mariao8kc: Stock Making Money

Today, I challenge the conclusions of a blog writer about markets, randomness, and technical analysis as a whole.

This opinion column could get exciting if the conversation continues beyond this challenge, and I hope it does.

Last week, Benzinga readers were alerted to a blog series challenging the effectiveness of technical analysis, especially the use of support and resistance on stock charts. The blog's writer, Adam Grimes of SMB Capital, makes a claim that almost any random line plopped onto a chart will behave like support or resistance.

He includes some nice examples, including a provocative quiz, and extends his theory to build an argument against almost the entire industry of technical analysis. (If you have not familiarized yourself with Grimes' six-part blog series, this might be a good time to do so.) His thesis is that the stock market is highly random - more random than most traders think - and therefore technical analysis tools (such as support, resistance, and indicators) usually provide no real "edge" for making money in the stock market.

Grimes' five-post argument, which can be found here, concludes in a sixth post that applies the thesis to real-world practice. Specifically, Grimes proposes a few profitable trading methods that allegedly do not violate the principle of the market being highly random.

I admire this latest post, as it moves beyond the academic nature of the former posts and addresses the personal implications of his thesis (which is always difficult work to do), as well as offering actual suggestions for action, rather than quitting after his critique. In other words, his final post took some guts, and I respect that.

However, I must admit that I feel slightly disappointed by the finale. I read the first five posts and was growing very excited that Grimes might actually reveal a trading method with a verifiable, non-random, profitable edge. Unfortunately, I must challenge him on his attempt. He has not.

More specifically, he has not actually shown his readers such a trading system, except in theory. I argue that Grimes' suggestions are far too general to actually be used for trading NYSE stocks. More importantly (and the fun part!), I extend my argument to challenge the use of technical analysis on any NYSE stock. Intrigued? Onward!

While awaiting Grimes' sixth post, I had formulated some guesses for what his conclusion might be. First, I had guessed that he might explain hedge-fund-like research for gaining a profitable edge based on special information. This is pretty standard fare in the finance industry, so this was my first guess. Interestingly, Grimes did not mention this at all.

Second, I had guessed that he might reveal a system for trading a "non-random" characteristic of the market - volatility clustering - which was the topic of his fourth post. Volatility clustering is a very human, non-random characteristic of the market, and there are ways to directly profit from it (like trading VIX long after unusual market moves). Although Grimes mentioned volatility clustering, he did not describe a way to directly profit from this characteristic of the market.

Third, I had guessed that Grimes might talk about tape-reading (one of the famous skills of SMB traders), arbitrage, dark pools, or some other way to trade based on inside knowledge of order flow. Grimes mostly overlooked these skills, however, and never mentioned ways to know more orders than the standard, public Level 2 orderbook.

Fourth, I had guessed that he might explain a news-based trading strategy (like buying volatility on certain news events).

Well, I did not find any of my guesses in Grimes' final post. No, instead, I found (in his words):

"Every edge, every advantage, we have as technical traders comes from an imbalance of buying and selling pressure." And again, as the ultimate application in the final section, "Limit trading to those times when there is actual buying or selling imbalance."

Aw. Really, that was the finale?

My disappointment comes for one reason: great idea, but how you can possibly know when that is happening?

How can you know when a stock has "buying pressure" or "selling pressure"? I mean, really know? I am not talking about 20/20 hindsight where someone pulls up a chart of a stock and jabs, "Can you see the buying pressure now?" No, I am talking about the right edge of the chart, that area by the margin that makes all bets fair and contains all the great mysteries of the stock market. Buying and selling pressure is easy when looking at a stock's history, but it is terribly difficult to know where people will buy and sell that stock in the future.

(If you think this is easy, maybe you should take the quiz again.)

The right edge of the chart is where consolidations look like breakouts, and continuations look like reversals. (I know some traders are grinning right now.) The problem with suggesting that traders "buy when there is buying pressure" is, well, the right edge of the chart. Because the right edge of the chart can look like *anything* you want it to look like. If all you have is a chart, NYSE's tape and stock chart, and the Level 2, then I have some serious doubts about your ability to judge when there is buying or selling pressure.

Track with me, because now it gets interesting. Quick.

My lingering doubt about using technical analysis for any NYSE stock is that the consolidated tape streaming out of NYSE headquarters is not the whole truth. It is only a tiny truth- a minuscule fraction of a stock's supply and demand.

Here we go. Do you remember back to your first days of learning about NYSE's tape (a.k.a. the "time and sales" of transactions from which a stock chart is derived)? Aha, let us quickly refresh. NYSE's tape includes transactions that are automatically or manually reported by the NYSE specialist or transacted over Electronic Communication Networks except - and this is a big except - transactions below 100 shares, dark pool transactions, options transactions, swaps, depository receipts trades, contracts for difference, delayed overseas trades, other derivatives volume, and delayed prints for "special" traders like specialists and majority shareholders.

Whew. Even listing out all of those hidden sources of supply and demand makes me cringe. Do you remember learning about any of those exceptions when you learned about the stock market?

These "other" transactions that never appear on NYSE's tape (nor your stock charts) can, at times, be the majority of a stock's price and volume history. The overwhelmingly vast majority! NYSE has warned investors that dark pools alone average 12%+ of daily volume (so that if a stock trades $1B, there was probably another $120M traded on dark pools that never made it onto the tape nor your stock chart). Moreover, this is only an average, so there are days when darkpool transactions are actually larger (reaching perhaps the majority) of NYSE public transactions on a particular stock. Even without these dark pools - just looking at NYSE's public tape - it is not uncommon for a given stock to trade a few hundred thousand shares during a day, and then suddenly NYSE prints a "block" of two million shares in post-market trading, which NYSE will say occurred "over time in the past." Do you recall seeing these prints? They show up all the time. These prints often come as a reminder for traders that some buying and selling pressure is invisible, occurs in hidden markets, is not reported in a timely manner, and can account for the majority of supply and demand.

But oh there's more.

So, we have recalled that an average of 12% of the true stock chart is invisible: historical price and volume data that is hidden in dark pools and never reported to the public. Moreover, "special" market participants have the privilege of delaying the printing of their trades, including specialists, majority shareholders, and several other classes of traders. Then, on top of all of this, we must also add the influence of High Frequency Trading (HFT), which is 50-70% of the tape (and, therefore, stock chart). Finally, we must add the biggest category of all: the effects of derivatives and funds markets. Here, I am talking about the influence of options transactions, swaps, contracts for difference, delayed overseas trades, arbitrage, foreign depository receipts trades, exotics, and other derivatives. These markets have real, non-instantaneous, and often massive effects on the price of a stock, and none of these effects have standardized reporting on the realtime tape or stock chart.

An example might help at this point. Say you are trading GE. You are watching bullish prints on the NYSE tape, a stock chart showing an strong upward trend, and a Level 2 orderbook that shows plenty of strong buyers willing to pay consistently higher prices. You determine that you have, as Grimes suggested, found "an edge" for a profitable trade based on "buying pressure." You buy GE.

Then, suddenly, a trader in Chicago buys 30,000 GE puts (contracts traded on a non-NYSE market that rise in value as the price of stock goes down). GE stock starts to collapse as news of this large transaction circulates, and you lose money.

Or maybe the NYSE specialist prints a delayed block of five million shares significantly below the current GE price, and GE collapses because of the surprise. Or maybe a darkpool trader sells a block of GE stock while buying it in his darkpool for better, hidden prices. Or maybe an international arbitrageur sells a block of GE because he is buying a paired, exotic option contract in Bermuda. The possibilities are endless.

So, what then? Well, beyond losing money, you are also forced to accept that the "buying pressure" you thought was there, was not really there. More importantly, you are forced to accept that you did not have sufficient knowledge to know if there even was buying pressure in the first place. Most importantly, you must consider whether you can *ever* have enough knowledge to determine if there is buying or selling pressure, given that you only have access to one data source (NYSE) that does not include dozens (if not hundreds) of other invisible and inefficiently-updated sources of supply and demand.

The point is not that one unusual event could occur in a secondary market and destroy one of your trades. No, the point is that invisible and secondary market transactions are occurring constantly, suddenly, enormously, unexpectedly, and are a significant (if not majority) amount of the true buying and selling pressure on NYSE stocks. At any time.

Which brings us back full circle. How can Grimes know that there is "an imbalance of buying and selling pressure" if over half of the tape and chart is HFT, 12%+ is kept secret on dark pools, and 100% is being randomly jerked around without warning by arbitrageurs, derivatives contracts, dark pool traders, depository receipts on alternate exchanges, exotics, and yet-to-be-reported "invisible" trades by privileged market participants?

So, there it is, my first challenge to Adam Grimes and all traders who use technical analysis to trade NYSE stocks. Can you explain how you can know if there is buying and selling pressure at the right edge of the chart, given the enormous and inefficiently-reported influence of outside money?

(I hope Adam Grimes knows that this challenge comes in good taste and good fun. Grimes is an extremely intelligent and gifted trader, and his opinion is probably worth many times that of a lowly staff writer for an opinion column. Nevertheless, I hope he enjoys a healthy debate every now and then; and why not discuss something so important for so many in the financial community. Cheers!)

Disclaimer: Benzinga has no affiliation with Adam Grimes or SMB Capital in any way whatsoever. This article was written to solely increase critical awareness of technical analysis, securities markets, and financial concepts. The views and opinions expressed by Adam Grimes and SMB Capital do not necessarily reflect those of Benzinga. Likewise, the views of this staff writer do not necessarily reflect those of Benzinga. Specifically, Benzinga realizes that technical analysis is a valuable tool for many traders and regularly provides diligent technical updates of the markets by experienced technicians for the benefit of these readers.

-- Aaron Wise

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Thursday, January 6, 2011

Stock Making Money

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