Saturday, October 4, 2008

Information - Price Divergence

This is one of the most reliable indicators helping you discern the market's intentions. Some theory first, not too much, I promise... rather like a brief refresher. Market is a discounting machine, meaning tomorrow's development is being factored in by today's price action. That's why one who acts on known information is always late - when information is known to everyone, it's being already acted on, and late arrivals will be taken advantage of. As an example, think of upgrades and downgrades issued AFTER a major price movements or earnings announcements. Price action is an ultimate truth in the market - and it means that if there is a divergence between what a price is supposed to do based on available information, and what price does in reality - it's a price action that you need to go with. More than that, such divergence serves as a very powerful indicator for you, because it shows you that at this junction Smart Money clashes with Crowd. Crowd goes with obvious - with what information says. Smart Money meanwhile takes contrarian position. This is an ultimate case of "Trade what you see, not what you think".

Now, let's use fresh example as practical illustration of the principle. Yesterday, while the markets were preparing to a 700B rescue bill vote (you can read a whole transcript of our trading session in trading logs, Oct 3), I was asked:

[11:48] {member} so..whats your thoughts after passage on mkt for the day?

Here is the answer:
[11:49] {Threei} seems like selloff in cards... with or without initial short-lived spike

... and follow-up comment:
[12:10] bill passage is now all but sure, yet market doesn't really running
[12:10] makes you think...
[12:11] that dump may be an outcome in any case

Indeed, this is exactly what happened: immediately after bull passage market dropped fast and hard. Let's see how I arrived to that conclusion (which naturally kept us out of long trades at the moment of House vote). When a project of this bill was first announced, market rallied for two days. When a bill was brought for a vote first time and rejected, market dropped 700 points. Natural conclusion is, market likes the bill and will go up when it passes the House. So, day of the vote comes, comments clearly show that the bill is going to pass, yet we see failry lackadaisical, if I may say so, movement. Market is positive but there is no serious upward pressure, no boiling, no bruning desire to buy everything in sight. That's your Information - Price divergence. Information says: bill will pass, market likes the bill, it's a long. Price says: beg to differ. You saw what happened next. Price always wins, and a trader makes money by being right on price, not on information.
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