How to Conquer Wall Street’s “Matrix”
Algorithm (noun): a process or set of rules to be followed in calculations or other problem-solving operations, especially by a computer.
As algorithmic trading becomes more pervasive, the investing world is starting to resemble the digital reality depicted by the movie The Matrix. But here’s the good news: average retail investors can actually beat the algorithms used by the Big Boys on Wall Street.
To learn how, I turned to an analyst on our staff who specializes in technical trading: Dr. Joe Duarte, chief investment strategist of Profit Catalyst Alert.
Dr. Duarte (pictured) has been a professional investor and independent analyst since 1990. He is a former registered investment advisor and author of the bestselling Options Trading for Dummies, and several other books including Market Timing for Dummies and Successful Biotech Investing.
Dr. Duarte is a medical doctor, and when it comes to investing, he’s also a skilled chartist. To outwit Wall Street’s Matrix, he’s the next best thing to Neo. My questions are in bold.
How are things in Texas?
To be honest, they’re a bit like the market right now, with the weather changing by the minute. If I had to describe them both, I would use the word hazy.
“Elves” is a slang term for technical analysts such as yourself. To borrow a phrase from Lord of the Rings, what do your “elf” eyes see at the moment?
Your latest video presentation on artificial intelligence, algorithms, and robo-trading provided a good context for our discussion today.
I tell ya what, though. I wish I had weather charts as reliable as the stock price charts that I scrutinize on a regular basis.
Well, the weather is chaotic, which means it’s by nature predictably unpredictable. Anything is possible at any time. On the other hand, the algorithms, aka “algos,” are complex, which means that they follow certain rules and they are more predictable.
Still, just as you noted in your recent video, the trading algos that operate the “passive” exchange-traded funds at Blackrock (NYSE: BLK) and Vanguard have no emotions. They just follow their trading instructions based on the simple principle of their programming: “If this happens, do this.”
Moreover, unlike humans, they seem to learn their lessons. That’s because the programs that instruct them on how to ply their wares are adjusted by humans which helps the machines learn. I think that’s pretty cool, in a scary sort of way.
Are you turning pro-algo here?
I’m just being pragmatic. In the old days, the market was run by cigar-chomping guys who took three-martini lunches. Their main goal was to take money from the unsuspecting masses.
Those guys were clever. And worse, because of their human frailties and potential for doubt, they were hard to predict. Their actions often made for crazy markets.
Isn’t that what the algos do?
Sure. But there’s a big difference. The wheeler-dealers of the past, once they made up their minds about what to do, were very good at covering their tracks. Algos are so fast in what they do that they either don’t care to hide what they’re doing or don’t have time to do so.
Ahhh, in other words, the algos leave behind bread crumbs for you to follow?
Yup. And if you know what to look for you can make better trading decisions.
Intriguing. You’re telling me that you can actually beat the algos at their own game. Tell me more.
In some ways, trading is often easier and can be more profitable now than when old fashioned stock brokers were in charge, if you know what to look for.
First the big picture: Algos run the market. As much as 80% of the daily volume (stocks and options) is due to algo activity. They can be tricky in what they do, but they can’t change volume related metrics.
How can you make sense of volume data?
There are three indicators that are found on price charts that tell you which way money is moving and which way it’s likely to go.
The Accumulation Distribution Indicator (ADI) is a sign of short seller activity. When this line falls it means short sellers, betting on a fall in price, are active. When this line rises, it signals short sellers are getting out of the position. Their reversal of strategy (short covering) causes the price of the stock to rise. Moreover, it further signals that there is less resistance to a move up in price once the buyers return.
On Balance Volume (OBV) gauges buyer interest in shares. When it falls, there is net selling in a stock. When it rises it means buyers are coming in.
When combined, these two indicators show whether money is moving in or out of a stock.
Yes, that’s correct. Moreover, big long-term rallies in prices are more likely when both ADI and OBV are rising simultaneously.
Cool. What’s the third indicator?
Volume by Price (VBP). This one is, in my opinion, the most important of them all in many ways, because those big bars on the left side of price charts are battleground price areas.
These price areas are where buyers and sellers are fighting for dominance of the price trend. Thus, a move above a large VBP bar, or a cluster of bars, means that buyers have gained the upper hand while a move below them is a sign that sellers are in control. These indicators are available on all major technical analysis programs.
So the upshot is, the average investor can get a good handle on what the algos are doing after all.
As we say in Texas, sho’ nuff.
There are two schools of analysis: technical and fundamental. Any closing thoughts on the merits of fundamental analysis?
Technical analysis should be viewed as a useful adjunct to fundamental analysis. There is no substitute for thorough research of individual companies, especially in developing a clear understanding of how management develops and executes strategies.
On the other hand, price charts paint a realistic picture of how the market (mostly algos) perceives management’s actions and the company’s prospects. Algos are just a faster and more sophisticated version of traditional brokers.
Thanks, doc. I appreciate your insights. Our readers need every tool they can get. The stock market has been rebounding, but it remains frustrating and volatile.
Well, this bear market ain’t my first rodeo. Glad to help.
PS: By using the methodologies described in the article above, Dr. Duarte has pinpointed a tiny, unknown company that has developed a revolutionary “black box” technology. You need to get in on the ground floor of this game-changing opportunity before the investment herd finds out and sends the share price soaring. Click here for details.
John Persinos is the editorial director of Investing Daily.