Investment Game 2016: Trading on the Edge

Dear participants,

With the Investment Game in its middle phase, we would like to share some suggestions that may help you improve your trading strategy for the last weeks of the competition. If you are still in the game, you have probably earnt some profit and are considering how to continue trading with minimum risks. Alternatively, you have already overcome moments of despair and blaming yourself for wasted opportunities or mistakes that caused evaporation of your gains, and are currently looking for an aggressive strategy to catch up leaders. Indeed, only three weeks are left until the announcement of the results, which means no sense to build a strategy on mispricing and the fundamental approach. At the same time, most of you are not familiar with aspects of scalping strategies, which allow playing on intense price movements. One of the options that we described in the previous article is to monitor events in companies and go with the flow of immediate reaction to publications of financial statements, public comments of the management, or exploit overshooting. In this article, we propose another situation when the expected volatility of a stock is higher, which provides opportunities for higher short-term gains. We tell about the mechanism of trading near significant price levels. Hopefully, you will be able to try it even if it is the first time you hear about technical analysis.

 

What is the mechanism?

Imagine a situation right after the announcement of earnings or publication of financial statements, which, for example, reveal that the company has outperformed market expectations. This puts an immediate upwards pressure on the price – active traders know that the stock will become more expensive, boost the demand and the price rockets straight away. But until what level? If we look from the future back to this event, the price will shortly settle at the fair level because the market is efficient – but this will happen when analysts manage to plug the new numbers into equity valuation models. Efficient markets imply that the guessing stage that precedes the discovery of the fair price should success in setting it very closely to the correct level, as mistakes of all market agents level out on average. However, at the first stage market participants have to guess where the upward impulse might turn around – that will be the level where the supply equals the demand. To rephrase, each trader asks, “At what level there exists a huge increase in supply?” because he can extract profits from the upward movement up until that level. Paradoxically, but quite logically, numerous market players know that the others will also focus on a significant level, since this is the most obvious choice. A concentration of limit orders (when the price reaches its top: “market supply” in economic terms, “resistance” of the price; when we consider a bottom: “market demand” and “support” respectively) occurs just below the significant level, and a turn exactly there becomes even more likely.

 

What levels to monitor?

So, what are those magic levels? Maybe those that end with many zeros? The game would be too easy if that was always the case, but some empirical evidence exists that round levels like 10 and 100 are associated with a higher volatility. The correct answer is, it highly depends on the stock. Firstly, these are target levels set in management reports as indicators of company’s success. Secondly, stock prices that affect the form of M&A deals or are otherwise associated with levels where significant volumes of options are concentrated may be more important than prices with many zeros.

The main argument of the technical analysis is that traders observe past prices when making decisions in the present, and tend to treat them as relevant information. For instance, if several years ago the price set an all-time high at 69.97 and then declined, the market prices in more doubt for the price increase from 69 to 71 than from 67 to 69. The previous turning point acts as an anchor, crossing which denotes high probability of some fundamental changes that have recently happened in the company, which makes further growth more probable. Failing to break through the significant level once again indicates the absence of these changes and sets the limit of the corridor where the fair price should be set for a longer time.

An anchoring level can be situated in the middle of a price corridor. This type of significant levels is characterized by multiple rebounces in both directions from the same price and called a median. If the level has been lately crossed without any associated rebounces, it cannot be considered significant anymore.

To bring it further, such line can be not only horizontal, but follow a certain trade. At this stage, we find important to warn you about limits of technical analysis. The more complicated is the pattern you have noticed and are planning to trade on, the less likely is that other market participants also find it obvious. It does not matter whether to use technical or fundamental analysis or both, one can profit only when the mispricing one is betting on closes. As long as the market does not marginally agree what you think the fair price is, you will suffer losses. Following this logic, until your technical analysis and that of major traders of the stock matches, you should not care whether you made a mistake or the market behaved irrationally (we believe it generally doesn’t, but you can find loads of literature on anomalies) to explain your losses.

 

When to trade?

If you have tried to go with the flow and scalp on announcements, you have probably encountered a situation when the impulse suddenly turns the other direction, and the losses eventually exceed the gains you had been expecting. Every trader understands that the immediate movement right after the announcement of news is largely unpredictable, since it reflects the difference in the actual outcome and market expectations right before the announcement, which is hardly predictable. Indeed, the mechanism described above does not point to any possible movements that are likely after the price reaches a level with high support/resistance – it would be overly optimistic to sell from such a level just because the price has reached it since the chance that this is not the overshooting yet and the upward movement will continue is extremely high. Fortunately, one can often observe an interesting feature related to significant levels. Recall the argument that a breakthrough can indicate some fundamental changes that would drive the growth further! This implies that a disrupted level is an indication of changed conditions within the company, i.e. new meaningful information. At the same time, if the chosen significant level is very strong, it should be tested more than once during one breakthrough. Consequently, many traders treat limit orders from the significant level as the most profitable strategy, meaning buying when the price breaks the resistance level and then goes down a little. Paradoxically, patience is a useful advice here. To avoid mistakes on false breakthroughs, opening a position before a candle with is body fully above the broken level is too risky.

 

The Trading Game participants should note that the described mechanism can be applied not only to stock markets. Currency and ETFs are usually more liquid, and there are more traders acting by the same strategy. On the other hand, those markets are much closer to strong-form efficiency, more than 50% of volume there is accountable to cyborgs (algorithmic trading), and it is almost impossible to catch up with the constantly changing flow. Additionally, to follow this strategy, any positions opened near events should be closed within 2-3 days – this strategy fails to make any longer predictions, which makes sense recalling that we tried to abstract from the fundamental approach in this method.

Overall, the main lesson is that you shouldn’t consider yourself cleverer than the market. However, scalpers try to anticipate its behavior of the nearest and make huge gains on it. The current competition is the best moment for you to try out new strategies and win if the best way to adopt one is yours! On this note, we wish you good luck with the remaining part of the Game and a deeper interest in exploring forces of the financial markets in the future!