The Market Maker’s Edge

osh Lukeman was (book published 2000) an institutional market maker who concentrated on technology stocks. He traded listed stocks and futures, and this book is both thorough and solid in its content.

Contents

The book was written with the goal are carefully laying out several variables necessary for a trader to be successful. The book is applicable to all traders and puts the emphasis on psychology and preparation.

Intellectuals tend to be poor traders, because they want to make sense out of something that cannot be made sense of. Think about the great bull market of the 1990s: were those astronomical valuations justified? In hindsight – no, but that did not stop people making exorbitant amounts of money. Those who believed that the euphoria was crazy were right, in the end, but they did not make a single dollar.

Thinking too much is a danger for traders. They should prepare, and act accordingly. Know your edge, and work on it. Just as success is an attitude, trading is a discipline. Those that do not treat it so will struggle to become profitable traders.

Trading is a way of life, and not just an occupation. It is impossible to separate who you are as a person, including your thoughts and your beliefs, from your results as a trader. There will always be something new to learn, and the only way to success is through continuous learning.

Key Themes

Risk control

Managing risk is the foundation of survival for all traders. Some of you may find my Twitter feed boring sometimes with all of the risk management tweets – but most traders do not manage their risk and most traders do not make money. There’s a strong correlation there. This book hammers the point home.

Trade only with money you can afford to lose

Putting yourself at risk with margin is only for the experienced as until recently you could end up owing brokerages much more than your initial deposit. Only until the ESMA regulation in 2018 came in was this no longer so. Still, many people put in money they can’t afford to lose, and if they lose 100% of that, it’s still a problem.

Trading is an emotional sport and when you do it for a living those emotional pitfalls are magnified. Traders need to be prepared for the absolute worst case scenario in every trade, because even if the chances are 0.1%, eventually that scenario will become reality.

Smaller is larger

The importance of financial management when it comes to position sizing cannot be overemphasised. Fight the urge to make money quickly – trading is about survival. Capital preservation and consistency are what make profitable traders, not hitting home runs with huge positions.

The smaller your positions, the less emotion you will attach to it. Don’t use too small a position size though; it has to be an amount that is material enough to be invested in the outcome. There is a direct correlation between smaller position size and higher profitability due to the reduced emotional attachment.

Large losses cause traders to be gun-shy and put the trader at a psychological disadvantage that arises out of desperation. Do not put yourself in that position and ensure you are trading the correct position size for your risk and portfolio.

Trade with balanced position sizes

Position sizes should be adjusted for stock price levels. Ideally, a 5% move should be weighting your position similarly whether it is a £1 stock or a £10 stock.

Bottom fishing

No stock is ever cheap or expensive. Many fall into the fallacy of believing that a stock that was £80 last week and is £40 today is cheap. Stock prices reflect supply and demand, and if there is an abundance of supply then that stock is going down. Traders should not catch falling knives and stop gambling how much supply there is in the market.

The myth of averaging down

A trader should never average down. “I’ll average down” really just means “I refuse to admit I was wrong the first time”. If you throw good money after bad, you are fighting momentum against you and risk compounding your losses. Think about it – a 50% loss requires a 100% return just to get back to breakeven. Can you fight those numbers? I can’t.

Underlying conditions

Many of you will have heard the phrase “the trend is your friend”, both in trading and investing. This is because trends tend to continue until they don’t, and so we can profit from this by going downstream with the stock.

Trend spotting is the key to profits

We want to catch the meat of the move, and not the bottom or top. When the trend gets to completion, volatility starts to increase, as the dying trend fights for its last breath. Volume starts to increase too as more market participants become active, and the trend enters into heavy support or heavy resistance.

Newton’s law of motion

This law states that objects in motion tend to stay in motion until an outside force stops them. When a stock is trending, it takes more effort for a seller to dampen the buying pressure than it does for the buyers to continue pushing the stock up. Only when we see large volume and large efforts by sellers to stop the stock going higher do we see a reversal of trend.

Fundamentals

Traders and market makers both act with increased conviction when the fundamentals and tehcnicals support one another. Both of these methods of analysis are of great value and there is no reason why we should not use both weapons at our disposal. When trading fundamentals, always wait for the price action to confirm your opinion. We want to make money, not be right.

Earnings surprises

Institutions act quickly when a company surprises the market. When a stock warns on profits or surprises to the downside, get out. Why hold a bad stock when there are others to own? Institutions will dump, and nobody is going to rush in on a profit warning. At the end of the day, bottom fishing is a mug’s game and whilst it can be done it should not be the bread and butter of your strategy.

When a company announces profits will be ahead, and surprises the market to the upside, this is positive confirmation that a stock is delivering on its objectives. When combined with technical analysis this can be a great trade opportunity for those with fast fingers. I like to trade earnings surprises because very often, a company that has just announced good news, is not likely to announce bad news straight afterwards.

There is a stock market anomaly called the post-earnings drift, which has shown that stocks that surprise to the upside often continue in that trend for up to sixty days. Of course, if you believe in the efficient market, then ignore this paragraph and get back in the classroom.

Cash flow

Many portfolio managers and analysts believe cash flow is an important yardstick for measuring the progress of a company regardless of its earnings.

Simple cash flow is net income plus accounting charges that eat into net income such as depreciation and amortisation. Those charges are only to the income statement and do not physically take away cash from the company.

Free cash flow is the ability of the company to produce cash that is free for shareholders such as buying back stock or in the form of dividends, without that cash harming the progress of the company. It is after all necessary maintenance or expansionary capex has been used.

Cash coming into the business can get many traders excited (including myself) and we saw this in stocks such as Gulf Keystone Petroleum, Rockrose Energy, and Regal Petroleum in 2018.

Organise your information flow

This is key for any trader as there is so much information out there that it can be blinding and even crippling. Information overload is real.

Use internet resources effectively and create a watchlist to keep on top of stocks that you are holding, want to hold, or are about to come into play.

The trade

Trading consists of entries, exits, and position sizes. We must exercise discipline to apply to ourselves in order to plan our trades and then trade our plans.

Entry

Entries can be based on a certain price or can be staggered (scaling in). Do not chase unless you have a good reason as fear of missing out has cost many traders their money.

Exit

Exits can again be based on a certain price or scaled out. Scaled exiting helps to balance the forces of greed and fear by taking some profit off the table. One of my own rules is if in doubt – sell half. This then means I benefit from any upside but I have protected my profit in the meantime. This strategy does only work if you sell half though

Maximising gains

Letting winners run is something that many traders struggle with (I certainly do). However, remember the wise words of Edwin Lefevre. “It was never my thinking that made big money for me. It was always my sitting. Got that? My sitting tight!”

The main way traders can make up for smaller losses and costs of trading, is by running winners and driving larger gains.

Technical analysis

Technical analysis works because mass psychology has an impact on a stock’s price. Prices are driven emotions, mainly fear and greed. Humans remember what happened in the past, and this causes pain or regret because of missed opportunities. The emotional attachment to missed opportunity increases a trader’s resolve not to miss the trade the next time around.

I have found that the backtest of a breakout is a reliable indicator for a good risk/ reward trade because of this.

Candlestick continuation patterns

The book argues to follow the trend and if the candle closed up then go long – don’t fight the trend. Likewise, if the candle closes down then do not go long and look to go short instead. These rules stop you fighting short term trends and force you to stay in tune with the market.

Support and resistance

These two zones become more significant each time they are tested. A stock that breaks down through a support that it has previously tested several times would be significant because the area is key. Breakouts that break out of long term resistance have been shown to be great trade opportunities.

The pulse of the market

Volume is the indicator that tells you what action is being done where. There are many battles fought between the bulls and the bears on a stock chart and volume tells us where these fights are at their most fierce. High volume represents intense emotional and monetary interest.

Block prints

A block print is defined as a trade in a round number, for example 10,000, or 50,000, that indicate that an institution is buying or selling and that the trade is part of an order being worked. Often, block prints will show up repeatedly and in similar amounts.

Volume capitulation

Volume capitulation is the crescendo that occurs at the top or bottom of a trend and marks the beginning of the end for the trend. It is caused by emotional exuberance that has reached an extreme.

Volume breakouts

Volume breakouts are price moves through significant support or resistance levels that are accompanies by above-average volume. Price breakouts that consist of institutional buyers mean that the price can continue rising indefinitely. The best breakouts are those on monster volume, as we know already know large volumes are significant.

Advanced trading tactics

Day trading can offer opportunities for large profits in the space of minutes (and lose large losses, too) but there are several trades that we can take advantage of.

The dead cat bounce

The dead cat bounce is a trade where a stock has fallen excessively due to bad news, and the stock rallies before continuing on its downward trajectory. This is because shorts begin to cover and amateurs are lured into the short lived bounce because they think the stock is now a bargain. Very rarely is this the case, and if you trade the dead cat bounce be sure to jump in and jump out very quickly.

Going long the up-hook

This seems like a fancy way of saying “buy the dip” to me. The up-hook is a chart pattern that occurs from the long side after a breakout on heavy volume dips on light volume. These patterns occur because of profit takers but new traders coming in who missed the move pick up the stock. Very often, this will be the previous resistance turning into support, and I like to trade these in a raging bull market.

Shorting the reverse hook

This is the exact opposite of going long the up-hook. Previous support is dumped through and then turns into resistance, only for the stock to continue falling again.

Breakaway gaps

These gaps are often in response to overwhelming supply or demand for a stock that is a direct result of fundamental news that is a surprise to the market.

Continuation gaps

A continuation gap takes place in the middle of a trend and is where bulls or bulls are worried that they will miss the move and jump in en masse, causing the price to shift in that direction.

Exhaustion gaps

These gaps represent the end of a move, and appear at the top of an uptrend or the bottom of a downtrend, often accompanied by larger than usual volume.

Artificial gaps

These gaps are meaningless gaps that may result as market makers move the price of a stock up or down in relation to what the Dow or is doing.

Psychology

All great traders subscribe to the idea that psychology is a huge part of trading, with many believing it has the greatest impact on a trader.

The first step towards successful trading is developing an awareness of the influence of psychological and emotional factors in your actions.

Listen to the market

The current stock price represents the belief and perception of all market participants in the market at that time. The stock may be trading well below its NAV, or well above it, but what is cheap can always become cheaper, and what is expensive and overbought can easily still double. Being right and making money when trading are two separate things. My opinion is that being right is an expensive hobby, because price is what I get paid by. Your goal as a trader is to make money. The market is always right. Always.

Accept responsibility

Taking responsibility for all of your actions takes a great deal of maturity, but once you get to this level, you achieve a much greater clarity on your trading than before.

You, and you alone, are in control of your mind and therefore your actions, and your results. When you accept this, you become empowered to choose how you want things to be. Want to be a profitable trader? Then you will start doing the things necessary to become one. Blaming others is a waste of time and energy, and will not get you anywhere in trading (and often in life).

Greed is an obstacle

Greed is a serious problem for traders, because it feeds on itself and fosters a state of lack. In trading, we need to leave our egos at the door, and temper our greed too.

Greedy traders are attached to what money represents to them at a personal level. Often, this is material things and the approval of their peers. This is why people buy expensive cars on credit that will depreciate rapidly when they still live at home at home with their parents. This is why we try to keep up the Joneses at our financial expensive in order to feel like we fit in. By defining our worth through our wealth, this causes self-esteem issues and problems in our trading.

Conquer frustration

Traders make some of their worst decisions when they are frustrated. Becoming attached to immediate results is one of the quickest ways to become frustrated, and I have learned that becoming attached to the process, and following my plan, this removes frustration in the short term causing me to make bad decisions in my trading. Little things affect little minds. We must be stronger.

Don’t look back

Regret is poisonous. If you followed your plan, then congratulate yourself even if you lost. I’d rather lose money and follow my plan, than make money by not following my plan. This might sound silly but consider this: if I am rewarded for not following my plan then what will I do next time? Deviate from my plan again. If I don’t follow my plan, in the long term I will not win.

Mistakes will always be made in the stock market, and it is our job not to beat ourselves up too much and ensure we learn from them.

Exude confidence

Traders must have unshakeable beliefs in their decisions. This comes from knowing your edge and actively working it – this creates a serene self-confidence and a positive state of mind.

I have found exercise helps to boost my mental confidence. It is proven to fill up the brain with endorphins and lifting heavy weights puts me in a good mindset for the trading day. I believe trading is a physically demanding sport and if you don’t work out or treat your body correctly then it will be difficult to live up to your potential.

Security is an illusion

There is no security in the markets. Trading for security puts two opposing forces side by side. Occupational trading heightens these fears and senses and so we must accept that trading is gambling, and that we can only control our entry, our exits, and our position sizes. We cannot control the outcomes in the short term and must trust in our process.