How to Trade what you See

1. How to complicate things

Before illustrating how to trade what you see, we must first go astray, off the path of righteousness, and do what will lead us to pain and loss. So what should you do if you want to lose money? Simply trade what you think is happening and/or should happen.

Take the following situation for example:

You decide to buy 100 shares of XYZ at 100 USD/share. You are rationally convinced that the stock has a decent future due to it's management, competition and the economic environment. Data from the first quarter's earnings come out and are exactly in line with the analysts' expectations: +3%. The market reacts with a 5% decline in the price of the stock. Which course of action would you take, and what are the reasons behind it?

You could:

a) remain convinced of your prior view and buy some more at a discount relative to where it was before;

b) you could stop & reverse (hence going short right after the news hits)

c) you could hold your position because “eventually it will come back”

d) you could stick to your stop loss, wherever it was, and re-assess after the news hits.

The above might seem ovbious to some, but when confronted with live markets and making real-time decisions, so often what is evident gets discarded. Usually what happens is:

1. you pull up all sorts of heavy macro and micro related research in order to find “the truth”
2. you consult sites like Zerohedge.com to see what's wrong with the world (because evidently you are right and the market is wrong to drive the shares down like that for no apparent reason)

Front page of Zerohedge.com site. It's the place to go for doomsday reports and for really in-depth analysis of what is doing the rounds during the week. But the market wouldn't/couldn't function properly if it were to gyrate on this type of analysis. Bottom line: Zerohedge is good for going more in-depth but until you have a firm grasp of the process detailed in this article, reading between the lines with Zerohedge will probably just confuse you.

3) You start to look for places on the chart where the fall may stop, and where of course you will double your position most likely. Because the market is evidently wrong. Earnings were in line with the expectations.

While you are doing all this, the market is clearly still in action and might be dropping even more. Bottom line is that you are not reacting to the market. You are reacting to your own hypothesis/thoughts and are completely distracted from what the market is actually doing.

This will only get you into trouble. So let's see a possible way to Trade what's evident.

2. How to see what's evident

It is our contention that “seeing what is evident” means “pay attention”. Pay attention to what (good) analysts are saying. They are paid to do that work. It's not our job to outguess them. It's our job to find out what the consensus about a certain report is; what flows were reported overnight or during a certain session; what news is doing the rounds. Paying attention is the key. We always look for ways to complicate our life and our trading habits. Here, we are going to see just how simple it can be.

Trading without having a firm handle on what is driving the market on any given day/week is a recipe for disaster so that will be the first check. The question is: how can we understand what the drivers for any given Week and any given Day are? We have to be able to do the same thing each day/week (in order for the process to be consistent).

a) The weekly themes must come first. This is what we can call “background check”. Every monday and for the rest of the week, the EU open reports published in the Skype Trading Room around 8 AM CET summarize what various Investment Banks deem to be important. This is the “background” check: what the market has in the back of it's mind; what the focal points will be; what the unresolved issues are.

Extract from the EU Open reports of the week going from November 3^rd to 7^th 2014.

It answers the question: what unresolved issues is the market keeping in mind? What will be the focal points this week?

b) Then we have the “foreground check”. Regarding the themes for each single day, having a Metastock Xenith subscription makes it very easy. The reason is that Reuters employs some very market-savy individuals that are well connected. Therefore, they usually report news and views that are very much in line with the market's overall thoughts. And that's the key isn't it? To pay attention to what the market is thinking, and then act accordingly.

The Front Page of Metastock Xentih: the most important stories are always on the top. It makes it really easy to identify the drivers for each day. Depending on the asset class, Xenith has a page of headlines that can be easily consulted before the open of each session (EU/NY/Asia).

Even if Xenith makes the foreground check reading extremely simple for all assets (especially Equities and Fixed Income) there is another way. By getting ahold of bank sheets, it is also possible to uncover the foreground sentiment drivers for the day ahead.

A typical Morning Report by Credit Agricole. A possible alternative for obtaining foreground info.

3. How to trade what's evident

So let us walk through a rather exciting day: the ECB rate decision on November 6, 2014. The ECB rate decision and more importantly, the press conference, happen in the afternoon European session /morning North American session. So let's see what the foreground situation was like, prior to the decision.  

ScotiaBank's Daily Points, published prior to the NY open.

Clearly, the rate decision did nothing and the market was waiting for the press conference.

And now let's see what the ScotiaBank Daily FX Update said.

ScotiaBank's Daily FX Update. Pay attention. ECB expected to hold policy and focus is on the press conference which is expected to have a similar tone to the last conference – Unlikely to shock!

The background, just to make things clearer for the reader, is that concerns over growth in the Eurozone, periphery debt, and deflation had been pushing the Euro lower for quite some time. Going into the meeting, the outlook was still bleak. But the consensus (what we need to pay attention to) was for Mr.Draghi to remain fairly neutral and not shock the markets. The market was positioned quite short going into the meeting, which also added to speculation that there might be a short squeeze looming (i.e. A pop higher).

So now that we have paid attention to the main message and know what the consensus is, we can plan our alternatives. The main trend is still down on the Euro so let's consider the alternatives:

1. Mr. Draghi is surprizingly dovish. We can expect the Euro to tumble.
2. Mr.Draghi is neutral as the market expects. We can expect a moderate stop hunt to the upside.
3. Mr.Draghi – for some strange reason - is bullish. We can expect a large pop to the upside.

So now that we have gone through the prep-work, we can go to the charts (hurray!). In FX the situation is a little more complex than in Equities though. We always need to stack the odds in our favour as much as possible, and in FX this means finding the appropriate currency pair to play, based on the theme or driver. In this case we are betting on probable Euro weakness so we need to decide which Euro pair is most adequate for participation, if the situation allows for it.

Again, we need to only pay attention to the charts and – for shorts – only look for evident downwards trending motion on large hourly charts. So take a look at the following Euro screener:

Euro screener: it's evident that the mest looking downtrends, to play euro weakness, are the first two on the left, EurUsd and EurGbp.

Source: FXCM MarketScope

So now that we have evidently chosen EurGbp and EurUsd as possible candidates, let's see them more clearly.

EurUsd vs EurGbp. Very much the same structure on both. So it's a toss up, pick whatever you can deal with better. Source: FXCM Marketscope

So now we've seen that the background structure on these Euro pairs are adequate for participation and we can decide how to trade the ECB press conference. Either you find a suitable trade a couple of hours before the event OR you trade reactively after the event.   

Here we're going to pick the EurGbp as price had pulled back quite a lot during the European morning and was stalling at the most recent range top, whereas the EurUsd was more in the middle of the recent range and might have been slightly more difficult to see – depending of course on how you like to tackle the foreground.

EurGbp foreground analysis. Source: FXCM Marketscope

Now of course this trade idea could have gone the other way, if Draghi had surprized the market to the upside – but that's not the point of Trading What You See/Paying Attention to what's evident.

One of the most complicated things to do for aspiring traders – and to experienced traders also, to a certain extent – is stick to the plan even if a couple of trades go downhill. In trading, you can make money (sometimes) doing the wrong thing. And you can lose money (less common) doing the right things. This makes it initially complicated for aspiring traders to actually understand if what they're doing is good or not.

So once again they key is to focus on the process. Losses are the cost of doing this job, because we are always in the realm of uncertainty & probabilities. So focus on developing and repeting a logical, sound, decision making process. Pay attention to the background conditions, then pay attention to foreground conditions, and only then check the charts that will most likely offer the best opportunities, given the sentiment influences of the day/session.

To sum up: Trading what you See can be translated into “pay attention” to what market participants are saying. Whether it's via bank sheets or news analysis, or assessing your surroundings on the chart, the key is to not overthink things. Just pay attention to what is evident and do not go looking for things that aren't straightforward. If bank sheets or industry analysts are talking about strong growth prospects for the US economy, accept that point of view and check to see if YM is giving an evident setup for example. If, like in our example, there is a big risk event looming, just find out what the consensus view is and prepare alternatives for potential deviations from consensus. You should find that just merely paying attention – and not looking to outsmart/outguess – will allow you to stay much more in tune with the markets and save a considerable amount of time and energy as well.

Good Luck!