Lessons From the Trading Pits

Spend time with a broker or pit trader from the era when all trades were executed in a trading pit at an exchange and you will learn about the open outcry and the information it provides. Pits were created to facilitate trade. To an untrained eye a trading pit looks like a mess of mad aggressive people wearing crazy colored jackets. But for a seasoned observer a trading pit reveals incredible amounts of information that is not available on screens or trading platforms. Professional traders monitor order flow. Pro traders use a combination of market generated information (technicals) and fundamentals (supply/demand or earnings) to define and refine strategies.

Seek an Edge

While at the CBOT and CME one of my duties as a broker was to relay and interpret price action to institutional traders and fund managers. It was as if I was a color commentator at a sporting event. For example, a bank from New York would call and ask who or what firm was buying or selling and how much. Meanwhile, a fund manager from overseas might ask how big the bid or offer was to find out if buyers or sellers were dominant. Another client might inquire if volume was light or heavy. Some traders sought support levels to buy or resistance prices to sell against. Some just wanted to know where to set risk or stop loss orders. They were seeking an edge. The questions varied, but there was some consistency to the information professional traders seek.

Think Like a Pro

To create a discipline or strategy follow the path professional traders take. The goal…Find the answers to the questions pros ask, day in and day out. I condensed these questions into an easy to remember acronym, VERTEX. To trade with pros, we must think like them.

Determine Value

The “V” stands for Value. Value is an area that buyers and sellers transact most often. It is considered a high-volume zone. A value area is defined as a standard deviation (roughly 70%) of volume surrounding a mean or fair price. In short, it is a congestion zone. Momentum (direction) is the movement away from a fair value area. When fair value is identified, a direction to favor is revealed.

Trends Require Energy

“E” is for Energy or momentum. Before markets trend, they often go through a consolidation phase. Think of such phases as load zones. Below average ranges and volume, along with similar opens and closes are like gun powder. Increased time spent consolidating leads to more powerful vertical moves.

Define Risk

The “R” represents Risk. Risk is an unexpected change in momentum. One of the toughest tasks a trader faces is to admit when a trade has gone bad, thus accepting a loss. There is no standard for defining risk, but for a start refer to the ATR (average true range). When entering a trade set risk at 50% of an average day range (ADR).

Timing Trends

“T” stands for Timing. Markets do two things: They trend and consolidate or run and rest. When a market is considered overbought or oversold it has moved too far too fast, thus favoring a rest period or consolidation phase. Therefore, the timing is not ideal to enter a trend type trade. On the other hand, when ranges and volume are below average during a period of consolidation, odds increase for a breakout or trend to begin. A trader should track ranges in various time frames (day, week, month). ATRs (average true range) can be used to identify when a trend is near an end or when one is about to begin.

Fundamental Events Expose Support/Resistance

The second “E in VERTEX stands for entry. Support or buy levels often form where long positions were previously taken (double tops/bottoms). Resistance levels form where sellers previously took a stand. Another area where support/resistance areas (reversals) form are defined old congestion zones. They are especially effective when retesting an area where a previous fundamental event changed the course of a trend. In other words, when old breakouts prices are retested, reversal often occur.

Project Exits

The “X” in VERTEX refers to eXit. This can be defined as a risk level or projected profit. Traders seek to ride a trade or trend until exhaustion. In other words, they seek maximum profit while minimizing risk along the way. Trailing a stop at a percentage of an average day range is a solid strategy. Once in a lucrative trade the goal is to mitigate risk as quickly as possible and pocket profits while the trade moves in your favor.

John Seguin
Senior Technical Analyst
Market Taker Mentoring, Inc.