement because they know human nature. Humans are psychologically trend followers. The tragic part is that they have a tough time dealing with losses, as in they will tend not to take a small loss. Instead they will let the loss grow in the hopes of price returning to breakeven.

Market makers use order flow to buy inventory at whole sale prices and then bid them up to retail "investors" who are watching the activity. When the activity is favorable, they jump in, generally with little thought to how they are going to get out. The market makers sell bits of their inventory on the way up, which can be noticed on volume spikes at extreme levels. These typically show up as reversal "dojis" on candlestick charts. After they sell a portion of their holdings, market makers are looking to replenish some of the inventory. So they bid the price down over time, looking to wipe out stops and limit orders. They do a very good job of wiping out stops at major moving averages like the 20, 50, and 200 day SMAs (which is why I don't use these averages). Once these stops are wiped out and sold to the market makers, they advance the price to favorably generate order flow in the positive direction, selling into the price increases. This process is repeated until the market makers have sold much of their inventory. Then they do the process in reverse by selling shares short and buying them back at lower prices.

All of this is detailed in Reminiscences of a Stock Operator. As a small retail investor, you have to realize what is going on, then react in a way that says, "I have to follow what the market makers are doing since I don't know what they are actually doing." This can be done by looking over longer time frames and reacting to slow changes in price and volume. Trend followers look to filter out the noise in the market and determine strategies to follow price manipulations by market makers as they change the direction of their campaign. I do have a cynical view, but it works.

On a side note, the 350 SMA was broken to the upside today. I would expect to see some major movement right now. If I had my options account up and running, I would place a straddle or strangle trade here to capture what I expect to be volatility in either direction over the next few months.

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