We are at the end of November, 2015, and the math is currently very interesting for traders. Despite the strong October rally, the probability of the bulls getting a new all-time high before testing the October low is still only about 50%. The all-time high is about 40 points above the current price. The October low is about 160 points below. Think about that. There is a 50% chance that the E-mini will go up 40 points before it falls about 160 points. If a trader saw this setup 10 times and he bought each time, he would make 40 points (or more) 4 times, for a total profit of 160 points. He would lose 160 points on 6 trades, for a total loss of 960 points, and a net loss of 800 points after 10 trades. Should the bulls buy here to make 40 points when they have a 50% chance of losing 160 points? Of course not, but they can still structure a winning strategy, as I discuss below.
The math for the bears is the opposite. They sell here and are risking 40 points to a new all-time high, hoping to make 160 points on a test of the October low, and they have a 50% chance of winning. The Trader’s Equation clearly favors shorting here.
If the math is so good for the bears, why isn’t the E-mini collapsing? There are several reasons. An important one is the issue of “dead money.” The E-mini went sideways for the first 7 months of the year. Traders want their money to earn them more money. Investors don’t mind holding onto positions in flat markets. Traders are looking to make money every day or every week or two. They get in and get out. Some day traders do this 20 or more times a day. Many fast money traders on Wall Street look to take profits within 1 to 10 days.
Holding positions long term
Traders contribute the biggest volume in the markets, and they are not willing to hold a position for months when they are not making money on their investment. They know the math favors the bears, but they also know that it might take another 7 months before the bears win. Since they create most of the volume on Wall Street and they believe that the E-mini is not likely to quickly drop 160 points, they bet against it, even though they might believe it eventually will get to the October low.
What does “bet against it” mean? It means that every strong selloff that they see, they buy, betting that any move down will only last a week or two before it reverses up. They also sell every rally, no matter how strong, betting that the bulls will fail to get a new all-time high. With most of the dollars buying low, selling high, and taking quick profits, the result is a trading range.
Traders know that eventually there will be a breakout and then a trend on the daily chart. They also know that their current style of trading will lose money once the breakout becomes clear. However, a good trader will have made so much money before then that the one final loss will be smaller than the total of all of his earlier profits. He also knows that he will not be paralyzed by the breakout. When he sees it, he will change his style of trading. He will no longer bet on reversals. Instead, he will quickly enter in the direction of the breakout and hold for a measured move and a swing profit.
Always a reason to buy or sell
There is another important point about the math. The structure I presented above favors the bears. They sell now, exit with a 40-point loss if the E-mini moves above the July high, and take a 160-point profit with a limit order at the October low. There is always both a reason to sell and a reason to buy. There has to be because otherwise no trades would take place. Even when the market is strongly breaking out, there is always a financially sound reason why institutions will bet against the breakout and take the other side.
An obvious one is that many had been trading using a trading range strategy, betting that even strong breakouts will fail, and they keep using it until they are clearly wrong. Once a breakout is strong enough, they will switch strategies and take a loss at the start of the new trend. Scaling in against a breakout that ultimately is successful and then taking a loss is financially wise because if they traded well, they made more than enough using this strategy to offset this one loss.
Structuring trades for better math
Many bulls are buying, despite apparently bad risk/reward and probability because they structure their trades to have better math. They are not planning on taking 40 points profit once there is a new all-time high. Instead, they are holding for a huge bull breakout and a continued bull trend on the monthly chart. An obvious target is a measured move up, based on the height of the 7-month trading range. Since the trading range is 300 points tall, they are buying here to make 300 points, not 40 points.
Also, many will get out well above the October low, and they are therefore risking less than 160 points. For example, they might be risking about 80 points to a little below the November low, and their profit target might be 300 points higher. They know there is a 50% chance of a new high, and they correctly might think that there is a 30-40% chance of a 300-point rally before a test of the October low. If their actual risk (the size of the biggest drawdown after buying) turns out to be only 50 points, and they make 200 points, this risk/reward more than offsets a 30-40% chance of success.
Institutions with deep pockets fade breakouts
Another reason why institutions will fade breakouts is that they have deep pockets and patience. They believe that they can scale in as the market goes against them and trust that there will eventually be a pullback that allows them to make a profit or at least avoid a loss. If the breakout turns out to be a climax that reverses quickly after they enter, these firms will get a quick profit. If the reversal does not happen until after a much bigger breakout, they can still make money or at least avoid a loss if they scale in and manage their trades well.
Most firms also use hedging strategies. They are taking opposite positions in other markets. For example, in a strong bull breakout, they might have a delta neutral position where they sell the E-mini during a strong bull breakout and simultaneously by calls in the N:SPY. They might also be shorting weak stocks or foreign indices, or even offsetting their E-mini trade in the forex or bond markets.
Are traders rational beings?
People naturally tend to assume that they are rational and that all other rational people behave the same. A day trader watching a 5-minute chart might buy a huge bull breakout and wonder why any institution would short and take the other side of his trade. However, if he looks at the 60-minute chart, he might discover that his huge rally is a two bar rally up to the moving average on the 60-minute chart in a strong bear trend. The 5-minute bull breakout is a 60-minute bear flag, and 60-minute traders are happy to be able to sell as a strong bull trend bar is forming just below the 60-minute, 20 bar moving average, betting that the rally is a bull trap.
This is true of all strong breakouts on any time frame. It is easy for a trader to assume that all institutions are trading his 5-minute chart. That is simply not the case. Some institutions see something entirely different when they look at higher time frames, and the result is that they are eager to bet against you because they see the breakout as a trap that will not last long on their time frame, even if it lasts 100 bars on yours.
Another example is the August bear trend on the daily chart. The E-mini fell 260 points in 4 days. Why would anyone buy when clearly the best thing to do was to sell? Well, it was the best thing if a trader was trading a 5-minute or 60-minute chart. However, the monthly chart had been above its 20-month EMA for 38 months, which is an exceptionally long time. Bulls were willing to buy above an average price for 3 years. That collapse on the daily chart was the first chance for the monthly bulls to finally buy at an average price in 38 bars on the monthly chart. They saw it as a brief opportunity to buy at a great price. While you were selling on the 5-minute, 60-minute, and daily charts, those monthly bulls were buying. They did not know where the bottom would be, but they were confident that it would not be far below wherever they bought. Many scaled in lower, correctly believing that the probability favored a test back to the July all-time high.
Institutions selling a bull rally
Some believe that the institutions selling during a strong bull breakout or buying during a strong bear breakout simply have terrible traders who consistently lose money. The firms instead more than offset those losses by collecting fees from other parts of their business. Think about that. If you run a firm that makes $100 million a year in commissions and fees, and consistently loses $90 million in trading, what are you going to do? Clearly, you will replace your traders or close down your trading operation. What are the odds that there are enough fools running firms to provide enough income to support the rest of Wall Street? It does not make sense. Yes, there are firms that lose for a few years in their trading operations, and others that go bankrupt, but there are too few of them to offset the huge number of dollars that are on the right side of a breakout. Although this explanation sounds plausible, the logic is just not there.
Which is the most important reason why a consistently profitable group of institutions is buying a strong bear breakout when you and many other institutions are making a lot of money selling, or why these firms are selling a strong bull breakout when you are making a lot of money buying? It is impossible to know. However, a trader should always assume that there is always an institution on the other side of every trade, no matter how illogical this appears. Just because you do not see the logic does not mean it isn’t there. It is. If you believe it is not, you just are not as smart as you think you are.
Institutions trade logically
Traders should also assume that most institutions are profitable over time and therefore are always trading logically. What appears to be illogical is always part of a profitable strategy, and therefore mathematically sound. Just because you cannot imagine their strategy does not mean they do not have a logical one. Yes, some institutions are barely profitable and give back most of their gains by taking the wrong side of a strong breakout, but even those institutions make enough money over the course of a year betting on failed breakouts so they end up with a least a small profit over time.
This is a fascinating topic because strong breakouts happen all of the time, and there are always institutions taking the opposite side, but it is impossible to know how many dollars are doing this for each of the many logical reasons to do it. What we are left with is that there is always a rational reason for profitable firms to take losing trades, just like there is for you and me. Traders should always be respectful of the institution taking the opposite side of a trade because that institution has done the math, even if you do not know what they are doing. Institutions know that they sometimes lose no matter what strategy they use, but they consistently win enough to offset their losses.
As an aside, the single biggest reason why some traders consistently win and others consistently lose, even though the losers have many winning trades, is that the winners are better at minimizing the number and size of their losing trades. Traders need to be more selective when they enter, and manage better once they are in a trade. They need to reduce the size and number of their losers because they already have enough winners to be consistently profitable.
Institutions taking losing trades
Let’s get back to institutions taking losing trades. Look at your own performance. If you are consistently profitable, you are still probably losing 40-60% of the time (unless you are a skilled day trader who wins 90% of the time). Yet you continue to take trades that you know will lose at least 50% of the time. You do it because you know that the average win more than offsets the average loss so that the strategy is profitable over time. Yes, it is far easier to make money in the direction of a strong breakout, but institutions will take the opposite side because they have determined that it is part of an overall profitable strategy.
As traders, we are happy that they are taking those trades. If there was a strong bull breakout, but no sellers, we could not buy until the market was so high that we would no longer want to buy. When there is a strong bear breakout, there sometimes are no buyers. The 1987 crash was an example. Even though the Dow fell 500 points in a day, once the selling began, you could not make money selling because there were no buyers to take the other side. The trading infrastructure could not handle the volume of selling, and no one could place sell orders and have them filled on the way down. If you were not short at the start of the crash, you missed the entire 500 points down.
That type of crash will probably never happen again. The hardware and software is probably good enough now so that traders will always be able to get reliable quotes and have their sell orders filled as the market quickly falls. Future crashes will probably be more like the May 6, 2010 Flash Crash when the Dow lost 9% in 36 minutes. There was enough buying all of the way down so that bears who were quick to act were able to short and make a lot of money very quickly.