Note: Reference pages are original posts on our Green Chip Membership Boards. Green Chip is a subscription only message board for those serious about beating the casinos. Click here for more information on Green Chip membership.

How the Pricing Structure of All Markets Really Works

Originally posted on Green Chip by the turtle

Despite what some others, such as fundamentalists or efficient market theorists may think, what is written below is how it really is. The analysis is equally applicable to commodities, futures, interest rates, currencies, forex, stocks, equities, and any other tradable market you care to mention. In the Wall Street world that I come from, money talks. The following comments may be considered just an”opinion by some, but I can personally attest to about a dozen people who have taken this approach and extracted over a billion dollars from the markets. In my mind, that turns it from an opinion into a fact. I hope some of you enjoy and can gain some insight from this

What Is Trend Following, And Why Does It Work?
----------------------------------------------------------------------

Okay, let’s just start with the basics. And that is that this whole general trading methodology that we call “trend following” is a very proven method that has been around and working for years. There is an extensive library of both technical and fundamental analysis that shows this is not only scientifically valid, it is also just plain common sense. There are periods when trend following works very well, and periods when it doesn’t. And the truth is, when trend following “doesn’t” work, it can sometimes be pretty ugly for a while. But for anyone that has the patience and discipline to sit through some of the rough times, I just cannot think of any more profitable way to extract money from the markets.

Before even talking about trend following as a methodology to trade the markets, or the ‘trends’ themselves as a price action phenomenon, perhaps we should start with a short basic discussion of what exactly is the ‘market’, and how and why do prices move to begin with. And of course, prices will have to move in order for anybody to make any money, for if the price were always the same, you would never have the opportunity to buy something cheaper and sell something higher and make a profit.

In its most simplest form, the “market” is basically just one big auction place, where both buyers and sellers bid and offer and compete for prices of different tradable products, such as the shares of stock in public companies, or a fixed quantity of a physical commodity like copper or soybeans. Obviously, buyers want to buy things at the lowest possible prices, while sellers want to sell things at the highest prices.

In purely economic terms, the main purpose of a marketplace, any marketplace, is “to facilitate trade.” In other words, the buyers and sellers need to have a place to come together to meet and do business. And whether this is going to be a physical meeting floor, or an electronic one, is not really important. Of course, when these buyers and sellers meet, it’s for the purpose of transacting business, exchanging goods for services, or money for goods. Now they may not always do any trading, because they may not always have a meeting of the minds on a mutually fair price, but if they weren’t going to at least try, then they wouldn’t bother to show up (at the auction house or trading floor or whatever you want to call it), in the first place.

In order to make these trades or exchanges, both buyers and sellers are going to have to compromise a little on the prices at which they are willing to trade. The price of a good or commodity (or share of stock for that matter) will move up and down in a “trading range”, the boundaries of which will be defined by the absolute last resolve of the buyers and sellers. The upper boundary will be the highest price at which buyers are willing to pay, any higher, there are still obviously going to be a lot of eager sellers, but no buyers willing to take them up on those higher prices. Conversely, the lower boundary of the trading range will be lowest price at which sellers are willing to part with their goods -- any lower, there will be plenty of buyers, but no sellers willing to give up what they have at such a cheap price. And so, prices will continually move in this trading range, with small changes in the upper and lower boundaries, as various different buyers and sellers, with slightly different agendas and price objectives, continue to enter and leave the marketplace. But of course, as I said before, nothing lasts forever. Eventually, the whole trading range picks itself up and shifts to a different level. Sometimes it just keeps on going and going, like the Energizer bunny, and that’s what we call a ‘trend’.

Now, what causes these shifts, you may ask? And the answer, although really quite simple, deserves a little detailed explanation. Even though I’m a diehard technical analyst, I know (and so should you), that it is not “technicals” that move the market. The technicals may be used to describe or measure or predict (or all of the above) the price movements of the markets, but that is not the underlying root cause. The root cause, the fundamental reason that all prices move and change in price, is just plain old fashioned supply and demand.

Let’s review basic economics. The supply curve is the one that is sloping up and to the right, while the demand curve is the one that is sloping down and to the left, with the point where they intersect being the fair market price at which both buyers and sellers are willing to meet. All you have to remember for now is that when either the supply line or the demand line moves, it causes a change in the intersection point.

While technicals may help to illustrate how the market moves, it is *fundamentals* that cause the move. And when the market price moves and keeps moving, that is a trend. These trends tend to proliferate more in commodity markets than in equity markets, meaning trend following methods will work better in commodities and futures than in equities, although they do sometimes work pretty strongly in equities as well. We can walk through some examples, first from the fundamental point of view, then from psychological standpoint, and finally, from a technical perspective.

To begin with, it is important to realize and understand the simple basic laws of economics. Specifically, if demand increases while supply stays constant, the price will rise, and if demand decreases while supply stays constant, prices fall. On the other hand, if supply increases while demand stays constant, prices will fall, and if supply decreases while demand stays constant, prices rise. We can start by thinking of a physical commodity, while keeping in mind that these same scenarios can also be extended to other physical products, to all financial products such as bonds or currencies, and to a slightly lesser extent, to stocks and even stock indexes as well.

Let’s take coffee. Brazil and other agricultural countries keep growing the crop at a pretty steady rate, and most of the rest of the world keeps drinking the stuff on a pretty regular basis as well. Let’s assume that most economic conditions are in equilibrium, i.e, the amount of land available to grow crops is all in use, and the technology for harvesting is mature and not undergoing any improvements. Now, assuming the supply is pretty steady and constant as just mentioned, what do you think would happen if all of a sudden, research scientists discovered that drinking five cups of coffee a day would greatly reduce the chances of ever getting a heart attack? Well, the demand for coffee, and thus the price of it, would go through the roof. Let’s say people decided that coffee was now worth $2 or even $3 per cup, instead of the $1 it used to cost. But the price is not going to jump that much all at once overnight, it is going to move up gradually, until a few coffee drinkers start thinking it is getting too expensive, even given this new wonderful medical benefit, and the demand starts to slack off. Now look at the other side of the coin. After years of research, scientists one day discover that drinking too much coffee will increase the chance of getting a heart attack. People will get scared, demand will decrease, and the price will drop hard and fast because nobody wants the stuff.

Okay, now let’s look at the supply side situation, which is perhaps more obvious to most commodity traders. We are going merrily along drinking our morning cups of coffee every day, and then one day, a big cold weather front hits the major coffee growing regions in South America, and half of the current crop freezes and dies on the vine. Since most of us need our morning coffee to start the day, (i.e. the demand remains pretty constant) and now all of a sudden the supply has been reduced, with no immediate hope of replacement, prices are going to go through the roof in one of the greatest bull market uptrends that you will ever see in your life. Finally, in the last of our four possible market scenarios, where the demand remains constant but the overall supply increases, perhaps due to some new technological innovation that improves harvesting efficiency, the extra glut of supply that will be coming into the market will start to send prices into a sharp selling spiral, i.e. a downward trend.

To summarize, as long as supply and demand are reasonably constant, and market economics are in equilibrium, the price of any item will remain in a relative trading range, subject to the interactions and the slight changing perspectives or agendas of the various buyers and sellers. But once either the supply or the demand (or both) fundamentally changes, even if it is temporary as opposed to permanent, the price will move out of that old trading range, and the market will seek to find a new level of equilibrium. This move to a new level can happen quickly or gradually, but as most markets tend to be more continuous instead of discrete, this move will usually not happen all in one quantum jump. It is precisely this gradual movement, going through a various range of prices, that we would commonly call a ‘trend’.

These same exact four scenarios can be extended to other all tradable items, not just physical products like coffee. And if we were to examine the reasons that cause these large fundamental (permanent or temporary) shifts in the supply and demand curves, and thus ultimately in market equilibrium, we would find that the answer is usually some large and important earth shattering event. Different kinds of weather patterns, such as floods or droughts or cold freezes, can most certainly wreck havoc with the supply side of physical commodities and crops such as coffee or soybeans or orange juice. Alternatively, a new scientific health or medical discovery may cause major shifts in the demand side of the equation.

But it’s not just the physical crops, or old style “commodities” that we are talking about here. Major political events, such as a war, election, assassination, etc, will undoubtedly have an effect on financial markets such as currencies and interest rates. The supply, demand, or both can be affected. Think about what happens when a country finds itself with a trade deficit that has to be corrected, or needs to raise money to finance a war. They go out to the capital markets and borrow money to finance their problems by issuing bonds (debt instruments), thus increasing the supply of bonds, and driving down the prices. If the deficit is not controlled, or the war then goes on longer than expected, more money needs to be borrowed, and the downtrend of bond prices will continue. As for currency markets, I’m sure most of you remember the hyperinflation of 1930’s Germany, where just the perception of their paper money no longer being valuable caused such a lack of demand that the currency deteriorated to being worthless (that must have been some downtrend in deutschmark futures, or, if you were a bank currency trader, it would have been a super bull uptrend in dollar/mark).

As trend followers, we will usually lose money when things are nice and quiet and normal in the world, but when some big upheaval or disaster strikes to throw the world out of whack, even for a short period of time, that is the time we make some decent profits. As long as we don’t have perfect control over the environment and all aspects of our lives, as long as we mortal humans are subject to the whims of mother nature or some depraved dictator somewhere in the world, there will be economic shifts taking place, and periods of trending markets will continue to exist.

Which brings us to the next issue, that of the “human element”. When we talk about “the market” (any market), what we are really talking about is the sum weighted composite values or opinions of all the many individual participants that make up that marketplace. And sometimes these people are well informed and make analytical and rational choices and decisions about things, and sometimes they don’t. Sometimes, when human emotions come into play, logic can go right out the window. But as we shall see, this will often validate the concepts of trend following, and lead to more potentially profitable trading opportunities.

Many times, people tend to believe exactly what they want to believe, whether it is true or not. And very often, especially in a small community such as a marketplace, once a few people start believing in something, they can have the ability to convince others, even if they don’t want to or are not trying to. What I am talking about here is often referred to as the ‘herd mentality’. If you have ever seen an old fashioned cattle stampede, even just in the movies, then you know what I mean. And once that herd starts running, you had better join in, or get the hell out of the way.

Sometimes the stampede is fundamentally justified, such as when the supply of a crop or other commodity is diminished by some natural event, yet the users of that product have constant need and demand for it. Buyers will then fall over each other driving the price higher and higher until it reaches some new equilibrium level, at which time the frenzy will die down and prices will stabilize. Other times, there will be absolutely no rhyme or reason for the price movement of something, aside from what Charles Mackay once called ‘popular delusions and the madness of crowds’. Many writers and traders point to the 16th century Dutch tulip bulb phenomenon as the classic example of the first major price trend.

At the peak of that market euphoria, tulip bulb prices were selling for what would be the equivalent of well over $100 per flower today. I think it could be fair to say that even if tulips were found to cure the common cold, or the black plague, one flower would probably not be worth that much money. Prices escalated beyond all reasonable values, and then kept going even further, simply due to what can be called the herd mentality of the marketplace. Or maybe it was just the ‘greater fool’ theory, which is an idea that basically says, I am going to buy something today, and I really don’t care if it’s worth the price I pay or not, as long I can turn around and make a profit by selling it back to somebody else at a higher price tomorrow. And you know, almost everybody makes money in these cases, except for the very last guy who bought at the top, he’s the one that gets stuck. By any name you want to call it, this is a concept that (still) exists in the real world, validates the methodology of trend following, and allows traders to make money. It is human nature, and it will never change. It is the fear of missing out on a good thing, as well as the greed of wanting to get even more, and these things will never change.

In the “tulip” example, in the NASDAQ dot com bubble of the late 1990’s, in the big oil market rally of the past few years, and in so many other similar examples, it is the trend followers making money at the expense of other types of traders. During these runaway moves, the people who trade counter trend, and believe that trading ranges and support and resistance levels will hold up, are the ones that lose. Some very smart analysts and economists and other people who just ‘think too much’, are not able to see the big picture, which is simply to jump on board the trend and run with the herd, and don’t stop to think about it.

So there you have it. Prices of all things sit in an equilibrium level type of trading range for a while, then something happens to change that level of equilibrium, and the whole price range moves to a new level. Sometimes there are valid underlying economic or fundamental reasons for the change, and sometimes there are none at all, and people are just fooled about the whole thing. But either way, the price does move, often picking up momentum along the way, and the trend followers jump on board and earn a nice living because of it.

This is the way the real world works, it has been this way for hundreds of years, and it will probably continue for hundreds more. The basic laws of economics of human nature will never change. Maybe the technology changes, but the markets, and the people that make them up, never change. People who espouse the death of trend following every few years will point to faster computers and better communications and more efficient markets. But the overall structure of market price movements, including trends, has not changed today from the tulip days of four hundred years ago, and probably never will. Now that we understand how markets work and how prices change and move, and the fundamental, economic, or psychological reasons that cause these (mostly temporary, but sometimes permanent) shifts in the supply and demand curves and thus the intersecting fair market values, we still have to figure out a way to take advantage of all this knowledge in order to try and make some money for ourselves, since that is still the ultimate point of all this.

It is fair to say that almost all individual traders, and even most firm trading desks, are at a huge informational disadvantage compared to the producers or suppliers of any given commodity (or stock). Let’s go back to one of my favorite examples, the Coffee market. And let’s assume that our scientific technology is so far advanced that we can get reliable weather reports giving us advance warning that a cold front is heading towards Brazil. The price of coffee may start to rise, as people anticipate a drop in available supplies, but nobody is going to know exactly what the new fair market price should be until they actually know how much of the crop was damaged and what is the remaining crop yield. At this point, the Folgers and Starbucks of the world will have their people out in the fields, checking to see exactly how many trees were damaged and what remains available to harvest. They will know long before we do about the net change in supply figures, and thus their bean counters or in-house economists will be able to calculate what the new prices should be. But we, sitting home at our trading desks, are not privy to, and cannot compete with, that information. And they are certainly not going to tell us, the general public, at least not until they have had time to adjust their own trading positions first.

The same thing can be said of all the financial markets. Let’s say a country needs to borrow money, or wants to increase or decrease the relative value of its currency on world market, in order to solve some internal fiscal or monetary problem. In this kind of situation, the political and financial leaders of that country will be figuring out exactly how much more currency to print, or how many more bonds to sell or redeem, so as to successfully solve their problem. But the sharpest traders on the major bank desks, let alone you or I sitting at home, are not going to know what those numbers are with a high enough degree of accuracy to successfully take a position in advance of the new equilibrium curve.

Because we just don’t know this information, and we cannot effectively or efficiently obtain it on a timely basis, we “infer” the answer by the use of technical analysis. In the simplest of cases, if we look at daily (or any other timeframe) price charts, and see the price of a stock or commodity is moving, we become aware that “something is up”. We may not know exactly what it is, but we can still take advantage of it. At some point, if the anomaly continues enough, it sets off some sort of trigger or signal in our brain (or in the trading system programmed into our computer), and we will notice. We arbitrarily define in advance just what it is going take to take to get us to notice, such as the price of something going higher than it has in the last 20 bars of a daily chart, or the price crossing over some moving average of itself. Then we react.

Technical analysis can take many different forms, some good and some bad. In my opinion, all the ‘bad’ forms tend to be predictive, as if to say there is a crystal ball telling us what is going to happen next. I personally do not believe that anybody can predict the future, when it comes to markets or anything else. On the other hand, the ‘good’ forms of technical analysis tend to be more reactive, we notice something is happening and we then react appropriately. As a trend follower, I will never buy (or sell) something because I think the price is going to go up (or down). In fact, I shouldn’t even be thinking that way to begin with, because I really have no idea, and I shouldn’t even kid myself that I do. What I do is to wait for the price to move by a certain amount first, and only then do I take a position, because I assume it is going to continue. And the truth is, I really have no idea either if it is going to continue going up or not, but I rely on Newton’s Law of Physics, which says that something in motion tends to stay in motion (until it stops).

We also have our own whole set of technical language which we use to describe and/or quantify the underlying economic fundamentals that we have been talking about previously. For example, I have explained that when supply and demand are in equilibrium, prices will tend to stay in some sort of trading range. But, if or when something happens to change that existing balance of supply and demand, the price will shift to a new level in order to reflect that change in market conditions. Some things are fairly stable and constant their entire lives, but when it comes to prices and values in the commodities or financial markets, we know that nothing remains the same forever. Whatever range we may be in presently, that whole price curve can move and be somewhere else in the future.

In the language of technical analysis, these conditions of equilibrium and shifting are known as periods of consolidations and trends. And it is pretty much a fact of life that both types of conditions can and do exist at some point during the life of any commodity or stock issue (although obviously not both at the same time). During the consolidations (periods of equilibrium), prices will remain in a trading range. Often times, a price starts moving up or down, and it looks like there is going to be some kind of a breakout from the current range. But in a true consolidation, if the price gets too high (or too low), the breakout fails and the price retreats back inside the trading range. Needless to say, during these times, trend followers lose money.

Of course there are other times when breakouts succeed and trends do successfully develop. The supply-demand equilibrium, and thus the fair market value or price, has indeed shifted to a different level, maybe due to some fundamental structural change in market conditions, or maybe just due to the psychological perception of one. It is important to once again emphasize that we as traders do not really care why the move is happening, all that matters is that we react appropriately in order to take advantage of the move and make some money for ourselves.

As I said, it is my opinion that nobody can predict when markets are really going to move, and which new breakouts are going to develop into successful trends, versus which ones will fail. People who spend time trying to develop systems that attempt to predict some market’s future price movements are focusing on the wrong thing. The whole idea of trend following is to just notice the trends and then react to them, not to try and predict the future. And that is really all that the Turtle system does, although we do have a few proprietary indicators and filters that may help us do a little bit better job of recognizing which current moves will potentially be the bigger ones, and then adjusting our trades appropriately. In the next section of this report, I will go into a little bit more detail of what the Turtle system is and how it works. It is not as amazingly complex as some other people would have you believe, but at the same time, it is all very systematic and structured and methodical, and there are a bunch of little nuances that do add up, and thus need to be followed faithfully.

The Turtles have used, and continue to use, systems and indicators that have been both developed and tested over as much data as possible. The fact that there may be some rough periods when this methodology does not perform well, or even as well as another (possibly curve fitted) system over some small data set such as a year or two of prices, does not at all compromise the long term validity and profitability of the methodology. Although I think it’s fair to say that all good traders will make small adjustments and refinements based on continuing research, there have really never been any major changes to our systems since we started. In other words, show me a system that has been profitable over the past twenty years, even with a few of rough spots, rather than one that has had superior performance, but has only been around for a couple of years and a small sample size of trades.

One other final thing we need to talk about is money management. Trend following is indeed a valid and profitable methodology, yet markets are in consolidations or trading ranges about seventy percent of the time. And since we don’t know when markets are going to trend or when they are going to consolidate, we have to trade them the same way all the time. Thus, you might be inclined to trade counter trend, because then you would be right seventy percent of the time. However, it turns out that this idea is actually pretty bad, and that trading like a trend follower is a much better strategy to follow in the long run. However, in order to make some long term profit by following a trading strategy that only works thirty percent of the time, it is obvious that your winning trades have to be larger than your losing ones. Knowing when and how long to ride your profits, as well as when and how quickly to cut your losses, is thus an integral part of this or any other similar trading strategy.

Most trend following systems have some kinds of rules telling you how to cut your losses and let your profits run. But the Turtle method is a little more sophisticated than most others, as we actually has two very different sets of money management rules. The first group of rules is related to position size in terms of portfolio theory and market volatility, and tells you how aggressively to load up on each new signal that comes along in order to make the most amount of raw profit with the highest degree of efficiency on any given trade. The second, and totally independent set of money management criteria, are derived from established risk of ruin tables and statistical probability theory, and are designed to keep you in the trading game for as long as it takes to get into the mathematical ‘long run’, regardless of how choppy the markets might be in any short term period.

The complete Turtle system is so strong that, despite some historically very bad, choppy, non-trending market periods, we have had only one (small) losing year in the past twenty years (all of which is verified by historical computer performance tests in the back of this report). Our key is that even when the markets are giving out false signals and there are no trends of which to take advantage, the two money management overlays just mentioned are good enough at controlling the losses and keeping you in the game to the point that as soon as one big trend does comes along, (and one always will if you have enough patience and discipline and capital), it can pull you right out of the hole and get back to the profitable side of the ledger.

So What Exactly Is The Turtle System Anyway?
---------------------------------------------------------------------

You know, I‘ve been trading like this and writing like this for so long now, and it’s all become just so ‘second nature’ to me, that sometimes I just tend to get ahead of myself a little bit. The Turtle system has been making money for over 25 years now, and the story of the people who became ‘Turtles’ is so well known, that I forget that not everybody knows who we are (yet). I also sometimes forget that even the people that do know who we are may still not be all that familiar with some of the market terminology that we use. I tend to write about trades from ‘breakouts’ and in ‘N’ terms, without ever really defining what I mean. So, let me take a small step back here and explain a little of our background—who we are and what we do.

The whole ‘Turtle’ story started with a poor guy from a working class family who rose to become the biggest and best futures trader in the world. It was a classic rags to riches (pun intended :-) story, and it was a million to one shot. All of his friends and peers thought Richard Dennis was a genius, a prodigy, a ‘natural’, but Rich was way more humble than that. He argued that what he did in the markets did not take any special talents, it was mostly common sense and discipline, and moreover, he thought that anybody could do it.

So Rich and his partners hired a bunch of people (the Turtles) and taught them all their trading methods. The emphasis was on technical analysis (mostly for reading chart patterns), with a healthy dose of money management (based on mathematic probability theory) thrown in for protection. By the time the ‘class’ was finished a couple of weeks later, all the Turtles had a pretty good idea of what to look for in the markets, and, in fact, for the first couple of months or so, we all chose exactly the same trades for our portfolios.

Basically, there are two different ways to approach analyzing the markets, from a ‘fundamental’ or from a ‘technical’ viewpoint – or, as Rich described it to us, from a ‘predictive’ or a ‘reactive’ viewpoint. The fundamental guys read a lot of research reports, extrapolate a lot of calculations, and try to determine if something is over or under valued, then they try to predict future prices. This whole sort of undertaking requires a lot of work, manpower, time and effort. There are firms out there who hire guys to do nothing all day except count crop reports, or try to read ‘between the lines’ of the Federal Reserve chairman’s latest speech.

But as they taught the Turtles, Rich Dennis and Bill Eckhardt thought this was all just a huge waste of time. They believed that almost nobody had enough time and resources to do this kind of work correctly. Rather, they believed, as do all pure technicians, that all the relevant information, known and unknown, past, present, and future, would already be reflected in the price movements of a daily bar chart. So that is what we were all taught to focus on, reading the charts. It’s funny now that I think about it, not only did we read charts, we actually kept and updated them ourselves – with a pencil and a ruler in a big paper book. Boy, those were the good old days; I didn’t even know what a computer was back then.

Anyway, back to the story. And that is that even the chart reading technicians have different approaches to the markets. Some draw lines and angles and waves and try to extend them out into the future to predict where prices are going. But we don’t do that either. The bottom line is that we don’t try to ‘predict’ anything. What we do is simply ‘react’. The price moves, and we react. We are trend followers. If the price starts moving up, we react by wanting to buy the market. If the price starts moving down, we react by wanting to sell the market. We never buy or sell because we ‘think’ the market is going to go up or down, we wait for it to start moving first, then we react by taking a position in the appropriate direction.

And when it comes time to get out of a position, it is basically the same thing. We look at our charts every day, and when we see that the market is no longer moving in our direction, and in fact may have started going in the ‘other’ direction, that is how and when we know it’s time to get out. And of course, when we first get into a trade, we have no idea where or when this exit point is going to take place.

So what exactly do we look for? Well, we look for trends to start, and we measure them in terms of ‘channel breakouts’. We start by defining a channel as some kind of horizontal or sideways movement of a bunch of daily bars, and then we look for a price level that penetrates out of that channel in one direction or the other. As it is written for a computer program, we are simply looking for “today’s price to be the highest high or the lowest low of the past X number of bars”.

As for the movement itself once a trade starts, we measure it not in absolute points, but in terms of daily ranges of volatility. Where most common charting programs calculate ATR (average true range), the Turtles use the term “N” (which stands for ‘normalization’). But it is really the same thing. Ten cents in beans, or five dollars in gold, or nine hundred points in the S&P, you get the idea. We use this N figure to measure the size and strength of a trend, and we also use it to calculate our risk and figure our pain threshold and stop loss points on each trade.

Every day, I (or my computer program) look over all the charts of all the different futures markets. And believe me, it really doesn’t take that long -- just a quick glance will suffice. And what I am searching for are markets that have been trading in a sideways consolidation for some period of time (the longer, the better, actually). I then look at what price the market would have to reach in order to ‘break out’ of that channel, and I tend to place buy stop orders above the channel and sell stop orders below the channel, then I just wait for my price to get hit. If it does, we’re in.