Translating Floor Trading Emotion into Screen-Based Trading

Movement in price is based simply on supply, demand and the human behavior relationship that exists in any market. And, clearly, opportunity always arises when this equation is out of balance. Whether trading the S&P, buying a house, a car or a Michael Jordan rookie card, how we make money buying and selling never changes.

My Path
Let me begin by saying that I have never read a trading book from cover to cover. Also, I started my career on the floor of the Chicago Mercantile Exchange (CME), not looking at a screen-based chart for the first year. On top of that, from an early age I was always taught not to accept something as true just because someone says so. What I do is apply simple logic to everything that presents a challenge, and trading presents a challenge second to none.

At the CME I could have taken a variety of classes and started reading all the books, but personally chose another means of gaining knowledge about trading the markets. I had two very good friends on the floor of the exchange; one worked for a firm, and the other traded for himself and was one of the more successful traders on the floor. I was young and ambitious and just wanted to learn how he was doing it and, fortunately, he was willing to give me advice.

As I stood next to him for a while he pointed out a trader across the pit and instructed, “Sam, see that guy over there? Let me know when he makes a trade.” I stood and watched the man across the pit and, when he raised his hands to bid for some contracts I alerted my friend.

Lessons from the Floor
It was loud in the pit as prices had been moving higher for some time. My friend pointed out to me how desperately the gentleman in question wanted to buy. He stood on his tiptoes yelling at high volume to anyone who would sell to him. Seconds after pointing out these human behavior traits to me my friend gladly filled his order by taking the other side of his trade, and we had a short position open; little did I know that my lesson had just begun. A few minutes later the market fell and we had a winning position. Being new at the game, I was impressed. In fact, it seemed too easy and very hard all at the same time. We had just profited from a position in minutes, which made it appear easy. The entry, however, came on the short side when it seemed everyone else wanted to buy in a very bad way and this didn’t make much sense at the time.

My friend explained, “That guy is somewhat new in the trading pits and consistently loses. Turns in the market happen when the novice trader has entered the market; therefore, all I have to do is find the novice trader and take the other side of his trade consistently.”

I could not believe that this was how my friend had become so successful. There had to be more to his strategy! But, indeed, this was the essence of his trading approach and he had little else to tell me. He did, however, give me a knowing smile at the end of the day. What was conveyed was something much more powerful than I realized at the time.

He was right. That novice trader was making his decision to buy based on emotion, not objective information. Had he looked at objective information, he would have seen that he was buying after a period of buying (late and high risk), into supply where banks are selling (low odds) and in the context of a market whose average price was falling (downtrend) (very low odds). In essence, he was entering a position when the odds were completely stacked against him. A profitable trader would never do that; the laws of supply and demand say you can’t consistently profit while entering positions when the objective odds are stacked against you.

For humans in general, it is emotion that drives behavior, not intellect. Traders who make trading decisions based on emotion versus objective information are facing low-odds/high-risk trading situations.

Others’ Mistakes Allowed Me to Profit
In profiling this type of trader two mistakes come to light. First, they buy after a period of buying and sell after a period of selling, which is late and high risk. Second, they buy into areas of supply and sell into areas of demand, which always is a low-odds trade. The laws of supply and demand and how one makes money buying and selling indicate that the odds are completely stacked against the trader who trades this way. Consistently finding this type of trader entering the markets would really tip the odds in my favor.

The laws and principles of supply and demand have, of course, been around much longer than the markets themselves and they apply to much more than just trading strategies. I was learning the core concepts of markets and how and why prices move and turn. All that was required was to first understand exactly how money is made trading anything. Additionally, it was about learning how to properly analyze the supply/demand and human behavior (emotion) in any market at any time.

Further, it’s important to notice that the focus is on the loser – what the majority of losers do wrong over and over again. The approach of discovering how to do things wrong in an effort to learn how to do something right has some impressive results. It worked for Plato and Aristotle, so why not apply it to trading?

Somebody Has to Pay More Than You
The only way we can make money buying something is if someone buys what we have at a higher price. For shorting, it’s the other way around. Sound simple? Think again. When we view a trading floor, a screen-based chart, or the account statements of tens of millions of investors, we quickly see that the actions of the majority of traders and investors are completely backwards on this concept.

On a trading floor, the person taking the other side of a trade is right in front of other floor traders. Seeing emotion and knowing things about that individual are tools that help stack the odds in favor of those who recognize what to look for.

But What about Finding Clues on a Screen?
In time, much preferring the comforts of my own home and a computer screen, I realized that the trading floor was not for me. The only question was, how does one read the markets if it’s not possible to actually see and hear the people trading? How can the emotion be witnessed? After all, it seemed that valuable information comes with physicality.

When I first looked at a chart I knew exactly what I should be looking for – as mentioned before, the novice trader who consistently makes the two mistakes. Though at first I didn’t know quite what this would look like on a price chart, I did know the exact information I was seeking. One need not look past the price action alone in their quest to identify an emotional opportunity in the markets in the form of a supply and demand imbalance to ultimately identify where banks are buying and selling in a market.

Price Action Reveals Buyers and Sellers It became time for me to begin translating human emotion on the trading floor to the computer screen. I chose Japanese candlesticks, as they make it easy to see where banks and novice retail traders are buying and selling in the markets. Candlesticks (price action) represent traders’ beliefs and expectations and hold the true objective information traders need when trading. I could have chosen just about any type of price chart, it really doesn’t matter.

Supply/Demand Grid December 4th, 2014. NASDAQ

Let’s take an objective look at the chart above. This is a chart of the NASDAQ Futures showing a supply zone from our Supply/Demand Grid which offered our students a quality shorting opportunity. This intraday chart shows a scenario that happens each day. Area “A” represents what a trading book will call sideways trading. Taking trading to a more professional level through objective simplicity, we will call it a price level at which supply and demand are out of balance. At “B,” we can objectively conclude that there is too much supply and not enough demand in price level “A,” this is the only reason prices fall from that level. Some may wish to short this “breakdown,” but I chose to let prices fall, as entering breakouts and breakdowns is hardly ever low risk and high odds. Furthermore, it is the decline in price from the level that tells us supply and demand are out of balance at the level, so it’s best to let the decline happen as that gives us all the key information we need to make a solid objective trading decision and take a quality trade. When candle “C” forms, one can objectively conclude that the majority of traders who bought on that candle are not consistently profitable. They are buying after an advance in price which is a novice move and a footprint of novice buyers. Most important, they are entering right into an area (supply) that we already know has a supply imbalance (too much supply).

Bringing in Lessons from the Floor
My friend from the trading floor would be glad to sell to this group of buyers as, objectively, the odds are stacked against them. The laws of supply and demand tell us that consistently profitable traders can’t consistently buy in this situation and profit over a career. When buying after a period of buying and into supply which is where banks are selling, the odds a trader will profit on a long position are very low. When we add human behavior into the equation, it is easy to see why the majority over and over are on the wrong side of the market. The short entry for this opportunity comes on candle “C,” and price proceeded to decline “D” for a low risk, high reward, and high probability trade.

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