Trading on Expectations
is the product of several years of observing the behaviorof both financial market participants and financial market prices, and trying to reconcilethose observations with my formal education and the conventional wisdom aboutmarkets. Academics assume market participants are rational and economists assumean air of scientific precision with complex mathematical formulas, while fundamentaland technical analysts deride each other's methods. However, at different times eachof these methods explains what the market is doing. Sometimes market prices can bepredicted using the economists' models. Sometimes market prices follow a "randomwalk" as the academics claim. Sometimes price is responding to the fundamentalnews developments and sometimes to the price patterns, trendlines, and breakoutlevels identified by technicians. This book draws from the different approaches anddevelops a coherent theory of price movements in the financial markets.Often lost in most approaches to the markets is the fact that individuals are at theroot of markets. Individuals' transactions create the data which the academicsanalyze, respond to fundamental data releases, and create the chart lines whichtechnicians scrutinize. People introduce some unique factors to market analysis,factors which the "natural science" approach does not accommodate. Economics isnot open to the same type of analysis as the physical sciences with which economicsstrives so hard to equate itself, because of the human element aspect of the markets.Asserting that people are at the root of markets, Chapters 1 through 3 establishthe need to address the "social" in the social science of economics and highlight therole that the subtleties of the human element introduce to the market. For example, inthe speculative markets most transactions are not prompted by a need for theinstrument itself—the way most transactions in consumer markets are prompted—norare the instruments "consumed." Rather, speculative market transactions are drivenby what participants think prices will do in the future.The resulting premise is that the combination of participants'
about the future determines the direction of prices in the markets.Today's buy and sell decisions are a function of traders' expectations about futureprices which, in turn, are determined by today's buy and sell decisions. This back andforth interaction between traders' actions and expectations explains the emergence ofprice trends when both market activity and sentiment are going in the same direction,trading ranges when the expectations are mixed, and trend reversals when thevariables are at odds.Chapters 4 through 7 explain the concept behind Contrary Opinion and theChicago Board of Trade Market Profile® as methods of measuring the expectationsand actions of market participants. Both methods are participant-derived; the formerby surveying trader sentiment (i.e., expectations) and the latter by identifying andmonitoring buying and selling
(not just prices going up and down). Takentogether these methods provide the components of a coherent theory of pricemovements, reconciling the discrepancies between the academics' and practitioners'perspectives. As Nobel Laureate Merton Miller wrote, "The CBOT Market Profile is aunique attempt to bridge [the] communication gap between the doers and thewatchers."Chapters 8 and 9 put the two approaches together into a single model, theSentiment-Activity Model. By monitoring participants' activity (Market Profile) as wellas their expectations (Sentiment numbers), one can detect when the market is in arandom-walk state (trading range), a coherent crowd-behavior state (trend), and when