This book is about gaining an advantage over your competitors.
To achieve this advantage, you must first discard the belief that there is a linear relationship between risk and reward. The primary objective of investing (and trading) is to identify asymmetric opportunities.To capitalize on these opportunities, you must learn to identify imbalances that reveal themselves in evolving market structure. But that is only the beginning—you must also understand the way you process and respond to information, so your ability to act is not blocked or distorted by peripheral influences.
Markets in Profile: Profiting from the Auction Process introduces a unified theory that explains the market’s auction process in relation to the human decision-making process, and the way market behavior affects human behavior. The bottom line? You
MARKETS ARE RATIONAL, PEOPLE ARE NOT
The “efficient markets” theory is half right. The market’s mechanism for allocating prices is extremely fair. It’s a simple two-way auction process by which price moves over time to facilitate trade either up or down—an extremely rational, efficient process.
The other half of the efficient market equation, however, is often wrong; people are seldom rationalwhentheymakefinancial decisions. The first step toward more profitable investing is to accept that market irrationality is due to the fact that people make decisions based on (unavoidably) incomplete information, which often results in the worst decisions being made when it is most important to be right.
Human nature is such that we tend to overweight information that supports our presupposed inclinations. We seek out a few pieces of the bigger picture that make us feel confident in our decisions. This recurring overconfidence is behind the idea that markets are “irrational in a predictable manner,” a landmark theory put forth by Nobel Prize–winning psychologists Daniel Kahneman and Amos Tversky.
But Kahneman and Tversky didn’t take this information to the next level. They didn’t explore how to take advantage of that fact. In this book, we show you how the auction process both records and reveals market structure—and how, within that structure, predictability manifests itself in recognizable forms such as the “excess” that occurs at the end of an auction. We show you how excess is formed, too, and how to view it objectively in order to better manage risk.
All markets alternate between periods of stability and crisis. By monitoring market structure in real-time context, it is possible to recognize paradigm shifts in equilibrium. Market indicators such as excess make it possible to identify when the status quo is changing, which results in opportunities to distinguish favorable (and unfavorable) investment opportunities. In other words, it is possible to ameliorate risk by recognizing imbalances caused by irrational human behavior such as the herd instinct, which pushes price away from value.
Everyone talks about the problems of investing and market behavior.We are proposing a solution, a means of interpreting market behavior through the lens of human consciousness, and then quantifying that information in a way that enables investing on a more probabilistic basis.
IS THIS BOOK FOR YOU?
While this is a collaborative work, the rest of the preface and many of the experiences shared throughout the book are written from the perspective of lead author Jim Dalton, who has spent his career furthering his understanding and mastery of the markets.
As the lead author, I’m often asked if I’m writing for investors or traders. I believe such distinctions are in many ways arbitrary for there is no line where one stops and the other ends. It’s a spectrum, and every individual and every institution falls on a different point. That point changes constantly depending on the phase of activity. Even the longest-term investor should change his decision-making process in order to exit or enter a position. Trim, add, raise cash, change asset allocation—these are all timing decisions. In The Tipping Point, Malcolm Gladwell could have been writing about markets when he described crime as not “a single discrete thing, but a word used to describe an almost impossibly varied and complicated set of behaviors.”
Perhaps you’re a growth investor. Or a value investor. Large cap, small cap—most institutional investors tend to pick a style and stick with it. The theories in this book are not dependant on the condition of the market, nor on what style is currently in favor. In fact, much of the power and appeal of these theories is that they are totally agnostic in terms of style, cap size, and asset class. The concepts you encounter are equally applicable to any style of investing, any timeframe, even any market, because the auction process works equally well for futures, real estate, art, even eBay.
The core idea is simple: all financial markets are measurable by time, price, and volume. This multidimensional approach to interpreting marketgenerated information enables you to differentiate between prices, because all prices are not equal. By extension, all opportunities are not equal, which is key in managing the probabilities of risk.
KNOW THE MARKET, KNOW YOURSELF,
The world wants absolute answers. This is why we are being careful to note that whatweare suggesting is not an academic model to replace the efficient market hypothesis. The conundrum is that mathematics and factor-model approaches are more consistent than human intuition, but they don’t allow for enough flexibility to respond to rapidly changing market situations. They don’t allow you to distance yourself from competitors who apply similar models. It’s like watching the world championship of poker—all the good players know the odds. That’s why winning takes another level of understanding.
This book separates the market mechanism from the investor. While it is possible to describe the workings of any market within a single coherent framework, that knowledge represents only half of the equation. It is not enough to grasp how markets work; you must also understand how you take in and process information, and then execute based on that information. This concept has gained currency since “Prospect Theory” established that we are not rational decision makers. Our emotions can weaken or completely eliminate our self-control . . . but we’ll save a thorough discussion of human behavior and neuroeconomics for a later chapter.
We’re simply suggesting that traditional fundamental analysis can be enhanced with real-time context—time, price, and volume. By interpreting analysis in relation to market-generated information, the investor can better understand the nature of change, which can positively influence trade location. Trade location is the key to controlling risk and taking advantage of asymmetric opportunities that occur within developing market structure. In recent years, the bifurcation of the brain has been explored thoroughly in popular media. We are not the first to suggest that successful investing (or successful anything) incorporates both sides of the brain. The goal is to balance the analytical hemisphere, made manifest in vital fundamental research, with the pattern recognition of the intuitive hemisphere in a present-tense process.
We’re talking about whole-brained investing—aholistic, context-based understanding of market activity. As in all things, balance is the key to success, a concept that will appear throughout this book.
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