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THE WORLDS SMARTEST

trader does not think aboutmarkets like normal peoplethink about markets. Nor-mal thinking is not going toput you on a level playing

field with Wall Streets rocket scientistsand a legion of hungry hedge funds scan-ning markets for opportunities.

Now, I may not know the worlds singlesmartest trader, or maybe I do. In 28years, Ive modeled the thinking pro-

cesses of those, who were at one time oranother, considered to be the best and thebrightest. And, Ive traded continuouslymyself during that same period.

In the last 20 years of running a tradingsystem research & development busi-ness, Ive also had the privilege of workingclosely & openly with a loosely-knit groupof world-class traders, most of whom areobscure, quietly running their private trad-

ing funds and raking in outlying returnsyear-after-year that would be the envy ofany hedge fund.

Remember, this composite mind, which Icall the worlds smartest trader does not,by nature, think about markets like nor-mal people think about markets. Normalminds trade systems & price patterns; oruse a linear thinking process trying to beatthe Street at fundamental analysis.

First of all the smartest trader in the worldis formless. This means that his (orher) behavior is essentially adaptive bynature, moving between strategic andtactical behavior according to the type ofmarket environment.

Second, the smartest trader in the worlduses principle-based trading methods.This means his trading methods are an ex-

Inside the Mind of the WorldsSmartest Trader: Part 1

tension of core trading principles which re-

flect primal market behavior and optimaldecision-making practices extracted fromvast stretches of market time. This is theonly way to insure consistent profitsthat his trading remains stable and robustover time.

Now, if I gather up that entire constellationof observations & experiences and con-dense it into the simplest possible tradingmodel, I would really end up with two mod-els: one tactical (shorter term) and the

other strategic (longer term) model. Ican describe the tactical model like this...

A. Degrees of Surprise

George Soros, Co-founder of the Quan-tum fund, is a legendary trader, famouslyknown for breaking the Bank of Englandin 1992. With an estimated current networth of around $8.5 billion, hes rankedby Forbes as the 27th richest person in

America. Soross trading was greatly influ-enced by philosopher Karl Popper and anoddball concept called reflexivity.

Popper, considered one of the more influ-ential philosophers of science of the 20thcentury, claimed that unexpectedness, ordegree of surprise, is the correct mea-sure of the information content of a scien-tific hypothesis. In other words, he pro-posed that when analyzing a body of data,

the unexpected data point or the observedoddity provides a richer source of informa-tion for drawing conclusions.

Lets call this the Popper Principle . Re-stated from a trading perspective: Unex-pected price action foreshadows di-rectional bias (trend).


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I believe this was (is) a seminal idea for Soros and it really deserves to be a seminalidea for anyone using technicals, because one of the primary goals of technical-analy-sis is to determine whether a trend is continuing or reversing.

The most effective technical-based trading tools which weve developed for clients arebased on this same idea of measuring the degree of surprise in price events, which wecall out of character price action.

We also think its critical to monitor the variance in perception among traders who pull

information from different points of view. Simply put, a day trader whose world-viewof a market is comprised of tick or intraday bars has a vastly different perception ofcurrent price action than another trader operating in that same market in a monthly orquarterly timeframe.

Surprise Comes in Two Flavors

The most important type of surprise in the technical world are counter-trend retrace-ments which are out-of-character (different from recent retracements). A second formare sustained directional moves (trend runs) which are out-of-character because theymove beyond normal objectives in terms of price or duration.

The essential point is simply that abnormal price action reveals important changes inorder flow and momentum and provides the context that the smartest trader in theworld keys off for tactical trade ideas. Lets call the movement into and out of a givenmarket at opportune times, smart money order flow.

Part B: Pre-conditions for a Tactical Entry

An effective model for trackingsmart money order flow into tac-tical trade entries has two coreelements. Well describe those

elements in terms of a buy.First, an unexpected (as de-scribed above) retracement oc-curs which reveals a changein the supply-demand dynam-ics and serves as a green lightalerting smart money tradersto begin stalking a possible buylong. Joseph Hart ofTrend Dy-namics called this the surpriseswing. And recall that the Pop-

per Principle says that unex-pected price events foreshadowdirectional bias (trend).

Recently (in 2006) we alertedsubscribers of the potential forimportant lows in PPH and Nat-ural Gas futures. Here are twoexamples that illustrate how weisolated those lows and then initi-ated long entries in them beforethey exploded. We cant reveal

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the exact algorithms we use in-house to identify when surprise swings occurs, and theactual process is more complicated than recited here, but the general idea is presented.

In late Spring and Summer of 2006, PPH was mired in a downtrend (see Chart 1,page 2). There were a couple of key countertrend reactions (A-to-B and C-to-D).Suddenly a surprise swing occurred in late June (E-F). This particular surpriseswing was out-of-character as it exceeded the previous rallies in amplitude.

Since price has already movedsignificantly away from the low,the trade location for going longis not attractive, but this typeof rally attracts the attention ofsmart money traders who willbegin stalking PPH to watch forlow risk buy entries or to accu-mulate longs on a retracementunder the assumption that thebuy-side order flow may beemerging as a new dominant

factor.

The second example (Chart 2,right) set up our recent buy inNatural Gas futures. In Augustand September of 2006, NatGas was in a severe liquida-tion burdened by news of ma-

jor hedge funds taking severelosses in Nat Gas positions.

From the top in early August,there were two distinct coun-tertrend reactions (A-to-B andC-to-D). After touching the $6handle there was a subtle sur-prise swing up in October which is out-of-character.

W.D. Gann, in How To Make Profits in Commodities, called this process overbal-ancing as the E-to-F move exceeded the previous corrections in both duration andamplitude. Again, this is the type of rally that draws the attention of smart moneytraders who consider this sort of price action indicative of a possible trend reversaland a reallocation by commodity traders back into the long side of Natural Gas.

So the first element, a surprise swing, hints that the order flow in a particularmarket may be reversing which, attracts large speculators and hedge funds.

Part C: Technical-based Variant Perception

In Part B, we described the first condition for a tactical long entry as a surpriseswing.

The second element is essentially a condition called variant perception. It comesin many colors, but was first coined by another wildly successful investor/trader,

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Michael Steinhardt who, like Soros, extracted multi-millions of dollars in profitsfrom markets using this principle. In Steinhardts case he considers a perception hesdeveloped about a market which is at variance from consensus to be a variant per-ception.

Technicals can be used for tracking variant perception among traders because tradersusing different types of data (intraday vs. weekly for example) draw varying conclu-sions about the import of adverse reactions.

After a rally, offers begin to come in and price begins to drop which forces action. Sell-ers, whether bears going short or bulls liquidating longs, sell because they anticipatethat price is going significantly lower in the near future.

If sellers think price is only going to move marginally lower, they would not feel anyurgency to sell. Volatility fuels that urgency to sell and creates an exaggerated percep-tion in the minds of sellers of price moving down to some projected price which longsbelieve is intolerable, and shorts believe is ample enough to offset their risk, hencethey liquidate or sell short.

This mental projection is

essentially a form of nega-tive sentiment and it direct-ly correlates with short-termprice action and volatility. Inother words, a violent movedown tends to equate with amore bearish (lower) projec-tion than an incremental movedown. Weve developed an in-dicator, called STS for short-term sentiment, which plots aminimum downside projection

where bearish short-term trad-ers expect price to go based onthe intensity of selling.

In the PPH (Chart 3, right),the blue line, at A, is the STSor short-term sentiment plot ofprojected downside based onthe onset of the sharp decline(from C).

But, large specs and hedgefunds are usually operating in ahigher timeframe. If they believe a trend is in the process of reversing, they will oftenstalk a retest of the low for two reasons. One, many of them are moving so muchcapital that they have to buy weakness (absorb offers) in order to initiate large sizepositions.

Two, many hedge funds trade with leverage so they must look for low risk entrieswhich accommodates a leveraged strategy and offsets the probability of being wrong.Therefore, after a surprise swing up, smart money bids will stack up at specific levels

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underneath a market anticipat-ing a retest of the low whichfacilitates smart money accu-mulation.

We use technical tools thataccurately determine wheresmart money bids will begin todefend (buy into) the retest, wecall this the bid (or offer) line.The light and dark green dots(near D, Chart 3) represent ourcalculation where smart mon-ey bids are stacked. Now keepin mind, the smart money hassuperior odds because theyretrading WITH the Popper Prin-ciple: that unexpected marketevents foreshadow directionalbias.

In PPH, you can see the short-term sentiment (STS) is belowthe smart money bid line (D),which means sellers believeprice is likely to drop to a pricelevel which is more pessimis-tic than smart money buyers,who are willing to accumulateat and below the bid line.

This is an example of a tech-nical-based variant percep-tion (or divergence) betweenshort-term sellers and highertimeframe smart money buy-ers willing to absorb offers atthe bid line. We call this a TT(tribal tactical) buy.

When this condition is real-ized, when smart money de-tects optimal trade location

and the offers are absorbed,new bids come in and price of-ten rises suddenly (see Chart4, upper right).

Lets review the Natural Gas ex-ample using the same trackingmodel. In Part B, we isolateda surprise swing up in NaturalGas (shown here at A, Chart 5,right). This subtle price action

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attracts the attention of smartmoney buyers who look to buya retest which creates stackedbids under the market at D.

Meanwhile, at C, the STS orshort-term sentiment plot ofprojected downside drops be-low the smart money bid line(at D).

In Chart 6, (right) we see thatsmart money buyers success-fully defended the bid line (atD) as they accumulated tacticallongs for a sharp move up.

These are two classic examplesof variant perception basedon technicals and we alerted

traders to both of these tradesBEFORE the rallies took place.We issue these timely alerts viae-mail in a PDF format, titledTribal Trading Tactics (if youarent getting them, sign-upHERE).

Keep in mind, in markets were always dealing with uncertainty and probability;sometimes the short-term bearish sellers increase in number and intensity and over-whelm buyers and price moves on down and a tactical buy (or sell) fails so risk man-agement is always important.

RISK MANAGEMENT:For sellers to breech the bid line and negate the trade weneed to see the high of a daily bar form completely below the bid line (lower lightgreen dots) and for the low of that signal bar to be breached to the downside. We alsoprovide a fixed price level as an alternate fail-safe stop (not shown here). You canreview that risk management process in more detail HERE.

At the beginning of this tour inside the mind of the worlds smartest trader, I said thesmartest trader in the world is formlessessentially adaptive by nature, movingbetween strategic and tactical behavior according to the type of market environ-ment. Weve already described a model for tracking smart money behavior at a tacti-

cal level. To explore how the smartest trader in the world thinks strategically... GoHere

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Tribal Trading Tactics and Ultimate Market Timing, Trend Dynamics are produced by Axis Analytics/Trend Dynamics, Inc. Web sites:www.Axis-Analytics.com and www.Trend-Dynamics.com PHONE: 805-481-4358 Fax: 805-714-3419 Mail: 122 Deer Trail Cir. ArroyoGrande, CA USA 93420. INQUIRIES can be directed to: Subscription Inquiries: Kristie Kophamer: [email protected] Technology: Taher Mashour: [email protected]
http://axis-analytics.com/freetrial.htmlhttp://axis-analytics.com/tribaltraders/free_pdfs/tt_specrep.pdfhttp://axis-analytics.com/pdfs/tt_started_pt2_ab.pdfhttp://axis-analytics.com/pdfs/tt_started_pt2_ab.pdfhttp://axis-analytics.com/pdfs/tt_started_pt2_ab.pdfhttp://axis-analytics.com/pdfs/tt_started_pt2_ab.pdfhttp://axis-analytics.com/tribaltraders/free_pdfs/tt_specrep.pdfhttp://axis-analytics.com/freetrial.html

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