TradingPub is committed to connecting you with top trading professionals like Kai Whitney, Owner of Red Bridge Capital Consulting LLC. Here is a summary of a terrific presentation he gave during our July Trade-A-Thon event. However, before we dive into his presentation, it is important to understand Kai's extensive experience and background in the financial world in order to better understand why his convictions are so strong.
Kai started his career in venture capital investing and the private equity, before moving to investment banking. While he worked in the investment banking industry, he learned how things are done on that side of the business. As a banker Kai was responsible for handling newly formed public companies. He would help guide them and put them in the right market positions. Further, he would trade those positions by means of special derivatives and other tools to ensure that proper growth opportunities were created for these companies.
He later worked for Bear Sterns, LLC where he traded as a market maker and worked closely with executives of some of the top S&P 500 companies and largest hedge funds. When he traded for these companies, he used several techniques to manipulate the markets and create liquidity by placing "spoof" positions above and below the market price in order to induce price volatility.
Bottom line, Kai learned that price is used by market makers as advertising in an attempt to get retail traders to act or react in a predictable fashion.
In this regard, Kai's presentation focused on the following key topics:
- Market Structure and how the markets really work using "Auction Market Theory"
- A Core Satellite Strategy (where core represents one's assets and longer-term trading and satellite is referred to as one's income generator)
- Fundamentals for trading NADEX (North American Derivatives Exchange)
- How to trade on NADEX and use your bias and understanding of price in relations to value in order to capture gains
Understanding how the markets really work, along with a good trading strategy, can really help a trader become more successful. The takeaway in this segment is understanding that there is more than just price in the market. Price can be manipulated in a number of ways whether by the means of buybacks, splits or by the market makers. For example, Apple recently had a stock split and this is just one variation of a price manipulation. There is more than price in the markets and learning more about "Auction Market Theory" can help clarify this notion.
When Kai made the transition to retail trading, he had less access to technology and information, in comparison to the days when he was a market maker, and was not able to adjust as quickly as he thought. He knew he had to learn more about tape reading, volume and order flow, so he could be successful as a retail trader. He knew, however, that investing based on price action alone is the equivalent of throwing your investment capital out of the window. This is one of the main reasons why he takes such a strong position against relying too much on price!
Market auctions occur every time you have a buyer and a seller at a given price level. This gives you a perceived value and a high and low range around this perceived value. In the following example, you see that prices are fluctuating within the perceived value range.
Volume helps market makers control the price fluctuation of a given security. However, they are also confined by volume and can't simply dump or buy everything at one price. So the process of buying and selling for an institution has to be done incrementally over time.
The area of perceived value, or where most volume occurs at a given time, is confined within one standard deviation from the mean. It represents about 68%-70% of the trades at that time, and this area of perceived value can be plotted for any time frame.
So what is the process of getting from one value area to the next? The top part of the graph above (marked with green) is called a balanced market. According to the efficient market theory, information in a given market is transparent and no trader has superior information than the other, thus the current market price represents the true equilibrium price. According to Kai, this theory is only partly correct, since volume shifts and inherent market maker pricing strategies, will conspire to move a market over time.
The job of an institutional trader is to trade as much as possible in the area of perceived value, and hide behind the volume in order to protect his hand. When the market maker reports to his client, he measures his price activity against the Volume Weighted Average Prove (VWAP). It is typical for trade values at the VWAP level to given a grade of "C" or average. It is only natural that market makers are going to look to outperform the VWAP and be considered "B" or "A" level traders by their clients. This creates a periodic move in pricing that is fueled by a market maker trying to outperform the VWAP
Market makers use most of their tricks and traps in the value area. These include iceberg orders, high-frequency trading moves, and trading algorithms among others. These programs represent about 70% of the volume per day on the NYSE and is a big component in today's trading environment. And, it is institutions that write these programs in order to help drive liquidity, and generate higher transaction volumes.
Dark pools and secondary deals are priced after the markets have closed. For example, a market maker will go to a big company and offer to trade 10M shares and take a 15% cut on this deal. The market maker will receive a check and then assume assume the risk of trading the 10 million shares. This is usually done via secondary negotiations and can take about 48 hours to report. This is a major reason why it is important to understand that price can be manipulated, and why retail traders should stay away from trading value areas where your competition is just too big, well equipped and prepared.
Core Satellite Strategy
Another concept that is important to understand is that markets will move from being balanced to imbalanced, as prices move from one value area to another. When this happens, a market will find itself auctioning out of one area and seeking the next area of buyers and sellers. The purpose of the institutional trader is to create value for their clients and to offset and transfer any risks in the process. This is done by trading in the value area, or by creating a market imbalance.
As mentioned earlier, retail traders should stay away from trades in the value area, and avoid getting chopped up by the bigger institutional traders. The best place for retail traders to get involved, is when the market becomes imbalanced and is looking for a new value level. This is where trending opportunities can be found and you can trade along with the big money players. Trying to guess tops and bottoms when prices are in the value area is a lost cause for most retail traders.
If you look at the numbers above you can see that the ask side increased, but the ask side is not getting more aggressive. When you read the tape you will see the bid to ask remains 3-1 in both cases 50/150 and 40/120. You want to look for imbalance and that is normally found on the outskirts of the value area, where you can trade with more success.
Institutional investors buy and sell large positions in the value area in order to get paid. But, if they consistently report a "C" grade VWAP results, they are at risk of being replaced by a more aggressive trader. So, in order to improve their performance, sooner or later they are going to have to speculate, and this is when you will see imbalance in the markets.
If you can take price in the context of value, then you can see that market makers are advertising a given action in the value areas. If they want to you to short a market, you will see 4-5 red bars, and right as you short it, they will start buying. Stay away from the value areas and trade on its edges.
Nadex is the North American Derivatives Exchange and exists to bring buyers and sellers together that are interested in trading binary options. Nadex is 100% transparent and there is no bias or manipulation whatsoever. Further, Nadex was designed with retail traders in mind, that are tired of being chopped up by instituional traders, market makers, high frequency trading algorithms, and dark pools.
Each Nadex binary option has a total value of $100, regardless of whether you are trading a market index, currency pair, or other commodity derivative. For example, if you buy a gold binary option at $50, then your risk is $50 and your upside is $50. Or if you buy a S&P 500 binary option at $20, then you are risking $20 and your upside is $80. In all cases, you know going in what your maximum gain and loss are at the time the binary option expires. If you have a belief that the price of a binary option will end up below or above a given value at a specific time, then you place your order to reflect your belief, all along knowing what your maximum risk and reward are.
When trading S&P 500 cash market, we should know that your competition consists of the institutions, market makers, dark pools etc. If you correctly read the price value areas and you know how the market trades, then in a given situation you should know that the market will either be going up or down. In this instance, you can now turn to Nadex and buy one or more binary option contracts inthe S&P 500. Your order ticket will tell you what your maximum risk and reward will be. The higher the risk, the greater the probability the trade will end up inthe money. For example if you buy in at $80, you are risking $80 to make $20, but the probability of success is 80%. If this risk/reward ratio is to uncomfortable, then look for a binary option with a price and expiration that has more even odds. With Nadex, instead of trading the market tick for tick, you can trade the value areas. You can also protect yourself in your normal trades with a Nadex hedge.
Nadex is a great way to get involved with all markets and you can see the list of all markets that is covers here:
Bull spreads can be used to hedge a position, but instead of trading two different contracts you put it all in one contract. You can buy at a price of your choice, but if you are dead wrong, the most you will lose is the amount specified in your order ticket as your Max Loss.
On the flip side if the market goes above the value, which you chose you do not have unlimited gain.
You will also note that the spreads are large, because there are no market makers in Nadex. When you sign up for a Nadex account, you are becoming a member of the exchange. As such, you can make your own market. You can establish your own price, and if the other side takes the trade, you are filled! Thi is the exact same thing institutions do, and with Nadex, the accuracy is superior and your risk is mitigated.
WATCH THE SESSION WITH KAI HERE
The Trading Pub Team