Adam Button Secrets to Trading

8/10/2019 Adam Button Secrets to Trading

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18 Secrets to Trading the News

Secrets toTrading the News

Adam Buttons

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Introduction

Watch the Soap Opera

Whats Expected Is What Matters

Whats Expected Isnt Always Whats Expected

Dont Fight the Narrative

Trade the Skew

Fade Moves on Disasters

Uncertainty Breeds Contempt

Beware the Growth Trap

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Contents


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rading headlines is a great way to earn a living from markets. Computers

can trade technical patterns, and algorithms can arbitrage different markets,

but they will never be able to fully interpret news.

Reading a headline, understanding what it means and making a trade is

one of the most rewarding experiences in markets. Its the feeling of being

completely synchronized with the market and understanding its rhythm.

Every situation is different and nothing unfolds exactly as planned, but

there are some ways to get an edge when youre trading news. Tese tips are

designed to help you make money.

Introduction


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All news isnt created equal, not by a long shot.

Whoever wrote that markets are efficient didnt live a day as a trader. Markets

move on the whims of people and, even collectively, people can be irrational.

Markets adopt themes, and traders quickly fall into the habit of trading them.

As this happens, correlations change and the same news brings a differentreaction. Tere is no dogmatic answer to the question What matters?

because the market evolves.

Te market is like a soap opera. Every day is full of twists, drama and

cliffhangers. Te most important thing is to stay immersed in the story.

When you miss an episode, the plot is harder to follow and understand. Over

time, characters and storylines appear and fade out.

For someone who trades news, taking a week of vacation can be a frightening

thought suddenly the story makes less sense and the flow of the market isharder to digest.

Tats not to say its a full-time job to follow the news. Even the most cursory

market reports offer a sense of what matters to markets.

Te main takeaway is to understand that whatever theme is in the spotlight

will impact markets more than it really should. It means that at one time

Greek election polls meant more than German GDP. At one time, US

housing starts meant more than non-farm payrolls.

In general, the market divides its focus between growth and inflation. When

you stay on top of the story, you can stay on top of the trade.

I wouldnt mind

so much if Iknew what was

happening on

the soaps.

Watch the

Soap Opera1


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On an airplane recently, I was reading a Wall Street Journalstory on the latest

non-farm payrolls report. Te headline said it was the worst jobs data in eight

months, and the story was filled with sensationalism and data. Economists

talked about what it meant for the economy and mused on the reasons for

high US unemployment.

I finished the article disgusted because it never mentioned what was expected.

Unemployment could be the worst in twelve months; heck, it could be the

worst in five years, but what matters to the market is whats expected.

Market prices arent built only on what we know about the past and present;

the main element is the future. If the UK unemployment rate rises to 8.1%

from 7.9%, thats bad news if youre a worker. But if expectations were for a

rise to 8.5%, then its great news if youre long on the pound.

Markets constantly weigh new information to try to form a picture of thefuture. Te market has a clear image of how the economy performed in the

past, a good sense of how its performing in the present and a murky idea

of how it will do in the near future. Markets change as the murky idea

gets clearer.

How are expectations formed?

Economists wield tremendous power in markets, and I dont mean the

economists at your local college. Te economists who matter are part of

teams of people who sit adjacent to the worlds largest trading floors andforecast nearly every economic data point.

Te good ones are responsive to markets and adjust forecasts in real time.

Some build complex models to make accurate forecasts. In the world, there are

perhaps 200 groups like this. Tey are called qualified economists, and their

forecasts are collected by major news services like Bloomberg and Reuters.

Whats Expected

Is What Matters2


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Te aim is to collect as many forecasts as possible on every piece of economic

data. Te idea is that a sampling of economists estimates will accurately reflect

market expectations. If there are 45 estimates for an economic data point, they

are sorted and the median forecast is listed as the consensus estimate.

Understanding whats expected gets a bit more complicated when data

isnt involved. Elections can have many outcomes, government budgets arecomplicated and trade deals are difficult to quantify.

At the end of the day, everything affects markets, but at the bottom line there

are growth and inflation. Of the two, growth is the more important because

it usually foreshadows inflation. Every piece of news fits in the growth puzzle

or the inflation puzzle so, most importantly, understand what kind of growth

and inflation is expected.

You could put it all into bricks

But I recommend diversifying your

investment to include sticks and

straw as a hedge.

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raders with a cursory understanding of expectations are dogmatic. Tey look

at the Bloomberg survey of economists expectations and assume it aligns with

market expectations. Tat isnt always the case.

First, understand how the consensus estimate is reached. News organizations

poll the head economists from big banks and research firms on what

they expect. Tey usually come to these numbers using economic models

or regression analysis. In other cases, the numbers are little more than

guesstimates. An important US indicator might have 5060 estimates, while

a second-tier indicator in Australia might have fewer than 10 forecasts. No

matter how many estimates, the median forecast is used as the consensus.

Te first way to gain an edge is to understand that there is a time lag in

expectations. Many economists estimates are collected a week or two beforethe data is released. In the time between, a number of data points could change

the outlook, and its rare for economists to update forecasts.

For instance, in the week before non-farm payrolls, there are many other

employment indicators, including the ADP estimate, the ISM employment

components and initial jobless claims. As these are released, the market

changes its expectations. Te consensus might remain at 180K for non-farm

employment change, but if those indicators are soft, traders will already have

priced in a reading near 150K.

If the result is 165K, the knee-jerk reaction might be for USD/JPY to go lower,

but traders who truly understand what the market expected are buying, and the

market is likely to reverse. Tat difference between economists expectations

and market expectations is a way to gain an edge.

Another instance when market expectations differ from economists

expectations are events that have binary outcomes. Te most common is an

Whats Expected

Isnt AlwaysWhats Expected3


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interest-rate decision that has only two realistic outcomes: cutting interest rates

or leaving them unchanged.

With central bank decisions, polling economists to understand whats

expected is filled with pitfalls. If 11 of 20 expect a rate cut, then a rate cut

is the consensus, but its not immediately clear how close it is. If 17 of 20

expect a cut, it appears to be an overwhelming consensus, but a dozen of thoseeconomists could believe its a very close call.

Aside from these obvious problems, economists have a tremendous amount of

pride in correctly predicting the path of interest rates. If a team of economists

have been predicting a rate cut for the past eight months, they loath sending

out a note to clients in the days leading up to the decision admitting theyve

been wrong all along.

Instead, look to derivatives markets. Overnight index swaps are often used as

a proxy for interest-rate expectations and they give market-based information,which is far more accurate than economists predictions. Tey can also be

boiled down to percentage probabilities. An economist will predict rate cut or

no rate cut, but the OIS market can show a 40% chance of a cut.

Te difference can be huge, and if there is any discrepancy, always go with the

OIS market.

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In a sense, markets are all numbers data, prices, profits and pips. Its easy

to try to tie a probability to every event and lose track of the bigger picture.

rends happen because of stories: the Australian dollar has soared because

of a decade-long mining boom. Te Japanese economy has floundered for

a decade because of near-zero inflation. Te US recovery is built on rising

home prices and consumer spending with employment gains on the way.

If you understand the narrative, its much easier to see where news fits

in. Sudden strength in manufacturing would add a third pillar to the US

recovery and make those employment gains more likely. Several more soft

manufacturing reports might mean nothing because they dont change the

underlying story.

Sometimes the story the idea can be more powerful than the

numbers. Tis is always the case with bubbles: buying real estate is always a

good investment. Gold is the only true store of wealth. China will power

past all challenges. Tese are all examples, but the market flirts with smallerideas constantly.

Te idea of US energy independence is a growing, powerful force in markets

that threatens to underpin a long-term dollar rally.

When an idea grips a market, oftentimes the data doesnt matter. ech boom

Internet companies never made money or showed a reasonable path to

profitability, but they traded at incredible valuations.

As Galbraith said, markets can remain illogical longer than you canremain solvent.

Some trends cant be fought with logic; embrace them. If youre waiting to

fight an illogical trend, you will have to be incredibly patient and accept that

timing the top is impossible.

Dont Fight the

Narrative4


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What if I told you about a level in a market that couldnt be breached? Such as

a ceiling or floor restraining price action.

For example, the Swiss National Banks EUR/CHF floor. Officials drew a line

at 1.2000 and promised to sell the franc in unlimited quantities to protect it.

Tere were questions about the credibility of the promise, but it has been kept.

When you bought the pair at 1.2020, the downside was limited to 20 pips butthe upside was unlimited.

Sometimes news events are like that. Clear lines like 1.2000 rarely apply, but

oftentimes markets head into news events in a position where its easier to move

in one direction than the other; thats called a skew.

I can illustrate with an economic data report. If the ISM manufacturing index

is expected at 51, the data could be either stronger than expected or weaker

than expected. Assuming an equal probability of either stronger/weaker, its a

coin flip, but market positioning isnt always like that. USD/JPY might haveclimbed 5 days in a row heading into the report on expectations that the

Federal Reserve would hike interest rates; there could also be a major level of

technical resistance nearby. If the report comes out stronger, there isnt much

upside left in USD/JPY, maybe 30 pips. On the other hand, if the report is

soft, it could change the dialogue and cause a powerful round of profit taking,

maybe 80 pips. Tats skew, and its something traders are always looking for.

Finding a skew in the market isnt always straightforward, but the way to search

for it is by working through different scenarios. Anticipate many different

outcomes and imagine how the market will react.

Not only is this a great way to find a skew, its also an ideal way to prepare for a

trade and learn about the theme in the market.

Trade the

Skew5


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Fear is the easiest emotion to trade against.

When an entirely unexpected event like a natural disaster or geopolitical

event takes place, the first reaction on trading floors is always the same

close positions.

Markets react to these events extraordinarily quickly the combinationof uncertainly, confusion and fear means a rush to the exits. rading floor

televisions captivate risk managers and traders lose focus. Its a very delicate

mental state, and when the market begins to move, everyone wants out.

It doesnt take an especially cool head to trade at those times because the

outcome is almost always the same. Fading the panic move is a surefire way

to profit. Unless the news means a third world war, the market will rebound.

And if it does mean a third world war, were all done for anyway.

Natural disasters are terrifying, but human nature is incredibly resilient.We rebuild stronger, and the economic impact is always less than feared.

Look at the bright side. Its better

to have loved money and lost thannever to have invested at all.

Fade Moves

on Disasters6


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Many market axioms are beaten to death, but I think that one is not repeated

often enough.

Te flip side of knowing what is moving the market is to know what isnt

moving the market. Tere is always an analyst willing to go on V and attach a

7.3% decline in the Japanese Nikkei to a softish data point from China. If you

know the theme, the story and whats important, you know that the declineisnt true.

When you know the news, you know that sometimes market moves are

inexplicable; this happens far more often than analysts like to admit.

At a certain level, this is okay. Flows move the market, and 4050 pip moves

in currencies are part of the background noise. In those times, it pays to be

comfortable with the uncertainty because it can be used to establish positions.

Te game changes when headlines cross and traders expect it to mean one typeof reaction, but the opposite happens or it happens on a scale way beyond

whats normal. People scramble for explanations, and traders with a fringe

knowledge of the news accept market fluctuations so they act as though

nothing has changed.

At this point, good news-traders start to realize the pieces no longer fit, and

they begin to close out positions. Great traders begin to fade all the most

popular trades because they realize that contempt is coming because when the

pieces dont fit, traders head to the exits.

When the stories begin to break down and volatility begins to rise, position

for contempt.

Uncertainty

Breeds Contempt7


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Its not about the state of growth; its about the pace of growth.

Te market doesnt like good growth; it likes accelerating growth. China may

be growing at 8%, but it was growing at 10% before, and the slowdown in the

pace of growth is what matters. Tis is called the second derivative, and its the

tectonic plate that markets shift on.

raders found it extremely difficult to invest in Europe since the crisis because

growth was nil. But markets can rally on zero growth if its stabilizing after a

recession. In fact, thats often when you see the strongest markets. A currency

doesnt bottom when growth bottoms; it bottoms when the pace of contraction

begins to slow.

Tis rule is clearest for growth but it applies for all news. Markets move at the

margins, not in the absolutes.

Beware the

Growth Trap8

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