Written by A.J. Brown

Three Keys to “External Stochastic Shocks”

Three Keys to "External Stochastic Shocks"I believe it was a Harvard study that determined when someone communicates a message to another, 7% of its meaning comes across in the words, 38% of its meaning comes across in the person’s voice qualities, and 55% of its meaning comes across in the person’s body language. (That explains why emails, instant messages and text messages are so often misinterpreted; the voice qualities and body language applied when reading them are the receivers’, making up 93% of the message, and most probably does not match the voice qualities and body language intended by the senders.)

With that said, what if the words, voice qualities and body language of a message were so carefully rehearsed that the meaning of the sender was intentionally made vague. This is actually a common practice in the financial market. Often, I believe this is done in order to mask the possibility that those message senders we look up to for advice and guidance, may not have a clue. That’s my opinion.


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Still, when investors are confronted with an outside message, they can’t help but pay attention. That distracts investors from responding to “standard” market forces. Instead investors react to the outside messages they receive. Or, more precisely what they read into those messages. Or, even more precisely what other so called experts (also known as analysts) read into those messages and then attempt to communicate back to those investors. It’s very tangled

Take for instance the post-meeting statements made after the Federal Open Market Committee (FOMC) meetings. My opinion is that investors do not know how to interpret a FOMC meeting announcement. The members of the Federal Reserve, in all their infinite wisdom, get together and make these carefully worded announcements. These announcements are released with any agreed upon monetary policy changes. It seems the members intentionally craft vague statements. This is nothing compared to what was done in the past. The transparency behind everything the Federal Reserve (Fed) does is at its highest ever in history. Still, the Fed leaves a lot in their statements for analysts, investors and traders to use to read in between the lines and on which to speculate

To see the effect on trading of investors interpreting these FOMC meeting announcements, let us examine Tuesday’s (September 22, 2010) session activity.

To correctly set the stage, we saw fairly heavy price gains the day before. Typically, left alone, without any external stimulus (e.g. a FOMC meeting announcement), the following trading day after such heavy price gains would see either profit taking, or a display of continued momentum. Typically, you would see something, anything. I refer to this as “digestion” of the previous day’s gains.

On the Tuesday in question, the market moved sideways as most traders simply sat on their hands in anticipation of the announcement scheduled for 2:15 PM Eastern. There were unfounded rumors ahead of the announcement that signaled the Fed would resume a plan of quantitative easing; it would buy more US treasury bonds. This was to be in response to a slowing US economy.

When 2:15 PM Eastern rolled around, the central bank announced that it would keep interest rates at a record low - near zero - for an “extended period” to keep credit flowing through the economy. That was expected. It went on to say that it would “provide additional accommodation if needed” to support the economic recovery. Put another way, the Fed announced it was going to do nothing at that time. However, the words chosen to say that follow on statement, or lack thereof, triggered the market activity that happened next.

Initially, after a morning of sitting on their hands in anticipation, investors responded with buying, possibly interpreting the statement as saying the recovery was moving along well enough that they did not need to take any action. Then, as the words were thought about and scrutinized, a different more dour meaning set in. Analysts aggravated investor emotions further by speaking their interpretations through many outlets.

Just to explain a little, many analysts use a sort of trending philosophy with previous FOMC post-meeting statements and the actions that followed, to find context clues to interpret a just released statement. In this particular case, at the end of the previous FOMC meeting, the post-meeting statement did not mention they were ready to provide additional accommodation if needed. This time it did. As a result, the interpretation was that the Federal Reserve saw trouble ahead, and the initial buying was followed with selling.

This is a great case study of everyone trying to read in between the lines and speculate what is going to happen next and when. Of course, what I want to draw attention to is that because of this distraction, the actual market forces, as weak as they had been, were completely overshadowed. We had massive gains the day before. Actual market forces would have dealt with those gains; digest them if you will. Instead, investors were wrapped around the axle about this scheduled “external stochastic shock”. Their trading was reactive to this “shock”.

The post-meeting statement itself, the analysts published interpretations of this statement (and analysts are always right on the mark - NOT!), and the investors own interpretations, played havoc with the internal fear and greed emotions that are always at work detracting from the normal economic forces at work.

What is interesting, once the statement came and went, and the market forces were allowed to rule again, activity picked up where it left off at the close of the previous day. Experienced investors were still poised to get out of long bullish trades before the market turned on them. In fact, I was poised to exit on the first sign of a reversal down. And note, just a hint of downward momentum, after a day of large gains, could start a mass of selling that would build on itself and accelerate the move down; a self fulfilling prophecy. You get the picture.

Also note, an upward move at that time, with the market, overall, lacking any long lasting internal momentum, could have only come from a continued chain of positive external stochastic shocks (e.g. headlines).

Here’s the scoop. At the time, the bulls were hanging their hats on the fragile economic recovery and the Fed’s promise to do everything possible to protect it. The bears pointed out every time there was a poor economic report and the threat of a double-dip recession. Neither side really had been able to take the upper-hand.

Here is what’s in investors’ thoughts when seeing a long term economic recovery. It comes down to employment numbers being up, strong retail sales, credit flow, and ultimately housing picking back up. After the FOMC September 21st, 2010, meeting announcement, those issues were still not clear in investors’ minds. Any news about these issues was a potential market mover.

What I would like to leave you with is a high note for us option traders. That is, no matter what direction the market takes, it should not matter to us. As options traders we have the potential to make money when the market goes up, down or sideways. It is becoming a pattern recognition specialist and ultimately a pattern utilization expert, that’s paramount.

Remember, there are three keys to our success as option traders:

  • First, we need to stay in tune with market action.
  • Second, we must keep our emotions “in check” even as the market swings through the inevitable highs and lows.
  • Third, we must be well prepared and have a specific plan of action to follow.
  • Only when we follow these three keys will we have the discipline to deal with whatever surprises the market might throw our way and the confidence to become successful traders.

    Let us trade the action in the charts. Let us not be taken by surprise by the effects of unpredictable “external stochastic shocks” especially when they are scheduled. Let us know that “reading in between the lines” is simply speculating and let us refrain from doing that. And, for sure, let us give little to no credibility to the talking head analysts out there, because their interpretations to date have proven no better than anyone else’s off the street.

    To your good trading.

    A.J. Brown

    8 Responses to “Three Keys to “External Stochastic Shocks””

    1. Pete Wehr @ 5:44 pm:

      The FOMC uses smoke and mirrors with every statement! Your last paragraph and 3 keys always hold true,No smoke and mirrors to that end! Pete

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    2. A.J. Brown @ 8:33 pm:

      Thanks Pete for responding to my blog post. And, yes, I agree with your statement about the FOMC.

      At the same time, I am challenged by why we give so much credibility to “analyst consensus”. Many times, when you dig deep, you find that analysts have other motives besides just helping followers of their messages, to be successful.

      For the last six years, every Monday night, I’ve been asking our Trading Trainer Learning Community web portal subscribers that attend our weekly Money Link webinar, to give me a consensus on the market’s bias. Why? Because the bias we come up with has been more accurate for guiding our trading than if we were to follow some of the biggest name talking-heads out there.

      True story!

      I hypothesize this is true because our traders have no other motives that to be successful at trading. Go figure!

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    3. Brian Napierala @ 11:30 am:

      Well put together, great insight. I think my favorite line was, ‘It is becoming a pattern recognition specialist and ultimately a pattern utilization expert’
      Don’t follow what is being told, use your brain, ‘recognize the pattern’ and follow your own path to success.
      Thanks

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    4. A.J. Brown @ 12:06 pm:

      Thanks for the compliments, Brian. Glad you liked that line. I can’t remember where I heard those terms… I remember it was in the context of working with people… but, it really applies to trading. After all, trading is recognizing the different permutations of mob mentality, isn’t it? And, your summary sentence is right on!

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    5. Kahlil Patterson @ 5:03 pm:

      Thanks A.J. As always, yours is a reliable voice (no pun

      intended) in this industry. This article is a great

      reminder of how important it is to ‘learn how’ vs

      to ‘listen to’ in deciphering what the market is dictating

      and not the “talking heads.”

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    6. A.J. Brown @ 5:26 pm:

      Thank Kahlil! You hit the nail right on the head.

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    7. Option Strategies @ 5:15 am:

      Great post. This really hellp me a lot to understand the topic.

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    8. Nextoption @ 12:23 pm:

      Great article dude. You are spot on about the talking heads. There was a time when i doubted the leve of influence they have over market movements but I guess in this age of super fast communication anything they blurt out gets picked up and spread ike wild fire. But as you said, trade the charts. trade what you see.

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