What do I mean by thin air? So far the NASDAQ is the only index to make it past the 50% Fibonacci retracement levels as measured from the highs seen in 2007 and the lows that were made in March of this year.

Both the Dow and the S&P 500 have rallied strongly from their March lows but have not made it over the 50% retracement level.

Click here to see the video “Is the Nasdaq Now in Thin Air”

Many professional traders – myself included – are looking at the NASDAQ’s Fibonacci retracement as it represents a potentially key turning point for this year’s market.

While not all the pieces are in place to go short or get out of long positions, one of the first clues is being put in place today by the Japanese candlestick charts.

In my new video, I share with you the NASDAQ retracement levels, as well as one of the key components that could lead to a potential reversal to the downside.

As always, our videos are free to watch and there is no need to register.

Click here to see the video “Is the Nasdaq Now in Thin Air”

Enjoy the video, all the best.

Investors in the second group, the non efficient crew, then base their investment decision on these overbought or oversold conditions, which is a rational decision. of sorts.  However, this line of thinking creates some fairly irrational pricing in the capital markets.

Small investors are, generally speaking, not nearly as effective in the trading skills and buy and sell for a variety of reasons ranging from educated guesses, a hunch they may feel, or advice from a third party who may, or may not, possess any real investment expertise.

Through in the hedge funds, quants and others of the computerized trading ilk and you end up with a hodge podge of investors all chasing potential profits.  Of course, they have all approached their market buying decision through different methodologies.  Nonetheless, they are all after the same goal.

The Fed’s economic policiy has to be thrown into the mix, at this point, as they use market measures to control inflation and unemployment.  The critics of the Fed’s actions are legion, with good reason.  It would seem that often do as much harm as good…just the same they are major players in the overall market scheme.

This begs the question for the trader:  Is the Market Wrong at Times?

Well, the answer is an easy one.  The market is always right, and if you trade why you think is right versus what the market has deemed to be right you are in for an unprofitable ride.  I always have to whisper to myself:  “The market is always right, and I am always wrong.”  This is a very tough pill to swallow, especially if you know a bit about economic theory and the way things “ought” to act given a specific set of variables.  Wrong. Wrong. Wrong.

Trade the market, not the news, not economic theory, not the general consensus not anything but what you see on the chart.  The Efficient Market Theories have one tenet quite right…there is a degree of randomness in the market that cannot be ignored, and the market often wanders in a direction that departs from common knowledge or well thought out economic principle.

The market is always right, because you have to trade exactly the price action on the market.  This makes life as a market scalper much simpler, as I don’t have to make intermediate and long term prognostication on the movement of the equity markets.  No, I am generally looking at what the market might do in the next five minutes, and that is a far easier proposition than the long term.

With the recent spate of bubbles in various equity markets the venerable efficient market theory and it’s corollary CAPM have come under vicious attack by a variety of academics who bear witness to the problems the theory presents.  The least of the problems lies in the very fact that it doesn’t work very well, especially when working with “long tails”: those ticklish anomalies that are ably described by Benoit Mendelbrot in “The Misbehavior of Markets.”

But academics don’t let loose of accepted ideology without a fight, despite a litany of  failures in the Efficient Market Theory’s predictive ability.  It is, at best, a dying testament to an irrational explanation, from an economic standpoint, to the inner workings of our equity markets. If a theoretical approach is not firmly grounded, it is not surprising that the predicted consequences that flow from it should fail to show up consistently in the way that investors and markets actually behave.  Such is the plight of Efficient Market Theory, and economist are scrambling for some sort of working model on the machinations that take place in the equity markets, and markets as a whole.  The idea of “rational investors” seems to have taken a terrible beating of late, but the question of completely abandoning EMT is beyond the scope of many economists and academic thinking.  After all, this theory has been doled out piecemeal to college students for decades as the “Holy Grail” of investing theories.  I suspect it’s demise will be a slow one, as academics are not fond of saying, “Geez, we were completely wrong on this one.”

Enter now, from stage left, the Adaptive Market Hypothesis.  The attempt to bring order and an overarching theoretical framework into analysis of the seemingly unruly behaviour of financial markets was a temptation that has for years proved too great for academics (and many market participants) to resist, but it has turned out to be a long and largely fruitless journey.  And Montier is none-too impressed with AMH:

“However, we are less convinced that AMH is a terribly useful concept. As we understand it, the AMH provides a halfway house where sometimes markets are irrational and sometimes they are rational. We would argue that the amount of time that markets are rational is near negligible. Instead markets seem to be in a constant state of disequilibrium – moving from boom to bust and back again, rarely if ever stopping off at “normal”.

If, as one of us has recently argued (Insight, June 25), the efficient markets hypothesis is the financial equivalent of a dead parrot, then the AMH may be a dodo.”

And so the quest to find a neat explanation for the way the market functions continues, without any real progress.  It seems most of the current literature spends hours debunking current theory and offers little in the way of explanation.

Why?

Mendelbrot had the problem pegged long ago, chaos and randomness…there has been no real explanations because a degree of randomness exists in the market and it is difficult to account for irrational behavior, or market noise.  Yet within this randomness certain substructures exists, fractals, and they are like signposts on a twisting winding road to nowhere.  The problem is simple, human nature has a hell of a time accepting randomness, surely, many argue, there must be some order in a disordered market.

The argument ranges on, and always will.

So what is a scalper?

Most scalpers, especially the scalpers who trade the eminis, seek to exploit the natural rhythm of the market and carve out small gains on each trade.  My goal is often 12 ticks, though that can change depending upon the mood of the market and an indicator I used (and have written a post about) called the Average True Range.  My trades seldom last more than 10 or 15 minutes and I exit.  I never carry positions overnight.  My account is trade free at the end of the trading session, or at least, the period of time I am trading.

I scalp because it suits my personality.  I like the fast paced action and the lack of dependence on intermediate term prognostications on the direction of the market.  Some scalpers, seek to exploit the big/ask disparities in the market, though that is never my goal.  Scalpers need to implement strict money management guidelines in their trading, and never risk more than 5% of their capital on a given trade.  There are a host of traits scalpers use, and those traits even vary from scalp trader to scalp trader.  The important thing to remember in scalping is that I am looking for very short term moves in the market to exploit, and I do not attempt to predict any overall direction of the market as a whole.  I am interested in certain moves in very specific contracts.  The market as a whole does not interest me and, generally speaking, I don’t pay much attention to overall market conditions.  I trade the chart I am looking at, not the news, not the economy, just the chart before me.

Swing traders are a different matter, though.

Swing traders are really fundamental traders who hold their positions longer than a single day. Most fundamentalists are actually swing traders since changes in corporate fundamentals generally require several days or even weeks to produce a price movement sufficient enough for the trader to claim a reasonable profit.  The important difference between a swing trader and a scalper are basic: A swing trader has a notion or idea which way the market is going to move, or which way an individual stock is going to move, and invests based upon his belief.  Swing traders usually identify a specific characteristic or event in the market and trade based upon this theory.   I should point out that though many swing traders are interested in market and stock fundamentals, there is also a field of swing trading that invest based solely on technical trading.  Oscillators, Gann lines, Dow theory….there are scads of theories that swing trader may implement to ascertain the timing and direction of the trades they choose to execute.

Technical Traders, Fundamental Traders and Efficient Market Traders.

There is scant space in this post to cover the myriad of styles these three titles cover.  I should also point out that there is often very little agreement upon methodology by the three trading camps.  Each lays claim to correctness, though I incorporate parts of all three trading styles into my personal trading style.  I will devote some posts in the future to contrasting the mindset of each of these trading theories.

The point here is a basic one, a trader ought to decide who and what he is and what style he will implement in his trading activities.  This decision is usually gained through extensive reading and trading experience.  There are some great books written on each of these trading styles, and all traders out to consider spending some time reading about the great theorists of trading and the style and rationale they employed to reach the conclusions they write about.

Some suggested reading would include:

Dr. Burton Malkiel, “A Random Walk Down Wall Street”  (efficient market theory)

Benjamin Graham and David Dodd, “Security Analysis”  (value investing, fundamental investing)

Benjamin Graham, “The Intelligent Investor”  (value investing, fundamental investing)

John Murphy, “Technical Analysis of Financial Markets” (technical trading)

J. Welles Wilder, “New Strategies in Technical Analysis” (technical trading)

Martin Pring, “Introduction to Technical Analysis” (technical trading)

Dr. Bill Williams, “Trading Chaos” (chaos and fractal theory)

Benoit Mendalbrot “The Misbehavior of Markets”

All of these fine books will provide you with a great theoretical background to begin your journey as a trader.  I have dog eared copies of each of the books, and often refer back to them to refresh my own knowledge base.

So read, trade, experiment…then find the style of trading with which you can succeed.  As always, best of luck trading.

Twenty five years in the stock business long ago dispelled any notion I learned in college that investors are anything close to rational, though the law of large numbers would seem to apply in that the more individuals participating in an individual issue the more likely the issue is likely to be priced properly. But history has, again and again, made it apparent that rational investors are a scarce commodity. Whether it be tulips, dot.com IPOs or houses, we are NOT rational, we are irrational. Lemming-like.

Mendelbrot theorized in “The Misbehavior of Markets” that long tails exist along any dispersion curve. With that statement he infers that catastrophic or unique events cannot be nearly encapsulated in any market theory for the exact opposite reason efficient theory draws its premise: Investors are rational.

For example, the premise during the dot.com bubble was something like this: things besides information can be efficiently distributed over the internet. I can remember looking at the business model for a dry dog food distribution operation and wondering how in the world a rational man could believe such a business model could work. It didn’t, even though the initial IPO skyrocketed, irrationally, to dizzying heights in early weeks of trading. And no the dot.com IPOs are resting in peace, after relieving millions of rational investors of their money.

Is the housing bubble any different? Well, maybe a little, as there was an overriding greed component to this bubble. Which brings me to my point: Investors aren’t rational, they’re greedy. Now don’t think for a second I believe greed is a bad thing, for it is greed, or the desire to earn a higher rate of return, that fuels capitalism. But this greed component often leaves up out on Mendelbrot’s long tail, and we have to find our way out of the long tail wilderness and back to the cozy equilibrium that exists in the main Bell curve structure.

But if Efficient Market Theory and it’s CAPM component are bunk, why is it taught at the university level with the reverence afforded holy books? Well, it’s partially true, until it comes to Long Tails, and then it falls apart. Boy, economics is tough stuff