It all started with apes

Once there was this amusing experiment with two apes. A dominant male and his lower-class comrade were presented with two sets of bananas set 6 meters apart. The bigger gorilla went for the bigger cluster of bananas, while the others were left for his smaller friend. One would think they each ate their bananas and that was that. Wrong, the smaller ape gave his to the dominant male and waited patiently for his share.

This would be very unlikely with, say, cats, but it works with apes, since their brain is developed enough to possess something academia calls The Theory of Mind. This means, that the smaller ape was able to guess what the dominant male might be thinking – that he knows about the second cluster of bananas and may come to "collect his due".

Humans can go a step further and by adding another logical loop ask questions like "does he know - that i know - that he knows?" We are able to go even further and philosophize about life, love and other things. We wield the powers of hindsight, reflection, imagination and abstraction.

In the light of this please consider the Forex markets, especially the most liquid FX pair of them all, the EURUSD. More than a trillion dollars exchanges "hands" in this particular marketplace daily and probably more than a million individual traders make decisions whether to buy or sell. This is the "collective consciousness" of the market. It considers the fundamentals and it considers the technicals, but just as importantly it is "self aware" as the professional traders do their best to outsmart the mass of retailers to get some liquidity.

The random walk

If you want to make fun of your friends who are staring at the screen in anguish as they are watching their losing position sink under water, you can make a dead serious face and with a deadpan delivery state: "theoretically, at this point, there are two things that may happen. The price may go up or the price may go down." You can hope they have not lost their sense of humour.

When I had been a trader for a year, I was confronted by an analyst who asked me "how can you make money in a market which behaves randomly?" He was referring to the 1973 book "A Random Walk Down the Wall Street", which is based on an axiom, that the most valid statistical model for describing markets is that of a random walk. In a nutshell this means, that at each tick of the market there is an imaginary coin-toss, which determines to which direction the market moves – up or down.

When confroneted with such logic I immidiately thought about trendlines: how is it possible, that if you draw a line through two tops or two bottoms, that this line will be "respected" by the market later on, be it just once or three times in a row. If the market was random, it would not do that. Or maybe it would?

To tell you the truth, from a pure mathematical perspective the market is random. But since markets are "constructed" by human decisions, this "randomness" is predictable. Only to a probability score, but nevertheless, predictable.

The fantasy of psychohistory and the holy grail of neural networks

It was more than half a lifetime ago when I read Isaac Asimov's seminal science fiction book Foundation for the first time. For me this book has remained the pinnacle of the genre due to the beauty and idealism of the central idea in the book: a mathematical methodology Asimov labels psychohistory.

The events in the book take place in a human universe of 25 million inhabited planets with the total count of humans running into trillions. Asimov introduces psychohistory as the method for predicting the future of the humankind.

In the book, just as in the real world, the decisions of a single human are based on the individual psyche and can therefore not be predicted with any accuracy without direct observation and knowledge about the person. This essentially means that for a remote analyst the choices of a single person are a mathematical "random walk". Psychohistory gets around this "randomness" by applying mathematical models to the behavior of the masses, not the individual. Asimov ventures, that the larger the masses, the more predictable they become. With the fictional 25 million inhabited planets the accuracy of the method reaches to such hights, that instead of calling it a predictive method, he labels it a "history".

To an extent these ideas hold true at the marketplace. Instead of psychohistory we can use mathematical models like neural networks. Neural network models originate from memory research and are essentially more simplistic, but much more disciplined versions of a human mind. You could say that they are as disciplined and almost as complex as an ant hive. Essentially they are computer programs or trading robots, which have the ability to learn and adapt to changing conditions in the marketplace. They are beautiful and fascinating, but they are also infinitely more simplistic than either apes or humans because they lack the ability to perceive the market as a collection of minds.

How the market copes with "randomness"?

The market has a hierarchy of traders. Large hedge funds and investment banks govern the majority of the speculative "cash" and retail traders, although far more numerous, govern the minority of equity (about 10%). Still, none of the big players have enough funds to influence the market singlehandedly. Especially something as liquid as the major pairs. Or if they can, they choose not to, as the risk/reward ratio of going against other large traders is not as profitable as moving with them and hunting the retailers instead.

Most large traders ask themselves "what are the others thinking," or, as it is phrased much more often, "what is the market thinking, what does the market want to do?" Instead of trying to be smarter than the markets and try to think how the market might react to a specific piece of news, they try to "read" the market after the news. This is exactly the theory-of-mind-type-of thinking, which neural networks or any type of mathematics is incapable of.

More often than not the market will follow rules, but seemingly it does this for one reason only: to break them. It will stage breakouts and fakeouts and squeezes, anything it can to upset and scare the average leveraged retailer or punish the less consummate professional. A good trader has to understand not only the rules themselves (e.g. what is a rising wedge), but also how the rules are broken.

There are two ways out of this conundrum. One is to use the indicators the professionals use so you would be paying attention at the same things they are. I do not claim to know for certain, but having spoken to some of them there are a few methods which are widely spread among the professional crowd. They look at the Reuters feed for the correct price benchmark, they look at the 50, 100 and 200 DMA, for market tops and bottoms they keep their eye on RSI divergence from price on daily, 4hr and 1hr chart. Fibonacci retracements are also often used. But no professional I have ever spoken to follows any rigid rules. It is much more about scoping out alternative views and building a case for a certain move piece by piece.

The second approach is to use methods which tell you what the larger traders are actually doing at the market. The most useful one for me is the volume information from currency futures traded on CME. As the futures are traded only by the professionals and not the retailer, it is easier to see which moves have volume behind them and which do not. This way it is easier to figure out the "name of the game" for the trading session. My favourite is the first half of the London session, which has become so familiar to me on a five minute chart and volume information, that I can almost "feel" what the large traders are thinking.

Final thoughts

As a collective consciousness the market is constantly evolving. With electronic trading and a large number of retail investors, trading has nowadays taken on an almost predatorial nature as the core of the collective mind of the market is on a constant hunt for the equity of the uninitiated small investor. Its a jungle and in order to survive one has to learn the rules and understand how they change and how they are broken. I am certain, that in my lifetime the markets will change many times over. It is my hope that i have the methods and the frame of mind necessary to keep abreast of these daunting evolutionary dynamics of the most complicated collective consciousness on this planet.