Chapter 15: Is the Market Always Correct?

Nov. 28, 1997

Everyone knows the market is always considered correct, and there isn't reason to even dispute this belief. Most of our beliefs have been previously written or have been stated for years or decades by experts.

Phantom has hinted his feeling as to how he felt about the market being correct. He made the statement that he didn't always agree. We felt it would be an important insight into trading plans by looking at his view on the subject.

Art Simpson (ALS): Phantom, do you feel the market is always correct?

Phantom of the Pits (POP): NO! NO! NO! Definitely not! Can you tell me who proved that to be a correct statement? Or can anyone tell me who proved it? This statement is the biggest reason traders are buying highs and selling lows.

ALS: They're going to put you away with that kind of statement. They're going to lock you up. You are going to lose all of your credibility unless you can make a good case for your disbelief, Phantom. You are taking on a lot of people.

POP: I guess I appear to be bad with that statement. The experts seldom know or acknowledge that trading is a losing game. A trader expects it to be a winning game. It is the same with the statement that the market is always correct. Whoever thinks it is possible the market could be wrong at times? Why do as many as 92% seem to lose in the markets?

I see the market as a continuing image of liquidity. A liquid market reacts differently to news situations and technical indicators than non-liquid markets. After all, what is the purpose of floor traders in the pits of different markets? It is to provide liquidity.

Liquid markets are the leaders in determining price. Non-liquid markets tend to be sloppy in price determination. We have the reason for different markets and the creation of new markets. It is to provide liquidity and ACCURATE price discovery.

If a news item is bullish or bearish in a non-liquid market, the bid and ask spread is usually wider than in a liquid market. Now, are we to believe a wide spread on bid and asked price is telling us the market is correct? I think not! Sure, you can try to make the same demand and supply argument in the market being correct, but lack of liquidity is an artificial market condition of demand and supply a lot of times. Not having an offer to sell is not the same as not having any product available. Sure, it can have an effect on changing price, but it is an artificial condition.

These artificial market conditions must be utilized in a good trading plan in order to survive. Our plan is to trade as long as you want. To not get caught in artificial market conditions requires criteria. Every trader has been told the market is always correct. The market is always in a process of moving away from what it currently says about a price. Does that say it is correct? It only says to me, "A market is more than a day!"

ALS: Yes, that is the first lesson you taught me in trading. I didn't even know who you were when I learned that from you. It didn't take me long to respect you and watch you in your trading. I've studied you ever since, and I feel I know you almost as well as you know yourself. I know there are those who study you now. I see by the respect shown toward you since you began this project that loyalty comes from the reflection of traders changing views about trading.

POP: A simple statement about markets being more than a day can change a person's thoughts and lead to a different outcome. It says the market is changing every day, and what price it shows now is surely not correct all the time and definitely not correct for long.

You often see larger market moves in thin markets. Those who direct a fund know new prices generate new orders. So why wouldn't they place desired positions in the market on thin days in the direction of their indicators? This does happen.

Now, are you telling me the market is correct at the close in thin markets at all times? I am telling you to look at both sides of the coin in thin markets. Why? The thin market move is not often going to hold without some kind of base building or reversal when liquidity comes into a market. The fund positioning in a thin market is going to see a slight advantage on thin days, but it is at their expense in the long run. After they have positioned, the market will tend to retrace.

When funds take profits in a thin market, it hurts their average price fill because the market will move farther than in very liquid markets. So it is a double-sided edge where there is a good side and a bad side. Okay, so it evens out pretty closely. Markets in trends do react differently in thin markets. It is important to have the knowledge of the difference of thin and liquid markets. This never occurs to a trader most of the time because they are using price to generate their positions.

Markets are more than a day! This alone tells you not to believe the markets are always correct! This is a good reason to use Rule 2. Not all of your position will be established until or unless the market proves you correct.

ALS: Isn't this a conflict to make the market prove you correct while not always believing the market is always correct? Doesn't this present an implied conflict in your trading plan?

POP: Isn't this the same conflict most traders use to get out of a position by getting stopped out? Even if the market were thin on the day they got stopped out? This is what traders think of when they say the pit is gunning for their stops. The fact is that, when the markets are thin, a trader's chance is greater of being stopped out of a good position.

Why shouldn't we turn this situation to our favor by using another rule in trading? Yes, there has been a third rule in my trading. Not everyone will want this rule. In the search for a third rule by our trader's input and their looking for a third rule, they have come close but not exact on Rule 3.. They wanted a rule to tell them where to take profits. This is their desired Rule 3, but they all have agreed they just could not justify a criteria for Rule 3 telling them when to take a profit.

You see, my Rule 3 takes into consideration both sides of the market instead of just taking profits. It also takes into account when to take positions off totally. Sometimes it will be to take profits and other times it will be to offset any position when the market's criteria says to do so.

Rule 3 uses the criteria of the market not always being correct.

ALS: Do you want to state Rule 3 here?

POP: No, I don't! I want the traders' input now that they know they have been on the right track of Rule 3 but not quite getting to the important point in the criteria. I want them to think about it and give us input. We will state Rule 3 shortly. To just state Rule 3 without a lot of thought on their part will make the rule a little less useful to them. We need more information for them so they understand my view on the market being correct.

I have indicated on the Futures Talk forum the importance of several aspects on offsetting positions. There have been those who have asked. I've passed it on lightly. Some who have read my posts to the forum are picking up on it. You'll be surprised at how punctual and accurate their input shall become after knowing they have been correct about a Rule 3 all the time.

We have traders for years and decades saying they see the market reflects all the market conditions by just looking at the last price. They continue to trade based on that fact. They make their trading programs based on that thought about the market always being correct. Why shouldn't I use that to my advantage with a Rule 3? Why shouldn't traders take advantage of that knowledge by modified behavior in their reaction to the current price?

I want to state again, "It just never occurred to most traders the market could be wrong! They think it is only their trading that is wrong all of the time. They continue to lose when they know they are correct. Just how can there be so much confilict in their trading plan. I'm saying the market is not always correct and that liquidity and timing are two elements that keep a market from always being correct.

In making this assumption, wouldn't this help in positioning and exits? It is not complicated, but another rule to keep the advantage of a situation from being unfavorable at all times. My rule looks at the liquidity situation of a market and uses that knowledge for Rule 3.

Let us further explain our position on this thought! To review the statement,"Is the market always correct?" let's start on even ground. Let's say we do not know either way whether the statement is or isn't accurate. Do we say the statement must be always correct or always incorrect to be a legitimate statement?

Why must we say always correct without exception? I start with the assumption that there are times when the market is not correct, and I will show you that side. It is important because I want to point out that you can trade correctly and lose money. Why do you lose money when you are correct? It is because the market is a true reflection of liquidity at any one time when a market is trading and not always based on a fundamental or a technical reason.

I know many experts are going to say that liquidity is really a technical or fundamental aspect of trading, and that helps prove the market is always correct. What about timing in a market? Is a market's timing always correct? Why does the market prove the most people wrong and make more losers than winners? Think about this very carefully. Is the market not as we had all been taught or thought? Let us research that further.

By assuming the market is not always correct, I am going to show you that you can devise a better trading plan by just knowing you must question the correctness of the market being correct.

Most traders use either fundamental or technical reasons for trading. I like to use what I call "tactical" reasons, which include aspects outside of purely technical or fundamental aspects. Let us use examples of how markets can react in situations to better show our point.

Say, for example, a report came out that the orange crop was the smallest in history and the night before the report we had the worst freeze in history in the Florida crop area. Based on fundamentals, the orange juice market should go higher normally. Based on technical indicators, let us say the market shows a bullish trend being established. Before the open, the public knows no other information. At the day's open, the market opens limit down with locked in sellers and offers, which build, and not one trade is made.

Now, the market is open and no trading is taking place and OJ is limit offer two hours into trading. The experts and the reports in the news make the following statement: "Well, we see the market is correct in proving that OJ was overpriced."

How can you say that the market is correct when there are no buyers willing to buy? Any shorts in the markets are not willing to buy back! This does not show the market to be right in my book! It only shows me there is no liquidity in the market at this time.

Say the market closes limit offer. Now, are we to believe that from close to tomorrow's open the market is always correct? And that this situation is correct during the time the market is closed and there is no market? How can the market be correct when there is no trading?

Okay, now we watch the next day's open in OJ, and it opens limit bid with no trading the entire day. No additional news is available except the news reports stating, "The market proved to be correct today in that OJ was under priced."

The only thing the news reports did for the last two days was to declare the current price correct. Let us say, for example, the stock market moved to a point of being halted for half an hour. Is the stock market right because of the halted trading?

While it is true we only have the current price to use to gauge our equity and balance our accounts, other criteria must be used to understand if the market is correct. I am not sure you are beginning to see my point here so we need to use another example.

ALS: When we say "market," are we talking about the price of a contract currently or does "market" mean what is or has happened over time in a market action of a contract?

POP: That is a very good observation, and the question needs to be answered. You hear reports the market moved up today. Is the market correct in moving up? Say it opened lower and closed higher than the low but lower than yesterday. Is this moving up a correct statement? Or what if the market opened on its high and closed on the low but a point higher than yesterday. Is the statement, "The market moved higher," correct? Is the market always correct?

What are the reporters referring to when they say the market? Their definition is "now," I believe. That is what they mean about the market: now. "Correct" can be different, depending on their reference point. Timing can be different, depending on when the observation is made.

I hope you are seeing my point, but let me use an example of how a pit in a thin market might react to various situations to better relate our thoughts on the market not always being correct. Keep in mind the market's price is a function of liquidity.

We will use a small pit in bread futures (no such futures contract). There are10 traders in the bread pit -- two are brokers, five are day-traders and three are position traders. Yesterday March bread closed at 66 cents a loaf. The daily limit on bread futures is10 cents.

The two brokers have orders on the open, and all are executed at 66 and 67 cents. The positon traders in the pit have all kept their existing positions and not traded. The day-traders have positions on the other side of what the brokers orders were.

Because little activity was taking place, the position traders in the pit decide to leave and trade something else. The day-traders don't see any big volume so they offset their positions with each other and the brokers orders when they come into the pit. When the day-traders in the pit have offset their positions, they leave and go to lunch for an extended time. Effectively for this day no change in open interest exists at this point. The only two left in the pit are the two brokers.

All of a sudden someone bought wheat, and it went limit up within 10 minutes. Now the pit brokers in the bread pit get large orders to buy bread futures. The brokers bid and bid and bid and now bread is bid limit up at 76 cents. The locals are eating lunch, and the position traders happen to be short. They all return to the pits as quickly as they can. No one wants to sell so the market closes limit bid.

Is the market always correct and correct now in bread futures? I still only see the market is not liquid. I don't see this as being a market that is correct. Okay, the experts say that, yes, demand and supply have proved the market is correct because demand outstrips supply.

No one wants to sell, but this may not be correct just because the wheat market went up. Traders think this way, though, and that is why I always look to sell the weakest market in a strong up move. It is because of the similar thinking toward the bread market that, when wheat goes limit up, bread should also.

Often, there are correlation's until the positions are or can be filled. At that point the true market takes over when there are now no buyers. There are times the markets are not correct. It happens and those are often times of great opportunity.

You would never think of this side of trading if you only see the market is always correct. The experts are going to tell you this view is more of an interpretation view. I am going to tell you the opportunity of the surprise side is often because of the market not being correct.

There are times I do not consider the market correct. I feel it is useful in questioning the correctness of the market in certain situations. If there are situations where I must question the market for correctness, then there is always a possibility the market is incorrect, and I must be prepared for it.

Some days when we are seeing a topping action and the market makes several moves up and then back down, we are not seeing anything but good liquidity. So can you say the market is correct? With good liquidity, I consider the market correct. With poor liquidity, I do not consider the market always correct but possibly distorted.

Anytime I consider the market distorted, it is my judgment as to whether I consider the market correct, and I do not want to leave it to the market.

ALS: Isn't that just another technical indicator you are using rather than debating the correctness of the market?

POP: If a market moves limit one way or the other and no trade takes place and you have both a gap and lack of liquidity, you can call the gap a technical indicator, but the lack of liquidity is a different flag in addition to a technical indicator. It is impossible to trade without liquidity, and those times are flagged as not fit for trading and a not-correct market.

You could have several days in a row of limit moves without the ability to establish a position. Which day do you want to pick as the one where the market is correct? Would you pick all of them, none of them or any one of them?

Art, let's go back to the traders for input on whether the market is always correct. They now know there is a Rule 3. Let them discover it as best as they can. We shall state Rule 3 soon.

ALS: Okay, we now wait for input! Is the market always correct?

Part II: Is the Market Always Correct?

There are great traders and many great ideas. You usually can tell the great ideas from experience, and in our search for answers we know the input from Alfredo A. is always very worthy indeed. We felt the following post by Alfredo A. (on the Futures Talk forum) important enough to put in this section.

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Alfredo A.'s post:

Phantom/Art/et al: Was travelling the past two weeks. Am excited by your concepts and developments of an eventual Rule Three relying heavily on volume/open interest/liquidity. I think you are definitely on the right track.

I personally don´t like and shy away from illiquid markets. We have all seen OJ go limit up for three days and then down for four sessions with no liquidity. You can get really hurt because you won´t even have a chance to implement Rules 1 and 2. (This is OJ, never mind pork bellies).

I like to watch OBV (on-balance volume) and be wary of major divergences. But a market (OJ) that sometimes trades only 300 lots of the first futures month per session is subject to violent price fluctuations, not to mention eventual attempts at manipulation, resulting in impairment of liquidity.

As for the markets being "correct," I daresay they are never correct, and that that´s where you have a chance of making some money. The only "correct" market I can imagine is the SPOT market, where someone actually stops and the other side actually tenders the merchandise.

If, on the date of expiration of a gold contract, the last contract tendered is, say, at US$300 per ounce, then that perhaps is as "correct" a price as you can get. But as for futures, the very fact prices fluctuate constantly during one session shows there are differences between traders; for a market to be "correct," there would have to be, by definition, unanimity. I think futures markets, at least in their nuances, are essentially "incorrect." (Ergo, the importance of being proven correct.) But I also guess this "incorrectness" adds to the fun of the game.

But, yes, I myself consider OI and volume very important, both as indicators of liquidity as well as giving us inklings about where prices might be going. It´s a shame the exchanges can´t get OI to us faster as they do with volume, but I suppose that would be an operational impossibility.

Best regards and good trading.

Alfredo A.

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Phantom felt Alfredo has lots of great ideas, and when we are fortunate enough to be presented with them, others should read them.

We need another chess piece on the board, and many of you have ideas and feel open interest and volume are very important. As Alfredo believes, they are important indicators of liquidity and give good feedback about where prices could be heading.

I believe we can trade our pawn in for another more useful piece to improve our trading. Phantom took note of Geoff Hughes' thoughts as they show correct interpretation of the importance of volume and liquidity.

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Geoff Hughes' view:

POP, what I THINK you are telling us is that Rule 3 pertains to volume. Volume = Liquidity. If a market rises on low volume, the market is incorrect, and a short order would be the best way to enter a trade. If the market rises on large volume, the market is correct, and a long trade would be the best route. This pattern would be reversed on a market that goes down. Open interest would be another factor in Rule 3. If open interest decreases in an up market, shorts are covering their losses. I think that's right . . . not quite sure . . .

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Phantom liked seeing Geoff's excellent interpretation of questioning a market with price and volume. David Palmer had great insight.

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David Palmer's post:

Phantom, ALS and all. Thanks for stirring the creative juices on this forum. I'm certainly a better trader for the effort. On the volume/liquidity thought, I remember reading a while back that Phantom had mentioned he looked to take profits within 3 or 4 days of high-volume days, so this must be part of Rule 3.

After reading the last posts, I attempted to build an indicator that would show me current volume relative to recent history. What I came up with was current volume divided by 45-day highest volume minus 45-day lowest volume times 100 to yield a percentage of range. I then averaged the percent volume over 5 days to smooth it and better see a trend.

Then, using Phantom's 1/3 theory, I put alerts at 67% and 33%. Tell me if I get out on a limb here. This could almost be used as a confidence indicator for the price-discovery process. Anything in the upper third of the range could be considered "correct" price discovery, and anything in the lower third would definitely be suspect. Nothing special about the exact numbers used.

This seems to make sense. Any thoughts on this, anyone?

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What do you think of David Palmer's ideas? Phantom was impressed and indicated, with good testing, even if the criteria had to be modified slightly, it would be a very useful indicator. We will call it the Palmer indicator after David Palmer. Think this one over and put your thoughts on paper.

Randy Hogan always gives his thoughts plenty of time for accuracy and they are always well thought out. Take a look at his thoughts on Rule 3:

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Randy Hogan's post:

Rule 3 thoughts . . . How often are markets thin? Can you tell a thin market as it's trading or does Rule 3 criteria get us away from the effects of making a trade in one?

The comments I've read about offsetting are after a position is taken and the market moves in your favor (near high of day on a long, for instance). If the market doesn't follow through immediately the next day (10 minutes in some markets, 30 minutes in others, etc.), the position is "offset." Is this Rule 3 protection?

Can a thin market or an incorrect one last more than 1 day? Rule 3 criteria changes daily so the market must continue to prove, eliminating the possibility the position was taken and added to in an "incorrect" market.

That was a stab in the dark (with maybe a little light on in the background)!

Thanks . . .

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Phantom's thoughts on Randy's ideas were that Rule 3 should do as he asked in getting away from making a trade in illiquid markets. Thin markets certainly can last more than a day. Alfredo had a good example in OJ.

Ulrich always questions both sides of a situation and has good insight. Phantom wanted to post part of his thoughts as being bold enough to agree the market is not always correct, a very big and unpopular stand. Here are a couple of Ulrich's ideas:

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Ulrich's ideas:

I stated the market is always correct before. I meant it in the way that your equity runs will always reveal the truth. If you lost, YOU lost. Not the market, the broker, etc. It was you putting on the trade, no one else.

The market itself is wrong most of the time. This is what gives opportunity to trade. If the market were to be right today, why should I trade it? I wouldn't expect a move -- would I? . . .

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Ulrich usually hits the nail on the head because he never gives up his search. That is a characteristic that leads to great trades.

Phantom appreciated all the input and didn't want to leave anyone out of the input process as he feels it is very useful. How often do you come face to face when the market is closed to search out ideas that have been around for a long time. Many of those ideas of the past are in need of discovery as to the correctness of them.

I asked Phantom if he would want to expand on the input he received. His comment was that, yes, indeed he would. We shall come up with what will be known not as Rule 3 (his rule) but "THE THIRD RULE," which is their rule.

Thanks for your input and thoughts on improving a knowledge and behavior search beyond Phantom's Rules 1 and 2.

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