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FEATURE ARTICLE

by John Carter. Author, Mastering the Trade

With enough mental gymnastics, just about any fact can become misshapen in favor to one’s confirmation bias, which is the most effective way to go on living a lie.
Criss Jami, Healology

The Markets Are Volatile— Are You Fighting the Tide or Flowing with It?

For those of us that like to trade and invest in various asset classes, whether it is stocks, options, futures or crypto-currencies, there is one thing they’ve all had in common in 2020— they’ve all been extremely volatile, chalking up crazy moves.

And behind every crazy move sits a combination of happiness and pain. One trader is right. The other is wrong, and will stay wrong until they can’t take the suffering any longer. This is called capitulation.

No move lasts forever.

We tend to be attracted to themes that fit our inner perspective of the world. This is known as confirmation bias. As a trader, and as a human, it is useful to be open to the idea that our conviction of what we “know” to be true can have absolutely nothing in common with actual reality. Think the world is going to come to an end due to COVID-19? Then you’ll ignore the signs of a rally and get whacked. Think stocks can go up forever? Then ignore the possibility of any other outcome and watch your stocks fall in value. In trading, confirmation bias can create an immense amount of frustration. It causes us to automatically filter out any information that disproves our outlook and accept only the information that validates our beliefs. This is obviously dangerous when we consider our relationships with things like politics, advertising, and consumerism. As the saying goes, “Lies are only as strong as the suckers that believe them.” In trading, it makes us easy prey for the machines, which are trading without the burden of beliefs. With the markets, whether it is an individual stock, crypto-currency, or entire asset class, there are thousands of data points a trader can study, but the reality is that only a handful of them will make an impact when it comes to results. More importantly, confirmation bias ensures that people’s viewpoints are skewed towards projections of their own inner worlds rather than any form of reality. John Maynard Keynes experienced this phenomenon first hand. Although at the top of his game in economic circles, he speculated huge sums in currency trades and lost a lot of money by having the right idea at the wrong time. This led to his famous quote: “The market can stay irrational longer than you can stay solvent.” The need to be right does not sway the markets. In reality, the market is not truly as “irrational” as Keynes would have us believe. The markets move based on thousands of different confirmation biases coming together, as well as different entry levels, account sizes, and emotions. This creates patterns and “flows” that can make trading and investing much less frustrating, when and if we get in synch with them. The markets aren’t irrational; we are. Irrationality is holding onto a trade that isn’t working. Because of our inherent fondness for confirmation bias, we are often ignorant of our motivations and create fictional narratives to explain our decisions, emotions, and history without realizing it . . . all to stay true to our perceptions about ourselves and the world. But in the end . . . what we attach our egos to, controls us. Hard. In trading, we have the opportunity to discard this made-up narrative about ourselves, to detach our egos from the process. A trade is either working or it is not working, regardless of the story you tell yourself about who you are and what you believe to be true. If it’s not working, the trade is wrong, so get out. By basing your trading behavior in reality instead of just your perception of what reality should be, no narrative confirmation is necessary. Your ego, which thinks it is protecting you, but is in reality abusing you, is out of a job. It’s a much easier way to live and a much smarter way to trade. As a discretionary trader, your main job is to override the fictional narrative of your life and not let it interfere with your next signal. Reality and theory are often at opposition with each other. For every flash crash, there is a 7-year bull market. For every housing crisis, there is new technology that changes the way we drill for oil or introduces an unseen game changer, like the blockchain. COVID-19 will go down as something similar to the 1929 stock market crash. Yet the world will adapt and moved on. Fiat currency is fiction and we should only own gold? Yes, I get it, but Walmart won’t exchange your gold for toilet paper. It only accepts fake money. Facebook’s earnings are up 79% but the stock drops the next day? In theory, it doesn’t make sense. In reality, the markets are very efficient at pricing in news well before that news is known. Trying to make sense of the markets based on “what is known” vs. “all the bad things that could happen” is like trying to predict how the person you are dating will turn out as a spouse based on how he or she holds a fork while eating a pork chop. With the markets, most data points and most theories that are available to the retail trader are just as irrelevant when it comes down to understanding what is really happening. Not only are they irrelevant to what is going on, we are also filtering them based on our own confirmation bias. In other words, the information is doubly useless. The potential for bad decisions in this situation is mind-boggling. With the markets, we don’t know what exactly is going to happen next, but we can understand the foundation of how and why they move. Without this foundation, all trading attempts will eventually dissolve into a pool of frustration and disappointment. “What did I do wrong?” the trader thinks. “I read all the books and plotted all of the moving averages.” They didn’t do anything wrong. They just didn’t understand the basic foundation of how markets naturally ebb and flow in all market conditions. They key is to understand these movements and trade with these natural currents. We will never beat the Ray Dalios of the world in terms of market information, but we can wade into the surf, catch a wave, and hang on for the ride. And we can exploit our edge as retail traders, which is liquidity. We can get in out and of anything fairly quickly. Which brings me to how the markets move regardless of the news, regardless of our inner beliefs, and regardless of the latest doom and gloom newsletter you just read in your inbox.

How Do the Markets Naturally Move?

Just as the moon’s gravitational pull affects the ocean’s tides, there is a constant pull on the markets. Human emotions and algorithmic-based buying and selling programs impact the rising and falling of all markets as well as individual stocks. The more intense the human emotion, the more crowded the trade, the larger the market swings. And in the markets, just like the ocean, there are periods of normal movement and there are storms. Like an ocean, a stock chart has ebbs and flows, peaks and valleys. As prices make new highs, some people are taking profits, while others are finally jumping in, tired of missing out on the move. The next series of movements will reflect this constantly changing dynamic. Eventually, however, all of the water returns to sea level. All prices revert back to the mean, their average price over a specific period of time. In a sideways trend, stocks rise and fall in a narrow, flat range. Calm seas. Think of a boat rising and falling gently with the waves. This is telling the story that the market is currently fairly valued in the eyes of investors. In this type of market, inexperienced traders often buy the highs (because it feels safer) and get stopped out on normal pullbacks, only to see the markets rally yet again. In this environment, buying the highs and shorting the lows is like trying to lose weight by eating more Twinkies. It’s fun but the results will be frustrating. In sideways markets, emotion plays a big role in these seemingly small movements. There will always be a group of traders who are not in synch. They get in at the highs and out at the lows based purely on emotion, in a roller coaster that looks like the graphic below. Oddly enough, many retail investors do well in sideways markets. They like the short term action and they love to short rallies to resistance and buy declines into support. And while it is easy to see these ebbs and flows in a sideways market, it is critical to understand that these same ebbs and flows also occur during strong uptrends and strong downtrends. They move exactly like sideways markets in terms of the ebbs and flows, they are just doing it at a different angle. Think of it as an ocean slowly rising and climbing up a hill due to global warming. The ebbs and flows are still the same, but because the volume of water is increasing, the ocean itself is moving higher at the same time. To look at it another way, if we entered another mini ice-age and the polar caps started to freeze over, the ocean levels would recede, but the waves would still ebb and flow and pound against the shore as they fell back gradually over hundreds of yards and eventual miles. That is how uptrends and downtrends work. You get the same ebbs as flows as a sideways market, but the overall value of the stock or crypto-currency is either surging forward (uptrend) or receding (downtrend). The key is that, in an uptrend, we are seeing a series of higher highs (HH) and a series of higher lows (HL). And, of course, in a downtrend, we are seeing lower lows (LL) and lower highs (LH) on each consecutive ebb and flow of the current. Strict trend traders will look to buy the first higher high out of a consolidation period, and hold on until that trend of higher highs and lower lows is ultimately broken. The key is that, in an uptrend, we are seeing a series of higher highs (HH) and a series of higher lows (HL). And, of course, in a downtrend, we are seeing lower lows (LL) and lower highs (LH) on each consecutive ebb and flow of the current. Strict trend traders will look to buy the first higher high out of a consolidation period, and hold on until that trend of higher highs and lower lows is ultimately broken. With the algorithms and their constant hunt for liquidity, typically found in the piling up of trailing stops, there are more false bull and false bear moves than there used to be. But before we can discuss that, let’s understand the basic foundation. As previously mentioned, the markets are always ebbing and flowing in one of three patterns: sideways, uptrend, or downtrend. All three patterns have different sets of emotional intensity, which is why down moves are always faster than sideways or up moves. In a down market, fear drives decisions, and fear of loss will override nearly all arguments for calm and logic. In an upmarket, there is fear of missing a move combined with the euphoria of making money. In a sideways market, conviction is at low levels all around and boredom is often an overriding emotion. For the uninitiated trader without a well-thought-out plan, the above image is the cycle they will naturally fall into. It might not be true for the first few trades, but the more active they are, the sooner and harder they typically fall into this unwitting rhythm. They start buying at the highs, getting stopped out and, even worse, reversing and going short at the lows. Think of these as price thrusts followed by emotional reactions. The thrust is the initial move after the smart money has taken their positions. The emotional market slaves come in and start buying the stop of this thrust, right when the smart money is cashing out. The position starts to go against them and the reaction phase is essentially a map of how they handle this move against them. If they had a good entry and have been trailing a stop, they are getting out fast with a profit. If they took a modest position near the highs, they get stopped out at a normal level for an acceptable (though preventable) loss. If they took the trade at the dead highs on impulse and didn’t place a stop or really think it through, then they fall into the confirmation bias trap and typically get out only when they can’t take the pain of being wrong any longer. That typically marks the low, which is usually a great entry level if you are watching and are in synch with this natural market rhythm. Who is taking the opposite side of this trade when these emotional whip horses are getting stopped out? Hopefully, after reading this, it’s you. Let other people’s stop losses be your new entry points. Of course, there can be fake out moves, but these usually happen on the smaller intraday time frames. The larger the time frame, the more solid the pattern. It is important to keep in mind that this general ebb and flow applies to all timelines, whether it is a monthly chart, a daily chart, or a five-minute chart. A steep downtrend with lower lows and lower highs on a five-minute chart can be part of an ongoing sideways pattern on a daily chart. As a rule of thumb, I defer to trading the pattern on the larger time frame. That is, if the daily chart is in an uptrend, I’m not going to get too excited about a short signal on a 30-minute chart. I’d rather wait for the next signal on the 30-minute chart that is aligned with the daily chart. This way I’m swimming with both the tide and the larger currents that are driving the tide. We can see how these emotional reactions create solid moves whether the trend is up, down, or sideways. For option traders that focus on time frames that last a few days to a few weeks for their trading positions, it is critical to understand these ebbs and flows and stay on the right side of them. While traders can get away with buying a stock at new highs and holding through the reaction, that is very difficult to do if you are buying calls (in an uptrend) or buying puts (in a downtrend). With a stock, there isn’t any premium decay, so the price is the price. If I buy FB (Facebook) at $180, and hold through a decline to $175, and it goes back to $180, I’m now “back to even” on my trade. Had I bought 30 day out calls, however, the story would be much different. If I’d bought the $175 calls at $8 with a 30-day expiration, with the stock at $180, and then I held through two weeks of chop and a pullback to $175, and then FB finally makes it back to $180 with two weeks left on the option, they would be trading around $6. So, even though I’m back to breakeven on the stock, I’m down 25% on my option position and the stock will have to get back to about $182 before I’m breakeven on the option. When trading directional options, it is critical to be “in flow” with these thrusts and reactions. Another tip that will save an exponential amount of frustration? Even if you plan to hold the option for two days, buy one that expires in 60 or 90 days, the premium decay will be negligible, and it will be much more forgiving if you time it wrong. Of course, for more advanced option traders that understand premium selling and constructing a theta-positive position, there are tons of advantages to selling options against these natural ebbs and flows. Option traders hop over to the expert side when, on a pullback within an uptrend, instead of buying call options, they are selling puts, either naked or as a spread. First, think of the other person who is taking the other side of this trade. The newbie option trader who, upon seeing the market fall, uptrend or no, jumps on the bandwagon by buying puts at the current market price. Who is taking the opposite side of this trade? You are. Not only are you selling puts on a decline into support, but, should the market stall out and “just trade sideways,” you can still make money — potentially even your max target on the trade. Selling puts instead of buying calls on a pullback to support gives the trader a huge edge. We can see how these thrusts and reactions naturally create support and resistance levels. Many times, these levels line up with Fibonacci extensions such as the 1.272% extension (resistance) on thrusts, and with .382% to .618% levels holding as a general zone on reactions. Just keep in mind these all naturally work together in the context of this natural ebbing and flowing of the markets — and how far they move past the prior levels on thrusts, and what levels hold on the reactions. As it relates to option strategies, the biggest complaint I hear in a situation like this — and it used to be my own complaint as well — is that, on a pullback to support, by selling puts instead of buying calls you are limiting gains. It’s a valid point but it can be addressed by position size. If you are planning to buy ten call options at $6 and sell them near the expected move of the stock during the next week at $9, that is a profit of $3,000. But if you sold an at the money ten lot put credit spread, $5 wide at $2, and you bought it back at a reasonable 80% of max profit (0.40), your profit would only be $1600. The easy answer? Up your put credit size. If I sold nineteen of the same put credit spreads, and my target was hit at 0.40, then my profit would be $3040, the same as my long call position, and just enough extra profit to cover the additional commission generated with the increased number of contracts. Usually if I’m teaching a class and explaining this concept, a “Professor Hindsight” in the back of the room will raise his hand and proclaim, “But what if the put credit spread play loses money?” Lord almighty. As if the long call has no chance of losing money. But while we’re on the subject, let’s take a look at the risk involved. Ten lots at $6 gives us a maximum risk of $6000 if it goes to zero. “But,” the ‘professor’ says, “I would have gotten out well before it went to zero.” Yeah, sure you would have. Let’s go with the max risk anyway, in case you get caught up in confirmation bias and the need to be right. Nineteen lots of an at the money, $5 wide put credit spread at $2 has a max risk of $3 x 19 lots, or $5,700. In other words, the risk involved is the same, and the logical reward, based on the expected move, is also the same. The main difference? With the long call, the stock has to move substantially higher, very quickly, in order for us to meet our profit objective. With the put credit spread, the stock could trade sideways and even slightly down, and we could still meet our same profit objective. Once a trader grasps this concept, the light bulb comes on and never turns off again. By selling premium, you can be wrong and still make money. Except for Professor Hindsight. His light bulb is shining its own, special light that nobody else can see. Usually the next argument from this individual is, “Well, with the put credit spread, I’m risking $5700 to make $3040, which is lopsided, but with my long call, my reward is unlimited.” It’s a fair theoretical point. But while I’ve yet to see a long call go to “infinity,” I’ve seen plenty stay within their expected moves and lose lots of premium. Add this to the fact that the hardest part of trading is holding onto a big winner. If this is a problem for you, and it probably is, do yourself a favor and focus on capturing the “expected move” and get out and on to the next setup. You can make a great living doing just that. Remember, with trading, we want to play the odds, not smoke the hopium pipe. At the end of the day, selling puts at support instead of buying calls is always the smarter choice. The consistency you will see in your P&L curve will more than make up for the rare times you miss a huge run up (greater than expected move) by holding short puts instead of buying long calls. And, hey, with that nineteen lot put credit spread, you could still buy a couple of calls just in case it really takes off. If you have a pullback to support in an already existing uptrend, you can buy an in the money call or sell an at the money put (or make it a spread to reduce risk). You can of course also sell one standard deviation or higher puts and put credit spreads. While the probabilities here are higher, there isn’t much meat on the bone. And, of course, you can also do all of the above. Just get some of that premium decay working in your favor. If you have a rally into resistance within an already existing downtrend, then you can look to buy in the money puts and/or sell at the money call credit spreads. The principles are the same in both uptrends and downtrends. If it’s a sideways market, you can sell call credit spreads on rallies to resistance and sell put credit spreads on declines to support. I often prefer to leg into iron condors like this rather than doing it all at once. Last but not least, if a trader wants to save themselves a lot of frustration, just assume the trend is going keep on going until it breaks its current trading cycle. The trend is your friend until it isn’t. We essentially play the trend until it ends. We don’t want to assume that it is about to end unless there are clear signals on the internals, such as a high SKEW reading or a low ten-day put call ratio average. There are also signs that a trend is about to end and we want to pay attention to those. The first sign is that we go from a trending market to a sideways market. The next thrust higher fails but it hasn’t turned into a downward trend. This is where a buildup in volatility pressure can happen and this energy can be released to the upside or the downside. There are many instances where it looked like a trend “might” fail, but in trading, the easiest path to stay on is the path of least resistance. Just assume the trend is your friend until it betrays you, then switch to playing the new trend. In addition, patterns start to form at trend change points, and these patterns also take into account the thrust and reaction moves we are now on the lookout for. There isn’t always a squeeze, but when there is, the corresponding move up or down is usually very powerful and creates a “greater than expected” move. The ultimate decision is whether the market trend continues or reverses and starts a new downward trajectory. It is helpful to spot the signs that this is in the process of happening. In the image above, we see how an upward trend morphs into a head and shoulders topping pattern, all with natural thrusts and reactions. Right next to that, we see how a downtrend can form a reversal by having a thrust move fail, creating a higher low (HL) and a subsequent reversal pattern. When we zoom into these moves, we can see the precise price action we are looking for to confirm a trend change. In the image above, we zoomed in on the higher low to see at what point the trend change is confirmed. I’ve also heard stories about people blowing out their accounts because “they put it all on a newsletter recommendation.” This was true recently with the crypto-currency craze, with people taking out mortgages to buy Bitcoin when it was at 18,000. There is a tendency for traders to feel more confident in a trade because it is being recommended by somebody else. In reality, it’s just a trade setup like any other, and it is important that a trader not get lured in with a false sense of security that this particular trade is going to work out exactly as planned. Remember, it’s always just about probabilities and risk control. Don’t get overconfident just because you read about something online. That said, traders must realize that they cannot make a living “trading the news” off any financial news channel. By the time something appears on television, it is way too late to react. Huge trading firms have already heard the news, and by the time it makes it to the public, they are dumping these positions off to the person who just heard about it on twitter. If anything, CNBC can be used as a fading tool — taking the opposite side of the news. Just keep the volume off so you don’t get sucked into the nonsense. Instead of financial news, I prefer playing some “brain focus” music like the Mind Amend channel on youtube or www.focusatwill.com. This type of music increases focus by damping down our reptilian brain, which is constantly on the lookout for danger, food, or sex. It’s easier to focus when you put those biological responsibilities on pause.

In Conclusion

Traders who do this for a living spend their days waiting for specific setups to take shape.Yet one of the biggest weaknesses of most traders is a need to be in every move. If the markets start running away, many traders just can’t help but jump in, fearing that they may be missing something big. This is a fatal flaw that will ruin any trader who can’t control this habit. If there is anything I can hammer into your brain as you dive into the markets, it is this: it is okay to miss moves. Professional traders miss moves; amateur traders try to chase every move. By listening to music or keeping a movies or series on in the background, traders have something they can use to pass the time while they wait for their specific setup to take shape. This makes them less prone to jump impulsively into trades just because they are bored or because they can’t stand missing out on a move. The goal is not to catch every move in the market. The goal is to take the specific setups that you have outlined as a part of your business plan. Otherwise you are just a gunslinger, and sooner or later all gunslingers get killed.

“Traders must realize that they cannot make a living “trading the news” off any financial news channel. By the time something appears on television, it is way too late to react.”

– JOHN CARTER

Founder of Simpler Trading. Author, Mastering the Trade

“Traders must realize that they cannot make a living “trading the news” off any financial news channel. By the time something appears on television, it is way too late to react.”

– JOHN CARTER

Founder of Simpler Trading. Author, Mastering the Trade

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