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Why Forex Volatility Hurts Retail Traders
Retail versus Institution Separate Takes | Same Information
by Mark Whistler
Foremost, it is important to note that institutions move markets, not retail traders. However, with many institutional and retail traders acting at similar time, it would almost appear as if they were trading from the same signals. Upon first glance, it would appear as if traditional indicators do indeed provide reliable signals for market movements.
In reality though, traditional indicators (like MACD, Stochastics and CCI) are providing "false signals", especially on shorter-term time frames. Institutional order flow has nothing to do with 'technical signals' and is truly derived from perceived risk aversion and future fundamentals.
Despite the true reality at hand, some retail traders continue to believe traditional technical analysis accurately looks into the fundamental mindset. What you MUST understand though, is common retail technicals have nothing (at all!) to do with institutional trading and do not accurately look into the minds of institutional traders. At the core of the issue, common technicals never accurately see into the minds of institutions, simply because the technicals are derived from an empirical event that has already occurred (lagging indicator) within price action, while fundamentals attempt to mitigate fundamental risk of today, while attempting to step in ahead of possible fundamental events of tomorrow.
Retail traders often lose, because even if they are able to perceptively step into the minds of institutions, trading successfully commands the trader is not only able to see the true fundamental paradigm, but also know when and where to implement a position to capitalize on such. In non-technical language, one may be able to accurately distinguish that a particular currency will lose value over the next year because of deterioration in fundamentals; however, successfully acting on the information is much, much more difficult, when considering the inherent volatility within Forex markets today. Looking at our first image, readers will note the significant rally in the EUR/USD into December 2008. The euro's momentary recovery can be attributed to a dead cat bounce from torrid selling in the previous months, coupled with the momentary loss of belief the US Dollar would continue to avert risk throughout the global economic crisis. Conspicuously, even if traders were able to accurately predict the U.S. Dollar was about to boldly recover from late fall rally in the euro, blindly taking a position could have been devastating, if implemented based on fundamental outlook alone. The single daily candle highlighted in late December shows almost 400 PIPs of volatility, which should serve as empirical evidence of the excessive volatility at hand within Forex markets.
The larger issue is simply while institutions and retail traders may have unearthed similar fundamental information (though often institutions have greater clarity) retail traders who act on technicals or fundamentals alone, will constantly fall victim to the inherent volatility within Forex today.
What's more, the indicators retail traders act upon are often significantly different than that of institutional traders, something many are not even aware of.
For example, when looking at descriptions of services banks and institutional companies provide for larger FX participants, one will note the first two technical strategies/indicators are almost always Volume Weighted Average Price (VWAP) and Time Weighted Average Price (TWAP).
However, the charting packages most retail traders use almost never contain VWAP and TWAP, as indicators. In fact, even MetaTrader (arguably the retail standard), does not contain VWAP and TWAP preloaded. Traders can find the code in the back of this book, on the Internet, and on my Websites fxVolatility.com and WallStreetRockStar.com; however, the aforementioned are not delivered already installed within the software's various custom and traditional indicators. The point here is the main indicators institutional traders are not only looking at, but also acting upon, are rarely visible within the retail trader's world. Most often the retail trader must actually intentionally seek out the indicators; but how can one find what one does not even know exists?
There's even more to the story, and as readers are about to witness, the paradigm behind retail technical analysis may have been flawed from the start. Even worse, the common technical indicators most retail traders covet could even show greater amounts of false signals in the future.
Lock, Stock and Dogma
To understand why technical indicators are becoming more and more troublesome in volatile markets, one must take a step back from the entire situation and examine the "nuts and bolts" of the larger situation at hand.
Constance Brown just about says it all in her book titled Technical Analysis for the Trading Professional (McGraw Hill, 1999), where she asks:
"Why does it appear to us that conventional technical
indicators are failing us as we approach the 21st Century? What has
changed?"
- Constance Brown Technical Analysis for the Trading
Professional
As a brief side note, while Brown's book is almost a decade old, the information is still extremely innovative, as she often examines the "truth" behind how and why indicators produce signals. Even more important, Brown also attempts to uncover how and why traders act on the information received.
In the case of failing technical indicators, Brown hypothesizes technical indicators are failing because too many people are acting on the same information - at the same time. She points out virtually every charting program comes with the same pre-loaded indicators, with the same pre-set variables. What's more, she also unmasks the unfortunate reality that many traders never even bother to question, or change the preset variables within the pre-loaded indicators. In essence, traders simply accept the "factory settings" within their indicators as dogma.
At first glance, it would seem common sense that many people acting on the same information – at the same time - would create a sort of 'self-fulfilling prophecy' within technical signals. However, the reality of the situation proves differently. Really, some people acting on the same information at the same time may create a slight amount of 'self fulfilling prophecy'; however, when too many people move in the same direction, at the same time, the real outcome is volatility. Think of it like this: If a troop of ten men run are running on the street together and suddenly need to stop before a busy street, all ten will likely be able to do so. However, if 1,000 men are running on a street and a few in front attempt to stop before a busy street, the mass of bodies in motion behind the will likely bump into one another, with the greater whole pushing the few in the front into the intersection. Someone call a paramedic.
Why would trading be any different? When a hundred thousand traders take the same position, at the same time, based on the same information, and suddenly the market moves just slightly opposite the herd's expectation, what will the obvious outcome be? You probably guessed it; the large mass-herd of traders moving in unison creates a pop of volatility as the collective whole attempts to switch directions.
Making matters worse, once the herd is pushed slightly into the intersection; electronic stop orders begin tripping across the world, like grids of lights rolling into darkness, as a mass blackout ensues. The "mass effect" of too many people acting on the same information, coupled with the domino effect of electronic stop orders being tripped globally, creates excessive volatility within intraday trading. While retail traders do not carry enough weight to propagate an all out "trend" in the world of Forex, they do create short-term volatility. I like to call it Herd Induced Intraday Volatility, or the "HIIV Effect."
Retail traders move like a swarm of bees and so when I see a clear signal from a common technical indicator on a 5, 15, or 30-minute chart, I look for the HIIV effect of volatility to begin stinging. By the way, with stop order rule changes coming (for U.S. retail Forex platforms) in July of 2009, the 'rolling blackout volatility' effect could wane, while overall reversal volatility could increase as traders hold losing positions as long as possible (it's just human psychology) until major critical technical points are hit.
While the removal of stop orders in U.S. trading platforms may help bolster longer periods of trending, major points reversal points could surface with fierce volatility...
HIIV Effect in Action
For traders having trouble believing the technical 'herd effect' I previously described actually exists, please take note of the following example.
(By the way, one needs to do nothing more than scan 5, 15 and 30-minute charts to discover plenty of examples of the HIIV effect.) Looking at Figure 2.2, traders will notice the 30-minute chart is clearly showing signs of a potential reversal pending, at least in terms of traditional technical indicators, like candlesticks and stochastics.
One cannot miss - even for a second - that the 30-minute chart is displaying three bearish candles (two red hangmen and one evening star). In addition, using the pre-loaded stochastic indicator (5, 3, 3) traders see a clear cross of the K-period (blue) under the D-period (red).
The aforementioned stochastics cross-under is occurring at the 80-line, the exact point many technicians believe produces a reversal. Seems like a clear short-entry point right? Hmm...
Look at Figure 2.3, which shows the EUR/USD rallied significantly after the appearance of the two hangmen, one evening star and a stochastics +80 cross-under.
There are two events occurring in this scenario:
First, institutional order-flow (read: fundamental mindset) likely believed the carry trade differential and risk facing oversold levels of the EUR/USD were prompting short covering and short-term relative range trend continuation, if even only for a moment.
Second, when the false signals appeared, many retail traders likely took short positions, expecting a larger reversal to ensue. However, when the reversal did not show, those same traders were forced to cover positions…en masse, thus helping fuel the torrid bull candle eight bars after our short signals (Figure 2.3). Often, when false signals surface, we see a slight amount of "wiggle" shortly after, while traders and institutions attempt to decipher the reality of the situation. As the dust begins to settle though and traders realize the technical indicator was false, a sharp move occurs as panic sets in. Again, the panic HIIV effect can be seen in Figure 2.3, eight bars after the final false hangman short signal.
The EUR/USD quickly (and sharply) rallied from the 1.3580 (roughly) area to the 1.3680 region in one 30-minute bar.
For the EUR/USD the aforementioned pop is 'faster than usual', thus we can infer many traders were caught going the wrong way. What's more, Figure 2.3 also shows stochastics trending downward during the bulk of the ensuing upward momentum, even after the false signals appeared.
Does all of this mean technical indicators can no longer be trusted whatsoever?
Not necessarily; however, there are a few critical points to consider. Foremost, common sense tells us that most retail traders attempt to take intraday positions, without taking much notice of long-term fundamentals. What this means is many traders likely take positions against the larger-trend, simply because their misunderstanding (or lack of will to do the proper research) hinders the mass contingency of "at home traders" from seeing the situation clearly. Moreover, retail traders often watch shorter-term timeframes, more often than they take note of the 4-hour, daily, weekly, and (even less often) monthly charts. Without a clue of the larger technical and/or inherent fundamental pictures, they are really just 'trading blind.'
Finding Sanity within the Chaos
What all of the previously mentioned translates to is an inferential conclusion where technical indicators (at least those commonly used by the mass army of retail traders) will provide false signals more often on shorter-term timeframes, over longer-term counterparts. Simply put, retail traders who are taking positions on shorter-term intraday timeframes (based on stock indicators), are actually making the situation worse, and only adding to intraday volatility – even more. It's important to note retail traders are not the sole blame for volatility, as many institutions can also make silly decisions as well. What's more, in today's trading environment, the historically transparent environment of fundamentals (GDP growth, inflation, interest rates and underlying economic reports) have many professional analysts scratching their heads with the added variables of present and future national debt, credit related (out of the blue) bombshells, inflation, deflation and risk aversion.
Thus, in the current Forex paradigm, the HIIV effect coupled with fundamental uncertainty are creating the "perfect storm" for erratic intraday movements and HIIV-derived volatility, contrary to traditional market-movement common sense.
When coming to terms with the fact that technical indicators are - indeed - failing in today's markets, many readers may perhaps be wondering if there is any way to truly put the odds back on their side? The answer is yes. The solution is three-fold. First, Retail traders can help remove uncertainty by spending more time attempting to learn and understand the larger fundamental paradigm, while also trying to perceive where future fundamentals will land. By doing so, retail traders are attempting to not only decipher why present volatility exists fundamentally, but also map future possibilities for seemingly unanticipated moves beyond today's price range.
Second, retail traders must also begin taking greater notice of institutional indicators such as VWAP (and other benchmarks), understanding that institutional order flow trumps all. Taking greater notice of VWAP (and other benchmarks) could provide at-home traders with superior insights into the institutional mindset and thus, potential future price action.
Third, retail traders must take the time to understand the philosophical and theoretical underpinnings of volatility/probability, while also seeing how the dynamics of markets demand the application of the principals of physics, helping put the odds of success back in their favor. All three aforementioned points could be of great benefit in helping defeat false technical signals, seemingly random price action, and the lack of volume/order transparency retail traders are faced with daily.
With everything we've covered in Chapter Two in mind, please make sure to remember common technical indicators (especially on shorter-term timeframes) are providing greater amounts of false signals, with each passing day.
It is arguable trading purely from technicals once allowed retail traders to clearly see the fundamental paradigm unfolding via price action; however, within today's Forex volatility, the bar for success has been moved much, much higher.
All participants must now pay attention to fundamentals, institutional-grade technicals, volatility/probability, and market-physics to truly trade profitably in the constantly changing markets of the 21st century...
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July 1, 2009
Dear Mark,
Your book is very powerful, a real game changer... an absolute work of genius."
N e w t o n illuminated natural forces, Einstein illuminated energy and now your work/book has finally broke through and illuminated the forces and energy behind price action and volatility in the markets... (Brilliant!)
On a personal note, my office book shelves are filled with trading books on all the popular subjects... personal psychology, money management, fundamental and analysis, technical analysis, etc... and at the end of the day, they start to all pretty much sound the same... I am actually embarrassed to admit how much time and effort I have put toward trying to learn and make all that stuff work.
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