Introduction to Technical Analysis and Market Influences

Transcription

1 Introduction to Technical Analysis and Imagine the world without technical charts or analysis software. Most of the charting was done with hand. During those times, percentage stop losses were popular. Technical analysis and charting came into existence during 1960s-1970s. And with evolution of technology, different indicators were introduced which replaced the primitive ways of analyzing stocks. Technical analysis includes technical charting and fundamental charting. Many times, people end up losing money because they don t ask the right questions at the appropriate time and therefore enter the stocks at wrong time. Have you ever thought, From technical charts, how do you determine what the market conditions are like? How do you determine how you're going to trade? Who's in control of price right now? Finding answers is easy, although it requires time and patience, but most importantly determination to explore, and think differently. People on Wall Street are no better than us. They just know things that we don't know; an understanding of market dynamics is a key component of being a successful investor. Market Structure and Dow s Theory A person watching the tide coming in and who wishes to know the exact spot which marks the high tide, sets a stick in the sand at the points reached by the incoming waves until the stick reaches a position where the waves do not come up to it, and finally recede enough to show that the tide has turned. This method holds good in watching and determining the flood tide of the stock market. Dow wrote this theory back in the 1890s; it was a series of articles for The Wall Street Journal, and it eventually became the basis of technical analysis. He hypothesized that the market moves in waves (he went to the beach and he saw the ocean waves coming in and that's where he came up with the theory. It was brilliant then that still stands). Rising Tide Equity Research ~ 1 ~

2 Informed buyers or bankers, wealthy individual corporations comprised fifty percent of all the market activity. Then came the average investor who accounted for forty percent of the market. So on the first dip, when the recommendations came out, is when the average investor or average trader came in. There was no concept of low short-term trading in the market in those days, and the uninformed investor accounted for the remaining ten percent. The uninformed investor came in at the end. He didn't have a lot of money; it was often uninformed investors buying at the top and then the cycle resumed because informed buyers sell at the top. The average investors would sell mid-way to two thirds down, and the uninformed investor would start selling out and then informed buyers start by coming back in. All basic trends and technical indicators today are based on this logic. Things have changed a century later. Computers are controlling the trades, and huge institutions bet money on market. The professional side of the market is very different than what most retail traders think. The retail side of trading is a very small world. The professional side is gigantic, spanning the globe in numerous interrelated financial markets. In order to be consistently successful one must understand the basic structure of the global stock and financial markets. Cycle of Market Participants This is the cycle of market participants we have today. There are nine distinct institutional and small lot market participants. Each group is separated out by how they buy, how they sell, how much money they have to invest, whether they're investing or trading on behalf of another person or if they're trading on behalf of themselves. All these different levels of the market participants cycle impact the market and make it much more dynamic and challenging for retail investors. Rising Tide Equity Research ~ 2 ~

3 High Frequency Trades and Dark Pools High frequency trading is an automated trading platform used by large investment banks, hedge funds, and institutional investors which utilize powerful computers to transact a large number of orders at extremely high speeds. General trading public became largely aware of this trading methodology following the 2010 flash crash. Here are some links which explains what happened: High Frequency Trading (HFT) is a huge sector in the global financial service industry. It even has its own conference internationally. It is not limited to the US or any one country. HFT is not going to go away. In fact, the sector has been growing exponentially. What is happening is that the governing bodies of the financial markets are investigating HFTs practices and creating rules and regulations in order to maintain an orderly and fair global market system (They are currently facing many new regulations the requirements in particular from the US SEC). These trades often occur ahead of some other investor participation, and allegedly increases the bid or decreases the ask of that security for that investor, thereby causing the investor to pay more for the trade. HFT helps squeeze money out of the bid/ask spreads, typically at a detriment to the retail investor. The trend of squeezing the spreads began on April 9th, 2001 the SEC required all US exchanges to convert trading from fractions into decimals. Prior to this change, the minimum spread between the bid and ask was 1/16th or $ cents. By converting to decimals, the potential minimum spread became $0.01 which was beneficial to all investors, because it substantially reduced the possible spread that a trader or market maker at an exchange could take for crossing a buy with a sale. With the introduction of Quad processors, HFTs can happen even faster. During this period there was a reduction in few banking regulations so that the banks could be trading high frequency. This changed the playing field for retail investors in that these large institutions were able to trade on the millisecond and retail investors were hindered in their ability to compete with these institutions. Furthermore, this deregulation created dark pools where these large players could trade on their own and their own agenda. These developments represented a paradigm shift in the matrix and the underlying dynamics of the market structure because there became different investment groups trading at different frequencies. High frequency traders are not day traders or floor traders, nor are they actual human beings placing orders. HFTs are computer generated order processing systems that uses algorithms to search for order flow that can be exploited to the advantage of the HFT company. There is no trader pushing the buy or sell order. HFTs trade in all the financial markets across the globe in every country. The algorithms are designed to find even the slightest arbitrage or cluster orders and trigger automated orders. It is completely automated. Algorithms are written by quantitative analysts with the most advanced programs based on quantitative analysis formulas that seek out sets of specific criteria. Essentially, banks, investment firms, or market makers who want to do HFT trading will go to a quantitative analyst who will develop formulas based on the criteria they're looking for and then that goes into the computer and the computer triggers the orders. For example, one of the HFT's favorite algorithms is to interpret earnings reports. They're able to pull that news out a millisecond before it arrives over at the retail side and it triggers the HFT orders. Rising Tide Equity Research ~ 3 ~

4 Retail trading systems are not as sophisticated as professional trading platforms, but retail trading systems attempt to mimic professional quantitative systems by using popular indicators such as MACD/Bollinger bands. This is rather primitive, and over simplistic algorithm. This creates cluster order flow. HFTs use these indicator formulas to find anomalies in cluster order flow. When cluster orders are identified by the HFT formula, it triggers automated electronic orders that cause whipsaw action in retail trades. Below are some mathematical patterns for normal trading orders, HFTs and dark pools. Normal order flow pattern: Assume there is an investor who has little market experience and thus purchases a stock with a market order. The investor is paying a high price on the bid/ask. Normal bid/ask will be separated by a small gap, and changes with the function time. Cluster pattern: Look at the slanting triangle. This is caused when HFTs compete with other HFTs thereby increasing bid and ask in matter in few seconds. Dark Pool controlled order pattern: Dark pool patterns are hidden (they are able to trade outside the normal exchanges) and they buy in a very tight range. The dark pools don't like to have anything disturbing their activity so they rarely purchase large blocks of shares, but buy millions of shares over several weeks. To do so, they go off the exchanges and trade in these dark pools. They buy in incremental orders, which don t become evident until the end of day because everything is recorded in the day in the tape. Assume a retail investor placed a huge limit order to buy a stock at $10 when the current PPS is $ HFTs would be very happy to bring the stock price down, (thereby gaining $.10 cents). This explains some of the quick price drops, and gap ups, we see in the market. Rising Tide Equity Research ~ 4 ~

5 HFTs trade on the millisecond. That means that the high frequency trading computer can fire up to 1000 orders per second or 60,000 orders per minute. That is sixty thousand times faster than what retail trader can trade. So by the time a retail investor gets the news and decides to buy or sell based on earnings, they're already pushing that price. Rising Tide Equity Research ~ 5 ~

6 The above figure is what an order flow looks like. There appears to be accumulation from dark pool trading (platform pattern), and then the news leaks out, HFTs begin chasing one another, forming the triangular pattern, firing in matter of seconds. At the top of the formation is some unfortunate retail investor trying to get a few trades and then it starts selling off and the dark pools resume accumulating. Due to the rapid fire, high volume trading strategies, these footprints are easy to identify in charts if you use hybrid indicators written for the modern electronic financial markets. Typical HFT pattern is shown below. Usually, an extraordinary long candle forms. It is important to note that HFTs move price and volume while dark pools move volume but not the price. Rising Tide Equity Research ~ 6 ~

7 Examples: Indicators used in the analysis include Balance of Power (BOP), Time Segmented Volume (TSV 38) and Volume. Observe the BOP on 7/13/2015 and see a sudden shift in volume as we move to 7/14/2015. On 7/14/2015, news of an offering at $7.50 was released pre-market. BOP moved from -20 to TSV dropped very quickly. It became a race between HFTs on one side, and insiders/small funds/retail traders on other end. This is a classic HFT pattern, involving a big spike in volume in short time frame with many of their orders being closed within a few seconds to minutes. Heavy buying at this price range bought the BOP above zero by the end of the week, and it turned positive. This is what is known as a Shift of Sentiment. A strong shift of sentiment, always assists in bullish moves. Rising Tide Equity Research ~ 7 ~

8 When a stock gaps up at the open, HFTs change their strategy as seen in the NYMX chart below. On 7/27/2015, NYMX received FDA approval and the price surged almost 100%. TSV moved from ve to + ve. BOP moved from 0 the previous day to 100 the next day. With huge volume, HFTs moved the price up on 20 time s average volume. In the preceding days, small funds and retail investors were buying and selling. However, accumulation/distribution patterns suggested a different story. Based on William A/D indicator, accumulation/distribution patterns showed divergent behavior, meaning stock has a higher chance to make a bullish move. BOP strength is declining, but still very strong. This suggests stock has a stronger tendency to sustain this movement. Highlighted in this example is a different way to interpret market, and use market sentiments based on market action (including HFTs and dark pools), because technical indicators can often predict incorrect data. When HFTs enter a stock, they are able to create rapid share price movement within seconds and are often competing with other HFTs during this rapid price movement. Next, investment bankers and hedge funds enter, driving the share price higher, leaving retail investors to buy the top before the share price begins to decline. HFT & Dark Pool Activity HFTs often chase dark pool activity as the dark pools consist of large equity firms with significant capital. These typically include large pension funds, mutual funds, and other institutions that possess billions in capital. If an entity of this magnitude is accumulating a position they want to exert as little influence on the share price as possible and are able to exert control of price action to make this happen. At some point, the Rising Tide Equity Research ~ 8 ~

9 investment community will be made aware of this position due to reporting requirements or an actual announcement of some form. Once HFTs identify this news, they may gap up the stock and fabricate a run, drawing in small funds and retail investors. These smaller investors end up chasing the price, causing an unsustainable move and, in the end, these investors will likely sustain large losses. Institutions who used dark pools to purchase large quantities of shares to create an observable pattern that HFTs entities attempt to identify and capitalize on. In a sense, it is a war between dark pool investors and HFTs. Dark pool investors want to cover their activity until they have accumulated or distributed their positions without influencing price action. HFTs seek out these dark pools due to the large amounts of equity they contain and attempt to use their algorithmic trading to profit from these large positions. In the end, the HFT organizations will make money, dark pool investors will have made their money, and retail investors will be left wondering what just happened to their investment. No part of this report may be reproduced in any form without the express written permission of Rising Tide Equity Research. Copyright Rising Tide Equity Research ~ 9 ~