As many of you are aware we do an awful lot of algorithmic trading and trading strategies based on order flow techniques. Principally this is because many years ago now we built a set of infrastructure to allow us to track this stuff in detail, and secondly it’s because it is so powerful (and very few have the access we do).
However without the infrastructure there are some general lessons and themes we can all learn from what we and our algos see.
1) It is natural for traders to focus on what we could call range trading.
The challenge with this is the idea is born out of trying to pick tops and bottoms in the market. The reason for this is that a lot of Retail Traders focus on much smaller timeframes. Essentially the most common way a Retail Trader trades can be demonstrated by the following image.
The black lines represent a channel we have drawn on the chart and the blue line is price. The most common response for a Retail Trader in this situation is to put an order to go short at the black line, where I have put a red circle on the image below.
This isn’t a bad strategy in low volatility environments and it is often referred to mean reversion. I actually had an individual who claimed to have 10 years experience in the markets tell me that this was the most profitable way as markets aren’t trending that often.
However range trading in this fashion tends to be around 35% to 40% accurate if you continued to do run this style of system through all trading conditions unless you have a really high probability way of determining we are in a strongly range bound market (and I’ve seen a lot of claims from people they can work this out and no-one who ever has). There is a reason the world’s brightest and best traders don’t use this technique. Given the accuracy, this is where Retail Traders normally fumble.
If I am placing my short order there, what I need to ensure I do is to limit my stop so that it is less than 1/3rd of the size of that range in order to remain consistently profitable on a long run average.
Here is where the behaviour gets interesting, let’s say price now breaks the range and moves up.
In theory you should be stopped out of the trade and you wait for the next signal. But here is where Retail Traders on average do one of three things. They either, reverse their position long to try and capture the move higher. They move their stop out as ‘it must turn soon’
Or they double down their position to make the loss seem smaller – often when they do this they cancel their stop on the grounds that it must come good at some point. The reality is, what price is likely to then do is the following.
And most likely everyone lost as they went through a similar process of reversing and not closing positions as it was no going their way.
What this actually leads to is the following overall behaviour that in general Retail Traders will on average will go short (sell) in an uptrend and go long (buy) in a downtrend.
To give you some proof of this I have included below a version of one of our in house systems we track. On the indicator I have marked a 50 line, this means anything above 50 means Retail traders are on net long, anything below 50 means Retail Traders are net short.
The first circle shows when Retail Traders went net short, we can see nice range trading then breaks out and Retail Traders continue to short the move higher as…’it must come down at some point’…
The second circle shows when Retail Traders finally went next long only for price to move lower, Retail Traders to flip to Net short then price moves higher again.
In all that move higher covered 1,000 pips which Retail Traders stayed short on average for the whole move. When armed with this knowledge it is easy to see a trick to play and what you will find a lot of brokers tend to do. Brokers simply take the opposite position to the Retail Traders, this is often referred to as their ‘B’ book.
It’s that simple.
If you had gone long when Retail Traders went short, you would have netted 1,000 pips in 2 months on one currency pair alone and you wouldn’t need to have even been at your desk trading.
We actually give a widget in our Live Trading Hub that shows you the average price Retail Traders got in at. What’s even better is that this is a widget based on the majority of those trading systems out there that claim to be ‘amazing’ and help you get rich quick.
If you ever look at it you will see the long traders are typically out of the money and the short traders are typically out of the money.
This also links to another problem of just holding those losing positions too damn long and booking profits far too early. Why we insist people write down trading plans and use as many tricks as possible to stay disciplined to their risk reward.
One of the simplest ways to find out what Retail Traders are doing though is by looking on social media sites like Twitter; you can soon get a feel for what the crowd is doing by looking at the #forex feeds.
My general advice is that it is better to form your own opinion and trade on your rules; don’t be tempted by that ’sure thing’ or that ‘amazing systems that makes you money every day’. Neither of these things exist; now start learning to trade properly.