Saturday, February 24, 2018

Profiting From a Dirty Secret of Trading

Kudos to Downtown Josh Brown for picking up on a Bloomberg article by Ben Carlson that illustrates how it's not rising rates that are a threat for stocks, but inflation.  Ben notes the human tendency to think in narratives:  this is happening because of that.  Such narratives quickly become consensus within and across trading floors.  That leads to a kind of conformity born of laziness.  Traders don't develop their own models of rates and inflation, so pick up on dominant narratives.  Excellent shorter-term opportunities can arise when those narratives are driving trader and investor behavior and excellent longer-term opportunities can arise when those consensus narratives are disconfirmed.

Jeff Miller points out that trading problems typically arise when markets change and we are no longer in our comfort zones.  (His site, by the way, does a nice job of tracking inflation numbers, economic sector by sector.)  We become particularly uncomfortable when our dominant narratives are challenged.  When we can't make meaning out of what we're seeing, we understandably behave in reactive ways to lessen our discomfort.

We gain flexibility when we view market narratives as hypotheses and not as conclusions.  This is where tracking correlations among markets can be incredibly helpful.  So often, traders focus on their own markets, failing to notice macro drivers that--rightly or wrongly--are impelling near term market flows.  On Friday, I was chatting with a valued trading colleague and we noted early in the session that the market's dominant cycle was cresting.  That led to a nice, early short trade in the ES futures.  As rates began to move lower, however, and stocks could not sustain downside momentum, I recognized that the "lower bonds, lower stocks" risk-parity bears had an opportunity to be trapped.  The unwind of that narrative led to nice trades as we detected the potential to move from a cyclical to a trending short-term trading environment.

There's a dirty secret no one likes to talk about:  large traders often don't do their own research.  They construct narratives based on recent price action and what others are saying on the sell side, trading floors, etc.  That conformity creates opportunity and is a great reason for tracking market chatter--but only as hypotheses!

Further Reading: