155 R U L E # 2 6
The Only
ties and capital—even now when electronic trading typically bypasses the traditional brokerage relationship.
One thing that remains constant in the process of financial evolu- tion is the concept of inside information. To this day, part of what peo- ple view as a trading edgeis knowing something ahead of time that is potentially market moving. This is not quite the same thing as a tip. Get- ting a tip means being advised what to do by someone who allegedly knows something. Market information or trading edge is more about finding a better way to do something that is already known to work. In the opening quote for this rule, it is apparent that Clemens understood the basic nature of the market and knew it could be exploited; his prob- lem was getting the information required to know whether he was in the right place at the right time. This is where the whole business of analysis and indicators came from—an attempt to quantify market in- formation to exploit what already works. The basics of trading have never really changed.
Remember, some of the biggest fortunes ever made from trading came at a time when the only tools available to traders were their guts, in- tuition, and knowledge of the crowd. I say this because, as you will have guessed by now, I put only a small part of my trade study into technical analysis. I know many will stop there and form some sort of value judg- ment. They might assume that because I don’t use what they have used, and they are making money with it, I must not know what they know; per- haps I don’t know the experts they know, or maybe I just have an axe to grind. They might say I am not qualified to discuss technical analysis be- cause I don’t use technical analysis the way they do. The proof is in the pudding, they would argue.
I say this about big-money traders and historical finance because suc- cess withoutanalysis is factual history—not because I feel that analysis has no place in trading. Quite the opposite. Successful technical analysis can be a very important part of lasting trading success but, as discussed in Rule #15, like it or not, it can only go so far. The fact is that using tech- nical analysis is like an unskilled carpenter using power tools. Without the basic knowledge of carpentry, an unskilled carpenter will make a wreck of house building when he is turned loose with better tools than he knows how to use. That brings us to this maxim of “the only indicator you need.”
But first we should clarify the thinking behind most of the indicators currently used. Most indicators and oscillators attempt to quantify the concept of overboughtor oversold. The psychology behind this thinking is actually very sound, in my opinion. The idea that the market can get overextended in one direction or the other is not a new idea. It is one of the cornerstones of successful trading. That is one of the concepts that
156 TRADER MAXIMS
ccc_trading_155-160_ch26.qxd 8/31/06 7:57 AM Page 156
will work for successful traders. The problem is not that the market can and will get overextended; the difficulty is in calculating when that point is reached. Oscillators and indicators are notorious for being laggingindi- cators for the simple fact that they are historical and not predictive. In most cases, due to the historical nature of these calculated mathematical concepts, they have often identified a reasonable overbought or oversold area but by the time the signal is verified, the 72-hour/bar rule (from Rule
#25) has come into play. The market you suspected was overextended has already begun correcting the other way, and usually that distance has been a substantial move already. Also, most oscillators and indicators are trend following; they help you get positioned in a trend but will never get you positioned at the turn. In addition, by the time the signal to enter the trend is verified and you execute, the very next correction will likely be right back to your entry price or a bit lower. No real progress in any case.
The newest class of oscillators and indicators attempt to be predic- tivein nature. Many of them are based on extremely complex computa- tions that can only be done in real time by computers. We call traders who use them the “black box” traders. Again, there is nothing wrong with this kind of approach except that it simply cannot account for the most critical part of trading: What is the crowd thinking?
It is crucial to remember when you are using oscillators or indicators of any kind that they are only mathematical computations. They are all moving averages in various degrees of complexity and performance. They are based on assumptions about the nature of markets and they work un- der the theory of probabilities. Behind all of these attempts to find a better way to do what is already known to work is the issue of historicalversus predictive. If you are willing to accept that indicators, oscillators, and technical analysis are historical and not predictive, you are left with the only indicator you really need: Who is getting in and who is getting out?
That brings us to the study of volume and open interest. In my view, this is the only indicator you really need because this is the only indicator that discloses fairly accurately what the crowd is thinking. Either people are getting into the market or they are leaving the market. Since we al- ready know that most active traders are losing every day, then we know that a change in open interest means people don’t want to play, are con- vinced they will win, or can’t take the pain any more. If open interest rises we can fairly safely assume that traders are confident to get into the mar- ket from both sides. If open interest is dropping we can safely assume the losers can’t take the heat anymore. If all of this is accompanied by higher or lower volume, then we can fairly safely judge the level of fear, panic, or hope that traders are expressing.
Now, to be fair with everyone, correctly reading volume and open in- terest is not as simple as I make it sound. But the underlying psychology
The Only Indicator You Need 157
ccc_trading_155-160_ch26.qxd 8/31/06 7:57 AM Page 157
will always be the same. By understanding the relationship between price action, volume, and open interest, you can get a fairly accurate read on what the crowd is thinking. Of course, this is an art form and not science.
Markets can change in character in a heartbeat and your understanding of V/OI may have been completely accurate 20 minutes ago but at this pre- cise moment something has changed. That is the dynamic part of trading and part of what makes V/OI so useful. V/OI is the first indicator devel- oped, and everything after is an attempt to improve upon what V/OI can do with one important difference: V/OI has no time/price relationship.
V/OI is historical from the point of view that it discloses how bigthe market is or whether that has changed somewhat. V/OI also discloses how thickthe market is and whether that, too, is changing. When you combine this information with a price advance or decline, you can discern whether more shorts or longs are opening positions or covering, whether they are executing more often or not, whether they are losing confidence in their positions, and a host of other types of information that make it possible to anticipate (not predict!) what is most likely to happen next. Once the market closes for the day and this data is compiled and released by the ex- changes, you have a fairly accurate picture of the mind of the market when you compare what you see to the price action and other indicators.
But because V/OI has no time/price component, you may see clearly that the market is setting up for a price advance or decline but there is no way to know how soon or how fast that change in price will occur. Al- though V/OI is the single most important indicator because it discloses the most likely thought process behind how prices got to be where they are, it still cannot predict or expose whether that thought process is ripe for change or whether the change is imminent. That is the whole purpose of all the so-called improved indicators and oscillators: to find the time/price relationship for that imminent change. The V/OI indicator shows you it is there; the others try to say the time is now.
If you personally had to choose between the two indications, “Some- thing in the market has changed” and “Whatever is coming, it will come at 11:00 A.M. tomorrow,” which would you rather have? In the case of the markets, knowing that something has changed is the better choice be- cause only one option is available: a reversal in price. Does it really matter if that reversal happens in the coming 20 minutes or if it will take 20 days, as long as you know that the change will most likely be in only the other direction?
As I have said many times before, I am not trying to oversimplify the issue of timing your trades. My intention is to help you understand that the first and best indicator will always be volume and open interest be- cause it provides a more critical component: the issue of a change to the structure of the market. In most cases, a change to the structure of the
158 TRADER MAXIMS
ccc_trading_155-160_ch26.qxd 8/31/06 7:57 AM Page 158
market means a price reversal of some kind because the traders who put the price where it is are no longer in the market. The thinking of the crowd has changed. Just knowing that piece of information can give your trading a distinct advantage. You just don’t know precisely when the change will result in a price reversal.
Before we close out this rule I want to sum up a few things. First, the study of V/OI is not a small one. You need to make a consistent effort to un- derstand how V/OI can and does change. It would be impossible in this book to have a discussion about all the different ways you can begin to in- terpret V/OI in the space we have. I have included titles in the Recom- mended Reading section that will help you better understand this important market study. Second, you must remember that all the other indicators and oscillators developed in the past 150 years are attempts to better quantify the price/time relationshipwith V/OI as the foundation to start from. V/OI quantifies the depth and nature of the game as it has been played to date;
V/OI tells you a change has happened or is happening. What you do with that data is a reflection of your skill at anticipating what is likely to happen next based on your understanding of the crowd’s needs.
Last, V/OI is never predictive. No indicator or oscillator can be predic- tive. No form of analysis can predict future price action with any degree of consistency. The important issue is to have the tools you need, and to know how to use them to improve upon what already works.
Samuel Clemens and the traders of his era didn’t have V/OI or any other indicator. If he did, he would have known exactly how to use it and what it means because he understood the basics to begin with. Focus your energy on learning the basics, then understanding V/OI. At that point the rest of your trading stands a good chance of falling into place as a winning approach.
The Only Indicator You Need 159
ccc_trading_155-160_ch26.qxd 8/31/06 7:57 AM Page 159
ccc_trading_155-160_ch26.qxd 8/31/06 7:57 AM Page 160
161 R U L E # 2 7