Pro traders know their point of reference before entering into a position
“A fisherman always sees another fisherman from afar.”
— Gordon Gekko
There are only two kinds of story — The one where there’s something outside the cave and the one where someone goes to find out.
We understand these stories. They’ve inspired, taught, and motivated us since we discovered how to make fire. Every book you read, every tv show, every movie, is based on one of them or takes place during the timeline of one.
The 95% hear something outside the cave. Motivated, they go out into unknown to save the tribe. But in saving the tribe, they are really saving themselves.
They’ve taken a course in basic survival, and they imagine returning as the triumphant hero.
A horizon, not a place. The 95% set out unsure of their destination. They head for the horizon and hope for the best, but it’s not like they go out unprepared.
Before the 95% go fishing, they go to the tackle shops and buy the latest equipment. The best rods, reels, and lures. Some take it even further an invest in sonar. Anything they think will give them an edge.
This isn’t a phenomenon that started last year; it’s been going on since we gathered around the campfire. It’s always been like this, and it always will be.
The 95% are always chasing the latest systems and techniques, but they are wasting their money because of one big mistake.
The 95% don’t realise that all the systems they buy and newsletters they read are designed to catch fishermen and not fish.
It’s not their fault. It’s the way human beings are wired.
The 95% are a never-ending supply of suckers because they’re always trying to find the magic bullet. They’re searching for the one thing that will help them achieve the life or the self-image they desire. And they’ll pay almost everything they have to get it.
Most people are dissatisfied with their lives. And paradoxically, it’s not the demographic you’d expect. The most disenfranchised with their lot is often the most outwardly successful.
It’s because they’ve done everything the system asks of them, and yet they know within themselves they were promised more. Somewhere between 35 and 45 years old, and stuck on the freeway, there comes a time when they ask, “Is this all there is?”
And this is why the lure of magical systems is so persuasive.
The 95% ask themselves, “What if…”
Instead of being lost at sea with the 95%, the 5% study the environment of their quarry. They study the ebb and flow of the current and the temperature of the water. They ask what time of the day their prey is most likely to be hungry and what their prey is most likely to eat. And they ask if this changes due to the season of the year.
The 5% club don’t think like fishermen. They think like fish.
The 5% club isn’t out in the middle of the ocean with the majority. You won’t find them blindly casting with the latest lure into the empty middle.
You’ll find them where the fish are, and using a hand-line.
Lost At Sea
This is the move from the Bitcoin low in August 2018. The 95% look at this low and read the news, and they take notice of the all the news that reinforces their belief. This is called confirmation bias.
The 95%, not being entirely clueless, have taken courses on technical analysis. Courses helpfully provided by their brokers. The 95% are taught changes in momentum precedes changes in price. They are trained to use moving averages and moving average based indicators. Indicators based on the relationships between the open, high, low, and close of each bar or candle.
Feeling good because a cryptocurrency guru is bullish on Bitcoin, they look at their indicators to confirm what they’re being told. Instead of asking the right questions, they dream of the profits and skip past the most critical aspect of speculation. Risk management.
If a move backed by an indicator signal and a positive comment from a respected guru doesn’t work, they go back to their charts and make something work. They change the indicator settings to the ones that visually seem to work best regardless of the difference from the settings they’re using now.
The 95% attempt to force the chart to fit their beliefs. Hypnotised by potential profits and blind to the actual level of risk, they spend hours, searching, confirming, and back-fitting the indicators on their charts to give them a level of comfort.
The 95% are thinking like fishermen. They have all the impressive-sounding tools. MACD, stochastics, Bollinger bands, and moving averages, but they don’t understand that all these tools do the same thing.
All of these tools attempt to tell you when the momentum of a price move through time diverges from the actual price. The tools are derived from the price bars themselves and use averages to give information.
And this leads to two main problems. First, because the indicators are based on averages, they provide lagging information. And second, they only work when the market they are measuring is trending. The cryptocurrency markets trend around fifteen to twenty percent of the time. And that’s a problem.
Of course, the people selling the lures have thought of that. After all, they’re in the business of catching the fisherman, and not the fish. They’ll even offer to sell you an indicator you can use to tell when the market is trending. And guess what — it’s based on moving averages too.
What setting works best? If the market you’re looking at isn’t trending; then, no problem. Just drop down a timeframe from daily to hourly. If you go down a timeframe, or you go down multiple timeframes, you’re sure to find a trend, even if the trend exists on a five-minute chart. But what setting works best?
At this point, the 95% is lost at sea. Blind luck might help them this time, but this behaviour, over time, mathematically guarantees they won’t be successful.
Financial markets, like coastlines, are fractal by nature. They’re self-similar. If you look at a five-minute chart, it seems the same as a daily chart.
When the 95% are looking for an entry into Bitcoin using a daily chart, the indicators they’re using, because they are moving average based, often give conflicting signals. The 95% don’t ask themselves how long the trade is likely to last. That’s not how they think.
They either change the indicator settings to match their opinion, or they move down a timeframe and take their entries from the shorter timeframe chart. The 95% don’t realise if you take a position on a daily chart and you expect the trade to last sixty days; then, if you drop down to hourly, the same signal can only be expected to continue sixty hours.
The mistake the 95% make is they enter into a market using shorter timeframes without factoring in how much into the distance this time frame will allow them to see. The 95% aren’t aware they’ve just changed the lens on their telescope.
The 95% use charts like this and expect it to tell them when Bitcoin or any other cryptocurrency is going to make them rich. In reality, all it’s doing is giving them a warning that the current movement of price through time is slowing down and might indicate a price reversal.
The 95% use multiple indicators to confirm the same thing. Some are called leading indicators, some are lagging, and some are supposed to measure volatility. But it’s all hype. They all use averaging of some sort, and they all use different settings.
Some indicators are bound between zero and a hundred, and some are unbounded. The indicators have signal lines too. Buy when the indicator crosses this line, and sell when it crosses another. It’s no wonder the 95% struggle to be consistent.
The 95% don’t realise; a single line can replace all the latest lures. Not a trend line, but a momentum line. Momentum lines can be drawn or just visually observed. They are lines connecting the previous two lows for a low and the previous two highs for a high. When price diverges from the momentum line, it’s a heads up that the speed of price movement has slowed. And that’s all it is.
What if you could put a probability on the price move off of a low coming back to test the low? And the same for a high?
Would you think that’s useful?
Instead of learning how to read indicators like MACD, stochastics, and Bollinger bands, instead of learning the “rules” of how to use them, and instead of constantly changing the settings to confirm your opinion, how about this.
Throw them away. All of them.
Instead of wasting energy learning how to use technical indicators based on lagging moving averages, the 5% club learn how to put a number on risk.
Being able to assign likelihoods to risk is the core skill that binds the games of luck and financial speculation together. It’s what separates the few from the many.
It’s how elite poker players can beat you without even looking at their hand. It’s how the MIT blackjack team syphoned millions from casinos back in the days when a million dollars meant something. And it’s how the 5% club can make money, even when they use the tools the 95% use.
The 5% club understand the trigger used for entry is the least important tool. The most critical skill and the one essential to be consistent is to understand risk management.
Risk management is how the same few elite players dominate the game of poker, and it’s how the 5% club achieve consistent returns.
This is how the 5% club view momentum. They replace all the indicators, settings, and rules with nothing more than a line.
The lines are drawn in this chart, but the 5% often use nothing but their eyes to visually “see” the information.
Up One, Over One
Rather than thinking about what the MACD is doing and worrying about the settings they’re using, the 5% club visualise a line and assign a probability to the next price movement.
The chart shows three lines. Blue, orange, and green. Note the blue line and point 1 on the chart.
The blue line is drawn from the last two lows. At point 1, if the price hasn’t diverged from the line; then, any move up has a low probability of success, and you can expect the low at point 1 to be tested or taken out.It’s Simple and effective.
In the China Crisis series, we talked about how we have difficulty trusting information unless it comes from complexity. Using a line you can trace with your eye, you can throw away all the complexity and synthetic rules of using indicators, and concentrate on the single factor that separates the few from the many.
The missing factor is — What is my risk?
Now focus on point 2 of the chart. The blue line has been extended to the right with a black dotted line. The low between point 1 and point 2 happened with maximum momentum and without any divergence. Price moved down through the blue line and traded sideways to point 2.
At point 2 the 5% club know the likelihood of the price making a new low has increased. Prices dropped over $1,200 in the next 28 hours.
Look at the orange line. It’s delineated from the two previous lows. The price did not diverge from it even though price did have a fast reaction away from the line.
A point 3, the 5% club expect the price to move down and make new lows. But they also know something else.
Imagine a square with a forty-five-degree angle going across from the lower left to upper right. This line represents the idealised price movement through time. The route across the square, up one and over one, is the ideal trend speed.
Now imagine a line that moves up two and over one. When this happens, the price has moved too fast through time. One of two things is most likely to happen next.
Price pauses and trades sideways, waiting for the forty-five-degree line to catch up.
Price aggressively moves down to meet the forty-five-degree line.
(This technique can be used with up moves and down moves.)
Roll Pitch Yaw
The 5% club know when they see a fast move down and because of the slope of the momentum line, in this case, the orange momentum line, the price will probably do one of two things.
If the 5% club see an emotion bar, like the bar in-between point 2 and 3, after a steep sloping momentum line; then, they know at this point the market tends to behave non-randomly.
They know the price should either pause and trade sideways or pause and rally.
The 95% think the only way to trade a market is to trade directionally. They think it’s all about the point difference; they think it’s about buying at 50 and selling at 100.
The 5% club don’t trade like this. Yes, they can and do take directional trades, but in situations like the move seen by the orange line, they know the implied volatility will have increased. The 5% club sell options underneath the low between points 2 and 3.
The price does not have to go up. All the price has to do is stay above the low between points 2 and 3. The 5% club know the probability of this happening is in their favour. Even if it’s at the low or slightly lower, the 5% club will profit from a phenomenon called a volatility crush.
At the low between point 2 and 3, the 5% club know that...
1. The trend momentum is unsustainable because of the slope of the orange momentum line.
2. Fear has entered the market, and anyone who does not know what they are doing is most likely to trade with their heart and not their head.
At point 4 the price has diverged from the orange momentum line for the first time. From the 27th of July until the 11th of August, the 5% club knew the odds of any low being a long-term low were not in their favour.
The 5% knew to either stay out or sell short any rally. The tool they use is a simple line, and it doesn’t even need to be drawn.
As price rallied from point 4, a new momentum line is drawn in green. Point 4 has the potential to be the low of the move because the low at point 4 diverged from the orange momentum line, but the 5% club understand that although the point 4 low has the potential to be a low it’s still not the highest probability.
Because the slope of the orange momentum line is too steep.
It's why the 95% lose money. The indicators they use do not account for the slope of the move. At point 4, the MACD is signalling a momentum divergence. Because the 95% have no underlying knowledge about what the tools they’re using are measuring, they lack the depth of understanding needed to interpret the signal. When price makes a new low at point X, the 95% are stopped out of the trade.
Precisely when the likelihood of a low is most in their favour, they have already lost one trade, and because the pain of losing is 250% more intense than the pleasure of a gain, they do what is necessary to avoid the pain in the future. This is when prices move up — without the 95%.
Eyeballing a line underneath lows or above highs and acknowledging the slope of the line is how the 5% club view the environment they’re fishing in.
The 5% club understand the roll, pitch, and yaw of price movement. It’s how they catch fish.
Out on the Edge
Instead of casting out into the unknown, the 5% club take positions at the edges.
On Tuesday, September the 4th, everything on the surface looked good. The news was positive, and Bitcoin was going up. The August low was twenty-two days and $2,200 away.
The “F” on the chart is Friday the 31st of August. Notice the dotted lines on the chart. The inside dotted line is the closest at the money option strike price of $7,000. The option expires next Friday. The outer lines represent the horizon.
Prices are expected to move anywhere between the upper and lower lines.
The 5% club take the implied volatility number from the options chain. (For more on IV, see the 4th Dimension series of articles, podcasts, and videos.) The rest is calculated using this simple formula.
The upper and lower lines represent the limit of normal movement. The price will close within these lines 68% of the time.
Fishing with the 5% Club
In previous articles, podcasts, and videos, we’ve discussed how the MIT blackjack team built their edge in the game of blackjack. They used the ratio of high-value cards to low-value cards left in the deck. To find the ratio they assigned cards 2 through 6 a value of plus 1. Cards 7 to 9 a value of zero, and cards 10 through Ace a value of minus 1.
If the ratio was at plus 6, it meant there was a higher likelihood of the dealer drawing a high-value card over a low-value card and going bust. At this point, the MIT card players would increase their bet size.
On the surface, all is looking good on Tuesday the 4th of September. The 95% using standard technical analysis indicators see a green light.
The 5% don’t.
They see this.
The high on Tuesday was already near to the top of the expected range. The high was at 85% of the range.
The volume of trade was low. The red box is showing the 5% an “air pocket.” It’s when prices rise without any demand.
The 5% ask the question: Is this market hot?
4. Then the 5% study the context of where this is happening relative to previous highs and lows.
5. Finally, the 5% know what season they're fishing in. They look at the seasonal data.
If this market is not hot, then it’s unlikely any new demand will suddenly come flooding in to overwhelm the overhead supply. The 5% club know this is the most likely scenario based on the context of the trend, seasonality, and interest of the masses.
The 5% club ask, “Do the people who know what they are doing, the 5%, have any reason to buy now? They ask, “Do the 5% buy when prices are within 15% of the upper limit of expected movement in a sideways market within a downtrend - especially at this time of the year?”
And finally, they know the 5% club do not chase trades. The first thing the 5% club do is ask, “What is the risk?”
The previous high is at $8,550. Because Bitcoin is in a sideways move in a down trending market, the 5% club know the most likely upside target is the previous high.
If the 5% club did enter here at $7,400, there’s around $1,150 of upside movement. What about downside movement?
Notice the “F” on the chart. The day before this was the last day anyone was caught. The low of this day was $6,800.
Entering at $7,400 gives $1,150 of upside gain against $600 of downside risk. That’s a risk-reward ratio of 1.91 to 1.
The trade would only have to be successful around 34% of the time to break even. If you were right four times out of ten, you’d have a profit.
Entry at $7,400 doesn’t look like a bad deal. It’s got a breakeven expectancy of 3.4 out of 10 trades.
But there are three problems the entry at $7,400 does not account for.
68% of the time price will close below the upper line within the next three days.
The $6,800 stop level is well within the expected normal range.
Price movement will have to be abnormal to the upside to move above the upper limit and only normal to the downside to take out the stop at $6,800. After taking into consideration the lack of demand, an abnormal move up is not the highest likelihood.
Point of Reference
The 5% take positions at locations with a point of reference. Trading with a point of reference gives the 5% direct market feedback on their trade decisions.
Look at the chart again. The evidence says there is no demand.
The 5% club turn this on its head and structure a trade around the upper expected move line. They get short at $7,400 and risk $300 to the upside.
The target is at the other end of the expected range around $6,300.
That’s risking $300 to make $1,100. A risk to reward ratio of 3.67 to 1. With this risk-reward ratio, the 5% could be wrong eight out of ten times and still break even.
The same goes for a long trade entry at the other end of the expected range. A long position taken around $6,300 allows for a tight stop and a good risk to reward ratio.
The 5% club trade at the edges, because they can engineer high probability risk to reward trades. Trading at the edges gives the 5% club direct market feedback. They know if trade taken at an edge fails; then, an abnormal move has happened.
And abnormal moves outside of the 68% expected horizon happen when demand overwhelms supply for an up move. Vice Versa for a down move.
And when demand overwhelms supply, the highest probability is for the price to go up.
Is the 5% club always right? No, they lose as many times as they win, but they always trade with a positive expectancy, and they always understand their next move.
The 5% club are patient and wait for events around the edges of risk. They understand the context of the position they’re taking, and they look to the horizon to take profits.